Test 8: answer key

Question 1 · 2 marks · Chapter 3: Risk Assessment and Internal Control · medium

Scenario. During the statutory audit of Aarav Precision Ltd. for FY 2025-26, CA Meera identified deficiencies in inventory access and purchase approval. Management corrected some matters. She must communicate significant deficiencies in internal control to those charged with governance under SA 265, considering written communication, timing, and the distinction between significant deficiencies and ordinary operational suggestions.

Which matter should CA Meera treat as a significant deficiency for written communication under SA 265?

1. Minor delay in sending monthly stock reports to the warehouse supervisor.
2. Stores clerk can approve high-value purchases without independent review; exceptions recurred. (correct answer)
3. Suggested colour coding of bin cards to improve warehouse efficiency.
4. One isolated omission of a signature on a low-value consumable voucher.

Answer: B — Stores clerk can approve high-value purchases without independent review; exceptions recurred.

Working. Assess whether the control is designed and operating to prevent or detect material misstatement. Repeated high-value approval exceptions indicate a control breakdown. Consider combination with other deficiencies. Communicate significant deficiencies in writing on a timely basis to TCWG and appropriate management.

Explanation. A significant deficiency is a deficiency or combination of deficiencies that is of sufficient importance to merit the attention of those charged with governance. Repeated exceptions in high-value purchase approval, with no independent review, affect the reliability of financial reporting and are more than an operational suggestion. Minor delay, colour coding, and an isolated low-value omission are ordinarily not significant deficiencies by themselves.

Where it goes wrong. Students treat every control weakness or efficiency suggestion as a significant deficiency, instead of assessing likelihood and potential magnitude.

Authority. SA 265: Communicating Deficiencies in Internal Control to Those Charged with Governance and Management, paras 4 and 8; ICAI Study Material, Chapter 3: Risk Assessment and Internal Control

Question 2 · 2 marks · Chapter 3: Risk Assessment and Internal Control · medium

What is the appropriate timing and mode of communicating significant deficiencies under SA 265?

1. Communicate orally only after the auditor's report is signed.
2. Communicate in writing only if management requests a copy.
3. Communicate in writing on a timely basis to TCWG and to appropriate management level. (correct answer)
4. Include the deficiency only in the management letter after the AGM.

Answer: C — Communicate in writing on a timely basis to TCWG and to appropriate management level.

Working. Identify significant deficiencies. Determine appropriate TCWG and management levels. Communicate in writing on a timely basis. Include description, potential effects, and sufficient context.

Explanation. SA 265 requires written communication of significant deficiencies to those charged with governance on a timely basis. The auditor must also communicate to management at an appropriate level of responsibility on a timely basis, in writing for significant deficiencies communicated or intended to be communicated to TCWG unless inappropriate. Oral communication only after signing or waiting for the AGM defeats timely remedial action.

Where it goes wrong. Students confuse the management letter, which is often after the audit, with the timely written communication required by SA 265.

Authority. SA 265: Communicating Deficiencies in Internal Control to Those Charged with Governance and Management, paras 9-11; ICAI Study Material, Chapter 3: Risk Assessment and Internal Control

Question 3 · 2 marks · Chapter 3: Risk Assessment and Internal Control · hard

Which statement correctly reflects the SA 265 approach to identifying a significant deficiency?

1. A combination of control deficiencies affecting the same assertion may be significant even without detected misstatement. (correct answer)
2. Every control weakness is significant irrespective of likelihood or potential magnitude.
3. A deficiency is significant only when the auditor has already quantified a misstatement.
4. Operational inefficiencies are always significant deficiencies under SA 265.

Answer: A — A combination of control deficiencies affecting the same assertion may be significant even without detected misstatement.

Working. Assess each deficiency individually and in combination. Consider likelihood of material misstatement, potential magnitude, susceptibility to fraud, subjectivity, and interaction with other deficiencies. Conclude whether attention of TCWG is merited.

Explanation. SA 265 explains that significance depends on the likelihood that a misstatement could occur and the potential magnitude of the misstatement, not only on whether a misstatement has actually been detected. A combination of deficiencies affecting the same significant account or assertion can therefore be significant. Not every weakness is significant, and operational inefficiency is not automatically a significant deficiency.

Where it goes wrong. Students require an actual misstatement before classifying a deficiency as significant, overlooking likelihood and aggregate effect.

Authority. SA 265: Communicating Deficiencies in Internal Control to Those Charged with Governance and Management, para 6; ICAI Study Material, Chapter 3: Risk Assessment and Internal Control

Question 4 · 2 marks · Chapter 3: Risk Assessment and Internal Control · medium

Which content should the written communication of significant deficiencies include under SA 265?

1. Only a one-line list of deficiencies without effects or context.
2. A guarantee that no fraud can occur after management's remediation.
3. A copy of the entire internal control manual with no auditor conclusions or context for TCWG.
4. Description of deficiencies, their potential effects, and sufficient context for understanding. (correct answer)

Answer: D — Description of deficiencies, their potential effects, and sufficient context for understanding.

Working. Describe the deficiency, its potential effects, and context. Explain that the purpose was not to express an opinion on internal control effectiveness. Limit reporting to deficiencies identified and judged significant.

Explanation. The written communication must include a description of the deficiencies and an explanation of their potential effects. It must also provide sufficient information for TCWG and management to understand the context, including that the audit was for expressing an opinion on the financial statements, internal control was considered to design audit procedures, and only significant deficiencies identified during the audit are reported.

Where it goes wrong. Students think a bare list of weaknesses is sufficient, ignoring potential effects and the required context about the scope of the audit.

Authority. SA 265: Communicating Deficiencies in Internal Control to Those Charged with Governance and Management, para 11; ICAI Study Material, Chapter 3: Risk Assessment and Internal Control

Question 5 · 2 marks · Chapter 9: Special Features of Audit of Different Types of Entities · medium

Scenario. CA Nitin is engaged by a sole proprietor to audit the accounts of his trading concern. The audit is not required by statute. The proprietor wants an audit report for a bank loan proposal but is unsure about scope, reporting format, and the auditor's liability. CA Nitin must decide how to document the engagement and protect against misunderstanding.

What is the most appropriate action by CA Nitin for the non-statutory audit of the sole proprietor?

1. Rely on oral instructions and issue a statutory audit report using the Companies Act wording.
2. Document agreed scope, limitations, reporting format and intended use in an engagement letter. (correct answer)
3. Refuse the engagement because sole traders cannot be examined under statutory audit.
4. Use the same statutory wording as a Companies Act audit report.

Answer: B — Document agreed scope, limitations, reporting format and intended use in an engagement letter.

Working. Clarify the purpose and scope. Issue an engagement letter. State limitations and form of report. Avoid implying statutory audit or absolute assurance. Document the agreed terms.

Explanation. A sole proprietor is not under a legal obligation to have accounts examined under statutory audit, but may do so for bank finance or other purposes. The auditor should obtain written terms defining scope, limitations, reporting format, and intended use, so that the proprietor does not misunderstand the level of assurance or the report's purpose. Using Companies Act statutory wording or relying on oral instructions is inappropriate.

Where it goes wrong. Students assume every audit report must follow the statutory company format, even when the engagement is contractual and non-statutory.

Authority. SA 210: Agreeing the Terms of Audit Engagements; ICAI Study Material, Chapter 9: Special Features of Audit of Different Types of Entities

Question 6 · 2 marks · Chapter 5: Audit of Items of Financial Statements · medium

Scenario. During the audit of Veda Foods Ltd., inventories include raw material, work-in-progress, finished goods, slow-moving items, goods in transit, and stock held at a third-party cold storage. CA Arjun is testing the lower of cost and net realisable value under AS 2 and the existence and condition of inventory under SA 501.

Slow-moving finished goods have a cost of ₹8 lakh and an estimated selling price of ₹7.2 lakh. Costs to complete and sell are ₹0.5 lakh. How should CA Arjun evaluate valuation under AS 2?

1. Carry at cost because loss is recognised only when goods are sold.
2. Carry at cost plus expected selling expenses as part of inventory cost.
3. Write down to estimated selling price less costs to complete and sell. (correct answer)
4. Write down only if management has formally declared the goods obsolete.

Answer: C — Write down to estimated selling price less costs to complete and sell.

Working. Compute NRV: ₹7.2 lakh minus ₹0.5 lakh = ₹6.7 lakh. Compare with cost ₹8 lakh. Carry at lower amount ₹6.7 lakh. Test whether write-down is recorded and disclosed appropriately.

Explanation. Inventory is measured at the lower of cost and net realisable value. NRV is estimated selling price less estimated costs of completion and costs necessary to make the sale. Here NRV is ₹6.7 lakh, below cost of ₹8 lakh, so the inventory should be written down by ₹1.3 lakh. Management's formal declaration of obsolescence is not a condition for write-down.

Where it goes wrong. Students either retain cost until sale or include selling expenses in cost instead of deducting them in computing NRV.

Authority. AS 2: Valuation of Inventories; SA 501: Audit Evidence - Specific Considerations for Selected Items; ICAI Study Material, Chapter 5: Audit of Items of Financial Statements

Question 7 · 2 marks · Chapter 5: Audit of Items of Financial Statements · hard

How should the auditor treat goods in transit at year-end when risks and rewards have passed to Veda Foods Ltd. before year-end?

1. Include goods in transit if risks and rewards have passed, regardless of physical location. (correct answer)
2. Exclude all goods in transit because physical possession is absent at year-end.
3. Include goods in transit only when the supplier has received full payment.
4. Include goods in transit only when the auditor physically inspects the goods at the year-end location.

Answer: A — Include goods in transit if risks and rewards have passed, regardless of physical location.

Working. Inspect purchase contracts and delivery terms. Examine shipping and receiving records around year-end. Determine when risks and rewards passed. Include or exclude goods in transit accordingly and test cut-off.

Explanation. Inventory is recognised based on control and risks and rewards, not merely physical location. If risks and rewards have transferred before year-end, goods in transit belong to the purchaser and should be included in inventory. Physical possession or payment to the supplier is not the sole criterion. The auditor should examine delivery terms and shipping documents.

Where it goes wrong. Students use physical possession as the only test for inventory inclusion, ignoring transfer of risks and rewards and cut-off terms.

Authority. AS 2: Valuation of Inventories; SA 501: Audit Evidence - Specific Considerations for Selected Items; ICAI Study Material, Chapter 5: Audit of Items of Financial Statements

Question 8 · 2 marks · Chapter 5: Audit of Items of Financial Statements · medium

Inventory held at a third-party cold storage is material. What is the appropriate SA 501 response?

1. Rely solely on management's oral assurance about quantities held.
2. Exclude third-party inventory from audit scope as it is outside entity premises.
3. Obtain only a copy of the warehouse's insurance policy as sufficient evidence of quantity and condition.
4. Request third-party confirmation and/or perform inspection or other appropriate procedures. (correct answer)

Answer: D — Request third-party confirmation and/or perform inspection or other appropriate procedures.

Working. Identify third-party inventory. Request direct confirmation of quantities and condition. Consider inspection or other procedures. Evaluate the third party's controls and records where relevant. Document results.

Explanation. When inventory under the custody and control of a third party is material, SA 501 requires the auditor to obtain sufficient appropriate evidence about its existence and condition by requesting confirmation from the third party and/or performing inspection or other appropriate procedures. Oral assurance or an insurance policy alone is not sufficient, and excluding the inventory is not permissible.

Where it goes wrong. Students believe third-party inventory is outside the auditor's responsibility or that a warehouse receipt alone is always sufficient.

Authority. SA 501: Audit Evidence - Specific Considerations for Selected Items, paras 7-8; ICAI Study Material, Chapter 5: Audit of Items of Financial Statements

Question 9 · 2 marks · Chapter 5: Audit of Items of Financial Statements · hard

Which approach is appropriate when applying the lower of cost and NRV to a mixed inventory population?

1. Offset NRV losses on some inventory items against unrealised gains on other dissimilar inventory items in the same financial statements.
2. Apply lower of cost and NRV item by item or by groups of similar items, without offsetting dissimilar gains. (correct answer)
3. Value entire inventory at NRV whenever any single item is slow-moving.
4. Use cost for all items if aggregate NRV exceeds aggregate cost.

Answer: B — Apply lower of cost and NRV item by item or by groups of similar items, without offsetting dissimilar gains.

Working. Identify inventory categories and similar groups. Compute cost and NRV for each item or group. Carry at lower amount. Aggregate only within appropriate groups. Test whether write-downs are recorded and disclosed.

Explanation. AS 2 generally requires inventory to be valued at the lower of cost and NRV item by item or by groups of similar items. Losses on some items should not be offset against unrealised gains on dissimilar items. If aggregate NRV exceeds aggregate cost, individual items may still require write-down. A single slow-moving item does not justify valuing the whole inventory at NRV.

Where it goes wrong. Students apply an aggregate lower-of-cost-or-NRV test and offset gains against losses, contrary to the item-by-item approach.

Authority. AS 2: Valuation of Inventories; ICAI Study Material, Chapter 5: Audit of Items of Financial Statements

Question 10 · 2 marks · Chapter 11: Ethics and Terms of Audit Engagements · hard

Scenario. XYZ & Co. has been the statutory auditor of a listed company for nine consecutive years. The engagement partner is concerned about the cooling-off period under Section 139(2) of the Companies Act, 2013, the treatment of network firms and common partners, and whether an audit firm can be reappointed immediately after completing its term.

Which statement is correct regarding auditor rotation and cooling-off for the listed company?

1. A listed company may reappoint the same audit firm after two years' cooling-off.
2. Rotation applies only to private companies with borrowings above ₹50 crore.
3. For listed companies, the same audit firm cannot be reappointed before five years after completion of term. (correct answer)
4. A common partner across audit firms permits treating those firms as one firm to bypass rotation and cooling-off requirements.

Answer: C — For listed companies, the same audit firm cannot be reappointed before five years after completion of term.

Working. Identify company class and applicable term limits. Compute consecutive years served. Apply the five-year cooling-off after completion of the permitted term. Evaluate network firms and common partners under the Rules and Code of Ethics.

Explanation. Under Section 139(2), listed companies and prescribed classes of companies cannot appoint an individual auditor for more than one term of five consecutive years or an audit firm for more than two terms of five consecutive years. After completion of the term, the auditor or firm cannot be reappointed in the same company before five years. Common partners and network considerations are relevant to rotation, but a common partner does not permit bypassing the cooling-off period.

Where it goes wrong. Students confuse the cooling-off period with a short break and overlook that common partners or network affiliations can attract rotation restrictions.

Authority. Companies Act, 2013, Section 139(2); Companies (Audit and Auditors) Rules, 2014, Rule 6; ICAI Code of Ethics

Question 11 · 2 marks · Chapter 8: Audit Report · medium

Scenario. During the audit of Sunrise Ltd. for FY 2025-26, a bank term loan instalment due on 31 December 2025 remained unpaid, interest due on 31 January 2026 remained unpaid, and the bank declared the company a wilful defaulter in February 2026. The auditor is reporting under Clause (ix) of Paragraph 3 of CARO 2020.

What does CARO 2020 Clause 3(ix)(a) require the auditor to report regarding defaults?

1. Report period and amount of default in repaying loans or interest, lender-wise for banks/FIs/Government. (correct answer)
2. Report only the total default if the amount exceeds ₹1 crore.
3. Report defaults only when the loan has been recalled by the lender and the account has been classified as a non-performing asset.
4. Report default only in directors' report, not in CARO.

Answer: A — Report period and amount of default in repaying loans or interest, lender-wise for banks/FIs/Government.

Working. Obtain loan-wise and lender-wise default data. Compare due dates with actual repayments. Report period and amount of default. Include lender-wise details for banks, financial institutions and Government.

Explanation. Clause 3(ix)(a) of CARO 2020 requires reporting whether the company has defaulted in repayment of loans or other borrowings or in payment of interest to any lender. The period and amount of default must be reported, with lender-wise details for defaults to banks, financial institutions and Government. The clause is not limited to defaults above ₹1 crore or to recalled or NPA accounts.

Where it goes wrong. Students apply a monetary threshold or require NPA classification before reporting a default under CARO 2020.

Authority. CARO 2020, Clause 3(ix)(a); ICAI Study Material, Chapter 8: Audit Report

Question 12 · 2 marks · Chapter 8: Audit Report · medium

What is the CARO 2020 requirement regarding a company declared a wilful defaulter?

1. Disclose only if the wilful-defaulter declaration is set aside by a court before the auditor signs the audit report.
2. Disclose only when the default exceeds the company's net worth.
3. Do not report because wilful defaulter status is confidential.
4. Report whether the company is a declared wilful defaulter by any bank, FI or other lender. (correct answer)

Answer: D — Report whether the company is a declared wilful defaulter by any bank, FI or other lender.

Working. Inquire of management and lenders. Examine lender communications and RBI or bank declarations. Report whether the company is a declared wilful defaulter. Consider disclosure implications in financial statements.

Explanation. Clause 3(ix)(b) requires the auditor to report whether the company is a declared wilful defaulter by any bank or financial institution or other lender. The reporting is not conditional on the declaration being set aside by a court, on exceeding net worth, or on confidentiality. The auditor should obtain evidence of any declaration and report accordingly.

Where it goes wrong. Students think wilful-defaulter status is confidential or reportable only after court confirmation, rather than a direct CARO reporting matter.

Authority. CARO 2020, Clause 3(ix)(b); ICAI Study Material, Chapter 8: Audit Report

Question 13 · 2 marks · Chapter 8: Audit Report · medium

Which reporting is required under CARO 2020 Clause 3(ix)(c) for term loans?

1. Report only whether security cover was adequate on the balance sheet date.
2. Report whether term loans were applied for the purpose obtained; if not, amount and actual use. (correct answer)
3. Report only the interest rate charged on term loans during the year.
4. Report whether quarterly stock statements filed with the lender agree with the books of account and whether any discrepancies exist.

Answer: B — Report whether term loans were applied for the purpose obtained; if not, amount and actual use.

Working. Obtain term-loan agreements and sanction terms. Trace utilisation to supporting payments and assets. Identify any diversion. Report amount diverted and actual use.

Explanation. Clause 3(ix)(c) requires reporting whether term loans were applied for the purpose for which they were obtained. If not, the amount of loan so diverted and the purpose for which it was used must be reported. It is not limited to security cover, interest rate, or stock statement reconciliation.

Where it goes wrong. Students confuse term-loan end-use reporting with general security or stock-statement reporting under other CARO clauses.

Authority. CARO 2020, Clause 3(ix)(c); ICAI Study Material, Chapter 8: Audit Report

Question 14 · 2 marks · Chapter 8: Audit Report · medium

What does CARO 2020 Clause 3(ix)(d) require regarding short-term funds?

1. Report only if short-term funds were used to pay statutory dues.
2. Report only if the company has negative operating cash flow and the lender has demanded immediate repayment.
3. Report whether short-term funds were used for long-term purposes, with nature and amount. (correct answer)
4. Report only if the lender has classified the account as NPA.

Answer: C — Report whether short-term funds were used for long-term purposes, with nature and amount.

Working. Identify short-term borrowings and their stated purpose. Trace utilisation to long-term assets or obligations. Report whether such use occurred and provide nature and amount.

Explanation. Clause 3(ix)(d) requires reporting whether funds raised on a short-term basis were utilised for long-term purposes. If yes, the nature and amount must be indicated. The reporting is not restricted to statutory dues, negative operating cash flow, or NPA classification.

Where it goes wrong. Students narrow the clause to NPA or cash-flow indicators and miss the direct short-term-to-long-term utilisation test.

Authority. CARO 2020, Clause 3(ix)(d); ICAI Study Material, Chapter 8: Audit Report

Question 15 · 2 marks · Chapter 10: Audit of Banks · medium

Scenario. CA N is conducting the statutory branch audit of a nationalized bank. The statutory central auditors have asked about the Long Form Audit Report (LFAR), its relationship with the main audit report, the persons responsible for preparing it, and the reporting expectations applicable to bank branch audits.

Which statement about the LFAR in a bank branch audit is correct?

1. LFAR is an additional report under terms of appointment/RBI, separate from and not a substitute for the main audit report. (correct answer)
2. LFAR is optional and may be replaced by a management representation letter.
3. LFAR is prepared only by the bank's internal audit department for RBI.
4. LFAR is a statutory audit opinion under Section 143 of the Companies Act and it replaces the main audit report for the branch.

Answer: A — LFAR is an additional report under terms of appointment/RBI, separate from and not a substitute for the main audit report.

Working. Review terms of appointment and RBI LFAR format. Complete the prescribed questionnaire and observations. Submit within applicable timelines to the bank and statutory central auditors. Keep it separate from the main audit report.

Explanation. The LFAR is a long-form audit report required under the terms of appointment and RBI requirements for bank audits. It is an additional report and does not substitute for the main statutory audit report. It is submitted by the statutory branch or central auditors as applicable, not by internal audit alone. It is not optional and cannot be replaced by a management representation letter.

Where it goes wrong. Students treat the LFAR as the main statutory audit opinion or as an optional internal document, rather than an additional RBI-prescribed report.

Authority. RBI Long Form Audit Report requirements for bank branches; ICAI Study Material, Chapter 10: Audit of Banks