Test 9: answer key

Question 1 · 2 marks · Chapter 2: Audit Strategy, Audit Planning and Audit Programme · medium

Scenario. ABC Ltd. is a manufacturing company. During planning, the auditor determined overall materiality at ₹2 crore based on anticipated profit before tax (PBT) of ₹80 crore. Performance materiality was set at ₹1.2 crore. At year-end, actual PBT is ₹60 crore due to a decline in sales. The auditor is considering revision of materiality and its impact on testing of trade receivables where tolerable misstatement was set at ₹80 lakh.

During the audit of ABC Ltd., the auditor initially determined overall materiality at ₹2 crore based on anticipated profit before tax (PBT) of ₹80 crore. At year-end, actual PBT is ₹60 crore due to a decline in sales. What should the auditor do?

1. Continue using the original materiality of ₹2 crore since it was set at planning.
2. Increase materiality to ₹2.5 crore to avoid over-auditing.
3. Use performance materiality only and ignore overall materiality revision.
4. Revise materiality based on actual PBT and assess impact on procedures. (correct answer)

Answer: D — Revise materiality based on actual PBT and assess impact on procedures.

Working. Step 1: Compare actual PBT (₹60 crore) with anticipated PBT (₹80 crore). Step 2: Determine if difference is substantial (25% decline). Step 3: Revise overall materiality, e.g., to ₹1.5 crore at 2.5% of revised PBT. Step 4: Reassess performance materiality and tolerable misstatement. Step 5: Adjust nature, timing and extent of further audit procedures.

Explanation. SA 320 requires the auditor to revise materiality if actual financial results are substantially different from the anticipated period-end results used initially. A decline in PBT from ₹80 crore to ₹60 crore is substantial and warrants revision. Continuing with the original materiality or increasing it would be inappropriate. Performance materiality alone cannot substitute for overall materiality.

Where it goes wrong. Students may think materiality once set at planning is not revised, or may incorrectly increase materiality to reduce work.

Authority. SA 320: Materiality in Planning and Performing an Audit, para 12; ICAI Study Material, Paper 5, Chapter 3

Question 2 · 2 marks · Chapter 2: Audit Strategy, Audit Planning and Audit Programme · medium

The auditor sets performance materiality at ₹1.2 crore when overall materiality is ₹2 crore. What is the primary purpose of setting performance materiality lower than overall materiality?

1. To ensure that all misstatements above ₹1.2 crore are corrected.
2. To reduce the probability that aggregate uncorrected misstatements exceed overall materiality. (correct answer)
3. To provide a buffer for potential fraud risk factors.
4. To comply with the requirement of SA 320 for all audits.

Answer: B — To reduce the probability that aggregate uncorrected misstatements exceed overall materiality.

Working. Step 1: Overall materiality = ₹2 crore. Step 2: Performance materiality = ₹1.2 crore (60%). Step 3: This lower threshold is used for designing procedures so that small misstatements are detected before they aggregate to material levels. Step 4: Document rationale.

Explanation. Performance materiality is set below overall materiality to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds overall materiality. It is not about correcting all misstatements above a threshold, nor a fraud buffer. SA 320 requires performance materiality for all audits, but the purpose is aggregation risk.

Where it goes wrong. Students may confuse performance materiality with tolerable misstatement or think it is optional.

Authority. SA 320: Materiality in Planning and Performing an Audit, para 9; ICAI Study Material, Paper 5, Chapter 3

Question 3 · 2 marks · Chapter 2: Audit Strategy, Audit Planning and Audit Programme · hard

The auditor of ABC Ltd. has set performance materiality at ₹1.2 crore. For auditing a specific class of transactions, the auditor determines tolerable misstatement. Which of the following is most appropriate?

1. Tolerable misstatement must equal overall materiality.
2. Tolerable misstatement can exceed performance materiality if controls are strong.
3. Tolerable misstatement should not exceed performance materiality. (correct answer)
4. Tolerable misstatement is irrelevant when using sampling.

Answer: C — Tolerable misstatement should not exceed performance materiality.

Working. Step 1: Performance materiality = ₹1.2 crore. Step 2: Tolerable misstatement for trade receivables = ₹80 lakh (less than ₹1.2 crore). Step 3: This ensures that misstatements in the account, when aggregated with others, do not exceed overall materiality. Step 4: Document linkage.

Explanation. Tolerable misstatement is the amount set by the auditor at less than performance materiality to reduce the probability that uncorrected and undetected misstatements exceed performance materiality. It should not exceed performance materiality. Strong controls may allow a higher tolerable misstatement within the performance materiality limit, but not above it. Tolerable misstatement is relevant for sampling.

Where it goes wrong. Students may think tolerable misstatement can be set independently of performance materiality or equal to overall materiality.

Authority. SA 320: Materiality in Planning and Performing an Audit, para 9; SA 530: Audit Sampling, para 6

Question 4 · 2 marks · Chapter 2: Audit Strategy, Audit Planning and Audit Programme · hard

If the auditor revises overall materiality from ₹2 crore to ₹1.5 crore due to lower actual PBT, and maintains performance materiality at 60% of overall materiality, what is the revised performance materiality?

1. ₹0.9 crore (correct answer)
2. ₹1.2 crore
3. ₹1.5 crore
4. ₹0.6 crore

Answer: A — ₹0.9 crore

Working. Step 1: Revised overall materiality = ₹1.5 crore. Step 2: Performance materiality factor = 60%. Step 3: ₹1.5 crore × 0.60 = ₹0.9 crore. Step 4: Update audit documentation and revise procedures.

Explanation. Performance materiality is 60% of overall materiality. Revised overall materiality = ₹1.5 crore. Revised performance materiality = 60% × ₹1.5 crore = ₹0.9 crore. This reduction requires the auditor to reassess whether the nature, timing and extent of further audit procedures remain appropriate.

Where it goes wrong. Students may forget to apply the percentage or incorrectly use the old performance materiality.

Authority. SA 320: Materiality in Planning and Performing an Audit, para 12; ICAI Study Material, Paper 5, Chapter 3

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

Scenario. Helping Hands is an NGO registered under FCRA receiving foreign contributions. The auditor is verifying compliance with FCRA and the utilisation of earmarked funds.

While auditing an NGO receiving foreign contributions, the auditor's primary procedure to verify FCRA compliance is to:

1. Confirm that funds are received in a designated FCRA bank account. (correct answer)
2. Verify that funds are spent only on administrative expenses.
3. Obtain a certificate from the NGO's chartered accountant.
4. Review the NGO's registration under Section 8 of Companies Act.

Answer: A — Confirm that funds are received in a designated FCRA bank account.

Working. Step 1: Obtain list of bank accounts. Step 2: Identify designated FCRA account. Step 3: Trace foreign contributions to that account. Step 4: Verify no foreign contribution is received in other accounts. Step 5: Report non-compliance if any.

Explanation. FCRA requires that all foreign contributions be received only in a designated bank account called the 'FCRA Account' in a scheduled bank. The auditor's primary procedure is to verify that foreign contributions are credited to this designated account and that no other account is used. Verifying administrative expenses or Section 8 registration does not directly address FCRA compliance for foreign funds.

Where it goes wrong. Students may focus on utilisation rather than the mandatory receipt mechanism under FCRA.

Authority. Foreign Contribution (Regulation) Act, 2010, Section 17; ICAI Study Material, Paper 5, Chapter 9

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

Scenario. XYZ Ltd. issued 10% debentures of ₹50 crore secured by hypothecation of plant and machinery. The debenture trust deed contains a debt-equity covenant of 2:1. The company also has a term loan from a bank. The auditor is verifying compliance with covenants and classification of borrowings.

XYZ Ltd. issued 10% debentures of ₹50 crore secured by hypothecation of plant and machinery. To verify the terms and conditions of the issue, the auditor should primarily examine:

1. The board resolution authorizing the issue.
2. The debenture trust deed executed with the trustees. (correct answer)
3. The prospectus filed with the Registrar of Companies.
4. The annual report of the previous financial year.

Answer: B — The debenture trust deed executed with the trustees.

Working. Step 1: Obtain copy of debenture trust deed. Step 2: Read clauses on security, interest, redemption, covenants. Step 3: Compare with accounting records and disclosures. Step 4: Verify compliance with terms. Step 5: Document findings.

Explanation. The debenture trust deed is the primary document containing the detailed terms and conditions of the debenture issue, including security, redemption, covenants, and trustee obligations. The board resolution authorizes the issue but does not contain full terms. The prospectus is for public offer and may not include all covenants. The annual report is a secondary source.

Where it goes wrong. Students may choose the board resolution as it authorizes the issue, but the trust deed contains the enforceable terms.

Authority. SA 500: Audit Evidence, para 6; Companies Act, 2013, Section 71

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

For the debentures issued by XYZ Ltd., the charge created on plant and machinery must be registered with the Registrar of Companies within how many days of creation?

1. 30 days (correct answer)
2. 60 days
3. 90 days
4. 120 days

Answer: A — 30 days

Working. Step 1: Identify date of creation of charge. Step 2: Verify Form CHG-1 filed with ROC. Step 3: Check date of filing is within 30 days. Step 4: Inspect register of charges. Step 5: Report delay if any.

Explanation. Section 77 of the Companies Act, 2013 requires that particulars of every charge created on assets of a company be filed with the Registrar of Companies within thirty days of the date of creation of the charge. This applies to charges securing debentures. Failure to register within 30 days affects enforceability.

Where it goes wrong. Students may confuse with other deadlines like 60 days for filing financial statements.

Authority. Companies Act, 2013, Section 77; ICAI Study Material, Paper 5, Chapter 5

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

The debenture trust deed of XYZ Ltd. requires a debt-equity ratio of 2:1. At year-end, the ratio is 2.5:1. What is the auditor's most appropriate action?

1. Ignore the breach as it is a non-financial covenant.
2. Report the breach in the audit report as a qualification.
3. Assess whether the breach requires reclassification of debentures as current. (correct answer)
4. Obtain a waiver letter from the trustees and continue classification.

Answer: C — Assess whether the breach requires reclassification of debentures as current.

Working. Step 1: Read covenant terms. Step 2: Compute actual ratio. Step 3: Assess if breach gives lender right to recall. Step 4: Determine classification as current if recall right exists. Step 5: Check for waiver obtained before year-end. Step 6: Document conclusion and disclosure.

Explanation. A breach of a debt covenant may give the lender the right to demand immediate repayment. Under applicable financial reporting framework, this may require classification of the related borrowings as current liabilities. The auditor should assess the implications, including whether the breach is waived before the reporting date. Ignoring or simply qualifying without assessing classification is inappropriate.

Where it goes wrong. Students may think covenant breaches only require disclosure, not reclassification.

Authority. SA 500: Audit Evidence, para 8; ICAI Study Manual, Paper 5, Chapter 5

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

The auditor of XYZ Ltd. is verifying compliance with the debt-equity covenant of 2:1 in the debenture trust deed. The actual ratio is 2.5:1. What is the primary audit concern?

1. The debentures must be immediately redeemed.
2. The interest rate on debentures must be increased.
3. The breach has no impact on financial statements.
4. The breach may require classification of debentures as current. (correct answer)

Answer: D — The breach may require classification of debentures as current.

Working. Step 1: Obtain covenant details. Step 2: Compute actual ratio. Step 3: Determine if breach triggers repayment right. Step 4: Assess classification as current. Step 5: Verify disclosure of breach and its implications. Step 6: Document.

Explanation. The primary audit concern is whether the covenant breach gives the lender the right to demand immediate repayment, which would require the debentures to be classified as current liabilities rather than long-term. Immediate redemption is not automatic. Interest rate changes are not automatic. The breach does impact financial statement classification and disclosure.

Where it goes wrong. Students may think covenant breaches have no accounting impact or only require note disclosure.

Authority. SA 500: Audit Evidence, para 8; ICAI Study Material, Paper 5, Chapter 5

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

Scenario. During the audit of a listed company, the firm appointed an engagement quality control reviewer (EQCR) under SA 220. The engagement partner is responsible for ensuring the EQR is completed before the audit report is dated.

Under SA 220, the engagement quality control reviewer should be appointed by:

1. The engagement partner
2. The firm (correct answer)
3. The audit committee of the client
4. The regulatory authority

Answer: B — The firm

Working. Step 1: Firm identifies engagements requiring EQR. Step 2: Firm appoints an eligible reviewer. Step 3: Reviewer must be objective and independent of engagement team. Step 4: Reviewer performs evaluation before report date. Step 5: Document appointment and review.

Explanation. SA 220 requires the firm to establish policies and procedures for the appointment of engagement quality control reviewers. The engagement partner does not appoint the reviewer; the firm does. The audit committee and regulatory authority are not responsible for appointing the EQCR under SA 220.

Where it goes wrong. Students may think the engagement partner appoints the reviewer, but this would impair objectivity.

Authority. SA 220: Quality Control for an Audit of Financial Statements, para 19; SQC 1: Quality Control for Firms, para 36

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

Scenario. PQR Ltd. has accepted deposits from the public and is required to maintain cost records under Section 148(1). The auditor is reporting under CARO 2020.

Under CARO 2020, the auditor of PQR Ltd. must report whether the company has complied with the directives issued by the Reserve Bank of India and the provisions of Sections 73 to 76 of the Companies Act, 2013 in respect of:

1. Deposits accepted from the public (correct answer)
2. Loans taken from banks
3. Inter-corporate deposits accepted from related parties
4. Advances received from customers

Answer: A — Deposits accepted from the public

Working. Step 1: Identify deposits accepted. Step 2: Verify compliance with Sections 73-76 and RBI directions. Step 3: Check whether any contravention exists. Step 4: Report nature of contravention and compliance with tribunal orders. Step 5: Document.

Explanation. CARO 2020 Clause (v) requires the auditor to report whether the company has complied with the directives issued by RBI and the provisions of Sections 73 to 76 of the Companies Act, 2013 and the rules made thereunder, where applicable, in respect of deposits accepted by the company. Loans from banks and inter-corporate deposits are not covered under this clause.

Where it goes wrong. Students may confuse deposits with borrowings or inter-corporate loans.

Authority. CARO 2020, Clause (v) of Paragraph 3; Companies Act, 2013, Sections 73-76

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

Under CARO 2020, which of the following amounts received by PQR Ltd. is most likely to be considered a 'deemed deposit'?

1. Advance received from a customer for supply of goods in ordinary course
2. Security deposit received from an employee
3. Loan taken from a bank against hypothecation of stock
4. Loan taken from a director not exempt under deposit rules (correct answer)

Answer: D — Loan taken from a director not exempt under deposit rules

Working. Step 1: Obtain list of amounts received. Step 2: Apply exclusions under Deposit Rules. Step 3: Identify amounts not excluded. Step 4: Classify as deemed deposits. Step 5: Verify compliance with Sections 73-76.

Explanation. A 'deemed deposit' includes amounts received as loans or advances that are not excluded under the Deposit Rules. Advances received in the ordinary course of business for supply of goods are excluded. Security deposits from employees are generally excluded. Bank loans are not deposits. A loan from a director, unless specifically exempt, is treated as a deemed deposit.

Where it goes wrong. Students may think all loans are borrowings, not deposits, or that director loans are always exempt.

Authority. CARO 2020, Clause (v) of Paragraph 3; Companies (Acceptance of Deposits) Rules, 2014, Rule 2(1)(c)

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

Under CARO 2020, the auditor's report on cost records must state whether:

1. Cost audit has been conducted by a cost accountant.
2. Cost records are reconciled with financial accounts.
3. Cost records have been prescribed and maintained. (correct answer)
4. Cost records are accurate and complete.

Answer: C — Cost records have been prescribed and maintained.

Working. Step 1: Check if cost records are prescribed for the company's industry. Step 2: Verify whether records are maintained. Step 3: Report as per CARO. Step 4: If not maintained, state fact and reasons. Step 5: Document.

Explanation. CARO 2020 Clause (vi) requires the auditor to report whether maintenance of cost records has been specified by the Central Government under Section 148(1) and whether such accounts and records have been made and maintained. The auditor is not required to express an opinion on the accuracy or completeness of cost records, nor on cost audit conducted.

Where it goes wrong. Students may think the auditor must report on cost audit or accuracy, but CARO only requires reporting on prescription and maintenance.

Authority. CARO 2020, Clause (vi) of Paragraph 3; Companies Act, 2013, Section 148(1)

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

If PQR Ltd. has not maintained cost records as prescribed under Section 148(1), the auditor should:

1. Issue a qualified opinion on the financial statements.
2. Report the fact and reasons for non-maintenance in CARO. (correct answer)
3. Resign from the audit engagement immediately without reporting.
4. Report the matter to the cost audit branch of the Ministry.

Answer: B — Report the fact and reasons for non-maintenance in CARO.

Working. Step 1: Identify non-maintenance. Step 2: Include in CARO report under Clause (vi) as unfavourable. Step 3: State reasons. Step 4: Consider impact on financial statements, if any. Step 5: Document.

Explanation. CARO 2020 Paragraph 4 requires that where the answer to any clause is unfavourable or qualified, the auditor's report shall state the basis for such answer. Therefore, if cost records are not maintained, the auditor should report the fact and reasons in the CARO section. This does not automatically lead to a qualified opinion on the financial statements.

Where it goes wrong. Students may jump to qualification of the audit opinion, but CARO reporting is separate.

Authority. CARO 2020, Clause (vi) of Paragraph 3; CARO 2020, Paragraph 4

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

Scenario. During a surprise verification of cash at a bank branch, the auditor finds foreign currency notes not recorded in the cash book. The branch manager states they are held for a customer.

During a surprise verification of cash at a bank branch, the auditor finds foreign currency notes of USD 5,000 not recorded in the cash book. The branch manager explains these are held for a customer. What should the auditor do?

1. Ignore the matter as foreign currency is not material.
2. Treat the amount as a deposit from the customer and obtain confirmation.
3. Report the irregularity and verify inclusion in closing cash balance. (correct answer)
4. Ask the manager to record the notes immediately in the cash book.

Answer: C — Report the irregularity and verify inclusion in closing cash balance.

Working. Step 1: Count and identify foreign currency notes. Step 2: Compare with cash book and other records. Step 3: Inquire about ownership and purpose. Step 4: Verify inclusion in closing cash balance. Step 5: Report as irregularity and assess impact. Step 6: Document.

Explanation. Foreign currency notes held at the branch must be recorded in the cash book. Unrecorded notes represent a control deficiency and possible misappropriation risk. The auditor should report the irregularity, verify whether the notes are included in the closing cash balance, and assess the impact on the branch's financial statements. Ignoring or asking the manager to record after the fact is not appropriate.

Where it goes wrong. Students may think the manager's explanation is sufficient or that the auditor should simply instruct recording.

Authority. SA 500: Audit Evidence, para 6; RBI Guidelines on Cash Management