Audit Evidence - Test 2: answer key

Question 1 · 2 marks · Chapter 4: Audit Evidence · medium

Scenario. Vardhan Auto Components Ltd manufactures transmission assemblies at four plants and reports inventory of ₹84 crore at 31 March 2027. M/s Sharma & Associates is conducting the statutory audit. The company maintains perpetual inventory records in its ERP and performs weekly cycle counts, followed by a year-end physical count. At the opening meeting, the audit senior discovers that the written count instructions were circulated only to plant managers; the counting teams have not been told how to identify third-party goods, damaged items or work-in-progress by stage of completion. Used count sheets are to be collected, but unused sheets are not numbered or reconciled. The instructions also permit dispatches to continue during counting, provided dispatch staff verbally inform the counting teams. At Plant 2, management reports a 7% shortage in alloy steel and proposes a single net adjustment against excess finished goods. The audit team observes cartons being shifted between aisles while count teams are working. Several count sheets contain overwritten quantities without initials. The ERP administrator explains that cycle-count differences are posted through a generic user ID. Plant 4 holds inventory representing 31% of the total balance, but management says attendance there is unnecessary because its weekly cycle counts have always agreed to the ERP. The audit team has also been informed that a significant quantity of work-in-progress at Plant 3 is held in a restricted-access furnace area. The partner must determine how to assess count instructions, observe inventory movements, test the accuracy and completeness of management's count records, and decide which locations merit attendance. Management insists that the auditor should merely sign the count attendance sheet and accept its consolidated year-end inventory report.

Before accepting management's proposed count arrangements, which review would most suitable satisfy the auditor's responsibility regarding management's instructions and procedures for physical inventory counting?

1. Check whether the plant managers have signed the count instructions and whether the final consolidated stock statement agrees with the general ledger.
2. Verify that each location has appointed counting personnel and that the ERP automatically records quantities entered by the respective teams.
3. Review the count instructions only for the procedures relating to finished goods, since raw materials and work-in-progress can be substantiated separately.
4. Evaluate controls over used and unused count sheets, recounts, damaged and obsolete items, work-in-progress stages, third-party stock and inventory movements. (correct answer)

Answer: D — Evaluate controls over used and unused count sheets, recounts, damaged and obsolete items, work-in-progress stages, third-party stock and inventory movements.

Explanation. SA 501, paragraph 4(a)(i), read with application paragraph A4, requires evaluation of management's instructions and procedures for recording and controlling physical inventory results. Relevant matters include used and unused count records, recount procedures, work-in-progress completion stages, obsolete or damaged items, third-party inventory and movement controls around the count. Merely obtaining signed instructions or reconciling consolidated totals does not establish that the procedures adequately prevent omissions or inaccurate recording.

Where it goes wrong. Confusing management's formal approval of count instructions with an evaluation of their actual adequacy.

Authority. SA 501

Question 2 · 2 marks · Chapter 4: Audit Evidence · hard

During the physical count, the auditor observes cartons being moved between aisles while counting teams are recording quantities. What is the most appropriate audit response?

1. Accept the movement because dispatches during counting are permissible whenever management has informed the counting personnel.
2. Observe whether movement controls are properly implemented and obtain relevant cut-off information for subsequent examination. (correct answer)
3. Stop all inventory movement permanently and treat the resulting quantities as the final year-end inventory balance.
4. Ignore the movement because attendance primarily requires inspecting stock and obtaining management's final inventory report.

Answer: B — Observe whether movement controls are properly implemented and obtain relevant cut-off information for subsequent examination.

Explanation. SA 501, paragraph A5, explains that observing management's count procedures includes observing controls over inventory movement before, during and after the count. Such observation helps establish whether the instructions are adequately designed and implemented. The auditor may also obtain cut-off information, including movement details, for subsequent procedures. Option a incorrectly assumes verbal notification is sufficient evidence that movements have been correctly controlled and recorded.

Where it goes wrong. Assuming that inventory movements during counting are harmless merely because management has prescribed a notification procedure.

Authority. SA 501

Question 3 · 2 marks · Chapter 4: Audit Evidence · medium

Which approach should the audit team adopt when performing test counts to evaluate the accuracy and completeness of Plant 2's physical inventory records?

1. Trace selected items from management's count records to physical inventory and selected physical items back to management's count records. (correct answer)
2. Select only high-value entries from management's final inventory report and agree their quantities with the ERP-generated stock ledger.
3. Recalculate the value of inventory appearing in the count sheets and compare the resulting aggregate with the trial balance.
4. Select physical items independently but trace them only to the purchase register, without examining management's completed count records.

Answer: A — Trace selected items from management's count records to physical inventory and selected physical items back to management's count records.

Explanation. SA 501, paragraph A7, explains that test counts should include tracing items selected from management's count records to physical inventory and tracing items selected from physical inventory to management's records. The first direction primarily assists in checking the existence of recorded quantities, while the reverse direction provides evidence regarding completeness. Option b tests recorded items only and may fail to identify physical inventory omitted from the records.

Where it goes wrong. Testing only from count sheets to physical stock and overlooking the reverse direction needed to test completeness.

Authority. SA 501

Question 4 · 2 marks · Chapter 4: Audit Evidence · hard

Management argues that attendance at Plant 4 is unnecessary because its weekly cycle counts have historically agreed with ERP records. What should primarily determine the auditor's selection of locations for attendance?

1. The number of plants operated by the company and the convenience of completing attendance at locations within one city.
2. The presence of perpetual inventory records and the frequency with which plant employees submit stock reconciliations.
3. The materiality of inventory at each location and the assessed risks of material misstatement, along with other relevant planning factors. (correct answer)
4. The auditor's ability to examine the largest warehouse first and apply its count results to all remaining locations.

Answer: C — The materiality of inventory at each location and the assessed risks of material misstatement, along with other relevant planning factors.

Explanation. SA 501, application paragraph A3, identifies the nature of inventory, work-in-progress stages, inventory risks, internal controls, timing, perpetual inventory systems and the materiality and risk associated with different locations as relevant planning considerations. Plant 4 represents 31% of total inventory, so its materiality and risk cannot be dismissed merely because management reports successful cycle counts. Option b treats perpetual records as a substitute for professional assessment of attendance requirements.

Where it goes wrong. Treating a history of satisfactory cycle counts as automatic justification for excluding a material location.

Authority. SA 501

Question 5 · 2 marks · Chapter 4: Audit Evidence · medium

Scenario. Kaveri Infrastructure Ltd is engaged in road construction and operates projects in several States. M/s K. Mehta & Co. is auditing its financial statements for the year ended 31 March 2027. The company has disclosed one arbitration claim of ₹3 crore, described as remote, but the audit team notices unusually high legal retainers and court-fee payments during the last quarter. Minutes of the Board's risk committee refer to a contractor dispute and a possible environmental claim, neither of which appears in the litigation schedule. The Company Secretary says the minutes are confidential and asks the auditors to rely on the CFO's oral statement that no other material claims exist. The external law firm has represented Kaveri in several proceedings. The CFO says the firm is unwilling to respond to a general inquiry because of restrictions imposed by its professional body. However, the law firm has issued case-specific advice to management, including its preliminary assessment of probable outflow. The audit senior recommends a specific inquiry listing known cases, management's assessment of outcomes and estimated financial implications, and requesting the lawyers to identify omissions or incorrect assessments. The CFO refuses to authorise any communication, arguing that the auditor should not disturb the lawyer-client relationship. He offers to renew the audit engagement on favourable terms if the matter is closed using management representations alone. The partner must decide how to identify potentially material litigation, when direct contact with external counsel is required, what a specific inquiry should contain, and what to do if management blocks communication and alternative procedures fail. The team must also distinguish a genuine legal restriction on counsel from management's commercial preference to avoid scrutiny.

Which combination of audit procedures would provide the most appropriate initial response to the possibility that Kaveri Infrastructure Ltd has omitted material litigation and claims?

1. Obtain a written statement from the CFO, examine the disclosed litigation schedule and accept the results if they agree.
2. Inquire of management and in-house legal personnel, review governance minutes and external legal correspondence, and examine legal expense accounts. (correct answer)
3. Inspect only the company's pending court-case register and rely on the Company Secretary to identify any omitted matters.
4. Obtain a management representation that no additional claims exist and examine the year-end provisions without reviewing legal expenses.

Answer: B — Inquire of management and in-house legal personnel, review governance minutes and external legal correspondence, and examine legal expense accounts.

Explanation. SA 501, paragraph 9, requires procedures designed to identify litigation and claims that may give rise to a risk of material misstatement. Specifically, the auditor should inquire of management and relevant personnel, including in-house legal counsel, review minutes of meetings of those charged with governance and correspondence with external legal counsel, and review legal expense accounts. Option a relies excessively on management's own schedule despite contradictory indications from minutes and legal expenses.

Where it goes wrong. Treating a management-prepared litigation schedule as a complete population of all actual and possible claims.

Authority. SA 501

Question 6 · 2 marks · Chapter 4: Audit Evidence · hard

The audit team has identified a potentially material environmental claim and assessed a risk of material misstatement. Which procedure is specifically required by SA 501?

1. Send a letter of inquiry, prepared by management and sent by the auditor, requesting external legal counsel to communicate directly with the auditor. (correct answer)
2. Ask the CFO to obtain a verbal legal opinion and summarise its conclusions for inclusion in the audit working papers.
3. Request the company's internal legal department to certify the likely outcome and dispense with communication with external counsel.
4. Obtain a copy of the case filing from management and rely on the court's stated allegations without seeking legal assessment.

Answer: A — Send a letter of inquiry, prepared by management and sent by the auditor, requesting external legal counsel to communicate directly with the auditor.

Explanation. SA 501, paragraph 10, requires direct communication with the entity's external legal counsel where identified litigation creates a risk of material misstatement or other material claims may exist. This communication is made through a letter of inquiry prepared by management and sent by the auditor, requesting counsel to communicate directly with the auditor. Option c is inadequate because internal legal personnel do not replace the prescribed direct external communication when the requirement is triggered.

Where it goes wrong. Confusing management's internal legal function with direct communication from the external lawyer handling the litigation.

Authority. SA 501

Question 7 · 2 marks · Chapter 4: Audit Evidence · medium

The external law firm's professional body restricts responses to general inquiry letters. Which alternative communication would be most appropriate under SA 501?

1. A letter asking the lawyers to confirm only the total provision recognised by management at the reporting date.
2. A letter seeking confirmation that the company has not received any unfavourable court judgment during the financial year.
3. A letter requesting the lawyers to provide an independent estimate without identifying any cases or management assessments.
4. A specific inquiry listing known cases, management's available assessments and estimated implications, and requesting the lawyers to identify omissions or incorrect assessments. (correct answer)

Answer: D — A specific inquiry listing known cases, management's available assessments and estimated implications, and requesting the lawyers to identify omissions or incorrect assessments.

Explanation. SA 501, paragraph A23, permits a specific inquiry when a general inquiry is unlikely to receive an appropriate response. Such a letter includes a list of litigation and claims, management's available assessment of each outcome and financial implications, and a request that external counsel confirm the reasonableness of these assessments and disclose further information if the list is incomplete or incorrect. Option a is too restrictive because it does not adequately address completeness.

Where it goes wrong. Assuming that a specific inquiry is merely a confirmation of the aggregate litigation provision.

Authority. SA 501

Question 8 · 2 marks · Chapter 4: Audit Evidence · hard

The CFO refuses permission for direct communication with external counsel and offers favourable future engagement terms if the audit team closes the matter using management representations. What is the most appropriate course of action?

1. Accept the offer if the CFO provides a signed representation covering the known litigation cases.
2. Withdraw the request for legal communication because management has contractual authority over its external legal advisers.
3. Maintain objectivity, pursue appropriate alternative procedures and modify the audit opinion if sufficient appropriate evidence remains unavailable. (correct answer)
4. Disclose the CFO's offer to shareholders immediately without completing any further audit procedures.

Answer: C — Maintain objectivity, pursue appropriate alternative procedures and modify the audit opinion if sufficient appropriate evidence remains unavailable.

Explanation. SA 501, paragraph 11, requires modification of the auditor's opinion in accordance with SA 705 when management refuses permission for communication with external counsel, or counsel cannot respond, and alternative procedures fail to obtain sufficient appropriate evidence. The engagement-retention offer must not compromise professional judgment. Section 112, Objectivity, of ICAI's revised Code of Ethics, 13th edition, applicable from 1 April 2026, prohibits judgment being compromised by undue influence. Option a wrongly substitutes management representations for unresolved audit evidence.

Where it goes wrong. Allowing commercial pressure or management influence to override the auditor's evidence requirements and professional objectivity.

Authority. ICAI Code of Ethics; SA 501; SA 705; Section 112

Question 9 · 2 marks · Chapter 4: Audit Evidence · medium

Scenario. Pravaan Consumer Products Ltd has two principal business segments: household appliances and industrial components, with operations in India and South-East Asia. M/s V. Raman & LLP is auditing its consolidated financial statements for the year ended 31 March 2027. Management determines segment results using separate product-level ledgers, but shared logistics, advertising and warehousing costs are allocated using revenue percentages. During the year, the CFO changed the allocation basis for warehousing costs to floor area, without documenting why the new basis better reflects resource consumption. The change makes the industrial-components segment profitable after two loss-making years. Management has not explained whether prior-period information was recast or whether the change and its effects are adequately disclosed. The audit team also identifies substantial inter-segment sales to a subsidiary and charges for shared services. The segment schedules eliminate inter-segment revenue but retain some corresponding expenses. The CFO says the eliminations are immaterial and declines to provide the underlying reconciliation workbook, stating that only the segment totals in the annual report matter. Budget-to-actual comparisons show a sharp rise in appliance margins despite stable selling prices and increased freight costs. Management asks the auditor to certify each segment's results separately for presentation to lenders, while asserting that the statutory audit report should not comment on the allocation methods. The engagement partner must determine what understanding of management's segment-determination methods is required, which allocation and elimination matters should be examined, what procedures can test the disclosures, and whether the auditor's responsibility extends to issuing a separate opinion on each segment. The team must also address whether management's refusal to provide reconciliation data is compatible with obtaining sufficient appropriate evidence.

Which matters should M/s V. Raman & LLP examine when evaluating management's methods for determining segment information?

1. Only the aggregate profitability of the company and whether the segment totals agree with consolidated revenue.
2. Only the segment assets and liabilities because the allocation of common expenses is entirely a management decision.
3. Inter-segment sales and eliminations, budget comparisons, allocation of assets and costs, and consistency with previous periods. (correct answer)
4. Only the previous year's segment disclosures because changes in allocation methods do not affect segment information.

Answer: C — Inter-segment sales and eliminations, budget comparisons, allocation of assets and costs, and consistency with previous periods.

Explanation. SA 501, application paragraph A27, identifies several relevant considerations when understanding management's methods for determining segment information. These include inter-segment sales, transfers and charges, elimination of inter-segment amounts, comparisons with budgets and expected results, allocation of assets and costs, and consistency with prior periods. The altered warehouse cost allocation directly affects these considerations. Option b incorrectly treats cost allocation as outside the auditor's evaluation of segment disclosures.

Where it goes wrong. Overlooking allocation methods and inter-segment eliminations while focusing exclusively on segment revenue and assets.

Authority. SA 501

Question 10 · 2 marks · Chapter 4: Audit Evidence · hard

Management requests a separate audit opinion on the profitability of the household-appliances and industrial-components segments for presentation to lenders. What is the auditor's responsibility under SA 501?

1. Issue a separate opinion on each segment because segment disclosures contain individual financial information.
2. Address presentation and disclosure of segment information in relation to the financial statements taken as a whole. (correct answer)
3. Issue an opinion only on the segment with the highest revenue because it represents the principal activity of the company.
4. Avoid examining segment information because it is supplementary information outside the auditor's responsibility.

Answer: B — Address presentation and disclosure of segment information in relation to the financial statements taken as a whole.

Explanation. SA 501, paragraph A26, clarifies that the auditor's responsibility regarding segment information relates to presentation and disclosure in the financial statements taken as a whole. The auditor is not required to perform procedures necessary to express an opinion on segment information presented on a stand-alone basis. Consequently, management cannot convert the statutory financial statement audit into separate segment assurance merely by requesting it for lenders.

Where it goes wrong. Confusing the auditor's responsibility for segment disclosures within the financial statements with a separate audit of every segment.

Authority. SA 501

Question 11 · 2 marks · Chapter 4: Audit Evidence · medium

The CFO has changed the warehouse-cost allocation method and refuses to provide the reconciliation workbook. Which audit response is most appropriate?

1. Obtain an understanding of the revised method, evaluate its likely compliance with the reporting framework, test its application where appropriate and perform analytical or other procedures. (correct answer)
2. Accept the revised method after comparing the resulting segment profits with management's annual budget and obtaining a written representation.
3. Require management to restore the previous allocation method because consistency prohibits any change in segment reporting methodology.
4. Reconcile only the consolidated profit figure and disregard segment-level eliminations because they cancel during consolidation.

Answer: A — Obtain an understanding of the revised method, evaluate its likely compliance with the reporting framework, test its application where appropriate and perform analytical or other procedures.

Explanation. SA 501, paragraph 13, requires the auditor to understand management's methods for determining segment information, evaluate whether those methods are likely to produce disclosures in accordance with the applicable financial reporting framework, test their application where appropriate, and perform analytical or other suitable procedures. A change in allocation methodology is not automatically prohibited, but its appropriateness and disclosure must be assessed. Option c incorrectly assumes consistency means that accounting methods can never change.

Where it goes wrong. Assuming that management's authority to change allocation methods eliminates the auditor's responsibility to evaluate their appropriateness.

Authority. SA 501

Question 12 · 2 marks · Chapter 4: Audit Evidence · hard

The appliance segment's reported margin has increased substantially despite stable selling prices and higher freight costs. Which procedure would provide the most appropriate evidence regarding the segment disclosures?

1. Accept the segment's reported profit because separate product-level ledgers provide sufficient support for the disclosed figures.
2. Verify only the arithmetic of the consolidated profit and assume the segment results are correct if the consolidated amount agrees.
3. Compare the current segment margin only with the previous year's total company margin and ignore inter-segment transactions.
4. Perform analytical procedures and investigate the unexpected margin movement, including cost allocations and inter-segment charges. (correct answer)

Answer: D — Perform analytical procedures and investigate the unexpected margin movement, including cost allocations and inter-segment charges.

Explanation. SA 501, paragraph 13(b), requires analytical procedures or other appropriate audit procedures for segment presentation and disclosure. Application paragraph A27 specifically highlights comparisons with budgets and expected results, allocation of assets and costs, and inter-segment transactions and charges. The unexplained margin increase requires investigation rather than acceptance of management's segment totals. Option b is insufficient because consolidated agreement does not establish that segment allocation and elimination methods were correctly applied.

Where it goes wrong. Assuming that agreement of consolidated figures automatically establishes the correctness of segment-level presentation and disclosure.

Authority. SA 501

Question 13 · 2 marks · Chapter 4: Audit Evidence · medium

Scenario. A company conducts its physical inventory count on 15 March instead of 31 March. The auditor attended the count and found no significant discrepancies. However, the company has substantial inventory receipts and dispatches during the intervening period. Which additional procedures are required?

A company conducts its physical inventory count on 15 March instead of 31 March. The auditor attended the count and found no significant discrepancies. However, the company has substantial inventory receipts and dispatches during the intervening period. Which additional procedures are required?

1. Test whether inventory changes between 15 March and 31 March are properly recorded, considering the reliability and adjustment of perpetual records and significant count differences. (correct answer)
2. Accept the 15 March count because attendance at a physical count automatically establishes the closing inventory balance for the reporting date.
3. Perform another complete physical count on 31 March because SA 501 does not permit an auditor to rely on interim physical inventory counts.
4. Obtain a management representation confirming that no material inventory changes occurred and avoid examining intervening transactions.

Answer: A — Test whether inventory changes between 15 March and 31 March are properly recorded, considering the reliability and adjustment of perpetual records and significant count differences.

Explanation. SA 501, paragraph 5, requires additional audit procedures where physical inventory counting occurs at a date other than the financial statement date. Under application paragraphs A9-A11, relevant considerations include controls over inventory changes, adjustments to perpetual records, their reliability and reasons for significant differences between actual counts and recorded quantities. Option c incorrectly assumes that an interim count is prohibited; it is permissible where the intervening movements are appropriately controlled and evidenced.

Where it goes wrong. Treating an interim physical count as automatically equivalent to the year-end inventory balance.

Authority. SA 501

Question 14 · 2 marks · Chapter 4: Audit Evidence · hard

Scenario. An auditor is unexpectedly prevented from attending a company's scheduled year-end physical inventory count due to a sudden government-imposed access restriction. Which procedure is specifically required under SA 501?

An auditor is unexpectedly prevented from attending a company's scheduled year-end physical inventory count due to a sudden government-imposed access restriction. Which procedure is specifically required under SA 501?

1. Accept management's completed count records after reviewing the stock reconciliation and obtaining written representations.
2. Make or observe physical counts on an alternative date and perform audit procedures on intervening transactions. (correct answer)
3. Treat attendance as permanently impracticable and immediately modify the audit opinion without attempting further procedures.
4. Substitute the company's perpetual inventory valuation report for the physical count and proceed with the original audit plan.

Answer: B — Make or observe physical counts on an alternative date and perform audit procedures on intervening transactions.

Explanation. SA 501, paragraph 6, specifically addresses situations where the auditor is unable to attend physical inventory counting due to unforeseen circumstances. The auditor shall make or observe some physical counts on an alternative date and perform audit procedures on intervening transactions. This differs from a conclusion that attendance is inherently impracticable. Option c is premature because the standard specifically prescribes an alternative-date count and intervening transaction procedures.

Where it goes wrong. Confusing an unforeseen inability to attend the scheduled count with a permanent situation of impracticability.

Authority. SA 501

Question 15 · 2 marks · Chapter 4: Audit Evidence · medium

Scenario. A pharmaceutical company's inventory is held in an isolated high-security facility where external visitors cannot safely enter. The auditor has determined that attendance at the physical count is genuinely impracticable. Which response is most appropriate?

A pharmaceutical company's inventory is held in an isolated high-security facility where external visitors cannot safely enter. The auditor has determined that attendance at the physical count is genuinely impracticable. Which response is most appropriate?

1. Accept a certificate signed by the warehouse manager because security restrictions remove the requirement for further audit procedures.
2. Require management to relocate the inventory temporarily so that the auditor can attend the physical count at the reporting date.
3. Perform alternative audit procedures, such as examining subsequent sales documentation relating to specific inventory items, and modify the opinion if sufficient evidence cannot be obtained. (correct answer)
4. Use the previous year's inventory count as sufficient evidence because the inventory remains at the same secured facility.

Answer: C — Perform alternative audit procedures, such as examining subsequent sales documentation relating to specific inventory items, and modify the opinion if sufficient evidence cannot be obtained.

Explanation. SA 501, paragraph 7, requires alternative audit procedures where attendance is impracticable and modification under SA 705 if sufficient appropriate evidence cannot be obtained through those procedures. Application paragraphs A12-A14 identify safety-related restrictions as a possible basis for impracticability and subsequent sale documentation as an example of alternative evidence. Option a is insufficient because a management certificate does not necessarily establish the existence and condition of material inventory.

Where it goes wrong. Assuming that a genuine attendance restriction automatically removes the auditor's obligation to obtain sufficient appropriate evidence.

Authority. SA 501; SA 705

Question 16 · 2 marks · Chapter 4: Audit Evidence · hard

Scenario. A company maintains continuous perpetual inventory records and performs rotating physical cycle counts throughout the year. Management argues that no annual physical verification is necessary because its ERP provides quantities at any point in time. Which statement most accurately reflects SA 501?

A company maintains continuous perpetual inventory records and performs rotating physical cycle counts throughout the year. Management argues that no annual physical verification is necessary because its ERP provides quantities at any point in time. Which statement most accurately reflects SA 501?

1. Perpetual records completely replace physical inventory counting when every stock movement is recorded electronically.
2. The auditor is required to attend every individual cycle count because physical verification must occur continuously.
3. Physical inventory counting is necessary only when the entity uses a periodical inventory system and does not maintain perpetual records.
4. Perpetual records do not eliminate the relevance of physical counts, which ordinarily occur at least once a year and may also help establish the reliability of those records. (correct answer)

Answer: D — Perpetual records do not eliminate the relevance of physical counts, which ordinarily occur at least once a year and may also help establish the reliability of those records.

Explanation. SA 501, application paragraph A1, explains that management ordinarily establishes procedures under which inventory is physically counted at least once a year, both as a basis for financial statement preparation and, where applicable, to ascertain the reliability of perpetual inventory records. Application paragraph A3 also identifies the existence of a perpetual inventory system as a planning factor. Option a wrongly treats an electronic record as conclusive evidence of physical existence.

Where it goes wrong. Confusing continuous accounting records with continuous physical verification and assuming that the former eliminates the latter.

Authority. SA 501

Question 17 · 2 marks · Chapter 4: Audit Evidence · medium

Scenario. A textile manufacturer has ₹18 crore of finished goods stored with an independent third-party warehouse operator. The operator's integrity is questioned following allegations of unauthorised stock withdrawals. Which approach is most appropriate under SA 501?

A textile manufacturer has ₹18 crore of finished goods stored with an independent third-party warehouse operator. The operator's integrity is questioned following allegations of unauthorised stock withdrawals. Which approach is most appropriate under SA 501?

1. Obtain quantity and condition confirmation or perform appropriate inspection procedures, considering additional procedures where the third party's integrity is doubtful. (correct answer)
2. Accept management's stock statement because the warehouse operator is legally responsible for safeguarding the inventory under the storage agreement.
3. Obtain confirmation only of inventory quantity, as condition and storage arrangements are outside the scope of SA 501.
4. Obtain a warehouse receipt from management and treat it as sufficient regardless of the operator's reliability or physical access.

Answer: A — Obtain quantity and condition confirmation or perform appropriate inspection procedures, considering additional procedures where the third party's integrity is doubtful.

Explanation. SA 501, paragraph 8, requires sufficient appropriate evidence regarding material inventory held by a third party through one or both of confirmation of quantities and condition, and inspection or other appropriate audit procedures. Application paragraph A16 indicates that where information raises doubts about the integrity or objectivity of the third party, additional or alternative procedures may be appropriate, including attendance at the count, service auditor reports and examination of warehouse receipts. Option c wrongly excludes inventory condition.

Where it goes wrong. Assuming that third-party custody automatically establishes reliable evidence of inventory existence and condition.

Authority. SA 501

Question 18 · 2 marks · Chapter 4: Audit Evidence · hard

Scenario. During physical inventory verification, the auditor of a company covered by CARO 2020 identifies aggregate discrepancies of 12% in the raw-material class and 4% in the finished-goods class. The raw-material difference has been adjusted in the books. What is the appropriate reporting conclusion?

During physical inventory verification, the auditor of a company covered by CARO 2020 identifies aggregate discrepancies of 12% in the raw-material class and 4% in the finished-goods class. The raw-material difference has been adjusted in the books. What is the appropriate reporting conclusion?

1. No discrepancy needs to be reported because management has adjusted the raw-material difference before the audit report is issued.
2. The auditor should report the discrepancy of 12% under the applicable inventory reporting clause, even though management has properly adjusted it in the books. (correct answer)
3. The auditor should report both classes because the combined discrepancy across all inventory categories exceeds the 10% threshold.
4. The auditor should report only discrepancies exceeding 15% in each class because CARO requires a higher threshold than SA 501.

Answer: B — The auditor should report the discrepancy of 12% under the applicable inventory reporting clause, even though management has properly adjusted it in the books.

Explanation. CARO 2020, paragraph 3(ii)(a), requires the auditor to report whether discrepancies of 10% or more in the aggregate for each class of inventory were noticed and, if so, whether they were properly dealt with in the books. The 12% raw-material discrepancy crosses the class-wise threshold, and its adjustment does not remove the reporting requirement. The 4% finished-goods difference does not independently cross the threshold. 【turn448910search24】

Where it goes wrong. Assuming that proper adjustment of a discrepancy removes the obligation to report its occurrence under CARO 2020.

Authority. CARO 2020

Question 19 · 2 marks · Chapter 4: Audit Evidence · medium

Scenario. During the statutory audit of a company, the auditor suspects that several material claims may have been omitted from the financial statements. Which set of procedures most directly addresses the completeness of litigation and claims?

During the statutory audit of a company, the auditor suspects that several material claims may have been omitted from the financial statements. Which set of procedures most directly addresses the completeness of litigation and claims?

1. Examine only the existing contingent-liability note and agree disclosed amounts with the general ledger.
2. Obtain an annual certificate from the CFO and inspect only those court cases individually disclosed by management.
3. Inquire of management and relevant internal personnel, review governance minutes and external legal correspondence, and examine legal expenses. (correct answer)
4. Review the legal provision calculation and assume that all underlying proceedings have already been identified by management.

Answer: C — Inquire of management and relevant internal personnel, review governance minutes and external legal correspondence, and examine legal expenses.

Explanation. SA 501, paragraph 9, prescribes specific procedures to identify litigation and claims that may cause material misstatement. These comprise inquiries of management and, where applicable, in-house legal counsel and others, reviews of governance minutes and correspondence with external legal counsel, and reviews of legal expense accounts. Application paragraphs A17-A20 explain the significance of these matters. Option b is inadequate because a management certificate and disclosed cases alone may not reveal omitted litigation.

Where it goes wrong. Testing the valuation of disclosed legal provisions without first establishing whether the population of claims is complete.

Authority. SA 501

Question 20 · 2 marks · Chapter 4: Audit Evidence · hard

Scenario. An external legal adviser indicates that a general inquiry letter is unlikely to receive a satisfactory response because of professional restrictions. The auditor therefore decides to issue a specific inquiry letter. Which combination of information should ordinarily be included?

An external legal adviser indicates that a general inquiry letter is unlikely to receive a satisfactory response because of professional restrictions. The auditor therefore decides to issue a specific inquiry letter. Which combination of information should ordinarily be included?

1. Only the aggregate litigation provision and the company's accounting policy for contingent liabilities.
2. Only the names of the external lawyers and a request for confirmation that the company has no undisclosed claims.
3. The list of cases and the auditor's independent assessment, without disclosing management's assessment or estimated implications.
4. A list of litigation and claims, management's available assessments and estimated financial implications, and a request to confirm their reasonableness or identify omissions. (correct answer)

Answer: D — A list of litigation and claims, management's available assessments and estimated financial implications, and a request to confirm their reasonableness or identify omissions.

Explanation. SA 501, application paragraph A23, describes the contents of a specific inquiry. It includes a list of litigation and claims, management's available assessment of each outcome and estimated financial implications including costs, and a request for external counsel to confirm the reasonableness of management's assessments and provide information where the list is incomplete or incorrect. Option c omits management's own assessments, which are an important component of the prescribed inquiry.

Where it goes wrong. Confusing a specific inquiry letter with an unrestricted request for external counsel to independently prepare the company's litigation assessment.

Authority. SA 501

Question 21 · 2 marks · Chapter 4: Audit Evidence · medium

Scenario. An auditor is reviewing a complex arbitration claim involving a substantial financial exposure. Management's assessment of the outcome differs significantly from the external legal counsel's advice. Which additional procedure may be considered appropriate under SA 501?

An auditor is reviewing a complex arbitration claim involving a substantial financial exposure. Management's assessment of the outcome differs significantly from the external legal counsel's advice. Which additional procedure may be considered appropriate under SA 501?

1. Meet with external legal counsel to discuss the likely outcome, ordinarily with management's permission and a management representative present. (correct answer)
2. Accept management's assessment because the company's board is ultimately responsible for accounting estimates and financial disclosures.
3. Replace direct external counsel communication with a written statement from the internal legal department.
4. Avoid discussing the matter with external counsel because litigation strategy and legal privilege prevent all auditor communication.

Answer: A — Meet with external legal counsel to discuss the likely outcome, ordinarily with management's permission and a management representative present.

Explanation. SA 501, application paragraph A24, states that the auditor may consider meeting with external legal counsel to discuss the likely outcome of litigation or claims in circumstances involving significant risk, complexity or disagreement between management and external counsel. Such meetings ordinarily require management's permission and are held with a management representative present. Option b overlooks the need to investigate substantial contradictory evidence rather than simply accept management's assessment.

Where it goes wrong. Assuming that the auditor must always accept management's legal assessment despite a material disagreement with external counsel.

Authority. SA 501

Question 22 · 2 marks · Chapter 4: Audit Evidence · hard

Scenario. At the conclusion of the audit, the auditor requests management and, where appropriate, those charged with governance to provide written representations concerning litigation and claims. What should these representations cover?

At the conclusion of the audit, the auditor requests management and, where appropriate, those charged with governance to provide written representations concerning litigation and claims. What should these representations cover?

1. Only litigation already recognised as a provision in the financial statements, excluding possible claims.
2. All known actual or possible litigation and claims whose effects should be considered, together with appropriate accounting and disclosure under the applicable framework. (correct answer)
3. Only cases in which court proceedings have formally commenced and a monetary amount has already been determined.
4. Only cases for which external counsel has provided a written probability assessment, excluding all other disputes.

Answer: B — All known actual or possible litigation and claims whose effects should be considered, together with appropriate accounting and disclosure under the applicable framework.

Explanation. SA 501, paragraph 12, requires the auditor to request written representations from management and, where appropriate, those charged with governance that all known actual or possible litigation and claims whose effects should be considered in preparing the financial statements have been disclosed to the auditor and appropriately accounted for and disclosed. Option a is too narrow because the representation is not restricted to recognised provisions or formally quantified court cases.

Where it goes wrong. Restricting written representations to recognised provisions instead of all known actual or possible material claims.

Authority. SA 501

Question 23 · 2 marks · Chapter 4: Audit Evidence · medium

Scenario. Management refuses permission for the auditor to communicate with external legal counsel. The external counsel also refuses to respond to the inquiry, and the auditor's alternative procedures do not provide sufficient appropriate audit evidence. What is the required consequence?

Management refuses permission for the auditor to communicate with external legal counsel. The external counsel also refuses to respond to the inquiry, and the auditor's alternative procedures do not provide sufficient appropriate audit evidence. What is the required consequence?

1. Issue an unmodified opinion because management's refusal is outside the auditor's control and has been disclosed internally.
2. Accept the legal expense ledger as conclusive evidence and retain the audit opinion without further consideration.
3. Modify the auditor's opinion in accordance with SA 705 because the auditor cannot obtain sufficient appropriate audit evidence. (correct answer)
4. Immediately terminate the statutory audit without issuing an auditor's report or communicating with those charged with governance.

Answer: C — Modify the auditor's opinion in accordance with SA 705 because the auditor cannot obtain sufficient appropriate audit evidence.

Explanation. SA 501, paragraph 11, expressly requires the auditor to modify the opinion in accordance with SA 705 when management refuses permission for communication or a lawyer refuses or is prohibited from responding, and sufficient appropriate evidence cannot be obtained through alternative procedures. Option b is inadequate because a legal expense ledger may assist in identifying claims but cannot necessarily establish the completeness and likely outcomes of material litigation.

Where it goes wrong. Treating management's refusal or counsel's non-response as an automatic excuse from the auditor's evidence and reporting responsibilities.

Authority. SA 501; SA 705

Question 24 · 2 marks · Chapter 4: Audit Evidence · hard

Scenario. An entity changes its method of allocating common administrative expenses among geographical segments. Which procedure most accurately reflects the auditor's responsibility under SA 501?

An entity changes its method of allocating common administrative expenses among geographical segments. Which procedure most accurately reflects the auditor's responsibility under SA 501?

1. Accept the change if consolidated profit remains unchanged, because segment allocation does not affect financial statement users.
2. Compare only the new allocation with the approved budget and accept the resulting segment figures without testing the application.
3. Require that the previous allocation method be followed indefinitely, irrespective of changes in business circumstances.
4. Understand the revised method, evaluate whether it produces framework-compliant segment disclosures, test its application where appropriate and investigate relevant inconsistencies. (correct answer)

Answer: D — Understand the revised method, evaluate whether it produces framework-compliant segment disclosures, test its application where appropriate and investigate relevant inconsistencies.

Explanation. SA 501, paragraph 13, requires the auditor to understand management's methods of determining segment information, evaluate whether those methods are likely to produce appropriate disclosures and test their application where appropriate. Application paragraph A27 highlights asset and cost allocation, expected-result comparisons and consistency with prior periods. Option c wrongly treats consistency as an absolute prohibition on changes, instead of requiring evaluation and appropriate disclosure of inconsistencies.

Where it goes wrong. Confusing consistency of segment reporting with an absolute prohibition on changing allocation methods.

Authority. SA 501

Question 25 · 2 marks · Chapter 4: Audit Evidence · medium

Scenario. An auditor examines the segment disclosures of a diversified company and discovers that an inter-segment elimination has not been correctly applied. Management argues that the error is irrelevant because each segment has its own independent profit figure. Which statement most accurately reflects the auditor's responsibility?

An auditor examines the segment disclosures of a diversified company and discovers that an inter-segment elimination has not been correctly applied. Management argues that the error is irrelevant because each segment has its own independent profit figure. Which statement most accurately reflects the auditor's responsibility?

1. The auditor may disregard the error if the total consolidated profit remains unchanged after consolidation.
2. The auditor must issue a separate modified opinion on the affected segment, even when the consolidated financial statements are not materially misstated.
3. The auditor's responsibility is restricted to verifying the arithmetic of each segment's revenue and expense schedules.
4. The auditor must evaluate segment presentation and disclosure as part of the financial statements taken as a whole, considering the effect of the incorrect elimination. (correct answer)

Answer: D — The auditor must evaluate segment presentation and disclosure as part of the financial statements taken as a whole, considering the effect of the incorrect elimination.

Explanation. SA 501, paragraph A26, establishes that the auditor's responsibility regarding segment information relates to presentation and disclosure in the financial statements taken as a whole. A separate audit opinion on every segment is not required. Nevertheless, an incorrect inter-segment elimination must be evaluated for its effect on the overall disclosures and financial statements. Option b incorrectly converts the responsibility into a separate segment-level opinion requirement.

Where it goes wrong. Either disregarding segment disclosure errors because consolidated totals appear correct or assuming that every segment requires an independent audit opinion.

Authority. SA 501