Audit Evidence - Test 5: answer key

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

Scenario. Zenith Manufacturing Ltd manufactures industrial valves and precision components at two manufacturing plants. For the year ended 31 March 2027, the company processed approximately 48,000 purchase invoices aggregating ₹96 crore. M/s Sharma & Associates is conducting its statutory audit. The audit team intends to test the effectiveness of the electronic purchase-approval control and verify the accuracy of recorded purchases. The ERP generates a purchase register, but manual journal entries posted directly into the general ledger are not included in the downloaded invoice population. Further, the application administrator can modify the approval status without an independent review. During the year, the company introduced a new procurement application at Plant 2, and the expected rate of control deviations has increased based on preliminary testing. The audit senior selects 60 invoices from March and another 15 high-value invoices using professional judgment. The senior describes the entire exercise as statistical sampling because 75 items have been selected. Several selected invoices lack the prescribed approval. Management argues that the missing approvals relate to temporary staff shortages and requests that the deviations not be projected because they are isolated incidents. The partner also notices that 20% of the invoice population represents approximately 85% of the monetary value. The team considers separating high-value invoices from the remaining population to improve testing efficiency. The audit partner must decide whether the sampling approach has been correctly classified, how sampling risk affects the audit conclusion, whether stratification is appropriate, and how identified misstatements should be evaluated. Management further suggests that examining the selected invoices is sufficient even though the population does not include manual purchase entries. The engagement team must therefore consider population completeness before accepting any conclusion based on its sample.

The audit senior claims that the purchase testing constitutes statistical sampling because the selected sample contains 75 invoices. Which assessment correctly distinguishes statistical and non-statistical sampling?

1. Statistical sampling is determined by sample size, whereas non-statistical sampling is used whenever fewer than 100 items are selected.
2. Statistical sampling requires random selection and probability theory for evaluating results, whereas non-statistical sampling relies on auditor judgment. (correct answer)
3. Statistical sampling requires complete examination of the population, whereas non-statistical sampling permits examination of selected transactions.
4. Statistical sampling uses the auditor's professional judgment exclusively, whereas non-statistical sampling requires mathematical probability calculations.

Answer: B — Statistical sampling requires random selection and probability theory for evaluating results, whereas non-statistical sampling relies on auditor judgment.

Explanation. SA 530, section 6.5 of the ICAI Study Material, distinguishes statistical sampling by two essential characteristics: random selection of sample units and the use of probability theory to evaluate sample results, including measurement of sampling risk. Non-statistical sampling relies on professional judgment in selecting and evaluating items. The number of invoices selected does not determine the sampling approach. Option a is the examiner's trap because even a relatively large sample may be non-statistical if its selection and evaluation are judgment-based.

Where it goes wrong. Confusing the size of an audit sample with the defining characteristics of statistical sampling.

Authority. SA 530; section 6

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

The partner is concerned that the sample may indicate that purchase approvals operate effectively even though approval failures exist throughout the population. Which sampling risk is being described?

1. Risk of under-reliance, which causes the auditor to assess controls as less effective than they actually are and affects audit efficiency.
2. Risk of incorrect rejection, which causes the auditor to conclude that recorded balances are overstated when no misstatement exists.
3. Non-sampling risk, which arises because the auditor selects fewer than all of the invoices in the purchase population.
4. Risk of over-reliance, which causes the auditor to conclude that controls are more effective than they actually are and affects audit effectiveness. (correct answer)

Answer: D — Risk of over-reliance, which causes the auditor to conclude that controls are more effective than they actually are and affects audit effectiveness.

Explanation. SA 530, section 6.5 and the discussion of sampling risk, explain that risk of over-reliance arises when the auditor concludes that controls are more effective than they actually are, or that no material misstatement exists when one does. This affects audit effectiveness because the auditor may fail to perform necessary additional procedures. Risk of under-reliance has the opposite effect and primarily affects efficiency. Option a describes under-reliance, not the risk identified in the question.

Where it goes wrong. Reversing over-reliance and under-reliance, particularly their respective effects on audit effectiveness and efficiency.

Authority. SA 530; section 6

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

The audit partner proposes separating the high-value purchase invoices from the remaining invoices before selecting samples. What is the principal benefit of this approach?

1. Stratification reduces variability within each sub-population and may reduce the overall sample size without increasing sampling risk. (correct answer)
2. Stratification eliminates sampling risk because each high-value invoice receives separate examination and evaluation procedures.
3. Stratification converts a non-statistical selection method into statistical sampling without requiring random selection.
4. Stratification eliminates the need to examine smaller invoices because high-value transactions determine the entire population's audit conclusion.

Answer: A — Stratification reduces variability within each sub-population and may reduce the overall sample size without increasing sampling risk.

Explanation. SA 530, section 6.9.1 of the ICAI Study Material, explains that stratification divides a heterogeneous population into sub-populations having similar characteristics. This reduces variability within each stratum and can allow the auditor to achieve the desired assurance with a smaller aggregate sample. Monetary-value stratification also directs greater audit attention towards high-value items. Option b is incorrect because stratification reduces variability but does not eliminate sampling risk or the need for appropriate testing of each relevant population.

Where it goes wrong. Assuming that stratification eliminates sampling risk rather than improving sampling efficiency by reducing within-stratum variability.

Authority. SA 530; section 6

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

The auditor identifies an unusual misstatement in one selected invoice. Management claims it is an isolated anomaly and asks the auditor to exclude it from the projected misstatement without further examination. What should the auditor do?

1. Exclude the error immediately because any misstatement relating to an individual invoice is not representative of the population.
2. Project the error to the entire population without investigating its origin or considering whether other transactions are affected.
3. Perform additional procedures to obtain a high degree of certainty that the error is not representative before excluding it from projection. (correct answer)
4. Ignore the error if the aggregate value of the invoices selected does not exceed the audit materiality threshold.

Answer: C — Perform additional procedures to obtain a high degree of certainty that the error is not representative before excluding it from projection.

Explanation. SA 530, sections 6.11 and 6.12, requires the auditor to investigate the nature and causes of identified misstatements and deviations. An anomaly may be excluded when projecting misstatements only after additional procedures provide a high degree of certainty that it is not representative of the population. Even then, its uncorrected effect must be considered separately. Option a is flawed because management's assertion that an error is isolated does not establish that conclusion.

Where it goes wrong. Treating a management-described isolated error as an anomaly without obtaining the required additional evidence.

Authority. SA 530

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

Scenario. Pravaan Consumer Products Ltd manufactures household appliances and distributes them through dealers and institutional customers. M/s K. Mehta & Co. is conducting the statutory audit for the year ended 31 March 2027. During the year, the company underwent a restructuring in which the Managing Director's spouse acquired a substantial ownership interest in Meridian Warehousing Pvt Ltd. Meridian subsequently entered into several storage and logistics arrangements with Pravaan. The company also established a special-purpose entity, Horizon Assets LLP, in which it holds only a nominal equity interest but possesses contractual rights to direct the entity's relevant operating and financing decisions. The Finance Director supplies a related-party register containing only parties disclosed in the previous year. He claims that transactions with Meridian and Horizon are ordinary commercial arrangements and therefore need not receive additional audit attention. The auditor discovers interest-free advances of ₹8 crore to Horizon and a transfer of a warehouse to Meridian at a price substantially below an independent valuation. No clear commercial justification is recorded in the relevant agreements. The ERP vendor master also contains no specific related-party identification field, and several significant contracts were renegotiated during the year without the usual finance review. The engagement team proposes examining shareholder registers, declarations of conflicts of interest, contracts with key management, investment records, regulatory filings and correspondence with professional advisers. Management resists this work, asserting that the disclosed related-party register is complete. The engagement partner must evaluate the relationships, understand the controls for identifying and approving related-party transactions, investigate unusual arrangements and determine whether the transactions have been appropriately accounted for and disclosed.

The Managing Director's spouse holds substantial ownership in Meridian Warehousing Pvt Ltd, which has entered into transactions with Pravaan. Separately, Pravaan can direct Horizon Assets LLP's relevant decisions despite holding only nominal equity. Which conclusion is most appropriate?

1. Both relationships require evaluation because related-party identification considers close family relationships and control exercised in substance through contractual arrangements. (correct answer)
2. Only Meridian may be related because a related party must always hold a majority of the voting shares of the reporting entity.
3. Only Horizon may be related because a spouse's ownership interest cannot create a related-party relationship under auditing requirements.
4. Neither entity is related because transactions with legally independent companies are outside the auditor's related-party responsibilities.

Answer: A — Both relationships require evaluation because related-party identification considers close family relationships and control exercised in substance through contractual arrangements.

Explanation. SA 550, sections 7.2, 7.3 and 7.5 of the ICAI Study Material, recognise relationships arising through control, significant influence, close family members of key management personnel and substantive control of special-purpose entities. Legal ownership alone is not decisive. Meridian's ownership by the Managing Director's spouse and Pravaan's contractual power over Horizon require appropriate evaluation. Option b incorrectly assumes that a majority shareholding is essential for every related-party relationship.

Where it goes wrong. Equating related-party status exclusively with direct majority share ownership and ignoring family relationships or control in substance.

Authority. SA 550

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

Which inquiries and risk-assessment procedures should the engagement team prioritise when management supplies only the previous year's related-party register?

1. Ask management only whether any new shareholders have been registered and accept its response if it agrees with the annual return.
2. Ask the Company Secretary to certify the register and inspect only transactions already classified as related-party transactions.
3. Inquire about related-party identities, changes, relationship nature, transaction types and purposes, and controls for identification, approval and disclosure. (correct answer)
4. Review the general ledger for transactions exceeding materiality and assume that all smaller related-party transactions are immaterial.

Answer: C — Inquire about related-party identities, changes, relationship nature, transaction types and purposes, and controls for identification, approval and disclosure.

Explanation. SA 550, section 7.7, requires inquiries of management about the identities of related parties, including changes from the previous period, the nature of relationships and the type and purpose of transactions. The auditor must also understand controls established for identification, accounting, disclosure and approval of significant related-party transactions and arrangements outside the normal course of business. Option b is inadequate because examining only transactions already classified by management cannot establish whether the population of related parties is complete.

Where it goes wrong. Limiting related-party audit procedures to the register prepared by management instead of independently evaluating relationships and completeness.

Authority. SA 550; section 7

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

The warehouse transfer to Meridian occurred at a price substantially below an independent valuation and lacks documented commercial justification. What should be the auditor's principal response?

1. Accept the transaction because related-party dealings are automatically permissible whenever management has approved them.
2. Treat the transaction as an ordinary sale because no direct cash consideration was required from Meridian.
3. Limit procedures to verifying the transfer entry and the resulting gain or loss in the general ledger.
4. Examine the underlying agreement, evaluate the business rationale and commercial terms, and assess appropriate accounting and disclosure. (correct answer)

Answer: D — Examine the underlying agreement, evaluate the business rationale and commercial terms, and assess appropriate accounting and disclosure.

Explanation. SA 550, particularly the requirements concerning significant related-party transactions outside the entity's normal course of business, requires the auditor to consider whether such transactions create significant risks and to inspect the underlying contracts or agreements. The business rationale, transaction terms and accounting treatment require evaluation. Section 7.6 of the ICAI Study Material explains that related-party transactions may occur on non-market terms or without consideration. Option a wrongly assumes management approval eliminates the auditor's assessment responsibilities.

Where it goes wrong. Assuming that management approval or legal documentation automatically establishes the commercial substance and fairness of a related-party transaction.

Authority. SA 550; Section 7

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

Which collection of records would provide the most useful corroborative evidence when investigating potentially undisclosed related-party relationships?

1. Only the purchase register, sales register and bank reconciliation statements prepared by the company's finance department.
2. Shareholder registers, conflict-of-interest declarations, regulatory filings, key-management contracts and correspondence with professional advisers. (correct answer)
3. Only the annual financial statements, the statutory audit report and the company's inventory valuation certificate.
4. Only the list of board-approved suppliers, customer confirmations and the current year's cash-flow statement.

Answer: B — Shareholder registers, conflict-of-interest declarations, regulatory filings, key-management contracts and correspondence with professional advisers.

Explanation. SA 550, section 7.7 and the records listed in the ICAI Study Material, section 7.8, identify shareholder registers, conflict-of-interest declarations, regulatory information, key-management agreements, investment records, significant contracts and professional-adviser correspondence as useful sources. These records may reveal relationships not included in the management register. Option a is inadequate because ordinary accounting registers alone may not disclose ownership connections, contractual control or close family relationships.

Where it goes wrong. Assuming that related-party relationships can be identified solely from accounting entries instead of examining ownership and governance records.

Authority. SA 550; section 7

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

Scenario. Suryodaya Components Ltd manufactures automotive electrical equipment and operates six production facilities. M/s V. Raman & LLP is conducting its statutory audit for the year ended 31 March 2027. The company has an internal audit department comprising eight professionally qualified employees. The department conducts periodic purchase reviews, payroll testing, verification of reconciliations and selected operational audits. However, the Head of Internal Audit reports to the Chief Financial Officer, who is responsible for several departments under review. Management also imposes restrictions on the circulation of internal audit findings to the Audit Committee and external auditors. The department has not maintained consistent documented review procedures or formal quality-control records. During preliminary meetings, the CFO proposes that the external audit team should rely substantially on the internal auditors' purchase testing and use their staff directly for checking year-end inventory, determining impairment provisions and evaluating complex revenue-recognition judgments. Two internal auditors assigned to the purchase review also participate in maintaining the vendor master and approving certain supplier changes. Their previous findings concerning purchase controls have already been communicated to the CFO and Audit Committee. The engagement partner recognises that internal audit has completed substantial work during the year and that using suitable work could reduce repetitive external testing. However, the partner is concerned about the department's organisational status, restrictions on reporting, conflicting operational responsibilities and quality-control weaknesses. The partner must assess whether the internal audit function possesses sufficient objectivity, competence and a systematic and disciplined approach. The team must also distinguish between using existing internal audit work and obtaining direct assistance, identify procedures that internal auditors must not perform for the external auditor, and retain responsibility for the final statutory audit opinion.

The internal audit department employs qualified auditors but has restricted access to the Audit Committee, lacks formal quality-control documentation and is influenced by the CFO. Which conclusion should the external auditor reach?

1. The external auditor should not use its work when the function's organisational status does not adequately support objectivity or it lacks a systematic and disciplined approach. (correct answer)
2. The external auditor may rely extensively on its work because professional qualifications compensate for restrictions on objectivity and quality control.
3. The external auditor may use its findings without independent evaluation because an internal audit function is a separate department within the company.
4. The external auditor should use all internal audit procedures provided that the head of the department signs the completed work papers.

Answer: A — The external auditor should not use its work when the function's organisational status does not adequately support objectivity or it lacks a systematic and disciplined approach.

Explanation. SA 610, sections 8.5 to 8.7 of the ICAI Study Material, requires evaluation of objectivity, competence and the systematic and disciplined approach of the internal audit function. The external auditor shall not use its work if its organisational status and relevant policies do not adequately support objectivity, if it lacks sufficient competence, or if it lacks a systematic and disciplined approach including quality control. Option b is incorrect because professional qualifications cannot compensate for impaired objectivity or inadequate quality controls.

Where it goes wrong. Assuming that technical competence alone makes internal audit work reliable despite organisational restrictions and weak quality-control arrangements.

Authority. SA 610

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

Assume that the external auditor has established that an internal audit function is objective, competent and systematic. Which combination of procedures is required before using its existing work?

1. Accept the internal audit reports after management approval and avoid performing any additional external audit procedures.
2. Repeat every procedure performed by internal audit because its work cannot contribute to external audit evidence.
3. Obtain an oral summary from the Head of Internal Audit and reduce substantive testing by the same proportion as internal audit coverage.
4. Discuss the planned use, read relevant internal audit reports and perform sufficient procedures on the body of work intended for use. (correct answer)

Answer: D — Discuss the planned use, read relevant internal audit reports and perform sufficient procedures on the body of work intended for use.

Explanation. SA 610, section 8.10, prescribes the external auditor's actions when planning to use work of the internal audit function. The auditor discusses planned use to coordinate activities, reads reports to understand the procedures and findings, and performs sufficient procedures on the body of work as a whole to determine its adequacy. Option a is incorrect because reading internal audit reports and obtaining management approval cannot replace the external auditor's independent evaluation of the work.

Where it goes wrong. Confusing permission to use internal audit work with automatic acceptance of its conclusions without external evaluation.

Authority. SA 610; section 8

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

The external auditor proposes assigning an internal auditor to assist with independently counting inventory at a branch location. Under which circumstances may such direct assistance be used?

1. Whenever the internal auditor has performed inventory verification in previous years, irrespective of the current auditor's supervision.
2. Whenever management authorises the work, even when the selected internal auditor has significant threats to objectivity.
3. Where permitted by law or regulation, after evaluating competence and objectivity, and under external auditor direction, supervision and review. (correct answer)
4. Whenever internal audit has already issued an inventory report, even if the external auditor cannot independently review the procedures performed.

Answer: C — Where permitted by law or regulation, after evaluating competence and objectivity, and under external auditor direction, supervision and review.

Explanation. SA 610, section 8.11, defines direct assistance as the use of internal auditors to perform audit procedures under the direction, supervision and review of the external auditor. Before using direct assistance, the external auditor must consider whether it is permitted by law or regulation and evaluate the competence and objectivity of the individuals concerned. Significant threats to objectivity or insufficient competence prohibit such use. Option b incorrectly treats management's authorisation as a substitute for these requirements.

Where it goes wrong. Assuming that management permission is sufficient to authorise direct assistance by internal auditors.

Authority. SA 610; section 8

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

The CFO argues that because the internal audit department has completed most of the testing, the external auditor's responsibility for sufficient audit evidence and the audit opinion is substantially reduced. Which statement is correct?

1. The internal audit function assumes responsibility for the financial statement audit wherever its work has been accepted.
2. The external auditor retains sole responsibility for the audit opinion, regardless of whether internal audit work or direct assistance is used. (correct answer)
3. The external auditor's responsibility is transferred to the internal audit head when internal audit reports directly to the Audit Committee.
4. The statutory auditor may delegate final audit judgments to internal auditors if their work has passed management review.

Answer: B — The external auditor retains sole responsibility for the audit opinion, regardless of whether internal audit work or direct assistance is used.

Explanation. SA 610, section 8.4, expressly states that the external auditor has sole responsibility for the audit opinion and that this responsibility is not reduced by using the work of the internal audit function or direct assistance from internal auditors. The external auditor must continue obtaining sufficient appropriate evidence and making significant judgments. Option d wrongly assumes that the responsibility for audit judgments can be transferred to internal personnel through management review or approval.

Where it goes wrong. Confusing permitted use of internal auditors with delegation of the statutory auditor's ultimate responsibility.

Authority. SA 610; section 8

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

Scenario. An auditor selects every 40th purchase invoice after choosing a random starting point. However, the company's records are arranged so that every 40th item relates to the same branch because the sequence repeats periodically. What is the most appropriate response?

An auditor selects every 40th purchase invoice after choosing a random starting point. However, the company's records are arranged so that every 40th item relates to the same branch because the sequence repeats periodically. What is the most appropriate response?

1. Continue the selection because a random starting point automatically eliminates every risk associated with systematic sampling.
2. Increase the interval to 80 without changing the starting point and presume that the revised sample will cover every branch.
3. Accept the sample because systematic sampling does not require the auditor to examine the organisation of the population.
4. Assess the periodic pattern and consider multiple random starting points or another selection method to improve representativeness. (correct answer)

Answer: D — Assess the periodic pattern and consider multiple random starting points or another selection method to improve representativeness.

Explanation. SA 530, section 6.9.3 of the ICAI Study Material, explains that systematic selection requires examination of whether the interval corresponds with a pattern in the population. Such a pattern may cause entire groups of transactions to be systematically excluded. The auditor may minimise this risk by selecting multiple random starting points or choosing another suitable method. Option a is flawed because a random starting point does not remove an inherent periodicity problem.

Where it goes wrong. Assuming that a random starting point makes systematic sampling representative even when the population has a matching recurring pattern.

Authority. SA 530; section 6

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

Scenario. While examining a sample of purchase transactions, an auditor fails to recognise that several invoices contain fictitious supplier details because the verification procedure was poorly designed. Even doubling the sample size would not necessarily correct this problem. Which risk is involved?

While examining a sample of purchase transactions, an auditor fails to recognise that several invoices contain fictitious supplier details because the verification procedure was poorly designed. Even doubling the sample size would not necessarily correct this problem. Which risk is involved?

1. Non-sampling risk, arising from inappropriate audit procedures or failure to recognise misstatements while interpreting audit evidence. (correct answer)
2. Sampling risk, arising because the sample was selected from less than the entire population of purchase transactions.
3. Risk of under-reliance, arising because the auditor has concluded that the purchase-approval control is less effective than it actually is.
4. Risk of incorrect rejection, arising because the sample suggests that recorded purchases contain misstatements when they do not.

Answer: A — Non-sampling risk, arising from inappropriate audit procedures or failure to recognise misstatements while interpreting audit evidence.

Explanation. SA 530, sections 6.5 and 6.6 of the ICAI Study Material, distinguish non-sampling risk from sampling risk. Non-sampling risk arises when the auditor uses inappropriate audit procedures, fails to recognise an existing misstatement or incorrectly interprets audit evidence. Increasing sample size does not automatically correct these failures. Option b describes sampling risk, which arises because a sample rather than the entire population is examined. The issue here concerns the quality and execution of the audit procedure.

Where it goes wrong. Confusing sampling risk with non-sampling errors that arise from inadequate audit procedures or incorrect interpretation.

Authority. SA 530

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

Scenario. While designing tests of details and tests of controls, an auditor establishes two separate acceptance limits. Which statement correctly distinguishes these limits?

While designing tests of details and tests of controls, an auditor establishes two separate acceptance limits. Which statement correctly distinguishes these limits?

1. Tolerable misstatement is the maximum permitted control deviation rate, whereas tolerable deviation rate is the monetary error accepted in account balances.
2. Tolerable misstatement applies only to statistical sampling, whereas tolerable deviation rate applies exclusively to non-statistical sampling.
3. Tolerable misstatement is a monetary benchmark for tests of details, whereas tolerable deviation rate is the maximum acceptable rate of control deviations. (correct answer)
4. Both terms indicate the expected errors in the population before testing, and therefore neither is an auditor-established acceptance limit.

Answer: C — Tolerable misstatement is a monetary benchmark for tests of details, whereas tolerable deviation rate is the maximum acceptable rate of control deviations.

Explanation. SA 530, sections 6.9.2 and the discussion of tolerable deviation rate in the ICAI Study Material, distinguish monetary misstatement from control deviations. Tolerable misstatement is the monetary amount set by the auditor when testing account balances or transaction classes. Tolerable deviation rate is the maximum control deviation rate the auditor is prepared to accept while relying on a control. Option d incorrectly confuses tolerable limits with expected misstatement or expected deviation rates.

Where it goes wrong. Confusing tolerable limits established before testing with the expected misstatement or expected deviation rate.

Authority. SA 530

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

Scenario. An auditor tests purchase-order approvals. The tolerable deviation rate is 4%, but preliminary audit work indicates an expected deviation rate of 7%. Assuming other factors remain unchanged, what is the most appropriate conclusion?

An auditor tests purchase-order approvals. The tolerable deviation rate is 4%, but preliminary audit work indicates an expected deviation rate of 7%. Assuming other factors remain unchanged, what is the most appropriate conclusion?

1. The sample size should be reduced because expected deviations exceed the tolerable rate and testing would otherwise become repetitive.
2. A larger sample would generally be required, although the auditor may decide not to perform control testing if the expected deviation is unacceptably high. (correct answer)
3. The auditor should accept the control without testing because expected deviations are already established through preliminary audit procedures.
4. The sample size remains unchanged because tolerable and expected deviation rates do not influence the extent of testing.

Answer: B — A larger sample would generally be required, although the auditor may decide not to perform control testing if the expected deviation is unacceptably high.

Explanation. SA 530, section 6.9.2, explains that an increase in the expected deviation rate generally requires a larger sample to estimate the actual rate with reasonable precision. The tolerable deviation rate represents the maximum deviation acceptable for control reliance, not the auditor's prediction. Where the expected deviation rate is unacceptably high, the auditor would normally decide not to perform tests of controls. Option d incorrectly ignores the relationship between expected deviation and sample size.

Where it goes wrong. Confusing expected deviation with tolerable deviation and assuming that a higher expected deviation permits a smaller sample.

Authority. SA 530; section 6

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

Scenario. An auditor selects the first 180 sales invoices recorded in September and uses the results to draw conclusions about the entire year's sales population. Which assessment is most appropriate?

An auditor selects the first 180 sales invoices recorded in September and uses the results to draw conclusions about the entire year's sales population. Which assessment is most appropriate?

1. The procedure is statistical random sampling because all the selected invoices are consecutive and can be easily identified.
2. The procedure is systematic sampling because all transactions have been selected from the same accounting period.
3. The procedure is haphazard sampling because the selection does not involve the use of probability tables.
4. The procedure is block sampling, which ordinarily does not provide a representative basis for conclusions about the entire population. (correct answer)

Answer: D — The procedure is block sampling, which ordinarily does not provide a representative basis for conclusions about the entire population.

Explanation. SA 530, section 6.9.3, identifies block sampling as the selection of contiguous items from within a population. Since transactions recorded consecutively may share similar characteristics, selecting one block may exclude important transactions occurring during other periods or locations. It is therefore ordinarily inappropriate when the auditor intends to draw inferences about the entire population. Option b is incorrect because systematic sampling involves a prescribed interval after a selected starting point.

Where it goes wrong. Assuming that examining a large number of consecutive items makes the sample representative of an entire year's population.

Authority. SA 530; section 6

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

Scenario. During tests of details, the auditor selects a purchase invoice but discovers that the selected document was cancelled before the transaction occurred. The audit procedure is therefore not applicable to that item. What should the auditor do?

During tests of details, the auditor selects a purchase invoice but discovers that the selected document was cancelled before the transaction occurred. The audit procedure is therefore not applicable to that item. What should the auditor do?

1. Select an appropriate replacement item because the original item does not constitute a transaction relevant to the particular audit test. (correct answer)
2. Treat the cancelled invoice as a misstatement because every selected document must be included in the population's valuation calculation.
3. Treat the cancelled invoice as a control deviation even though the test is designed to examine monetary misstatements.
4. Remove the invoice from the sample without selecting a replacement and reduce the sample size accordingly.

Answer: A — Select an appropriate replacement item because the original item does not constitute a transaction relevant to the particular audit test.

Explanation. SA 530, section 6.10(ii), explains that where an audit procedure is not applicable to a selected item, the auditor performs the procedure on a replacement item. However, if the auditor cannot apply the designed procedure or suitable alternative procedures to a selected item, the item is treated as a misstatement for tests of details or a deviation for tests of controls. Option b wrongly treats a properly cancelled document as a misstatement without considering whether the procedure is applicable.

Where it goes wrong. Confusing an inapplicable selected item with an item on which the auditor is unable to obtain evidence.

Authority. SA 530; section 6

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

Scenario. An auditor identifies several purchase-approval deviations in the sample. They all relate to one branch and the same month, suggesting that a common event may have caused the failures. What is the most appropriate next step?

An auditor identifies several purchase-approval deviations in the sample. They all relate to one branch and the same month, suggesting that a common event may have caused the failures. What is the most appropriate next step?

1. Project the observed deviations immediately without investigating their causes because the sample is statistically selected.
2. Exclude the deviations because their common location and timing demonstrate that they are isolated from the remaining population.
3. Investigate their nature and causes, assess possible wider implications and perform additional procedures where necessary. (correct answer)
4. Discontinue testing because a common cause establishes that management has already detected the control failure.

Answer: C — Investigate their nature and causes, assess possible wider implications and perform additional procedures where necessary.

Explanation. SA 530, section 6.11, requires the auditor to investigate the nature and cause of identified deviations or misstatements and evaluate their effects on the purpose of the procedure and other audit areas. A common location and period may indicate a broader control failure requiring expanded testing of similar transactions. It does not automatically establish an anomaly. Option b is incorrect because an anomaly requires additional evidence demonstrating that the deviation does not affect the remainder of the relevant population.

Where it goes wrong. Treating a group of deviations with common characteristics as automatically isolated rather than investigating whether they indicate a wider control failure.

Authority. SA 530; section 6

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

Scenario. A company increases its annual purchase population from 50,000 invoices to 1,00,000 invoices. The assessed risk, tolerable misstatement, expected misstatement and desired assurance remain unchanged. Which statement about sample size is generally appropriate?

A company increases its annual purchase population from 50,000 invoices to 1,00,000 invoices. The assessed risk, tolerable misstatement, expected misstatement and desired assurance remain unchanged. Which statement about sample size is generally appropriate?

1. The auditor must double the sample size because the population has doubled and every transaction requires proportional coverage.
2. For a sufficiently large population, doubling the number of sampling units has little or no effect on sample size, other factors remaining unchanged. (correct answer)
3. The auditor must reduce the sample size because larger populations always provide greater assurance regarding transaction processing.
4. The auditor must examine every purchase invoice because SA 530 does not permit sampling from populations exceeding 50,000 items.

Answer: B — For a sufficiently large population, doubling the number of sampling units has little or no effect on sample size, other factors remaining unchanged.

Explanation. SA 530, sections 6.9.2 and 6.9.2A of the ICAI Study Material, explain that for sufficiently large populations the actual number of sampling units has little effect on sample size. Factors such as assessed risk, tolerable misstatement, expected misstatement and desired assurance are more significant. Small populations may make complete examination more efficient. Option a incorrectly assumes that sample size must increase in direct proportion to the population size.

Where it goes wrong. Assuming that sample size must increase proportionately whenever the number of transactions in a large population increases.

Authority. SA 530

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

Scenario. An entity establishes a special-purpose entity in which it owns only 5% of the voting equity. However, the entity controls the relevant operating and financing decisions through contractual arrangements and receives substantially all economic benefits. What is the most appropriate conclusion under SA 550?

An entity establishes a special-purpose entity in which it owns only 5% of the voting equity. However, the entity controls the relevant operating and financing decisions through contractual arrangements and receives substantially all economic benefits. What is the most appropriate conclusion under SA 550?

1. The special-purpose entity may constitute a related party because substantive control can exist even where the reporting entity owns little or none of its equity. (correct answer)
2. The special-purpose entity cannot constitute a related party because the reporting entity does not own a majority of the voting equity.
3. The special-purpose entity becomes related only when it records an outstanding receivable or payable in the reporting entity's books.
4. The special-purpose entity is necessarily independent because contractual decision-making rights are irrelevant to identifying related parties.

Answer: A — The special-purpose entity may constitute a related party because substantive control can exist even where the reporting entity owns little or none of its equity.

Explanation. SA 550, section 7.5, recognises that a special-purpose entity may be a related party when the reporting entity controls it in substance, even where it owns little or none of its equity. Control and significant influence must be evaluated through the actual rights, arrangements and economic relationships. Option b incorrectly makes majority shareholding an absolute condition for related-party status, ignoring substantive contractual control.

Where it goes wrong. Equating legal share ownership with control and overlooking contractual rights that establish substantive control.

Authority. SA 550; section 7

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

Scenario. A company regularly purchases raw materials from an entity under common ownership. The transactions are conducted at market prices under normal commercial terms. Which statement most accurately reflects the auditor's assessment under SA 550?

A company regularly purchases raw materials from an entity under common ownership. The transactions are conducted at market prices under normal commercial terms. Which statement most accurately reflects the auditor's assessment under SA 550?

1. Every related-party transaction automatically carries a higher risk of material misstatement than comparable transactions with unrelated parties.
2. A related-party relationship eliminates the possibility of fraud because transactions are reviewed by common management.
3. Transactions in the ordinary course of business are excluded from related-party evaluation and disclosure requirements.
4. Such transactions may not carry higher risk than comparable unrelated-party transactions, although their relationship and disclosure still require appropriate evaluation. (correct answer)

Answer: D — Such transactions may not carry higher risk than comparable unrelated-party transactions, although their relationship and disclosure still require appropriate evaluation.

Explanation. SA 550, section 7.6, explains that many related-party transactions occur in the normal course of business and may carry no higher risk of material misstatement than similar transactions with unrelated parties. However, their related-party nature and applicable accounting disclosures must still be considered. Complex structures, ineffective information systems or non-market terms may increase risk. Option c is incorrect because ordinary commercial terms do not remove the relationship from related-party reporting requirements.

Where it goes wrong. Assuming either that every related-party transaction is automatically high-risk or that ordinary-course transactions need not be identified and disclosed.

Authority. SA 550; section 7

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

Scenario. The Head of Internal Audit reports directly to the Finance Manager, who controls the departments being examined under statutory audit. Internal auditors are technically qualified and have considerable experience. Which conclusion is appropriate?

The Head of Internal Audit reports directly to the Finance Manager, who controls the departments being examined under statutory audit. Internal auditors are technically qualified and have considerable experience. Which conclusion is appropriate?

1. The external auditor may rely extensively on internal audit work because competence is the most important factor and reporting relationships are secondary.
2. The external auditor may use the work without modification because professional qualifications remove the possibility of management influence.
3. The external auditor shall not use the function's work if its organisational status and relevant policies do not adequately support internal auditor objectivity. (correct answer)
4. The external auditor may accept internal audit work provided that the Finance Manager signs a statement confirming its accuracy.

Answer: C — The external auditor shall not use the function's work if its organisational status and relevant policies do not adequately support internal auditor objectivity.

Explanation. SA 610, sections 8.5 to 8.7 of the ICAI Study Material, requires evaluation of the objectivity, competence and systematic and disciplined approach of the internal audit function. Objectivity is affected where management can influence the scope, findings or reporting of internal audit. A high level of competence cannot compensate for inadequate organisational support for objectivity. Option a is therefore incorrect because technical qualifications do not neutralise management influence over the audit function.

Where it goes wrong. Treating competence as a substitute for objectivity when determining whether internal audit work can be used.

Authority. SA 610

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

Scenario. The external auditor plans to use internal audit work relating to routine purchase approvals and payroll processing. Which arrangement is most appropriate for coordinating the two functions?

The external auditor plans to use internal audit work relating to routine purchase approvals and payroll processing. Which arrangement is most appropriate for coordinating the two functions?

1. Allow internal audit to determine its own coverage and sample size without discussing the external auditor's audit strategy or materiality.
2. Discuss timing, nature and extent of work, materiality, selection methods, documentation and reporting, and perform sufficient procedures on the work intended for use. (correct answer)
3. Accept the internal audit department's annual report as sufficient evidence without reading the relevant detailed findings or working papers.
4. Ask management to certify that internal audit has completed the planned procedures and transfer responsibility for evaluating their results.

Answer: B — Discuss timing, nature and extent of work, materiality, selection methods, documentation and reporting, and perform sufficient procedures on the work intended for use.

Explanation. SA 610, section 8.10, requires the external auditor to discuss planned use with the internal audit function, read relevant reports and perform sufficient procedures on the body of work intended for use. Coordination may cover timing, nature and extent of coverage, materiality, selection methods, sample sizes, documentation and review procedures. Option c is insufficient because an annual summary does not establish the adequacy or reliability of the specific procedures the external auditor proposes to use.

Where it goes wrong. Confusing coordination with automatic reliance on an internal audit summary without examining the underlying work.

Authority. SA 610; section 8

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

Scenario. An external auditor plans to obtain direct assistance from internal auditors for several audit procedures. Which proposed assignment is not prohibited merely because it involves direct assistance, assuming legal permission, adequate competence and objectivity, and appropriate supervision?

An external auditor plans to obtain direct assistance from internal auditors for several audit procedures. Which proposed assignment is not prohibited merely because it involves direct assistance, assuming legal permission, adequate competence and objectivity, and appropriate supervision?

1. Observing specified routine inventory-count procedures and performing test counts under the external auditor's direction, supervision and review. (correct answer)
2. Determining the appropriate impairment assumptions for a highly material asset subject to significant management judgment and high valuation risk.
3. Evaluating a complex revenue-recognition judgment involving unusual contracts that the internal audit function has already reported to the Audit Committee.
4. Making the external auditor's final decision about reliance on the internal audit function and the extent of work required for the audit.

Answer: A — Observing specified routine inventory-count procedures and performing test counts under the external auditor's direction, supervision and review.

Explanation. SA 610, section 8.11, permits appropriately controlled direct assistance where legal or regulatory requirements allow it and the internal auditor's competence and objectivity have been assessed. Routine inventory observations and test counts may be suitable assignments under the external auditor's direction, supervision and review. Significant audit judgments, higher assessed risks requiring more than limited judgment, previously reported internal audit work and decisions about using internal audit are prohibited areas. Options b, c and d therefore fall outside permissible direct assistance.

Where it goes wrong. Assuming that internal auditors can perform any audit procedure under supervision, including significant judgments and decisions reserved for the external auditor.

Authority. SA 610; section 8