Audit of Items of Financial Statements - Test 1: answer key

Question 1 · 2 marks · Chapter 5: Audit of Items of Financial Statements · medium

Scenario. M/s Sharma & Associates have been appointed statutory auditors of Alpha Infotech Ltd, an unlisted public company engaged in developing enterprise software. During the financial year 2026-27, the company undertook a preferential allotment of 10 lakh equity shares having a face value of Rs. 10 each at a premium of Rs. 5 per share. The authorised share capital before the allotment was Rs. 12 crore, while the examined under statutory audit opening issued and fully paid-up capital stood at Rs. 9 crore. The board and shareholders had approved the issue, and management provided copies of the relevant resolutions and PAS-3 filed with the Registrar of Companies. The allotment register indicates that the entire issue was completed. However, the call register reveals that the final call of Rs. 5 per share remains unpaid on 1.2 lakh shares. The general ledger records the full issued capital of Rs. 10 crore with calls in arrears of Rs. 6 lakh. Interestingly, the electronic share register marks every shareholder as fully paid. The finance controller has administrator access to the share-register application and can modify payment status without an independent approval or an accessible audit trail. The company also transferred Rs. 60 lakh from its Securities Premium Account towards an interim dividend, claiming that securities premium represents shareholders' funds. Another portion of the preferential allotment proceeds was advanced to a promoter-associated entity, although the offer documents specified expansion of the company's development centre as the purpose of raising funds. A bank confirmation obtained independently by the auditors also differs from the balance appearing in the company's special bank account reconciliation. The CFO has requested that the audit team rely on management representations because the original transaction vouchers are temporarily unavailable. The engagement partner must determine the appropriate audit response, statutory reporting implications and presentation of share capital.

Which audit approach would provide the most appropriate evidence regarding the authorised, issued and paid-up share capital of Alpha Infotech Ltd?

1. Accept the CFO's representation and agree the closing share capital directly with the trial balance.
2. Examine the MOA, verify the allotment resolutions and PAS-3, reconcile the register with bank receipts and call records, and independently investigate the system discrepancy. (correct answer)
3. Verify the number of shares only from the annual return and assume the shares recorded as allotted are fully paid.
4. Obtain a certificate from the company's internal auditor and use it instead of independently checking the allotment records.

Answer: B — Examine the MOA, verify the allotment resolutions and PAS-3, reconcile the register with bank receipts and call records, and independently investigate the system discrepancy.

Explanation. The auditor should verify authorised capital by examining the Memorandum of Association and examine the relevant resolutions, allotment records and statutory filings to establish valid changes in capital. The closing issued and paid-up amounts should be reconciled with the examined under statutory audit opening balances and current-year transactions. The calls in arrears must also be substantiated separately. SA 500, paragraphs 6 and 7, requires sufficient appropriate evidence rather than reliance on management assertions. The other options improperly substitute internal or management-generated evidence for independent verification.

Where it goes wrong. Confusing issued capital with fully paid-up capital and assuming that a ledger balance or management representation establishes the actual payment status.

Authority. SA 500

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

Considering the preferential allotment and subsequent diversion of proceeds, which reporting consideration is specifically required under CARO 2020?

1. Report only whether the allotment was approved by the board, without examining utilisation of proceeds.
2. Report only the number of shares allotted and the amount of premium received under Schedule III.
3. Report the diversion exclusively under the fixed-asset clause because the funds were intended for expansion.
4. Examine compliance with Sections 42 and 62 and whether the funds raised were used for their stated purposes; report the amount involved and nature of non-compliance if requirements are not met. (correct answer)

Answer: D — Examine compliance with Sections 42 and 62 and whether the funds raised were used for their stated purposes; report the amount involved and nature of non-compliance if requirements are not met.

Explanation. Paragraph 3(x)(b) of CARO 2020 requires the auditor to examine whether preferential allotment or private placement of shares or convertible debentures during the year complies with Sections 42 and 62 of the Companies Act, 2013. It also requires examination of whether the funds raised have been used for the purposes for which they were raised. If not, the auditor must report details of the amount involved and nature of non-compliance. The other options incorrectly restrict the reporting requirement to approvals, capital disclosure or asset acquisition.

Where it goes wrong. Assuming CARO 2020 examines only the legality of allotment and does not require examination of the subsequent utilisation of the proceeds.

Authority. CARO 2020

Question 3 · 2 marks · Chapter 5: Audit of Items of Financial Statements · medium

How should the audit team deal with the Rs. 60 lakh transferred from the Securities Premium Account towards an interim dividend?

1. Require reversal of the impermissible utilisation because payment of dividends is not an authorised application under Section 52, and evaluate the resulting misstatement. (correct answer)
2. Accept the utilisation because securities premium is a component of shareholders' funds and may be distributed as dividends.
3. Accept the utilisation provided the board has passed a resolution and the company has sufficient cash balances.
4. Reclassify the amount as a preliminary expense because such expenses can be written off against securities premium.

Answer: A — Require reversal of the impermissible utilisation because payment of dividends is not an authorised application under Section 52, and evaluate the resulting misstatement.

Explanation. Section 52(2) of the Companies Act, 2013 specifies the purposes for which the Securities Premium Account may be applied. These include fully paid bonus shares, writing off preliminary expenses, specified issue expenses, providing for redemption premium and buyback under Section 68. Payment of dividends is not included. The auditor should verify the underlying transaction, require an appropriate correction and consider materiality and reporting consequences if management refuses. Board approval or availability of cash cannot convert a prohibited application into a permitted one.

Where it goes wrong. Treating securities premium as an unrestricted revenue reserve merely because it appears within shareholders' equity.

Authority. Section 52; Section 68

Question 4 · 2 marks · Chapter 5: Audit of Items of Financial Statements · hard

Which presentation is required for the unpaid calls identified by the audit team?

1. Exclude the unpaid amount from issued share capital and disclose only the number of shares forfeited during the year.
2. Present the entire issued capital as fully paid and disclose the unpaid calls only in the directors' report.
3. Disclose subscribed and fully paid shares separately from subscribed but not fully paid shares, and disclose calls unpaid, including the aggregate amount unpaid by directors and officers. (correct answer)
4. Transfer the unpaid calls to securities premium and disclose the amount only when the shareholders are asked to pay.

Answer: C — Disclose subscribed and fully paid shares separately from subscribed but not fully paid shares, and disclose calls unpaid, including the aggregate amount unpaid by directors and officers.

Explanation. Schedule III, Part I, requires disclosure of the number of shares issued, subscribed and fully paid and subscribed but not fully paid. It also specifically requires disclosure of calls unpaid, showing the aggregate value of calls unpaid by directors and officers. The auditor must therefore reconcile the call register, shareholders' balances and general ledger before accepting the presentation. The alternatives either omit the prescribed details, misclassify the unpaid amount or incorrectly treat calls in arrears as securities premium.

Where it goes wrong. Overlooking the separate disclosure of calls unpaid by directors and officers or treating unpaid calls as if the shares were fully paid.

Authority. Schedule III; Guidance Note on Audit of Financial Statement Items

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

Scenario. M/s K. Mehta & Co. are conducting the statutory audit of Zenith Manufacturing Pvt Ltd, a large industrial equipment manufacturer. The company has an existing paid-up equity share capital of Rs. 100 crore, free reserves of Rs. 35 crore and a Securities Premium Account balance of Rs. 5 crore. During the year, the company completed a buyback of 20 lakh fully paid-up equity shares having a nominal value of Rs. 10 each at a buyback price of Rs. 90 per share. The aggregate consideration of Rs. 18 crore was funded partly from free reserves and partly from securities premium. The Articles of Association contain a buyback authorisation, and shareholders passed a special resolution. The company represents that the transaction was within the permissible statutory limits. Its working papers show post-buyback outstanding debt of Rs. 180 crore and adjusted paid-up equity capital and free reserves of Rs. 117 crore. Management therefore claims that the prescribed debt-to-capital and free-reserves ratio has been satisfied. The audit team discovers that, although the buyback was completed, the securities certificates were physically destroyed on the eleventh day after completion. The company filed its return of buyback with the Registrar of Companies on the twenty-fifth day. The prescribed buyback register has not been updated consistently with the transaction records. The CFO proposes transferring Rs. 18 crore to Capital Redemption Reserve, arguing that the entire cash consideration represents capital extinguished. The company has also experienced a severe reduction in operating cash flows, delayed collection from major customers and withdrawal of an important working-capital facility. Its cash-flow forecasts indicate a possible funding shortfall within the next twelve months. Management insists that the buyback demonstrates financial confidence and that the ratio under Section 68 conclusively establishes solvency. The engagement team must evaluate the statutory requirements, reserve accounting, subsequent compliance and the implications of the financial difficulties for the audit opinion.

The buyback consideration represents approximately 13.33% of the aggregate of paid-up capital and free reserves existing before the transaction. Assuming the other statutory conditions are satisfied, which approval is required under Section 68(2)?

1. A special resolution of shareholders is required because the proposed buyback exceeds the 10% threshold for board approval. (correct answer)
2. A board resolution alone is sufficient because every buyback involving fully paid shares can be approved by directors.
3. A resolution of the audit committee is sufficient if the buyback is funded from free reserves.
4. A special resolution of the Tribunal is required because the buyback exceeds 10% of paid-up capital.

Answer: A — A special resolution of shareholders is required because the proposed buyback exceeds the 10% threshold for board approval.

Explanation. Section 68(2)(b) permits buyback with a board resolution where the buyback does not exceed 10% of the total paid-up equity capital and free reserves, subject to the statutory conditions. Where the proposed buyback exceeds that threshold, but remains within the overall permissible limit, authorisation by a special resolution passed at a general meeting is required. The percentage must not be confused with the separate 25% ceiling under Section 68(2). Approval by an audit committee or Tribunal is not a substitute for the prescribed shareholder approval.

Where it goes wrong. Confusing the 10% board-approval threshold with the separate 25% statutory buyback ceiling.

Authority. Section 68

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

What amount should the company transfer to the Capital Redemption Reserve in respect of the buyback, assuming the buyback is funded from free reserves and securities premium?

1. Rs. 18 crore, equal to the entire cash consideration paid to shareholders.
2. Rs. 16 crore, equal to the buyback premium paid over nominal value.
3. Rs. 2 crore, equal to the nominal value of the shares purchased. (correct answer)
4. Rs. 5 crore, equal to the balance of the Securities Premium Account before the transaction.

Answer: C — Rs. 2 crore, equal to the nominal value of the shares purchased.

Explanation. Section 69(1) of the Companies Act, 2013 requires a company purchasing its own shares out of free reserves or the Securities Premium Account to transfer a sum equal to the nominal value of the shares purchased to the Capital Redemption Reserve Account. Here, 20 lakh shares of Rs. 10 each have a nominal value of Rs. 2 crore. The transfer is not based on the cash consideration or the buyback premium. The auditor should verify the funding source, nominal amount extinguished and corresponding reserve transfer.

Where it goes wrong. Calculating the Capital Redemption Reserve transfer using the buyback consideration instead of the nominal value of shares purchased.

Authority. Section 69

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

The post-buyback debt-to-paid-up-capital-and-free-reserves ratio is approximately 1.54:1. Nevertheless, the forecasts indicate a significant funding shortfall within twelve months. What should the auditor primarily do?

1. Accept management's solvency conclusion because the statutory debt ratio is below 2:1.
2. Disregard the forecasts because the buyback has already been authorised by shareholders.
3. Treat the buyback as sufficient evidence that the company can continue operating without additional examination.
4. Evaluate management's going concern assessment, examine cash-flow forecasts and financing plans, test the underlying assumptions and consider the adequacy of related disclosures. (correct answer)

Answer: D — Evaluate management's going concern assessment, examine cash-flow forecasts and financing plans, test the underlying assumptions and consider the adequacy of related disclosures.

Explanation. SA 570, particularly paragraphs 19 and 21, requires the auditor to evaluate management's assessment of the entity's ability to continue as a going concern and perform additional procedures when events or conditions may cast significant doubt on that ability. Compliance with the buyback debt ratio does not establish that the entity has sufficient liquidity or will meet its obligations. The auditor should critically examine cash-flow projections, available facilities, assumptions and management's mitigation plans, and assess whether adequate disclosures have been made.

Where it goes wrong. Treating compliance with a statutory buyback ratio as conclusive evidence of going concern and ignoring adverse operating and liquidity indicators.

Authority. SA 570

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

The company destroyed the bought-back securities on the eleventh day after completion and filed its return of buyback on the twenty-fifth day. Which conclusion is correct?

1. Both actions comply because the Companies Act provides thirty days for destruction and filing of the return.
2. Destruction was delayed beyond the prescribed seven-day period, although the return was filed within the prescribed thirty-day period. (correct answer)
3. The return is delayed because it must be filed within seven days, whereas destruction may occur within thirty days.
4. Neither requirement applies where the buyback has been approved through a special resolution.

Answer: B — Destruction was delayed beyond the prescribed seven-day period, although the return was filed within the prescribed thirty-day period.

Explanation. Section 68(7) of the Companies Act, 2013 requires the company to extinguish and physically destroy securities bought back within seven days after completion of the buyback. Section 68(10) requires filing of the prescribed return of buyback with the Registrar and, where applicable, the securities regulator within thirty days of completion. Consequently, destruction on the eleventh day is a statutory non-compliance, whereas filing on the twenty-fifth day satisfies the stated return-filing timeline. Shareholder approval does not waive these post-buyback obligations.

Where it goes wrong. Interchanging the seven-day extinguishment requirement with the thirty-day return-filing requirement.

Authority. Section 68

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

Scenario. M/s V. Raman & LLP are the statutory auditors of Suryodaya Sugar Mills Ltd, an unlisted public company developing specialised sugar-processing technology. During 2026-27, the company issued 2.5 lakh equity shares at a discount to certain employees and directors who had developed a proprietary fermentation process and contributed valuable intellectual property. The shares belong to a class already issued by the company. Management supplied only a board resolution approving the allotment; the resolution does not record the current market price, the precise consideration or the classes of employees and directors receiving the shares. No shareholders' special resolution has been provided. The company also operated an Employee Stock Option Scheme. The CFO granted options to certain senior employees with a proposed vesting period of nine months. A grant to one identified employee represented 3% of the company's issued capital. Further options were granted to employees of its holding company. Management has not produced separate shareholder approvals for these grants. Entries in the employee stock option register, maintained in Form SH-6, are incomplete, and some options shown as exercised in the payroll system have not been reconciled with the allotment records. A further independence concern emerges when the engagement partner discloses that his wife acquired shares of Suryodaya Sugar Mills Ltd having a face value of Rs. 1.40 lakh, forty-five days before the disclosure to the audit firm. The partner believes the holding is immaterial and proposes continuing without corrective action. Management has also restricted the audit team from accessing the complete electronic share register and the original independent valuation reports. The system administrator can alter grant dates and employee eligibility data without retaining an adequate audit trail. The finance director insists that the audit should be completed using board extracts and written representations alone, as the company is preparing for a major financing transaction. The engagement team must evaluate the legality of the issues, the ESOP records, independence and the consequences of insufficient audit evidence.

Which finding most directly establishes non-compliance with the statutory conditions governing the sweat equity issue?

1. The shares were issued to employees who contributed intellectual property instead of receiving cash remuneration.
2. The company issued shares belonging to a class already issued, but the shares rank pari passu with existing equity shares.
3. The issue was supported only by a board resolution instead of the special resolution required under Section 54. (correct answer)
4. The employees received shares at a discount, although the shares were allotted for providing technological expertise.

Answer: C — The issue was supported only by a board resolution instead of the special resolution required under Section 54.

Explanation. Section 54(1) of the Companies Act, 2013 permits sweat equity shares of a class already issued, provided the statutory conditions are fulfilled. These include authorisation through a special resolution specifying the number of shares, current market price, consideration, if any, and the relevant classes of directors or employees. Shares may be issued at a discount or for non-cash consideration relating to know-how, intellectual property rights or value additions. Therefore, the absence of the required special resolution is the decisive defect, not the discount or nature of consideration.

Where it goes wrong. Assuming that a board resolution alone is sufficient because sweat equity is an employee compensation arrangement.

Authority. Section 54

Question 10 · 2 marks · Chapter 5: Audit of Items of Financial Statements · hard

Which conclusion should the auditor reach regarding the ESOP grants made by Suryodaya Sugar Mills Ltd?

1. The nine-month vesting period violates the prescribed minimum one-year period; separate resolutions are also required in specified cases, and option holders have no voting or dividend rights before shares are issued. (correct answer)
2. The nine-month vesting period is valid where the board approves the grant, and option holders obtain voting rights immediately upon vesting.
3. A single ordinary resolution is sufficient for all grants, and option holders become entitled to dividends from the date of grant.
4. The minimum vesting period applies only to listed companies, and maintenance of Form SH-6 is optional for an unlisted company.

Answer: A — The nine-month vesting period violates the prescribed minimum one-year period; separate resolutions are also required in specified cases, and option holders have no voting or dividend rights before shares are issued.

Explanation. Rule 12 of the Companies (Share Capital and Debentures) Rules, 2014 prescribes a minimum one-year period between grant and vesting of ESOPs, subject to the stated exception for replacement options following a merger or amalgamation. Rule 12(4) requires separate shareholder resolutions for specified grants, including grants to holding or subsidiary company employees and identified employees receiving options of at least 1% of issued capital. Rule 12 also provides that option holders have no voting or dividend rights until shares are issued on exercise and requires maintenance of Form SH-6.

Where it goes wrong. Confusing the grant or vesting of an option with the actual issue of equity shares and overlooking the separate-approval requirements.

Authority. Schedule III; Guidance Note on Audit of Financial Statement Items

Question 11 · 2 marks · Chapter 5: Audit of Items of Financial Statements · medium

What is the appropriate course of action regarding the engagement partner's wife's shareholding of Rs. 1.40 lakh face value, acquired forty-five days before disclosure?

1. Continue the audit without action because the partner's spouse is not a director or employee of the audit client.
2. Ensure corrective action to bring the relative's holding within the prescribed limit within sixty days from acquisition, and evaluate the auditor's eligibility and independence consequences if not rectified. (correct answer)
3. Obtain a written representation from the CFO stating that the investment is immaterial and retain the partner as engagement partner.
4. Transfer the investment to another family member while retaining the same economic interest and treat the matter as resolved.

Answer: B — Ensure corrective action to bring the relative's holding within the prescribed limit within sixty days from acquisition, and evaluate the auditor's eligibility and independence consequences if not rectified.

Explanation. Section 141(3)(d)(i) of the Companies Act, 2013, read with Rule 10 of the Companies (Audit and Auditors) Rules, 2014, restricts the holding of securities by an auditor's relative above the prescribed face-value threshold of Rs. 1 lakh. Where the relative acquires an excess holding, corrective action must be taken within sixty days of acquisition. Section 141(4) addresses the consequences of incurring disqualification after appointment. ICAI Code of Ethics Section 510 also requires evaluation of financial-interest threats to independence. Management representation does not cure the statutory restriction.

Where it goes wrong. Treating a relative's financial interest as automatically immaterial or assuming that the sixty-day corrective-action period begins when the auditor discovers the investment.

Authority. ICAI Code of Ethics; Section 141; Section 510

Question 12 · 2 marks · Chapter 5: Audit of Items of Financial Statements · hard

Assume that, after performing feasible alternative procedures, the auditor still cannot obtain sufficient appropriate evidence regarding a material but non-pervasive portion of the share-based compensation and equity disclosures. Management refuses further access. What is the appropriate reporting consequence?

1. Issue an unmodified opinion because written representations are sufficient evidence when management restricts access.
2. Issue an adverse opinion because every limitation on access necessarily indicates fraud.
3. Issue a disclaimer of opinion because every missing share register creates a pervasive limitation.
4. Consider a qualified opinion due to inability to obtain sufficient appropriate audit evidence, since the possible effects are material but not pervasive. (correct answer)

Answer: D — Consider a qualified opinion due to inability to obtain sufficient appropriate audit evidence, since the possible effects are material but not pervasive.

Explanation. SA 500 requires sufficient appropriate audit evidence to support the auditor's conclusions. Where management restricts access, the auditor should attempt appropriate alternative procedures and evaluate whether the evidence obtained is adequate. Under SA 705, paragraph 7(b), a qualified opinion is appropriate when the auditor cannot obtain sufficient appropriate evidence and the possible effects of undetected misstatements could be material but not pervasive. A disclaimer is appropriate when the possible effects are material and pervasive. Written representations alone do not replace necessary substantive evidence.

Where it goes wrong. Automatically issuing a disclaimer or accepting written representations without assessing the materiality and pervasiveness of the evidence limitation.

Authority. SA 500; SA 705

Question 13 · 2 marks · Chapter 5: Audit of Items of Financial Statements · medium

Scenario. During an audit, the auditor finds that a company increased its authorised share capital by altering the capital clause of its MOA. The Articles permit such an alteration. Which evidence should the auditor primarily examine to establish the validity of the increase?

During an audit, the auditor finds that a company increased its authorised share capital by altering the capital clause of its MOA. The Articles permit such an alteration. Which evidence should the auditor primarily examine to establish the validity of the increase?

1. A special resolution of shareholders and an approval letter from the Tribunal.
2. Only a board resolution, since the alteration of authorised capital is an administrative matter.
3. An ordinary resolution passed by shareholders, the altered MOA and evidence of the prescribed filing with the Registrar of Companies. (correct answer)
4. An ordinary resolution of creditors together with confirmation from the company's bankers.

Answer: C — An ordinary resolution passed by shareholders, the altered MOA and evidence of the prescribed filing with the Registrar of Companies.

Explanation. Section 61(1)(a) of the Companies Act, 2013 permits a company limited by shares, if authorised by its Articles, to alter its MOA in general meeting to increase its authorised share capital. The alteration requires an ordinary resolution rather than a special resolution. The auditor should examine the shareholders' resolution, the amended capital clause and the prescribed filing, including Form SH-7. The board cannot independently alter the authorised capital merely by passing a board resolution. Tribunal approval is not the normal requirement for this alteration.

Where it goes wrong. Confusing alteration of authorised capital under Section 61 with transactions that specifically require special resolutions or Tribunal approval.

Authority. Section 61

Question 14 · 2 marks · Chapter 5: Audit of Items of Financial Statements · hard

Scenario. A company issues equity shares at a discount to a creditor under an ordinary bilateral debt settlement agreement. The arrangement is not part of a statutory resolution plan or a debt restructuring scheme complying with applicable RBI directions. The amount raised through the issue is Rs. 8 lakh. Which consequence follows under Section 53?

A company issues equity shares at a discount to a creditor under an ordinary bilateral debt settlement agreement. The arrangement is not part of a statutory resolution plan or a debt restructuring scheme complying with applicable RBI directions. The amount raised through the issue is Rs. 8 lakh. Which consequence follows under Section 53?

1. The shares are void, and the company and every officer in default may incur a penalty up to Rs. 5 lakh, being the lesser statutory amount, with refund of monies carrying 12% annual interest. (correct answer)
2. The shares remain valid, provided the creditor accepts the reduced issue price and the board approves the settlement.
3. The shares are valid if the creditor agrees not to claim interest, although the company must transfer the discount to securities premium.
4. The company must only refund the discount portion without interest, while the shares remain valid until cancellation by shareholders.

Answer: A — The shares are void, and the company and every officer in default may incur a penalty up to Rs. 5 lakh, being the lesser statutory amount, with refund of monies carrying 12% annual interest.

Explanation. Section 53(1) generally prohibits issue of shares at a discount, except for sweat equity under Section 54 and the specific creditor debt-conversion exception under Section 53(2A). The latter requires conversion under a statutory resolution plan or debt restructuring scheme in accordance with applicable RBI guidelines or directions. An ordinary bilateral settlement does not qualify. Under Section 53(2), the discounted shares are void; under Section 53(3), the company and every officer in default may face the prescribed penalty and the company must refund all monies with interest at 12% per annum from the date of issue.

Where it goes wrong. Assuming every conversion of a creditor's debt into shares qualifies for the statutory discount exception.

Authority. Section 53; Section 54

Question 15 · 2 marks · Chapter 5: Audit of Items of Financial Statements · medium

Scenario. A company has a substantial Securities Premium Account balance. Which proposed utilisation would be specifically permissible under Section 52(2) of the Companies Act, 2013?

A company has a substantial Securities Premium Account balance. Which proposed utilisation would be specifically permissible under Section 52(2) of the Companies Act, 2013?

1. Payment of an interim dividend to equity shareholders in accordance with the board recommendation.
2. Settlement of an operating expense relating to routine employee salaries and wages.
3. Creation of an unrestricted general reserve for distribution in future financial years.
4. Provision for the premium payable on redemption of redeemable preference shares or debentures. (correct answer)

Answer: D — Provision for the premium payable on redemption of redeemable preference shares or debentures.

Explanation. Section 52(2)(d) expressly permits application of the Securities Premium Account towards providing for the premium payable on redemption of redeemable preference shares or debentures. The statutory purposes also include fully paid bonus shares, specified preliminary and issue expenses and buyback under Section 68. Payment of dividends, routine operating expenditure and creation of an unrestricted distributable general reserve are not authorised purposes. The auditor should inspect the redemption terms, approval, accounting entries and actual application to verify that the utilisation conforms to Section 52.

Where it goes wrong. Assuming that any expense or distribution approved by the board can be charged to securities premium.

Authority. Section 52; Section 68

Question 16 · 2 marks · Chapter 5: Audit of Items of Financial Statements · hard

Scenario. A company proposes to utilise its Capital Redemption Reserve balance to write off accumulated losses and preliminary expenses. The directors argue that the reserve was originally created from profits and is therefore freely available. Which conclusion is correct?

A company proposes to utilise its Capital Redemption Reserve balance to write off accumulated losses and preliminary expenses. The directors argue that the reserve was originally created from profits and is therefore freely available. Which conclusion is correct?

1. The utilisation is permissible because CRR is a revenue reserve once sufficient profits have been earned.
2. The utilisation is not permissible because CRR may be applied only towards paying up unissued shares as fully paid bonus shares to members. (correct answer)
3. The utilisation is permissible if approved through an ordinary resolution and disclosed in the directors' report.
4. The utilisation is permissible for preliminary expenses but not for accumulated business losses.

Answer: B — The utilisation is not permissible because CRR may be applied only towards paying up unissued shares as fully paid bonus shares to members.

Explanation. Section 69(2) of the Companies Act, 2013 restricts the application of the Capital Redemption Reserve Account to paying up unissued shares of the company to be issued to members as fully paid bonus shares. It is not a free reserve available for ordinary business purposes or distribution. Consequently, writing off accumulated losses or preliminary expenses against CRR is not permitted. The fact that a transfer to CRR may originate from profits does not remove the statutory restriction on its subsequent utilisation.

Where it goes wrong. Treating CRR as an ordinary revenue reserve merely because it may be created through a transfer from profits.

Authority. Section 69

Question 17 · 2 marks · Chapter 5: Audit of Items of Financial Statements · medium

Scenario. A company is assessing its available free reserves before undertaking a proposed buyback. Its latest examined balance sheet includes general reserve of Rs. 8 crore, surplus available for distribution of Rs. 12 crore, revaluation reserve of Rs. 6 crore and unrealised fair-value gains of Rs. 2 crore. Assuming the first two balances are otherwise available for distribution, what amount qualifies as free reserves from the information given?

A company is assessing its available free reserves before undertaking a proposed buyback. Its latest examined balance sheet includes general reserve of Rs. 8 crore, surplus available for distribution of Rs. 12 crore, revaluation reserve of Rs. 6 crore and unrealised fair-value gains of Rs. 2 crore. Assuming the first two balances are otherwise available for distribution, what amount qualifies as free reserves from the information given?

1. Rs. 28 crore, because all reserves and accumulated gains are shareholders' funds.
2. Rs. 26 crore, because only the unrealised fair-value gains must be excluded.
3. Rs. 20 crore, because revaluation reserve and unrealised fair-value gains are excluded. (correct answer)
4. Rs. 14 crore, because only general reserve and revaluation reserve qualify.

Answer: C — Rs. 20 crore, because revaluation reserve and unrealised fair-value gains are excluded.

Explanation. Section 2(43) of the Companies Act, 2013 defines free reserves as reserves available for distribution as dividend according to the latest examined balance sheet. It specifically excludes amounts representing unrealised gains, notional gains or revaluation of assets and specified changes in carrying amounts recognised in equity, including fair-value measurement adjustments. Thus, the general reserve of Rs. 8 crore and distributable surplus of Rs. 12 crore qualify on the stated assumptions, whereas the revaluation reserve and unrealised fair-value gains are excluded.

Where it goes wrong. Assuming that all balances appearing under reserves and surplus automatically qualify as free reserves for buyback calculations.

Authority. Section 2

Question 18 · 2 marks · Chapter 5: Audit of Items of Financial Statements · hard

Scenario. During verification of share application money, the auditor obtains a bank confirmation showing a balance different from the company's reconciliation. Management offers to prepare and dispatch another confirmation directly to the bank and asks the bank to send its response to the finance department. What should the auditor do?

During verification of share application money, the auditor obtains a bank confirmation showing a balance different from the company's reconciliation. Management offers to prepare and dispatch another confirmation directly to the bank and asks the bank to send its response to the finance department. What should the auditor do?

1. Maintain control over the external confirmation process, independently dispatch the request, receive the response directly and investigate the discrepancy through supporting evidence. (correct answer)
2. Accept management's proposal because bank confirmations are reliable regardless of who prepares and receives them.
3. Use the company's reconciliation as conclusive evidence and ignore the bank's response if the difference is explained verbally.
4. Accept a management representation confirming the balance and discontinue further procedures concerning the bank account.

Answer: A — Maintain control over the external confirmation process, independently dispatch the request, receive the response directly and investigate the discrepancy through supporting evidence.

Explanation. SA 505, particularly paragraphs 7 to 9, requires the auditor to maintain control over external confirmation requests and consider their design, dispatch and receipt. The auditor should independently select the confirming party, address and send the request, and receive the response directly. A difference between the confirmation and the client's records must be investigated under SA 505 paragraph 12, including examination of supporting documents for reconciling items. Allowing management to control dispatch and receipt weakens the reliability of the evidence.

Where it goes wrong. Confusing the independence of the confirming bank with independence of the confirmation process itself.

Authority. SA 505

Question 19 · 2 marks · Chapter 5: Audit of Items of Financial Statements · medium

Scenario. While reviewing the share capital note, the auditor discovers that a shareholder owns 6.8% of the company's equity shares. The financial statements disclose the names and holdings of promoters but omit the shareholder's individual holding. What is the appropriate conclusion under Schedule III, Part I?

While reviewing the share capital note, the auditor discovers that a shareholder owns 6.8% of the company's equity shares. The financial statements disclose the names and holdings of promoters but omit the shareholder's individual holding. What is the appropriate conclusion under Schedule III, Part I?

1. The omission is acceptable because only shareholders holding more than 10% require individual disclosure.
2. The omission is acceptable if the shareholder is not a director or key managerial person.
3. Individual disclosure is necessary only when the shares are partly paid-up or subject to transfer restrictions.
4. The company must disclose the number of shares held by each shareholder holding more than 5% of shares, separately for the relevant class. (correct answer)

Answer: D — The company must disclose the number of shares held by each shareholder holding more than 5% of shares, separately for the relevant class.

Explanation. Schedule III, Part I, requires disclosure of shares in the company held by each shareholder holding more than 5% shares, specifying the number of shares held. The threshold is not restricted to promoters, directors or key managerial personnel. The auditor should verify the shareholder register, class-wise ownership and completeness of the shareholding disclosures. A 6.8% holding therefore crosses the prescribed threshold even when the shareholder has no managerial position and the shares are fully paid.

Where it goes wrong. Confusing the 5% shareholder disclosure threshold with promoter disclosures or assuming that only directors and major controlling shareholders are covered.

Authority. Schedule III; Guidance Note on Audit of Financial Statement Items

Question 20 · 2 marks · Chapter 5: Audit of Items of Financial Statements · hard

Scenario. A company reports calls in arrears of Rs. 45 lakh. The call register contains shareholder-wise outstanding amounts, but the amount recorded in the general ledger is lower by Rs. 8 lakh. Management explains that several shareholders made payments shortly after year-end. Which procedure would provide the most persuasive evidence of the closing balance?

A company reports calls in arrears of Rs. 45 lakh. The call register contains shareholder-wise outstanding amounts, but the amount recorded in the general ledger is lower by Rs. 8 lakh. Management explains that several shareholders made payments shortly after year-end. Which procedure would provide the most persuasive evidence of the closing balance?

1. Accept management's explanation and reduce calls in arrears by Rs. 8 lakh because subsequent receipts automatically relate to the reporting date.
2. Reconcile the shareholder-wise call register and call notices with the general ledger, trace receipts to bank statements, examine subsequent collections and independently investigate the difference. (correct answer)
3. Verify only the total number of shareholders because a difference in calls in arrears cannot affect paid-up capital.
4. Obtain a certificate from the company secretary confirming the outstanding calls and avoid examining individual shareholder balances.

Answer: B — Reconcile the shareholder-wise call register and call notices with the general ledger, trace receipts to bank statements, examine subsequent collections and independently investigate the difference.

Explanation. The auditor must establish the completeness, existence and correct valuation of the reported paid-up capital and calls in arrears. This involves reconciling the shareholder-wise register and call notices with the ledger, examining bank receipts and checking whether subsequent payments relate to balances genuinely outstanding at the reporting date. Differences must be investigated rather than automatically adjusted through subsequent receipts. SA 500 requires sufficient appropriate audit evidence, while Schedule III requires proper disclosure of calls unpaid, including amounts attributable to directors and officers.

Where it goes wrong. Treating post-year-end collections as automatic proof that the corresponding calls were paid before the reporting date.

Authority. SA 500

Question 21 · 2 marks · Chapter 5: Audit of Items of Financial Statements · medium

Scenario. A company proposes issuing equity shares at a discount to an external technology consultant who has supplied specialised know-how. The consultant is neither an employee nor a director. Management intends to classify the issue as sweat equity under Section 54. Which assessment is correct?

A company proposes issuing equity shares at a discount to an external technology consultant who has supplied specialised know-how. The consultant is neither an employee nor a director. Management intends to classify the issue as sweat equity under Section 54. Which assessment is correct?

1. The issue does not qualify as sweat equity under Section 54 because the recipient must be an employee or director; the general prohibition on discounted shares otherwise applies. (correct answer)
2. The issue qualifies because any person supplying technical know-how may receive sweat equity at a discount.
3. The issue qualifies if the consultant accepts non-cash consideration and the board approves the number of shares.
4. The issue qualifies whenever the shares belong to a class already issued, irrespective of the recipient's status.

Answer: A — The issue does not qualify as sweat equity under Section 54 because the recipient must be an employee or director; the general prohibition on discounted shares otherwise applies.

Explanation. Section 54 of the Companies Act, 2013 defines sweat equity shares as equity shares issued to employees or directors at a discount or for consideration other than cash for providing know-how, intellectual property rights or value additions. The recipient must therefore belong to the statutory category. The fact that an external consultant supplies valuable technical knowledge does not by itself make the consultant eligible for sweat equity. Unless another statutory exception applies, an issue at discount would attract the prohibition under Section 53.

Where it goes wrong. Focusing only on the nature of the consideration and ignoring the statutory eligibility of the recipient.

Authority. Section 53; Section 54

Question 22 · 2 marks · Chapter 5: Audit of Items of Financial Statements · hard

Scenario. During the audit of an unlisted public company, the auditor identifies a preferential allotment of convertible debentures made during the year. The allotment complied with the relevant approvals, but a portion of the proceeds was invested in an activity different from the purpose specified in the offer documentation. Which CARO 2020 reporting requirement is most directly relevant?

During the audit of an unlisted public company, the auditor identifies a preferential allotment of convertible debentures made during the year. The allotment complied with the relevant approvals, but a portion of the proceeds was invested in an activity different from the purpose specified in the offer documentation. Which CARO 2020 reporting requirement is most directly relevant?

1. Paragraph 3(i), because all proceeds raised through convertible instruments are required to be reported as property, plant and equipment.
2. Paragraph 3(v), because every preferential allotment is treated as a deposit received from public investors.
3. Paragraph 3(x)(b), requiring examination of compliance with Sections 42 and 62 and utilisation of proceeds for the stated purposes, with details of non-compliance reported. (correct answer)
4. Paragraph 3(xix), because the auditor need not examine the statutory validity of the allotment where funds have been raised.

Answer: C — Paragraph 3(x)(b), requiring examination of compliance with Sections 42 and 62 and utilisation of proceeds for the stated purposes, with details of non-compliance reported.

Explanation. CARO 2020 paragraph 3(x)(b) specifically covers preferential allotment or private placement of shares and convertible debentures, whether fully, partly or optionally convertible. The auditor must examine compliance with Sections 42 and 62 of the Companies Act, 2013 and ascertain whether the funds have been used for their intended purposes. Non-compliance must be reported with details of the amount involved and its nature. The requirement is not restricted to equity shares or to whether the original approval was properly obtained.

Where it goes wrong. Assuming that the CARO clause covers only shares and does not extend to convertible debentures or subsequent utilisation of proceeds.

Authority. CARO 2020

Question 23 · 2 marks · Chapter 5: Audit of Items of Financial Statements · medium

Scenario. A company redeems fully paid-up preference shares having a nominal value of Rs. 6 crore entirely out of profits otherwise available for dividend. No fresh issue of shares has been made specifically to finance the redemption. What reserve adjustment should the auditor verify?

A company redeems fully paid-up preference shares having a nominal value of Rs. 6 crore entirely out of profits otherwise available for dividend. No fresh issue of shares has been made specifically to finance the redemption. What reserve adjustment should the auditor verify?

1. Transfer Rs. 6 crore to securities premium because redemption from profits is equivalent to issuing shares at a premium.
2. Transfer only the premium payable on redemption to CRR because the nominal capital has already been extinguished.
3. Make no transfer because CRR is required only for buyback transactions under Section 68.
4. Transfer Rs. 6 crore, equal to the nominal value of preference shares redeemed out of profits, to Capital Redemption Reserve. (correct answer)

Answer: D — Transfer Rs. 6 crore, equal to the nominal value of preference shares redeemed out of profits, to Capital Redemption Reserve.

Explanation. Section 55(2)(d) of the Companies Act, 2013 requires transfer to the Capital Redemption Reserve Account of an amount equal to the nominal value of shares redeemed otherwise than out of proceeds of a fresh issue made for the purpose of redemption. Here, the entire Rs. 6 crore redemption is financed from profits otherwise available for dividend. Consequently, the full nominal amount must be transferred to CRR. The auditor should examine the redemption terms, source of funds, nominal value extinguished and corresponding accounting entries.

Where it goes wrong. Confusing the transfer to CRR for redemption of preference shares under Section 55 with the separate treatment of redemption premium under Section 52.

Authority. Section 55

Question 24 · 2 marks · Chapter 5: Audit of Items of Financial Statements · hard

Scenario. A company proposes financing its equity share buyback using the proceeds of a fresh equity issue completed earlier in the same financial year. Management argues that the fresh issue is a lawful source of funds under Section 68 and that the buyback will remain within the permitted percentage limits. Which conclusion should the auditor draw?

A company proposes financing its equity share buyback using the proceeds of a fresh equity issue completed earlier in the same financial year. Management argues that the fresh issue is a lawful source of funds under Section 68 and that the buyback will remain within the permitted percentage limits. Which conclusion should the auditor draw?

1. The buyback is permissible because proceeds of every fresh issue can be used to purchase any class of shares.
2. The buyback cannot be financed from proceeds of an earlier issue of the same kind of shares, notwithstanding compliance with the percentage limits. (correct answer)
3. The buyback is permissible if the shareholders pass a special resolution approving the use of the proceeds.
4. The buyback is prohibited only when the proceeds of the fresh issue are received from existing promoters.

Answer: B — The buyback cannot be financed from proceeds of an earlier issue of the same kind of shares, notwithstanding compliance with the percentage limits.

Explanation. Section 68(1) permits buyback out of free reserves, the Securities Premium Account or proceeds of an issue of shares or other specified securities. However, its proviso specifically prohibits a buyback of any kind of shares or specified securities out of the proceeds of an earlier issue of the same kind of shares or specified securities. This restriction is independent of the percentage limits and approval requirements under Section 68(2). A special resolution cannot override this statutory prohibition.

Where it goes wrong. Reading the permitted funding sources under Section 68(1) without considering the express restriction relating to proceeds from an earlier issue of the same kind.

Authority. Section 68

Question 25 · 2 marks · Chapter 5: Audit of Items of Financial Statements · medium

Scenario. At the reporting date, a company has granted ESOPs to employees, but a substantial number of options remain unexercised. The accounts department proposes including these options in issued and paid-up equity share capital because employees have already completed the grant formalities. What is the appropriate audit conclusion?

At the reporting date, a company has granted ESOPs to employees, but a substantial number of options remain unexercised. The accounts department proposes including these options in issued and paid-up equity share capital because employees have already completed the grant formalities. What is the appropriate audit conclusion?

1. Unexercised options do not constitute issued or paid-up share capital; the relevant share-based payment balance and shares reserved for issue under options should be appropriately presented and disclosed. (correct answer)
2. All granted options should be recorded as fully paid-up equity shares once the vesting conditions have been communicated to employees.
3. Options should be treated as calls in arrears because employees have not yet paid the exercise price to the company.
4. The options should be disclosed as shares bought back because the company has not yet received consideration from employees.

Answer: A — Unexercised options do not constitute issued or paid-up share capital; the relevant share-based payment balance and shares reserved for issue under options should be appropriately presented and disclosed.

Explanation. Granting an option does not itself amount to allotment or issue of an equity share. The auditor should distinguish the ESOP grant, vesting and exercise stages and verify whether shares have actually been allotted after exercise. Schedule III requires disclosure of shares reserved for issue under options and relevant commitments. The corresponding share-options-outstanding balance should also be appropriately presented under reserves and surplus, applying the applicable accounting framework. Unexercised options cannot be reported as issued or paid-up capital or as calls in arrears.

Where it goes wrong. Equating the grant or vesting of an ESOP with actual allotment of shares and recognising unexercised options as paid-up capital.

Authority. Schedule III; Guidance Note on Audit of Financial Statement Items