Audit of Items of Financial Statements - Test 2: answer key

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

Scenario. M/s Sharma & Associates are conducting the statutory audit of Trident Engineering Ltd, a listed manufacturer of industrial equipment. During 2026-27, the company obtained a secured term loan of Rs. 48 crore from National Commercial Bank against its manufacturing facility and a working capital cash-credit facility of Rs. 26 crore secured against inventories and trade receivables. The company also issued secured non-convertible debentures of Rs. 15 crore under a debenture trust deed. The audit team independently obtained a confirmation from the lending bank. The confirmation showed an outstanding term loan of Rs. 47.60 crore, whereas the general ledger reflected Rs. 44.60 crore. Management attributed the difference to an adjustment relating to a devolved letter of credit but could not produce the original supporting documents. The treasury manager requested that the auditors accept an internal reconciliation prepared by the finance department. Further examination revealed that the charge created over a newly acquired manufacturing facility on 20 January 2027 had not been registered with the Registrar of Companies. The CFO stated that the bank was aware of the security and therefore registration was unnecessary. The term loan agreement requires the company to maintain a debt service coverage ratio of at least 1.25. The actual ratio at 31 March 2027 was 0.91, giving the lender the contractual right to demand immediate repayment. Management classified the borrowing as non-current, relying on an oral assurance allegedly received from the bank. No written waiver was available by the reporting date. Additionally, an interest instalment of Rs. 12 lakh due during the year was paid 49 days after its contractual due date. The finance director believes that subsequent settlement removes the requirement for reporting the default. Access to the electronic borrowing register is restricted to selected finance personnel, who can modify entries without a complete audit trail. The audit partner must evaluate the discrepancies, classification, statutory registration and reporting implications.

What should the audit team primarily do regarding the Rs. 3 crore difference between the independently confirmed term loan and the general ledger balance?

1. Obtain the bank's loan statement, independently investigate the difference, examine the letter-of-credit documents and trace all reconciling items to supporting accounting records. (correct answer)
2. Accept the finance department's reconciliation because the lender has independently confirmed the existence of the borrowing.
3. Adjust the general ledger to the bank confirmation without examining the underlying transactions or identifying the reconciling items.
4. Obtain a written representation from the CFO confirming the difference and restrict further examination to the interest expense account.

Answer: A — Obtain the bank's loan statement, independently investigate the difference, examine the letter-of-credit documents and trace all reconciling items to supporting accounting records.

Explanation. SA 500, particularly paragraphs 6 and 7, requires sufficient appropriate audit evidence. SA 505 requires the auditor to evaluate differences revealed through external confirmations and obtain further evidence where necessary. The auditor should examine the loan statement, devolved letter-of-credit documents, repayment records and relevant journal entries. A bank confirmation establishes independent evidence of the amount claimed by the lender, but it does not automatically explain the difference. Management's reconciliation or representation cannot replace examination of the supporting transactions.

Where it goes wrong. Assuming that an independent confirmation automatically resolves every difference between the lender's records and the company's books.

Authority. SA 500; SA 505

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

What is the legal consequence if the charge created over the manufacturing facility remains unregistered under Section 77 of the Companies Act, 2013?

1. The borrowing itself becomes void, and the lender automatically loses its contractual right to recover the loan.
2. The charge cannot be taken into account by a liquidator or other creditor unless duly registered, but the company's obligation to repay the secured borrowing remains unaffected. (correct answer)
3. The charge remains fully enforceable against every creditor because the bank's knowledge substitutes for registration with the Registrar.
4. The company may treat the borrowing as unsecured without examining the underlying agreement or reporting the registration default.

Answer: B — The charge cannot be taken into account by a liquidator or other creditor unless duly registered, but the company's obligation to repay the secured borrowing remains unaffected.

Explanation. Section 77(3) of the Companies Act, 2013 provides that an unregistered charge cannot be taken into account by the liquidator or any other creditor unless it is duly registered and a registration certificate is issued. However, Section 77(4) expressly states that this does not prejudice the contract or obligation for repayment of the money secured by the charge. The bank's awareness of the security does not replace statutory registration. The auditor should examine the registration status and related disclosures.

Where it goes wrong. Confusing the enforceability of the underlying repayment obligation with the statutory consequences of an unregistered charge.

Authority. Section 77

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

Considering the covenant breach and absence of a written waiver at the reporting date, what should the auditor conclude regarding the term loan classification?

1. Retain non-current classification because the loan originally had a five-year repayment period.
2. Retain non-current classification because management has received an oral assurance from the bank.
3. Require current classification because the covenant breach gives the lender a right to demand repayment and no effective waiver was obtained by the reporting date. (correct answer)
4. Classify the entire loan as contingent liability because the lender has not actually demanded repayment.

Answer: C — Require current classification because the covenant breach gives the lender a right to demand repayment and no effective waiver was obtained by the reporting date.

Explanation. The borrowing audit procedures in Chapter 5 require examination of loan covenants and determination of whether debt should be classified as current when contractual provisions are breached. Where a breach makes repayment immediately demandable, the auditor should verify whether the lender has formally waived enforcement. Under Ind AS 1, paragraphs 74 and 75, the right to defer settlement must exist at the reporting date. An oral assurance or a waiver obtained only subsequently does not automatically establish that right.

Where it goes wrong. Classifying borrowings solely according to their original contractual maturity while ignoring covenant breaches and the lender's existing repayment rights.

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

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

Which conclusion is appropriate regarding the interest instalment paid 49 days after its contractual due date?

1. No disclosure or reporting is required because the amount was eventually paid before completion of the audit.
2. The auditor should report only the outstanding interest balance at year-end without identifying the period of delay.
3. The delay should be reported only if the lender has formally classified the company as a wilful defaulter.
4. The auditor should examine the delay and report the amount, nature of default, lender and number of days unpaid under the applicable CARO reporting requirement. (correct answer)

Answer: D — The auditor should examine the delay and report the amount, nature of default, lender and number of days unpaid under the applicable CARO reporting requirement.

Explanation. Paragraph 3(ix)(a) of CARO 2020 requires the auditor to examine whether the company has defaulted in repayment of loans or other borrowings or payment of interest. Where a default exists, the period and amount must be reported using the prescribed format, including nature of borrowing, lender, amount not paid, whether principal or interest, and number of days delayed or unpaid. Subsequent settlement does not erase the historical default during the reporting period.

Where it goes wrong. Assuming that a default ceases to be reportable merely because the company subsequently clears the overdue amount.

Authority. CARO 2020

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

Scenario. M/s K. Mehta & Co. have been appointed statutory auditors of Solara Auto Components Ltd, a manufacturer of automobile components. The company purchases specialised steel, packaging materials and engineering services from several domestic suppliers. Its accounts payable ageing report shows outstanding balances of Rs. 4.80 crore exceeding two years, including Rs. 1.65 crore relating to suppliers with whom the company has had no recent transactions. The finance director proposes writing back the entire Rs. 1.65 crore as miscellaneous income because the balances have remained unpaid for several years. However, no supplier correspondence, legal release or other documentary evidence supporting extinguishment of these liabilities is available. Some supplier master records have also been changed by the accounts supervisor without independent authorisation. During cut-off testing, the auditors identify goods received at the company's warehouse on 29 March 2027 against purchase orders issued before year-end. The corresponding supplier invoices were received on 4 April 2027 and recorded in the following financial year. The company maintains its purchase register primarily according to invoice-entry dates rather than goods-receipt dates. The auditors also identify a significant steel supplier registered as a micro enterprise. Its goods were accepted on 1 July 2026, and the written payment agreement specified settlement within 35 days. The company paid the invoice on 23 August 2026 but did not calculate statutory interest for the delayed payment. The finance controller argues that no such interest is payable because the supplier accepted the delayed payment voluntarily. When M/s K. Mehta & Co. proposes sending independent balance confirmations to significant vendors, management requests that one major supplier be excluded because its balance is disputed. The CFO offers a written representation instead. The engagement team must evaluate completeness, cut-off, valuation, confirmation reliability and the disclosures required under the MSMED Act, 2006.

Which procedure is most appropriate for detecting the understatement of trade payables arising from goods received on 29 March but invoiced on 4 April?

1. Verify only invoices recorded in March and assume that subsequent invoices belong to the next accounting period.
2. Examine goods-receipt records, purchase orders and subsequent invoices to identify goods received before year-end and determine whether the related liability should have been recognised. (correct answer)
3. Examine only supplier payments made during March because unpaid invoices cannot represent year-end liabilities.
4. Compare the closing payable balance with the previous year and accept management's explanation for any decrease.

Answer: B — Examine goods-receipt records, purchase orders and subsequent invoices to identify goods received before year-end and determine whether the related liability should have been recognised.

Explanation. The Chapter 5 audit procedures for trade payables require cut-off testing to ensure that goods received before year-end have been recorded as purchases and included in trade creditors. The auditor should examine subsequent invoices and expense vouchers, match invoice dates with inward gate-entry records and verify the date on which risks and rewards transferred to the company. SA 500 requires supporting evidence for the relevant assertions. Invoice-entry date alone cannot determine the accounting period.

Where it goes wrong. Using the supplier's invoice date as the sole basis for recording purchases instead of examining receipt of goods and transfer of risks and rewards.

Authority. SA 500

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

Management refuses to permit direct confirmation from the major disputed supplier. What is the auditor's appropriate response under SA 505?

1. Accept management's explanation and exclude the supplier because disputed balances are unsuitable for external confirmation.
2. Issue an adverse opinion immediately because refusal to send one confirmation establishes intentional misstatement.
3. Enquire into management's reasons, evaluate their validity and fraud implications, perform alternative procedures and communicate unreasonable refusal or inadequate evidence to those charged with governance. (correct answer)
4. Replace the confirmation procedure with a written representation and conclude that the balance has been independently substantiated.

Answer: C — Enquire into management's reasons, evaluate their validity and fraud implications, perform alternative procedures and communicate unreasonable refusal or inadequate evidence to those charged with governance.

Explanation. SA 505, paragraphs 8 and 9, specifically addresses management's refusal to permit an external confirmation. The auditor must enquire into the reasons, seek evidence supporting their validity, evaluate the implications for assessed risks including fraud, and perform alternative procedures to obtain relevant and reliable evidence. If the refusal is unreasonable or alternative procedures are unsuccessful, the auditor must communicate with those charged with governance and consider the implications for the audit opinion under SA 705.

Where it goes wrong. Treating management's refusal as either automatically conclusive evidence of fraud or an acceptable reason to replace independent verification with management representation.

Authority. SA 505; SA 705

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

What should the auditors require before accepting the proposed write-back of Rs. 1.65 crore relating to old supplier balances?

1. Accept the write-back automatically because liabilities outstanding for more than two years are presumed legally extinguished.
2. Write back the balances immediately because the suppliers have not initiated legal proceedings against the company.
3. Transfer the balances to a capital reserve because old trade payables do not arise from current operating activities.
4. Examine the underlying transactions, supplier correspondence, subsequent settlements and management's basis for extinguishment, including appropriate senior-management authorisation. (correct answer)

Answer: D — Examine the underlying transactions, supplier correspondence, subsequent settlements and management's basis for extinguishment, including appropriate senior-management authorisation.

Explanation. Chapter 5 requires the auditor to review management's process for identifying liabilities no longer payable, compare the method with previous years and examine whether write-backs have been approved by an appropriate senior authority, such as the CEO or Managing Director. Ageing alone does not establish extinguishment of an obligation. Under SA 500, the auditor should obtain supporting evidence for the completeness and valuation of liabilities, including relevant correspondence and subsequent transactions.

Where it goes wrong. Equating an old or inactive supplier account with a legally extinguished liability and automatically treating the balance as income.

Authority. SA 500

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

Which treatment is correct for the delayed payment to the registered micro enterprise supplier?

1. Interest is payable from the date immediately following the agreed 35-day payment period at three times the RBI-notified bank rate, compounded with monthly rests, with applicable additional disclosures under Section 22. (correct answer)
2. Interest is payable only at the ordinary contractual rate from the date of the supplier's demand, and no separate annual disclosure is required.
3. Interest is payable at the ordinary bank rate on a simple-interest basis from the invoice date, irrespective of the agreed payment period.
4. No interest is payable because the supplier voluntarily accepted payment after the agreed period without initiating legal proceedings.

Answer: A — Interest is payable from the date immediately following the agreed 35-day payment period at three times the RBI-notified bank rate, compounded with monthly rests, with applicable additional disclosures under Section 22.

Explanation. Under Sections 15 and 16 of the MSMED Act, 2006, a written payment period cannot exceed 45 days from acceptance or deemed acceptance. Where a valid agreed period of 35 days is exceeded, interest becomes payable from the day immediately following the agreed date at three times the RBI-notified bank rate, compounded with monthly rests. Section 22 requires specified disclosures of unpaid principal and interest, payments made beyond the appointed day and accrued or further interest. Voluntary acceptance does not waive statutory interest.

Where it goes wrong. Assuming that the supplier's acceptance of delayed payment overrides the mandatory statutory interest provisions or that the 45-day maximum is an ordinary contractual entitlement.

Authority. Section 22

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

Scenario. M/s V. Raman & LLP are conducting the statutory audit of Meridian Foods Ltd, a company manufacturing packaged food products. During 2026-27, the company sold approximately 80,000 products covered by a two-year replacement warranty. Management recognised a warranty provision of Rs. 40 lakh based on 0.5% of annual sales. However, the company's internal quality reports indicate a significant increase in product defects during the final quarter, and subsequent warranty claims have increased substantially. The CFO obtained an actuarial estimate from a consulting firm with which the company has a long-standing commercial relationship. The report assumes that the defect rate will return to its historical average. The audit team has not received the underlying product-failure data, assumptions or detailed calculations supporting the estimate. The company is also involved in litigation initiated by a former distributor claiming damages of Rs. 3.20 crore. Its external legal adviser has assessed an adverse outcome as probable and has provided a reasonably estimable settlement range. Management has nevertheless disclosed the matter only as a contingent liability. The legal department refuses the auditor's request for direct communication with external counsel, stating that such communication would violate confidentiality. Separately, Meridian Foods Ltd has assured a bank borrowing of Rs. 8 crore obtained by its subsidiary. The subsidiary has breached a financial covenant, and the lender has issued a notice indicating that invocation of the guarantee is possible. The company's legal team assesses the likelihood of invocation as possible but not probable. Management has included the guarantee in a generic disclosure without separately identifying its nature or amount. The engagement team also discovers that previous-year warranty estimates were consistently lower than actual claims and that the CFO has overridden certain provisions in the accounting system without documented approval. The audit partner must evaluate the recognition, completeness and measurement of provisions, obtain reliable legal and actuarial evidence, assess disclosure adequacy and determine the implications of management's restrictions.

Which criterion should primarily govern recognition of the warranty provision for Meridian Foods Ltd?

1. A provision should be recognised whenever management considers a warranty payment commercially desirable, irrespective of any past event.
2. A provision should be recognised only when individual customers have obtained a final court decree requiring replacement.
3. A provision should be recognised when a present legal or constructive obligation arises from past sales, an outflow of resources is probable and the amount can be reliably estimated. (correct answer)
4. A provision should be recognised only after the entire warranty period has expired and all replacement claims have been settled.

Answer: C — A provision should be recognised when a present legal or constructive obligation arises from past sales, an outflow of resources is probable and the amount can be reliably estimated.

Explanation. The provision-recognition principles under AS 29 or Ind AS 37 require three conditions: a present obligation, legal or constructive, arising from a past event; probable outflow of resources embodying economic benefits; and a reliable estimate of the obligation. Product sales carrying warranty commitments can create such an obligation. Waiting until claims are finally settled would generally understate the liability. A management preference alone, without an obligating event, is not sufficient for recognising a provision.

Where it goes wrong. Confusing the settlement of an obligation with its recognition and overlooking constructive obligations arising from products sold with warranties.

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

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

Management refuses direct communication with its external legal adviser concerning the distributor litigation. Which audit response is most appropriate?

1. Accept the refusal because lawyer-client confidentiality automatically exempts the auditor from obtaining legal evidence.
2. Rely exclusively on the CFO's written representation because management is responsible for estimating litigation provisions.
3. Treat the legal claim as remote because management has classified it as a contingent liability.
4. Seek direct communication with external legal counsel under SA 501, perform appropriate alternative procedures if communication is restricted, and evaluate the resulting evidence limitation and reporting implications. (correct answer)

Answer: D — Seek direct communication with external legal counsel under SA 501, perform appropriate alternative procedures if communication is restricted, and evaluate the resulting evidence limitation and reporting implications.

Explanation. SA 501, paragraph 9, requires the auditor to seek direct communication with the entity's external legal counsel when a risk of material misstatement relating to litigation or claims is identified. If management refuses permission or legal restrictions prevent communication, the auditor should consider alternative procedures and evaluate whether sufficient appropriate evidence is available. Where evidence remains insufficient, the auditor considers the implications under SA 705. Management's classification alone cannot override independent legal evidence.

Where it goes wrong. Assuming that confidentiality concerns or management's control over legal correspondence automatically eliminate the auditor's responsibility to obtain appropriate evidence.

Authority. SA 501; SA 705

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

What must the auditors evaluate before relying on the actuarial report supporting the warranty provision?

1. The expert's competence, capabilities and objectivity, understanding of the work performed, assumptions and methods used, and relevance, completeness and accuracy of the underlying data. (correct answer)
2. Only the expert's professional qualification and the final amount appearing in the report, without examining the supporting assumptions.
3. Only whether the expert is registered as a consulting firm and whether management has approved the valuation in writing.
4. Only whether the actuarial report agrees with management's existing provision and whether the CFO has signed the representation.

Answer: A — The expert's competence, capabilities and objectivity, understanding of the work performed, assumptions and methods used, and relevance, completeness and accuracy of the underlying data.

Explanation. SA 500, particularly paragraphs 8 and 9 and the related application guidance on management's experts, requires the auditor to evaluate the competence, capabilities and objectivity of the expert, obtain an understanding of the expert's work and assess whether its findings provide appropriate audit evidence. The auditor should examine the assumptions, methods and source data, including their relevance, completeness and accuracy. A professionally qualified expert's report is not automatically sufficient without such evaluation.

Where it goes wrong. Assuming that obtaining an actuarial report is equivalent to obtaining sufficient appropriate evidence without evaluating the expert's work.

Authority. SA 500

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

How should the subsidiary borrowing guarantee be presented if invocation is considered possible but not probable at the reporting date?

1. Recognise a provision for the entire assured borrowing because every corporate guarantee creates an immediate payable liability.
2. Disclose the amount and nature of the guarantee as a contingent liability, without recognising a provision while the probability condition for provision recognition is not met. (correct answer)
3. Ignore the guarantee because the subsidiary remains the primary borrower and no payment has been demanded from the parent.
4. Recognise the guarantee as a trade payable because it relates to a borrowing obtained by a subsidiary undertaking.

Answer: B — Disclose the amount and nature of the guarantee as a contingent liability, without recognising a provision while the probability condition for provision recognition is not met.

Explanation. Under AS 29 or Ind AS 37, a possible obligation arising from past events, or a present obligation for which an outflow is not probable, is generally treated as a contingent liability rather than a recognised provision, unless the possibility of outflow is remote. Schedule III, Part I, requires contingent liabilities to include guarantees and other money for which the company is contingently liable. The auditor should examine the guarantee agreement, subsidiary's financial position and lender correspondence before assessing the appropriate disclosure.

Where it goes wrong. Confusing the existence of a guarantee with an automatic requirement to recognise the entire assured amount as a provision.

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

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

Scenario. A company created a charge over its factory building on 10 September 2026 but did not register it within the initial statutory period. Under the current wording of Section 77, which statement correctly describes the additional registration periods for a charge created after the commencement of the Companies (Amendment) Act, 2019?

A company created a charge over its factory building on 10 September 2026 but did not register it within the initial statutory period. Under the current wording of Section 77, which statement correctly describes the additional registration periods for a charge created after the commencement of the Companies (Amendment) Act, 2019?

1. The Registrar may permit registration only within thirty additional days, and no further extension is available under Section 77.
2. The Registrar may permit registration within one hundred and twenty days from creation without additional fees or an application.
3. The Registrar may permit registration within sixty days of creation on payment of additional fees and, on application, a further sixty days with ad valorem fees. (correct answer)
4. The Registrar may permit registration within three hundred days of creation on payment of ordinary filing fees, irrespective of the date of the charge.

Answer: C — The Registrar may permit registration within sixty days of creation on payment of additional fees and, on application, a further sixty days with ad valorem fees.

Explanation. Section 77(1) of the Companies Act, 2013 ordinarily requires registration within thirty days of charge creation. For charges created on or after commencement of the Companies (Amendment) Act, 2019, the Registrar may allow registration within sixty days of creation on payment of additional fees. If registration is not completed within that period, the Registrar may allow a further period of sixty days on application and payment of ad valorem fees. The older three-hundred-day period applies to the specified pre-amendment charges.

Where it goes wrong. Applying the former three-hundred-day provision to charges created after the 2019 amendment or treating the additional registration period as automatic.

Authority. Section 77

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

Scenario. During an audit, the auditor identifies a company's failure to comply with the registration requirements of Chapter VI of the Companies Act, 2013. There is no evidence of wilfully furnishing false particulars or knowingly suppressing material information. What penalty is prescribed under Section 86(1)?

During an audit, the auditor identifies a company's failure to comply with the registration requirements of Chapter VI of the Companies Act, 2013. There is no evidence of wilfully furnishing false particulars or knowingly suppressing material information. What penalty is prescribed under Section 86(1)?

1. The company is liable to a penalty of Rs. 1 lakh and every officer in default is liable to Rs. 25,000.
2. The company is liable to a penalty of Rs. 10 lakh and every officer in default is liable to Rs. 1 lakh.
3. The company is liable to a penalty of Rs. 2 lakh and every officer in default is liable to Rs. 50,000.
4. The company is liable to a penalty of Rs. 5 lakh and every officer in default is liable to a penalty of Rs. 50,000. (correct answer)

Answer: D — The company is liable to a penalty of Rs. 5 lakh and every officer in default is liable to a penalty of Rs. 50,000.

Explanation. Section 86(1) of the Companies Act, 2013 prescribes a penalty of Rs. 5 lakh for the company and Rs. 50,000 for every officer who is in default when there is non-compliance with the provisions of the chapter dealing with registration of charges. Section 86(2) separately provides for action under Section 447 where any person wilfully furnishes false or incorrect information or knowingly suppresses material information required to be registered under Section 77. The two consequences should not be confused.

Where it goes wrong. Applying the earlier criminal fine provisions or confusing ordinary charge-registration defaults with wilful false reporting attracting Section 447.

Authority. Section 447; Section 77; Section 86

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

Scenario. A company has an outstanding secured borrowing of Rs. 20 crore against an immovable property whose market value at the reporting date is Rs. 12 crore. How should the auditor evaluate the security classification in the financial statements?

A company has an outstanding secured borrowing of Rs. 20 crore against an immovable property whose market value at the reporting date is Rs. 12 crore. How should the auditor evaluate the security classification in the financial statements?

1. Examine whether the borrowing is classified as secured only to the extent of Rs. 12 crore and whether the remaining portion is appropriately reflected as unsecured. (correct answer)
2. Accept the entire borrowing as secured because a valid registered charge exists over the immovable property.
3. Classify the entire borrowing as unsecured because the market value of the property is lower than the outstanding borrowing.
4. Classify the entire borrowing as secured provided the lender has not initiated recovery proceedings against the company.

Answer: A — Examine whether the borrowing is classified as secured only to the extent of Rs. 12 crore and whether the remaining portion is appropriately reflected as unsecured.

Explanation. The Chapter 5 borrowing audit procedures require examination of the value of security against the outstanding loan. Where the value of security falls below the outstanding borrowing, the auditor should examine whether the amount is classified as secured only to the extent of the market value of the security. Schedule III also requires borrowings to be sub-classified as secured and unsecured, with the nature of security separately disclosed. A registered charge does not automatically establish full security coverage.

Where it goes wrong. Assuming that the existence of a registered charge establishes that the entire borrowing is secured regardless of the recoverable value of the collateral.

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

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

Scenario. During verification of secured non-convertible debentures, which combination of procedures would provide the most appropriate evidence concerning their existence, terms and valuation?

During verification of secured non-convertible debentures, which combination of procedures would provide the most appropriate evidence concerning their existence, terms and valuation?

1. Inspect only the debenture issue advertisement and rely on the finance controller's calculation of interest and closing balance.
2. Examine the debenture trust deed, verify redemption terms and restrictive covenants, obtain independent confirmation and recompute interest and applicable premium or discount amortisation. (correct answer)
3. Verify the original issue proceeds from the bank statement and assume that the outstanding amount remains unchanged until redemption.
4. Examine the board minutes and obtain a certificate from the company's registrar without checking contractual interest or repayment conditions.

Answer: B — Examine the debenture trust deed, verify redemption terms and restrictive covenants, obtain independent confirmation and recompute interest and applicable premium or discount amortisation.

Explanation. Chapter 5 requires the auditor to examine the debenture trust deed to understand terms, redemption dates, borrowing restrictions and compliance with covenants. The auditor should obtain independent confirmation, agree recorded balances with the contractual terms, recompute interest and verify amortisation of any issue premium or discount. When debt is retired, the auditor should also verify discharge of the assets securing the debt. Merely checking issue proceeds or board approval does not establish the accuracy of outstanding debenture liabilities.

Where it goes wrong. Confusing verification of the original issue proceeds with verification of the continuing existence, valuation and contractual obligations of debentures.

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

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

Scenario. A company has raised short-term working-capital borrowings of Rs. 12 crore, but used Rs. 4 crore to construct a new manufacturing facility expected to be operational over the next five years. Which CARO 2020 reporting requirement is most directly applicable?

A company has raised short-term working-capital borrowings of Rs. 12 crore, but used Rs. 4 crore to construct a new manufacturing facility expected to be operational over the next five years. Which CARO 2020 reporting requirement is most directly applicable?

1. Paragraph 3(ix)(c), which exclusively reports short-term borrowings used to repay term loans of another company.
2. Paragraph 3(ix)(a), which requires reporting every transfer between current and non-current assets.
3. Paragraph 3(ix)(f), which requires reporting only loans obtained by pledging securities held in subsidiary companies.
4. Paragraph 3(ix)(d), requiring the nature and amount of short-term funds utilised for long-term purposes to be indicated. (correct answer)

Answer: D — Paragraph 3(ix)(d), requiring the nature and amount of short-term funds utilised for long-term purposes to be indicated.

Explanation. CARO 2020, paragraph 3(ix)(d), specifically requires the auditor to examine whether funds raised on a short-term basis have been utilised for long-term purposes. Where this has occurred, the nature and amount must be indicated. Construction of a manufacturing facility representing a long-term investment funded from short-term working-capital borrowings falls within this reporting consideration. Paragraph 3(ix)(c), by contrast, deals with whether term loans were applied for the purposes for which they were obtained.

Where it goes wrong. Confusing the reporting of short-term funds used for long-term purposes under clause (ix)(d) with diversion of term loans under clause (ix)(c).

Authority. CARO 2020

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

Scenario. Before accepting appointment as statutory auditor, a partner of the proposed audit firm discloses that he has an outstanding personal loan of Rs. 5.60 lakh from the company. The loan was obtained on ordinary commercial terms. What should be concluded?

Before accepting appointment as statutory auditor, a partner of the proposed audit firm discloses that he has an outstanding personal loan of Rs. 5.60 lakh from the company. The loan was obtained on ordinary commercial terms. What should be concluded?

1. The partner is disqualified because indebtedness exceeding Rs. 5 lakh to the company attracts the restriction under Section 141(3)(d)(ii), read with Rule 10(2). (correct answer)
2. The partner is eligible because a loan obtained on ordinary commercial terms is automatically exempt from auditor disqualification.
3. The partner is eligible provided the company has disclosed the loan in its financial statements and obtained board approval.
4. The partner is eligible because the indebtedness restriction applies only to unsecured loans and not to secured personal borrowings.

Answer: A — The partner is disqualified because indebtedness exceeding Rs. 5 lakh to the company attracts the restriction under Section 141(3)(d)(ii), read with Rule 10(2).

Explanation. Section 141(3)(d)(ii) of the Companies Act, 2013, read with Rule 10(2) of the Companies (Audit and Auditors) Rules, 2014, provides that a person or their relative or partner indebted to the company or specified related companies in excess of Rs. 5 lakh is not eligible for appointment as auditor. The provision does not provide a general exemption merely because the loan bears ordinary commercial interest or is secured. The outstanding Rs. 5.60 lakh therefore creates a statutory eligibility and independence issue.

Where it goes wrong. Assuming that an arm's-length personal loan is automatically excluded from the statutory indebtedness disqualification.

Authority. Section 141

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

Scenario. A company has paid statutory interest to a micro enterprise supplier under Section 16 of the MSMED Act but has claimed the amount as an ordinary deductible business expenditure. It has also omitted the additional information required under Section 22 from its annual statement of accounts. Which conclusion is correct?

A company has paid statutory interest to a micro enterprise supplier under Section 16 of the MSMED Act but has claimed the amount as an ordinary deductible business expenditure. It has also omitted the additional information required under Section 22 from its annual statement of accounts. Which conclusion is correct?

1. The interest is deductible because it has been paid, while non-disclosure under Section 22 attracts only a warning from the auditor.
2. The interest is not allowable as a deduction under Section 23, and contravention of Section 22 attracts a fine of not less than Rs. 10,000 under Section 27. (correct answer)
3. The interest is deductible if the supplier has accepted the delayed payment, although the principal amount must be disclosed under Section 22.
4. The interest is deductible when calculated at three times the bank rate, while Section 27 prescribes a maximum fine of Rs. 10,000.

Answer: B — The interest is not allowable as a deduction under Section 23, and contravention of Section 22 attracts a fine of not less than Rs. 10,000 under Section 27.

Explanation. Section 23 of the MSMED Act, 2006 expressly disallows interest payable or paid under the Act as a deduction for computation of income under the Income-tax Act, 1961. Section 22 requires additional disclosures in annual accounts relating to unpaid principal, interest due, payments made beyond the appointed day and accrued or further interest. Section 27(2) prescribes a fine of not less than Rs. 10,000 for contravention of Section 22. Payment of the interest does not make it tax-deductible.

Where it goes wrong. Confusing accounting recognition of statutory interest with its tax deductibility and mistaking the statutory minimum fine for a maximum limit.

Authority. Section 16; Section 22; Section 23; Section 27

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

Scenario. While planning external confirmations of trade payables, which procedure is preferable under the Chapter 5 guidance?

While planning external confirmations of trade payables, which procedure is preferable under the Chapter 5 guidance?

1. Send confirmation requests only to suppliers whose closing balances are material, excluding suppliers with significant purchases but negligible year-end balances.
2. Use positive confirmations showing management's balance and accept silence from suppliers as evidence of agreement.
3. Prefer a blank-balance confirmation request asking suppliers to state their own balance, maintain strict auditor control over dispatch and receipt, and include vendors with material purchases. (correct answer)
4. Allow management to select vendors and receive their responses directly before forwarding copies to the auditor.

Answer: C — Prefer a blank-balance confirmation request asking suppliers to state their own balance, maintain strict auditor control over dispatch and receipt, and include vendors with material purchases.

Explanation. Chapter 5 recommends direct confirmation for significant period-end trade payable balances and suppliers from whom material purchases were made during the year even where their closing balance is not significant. A blank-balance confirmation, asking the supplier to state its own records, is preferable because it reduces the risk of simply agreeing with management's stated amount. The auditor should maintain strict control over selection, dispatch and receipt. These procedures are consistent with SA 505.

Where it goes wrong. Selecting suppliers only on the basis of closing balances and overlooking significant purchase activity or allowing management to control the confirmation process.

Authority. SA 505

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

Scenario. An auditor suspects that year-end trade payables may be understated because the company records invoices only when approved by the accounts department. Which substantive procedure is most effective for identifying unrecorded liabilities?

An auditor suspects that year-end trade payables may be understated because the company records invoices only when approved by the accounts department. Which substantive procedure is most effective for identifying unrecorded liabilities?

1. Compare the current year's closing creditors with the previous year's closing creditors and investigate only substantial decreases.
2. Examine subsequent cash disbursements, invoices received after year-end and goods-receipt records, tracing transactions back to determine whether obligations existed at the reporting date. (correct answer)
3. Obtain management's written representation that every supplier invoice has been approved and entered into the purchase ledger.
4. Examine only the purchase ledger balances and reconcile them to the trial balance without testing transactions recorded after year-end.

Answer: B — Examine subsequent cash disbursements, invoices received after year-end and goods-receipt records, tracing transactions back to determine whether obligations existed at the reporting date.

Explanation. SA 500 and SA 330 require the auditor to obtain sufficient appropriate evidence responsive to the risk of material misstatement. To test completeness of trade payables, the auditor should examine subsequent payments, supplier invoices received after year-end, goods-receipt records and related purchase documentation. This helps identify obligations arising from goods or services received before the reporting date but omitted from the ledger. Merely analysing closing balances or relying on written representations does not provide sufficient evidence of completeness.

Where it goes wrong. Testing only recorded liabilities for accuracy and existence while neglecting the possibility that liabilities were omitted entirely.

Authority. SA 330; SA 500

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

Scenario. The auditor observes that management's provision estimates have been consistently lower than actual expenditure in previous years. Under SA 540, which audit responsibility is most directly relevant?

The auditor observes that management's provision estimates have been consistently lower than actual expenditure in previous years. Under SA 540, which audit responsibility is most directly relevant?

1. Accept management's estimate because the prior-year actual outcomes cannot be considered when evaluating a current accounting estimate.
2. Treat every difference between an estimate and actual expenditure as conclusive evidence of fraudulent financial reporting.
3. Review management's judgments and decisions in making accounting estimates for indicators of possible management bias and evaluate whether estimates and disclosures are reasonable. (correct answer)
4. Require the company to use the highest possible estimated liability in every accounting period, irrespective of available evidence.

Answer: C — Review management's judgments and decisions in making accounting estimates for indicators of possible management bias and evaluate whether estimates and disclosures are reasonable.

Explanation. SA 540, paragraph 21, requires the auditor to review the judgments and decisions made by management in making accounting estimates to identify indicators of possible management bias. Repeated understatement of warranty or litigation provisions may indicate systematic bias and warrants examination of assumptions, methods, source data and prior estimates. It does not automatically establish fraud, nor does the auditor simply impose the highest possible liability. The auditor evaluates whether the estimate and its disclosures are reasonable under the applicable framework.

Where it goes wrong. Confusing indicators of management bias with conclusive proof of fraud, or assuming that the auditor must automatically adopt the most conservative estimate.

Authority. SA 540

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

Scenario. A company expects substantial operating losses during the next financial year because of declining demand and increased production costs. Management proposes creating a provision for the entire forecast operating loss at the current reporting date. What should the auditor conclude?

A company expects substantial operating losses during the next financial year because of declining demand and increased production costs. Management proposes creating a provision for the entire forecast operating loss at the current reporting date. What should the auditor conclude?

1. Recognise the entire forecast loss because management has already approved the next year's operating budget.
2. Recognise half the forecast loss as a provision and disclose the remaining amount as a contingent liability.
3. Recognise the provision if the company has experienced operating losses during the immediately preceding year.
4. Do not recognise a provision merely for future operating losses because they do not represent a present obligation arising from a past obligating event, although impairment indicators may require examination. (correct answer)

Answer: D — Do not recognise a provision merely for future operating losses because they do not represent a present obligation arising from a past obligating event, although impairment indicators may require examination.

Explanation. AS 29 and Ind AS 37 do not permit recognition of provisions for future operating losses because such losses do not represent present obligations arising from past obligating events. They relate to future operations rather than an existing liability at the reporting date. However, an expectation of future operating losses may indicate impairment of assets and require the auditor to evaluate the relevant impairment assessment. The entity must not create a liability merely to absorb anticipated future losses.

Where it goes wrong. Treating an adverse future business forecast as an existing liability instead of distinguishing expected operating losses from present obligations.

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

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

Scenario. While reviewing the trade payables ageing schedule, the auditor finds that management has presented a single consolidated ageing figure for all vendors. Which presentation is required under Schedule III, Part I, of the Companies Act, 2013?

While reviewing the trade payables ageing schedule, the auditor finds that management has presented a single consolidated ageing figure for all vendors. Which presentation is required under Schedule III, Part I, of the Companies Act, 2013?

1. Separately classify MSME dues, other dues, disputed MSME dues and disputed other dues, with ageing buckets and appropriate treatment of items for which no due date is specified and of unbilled dues. (correct answer)
2. Present only the total amount due to all suppliers, divided into current and non-current categories according to the company's accounting policy.
3. Disclose only balances outstanding beyond three years, separately identifying government suppliers and other private suppliers.
4. Present ageing exclusively according to invoice date, without distinguishing MSME suppliers or disputed and undisputed balances.

Answer: A — Separately classify MSME dues, other dues, disputed MSME dues and disputed other dues, with ageing buckets and appropriate treatment of items for which no due date is specified and of unbilled dues.

Explanation. Schedule III, Part I, requires a trade payables ageing schedule separately identifying MSME dues, other dues, disputed dues relating to MSME suppliers and disputed dues relating to other suppliers. Ageing is presented in prescribed time bands of less than one year, one to two years, two to three years and more than three years. Where no due date is specified, ageing is determined from the transaction date. Unbilled dues must be disclosed separately. A single consolidated ageing figure is therefore insufficient.

Where it goes wrong. Confusing the trade payables ageing schedule with the general current/non-current liability classification and overlooking mandatory MSME and disputed-dues categories.

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

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

Scenario. A company has obtained a term loan of Rs. 10 crore for purchasing specialised manufacturing machinery. During the audit, the auditor discovers that Rs. 2 crore was diverted to meet routine employee salary obligations. Which CARO 2020 reporting requirement is most directly applicable?

A company has obtained a term loan of Rs. 10 crore for purchasing specialised manufacturing machinery. During the audit, the auditor discovers that Rs. 2 crore was diverted to meet routine employee salary obligations. Which CARO 2020 reporting requirement is most directly applicable?

1. Report under paragraph 3(ix)(d) only because every diversion of term-loan funds is treated as utilisation of short-term funds for long-term purposes.
2. Report under paragraph 3(ix)(c), indicating the amount of term loan diverted and the purpose for which it was utilised. (correct answer)
3. Report under paragraph 3(ix)(b) automatically because utilisation for salaries establishes that the company is a wilful defaulter.
4. Report under paragraph 3(ix)(a) only if the company also defaults in repayment of the term loan.

Answer: B — Report under paragraph 3(ix)(c), indicating the amount of term loan diverted and the purpose for which it was utilised.

Explanation. CARO 2020, paragraph 3(ix)(c), requires the auditor to examine whether term loans were applied for the purpose for which they were obtained. Where they were not, the amount diverted and the purpose for which it was used must be reported. Here, the sanctioned purpose was purchasing machinery, whereas Rs. 2 crore was diverted towards routine salaries. Paragraph 3(ix)(d) separately deals with short-term funds used for long-term purposes, while paragraph 3(ix)(b) concerns declared wilful defaulters.

Where it goes wrong. Confusing diversion of term-loan proceeds with short-term borrowing misapplication or assuming that every diversion automatically establishes wilful-default status.

Authority. CARO 2020