Audit of Items of Financial Statements - Test 3: 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 Apex Industrial Systems Ltd, a manufacturer of specialised engineering equipment. During 2026-27, the company acquired a new manufacturing facility comprising land, buildings and specialised machinery. The purchase consideration for the machinery was Rs. 4.80 crore. Additional expenditure included freight of Rs. 12 lakh, installation and testing costs of Rs. 8 lakh, employee training expenses of Rs. 5 lakh and an inauguration ceremony costing Rs. 3 lakh. Management capitalised the entire expenditure under Property, Plant and Equipment (PPE). The fixed asset register contains the new machinery but does not contain complete serial numbers or location details. The company conducted physical verification through its own employees, but the verification sheets do not identify the individual assets. Several discrepancies between the physical records and fixed asset register remain unresolved. The plant head has instructed the accounts department not to record shortages because the machinery is still covered by the supplier's warranty. The audit team also identifies a factory building acquired during the previous financial year. The original title deed is held by a lending bank as security for a term loan. Management has not obtained written confirmation from the bank identifying the property or confirming custody of the original deed. The company's register of charges also contains incomplete details of the mortgage. One additional industrial plot is recorded in the company's financial statements, although its conveyance deed continues to identify the promoter as the registered owner. The CFO states that beneficial ownership is sufficient evidence and refuses to provide further documentation. The audit team must determine the appropriate verification procedures, identify possible misstatements in capitalisation, and evaluate the requirements concerning physical verification, legal ownership and reporting under CARO 2020.

Which conclusion regarding the expenditure capitalised on the newly acquired machinery is most appropriate under AS 10 (Revised)?

1. Capitalise freight, installation, testing, employee training and inauguration expenses because all were incurred before production commenced.
2. Capitalise freight, installation and testing costs, but charge employee training and inauguration expenditure to the Statement of Profit and Loss. (correct answer)
3. Capitalise the employee training and inauguration expenses, but charge freight and installation expenditure to the Statement of Profit and Loss.
4. Capitalise only the purchase consideration because expenditure incurred after delivery cannot form part of the asset's cost.

Answer: B — Capitalise freight, installation and testing costs, but charge employee training and inauguration expenditure to the Statement of Profit and Loss.

Explanation. AS 10 (Revised), particularly paragraphs 16 and 17, requires directly attributable costs necessary to bring an asset to the location and condition required for intended operation to be included in its cost. Freight, installation and testing expenditure generally satisfy this condition. Employee training and inauguration costs do not qualify as directly attributable costs of bringing the machinery to working condition and should be expensed. The fact that expenditure was incurred before production commenced does not automatically make it capital expenditure.

Where it goes wrong. Treating every expenditure incurred before commercial production as capital expenditure instead of distinguishing directly attributable costs from general operating expenditure.

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

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

The original title deed of the factory building is held by the lending bank as security. Which procedure would provide the most appropriate evidence of the company's rights and obligations concerning the building?

1. Accept the CFO's written representation because the company has recorded the building in its fixed asset register.
2. Rely exclusively on the bank's loan confirmation because the existence of a secured loan automatically proves legal ownership.
3. Inspect the building physically and accept the company's possession as conclusive evidence of legal title.
4. Examine the conveyance deed, obtain lender confirmation that the original title deed is held as security, and inspect the relevant charge records. (correct answer)

Answer: D — Examine the conveyance deed, obtain lender confirmation that the original title deed is held as security, and inspect the relevant charge records.

Explanation. The Chapter 5 PPE audit procedures require the auditor to examine the conveyance deed or sale deed to establish legal ownership of land and buildings. Where original title deeds are held by a lender as security, the auditor should obtain confirmation from the lender identifying the documents held. The register of charges should also be examined. SA 500 requires sufficient appropriate evidence for the relevant assertions. Physical possession and management representation alone do not establish legal title.

Where it goes wrong. Confusing physical possession or the existence of a mortgage with conclusive evidence that the company legally owns the property.

Authority. SA 500

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

The physical verification records identify no individual asset numbers and discrepancies remain unresolved. What should the auditor primarily evaluate under CARO 2020?

1. Whether physical verification was conducted at reasonable intervals, material discrepancies were identified and whether such discrepancies have been properly dealt with in the books of account. (correct answer)
2. Whether the company conducted a complete physical verification on every reporting date and obtained a fresh valuation certificate for each asset.
3. Whether the management conducted physical verification only through an independent external agency and obtained a statutory certificate for every item.
4. Whether management has obtained supplier warranties for the missing assets and consequently avoided accounting for identified shortages.

Answer: A — Whether physical verification was conducted at reasonable intervals, material discrepancies were identified and whether such discrepancies have been properly dealt with in the books of account.

Explanation. Paragraph 3(i)(b) of CARO 2020 requires reporting whether PPE has been physically inspected by management at reasonable intervals, whether material discrepancies were noticed and whether they were properly dealt with in the books of account. Chapter 5 further requires examination of verification working papers, asset identification numbers, reconciliation with the fixed asset register and treatment of discrepancies. A supplier warranty does not establish the existence of an asset or remove the requirement to account for shortages.

Where it goes wrong. Assuming that a supplier warranty or management's assertion compensates for inadequate physical verification and unresolved discrepancies.

Authority. CARO 2020

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

The industrial plot is recorded as PPE, but its conveyance deed identifies the promoter as registered owner. Which reporting and disclosure approach is most appropriate?

1. Accept the accounting treatment if the promoter provides an undertaking that the plot will eventually be transferred to the company.
2. Report the plot only under the inventory verification clause because the land has not yet been used for manufacturing.
3. Examine the legal ownership evidence and the reason for the title mismatch, and consider the prescribed title-deed disclosure and CARO 2020 reporting requirements. (correct answer)
4. Exclude the plot from the audit because properties held in the names of promoters are outside the auditor's scope.

Answer: C — Examine the legal ownership evidence and the reason for the title mismatch, and consider the prescribed title-deed disclosure and CARO 2020 reporting requirements.

Explanation. Schedule III, Part I, requires disclosure of immovable properties whose title deeds are not held in the company's name, except specified leased properties. The prescribed details include the description, gross carrying value, name of the title holder, relationship where relevant, period held and reason for the title mismatch, including whether the matter is disputed. CARO 2020 paragraph 3(i)(c) also requires the auditor to report on title deeds of immovable properties disclosed in the financial statements. Management's assertion of beneficial ownership does not eliminate these requirements.

Where it goes wrong. Assuming that beneficial ownership asserted by management automatically satisfies the legal-title verification and prescribed disclosure requirements.

Authority. CARO 2020

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

Scenario. M/s K. Mehta & Co. are the statutory auditors of Zenith Renewable Energy Ltd, which is constructing a specialised power-generation facility expected to take approximately eighteen months to become operational. On 1 April 2026, the company obtained a specific term loan of Rs. 5 crore carrying interest at 10% per annum. Expenditure on the project commenced on 15 April 2026, while technical planning, regulatory approvals and engineering activities necessary to prepare the facility began on 1 June 2026. The finance department started capitalising all interest from 1 April, including the period when the land was merely held without any development activity. Further, construction activities were completely suspended from September to December 2026 due to an unresolved contractual dispute with the principal contractor. No substantial technical or administrative work relating to the project was undertaken during this period. Management nevertheless capitalised the interest for all twelve months, claiming that the borrowing continued to remain outstanding. The facility was substantially completed and capable of operating as intended on 1 February 2027. However, commercial production was postponed until April because management was waiting for confirmed customer orders. The finance controller proposes commencing depreciation only when the first commercial batch is produced. The company's CWIP records show several projects outstanding for more than three years. One project is temporarily suspended, another has exceeded its original estimated cost, and a third is significantly overdue. The project-wise records do not reconcile with the general ledger, and the CFO has restricted the auditors' access to original contractor certificates. Management proposes providing only the aggregate CWIP figure in the financial statements. The audit team must assess borrowing-cost capitalisation, suspension and cessation dates, depreciation commencement, CWIP valuation and the prescribed ageing and completion disclosures.

On which date should capitalisation of borrowing costs ordinarily commence, considering the facts concerning the project?

1. 1 April 2026, when the company obtained the specific term loan and started incurring borrowing costs.
2. 15 April 2026, when the first expenditure on acquiring or constructing the facility was incurred.
3. 1 February 2027, when the facility was substantially completed and became capable of intended operation.
4. 1 June 2026, when expenditure, borrowing costs and activities necessary to prepare the qualifying asset were simultaneously present. (correct answer)

Answer: D — 1 June 2026, when expenditure, borrowing costs and activities necessary to prepare the qualifying asset were simultaneously present.

Explanation. AS 16, paragraphs 14 to 16, requires capitalisation to commence only when all three conditions are satisfied: expenditure on the qualifying asset is being incurred, borrowing costs are being incurred, and activities necessary to prepare the asset for intended use or sale are in progress. Although the loan was obtained on 1 April and expenditure began on 15 April, active preparatory activities commenced only on 1 June. Therefore, the earliest date satisfying all three conditions is 1 June 2026.

Where it goes wrong. Starting capitalisation merely when the loan is obtained or the first expenditure is incurred, without checking whether qualifying preparatory activities have commenced.

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

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

How should the auditors evaluate borrowing costs capitalised during the four-month construction suspension?

1. Continue capitalisation because the term loan remains outstanding and the company is contractually obliged to pay interest.
2. Require suspension of capitalisation during the extended interruption in active development, because borrowing costs during that period represent the cost of holding a partially completed asset. (correct answer)
3. Continue capitalisation because the contractor dispute is a commercial matter and cannot affect accounting for the qualifying asset.
4. Capitalise interest during the suspension but reverse the entire amount only when the facility is eventually commissioned.

Answer: B — Require suspension of capitalisation during the extended interruption in active development, because borrowing costs during that period represent the cost of holding a partially completed asset.

Explanation. AS 16, paragraphs 17 and 18, requires suspension of capitalisation during extended periods in which active development is interrupted. Borrowing costs incurred during such interruption are regarded as costs of holding a partially completed asset rather than costs directly attributable to preparing it for intended use. Capitalisation may continue during substantial technical or administrative work and temporary delays that are a necessary part of the preparation process. However, a prolonged suspension of all development activities due to a contractor dispute requires suspension.

Where it goes wrong. Assuming that continuing to incur interest on a borrowing automatically permits capitalisation even when active development has been interrupted.

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

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

The facility became capable of operating as intended on 1 February 2027, but commercial production began only in April. From which date should depreciation ordinarily commence?

1. 1 April 2027, because depreciation can commence only when the first commercial production batch is manufactured.
2. 1 April 2026, because the company began incurring interest and project expenditure from that date.
3. 1 February 2027, because depreciation begins when the asset is available for use in the manner intended by management. (correct answer)
4. 1 March 2027, because the asset must remain idle for one complete month after construction before depreciation commences.

Answer: C — 1 February 2027, because depreciation begins when the asset is available for use in the manner intended by management.

Explanation. Schedule II to the Companies Act, 2013, read with the applicable provisions of AS 10, requires depreciation to commence when an asset is available for use, meaning it is in the location and condition necessary to operate in the manner intended by management. The date of actual production or commercial utilisation is not the determining factor. Since the facility was capable of intended operation from 1 February 2027, depreciation should commence from that date notwithstanding management's decision to postpone commercial production.

Where it goes wrong. Confusing the date an asset becomes available for use with the date on which it first generates revenue or is actually used.

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

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

Which CWIP disclosure approach is required for the overdue, cost-overrun and temporarily suspended projects?

1. Present the ageing schedule in the prescribed time bands, separately identify projects in progress and temporarily suspended projects, and provide the completion schedule for projects overdue or exceeding their original estimated cost. (correct answer)
2. Present only the aggregate CWIP balance because project-wise completion estimates are internal management information rather than financial statement disclosures.
3. Disclose only projects temporarily suspended for more than three years and exclude cost-overrun projects that remain under construction.
4. Provide the completion schedule for every project regardless of delay or cost overrun, but exclude ageing information for ongoing projects.

Answer: A — Present the ageing schedule in the prescribed time bands, separately identify projects in progress and temporarily suspended projects, and provide the completion schedule for projects overdue or exceeding their original estimated cost.

Explanation. Schedule III, Part I, requires a CWIP ageing schedule with buckets of less than one year, one to two years, two to three years and more than three years, separately identifying projects in progress and temporarily suspended projects. For CWIP whose completion is overdue or whose cost has exceeded the original plan, a separate completion schedule showing the expected time for completion is required. Details of suspended projects must be separately given. The ageing totals must reconcile with the balance sheet amount.

Where it goes wrong. Confusing the general ageing schedule applicable to CWIP with the separate completion schedule required for overdue or cost-overrun projects.

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

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

Scenario. M/s V. Raman & LLP have been appointed statutory auditors of Orion Medical Technologies Ltd, a manufacturer of specialised diagnostic equipment. The company owns several production facilities and has developed proprietary software used to operate its diagnostic machinery. During the year, the board approved a revaluation of the company's production equipment. The revaluation increased the aggregate net carrying amount of the plant and machinery class by 12.5%. The valuation report was prepared by a consulting professional engaged directly by the CFO, but the team has not established whether the professional is a registered valuer under the Companies Act, 2013. The company also capitalised Rs. 85 lakh spent on an internal research project involving artificial intelligence applications. The project was still undergoing preliminary investigation and alternative evaluation at the reporting date. Management argues that the expenditure will eventually produce a valuable commercial product and should therefore be recognised as an intangible asset. The auditors further identify a software development project classified under intangible assets under development. The project expenditure includes research costs, development costs and general administrative overheads. The company cannot distinguish expenditure incurred during the research phase from expenditure incurred during the subsequent development phase. Moreover, the development records are maintained on an application that permits the project manager to amend historical cost entries without independent authorisation. An IT audit report identifies missing access logs and unexplained changes in project completion dates. The directors have also capitalised internally generated goodwill based on a consultant's estimate of the company's increased market reputation. The engagement team has requested supporting documentation and independent access to the project records, but management has refused, citing commercial confidentiality. The auditors must evaluate the accounting treatment, revaluation evidence, intangible-asset recognition, IT-related audit risks and the disclosures and reporting requirements applicable to PPE and intangible assets.

The aggregate net carrying value of the plant and machinery class has increased by 12.5% due to revaluation. What should the auditor specifically examine under CARO 2020?

1. Whether the revaluation was approved by shareholders through a special resolution and whether the entire increase was transferred to general reserve.
2. Whether the revaluation was based on valuation by a Registered Valuer and whether the amount of change is appropriately reported because it exceeds the prescribed 10% threshold. (correct answer)
3. Whether the revaluation was supported by a management certificate, since appointment of a registered valuer is optional for CARO reporting.
4. Whether the revaluation resulted in a cash inflow and whether the amount was immediately realised through disposal of the machinery.

Answer: B — Whether the revaluation was based on valuation by a Registered Valuer and whether the amount of change is appropriately reported because it exceeds the prescribed 10% threshold.

Explanation. CARO 2020 paragraph 3(i)(d) requires the auditor to examine whether PPE, including right-of-use assets, or intangible assets have been revalued during the year and whether the revaluation is based on valuation by a Registered Valuer. The amount of change must be specified where the change is 10% or more in the aggregate net carrying value of each class. Since the plant and machinery class has increased by 12.5%, the reporting threshold is crossed.

Where it goes wrong. Confusing the requirement to use a Registered Valuer with the separate 10% threshold governing reporting of the amount of change.

Authority. CARO 2020

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

Which audit procedure is most appropriate where an item of PPE contains significant components with substantially different useful lives?

1. Depreciate the entire asset over the shortest useful life because separate depreciation of components is not permitted under AS 10.
2. Depreciate the entire asset over its average useful life without considering the value of individual components.
3. Charge depreciation on each component only when it is physically replaced and expense the remaining cost annually.
4. Obtain the component-wise cost allocation and verify that each significant component is depreciated separately using the appropriate depreciation method and useful life. (correct answer)

Answer: D — Obtain the component-wise cost allocation and verify that each significant component is depreciated separately using the appropriate depreciation method and useful life.

Explanation. AS 10 (Revised), particularly paragraph 43, requires each part of an item of PPE with a cost significant in relation to the total cost to be depreciated separately. The auditor should obtain the component identification and cost allocation maintained by management, assess whether the allocation is reasonable and verify the depreciation method and useful life selected for each significant component. A single blended useful life may materially distort depreciation where major components have substantially different consumption patterns.

Where it goes wrong. Assuming that an asset must always be depreciated as one indivisible unit even when significant components have different useful lives.

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

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

How should the Rs. 85 lakh expenditure on the artificial intelligence research project be treated under AS 26?

1. Recognise it as an intangible asset because management expects the research to produce a commercially valuable product in future years.
2. Recognise it as an intangible asset if the board has approved the project and the company has allocated a research budget.
3. Recognise the research expenditure as an expense when incurred because an intangible asset arising from the research phase cannot be recognised. (correct answer)
4. Defer the research expenditure until commercial production begins and then amortise it over the expected product life.

Answer: C — Recognise the research expenditure as an expense when incurred because an intangible asset arising from the research phase cannot be recognised.

Explanation. AS 26, paragraphs 40 to 42, prohibits recognition of an intangible asset arising from research or the research phase of an internal project. Expenditure incurred during the research phase must be recognised as an expense when incurred because the entity cannot demonstrate that an identifiable asset with probable future economic benefits exists at that stage. Management's commercial expectations or board approval cannot override this requirement. Capitalisation is considered only for development expenditure when all prescribed recognition criteria are demonstrated.

Where it goes wrong. Confusing expected future commercial benefits or project approval with satisfaction of the specific recognition requirements for an internally generated intangible asset.

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

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

The project application permits unauthorised modification of historical cost entries, and management refuses access to detailed records. What is the most appropriate initial audit response?

1. Reassess the risks of material misstatement, understand the relevant IT controls, obtain alternative reliable evidence and extend substantive procedures where necessary. (correct answer)
2. Accept the project cost report because management maintains responsibility for the application and has approved the final CWIP balance.
3. Treat all internally developed software as non-existent and immediately issue an adverse opinion without further audit procedures.
4. Limit testing to the amortisation calculation because changes in historical development costs do not affect the existence of intangible assets.

Answer: A — Reassess the risks of material misstatement, understand the relevant IT controls, obtain alternative reliable evidence and extend substantive procedures where necessary.

Explanation. SA 315 requires the auditor to understand the entity's information system and assess risks arising from deficiencies in relevant IT controls. SA 330 requires responsive audit procedures addressing the assessed risks, while SA 500 requires sufficient appropriate evidence. Unauthorised modification of historical costs and missing access logs undermine the reliability of management-generated reports. The auditor should obtain alternative source documentation, inspect available audit trails, reconcile costs and assess physical or operational evidence. An adverse opinion cannot be issued automatically without evaluating the resulting misstatement or evidence limitation.

Where it goes wrong. Assuming that management approval makes IT-generated reports reliable, or treating every control weakness as automatic proof that the recorded asset does not exist.

Authority. SA 315; SA 330; SA 500

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

Scenario. A company adopts a residual value of 8% of original cost for a class of machinery, whereas Schedule II ordinarily restricts residual value to 5%. It also adopts a useful life different from the life specified in Part C of Schedule II. What should the auditor require?

A company adopts a residual value of 8% of original cost for a class of machinery, whereas Schedule II ordinarily restricts residual value to 5%. It also adopts a useful life different from the life specified in Part C of Schedule II. What should the auditor require?

1. Require automatic reversal of both estimates because Schedule II does not permit any departure from its prescribed useful lives or residual values.
2. Accept the estimates without further examination because management can independently determine the useful life and residual value of PPE.
3. Verify that the departures are disclosed in the financial statements and justified with supporting technical advice. (correct answer)
4. Accept the residual value deviation if the depreciation method is straight-line, but reject every change in useful life.

Answer: C — Verify that the departures are disclosed in the financial statements and justified with supporting technical advice.

Explanation. Schedule II, paragraph 3(i), to the Companies Act, 2013 provides that useful life should not ordinarily differ from that specified in Part C and residual value should not exceed 5% of original cost. Where a company adopts a different useful life or residual value, the financial statements must disclose the difference and provide justification duly supported by technical advice. The auditor should examine the supporting assessment and disclosure rather than automatically accepting or rejecting every departure.

Where it goes wrong. Treating the Schedule II useful-life and residual-value provisions as absolute prohibitions instead of recognising the prescribed exception supported by technical advice and disclosure.

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

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

Scenario. A machine costing Rs. 48 lakh has an estimated residual value of 5% of original cost and a useful life of 10 years. Under the straight-line method, it became available for use on 1 October 2026. Assuming a financial year ending 31 March 2027, what depreciation should be charged for the year?

A machine costing Rs. 48 lakh has an estimated residual value of 5% of original cost and a useful life of 10 years. Under the straight-line method, it became available for use on 1 October 2026. Assuming a financial year ending 31 March 2027, what depreciation should be charged for the year?

1. Rs. 2.28 lakh. (correct answer)
2. Rs. 4.80 lakh.
3. Rs. 2.40 lakh.
4. Rs. 4.56 lakh.

Answer: A — Rs. 2.28 lakh.

Explanation. The depreciable amount is cost less residual value. Residual value is 5% of Rs. 48 lakh, or Rs. 2.40 lakh. Therefore, the depreciable amount is Rs. 45.60 lakh. Annual straight-line depreciation over 10 years is Rs. 4.56 lakh. Since the machine became available for use on 1 October 2026, depreciation for six months is Rs. 4.56 lakh multiplied by 6/12, giving Rs. 2.28 lakh. The calculation follows Schedule II and the depreciation commencement principle under AS 10.

Where it goes wrong. Charging a full year's depreciation or calculating depreciation on the entire original cost without deducting residual value.

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

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

Scenario. During audit, the company has not charged depreciation on an ordinary freehold land parcel because management believes land has an unlimited useful life. Which conclusion is correct?

During audit, the company has not charged depreciation on an ordinary freehold land parcel because management believes land has an unlimited useful life. Which conclusion is correct?

1. The auditor should require depreciation on every land parcel because all items classified as PPE must be depreciated.
2. The auditor should require depreciation only when the land has been used for commercial operations for more than one year.
3. The auditor should accept the omission only if the land was acquired through a government grant rather than purchased.
4. The auditor may accept the treatment where the freehold land has an unlimited useful life, while separately examining whether any impairment indicator exists. (correct answer)

Answer: D — The auditor may accept the treatment where the freehold land has an unlimited useful life, while separately examining whether any impairment indicator exists.

Explanation. AS 10 (Revised) recognises that land and buildings are separable assets and that land ordinarily has an unlimited useful life and therefore is not depreciated. An exception may arise where the useful life of the land itself is limited. The auditor should examine the nature of the land, ownership documents and any restrictions affecting its useful life. The absence of depreciation does not remove the need to consider impairment indicators under AS 28.

Where it goes wrong. Assuming that every asset included within PPE must necessarily be depreciated irrespective of its useful life.

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. A machine with an original cost of Rs. 30 lakh and accumulated depreciation of Rs. 18 lakh up to the date of disposal is sold for Rs. 10 lakh. Which accounting verification should the auditor perform?

A machine with an original cost of Rs. 30 lakh and accumulated depreciation of Rs. 18 lakh up to the date of disposal is sold for Rs. 10 lakh. Which accounting verification should the auditor perform?

1. Retain the asset at its original cost and credit the sale proceeds directly to accumulated depreciation.
2. Verify removal of original cost and accumulated depreciation, compare the Rs. 12 lakh carrying amount with net sale proceeds and ensure the Rs. 2 lakh loss is correctly recognised. (correct answer)
3. Retain the accumulated depreciation in the books and recognise the entire sale proceeds as miscellaneous income.
4. Reverse all depreciation charged in earlier years and transfer the sale proceeds directly to the revaluation reserve.

Answer: B — Verify removal of original cost and accumulated depreciation, compare the Rs. 12 lakh carrying amount with net sale proceeds and ensure the Rs. 2 lakh loss is correctly recognised.

Explanation. AS 10 (Revised), particularly paragraphs 67 and 68, requires derecognition of an item of PPE on disposal or when no future economic benefits are expected from its use or disposal. The auditor should verify the sale documentation, management approval, original cost and accumulated depreciation up to the disposal date. The carrying amount is Rs. 12 lakh, being Rs. 30 lakh less Rs. 18 lakh. Against sale proceeds of Rs. 10 lakh, the resulting loss is Rs. 2 lakh, subject to any relevant disposal costs.

Where it goes wrong. Recognising sale proceeds as income without removing the original cost and accumulated depreciation of the disposed asset.

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. While reviewing the company's fixed asset documentation, the auditor discovers that PPE records contain only asset names and gross values, while intangible asset records do not identify individual assets. Which CARO 2020 requirement is most directly relevant?

While reviewing the company's fixed asset documentation, the auditor discovers that PPE records contain only asset names and gross values, while intangible asset records do not identify individual assets. Which CARO 2020 requirement is most directly relevant?

1. Paragraph 3(i)(a), requiring proper records with full particulars, including quantitative details and situation of PPE, and proper records showing full particulars of intangible assets. (correct answer)
2. Paragraph 3(ii), requiring physical verification of all intangible assets and annual certification of their fair values by management.
3. Paragraph 3(iv), requiring the auditor to identify all internally generated goodwill and certify its recoverable amount.
4. Paragraph 3(i)(d), requiring a Registered Valuer to certify every fixed asset register maintained by the company.

Answer: A — Paragraph 3(i)(a), requiring proper records with full particulars, including quantitative details and situation of PPE, and proper records showing full particulars of intangible assets.

Explanation. CARO 2020 paragraph 3(i)(a)(A) requires proper records showing full particulars, including quantitative details and situation of PPE. Paragraph 3(i)(a)(B) separately requires proper records showing full particulars of intangible assets. The auditor should evaluate the adequacy and completeness of the records and consider their ability to support verification, accounting and disclosure. The other clauses deal with different matters such as physical verification, revaluation or other reporting requirements and cannot replace the record-maintenance requirement.

Where it goes wrong. Confusing the requirement to maintain proper asset records with the separate requirements concerning physical verification or valuation.

Authority. CARO 2020

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

Scenario. An auditor finds that the title deeds of an immovable property disclosed in the balance sheet are held in the name of a director's relative. The property is not leased to the company under an executed lease agreement. Which statement is correct?

An auditor finds that the title deeds of an immovable property disclosed in the balance sheet are held in the name of a director's relative. The property is not leased to the company under an executed lease agreement. Which statement is correct?

1. The auditor may ignore the matter if the director's relative has provided a declaration confirming that the property belongs beneficially to the company.
2. The matter requires disclosure only when the property has been pledged as security against a bank borrowing.
3. The auditor should report the matter under CARO 2020 paragraph 3(i)(c), with the prescribed details concerning title holder, relationship, carrying value, period held and reason for mismatch. (correct answer)
4. The auditor should disclose the property only in the fixed asset reconciliation without identifying the title holder or reason for the mismatch.

Answer: C — The auditor should report the matter under CARO 2020 paragraph 3(i)(c), with the prescribed details concerning title holder, relationship, carrying value, period held and reason for mismatch.

Explanation. CARO 2020 paragraph 3(i)(c) requires the auditor to examine whether title deeds of all immovable properties disclosed in financial statements are held in the company's name, except specified properties held as lessee under duly executed lease agreements. Where title deeds are not in the company's name, prescribed information including gross carrying value, title holder, relationship, period held and reason for the difference must be reported. The director's relative's declaration does not replace legal-title verification or the statutory reporting requirement.

Where it goes wrong. Assuming that a declaration of beneficial ownership or a relationship with the title holder removes the requirement for disclosure and reporting.

Authority. CARO 2020

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

Scenario. Management proposes recognising internally generated goodwill of Rs. 2 crore based on an external consultant's estimate of the company's improved market reputation and customer loyalty. What should the auditor conclude under AS 26?

Management proposes recognising internally generated goodwill of Rs. 2 crore based on an external consultant's estimate of the company's improved market reputation and customer loyalty. What should the auditor conclude under AS 26?

1. Recognise goodwill if the consultant is independent and has used a discounted cash-flow valuation method.
2. Recognise goodwill if the board approves the valuation and the amount is disclosed separately in the balance sheet.
3. Recognise goodwill only when the company has operated profitably for three consecutive financial years.
4. Do not recognise internally generated goodwill as an asset because it is not an identifiable resource controlled by the enterprise that can be measured reliably at cost. (correct answer)

Answer: D — Do not recognise internally generated goodwill as an asset because it is not an identifiable resource controlled by the enterprise that can be measured reliably at cost.

Explanation. AS 26, paragraphs 35 to 37, expressly prohibits recognition of internally generated goodwill as an asset. Such expenditure may contribute to expected future economic benefits, but internally generated goodwill is not an identifiable resource controlled by the enterprise whose cost can be measured reliably. A consultant's valuation, management approval or a history of profitability cannot overcome this recognition restriction. The auditor should require correction of the accounting treatment and evaluate the related misstatement if management refuses.

Where it goes wrong. Confusing a valuation of the company's overall reputation or market value with the recognition of a separately identifiable and controlled intangible asset.

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 statutory audit firm is asked by its existing audit client to design and implement a new financial information system incorporating the fixed asset register, depreciation calculations and asset-disposal workflows. Which response is appropriate?

A statutory audit firm is asked by its existing audit client to design and implement a new financial information system incorporating the fixed asset register, depreciation calculations and asset-disposal workflows. Which response is appropriate?

1. Accept the engagement if the audit committee approves the project and the firm uses a separate implementation team.
2. Decline the prohibited non-audit service because Section 144 bars the statutory auditor from designing and implementing financial information systems for the company. (correct answer)
3. Accept the engagement if the system is limited to PPE rather than the general ledger or financial statements.
4. Accept the engagement if the audit partner independently reviews the implementation work before issuing the audit report.

Answer: B — Decline the prohibited non-audit service because Section 144 bars the statutory auditor from designing and implementing financial information systems for the company.

Explanation. Section 144 of the Companies Act, 2013 prohibits an auditor appointed under the Act from providing specified services to the company, its holding company or subsidiary, including the design and implementation of any financial information system. A fixed asset and depreciation application that forms part of the company's financial information system falls within this prohibition. Audit committee approval, separate staffing or subsequent partner review cannot override the statutory restriction. The firm must decline the proposed prohibited service.

Where it goes wrong. Assuming that audit committee approval or separation of implementation and audit teams can override the express prohibition under Section 144.

Authority. Section 144

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

Scenario. A company obtains a specific borrowing of Rs. 5 crore at 10% per annum exclusively for constructing a qualifying asset. The entire borrowing is specifically attributable to the project, and interest of Rs. 50 lakh is incurred during the accounting period. Temporary investment of the unutilised borrowing generates income of Rs. 4 lakh. What amount of borrowing costs should be capitalised under AS 16?

A company obtains a specific borrowing of Rs. 5 crore at 10% per annum exclusively for constructing a qualifying asset. The entire borrowing is specifically attributable to the project, and interest of Rs. 50 lakh is incurred during the accounting period. Temporary investment of the unutilised borrowing generates income of Rs. 4 lakh. What amount of borrowing costs should be capitalised under AS 16?

1. Rs. 46 lakh. (correct answer)
2. Rs. 50 lakh.
3. Rs. 40 lakh.
4. Rs. 54 lakh.

Answer: A — Rs. 46 lakh.

Explanation. AS 16, paragraph 10, provides that borrowing costs directly attributable to the acquisition, construction or production of a qualifying asset are capitalised. For specific borrowings, the eligible amount is the actual borrowing costs incurred during the period, reduced by any income earned from temporary investment of those borrowings. Thus, Rs. 50 lakh interest less Rs. 4 lakh investment income gives eligible borrowing costs of Rs. 46 lakh. Capitalising the gross interest without deducting the investment income would overstate the qualifying asset's cost.

Where it goes wrong. Capitalising the entire interest incurred on specific borrowings without deducting income earned from temporary investment of the unutilised funds.

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

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

Scenario. A project has remained in CWIP for three years and four months. It is still under active construction and has not been temporarily suspended. Under Schedule III, how should the balance be presented in the CWIP ageing schedule?

A project has remained in CWIP for three years and four months. It is still under active construction and has not been temporarily suspended. Under Schedule III, how should the balance be presented in the CWIP ageing schedule?

1. Under projects temporarily suspended, in the one-to-two-year ageing column.
2. Under projects in progress, in the two-to-three-year ageing column.
3. Under projects in progress, in the more-than-three-year ageing column. (correct answer)
4. Under completed PPE, because CWIP cannot remain outstanding beyond three financial years.

Answer: C — Under projects in progress, in the more-than-three-year ageing column.

Explanation. Schedule III, Part I, requires CWIP to be classified between projects in progress and projects temporarily suspended and presented in the prescribed ageing buckets: less than one year, one to two years, two to three years and more than three years. Since the project has remained under active construction for three years and four months, it belongs in projects in progress under the more-than-three-year category. The three-year threshold does not automatically require the project to be transferred to completed PPE.

Where it goes wrong. Confusing the more-than-three-year ageing category with the temporarily suspended project category or assuming that old CWIP must automatically be capitalised as completed PPE.

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

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

Scenario. A company revalues a class of PPE during the year. The aggregate change in the net carrying value of the class is 9.8%. The valuation is supported by a Registered Valuer. Which CARO 2020 reporting conclusion is most appropriate?

A company revalues a class of PPE during the year. The aggregate change in the net carrying value of the class is 9.8%. The valuation is supported by a Registered Valuer. Which CARO 2020 reporting conclusion is most appropriate?

1. No reporting is necessary because the change is below 10%, including whether valuation was performed by a Registered Valuer.
2. The auditor must report the amount of change because every revaluation automatically exceeds the prescribed threshold.
3. The auditor must report only the revised carrying amount but need not examine whether the valuer is registered.
4. The auditor should report that revaluation occurred and examine whether it was based on a Registered Valuer; the specific 10% threshold for specifying the amount of change has not been crossed. (correct answer)

Answer: D — The auditor should report that revaluation occurred and examine whether it was based on a Registered Valuer; the specific 10% threshold for specifying the amount of change has not been crossed.

Explanation. CARO 2020 paragraph 3(i)(d) requires the auditor to examine whether PPE or intangible assets have been revalued and whether the revaluation is based on a Registered Valuer. It separately requires the amount of change to be specified where the change is 10% or more in the aggregate net carrying value of each class. A change of 9.8% does not cross that reporting threshold, but the revaluation and the Registered Valuer requirement remain relevant to the auditor's examination.

Where it goes wrong. Treating the 10% threshold as an exemption from reporting the existence of a revaluation or from examining the Registered Valuer requirement.

Authority. CARO 2020

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

Scenario. A company revalued a class of PPE during the previous financial year and has continued presenting the revised carrying amounts in subsequent balance sheets. Which disclosure should the auditor verify under Schedule III, Part I?

A company revalued a class of PPE during the previous financial year and has continued presenting the revised carrying amounts in subsequent balance sheets. Which disclosure should the auditor verify under Schedule III, Part I?

1. Disclosure of the original historical cost alone, because revaluation increases are required to be removed from subsequent balance sheets.
2. For the first five years subsequent to the date of revaluation, disclosure of the revised figures together with a note indicating the amount and date of the increase or reduction. (correct answer)
3. Disclosure of the revised value only in the year of revaluation, because subsequent-year notes are prohibited under Schedule III.
4. Disclosure of the revaluation increase only when the asset is sold and the resulting profit becomes realised.

Answer: B — For the first five years subsequent to the date of revaluation, disclosure of the revised figures together with a note indicating the amount and date of the increase or reduction.

Explanation. Schedule III, Part I, requires where amounts have been added or written off on revaluation of assets that subsequent balance sheets show the revised figures. A note must also disclose the amount of the increase or reduction and the date thereof for the first five years subsequent to the date of the revaluation. The auditor should examine whether the note is complete and whether the revised carrying values and related depreciation are accurately reflected.

Where it goes wrong. Assuming that revaluation disclosures are required only in the year of revaluation and need not continue in the following five years.

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. An internally generated software project has moved into its development phase. Management can demonstrate technical feasibility, intention to complete, ability to use the software and probable future economic benefits. However, it cannot demonstrate the availability of adequate financial resources or reliably measure expenditure attributable to development. What is the appropriate accounting conclusion under AS 26?

An internally generated software project has moved into its development phase. Management can demonstrate technical feasibility, intention to complete, ability to use the software and probable future economic benefits. However, it cannot demonstrate the availability of adequate financial resources or reliably measure expenditure attributable to development. What is the appropriate accounting conclusion under AS 26?

1. Capitalise the entire project because four out of the six prescribed development conditions have been satisfied.
2. Capitalise the software from the original research stage because technical feasibility has now been established.
3. Do not recognise development expenditure as an intangible asset until all six specified recognition conditions can be demonstrated. (correct answer)
4. Capitalise all project costs but defer amortisation until the software generates sufficient operating revenue.

Answer: C — Do not recognise development expenditure as an intangible asset until all six specified recognition conditions can be demonstrated.

Explanation. AS 26, paragraphs 44 and 45, requires an intangible asset arising from development to be recognised if and only if the enterprise demonstrates all six specified conditions. These include technical feasibility, intention to complete, ability to use or sell, probable future economic benefits, availability of adequate resources and reliable measurement of attributable development expenditure. Since the last two conditions cannot be demonstrated, the development expenditure cannot be recognised as an intangible asset at this stage. Earlier expenditure already expensed cannot subsequently be reinstated.

Where it goes wrong. Assuming that satisfaction of most development recognition conditions is sufficient even though AS 26 requires demonstration of every prescribed condition.

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