Audit of Items of Financial Statements - Test 4: 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 Pratham Auto Components Ltd, a manufacturer of specialised automobile components. At 31 March 2027, the company reports closing inventory of Rs. 18.60 crore comprising raw materials, work-in-progress and finished goods. The auditors identify a batch of 2,400 finished motor units having a recorded cost of Rs. 1,180 per unit. The estimated selling price is Rs. 1,225 per unit, while estimated distribution and selling expenses are Rs. 70 per unit. Management has continued valuing the batch at historical cost because the selling price exceeds the recorded cost. The company's annual physical inventory count was conducted on 28 March 2027 under the supervision of warehouse employees. The auditors attended the count, but several differences between physical quantities and the perpetual inventory records remained unreconciled. A particular class of raw materials showed a discrepancy representing 11.4% of its recorded quantity. The plant controller instructed the accounts department to retain the book quantities, claiming that the differences were within internal stock-tolerance limits. The company also stores substantial quantities of components at an independent job worker's premises. Some materials lying there belong to the company, whereas other materials are received from customers for processing. Management has included the entire quantity in its closing inventory report. The job worker's records contain no clear ownership classification, and management has refused to permit direct confirmation from the job worker. The engagement team has also identified weaknesses in the inventory application. Warehouse supervisors can modify stock quantities without independent approval, and the application does not preserve complete transaction histories. The finance director proposes relying on the physical verification certificate and management representation. The auditors must assess valuation, physical verification evidence, ownership, reconciliation and the reporting implications of the identified discrepancies.

What is the appropriate valuation of the 2,400 finished motor units under AS 2, Inventories, and what adjustment should the auditor recommend?

1. Value the units at Rs. 1,155 each and recommend a total write-down of Rs. 60,000. (correct answer)
2. Retain the cost of Rs. 1,180 per unit because the selling price exceeds the recorded cost.
3. Value the units at Rs. 1,225 each and recognise an unrealised inventory appreciation of Rs. 1,08,000.
4. Value the units at Rs. 1,110 each and recommend an inventory write-down of Rs. 1,68,000.

Answer: A — Value the units at Rs. 1,155 each and recommend a total write-down of Rs. 60,000.

Explanation. AS 2, paragraph 5, requires inventories to be measured at the lower of cost and net realisable value. NRV is Rs. 1,225 less selling expenses of Rs. 70, giving Rs. 1,155 per unit. The difference from recorded cost is Rs. 25 per unit. Therefore, the total write-down is 2,400 multiplied by Rs. 25, amounting to Rs. 60,000. A selling price higher than cost does not establish that NRV exceeds cost after deducting necessary selling expenses.

Where it goes wrong. Comparing cost directly with selling price instead of calculating NRV after deducting estimated completion and selling costs.

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 auditors attended the physical inventory count on 28 March, whereas the financial statements are prepared as at 31 March. Which additional procedure is most appropriate under SA 501?

1. Accept the 28 March count as conclusive evidence because the company maintains perpetual inventory records.
2. Require a complete second physical count on 31 March irrespective of the reliability of the intervening inventory records.
3. Perform procedures to obtain evidence that inventory movements between 28 March and 31 March have been properly recorded and that the final closing balance is reliable. (correct answer)
4. Obtain a written representation from the warehouse manager confirming that no significant stock movements occurred during the intervening period.

Answer: C — Perform procedures to obtain evidence that inventory movements between 28 March and 31 March have been properly recorded and that the final closing balance is reliable.

Explanation. SA 501, paragraph 5, addresses situations where physical inventory counting is conducted at a date other than the financial statement date. The auditor must perform audit procedures to obtain evidence regarding whether changes in inventory between the count date and reporting date have been properly recorded. This includes testing receipts, dispatches, production consumption and other movements. Merely accepting perpetual records or obtaining management representation does not establish the accuracy of intervening movements.

Where it goes wrong. Assuming that attendance at an interim inventory count automatically establishes the closing inventory balance without testing subsequent movements.

Authority. SA 501

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

Which evidence would most appropriately establish the existence and ownership of inventory held at the independent job worker's premises?

1. Accept the company's warehouse dispatch register and assume that all goods sent to the job worker remain company property.
2. Obtain a declaration on the job worker's business letterhead, signed by an authorised representative, confirming the company's inventory held there, and reconcile it with job-work and ownership records. (correct answer)
3. Include the entire quantity reported by the job worker because goods physically located outside the company premises are presumed to belong to the company.
4. Obtain a representation from the CFO confirming that the complete job-work inventory belongs to the company.

Answer: B — Obtain a declaration on the job worker's business letterhead, signed by an authorised representative, confirming the company's inventory held there, and reconcile it with job-work and ownership records.

Explanation. SA 501 requires appropriate evidence concerning inventory held by third parties when material to the financial statements. The Chapter 5 procedures specifically recommend obtaining a declaration from the third party on its business letterhead, signed by an authorised person, confirming inventory belonging to the entity and held on its behalf. The auditor should reconcile such confirmation with job-work agreements and stock records. Customer-owned materials and consignment goods must not be included merely because they are physically located with the job worker.

Where it goes wrong. Confusing physical possession with legal ownership and including customer-owned or consignment inventory in the company's closing stock.

Authority. SA 501

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

What is the most appropriate reporting consequence of the 11.4% discrepancy in the raw materials class, where management has not properly adjusted the difference?

1. No CARO reporting is necessary because discrepancies below 15% are considered insignificant.
2. Report the discrepancy only if the total inventory shortage across all classes exceeds 25% of closing inventory.
3. Report the discrepancy only when the external auditor personally conducted the physical verification rather than observing management's count.
4. Report under CARO 2020 paragraph 3(ii)(a), specifying discrepancies of 10% or more in aggregate for each class and whether they have been properly dealt with in the books. (correct answer)

Answer: D — Report under CARO 2020 paragraph 3(ii)(a), specifying discrepancies of 10% or more in aggregate for each class and whether they have been properly dealt with in the books.

Explanation. CARO 2020, paragraph 3(ii)(a), requires the auditor to report whether inventory has been physically inspected by management at reasonable intervals, whether discrepancies of 10% or more in aggregate for each class of inventory were noticed and whether they have been properly dealt with in the books. The threshold is not 15% or a combined percentage across all inventory classes. The auditor must evaluate the discrepancy and its accounting treatment rather than relying on management's internal tolerance limits.

Where it goes wrong. Confusing the 10% reporting threshold for each class of inventory with an internally prescribed stock-tolerance percentage or an overall inventory threshold.

Authority. CARO 2020

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

Scenario. M/s K. Mehta & Co. are conducting the statutory audit of Nova Electronics Ltd, an electronics distributor with substantial year-end credit sales. Trade receivables at 31 March 2027 amount to Rs. 32 crore. One major customer, representing approximately 27% of total receivables, has an outstanding balance of Rs. 8.64 crore. The customer has raised a quality dispute involving Rs. 1.20 crore, but management continues to classify the entire balance as undisputed and considered good. The audit team proposes circularising significant customer balances. The CFO, however, requests that the major customer be excluded because the company is negotiating a long-term commercial arrangement with it. Management instead proposes sending negative confirmation requests to all customers. The auditors discover that several customer master records can be created by sales personnel without independent verification, and the same personnel can authorise dispatches and modify customer credit limits. During year-end cut-off testing, the team discovers invoices dated 31 March 2027 for goods that were actually dispatched on 2 April 2027. Conversely, certain goods dispatched on 29 March were invoiced only on 5 April. Management maintains that invoice dates determine the accounting period. Subsequent examination also reveals substantial customer returns and credit notes issued in April, some relating to sales recorded during the final week of March. Several confirmation requests sent to customers have not received responses. The CFO offers a signed representation confirming that all outstanding balances are recoverable and all sales have been correctly recorded. The engagement partner suspects possible premature revenue recognition and overstatement of receivables. The team must determine appropriate confirmation methods, alternative procedures, year-end cut-off adjustments and valuation evidence.

Which approach is preferable when the auditors seek confirmation of the Rs. 8.64 crore balance from the major customer?

1. Send a positive confirmation showing the company's balance and treat the absence of a reply as acceptance.
2. Permit the CFO to communicate the balance directly to the customer and forward the customer's response to the audit team.
3. Use a blank-balance confirmation request asking the customer to state its own balance, maintain control over dispatch and receipt, and investigate any differences. (correct answer)
4. Use negative confirmation only because the customer represents a substantial portion of total receivables and may not respond to positive requests.

Answer: C — Use a blank-balance confirmation request asking the customer to state its own balance, maintain control over dispatch and receipt, and investigate any differences.

Explanation. SA 505 requires the auditor to maintain control over external confirmation requests, including their selection, preparation, dispatch and receipt. Chapter 5 recommends a confirmation without any balance mentioned because the customer is required to independently state the amount according to its records. This reduces the risk of simply agreeing with management's figure. The significant and disputed balance makes independent confirmation particularly important. Silence in response to a positive confirmation is not equivalent to an affirmative response.

Where it goes wrong. Confusing positive confirmation with implied acceptance and overlooking the greater evidential value of an independently stated balance.

Authority. SA 505

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

The company recorded sales invoices on 31 March 2027 for goods actually dispatched on 2 April 2027. What should the auditor primarily investigate?

1. Whether the sales were prematurely recognised at year-end and whether the corresponding trade receivables and inventory require adjustment based on the applicable revenue-recognition criteria. (correct answer)
2. Whether the goods were included in the March physical inventory count, without examining the sales recognition or dispatch documentation.
3. Whether the customer has subsequently paid the invoice, because collection after year-end validates the original March revenue recognition.
4. Whether the invoices were generated through an authorised application, because invoice authorisation establishes the transfer of goods.

Answer: A — Whether the sales were prematurely recognised at year-end and whether the corresponding trade receivables and inventory require adjustment based on the applicable revenue-recognition criteria.

Explanation. The Chapter 5 trade-receivables cut-off procedures require the auditor to examine invoices issued during the last few days of the reporting year and verify that corresponding goods were actually dispatched rather than remaining with the company. SA 500 requires appropriate supporting evidence for recorded transactions. Where revenue recognition conditions have not been satisfied by year-end, premature sales and receivables must be corrected and inventory adjusted as appropriate. Subsequent collection does not automatically validate an incorrect recognition date.

Where it goes wrong. Treating invoice generation or subsequent collection as conclusive evidence of year-end revenue recognition without examining actual dispatch and transfer of control.

Authority. SA 500

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

Several customers have not responded to confirmation requests. Which alternative procedure would provide the most appropriate evidence regarding their outstanding receivable balances?

1. Treat non-response as confirmation of the amount shown in the company's receivables ledger.
2. Ask the credit-control department to certify the balances and accept the certificate as independent evidence.
3. Exclude the non-responding customers from substantive testing because confirmation requests have already been dispatched.
4. Trace subsequent cash receipts to bank records and examine underlying invoices, dispatch evidence and detailed customer-account transactions. (correct answer)

Answer: D — Trace subsequent cash receipts to bank records and examine underlying invoices, dispatch evidence and detailed customer-account transactions.

Explanation. SA 505 requires the auditor to perform alternative procedures when an external confirmation response is not received. Chapter 5 specifically identifies subsequent cash receipts, examination of underlying invoices and detailed analysis of identifiable transactions as suitable procedures for trade receivables. These procedures help establish existence and accuracy where confirmation is unavailable. A non-response is not positive evidence of agreement, and an internal credit-control certificate does not provide equivalent independent evidence.

Where it goes wrong. Treating a customer's silence as confirmation or assuming that dispatching a confirmation request eliminates the need for further substantive procedures.

Authority. SA 505

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

The audit team discovers substantial customer returns and credit notes issued in April relating to sales recorded in the final week of March. Which procedure is most appropriate?

1. Ignore all April credit notes because transactions occurring after the reporting period cannot affect March financial statements.
2. Examine subsequent credit notes, return-receiving records and related correspondence to identify sales recognised prematurely or deductions relating to the examined under statutory audit period. (correct answer)
3. Treat all subsequent customer returns as new expenses of the following financial year without investigating their original sales transactions.
4. Reverse every March sale because customer returns after year-end automatically establish that no sale occurred.

Answer: B — Examine subsequent credit notes, return-receiving records and related correspondence to identify sales recognised prematurely or deductions relating to the examined under statutory audit period.

Explanation. The Chapter 5 audit procedures for trade receivables require examination of credit notes issued after year-end to identify whether they relate to sales belonging to the period under audit. The auditor should inspect receiving records, dispatch evidence, customer correspondence and authorisation of deductions. Under SA 560, subsequent events may provide evidence concerning conditions existing at the reporting date. However, not every subsequent return automatically invalidates the original sale; the underlying facts must be evaluated.

Where it goes wrong. Assuming that all post-year-end credit notes are irrelevant to the examined under statutory audit period or automatically require reversal of every related sale.

Authority. SA 560

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

Scenario. M/s V. Raman & LLP are the statutory auditors of Meridian Pharma Products Ltd, a company manufacturing pharmaceutical formulations and distributing medical products. The company follows Indian Accounting Standards and reports trade receivables of Rs. 42 crore at 31 March 2027. The ageing schedule shows Rs. 6.20 crore outstanding for more than one year. Included in this amount is Rs. 2.40 crore due from a distributor against whom insolvency proceedings commenced during the financial year. No specific allowance has been recorded because the CFO expects recovery through future business dealings. The company's expected credit loss model is based exclusively on historical default percentages. The model has not been adjusted for the recent decline in the distributor network's financial position or the deterioration in market conditions. The auditors also discover that a significant customer has disputed several invoices, but the dispute is not reflected in the debtor ageing analysis. Subsequent receipts provide evidence of collection difficulties for certain balances. During the year, management wrote off Rs. 80 lakh of customer balances directly from the receivables ledger. The finance manager approved these adjustments without documented authorisation from the appropriate senior authority. The movement schedule of the allowance for doubtful accounts does not reconcile with the general ledger. Further, sales personnel have access to the receivables application and can alter customer balances and process write-offs without independent approval. Several changes to customer records lack a verifiable audit trail. The CFO has asked the audit team not to investigate selected customer balances because the company expects to retain those customers commercially. A related-party customer also has a substantial outstanding balance, although no subsequent payments have been received. Management proposes resolving all audit concerns through a written representation. The engagement team must evaluate recoverability, impairment allowances, write-off authorisation, related-party disclosures and the reliability of the receivables system.

Meridian Pharma Products Ltd follows Ind AS. For its trade receivables without a significant financing component, which impairment approach should the auditor expect management to apply?

1. A specific impairment allowance only after individual customers are formally declared insolvent by a competent authority.
2. An incurred-loss approach recognising impairment only when an actual default has occurred.
3. A provision based exclusively on historical losses, without considering subsequent economic conditions or reasonable forward-looking information.
4. The simplified approach under Ind AS 109, measuring the loss allowance at lifetime expected credit losses using appropriate historical, current and forward-looking information. (correct answer)

Answer: D — The simplified approach under Ind AS 109, measuring the loss allowance at lifetime expected credit losses using appropriate historical, current and forward-looking information.

Explanation. Ind AS 109, paragraph 5.5.15, requires an entity to measure the loss allowance at lifetime expected credit losses for trade receivables without a significant financing component, using the simplified approach. The assessment should incorporate relevant historical loss experience, current conditions and reasonable forward-looking information. Waiting for formal insolvency or using only incurred losses is inconsistent with the expected-credit-loss approach. The auditor should examine the methodology, data and assumptions underlying management's provision matrix.

Where it goes wrong. Applying an incurred-loss model or relying exclusively on historical default percentages instead of the lifetime expected credit-loss approach.

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

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

The Rs. 2.40 crore debtor is undergoing insolvency proceedings, and management has not recognised any specific allowance. Which audit response is most appropriate?

1. Accept the balance at its original invoice amount because insolvency proceedings do not establish the amount ultimately recoverable.
2. Investigate the insolvency proceedings, subsequent receipts, available recovery evidence and expected credit losses, and assess whether the recorded allowance adequately reflects the credit risk. (correct answer)
3. Write off the entire balance immediately because insolvency proceedings conclusively establish that no recovery is possible.
4. Reclassify the amount as inventory because the customer may return the goods during the insolvency process.

Answer: B — Investigate the insolvency proceedings, subsequent receipts, available recovery evidence and expected credit losses, and assess whether the recorded allowance adequately reflects the credit risk.

Explanation. SA 500 requires sufficient appropriate evidence regarding the valuation of trade receivables, while SA 540 is relevant when evaluating management's accounting estimates. The Chapter 5 procedures require examination of aged balances, debtors under litigation, doubtful accounts and subsequent recoveries. Under Ind AS 109, insolvency proceedings are significant credit-risk information that must be considered in measuring expected credit losses. However, insolvency does not automatically establish complete non-recoverability or justify writing off the entire balance without evidence.

Where it goes wrong. Confusing the existence of insolvency proceedings with conclusive proof of total non-recoverability, or ignoring the impairment implications altogether.

Authority. SA 500; SA 540

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

How should the audit team evaluate the Rs. 80 lakh customer write-offs made by the finance manager?

1. Verify that the write-offs were approved by an appropriate authorised authority, examine supporting evidence and reconcile the movements in bad debts and allowance accounts. (correct answer)
2. Accept the write-offs because a receivable can be removed whenever the credit-control department considers collection uneconomical.
3. Reverse every write-off because only a court decree can authorise removal of trade receivables from the books.
4. Transfer all written-off balances to the fixed asset register because the company may recover them in future years.

Answer: A — Verify that the write-offs were approved by an appropriate authorised authority, examine supporting evidence and reconcile the movements in bad debts and allowance accounts.

Explanation. Chapter 5 requires the auditor to verify that write-offs of receivable balances have been approved by an appropriate authority, such as the Board of Directors in the case of a company. The auditor should examine supporting documentation, investigate unusual adjustments and prepare a schedule of movements in bad debts and allowance accounts. Under SA 500, approval and evidence of the underlying uncollectibility must be evaluated. Informal approval by a finance manager cannot automatically establish proper authorisation.

Where it goes wrong. Assuming that management's operational decision to remove a debtor is sufficient evidence of proper write-off approval and accounting.

Authority. SA 500

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

The CFO asks the audit team to exclude the related-party debtor from detailed recoverability testing because the company intends to maintain its commercial relationship. What should the auditor do?

1. Accept the request because related-party receivables are normally recoverable when transactions are commercially important.
2. Restrict testing to checking the original sales invoices and exclude subsequent collection information from the audit.
3. Examine recoverability, authorisation and commercial reasonableness of the transactions and ensure appropriate related-party disclosures under the applicable financial reporting framework. (correct answer)
4. Classify the balance automatically as a contingent asset because the customer is related to the company.

Answer: C — Examine recoverability, authorisation and commercial reasonableness of the transactions and ensure appropriate related-party disclosures under the applicable financial reporting framework.

Explanation. The Chapter 5 audit procedures specifically require review of related-party receivables for collectability, appropriate authorisation and whether the transaction values are reasonable and at arm's length. SA 550 requires the auditor to remain alert to related-party transactions and their financial reporting implications. The applicable disclosure framework, such as Ind AS 24 or AS 18, must also be considered. Commercial importance does not justify excluding the balance from audit procedures or ignoring credit-risk indicators.

Where it goes wrong. Assuming that related-party status or an ongoing commercial relationship establishes recoverability and removes the need for independent audit evidence.

Authority. SA 550

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

Scenario. A company maintains different cost formulas for two categories of inventory. The categories differ materially in their nature and their use in the company's operations. Which statement is correct under AS 2?

A company maintains different cost formulas for two categories of inventory. The categories differ materially in their nature and their use in the company's operations. Which statement is correct under AS 2?

1. The company must use FIFO for every category because AS 2 prohibits the weighted-average method.
2. Different cost formulas may be justified for inventories having different nature or use, provided the chosen formulas are applied consistently to inventories of similar nature and use. (correct answer)
3. The company may change the cost formula annually for each individual inventory item to maximise reported profits.
4. The company must use weighted average for all inventories because different inventory categories cannot have separate valuation methods.

Answer: B — Different cost formulas may be justified for inventories having different nature or use, provided the chosen formulas are applied consistently to inventories of similar nature and use.

Explanation. AS 2, paragraphs 21 and 22, permits FIFO or weighted-average cost formulas for ordinarily interchangeable inventories. The same cost formula should be used for inventories having a similar nature and use to the enterprise. Inventories having a different nature or use may justify different formulas. The auditor should examine the consistency and reasonableness of management's policy. An arbitrary annual change merely to influence reported profits is not acceptable.

Where it goes wrong. Confusing consistency of accounting policy with a requirement that every category of inventory must necessarily use one identical cost formula.

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 manufacturer reports the following expenditure for an inventory batch of 800 work-in-progress units: materials Rs. 4,80,000, including abnormal wastage of Rs. 30,000; direct labour Rs. 2,00,000; variable production overhead Rs. 1,00,000; and fixed production overhead Rs. 2,40,000. Normal production capacity is 1,200 units. What amount should be included in the inventory cost, applying AS 2?

A manufacturer reports the following expenditure for an inventory batch of 800 work-in-progress units: materials Rs. 4,80,000, including abnormal wastage of Rs. 30,000; direct labour Rs. 2,00,000; variable production overhead Rs. 1,00,000; and fixed production overhead Rs. 2,40,000. Normal production capacity is 1,200 units. What amount should be included in the inventory cost, applying AS 2?

1. Rs. 10,80,000, because every material and overhead expenditure incurred during the period should be included.
2. Rs. 9,90,000, because abnormal wastage is included but fixed overhead must be excluded when actual production is below normal capacity.
3. Rs. 9,40,000, because all fixed production overhead is expensed whenever actual production is below normal capacity.
4. Rs. 9,10,000, because abnormal wastage is excluded and fixed production overhead is allocated using normal capacity. (correct answer)

Answer: D — Rs. 9,10,000, because abnormal wastage is excluded and fixed production overhead is allocated using normal capacity.

Explanation. AS 2, paragraphs 8 to 13, requires inventory cost to include purchase and conversion costs while excluding abnormal wastage. The eligible material cost is Rs. 4,50,000. Direct labour and variable overhead total Rs. 3,00,000. Fixed overhead is allocated at Rs. 2,40,000 divided by 1,200 units, or Rs. 200 per unit. For 800 units, this is Rs. 1,60,000. Total inventory cost is therefore Rs. 9,10,000. Unallocated fixed overhead and abnormal wastage are charged to expense.

Where it goes wrong. Allocating the entire fixed overhead to low actual production or including abnormal wastage in inventory valuation.

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. Inventory is material to the financial statements, but the auditor is informed that management's physical stock count will be conducted on 31 March. Which procedure is specifically required under SA 501?

Inventory is material to the financial statements, but the auditor is informed that management's physical stock count will be conducted on 31 March. Which procedure is specifically required under SA 501?

1. Attend the physical inventory counting unless impracticable, evaluate management's counting instructions, observe the procedures, inspect inventory and perform test counts. (correct answer)
2. Obtain the final inventory valuation report and rely on management's assertion that every inventory item was physically checked.
3. Avoid physical attendance and perform analytical procedures comparing inventory balances with previous-year figures.
4. Request the warehouse manager's written representation and treat it as a substitute for attending the inventory count.

Answer: A — Attend the physical inventory counting unless impracticable, evaluate management's counting instructions, observe the procedures, inspect inventory and perform test counts.

Explanation. SA 501, paragraph 4, requires the auditor, when inventory is material, to obtain sufficient appropriate evidence regarding its existence and condition by attending physical inventory counting unless impracticable. Attendance includes evaluating management's instructions and procedures, observing the performance of count procedures, inspecting inventory and performing test counts. The auditor should subsequently evaluate whether final inventory records accurately reflect the actual count results. Analytical procedures or written representations alone are not substitutes for required attendance.

Where it goes wrong. Treating management's physical verification certificate or analytical procedures as substitutes for the auditor's attendance at a material inventory count.

Authority. SA 501

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

Scenario. The replacement cost of a raw material has fallen below its recorded cost. However, the finished goods manufactured using this material are expected to be sold at or above their total production cost. What should the auditor conclude under AS 2?

The replacement cost of a raw material has fallen below its recorded cost. However, the finished goods manufactured using this material are expected to be sold at or above their total production cost. What should the auditor conclude under AS 2?

1. The raw material must always be written down to its replacement cost whenever market prices decline.
2. The entire quantity of raw material should be written off because replacement cost is always the appropriate NRV.
3. The raw material need not be written down merely because its replacement cost has declined, where the finished goods are expected to be sold at or above cost. (correct answer)
4. The raw material should be revalued at the future selling price of the finished goods instead of its purchase cost.

Answer: C — The raw material need not be written down merely because its replacement cost has declined, where the finished goods are expected to be sold at or above cost.

Explanation. AS 2, particularly paragraph 26, explains that materials and other supplies held for use in production are not written down below cost when the finished products in which they will be incorporated are expected to be sold at or above cost. A decline in replacement cost may indicate that material costs are not recoverable when the finished products are expected to be sold below cost. The auditor must therefore consider the expected realisable value of finished goods rather than treating replacement cost as an automatic write-down basis.

Where it goes wrong. Automatically equating a fall in raw-material replacement cost with a requirement to write down every item of raw material.

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 been sanctioned aggregate working-capital limits of Rs. 8 crore by banks against the security of inventories and trade receivables. During the year, it filed quarterly statements with the banks showing current asset values different from those recorded in the books. Which CARO 2020 requirement is applicable?

A company has been sanctioned aggregate working-capital limits of Rs. 8 crore by banks against the security of inventories and trade receivables. During the year, it filed quarterly statements with the banks showing current asset values different from those recorded in the books. Which CARO 2020 requirement is applicable?

1. Paragraph 3(ii)(a), because the auditor is required to reconcile physical inventory counts with stock statements submitted to banks.
2. Paragraph 3(ix)(c), because every difference between working-capital statements and books constitutes diversion of term-loan funds.
3. Paragraph 3(iii), because differences in bank statements automatically indicate that loans were granted to third parties without repayment schedules.
4. Paragraph 3(ii)(b), requiring examination of whether quarterly returns or statements filed with banks or financial institutions agree with the books of account, with details of discrepancies reported. (correct answer)

Answer: D — Paragraph 3(ii)(b), requiring examination of whether quarterly returns or statements filed with banks or financial institutions agree with the books of account, with details of discrepancies reported.

Explanation. CARO 2020, paragraph 3(ii)(b), applies where the company has been sanctioned working-capital limits exceeding Rs. 5 crore in aggregate from banks or financial institutions on the security of current assets. The auditor must examine whether quarterly returns or statements filed with such lenders agree with the books of account. Where differences exist, the auditor must give details. The applicable threshold is crossed in this case because sanctioned limits aggregate to Rs. 8 crore.

Where it goes wrong. Confusing physical inventory verification under paragraph 3(ii)(a) with reconciliation of current-asset statements submitted to lenders under paragraph 3(ii)(b).

Authority. CARO 2020

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

Scenario. A company has trade receivables with specified contractual due dates and certain unbilled receivables for which no invoice has yet been raised. Which approach should be followed for the Schedule III ageing disclosure?

A company has trade receivables with specified contractual due dates and certain unbilled receivables for which no invoice has yet been raised. Which approach should be followed for the Schedule III ageing disclosure?

1. Determine every ageing period from the invoice date and combine unbilled receivables with balances outstanding for less than six months.
2. Determine ageing from the due date of payment, use the transaction date where no due date is specified and disclose unbilled dues separately. (correct answer)
3. Determine ageing from the date of the last customer reminder and include unbilled dues under disputed receivables.
4. Determine ageing from the date of the original sales order and exclude balances for which the customer has not issued an acceptance.

Answer: B — Determine ageing from the due date of payment, use the transaction date where no due date is specified and disclose unbilled dues separately.

Explanation. Schedule III, Part I, requires the trade receivables ageing schedule to be prepared with reference to the due date of payment. Where no due date is specified, similar information is presented from the transaction date. Unbilled dues are required to be disclosed separately. The auditor should verify ageing classifications, due dates and the completeness of the underlying customer balances. Using reminder dates or automatically combining unbilled amounts with invoiced balances can distort the prescribed disclosure.

Where it goes wrong. Confusing the invoice date or customer reminder date with the prescribed ageing reference and failing to disclose unbilled dues separately.

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

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

Scenario. An auditor obtains a positive confirmation from a customer at 31 December, three months before the reporting date. What should the auditor do before using that confirmation as evidence of the receivable balance at 31 March?

An auditor obtains a positive confirmation from a customer at 31 December, three months before the reporting date. What should the auditor do before using that confirmation as evidence of the receivable balance at 31 March?

1. Evaluate the intervening transactions and obtain evidence that receipts, credit notes, additional sales and other movements between the confirmation date and reporting date have been properly recorded. (correct answer)
2. Treat the December response as conclusive evidence of the March balance because the customer has independently acknowledged the original amount.
3. Adjust the March balance to the December confirmation and ignore transactions occurring after the confirmation date.
4. Obtain a management representation that no material transaction occurred after December and accept it without further testing.

Answer: A — Evaluate the intervening transactions and obtain evidence that receipts, credit notes, additional sales and other movements between the confirmation date and reporting date have been properly recorded.

Explanation. SA 505 requires the auditor to evaluate the relevance and reliability of external confirmations for the specific assertion and date being tested. When confirmations are obtained at a date other than the reporting date, the auditor must perform appropriate procedures over the intervening period. Chapter 5 also permits confirmation at a date reasonably close to the balance-sheet date. Subsequent receipts, sales, credit notes and adjustments must be examined to reconcile the confirmed balance with the year-end amount.

Where it goes wrong. Assuming that an independent confirmation obtained at an earlier date automatically establishes the closing balance without examining intervening transactions.

Authority. SA 505

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

Scenario. Under SA 505, an auditor is considering using negative confirmations as the sole substantive audit procedure for a large population of trade receivables. Which combination of circumstances would support such an approach?

Under SA 505, an auditor is considering using negative confirmations as the sole substantive audit procedure for a large population of trade receivables. Which combination of circumstances would support such an approach?

1. Receivables are highly material, credit risk is significant, and management expects customers to respond only when balances are incorrect.
2. The population consists of a few large disputed balances, controls are weak, and the expected exception rate is substantial.
3. The assessed risk of material misstatement is low, relevant controls are effective, the population contains numerous small homogeneous balances, the expected exception rate is very low and recipients are unlikely to disregard requests. (correct answer)
4. Customers have historically ignored confirmation requests, but management believes that all recorded receivables are recoverable.

Answer: C — The assessed risk of material misstatement is low, relevant controls are effective, the population contains numerous small homogeneous balances, the expected exception rate is very low and recipients are unlikely to disregard requests.

Explanation. SA 505, paragraph 15, permits negative confirmations to be used as the sole substantive audit procedure only when specified conditions are met. The assessed risk of material misstatement must be low and relevant controls effective; the population must comprise many small homogeneous balances; a very low exception rate must be expected; and circumstances must not indicate that recipients will disregard the requests. Negative confirmations provide less persuasive evidence than positive confirmations and are inappropriate merely because customers may not respond.

Where it goes wrong. Assuming that negative confirmations are suitable whenever the customer population is large, without considering assessed risk, control effectiveness and expected response behaviour.

Authority. SA 505

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

Scenario. An auditor selects goods-dispatch documents from the last few days of March and traces them to sales invoices and the receivables ledger. Which assertion is the primary focus of this procedure?

An auditor selects goods-dispatch documents from the last few days of March and traces them to sales invoices and the receivables ledger. Which assertion is the primary focus of this procedure?

1. Existence, because the auditor is primarily confirming that every customer listed in the receivables ledger has a valid legal identity.
2. Valuation, because the auditor is primarily determining whether customers will be able to pay the amounts recorded in the ledger.
3. Rights and obligations, because the auditor is primarily establishing the legal ownership of goods remaining in the warehouse.
4. Completeness and cut-off, because the auditor is checking that goods dispatched before year-end have been recorded in the appropriate accounting period. (correct answer)

Answer: D — Completeness and cut-off, because the auditor is checking that goods dispatched before year-end have been recorded in the appropriate accounting period.

Explanation. The Chapter 5 trade-receivables procedures require the auditor to ensure that all goods dispatched prior to year-end have been invoiced and included in receivables on a test-check basis. This addresses completeness and cut-off. The auditor should trace shipping documents and dispatch logs to sales invoices and the receivables ledger and also examine subsequent invoices relating to pre-year-end dispatches. Existence testing generally proceeds in the opposite direction, from recorded balances to underlying evidence.

Where it goes wrong. Confusing completeness testing, which traces source documents into the accounts, with existence testing, which verifies recorded balances against supporting evidence.

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 company maintains an allowance for doubtful debts. Which combination of audit procedures would provide the most appropriate evidence regarding the adequacy of the allowance?

A company maintains an allowance for doubtful debts. Which combination of audit procedures would provide the most appropriate evidence regarding the adequacy of the allowance?

1. Verify only the opening and closing allowance balances and accept the current-year provision percentage if unchanged from the previous year.
2. Examine the ageing schedule, disputed and litigated accounts, subsequent collections, management's estimation methodology and movements in bad debts and allowance balances. (correct answer)
3. Test only receivables collected after year-end because subsequent receipts establish the recoverability of every other outstanding balance.
4. Confirm only the total allowance with management and avoid checking individual customer balances because impairment is an estimation matter.

Answer: B — Examine the ageing schedule, disputed and litigated accounts, subsequent collections, management's estimation methodology and movements in bad debts and allowance balances.

Explanation. The Chapter 5 trade-receivables valuation procedures require examination of the allowance methodology, comparison with previous years, review of ageing reports, identification of litigated and doubtful debtors, and assessment of appropriate provision rates. The auditor should also prepare a movement schedule for bad debts, allowances and write-offs and compare bad debt expense with sales across periods. SA 540 requires evaluation of the methods, assumptions and data used in accounting estimates. Historical consistency alone does not establish adequacy.

Where it goes wrong. Assuming that applying the previous year's provision percentage consistently is sufficient without investigating ageing, litigation, actual defaults and changing credit conditions.

Authority. SA 540

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

Scenario. A company purchases raw materials for Rs. 10,00,000. It receives a trade discount of Rs. 50,000, pays non-refundable import duty of Rs. 40,000 and refundable GST of Rs. 1,80,000, incurs inward freight of Rs. 20,000 and suffers abnormal transit wastage costing Rs. 10,000. What amount should be included in inventory cost under AS 2, assuming the wastage is not recoverable?

A company purchases raw materials for Rs. 10,00,000. It receives a trade discount of Rs. 50,000, pays non-refundable import duty of Rs. 40,000 and refundable GST of Rs. 1,80,000, incurs inward freight of Rs. 20,000 and suffers abnormal transit wastage costing Rs. 10,000. What amount should be included in inventory cost under AS 2, assuming the wastage is not recoverable?

1. Rs. 10,10,000.
2. Rs. 11,90,000.
3. Rs. 10,20,000. (correct answer)
4. Rs. 11,10,000.

Answer: C — Rs. 10,20,000.

Explanation. AS 2, paragraphs 8 and 9, includes purchase price after deducting trade discounts and rebates, non-refundable taxes and duties, and transport and handling costs directly attributable to acquisition. Refundable GST is excluded, as it is recoverable from the authorities. The abnormal transit wastage is also excluded from inventory cost and recognised as an expense. Thus, inventory cost equals Rs. 10,00,000 minus Rs. 50,000 plus Rs. 40,000 plus Rs. 20,000, giving Rs. 10,10,000.

Where it goes wrong. Including recoverable GST or abnormal wastage in inventory cost and failing to deduct trade discounts.

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. A company's recorded inventory includes goods received on consignment from another supplier and goods dispatched to customers on approval but not yet accepted by them. Which procedure most suitable addresses the rights and obligations and completeness assertions?

A company's recorded inventory includes goods received on consignment from another supplier and goods dispatched to customers on approval but not yet accepted by them. Which procedure most suitable addresses the rights and obligations and completeness assertions?

1. Accept the inventory listing because the company physically possessed all the goods at some point during the reporting period.
2. Exclude all goods held outside the company's premises and recognise all goods dispatched as sales on the date of dispatch.
3. Confirm the total quantities with the warehouse manager and accept the entire amount as inventory without examining the underlying agreements.
4. Examine consignment and sale-or-return agreements, identify ownership of the goods and verify whether unaccepted approval goods belonging to the company remain included in closing inventory. (correct answer)

Answer: D — Examine consignment and sale-or-return agreements, identify ownership of the goods and verify whether unaccepted approval goods belonging to the company remain included in closing inventory.

Explanation. AS 2 and the Chapter 5 inventory audit procedures require consideration of ownership and the terms under which goods are held or dispatched. Goods received on consignment belong to the consignor and should not be included in the company's inventory. Goods sent on approval remain the company's inventory until acceptance or other recognition requirements are satisfied. The auditor should inspect consignment agreements, memoranda records, customer acceptance documents and relevant correspondence to establish correct rights, obligations and completeness.

Where it goes wrong. Confusing physical possession or dispatch with ownership and treating all consignment or sale-on-approval goods as ordinary company inventory or completed sales.

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. During the audit of a company, management refuses access to certain customer records and offers a signed representation confirming that all trade receivables are genuine and recoverable. The auditor cannot obtain sufficient appropriate evidence through the procedures performed so far. Which conclusion is correct under SA 580?

During the audit of a company, management refuses access to certain customer records and offers a signed representation confirming that all trade receivables are genuine and recoverable. The auditor cannot obtain sufficient appropriate evidence through the procedures performed so far. Which conclusion is correct under SA 580?

1. The auditor may accept the representation as conclusive evidence because management is responsible for preparing the financial statements.
2. The auditor should issue an unmodified opinion because written representations are equivalent to third-party confirmations when signed by the CFO.
3. The auditor must stop examining the receivables because representations obtained from senior management remove the need for additional procedures.
4. The auditor should treat the representation as necessary supplementary evidence but not a substitute for other required audit evidence, and evaluate the impact of the unresolved limitation under SA 705. (correct answer)

Answer: D — The auditor should treat the representation as necessary supplementary evidence but not a substitute for other required audit evidence, and evaluate the impact of the unresolved limitation under SA 705.

Explanation. SA 580, paragraphs 3 and 4, establishes that written representations are necessary audit evidence but do not provide sufficient appropriate audit evidence on their own regarding matters that require independent verification. The auditor must continue seeking alternative procedures and reliable evidence under SA 500. Where management's restriction prevents sufficient evidence and possible undetected misstatements could be material, the auditor must evaluate the appropriate modification under SA 705. A signed management representation cannot automatically justify an unmodified opinion.

Where it goes wrong. Treating management representation as a replacement for independent audit evidence and overlooking the possible reporting consequences of an unresolved scope limitation.

Authority. SA 500; SA 580; SA 705