Audit Report and CARO, 2020 - Test 3: answer key

Question 1 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · medium

Scenario. M/s Sharma & Associates are the statutory auditors of Alpha Components Ltd., a company engaged in manufacturing specialised industrial equipment. During the audit for FY 2025-26, the engagement team examined the company's revenue recognition, inventory valuation and impairment of trade receivables. The company had entered into several long-term supply contracts containing complicated acceptance clauses. It had recognised a substantial portion of revenue before obtaining the customers' final acceptance certificates. The auditors obtained sufficient appropriate evidence from customer confirmations, contract documents and subsequent correspondence to establish that the recognition criteria had not been satisfied for a material portion of the reported revenue. The auditors also discovered that obsolete inventory amounting to ₹2.8 crore had been included at historical cost despite clear evidence of reduced net realisable value. Management refused to make the necessary adjustments, arguing that the inventory could eventually be sold at its recorded value. In addition, receivables amounting to ₹11 crore, forming a substantial proportion of total current assets, were demonstrably irrecoverable. The financial statements contained no adequate provision or disclosure for these amounts. After evaluating the aggregate effects, the engagement partner concluded that the identified misstatements were material and pervasive, affecting revenue, assets, profitability and the overall presentation of the financial statements. All relevant audit evidence had been obtained, and the management's explanations had been independently evaluated. The Board requested the auditors to restrict the reporting modification to a paragraph explaining the revenue recognition issue, while retaining an unmodified opinion. The engagement partner must decide the appropriate opinion under SA 705 and determine whether the effects of the individual matters can be considered separately from their aggregate impact.

Considering that sufficient appropriate audit evidence has been obtained and the identified misstatements are both material and pervasive, which opinion should M/s Sharma & Associates express?

1. A qualified opinion because the company has identified the underlying transactions and the misstatements can be quantified.
2. An adverse opinion because the identified misstatements, individually or in aggregate, are material and pervasive. (correct answer)
3. A disclaimer of opinion because material misstatements in several financial statement items automatically indicate an evidence limitation.
4. An unmodified opinion accompanied by an Emphasis of Matter paragraph explaining the management's accounting decisions.

Answer: B — An adverse opinion because the identified misstatements, individually or in aggregate, are material and pervasive.

Explanation. Under SA 705 (Revised), paragraph 7, an adverse opinion is required when the auditor has obtained sufficient appropriate audit evidence and concludes that misstatements, individually or in aggregate, are both material and pervasive. Here, the auditor has established actual misstatements affecting multiple significant financial statement areas. A disclaimer concerns inability to obtain evidence, while an Emphasis of Matter paragraph cannot replace a required adverse opinion.

Where it goes wrong. Confusing actual, evidenced material misstatements with an inability to obtain sufficient appropriate audit evidence.

Authority. SA 705

Question 2 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · hard

Assume that the receivables and revenue issues are subsequently resolved through additional evidence, leaving only the ₹2.8 crore inventory overvaluation. The amount is material but does not have pervasive effects. Management continues refusing adjustment. What opinion should the auditor express?

1. An adverse opinion because any uncorrected material inventory overvaluation necessarily affects the entire financial statements.
2. A disclaimer because management's refusal to correct a known misstatement means that audit evidence is unavailable.
3. An unmodified opinion because the inventory valuation issue is supported by management's accounting records.
4. A qualified opinion because sufficient appropriate evidence establishes a material misstatement whose effects are not pervasive. (correct answer)

Answer: D — A qualified opinion because sufficient appropriate evidence establishes a material misstatement whose effects are not pervasive.

Explanation. SA 705 (Revised), paragraph 6, requires a qualified opinion where the auditor has obtained sufficient appropriate audit evidence and concludes that misstatements are material but not pervasive. The inventory overvaluation is an established accounting misstatement, and management's refusal does not convert it into a scope limitation. An adverse opinion would overstate its pervasiveness, while a disclaimer would incorrectly imply inability to obtain evidence.

Where it goes wrong. Treating management's refusal to correct an identified misstatement as an inability to obtain audit evidence.

Authority. SA 705

Question 3 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · medium

Suppose the auditors establish that the receivables of ₹11 crore are irrecoverable, but the amount is confined to a specific category of receivables. Which additional consideration would most strongly support an adverse opinion rather than a qualified opinion?

1. The receivables represent or could represent a substantial proportion of the financial statements, making the effects pervasive despite being confined to one category. (correct answer)
2. The receivables relate to several customers, irrespective of their proportion or effect on the financial statements as a whole.
3. Management has refused to provide a written representation, even though sufficient independent evidence establishes the actual overstatement.
4. The receivables have remained outstanding for more than six months, irrespective of the amount and financial statement impact.

Answer: A — The receivables represent or could represent a substantial proportion of the financial statements, making the effects pervasive despite being confined to one category.

Explanation. SA 705, paragraph 5, explains that effects may be pervasive even when confined to specific elements, accounts or items if they represent or could represent a substantial proportion of the financial statements. Therefore, an identified receivable misstatement may justify an adverse opinion where its magnitude makes the overall financial statements misleading. The number of customers or the age of balances alone does not establish pervasiveness.

Where it goes wrong. Assuming that a misstatement confined to one financial statement category can never be pervasive.

Authority. SA 705

Question 4 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · hard

The engagement partner is evaluating the inventory, revenue and receivables misstatements separately. Which approach is required before deciding the appropriate modified opinion?

1. Assess each error independently and select the opinion corresponding to the largest individual misstatement.
2. Disregard smaller errors because only the largest individual misstatement determines the audit opinion.
3. Evaluate the materiality and pervasiveness of misstatements both individually and in aggregate across the financial statements. (correct answer)
4. Issue a qualified opinion whenever the individual misstatements arise from different accounting policies and different financial statement elements.

Answer: C — Evaluate the materiality and pervasiveness of misstatements both individually and in aggregate across the financial statements.

Explanation. SA 705 (Revised), paragraphs 6 and 7, requires consideration of misstatements individually or in aggregate when determining whether their effects are material and pervasive. An auditor cannot isolate related misstatements merely because they affect different accounts or arise from different accounting treatments. The aggregate effect may be pervasive even where individual issues appear less significant when considered separately.

Where it goes wrong. Evaluating material misstatements independently without considering their combined effect on the financial statements.

Authority. SA 705

Question 5 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · medium

Scenario. M/s K. Mehta & Co. are the statutory auditors of Zenith Manufacturing Ltd., a company engaged in the production of automobile components. The audit engagement was accepted before the commencement of the financial year. During the audit, the engagement team discovered substantial weaknesses in the inventory-management system. The ERP application contained incomplete transaction histories, several stock movements had been recorded without supporting vouchers and the company had not retained the original documents relating to a significant consignment of raw materials. The auditors requested management to provide physical access to the relevant warehouse, original purchase records and read-only access to the ERP audit logs. Management refused, citing operational confidentiality and the possibility of disrupting production. The auditors formally requested removal of this restriction, explaining that the limitation could affect their ability to express an unmodified opinion. Management maintained its refusal. The matter was communicated to the Audit Committee, which instructed the auditors to consider reasonable alternative procedures before reaching a conclusion. The audit team subsequently examined goods-received notes, independent supplier confirmations, dispatch records, subsequent payments and available warehouse movement records. These procedures resolved most differences, but sufficient appropriate evidence remained unavailable for a material inventory balance. The possible effects of undetected misstatements were confined to the inventory and related cost-of-sales balances and were not expected to represent a substantial proportion of the financial statements. The auditors concluded that the possible effects were material but not pervasive. Management nevertheless insisted that the audit report should contain an unmodified opinion because no actual misstatement had been conclusively established. The engagement partner must determine the correct reporting consequence of this inability to obtain evidence.

Immediately after discovering that management has restricted access to important audit records, what is the auditor's first required action under the management-imposed limitation provisions of SA 705?

1. Immediately issue a disclaimer because management's refusal automatically establishes pervasive misstatement.
2. Withdraw from the engagement without discussing the restriction with management or governance.
3. Request management to remove the imposed limitation because it may require a modified opinion. (correct answer)
4. Issue a qualified opinion before attempting alternative audit procedures or obtaining further explanations.

Answer: C — Request management to remove the imposed limitation because it may require a modified opinion.

Explanation. SA 705 (Revised), the requirements dealing with management-imposed limitations after acceptance of an engagement, require the auditor first to request management to remove a limitation likely to result in a qualified opinion or disclaimer. The auditor should not immediately disclaim without following the prescribed process. If management removes the restriction, the auditor proceeds with the required audit procedures.

Where it goes wrong. Jumping directly to a modified opinion without first requesting management to remove the scope limitation.

Authority. SA 705

Question 6 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · hard

Management refuses to remove the limitation and the Audit Committee is informed. What should the auditor do next before determining the final opinion?

1. Accept management's refusal and proceed directly to an adverse opinion because the records are incomplete.
2. Determine whether alternative procedures can provide sufficient appropriate audit evidence regarding the affected balances. (correct answer)
3. Treat the Audit Committee's acknowledgement as sufficient evidence and issue the report without further investigation.
4. Immediately disclaim an opinion because alternative procedures are prohibited after a management-imposed limitation.

Answer: B — Determine whether alternative procedures can provide sufficient appropriate audit evidence regarding the affected balances.

Explanation. SA 705 (Revised), provisions dealing with management-imposed limitations after acceptance, require the auditor to communicate the matter to those charged with governance, unless all of them are involved in managing the entity, and determine whether alternative procedures can obtain sufficient appropriate evidence. The auditor must evaluate available alternatives rather than assuming that management's refusal automatically determines the opinion.

Where it goes wrong. Confusing communication of a scope limitation to governance with completion of the audit evidence-gathering process.

Authority. SA 705

Question 7 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · medium

After performing reasonable alternative procedures, the auditor remains unable to verify the inventory balance. The possible effects are material but not pervasive. Which opinion is appropriate?

1. An adverse opinion because the auditor cannot establish whether the inventory is correctly valued.
2. A disclaimer because every inability to verify inventory necessarily has pervasive financial statement effects.
3. An unmodified opinion because alternative procedures were attempted even though they did not provide sufficient evidence.
4. A qualified opinion because the possible effects of undetected misstatements are material but not pervasive. (correct answer)

Answer: D — A qualified opinion because the possible effects of undetected misstatements are material but not pervasive.

Explanation. SA 705 (Revised), paragraph 8, requires a qualified opinion where the auditor cannot obtain sufficient appropriate audit evidence and concludes that the possible effects of undetected misstatements, if any, could be material but not pervasive. The auditor need not prove an actual misstatement to qualify the opinion. An adverse opinion requires established material and pervasive misstatements, while a disclaimer requires possible pervasive effects.

Where it goes wrong. Assuming that a qualified opinion always requires an identified actual misstatement rather than a material but non-pervasive evidence limitation.

Authority. SA 705

Question 8 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · hard

Assume alternatively that the inaccessible inventory and related records represent a substantial proportion of the financial statements. The auditor cannot withdraw before issuing the report because of applicable legal and practical constraints. What is the appropriate course?

1. Express a qualified opinion because the effects of the inaccessible records are confined to inventory and related cost of sales.
2. Express an adverse opinion because pervasive effects can always be treated as established material misstatements.
3. Disclaim an opinion because the possible effects are material and pervasive and withdrawal is not practicable. (correct answer)
4. Express an unmodified opinion because management has accepted responsibility for the inaccessible records.

Answer: C — Disclaim an opinion because the possible effects are material and pervasive and withdrawal is not practicable.

Explanation. SA 705 (Revised), provisions relating to management-imposed limitations after acceptance, require withdrawal where practicable when possible undetected misstatements could be both material and pervasive. If withdrawal before issuing the report is not practicable or permitted, the auditor shall disclaim an opinion. A qualified opinion would be inadequate to communicate the gravity of a pervasive evidence limitation.

Where it goes wrong. Ignoring the withdrawal requirement and assuming that every scope limitation must result in a qualified opinion.

Authority. SA 705

Question 9 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · medium

Scenario. M/s V. Raman & Associates are the statutory auditors of Suryodaya Infrastructure Ltd., a listed company engaged in large infrastructure and renewable-energy projects. During the audit, the engagement team evaluated three significant uncertainties involving a major government concession, a cross-border arbitration proceeding and the restructuring of a substantial overseas subsidiary. The auditors obtained sufficient appropriate evidence regarding the individual circumstances and reviewed independent legal opinions, contractual documents, lender correspondence and subsequent developments. However, the possible outcomes of these matters were highly interdependent. The outcome of the arbitration could affect the government's concession decision, while the concession decision could materially affect the subsidiary's restructuring and the recoverability of its assets. The auditors concluded that, despite having obtained sufficient evidence regarding each individual uncertainty, the potential interaction and cumulative effect of the uncertainties made it impossible to form an overall opinion on the financial statements. The engagement partner considered the situation to be an extremely rare circumstance involving multiple uncertainties within the meaning of SA 705. Separately, the auditors identified an actual understatement of warranty liabilities amounting to ₹3.6 crore. The understatement was material but confined to a specific liability and related expense balance. Management refused to correct it. The auditors also considered whether certain other matters could be described as Key Audit Matters, but no separate legal requirement for KAM reporting existed. The Board asked the auditors to issue a qualified opinion rather than a disclaimer and to include a conventional description of all auditor responsibilities. The engagement partner must determine the appropriate opinion, treatment of the separately identified misstatement, and consequential changes in the auditor's report.

The auditors have sufficient appropriate evidence regarding each of the three individual uncertainties but cannot form an overall opinion because of their potential interaction and cumulative effects. Which reporting treatment is required?

1. A disclaimer of opinion because extremely rare circumstances involving multiple uncertainties prevent formation of an overall opinion. (correct answer)
2. A qualified opinion because sufficient evidence regarding individual uncertainties has already been obtained.
3. An adverse opinion because the interaction of uncertainties establishes that the financial statements are materially misstated.
4. An unmodified opinion with an Emphasis of Matter paragraph describing all three uncertainties.

Answer: A — A disclaimer of opinion because extremely rare circumstances involving multiple uncertainties prevent formation of an overall opinion.

Explanation. SA 705 (Revised), paragraph 9, addresses extremely rare circumstances involving multiple uncertainties. Even where sufficient appropriate audit evidence has been obtained regarding each individual uncertainty, the auditor may be unable to form an opinion because of their potential interaction and cumulative effect on the financial statements. In such circumstances, the auditor shall disclaim an opinion. This is distinct from an ordinary material misstatement or conventional evidence limitation.

Where it goes wrong. Assuming that a disclaimer is possible only when individual audit evidence has not been obtained.

Authority. SA 705

Question 10 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · hard

The auditors have decided to disclaim an opinion because of the multiple uncertainties. What should happen to the separately identified ₹3.6 crore warranty liability understatement?

1. It should be ignored because the disclaimer automatically eliminates the auditor's obligation to disclose other identified reporting matters.
2. It should be presented as the sole basis for a qualified opinion, replacing the disclaimer caused by the multiple uncertainties.
3. Its nature and effects should also be described in the Basis for Disclaimer of Opinion section because it independently represents a matter requiring modification. (correct answer)
4. It should be mentioned only in the management representation letter because the auditor cannot report identified errors while disclaiming.

Answer: C — Its nature and effects should also be described in the Basis for Disclaimer of Opinion section because it independently represents a matter requiring modification.

Explanation. SA 705 (Revised), requirements concerning the Basis for Opinion section, provide that even when the auditor expresses an adverse opinion or disclaims an opinion, the auditor shall describe the reasons for other matters of which the auditor is aware that would have required a modification, together with their effects. Consequently, the identified warranty liability understatement cannot simply be omitted from the reporting basis because a separate disclaimer is required.

Where it goes wrong. Believing that a disclaimer removes the requirement to report separately identified material misstatements.

Authority. SA 705

Question 11 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · medium

When describing auditor responsibilities in the report containing a disclaimer due to inability to obtain sufficient appropriate evidence, which modification is required under SA 705?

1. Retain the entire conventional auditor-responsibilities section, including the normal statement that sufficient appropriate evidence supports the opinion.
2. Include only the responsibility to prepare the financial statements and exclude the auditor's independence statement.
3. Replace the auditor-responsibilities section with management's confirmation that the accounts are free from material misstatement.
4. Describe responsibility to conduct the audit under SAs and issue a report, explain the inability to obtain evidence, and retain the independence and ethical-responsibilities statement. (correct answer)

Answer: D — Describe responsibility to conduct the audit under SAs and issue a report, explain the inability to obtain evidence, and retain the independence and ethical-responsibilities statement.

Explanation. SA 705 (Revised), the provisions dealing with the description of auditor responsibilities when disclaiming an opinion, require an amended description. It includes responsibility to conduct the audit under SAs and issue a report, explains that sufficient appropriate evidence could not be obtained because of the matters described in the Basis for Disclaimer of Opinion section, and retains the independence and other ethical-responsibilities statement. The conventional full description is not retained unchanged.

Where it goes wrong. Assuming that a disclaimer changes only the Opinion paragraph while leaving all auditor-responsibility wording unchanged.

Authority. SA 705

Question 12 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · hard

The company is listed, but no law or regulation specifically requires KAM communication in the circumstances. What is the appropriate treatment of the KAM section when the auditor disclaims an opinion?

1. Include every significant matter as a KAM because listed-entity reporting requirements override the disclaimer provisions.
2. Omit the KAM section because, unless law or regulation requires otherwise, a report containing a disclaimer shall not include a KAM section under SA 701. (correct answer)
3. Include only the warranty liability as a KAM because identified misstatements must always be reported separately from the disclaimer.
4. Include a KAM section stating that the auditor has no responsibility for the identified uncertainties.

Answer: B — Omit the KAM section because, unless law or regulation requires otherwise, a report containing a disclaimer shall not include a KAM section under SA 701.

Explanation. SA 705 (Revised), section 5.9 in the ICAI study material, provides that unless required by law or regulation, an auditor's report containing a disclaimer of opinion shall not include a Key Audit Matters section in accordance with SA 701. The listed status does not remove this specific restriction. The auditor must nevertheless describe the matters giving rise to the disclaimer and other identified matters requiring modification in the appropriate Basis section.

Where it goes wrong. Applying the general KAM requirement for listed entities without considering the specific restriction where an opinion is disclaimed.

Authority. SA 701; SA 705; section 5

Question 13 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · medium

Scenario. An auditor has obtained sufficient appropriate audit evidence and identifies a material misstatement in the classification of long-term borrowings as current liabilities. The effect is confined to that classification and is not pervasive. Which reporting conclusion follows?

An auditor has obtained sufficient appropriate audit evidence and identifies a material misstatement in the classification of long-term borrowings as current liabilities. The effect is confined to that classification and is not pervasive. Which reporting conclusion follows?

1. A qualified opinion because the identified misstatement is material but not pervasive. (correct answer)
2. An adverse opinion because the misstatement affects both current liabilities and working capital ratios.
3. A disclaimer because the auditor cannot accept the management's accounting classification.
4. An unmodified opinion because the total amount of liabilities is unchanged by the classification.

Answer: A — A qualified opinion because the identified misstatement is material but not pervasive.

Explanation. SA 705 (Revised), paragraph 6, requires a qualified opinion when sufficient appropriate audit evidence establishes misstatements that are material but not pervasive. Even when total liabilities remain unchanged, incorrect classification may materially affect users' understanding and decisions. An adverse opinion requires pervasive effects, while a disclaimer is concerned with inability to obtain sufficient appropriate evidence.

Where it goes wrong. Assuming that a misstatement cannot be material merely because it does not change the total amount of liabilities.

Authority. SA 705

Question 14 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · hard

Scenario. A company has omitted material impairment losses on its two largest operating divisions. The auditor has independently substantiated the recoverable amounts and concludes that the aggregate overstatement of assets and profits is material and pervasive. Which opinion is appropriate?

A company has omitted material impairment losses on its two largest operating divisions. The auditor has independently substantiated the recoverable amounts and concludes that the aggregate overstatement of assets and profits is material and pervasive. Which opinion is appropriate?

1. A qualified opinion because the impairment losses arise from two identifiable operating divisions.
2. A disclaimer because valuation estimates always involve uncertainty, even when sufficient evidence exists.
3. An adverse opinion because sufficient evidence establishes material and pervasive misstatements in the financial statements. (correct answer)
4. An unmodified opinion with a Basis for Opinion paragraph because management has disclosed the impairment assumptions.

Answer: C — An adverse opinion because sufficient evidence establishes material and pervasive misstatements in the financial statements.

Explanation. SA 705 (Revised), paragraph 7, requires an adverse opinion where the auditor has obtained sufficient appropriate audit evidence and concludes that misstatements are material and pervasive. The fact that the impairment issues relate to identifiable divisions does not prevent pervasiveness if the aggregate effects substantially distort the financial statements. A disclaimer would incorrectly suggest an inability to obtain evidence.

Where it goes wrong. Confusing identifiable accounting areas with non-pervasive financial statement effects.

Authority. SA 705

Question 15 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · medium

Scenario. The auditor cannot independently verify a material balance because the company has lost its underlying records. The possible effects are material but restricted to that particular balance and related disclosures. Which opinion should be expressed?

The auditor cannot independently verify a material balance because the company has lost its underlying records. The possible effects are material but restricted to that particular balance and related disclosures. Which opinion should be expressed?

1. An adverse opinion because the missing records indicate that the recorded balance is materially incorrect.
2. A qualified opinion because the possible effects of undetected misstatements are material but not pervasive. (correct answer)
3. A disclaimer because any missing accounting record necessarily affects the financial statements as a whole.
4. An unmodified opinion because the auditor has not established that an actual misstatement exists.

Answer: B — A qualified opinion because the possible effects of undetected misstatements are material but not pervasive.

Explanation. SA 705 (Revised), paragraph 8, requires a qualified opinion when the auditor cannot obtain sufficient appropriate audit evidence and concludes that possible effects of undetected misstatements could be material but not pervasive. The auditor does not need proof of an actual error to qualify the opinion. A disclaimer requires possible material and pervasive effects, while an adverse opinion requires established material and pervasive misstatements.

Where it goes wrong. Assuming that absence of evidence automatically requires a disclaimer or, alternatively, permits an unmodified opinion because no actual error was proven.

Authority. SA 705

Question 16 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · hard

Scenario. An auditor cannot obtain evidence regarding a major overseas subsidiary because its records are inaccessible. The subsidiary represents approximately 65 per cent of consolidated assets and revenue. The possible effects of undetected misstatements are material and pervasive. What is the appropriate opinion?

An auditor cannot obtain evidence regarding a major overseas subsidiary because its records are inaccessible. The subsidiary represents approximately 65 per cent of consolidated assets and revenue. The possible effects of undetected misstatements are material and pervasive. What is the appropriate opinion?

1. A qualified opinion because the limitation relates to one subsidiary rather than the entire group.
2. An adverse opinion because the auditor must presume the subsidiary's financial statements are materially misstated.
3. An unmodified opinion because the parent company has accepted responsibility for the subsidiary's financial records.
4. A disclaimer because the possible effects of undetected misstatements are both material and pervasive. (correct answer)

Answer: D — A disclaimer because the possible effects of undetected misstatements are both material and pervasive.

Explanation. SA 705 (Revised), paragraph 9, requires a disclaimer where the auditor is unable to obtain sufficient appropriate audit evidence and the possible effects of undetected misstatements could be material and pervasive. Although the limitation relates to one subsidiary, its significance as a substantial proportion of consolidated assets and revenue supports a conclusion of pervasiveness. The limitation does not establish an actual misstatement for an adverse opinion.

Where it goes wrong. Assuming that a limitation concerning only one component can never have pervasive effects on consolidated financial statements.

Authority. SA 705

Question 17 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · medium

Scenario. While evaluating whether an established misstatement is pervasive, which combination correctly reflects the meaning of pervasiveness under SA 705?

While evaluating whether an established misstatement is pervasive, which combination correctly reflects the meaning of pervasiveness under SA 705?

1. Effects are pervasive only when misstatements affect every individual financial statement and every accounting balance.
2. Effects are pervasive whenever an individual misstatement exceeds the auditor's overall materiality by any amount.
3. Effects are pervasive when they are not confined to specific elements, or if confined, represent a substantial proportion, or concern disclosures fundamental to users' understanding. (correct answer)
4. Effects are pervasive whenever management refuses to correct a misstatement or disagrees with the auditor's accounting judgement.

Answer: C — Effects are pervasive when they are not confined to specific elements, or if confined, represent a substantial proportion, or concern disclosures fundamental to users' understanding.

Explanation. SA 705 (Revised), paragraph 5, defines pervasive effects through three alternatives: they are not confined to specific elements, accounts or items; if confined, they represent or could represent a substantial proportion of the financial statements; or, in relation to disclosures, they are fundamental to users' understanding. The concept is not restricted to misstatements affecting every statement or exceeding a fixed numerical threshold.

Where it goes wrong. Interpreting pervasiveness as an absolute requirement that every financial statement or account must be affected.

Authority. SA 705

Question 18 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · hard

Scenario. Management has incorrectly recorded two separate transactions, each below individual materiality. When aggregated, their effects materially overstate profits and materially distort the financial position. What should the auditor consider?

Management has incorrectly recorded two separate transactions, each below individual materiality. When aggregated, their effects materially overstate profits and materially distort the financial position. What should the auditor consider?

1. The errors must be ignored because each individual transaction is below materiality.
2. The auditor must evaluate the combined effects because SA 705 considers misstatements individually or in aggregate. (correct answer)
3. A disclaimer is required because aggregation prevents the auditor from determining the actual financial effects.
4. An unmodified opinion is appropriate because the transactions were recorded in separate accounting periods.

Answer: B — The auditor must evaluate the combined effects because SA 705 considers misstatements individually or in aggregate.

Explanation. SA 705 (Revised), paragraphs 6 and 7, explicitly considers misstatements individually or in the aggregate when determining whether the financial statements are materially misstated and whether their effects are pervasive. Small errors cannot automatically be disregarded when their combined impact is material. If sufficient evidence establishes the aggregate effects as material and pervasive, an adverse opinion is required.

Where it goes wrong. Assessing every misstatement separately and overlooking the aggregate effect on the financial statements.

Authority. SA 705

Question 19 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · medium

Scenario. After accepting the audit engagement, the auditor learns that management has prohibited access to certain important accounting records. Which statement correctly describes the auditor's initial responsibility under SA 705?

After accepting the audit engagement, the auditor learns that management has prohibited access to certain important accounting records. Which statement correctly describes the auditor's initial responsibility under SA 705?

1. Immediately withdraw from the engagement without requesting management to reconsider the imposed restriction.
2. Issue an adverse opinion because management's refusal to provide documents proves that the accounts are materially misstated.
3. Continue the audit without modification because management is legally responsible for maintaining all accounting records.
4. Request management to remove the limitation when it is likely to necessitate a qualified opinion or disclaimer. (correct answer)

Answer: D — Request management to remove the limitation when it is likely to necessitate a qualified opinion or disclaimer.

Explanation. SA 705 (Revised), the provisions addressing management-imposed limitations after acceptance, require the auditor to request removal of a limitation that is likely to result in a qualified opinion or disclaimer. The auditor should then consider communication with those charged with governance and alternative procedures if management refuses. An adverse opinion cannot be based merely on management's failure to provide records.

Where it goes wrong. Treating the first discovery of a scope restriction as an automatic ground for immediate withdrawal or an adverse opinion.

Authority. SA 705

Question 20 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · hard

Scenario. After communicating a management-imposed scope limitation to those charged with governance and exhausting reasonable alternative procedures, the auditor concludes that possible undetected misstatements are material and pervasive. Withdrawal before issuing the report is practicable. What should the auditor do?

After communicating a management-imposed scope limitation to those charged with governance and exhausting reasonable alternative procedures, the auditor concludes that possible undetected misstatements are material and pervasive. Withdrawal before issuing the report is practicable. What should the auditor do?

1. Issue a qualified opinion because alternative procedures have already been exhausted.
2. Issue an adverse opinion because all management-imposed restrictions are treated as established misstatements.
3. Withdraw from the audit where practicable, communicating identified matters that would have required modification before withdrawal. (correct answer)
4. Issue an unmodified opinion because the Board has been informed about the restriction and has accepted responsibility.

Answer: C — Withdraw from the audit where practicable, communicating identified matters that would have required modification before withdrawal.

Explanation. SA 705 (Revised), the requirements concerning a management-imposed limitation after acceptance, provide that when possible effects could be both material and pervasive, the auditor shall withdraw where practicable and possible under applicable law or regulation. Before withdrawal, identified matters that would have given rise to a modified opinion must be communicated to those charged with governance. A disclaimer is relevant where withdrawal is not practicable or possible.

Where it goes wrong. Jumping directly to a disclaimer without considering whether withdrawal is practicable in the circumstances.

Authority. SA 705

Question 21 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · medium

Scenario. An auditor issues a qualified opinion because a material misstatement is confined to a specific financial statement item. Which wording is most appropriate in the Opinion section?

An auditor issues a qualified opinion because a material misstatement is confined to a specific financial statement item. Which wording is most appropriate in the Opinion section?

1. In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion section, the financial statements give a true and fair view. (correct answer)
2. In our opinion, the financial statements do not give a true and fair view in any material respect because of the identified matter.
3. We do not express an opinion on the financial statements because the identified misstatement could affect users' decisions.
4. In our opinion, the financial statements give a true and fair view, subject to management's future correction of the identified matter.

Answer: A — In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion section, the financial statements give a true and fair view.

Explanation. SA 705 (Revised), paragraph 16 and the related reporting requirements, prescribe the wording for a qualified opinion. Where the matter is an established misstatement, the wording uses “except for the effects” of the matter described in the Basis for Qualified Opinion section. The expression “except for possible effects” is used for an inability to obtain evidence. An adverse opinion and disclaimer require fundamentally different Opinion wording.

Where it goes wrong. Confusing the wording for a known misstatement with wording for a possible misstatement caused by an evidence limitation.

Authority. SA 705

Question 22 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · hard

Scenario. An auditor qualifies the opinion because inventory records are unavailable and possible effects could be material but not pervasive. Which expression should appear in the Opinion section?

An auditor qualifies the opinion because inventory records are unavailable and possible effects could be material but not pervasive. Which expression should appear in the Opinion section?

1. Except for the effects of the identified inventory overstatement, the financial statements give a true and fair view.
2. Except for the possible effects of the matter described in the Basis for Qualified Opinion section, the financial statements give a true and fair view. (correct answer)
3. The financial statements do not present a true and fair view because inventory is materially misstated throughout the entity.
4. We do not express an opinion because the inventory limitation affects an entire category of accounting records.

Answer: B — Except for the possible effects of the matter described in the Basis for Qualified Opinion section, the financial statements give a true and fair view.

Explanation. SA 705 (Revised), paragraph 16, distinguishes between a qualified opinion arising from an actual misstatement and one arising from inability to obtain evidence. Where the auditor cannot obtain evidence and possible effects are material but not pervasive, the qualified opinion uses wording referring to the “possible effects” of the matter described in the Basis for Qualified Opinion section. Actual established misstatements require wording referring to their effects.

Where it goes wrong. Using the expression “effects” for an evidence limitation when the auditor cannot establish the actual financial statement misstatement.

Authority. SA 705

Question 23 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · medium

Scenario. A material misstatement relates to a specific monetary amount in the financial statements. Which information should the auditor ordinarily include in the Basis for Modified Opinion section?

A material misstatement relates to a specific monetary amount in the financial statements. Which information should the auditor ordinarily include in the Basis for Modified Opinion section?

1. Only management's reason for choosing the accounting treatment, without reference to the resulting financial statement impact.
2. Only the difference between management's treatment and the auditor's proposed treatment, without quantifying the effect.
3. A description of the matter and quantification of its financial effects, unless quantification is impracticable; if impracticable, state that fact. (correct answer)
4. A general statement that the financial statements are materially misstated, without identifying the affected monetary amounts.

Answer: C — A description of the matter and quantification of its financial effects, unless quantification is impracticable; if impracticable, state that fact.

Explanation. SA 705 (Revised), requirements dealing with the Basis for Modified Opinion, require a description and quantification of the financial effects when a material misstatement relates to specific amounts, including quantitative disclosures in the notes. This is subject to impracticability; if quantification is not practicable, the auditor must state that fact. A vague statement without describing the identified matter does not adequately explain the basis of the modification.

Where it goes wrong. Assuming that describing the accounting disagreement is sufficient when the standard also requires quantification of the financial effects, unless impracticable.

Authority. SA 705

Question 24 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · hard

Scenario. A company has omitted a material disclosure required by the applicable financial reporting framework. The auditor has sufficient evidence about the omitted information. Which action is consistent with SA 705?

A company has omitted a material disclosure required by the applicable financial reporting framework. The auditor has sufficient evidence about the omitted information. Which action is consistent with SA 705?

1. Issue an unmodified opinion because omitted disclosure is not a monetary misstatement and cannot affect the audit opinion.
2. Mention the omission only in an Emphasis of Matter paragraph without discussing it with those charged with governance.
3. Issue a disclaimer because the auditor cannot quantify the effect of any missing disclosure.
4. Discuss the non-disclosure with governance, describe its nature in the Basis section and include omitted disclosure when practicable unless prohibited by law or regulation. (correct answer)

Answer: D — Discuss the non-disclosure with governance, describe its nature in the Basis section and include omitted disclosure when practicable unless prohibited by law or regulation.

Explanation. SA 705 (Revised), requirements concerning material misstatements involving non-disclosure, require the auditor to discuss the omission with those charged with governance and describe the nature of the omitted information in the Basis for Modified Opinion section. Unless prohibited by law or regulation, the auditor includes the omitted disclosures when practicable and when sufficient appropriate evidence about the information has been obtained. Narrative and disclosure misstatements cannot simply be ignored.

Where it goes wrong. Assuming that only numerical misstatements can require a modified opinion and that disclosure omissions can be handled solely through an Emphasis of Matter paragraph.

Authority. SA 705

Question 25 · 2 marks · Chapter 8: Audit Report and CARO, 2020 · medium

Scenario. An auditor expects to issue an adverse opinion because material and pervasive misstatements have been established. Which communication requirement applies before issuing the auditor's report?

An auditor expects to issue an adverse opinion because material and pervasive misstatements have been established. Which communication requirement applies before issuing the auditor's report?

1. Communicate the circumstances leading to the expected modification and the proposed wording of the modification to those charged with governance. (correct answer)
2. Communicate the final adverse opinion only to the shareholders after publication of the annual report.
3. Communicate only the numerical financial effects to management, without discussing the proposed wording of the opinion.
4. Obtain management's written approval of the adverse opinion before communicating the matter to the Audit Committee.

Answer: A — Communicate the circumstances leading to the expected modification and the proposed wording of the modification to those charged with governance.

Explanation. SA 705 (Revised), section 5.10 of the ICAI study material, requires the auditor to communicate with those charged with governance when the auditor expects to modify the opinion. The communication covers the circumstances that led to the expected modification and the wording of the modification. This provides governance with an opportunity to understand and discuss the proposed reporting conclusion; it does not give management or the Audit Committee authority to veto an appropriate audit opinion.

Where it goes wrong. Confusing the auditor's obligation to discuss the expected modification with obtaining management's permission to issue a modified opinion.

Authority. SA 705; section 5