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Standards on Auditing
1. You are an audit senior working for the firm Bohra & Company. You are currently carrying out the
audit of Wisdom Ltd., a manufacturer of waste paper bins. You are unhappy with Wisdom Ltd.’s
inventory valuation policy and have raised the issued several times with the audit manager. He
has dealt with the client for a number of years and does not see what you are making an objection
about. He has refused to meet you on site to discuss those issues.
As the audit manager had dealt with Wisdom Ltd. for so many years, the other partners have
decided to leave the audit of Wisdom Ltd. in his capable hands. Comment on the situation
outlines above.
Ans: Quality Control Issues on an engagement: Several quality control issues are raised in the
scenario:

Engagement Partner: An engagement partner is usually appointed to each audit engagement

undertaken by the the firm, to take responsibility for the engagement on behalf of the firm.
Assigning the audit to an experienced audit manager is not sufficient.
The lack of an audit engagement partner also means that several of the requirements of SA 220
on “Quality Control for an Audit of Financial Statement”, about ensuring that engagements in
relation to independence and directing, supervising and reviewing the audit are not in place.

Conflicting Views: In this scenario the audit manager and senior have conflicting views about the
valuation of inventory. This does not appear to have been handled well, with the manager
refusing to discuss the issued with the senior.
SA 220 on “Quality Control for an Audit of Financial Statement”, requires that the audit
engagement partner takes responsibility for settling disputes in accordance with the firm’s policy
in respect of resolution of difference of opinion required by SQC 1” Quality Controls for Firms that
Perform Audits and Reviews of Historical Financial Information, and Other Assurance and Related
Services Engagements”. In this case, the lack of engagement partner may have contributed to
this failure to resolve the disputes. In any event, at best, the failure to resolve the difference of
opinion is a breach of the firm’s policy under SQC 1. At worst, it indicates that the firm does not
have a suitable policy concerning such disputes required by SQC.1 “Quality control for Firms that
Perform Audits and Reviews of Historical Financial Information, and Other Assurance and Related
Services Engagements”.

2. (a) Intelligent Ltd. entered into an agreement with Mr. Intellectual on 15th March,2016, whereby
it agreed to pay him Rs. 2 lakhs per months as retainership fee for consultation in IT department.
However, no amount was actually paid and Rs. 24 lakhs was provided in the Statement of Profit
and Loss for the year ending on March 31st, 2016. Management of the company uttered
that need-based consultation was obtained throughout the year. However, on investigation, no
documentary or other evidence of receipt of such service was found. As
the auditor of Innocent Ltd., what would be your approach?
Ans: (a) Fraud Committed by Management of the Company :As per SA 240 on “The Auditor
Responsibilities

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Relating to Fraud in an Audit of Financial Statement”, fraud can be committed by management

overriding controls using such techniques as recording fictitious journal entries, particularly close
to the end of an accounting period, to manipulate operating results or achieve other objectives.
In the given case, Intelligent Ltd. has entered into an agreement with Mr. Intellectual, at year-end,
for consultation in IT department. It also charged yearly fee of Rs. 24 lakhs in the Statement of
Profit and Loss, however, no documentary or other evidence of receipt of such service was found,
on investigation, it is clear that company has passed fictitious journal entries, near year-end, to
manipulate the operating results .
Accordingly, the auditor would adopt the approach which will be based on the result of
misstatement on the basis of such fictitious journal entry, i.e. if, as a result of a misstatement
resulting from fraud or suspected fraud, the auditor encounters exceptional circumstances that
bring into question the auditor’s ability to continue performing the audit, the auditor shall
determine the professional and legal responsibilities applicable in the circumstances, including
whether there is a requirement for the auditor to report to the person or persons who made the
audit appointment or, in some cases, to regulatory authorities; or the auditor may consider for
appropriateness of withdrawal from such engagement, where withdrawal from the engagement
is legally permitted.
In addition, the auditor is required to report according to section 143(2) of the Companies Act,
2013. As per Section 143(2), if an auditor of a company, in the course of the performance of his
duties as auditor, has reason to believe that an offence involving fraud is being or has been
committed against the company by officers or employees of the company, he shall immediately
report the matter to the audit committee within 2 days of his knowledge (as amount involved is
less than one crore rupees) and after following the prescribed procedure such as reporting on :
(i) Nature of Fraud with description;
(ii) Approximate amount involved; and
(iii) Parties involved etc.

3.(b) In the course of audit of Zed Ltd, its auditor wants to rely on audit evidence obtained in
previous audit in respect of effectiveness of internal controls instead of retesting
the same during the current audit. As an advisor to the auditor kindly caution him about
the factors that may warrant a re-test of controls.
Ans: (b) As per SA 330 on “The Auditor’s Responses to Assessed Risks”, changes may affect the
relevance of the audit evidence obtained in previous audits such that there may no longer be a
basis for continued reliance.
The auditor’s decision on whether to rely on audit evidence obtained in previous audits for
controls is a matter of professional judgment. In addition, the length of time between retesting
such controls is also a matter of professional judgment .
Factors that may warrant a re-test of controls are-
(i) A deficient control environment.
(ii) Deficient monitoring of controls.
(iii) A significant manual element to the relevant controls.

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(iv) Personnel changes that significantly affect the application of the control.
(v) Changing circumstances that indicate the need for changes in the control.
(vi) Deficient general IT-controls.

4. (a) Gama Ltd. is a mobile phone operating company. Barring the marketing function it had outsourced
the entire operations like maintenance of mobile infrastructure, customer billing, payroll, accounting
functions, etc. Assist the auditor of Gama Ltd. as to how he can obtain an understanding of how Gama
Ltd. uses the services of the outsourced agency in its operations.

Ans: (a) Understanding How User Entity Uses the Services of Service Organisation:

As per SA 402 on “Audit Considerations Relating to an Entity Using a Service Organisation”, when
obtaining an understanding of the user entity in accordance with SA 315 “Identifying and
Assessing the Risks of Material Misstatement through Understanding the Entity and its
Environment”, the user auditor shall obtain an understanding of how a user entity uses the
services of a service organisation in the user entity’s operations, including:
I. The nature of the services provided by the service organisation and the significance of
those services to the user entity, including the effect thereof on the user entity’s internal
control;
II. The nature and materiality of the transactions processed or accounts or financial
reporting processes affected by the service organisation;
III. The degree of interaction between the activities of the service organisation and those of
the user entity; and
IV. The nature of the relationship between the user entity and the service organisation,
including the relevant contractual terms for the activities undertaken by the service
organisation.

5.(b) While verifying the employee records in a company, it was found that a major portion of the
labour employed was child labour. On questioning the management, the auditor was told that it
was outside his scope of the financial audit to look into the compliance with other laws. Comment.
Ans: (b) Compliance with Other Laws: As per SA 250, “Consideration of Laws and Regulations in an
Audit of Financial Statements”, the auditor shall obtain sufficient appropriate audit evidence
regarding compliance with the provisions of those laws and regulations generally recognised to have
a direct effect on the determination of material amounts and disclosures in the financial statements
including tax and labour laws.

Further, non-compliance with other laws and regulations may result in fines, litigation or other
consequences for the entity, the costs of which may need to be provided for in the financial
statements, but are not considered to have a direct effect on the financial statements.

If the auditor suspects there may be non-compliance, the auditor shall discuss the matter with
management. If management does not provide sufficient information that supports that the entity
is in compliance with laws and regulations and, in the auditor’s judgment, the effect of the suspected

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non-compliance may be material to the financial statements, the auditor shall consider the need to
obtain legal advice.

If the auditor is precluded by management from obtaining sufficient appropriate audit evidence to
evaluate whether non-compliance that may be material to the financial statements has, or is likely
to have, occurred, the auditor shall express a qualified opinion or disclaim an opinion on the financial
statements on the basis of a limitation on the scope of the audit.

In the instant case, major portion of the labour employed in the company was child labour. While
questioning by auditor, reply of the management that it was outside his scope of financial audit to
look into the compliance with other laws is not acceptable as it may have a material effect on
financial statements.

Thus, auditor should ensure the disclosure of above fact and provision for the cost of fines, litigation
or other consequences for the entity. In case, the auditor concludes that non-compliance has a
material effect on the financial statements and has not been adequately reflected in the financial
statements, the auditor shall express a qualified or adverse opinion on the financial statement.

6.(c) Lakshya Ltd. has a branch office located outside India. Company is in the process of
appointment of non-Chartered Accountant as an auditor but otherwise qualified person from
country where the branch office is situated. Statutory auditor is of the opinion that non-Chartered
Accountant cannot be appointed as branch auditor. Comment.
Ans:
(c) Non-Chartered Accountant as Branch Auditor: As per section 143(8) of the Companies Act, 2013,
where a company has a branch office, the accounts of that office shall be audited either by the auditor
appointed for the company under this Act or by any other person qualified for appointment as an
auditor of the company. Where the branch office is situated in a country outside India, the accounts
of the branch office shall be audited either by the company’s auditor or by an accountant or by any
other person duly qualified to act as an auditor of the accounts of the branch office in accordance
with the laws of that country and the duties and powers of the company’s auditor with reference to
the audit of the branch and the branch auditor, if any, shall be such as may be prescribed.

Thus, a non- Chartered Accountant can be appointed as an auditor of branch office located outside
India provided he is qualified for appointment as an auditor in that country.

7.You are also required to discuss the applicability of SA 600 using the work of another auditor by
the head office auditor in regard to branch located outside India, if non-Chartered Accountant is
appointed.

Ans: Using the Work of Another Auditor: When the accounts of the branch are audited by a person
other than the company’s auditors, there is need for a clear understanding of the role of such auditor
and the company’s auditor in relation to the audit of accounts of the branch and the audit of the
company as a whole. Also, there is great necessity for a proper rapport between these two auditors

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for the purpose of an effective audit. In recognition of these needs, the Council of the Institute of
Chartered Accountants of India has dealt with these issues in SA 600, “Using the Work of another
auditor”. It makes clear that in certain situations, the statute governing the entity may confer the
right on the principal auditor to visit a component and examine the books of accounts and other
records of the said component, if he thinks it necessary to do so. Where another auditor has been
appointed for the component, the principal auditor would normally be entitled to rely upon the work
of such auditor unless there are special circumstances to make it necessary for him to visit the
component and/or to examine the books of accounts and other records of the said component.
Further, it requires that the principal auditor should perform procedures to obtain sufficient
appropriate audit evidence, that the work of the other auditor is adequate for the principal auditors’
purpose, in context of the specific assignment.

Audit Strategy Planning and

Programming
8. You are the manager responsible for the audit of Worth Ltd. which has a year end of 31 March.
This is the first year that your firm has undertaken the audit of Worth Ltd., having succeeded the
previous auditors at the last annuals general meeting following a successful tender for the audit.
Your firm has an office in Telangana and in 15 other location throughout the India.
You have had preliminary discussions with the management of Worth Ltd. and obtained some
background information about the company. The company produces fertilizer in a factory on the
outskirts of Liverpool. The head office is situated in Telangana. There are ten depots throughout
the country which hold large stocks of fertilizer so that local demand for its products can be met
quickly. Inventory records are not maintained and a full count is carried out at the year end.
You have also read recent government press release that indicates that ‘L’, a product which forms
a major part of the company’s sales, contains a chemical that has been identified as being
potentially dangerous to those who handle it. An official government working party has been set
up to review the situation.
Requirement

(b) Identify the circumstances that should be taken into account when planning the audit of
Worth Ltd., and set out your outline audit approach in these areas.
(c) Explain the objectives of audit planning.
Ans: (a) Auditing Planning
Circumstances Outline audit approach
This is the first year that the firm • In order to be satisfied about the
Has undertaken the audit of previous financial statements the
Worth Ltd. auditor should:
1. Hold consultations with management.

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2. Review client’s records, working papers and

accounting and control procedures for the
previous period
3. (Possibly) hold consultations with the previous
auditor.
4. Be familiarizing with the nature of the
business, market, accounting systems etc by
discussions with management and by review of
interim/management accounts.
Worth Ltd. has • The staff must be planned to carry out
- A head office in Telangana the audit from the firm’s offices
- A factory in Livepool throughout the country.
- Ten depots throughout • They must all be adequately briefed and
the country provided with a copy of the audit plan
detailing their specific tasks and
deadlines.
No inventory records have been • It is very important that the auditors are
maintained but a full inventory satisfied with the inventory count
count is to be carried out at the • The written count instruction must be
year end. reviewed well in advance of the year
end, so that improvement can be
suggested by the auditors and
incorporated into the client’s
instructions.
• The auditors should ensure that
sufficient staff with the necessary
experienced is available to attend the
count at all material locations.
‘L’ a major product of the Ascertain
company, has been identified as - For how long Worth Ltd. has been selling
being potentially dangerous ‘L’ and in what quantity?
- How much ‘L’ the company now holds in
inventory?
Ensure that the firm keeps up-to-date with
the findings of the government working
party.
Consider whether any of the employees of
Worth Ltd. may have been harmed and, if so,
the consequential liability of the company to
them.

(b) Objectives of the audit planning

(i) To ensure that appropriate attention is devoted to important areas of the audit: This is
done via a formal written audit plan, laying down the objectives and the procedures to be
followed in order to meet those objectives.

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(ii) To facilitate review: Work should be delegated to staff with the appropriate level of
experience. All work should be properly supervised and reviewed by a more senior
member of staff.
(iii) To ensure that potential problems are identified: The auditor must ensure that resources
are directed towards material/high risk areas.
(iv) To assist in the proper assignment of work: This may be to members of the audit team
or to experts or other auditors. It helps the audit to proceed in a timely and efficient
manner.

9.(a) As an internal auditor for a large manufacturing concern, you are asked to verify
whether there are adequate records for identification and value of Plant and Machinery,
tools and dies and whether any of these items have become obsolescent and not in use.
Draft a suitable audit programme for the above.
Ans: (a) The Internal Audit Programme in connection with Plant and Machinery, Tools and Dies
may be on the following lines:
(i) Internal Control Aspects - The following may be incorporated in the audit programme to
check the internal control aspects:
(a) Maintaining separate register for hired assets, leased asset and jointly owned assets.
(b) Maintaining register of fixed asset and reconciling to physical inspection of fixed asset
and to nominal ledger.
(c) All movements of assets are accurately recorded.
(d) Authorisation be obtained for –
(i) a declaring a fixed asset scrapped.
(ii) selling a fixed asset.
(e) Check whether additions to fixed asset register are verified and checked by authorised
person.
(f) Proper recording of all additions and disposal.
(g) Examining procedure for the purchase of new fixed assets, including written authority,
work order, voucher and other relevant evidence.
(h) Regular review of adequate security arrangements.
(i) Periodic inspection of assets is done or not.
(j) Regular review of insurance cover requirements over fixed assets.

(ii) Assets Register: To review the registers and records of plant, machinery, etc. showing
clearly the date of purchase of assets, cost price, location, depreciation charged, etc.

(iii) Cost Report and Journal Register: To review the cost relating to each plant and machinery
and to verify items which have been capitalised.

(iv) Code Register: To see that each item of plant and machinery has been given a distinct code
number to facilitate identification and verify the maintenance of Code Register.

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(v) Physical Verification: To see physical verification has been conducted at frequent
intervals.

(vi) Movement Register: To verify (a) whether a Movement Register for movable equipments
and (b) log books in case of vehicles, etc. are being maintained properly.

(vii) Assets Disposal Register: To review whether assets have been disposed off after proper
technical and financial advice and sales/disposal/retirement, etc. of these assets are
governed by authorisation, sales memos or other appropriate documents.

(viii) Spare Parts Register: To examine the maintenance of a separate register of tools, spare
parts for each plant and machinery.

(ix) Review of Maintenance: To scrutinise the programme for an actual periodical servicing
and overhauling of machines and to examine the extent of utilization of maintenance
department services.

(x) Review of Obsolescence: To scrutinise whether expert’s opinion have been obtained from
time to time to ensure purchase of technically most useful efficient and advanced
machinery after a thorough study.

(xi) Review of R&D: To review R&D activity and ascertain the extent of its relevance to the
operations of the organisation, maintenance of machinery efficiency and prevention of
early obsolescence.
10.(b) M/s Abu & Co. was appointed as auditor of Grand Airways Ltd. As the audit partner,
what factors shall be considered in the development of overall audit plan?

Ans: (b) Development of an Overall Plan: Overall plan is basically intended to provide direction for
audit work programming and includes the determination of timing, manpower development and co-
ordination of work with the client, other auditors and other experts. The auditor should consider the
following matters in developing his overall plan for the expected scope and conduct of the audit-

(i) Terms of his engagement and any statutory responsibilities.

(ii) Nature and timing of reports or other communications.

(iii) Applicable Legal or Statutory requirements.

(iv) Accounting policies adopted by the clients and changes, if any, in those policies.

(v) The effects of new accounting and auditing pronouncement on the audit.

(vi) Identification of significant audit areas.

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(vii) Setting of materiality levels for the audit purpose.

(viii) Conditions requiring special attention such as the possibility of material error or fraud or
involvement of parties in whom directors or persons who are substantial owners of the entity are
interested and with whom transactions are likely.

(ix) Degree of reliance to be placed on the accounting system and internal control.

(x) Possible rotation of emphasis on specific audit areas.

(xi) Nature and extent of audit evidence to be obtained.

(xii) Work of the internal auditors and the extent of reliance on their work, if any in the audit.

(xiii) Involvement of other auditors in the audit of subsidiaries or branches of the client and
involvement of experts.

(xiv) Allocation of works to be undertaken between joint auditors and the procedures for its control
and review.

(xv) Establishing and coordinating staffing requirements.

Risk Assessment and Internal Control

11.De-garment Ltd. is a retailer of fashion accessories. It has a turnover of Rs. 54 million and 150
shops throughout the India. It also has six regional warehouses from which the shops are supplied
with goods.
The company has an internal audit department which is based at the company’s head office in
Delhi. Internal auditors make regular visits to the shops and warehouses.
This is the first year that your firm has acted as auditor for De-garments Ltd. The partner in charge
of the audit has expressed his opinion that the internal audit department might be able to assist
the external audit team in carrying out its work.
Requirements
(a) State, with reasons, the information that you would require to make an assessment of the
likely effectiveness and the relevance of the internal audit function.
(b) Described four typical procedures that might be carried out by the internal auditors during
their visits to the shops and warehouses and on which you might wish to rely.
(c) Assuming that you intend to rely on the work of the internal audit department of De-garments
Ltd., describe briefly the effect this will have on your audit of company’s financial statements.
1. Ans: (a)

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Information Reason
The organizational status and reporting The degree of objectivity is increased when
responsibilities of the internal auditor and any internal audit:
constraints and restrictions thereon. - is free to plan and carry out its
work and communicate fully with
the external auditor
- has access to the highest level of
management.
Areas of responsibility assigned by Not all areas in which internal audit may
management to internal audit, such as review operate will be relevant to the external
of auditor.
- Accouting systems and internal - (Relevant)
controls - (Not-relevant)
- Implementation of corporate plans
Routine tasks carried out by internal audit In these respects staff are not functioning
staff such as authorization of petty cash as internal audit, they are working simply
reimbursements. as an internal control.
Internal auditors formal terms of reference Internal auditor’s role will be most relevant
where it:
- Has a bearing on the financial
statements.
- Involves a specialization
Internal audit documentation such as an audit It is more likely that due professional care
manual and audit plans is being exercised where the work of
internal audit is properly planned,
controlled, recorded and reviewed.
Professional membership and practical Unless internal audit is technically
experience (including computer auditing competent it is inappropriate to place
skills) of internal audit staff. reliance on it.
Internal audit reports generated and feedback How the company responds to internal
thereon. audit findings may be regarded as a
measure of the department’s
effectiveness.
Number of staff, computer facilities and any The effectiveness of internal audit (and
other resources available to internal audit. hence the reliance placed thereon) will be
limited if the department is under-
resourced.

(b) Typical procedures

(i) Inspection of tangible non-current assets: Assets seen at the warehouses (e.g. delivery vehicle
fleet) should be noted and subsequently agreed to the fixed asset register maintained at head
office (HO). Assets recorded in the register (e.g. shop fixtures and fittings) should be selected for
inspection prior to visits to ensure their existence.
(ii) Attendance at inventory counts: Periodic counts (eg monthly) should be attended on a rotational
basis at warehouses and larger shops to ensure adherence to the company’s procedures. Test
counts should be made to confirm the accuracy and completeness of the inventory counts.

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(iii) Cash: Cash should be be carried out on each register takings (and petty cash floats) whenever
shops (and warehouses) are visited on a ‘surprise’ basis.
(iv) Goods dispatch: Internal control procedures should be observed to be in operation, for example
to ensure that all dispatches are documented and destined for the company’s retail outlets.
(v) Employee verification: Payroll procedures are likely to be carried out at HO, warehouses and
shops informing HO on a weekly basis of hours worked by employees, illness and holiday etc.
However, new employees, especially in the shops (and probably also in the warehouses) will be
recruited locally and their details notified to HO.
Internal audit will be able to select a sample of employees from HO records and ensure on the visits
to shops and warehouses’ that these represent bona fide employees.
(c) Effect on audit
(i) Systems documentation: The accuracy of systems documentations which has been prepared by
internal audit need only be confirmed using ‘walk-through tests’. This saves time (if the systems
documentation is correct) since only copies will be required for the audit file.
(ii) Tests of controls: The level of independent testing (i.e. the external auditor ) can be reduced
where controls have been satisfactorily tested by internal audit, especially if error rates are found
to be similar. In particular, attendance at stocktaking at the year end may be limited to those
locations with the highest stockholdings.
(iii) Substantive procedures: Internal audit’s evidence (e.g. concerning the existence of tangible non-
concern assets), will reduce sample sizes for year end verification work. Substantive procedures
may also be reduced where the internal audit checks reconciliations’ (e.g. of supplier’s statement
to ledger balances, receivable and payables controls accounts and bank reconciliations)

Audit under CIS Environment

12.(a) You are a member of an audit team of RKP Associates, auditors of a Multinational Company YB
CO. Ltd. The company is working in CIS environment. The partner in charge of RKP Associates asked you
to draw out the audit plan for evaluating the reliability of controls.
Ans. (a) Audit Plan for Evaluating the Reliability of Controls in CIS Environment: In evaluating the effects
of acontrol, the auditor needs to assess the reliability by considering the various attributes of a control.
Some of the attributes for example are that the control is in place and is functioning as desired, generality
versus specificity of the controls with respect to the various types of errors and irregularities that might
occur, general control inhibit the effect of a wide variety of errors and irregularities as they are more
robust to change controls in the application sub-system which tend to be specific control because
component in these sub-system execute activities having less variety, that whether the control acts to
prevent, detect or correct errors etc.
The auditor focuses here on-
(i) Preventive controls: Controls which shop errors or irregularities from occurring.
(ii) Detective controls: Controls which identify errors and irregularities after they occur.

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(iii) Corrective controls: Controls which remove the effects of errors and irregularities after they
have been identified.
The auditors are expected to see a higher density of preventive controls at the early stages of
processing or conversely they expect to see more detective and corrective controls later in system
processing.
Further, while evaluating the reliability of controls, the auditor should:
(i) Ensure that authorized, correct and complete data is made available for processing;
(ii) Provide for timely detection and correction of errors.
(iii) Ensure that the case of interruption in the work of the CIS environment due to power,
mechanical or processing failures, the system restarts without distorting the completion of
the entries and records;
(iv) Ensure that accuracy and completeness of output;
(v) Provide adequate data security against fire and other calamities, wrong processing, frauds
etc.,
(vi) Prevent unauthorized amendments to the program;
(vii) Provide for safe custody of source code of application software and data files.

13. (b ) ”The method of collecting Audit evidence and evaluating the same changes drastically under
CIS Environment”.- Comment.
Ans: (b) Auditor must provide a competent, independent opinion as to whether the financial statements
records and report a true and fair view of the state of affairs to an entity. However, computer systems
have affected how auditors need to collect and evaluate evidence. These aspects are discussed below:
(i) Changes to Evidence Collection: Collecting evidence on the reliability of a computer system is
often more complex than collecting evidence on the reliability of a manual system. Auditors have
to face a diverse and complex range of internal control technology that did not exist in manual
system,like:
(1) accurate and complete operations of a disk drive may require a set of hardware controls not
required in manual system,
(2) system development control include procedures for testing programs that again are not
necessary in manual control.
Since, Hardware and Software develop quite rapidly, understanding the control technology is not
easy. With increasing use of data communication for data transfer, research is focused an
cryptographic controls to project the privacy of data. Unless auditor’s keep up with these
developments, it will become difficult to evaluate the reliability of communication network
competently.
The continuing and rapid development of control technology also makes it more difficult for
auditors to collect evidence on the reliability of controls. Even collection of audit evidence
through manual means is not possible. Hence, auditors have to run through computer system
themselves if they are to collect the necessary evidence. Hough generalized audit softwares are
available the development of these tools cannot be relied upon due to lack of information. Often
auditors are forced to compromise in some way when performing the evidence collection.

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(ii) Changes of Evidence Evaluation – With increasing complexity of computer systems and control
technology, it is becoming more and more difficult for the auditors to evaluate the consequences
of strength and weaknesses of control mechanism for placing overall reliability on the system.
Auditors need to understand:
(1) whether a control is functioning reliably or multi functioning,
(2) traceability of control strength and weakness through the system . In a shared data
environment a single input transaction may update multiple data item used by diverse,
physically disparate user, which may be difficult to understand.
Consequences of errors in a computer system are a serious matter as errors in computer system
tend to be Deterministic, i.e. an erroneous program will always execute data incorrectly. Moreover, the
errors are generated at high speed and the cost and effort to correct and rerun program may be high.
Errors in computer program can involve extensive redesign and reprogramming. Thus, internal controls
that ensure high quality computer systems should be designed implemented and operated upon. The
auditors must ensure that these control are sufficient to maintain assets safeguarding, data integrity,
system effectiveness and system efficiency and that they are in position and functioning.

14.(a) Saras, a limited company having turnover of approximately Rs. 80 crores uses a tailor made
accounting software package. In the said package, all transactions are recorded, processed and the final
accounts generated from the system. The management tells you that in view of the voluminous nature
of day books, there is no need to print them and that audit can be conducted on the computer itself.
The management further assures you that any 'query based reports' as required can be generated and
printed. As a statutory auditor of the company, enumerate the procedures you would adopt to conduct
the audit.

Ans:(a) A key feature of the accounting software package used by the company definitely involves
the absence of a clear audit trail. In other words, transactions cannot be easily traced or co-related
from the individual supporting documents of those transactions. Moreover, the management does
not wish to print the daybooks in view of the voluminous nature since it may involve extensive costs.
This has naturally led to extensive dependence by management upon the "exception reporting"
principle.

From the auditor's point of view, it must also be conceded, the exception reports in the form of
'query-based reports' which isolate the above data provide him with the very material that he
requires for most of his verification work. The only problem which it raises, and it is a serious one, is
that he cannot simply assume that the programmes which produce the exception reports are reliable
in respect of the following factors:

(i) operating accurately;

(ii) printing out all the exceptions which exist; and

(iii) bound by programmed control parameters which meet the company's genuine internal control
requirements.

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In view of the above, whether management relies upon exception reports, it effectively eliminated
the audit trail between input and output and the auditor is forced to test the invisible processes
which purport to embody the controls, and produce the output such as it is. These tests, which
invariably involve the use by the auditor of the computer itself, are known as tests through the
machine. In the 'through the machine' approach, the auditor starts by proving the accuracy of the
input data, and then thoroughly examines (by applying tests) the processing procedures with a view
to establishing the following that:

(i) all input is actually entered into the computer.

(ii) neither the computer nor the operators can cause undetected irregularities in the final reports.

(iii) the programmes appear, on the evidence of rejection and exception routines, to be functioning
correctly.

(iv) all operator intervention during processing is logged and scrutinised by the DP manager.

The auditor in such circumstances will have to first evaluate the existing controls. For the same, he
has to do the following:

(i) Evaluate the internal control system especially the controls and checks existing for recording the
transactions, i.e., he has to verify at what level transactions can be entered into the system and what
checks are available to prevent any unauthorised data entry and for rectifying errors/omissions in
the transactions entered.

(ii) Evaluate at what level there authority is given for modification of transactions already entered. Is
there any authority given only to a senior employee to carry out modifications? Or is it that once
transactions are entered and validated, no further modifications are possible thereto.

(iii) Whether there is a provision in the software for carrying out an on line audit of transactions, i.e.
whether there a separate module in the package, where a separate password given to the auditor
and once he has seen and approved a particular transaction/set of transactions, the same would be
locked and no modifications would be possible by anyone (including the senior most employee) in
the company.

(iv) Whether there are proper procedures for backup of data on a regular basis and whether the said
procedures are being strictly followed.

(v) In case of any loss of data whether there is a clear defined recovery procedure to minimize the
loss of data due to power failures or any human errors.

(vi) The auditor may introduce some dummy data into the system and see the results obtained.

After the auditor has evaluated the above procedures, he has to prepare an audit plan depending on
the results obtained from his earlier evaluation. Since the daybooks are not being printed, the plan
can contain procedures wherein data is verified directly on the computer from the

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vouchers/invoices, etc. The audit plan will also require a lot of analytical procedures to be performed.
Depending on the importance of various expense heads and other important account heads, the
auditor will also obtain various reports from the system depending on various queries that he would
have to identify. Some illustrative reports can be:

(i) To check whether proper classification is done for revenue/capital – a report can be obtained of
all purchases (not being raw materials or other routine purchases) exceeding Rs. 1 lakh.

(ii) To check whether all freight outward bills are accounted for a report containing a month-wise co-
relation between goods despatched and freight amount paid. The same can be further co-related
with the freight rates obtained from the bills.

Once the auditor has performed the above procedures, he would be able to form an opinion whether
reliance can be placed on the accounting systems and the data recorded. If the auditor finds that
reliance cannot be placed on the systems he can inform the management about the fact and also
that the daybooks, etc., will need to printed to allow him to conduct the audit. The finalisation
procedures to be followed even under this system would remain more or less similar to other
accounting systems. The auditor can obtain reports of depreciation on fixed assets, inventory
valuation and using the normal procedures find out whether reliance can be placed on them, e.g., if
while valuing stocks the system is using the LIFO method, the same would not be acceptable and will
need to be modified. Similarly depreciation calculations will have to verify on a random basis to find
out its reliability.

15.(b) “The auditor must evaluate major clauses of control used in a Computerised Information
system to enhance its reliability” – Comment.

Ans: (b) The reliability of a component is a function of control that acts on the component. In a
computer system the following are the major types of controls and used to enhance component
reliability which the auditor must evaluate:

(i) Authenticity Control: They are exercised to verify the identity of the individuals or process
involved in a system. (Pass word, digital signature etc.)

(ii) Accuracy Control: These attempts to ensure the correctness of the data and processes in a system
(Programme validation check).

(iii) Completeness Control: This ensures that no data is missing and all processing is carried through
to its proper conclusion.

(iv) Privacy Control: This ensures the protection of data from inadvertent or unauthorised disclosure.

(v) Audit Trail Controls: This ensures the traceability of all events occurred in a system.

(vi) Redundancy Control: It ensures that processing of data is done only once.

(vii)Existence Control: It attempts to ensure the on going availability of all system resources.

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(viii)Asset safeguarding controls: It attempts to ensure that all resources within a system are
protected from destruction or corruption.

(ix) Effectiveness Control: It attempts to ensure that the system achieves its goals.

(x) Efficiency Control: It attempts to ensure that a system uses minimum resources to achieve its
goals.

The Company Audit

16. (a ) Fine Ltd. is engaged in the production of Jute. In January, 2012, the management of the company
decided to expand its business and started manufacturing jute bags. For such expansion, it required fund
of Rs. 80 lakhs which was financed from Good Bank. The loan was repayable in 10 equal yearly
installments (including interest) of Rs. 20 lakhs beginning from 31st March, 2012 onwards. The company
was regular in payment of installment s till 31st March, 2015. Due to improvement in financial condition
of the company, it decided for onetime settlement for its outstanding loan. Subsequently, Good Bank
rescheduled the loan to Rs. 50 lakhs to be repaid in August, 2015.
The accountant of the company has disclosed the said loan under the head “Long-term Borrowings” in
The Balance Sheet of the company for the financial year 2014-15. As the auditor of Fine Ltd., Kindly
guide the management with regard to disclosure of such liabilities in accordance with Schedule III of
the Companies Act, 2013?
Ans: Reporting Requirement as per Schedule III to the Companies Act, 2013: As per the general instructions
for preparation of Balance Sheet, provided under Schedule III to the Companies Act, 2013, current maturities
of l ong-term debt is required to be disclosed under the head “Other Current Liabilities” in the notes to
accounts.
It may be noted that “Current Maturities of Long-Term Debt” refers to that portion of liabilities of a company
that are becoming due in next 12 months. Since, these obligations are repayable in next 12 months, they are
shifted from Long-Term Liabilities section of the Balance Sheet to Current Liabilities section.
In the given case, Find Ltd. has taken a loan, from Good bank, of Rs. 80 lakhs, repayable in 10 equal yearly
Installments (including interest) of Rs. 20 lakhs. The company has repaid its four installments upto 31 st
March,2015. Further, due to good financial condition of the company, it decided for its entire outstanding loan
as on 31st March, 2015, to be repaid in August, 2015.Thus, it is clear that the outstanding loan of Rs. 50 lakhs,
taken from Good Bank, is repayable in next 12 months.
However, the accountant of the company has disclosed the said loan under the head “Long-term
Borrowings”. Therefore, the management of the company is advised to show the amount of outstanding loan
under the head “Other Current Liabilities” and further classify it under sub-heading “Current Maturities of
Long-Term Debt” of heading “Other Current Liabilities” in the notes to accounts.

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17. (b ) Amudha Ltd. is a Mumbai based company. The total turnover of the company Rs. 10 crores for the
year 2015-16. The company has a branch office at an area which was recently affected by flood. The
transportation services are not available due to destruction caused by flood. The branch office recorded
turnover of Rs.1,50,000 in the Financial Year 2015-16. No audit of branch has been carried out. The statutory
auditor of the company has made no reference of the above branch in his report. Comment.
Ans: Branch Audit: As per section 143(8) of the Companies Act, 2013 if a company has a branch office, the
accounts of that office shall be audited either by the auditor appointed for the company (herein referred to as
the company’s auditor) under this Act or by any other person qualified for appointment as an auditor of the
company under this Act and appointed as such under section 139, or where the branch office is situated in a
country outside India, the accounts of the branch office shall be audited either by the company’s auditor or by
an accountant or by any other person duly qualified to act as an auditor of the accounts of the branch office in
accordance with the laws of that country.
In the given situation, Amudha Ltd. is a Mumbai based company, having total turnover of Rs. 10 Crore. The
Company is having a branch office at an area which is recently affected by flood.
Therefore, the company has to get its branch audited. In case no branch audit has been carried out, company’s
auditor is required to mention this fact in the audit report and deal appropriately. Thus, no reference of above
branch in statutory auditor’s report is not correct.

18. As an auditor, how would you deal with the following situations:
(a) R and H Associates, Chartered Accountants in practice have been appointed Statutory Auditor of Krishna
Ltd. for the accounting year 2015-16. Mr. H,a subsidiary company of Krishna Ltd.
Ans: Auditor Holding Securities of a Company : As per sub-section (3)(d)(i) of Section 141 of the
Companies Act, 2013 along with Rule 10 of the Companies (Audit and Auditors) Rule, 2014, a person
shall not be eligible for appointment as an auditor of a company, who, or his relative or partner is
holding any security of or interest in the company or its subsidiary, or of its holding or associate
company or a subsidiary of such holding company. Provided that the relative may hold security or
interest in the company of face value not exceeding rupees one lakh.

Also, as per sub-section (4) of Section 141 of the Companies Act, 2013, where a person appointed
as an auditor of a company incurs any of the disqualifications mentioned in sub-section (3) after
his appointment, he shall vacate his office as such auditor and such vacation shall be deemed to
be a casual vacancy in the office of the auditor.

In the present case, Mr. H, Chartered Accountant, a partner of M/s R and H Associates, holds 100
equity shares of Shiva Ltd. which is a subsidiary of Krishna Ltd. Therefore, the firm, M/s R and H
Associates would be disqualified to be appointed as statutory auditor of Krishna Ltd. as per section
141(3)(d)(i), which is the holding company of Shiva Ltd., because Mr. H one of the partner is holding
equity shares of its subsidiary.

19.Rick Ltd. is a subsidiary of Ajanta Ltd., whose 20% shares have been held by Central Government,
25% by Uttar Pradesh Government and 10% by Madhya Pradesh Government. Rick Ltd. appointed Mr.
Remo as statutory auditor for the year.

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Ans: According to Section 139(7) of the Companies Act, 2013, the auditors of a government company
shall be appointed or re-appointed by the Comptroller and Auditor General of India. As per section
2(45), a Government company is defined as any company in which not less than 51% of the paid-up
share capital is held by the Central Government or by any State Government or Governments or partly
by the Central Government and partly by one or more State Governments and includes a company
which is a subsidiary of a Government Company as thus defined”.

In the given case Ajanta Ltd is a government company as its 20% shares have been held by Central
Government, 25% by U.P. State Government and 10% by M.P. State Government. Total 55% shares
have been held by Central and State governments. Therefore, it is a Government company.

Rick Ltd. is a subsidiary company of Ajanta Ltd. Hence Rick Ltd. is covered in the definition of a
government company. Therefore, the Auditor of Rick Ltd. can be appointed only by C & AG.

Consequently, appointment of Mr. Remo is invalid and he should not give acceptance to the Directors
of Rick Ltd.

20.Futura Ltd. appointed CA Innocent as an auditor for the company for the current financial year.
Further the company offered him the services of actuarial, investment advisory and investment banking
which was also approved by the Board of Directors.
Ans: Services not to be Rendered by the Auditor: Section 144 of the Companies Act, 2013 prescribes
certain services not to be rendered by the auditor. An auditor appointed under this Act shall provide
to the company only such other services as are approved by the Board of Directors or the audit
committee, as the case may be, but which shall not include any of the following services (whether
such services are rendered directly or indirectly to the company or its holding company or subsidiary
company), namely:
(i) accounting and book keeping services;
(ii) internal audit;
(iii) design and implementation of any financial information system;
(iv) actuarial services;
(v) investment advisory services;
(vi) investment banking services;
(vii) rendering of outsourced financial services;
(viii) management services; and
(ix) any other kind of services as may be prescribed.

Further section 141(3)(i) of the Companies Act, 2013 also disqualifies a person for appointment as an
auditor of a company who is engaged as on the date of appointment in consulting and specialized
services as provided in section 144.

In the given case, CA Innocent was appointed as an auditor of Futura Ltd. He was offered additional
services of actuarial, investment advisory and investment banking which was also approved by the

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Board of Directors. The auditor is advised not to accept the services as these services are specifically
notified in the services not to be rendered by him as an auditor as per section 144 of the Act.

21. Mr. Abhar, a Chartered Accountant, bought a car financed at Rs. 7,00,000 by Chaudhary Finance
Ltd., which is a holding company of Charan Ltd. and Das Ltd. He has been the statutory auditor of Das
Ltd. and continues to be even after taking the loan.
Ans: According to section 141(3)(d)(ii) of the Companies Act, 2013, a person is not eligible for
appointment as auditor of any company, If he is indebted to the company, or its subsidiary, or its
holding or associate company or a subsidiary of such holding company, in excess of rupees five lakh.

In the given case Mr. Abhar is disqualified to act as an auditor under section 141(3)(d)(ii) as he is
indebted to M/s Chaudhary Finance Ltd. for more than Rs.5,00,000. Also, according to section
141(3)(d)(ii) he cannot act as an auditor of any subsidiary of Chaudhary Finance Ltd. i.e. he is also
disqualified to work in Charan Ltd. & Das Ltd. Therefore he has to vacate his office in Das Ltd. Even
though it is a subsidiary of Chaudhary Finance Ltd.

Hence audit work performed by Mr. Abhar as an auditor is invalid, he should vacate his office
immediately and Das Ltd should appoint another auditor for the company.

22. M/s SSS & Co. is an audit firm having partners CA. Satyam, CA. Shivam and CA. Sundaram. CA.
Satyam, CA. Shivam and CA. Sundaram are holding appointment as an auditor in 4, 6 and 10 companies
respectively.

(a) Provide the maximum number of audits remaining in the name of M/s SSS & Co.
(b) Provide the maximum number of audits remaining in the name of individual partner i.e. CA.
Satyam, CA. Shivam and CA. Sundaram.
(c) Can M/s SSS & Co. accept the appointment as an auditor in 60 private companies having paid-
up share capital less than Rs.100 crore, 2 small companies and 1 dormant company?
(d) Would your answer be different, if out of those 60 private companies, 45 companies are having
paid-up share capital of Rs. 110 crore each?

Ans: Ceiling on Number of Audit: As per section 141(3)(g) of the Companies Act, 2013, a person shall not
be eligible for appointment as an auditor if he is in full time employment elsewhere or a person or a
partner of a firm holding appointment as its auditor, if such person or partner is at the date of such
appointment or reappointment holding

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appointment as auditor of more than 20 companies other than one person companies, dormant
companies, small companies and private companies having paid-up share capital less than Rs. 100
crore.

As per section 141(3)(g), this limit of 20 company audits is per person. In the case of an audit firm
having 3 partners, the overall ceiling will be 3 × 20 = 60 company audits. Sometimes, a chartered
accountant is a partner in a number of auditing firms. In such a case, all the firms in which he is
partner or proprietor will be together entitled to 20 company audits on his account.

In the given case, CA. Satyam is holding appointment in 4 companies, whereas CA. Shivam is having
appointment in 6 Companies and CA. Sundaram is having appointment in 10 Companies. In aggregate
all three partners are having 20 audits.

(a) Therefore, M/s SSS & Co. can hold appointment as an auditor of 40 more companies:

Total Number of Audits available to the Firm = 20*3 = 60

Number of Audits already taken by all the partners

in their individual capacity = 4+6+10 = 20

Remaining number of Audits available to the Firm = 40

(b) With reference to above provisions an auditor can hold more appointment as auditor

= ceiling limit as per section 141(3)(g) - already holding appointments as an auditor

Hence (1) CA. Satyam can hold: 20 - 4 = 16 more audits. (2) CA. Shivam can hold 20 - 6 = 14 more
audits and (3) CA. Sundaram can hold 20 -10 = 10 more audits.

(c) In view of above disussed provisions M/s SSS & Co. can hold appointment as an auditor in all the
60 private companies having paid-up share capital less than Rs. 100 crore, 2 small companies and
1 dormant company as these are excluded from the ceiling limit of company audits given under
section 141(3)(g) of the Companies Act, 2013.
(d) As per fact of the case, M/s SSS & Co. is already having 20 company audits and they can also
accept 40 more company audits. In addition, they can also conduct the audit of one person
companies, small companies, dormant companies and private companies having paid up share
capital less than Rs. 100 crores. In the given case, out of the 60 private companies, M/s SSS & Co.
is offered 45 companies having paid-up share capital of Rs. 110 crore each.

Therefore, M/s SSS & Co. can also accept the appointment as an auditor for 2 small companies,
1 dormant company, 15 private companies having paid-up share capital less than Rs. 100 crore
and 40 private companies having paid-up share capital of Rs. 110 crore each in addition to above
20 company audits already holding.

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23. CA. Rock is a partner in M/s Ajay & Associates and M/s Vijay & Associates simultaneously. M/s Ajay
& Associates has completed its tenure of 10 years as an auditor in Sanjay Ltd. immediately preceding
the current financial year. It may be noted that the provisions for applicability of rotation of auditors
are applicable to Sanjay Ltd. Now, the company wants to appoint M/s Vijay & Associates as auditor for
5 years.

(a) Whether M/s Vijay & Associates is allowed to accept the appointment as auditor of Sanjay Ltd.?
(b) Would your answer be different from above if CA. Rock, being in-charge of M/s Ajay &
Associates and certifying authority of financial statements of Sanjay Ltd., retires from the
partnership in M/s Ajay & Associates and joins M/s Vijay & Associates?

Ans: (a) Audit Firm having Common Partner: Section 139(2) of the Companies Act, 2013 provides that
as on the date of appointment, no audit firm having a common partner or partners to the other audit firm,
whose tenure has expired in a company immediately preceding the financial year, shall be appointed as
auditor of the same company for a period of five years.

In the given case, CA. Rock is a common partner in M/s Ajay & Associates and M/s Vijay & Associates.
The tenure of 10 years of M/s Ajay & Associates as an auditor has been expired in Sanjay Ltd.
immediately preceding the current financial year i.e. the firm shall not be eligible for re-appointment
as auditor in the same company for 5 years from the completion of such term.

Therefore, M/s Vijay & Associates will also be disqualified to be appointed as auditor of Sanjay Ltd.
for next 5 financial years as CA. Rock was the common partner of M/s Vijay & Associates whose
tenure in Sanjay Ltd. has expired.

(b) Retiring Partner being In-charge in Previous Audit Firm: As per 139(2) of the Companies Act,
2013 read with the explanation given under Companies (Audit and Auditors) Rules, 2014 for the
purpose of rotation of auditors, if a partner, who is in-charge of an audit firm and also certifies the
financial statements of the company, retires from the said firm and joins another firm of chartered
accountants, such other firm shall also be ineligible to be appointed for a period of 5 years.

In the given case, CA. Rock was in-charge of M/s Ajay & Associates and certifying authority of financial
statements of Sanjay Ltd. who retires from the said firm and joins M/s Vijay & Associates. The tenure
of 10 years of M/s Ajay & Associates as an auditor has been expired in Sanjay Ltd. immediately
preceding the current financial year i.e. the firm shall not be eligible for re-appointment as auditor
in the same company for 5 years from the completion of such term.

Therefore, M/s Vijay & Associates will also be disqualified to be appointed as auditor of Sanjay Ltd.
for next 5 financial years as newly joined partner CA. Rock has retired from M/s Ajay & Associates
immediately preceding the current financial year whose tenure in Sanjay Ltd. has expired.

23. (a) FX Ltd. is engaged in the business of newspaper and radio broadcasting. It operates through
different brand names. During the Financial Year 15-16, it incurred substantial amounts on external
trade, business communication and branding expenses by participation in various corporate social

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responsibility initiatives. The company expects to benefits by this expenditure by attracting new
customers over a period of time and accordingly it has capitalised the same under ‘brand development
expenses’ and intends to amortise the same over the period in which it expects the benefits to flow. As
the statutory auditor of the company, do you concur with this treatment? Give reasons.

Ans: (a) Capitalisation of Expenses: As per Accounting Standard 26 on “Intangible Assets”,

expenditure on an intangible item should be recognised as an expense when it is incurred unless it
forms part of the cost of an intangible asset that meets the recognition criteria.

In the given case, FX Ltd. incurred substantial amounts on external trade, business communication
and branding expenses by participation in various corporate social responsibility initiatives. The
company expects to benefits by this expenditure by attracting new customers over a period of time
and accordingly it has capitalised the same under brand development expenses. Here, no intangible
assets or other asset is acquired or created that can be recognised.

Therefore, the accounting treatment by the company to amortise the entire expenditure over the
period in which it expects the benefits to flow is not correct and the same should be debited to the
Statement of Profit and Loss in the year of incurring.

(b) Dabloo Ltd. is facing financial crunch and has sold significant part of machinery to repay 25%
amount of wages overdue. Many workers have also left the company due to non-payment of
wages. Dabloo Ltd. is also considering filing for bankruptcy. The financial statements (and notes
thereto) do not disclose the fact. As an Auditor, how would you deal with the situation? You are
also required to identify the type of opinion you would issue and draft the same.

Ans: (b) Disclosure for Uncertainty about Going Concern: As per SA 570 “Going Concern”, it is the
responsibility of the Auditor to obtain sufficient appropriate audit evidence about the
appropriateness of management’s use of the going concern assumption in the preparation and
presentation of the financial statements and to conclude whether there is a material uncertainty
about the entity’s ability to continue as a going concern.

In the given case, Dabloo Ltd. has sold significant part of machinery to repay its wages overdue and
also considering filing for bankruptcy. These events indicate a material uncertainty that may cast
significant doubt on the company’s ability to continue as a going concern and, therefore, it would be
unable to realize its assets and discharge its liabilities in the normal course of business.

Thus, the auditor should ask the management for its adequate disclosure in the financial statement
and include the same in his report. However, if the management fails to make adequate disclosure,
the auditor should express a qualified or adverse opinion. In view of circumstances mentioned in SA
705 “Modifications to the Opinion in the Independent Auditor’s Report”, the auditor should give
adverse opinion in above case as follows -

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In our opinion, because of the omission of the information mentioned in the Basis for Adverse
Opinion paragraph, the financial statements do not give information required by the Companies Act,
2013 in the manner so required and also do not give a true and fair view in conformity with the
accounting principles generally accepted in India:

(i) In the case of the Balance sheet, of the state of affairs of the Company as at March 31,20xx;

(ii) In the case of the Profit & Loss account, of the profit/loss for the year ended on that date; and

(iii) In the case of the Cash flow statement, of the cash flow for the year ended on that date.

24. OST Limited, a manufacturing company donated Rs. 45,000 and Rs. 55,000 to Charitable
Societies namely ‘Healthy World Charitable Foundation’ and ‘Learning Kids Foundation’
respectively during the financial year 2015-16. The company has not taken any approval in general
meeting for such donation. The average net profits of the company for the last three years were Rs.
15 lakhs. As an auditor, what will be your comment?

Ans: (c) Donation to Charitable Institutions: Section 181 of the Companies Act, 2013 provides that
the Board of Directors of a company may contribute to bona fide charitable and other funds with
prior permission of the company in general meeting for such contribution in case any amount the
aggregate of which, in any financial year, exceed 5 per cent of its average net profits for the three
immediately preceding financial years.

In the instant case, OST Limited has given donation of Rs. 1,00,000/- (Rs. 45,000/- + Rs. 55,000/-) to
two charitable organisations. The average profit of the last 3 years is Rs. 15 lakhs and the 5% of this
works out to Rs. 75,000. Hence the maximum of donation could be Rs. 75,000 only. For excess of Rs.
25,000 the company is required to take prior permission in general meeting which is not been taken.

Therefore, by paying donations of Rs. 1,00,000 which is more than Rs. 75,000, the Board has
contravened the provisions of section 181 of the Companies Act, 2013. Hence, the auditor should
qualify his report accordingly.

25.As a Statutory Auditor, how would you report the following under CARO, 2016:
(i) A term loan was obtained from a bank for Rs. 110 lakh for acquiring R&D equipment, out of
which Rs. 45 lakh was used to buy a car for use of the concerned director who was overlooking
the R&D activities.

Ans: Utilisation of Term Loans: According to clause (xi) of Para 3 of CARO, 2016,the auditor is
required to comment whether term loans were applied for the purpose for which the loans were
obtained.

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The auditor should examine the terms and conditions of the term loan with the actual utilisation
of the loans. If the auditor finds that the fund has not been utilized for the purpose for which
they were obtained, the report should state the fact.

In the instant case, term loan taken for the purpose of R&D equipment has been utilized for the
purchase of car which has no relation with R&D equipment.

Therefore, car though used for R&D Director cannot be considered as R&D equipment. The auditor
should state the fact in his report that out of the term loan taken for R&D equipment, Rs. 45 lakh
was not utilised for the purpose of acquiring R&D equipment.

26. Physical verification of only 50% of items of inventory has been inventory has been
conducted by the company. The balance 50% will be conducted in next year due to lack of time
and resources.

Ans: Physical Verification of Inventory: Clause (ii) of Para 3 of CARO, 2015 requires the auditor to
report on whether physical verification of inventory has been conducted at reasonable intervals by
the management. Physical verification of inventory is the responsibility of the management which
should verify all material items at least once in a year and more often in appropriate cases. The
auditor in order to satisfy himself about verification at reasonable intervals should examine the
adequacy of evidence and record of verification.

In the given case, the above requirement of CARO, 2015 has not been fulfilled as such and the auditor
should point out the specific areas where he believes the procedure of inventory verification is not
reasonable. He may consider the impact on financial statement and report accordingly.

Liabilities of Auditors
27. Indicate the precise nature of auditor’s liability in the following situations and support your views
with authority,
if any:
(a) Certain weaknesses in the internal control procedure in the payment of wages in a large
construction company were noticed by the statutory auditor who in turn brought the same
to the knowledge of the Managing Director of the company. In the subsequent year huge
defalcation came to the notice of the management. The origin of the same was traced to the
earlier year. The management wants to sue the auditor for negligence and also plans to file
a complaint with the Institute.
(b) Based upon the legal opinion of a leading advocate appointed by auditor, X Ltd. should made
a provision of Rs. 5 crores towards Income Tax liability. The assessing authority has worked
out the liability at Rs, 15 crores. It is observed that the opinion of the advocate was
inconsistent with legal position with regard to certain revenue items.

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Ans: (a) In the given case, certain weaknesses in the internal control procedure in the payment of
wages in a large construction company were noticed by the statutory auditor and brought the
same to the knowledge of the Managing Director of the company. In the subsequent year, a huge
defalcation took place, the ramification of which stretched to the earlier year. The management
of the company desires to sue the statutory auditor for negligence. The precise nature of auditor's
liability in the case can be ascertained on the basis of the under noted considerations:
(i) Whether the defalcation emanated from the weaknesses noticed by the statutory auditor,
the information regarding which was passed on to the management; and
(ii) Whether the statutory auditor properly and adequately extended the audit programme of the
previous year having regard to the weaknesses noticed.

SA 265 on “Communicating Deficiencies in Internal Control to Those Charged with Governance and
Management” clearly mentions that, “The auditor shall determine whether, on the basis of the audit
work performed, the auditor has identified one or more deficiencies in internal control. If the auditor
has identified one or more deficiencies in internal control, the auditor shall determine, on the basis
of the audit work performed, whether, individually or in combination, they constitute significant
deficiencies. The auditor shall communicate in writing significant deficiencies in internal control
identified during the audit to those charged with governance on a timely basis. The auditor shall also
communicate to management at an appropriate level of responsibility on a timely basis”. The fact,
however, remains that, weaknesses in the design of the internal control system and non-compliance
with identified control procedures increase the risk of fraud or error. If circumstances indicate the
possible existence of fraud or error, the auditor should consider the potential effect of the suspected
fraud or error on the financial information. If the auditor believes the suspected fraud or error could
have a material effect on the financial information, he should perform such modified or additional
procedures ashe determines to be appropriate. Thus, normally speaking, as long as the auditor took
due care in performing the audit work, he cannot be held liable.

The fact that the matter was brought to the notice of the managing director may be a good defence
for the auditor as well. According to the judgement of the classic case In re Kingston Cotton Mills Ltd.,
(1896) it is the duty of the auditor to probe into the depth only when his suspicion is aroused. The
statutory auditor, by bringing the weakness to the notice of the managing director had alerted the
management which is judicially held to be primarily responsible for protection of the assets of the
company and can put forth this as defence against any claim arising subsequent to passing of the
information to the management. In a similar case S.P. Catterson & Sons Ltd. (81 Acct. L. R.68), the
auditor was acquitted of the charge.

(b) SA 620 on "Using the Work of an Auditor’s Expert" discusses the auditor's responsibility in relation
to and the procedures the auditor should consider in, using the work of an expert as audit evidence.
During the audit, the auditor may seek to obtain, in conjunction with the client or independently,
audit evidence in the form of reports, opinions, valuations and statements of an expert, e.g., legal
opinions concerning interpretations of agreements, statutes, regulations, notifications, circulars, etc.
Before relying on advocate's opinion, the auditor should have seen that opinion given by the expert
is prima facie dependable. The question states very clearly that the opinion of the advocate was

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inconsistent with legal position with regard to certain items. It is, perhaps, quite possible that auditor
did not seek reasonable assurance as to the appropriateness of the source data, assumptions and
methods used by the expert properly.

In fact, SA 620 makes it incumbent upon the part of the auditor to resolve the inconsistency by
discussion with the management and the expert. In case, the expert's' work does not support the
related representation in the financial information the inconsistency in legal opinions could have been
detected by the auditor if he had gone through the same. This seems apparent having regard to wide
difference in the liability worked out by the assessing authority. Under the circumstance, the auditor
should have rejected the opinion and insisted upon making proper provision.

28. (a) In assessment procedure of ABC Ltd., Income Tax Officer observed some irregularities.
Therefore, he started investigation of books of accounts audited and signed by Mr. X, a practicing
Chartered Accountant. While going through books he found that ABC Ltd. used to maintain two sets of
books of accounts, one is the official set and other is covering all the transactions. Income Tax
Department filed a complaint with the Institute of Chartered Accountants of India saying Mr. X had
negligently performed his duties. Comment.

Ans: (a) Liability of Auditor: It is the auditor’s responsibility to audit the statement of accounts and
prepare tax returns on the basis of books of accounts produced before him. Also if he is satisfied with
the books and documents produced to him, he can give his opinion on the basis of those documents
only by exercising requisite skill and care and observing the laid down audit procedure.

In the instant case, Income tax Officer observed some irregularities during the assessment
proceeding of ABC Ltd. Therefore he started investigation of books of accounts audited and signed
by Mr. X, a practicing Chartered Accountant. While going through the books, he found that ABC Ltd.
used to maintain two sets of books of accounts, one is the official set and other is covering all the
transactions. Income Tax Department filed a complaint with the ICAI saying Mr. X had negligently
performed his duties.

Mr. X, the auditor was not under a duty to prepare books of accounts of assesse and he should, of
course, neither suggest nor assist in the preparations of false accounts. He is responsible for the
books produced before him for audit. He completed his audit work with official set of books only.

In this situation, as Mr. X, performed the auditing with due skill and diligence, therefore, no question
of negligence arises. It is the duty of the Department to himself investigate the truth and correctness
of the accounts of the assessee.

29. Briefly explain the criminal liabilities of an auditor under the Companies Act, 2013.

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Ans: (b) Criminal Liability of an Auditor under the Companies Act, 2013: The circumstances in which
an auditor can be prosecuted under the Companies Act and the penalties to which he may be
subjected are briefly stated below-

(i) Criminal liability for Misstatement in Prospectus - As per Section 34 of the Companies Act, 2013,
where a prospectus, issued, circulated or distributed includes any statement which is untrue or
misleading in form or context in which it is included or where any inclusion or omission of any matter
is likely to mislead, every person who authorises the issue of such prospectus shall be liable under
section 447.

This section shall not apply to a person if he proves that such statement or omission was immaterial
or that he had reasonable grounds to believe, and did up to the time of issue of the prospectus
believe, that the statement was true or the inclusion or omission was necessary.

(ii) Punishment for False Statement - According to Section 448 of the Companies Act, 2013, if in any
return, report, certificate, financial statement, prospectus, statement or other document required
by, or for, the purposes of any of the provisions of this Act or the rules made thereunder, any person
makes a statement-

(1) which is false in any material particulars, knowing it to be false; or

(2) which omits any material fact, knowing it to be material,

he shall be liable under section 447.

Punishment for Fraud - As per Section 447 of the Companies Act, 2013, without prejudice to any
liability including repayment of any debt under this Act or any other law for the time being in force,
any person who is found to be guilty of fraud, shall be punishable with imprisonment for a term
which shall not be less than 6 months but which may extend to 10 years and shall also be liable to
fine which shall not be less than the amount involved in the fraud, but which may extend to three
times the amount involved in the fraud.

It may be noted that where the fraud in question involves public interest, the term of imprisonment
shall not be less than 3 years.

Explanation — For the purposes of this section—

(i) “fraud” in relation to affairs of a company or any body corporate, includes any act, omission,
concealment of any fact or abuse of position committed by any person or any other person with the
connivance in any manner, with intent to deceive, to gain undue advantage from, or to injure the
interests of, the company or its shareholders or its creditors or any other person, whether or not
there is any wrongful gain or wrongful loss;

(ii) “wrongful gain” means the gain by unlawful means of property to which the person gaining is
not legally entitled;

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(iii) “wrongful loss” means the loss by unlawful means of property to which the person losing is legally
entitled.

Audit Report
30. (a) Zee Pvt. Ltd. has submitted the financial statement s for the year ended 31-3-16 for audit. The
audit assistant observes and brings to your notice that the company’s records show following dues:
Income Tax relating to Assessment Year 2012-13 Rs. 125 lacs – Appeal is pending before Hon’ble ITAT
since 30-9-14. Customs duty Rs. 85 lakhs –Demand notice received on 15-9-15 but no action has
been taken to pay or appeal.
As an auditor, how would you bring this fact to the members?

Ans: Non-Compliance of Laws and Regulations: As per SA 250 “Consideration of Laws and
Regulations in an Audit of Financial Statement”, it is the responsibility of management, with the
oversight of those charged with governance, to ensure that the entity’s operations are conducted
in accordance with the provisions of laws and regulations, including compliance with the
provisions of laws and regulations that determine the reported amounts and disclosures in an
entity’s financial statements.

The auditor is responsible for obtaining reasonable assurance that the financial statements, taken as
a whole, are free from material misstatement, whether caused by fraud or error. In conducting an
audit of financial statements, the auditor takesinto account the applicable legal and regulatory
framework. Owing to the inherent limitations of an audit, there is an unavoidable risk that some
material misstatements in the financial statements may not be detected, even though the audit is
properly planned and performed in accordance with the SAs.

If the auditor concludes that the non-compliance has a material effect on the financial statements,
and has not been adequately reflected in the financial statements, the auditor shall express a qualified
or adverse opinion on the financial statements.

Further, the auditor is required to report on certain matters specified in Para 3 of CARO, 2016 under
section 143(11) of the Companies Act, 2013.

One of such matter is non-payment of dues to Government, on account of any dispute. As per clause
(vii)(b) of Para 3 of CARO, 2016, in case dues of income tax or sales tax or service tax or duty of customs
or duty of excise or value added tax have not been deposited on account of any dispute, then the
amounts involved and the forum where dispute is pending shall be mentioned.

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In the present case, there is Income Tax demand of Rs.125 Lacs and the company has gone for an
appeal, it needs considerations as to whether the entire demand is disputed, because it is difficult to
presume that the demand by Income Tax authority is without any basis. Therefore, as per AS 29
“Provisions, Contingent Liabilities and Contingent Assets”, partly to the extent the company considers
that the demand is based on some logical basis, that amount may be provided for and the remaining
may be disclosed as the contingent liability. Further, it should be brought to notice of the members
by reporting.

Additionally, the demand notice has been received for Customs duty of Rs.85 lakhs and is outstanding on
the closure of financial year, for which no action has been taken by the management. Therefore, it should
also be brought to notice of the members by reporting.

31. CCE Ltd closed its manufacturing operations and sold all its manufacturing fixed assets during the
financial year ended 31st March, 2016 . However it intends to continue its operations as a trading
company. In respect of other fixed assets, the company carried out a physical verification as at the
end of 31st March, 2016 and found a material discrepancy to the tune of Rs. 1 lac, which has written off
and is disclosed separately in the Statement of Profit and Loss. Kindly incorporate the above in your
audit report.
Ans: Disclosure in Audit Report: As per SA 570 “Going Concern”, when the auditor concludes that
the use of the going concern assumption is appropriate in the circumstances but a material uncertainty
exists, the auditor shall determine whether the financial statements-

(i) Adequately describe the principal events or conditions that may cast significant doubt on
the entity’s ability to continue as a going concern and management’s plans to deal with
these events or conditions; and
(ii) Disclose clearly that there is a material uncertainty related to events or conditions that
may cast significant doubt on the entity’s ability to continue as a going concern.

The auditor is further required to specifically include certain matters as per CARO, 2016 under section
143 of the Companies Act, 2013. According to clause (i)(b) of Para 3 of CARO, the auditor has to
comment whether the fixed assets have been physically verified by the management at reasonable
intervals; whether any material discrepancies were noticed on such verification and if so, whether
the same have been properly dealt with in the books of account.

In the given case, CCE Ltd. has sold out its manufacturing fixed assets during the year. However, it
intends to continue its operations as a trading company. Therefore, selling of manufacturing fixed
assets does not affect the going concern assumption of the company. Additionally, while carrying out
physical verification of fixed assets, a material discrepancy to the tune of Rs.1 lac was found, which
was written off and disclosed separately in the Statement of Profit and Loss. Hence, this fact needs
to be disclosed in the Audit Report as follows:

Para in the Audit Report-

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We have made our viewpoint from the facts of the case and on the basis of guidance drawn from AS
1. We report as under-

As per Accounting Standard (AS) 1, “Disclosure of Accounting Policies”, “the enterprise is normally
viewed as a going concern that is as continuing its operation for the foreseeable future. It is assumed
that the enterprise has neither the intention nor the necessity of liquidation or of curtailing materially
the scale of its operations.” Although the company has disposed off its manufacturing fixed assets
during the financial year ending on 31-03-2016, it is still a going concern in the form of a trading
company. We also report that on physical verification of other fixed assets, a material discrepancy to
the tune of Rs.1 Lac was noticed and that the same has been properly dealt with in the books of
account.

Audit Committee & Corporate

Governance
32. Visual Limited, a company incorporated in India has nine members in its Audit Committee. Due to
recessionary conditions in India the revenue of the company is going down and there is slowdown in
other activities of the company. Therefore, it was expected that there would not be significant work
for members of the Audit Committee.

Considering the overall recession in the company and the economy, the members of the Committee
decided unanimously to meet only once at the year end. They reviewed monthly information
system of the Company and found no errors.

As an auditor of Visual Limited would you consider the decision taken by the Audit Committee to
hold the meeting once in a year, is complying with the Clause 49 of the (SEBI) Listing Agreement?
Also state the quorum requirements for such meetings.
Ans: Holding of Meeting and Review Requirements as per Clause 49 of the (SEBI) Listing Agreement:
One of the requirement as stipulated under clause 49 [Clause 49 (III) (B)] (on which Section 177 of
the Companies Act, 2013 relating to audit committee, is silent) is – The Audit Committee should meet
at least four times in a year and not more than one hundred and twenty days shall lapse between
two meetings.

The quorum shall be either two members or one third of the members of the audit committee
whichever is greater, but there should be a minimum of two independent members present.

In this case, Visual Limited is a company incorporated in India and have 6 members in it’s Audit
Committee. Contention of audit committee members to meet only once due to recessionary
conditions in India, at the year end is not in line with the clause 49 of the (SEBI) Listing Agreement.

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Besides, there is a mandatory review requirement as per Clause 49 (III) (E), according to which the
Audit Committee shall mandatorily review the following information:

(1) Management discussion and analysis of financial condition and results of operations;
(2) Statement of significant related party transactions (as defined by the Audit Committee),
submitted by management;
(3) Management letters / letters of internal control weaknesses issued by the statutory auditors;
(4) Internal audit reports relating to internal control weaknesses; and
(5) The appointment, removal and terms of remuneration of the Chief internal auditor shall be
subject to review by the Audit Committee.

In the instant situation, though, the Audit Committee has reviewed monthly information system, but,
failed to comply with the above requirements mentioned at point no. 1 to 5 of Clause 49 (III) (E) of
Listing Agreement.

33. The audit committee has been granted several roles under Clause 49 of the Listing Agreement.
Oversight of the company’s financial reporting process; recommendation for appointment of auditors;
approval of payment to statutory auditors etc. are some of the roles that an audit committee perform.
State the role of Audit Committee as provided under Clause 49 of the Listing Agreement.

Ans: Role of Audit Committee: The role of the audit committee as provided under Clause 49 shall include
the following -

(i) Oversight of the company’s financial reporting process and the disclosure of its financial
information to ensure that the financial statement is correct, sufficient and credible;

(ii) Recommendation for appointment, remuneration and terms of appointment of auditors of the
company;

(iii) Approval of payment to statutory auditors for any other services rendered by the statutory
auditors;

(iv) Reviewing, with the management, the annual financial statements and auditor's report thereon
before submission to the board for approval, with particular reference to:

(a) Matters required to be included in the Director’s Responsibility Statement to be included in

the Board’s report in terms of clause (c) of sub-section 3 of section 134 of the Companies
Act, 2013.
(b) Changes, if any, in accounting policies and practices and reasons for the same.
(c) Major accounting entries involving estimates based on the exercise of judgment by
management.
(d) Significant adjustments made in the financial statements arising out of audit findings.
(e) Compliance with listing and other legal requirements relating to financial statements.
(f) Disclosure of any related party transactions.

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(g) Qualifications in the draft audit report.

(i) Reviewing, with the management, the quarterly financial statements before submission to
the board for approval;
(ii) Reviewing, with the management, the statement of uses/application of funds raised through
an issue (public issue, rights issue, preferential issue, etc.), the statement of funds utilized for
purposes other than those stated in the offer document/prospectus/notice and the report
submitted by the monitoring agency monitoring the utilisation of proceeds of a public or
rights issue, and making appropriate recommendations to the Board to take up steps in this
matter;
(iii) Review and monitor the auditor’s independence and performance, and effectiveness of audit
process;
(iv) Approval or any subsequent modification of transactions of the company with related parties;
(v) Scrutiny of inter-corporate loans and investments;
(vi) Valuation of undertakings or assets of the company, wherever it is necessary;
(vii) Evaluation of internal financial controls and risk management systems;
(viii) Reviewing, with the management, performance of statutory and internal auditors, adequacy
of the internal control systems;
(ix) Reviewing the adequacy of internal audit function, if any, including the structure of the
internal audit department, staffing and seniority of the official heading the department,
reporting structure coverage and frequency of internal audit;
(x) Discussion with internal auditors of any significant findings and follow up there on;
(xi) Reviewing the findings of any internal investigations by the internal auditors into matters
where there is suspected fraud or irregularity or a failure of internal control systems of a
material nature and reporting the matter to the board;
(xii) Discussion with statutory auditors before the audit commences, about the nature and scope
of audit as well as post-audit discussion to ascertain any area of concern;
(xiii) To look into the reasons for substantial defaults in the payment to the depositors, debenture
holders, shareholders (in case of non-payment of declared dividends) and creditors;
(xiv) To review the functioning of the Whistle Blower mechanism;
(xv) Approval of appointment of CFO (i.e., the whole-time Finance Director or any other person
heading the finance function or discharging that function) after assessing the qualifications,
experience and background, etc. of the candidate;
(xvi) Carrying out any other function as is mentioned in the terms of reference of the Audit
Committee.

It is important to note that the term "related party transactions" shall have the same meaning as
provided in Clause 49(VII) of the Listing Agreement.

If the company has set up an audit committee as per section 177 of the Companies Act, the
company agrees that the said audit committee shall have such additional functions /features as is
contained in the Listing Agreement.

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Audit of Consolidated Financial

Statements
34. (a) “Permanent Consolidation Adjustments are made only on the first occasion of the preparation
and presentation of consolidated financial statements”. What are the Permanent Consolidation
Adjustments? Explain the role of auditor in this context.

Ans: (a) Permanent Consolidation Adjustments: Permanent consolidation adjustments are those
adjustments that are made only on the first occasion of the preparation and presentation of consolidated
financial statements. Permanent consolidation adjustments are-

(i) determination of excess or deficit of the cost to the parent of its investment in a subsidiary over
the parent’s portion of equity of the subsidiary, at the date on which investment in the subsidiary is
made (determination of goodwill or capital reserve);

(ii) determination of the amount of equity attributable to minorities at the date on which investment
in subsidiary is made; and

(iii) determination of goodwill or capital reserve arising on application of equity method to account
for investments in associates in consolidated financial statements.

Role of Auditor – Verification Procedure:

(i) The auditor should verify that the above calculations have been made appropriately.

(ii) The auditor should pay particular attention to the determination of pre-acquisition reserves of
the subsidiary and associates. Date(s) of investment in subsidiary and associates assumes importance
in this regard.

(iii) The auditor should also examine whether the pre-acquisition reserves have been allocated
appropriately between the parent and the minorities of the subsidiary.

(iv) The auditor should also verify the changes that might have taken place in these permanent
adjustments on account of subsequent acquisition of shares in the subsidiary/ associates, disposal of
the subsidiary/associate in the subsequent years.

(v) The auditor should also examine the joint venture agreements, to establish whether any change
has taken place in the interest of the parent in the joint venture.

(vi) It may happen that in the case of one subsidiary, goodwill arises and in the case of another
subsidiary a capital reserve arises. The parent may choose to net off these amounts to disclose a
single amount in the consolidated balance sheet. In such cases, the auditor should verify that the

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gross amounts of goodwill and capital reserves arising on acquisition of various subsidiaries have
been disclosed in the notes to the consolidated financial statements to reflect the excess/shortage
over the parents’ portion of the subsidiary’s equity.

35. While doing the audit of consolidated Financial Statements, which current period consolidation
adjustments are to be taken into account?

Ans: (b) Following are the Current Period Consolidation Adjustments while making Consolidation
of Financial Statements:

(i) Elimination of intra-group transactions relating to interest or management fees etc.

(ii) Elimination of unrealized intra-group profits on assets acquired from other subsidiaries.

(iii) Elimination of intra-group indebtedness.

(iv) Adjustments for harmonizing different accounting policies of parent unit and its subsidiaries.

(v) Adjustments for impairment loss that might exist for goodwill.

(vi) Adjustment for significant events that occur between date of financial statements of the parent
and of its components when the date/s of financial statements of components are different from the
reporting date.

(vii) Determination of movement in equity attributable to the minorities since the date of acquisition
of the subsidiary.

(viii) Treatment of minority interests’ share of the losses, if such losses exceed the minority interests’
share in the equity.

Audit of Banking Company

36. (a) Feel Good Bank Ltd. appoints Secure & Co, a firm of Chartered Accountants for a special
assignment of ascertaining the quality of its loans and advances portfolio independently. What would
be the areas you would focus on such a review?
Ans: Secure & Co should focus on the following aspects in the review of loans and advances
portfolio of Feel Good bank:

Whether

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(i) The Advances made after ascertaining the credit worthiness of the borrower and released
after proper sanction.
(ii) All necessary documents like agreements demand promissory notes, letter of
hypothecation etc., have been properly obtained and appropriately stamped.
(iii) The Borrower has complied with all the terms of sanction.
(iv) Sufficient margins have been kept against the security.
(v) The securities are in possession of the bank are in safe custody of two or more officials.
(vi) The loan accounts have been operated within the sanctioned limits/ drawing power and
wherever excess whether they are properly reported and recovered promptly.
(vii) Surprise checks on the assets hypothecated to the bank done,
(viii) The operation of the account is reviewed at least one a year.
(ix) The market value of the security given ascertained periodically.
(x) Adequate insurance is taken in respect of the assets that are offered as security.
(xi) The borrower submits periodic stock and book debts statements where the facilities are
secured against them and whether a review is done to ensure non-moving, obsolete,
unrealizable debtors are removed from the same.
(xii) The financials of the borrower are periodically obtained and reviewed for any sign of
credit risk.

37. (b) Your firm has been appointed as Central Statutory Auditors of a Nationalised Bank.
The Bank follows financial year as accounting year. State your views on the following issues which
were brought to your notice by your Audit Manager.
(I) The bank has recognized on accrual basis income from dividends on securities and Units of
Mutual Funds held by it as at the end of financial year. The dividends on securities and
Units of Mutual Funds were declared after the end of financial year.
Ans: It is not a prudent practice to treat dividend on shares of corporate bodies and units of
mutual funds as income unless these are actually received. Accordingly, income from dividend on
shares of corporate bodies and units of mutual funds should be booked on cash basis. In respect
of income from government securities and bonds and debentures of corporate bodies, where
interest rates on these instruments are pre-determined, income could be booked on accrual basis,
provided interest is serviced regularly and as such is not in arrears. It was further, however,
clarified that banks may book income on accrual basis on securities of corporate bodies/public
sector undertakings in respect of which the payment of interest and repayment of principal have
been guaranteed by the central government or a State government. Banks may book income from
dividend on shares of corporate bodies on accrual basis, provided dividend on the shares has been
declared by the corporate body in its annual general meeting and the owner's right to receive
payment is established. This is also in accordance with AS 9 as well. In the instant case, therefore,
the recognition of income by the bank on accrual basis is not in order.

38. The bank is a consortium member of Cash Credit Facilities of Rs. 50crores to X Ltd. Bank’s own share
is Rs. 10 crores only. During the last two quarters against a debit of Rs. 1.75 crores towards interest the

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credits in X Ltd’s account are to the tune of Rs. 1.25 crores only. Based on the certificate of lead bank,
the bank has classified the account of X Ltd as performing.
Ans: The bank is a consortium member of cash credit facilities of Rs.50 crores to X Ltd. Bank's own
share is Rs.10 crores only. During the last two quarters against a debit of Rs.1.75 crores towards
interest, the credits in X Ltd's account are to the tune of Rs.1.25 crores only. Sometimes, several
banks form a group (the 'consortium') under the leadership of a 'lead bank' to make advance to a
large customer on same conditions and security with proportionate rights. In such cases, each
bank may classify the advance given by it according to its own experience of recovery and other
factors. Since in the last two quarters, the amount remains outstanding and, thus, interest amount
should be reversed. This is despite the certificate of lead bank to classify that the account as
performing. Accordingly, the amount should be shown as non-performing asset.

39 . As a branch auditor of a Nationalised bank, how would you classify the following advances based
on securities?

(xvii) Advances covered by ECGC/DISGC guarantees.

(xviii) An account which is fully secured but the margin in which is lower than that stipulated by
the bank.
(xix) Advances covered against cheques purchased including self cheques.
(xx) Advances against supply bill.

Ans: (a) Classification of Advances of a Bank based on Security:

(i) Advances covered by ECGC/DICGC guarantee should be treated as covered by guarantee to the
extent of guarantee cover available. The amount received from ECGC/DICGC and kept in sundry
creditor account pending adjustment should be deducted from advances.

(ii) An account which is fully secured but the margin in which is lower than stipulated by the bank
should nevertheless be treated as fully secured for the purpose of balance sheet presentation.

(iii) Cheques purchased including self cheques should be treated as unsecured.

(iv) Advances against supply bill unless collaterally secured, should be classified as unsecured even if
they have been accepted by the drawee.

40. (b) As the concurrent auditor of Nagpur Main Branch of XYZ Bank Ltd., state the issues which
have to be considered in the audit of advances.

Anss: (b) Audit of Advances: The items to be covered in the current audit of advances of a bank are
as follows-

(i) Ensure that loans and advances are sanctioned properly.

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(ii) Verify whether the sanctions are in accordance with the delegated authority.

(iii) Ensure that securities and documents have been received and properly charged/registered.

(iv) Ensure that post disbursement supervision and follow up is proper.

(v) Verify whether there is any misuse of loans and advances and whether there are instances
indicative of diversion of funds.

(vi) Check whether letters of credit issued by the branch are within the delegated power and ensure
that they are genuine trade transactions.

(vii) Check bank guarantees issued are properly worked and recorded.

(viii) Ensure proper follow up of overdue bills of exchange.

(ix) Verify the classifications of advances are as per RBI directions.

(x) Verify whether the submission of claims to DICGC and ECGC is in time.

(xi) Verify the instances of exceeding delegated powers have been promptly reported.

(xii) Verify the frequency and genuiness of such exercise of authority beyond to delegated powers of
the concerned officials.

Audit of General Insurance Company

41. Khandelwal & Co., Chartered Accountants are the Auditors of Max Healthy General Insurance
Company Limited. As on March 31, 2016 the Management made a provision for claims outstanding.
Enumerate the steps to be taken by the Auditor while verifying the “Claims Provision”.
Ans:
Verification of “Claims Provision” in the Case of a General Insurance Company: The outstanding
liability at the year-end is determined at the divisions/branches where the liability originates for
outstanding claims. Thereafter, based on the total consolidated figure for all the
divisions/branches, the Head Office considers a further provision in respect of outstanding claims.
The auditor should satisfy himself that the estimated liability provided for by the management is
adequate with reference to the relevant claim files/dockets, keeping in view the following:
(i) That provision has been made for all unsettled claims as at the year-end on the basis of
claims lodged/communicated by the parties against the company. The date of loss (and not
the date of communication thereof) is important for recording/ recognizing the claim as
attributable to a particular year.

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(ii) That provision has been made for only such claims for which the company is legally liable,
considering particularly, (a) that the risk was covered by the policy, if in force, and the
claims arose during the currency of the policy; and (b) that claim did not arise during the
period the company was not supposed to cover the risk.
(iii) That the provision made is normally not in excess of the amount insured except in some
categories of claims where matters may be sub-judice in legal proceedings which will
determine the quantum of claim, the amount of provision should also include survey fee
and other direct expenses.
(iv) That in determining the amount of provision, events after the balance sheet date have been
considered.
(v) That the claims status reports recommended to be prepared by the Divisional Manager on
large claims outstanding at the year-end have been reviewed with the contents of relevant
files or dockets for determining excess/short provisions.
(vi) That in determining the amount of provision, the ‘average clause’ has been applied in case
of under-insurance by parties.
(vii) That the provision made is net of payments made ‘on account’ to the parties wherever such
payments have been booked to claims.
(viii) That in case of co-insurance arrangements, the company has made provisions only in
respect of its own share of anticipated liability.
(ix) That wherever an unduly long time has elapsed after the filing of the claim and there has
been no further communication and no litigation or arbitration dispute is involved, the
reasons for carrying the provision have been ascertained.
(x) That wherever legal advice has been sought or the claim is under litigation, the provisions
is made according to the legal advisor’s view and differences, if any, are explained.
(xi) That in the case of amounts purely in the nature of deposits with courts or other authorities,
adequate provision is made and deposits are stated separately as assets and provisions are
not made net of such deposits.
(xii) That no contingent liability is carried in respect of any claim intimated in respect of policies
issued.
(xiii) That the claims are provided for net of estimated salvage, wherever applicable.
(xiv) That intimation of loss is received within a reasonable time and reasons for undue delay in
intimation are looked into.
(xv) That provisions have been retained as at the year-end in respect of guarantees given by
company to various Courts for claims under litigation.
(xvi) That due provision has been made in respect of claims lodged at any office of the company
other than the one from where the policy was taken, e.g., a vehicle insured at Mumbai
having met with an accident at Chennai necessitating claim intimation at one of the offices
of the company at Chennai.

In cases of material differences in the liability estimated by the management and that which ought
to be provided in the opinion of the auditor, the same must be brought out in the auditor’s report
after obtaining further information or explanation from the management.

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42. (a) “In an audit of an insurance company, the Receipts and Payments Account is also subjected to
audit”. Comment.

Ans: (a) Audit of Receipts and Payments Account: Every insurer, in respect of insurance business
transacted by him and in respect of his shareholders’ funds, should prepare at the end of each financial
year, a Balance Sheet, a Profit and Loss Account, a separate account of receipts and payments and a
Revenue Account in accordance with the Regulations made by the IRDA. Since receipts and payments
account has been made a part of financial statements of an insurer, it is implied that the receipts and
payments account is also required to be audited.

The IRDA (Preparation of Financial Statements and Auditor’s Report of Insurance Companies)
Regulations require that the auditor of an insurance company should:

(i) report whether the receipts and payments account of the insurer is in agreement with the books
of account and returns;

(ii) express an opinion as to whether the receipts and payments account has been prepared in
accordance with the provisions of the relevant statutes; and

(iii) express an opinion whether the receipts and payments account give a true and fair view of the
receipts and payments of the insurer for the financial year/period under audit.

It may hence be said that auditor is required to audit the Receipts and Payments Account of the
insurer and also express an opinion on the same.

Audit under Fiscal Laws

43. (i) Discuss briefly Income Computation and Disclosure Standards (ICDS) to be followed by
assessees under the Income-tax Law.
Ans: Income Computation and Disclosure Standards (ICDS): Section 145 of the Income Tax Act,
1961 deals with the method of accounting.

Under section 145(1), income chargeable under the heads “Profits and gains of business or
profession” or “Income from other sources” shall be computed in accordance with either the cash
or mercantile system of accounting regularly employed by the assessee.

Section 145(2) empowers the Central Government to notify in the Official Gazette from time to
time, income computation and disclosure standards to be followed by any class of assessees or in
respect of any class of income.

Accordingly, the Central Government has, in exercise of the powers conferred under section 145(2),
notified ten income computation and disclosure standards (ICDSs) to be followed by all assessees,

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following the mercantile system of accounting, for the purposes of computation of income
chargeable to income-tax under the head “Profit and gains of business or profession” or “ Income
from other sources”. This notification shall come into force with effect from 1st April, 2015, and
shall accordingly apply to the A.Y. 2016-17 and subsequent assessment years.

All the notified ICDSs are applicable for computation of income chargeable under the head “Profits
and gains of business or profession” or “Income from other sources” and not for the purpose of
maintenance of books of accounts. In the case of conflict between the provisions of the Income‐tax
Act, 1961 and the notified ICDSs, the provisions of the Act shall prevail to that extent.

The Central Government has prescribed 10 Income Computation and Disclosure Standards (ICDSs)
as under:

A. ICDS I relating to Accounting Policies.

B. ICDS II relating to Valuation of Inventories.
C. ICDS III relating to Construction Contracts.
D. ICDS IV relating to Revenue Recognition.
E. ICDS V relating to Tangible Fixed Assets.
F. ICDS VI relating to the Effects of Changes in Foreign Exchange Rates.
G. ICDS VII relating to Government Grants.
H. ICDS VIII relating to Securities.
I. ICDS IX relating to Borrowing Costs.
J. ICDS X relating to Provisions, Contingent Liabilities and Contingent Assets.

The above ICDSs are to be followed by all assessee following mercantile system of accounting.
Therefore, it is clear that those assessees who are following cash system of accounting need not
follow the ICDSs notified above.

44. (ii) While conducting the tax audit of A & Co. you observed that it made an escalation claim
to one of its customers but which was not accounted as income. What is your reporting responsibility?
Ans: (b) Clause 16(c) of Form 3CD: A tax auditor has to report under clause 16(c) of Form 3CD on
any escalation claim accepted during the previous year and not credited to the profit and loss
account under clause 16(c) of Form 3CD.

The escalation claim accepted during the year would normally mean “accepted during the relevant
previous year”. If such amount are not credited to Profit and Loss Account the fact should be
reported. The system of accounting followed in respect of this particular item may also be brought
out in appropriate cases. If the assessee is following cash basis of accounting with reference to this
item, it should be clearly brought out since acceptance of claims during the relevant previous year
without actual receipt has no significance in cases where cash method of accounting is followed.

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Escalation claims should normally arise pursuant to a contract (including contracts entered into in
earlier years), if so permitted by the contract. Only those claims to which the other party has signified
unconditional acceptance could constitute accepted claims. Mere making claims by the assessee or
claims under negotiations cannot constitute accepted claims. After ascertaining the relevant factors
as outlined above, a decision whether to report or not, can be taken.

45. (a) XYZ Pvt. Ltd., a company in which public are not substantially interested, issued 1,00,000 equity
shares at a premium of Rs. 70 per share (face value Rs. 10 per share). The fair market value of the shares
as on the date of issue was Rs. 60 per share.

As the tax auditor of XYZ Pvt. Ltd., how would you report the same in your tax audit report?

Ans: (a) Reporting for Issue of Shares for Value Exceeding Fair Market Value: In this case, XYZ Pvt. Ltd.
is a company, other than a company in which the public are substantially interested. It has received
consideration for issue of shares of Rs.80 per share (Face value Rs.10 per share + Premium Rs.70 per share)
which exceeds the face value of Rs. 10 per share and fair market value of the shares of Rs.60 per share.

Provisions and Explanations: A tax auditor has to furnish the details of shares issued during the
previous year, under clause 29 of Form 3CD, in case, the assessee received any consideration for
issue of shares which exceeds the fair market value of the shares as referred to in section 56(2)(viib)
of the Income Tax Act, 1961.

Section 56(2)(viib) provides that where a company, not being a company in which the public are
substantially interested, receives, in any previous year, from any person being a resident, any
consideration for issue of shares that exceeds the face value of such shares, the aggregate
consideration received for such shares as exceeds the fair market value of the shares shall be
chargeable to income-tax under the head “Income from other sources”.

Since section 56(2)(viib) is applicable to companies in which public is not substantially interested,
reporting under this clause is to be done only for corporate assessees. The auditor should obtain
from the auditee, a list containing the details of shares issued, if any, by him to any person being a
resident and verify the same from the books of accounts and other relevant documents.

Conclusion: As per the facts of the case, provisions and explanations given above, the income
generated by XYZ Pvt. Ltd., due to differences in consideration received and fair market value of
shares issued, is chargeable to income-tax under the head “Income from other sources” as per
section 56(2)(viib) of the Income Tax Act, 1961.

Therefore, the tax auditor of XYZ Pvt. Ltd. is required to furnish the details of shares issued under
clause 29 of Form 3CD.

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46. (b) X Ltd. has sold one of its buildings situated in Kolkata during the year for a consideration of Rs.
40 lakh. However, the stamp duty value assessed by the authority of Government of West Bengal is Rs.
48 lakh.As a Tax auditor, what will be your reporting requirement? Will it make any difference, if value
adopted is more than that asassessable by any Authority assessable by any Authority assessable by any
Authority of a State Government?

Ans: (b) Reporting for Sale of Building for Value Less Than Adopted by Authority: In this case, X
Ltd. has sold one of its buildings situated in Kolkata for a consideration of Rs.40 Lakh which is less than
the value assessed by the Government of West Bengal i.e. Stamp Duty value of Rs.48 Lakh.

Provisions and Explanations: As per Clause (17) of Form 3CD, the tax auditor is required to furnish
detailed information in case if any land or building or both is transferred during the previous year for
a consideration less than value adopted or assessed or assessable by any authority of a State
Government referred to in section 43CA or 50C of the Income-tax Act, 1961, as under:

Details of Consideration received Value adopted or assessed

property or accrued or
assessable

The auditor should obtain a list of all properties transferred by the assessee during the previous year.
He may also verify the same from the statement of profit and loss or balance sheet, as the case may
be. Further, the auditor has to furnish the amount of consideration received or accrued, during the
relevant previous year of audit, in respect of land/building transferred during the year as disclosed
in the books of account of the assessee.

For reporting the value adopted or assessed or assessable, the auditor should obtain from the
assessee a copy of the registered sale deed in case, the property is registered. In case the property
is not registered, the auditor may verify relevant documents from relevant authorities or obtain third
party expert like lawyer, solicitor representation to satisfy the compliance of section 43CA / section
50C of the said Act. In exceptional cases where the auditor is not able to obtain relevant documents,
he may state the same through an observation in his report 3CA/CB.

Conclusion: As discussed in fact of the cases, X ltd. has sold a building for an amount which is less
than the stamp duty value. Hence, the tax auditor is required to report the details of property,
consideration received or accrued and valued adopted or assessed or assessable under Clause (17)
of Form 3CD.

Further, if value adopted is more than that assessable by any authority of State Government, no
reporting is required by Tax Auditor.

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47. Draft an audit programme for conducting the audit of a Public Trust registered under section 12A of
the Income-tax Act, 1961.

Ans: c) Audit Programme for Conducting Audit of Public Trust: An auditor should conduct routine
checking during the course of audit of a public trust, in the following manner -

(i) Check the books of account and other records having regard to the system of accounting and
internal control;

(ii) Vouch the transactions of the trust to satisfy that:

(1) the transaction falls within the ambit of the trust

(2) the transaction is properly authorized by the trustees or other delegated authority as may be
permissible in law;
(3) all incomes due to the trust have been properly accounted for on the basis of the system of
accounting followed by the trust;
(4) all expenses and outgoings appertaining to the trust have been recorded on the basis of the
system of accounting followed by the trust;
(5) amounts shown as applied towards the object of the trust are covered by the objects of trust
as specified in the document governing the trust.

(iii) Obtain trial balance on the closing date certified by the trustees’ duly certified by the trustee;

(iv) Obtain Balance Sheet and Profit & Loss Account of the trust authenticated by the trustees and
check the same with the trial balance with which they should agree.

Audit of Public Sector Undertakings

47. What is a comprehensive audit of public enterprises? Discuss some of the areas to be examined
therein.
Ans: Comprehensive Audit of Public Enterprises: Areas to be examined: The scope and extent of
audit of public sector enterprises is determined by the Comptroller and Auditor General of India.
Audit of public enterprises in India is not restricted to financial and compliance audit; it extends
also to efficiency, economy and effectiveness with which these operate and fulfil their objectives
and goals. Another aspect of such audit relates to questions of propriety; this audit is directed
towards an examination of management decisions in sales, purchases, contracts, etc. to see
whether these have been taken in the best interests of the undertaking and conform to accepted
principles of financial propriety. Comprehensive audit involves assessing efficiency and
effectiveness of public enterprises in its entirety to be conducted on the basis of certain standards
and criterion. Public enterprises have been set-up with socio-objectives. An objective assessment
with reference to such objectives’ fulfillment would require comprehensive audit.

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The starting point of a comprehensive audit of a public enterprise, which covers aspects of
economy, efficiency and effectiveness, is the preparation of an audit programme based on the
study of decisions relating to the setting up of the enterprise, its objectives, the areas of operation,
organisation, financial and operational details available in the annual reports and accounts, capital
and operational budgets, deliberations of the board of directors, material in the earlier audit
inspection reports on the enterprise and other relevant available papers. These audit programmes
(or guidelines) identify the areas/aspects which require further detailed audit analysis and criteria,
the data required for such analysis and the sources of such data, the extent of the audit analysis
including the test checks to be applied and the instructions to the audit parties assigned to the
work.

The areas covered by comprehensive audit are those of investment decisions, project formulation
and management, organisation, delegation of powers and management information systems,
organisational effectiveness, capacity utilisation, management of equipment, plant and machinery,
production performance, use of materials, productivity of labour, idle capacity, costs and prices,
development of complementary ancillary small scale industries, materials management, sales and
credit control, budgetary and internal control systems, etc. The areas covered in comprehensive
audit will naturally vary from enterprise to enterprise depending on the nature of the enterprise,
its objectives and operations. Some of the broad areas are listed below:

 Comparison of overall capital cost of the project with the approved planned costs.
 Production or operational outputs vis-a-vis under-utilisation of the installed capacity.
 Systems of project formulation and implementation.
 Planned rate of return
 Cost control measures.
 Research and development programmes.
 System of repairs and maintenance.
 adequate purchase policies
 Effective and economical procedures
 Project planning
 Undue waste, unproductive time for men and machines, wasteful utilisation or even non-
utilisation of resources

48. a) Briefly explain performance audit? What are the considerations need to be taken care while
performing such audit.

Ans: (a) Performance Audit: A performance audit is an objective and systematic examination of evidence
for the purpose of providing an independent assessment of the performance of a government
organization, program, activity, or function in order to provide information to improve public
accountability and facilitate decision- making by parties with responsibility to oversee or initiate corrective
action. Performance audits include economy and efficiency; and program audits.

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Economy and efficiency audits may, for example, consider whether the entity -

(i) is following sound procurement practices;

(ii) is acquiring the appropriate type, quality, and amount of resources at an appropriate cost;

(iii) is properly protecting and maintaining its resources;

(iv) is avoiding duplication of effort by employees and work that serves little or no purpose;

(v) is avoiding idleness and overstaffing;

(vi) is using efficient operating procedures;

(vii) is using the optimum amount of resources (staff, equipment, and facilities) in producing or
delivering the appropriate quantity and quality of goods or services in a timely manner;

(viii) is complying with requirements of laws and regulations that could significantly affect the
acquisition, protection, and use of the entity's resources;

(ix) has an adequate management control system for measuring, reporting, and monitoring a
program's economy and efficiency; and

(x) has reported measures of economy and efficiency that are valid and reliable.

Program audits may, for example -

(i) assess whether the objectives of a new, or ongoing program are proper, suitable, or relevant;

(ii) determine the extent to which a program achieves a desired level of program results;

(iii) assess the effectiveness of the program and/or of individual program components;

(iv) identify factors inhibiting satisfactory performance;

(v) determine whether management has considered alternatives for carrying out the program that
might yield desired results more effectively or at a lower cost;

(vi) determine whether the program complements, duplicates, overlaps, or conflicts with other
related programs;

(vii) identify ways of making programs work better;

(viii) assess compliance with laws and regulations applicable to the program;

(ix) assess the adequacy of the management control system for measuring, reporting, and
monitoring program's effectiveness; and

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(x) determine whether management has reported measures of program effectiveness that are
valid and reliable.

49. Enumerate the right of C&AG of India to conduct a supplementary audit of the financial
statement of a company, or comment upon or supplement audit report provided under section
143(6) of the Companies Act, 2013.

Ans: (b) Right of C&AG of India under section 143(6) of the Companies Act, 2013: According to
section 143(6) of the Companies Act, 2013, the Comptroller and Auditor-General of India shall within
sixty days from the date of receipt of the audit report have a right to,

(i) conduct a supplementary audit of the financial statement of the company by such person or
persons as he may authorize in this behalf; and for the purposes of such audit, require information
or additional information to be furnished to any person or persons, so authorised, on such
matters, by such person or persons, and in such form, as the Comptroller and Auditor-General of
India may direct; and

(ii) comment upon or supplement such audit report.

It may be noted that any comments given by the Comptroller and Auditor-General of India upon,
or supplement to, the audit report shall be sent by the company to every person entitled to copies
of audited financial statements under sub-section (1) of section 136 i.e. every member of the
company, to every trustee for the debenture- holder of any debentures issued by the company,
and to all persons other than such member or trustee, being the person so entitled and also be
placed before the annual general meeting of the company at the same time and in the same
manner as the audit report.

Cost Audit
50 (a) Expro Ltd. is engaged in the production of steel. A Chartered Accountant Firm ‘M/s Manan &
Co.’ was appointed as the statutory auditor of Expro Ltd. for the current financial year. During the year,
the management of the company realized that the company is required to maintain cost records in their
books of account and get it audited. Therefore, in a general meeting, the members of the company
appointed M/s Manan & Co. as the cost auditor of the company. You are required to examine the
validity of appointment of M/s Manan & Co. as the cost auditor.

Ans: (a) Qualification and Appointment of Cost Auditor: According to section 148(3) of the Companies
Act, 2013 read with Companies (Audit & Auditors) Rules, 2014 –

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(i) in the case of companies which are required to constitute an audit committee, the Board shall
appoint an individual, who is a cost accountant in practice, or a firm of cost accountants in practice,
as cost auditor on the recommendations of the Audit committee;

(ii) in the case of other companies which are not required to constitute an audit committee, the
Board shall appoint an individual who is a cost accountant in practice or a firm of cost accountants
in practice as cost auditor.

It is also provided that no person appointed under section 139 as an auditor of the company shall be
appointed for conducting the audit of cost records.

In the given case, the members of Expro Ltd. appointed M/s Manan & Co., a practicing Chartered
Accountant Firm and the statutory auditor of the company, as the cost auditor.

Therefore, the appointment of the CA firm as cost auditor made by the company is not valid. The
Board shall appoint a cost accountant in practice or a firm of cost accountants in practice to conduct
such cost audit.

51. (b) “Like every other audit, a systematic planning for cost audit is also necessary”. Indicate the
matters to be included in a Cost Audit Programme.

Ans: (b) Matters to be included in Cost Audit Programme: It is a true statement that like any other
audit a systematic planning for cost audit is also necessary. Therefore, the cost audit programme
should include all the usual broad steps that a financial auditor includes in his audit programme. This
would require that the various aspects like what to be done, when to be done and by whom to be
dome are adequately takes care of. However, looking to the basic difference in cost audit and
financial audit as allocation and apportionment of expenses, statutory requirement etc. should
require special consideration. Cost audit, in order to be effective, should be completed at one time
as far as practicable. Based on above factors a set of procedures and instructions are evolved which
may be termed the cost audit programme. Matters to be included in the Cost Audit Programme may
be divided into following two stages-

(I) Review of Cost accounting record: This will include -

(i) Method of costing in use - batch, process or unit.

(ii) Method of accounting for raw materials; stores and spares, wastages, spoilage defectives, etc.

(iii) System of recording wages, salaries, overtime and spares, wastages, etc.

(i) Basis of allocation of overheads to cost centres and of absorption by products and
apportionment of service department’s expenses.
(ii) Treatment of interest, recording of royalties, research and development expenses, etc.

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(iii) Method of accounting of depreciation.

(iv) Method of stock-taking and its valuation including inventory policies.
(v) System of budgetary control.
(vi) System of internal auditing.

(II) Verification of cost statement and other data: This will mainly cover-

(i) Licensed, installed and utilised capacities.

(ii) Financial ratios.

(iii) Production data.

(iv) Cost of raw material consumed, wages and salaries, stores, power and fuel, overheads provision
for depreciation etc.

(v) Sales realisation.

(vi) Abnormal non-recurring and special costs.

(vii) Cost statements.

(viii) Reconciliation with financial books.

Some other factors which need to be brought into cost audit programme includes system of cost
accounting, range of products, areas to be covered etc. indicating allocation of manpower and the
time to be taken for computing the audit.

Internal Audit, Management and

Operational Audit
52. (a) Explain in brief the behavior aspects encountered in the management audit and state the ways to
solve them.
(b ) The Managing Director of xYuki Ltd is concerned about high employee attrition rate in his
company. As the internal auditor of the company he requests you to analyze the causes for the same.
What factors would you consider in such analysis?
Ans: Behavioural aspects encountered in Management Audit : Financial auditors deal mainly with
figures. Management auditors deal mainly with people. There are many causes for behavioural
problems arising in the review function of management audit. Particularly, when management
auditors performs comprehensive audit of operations, they cannot be as well informed about such
operations as a financial auditor in a financial department. Operating processes may be unfamiliar
and complex. The operating people may be speaking a language and using terms that are foreign

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to the auditor’s experience. The nature and causes of behavioural problems that the management
auditor is likely to face in the discharge of the review function that is expected of him and possible
solutions to overcome these problems are discussed below:
(i) Staff / Line conflict: Management auditors are staff people while the members of other
departments are line people. Management auditors tend to discount the difficulties the
line staff may face, if called on to act on the ideas of management auditors. Management
auditors are specialists in their field and they may think their approach and solutions are
the only answers.
(ii) Control: The management auditor is expected to evaluate the effectiveness of controls,
there is an instinctive reaction from the auditee that the report of the auditor may affect
them. There is a fear that the action taken based on the management audit report will
affect the line people. It breeds antagonism. The causes are as under:
(1) Fear of criticism stemming from adverse audit findings.
(2) Fear of change in day to day working habits because of changes resulting from audit
recommendations.
(3) Punitive action by superior prompted by reported deficiencies.
(4) Insensitive audit practices.
(5) Hostile audit style.

Solution to behavioural problems: The following steps may be taken to overcome the aforesaid
problems:

(1) To demonstrate that audit is part of an overall programme of review for protective
and constructive benefit.
(2) To demonstrate the objective of review is to provide maximum service in all feasible
managerial dimensions.
(3) To demonstrate the review will be with minimum interference with regular operation.
(4) The responsible officers will be involved in the process of review of the findings and
recommendations before the audit report is formally released.

It is essential to create an atmosphere of trust and friendliness so that audit reports will be
understood in their proper perspective.

Finally, it needs hardly any emphasis that there should be right management culture, enlightened
auditees and auditors of the right calibre. May be to expect a combination at all times of all the
three is asking for the impossible. But, a concerted effort by the management, auditors and
auditees to achieve a more acceptable climate would go a long way to achieve the goal.

(b) The factors responsible for high employee attrition rate are as under:

(i) Job Stress & work life imbalance

(ii) Wrong policies of the Management
(iii) Unbearable behaviour of Senior Staff
(iv) Safety factors

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(v) Limited opportunities for promotion

(vi) Low monetary benefits
(vii) Lack of labour welfare schemes
(viii) Whether the organization has properly qualified and experienced personnel for the
various levels of works?
(ix) Is the number of people employed at various work centres excessive or inadequate?
(x) Does the organization provide facilities for staff training so that employees and
workers keep themselves abreast of current techniques and practices?

Internal Audit, Management and Operational Audit

53. (a) You have been appointed as management auditor of a large engineering company suffering from
a working capital crunch. Enlist and discuss the related areas which you would probe into to overcome
the company’s problem.

Ans:
1. (a) Action Plan to Overcome Working Capital Crunch: Adequate working capital is required for
liquidity and smooth operations of the company. To ensure an adequate flow of working capital to
the manufacturing company, the following action plan may be considered -

(i) Working Capital Estimation: The company should start by preparing a statement of the projected
working capital requirements. This should be based on the functional budgets in sales, production,
expenses, capital expenditure and the Master Budget consisting of projected profit and loss and the
Balance Sheet.

(ii) Cash Flow Statement / Cash Budget: Month-wise cash budgets showing inflows and outflows of
cash heading-wise should be prepared to analyse the major inflows and outflows affecting the entity.
At this stage any wasteful outflow can be traced and eliminated. Bank reconciliation should be
undertaken periodically so that outstandings can be traced and acted upon. This is also necessary to
reduce the float time.

(iii) Inventory / Stock Management: Raw materials and inventories should be classified properly to
determine the level of stock of materials. The method of costing also needs to be looked at minutely.
There is a need to establish linkage with the production pattern and work backwards accounting for
time factor in receipt of material. This needs to be worked out carefully since at no cost, production
schedule should be hampered. The caution also need to be exercised that there is not
unused/obsolete inventory. The system of inventory management needs to be looked at so as to
check the avoidable wastes/scraps generated during storage and handling. Just in time philosophy
will enable the company to reduce processing time, stocks and related costs. The adoption of such a
mechanism would bring down the cost to a considerable extent.

(iv) Credit Management: The company should lay down a proper policy for evaluating customers,
determining the credit period and offering discounts for early payment. An age-wise analysis of

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debtors should also be prepared so as to avoid credit to defaulters. The sale department needs to be
geared up so that realisation can be made in time. A careful analysis should be done of various
customers according to pattern of sales so as to exercise control on their respective debit balances.
The company should through its purchase department endeavour to avail the maximum credit
period from its creditors. This would enhance the working capital of the company.

(v) Funds Flow Analysis: The company should prepare a funds flow analysis, distinguishing between
long-term and short-term sources and applications.

(vi) Investment Management: The idle funds of the company, if any, should be invested in short-
term securities to augment the income.

(vii) WIP Analysis: Minimum WIP should be monitored and for the purpose it is necessary to ensure
that no bottlenecks develop at any stage during the production process.

54. (b) Amazekart, a manufacturing unit does not accept the recommendations for improvements
made by the Operational Auditor. Suggest an alternative way to tackle the hostile management.

Ans: (b) Alternative Way to Tackle the Hostile Management: While conducting the operational
audit, the auditor has to come across many irregularities and areas where improvement can be made
and therefore he gives his suggestions and recommendations.

These suggestions and recommendations for improvements may not be accepted by the hostile
managers and in effect there may be cold war between the operational auditor and the managers.
This would defeat the very purpose of the operational audit.

The Participative Approach comes to the help of the auditor. In this approach the auditor discuses
the ideas for improvements with those managers that have to implement them and make them feel
that they have participated in the recommendations made for improvements. By soliciting the views
of the operating personnel, the operational audit becomes co-operative enterprise.

This participative approach encourages the auditee to develop a friendly attitude towards the
auditors and look forward to their guidance in a more receptive fashion. When participative method
is adopted then the resistance to change becomes minimal, feelings of hostility disappear & gives
room for feelings of mutual trust. Team spirit is developed. The auditors and the auditee together
try to achieve the common goal. The proposed recommendations are discussed with the auditee
and modifications as may be agreed upon are incorporated in the operational audit report. With this
attitude of the auditor it becomes absolutely easy to implement the proposed suggestions as the
auditee themselves take initiative for implementing and the auditor do not have to force any change
on the auditee.

Hence, Operational Auditor of Amazekart manufacturing unit should adopt above mentioned
participative approach to tackle the hostile management of Amazekart.

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Investigation and Due Diligence

55. An American Company engaged in the business of manufacturing and distribution of industrial gases,
is interested in acquiring a listed Indian Company having a market share of more than 65% of the industrial
gas business in India, request you to conduct a “Due Diligence” of this Indian Company and submit your
Report.
i) As due Diligence Auditor, what key areas you will cover in your review?
ii) List out the contents of your Due Diligence Review Report that you will submit to your USA
based Client.
Ans: Due Diligence – Key Areas: The American company engaged in the business of manufacturing
and distribution of industrial gases wishing to acquire a listed Indian company has commissioned
the Due Diligence Audit to assess the strengths and weaknesses of this company. It is quite
important for the acquirer to assess the proposal from different angles and specifically as per terms
of the assignment and also see whether proposed merger would create operational synergies. On
the other hand, financial due diligence review would be performed after the commercial valuation.
Accordingly, while a preliminary review might be performed during initial stages of the
restructuring exercise and may in fact, be performed simultaneously with the commercial
evaluation, at a later stage, financial due diligence may be performed on the books of account and
other information directly pertaining to the financial matters of the entity. In addition, a legal due
diligence may be required where legal aspects of functioning of the entities are reviewed; for
example, the legal aspects of property owned by the entity or compliance with various statutory
requirements under various laws. Like other due diligence exercises, environmental and personnel
due diligence are also carried out in order to establish whether various propositions with regard to
environment and personnel of the enterprise under review are appropriate. In any case, it is quite
important to look behind the veil of initial information provided by the company and to assess the
benefits and costs of the proposed acquisition/merger by inquiring into all relevant aspects of the
past, present and future of the business to be acquired. Some of the significant key areas which
shall be covered under the review are as under:
(1) Historical Background: The accountant should begin the financial due diligence review by
looking into the history of the company and the background of the promoters. The details of
how the company was set up and who were the original promoters have to be gone into, before
verification of financial data in detail. An eye into the history of the company may reveal its
turning points, survival strategies adopted from time to time, the market share enjoyed by and
changes therein, product life cycle and adequacy of resources. It could also help the accountant
in determining whether, in the past, any regulatory requirements have had an impact on the
business of the said company. This could, inter alia, include the nature of business(es), location
of production facilities, warehouses, offices, products or services and markets.

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(2) Significant Accounting Policies: The accounting policies being followed by the company and
the appropriateness thereof is another key area. The impact of the recent changes in the
accounting policies in the recent past keeping in view its intention of offering itself for sale. The
accountant has to look at the main effect of accounting policies on the overall profitability and
their correctness. It is also quite important to ascertain significant accounting policies used by
the company, that changes that have been made to the accounting policies in the recent past,
the areas in which accounting policies followed by the company are different from those
adopted by the acquiring enterprise and the effect of such differences. Finally, examine
whether the financial statements of the company have been prepared in accordance with the
governing statutory requirements.
(3) Review of Financial Statements: An evaluation of the profit reported by the company would
be largely based upon its operating results. Any extraordinary item of income or expense that
might have affected the operating results would require close examination. It is advisable to
compare the actual figures with the budgeted figures for the period under review and those of
the previous accounting period. It is important that the trading results for the past four to five
years are compared and the trend of normal operating profit arrived at. The normal operating
profits should further be benchmarked against other similar companies. Besides the above, and
based on the trend of operating results, the accountant has to advise the acquiring enterprise,
through due diligence report, on the indicative valuation of the business. The exercise to
evaluate the balance sheet of the company has to take into consideration the basis upon which
assets have been valued and liabilities have been recognised. The net worth of the business has
to be arrived at by taking into account the impact of over/under valuation of assets and
liabilities.
(4) Cash Flow: A review of historical cash flows and their pattern would reflect the cash generating
abilities of the company and should highlight the major trends. It is important to know if the
company is able to meet its cash requirements through internal accruals or does it have to seek
external help from time to time. It is necessary to check:
(a) Whether the company is able to honour its commitments to its trade payables, to the
banks, to government and other stakeholders;
(b) How well is the company able to turn its trade receivables and inventories;
(c) How well does it deploy its funds; and
(d) Whether any funds are lying idle or is the company able to reap maximum benefits out of
the available funds.
(5) Financial Projections: The projections for the next five years with detailed assumptions and
workings and the appropriateness of assumption used in the preparation and presentation of
financial projections. If the accountant is of the opinion that as assumption used by the
company are unrealistic, the accountant should consider its impact on the overall valuation of
the company.
(6) Human Resources: In the Indian context, the status of work force, staff and employees is a
complex problem. It is important to work out how much of the labour force has to be retained.
It is also important to judge the job profile of the administrative and managerial staff to gauge
which of these match the requirements of the new incumbents. The aspects whether all

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employee benefits like PF, Gratuity, ESI and superannuation have been properly paid/funded.
The pay packages of the key employees will be thoroughly reviewed since this can be a crucial
factor in future employee costs.
(7) Statutory Compliance: This is one area that has to be examined in detail. It is important to
make a list of laws that are applicable to the entity as well as to make a checklist of compliance
required from the company under those laws. If the company has not been regular in its legal
compliance, it could lead to punitive charges under the law. The impact on such violations be
quantified and assessed in respect of entity; financial status and even on its governing concern
status.

56. Contents of a Due Diligence Report: Briefly, the contents of a due diligence report can be discussed
under:

 Terms of reference and scope of verification.

 Objective of due diligence.
 Brief history of the company including shareholding pattern.
 Assessment of management structure.
 Assessment of financial liabilities with special emphasis on Interlocking investments and
financial obligations with group/associates companies, amounts receivables subject to
litigation, any other likely liability which is not provided for in the books of account.
 Assessment of valuation of assets including comments on properties, terms of leases, lien and
encumbrances including status of charges, liens, mortgages, assets and properties of the
company.
 Assessment of operating results.
 Assessment of taxation and statutory liabilities.
 Assessment of possible liabilities on account of litigation and legal proceedings against the
company and suggestion on ways and means including affidavits, indemnities, to be executed
to cover unforeseen and undetected contingent liabilities.
 Assessment of net worth.
 Suggestions on various aspects to be taken care of before and after the proposed merger /
acquisition.
 Status of franchises, license and patents.

Finally, an executive summary may be prepared highlighting the significant areas.

57. (a) Mr. Manan is above 80 years old and wishes to sell his proprietary business of manufacture of
specialty chemicals. Preeto Ltd. wants to buy the business and appoints you to carry out a due diligence
audit to decide whether it would be worthwhile to acquire the business. What procedures you would
adopt before you could render any advice to Preeto Ltd.?

Ans: (a) Due Diligence: A due diligence audit on behalf of Preeto Ltd. with a view to acquiring the business
shall involve following steps -

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(i) Brief history of the target and background of its promoters – The accountant should begin the
financial due diligence review by looking into the history of the company and the background of the
promoters. The details of how the company was set up and who were the original promoters have
to be gone into, before verification of financial data in detail. An eye into the history of the target
may reveal its turning points, survival strategies adopted by the target from time to time, the market
share enjoyed by the target and changes therein, product life cycle and adequacy of resources. It
could also help the accountant in determining whether, in the past, any regulatory requirements
have had an impact on the business of the target. Broadly, the accountant should make relevant
enquiries about the history of target's business products, markets, suppliers, expenses, operations.

(ii) Accounting policies - The accountant should study the accounting policies being followed by the
target and ascertain whether any accounting policy is inappropriate. The accountant should also see
the effects of the recent changes in the accounting policies. The target might have changed its
accounting policies in the recent past keeping in view its intention of offering itself for sale. The
overall scope has to be based on the accounting policies adopted by the management. The
accountant has to look at the main effect of accounting policies on the overall profitability and their
correctness. It is reiterated that the accountant should mainly look at all material changes in
Accounting Policies in the period subjected to review very carefully.

The accountant's report should include a summary of significant accounting policies used by the
target, that changes that have been made to the accounting policies in the recent past, the areas in
which accounting policies followed by the target are different from those adopted by the acquiring
enterprise, the effect of such differences.

(iii) Review of Financial Statements - Before commencing the review of each of the aspect covered
by the financial statements, the accountant should examine whether the financial statements of the
target have been prepared in accordance with the Statute governing the target, Framework for
Preparation and Presentation of the Financial Statements and the relevant Accounting Standards. If
not the accountant should record the deviations from the above and consider whether it warrant an
inclusion in the final report on due diligence.

After having an overall view of the financial statements, as mentioned in the above paragraphs, the
accountant should review the operating results of the target in great detail. It is important to make
an evaluation of the profit reported by the target. The reason being the price of the target would be
largely based upon its operating results. The accountant should consider the presence of an
extraordinary item of income or expense that might have affected the operating results of the target.
It is advisable to compare the actual figures with the budgeted figures for the period under review
and those of the previous accounting period.

(iv) Taxation - Tax due diligence is a separate due diligence exercise but since it is an integral
component of the financial status of a company, it is generally included in the financial due diligence.
It is important to check if the company is regular in paying various taxes to the Government.
Generally taxes are levied both by the Central Government as well as by the State Government.

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Further taxes may be direct or indirect. Most of the tax laws require the enterprise to register itself
with the government and it is important to check if all necessary registrations have been made. The
accountant has to also look at the tax effects of the merger or acquisition.

(v) Cash Flow - A review of historical cash flows and their pattern would reflect the cash generating
abilities of the target company and should highlight the major trends. It is important to know if the
company is able to meet its cash requirements through internal accruals or does it have to seek
external help from time to time. It is necessary to check if a) Is the company able to honour its
commitments to its creditors, to the banks, to government and other stakeholders b) How well is the
company able to turn its debtors and stocks c) How well does it deploy its funds d) Are there any
funds lying idle or is the company able to reap maximum benefits out of the available funds?

(vi) Financial Projections - The accountant should obtain from the target company the projections
for the next five years with detailed assumptions and workings. He should ask to give projections on
optimistic, pessimistic and most likely bases.

Ordinarily, it would be desirable that the accountant evaluates the appropriateness of assumption
used in the preparation and presentation of financial projections. If, the accountant is of the opinion
that as assumption used by the target is unrealistic, the accountant should consider its impact on the
overall valuation of the company. He should offer his comments on all the assumption, highlighting
those which, in his opinion are not inappropriate. In case he feels the projections provided by the
target are not achievable or aggressive he has to mention this in his report. He should thoroughly
check the arithmetic of the calculations made for financial projections.

(vii) Management and Employees - In the Indian context, the status of work force, staff and
employees and their demands is a complex problem. In most of the companies which are available
for take over the problem of excess work force is often witnessed. It is important to work out how
much of the labour force has to be retained. It is also important to judge the job profile of the
administrative and managerial staff to gauge which of these match the requirements of the new
incumbents. Due to complex set of labour laws applicable to them, companies often have to face
protracted litigation from its workforce and it is important to gauge the likely impact of such
litigation.

It is important to see if all employee benefits like Provident Fund (P.F.), Employees State Insurance
(E.S.I), Gratuity, leave and Superannuation have been properly paid/ provided for/funded. In case of
un-funded Gratuity, an actuarial valuation of the liability has to be obtained from a reputed actuary.
The assumptions regarding increase in salaries, interest rate, retirement etc. have to be gone into to
see if they are reasonable. It is also necessary to see if the basic salary /wage considered for the
valuation is correct and includes all elements subject to payment of Gratuity. In the case of PF, ESI
etc. the accountant has to see if all eligible employees have been covered.

It is very important to consider the pay packages of the key employees as this can be a crucial factor
in future costs. One has to carefully look at Employees Stock Option Plans; deferred compensation
plans; Economic Value Addition and other performance linked pay; sales incentives that have been

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promised etc. It is also important to identify the key employees who will not continue after the
acquisition either because they are not willing to continue or because they are to be transferred to
another company within the 'group' of the target company.

(viii) Statutory Compliance - During a due diligence this is one aspect that has to be investigated in
detail. It is important therefore, to make a list of laws that are applicable to the entity as well as to
make a checklist of compliance required from the company under those laws. If the company has
not been regular in its legal compliance it could lead to punitive charges under the law. These may
have to be quantified and factored into the financial results of the company.

In addition to the above steps, the following further points have to be seen:

(i) Reason for sale of business and the effect on turnover and profits due to the exist of the
present proprietor.

(ii) The length of the lease under which business has been operating.

(iii) The unexpired period of patents if any held by the vendors.

(iv) The age of managerial staff and prospects of their continuing in service in the new
environment; the effect of trained managerial staff learning the organisation in
production/sales/administrative and the financial liability to pay terminal benefits/compensation,
etc.

(v) If bulk sales are to a few limited customers, the profitability should be discounted greatly,
because any substantial withdrawal of customers might cause business crashes.

(vi) A company with a sound financial structure can better withstand the stresses and strains of
business. A low debt-equity ratio would indicate an ability to grow through debt financing without
raising equity.

(vii) The cash generated from operations; the need for redeployment of resources and funds
needed for repayment of loans become major factors in determining growth potential.

(viii) The valuation of goodwill if any should be on reasonable basis having regards to all factors
mentioned above.

58. (b) Runri Ltd., a company engaged in manufacturing of chemicals is consistently recording
higher sales turnover, but declining net profits since the last 5 years. As an investigator appointed
to find out the reasons for the same, what are the points you would verify?

Ans: (b) Investigation for Higher Sales Turnover: As per the facts that there has beenconsistently
high turnover but declining net profits is an anomalous situation. It may be attributed to one or more
following reasons requiring further investigation -

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(i) Unfavourable Sales mix - Where the company sells different chemical products with different
product margins, the product with the maximum PV ratio/margin should have a higher share in
the total sales. If due to revision of sales mix, more quantities of unprofitable products are sold,
profits will be reduced in spite of an increase in sales.

(ii) Negative Impact of Financial Leverage - Where the company does not have sufficient own
funds (equity) but has a higher debt-equity ratio, the interest commitments will be higher. As the
volume of its operation increases, higher debt and interest charges would result in lower profits.

(iii) Other Items Included in Sales - The figure of sales as per Profit and Loss Account may include
incidental revenues, e.g., freight, excise duty, sales-tax, etc. where the amount of excise duty goes
up considerably the total sales may show an increase which is not represented by a real increase
in sales quantity/value.

(iv) High Administrative and Selling Expenses - Administrative and selling costs are generally
period costs which are fixed in nature. Their increase is generally not proportional to sale increase.
However, a reduction in profit could also be due to increase in administrative overheads and sales
overheads at a rate higher than the rate of increase in sales.

(v) Cost-Price Relationship - If the increases in cost of raw materials and labour has not been
compensated by a corresponding increase in the sales price this would also result in higher sales
and declining profits. In spite of same sales quantity, for the increasing cost of raw materials and
other services, per unit values of the product has been increased which is however unmatched by
the increase in cost.

(vi) Competitive Price - Where sales have been made at cut-throat prices in order to eliminate
competition from the market, the profits would be in the declining trend in the short-run.

(vii) Additions to Fixed Assets - Where there are heavy additions to fixed assets and consequent
depreciation charges in the initial years of additions, there may be reduction in profits in spite of
increased sales.

Professional Ethics
59. Comment on the following with reference to the Chartered Accountants Act, 1949 and schedules
thereto:
(a) Mr. Prateek a Chartered Accountant was invited by the ASSOCHEM to present a paper in a
symposium on the issues facing Indian Leather Industry. During the course of his presentation he
shared some of the vital information of his client’s business under the impression that it will help the
Nation to compete with other countries at international level.

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Ans: Disclosure of Client’s Information: Clause (1) of Part I of the Second Schedule to the Chartered
Accountants Act, 1949 deals with the professional misconduct relating to the disclosure of information by
a chartered accountant in practice relating to the business of his clients to any person other than his client
without the consent of his client or otherwise than as required by any law for the time being in force
would amount to breach of confidence. The Code of Ethics further clarifies that such a duty continues
even after completion of the assignment. The Chartered Accountant may however, disclose the
information in case it is required as a part of performance of his professional duties. In the given case, Mr.
Prateek has disclosed vital information of his client’s business without the consent of the client under the
impression that it will help the nation to compete with other countries at International level. Thus it is a
professional misconduct covered by Clause (1) of Part I of Second Schedule to the Chartered Accountants
Act, 1949.

60. The superannuation-cum-pension fund for the employees of a company was under a separate ‘trust’.
Both the company and the trust were under the same management. The auditor, who was auditing the
accounts of the company as well as the trust noted some irregularities in the operation of the trust and
commented upon these irregularities in the confidential report given to the trustees, but did not mention
about these irregularities in his report on the Annual accounts of the Trust.
Ans: Disclosure of Material Facts: A Chartered Accountant in practice is deemed to be guilty of
professional misconduct under Clause (5) of Part I of the Second Schedule if he “fails to disclose a material
fact known to him which is not disclosed in a financial statement but disclosure of which is necessary to
make the financial statement not misleading”. In this case, the Chartered Accountant was aware of the
contraventions and irregularities committed by the trust as these were referred to in the confidential
report given by the Chartered Accountant to the trustees of the company. However, he had issued the
annual accounts without any qualification. On similar facts it was held by the Supreme Court in Kishorilal
Dutta vs. P. K. Mukherjee that it was the duty of the Chartered Accountant to have disclosed the
irregularities and contravention to the beneficiaries of the fund in the statement of accounts signed by
him. Accordingly, in the present case also it has to be held that the Chartered Accountant is guilty of
professional misconduct if the amount of irregularities is proved material.

61. Mr. Unique, a chartered accountant did not maintain books of account for his professional earnings
on the ground that his income is less than the limits prescribed u/s 44AA of the Income Tax Act, 1961.
Ans: Maintenance of Books of Account: As per the Council General Guidelines 2008, under Chapter 5 on
maintenance of books of accounts, it is specified that if a chartered accountant in practice or the firm of
Chartered Accountants of which he is a partner fails to maintain and keep in respect of his/its professional
practice, proper books of account including the Cash Book and Ledger, he is deemed to be guilty of
professional misconduct. Accordingly, it does not matter whether section 44AA of the Income Tax Act,
1961 applies or not. Hence, Mr. Unique is guilty of professional misconduct.

62. Mr. Reddy, a Chartered Accountant has sent letters under certificate of posting to the previous
auditor informing him his appointment as an auditor before the commencement of audit by him.

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Ans: Communication with the Previous Auditor: Clause (8) of Part I of the First Schedule to the Chartered
Accountants Act, 1949 requires communication by the incoming auditor with the previous auditor before
accepting a position by him. The Council of the Institute has taken the view that a mere posting of a letter
“under certificate of posting” is not sufficient to establish communication with the retiring auditor unless
there is some evidence to show that the letter has in fact reached the person communicated with. A
Chartered Accountant who relies solely upon a letter posted “under certificate of posting” therefore does
so at his own risk. Since the letters were sent by Mr. Reddy to the previous auditor informing him of his
appointment as an auditor before the commencement of audit by him under Certificate of Posting is not
sufficient to prove communication with the retiring auditor. In the opinion of the Council, communication
by a letter sent “Registered Acknowledgement Due” or by hand against a written acknowledgement would
in the normal course provide positive evidence. Hence Mr. Reddy is guilty of professional misconduct
under Clause (8) of Part I of First Schedule to the Chartered Accountants Act, 1949.

63. CA. Arjit registered his proprietorship firm last year and started practicing in the name of “M/s Arjit
& Co.”. He is of the view that a professional need to maintain books of accounts only if his earnings
exceed the minimum prescribed limit as per section 44AA of the Income Tax Act, 1961. Therefore, he
decided not to maintain his books of accounts as his earnings are below the prescribed limit given under
section 44AA of the said Act.

Ans: (a) Maintenance of Books of Accounts: Chapter V of the Council General Guidelines, 2008 specifies
that a member of the Institute in practice or the firm of Chartered Accountants of which he is a partner
shall maintain and keep in respect of his/its professional practice, proper books of accounts including the
following:

(i) a Cash Book

(ii) a Ledger

Thus, a Chartered Accountant in practice is required to maintain books of accounts. In the instant case,
CA. Arjit does not maintain books of accounts bearing in mind the provisions of section 44AA of the Income
Tax Act, 1961.

Accordingly, it does not matter whether section 44AA of the Income Tax Act, 1961 applies or not. Hence,
Mr. Arjit, being a practicing Chartered Accountant will be held guilty of professional misconduct for
violation of Council General Guidelines, 2008.

64. CA. Sufi is practicing since 2008 in the field of company auditing. Due to his good practical
knowledge, he was offered editorship of a ‘Company Audit’ Journal which he accepted. However, he
did not take any permission from the council regarding such editorship.

Ans: (b) Permission from the Council: As per Clause (11) of Part I of First Schedule to the Chartered
Accountants Act, 1949, a Chartered Accountant in practice will be deemed to be guilty of professional
misconduct if he engages in any business or occupation other than the profession of Chartered
Accountant unless permitted by the Council so to engage.

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However, the Council has granted general permission to the members to engage in certain specific
occupation. In respect of all other occupations specific permission of the Institute is necessary.

In the instant case, CA. Sufi accepted editorship of a journal for which he did not take any permission
from the Council. In this context, it may be noted that the editorship of professional journals is
covered under the general permission.

Therefore, CA. Sufi shall not be held guilty of professional misconduct in terms of Clause (11) of Part
I of First Schedule to the Chartered Accountants Act, 1949.

65. As a Chartered Accountant in practice, Mr. Denis is offered to conduct a review of the "Profit
Forecast" prepared by a company in connection with its application for a term loan from a financial
institution.

Ans: (c) Certification of Financial Forecast: Under Clause (3) of Part I of Second Schedule to the
Chartered Accountants Act, 1949, a CA in practice is deemed to be guilty of professional misconduct
if he permits his name or the name of his firm to be used in connection with an estimate of earnings
contingent upon future transactions in manner which may lead to the belief that he vouches for the
accuracy of the forecast.

Further, SAE 3400 “The Examination of Prospective Financial Information”, provides that the
management is responsible for the preparation and presentation of the prospective financial
information, including the identification and disclosure of the sources of information, the basis of
forecasts and the underlying assumptions. The auditor may be asked to examine and report on the
prospective financial information to enhance its credibility, whether it is intended for use by third
parties or for internal purposes. Thus, while making report on projection, the auditor need to
mention that his responsibility is to examine the evidence supporting the assumptions and other
information in the prospective financial information, his responsibility does not include verification
of the accuracy of the projections, therefore, he does not vouch for the accuracy of the same.

Hence, Mr. Denis may accept the offer if the above requirements are complied with.

66. CA. Sonu and CA. Monu are two partners of the CA firm ‘Sonu Monu and Associates’. Being very
pious, CA. Sonu organised a religious ceremony at his home for which he instructed his printing agent
to add his designation “Chartered Accountant” with his name in the invitation cards. Later on, the
invitations were distributed to all the relatives, close friendsand clients of both the partners.
Ans: (d) Printing of Designation “Chartered Accountant” on Invitations for Religious Ceremony: As per
Clause (6) of Part I of the First Schedule to the Chartered Accountants Act, 1949, a Chartered Accountant
in practice shall be deemed to be guilty of professional misconduct if he solicits clients or professional
work either directly or indirectly by circular, advertisement, personal communication or interview or by
any other means.

However, the Council of the ICAI is of the view that the designation “Chartered Accountant” as well as the
name of the firm may be used in greeting cards, invitations for marriages, religious ceremonies and any

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other specified matters, provided that such greeting cards or invitations etc. are sent only to clients,
relatives and close friends of the members concerned.

In the given case, CA. Sonu has instructed to write designation “Chartered Accountant” on invitation
cards for a religious ceremony and distributed the same to all the relatives, close friends and clients
of both the partners.

In this context, it may be noted that the Council has allowed using designation “Chartered
Accountant” in invitations for religious ceremony, provided these are sent to clients, relatives and
close friends of the members concerned only.

Therefore, CA. Sonu would be held guilty of professional misconduct under the said clause for
sending such invitations to the relatives, close friends and clients of CA. Monu as well.

Write a short note on the following:

66. Areas excluded from the scope of peer reviewer
Ans: (a) Areas excluded from scope of Peer Reviewer are:
• Management Consultancy Engagements;
• Representation before various Authorities;
• Engagements to prepare tax returns or advising clients in taxation matters;
• Engagements for the compilation of financial statements;
• Engagements solely to assist the client in preparing, compiling or collating information
other than financial statements;
• Testifying as an expert witness;
• Providing expert opinion on points of principle, such as Accounting Standards or the
applicability of certain laws, on the basis of facts provided by the client; and
• Engagement for Due diligence.

67. Principal Methods of Selection of Samples.

Ans: (b) Principle Methods of Selection of Samples: According to SA 530 “Audit Sampling”, the principal
methods of selecting samples are the use of random selection, systematic selection, monetary unit
sampling selection, haphazard selection and block selection. Each of these methods is discussed below-

• Random selection: This method is applied through random number generators, for
example, random number tables.
• Systematic selection: In this method the number of sampling units in the population is
divided by the sample size to give a sampling interval, for example 50, and having
determined a starting point within the first 50, each 50th sampling unit thereafter is
selected. Although the starting point may be determined haphazardly, the sample is more

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likely to be truly random if it is determined by use of a computerised random number

generator or random number tables.
• Monetary Unit sampling: This method is a type of value-weighted selection in which
sample size, selection and evaluation results in a conclusion in monetary amounts.
• Haphazard selection: In this method the auditor selects the sample without following a
structured technique. Although no structured technique is used, the auditor would
nonetheless avoid any conscious bias or predictability and thus attempt to ensure that all
items in the population have a chance of selection. Haphazard selection is not appropriate
when using statistical sampling.
• Block selection: This method involves selection of a block(s) of contiguous items from
within the population. Block selection cannot ordinarily be used in audit sampling because
most populations are structured such that items in a sequence can be expected to have
similar characteristics to each other, but different characteristics from items elsewhere in
the population. Although in some circumstances it may be an appropriate audit
procedure to examine a block of items, it would rarely be an appropriate sample selection
technique when the auditor intends to draw valid inferences about the entire population
based on the sample.

68. Classes of Companies Required to Constitute Audit Committee.

Ans: Classes of Companies Required to Constitute Audit Committee: As per section 177 of the
Companies Act, 2013 read with the rules, every listed company and the following classes of
companies shall constitute an Audit Committee -

(i) all public companies with a paid up capital of ten crore rupees or more;
(ii) all public companies having turnover of one hundred crore rupees or more;
(iii) all public companies, having in aggregate, outstanding loans or borrowings or
debentures or deposits exceeding fifty crore rupees or more.

Explanation- The paid up share capital or turnover or outstanding loans, or borrowings or

debentures or deposits, as the case may be, as existing on the date of last audited Financial
Statements shall be taken into account for the said purpose.

69. Classification of frauds by NBFC.

Ans: Classification of Frauds by NBFC: In order to have uniformity in reporting, frauds have been
classified as under -

(i) Misappropriation and criminal breach of trust.

(ii) Fraudulent encashment through forged instruments, manipulation of books of
account or through fictitious accounts and conversion of property.
(iii) Unauthorised credit facilities extended for reward or for illegal gratification.
(iv) Negligence and cash shortages.
(v) Cheating and forgery.

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(vi) Irregularities in foreign exchange transactions.

(vii) Any other type of fraud not coming under the specific heads as above.

Cases of ‘negligence and cash shortages’ and ‘irregularities in foreign exchange transactions’
referred to in items (iv) and (v) above are to be reported as fraud if the intention to cheat/ defraud
is suspected/ proved. However, the following cases where fraudulent intention is not suspected/
proved, at the time of detection, will be treated as fraud and reported accordingly:

(i) cases of cash shortages more than Rs.10,000/- and

(ii) cases of cash shortages more than Rs.5000/- if detected by management/ auditor/
inspecting officer and not reported on the occurrence by the persons handling cash.

NBFCs having overseas branches/offices should report all frauds perpetrated at such
branches/offices also to the Reserve Bank as per the prescribed format and procedures.

70. . Compliance of Prudential Norms of RBI by NBFC.

Ans: (d) Compliance of Prudential Norms by NBFC:

(i) The auditor has to verify the compliance of prudential norms relating to

(1) income recognition; (2) Income from investments; (3) Asset classification; (4) Provision for bad
and doubtful debts; (5) Capital adequacy norm; (6) Prohibition of granting loans against its own
shares; (7) Prohibition on loans and investments for failure to repay public deposits and (8) Norms
for concentration of credit etc.

(ii) The auditor shall ensure that Board of the NBFC shall frame a policy for granting demand/call
loans and implement the same.

(iii) The auditor should verify the classification of advances and loans as
standard/substandard/doubtfull/loss and that proper provision has been made in accordance
with the directions.

(iv) Auditor should ensure that unrealised income from non-performing assets has not been taken
to Statement of Profit and Loss.

(v) The auditor should check all NPAs of the previous years to verify whether during the current
year any payments have been received or still they continue to be NPA during the current year
also.

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