CA Inter FM + SM — Question Paper — May 2017

STATEMENT (a) – INCORRECT

When financial statements are misstated and such misstatement is material and pervasive, the auditor should issue an adverse opinion, not a qualified opinion. Per SA 705 (Standards on Auditing 705) on Modifications to the Opinion in the Independent Auditor's Report, the nature of the misstatement determines the type of modification: (i) Qualified Opinion – issued when the misstatement is material but not pervasive, affecting only a specific area or component. (ii) Adverse Opinion – issued when the misstatement is both material and pervasive, rendering the financial statements fundamentally unreliable and not presenting a true and fair view. Since the question specifies the misstatement is both material and pervasive, the correct audit opinion is adverse, not qualified. The statement conflates two distinct situations and is therefore incorrect.

STATEMENT (b) – INCORRECT

Under Section 134(1) of the Companies Act, 2013, the financial statements of a company must be approved and signed by at least two directors (or one director if the company has only one director). However, the Act does not mandate that one of these directors must be the Managing Director. The statutory requirement is simply that two directors must approve the statements; the composition can be any two directors, whether independent, executive, or otherwise. The statement is overly restrictive and misrepresents the legal position by imposing an unnecessary condition about the MD's involvement. The actual requirement is flexible as to which specific directors sign, provided the minimum number requirement is met.

Vouching and Verification of Assets and Liabilities

(a) Trademarks and Copyrights

Trademarks and copyrights are intangible assets and require careful verification both for existence and valuation.

Existence and Ownership: The auditor should inspect the registration certificates issued by the Registrar of Trademarks (under the Trade Marks Act, 1999) or the Copyright Office (under the Copyright Act, 1957). Verify that the entity is the registered owner or has a valid assignment/license agreement.

Validity: Check the renewal dates — trademarks are valid for 10 years and must be renewed; copyrights have varying periods. Confirm that no trademark has lapsed or is subject to cancellation proceedings.

Valuation: Verify that the assets are recorded at cost of acquisition or development costs per AS 26 (Intangible Assets). If purchased, vouch the purchase agreement, legal fees, and registration fees. Examine whether amortisation policy is consistent and appropriate.

Impairment: Check whether any impairment review has been carried out where there are indicators of impairment.

Legal Disputes: Review minutes of board meetings and legal opinions to determine if any trademark/copyright is under litigation, which may affect carrying value.

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(b) Investment Income in the Case of Charitable Institutions

Charitable institutions enjoy tax exemptions under Section 11 and Section 12 of the Income Tax Act, 1961, subject to conditions. The auditor must verify that investment income is properly accounted for and applied to charitable objects.

Verification of Investments: Physically inspect or confirm with custodians the investment certificates, fixed deposit receipts, bond certificates, and demat statements as at year-end. Reconcile with the investment register.

Income Verification: Vouch interest income against bank statements, interest warrants, TDS certificates (Form 26AS). For dividend income, cross-check with dividend warrants and company announcements. Verify accrual of interest on fixed deposits.

Application of Income: Under Section 11, at least 85% of income must be applied toward charitable objects in India. Verify that the institution has applied the required proportion or has set apart amounts with a valid notice to the Assessing Officer.

Investments Permitted: Check that investments are made only in modes specified under Section 11(5) of the Income Tax Act, 1961 (e.g., government securities, scheduled banks, post office savings). Investments outside these modes may result in loss of exemption.

Audit Report: If the auditor is conducting a tax audit under Section 12A/12AA, the report in Form 10B must be verified for accuracy.

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(c) Contingent Liabilities

Contingent liabilities are not recorded in the books but must be disclosed as per AS 29 (Provisions, Contingent Liabilities and Contingent Assets). Verification is critical to ensure completeness of disclosure.

Enquiry from Management: Obtain a management representation letter confirming all known contingent liabilities. Enquire from management about pending legal cases, disputed tax demands, guarantees given, and bills discounted.

Review of Legal Cases: Obtain a list of all pending litigation. Correspond directly with the entity's lawyers and legal counsel to assess the probability and likely amount of any adverse outcome.

Review of Tax Assessments: Check notices received from Income Tax, GST, Customs, or Excise authorities for demands under dispute. Verify the amounts and the stage of appeals.

Bank Guarantees and Letters of Credit: Confirm outstanding bank guarantees and letters of credit with bankers. Review the register of guarantees given on behalf of subsidiaries or third parties.

Bills Discounted: Obtain a certificate from the bank of bills discounted but not yet matured.

Disclosure: Verify that the nature, estimate, and uncertainties of each contingent liability are properly disclosed in the notes to accounts as required by AS 29.

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(d) Leasehold Rights

Leasehold rights represent the right to use an asset for a specified period under a lease agreement and must be verified for existence, valuation, and proper accounting.

Title and Agreement: Inspect the original lease agreement/deed and confirm it is duly stamped and registered where required. Note the lease period, rental terms, renewal options, and any restrictions on the lessee.

Existence: Physically verify the leasehold property (land or building) or obtain confirmation from the lessor. Ensure the entity is in actual possession and the lease has not been terminated or surrendered.

Valuation and Amortisation: Verify that leasehold rights are recorded at cost (premium paid plus legal charges) and are being amortised over the lease period per AS 26. The amortisation rate and method should be consistent year to year.

Lease Rentals: Vouch lease rental payments against the lease deed terms, payment receipts, and bank statements. Confirm there are no arrears in rent that could lead to forfeiture.

Ind AS Consideration: If the entity applies Ind AS 116 (Leases), verify the recognition of a right-of-use (ROU) asset and corresponding lease liability and ensure subsequent measurement (depreciation + interest) is correctly done.

Renewal and Expiry: Examine whether the lease is nearing expiry and whether renewal is assured. If the lease cannot be renewed, assess whether impairment or write-down is necessary.

Audit Programme for Government Grant of ₹2,40,000 received by National College

Objective: To verify that the grant of ₹2,40,000 received from Government nodal agencies for a research project on rural health systems has been properly received, accounted for, utilised for the intended purpose, and reported in accordance with the terms and conditions of the grant.

1. Preliminary Steps

Obtain and study the grant agreement/sanction letter issued by the Government nodal agency. Understand the terms, conditions, and objectives of the project. Review the budget approved under the grant to identify specific heads of expenditure permitted. Ascertain the reporting obligations and utilisation certificate requirements imposed by the funding agency.

2. Receipt of Grant

Verify the sanction order to confirm the sanctioned amount of ₹2,40,000, the instalment schedule, and conditions precedent to release. Trace the receipt of grant money into the bank account of the college by examining bank statements and cash book entries. Confirm that the amount received matches the sanctioned/released amount and that no deductions were made at source. Check whether the grant was credited to a separate earmarked fund account or project account as required by the terms.

3. Opening and Maintenance of Separate Accounts

Verify that a separate project account or fund account has been maintained exclusively for this grant, as is required for government-funded projects. Check whether the college has opened a separate bank account for the grant proceeds (if stipulated in the grant agreement). Confirm that general college funds have not been mixed with grant funds (commingling of funds must not have occurred).

4. Accounting and Booking of Expenditure

Review the project ledger and ensure all expenditure is classified under the approved budget heads (e.g., salaries/remuneration of research staff, field survey expenses, data collection costs, stationery, travel, equipment, etc.). Vouch all payments made from the grant by examining vouchers, bills, invoices, and supporting documents. Verify that expenditure is incurred only on items permitted under the grant agreement. Check that each payment is authorised by the appropriate authority (Project Coordinator/Principal/Trust). Ensure that expenditure incurred but not yet paid is accounted for as a liability (accruals basis if applicable).

5. Verification of Specific Expenditure Heads

- Salaries and Remuneration: Verify appointment letters, attendance records, and payment vouchers for research staff. Confirm salary rates are within sanctioned limits.
- Travel and Field Expenses: Examine travel claims with supporting tickets, bills; verify they relate to project-related fieldwork in rural areas.
- Equipment and Assets: Check purchase orders, invoices, and physical existence of equipment. Verify whether assets purchased from grant funds are required to be returned or transferred to the Government after project completion, as per grant terms.
- Overheads/Indirect Costs: Confirm that overhead charges allocated to the project do not exceed the percentage permitted under the grant terms.

6. Unspent Balance and Refund

Compute the balance of unspent grant money, if any. Verify whether such balance has been refunded to the Government or carried forward as per the grant agreement. Check whether interest earned (if any) on grant money kept in a bank account has been separately accounted for and reported, as often required under government grants.

7. Compliance and Utilisation Certificate

Verify whether a Utilisation Certificate in the prescribed format (as required by the funding agency) has been prepared and submitted. Confirm the certificate correctly states the amount received, the amount utilised, and the unspent balance. Check compliance with General Financial Rules (GFR) or other applicable government guidelines if the grant is from a Central Government nodal agency. Ensure compliance with Foreign Contribution (Regulation) Act, 2010 (FCRA) if any portion of the grant is foreign-funded.

8. Reconciliation

Reconcile total grants received with total expenditure charged to the project plus unspent balance. Reconcile bank statement balances with the project cash book/ledger.

9. Disclosure and Reporting

Verify that the grant and related expenditure are disclosed in the financial statements of the college/trust in accordance with applicable accounting principles. Check the Trustees' Report or Annual Report for disclosure of the project, its objectives, progress, and financial position.

10. Other Matters

Ascertain whether any prior approval was required (and obtained) for budget re-appropriation between heads. Check whether the project activities have actually been carried out — examine progress reports, field visit records, and publications/outputs if any, as utilisation must be substantive and not merely on paper.

Conclusion: The audit programme should ensure that ₹2,40,000 has been received intact, spent only for the permitted purpose of research on rural health systems, properly accounted for in separate books, and reported to the Government nodal agency through a valid Utilisation Certificate.

Answer to (a): Emphasis of Matter Paragraph

As per SA 706 (Revised) – Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor's Report, an Emphasis of Matter (EOM) paragraph is a paragraph included in the auditor's report that refers to a matter appropriately presented or disclosed in the financial statements that, in the auditor's judgment, is of such fundamental importance that it is essential for users' understanding of the financial statements.

When it is used: The auditor includes an EOM paragraph when: (i) there exists a material uncertainty related to events or conditions that may cast significant doubt on the entity's ability to continue as a going concern, and adequate disclosure has been made; (ii) there is significant uncertainty regarding pending litigation or regulatory matters disclosed in the financial statements; (iii) the entity has applied a new accounting standard before its effective date; (iv) a major catastrophe has had a significant effect on the entity's financial position; or (v) there is any other matter the auditor considers fundamental to users' understanding.

Manner of its use: The EOM paragraph is placed immediately after the Opinion paragraph and must carry the heading "Emphasis of Matter." It must: (i) contain a clear reference to the matter being emphasized and indicate where the relevant disclosures can be found in the financial statements; (ii) explicitly state that the auditor's opinion is not modified in respect of the matter emphasized; and (iii) not substitute for a disclosure that the financial statements should contain — proper disclosure in the notes is a pre-condition. The EOM paragraph draws attention without altering the nature of the audit opinion.

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Answer to (b): Internal Controls for Application Process at a Service Bureau

A service bureau processes data on behalf of client organisations. To establish a robust system of internal control for the application process, the following requirements must be kept in mind:

(i) Authorization Controls: Every application or transaction submitted for processing must be duly authorized by a responsible official to prevent unauthorized or fictitious entries.

(ii) Input Controls: Proper validation checks (format checks, range checks, existence checks) must be built into the system to ensure only accurate and complete data is accepted for processing.

(iii) Segregation of Duties: The functions of data preparation, data entry, processing, and output review must be performed by different personnel to prevent fraud and errors.

(iv) Control Totals: Batch totals, hash totals, and record counts must be used to verify that all input records are processed completely and no data is lost or added during processing.

(v) Access Controls: Access to the application system must be restricted to authorized users only through passwords, access logs, and user profiles to prevent unauthorized interference.

(vi) Audit Trail: The system must maintain a complete and retrievable audit trail of all transactions processed — including who processed them, when, and any modifications made.

(vii) Output Controls: Outputs (reports, processed data) must be reviewed and reconciled by client officials before acceptance. Distribution of output must be restricted to authorized recipients.

(viii) Error Handling Procedures: Rejected or error transactions must be logged, corrected, and reprocessed in a controlled manner with proper authorization.

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Answer to (c): General Purpose Financial Statements

General Purpose Financial Statements (GPFS) are financial statements prepared and presented to meet the information needs of a wide range of external users who cannot demand special-purpose reports tailored to their specific requirements. The concept is rooted in the ICAI Framework for Preparation and Presentation of Financial Statements and the Conceptual Framework under Ind AS.

Objective: GPFS aim to provide information about the financial position, financial performance, and cash flows of an entity that is useful to a broad spectrum of users in making economic decisions.

Primary Users: Investors (present and potential), creditors and lenders, employees, customers, government and regulatory agencies, and the general public.

Components: As per Schedule III of the Companies Act, 2013 and applicable accounting standards, GPFS typically comprise: (i) Balance Sheet; (ii) Statement of Profit and Loss; (iii) Cash Flow Statement (mandatory for certain classes); (iv) Statement of Changes in Equity (under Ind AS); and (v) Notes to Accounts forming an integral part of the financial statements.

Limitations: GPFS are not designed to show the value of the entity but to provide information useful for estimation. They do not fulfil all informational needs of every user group — for instance, tax authorities may require tax-specific disclosures beyond GPFS.

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Answer to (d): Re-appointment of Retiring Auditor at AGM (Companies not covered under Rotation)

For companies not subject to mandatory auditor rotation under Section 139(2) of the Companies Act, 2013, the provisions for re-appointment of a retiring auditor at the Annual General Meeting are governed by Section 139(9) and Section 139(10).

General Rule [Section 139(9)]: Subject to the provisions of Section 139, at every AGM, a retiring auditor shall be re-appointed, unless:
(i) He is not qualified for re-appointment under Section 141;
(ii) He has given notice in writing of his unwillingness to be re-appointed;
(iii) A resolution has been passed at that AGM appointing somebody else in his place or providing expressly that he shall not be re-appointed; or
(iv) Where notice of an intended resolution to appoint another person has been given, but that person becomes incapacitated, disqualified, or deceased before the resolution can be acted upon.

Where no auditor is appointed or re-appointed [Section 139(10)]: If at any AGM no auditor is appointed or re-appointed, the existing auditor shall continue in office until a new auditor is duly appointed.

Special Notice [Section 140(4)]: If a member wishes to propose a resolution to appoint a different auditor at the AGM, special notice of such resolution must be given. The company must send a copy of such notice to the retiring auditor who has the right to make written representations to be circulated to members.

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Answer to (e): The Purpose of Providing Depreciation

Depreciation is the systematic allocation of the depreciable amount of a tangible asset over its useful life, as governed by AS 10 – Property, Plant and Equipment and mandated under Schedule II of the Companies Act, 2013. The purposes of providing depreciation are:

(i) Matching of Cost with Revenue (Matching Principle): Depreciation ensures that the cost of an asset is matched with the revenue it helps generate over its useful life, resulting in a true and fair profit figure.

(ii) True and Fair View of Financial Position: Showing assets at Written Down Value (cost less accumulated depreciation) rather than original cost reflects a more realistic picture of the asset's remaining economic value.

(iii) Compliance with Legal Requirements: Schedule II of the Companies Act, 2013 prescribes useful lives for various categories of assets; charging depreciation accordingly is a statutory obligation for companies.

(iv) Retention of Funds for Asset Replacement: By charging depreciation as an expense (a non-cash charge), funds equivalent to the depreciation amount are retained within the business, building up a fund to finance the replacement of the asset at the end of its useful life.

(v) Correct Computation of Taxable Income: Depreciation is allowed as a deduction under Section 32 of the Income Tax Act, 1961, reducing taxable income. This incentivises investment in productive assets.

(vi) Avoidance of Fictitious Profits: Without depreciation, profits would be overstated, leading to excessive dividends being paid out of capital, which would impair the entity's long-term financial stability.