CA Inter FM + SM — Question Paper — November 2011

SHORT NOTES ON ANY FOUR OF THE FOLLOWING

(a) Importance of Working Papers

Working papers, as governed by SA 230 (Audit Documentation), are the records prepared by or obtained by the auditor in connection with the performance of the audit. Their importance can be understood from the following points:

1. Evidence of Audit Work: Working papers provide evidence that the audit was planned and performed in accordance with Standards on Auditing and applicable legal requirements. They demonstrate that sufficient appropriate audit evidence was obtained.

2. Basis for Audit Report: The audit report and opinion are based on the conclusions drawn from working papers. They support the auditor's opinion on the financial statements.

3. Assistance in Planning Future Audits: Working papers of the current year serve as a guide and reference for planning the subsequent year's audit. Permanent audit files contain information of continuing relevance.

4. Supervision and Review: Working papers facilitate the supervision and review of audit work by the engagement partner and quality control reviewer, ensuring that the work delegated to assistants has been properly performed.

5. Defense in Legal Proceedings: In case of any legal dispute or professional negligence claim, working papers serve as documentary evidence to prove that the auditor exercised due professional care and performed the audit diligently.

6. Coordination of Work: Where multiple team members are involved, working papers help in coordinating and integrating the work of different assistants and avoid duplication.

Working papers must be retained for a minimum of 7 years from the date of the audit report as per ICAI guidelines.

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(b) Reliability of Audit Evidence

As per SA 500 (Audit Evidence), the auditor must obtain sufficient appropriate audit evidence. Appropriateness refers to the quality of audit evidence, i.e., its relevance and reliability. The following factors determine the reliability of audit evidence:

1. Source — External vs. Internal: Evidence obtained from independent external sources (e.g., bank confirmation, trade receivable confirmation) is more reliable than evidence generated internally by the entity.

2. Effectiveness of Internal Controls: Evidence obtained from internal records is more reliable when the related internal controls are strong and effective. Weak internal controls reduce the reliability of internally generated evidence.

3. Auditor's Direct Knowledge: Evidence obtained directly by the auditor through physical inspection, observation, or recomputation is more reliable than evidence obtained indirectly or by inference.

4. Documentary vs. Oral Evidence: Documentary evidence (written or electronic) is more reliable than oral representations. Original documents are more reliable than photocopies or faxes.

5. Authenticity of Documents: Evidence is more reliable when it is obtained from original documents rather than reproductions, scanned copies, or documents of doubtful authenticity.

Generalizations on Reliability:
- External confirmation from banks > Management representation
- Auditor's own count of inventory > Inventory list provided by client
- Signed contracts > Verbal agreement noted in meeting minutes

The auditor should be aware that reliability is a matter of degree and no single piece of evidence is conclusive on its own.

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(c) Audit of Sale of Investments

During the audit of sale of investments, the auditor should satisfy himself on the following aspects:

1. Authorization: Verify that the sale of investments was duly authorized by the Board of Directors or the appropriate authority as per the entity's policies and articles of association.

2. Existence and Ownership: Confirm that the investments existed and were owned by the entity before the sale by examining investment registers, broker's notes, demat account statements, or share certificates.

3. Proper Recording — Profit or Loss: Verify that the profit or loss on sale has been correctly computed as the difference between sale proceeds and the carrying amount (cost or amortised cost) of the investment, and properly classified in the Statement of Profit & Loss under the applicable head per Ind AS 109 / AS 13.

4. Completeness of Sale Proceeds: Ensure that the entire sale proceeds have been received and accounted for. Reconcile proceeds with broker notes, bank statements, and demat account.

5. Cut-off: Verify that the sale has been recorded in the correct accounting period — delivery/settlement date vs. trade date treatment as applicable.

6. Tax Implications: Check whether applicable capital gains tax (short-term or long-term) has been correctly computed and provision made as required under the Income Tax Act, 1961.

7. Compliance with Restrictions: Examine whether any investments were subject to lock-in periods, pledges, or restrictions and that no such encumbered investments have been sold without discharge of the restriction.

8. Disclosure: Verify that adequate disclosures regarding profit/loss on sale are made in the financial statements as required by applicable accounting standards.

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(d) Verification of Assets Acquired on Lease

With the adoption of Ind AS 16 (Property, Plant & Equipment) and Ind AS 116 (Leases), right-of-use assets and finance lease assets appear on the lessee's balance sheet. The auditor should verify the following:

1. Classification of Lease: Ascertain whether the lease is an operating lease or a finance lease (under AS 19) or a right-of-use asset (under Ind AS 116). The classification determines the accounting treatment.

2. Existence of Lease Agreement: Examine the lease deed/agreement to confirm the terms, tenure, lease payments, renewal options, purchase option, and escalation clauses. Ensure the agreement is legally valid.

3. Recognition and Initial Measurement: Under Ind AS 116, verify that the right-of-use asset is recognized at the present value of future lease payments plus initial direct costs, and the corresponding lease liability is correctly recorded.

4. Depreciation / Amortisation: Check that the right-of-use asset or finance lease asset is being depreciated over the lease term (or useful life if ownership transfers) using an appropriate method consistently applied.

5. Lease Liability: Verify that the lease liability is unwound using the effective interest rate method and that repayments correctly split between the principal and finance charge components.

6. Disclosure Requirements: Confirm that disclosures required under Ind AS 116 — including maturity analysis of lease liabilities, amounts recognized in P&L, and short-term/low-value lease exemptions — are properly made.

7. Physical Verification: Where possible, physically verify the existence of the leased asset and confirm it is being used in the business.

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(e) Advantages of Statistical Sampling in Auditing

Statistical sampling, as discussed under SA 530 (Audit Sampling), involves the use of probability theory to evaluate sample results and draw conclusions about the population. Its advantages include:

1. Objectivity: Statistical sampling removes personal bias from sample selection. Since items are selected on a random basis, the sample is free from subjective judgment of the auditor.

2. Quantification of Sampling Risk: The auditor can mathematically measure and control sampling risk — i.e., the risk that the conclusion drawn from a sample differs from the conclusion if the entire population were tested.

3. Defensibility: Because the methodology is scientific and documented, the auditor can defend the sample size and selection method before courts, regulators, or peer reviewers.

4. Optimum Sample Size: Statistical techniques help in determining the most efficient sample size — neither too small (risky) nor too large (wasteful) — thereby optimizing audit effort and cost.

5. Projecting Errors: Statistical sampling allows the auditor to project the errors found in the sample to the entire population with a measurable degree of confidence, enabling a more precise conclusion.

6. Consistency: The use of standardized statistical methods ensures consistency in audit approach across different audit engagements and over different years.

7. Reliability: Statistical conclusions carry a specified confidence level (e.g., 95%), making audit conclusions more scientifically reliable as compared to judgmental sampling.

Limitation to note: Statistical sampling requires knowledge of probability theory and may not always be suitable for small populations or qualitative judgments.