CA Inter FM + SM

Answer: The following 8 statements are evaluated:

(i) Substantial review is a technique for gathering audit evidence — INCORRECT. The standard techniques for gathering audit evidence per SA 500 are: inspection, observation, enquiry, confirmation, recalculation, re-performance, and analytical procedures. 'Substantial review' is not recognized as a distinct audit evidence gathering technique; it may be confused with substantive procedures, which are a type of audit procedure, not an evidence-gathering technique.

(ii) Dividing population into groups is block sampling — INCORRECT. Block sampling involves selecting a continuous sequence of items from the population. Dividing the population into groups is called stratified sampling, where each stratum is sampled to ensure better representation. These are distinct sampling methods.

(iii) A flowchart is a graphic presentation of internal control system — CORRECT. Flowcharts are indeed graphical/visual representations used to depict the flow of transactions, documents, and controls through the company's system of internal control. They show key decision points and control procedures at each stage.

(iv) Auditor must maintain professional skepticism throughout audit — CORRECT. Per SA 200 (Overall Objectives of the Independent Auditor), maintaining professional skepticism is a fundamental requirement throughout all phases of the audit engagement, from planning through completion.

(vi) CG permission needed to remove auditors before term expiry, not after — CORRECT. Section 140(1) of the Companies Act 2013 requires Central Government approval only when auditors are removed before completion of their term. When auditors are simply not reappointed after their term expires, no such approval is required.

(vii) SAs need not be followed as they are only for reference — INCORRECT. Standards on Auditing (SA) issued by ICAI are mandatory and binding on all practicing chartered accountants. They establish the benchmark for audit quality and must be complied with, not treated as optional reference materials.

(viii) Unqualified opinion is issued when financial statements give true and fair view — CORRECT. Per SA 700 (Forming an Opinion and Reporting on Financial Statements), an auditor expresses an unqualified/clean opinion when the financial statements are prepared in all material respects in accordance with the applicable accounting framework and present a true and fair view.

(x) Auditor's right of lien is unconditional — INCORRECT. The auditor's right of lien under Section 140(5) of the Companies Act 2013 is conditional, not absolute. It cannot be exercised in all circumstances and is subject to legal conditions and limitations. The lien is also subject to the rights of secured creditors and other legal constraints.

VOUCHING AND VERIFICATION

(a) Foreign Travel Expenses

Foreign travel expenses are susceptible to misuse and require careful vouching. The auditor should:

1. Purpose and Authorization: Verify that each foreign trip was duly authorized by a competent authority (Board resolution or management approval). Check that the purpose of travel was business-related and not personal.

2. Documentary Evidence: Examine passports, visa copies, air tickets (boarding passes), and hotel bills to confirm actual travel occurred. Cross-check travel dates with passport stamps.

3. Expense Claims and Vouchers: Verify expense statements/claims submitted by the employee with supporting bills — hotel invoices, meal receipts, local conveyance, etc. Check currency conversion at the correct RBI reference rate applicable on the date of expenditure.

4. Foreign Exchange Compliance: Ensure foreign exchange was obtained through proper banking channels in accordance with FEMA (Foreign Exchange Management Act, 1999). Check Form A2 for remittances and bank receipts.

5. Accounting Treatment: Verify that expenses are correctly converted to INR and charged to the appropriate revenue head. Ensure expenses are not capitalized unless related to a capital project.

6. Income Tax Compliance: Check whether perquisite tax has been deducted where personal component exists, as per Section 17 of the Income Tax Act, 1961.

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(b) Receipt of Capital Subsidy

Capital subsidy received from government authorities requires careful verification regarding receipt, accounting treatment, and compliance.

1. Sanctioning Authority and Letter: Obtain and examine the subsidy sanction letter from the Government/sponsoring authority. Verify the scheme under which subsidy was granted (Central/State government scheme) and the specific conditions attached.

2. Eligibility and Compliance: Verify that the entity met all eligibility conditions stipulated in the scheme — nature of project, location, investment amount, employment generation, etc.

3. Receipt Verification: Confirm receipt through bank statement and bank advice. Ensure the amount received matches the sanctioned amount or check for any deductions.

4. Accounting Treatment: As per AS 12 – Accounting for Government Grants, capital subsidies (grants related to specific fixed assets) should either be:
- Deducted from the gross value of the asset concerned, or
- Treated as deferred income and recognized in the profit and loss account over the useful life of the asset.
Verify that the entity has consistently followed one of the two methods.

5. Disclosure: Ensure proper disclosure in financial statements including the nature of grant, accounting policy adopted, and any unfulfilled conditions that could require repayment.

6. Repayment Risk: Check whether any conditions of the grant have been violated which could trigger a repayment obligation, and verify appropriate provisioning if applicable.

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(c) Royalties Received

Royalties received arise from licensing of intellectual property, patents, copyrights, or mineral rights and need both vouching and verification.

1. Royalty Agreement: Examine the royalty agreement/license deed to understand the basis of computation — percentage of sales, per unit produced, fixed fee, etc. Note the agreement period, payment frequency, and any minimum guarantee clause.

2. Statements from Licensees: Obtain and verify royalty statements submitted by the licensees showing the production/sales figures on which royalty is calculated. Cross-check these with independently verifiable data where possible.

3. Calculation Verification: Recompute the royalty amount based on the agreed rate and the figures provided. Verify that the correct rate has been applied as per the agreement.

4. Receipt in Bank: Confirm receipt through bank statements and bank credit advices. Reconcile total royalty income per books with payments received from each licensee.

5. Cut-off and Accrual: Ensure that royalties accrued but not received at year-end are properly recognized as income (accrual basis) and shown as receivable. Verify no royalty income has been omitted or deferred without basis.

6. TDS Compliance: Check whether TDS has been deducted by the payer under Section 194 of the Income Tax Act, 1961. Reconcile Form 26AS with books of account for TDS credit.

7. Foreign Royalties: If royalties are received from abroad, verify FEMA compliance and proper conversion to INR at applicable rates.

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(d) Goods Sent Out on Sale or Return Basis

Goods sent on sale or return basis (also called consignment on approval) require verification to ensure correct cut-off and that ownership/revenue recognition is properly recorded.

1. Memorandum Records: Examine the memorandum records or consignment register maintained to track goods sent out on approval — including details of goods, quantity, value, customer name, and dispatch date.

2. Confirmation/Approval from Customers: Verify whether customers have confirmed acceptance of goods. Until acceptance (or expiry of the return period), these goods remain the property of the seller.

3. Revenue Recognition: As per AS 9 – Revenue Recognition, revenue should be recognized only when the buyer accepts the goods, not at the time of dispatch. Verify that no sales entry has been made for unconfirmed goods.

4. Inventory Treatment: Goods not yet confirmed by customers should be included in closing inventory at cost. Verify that such goods are not excluded from year-end stock, which would understate inventory and overstate COGS.

5. Cut-off Procedures: For goods sent near year-end, perform cut-off procedures — examine dispatch notes, customer acknowledgements, and confirmations received after year-end to ascertain whether goods were accepted before or after the balance sheet date.

6. Physical Verification: If possible, obtain balance confirmations from customers holding goods on approval to verify quantities outstanding. Cross-check with the memorandum register.

7. Return of Goods: Verify entries for goods returned by customers are properly recorded as reversals and the goods reinstated in inventory at original cost.

Note: All five sub-parts are solved below. Attempt any four in the examination.

(a) Written Communication in respect of Deficiencies of Internal Control

SA 265 – Communicating Deficiencies in Internal Control to Those Charged with Governance and Management – governs this area.

During the audit, when the auditor identifies deficiencies in internal control, he is required to communicate them appropriately. SA 265 classifies deficiencies into two categories:

1. Significant Deficiency – A deficiency or combination of deficiencies in internal control that, in the auditor's professional judgement, is of sufficient importance to merit the attention of those charged with governance (TCWG).
2. Other Deficiencies – Less severe deficiencies that need not be reported to TCWG but should be communicated to management.

Form of Communication: The auditor shall communicate significant deficiencies in writing to TCWG on a timely basis. Similarly, other deficiencies identified that are of sufficient importance shall be communicated to the appropriate level of management in writing.

Contents of Written Communication must include:
- A description of each deficiency and an explanation of its potential effects.
- Sufficient information to enable TCWG and management to understand the context of the communication.
- A statement that the purpose of the audit was to express an opinion on the financial statements and not to provide assurance on internal control.
- A statement that the matters reported are limited to deficiencies identified during the audit and that additional deficiencies may exist.

Timing: Communication should be made on a timely basis so that corrective action can be taken. The auditor may discuss matters orally first, but written communication must follow.

If the entity has an internal audit function, the auditor considers whether it is appropriate to communicate with the internal auditor as well.

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(b) Audit Enquiry with respect to Companies Act, 2013

Under Section 143(1) of the Companies Act, 2013, every auditor of a company shall have the right of access at all times to the books of account and vouchers of the company and shall be entitled to require from the officers of the company such information and explanation as he may consider necessary for performance of his duties.

Section 143(1) specifically requires the auditor to make enquiries with respect to the following matters:

1. Loans and Advances – Whether loans and advances made by the company on the basis of security have been properly secured and whether the terms on which they have been made are prejudicial to the interests of the company or its members.

2. Transactions Represented as Book Entries – Whether transactions of the company which are represented merely by book entries are prejudicial to the interests of the company.

3. Shares, Debentures, and Securities – Where the company is not an investment company or a banking company, whether so much of the assets of the company as consist of shares, debentures, and other securities have been sold at a price less than that at which they were purchased.

4. Loans and Advances as Deposits – Whether loans and advances made by the company have been shown as deposits.

5. Personal Expenses – Whether personal expenses have been charged to revenue account.

6. Cash Received for Shares – Where it is stated in the books and documents of the company that any shares have been allotted for cash, whether cash has actually been received in respect of such allotment, and if no cash has actually been received, whether the position as stated in the account books and the balance sheet is correct, regular, and not misleading.

These enquiries are mandatory but the results need not necessarily be reported in the Auditor's Report unless the answers to the enquiries are unsatisfactory. The auditor exercises professional judgement to determine whether findings need to be reported.

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(c) Compilation Engagement

A compilation engagement is governed by SRS 4410 – Engagements to Compile Financial Statements issued by ICAI.

Meaning: A compilation engagement is one in which the accountant applies accounting and financial reporting expertise to assist management in the preparation and presentation of financial statements based on information provided by management, without expressing any assurance thereon.

Key Features:
- The accountant does not verify the accuracy or completeness of information provided by management.
- No audit or review procedures are performed; hence no assurance (positive or negative) is expressed.
- The product is financial statements compiled from the records and information supplied by the entity.
- The report clearly states that no assurance is provided.

Objective: The objective is to use accounting expertise (not auditing expertise) to collect, classify, and summarise financial information.

Compilation Report must include:
- Title clearly indicating it is a report on a compilation engagement.
- Statement that the engagement was performed in accordance with SRS 4410.
- Statement that no assurance is expressed on the financial statements.
- A paragraph that management is responsible for the financial statements.
- Date, signature, and address of the accountant.

Distinction from Audit/Review: In an audit, reasonable assurance is expressed; in a review, limited assurance is expressed; in a compilation, no assurance is expressed at all. Compilation is purely an accounting service.

Independence: SRS 4410 does not require the accountant to be independent, though he must comply with relevant ethical requirements.

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(d) Scrutiny of General Ledger

The General Ledger (GL) is the principal book of accounts containing all ledger accounts. Scrutiny of the General Ledger is a fundamental substantive audit procedure designed to detect errors, frauds, and unusual transactions.

Purpose of Scrutiny:
- To verify that all transactions are properly classified and posted to correct accounts.
- To identify unusual or non-recurring entries that may indicate manipulation.
- To ensure that entries are supported by proper vouchers and documentation.
- To detect round-sum entries, journal entries passed at period-end without adequate narration, and entries passed by unusual personnel (e.g., senior management overriding controls).

Procedure followed during GL Scrutiny:

1. Review of Journal Entries – The auditor reviews journal entries and other adjustments made during the preparation of financial statements. SA 240 (Responsibilities of the Auditor Relating to Fraud) specifically requires the auditor to examine journal entries for signs of management fraud.

2. Checking Narrations – Entries with vague or incomplete narrations are investigated further.

3. Large and Unusual Items – Unusually large debits to income accounts or credits to expense accounts are scrutinised.

4. Contra Entries – Entries that offset each other are verified for genuineness.

5. Frequency and Timing – Entries passed at the last working day of the period (end-of-period entries) receive special attention.

6. Authorisation – Vouching that all entries are duly authorised by appropriate personnel.

7. Casting and Cross-Casting – Checking arithmetic accuracy of ledger balances.

The extent of scrutiny depends on the assessed risk of material misstatement; higher risk areas warrant more detailed examination of ledger accounts.

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(e) Management Representation

SA 580 – Written Representations – deals with management representations.

Meaning: A management representation is a written statement provided by management to the auditor confirming certain matters or supporting audit evidence. It is one of the forms of audit evidence, though it is the least reliable form and cannot be a substitute for other evidence.

Requirement: SA 580 requires the auditor to obtain written representations from management that they have fulfilled their responsibility for the preparation of financial statements, that all information relevant to the audit has been provided, and that all transactions have been recorded and reflected in the financial statements.

Form: Representations are typically contained in a Management Representation Letter addressed to the auditor and signed by those with appropriate responsibilities (generally CEO/MD and CFO).

Contents of the Letter include:
- Acknowledgment of management's responsibility for the financial statements.
- Confirmation that accounting policies used are appropriate.
- Confirmation that all liabilities, contingencies, and commitments have been disclosed.
- Confirmation that subsequent events have been considered up to the date of the letter.
- Confirmation regarding related party transactions, if any.
- Specific representations relating to the nature of the entity's business (e.g., inventory, litigation).

Date: The representation letter is dated the same date as the auditor's report.

Reliability: Because management representations are provided by the same party whose financial statements are being audited, they cannot be treated as substitute for other audit evidence. If management refuses to provide written representations, it constitutes a limitation on scope which may result in a qualified or disclaimer of opinion under SA 705.

Doubts on Reliability: If the auditor has doubts about the competence, integrity, or diligence of management, he re-evaluates the reliability of all representations received and considers the impact on audit opinion.