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Audit Insights and Answers

I am sharing my audit experiences in a question-and-answer format to make them more engaging and to impart the knowledge I have gained through my practical audit experiences. Happy learning! 🤗

Q. How would you detect ghost employees in a company, similar to the fraud that occurred in the Satyam scandal?
A.
Cross-Verification: Compare employee records with HR attendance, project management systems, and IT logs to ensure active participation.

Physical Verification of Employees: Conduct spot checks and physical verification by managers or department heads to confirm the presence of employees.

Reconciliation of Laptops and Assets: Cross-check the issuance of laptops and other company assets to ensure they are assigned to active employees, and reconcile these records.

Segregation of Duties: Ensure that payroll processing and employee record management are handled by different individuals to prevent fraudulent activities.

Monitor Unusual Payroll Patterns: Watch for patterns such as employees receiving salary payments despite minimal or no attendance.

Employee Database Reconciliation: Reconcile HR, payroll, and IT systems regularly to identify discrepancies, duplicates, or errors.

Anonymous Whistleblowing Channels: Provide an anonymous system for employees to report suspicious activities, including ghost employee concerns.

Q. I was auditing a client where the employee who was the head of procurement was purchasing major raw materials from his son. Would this procurement be considered a Related Party Transaction (RPT) under Ind-AS 24?

A. 1. If the Employee is a Key Management Personnel (KMP):

RPT Status: Yes, the procurement will be considered a Related Party Transaction (RPT).

Explanation: Under Ind-AS 24, transactions with key management personnel (KMP) or their close family members (including their children, parents, or spouse) are classified as related party transactions. As the head of procurement, the employee holds significant decision-making power over procurement. When this employee purchases raw materials from their son, the transaction is considered related party because the son is a close family member, and the employee has influence over the procurement decisions.

2. If the Employee is NOT a Key Management Personnel (KMP):

Possibility 1: Transaction is an RPT:

RPT Status: Yes, the procurement could still be considered a Related Party Transaction (RPT).

Explanation: Ind-AS 24 defines related parties not just as KMP but also as close family members of any employee, even if they are not KMP. If the employee has the authority or influence over procurement decisions, this could still be considered an RPT due to the familial relationship and the potential for conflict of interest. In this case, the son of the employee would be considered a related party, and the procurement transaction may require disclosure.

Possibility 2: Transaction is NOT an RPT:

RPT Status: No, the procurement may not be considered an RPT.

Explanation: If the employee is not a KMP and does not have significant influence over procurement decisions (for example, if the decision-making is entirely independent or based on other criteria), the procurement may not qualify as an RPT. Under Ind-AS 24, only close family members of KMPs are automatically considered related parties for the purpose of transactions. In this case, unless there is a direct financial interest or other factors, the procurement may not need to be disclosed as an RPT.

Q. We were auditing a client who had a case filed against him by a vendor for not paying service fees. However, the client lost the case but denied making the provision, stating that the case started after the cut-off date and was lost after the cut-off date. The client argued that since the condition of the case did not exist at the balance sheet date, it would not be a subsequent adjusting event. However, we stated that the services were provided before the cut-off date.

A. As per Ind AS 37 (Provisions, Contingent Liabilities, and Contingent Assets), the key factor in recognizing a provision is whether a present obligation exists due to a past event at the reporting date. The condition that gives rise to the obligation is the provision of services by the vendor, which occurred before the balance sheet date. The subsequent legal case and its outcome are merely confirmations of the obligation, not the condition itself.

Under Ind AS 10 (Events After the Reporting Period), an adjusting event is one that provides additional evidence of a condition that already existed at the reporting date. In this case, the obligation to pay for the services already existed before the cut-off date, irrespective of when the dispute arose or when the case was lost. The client’s argument that the legal case did not exist at the balance sheet date is irrelevant because the underlying condition—the provision of services and the obligation to pay—already existed. The court ruling only confirms this pre-existing liability, making it an adjusting event that should be recognized in the financial statements. Therefore, the client should have made a provision for the unpaid service fees.

Q. We were preparing the financial statements of the company and identified three issues that we believed could cast significant doubt on the company's ability to continue as a going concern, requiring disclosure. However, management denied the need for such a disclosure. The three issues were as follows:

The company reported losses in its financial statements, although EBITDA had been positive for the past five years.

The company had sufficient cash to fund operations for the next 12 months, but there was no visibility beyond that period.

The company had acquired a major subsidiary that was generating losses, ultimately leading to its closure.

Should a going concern disclosure be required?

A. Yes, a going concern disclosure is necessary considering the identified risks. While EBITDA has remained positive, the company has been reporting financial losses, which could erode its net worth over time. Though the company has sufficient cash to sustain operations for 12 months, the lack of visibility beyond this period raises concerns about its ability to secure future funding. Additionally, the acquisition of a loss-making subsidiary and its subsequent closure indicate financial strain, which could impact the company's overall stability. As per Ind AS 1 (Presentation of Financial Statements) and SA 570 (Revised) – Going Concern, management must assess and disclose any material uncertainties that could cast doubt on the company’s ability to continue operating. If there are credible plans to secure financing or improve profitability, the financials can be prepared on a going concern basis with appropriate explanations. However, if future funding remains uncertain, adequate disclosures must be made to ensure transparency.

Q. We were auditing a client who used to convert paddy into rice. In this process, they used to test the paddy at the time of purchase and the rice at the time of sale. The client was including the cost of inventory for both. However, we advised that they can include the paddy testing expenses, but not the rice testing expenses, as the rice testing was performed after the completion of the rice processing. Who is right here? - March 10, 2025

A. As per Ind AS 2, the cost of inventory should include all costs directly attributable to bringing the inventory to its current condition and location. Testing expenses for paddy are directly related to its purchase, so they can be capitalized. However, testing of rice after the processing is not directly attributable to bringing the inventory to its current condition and should be expensed.

Q. The company consumes consumables and spare parts as part of the manufacturing process.

Should the consumption of spare parts and consumables be recorded under "Other Expenses" or "Cost of Materials Consumed" in the Profit and Loss statement?

Where should the inventory be reported?- February 17, 2025

A. Classification in Profit and Loss Statement:
Consumables & spare parts used directly in production should be recorded under "Cost of Materials Consumed."
If used for maintenance or other non-production activities, they should be recorded under "Other Expenses."

Inventory Reporting:
Raw materials & consumables are shown under "Inventories" in the Current Assets section of the Balance Sheet.

Q. I was auditing a client where Company A sold a product to Company B, and B subsequently sold the same product to Company C. Due to an issue with the product, C returned it directly to A. A had recorded the sale at the time of the initial transaction, and B had also recorded its sale. How should the direct return to A be treated?- 5th February 2025

A. The return should be treated based on the nature of the transaction:

For Company A: Since the product was returned directly by C, A should reverse the original sale if it accepts the return. If A issues a refund or credit, it should record a sales return and adjust revenue accordingly.

For Company B: B should assess if it needs to reverse its sale to C. If B refunds C, it should record a sales return and adjust revenue. If A directly refunds C, B may not need an adjustment.

For Company C: C should record a purchase return to reverse the inventory and adjust accounts payable or request a refund from B (or A, if directly refunded).

Q. We were auditing a company that sells milk and milk-related products. On March 31st, the goods left the factory before 12:00 AM but were delivered after 12:00 AM on April 1st. Should the revenue be recognized on March 31st, or should it be reversed? - 23rd January 2025

A. Revenue recognition depends on the transfer of control:

If control transferred when goods left the factory (Ex-works terms) → Recognize revenue on March 31st.

If control transferred upon delivery (FOR terms) → Reverse and recognize revenue on April 1st.

Review shipping terms and contracts to determine the correct treatment

Q. I was auditing a client engaged in software development. If the client delays the delivery of software, a penalty is incurred. Assuming the software cost is ₹1 crore and a penalty of ₹1 lakh arises due to the delay, how would this ₹1 lakh penalty be reflected in the financial statements?- 22nd January 2025

A.
Reduction from Revenue:
If the penalty is directly linked to the software price (e.g., a contractual obligation where the penalty reduces the agreed price of the software), it should be adjusted as a reduction in revenue. For example, if the software is billed at ₹1 crore and a ₹1 lakh penalty applies, the net revenue would be ₹99 lakhs.
Expense Recognition:
If the penalty is not directly tied to the software price but arises as a separate obligation (e.g., breach of delivery timelines or other terms), it should be recognized as an operating expense in the profit and loss statement.

The penalty of ₹1 lakh due to the delay in software delivery would be recognized as an expense in the financial statements. It should be recorded under "penalties" or a similar account within operating expenses in the profit and loss statement for the period in which the delay occurred. This reduces the net profit of the client.

Q. I have practical experience that can help students crack any big firm interview. The courses are pre-recorded and delivered to students once they make the payment. The courses have a validity of 365 days, during which students can ask their questions. When should the revenue be recognized? - 18th January 2024

A. If Split is available then
If the courses are pre-recorded and delivered immediately upon payment, the primary performance obligation (delivering the course content) is satisfied at the point of delivery. In this case:

Revenue from course delivery can be recognized immediately upon payment since the service has been provided.
However, if you are offering ongoing doubt support as part of the package, the portion of the payment attributable to that support should be recognized over the 365-day period, as the support is a separate performance obligation fulfilled over time.

This means you may need to allocate the revenue between the course content (recognized immediately) and the doubt support (recognized over time).

No split available
If no clear split is available between the pre-recorded course delivery and the ongoing doubt support, you can adopt a proportional allocation method or treat the entire service as a single performance obligation. Here's how you could handle it:

Treat as a Single Obligation (If inseparable): If the course content and doubt support are inseparable, recognize the revenue over the 365-day period evenly. This reflects the continuous provision of access and support throughout the year.
Estimate a Reasonable Allocation (Preferred Approach): If you can reasonably estimate the value of doubt support (e.g., based on time, costs, or expected usage), allocate a portion of the revenue to it and recognize:
- The portion for course delivery immediately upon payment.
- The portion for doubt support over the 365 days.

Q. Share price: ₹2000

Exercise price: ₹200

Fair value: ₹100 (to be amortized over the vesting period)

After one year:

Share price drops to ₹20. Since the employee will no t exercise this option, the question arises: should the amortized amount of the fair value be reversed? - 16th January 2025

A. As per Ind AS 102 (Share-based Payment), the fair value of a stock option is determined at the grant date and remains fixed, irrespective of changes in the share price during the vesting period. This fair value, ₹100 in the given scenario, is amortized over the vesting period and recognized as an expense in the financial statements.

Even if the share price drops significantly, making the option unlikely to be exercised (e.g., the share price drops to ₹20 while the exercise price is ₹200), the expense already recognized is not reversed. The recognition of the expense reflects the cost of granting the option to the employee, not the likelihood of it being exercised. If the option ultimately lapses or is not exercised, the amounts previously recognized in equity remain unchanged and are not reversed. Thus, the fair value amortized in prior periods is retained in the financial statements, and no reversal is made for the decline in the share price.

Q. I was conducting an inventory count for a company that deals in rice and lentils. During the inventory count, we asked for the weight of 1 ton of rice. However, the weight was reduced by 50 kg. When we asked for an explanation, we were told that it was due to moisture loss, which is very common in this business. How should we account for this? - 14th January 2025

A. It depends on the percentage of moisture loss. If the moisture loss is equivalent to the standard loss defined in the company policy, no adjustment would be required, and the cost would be allocated to the remaining inventory through the Bill of Materials (BOM). However, if the moisture loss is less or more than the standard percentage, the difference would need to be adjusted in the cost of consumption separately.

If in case 5% is the standard moisture loss percentage then adjustment for moisture loss is automatically accounted for during the next process of rice, and the associated cost is allocated to the resulting 950 kg of processed rice. There is no need to make a special adjustment in the financial statements as this is handled through standard operational processes.

Let’s understand this with a real life example: In rice production, there are multiple stages of processing paddy. To summarize:

First, the husk is removed from the paddy to produce brown rice.
Then, the bran is removed from the brown rice to produce white rice.

Example: Suppose we start with 1 ton (1,000 kg) of brown rice. When processed into white rice, the company has following standard % defined for conversion:

80% becomes white rice (800 kg).
14% becomes bran (140 kg).
6% is attributed to moisture loss (60 kg).

Generally companies use a Bill of Materials (BOM) system to predefine these percentages. When the company runs the BOM, the system automatically applies these percentages to allocate quantities and costs. However, in this case, as in our case the actual moisture loss was only 50 kg, instead of the expected 60 kg. This means there is a 10 kg difference that needs adjustment in cost of consumption.

Adjustment Process:

The system will allocate costs for 800 kg of white rice, 140 kg of bran, and 60 kg of moisture loss based on the BOM.
Since the actual moisture loss is only 50 kg, the excess 10 kg will be adjusted in cost of consumption.

To gain practical exposure and learn how the Big 4 conduct audits, or if you are targeting a career in the audit department, check out my courses here .

Q. We were auditing a company that procured lentils and simply cleaned them. We stated that this should be accounted for as a trading activity; however, the company was recording it as manufacturing - 23rd October 2023

A. The activity of procuring lentils and merely cleaning them should generally be classified as a trading activity, not manufacturing. This is because manufacturing typically involves a transformation process where raw materials are converted into a new product with distinct characteristics.

Cleaning lentils does not change their fundamental nature; it is a preparatory process rather than a transformative one. Therefore, the revenue and costs associated with this activity should be recorded under trading, aligning with accounting standards that emphasize the nature of the activity rather than internal classifications.

Q. I was auditing a client who acted as an intermediary. He would connect the party with the person executing the work and, for this arrangement, charged a commission of 30% of the total revenue, while the remaining 70% was paid to the person executing the work. The agreement was directly between the person and the party. The client was recognizing revenue on a 100% basis, but we suggested that he should account for only 30% as revenue. Who is correct? - 3rd March 2024

A. In this case, the auditors are correct in recommending that the client recognize only the 30% commission as revenue instead of 100% of the total revenue.
Explanation:

Principal vs. Agent Framework:
- As auditors, you rightly applied the principal-agent framework to assess whether the client was acting as a principal (controlling the goods or services) or an agent (facilitating the transaction).
- The client acts as an agent because:
  - The agreement is directly between the person executing the work and the party.
  - The client’s role is limited to facilitating the arrangement and earning a commission.
Revenue Recognition Standards (Ind AS 115 ):
- According to revenue recognition standards, an agent should report revenue only to the extent of the fee or commission they retain.
- Since the client retains 30% as their commission, that is the amount they should recognize as revenue.
Avoiding Financial Misstatements:
- Recognizing 100% of the revenue misrepresents the client’s financial performance by inflating revenue and corresponding costs.
- This can lead to regulatory concerns, misinterpretation by stakeholders, and non-compliance with accounting standards.

Final Conclusion:

The auditors were correct in their suggestion. The client must recognize only the 30% commission as revenue, as this reflects the economic reality of their role as an agent in the transaction. Recognizing 100% of the revenue is inappropriate and violates proper accounting principles.

Q. I was auditing a client who imported goods into India and resold them within India. The risk and rewards were transferred when the vendor dispatched the goods from their port, and the liability shifted to the client. What documents do we need to ensure that the purchases are recognized in the books correctly? - 21st February 2024

A. Under Ind AS 115, purchases should be recognized when the client obtains control over the goods, which aligns with the transfer of risks and rewards as per the shipping terms. In this case, purchases should be recognized when the goods are dispatched from the vendor’s port, supported by the Bill of Lading and shipping terms agreement.

Q. I was auditing a client who had purchased plant and machinery. The issue is that the client does not have an invoice but has received the machine. The client has capitalized it and started depreciating it. We only have one proof: the physical existence of the machinery. Can we capitalize and depreciate it under these circumstances? - 18 February 2024

A. Under Ind AS 16: Property, Plant and Equipment, an asset can be capitalized only if its cost is reliably measurable, ownership is established, and future economic benefits are expected. In this case, physical existence alone is insufficient without supporting documentation, such as an invoice, payment proof, or vendor correspondence. Without these, the cost cannot be reliably verified, making capitalization and depreciation non-compliant.

If alternative evidence is available (e.g., payment records or delivery receipts), the client may estimate the cost, perform impairment testing, and disclose the lack of documentation. Otherwise, the asset should not be capitalized. Strengthening internal controls is essential to prevent similar issues.

Q. A friend called me and explained that one of his clients has converted stock-in-trade into capital goods, which has been capitalized in PPE. The client used to value stock at the weighted average cost. At what amount should the stock-in-trade be capitalized - 14 February 2024

A. The stock-in-trade should be capitalized in PPE at its carrying amount, which is the weighted average cost at the date of conversion. Any additional costs incurred to make the asset ready for use (e.g., installation or modifications) should also be added. This approach aligns with Ind AS 16 and Ind AS 2. Post-capitalization, the asset will be depreciated based on its useful life, and the transaction must be disclosed in the financial statements.

Q. I was auditing a client who had acquired a business. The client calculated the goodwill. Over how many years should the goodwill be amortized? - 11 February 2024

A. Under Ind AS 103, goodwill is not amortized but tested for impairment annually or whenever there are indications of impairment. Any impairment loss is recognized in the profit and loss statement and cannot be reversed. This approach reflects goodwill's indefinite useful life.

Q. I was auditing a client, and there was a requirement to create a provision for doubtful debts. However, based on the client's estimation, they had created a provision for 30% of the total amount. In our opinion, the provision should be 100%. What should we do in this case? - 8th February 2024

A. As auditors, if you believe the provision for doubtful debts should be 100% instead of 30%, you should:

Discuss with the client: Present your reasoning, supported by evidence, to justify the higher provision.
Assess the client’s estimation process: Evaluate if their assumptions align with Ind AS 109 (Expected Credit Loss model) for financial instruments.
Document discrepancies: If the client disagrees, document the difference as an audit adjustment.
Report if necessary: If material and unresolved, include the matter in your audit report under the appropriate section, such as Key Audit Matters or a qualified opinion.

Q. I was auditing a client, and their machine was operational. It was purchased 3-4 years ago, but it encounters problems 3-4 times every year. As per the Companies Act, the useful life of the machine is 15 years. However, as an auditor, I recommended adjusting the useful life of the machine. The client questioned how they could reduce the useful life when it is determined as per the Companies Act. How can we adopt a different useful life? What steps should I take next? - 7th February 2024

A. As an auditor, you can recommend revising the useful life of the machine if its actual performance deviates significantly from the assumptions in the Companies Act. Document evidence of frequent breakdowns and maintenance issues to justify a shorter life. Discuss with management to revise estimates based on technical evaluations and historical performance. Ensure compliance with relevant accounting standards, which allow for reassessment of asset life when supported by reasonable evidence

Q. I was auditing a company, and there were 100 ongoing legal cases against it. Based on the lawyer's assessment, the company created provisions for unfavorable cases. However, for favorable cases, they did not take any action. We suggested creating a contingent liability in such cases, but the company refused. What steps should we take to evaluate this? 4th February 2024

A. To evaluate the situation, review the lawyer's assessments and rationale for classifying cases as favorable or unfavorable. Explain to the company that contingent liabilities must be disclosed under accounting standards if there is a possible obligation (i.e. A possible obligation is a potential liability that arises from past events, dependent on uncertain future events beyond the entity's control) based on future outcomes. Assess the materiality and likelihood of losses for all cases, ensuring that significant cases are appropriately disclosed.

Q. I was auditing a client, and CSR was applicable to the client last year as the conditions for CSR applicability, as per the Companies Act, were fulfilled in that year. However, in the current year, the conditions were not being met. We stated that since the company had crossed the threshold in the previous year, it must comply with CSR requirements for subsequent years as well. The company disagreed. Who is correct? - 20th January 2024

A. In this scenario, you are correct. As per Section 135 of the Companies Act, 2013, once a company meets the CSR applicability thresholds in a financial year (net worth, turnover, or net profit criteria), it is required to comply with CSR provisions for that year and continue to do so for the subsequent three financial years, even if it no longer meets the thresholds in the subsequent years.
Therefore, the company is obligated to undertake CSR activities and comply with related provisions for the current and subsequent years, regardless of its financial position in those years. You should explain this requirement to the company and ensure compliance is documented in your audit report if they fail to adhere.

Q. I was auditing a company, and whenever the company gave an advance of more than 100 crores to a vendor, approval from the Board of Directors was required. However, the company did not obtain such approval. We qualified the ICFR (Internal Control over Financial Reporting) opinion. What kind of opinion should be issued on the main audit report in this case? 13th January 2024

A. If the company failed to obtain Board approval for advances exceeding 100 crores, the opinion on the main audit report depends on the severity of the issue. A qualified opinion should be issued if the non-compliance is material but not pervasive, specifying the impact on financial statements. However, if the issue is material and pervasive, significantly undermining the financial statement's reliability, an adverse opinion would be appropriate. The auditor should clearly disclose the nature of the non-compliance and its implications in the report.

Q. The client was creating deferred tax assets, but there is no visibility as to when the company would become profitable. As auditors, we proposed reversing the deferred tax assets since there is no evidence of future profitability. However, the company claimed they would soon generate profits, but without providing any supporting evidence. What should we do in this situation?12th January 2024

A. As per Ind AS 12 (Income Taxes), deferred tax assets can only be recognized to the extent that it is probable there will be sufficient future taxable profits to utilize the assets. In this case, if the company cannot provide reliable and convincing evidence, such as detailed business plans or contracts, to substantiate future profitability, the recognition of deferred tax assets is not appropriate. As auditors, you should recommend reversing the deferred tax assets. If the company refuses, document your assessment and consider issuing a qualified opinion or including an emphasis of matter in the audit report, as unsupported deferred tax assets could materially misstate the financial statements.

Q. I was auditing a client that exports goods outside India. The client had a customer in Russia to whom they exported goods worth $100,000. The Russian customer had provided a $50,000 advance, but this advance was against a different order, not the goods already exported. The client adjusted both amounts and reported a net $50,000 as accounts receivable. We objected, stating that they should report $100,000 as trade receivables and $50,000 as an advance from the customer, as these transactions are separate and subject to FEMA regulations. Who is correct? 25th November 2024 -

A. As the auditor, you are correct in objecting to the netting of $50,000 advance against the $100,000 trade receivables, as these represent two distinct transactions. Under FEMA (Foreign Exchange Management Act) and accounting standards, trade receivables and advances from customers must be presented separately when they relate to different transactions. Reporting $100,000 as trade receivables and $50,000 as advances ensures compliance with FEMA regulations and accurate representation of the company's financial position. If the client does not make the required adjustments, you should document the issue and consider its materiality to determine whether a qualification or emphasis of matter is needed in your audit report.

Q. I was auditing a client who had made a provision for expenses amounting to 10 crores as of March 31, 2023. In the subsequent year, they reversed 5 crores of the provision and recorded it as other income. We argued that this was a case of restatement of the financial statements, as the provision was material and not utilized. Who is correct? 13th November 2023

A. Reversing 5 crores of a material provision in the subsequent year and recording it as other income suggests that the original provision was either overstated or not justified. As per accounting standards (e.g., Ind AS 8), this should be treated as an error or restatement of the prior period financial statements, not as an adjustment to the current year's income. The company must reassess the basis for the provision and correct the prior year's financials to ensure accurate reporting. If they refuse, you may need to qualify your audit opinion.

Q. I was auditing a client who manufactures cars. The client received a special order worth crores of rupees to build a car that would take a few years to complete. As per the agreement with the customer, if there is any change in costs due to unforeseen reasons, an additional amount would be charged separately, beyond the initially agreed amount. How should this incremental revenue be treated? 10th November 2023

A. The incremental revenue from cost changes should be treated as variable consideration under Ind AS 115 (Revenue from Contracts with Customers). It should be included in the transaction price only if it is highly probable that a significant reversal of revenue will not occur when the uncertainty is resolved. The client should regularly reassess the estimated variable consideration based on the latest available information and account for it as part of the ongoing revenue recognition for the project.

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Audit Insights and Answers

I am sharing my audit experiences in a question-and-answer format to make them more engaging and to impart the knowledge I have gained through my practical audit experiences. Happy learning! 🤗

Q. I was auditing a client where the employee who was the head of procurement was purchasing major raw materials from his son. Would this procurement be considered a Related Party Transaction (RPT) under Ind-AS 24?

Q. The company consumes consumables and spare parts as part of the manufacturing process.

Q. Share price: ₹2000