The Hindu Business Line : Increasing stress on standards

Distribution of marks for the various topics is as follows: AS and AAS - 51; company audit - 25; special audit (educational institution) - 16; audit procedures (vouching and verification) - 16; government audit - 8; and others - 16. Total marks - 132.

As was the practice, candidates are required to answer Q1 and 2 which are compulsory and any four of the rest.

A candidate thorough with the AS and AAS can score good marks. The questions have a good depth and are likely to cause certain amount of confusion, particularly the question on loss on contract, and on AS 16. The paper does not pose any specific problem to a well prepared candidate though.

All the questions are fresh and for once, they were not lifted from old question papers.

ANSWERS TO QUESTIONS

As an auditor comment on the following

Q1 a: You are a principal auditor of Sri Company Ltd, which has 3 branches, the accounts of which are subject to audit by qualified branch auditors. One of the branch auditors qualified his report for non-provision of doubtful debts, which he considered to be material for the company as a whole. Subsequent to their reporting but before you could sign the audit report on the accounts of the company as a whole the management informed you that the debt under the subject matter of qualification in the branch auditor's report had been fully recovered.

According to AAS 19, subsequent events are those events, which occur between the date of balance sheet and the date of auditors report. In case of an audit of a component of an entity such as a branch or an office, subsequent events refer to the events occurring between the date of balance sheet and release of report by the branch auditor.

The principal auditor of the company should consider the reports of the branch auditors while compiling his report on the company as a whole. The branch auditors are required to qualify the report on those items, which they consider to be material and it is the prerogative of the principal auditor to deal with the qualifications in the light of other information available with him.

In the given case, the branch auditor is right in qualifying the report since he is of the opinion that the non-provision for doubtful debts is material.

Subsequently, by the time the audit report of the company is finalised, the company informs the auditor that the debt in question was realised. This apparently is an event occurring after the branch audit report is released and before the date of the auditors report.

The auditor should subject this information to such further examination as he deems fit and if he is satisfied, he can delete the qualification as suggested by the branch auditor. The auditor should document the reasons for not carrying the qualification of the branch auditor in his report on the company as a whole.

Q1.b: A Ltd is a holding company of B Ltd. B Ltd is going to start a new project estimated to cost Rs 20 crore. For this A Ltd made an investment of Rs 10 crore in the share of B Ltd by borrowing the same from a financial institution at 10 per cent p.a. As on March 31, 2005, the project was not completed and the directors of A Ltd wanted to capitalise the interest upto March 31, 2005, on the borrowing amounting to Rs 1 crore and add it to the cost of investments

AS 16 on accounting for borrowing costs requires the interest on borrowings for qualifying assets to be added to the cost of the asset. AS 13 on accounting for investments classifies the investments as current investments and long-term investments and requires long-term investments to be carried to the financial statements at cost price. Investments are not "qualifying assets" as per AS 16.

In the given question, A Ltd is the holding company. It made further investment in B Ltd. Its share holdings in the subsidiary company are investments and to be classified as long-term investments, they are to be carried at cost price.

AS 21 dealing with consolidated financial statements also does not require the revaluation of long-term investments in subsidiary company. A Ltd, cannot therefore, capitalise the interest and value its investments at Rs 11 crore.

Q1.c: The contractor entered into a contract for building roads for Rs 2 crore. After completing 60 per cent of the contract he came to know that the cost of completing the contract would be Rs 2.40 crore. The accountant transferred Rs 24 lakh; i.e 60 per cent of the total loss of Rs 40 lakh to the profit and loss account for the current year.

As per AS 7 on accounting for contracts, when it is probable that the contract results in a loss, the loss should be recognised immediately irrespective of:

a. Whether or not work has commenced on the contract;

b. The stage of completion of contract activity; or

c. The amount of profits expected to arise on other contracts, which are not treated as a single construction contract

In the given question, the accountant transfers Rs 24 lakh being proportionate loss (60 per cent) to the profit and loss account in the current year.

But, to comply with AS7, the entire loss should be recognised immediately in the year in which loss is anticipated. Therefore, the entire loss of Rs 40 lakh should be recognised in the current year and not proportionate amount of Rs 24 lakh.

Q1.d: Finished goods costing worth Rs 10 lakh were damaged due to floods in July 2004. These goods were included in the closing stock as on March 2005 at an estimated realisable value of Rs 4 lakh. These goods ultimately could be sold for Rs 3 lakh only in the accounting year 2005-06. The difference of Rs 1 lakh was debited to prior period expenditure in the accounting year 2005-06.

As per AS 5, prior period items are income or expenses that arise in the current period as a result of errors or omissions in the preparation of financial statements of one or more prior periods.

In the given question, goods were estimated to realise Rs 4 lakh and carried to balance sheet as such. In the subsequent year, the goods realised only Rs 3 lakh, resulting in a loss of Rs 1 lakh. The loss of Rs 1 lakh cannot be attributed to any omission or error. It is merely an adjustment of an estimate. Therefore, the loss cannot be treated as a prior period loss in the year 2005-06.

Q2: Give your comments on the following

Q.2. a: i) M/s A & Co chartered accountants were appointed first auditors of KLM Ltd by its board of directors (BoDs). The shareholders of the company removed M/s A & Co before the expiry of their term by an ordinary resolution in an extraordinary general meeting and appointed another auditor in their place. M/s A & Co have objected that without prior approval of the Central Government their removal is illegal.

Permission of the Central Government is required to remove any auditor before the expiry of his term. However, such permission is not required to remove the first auditor appointed by the BoDs. Such auditor can be removed by the shareholders at a meeting.

In the given question, A & Co, are appointed by the board of directors and are removed by the shareholders at an EGM. Permission of the Central Government is not required for such removal. Therefore, the objection of the auditors is not valid.

ii) The articles of association of ABC Ltd do not authorise the company to buyback its own shares. However, a special resolution has been passed in the general meeting of the company authorising the buyback. The directors of the company are of the opinion that even without authority in the articles of association the buyback is possible due to special resolution passed in the general meeting authorising the buyback

S.77 A of the Companies Act stipulates a provision in the Articles of Association of the company as a prerequisite for buyback of shares. In the given question, the company passes a special resolution to buyback its shares. But, the Articles of Association are not amended to that effect. Therefore, the special resolution in the general meeting of the company will not be effective for such buyback.

There the contention of the board of directors is not tenable

Q2 b: W Ltd approached SB &Co, a leading firm of chartered accountants having two partners S & B to conduct the audit for the year ended on March 31, 2006. Mr B is holding 500 equity shares at Rs 50 each in W Ltd. Can SB & Co accept audit of W Ltd.

S.226 (3) lays down the disqualifications to be appointed as auditor of a company. Among other things, holding of any securities carrying voting rights is a disqualification to be appointed as auditors. If any of the partners is disqualified to be appointed as the auditor, the firm in which he is a partner is also disqualified to be appointed as auditors of the firm.

In the given question, B is holding 500 equity shares of Rs 50 each in W Ltd. Consequently, the firm SB & Co are disqualified to be appointed as the auditors. They cannot accept the audit.

Q2.c: In a medium size trading organisation the accountant was given additional responsibility of making recoveries from the debtors. On one occasion, when an insurance claim of Rs 25,000 was received, he credited the same to the account of a debtor and misappropriated the cash, which he had recovered from the said debtor. Pinpoint the weakness in the internal control system, which led to this situation.

As a good internal control, the following procedures are to be laid down.

a) The same person should not be given the responsibilities to do accounting and also handle cash transactions.

b) Collections from debtors should not be entrusted to the accountant.

c) Collections from debtors should be only by way of negotiable instruments and not in cash.

d) Insurance claims from insurance company should be handled independently by another person.

e) The accounting system should be independently monitored by a responsible person.

In the given situation, all the above procedures were violated. Since the same person was handling accounts and collections, he had access to manipulate the accounts and resort to teeming and lading.

The second drawback was to accept cash from debtors, which gives a wide scope of misappropriation of cash, which was perpetuated by the employee.

Thirdly, since he was accounting for the insurance claim, he had access to the same and utilised it to perpetuate the fraud.

Since there was no system to monitor the accounting entries, the clerk could resort to the fraud.

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