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'A' chapters in the ABC in each chapter. in order, from questions during the
analysis easy to difficult. final revision

Step 1: Prioritize your chapters Step 2: Identify key concept

Chapters in the index are Identify the key concepts for each
categorized as A, B, or C based on chapter using the list provided at
their importance. Focus more on 'A' the start of the chapter. Ensure you
chapters, as they carry the most understand them thoroughly. If you
weight, and give adequate struggle with a question, revisit the
attention to 'B' chapters. While all concepts, review them, and
chapters must be covered, this strengthen your understanding
approach helps manage time before moving forward.
efficiently for better results.

Step 3: Start easy Step 4: Last Day Revision (LDR)

The questions are segregated by Focus on solving LDR questions
IND-AS. Start with Question 1, as during the final revision. In the 1.5
they progress from easy to difficult, days before the exam, prioritize these
helping you build confidence questions as they cover the most
throughout the chapter. Pay close critical concepts from each chapter.
attention to the “EXAM INSIGHTS” You'll find a quick summary of LDR
to avoid common mistakes. question numbers listed right before
each chapter for easy reference.
Table of Contents
s

Sr. Particulars PAGE NO. IMP

1 Introduction to Indian Accounting Standards 1-1 – 1-4 C
2 Conceptual Framework for Financial Reporting under Indian 2-1 –2-8 C
Accounting Standards (Ind AS)
3 Ind AS on Presentation of Items in the Financial Statements
3.1 Ind AS 1 “Presentation of Financial Statements” 3.1-1 – 3.1-12 C
3.2 Ind AS 34 “Interim Financial Reporting” 3.2-1 – 3.2-10 C
3.3 Ind AS 7 “Statement of Cash Flows” 3.3-1 – 3.3-16 B
4 Ind AS on Measurement based on Accounting Policies
4.1 Ind AS 8 “Accounting Policies, Changes in Accounting Estimates 4.1-1 – 4.1-13 C
and Errors”
4.2 Ind AS 10 “Events after the Reporting Period” 4.2-1 – 4.2-10 C
4.3 Ind AS 113 “Fair Value Measurement” 4.3-1 – 4.3-6 B
5 Ind AS 115 “Revenue from Contracts with Customers” 5-1 – 5-38 A
6 Ind AS on Assets of the Financial Statements
6.1 Ind AS 2 “Inventories” 6.1-1 – 6.1-13 C
6.2 Ind AS 16 “Property, Plant and Equipment” 6.2-1 – 6.2-20 B
6.3 Ind AS 23 “Borrowing Costs” 6.3-1 – 6.3-12 B
6.4 Ind AS 36 “Impairment of Assets” 6.4-1 – 6.4-14 B
6.5 Ind AS 38 “Intangible Assets” 6.5-1 – 6.5-14 C
6.6 Ind AS 40 “Investment Property” 6.6-1 – 6.6-10 C
6.7 Ind AS 105 “Non-current Assets Held for Sale and Discontinued 6.7-1 – 6.7-15 B
Operations”
6.8 Ind AS 116 “Leases” 6.8-1 – 6.8-28 A
7 Other Indian Accounting Standards
7.1 Ind AS 41 “Agriculture” 7.1-1 – 7.1-10 B
7.2 Ind AS 20 “Accounting for Government Grants and Disclosure 7.2-1 – 7.2-12 C
of Government Assistance”
7.3 Ind AS 102 “Share Based Payment” 7.3-1 – 7.3-19 A
8 Ind AS on Liabilities of the Financial Statements
8.1 Ind AS 19 “Employee Benefits” 8.1-1 – 8.1-15 C
8.2 Ind AS 37 “Provisions, Contingent Liabilities and Contingent 8.2-1 – 8.2-9 C
Assets”
9 Ind AS on Items impacting the Financial Statements
9.1 Ind AS 12 “Income Taxes” 9.1-1 – 9.1-13 B
9.2 Ind AS 21 “The Effects of Changes in Foreign Exchange Rates” 9.2-1 – 9.2-13 B
10 Ind AS on Disclosures in the Financial Statements
10.1 Ind AS 24 “Related Party Disclosures” 10.1-1 – 10.1-5 C
10.2 Ind AS 33 “Earnings per Share” 10.2-1 – 10.2-13 B
10.3 Ind AS 108 “Operating Segments” 10.3-1 – 10.3-10 C
11 Accounting and Reporting of Financial Instruments 11-1 – 11-54 A
12 Ind AS 103 “Business Combinations” 12-1 – 12-39 A
13 Consolidated and Separate Financial Statements of Group 13-1 – 13-52 A
Entities
14 Ind AS 101 “First-time Adoption of Indian Accounting 14-1 – 14-8 C
Standards”
15 Analysis of Financial Statements 15-1 – 15-18 C
16 Professional and Ethical Duty of a Chartered Accountant 16-1 -16-6 B
17 Accounting and Technology 17-1 – 17-3 C
18 Case Scenarios 18-1 – 18-24

ABC Analysis

Very Important, Moderately Less critical but still

A Read on priority
B Important
C essential

Ensure you thoroughly read all chapters without skipping any. The ABC analysis is
designed to help you prioritize based on past trends, but it should not replace
comprehensive preparation.
 A

CHAPTER 5
IND AS 115: REVENUE FROM CONTRACTS WITH CUSTOMERS

CONCEPTS OF THIS IND AS

• Scope and definition of the standard
• Contract identification
• Criteria for revenue recognition
• Accounting for contract combinations and modifications LDR Questions
• Identifying and satisfying performance obligations Q 12 Q 26
• Transaction price determination and allocation to performance obligations Q 33 Q 34
• Allocation of discounts to performance obligations
• Accounting for transaction price changes
• Treatment of variable considerations
• Handling of contract costs
• Presentation and disclosure requirements

QUICK REVIEW OF IMPORTANT CONCEPTS

To achieve the core principle, an entity should apply the following five-step model:
Allocate the Recognise revenue
Identify the Identify the transaction price when or as an
Determine the
contract(s) with a Performance to the entity satisfies
Transaction Price
customer Obligations performance performance
obligations obligations

STEP 1: Identify the contract(s) with a customer

An accounting contract exists only when an arrangement with a customer meets each of the following five criteria:

Have the parties approved the

contract? (approval may be Can the entity identify each
Consider if the contract meets
written, oral, or implied, as long party's rights regarding the
each of the five criteria to pass
as the parties intend to be goods/services to be
Step 1:
bound by the terms and transferred?
conditions of the contract)

Is it probable that the entity will

Can the entity identify the collect substantially all of the
payment terms for the Does the contract have consideration to which it will be
goods/services to be commercial substance? entitled in exchange for the
transferred? goods/services that will be
transferred to the customer?

Step 2

5-1 Chapter 5 Ind AS 115: Revenue from Contracts with Customers

 Step 2: Identifying performance obligations
A contract with a customer may also include promises that are implied by an entity's customary business
practices, published policies or specific statements if, at the time of entering into the contract, those promises
create a valid expectation of the customer that the entity will transfer a good or service to the customer.
Therefore. performance obligations under a contract with the customer are not always explicit or clearly
mentioned in the contract, but there can be implied promises or performance obligation under the contract as
well.
Performance obligations has been defined as a promise in a contract with a customer to transfer to the customer
either:
a) good or service (or a bundle of goods or services) that is distinct; or
b) a series of distinct goods or services that are substantially the same and that have the same pattern of
transfer to the customer.

Step 3: Determining the transaction price

The consideration promised in a contract with a customer may include fixed amounts, variable amounts, or
both.

• For the purpose of determining the transaction price, an entity shall assume that the goods or services will
be transferred to the customer as promised in accordance with the existing contract and that the contract
will not be cancelled, renewed or modified.
• The nature, timing and amount of consideration promised by a customer affect the estimate of the
transaction price.
• When determining the transaction price, an entity shall consider the effects of all the following
• Transaction Price
i. Consideration payable to customer
ii. Significant Financing component
iii. Variable consideration
iv. Constraining estimates of variable considerations
v. Non cash consideration

Step 4: Allocating the transaction price to performance obligations

Allocate the transaction price to each performance obligation identified in the contract on a relative stand-alone
selling price basis except for
• allocating discounts, and
• allocating variable consideration

Determining stand alone The stand-alone selling price is the price at which an entity would sell a promised
selling price good or service separately to a customer. The best evidence of a stand-alone
selling price is - the observable price of a good or service when the entity sells
that good or service separately in similar circumstances and to similar
customers.
Suitable methods for estimating the stand-alone selling price of a good or service
include, but are not limited to, the following:
(a) Adjusted market assessment approach
(b) Expected cost plus a margin approach
(c) Residual approach
A combination of methods may need to be used to estimate the stand-alone
selling prices of the goods or services promised in the contract if two or more of
those goods or services have highly variable or uncertain stand-alone selling
prices.
Allocation of a discount Allocate a discount proportionately to all performance obligations in the contract
on the basis of the relative stand-alone selling prices of the underlying distinct
goods or services.
When to allocate discount to Allocate a discount entirely to one or more, but not all, performance obligations
‘less than all’ performance in the contract if all of the following criteria are met:
Chapter 5 Ind AS 115: Revenue from Contracts with Customers 5-2
obligations? (a) the entity regularly sells each distinct good or service (or each bundle of
distinct goods or services) in the contract on a stand-alone basis;
(b) the entity also regularly sells on a stand-alone basis a bundle (or bundles) of
some of those distinct goods or services at a discount to the stand-alone selling
prices of the goods or services in each bundle; and
(c) the discount attributable to each bundle of goods or services described in (b)
above is substantially the same as the discount in the contract and an analysis of
the goods or services in each bundle provides observable evidence of the
performance obligation (or performance obligations) to which the entire
discount in the contract belongs.
NOTE: As a first step, always allocate the discount entirely to one or more
performance obligations in the contract (if applicable), and then as a second step,
use the residual approach to estimate the stand-alone selling price of a good or
service.
Allocation of variable Variable consideration may be attributable to (1) the entire contract or (2) a
consideration specific part of the contract, such as either of the following:
(a) one or more, but not all, performance obligations in the contract.
(b) one or more, but not all, distinct goods or services promised in a series of
distinct goods or services that forms part of a single performance obligation.
How to Allocate variable Allocate a variable amount (and subsequent changes to that amount) entirely to
consideration? a performance obligation or to a distinct good or service that forms part of a
single performance obligation if both of the following criteria are met:
• the terms of a variable payment relate specifically to the entity's efforts to
satisfy the performance obligation or transfer the distinct good or service (or
to a specific outcome from satisfying the performance obligation or
transferring the distinct good or service); and
• allocating the variable amount of consideration entirely to the performance
obligation or the distinct good or service when considering all of the
performance obligations and payment terms in the contract.

Step 5: Satisfying performance obligation

Satisfaction of Revenue
Transfer of
performance recognition
control
obligation achieved

Question & Answers

Question 1

XYZ Ltd. sells goods to its customer with a promise to give discount of 5% on list price of the goods provided
that the payments are received from customer within 15 days. XYZ Ltd. sold goods of ₹ 5 lakhs to ABC Ltd.
between 17th March, 20X1 and 31st March, 20X1. ABC Ltd. paid the dues by 15th April, 20X1 with respect to
sales made between 17th March, 20X1 and 31st March, 20X1. Financial statements were approved for issue by
Board of Directors on 31st May, 20X1. State whether discount will be adjusted from the sales at the end of
the reporting period. (RTP May’22)

Answer 1
As per Ind AS 115, if the consideration promised in a contract includes a variable amount, an entity shall
estimate the amount of consideration to which the entity will be entitled in exchange for transferring the
promised goods or services to a customer.
In the instant case, the condition that sales have been made exists at the end of the reporting period

5-3 Chapter 5 Ind AS 115: Revenue from Contracts with Customers

and the receipt of payment within 15 days’ time after the end of the reporting period and before the
approval of the financial statements confirms that the discount is to be provided on those sales. Therefore,
it is an adjusting event.
Accordingly, XYZ Ltd. should adjust the sales made to ABC Ltd. With respect to discount of 5% on the list
price of the goods.

Question 2

A construction services company enters into a contract with a customer to build a water purification plant.
The company is responsible for all aspects of the plant including overall project management, engineering and
design services, site preparation, physical construction of the plant, procurement of pumps and equipment
for measuring and testing flow volumes and water quality, and the integration of all components.
Determine whether the company has a single or multiple performance obligations under the contract?
(MTP 4 Marks Apr’21, Old & New SM)

Answer 2
Determining whether a good or service represents a performance obligation on its own or is required to be
aggregated with other goods or services can have a significant impact on the timing of revenue recognition.
While the customer may be able to benefit from each promised good or service on its own (or together with
other readily available resources), they do not appear to be separately identifiable within the context of
the contract. That is, the promised goods and services are subject to significant int egration, and as a result
will be treated as a single performance obligation.
This is consistent with a view that the customer is primarily interested in acquiring a single asset (a water
purification plant) rather than a collection of related components and services.

Question 3

During 20X1-20X2, XYZ Ltd. completed a large contract to supply a customized equipment for one customer
for a total consideration of ₹ 5,00,000 received fully in cash. As a special arrangement and in order to procure
the customer's order, XYZ Ltd agreed to maintain the equipment for three years from the date of installation.
Had there been no maintenance requirement, the sale would have been for an amount of ₹ 4,85,500. If
maintenance alone was required, it would have cost the customer ₹ 12,500 per annum.
Explain the requirements of Ind AS in relation to the XYZ Ltd.’s supply of customized contract and the
maintenance that has been agreed to be provided to the customer. Ignore discounting and calculate the
amounts to be recognized in the financial statements as at 31st March, 20X2. (MTP 4 Marks, Mar‘22)
Answer 3
As per para 81 of Ind AS 115
• a customer receives a discount for purchasing a bundle of goods or services if the sum of the stand -
alone selling prices of those promised goods or services in the contract exceeds the promised
consideration in a contract.
• except when an entity has observable evidence in accordance with paragraph 82 that the entire
discount relates to only one or more, but not all, performance obligations in a contract, the entity shall
allocate a discount proportionately to all performance obligations in the contract.
• the proportionate allocation of the discount in those circumstances is a consequence of the entity
allocating the transaction price to each performance obligation on the basis of the relative stand-alone
selling prices of the underlying distinct goods or services.
Amount to be recognized:
In this case, there are two separately identifiable performance obligations one being sale of the equipment
and second being maintenance contract for three years.
For recognition of revenue, relative stand-alone selling price of the individual components may be taken and
the consideration allocated in proportion of relative fair values, i.e. 4,85,500: 37,500* (i.e. 12,500 x 3).
Hence, the sale of equipment should be recognised at ₹ 4,64,149 [₹ 5,00,000 x {4,85,500 / (4,85,500 +
37,500)}] when all other conditions for sale of the equipment are fulfilled and the revenue from maintenance
services of ₹ 35,851 [₹ 5,00,000 x {37,500 / (4,85,500 + 37,500)}] should be the service revenue recognised
over a period of three years as per its stage of completion.
Chapter 5 Ind AS 115: Revenue from Contracts with Customers 5-4
 Question 4

Telco T Ltd. enters into a two-year contract for internet services with Customer C. C also buys a modem and a
router from T Ltd. and obtains title to the equipment. T Ltd. does not require customers to purchase its
modems and routers and will provide internet services to customers using other equipment that is compatible
with T Ltd.’s network. There is a secondary market in which modems and routers can be bought or sold for
amounts greater than scrap value.
Determine how many performance obligations does the entity T Ltd. have?
(MTP 6 Marks, Oct’21 & Apr’22, Old & New SM)

Answer 4
T Ltd. concludes that the modem and router are each distinct and that the arrangement includes three
performance obligations (the modem, the router and the internet services) based on the following evaluation:
Criterion 1: Capable of being distinct
• C can benefit from the modem and router on their own because they can be resold for more than scrap
value.
• C can benefit from the internet services in conjunction with readily available resources –
i.e. either the modem and router are already delivered at the time of contract set- up, they could be bought
from alternative retail vendors or the internet service could be used with different equipment.
Criterion 2: Distinct within the context of the contract
• T Ltd. does not provide a significant integration service.
• The modem, router and internet services do not modify or customize one another.
• C could benefit from the internet services using routers and modems that are not sold by T Ltd. Therefore,
the modem, router and internet services are not highly dependent on or highly inter-related with each
other.

Question 5

Entity WIVITSU Ltd. enters into a three-year service contract with a customer CD Ltd. for Rs. 4,50,000
(Rs.1,50,000 per year). The standalone selling price for one year of service at inception of the contract is
Rs.1,50,000 per year. WIVITSU Ltd. accounts for the contract as a series of distinct services.
At the beginning of the third year, the parties agree to modify the contract as follows:
(i) the fee for the third year is reduced to Rs.1,20,000; and
(ii) CD Ltd. agrees to extend the contract for another three years for Rs.3,00,000 (Rs.1,00,000 per year).
The standalone selling price for one year of service at the time of modification is Rs. 1,20,000. How should
WIVITSU Ltd. account for the modification? Analyze. (MTP 5 Marks, Apr’21)

Answer 5
Paragraph 20 of Ind AS 115, inter alia, states that, “An entity shall account for a contract modification as a
separate contract if both of the following conditions are present:
(a) the scope of the contract increases because of the addition of promised goods or services that are
distinct (in accordance with paragraphs 26–30); and
(b) the price of the contract increases by an amount of consideration that reflects the entity’s stand -alone
selling prices of the additional promised goods or services and any appropriate adjustments to that
price to reflect the circumstances of the particular contract.
In accordance with the above, it may be noted that a contract modification should be accounted for
prospectively if the additional promised goods or services are distinct and the pricing for those goods or
services reflects their stand-alone selling price.
In the given case, even though the remaining services to be provided are distinct, the modification should
not be accounted for as a separate contract because the price of the contract did not increase by an amount
of consideration that reflects the standalone selling price of the additional services. The modification would
be accounted for, from the date of the modification, as if the existing arrangement was terminated and a
new contract created (i.e. on a prospective basis) because the remaining services to be provided are

5-5 Chapter 5 Ind AS 115: Revenue from Contracts with Customers

distinct.
WIVITSU Ltd. should reallocate the remaining consideration to all of the remaining services to be provided
(i.e. the obligations remaining from the original contract and the new obligations). WIVITSU Ltd. will
recognize a total of Rs.4,20,000 (Rs.1,20,000 + Rs.3,00,000) over the remaining four-year service period
(one year remaining under the original contract plus three additional years) or Rs.1,05,000 per year.

Question 6

As a part of its sales promotion activities, MIL distributes office utility articles along with its product catalogues
to medical practitioners to familiarize & encourage them to prescribe medicines manufactured by it. No
conditions are attached with the items distributed.
Whether the distribution of office utility articles to medical practitioners is covered by Ind AS 115 ‘Revenue
from Contracts with Customers’? If not, how should the same be accounted by MIL? Give reasons.
(MTP 4 Marks, Mar‘22)
Answer 6
The term ‘contract’ is defined in Ind AS 115 as an agreement between two or more parties that creates
enforceable rights and obligations. In the given case:
• Gifts are distributed by MIL to doctors as a part of its sales promotion activities without there being an
agreement between MIL and the doctors creating enforceable rights and obligations.
• The doctors to whom gifts are distributed are not ‘customers’ of MIL as they have not contracted with it
to obtain goods or services in exchange for consideration.
• The items distributed as gifts are not an output of MIL ordinary activities.
In view of the above, the distribution of gifts to doctors does not fall under the scope of Ind AS 115.
As per Ind AS 38, sometimes expenditure is incurred to provide future economic benefits to an entity, but
no intangible asset or other asset is acquired or created that can be recognised. In the case of the supply
of goods, the entity recognises such expenditure as an expense when it has a right to access those goods.
Examples of expenditure that is recognised as an expense when it is incurred include expenditure on
advertising and promotional activities (including mail order catalogues).
Items acquired by MIL to be distributed as gifts as a part of sales promotion activities have no other purpose
than to undertake those activities. In other words, the only benefit of those items for MIL is to develop or
create brands or customer relationships, which in turn generate revenue. Ind AS 38 requires an entity to
recognise expenditure on such items as an expense when the entity has a right to access those goods. Ind
AS 38 states that an entity has a right to access goods when it owns them, or otherwise has a right to access
them regardless of when it distributes the goods.
In view of the above, MIL should recognise the cost of the items to be distributed as gifts as an expense
when it owns those items, or otherwise has a right to access them, regardless of when it distributes the
items to doctors.

Question 7

A manufacturer gives warranties to the purchasers of its goods. Under the terms of the warranty, the
manufacturer undertakes to make good, by repair or replacement, manufacturing defects that become
apparent within three years from the date of sale to the purchasers.
On 30 April 20X1, a manufacturing defect was detected in the goods manufactured by the entity between 1
March 20X1 and 30 April 20X1.
At 31 March 20X1 (the entity’s reporting date), the entity held approximately one week’s sales in inventories.
The entity’s financial statements for the year ended 31 March 20X1 have not yet been finalised.
Three separate categories of goods require separate consideration:
Category 1—defective goods sold on or before 31 March 20X1
Category 2—defective goods held on 31 March 20X1
Category 3—defective goods manufactured in 20Xb1-20X2
State the accounting treatment of the above categories in accordance with relevant Ind AS. (RTP May‘21)

Chapter 5 Ind AS 115: Revenue from Contracts with Customers 5-6

 B

CHAPTER 6.3 IND AS 23: BORROWING COST

CONCEPTS OF THIS IND AS

• Definitions of borrowing costs, qualifying assets, and related terms
• Conditions and requirements for capitalization of borrowing costs
• Suspension and cessation of capitalization LDR Questions
• Disclosure requirements for compliance Q5
• Difference between Ind AS 23 and AS 16 Q7

QUICK REVIEW OF IMPORTANT CONCEPTS

Form Part of the cost of Acquisition of a

that asset qualifying asset
Are interests and other
costs incurred for
borrowing of funds
If are directly Construction of a
attributable to the qualifying asset

Borrowing Costs

Recognised as an Production of a
expense qualifying asset

Other Borrowing Costs

In the period in which it

is incurred

Borrowing Cost includes

Calculated using the effective interest

Interest Expense
method as described in Ind AS 109

Recognised in accordance with Ind AS

Borrowing Cost includes Interest in respect of liabilities
116

Recognised to the extent that they

Exchange differences arising from
are regarded as an adjustment to
foreign currency borrowings
interest cost

Chapter 6.3 Ind AS 23: Borrowing Costs 6.3 - 1

 inventories Note:
With regard to exchange difference
period of time to get ready for its intended use or sale
Qualifying asset that necessarily takes a substantial
Manufacturing plants required to be treated as borrowing costs:
• The adjustment amount should be
power generation facilities
Includes
equivalent to the exchange loss not
intangible assets exceeding the difference between the cost
of borrowing in functional currency vis-a-vis
investment properties the cost of borrowing in a foreign currency.
• The realised or unrealised gain to the
bearer plants extent of the unrealised exchange loss
previously recognised as an adjustment
Assets ready for their intended should also be recognised as an adjustment
use or sale, when acquired. to interest.

Excludes Financial assets, and Borrowing costs = Actual Borrowing costs

inventories that are incurred on that borrowing during the
manufactured, or otherwise
produced, over a short period period – Investment income on the
of time temporary investment of those borrowings,
if any.

Calculation of Borrowing Cost

Borrowing cost on funds

Borrowing cost on funds
borrowed for general use but
borrowed for specific use
applied

Step 2: Calculation of
Borrowing cost to be
Expenditure incurred on Step 1: Calculate Capitalisation capitalised:
Rate (CR*)
QA** x Interest rate Expenditure Incurred on QA x
on such specific borrowings Capitalisation Rate

𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑐𝑜𝑠𝑡𝑠 𝑜𝑛 𝑎𝑙𝑙 𝑡ℎ𝑒 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔𝑠 𝑜𝑓 𝑡ℎ𝑒 𝑒𝑛𝑡𝑖𝑡𝑦
(𝑟𝑒𝑓𝑒𝑟 𝑛𝑜𝑡𝑒 3 𝑏𝑒𝑙𝑜𝑤 𝑓𝑜𝑟 𝑒𝑥𝑐𝑒𝑝𝑡𝑖𝑜𝑛)
CR* = 𝑇𝑜𝑡𝑎𝑙 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔𝑠 𝑜𝑓 𝑡ℎ𝑒 𝑒𝑛𝑡𝑖𝑡𝑦 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑝𝑒𝑟𝑖𝑜𝑑
(𝑒𝑥𝑐𝑙𝑢𝑑𝑖𝑛𝑔 𝑠𝑝𝑒𝑐𝑖𝑓𝑖𝑐 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔𝑠)
QA** = Qualifying Asset
Note:
1. The amount of borrowing costs that an entity capitalises during a period shall not exceed the amount of
borrowing costs it incurred during that period.
2. In some circumstances, it is appropriate to include all borrowings of the parent and its subsidiaries when
computing a weighted average of the borrowing costs; in other circumstances, it is appropriate for each
subsidiary to use a weighted average of the borrowing costs applicable to its own borrowings.
3. All outstanding borrowings of the entity during the period (as stated in the formula) shall exclude
borrowings made specifically for the purpose of obtaining a qualifying asset until substantially all the
activities necessary to prepare that asset for its intended use or sale are complete

Commencement of capitalisation
starts form the date when the entity first meets all of the following conditions:
• It incurs expenditures for the asset
• It Incurs borrowing costs
• It undertakes activities that are necessary to prepare the asset for its intended use or sale.

6.3 - 2 Chapter 6.3 Ind AS 23: Borrowing Costs

 Question & Answers

Question 1
How will you capitalize the interest when qualifying assets are funded by borrowings in the nature of bonds
that are issued at discount?
Y Ltd. issued at the start of year 1, 10% (interest paid annually and having maturity period of 4 years) bonds
with a face value of Rs. 2,00,000 at a discount of 10% to finance a qualifying asset which is ready for intended
use at the end of year 2.
Compute the amount of borrowing costs to be capitalized if the company amortizes discount using Effective
Interest Rate method by applying 13.39% p.a. of EIR. (RTP May’21, SM)
Answer 1
Capitalization Method
As per the Standard, borrowing costs may include interest expense calculated using the effective interest
method. Further, capitalization of borrowing cost should cease where substantially all the activities necessary to
prepare the qualifying asset for its intended use or sale are complete.
Thus, only that portion of the amortized discount should be capitalized as part of the cost of a qualifying asset
which relates to the period during which acquisition, construction or production of the asset takes place.
Capitalization of Interest
Hence based on the above explanation the amount of borrowing cost of year 1 & 2 are to be capitalized and
the borrowing cost relating to year 3 & 4 should be expensed.
Quantum of Borrowing
The value of the bond to Y Ltd. is the transaction price ie Rs. 1,80,000 (2,00,000 – 20,000) Therefore, Y Ltd will
recognize the borrowing at Rs. 1,80,000.
Computation of the amount of Borrowing Cost to be Capitalized
Y Ltd will capitalise the interest (borrowing cost) using the effective interest rate of 13.39% for two years as
the qualifying asset is ready for intended use at the end of the year 2, the details of which are as follows:
Year Opening Interest expense @ Total Interest paid Closing
Borrowing 13.39% to be capitalised Borrowing
(1) (2) (3) (4) (5) = (3) – (4)
1 1,80,000 24,102 2,04,102 20,000 1,84,102
2 1,84,102 24,651 2,08,753 20,000 1,88,753
48,753
Accordingly, borrowing cost of Rs. 48,753 will be capitalized to the cost of qualifying asset.
Question 2
An entity constructs a new office building commencing on 1st September, 20X1, which continues till 31st
December, 20X1 (and is expected to go beyond a year). Directly attributable expenditure at the beginning of
the month on this asset are Rs. 2 lakh in September 20X1 and Rs. 4 lakh in each of the months of October to
December 20X1.
The entity has not taken any specific borrowings to finance the construction of the building but has incurred
finance costs on its general borrowings during the construction period. During the year, the entity had issued
9% debentures with a face value of Rs. 30 lakh and had an overdraft of Rs. 4 lakh, which increased to Rs. 8
lakh in December 20X1. Interest was paid on the overdraft at 12% until 1st October, 20X1 and then the rate
was increased to 15%.
Calculate the capitalization rate for computation of borrowing cost for the period ending 31st December
20X1, in accordance with Ind AS 23 'Borrowing Cost'. (MTP 5 Marks, Mar’21, PYP 8 Marks Nov ’19)
Answer 2
Calculation of capitalization rate on borrowings other than specific borrowings
Nature of general Period of Amount of loan Rate of Weighted average amount
borrowings outstanding (Rs.) interest p.a. of interest
balance (Rs.)
a b c d = [(b x c) x (a/12)]
9% Debentures 12 months 30,00,000 9% 2,70,000

Chapter 6.3 Ind AS 23: Borrowing Costs 6.3 - 3

 Bank overdraft 9 months 4,00,000 12% 36,000
2 months 4,00,000 15% 10,000
1 month 8,00,000 15% 10,000
46,00,000 3,26,000
Weighted average cost of borrowings
= {30,00,000 x(12/12)} + {4,00,000 x (11/12)} + {8,00,000 x (1/12)} = 34,33,334
Capitalization rate = (Weighted average amount of interest / Weighted average of general borrowings) x 100
= (3,26,000 / 34,33,334) x 100 = 9.50% p.a.

Exam Insights:
Some examinees correctly calculated the amount of finance cost but failed to calculate the weighted
average capital. Due to this they arrived into wrong capitalization rate.

Question 3
VIVI Ltd. has taken a loan of USD 20,000 on ApriI 1, 20X1 for constructing a plant at an interest rate of 5 % per
annum payable on annual basis.
On April 1, 20X1, the exchange rate between the currencies i.e. USD vs Rupees was Rs. 45 per USD. The
exchange rate on the reporting date i.e. March 31, 20X2 is Rs. 48 per USD.
The corresponding amount could have been borrowed by VIVI Ltd. from State bank of India in local currency
at an interest rate of 11% per annum as on ApriI 1, 20X1.
Compute the borrowing cost to be capitalized for the construction of plant by VIVI Ltd. for the period ending
31st March, 20X2. (MTP 8 Marks, Apr’19 & Apr’22, SM)
Answer 3
In the above situation, the Borrowing cost needs to determine for interest cost on such foreign currency loan
and eligible exchange loss difference if any.
(a) Interest on Foreign currency loan for the period:
USD 20,000 x 5% = USD 1,000
Converted in Rs. : USD 1,000 x Rs. 48/USD = Rs. 48,000
(b) Interest that would have resulted if the loan was taken in Indian Currency:
USD 20,000 x Rs. 45/USD x 11% = R5. 99,000
(c) Difference between Interest on Foreign Currency borrowing and local Currency borrowing Rs. 99,000-
48,000 = Rs. 51,000
Increase in liability due to change in exchange difference: USD 20,000 x (48 -45) = Rs. 60,000
Hence, out of Exchange loss of Rs. 60,000 on principal amount of foreign currency loan, only exchange loss to
the extent of Rs. 51,000 is considered as borrowing costs.
Total borrowing cost to be capitalized is as under :
Interest cost on borrowing Rs. 48,000
Exchange difference to the extent considered be Rs. 51,000
an adjustment to Interest cost
Rs. 99,000
The exchange difference of Rs. 51,000 has been capitalized as borrowing cost and the remaining Rs. 9,000 will
be expensed off in the Statement of Prost and loss.
Question 4
PQR Limited is engaged in Tourism business in India. The company has planned to construct a Holiday Resort
(Qualifying Asset) at Shimla. The cost of the project has been met out of borrowed funds of ₹ 100 lakhs at the
rate of 12% p.a. ₹ 40 lakhs were disbursed on 1st April 20X2 and the balance of ₹ 60 lakhs were disbursed on
1st June 20X2. The site planning work commenced on 1st June 20X2, since the Chief engineer of the project
was on medical leave. The company commenced physical construction on 1st July 20X2 and the work of
construction continued till 30th September 20X2 and thereafter the construction activities stopped due to
landslide on the road which leads to construction site. The road blockages have been cleared by the
government machinery by 31st December 20X2. Construction activities have resumed on 1st January 20X3
and has completed on 28th February 20X3.

6.3 - 4 Chapter 6.3 Ind AS 23: Borrowing Costs

The date of opening has been scheduled for 1st March 20X3, but unfortunately, the District
Administration gave permission for opening on 16th March 20X3, due to lack of safety measures like fire
extinguishers which had not been installed by then.
Determine the amount of borrowing cost to be capitalized towards construction of the resort when
(i) Landslide is not common in Shimla and delay in approval from District Administration Office is minor
administrative work leftover.
(ii) Landslide is common in Shimla and delay in approval from District Administration Office is major
administrative work leftover. (RTP May’24)

Answer 4
As per Ind AS 23 ‘Borrowing Costs’, the commencement date for capitalisation of borrowing cost on qualifying
asset is the date when the entity first meets all of the following conditions:
(a) it incurs expenditures for the asset;
(b) it incurs borrowing costs; and
(c) it undertakes activities that are necessary to prepare the asset for its intended use or sale.
Further, an entity also does not suspend capitalising borrowing costs when a temporary delay is a necessary
part of the process of getting an asset ready for its intended use or sale. For example, capitalisation continues
during the extended period that high water levels delay construction of a bridge, if such high-water levels
are common during the construction period in the geographical region involved.
An entity shall cease capitalising borrowing costs when substantially all the activities necessary to prepare
the qualifying asset for its intended use or sale are complete.
Further, paragraph 23 explains that an asset is normally ready for its intended use or sale when the physical
construction of the asset is complete even though routine administrative work might still continue. If minor
modifications, such as the decoration of a property to the purchaser’s or user’s specification, are all that are
outstanding, this indicates that substantially all the activities are complete.
In the given case since the site planning work started for the project on 1st June, 20X2, the commencement
of capitalisation of borrowing cost will begin from 1st June, 20X2.
(i) When landslide is not common in Shimla and delay in approval from District Administration Office is
minor administrative work leftover
In such a situation, suspension of capitalisation of borrowing cost on construction work will be considered for 3
months i.e. from October, 20X2 to December, 20X2 and cessation of capitalization of borrowing cost shall stop
at the time of completion of physical activities.
Accordingly, the borrowing cost to be capitalized will be effectively for 6 months i.e. from 1st June, 20X2 to
30th September, 20X2 and then from 1st January, 20X3 to 28th February, 20X3 i.e. total 6 months. The amount
of borrowing cost will be ₹ 6,00,000 (1,00,00,000 x 6/12 x 12%).
(ii) When landslide is common in Shimla and delay in approval from District Administration Office is major
administrative work leftover
Since landslides are common in Shimla during monsoon period, there shall be no suspension of capitalisation
of borrowing cost during that period.
Further, an asset can be considered to be ready for its intended use only on receipt of approvals and after
compliance with regulatory requirements such as “Fire Clearances” etc. These are very important to declare
the asset as ready for its scheduled operation.
In the given case, obtaining the safety approval is a necessary condition that needs to be complied with strictly
and before obtaining the same the entity will not be able to use the building. Accordingly, it is appropriate to
continue capitalisation until the said approvals are obtained.
Hence, the capitalisation of the borrowing cost will be for 9.5 months i.e. from 1st June, 20X2 till 15th
March, 20X3. The amount of borrowing cost will be ₹ 9,50,000 (1,00,00,000 x 9.5/12 x 12%).

Question 5 LDR

Nikka Limited has obtained a term loan of ₹ 620 lacs for a complete renovation and modernisation of its
Factory on 1st April, 20X1. Plant and Machinery was acquired under the modernisation scheme and
installation was completed on 30th April, 20X2. An expenditure of ₹ 510 lacs was incurred on installation of
Plant and Machinery, ₹ 54 lacs has been advanced to suppliers for additional assets (acquired on 25th April,
20X1) which were also installed on 30th April, 20X2 and the balance loan of ₹ 56 lacs has been used for working

Chapter 6.3 Ind AS 23: Borrowing Costs 6.3 - 5

 capital purposes. Management of Nikka Limited considers the 12 months period as substantial period of time
to get the asset ready for its intended use.
The company has paid total interest of ₹ 68.20 lacs during financial year 20X1-20X2 on the above loan. The
accountant seeks your advice how to account for the interest paid in the books of accounts. Will your answer
be different, if the whole process of renovation and modernization gets completed by 28th February,
20X2?(MTP 6 Marks, Mar’23, RTP Nov ’21, SM) (Similar concept different figures PYP 7 Marks May’22)

Answer 5
As per Ind AS 23, Borrowing costs that are directly attributable to the acquisition, construction or production of
a qualifying asset form part of the cost of that asset. Other borrowing costs are recognized as an expense.
Where, a qualifying asset is an asset that necessarily takes a substantial period of time to get ready for its
intended use or sale.
Accordingly, the treatment of Interest of ₹ 68.20 lacs occurred during the year 20X1-20X2 would be as follows:
(i) When construction of asset completed on 30th April, 20X2
The treatment for total borrowing cost of ₹ 68.20 lakh will be as follows:
Purpose Nature Interest to be capitalized Interest to be charged to
profit and loss account
₹ in lakh ₹ in lakh
Modernization and Qualifying asset [68.20 x (510/620)]
renovation of plant and = 56.10
machinery
Advance to suppliers Qualifying [68.20 x (54/620)] = 5.94
for additional assets asset
Working Capital Not a qualifying [68.20 x (56/620)] = 6.16
asset ______

62.04 6.16
(ii) When construction of assets is completed by 28th February, 20X2
When the process of renovation gets completed in less than 12 months, the plant and machinery and the
additional assets will not be considered as qualifying assets (until and unless the entity specifically considers that
the assets took substantial period of time for completing their construction). Accordingly, the whole of interest
will be required to be charged off / expensed off to Profit and loss account.

Exam Insights:
This question was on Ind AS 23. A very few examinees have committed mistake in consideration where the
examinees had to analyse the treatment of borrowing cost i.e., whether to capitalise or to expense off in the
statement of Profit and Loss. The performance of the examinees in this question is above average and they
have scored 4-5 marks on an average. However, some of the examinees have even scored full out of 7 marks.

Question 6
WEPL Construction Company is constructing a huge building project consisting of four phases. It is expected
that the full building will be constructed over several years but Phase I and Phase II of the building will be
operational as soon as they are completed.
Following is the detail of the work done on different phases of the building during the current year:
(₹ in lakh)
Phase I Phase II Phase III Phase IV
₹ ₹ ₹ ₹
Cash expenditure 10 30 25 30
Building purchased 24 34 30 38
Total expenditure 34 64 55 68
Total expenditure of all phases 221
Loan taken @ 15% at the beginning of the year 200
After taking substantial period of construction, at the mid of the current year, Phase I and Phase II have
become operational. Find out the total amount to be capitalized and to be expensed during the year.

6.3 - 6 Chapter 6.3 Ind AS 23: Borrowing Costs

 (RTP Nov’22)

Answer 6
Particulars ₹
1 Interest expense on loan ₹ 2,00,00,000 at 15% 30,00,000
2 Total cost of Phases I and II (₹ 34,00,000 +64,00,000 98,00,000
3 Total cost of Phases III and IV (₹ 55,00,000 + ₹ 68,00,000) 1,23,00,000
4 Total cost of all 4 phases 2,21,00,000
5 Total loan 2,00,00,000
Interest on loan used for Phases I & II, based on proportionate
30,00,000 13,30,317(approx)
Loan amount = 2,21,000
× 98,00,000
6
Interest on loan used for Phases III & IV, based on
30,00,000 16,69,683
proportionate Loan amount = ×
1,23,00,000
2,21,000
7 (approx.)
Accounting treatment:
1.For Phase I and Phase II
Since Phase I and Phase II have become operational at mid of the year, half of the interest amount of ₹
6,65,158.50 (i.e. ₹ 13,30,317/2) relating to Phase I and Phase II should be capitalized (in the ratio of asset
costs 34:64) and added to respective assets in Phase I and Phase II and remaining half of the interest amount
of ₹ 6,65,158.50 (i.e. ₹ 13,30,317/2) relating to Phase I and Phase II should be expensed off during the year.
2.For Phase III and Phase IV
Interest of ₹ 16,69,683 relating to Phase III and Phase IV should be held in Capital Work-in-Progress till assets
construction work is completed, and thereafter capitalized in the ratio of cost of assets. No part of this interest
amount should be charged/expensed off during the year since the work on these phases has not been
completed yet.

Question 7 LDR

LT Ltd. is in the process of constructing a building. The construction process is expected to take about 18
months from 1st January 20X1 to 30th June 20X2. The building meets the definition of a qualifying asset. LT
Ltd. incurs the following expenditure for the construction:
1st January, 20X1 ₹ 5 crores
30th June, 20X1 ₹ 20 crores
31st March, 20X2 ₹ 20 crores
30th June, 20X2 ₹ 5 crores
On 1st July 20X1, LT Ltd. issued 10% Redeemable Debentures of ₹ 50 crores. The proceeds from the debentures
form part of the company's general borrowings, which it uses to finance the construction of the qualifying
asset, i.e., the building. LT Ltd. had no borrowings (general or specific) before 1st July 20X1 and did not incur
any borrowing costs before that date. LT Ltd. incurred ₹ 25 crores of construction costs before obtaining
general borrowings on 1st July 20X1 (pre-borrowing expenditure) and ₹ 25 crores after obtaining the general
borrowings (post-borrowing expenditure).
For each of the financial years ended 31st March 20X1, 20X2 and 20X3, calculate the borrowing cost that LT
Ltd. is permitted to capitalize as a part of the building cost. (RTP May’23) (MTP 8 Marks March’24)

Answer 7
Applying paragraph 17 of Ind AS 23 to the fact pattern, the entity would not begin capitalising borrowing costs
until it incurs borrowing costs (i.e. from 1 st July, 20X1)
In determining the expenditures on a qualifying asset to which an entity applies the capitalisation rate
(paragraph 14 of Ind AS 23), the entity does not disregard expenditures on the qualifying asset incurred before
the entity obtains the general borrowings. Once the entity incurs borrowing costs and therefore satisfies all
three conditions in para 17 of Ind AS 23, it then applies paragraph 14 of Ind AS 23 to determine the
expenditures on the qualifying asset to which it applies the capitalisation rate.

Chapter 6.3 Ind AS 23: Borrowing Costs 6.3 - 7

 Calculation of borrowing cost for financial year 20X0-20X1
Expenditure Capitalization Period Weighted average
(current year) Accumulated Expenditure
Date Amount
1st January 20X1 ₹ 5 crore 0/3 Nil
Borrowing Costs eligible for capitalisation = NIL. LT Ltd. cannot capitalise borrowing costs before
1st July, 20X1 (the day it starts to incur borrowing costs).
Calculation of borrowing cost for financial year 20X1-20X2
Expenditure Capitalization Period Weighted average
(current year) Accumulated Expenditure
Date Amount
1st January, 20X1 ₹ 5 crore 9/12* ₹ 3.75 crore
30th June, 20X1 ₹ 20 crore 9/12 ₹ 15 crore
31st March, 20X2 ₹ 20 crore 0/12 Nil
Total ₹ 18.75 crore
Borrowing Costs eligible for capitalisation = 18.75 cr. x 10% = ₹ 1.875 cr.
*LT Ltd. cannot capitalise borrowing costs before 1st July, 20X1 (the day it starts to incur borrowing costs).
Accordingly, this calculation uses a capitalization period from 1st July, 20X1 to 31st March, 20X2 for this
expenditure.
Calculation of borrowing cost for financial year 20X2-20X3
Expenditure Capitalization Period Weighted average
(current year) Accumulated Expenditure
Date Amount
1st January, 20X1 ₹ 5 crore 3/12 ₹ 1.25 crore
30th June, 20X1 ₹ 20 crore 3/12 ₹ 5 crore
31st March, 20X2 ₹ 20 crore 3/12 ₹ 5 crore
30th June, 20X2 ₹ 5 crore 0/12 Nil
Total ₹ 11.25 crore
Borrowing costs eligible for capitalisation = ₹ 11.25 cr. x 10% = ₹ 1.125 cr.

Question 8

X Ltd. commenced the construction of a plant (qualifying asset) on 1 st September, 20X1, estimated to cost ₹
10 crores. For this purpose, X has not raised any specific borrowings, rather it intends to use general
borrowings, which have a weighted average cost of 11%. Total borrowing costs incurred during the period,
viz., 1st September, 20X1 to 31st March, 20X2 were ₹ 0.5 crore.
The other relevant details are as follows: (₹ in crore)
Month Cost of construction Cash outflows (paid in advance at
Accrued the start of each month)
September 1.50 3.00
October 0.50 1.70
November 1.50 2.50
December 0.50 -
January 1.80 1.00
February 0.70 -
March 3.00 1.50
Based on the above information, discuss the treatment of borrowing cost as per cash outflow basis and accrual
basis and also suggest the appropriate amount of interest that should be capitalised to the cost of the plant
in the financial statements for the year ended 31st March, 20X2? (RTP May’22)
Answer 8
Paragraph 14 of Ind AS 23, inter-alia, states that to the extent that an entity borrows funds generally and
uses them for the purpose of obtaining a qualifying asset, the entity shall determine the amount of

6.3 - 8 Chapter 6.3 Ind AS 23: Borrowing Costs

borrowing costs eligible for capitalisation by applying a capitalisation rate to the expenditures on
that asset. The capitalisation rate shall be the weighted average of the borrowing costs applicable to all
borrowings of the entity that are outstanding during the period. However, an entity shall exclude from
this calculation borrowing costs applicable to borrowings made specifically for the purpose of obtaining a
qualifying asset until substantially all the activities necessary to prepare that asset for its intended use or
sale are complete. The amount of borrowing costs that an entity capitalises during a period shall not
exceed the amount of borrowing costs it incurred during that period.
In this context, a question arises whether such expenditure should be based on costs accrued or actual cash
outflows. To contrast these two alternatives, presented below is the computation of borrowing costs based
on both the alternatives:

Month Cost of Average capital Cash outflows Average capital

construction expenditure (paid in advance at expenditure
Accrued the start of each
month)
September 1.50 1.50 x 7/12 = 0.875 3.00 3.00 x 7/12 = 1.75
October 0.50 0.50 x 6/12 = 0.25 1.70 1.70 x 6/12 = 0.85
November 1.50 1.50 x 5/12 = 0.625 2.50 2.50 x 5/12 = 1.04
December 0.50 0.50 x 4/12 = 0.17 --
January 1.80 1.80 x 3/12 = 0.45 1.00 1 x 3/12 = 0.25
February 0.70 0.70 x 2/12 = 0.12 --
March 3.00 3.00 x 1/12 = 0.25 1.50 1.50 x 1/12 = 0.125
9.50 2.74 9.70 4.02
If the average capital expenditure on the basis of costs accrued is taken, the borrowing costs eligible to be
capitalised would be ₹ 2.74 crore x 11% = 0.30 crore. Whereas, if average capital expenditure on the basis of
cash flows is taken, the borrowing costs eligible to be capitalised would be ₹ 4.02 crore x 11% = 0.44 crore.
Thus, there is a wide variance in the amount of borrowing cost to be capitalised, based on the accrual
basis and on actual cash flows basis. This divergence is often experienced during the implementation of large
projects, for example, an advance given to a supplier involves an upfront cash outflow while the actual
expenditure accrues in later periods (with the receipt of goods and services).
As per paragraph 18 of Ind AS 23, expenditures on a qualifying asset include only those expenditures that have
resulted in payments of cash, transfers of other assets or the assumption of interest-bearing liabilities.
Expenditures are reduced by any progress payments received and grants received in connection with the asset
(see Ind AS 20, Accounting for Government Grants and Disclosure of Government Assistance). The average
carrying amount of the asset during a period, including borrowing costs previously capitalised, is normally
a reasonable approximation of the expenditures to which the capitalization rate is applied in that period.
Where cash has been paid but the corresponding cost has not yet accrued interest becomes payable on
payment of cash. Therefore, the amount so paid should be considered for determining the amount of
interest eligible for capitalisation, subject to the fulfillment of other conditions prescribed in paragraph 16
of Ind AS 23. Accordingly, in the present case, interest should be computed on the basis of the cash
flows rather than on the basis of costs accrued. Therefore, the amount of interest eligible for capitalisation
would be ₹ 0.44 crore.
Another important factor to be noted is that paragraph 14 requires, inter alia, that the amount of borrowing
costs that an entity capitalises during a period shall not exceed the amount of borrowing costs it incurred during
that period. Thus, the amount of borrowing costs to be capitalised should not exceed the total borrowing costs
incurred during the period, that is ₹ 0.5 crore.

Question 9

X Ltd. commenced the construction of a plant (qualifying asset) on 1st September, 20X1, estimated to cost ₹
10 crores. For this purpose, X Ltd. has not raised any specific borrowings, rather it intends to use general
borrowings, which have a weighted average cost of 11%. Total borrowing costs incurred during the period,
viz., 1st September, 20X1 to 31st March, 20X2 were ₹ 0.5 crore.
The other relevant details are as follows: (₹ in crore)

Chapter 6.3 Ind AS 23: Borrowing Costs 6.3 - 9

 Month Cost of construction accrued Cash outflows (paid in advance at the start of
each month)
September 1.50 3.00
October 0.50 1.70
November 1.50 2.50
December 0.50 —
January 1.80 1.00
February 0.70 —
March 3.00 1.50
What is the amount of interest that should be capitalised to the cost of the plant in the financial statements
for the year ended 31st March, 20X2? (RTP Nov ‘24)
Answer 9
Paragraph 14 of Ind AS 23, inter-alia, states that to the extent that an entity borrows funds generally and uses
them for the purpose of obtaining a qualifying asset, the entity shall determine the amount of borrowing costs
eligible for capitalization by applying a capitalization rate to the expenditures on that asset. The capitalization
rate shall be the weighted average of the borrowing costs applicable to all borrowings of the entity that are
outstanding during the period. However, an entity shall exclude from this calculation borrowing costs applicable
to borrowings made specifically for the purpose of obtaining a qualifying asset until substantially all the
activities necessary to prepare that asset for its intended use or sale are complete. The amount of borrowing
costs that an entity capitalizes during a period shall not exceed the amount of borrowing costs it incurred during
that period.
In this context, a question arises whether such expenditure should be based on costs accrued or actual cash
outflows. To contrast these two alternatives, presented below is the computation of borrowing costs based on
both the alternatives:
Month Costs accrued Average capital Cash outflows Average capital
expenditure expenditure
September 1.50 1.50 x 7/12 = 0.875 3.00 3.00x7/12=1.75
October 0.50 0.50 x 6/12 = 0.25 1.70 1.70x6/ 12 = 0.85
November 1.50 1.50 x 5/12 = 0.625 2.50 2.50x5/12 = 1.04
December 0.50 0.50 x 4/12 = 0.17 - -
January 1.80 1.80 x 3/12 = 0.45 1.00 1x3/12 = 0.25
February 0.70 0.70 x 2/12 = 0.12 - -
March 3.00 3.00 x 1/12 = 0.25 1.50 1.50x1/12 = 0.13
9.50 2.74 9.70 4.02
If the average capital expenditure on the basis of costs accrued is taken, the borrowing costs eligible to be
capitalised would be ₹ 2.74 crore x 11% = 0.30 crore. Whereas if average capital expenditure on the basis of
cash flows is taken, the borrowing costs eligible to be capitalised would be ₹ 4.02 crore x 11% = 0.44 crore. Thus,
there is a wide variance in the amount of borrowing cost to be capitalised, based on the accrual basis and on
actual cash flows basis.
In this regard, paragraph 18 of Ind AS 23 states that expenditures on a qualifying asset include only those
expenditures that have resulted in payments of cash, transfers of other assets or the assumption of interest-
bearing liabilities. Expenditures are reduced by any progress payments received and grants received in
connection with the asset (see Ind AS 20, Accounting for Government Grants and Disclosure of Government
Assistance). The average carrying amount of the asset during a period, including borrowing costs previously
capitalised, is normally a reasonable approximation of the expenditures to which the capitalisation rate is
applied in that period.
Where cash has been paid but the corresponding cost has not yet accrued interest becomes payable on payment
of cash. Therefore, the amount so paid should be considered for determining the amount of interest eligible for
capitalisation, subject to the fulfillment of other conditions prescribed in paragraph 16 of Ind AS 23. Accordingly,
in the present case, interest should be computed on the basis of the cash flows rather than on the basis of costs
accrued. Therefore, the amount of interest eligible for capitalisation would be ₹ 0.44 crore.
Another important factor to be noted is that paragraph 14 requires, inter alia, that the amount of borrowing
costs that an entity capitalises during a period shall not exceed the amount of borrowing costs it incurred during
that period.

6.3 - 10 Chapter 6.3 Ind AS 23: Borrowing Costs

Thus, the amount of borrowing costs to be capitalised should not exceed the total borrowing costs
incurred during the period, that is ₹ 0.5 crore.

Multiple Choice Questions (MCQ)

1. When will the specific borrowings be considered as general borrowings?

(a) When substantially all the activities necessary to prepare the qualifying asset (for which specific
borrowings was taken) for its intended use or sale are complete
(b) When activities necessary to prepare the qualifying asset (for which specific borrowings was taken) for
its intended use or sale have been started
(c) When substantially all the activities necessary to prepare the qualifying asset (for which specific
borrowings was taken) for its intended use or sale are near to complete
(d) Specific borrowing are never considered as general borrowings in any circumstances
Ans: (a)

2. Borrowing costs do not include

(a) Interest expense calculated using the effective interest rate method as described in Ind AS 109
Financial Instruments
(b) Interest in respect of lease liabilities recognized in accordance with Ind A5 116, Leases
(c) Exchange differences arising from foreign currency borrowings to the extent that they are regarded as
an adjustment to interest costs
(d) Interest expenses on own finance resources or interest notional expenses
Ans: (d)

3. In determining the borrowing costs to be capitalised, the amount of expenditure on a qualifying asset
include only those expenditures that have resulted in
(a) Payments of cash
(b) Transfers of other assets
(c) The assumption of interest-bearing liabilities
(d) All of the above
Ans: (d)

4. Which of the following is not a qualifying asset?

(a) Financial assets
(b) Investment properties
(c) Intangible plants
(d) Bearer plants
Ans: (a)

5. In case of specific borrowings, the borrowing cost is capitalized-

(a) To the extent the borrowings are utilised for construction of the qualifying asset
(b) To the extent of the expenditure incurred on construction of the qualifying asset
(c) On total amount of specific borrowings from commencement date less income on temporary
investment made out of such borrowings
(d) On half of the specific borrowing amount
Ans: (c)

6. What will be the treatment of exchange difference resulting into unrealised gain while capitalising the
borrowing cost on foreign currency borrowings taken for construction of a qualifying asset?
(a) a would not be adjusted to interest even if there was an adjustment to interest in the previous year on
account of unrealised exchange loss on settlement of translation of same borrowings

Chapter 6.3 Ind AS 23: Borrowing Costs 6.3 - 11

 (b) It would be adjusted to interest to the extent of an adjustment to interest in the previous year an
account of unrealised exchange loss on settlement or translation of same borrowings
(c) It will be adjusted to interest irrespective of the fact that whether there was an adjustment to interest
in the previous year on account of unrealised exchange loss (on settlement or translation of same
borrowings) or not
(d) It will be adjusted to interest fully only if there was an adjustment to interest in the previous year on
account of unrealised exchange loss on settlement or translation of same barrowings
Ans: (b)

7. Which of the following would be considered as borrowing cost to be capitalised?

(a) Interest on working capital
(b) Interest on borrowings used for manufacturing inventories in large quantities on a repetitive basis
(c) Interest on borrowings utilised to acquire biological assets measured at fair value
(d) Dividend paid on redeemable preference shares used to fund the development of a qualifying asset
Ans: (d)

8. In determining the borrowing costs to be capitalised, the amount of expenditure on a qualifying asset are
not reduced by
(a) Progress payments received
(b) Grants received in connection with the asset
(c) Income on temporary investment of specific borrowings
(d) Both (a) and (b)
Ans: (c)

9. The capitalisation rate is

(a) The weighted average of the borrowing costs applicable to all the general borrowings of the entity that
are outstanding during the period
(b) The weighted average of the borrowing costs applicable to all the general and specific borrowings of
the entity that are outstanding during the period
(c) The weighted average of the borrowing costs applicable to all the specific borrowings of the entity that
are outstanding during the period
(d) The weighted average of the borrowing costs applicable to those general borrowings of the entity only
that are used during the period for construction of that particular qualifying asset
Ans: (a)
10. Adit Labs are planning to expand their business and open two more branches in the vicinity of two new
hospitals being built in the area. The enterprise is using funds from their general borrowings for this
expansion project. The finance director of the company has briefly read about the capitalisation of the
interest paid on the borrowings. He has sought your clarification on this matter if his entity can capitalise
interest of 10% which is the highest interest rate of all the borrowings they have made during the year.
Which of the following are correct about the capitalisation of interest on borrowings made by a company
as per Ind AS 23 Borrowing Costs?
(a) Finance director is right, and be can use 10% as capitalisation rate for calculating the eligible borrowing
costs to be capitalised on the qualifying asset
(b) Capitalisation rate should be weighted average of all the borrowing costs applicable to the borrowings
of the enterprise that are outstanding during the period, other than borrowings made specifically for
the purpose of obtaining a qualifying asset
(c) Interest paid on general borrowing have to be calculated in accordance with ICDS (Income
Computation and Disclosure Standards) which is also required for calculation of current tax and
deferred tax
(d) Entity should use the lowest interest rate of all the borrowings outstanding during the period as
capitalisation rate to calculate the eligible borrowing cost
Ans: (b)

6.3 - 12 Chapter 6.3 Ind AS 23: Borrowing Costs

CHAPTER 18 : CASE SCENARIOS

LDR Questions
Q3
Q 14

CS 1 (RTP May’24)

FA Ltd. is a company which manufactures aircraft parts and engines and sells them to large multinational
companies like Boeing and Airbus Industries. Following are the details of some of the transactions entered
into by the company:
i. On 1st April 20X2, the company began the construction of a new production line in its aircraft parts
manufacturing shed.
Costs relating to the production line are as follows:
Details Amount ₹
Costs of the basic materials (list price ₹ 12.5 lakhs less 20% trade discount) 10.00
Recoverable goods and services tax incurred but not included in the purchase cost 1.00
Employment costs of the construction staff for three months till 30th June 20X2 1.20
Other overheads directly related to the construction 0.90
Payments to external advisors relating to the construction 0.50
Expected dismantling and restoration costs 2.00
The production line took two months to make ready for use and was brought into use on 31st May 20X2.
The other overheads were incurred during the two-month period ended on 31st May 20X2. They included an
abnormal cost of ₹ 0.3 lakhs caused by a major electrical fault.
The production line is expected to have a useful economic life of eight years. After 8 years, FA Ltd. is legally
required to dismantle the plant in a specified manner and restore its location to an acceptable standard. The
amount of ₹ 2 lakhs included in the cost estimates is the amount that is expected to be incurred at the end of
the useful life of the production line. The appropriate discount rate is 5%. The present value of ₹ 1 payable
in 8 years at a discount rate of 5% is approximately ₹ 0.68.
Four years after being brought into use, the production line will require a major overhaul to ensure that it
generates economic benefits for the second half of its useful life. The estimated cost of the overhaul, at
current prices, is ₹ 3 lakhs.
No impairment of the plant had occurred by 31st March 20X3.
ii. During the year ended 31st March 20X3, FA Ltd. provided consultancy services to a customer regarding the
installation of a new production system related to aircraft parts. The system has caused the customer
considerable problems, so the customer has taken legal action against the Company for the loss of profits
that has arisen as a result of the problems with the system. The customer has claimed damages to the tune
of ₹ 1.6 lakhs.
The legal department of FA Ltd. considers that there is a 25% chance the claim can be successfully
defended. The legal department further stated that they are reasonably confident the Company is covered
by insurance against these types of loss. Th accountant feels nothing needs to be provided for this claim as
the Company is suitably covered against any possible losses.

Chapter 18: Case Scenarios 18 - 1

 iii. FA Ltd. has an associate company, Flynet Limited. Following are the information of Flynet Limited for the
year ended 31st March 20X3:
Particulars ₹ in lakhs
Net Income after taxes 120
Decrease in accounts receivables 20
Depreciation 25
Increase in inventory 10
Increase in accounts payable 7
Decrease in wages payable 5
Tax charge for the year (deferred tax liabilities) 15
Profit from sale of land 2
On the basis of the facts given above, chose the most appropriate answer to Questions 1 to 5 below based on
the relevant Indian Accounting Standards (Ind AS).

1. Which of the following items need to be capitalized in determining the cost of Production Line?
(Chapter Ind AS 16 “Property, Plant and Equipment”)
(a) Abnormal cost of ₹ 0.3 lakhs
(b) Recoverable GST of ₹ 1 lakhs
(c) Initial estimate of the costs of dismantling and removing the item and restoration of site of ₹ 2 lakhs
(d) Initial estimate of the costs of dismantling and removing the item and restoration of site of ₹ 1.36
lakhs
Ans:(d)
Reason : As per para 16(c) of Ind AS 16, elements of cost of PPE includes the initial estimate of the costs of
dismantling and removing the item and restoring the site on which it is located, the obligation for which an
entity incurs either when the item is acquired or as a consequence of having used the item during a particular
period for purposes other than to produce inventories during that period.

2. Calculate the company’s associate Flynet Ltd.’s cash flow from operations. (Chapter Ind AS 7 “Statement
of Cash Flows”)
(a) ₹ 158 lakhs
(b) ₹ 170 lakhs
(c) ₹ 174 lakhs
(d) None of the above
Ans:(b)
Cash flow from operating activities – Indirect method
Particulars ₹ in lakhs
Net Income after taxes 120
Add /(Less) No- cash or non-operating item:
Depreciation 25
Profit from sale of land (2)
Tax charges for the year (deferred tax liabilities) 15
158
Decrease in accounts receivables 20
Increase in inventory (10)
Increase in accounts payable 7
Decrease in wages payable (5)
Cash flow from operations 170

3. What accounting treatment should be done in FA Ltd.’s books for the year ending 31st March 20X3, as
the customer has taken legal action against the Company on the loss of profits that has arisen as a result
of the problems with the system?
(Chapter Ind AS 37 “Provisions, Contingent Liabilities and Contingent Assets”)

18 - 2 Chapter 18: Case Scenarios

 (a) Nothing needs to be provided for claim instituted by the customer as the Company is suitably covered
against any possible losses.
(b) Provision of ₹ 1.6 lakhs should be recognised with a corresponding charge to profit or loss.
(c) Provision of ₹ 0.4 lakhs as per best possible outcome should be recognised with a corresponding
charge to profit or loss.
(d) Contingent Liability would be disclosed in the 31st March 20X3 financial statements. Charge to profit
or loss if any would be recognised in the period when the claim is settled.
Ans:(b)
Reason:
In accordance with Ind AS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’, the claim made by
the customer needs to be recognised as a liability in the financial statements for the year ended 31st March
20X3.
The standard stipulates that a provision should be made when, at the reporting date:
– An entity has a present obligation arising out of a past event.
– There is a probable outflow of economic benefits.
– A reliable estimate can be made of the outflow.
Since, all three of the above conditions are satisfied here, a provision is required to be made.
The provision should be measured at the amount the entity would rationally pay to settle the obligation at
the reporting date. Where there is a range of possible outcomes, the individual most likely outcome is often
the most appropriate measure to use. In this case, a provision of ₹ 1.6 lakhs seems appropriate, with a
corresponding charge to profit or loss.

4. Compute the total amount to be charged to the Statement of Profit and Loss with respect to Production
Line for the year ending 31st March 20X3 and the balance of Provision for Dismantling Cost carried to
Balance Sheet. (Chapter Ind AS 16 “Property, Plant and Equipment”)
(a) ₹ 1.70 lakhs; ₹ 1.36 lakhs
(b) ₹ 1.42 lakhs; ₹ 1.70 lakhs
(c) ₹ 1.76 lakhs; ₹ 1.42 lakhs
(d) ₹ 1.42 lakhs; ₹ 1.76 lakhs
Ans:(c)
5. Compute the cost of the production Line to be capitalized initially on 31st May, 20X2.
(Chapter Ind AS 16 “Property, Plant and Equipment”)
(a) ₹ 13.26 lakhs
(b) ₹ 14.60 lakhs
(c) ₹ 13.96 lakhs
(d) ₹ 15.76 lakhs
Ans:(a)
Reason for 4 & 5:
Statement showing computation of cost of production line
Particulars ₹ in lakhs
Purchase cost 10.00
GST – recoverable goods and services tax not included -
Employment costs during the period of getting the production line ready for 0.80
use [(1.2/3 month) x 2 month]
Other overheads – abnormal costs of ₹ 0.3 lakhs has been excluded (0.90- 0.30) 0.60
Payment to external advisors – directly attributable cost 0.50
Dismantling costs – recognized at present value (2 lakhs x
0.68) 1.36
Total 13.26

Chapter 18: Case Scenarios 18 - 3

 Provision for dismantling cost carried to Balance Sheet
Particulars ₹ in lakhs
Non-current liabilities (₹ 2 lakhs x 0.68) 1.36
Add: Finance cost (1.36 x 5% x 10/12) 0.06
Net book value – carried to Balance Sheet 1.42
Extract of Statement of Profit and Loss
Particulars ₹ in lakhs
Depreciation (W.N.) 1.70
Finance cost (1.36 x 5% x 10/12) 0.06
Amounts carried to Statement of Profit & Loss 1.76
Working Note:
Calculation of depreciation charge
Particulars ₹ in lakhs
The asset is split into two depreciable components out of the total
capitalization amount of 13.26 lakhs:
• Depreciation for ₹ 3 lakhs with a useful economic life of four
years (3 lakhs x ¼ x 10/12). 0.63
(This is related to a major overhaul to ensure that it generates
economic benefits for the second half of its useful life)
• Depreciation for ₹ 10.26 lakhs (13.26 – 3.00) with a useful
economic life of eight years will be: ₹ 10.26 lakhs x 1/8 x 10/12 1.07
Total depreciation to be charged to Statement of Profit and Loss for
the year ended 31st March 20X3 1.70

CS 2 (RTP May’24)

HS Limited (HSL) is a car manufacturing company. During the year, HSL has entered into many transactions,
details of which are given below.
i. With the intention to expand, HSL has entered into a Share Purchase Agreement ("SPA") with the
shareholders of FM Limited to purchase 30% stake in FM Limited as at 1st June 20X2 at a price of ₹ 30 per
share. As per the terms of SPA, HSL has an option to purchase an additional 25% stake in FM Limited on or
before 15th June 20X2 at a price of ₹ 30 per share. Similarly, the selling shareholder has an option to sell
additional 25% stake in FM Limited on or before 15th June, 20X2 to HSL at a price of ₹ 30 per share. The
decisions on relevant activities of FM Limited are made in Annual General Meeting / Extraordinary General
Meeting (AGM / EGM). A resolution in AGM / EGM is passed when more than 50% votes are cast in favour
of the resolution. An AGM / EGM can be called by giving atleast 21 days advance notice to all shareholders.
ii. During the year, HSL issued Compulsory Convertible Debentures ("CCDs") on a private placement basis for
₹ 100 lakh. Each CCD is convertible into 5 shares at the end of 4 years from the date of issue and an annual
interest is payable at the rate of 6% p.a. At initial recognition, HSL recognized a liability component of
compound instrument at ₹ 20,79,063. HSL also incurred expenses of ₹ 2,00,000 in connection with the issue
of the instrument. Nature of expenses includes fees paid to legal advisors, registration and regulatory fees.
iii. HSL acquired a 40% stake in NM Limited as at 1st January, 20X2 for ₹ 8,00,000 and classified the investment
in NM Limited as an associate. As at 1st January, 20X2, the carrying amount and fair value of plant &
equipment of NM Limited is ₹ 3,00,000 and ₹ 5,00,000 respectively with remaining useful life of 5 years
(i.e. 20 quarters). From 1st January, 20X2 to 31st March, 20X2, NM Limited generated a profit of ₹ 50,000.
iv. While selling a car, HSL provides a trade discount of 1% on sale price which is mentioned on the invoice.
HSL provides a credit period of 7 days to its customers, however if paid upfront then HSL gives an additional
cash discount of 2%. HSL also provides a voucher worth ₹ 500 with a validity of 1 year which can be used
at an apparel store.

18 - 4 Chapter 18: Case Scenarios

On the basis of the facts given above, chose the most appropriate answer to Questions 6 to 10 below
based on the relevant Indian Accounting Standards (Ind AS).
1. At what amount HSL shall carry its investments in NM Limited in its consolidated financial statements as
at 31st March, 20X2? (Chapter Consolidated and Separate Financial Statements of Group Entities)
(a) ₹ 8,00,000
(b) ₹ 8,20,000
(c) ₹ 8,16,000
(d) ₹ 8,10,000
Ans:(c)
Reason:
As per para 10 of Ind AS 28, under the equity method, on initial recognition the investment in an associate
or a joint venture is recognised at cost, and the carrying amount is increased or decreased to recognise the
investor’s share of the profit or loss of the investee after the date of acquisition.
Accordingly,
Cost of investment for 40% stake on acquisition date ₹ 8,00,000
Add: Share of post-acquisition profit and loss (50,000 x 40%) ₹ 20,000
Less: Share of post-acquisition loss due to additional
depreciation [{(5,00,000 – 3,00,000)/20} x 40%] (₹ 4,000)
₹ 8,16,000

2. How should HSL account for the trade discount, cash discount and voucher given to customers on sale
of a car? (Chapter Ind AS 115 “Revenue from Contracts with Customers”)
(a) Trade discount shall be reduced from the revenue however cash discount and value of voucher shall
be charged as expenses.
(b) Trade discount and cash discount both shall be reduced from the revenue however value of voucher
shall be charged as expenses.
(c) Trade discount, cash discount and value of voucher shall be charged as expenses.
(d) Trade discount, cash discount and value of voucher shall be reduced from revenue.
Ans:(d)
Reason:
Discounts and vouchers are incentives given to customers. Incentives For , Paragraph 70 of Ind AS 115, inter-
alia, states that consideration payable to a customer includes cash amounts that an entity pays, or expects to
pay, to the customer (or to other parties that purchase the entity’s goods or services from the customer).
Consideration payable to a customer also includes credit or other items (for example, a coupon or voucher)
that can be applied against amounts owed to the entity (or to other parties that purchase the entity’s goods
or services from the customer). An entity shall account for consideration payable to a customer as a reduction
of the transaction price and, therefore, of revenue. Therefore, cash incentives (payments given to the customer)
would be considered as a reduction in the transaction price and in the measurement of revenue when the goods
are delivered.

3. What shall be the accounting treatment of directly attributable expenses of ₹ 2 lakh incurred in
connection with the issue of Compulsory Convertible Debentures?
(Chapter Accounting and Reporting of Financial Instruments)
(a) Entire ₹ 2,00,000 shall be recognized as expenses in the statement of profit and loss in the
current year.
(b) Entire ₹ 2,00,000 shall be reduced from equity in the current year.
(c) A proportion of ₹ 1,58,419 shall be reduced from equity and Balance of ₹ 41,581 shall be
recognized as interest cost over the period of 4 years using an effective interest method.
(d) Entire ₹ 2,00,000 shall be recognized as interest cost over the period of 4 years using effective
interest method.
Ans:(c)
Reason :
Compulsory convertible debentures with annual interest payout is a compound financial instrument. As per
the information given in the question the liability element to be initially recognised is ₹ 20,79,063. Hence

Chapter 18: Case Scenarios 18 - 5

 the equity element would be ₹ 79,20,937 (1,00,00,000 – 20,79,063). Transaction cost of ₹ 2,00,000 will be
apportioned in equity and liability component in the ratio of 79,20,937 : 20,79,063, which would be as
follows:
Transaction cost attributable to equity = 2,00,000 x (79,20,937 / 1,00,00,000) = ₹ 1,58,419
Transaction cost attributable to liability = 2,00,000 x (20,79,063 / 1,00,00,000) = ₹ 41,581

4. With more acquisitions, at the end of the year, HSL has investments in 2 subsidiaries, 3 associates and 1
joint venture. Which of the following statements is correct in relation to accounting of these investments
in separate financial statements? (Chapter Consolidated and Separate Financial Statements of Group
Entities)
(a) HSL is required to measure all such investments at cost.
(b) HSL has an option to account for the investments in associates and joint ventures using equity
method of accounting and carry the investments in subsidiaries at cost.
(c) HSL has an option for each investment to measure either at cost or in accordance with Ind AS
109.
(d) HSL has an option to measure all such investments either at cost or in accordance with Ind AS
109. The option is available for each category of investments separately (i.e. subsidiaries,
associates and joint venture).
Ans:(d)
Reason:
As per para 10 of Ind AS 27, when an entity prepares separate financial statements, it shall account for
investments in subsidiaries, joint ventures and associates either: (a) at cost, or (b) in accordance with Ind AS
109. The entity shall apply the same accounting for each category of investments.
In the present case, investment in subsidiaries, associates and joint ventures are considered to be different
categories of investments. Further, Ind AS 27 requires accounting for the investment in subsidiaries, joint
ventures and associates either at cost, or in accordance with Ind AS 109 for each category of Investment.
Thus, an entity can carry its investments in subsidiaries at cost and its investments in associates or joint
ventures as financial assets in accordance with Ind AS 109 in its separate financial statements.

5. With respect to the SPA entered by HSL, determine the date when HSL gained control over FM Limited
(Chapter Consolidated and Separate Financial Statements of Group Entities)
(a) 1st June, 20X2.
(b) 15th June, 20X2.
(c) On the date of AGM/EGM
(d) On the date when the resolution for AGM/EGM is issued.
Ans:(a)
Reason :
Paragraph 10 of Ind AS 110 ‘Consolidated Financial Statements’, states that an investor has power over an
investee when the investor has existing rights that give it the current ability to direct the relevant activities,
i.e. the activities that significantly affect the investee’s returns.
As per the facts given in the question, HSL. has 15 days to exercise the option to purchase 25% additional
stake in FM Ltd. which will give it majority voting rights of 55% (30% + 25%). This is a substantive potential
voting rights which is currently exercisable.
Further, the decisions on relevant activities of FM Ltd. are made in AGM / EGM. An AGM / EGM can be called
by giving atleast 21 days advance notice. A resolution in AGM / EGM is passed when more than 50% votes
are casted in favour of the resolution. Thus, the existing shareholders of FM Ltd. are unable to change the
existing policies over the relevant activities before the exercise of option by HSL. HSL can exercise the option
and get voting rights more than 50% at the date of AGM / EGM. Accordingly, the option contract gives HSL
the current ability to direct the relevant activities even before the option contract is settled. Therefore, HSL
controls FM Ltd. as at 1st June, 20X2.

18 - 6 Chapter 18: Case Scenarios

CS 3 (MTP 10 Marks Mar’24) LDR

U Ltd. is engaged in mining and many other industries and prepares its financial statements following Indian
Accounting Standards and follows April-March as their financial year. During the year 20X2 -20X3, the
company has faced some issues and for their solution seeks your professional advice.
(i) U Ltd. and F Ltd. are partners of a joint operation engaged in the business of mining precious metals. The
entity uses a jointly owned drilling plant in its operations. During the year ended 31 st March 20X3, an
inspection was conducted by the government authorities in the mining fields. The inspection authorities
concluded that adequate safety measures were not followed by the entity. As a consequence, a case was
filed and a penalty of ₹ 50 crores has been demanded from U Ltd.
The legal counsel of the company has assessed the demand and opined that appeals may not be useful,
and the appeal orders will be unfavourable to the joint arrangement. Out of ₹ 50 crores (to be paid by U
Ltd.), ₹ 30 crore will be reimbursed by F Ltd. later, as per the terms of the Joint Operation Agreement. At
the year end, actual reimbursement was not received from F Ltd.
(ii) On 1st April 20X2, U Ltd. leased a machine from D Ltd. on a three-year lease. The expected future economic
life of the machine on 1st April 20X2 was eight years. If the machine breaks down, then under the terms of
the lease, D Ltd. would be required to repair the machine or provide a replacement.
D Ltd. agreed to allow U Ltd. to use the machine for the first six months of the lease without the payment
of any rental as an incentive to U Ltd. to sign the lease agreement. After this initial period, lease rentals of
₹ 2,10,000 were payable six-monthly in arrears, the first payment falling due on 31st March 20X3.
(iii) U Ltd. has issued 10,00,000, 9% cumulative preference shares. The Company has arrears of ₹ 15 crores of
preference dividend as on 31st March 20X3, it includes current year arrears of ₹ 1.75 crores. The Company
did not declare any dividend for equity shareholders as well as for preference shareholders.
Further U Ltd. has also issued certain optionally convertible debentures, which are outstanding as at the
year end.
(iv) On 1st January 20X3, U Ltd. acquired 30% of the shares of T Ltd. The investment was accounted for as an
associate in U Ltd.’s consolidated financial statements. Both U Ltd. and T Ltd. have an accounting year end
of 31st March 20X3. U Ltd. has no other investments in associates.
Net profit for the year in T Ltd.’s income statement for the year ended 31 st March 20X3 was ₹ 0.23 crores.
It declared and paid dividend of ₹ 0.1 crore on 1st March 20X3. No other dividends were paid in the year.
(v) On 1st January, 20X3, U Ltd. also acquired a 60% stake in S Ltd. The cash consideration payable was ₹ 1
crore to be paid immediately, and ₹ 1.21 crores after two years. The fair value of net assets of S Ltd. at
acquisition date was ₹ 3 crores. U Ltd. has calculated that its cost of capital is 10%. Non- controlling interest
is measured at the proportionate share of identifiable net assets.
Analyze the transactions mentioned above and choose the most appropriate option in the below questions
1 to 5 in line with relevant Ind AS:

1. With respect to a joint operation engaged in the business of mining precious metals, how will the liability
be disclosed in the books of U Ltd.?
(Chapter – 8.2 Unit 2: Ind AS 37 “Provisions, Contingent Liabilities and Contingent Assets”)
(a) Provision for ₹ 20 crores and a contingent liability for ₹ 30 crores
(b) Contingent liability for ₹ 50 crores
(c) Provision for ₹ 30 crores and a contingent liability for ₹ 20 crores
(d) Provision for ₹ 50 crores.
Ans:(d)

2. Calculate the current liability of leased machine from D Ltd. to be shown in the balance sheet as at 31st
March 20X3. (Chapter – 6.8 Unit 8: Ind AS 116 “Leases”)
(a) ₹ 70,000
(b) ₹ 1,40,000
(c) ₹ 3,50,000
(d) ₹ 4,20,000
Ans:(a)

Chapter 18: Case Scenarios 18 - 7

ADVANCED FINANCIAL
MANAEGEMENT

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'A' chapters in the ABC in each chapter. in order, from questions during the
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Chapters in the index are Identify the key concepts for each
categorized as A, B, or C based on chapter using the list provided at
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weight, and give adequate struggle with a question, revisit the
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Table of Contents
s

Sr. Particulars PAGE NO. IMP

1 Financial Policy and Corporate Strategy 1-1 – 1-7 B
2 Risk Management 2-1 – 2-9 C
3 Advanced Capital Budgeting Decisions 3-1 – 3-42 A
4 Security Analysis 4-1 – 4-9 C
5 Security Valuation 5-1 – 5-40 B
6 Portfolio Management 6-1 – 6-49 A
7 Securitization 7-1 – 7-8 B
8 Mutual Funds 8-1 – 8-29 B
9 Derivatives Analysis and Valuation 9-1 – 9-29 A
10 Foreign Exchange Exposure and Risk Management 10-1 – 10-37 A
11 International Financial Management 11-1 – 11-21 C
12 Interest Rate Risk Management 12-1 – 12-19 C
13 Business Valuation 13-1 – 13-26 C
14 Mergers, Acquisitions and Corporate Restructuring 14-1 – 14-29 A
15 Startup Finance 15-1 – 15-17 B
16 Case Scenarios 16-1 – 16-16 A

ABC Analysis

Very Important, Moderately Less critical but still

A Read on priority
B Important
C essential

Ensure you thoroughly read all chapters without skipping any. The ABC analysis is
designed to help you prioritize based on past trends, but it should not replace
comprehensive preparation.
 A

CHAPTER 3: ADVANCED CAPITAL BUDGETING DECISIONS

CONCEPTS OF THIS CHAPTER

• Current trends in Capital Budgeting
• Risk in Investment Decisions
• Factors Affecting Capital Budgeting: Influence of internal (e.g., cash flow) and
external (e.g., economic conditions) factors. LDR Questions
• Methods for Incorporating Risk Q 13 Q 32
• Adjusted Present Value (APV) Q 24 Q 38
• Optimum Replacement Cycle

QUICK REVIEW OF IMPORTANT FORMULAS

1. Cash Flow after tax: (R-C) × (1-T) + D × T. Where R is Revenue, C is Cost, T is Tax rate and D is Depreciation.
Conversion of cashflow from real to nominal or nominal to real
Rn = Rr ∗(1+P) Where, Rn is Nominal return, Rr is Real return, P is Expected Inflation Rate (%).
Conversion of discount rate from real to nominal or nominal to real
(1+ Rn) = (1+ Rr) ∗ (1+P) Where, Rn is Nominal rate of return (%),Rr is Real rate of return (%)
P is Expected Inflation Rate (%).

2. Statistical Methods of Incorporating Risk in Capital Budgeting:

2.1 Probability weighted Cashflows: Expected Value :∑𝑷𝒊 𝑵𝑪𝑭𝒊
Where, Pi is the probability and NCFi is the Net Cash flows.
∑(𝐱−𝐱̅)𝟐
2.2 Variance: = ∑ 𝐏𝐢(𝐱 − 𝐱̅)𝟐
𝐧
Where x is Net cash flow, 𝐱̅ is the expected net cashflow and Pi is the probability.

Variance as per Hillers Model: σ2 = ∑(𝟏 + 𝐫)−𝟐𝐢 σ𝟐𝐢

Where, 1+r is the discount rate and i is the time.
2.3 Standard Deviation: √𝛔𝟐 = √Variance
Standard Deviation
2.4 Coefficient of Variation:
Expected Cashflow

3. Conventional Methods of Incorporating Risk in Capital Budgeting:

3.1 Risk Adjusted Discount Rate (RADR)
RADR= R f + β(R m − R f ) or RADR = Rf + Risk Premium
Where,𝑅𝑚 is Market return 𝑅𝑓 is Risk free rate of return and β is beta
Risk premium = Risk index × (Minimum required return of firm – Risk free rate)

Certain Cashflows
3.2 Certainty Equivalent = Expected Risky Cashflows

3-1 Chapter 3: Advanced Capital Budgeting Decisions

 α × NCF
4. NPV= ∑ − Initial Investment
(1+k)n
Where, 𝛼 is Risk Adjustment factor, NCF is net cash flow without risk adjustment, K is Risk free rate and
n is number of periods.
• Higher the CE of project - lower the risk and
• Lower the CE of project - higher the risk
Expected Net Present Value (Multiple Periods) = Sum of Present Value of Cashflows calculated
Individually – Initial Investment
Adjusted Present Value: Base Case NPV (on unlevered cost ofcapital) + PV of tax benefits on interest
𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕 𝑪𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘
5. Profitability Index =
𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
6. Replacement Decision:
Step 1: Net Cash flow = Cost of new Machine – (tax saving + market value of old machine) [usually a
negative value]
Step 2: (Change in Sales +/- Change in Operating Cost – Change in Depreciation) × (1- Tax) + Change in
Depreciation) × (1- Tax) + Change in Deprecation
Or
(Change in Sales +/- Change in Operating Cost ) ×(1- Tax) + (Change in Depreciation × Tax)
Step 3: Present Value of Cashflows = Present Value of Yearly Cash Flows + Present Value of Salvage
Step 4: NPV = Step 1 [cash outflow i.e - ve value] + Step 3 [ cash inflow i.e +ve value]
𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐂𝐚𝐬𝐡 𝐎𝐮𝐭𝐟𝐥𝐨𝐰 (𝐏𝐕𝐂𝐅)
7. Optimum Replacement Cycle: Equivalent Annual Cost (EAC) = 𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐕𝐚𝐥𝐮𝐞 𝐀𝐧𝐧𝐮𝐢𝐭𝐲 𝐅𝐚𝐜𝐭𝐨𝐫( 𝐏𝐕𝐀𝐅)

Question & Answers

Topic : Different Methods for Best Project Calculation

Question 1
DISCUSS the advantages of Certainty Equivalent Method. (MTP 2 Marks, Mar’21)
Answer 1
advantages of Certainty Equivalent Method:
1. The certainty equivalent method is simple and easy to understand and apply.
2. It can easily be calculated for different risk levels applicable toF different cash flows. For example, if in a
particular year, a higher risk is associated with the cash flow, it can be easily adjusted and the NPV can be
recalculated accordingly.

Question 2
Adjustment of risk is required in capital budgeting decision, give reasons for it. (PYP 2 Marks Dec’21 & Nov’18)

Answer 2
Reasons for adjustment of Risk in Capital Budgeting decisions are as follows:
There is an opportunity cost involved while investing in a project for the level of risk. Adjustment of risk is
necessary to help make the decision as to whether the returns out of the project are proportionate with the
risks borne and whether it is worth investing in the project over the other investment options available.
Risk adjustment is required to know the real value of cash Inflows. Higher risk will lead to higher risk premium
and also the expectation of higher return.

Exam Insights: This question has an internal choice also in which examinees were asked for reasons of
adjustment of risk in Capital budgeting decision. Very few students attempted this question, and no
one answered satisfactorily.

Chapter 3: Advanced Capital Budgeting Decisions 3-2

 Question 3

EXPLAIN the concept of risk adjusted discount rate. (MTP 5 Marks, Oct’23, SM)

Answer 3
Risk Adjusted Discount Rate: The use of risk adjusted discount rate (RADR) is based on the concept that
investors demand higher returns from the risky projects. The required rate of return on any investment should
include compensation for delaying consumption plus compensation for inflation equal to risk free rate of return,
plus compensation for any kind of risk taken. If the risk associated with any investment project is higher than
risk involved in a similar kind of project, discount rate is adjusted upward in order to compensate this additional
risk borne.
A risk adjusted discount rate is a sum of risk-free rate and risk premium. The Risk Premium depends on the
perception of risk by the investor of a particular investment and risk aversion of the Investor.
So Risks adjusted discount rate = Risk free rate+ Risk premium
Risk Free Rate: It is the rate of return on Investments that bear no risk. For e.g., Government securities yield a
return of 6 % and bear no risk. In such case, 6 % is the risk -free rate.
Risk Premium: It is the rate of return over and above the risk-free rate, expected by the Investors as a reward
for bearing extra risk. For high-risk project, the risk premium will be high and for low risk projects, the risk
premium would be lower.

Question 4

A new project “Wiwitsu” requires an initial outlay of ₹ 4,50,000. The company uses certainty equivalent
method approach to evaluate the project. The risk-free rate is 7%. Following information is available:
Year Cash Flow After Tax (₹) Certainty Equivalent Coefficient
1 1,50,000 0.90
2 2,25,000 0.80
3 1,75,000 0.58
4 1,50,000 0.56
5 70,000 0.50
PV Factor at 7%
Year 1 2 3 4 5
PV Factor 0.935 0.873 0.816 0.763 0.713
Is investment in the project beneficial based on above information? (MTP 5 Marks Sep’23)
(Same concept different figures PYP 5 Marks Jan’21)

Answer 4
Calculation of Net Present Value of the Project
Year Cash Inflows After C.E. Adjusted Cash Present Value Present Value
Tax (in ₹) Inflows (in ₹) Factor (in ₹)
1 1,50,000 0.90 1,35,000 0.935 1,26,225
2 2,25,000 0.80 1,80,000 0.873 1,57,140
3 1,75,000 0.58 1,01,500 0.816 82,824
4 1,50,000 0.56 84,000 0.763 64,092
5 70,000 0.50 35,000 0.713 24,955
Total Present Value of Cash Inflows 4,55,236
Less: Initial Investment or Cash Outflow required for “Wiwitsu” (4,50,000)
Net Present Value 5,236
Conclusion: As the Net Present Value of the project after considering the Certainty Equivalent factors are still
positive; it may be advised to invest in project “Wiwitsu”

3-3 Chapter 3: Advanced Capital Budgeting Decisions

Question 5

Determine the Risk Adjusted Net Present Value of the following projects:
A B C
Net cash outlays (₹) 70,000 1,20,000 2,20,000
Project life 5 years 5 years 5 years
Annual cash inflow (₹) 30,000 42,000 70,000
Coefficient of Variation 2.2 1.6 1.2
The company selects the risk-adjusted discount rate on the basis of the Coefficient of variation.
Coefficient of Variation Applicable Risk adjusted discount rate (i) PVIFA (i,5)
0 10% 3.791
0.4. 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2 22% 2.864
>2.0 25% 2.689
Which project should be selected by the company based on Risk Adjusted NPV? (PYP 5 Marks Nov’22)
(Same concept different figures MTP 5 Marks, March’19, & New SM)

Answer 5
Selection of project on the basis of Risk Adjusted Net Present Value
Particulars A B C
Co efficient of Variation 2.2 1.6 1.2
Applicable discount rate (%) 25 18 16
Annual cash inflow (₹) 30,000 42,000 70,000
Relevant PVIFA 2.689 3.127 3.274
PV of cash inflow (₹) 80,670 1,31,334 2,29,180
Less: Cash outflow (₹) 70,000 1,20,000 2,20,000
Risk adjusted NPV (₹) 10,670 11,334 9,180
Conclusion: Project B should be selected as its Risk adjusted NPV is high.
Exam Insights: In this Numerical problem, by giving some details about three projects, examiners were
asked to select a project for investment, based on Risk Adjusted NPV of cash i nflows. Since it was a
direct question and similar problem has been solved in the study material, many attended it correctly
and scored full mark Hence, a good performance was perceived.

Question 6

K.P. Ltd. is investing Rs.50 lakhs in a project. The life of the project is 4 years. Risk free rate of return is 6% and
risk premium is 6%, other information is as under:
Sales of 1st year Rs.50 lakhs
Sales of 2nd year Rs.60 lakhs
Sales of 3rd year Rs.70 lakhs
Sales of 4th year Rs.80 lakhs
P/V Ratio (same in all the years) 50%
Fixed Cost (Excluding Depreciation) of 1st year Rs.10 lakhs
Fixed Cost (Excluding Depreciation) of 2nd year Rs.12 lakhs
Fixed Cost (Excluding Depreciation) of 3rd year Rs.14 lakhs
Fixed Cost (Excluding Depreciation) of 4th year Rs.16 lakhs
Ignoring interest and taxes,
You are required to calculate NPV of given project on the basis of Risk Adjusted Discount Rate.
Discount factor @ 6% and 12% are as under:

Chapter 3: Advanced Capital Budgeting Decisions 3-4

 ear 1 2 3 4
Discount Factor @ 6% 0.943 0.890 0.840 0.792
Discount Factor@ 12% 0.893 0.797 0.712 0.636
(PYP 5 Marks, Jul’21)

Answer 6
Calculation of Cash Flow
Year Sales P/V ratio Contribution Fixed Cost Cash Flows (Rs. in lakhs)
(Rs. in Lakhs) (A) (B) (Rs. in Lakhs) (Rs. in Lakhs) (E) = (C – D)
(C) = (A x B) (D)
1 50 50% 25 10 15
2 60 50% 30 12 18
3 70 50% 35 14 21
4 80 50% 40 16 24
When risk-free rate is 6% and the risk premium expected is 6%, then risk adjusted discount rate would be 6%
+ 6% =12%.
Calculation of NPV using Risk Adjusted Discount Rate (@ 12%)
Year Cash flows Discounting Factor @ 12% Present Value of Cash Flows
(Rs. in Lakhs) (Rs. in lakhs)
1 15 0.893 13.395
2 18 0.797 14.346
3 21 0.712 14.952
4 24 0.636 15.264
Total of present value of Cash flow 57.957
Less: Initial Investment 50.000
Net Present value (NPV) 7.957

Exam Insights: It was a numerical problem requiring calculation of NPV on the basis of Risk Adjusted
Discount Rate (RADR). Fair performance of the examinees was observed.

Question 7

JB Consultancy Group has determined relative utilities of cash flows of two forthcoming projects of its client
company as follows:
Cash Flow in ₹ -150000 -100000 -40000 150000 100000 50000 10000
Utilities -100 -60 -3 40 30 20 10
The distribution of cash flows of project X and Project Y are as follows:
Project X
Cash Flow (₹) -150000 - 100000 150000 100000 50000
Probability 0.10 0.20 0.40 0.20 0.10
Project Y
Cash Flow (₹) - 100000 -40000 150000 50000 100000
Probability 0.10 0.15 0.40 0.25 0.10
Which project should be selected and why?(RTP Nov’24)

Answer 7
Evaluation of project utilizes of Project X and Project Y
Project X
Cash flow (in ₹) Probability Utility Utility value
-1,50,000 0.10 -100 -10
-1,00,000 0.20 -60 -12

3-5 Chapter 3: Advanced Capital Budgeting Decisions

 1,50,000 0.40 40 16
1,00,000 0.20 30 6
50,000 0.10 20 2
2

Cash flow (in ₹) Project Y

Probability Utility Utility value
-1,00,000 0.10 -60 -6
-40,000 0.15 -3 -0.45
1,50,000 0.40 40 16
50,000 0.25 20 5
1,00,000 0.10 30 3
17.55
Project X should be selected as its expected utility is more.

Question 8

XYZ Ltd. is considering taking up one of the two projects-Project-X and Project-Y. Both the projects having
same life require equal investment of ₹ 1600 lakhs each. Both are estimated to have almost the same yield. As
the company is new to this type of business, the cash flow arising from the projects cannot be estimated with
certainty. An attempt was therefore, made to use probability to analyse the pattern of cash flow from other
projects during the first year of operations. This pattern is likely to continue during the life of these projects.
The results of the analysis are as follows:
Project X
Cash Flow (in ₹ Lakh) Probability
220 0.10
260 0.20
300 0.40
340 0.20
380 0.10
Project Y
Cash Flow (in ₹ Lakh) Probability
180 0.10
260 0.25
340 0.30
420 0.25
500 0.10
Required:
Evaluate which of the two projects bears more risk for every percent of expected return.
(MTP 6 Marks Sep’24)

Answer 8
To determine which of the two projects bears more risk for every percent of expected return first we shall
calculate Variance and Standard Deviation of both the projects.
(i) Project X
Expected Net Cash Flow
= (0.10 x 220) + (0.20 x 260) + (0.40 x 300) + (0.20 x 340) + (0.10 x 380)
= 22 + 52 + 120 + 68 + 38 = 300
σ2 = 0.10 (220 – 300)2 + 0.20 (260 – 300)2 + 0.40 (300 – 300)2 + 0.20 (340 – 300)2 + 0.10 (380 – 300)2
= 640 + 320 + 0 + 320 + 640 = 1920
σ = √1920 = 43.82

Chapter 3: Advanced Capital Budgeting Decisions 3-6

(ii) Project Y
Expected Net Cash Flow
= (0.10 X 180) + (0.25 X 260) + (0.30 X 340) + (0.25 X 420) + (0.10 X 500)
= 18 + 65 + 102 + 105 + 50 = 340
σ2 = 0.10 (180 – 340)2 + 0.25 (260 – 340)2 + 0.30 (40 – 340)2 + 0.25 (420 – 340)2 + 0.10 (500 – 340)2
= 2560 + 1600 + 0 + 1600 + 2560 = 8320
σ = √8320 = 91.21

Now we shall calculate Coefficient of Variation

Standard Deviation
Coefficient of Variation = Mean
43.82
Project X = = 0.146 or 14.61%
300
91.21
Project Y = = 0.268 or 26.83%
340

Question 9

Viv Tsu Ltd. is considering one of two mutually exclusive proposals, Projects A and B, which require cash
outlays of Rs. 34,00,000 and Rs. 33,00,000 respectively. The certainty- equivalent (C.E) approach is used in
incorporating risk in capital budgeting decisions. The current yield on government bonds is 5% and this is used
as the risk-free rate. The expected net cash flows and their certainty equivalents are as follows:
Year-end Project A Project B
Cash Flow (Rs.) C.E. Cash Flow (Rs.) C.E.
1 16,75,000 0.8 16,75,000 0.9
2 15,00,000 0.7 15,00,000 0.8
3 15,00,000 0.5 15,00,000 0.7
4 20,00,000 0.4 10,00,000 0.8
5 21,20,000 0.6 9,00,000 0.9
PV factor at 5% are as follows:
Year 1 2 3 4 5
PV factor 0.952 0.907 0.864 0.823 0.784
DETERMINE which project should be accepted. (MTP 8 Marks Mar’21)
(Same concept different figures RTP Nov’20)

Answer 9
Statement Showing the Net Present Value of Project A
Year end Cash Flow (Rs.) C.E. Adjusted Cash flow (Rs.) Present value Total Present value
(a) (b) (c) = (a) × (b) factor at 5% (d) (Rs.) (e) = (c) × (d)
1 16,75,000 0.8 13,40,000 0.952 12,75,680
2 15,00,000 0.7 10,50,000 0.907 9,52,350
3 15,00,000 0.5 7,50,000 0.864 6,48,000
4 20,00,000 0.4 8,00,000 0.823 6,58,400
5 21,20,000 0.6 12,72,000 0.784 9,97,248
PV of total Cash Inflows 45,31,678
Less: Initial Investment 34,00,000
Net Present Value 11,31,678

Statement Showing the Net Present Value of Project B

Year end Cash Flow (Rs.) C.E. Adjusted Cash flow (Rs.) Present value Total Present value
(a) (b) (c) = (a) × (b) factor at 5% (d) (Rs.) (e) = (c) × (d)
1 16,75,000 0.9 15,07,500 0.952 14,35,140

3-7 Chapter 3: Advanced Capital Budgeting Decisions

 2 15,00,000 0.8 12,00,000 0.907 10,88,400
3 15,00,000 0.7 10,50,000 0.864 9,07,200
4 10,00,000 0.8 8,00,000 0.823 6,58,400
5 9,00,000 0.9 8,10,000 0.784 6,35,040
PV of total Cash Inflows 47,24,180
Less: Initial Investment 33,00,000
Net Present Value 14,24,180
Project B has NPV of Rs. 14,24,180 which is higher than the NPV of Project A. Thus, Viv Tsu Ltd. should accept
Project B.

Question 10

An enterprise is investing ₹ 100 lakhs in a project. The risk-free rate of return is 7%. Risk premium expected by
the Management is 7%. The life of the project is 5 years. Following are the cash flows that are estimated over
the life of the project.
Year Cash flows (₹ in lakhs)
1 25
2 60
3 75
4 80
5 65
CALCULATE Net Present Value of the project based on Risk free rate and also on the basis of Risks adjusted
discount rate. (MTP 5 Marks Apr’22 & Aug’18, RTP May’19, Nov’19 & Nov’23, SM)

Answer 10
The Present Value of the Cash Flows for all the years by discounting the cash flow at 7% is calculated as below:
Year Cash flows Discounting Factor Present value of Cash Flows
(₹ in lakhs) @7% (₹ in Lakhs)
1 25 0.935 23.38
2 60 0.873 52.38
3 75 0.816 61.20
4 80 0.763 61.04
5 65 0.713 46.35
Total of present value of Cash flow 244.34
Less: Initial investment 100
Net Present Value (NPV) 144.34
Now, when the risk-free rate is 7 % and the risk premium expected by the Management is 7 %.
So, the risk adjusted discount rate is 7 % + 7 % =14%.
Discounting the above cash flows using the Risk Adjusted Discount Rate would be as below:
Year Cash flows Discounting Factor Present Value of Cash Flows
(₹ in Lakhs) @14% (₹ in lakhs)
1 25 0.877 21.93
2 60 0.769 46.14
3 75 0.675 50.63
4 80 0.592 47.36
5 65 0.519 33.74
Total of present value of Cash flow 199.80
Initial investment 100
Net present value (NPV) 99.80

Chapter 3: Advanced Capital Budgeting Decisions 3-8

 Question 11
The Textile Manufacturing Company Ltd. is considering one of two mutually exclusive proposals, Projects M
and N, which require cash outlays of ₹ 17,00,000 and ₹ 16,50,000 respectively. The certainty-equivalent (C.E)
approach is used in incorporating risk in capital budgeting decisions. The current yield on Treasury bond is 6%.
The expected net cash flows and their respective certainty equivalents are as follows:
Project M Project N
Year-end Cash Flow ₹ C.E. Cash Flow ₹ C.E.
1 9,00,000 0.8 9,00,000 0.9
2 10,00,000 0.7 9,00,000 0.8
3 10,00,000 0.5 10,00,000 0.7
Present value factors of ₹ 1 discounted at 6% at the end of year 1, 2 and 3 are 0.943, 0.890 and 0.840
respectively. Required:
(i) Recommend which project should be accepted?
(ii) Suppose if risk adjusted discount rate method is to be used for evaluation then which project would be
appraised with a higher discount rate and why? (MTP 8 marks Mar’24) (Same concept different figures SM)

Answer 11
(i) Statement Showing the Net Present Value of Project M
Year Cash Flow (₹) C.E. Adjusted Cash flow (₹) Present value Total Present
end (a) (b) (c) = (a) × (b) factor at 6% (d) value (₹)
(e) = (c) × (d)
1 9,00,000 0.8 7,20,000 0.943 6,78,960
2 10,00,000 0.7 7,00,000 0.890 6,23,000
3 10,00,000 0.5 5,00,000 0.840 4,20,000
17,21,960
Less: Initial Investment 17,00,000
Net Present Value 21,960

Statement Showing the Net Present Value of Project N

Year Cash Flow (₹) C.E. Adjusted Cash flow (₹) Present value Total Present
end (a) (b) (c) = (a) × (b) factor value (₹)
(d) (e) = (c) × (d)
1 9,00,000 0.9 8,10,000 0.943 7,63,830
2 9,00,000 0.8 7,20,000 0.890 6,40,800
3 10,00,000 0.7 7,00,000 0.840 5,88,000
19,92,630
Less: Initial Investment 16,50,000
Net Present Value 3,42,630
Decision: Since the net present value of Project N is higher, so the project N should be accepted.
(ii) Since Certainty - Equivalent (C.E.) Co-efficient of Project M (2.0) is lower than Project N (2.4), Project M is
riskier than Project N and as "higher the riskiness of a cash flow, the lower will be the CE factor".
Thus, if risk adjusted discount rate (RADR) method is used, Project M would be analysed with a higher rate.

Question 12

A firm can make investment in either of the following two projects. The firm anticipates its cost of capital to
be 10%. The pre-tax cash flows of the projects for five years are as follows:
Year 0 1 2 3 4 5
Project A (₹) (2,00,000) 35,000 80,000 90,000 75,000 20,000
Project 8 (₹) (2,00,000) 2,18,000 10,000 10,000 4,000 3,000
Ignore Taxation.
An amount of ₹ 35,000 will be spent on account of sales promotion in year 3 in case of Project A. This has not
been taken into account in calculation of pre-tax cash flows.

3-9 Chapter 3: Advanced Capital Budgeting Decisions

The discount factors are as under:
Year 0 1 2 3 4 5
PVF (10%) 1 0.91 0.83 0.75 0.68 0.62
You are required to calculate for each project:
(i) The payback period
(ii) The discounted payback period
(iii) Desirability factor
(iv) Net Present Value (MTP 10 Marks, Oct’20) (Same concept different figures MTP 10 Marks Sep’23)

Answer 12
Calculation of Present value of cash flows
Year PV factor Project A Project B
@ 10% Cash flows (₹) Discounted Cash flows (₹) Discounted
Cash flows Cash flows
0 1.00 (2,00,000) (2,00,000) (2,00,000) (2,00,000)
1 0.91 35,000 31,850 2,18,000 1,98,380
2 0.83 80,000 66,400 10,000 8,300
3 0.75 55,000 (90,000 -35,000) 41,250 10,000 7,500
4 0.68 75,000 51,000 4,000 2,720
5 0.62 20,000 12,400 3,000 1,860
Net Present Value 2,900 18,760

(i) The Payback period of the projects:

Project-A: The cumulative cash inflows up-to year 3 is ₹1,70,000 and remaining amount required to equate
the cash outflow is ₹ 30,000 i.e. (₹ 2,00,000 – ₹ 1,70,000) which will be recovered from year-4 cash inflow.
Hence, Payback period will be calculated as below:
Rs.30,000
3 years + = 3.4 years or 3 years 4.8 months or 3 years 4 months and 24 days
RS.75,000

Project-B: The cash inflow in year-1 is ₹ 2,18,000 and the amount required to equate the cash outflow is
₹ 2,00,000, which can be recovered in a period less than a year. Hence, Payback period will be calculated as
Rs.2,00,000
below: = 0.917 years or 11 months
RS. 2,18,00,000

(ii) Discounted Payback period for the projects:

Project-A: The cumulative discounted cash inflows up-to year 4 is ₹ 1,90,500 and remaining amount required to
equate the cash outflow is ₹ 9,500 i.e. (₹ 2,00,000 – ₹ 1,90,500) which will be recovered from year-5 cash inflow.
Hence, Payback period will be calculated as below:
RS.9.500
4 years + RS.12,400 = 4.766 years Or 4 Year 1.19 months Or 4 Year 9 months and 6 days.

Project-B: The cash inflow in year-1 is ₹1,98,380 and remaining amount required to equate the cash outflow is ₹
1,620 i.e. (₹ 2,00,000 – ₹ 1,98,380) which will be recovered from year-2 cash inflow. Hence, Payback period will
be calculated as below
𝑅𝑠.1620
1 year+ = 1.195 years Or 1 Year 2.34 months Or 1 Year 2 months and 10 days.
𝑅𝑆.8300

(iii) Desirability factor of the projects

Discounted value Cashlnflows
Desirability Factor (Profitability Index) =
Discounted valueof Cashoutflows

₹ 2,02,900
Project A = = 1.01
2,00,000

₹ 2,18,760
Project B = = 1.09
2,00,000

Chapter 3: Advanced Capital Budgeting Decisions 3 - 10

 (iv) Net Present Value (NPV) of the projects: Please refer the above table.
Project A - ₹ 2,900 Project B - ₹ 18,760

Question 13 LDR

X Ltd. is considering two mutually exclusive projects A and B.

Net Cash flow probability distribution of each project has been given below:
Project-A Project-B
Net Cash Flow (₹) Probability Net Cash Flow (₹) Probability
1,72,000 0.30 3,38,000 0.20
1,82,000 0.30 3,18,000 0.30
1,92,000 0.40 2,98,000 0.50
COMPUTE the following:
(I) Expected Net Cash Flow of each project.
(II) Variance of each project.
(III) Standard Deviation of each project.
(IV) Coefficient of Variation of each project.
(V) IDENTIFY which project do you recommend? Give reason.
(MTP 8 Marks Mar’22 & Mar’23, PYP 10 Marks Nov’20) (Same concept different figures RTP Nov’21)

Answer 13
(I) Calculation of Expected Net Cash Flow (ENCF) of Project A and Project B
Project A Project B
Net Cash Flow (₹) Probability Expected Net Net Cash Probability Expected Net
Cash Flow (₹) Flow (₹) Cash Flow (₹)
1,72,000 0.30 51,600 3,38,000 0.20 67,600
1,82,000 0.30 54,600 3,18,000 0.30 95,400
1,92,000 0.40 76,800 2,98,000 0.50 1,49,000
ENCF 1,83,000 3,12,000

(II) Variance of Projects

Project A
Variance (σ2) = (1,72,000 – 1,83,000)2 × (0.3) + (1,82,000 - 1,83,000)2 × (0.3) + (1,92,000 – 1,83,000)2 × (0.4)
= 3,63,00,000 + 3,00,000 + 3,24,00,000
= 6,90,00,000
Project B
Variance(σ2) = (3,38,000 – 3,12,000)2 × (0.2) + (3,18,000 – 3,12,000)2 × (0.3) + (2,98,000 – 3,12,000)2 × (0.5)
= 13,52,00,000 + 1,08,00,000 + 9,80,00,000
= 24,40,00,000

(III) Standard Deviation of Projects

Project A
Standard Deviation (σ) = √Variance (σ2 )= √6,90,00,000 = 8,306.624

Project B
Standard Deviation (σ) =√Variance (σ2 )= √24,40,00,000= 15,620.499

3 - 11 Chapter 3: Advanced Capital Budgeting Decisions

 A

CHAPTER 10: FOREIGN EXCHANGE EXPOSURE & RISK

MANAGEMENT

CONCEPTS OF THIS CHAPTER LDR

Factors Affecting Exchange Rates | SWIFT's Role| Payment Gateways | Questions
Exchange Rate Determination | Foreign Currency Market| Foreign Exchange Q 37
Risk Management Q 41
Q 43

QUICK REVIEW OF IMPORTANT FORMULAS

1. Relationship between direct and indirect quote:
𝐀𝐬𝐤 −𝐁𝐢𝐝
Direct Quote = 1/(Indirect Quote)% Spread = 𝐁𝐢𝐝
× 𝟏𝟎𝟎

2. Forward Rate = Spot Rate ± Premium/Discount

𝐅𝐨𝐫𝐰𝐚𝐫𝐝 𝐏𝐫𝐞𝐦𝐢𝐮𝐦
Forward Premium % = 𝐒𝐩𝐨𝐭 𝐑𝐚𝐭𝐞
× 𝟏𝟎𝟎

𝐅𝐨𝐫𝐰𝐚𝐫𝐝 𝐏𝐫𝐞𝐦𝐢𝐚 𝟏𝟐
Forward Premium (Annualized): 𝐒𝐩𝐨𝐭 𝐑𝐚𝐭𝐞
× 𝐆𝐢𝐯𝐞𝐧 𝐏𝐞𝐫𝐢𝐨𝐝 × 𝟏𝟎𝟎

3. Forward Rate as per Covered Interest Parity :

1+ Current domestic interest rate
= Current spot rate (Direct Q) × 1+ Interest rate of foreign market

4. Expected Future Spot Rate as per Uncovered Interest Parity:

1 + Current domestic interest rate
= Current spot rate (Direct Q) × 1 + Interest rate of foreign market

5. Purchasing Power Parity (Absolute Form) :

Price level in domestic market
Spot Rate = 𝛼 × Price level in foreign market

Where, 𝛼 = Sectoral constant for adjustment

6. Purchasing Power Parity (Relative Form) :

1+Domestic Inflation Rate
Expected Spot Rate = Current Spot Rate (Direct Q) × 1+ Foreign Inflation Rate

7. International Fisher Effect:

𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐒𝐩𝐨𝐭 𝐑𝐚𝐭𝐞 𝟏+ 𝐃𝐨𝐦𝐞𝐬𝐭𝐢𝐜 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐫𝐚𝐭𝐞
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐒𝐩𝐨𝐭 𝐑𝐚𝐭𝐞
= 𝟏+𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐫𝐚𝐭𝐞 𝐢𝐧 𝐅𝐨𝐫𝐞𝐢𝐠𝐧 𝐦𝐚𝐫𝐤𝐞𝐭

8. Re/$ = 85.10/85.20
Bid Ask
Bid is Always lesser than ask.
9. Nostro, Vostro and Loro:
- Nostro: Our account with you. Vostro: Your account with us. Loro: Their account with you.

10 - 1 Chapter 10: Foreign Exchange Exposure & Risk Management

 Question & Answers
Question 1

All dealings in Foreign Exchange effect the Exchange Position whether delivery has taken place or not, but
Cash Position is affected only when actual delivery has taken place. Explain. (MTP 4 Marks, Nov’21)

Answer 1
Yes, this statement is correct because while Exchange Position is referred to total of purchases or sale of
commitment of a bank to purchase or sale foreign exchange whether actual delivery has taken place or not. In
other words, all transactions for which bank has agreed with counter party are entered into exchange position
on the date of the contract.
While Cash Position is outstanding balance (debit or credit) in bank’s Nostro account. Since all foreign
exchange dealings of bank are routed through Nostro account it is credited for all purchases and debited for
sale by bank.
Therefore, all transactions effecting Cash position will affect Exchange Position not vice versa.

Question 2

“Netting helps in minimizing the total value of intercompany fund flows”. EXPLAIN.
(MTP 4 Marks, Apr’22, Mar’22)

Answer 2
Yes, to some extent the given statement is correct as it is a technique of optimizing cash flow movements
with the combined efforts of the subsidiaries thereby reducing administrative and transaction costs
resulting from currency conversion. There is a coordinated international interchange of materials, finished
products and parts among the different units of MNC with many subsidiaries buying /selling from/to each
other.
Advantages derived from netting system includes:
1) Reduces the number of cross-border transactions between subsidiaries thereby decreasing the overall
administrative costs of such cash transfers
2) Reduces the need for foreign exchange conversion and hence decreases transaction costs associated
with foreign exchange conversion.
3) Improves cash flow forecasting since net cash transfers are made at the end of each period
4) Gives an accurate report and settles accounts through coordinated efforts among all subsidiaries.

Question 3

What are the parameters to identify currency risk? List out the ways to minimize such risk.
(MTP 4 Marks, Apr’24) (RTP Nov’19)

Answer 3
Some of the parameters to identity the currency risk are as follows:
(i) Government Action: The Government action of any country has visual impact in its currency. For
example, the UK Govt. decision to divorce from European Union i.e. Brexit brought the pound to its
lowest since 1980’s.
(ii) Nominal Interest Rate: As per interest rate parity (IRP) the currency exchange rate depends on the
nominal interest of that country.
(iii) Inflation Rate: Purchasing power parity theory discussed in later chapters impact the value of currency.
(iv) Natural Calamities: Any natural calamity can have negative impact.
(v) War, Coup, Rebellion etc.: All these actions can have far reaching impact on currency’s exchange rates.
(vi) Change of Government: The change of government and its attitude towards foreign investment also
helps to identify the currency risk.
Ways to minimize such risk are:-
(1) Money Market Hedging.

Chapter 10: Foreign Exchange Exposure & Risk Management 10 - 2

 (2) Currency Options.
(3) Forward Contract.
(4) Make Invoice in Home Currency.

Question 4

Briefly explain Asset and Liability Management (ALM). (PYP 4 Marks, Nov’22)

Answer 4
Asset-Liability Management (ALM) is one of the important tools of risk management in commercial banks of
India. Indian banking industry is exposed to a number of risks prevailing in the market such as market risk,
financial risk, interest rate risk etc. The net income of the banks is very sensitive to these factors or risks.
ALM is a comprehensive and dynamic framework for measuring, monitoring and managing the market risk
of a bank. It is the management of structure of Balance Sheet (liabilities and assets) in such a way that the
net earnings from interest are maximized within the overall risk preference (present and future) of the
institutions. The ALM functions extend to liquidly risk management, management of market risk, trading risk
management, funding and capital planning and profit planning and growth projection.
Banks and other financial institutions provide services which expose them to various kinds of risks like credit
risk, interest risk, and liquidity risk. Asset liability management is an approach that provides institutions with
protection that makes such risk acceptable. Asset-liability management models enable institutions to
measure and monitor risk, and provide suitable strategies for their management.
It is therefore appropriate for institutions (banks, finance companies, leasing companies, insurance
companies, and others) to focus on asset-liability management when they face financial risks of different
types. Asset-liability management includes not only a formalization of this understanding, but also a way to
quantify and manage these risks.
In a sense, the various aspects of balance sheet management deal with planning as well as direction and
control of the levels, changes and mixes of assets, liabilities, and capital.
Exam Insights: Poor performance has been observed in this theoretical question on Interest Rate Risk
Management as most of examinees could not understand the question and written irrelevant points in
their answers.

Question 5

Write a short note on Money Market Hedging. (PYP 4 Marks, Nov’22)

Answer 5
At its simplest, a money market hedge is an agreement to exchange a certain amount of one currency for a
fixed amount of another currency, at a particular date. For example, suppose a business owner in India
expects to receive 1 million USD in six months. This Owner could create an agreement now (today) to
exchange 1Million USD for INR at roughly the current exchange rate. Thus, if the USD dropped in value by
the time the business owner got the payment, he would still be able to exchange the payment for the original
quantity of U.S. dollars specified.
Advantages of Money Market Hedging
(i) Fixes the future rate, thus eliminating downside risk exposure.
(ii) Flexibility with regard to the amount to be covered.
(iii) Money market hedges may be feasible as a way of hedging for currencies where forward contracts are
not available.
Disadvantages of Money Market Hedging
(i) More complicated to organize than a forward contract.
(ii) Fixes the future rate - no opportunity to benefit from favorable movements in exchange rates.

Exam Insights: Average performance has been noticed in this theoretical question on Foreign Exchange
Exposure and Risk Management.

10 - 3 Chapter 10: Foreign Exchange Exposure & Risk Management

Question 6

The SWIFT plays an important role in Foreign Exchange dealings. Explain. (MTP 4 Marks Sep’24)

Answer 6
The SWIFT plays an important role in Foreign Exchange dealings because of the following reasons:
• In addition to validation statements and documentation it is a form of quick settlement as messaging
takes place within seconds.
• Because of security and reliability helps to reduce Operational Risk.
• Since it enables its customers to standardize transaction it brings operational efficiencies and
reduced costs.
• It also ensures full backup and recovery system.
• Acts as a catalyst that brings financial agencies to work together in a collaborative manner for mutual
interest.

Question 7

WAVELENGTH Ltd. an Indian firm needs to pay JAPANESE YEN (JY) 1 crore on 30th June. In order to hedge the
risk involved in foreign currency transaction, the firm is considering two alternative methods i.e. forward
market cover and currency option contract.
On 1st April, following quotations (JY/INR) are made available:
Spot 3 months forward
1.7825/1.8245. 1.8726./1.8923
The prices for forex currency option on purchase are as follows:
Strike Price JY 1.8855
Call option (June) JY 0.047
Put option (June) JY 0.098
For excess or balance of JY covered, the firm would use forward rate as future spot rate. You are required to
recommend cheaper hedging alternative for WAVELENGTH LTD.
Note: Except rates round off other calculations to nearest rupees. (MTP 6 Marks, Mar’24 , 8 Marks Nov’21)
(SM)

Answer 7
(i) Forward Cover
1
3-month Forward Rate = 1.8726 = ₹ 0.5340/JY
Accordingly, INR required for JY 1,00,00,000 (1,00,00,000 X ₹ 0.5340) = ₹ 53,40,000
(ii) Option Cover
To purchase JY 1,00,00,000, WAVELENGTH LTD shall enter into a Put Option @ JY 1.8855/INR
₹
JY1,00,00,000 53,03,633
Accordingly, outflow in INR ( 1.8855 )

INR 5303633×0.098
Premium ( ) 2,91,588
1.7825

55,95,221
Since outflow of cash is least in case of Forward Cover, same should be opted for.

Question 8

Mr. Mammen, an Indian investor invests in a listed bond in USA. If the price of the bond at the beginning of
the year is USD 100 and it is USD 103 at the end of the year. The coupon rate is 3% payable annually.
CALCULATE the return on investment in terms of home country currency if:
Chapter 10: Foreign Exchange Exposure & Risk Management 10 - 4
 (i) USD is Flat.
(ii) USD appreciates during the year by 3%.
(iii) USD depreciates during the year by 3%.
(iv) Indian Rupee appreciates during the year by 5%. (MTP 6 Marks, Oct’22, RTP May ’22)

Answer 8
(i) If USD is flat
(Price at end − Price at begining)+Interest (103 − 100) + 3
Return = = = 3 +3/100 = 0.06 say 6%
Price at beginning 100

(ii) If USD appreciates by 3%

(1+0.06) (1+0.03) -1 = 1.06 X1.03 - 1 = 0.0918 i.e. 9.18%
(iii) If USD depreciates by 3%
(1+0.06) (1-0.03) -1 = 1.06 X 0.97 - 1 = 0.0282 i.e. 2.82%
(iv) If Indian Rupee is appreciated by 5%
(1+0.06) (1-0.05) -1 = 1.06 X 0.95 - 1 = 0.007 i.e. 0.7%.

Question 9

An Indian company needs $ funds for six months and it obtains the following quotes (Rs./$)
Spot: 35.90/36.10
3 - Months forward rate: 36.00/36.25
6 - Months forward rate: 36.10/36.40
$ or Rs. Interest rates:
3 - Months interest rate: Rs.: 12%, $: 6%
6 - Months interest rate: Rs.: 11.50%, $: 5.5%
(i) Advise whether the company should borrow in INR or USD.
(ii) Evaluate the rate of interest after 3 - months to make the company indifferent between 3 - months
borrowing and 6 - months borrowing in the case of:
(i) Rupee borrowing
(ii) Dollar borrowing
Note: For the purpose of calculation, please take the units of dollar and rupee as 100 each.
(MTP 8 Marks, Mar’21, PYP 8 Marks Nov’18)

Answer 9
(i) If company borrows in $ then outflow would be as follows:
Let company borrows $ 100 $ 100.00
Add: Interest for 6 months @ 5.5% $ 2.75
Amount Repayable after 6 months $ 102.75
Applicable 6-month forward rate 36.40
Amount of Cash outflow in Indian Rupees Rs. 3,740.10
If company borrows equivalent amount in Indian Rupee, then outflow would be as follows:
Equivalent Rs. amount Rs. 36.10 x 100 ₹3,610.00
Add: Interest @11.50% ₹207.58
₹3817.58
Since cash outflow is more in Rs. borrowing then borrowing should be made in $.
(ii) (a) Let ‘ir ’ be the interest rate of Rs. borrowing make indifferent between 3 months borrowings and 6
months borrowing then
(1 + 0.03) (1 + ir ) = (1 + 0.0575)
ir = 2.67% or 10.68% (on annualized basis)
(a) Let ‘id’ be the interest rate of $ borrowing after 3 months to make indifference between 3 months
borrowings and 6 months borrowings. Then,
(1 + 0.015) (1 + id ) = (1 + 0.0275)
id = 1.232% or 4.93% (on annualized basis)

10 - 5 Chapter 10: Foreign Exchange Exposure & Risk Management

Question 10

A bank enters into a forward purchase TT covering an export bill for Swiss Francs 1,00,000 at ₹ 32.4000 due
25th April and covered itself for same delivery in the local inter bank market at ₹ 32.4200. However, on 25th
March, exporter sought for cancellation of the contract as the tenor of the bill is changed.
In Singapore market, Swiss Francs were quoted against dollars as under:
Spot USD 1 = Sw. Fcs. 1.5076/1.5120
One month forward 1.5150/ 1.5160
Two months forward 1.5250 / 1.5270
Three months forward 1.5415/ 1.5445
and in the interbank market US dollars were quoted as under:
Spot USD 1 = ₹ 49.4302/4455
Spot / April 4100/4200
Spot/May 4300/4400
Spot/June 4500/4600
Calculate the cancellation charges, payable by the customer if exchange margin required by the bank is
0.10% on buying and selling. (MTP 6 Marks, Oct’23, SM)

Answer 10
First the contract will be cancelled at TT Selling Rate
USD/ Rupee Spot Selling Rate ₹ 49.4455
Add: Premium for April ₹ 0.4200
₹ 49.8655
Add: Exchange Margin @ 0.10% ₹ 0.04987
₹ 49.91537 Or 49.9154
USD/ Sw. Fcs One Month Buying Rate Sw. Fcs. 1.5150
Sw. Fcs. Spot Selling Rate (₹49.91537/1.5150) ₹ 32.9474
Rounded Off ₹ 32.9475
Bank buys Sw. Fcs. Under original contract ₹ 32.4000
Bank Sells under Cancellation ₹ 32.9475
Difference payable by customer ₹ 00.5475
Exchange difference of Sw. Fcs. 1,00,000 payables by customer ₹ 54,750 (Sw. Fcs. 1,00,000 x ₹ 0.5475)

Question 11

On January 28, 2023, an importer customer requested a Bank to remit Singapore Dollar (SGD) 2,500,000
under an irrevocable Letter of Credit (LC). However, due to unavoidable factors, the Bank could affect the
remittances only on February 4, 2023. The inter-bank market rates were as follows:
January 28, 2023 February 4, 2023
US$ 1 = ₹ 80.91/80.97 ₹ 80.85/80.90
GBP £ 1 = US$ 1.7765/1.7775 US$ 1.7840/1.7850
GBP £ 1 = SGD 2. 1380/2.1390 SGD 2.1575/2.1590
The Bank wishes to retain an exchange margin of 0.125% on ₹/ SGD.
Required:
Estimate how much does the customer stand to gain or lose due to the delay?
(Note: Calculate the rate in multiples of 0.0001) (MTP 6 Marks, Apr’24) (RTP Nov’18, SM)

Answer 11
On January 28, 2023, the importer customer requested to remit SGD 25 lakhs.
To consider sell rate for the bank:
US $ = ₹ 80.97
Pound 1 US$ 1.7775
Pound 1 = SGD 3.1380

Chapter 10: Foreign Exchange Exposure & Risk Management 10 - 6

 Therefore, SGD 1 Rs.80.97∗ 1.7775
=
SGD 2.1380

SGD 1 = ₹ 67.3172
Add: Exchange margin (0.125%) = ₹ 0.0841
= ₹ 67.4013
On February 4, 2023 the rates are
US $ = ₹ 80.90
Pound 1 = US$ 1.7850
Pound 1 = SGD 2.1575
Therefore, SGD 1 Rs.80.90∗ 1.7850
= SGD 2.1575

SGD 1 = ₹ 66.9323
Add: Exchange margin (0.125%) = ₹ 0.0837
= ₹ 67.0160
Hence, Gain to the importer
= SGD 25,00,000 (₹ 67.4013 – ₹ 67.0160) = ₹ 9,63,250

Question 12

A UK based exporter exported goods to USA. The Invoice amount is $ 7,00,000 and credit period is 3
months. Exchange rates in London areas follows: -
Spot Rate ($/£) 1.5865 – 1.5905
3-month Forward Rate ($/£) 1.6100 – 1.6140
Rates of interest in Money Market:
Deposit Loan
$ 7% 9%
£ 5% 8%
Justify your stand to choose money market hedge (including steps) instead of Forward Contract.
Note: Make calculation up to 2 decimal points. (RTP May’24) (RTP May ’19 SM)

Answer 12
Amount expected to be received under Money Market Hedge.
Identify: Foreign currency is an asset. Amount $ 7,00,000.
Create: $ Liability.
Borrow: In $. The borrowing rate is 9% per annum or 2.25% per quarter.
Amount to be borrowed: 7,00,000 / 1.0225 = $ 6,84,596.58
Convert: Sell $ and buy £. The relevant rate is the Ask rate, namely,1.5905 per £,
(Note: This is an indirect quote).
Amount of £s received on conversion is 4,30,428.53 (6,84,596.58 /1.5905).
Invest: £ 4,30,428.53 will be invested at 5% for 3 months and get £ 4,35,808.89
Settle: The liability of $ 6,84,596.58 at interest of 2.25 per cent quartermatures to $7,00,000 receivable
from customer.
Using forward rate, amount receivable is = 7,00,000 / 1.6140 = £ 4,33,705.08
Amount received through money market hedge = £ 4,35,808.89
Gain = £ 4,35,808.89– £ 4,33,705.08= £ 2103.81
Justification: By following the prescribed steps under hedging we found the exporter receives £ 4,33,705.08
by using forward cover whilehe receives £ 4,35,808.89 through money market hedge. Thus, money market
hedge helps exporter to receive £ 2103.81 more than the amount received using Forward contract. Hence it is
more beneficial.

Question 13

Mr. Vivit Su as Treasurer for your bank working under you sold HK$ 10 million value Spot to your customer
at ₹ 10.53/ HK$ and covered yourself in the London market on the same day when the exchange rates

10 - 7 Chapter 10: Foreign Exchange Exposure & Risk Management

were:
US$ 1 = H.K.$ 7.8880 / 7.8920
Local interbank market rates for US$ were:
Spot US$ 1 = ₹ 82.70 / 82.85
Required:
(i) Calculate Cover Rate
(ii) Calculate Profit or loss in the transaction
(iii) Do you agree with the views of the Internal Auditor that Mr. Vivit Su has a speculative nature?
Note: Ignore brokerage. (MTP 6 Marks Sep’24)

Answer 13
(i) Rupee – Dollar Selling Rate = ₹ 82.85
Dollar – Hong Kong Dollar Buying Rate: = H.K.$ 7.8880
Hong Kong Dollar (Selling) Cross Rate: = ₹ 82.85 / 7.8880
= ₹ 10.5033
(ii) Profit / Loss to the Bank
Amount received from customer
(HK$ 10 million × 10.55) ₹ 10,55,00,000
Amount paid on cover deal
(HK$ 10 million × ₹10.5033) ₹ 10,50,33,000
Profit to Bank ₹4,67,000
To some extent, we agree with views of Internal Auditor as the gain on the same transaction is bit lesser
keeping in view the amount involved.

Question 14
Followings are the spot exchange rates quoted at three different forexmarkets:
USD/INR 48.30 in Mumbai
GBP/INR 77.52 in London
GBP/USD 1.6231 in New York
The arbitrageur has USD1,00,00,000. Assuming that there are no transaction costs, explain whether there is
any arbitrage gain possible from the quoted spot exchange rates. (MTP 4 Marks Oct’24)

Answer 14
The arbitrageur can proceed as stated below to realize arbitrage gains.
(i) Buy ₹ from USD 10,000,000 At Mumbai 48.30 × 10,000,000
₹ 483,000,000
₹483000000
(ii) Convert these ₹ to GBP at London ( ₹77.52 )
(iii) Convert GBP to USD at New York GBP 6,230,650.155 × 1.6231USD 10,112,968.26
There is net gain of USD 10,112968.26 less USD 10,000,000 i.e.USD 112,968.26

Question 15
WEPL Ltd. has made purchases worth USD 80,000 on 1st May 2020 for which it has to make a payment on 1st
November 2020. The present exchange rate is INR/USD 75. The company can purchase forward dollars at
INR/USD 74. The company will have to make an upfront premium @ 1 per cent of the forward amount
purchased. The cost of funds to WEPL Ltd. is 10 per cent per annum.
The company can hedge its position with the following expected rate of USD in foreign exchange market on
1st May 2020:
Exchange Rate Probability
(i) INR/USD 77 0.15
(ii) INR/USD 71 0.25
(iii) INR/USD 79 0.20
(iv) INR/USD 74 0.40
You are required to advise the company for a suitable cover for risk.
(MTP 8 Marks, Mar’23, PYP 8 Marks Nov ’20) (Same concepts different figures RTP Nov’24)

Chapter 10: Foreign Exchange Exposure & Risk Management 10 - 8

 Answer 15
(I) If WEPL Ltd. does not take forward (Unhedged Position):
Expected Rate = ₹ 77 X 0.15 + ₹ 71 X 0.25 + ₹ 79 X 0.20 + ₹ 74 X 0.40
= ₹ 11.55 + ₹ 17.75 + ₹ 15.80 + ₹ 29.60 = ₹ 74.70
Expected Amount Payable = USD 80,000 X ₹ 74.70 = ₹ 59,76,000
(II) If the WEPL Ltd. hedge its position in the forward market:
Particulars Amount (₹)
If company purchases US$ 80,000 forward premium is (80000 × 74 × 1%) 59,200
Interest on ₹ 59,200 for 6 months at 10% 2,960
Total hedging cost (a) 62,160
Amount to be paid for US$ 80,000 @ ₹ 74.00 (b) 59,20,000
Total Cost (a) + (b) 59,82,160
Advice: Since cashflow is less in case of unhedged position company should opt for the same.

Question 16

On April 3, 2016, a Bank quotes the following:

Spot exchange Rate (US $ 1) INR 66.2525 INR 67.5945
2 months’ swap points 70 90
3 months’ swap points 160 186
In a spot transaction, delivery is made after two days. Assume spot date as April 5, 2016.
Assume 1 swap point = 0.0001,
Calculate:
(i) swap points for 2 months and 15 days. (For June 20, 2016),
(ii) foreign exchange rate for June 20, 2016, and
(iii) the annual rate of premium/discount of US$ on INR, on an average rate.
(MTP 8 Marks Mar’19, RTP Nov’22, SM)

Answer 16
(i) Swap Points for 2 months and 15 days
Bid Ask
Swap Points for 2 months (a) 70 90
Swap Points for 3 months (b) 160 186
Swap Points for 30 days (c) = (b) – (a) 90 96
Swap Points for 15 days (d) = (c)/2 45 48
Swap Points for 2 months & 15 days (e) = (a) + (d) 115 138
(ii) Foreign Exchange Rates for 20th June 2016
Bid Ask
Spot Rate (a) 66.2525 67.5945
Swap Points for 2 months & 15 days (b) 0.0115 0.0138
66.2640 67.6083
(iii) Annual Rate of Premium
Bid Ask
Spot Rate (a) 66.2525 67.5945
Foreign Exchange Rates for 20th June 2016 (b) 66.2640 67.6083
Premium (c) 0.0115 0.0138
Total (d) = (a) + (b) 132.5165 135.2028
Average (d) / 2 66.2583 67.6014
Premium 0.0115 12 0.0138 12
× 2.5 × 100 67.6014
× 2.5 × 100
66.2583
= 0.0833% = 0.0980%

10 - 9 Chapter 10: Foreign Exchange Exposure & Risk Management

Question 17

Shanti exported 200 pieces of a designer jewellery to USA at $ 200 each. To manufacture and design this
jewellery she imported raw material from Japan of the cost of JP¥ 6000 for each piece.
The labour cost and variable overhead incurred in producing each piece of jewellery are ₹ 1,300 and ₹ 650
respectively.
Suppose Spot Rates are:
₹/ US$ ₹ 65.00 – ₹ 66.00
JP¥/ US$ JP¥ 115 – JP¥ 120
Shanti is expecting that by the time the export remittance is received and payment of import is made the
expected Spot Rates are likely to be as follows:
₹/ US$ ₹ 68.90 – ₹ 69.25
JP¥/ US$ JP¥ 105 – JP¥ 112
You are required to calculate the resultant transaction exposure. (MTP 6 Marks, Oct’21)

Answer 17
Profit as per Spot Rates
₹
Sales Revenue (US$ 200 X 200 X ₹ 65) 26,00,000
Less: Cost of Imported Raw Material (200 X 6000/115 X ₹ 66) 6,88,696
Labour Cost (200 X ₹ 1,300) 2,60,000
Variable Overheads (200 X ₹ 650) 1,30,000
Profit 15,21,304

Profit as per expected Spot Rates

₹
Sales Revenue (US$ 200 X 200 X ₹ 68.90) 27,56,000
Less: Cost of Imported Raw Material (200 X6000/105 X ₹ 69.25) 7,91,429
Labour Cost (200 X ₹ 1,300) 2,60,000
Variable Overheads (200 X ₹ 650) 1,30,000
Profit 15,74,571
Increase/ (Decrease) in Profit due to Transaction Exposure = ₹ 53,267
(₹ 15,74,571– ₹ 15,21,304)

Question 18

WAVELENGTH has taken a six-month loan from its foreign collaborator for USD 2 million. Interest is payable
on maturity @ LIBOR plus 1%. The following information is available:
Spot Rate INR/USD 68.5275
6 months Forward rate INR/USD 68.4575
6 months LIBOR for USD 2%
6 months LIBOR for INR 6%
You are required to:
(i) Calculate Rupee requirements if forward cover is taken.
(ii) Advise the company on the forward cover.
What will be your opinion if spot rate of INR/USD is 68.4275 (RTP May’23)
Answer 18
Rupee requirement if forward cover is taken:
6 Month Forward rate 68.4575
6 US$ 30,000
Interest amount (20,00,000 x 3%* x )
12

Principal amount US$ 20,00,000

US$ 20,30,000
Chapter 10: Foreign Exchange Exposure & Risk Management 10 - 10
 A

CHAPTER 16: CASE SCENARIO

Question & Answers

CS 1 (RTP May’24)

(Chapter 7- Securitization)
Grow More Ltd. an NBFC is in the need of funds and hence it sold its receivables to MAC Financial Corporation
(MFC) for ₹ 100 million. MFC created a trust for this purpose called General Investment Trust (GIT) through
which it issued securities carrying a different level of risk and return to the investors. Further, this structure
also permits the GIT to reinvest surplus funds for short term as per their requirement.
MFC also appointed a third party, Safeguard Pvt. Ltd. (SPL) to collect the payment due from obligor(s) and
passes it to GIT. It will also follow up with defaulting obligor and if required initiate appropriate legal action
against them.

Based on above scenario, answer the following questions:

1. The securitized instrument issued for ₹ 100 million by the GIT falls under category of ……….
(a) Pass Through certificate (PTCs)
(b) Pay Through Security (PTS)
(c) Stripped Security
(d) Debt Fund.
Ans:(b)

2. In the above scenario, the Originator is………………….

(a) Grow More Ltd.
(b) MAC Financial Corporation (MFC)
(c) General Investment Trust (GIT)
(d) Safeguard Pvt. Ltd.
Ans:(b)

3. In the above scenario, the General Investment Trust (GIT) is a/an………………….

(a) Obligor
(b) Originator
(c) Special Purpose Vehicle (SPV)
(d) Receiving and Paying Agent (RPA)
Ans:(c)

Chapter 16: Case Scenario 16 - 1

 4. In the above scenario, the Safeguard Pvt. Ltd. (SPL) is a/an………………
(a) Obligor
(b) Originator
(c) Special Purpose Vehicle (SPV)
(d) Receiving and Paying Agent (RPA)
Ans:(d)

5. Which of the following statement holds true?

(a) When Yield to Maturity in market rises, prices of Principle Only (PO) Securities tend to rise.
(b) When Yield to Maturity in market rises, prices of Principle Only (PO) Securities tend to fall.
(c) When Yield to Maturity in market falls, prices of Principle Only (PO) Securities tend to fall.
(d) When Yield to Maturity in market falls, prices of Principle Only (PO) Securities remain the same.
Ans:(b)

CS 2 (RTP May’24)

(Chapter 4- Security Analysis)

You are a financial analyst at a prominent investment firm and have been tasked with empirically verifying
the weak form of Efficient Market Hypothesis (EMH) Theory for the XYZ Stock Index, a collection of diverse
stocks. You decided to conduct three different tests to assess whether the stock market follows the principles
of the weak form of EMH.
Test 1
For the past five years, you collected daily price changes of the stocks in the XYZ Stock Index. You calculated
correlation coefficients for different lag periods and analyzed whether past price changes exhibit any
significant correlation with future price changes. You considered price changes to be serially independent.
The results indicated that most auto correlation coefficients are close to zero and statistically insignificant,
suggesting those past price changes do not predict future price changes.
Test 2
You further investigated the randomness of price changes in the XYZ Stock Index. Analyzing the sequence of
daily price changes, you count the number of runs where price changes are consistently positive or negative.
Upon comparing the observed number of runs with the expected number based on randomness, you find that
they align closely, supporting the idea that price changes follow a random pattern.
Test 3
To examine the efficacy of trading strategies based on historical price trends, you implemented a simple
trading rule for the XYZ Stock Index. The rule involves buying when the price crosses a moving average of 5%
threshold and selling when it crosses another 7% threshold. Over a period of testing, you computed the
returns generated by the trading strategy. The results revealed that the returns are not consistently better
than random chance, implying that past price trends do not reliably predict future price movements.
Conclusion:
After conducting the three tests the evidence supports the weak form of Efficient Market Theory for the XYZ
Stock Index you concluded that past price trends do not reliably predict future price movements.
(RTP May’24)

Based on the above information answer the following questions:

1. Test 1 is …………………
(a) Serial Correlation test
(b) Filter Rules test
(c) Run test
(d) Variance Ratio test
Ans:(a)

2. Test 2 is ………………….
(a) Serial Correlation test
(b) Filter Rules test

16 - 2 Chapter 16: Case Scenario

(c) Run test
(d) Variance Ratio test
Ans:(c)

3. Test 3 is ………………
(a) Serial Correlation test
(b) Filter Rules test
(c) Run test
(d) Variance Ratio test.
Ans:(b)

4. The Filter Rule Test should not be applied for buy and hold strategy if…………….
(a) the behavior of stock price changes is predictable.
(b) the behavior of stock price changes is dependent on pasttrends.
(c) the behavior of stock price changes is correlated.
(d) the behavior of stock price changes is random.
Ans:(d)

5. Results of your studies support the……………

(a) Semi-strong EMH Theory
(b) Strong EMH Theory
(c) Random Walk Theory
(d) Markowitz Theory
Ans:(c)

CS 3 (MTP 8 Marks Mar’24)

(Chapter 8: Mutual Funds)

Mr. Y has invested in the three mutual funds (MF) as per the following details:
Particulars MF ‘X’ MF ‘Y’ MF ‘Z’
Amount of Investment (₹) 4,00,000 8,00,000 4,00,000
Net Assets Value (NAV) at the time of purchase (₹) 10.30 10.10 10
Dividend Received up to 31.03.2023 (₹) 9,000 0 6,000
NAV as on 31.03.2023 (₹) 10.35 10 10.30
Effective Yield per annum as on 31.03.2023 (percent) 9.66 -11.66 24.15
Assume 1 Year = 365 days (MTP Mar’24)

On the basis of above information, choose the most appropriate answer to the following questions:

1. Total NAV of MF ‘Y’ as on 31.03.2023 would be approximately ……………

(a) ₹ 401941.73
(b) ₹ 412000.00
(c) ₹ 792079.20
(d) ₹ 82500.00
Ans: (c)

2. Total Yield of MF ‘X’ in terms of ₹ would be approximately ……………..

(a) ₹ 10941.73
(b) ₹ 7,920.80
(c) ₹ 18,000.00
(d) ₹ 12450.45
Ans: (a)
3. Number of days for which MF ‘X’ is held would be approximately………….
(a) 31 Days
(b) 68 Days

Chapter 16: Case Scenario 16 - 3

 (c) 103 Days
(d) 85 Days
Ans: (c)

4. Number of days for which MF ‘Y’ is held would be………….

(a) 31 ays
(b) 68 Days
(c) 103 Days
(d) 85 Days
Ans: (a)

CS 4 (MTP 8 Marks Mar’24)

(Chapter 5: Security Valuation)

WAVELENGTH Ltd. is planning to expand its business and therefore raising fund by issuing a convertible bond
of ₹ 10 crore. An investor “Mr. X” is interested to invest in the bond of WAVELENGTH Ltd. Mr. X has following
data related to the convertible bond.
The data given below relates to a convertible bond:
Face value ₹ 250
Coupon rate 12%
No. of shares per bond 20
Market price of share ₹ 12
Straight value of bond ₹ 235
Market price of convertible ₹ 265
bond Maturity 5 Years

You, being an expert of the matter, are required to answer his questions. Select the most appropriate
alternative:

1. The percentage of downside risk of the bond is approximately……………..

(a) 10.42%
(b) 6.38%
(c) 2.13%
(d) 12.77%
Ans: (d)

2. The conversion premium in percentage term of the bond is……………..

(a) 12.77%
(b) 10.42%
(c) 2.18%
(d) 13.45%
Ans: (b)

3. The conversion parity price of the stock is…………….

(a) ₹ 11.75
(b) ₹ 12.00
(c) ₹ 13.25
(d) ₹ 12.50
Ans: (c)

4. If he wants a yield of 15% the maximum price he should be ready to pay for is…………….
(a) 217.41
(b) 224.81
(c) 240.00

16 - 4 Chapter 16: Case Scenario

(d) 232.32
Ans: (b)

CS 5 (MTP 6 Marks Mar’24)

(Chapter 4: Security Analysis)

Suppose you are a financial consultant and following 3 clients have approached to you seeking advise on the
investment to be made in securities. All these clients have different background and risk appetite as well as
perception to the market.
• Client A wants to invest in Fixed income avenues and therefore he is looking at the credit rating of the
securities as well as financial ratios such as interest coverage, earning power etc and the general prospect
of the industry.
• Client B wants to earn a fixed income over a period of time by holding the security till its maturity.
• Client C wants to earn more by taking more risk. Therefore, he is more interested to invest in stocks. He
believes that Price reflects all information found in the record of past prices and volumes.

On the basis of above information, choose the most appropriate answer to the MCQs.

1. The main factor to be considered in selecting fixed income avenue for client A shall be………………..
(a) Yield to maturity
(b) Risk of Default
(c) Tax Shield
(d) Liquidity
Ans: (b)

2. The main factor that have to be evaluated in the selection of Bond for Client B shall be………………..
(a) Yield to maturity
(b) Risk of Default
(c) Tax Shield
(d) Liquidity
Ans: (a)

3. If Weak form efficiency is prevailing in the market then which approach is best for selection of Equity
Shares?
(a) Technical Analysis
(b) Fundamental Analysis
(c) Random selection Analysis
(d) None of the above.
Ans: (b)

CS 6 (MTP 8 Marks Mar’24)

(Chapter 14: Mergers, Acquisitions and Corporate Restructuring)

AES Ltd. wants to acquire DNF Ltd. and has offered a swap ratio of 1:2 (0.5 shares for every one share of DNF
Ltd.). Following information is provided:

AES Ltd. DNF Ltd.

Profit after tax ₹ 36,00,000 ₹ 7,20,000
Equity shares outstanding (Nos.) 12,00,000 3,60,000
PE Ratio 10 times 7 times
Market price per share ₹ 30 ₹ 14

On the basis of above information, choose the most appropriate answer to the following questions:

Chapter 16: Case Scenario 16 - 5

 1. The number of equity shares to be issued by AES Ltd. for acquisition of DNF Ltd. would be………………
(a) 1,68,000
(b) 1,80,000
(c) 2,40,000
(d) 3,00,000
Ans: (b)

2. The EPS of AES Ltd. after the acquisition would be………………

(a) ₹ 2
(b) ₹ 3
(c) ₹ 3.13
(d) ₹ 4.00
Ans: (c)

3. The equivalent earnings per share of DNF Ltd. would be………..

(a) ₹ 1
(b) ₹ 1.50
(c) ₹ 1.57
(d) ₹ 2.00
Ans: (c)

4. If AES Ltd. PE multiple remains unchanged then its expected market price per share after the acquisition
would be………………
(a) ₹ 14
(b) ₹ 30
(c) ₹ 31.30
(d) ₹ 40.00
Ans: (c)

CS 7 (MTP 10 Marks Apr’24)

(Chapter 13: Business Valuation)

During one business meeting at XYZ Ltd., one of the members pointed out that while evaluating the
performance of any company one should not only see its Operating Income but should also analyse its Capital
structure as well. Weighted Average Cost of Capital changes on the basis of capital structure keeping all other
factors unchanged.
He presented data relating to 3 companies Alpha Ltd., Beta Ltd. and Gama Ltd. whose operating Income are
equal, but their capital structure is different.
The following information relating to these 3 companies is as follows:
(in ₹ 000)
Alpha Ltd. Beta Ltd. Gama Ltd.
Total invested capital 20,00,000 20,00,000 20,00,000
Debt/Assets ratio 0.8 0.5 0.2
Shares outstanding 61,000 83,000 1,00,000
Pre tax Cost of Debt 16% 13% 15%
Cost of Equity 26% 22% 20%
Operating Income (EBIT) 5,00,000 5,00,000 5,00,000
The Tax rate is uniform 35% in all cases. The industry PE ratio is 11X. (MTP April’24)
Based on above case scenario, choose the most appropriate answer of the following:

1. The weighted average cost of capital of Alpha Ltd. shall approximately be ……………….
(a) 13.520%
(b) 15.225%
(c) 17.950%

16 - 6 Chapter 16: Case Scenario

ADVANCED AUDITING, ASSURANCE
AND PROFESSIONAL ETHICS
REVIEWER

CA Final
May / November 2025

Publisher:

Wavelength Educom Private Limited

202 Professional Plaza,17 Punit Nagar,
Near Malhar point, Old Padra Road,
Vadodara – 390007, Gujarat
 YOU MUST BE WONDERING

How to Read this book?

Step 1 Step 2 Step 3 Step 4
Prioritize more time for Identify key concepts Solve questions Focus on solving LDR
'A' chapters in the ABC in each chapter. in order, from questions during the
analysis easy to difficult. final revision

Step 1: Prioritize your chapters Step 2: Identify key concept

Chapters in the index are Identify the key concepts for each
categorized as A, B, or C based on chapter using the list provided at
their importance. Focus more on 'A' the start of the chapter. Ensure you
chapters, as they carry the most understand them thoroughly. If you
weight, and give adequate struggle with a question, revisit the
attention to 'B' chapters. While all concepts, review them, and
chapters must be covered, this strengthen your understanding
approach helps manage time before moving forward.
efficiently for better results.

Step 3: Start easy Step 4: Last Day Revision (LDR)

The questions are segregated by Focus on solving LDR questions
Standards on Auditing. Start with during the final revision. In the 1.5
Question 1, as they progress from days before the exam, prioritize these
easy to difficult, helping you build questions as they cover the most
confidence throughout the critical concepts from each chapter.
chapter. Pay close attention to the You'll find a quick summary of LDR
“EXAM INSIGHTS” to avoid question numbers listed right before
common mistakes. each chapter for easy reference.
Table of Contents
s
Sr. Particulars PAGE NO. IMP
1 QUALITY CONTROL B
1.1 SQC 1- Quality Control for Firms that Perform Audit and 1.1 - 1 – 1.1-9
Reviews of Historical Financial Information, and other
Assurance and Related Services Engagements
1.2 SA 220- Quality Control for an Audit of Financial Statements 1.2 -1 – 1.2-4
2 GENERAL AUDITING PRINCIPLES AND AUDITOR’S B
RESPONSIBILITIES
2.1 SA 240-The Auditor’s Responsibilities Relating to Fraud in an 2.1-1 – 2.1-6
Audit of Financial Statements
2.2 SA 250- Consideration of Laws and Regulations in an Audit of 2.2-1 – 2.2-7
Financial Statements
2.3 SA 260- Communication with Those Charged with Governance 2.3-1 – 2.3-2
2.4 SA 299- Joint Audit of Financial Statements 2.4-1 – 2.4-2
2.5 SA 402- Audit Considerations Relating to an Entity Using a 2.5-1 – 2.5-3
Service Organisation
3 AUDIT PLANNING, STRATEGY & EXECUTION C
3.1 SA 210- Understanding the Terms of Audit Engagement 3.1-1 -3.1-3
3.2 Audit Plan, Audit Programme & Audit Strategy 3.2-1 – 3.2-5
3.3 SA 600-Using the work of another Auditor 3.3-1 – 3.3-3
3.4 SA 610- Using the work of an Internal Auditor 3.4 -1
3.5 SA 620- Using the work of an Auditor’s Expert 3.5-1 – 3.5-5
3.6 SA 540- Auditing Accounting Estimates, including Fair Value 3.6-1 – 3.6-5
Accounting Estimates & Related Disclosures
3.7 SA 520- Analytical Procedures 3.7-1
4 MATERIALITY, RISK ASSESSMENT AND INTERNAL CONTROL A
4.1 Risk Assessment- SA 315 & SA 330 4.1- 1- 4.1-6
4.2 Internal Control 4.2-1 – 4.2-10
4.3 SA 320-Materiality in Planning & Performing an Audit 4.3-1 – 4.3-4
5 AUDIT EVIDENCE A
5.1 SA 500- Audit Evidence 5.1-1 – 5.1-8
5.2 SA 501- Audit Evidence- Specific Considerations for selected 5.2-1 – 5.2-6
items
5.3 SA 505- External Confirmations 5.3-1 – 5.3-4
5.4 SA 510- Initial Audit Engagements- Opening Balances 5.4-1 – 5.4-2
5.5 SA 530- Audit Sampling 5.5-1 – 5.5-3
5.6 SA 550- Related Parties 5.6-1 – 5.6-3
6 COMPLETION AND REVIEW C
6.1 SA 560- Subsequent Events 6.1-1 – 6.1-4
6.2 SA 570- Going Concern 6.2-1 – 6.2-6
6.3 SA 580- Written Representations 6.3-1 – 6.3-3
7 REPORTING A
7.1 SA 700- Forming an Opinion and Reporting on Financial 7.1-1 - 7.1-8
Statements
7.2 SA 701- Communicating Key Audit Matters in the Independent 7.2-1 – 7.2-4
Auditor’s Report
7.3 SA 705- Modifications to the Opinion in the Independent 7.3-1 – 7.3-13
Auditor’s Report
7.4 SA 706- Emphasis of Matter Paragraphs and Other Matter 7.4-1 – 7.4-2
Paragraphs in the Independent Auditor’s Report
7.5 SA 710- Comparative Information 7.5-1 – 7.5-2
7.6 SA 720- Auditors Responsibility relating to Other Information 7.6-1 – 7.6-3
7.7 Duties of Auditors 7.7-1 – 7.7-2
7.8 Companies Auditor’s Report Order, 2020 7.8-1 – 7.8-16
8 SPECIALISED AREAS B
8.1 SA 800- Special Considerations- Audits of Financial Statements 8.1-1 – 8.1-3
prepared in accordance with Special Purpose Framework
8.2 SA 805- Special Considerations- Audits of Single Financial 8.2-1 – 8.2-2
Statements and Specific Elements, Accounts or Items of a
Financial Statement
8.3 SA 810- Engagements to report on Summary Financial 8.3-1 – 8.3-3
Statements
9 RELATED SERVICES B
9.1 SRS 4400- Engagements to perform agreed upon procedures 9.1-1 – 9.1-4
regarding Financial Information
9.2 SRS 4410- Compilation Engagements 9.2-1 – 9.2-5
10 REVIEW OF FINANCIAL INFORMATION C
10.1 SRE 2400- Engagement to Review Historical Financial 10.1-1 – 10.1-4
Statements
10.2 SRE 2410- Review of Interim Financial Information performed 10.2-1 – 10.2-3
by Independent Auditor of Entity
11 PROSPECTIVE FINANCIAL INFORMATION AND OTHER C
ASSURANCE SERVICES
11.1 SAE 3400- Examination of Prospective Financial Information 11.1-1 – 11.1-5
11.2 SAE 3402- Assurance Reports on Controls at a Service 11.2-1 – 11.2-2
Organisation
11.3 SAE 3420- Assurance Engagements to Report on the 11.3-1 – 11.3-2
Compilation of Pro- Forma Financial Information included in
the Prospectus
12 DIGITAL AUDITING & ASSURANCE 12-1 -12-17 B
13 GROUP AUDITS 13-1 – 13-17 B
14 SPECIAL FEATURES OF AUDIT OF BANKS & NON-BANKING A
FINANCIAL COMPANIES
14.1 Special Features of Audit of Banks 14.1-1 – 14.1-19
14.2 Special Features in Audit of Non-Banking Financial Companies 14.2-1 – 14.2-10
15 OVERVIEW OF AUDIT OF PUBLIC SECTOR UNDERTAKINGS 15-1 – 15-12 C
16 INTERNAL AUDIT 16-1 -16-11 C
17 DUE DILIGENCE, INVESTIGATION & FORENSIC AUDIT 17-1 – 17-22 B
18 EMERGING AREAS: SUSTAINABLE DEVELOPMENT GOALS 18-1 – 18-12 B
(SDG) & ENVIRONMENT, SOCIAL AND GOVERNANCE (ESG)
ASSURANCE
19 PROFESSIONAL ETHICS & LIABILITIES OF AUDITORS 19-1 – 19-51 A
20 CASE SCENARIOS 20 -1 – 20-76 A
ABC Analysis

Very Important, Moderately Less critical but still

A Read on priority
B Important
C essential

Ensure you thoroughly read all chapters without skipping any. The ABC analysis is
designed to help you prioritize based on past trends, but it should not replace
comprehensive preparation.

ABBREVIATIONS : -
TCWG= Those Charged with Governance FS= Financial Statements

FRF= Financial Reporting Framework RPT= Related Party Transactions

EOM= Emphasis of Matter Paragraph OMP= Other Matters Paragraph

SAAE= SufÏcient Appropriate Audit Evidence SFS= Summary Financial Statements

KAM= Key Audit Matters CFS= Consolidated Financial Statements

AFS= Audited Financial Statements

 B
CHAPTER 1: QUALITY CONTROL

CONCEPTS OF THIS CHAPTER

• Importance of audit quality
• Role of quality control system in a firm
• Grasp SQC 1 and SA 220 requirements
• Apply SQC 1 and SA 220 in practice
• Ethics’ significance in audit engagements
• Difference between SQC 1 and SA 220
• Relationship between SQC 1 and SA 220
• Mechanisms for auditing quality review

Chapters Page Number LDR Questions

Chapter 1.1: SQC 1 Quality Control for Firms that 1.1-1 – 1.1-9 Q4
Perform Audit and Reviews of Historical Financial
Information, and other Assurance and Related
Services Engagements
Chapter 1.2: SA 220 Quality Control for an Audit 1.2-1-1.2-4 Q3
of Financial Statements

Chapter 1.1: SQC 1: Quality Control for Firms that Perform Audit and Reviews of Historical
Financial Information, and other Assurance and Related Services Engagements

QUICK REVIEW OF IMPORTANT CONCEPTS

Elementsof
system of
quality control

Leadership Acceptance &

Ethical continuance of Human Engagement
responsibilities Monitoring
requirements client resources performance
for quality relationships
within firm and specific
engagement
1. Integrity. 1. Supervision.
1. Promote internal 2. Objectivity. 2. Review.
culture Firm should ensure that
3. Professional 3. Consultation. policies and procedures
2. Require managing competence & due 4. Differences of relating to the system
partner to assume care. of quality control are
Opinion.
ultimate 4. Confidentiality. relevant, adequate,
responsibility for 5. Engagement
5. Professional operating effectively
Quality Control. Quality Control and complied with in
behaviour.
3. Recognise & Review. practice.
reward high quality 6. Engagement
work. documentation.

1.1 - 1 Chapter 1.1 SQC 1 – Quality Control for Firm

 Questions & Answers

Question 1

J.A.C.K. & Co., a Chartered Accountant firm was appointed as the statutory auditor of Falcon Ltd. after
ensuring the compliance with relevant provisions of the Companies Act, 2013. Mr. Jay was the engagement
partner for the aforesaid audit and prior to commencement of the audit, Mr. Jay had called for a meeting
of the engagement team in order to direct them and assign them their responsibilities. At the end of
meeting, Mr. Jay assigned review responsibilities to two of the engagement team members who were the
most experienced amongst all, for reviewing the work performed by the less experienced team members.
While reviewing the work performed by the less experienced members of the engagement team, what shall
be the considerations of the reviewers? (MTP 5 Marks, Mar’21)

Answer 1
As per SQC 1, “Quality Control for Firms that Perform Audits and Reviews of Historical Financial Information,
and Other Assurance and Related Services Engagements”, review responsibilities are determined on the basis
that more experienced team members, including the engagement partner, review work performed by less
experienced team members.
In the given situation, Mr. Jay, engagement partner assigned review responsibilities to two of the engagement
team members who were the most experienced team members.
While reviewing the work performed by less experienced members of the engagement team, both the more
experienced Reviewers should consider whether:
(i) The work has been performed in accordance with professional standards and regulatory and legal
requirements.
(ii) Significant matters have been raised for further consideration.
(iii) Appropriate consultations have taken place and the resulting conclusions have been documented and
implemented.
(iv) There is a need to revise the nature, timing and extent of work performed.
(v) The work performed supports the conclusions reached and is appropriately documented.
(vi) The evidence obtained is sufficient and appropriate to support the report; and
(vii) The objectives of the engagement procedures have been achieved.

Question 2

(Includes concepts of SA 220-Quality Control for an Audit of Financial Statements)

CA Ragini is offered an appointment to act as Engagement Quality Control Reviewer (EQCR) for the audit of
the financial year 2022-23 of XPM Limited, a listed company operating from a small town. She is also based
in the same town and was not engaged previously to conduct an audit of a listed entity. She accepts the
appointment to act as ECQR. She performs the review by ticking a Yes/No checklist and signing on some of
the working papers prepared by the engagement team. The audit file does not contain any material
misstatement which shows that the work of EQCR is separate from the work of the engagement team. Do
you agree with the approach adopted by EQCR? Comment. (MTP 5 Marks Sep’23)

Answer 2
As per SQC 1 engagement quality control reviewer can be a partner, other person in the firm (member of ICAI),
suitably qualified external person, or a team made up of such individuals, with sufficient and appropriate
experience and authority to objectively evaluate, before the report is issued, the significant judgments the
engagement team made and the conclusions they reached in formulating the report.
It also states that the engagement quality control reviewer for an audit of the financial statements of a listed
entity is an individual with sufficient and appropriate experience and authority to act as an audit engagement
partner on audits of financial statements of listed entities.
In addition, the work of EQCR involves objective evaluation of the significant judgments made by the
engagement team and ensuring that the conclusions reached by the team in formulating audit report are
appropriate. It is necessary for EQCR to have the requisite technical expertise and experience to enable her

Chapter 1.1 SQC 1 – Quality Control of Firms 1.1 - 2

 to perform the assigned role of evaluating the work of engagement team so that any possible misstatement
can be avoided. Without ensuring the appropriate technical expertise and experience, the whole purpose of
EQCR is defeated. Therefore, it was not appropriate for her to accept appointment as ECQR for listed entity.
Further, SA 220 states that the engagement quality control reviewer shall document, for the audit
engagement reviewed, that the procedures required by the firm’s policies on engagement quality control
review have been performed. It also states that it shall also be documented that the reviewer is not aware
of any unresolved matters that would cause the reviewer to believe that the significant judgments the
engagement team made and the conclusions they reached were not appropriate.
In the given situation, CA Ragini is offered an appointment to act as Engagement Quality Control Reviewer
(EQCR) for the audit of the financial year 2022-23 of XPM Limited, a listed company operating from a small
town. She has accepted the appointment and performed the review by ticking a Yes / No checklist and signing
on some of the working papers prepared by the engagement team.
In the instant case, there are no working papers to show that evaluation has been done by EQCR on
conclusions reached by engagement team. Mere ticking of a Yes/No checklist and signing on some working
papers of engagement team shows that no such evaluation and review of work performed by engagement
team has been made by EQCR. Therefore, her approach was not proper in performing work of EQCR.

Question 3

JJJ & Associates, an audit firm working mainly in field of statutory audits, has been selected by Quality
Review Board (QRB) for review. During review, it has been found that Audit Firm Under Review (AFUR) has
not maintained quality of audits of selected companies as evidenced from their respective audit files. AFUR
has not complied with requirements of SA 501 and SA 505 in these cases. Further, in these cases, companies
had not complied with accounting standards as required by law and AFUR has issued clean audit reports.
Dwell upon functions of QRB in this regard. (MTP 5 Marks Oct’23)

Answer 3
Central Government has constituted a Quality Review Board as an independent body under the Chartered
Accountants Act, 1949 to review the quality of services provided by the Chartered Accountants in India
including audit services.
Accordingly, u/s 28B of the Chartered Accountants Act, 1949, the Board shall perform the following
functions, namely: -
(a) to make recommendations to the Council with regard to the quality of services provided by the
members of the Institute
(b) to review the quality of services provided by the members of the Institute including audit services
(c) to guide the members of the Institute to improve the quality of services and adherence to the various
statutory and other regulatory requirements and
(d) to forward cases of non-compliance with various statutory and regulatory requirements by the
members of the Institute or firms, noticed by it during the course of its reviews, to the Disciplinary
Directorate for its examination.
In the given situation, AUFR has not performed audits of selected companies qualitatively and has failed
to perform audits in accordance with Standards on Auditing, Further, it has issued clean reports despite
non-adherence to accounting standards by respective companies. Therefore, QRB is empowered to act
on the lines mentioned above in respect of AUFR.

Question 4 LDR

M/s Chandra & Co., Chartered Accountants were appointed as Statutory Auditors of Green Essence Limited
for the F.Y 2021-2022. The previous year's audit was conducted by M/s. Nath & Associates. After the audit
was completed and report submitted, it was found that closing balances of last financial year i.e., 2020-21
were incorrectly brought forward. It was found that M/s Chandra & Co. did not apply any audit procedures
to ensure that correct opening balances have been brought forward to the current period. A ccordingly, a
complaint was filed against Chandra & Co. in relation to this matter. You are required to inform what policies

1.1 - 3 Chapter 1.1 SQC 1 – Quality Control for Firm

are required to be implemented by Chandra & Co. for dealing with such complaints and allegations as
required by Standard on Quality Control (SQC). (MTP 5 Marks March 22, PYP 5 Marks Jan’21)

Answer 4
In the given question, Chandra & Co. did not apply audit procedures to ensure that opening balances had been
correctly brought forward. A complaint was filed against the auditors in this context. As per Standard on Quality
Control (SQC) 1 “Quality Control for Firms that Perform Audits and Reviews of Historical Financial Information,
and Other Assurance and Related Services Engagements”,
(i) The firm should establish policies and procedures designed to provide it with reasonable assurance that it
deals appropriately with:
(a) Complaints and allegations that the work performed by the firm fails to comply with professional
standards and regulatory and legal requirements; and
(b) Allegations of non-compliance with the firm’s system of quality control.
(ii) Complaints and allegations (which do not include those that are clearly frivolous) may originate from within
or outside the firm. They may be made by firm personnel, clients or other third parties. They may be received
by engagement team members or other firm personnel.
(iii) As part of this process, the firm establishes clearly defined channels for firm personnel to raise any concerns
in a manner that enables them to come forward without fear of reprisals.
(iv) The firm investigates such complaints and allegations in accordance with established policies and procedures.
The investigation is supervised by a partner with sufficient and appropriate experience and authority within
the firm but who is not otherwise involved in the engagement, and includes involving legal counsel as
necessary. Small firms and sole practitioners may use the services of a suitably qualified external person or
another firm to carry out the investigation. Complaints, allegations and the responses to them are
documented.
(v) Where the results of the investigations indicate deficiencies in the design or operation of the firm’s quality
control policies and procedures, or non-compliance with the firm’s system of quality control by an individual
or individuals, the firm takes appropriate action.

Question 5

HK & Co. Chartered Accountants have been auditors of SAT Ltd (a listed entity) for the last 8 financial years.
CA. H, partner of the firm, has been handling the audit assignment very well since the appointment. The
audit work of CA. H and her team is reviewed by a senior partner CA. K to assure that audit is performed in
accordance with professional standards and regulatory and legal requirements. CA. K was out of India for
some personal reasons, so this year CA. G has been asked to review the audit work. In your opinion, what
areas CA. G should consider at the time of review. List any four areas and also comment whether firm is
complying with Standard on Quality Control or not. (PYP 5 Marks July 21)

Answer 5
Compliance with Standard on Quality Control on review of audit work -
As per SQC 1, an engagement quality control review for audits of financial statements of listed entities includes
considering the following:
(i) The work has been performed in accordance with professional standards and regulatory and legal
requirements;
(ii) Significant matters have been raised for further consideration;
(iii) Appropriate consultations have taken place and the resulting conclusions have been documented and
implemented;
(iv) There is a need to revise the nature, timing and extent of work performed;
(v) The work performed supports the conclusions reached and is appropriately documented;
(vi) The evidence obtained is sufficient and appropriate to support the report; and
(vii) The objectives of the engagement procedures have been achieved.
The firm should establish policies and procedures:
(i) Setting out criteria for determining the need for safeguards to reduce the familiarity threat to an
acceptable level when using the same senior personnel on an assurance engagement over a long period
of time; and
Chapter 1.1 SQC 1 – Quality Control of Firms 1.1 - 4
 (ii) For all audits of financial statements of listed entities, requiring the rotation of the engagement partner
after a specified period in compliance with the Code.
The familiarity threat is particularly relevant in the context of financial statement audits of listed entities. For
these audits, the engagement partner should be rotated after a pre- defined period, normally not more than
seven years.
From the facts given in the question and from the above stated paras of SQC 1, it can be concluded that firm
is not complying with SQC 1 as Engagement Partner H is continuing for more than 7 years.
Exam Insights: Most of the examinees did not highlight regarding the rotation of the engagement partner
for a maximum period of seven years and hence the firm is not complying with SQC 1.

Question 6

PQR & Associates, Chartered Accountants, is a partnership firm having 3 partners CA P, CA Q and CA R. PQR
& Associates are appointed as Statutory Auditors of ABC Limited, a listed entity for the financial year 2021-
22 and CA P is appointed as Engagement Partner for the audit of ABC Limited. Before issuing the Audit
Report of ABC Limited, CA P asked CA R to perform Engagement Quality Control Review and is of the view
that his responsibility will be reduced after review by CA R. Whether the contention of CA P is correct? What
are the aspects that need to be considered by CA R while performing Engagement Quality Control Review
for audit of financial statements of ABC Limited? (PYP 5 Marks May ‘22)

Answer 6
As per SQC 1, “Quality Control for Firms that Perform Audit and Reviews of Historical Financial Information,
and other Assurance and Related Services Engagements”, the review does not reduce the responsibilities of
the engagement partner. Hence, contention of CA. P that after engagement quality control review by CA. R,
his responsibility will be reduced, is not correct.
However, CA. R needs to consider the following aspect while performing Engagement Quality Control Review
for audit of financial statements of a listed entity ABC Ltd.:
1. The engagement team’s evaluation of the firm’s independence in relation to the specific engagement.
2. Significant risks identified during the engagement and the responses to those risks.
3. Judgments made, particularly with respect to materiality and significant risks.
4. Whether appropriate consultation has taken place on matters involving differences of opinion or other
difficult or contentious matters, and the conclusions arising from those consultations.
5. The significance and disposition of corrected and uncorrected misstatements identified during the
engagement.
6. The matters to be communicated to management and those charged with governance and, where
applicable, other parties such as regulatory bodies.
7. Whether working papers selected for review reflect the work performed in relation to the significant
judgments and support the conclusions reached.
8. The appropriateness of the report to be issued.
Engagement quality control reviews for engagements other than audits of financial statements of listed
entities may, depending on the circumstances, include some or all of these considerations.

Exam Insights: Responsibility of engagement partner and aspects to be considered while performing
engagement quality control review: Examinees concluded the answer without giving reference of SQC 1
and majority of them covered only one aspect of independence of engagement team and failed to mention
all other aspects to be covered under quality review.

Question 7

AP & Associates, Chartered Accountants, are Statutory Auditors of XP Limited for the last four years. XP
Limited is engaged in the manufacture and marketing of FMCG Goods in India. During 2021-22, the Company
has diversified and commenced providing software solutions in the area of "e-commerce" in India as well
as in certain European countries. AP & Associates, while carrying out the audit for the current financial year,
1.1 - 5 Chapter 1.1 SQC 1 – Quality Control for Firm
came to know that the company has expanded its operations into a new segment as well as new geography.
AP & Associates does not possess necessary expertise and infrastructure to carry out the audit of this
diversified business activities and accordingly wishes to withdraw from the engagement and client
relationship. Discuss the issues that need to be addressed before deciding to withdraw.
(PYP 5 Marks Nov’22)

Answer 7
Acceptance and Continuance of Client Relationships and Specific Engagements: As per SQC 1, “Quality
Control for Firms that Perform Audit and Reviews of Historical Financial Information, and other Assurance
and Related Services Engagements”, the firm should establish policies and procedures for the acceptance
and continuance of client relationships and specific engagements, designed to provide it with reasonable
assurance that it will undertake or continue relationships and engagements only where it is competent to
perform the engagement and has the capabilities, time and resources to do so.
In the given case, AP & Associates, Chartered Accountants, statutory auditors of XP Limited for the last four
years, came to know that the company has expanded its operations into a new segment as well as new
geography. AP & Associates does not possess necessary expertise for the same, therefore, AP & Associates
wish to withdraw from the engagement and client relationship. Policies and procedures on withdrawal from
an engagement or from both the engagement and the client relationship address issues that include the
following:
• Discussing with the appropriate level of the client’s management and those charged with its governance
regarding the appropriate action that the firm might take based on the relevant facts and circumstances.
• If the firm determines that it is appropriate to withdraw, discussing with the appropriate level of the
client’s management and those charged with its governance withdrawal from the engagement or from
both the engagement and the client relationship, and the reasons for the withdrawal.
• Considering whether there is a professional, regulatory or legal requirement for the firm to remain in
place, or for the firm to report the withdrawal from the engagement, or from both the engagement and
the client relationship, together with the reasons for the withdrawal, to regulatory authorities.
• Documenting significant issues, consultations, conclusions and the basis for the conclusions.
AP & Associates should address the above issues before deciding to withdraw.
Exam Insights: SQC 1 - Issues to be addressed at the time of withdrawal from the audit engagement: Very
few examinees gave reference of SQC 1 and the documentation requirement under SQC 1. Many examinees
referred to the procedure to be followed by the auditor at the time of resignation from audit engagement
and various statutory forms to be filed with the registrar of companies.

Question 8

TPX & Co., Chartered Accountants is a large audit firm. It maintains audit documentation both electronically
and in physical form (hard files). The physical files are neither scanned and incorporated into electronic files
nor cross-referenced to the electronic files. Further, there are many instances where audit working papers
do not contain details as to whether information was obtained from client or prepared by engagement
team. How do you view above situation from point of view of quality control system in audit firm? Analyse.
(MTP 5 Marks Mar’24)

Answer 8
In accordance with SQC 1,” Quality Control for Firms that Perform Audits and Reviews of Historical Financial
Information and Other Assurance and Related Services Engagements” the firm should establish policies and
procedures designed to maintain confidentiality, safe custody, integrity, accessibility and retrievability of
engagement documentation.
In the given situation, the physical files are neither scanned and incorporated in the electronic files nor cross-
referenced to the electronic files. Inability to do so shows that firm has not established policies and procedures
to maintain integrity of engagement documentation. Lack of ensuring the same makes it difficult to
demonstrate completeness of audit files and whether these were assembled within 60 days timeframe
stipulated in SQC 1.

Chapter 1.1 SQC 1 – Quality Control of Firms 1.1 - 6

 Where engagement documentation is in paper, electronic, or other media, the integrity, accessibility or
retrievability of the underlying data may be compromised if the documentation could be altered, added to or
deleted without the firm’s knowledge, or if it could be permanently lost or damaged. One of the reasons for
designing and implementing appropriate controls for engagement documentation in this regard is the
protection of the integrity of information at all stages of engagement.
For the practical reasons, original paper documentation may be electronically scanned for inclusion in
engagement files. In that case, the firm implements appropriate procedures requiring engagement teams to:
(a) Generate scanned copies that reflect the entire content of the original paper documentation, including
manual signatures, cross- references and annotations;
(b) Integrate the scanned copies into the engagement files, including indexing and signing off on the scanned
copies as necessary; and
(c) Enable the scanned copies to be retrieved and printed as necessary.
It has also been stated that there are many instances where audit working papers do not contain details
as to whether information was obtained from the client or prepared by the engagement team. It is
important to identify the source of the document, and the information used as audit evidence to ensure
its reliability. It could have potential risks of non-compliance with standards on auditing.

Question 9

SS Ltd. is a company listed in India. The Company has appointed M/s Z & Co. as auditors. Mr. Q, a CA has
recently joined the firm and has been appointed as the engagement partner for the first time. He
understands that it is necessary to ensure the compliance of independence for the audit team as per
standard audit practices. But he could not find as such, any policies and procedures available with the firm
in documented form. Why do you think that the firm should have policies and procedures to ensure the
independence of the firm in every assignment? How does an engagement partner ensure the compliance
of independence? Discuss with reference to relevant SAs. (PYP 5 Marks Nov’23)

Answer 9
As per SQC 1, “Quality Control for Firms that Perform Audits and Reviews of Historical Financial Information,
and Other Assurance and Related Services Engagements,” the firm should establish policies and procedures
designed to provide it with reasonable assurance that the firm, its personnel and, where applicable, other s
subject to independence requirements (including experts contracted by the firm and network firm
personnel), maintain independence where required by the Code. Such policies and procedures should enable
the firm to:
(i) Communicate its independence requirements to its personnel and, where applicable, to others subject
to them; and
(ii) Identify and evaluate circumstances and relationships that create threats to independence, and to take
appropriate action to eliminate those threats or reduce them to an acceptable level by applying
safeguards, or, if considered appropriate, to withdraw from the engagement.
Further, as per SA 220, “Quality Control for an Audit of Financial Statements”, the engagement partner shall
form a conclusion on compliance with independence requirements that apply to the audit engagement.
In doing so, the engagement partner shall:
(i) Obtain relevant information from the firm and, where applicable, network firms, to identify and
evaluate circumstances and relationships that create threats to independence.
(ii) Evaluate information on identified breaches, if any, of the firm’s independence policies and
procedures to determine whether they create a threat to independence for the audit engagement;
and

(iii) Take appropriate action to eliminate such threats or reduce them to an acceptable level by applying
safeguards, or, if considered appropriate, to withdraw from the audit engagement, where withdrawal
is permitted by law or regulation. The engagement partner shall promptly report to the firm any
inability to resolve the matter for appropriate action.

1.1 - 7 Chapter 1.1 SQC 1 – Quality Control for Firm

 Exam Insights: Compliance of independence requirements under SQC 1 & SA 220: Majority of the
examinees mentioned only SQC 1& SA 220 without discussing the relevant provisions of ensuring the
compliance of independence requirements pursuant to aforesaid SAs in respect of the firm and
engagement partner and offered irrelevant explanation.

Question 10
(Includes concepts of SA 220)
CA Giri is a senior partner of M/s TSV Associates. M/s TSV Associates is a reputed firm of Chartered
Accountants which has been in practice for more than five decades. The firm undertakes statutory audits of
large listed companies across various industry sectors and has more than fifty qualified experienced
professionals. CA Giri has been assigned as an Engagement Quality Control Reviewer for an audit issues
engagement of a listed company. What are the aspects, which would be looked into by CA Giri as an EQCR in
relation to the engagement?
Upon completion of the review, CA Giri has identified certain, with respect to revenue recognition and
adequacy of provisions relating to onerous contracts. The views of CA Giri are not accepted by the
Engagement Partner. Suggest the ways of resolving the differences of opinion between CA Giri and the
engagement partner. (PYP 5 Marks May ‘24)

Answer 10
As per SA 220, “Quality Control for an Audit of Financial Statements”, for audits of financial statements of listed
entities, CA. Giri, the engagement quality control reviewer, on performing an engagement quality control
review, shall also consider the following:
(i) The engagement team’s evaluation of the firm’s independence in relation to the audit engagement;
(ii) Whether appropriate consultation has taken place on matters involving differences of opinion or other
difÏcult or contentious matters, and the conclusions arising from those consultations;
(iii) Whether audit documentation selected for review reflects the work performed in relation to the significant
judgments made and supports the conclusions reached.
As per SQC 1, “Quality Control for Firms that Perform Audits and Reviewsof Historical Financial Information,
and Other Assurance and Related Services Engagements,”, there might be difference of opinion within
engagement team, with those consulted and between engagement partner and engagement quality control
reviewer. The report should only be issued after resolution of such differences. In case, recommendations of
engagement quality control reviewer are not accepted by engagement partner and matter is not resolved to
reviewer’s satisfaction, the matter should be resolved by following established procedures of firm like by
consulting with another practitioner or firm, or a professional or regulatory body.
In the given situation, under completion of review, CA. Giri, Engagement Quality Control Reviewer has identified
certain issues. However, the view of CA Giri, the EQCR are not accepted by the Engagement Partner. This
difference of opinion among the CA Giri and Engagement Partner shouldbe resolved with abovementioned
manner as per SQC 1.

Question 11

SPS & Associates, Chartered Accountants, are statutory auditors of Grec Limited for the last two years. Grec
Limited is engaged in the manufacturing and marketing of pharmaceutical goods in India. During the year
2023-24, the company has diversified and commenced providing software solutions in "e-commerce" in
India as well as in certain African countries. SPS & Associates, while carrying out the audit, noticed that the
company has expanded its operations into a new segment as well as in a new country. SPS & Associates
does not possess the necessary expertise and infrastructure to carry out the audit of these diversified
business activities and accordingly wishes to withdraw from the engagement and client relationship. Discuss
the issues that need to be addressed before deciding to withdraw. (MTP 5 Marks Sep’24)
Answer 11
As per SQC 1, “Quality Control for Firms that Perform Audits and Reviews of Historical Financial Information,
and Other Assurance and Related Services Engagements”, the firm should establish policies and procedures for
the acceptance and continuance of client relationships and specific engagements, designed to provide it with

Chapter 1.1 SQC 1 – Quality Control of Firms 1.1 - 8

 reasonable assurance that it will undertake or continue relationships and engagements only where it is
competent to perform the engagement and has the capabilities, time and resources to do so.
In the given case, SPS & Associates, Chartered Accountants, statutory auditors of Grec Limited for the last two
years, came to know that the company has expanded its operations into a new segment as well as in new
country. SPS & Associates does not possess the necessary expertise for the same, therefore, SPS & Associates
wish to withdraw from the engagement and client relationship. Policies and procedures on withdrawal from
an engagement or from both the engagement and the client relationship address issues that include the
following:
Discussing with the appropriate level of the client’s management and those charged with its governance
regarding the appropriate action that the firm might take based on the relevant facts and circumstances.
If the firm determines that it is appropriate to withdraw, discussing with the appropriate level of the client’s
management and those charged with governance withdrawal from the engagement or from both the
engagement and the client relationship, and the reasons for the withdrawal.
Considering whether there is a professional, regulatory, or legal requirement for the firm to remain in place, or
for the firm to report the withdrawal from the engagement, or from both the engagement and the client
relationship, together with the reasons for the withdrawal, to regulatory authorities.
Documenting significant issues, consultations, conclusions, and the basis for the conclusions.
SPS & Associates should address the above issues before deciding to withdraw.

1.1 - 9 Chapter 1.1 SQC 1 – Quality Control for Firm

 A
CHAPTER 5: AUDIT EVIDENCE

CONCEPTS OF THIS CHAPTER

• Procedures related to audit evidence
• Review SAs: SA 500, SA 501, SA 505, SA 510, SA 530, SA 550
• Application of above SAs in practice
• Understand concepts with analytical examples and case studies
• Knowledge of practical situations auditors face in evidence procedures

Chapters Page Number LDR Questions

Chapter 5.1: SA 500- Audit Evidence 5.1-1 – 5.1-8 Q 7 MCQ
Chapter 5.2: SA 501- Audit Evidence- Specific 5.2-1 – 5.2-6 Q5
Considerations for selected items
Chapter 5.3: SA 505- External Confirmations 5.3-1 – 5.3-4 Q3
Chapter 5.4: SA 510- Initial Audit Engagements- 5.4-1 – 5.4-2 -
Opening Balances
Chapter 5.5: SA 530- Audit Sampling 5.5-1 – 5.5-3 -
Chapter 5.6: SA 550- Related Parties 5.6-1 – 5.6-3 -

Chapter 5.1: SA 500- Audit Evidence

QUICK REVIEW OF IMPORTANT CONCEPTS

Scope
Design and perform audit procedures in such a way as to enable the auditor to obtain sufÏcient appropriate
audit evidence to be able to draw reasonable conclusions on which tobase the auditor’s opinion.

Methods to obtain Audit Evidence

Inspection
• Inspection • Recalculation • Observation
• Reperformance • Inquiry and confirmation • Analytical procedures

Using the Work of management’s expert

a. Evaluate the competence, capabilities and objectivity of that expert;
b. Obtain an understanding of the work of that expert; and
c. Evaluate the appropriateness of that expert’s work as audit evidence for the relevant assertion.

Audit procedures to obtain audit evidence

1. Risk Assessment procedures
2. Further audit procedures comprisingof: Test of controls and Substantive procedures.

5.1 - 1 Chapter 5.1 SA 500 – Audit Evidence

 Questions & Answers

Question 1

(Includes concepts of SA 620- Using Work of Auditor’s Expert)

ABC Ltd. appointed Mr. Anand for the actuarial calculation of liabilities associated with insurance contracts
and employee benefit plans. These calculations and valuations are then adopted by management in
preparing the financial statements. Kindly guide Mr. Sushil, the statutory auditor of ABC Ltd, on the use of
information prepared by management's appointed expert as audit evidence. Also, explain Mr. Sushil the
matters that can impact the nature, timing and extent of audit procedures regarding information t o be used
as audit evidence which has been prepared using the work of a management’s expert. (MTP 4 Marks Sep’23)

Answer 1
As per SA 500, “Audit Evidence”, when information to be used as audit evidence has been prepared using the
work of a management expert, the auditor shall, to the extent necessary, having regard to the significance of
that expert’s work for the auditor’s purposes:
(i) Evaluate the competence, capabilities and objectivity of that expert;
(ii) Obtain an understanding of the work of that expert; and
(iii) Evaluate the appropriateness of that expert’s work as audit evidence for the relevant assertion.
Further, the nature, timing and extent of audit procedures in relation to the requirement relating to information
to be used as audit evidence prepared using the work of a management’s expert may be affected by such
matters as:
(i) The nature and complexity of the matter to which the management’s expert relates.
(ii) The risks of material misstatement in the matter.
(iii) The availability of alternative sources of audit evidence.
(iv) The nature, scope and objectives of the management’s expert’s work.
(v) Whether the management’s expert is employed by the entity or is a party engaged by it to provide relevant
services.
(vi) The extent to which management can exercise control or influence over the work of the management’s
expert.
(vii) Whether the management’s expert is subject to technical performance standards or other professional or
industry requirements.
(viii) The nature and extent of any controls within the entity over the management’s expert’s work.

Question 2

During the course of the audit of TK Home Private Limited, a recognized export house engaged in manufacturing
of T-shirts under brand name of “TK”. CA Tripti is verifying export revenues of the company for the year 2022-
23. She has verified transactions entered in “Export Sales” account maintained in accounting software from
relevant export invoices. The export sales are being made on payment of IGST, for which a refund is
automatically credited in the account of the company after the goods are shipped.
On enquiring from internal audit staff regarding the recognition of export revenues, she is told that export sales
are recognized for the year on the basis of “Bills of Lading”. However, she is not convinced with such a response
and feels that the same does not appear to be proper.
She finds that three export invoices bearing dates in the month of March 2023 having a value of ₹ 75.00 lacs
have not been recognized in export revenue on the ground that bills of lading for these invoices were issued in
the month of April 2023.
Discuss from what sources she can obtain reliable audit evidence in this regard. How can she challenge
management’s assertion regarding the completeness of export revenues for the year 2022-23? (SM)

Answer 2
She can obtain reliable audit evidence by going through GST returns filed by the company on GST portal and
correlating the same with e-way bills. She can obtain audit evidence about how company has reflected its export

Chapter 5.1 SA 500 – Audit Evidence 5.1 - 2

 sales in its GST returns and whether export sales pertaining to three invoices having value of ₹ 75.00 lacs are
reflected in such returns.
Further, e-way bills generated on the portal would provide evidence that goods have moved out of the company’s
premises. The export revenue should have been booked at the time the goods moved out of the company’s
premises. The company is claiming an IGST refund. The refund is linked to the monthly sales return. This aspect
can also be verified.
“Bill of Lading” is only a document issued by the carrier to the shipper of goods that goods have been taken on
board. She should challenge and counter management’s assertion on the above grounds and point out violations
of relevant accounting standards and principles. In this way, she can obtain reliable audit evidence.
Highlighting such digital and other evidence, she can challenge management’s assertion regarding the
completeness of export revenues and point out that export revenues are understated.

Question 3

Yupee (P) Ltd. got incorporated on 15th May 2021 and Mr. Harsh, the director of Yupee (P) Ltd. proposed to
Kamal & Co. on 24th May 2021, for being appointed as its statutory auditor. Mr. Kamal, the sole proprietor of
Kamal & Co., after checking the compliance with all the statutory requirements, accepted the said offer and
issued an audit engagement letter vide email to Yupee (P) Ltd.
Mr. Harsh found all terms of audit engagement to be proper but in the paragraph relating to auditor’s
responsibly in the engagement letter, as produced below:-
“We will conduct our audit in accordance with Standards on Auditing (SAs), issued by the Institute of Chartered
Accountants of India (ICAI). Those Standards require that we comply with ethical requirements and plan and
perform the audit to obtain reasonable assurance about whether the financial statements are free from
material misstatement.”
Certain queries raised in his mind that what does reasonable assurance meant? Which Standard on Auditing
requires the auditor to obtain such reasonable assurance? Is it possible to give absolute assurance on such
financial statements?
Assuming that you are Mr. Kamal, the newly appointed statutory auditor of Yupee (P) Ltd. Please address to
the queries of Mr. Harsh as stated above. (MTP 5 Marks, Apr’22)

Answer 3
As per SA 200, “Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with
Standards on Auditing”, the auditor is required:-
“To obtain reasonable assurance about whether the financial statements as a whole are free from material
misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether
the financial statements are prepared, in all material respects, in accordance with an applicable financial
reporting framework.”
Reasonable assurance is a high level of assurance and is less than absolute assurance. It is obtained when the
auditor has obtained sufficient appropriate audit evidence to reduce audit risk (i.e., the risk that the auditor
expresses an inappropriate opinion when the financial statements are materially misstated) to an acceptably low
level.
The auditor is not expected to, and cannot, reduce audit risk to zero and cannot therefore obtain absolute
assurance that the financial statements are free from material misstatement due to fraud or error. This is
because there are inherent limitations of an audit, which result in most of the audit evidence on which the
auditor draws conclusions and bases the auditor’s opinion being persuasive rather than conclusive. The inherent
limitations of an audit arise from:
• The nature of financial reporting;
• The nature of audit procedures; and
• The need for the audit to be conducted within a reasonable period of time and at a reasonable cost.

Question 4

M/s SG & Co. Chartered Accountants were appointed as Statutory Auditors of XYZ Limited for the F.Y 2020-
2021. The Company implemented internal controls for prevention and early detection of any fraudulent

5.1 - 3 Chapter 5.1 SA 500 – Audit Evidence

activity. Auditors carried out test of controls and found out no major observations. After the completion of
audit, audit report was submitted by the auditors and audited results were issued. Fraud pertaining to the
area of inventory came to light subsequently for the period covered by audit and auditors were asked to
make submission as to why audit failed to identify such fraud. Auditors submitted that because of inherent
limitations of audit, it is not possible to get persuasive evidence of certain matters like fraud. Do you think
auditor made correct statement? Also discuss certain subject matters or assertions where it is difficult to
detect material misstatements due to potential effects of inherent limitations. (PYP 5 Marks, Jul’21)
Answer 4
Certain assertions or subject matters where it is difficult to detect material misstatements due to potential
effects of inherent limitations -
As per SA 200 - “Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance
with Standards on Auditing” and as per SQC 1 because of the inherent limitations of an audit, there is an
unavoidable risk that some material misstatements of the financial statements may not be detected, even
though the audit is properly planned and performed in accordance with SAs.
Accordingly, the subsequent discovery of a material misstatement of the financial statements resulting from
fraud or error does not by itself indicate a failure to conduct an audit in accordance with SAs. However, the
inherent limitations of an audit are not a justification for the auditor to be satisfied with less-than-persuasive
audit evidence.
Whether the auditor has performed an audit in accordance with SAs is determined by the audit procedures
performed in the circumstances, the sufficiency and appropriateness of the audit evidence obtained as a result
thereof and the suitability of the auditor’s report based on an evaluation of that evidence in the light of the
overall objectives of the auditor.
In view of above, it can be concluded that auditors did not give correct statement.
In the case of certain assertions or subject matters, the potential effects of the inherent limitations on the
auditor’s ability to detect material misstatements are particularly significant. Such assertions or subject matters
include:
(i) Fraud, particularly fraud involving senior management or collusion.
(ii) The existence and completeness of related party relationships and transactions.
(iii) The occurrence of non-compliance with laws and regulations.
(iv) Future events or conditions that may cause an entity to cease to continue as a going concern.
Exam Insights: Examinees did not understand the requirement of the question and they wrongly concluded
that the contention of auditor was correct. Examinees failed to highlight that inherent limitations of an audit
are not a justification for the auditor to be satisfied with less-than-persuasive audit evidence. Majority of
examinees could not list out the assertions or subject matters where it was difficult to detect material
misstatements due to potential effects of inherent limitations. Lack of understanding of SA 200 was obvious
in majority of cases.

Question 5
You are the team leader of 10 members for an audit of a Multinational Company. All the team members are
concerned about audit documentation in order to provide evidence that the audit complies with SAs. Hence,
the team members wish to document every matter concerned. In your opinion it is neither necessary nor
practicable for the auditor to document every matter considered or professional judgement made in an
audit. Further you feel that it is unnecessary for the auditor to document separately compliance with matters
for which compliance is demonstrated by documents included within the audit file. Illustrate by giving
examples with reference to relevant Standard on Auditing. (PYP 5 Marks, May’22)

Answer 5
SA 230, “Audit Documentation”, provides evidence that the audit complies with SAs. However, it is neither
necessary nor practicable for the auditor to document every matter considered, or professional judgment
made, in an audit.
For example,
(i) the existence of an adequately documented audit plan demonstrates that the auditor has planned the
audit.

Chapter 5.1 SA 500 – Audit Evidence 5.1 - 4

 (ii) the existence of a signed engagement letter in the audit file demonstrates that the auditor has agreed
the terms of the audit engagement with management, or where appropriate, those charged with
governance.
(iii) An auditor’s report containing an appropriately qualified opinion demonstrates that the auditor has
complied with the requirement to express a qualified opinion under the circumstances specified in the
SAs.
(iv) In relation to requirements that apply generally throughout the audit, there may be a number of ways
in which compliance with them may be demonstrated within the audit file:
• For example, there may be no single way in which the auditor’s professional skepticism is documented.
But the audit documentation may nevertheless provide evidence of the auditor’s exercise of professional
skepticism in accordance with SAs. Such evidence may include specific procedures performed to
corroborate management’s responses to the auditor’s inquiries.
• Similarly, that the engagement partner has taken responsibility for the direction, supervision and
performance of the audit in compliance with the SAs may be evidenced in a number of ways within the
audit documentation. This may include documentation of the engagement partner’s timely involvement
in aspects of the audit, such as participation in the team discussion required by SA 315, “Identifying and
Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment”.

Exam Insights:
SA 230 on Audit Documentation - Necessity of maintaining documentation for each and every matter:
Examinees failed to understand the requirement of the question and explained that audit documents
are to be maintained in temporary and permanent audit files. Illustrations as required by the question
were also not mentioned by most of the examinees.

MULTIPLE CHOICE QUESTIONS (MCQ)

1. The audit team has obtained the following results from the trade receivables circularization of Nemi Co
for the year ended 31 March 2023.
Customer Balance as per Balance as per customer Comment
sales ledger confirmation
₹ ₹
AM Co. 2,25,000 2,25,000
AN Co. 3,50,000 2,75,000 Invoice raised on 29 March 2023
AO Co. 6,20,000 4,80,000 Payment made on 30 March 2023
AP Co. 5,35,000 5,35,000 A balance of ₹ 45,000 is currently
AR Co. 1,78,000 No reply being disputed by AP Co.
Which of the following statements in relation to the results of the trade receivables circularization is TRUE?
(MTP 1 Mark Sep’23 ,Apr’19 & Apr’21)
(a) No further audit procedures need to be carried out in relation to the outstanding balances with AM Co.
and AP Co.
(b) The difference in relation to AN Co. represents a timing difference and should be agreed to a pre - year-
end invoice.
(c) The difference in relation to AO Co. represents a timing difference and should be agreed to pre - year-
end bank statements.
(d) Due to the non-reply, the balance with AR Co. cannot be verified and a different customer balance should
be selected and circularized.
Ans: (b)

2. You are the audit manager of Ranker & Co are responsible for the audit work to be managed for the fixed
assets of the company. Ranker & Co has 5 properties amounting to Rs.11.5 crore. One of the important
tasks ahead for you is to confirm the ownership of these properties.
Which of the following would provide the most persuasive evidence of the ownership?
(MTP 1 Marks Apr’21)

5.1 - 5 Chapter 5.1 SA 500 – Audit Evidence

 (a) To conduct a physical inspection of all the properties located at different areas.
(b) To ask the management registration documents of these properties and inspect and verify them.
(c) To check whether all the properties are recorded properly in the fixed asset register and depreciation
has been calculated correctly.
(d) Enquire with the management if these properties are insured and review the insurance documentation.
Ans: (b)

3. JIN Ltd issued a prospectus in respect of an IPO which had the auditor’s report on the financial statements
for the year ended 31 March 2022. The issue was fully subscribed.
During this year, there was an abnormal rise in the profits of the company for which i t was found later
on that it was because of manipulated sales in which there was participation of Whole-time director and
other top officials of the company. On discovery of this fact, the company offered to refund all moneys
to the subscribers of the shares and sued the auditors for the damages alleging that the auditors failed
to examine and ascertain any satisfactory explanation for steep increase in the rate of profits and related
accounts.
The company emphasized that the auditor should have proceeded with suspicion and should not have
followed selected verification. The auditors were able to prove that they found internal controls to be
satisfactory and did not find any circumstance to arouse suspicion.
The company was not able to prove that auditors were negligent in performance of their duties. Which of
the following is correct: (MTP 1 Mark Mar’23)
(a) The stand of the company was correct in this case. Considering the nature of the work, the Auditors
should have proceeded with suspicion and should not have followed selected verification.
(b) The approach of the auditors looks reasonable in this case. The auditors found internal controls to be
satisfactory and also did not find any circumstance to arouse suspicion and hence they performed their
procedures on the basis of selected verification.
(c) In the given case, the auditors should have involved various experts along with them to help them on
their audit procedures. Prospectus is one area wherein management involves various experts and hence
the auditors should also have done that. In the given case, by not involving the experts the auditors did
not perform their job in a professional manner. If they had involved experts like forensic experts etc.,
the manipulation could have been detected. Hence the auditors should be held liable.
(d) In case of such type of engagements, the focus is always on the management controls. If the controls
are found to be effective, then an auditor can never be held liable in respect of any deficiency or
misstatement or fraud.
Ans: (b)

4. The following inherent limitations in an audit affect the auditor’s ability to detect material misstatements
except: (MTP 1 Mark Sep’22)
(a) Test and sampling.
(b) Audit process permeated by judgement.
(c) Poor corporate governance.
(d) Audit evidence.
Ans: (c)

5. Below is an extract from the list of supplier statements as at 31st March 2022 held by the Company and
corresponding payables ledger balances at the same date along with some commentary on the noted
differences:
Supplier Statement balance Payables ledger balance
₹'000 ₹'000
Shubh Company 78 66
Labh Company 235 205
The difference in the balance of Shubh Company is due to an invoice which is under dispute due to defective
goods which were returned on 30th March 2022. Which of the following audit procedures should be carried out
to confirm the balance owing to Shubh Company?

Chapter 5.1 SA 500 – Audit Evidence 5.1 - 6

 (I) Review post year-end credit notes for evidence of acceptance of return.
(II) Inspect pre year-end goods returned note in respect of the items sent back to the supplier.
(III) Inspect post year-end cash book for evidence that the amount has been settled.
(MTP 1 Mark Sep’22, RTP May’21)
(a) 1, 2 and 3.
(b) 1 and 3 only.
(c) 1 and 2 only.
(d) 2 and 3 only.
Ans: (c)

6. You are the audit senior in charge of the audit of Swadhyay Co. and have been informed by your audit
manager that during the current year a fraud occurred at the client. A payroll clerk sets up fictitious
employees and the wages were paid into the clerk’s own bank account. This clerk has subsequently left
the company, but the audit manager is concerned that additional frauds have ta ken place in the wages
department. Which of the following audit procedures would be undertaken during the audit of wages as
a result of the manager’s assessment of the increased risk of fraud?
(1) Discuss with the payroll manager the nature of the payroll fraud, how it occurred and the financial
impact of amounts incorrectly paid into the payroll clerk’s bank account.
(2) Review the supporting documentation to confirm the total of the fraudulent payments made and
assess the materiality of this misstatement.
(3) Review and test the internal controls surrounding setting up of and payments to new joiners to assess
whether further frauds may have occurred.
(4) Review the legal action taken by the management against the payroll clerk who was involved in the
fraud and see whether he is punished for his actions. (MTP 2 Marks Oct’19, MTP 1 Mark Apr’23)
(a) Audit procedures 1,2,3.
(b) Audit procedures 2,3,4.
(c) Audit procedures 1,3,4.
(d) Audit procedures 1,2,4.
Ans: (a)

7. Andromeda Limited issued a prospectus in respect of an IPO which had the auditor’s report on the
financial statements for the year ended 31st March, 2021. The issue was fully subscribed. During this
year, there was an abnormal rise in the profits of the company for which it was found later that it was
because of Dealer dumping technique used by the company to inflate the sales. Upon further
investigation it was identified that the Whole-time director and other top officials of the company were
involved in the scheme. On discovery of this fact, the company offered to refund all moneys to the
subscribers of the shares and sued the auditors for the damages alleging that the auditors failed to
examine and ascertain any satisfactory explanation for steep increase in the rate of profits and related
accounts.
The company emphasized that the auditor should have proceeded with suspicion and should not have
followed selected verification. In response, the auditors were able to prove that they found internal
controls to be satisfactory based on the samples which were selected for testing design and operating
effectiveness and did not find any circumstance to arouse suspicion. Further, they were able to prove to
the satisfaction that the sampling performed for substantive procedures was also appropriate as per
sampling guidelines and was sufficient to reflect the population.
The company was not able to prove that auditors were negligent in the performance of their duties. You
are required to advise on the same. (MTP 1 Mark Nov’21, Oct 19 & Mar’22)
(a) The stand of the company was correct in this case. Considering the nature of the work, the Auditors
should have proceeded with suspicion and should not have followed selected verification.
(b) The approach of the auditors appears to be reasonable in this case. The auditors found internal controls
to be satisfactory and also did not find any circumstance to arouse suspicion and hence they performed
their procedures on the basis of selected verification.

5.1 - 7 Chapter 5.1 SA 500 – Audit Evidence

 (c) In the given case, the auditors should have involved various experts along with them to help them on
their audit procedures. Prospectus is one area wherein management involves various experts and hence
the auditors should also have done that. In the given case, by not involving the experts the auditors did
not perform their job in a professional manner. If they had involved experts like forensic experts etc.,
the manipulation could have been detected. Hence the auditors should be held liable.
(d) In case of such type of engagements, the focus is always on the management controls. If the controls are
found to be effective, then an auditor can never be held liable in respect of any deficiency or
misstatement or fraud.
Ans: (b)

8. Mr. C, auditor of a listed company, DEX Limited, signed its audit report on 21.8.2021. The regulator called
the audit file in connection with some proceedings on 20.7.2022. He submitted audit files in the form of
editable Excel files without any security feature on 10.8.2022. It later transpired that the audit file was
modified between 20.7.2022 and 10.8.2022 by deleting certain information and adding fresh information
in its place. Which of the following statements is likely to be correct in this regard? (MTP 1 Mark Oct’23)
(a) Audit file was required to be assembled by 21.8 2021. Modification in the audit file after 21.8.2021 was
generally not permissible.
(b) Audit file was required to be assembled by 21.8 2021. Modification in the audit file before 20.7.2022 was
generally permissible.
(c) Audit file was required to be assembled by 20.10.2021. Modification in the audit file before 20.7.2022
was generally permissible.
(d) Audit file was required to be assembled by 20.10.2021. Modification in the audit file after 20.10.2021
was generally not permissible except in certain exceptional circumstances.
Ans: (d)

9. Bahu Subahu Co. LLP is an old firm of Chartered Accountants with Bahu and Subahu as the audit partners.
The firm has various statutory audit and internal audit engagements which are looked after by Bahu and
Subahu respectively. In the previous year ended 31 March 2022, one of the audit engagements of the firm
was picked up for peer review and peer reviewer raised various observations regarding the audit
documentation. Some of the information regarding audits were missing from the audit files as per the
observation of the peer reviewer.
Bahu and Subahu are in the process of establishing a robust mechanism for audit documentation so that
the same is available for a long duration and would lead to audit efficiencies also in the future years. Bahu
and Subahu would like to understand the period for which audit documentation should be maintained by
them as per the Standard on Auditing 230. Please advise. (MTP 1 Mark, Mar’23, RTP May’19)
(a) 10 years.
(b) 9 years.
(c) 8 years.
(d) 7 years.
Ans: (d)

Chapter 5.1 SA 500 – Audit Evidence 5.1 - 8