Revenue, Repairs, and a Bank Covenant: The Audit Sign-Off
You are on the internal audit committee of Surya Traders, a small private company applying for a working-capital loan. The draft profit before tax is ₹18.40 lakh. The bank covenant requires net profit of at least ₹16 lakh and a debt–equity ratio no higher than 2:1. Three entries are disputed. First, sales of ₹2.10 lakh were recorded to a customer whose cheque bounced after year-end; the customer has since written to cancel the order, and the goods remain in Surya’s godown. Second, ₹1.50 lakh spent on repairing a packing machine has been capitalised as “machine improvement”; the machine’s output is unchanged. Third, the accountant changed depreciation from written-down value at 15% to straight-line over 10 years, increasing profit by ₹0.90 lakh, and has not disclosed the change. A ₹4 lakh contingent liability from a pending tax appeal is also omitted. The managing partner says all three choices are “commercial decisions” and asks you to sign the draft so the loan file can move.
1. Classify the disputed entries and compute adjusted profit before tax. State whether the bank covenant is met.
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The ₹2.10 lakh sale fails a basic revenue-recognition condition: the customer has cancelled, the cheque bounced, and the goods remain in Surya’s godown. The sale should be reversed. The ₹1.50 lakh repair merely restores the packing machine’s existing performance and does not increase output; it should be expensed, not capitalised. The depreciation change may be legitimate if the useful-life estimate is supported, but here it increases profit by ₹0.90 lakh with no disclosure; for covenant testing it should be treated as unsupported until justified and disclosed. The omitted ₹4 lakh tax appeal is a contingent liability that at least requires disclosure, even if an outflow is not probable.
Ignoring tax effects, adjusted profit before tax = 18.40 − 2.10 − 1.50 = ₹14.80 lakh. If the ₹0.90 lakh depreciation benefit is also reversed, adjusted profit is ₹13.90 lakh. Either figure is below the ₹16 lakh covenant. The covenant is therefore not met on the draft as adjusted.
2. Can you sign the draft as presented? What audit or communication action follows?
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You cannot sign the draft as a clean, true-and-fair presentation. The revenue reversal and the capitalised repairs are material misstatements, and the undisclosed depreciation change and omitted contingent liability are disclosure defects. The first step is to request adjustment and disclosure by management, with a written list of the proposed corrections and their profit impact. If management refuses, the auditor should consider a qualified opinion because the misstatements are material, or an adverse opinion if they are pervasive. The matter should be documented and communicated to those charged with governance. Because the draft is being used to support a loan covenant, the bank’s reliance on materially overstated profit is a serious concern; silence is not a neutral option.
3. Evaluate the managing partner’s argument that these are “commercial decisions” that the auditor should accept.
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A commercial motive does not determine accounting treatment. The question is whether the transaction meets recognition, measurement, and disclosure requirements, not whether the partner wants a larger profit. Reversing a cancelled sale, expensing repairs that do not improve the asset, disclosing a depreciation change, and disclosing a contingent liability are all matters of faithful representation and neutrality. Describing them as “commercial decisions” blurs the distinction between business judgement and reporting judgement.
If anything, the presence of a loan covenant increases the need for scepticism: the entries conveniently move profit toward a threshold. The auditor should apply professional scepticism, document the rationale, and not accept management’s label as evidence. A “commercial decision” explanation may be relevant to why a transaction occurred, but it cannot override the reporting framework.