Two Unresolved Misstatements and a Going-Concern Doubt in a Dehradun Audit
You are finalising the statutory audit of a Dehradun auto-components company for FY 2024-25. Revenue is ₹18.4 crore, profit before tax ₹1.12 crore, net worth ₹1.90 crore and total assets ₹9.60 crore. You have set overall materiality at ₹6 lakh (about 5 per cent of PBT) and performance materiality at ₹4.20 lakh. Two matters remain unresolved. (a) A GST demand of ₹42 lakh for FY 2022-23 has been confirmed by the appellate authority; counsel puts the probability of outflow as high and the amount as reliably estimable, but management has made no provision and no disclosure. (b) ₹28 lakh spent on replacing worn-out machine parts has been capitalised, and depreciation of ₹2.8 lakh charged on it, although the spend merely restores earlier capacity. Separately, the company has incurred cash losses of ₹3.1 crore, current liabilities exceed current assets by ₹2.4 crore, the bank has not renewed the working-capital limit, and the promoter has offered only an unregistered letter promising support for twelve months. Management refuses every adjustment and hints it will appoint another auditor.
1. Using the materiality figures, decide the opinion under SA 705 and show why it is not an adverse opinion.
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Quantify first.
- GST: unprovided liability ₹42 lakh; if provided, PBT falls from ₹112 lakh to ₹70 lakh.
- Machine parts: expense of ₹28 lakh wrongly capitalised, less depreciation of ₹2.8 lakh already charged = net overstatement of profit ₹25.2 lakh; PBT falls further to ₹44.8 lakh.
- Combined misstatement ₹67.2 lakh = 60 per cent of PBT and about 11 times overall materiality of ₹6 lakh. Clearly material, and clearly above performance materiality of ₹4.20 lakh.
Both are GAAP departures: the confirmed demand is a present obligation that is probable and estimable, so a provision is required; routine replacement of worn-out parts that restores, rather than enhances, capacity must be expensed, not capitalised.
Pervasiveness test (SA 705): is the effect confined to specific elements, or does it represent a substantial proportion of the financial statements, or does it relate to disclosures fundamental to users' understanding? Here it is confined to two identified, quantified items; after correction the company still reports a profit of ₹44.8 lakh and a positive net worth of ₹1.90 crore; nothing turns on estimation uncertainty spread across the statements.
Conclusion: a qualified ('except for') opinion - material but not pervasive, with a Basis for Qualified Opinion paragraph quantifying both effects and the relevant note references. Adverse would be correct only if correction turned profit into loss or net worth negative; had the demand been, say, ₹1.5 crore, that threshold would be crossed.
2. How should the going-concern matter be handled and reported, given that a qualified opinion is already being issued?
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Assess, do not assume. The indicators are real: cash losses of ₹3.1 crore, negative working capital of ₹2.4 crore, and an unrenewed cash-credit limit. SA 570 requires the auditor to evaluate management's assessment, not to accept a letter at face value. Procedures: obtain the cash-flow forecast for at least twelve months and test its assumptions against post-year-end orders and collections; read bank correspondence and the sanction file; confirm whether the promoter's support is enforceable and whether he actually has the means; inspect subsequent receipts.
An unregistered letter promising support, with no cash-flow schedule behind it, is weak evidence; it is not a binding commitment and does not by itself remove the doubt. On the facts, a material uncertainty exists.
Reporting:
- If the going-concern basis is appropriate and the notes disclose the uncertainty adequately, the opinion on the financial statements remains unmodified on this count, but the report carries a separate section headed 'Material Uncertainty Related to Going Concern' describing the events and referring to the note.
- If disclosure is inadequate, that is a further SA 705 matter - qualified, or adverse if pervasive.
- If the auditor concludes the going-concern basis itself is inappropriate, the opinion is adverse.
The going-concern section and the Basis for Qualified Opinion for the GST and capitalisation items coexist; one does not replace the other, and the going-concern paragraph is not a substitute for the modification.
3. Management threatens to replace the auditor unless the report is clean. What is the correct professional response, and what must be documented?
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The opinion does not change. The threat of removal is a self-interest/intimidation threat under the ethical code, not audit evidence. The auditor's duty is to report to the members, who appoint and remove auditors, not to the management that engages the firm day to day.
Sequence of action:
- Communicate the uncorrected misstatements and the going-concern findings to those charged with governance (SA 260) and to the board/audit committee, in writing, with the quantified effects.
- Obtain written representations (SA 580) covering the GST demand, the capitalisation policy and management's going-concern plans; refusal to give them is itself reportable.
- Consider SA 250 for the confirmed statutory demand - it is a non-compliance whose financial effect is being suppressed; report to those charged with governance and, where the law requires, to the regulator.
- Issue the qualified report. If the company then removes the auditor, that is a matter for the members in general meeting; resignation, if it happens, follows the statutory route with the prescribed form and a statement of reasons.
Document: the misstatement schedule with materiality workings, minutes of the discussion, the promoter letter and why it was not accepted as sufficient evidence, the going-concern forecast review, and the written communications. A clean report issued under pressure is a disciplinary matter, not a commercial decision.