(a) Narley Co
(i) Matters to be considered before acceptance of engagement
When considering acceptance of the engagement to review Narley Co’s prospective financial information (PFI), Jansen & Co must consider whether it is ethically acceptable to perform the review. The review of the PFI represents a non-assurance service and the IESBA Code of Ethics for Professional Accountants (the Code) states that providing this service in addition to the audit may create an advocacy threat. An advocacy threat arises when the auditor is asked to promote or represent their client in some way. In this situation there is a risk of the auditor being seen to promote the interests of the client with a third party such as a bank. As a result, there is a danger that the auditor will be biased in favour of the client and therefore cannot be fully objective. Accepting the assignment may also create a self-interest threat as a result of the auditor being perceived to have an interest in the outcome of negotiations with a third party and which may motivate the auditor to behave in order to protect that interest. A self-review threat may also arise because the negotiations may result in facts and amounts which will form part of the audited financial statements. As a result, the auditor will be auditing financial statements which in part at least represent work which they themselves have performed. It follows that there is a risk that the auditor will not be sufficiently objective in performing the audit and may fail to identify any shortcomings in their own work.
In the case of Narley Co, the advocacy threat appears to be particularly significant as the audit firm could be seen to be promoting the interests of the audit client to the bank. The auditor should therefore only accept the engagement if adequate safeguards can be put in place to manage the threat to independence to an acceptable level. Potential safeguards might include the following:
– The use of separate teams of suitably experienced staff for the audit and the review of the PFI;
– Independent senior review of the PFI working papers;
– Discussion of the potential ethical issues and threats to auditor independence with those charged with governance at Narley Co.
It should be noted, however, that it would not be possible to manage a significant advocacy threat through such safeguards and in such a case the appointment should not be accepted.
ISAE 3400 The Examination of Prospective Financial Information provides further guidance on the issues which the auditor should consider before accepting an engagement to examine PFI. According to ISAE 3400, the auditor should consider amongst other things:
– The intended use of the information – for example, whether it will be used solely for the purpose of the proposed loan finance;
– Whether the information will be for general or limited distribution – the auditor needs to consider who will receive the report and potentially rely upon it;
– The nature of the assumptions, that is, whether they are best-estimate or hypothetical assumptions – in this case it seems likely that they will be best estimate assumptions as Narley Co expects to obtain finance in order to fund its planned expansion;
– The elements to be included in the information – Jansen & Co needs to clarify the exact content of the PFI which they are being asked to report on, for example, whether it only includes the forecast statements of profit or loss or whether it also includes forecast statements of financial position and forecast cash flow statements; and
– The period covered by the information – shorter term forecasts are likely to be more reliable than projections over a longer period.
Jansen & Co must also consider whether the firm has sufficient staff available with the appropriate skills and experience to perform the review engagement in line with the client’s required reporting deadlines.
Overall, the auditor must assess the risks associated with the review engagement and should not accept an engagement when the assumptions are clearly unrealistic or when the auditor believes that the prospective financial information will be inappropriate for its intended use.
(ii) Examination procedures to be performed
The examination procedures which should be performed in respect of Narley Co’s forecast statements of profit or loss include the following:
The arithmetic accuracy of the forecast statements of profit or loss should be confirmed;
– Confirmation that the accounting policies used in the forecast statements are consistent with those used in the audited financial statements and that they comply with IFRS;
– Discuss the key assumptions which have been made by the client in the preparation of the forecast statements with management assessing their reasonableness and consistency with the audit firm’s cumulative knowledge and understanding of the client;
– Review of market research documentation in Narley Co’s existing markets and the new market and discuss it with management to assess whether the growth patterns being forecast in revenue represent reasonable and realistic expectations;
Obtain copies of any new customer contracts for existing and new markets to confirm the reasonableness of the projected growth in revenue.
– Obtain a written representation from management confirming the reasonableness and completeness of the assumptions they have made in preparing the forecasts;
The competence and experience of the client staff who have prepared the forecasts should be assessed; the assessment should include the accuracy of PFI which has been prepared in previous periods and the reasons for any significant variances compared to actual outcomes;
– Recalculation of depreciation to ensure the correct inclusion of depreciation on the new HGVs and warehousing facilities within the forecast statements;
– Obtain and review a breakdown of operating expenses in order to ensure that all items have been appropriately included, for example: advertising and marketing costs for the campaign in the new jurisdiction; additional staff costs for the new drivers including recruitment expenses; any trading tariffs relevant to operating in the new market and any foreign currency and exchange implications;
– Recent utility bills should be inspected and an assessment of the reasonableness of forecast utility overheads should be performed;
– Obtain and review the supporting documentation for Narley Co’s existing loan agreements with the bank as well as the draft documentation for the new loan; the forecast finance costs should be recalculated and agreed to the forecast statements;
– Perform analytical review, followed by discussion with management to seek corroborating evidence of key trends and ratios including:
Growth in revenue (26% from 20X8 to 20X9; 29% from 20X9 to 20Y0)
– Cost of sales as a percentage of revenue (75·5% in 20X8; 71·3% in 20X9; 69·7% in 20Y0)
– The declining trend in administrative expenses (decrease of 4·2% from 20X8 to 20X9; 5·6% from 20X9 to 20Y0)
– The increase in the net profit margin (6·9% in 20X8; 15·2% in 20X9; 20·4% in 20Y0).
(b) Watson Co
Quality control issues raised by the audit supervisor’s email
ISA 220 Quality Control for an Audit of Financial Statements requires the auditor to implement quality control procedures at the engagement level which provide reasonable assurance that the audit complies with professional standards and applicable legal and regulatory requirements and that the auditor’s report is appropriate in the circumstances. The overall quality of each audit assignment is the responsibility of the audit engagement partner and effective engagement performance entails adequate direction, consultation, supervision and review. In this case, the conduct of the audit raises a number of quality control issues in relation to the effective performance of the audit of Watson Co’s financial statements, including the following:
Share-based payment scheme:​​​​​​​
The failure to identify the new cash-settled share-based payment scheme as a potentially high risk area indicates inadequate planning and a lack of consultation with the client. The share-based payment scheme is a complex and judgemental area and given that the scheme was only introduced in the year, it should have been identified as a key area of audit risk.
​​​​​​The assignment of a part-qualified supervisor to the audit of a listed entity is also indicative of poor audit planning. The audit supervisor appears to have inadequate skills and expertise to audit this public interest entity. This is evidenced by the incorrect treatment of the share-based payment scheme and the audit supervisor’s comment that basing the expense in the profit or loss account on the valuation at the date of grant is appropriate and that the recognition of an equity reserve on the statement of financial position is correct in the email to the audit manager. According to IFRS 2 Share‑based Payments, the valuation of the share appreciation rights for a cash-settled scheme should be updated at the reporting date and the standard requires recognition of the cumulative cost of the scheme as a liability, not as an equity reserve.
The audit supervisor also fails to recognise that a share-based payment scheme with the directors of Watson Co constitutes a related party transaction. While the supervisor is correct in saying that the cost of the scheme this year of $195,000 is immaterial on a quantitative basis (it represents only 0·36% of profit before taxation and 0·84% of total assets), as a related party transaction with directors, the scheme should be considered to be material by nature and should be fully disclosed in the notes to the financial statements in accordance with IAS 24 Related Party Disclosures. The related party disclosures are particularly important for a listed entity such as Watson Co. In line with ISA 450 Evaluation of Misstatements Identified During the Audit, all misstatements should be accumulated and therefore the error should also have been included in the audit working papers and adjustment should have been requested.
Other quality control issues include:
​​​​​​​– The staffing levels on the audit also appear to be inadequate given that there are only two audit team members. This is again indicative of poor audit planning.
– In addition, it is clear that the audit manager should have been replaced earlier and that Watson Co has failed to provide adequate direction and supervision of the audit.
– The original audit manager, Rodney Evans, has also provided an inadequate briefing meeting prior to the commencement of the audit work. The advice to follow last year’s working papers is inappropriate as the auditor must always be on the look out for new situations and issues such as the new share-based payment scheme.
– Jansen & Co has also failed to monitor the progress of the audit and therefore to update and change the audit plan as necessary during the course of the audit as required by ISA 300 Planning an Audit of Financial Statements. This is evidenced by the fact that the audit clearance meeting is scheduled for next week and the initial manager review is only just taking place. In addition, there appears to be no evidence of engagement partner oversight over the course of the audit fieldwork and it is the engagement partner’s responsibility to ensure that they have reviewed the documentation to ensure that sufficient appropriate evidence has been obtained and that the auditor’s report issued in the circumstances is appropriate.
– There appears to be a lack of audit evidence in relation to the firm of external valuers which has been used to value the share options. ISA 500 Audit Evidence requires the auditor to obtain sufficient and appropriate audit evidence that the valuation work performed by the management expert is adequate for the purposes of the audit. The auditor must therefore evaluate whether management’s expert possesses the necessary competence, capabilities and objectivity to perform the valuations and whether the scope of their work is satisfactory for audit purposes. The ‘checking out’ of the expert online with reference to a website is clearly inadequate for audit purposes and this again reflects the inexperience and lack of expertise of the audit supervisor and poor audit planning with respect to the staffing on the audit.​​​​​​​