4、You are an audit manager at Thornhill & Co responsible for the audit of Northwest Co, a subsidiary of Valerian Co. A different audit firm is responsible for the audit of Valerian Co and the Valerian Group financial statements.
The audit of the financial statements of Northwest Co for the year ended 31 July 2016 is nearing completion, but the following issues require your attention before the auditor’s report is signed and your final communication is made to the group auditor in response to their request for information. The draft financial statements of Northwest Co recognise a loss before tax of $50,000.
Northwest Co has been loss making for several years and it generates insufficient cash to meet its significant debt obligations. The company relies on support from Valerian Co in order to continue trading. The management of Valerian Co has confirmed verbally that it will continue to support Northwest Co, but has not provided a formal letter of support despite a number of requests.
You are aware that Valerian Co is the subject of a major lawsuit following an industrial accident which resulted in significant pollution of local agricultural land and, most seriously, loss of life. You attempted to discuss the matter with the directors of Valerian Co but they refused, saying that it had already been investigated by the group auditor. The group auditor informed you that the case is ongoing and that they have obtained satisfactory representations from both management and legal advisers stating that they were confident of successfully defending the claim. When you asked for copies of the representations, the group auditor refused saying it was a matter relevant to the parent company and that it was not relevant to the audit of Northwest Co.
Shortly after making your enquiries, you received a phone call from the group engagement partner who said that the board of Valerian Co was concerned that you might modify the auditor’s report of Northwest Co. He also said that, as the only person with full oversight of audit matters relating to the Valerian Group, he did not think that it would be necessary to modify the auditor’s report of Northwest Co and that he would oppose any attempt to do so. He suggested that if the debt in the financial statements of Northwest Co was the reason for seeking parental support that he would transfer it to the Group and the letter of support would no longer be necessary.
Required:
(a) Discuss how professional scepticism should be applied to the statements made by the management and auditors of Valerian Co regarding the outstanding legal case.
Application of professional scepticism
Potential for material misstatement
Without support from the parent, it is unlikely that Northwest Co would be considered a going concern. There is therefore a risk in relation to the going concern status of Northwest Co and a risk of material misstatement in the financial statements if an incorrect basis of preparing the accounts is selected. Professional scepticism requires the auditor to remain alert for any circumstances which may cause the financial statements to be materially misstated especially in relation to going concern matters.
Internally generated evidence
In order to reach a satisfactory conclusion in this matter, it would be essential to receive formal confirmation of support from Valerian Co. The auditor must be sceptical of this form of evidence because it is prepared by management and this sort of internally generated evidence is, generally, not as reliable as other forms of externally generated evidence.
Use of judgement
The ability to provide support to Northwest Co is also a matter of judgement. The management of Valerian Co would need to forecast their own cash flows and make a judgement as to whether they will have sufficient capacity to meet Northwest Co’s obligations in the event that the subsidiary cannot. Clearly, such forecasts are prone to uncertainty and management bias.
In this case Valerian Co is itself facing a material uncertainty regarding the outcome of the legal case. It is plausible that this could affect their ability to provide full support. The failure to supply a formal letter of support adds weight to this concern. The auditor must therefore remain sceptical when considering management’s pledge of support to Northwest Co.
Suspicious behaviour
The group engagement partner’s request not to modify the audit opinion should also promote scepticism. This is an unusual request and appears to be based on pressure by the directors of Valerian Co. This reinforces the suspicion that both the group auditor and the directors of Valerian Co may be trying to conceal some sort of problem. It is possible that the outcome of the legal case is less favourable than is currently suggested and this may require some form of modification to the group accounts. This may, in turn, trigger further repercussions which Valerian Co is seeking to avoid.
Heightened scepticism
Based upon these concerns, the auditor needs to remain sceptical and alert for other factors which raise concerns in relation to the going concern status of Northwest Co. They should also be sceptical of all judgements made by management, particularly in relation to the forecasts prepared to assist with the assessment of going concern. It is possible that they are being overoptimistic in their estimates in order to make forecasts appear better than is reasonable to expect.
(b) Comment on the ethical and professional issues raised, considering any implications for completion of the audit, in respect of:
(i) The evidence obtained in relation to the support offered by Valerian Co.
(ii) The request not to modify the auditor’s report of Northwest Co.
Note: The total marks will be split equally between each part.
(i) Offer of support by Valerian Co
Insufficient evidence
Without the financial support of its parent company, Northwest Co would not be considered a going concern. A verbal pledge of support from Valerian Co would not be considered sufficient, reliable evidence in regard to this matter.
Ability to provide parental support
In addition to a letter of support, the auditor of Northwest Co would need to obtain sufficient appropriate evidence that Valerian Co can provide the support which they promise.
The statement by the group auditor that they have received adequate representations from the directors and legal advisers of the company does not constitute sufficient appropriate evidence. At the very least, the auditor of Northwest Co would need copies of those representations. While the representations from management would suffer from the same lack of reliability, representations from the legal advisers would represent third party evidence and, as such, be more reliable.
Uncertainty surrounding legal case
Given the uncertainty surrounding the court case and the gravity of preparing the financial statements on an incorrect basis, Thornhill & Co may seek further documentary evidence before concluding on the going concern status of the company. This could include correspondence between Valerian Co and their legal advisers, minutes of board meetings, copies of Valerian Co’s assessments of going concern and their current statement of financial position.
Conduct of client and group auditor
The suspicious behaviour of both the directors and auditors of Valerian Co suggests that they are not being entirely honest with Thornhill & Co. If their statements regarding the likely outcome of the legal case are appropriate and there are no other concerns, then there is no reason why they would not be able to provide copies of the representations and a written letter of support to the auditor of Northwest Co.
This increases the need for professional due care during the audit process, particularly in relation to the re-appraisal of fraud risk and the potential for material misstatement in relation to the going concern status of the company and associated disclosures in the financial statements.
Further procedures
The auditor should communicate with those charged with governance of Northwest Co and explain the requirements to obtain sufficient appropriate evidence in this matter. The auditor should also explain the consequences of not receiving this information in terms of the impact this will have on the going concern status of the company and the adjustments they would be required to make to the financial statements.
Finally, the auditor should explain that if the additional evidence is not received and the recommended adjustments are not made, then this will lead to a modification of the auditor’s report. The fact that necessary audit evidence is being withheld would constitute a limitation in the scope of the audit, which may result in a qualified opinion or a disclaimer of opinion being issued.
(ii) The request not to modify the auditor’s report
Intimidation
By trying to influence the decisions in relation to the audit of Northwest Co, the group auditor is creating an intimidation threat to objectivity. IESBA’s Code of Ethics for Professional Accountants defines this as the threat that a professional accountant will be deterred from acting objectively because of actual or perceived pressures.
Responsibility for the opinion
As the auditor of Northwest Co, the responsibility for determining the final audit opinion and wording of the auditor’s report remains with Thornhill & Co. If, based upon the evidence obtained, the engagement partner believes that a modification to the auditor’s report is necessary, then they should follow this through, regardless of the opinion of the group auditor and the board of the parent company. The group partner’s ‘oversight’ of the whole audit is irrelevant to the audit of Northwest Co; as a company in its own right, it must be audited in accordance with International Standards on Auditing.
Transferring the debt to the parent
The suggestion to transfer the debts into the parent company would not resolve the problem; if the debt obligations were ‘transferred’ to the parent using an appropriate journal, they would be replaced by a matching liability to the parent company in the financial statements of Northwest Co, and the same problem would exist and while this would be eliminated in the consolidated accounts, this does not allow the auditor of Northwest Co to gather sufficient appropriate evidence in relation to the going concern status of the company.
Possible manipulation of the financial statements
It is possible that the group engagement partner is recommending some form of inappropriate accounting treatment to transfer the debt into the parent company without any matching liability in Northwest’s accounts, for example, by transferring the debts and then consequently cancelling any obligations from Northwest Co due to Valerian Co. This form of accounting manipulation could be used to disguise the true financial position of the group and may constitute fraud. Any suggestion to pursue this line of action should be firmly refused.
Integrity of the group auditor
The overall integrity of the group engagement partner must be questioned. His aggressive attitude towards the audit of Northwest Co and his reluctance to cooperate by providing evidence in relation to the lawsuit indicate some form of inappropriate conduct in the audit of the parent company and group accounts. This matter should be discussed with the audit engagement partner and possibly with other senior partners, possibly including the firm’s designated ethics partner. Further, the suggestion that ‘he’ would transfer the debt from Northwest Co to the parent company suggests that the auditor is becoming involved in the accounting transactions included in the financial statements and may suggest that the firm’s independence is compromised.
Position as auditor of Northwest Co
Given the intimidation threat and the potential concerns relating to the audit of the parent and the group, Thornhill & Co may consider resignation from the audit of Northwest Co, if permitted, or may not seek re-election as auditor for the following year.