It is 1 July 20X5. You work in the audit department of Saul & Co. The Goodman Group (the Group) is an audit client of your firm and the audit for the financial year ended 31 December 20X4 is in the completion stage. The Group, which is not listed, installs and maintains security systems for businesses and residential customers.
Materiality for the audit of the Group financial statements has been determined to be $400,000. You are reviewing the audit working papers, and have gathered the following information:
Fraud
The Group finance director has informed the audit team that during the year, a fraud was carried out by a manager, Mike Trout, in one of the Group’s procurement departments. The manager had raised fictitious supplier invoices and paid the invoiced amounts into his personal bank account. When questioned by the Group’s finance director, Mike Trout confessed that he had stolen $40,000 from the Group. The finance director asked the audit team not to perform any procedures in relation to the fraud, as the amount is immaterial. He also stated that the financial statements would not be adjusted in relation to the fraud.
The only audit evidence on file is a written representation from management acknowledging the existence of the fraud, and a list of the fictitious invoices which had been raised by the manager, provided by the finance director. The audit working papers conclude that the fraud is immaterial and no further work is needed.
Development costs
In August 20X4, the Group commenced development of a new security system, and incurred expenditure of $600,000 up to the financial year end, which has been capitalised as an intangible non current asset. The only audit evidence obtained in relation to this balance is as follows:
– Agreement of a sample of the costs included in the $600,000 capitalised to supporting documentation such as supplier invoices.
– Cash flow projection for the project, which indicates that a positive cash flow will be generated by 20X8. The projection has been arithmetically checked.
– A written representation from management stating that ‘management considers that the development of this new product will be successful’.
You are aware that when the Group finance director was asked about the cash flow projection which he had prepared, he was reluctant to answer questions, simply saying that ‘the assumptions underlying the projection have been agreed to assumptions contained in the Group’s business plan’. He provided a spreadsheet showing the projection but the underlying information could not be accessed as the file was password protected and the Group finance director would not provide the password to the audit team.
Trade receivables
Trade receivables recognised in the Group’s current assets includes a balance of $500,000 relating to a specific customer, Hamlyn Co. Audit procedures indicate that at 31 December 20X4, the balance was more than six months overdue for payment. In relation to this balance, the following procedures have been performed:
– Agreement of the balance to invoices and original customer order.
– Discussion with the Group credit controller who states that ‘we are in discussions with Hamlyn Co and we are confident that some or all of the amount due to us will be paid. We have always allowed this customer extended credit terms and they have always paid eventually.’
Hamlyn Co was included in the trade receivables direct confirmation audit procedure, whereby a sample of customers were asked to confirm the outstanding balance, but no reply was received.
Required:
(a) (i) Discuss the implications of the fraud for the completion of the audit, and the actions to be taken by the auditor.
In respect of the development costs and trade receivables:
(ii) Comment on the sufficiency and appropriateness of the audit evidence obtained, and
(iii) Recommend the actions to be taken by the auditor, including the further evidence which should be obtained.
(b) The audit work is now complete and the Group auditor’s report is due to be issued in the next few days. Materiality for the audit of the Group financial statements has continued to be determined to be $400,000. You have been tasked with reviewing the draft auditor’s report and the following supplementary information which has been prepared at the end of the audit:
– The audit partner has concluded that the fraud is immaterial and that all necessary work has been performed by the audit team.
– Further audit procedures were successfully performed on the development costs, and a conclusion was reached by the audit team that the recognition of the $600,000 as an intangible asset is appropriate.
– A letter was received from Hamlyn Co’s administrators on 29 July 20X5, stating that Hamlyn Co is in liquidation, and that its creditors will receive a payment of 10% of outstanding balances. The audit team has concluded that $50,000 can remain recognised as a trade receivable, and that $450,000 should be written off as irrecoverable. However, the Group refuses to make any adjustment, and the full $500,000 remains recognised as a trade receivable in the final Group financial statements.
Draft auditor’s report
Based on the above conclusions, the audit supervisor has drafted the auditor’s report which includes the following extract:
Basis for opinion and opinion
Audit procedures indicate that trade receivables are overstated by $500,000. For this reason we consider that the Group financial statements are likely to be materially misstated and do not fairly present the financial position and performance of the Group for the year ended 31 December 20X4.
Emphasis of matter
There are two matters to which we draw your attention:
1. A fraud was discovered, as a result of which we have determined that $40,000 was stolen from the Group. This does not impact the financial statements but we wish to highlight the illegal activity which took place during the year.
2. The Group finance director obstructed our audit by refusing to allow access to audit evidence. He has also refused to adjust the financial statements in relation to the material misstatement of trade receivables, which led to the qualified audit opinion being issued. For this reason, we wish to resign as auditor with immediate effect.
Required:
Critically appraise the extract from the proposed auditor’s report of the Goodman Group for the year ended 31 December 20X4.
Note: You are NOT required to re-draft the extracts from the auditor’s report.
(a) (i) Fraud
If the full extent of the fraud is $40,000, then the audit team is correct to determine that the fraud is immaterial to the financial statements. However, without performing further procedures it is not possible to reach that conclusion. There is no auditor-generated evidence to support the assertion that $40,000 is the total amount of stolen funds. Relying solely on a conversation between the Group finance director and the manager who carried out the fraud and a list of invoices provided by the Group finance director is not acceptable as this evidence is not sufficiently reliable.
Indeed, the Group finance director could be involved with the fraud, and is attempting to deceive the auditor and minimise the suspected scale of the fraud in order to deter further procedures being carried out, or investigation or actions being taken. The auditor should approach the comments made by the Group finance director with an attitude of professional scepticism, especially given that he has asked the audit team not to investigate further, which raises suspicion that he may be covering up the fact that the fraud was on a larger scale than has been made known to the auditor.
There are two courses of action for the auditor. First, further independent investigations should be carried out in order for the auditor to obtain sufficient and appropriate evidence relating to the amount of the fraud. This is particularly important given that the Group finance director seems unwilling to make any adjustment to the financial statements. If the fraud is actually more financially significant, the financial statements could be materially misstated, but without further audit evidence, the auditor cannot determine whether this is the case.
Second, the auditor should consider whether reporting is necessary. ISA 240 The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements requires that when fraud has taken place, auditors shall communicate these matters on a timely basis to the appropriate level of management in order to inform those with primary responsibility for the prevention and detection of fraud of matters relevant to their responsibilities. Given that the Group finance director alerted the auditor to the fraud, it seems likely that management and those charged with governance are already aware of the fraud. However, the auditor should consider whether a formal, written communication is needed.
In addition to reporting to management and those charged with governance, ISA 240 requires that the auditor shall determine whether there is a responsibility to report the occurrence or suspicion to a party outside the entity. The auditor’s duty to maintain the confidentiality of client information makes such reporting potentially difficult, and the auditor may wish to take legal advice before reporting externally.
Tutorial note: Anti-money laundering legislation is likely to impose a duty on auditors to report suspected money laundering activity. Suspicions relating to fraud are likely to be required to be reported under this legislation. Therefore credit will be awarded for relevant consideration of whether Saul & Co should report the fraud on this basis.
(ii) and (iii) Audit evidence
Development costs
Given that the development costs are material to the Group financial statements, more audit work should have been carried out to determine whether it is acceptable that all, or some, of the $600,000 should have been capitalised. There is a risk that research costs, which must be expensed, have not been distinguished from development costs, which can only be capitalised when certain criteria have been met. Currently, there is not sufficient, appropriate audit evidence to conclude that the accounting treatment is appropriate, and intangible assets could be materially misstated.
Agreement of amounts to invoice provides evidence of the value of expenditure, but does not provide sufficient, appropriate evidence as to the nature of the expenditure, i.e. the procedure is not necessarily an evaluation of whether it is capital or revenue expenditure.
Performing an arithmetic check on a spreadsheet does provide some evidence over the accuracy of the calculations but does not provide sufficient, appropriate evidence on the validity of the projections, and in particular, there is no evidence that the assumptions are sound. Given that the Group finance director has not allowed the audit team access to information supporting the spreadsheet and has refused to answer questions, he may have something to hide, and the audit of the projection should be approached with a high degree of professional scepticism. The assumptions may not be sound and may contradict other audit evidence.
The attitude and actions of the Group finance director, which indicate a lack of integrity, should be discussed with the audit committee, as the committee should be in a position to discuss the situation with him, with the objective of making all necessary information available to the audit team.
Finally, there appears to be over-reliance on a written representation from management. ISA 580 Written Representations states that written representations should be used to support other audit evidence and are not sufficient evidence on their own. In this situation, it appears that the representation is the only evidence which has been sought in regard to the likely success of the new product development which is inappropriate.
Further evidence should be obtained to distinguish between research costs and development costs, and to support whether the development costs meet the recognition criteria in IAS 38 Intangible Assets, and to confirm whether all of the $600,000 should be capitalised. Further evidence should be obtained, including:
– A discussion with the project manager to obtain their view on the likely launch date for the new product, anticipated level of demand, any problems foreseen with completion of the project.
– A further review of a sample of the costs included in the $600,000, including evaluation of whether the costs are capital or revenue in nature.
– For the sample of costs, review purchase invoices and ensure they are in the name of the company to confirm the rights and obligations assertion of the capitalised costs.
– Results of any market research to support the assertion that the new product will generate future economic benefit.
– A discussion with management to identify how they have incurred development costs without carrying out any research first.
– Assuming that the Group finance director makes the supporting documentation, including assumptions, available to the audit team, the assumptions should be reviewed for reasonableness, with the auditor considering whether they are in line with business understanding and with other audit evidence obtained.
Trade receivables
The trade receivable is material to the Group financial statements and currently there is not sufficient, appropriate audit evidence to determine whether the amount should remain recognised within current assets. The Group financial statements could be materially misstated if any necessary reduction in value is not recognised.
Agreeing the balance to invoices and order forms may provide evidence of existence but it does not provide evidence on the recoverability of the balance. Including the balance owed by Hamlyn Co in the direct confirmation sample was appropriate given the materiality of the amount involved, but again this would not indicate the recoverability of the balance, even if Hamlyn Co had replied, so additional procedures would have always been required. Therefore there does not appear to be appropriate audit evidence to confirm the valuation of the trade receivable.
Discussing the situation with the credit controller will provide some relevant background information, but on its own it is not sufficiently robust evidence to support the continued recognition of the balance. Further evidence should be obtained including:
– Any written correspondence between the Group and Hamlyn Co indicating the measures which the Group has taken to attempt to recover the debt, and the response from Hamlyn Co.
– Search public registers for evidence of whether Hamlyn Co has been placed in administration or receivership (e.g. Companies House or equivalent), this will indicate the need for an impairment review if it is listed.
– Review of post year-end cash receipts for any amounts received from Hamlyn Co.
(b) Critique of auditor’s report
Headings and structure
The report should not have the opinion and basis for opinion combined in one paragraph. The report should start with the opinion paragraph, which is then followed by the basis for opinion.
In addition to separating out the paragraphs, they should be given appropriate headings. According to ISA 705 Modifications to the Opinion in the Independent Auditor’s Report, when the opinion is modified, the heading should be used to denote the type of modification which is being made to the opinion – in this case the title ‘Qualified opinion’ seems most appropriate. The basis for opinion paragraph should be headed ‘Basis for qualified opinion’.
Qualified opinion
The qualified opinion paragraph should be worded differently. According to ISA 705, when the opinion is modified the following wording should be used ‘except for the effects of the matter(s) described in the Basis for Qualified Opinion section, the accompanying financial statements present fairly, in all material respects (or give a true and fair view of)…’.
The draft opinion paragraph uses different wording – in particular, using the phrase ‘the financial statements are likely to be materially misstated’ does not indicate that a firm conclusion has been reached, and could give users of the report some doubt as to the credibility of the auditor’s opinion.
Basis for qualified opinion
This paragraph should contain further information on the reasons for the modification including a description and quantification of the financial effects of the material misstatement. In this case, the paragraph should refer to the overstatement of trade receivables of $450,000, and the overstatement of profit by the same amount. Currently, the paragraph refers to an overstatement of $500,000, which contradicts the conclusion based on audit evidence.
Emphasis of matter paragraph
According to ISA 706 Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report, an emphasis of matter (EOM) paragraph is used when the auditor considers it necessary to draw users’ attention to a matter which is of such importance that it is fundamental to users’ understanding of the financial statements. The matter discussed in the EOM paragraph must be properly presented and disclosed in the financial statements.
The draft auditor’s report includes an EOM which is being used to discuss two matters, neither of which are appropriate for inclusion in an EOM. First, the EOM describes the fraud which has taken place during the year. This matter is immaterial in monetary terms and therefore is not likely to be considered to be fundamental to users’ understanding of the financial statements.
In addition, it is not professional to highlight illegal activity in this way, and it could increase the risk of litigation from the Group, as this amounts to a breach of confidentiality.
Second, the EOM refers to the difficulties encountered in the audit of trade receivables due to the Group finance director refusing to allow full access to necessary sources of evidence. This matter should not be reported to shareholders in the auditor’s report. The appropriate method of reporting is to those charged with governance of the Group, as required by ISA 260 Communication With Those Charged With Governance. ISA 260 requires the auditor to communicate to those charged with governance regarding a range of matters, including significant difficulties, if any, encountered during the audit.
Related to this, stating that it is the Group finance director personally who is responsible for the material misstatement and hence the modification of the auditor’s opinion is not professional and could raise further legal problems, for example, the Group finance director could accuse the audit firm of making false statements or defamation of character.
In addition, referring to the potential resignation of the audit firm anywhere in the auditor’s report is not appropriate. This matter should be discussed with those charged with governance who will then take the matter up with the Group’s shareholders.