(a)    (i) Ethical and professional matters
Temporary recruitment of audit partner
Seconding a member of staff to an audit client may create a self-review threat. This would arise if the member of staff returns to the audit firm and considers matters or documentation which is the result of work which they performed while on assignment to the client.
In this situation, it is likely that the individual would be involved in preparing the financial systems of Gull Co for the flotation. If this is the case, it would create a significant threat to objectivity. This would be reduced if the role was focused on non-financial matters.
Additionally, the member of staff would work alongside employees of the client on a daily basis. This would overstep the normal professional boundary between auditor and client and may compromise the objectivity of the member of staff due to their familiarity with employees of the client.
In order to reduce this threat, the member of staff seconded to Gull Co should not be a current or future member of the audit team.
An additional risk would be if the seconded member of staff assumed managerial responsibilities of the client. This is not permitted. Given that Gull Co has specifically requested a partner, it appears as though they require someone senior, indicating that they may need someone to either make or significantly influence decision making.
In order to reduce this risk, the use of a less senior member of staff with relevant experience of the flotation process could be proposed and make it clear in the contract that they are not able to make decisions for Gull Co and that decision making will always remain their responsibility
Alternatively, it could be recommended that Gull Co recruit the assistance of either the management or transaction advisory services team to assist them with the flotation as a separate engagement, thus circumventing the ethical threats identified.
Recruitment services
In relation to the request for Raven & Co to provide assistance in recruiting new members of the board, this could give rise to self-interest, familiarity or intimidation threats as the firm would essentially be advising on the recruitment of staff who will ultimately be in senior management positions and responsible for the running of and oversight of a listed company. These new members of staff may also go on to be included in any audit committee which the company sets up and will be responsible for assessing the independence of the external auditors. Being involved in any decision on who should be appointed to such a senior position is also likely to involve the firm taking on a management responsibility which is not appropriate. Given that Gull Co is potentially going to be a listed company, Raven & Co should not be involved in any activity which involves searching for suitable candidates or undertaking any reference checks of prospective candidates. This request should be turned down by Raven & Co due to the potential management responsibility involved.
Tutorial note: Credit will be awarded for relevant comments relating to the professional benefits of accepting the assignment.
(ii) Implications of governance and board structure on audit process
Structure of the board
As a private company with the majority of shares held by the Brenner family, the auditor’s report addressed to the shareholders as a body would have been aimed predominantly at the Brenner family. However, the predominance of the Brenner family may undermine the independence of the board. The board may be accustomed to operating in the interests of the family as the majority shareholders. However, once the company is listed, the board will be required to consider the interests of the new shareholders as a group. The executive members of the board are either Brenner family members or long-term employees of the company and potentially loyal to the existing ownership.
With only one non-executive director, the board currently lacks independent oversight and the opinions and decisions of the executive board may not be subject to appropriate levels of challenge and scrutiny.
In addition, non-executive board members are specifically required to scrutinise the performance of management, consider the integrity of the financial statements, determine director remuneration and participate in the appointment and removal of directors. With limited experience outside IT consultancy and limited time, the current non-executive is unlikely to be able to fulfil these roles effectively on their own.
There is no indication that management lacks integrity but Raven & Co must remain sceptical of the motivations of the family, particularly leading up to a listing. There will be an incentive to overstate performance and position to inflate the value of the company. With little effective oversight of the executive board, Raven & Co must remain alert for this possibility, particularly when auditing matters involving management judgement in subsequent financial periods.
Audit committee
The lack of any form of audit committee is a significant departure from corporate governance best practice. The audit committee fulfils a number of significant roles, including monitoring the integrity of the financial statements, reviewing internal financial controls, monitoring the independence of the external auditor and communicating with the external auditor on matters relating to the external audit. The audit committee should have a member with relevant financial expertise and this will become of even more importance once the company is listed.
In the absence of an audit committee, Raven & Co will have to communicate directly with the board including the requirement to communicate how the auditor has maintained their independence in line with ISA 260 Communication with Those Charged with Governance. This may affect the independence of Raven & Co, or at least the perception of their independence. It may also reduce the effectiveness of communications between the auditor and the company; the audit committee is responsible for communicating relevant matters, such as deficiencies in internal control, up to the executive board for their consideration. Without an audit committee, matters of significance to the audit may not be given sufficient prominence by the board. Further, the audit committee is responsible for reviewing the integrity of the financial statements and internal controls and currently there is no-one at Gull Co capable of carrying out this role. Overall this may make it harder for Raven & Co to discuss and communicate key findings from the audit including the auditor’s qualitative assessment of the company’s accounting practices. Also with the lack of an objective audit committee, it may be harder for Raven & Co fulfil their responsibilities to communicate any significant difficulties which are encountered during the audit.
Listed status
Further as a listed company, Gull Co will be subject to increased scrutiny and pressure to achieve performance levels, which may motivate the board to manipulate the financial statements to present an improved picture of performance. For Raven & Co, this increases the level of audit risk and is likely to have a significant impact on the firm’s assessment of the risk of fraud and management override. This is likely to have a significant impact on the firm’s approach to auditing areas of the financial statements subject to judgement, such as management estimates and revenue recognition.
As a listed company, Gull Co may be required to produce more detailed financial statements probably in a shorter time frame and as mentioned above, the lack of financial expertise and lack of objective scrutiny by an audit committee may result in errors or omissions. This again increases the level of audit risk faced by Raven & Co and a lot more detailed testing may need to be performed to ensure compliance with appropriate accounting standards and listing rules.
Further, once listed, the auditor’s report issued for Gull Co will be available to a much wider audience and will require additional disclosures in line with ISA 701 Communicating Key Audit Matters in the Independent Auditor’s Report. This will add another level of work and complexity to the audit of Gull Co.
(b)    Military research project
The research expenses represent 10·8% of profit for the year so they are material to the financial statements.
Raven & Co is unable to obtain sufficient appropriate evidence relating to the research expenses. Given the limitation imposed by management, the auditor will be unable to form a conclusion about the occurrence, completeness, accuracy or classification of the associated expenses.
ISA 705 (Revised) Modifications to the Opinion in the Independent Auditor’s Report requires that when management imposes a limitation on the scope of the audit, the auditor should request that they remove the limitation. If management refuses, the auditor should communicate the matter to those charged with governance, explaining the implications of the matter and the impact on this year’s audit opinion. In addition, as this is a matter which is likely to arise again in future audits, the auditor should stress that the compound effect of this and the likelihood that there may be development cost implications to consider in the future may give rise to both a material and pervasive matter, which would give rise to a disclaimer of opinion.
As well as the implications on the auditor’s report, those charged with governance should be informed that in accordance with ISA 210 Agreeing the Terms of Audit Engagements, the auditor may not be able to accept the audit engagement in the future if management continues to impose the limitation on the scope of the auditor’s work and the auditor believes that it may result in them disclaiming their opinion.
In the current year under these circumstances, it will be necessary to issue a modified opinion. Given the claimed value of the expenses, it is likely that the matter will be considered material but not pervasive to the financial statements and a qualified opinion will be issued.
A ‘Basis for Qualified Opinion’ paragraph should be included immediately after the audit opinion describing the matter giving rise to the modification.
Fire
Audit procedures have confirmed that the matter has been satisfactorily reflected in the financial statements. There are therefore no misstatements relevant to this matter and no modification to the audit opinion is necessary.
However, the accident caused the temporary suspension of operations for a number of months, with a significant impact on the results for the year. Overall, the associated reduction in sales and the expenses relating to the repairs have contributed to a $46 million reduction in profits. This may make interpretation of the current year’s results difficult. Crow Co is still unable to operate at full capacity, so the matter will continue to affect performance in the following year.
This represents a major catastrophe which has had and continues to have a significant effect on the company’s financial position. The disclosures provided by management in relation to this constitute a matter of fundamental importance to users, and should be referred to in an emphasis of matter paragraph by Raven & Co, as described in ISA 706 (Revised) Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report.
The auditor should include the paragraph in a separate section of the auditor’s report with an appropriate heading that includes the term ‘emphasis of matter’. It may be appropriate for the paragraph to be entitled ‘Emphasis of matter – effects of a fire.’ The placement of the paragraph depends on the auditor’s judgement in terms of the significance and the nature of the matter being described. It is likely that in these circumstances it should be placed directly after the basis for qualified opinion paragraph.
The paragraph should clearly reference the matter being emphasised including a reference to where the full description of the matter may be found in the financial statements. The paragraph should make it clear that the audit opinion is not modified in respect of this matter.