(a)    (i) Ethical and other matters to be considered before accepting Setter Co as a client of the firm
Requirements and guidance relevant to accepting and continuing client relationships is contained in ISQC 1 Quality Control for Firms that Perform Audits and Reviews of Financial Statements and Other Assurance and Related Services Engagements. The fundamental requirements are that a firm must consider:
– Its competence to perform the engagement and whether the firm has the capabilities, including time and resources to do so,
– Whether the relevant ethical requirements can be complied with, and
– The integrity of the client, and whether there is information which would lead it to conclude that the client lacks integrity.
Competence and resources
Looking at each consideration in turn, there seems no reason why Pointer & Co would not have the competence to carry out the assignment, which is a limited assurance review of historical financial statements. Being a firm of Chartered Certified Accountants, and performing assurance services such as the audit of Vizsla Co, means that the firm has the relevant knowledge and experience to perform a high quality limited assurance review.
However, the pressure to perform the audit for a low fee could impact on Pointer & Co’s ability to perform a high quality limited assurance review if insufficient resources are made available, given the potential restriction on the fee which can be charged to provide the service. ISQC 1 also mentions that where the client is aggressively concerned with maintaining the firm’s fees as low as possible, this can indicate a lack of integrity of the client.
Ethical issue
In terms of ethics there are several matters to consider. First, it appears that Vizsla Co is putting pressure on Pointer & Co to accept the engagement. Vizsla Co is a relatively significant client of Pointer & Co, providing 10% of the firm’s annual practice income, and there is an intimidation threat in that Vizsla Co has threatened to move to another audit provider if Pointer & Co does not accept Setter Co as a client and perform the work for a low fee. This could also be perceived as a self-interest threat in that Pointer & Co has a financial interest in maintaining a good relationship with Vizsla Co.
A further ethical issue arises from the suggestion that Pointer & Co should provide tax planning advice to Setter Co and prepare its tax submissions. This would give rise to a self-review threat because Pointer & Co would have some input to the tax figures which form part of the financial statements which would then be subject to the limited assurance review. Providing the tax planning advice could also be seen as acting on behalf of management, further impairing the objectivity of the limited assurance provided on the financial statements.
Pointer & Co should consider whether safeguards can be used to reduce any ethical threats to an acceptable level, for example, through the use of separate teams to provide the limited assurance review and the tax services and by having an independent second partner to review the work performed. If safeguards do not reduce the threats to an acceptable level, then the tax service should not be carried out in addition to the limited assurance review.
Client integrity
Preparing the personal tax computations of Gordon Potts is less of an ethical issue in terms of objectivity as his personal tax is a separate issue and not reflected in the company’s financial statements, but there may be other issues with providing this advice, linked to integrity, which will be discussed next.
The integrity of Gordon Potts will need to be carefully evaluated. There is nothing wrong with him having business interests in several companies, though information about each of these will need to be obtained. The key issues with integrity relate to the breach of employment law and his taking money from a company pension plan to set up a business which is managed by his son. The breach of employment law indicates that Gordon Potts has a questionable reputation and possibly that he has been involved in criminal activity, depending on what laws have been breached, and the seriousness of the non-compliance. The information comes from a newspaper article, so it may not be very credible and may not even be true, and more information will need to be sought on this issue.
Taking money from the company pension plan is likely to be a breach of the relevant regulations, and it would seem that this was done for the benefit of his son. The fact that this business is located in a foreign country makes the business arrangements complicated, and while it could be completely innocent, it could also mean that there is something more sinister behind the connections between the companies, for example, it could be an arrangement to facilitate money laundering.
Pointer & Co must obtain sufficient information to carefully evaluate the appropriateness of accepting Setter Co as a client, and they must document the acceptance decision in accordance with ISQC 1.
(ii) The importance of obtaining customer due diligence and the information which should be obtained
Customer due diligence (CDD), also called know your client procedures, is needed as part of anti-money laundering regulations, which all audit firms should have in place when accepting new clients. It refers to the firm obtaining information to be able to identify who the prospective client is and verify identity by reference to independent and reliable source material. This is a crucial part of risk assessment when taking on a new client and allows the firm to understand not only the identity of the prospective client, but also the nature of the business and its source of funds.
Specifically, the firm should address the following as part of customer due diligence:
– Identify the customer and verify their identity using documents, data or information obtained from a reliable and independent source.
– Confirm the identities of all shareholders, including the specific family members who collectively own 90% of the company’s share capital, and the other shareholder(s) who own the remaining 10%.
– Identify any beneficial owner who is not the client. This is the individual (or individuals) behind the client who ultimately own or control the client or on whose behalf a transaction or activity is being conducted.
– Where a business relationship is established, understand the purpose and intended nature of the relationship, for example, details of the customer’s business or the source of the funds.
Businesses must also conduct ongoing monitoring to identify large, unusual or suspicious transactions as part of CDD. All of the documents obtained for the purpose of carrying out CDD checks must be retained for a minimum of five years from the end of the business relationship.
In this scenario, the information which should be obtained includes:
– To confirm the identity of Gordon Potts, photographic evidence, for example his passport, should be seen and a copy taken, along with other means of identification showing his address, for example, recent utility bills or bank statements
– In relation to Setter Co, the company certificate of incorporation should be seen, to confirm its legal status and the date and place of incorporation.
– A Companies House search (or equivalent) on Setter Co should take place, this will confirm the existence of the company, the shareholders and directors and will provide some financial information. This will confirm that Gordon Potts is the ‘beneficial owner’ of the entity – i.e. that he is the person who owns or controls, directly or indirectly, more than 25% of the shares or voting rights or who otherwise exercises control over the directors.
– The identity of the other companies controlled by Gordon Potts should also be found, and searches on them conducted, to confirm their existence and the nature of the relationship with Setter Co.
– The latest financial statements of Setter Co, and the other companies in which Gordon Potts has an interest should be reviewed. This will help Pointer & Co to understand the businesses and their relationship with each other, identify the sources of income and whether there are significant transactions between the companies.
– Identify the source of funding for the company, whether there are bank loans or other providers of finance, and the nature of the finance provided in terms of when it is repayable, whether any company assets are provided as collateral for the debt, and whether Gordon Potts or other shareholders have made personal guarantees in respect of any sources of company finance.
– While not strictly part of confirming the identity of Gordon or his companies, Pointer & Co would clearly need to obtain further information about the breach of employment law, and confirm the facts surrounding the situation. Currently the only information available is from a newspaper article and this may not be a credible source.
(b)    Examination procedures on the operating profit forecast of Vizsla Co
General procedures:
– Enquire as to the identity of the preparer of the operating profit forecast, and assess their competence, especially given that interest costs have been included as part of operating profit which is incorrect.
– Obtain an understanding as to the procedures and controls which have been followed in the preparation of the forecast, for example, has the forecast been approved by a senior member of the company’s accounting team.
– Confirm that the accounting policies applied in Vizsla Co’s financial statements have been consistently applied in the preparation of the operating profit forecast, for example, that design costs are expensed rather than capitalised as a development cost.
– Confirm that the assumptions underpinning the forecast are in line with knowledge of the business obtained from performing the company’s audit, for example, the seasonality of the sales can be confirmed by looking at the audit evidence obtained in the audit of revenue.
– Re-cast the forecast to ensure it is arithmetically correct.
Specific procedures:
– Enquire whether a more detailed profit forecast is available, or ask management to prepare one, for example, detailing out cost of sales and other expenses. In addition, request a forecast statement of financial position and statement of cash flows.
Tutorial note: There could be matters which make the profit forecast unachievable revealed through assessment of the statement of financial position and statement of cash flows, e.g. the timing of the working capital cycle may make achieving the profit forecast unachievable if funds are not available at certain points of time especially given the seasonal nature of the business.
– Request that management prepares a profit forecast in the same format as audited financial statements and in accordance with IFRS Standards, i.e. the interest cost should be shown below the operating profit line.
– Having obtained the cost of sales figure for each six-month period, recalculate the gross profit figures given in the forecast. Compare this to gross profit margins in the prior year audited financial statements and investigate any anomalies.
– Having obtained a break down showing the components of cost of sales and other expenses, for each significant category of expense, perform analytical review to confirm that the forecast costs appear to be in line with expectations, and discuss any unusually high or low forecast costs with management.
– Based on the above, assess whether there are any missing categories of expenditure which have not been included in the forecast, e.g. there is no depreciation included in the forecast.
– For revenue, which is forecast to increase by a significant amount (e.g. 11·8% increase comparing the six months ending 31 March 2019 and 31 March 2020), consider whether the forecast appears overly optimistic. For instance, there is not a corresponding increase in marketing costs to support the forecast increase in revenue.
– Compare revenue in the year forecast to 30 September 2019 with revenue from prior years’ audited financial statements. Investigate any unusual trends through discussion with management.
– Review any marketing plans and discuss with an appropriate senior member of staff, for example, the sales director, to establish the rationale for forecasting a significant increase in revenue, for example, there may be plans to introduce new product lines. Consider this in light of the fact that design costs and marketing are not forecast to increase by a significant amount.
– Review the design costs as they appear to be fairly static with just a small increase to achieve a much bigger % increase in revenue. Discuss with management and assess if such an increase in revenue can be achieved with such a small increase in design costs.
– Confirm costs to appropriate supporting documentation, e.g. staff costs to human resources projected costs, marketing costs to advertising budgets.
– Assess whether the overdraft is likely to be repaid in September 2019, for example, by obtaining and reviewing the cash flow forecast prepared for the same period as the operating profit forecast.
– Discuss with management the rationale for using 30% of revenue as a basis for determining the amount of other expenses. In addition, compare this to the results of audit procedures performed on expenses to gauge whether 30% appears to be a reasonable basis.