(a) Lavenza Co
(i) Matters to consider before accepting the review engagement
Before accepting the review engagement to review and provide an assurance report on Lavenza Co’s cash flow forecast, ISAE 3400 The Examination of Prospective Financial Information identifies a number of matters which need to be considered:
The intended use of the information
Moritz & Co must consider, for example, whether the cash flow forecast and assurance report will be used solely for the purpose of the increase in Lavenza Co’s overdraft facility. If Lavenza Co is planning to use the assurance report for purposes other than an extension to its current overdraft, for example, to arrange new loan finance from the company’s bank, this must be made clear to Moritz & Co.
Whether the information will be for general or limited distribution
Moritz & Co needs to consider who will receive the report and potentially rely upon it as this will impact on the firm’s assessment of the risk associated with the engagement. If the cash flow forecast is intended for general distribution, this will increase the level of risk for Moritz & Co as a larger audience will rely on it. In this case, if the information will be used solely in support of the application to the bank and will not be made available to other parties, this should be confirmed before accepting the engagement and will reduce the risk of the assignment.
The period covered by the cash flow forecast and the key assumptions used
Moritz & Co must also consider the period covered by the cash flow forecast and the key assumptions which have been used in its preparation. Short-term forecasts are likely to be easier to verify and provide assurance on than longer term projections. ISAE 3400 states that a prospective financial information (PFI) engagement should not be accepted when the assumptions used in its preparation are clearly unrealistic or when the practitioner believes that the PFI will be inappropriate for its intended use. In the case of Lavenza Co, although the forecast is only for 12 months, the growth rates assumed in relation to its operating cash receipts may, for example, be judged to be unrealistic given recent trends in its business and the requested overdraft facility of $17 million for the next six months may prove to be insufficient.
The scope of the work
Moritz & Co will need to consider the specific terms of the engagement, the level of assurance being sought by Lavenza Co and the form of the report required by the bank. Moritz & Co will need to identify clearly the elements which it is being asked to report on – for example, is it being asked to report on the cash flow forecast only or is the firm also being asked to report on accompanying narrative or other PFI. Due to the uncertainty of forecasts and the inevitable subjectivity involved in their preparation, Moritz & Co will need to confirm that it is only being asked to provide negative assurance as to whether management’s assumptions provide a reasonable basis for the cash flow forecast and to give an opinion as to whether it is properly prepared on the basis of these assumptions.
Resources and skills
The firm needs to consider whether it has sufficient staff available with the appropriate skills and experience needed to perform the PFI engagement for Lavenza Co. Moritz & Co should also consider whether it can meet the deadline for completing the work and whether it will have access to all relevant information and client staff. Given the company’s predicted need for cash in the next six months, presumably the extended overdraft facility will need to be provided very soon and this may lead to Moritz & Co being under pressure to meet a tight reporting deadline.
Client integrity
ISQC 1 Quality Control for Firms that Perform Audits and Reviews of Financial Information, and Other Assurance and Related Services Engagements requires Moritz & Co to consider the integrity of Lavenza Co’s management in relation to the acceptance decision. In particular, the firm should consider management’s reasons for appointing a different firm from its auditors and the potential for management bias in the preparation of a cash flow forecast in support of its required overdraft facility.
In addition to the matters identified by ISAE 3400 and ISQC 1, Moritz & Co should also consider the following ethical matters before accepting the review engagement:
Ethical matters
Given that Moritz & Co are not the auditors, the firm’s independence from Lavenza Co will not have been previously considered. In this regard, it is important to ensure that there are no threats to the firm’s objectivity which might prevent it from accepting the appointment. If the firm is not independent and its objectivity is compromised, the reliability of the assurance report will be undermined.
Moritz & Co should also consider why the auditors have not been asked to provide the assurance report on Lavenza Co’s cash flow forecast. In order to provide an assurance report on PFI, a good understanding of the client and its business is required and the incumbent audit firm will usually have the requisite knowledge and understanding. Moritz & Co should therefore consider whether the use of a different firm creates a risk that the client may be hoping that the firm may not be in a position to effectively challenge the key assumptions underlying the preparation of the forecast. When a professional accountant is asked to perform work for a non-audit client, they should be given permission by the client to contact its auditors in order to obtain relevant information. If this permission is not given, the appointment should be declined.
Overall, Moritz & Co must assess the risks associated with the review engagement and should not accept an engagement when the assumptions are clearly unrealistic or when the firm believes that the prospective financial information will be inappropriate for its intended use.
(ii) Examination procedures on cash flow forecast
– Cast the cash flow forecast to confirm its mathematical accuracy.
– Confirm the consistency of the accounting policies used in the preparation of the forecast financial statements with those used in the last audited financial statements.
– Agree the opening cash position of $9,193,000 to the cash book and the bank statement.
– Discuss the key assumptions underlying the preparation of the forecast with management, including:
o     the predicted growth rates in operating cash receipts of 13·4% over the year compared to an equivalent growth rate of only 7·3% in operating cash payments.
o     the stated collection and payment periods in relation to receivables and payables.
o     confirm that the assumptions appear reasonable and are consistent with the firm’s knowledge and understanding of the client.
– Analytically review the forecast trends in cash flows comparing with them with historical cash flow statements and other forecast data which is available for the sector and local economy and investigate any significant differences.
– Agree the settlement discount of 8% and the late payment penalty of 5% penalty terms with suppliers to supporting contractual documentation; agree to purchase ledger payments in order to confirm that discounts are taken and penalties are paid.
– Agree the predicted collection and payment periods to the most recent sales ledgers and purchase ledgers.
– Recalculate the patterns of cash flows based on management’s historical analysis of credit sales to confirm that the forecast has been properly prepared on the basis of these assumptions.
– Perform sensitivity analyses on the cash flow forecast by varying the key assumptions (in particular, in relation to growth rates and payment periods) and assessing the impact of these variations on the company’s forecast cash position.
– Agree the salary payments to the latest payroll records and cash book payments analyses to confirm accuracy and completeness.
– Obtain and review a breakdown of the forecast overhead payments and compare it to historical management accounts and current budgets. Review the schedule to ensure that non-cash items such as depreciation, amortisation and bad debts have not been included.
– For a sample of overhead costs, review the supporting documentation such as invoices and utility bills and agree the amount paid each month to the cash book.
– Obtain and review budgets and analyses of costs to date for the new shops and the online marketing campaign ensuring that the forecast includes all of the budgeted costs and does not include any costs which have already been incurred. Agree a sample of costs to supporting documentation such as invoices, quotations and lease agreements.
– Review board minutes for discussion of the new shops and the marketing campaign.
– Review the outcomes of previous management forecasts and assess their accuracy compared to actual data.
– Assess the competence and experience of the preparer of the forecast.
– Discuss possible cost omissions with the preparer of the forecast, for example, Lavenza Co’s cash flow forecast does not include finance costs, tax payments and does not include any capital expenditure other than the new shops.
– Obtain written representations from management confirming the reasonableness of their assumptions and that all relevant information has been provided to Moritz & Co.
– Request confirmation from the bank of the potential terms of the additional finance being negotiated, to confirm the interest rate.
– Consider whether the finance charge in the forecast cash flow appears reasonable.
Tutorial note: Credit will be awarded for relevant numerical analysis of the cash flow forecast applied appropriately within the answer.
(b) Beaufort Co – ethical and professional issues arising
Long association of senior audit personnel
Frances Stein’s eight-year tenure as audit engagement partner creates a familiarity threat for Moritz & Co. The threat arises because using the same senior audit personnel on an audit assignment over a long period of time may cause the auditor to become too familiar and too trusting with the client resulting in less professional scepticism being exercised and the possibility of material misstatements going undetected. According to the IESBA International Code of Ethics for Professional Accountants (the Code), with listed audit clients key audit partners must be rotated after seven years unless exceptional circumstances arise. In this case, the Code permits the partner’s tenure to be extended for one further year where this is deemed to be necessary in order to maintain audit quality. The Code also clarifies that if an existing audit client becomes listed, the length of time which the partner has already served on the client is included in the period to be considered. In the case of Beaufort Co, therefore, Frances Stein has already served as a key audit partner for the maximum possible period of eight years and following the listing of the client next year, it would be appropriate for her to be replaced by another audit partner. The code does allow an exception, which states that with the agreement of those charged with governance, she could serve for a maximum of an additional two years. After this, she may not serve as a key partner on the audit for a minimum of five further years.
Fee dependence
Over dependence on an audit client for fee income leads to a self-interest and intimidation threat for the auditor. The self-interest threat arises as the firm will have a financial interest in the client due to its dependency on the client and its concern about the impact on its business if it were to lose the client. In the case of a listed client, the Code states that an audit firm’s independence is threatened and should be reviewed if the total fees from a single client exceed 15% of its total fee income for two consecutive years. In this case, the 15% limit has been exceeded in both 20X4 and 20X5 and following the listing of the company’s shares in September 20X5, Moritz & Co is required to review its dependence on the client. If retained as a client, the level of fees should be disclosed to those charged with governance and it should be discussed whether prior to the audit opinion being issued, having an independent pre-issuance or post-issuance review performed on the engagement by an external party or by the firm’s professional regulatory body is enough to mitigate the threat.
Provision of bookkeeping and accounting services
The provision of bookkeeping and accounting services for Beaufort Co creates a self-review threat for Moritz & Co. The self-review threat arises because the auditor is generating figures for inclusion in the financial statements on which they will then give an opinion. As a result, the auditor may be less likely to highlight errors if they are aware that another member of the firm has calculated the figures. For a listed client, the Code states that a firm is not permitted to provide accounting and bookkeeping services. The Code does, however, make an exception for divisions of a company if the services are of a routine and mechanical nature, a separate team is used and the service which the firm provides relates to matters which are immaterial to the division and the company. Following Beaufort Co’s listing in September 20X5, therefore, Moritz & Co will no longer be able to provide the payroll services for Beaufort Co although it may still be able to maintain the financial records for the small division if the conditions stated in the Code are satisfied.
Share prospectus
Moritz & Co has been asked to assist in the preparation of the share prospectus document and to provide an accountant’s report on financial data, business risks and a business plan which recommends the shares to investors. Performance of these services for Beaufort Co would create an advocacy threat for the auditor. The advocacy threat arises because the auditor is effectively being asked to promote and represent their client’s position to the point where the auditor’s objectivity is compromised. The Code prohibits an auditor from acting in this way for an audit client and Moritz & Co should politely decline to assist in the preparation of the document and to endorse the recommendation to investors to purchase the shares. It may be possible, however, for the auditor to provide an accountant’s report on some elements of the prospectus. Moritz & Co may be able to provide an opinion on the financial information if, for example, it limits the form of opinion to stating that it has been properly compiled on the basis stated within the document and that this basis is consistent with the accounting policies of the company.
Review of audit appointment
Margaret Shelley’s comment that Beaufort Co is currently reviewing the audit appointment and that it is looking for an audit firm which is capable of taking it through the listing process and providing a full range of services in the future represents an intimidation threat to the auditor’s objectivity. The intimidation threat arises because Margaret Shelley is applying pressure on Moritz & Co to offer a range of services which will result in breaches of the Code for the audit firm. She is effectively intimidating the firm by threatening to appoint another audit firm if Moritz & Co does not comply. Moritz & Co should explain its ethical duties to those charged with governance and identify clearly the services which it will not be able to provide if it continues as the company’s auditor after the stock market listing in September 20X5.