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Section B Ans Sunway Tutorial Question
Audit and assurance (Sunway College)
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Tutorial Question (B)- Professional and Ethical
Considerations
1(i)
Intimidation Threat
The fact that Blythe Co. put audit out to
tender would inevitably put pressure on the
audit firms to quote a low fee to increase
the chances of being appointed. This threat
was clearly seen when Fox & Steeple
indicated that there would not be an
interim audit for this new client when it is
necessary since the former lacked
knowledge about the client’s internal
control system.
Also, by granting non-assurance services
to the same firm as auditor as seen in Gray
Co. & Huggins Co. allow the clients to
exert pressure on the firm with threat of
termination because they know that the
latter would be unwilling to lose them and
thus the fees.
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Familiarity Threat
Fox & Steeple has long association with
both Huggins Co. & Gray Co. which can
threaten
the
engagement
team’s
independence if there was no rotation of
senior member of the team such as the
engagement partner and manager during
this period.
The relationship that had built up with the
client management may cause them to
sympathise with the client’s situation to the
extent that their independence is affected.
Self-interest Threat
By providing non-assurance services to
both Huggins Co. & Gray Co. can result in
the firm financially dependent on them if
the service concerned is recurring in nature
such as financial reporting and taxation
services seen in Gray Co. The fear of
losing the client and thus the fees may
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motivate the firm to compromise.
Self-review Threat
The provision of corporate finance service
to Huggins Co. and Financial Reporting,
tax service and due diligence to Gray Co.
can result in the outcome being included in
the Financial Statement and subsequently
subject to audit. It is unlikely that the
auditors who come from the same firm
would reveal the errors made by their
fellow colleagues providing the nonassurance services in order to safeguard
the firm’s reputation.
(ii)
Detection Risk
The fact that Blythe Co. is a new client
implies that the firm lacked prior
knowledge and experience of this client
which could seriously threaten its ability to
identify the fraud and errors.
Inventory Valuation
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The inventories of both Blythe Co. &
Huggins
Co.
are
portable
and
exchangeable due to the nature of the
business these two companies are
operating in. This would increase the
chances
of
the
inventory
being
misappropriated especially if they are
valuable. This would inevitably result in
over valuation of inventory if no physical
count is carried out at the year end.
As for Gray Co., the advancement in
technology may have rendered its software
solutions obsolete and thus warrant
valuation at NRV. Inventory would be
overstated if they continued to be valued at
cost.
Weak Control Environment
By not appreciating the value created by
audit, the Finance Director of Blythe Co.
can be said to represent a weak control
environment which can have subsequent
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impact on the strength of the control
procedures. The firm’s ability to rely on
the company’s internal control system to
reduce substantive testing will not be
possible.
This was further made worse by the fact
that the company is cost conscious which
means priority will not be placed on
internal control.
Expectation Gap
The management of Huggins Co. appeared
to suffer from expectation gap as seen
from their request that auditor undertake
thorough examination of the company’s
computerised system which is clearly not
the responsibility of the auditor.
Even for those computerised systems that
relate to financial information and
financial reporting, auditor involvement
cannot be regarded as thorough and is
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purely to allow auditor to decide whether
reliance can be placed on them in the audit
of financial statement.
Integrity of Client Management
By requesting that the audit report should
not attract adverse criticisms raises doubt
on the Huggins Co. management’s
integrity which can have implication on
the reliability of representations made by
them to the auditor.
Accordingly, the auditor’s nature, timing
and extent of audit would have to be
altered accordingly to response to this
threat.
(iii)
In view of the high detection risk
involving Blythe Co. as seen above, the
staff who will be assigned to audit this
company should ideally be more senior to
increase the chances of uncovering the
frauds and errors. Preferably, they should
also have experience in auditing clients in
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similar business as Blythe Co.
The long association with Huggins Co. &
Gray Co. necessitate the rotation of senior
audit staff who had been involved in
auditing these companies to avoid the
familiarity threat discussed above.
Likewise, those staff who had been
involved in the provision of non-audit
services to Huggins Co. & Gray Co.
previously should not be involved in the
audit of these companies to avoid possible
self-review threat.
2(a)
By requesting that only certain staff be
included in the audit team and that trainees
to be excluded suggested that this client
may have had some bad experience
dealing with the firm’s staff previously.
This is a matter that relates to personnel
control, a component of quality control
procedures. Review ought to be carried
out to identify weakness in recruitment
and/ or training.
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Xavier by virtue of his position as
accountant in charge of the audit team is a
relatively senior member of the team. By
assigning him to audit Almond three years
in a row can raise the issue of familiarity
threat if he had already established some
good relationship with the client’s senior
management. Otherwise, the Finance
Director will not request for his inclusion
in the team.
Besides that, as a young auditor, he should
be exposed to auditing clients from
different industries and it is thus not a
good idea to assign him to audit Almond
again.
By obliging to the client’s request can
upset the firm’s staff planning as those
staff requested by the Finance Director of
Almond could have already been assigned
to audit other companies.
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Hence, the firm should politely reject the
client’s request by convincing it that
whoever staff assigned to audit the
company are competent in undertaking
those tasks assigned to them and that their
work will be under the close supervision of
their respective superior.
Also, by assigning only senior staff to
audit the company would mean that the
former will be involved in performing
work that can be performed by junior staff.
This would inevitably increase the audit
cost.
(b)
The fact that Alex had resigned to join a
totally different profession showed that his
interest was not in audit. This incident
indicates possible weaknesses in the firm’s
recruitment process for not able to
successfully screen through the applicants
resulting in wastage in training and hiring
cost.
What Alex had done represents a violation
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of the fundamental principle of integrity
and can have implication on the audit risk
and the validity of the opinion issued. This
incident may have occurred because of the
firm’s culture that over emphasise on
completing the audit within the time
budget that had caused Alex to cheat to
avoid punishment.
If the audit report for Phantom had yet to
be issued, work previously undertaken by
Alex ought to be subjected to re-review to
ensure similar incident did not occur in
other areas.
There are also doubts over the competency
of Kurt as an accountant in charge as
clearly he did not manage to uncover the
omission of work if not because of
disclosure by Alex. The engagement
partner would have to re-evaluate the
quality of review undertaken by Kurt in
other audits to decide the most suitable
course of action for him such as sending
him for further training before assuming
similar role in other audit.
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(c)
Based on the information given, it is
clear that the payment of $4.5mil out of
court settlement is an adjusting post
reporting period event. The payment
confirmed the existence of the contingent
liability as at the year end. As such, the
client should have made a provision
equivalent to $4.5mil for the year ended
31st December 2003 instead of just
disclosure. The auditor is in a position to
know about the said payment as it was
made before the audit report was signed
when the audit team should still be
actively gathering audit evidence.
The failure to take note of this payment
revealed weaknesses in the undertaking of
review of subsequent events. Similar work
undertaken by the audit team in other audit
assignments ought to be re-reviewed to
make sure that the same error did not
occur.
Jamie’s decision of not disclosing the error
to the client management showed that she
suffered self-interest threat to objectivity
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which requires the auditor to avoid
biasness, conflict of interest situations or
subject to the pressure of others.
She could have been motivated by her
desire to protect the interest of fellow
colleague and the firm. To avoid the worse
consequences if the client were to find out
the error themselves, it is appropriate that
Jamie inform this matter to the
engagement partner who should then
approach the client for a prior year
adjustment. Failing which, the audit report
would be qualified over the validity of the
opening positions.
3(a)
Perform analytical procedures by
comparing current year’s sales growth
with that of the industry average. Should
CD sales’ growth rate far exceed the latter
(by at least 25%), this would trigger the
auditor into investigating the causes and
thus uncover the fraud.
Direct confirmation with a sample of new
sales agents concerning the amount
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outstanding as at the year-end. Should the
request meet with non-replies or replies
that such companies do not exist, this
would alert auditor to the possibility of
fictitious sales agents.
Review post reporting period cash book
for payments made by these sales agents.
Should payments not been made within the
credit period and yet no action was taken
to recover them, this would raise doubt
about the validity of the said agents.
Obtain direct confirmation from a sample
of existing sales agents on the amount
outstanding as at the year end. The fact
that they disputed the amount and claimed
that the amount outstanding recorded by
CD Sales as too high would suggest to the
auditor the possibilities of wrong treatment
of goods on sale and return basis.
Auditor’s review of post reporting period
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journal entries would reveal the many
repurchases that took place which are
unusual. This would warrant investigation
by the auditor and thus the discovery of
fraud.
Review the agreement entered into
between CD Sales and a sample of the
sales agents. The terms and conditions of
the sales i.e. sale or return would have
caused the auditor to scrutinise the client’s
method of recognising the sales leading to
the discovery of the overstatement.
Perform
analytical
procedure
by
comparing CD sales’ gross profit margin
with that of the industry average. The fact
that it is much higher than the latter (by at
least 20%) suggests possible capitalisation
of cost of sales.
Physical count of inventory would reveal
that the closing quantity is higher than the
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book quantity whereas similar count of
NCA revealed the opposite result. This
would alert the auditor to the possibility of
inventory being capitalised as NCA.
Review of director’s service contract
would highlight that their remunerations
are linked to the performance of the
company which is a form of inherent risk
as this would motivate them to manipulate
the reported profit. This should result in
auditor scrutinising the sales for
overstatement and cost of sales for
understatement and thereby uncover the
fraud perpetrated by Mr. A Long.
(b)
The signing of the confidentiality
agreement effectively limited the scope of
the auditor, prohibiting him from
undertaking certain procedures which are
expected of him as an auditor.
He should have declined to sign it when
first approached by the client as
Companies Act had granted auditor free
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access to all accounting records and
information.
Since the said agreement had been signed,
the auditor is required to qualify the audit
report on the ground that sufficient
appropriate evidence was not obtained.
Should the limitation be deemed material
and pervasive, a disclaimer opinion would
have to be issued. Otherwise, a qualified
opinion would suffice.
The failure to report the above matter in
the audit report would render the auditor
negligent in the discharging of his duties.
(c)
Audit offers a high level of assurance
while review offers only limited assurance.
This was principally due to the amount of
work that was carried out for audit to
gather sufficient appropriate evidence. In
the case of review, the scope of work is
limited to only enquiry and analytical
procedure.
Accordingly, the opinion expressed in an
audit is known as positive assurance as
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auditor directly concluded that the
financial statement shows a true and fair
view. This is unlike review engagement
where the opinion expressed is in negative
form by indicating that there is nothing
that had come to the auditor’s attention to
make him conclude that the financial
statement does not show true and fair view.
(d)
According to ISA 240, auditor is not
responsible for detecting the frauds. Such
responsibilities lie with the client
management and those charged with
governance. However, the fact that fraud if
occurred could cause the financial
statement to be materially misstated, the
standard did require the auditor to
undertake risk assessment of the client’s
financial
statement
for
possible
misstatement due to fraud and then
subsequently react accordingly by
changing the nature, timing and extent of
the audit to ensure reasonable assurance
that the financial statement is freed of
misstatement associated with fraud.
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This is because fraud may result from
forgery, collaboration among several
parties, management overriding of controls
as seen in this case which the normal audit
procedures will not detect them. As such,
auditor should maintain a sceptical mind
set by alerting to the presence of fraud risk
factors such as pressures and incentives
that may exist, which will motivate the
client management to commit fraud.
In this case, the failure to discover the
frauds appeared to be due to the signing of
the confidentiality agreement which had
limited the auditor’s scope. Should the
audit report not be qualified on this
ground, auditor can be sued for negligence.
However, the auditor’s liability can be
mitigated by the fact that the report offered
a limited level of assurance and the
assurance expressed was negative. As
such, the bank should not have placed total
reliance on it without performing its own
independent verification.
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4(a)
The difference between fraud and error
depends on whether the underlying action
that results in misstatement in financial
statement was intentional or unintentional.
If intentional, it would be fraud.
Detection of fraud and error
*For discussion on fraud, please refer to
previous answer found in Q3(d).
As for errors, auditor certainly would be
responsible for detecting them to ensure
that the users will not be misled by what
was reported in the financial statement.
However, it is important to appreciate that
auditor will only be interested in detecting
material errors that would cause the
economic decision of the users relying on
the financial statement to change. Focusing
on immaterial errors will only affect the
efficiency of audit unless cumulatively
their effect on the Financial Statement is
material.
Reporting of fraud and error
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To shareholders:
Auditor’s responsibility to this group is the
same regardless of whether the
misstatement was due to fraud or error.
Auditor merely highlights to shareholders
their effect on the financial statement. If
the misstatement is regarded as material
but not pervasive, a qualified opinion
would be issued. Otherwise, an adverse
opinion is necessary.
Should auditor encounter limitation on
scope in the detection of fraud or error, the
audit report will be qualified accordingly
on the ground that sufficient, appropriate
evidences were not obtained.
To those charged with governance:
In the event that the fraud involves
operating management, reporting will be
made to this group who plays the oversight
function in the company.
However, should the fraud involve
member of those charged with governance,
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advice should be obtained from solicitor
on the best course of action. Reporting of
fraud is regardless of the amount involved
as the nature itself is material. This is
unlike errors where auditor will only report
material errors with the hope that the
financial statement will be changed
accordingly to avoid qualification.
To regulatory authority:
The duties to report error or fraud to this
group would depend on whether any
obligation exists under the laws and
regulation to make the reporting
mandatory in order to safeguard
confidentiality owed to the client.
(b)
Professional scepticism
The state of mind of PA characterised by
their alertness to the presence of actual or
suspected frauds such as paying attention
to unusual relationship that established
from analytical procedures or the presence
of fraud risk factors such as pressure and
incentives that can motivate the client to
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be involved in fraudulent activities.
At the same time, this concept also
requires the auditor not to over rely on past
relationship
with
the
client
notwithstanding that frauds did not
previously occur. Also, the professional
accountant must always be on the look-out
for possible management overriding of
control such as transaction which was not
previously approved by a senior personnel
was now approved by him or her.
Role of professional scepticism in the
detection of fraud
As seen in (a) above, fraud is intentional
and thus planned. Audit procedures that
are effective in detecting errors may not be
effective in detecting fraud. This will
therefore require the auditor to be extra
careful in identifying the signs of fraud.
Since fraud is well planned, their detection
will not be clear cut, maintaining
professional scepticism would allow
auditor to pay attention on those areas or
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signs that would otherwise be mistaken as
pure errors.
Also, it is a defend for auditors against the
accusation of negligence for not detecting
frauds that present in client’s financial
statement.
(c)
Earning management is defined as
purposeful intervention by management in
the financial reporting process in order to
achieve personal gains. This can happen
for instance if directors’ remuneration is
linked to the performance of the company
or they have been given a large block of
share options. A reported improvement in
the corporate performance can send the
share price to soar.
Auditors find difficulties in detecting the
fraud because of limitations in the
financial reporting process as described
below:
Preparation of financial statement involves
the exercising of judgement and
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estimation. This provides an opportunity
for management to cover up a fraud by
claiming that it is their judgement. It does
not help that auditor also lacked expertise
in these areas especially if client operates
in complex, specialised industry.
In addition, accounting standards often
allow more than one way of treating a
transaction or event such as depreciation.
It is difficult for auditor to conclude
whether a particular choice made is most
suitable for the client.
Financial reporting also emphasises on the
consideration of substance over form
because we are following conceptual
framework
in
preparing
financial
statement. This added additional difficulty
to the auditor in this very much
judgemental area.
Earning management could also be the
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results of collaboration involving several
parties, forgery or even bribery to cover up
the trails. This makes it difficult for the
auditor to uncover them due to the well
planned nature of these incidents.
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