Expense Verification and Fraudulent Transactions
Question 1
It is to be noted that the auditor firm, “Mole & Co.” is certainly not responsible for detection and prevent of fraud according to ISA 240. ISA 240 states that it is the management or persons charged with the responsibility of governing and overseeing the day-to-day operations to timely detect and prevent any kind of fraudulent activity. So, it is not the responsibility of the auditor to detect or prevent fraud. However, ISA 240 also states that the auditor should possess as well as acquire “reasonable assurance” that the financial statements prepared by the organisation is free from any kind of “material misstatements”, “fraud” and errors.”
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Audit risk |
Response |
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There is an inherent risk of overstating the expenses. The last CFO of Ratty Ltd left the organisation just before the year end complaining about the fraudulent expenses. This issue was also raised by the newly appointed CFO. |
The substantive procedures concerning the test of various expenses must be carried out by the auditors in order to obtain reasonable assurance regarding the presence of fraudulent expenses transactions such as verification of purchase invoices regarding different incurred expenses such as advertising. Confirmation can also be drawn from the vendors if suspicion arises. |
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Inherent risk in the “Intangible asset” account as the account might be overstated. It is to be noted that within the year, Ratty have incurred a total of £1.2m million towards development of certain new products which are at different stages of development including an unsuccessful attempt of developing a vaccine for Covid-19. The whole amount has been capitalized by Ratty just to portray and added net profit because of the loan covenant where it states of maintenance of a specific amount of net profit every year. This is why the entire amount of £1.2m million has been capitalized and not recorded as an expense which is not advisable according to IAS 38 because the vaccine development attempt has failed and many new products are in different stages of development where there is no fixed proof that the assets have entered it final development phase and ready to be used or sold. |
There should be a substantive review of all development expenditure just in order to prove that all assets which has been capitalised met the capitalisation criteria as stated under IAS 38. |
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Inherent risk in the “Sales account” as there are enhanced reported cases of sales return within the year and post the year end concerning the sales effected during the year. So, there may be situation of overstatement of sales just to enhance and maintain the net profit. |
All sales related transactions must be substantially checked in details both concerning the test of balances and test of transactions juts to prove that all sales transactions and sales return transactions have been properly accounted for. There should be “Inspection” of all sales return invoices on a random basis and verified against the transactions passed within the sales ledger to check that all sales returns transactions have been accounted for. |
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Inherent risk the inventory account. It has been reported by the auditor who attended the inventory count of Ratty stated that there was actual movement of inventory when the count was taking place. |
Physical inventory check is to be re-done. Inspection of all relevant documentation concerning the inward and outward movement of inventory is to be checked for both completeness and Accuracy. |
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Inherent risk within the “Plant and equipment account” as the surplus plant was sold for a profit of £130,000 which is to be investigated. |
The documents concerning the sale of the machinery must be reviewed such as sales invoices. An additional “Confirmation” may also be drawn from the purchaser regarding the data and purchase price. The accounting policy especially concerning depreciation must be checked to review the accuracy of the calculation and accounting for the sale of surplus plant. |
The two substantive audit procedures which Mole & Co. should carryout during the audit of Ratty’s inventory firstly includes “Physical inventory count.” The physical inventory count has already been done but there are noticeable glitches such as movement of inventory during count so re-counting should be conducted. The second procedure may include taking out random samples from the inventory records and tracing it back to the warehouse records which would check for the existence of the inventory. The record for outward movement of inventory as per the warehouse records could be verified against the delivery confirmation receipts to check for existence and accuracy.
The two ethical principles which are at risk here if Mole & Co intends to accept the internal audit function apart from providing the external audit service and discussing such matter while playing golf with the new CFO of the audit client are “Objectivity” and “Professional behaviour.” The “Objectivity” is at risk because there may be an undue influence by the new CFO and presence of conflict of interest if the internal audit function is accepted by Mole which might affect the professional judgement of Mole as an external auditor. Apart from this fact there is a “Familiarity” threat to the independence of the auditor may rise if the auditor accepts the invitation to visit the golf club and play golf with the current audit client’s CEO amidst the on-going external audit. The “Professional behaviour” may be at risk if Mole intends to accept the internal audit service along with the performance of the external audit because the law, rules and regulations stipulates an external auditor to perform certain other assurance services such as internal audit for the same client under an external audit.
According to the recent changes being integrated within the “Sarbanes Oxley Act of 2002”, the external auditors cannot specifically rely on the management’s version or narrative on the internal controls or audit to reach a desired conclusion. The external auditors are now not allowed by the Act to carryout similar audit strategies which has been adopted by the internal audit. Now, internal audit function may portray the management’s narrative and hence the external auditors must not rely on it and should carry out an independent independent assessment of the fairness and reliability of the financial records that is whether it is reasonably devoid of material misstatement, frauds and errors. Hence, the offer of conducting an “Internal audit function” along with an external audit performance should not be done by “Mole & Co.” So, Mole should not accept the offer of the current CFO of Ratty.
Capitalisation Criteria for Development Expenditure
The two limitations of external audit firstly include that the external audit is very time consuming and a costly affair where there is a substantial need of time to conduct the audit and involvement of a substantial outflow of funds to the external auditor or audit firm for conduction of the audit. The second limitation is that the external audit being a costly affair does not provide an absolute assurance and only provides a mere “reasonable assurance” as it is based upon “test checks” and choice of samples which may not completely reveal the presence of all fraudulent transactions or errors.
In the case of “Crocodile.com”, where a key customer has made default in payment of £300,000 standing to his account at the year end and the finance director has said that he will write off the outstanding amount as bad debt in the next financial year, the audit report should be modified and an “Qualified” report is to be offered as the subsequent in question is an “Adjusting type.” The amount has been outstanding in the present years and any bad debt is to be written off from the balance sheet of the financial year ended September, 2021 and not from 2022.
In this case of “Peter and Wendy Ltd.”, the tax authorities have started an enquiry concerning the tax affairs of the company on November, 2021 which is beyond the balance sheet date and nothing has been finalised nor can be said before the inquiry gets completed. This is thus a subsequent event of “non-adjusting type.” Here, the management have already mentioned the situation as “notes to financial statements” which is enough and hence the report does not need any modification and hence an “Unqualified audit report” can be offered to “Peter and Wendy Ltd.”
Here, in this case of HFD, the audit report is to be modified because the charity, HFD have recently received a government grant of £250,000 and have credited the entire amount to the “P/L Account” which is not at all the correct accounting treatment and in place of it it should have been credited to the “P/L Account” over the entire useful life of te asset being purchased with such a grant. The “Director of Finance” has not agreed to change the accounting treatment irrespective of possession of the knowledge that the present accounting treatment is a wrong one. This wrong accounting treatment have caused material errors in calculation and misstatement within the financial statements. So, there is detected material misstatement and the management is not willing to cooperate with the auditor in incorporating the changes mentioned by the auditor. Hence, an “Adverse” audit report should be offered.
Here, in this case of “Hook Ltd”, the audit report should be modified. This is because the balance sheet contains a “non-current asset”, “a new constructed property” at cost amounting to £3.2 million wherein there is an inclusion of a “project management fees” amounting to £250,000. There has been no substantial proof existing regarding the calculation of the “project management fees” by the “Director of Finance.” The “Director of Finance” have estimated the cost all by himself without any concrete evidence of the actual costs incurred for the project management. The “profit before tax” for the year is amounted to £780,000 and hence it can be concluded that the amount of “project management fees” is material. Therefore, there can be material misstatements or errors in calculation present within the material “project management fees” for which no satisfactory audit procedures have been run. Hence, a “Qualified” audit report is to be offered here in this regard.
Sales Transactions and Returns
The “Letter of Representations” is a special letter which is provided at the end of the audit process and is considered as an eminent part of the audit evidence to preserved and used by the auditor as and when required especially when any legal suit is filed against the auditor. It is to be considered that an “Audit engagement letter” is provided by the auditor to the firm and its management at the beginning of the audit which contains all relevant information on the audit to be conducted such as scope, purpose, duration and many more. It can be used by the management as a document and may be produced at the court of law if any dispute arises between the auditor and the client. Hence, it is a legally enforceable document that confirms the legal contract between the auditor and the audit firm. Now, if the auditor needs to be sued for any professional misconduct such as negligence, then this document of audit engagement letter comes into use. On the other hand, the “Letter of Representation” which is provided at the end of the audit process is provided by the officers of the client under audit that is the executives to the auditor or the audit firm who have conducted the audit. However, it is to be specifically noted here that this particular letter is also drafted by the auditor himself and then is sent to the management of the audit client to duly sign on it and then return it to the auditor who would then preserve such a document as an important audit evidence.
It is to be noted that the primary purpose of this report is to set out the responsibilities of the persons to be charged with the role of managing the company. The executives of the client company under audit this provide the much-needed representations regarding their true responsibilities and also certifies their knowledge on certain key matters which have been undertaken by them or by any of their subordinates under their delegation of authority. Thus, the primary aim of the “Letter of Representation” according to ISA 580, is to eradicate any kind of confusion regarding the true role and function of the management personnel and different their true actions from that of the auditor. So, the specific types of representations which are required and mostly seen on a “Letter of Representation” includes the following:
- The prepared financial statements are in conformity with the applicable frameworks for financial reporting.
- The “Letter of Representation” also portrays that all transactions and related information have duly recoded within the financial statements to best of the knowledge of the executives.
- Certification regarding the appropriateness of future plan and correct accounting policies.
- Representations of specific assertions thereby certifying those used assertions.
- Certification of the fact that the internal control responsibility lies on the able shoulders of the management personnel.
- Finally, through the “Letter of Representation”, the management certifies the fact that if there is any uncorrected misstatement, then such misstatement is completely immaterial.
Now, speaking about the significance of this “Letter of Representation” within the audit process, it can be said that this letter is an eminent part of the audit evidence because this letter signifies that the financial statement is prepared according to applicable laws and frameworks and reveals the true and fair view of the entity under audit. Now, if such a letter is not duly signed by the management, then it raises doubts regarding the fairness and reliability of the prepared financial statements itself. Hence, there is a limitation of the scope of audit itself and as a result the auditor might distance himself from forming an opinion on the prepared financial statements and ultimately provide a “Disclaimer of Opinion.”
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