Reporting Master Class

As a result of the going concern review undertaken at the completion stage, the audit engagement partner has decided that there is a material uncertainty regarding the going concern status of Murray Co. He has requested that the directors make adequate disclosure in the final version of the financial statements for the year ended 31 December 20X4.

Required:

(i) Describe the impact on the auditor's report for the year ended 31 December 20X4 if: The directors include disclosure regarding the material uncertainty over going concern, which in the partner's view is adequate. (3 marks)

(ii) Describe the impact on the auditor's report for the year ended 31 December 20X4 if: The directors refuse to include any disclosure on the matter. (3 marks)

Solution:

• (i) If adequate disclosure is made: The opinion remains unmodified. An additional section, "Material Uncertainty Related to Going Concern," is added to draw attention to the disclosure, but our opinion is not modified in respect of this matter.
• (ii) If disclosure is refused: The opinion is modified. The lack of disclosure is a material misstatement. An adverse opinion would be issued if the matter is pervasive, and a qualified opinion if it is not. The "Basis for Opinion" section would be amended to explain the misstatement.

ISA 260 Communication with Those Charged with Governance deals with the auditor's responsibility to communicate with those charged with governance in relation to an audit of financial statements.

Required:

(i) Describe TWO specific responsibilities of those charged with governance. (2 marks)

(ii) Explain FOUR examples of matters that might be communicated to them by the auditor. (4 marks)

Solution:

• (i) Responsibilities of those charged with governance: They are responsible for overseeing the strategic direction of the entity, ensuring good corporate governance, and implementing and monitoring internal controls to prevent fraud and errors.
• (ii) Matters to be communicated by the auditor:
  • The planned scope and timing of the audit, including the audit approach to risks and internal controls.
  • Significant findings from the audit, such as significant deficiencies in internal control.
  • Audit adjustments that have a material effect on the financial statements.
  • A statement on independence issues affecting the audit and related safeguards.

For each of the following situations, describe the implications for the independent auditor's report.

(a) Aragon Co operates a perpetual inventory system. No year-end count is performed. You have reviewed the level of adjustments made each month after each perpetual count and concluded that due to the significance of the adjustments, the inventory system is not reliable. You have requested that a full year-end count is performed but management have refused saying it would be too disruptive. The inventory balance is $4 million. Sales revenue is $50 million and profit for the year is $15 million.

(b) Boleyn Co has not made allowance for an irrecoverable debt of $50,000 in respect of a customer declared bankrupt just after the year-end. Profit for the year is $500,000.

(c) Seymour Co is being sued by a competitor for the theft of intellectual property. The amount of the claim is material and the case could go either way. The claim is not mentioned anywhere in the financial statements.

(d) Howard Co is a cash retailer. There is no system to confirm the accuracy of cash sales.

(e) Cleves Co has neglected to include a statement of profit or loss in its financial statements.

(f) Parr Co is involved in a major court case that would bankrupt the company if lost. The directors assess and disclose the case as a contingent liability in the accounts. The auditors agree with the treatment and disclosure.

Solution:

• Aragon Co (no year-end inventory count): This is an inability to obtain sufficient appropriate evidence. As the balance is material but not pervasive, a qualified opinion would be issued. The report would state, "Except for the possible effects of the matter described..."
• Boleyn Co (irrecoverable debt not written off): This is a material misstatement. As it is material but not pervasive, a qualified opinion would be issued, with an explanation in the "Basis for Opinion" section.
• Seymour Co (litigation not disclosed): This is a material misstatement (omitted disclosure). As it is material but not pervasive, a qualified opinion would be issued.
• Howard Co (no system for cash sales): This is an inability to obtain sufficient appropriate evidence. As the effect is pervasive, a disclaimer of opinion would be issued. The auditor would state that they do not express an opinion.
• Cleves Co (missing statement of profit or loss): This is a material and pervasive misstatement. An adverse opinion would be issued, as the financial statements do not give a true and fair view.
• Parr Co (litigation with adequate disclosure): The financial statements are not misstated. An unmodified opinion would be issued, with an "Emphasis of Matter" or "Material Uncertainty Related to Going Concern" paragraph drawing attention to the disclosure.

You are the audit manager of Brakes Co, a listed client. Brakes Co is a global manufacturer of braking systems for use in domestic and commercial motor vehicles. $250,000 was raised through a new share issue in the year. Draft profit before tax is $9m and total assets are $37m. The audit is nearly complete and you are undertaking an overall review of the audit evidence on file.

(a) Explain the importance of the overall review of evidence obtained. (3 marks)

(b) During your review you notice that the section of the file relating to share capital and reserves is incomplete.

Required: Describe audit procedures that should be performed in respect of Brake's share capital and reserves. (4 marks)

(c) The following matters arising during the audit of Brakes Co have been noted on file for your attention:

(i) A customer of Brakes Co had to withdraw one of their family car models this year due to concerns over the safety of the braking system. The customer has lodged a legal claim against Brakes Co for $10 million for the negligent supply of faulty braking systems. The company's lawyers believe that there is an 80% chance that Brakes Co will lose the case but the directors believe that their quality control procedures have always been robust and that the braking systems will be proven to have been safe. They have however decided to disclose the matter in the financial statements as a contingent liability. (5 marks)

(ii) Brakes Co also produces and sells brake fluid. Another customer has recently returned a small batch of brake fluid because the fluid appeared to be contaminated with oil. Brakes Co issued the customer with a credit note for the full value of $137,500 and correctly accounted for this in the draft financial statements. As the brake fluid was returned before the year-end, Brakes Co has included it in the year-end inventory listing at cost of $125,000. Brakes Co may be able to re-filter and re-sell the brake fluid at the original selling price, but filtering will cost a further $62,500. (4 marks)

(iii) Four months ago, Brakes Co began renting some additional warehouse space from a third party storage provider, Whitby Co. At the year end, raw materials with a value of $3.2 million belonging to Brakes Co were stored at Whitby Co's premises. The directors of Brakes Co did not make you aware of the new third party storage facility. Consequently, no audit procedures were performed to verify the raw materials. (4 marks)

Required: Discuss each of these issues and describe the impact on the independent auditor's report if the above issues remain unresolved.

Solution:

(a) Importance of overall review: The overall review ensures that sufficient appropriate evidence has been obtained, that the evidence supports the conclusions reached, and that work has been performed in accordance with professional standards. It helps ensure the audit opinion is justified and well-documented.

(b) Share capital and reserves procedures:

• Inspect board minutes to verify the amount of share capital issued during the year.
• Agree cash receipts from the share issue to the bank statement.
• Agree opening reserves to prior-year closing reserves and reconcile all movements, agreeing them to supporting documentation.

(c) Impact on auditor's report:

• (i) Faulty brake systems: The claim is material and pervasive. Since payment is probable (80% chance), a provision should be made. As the directors refuse to do so, a material and pervasive misstatement exists. An **adverse opinion** is appropriate, stating that the financial statements "do not give a true and fair view." The basis for this opinion would explain the failure to recognize the provision.
• (ii) Contaminated brake fluid: Inventory should be valued at the lower of cost ($125,000) and net realisable value ($137,500 - $62,500 = $75,000). The correct valuation is $75,000. The inventory is overstated by $50,000. This is not material (0.6% of profit, 0.1% of assets), so the audit opinion will not be modified. Management should be asked to correct the misstatement.
• (iii) Inventory held at Whitby Co: The auditor has not obtained sufficient appropriate evidence for a material balance ($3.2 million). This is an inability to obtain evidence that is material but not pervasive. A **qualified opinion** is appropriate, using the "except for" wording. The basis for the opinion would explain that the auditor was unable to verify the existence and valuation of this inventory.