Question: Fraudulent activities can be carried out through the use of journal entries. State the characteristics of journal entries that external auditors should select for testing to identify fraudulent activities.

23 Oct 2022,12:51 AM

 

ANSWER ALL QUESTIONS

 

1. Your firm has been appointed as the external auditor of two unrelated clients: Sahara Ltd (Sahara) and Nature plc (Nature). You are the audit senior and the engagement partner has asked you to consider the described below are situations which have arisen at Sahara and Nature.

 

Sahara Ltd (Sahara)

(i) Your firm has been appointed as the external auditor of Sahara for the year ending 31 March 2021. Sahara was incorporated on 1 April 2019 and was not previously required to have an audit under the Companies Act 2006. Sahara provides corporate customers with an online employee benefit platform called 'Vision'. Vision gives the employees of Sahara customers employees access to a range of discounted leisure services. Leisure services are advertised on the Vision platform by external companies, such as restaurants and cinemas, who then supply the service to the customers' employees.

 

Sahara’s number of employees has grown rapidly and requires more office space. The board has approved the relocation of Sahara's offices from London to Dundee. Sahara signed a lease for offices in Dundee which commences on 1 June 2021. On 1 March 2021, Sahara informed its employees that if they do not wish to relocate to Dundee, they will be made redundant. Employees will receive a redundancy payment equal to one month's salary for each year they have worked at Sahara. Sahara's finance director estimates that 20% of Sahara's employees will be made redundant. Sahara's directors do not intend to include any amounts relating to the redundancies in the financial statements for the year ending 31 March 2021.

 

Statement of profit or loss for the year ending 31 March (extract )

	2021 (estimated) £’000	2020 (unaudited) £’000
Revenue	11,146	3,961
Profit before tax	1,413	133

 

Notes to the financial statements for the year ending 31 March (extract)

	2021 (estimated) £’000	2020 (unaudited) £’000
Employees – payroll costs
Wages and salaries	3,152	1,431
Social security costs	284	158
	3,436	1,589
Average monthly number of employees during the year
Total employees	97	38

 

 

(ii) Your firm is performing an engagement to examine and provide assurance on Sahara's cash flow forecast for the three years ending 31 March 2024, the forecast has been prepared by Sahara's directors in support of a loan application. Sahara's bank requires the forecast to be examined and reported on by independent accountants. The cash flow forecast has been prepared on the assumption that revenue will grow by 8% per annum. Your firm believes this is highly unrealistic because current revenue growth for Sahara and the industry in which it operates is 2% per annum and 3% per annum respectively. Sahara are in the process of tendering for a government contract and you notice that one of the audit partners, Rachel Reeves, who has a law degree, is undertaking the negotiations on their behalf.

 

Nature plc (Nature)

 

(i) Your firm has recently been appointed as the external auditor of Nature, a listed company, for the year ended 30 November 2021, following the resignation of the previous auditor. Nature is an online retailer offering customers a choice of over 2,000 items of groceries and household goods. Customers place their orders online and their orders are hand-picked and delivered to customers by Nature using its own delivery vehicles. Nature operates from 10 freehold distribution centres throughout the UK.

 

Statement of profit or loss for the year ended 30 November (extract)
	2021 (unaudited) £’000	2020 (audited) £’000
Loss on sale of delivery vehicles	(45)	(25)
Depreciation charge for delivery vehicles	(47)	(55)
Draft statement of financial position as at 30 November (extract)
Non-current assets
Delivery vehicles (carrying value)	664	558

 

In addition, the engagement partner has provided you with the following information. The delivery vehicles are serviced and repaired in Dragon's workshops. It is company policy to replace delivery vehicles every six years. Delivery vehicles are purchased from a UK dealer. Employees in Dragon's workshops modify the delivery vehicles to make them suitable for transporting frozen food and to brand the delivery vehicles with Dragon's corporate identity. All costs associated with both purchasing and modifying the delivery vehicles, including time spent by Dragon's workshop employees, is included in the cost of delivery vehicles in the non-current asset register. The cost less any estimated residual value is depreciated on a straight-line basis over six years.

 

(ii) Your firm has accepted an assurance engagement to provide an opinion on Nature's greenhouse gas (GHG) statement for the year ended 30 November 2021. Nature has estimated the emissions figures for the period July to  November 2021 and is required to disclose this fact in the GHG statement. Your firm is satisfied with the basis of the estimate and that it has been appropriately disclosed by Nature. The inclusion of estimates is fundamental to users' understanding of the GHG statement.

 

Required:

 

• Explain why payroll costs of Sahara and non-current assets of Nature have been identified as key areas of audit risk and describe the procedures that should be included in the audit plan to address those risks.

 

• Identify and explain the matters that your firm should have considered before accepting appointment as external auditor of Nature.

 

• For each situation listed above as (ii), state, with reasons, the implications for your firm's audit or assurance reports.

.

 

2. Your firm Review LLP (Review), a firm of chartered accountants, is the external auditor of Dot plc (Dot), a listed company. Dot employs 2,500 consultants and provides management consultancy services to clients throughout the world. All consultancy services are provided under fixed-price contracts.

 

You are the audit manager responsible for the audit of Dot. You will be attending Dot's forthcoming audit committee meeting with Sarah Connor, the audit engagement partner. Sarah has provided you with a copy of the audit committee's agenda and has requested that you research each agenda item so that you are in a position to answer any questions. An extract  from the agenda is given below.

 

Extract from the audit committee's agenda

 

• External auditor's report to those charged with governance

Following the audit of the year ended 31 October 2021 Review will present to the audit committee a report which highlights the following internal control deficiencies:

 

(i) The company's policy requires that each month, contract managers compare the costs incurred to date and the expected costs to complete each contract with the total budgeted costs. This comparison was not made in 50% of the contracts examined by the auditors.

 

(ii) Dot has signed a contract with Roads Ltd (Roads) to manage all of the consultants' transport arrangements. The contract requires that all airfares and hotels must be booked through the website recently developed by Roads for this purpose. However, some consultants claim that the website is often unreliable and is not user friendly. Consequently, consultants frequently book airline tickets and hotel rooms directly with the airline and hotel. They subsequently reclaim the cost from Dot by submitting their receipts along with manual expense claim forms.

 

(iii) Bank reconciliations have not been performed since January 2021 due to staff shortages in Dot's accounts department.

 

(iv) Dot's purchase ledger clerk is responsible for placing orders with suppliers, posting invoices to the purchase ledger and making payments to suppliers.

 

(v) Dot does not have a policy in place requiring review of its aged receivables.

 

(2) Rotation of the audit engagement partner

 

A letter has been received from Review advising that Sarah Connor is due to be rotated off the audit team as she has been the audit engagement partner for five years. The audit committee will discuss the chief executive's proposal that Sarah continues in her role to help future audits run smoothly. Dot's current chief executive has recently announced his retirement.

 

(3) Review's response to the invitation to provide non-audit services

 

Review has stated that there is capacity to undertake non-audit services for Dot:

 

Invitation (i) To assist with, and take responsibility for, the recruitment of a new chief executive.

 

Invitation (ii) To provide payroll services for Dot, on an outsourced basis, as the audit committee is unhappy with the performance of the company currently providing these services.

 

(4) Potential conflict of interest

 

Review has advised that they have been approached by Star Ltd (Star) to act as external auditor. Star is one of Dot's major competitors. Review has indicated that they will only accept appointment at Star if they have Dot's informed consent to act. Review has stated that they will implement a number of procedures to address any conflict of interest.

 

Required:

 

• For each internal control deficiency listed as (i) to (v) in agenda item (1):

(1) Outline what should have been included in the report to those charged with governance regarding the items in Dot's financial statements that are at risk of misstatement because of the deficiency.

(2) Outline the recommendations to address the deficiency and list the audit evidence the audit team should have included in the audit file to address.

 

• In respect of agenda item (2), identify and explain the threats to Review's objectivity and state, with reasons, how Review should respond to the proposal that Sarah Connor continues as audit engagement partner.

 

• For each invitation to provide non-audit services listed as (i) and (ii) in agenda item (3), draft notes that identify and explain the threats to Review’s objectivity and state, with reasons, how Review should address those threats.

 

• In respect of agenda item (4), outline the procedures that Review should implement to address the potential conflict of interest.

 

3. Your firm has been engaged by Traveller Ltd (Traveller) to undertake a review of and provide an assurance report on the interim financial information of Traveller for the six months ended 31 May 2021. You are training to be a Chartered Accountant and have been asked to assist the engagement partner on this review. The terms of engagement include making enquiries of management and applying analytical procedures and other review procedures to the financial information. Your firm is not the external auditor of Travellers.

 

Traveller's principal activity is the manufacture of uniforms for airline pilots and cabin crew. The design of the uniforms is agreed with each airline and the uniforms are manufactured in Traveller 's workshop in London. The airlines are invoiced in sterling on delivery of the uniforms and are required to pay Traveller within 30 days of the invoice date. Traveller's revenue grew steadily, at between 6% and 8% per annum, over the five years ended 31 May 2020.

 

As a result of a large airline customer entering administration, the directors decided to diversify the business. Traveller rented ten leasehold retail units in major UK cities and in December 2020 began to retail men's suits directly to the public. Suits are either ready-made under the 'X' brand or made-to-measure for those customers wanting a quality handmade suit. Orders for made-to-measure suits are taken in the retail units and the suits are manufactured in the London workshop. The budgeted revenue for the first six months of retail trading was £2.4 million. Before December 2020, cloth for the manufacture of uniforms for airline pilots and cabin crew was purchased from European suppliers. In December 2020, Traveller began to purchase cloth directly from UK wholesalers. Ready-made suits are purchased directly from manufacturers in China. All suppliers are paid in sterling.

 

In April 2021, Traveller received notification of legal proceedings from a competitor, X Clothing Ltd, claiming significant damages for an alleged infringement of a trademark. Traveller's lawyers believe that the claim could be successful.

 

The following relates to Traveller's interim financial information:

 

Statement of profit or loss for the six months ended 31 May (extract)
	2021 £’000	2020 £’000
Current assets
Inventory	4,533	2,694
Trade receivables	4,025	2,420
Current liabilities
Trade payables	766	682

 

As part of your analytical procedures, you have calculated a number of ratios and identified the following to discuss with Traveller's management:

 

Six months ended 31 May
	2021	2020
Increase in airline revenue	16.8%	7.5%
Gross profit margin	33.0%	28.5%
Operating margin	13.8%	15.2%
Inventory days	65.8 days	47.3 days
Trade receivables collection period	43.3 days	30.4 days
Trade payables payment period	22.1 days	27.9 days

 

Six months ended 31 May
	2021	2020
Revenue
Airline (credit)	16,958	14,523
Retail (cash)	1,807	--
	18,765	14,523
Cost of sales (including labour)	(12,570)	(10,390)
Gross profit	6,195	4,133
Operating expenses	(3,612)	(1,921)
Profit from operations	2,583	2,212

 

 

Required:

 

• Define the inherent risk and its types and explain limitations of using analytical procedures as a source of evidence when providing an assurance report on the interim financial information of Traveller.

  (5)

 

(b)         Identify the enquiries you should make of the management of Traveller to ascertain the reasons for the changes in each of the ratios calculated as part of your analytical procedures.

 

• List any documentation that should be requested from the management of Traveller that would be useful for your analytical procedures and other review procedures in the light of the ratios calculated and reviewing the interim financial information.

 

4. You are the auditor of Harrys Ltd (Harrys) which has a financial year-end of 31 December. For the year ended 31 December 2021, Harrys Ltd had revenue of £30 million and profit for the year of £5 million. During this year, a new Financial Director (FD) was appointed as a result of the dismissal of the previous FD, Mr Tom. It was discovered that Mr Tom was involved with the chief buyer in the purchasing department of Colours Ltd (Colours) and a purchase ledger clerk in the accounts department for two years. Mr Tom had defrauded Harrys Ltd of £250,000. It transpired that Mr Tom’s brother was a chief buyer of Colours and he was entitled to a further 20% discount on Colours purchases which was unauthorised.

 

The fraud was not discovered by your audit firm but by one of the directors who is good friends with Mr Tom’s sister-in-law. The other directors of Harrys have written to your audit firm claiming that your audit did not uncover the fraud and your audit firm has been negligent, especially since you helped develop the systems of internal control. They also claim that your audit should have detected frauds during the audits and have requested an explanation as to how your audits could have missed it.

 

The other directors of Harrys are now threatening legal action. You have explained that no system of internal control can guarantee the discovery of fraudulent activity and that an independent review of your audit documentation will confirm that you were not negligent. You have sought legal advice and your solicitors have suggested that you make an out-of-court settlement of £40,000 to Harrys.

 

Required:

 

• Outline the current regulatory and professional requirements in connection with the auditors’ responsibility for the detection of fraud.

(5)

 

(b)      Explain why you might consider the out-of-court settlement to be reasonable and what impact such settlements may have on the auditing profession.

 

(c)      Fraudulent activities can be carried out through the use of journal entries. State the characteristics of journal entries that external auditors should select for testing to identify fraudulent activities.

 

(d)     Using contemporary case law and literature, critically discuss the auditor’s liability for the audit and provide examples of how auditors can limit that liability.