QUESTION 3: Auditor liability
Julia Smith has been the partner in charge of the audit of the clothing manufacturer, Euphoric Colours Pty Ltd (Will be referred to as Euphoric throughout the rest of the question). Her audit firm (CMA Associates) was in charge of the audit for the period ending 30th June 2020. Euphoric has had excellent growth and profits in the past ten years of operations mainly through the excellent leadership of management, led by Brian Lekleys. Julia has always maintained a close relationship with Euphoric and has also given some constructive feedback to Euphoric’s management which has been instrumental in the sustained growth of Euphoric. One of the recommendations included the installation of a cloud-based online accounting system. Over the last few years, CMA Associates asked Julia to rotate the staff involved in the audit of Euphoric. This has been ignored by Julia and the management of Euphoric on the basis that the existing audit staff of Euphoric are familiar with the business and this saves resources when undertaking the audit. However, Julia has agreed to changes in staff for the current year’s audit.
During the latter half of 2019, Euphoric decided to expand their operations and began a $1.5 million upgrade of its manufacturing facilities. The $1.5 million was obtained as a loan from ANZ Bank. A loan of $1.5 million at a fixed 6% interest per annum was secured with the bank. Euphoric supplied financial information to the bank outlining their ability to continue as a going concern and therefore being able to meet their short term and long term commitments. The assessment of Euphoric’s ability to continue as a going concern was made by assuming the $1.5 million loan had been successful and this was included as a liability in the assessment of going concern. The assessment was conducted by CMA Associates. The assessment and documentation of the assessment was a key requirement from ANZ before loan would be approved.
For the first few years of the audit of Euphoric, internal controls were assessed as inadequate and the accounting staff employed by Euphoric were considered to have inadequate qualifications for the responsibilities they are assigned with. Extensive audit evidence was collected and tested during the initial audits of Euphoric. There were numerous adjusting entries being identified by the auditors before the financial reports were finalised and published. Over the last few years, the staff have improved in their knowledge and use of the online accounting system considerably with improvements in the control system as well. This has resulted in no audit adjustments occurring in the financial reports for the last three audits of Euphoric. Consequently, Julia has assessed detection risk as high and the amount of evidence collected and tested during the audit has gradually decreased over the last three years. Indeed, during the last three years of the audit, Julia has been able to spend less time on the audit of Euphoric because of the relative ease of doing the audit and the co-operation of both management and employees of Euphoric with Julia’s audit team.
Julia had decided that the total time budget for the engagement should be kept to approximately the same as in recent years for the audit conducted for the year ended 30th June 2020. The senior in charge of the audit, Ryan White, is new on the job but highly competent. It is Ryan’s first audit engagement and he has never had any previous experience auditing a clothing manufacturer. During this reporting period, Euphoric experienced challenges in keeping up with their sales targets due to Covid-19 pandemic, which increased their inventory levels significantly. Due to the constraints imposed by the pandemic in undertaking audit engagements, it is anticipated that more time is needed to conduct the audit. However, based on Ryan’s competency and efficiency in conducting audits Julia hoped that no extra time is required to complete the audit for Euphoric.
The interim tests of the internal controls took longer than expected because of the use of several new assistants. There were changes in the accounting staff in Euphoric during the period as some staff were made redundant during this period. A number of errors were identified during the testing of the new online accounting system.
Ryan assigned the responsibility for auditing inventory to an assistant who is also auditing Euphoric for the first time but is competent and extremely fast in his work. Even though the total value of inventory has increased during the period, Ryan advised the assistant to reduce the amount of evidence collected and tested compared to prior years because he wanted to focus on the other aspects of the audit. The assistant also found a number of items of inventory overstated due to errors in pricing and obsolescence, but the combined effect of these errors was not material so he does not document the misstatements in the audit working papers.
During the testing of the inventory, many obsolete items were listed on the obsolete inventory report but none were material. Therefore, Ryan decided they did not require any further attention or testing as he had to come up with alternative audit procedures. Additional time has already been taken to verify inventory counts using technology such as live camera feeds. A note was made in the working papers to indicate obsolete inventory was found but a further note was recorded indicating that sufficient investigation had been undertaken to verify that obsolescence was not an issue in relation to the final balance for inventory.
The audit was completed on schedule and in less time than the previous year’s audit. There were only a few adjusting entries for the year and none of the adjustments were material. Julia was extremely pleased with the results and wrote a special letter to Ryan and the inventory assistants complimenting them on the quality of the audit during a tough time for the auditors.
Three months after the release of the financial reports, CMA associates received a telephone call from Euphoric and was informed that the company is in serious financial trouble. Subsequent investigation by the management of Euphoric had revealed that the inventory had been significantly overstated. The main reason for this overstatement was the inclusion of obsolete inventory in the final inventory balance. There were also errors in the pricing of inventory due to the reduction of prices to sustain online sales during times of lockdown. In addition, the inclusion of non-existent inventory in the final inventory further inflated the final balance of inventory. The new financial controller had intentionally overstated the inventory to compensate for the reduction in sales volume compared to the previous years. Errors were also found in the computer report of obsolete items prepared for Ryan by the IT manager who assisted in the audit of the inventory. Euphoric was placed into liquidation in early January 2021 with little likelihood of creditors being repaid any monies by Euphoric.
Discuss whether or not you believe the audit firm would be held liable if they were sued by the shareholders of Euphoric Pty Ltd.
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