Week 2 Workshop

Negligence

Are the following examples of an auditor being negligent?

Case Yes/No

Auditor failed to note that a confirmation signature No. Not a hand-writing expert.
was a forgery.

Auditor allowed client to mail debtor confirmation Yes

letters to reduce audit fees.

Auditor failed to discover a material misstatement Yes

of sales and accounts receivable. Analytical
procedures showed an unusual increase near the
year-end, but no extra procedures were conducted.

Client’s provision for uncollectible loans was Yes

materially misstated. Many loans were not properly
secured, and some involved assets where no title
was held. The issue was not addressed in the
working papers.

Auditor used a sample of 50 for all substantive No. Only a sample of zero would be
procedures for tests of year-end balances. negligent.

Q2.17

Vera Crosden & Beryl Sykes, a medium-sized accounting firm, was engaged to audit Posh Supply
Company Ltd. Several staff were involved in the audit, all of whom had attended the firm’s in-house
training program in effective auditing methods. Throughout the audit, Crosden spent most of her
time in the field planning the audit, supervising the staff and reviewing their work.

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A significant part of the audit entailed verifying the physical count, cost and summarisation of
inventory. Inventory was highly significant to the financial statements, and Crosden knew that the
inventory was pledged as collateral to the National Commercial Bank for a large loan. In reviewing
Posh’s inventory count procedures, Crosden told the managing director that she believed the
method of counting inventory at different locations on different days was highly undesirable. The
managing director stated that it was impractical to count all inventory on the same day because of
personnel shortages and customer preference. After considerable discussion, Crosden agreed to
permit the practice if the managing director would sign a statement that no other method was
practical. The audit firm had one person at each site to audit the inventory count procedures and
actual count. There were 17 locations.

Eighteen months later, Crosden learned that the worst had happened. Management below the
managing director’s level had conspired to materially overstate inventory as a means of covering up
obsolete inventory and inventory losses due to mismanagement. The misstatement had occurred by
physically transporting inventory at night to other locations after it had been counted in a given
location. The accounting records were inadequate to uncover these illegal transfers.

Both Posh Supply Company Ltd and the National Commercial Bank sued Vera Crosden & Beryl Sykes.

Question Answer

What defence should Crosden & Sykes
use in the action by Posh?
Crosden & Sykes should use the defences of meeting
generally accepted auditing standards and
contributory negligence. The fraud perpetuated by
Posh Supply Company was a reasonably complex one
and difficult to uncover except by the procedures
suggested by Crosden.

In most circumstances it would not be necessary to

physically count all inventory at different locations on
the same day. Furthermore the president of the
company contributed to the failure of finding the
irregularity by refusing to follow Crosden's
suggestion. There is evidence of that through his
signed statement.

What defence should Crosden & Sykes
use in the action by the National
Commercial Bank?
There are two defences Crosden & Sykes should use
in an action by National Commercial Bank. First there
is a lack of privity of contract. Although this was a
known third party, it does not mean that there is any
duty to that party in this situation (see Esanda). This
defence is very likely to succeed if it is an audit under
the Corporations Act.

The second defence is that the auditor followed

appropriate auditing standards in the audit of
inventory, including the employment of due care.
Ordinarily it is unreasonable to expect an auditor to
find such an unusual problem in the course of an

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Question Answer

ordinary audit. The fact that the auditor did not

uncover the fraud does not mean the auditor has any
responsibility for it.

Is Crosden likely to be successful in her

The auditor is more likely to be successful in her
defence?
defence against the client using contributory
negligence defence if it is a non-statutory audit, but
the failure of the plaintiff to take appropriate
reasonable steps is a consideration.

The company has responsibility for instituting an

adequate internal control structure. The managing
director's statement that it was impractical to count
all inventory on the same day because of personnel
shortages and customer preferences puts
considerable burden on the company for its own loss.

It is also unlikely that National Commercial Bank will

be successful in an action. The court is likely to
conclude that Crosden followed due care in the
performance of her work. The fact that there was not
a count of all inventory on the same date is unlikely
to be sufficient for a successful action.

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Q2-22

Smith is the auditor for Juniper Manufacturing Corporation Ltd, a closely held company that has a
30 June balance date. Juniper arranged for a substantial bank loan that depends on the bank
receiving, by 30 September, audited financial statements that show a current ratio of at least 2 to 1.
The loan from the bank is identified in the engagement letter as the reason for the audit. On 25
September, just before the audit report was to be issued, Smith received an anonymous letter on
Juniper’s stationery indicating that a five-year lease by Juniper, as lessee, of a factory building
accounted for in the financial statements as an operating lease was, in fact, a capital (financial) lease.
The letter stated that there was a secret written agreement with the lessor modifying the lease and
creating a capital lease.

Smith confronted the managing director of Juniper, who admitted that a secret agreement existed
but said it was necessary to treat the lease as an operating lease in order to meet the current ratio
requirement of the pending loan and that no one would ever discover the secret agreement with the
lessor. The managing director said that, if Smith didn’t issue his report by 30 September, Juniper
would sue Smith for substantial damages that would result from not getting the loan. Under this
pressure, and because the working papers contained a copy of the five-year lease agreement that
supported the operating lease treatment, Smith issued his report with an unmodified opinion on 29
September.

In spite of the fact that the loan was received, Juniper went bankrupt within two years. The bank is
suing Smith to recover its losses on the loan, and the lessor is suing Smith to recover uncollected
rents.

Question Answer

Is Smith liable to the bank?
Yes. Smith was a party to the issuance of false
financial statements. The elements necessary to
establish an action for common law fraud are
present. There was a material misstatement of fact,
knowledge of falsity, intent that the plaintiff bank rely
on the false statement, actual reliance, and damage
to the bank as a result thereof. If the action is based
on fraud there is no requirement that the bank
establish privity of contract with the auditor.

Is Smith liable to the lessor?
No. The lessor was a party to the secret agreement.
As such, the lessor cannot claim reliance on the
financial statements and cannot recover uncollected
rents. Even if he or she was damaged indirectly, his or
her own fraudulent actions led to his or her loss, and
the equitable principle of "unclean hands" precludes
him or her from obtaining relief.

Is there potential for criminal action Yes. Smith had knowledge that the financial
against Smith? statements did not follow appropriate accounting
principles and willingly prepared an unmodified

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Question Answer

opinion. The financial statements were not in

accordance with accounting standards. That is a
criminal act because there was intent to deceive.

Audit Expectation Gap?

1 2 3 4 5 6 7
The auditor is The auditor is not responsible for
responsible for detecting all fraud
detecting all
fraud
The auditor is The auditor is not responsible for
responsible for the strength of internal controls
the strength of
internal controls
The auditor is The auditor is not responsible for
responsible for maintaining accounting records
maintaining
accounting
records
Audited financial Audited financial statements may
statements have have errors
no errors
The entity is The entity may not be well-
well-managed managed

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Ethics Case

In his capacity as an audit senior, Ben spent the last day of the financial year performing stocktake
observation procedures. His assignment that day included taking test measurements at a client’s
grain silo in a small town. Ben had assessed grain stocks on two previous audits and was the senior-
in-charge in this audit.

Ben’s observations of the quantity of grain in the silo fell ten percent below the client’s records. His
attention was drawn to the discrepancy in the two measurements of what was in the silo because, in
his judgment, such a gap was significant enough to be material. The resulting difference between
stock reported by the client and the audited amount was enough to cause a significant drop in net
profit. Ben documented his findings in the working papers and proposed an adjusting journal entry
for the difference.

On investigating the matter further, Ben determined that a discrepancy in the grain stocks had also
surfaced two months previously. The quantity of grain as reported by a government inspector at that
time was lower than in the client’s records. The difference in the stock valuation, however, was not
as great as that in Ben’s tests. Still no adjustment to the client’s records was made. This information
was also documented in the working papers.

Prior to discussing the discrepancy with the client, Ben told Fran, the engagement partner, about the
problem. Fran, who had substantial experience in the industry, advised Ben that this would be a
sensitive issue with the client. She also pointed out that grain stocks are notoriously difficult to
measure, with the potential for errors as large as ten percent. Fran promised to handle the matter
personally and therefore told Ben not to discuss the discrepancy with the client. The partner kept
the stock working papers.

After completion of the field work, Ben returned to the office to wrap up his work engagement. The
stock audit working papers were still not in the file. Upon Ben’s inquiry, Fran handed him a new set
of working papers. These working papers which had been dated as of the audit date, had been
signed off by Fran and substantiated the carrying amount. Ben’s subsequent questioning of the
partner revealed that Fran had personally performed additional work on the grain inventory after
the client’s year-end. Based on her own evidence gathering, the partner substituted her own
working papers for the documentation that Ben had prepared. No evidence remained of Ben’s
proposed adjustments. An unmodified opinion was subsequently issued.

What are the ethical issues? Integrity: honesty, fair dealing, It would appear that Fran has
being truthful and been less than honest and has
straightforward engaged in deceptive
behaviour.

Objectivity: avoiding bias, not It appears than Fran has not

being unduly influenced by behaved objectively. She has
others changed the working papers
prepared by Ben to alter her
client’s results.

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 Professional competence and Fran does not appear to have
due care: maintaining applied relevant technical skills
professional skill at the to the assessment of stock.
required level, acting with
diligence

Confidentiality Not relevant.

Professional behaviour: acting Fran has not conducted herself

in accordance with laws and in in a manner consistent with
a way that does not bring the good reputation of the
discredit on the profession profession.

What should Ben do? a) report this to one of

the other partners;
b) report this to the
client;
c) report this to CPA
Australia;
d) report this to ASIC.

Each option must be

considered on its merits
remembering that it will be
difficult for Ben to prove Fran
has behaved unethically as she
has destroyed the working
papers which could prove her
guilt.

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Ethical Dilemma
You are the external auditor of a hospital trust. The trust is hoping, and expecting, to receive
enhanced status in the near future, which will afford it more autonomy and provide opportunities to
pursue a number of exciting projects.

As the trust passed its financial year end, some unforeseen liabilities came to light. The trust’s
director of finance and chief executive had reported to the board of trustees and the regulator that
the trust would break even for the year. The director of finance then made a number of accounting
adjustments in order to ensure that the trust would meet its financial responsibilities, including the
requirement to break even each and every year.

The adjustments required changing the accounting policy in respect of stock, which had previously
been valued on a ‘first in, first out’ basis as specified by International Financial Reporting Standards.
In addition, certain salaries have been capitalised, and the trust has failed to account for its share of
liabilities under a partnership agreement with a local authority, which has yet to prepare the
memorandum account.

The adjustments come to your attention during your audit process, and you do not accept that they
are correct. As they are material, if the trust does not amend its accounts, you will have to qualify
your audit opinion on the year end accounts. When you discuss the issues with the director of
finance, he is emphatic that his view represents a legitimate interpretation of accounting policy. He
indicates that if you do not accept it, he will ensure that the trust appoints different auditors next
year. He also threatens to tell the local newspaper that your firm is determined to make the trust’s
financial position look worse than it is.

Key Fundamental Principles

Integrity: Would you be acting with integrity if you were influenced by the finance director’s threats,
and accepted his year end adjustments?
Objectivity: How can you maintain your professional objectivity in the face of the threats made by
the finance director? If your firm’s local reputation and continued engagement by the trust affect
your own position, how can you avoid self-interest influencing your ethical judgement?
Professional competence and due care: You must observe relevant auditing and accounting
standards, policies and procedures, so that you demonstrate your professional competence.
Confidentiality: Confidential information acquired as a result of professional and business
relationships should not be used to your personal advantage. (not relevant here)
Professional behaviour: You are required to perform your work in accordance with applicable law
and regulations, including relevant auditing standards. How should you act so as not to discredit
yourself, your firm or your profession?

Resolution

Steps Details

Identify relevant facts The director of finance has adjusted the year end financial
statements primarily in the interests of the trust and those working
within it. You are being intimidated by the director of finance, who
is asking you to compromise your objectivity. You must research the
relevant accounting requirements to ensure that your technical

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Steps Details

knowledge is accurate and up to date.

Identify affected parties Key affected parties are you, your firm, the director of finance, the chief
executive, the trust and the general public. Others employed within the
trust may also be affected.

Who should be Within the trust, you should involve the director of finance, the audit
involved? committee and, if necessary, the chief executive. However, you should
also involve senior members of your firm, as the firm will take
responsibility for the audit report and its reputation is being threatened
in terms of both competence and ethics.
Possible course of You should ensure that your technical knowledge is accurate and up to
action date by reviewing the relevant accounting standards, guidance and
manuals issued by the government health department and discussing
the technical issues with appropriate members of your firm and, if
necessary, your professional body. You will then be able to discuss the
issues further with the director of finance and the chief executive, if
appropriate, and refer them to the relevant accounting standards and
the ethical requirements of your professional body.

If this fails to persuade the directors to make the changes to the

financial statements that you consider necessary, you should formally
report the implications of this to the trust’s audit committee, setting
out the requirements of the accounting and auditing standards
concerned, and the necessary amendments to the financial statements.
You should explain the consequences for your report – a qualified audit
opinion – if the trust fails to amend the financial statements.

You should make senior members of your firm aware of the accounting
issues and the threats – to objectivity and to the firm’s reputation. They
should be involved in the drafting of the report to the audit committee,
and then kept informed of developments.

You and your firm should consider whether the intimidation from the
director of finance should be reported to the chief executive and the
chair of the audit committee. You should document, in detail, the steps
that you take in resolving your dilemma, in case your ethical judgement
is challenged in the future. In particular, if you conclude that the
financial statements continue to be materially misstated, your firm
must issue a qualified audit opinion, and it is essential that you
document fully the reasons for doing so.

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Threats to Compliance with Fundamental Principles

Situation Self- Self- Advocacy Familiarity Intimidation

interest review
Auditor has a direct X
financial interest in the
audit client
Audit firm acts as X
promoter for share issues
for audit client
Audit manager was until X
recently CFO of the audit
client
Member of audit team X
has an immediate family
member who is a director
or officer of audit client
Audit personnel authorise X
client transactions,
prepare source
documents and/or
determine journal entries
A former partner of the X
audit firm is a director or
officer of the audit client
Auditor has a material X
indirect financial interest
in the client
Engagement partner for X
audit client has been
same for 7 years
Non-assurance services X
are provided to the client,
whereby audit firm
determines which
recommendation should
be implemented
Senior members of audit X
team have received
significant gifts from audit
client directors
Audit client is threatening X
to replace its auditors
over a disagreement on
accounting standards
Audit fees for this client X
constitute 50% of total
audit fees
Audit firm performs X
valuations for an audit

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Situation Self- Self- Advocacy Familiarity Intimidation
interest review
client which will be
incorporated in client’s
financial report
Audit client is complaining X
about the level of audit
fees, and exerting
pressure to reduce extent
of audit work
Audit firm acts on behalf X
of audit client in litigation
Audit partner on X
engagement will be taking
up CFO position with
client in 6 months
Audit firm designs and X
implements IT systems for
the client
Audit fees include a bonus X
contingent on granting of
a loan to client

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Provision of Non assurance services to Assurance Clients

Service Violation of Comments

Independence
Requirements
?

Authorising, executing or Yes Self-interest or self-review threat

consummating a transaction,
or exercising authority on
behalf of the client, or having
the authority to do so

Determining which Yes Self-interest or self-review threat

recommendation of the Firm
should be implemented

Reporting in a management Yes Self-interest or self-review threat

role to those charged with
governance

Preparing accounting records Yes Self-review threat

or financial statements for
client May be permitted for non-listed clients if those
staff are not involved in audit, client originates
source documents, no managerial decision
making, obtaining client approval for
adjustments. May be permitted for short-term,
emergency situations with similar provisions.

Performing material Yes Self-review threat

valuations for clients to be Permitted if valuation only for tax returns or tax
incorporated in financial planning, subject to external review by ATO.
statements

Provision of tax services to No

audit clients

Provision of internal audit No Potential self-review threat

services to clients
Permitted provided:
Client responsible for internal audit activities
and for internal controls
A designated senior member of management is
responsible for internal audit activities
Audit committee approves scope, risk and
frequency of internal audit work
Client evaluates adequacy of internal audit

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Service Violation of Comments
Independence
Requirements
?

work and acts on reports from the Firm

Findings are reported to the audit committee
Internal audit staff are not involved in the audit

Provision of IT systems No Potential self-review threat

services to audit clients
Permitted provided:
Client responsible for internal controls
A designated senior member of management is
responsible for management decisions
concerning design and implementation
Client evaluates adequacy and results of design
and implementation of system
Client is responsible for operation of the
system and the data used/generated
Staff are not involved in the audit

Temporary staff assignments No Potential self-review threat

to client
Permitted provided:
No involvement in management decisions
No approval of agreements or documents
No authority to commit the client
Client responsible for directing and supervising
personnel
Staff are not involved in the audit

Provision of litigation services No Could involve estimation of legal damages

which may become contingent liabilities in the
financial report. This would create a self-review
threat.

Permitted provided:
No involvement in management decisions
Staff are not involved in the audit
Independent experts are consulted

Provision of legal services Yes Where firm acts in an advocacy role in litigation
where amounts are material, advocacy and
self-review threats are created.

Recruitment of senior No If limited to reviewing applications and

management providing advice on suitability to the client’s

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Service Violation of Comments
Independence
Requirements
?

selection panel.

Financial services, e.g. Yes Advocacy and self-review threats

promoting or dealing in client
shares

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