AAA - Revision Material

Dec 2011 Q4 - Cedar

QUESTION

You are an audit manager in Cedar & Co, responsible for the audit of Chestnut Co, a large company which
provides information technology services to business customers. The finance director of Chestnut Co, Jack
Privet, contacted you this morning, saying:

‘I was alerted yesterday to a fraud being conducted by members of our sales team. It appears that several sales
representatives have been claiming reimbursement for fictitious travel and client entertaining expenses and
inflating actual expenses incurred. Specifically, it has been alleged that the sales representatives have claimed
on expenses for items such as gifts for clients and office supplies which were never actually purchased, claimed
for business-class airline tickets but in reality had purchased economy tickets, claimed for non-existent business
mileage and used the company credit card to purchase items for personal use.

I am very worried about the scale of this fraud, as travel and client entertainment is one of our biggest expenses.
All of the alleged fraudsters have been suspended pending an investigation, which I would like your firm to
conduct. We will prosecute these employees to attempt to recoup our losses if evidence shows that a fraud has
indeed occurred, so your firm would need to provide an expert witness in the event of a court case. Can we meet
tomorrow to discuss this potential assignment?’

Chestnut Co has a small internal audit department and in previous years the evidence obtained by Cedar & Co
as part of the external audit has indicated that the control environment of the company is generally good. The
audit opinion on the financial statements for the year ended 31 March 2011 was unmodified.

Required:

(a) Assess the ethical and professional issues raised by the request for your firm to investigate the
alleged fraudulent activity. (6 marks)

(b) Explain the matters that should be discussed in the meeting with Jack Privet in respect of planning
the investigation into the alleged fraudulent activity. (6 marks)

(c) Evaluate the arguments for and against the prohibition of auditors providing non-audit services to
audit clients. (6 marks)
(18 marks)
 AAA - Revision Material
Dec 2011 Q4 - Cedar

SOLUTION

(a)

1. Non-audit services. The investigation of the fraud would constitute the provision of non-audit services.
Whilst we are able to provide non audit services, we should ensure that they do not compromise our primary
function as an auditor. The audit committee would be involved in making the decision as to whether it is
appropriate for our firm to investigate the fraud;
2. Self-review threat. The scenario tells us that the amounts involved are potentially large as this is one of the
client’s biggest expenses and that the client hopes to reclaim amounts lost from the fraud. This could lead to
material figures in the financial statements. There is a self-review threat in that the auditor would be
providing an opinion on a figure that they themselves have generated;
3. Lack of controls. It appears also that the fraud may have arisen from a lack of control within the business.
As part of the fraud review, we may well recommend improved controls. Once again a self-review threat
exists by expressing an opinion on controls that we have designed;
4. Advocacy. By representing our client as an expert witness, we will be advocating our client’s position which
directly contravenes our independence as auditor;
5. Independence. It may be possible to manage the independence risk by using separate teams for the audit
and the fraud investigation;
6. Perception. On the other hand, there is still the risk of perception. Even if we use separate teams, it may be
perceived by outsiders that we have not been independent in either the audit or the fraud investigation.

(b)

The first thing to discuss would be who would actually be using the report we produce into the fraud. For
example, there is a greater risk if the report is being used by the insurance company to assess the claim as any
inaccuracy could lead to the insurance firm taking legal action against us.

The next thing would be to establish the scale of the fraud. We are told that the alleged fraudsters have been
suspended but we don’t know how many this is and the number and amount of transactions involved. These
pieces of information are vital to establish the amount of work we would have to perform on this engagement
and therefore the fee would have to charge.
We should also ascertain how the fraud was discovered. This would help us to understand for example the
quality of monitoring controls. It would also help to determine an approach to the work by knowing if we would
need to interview a whistleblower.
Given the control environment is generally good, we would need to understand why the controls failed to prevent
a fraud from occurring even if they detected that it had occurred. A requirement of the engagement may well be
to make control recommendations and we would need to understand weaknesses in order to focus our testing of
controls on the engagement.

We should discuss the scope of the work we would perform. For example, it may consist of analytical review,
review of relevant transactions, testing of controls and interviewing relevant members of staff. As this is a
bespoke engagement the type of work we perform is not predetermined and client expectations must be
managed in terms of what we will and won’t do.

We must also determine whether or not the police have been informed. If not, we may have to inform them
raising issues of breaching confidentiality or we may have to encourage the client to report the issue if this is
considered necessary. The scope of our audit could be affected if there is a concurrent police investigation.

(c)

Arguments for prohibiting non audit services could include:

- Increased independency
- Less fee dependency
- Elimination of management threat

Arguments against the prohibition could include:

- Not being able to utilise the auditor’s knowledge of the client

- Missed commercial opportunity
- Reduction in quality of non-audit services if they have to be performed by another firm who does not
have the inherent knowledge.