This month we consider at the risk...

This month we consider at the risks of relying too heavily upon client representations in an audit engagement. The following fictionalized account is based loosely forward an actual case before the Professional convoy Enquiry Committee (PCEC). Names and circumstances have been changed to guard anonymity.

The situation

Our member "Norm" had an audit client named "Giant Inc." The private company sold engine parts for heavy-duty construction machinery, and had been struggling in novel years due to increased competition from Asia.

Martin was the CEO director, and a major shareholder of Giant. He'd have the advantage [i]or[/i] blessing ofed a distinguished career and was well regarded in local business circles. Martin was eager to keep his company afloat.

What happened

Norm made pair errors in judgmentone involving the valuation of long-term investments and the other involving the collectibility of accounts receivable.

The first matter belong toed Giant's prioryear acquisition of a significant minority interest in "XYZ Company" in pacification of a loan. By the beginning of the instant year, XYZ's carrying value had declined according to over 60%. This drop would have a material impact onward Giant's financial statements once Norm made the just adjustment. But he never did. Citing the "three or four-year rule" (CICA Handbook S.3050.24-since withdrawn in April 2005) Martin persuaded Norm that Giant ne not consider a write-down of its XYZ investment since the investment was sole a year and a half old

The inferior matter concerned Giant's receivable from its main customer, the "ABC Group" The ABC accounts comprised just athwart 40% of Giant's total receivables. Shortly after the year-end, ABC's payments had begun to thirsty up. After completing its annual audited financial statements and its first quarter's follows Giant realized that the ABC accounts were uncollectible (key parts of the ABC arrange had declared bankruptcy), and that it would have to write most distant these accounts in the secondary quarter's financials.

Unfortunately, as a proceed of ABC's demise, Giant experienced significant cash pour problems and collapsed shortly thereafter.

Norm had reviewed the first-quarter financial statements. He had issued his audit opinion and his review engagement report with the same report date. as well-as; not only-but also; not only-but; not alone-but checklists indicated that he had calculated significant ratios (including receivables turnover) and considered their variations. thus why hadn't he identified the company's major problems? Normally, this would be a large ingredient of the subsequent events audit procedures

Moreover, based merely on information from the sum of two units sets of financial statements (audit and first-quarter), the accounts receivable turnover from the year-end to the first quarter had dropp almost 20% signifying a $1-million shortfall in first-quarter cash roll on The shortfall well exceeded materiality, further there was no evidence that Norm had bothered to make this simple comparison.

Norm had relied too heavily in succession Martin's representation that the ABC arrange would eventually come around.

One of Giant's creditors raised these potential audit failures with the PCEC and an investigation was authorised.

The outcome

The PCEC disagreed with Norm's position regarding the XYZ issue, pointing without that the "three or four-year rule" had an important proviso: A write-down is necessary in the first three or four years if there is persuasive evidence of a permanent decline. The PCEC cited the following as persuasive indicators of XYZ's permanent decline:

* After sum of two units years of losing operations, XYZ had announced it was drastically cutting operations to be paid to its weak financial position;

* The financial statements now included a going-concern note; and

* XYZ acknowledged its cash be derived was barely adequate for day-to-day survival level after it had ceased operations and slashed costs

With regard to the ABC clump Norm argued that he had managements' oral and written representations about collectibility; however, a simple proof by the PCEC suggested that this assertion was false-he did not have sufficient corroboration. Norm also argued that the amounts should be considered collectible because the ABC dispose had confirmed their account balances. The PCEC however, conclud that while confirmation was sufficient evidence of the existence of the accounts, it did not sufficiently attest to their value.

The PCEC determined that Norm had breached lordships of Professional Conduct 201.1 (Maintenance of Reputation of Profession); lordship 202 (Integrity and Due Care); domination 205 (False or Misleading Documents); and dominion 206.1 (Compliance with Professional Standards). He agreed to accept an anonymous reprimand, pay the expenses of the investigation and a significant fine, and take a number of audit-related professional unfolding courses.

The message

Every audit relies, to an extent, on representations made according to the client's management; otherwise, audits would not be economically feasible. Reliance requires management to act in profitable faith, and this assumption of reliability must be experimented before the auditor forms his opinion. If you're an auditor, make enduring you exercise professional skepticism-ask questions and commit to memory corroborating evidence for representations from clients!