Fraud Risk and Management Override
You are the audit manager on the audit of NuTech Manufacturing, a private company. During the audit, you discover that the controller, who has been with the company for 10 years, has been processing journal entries to increase revenue at quarter-end without supporting documentation. The entries are reversed at the beginning of the next quarter. The total effect is to increase annual revenue by $500,000, which is 5% of total revenue and exceeds the materiality threshold of $400,000. The controller is a close friend of the CEO and has significant influence over the accounting department. When questioned, the controller explained that the entries were necessary to "smooth earnings" for the bank and that the CEO was aware of them. The CEO confirmed that he knew about the entries but did not think they were material. The company is currently negotiating a loan renewal, and the bank requires a minimum revenue threshold. The controller has been uncooperative and has not provided the requested documentation.
1. Assess the fraud risk and determine the appropriate audit response.
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The situation indicates a high risk of material misstatement due to fraud, specifically fraudulent financial reporting. The controller's journal entries lack support, are reversed, and are intended to smooth earnings. The controller has significant influence and is a close friend of the CEO, increasing the risk of collusion. The CEO's knowledge and tolerance of the entries indicate a tone at the top that is conducive to fraud. The loan covenant creates pressure to meet revenue thresholds. The controller's uncooperativeness is a red flag. Under AU-C 240, the auditor should:
- Treat the risk as a significant risk and design procedures to address it.
- Perform journal entry testing, focusing on entries at quarter-end, unusual accounts, and entries without support.
- Interview the controller and CEO with professional skepticism, and document their responses.
- Consider whether the fraud is material. The $500,000 overstatement exceeds materiality, so it is material.
- Communicate the fraud to those charged with governance (e.g., the board of directors or audit committee).
- Consider withdrawing from the engagement if management is uncooperative and the fraud is not resolved.
- Evaluate the impact on the audit opinion. If management refuses to correct the misstatement, the auditor should issue a qualified or adverse opinion.
- Consider reporting to the bank if the auditor suspects fraud and has a duty to report under laws and regulations (e.g., if the bank relies on the financial statements).
2. What actions should the auditor take if management refuses to correct the misstatement and the controller remains uncooperative?
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If management refuses to correct the material misstatement and the controller remains uncooperative, the auditor should:
- Document the refusal and the uncooperative behavior.
- Communicate the matter to those charged with governance, preferably in writing, and request that they intervene.
- Consider the implications for the audit opinion. Since the misstatement is material, the auditor should issue a qualified opinion (if the effect is not pervasive) or an adverse opinion (if pervasive). The auditor should include a basis for the modified opinion in the auditor's report.
- Evaluate whether the auditor can continue to rely on management representations. If management is dishonest, the auditor may need to withdraw from the engagement. Under AU-C 220, the auditor should consider whether withdrawal is appropriate.
- If the auditor withdraws, communicate the reasons to those charged with governance and consider any regulatory reporting requirements.
- The auditor should also consider the impact on the loan covenant and whether the bank should be informed. In some jurisdictions, the auditor may have a duty to report fraud to regulators or the bank if the financial statements are used for loan purposes. However, confidentiality rules apply; the auditor should seek legal advice.