Fraud at a manufacturing client and the auditor's response
You are the engagement partner on the audit of MetalWorks Ltd for the year ended 31 December 20X5. Materiality is R500,000. The team discovers that the financial director, Mr Naidoo, created a fictitious supplier, IronEdge, and approved 14 invoices totalling R2,300,000 during the year. Payments went to a bank account he controlled. The invoices were recorded as inventory purchases. Inventory at year-end includes R1,900,000 of goods that do not exist; the remaining R400,000 has been expensed. Mr Naidoo has resigned and repaid R800,000; the rest is unlikely to be recovered. The CEO and audit committee are shocked. The audit committee chair asks whether the audit can be completed and what should be reported. Management has not adjusted the financial statements. The company has a bank covenant requiring audited profit before tax above R5,000,000. Unadjusted profit is R5,600,000; the correction would reduce it to R3,700,000.
1. Evaluate the impact of the fraud on the audit opinion for the 20X5 financial statements. State the type of opinion and the basis.
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The misstatement is material. Inventory is overstated by R1,900,000 and profit is overstated by R1,900,000 (from R5,600,000 to R3,700,000). Materiality is R500,000, so the misstatement is 3.8 times materiality. Management has refused to adjust, so the financial statements are materially misstated.
Under ISA 705, the auditor must modify the opinion. A qualified opinion is appropriate if the effect is material but not pervasive. An adverse opinion is appropriate if the effect is material and pervasive. Pervasiveness is a matter of judgement. Here the fraud affects inventory, cost of sales, profit, and the bank covenant. The covenant breach may create going concern risk, and the fraud involves management override, which undermines the reliability of management representations and may affect other balances. On these facts, an adverse opinion is likely appropriate because the misstatement is material and pervasive to the financial statements as a whole. If the auditor concludes the effect is confined to inventory and profit and is not pervasive, a qualified opinion would be appropriate.
The audit can be completed if the auditor can obtain sufficient appropriate evidence. The auditor should not withdraw merely because a fraud exists, but should consider withdrawal if management obstructs the audit or refuses to take necessary action. The basis for the modified opinion must be described in the audit report, including the quantified effect.
2. Describe the auditor's responsibilities under ISA 240 and the communications required. Include the effect of the bank covenant.
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ISA 240 requires the auditor to identify and assess the risks of material misstatement due to fraud, design and perform procedures responsive to those risks, and remain alert throughout the audit. When fraud is identified, the auditor must communicate to management and, where appropriate, those charged with governance on a timely basis. Because the financial director is involved, the auditor should communicate directly with the audit committee and consider whether the CEO or others may be implicated. The auditor should also assess the reliability of written representations and other audit evidence.
The auditor should consider legal and regulatory reporting obligations. In many jurisdictions, including South Africa, the auditor may have a duty to report suspected fraud or theft to the appropriate authorities, and should take legal advice before doing so. The auditor should also consider the effect on the audit report, including key audit matters.
The bank covenant is critical. The correction reduces profit to R3,700,000, below the R5,000,000 covenant. This may mean the covenant is breached, which could trigger repayment demands and cast doubt on going concern. The auditor should obtain the loan agreement, assess management's plans, and seek evidence from the bank, such as a waiver. If a material uncertainty remains, the audit report should include a going concern paragraph. The breach may also require disclosure in the financial statements.
3. What should the auditor do if the CEO and audit committee refuse to allow communication with the bank or refuse to adjust the financial statements?
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If management refuses to adjust the financial statements, the auditor should issue the modified opinion described above. The auditor cannot issue an unmodified opinion when the financial statements are materially misstated.
If the CEO and audit committee refuse to allow communication with the bank, the auditor must consider whether this restricts the audit. The auditor needs evidence about the covenant and going concern. If the restriction prevents the auditor from obtaining sufficient appropriate evidence, the auditor should consider a disclaimer of opinion on the financial statements, or a qualified opinion if the possible effects are material but not pervasive. The auditor should also consider whether the refusal is itself evidence of a wider governance problem.
Under ISA 250, if management or those charged with governance do not take remedial action in response to identified fraud, the auditor should consider withdrawing from the engagement and reporting to the appropriate authorities. The auditor should document the matter, take legal advice, and communicate with those charged with governance before withdrawing. Withdrawal does not relieve the auditor of reporting obligations where law or regulation requires reporting.