Question

Allen & Watkins LLP audited the December 31, 20X5, financial statements of Giant Sports Mart. Fieldwork was completed during the month of February 20X6. The audit partner, John Watkins, CPA, reviewed and signed off on the audit working papers on February 28, 20X6. John then met with the Board of Directors on March 5, 20X6, to discuss the financial results and get them to approve the financial statements. Giant Sports Mart had an exceptional year — although the economic recession had hurt many local companies, Giant Sports Mart did not seem to be impacted. Allen & Watkins issued an unqualified opinion. The audited financial statements were distributed to investors on March 6, 20X6. It came to light in May 20X6 that a significant portion of sales recorded in 20X5 were between Giant Sports Mart and a company owned by the president’s wife. Revenues and profits were materially overstated. Allen & Watkins LLP did not identify that these fraudulent transactions were between related parties and, as a result, the financial statements did not adequately disclose the existence of the relationship. Investors viewed the positive results found in the audited financial statements as a good indicator of the company’s success at weathering the economic recession. Based on the financial results, investors provided additional capital for expansion. Required: a. What are Allen & Watkins’s responsibilities in identifying the fraudulent overstatement of revenues? (3 marks)

b. Provide two examples of pressures that contributed to the fraudulent overstatement of revenues. (2 marks)

c. What are Allen & Watkins’s responsibilities in identifying related parties? (2 marks)

d. What procedures would Allen & Watkins have performed regarding related-party transactions during the 20X5 audit? (4 marks)

e. What discussions should the audit engagement team at Allen & Watkins have had regarding fraudulent transactions involving related parties? (2 marks)

f. Evaluate whether Allen & Watkins should have identified the material misstatement. (3 marks)

g. What would have been included in the management representation letter specific to related parties? (2 marks)

h. What date would be used for the audit report date for the December 31, 20X5, year-end audit? (2 marks)

i. Assuming that Allen & Watkins found the overstatement of revenues during fieldwork and management refused to adjust the financial statements, which audit opinion should have been issued? (3 marks)

j. Discuss whether the discovery of fraudulent financial reporting is a subsequent event. (2 marks)

k. Discuss whether Allen & Watkins has a responsibility to perform additional procedures related to the discovery of the overstatement of revenues. (4 marks)

l. Assume that Giant Sports Mart’s management decides to revise the 20X5 financial statements in May 20X6. What actions should Allen & Watkins take? (6 marks)

Answer 1

a) Allen & Watkins should conduct the audit procedures that are necessary to identify and appropriately assess the risks of material misstatement include consideration of both external factors and company-specific factors. Thereby providing a basis for designing and implementing responses to the risks of material misstatement.

b) First pressure is due to President's wife who owned the company with whom significant portion of sales recorded in 20X5 were Giant Sports Mart. and second may be due to incentives offered to override the committed fraud.

c) Following are the Allen & Watkins’s responsibilities in identifying related parties:-

• Review prior year working papers for names of known related parties;
• Review minutes of the meetings of shareholders and the board of directors and other relevant statutory records such as the register of directors’ interests;
• Review the entity’s procedures for identification of related parties;Inquire as to the affiliation of directors and officers with other entities;

d) Audit procedures that Allen & Watkins would have performed in regard to related-party transactions include 1) testing how related-party transactions are identified and coded in the company’s enterprise resource planning (ERP) system, 2) interviewing accounting personnel responsible for reporting related-party transactions in the company’s financial statements, and 3) analyzing presentation of related-party transactions in financial statements.

e) Allen & Watkins should discuss that there is evidence that fraud may exist, that matter should be brought to the attention of an appropriate level of management. This is appropriate even if the matter might be considered inconsequential, such as a minor defalcation by an employee at a low level in the entity's organization. Fraud involving senior management and fraud (whether caused by senior management or other employees) that causes a material misstatement of the financial statements should be reported directly to the audit committee in a timely manner and prior to the issuance of the auditor's report.

f) Yes Allen & Watkins should have identified the material misstatement as the transaction occurs with a party that falls outside the definition of a related party (as defined by the accounting principles applicable to that company), with either party able to negotiate terms that may not be available for other, more clearly independent, parties on an arm's-length basis;

g) A management representation letter is a form letter written by a company's external auditors, which is signed by senior company management.

• Management is responsible for the proper presentation of the financial statements in accordance with the applicable accounting framework
• There are no unrecorded transactions
• All related party transactions have been disclosed.
• Management is responsible for systems designed to detect and prevent fraud.

h)  The auditor may use "dual dating," for example, "February 28, 2006, except for Note, as to which the date is May 1, 2006," or may date the report as of the later date. In the former instance, the responsibility for events occurring subsequent to the original report date is limited to the specific event referred to in the note (or otherwise disclosed).

i) Qualified Opinion should have been issued that states, except for the effects of the matter(s) ( related parties ) to which the qualification relates, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the entity in conformity with generally accepted accounting principles.

j) Yes discovery of fraudulent financial reporting is a subsequent event. Subsequent event means Events After the Reporting Period the accounting and disclosure requirements concerning transactions and events that occur between the reporting date and the (expected) date of approval of the financial statements.

k) Allen & Watkins will enter a much expanded arena of procedures to detect fraud. A process in which the auditor (1) gathers information needed to identify risks of material misstatement due to fraud, (2) assesses these risks after taking into account an evaluation of the entity’s programs and controls and (3) responds to the results.

l) Actions Allen & Watkins should take are as follows:-

• Increase the substantive testing of the valuation of numerous significant accounts at year end because of significantly deteriorating market conditions, and
• Obtain more persuasive audit evidence from substantive procedures due to the identification of pervasive weaknesses in the company's control environment.