- 30 Marks
AA – L2 – Q20 – Risk Assessment and Internal Control
Question
You are the partner in charge of a four partner firm of Chartered Accountants. Your firm has been invited to tender for the audit of ConnectSphere Mobile for the year ended 31 December 20X8.
ConnectSphere Mobile was established two years ago, and provides a mobile phone service for individuals and business. The system being established by the company comprises:
- Small portable mobile phones, which allow subscribers (users) to contact or be contacted by any other telephone.
- The mobile phones can be used within range of a local relay station, which receives calls from and sends calls to the mobile phone.
- The local relay stations are linked to a central computer which connects the calls to other users. Frequently, this is through a computer’s telephone network.
Currently, the local relay stations cover one large city with a population of about 1,000,000. Within the next year the system will cover all large cities in Zamora with a population of over 250,000. By 20X7, the system will cover all trunk roads and cities with a population of over 100,000. Extending the coverage of the system will involve considerable capital expenditure on new relay stations and require additional borrowings.
The cost of the relay stations and central computer are capitalised and are written off over six years.
The mobile phones are manufactured by other companies and sold through retailers. ConnectSphere Mobile does not sell the phones, but it pays ₵2,000 to the retailer for each phone sold and subscription by the customer to ConnectSphere Mobile. This payment is capitalised in the financial statements of ConnectSphere Mobile and written off over four years.
Subscribers are invoiced monthly with a fixed line rental and a variable call charge. Other operators are charged for the time spent by their customers contacting ConnectSphere Mobile’s subscribers (customers). These charges are logged and calculated by the company’s main computer.
All the shares are owned by three wealthy individuals who are non-executive directors. They will receive a fixed salary. They do not plan to make any further investment in the company.
Establishing the network of relay stations and subscribers will result in the company making losses for at least three years. Current borrowings are about 20% of the shareholders’ funds. Because of the substantial capital expenditure and trading losses, it is expected the company will be highly geared by 20X7.
As the company will not be profitable, the non-executive directors have decided that executive directors should receive a basic salary and a bonus based on the number of subscribers to the system.
The owners plan to float the company on the Zamora Stock Exchange in 20X7. The flotation will involve:
- issuing new shares to the general public to provide funds for the company; and
- the three non-executive directors selling some of their shares.
You are aware that ConnectSphere Mobile has a number of very large competitors, each of which has a large number of users and comprehensive coverage (i.e. over 90% of the population are within range of a relay station).
Required:
(a) Consider the risks associated with the audit of ConnectSphere Mobile.
(b) Describe the ethical matters you should consider in deciding whether your audit firm should accept the audit. This should include considering whether your firm has the technical and logistical ability to carry out the audit.
(c) Conclude on whether you would advise your firm to accept or decline the audit, giving your principal reasons for coming to this decision.
Answer
(a) Risks associated with the audit
There appear to be considerable risks associated with undertaking the audit. In particular, ConnectSphere Mobile appears to have a very high inherent risk. Looking at the matters in (1) to (11) in the question:
(i) The low coverage of the country will be a disincentive to new subscribers. Initially, subscribers will only be those who operate in the town with a population of 1,000,000. The service will not be available when the subscribers are outside that town. I will have to consider whether the company has the financial resources to develop to towns with a population of 250,000 in the next year and its planned developments to 20X7. The company’s plans for extending the network do not appear to be realistic, as many mobile phones are used on trunk roads and other roads. Trunk roads will not be covered until 20X7, and coverage of other roads is not mentioned. These plans are likely to be a serious disincentive to new subscribers joining the system when competitors cover most of the country.
(ii) The central computer is pivotal to the organisation, as it relays the calls and calculates the bills for subscribers. Will this computer and its software be reliable? The consequences of a breakdown of the computer will be very serious. Ideally, there should be more than one computer running the system and the system should be able to monitor if one of the computers fails.
(iii) What is the capacity of the main computer? With the planned expansion, it is probable that it will run out of capacity in the near future. Is it possible to expand the capacity of the computer? Has the cost of upgrading the computer been included in future forecasts. Will the current software be able to process a large increase in subscribers, or will it have to be rewritten (at substantial cost)?
(iv) Is it reasonable to amortise the cost of the relay stations and main computer over six years? Six years may be realistic for the ‘buildings’ part of capital expenditure, but it may be too long for electronic components including the main computer and transmitters.
(v) Is the discount paid to retailers for the purchase of the phones recoverable? The question says it is capitalised and amortised over four years. Do subscribers remain connected to a single operator for as long as four years (if many change in less than four years, this amortisation period is too long), and are subscribers likely to change their phones within four years (to update to a more advanced model)?
(vi) Paying the executive directors a bonus based on the number of subscribers of the system could encourage them to obtain as many subscribers as possible (by offering discounted prices) rather than charging a realistic price which will ensure the long-term future of the company. However, the executive directors should be concerned with the long term future of the company, as this will ensure that continue to be paid (rather than have to find a new job when the company fails).
(vii) In view of the planned high borrowings and future trading losses, there is a very serious risk the company may not be a going concern. This increases the risk of my firm being sued for negligence. Also, ConnectSphere Mobile will put severe pressure on me to give an unmodified auditor’s report. This pressure will increase because my audit firm is small and ConnectSphere Mobile is a relatively large and rapidly growing company.
(viii) As an alternative to the company not being a going concern, there is the risk that other investors may purchase more shares in the company (to provide additional equity finance) or purchase the company outright from the existing directors (or the administrator/liquidator). If this occurs, recent financial statements will be subject to close scrutiny. The standard of audit work will have to be high, and the problems mentioned above (e.g. complex computer systems and depreciation rates which may be inaccurate) could lead to undetected material misstatements in the financial statements. Thus, there is a high risk that legal action for negligence could be taken against my audit firm following a take-over or purchase of shares.
(ix) Flotation of the company on the Zamora Stock Exchange is a further risk. Immediately prior to the flotation, the audit work carried out by my firm will be subject to close scrutiny. So, I will have to be very careful in my work which would increase the cost of the audit and reduce its profitability. Also, when the company becomes quoted on the Zamora Stock Exchange, it is probable I will be replaced as auditor, as my firm will be ‘too small’.
(x) This is a high technology industry. The technology or customer requirements may change, which could make parts of the equipment obsolete. Alternatively, it could be expensive to modify the equipment or software to meet the demands of subscribers. Is the company currently providing a similar range of facilities to other mobile phone companies? If its service is not as comprehensive as other mobile phone companies, it may not be successful in breaking into the market.
(xi) This appears to be a very competitive industry. Are the competitors profitable, or are they making losses to keep prices low to prevent other companies entering the market? Establishing ConnectSphere Mobile as a major company in the market will probably require large expenditure on advertising and offering new subscribers a service at a lower price than competitors. Both of these factors will tend to make ConnectSphere Mobile unprofitable (as note (1) in the question suggests).
(xii) I will have to consider the reputation of the three major shareholders and the executive directors. If they have been directors of companies which have failed, or been involved in financial or other wrongdoings, this will increase the inherent risk. The reputation of the financial director and the quality of the accounting records are other factors which will have to be considered.
There appear to be considerable risks associated with undertaking the audit. In particular, ConnectSphere Mobile appears to have a very high inherent risk. Looking at the matters in (1) to (11) in the question:
(i) The low coverage of the country will be a disincentive to new subscribers. Initially, subscribers will only be those who operate in the town with a population of 1,000,000. The service will not be available when the subscribers are outside that town. I will have to consider whether the company has the financial resources to develop to towns with a population of 250,000 in the next year and its planned developments to 20X7. The company’s plans for extending the network do not appear to be realistic, as many mobile phones are used on trunk roads and other roads. Trunk roads will not be covered until 20X7, and coverage of other roads is not mentioned. These plans are likely to be a serious disincentive to new subscribers joining the system when competitors cover most of the country.
(ii) The central computer is pivotal to the organisation, as it relays the calls and calculates the bills for subscribers. Will this computer and its software be reliable? The consequences of a breakdown of the computer will be very serious. Ideally, there should be more than one computer running the system and the system should be able to monitor if one of the computers fails.
(iii) What is the capacity of the main computer? With the planned expansion, it is probable that it will run out of capacity in the near future. Is it possible to expand the capacity of the computer? Has the cost of upgrading the computer been included in future forecasts. Will the current software be able to process a large increase in subscribers, or will it have to be rewritten (at substantial cost)?
(iv) Is it reasonable to amortise the cost of the relay stations and main computer over six years? Six years may be realistic for the ‘buildings’ part of capital expenditure, but it may be too long for electronic components including the main computer and transmitters.
(v) Is the discount paid to retailers for the purchase of the phones recoverable? The question says it is capitalised and amortised over four years. Do subscribers remain connected to a single operator for as long as four years (if many change in less than four years, this amortisation period is too long), and are subscribers likely to change their phones within four years (to update to a more advanced model)?
(vi) Paying the executive directors a bonus based on the number of subscribers of the system could encourage them to obtain as many subscribers as possible (by offering discounted prices) rather than charging a realistic price which will ensure the long-term future of the company. However, the executive directors should be concerned with the long term future of the company, as this will ensure that continue to be paid (rather than have to find a new job when the company fails).
(vii) In view of the planned high borrowings and future trading losses, there is a very serious risk the company may not be a going concern. This increases the risk of my firm being sued for negligence. Also, ConnectSphere Mobile will put severe pressure on me to give an unmodified auditor’s report. This pressure will increase because my audit firm is small and ConnectSphere Mobile is a relatively large and rapidly growing company.
(viii) As an alternative to the company not being a going concern, there is the risk that other investors may purchase more shares in the company (to provide additional equity finance) or purchase the company outright from the existing directors (or the administrator/liquidator). If this occurs, recent financial statements will be subject to close scrutiny. The standard of audit work will have to be high, and the problems mentioned above (e.g. complex computer systems and depreciation rates which may be inaccurate) could lead to undetected material misstatements in the financial statements. Thus, there is a high risk that legal action for negligence could be taken against my audit firm following a take-over or purchase of shares.
(ix) Flotation of the company on the Zamora Stock Exchange is a further risk. Immediately prior to the flotation, the audit work carried out by my firm will be subject to close scrutiny. So, I will have to be very careful in my work which would increase the cost of the audit and reduce its profitability. Also, when the company becomes quoted on the Zamora Stock Exchange, it is probable I will be replaced as auditor, as my firm will be ‘too small’.
(x) This is a high technology industry. The technology or customer requirements may change, which could make parts of the equipment obsolete. Alternatively, it could be expensive to modify the equipment or software to meet the demands of subscribers. Is the company currently providing a similar range of facilities to other mobile phone companies? If its service is not as comprehensive as other mobile phone companies, it may not be successful in breaking into the market.
(xi) This appears to be a very competitive industry. Are the competitors profitable, or are they making losses to keep prices low to prevent other companies entering the market? Establishing ConnectSphere Mobile as a major company in the market will probably require large expenditure on advertising and offering new subscribers a service at a lower price than competitors. Both of these factors will tend to make ConnectSphere Mobile unprofitable (as note (1) in the question suggests).
(xii) I will have to consider the reputation of the three major shareholders and the executive directors. If they have been directors of companies which have failed, or been involved in financial or other wrongdoings, this will increase the inherent risk. The reputation of the financial director and the quality of the accounting records are other factors which will have to be considered.
(b) Professional and ethical matters
(i) The size of the audit fee. IESBA’s International Code of Ethics for Professional Accountants requires extra safeguards where the fees for audit and other recurring work paid by one client exceed 15% of the gross practice income for listed and other public interest companies. If the planned audit fee is over 15% of the current practice income it could be argued the firm should not accept the audit. However, the rate of expansion of ConnectSphere Mobile will probably be much greater than the increase in income of the audit practice, so the 15% rule may become a problem in the next few years.
In practice, it is undesirable for the audit fee to approach 15% of the practice income, as reliance on such a large audit fee could be seen to affect my firm’s independence.
(ii) My audit firm may be able to audit ConnectSphere Mobile at its current size. However, when the system covers all towns with a population of over 250,000, on occasions audit work will probably have to cover all areas of the country, and it is most unlikely that my audit firm will have sufficient staff to perform this work.
(iii) Whether my firm is technically competent to perform the audit, and whether the size of the firm being audited is too large for the experience of my practice. Mobile telephone companies are very complex and have specialised accounting procedures, both in terms of the accounting system and the ways matters are treated in the financial statements (e.g. the advance payment of ₵2,000 given towards the purchase of phones purchased by new subscribers). My firm will probably not have experience in auditing the computerised accounting system which controls calls and generates bills for subscribers. This requires specialised computer auditing techniques. Also, my firm will be unfamiliar with many of the accounting treatments for non-current assets. This lack of experience will probably mean that the audit will be too high a risk for my audit firm (i.e. my firm’s inexperience will mean that a satisfactory audit cannot be carried out, so there will be a high risk of material misstatements in the financial statements, which increases the risk of litigation being brought against me).
(iv) I will have to consider whether I have adequate professional indemnity insurance (PII) cover. This is unlikely in view of the size of ConnectSphere Mobile, so there will be an increased cost of obtaining more PII cover. The insurance company may refuse to increase my firms PII cover, because they perceive this is a high risk audit which is exacerbated by the small size of my firm.
Other matters I will have to consider will include ensuring:
(i) Partners of my audit firm have no family or personal relationships with the directors of ConnectSphere Mobile. These relationships also apply to any staff involved in the audit. Ideally, no member of my firm should have relationships with the directors of ConnectSphere Mobile.
(ii) No-one in the audit firm should own shares or any investments in ConnectSphere Mobile.
(iii) No-one in the audit firm should be a beneficiary or trustee of a trust which holds shares in ConnectSphere Mobile. IESBA’s International Code of Ethics for Professional Accountants does allow employees of the audit firm to be a beneficiary of shares in an audit client, but that employee must not be employed on the audit of that client.
(iv) Employees and partners of the audit firm must not vote on the appointment, removal or remuneration of a firm which is an audit client.
(v) The audit firm should not make a loan to or accept a loan from an audit client (exceptions to this rule apply where the audit client is a bank or other financial institution which does not appear to apply in this case).
The audit fee has been considered earlier in this section. However, the audit fee should be sufficient for my firm to perform the audit to a satisfactory standard. Thus, it would not be acceptable to offer a very low fee (often called ‘lowballing’) in order to obtain the audit, as this would impose pressure on the time allowed to carry out the audit.
This could lead to inadequate audit work being carried out which would increase the risk that material misstatements in the financial statements may not be detected.
(i) The size of the audit fee. IESBA’s International Code of Ethics for Professional Accountants requires extra safeguards where the fees for audit and other recurring work paid by one client exceed 15% of the gross practice income for listed and other public interest companies. If the planned audit fee is over 15% of the current practice income it could be argued the firm should not accept the audit. However, the rate of expansion of ConnectSphere Mobile will probably be much greater than the increase in income of the audit practice, so the 15% rule may become a problem in the next few years.
In practice, it is undesirable for the audit fee to approach 15% of the practice income, as reliance on such a large audit fee could be seen to affect my firm’s independence.
(ii) My audit firm may be able to audit ConnectSphere Mobile at its current size. However, when the system covers all towns with a population of over 250,000, on occasions audit work will probably have to cover all areas of the country, and it is most unlikely that my audit firm will have sufficient staff to perform this work.
(iii) Whether my firm is technically competent to perform the audit, and whether the size of the firm being audited is too large for the experience of my practice. Mobile telephone companies are very complex and have specialised accounting procedures, both in terms of the accounting system and the ways matters are treated in the financial statements (e.g. the advance payment of ₵2,000 given towards the purchase of phones purchased by new subscribers). My firm will probably not have experience in auditing the computerised accounting system which controls calls and generates bills for subscribers. This requires specialised computer auditing techniques. Also, my firm will be unfamiliar with many of the accounting treatments for non-current assets. This lack of experience will probably mean that the audit will be too high a risk for my audit firm (i.e. my firm’s inexperience will mean that a satisfactory audit cannot be carried out, so there will be a high risk of material misstatements in the financial statements, which increases the risk of litigation being brought against me).
(iv) I will have to consider whether I have adequate professional indemnity insurance (PII) cover. This is unlikely in view of the size of ConnectSphere Mobile, so there will be an increased cost of obtaining more PII cover. The insurance company may refuse to increase my firms PII cover, because they perceive this is a high risk audit which is exacerbated by the small size of my firm.
Other matters I will have to consider will include ensuring:
(i) Partners of my audit firm have no family or personal relationships with the directors of ConnectSphere Mobile. These relationships also apply to any staff involved in the audit. Ideally, no member of my firm should have relationships with the directors of ConnectSphere Mobile.
(ii) No-one in the audit firm should own shares or any investments in ConnectSphere Mobile.
(iii) No-one in the audit firm should be a beneficiary or trustee of a trust which holds shares in ConnectSphere Mobile. IESBA’s International Code of Ethics for Professional Accountants does allow employees of the audit firm to be a beneficiary of shares in an audit client, but that employee must not be employed on the audit of that client.
(iv) Employees and partners of the audit firm must not vote on the appointment, removal or remuneration of a firm which is an audit client.
(v) The audit firm should not make a loan to or accept a loan from an audit client (exceptions to this rule apply where the audit client is a bank or other financial institution which does not appear to apply in this case).
The audit fee has been considered earlier in this section. However, the audit fee should be sufficient for my firm to perform the audit to a satisfactory standard. Thus, it would not be acceptable to offer a very low fee (often called ‘lowballing’) in order to obtain the audit, as this would impose pressure on the time allowed to carry out the audit.
This could lead to inadequate audit work being carried out which would increase the risk that material misstatements in the financial statements may not be detected.
Other matters covered by the IESBA’s International Code of Ethics for Professional Accountants include the following:
(i) When my audit firm is asked to accept the audit appointment, I must ask the client’s permission to communicate with the existing auditor. If this permission is refused, my audit firm should carefully consider whether to accept appointment as auditor.
(ii) My audit firm should write to the existing auditor requesting all the information which ought to be made available to decide whether or not to accept the audit appointment.
(iii) My audit firm should consider the reply from the existing auditor. If adverse comments are made by the existing auditor, I will have to consider whether to accept the audit appointment.
(iv) If the existing auditor does not reply to my firm’s letter, a further letter should be sent. My audit firm should then assess all the available information and take a decision about whether or not to accept the audit work.
(v) Before finally accepting the audit, my firm should prepare a letter of engagement and ask the directors of ConnectSphere Mobile to sign it.
(i) When my audit firm is asked to accept the audit appointment, I must ask the client’s permission to communicate with the existing auditor. If this permission is refused, my audit firm should carefully consider whether to accept appointment as auditor.
(ii) My audit firm should write to the existing auditor requesting all the information which ought to be made available to decide whether or not to accept the audit appointment.
(iii) My audit firm should consider the reply from the existing auditor. If adverse comments are made by the existing auditor, I will have to consider whether to accept the audit appointment.
(iv) If the existing auditor does not reply to my firm’s letter, a further letter should be sent. My audit firm should then assess all the available information and take a decision about whether or not to accept the audit work.
(v) Before finally accepting the audit, my firm should prepare a letter of engagement and ask the directors of ConnectSphere Mobile to sign it.
(c) Conclusion
From the discussion above, my firm should not offer itself nor accept the appointment as auditor of ConnectSphere Mobile. The main reasons for this decision are:
(i) ConnectSphere Mobile appears to be too large a company for my firm to audit, and it is likely to grow faster than my audit firm. The audit fee will probably exceed IFAC’s limit of 15% of the practice income, and if this is not exceeded now, it is likely to be exceeded in the next few years.
(ii) ConnectSphere Mobile is a specialised company with complex computer systems. It is probable my firm will not have the skills to perform this work.
(iii) The accounting conventions for ConnectSphere Mobile will probably be unfamiliar to my firm, particularly the treatment of the ₵2,000 given to new subscribers to purchase the phones and the lives of the non-current assets. I will probably not have the skills to consider whether these treatments are satisfactory, and this could lead to me not detecting material misstatements in the financial statements.
(iv) ConnectSphere Mobile appears to be undercapitalised. Currently, 20% but this will increase substantially with expansion of the network, losses in early years of trading. Thus, there is a serious risk that ConnectSphere Mobile will fail or be taken over, which could result in my firm being sued for negligence.
(v) The large size of ConnectSphere Mobile and the small size of my audit firm could compromise the independence of my firm. Third parties (including shareholders) will perceive my firm is not independent (on the relative size criteria), and ConnectSphere Mobile could bring severe pressure on my firm which would be hard to resist (i.e. they will ask for an unmodified auditor’s report to be given when I should either give a modified opinion or a material uncertainty relating to going concern paragraph).
(vi) The potential listing of the company on a Zamora Stock Exchange increases the audit risk, as there will be greater scrutiny of the financial statements prior to listing, which could highlight problems in the financial statements.
(vii) Finally, because of the large size of ConnectSphere Mobile and the large audit fee, ConnectSphere Mobile may attempt to ‘squeeze’ the audit fee. I may have to accept this reduced audit fee (as I would be reluctant to lose such a large audit fee) and this could result in a reduction in the time to perform the audit and thus increase the risk of me not detecting material misstatements in the financial statements.
From the discussion above, my firm should not offer itself nor accept the appointment as auditor of ConnectSphere Mobile. The main reasons for this decision are:
(i) ConnectSphere Mobile appears to be too large a company for my firm to audit, and it is likely to grow faster than my audit firm. The audit fee will probably exceed IFAC’s limit of 15% of the practice income, and if this is not exceeded now, it is likely to be exceeded in the next few years.
(ii) ConnectSphere Mobile is a specialised company with complex computer systems. It is probable my firm will not have the skills to perform this work.
(iii) The accounting conventions for ConnectSphere Mobile will probably be unfamiliar to my firm, particularly the treatment of the ₵2,000 given to new subscribers to purchase the phones and the lives of the non-current assets. I will probably not have the skills to consider whether these treatments are satisfactory, and this could lead to me not detecting material misstatements in the financial statements.
(iv) ConnectSphere Mobile appears to be undercapitalised. Currently, 20% but this will increase substantially with expansion of the network, losses in early years of trading. Thus, there is a serious risk that ConnectSphere Mobile will fail or be taken over, which could result in my firm being sued for negligence.
(v) The large size of ConnectSphere Mobile and the small size of my audit firm could compromise the independence of my firm. Third parties (including shareholders) will perceive my firm is not independent (on the relative size criteria), and ConnectSphere Mobile could bring severe pressure on my firm which would be hard to resist (i.e. they will ask for an unmodified auditor’s report to be given when I should either give a modified opinion or a material uncertainty relating to going concern paragraph).
(vi) The potential listing of the company on a Zamora Stock Exchange increases the audit risk, as there will be greater scrutiny of the financial statements prior to listing, which could highlight problems in the financial statements.
(vii) Finally, because of the large size of ConnectSphere Mobile and the large audit fee, ConnectSphere Mobile may attempt to ‘squeeze’ the audit fee. I may have to accept this reduced audit fee (as I would be reluctant to lose such a large audit fee) and this could result in a reduction in the time to perform the audit and thus increase the risk of me not detecting material misstatements in the financial statements.
- Uploader: Samuel Duah