TASK

Background

You are the audit manager of RFC, an accounting firm with offices located throughout regional NSW and Victoria, including towns such as Bendigo, Albury, Wagga, Bathurst and Tamworth. RFC is a middle tier firm which provides audit and accounting services across a range of industries. During May 2020 you met with the audit senior of RFC, Wayne Campbell to discuss several findings related to some of RFC’s clients.

Pocket Pty Ltd

Wayne tells you about Pocket Ltd, a large client based in Bendigo, primarily involved in property development. Pocket’s business model involves purchasing and redeveloping buildings within the central business district of Bendigo which Pocket then leases to businesses. With the impacts of Covid 19 and a general decline in audit revenues in Bendigo, RFC as become increasingly dependent on Pocket to keep its Bendigo operations viable. 

The Managing Director of Pocket is Bruce Morse. Bruce is well respected throughout the community and served as Mayor for a term in the 1990s. Bruce has helped Pocket to grow from humble beginnings and exerts significant influence on the board of directors. Bruce also has range of connections to the business community within Bendigo, including the audit partner of RFC, with whom Bruce socialises on weekends. 

Wayne tells you that as part of the redevelopment of a building in the CBD of Bendigo, Pocket engaged the services of a local building firm, Prescott Builders. On his way home from work one day, Wayne tells you he drove past Bruce’s large home (nestled on top of a hill) and saw a Prescott Builders truck parked outside, and that scaffolding and other building materials were in place on Bruce’s home. The next day Wayne said he saw people in Prescott Builders uniforms working on the house, painting, replacing roofing materials and the like. 

Wayne then says that as part of his yearend procedures on the audit of Pocket Ltd, he obtained copies of tenders for the work being performed by Prescott on the CDB buildings owned by Pocket. Wayne said his examination of the tenders revealed that Prescott was far and away the most expensive of the tenderers. Wayne said he followed this up by looking at the board minutes and found that Bruce had convinced the board of Pocket to go with Prescott based on their superior quality. 

Wayne tells you he is concerned that there may have been some wrongdoing on the part of Bruce. Wayne tells you he has already raised the issue with the audit partner, whose response was to shrug his shoulders and say that there was no issue worth pursuing and even if there was, there was nothing RFC could do about it.

Walker Ltd

Next, Wayne tells you about Walker Ltd, a travel company which arranges and promotes Chinese tours of regional/outback Australia and owns a chain of boutique souvenir stores. RFC has been auditing Walker since it was first listed on the ASX in 1993. The financial reports of Walker have never been qualified/modified by RFC but Wayne says that Walker has been returning losses for the last 2 years, which he says are due to short term issues involving the pandemic and a declining perception of Australia as a worthwhile travel destination amongst Chinese travellers. While Walker has no significant long-term debts, it is close to the limit of its bank overdraft.

During the year, Wayne tells you that Walker upgraded its accounting system from a largely manual system to a computerised system. As part of this process, a consultant was hired to assist with the conversion. The system has been in place for 7 months, and the board of directors and senior management have indicated that they are happy with how it is operating. Wayne says, given his lack of experience with accounting systems of this kind, he recently attended a course run by his professional accounting body on how to audit such a system. An external consultant approved the functioning of the system and the internal auditors of Walker also examined the changeover and running of the accounting system and confirmed that everything is operating as it should. Wayne says that he placed reliance on the work of the consultant and the internal auditors as part of his audit. 

Wayne goes on to say that the parent company of Walker, Run Ltd, recently completed a takeover of Walker. The takeover was based on the perception that Walker’s trading share price of 85c was lower than the net asset backing price of $1.22 per share, as determined from the audited financial reports. Wayne says that after the acquisition process was completed, it was discovered that there were serious errors in the changeover to the new accounting system which meant that the inventory of the souvenir shops was misstated and that the resulting write down of inventory meant the asset backing per share was now 80c per share. Run Ltd is now suing RFC for alleged negligence for the loss of 42c per share. 

Pump Ltd

Lastly, Wayne tells you that RFC have recently been approached to conduct the audit of Pump Ltd, a company which creates mobile phone apps and games, for the year ended 30 June 2020.

RFC has not previously audited Pump’s financial report, although it has undertaken other types of engagements for Pump. Last year Pump hired RFC to assist in the redesign of Pump’s accounting software to ensure that internal controls over online sales and transactions were adequate to ensure the confidentiality of customer data and accuracy of recording transactions. The new software was implemented at the beginning of the current year and appears to be working satisfactorily. As part of this year’s audit, you expect to review the internal controls at Pump, including the controls within the IT systems.

As part of Pump’s financing arrangements with its bank, Honest Ltd, it has a loan covenant that stipulates that the quick asset ratio cannot be less than 1:1 or Honest Ltd has the right to withdraw all funding. Wayne says that the board has advised him that Pump’s quick asset ratio is currently at 0.9:1 due to legal action over intellectual property rights which are holding up the sale of various apps and games. The board has asked Wayne to ignore this temporary breach of the loan covenant, explaining that Pump is a stable and financially sound company, and that the ratio will return to a positive level on resolution of the legal dispute, which it believes with certainty that it will win. The board has indicated that unnecessarily disclosing this within the audit report would force it to reconsider its plans to use your audit firm for other engagements.

Lastly, Wayne says that as a result of Pump’s current cash flow difficulties, the board has requested that RFC’s audit fee for 2021 be paid in Pump shares. The board has indicated that the market value of the shares will equate to the value of the audit fee charged by RFC.

Required:

Question 1

In relation to Pocket, use the AAA model to recommend a suitable course of action for Wayne. Use the following template to guide your response.

American Accounting Association Model                     Decision-making process

1. Determine the facts                                                     The facts are ...

2. Define the ethical issues

3. Identify the major principles, rules, and values

4. Specify the alternatives

5. Compare values and alternatives

6. Assess the consequences

7. Make your decision

Question 2

In relation to Walker, and by referring to case law the auditing standards:

• Outline the major questions which would need to be addressed to determine whether RFC has been negligent in performing its audit of Walker. 

• Outline the major issues to be determined in ascertaining whether Walker is guilty of contributory negligence.

• Assuming that Wayne, as auditor, was negligent, determine whether a duty of care is owed to the directors of Run Ltd regarding their actions in taking over Walker.

Question 3

In relation to Pump.

• Identify and explain three separate key threats to RFC’s independence that may arise under APES 110.

• For each independence threat identified above, describe the course of action RFC needs to take to ensure compliance with APES 110.