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  • 20 Marks

AAA – July 2023 – L3 – Q2 – Assurance services | The audit approach | Planning

Discuss matters to consider before accepting a review engagement and recommend procedures for examining a cash flow forecast.

Eebuks Ltd is a retailer of academic textbooks that sells through its own network of bookshops and online through its website. The revenue from the website includes both cash sales and sales on credit to educational institutions. The company has provided historical analysis from its trade receivables ledger indicating that for sales made on credit, 25% payment is received in the month of sale, 70% after 30 days, and the remainder are irrecoverable debts.

You are a Manager in Makafui & Associates, a firm of Chartered Accountants offering a range of services from audit to non-audit for its clients. On 1 July 2023, your firm was asked by Eebuks Ltd, a company that is not an audit client of your firm, to consider a potential engagement to review and provide an assurance report on Prospective Financial Information. Makafui & Associates has already conducted specific client identification procedures in line with money laundering regulations with satisfactory results.

Additionally, Eebuks Ltd has approached your firm to obtain an independent assurance opinion on its cash flow forecast, which is being prepared for its bankers in support of an application for an increase in its existing overdraft facility.

Required:

a) In line with ISAE 3400: The Examination of Prospective Financial Information, discuss FIVE (5) matters to be considered by Makafui & Associates before accepting the engagement to review and report on Eebuks Ltd’s Prospective Financial Information. (10 marks)

b) Assuming Makafui & Associates accepts the engagement, recommend EIGHT (8) procedures to be performed in respect of Eebuks Ltd’s cash flow forecast. (10 marks)

a) Matters to Consider Before Accepting the Review Engagement:

Before accepting the review engagement to provide an assurance report on Eebuks Ltd’s cash flow forecast, ISAE 3400 The Examination of Prospective Financial Information identifies several matters that need consideration:

  1. Intended Use of the Information: The firm should determine whether the cash flow forecast and assurance report will be used solely to support the increase in Eebuks Ltd’s overdraft facility. If the report is intended for other purposes, such as securing additional loans, this must be clarified as it affects the risk assessment.
  2. Distribution of the Information: The firm should consider whether the information will be distributed generally or to a limited audience. General distribution increases the risk associated with the engagement due to a broader audience relying on the information.
  3. Period Covered and Key Assumptions: Makafui & Associates should evaluate the period covered by the forecast and the assumptions used. Unrealistic assumptions or long-term forecasts may introduce significant risk, making the engagement inappropriate.
  4. Scope of Work: The firm must clearly define the scope, including the specific elements of the forecast to be reviewed. The level of assurance required by Eebuks Ltd and the form of the report should also be considered to ensure the engagement meets the client’s needs.
  5. Resources and Skills: The firm should assess whether it has the necessary staff with the required expertise to complete the engagement within the deadline and whether they will have access to all relevant information.
  6. Client Integrity: ISQC 1 requires an evaluation of the client’s integrity. Makafui & Associates should assess the reasons for appointing a different firm from the auditors and consider potential biases in the forecast.
  7. Ethical Matters: The firm must ensure no threats to independence or objectivity exist, particularly if the incumbent auditors were not chosen to provide the assurance report. Permission to contact the auditors should be obtained; otherwise, the engagement should be declined.

b) Procedures to Examine Eebuks Ltd’s Cash Flow Forecast:

  1. Mathematical Accuracy: Cast the cash flow forecast to confirm its mathematical accuracy.
  2. Consistency with Accounting Policies: Confirm the consistency of the accounting policies used in the preparation of the forecast with those used in the last audited financial statements.
  3. Opening Cash Position: Agree the opening cash position to the cash book and the bank statement.
  4. Key Assumptions Review: Discuss the key assumptions with management, such as collection and payment periods, and assess their reasonableness.
  5. Analytical Review: Perform an analytical review by comparing forecast trends with historical cash flows and sector data, investigating any significant differences.
  6. Recalculate Cash Flow Patterns: Recalculate the patterns of cash flows based on historical data to ensure accuracy in the forecast preparation.
  7. Sample Testing of Overheads: Obtain a breakdown of forecast overheads and compare it with historical data. Ensure that non-cash items like depreciation are excluded from the cash flow forecast.
  8. Review Supporting Documentation: For significant costs, review supporting documents like invoices or agreements to verify the accuracy and completeness of forecast payments.
  9. Board Minutes Review: Review board minutes to identify discussions or decisions relevant to the cash flow forecast.
  10. Sensitivity Analysis: Conduct sensitivity analyses by varying key assumptions to assess the impact on the cash position.
  11. Bank Confirmation: Obtain confirmation from the bank regarding the terms of the additional finance and ensure the forecast accurately reflects these terms.
  12. Management Representations: Obtain written representations from management confirming the reasonableness of their assumptions and completeness of the information provided.
  • 20 Marks

AAA – Nov 2015 – L3 – Q3 – Assurance services

This question addresses the considerations before accepting an engagement to review prospective financial information and the reporting requirements thereafter.

You are a manager in BS Cipax, a medium-sized firm which offers a range of services to audit and non-audit clients. You have been asked to consider a potential engagement to review and provide a report on the prospective financial information of Filtane Limited, a company which has been an audit client of BS Cipax for six years. The audit of the financial statements for the year ended 31 August 2015 has been completed and your firm issued an unmodified report. Filtane Limited operates a chain of fashion stores across the country.

Currently its merchandise are out of date and it sells clothing which do not reflect the latest and in mode fashion labels which are becoming more popular especially with the youth. Management is planning to revamp its image and stock the latest fashion in Africa and across the other continents. It also intends to invest in the latest technologies to include online real time trading on the internet order to attract more customers, especially the up-and-coming youth, trendy middle-aged persons and even those far from its shops by attracting them to shop over the internet. The company has sufficient cash to fund half of the necessary capital expenditure, and has approached its bank, Boafo Bank Limited, with a loan application of GHS32 million for the remainder of the funds required. Most of the cash will be used to invest in acquiring inventory and the technology for ensuring secure and safe online trading. The remaining cash will be used for refurbishment of the shops. Management had informed the Audit team, in the invitation to start the audit, of its intention to use the audited financial statements as the basis for preparing the prospective financial information to be used to seek for the loan from Boafo Bank Limited. The draft forecast statements of profit or loss for the years ending 31 August 2016 and 2017 are shown below, along with the key assumptions which have been used in their preparation. The audited statement of profit or loss for the year ended 31 August 2015 is also shown below.

The forecast has been prepared for use by the bank in making its lending decision, and was to be accompanied by other prospective financial information including a forecast statement of cash flows. Note 1: The forecast increase in revenue is based on the following assumptions:
(i) All shops will be stocked with new modern and in mode fashion to attract new customers to the shops and many persons who don’t live in the vicinity of the shops will also be attracted through online shopping by December, 2015.
(ii) Prices will increase by an average of 25% in December 2015.
Note 2: Operating expenses include mainly staff costs, depreciation of property and fittings, and repairs and maintenance to the shop fittings and equipment as well as ensuring continuous safe and secure on-line shopping.

Required:

a) i) Explain the matters to be considered by BS Cipax before accepting the engagement to review and report on the prospective financial information of Filtane Limited. (5 marks)

ii) Assuming the engagement is accepted, and the results of the examination procedures show that the prospective financial information have been prepared in accordance with the assumptions and appear reasonable, discuss the issues that will be in the report your firm will issue in respect of the forecast statement of profit or loss. (8 marks)

b) Boafo Bank Limited gave the loan to Filtane Limited on 15 October 2015, and a review of the first six months of operation in May 2016 of the new shops revealed that the company was not doing well and could not pay the first installment for the loan from Boafo Bank Limited. Further investigation revealed that the audited financial statements signed by BS Cipax, which showed a profit of GHS20.2M, should have been of a loss of GHS4.3M.

Boafo Bank Limited has indicated its intention to sue your firm for negligence on the basis that it placed reliance on the financial statements audited by your firm.

Required:

Comment on the matters that you should consider in deciding whether your firm will contest the matter in court or seek an out-of-court settlement with the bank. (7 marks)

i) Before accepting the engagement to review the company’s prospective financial information, there are several matters to be considered. A significant matter is whether it is ethically acceptable to perform the review. The review would constitute a non-assurance service provided to an audited entity, and IESBA’s Code of Ethics for Professional Accountants states that this may create self-interest, self-review, and advocacy threats to independence. In this case, the advocacy threat may be deemed particularly significant as BS Cipax could be perceived as promoting the client’s position to the bank. The review engagement should only be provided if safeguards can be used to reduce the threat to an acceptable level, which may include:

  • Having a professional accountant who was not involved with the non-assurance service review the non-assurance work performed or otherwise advise as necessary.
  • Discussing ethical issues with those charged with governance of the client.
  • Using separate teams to work on the audit and on the review engagement.

As well as ethical matters, ISAE 3400 “The Examination of Prospective Information” requires that certain matters are considered before a review engagement is accepted. The firm must also consider the specific terms of the engagement. For example, the firm will need to clarify whether the bank has requested a review report to be issued, and what exact information will be included in the application to the bank. It is likely that more than just a forecast statement of profit or loss is required, for example, a forecast statement of cash flows and accompanying narrative, including key assumptions, is likely to be required for a lending decision to be made.

ISAE 3400 also requires that consideration should be given to the intended use of the information and whether it is for general or limited distribution. It seems in this case the review engagement and its report will be used solely in connection with raising bank finance, but this should be confirmed before accepting the engagement.

The period covered by the prospective financial information and the key assumptions used should also be considered. ISAE 3400 states that the auditor should not accept an engagement when the assumptions used are clearly unrealistic or when the auditor believes that the prospective financial information will be inappropriate for its intended use. For example, the assumption that the necessary capital expenditure can take place by September 2014 may be overly optimistic.

The firm should also consider whether there are staff available with appropriate skills and experience to perform the review engagement and the deadline by which the work needs to be completed. If the work on the shops is scheduled to be completed by September 2014, presumably the cash will have to be provided very soon, meaning a tight deadline for the review engagement to be performed. (5 marks)

ii) The report by an auditor on an examination of prospective financial information should contain the following:

  • Title;
  • Addressee;
  • Identification of the prospective financial information;
  • A reference to the ISAE or relevant national standards or practices applicable to the examination of prospective financial information;
  • A statement that management is responsible for the prospective financial information, including the assumptions on which it is based;
  • When applicable, a reference to the purpose and/or restricted distribution of the prospective financial information;
  • A statement of negative assurance as to whether the assumptions provide a reasonable basis for the prospective financial information;
  • An opinion as to whether the prospective financial information is properly prepared on the basis of the assumptions and is presented in accordance with the relevant financial reporting framework;
  • Appropriate caveats concerning the achievability of the results indicated by the prospective financial information;
  • Date of the report, which should be the date procedures have been completed;
  • Auditor’s address; and
  • Signature.

Such a report would:

  • State whether, based on the examination of the evidence supporting the assumptions, anything has come to the auditor’s attention which causes the auditor to believe that the assumptions do not provide a reasonable basis for the forecast. E.g.:
    • Based on our examination of the evidence supporting the assumptions, nothing has come to our attention which causes us to believe that these assumptions do not provide a reasonable basis for the forecast.
  • Express an opinion as to whether the prospective financial information is properly prepared on the basis of the assumptions and is presented in accordance with the relevant financial reporting framework. E.g.:
    • Further, in our opinion, the forecast is properly prepared on the basis of the assumptions and is presented in accordance with International Financial Reporting Standards (IFRS).
  • State that actual results are likely to be different from the prospective financial information since anticipated events frequently do not occur as expected, and the variation could be material. (8 marks)

An injured party must prove ALL of the following three things in order to succeed in a claim for financial loss against an auditor for negligence:

  • That the auditor owes a duty of care;
  • That the duty of care has been breached;
  • That financial loss has been suffered that was caused by the negligence.

 

bi) Looking at the strict interpretation of the first requirement, the auditor owes a duty of care only to the shareholders as a body and not to Boafo Bank Limited as an outsider. The courts, however, have accepted that if the Auditor, at the time of signing the report, knew that someone other than the shareholders as a body would rely on the report, then the duty of care extends to that person. The facts of this case show that at the time the auditor signed the Audit Report, he was aware that it was Financial Statements going to form the basis for preparing the projected financial information to be used to seek the bank facility from Boafo Bank Limited. This means it is probable that a court will rule that requirement 1 above has been proved. (2 marks)

ii) A breach of duty of care must be proved for a negligence claim against the audit firm to be successful. Duty of care generally means that the audit firm must perform the audit work to the required standard and that relevant legal and professional requirements and principles have been followed. For an audit firm, it is important to be able to demonstrate that ISAs have been adhered to. There is no evidence in the facts as given to enable us to reach the conclusion that the duty of care has been breached or not. Looking at the fact that a loss of GHS4.3M was stated as a profit of GHS20.2M, a difference of GHS24.5M, if this error in the Income Statement is confirmed, it is likely to be interpreted by a court to mean that the auditor did not perform the duties expected of him/her with all the skill, care, and caution which a reasonably competent, careful, and cautious auditor would use. What is reasonable skill, care, and caution will depend on the particular circumstances of each case. In this case, however, an error is material by all standards and will be proof that the auditor has acted negligently unless he can prove that the circumstance that caused this material error was beyond his/her control. Requirement 2 appears to be likely to be proved. (2 marks)

iii) Requirement 3 is easy to prove since the loan was given on the basis of the projected financial information based on the audited financial statements, it is likely that a court will not need any serious persuasion to agree with the Bank that its financial loss was caused by the negligence of the auditor. From this discussion, the Auditors must seek an out-of-court settlement to avoid the bad publicity and likely litigation costs since it is probable that they would be found to be professionally liable to the Bank and the Bank is likely to succeed in the court. (1 mark)

Total: 7 marks

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