Question

In class we discussed the Molex case, where there was an issue around the lack of information on the representation letter that was deemed to be unacceptable by the external auditors.    This situation caused the external auditors to be removed and the CEO and CFO to be replaced.    Please answer the following three (3) questions:

1. Why is it important for management to include all relevant accounting, control, and other significant business matters in the representation letter?
2. Why is the representation letter important confirmation audit evidence for the external auditors to use in their final evaluation of the audit?  
3. Based on your understanding of the case and review of class materials, what would be your professional auditor conclusion if you believed that the representation letter was not complete or factually accurate?

Answer 1

Why is it important for management to include all relevant accounting, control, and other significant business matters in the representation letter

A management representation letter is a form letter written by a company's external auditors, which is signed by senior company management. The letter attests to the accuracy of the financial statements that the company has submitted to the auditors for their analysis. The CEO and the most senior accounting person (such as the CFO) are usually required to sign the letter.

In essence, the letter states that all of the information submitted is accurate, and that all material information has been disclosed to the auditors. The auditors use this letter as part of their audit evidence. The letter also shifts some blame to management, if it turns out that some elements of the audited financial statements do not fairly represent the financial results, condition, or cash flows of the business. Following is a sample of the representations that may be included in the management representation letter:

1. Management is responsible for the proper presentation of the financial statements in accordance with the applicable accounting framework

2. All financial records have been made available to the auditors

3. All board of directors minutes are complete

4. Management has made available all letters from regulatory agencies regarding financial reporting noncompliance

5. There are no unrecorded transactions

6. The net effect of all uncorrected misstatements is immaterial

7. The management team acknowledges its responsibility for the system of financial controls

8. All related party transactions have been disclosed

9. All contingent liabilities have been disclosed

10. All unasserted claims or assessments have been disclosed

Auditors typically do not allow management to make any changes to the content of this letter before signing it, since this would effectively reduce the liability of management.

An auditor typically will not issue an opinion on a company's financial statements without first receiving a signed management representation letter.

The Public Company Accounting Oversight Board provides considerable detail regarding the content of a management representation letter in its AU Section 333.

Companies Act 2013 has increased the responsibility of the auditor to manifold. The auditor has to take into consideration many factors while issuing report To the members of the company.

As per section 143 (2) of Companies Act, 2013 it is the duty of auditor to make a report addressing to the members of the company on the accounts

Examined by him and every financial statement which are laid before the company in the general meeting and the report shall take into account the Accounting and auditing standards. Section 143 (9) stated that every auditor shall comply with the auditing standards.

As per section 143 (3) (a) the auditor’s report shall also state whether he has sought and obtained all the information and explanations which to the best of His knowledge and belief were necessary for the purpose of his audit and if not, the details thereof and the effect of such information on the financial Statements.

Thus the audit evidence and audit documentation plays an important role to ensure that auditor has complied with the requirements of Companies Act 2013.

The management of the company is well informed about the internal environment and day to day activities of the company as compared to the auditor who Visits the company for a comparative short duration to conduct the audit. In such situation, the auditor has to discuss with the management and in certain Cases rely on the management’s view / discussion while forming opinion on the financial statement. Thus, as important audit evidence regarding the Information provided by management, a written representation should be taken from the management of the company.

It is responsibility & right of an Auditor to take written representation from management & higher Authority I.e., TCWG, as applicable, to fix the responsibility that there are no material miss-statement is done by the management in preparation & presentation of financial statement of the company and to assure that the financial statements are prepared are as per Accounting standard and related rules & regulations as applicable on company.

Why is the representation letter important confirmation audit evidence for the external auditors to use in their final evaluation of the audit

Audit evidence is the information used by the auditor in arriving at the conclusions on which the auditor’s opinion is based. Written representations are Necessary information that the auditor requires in connection with the audit of entity’s financial statements. Accordingly, similar to responses to inquiries,Written representations are audit evidence.

Although written representations provide necessary audit evidence, they do not provide sufficient appropriate audit evidence on their own about any of the Matters with which they deal. Furthermore, the fact that management has provided reliable written representations does not affect the nature or the extent Of other audit evidence that the auditor obtains about the fulfillment of management’s responsibilities or about specific assertions.

Although written representations provide necessary audit evidence they do not provide sufficient appropriate audit evidence on their own about any of the Matters with which they deal. In case the audit evidence contradicts with other audit evidences, the auditor should investigate the circumstances and Consider the reliability of representation made by the management. Written representations from management are a valuable source of evidence, but like Any other evidence, they have to be corroborated.

As explained, the proposed purpose of management representations is to demonstrate the
acceptance by management of its responsibility and accountability for the financial statements. The purpose of internal confirmations is to provide audit evidence relating to assertions at thelevel of account balances and transactions where other audit evidence cannot reasonably be expected to exist.

In the absence of other audit evidence, however, the issue arises about the value and nature of internal confirmations as evidence. Since representations related to assertions (internal
confirmations) have been recently in the centre of some well-publicized scandals, one might
conclude that their value is low. The purpose of the following discussion is to establish whether this conclusion is, indeed, appropriate

While other audit evidence may be readily available for some assertions, it may be more difficult to obtain for other assertions. For some assertions, the only audit evidence available may be management’s response to the auditor’s inquiry. In this context, a written internal confirmation is an acknowledgement by management that they accept responsibility and accountability for the assertion. This acknowledgement represents an important principle comprising two “subprinciples:”
• Management’s confirmation of completeness of information provided in the internal
confirmation; and
• Management’s responsibility for compliance with the relevant financial reporting
framework’s requirements relating to the assertion

. It is difficult to establish what evidence internal confirmations provide when no other evidence can reasonably be expected. Evidence generated internally is weaker than external evidence (although this assumption has been challenged).10 In addition, management members providing confirmations may find themselves in the position of conflict of interest. It may not be reasonable to expect management to provide information leading to a downward adjustment of the net income figure when the management has a vested interest in higher net income. The question that needs to be addressed is whether in such circumstances a confirmation can provide a form of audit evidence. The broadest theoretical definition considers evidence “all influences on the mind of the auditor .Other definitions describe evidence as any information supporting or undermining an assertion. A definition circumscribed to information is also used in ISA 500. The first definition implies that evidence is broader than information. However, the prevailing view is that for assurance purposes, evidence is information.

Internal confirmations would meet the first definition – their purpose is to influence the mind of the auditor. But do they meet the second (and relevant for assurance purposes) definition, i.e.can internal confirmations constitute sufficient appropriate audit evidence on their own?

Recent events have caused some to believe that representations related to assertions (internal confirmations) provide evidence of low value. Some business scandals involved reliance by the auditor on misleading representations related to assertions (internal confirmations). Unless a business failure occurs, it is difficult to determine whether an internal confirmation is true or not. The question is, what is it that separates the misleading and true representations? A possible answer is – the three ethical factors discussed in A2 (competence, integrity, due care). In other words, some managements provide representations that are suitable evidence and take responsibility and accountability for them, while others do not. Numerous lawsuits against managements involved in the scandals lend some credence to this conclusion.

Completeness is described as, “all transactions and events that should have been recorded have been recorded.”14 Only when all transactions, other events and conditions are recorded, the relevant balance or class of transactions achieved representational faithfulness. This is important, as representational faithfulness is an essential ingredient of reliable financial statements. Therefore, there is a direct link between completeness and reliable financial statements. The issue with completeness is that, unlike other assertions, it deals with transactions, events and conditions that may not be necessarily in the audit population. This characteristics has a bearing on the extent, nature and timing of auditing procedures.

Representations related to assertions (internal confirmations) of completeness often constitute a significant element of audit evidence pertaining to an account or class of transactions. This is due to the nature of the completeness assertion – it may be impossible for an auditor to obtain sufficient appropriate audit evidence of completeness when no underlying records exist (for example, unrecorded liabilities or potential and likely claims). A written internal confirmation may be the only evidence available. The evidential value of such internal confirmation, however, will not be identical on every audit. As explained in the preceding discussion, the quality will vary based on management’s integrity, competence and due care.

conclusion- the representation letter was not complete or factually accurate

(1) Audit industry was suffering from the coporate accounting scandals these years. Arthur anderson was convicetd of obstruction of justice for shredding documents related to its Enron audit and was forced to surrender its licenses. Besides, several of Deloitte & Touch's largest clients were also hit with fraud and accounting problems. The SEC regulations were tightened and new regulations were adopted such as the Sarbannes Oxley Act of 2003. The auditirs were under more pressure and under stricter supervision so they would be sensitive to any potential fraud.

(2) Even though it was a small amount, it would still affect the shareholders. The Managements's option to claim that the error was immaterial was aimed to increase the share price and avoid the risk that a fraud may cause. Since king was vice chairman of the board and owned 0.2% of voting common stock and 201,293 stock options, he had the intention to hide the material issue so that share price would increase

When computing consolidate financial report , Molex failed to preapre elimination entry about intercompany profit transaction. Since Molex subsidiaries had not sold thses inventories to external customers, the sales, COGS and inventories that had not acheived in the respect of group company should be eliminated.

(3). On July 21, 2004, both King and Bullock were aware of the problem and concluded the amount involved were not material. On Sep10,2004, King and Bullock signed the Management representation letter for the annual financial statements and 10-K on Aug20, 2004 with no mention of inventory error. The CEO and CFO didn't discuss the error with Deloitte & Touche until Oct 15. They signed the letter which guaranteed that they had disclosed all the financial records and related data and there were no material transactions in the records,etc. But actually they didn't disclose the error of inventory and breach the letter. Deloitte & Touche thought it was a fraud and the auditors were concerned about the significance of omission to the audit committe and the trust between the auditors and CEO and CFO.