Question

Your firm is the incumbent auditor on Biotech Ltd, a pharmaceutical company. Since the previous audit, the company has listed on the Australian Securities Exchange which means the company has to meet additional reporting regulations. Due to rapid growth, Biotech Ltd is financially stretched and its accounting systems are struggling to cope with the growth in the business. You recently read an article in the Australian Financial Review, which stated that Biotech Ltd is currently under investigation by the Australian Taxation Office (ATO) for alleged failure to pay the appropriate amount of Pay As You Go (PAYG) tax on their payroll.

Biotech Ltd is a pharmaceutical company, developing drugs to be licensed for use around the world. Products include medicines such as tablets, medical gels and creams. The market is very competitive, encouraging rapid product innovation. New products are continually in development and improvements are made to existing formulations. Drugs must meet very stringent regulatory requirements prior to being licensed for production and sale. You are aware that during the 2020 financial year, Biotech Ltd lost several customer contracts to overseas competitors.

Biotech Ltd approached its bank during the year to extend its borrowing facilities. An extension of $20 million was sought to its existing loan to support the on-going development of new drugs. The long-term borrowings are subject to debt covenants in which the company must maintain a current ratio of 3.5:1.

In addition, the company asked the bank to make cash of $5 million available if an existing court case against the company is successful. The court case is being brought by an individual who suffered severe side effects when participating in a clinical trial in 2016.

On 8 June 2020, the Company announced to the market it had been the victim of a cyber-security incident that resulted in supplier and customer details being disclosed on the dark web. The Company is assessing the costs of the incident and the subsequent reduction in revenue. The Company expects this to have a material impact on future earnings.

Minutes from the Audit Planning meeting with Simon Jones (Finance Director of Biotech Ltd) held on 30^th April 2020:

Due to the current government restrictions, the planning meeting with Simon Jones was held via Zoom. In attendance at the meeting was the Audit Partner (Michael), the Audit Manager (Amanda) and the Audit Senior (David).

The following key items were discussed during the meeting:

• Mr Jones raised concerns about the conduct of the previous audit, stating numerous examples of when he and his staff had been interrupted when they were busy. He stated that he wanted guarantees that this year's audit will be more efficient, less intrusive and cheaper, otherwise he will seek an alternative auditor in future.
• Michael reminded Mr Jones that fees relating to the audit engagement from the previous year were still outstanding.
• Both Michael and Mr Jones also discussed the range of non-audit services provided to Biotech Ltd, which includes payroll preparation, tax computation and advice.
• Mr Jones gave the audit team an update on the court case pertaining to the individual who suffered severe side effects from a company trial (refer above). According to legal advice provided to Mr Jones by the company’s legal counsel, it is more likely than not that Biotech will lose the court case, which would result in a significant amount of cash having to be paid as a settlement.
• Amanda asked Mr Jones if he considered the decline in profitability as an indicator of a material uncertainty surrounding the going concern assumption. Mr Jones responded by saying, “Look, everything might seem dire, but we have it under control. We will be here this time next year, so keep that in mind”. Michael then looked at Amanda and David and said, “Make sure that you mention the conversation that we have just had with Mr Jones about the appropriateness of the going concern assumption in the audit working papers. This should be sufficient enough audit evidence for us.”
• Mr Jones also mentioned the following: “As you know, Biotech Ltd has a Goodwill asset on the balance sheet. This is an indefinite useful life intangible asset. In accordance with the Accounting Standards (AASB 138), we are required to test the asset for impairment every year. We usually prepare a Value in Use calculation based on discounted future cash flows that we expect to generate in the next five years. I have completed this year’s calculation by rolling forward the prior year’s calculation and have just updated the dates. There was no need to update the future cash flow figures.”

The Audit Team

The audit team consists of 4 people. The partner is Michael. He has been the audit partner on the Biotech Ltd audit for 6 years. The audit manager is Amanda. This is Amanda’s first time on the Biotech Ltd audit. David is the audit senior and is responsible for the initial audit planning. David has recently completed the Graduate Diploma of Chartered Accounting. David has just been offered a well-paying accountant position at Biotech but he has not yet decided whether to accept the position. The graduate on the audit is Audrey. Audrey’s friend is the receptionist at Biotech Ltd. The receptionist has no accounting knowledge and has no involvement with the recording or processing of accounting transactions.

Accounts Receivable / Sales Accounting Cycle and Internal Control System

At the end of each month, the sales manager determines the amount of products required to meet sales demand for the following month based on sales orders received. He reviews the sales orders received from customers and then prepares the pre-numbered inventory requisition forms, which he then sends to the warehouse managers so that they can prepare the goods for delivery. One copy of the sales order and inventory requisition form is sent to the warehouse, one copy is sent to the accounts receivable department and one copy is filed in the sales department.

The warehouse prepares the goods for delivery to the customers and generates the delivery document. When the goods have been delivered, the signed delivery document, which includes the delivery details, is forwarded to the accounts receivable department. The other copy is filed in the warehouse. The accounts receivable clerk matches the signed delivery document with the sales order and inventory requisition form. Once satisfied that all of the details agree, the clerk generates the sales invoice. Once generated, the clerk does another check to ensure that all details per the sales invoice agrees to the delivery document and sales order. Once satisfied, she writes “checked” on the sales invoice and sends it to the customer. At the end of every week, a different clerk in the Accounts Receivable team reviews the bank statements for receipt of payments from customers and performs a reconciliation against the sales invoices. Once a customer has paid the sales invoice, the clerk stamps “received” on the sales invoice and files that along with all the other documents in date order.

The walk-through of the accounts receivable/sales cycle confirmed that the accounting and internal control system was working as documented above.

Test of control:

As part of the audit, Audrey tested the controls over the accounts receivable system. She selected a sample of twenty sales transactions and tested the control that all details had been checked. Out of the 20 sales transactions that were selected for testing, 5 sales invoices in the sample did not have the word “checked” written on them. When documenting the results of the test performed, Audrey concluded that the internal control did not operate effectively and consistently throughout the year but that no further audit work is required.

Substantive test

In order to test the occurrence of the sales transactions, Audrey selected a sample of sales invoices and traced them to the General Ledger to test that they were properly recorded.

Subsequent events not previously mentioned

• One of Biotech Ltd’s major customers went into liquidation in July 2020. The balance due from the customer at 30 June 2020 was $564,000. This is a material amount. There has been no provision/allowance for doubtful debts raised for this debtor in the financial statements for the year ended 30 June 2020. Biotech Ltd’s legal adviser stated in a telephone call that that the probability of any funds being received from the debtor is remote.

• On 2 July 2020, Biotech Ltd declared a one-for-five rights issue of 100,000 shares at $2.20. These shares were payable in full on 31 July 2020.

Misstatements identified

Description	Amount	Management Action
Biotech Ltd has also been involved in a court case with a former employee since early 2018, who is suing for unfair dismissal. To date, the audit evidence that we have obtained is a verbal confirmation from Biotech Ltd’s management that they have received a claim of $250,000 against them. Biotech Ltd’s legal adviser believes it is probable that the company will be found guilty and will have to pay the amount. The amount of $250,000 is material. The $250,000 has not been recognised as a provision in the financial statements for the year ended 30 June 2020.	$250,000	Management disagreed with the advice from the legal adviser. As such, they have not corrected the accounts in the final Financial Statements. The audit team believes this amount should be recorded in the financial statements at 30 June 2020.
Due to the effects of Covid-19, the audit team were unable to attend the inventory stock count of Biotech Ltd. As such, they were unable to obtain sufficient audit evidence surrounding the existence of inventory. The inventory balance in the financial statements as at 30 June 2020 is $2,345,000, which is material.	$2,345,000	None required.

What is the audit opinion for the above case study?

Answer 1

Given in the case:

• Expected Current Ratio: 3.5:1. (Standard Current Ratio is 2:1).
• Court Case - If won, Raising $5m. If lost, $250,000 shall have to be paid.
• Impairment of Assets in near future is needed. This is already communicated to the management and no further work is needed.
• Audit team is clear. Lower level is receptionist who has no accounting or auditing knowledge. So, various kinds of mismanagement is dropped from the list.
• Every month-end sales and inventory department reviews the inventory requirement and is communicated to accounts receivables department. Weekly Bank Reconciliation is done. Every stage is working fine.
• Sample Testing of Internal Control is not satisfactory at root level. Yet, no further audit is required as there is no mismanagement of inventory is involved.
• Substantiative test is normal.
• Major Customer has went into liquidation. Receivable from it is $ 564,000 which is substantial amount. There is no corresponding reserve made. Probability of receiving amount is remote.
• Rights issue is declared and is due in within a month.

Required: Audit Opinion

Answer:

Opinion of Auditor changes from person to person. The analysis and interpretation of the enterprise is different for different auditors. However, from the given facts above, following things are clear.

• Company has payables more than receivables.
• Company is old and has generated goodwill. Intangible assets aid in boosting financial statements. But, there are certain things which are not mentioned in these statements.
• Liabilities accrued after the Balance Sheet date is also higher in short-term.

Opinion to be given is: Qualified Opinion.

Qualified Opinion is clean report about the company's affairs except a few things about which auditor is not clear about. There is a material issue in the organization which keeps it away from GAAP. In this case, it is clear that the amount of loss is known to the organization and also communicated to auditor. Thus, Qualified Opinion suits best.

Qualified Opinion is still acceptable for accounting information users.

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