Question

CLEAN & DRY

You are conducting the annual financial statement audit engagement of Clean & Dry, a large dry cleaning operation with 100 outlets all across Canada. Clean & Dry is 100% owned by Bob Clarke.

This is the first time you have worked on the Clean & Dry engagement. However, they have been your firm’s client for the past five years. You know, however, from previous audit engagements in which chemicals are used, that there is an environmental risk of improper disposal of the waste water containing contaminants. You also know that companies such as Clean & Dry are required to hire a toxic waste disposal company to regularly remove the contaminated liquid on a regular basis.

As part of your endeavour to gain “knowledge of the client’s business,” you arrange a tour of one of the dry cleaning outlets with Sammy Chu, the company’s Chief Operating Officer (COO) who oversees all operations. Sammy is excited to explain the process to you. “Dry cleaning is a process that cleans clothes without water. The cleaning fluid that is used is a liquid, and all garments are immersed and cleaned in a liquid solvent. The fact that there is no water is why the process is called ‘dry.’” After the process is complete, waste sludge is produced, which contains a combination of water, solvent, and soils. These are considered hazardous waste by the governmental regulations.” You then learn that each outlet collects the sludge in metal drums. Each outlet produces approximately 5,000 litres of waste sludge per month that has to be removed at each facility at a considerable cost to the company.

When you arrive at the head office to start your audit, you are provided with a copy of the draft financial statements for the year-ended September 30, 2012. You start by analyzing the financial results and comparing the numbers to last year. You notice that revenue has remained constant this year, which is consistent with prior years. However, you notice that net income is up 30%. Further income statement analysis shows that waste disposal costs are considerably lower this year compared to last year. Discussions with the accounts payable manager indicate that the disposal company charges $100 per drum. Each drum contains 400 litres of water. You estimate that they have only expensed 2 months worth of disposal costs for the entire year.

When you question Sammy Chu about this, he starts to get a little uneasy. “Why are you asking so many questions? This is not an environmental audit so you don’t have to worry about any of that.”

Required:
Uncomfortable with his response, you decide to send an e-mail to the engagement partner outlining your concerns along with your recommended course of action. (Assume that the owner, Bob Clarke did not know what Sammy was doing)

Answer 1

Dear Audit Partner,

Hope you are doing well.

As discussed with you earlier, I visited one of the Company's cleaning outlets with Mr. Sammy, COO of the Company. Upon reaching the outlet, I was given a copy of financial statement. On reading the financial statement, I note following which requires your attention-

1. The Company generates as much as 5000 litrest of waste sludge per month and disposal of such wastage requires outlay of $100 per drum. On reviewing the financials, I note that revenue is consistent with the previous year however cost of disposal, a significant cost for the company, has come down drastically resulting in net income increasing by 30%. On further detailed review, I note that the cost of disposal covers as much as 2 months cost only based on the re-computation.

2. The Company is regulated by the environmental regulation of the country classifies these waste as hazardous wastage and requires the Company to engage waste handling company. It is imperative upon company to dispose the wastage in responsible manner in compliance with the law.

Standard on auditing 250- Consideration of laws and regulations in an audit of financial statements provides that it is responsibility of management, with the oversight of those charged with governance, to ensure that the entity’s operations are conducted in accordance with the provisions of laws and regulations, including compliance with the provisions of laws and regulations that determine the reported amounts and disclosures in an entity’s financial statements.

SA 250 requires auditors to plan and execute an audit to obtain sufficient and appropriate evidence for the financial statements compliance with laws and regulations. SA provides that an auditor shall perform inquiry of management and, where appropriate, those charged with governance, as to whether the entity is in compliance with such laws and regulations; and (b) Inspecting correspondence, if any, with the relevant licensing or regulatory authorities.

I propose following action point to obtain the evidence for ensuring that financial statements are in compliance with law-

a. setup a meeting with Mr. Bob Clarke to obtain his understanding of the matter;

b. Requesting management to furnish the correspondence with disposal management company as well as law enforcement authorities.

I request your immediate attention and concurrence to proceed further.

Regards,

XYZ.