Question

Ball Construction Corporation

You are the audit senior of Ball Construction Corporation (BC), a small public company that enters into construction contracts with individuals and developers and builds to their specifications. BC is a Canadian company, but recently opened a branch in the southwestern United States.

It is September and the audit fieldwork for this year's audit engagement has just been completed. You are in the process of finalizing the audit file. The following is documented in the audit file:

Risk Assessment

Although BC's audit is recurring and we are familiar with its operations and systems, we determined that the audit risk for this year has increased from medium to high. There are three main reasons for the change:

• •Recent declines and instability in the U.S. housing market have created a high-credit-risk situation.
• •BC's controller left in March 2020, and the position had not been filled by year end.
• •The bank increased the interest rate on the company's operating line during the year, suggesting that it views BC as a higher risk than before.

Audit Approach

No information systems issues were noted in prior years. While we identified isolated control weaknesses in this year's review of the systems, overall the controls appear reliable. We will use a combined approach, and, because of the increased risk, we will increase the amount of substantive work.

Materiality

Planning materiality was set at $242,000.

• 1.Internal control
  • (a)When the controller left, the finance department staff took on additional duties. We noted that during the latter part of the year, the same individual was creating purchase orders, entering invoices into the system, and preparing the cheque runs. The CFO said the situation was unavoidable, and noted that the accounting manager reviewed the cheque runs and prepared the bank reconciliations.
  • (b)We noted that many journal entries had not been approved. The CFO said that he trained most of the employees responsible for the entries, so he knows what the entries are for. He also said, “Our management review of reports and financial statements would uncover any incorrect entries.”
  • (c)The CFO relies on senior management to review, approve, and sign reports generated by the finance department, such as the costing report by project. Testing of a sample of reports indicated that most reports had been appropriately approved. However, some reports were found on a construction manager's desk. When asked about them, she explained, “I'm so busy managing the jobs that I have that I haven't had time yet to look them over.” The signed reports were given to the audit team the next day and the audit testing was completed.
• 2.Accounts receivable and allowance for doubtful accounts

We sent confirmations to a sample of accounts receivable and noted the following issues based on the responses received:

• •One confirmation was returned stating that a receivable balance, related to a $1,542,000 contract, was overstated based on the progress report. Upon examination of the relevant report, we noted that a transposition error had occurred (86 percent completion was used when it should have been 68 percent). This represents a known error of $277,560. The CFO agreed that it was an error but was satisfied that this was an isolated issue and would normally have been caught by the supervisor's review. The CFO does not want to adjust for this error.
• •The CFO was quite adamant that no adjustments be made to the financial statements, declaring that “the statements fairly and accurately represent the financial situation of BC.”

Required

a.  

What type of audit report should be prepared, assuming the CFO does not change his position? Discuss.

b.  

Prepare the draft management letter.

Answer 1

SOLUTION

(a)       During the course of the audit, there was an error as a result of a transposition error. This caused trade accounts receivable and sales to be overstated. A progress billing error was made where a completion rate of 86% was used instead of 68%. It appears that this error is isolated and represents a known error of $277,560 ($1,542,000 × 18%). However, we will need to determine whether the same transposition error was made to the Construction in Progress account, and whether that account will need an adjustment as well.

The adjustments need to be discussed again with the CFO. Based on conversations to date, he is reluctant to record any adjustments. However, this should be recorded because net income is overstated. This amount is greater than our calculated materiality and therefore will have an impact on our audit report if the adjustment is not made. This fact, on its own, does not make the financial statements misleading. However, if we consider the users of the financial statements (such as the bank) and their reliance on our audit report, the statements as presented by management are misleading.

If Ball Construction Corporation (BC) wants a clean audit report, it must address the issue highlighted and make the required entry. Once again, we must request that management book the adjustment. If management will still not make the adjustments to the financial statements for the material error, we will have to issue a reservation in our audit report due to IFRS (GAAP) departures.

Because the reservation does not relate to a scope limitation and we are aware of the required adjustment, we would not issue a denial of opinion. Reporting options would include a qualified opinion or an adverse opinion. A qualified opinion would be justified if we are comfortable that we can express a positive opinion on the financial statements as a whole and we can fully disclose in our report the reasons for the qualification. In this situation, because we are certain of the effects of the adjustments, I believe that we can issue a qualified opinion.

(b)       Management Letter Points

The following operational issues were noted:

1.         The company decided to expand operations into the United States without much discussion so that they could get in "before slowdown" occurred. Expanding into another market at a time when that market is expected to "crash" and do poorly is a really bad operational and financial decision; the fact that this expansion was approved without much discussion is strongly indicative that there is insufficient operational oversight by the board of directors, who should be willing to speak out against decisions that are bad for the company as a whole.

•           Recommendation: Review the composition of the board for financial and industry experience; ensure qualified to be in this position.

•           Recommendation: Review the decision-making process to determine who was involved in the decision; review the performance and qualifications of those involved in the decision.

•           Recommendation: Implement proper processes for large operational decisions; ensure the approval of the board of directors and senior management is needed before such events can go ahead.

2.         Improper segregation of duties in the payables department have been noted; if the same person is able to order goods, record the order in the system, and send a cheque for those goods, the risk of fraud as a result increases (i.e., the employee could record a fictitious purchase order in the system then send a cheque to him or herself).

•           Recommendation: Separate the recording of an invoice from the payment of that invoice (oversight of cheque runs, currently in place, insufficient).

3.         Controls over financial reporting are very weak. Unauthorized entries in the accounting system have been noted; if individuals are able to make unauthorized entries, we cannot rely on the underlying financial data (as we would have no documentation to which we could vouch the transaction), and a qualified opinion may be necessary.

•           Recommendation: Restrict access to accounting system to accounting staff. Put policies in place that require authorization from higher management for all manual journal entries. Ensure all recorded manual entries have a time/date/account stamp indicating who entered the accounting entry.

Other

The CFO has displayed a pattern of lack of interest in financial controls, a proven bias towards misstating the financial statements (unwillingness to adjust the adjustment found). This could be the reason that the original Controller quit (i.e., did not want to perform unethical behaviors).

We should consider whether or not we want to be associated with a company that has a financial officer that seems to display unethical behavior.