Question

You are the senior auditor on the year-end financial statement audit of LRM Construction Co. You are conducting a preliminary review of the audit working papers for the audit of executive payroll, completed by Sophie Chow, a junior auditor on the audit team.

Upon your review, you are surprised to see that the audit file documents contain a note that LRM’s Controller, James Myers, received a salary plus bonus payments of $10 million this year. This was significantly more than he was paid in the past and also more than was paid to any other executive of the company, including the chief executive officer. Sophie did not mention the reason for this increase in the working papers, but did state that the results of the testing done on the executive payroll concluded that salaries were recorded properly and no further work was required.

You are not comfortable with this and ask Sophie if she knows the reason for the Controller’s significant increase in compensation this year. She tells you that during her discussions with James, he was very frank when she asked him outright why he was being paid so well this year. James hesitated, and then explained that this year LRM had received a huge contract in China to construct a manufacturing facility. This was a great opportunity for the company and the $10 million was not actually part of his salary, but money that was used to pay bribes in China. James said, “this is unfortunately standard business practice in China. We wouldn’t even have landed the contract if we didn’t pay off a few people. Even the building inspectors had to be bribed so we could proceed. To keep it off our books, I volunteered to add it to my salary and make the payments personally. Everything is okay with the tax guys as I have paid taxes on the full amount.”

Required:

Draft interim review comments concerning this area of the payroll audit, also identifying any further audit work that will need to be done for this area of the audit. Include a note as to further impacts that the Controller’s comments would have on other aspects of the audit process.

Answer 1

mm/dd/yy

Directors

LRM Construction Company

Dear

We are pleased to submit this comment letter to LRM Construction Company.

Our Views on the Audit of Executive payroll are set out in this letter.

As per applicable INTERNATIONAL STANDARD ON AUDITING 315 IDENTIFYING AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT THROUGH UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT

Risk Assessment Procedures and Related Activities

5.The auditor shall perform risk assessment procedures to provide a basis for the identification and assessment of risks of material misstatement at the financial statement and assertion levels. Risk assessment procedures by themselves, however, do not provide sufficient appropriate audit evidence on which to base the audit opinion.

6. The risk assessment procedures shall include the following:

(a) Inquiries of management, and of others within the entity who in the auditor’s judgment may have information that is likely to assist in identifying risks of material misstatement due to fraud or error.

(b) Analytical procedures.

(c) Observation and inspection.

As per applicable INTERNATIONAL STANDARD ON AUDITING 240 THE AUDITOR’S RESPONSIBILITIES RELATING TO FRAUD IN AN AUDIT OF FINANCIAL STATEMENTS

Responsibility for the Prevention and Detection of Fraud 4.

The primary responsibility for the prevention and detection of fraud rests with both those charged with governance of the entity and management. It is important that management, with the oversight of those charged with governance, place a strong emphasis on fraud prevention, which may reduce opportunities for fraud to take place, and fraud deterrence, which could persuade individuals not to commit fraud because of the likelihood of detection and punishment. This involves a commitment to creating a culture of honesty and ethical behavior which can be reinforced by an active oversight by those charged with governance. Oversight by those charged with governance includes considering the potential for override of controls or other inappropriate influence over the financial reporting process, such as efforts by management to manage earnings in order to influence the perceptions of analysts as to the entity’s performance and profitability

As per applicable INTERNATIONAL STANDARD ON AUDITING 520 ANALYTICAL PROCEDURES

Paragraph 7 Investigating Results of Analytical Procedures.

If analytical procedures performed in accordance with this ISA identify fluctuations or relationships that are inconsistent with other relevant information or that differ from expected values by a significant amount, the auditor shall investigate such differences by:

(a) Inquiring of management and obtaining appropriate audit evidence relevant to management’s responses; and

(b) Performing other audit procedures as necessary in the circumstances.

Investigating Results of Analytical Procedures .

Audit evidence relevant to management’s responses may be obtained by evaluating those responses taking into account the auditor’s understanding of the entity and its environment, and with other audit evidence obtained during the course of the audit.

The need to perform other audit procedures may arise when, for example, management is unable to provide an explanation, or the explanation, together with the audit evidence obtained relevant to management’s response, is not considered adequate.

Interim Review Comments:

As per applicable ISA and its requirement we have noticed misstament of finnacial statement as expenses on possible construction in china is regarded as huge increase in the salary of controller. There also seems to be an intention of fraud. While carrying out audit procedure controller stated that the increase in salary is just an expense related to construction in china and also regarded it as a bribe standard practice in china.

To rule out possible effects of misstatement on other areas of financial statements company should report and disclose this transaction in financial statements for use of stakeholders.

We would be pleased to discuss our comments with members of the LRM Construction Company's Board or its staff.

Sincerely

abc

NOTE: Further impact on audit process

Extensive and additional audit procedures as per ISA 520 needed to be performed as controllers comments gives indication of possible other misstatements, any such increase in wages/salary is to be completely verified by applying audit procedure and demanding explanation from company for the same.

While other areas of audit also needs to be done with same professional skepticism.