Q4 Sept_Dec 2016 – ACCA P7

Overview Points

  • You are the auditor to a subsidiary, Northwest Co.
  • The Year End is 31 July 2016
  • Northwest is recording a Loss Before Tax of $50,000
  • The letter of support : A key issue in determining the appropriateness of the going concern status of Northwest Co – Management has failed to provide a formal letter of support, and instead will only give a verbal representation that it will continue to support Northwest Co…is this because, management of Valerian Co know that, legally that cannot provide financial support into the future? Is it because Valerian is not going to have sufficient spare financial resources to support Northwest Co into the future?? What are the implications for the Going Concern status of Northwest Co in this event?? Does the management of Northwest Co have a contingency plan in place??...failure to provide the letter of support, could be seen as inability to gather sufficient and appropriate evidence for the Audit of Northwest Co and hence result in an audit report modification

(A)– Application of Professional Scepticism

Statement made by Management regarding the non provision of “Letter of Support”.

A letter of support (aka comfort letter) is an agreement made between a parent entity and its subsidiary or fellow subsidiary under which one entity agrees to provide support, in the form of funding, to the other entity in order that it may meet its debts and liabilities.

A letter of support may be required from the parent entity where it appears that a subsidiary is not a going concern and will be unable to pay non group creditors as they fall due.

Note, it is only a letter and if there is no formal agreement in place, then limited reliance can be placed on it

Management has failed to provide a formal letter of support, and instead will only give a verbal representation that it will continue to support Northwest Co…is this because, management of Valerian Co know that, legally that cannot provide financial support into the future? Failure to provide the letter of support,will likely mean that Northwest will be unable to continue trading as a going concern. Hence, there is therefore a risk that the 31 July 2016 accounts will be prepared on an incorrect basis.

Furthermore, the letter of support is an internally generated piece of evidence, provided by the parent, Valerian Co. The auditor must be sceptical of this form of evidence because it is prepared by management and generally speaking, internally generated evidence is not as reliable as externally generated evidence.

The outcome of the legal case could affect the ability of Valerian to provide support to Northwest Co. The auditor must therefore remain sceptical when considering management pledge of support to Northwest Co.

Auditors of Valerian Co – The Parent Entity

Thornhill & Co are auditors to a component of the Group, i.e. Northwest Co, and are not the group auditors.

Therefore, I would agree with the comment from the Auditors of Valerian, where they are refusing to provide copies of the representations from the management and legal advisers to Valerian regarding the major lawsuit.

However, the comment by the group auditor to us, as auditor of Northwest Co, to not modify the audit opinion should also promote scepticism. This reinforces the suspicion that both the group auditor and the directors of Valerian Co may be trying to conceal some sort of problem.

(B)Ethical and Professional Issues Raised in respect of the Completion of the Audit

Issue / Ethical Issues / Professional Issues
Evidence Obtained in relation to Support offered by Valerian Co / Failure on the client’s behalf to co-operate with the component auditor. / Management has failed to provide a formal letter of support, and instead will only give a verbal representation that it will continue to support Northwest Co….failure to provide the letter of support, could be seen as inability to gather sufficient and appropriate evidence for the Audit of Northwest Co and hence result in an audit report modification.i.e. except for or disclaimer of opinion.
- A letter of support may be required from the parent entity where it appears that a subsidiary is not a going concern and will be unable to pay non group creditors as they fall due.
Note, it is only a letter and if there is no formal agreement in place, then limited reliance can be placed on it. Therefore the auditor of Northwest Co. would need to obtain sufficient appropriate audit evidence that Valerian Co can provide the support which they promise.
- In addition to the letter of support, the uncertainty surrounding the outcome of the legal action may cause Thornhill & Co to seek further evidence before concluding on the going concern status of Northwest Co. This could include inspecting correspondence between Valerian Co and their legal advisers and inspecting the minutes of directors meetings relating to this issue.
- The failure to provide the letter of support could mean that the directors and auditors of Valerian Co they are not being entirely honest with the component auditors, Thornhill & Co. This increases the need for professional due care during the audit process, particularly in relation to the re-appraisal of fraud risk and the potential for misstatement in relation to the going concern status of the company and the related disclosures in the financial statements.
Request not to modify the Auditor’s report of Northwest Co. / Intimidation threat – The request not to modify the auditor report on Northwest Co could be seen as an intimidation threat.
The overall integrity of the group engagement partner must be questioned. His aggressive attitude towards the audit of Northwest Co indicate some form of inappropriate conduct in the audit of the parent company and group accounts. This matter should be discussed with the firms designated ethics partner. Also an ethical threat arises, as the Group Auditor has said that he would transfer the debt in Northwest Co to Valerian and hence no letter of support would then be required. The group auditor initiating this transaction between Northwest Co and Valerian Co is not the role of the group auditor. This action would threaten the independence of the group auditor as it could lead to a self review threat / - The responsibility for determining the final audit opinion on Northwest Co. lies with Thornhill & Co. and not the group auditor. The group partner’s “oversight “ of the whole audit is irrelevant to the audit of Northwest Co.
- Given the intimidation threat and the potential concerns relating to the audit of the parent and the group, Thornhill & Co may consider resignation from the audit of Northwest Co, if permitted, or may not seek re-election as auditor for the following year.