You are the external auditor of ZYX plc. The company has a year end of 31 December 1988. On reading the minutes of board meetings, you discovered the following:

(a) On 26 june 1988, an employee was seriously injured by a defective piece of machinery. The fault in this machine had been brought to the company’s attention long before the accident, but had been ignored. It is expected that the employee will sue the company for several hundred thousand pounds.

(b) On 12 January 1989, one of the company’s major customers went into liquidation, owing ZYX plc £80,000. Unsecured creditors were not expected to receive any payment.

You approach the managing director of the company to ask why there is no mention of either of these matters in the draft accounts. The managing director replied that the claim in respect of the accident cannot be provided for because the amounts involved have not been finalised and, anyway, the matter would probably be settled out of court. The bad debt need not be disclosed because the liquidation occurred after the balance sheet date. He went on to suggest that you have no interest in these matters because your appointment as an auditor extends to an examination of the accounting records only and not to the board minutes.

According to ZYX’s draft accounts, turnover for the year was £8m and net profit before tax was £750,000.

(a) Bearing in mind the provisions of SSAP 18 on Accounting for Contingencies and SSAP 17 on Accounting for Post Balance Sheet Events, draft an audit report for ZYX plc. You should assume that the company refused to alter the statements.

(b) How would you respond to the managing director's assertion that your investigation should be restricted to the accounting records only?