Your firm is the external auditor of Octavia Ltd (Octavia). The team conducting the audit for the year ended 31 December 2X10 has recently returned to the office following completion of the audit fieldwork. You are conducting your final review procedures. The audit file contains the following relevant information:

(i) Historically, Octavia's core business has been the manufacture of cast iron railings for supply to the construction industry. Over recent years Octavia has also developed a growing customer base for the manufacture of specialist cast metal products, an area where the company has established a recognized niche market.

In its core business, Octavia has seen its revenues decline by 30 per cent and its gross profit margins worsen over the last five years. These effects have been caused by increasing competition from overseas competitors who have lower operating costs. This has resulted in trading losses for Octavia in recent years, including the year ended 31 December 2X10.

Octavia underwent a major factory reorganization during the year to enable it to diversify its activities away from its core business and concentrate on its specialist cast metal business. This reorganization, which was completed in November 2X10, was partly funded by a large bank loan. The profit and cash-flow forecasts prepared by the company to support the application for bank finance indicated a return to profitability for the year ending 31 December 2X11.

(ii) During the year one of Octavia’s major customers went into liquidation. Octavia has presented a claim to the customer’s liquidator both for recovery of the outstanding debt, and for the return of product which was supplied to the customer on a sale or return basis. Octavia has negotiated a sale of the returned product to another of its customers, dependent upon the successful recovery from the liquidator of the product in question. Initial indications from the liquidator are that 50 per cent of the outstanding debt is likely to be recovered by Octavia. The liquidator is also pursuing the recovery of the sale or return product on Octavia’s behalf.
Octavia has included the receipt of this proportion of the debt, and the sale of the returned product to its alternative customer, within its cash-flow forecast.

(iii) Shortly before 31 December 2X10 the company’s solicitors notified the company of an action being brought by a former employee who suffered a serious injury from an accident which occurred whilst operating heavy machinery in Octavia’s factory. The former employee claims that the company did not have the necessary health and safety procedures in place to ensure that such an accident could not occur. The former employee is pressing for at least £750 000 in damages, an amount which is material to the financial statements of the company.
The directors of Octavia are adamant that the accident occurred due to the employee’s own negligence, and they maintain that their health and safety procedures are of an excellent standard. Octavia has to date had an exemplary accident record and previous health and safety inspections have raised no material issues. Octavia’s solicitors have told the directors that the case is unlikely to come to court for at least 18 months. The company’s insurance policy provides an element of cover for such situations. For these reasons the directors have not provided for the claim in the financial statements. However, a reference to the action has been made in the notes to the financial statements.

Required:

(a) Briefly set out the reasons why work performed by audit staff during an audit is reviewed by other more senior staff or the engagement partner.

(b) Identify the matters to which you would direct your attention during the subsequent events review in the audit of Octavia.

(c) Comment on the treatment in the financial statements of the matter referred to in (iii) above and indicate, with reasons, what kind of audit report modification, if any, may be appropriate.