Question 5 (8 marks)

In his capacity as an audit senior, Sam spent the last day of the financial year performing stocktake observation procedure. His assignment that day included taking test measurements at a client's grain silo in a small country town. Sam had assessed grain stocks on two previous audits and was the senior-in-charge in this audit.

Sam' observations of the quality of grain in the silo fell 10% below the client's records. Sam's attention was drawn to the discrepancy in the two measurements of what was in the silo because, in his judgment, such a gap was significant enough to be material. The resulting difference between stock as reported by the client and the audited amount was enough to cause a significant drop in net profit. Sam documented his findings in the work papers and proposed an adjusting entry for the difference.

Upon investigating the matter further, Sam determined that a discrepancy in the grain stocks had also surfaced two months previously. The quantity of grain as reported by a government inspector at that time was lower than that on the client's records. The difference in the stock valuation, however, was not as great as that in Sam's tests. Still no adjustments to the client's record was made. This information was also documented in the audit working papers.

Prior to discussing the discrepancy with the client, Sam told Michael, the audit partner about the problem. Michael, who had substantial experience in the industry, advised Sam that this would be a sensitive issue with the client. He also pointed out that grain stocks are notoriously difficult to measure, with the potential for errors as large as 10%. Michael promised that he would handle the matter personally and therefore told Sam not to discuss the discrepancy with the client. The audit partner kept the stock work papers.

After completion of the field work, Sam returned to the office to wrap up his work on the audit engagement. The stock audit work papers were still not in the file. Upon Sam's inquiry, Michael handed him a new set of work papers. These work papers which had been dated as of the audit date, had been signed off by Michael and substantiated the book amount. Sam's subsequent questioning of the partner revealed that Michael had personally performed additional work on the grain inventory after the client's year end. Based on his own evidence gathering, the partner had substituted his own work papers for the documentation that Sam had prepared. No evidence remained of Sam's proposed adjustments. An unqualified opinion was subsequently issued.

Required:

(i)What are the ethical issues? Describe the fundamental principles that are potentially breached by Michael.

(ii)Consider at least four alternative courses of actions and recommend what Sam should do?