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This is a question about audit quality and auditor liability. Ariana Excellente has been the partner in charge of the audit of Black 'n' White

This is a question about audit quality and auditor liability.

Ariana Excellente has been the partner in charge of the audit of Black 'n' White (BnW), a clothing manufacturer. Her audit firm is in charge of the audit for the period ending 30thJune 2018. BnW has had excellent growth and profits in the past ten years of operations mainly through the excellent leadership of management, led by JT Slim. Excellente has always maintained a close relationship with BnW and has also made some constructive comments to BnW's management which have aided in the success of BnW. One of those recommendations included the installation of a computerised accounting system. Several times, over the last few years, Excellente's firm has asked her to rotate the staff for the audit of BnW. This has been resisted by both Ariana and the management of BnW on the basis that the audit staff used for the audit of BnW are familiar with the client which saves time and money when undertaking the audit. However, Ariana has agreed to changes in personnel in the current year's audit.

During the period, BnW decided to expand their operations and began a $2 million upgrade of their manufacturing facilities. The $2 million was obtained by borrowing from the bank. A loan of $2 million at a fixed 5% interest per annum was secured with ANZ Bank. BnW supplied financial information to the bank outlining their ability to continue as a going concern and therefore be able to meet their short term and long term commitments. The assessment of BnW's ability to continue as a going concern was made by assuming the $2 million loan had been successful and the $2 million liability was included in the assessment of going concern. The assessment was conducted by Ariana's audit firm. The assessment and documentation of the assessment by Ariana's firm was a key requirement from ANZ before the bank would loan the $2 million to BnW.

For the first few years of the audit of BnW, internal controls were assessed as inadequate and the accounting personnel employed by BnW were considered to have inadequate qualifications for their responsibilities. Extensive audit evidence was collected and tested during the initial audits of BnW, with numerous adjusting entries being identified by the auditors before the reports could be finalised and published. Over the last few years, the staff have improved in their knowledge and use of the accounting system with a noticeable improvement in the control system resulting in no audit adjustments occurring in the reports for the last three audits of BnW. As a result, Ariana has assessed detection risk as high and the amount of evidence collected and tested during the audit has gradually decreased over the last three years. Indeed, during the last three years of the audit, Ariana has been able to spend less time on the audit of BnW because of the relative ease of doing the audit and the co-operation of both management and employees of BnW with Ariana's external audit team.

In the current year's audit, Ariana decided that the total time budget for the engagement should be kept to approximately the same as in recent years. The senior in charge of the audit, Nathan Buckman, is new on the job and highly competent. It is Nathan's first audit engagement and he has never had any previous experience auditing a manufacturing organisation. During the current reporting period, BnW acquired a new division through a merger, which will add to the time it takes to conduct the audit, but it is anticipated by Nathan that his efficiency in conducting audits will ensure that no extra time or work is required to complete the audit.

The interim tests of the internal controls take longer than expected because of the use of several new assistants and a change in the accounting system to computerise the inventory records and several other aspects of the accounting records. There were also changes in the accounting personnel in BnW during the period. A number of errors have been identified during the testing of the new accounting system.

At the end of the year, Nathan assigns responsibility for inventory to an assistant who is also auditing BnW for the first time but is competent and extremely fast in their work. Even though the total value of inventory has increased during the period, Nathan reduces the amount of evidence collected and tested compared to prior years because there have been few errors identified in last year's audit of the inventory. During the audit, Nathan finds a number of items of inventory overstated due to errors in pricing and obsolescence, but the combined effect of these errors is not material so Nathan does not document the misstatements in the audit working papers.

During the testing of the inventory, many obsolete items were listed on the obsolete inventory report but none were material and Nathan decided they did not require any further attention or testing. A note was made in the working papers to indicate obsolete inventory was found but a further note was recorded indicating that sufficient investigation had been undertaken to verify that obsolescence was not an issue in relation to the final balance for inventory.

The audit was completed on schedule and in less time than the previous year's audit. There were only a few adjusting entries for the year and none of the adjustments were material. Ariana was extremely pleased with the results and wrote a special letter to Nathan and the inventory assistants complimenting them on the quality of the audit.

Six months after the release of the financial reports, Ariana's firm received a telephone call from BnW and was informed that BnW was in serious financial trouble. Subsequent investigation by the management of BnW had revealed that the inventory had been significantly overstated. The main reason for this overstatement was the inclusion of obsolete inventory (mainly from the new division) in the final inventory balance. There were also errors in the pricing of inventory due to a fault in the software used to record inventory. In addition, the inclusion of non-existent inventory in the final inventory further inflated the final balance of inventory. The new financial controller had intentionally overstated the inventory to compensate for the reduction in sales volume compared to the previous year. Errors were also found in the computer report of obsolete items prepared for Nathan by the IT manager who assisted in the audit of the inventory. BnW was placed into voluntary administration in February 2019 with little likelihood of creditors being repaid in full by BnW.

REQUIRED:

Discuss whether or not you believe the audit firm would be held liable if they were sued by ANZ Bank.

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