Winston Black was an audit partner at Maharajah, Davis, LLP. He was in the process of reviewing the audit files for the audit of a new client, McMullan Resourcing. McMullan was in the business of heavy construction. Winston was conducting his first review after the field work had been substantially completed. Normally, he would have done an initial review during the earlier planning phases as required by his firm's policies; however, he had been overwhelmed by an emergency with his largest and most important client. He rationalized not reviewing the details of the client risk analysis or other audit planning information because (1) the audit was being overseen by Sara Beale, a manager in whom he had confidence, and (2) there were a few days of field work left, when any additional audit work could be completed. Winston then found that he was confronted with several problems. First, he found that his firm may have accepted McMullan without complying with its new client acceptance procedures. McMullan came to Maharajah, Davis on a recommendation from a friend of Winston's. Winston got "credit" for the new business, which was important to him because it would affect his compensation from the firm. Because Winston was busy, he told Sara to conduct a new client acceptance review and let him know if there were any problems. He never heard from Sara and assumed everything was in order. In reviewing Sara's preplanning documentation, he saw a check mark in the box "contact prior auditors" but found no details indicating if it was done. When he asked Sara about this, she responded, "I called Gardner Smith [the responsible partner with McMullan's prior audit firm] and left a voicemail message for him. He never returned mycall. I talked to Ted McMullan about the change of auditors, and he told me that he informed Gardner about the change and that Gardner said, 'Fine, I'll help in any way I can.' Ted said Gardner sent over copies of analyses of fixed assets and equity accounts, which Ted gave to me. I asked Ted why they replaced Gardner's firm, and he told me it was over the tax contingency issue and the size of their fee. Other than that,Ted said the relationship was fine." The tax contingency issue that Sara referred to was a situationin which McMullan had entered into litigation with a bank from which it had received a loan. The result of the litigation was that the bank forgave McMullan several hundred thousand dollars in debt. This was a windfall to McMullan, and they recorded it as a capital gain, taking the position that it was not regular income. The prior auditors disputed this position and insisted that a contingent tax liability be recorded. This upset McMullan, but the company agreed in order to receive an unqualified opinion. Before hiring Maharajah, Davis as their new auditors, McMullan requested that Maharajah, Davis review the situation. Maharajah, Davis believed the contingency was remote and agreed to the elimination of the contingent liability.
The second problem involved a long-term contract with a customer in Montreal. Under IFRS, McMullan was required to recognize income on this contract using the percentage-of-completion method. The contract was partially completed as of the year-end and was material to the financial statements. When Winston went to review the copy of the contract in the audit files, he found three things. First, there was a contract summary prepared by the sales manager that set out its major features. Second, there was a copy of the
contract written in French. Third, there was a signed confirmation (in English) confirming the terms and status of the contract. The space on the confirmation requesting information about any contract disputes was left blank, indicating no such problems.
Winston's concern about the contract was that to recognize income in accordance with IFRS, the contract had to be enforceable. Often, contracts contain a cancellation clause that might mitigate enforceability. Because he was not able to read French, Winston could not tell whether the contract contained such a clause. When he asked Sara about this, she responded that she had asked the company's vice-president of sales about the contract and he had told her that it was their standard contract. The company's standard contract did have a cancellation clause in it, but it required mutual agreement and could not be cancelled unilaterally by the buyer.
REQUIRED
a. Evaluate whether Maharajah, Davis, LLP, complied with generally accepted auditing standards in their acceptance of McMullan Resources as a new client. What can they do at this point in the engagement to resolve any deficiencies if they exist?
b. Consider whether sufficient audit work has been done with regard to McMullan's Montreal contract. If not, what more should be done?
c. Evaluate and discuss whether Winston and Sara conducted themselves in accordance with generally accepted auditing standards.