Relying too much on Management's Representations

This month we look at the risks of relying too heavily on client representations in an audit engagement. The following fictionalized account is based loosely on an actual case before the Professional Conduct Enquiry Committee (PCEC). Names and circumstances have been changed to preserve anonymity.

The

Our member "Norm" had an audit client named "Giant Inc." The private company sold engine parts for heavy-duty construction machinery, and had been struggling in recent years due to increased competition from Asia.

Martin was the CEO, director, and a major shareholder of Giant. He'd enjoyed a distinguished career and was well respected in local business circles. Martin was keen to keep his company afloat.

What happened

Norm made two errors in judgmentone involving the valuation of long-term investments and the other involving the collectibility of accounts receivable.

The first matter concerned Giant's prioryear acquisition of a significant minority interest in "XYZ Company" in settlement of a loan. By the beginning of the current year, XYZ's carrying value had declined by over 60%. This drop would have a material impact on Giant's financial statements once Norm made the proper adjustment. But he never did. Citing the "three or four-year rule" (CICA Handbook S.3050.24-since withdrawn in April 2005), Martin persuaded Norm that Giant need not consider a write-down of its XYZ investment since the investment was only a year and a half old.

The second matter concerned Giant's receivable from its main customer, the "ABC Group." The ABC accounts comprised just over 40% of Giant's total receivables. Shortly after the year-end, ABC's payments had begun to dry up. After completing its annual audited financial statements and its first quarter's results, Giant realized that the ABC accounts were uncollectible (key parts of the ABC group had declared bankruptcy), and that it would have to write off these accounts in the second quarter's financials.

Unfortunately, as a result of ABC's demise, Giant experienced significant cash flow problems and collapsed shortly thereafter.

Norm had reviewed the first-quarter financial statements. He had issued his audit opinion and his review engagement report with the same report date. Both checklists indicated that he had calculated significant ratios (including receivables turnover) and considered their variations. So why hadn't he identified the company's major problems? Normally, this would be a large component of the subsequent events audit procedures.

Moreover, based only on information from the two sets of financial statements (audit and first-quarter), the accounts receivable turnover from the year-end to the first quarter had dropped almost 20%, signifying a $1-million shortfall in first-quarter cash flow. The shortfall well exceeded materiality, yet there was no evidence that Norm had bothered to make this simple comparison.

Norm had relied too heavily on Martin's representation that the ABC group would eventually come around.

One of Giant's creditors raised these potential audit failures with the PCEC, and an investigation was authorised.

The outcome

The PCEC disagreed with Norm's position regarding the XYZ issue, pointing out that the "three or four-year rule" had an important proviso: A write-down is necessary in the first three or four years if there is persuasive evidence of a permanent decline. The PCEC cited the following as persuasive indicators of XYZ's permanent decline:

* After two years of losing operations, XYZ had announced it was drastically cutting operations due to its weak financial position;

* The financial statements now included a going-concern note; and

* XYZ acknowledged its cash flow was barely adequate for day-to-day survival even after it had ceased operations and slashed costs.

With regard to the ABC Group, Norm argued that he had managements' oral and written representations about collectibility; however, a simple test by the PCEC suggested that this assertion was false-he did not have sufficient corroboration. Norm also argued that the amounts should be considered collectible because the ABC group had confirmed their account balances. The PCEC, however, concluded that while confirmation was sufficient evidence of the existence of the accounts, it did not sufficiently attest to their value.

The PCEC determined that Norm had breached Rules of Professional Conduct 201.1 (Maintenance of Reputation of Profession); Rule 202 (Integrity and Due Care); Rule 205 (False or Misleading Documents); and Rule 206.1 (Compliance with Professional Standards). He agreed to accept an anonymous reprimand, pay the costs of the investigation and a significant fine, and take a number of audit-related professional development courses.

The message

Every audit relies, to some extent, on representations made by the client's management; otherwise, audits would not be economically feasible. Reliance requires management to act in good faith, and this assumption of reliability must be tested before the auditor forms his opinion. If you're an auditor, make sure you exercise professional skepticism-ask questions and get corroborating evidence for representations from clients!

Comments or questions? Contact me at utley@ica.bc.ca.

Please note: The contents of this article are only for the general guidance of readers. The PCEC deals with each case individually, based on its specific facts and circumstances.