Deck 37: The Fund of Funds: Valuation of Investments

Question 1

Consult Paragraphs 4-8 of PCAOB Auditing Standard No. 15. Based on your understanding of audit evidence, did Arthur Andersen rely on sufficient appropriate audit evidence in auditing the valuation assertion related to FOF's natural resources assets? Why or why not?

Answer 1

Audit evidence
It is the information collected by audit team while reviewing company's financial transactions, internal controls, and other factors and which are recorded in working papers to be used as the basis for making a conclusion and giving an opinion.
In the present case, F is a successful mutual fund involved in natural resource asset investments. F used to purchase oil and gas properties from K Company which was owned by Mr. J. The auditor of K Company is A.
In this case, it was found that K Company overcharged F mutual fund for the oil and gas properties so the trustee of F sued the auditor A for failing to inform about the fraudulent transactions of K Company. A was liable to pay around $70 million.
According to auditor A, they reviewed transactions between F mutual fund and K Company for which some evidence is available. They also did some information gathering from the office of K Company for the audit of F mutual fund and testified that they obtained the documents from K Company.
As per paragraph 4 of PCAOB Auditing Standard No. 15, an auditor can only obtain sufficient and relevant evidence if he/she plans the audit procedures and performs them as planned. The evidence obtained in such manner can be used as the basis for his or her opinion.
As per paragraph 5 of PCAOB Auditing Standard No. 15, the quantity of evidence required by an auditor depends on the quality of evidence, possibility of the existence of misstatements and the limitations in controls of an entity.
In addition, paragraph 5 also justifies that if the quality of evidence obtained is poor, it is irrelevant to obtain the same type of evidence in large quantity.
As per paragraph 6 of PCAOB Auditing Standard No. 15, Audit evidence which provides relevant and reliable conclusions which can be used by the auditor to form an opinion are considered the most appropriate.
While testing the values related to F's natural resource assets, A did not rely on the evidence. K Company prepared a summary of sales showing a comparison between prices charged by it to F mutual fund and other industry purchasers.
Even though this statement is relevant as audit evidence but it cannot be fully relied upon as it is prepared by K Company itself who is the vendor of the properties. Such statement is biased and can be manipulated by K Company for its own benefit.
In addition, the statement also revealed that K Company's profits on sales to F were comparatively higher than the profits on all other sales. This raises doubts about the transactions that whether they were actually done on normal price or inflated price.
Finally, it seems that auditor A was unable to gather enough evidence to support the valuation assertion. The evidence clearly shows that K Company charged a high price to F.
So, it can be concluded that A was unable to gather sufficient and appropriate audit evidence in auditing the valuation assertion related to F mutual fund natural resources assets and should have gathered more and better evidence.

Question 2

Consult Paragraph 10 of PCAOB Auditing Standard No. 15. Next, consider the series of comparisons prepared by the Denver office of Arthur Andersen of prices charged by the King group to FOF, King affiliates, and other knowledgeable industry purchasers. Can you think of any additional evidence that would have strengthened the "Summary of 1968 Sales"?

Answer 2

Audit evidence
It is the information collected by audit team while reviewing company's financial transactions, internal controls, and other factors and which are recorded in working papers to be used as the basis for making a conclusion and giving an opinion.
Here, F is a successful mutual fund involved in natural resource asset investments. F used to purchase oil and gas properties from K Company which was owned by Mr. J. The auditor of K Company is A.
It was found that K Company overcharged F mutual fund for the oil and gas properties so the trustee of F sued the auditor A for failing to inform about the fraudulent transactions of K Company.
In this case, it can be noticed that as per the summary of the sales provided by K Company the transaction between K Company and F mutual fund has been made with unusually high-profit margin ratio that is 62% as compared to other sales.
A should obtain relevant and comparable data of similar transactions in the industry. Such information shall provide additional evidence which would support the summary of sales evidence.
As per paragraph 10 of PCAOB Auditing Standard No. 15, an auditor should always check the quantity, quality, and reliability of the information obtained from the company for the purpose of conducting an audit.
The information gathered by an auditor from the audit evidence must be accurate, complete, and relevant for purposes of the audit.
Firm A as an auditor is required to obtain additional evidence for such transaction which would support the price that was being charged by K Company is on arm's length basis.
A should obtain audit evidence which shows that there is no such influence or control of one party to other and the transaction was executed in an unbiased manner within the objective of the business.
The evidence must prove the fact that the transaction was legal, fair and executed with integrity and honesty.Hence, it can be concluded that the "Summary of Sales" alone will not provide sufficient and appropriate audit evidence.

Question 3

Consult Paragraphs 24-27 of PCAOB Auditing Standard No. 14. Based on the case information presented, do you believe that the management of FOF exhibited bias in their estimates? Why or why not? Next, if they did exhibit bias, please identify two steps that you would take if you were auditing FOF.

Answer 3

Substantive analytical procedures
It is a process developed to obtain evidence by comparing the recorded values with results as expected by the auditors. Any variation in the values and results are analyzed. Generally, the evidence is obtained at an assertion level related to accounting balances or classes of transactions.
Here, F is a successful mutual fund involved in natural resource asset investments. F used to purchase oil and gas properties from K Company which was owned by Mr. J. The auditor of K Company is A.
It was found that K Company overcharged F mutual fund for the oil and gas properties so the trustee of F sued the auditor A for failing to inform about the fraudulent transactions of K Company.
In this case, K Company provided a summary of sales to auditor A for verification. According to the summary of the sales provided by K Company, the transaction between K Company and F mutual fund has been made with unusually high-profit margin ratio that is 62% as compared to other sales.
As per the paragraph 24 of PCAOB Auditing Standard No. 14 the preparation of financial statement is responsibility of the management so, the auditor should review the accounting policies, any interest of management, judgments made by management and disclosures while detecting the misstatements in financial statements which are material.
As per the paragraph 27 of PCAOB Auditing Standard No. 14, the auditor should check whether the estimates of financial statements are unbiased and reasonable by comparing them with the estimates of evidence obtained by them.
Due to the limitation of scope and time while performing audit procedures in testing the valuation, audit professional needs to pay more attention to the possibility that management bias might exist.
While performing substantive analytical procedures, the auditor relies on the test to detect misstatements related to the valuation assertion. The evidence obtained through substantive analytical procedures should support the management assertions.
The auditor's evidence obtained from performing substantive analytical procedures will not be adequate when there is management's interest. This is because management is considered to be an influential position for preparation of financial statement and they can easily alter or manipulate the information in the financial statement. This increases the significant risk of material misstatement.
It is due to all these reasons K Company's sales summary would not be reliable since the report is biased as it is prepared by K Company. Thus, the auditors should remain independent and rely on their own professional judgment.
The auditor should obtain information from third party sources to complete this test or perform alternative audit procedures. The auditor can also seek external confirmation. An auditor must be very careful while using the results of substantive analytical procedures as those results are not conclusive but persuasive.

Question 4

Do you believe Andersen had a duty of client confidentiality to KRC that would prohibit the firm from disclosing to FOF any relevant knowledge it may have had related to KRC's costs? Why or why not?