5
QUESTION 2 75 marks
You are the senior in charge of the audit of AdWise Ltd (AdWise), a company listed on the
JSE Ltd and you are presently engaged on the audit for the 31 January 2006 year end.
AdWise specialises in the placement and maintenance of advertising billboards. AdWise
owns the billboards, which are generally placed on private land, sports grounds and land
owned by local authorities. Historically, the company has had two main sources of revenue:
Fees for the design and printing or construction of the advertising media for the
billboards. This work is generally quoted for and invoiced on completion of the work.
Monthly maintenance and advertising fees charged to clients for the advertisements
placed on the billboards.
AdWise has been struggling to achieve revenue growth and profitability over the past few
years and the companys share price at the start of the 2006 financial year was at an all time
low.
New Managing Director
In February 2005, AdWise engaged Abraham Headblock, a noted turnaround specialist as
its new Managing Director, notwithstanding the fact that he is an unrehabilitated insolvent,
having been sequestrated in 2004 after the collapse of Jackbled Ltd. He assumed all of the
responsibilities of Chief Executive Officer, whilst Richard Minddump, a Chartered Accountant
(South Africa), was appointed as the companys Financial Director.
PoleWise campaign
In May 2005, at the instigation of Abraham Headblock, the company embarked on an
ambitious expansion programme. This included the introduction of a new form of billboard
advertising, which places smaller billboards on lampposts along arterial roads in South
Africas major cities. This campaign, called PoleWise, targets smaller, local businesses.
AdWise has entered into contracts with the relevant local authorities for the placement of the
billboards.
AdWise introduced a new form of contract for PoleWise clients because of perceived risks
related to smaller businesses. These contracts contain amongst others the following terms:
At the commencement of the contract PoleWise clients pay a once-off fee for the right to
advertise for a three-year period in the PoleWise campaign. AdWise has also entered
into an agreement with a major bank, in terms of which the bank will provide finance for
this payment to approved clients. There is no recourse against AdWise in terms of this
agreement. The amounts charged by AdWise for the right to advertise have been
evaluated and represent the fair value of the revenue streams.
PoleWise clients pay monthly maintenance fees in advance to AdWise. You are aware
that AdWise prepares detailed estimates of the maintenance costs for each contract in
order to ensure that a reasonable profit is generated. Maintenance costs are not
incurred evenly over the period of the contract.
PoleWise clients are also charged for the design and set-up of their billboards and, as is
the case with the established clients, are invoiced separately for this work on its
completion.
6
While the Polewise campaign significantly increased revenue, high start up costs resulted in
increased operating losses for 2006.
In view of the companys profit history and its current financial position (see page 7), you
consider that there is a significant risk that AdWise management may have deliberately
overstated the companys profitability by prematurely recognising revenue from the
PoleWise campaign.
You have already documented the system of internal control over the recording of revenue
and have satisfactorily tested controls over
the day-to-day recording of amounts invoiced to clients;
the recording of receipts from clients;
the maintenance of the accounts receivable records; and
the integrity and mathematical accuracy of related reports and schedules.
Management has provided written representations about the appropriateness of revenue.
These audit procedures enabled you to conclude satisfactorily on all aspects of revenue and
accounts receivable, except for the accuracy and cut-off assertions in respect of revenue
and the valuation and allocation assertion in respect of deferred revenue reflected on the
balance sheet.
Fraud at AdWise
AdWise makes use of a fully integrated accounting package, which incorporates an accounts
payable module. The company makes payments using an electronic funds transfer facility
provided by its bankers. The following are some of the features of the accounts payable and
settlement processes:
The system generates recommended purchase orders based on a system of purchase
requisitions. The recommended purchase orders identify preferred suppliers, the
quantities to be ordered and the most recent cost price. The orders are then reviewed by
the buyers and amended where necessary and approved on-line. Approved orders are
sent electronically to suppliers.
Details of goods and services received are captured on the system and matched against
the orders. The system then generates goods received advices.
Invoices received from suppliers are matched against the orders and goods received
advices.
At the end of each month, the system accesses the transaction details pertaining to each
supplier and the relevant credit terms.
The system then calculates the amount payable to each supplier.
The amounts payable and the suppliers’ banking details are transmitted electronically to
the company’s bankers. Payment is effected by means of the Electronic Funds Transfer
(EFT) system.
The internal audit department of AdWise recently detected a fraud amounting to R1,5 million.
A senior employee in the accounts payable department, acting alone, was able to create a
number of fictitious suppliers accounts and to process journal adjustments to these
accounts. This enabled the employee to transfer funds to bank accounts operated in the
names of the fictitious suppliers.
7
The Managing Director of AdWise has expressed concern about the fact that the external
auditors failed to report the control weaknesses that made the fraud possible.
Financial position
You obtained the following summary of the companys financial position at 31 January 2006,
as reflected in the draft financial statements, and you recorded notes summarising important
transactions and events affecting the key account headings.
2006 2005
Notes R000 R000
Non-current assets
Current assets
1
2
21 000
12 000
21 000
6 000
Total assets 33 000 27 000
Share capital
Accumulated loss
Interest-bearing liabilities
Non-interest-bearing liabilities
3
4
5
5
22 000
(26 000)
16 000
21 000
20 000
(9 000)
10 000
6 000
Equity and liabilities 33 000 27 000
Notes
1 (a) In April 2005, AdWise sold its office buildings to Gracie Headblock Properties Ltd,
a property development company owned by Abraham Headblocks wife. The
properties were sold for their book value of R14 million against a market value of
R16 million. The proceeds from the sale were used to expand the companys
operations.
(b) The increase in non-current assets, notwithstanding the sale of the properties,
resulted from significant payments to local authorities and other property owners
in order to secure the rights to place billboards. Various cash payments totalling
R4 million, described as incentives, are also included in non-current assets.
These payments were apparently made to councillors employed by various local
authorities. All of these payments were approved by Abraham Headblock and
Richard Minddump.
2 Current assets have increased because of increased business activity but also
because of advances to graphic designers for new concepts to be used on billboards.
3 In April 2005, Gracie Headblock subscribed for shares valued at R2 million in AdWise.
Both you and the directors are satisfied that
AdWise has sufficient authorised share capital;
R2 million represents fair value; and
the issue of these shares was properly approved and recorded by AdWise.
4 AdWise incurred a loss of R17 million as a result of start-up costs and increased
overheads of the expansion programme and the implementation of the Polewise
campaign. These cost increases were not fully covered by the increases in the
revenue and margins.
8
5 The interest-bearing liabilities represent overdrafts and revolving credit facilities. In
order to sustain its cash flows, AdWise followed a policy of delaying payments to
suppliers, increasing non-interest-bearing liabilities. In spite of this, the company had
exceeded its banking facilities and so had difficulty in meeting its salary commitments
at the end of February 2006. A number of February 2006 cheques were also
returned marked Refer to drawer.
REQUIRED Marks
(a) Discuss the appropriate accounting treatment for the revenue arising from the
once-off fee and the monthly maintenance fee to Polewise clients. Confine
your answer to the once-off fee and the monthly maintenance fee.
8
(b) Describe the substantive audit procedures that you would perform to
determine whether revenue from the once-off fees and the monthly
maintenance fees is accurately recorded in the appropriate accounting period.
Ignore VAT and other tax implications.
12
(c) With regard to the fraud identified at AdWise
(i) prepare a table in which you
identify the weaknesses in the internal control system for accounts
payable and EFT payments that permitted the senior employee to commit
the fraud reported by the internal auditors; and
for each of the weaknesses identified above, describe the internal controls
that should have been implemented by AdWise to prevent or detect the
fraud;
4
16
(ii) explain the responsibilities of the external auditors concerning the
detection and reporting of weaknesses in a system of internal control; and
7
(iii) discuss the specific adjustments you would make to your audit plan in
response to the risk resulting from the controls identified in (c)(i) not
operating effectively during the period.
8
(d) With regard to your notes on the companys financial position and the actions
of the directors, discuss all issues concerning professional ethics and the
Companies Act that should have been considered by the directors of AdWise.
Exclude from your answer the matters relating to the share issue already
considered by the directors, as listed in note 3 of the financial position
summary.
20
TOTAL MARKS 75
Offcanvas menu