You are the audit senior of Ball Construction Corporation (BC), a small public company that enters into construction contracts with individuals and developers and builds to their specifications. BC is a Canadian company, but recently opened a branch in the southwestern United States.
It is September and the audit fieldwork for this year's audit engagement has just been completed. You are in the process of finalizing the audit file. The following is documented in the audit file:
Risk Assessment
Although BC's audit is recurring and we are familiar with its operations and systems, we determined that the audit risk for this year has increased from medium to high. There are three main reasons for the change:
• Recent declines and instability in the U.S. housing market have created a high credit-risk situation.
• BC's controller left in March 2012, and the position had not been filled by year end.
• The bank increased the interest rate on the company's operating line during the year, suggesting that it views BC as a higher risk than before.
Audit Approach
No information systems issues were noted in prior years. While we identified isolated control weaknesses in this year's review of the systems, overall the controls appear reliable. We will use a combined approach, and, because of the increased risk, we will increase the amount of substantive work.
Materiality
Planning materiality was set at $242,000.
1. Internal control
(a) When the controller left, the finance department staff took on additional duties. We noted that during the latter part of the year, the same individual was creating purchase orders, entering invoices into the system, and preparing the cheque runs. The CFO said the situation was unavoidable, and noted that the accounting manager reviewed the cheque runs and prepared the bank reconciliations.
(b) We noted that many journal entries had not been approved. The CFO said that he trained most of the employees responsible for the entries, so he knows what the entries are for. He also said, "Our management review of reports and financial statements would uncover any incorrect entries."
(c) The CFO relies on senior management to review, approve, and sign reports generated by the finance department, such as the "Costing Report by Project." Testing of a sample of reports indicated that most reports had been appropriately approved. However, some reports were found on a construction manager's desk. When asked about them, she explained, "I'm so busy managing the jobs that.
I have that I haven't had time yet to look them over." The signed reports were given to the audit team the next day and the audit testing was completed.
2. Accounts receivable and allowance for doubtful accounts.
We sent confirmations to a sample of accounts receivable and noted the following issues based on the responses received:
• One confirmation was returned stating that a receivable balance, related to a $1,542,000 contract, was overstated based on the progress report. Upon examination of the relevant report, we noted that a transposition error had occurred (86% completion was used when it should have been 68%). This represents a known error of $277,560. The CFO agreed that it was an error, but was satisfied that this was an isolated issue and would normally have been caught by the supervisor's review. The CFO does not want to adjust for this error.
• The CFO was quite adamant that no adjustments be made to the financial statements, declaring that "the statements fairly and accurately represent the financial situation of BC."
Required
(a) What type of audit report should be prepared, assuming the CFO does not change his position? Discuss.
(b) Prepare the draft management letter.