ACC 421 Module 8 Audit Reporting Assignment Example

Except For: Evaluating Misstatements and Drafting a Qualified Opinion for a Composite Linen Rental Company

[Student Name]

Southern New Hampshire University

ACC 421: Auditing and Forensic Accounting

Module Eight Assignment

[Instructor Name]

[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

Except For: Evaluating Misstatements and Drafting a Qualified Opinion for a Composite Linen Rental Company

Introduction

Fieldwork at the linen rental company is complete, and the engagement partner must decide what the auditor's report will say. Three matters require evaluation: the fictitious vendor payments investigated in the forensic project, a related insurance claim, and a disagreement with management about how long rental garments last. Each is evaluated against overall materiality of $260,000 and qualitative factors, and the resulting opinion, the paragraphs that support it and the required communications are set out below (American Institute of Certified Public Accountants, 2019).

The Fictitious Vendor Loss

The current year includes $138,900 of payments to the fictitious vendor, recorded as repair and maintenance expense. Profit was not inflated, since the money left the company and hit expense, but the classification was wrong and the nature of the loss was not disclosed. Management agreed to reclassify the amount as a loss from employee theft and to disclose the scheme, its total of $288,400 over two years and the remedial steps taken. Because the correction was made, no misstatement remains, and the matter does not affect the opinion. It remains highly significant in two other ways: it reveals a material weakness in internal control over payments, and it requires the auditor to consider whether any member of management was involved, which the forensic work did not indicate.

The Insurance Claim

The company has filed a claim under its employee dishonesty policy, which covers up to $250,000 per occurrence after a $5,000 deductible. The insurer has acknowledged the claim but not accepted it. A recovery is recognized only when it is probable, and at this point it is not, so the claim is disclosed in the notes but no receivable is recorded. Management initially wanted to record the recovery to offset the loss; it agreed to disclosure after discussion.

The Garment Amortization Disagreement

During the year management lengthened the service life used to write down rented garments from four to five years, which reduced amortization expense. The audit team compared the new life with the company's own replacement records, which show that garments are replaced on average after 3.8 years because of wear, staining and losses at customer sites. The evidence does not support five years. At four years, amortization expense would be $420,000 higher and inventory $420,000 lower. Management declined to change the estimate, stating that improved laundry chemistry will extend garment life, but it provided no data to support that expectation.

Table 1. Summary of Uncorrected Misstatements

Material and Pervasive?

The $420,000 overstatement is material: it exceeds overall materiality by more than half, represents about 12 percent of pretax income and would move the debt service coverage ratio closer to the covenant limit, a matter the bank cares about. It is not pervasive, however. It affects one asset account, one expense line and the related totals, it can be described precisely, and users can adjust for it from the auditor's report. The statements as a whole are not rendered misleading. Under the reporting standards, that combination, significant in size yet contained to one area, leads to an except-for qualification rather than an adverse opinion (Arens et al., 2020).

Draft Report Language

Qualified opinion. The opinion paragraph will follow the standard form: apart from the effects of the garment matter described in the basis paragraph, the balance sheet, income, and cash flows shown for the year are, in all material respects, fairly stated under U.S. GAAP.

Basis for qualified opinion. The Company amortizes its rental garments over an estimated service life of five years. Based on the Company's replacement history, an estimated life of four years would be consistent with accounting principles generally accepted in the United States of America. Had a four-year life been used, inventory of rental garments would have been decreased by $420,000, and net income would have been decreased by $315,000, after related income tax effects, as of and for the year ended December 31.

Why Not an Adverse Opinion or a Clean One?

An unmodified opinion is not available because the misstatement is material and uncorrected; issuing one would tell the bank that the statements are fairly presented when the auditor's own evidence says otherwise. An adverse opinion would overstate the problem. It would signal that nothing in the report deserves trust, when in fact every other account was audited without exception and the single problem can be quantified in two lines. The qualified opinion gives users exactly what they need: confidence in the statements overall, and a precise adjustment for the one disputed estimate. It also leaves the door open for management to correct the estimate and receive an unmodified opinion on the corrected statements, which the partner will encourage before the report is released.

Going Concern and Other Communications

The auditor must also evaluate whether the company can be expected to keep operating for a reasonable period, the going concern question. Carson et al. (2013) note that going concern judgments are among the most consequential an auditor makes and that both missed and unnecessary warnings carry costs. Here, even after the adjustment the company disputes, operating cash flow covers debt service, and the bank has indicated it will waive any technical covenant effect, so no going concern paragraph is needed. Separately from the report, the auditor will communicate in writing to the owner, as the person charged with governance, the material weakness in payables controls that allowed one employee to set up and pay a vendor, along with the significant deficiency in the nightly cash reconciliation found in Module Three.

Conclusion

The fictitious vendor loss has been corrected and disclosed and does not affect the opinion; the insurance recovery is disclosed but not recognized. The $420,000 overstatement from an unsupported garment life is material but not pervasive, so the auditor will issue a qualified opinion with a basis paragraph quantifying its effect. No going concern doubt exists, and the control deficiencies will be communicated in writing.

References

American Institute of Certified Public Accountants. (2019). Auditor reporting and amendments, including amendments addressing disclosures in the audit of financial statements (Statement on Auditing Standards No. 134). Author.

Arens, A. A., Elder, R. J., Beasley, M. S., & Hogan, C. E. (2020). Auditing and assurance services (17th ed.). Pearson.

Carson, E., Fargher, N. L., Geiger, M. A., Lennox, C. S., Raghunandan, K., & Willekens, M. (2013). Audit reporting for going-concern uncertainty: A research synthesis. Auditing: A Journal of Practice & Theory, 32(Suppl. 1), 353-384. https://doi.org/10.2308/ajpt-50324