Limited-Use Financial Statements Should Not Limit Audit Work

The situation

The 2004 financial statements of ABC Mortgage Corporation, a provincially regulated mortgage broker, came under the scrutiny of its provincial regulator late that same year. As the result of a subsequent investigation, ABC had to make various changes to its financial statements, and its auditors were reported to the PCEC.

ABC hired John* and his mid-sized firm as its new auditors for 2005. The 2005 audited financial statements were issued and filed with the regulator in due course.

While investigating the work done by ABC's previous auditors, the PCEC reviewed the company's 2005 financial statements and found enough cause for concern about disclosure that it decided to recommend a separate investigation-this one involving John.

What happened

In planning the 2005 audit, John had reviewed the correspondence between the regulator and ABC, which outlined the issues raised and the corrective action required.

It seemed the regulator was mainly concerned about investment guarantees. ABC had apparently been providing "handshake guarantees" to investors, assuring them-in contravention of securities legislation-that they would not lose money.

While ABC agreed to cease this practice immediately, there were still guarantees outstanding on existing mortgages during 2005. Moreover, there was no note disclosure in the 2005 financial statements concerning the contingencies that could arise as the result of any guarantees.

John told the PCEC he was not aware of any "written" guarantees between ABC and its investors and, therefore, did not believe note disclosure was necessary. The extent of his audit work in this area was to obtain management's representations that there were no outstanding claims or contingent liabilities.

The regulator's second major concern was that the company's 2004 financial statements reflected mortgages receivable and payable as assets and liabilities, respectively, of the company, when, in fact, title to both rested with ABC's lenders and borrowers. Moreover, without these assets and liabilities, ABC was offside on its working capital requirements in 2004, breaking a condition of its registration.

ABC's 2005 balance sheet properly excluded the mortgages receivable and payable. The comparative figures were also reclassified to conform to the current year's presentation. However, there was no note disclosure to describe the material error or to explain the effect of correcting this error on the current and prior-period financial statements, as required by CICA Handbook Section 1506.30.

John agreed with the PCEC that the change in accounting treatment constituted the correction of an error, but argued that specific note disclosure was not necessary because correcting this error had not had an impact on earnings, shareholder's equity, or retained earnings and, in his professional judgment, the only users of the financial statements were ABC and the regulator, both of which were already aware of the error.

The PCEC disagreed, stating that financial statements should be prepared in accordance with GAAP even when the number of users is limited, and that investors could very well be users of ABC's financial statements as well, given the company's practice of providing guarantees on its mortgages.

During the PCEC investigation into the 2004 audit, the former auditor said he had never been contacted to discuss the restatement of the financial statements. John told the PCEC he had left his predecessor a voice mail message. The PCEC determined that this was inadequate communication considering the material adjustment made to the client's accounts.

The outcome

The PCEC concluded that John had breached Rule 202 (Due Care) and Rule 206 (Compliance with Professional Standards), citing inadequate disclosure in the financial statements in two respects: the contingency note on the mortgage guarantees and the correction of an error note with regard to the elimination of material assets and liabilities. John had failed to recognize these departures from GAAP and had made no recommendations to his client-nor had he qualified his audit opinion.

In addition, the PCEC determined that John had breached Rule 201.1 (Maintenance of the Reputation of the Profession) in failing to properly consult with the former accountant. Note: It is professional courtesy to obtain full information from the previous accountant where such an error is found; readers can refer to Council Interpretation 201.1/5-8 for more on this issue.

John was given an anonymous reprimand and was required to pay a fine and the costs of the investigation.

The message

By taking on a new client that had just been investigated by its regulator, John had taken on a high audit risk-one to which he should have paid more heed. Furthermore, he should have known that limited users do not reduce the need for proper financial statement disclosure in an audit. His professional judgment had been lacking.

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

[Sidebar]

Auditing in a regulated industry?

Carefully consider the regulator's concerns!

[Sidebar]

* Please note: This fictionalized account is based loosely on an actual case before the PCEC (Professional Conduct Enquiry Committee). Names and circumstances have been changed to preserve anonymity. The contents of this article are only intended for the general guidance of readers. The PCEC deals with each case individually, based on its specific facts and circumstances.

[Author Affiliation]

By Chris Utley, CA, Director of Ethics