Your firm has recently been appointed as external auditor to EWheels. EWheels is a private dot.

com company that operates an internet auction service for the sale of used motor vehicles. You are planning the audit of the financial statements. The company has been in existence for four years and has grown rapidly. It was founded by three individuals who are a former car auctioneer, an internet specialist with an interest in cars, and an accountant. The company now has three offices and some 100 employees. The on-line car auction market is very competitive. The company is the biggest provider of the service in the south of the country, but the directors have ambitious plans which include an aggressive marketing campaign, the take-over of a number of target competitors and additional office space and staff, all of which will require considerable additional finance. The company is financed partly by private capital brought in by the three founders, and partly by bank loans. The three founders were all directors, but the accountant resigned six months ago and has commenced a legal action against the company for a considerable amount of money, claiming that he has effectively been excluded from management by the other two directors. The companys statement of financial position shows net liabilities. The company has not yet made a profit although preliminary figures indicate that it has reached break-even point in the current year. Your firm has discovered that the previous auditors were not re-appointed because they refused to issue an unmodified audit opinion on the previous years financial statements, and instead made reference to the going concern status of the company in their audit report. Your firm has made it clear to the directors that it may be necessary to make reference to the going concern status of the company again in the current year, but they have indicated that they would prefer an unmodified report if at all possible. You are also aware that loan facilities for this type of company are becoming more scarce, as there are too many companies seeking such finance. The director who resigned six months ago was responsible for the day to day accounting function and for the preparation of the financial and management accounts. The company has been unsuccessful in recruiting a permanent replacement and has used a number of temporary accountants. Your initial investigations have highlighted a number of weak-nesses in the operation of the accounting and internal control systems. Required: (a) Explain your understanding of audit risk. (4 marks) (b) Describe the risks associated with the audit of EWheels. (7 marks) (c) List the enquiries you will make and the procedures you will perform in deciding whether to make reference to the going concern status of Ewheels in your audit report on the financial statements.

(5 marks) (d) Describe the different ways in which your audit report might refer to the going concern status of the company. (4 marks) Audit risk (i) Audit risk is the product of inherent risk, control risk and detection risk. Audit risk is established by the auditor and the nature and extent of testing in a particular audit are determined by an assessment of the other elements of risk. (ii) Inherent risk is the risk that material errors will occur both at the entity level, and at the level of individual transactions and balances. Certain account balances and certain entities are more inherently risky than others. For example, inventory is more inherently risky than cash, volatile businesses are more inherently risky than stable businesses. (iii) Control risk is the risk that internal controls will not prevent or detect material errors, both at the entity level, and at the level of individual transactions and balances. (iv) Detection risk is the risk that auditors will fail to detect material errors (due to human error or sampling risk, for example). (b) Risks associated with the audit (i) In the case of EWheels, the level of inherent risk, control risk and detection risk all appear to be higher than normal. (ii) EWheels is in a volatile sector of the economy. It has grown rapidly and is planning further expansion which will require additional resources. There is a real risk of over-trading, i.e. that the business will exhaust its cash resources too soon as a result of rapid growth. In such circumstances, there is a risk that creditors will go unpaid and that the business will be forced into liquidation. This is risky for both the directors and for the auditors. (iii) In a highly competitive sector, there is a possibility that the company itself will be vulnerable to take-over, particularly if it is in a weak financial position which it appears to be with net liabilities. The dispute between the exdirector and the current directors means that the current directors do not have overall control of the company. It is particularly important in take-over situations for auditors to be cautious in the audit opinion they give. (iv) The overall control environment at EWheels is weak. There has been no proper control of the accounting function for six months and errors are appearing as a result. This may mean that the accounting records are unreliable and the financial statements may be materially misstated. (v) The attitude of the directors (which is relevant to the overall control environment) is suspect, they have indicated that they would prefer an unmodified opinion in circumstances which may warrant a modified opinion. They also appear to be overly ambitious in their expansion plans.

(vi) EWheels is suffering from financial pressures; it wishes to expand but additional resources are needed and they are becoming scarcer, loan finance may become more expensive. The ex-director is claiming a substantial amount of money from the company. It may be preferable for the company to seek further equity finance or to delay the expansion plans. (vii) The audit is also risky for the firm because this is the first year of audit (and mistakes are therefore more likely to be made) and because there is pressure to issue an unmodified opinion. It will be important for the firm to ensure that adequate time and resources are allocated to what is likely to be a difficult audit. Any pressure by the directors to complete the audit quickly should be resisted. (c) Reference to going concern status (i) It will be necessary to review the overall financing position of the company in detail. This will involve examining budgets and cash flow forecasts, and performance against budgets and cash flow forecasts. If this information is not available for whatever reason, it will probably be necessary for the directors to produce it.

(ii) The relationship between the company and its bankers should be investigated thoroughly, because if the relationship is poor, additional finance is unlikely to be forthcoming. (iii) It is likely that financial information will be sent to the bank on a regular basis and this should be inspected. It will be necessary to inspect correspondence with the bank and possibly for the auditors to make their own enquiries of the bank, although banks do not normally provide much information to auditors in this context. (iv) Enquiries should be made of directors about that availability of additional equity and other finance which will be necessary for the planned expansion. All statements in this respect should be corroborated and supported by documentation. (v) Enquiries should be made of the companys lawyers as to the nature and likely outcome of the dispute with the ex-director. It will be necessary to make either a provision or disclosure in the financial statements unless it is very unlikely that any amount will be payable to him.

(d) Audit reports (i) The audit report would probably be modified by means of the inclusion of an emphasis of matter paragraph, highlighting the problem. This would only be possible however, if the matter were adequately disclosed in the financial statements. (ii) If the matter were not adequately disclosed in the financial statements, it might be necessary to issue an except for opinion, because the auditor would conclude that the financial statements were not free from material misstatement. (iii) An adverse opinion stating that the financial statements do not fairly present the position at all because of the lack of disclosure might be necessary if the auditors considered the matter to be pervasive to the financial statements as a whole. (iv) In extreme circumstances, where it was clear that the company was not a going concern, and the financial statements were still prepared on a going concern basis, it would probably be necessary to issue an adverse opinion.