CD Sales plc was a growth orientated entity that was dominated by its managing director, Mr A Long. The entity sold quality music systems direct to the public. A large number of sales persons were employed on a commission only basis. The music systems were sent to the sales agents who then sold them direct to the public using telephone sales techniques. The music systems were supplied to the sales agents on a sale or return basis and CD Sales plc recognised the sale of the equipment when it was received by the sales agents. Any returns of the music systems were treated as re-purchases in the period concerned.
The entity enjoyed a tremendous growth record. The main reasons for this apparent expansion were as follows:
(a) Mr A Long falsified the sales records. He created several fictitious sales agents who were responsible for 25% of the annual turnover.
(b) at the year end, Mr Long despatched nearly all of his stock of music systems to the sales agents and re- purchased those that they wished to return after the year end.
(c) 20% of the cost of sales were capitalised. This was achieved by the falsification of purchase invoices with the co-operation of a supplier. Suppliers furnished CD Sales with invoices for tangible non-current assets but supplied music systems.
(d) the directors of the entity enjoyed a bonus plan linked to reported profits. Executives could earn bonuses ranging from 50% to 75% of their basic salaries. The directors did not query the unusually rapid growth of the entity, and were unaware of the fraud perpetrated by Mr A Long.
Mr A Long spent large sums of money in creating false records and paying accomplices in order to conceal the fraud from the auditors. He insisted that the auditor should sign a ‘confidentiality' agreement which effectively prevented the auditor from confirming sales with independent third parties, and from examining the service contracts of the directors. This agreement had the effect of preventing the auditors from discussing the affairs of the entity with the sales agents. The fraud was discovered when a disgruntled director wrote an anonymous letter to the Stock Exchange concerning the reasons for CD Sales plc's growth. The auditors were subsequently sued by a major bank that had granted a loan to CD Sales plc on the basis of interim financial statements. These financial statements had been reviewed by the auditors and a review report issued.
(a) Explain the key audit tests which would normally ensure that such a fraud as that carried out by Mr A Long would be detected.
(b) Discuss the implications of the signing of the ‘confidentiality' agreement by the auditors.
(c) Explain how the ‘review report' issued by the auditors on the interim financial statements differs in terms of its level of assurance from the auditors' report on the year end financial statements.
(d) Discuss whether you feel that the auditors are guilty of professional negligence in not detecting the fraud.