Mobile Sales

Mobile Sales, a limited liability company, was a growth orientated company that was dominated by its managing director, Mr A Long. The company sold modern mobile 'smartphones' direct to the public. A large number of sales persons were employed on a commission only basis. The mobile phones were sent to the sales agents who then sold them direct to the public using telephone sales techniques. The mobile phones were supplied to the sales agents on a sale or return basis and Mobile Sales recognised the sale of the equipment when it was received by the sales agents. Any returns of the mobile phones were treated as re-purchases in the period concerned.

The company enjoyed a tremendous growth record. The main reasons for this apparent expansion were:

(1) Mr A Long falsified the sales records. He created several fictitious sales agents who were responsible for 25% of the company's revenue.

(2) At the year end, Mr Long despatched nearly all of his inventories of mobile phones to the sales agents and re-purchased those that they wished to return after the year end.

(3) 20% of the cost of sales were capitalised. This was achieved by the falsification of purchase invoices with the co-operation of the supplier company. Suppliers furnished the company with invoices for non-current assets but supplied music systems.

(4) The directors of the company 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 company, and were unaware of the fraud perpetrated by Mr A Long.

Mr A Long spent large sums of money in creating false records and bribing accomplices in order to conceal the fraud from the auditor. He insisted that the auditor should sign a 'confidentiality' agreement which effectively precluded the auditor from corroborating sales with independent third parties, and from examining the service contracts of the directors. This agreement had the effect of preventing the auditor from discussing the affairs of the company with the sales agents.

The fraud was discovered when a disgruntled director wrote an anonymous letter to the Stock Exchange concerning the reasons for Mobile Sales's growth. The auditor was subsequently sued by a major bank that had granted a loan to Mobile Sales on the basis of interim financial statements. These financial statements had been reviewed by the auditor and a review report issued.

Required

a) Explain the key audit tests which would normally ensure that such a fraud as that perpetrated by Mr A Long would be detected.

b) Discuss the implications of the signing of the 'confidentiality' agreement by the auditor.

c) Explain how the 'review report' issued by the auditor on the interim financial statements differs in terms of its level of assurance from the auditor's report on the year end financial statements.

d) Discuss where you feel that the auditor is guilty of professional negligence in not detecting the fraud.