QUESTION
You are the senior in charge of the audit of AdWise Ltd (AdWise), a company listed on the JSE Ltd and you are presently engaged on the audit for the 31 January 2006 year end. AdWise specialises in the placement and maintenance of advertising billboards. AdWise owns the billboards, which are generally placed on private land, sports grounds and land owned by local authorities. Historically, the company has had two main sources of revenue:
• Fees for the design and printing or construction of the advertising media for the billboards. This work is generally quoted for and invoiced on completion of the work.
• Monthly maintenance and advertising fees charged to clients for the advertisements placed on the billboards.
AdWise has been struggling to achieve revenue growth and profitability over the past few years and the company's share price at the start of the 2006 financial year was at an all time low.
New Managing Director
In February 2005, AdWise engaged Abraham Headblock, a noted 'turnaround specialist' as its new Managing Director, notwithstanding the fact that he is an unrehabilitated insolvent, having been sequestrated in 2004 after the collapse of Jackbled Ltd. He assumed all of the responsibilities of Chief Executive Officer, whilst Richard Minddump, a Chartered Accountant (South Africa), was appointed as the company's Financial Director.
PoleWise campaign
In May 2005, at the instigation of Abraham Headblock, the company embarked on an ambitious expansion programme. This included the introduction of a new form of billboard advertising, which places smaller billboards on lampposts along arterial roads in South Africa's major cities. This campaign, called 'PoleWise', targets smaller, local businesses. AdWise has entered into contracts with the relevant local authorities for the placement of the billboards.
AdWise introduced a new form of contract for PoleWise clients because of perceived risks related to smaller businesses. These contracts contain amongst others the following terms:
• At the commencement of the contract PoleWise clients pay a once-off fee for the right to advertise for a three-year period in the PoleWise campaign. AdWise has also entered into an agreement with a major bank, in terms of which the bank will provide finance for this payment to approved clients. There is no recourse against AdWise in terms of this agreement. The amounts charged by AdWise for the right to advertise have been evaluated and represent the fair value of the revenue streams.
• PoleWise clients pay monthly maintenance fees in advance to AdWise. You are aware that AdWise prepares detailed estimates of the maintenance costs for each contract in order to ensure that a reasonable profit is generated. Maintenance costs are not incurred evenly over the period of the contract.
• PoleWise clients are also charged for the design and set-up of their billboards and, as is the case with the established clients, are invoiced separately for this work on its completion.
While the Polewise campaign significantly increased revenue, high start up costs resulted in increased operating losses for 2006.
In view of the company's profit history and its current financial position (see page 7), you consider that there is a significant risk that AdWise management may have deliberately overstated the company's profitability by prematurely recognising revenue from the PoleWise campaign.
You have already documented the system of internal control over the recording of revenue and have satisfactorily tested controls over -
• the day-to-day recording of amounts invoiced to clients;
• the recording of receipts from clients;
• the maintenance of the accounts receivable records; and
• the integrity and mathematical accuracy of related reports and schedules.
Management has provided written representations about the appropriateness of revenue.
These audit procedures enabled you to conclude satisfactorily on all aspects of revenue and accounts receivable, except for the accuracy and cut-off assertions in respect of revenue and the valuation and allocation assertion in respect of deferred revenue reflected on the balance sheet.
Fraud at AdWise
AdWise makes use of a fully integrated accounting package, which incorporates an accounts payable module. The company makes payments using an electronic funds transfer facility provided by its bankers. The following are some of the features of the accounts payable and settlement processes:
• The system generates recommended purchase orders based on a system of purchase requisitions. The recommended purchase orders identify preferred suppliers, the quantities to be ordered and the most recent cost price. The orders are then reviewed by the buyers and amended where necessary and approved on-line. Approved orders are sent electronically to suppliers.
• Details of goods and services received are captured on the system and matched against the orders. The system then generates goods received advices.
• Invoices received from suppliers are matched against the orders and goods received advices.
• At the end of each month, the system accesses the transaction details pertaining to each supplier and the relevant credit terms.
• The system then calculates the amount payable to each supplier.
• The amounts payable and the suppliers' banking details are transmitted electronically to the company's bankers. Payment is effected by means of the Electronic Funds Transfer (EFT) system.
The internal audit department of AdWise recently detected a fraud amounting to R1,5 million. A senior employee in the accounts payable department, acting alone, was able to create a number of fictitious suppliers' accounts and to process journal adjustments to these accounts. This enabled the employee to transfer funds to bank accounts operated in the names of the fictitious suppliers.
The Managing Director of AdWise has expressed concern about the fact that the external auditors failed to report the control weaknesses that made the fraud possible.
Financial position
You obtained the following summary of the company's financial position at 31 January 2006, as reflected in the draft financial statements, and you recorded notes summarising important transactions and events affecting the key account headings.
2006 2005
Notes R'000 R'000
Non-current assets
Current assets
1
2
21 000
12 000
21 000
6 000
Total assets 33 000 27 000
Share capital
Accumulated loss
Interest-bearing liabilities
Non-interest-bearing liabilities
3
4
5
5
22 000
(26 000)
16 000
21 000
20 000
(9 000)
10 000
6 000
Equity and liabilities 33 000 27 000
Notes
1 (a) In April 2005, AdWise sold its office buildings to Gracie Headblock Properties Ltd, a property development company owned by Abraham Headblock's wife. The properties were sold for their book value of R14 million against a market value of R16 million. The proceeds from the sale were used to expand the company's operations.
(b) The increase in non-current assets, notwithstanding the sale of the properties, resulted from significant payments to local authorities and other property owners in order to secure the rights to place billboards. Various cash payments totalling R4 million, described as 'incentives', are also included in non-current assets.
These payments were apparently made to councillors employed by various local authorities. All of these payments were approved by Abraham Headblock and Richard Minddump.
2 Current assets have increased because of increased business activity but also because of advances to graphic designers for new concepts to be used on billboards.
3 In April 2005, Gracie Headblock subscribed for shares valued at R2 million in AdWise.
Both you and the directors are satisfied that -
• AdWise has sufficient authorised share capital;
• R2 million represents fair value; and
• the issue of these shares was properly approved and recorded by AdWise.
4 AdWise incurred a loss of R17 million as a result of start-up costs and increased overheads of the expansion programme and the implementation of the Polewise campaign. These cost increases were not fully covered by the increases in the revenue and margins.
5 The interest-bearing liabilities represent overdrafts and revolving credit facilities. In order to sustain its cash flows, AdWise followed a policy of delaying payments to suppliers, increasing non-interest-bearing liabilities. In spite of this, the company had exceeded its banking facilities and so had difficulty in meeting its salary commitments at the end of February 2006. A number of February 2006 cheques were also returned marked "Refer to drawer".
REQUIRED Marks
(a) Discuss the appropriate accounting treatment for the revenue arising from the once-off fee and the monthly maintenance fee to Polewise clients. Confine your answer to the once-off fee and the monthly maintenance fee.
(b) Describe the substantive audit procedures that you would perform to determine whether revenue from the once-off fees and the monthly maintenance fees is accurately recorded in the appropriate accounting period.
Ignore VAT and other tax implications.
(c) With regard to the fraud identified at AdWise -
(i) prepare a table in which you -
• identify the weaknesses in the internal control system for accounts payable and EFT payments that permitted the senior employee to commit the fraud reported by the internal auditors; and
• for each of the weaknesses identified above, describe the internal controls that should have been implemented by AdWise to prevent or detect the fraud;
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(ii) explain the responsibilities of the external auditors concerning the detection and reporting of weaknesses in a system of internal control; and
(iii) discuss the specific adjustments you would make to your audit plan in response to the risk resulting from the controls identified in (c)(i) not operating effectively during the period.
(d) With regard to your notes on the company's financial position and the actions of the directors, discuss all issues concerning professional ethics and the Companies Act that should have been considered by the directors of AdWise.
Exclude from your answer the matters relating to the share issue already considered by the directors, as listed in note 3 of the financial position summary.