Reference no: EM132622174

Question - East Factory is a company operating in the manufacturing industry and is led by its managing director, Mr Leong. The company had enjoyed a rapid growth in the previous year due to the following reasons:

a) Mr Leong had been falsifying the sales records of the company by creating several fictitious sales agents who were responsible for 30% of the company's revenue.

b) 25% of the cost of sales was capitalized by falsification of purchase invoices with the co-operation of the supplier companies.

c) The directors of the company were rewarded lucrative bonus plans linked to the reported profits. Hence the directors did not query the abnormal rapid growth of the company and were unaware of the fraud committed by Mr Leong.

Mr Leong spent large sums of money in creating false records and bribing accomplices in order to conceal the fraud from auditors. He insisted that the auditor should sign a "confidentiality" agreement which effectively precluded the auditors 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 an unsatisfied director wrote an anonymous letter to the Stock Exchange concerning the reasons for East Factory's growth. The auditors were subsequently sued by a major bank that had granted a loan to East Factory on the basis of interim accounts. These accounts had been reviewed by the auditor and a review report was issued. (August 2019)

Required -

a) Discuss whether the auditors are guilty of professional negligence in not detecting the fraud.

b) Explain how can an audit firm minimize its potential for paying damages in cases involving torts?