5-17: The following are five independent situations. Joanie Brogan is a partner in an audit firm that operates as a limited liability partnership (LLP). The firm has been sued for an alleged audit fai

5-17: The following are five independent situations.

1. Joanie Brogan is a partner in an audit firm that operates as a limited liability partnership (LLP). The firm has been sued for an alleged audit failure related to an audit engagement handled by a different partner in the firm.  While Brogan had no involvement in the engagement, she is concerned that the plaintiff may successfully sue her seeking restitution from her  personal assets.
2. A lawsuit has been filed against Carter Hockaday, CPA, charging him with  constructive fraud in the audit of Broughton Company’s financial  statements. Hockaday has examined all the audit documentation in his files and reviewed all relevant auditing standards. He is convinced that his  audit fully complies with standards of the profession but is uncertain  what he should use as his primary defense tactic.
3. West Camera Co. filed for bankruptcy in January 2015. A recent blog suggested  that West’s external auditors should be sued for failing to include a  going concern explanatory paragraph in the firm’s opinion on the financial      statements issued before the bankruptcy, even though the fair presentation  of the financial statements is not being disputed.
4. The audit firm Weaver and Jones, LLP, received a subpoena for its documentation related to the audit of Westbrook Corporation’s financial  statements. The firm has refused to respond, alleging that the documentation is considered privileged communication between the firm and  its client.
5. Spencer Cullen, CPA, is a defendant in a lawsuit alleging that Cullen should be held legally liable for gross negligence for a fraud involving the  valuation of securities included in the financial statements of one of his      clients. Cullen was uncertain how to establish a correct valuation for the  securities and decided to rely on the price estimation supplied by management.

Required:

Analyze each situation and provide your assessment of the potential resolution of each scenario, including potential liability for the auditor or audit firm involved.

5-19: The following independent scenarios describe auditor behavior on an audit engagement.

1. Chad Lewis is the lead audit partner on the audit engagement of a publicly traded company. Chad followed auditing standards on the audit engagement and issued an unmodified opinion. It was subsequently discovered that the financial statements contained a material misstatement that had been undetected by the management of the company and by the audit team.

2. Maria Marquez, CPA, is a sole proprietor. She recently accepted a new audit client who was applying for a bank loan and needed to present audited financial statements to the bank. Maria was not able to complete the audit engagement by herself, so she hired several college students to assist her. The students completed the audit procedures without much guidance, and Maria issued an unmodified opinion on the client’s financial statements.

3. On a recent audit engagement, the client firm neglected to inform the audit firm that a significant percentage of inventory was stored at an outside warehouse. As a result, the auditors did not observe the physical inventory count for that inventory, which represented 20% of the client’s inventory balance. The auditors were able to satisfy themselves that the inventory existed through alternative procedures, and issued an unmodified opinion on the financial statements as a whole.

4. The audit engagement partner, Marc Johnson, recently received a subpoena for workpapers related to an audit engagement on which his audit firm has been named as a defendant. Marc asked the staff auditor to remove and discard two memos from the workpaper files documenting communication between the engagement partner and the CFO regarding the goodwill impairment analysis.

5. Melissa Louis is the lead engagement partner on a publicly traded company. The company’s CEO recently approached Melissa and informed her that they had identified a material misstatement in the prior year’s financial statements, which had been audited by Melissa’s firm and submitted to the SEC. The CEO suggested they correct the misstatement by recording a journal entry in the current year for half of the amount of the misstatement, and in the following year for the remaining half. Melissa agreed to this plan to avoid a public announcement of a restatement and a potential lawsuit, since the amount of the journal entries recorded in the current and subsequent years would be considered immaterial to the financial statements.

Required:

For each of the scenarios listed above, discuss whether the auditor’s behavior would be considered nonnegligence, ordinary negligence, gross negligence, constructive fraud, fraud, or criminal behavior.

5-23: In order to expand its operations, Barton Corp. raised $5 million in a public offering of common stock, and also negotiated a $2 million loan from First National Bank. In connection with this financing, Barton engaged Hanover & Co., CPAs, to audit Barton’s financial statements. Hanover knew that the sole purpose of the audit was so that Barton would have audited financial statements to provide to First National Bank and the purchasers of the common stock. Although Hanover conducted the audit in conformity with its audit program, Hanover failed to detect material acts of embezzlement committed by Barton Corp.’s president. Hanover did not detect the embezzlement because of its inadvertent failure to exercise due care in designing the audit program for this engagement.

After completing the engagement, Hanover issued an unmodified opinion on Barton’s financial statements. The financial statements were relied upon by the purchasers of the common stock in deciding to purchase the shares. In addition, First National Bank approved the loan to Barton based on the audited financial statements. Within sixty days after the sale of the common stock and the issuance of the loan, Barton was involuntarily petitioned into bankruptcy. Because of the president’s embezzlement, Barton became insolvent and defaulted on the loan from the bank. Its common stock became virtually worthless. Actions have been brought against Hanover by:

§ The purchasers of the common stock, who have asserted that Hanover is liable for damages under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934.

§ First National Bank, based upon Hanover’s negligence.

§ Trade creditors who extended credit to Barton based upon Hanover’s negligence.

Required: 

a. Discuss whether you believe Hanover will be found liable to the purchasers of common stock.

b. Indicate whether you believe First National Bank will be successful in its claim against Hanover.

c. Indicate whether you believe the trade creditors will be successful in their claim against Hanover.*

6-26: Auditors provide “reasonable assurance” that the financial statements are “fairly stated, in all material respects.” Questions are often raised as to the responsibility of the auditor to detect material misstatements, including misappropriation of assets and fraudulent financial reporting.

Required: 

a. Discuss the concept of “reasonable assurance” and the degree of confidence that financial statement users should have in the financial statements.

b. What are the responsibilities of the independent auditor in the audit of financial statements? Discuss fully, but in this part do not include fraud in the discussion.

c. What are the responsibilities of the independent auditor for the detection of fraud involving misappropriation of assets and fraudulent financial reporting? Discuss fully, including your assessment of whether the auditor’s responsibility for the detection of fraud is appropriate.

6-27: The following information was obtained from several accounting and auditing enforcement releases issued by the Securities and Exchange Commission (SEC) after its investigation of fraudulent financial reporting involving Just for Feet, Inc.:

Just for Feet, Inc., was a national retailer of athletic and outdoor footwear and apparel based in Birmingham, AL. The company incurred large amounts of advertising expenses and most vendors offered financial assistance through unwritten agreements with Just for Feet to help pay for these advertising expenses. If Just for Feet promoted a particular vendor’s products in one of its advertisements, that vendor typically would consider agreeing to provide an “advertising co-op credit” to the Company to share the costs of the advertisement. Just for Feet offset this co-op revenue against advertising expense on its income statement, thereby increasing its net earnings. Although every vendor agreement was somewhat different, Just for Feet’s receipt of advertising co-op revenue was contingent upon subsequent approval by the vendor. If the vendor approved the advertisement, it would usually issue the co-op payment to Just for Feet in the form of a credit memo offsetting expenses on Just for Feet’s merchandise purchases from that vendor. The company’s CFO, controller, and VP of Operations directed the company’s accounting department to book co-op receivables and related revenues that they knew were not owed by certain vendors, including Asics, New Balance, Nike, and Reebok. These fraudulent practices resulted in over $19 million in fictitious pretax earnings being reported, out of total pretax income of approximately $43 million. The SEC ultimately brought charges against a number of senior executives at Just for Feet and some vendor representatives.

Required: 

a. What does it mean to approach an audit with an attitude of professional skepticism?

b. What circumstances related to the accounting treatment of the vendor allowances should increase an auditor’s professional skepticism?

c. What factors might have caused the auditor to inappropriately accept the assertions by management that the vendor allowances should be reflected in the financial statements?

d. Develop three probing questions related to the vendor allowances that the auditor should have asked in the audit of Just for Feet’s financial statements.

6-30: The following are various management assertions (a. through m.) related to sales and accounts receivable.

Management Assertion:

a. Receivables are appropriately classified as to trade and other receivables in the financial statements and are clearly described.

b. Sales transactions have been recorded in the proper period.

c. Accounts receivable are recorded at the correct amounts.

d. Sales transactions have been recorded in the appropriate accounts.

e. All required disclosures about sales and receivables have been made.

f. All accounts receivable have been recorded.

g. Disclosures related to receivables are at the correct amounts.

h. Sales transactions have been recorded at the correct amounts.

i. Recorded accounts receivable exist.

j. Disclosures related to sales and receivables relate to the entity.

k. Recorded sales transactions have occurred.

l. There are no liens or other restrictions on accounts receivable.

m. All sales transactions have been recorded.

Required:

a. Explain the differences among management assertions about classes of transactions and events, management assertions about account balances, and management assertions about presentation and disclosure.

b. For each assertion, indicate whether it is an assertion about classes of transactions and events, an assertion about account balances, or an assertion about presentation and disclosure.

c. Indicate the name of the assertion made by management. (Hint: See Table 6-3.)