NEW CLIENTS, LEGAL LIABILITY AND MATERIALITY
Comparative Sociology of Health and Medicine
October 22, 2018Logic and Discrete Mathematics
October 22, 2018The Lakeside Company: Auditing Cases
- NEW CLIENTS, LEGAL LIABILITY AND MATERIALITY
During August of 2010, the Virginia-based CPA firm of Abernethy and Chapman underwent a peer review of its quality control procedures and its quality control document. Although the final report of the outside review team was favorable, it did criticize the lack of control demonstrated in accepting new audit engagements. Until that time, this decision was left solely to the managing partner who often made little or no investigation of a potential client before committing the firm’s services. The review team pointed out that this policy failed to protect the firm against becoming involved in engagements with undesirable clients.
Following the peer review, Abernethy and Chapman created a three-partner committee to screen each potential client. This group, called the Client Screening Committee, was empowered to make the ultimate decision as to whether the firm should actively seek a particular audit. Under guidelines established by this committee, a partner was put in charge of researching any possible new engagement. This partner had to complete several forms and provide other data describing every potential client. The partner also had to attach a final recommendation letter evaluating the wisdom of seeking the audit. The committee would then review all of this documentation and instruct the partner as to the appropriate course of action.
The addition of a client with potential plans to go public in the next few years will bring Abernethy and Chapman under the regulations of the PCAOB. In order to adequately plan this increased regulation and impact on the firm’s practice, Richard Abernethy also asked Bob Zimmerman to evaluate how their client review process would interact with the registration process. The partners are now considering whether they wish to become registered and are actively assessing the resources they would need to commit to such a strategy.
Regardless of the decision to become registered, Abernethy and Chapman’s client review process requires the following two documents to be completed for each new engagement—”Analysis of Potential Legal Liability” and “Information from Predecessor Auditor” (presented in Exhibits 2-1 and 2-2). Before completing these forms, the in-charge partner learns as much as possible about the potential client and its industry. For example, either the partner or a member of the audit staff reviews recent annual reports and tax returns, tours the company facilities, reads any applicable AICPA Industry Audit Guides, and talks with the business references furnished by the potential client. In addition, the partner always discusses the new engagement with the company’s predecessor auditors. To keep from burdening the predecessor auditor with inquiries from numerous firms, the discussion is only made after the engagement has been offered to a specific new firm.
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In investigating the Lakeside Company, Richard Abernethy was aware that much might be learned from a conference with the predecessor CPA firm, King and Company. Once the Lakeside engagement had been offered to Abernethy and Chapman, the partner began to seek a meeting with the predecessor auditor. Because of the confidential nature of audit information, arrangements for this discussion were made through Benjamin Rogers, president of Lakeside. An appointment was scheduled for June 15, 2012 so that Abernethy could talk with William King, the managing partner of King and Company.
At this meeting, King did not appear to be surprised that the Lakeside Company was seeking a new independent auditing firm. He talked quite candidly with Abernethy about the engagement. “I assumed when we qualified our year 2011 opinion that it would be our last year on the job. Rogers is really interested in stimulating growth and becoming president of a large company. He never talked about going public with me, but I am not surprised. I am positive that he did not like taking that ‘impairment of value’ problem to his stockholders or to the banks that finance his inventory. That could scare them and put a damper on his expansion.
“I was comfortable working with Rogers. He and all of the members of his organization appear to be people of integrity. However, he was always unhappy with our fees. Have you discussed with him how much the audit will cost if he goes forward with his public offering? I honestly don’t believe that he understands the purpose of an audit or all of the work that the job entails.
“I must admit that Rogers argued vehemently against writing down the reported value of the sixth store. He based his arguments on two points: first, that no real impairment existed, and second, that even if Store 6 represented an impairment, the potential loss was not material. As to the impairment issue, our firm was never able to satisfy itself that Lakeside was not going to be stuck holding a totally worthless building in a failed shopping center. Rogers simply disagreed; he could only see the most optimistic possibilities for that store. Unfortunately, the materiality question was even more complex. The company has a net investment of approximately $186,000 in that store out of $3.6 million in total assets. Rogers contended that, at the very worse, he could sell the building for around $100,000. Of course, that’s all in his crystal ball. We obtained an appraisal that came in at $150,000. With the company having a net worth of less than a million dollars, our partners felt that write-off of the potential asset impairment was absolutely necessary. When he would not recognize this loss, we felt that a material misstatement existed within the financial statements and a qualification was required.
“The company’s situation is really quite unique. The audio and video equipment retail stores are only marginal operations. Rogers ruined them when he turned them into Cypress outlets. The market in the Richmond area is just not strong enough for that particular brand alone. On the other hand, he has done exceptionally well with the distributorship side of the business. Across Virginia and North Carolina a very large potential demand seems to have developed for Cypress products. I can see why he is planning on major growth in his distributorship business. Rogers is just now beginning to
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tap into that market. Consequently, he is trying to operate one stagnant and one prospering business at the same time. I certainly foresee the distributorship sales growing rapidly over the next few years. I will be interested in seeing how well the internal systems of the company are able to adapt to that expansion, especially since Rogers dislikes spending any money. Does he know what it will cost to meet PCAOB standards in the area of his internal control?””
Before ending the conversation, King assured Abernethy that their audit documentation of past examinations would be available for review if Abernethy and Chapman were retained to do Lakeside’s current audit. The audit documentation of King and Company consisted of a permanent file of information gathered about Lakeside and annual files containing all of the evidence accumulated during each of the previous yearly examinations.
If the firm decides to accept this engagement, then the engagement team must establish a preliminary judgment about materiality. This judgment normally takes place during the planning phase of the audit. However, due to significant uncertainty surrounding Store 6, the Client Screening Committee asked Wallace Andrews, a manager in the firm, to complete the form “A Preliminary Judgment about Materiality” (presented in Exhibit 2-3) to see just how material a potential write-down of Store 6 would be.
Andrews must decide on the combined amount of misstatement in the financial statements that the firm would consider material. Materiality is the amount of a misstatement on the financial statements that makes it probable that a reasonable user of the financial statements would change his or her decision due to this misstatement. For example, if the net income of Lakeside was overstated by one million dollars, would that change the decision of a creditor to loan money to the company? What if net income was only overstated by $100?
Andrews will consider both quantitative and qualitative factors in determining the preliminary judgment about materiality. He knows that materiality is a relative rather than an absolute concept, meaning that the size of the client impacts the level of materiality. Because materiality is relative, it is necessary to have quantitative bases for establishing whether misstatements are material. A base is a critical item of which financial statement users tend to focus while making decisions. The base will vary depending on the nature of the client’s business. Typical bases include net income before taxes, net sales, total assets, and stockholders’ equity. For example, Wallace might determine that 3% to 5% of net income before taxes is a reasonable range for the quantitative part of the preliminary judgment. Wallace will also consider qualitative factors. Certain types of misstatements are likely to be more important to users than others, even if the dollar amounts are the same. For example, misstatements that involve fraud may be more important to users than misstatements due to unintentional errors. Fraud reflects on the integrity of management and other employees of the client. For example, if the firm suspects fraud, Wallace might choose the lower end of the range determined in quantitative part as the preliminary judgment about materiality.
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(4) What is the purpose of a peer review? Why have peer reviews become necessary? What does the peer review team examine?
(5) What is the purpose of audit documentation, and what general data should be found in (a) a permanent file and (b) a current analysis file?
(6) King mentioned that Rogers did not fully comprehend the purpose of an audit. What obligation does a CPA firm have to ensure that a client understands the audit function? What additional auditing procedures will need to be performed if Lakeside does go public?
(7) Rogers apparently does not like paying for an audit. Should Abernethy suggest that a review rather than an audit be made of Lakeside’s financial statements? What is the difference between a review and an audit? What would be the financial impact of an audit on the level of fees if Lakeside were to go public?
(8) Richard Abernethy has to make a recommendation to the partner review committee as to whether the CPA firm should seek the audit engagement of the Lakeside Company. If you were Abernethy, what would you recommend?
(1)
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(2) If the firm of Abernethy and Chapman does accept this audit engagement, an assessment will be made of the audit documentation produced by the predecessor auditor. Prepare a list of the specific contents of the King and Company audit documentation that should be evaluated by Abernethy and Chapman. Indicate each area that should be addressed and the purpose of studying these particular areas of the audit documentation. For example, one item that Abernethy and Chapman should review is the adjusting entries proposed by King and Company resulting from their audit. Abernethy and Chapman should examine these to determine the type and materiality of the proposed adjustments. [Case2-2.doc]
(3) Determine the preliminary judgment about materiality for the Lakeside audit as a whole. Express your answer as a dollar amount. Determine the appropriate level of materiality based on an analysis of the information in this case and Case 1. Also, use the financial statement information presented in Case 3 for the quantitative portion (see Exhibits 3-4, 3-5 and 3-6). Fully support and discuss the materiality level that you determine. Document your analysis by completing the form in Exhibit 2-3. Based on this materiality level, would the impairment loss be material if the carrying value of Store 6 is completely impaired? What if half the carrying value is impaired? How might this impact the firm’s decision whether or not to accept the Lakeside engagement? [Case2-3.doc]
(4) Assume that Abernethy and Chapman audits Lakeside’s 2012 financial statements and gathers sufficient, competent evidence to render an unqualified opinion without any mention of the impairment. Assume further that Lakeside opts to issue comparative statements showing figures for 2011 and 2012. Write a single audit report that will inform the reader of both opinions as well as the examination made by the previous auditors. [Case2-4.doc]
APPLY YOUR RESEARCH
Use library resources such as searchable databases to research the following topics.
(1) Write a report describing the purpose of a peer review. Discuss the reasons that peer reviews have become necessary and the type of examination that is performed.
(2) King and Company had to make a decision as to the materiality of a potential problem. Write a report describing the methods used by auditors in making this type of judgment.
(3) The auditor’s exposure to lawsuits has been increasing over the last few decades. Write a report describing the profession’s exposure to legal liability. Why has the auditor’s exposure to liability been increasing? What has the profession done to deal with this situation?
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CONSULTING PARTNER REVIEW
Bob Zimmerman, the consulting partner on the Lakeside engagement, is concerned about the following issues and would like for you to respond to them. The audio clips are available online at www.pearsonhighered.com/arens.
(1) Estimating future cash flows and current market value.
(2) Preliminary assessment of materiality.
THE IMPACT OF SARBANES-OXLEY
(1) According to Case 1, the Lakeside Company is considering a public offering of stock to finance its growth. The firm of Abernethy and Chapman does not presently have any audit clients that are public companies. What steps would Abernethy and Chapman have to take before accepting a public company as a client? In particular, how would the Sarbanes-Oxley Act impact the firm’s decision to accept such a company as an audit client? What additional requirements are there for a CPA firm that is registered to practice before the SEC compared with a CPA firm that is not registered? Is the firm of Abernethy and Chapman capable of meeting these standards?
(2) According to Case 1, the Lakeside Company is considering a public offering of stock to finance its growth. What additional requirements are there for a publicly traded company compared with a nonpublic company? What issues have arisen so far in the case that should be addressed as Lakeside considers going public?