section 12 completing the audit reporting to management, and

12

INStRUCtoR RESoURCE MaNUal — Do Not CoPy oR REDIStRIbUtE

Completing the audit, Reporting to Management,and External Reporting12.1 EyeMax Corporation . . . . . . . . . . . . . . . . . . . . . . . 369 Evaluation of Audit Differences

12.2 Auto Parts, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379 Considering Materiality When Evaluating

Accounting Policies and Footnote Disclosures

12.3 K&K, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385 Leveraging Audit Findings to Provide

Value-Added Insights

12.4 Surfer Dude Duds, Inc. . . . . . . . . . . . . . . . . . . . . . . 391 Considering the Going-Concern Assumption

12.5 Murchison Technologies, Inc. . . . . . . . . . . . . . . . . . 395 Evaluating an Attorney’s Response and Identifying

the Proper Audit Report

CASeS INCLUDeD IN ThIS SeCTION

369Copyright © 2009 by Pearson Education, Inc., Upper Saddle River, NJ 07458


The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. It was adapted from an article authored by D. Burgstahler, S. Glover, and J. Jiambalvo, Auditing : A Journal of Practice and Theory, (2000, Vol. 1, page 79). EyeMax is a fictitious company. All characters and names represented are fictitious; any similarity to existing companies or persons is purely coincidental.

EyeMax CorporationEvaluation of audit DifferencesMark S. Beasley · Frank A. Buckless · Steven M. Glover · Douglas F. Prawitt

To illustrate issues associated with completing [1]

the audit.To illustrate the degree of judgment and negotia-[2]

tion involved in requiring clients to book adjust-ments to their financial statements.To revisit the concepts of tolerable misstate-[3]

ment, materiality, and audit sampling.

This case is designed to help students decom-[4]

partmentalize their sampling knowledge from their general business and audit knowledge.To illustrate differences in “hard” versus “soft” [5]

(e.g., estimates based on judgment) adjustments.To illustrate the importance of projected mis-[6]

statement and sampling risk in the evaluation of misstatements detected in sampling applications.

INSTRUCTIONAL ObjeCTIveS

KEY FACTSEyeMax is engaged in research and development, manufacture and sale of medical devices used ��by ophthalmologists during eye surgeries. Customers of the product lines are primarily doctors of ophthalmology and laser-eye clinics.EyeMax has been an audit client for 5 years. In the planning phase of the audit, both inherent ��risk and control risk were assessed at less than the maximum but the audit plan specifies an audit approach that relies primarily on substantive testing.Planned audit fieldwork has been completed and students are asked to consider four items ��posted to the summary of audit differences in order to determine the minimum adjustment (if any) to the financial statements they would require before issuing a “clean opinion.”All items posted to the Summary of Audit Differences have been discussed with the client and the ��client agrees with the auditors’ position on each item. However, because earnings have already been announced they would prefer not to book any of the items in the fiscal year under audit.Total financial statement materiality was set at $625,000, which is equal to approximately 5% of ��earnings before taxes. One of the four items posted to the Audit Summary is based on audit sampling. The case in ��the student’s casebook provides the aggregate total of the known misstatements (i.e., before misstatement projection or any consideration of sampling risk), which is $288,662. In the case extension or follow-up assignment (the case extension is located at the end of these teaching notes and can be used at the option of the instructor) students are also provided with aggregate projected misstatement which is $614,690.

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Section 12: Completing the audit, Reporting to Management, and External Reporting


USE OF CASEThis case provides a very rich setting to address a number of issues related to the completion of the audit. We recommend using it to apply concepts covered in the “Completing the Audit” chapter/module. The case is designed to illustrate the issues surrounding end-of-audit adjustments. The case is also designed to reinforce student’s understanding of tolerable misstatement, materiality, and audit sampling.

In our experience, even though students have a basic understanding of materiality, many of them have difficulty not requiring the client to adjust for proposed audit adjustments related to misstatements in the financial statements. In particular students have difficulty not requiring adjustment when misstatements are due to the misapplication of GAAP.

The case requires students to decide which of the individual adjustments to make and in what amount. Some students select proposed adjustments that are less subjective while others simply select one of the largest misstatements to correct. These differences lead to good class discussions about the differences in “hard” and “soft” proposed adjustments.

The students do not have the case extension or follow-up assignment in their casebook. We have used the case as both an in-class and out-of-class exercise where students complete the original case individually. Before discussing the original version of the case we ask students to complete the case extension assignment in small groups in class (the case extension is located at the end of these teaching notes). In the students’ or original version of the case, students are provided with only the known misstatements. Another option we have used is to have students explain their original computation individually to an instructor or TA who role play the client and then after that discussion, the instructor or TA provides the students with the case extension.

To properly evaluate the potential misstatements in accounts receivable, students need to project the sample misstatements to the population. It is very common in practice for auditors to take a random sample and then evaluate the results judgmentally. In fact, judgmental evaluation of audit samples is used to the virtual exclusion of statistical evaluation in practice.1 We have found that even students who have had relatively little training in sampling understand the need to project misstatement to the population. Projection using ratio estimation is a relatively intuitive concept and it is common in practice. That said, in our experience even students that have had relatively extensive training in audit sampling have difficulty applying their knowledge of audit sampling. An important concept in the theories of memory and learning is that repeated access of difficult concepts after periods of nonuse increases the likelihood that the knowledge will be accessed in future decisions. To increase the salience of the learning experience we do not tip the students off to the need to consider projection and sampling risk before completing the case.

The aggregation of known non-sampling misstatement and projected sampling misstatement is less than 2% below materiality (see Exhibit A at the end of these teaching notes). Therefore, students understanding the need to project should also consider the uncertainty surrounding the misstatement projection due to sampling risk (AU 350, Audit Sampling).2 While we do not anticipate students will calculate the statistically derived upper confidence bound, they should be aware that aggregate misstatement including an upper confidence bound will exceed materiality. While many students do calculate projected misstatement, many do not consider sampling risk. It is common for students to require no adjustments to the financial statements even when aggregate projected misstatement is just barely below materiality. In the case extension, all students are provided with aggregate projected misstatement. In the small group settings, students then discuss and explain to one another the concepts of misstatement

1 An article by Burgstahler, Glover and Jiambalvo, “Error Projection and Uncertainty in the Evaluation of Aggregate Error,” in Auditing : A Journal of Practice and Theory, spring 2000, p. 79-99, provides an excellent discussion of the current sampling practices. This article also reports the results of auditor judgment related to a case similar to EyeMax. These authors conclude that auditors tend to underestimate the effects of both projected error and sampling uncertainty.2 The misstatement projection is based on ratio estimation, however the information provided is sufficient to utilize difference estimation and the case was constructed so that projected misstatement is essentially the same using either method of projection.

371

Case 12.1: EyeMax Corporation


projection, materiality, and in some cases sampling risk. Again, in our experience even after seeing aggregate projected misstatement, many groups fail to consider sampling risk. This case can help students decompartmentalize their sampling knowledge from their general business and audit knowledge. Suggested discussion topics. Given that materiality is $625,000, the level of potential aggregate misstatement including upper bounds suggests a significant adjustment would be required to reduce audit risk to an acceptable level.3 The auditor’s alternative courses of action can be discussed (e.g., increase materiality, take another sample, have client extensively test accounts receivable, book an adjustment). When asked what adjustments they would recommend after seeing the aggregate overstatement including the upper bounds, students often suggest adjusting inventory and accounts receivable. Instructors can then discuss the difference between “hard” and “soft” misstatements, and the negotiations that would likely occur between the client and the auditor. Have the students imagine explaining to the client that while they really only found a few thousand dollars in known misstatement in accounts receivable that they would like to recommend making hundreds of thousands of dollars in adjustments. Instructors can also ask a student what the journal entry to make an adjustment to accounts receivable would be (i.e., individual customer accounts vs. a contra account). Further, a discussion about what the upper bound really represents, a relatively conservative estimate of the ‘worst case scenario’, can be beneficial to students. In regards to the negotiations, students often imagine the auditors will always take a “hard-line” position because, after all, the client agrees the misstatements are real and they released earnings without permission. However, the facts in the case indicate that the client issued an earnings release at the same time as in prior years, it was the auditors who were behind schedule. Further, the auditor will be interested in maintaining a good continuing relationship. While the release of SAB No. 99, “Materiality,” SAS No. 89, “Audit Adjustments,” and SAS No. 107, “Audit Risk and Materiality in Conducting an Audit,” likely increase the likelihood some adjustments will be made, those standards do not require that immaterial misstatements be adjusted. In addition, instructors may wish to discuss the role of the audit committee in considering the auditors’ request for adjustments. Many students have difficulty with the notion of materiality—they want to book all adjustments so that the financial statements are “correct.” They particularly have a difficult time applying materiality to an accounting treatment not in compliance with GAAP.

Optional additional instructions that can be provided to students:The information regarding the items posted to the summary is to provide you with an ��understanding of the nature of these proposed adjustments. You do not need to evaluate the appropriateness of the auditor’s decisions with respect the application of GAAP.None of the individual proposed adjustments exceed the related tolerable misstatement, ��thus none require adjustment on this basis alone.Client’s use of “non-GAAP” accounting (e.g�� ., EyeMax’s accounting for the facility lease) does not preclude the auditors from issuing an unqualified opinion as long as the non-GAAP accounting does not result in a material misstatement to the financial statements.

PROFESSIONAL STANDARDSRelevant professional standards for this assignment include AU Section 350, “Audit Sampling,” SAB No. 99, “Materiality,” AU Section 380, “The Auditor’s Communication With Those Charged With Governance,” and AU Section 312 “Audit Risk and Materiality in Conducting an Audit.”

3 The upper bounds are calculated using an acceptable risk of incorrect acceptance of 10%.

372



QUeSTIONS AND SUGGeSTeD SOLUTIONS

Which of the following three alternatives best describes the conditions under which you would [1]

issue a clean opinion for EyeMax? (select one)

a. I would not be willing to issue a clean opinion even if EyeMax is willing to make adjustments for items on the Summary of Audit Differences.

b. I would be willing to issue a clean opinion without any adjustments.

c. I would be willing to issue a clean opinion only if EyeMax is willing to make some adjustments to their financial statements for items on the Summary of Audit Differences.

Briefly explain your choice:

Having students identify the correct solution before the classroom discussion is not as critical as the learning that takes place in the classroom. Furthermore, there is not one absolutely correct answer given the degree of professional judgment involved. That said, the facts of the case as discussed in further detail below suggest that option “C” is the most appropriate (in both the student version of the case and in the case extension) because the aggregation of known non-sampling misstatement and projected sampling misstatement is less than 2% below materiality. Therefore, students understanding the need to project should also consider the uncertainty surrounding the misstatement projection due to sampling risk (AU 350, Audit Sampling). Aggregate upper misstatement bound is significantly greater than materiality.

If you selected options “a” or “b” in question 1, assume now that the client has decided that they [2]

will make an adjustment of up to $250,000 to their financial statements. Please decompose the total adjustment you would recommend into the individual account classifications included on the Summary of Audit Differences in the space provided below (e.g., what adjustment would you require for warranty expense, repair and maintenance expense, etc? The dollar values of your individual account adjustments should sum to no more than $250,000).

If you selected item “c” in question 1, what is the minimum total adjustment that you would require before issuing a clean opinion? $ _______________. Please decompose this total adjustment into the individual account classifications included on the Summary of Audit Differences in the space provided below (e.g., what adjustment, if any, would you require for warranty expense, repair and maintenance expense, etc? The dollar values of your individual account adjustments should sum to your required minimum adjustment).

Warranty expense

Repair and maintenance expense

Litigation expense

Accounts Receivables/Sales

Total

Please briefly explain your decisions:

373

Case 12.1: EyeMax Corporation


Student responses will vary. To properly evaluate the potential misstatements in accounts receivable, students need to project the sample misstatements to the population. It is very common in practice for auditors to take a random sample and then evaluate the results judgmentally. We have found that even students who have had relatively little training in sampling understand the need to project misstatement to the population. Projection using ratio estimation is a relatively intuitive concept and it is common in practice. That said, in our experience even students that have had relatively extensive training in audit sampling have difficulty applying their knowledge of audit sampling. Given that materiality is $625,000, the level of potential aggregate misstatement including upper bound (sampling risk) suggests a significant adjustment would be required to reduce audit risk to an acceptable level. The auditor’s alternative courses of action can be discussed (e.g., increase materiality, take another sample, have client extensively test accounts receivable, book an adjustment).

The aggregation of known non-sampling misstatement and projected sampling misstatement is less than 2% below materiality. Exhibit A at the end of these teaching notes can be used as an overhead when debriefing the case. Therefore, students understanding the need to project should also consider the uncertainty surrounding the misstatement projection due to sampling risk (AU 350, Audit Sampling). While we do not anticipate students will calculate the statistically derived upper confidence bound, they should be aware that aggregate misstatement including an upper confidence bound will exceed materiality. While many students do calculate projected misstatement, many do not consider sampling risk. It is common for students to require no adjustments to the financial statements even when aggregate projected misstatement is just barely below materiality. With respect to the amount of the adjustment, a formal evaluation of the aggregate misstatements suggests an upper bound about $310,000 above materiality. Thus an adjustment of around $310,000 can be justified. Assuming the auditor chooses not to increase their acceptable audit risk or materiality, and assuming the auditor chooses to not conduct any additional tests, then the total adjustment to the financial statements might be comprised of the following components:

Repair and maintenance expense 200,000Warranty expense 70,000Accounts receivables/sales 40,000

Total $310,000

Projected Misstatement and Upper Limit Calculation. As noted previously, the projected misstatement reported in the case extension is based on ratio estimation. Projected misstatement based on difference estimation is also provided below.

Projected Misstatement Point Estimate—Ratio Estimation

Projected Misstatement=

$8,662 (known sample error)$12,600,000 (population) $326,096 (total tested)

Projected Misstatement = $ 334,690

Projected Misstatement Point Estimate—Difference Estimation

$8,662 (known sample error)x 1,545 (number of accounts) = $334,570

40 (sample size)

374



Upper Limit

CPI = NZA (SD/SQRT(n)) (SQRT ((N-n)/N))

Where:CPI = computed precision interval N = population sizeZA = confidence coefficient for ARIA SQRT = square rootSD = population standard deviation n = sample size(SQRT ((N-n)/N)) = finite correction factor

CPI = 1,545 x 1.64 *(806/SQRT(40))*(SQRT(1,505/1,545)) = $318,889.

Therefore the upper 90% confidence bound using ratio projection is $653,579 ($334,690 + $318,889)

The case requires students to decide which of the individual adjustments to make and in what amount. Some students select proposed adjustments that are less subjective while others simply select one of the largest misstatements to correct. These differences lead to good class discussions about the differences in “hard” and “soft” proposed adjustments. After seeing the upper bound, some students may question whether a larger adjustment is required to accounts receivable because according to the case tolerable misstatement for any account cannot exceed $468,750 (75% of materiality). Tolerable misstatement is more of a scoping tool than it is an evaluation tool; however, some auditors may require a larger adjustment and that decision will likely be dependent on how important the assertions associated with the accounts receivable account are to the financial statement users. In the final evaluation of likely audit differences and proposed adjustments, most auditors will focus more on the best estimate of misstatement, projected error, which for accounts receivable is below tolerable even before the $40,000 adjustment proposed above. The auditor does want ample margin for error between the unadjusted most likely aggregate misstatements and materiality to provide an appropriate allowance for sampling risk and other potential undetected misstatements. The proposed adjustments above appear to about the minimum level required to provide sufficient margin for error.

Case ExtensionAfter Exhibit A on the next page, we provide a case extension in the instructor teaching notes. The purpose of the extension is to ensure all students understand the need for projection of the sampling results to the sampling population. The extension also asks students to specifically consider sampling risk. Before discussing the original version of the case we ask students to complete the case extension assignment individually or in small groups in class. Another option we have used is to have students explain their original computation individually to an instructor or TA who might role play the client and then after that discussion, the instructor or TA provides the students with the case extension. In the students’ or original version of the case, students are provided with only the known misstatements. The students do not have the case extension or follow-up assignment in their casebook.

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EyeMax Corporation - Case ExtensionEvaluation of audit Differences Assume the same set of facts for EyeMax as already provided. The task is basically the same. The firm you work for requires that when misstatements are identified using audit sampling, the auditor is required to project the known misstatements found in the sample to the population (i.e., form a point estimate) so that it can be considered on the Summary of Audit Differences. The aggregate of total projected misstatement and other known misstatements is then compared to materiality and appropriate consideration should be given to sampling risk. The consideration of sampling risk is particularly important if the total sum of the projected and known misstatements is less than, but close to, materiality.

The following proposed adjustments were recorded on the Summary of Audit Differences:

Known Misstatement

Known and Projected

MisstatementWarranty expense 130,000 130,000Repair and maintenance expense 200,000 200,000Litigation expense (50,000) (50,000)Accounts receivables (Sales) 8,662 334,690

Total $288,662 $614,690

The only difference in the facts presented between the original case and this extension is that projected misstatement is provided. Assume that you are the auditor responsible for the EyeMax audit. It is now March 30, and all planned fieldwork has been completed. Recall that total financial statement materiality has been set at $625,000. Taking into account the information provided, please answer the following question.

Which of the following three alternatives best describes the conditions under which you would issue a clean opinion for EyeMax? (select one)

a. I would not be willing to issue a clean opinion even if EyeMax is willing to make adjustments for items on the Summary of Audit Differences.

b. I would be willing to issue a clean opinion without any adjustments.

c. I would be willing to issue a clean opinion only if EyeMax is willing to make some adjustments to their financial statements for items on the Summary of Audit Differences

Briefly explain your choice:

377

Case 12.1: EyeMax Corporation - Case Extension

If you selected item “c” on the previous page, please complete the following:

What is the minimum dollar value of the total adjustment to income that you would require before issuing a clean opinion?

$

Please decompose the total required adjustment into the individual account classifications included on the Summary of Audit Differences in the space provided below. (The dollar values of the individual adjustments should sum to the total adjustment above.)

Warranty expense $

Repairs and maintenance expense $

Litigation expense $

Accounts receivables/sales $

Total $

Briefly explain:



The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. Auto Parts, Inc. is a fictitious company. All characters and names represented are fictitious.

auto Parts, Inc.Considering Materiality When Evaluating accounting Policies and Footnote DisclosuresMark S. Beasley · Frank A. Buckless · Steven M. Glover · Douglas F. Prawitt

To illustrate the importance of considering both [1]

the quantitative and qualitative issues when as-sessing the materiality of an accounting method choice.To provide students hands-on experience with [2]

balancing client preferences, materiality consid-erations and requirements of technical standards.

To illustrate the degree of judgment (and often [3]

negotiation) involved in determining what to re-quire an audit client to disclose in their financial statements.To revisit issues associated with audit opinion [4]

choices when faced with changes in accounting principles and estimates.


KEY FACTSAuto Parts, Inc. is a manufacturer of automobile subassemblies marketed primarily to the “big ��three” U.S. automakers.During 2008, Auto Parts significantly expanded its plant to accommodate increased product ��demand.Prior to 2008, the company accounted for tooling supplies by expensing the supplies as ��purchased. However, due to higher levels of tooling supplies inventory in 2008, the company decided to change their accounting policy and began capitalizing tooling inventory.The client’s December 31, 2008 balance sheet reflects tooling supplies inventory of $300,000.��Even though the client realizes they have changed their policy, they would prefer to not include ��a disclosure in their financial statements associated with the change in policy because they view the effects as immaterial.

USE OF CASEThis case is based on an actual audit client situation. However, the names, industry and facts have been changed to avoid identification. We ask students to complete this case as either an outside of class writing assignment or as an in-class exercise. We usually permit students to work in small groups when completing this assignment and typically use this case as we study materiality concepts. We find that this case leads to active discussion about the accounting and disclosure issues as well as discussion of audit issues related to the determination of materiality. We find that student responses differ widely.

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380



PROFESSIONAL STANDARDSRelevant professional standards for this assignment are AU Section 312, “Audit Risk and Materiality in Conducting an Audit,” AU Section 380, “The Auditor’s Communication With Those Charged With Governance,” AU Section 508, “Reports on Audited Financial Statements,” SAB 99, “Materiality,” and “SFAS 154: Accounting Changes and Error Corrections -- a replacement of APB No. 20 and SFAS No. 3.”


Describe whether you agree that capitalization of the tooling inventory is the preferable method [1]

of accounting for Auto Parts, Inc.

The client’s change in policy is appropriate. Auto Parts, Inc. likely purchases tooling supplies in large quantities in order to take advantage of supplier discounts and in the current year they increased their purchases in anticipation of a price increase. It appears that the items purchased can remain in inventory for weeks or months creating a future economic benefit. The preferred accounting method for tooling supplies is to capitalize them on-hand tooling supply in other assets and then expense supplies as they are placed in service. The decision regarding capitalization or expense is based on the concepts of future economic value, the matching principle, classification, and disclosure. Accrual accounting requires expenses to be matched to the revenues they help produce in a given period.

Technically, to expense tooling costs at the time of purchase violates the matching principle. While the “technically proper” treatment of accounting for tooling supplies was also to capitalize in the prior and earlier years, accounting and auditing standards allow for the pervasive constraints of cost-benefit and materiality. Prior to 2008, the amount of tooling supplies on-hand at year-end was immaterial. As such, the costs associated with capitalizing, tracking, counting, etc. exceeded the benefits, at least in the client’s eyes.

The cost-benefit concept can lead to interesting discussions regarding whether, in situations like Auto Parts, it really would have been all that difficult or costly for the client to count the tooling supplies at year-end. The problem with not accounting appropriately for tooling supplies, as in this example, is that if and when it becomes material the client and the auditor have to exert time and energy to determine the proper way to account for the change. In other words, not following GAAP in this situation may ultimately been more costly than following GAAP all along.

Assuming the policy change is considered material, how should it be reported and disclosed in [2]

the 2008 financial statements and what effect, if any, would the accounting change have on the auditor’s report?

Based on SFAS 154 it appears there are 3 possible ways to account for the policy change: a change in accounting principle, a change in accounting estimate, or a change in accounting error. The best argument for considering the client’s policy change as a change in accounting principle seems to be that the client previously used the cash method to account for tooling supplies and now will used the accrual method of accounting. According to SFAS 154, a change in accounting principle requires that financial statements for each individual prior period presented shall be adjusted to reflect the period-specific effects of applying the new accounting principle. However, the cash method is non-GAAP, furthermore, paragraph 5(a) of SFAS 154 states that an “initial adoption of an accounting principle in recognition of events or transactions occurring for the first time or that previously were immaterial in their effect…is [not] a change in accounting principle.” Given that the prior year transactions were considered immaterial, suggests the client’s policy change is not a change in accounting principle.

381

Case 12.2: auto Parts, Inc.


The best argument for considering the policy change a change in accounting estimate seems to be that the client previously estimated useful life of the supplies as zero and now the useful life is indefinite and will be expensed as used. If the tooling supplies were a depreciable asset, then paragraph 2e of SFAS 154 states that a change in the method of valuing depreciation, amortization, etc. of depreciable assets is considered a change in estimate effected by a change in accounting principle. As such, prospective accounting adjustments only are required. SFAS 154 paragraph 19 states , “A change in accounting estimate shall be accounted for in…the period of change and future periods…A change in accounting estimate shall not be accounted for by restating or retrospectively adjusting amounts…” If the change qualifies as a change in accounting estimate the financial statements would be affected as follows:

The current year’s financial statements as well as future statements will be reported ��consistent with the new policy. Therefore the policy change in 2008 resulted in a $330,000 reduction in expense (and a related increase to net income) and a $330,000 increase to other current assets when they capitalized unused tooling supplies in 2008. A footnote would be added to discuss the change.SFAS 154 does not require retrospective application to prior periods’ financial statements. ��Therefore, no adjustment should be made for the $35,000 expensed in 2007, but still on hand at the beginning of 2008.

The third way the policy change could be characterized is a change in accounting error. The prior way of accounting for tooling supplies, the cash method, is not consistent with GAAP as such the change in policy represents a correction of an accounting error. However, the client would likely argue that past years do not represent an error as GAAP allows for the pervasive cost constraint. Given that the cash basis is not acceptable under GAAP it seems this policy change is best considered a correction of accounting error. To properly account for a correction in accounting error, the change in policy would be disclosed and when the comparative 2007 and 2008 statements are issued, 2007 would be adjusted to show $35,000 more in other assets and $35,000 less in expense. Similarly, the 2008 statements would show $35,000 more in expense. However, regardless of how the change is accounted for, the impact on 2008 is similar in magnitude because of the small amount of inventory on hand at the beginning of 2008. The primary issue the auditor and client need to resolve is a determination of whether the effect of the change is material and will require disclosure. Even if the client and auditor decide to account for the change as a correction of an error, the previously issued 2007 annual report would not need to recalled and restated because the impact on 2007 is so small. Rather the adjustment would be made to the 2007 comparative financial statements presented in the 2008 annual report.

In general, how do auditors develop an estimate of financial statement materiality? For Auto [3]

Parts, Inc., what is your estimate of financial statement materiality? Are there qualitative factors that might impact your decision about the materiality of the accounting treatment and the related disclosure?

Materiality is commonly defined as follows: “A misstatement in the financial statements can be considered material if knowledge of the misstatement would affect the decision of a reasonable user of the financial statements.” The determination of materiality requires professional judgment. While professional standards provide relatively little specific guidance on how to assess what is material to a reasonable user, auditing firms have developed policies and procedures to assist auditors. These policies and procedures often suggest that

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the auditors apply a percentage to various bases (e.g., net income before tax, total assets, total revenues, etc.). Because materiality is a relative rather than an absolute concept, the materiality assessment for one client may differ significantly from that of other clients of similar size. Student assessments of materiality will likely differ. In the SEC’s Staff Accounting Bulletin (SAB) No. 99 the staff specifically mention a 5% threshold and indicate they have, “no objection to such a ‘rule of thumb’ as an initial step in assessing materiality.” As a result of SAB 99 we believe that 5% of net income before tax now represents a generally accepted upper bound for public companies. For the current year audit of Auto Parts, this rule of thumb would yield an estimate of planning materiality of approximately $300,000 ($6 million X 5%). Based purely on a quantitative analysis, it appears that the amount of tooling inventory in question (the $300,000 recorded as an asset) falls very near to the materiality threshold of 5%.

We usually combine the discussion of question #4 with the discussion of qualitative factors in question #3. Several qualitative factors would (and did in the actual case) influence the auditor’s assessment of materiality. While the SEC staff do not object to percentage thresholds, they also warn, “quantifying, in percentage terms, the magnitude of a misstatement is only the beginning of an analysis of materiality; it cannot appropriately be used as a substitute for a full analysis of all relevant considerations. The staff reminds registrants and the auditors of their financial statements that exclusive reliance on this or any percentage or numerical threshold has no basis in the accounting literature or the law.” The following list identifies some of the qualitative factors:

Degree of misstatement.[a] The policy change implemented in 2008 will also not result in a misstatement in 2008 and any correction to 2007 would be very slight. In fact, the change in accounting policy results in a better treatment of tooling supplies in the most recent financial statements. Given that net income is not misstated, the auditor faces an issue that involves a matter of presentation and disclosure.

Impact on trends. [b] Auto Part’s earnings per share have steadily increased over the past five years with a cumulative return of 140% over that period. Capitalizing on-hand supplies and not disclosing the accounting change will suggest a pretax earnings growth of 20% [($6,000,000-5,000,000)/$5,000,000] while capitalizing and disclosing the accounting change may suggest a pretax earnings growth of approximately 13.5% [($6,000,000-5,000,000-330,000))/[5,000,000]).1 Additionally, capitalizing and not disclosing the accounting change will suggest a return on assets of 11.7% ($6,000,000/[($47,000,000 + $56,000,000]) /2]) while capitalizing and disclosing the change may suggest a return on assets of 11% ($6,000,000-$330,000/[($47,000,000+$56,000,000-$330,000) /2]). Auto Part’s will show an impressive pretax earnings growth whether the accounting change is disclosed. The impact of the disclosure on Auto Part’s return on assets is minimal.

Client’s justification.[c] Auditors are always concerned about the underlying motivation in a proposed change, particularly when it results in an increase in net income. If the auditor believes that the client is making the change for the “wrong” reasons (i.e., improve earnings trend instead of to better comply with the matching principle) then they might use a lower assessment of audit materiality with respect to the policy change in question. To assess the client’s motivation, the auditors would consider things such as the effect of the change on the client’s trend in reported earnings. In the Auto Parts case, there may be a concern that management wants to continue to report high earnings growth. If, for example, a new accounting policy would change the current year earnings from a negative trend to a positive trend, the auditors may consider reducing the level of audit materiality with respect to the policy. As previously noted, disclosure of the policy change will not significantly affect the earnings trend.

1 The computations assume 2007 financial statements are not adjusted for the supplies on hand at December 31, 2007.

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Case 12.2: auto Parts, Inc.


Management Integrity/Audit History.[d] In a situation like Auto Parts where the client has expressed a preference that may conflict with the auditor’s preference, auditors carefully consider management integrity and the client-auditor relationship extended over several previous audit engagements. If, over time, an audit client has been confrontational and aggressive, then this policy change may be symptomatic of a larger problem. This may encourage the auditor to take a “hard line” on such issues and use a lower materiality assessment. Alternatively, if (1) the auditor-client relationship has been positive, (2) similar issues have not been common in prior year engagements, and (3) the auditor believes that management has a high degree of integrity, then the auditor would certainly take these factors into consideration when assessing the degree of materiality associated with an accounting policy change. In the actual case, the auditors had a positive history with the client, and the auditors believed management possessed a high degree of integrity.

Other qualitative factors students may include:

whether the misstatement arises from an item capable of precise measurement or whether ��it arises from an estimate and, if so, the degree of imprecision inherent in the estimatewhether the misstatement hides a failure to meet analysts’ consensus expectations for ��the enterprise whether the misstatement affects the registrant’s compliance with loan covenants or ��other contractual requirements whether the misstatement has the effect of increasing management’s compensation - for ��example, by satisfying requirements for the award of bonuses or other forms of incentive compensation

Do you concur with management’s assessment that the accounting change is immaterial and, [4]

therefore, requires no disclosure? Why or why not?

We find that most students do not concur with management. Students generally indicate that disclosure must be made for two reasons: (1) GAAP requires disclosure and (2) students believe that without disclosure of the new method the new tooling supply asset account of $330,000 with an accompanying net income boost is material. Most likely any disclosure for this policy change would appear in the footnote discussing “other assets.”

Interestingly, when asked if students are prepared to lose the client if the client disagrees and refuses to disclose, students often indicate that they are not prepared to lose the client over this issue. This case provides an opportunity to highlight some of the conflicts and pressures faced by auditors in practice. As good business people, auditors are certainly aware of the ramifications of the various alternatives they face. Threatening to issue a qualified report or forcing the client to make the unwanted disclosure runs the risk of losing this client. However, auditors are expected to exercise due professional care and protect the interests of the public. Auditors frequently face pressures to balance their professional interests with that of the public. In addition, the Sarbanes-Oxley Act of 2002 and increased public scrutiny have had a profound affect on how both auditors and management view accounting issues in regards to materiality. In the actual case, the auditors did concur with management due to the fact that the tooling supplies on-hand at the end of the prior years was immaterial and the client’s change is appropriate given the economic circumstances in the current year (the client basically pre-paid for tooling supplies). The effect on the current year was considered potentially material due to the quantitative size; however in considering the qualitative factors discussed above, the auditor did not perceive any attempt on behalf of management to inappropriately

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manage earnings or trends and the client/audit history had been positive. Even if adjustment to 2007 and disclosure regarding the change is not made in the financial statements, the auditors would inform the audit committee of the change in accounting policy as well as any proposed audit adjustments (AU 380, “The Auditor’s Communication With Those Charged With Governance”). This case is based on an actual audit that occurred prior to the release of SAB 99, “Materiality,” SAS No. 89, “Audit Adjustments,” and SAS No. 107, “Audit Risk and Materiality in Conducting an Audit.” While these releases are expected to influence audit adjustment decisions as well as increase the auditor’s scrutiny of client’s justifications based on “immateriality,, none of these releases require adjustments or disclosures for immaterial items.



The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. K&K is a fictitious company. All characters and names repre-sented are fictitious; any similarity to existing companies or persons is purely coincidental.

K&K, Inc.leveraging audit Findings to Provide Value-added InsightsMark S. Beasley · Frank A. Buckless · Steven M. Glover · Douglas F. Prawitt

To help students learn to identify key issues to [1]

consider when auditing the production process and inventories for a manufacturing firm.To help students understand the role of a manu-[2]

facturing client’s costing system in the context of a financial statement audit.

To help students understand how insights gained [3]

through a financial statement audit can be ap-plied to add additional value to a client.To help students understand that concepts from [4]

a variety of areas and disciplines can often be used to provide added value to a client.


KEY FACTSThe student takes on the role of a second-year audit senior with the task of reviewing selected ��audit files and reporting any areas of concern. In addition, the manager has asked for an analysis of where the firm can offer and provide added-value insights to the client.The accounting firm, Spencer and Loveland, is a medium-sized, regional accounting firm. ��Spencer and Loveland has earned a reputation for not only providing high-quality auditing services, but also for analyzing a client’s current situation and developing measures to add value above and beyond the normal financial statement audit.The new client, K&K, Inc., is a manufacturer of a variety of picture frames. For years their market ��has focused on manufacturing and selling large, ornate, hand-crafted picture frames to portrait studios and specialty retailers. They recently automated the production of small, plastic frames which has seemed to go well.Over the past year, K&K experienced a decline in growth and profitability. K&K’s production ��manager believes that, due to rising costs of skilled labor required to produce the large ornate frames, the profitability of the larger frames is declining. He recommends, based on internal cost accounting reports, that the larger frame production line be eliminated and that the company focus more on the less labor-intensive plastic frame line.The plastic frames require the use of an expensive system of machines, the RX-1000 system. ��The initial cost of the system was $380,000. The system requires monthly maintenance costing approximately $2,450 per month.The RX-1000 has produced so many plastic frames in the past few months that K&K rented out ��an additional storage facility to hold the finished plastic frame inventory.Inventory costs consist of direct materials and direct labor, as well as overhead, which continues ��to be allocated to both product lines from a common, company-wide cost pool using direct labor hours as the cost driver.

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USE OF CASEThis case is designed to provide students with an opportunity to obtain experience in analyzing audit issues related to a client’s inventory and production processes. The case also provides a good framework to help students look for different ways to add value beyond their audit services for the client. The case is intended to help students understand that the concepts they are learning in other accounting classes, including cost and managerial accounting, are relevant when auditing. This case incorporates cost and managerial accounting concepts that must be applied for the audit firm to add value to the client. This case is designed for use as an out-of-class exercise for the students to analyze information given in the case and to prepare a memo reporting their findings and suggestions. It can also be used as an extended in-class group analysis and discussion exercise.

PROFESSIONAL STANDARDSRelevant professional standards for this assignment include AU Section 311, “Planning and Supervision,” AU Section 326, “Audit Evidence,” and AU Section 331, “Inventories.”

SUGGeSTeD SOLUTION

Briefly list and explain the primary audit risks in the production and inventory area of the [1]

K&K audit.

The primary risk in the inventory segment is the inventory of metal frames that didn’t sell as well as K&K anticipated. K&K’s inventory may include a number of these frames that may or may not be able to be sold. A risk exists that these frames on hand are valued at higher than their realizable market values. A related risk is that the machines used to make the metal frames are not valued properly.

A risk is also emerging that K&K is producing more plastic frames than the company is currently capable of selling. K&K could be left with large amounts of raw materials and finished goods currently on-hand, raising both managerial and auditing concerns associated with excess inventory.

Another area of concern in the production cycle relates to the manufacturing machinery. The auditors must address the risks involving the correct valuation and depreciation of the manufacturing machinery. Because this is the audit firm’s first year auditing K&K, they will want to verify the appropriateness of the depreciation methods as well as the reasonableness of the useful lives used for depreciation. In addition, the auditor should be concerned about the correctness of the original value used for the machinery and about the accuracy of the depreciation calculations.

As with all audits of inventory, the auditors must also address the risk pertaining to the accuracy of the company’s inventory count. During the year, K&K stored their finished-goods inventory in more than one location, which increases the risk that the company’s records of the inventory count could be misstated.

Another risk that exists with K&K’s audit is the accuracy of the costing of finished goods inventory. One risk to address with respect to this topic involves the correctness of the direct labor hours used for costing the frames. Because direct labor hours are used as the driver for inventory overhead costs, the potential effects of this number being misstated could be significant. The second area requiring attention is the risk that incorrect pricing is used for the raw materials inventory and that the same costing method is not being consistently applied. Any evidence of error in these areas could indicate a risk that the cost of finished goods inventory is misstated.

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Case 12.3: K&K, Inc.


Identify any accounting or auditing issues in the way K&K handles its product costs, including [2]

overhead allocation, that need to be addressed in the current audit.

Upon reviewing K&K’s breakdown of overhead costs, $275 worth of Sales Bonuses has been included as part of overhead. These bonuses should not be included as a part of the overhead computation, as they qualify as period costs rather than product costs. This misclassification indicates a risk that other classification errors may exist in overhead or other areas of the audit and may point to a weakness in internal controls.

Due to the fact that K&K has historically produced a homogeneous, labor-intensive product line, it was probably appropriate for them to apply overhead costs based on a direct labor cost driver. However, because the new plastic frame production line is machine-intensive, applying overhead based on direct labor hours from a common overhead pool is not appropriate. A new costing system involving separate cost pools and cost drivers should be used to apply the overhead for the two product lines. This issue is discussed further in the answer to question #3.

This problem in overhead allocation may be a concern from an auditing perspective, because Cost of Goods Sold may not be correctly stated. Too much cost is being allocated to the custom frame line (which sell immediately since they are made to order) and too little is being allocated to the plastic frame line. Since inventory of plastic frames is relatively large (and increasing), ending inventory for plastic frames is likely to be understated and Cost of Goods Sold is likely to be overstated. However, in addition to addressing the auditing concern, the auditors are in a position to use insights gained through the audit together with their expertise to add value to the client. It is important to note that auditors can use their knowledge in a variety of areas (such as management accounting) to enhance the services they provide to their clients.

Review the analysis performed by K&K on the two product lines. K&K’s management is [3]

debating the elimination of the manual line given that it is no longer profitable. Should K&K discontinue the labor-intensive custom frame product line? Why or why not?

As discussed in the answer to question #2 above, K&K’s current overhead allocation system uses a single cost pool and direct labor hours to allocate overhead. This is not appropriate because one line is very labor-intensive with few overhead costs, while the other is less labor-intensive but incurs more overhead costs, such as costly maintenance and depreciation. Because of the overhead allocation, the majority of overhead costs associated with the plastic line are being passed on to the manual line. As a result, the manual line appears less profitable and the automated line appears more profitable. By using direct labor hours as a single cost driver, K&K may assume that it would be beneficial to discontinue the manual line. However, this decision could send K&K into a “death spiral,” as costs currently allocated to the manual line would not be eliminated but would instead shift to the plastic line.

To encourage appropriate product line decisions, Exhibit 1 shows K&K’s overhead costs traced to each product line. Sales bonuses were not included in overhead calculations because they are not a product cost. By tracing overhead costs to specific lines, we see that over half of total overhead costs are attributable to the plastic line. Other overhead costs must then be allocated to each line based upon a relevant cost driver. Facility rent is usually allocated based on the use of square footage. For this example, we assumed that square footage was shared equally between the two product lines. Because utilities are associated with production levels, we assumed that utilities could be allocated based on units of production. Based on these assumptions, we see that the overhead per unit for the custom line drops to $.90 and the overhead per unit for the plastic line increases to $.47.

By applying these updated overhead rates to K&K’s cost breakdown, it becomes apparent that the manual line is still profitable and the plastic line is actually losing money. Based on these calculations, discontinuing the custom line would be disastrous for K&K.

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Instead, the company should focus on increasing the sales and production volume of the new line or increasing prices. If these measures fail, K&K should consider dropping the plastic frames line, based, of course, on an analysis of marginal revenues and costs related to that line.

Students should have made an effort to develop a new cost breakdown. A new (and improved) analysis by product is included in the instructional notes (Exhibit 2). Note that there are several different ways to appropriately approach the problem, so students’ solutions may vary. Students’ solutions should be evaluated individually based on the reasonableness of assumptions made and the quality of reasoning and presentation.

Based on your analysis, prepare a memo to the audit manager suggesting areas in K&K’s [4]

inventory and production-costing systems where your firm could provide advice and value-added services to the client. In addition, given K&K is a non-public company, suggest any areas in which your firm might be able to provide consulting services that would be of value to the client.

The memo should be professional in appearance and in substance, and should be well written. The memo should include the points brought out in the preceding questions, which are designed to help prepare the students to make reasoned and informed recommendations. The memo should also include clear statements concerning the risks and concerns encountered by the audit team. Additionally, the memo should contain clear recommendations about the areas in which the audit team can provide value-added services to the client. There are no strictly right or wrong recommendations as long as students demonstrate that they weighed the issues and evidence and made a reasonable decision based on the information provided.

The primary recommendation that the students should arrive at in terms of adding value should relate to the need for K&K to implement a new cost allocation system that assigns costs more accurately. A more accurate system will not only resolve some audit risks relating to valuation of inventory and Cost of Goods Sold, but will also help management make better decisions relating to their two product lines.

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Case 12.3: K&K, Inc.


exhIbIT 1 - bReAkDOwN Of OveRheAD COSTS

Production Facility Rent $ 5,250 /month $ 63,000 Production Facility Utilities 750 /month 9,000 Misc. Indirect Materials 350 /month 4,200 Maintenance on RX-1000 system 1,650 /month 19,800 Replacement Parts for RX-1000 system 800 /month 9,600 Depreciation for RX-1000 system 5,278 /month 63,336 Depreciation for Custom Frame Machinery 675 /month 8,100 Total Annual Overhead Costs $ 14,753 /month1 $ 177,036

Traceable Overhead Costs Custom PlasticDepreciation $ 8,100 1/2 Indirect Materials $ 2,100 1/2 Indirect Materials 2,100 Maintenance RX-1000 19,800 Replacement RX-1000 9,600 Depreciation RX-1000 63,336 Total Traceable Costs $ 10,200 $ 94,836

Other Cost Allocations Total Custom PlasticProduction Facility Rent2 $ 63,000 $ 31,500 $ 31,500Production Facility Utilities3 9,000 1,286 7,714Overhead Allocated $ 72,000 $ 32,786 $ 39,214

Total Custom PlasticTotal Overhead $ 177,036 $ 42,986 $ 134,050

Per Unit $ 0.90 $ 0.47

Total Overhead- Discontinued Custom Line4

Total Custom Plastic$ 166,836 — $ 166,836

Per Unit — $ 0.58

Assumptions1. Sales bonuses are not included in overhead allocations2. Facility Rent is allocated using sq footage. Sq ft are assumed to be shared equally3. Facility Utilities are allocated using units of production4. Traceable costs are eliminated when lines are discontinued

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exhIbIT 2 - New ( ImpROveD) COmpARISON COST bReAkDOwN(Based on Annual Volume of 48,000 Custom Frames and 288,000 Plastic Frames)

Custom Frames Plastic Frames If Custom Frames are Discontinued Size Size Size Size Size Size Size Size SizeSales Price Small Medium Large Sales Price 5X7 8X10 11X14 Sales Price 5X7 8X10 11X14Maple w/ regular $ 32.50 $ 49.50 $ 66.00 Tan w/ regular $ 0.70 $ 0.85 $ 1.00 Tan w/ regular $ 0.70 $ 0.85 $ 1.00 Maple w/ nonglare 33.50 50.75 68.00 Tan w/ nonglare 0.75 0.90 1.07 Tan w/ nonglare 0.75 0.90 1.07 Oak w/ regular 35.00 55.50 73.00 Brown w/ regular 0.70 0.85 1.00 Brown w/ regular 0.70 0.85 1.00 Oak w/ nonglare 36.00 56.50 75.00 Brown w/ nonglare 0.75 0.90 1.07 Brown w/ nonglare 0.75 0.90 1.07 Cherry w/ regular 42.75 62.00 81.00 Black w/ regular 0.70 0.85 1.00 Black w/ regular 0.70 0.85 1.00 Cherry w/ nonglare 43.75 63.00 83.00 Black w/ nonglare 0.75 0.90 1.07 Black w/ nonglare 0.75 0.90 1.07 Total Costs Total Costs Total Costs Maple w/ regular $ 30.65 $ 44.70 $ 57.40 Tan w/ regular $ 0.81 $ 0.88 $ 0.98 Tan w/ regular $ 0.92 $ 0.99 $ 1.09 Maple w/ nonglare 31.15 45.45 58.50 Tan w/ nonglare 0.82 0.90 1.01 Tan w/ nonglare 0.93 1.01 1.12 Oak w/ regular 34.15 50.30 64.40 Brown w/ regular 0.81 0.88 0.98 Brown w/ regular 0.92 0.99 1.09 Oak w/ nonglare 34.65 51.05 65.50 Brown w/ nonglare 0.82 0.90 1.01 Brown w/ nonglare 0.93 1.01 1.12 Cherry w/ regular 37.90 56.30 71.90 Black w/ regular 0.81 0.88 0.98 Black w/ regular 0.92 0.99 1.09 Cherry w/ nonglare 38.40 57.05 73.00 Black w/ nonglare 0.82 0.90 1.01 Black w/ nonglare 0.93 1.01 1.12 Margin Margin Margin Maple w/ regular $ 1.85 $ 4.80 $ 8.60 Tan w/ regular $(0.11) $(0.03) $ 0.02 Tan w/ regular $(0.22) $(0.14) $(0.09)Maple w/ nonglare 2.35 5.30 9.50 Tan w/ nonglare (0.07) (0.00) 0.06 Tan w/ nonglare (0.18) (0.11) (0.05)Oak w/ regular 0.85 5.20 8.60 Brown w/ regular (0.11) (0.03) 0.02 Brown w/ regular (0.22) (0.14) (0.09)Oak w/ nonglare 1.35 5.45 9.50 Brown w/ nonglare (0.07) (0.00) 0.06 Brown w/ nonglare (0.18) (0.11) (0.05)Cherry w/ regular 4.85 5.70 9.10 Black w/ regular (0.11) (0.03) 0.02 Black w/ regular (0.22) (0.14) (0.09)Cherry w/ nonglare 5.35 5.95 10.00 Black w/ nonglare (0.07) (0.00) 0.06 Black w/ nonglare (0.18) (0.11) (0.05)

The per unit margin numbers were derived by using the following summarized unit cost data:

Custom Frames Plastic Frames If Custom Frames are Discontinued Size Size Size Size Size Size Size Size Size

Wood Small Medium Large Plastic 5X7 8X10 11X14 Plastic 5X7 8X10 11X14Maple $ 9.25 $ 14.80 $ 18.50 Tan $ 0.10 $ 0.15 $ 0.23 Tan $ 0.10 $ 0.15 $ 0.23 Oak 12.75 20.40 25.50 Brown 0.10 0.15 0.23 Brown 0.10 0.15 0.23 Cherry 16.50 26.40 33.00 Black 0.10 0.15 0.23 Black 0.10 0.15 0.23 Glass Glass Glass Regular $ 4.50 $ 5.00 $ 6.00 Regular $ 0.06 $ 0.09 $ 0.11 Regular $ 0.06 $ 0.09 $ 0.11 Nonglare 5.00 5.75 7.10 Nonglare 0.08 0.11 0.14 Nonglare 0.08 0.11 0.14 Labor 16.00 24.00 32.00 Labor 0.18 0.18 0.18 Labor 0.18 0.18 0.18 Overhead per unit $ 0.90 $ 0.90 $ 0.90 Overhead per unit $ 0.47 $ 0.47 $ 0.47 Overhead per unit $ 0.58 $ 0.58 $ 0.58

NOTE: The numbers above are rounded to the second decimal for presentation purposes; however, the math was performed in Excel without rounding.



This case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. The case was inspired by discussions with Craig Isom, a former audit partner, and we gratefully acknowledge his contribution to its development. Surfer Dude Duds is a fictitious company. All characters and names represented are fictitious; any similarity to existing companies or persons is purely coincidental.

Surfer Dude Duds, Inc.Considering the Going-Concern assumptionMark S. Beasley · Frank A. Buckless · Steven M. Glover · Douglas F. Prawitt

To expose students to the behind-the-scenes is-[1]

sues involving going-concern evaluationsTo illustrate circumstances when an auditor would [2]

issue a going-concern explanatory paragraph and the implications of such a modification from the perspective of both the client and the auditor.

To understand the effect that a going-concern ex-[3]

planatory paragraph has on a company’s struggle for survival—the “self-fulfilling prophecy” effect.To highlight the importance of the auditor ex-[4]

ercising independent judgment even in light of friendly client-auditor relationships.


KEY FACTSSurfer Dude Duds, Inc. is a clothing and accessories company specializing in the California ��“surfer” culture. The mild economic recession has especially impacted the clothing industry, and analysts forecast that continuing hard times lie ahead. Surfer Dude found itself unable to meet all of its financial obligations and the future of the company is in doubt. Mark has been the audit partner for Surfer Dude for the last six years, which has helped him ��develop a strong, personal friendship with George Baldwin, the company CEO.During the previous six years on the Surfer Dude audit, the audit report had always indicated a ��“clean” opinion on the company’s financial statements. Mark consulted with his concurring partner on the audit and decided that the only alternative ��for this year’s audit of Surfer Dude’s financial statements was to add a going-concern explanatory paragraph to the audit report.Mark told George of his decision and George replied that a going-concern explanatory paragraph ��would become a self-fulfilling prophecy that would ultimately damage the company, leading to its failure and the unemployment of Surfer Dude employees.

USE OF CASEThis case is an excellent tool for emphasizing pressures auditors face when trying to balance satisfying their clients with remaining loyal to their duty to the public. Class discussion of this case could be centered around the theme of independence and the pressures the auditors feel as they attempt to remain independent of their clients while still maintaining a close, working relationship beneficial to both the client and the audit firm. In doing so, the instructor should help students recognize the principal duty of the auditor and the importance of focusing on fulfilling their obligations to protect public interests. At the same time, the case also illustrates the reality of close auditor-client relationships that often develop. We find that this usually leads to a discussion of how a going-concern explanatory paragraph can negatively impact a company by becoming a “self-fulfilling prophecy” in that the going-concern disclosure casts such doubt about the company that

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stakeholders (e.g., creditors, customers) no longer engage in transactions with the client. The in-class discussion should also highlight the fact that full and complete disclosure is the best approach for both the auditor and the client.

PROFESSIONAL STANDARDSRelevant professional standards for this assignment include AU Section 220, “Independence,” AU Section 341, “The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern,” ET Section 53, “Article II-The Public Interest,” ET Section 55, “Article IV-Objectivity and Independence,” and ET Section 101, “Independence.”

SUGGeSTeD SOLUTION

What are Mark’s options?[1]

The first option available to Mark is to withdraw as the partner in charge of the audit if he feels his objectivity is in any way compromised. If he feels unsure about his ability to make a judgment with complete objectivity and professionalism, he could withdraw from the audit and allow another partner to deal with Surfer Dude and issue the appropriate audit report.

Another possibility for Mark is to not include a going-concern paragraph in the audit report with the hope that it would allow Surfer Dude the opportunity to improve their worsening financial condition. This option would satisfy Mark’s desire to help Surfer Dude by not causing them any possible further damage. But by doing so, Mark may be compromising his duty to the public whose interests he is obligated to protect. Such actions could lead to serious negative consequences for the public, for the profession, for Mark’s firm, and for Mark himself if Surfer Dude ultimately fails.

A third option available to Mark is to include a going-concern explanatory paragraph in the audit report. He would do so at the risk of losing his friendship and future business relationship with George and Surfer Dude. In addition, Mark knows that the issuance of a going-concern report modification could further limit the likelihood of Surfer Dude overcoming their financial difficulties.

It may be possible for Mark to delay issuing an opinion on the audited financial statements for a few weeks until further information is available as to whether Surfer Dude will be successful in obtaining new financing or resolving in some other way the substantial doubt about the entity’s ability to continue in existence during the coming year. This is clearly not a permanent resolution, but may provide time for some of the doubts to be resolved one way or the other.

How might a going-concern explanatory paragraph become a “self-fulfilling prophecy” for [2]

Surfer Dude?

George Baldwin’s emotional plea to Mark is that the issuance of a going-concern explanatory paragraph would eventually put them out of business. Creditors would not want to loan them more money and may even withdraw existing credit, vendors might require C.O.D. on purchases, and customers may not buy from them out of fear that Surfer Dude may not stand behind its sales return policy. In fact, it is quite possible that a going-concern explanatory paragraph could cause such a reaction. By stating to the public that the ability of this company to continue as a going concern is in doubt, many key stakeholders (suppliers, customers, creditors, shareholders, and employees) might react in ways to protect their own interests that would be adverse to Surfer Dude’s viability. Unless they look beyond the going-concern modification and believe the company will pull out of the hard times, stakeholder reaction to the auditor’s report could make the company’s chances of survival even slimmer.

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Case 12.4: Surfer Dude Duds, Inc.


What potential implications arise for the accounting firm if they issue an unqualified report [3]

without the going-concern explanatory paragraph?

The implications for the audit firm that could arise if a clean opinion is issued should be one of Mark’s major concerns in this case. First, if a clean opinion is issued and Surfer Dude reverses the negative trends as George predicts, then Mark’s firm will be able to continue in a friendly working-relationship with Surfer Dude, and there will be little, if anything, in the way of negative consequences. However, if the company fails to continue as a going concern within the next year and the auditor fails to report such a possibility in advance, then the auditor faces an increased risk of liability to the stakeholders who relied upon the firm’s audit report. This possibility has the potential to be extremely expensive and damaging to the firm’s credibility. There are also potential implications for the public, for Mark, and for the auditing profession as a whole.

Discuss the importance of full and accurate auditor reporting to the public, and describe possible [4]

consequences for both parties if the going-concern explanatory paragraph and footnote are excluded. How might Mark convince George that a going-concern report is in the best interests of all parties involved?

The auditor’s primary duty is to report accurately and fully to the public. Independent auditors must always act to protect the best interests of the public. The value of the auditing profession is grounded on the public’s trust that the auditor is reporting honestly and objectively. When auditors fail to meet this expectation, the public’s trust in them is damaged and the value of the audit is undermined.

To convince George that a going-concern opinion is the best option for all parties, Mark must help him see the possible negative results as well as the potential benefits to George’s company. On the surface, George believes that the absence of a going-concern explanatory paragraph would allow Surfer Dude the opportunity to recover from their financial difficulties. But in reality, by not issuing such an opinion they could face much more serious consequences. Surfer Dude also has an obligation to accurately report their financial condition to the public and its stakeholders. Failing to do so could expose George and his company to a greater amount of potential liability from potential lawsuits from the company’s stakeholders. It is true that a going-concern report modification will publicly highlight the difficulties that Surfer Dude is experiencing and therefore make other business transactions more difficult. However, the consequences of not reporting fully and completely are potentially much more negative than those associated with not disclosing the going-concern issue. Mark must help George realize that full disclosure to the company’s stakeholders is in his and his company’s best interest.

Is it appropriate for an audit partner to have a friendly personal relationship with a client? At [5]

what point could a personal relationship become an independence issue?

The AICPA Code of Professional Conduct does not prohibit audit partners from having personal friendships with their clients. In fact, audit firms routinely expend considerable resources in strengthening professional ties and relationships, including with clients and prospective clients. As long as such relationships do not impair the independent judgment of the auditor, it would not be considered inappropriate. The key, however, is that the relationship must not affect the independence (in fact or in appearance) of the auditor. If the audit partner begins to feel as a result of his relationship with the client a stronger commitment to the client than to the public, the partner should withdraw from the engagement. To some extent, the requirement for the involvement of a quality review partner on every audit engagement is designed to help ensure that the engagement partner is not “too close” to the situation to be completely objective.

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What factors might motivate Mark to be objective in his decision, despite his personal concern [6]

for his friend?

There are several factors present that encourage Mark to be impartial in his decision. However, the most important factors are his personal integrity, his commitment to his firm, and his duty to the public. Mark can not allow himself to be influenced by his personal concern for his friend or his fear of losing a client. His duty as an auditor is to protect the interests of the public. Failing to do so could result in serious negative consequences, including possible litigation and loss of reputation, for himself and his audit firm. These loyalties to the public and his firm should motivate Mark to remain completely objective in his decision.

In your opinion, what should Mark do? Briefly justify your position.[7]

Students may express a variety of opinions, but the best option is for Mark to remain completely objective in his audit opinion. If the going-concern explanatory paragraph is the most accurate representation of the company’s financial condition, then Mark is obligated to report his substantial doubt about the company’s ability to continue. In doing so, he must help George see the possible benefits that could come of this explanatory paragraph and the possible negative results of failing to include the explanatory paragraph.



The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. Murchison is a fictitious company. All characters and names represented are fictitious; any similarity to existing companies or persons is purely coincidental.

Murchison technologies, Inc.Evaluating an Attorney’s Response and Identifying the Proper audit ReportMark S. Beasley · Frank A. Buckless · Steven M. Glover · Douglas F. Prawitt

To illustrate proper accounting treatment for [1]

loss contingencies.To provide an opportunity for students to evalu-[2]

ate how different attorney judgments about loss contingencies affect auditor reporting.

To highlight the nature and timing of attorney [3]

confirmation letters to auditors. To illustrate how attorney confirmation respons-[4]

es affect the auditor’s evaluation of a client’s accounting for contingencies.


KEY FACTSThis case involves Murchison Technologies, Inc. which is a hypothetical developer of a •patient-billing software system marketed as MEDTECH Software.The accounting firm of Custer and Custer, LLP, was first engaged to review Murchison’s •financial statements four years ago. For the past two years, the audit firm audited the company’s year-end financial statements and issued standard, unqualified reports on those statements. The audit firm is in its third year of serving as auditor. Custer and Custer, LLP, is completing the audit of the December 31, 2008 financial •statements. As part of the final audit procedures, a confirmation request was sent to Murchison’s outside legal counsel asking for the standard attorney confirmation about material outstanding claims against Murchison.Based on discussions with the client, Custer and Custer does not expect any substantive •litigation issues to be identified in the attorneys’ responses. The auditor’s only litigation concern is the alleged copyright infringement apparently filed against Murchison in October 2008.The audit firm’s review of the board of directors’ minutes and discussions with management •indicate that the probability of unsuccessful outcome is extremely low. The litigation case involves another software developer, Physicians Software, Inc., who claims •that Murchison’s MEDTECH Software violates a copyright held by Physicians Software. They are suing Murchison for $220,000.Management believes the suit is immaterial in light of Murchison’s total assets of $7 million •on December 31, 2008 and total revenues and pretax income of $22 million and $1.8 million, respectively, for the year then ended.Custer & Custer received all three requested attorney confirmation responses. Two of those •responses provided no surprises. However, the third response, which is provided in the student’s case materials, is puzzling. The attorney states that they believe the likelihood of a negative outcome is more than remote but less than likely, with possible ranges of loss extending from $150,000 to $200,000.

12.5C a S E

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USE OF CASEThis case is appropriate when discussing auditor reports and completing the audit. Some instructors cover audit reports early in the course, while others discuss audit reports at the end. This case will work for either approach. Instructors planning to use this case early in the course should briefly discuss the purpose and typical timing of attorney letters or refer students to the relevant textbook section discussing attorney confirmation letters. Given that the use of attorney confirmation letters is a relatively easy concept for students to understand, covering them early in the semester should not pose much difficulty. Other instructors may chose to wait to cover this case when discussing final stage audit procedures.

Since the case requires a review of accounting issues related to contingencies, we suggest having students read the background material in advance of any in-class discussion of the case. While the background material is not lengthy, having students read the material during the class period may require too much valuable in-class time. Additionally, some of the American Bar Association information included in the student materials contains some legal terminology, which may be difficult reading for some students. Having time outside class to digest that material should be beneficial. Furthermore, the first question requires students to summarize relevant accounting guidance related to contingencies. Some students may need to refer to a current text of professional standards or an intermediate accounting text to answer that question.

Once students have an opportunity to consider the background information, the case can easily be completed as an in-class group assignment. A useful in-class activity is to have students answer all questions in small four-person groups. Alternatively, the instructor may assign each group a different question. Given that question 4 provides six different scenarios related to auditor reporting about this litigation case, instructors may find it especially helpful to assign each group a different scenario described in questions 4.a through 4.f. Once each group has had time to answer the assigned questions, the class can reconvene to discuss the various group solutions. Instructors can call on students to report their group’s solutions orally during class. The instructor should randomly call on individual students to share their group’s answers to ensure that all students take responsibility for learning the material.

This case can also be used as an out-of-class assignment that can be completed in groups or individually. An out-of-class activity could simply involve having students or groups prepare typed solutions to each of the questions. On the day the solutions are due, a portion of the class should be devoted to reviewing student answers. If the written solutions are individually completed, students can be divided into small groups of three-to-five individuals to share their solutions with other group members.

This case is also appropriate for a senior seminar or capstone accounting course, since the case blends financial accounting and auditor reporting issues. One way to increase the emphasis of the financial reporting issues is to require students to prepare a draft of the related financial statement footnote disclosure, assuming the loss contingency was considered reasonably possible and material. The solution to question 1 provides a brief overview of the required content of the footnote disclosure. Another way to modify the case is to ask students how the auditor would be impacted if the litigation case was not filed against Murchison until after the completion of evidence gathering procedures but before the audit report was issued.

PROFESSIONAL STANDARDSRelevant professional standards for this assignment include AU Section 312 “Audit Risk and Materiality in Conducting an Audit,” AU Section 337 “Inquiry of a Client’s Lawyer Concerning Litigation, Claims, and Assessments, AU Section 508, “Reports on Audited Financial Statements,” and Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies.”

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Case 12.5: Murchison technologies, Inc.



In this case, students are required to evaluate the attorney’s confirmation response letter in light of the background information provided. Specifically, students are asked to identify the correct audit report that should be issued for a variety of changing circumstances surrounding the outstanding claim.

Review the requirements of Statement of Financial Accounting Standards (SFAS) No. 5, [1]

Accounting for Contingencies. Describe the three ranges of loss contingencies outlined in SFAS No. 5 and summarize briefly the accounting and disclosure requirements for each of the three ranges.

Exhibit I of AU Section 337 presents excerpts from SFAS No. 5 that describe these three ranges of loss contingencies, which range from probable to remote:

Probable – The future event or events are likely to occur.Reasonably possible – The chance of the future event or events occurring is more than remote, but less than likely.Remote – The chance of the future event or events occurring is slight.

Exhibit I of AU Section 337 also notes that SFAS No. 5 requires that an estimated loss from a loss contingency must be accrued by a charge to income if both of the following conditions are met:

Information available prior to the issuance of the financial statements indicates that it a.

is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements.The amount of the loss can be reasonably estimated.b.

Disclosure in the footnotes to the financial statements must be made when there is at least a reasonable possibility that a loss or an additional loss will be incurred. The disclosure shall indicate the nature of the litigation, progress of the case, how management will respond, likelihood of unfavorable outcome, and an estimate of the possible range of loss or state that such an estimate cannot be made. No disclosure is necessary if the likelihood of the loss contingency is assessed as remote.

Based on your review of the attorney’s confirmation, which of the three ranges of probability of [2]

loss do you think the Physicians Software, Inc., claim falls? How does that assessment differ from management’s assessment of the loss probability?

Given that the attorney’s response explicitly states that they believe “the likelihood of negative future outcome occurring against Murchison in this case is more than remote but less than likely,” the case appears to fall into the reasonably possible range of loss. That assessment is in conflict with management’s assessment of the outcome. Custer and Custer’s review of Murchison’s board of directors’ minutes and their discussions with management both indicated that management viewed the likelihood of a negative outcome to be in the remote likelihood of loss.

Assuming that management and the attorney’s assessments differ, how would you resolve [3]

such differences when assessing the potential for an unfavorable outcome associated with the claim? What are the pros and cons of relying on the attorney’s assessment versus management’s assessment?

As a first step, the auditors should provide management with a copy of the attorney’s response letter. Given that management is responsible for the financial statements, it is management’s responsibility to resolve this financial reporting issue with its outside attorney. Perhaps management and their attorney have failed to share relevant information with one another

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about the case, which might explain differences in their assessments of the likely outcome. The auditor can help facilitate these discussions; however, ultimately it is management’s responsibility to prepare the financial statements and related disclosures. The advantage of relying on the attorney’s assessment is that the auditor is able to rely on evidence obtained from an external party who is an expert in assessing legal claims. Given the subjective nature of evaluating loss contingencies, there is significant potential for management’s bias to affect (either intentionally or unintentionally) their judgment about the likely outcome of the case. Naturally, the potential negative effect on pretax earnings associated with accounting for and disclosing loss contingencies provides an incentive for management to under assess the potential for loss. As a result, seeking the advice of an outside legal expert offers tremendous advantage to the auditor since the attorney’s assessment should be more objective than management’s. Additionally, outside attorneys have extensive legal training and experience. So, the outside attorney is likely to be more objective and more qualified to make loss contingency assessments than management. One disadvantage of relying on the assessment of the outside legal counsel is that they may be more conservative in making their assessment than management. An outside attorney may prefer to err on the side of conservatism when providing legal assessments to external auditors to minimize legal liability. Another potential disadvantage of relying on the outside attorney’s assessment is that the assessment may not be completely reliable because the attorney has not received the most up-to-date and complete information about the case from management. This disadvantage is most acute when management and the outside attorney’s assessments are in agreement. For example, management might have pertinent information that would lead one to conclude the likely outcome of a contingency is reasonably possible or even probable. Management might withhold this information from both the attorney and the auditor. In that case, the auditor may not obtain a reliable assessment of the likely outcome of a contingency from the outside attorney.

In preparation for tomorrow’s meeting with the partner and likely subsequent meeting with [4]

Murchison management, develop recommended responses to the following possible scenarios. In developing your responses, assume that each scenario is independent of the others:

If generally accepted accounting principles require disclosure of this contingency, how would [a]

you respond to management’s decision against disclosure because they view the claim as immaterial to the December 31, 2008 financial statements? Do you believe the potential loss is material? Why or why not?

The auditor would most likely note that it would be in management’s best interest to provide disclosure about the contingency, since most users would view the claim as material to the financial statements. The auditor could argue that, while omitting such disclosure may have desired short term benefits, the potential harm to the company and management would be greater should the ultimate outcome of the contingency be consistent with legal counsel’s estimates. Such harm could involve additional legal action against the company and management from the venture capitalists and bankers. Given that the known users of the financial statements include venture capitalists and bankers who are likely to be closely monitoring pretax income, most users would likely argue that the attorney’s assessment of the range of potential loss is material. While professional standards do not provide guidance for estimating financial statement materiality, practitioners often use a range of 5 to 10 percent of pretax income to estimate materiality for a for-profit business that is accountable to venture capitalists and creditors. Given that pretax income for the current year is $1.8 million, a reasonable estimate of materiality would range from $90,000 to $180,000. Because the attorney’s estimated potential loss range of $150,000 to $200,000 extends beyond the high end of the auditor’s materiality estimate, most would argue that the loss contingency is material to the current year financial statements.

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Assume that even though you convince management that the claim is material, they refuse [b]

to provide any disclosure that might be required. Prepare a draft of the auditor’s report that would be issued in that scenario.

In this scenario, management is choosing to omit a required material footnote disclosure, which clearly violates generally accepted accounting principles. In this case, both the auditor and management agree that the likelihood is reasonably possible and material. Because the assessment of the outcome falls in the range of reasonably possible, no accounting entry is required. Therefore information presented on the balance sheet and income statement is fairly stated. Only the required footnote is inappropriately excluded. In those circumstances, AU Section 508 would require that the auditor issue a qualified audit opinion due to a departure from generally accepted accounting principles. [Note: given that Murchison is privately-held, the auditor would report in accordance with Auditing Standards (AU) Section 508. If, however, Murchison was a public company, the scope paragraph in the auditor’s report would refer to PCAOB standards in accordance with PCAOB Auditing Standard No. 1, “References in Auditors’ Reports to the Standards of the Public Company Accounting Oversight Board.”] An example of the auditor’s report in this circumstance is provided below:

Custer & Custer, LLPReport of Independent Auditor

To the Board of Directors and Stockholders of Murchison Technologies, Inc.

We have audited the accompanying balance sheets of Murchison Technologies, Inc. as of December 31, 2008 and 2007, and the related statements of income, retained earnings, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

The Company’s financial statements do not disclose the litigation suit filed on October 16, 2008 against Murchison Technologies, Inc., for alleged copyright infringement related to the MEDTECH Software. The plaintiffs seek damages of $220,000. In our opinion, disclosure of this information is required by generally accepted accounting principles.

In our opinion, except for the omission of the information discussed in the preceding paragraph, the financial statements referred to above present fairly in all material respects, the financial position of Murchison Technologies, Inc., as of December 31, 2008 and 2007 and the results of operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.

Custer & Custer, LLPFebruary 17, 2009

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Assume that you determine, through subsequent discussions with the attorney, that a more [c]

likely estimate of the range of loss falls between $30,000 to $45,000. What type of financial statement disclosure do you believe is required in that case? Prepare a draft of the auditor’s report that you would issue in that scenario.

In this scenario, both management and the auditor would likely conclude that the uncertainty is immaterial to the financial statements of Murchison Technologies. The range of loss of $30,000 to $45,000 falls below the conservative rule of thumb materiality estimate described in the solution to question 4.a. In this situation, no footnote disclosure would be required given the lack of materiality. Assuming there are no other material adjusting entries, the auditor would issue the following standard, unqualified report:

Custer & Custer, LLPReport of Independent Auditor




In our opinion, the financial statements referred to above present fairly in all material respects, the financial position of Murchison Technologies, Inc., as of December 31, 2008 and 2007 and the results of operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.


What if you learn that management has pertinent information available about the case [d]

(and the case is deemed material) but refuses to share that information with you? Prepare a draft of the auditor’s report that you would issue in that scenario.

In this scenario, management is restricting the auditor from examining pertinent information related to a material uncertainty. Since this represents a client-imposed scope limitation, the auditor would likely issue a disclaimer of opinion. An example of a disclaimer report follows:

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Custer & Custer, LLP

Report of Independent Auditor


We were engaged to audit the accompanying balance sheets of Murchison Technologies, Inc. as of December 31, 2008 and 2007, and the related statements of income, retained earnings, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management.

The Company did not make available documents and other information related to a litigation suit filed on October 16, 2008 against Murchison Technologies, Inc., for alleged copyright infringement related to the MEDTECH Software. The plaintiffs seek damages of $220,000. Further, other evidence related to the litigation is not available and we are unable to perform other auditing procedures related to this case.

Since the Company did not make available documents and other information and we were not able to apply other auditing procedures to satisfy ourselves as to the outstanding litigation claim against Murchison Technologies, Inc., the scope of our work was not sufficient to enable us to express, and we do not express, an opinion on those financial statements.


Assume that you convinced management to disclose the contingency in the footnotes to [e]

the December 31, 2008 financial statements and that your audit report on those financial statements was a standard, unqualified audit report. What would your responsibilities be if you learned two months after the issuance of the report that Murchison settled the case for $190,000?

In this scenario, management properly complied with generally accepted accounting principles by including a footnote disclosure in the December 31, 2008 financial statements. At completion of the audit (i.e., the auditor’s report date), all available information indicated that the likelihood of a material negative outcome was deemed to be reasonably possible, which required footnote disclosure. Given that the financial statements included the disclosure, the auditor’s issuance of a standard, unqualified opinion report was correct. The subsequent settlement of the litigation case for $190,000 does not impact the auditor’s issuance of the standard, unqualified report. The settlement represents a subsequent discovery of fact that occurred after the issuance of the auditor’s report. Thus, the previously issued financial statements were fairly presented at the time the audit tests were completed. No further auditor action would be required.

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Assume that the settlement of the litigation prohibits future sales of MEDTECH software. [f]

What implication would that have on the auditor’s report on the December 31, 2008 financial statements?

Given that Murchison’s sole product for generating revenues is the MEDTECH Software, a litigation settlement that prohibits future sales of that software would likely cause the auditor to have substantial doubt about Murchison’s ability to continue as a going concern. If the auditor continues to have substantial doubt about the entity’s ability to continue as a going concern after considering management’s plan to address its problems, the auditor would add an explanatory paragraph to the auditor’s report. Here is an example of that type of report, which assumes that the related footnote disclosure is provided:

Custer & Custer, LLP

Report of Independent Auditor




In our opinion, the financial statements referred to above present fairly in all material respects, the financial position of Murchison Technologies, Inc., as of December 31, 2008 and 2007 and the results of operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.

The accompanying financial statements have been prepared assuming that Murchison Technologies, Inc., will continue as a going concern. As discussed in Note X to the financial statements, Murchison recently settled outstanding litigation associated with the alleged copyright infringement related to its MEDTECH Software. That settlement prohibits Murchison from any future sales of the MEDTECH Software product. That settlement arrangement raises substantial doubt about the company’s ability to continue as a going concern. Management’s plans in regard to this matter are also described in Note X. The financial statements do not include any adjustments that might arise from the outcome of this uncertainty.


403



Discuss why the attorney’s letter is being received so close to the completion of the audit. Was [5]

the request for the attorney’s response an oversight that should have been taken care of closer to December 31, 2008, or was Custer & Custer appropriate in not requesting the response until close to the end of the audit?

Auditors typically time the receipt of the attorney’s response to closely coincide with the day the auditor has completed the collection and evaluation of sufficient, appropriate audit evidence. Given that the ultimate outcome of a loss contingency is dependent on the outcome of a future event, auditors prefer to wait until the audit is almost complete so that the attorney has the opportunity to consider the most recent developments in the case when preparing the attorney’s response to the auditor. Therefore, the request for the attorney’s response was not an oversight on the part of the auditors, Custer & Custer. Rather, the auditors purposefully timed the request from the attorney so that the related response would be received as close to the completion of the audit as is practical in the circumstances.

Assume that Custer & Custer was delayed a month in completing the collection of audit [6]

evidence. What actions would be appropriate relating to gathering evidence about potential contingencies?

Given the information contained in the solution to question 5, the auditor should consider requesting the outside attorney to update in writing the attorney’s earlier response. This would be particularly appropriate if events related to the case have occurred, such as depositions taken, offers of proposed settlements received, or the trial has started. In some cases, the auditor may conclude that a discussion about the case with the outside attorney may be sufficient. Paragraph 10 of AU Section 337 notes that in special circumstances, the auditor may obtain a response concerning matters covered by the attorney’s response letter in a conference, which offers a more detailed discussion and explanation than a written reply. That paragraph notes that the auditor should appropriately document conclusions reached concerning the accounting for a loss contingency. In addition to performing follow up procedures with the outside attorney, the auditor would also update all subsequent events procedures through the new date. That would include, among other procedures, updating inquiries with management and reviewing recent board of directors’ minutes for issues related to the financial statements under audit, including issues related to loss contingencies. The letter of representation obtained from management should be dated as of the new audit completion date.

Review the ABA policy statement excerpts in Exhibit 1. What limitations exist as it relates to [7]

the attorney’s response? To what extent should auditors rely solely on attorney responses to identify outstanding claims against audit clients?

The ABA policy notes the attorney’s response contains these limitations:The response is limited to matters which have been given substantive attention by a.

the lawyer in the form of legal consultation and, where appropriate, involves legal representation since the beginning of the period or periods being reported upon.The attorney’s response only addresses legal services performed by the attorney’s b.

firm since the beginning of the fiscal period under audit related to overtly threatened or pending litigation, whether or not specified by the client. The attorney’s firm has not performed a review of the client’s transactions or other matters for the purpose of identifying other loss contingencies.

Paragraph 02 of AU Section 337 notes that management is responsible for adopting policies and procedures to identify, evaluate, and account for litigation, claims, and assessments as a basis for the preparation of financial statements in accordance with generally accepted accounting principles. Paragraph 07 of AU Section 337 notes that the auditor normally

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performs the following procedures in addition to obtaining the attorney’s response letter:Reading minutes of meetings of stockholders, directors, and appropriate committees a.

held during and subsequent to the period being audited.Reading contracts, loan agreements, leases, and correspondence from taxing or other b.

governmental agencies, and similar documents.Obtaining information concerning guarantees from bank confirmations.c.

Inspecting other documents for possible guarantees by the client.d.

Paragraph 08 of AU Section 337 also notes that a letter of audit inquiry to the client’s attorney is the auditor’s primary means of obtaining corroboration of the information furnished by management.

section 12 completing the audit reporting to management, and

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