CASE 9

DISCUSSION
(1)
Any company which does not maintain an extensive accounting staff will often rely on
the independent auditors for information concerning the application of authoritative
pronouncements. Most CPA firms assume some responsibility for eeping client
companies aware of important accounting standards and the potential effects on
financial reporting. !hus" #ogers$ lac of nowledge about Statement 34 is not
unusual% a bigger surprise might be that the company$s auditors had not previously
discussed the re&uirement with this client.
(')
(here possible" expense accounting follows the matching principle which states that
expenses should be recogni)ed in the period in which they assist in generating
revenues. An asset produces no revenues prior to being placed into service.
!herefore" any expense recognition (such as depreciation or interest) would be
inappropriate during construction. *nly after the asset is in use generating revenues"
should any related expense be recorded.
(+)
!heoretically" the management of the client company prepares all financial figures
which are then corroborated by the independent auditors. ,owever" -aeside
apparently has no one on its staff with the expertise to mae this particular
calculation. .n such cases" the auditor is fre&uently forced to generate the data" and
provide figures which are presented to the client as proposed ad/ustments. -aeside
should be warned though that this tas is outside the realm of a normal audit and" if
extensive" may re&uire an additional fee.
(0)
!his &uestion offers another opportunity for interesting class discussion. 1tudents
often view accounting as a discipline in which all &uestions can be ultimately resolved
by an ade&uate nowledge of accounting standards. .n this instance" they face a case
of financial statement manipulation that is being carried out by the client within the
framewor of accounting$s own official guidelines. A review of 2A13 Statement 13 can
be assigned to assist the students in analy)ing this case. Paragraph '4 of this
pronouncement states5
6.nsofar as the separate financial statements of the related parties are concerned" the
classification and accounting shall be the same as for similar leases between
unrelated parties except in cases where it is clear that the terms of the transaction
have been significantly affected by the fact that the lessee and lessor are related. .n
such cases the classification and7or accounting shall be modified as necessary to
recogni)e economic substance rather than legal form. !he nature and extent of
leasing transactions with related parties shall be disclosed.6
After reading 2A13 Statement 13" students may argue that the lease is actually for a
number of years (probably the life of the building) and that the proposed series of
one8year contracts is only a sham to create the appearance of an operating lease. .n
reality" the lease (or so this argument would go) is for over 9:; of the economic life
of the property. ,owever" if new lease payments are to be negotiated each period (or
if -aeside intends to stay for only a short time in that location)" a legitimate
economic reason may exist for this arrangement. <nless -aeside can show such a
rationale for the one8year leases" the auditor will probably use the 6actual6 life of the
lease as /ustification for re&uiring capitali)ation.
!he auditors also need to verify that the ='1">>> payment for the building has not
been 6significantly affected6 by the relationship between -aeside and #ogers.
Abernethy and Chapman will want to learn how this figure was determined and"
perhaps" see information about rental rates for similar property in the vicinity of
that store. #ogers states that 6the price is &uite reasonable for that store at that
location"6 but his opinion does not provide the auditors with much assurance.
#egardless of the accounting" as a related party transaction" the auditors must ensure
that the nature and extent of the lease has been fully disclosed within the financial
statements. #ogers has indicated that such reporting will be made. ?ven if the lease
were deemed to be an operating lease" the information included within these notes
could be used by readers to come to an understanding of the nature of this
transaction. !his case indicates the importance of a complete nowledge of
accounting. A decision8maer need not be limited to woring with /ust the numbers
presented in financial statements but should become capable of using and
understanding all of the information that is provided.
(:)
!he recording of accounting information is normally based on ob/ective evidence
gathered by analy)ing the impact of transactions that occur between the reporting
entity and outside parties. ,owever" related party transactions do not provide
evidence with the same degree of ob/ectivity. 1ales prices or contracts" for example"
might not be negotiated as they would otherwise be with outsiders. 2igures may
simply be fixed by management. Conse&uently" to inform the financial statement
readers of the impact of these dealings" the relationship must be described along with
the details of the transactions.
(@)
!he potential impairment of value of 1tore 1ix has been an underlying problem
throughout the -aeside audit. .n discussing this issue" students fre&uently
concentrate on the wrong issues5 client retention versus safety from litigation. Audit
opinions" however" should be based on the actual evidence accumulated and the
related reporting employed by the client" not on the avoidance of problems. 1uch a
limited approach fails to recogni)e the auditor$s function5 to gather corroborative
evidence on which to base an opinion as to the fair presentation of the financial
statements. Airtually no corroborative evidence is presented in these cases in
connection with 1tore 1ix and its potential impairment of value% therefore" students
have no basis for any specific course of action. .n practice" auditors first gather as
much evidence as possible and only then do they mae a final determination when
faced with this type problem.
1tudents can be ased to list the inds of evidence Abernethy and Chapman might
see in evaluating the possibility of a material impairment of value in connection with
1tore 1ix. !his exercise is a good techni&ue for demonstrating the necessity of
creativity in the auditor$s wor. !he auditor needs to consider all possible ways to
gain assurance about the future of this store. A few of the evidence8gathering
procedures that might be carried out would include5
Biscussion with the owners and managers of the shopping center as to their
strategies for renting more space and improving customer traffic.
2urther in&uiry of #ogers as to a /ustification for his favorable forecast
regarding this store. .f these pro/ections are based on tangible data or on
specific plans" the auditors will have much more assurance than if #ogers is
simply acting on intuition.
!al to owners and managers of the stores located in the shopping center to
see whether their pro/ections are similar to those of #ogers.
1earch for any studies that have been prepared on the consumer electronics
business which might a) pro/ect a brea8even point for a store or b) assess the
riss involved in the failure of a single outlet.
,ire a real estate appraiser to estimate the sales value of the building if it
should have to be sold. !his valuation will enable the auditor to anticipate the
potential loss being faced by -aeside.
*ne final point should be made in connection with this potential impairment of value.
!he implication is made throughout these cases that the primary responsibility for
resolving this issue lies with the auditors. !hat is not correct. !he financial
statements are representations of the management of the client company. As such"
management is responsible for /ustifying the financial reporting. <nless #ogers maes
a significant attempt to prove his present position in this controversy" the auditors
will have trouble rendering an un&ualified opinion.
(9)
-ittle doubt exists that #ogers has issued a subtle threat to the new audit firm. *ne of
the primary reasons for investigating the integrity of management prior to accepting
an engagement is to avoid the possibility of this type of blacmail. !his warning was
issued in such a way by #ogers that Abernethy and Chapman will probably not need to
consider the possibility of resigning but" if a similar threat is ever made in an overt
manner" immediate resignation by the CPA firm should be considered.