THE LAKESIDE COMPANY: AUDITING CASES

9. RESOLVING AUDIT PROBLEMS

Early in 2010, Wallace Andrews, manager with the CPA firm of Abernethy and Chapman,
visited the headquarters of the Lakeside Company, Andrews was making a periodic
review of the audit work performed to date by Carole Mitchell, Art Heyman, and Paul
Reubens. He also wanted to discuss the examination with Benjamin Rogers, president of
Lakeside. During every engagement, Abernethy and Chapman auditors attempt to keep
the clients senior management advised of the progress being made. In addition, several
matters had been brought to Andrews attention that he felt should be discussed with
Rogers.
The first of these issues concerned a major addition being made to the company
warehouse. In reading the minutes of the board of directors meetings (see Exhibit 9-1),
Andrews had noted the boards approval of a $220.000 expansion and renovation to this
facility. Early in December, Andrews inspected the actual construction work, which was
approximately one-fourth complete at that time. Then, at year-end, a bank confirmation
was malled to the Virginia Capital Security Bank, the organization financing the project
(see Exhibit 9-2). The completed confirmation returned by the bank indicated that
Lakeside had borrowed $100.000 to date.
When asked about the construction, Rogers described Lakesides negotiation of a
$200.000 mortgage loan to finance the expansion. The case was to be provided to the
company in four equal monthly installments beginning on November 15. According to
Rogers, This entire construction project, both the addition and the renovation, should be
finished by March 1, 2010. Although we cant be sure of the total cost just yet, it should
be approximately $225.000. We will use Lakesides own funds to finance costs over and
above the $200.000 loan. We borrowed the money from Virginia Capital at a 10% rate. I
talked to a number of other banks and lenders but that was the best rate that was available
at that time.

Several potential accounting problems involving the expansion concerned Andrews.

First, he was worried that Lakeside might already be recording depreciation expense on
the addition even thought it was not yet in operation. Rogers assumed that the companys
method of accounting was correct but suggested that Andrews discuss the handling of thi
matter with the controller.
Andrews also wanted to verify that Lakeside was properly capitalizing the interest costs
incurred during the construction as required by statement 34 of the Financing Accounting
Standard Board (FASB). Rogers confessed that he knew nothing about this particular
accounting pronouncement. He was virtually certain, though, that Lakeside would have
expensed any interest on the debt. However, no interest charges had yet been paid or
recorded in connection with the project. Rogers suggested that the audit team calculate
an adjustment to capitalize this interest for the current period.
Andrews final concern in auditing the warehouse expansion involved Lakesides method
of separating repair expenses from capitalized costs. Improper capitalization of expenses
was an issue in several recent accounting scandals, and this issue was discussed during
the fraud brainstorming session by the audit team. The board of directors minutes had
indicated that the old warehouse facility was to be repair as part of the construction work.
Andrews was interested in the procedures being used by the company to isolate these
repair costs. Rogers replied that no special techniques had been incorporated to account
for the construction project. As with all expenditures, except for inventory purchases,
which were handled separately, invoices were coded by the Controllers Office upon
receipt. This process required each invoice to be stamped and an account number written
in to identify the appropriate debit entry for the transaction. Thus, all invoices were
reviewed and classified at that time to separate capital expenditures from repair
expenses. Rogers stated that his signature was also necessary on all invoices that required
a payment of over $200, but he made no attempt to verify the accuracy of the account
coding.

Andrews then moved the discussion to the issue of the seventh store, which Lakeside had
begun operating on December 1, 2009, In Williamsburg, Virginia. Carole Mitchell had
informed Andrews that Lakeside made a $21.000 payment on November 28, 2009, to
Rogers Development Company, the corporation, which constructed this building and was
leasing it to Lakeside. She also revealed that Benjamin Rogers and his wife own Rogers
Development Company. The entire $21.000 had been charged by Lakeside to a prepaid
rent account with 1/12 of this total being subsequently reclasiffied to Rent Expense for
the month of December. Andrews was very concerned as to whether this rental agreement
constituted a capitalized lease based on the criteria established by statement 13 of the
FASB. He was also concerned as to the possibility that Rogers Development Company
might actually be a variable interesr entity (also known as a special-purpose entity) that
may need to be consolidated with the Lakeside Companys financial statements.
Roger adamantly refused to even entertain the possibility that this arrangement might be
a capital lease or that Rogers Development Company might be a special-purpose entity.
He immediately brought out the rental contract (see Exhibit 9-3) between Lakeside and
his construction company. The agreement is for one year only. We will renegotiation on
a year-by-year basis; the board of directors fully agrees with the handling of this matter.
In addition, the price is quite reasonable for that store at that location. I even checked into
this matter with a lawyer before drawing up the contract. Neither a bargain purchase
option nor a transfer of ownership is included in the lease. The building has a useful life
of at least 25 years; thus, the one-year contract is for a period of time less than 75% of the
propertys economic life. Finally, since the residual value is not guaranteed, the $21.000
payment fails to satisfy the 90% present value criterion. This lease simply does not meet
any test for being a capital lease.
Andrews was quite surprised by Rogers fervor and knowledge of this FASB Statement.
Upon further questioning, the president indicated that growth is important to me. To
grow, Lakeside has to be able to borrow money and, thus, needs a good debt/equity ratio.
By financing the building in this manner, the construction debt is actually mine and not
that of the company. I plan to earn a reasonable return on my investment but, even more

importantly, Lakeside maintains its borrowing potential. I do realize that this lease
qualifies as a related party transaction and will have to be disclosed in a note to the
financial statements. However, Im not sure that anyone actually reads those notes.
Andrew was concerned by Rogers contentions and decided to discuss the issue with Dan
Cline, the audit partner on the engagement, before taking further action. He wanted to
read statements 13 once again to see if any guidance was offered by the pronouncement
about capital leases. Andrews also wanted to review FASB Interpretation 46 about
variable interest entities. Thus, he chose to forgo additional discussion with Rogers
concerning the lease and moved to his final agenda item: Lakesides store six.
Store Six began operations in November 2007 but had never proven successful. The
previous audit firm had even qualified its opinion on Lakeside s 2008 financial
statements because of Rogers unwillingness to record or disclose the impairment of the
value of the companys investment. Although sales were up slightly in 2009, the store
continued to show a considerable loss after two years of operation. The adjacent shopping
center was still having its own problems, with less than 60% of the available space being
rented. Andrews did not believe that store six was capable of generating a profit in the
foreseeable future.
When questioned, Rogers was somewhat philosophical about the situation. We studied
that marked before we went into it. We felt that the location had longrange potential and
we still do. Lakeside is not the kind of company that enters an area on an impulse and
then pulls up stakes if things dont go our way at first. We can make that store profitable,
and we will. I wasted too much time last year arguing with king and company over this
issue. As you know, that firm is gone and the store is still at the shopping center making
sales. Store Six will be doing business for as long as Lakeside is in business. I really have
nothing further to say on the matter.
DISCUSSION QUESTIONS

1. Why would a companys principal officer not know about an important

accounting pronouncement by the FASB?
2. Why is depreciation expense not recorded until after an asset is put into use?
3. Rogers suggested that Abernethy and Chapman calculate the amount of interest
that should be capitalized this year for the construction project. Since the financial
statements are the responsibility of the management, is this action appropriate for
an audit engagement?
4. What should Andrews do now concerning the lease arrangement that has been
created for the seventh store? Will Lakeside s financial statements be fairly
presented if this lease is reported as an operating lease rather than a capitalized
lease? Is inclusion within the notes to the financial statements an adequate way of
reporting this lease?
5. Why are related party transactions separately disclosed in financial statement
notes?
6. Despite Rogers assurance Store Six could still be closed down, resulting in a large
loss to Lakeside. The audit opinion was qualified in the previous year, and the
situation has not changed significantly. Should Abernethy and Chapman give a
similar opinion this year to protect the firm from potential liability? What should
Abernethy and Chapman do now in connection with the uncertainty involved with
Store Six?
7. When Rogers made reference to the firing of King and Company, was he issuing a
threat to the current auditors? If so, how should Abernethy and Chapman react to
such a threat?
EXERCISE
1. Following his discussion with Rogers, Andrews talked briefly with Carole
Mitchell concerning the warehouse expansion. She indicated that Art Heyman had
already prepared an analysis of the Repairs and Maintenance account (see Exhibit
9-4). In addition, based on the debits to the warehouse account (see Exhibit 9-5),
he had located the invoices substantiating the capitalized transactions (see Exhibit
9-6). The audit team discovered two other related invoices (see Exhibit 9-7) while
reviewing the invoices received by Lakeside subsequent to the end of 2009.

Perform the necessary steps to test the warehouse account (#111-1) and document
your procedures on an audit document similar to the one in Exhibit 9-4. Indicate
and prepare on the audit document any proposed correcting entries that are needed
to ensure fair presentation of this financial information. (case 9-1.doc)