SULTHAN HAKIM/ 145020308121003

International Undergraduate Program in Accounting of Brawijaya University

Course: Auditing Laboratory

AUDITING CASES: 2. NEW CLIENTS AND AN AUDITORS LEGAL LIABILITY

DISCUSSION QUESTIONS

1. The question of materiality is certainly one of the most complex issues in all of
auditing. No clear-cut guidelines have ever been established to aid the auditor in
deciding whether a specific balance or transaction is "material." This lack of an official
standard provides the auditor with the freedom to base all final decisions on
professional judgment. Unfortunately, without a formal rule, the auditor has little
guidance in applying judgment to a particular situation.

Materiality has traditionally been held to be any factor that would influence the
decisions of those parties relying on the financial statements. Identifying a proper
basis of comparison is an important aspect in determining whether an uncertainty is
material. Net income is the most obvious standard of comparison, although another
consideration is which of the statements is affected (e.g., Balance Sheet, Income
Statement, or both?). The situation questioned by King and Company involves an
investment in fixed assets. Comparing the potential loss to total assets, investment in
stores, and owners' equity would seem a reasonable basis for judging materiality.
Another possible basis is the effect of the asset write-off on net income.

In the Lakeside case, each auditor would have to decide independently as to whether
Store Six represents a material contingency for this client. The potential closing of
Store Six is certainly an unusual occurrence and for that reason should be evaluated
against the client's $500,000 net worth and the $1.8 million in total assets reported in
the case. In making these comparisons, the auditor needs to anticipate the potential loss.
Although the total loss could amount to $186,000, Rogers has suggested $136,000 as a
maximum figure. Unfortunately, estimates provided by the president of the client
company are circumstantial evidence, having little power to persuade.

In the view of the authors, this potential loss (of over $100,000) for a company with a
net worth of only $500,000 would certainly appear to be material. Other comparisons
based on total assets or income would give similar results.

2. The CPA firm must talk with the predecessor auditor before accepting the engagement.
The new auditors can learn about the integrity of the potential client's management as
well as about any accounting or auditing problems that might be encountered. If
Rogers prohibits this meeting, Abernethy should carefully explain the necessity of
the procedure. The client may not be fully aware of audit practices and fail to
understand that such discussions are a normal part of investigating new clients. Should
the client still insist that no communication be made with the previous auditor,
Abernethy would normally have to reject the new engagement unless very unusual
 circumstances surrounded the client's request.

3. The information given by the predecessor auditor as to the integrity of the client's
management must weigh heavily in the decision to seek a new client. Because of the
potential legal liability faced by independent auditors, the decision to accept a client
has become quite important. No auditor wants to perform an engagement for a
company with a management that cannot be trusted. However, in evaluating the
assertions of King and Company, Abernethy must realize that this firm has just been
fired from the Lakeside audit. Some potential bitterness toward the client is certainly
possible. Thus, auditors usually seek references from other than just the predecessor
auditor before deciding whether to actively pursue a new audit client.

4. In a peer review, a team of outside auditors is hired by a CPA firm to review its system
of quality controls, the policies and procedures utilized by that organization to ensure
that its members are following all professional standards audit, accounting and review,
ethics, etc. This review helps to ensure that the firm is fulfilling its professional
responsibilities. If the peer review team discovers practices that are unprofessional or
inadequate, the firm can make immediate corrections to rectify the problems.

Peer reviews originated in the 1970s when litigation of CPA firms became rampant, and
congressional investigations of the profession indicated that drastic improvements were
needed. The peer review process was instigated to provide firms with a means of
getting outside consultation about their professional practices. Rather than discovering
problems only after losing a lawsuit, the firms were periodically reviewed by these
outside teams to catch problems before they grew to be too large.

A peer review team looks at the means by which the public accountant ensures quality
control within its practice. For example, the acceptance of new clients should be
properly monitored by the firm. Adequate consultation needs to be made available to all
staff members so that audit problems can be properly resolved. Hiring and promotion
practices should be established and in place to provide sufficient staffing for all
engagements. The peer review team looks at all areas of quality control to ascertain that
problems do not exist that could lead to substandard work. In addition, the team
reviews the audit documents for a selected number of engagements to see if
sufficient, competent evidence is being gathered and properly documented.

5. Audit documents are intended to provide a record of the auditor's examination and the
evidence accumulated. Thus, all testing done in each audit area should be documented
and included within the working paper file. In addition, the audit documents must
verify that the examination was planned and the auditing staff was properly supervised.
Any auditing or accounting problems encountered during the engagement have to be
spelled out in the audit documents along with an explanation of the resolution of each
issue.

The permanent file will hold all data about the client that is not anticipated to change
dramatically from year to year. It can be reviewed by the auditor prior to beginning the
engagement to gain insight into the organization of the company. A permanent file will
normally include items such as the articles of incorporation, organization chart, chart of
accounts, contracts, other long-term legal agreements, and a written description of the
 company as well as its organization and history.

The annual working paper ("current") file contains documentation of the evidence
gathered during a specific audit. Thus, the results of confirmations, inquiry,
observations, inspection, calculations, and all other testing are placed within these audit
documents. The contents of this file must substantiate the audit opinion and also that
the auditor followed generally accepted auditing standards on this particular
engagement.

6. As a professional, the independent auditor has a responsibility to ensure that a

prospective client understands the function of an audit prior to accepting an
engagement. Not every member of the business community will have the background
knowledge to comprehend the purpose of the attest function and the extensive testing
procedures that it requires. In addition, many possible clients do not require the degree
of assurance provided by an audit but are not aware of alternatives such as compilations
and reviews. Since independent auditors have knowledge of the attest function and are
offering these services to the public, responsibility for a full understanding by the client
lies with the firm. In addition, the firm is required to reach an understanding of the
audit function with the firm and the engagement letter is used to document this
understanding.

7. The providing of adequate service to a client would always require that the CPA firm
suggest a review rather than an audit whenever it might meet the company's intended
objectives. The client must understand, though, that a review is substantially less than
an audit. Procedures are limited primarily to inquiries of the client's management along
with analytical procedures applied to the financial statements. The report then states
that the firm was not aware of any material modifications to the financial statements
that require adjustment to be in conformity with generally accepted accounting
principles (a limited or "negative" assurance).

In a review, control risk is not assessed, tests of controls are not made, and adequate
substantive testing procedures are not performed on which to base an opinion as to the
fair presentation of the financial statements. Because these procedures are omitted, a
review is less expensive than an audit. However, the banks and stockholders must be
willing to accept the lesser degree of assurance being provided by the independent
auditor. The client should be made aware of this option but also the potential problems
of not having a complete examination. Of course, if Lakeside pursues the public
offering a review will not be adequate.

8. Many students may want to reject this engagement based on the internal control
problems, the impairment of value issue, and Rogers' arguments with the predecessor
auditors, but such situations are not uncommon occurrences in auditing. Public
accounting is not a risk-free profession; no perfect audit client ever exists. Thus, a firm
must be able to assess the problems involved and weigh them against potential
rewards. Abernethy and Chapman has an opportunity here to pick up a new client in a
new industry. In addition, Lakeside has demonstrated the possibility of significant
growth in the future. However, the auditing firm needs to seek some resolution for the
uncertainty before becoming involved. Since that problem is already obvious, an
understanding should be reached with Lakeside prior to beginning the engagement. If
this issue can be successfully resolved, the auditor should seek this new client.
 EXERCISES

1. Exhibits 2-1
1. Privately held
2. The basic liability to the client is for losses occurring as a result of any firm
negligence. If Abernethy and Chapman performs the engagement as an average,
prudent auditor would, no problem exists. If not, the client may sue for return of
its audit fee as well as any other resulting losses. A special problem area exists in
the Lakeside case: the client's weak internal control. Such weaknesses increase
the likelihood of fraud or embezzlement. The control problems also make
discovery of such defalcations more difficult. In addition, proving that the firm is
innocent of negligence is often difficult to do if the client loses money through
defalcations not discovered by the auditor.
3. The current stockholders
Cypress Products
Two banks financing the inventory
National Insurance Company of Virginia (mortgage loans)
Possibly other creditors
4. As Rogers has expressed considerable interest in expansion, the CPA firm
should anticipate that the financial statements could be presented to potential
stockholders or lenders.
5. As a privately held business, this audit does not fall under federal security laws.
Thus, the auditor is bound by common law and is judged under such precedents
as the Ultramares case, the CIT Financial Corp. case, and the Rusch Factors case.
In the Lakeside audit, the CPA firm should have no liability to third parties
unless the audit is performed in a grossly negligent manner or the firm is
negligently responsible for careless financial misrepresentations. In a few
jurisdictions, they may be held liable to foreseen or foreseeable beneficiaries for
ordinary negligence.

1. Exhibits 2-2
1. Predecessor auditor indicated no problems with the integrity of the Lakeside
Management
2. A major problem existed between Lakeside and the predecessor auditor
involving an explanatory paragraph in the 2005 report. This uncertainty issue
revolved around the potential loss foreseen in the possible closing of one of
Lakesides stores.
3. Predecessor auditor stated that the firm was discharged over the wording of the
previous audit opinion.
4. The predecessor auditor also mentioned weaknesses in Lakeside's internal
control and Rogers' unwillingness to improve these systems.
5. Predecessor auditor stated that the audit audit documents could be reviewed.
6. No limitation was indicated.
 2. The auditor will perform a number of steps in reviewing the audit documents of the
predecessor auditor. The major objective is to examine the types of information that
would be available to an auditor in an ongoing engagement. Through this review, the
auditor can gain satisfaction as to the validity of beginning account balances as well
as accounting principles applied in the previous audits. By relying on the work of the
predecessor auditor, the extensive review necessary in an initial audit can be held to
a minimum.

The audit working paper review should include the following steps:

Determine that satisfactory evidence has been obtained to verify beginning-of-year

balances in such accounts as inventory, land, buildings, equipment, paid-in capital,
and retained earnings.
Ascertain the specific accounting principles applied in the previous fiscal year.
Review internal control evaluations for obvious weak areas and for strengths.
Review the analysis of contingencies.
Watch for any problem areas (such as slow collection of accounts receivable) that
were singled out in the previous year.
Review the adjusting entries proposed by the auditors to determine the type and
materiality of these adjustments.

3. This answer assumes that King and Company, the predecessor auditor, has no reason to
believe that their previous report is not still appropriate. Furthermore, that firm has
reviewed the current financial statements and obtained a representation letter from
Abernethy and Chapman, the successor auditor, stating that the current year's audit has
not revealed anything that would have a material effect on the prior year's audit.
 INDEPENDENT AUDITOR'S REPORT

To the Stockholders:

We have audited the accompanying balance sheet of the Lakeside Company as of

December 31, 2009, and the related statements of income, retained earnings, and cash
flows for the year 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 audit. The financial statements of Lakeside Company as of
December 31, 2008, were audited by other auditors whose report dated [give date], on
those statements included a qualified opinion because of inadequate disclosure of an
impairment of value. The impairment of value concerned the Company's investment in one
of its stores.

We conducted our audit 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 audit provides a
reasonable basis for our opinion.

In our opinion, the 2009 financial statements referred to above present fairly, in all
material respects, the financial position of the Lakeside Company as of December 31,
2009, and the results of its operations and its cash flows for the year then ended in
conformity with accounting principles generally accepted in the United States of America.

Abernethy and Chapman

Certified Public Accountants
Date: (last day of audit fieldwork)