Case2

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Mercy College *

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520

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Accounting

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Apr 3, 2024

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Case 1 DISCUSSION (1) King and Company faced a materiality question in forming its year 2011 audit opinion. How do auditors evaluate the materiality of an item in a specific engagement? Do you believe that the possible impairment of the investment in the sixth store was actually material to the Lakeside Company? Auditors evaluate the materiality of an item in a specific engagement by considering both quantitative and qualitative factors. Quantitative means they assess the financial significance of the item relative to key financial metrics. For example, net income, total assets, or equity. Qualitative is to consider the impact of the item on the financial statement user’s decision making and the nature of the misstatement. Also, they may consider industry standards and regulatory requirements. Whether the possible impairment of the investment in the sixth store at Lakeside Company is material, the auditor must assess the potential effect of the impairment on the financial position, results of operations, and cash flows of the company. The size of the impairment relative to the company’s assets and net worth, the significance of the store to the company’s overall operations, and the impact on stakeholders’ decision making should be considered. In my opinion, the impairment of the sixth store could be material given its significance to Lakeside’s operations and financial statements. The auditor should carefully evaluate the potential impairment and its implications for the financial statements and communicate any material findings to stakeholders.

DISCUSSION (2) If Rogers had not consented in having Abernethy talk with the predecessor auditor, what actions would have been open to Abernethy? Direct communication with the predecessor auditor can be valuable. However, if Rogers had not consented to Abernethy speaking with the predecessor auditor, Abernethy could explore alternative avenues to gather information about Lakeside Company. This includes requesting documentation from the predecessor auditor, reviewing public information, interviewing other stakeholders, evaluating other sources of information, and assessing risk factors. For instance, Abernethy could request audit workpapers and financial statements, review publicly available information such as regulatory filings, interview management or key employees, explore industry contacts, and carefully assess risk factors associated with Lakeside's engagement. These actions would provide valuable insights into Lakeside's financial condition and help identify potential areas of concern for audit risk.

Case 2 - Exercise 1 Abernethy and Chapman ANALYSIS OF POTENTIAL LEGAL LIABILITY Potential Client: Lakeside Company Type of Engagement: Legal Analysis Engagement Form Completed By: Date: 3/16/2024 (1) Is the potential client privately held or publicly held? The potential client, Lakeside Company, is privately held. (2) Evaluate the possible liability to the client that Abernethy and Chapman might incur, if the engagement is accepted. If Abernethy and Chapman accept the engagement with Lakeside Company, they could potentially face liability if their audit fails to detect material misstatements or fraud in the financial statements. This could result in financial losses for Lakeside and its stakeholders. Additionally, if Abernethy and Chapman's audit procedures are found to be negligent or inadequate, they could be held legally responsible for any resulting damages. (3) List the third parties that presently have a financial association with the potential client and could be expected to see the financial statements. These parties are also called primary and foreseen beneficiaries. The third parties that presently have a financial association with the potential client, Lakeside Company, and could be expected to see the financial statements are creditors, investors, suppliers, regulator, and potential acquirers.

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(4) Discuss the possibility that other third parties will be brought into a position where they would be expected to see the financial statements of the potential client. These parties are also called foreseeable beneficiaries. Other third parties, including potential business partners or joint venture collaborators, government agencies for regulatory compliance, industry analysts or financial advisors, prospective employees or executives, legal counsel for legal proceedings or transactions, and insurance providers for risk assessment, could also become foreseeable beneficiaries, thus expected to view Lakeside Company's financial statements. (5) Evaluate the possible legal liability to third parties, both present and potential, that Abernethy and Chapman might incur if the engagement is accepted. Accepting the engagement with Lakeside Company may expose Abernethy and Chapman to potential legal liabilities concerning both current and prospective third parties. Present stakeholders like investors, creditors, and suppliers depend on accurate financial data for their decisions. Any misrepresentation in the financial statements could lead to financial losses for these parties, prompting legal recourse against the auditors for negligence. Similarly, future stakeholders such as potential investors, lenders, or business collaborators may suffer harm if they rely on misleading financial statements. In such instances, Abernethy and Chapman could face legal allegations of professional negligence or breach of duty. Hence, a thorough assessment of the potential legal ramifications is crucial before committing to the engagement.

Abernethy and Chapman INFORMATION FROM PREDECESSOR AUDITOR Potential Client: Lakeside Company Form Completed By: Predecessor Auditor: King and Company Date of Interview: 3/16/2024 (1) Discuss the predecessor auditor's evaluation of the integrity of the management of the potential client. The predecessor auditor indicated confidence in Lakeside's management integrity, noting they appeared to be people of integrity. However, concerns arose regarding management's sensitivity to fees, reluctance to acknowledge asset impairment, and overly optimistic growth projections, suggesting potential discrepancies between management's perspectives and auditor recommendations. (2) Did the predecessor auditor reveal any disagreements with management as to accounting principles, auditing procedures, or other similarly significant matters? If so, fully describe these disagreements. Yes, the predecessor auditor revealed a disagreement with management over the impairment of the investment in the sixth store at Lakeside Company. The auditor recommended recognizing the impairment based on professional judgment and appraisal values, but Rogers disagreed and refused to acknowledge it in the financial statements. (3) What was the predecessor auditor's understanding as to the reasons for the change in auditors? The predecessor auditor, King, understood that Lakeside Company sought a new independent auditing firm primarily because Rogers, the company's president, was interested in stimulating growth and becoming the president of a larger company. While Rogers did not directly discuss plans to go public with King, there were indications that Lakeside's expansion plans and potential public offering motivated the change in auditors. Additionally, Rogers' dissatisfaction with the predecessor auditor's fees and concerns about the impairment of an asset also contributed to the decision to seek a new auditing firm.

(4) Did the predecessor auditor give any indication of other significant audit problems associated with the potential client? Yes, the predecessor auditor indicated potential audit problems related to challenges in valuing and impairing an asset, specifically the sixth store, where management disagreed with the auditor's recommendation. This disagreement highlighted a significant issue regarding the proper treatment of a material accounting matter, indicating potential difficulties in aligning management's perspectives with auditing standards and accurately reflecting financial realities. (5) Did the predecessor auditor indicate any problem in allowing Abernethy and Chapman to review prior years' audit documentation for the potential client? If "yes," explain. No, the predecessor auditor did not indicate any problem in allowing Abernethy and Chapman to review prior years’ audit documentation for the potential client. (6) Was the predecessor auditor's response limited in any way? Yes, the predecessor auditor's response was limited in that it did not express any explicit concerns or objections to allowing Abernethy and Chapman to review prior years' audit documentation for the potential client. However, it's important to note that the response may not have provided detailed information about any restrictions or conditions associated with accessing the audit documentation.

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Case 2 - Exercise 2 Abernethy and Chapman Review of Predecessor Auditor's Documentation Client: Lakeside Company Predecessor Auditor: King and Company Prepared by: Date: 3/16/2024 Prepare a list of the specific contents of the predecessor auditor's documentation that should be examined by Abernethy and Chapman. Indicate each area that should be reviewed and the purpose of studying these particular areas of the audit documentation. Use the following format. Area that Should be Reviewed Purpose of Review Proposed Adjusting Entries To determine the type and materiality of the proposed adjustments Audi Workpapers To understand the audit procedures performed, evidence obtained, and conclusions reached by the predecessor auditor. Financial Statements To compare with current financial statements, assess accounting treatments, and identify potential misstatements or irregularities. Management Letters To understand any significant issues or recommendations communicated to management by the predecessor auditor. Internal Control Documentation To evaluate the effectiveness of internal controls and identify areas of weakness or risk. Correspondence with Management To understand any communications or discussions regarding accounting policies, practices, or significant matters. Legal and Regulatory Compliance Documentation To ensure compliance with applicable laws and regulations and identify any legal or regulatory issues. Engagement Letters and Contracts To understand the scope of the engagement, responsibilities of both parties, and any limitations or special considerations.