RESOLVING AUDIT PROBLEMS

Early in 2013, 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 client's 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 Board's 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 mailed 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 Lakeside's negotiation of a

$200,000 mortgage loan to finance the expansion. The cash 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, 2013. Although we can't be sure of the total cost just yet, it should be approximately $225,000. We will use Lakeside's 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 the 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 though it was not yet in operation. Rogers assumed that the company's method of accounting was correct but suggested that Andrews discuss the handling of this 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 Financial

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Accounting Standards 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 appropriate adjustment to capitalize this interest for the current period.

Andrews' final concern in auditing the warehouse expansion involved Lakeside's 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 repaired 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 Controller's 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, 2012, in Williamsburg, Virginia. Carole Mitchell had informed Andrews that Lakeside made a $21,000 payment on November 28, 2012, to Rogers Development Company, the corporation that 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 reclassified 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 interest entity (also known as a special purpose entity) that may need to be consolidated with the Lakeside Company's financial statements.

Rogers 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 renegotiate 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

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75% of the property's 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, I'm not sure that anyone actually reads those notes."

Andrews 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 Statement 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: Lakeside's Store 6.

Store 6 first began operations in November of 2010 but had never proven successful. The previous audit firm had even qualified its opinion on Lakeside's 2011 financial statements because of Rogers' unwillingness to record or disclose the impairment of the value of the company's investment. Although sales were up slightly in 2012, 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. Reviewing King and Company’s workpapers disclosed that, last year, an appraisal had been obtained and set the value of the store at $150,000. Andrews believes that Store 6 is capable of generating only a marginal profit over it’s expected life of twenty years. See the cash flows by store in Case 7.

When questioned, Rogers was somewhat philosophical about the situation. "We studied that market before we went into it. We felt that the location had long-range potential and we still do. When Rogers was reminded of the appraisal he was adamant, “I rejected that amount last year!” “I am not planning to sell the store. I believe that my decision to operate that store in the long-term will be a wise investment.” Lakeside is not the kind of company that enters an area on an impulse and then pulls up stakes if things don't go our way at first. We can make that store a success, 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 6 will be doing business for as long as Lakeside is in business. I really have nothing further to say on the matter."

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DISCUSSION QUESTIONS

(1) Why would a company's 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 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) 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 2012.

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. [Case9-1.doc]

(2) Despite Rogers' assurances, Store 6 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. Perform an impairment test given the

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information available. What should Abernethy and Chapman do now in connection with the uncertainty involved with Store 6? Should Abernethy and Chapman give a similar opinion this year to protect the firm from potential liability? (Hint: information for this question makes use of information from Case 3 and Case 7).

APPLY YOUR RESEARCH

Use library resources such as searchable databases to research the following topic.

(1) The Lakeside Company is leasing its Store 7 from Rogers Development Company, a corporation owned by the president of Lakeside and his spouse. Write a report discussing the issue of variable interest entities (sometimes called special purpose entities"). Does Rogers Development Company meet the definition of an variable interest entity? If so, should it be consolidated into the financial statements of Lakeside? (Hint: Read Interpretation No. 46 by the FASB at www.fasb.org).

CONSULTING PARTNER REVIEW

Bob Zimmerman, the consulting partner on the Lakeside engagement, is concerned about the following issues and would like for you to respond to them. The audio clips are available online at www.prenhall.com/arens.

(1) Computing interest to be capitalized (2) Net income and asset impairment