Solutions 12e FINAL

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The Lakeside Company:

Auditing Cases

SOLUTIONS MANUAL 12e

Sarbanes-Oxley issues have been incorporated in two ways. First, case content has been altered to include Lakeside’s consideration of financing expansion through an initial public offering, and the resulting impact such a decision would have on Lakeside and on Abernathy and Chapman, CPAs. Second, the discussion questions and exercises have been expanded to include consideration of Sarbanes-Oxley and new auditing and independence standards, both by adding a section in the end-of-chapter material and by reference in the other questions where appropriate.

Ethics questions are now specifically identified with an ethics logo. The ethics questions are often open ended, and this solutions manual does not try to give exact answers to these questions. Rather, we intend to give some ideas for classroom discussion, and to help with student research on these questions.

Fraud questions are now specifically identified with a fraud triangle.

Fra ud

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A NOTE ON RESEARCH ASSIGNMENTS

The "Apply Your Research" and "Consulting Partner Review" assignments included at the end of several cases do not lend themselves to definitive solutions that could be included in an instructor's manual. The assignments are simply not intended to be exercises in arriving at a predetermined answer. Rather, the applications of the suggested readings have the following objectives: - To provide a means for improving the writing skills of students. From all

reports, accounting majors too often leave college lacking in the basic ability to compose and construct sentences and paragraphs. Accounting and auditing (especially as one moves up in an organization) obviously require skills other than the purely quantitative. Memos, reports, footnotes, audit and accounting guides, etc., all require accountants and auditors to be effective communicators of the written word. Indeed, the instructor may want to team up with a member of the school's English or communications department to enhance the effectiveness of these assignments. The auditing instructor can then evaluate the technical and research portions of the assignment, while the English instructor would make suggestions as to grammar, syntax, construction of sentences and paragraphs, logic of the thought process, etc. As a preliminary step, the instructor may want to assign articles such as "Word Crunching: A Primer for Accountants" from the March 1990 issue of the Journal of Accountancy.

- To introduce students to accounting and business journals as well as other important publications. After college, students must be able to "keep current" or their effectiveness will quickly decline. In most cases, this continuation of their education is provided by the regular reading of publications such as The Wall Street Journal, Journal of Accountancy, CPA Journal, and Forbes. These assignments require the students to begin reading these journals prior to graduation. The students should become comfortable with their ability to understand and use the materials in professional publications. In addition, real-world aspects of many accounting issues are presented through these various readings.

- To develop the students' ability to derive viable solutions to auditing problems. Unfortunately, students in college often come to the belief that all auditing issues can be resolved simply by applying the pronouncements of various authoritative bodies. Textbooks too often present problems that have one ultimate answer. However, in many real cases, no definitive solutions actually exist. Thus, when faced with such problems, students must be capable of reviewing the available literature and then using that information as a basis for arriving at a workable

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decision.

- To promote auditing research. In most of these library assignments, students are provided with one or more resources as starting points for their research. However, the instructor should always push the students to look for more and different types of information. The ultimate purpose of these assignments is to force the students into the library and online sources to do the searching for themselves. One excellent method of introducing the assignments is to use some class time to illustrate the various methods of research that are available to them, including electronic resources, such as the following:

o http://www.sec.gov o http://www.PCAOBUS.org o http://www.AICPA.org o http://www.FASB.org

o Your state society of CPAs also operates sites.

If possible, a business librarian or a research librarian may be enlisted to discuss the various search techniques that can be used at the school's library for research purposes. Developing the ability to find information is one of the most important skills that can be achieved by an accounting major.

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INTRODUCTORY CASE

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

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The staff auditor performs many of the detailed audit procedures, such as preparing and controlling accounts receivable confirmations. In general the work of the staff auditor is controlled by the audit program and supervised by the senior auditor.

The senior auditor coordinates the audit at the client's location and performs many of the more difficult audit procedures, such as analytical review procedures. Usually the detailed work performed by the audit senior is more sophisticated and requires the experience gained by someone holding that rank. The audit senior is supervised by the manager.

The manager and the partner have supervisory roles. Managers and partners often have more than one audit team under supervision at any given time.

The partner is the person who has responsibility for determining whether the firm’s signature can be attached to audit report.

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The partner-in-charge of an audit is the definitive decision-making position on the audit team. Although the manager and senior auditor make several decisions, they must get ultimate approval from the partner-in-charge of the audit. The consulting partner's role is to add a further degree of objectivity to the audit. The consulting partner reviews and critiques certain crucial decisions made by the audit team, such as the final audit report. The partners should be rotated to assure independence.

Sarbanes-Oxley (SOX-S203) requires the identification of a Leading Partner and a Reviewing Partner. Both partners must be rotated every five years.

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An accounting firm is a business like any other, and its management must recognize that a marketing strategy is probably necessary to generate a continual flow of sufficient operating revenues. However, in the accounting profession, disagreement exists as to the extent that such marketing should take. In the past, overt marketing was not permitted since it was considered to be unprofessional. This position was supported based on the reasoning that a firm

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should be selected based solely on the quality of its service. No reliable system existed, though, for conveying such information to potential clients. Hence, firms with many clients tended to remain large, while smaller firms often found growth to be nearly impossible. In the free market system espoused by the United States, restrictions on such practices as advertising and solicitation were inevitably overturned. Over the past three decades, attitudes toward marketing have changed dramatically as competition has become much more intense. Advertisements by CPA firms in newspapers and magazines are now common. Newsletters such as that distributed by Abernethy and Chapman are also frequently used to increase a firm's name recognition in the business community. In the current world of business, some type of marketing strategy seems imperative if an accounting firm is to compete. Whether that marketing should extend to formal advertising is often a question of firm policy. Most importantly, the firm must ensure that potential clients know of its presence and the services that it offers. A client will probably not select a CPA firm based on advertising. However, the client may initially become aware of the firm only through some type of marketing.

Interestingly, some members of the accounting profession view marketing as having had a negative impact on the profession as a whole. Price competition for new clients is often associated with the marketing of a firm. These critics assert that lowered fees result in sloppy and hurried audit work that can decrease the overall reputation of the profession. (Additional resources discussing this issue can be found in the "Suggested Readings" at the end of this case.)

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A national or international CPA firm might consider acquiring Abernethy and Chapman for several reasons:

- Although only a regional firm, Abernethy and Chapman apparently has a client base that includes a number of large clients in several different industries. By acquiring the local firm, the larger organization will frequently be able to retain these customers, thus increasing its own client list.

- The larger firm may be interested in moving into this geographical region, and buying the local firm will provide an instant base on which to build a practice in the area.

- The larger firm may already have an office in this location and feels that combining the practices will reduce expenses.

Abernethy and Chapman might have several reasons for viewing an acquisition in a favorable light:

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- Frequently, the purchase price will be a considerable amount of money because of the goodwill inherent in an established accounting firm. The offer to sell may be especially tempting if the partners are nearing retirement age and the future of the firm appears uncertain.

- The smaller firm may have trouble dealing with increased competition from bigger firms. Often clients may decide that a change to a nationally known CPA firm should be made to add extra stature to the audit report. If a local organization has only a few large clients, it cannot economically afford to lose a significant amount of revenue in this way. A merger may help the firm to keep its clients.

- The regional firm may also desire the additional backup services offered by large organizations. National CPA firms usually have experts in many industries as well as in specific audit areas who are available for consultation. In a smaller firm, this degree of assistance is not always available when a difficult accounting or auditing problem is encountered. - PCAOB registration and SEC practice presents hurdles that might be

overcome through a merger with a larger firm.

Many mergers have occurred in the auditing profession during recent years. Critics assert that this trend has reduced competition and will inevitably lead to a decrease in audit quality. Proponents counter by stating that mergers lead to more efficient operations and, thus, improve audit quality. Obviously, mergers will create a drastic change in the profession as more of the smaller firms disappear. Audit work in this country may possibly become concentrated within the largest CPA firms. Whether this result is good for the auditing profession may be merely a question of perspective. To the smaller firms struggling to survive and grow, the mergers are usually considered a threat as the bigger firms become more competitive. To the larger firms, the chance for continued growth and more efficient operations is always an important objective.

See the Sarbanes-Oxley section below for a follow-up question related to the impact of SOX on the auditing profession.

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Moving staff from one area of a CPA firm to another can cause the perception of an independence problem. For example, the appearance of independence may be in question if a member of the consulting staff helps to install a new accounting system for a client and then she moves to the audit staff to audit this same client.

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the impact of SOX, in particular the list of proscribed activities for registered CPA firms.

SUGGESTED ANSWERS TO EXERCISE

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The question requires students to address all the elements of a quality control system, as included in Statement on Quality Control Standards No. 2. In some cases, students should recognize the need for additional information.

To: DeAnna Malott From:

Date:

Re: Quality Control Standards at Abernethy and Chapman

Overview: I was employed by the firm of Abernethy and Chapman to review the quality control standards within the firm. The following represents my evaluation of these standards according to the six elements required by the AICPA.

Evaluation: Standard Existing Procedures Recommendations Additional Information Needed Leadership

responsibilities The case does _{not explicitly} address this standard.

However, the firm has some items in place, such as a partner

dedicated to monitoring the system.

The firm should have policies in place that establish the “tone at the top” for quality within the firm.

What specific policies does the firm have to demonstrate leadership

responsibilities for quality within the firm?

Relevant ethical requirements

Firm requires its employees to sever all

financial ties to audit clients.

The AICPA's Code of Professional

Conduct does not require all

employees to sever ties with all audit clients. For example, staff auditors not working on a particular

The case does not mention spouses or dependents of the employees. Spouses and dependents must also be independent, as defined by

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engagement need not sever ties. In this case, the firm

exceeds the minimum level of conduct for independence. The case does not

address other ethical requirements.

Section 100--Rule 101 of the Code. In this case, the firm should

strengthen its requirements. How does the

firm meet other ethical requirements? Acceptance and continuation of clients

This case does not address this control standard. It does note that the firm is

attempting to gain more clients through an extensive marketing program.

It is important to have many controls when considering a potential client, so that the potential risks of legal

exposure are not too great. (Note: This topic is addressed in Case 2.)  Human resources The firm considers experience and technical competence in assigning personnel to audit engagements. The firm hires

only college graduates with a major in accounting and requires that each professional sit for the CPA exam within one year of

employment. The firm requires

This appears to be a reasonable quality control.

This seems to be a more than adequate quality control procedure. In fact, many firms hire professionals, such as computer experts, who were not

accounting majors.

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40 hours of continuing education per year; however, the case does not address the issue of the type of education (e.g., accounting and auditing versus other courses).  The firm promotion procedures consider seniority and technical competence, which seems to be an adequate control. that a minimum number of continuing professional education hours be in accounting- and auditing-related courses.

The case does not address the issue of assessment of technical competence. Many firms require a written assessment of performance after each engagement. Engagement

performance The firm requires_{that a consulting} partner be assigned to each audit engagement. The consulting partner assures that the work performed by the engagement team meets applicable professional standards and regulatory requirements. This helps to ensure objectivity, as the consulting

The firm should have a mechanism for consultation with authoritative

literature and other sources, including outside experts, if its professional staff lacks expertise in a particular area.

It is not clear from the case how the team documents the work performed on an audit engagement. An evaluation of audit documentation is necessary for complete evaluation of the quality controls.

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auditor is not a direct part of the engagement. The firm seems

to have a clear chain of

command and adequate supervision on the audit. The staff auditors report to the senior auditor, who in turn reports to the manager. The partner-in-charge has an overall supervisory position.

Monitoring The firm has a _{partner, DeAnna} Malott, assigned to monitor the quality control standards. A comprehensive system of documentation of the quality controls should be developed.

The case does not mention what types of documents are required to support these controls, but documentation is extremely important. For example, many firms require employees to submit a listing of all financial ties to companies so that the firm can monitor its independence. Conclusion: The firm has many policies related to quality control standards. However, the firm has room for improvement in many of the areas, particularly in the acceptance and continuation of clients.

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SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTIONS

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Students should be encouraged to visit the PCAOB website (http://www.pcaobus.org) when answering this question:

- Registration – CPA firms must be registered to be associated with public companies. The application for registration is an online process. There is a fee, it is small relative to other costs of maintaining the registered status and changing the nature of the firm to comply with PCAOB rules. Here is the fee structure from their website:

- Inspection - The PCAOB operates a system of inspections and publicizes the results, per its authority under the SOX Act:

- The Act provides that an inspection shall include at least the following three general components:

• An inspection and review of selected audit and review

engagements of the firm, performed at various offices and by various associated persons of the firm;

• An evaluation of the sufficiency of the quality control system of the firm, and the manner of the documentation and communication of that system by the firm; and

• Performance of such other testing of the audit, supervisory, and

quality control procedures of the firm as are necessary or appropriate in light of the purpose of the inspection and the responsibilities of the Board.

- Regular inspections are on a three-year cycle, although smaller firms may be less frequent. Special inspections can be required by the PCAOB.

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SOX-proscribed activities:

Proscribed activities under SOX (section 201):

Section 201: Services Outside The Scope Of Practice Of Auditors; Prohibited Activities.

It shall be "unlawful" for a registered public accounting firm to provide any non-audit service to an issuer contemporaneously with the non-audit, including: (1) bookkeeping or other services related to the accounting records or financial statements of the audit client; (2) financial information systems design and implementation; (3) appraisal or valuation services, fairness opinions, or contribution-in-kind reports; (4) actuarial services; (5) internal audit outsourcing services; (6) management functions or human resources; (7) broker or dealer, investment adviser, or investment banking services; (8) legal services and expert services unrelated to the audit; (9) any other service that the Board determines, by regulation, is impermissible. The Board may, on a case-by-case basis, exempt from these prohibitions any person, issuer, public accounting firm, or transaction, subject to review by the Commission.

It will not be unlawful to provide other non-audit services if they are pre-approved by the audit committee in the following manner. The bill allows an accounting firm to "engage in any non-audit service, including tax services," that is not listed above, only if the activity is pre-approved by the audit committee of the issuer. The audit committee will disclose to investors in periodic reports its decision to pre-approve non-audit services. Statutory insurance company regulatory audits are treated as an audit service, and thus do not require pre-approval.

The pre-approval requirement is waived with respect to the provision of non-audit services for an issuer if the aggregate amount of all such non-audit services provided to the issuer constitutes less than 5% of the total amount of revenues paid by the issuer to its auditor (calculated on the basis of revenues paid by the issuer during the fiscal year when the non-audit services are performed), such services were not recognized by the issuer at the time of the engagement to be non-audit services; and such services are promptly brought to the attention of the audit committee and approved prior to completion of the audit.

The authority to pre-approve services can be delegated to 1 or more members of the audit committee, but any decision by the delegate must be presented to the full audit committee.

- Partner rotation - The rotation of the lead partner and the reviewing partners are required by the SOX Act.

- Quality Control Standards – Registered firms must maintain the SEC practice requirements:

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- AICPA Quality Control Standards for public company audits are summarized at: http://cpcaf.aicpa.org/Resources/

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CASE 1

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Financial statements are frequently relied on by outside parties such as stockholders and banks when making decisions about an enterprise. Should equity securities be bought or sold? Should a long-term loan be given? However, financial statements are the representations of the management of the company. As such, these statements will not necessarily be fairly presented. Material misstatements may exist in the form of errors, irregularities, or illegal acts. The management might, for example, have an insufficient knowledge of generally accepted accounting principles to produce appropriate statements. Human error or bias is also possible in the gathering and reporting of financial information. In addition, the management may have fraudulently manipulated the data in hopes of achieving some objective.

Outside parties are aware that the financial information produced by a company and its management may not always be reliable. Hence, to add credibility to this reporting process, independent experts are retained to audit the financial statements and test the underlying accounting records. These auditors then issue an opinion for the benefit of outside parties as to the fair presentation of the financial statements in conformity with generally accepted accounting principles. This added degree of assuredness allows decision-makers to rely on reported financial information.

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A CPA firm could not be expected to maintain expertise in every potential industry that it might audit. In reviewing a potential client, the firm should evaluate its ability to gain the necessary industry expertise prior to the actual audit, but no requirement exists that this knowledge must be possessed prior to accepting the engagement.

Each industry may have its own specific accounting practices. In addition, certain industries frequently offer unique auditing problems. Thus, without a thorough investigation, the auditor cannot ascertain the knowledge that will be needed in examining a potential client. In the consumer electronics business, for example, the methods of distribution as well as credit policies would be significantly different from those found in a car dealership. Damaged or obsolete inventory are other problems that might be more important in this specific industry. Hence, a knowledge of one type of operation does not necessarily mean that the auditor has the expertise needed to examine a client operating in a

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different industry.

Auditing standards require that auditor to have the expertise by the completion of the audit, but this expertise need not be in place at the beginning. It would be unethical to misrepresent a firm’s experience, but it need not be volunteered. (3)

A profit-sharing bonus plan gives employees an added incentive to seek increases in company income; a larger profit figure will lead to a larger bonus at the end of the year. Consequently, employees may be tempted to inflate income artificially by creating false sales or deferring the recording of expenses. An auditor must always be alert for situations that can promote the possibility of such irregularities. A profit-sharing bonus plan may well have only positive effects on company employees. However, the auditor should not be so naive as to fail to recognize that some individuals may take advantage of such plans by manipulating the financial records.

This problem may be especially significant in the Lakeside Company because the bonus plan is new and the stores are geographically located at a distance from the home office. New plans require adaptation by company controls and such separation always increases potential control concerns. In addition, Rogers has already mentioned that some of the internal control systems are no longer adequate. Thus, the possibility of inflated income figures is even more of a possibility.

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Critics of the auditing profession have argued vehemently for a number of years that advisory services such as those discussed in this question taint the appearance (and possibly the reality) of independence. These services may appear, to the public, to give the audit firm a financial interest in the success of the company. This argument holds that the firm will now want the client to succeed as proof of the quality of the advice that was given. In addition, the audit team may be less judicious in investigating these systems since they are aware that members of their own firm designed and installed them.

Audit firms counter by stating that adequate safeguards have been put into place to ensure continued independence. For example, advisory services are frequently rendered by a separate division of the firm so that no proximity exists between this function and the audit staff. In addition, firms are not allowed to give many types of advice that might jeopardize their independence. Finally, audit firms must make certain that their services are limited to making recommendations, and are not for carrying out management decisions. The firm cannot make decisions for the client.

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Sarbanes-Oxley specifically proscribes various activities that have traditionally been part of the CPA’s repertoire. Design of accounting systems is prohibited, although helping a client with selection and implementation of off-the-shelf packages would be acceptable. So, in this case, it depends on what the client means by “developing.” In the event that Lakeside goes forward with its public offering Abernathy and Chapman will need to decide whether to remain independent so they can continue as Lakeside’s auditor, or sacrifice independence to do systems consulting. Sarbanes-Oxley prevents trying to do both.

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In his article "The Initial Audit Engagement Conference" in the Journal of Accountancy for September 1976, Bernard Valek lists a number of steps that can be performed in a plant tour to avoid later "surprises" as well as to assist the firm in establishing an appropriate audit fee. The first three are typical of a plant tour. The others go beyond the typical tour. Students should not be expected to anticipate each of these procedures but the question can be used to emphasize the importance of the auditor's complete understanding of the audit client. These steps include:

* Inspect inventory for possible obsolescence and an indication of the major product lines of the company.

* Verify the presence or absence of a perpetual inventory system.

* Review manufacturing facilities for indication of level of activity as well as any idle machinery.

* Review journals for careful preparation.

* Review general ledger activity for unusual entries.

* Review monthly financial statements for unusual variations. * Review bank reconciliations, and compare to general ledger.

* Examine accounts receivable reconciliation to general ledger balance. * Review client physical inventory method.

* Discuss with client the policy for valuing inventory and identifying obsolete inventory items.

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* Review depreciation schedules, and recalculate a sample of the depreciation expense figures.

* Review income tax returns.

* Examine information relating to any capital stock or retained earnings transactions for the past year.

* Review minutes of board of directors' meetings and stockholders' meetings for unusual or material matters.

* Read lease agreements. * Review past audit reports.

(6) A company may not want its CPAs to audit a client's records because the auditors gain a substantial amount of competitive information during an audit. However, CPAs are bound by confidentiality under the AICPA's Code of Professional Conduct. Also, a CPA's knowledge of the industry gained from having several clients in the same industry provides him or her with insights he/she may not have otherwise had.

SUGGESTED ANSWERS TO EXERCISES

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(a) and (b) The independent auditor must be able to review massive quantities of information and identify the fraud risk factors that may affect the amount of evidence to be gathered or the opinion to be rendered. This question calls upon the judgment abilities of the students. The format used by students for this memo is not important as long as it is clear and understandable. SAS 99 requires use of a brainstorming session in the planning stage to be sure that everyone associated with the audit understands the nature of the business and the potential risk of fraud. These sessions can also occur during the audit if additional evidence presents itself. Potential problems that students would be expected to identify are as follows. Additional fraud risk factors may also be identified by the students.

Fraud Risk Factors Auditor Follow Up

Internal Control - The president of the company admits that the company's internal control is antiquated. Control problems may be heightened in that operations extend throughout two

Since understanding the internal control is one of the prerequisites for ultimately determining the amount of substantive testing that will be required, the weakness of the various controls

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states. may require the extensive gathering of

evidence, or even preclude an opinion. Uncertainty Involved with the Sixth

Store - A qualified opinion was issued by the predecessor auditor in

connection with this store.

Abernethy and Chapman must face the question as to whether this issue can be resolved during 2009.

Inventory - The mere size of the inventory of a business like Lakeside would make this account a critical audit area.

The auditor will face the problem of verifying the existence, cost, value, presentation, and ownership of the electronic equipment.

Distributorship Sales - The case indicates that these sales have risen dramatically during the past two years.

Any sudden change or fluctuation in an account balance will always warrant the auditor's attention. In this instance, the auditor will be especially interested in verifying the validity of these sales figures.

Bonus System - This system has been recently installed by Lakeside, so very little is known about its effects upon the financial results of the company.

This factor alone can cause difficulty in the auditor's examination. In addition, any bonus system will provide an incentive for the employees to falsify the company's financial records. The auditor must be aware that employees can benefit from producing falsely inflated income figures.

Related Party Transactions - The case indicates that Lakeside has begun to have financial dealings with the president of the company.

Obviously, nothing is wrong with this arrangement, but such related party transactions are often difficult for the auditor to verify. In addition, they require clear disclosure.

Rental Agreements - Five of the stores have been leased and, apparently, Store Seven will be rented from Rogers. Rental agreements pose the question as to the need for capitalizing the lease.

Abernethy and Chapman will have to read the various agreements to see if any of them qualify as a capital lease under the criteria established by the Financial Accounting Standards Board. Accounts Receivable - All

distributorship sales are made on credit.

The size of the receivable account and the problem of determining collectibility will be a critical audit area for the auditor.

Loan Agreements - Lakeside has a number of loans outstanding.

The auditor will need to study each loan agreement to ascertain that the company is not violating any of the loan covenants.

Inventory Returns - For distributorship

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can be returned within four months. As of the end of the year, Lakeside will have a large contingent liability associated with the inventory items sold during the last four months.

ability to estimate the amount must be a concern.

Possible public offering of stock A public offering raises risk for

manipulation of the financial statements in order to attract capital. In addition, the number of potential readers of financial statements has changed dramatically, making the risk

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INDEPENDENT AUDITOR'S REPORT

To the Board of Directors:

We have audited the accompanying balance sheet of the Lakeside Company as of December 31, 2011, 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.

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.

During 2010, the Lakeside Company made a large investment in a retail store located in the eastern sector of Richmond, Virginia. This store has failed to reach a break-even sales point to date, and total recovery of the Company's investment is highly uncertain. In our opinion, the chances are reasonably possible that the asset's value has been permanently impaired and should be reduced to the net realizable value in conformity with generally accepted accounting principles. Management of the company has refused to recognize this impairment loss.

In our opinion, except for the effects of not recording or disclosing the impairment of value of the asset, as discussed in the preceding paragraph, the aforementioned financial statements present fairly, in all material respects, the financial position of the Lakeside Company at December 31, 2011, 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.

King and Company (signed), Certified Public Accountants Date: (last day of audit fieldwork)

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SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTIONS

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The issuance of stock is regulated by the Securities and Exchange Commission and the accounting, auditing and reporting is regulated by the PCAOB since 2002. A summary of the regulations follows:

Issuance of stocks are regulated primarily under the SEC acts of 1933 and 1934. Registration with the SEC is required, which includes financial reporting. The laws are summarized at: http://www.sec.gov/about/laws.shtml.

The financial reporting and auditing for public companies has been regulated by the PCAOB since 2002. The PCAOB registers, inspects and disciplines the auditors of public companies. Its effect on the public companies is indirect, through the regulation of the auditors.

Encourage students to visit the SEC EDGAR site to understand the nature of electronic, public financial information.

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CPA firms wishing to be associated with public companies must be registered firms, accept the inspection process, and be subject to the discipline of the the PCAOB. CPAs in public practice ofhave three choices. It is not only public vs.

private, because some CPA firms are choosing to give up the requirement for independence and perform accounting, tax, and consulting services that are not possible for registered CPA firms. Thus their clients have two CPA firms, one for the non-independent services and one for the audit. In the case of Abernathy and Chapman, they will need to choose the nature of their practice. This is a major strategic choice. Most CPA firms do not perform public company audits. Large international and national firms handle almost all of the companies on the exchanges.

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CASE 2

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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 $1,000,000 net worth and the $3.6 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 less than $100,000 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 at least $100,000) for a company with a net worth of only $1,000,000 would certainly appear to be material. Other comparisons based on total assets or income would give similar results. (The issue of materiality is considered in more depth in exercise 3 below).

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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

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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

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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 (or “working papers”) 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)

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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.

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SUGGESTED ANSWERS TO EXERCISES Case 2 - Exercise 1

Abernethy and Chapman

ANALYSIS OF POTENTIAL LEGAL LIABILITY

Potential Client: The Lakeside Company

Type of Engagement: Audit Form Completed By:

Date:

(1) Is the potential client privately held or publicly held? Privately held

(2) Evaluate the possible liability to the client that Abernethy and Chapman might incur, if the engagement is accepted.

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) 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 current stockholders Cypress Products

Two banks financing the inventory

National Insurance Company of Virginia (mortgage loans) Possibly other creditors

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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. 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) Evaluate the possible legal liability to third parties, both present and potential, that Abernethy and Chapman might incur if the engagement is accepted.

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.

INFORMATION FROM PREDECESSOR AUDITOR

Potential Client: Lakeside Company Form Completed By:

Predecessor Auditor: King & Company

Date of Interview:

(1) Discuss the predecessor auditor's evaluation of the integrity of the management of the potential client.

Predecessor auditor indicated no problems with the integrity of the Lakeside management.

(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.

(29)

A major problem existed between Lakeside and the predecessor auditor involving an explanatory paragraph included in the 2008 report. This uncertainty issue revolved around the potential loss foreseen in the possible closing of one of Lakeside's stores.

(3) What was the predecessor auditor's understanding as to the reasons for the change in auditors?

Predecessor auditor stated that the firm was discharged over the wording of the previous audit opinion.

(4) Did the predecessor auditor give any indication of other significant audit problems associated with the potential client?

The predecessor auditor also mentioned weaknesses in Lakeside's internal control and Rogers' unwillingness to improve these systems. (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.

Predecessor auditor stated that the audit audit documents could be reviewed.

(6) Was the predecessor auditor's response limited in any way? No limitation was indicated.

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Case 2 - Exercise 2

[Note: 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].

Review of Predecessor Auditor's Documentation

Client: The Lakeside Company

Predecessor Auditor: King & Company Prepared by:

Date:

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

Tests of beginning balances in accounts including inventory, land, buildings, equipment, paid-in-capital, and retained earnings.

To determine that satisfactory evidence has been obtained to verify beginning-of-year balances, since ending

balances are audited by successor auditor.

Ascertain the specific accounting principles applied in the previous fiscal year.

To determine if client consistently applies accounting principles in the current year.

Review internal control evaluations. To determine if there were any internal control weaknesses/deficiencies noted or if there are any particularly strong areas of control noted.

Review the analysis of contingencies. To determine if adjustments or disclosures need to be made for contingencies in the current year. Any problem areas (such as slow

collection of accounts receivable) that were singled out in the previous year.

To determine if the problems continue to exist in the current year.

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(3)

Note: Student answers will vary greatly due to the nature of the assignment. Consider asking several students for their materiality level to see the range of answers. This should lead to a good discussion about auditor judgment.

Preliminary Judgment about Materiality

Client: Lakeside Company

Balance Sheet Date: December 31, 2012 Prepared by:

Determine the preliminary judgment about materiality for the client as a whole. Express your answer as a dollar amount. Determine the appropriate level of materiality based on all analyses completed for the client thus far. Fully support and discuss the materiality level that you determine.

Quantitative Considerations: Because materiality is relative, it is necessary to have bases for establishing whether misstatements are material. A base is a critical item of which users tend to focus while making decisions. The base will vary depending on the nature of the client’s business. Typical bases may include net income before taxes, net sales, total assets and stockholders’ equity.

Percentages typically range from 1%-10% depending on the base.

Base (from previous year) Dollar Amount of Base Percentage Range Base x Percentage

Net income before taxes

$408,000 3%-6% $12,240-$24,480

Total assets $3,628,000 1%-3% $36,280-$108,840

Net sales $10,754,000 1%-3% $107,540-$322,620

Qualitative Considerations: Certain types of misstatements are likely to be more important to users than others, even if the dollar amounts are the same. For example, misstatements that involve fraud may be more important to users than misstatements due to unintentional errors. Fraud reflects on the integrity of management and other employees of the client.

Item to be Considered Impact on Materiality

Outdated accounting systems Reduce the level

New client Reduce the level

Previous year qualified opinion Reduce the level

Preliminary Judgment about Materiality: Combine the quantitative and qualitative considerations into one overall materiality level.

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Discussion: Discuss how you arrived at this dollar amount for the preliminary judgment about materiality. That is, how did you combine the qualitative and quantitative considerations to arrive at this dollar amount?

The preliminary judgment about materiality is set at $50,000. Since there are three qualitative considerations that reduce the level, we chose the lower of the ranges of the quantitative considerations. The average of the lower ranges is $52,020 [($12,240 + $36,280 + $107,540) / 3 = $52,020]. We rounded to a conservative $50,000 for ease of application.

The bases were chosen based on the nature of the client’s business. Typical users of the financial statements of a company in consumer electronics industry will likely focus on profits, net sales and total assets. The percentage ranges are typical for the bases. Assets and net sales are typically the largest bases and thus have smaller percentage ranges than does net income before taxes. (Some students may have chosen total liabilities or total stockholders’ equity since banks are a major user of the financial statements).

At a $50,000 materiality level, then a total impairment of the carrying value of Store 6 ($186,000) would be material, as would an impairment of half the carrying value. The firm should discuss with Rogers the strong possibility of a write down of Store 6, should an impairment test warrant one. (Note: In Case 9, the students are required to perform an impairment test for Store 6).

(4)

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.

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INDEPENDENT AUDITOR'S REPORT

To the Stockholders:

We have audited the accompanying balance sheet of the Lakeside Company as of December 31, 2012, 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, 2011, 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 2012 financial statements referred to above present fairly, in all material respects, the financial position of the Lakeside Company as of December 31, 2012, 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)

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CASE 3

(1)

Although this question can be answered by a simple reading of Exhibit 3-1, it does force the student to consider the contractual obligations being assumed by both parties. One portion of this letter that might warrant discussion is the CPA firm's declaration that absolute assurance is not being given in regard to major misstatements. The students can be queried as to the reasons for including this statement. In addition, the students can be asked to discuss the method by which the client company can draw the distinction between reasonable assurance and absolute assurance. As a different line of questioning, the students can discuss other responsibilities that could have been accepted by either party.

The engagement letter is required. Responsibilities of the CPA firm found in the engagement letter:

* To perform an audit in order to express an opinion on the client's financial statements,

* To make a search for material misstatements, * To report any internal control weaknesses, * To report any potential fee changes,

* To provide the final audit report by February 22, 2013. Responsibilities of the client:

* To pay the audit fee,

* To provide a year-end trial balance by January 17, 2013, and an interim trial balance by October 17, 2012,

* To provide audit documents to the CPA firm as specified. (2)

In performing analytical procedures, auditor expectations should be derived from a wide variety of sources. For cost of goods sold, Abernethy and Chapman

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should consider each of the following in arriving at an anticipated total:

- Past figures. If cost of goods sold has always been a certain percentage of Lakeside's sales, that same relationship would be expected to continue unless other factors have changed. Had Lakeside, for example, switched from cheaper products to more expensive ones, the relationship between cost of goods sold and sales would possibly be affected. Or, if Lakeside has dropped the Cypress line in order to sell the products of some other manufacturer, a similar change might have been anticipated. However, without an adjustment of this type, cost of goods sold as a percentage of sales would be expected to remain stable.

- Industry averages. By studying trade publications, Abernethy and Chapman can determine an industry average for cost of goods sold as a percentage of sales. Although Lakeside's results could not be expected to be exactly the same as this average, the auditors should not anticipate a significant variation to occur without some adequate explanation.

- Competitors. If available, the financial statements of competing companies can be used to determine the normal relationship of cost of goods sold to sales. Although no two companies are ever alike, important comparisons such as this one should be made between similar companies.

- Budgeted figures. If Lakeside has an annual budget, the numbers estimated by the company at the beginning of the period can be used by the auditor in establishing an expected cost of goods sold.

(3)

- Lakeside holds an inventory of high-technology items: consumer electronic equipment. Obsolescence of a portion of this merchandise is an ever-present danger because of new innovations. The inventory can also be easily damaged, a problem that is not always visually obvious. - Lakeside distributes merchandise to retail stores. A generous return policy

is provided; thus, an estimate must be made of the sales returns that will be received by the company after the audit is concluded.

- Lakeside sells on credit throughout two states. Hence, estimating collections from accounts receivable may be difficult.

- Lakeside rents a number of its stores. The auditor must determine whether capitalization of these leases is required.

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debt is being properly reported and disclosed. The interest expense associated with these liabilities must also be correctly calculated and recognized. In addition, the auditors need to verify that all loan covenants are being met.

- Lakeside is considering going public. A company attempting to raise significant capital may be tempted to overestimate assets and revenues. The auditor needs to be particularly careful on accounts that lend themselves to significant estimate.

(4)

The auditor must be satisfied that sufficient, competent evidence has been obtained to substantiate an opinion concerning the fair presentation of the client's financial statements. The decision as to the sufficiency of this evidence is left solely to the judgment of the auditor. Only through years of experience can the auditor develop the ability to make this determination. Although specific guidelines for this decision are not available, all significant problems must be resolved and all suspicious occurrences should be investigated. Evidence needs to be accumulated for each significant area of the financial statements to substantiate the assertions made by the client about its reported balances. Where inherent risk and control risk are judged to be high, the auditor must take steps to reduce detection risk to an acceptable level. In such cases, several steps are possible: performing additional substantive testing, using more experienced staff personnel, performing testing procedures closer to the balance sheet date, or relying on more effective testing procedures.

Another factor that influences the auditor's decision is the quality of evidence being accumulated. Some information may come directly to the auditors from outside parties, data that is usually considered to be of a higher quality than evidence prepared by the client company. Less evidence is required if it is judged by the auditor to be of a high quality.

Although each of these factors is considered, the ultimate decision still must rest with the auditor's judgment. This individual is taking responsibility for the audit opinion as well as accepting the risks involved in circulating this report. Thus, the auditor must be satisfied that, based upon the wisdom gained through years of audit experience, sufficient evidence has been obtained.

(5)

Any discussion as to the "quality" of evidence being gathered by analytical procedures must be based on the objective of the testing. Analytical procedures performed in the planning stage are not primarily designed for the purpose of indicating the fair presentation of financial information. Instead, they are used in the assessment of risk, to alert the auditor to potential problem areas that may

Solutions 12e FINAL

The Lakeside Company:

Auditing Cases

SOLUTIONS MANUAL 12e

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