What is Auditor Legal Liability?

5-17 Following are eight statements with missing terms involving auditor legal liability. 

Contributory negligence is generally only available as a defense in suits brought by clients. 

Under the Ultramares doctrine, an auditor is generally not liable for ordinary negligence to third parties lacking privity of contract . 

A third party lacking privity will often be successful in bringing a claim against the auditor if they can demonstrate fraud or gross negligence . 

The broadest class of third parties under common law is known as foreseen users . 

Under the 1933 Act, plaintiffs do not have to demonstrate reliance on financial statements , but need merely demonstrate the existence of a(n) material error or omission . 

The auditor will use a defense of due diligence in a suit brought under the 1933 Securities Act. 

Based on the ruling in Hochfelder v. Ernst & Ernst, an auditor generally must have knowledge and intent to deceive to be found guilty of a violation of Rule 10b-5 of the 1934 Act. 

After passage of the Private Securities Litigation Reform Act, auditors generally have separate and proportionate liability in federal securities cases. 

5-19  The following are five independent situations. 

Joanie Brogan is a partner in an audit firm that operates as a limited liability partnership (LLP). The firm has been sued for an alleged audit failure related to an audit engagement handled by a different partner in the firm. While Brogan had no involvement in the engagement, she is concerned that the plaintiff may successfully sue her seeking restitution from her personal assets. 

In this case, since Joanie Brogan is not liable for the service performed by the other partners of the firm, she can file a suit against the plaintiff. Hence, her personal assets cannot be sold in the process of the conflict resolution. 

A lawsuit has been filed against Carter Hockaday, CPA, charging him with constructive fraud in the audit of Broughton Company’s financial statements. Hockaday has examined all the audit documentation in his files and reviewed all relevant auditing standards. He is convinced that his audit fully complies with standards of the profession but is uncertain what he should use as his primary defense tactic. 

In this case, since Carter Hockaday is absolutely convinced that the audit work he performed complies with the auditing standards, he can use all documentation related files as a defense against the lawsuit. 

West Camera Co. filed for bankruptcy in January 2018. A recent blog suggested that West’s external auditors should be sued for failing to include a going concern explanatory paragraph in the firm’s opinion on the financial statements issued before the bankruptcy, even though the fair presentation of the financial statements is not being disputed. 

In the present case, it is presumed that the West Camera Co.’s external auditors performed their audit work on the basis of information provided by the company management to them. Therefore, they cannot be found guilty of not qualifying the audit firm’s opinion on the financial statements of West Camera Co before bankruptcy. 

The audit firm Weaver and Jones, LLP, received a subpoena for its documentation related to the audit of Westbrook Corporation’s financial statements. The firm has refused to respond, alleging that the documentation is considered privileged communication between the firm and its client. 

In this situation, a third party needs to be involved for the conflict resolution between the audit firm and Westbrook Corporation. Therefore, Westbrook Corporation needs to give its assertion to the audit firm through arbitration. 

Spencer Cullen, CPA, is a defendant in a lawsuit alleging that Cullen should be held legally liable for gross negligence for a fraud involving the valuation of securities included in the financial statements of one of his clients. Cullen was uncertain how to establish a correct valuation for the securities and decided to rely on the price estimation supplied by management. 

In the present case, since one of the clients of the audit firm relied on the fraudulent financial reporting which was prepared by Cullen, a lawsuit should be filed by the audit firm against Cullen for the fraud related to the valuation of securities. 

5-23  In order to expand its operations, Gibson Corp. raised $5 million in a public offering of common stock, and also negotiated a $2 million loan from Citizens National Bank. In connection with this financing, Gibson engaged Horton & Co., CPAs, to audit Gibson’s financial statements. Horton knew that the sole purpose of the audit was so that Gibson would have audited financial statements to provide to Citizens National Bank and the purchasers of the common stock. Although Horton conducted the audit in conformity with its audit program, Horton failed to detect material acts of embezzlement committed by Gibson Corp.’s president. Horton did not detect the embezzlement because of its inadvertent failure to exercise due care in designing the audit program for this engagement. 

After completing the engagement, Horton issued an unqualified opinion on Barton’s financial statements. The financial statements were relied upon by the purchasers of the common stock in deciding to purchase the shares. In addition, Citizens National Bank approved the loan to Gibson based on the audited financial statements. Within 60 days after the sale of the common stock and the issuance of the loan, Gibson was involuntarily petitioned into bankruptcy. Because of the president’s embezzlement, Gibson became insolvent and defaulted on the loan from the bank. Its common stock became virtually worthless. Actions have been brought against Horton by 

The purchasers of the common stock, who have asserted that Horton is liable for damages under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. 

Citizens National Bank, based upon Horton’s negligence. 

Trade creditors who extended credit to Gibson based upon Horton’s negligence. 

Discuss whether you believe Horton will be found liable to the purchasers of common stock. 

In case the suit is carried under the rule 10b-5 of the Securities Exchange Act, 1934 then Horton will be unaccountable to the purchasers of the common stock. But in case the suit is carried under the Securities Act, 1933 and the purchasers are initial buyers then the plaintiff may be succeeded as they only prove the presence of significant error. 

Indicate whether you believe Citizens National Bank will be successful in its claim against Horton. 

Horton had the knowledge about the financial statements which were used to raise finances from Citizens National Bank. Therefore, he is most likely to be held responsible for the carelessness towards the bank as a third party which depended on the financial statements. 

Indicate whether you believe the trade creditors will be successful in their claim against Horton. 

Yes. Under the common law, trade creditors will be successful in their claim against Horton. This is because of the gross negligence by Horton which led to the creditors to believe the false financial statements. 

6-26  The following are selected portions of the report of management from a published annual report. 

Report of Management Management’s Report on Internal Control Over Financial Reporting 

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is a process designed under the supervision of its Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external reporting in accordance with accounting principles generally accepted in the United States of America. Management evaluates the effectiveness of the Company’s internal control over financial reporting using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in  Internal Control–Integrated Framework  (2013). Management, under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2019, and concluded it is effective. 

Management’s Responsibility for Consolidated Financial Statements 

Management is also responsible for the preparation and content of the accompanying consolidated financial statements as well as all other related information contained in this annual report. These financial statements have been prepared in conformity with accounting principles generally accepted in the United States, and necessarily include amounts, which are based on management’s best estimates and judgments. 

What are the purposes of the two parts of the report of management? 

The first part of the report of management states that a company should outline its responsibilities for Internal Control over Financial Reporting. 

The second part of the report of management states that the management of the company is responsible for fairness of the company’s financial statements. 

What is the auditor’s responsibility related to the report of management? 

The auditor is responsible for both the expression of an opinion on the fairness of the presentation of client’s financial statement and for the expression of an opinion on the effectiveness of the Internal Control over Financial Reporting. 

6-27 Auditors provide “reasonable assurance” that the financial statements are “fairly stated, in all material respects.” Questions are often raised as to the responsibility of the auditor to detect material misstatements, including misappropriation of assets and fraudulent financial reporting. 

Discuss the concept of “reasonable assurance” and the degree of confidence that financial statement users should have in the financial statements. 

The auditing standards states that reasonable assurance is a high level of assurance. Therefore, the user financial statement should have a higher level of confidence in the company’s financial statement. The reasonable assurance is not a complete assurance because there are some existing risks in audited statement that involve material misstatements. 

What are the responsibilities of the independent auditor in the audit of financial statements? Discuss fully, but in this part do not include fraud in the discussion. 

The independent auditor is responsible for expressing an opinion in the fairness of the financial statements. The management is responsible for the proper recording of the books of accounts, adequacy of financial statements and safeguarding of assets. 

In order for the auditor to form an opinion, he should perform his audit in line with auditing and accounting standards. These standards establish the measure of the appropriateness of the audit which require that the auditor should get enough suitable evidence in the financial statements on management assertions. 

An independent auditor should have all abilities of a qualified person in the profession which do not involve those of an appraiser, expert in materials, insurer, or lawyer. 

What are the responsibilities of the independent auditor for the detection of fraud involving misappropriation of assets and fraudulent financial reporting? Discuss fully, including your assessment of whether the auditor’s responsibility for the detection of fraud is appropriate. 

An independents auditor has the responsibility to obtain reasonable assurance that significant misstatement involved in the financial statement are detected, whether are due to fraud or error. Though, it is more difficult to detect fraud instead of errors as employees or the management committing the fraud usually attempt to conceal the fraud but this cannot change the responsibility of an auditor to plan to conduct the audit. 

During the auditing process, the auditor can uncover situation that might cause doubts or false financial reporting. The auditor usually evaluates the possibility of significant misappropriation of assets as part of understanding the internal control and assessing control risks. Any evidence must be explained when the auditor’s failure to follow prescribed procedures or he considers that a substantial fraud could result. 

6-30  The following general ledger accounts are included in the trial balance for an audit client, Jones Wholesale Stationery Store. 

Accounts payable	Depreciation expense—	Prepaid insurance
Accounts receivable	furniture and equipment	Property tax expense
Accrued interest expense	Furniture and equipment	Property tax payable
Accrued sales salaries	Income tax expense	Purchases
Accumulated depreciation—	Income tax payable	Rent expense
furniture and equipment	Insurance expense	Retained earnings
Advertising expense	Interest expense	Salaries, office and general
Allowance for doubtful accounts	Inventory	Sales
Bad debt expense	Loans payable	Sales salaries expense
Cash	Notes payable	Telecommunications
Common stock	Notes receivable—trade	expense

Identify the accounts in the trial balance that are likely to be included in each transaction cycle. Some accounts will be included in more than one cycle. Use the format that follows. 

Cycle	Balance Sheet Accounts	Income Statement Accounts
Sales and Collection	Cash  Notes receivable-trade  Accounts receivable  Allowance for doubtful accounts	Bad debt expense  Sales
Acquisition and payment	Cash  Accounts payable  Furniture and equipment  Prepaid insurance  Property tax payable  Income tax payable  Accumulated depreciation-Furniture and equipment  Inventory	Property tax expense  Telecommunication expense  Rent expense  Purchases  Inco tax expense  Insurance expense  Depreciation Expenses-Furniture and equipment  Advertising expense
Payroll and personnel	Accrued sales salaries  Cash	Salaries, office and general  Sales salaries expense
Inventory and warehousing	inventory	Purchases
Capital acquisition and repayment	Notes payable  Retained earnings  Loans payable  Common stock  Cash  Accrued interest expense	Interest expense

How will the general ledger accounts in the trial balance most likely differ if the company were a retail store rather than a wholesale company? How will they differ for a hospital or a government unit? 

In the trial balance, the general ledger accounts do not differ much between wholesale and retail companies unless there are departments having various categories. There is huge difference for hospitals and government units. They also have things like drug and laboratory expenses, and accounts like interest income, insurance expenses etc. Hospitals have different categories of revenue accounts instead of sales. Government unit use fund accounting systems which have totally different titles. 

7-25  The following questions concern audit documentation. Choose the best response. 

Which of the following is  not  a primary purpose of audit documentation? 

To coordinate the audit 

To assist in preparation of the audit report 

To support the financial statements 

To provide evidence of the audit work performed 

Answer 

The correct answer is option (3): To support the financial statements. 

During an audit engagement, pertinent data are compiled and included in the audit files. The audit files primarily are considered to be 

evidence supporting financial statements. 

a client-owned record of conclusions reached by the auditors who performed the engagement. 

support for the auditor’s representations as to compliance with auditing standards. 

a record to be used as a basis for the following year’s engagement. 

Answer 

The correct answer is option (3): support for the auditor’s representations as to compliance with auditing standards. 

Although the quantity, type, and content of audit documentation will vary with the circumstances, audit documentation generally will include the 

copies of those client records examined by the auditor during the course of the engagement. 

evaluation of the efficiency and competence of the audit staff assistants by the partner responsible for the audit. 

auditor’s comments concerning the efficiency and competence of client management personnel. 

auditing procedures followed and the testing performed in obtaining audit evidence. 

Answer 

The correct is option (4): auditing procedures followed and the testing performed in obtaining audit evidence. 

7-30  The following are various audit procedures performed to satisfy specific transaction-related audit objectives as discussed in  Chapter 6 . The general transaction-related audit objectives from  Chapter 6  are also included. 

Audit Procedures 

Trace from receiving reports to vendors’ invoices and entries in the acquisitions journal. 

Add the sales journal for the month of July and trace amounts to the general ledger. 

Examine expense voucher packages and related vendors’ invoices for approval of expense account classification. 

Observe opening of cash receipts to determine that cash receipts are promptly deposited and recorded. 

Ask the accounts payable clerk about procedures for verifying prices, quantities, and extensions on vendors’ invoices. 

Vouch entries in sales journal to sales invoices and related shipping documents. 

Examine the footnotes about the company’s policies for recording revenue transactions to determine whether the disclosures are understandable. 

General Transaction-Related Audit Objectives 

Occurrence	Posting and Summarization	Presentation
Completeness	Classification
Accuracy	Timing

Identify the type of audit evidence used for each audit procedure. 

Identify the general transaction-related audit objective or objectives satisfied by each audit procedure. 

Audit Procedure	Audit evidence	Transaction related audit objective
1. Trace from receiving reports to vendors’ invoices and entries in the acquisitions journal.	Inspection	Completeness
2. Add the sales journal for the month of July and trace amounts to the general ledger.	Recalculation	Posting and summarization
3. Examine expense voucher packages and related vendors’ invoices for approval of expense account classification.	Inspection	Classification
4. Observe opening of cash receipts to determine that cash receipts are promptly deposited and recorded.	Observation	Timing
5. Ask the accounts payable clerk about procedures for verifying prices, quantities, and extensions on vendors’ invoices.	Enquiries of client	Accuracy
6. Vouch entries in sales journal to sales invoices and related shipping documents.	Inspection	Occurrence
7. Examine the footnotes about the company’s policies for recording revenue transactions to determine whether the disclosures are understandable.	Observation	Presentation

8-33  Target and Kohl’s are chains of stores that cater to customers who desire name-brand goods at lower prices. The Securities and Exchange Commission (SEC) Form 10-K filing rules require management of U.S. public companies to include background information about the business, as well as the most recent financial condition and results of operations. Access each company’s most recent Form 10-K. These can be obtained through the SEC website (www.sec.gov), or directly from the investor relations section of the Target (www.target.com) and Kohl’s (www.kohls.com) websites. 

Read the description of each company’s business in Part I, Item 1 of Form 10-K. Evaluate the similarity of each company as a basis for making financial comparisons. 

Solution 

Form 10-K is a comprehensive summary of the business which is an annual compulsory return filed by every company to security and exchange commission. Part I of form 10-K includes: 

Business 

Risk factors 

Properties 

Legal Proceedings 

In terms of art I, Item I of form 10-K Kohl's company had provided more comprehensive description than Target Co. Both the companies had specifically mentioned about the nature of business i.e. departmental store retailing chain dealing in service and marketing functions. Both the companies have highlighted their market segmentation, supply chain process, innovation-driven mechanism, and infrastructure components etc, but Kohl's company has provided a diagrammatic presentation about their brands as well as customer traffic, which is more attractive and appealing than Target Company. 

The following comparisons between the companies can be made based on the financial parameters: 

1. Revenue: 

The revenue of Target Company had increased i.e. 1.88% increase in case of Target Company and 0.95% increase in case of Kohl's company. 

Sr. No	Companies	Revenue
1.	Target company	Increase by 1.88%
2.	Kohl’s company	Increase by 0.95%

2. Earnings from operational business: 

The earnings from continued business operations had fallen in the case of both companies but the earning percentage of Target Company has fallen at a larger rate (16.5%) against Kohl's company (12.22%). 

Sr. No	Companies	Earnings from operational business
1.	Target company	Decrease by 16.5%
2.	Kohl’s company	Decrease by 12.22%

3. Earnings Per Share from continuing business: 

In both the cases Earnings Per Share had gone down, the Earnings Per Share of Target company has gone down from 4.24 to 3.86 per share and the EPS of Kohl's company had gone down from 4.24 to 4.01 per share. Again the EPS of Target Company had fallen at a greater rate in comparison to Kohl's Company. 

Sr. No	Companies	Earnings Per Share
1.	Target company	Decrease from 4.24 to 3.86
2.	Kohl’s company	Decrease from 4.24 to 4.01

4. Assets Base: 

In both the companies the total assets on which return are dependent had fallen. Total assets had gone down by 82.71% in case of Target Company and 5.07% in case of Kohl's company. 

Sr. No	Companies	Asset base
1.	Target company	Decrease by 82.71%
2.	Kohl’s company	Decrease by 5.07%

5. Long-term Debt: 

In the case of both companies the long-term financial solvency of the companies which is based on Long-term debt had gone up. The long-term debt had increased by 1.78% in case of Target Company and 0.43% in case of Kohl's company. 

Sr. No	Companies	Long-term Debt
1.	Target company	Increase by 1.78%
2.	Kohl’s company	Increase by 0.43%

Conclusion: 

After examining the financial statements as well as analysis on the same financial parameters, we can conclude that the financial position of both the companies had gone down. But the financial status of Target Company is more unfavorable than Kohl's company. 

Note: The increase and decrease in the percentage of financial data are calculated on the basis of comparative analysis of two financial years of the same company i.e. 2014 and 2015 and the source is Form 10K which is available on the security exchange commission website. 

Each company follows what is called a 52/53-week year in which the fiscal year ends on the Saturday nearest January 31. Given the nature of these companies, why does a year end near January 31 make sense? Note that most public companies have a December 31 year end. 

Solution 

The accounting period of the companies is subjective and simply based on the nature and type of business they are dealing with. In the case of departmental business or retail chain business, 52 weeks concept is followed where the fiscal year ends on 31st January due to the following reason: 

Nature of business i.e. it differs from business to business 

The accounting period is too close to heavy sale season due to festivals. 

Delay in the preparation of financial statements because of heavy sales in the last months of the fiscal period and the majority of the staff is diverted to sales floor. 

Use the financial statements included in Part II, Item 8 to calculate the gross margin percentage and inventory turnover ratio for each company for the most recent year. Which company has the higher gross margin percentage? Which company has the higher inventory turnover? 

Solution 

In relation to net sales of the companies, Kohl's company has a greater gross margin i.e. 36.4% against 29.4% of Target Company. 

Sr. No	Companies	Gross margin
1.	Target company	Increase by 36.4%
2.	Kohl’s company	Increase by 29.4%

The inventory turnover of both the companies has gone down by few fractions i.e. no much change in the inventory conversion rate. 

Sr. No	Companies	Inventory turnover ratio
1.	Target company	Decreased from 5.84 to 5.83 times
2.	Kohl’s company	Decreased from 3.17 to 3.15 times

Evaluate whether the relation between the gross margin percentage and inventory turnover makes sense given the description of each company’s business. 

Solution 

The relation between the gross margin percentage and inventory turnover makes sense . This is because there exist a strong relationship between Gross margin percentage and inventory turnover. The better the inventory turnover ratio the better will be the gross margin. In other words, if the companies are able to increase the inventory rate i.e. sell the inventory at the faster rate provided margin should not reduce then in such a case, gross margin will improve comprehensively. 

8-34  You are evaluating audit results for assets in the audit of Roberts Manufacturing. You set the preliminary judgment about materiality at $50,000. The account balances, performance materiality, and estimated overstatements in the accounts are shown next. 

Account	Account Balance	Performance Materiality	Estimate of  Total Overstatements
Cash	$ 50,000	$ 5,000	$ 1,000
Accounts receivable	1,200,000	30,000	20,000
Inventory	2,500,000	50,000	?
Other assets	250,000	15,000	12,000
Total	$4,000,000	$100,000	?

Assume you tested inventory amounts totaling $1,000,000 and found $10,000 in overstatements. Ignoring sampling risk, what is your estimate of the total misstatement in inventory? 

The direct projection of the error is calculated as follows: 

Based on the audit of the assets accounts and ignoring other accounts, are the overall financial statements acceptable? Explain. 

The overall financial statements is not all acceptable. This is because when we include the error of inventory, the total overstatement errors are $58,000 which exceeds the materiality of $50,000. 

What do you believe the auditor should do in the circumstances? 

The auditor can choose either to propose audit adjustment so that the unadjusted amount is less than materiality, or conduct extra testing to get the better estimate of the misstatements. 

References 

Elder, R. J., Beasley, M. S., Hogan, C. E., & Arens, A. A. (2019).  Auditing and Assurance Services, Global Edition . Pearson Education Limited.