An audit client of the Peninsula CPA firm is extensively involved in defense contracting. During the past year, the Defense Department has conducted an ongoing investigation of the client for possible overbillings on governmental contracts.
Most of these overbillings would be considered illegal. After an extensive investigation, it is determined that some of the billings were illegal. The client reached an agreement with the Defense Department whereby the client did not admit guilt but agreed to make restitution to the government of $7.2 million, to pay a fine of $600,000, and to establish procedures to ensure that the government will not be overbilled in the future.
The client cooperates with the auditor and discloses the details of the investigation and settlement during the course of the audit. The auditor verifies the nature of the act and is convinced that the client's characterization is correct. The auditor discusses the need to disclose the nature of these transactions-the restitution and the fine-either as a line item or in a footnote to the financial statements. Management replies that it has adequately dealt with the situation by classifying the transactions as part of the cost of doing business with the government, that is, as marketing and administrative costs associated with governmental clients. Besides, management states, “The agreement reached with the Defense Department does not require the admission of guilt on our part. Therefore, classifying the costs as losses from illegal acts would be totally improper because there is no allegation or proof of illegality."

Required
a. How should the auditor respond to the client? Indicate explicitly your opinion on the necessary disclosure, if any, in the company's financial statements.
b. Should the situation be discussed with the auditor's attorney or the client's legal counsel (or both) before determining whether an illegal act that should be disclosed has occurred?
c. Should the settlement be discussed with the audit committee before determining the proper treatment on the financial statements? What should your response be if the audit committee believes these transactions do not require separate disclosure because the client did not admit guilt?
d. Would any of your answers change if the client admitted guilt and paid a smaller fine?