Takema Yost & Co., a medium-sized CPA firm, was engaged to audit Stuart Supply Company. Several staff were involved in the audit, all of whom had attended the firm’s in-house training program on effective auditing methods. Throughout the audit, Yost spent most of her time in the field planning the audit, supervising the staff, and reviewing their work. 

A significant part of the audit entailed verifying the physical count, cost, and summarization of inventory. Inventory was highly significant to the financial statements, and Yost knew the inventory was pledged as collateral for a large loan to First City National Bank. In reviewing Stuart’s inventory count procedures, Yost told the president she believed the method of counting inventory at various locations on different days was highly undesirable. The president stated that it was impractical to count all inventory on the same day because of personnel shortages and customer preference. After considerable discussion, Yost agreed to permit the practice if the president signed a statement that no other method was practical. The CPA firm had at least one person at each site to audit the inventory count procedures and actual count. There were more than 40 locations. 

Eighteen months later, Yost found out that the worst had happened. Management below the president’s level had conspired to materially overstate inventory as a means of covering up obsolete inventory and inventory losses resulting from mismanagement. The misstatement occurred by physically transporting inventory at night to other locations after it had been counted in a given location. The accounting records were inadequate to uncover these illegal transfers. 

Both Stuart Supply Company and First City National Bank sued Takema Yost & Co. 

Answer the following questions, setting forth reasons for any conclusions stated: 

a. What defense should Takema Yost & Co. use in the suit by Stuart? 

b. What defense should Takema Yost & Co. use in the suit by First City National Bank? 

c. Is Yost likely to be successful in these defenses? 

d. Would the issues or outcome be significantly different if the suit was brought under the Securities Exchange Act of 1934?