Murchison Technologies, Inc. recently developed a patient-billing software system that they market to physicians and dentists. Jim Archer and Janice Johnson founded the company in Austin, Texas five years ago after working at IBM for more than 15 years. Jim worked as a software programmer and Janice worked as a sales representative, frequently calling on stand-alone medical practices. Together, they identified a need for software to help physician and dental offices track charges for patient services provided by doctors and their staff. With the initial backing of three local venture capitalists, they left IBM, created Murchison Technologies, and devoted their full-time efforts to the development of the billing system software.

For more than three years, they worked on developing the software. After extensive pilot testing, the company shipped its first product to customers in early 2001, just more than three years ago. Sales have been surprisingly strong for the product, which is marketed as MEDTECH Software. Feedback from physicians and dentists has been extremely positive. Most note that billing clerks and office stafffind the system quite flexible in tracking numerous types of services for large numbers of patients. Most are pleased with the ability to customize system features for their unique practice needs. Another key to the product's success is the relative cost of the software and the minimal upgrades required of the office microcomputers and networks to operate the software.

The company has gradually added employees to their staff. Currently, Murchison employs about 60 people, including software programmers who continually update the software for emerging technological developments. Janice serves as chief executive officer (CEO), and Jim serves as president. While both serve on the board of directors, they ultimately are accountable to the board, which also includes representatives from the three venture capitalists and two local bankers who financed company expansions through commercial loans issued three years ago.

Your firm, Custer \& Custer, LLP, was first engaged by Murchison four years ago to perform a review of their December 31, 2000 financial statements. In the subsequent year, the company engaged your firm to conduct the audit of its December 31, 2001 financial statements to fulfill requirements of the loan agreements. Custer \& Custer issued standard, unqualified reports on both the 2001 and 2002 annual financial statements.

BACKGROUND ABOUT THE AUDIT

Your firm is in the process of completing the audit of the December 31, 2003 financial statements. Currently it is February 17, 2004 and most of the detailed audit testing is complete. As audit senior, you are wrapping up the review of staff audit files. The partner anticipates performing the review and signing off on audit files tomorrow. This should allow fieldwork to be completed in the next day or two.

In preparation for completion of fieldwork, you recently worked with the client to send requests to outside legal counsel asking them to provide the standard attorney letter response regarding material outstanding claims against the company. You sent requests for attorney confirmations to three law firms providing legal representation for the company.

Based on all the audit work performed, you do not expect any substantive issues related to outstanding litigation claims against Murchison. Your only concern relates to an alleged copyright infringement claim against Murchison that apparently was filed in October 2003. You learned about this case during your review of the November 2003 minutes of the board of directors' meeting. The minutes made reference to the case being filed; however, based on notations about the board's discussion it appeared to you that the probability of an unsuccessful outcome related to this case is extremely low. Apparently, another software development company, Physicians Software, Inc., claims that Murchison's MEDTECH software violates a copyright held by Physicians Software. They are suing Murchison for \(\$ 220,000\).

Your subsequent inquiries of management about the case confirmed your expectation of a very low likelihood of unfavorable outcome. In addition, management believes the claim is immaterial relative to the December 31, 2003 financial statements. Those financial statements indicate that Murchison's total assets as of December 31, 2003 were \(\$ 7\) million, with revenues of \(\$ 22\) million and pretax income of \(\$ 1.8\) million, respectively, for the year then ended.

You received two of the attorney confirmation letters in the mail yesterday. Your review of the attorney responses produced no surprises. Most of the issues being handled by those attorneys relate to collection efforts on delinquent receivables. Those same firms also helped management develop contracts for special sales agreements with two new customers.

One of your audit staff members just delivered mail from the office after running by the office during lunch to pick up a few supplies. You are pleased to see that today's mail includes the attorney confirmation from the third law firm. You quickly open the envelope to make sure all is OK. You begin reading the letter, which is presented in the pages that follow.

You are a little surprised to read the attorney's assessment of the case, and some of the language referencing American Bar Association (ABA) policies puzzles you. You quickly link to professional standards stored on your laptop to review the relevant ABA policy statements. An excerpt of those statements, which are presented as an appendix to Statement on Auditing Standards No. 47, Inquiry of a Client's Lawyer Concerning Litigation, Claims, and Assessments, is presented in Exhibit 1 on the pages that follow.

You want to closely evaluate the information contained in the letter in order to have ideas about possible accounting treatment and audit reporting issues so that you can discuss those intelligently with the partner tomorrow. It is also likely that the partner will want to discuss those issues with Murchison's management. In order to properly prepare, please complete the following items noted below.

REQUIREMENTS

1. Review the requirements of Statement of Financial Accounting Standards (SFAS) No. 5, Accounting for Contingencies. Describe the three ranges of loss contingencies outlined in SFAS No. 5 and summarize briefly the accounting and disclosure requirements for each of the three ranges.

2. Based on your review of the attorney's confirmation, which of the three ranges of probability of loss do you think the Physicians Software Inc., claim falls? How does that assessment differ from management's assessment of the loss probability?

3. Assuming that management and the attorney's assessments differ, how would you resolve such differences when assessing the potential for an unfavorable outcome associated with the claim? What are the pros and cons of relying on the attorney's assessment versus management's assessment?

4. In preparation for tomorrow's meeting with the partner and likely subsequent meeting with Murchison management, develop recommended responses to the following possible scenarios. In developing your responses, assume that each scenario is independent of the others:

a. If generally accepted accounting principles require disclosure of this contingency, how would you respond to management's decision against disclosure because they view the claim as immaterial to the December 31, 2003 financial statements? Do you believe the potential loss is material? Why or why not?

b. Assume that even though you convince management that the claim is material, they refuse to provide any disclosure that might be required. Prepare a draft of the auditor's report that would be issued in that scenario.

c. Assume that you determine, through subsequent discussions with the attorney, that a more likely estimate of the range of loss falls between \(\$ 30,000\) to \(\$ 45,000\). What type of financial statement disclosure do you believe is required in that case? Prepare a draft of the auditor's report that you would issue in that scenario.

d. What if you learn that management has pertinent information available about the case (and the case is deemed material) but refuses to share that information with you? Prepare a draft of the auditor's report that you would issue in that scenario.

e. Assume that you convinced management to disclose the contingency in the footnotes to the December 31, 2003 financial statements and that your audit report on those financial statements was a standard, unqualified audit report. What would your responsibilities be if you learned two months after the issuance of the report that Murchison settled the case for \(\$ 190,000\) ?

f. Assume that the settlement of the litigation prohibits future sales of MEDTECH software. What implication would that have on the auditor's report on the December 31, 2003 financial statements?

5. Discuss why the attorney's letter is being received so close to the completion of the audit. Was the request for the attorney's response an oversight that should have been taken care of closer to December 31, 2003, or was Custer \& Custer appropriate in not requesting the response until close to the end of fieldwork?

6. Assume that Custer \& Custer was delayed a month in completing fieldwork. What actions would be appropriate relating to gathering evidence about potential contingencies?

7. Review the \(\mathrm{ABA}\) policy statement excerpts in Exhibit 1. What limitations exist as it relates to the attorney's response? To what extent should auditors rely solely on attorney responses to identify outstanding claims against audit clients?