Abernethy and Chapman INFORMATION FROM PREDECESSOR AUDITOR Potential Client Form Completed By Predecessor Auditor Date of Interview (1) Discuss the predecessor auditor's evaluation of the integrity of the management of the potential client. (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. (3) What was the predecessor auditor's understanding as to the reasons for the change in auditors? (4) Did the predecessor auditor give any indication of other significant audit problems associated with the potential client? Did the predecessor auditor indicate any problem in allowiing Abernethy and Chapman to review prior years' audit documentation for the potential client? If "yes," explain. (5) Was the predecessor auditor's response limited in any way? (6) 2 The Lakeside Company: Auditing Cases 2. NEW CLIENTS, LEGAL LIABILITY AND MATERIALITY During August of 2010, the Virginia-based CPA firm of Abernethy and Chapman underwent a peer review of its quality control procedures and its quality control document Although the final report of the outside review team was favorable, it did criticize the lack of control demonstrated in accepting new audit engagements. Until that time, this decision was left solely to the managing partner who often made little or no investigation of a t potential client before committing the firm's services. The review team pointed out that this uopolicy failed to protect the firm against becoming involved in engagements with undesirable clients. Following the peer review, Abernethy and Chapman created a three-partner committee to screen each potential client. This group, called the Client Screening Committee, was empowered to make the ultimate decision as to whether the firm should actively seek a particular audit. Under guidelines established by this committee, a partner was put in charge of researching any possible new engagement. This partner had to complete several forms and provide other data describing every potential client. The bshog partner also had to attach a final recommendation letter evaluating the wisdom of seeking the audit. The committee would then review all of this documentation and instruct the partner as to the appropriate course of action. The addition of a client with potential plans to go public in the next few years will bring Abernethy and Chapman under the regulations of the PCAOB. In order to adequately plan this increased regulation and impact on the firm's practice, Richard Abernethy also asked Bob Zimmerman to evaluate how their client review process would blinteract with the registration process. The partners are now considering whether they wish Ito become registered and are actively assessing the resources they would need to commit to such a strategy Regardless of the decision to become registered, Abernethy and Chapman's client review process requires the following two documents to be completed for each new engagement-"Analysis of Potential Legal Liability" and "Information from Predecessor Auditor" (presented in Exhibits 2-1 and 2-2). Before completing these forms, the in-charge partner learns as much as possible about the potential client and its industry. For example, either the partner or a member of the audit staff reviews recent annual reports and tax returns, tours the company facilities, reads any applicable AICPA Industry Audit Guides, aand talks with the business references furnished by the potential client. In addition, the partner always discusses the new engagement with the company's predecessor auditors. To keep from burdening the predecessor auditor with inquiries from numerous firms, the discussion is only made after the engagement has been offered to a specific new firm. In investigating the Lakeside Company, Richard Abernethy was aware that mu might be leamed from a conference with the predecessor CPA firm, King and Compan Once the Lakeside engagement had been offered to Abernethy and Chapman, the partn began to seek a meeting with the predecessor auditor. Because of the confidential natun of audit information, arrangements for this discussion were made through Benjam Rogers, president of Lakeside. An appointment was scheduled for June 15, 2012 so tha Abernethy could talk with William King, the managing partner of King and Company. At this meeting, King did not appear to be surprised that the Lakeside Company was seeking a new independent auditing firm. He talked quite candidly with Abemethy about the engagement. "I assumed when we qualified our year 2011 opinion that it would be our last year on the job. Rogers is really interested in stimulating growth and becoming president of a large company. He never talked about going public with me, but I am no surprised. I am positive that he did not like taking that 'impairment of value' problem to his stockholders or to the banks that finance his inventory. That could scare them and put a damper on his expansion. was comfortable working with Rogers. He and all of the members of his organization appear to be people of integrity. However, he was always unhappy with our ofees. Have you discussed with him how much the audit will cost if he goes forward with his enpublic offering? I honestly don't believe that he understands the purpose of an audit or all beof the work that the job entails. mmust admit that Rogers argued vehemently against writing down the reported value of the sixth store. He based his arguments on two points: first, that no real impairment existed, and second, that even if Store 6 represented an impairment, the potential loss was not material. As to the impairment issue, our firm was never able to satisfy itself that Lakeside was not going to be stuck holding a totally worthless building in oyoba failed shopping center. Rogers simply disagreed; he could only see the most optimistic dpossibilities for that store. Unfortunately, the materiality question was even more complex bloo The company has a net investment of approximately $186,000 in that store out of $3.6 a million in total assets. Rogers contended that, at the very worse, he could sell the building mfor around $100,000. Of course, that's all in his crystal ball. We obtained an appraisal that came in at $150,000. With the company having a net worth of less than a million dollars, our partners felt that write-off of the potential asset impairment was absolutely necessary. When he would not recognize this loss, we felt that a material misstatement existed within the financial statements and a qualification was required. prde wen The company's situation is really quite unique. The audio and video equipment retail stores are only marginal operations. Rogers ruined them when he turned them into Cypress outlets. The market in the Richmond area is just not strong enough for that particular brand alone. On the other hand, he has done exceptionally well with the ndistributorship side of the business. Across Virginia and North Carolina a very large 2bpotential demand seems to have developed for Cypress products. I can see why he is eplanning on major growth in his distributorship business. Rogers is just now beginning to vino e tap into that market. Consequently, he is trying to operate one stagnant and one prospering business at the same time. I certainly foresee the distributorship sales growing rapidly over the next few years. I will be interested in seeing how well the internal systems bueof the company are able to adapt to that expansion, especially since Rogers dislikes oospending any money. Does he know what it will cost to meet PCAOB standards in the area of his internal control? Before ending the conversation, King assured Abernethy that their audit bdocumentation of past examinations would be available for review if Abernethy and Chapman were retained to do Lakeside's current audit. The audit documentation of King and Company consisted of a permanent file of information gathered about Lakeside and nwannual files containing all of the evidence accumulated during each of the previous yearly examinations. If the firm decides to accept this engagement, then the engagement team must establish a preliminary judgment about materiality. This judgment normally takes place during the planning phase of the audit. However, due to significant uncertainty surrounding Store 6, the Client Screening Committee asked Wallace Andrews, a manager in the firm, to complete the form "A Preliminary Judgment about Materiality" (presented in Exhibit 2-3) to see just how material a potential write-down of Store 6 would be. e to sanqa Andrews must decide on the combined amount of misstatement in the financial statements that the firm would consider material. Materiality is the amount of a misstatement on the financial statements that makes it probable that a reasonable user of the financial statements would change his or her decision due to this misstatement. For texample, if the net income of Lakeside was overstated by one million dollars, would that tachange the decision of a creditor to loan money to the company? What if net income was 0 vilut ton Lib aiege bsgonly overstated by $100? Go ol s1w ob Andrews will consider both quantitative and qualitative factors in determining the aspreliminary judgment about materiality. He knows that materiality is a relative rather than ban absolute concept, meaning that the size of the client impacts the level of materiality. Because materiality is relative, it is necessary to have quantitative bases for establishing whether misstatements are material. A base is a critical item of which financial statement users tend to focus while making decisions. The base will vary depending on the nature of the client's business. Typical bases include net income before taxes, net sales, total assets, and stockholders' equity. For example, Wallace might determine that 3 % to 5 % of net income before taxes is a reasonable range for the quantitative part of the preliminary judgment. Wallace will also consider qualitative factors. 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 choose the lower end of the range determined in quantitative part as the preliminary judgment about materiality. odt ni and other employees of the client. For example, if the firm suspects fraud, Wallace might 9 Abernethy and Chapman INFORMATION FROM PREDECESSOR AUDITOR Potential Client Form Completed By Predecessor Auditor Date of Interview (1) Discuss the predecessor auditor's evaluation of the integrity of the management of the potential client. (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. (3) What was the predecessor auditor's understanding as to the reasons for the change in auditors? (4) Did the predecessor auditor give any indication of other significant audit problems associated with the potential client? Did the predecessor auditor indicate any problem in allowiing Abernethy and Chapman to review prior years' audit documentation for the potential client? If "yes," explain. (5) Was the predecessor auditor's response limited in any way? (6) 2 The Lakeside Company: Auditing Cases 2. NEW CLIENTS, LEGAL LIABILITY AND MATERIALITY During August of 2010, the Virginia-based CPA firm of Abernethy and Chapman underwent a peer review of its quality control procedures and its quality control document Although the final report of the outside review team was favorable, it did criticize the lack of control demonstrated in accepting new audit engagements. Until that time, this decision was left solely to the managing partner who often made little or no investigation of a t potential client before committing the firm's services. The review team pointed out that this uopolicy failed to protect the firm against becoming involved in engagements with undesirable clients. Following the peer review, Abernethy and Chapman created a three-partner committee to screen each potential client. This group, called the Client Screening Committee, was empowered to make the ultimate decision as to whether the firm should actively seek a particular audit. Under guidelines established by this committee, a partner was put in charge of researching any possible new engagement. This partner had to complete several forms and provide other data describing every potential client. The bshog partner also had to attach a final recommendation letter evaluating the wisdom of seeking the audit. The committee would then review all of this documentation and instruct the partner as to the appropriate course of action. The addition of a client with potential plans to go public in the next few years will bring Abernethy and Chapman under the regulations of the PCAOB. In order to adequately plan this increased regulation and impact on the firm's practice, Richard Abernethy also asked Bob Zimmerman to evaluate how their client review process would blinteract with the registration process. The partners are now considering whether they wish Ito become registered and are actively assessing the resources they would need to commit to such a strategy Regardless of the decision to become registered, Abernethy and Chapman's client review process requires the following two documents to be completed for each new engagement-"Analysis of Potential Legal Liability" and "Information from Predecessor Auditor" (presented in Exhibits 2-1 and 2-2). Before completing these forms, the in-charge partner learns as much as possible about the potential client and its industry. For example, either the partner or a member of the audit staff reviews recent annual reports and tax returns, tours the company facilities, reads any applicable AICPA Industry Audit Guides, aand talks with the business references furnished by the potential client. In addition, the partner always discusses the new engagement with the company's predecessor auditors. To keep from burdening the predecessor auditor with inquiries from numerous firms, the discussion is only made after the engagement has been offered to a specific new firm. In investigating the Lakeside Company, Richard Abernethy was aware that mu might be leamed from a conference with the predecessor CPA firm, King and Compan Once the Lakeside engagement had been offered to Abernethy and Chapman, the partn began to seek a meeting with the predecessor auditor. Because of the confidential natun of audit information, arrangements for this discussion were made through Benjam Rogers, president of Lakeside. An appointment was scheduled for June 15, 2012 so tha Abernethy could talk with William King, the managing partner of King and Company. At this meeting, King did not appear to be surprised that the Lakeside Company was seeking a new independent auditing firm. He talked quite candidly with Abemethy about the engagement. "I assumed when we qualified our year 2011 opinion that it would be our last year on the job. Rogers is really interested in stimulating growth and becoming president of a large company. He never talked about going public with me, but I am no surprised. I am positive that he did not like taking that 'impairment of value' problem to his stockholders or to the banks that finance his inventory. That could scare them and put a damper on his expansion. was comfortable working with Rogers. He and all of the members of his organization appear to be people of integrity. However, he was always unhappy with our ofees. Have you discussed with him how much the audit will cost if he goes forward with his enpublic offering? I honestly don't believe that he understands the purpose of an audit or all beof the work that the job entails. mmust admit that Rogers argued vehemently against writing down the reported value of the sixth store. He based his arguments on two points: first, that no real impairment existed, and second, that even if Store 6 represented an impairment, the potential loss was not material. As to the impairment issue, our firm was never able to satisfy itself that Lakeside was not going to be stuck holding a totally worthless building in oyoba failed shopping center. Rogers simply disagreed; he could only see the most optimistic dpossibilities for that store. Unfortunately, the materiality question was even more complex bloo The company has a net investment of approximately $186,000 in that store out of $3.6 a million in total assets. Rogers contended that, at the very worse, he could sell the building mfor around $100,000. Of course, that's all in his crystal ball. We obtained an appraisal that came in at $150,000. With the company having a net worth of less than a million dollars, our partners felt that write-off of the potential asset impairment was absolutely necessary. When he would not recognize this loss, we felt that a material misstatement existed within the financial statements and a qualification was required. prde wen The company's situation is really quite unique. The audio and video equipment retail stores are only marginal operations. Rogers ruined them when he turned them into Cypress outlets. The market in the Richmond area is just not strong enough for that particular brand alone. On the other hand, he has done exceptionally well with the ndistributorship side of the business. Across Virginia and North Carolina a very large 2bpotential demand seems to have developed for Cypress products. I can see why he is eplanning on major growth in his distributorship business. Rogers is just now beginning to vino e tap into that market. Consequently, he is trying to operate one stagnant and one prospering business at the same time. I certainly foresee the distributorship sales growing rapidly over the next few years. I will be interested in seeing how well the internal systems bueof the company are able to adapt to that expansion, especially since Rogers dislikes oospending any money. Does he know what it will cost to meet PCAOB standards in the area of his internal control? Before ending the conversation, King assured Abernethy that their audit bdocumentation of past examinations would be available for review if Abernethy and Chapman were retained to do Lakeside's current audit. The audit documentation of King and Company consisted of a permanent file of information gathered about Lakeside and nwannual files containing all of the evidence accumulated during each of the previous yearly examinations. If the firm decides to accept this engagement, then the engagement team must establish a preliminary judgment about materiality. This judgment normally takes place during the planning phase of the audit. However, due to significant uncertainty surrounding Store 6, the Client Screening Committee asked Wallace Andrews, a manager in the firm, to complete the form "A Preliminary Judgment about Materiality" (presented in Exhibit 2-3) to see just how material a potential write-down of Store 6 would be. e to sanqa Andrews must decide on the combined amount of misstatement in the financial statements that the firm would consider material. Materiality is the amount of a misstatement on the financial statements that makes it probable that a reasonable user of the financial statements would change his or her decision due to this misstatement. For texample, if the net income of Lakeside was overstated by one million dollars, would that tachange the decision of a creditor to loan money to the company? What if net income was 0 vilut ton Lib aiege bsgonly overstated by $100? Go ol s1w ob Andrews will consider both quantitative and qualitative factors in determining the aspreliminary judgment about materiality. He knows that materiality is a relative rather than ban absolute concept, meaning that the size of the client impacts the level of materiality. Because materiality is relative, it is necessary to have quantitative bases for establishing whether misstatements are material. A base is a critical item of which financial statement users tend to focus while making decisions. The base will vary depending on the nature of the client's business. Typical bases include net income before taxes, net sales, total assets, and stockholders' equity. For example, Wallace might determine that 3 % to 5 % of net income before taxes is a reasonable range for the quantitative part of the preliminary judgment. Wallace will also consider qualitative factors. 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 choose the lower end of the range determined in quantitative part as the preliminary judgment about materiality. odt ni and other employees of the client. For example, if the firm suspects fraud, Wallace might 9