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Case 2 -

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 potential client before committing the firms services. The review team pointed out that this policy 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 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 firms practice, Richard Abernethy also asked Bob Zimmerman to evaluate how their client review process would interact with the registration process. The partners are now considering whether they wish to 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 Chapmans client review process requires the following two documents to be completed for each new engagementAnalysis 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, and talks with the business references furnished by the potential client. In addition, the partner always discusses the new engagement with the companys 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 much might be learned from a conference with the predecessor CPA firm, King and Company. Once the Lakeside engagement had been offered to Abernethy and Chapman, the partner began to seek a meeting with the predecessor auditor. Because of the confidential nature of audit information, arrangements for this discussion were made through Benjamin Rogers, president of Lakeside. An appointment was scheduled for June 15, 2012 so that 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 Abernethy 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 not 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.

I 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 fees. Have you discussed with him how much the audit will cost if he goes forward with his public offering? I honestly dont believe that he understands the purpose of an audit or all of the work that the job entails.

I must 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 a failed shopping center. Rogers simply disagreed; he could only see the most optimistic possibilities for that store. Unfortunately, the materiality question was even more complex. The company has a net investment of approximately $186,000 in that store out of $3.6 million in total assets. Rogers contended that, at the very worse, he could sell the building for around $100,000. Of course, thats 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.

The companys 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 distributorship side of the business. Across Virginia and North Carolina a very large potential demand seems to have developed for Cypress products. I can see why he is planning on major growth in his distributorship business. Rogers is just now beginning to 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 of the company are able to adapt to that expansion, especially since Rogers dislikes spending 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 documentation of past examinations would be available for review if Abernethy and Chapman were retained to do Lakesides current audit. The audit documentation of King and Company consisted of a permanent file of information gathered about Lakeside and annual 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.

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 example, if the net income of Lakeside was overstated by one million dollars, would that change the decision of a creditor to loan money to the company? What if net income was only overstated by $100?

Andrews will consider both quantitative and qualitative factors in determining the preliminary judgment about materiality. He knows that materiality is a relative rather than an 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 clients 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 and other employees of the client. For example, if the firm suspects fraud, Wallace might choose the lower end of the range determined in quantitative part as the preliminary judgment about materiality.

Abernethy and Chapman

ANALYSIS OF POTENTIAL LEGAL LIABILITY

Potential Client:

Type of Engagement:

Form Completed By: Date:

Is the potential client privately held or publicly held?

Evaluate the possible liability to the client that Abernethy and Chapman might incur, if the engagement is accepted.

List the third parties that presently have a financial association with the potential client and could be expected to see the financial statements. These parties are also called primary and foreseen beneficiaries.

Discuss the possibility that other third parties will be brought into a position where they would be expected to see the financial statements of the potential client. These parties are also called foreseeable beneficiaries.

Evaluate the possible legal liability to third parties, both present and potential, that Abernethy and Chapman might incur if the engagement is accepted.

Exhibit 2-2 Abernethy and Chapman

INFORMATION FROM PREDECESSOR AUDITOR

Potential Client:

Form Completed By:

Predecessor Auditor:

Date of Interview:

Discuss the predecessor auditors evaluation of the integrity of the management of the potential client.

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.

What was the predecessor auditors understanding as to the reasons for the change in auditors?

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 allowing Abernethy and Chapman to review prior years audit documentation for the potential client? If yes, explain.

Was the predecessor auditors response limited in any way?

Exhibit 2-3 Abernethy and Chapman

Preliminary Judgment about Materiality

Client: Balance Sheet Date: Prepared by:

Determine the preliminary judgment about materiality for the client as a whole. Express your answer as a dollar amount. Determine the appropriate level of materiality based on all analyses completed for the client thus far. Fully support and discuss the materiality level that you determine.

Quantitative Considerations: Because materiality is relative, it is necessary to have bases for establishing whether misstatements are material. A base is a critical item of which users tend to focus while making decisions. The base will vary depending on the nature of the clients business. Typical bases may include net income before taxes, net sales, total assets and stockholders equity. Percentages typically range from 1% to 10% depending on the base.

Base (from previous year) Dollar Amount of Base Percentage Range Base Percentage Qualitative Considerations: 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 and other employees of the client.

Item to be Considered Impact on Materiality (Increase or Decrease) Preliminary Judgment about Materiality: Combine the quantitative and qualitative considerations into one overall materiality level.

Materiality level: $ Discussion: Discuss how you arrived at this dollar amount for the preliminary judgment about materiality. That is, how did you combine the qualitative and quantitative considerations to arrive at this dollar amount?