Case 6-3Richards & Co: Year-end Audit Engagement

Paul Lewis is the quality review partner on the Richards & Co. engagement. He was reviewing the workpapers prior to the December 31, 2015, annual audit when he came across transactions that caused him a great deal of concern. He wondered if the firm's auditors had handled them properly. The following information appeared in a memo to the file that prompted his concern.

Memo to File: Supplier Credits for Returned Product

For the last three quarters of the year, Richards has engaged in last-minute transactions that are questionable. The facts are, according to the client, that Richards received credits from a cellular phone supplier and promised to repay the supplier by purchasing cellular telephone and repair services at inflated prices in the subsequent quarter. The client has been unable to produce any supporting documents with respect to the promised purchases, and we have not been able to trace any such payments to cash disbursements.

The client has produced credit memos in the amount of $10 million, $7 million, and $4 million for December 31, 2015, September 30, 2015, and June 30, 2015, respectively, which is about 15 percent of the reported net income for 2015. The memos are marked to indicate that the credit was being provided in connection with defective telephone components. However, we could not identify any shipping documents to confirm that the components were returned to the supplier.Exhibit 1 shows the reported net income amounts by quarter and what they would have been without the credits.

EXHIBIT 1 Net Income Amounts
	Quarters for 2015
	March 31	June 30	September 30	December 31
Reported net income	$36 million	$32 million	$33 million	$34 million
Net income w/o credits	$36 million	$28 million	$26 million	$24 million
Difference	-----$0-----	$ 4 million	$ 7 million	$10 million
Percentage		14.3%	26.9%	41.7%

We have filed 10-Q quarterlyreports to the SEC based on the reported net income. We recommend, however, the firm conduct due diligence prior to publishing the 10-K annual report.

The client assures us that the promised purchases will be made and the only reason for not doing so is a cash flow problem. We are relying on management's representations in that regard. Richards is currently negotiating a loan for $20 million.

Questions

1. Does it seem from the limited data that the credit memo transactions can be justified as adjustments to reported net income amounts? Explain.
2. From an audit perspective, do you think the firm followed generally accepted auditing standards? Explain.
3. Based on the limited facts presented, do you think the firm violated any provisions of the Securities Exchange Act of 1934? Explain with reference to the auditors' legal liability.