Cook and Thomas, LLC: Balancing Auditor Liability, Client Confidentiality, and the Public Interest

COOK AND THOMAS, LLC

As a partner for the international public accounting firm Cook and Thomas, LLC, you are comfortable with complex problems and situations, but the current engagement of Fine Furniture Manufacturing is particularly challenging. Since joining Cook and Thomas, LLC out of college you have been located in the Chicago, Illinois office. For the past two years, you have been assigned as engagement partner on the annual financial statement audit of Fine Furniture Manufacturing. Fine Furniture has been a client of the firm for 12 years out of the Chicago office and has traditionally been an uneventful audit. You and your audit engagement team are currently completing the year-end audit of Fine Furniture Manufacturing for the year ended December 31, 2014.

Fine Furniture Manufacturing is a medium-sized publicly held corporation established in 1982. The company specializes in manufacturing wood furniture including park benches, patio furniture, and rocking chairs. Nearly all of the furniture produced by Fine Furniture Manufacturing is constructed using a revolutionary and proprietary product called ''paple'' that is supplied by Paple Lumber Supply in Atlanta, Georgia. Since its founding in 1991, Paple Lumber Supply has revolutionized the lumber industry by creating a hybrid wood product that is a cross between pine and maple (hence, paple). Paple has the economic benefits of pine lumber with the sturdiness and longevity of maple wood. Paple Lumber Supply is the only company of its kind to manufacture paple lumber. Paple Lumber Supply's largest customer is Fine Furniture Manufacturing. Paple Lumber Supply is also a publicly held corporation and is audited by the Atlanta office of your firm, Cook and Thomas, LLC.

As a manufacturer of wood furniture, Fine Furniture Manufacturing sells its products wholesale to retail stores. Fine Furniture Manufacturing's largest customer is Front Porch Furniture in St. Louis, Missouri. Front Porch Furniture is audited by the St. Louis office of your firm, Cook and Thomas, LLC. Front Porch Furniture is a publicly held corporation established in 1985 specializing in high-quality outdoor furniture. Front Porch Furniture's largest supplier of inventory is Fine Furniture Manufacturing and a majority of its sales are derived from Fine Furniture Manufacturing's products. Front Porch Furniture has multiple store locations throughout the Midwest and advertises that it specializes in ''bringing you the best of southern living.''

Over the past five years, Front Porch Furniture has experienced continued growth in sales of furniture manufactured by Fine Furniture Manufacturing. Due to the increased sales, Front Porch Furniture plans to expand its store locations into the Colorado region by opening eight new store locations in the next year. Front Porch Furniture is currently in the process of securing a ten-year, 6 percent note payable in the amount of $30 million from Mutual Trust Bank for the expansion. One large factor in the bank's consideration of the note is an analysis of Front Porch Furniture's 2014 financial statements. Mutual Trust Bank will provide final approval on the note after it reviews the audited 2014 financial statements.

The Chicago office of Cook and Thomas, LLC has an uneventful history with Fine Furniture Manufacturing and has issued unmodified (clean) audit opinions every year since it began auditing the company. Fine Furniture has been historically profitable and its financial performance has generally been in line with that of its competitors. The client is not followed by a large number of analysts given its niche as a mid-market, publicly held company and thus does not face the scrutiny or pressure of larger public companies that have a large analyst following and consensus analyst forecasts. The financial performance during the first three quarters of the current year has been relatively consistent with prior year's results and those of its peers.

However, during the fourth quarter of the current fiscal year under audit, Fine Furniture Manufacturing experienced drastically increased costs of production relating to two unforeseen factors that occurred during the last two months of the year. Specifically, the company experienced material and uninsured damages to the company's custom manufacturing equipment. Additionally, the company was unable to favorably negotiate its union contract and has experienced increased pension expenses that are material to the company. Therefore, the Fine Furniture Manufacturing engagement team believes these factors raise substantial doubt about the ability of Fine Furniture to continue as a going concern. Under current standards, the going concern decision requires the auditor to consider whether there is substantial doubt about the ability of the client to remain a going concern through the next fiscal year-end.^[1]

During the audit, you have discussed Fine Furniture Manufacturing's ability to continue as a going concern with its management. Despite the conversations, the client will not agree to provide consent to disclose (prior to the release of the audit opinion) the audit firm's substantial doubt about its ability to continue as a going concern to either its primary supplier (Paple Lumber Supply) or its primary customer (Front Porch Furniture). The client refuses to provide consent because both management and the audit committee believe Fine Furniture Manufacturing can navigate the issues giving rise to the going concern opinion, and further believes the company will remain a viable concern for years to come. As noted by management, auditors in general have a relatively poor track record for issuing going concern opinions in the year prior to a client filing for bankruptcy. Fine Furniture has appropriately disclosed its plans to address the relevant factors causing Cook and Thomas' substantial doubt about its ability to continue as a going concern in the footnotes to the financial statements to be filed soon with the Securities and Exchange Commission (SEC). Regardless of the client's beliefs and footnote disclosure, you and your audit team believe there is substantial doubt the company can continue as a going concern and have determined the audit report must include a going concern paragraph. Fine Furniture Manufacturing, Paple Lumber Supply, and Front Porch Furniture all have December 31 fiscal year-ends and similar expected audit opinion dates on or about February 25, 2015.^[2]All three companies are audited by different offices, engagement partners, and audit engagement teams of Cook and Thomas, LLC.

As partner of the audit engagement, you are concerned about Fine Furniture's ability to continue as a going concern and the implications regarding the audits of Paple Lumber Supply and Front Porch Furniture. You are especially concerned with the audit report to be issued for Front Porch Furniture since the audit report will be relied upon by Mutual Trust Bank before approving a note payable. As the auditor of the Fine Furniture Manufacturing, do you have a duty to inform the engagement teams of Paple Lumber Supply and Front Porch Furniture that your client has a going concern issue? Or do you have a duty to uphold your client's right to confidentiality and withhold the information from the other engagement teams until Fine Furniture's audited financial statements are filed with the SEC?

Suppose both engagement teams for Paple Lumber Supply and Front Porch Furniture issue unmodified opinions for their respective clients. If Fine Furniture Manufacturing were to become insolvent, and Paple Lumber Company and/or Front Porch Furniture were unable to locate alternative customers or wholesale product sources, respectively, then Cook and Thomas would likely face litigation if Paple Lumber Company and/or Front Porch Furniture were to file for bankruptcy shortly after receiving clean unmodified audit opinions. Alternatively, the firm may face litigation, under client confidentiality rules, from Fine Furniture Manufacturing if the pending going concern opinion is disclosed to the Paple Lumber Company and/or Front Porch Furniture engagement team(s) prior to public release of the opinion.

The Cook and Thomas' policy regarding potential going concern issues requires you to consult with the national office of the firm. The national office has expertise regarding technical and subjective issues including going concern situations, and is able to assist engagement partners in making more difficult decisions. Your consultation with the national office is just a few days away. In preparation for your meeting with the national office, you decide to refresh your understanding of the issues by researching an auditor's duty to the public, client confidentiality, and legal liability.

Auditor's Duty to the Public

You decide to begin your reading with the American Institute of Certified Public Accountants' (AICPA) Code of Professional Conduct. The AICPA emphasizes the auditor's duty to the public in its Code of Professional Conduct by stating, ''Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to the profession'' (AICPA 1988, 53).

The Code of Professional Conduct acknowledges potential conflicting pressures from various stakeholder groups and states, ''In resolving those conflicts, members should act with integrity, guided by the precept that when members fulfill their responsibility to the public, clients' and employers' interests are best served'' (AICPA 1988, 53.02). Additionally, the Code of Professional Conduct states, ''Those who rely on certified public accountants expect them to discharge their responsibilities with integrity, objectivity, due professional care, and a genuine interest in serving the public. They are expected to provide quality services, enter into fee arrangements, and offer a range of servicesall in a manner that demonstrates a level of professionalism consistent with these Principles of the Code of Professional Conduct'' (AICPA 1988, 53.03).

A fundamental understanding of the term ''public interest'' is essential to following the AICPA's Code of Professional Conduct. The International Federation of Accountants (IFAC 2012) defines the ''public interest'' in a recent policy position. The IFAC defines the public interest as ''the net benefits derived for, and procedural rigor employed on behalf of, all society in relation to any action, decision, and policy.'' The broadness of the definition comes from the IFAC's very broad definition of the ''public.'' According to the IFAC, the public includes all individuals and groups because accountants directly and indirectly affect all levels of society. Therefore, the public includes investors, shareholders, and business owners; consumers and suppliers; and taxpayers, electorates, and citizens (IFAC 2012).

During your reading, you come across four publications that discuss the auditor's duty to the public. In the first article, the authors adopt a ''common good'' definition of the public interest by focusing on the advancement of the good of institutions, communities, and individuals. This definition identifies both mutual interests of society and private interests of individuals (Shapiro and Naughton 2013). In the second article, the author argues the AICPA's Code of Professional Conduct should explicitly state that the interest of the public outweighs client confidentiality when there is a conflict of interest between the two (Bowie 1986). However, the author also observes when the conflict is not obvious, the Certified Public Accountant (CPA) may not even know the public good is threatened (Bowie 1986). A third article suggests the public interest is clearly dominant, in contrast to the interests of both auditors and clients (Waples and Shaub 1991). In the fourth article, the authors view the AICPA's Code of Professional Conduct as a transitional document, suggesting that ''the profession should always be searching for the changes that will improve the level of professional service to the public we are commissioned to serve'' (Collins and Schultz 1995, 40).

These observations regarding public interest are notable in that they are silent with respect to the degree that negative impacts on the accounting firm may indirectlyhave on the greater public good. Consider for example the impact that negative litigation outcomes against auditors on matters regarding client confidentiality and the public interest may have. The annual audit client acceptance and retention requirements of the profession, by definition, involve risk and reward judgments by auditors. To the extent litigation risks are perceived to be increased, whether by virtue of client characteristics or by auditing and accounting standards, fees can be expected to rise to counter this risk. You note that this may or may not serve the greater public interest.

While the AICPA's Code of Professional Conduct and the views of others who have published on the matter of the auditor's duty to the greater public interest seem to suggest this outweighs client confidentiality matters, you feel that, in order to cover all the bases, you would be well suited to review the authoritative requirements insofar as they relate to confidentiality.

Auditor's Client Confidentiality Responsibilities

In addition to your duty to the public as an auditor, you also hold client confidentiality responsibilities. Rule 301 of the AICPA's Code of Professional Conduct addresses client confidentiality by stating ''a member in public practice shall not disclose any confidential client information without the specific consent of the client'' (AICPA 1992). Therefore, Rule 301 suggests that client confidentiality is necessary regardless of the auditor's motivation to protect the public good.

You value the service that you as an audit partner provide to the profession, its clients, and the capital markets. You also know that you cannot provide these services if you are not a CPA and are becoming increasingly concerned that resolving the Fine Furniture issues may place you into an uncomfortable position, even to the point of potentially committing an act that is discreditable to the auditing profession. This is of great concern to you personally as this could result in the loss of your CPA credential and other disciplinary outcomes.

In addition to considering the requirements of Rule 301, you also realize that compliance with the SEC's Regulation Fair Disclosure (Reg FD) is necessary. Reg FD was implemented to ''level the playing field'' and requires any material client information to be disseminated to allpotential stakeholders concurrently to minimize the advantage that one stakeholder group might have over another.

During your reading you find an interesting article concerning client confidentiality Werner (2009). In the article, Werner describes a factual case in which an honest client of a firm (Dallas office) sold a material amount of product on credit to a dishonest client of the same firm (Los Angeles office). Neither clients' audited financial statements had yet been issued, nor was the dishonest client's audit team aware that the honest client's accounts receivable balance was not collectible. The Los Angeles audit team also recognized that Rule 301 of the AICPA's Code of Professional Conduct precluded informing the Dallas audit team. Leadership of the firm was equally aware that the Dallas audit engagement team could not sign their audit opinion unless the receivable balance (from the dishonest client) was fully reserved.^[3]Werner (2009) also describes two hypothetical scenarios an auditor might encounter regarding client confidentiality as follows:

1. The CPA learns during the current audit that the client has not properly accounted for a transaction, but the CPA'sknowledge was obtained during work for another client; and
2. The CPA firm has material information from the audit of another client that would cause the engagement partner on acurrent audit to take exception or give an adverse opinion on the current audit client's financial statements.

In the first scenario, Werner (2009)indicates that the CPA should consult legal counsel and attempt to develop audit evidence and support from the current client's books and records, without revealing the confidential information obtained from the second client. Absent the ability to independently develop information from the current client, the auditor should consider resigning because the issuance of a known incorrect audit opinion is not a viable option. In the second circumstance, the CPA firm is not expected to act on the information if it is unable to connect an issue discovered on one audit with the financial statements under audit at another client (Werner 2009).^[4]

You consider again the two scenarios set forth by Werner (2009). In the first case, the professional literature is silent and the CPA's legal counsel might advise that legal obligations to disclose certain information override Rule 301, especially if the client is a publicly traded entity (Werner 2009). In the second scenario, the professional literature is again silent and Werner (2009, 66) concludes ''there appears to be no duty to search for information on one client's audit that may be relevant to another client.'' However, you know from the popular press that firms have experienced negative litigation outcomes when choosing to protect the public interest andwhen preserving client confidentiality. You next turn your attention to client confidentiality litigation involving auditors.

Selected Client Confidentiality Litigation

In your search for client confidentiality litigation, you come across a number of interesting and, potentially, applicable cases. To organize your thoughts you create a table to provide a summary of selected client confidentiality litigation against auditors (see Exhibit 1).^[5]

As detailed in the cases in Exhibit 1, the courts have produced mixed conclusions regarding the balance between the auditor's duty to the public and client confidentiality. For example, Peat Marwick Mitchell (PMM) became awarethrough a consulting contract with an audit clientthat previously issued audited (unqualified opinion)^[6]and interim (though not reviewed) financial statements were materially misstated. PMM was subsequently sued, related to the misstated financials. The firm remained silent, citing client confidentiality rules, and the court ruled the firm had no obligation related to the interim financial information as a review report was not issued. However, PMM's motion to dismiss the suit was denied by the court with respect to the audited financial statements (Cashell and Fuerman 1995).^[7]Conversely, Alexander Grant was sued and found guilty of negligence and breach of contract involving the revelation of confidential information about one client in an effort to protect other clients and the greater public interest (Beach 1984).

Several months after issuing an unqualified audit opinion on a privately held audit client (American Fuel & Supply Company, Inc.), Touche Ross (Touche) discovered a material misstatement in the audited financial statements (Knapp 2010). Touche advised the client of its intent to withdraw the audit opinion and notify all parties known to be relying on the financial statements.^[8]The client's counsel threatened legal action against Touche for violating client confidentiality. In an apparent compromise, Touche notified the client's only secured creditorbut none of the unsecured creditors. Touche was subsequently sued by an unsecured creditor and found negligent in failing to notify the plaintiff of the opinion withdrawal (Knapp 2010).

Arthur Andersen lost a litigation case in which the firm did not reveal confidential information about one client to another client, and was sued by the uninformed client (Beach 1984). The court held: ''Assuming that the duty of confidentiality applies in this instance, when an auditor finds its independence in question, or a conflict of interest developing,there is testimony that it may (1) strongly encourage one client to make the necessary disclosure; (2) disclose that it has relevant information not available to the other client; or (3) resign from one account. Arthur Andersen did none of these'' (Werner 2009, 63; emphasis added).

Arthur Young refused an IRS summons for the tax accrual workpapers of a client citing accountant-client privilege, which was upheld by an appeals court. However, the U.S. Supreme Court overturned the appellate decision, indicating that a CPA

[1] In August 2014, the Financial Accounting Standards Board (FASB) issued an updated standard, Accounting Standards Update No. 2014-15, that will explicitly require management to assess an entity's ability to continue as a going concern, and to provide footnote disclosures in certain circumstances. The updated standard is effective for entities with fiscal years ending after December 15, 2016. The standard continues to use a ''substantial doubt'' framework, but extends the forward-looking period to within one year after the audit report issuance date. See the FASB website for additional detail. In September 2014 the Public Company Accounting Oversight Board (PCAOB) issued a practice alert reminding auditors of their responsibilities in a going concern context, and indicated that a new auditing standard may be proposed to align with the FASB's updated standard. See the PCAOB website for additional information.

[2] The Sarbanes-Oxley Act of 2002 now requires most public companies to file audited financial statements with the Securities and Exchange Commission within 60 days of their fiscal year-end.

[3] Ultimately, the press reported an SEC investigation of the Los Angeles client, thus allowing the Dallas office to use that public information in finalizing its opinion on the appropriate application of GAAP for its client (Werner 2009).

[4] The first scenario described by Werner (2009)implies that the auditor becomes aware of an error in the application of Generally Accepted Accounting Principles (GAAP). The second scenario simply discusses the auditor's knowledge of material information obtained from another audit client that might impact another audit opinion and is more analogous to the hypothetical setting we use in this case.

[5] It is important to note that the court cases cited in Exhibit 1 comprise state and federal cases. This case represents a hypothetical case with clients located in three separate states and thus the results coulddiffer based on jurisdiction. However, a number of the cases cited (and other litigation involving auditors) rely, in part, on common law (versus statutory law), and the ultimate outcomes of future cases may, or may not, draw from prior legal rulings.

[6] Currently referred to as an unmodified opinion.

[7]Werner (2009)documents that the AICPA changed its auditing standards subsequent to the PMM case, requiring auditors to withdraw their opinion in such a circumstance unless the client has already publicly disclosed the issue.

Answer the following questions.

• Describe the ethical dilemma Cook and Thomas auditors are facing in the case.
• related to 'Public Interest', 'Ethical Conflicts', and 'Confidential Client Information' for Members in Public Practice
• Discuss your conclusion. As described on page 19 of the case, 'do you (auditors) have a duty to inform the engagement teams of Paple Lumber Supply and Front Porch Furniture that your client has a going concern issue? Or do you have a duty to uphold your client's right to confidentiality and withhold the information from the other engagement teams until Fine Furniture's audited financial statements are filed with the SEC?'