Kay & Lee LLP was retained as the auditor for Holligan Industries to audit the financial statements required by prospective banks as a prerequisite to extending a loan to the client. The auditor knows whichever bank lends money to the client is likely to rely on the audited statements. After the audit report is issued, the bank that ultimately made the loan discovers that the client’s inventory and accounts receivable were overstated. The client subsequently went bankrupt and defaulted on the loan. The bank alleged that the auditor failed to communicate about the inadequacy of the client’s internal recordkeeping and inventory control. Moreover, the bank claims that the auditors were grossly negligent in not discovering the overvaluation of inventory and accounts receivable.

The auditors asserted that there was no way for them to know that the client included in the inventory account $1 million of merchandise in transit to a customer on December 31, 2015. The shipping terms were unclear so the auditors accepted management’s representations in that regard (FOB Destination). As for the receivables, the auditors claimed the client falsified confirmations by sending them to a post office address, retrieving them, and then confirming the stated balances.

3. Critically evaluate the auditors’ statements about the inventory and receivables with respect to generally accepted auditing standards and the firm’s ethical responsibilities.