Marshall and Wyatt, CPAs, has been the independent auditor of Interstate Land Development Corporation for several years. During these years, Interstate prepared and filed its own annual income tax returns.

During 20X4, Interstate requested Marshall and Wyatt to audit all the necessary financial statements of the corporation to be submitted to the Securities and Exchange Commission (SEC) in connection with a multistate public offering of 1 million shares of Interstate common stock.

This public offering came under the provisions of the Securities Act of 1933. The audit was performed carefully and the financial statements were fairly presented for the respective periods. These financial statements were included in the registration statement filed with the SEC.

While the registration statement was being processed by the SEC, but before the effective date, the Internal Revenue Service (IRS) obtained a federal court subpoena directing Marshall and Wyatt to turn over all its working papers relating to Interstate for the years 20X1-20X4. Marshall and Wyatt initially refused to comply for two reasons. First, Marshall and Wyatt did not prepare Interstates tax returns. Second, Marshall and Wyatt claimed that the working papers were confidential matters subject to the privileged communications rule. Subsequently, however, Marshall and Wyatt did relinquish the subpoenaed working papers.

Upon receiving the subpoena, Wyatt called Dunkirk, the chairman of Interstates board of directors, and asked him about the IRS investigation. Dunkirk responded, Im sure the IRS people are on a fishing expedition and that they will not find any material deficiencies.

A few days later Dunkirk received a written memorandum from the IRS stating that it was contending Interstate had underpaid its taxes during the period under review. The memorandum revealed that Interstate was being assessed $800,000, including penalties and interest for the three years. Dunkirk forwarded a copy of this memorandum to Marshall and Wyatt. This $800,00 assessment was material relative to the financial statements as of December 31, 20X4. The amount for each year individually, exclusive of penalty and interest, was not material relative to each respective year.

1. In general terms, discuss the extent to which a CPA firms potential liability to third parties is increased in an SEC registration audit.
2. Discuss the implications of the IRS investigation, if any, relative to Marshall and Wyatts examination of Interstates 20X4 financial statements. Discuss any additional investigative procedures that the auditors should undertake or any audit judgments that should be made as a result of this investigation.
3. Can Marshall and Wyatt validly refuse to surrender the subpoenaed working papers to the IRS? Explain.