QUESTION 1

a) Based on your opinion, why studying auditing is different from studying other accounting topics? How might understanding auditing concepts prove useful for consultants, business managers and other business decision makers?

(10 marks)

b) Dale Boucher, the owner of a small electronics firm, asked Sally Jones, independent auditor, to conduct an audit of the company's records. Boucher told Jones that the audit was to be completed in time to submit audited financial statements to a bank as part of a loan application. Jones immediately accepted the engagement and agreed to provide an auditor's report within one month. Boucher agreed to pay Jones her normal audit fee plus a percentage of the loan if it was granted.

Jones hired two recent accounting graduates to conduct the audit, and spent several hours telling them exactly what to do. She told the new hires not to spend time considering internal control but to concentrate on proving the mathematical accuracy of the general and subsidiary ledgers and summarizing the data in the accounting records that supported Boucher's financial statements. The new hires followed Jones's instructions and after two weeks gave Jones the financial statement excluding notes. Jones reviewed the statements and prepared an audit report with an unmodified opinion. The report did not refer to any auditing standards, no audit procedures were conducted to evaluate the appropriateness of accounting policies used and the reasonableness of accounting estimates made.

Required:

Indicate how the action(s) of Jones resulted in failure to comply with auditing standards and ethical requirements. (20 marks)

QUESTION 2

Part I:

Merry-Go-Round (MGR), a clothing retailer located primarily in shopping malls, was founded in 1968. By the early 1990s, the company had gone public and had expended to approximately, 1500 stores, 150,000 employees and $1 billion in annual sales. The company's locations in malls targeted the youth and teen market. The company was listed by Forbes magazine as one if the top 25 companies in the late 1980s. However, in the early 1990s, the company faced many challenges. One of its co-founders died, and the other left to pursue unrelated business interests. The company faced stiff competition from the other retailers (e.g. Gap and Banana Republic), fashion trends changed and mall traffic declined. Sales fell, and experts speculated that MGR failed to anticipate the key industry trends and lost sight of its customer market. To try to regain its strong position, the company acquired Chess King, Inc., a struggling chain of men's clothing stores located in malls, in 1993.

The company's sales continued to fall and, later in 1993, it brought back one of its co-founders to manager the company and wrote down a significant amount of inventory. However, this inventory write-down caused the company to violate loan covenants. Facing bankruptcy, the company, based on the evidence of its newly hired law firm Swidler and Berlin, hired turnoaround specialists from Ernst & Young (EY) to help overcome the financial crisis and develop a long-term business plan. However, the company's decline continued, and it filled Chapter 10 reorganization in 1994. In 1996, the remaining assets were sold for pennies on the dollar.

Subsequently, a group of 9,000 creditors (including former employees and stockholders) began litigation against parties it deemed responsible for their losses. These parties included EY, which the creditor sued for $4 billion in punitive and compensatory damages (EY's fees from MGR totalled $4.5 million).

The lawsuit alleged that EY'S incompetence was the main cause of MGR's decline and demise. The lawsuit alleged in part that:

The turnaround team did not act fast enough.

The leader of the team took an eight-day vacation at a critical point during the engagement.

The cost-cutting strategy called for only $11 million in annual savings, despite the fact that the company was projected to lose up to $200 million in 1994.

While store closings were key to MGR's survival, by 1995 only 230 of 1,434 stores had been closed and MGR still operated two stores in some malls.

The turnaround team included inexperienced personnel - a retired consultant, a partner with little experience in USA and with retail firms, and two recent college graduates.

EY charged exorbitant hourly rates and charged unreasonable expenses (e.g. charges included reimbursement for a dinner for three of the consultants totalling excess of $200).

EY declined any wrongdoing, but in April 1999 agreed to pay $185 million to settle the injured parties.

EY gad a close relationship with Rouse Co., one of MGR's primary landlords (EY was soliciting business from Rouse and provided significant tax services).

Swidler (the law firm that recommended EY to MGR) and EY had participated in at least 12 different business arrangements, some of which resulted in Swidler receiving significant fees from EY.

EY did not disclose either of these relationships to MGR.

Required

a) Consider whether there should be specific professional standards for independent auditors who consult. Given that non-auditors who consult do not have formal professional standards to adhere to, describe the advantages and disadvantages that result from having such standards.

(25 marks)

b) Do you think that EY acted unethically given it had these relationship?

(10 marks)

c) How could these relationship have affected EY's advice to MGR? In other words, refer to the charges above and speculate as to whether any of the charges against EY may have stemmed from the relationships described above.

(15 marks)

QUESTION 3

Naim & Amir audited the accounts of Murni Batik Sdn Bhd, a textile company. Upon completion of the audit, the auditors issued 15 copies of the audited financial statements. The firm is aware that Murni Batik wanted the number of copies of the auditor's report to furnish to banks and other potential lenders.

The statement of financial position was misstated by approximately RM 800,000. Instead of having RM 600,000 net worth, the company was insolvent. The management of Murni Batik had altered certain financial disclosures in the books to avoid insolvency. The assets has been overstated by RM 500,000 of fictitious and non0existing accounts receivable and RM 300,000 of non-existing textiles as inventory. The audit failed to detect theses fraudulent entries. Encik Seong,

relying on the audited financial statements, loaned Murni Batik RM 250,000. He seeks to recover his loss from Murni Batik and the auditors.

Required:

What would Encik Seong have to prove to be able to recover his loss from the auditors? Give reasons to support your answer.

(20 marks)

[Total marks: 100 marks]