Question 2 Legal liability, including Lakeside (15 marks) (a) Three and a half months after their balance date, Gemstones defaulted on a major loan mortgaged against their assets and filed for liquidation. The liquidator (acting only for the client) determined inventory, reported at $10,000,000 on the most recent year-end Balance Sheet, was only worth $1,900,000 because the majority was counterfeit and/or damaged. This led to his questioning the due care exercised during the just completed audit. You were nearing the end of your 6 month probation period at your audit firm at the time of the audit. You had been assigned to the audit engagement team for Gemstones and carefully reviewed the permanent working paper file Gemstones was a high-end distributor of gemstones and precious jewellery items. Your first scheduled task had been to assist your audit senior with attending the annual warehouse stocktake. On the morning of the stocktake you received a call from your audit senior advising she was ill and would not be able to attend the warehouse. She expressed every confidence in you and explained past stocktakes with the client presented no problems as client staff & count processes had been properly executed. You attended, observed the count & recorded some test counts as required and left happy with your first experience with these procedures. The follow-up procedures for the test counts showed no errors and inventory was reported on the balance sheet at $10,000,000. Your audit senior documented the figure as correct and concluded the inventory cost was true and fair. Discuss your audit firms potential legal liability based on these circumstances. Your discussion needs to include relevant case law (precedent) and refer to any relevant ASAs that may be influential in deciding potential liability. (10 marks) (b) Which specific circumstances (facts) in the Lakeside case study illustrate the very strong possibility that Abernethy & Chapman will owe a liability to third parties. Make sure your brief discussion includes relevant case law, why it is relevant and identifies the relevant third parties. (5 marks)

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