Solutions 12e FINAL

The Lakeside Company: Auditing Cases SOLUTIONS MANUAL 12e Table of Contents John M. Trussel and J. Douglas Frazer A Note on Ethics, Fraud and SOX Questions 2 A Note on Research Assignments 3 Introductory Case 5 Case 1

14

Case 2

22

Case 3

33

Case 4

44

Case 5

58

Case 6

74

Case 7

82

Case 8

92

Case 9

101

Case 10

110

Case 11

116

Case 12

125

Case 13

136

A NOTE ON ETHICS, FRAUD, AND SOX QUESTIONS The Lakeside Company: Auditing Cases, 12th edition, has been updated in light of the accounting scandals of the early 2000s, the passage of the Sarbanes-Oxley Act of 2002, and the renewed interest in ethics within the accounting and auditing profession. Sarbanes-Oxley issues have been incorporated in two ways. First, case content has been altered to include Lakeside’s consideration of financing expansion through an initial public offering, and the resulting impact such a decision would have on Lakeside and on Abernathy and Chapman, CPAs. Second, the discussion questions and exercises have been expanded to include consideration of Sarbanes-Oxley and new auditing and independence standards, both by adding a section in the end-of-chapter material and by reference in the other questions where appropriate. Ethics questions are now specifically identified with an ethics logo. The ethics questions are often open ended, and this solutions manual does not try to give exact answers to these questions. Rather, we intend to give some ideas for classroom discussion, and to help with student research on these questions. Fra Fra ud ud

Fraud questions are now specifically identified with a fraud triangle.

A NOTE ON RESEARCH ASSIGNMENTS The "Apply Your Research" and "Consulting Partner Review" assignments included at the end of several cases do not lend themselves to definitive solutions that could be included in an instructor's manual. The assignments are simply not intended to be exercises in arriving at a predetermined answer. Rather, the applications of the suggested readings have the following objectives: -

To provide a means for improving the writing skills of students. From all reports, accounting majors too often leave college lacking in the basic ability to compose and construct sentences and paragraphs. Accounting and auditing (especially as one moves up in an organization) obviously require skills other than the purely quantitative. Memos, reports, footnotes, audit and accounting guides, etc., all require accountants and auditors to be effective communicators of the written word. Indeed, the instructor may want to team up with a member of the school's English or communications department to enhance the effectiveness of these assignments. The auditing instructor can then evaluate the technical and research portions of the assignment, while the English instructor would make suggestions as to grammar, syntax, construction of sentences and paragraphs, logic of the thought process, etc. As a preliminary step, the instructor may want to assign articles such as "Word Crunching: A Primer for Accountants" from the March 1990 issue of the Journal of Accountancy.

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To introduce students to accounting and business journals as well as other important publications. After college, students must be able to "keep current" or their effectiveness will quickly decline. In most cases, this continuation of their education is provided by the regular reading of publications such as The Wall Street Journal, Journal of Accountancy, CPA Journal, and Forbes. These assignments require the students to begin reading these journals prior to graduation. The students should become comfortable with their ability to understand and use the materials in professional publications. In addition, real-world aspects of many accounting issues are presented through these various readings.

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To develop the students' ability to derive viable solutions to auditing problems. Unfortunately, students in college often come to the belief that all auditing issues can be resolved simply by applying the pronouncements of various authoritative bodies. Textbooks too often present problems that have one ultimate answer. However, in many real cases, no definitive solutions actually exist. Thus, when faced with such problems, students must be capable of reviewing the available literature and then using that information as a basis for arriving at a workable

decision. -

To promote auditing research. In most of these library assignments, students are provided with one or more resources as starting points for their research. However, the instructor should always push the students to look for more and different types of information. The ultimate purpose of these assignments is to force the students into the library and online sources to do the searching for themselves. One excellent method of introducing the assignments is to use some class time to illustrate the various methods of research that are available to them, including electronic resources, such as the following: o http://www.sec.gov o http://www.PCAOBUS.org o http://www.AICPA.org o http://www.FASB.org o Your state society of CPAs also operates sites. If possible, a business librarian or a research librarian may be enlisted to discuss the various search techniques that can be used at the school's library for research purposes. Developing the ability to find information is one of the most important skills that can be achieved by an accounting major.

INTRODUCTORY CASE SUGGESTED ANSWERS TO DISCUSSION QUESTIONS (1) The staff auditor performs many of the detailed audit procedures, such as preparing and controlling accounts receivable confirmations. In general the work of the staff auditor is controlled by the audit program and supervised by the senior auditor. The senior auditor coordinates the audit at the client's location and performs many of the more difficult audit procedures, such as analytical review procedures. Usually the detailed work performed by the audit senior is more sophisticated and requires the experience gained by someone holding that rank. The audit senior is supervised by the manager. The manager and the partner have supervisory roles. Managers and partners often have more than one audit team under supervision at any given time. The partner is the person who has responsibility for determining whether the firm’s signature can be attached to audit report. (2) The partner-in-charge of an audit is the definitive decision-making position on the audit team. Although the manager and senior auditor make several decisions, they must get ultimate approval from the partner-in-charge of the audit. The consulting partner's role is to add a further degree of objectivity to the audit. The consulting partner reviews and critiques certain crucial decisions made by the audit team, such as the final audit report. The partners should be rotated to assure independence. Sarbanes-Oxley (SOX-S203) requires the identification of a Leading Partner and a Reviewing Partner. Both partners must be rotated every five years. (3) An accounting firm is a business like any other, and its management must recognize that a marketing strategy is probably necessary to generate a continual flow of sufficient operating revenues. However, in the accounting profession, disagreement exists as to the extent that such marketing should take. In the past, overt marketing was not permitted since it was considered to be unprofessional. This position was supported based on the reasoning that a firm

should be selected based solely on the quality of its service. No reliable system existed, though, for conveying such information to potential clients. Hence, firms with many clients tended to remain large, while smaller firms often found growth to be nearly impossible. In the free market system espoused by the United States, restrictions on such practices as advertising and solicitation were inevitably overturned. Over the past three decades, attitudes toward marketing have changed dramatically as competition has become much more intense. Advertisements by CPA firms in newspapers and magazines are now common. Newsletters such as that distributed by Abernethy and Chapman are also frequently used to increase a firm's name recognition in the business community. In the current world of business, some type of marketing strategy seems imperative if an accounting firm is to compete. Whether that marketing should extend to formal advertising is often a question of firm policy. Most importantly, the firm must ensure that potential clients know of its presence and the services that it offers. A client will probably not select a CPA firm based on advertising. However, the client may initially become aware of the firm only through some type of marketing. Interestingly, some members of the accounting profession view marketing as having had a negative impact on the profession as a whole. Price competition for new clients is often associated with the marketing of a firm. These critics assert that lowered fees result in sloppy and hurried audit work that can decrease the overall reputation of the profession. (Additional resources discussing this issue can be found in the "Suggested Readings" at the end of this case.) (4) A national or international CPA firm might consider acquiring Abernethy and Chapman for several reasons: -

Although only a regional firm, Abernethy and Chapman apparently has a client base that includes a number of large clients in several different industries. By acquiring the local firm, the larger organization will frequently be able to retain these customers, thus increasing its own client list.

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The larger firm may be interested in moving into this geographical region, and buying the local firm will provide an instant base on which to build a practice in the area.

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The larger firm may already have an office in this location and feels that combining the practices will reduce expenses.

Abernethy and Chapman might have several reasons for viewing an acquisition in a favorable light:

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Frequently, the purchase price will be a considerable amount of money because of the goodwill inherent in an established accounting firm. The offer to sell may be especially tempting if the partners are nearing retirement age and the future of the firm appears uncertain.

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The smaller firm may have trouble dealing with increased competition from bigger firms. Often clients may decide that a change to a nationally known CPA firm should be made to add extra stature to the audit report. If a local organization has only a few large clients, it cannot economically afford to lose a significant amount of revenue in this way. A merger may help the firm to keep its clients. -

The regional firm may also desire the additional backup services offered by large organizations. National CPA firms usually have experts in many industries as well as in specific audit areas who are available for consultation. In a smaller firm, this degree of assistance is not always available when a difficult accounting or auditing problem is encountered.

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PCAOB registration and SEC practice presents hurdles that might be overcome through a merger with a larger firm.

Many mergers have occurred in the auditing profession during recent years. Critics assert that this trend has reduced competition and will inevitably lead to a decrease in audit quality. Proponents counter by stating that mergers lead to more efficient operations and, thus, improve audit quality. Obviously, mergers will create a drastic change in the profession as more of the smaller firms disappear. Audit work in this country may possibly become concentrated within the largest CPA firms. Whether this result is good for the auditing profession may be merely a question of perspective. To the smaller firms struggling to survive and grow, the mergers are usually considered a threat as the bigger firms become more competitive. To the larger firms, the chance for continued growth and more efficient operations is always an important objective. See the Sarbanes-Oxley section below for a follow-up question related to the impact of SOX on the auditing profession. (5) Moving staff from one area of a CPA firm to another can cause the perception of an independence problem. For example, the appearance of independence may be in question if a member of the consulting staff helps to install a new accounting system for a client and then she moves to the audit staff to audit this same client. See the Sarbanes-Oxley section below for a follow-up question/answer related to

the impact of SOX, in particular the list of proscribed activities for registered CPA firms. SUGGESTED ANSWERS TO EXERCISE (1) The question requires students to address all the elements of a quality control system, as included in Statement on Quality Control Standards No. 2. In some cases, students should recognize the need for additional information. To: DeAnna Malott From: Date: Re: Quality Control Standards at Abernethy and Chapman Overview: I was employed by the firm of Abernethy and Chapman to review the quality control standards within the firm. The following represents my evaluation of these standards according to the six elements required by the AICPA. Evaluation: Standard Leadership responsibilities

Relevant ethical requirements

Existing Procedures

Recommendations

The case does The firm should have not explicitly policies in place that address this establish the “tone at standard. the top” for quality However, the firm within the firm. has some items in place, such as a partner dedicated to monitoring the system. Firm requires its The AICPA's Code of employees to Professional sever all Conduct does not financial ties to require all audit clients. employees to sever ties with all audit clients. For example, staff auditors not working on a particular

Additional Information Needed What specific policies does the firm have to demonstrate leadership responsibilities for quality within the firm?

The case does not mention spouses or dependents of the employees. Spouses and dependents must also be independent, as defined by

Acceptance and continuation of clients

Human resources

engagement need Section 100-not sever ties. In this Rule 101 of the case, the firm Code. In this exceeds the case, the firm minimum level of should conduct for strengthen its independence. requirements. The case does not How does the address other ethical firm meet other requirements. ethical requirements? This case does It is important to  not address this have many controls control standard. when considering a It does note that potential client, so the firm is that the potential attempting to risks of legal gain more clients exposure are not too through an great. (Note: This extensive topic is addressed in marketing Case 2.) program. The firm This appears to be a considers reasonable quality experience and control. technical competence in assigning personnel to audit engagements. The firm hires This seems to be a only college more than adequate graduates with a quality control major in procedure. In fact, accounting and many firms hire requires that professionals, such each as computer experts, professional sit who were not for the CPA accounting majors. exam within one year of employment. The firm requires Many states require

40 hours of continuing education per year; however, the case does not address the issue of the type of education (e.g., accounting and auditing versus other courses).  The firm promotion procedures consider seniority and technical competence, which seems to be an adequate control.

Engagement performance

that a minimum number of continuing professional education hours be in accounting- and auditing-related courses.

The firm requires The firm should have that a consulting a mechanism for partner be consultation with assigned to each authoritative audit literature and other engagement. sources, including The consulting outside experts, if its partner assures professional staff that the work lacks expertise in a performed by the particular area. engagement team meets applicable professional standards and regulatory requirements. This helps to ensure objectivity, as the consulting

The case does not address the issue of assessment of technical competence. Many firms require a written assessment of performance after each engagement. It is not clear from the case how the team documents the work performed on an audit engagement. An evaluation of audit documentation is necessary for complete evaluation of the quality controls.

auditor is not a direct part of the engagement. The firm seems to have a clear chain of command and adequate supervision on the audit. The staff auditors report to the senior auditor, who in turn reports to the manager. The partner-incharge has an overall supervisory position. Monitoring

The firm has a partner, DeAnna Malott, assigned to monitor the quality control standards.

A comprehensive system of documentation of the quality controls should be developed.

The case does not mention what types of documents are required to support these controls, but documentation is extremely important. For example, many firms require employees to submit a listing of all financial ties to companies so that the firm can monitor its independence.

Conclusion: The firm has many policies related to quality control standards. However, the firm has room for improvement in many of the areas, particularly in the acceptance and continuation of clients.

SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTIONS (1) Students should be encouraged to visit the (http://www.pcaobus.org) when answering this question:

PCAOB

website

Registration – CPA firms must be registered to be associated with public companies. The application for registration is an online process. There is a fee, it is small relative to other costs of maintaining the registered status and changing the nature of the firm to comply with PCAOB rules. Here is the fee structure from their website:

Inspection - The PCAOB operates a system of inspections and publicizes the results, per its authority under the SOX Act: The Act provides that an inspection shall include at least the following three general components: • An inspection and review of selected audit and review engagements of the firm, performed at various offices and by various associated persons of the firm; • An evaluation of the sufficiency of the quality control system of the firm, and the manner of the documentation and communication of that system by the firm; and • Performance of such other testing of the audit, supervisory, and quality control procedures of the firm as are necessary or appropriate in light of the purpose of the inspection and the responsibilities of the Board. Regular inspections are on a three-year cycle, although smaller firms may be less frequent. Special inspections can be required by the PCAOB. -

Maintenance of independence under PCAOB rules and SOX-

proscribed activities: Proscribed activities under SOX (section 201): Section 201: Services Outside The Scope Of Practice Of Auditors; Prohibited Activities. It shall be "unlawful" for a registered public accounting firm to provide any nonaudit service to an issuer contemporaneously with the audit, including: (1) bookkeeping or other services related to the accounting records or financial statements of the audit client; (2) financial information systems design and implementation; (3) appraisal or valuation services, fairness opinions, or contribution-in-kind reports; (4) actuarial services; (5) internal audit outsourcing services; (6) management functions or human resources; (7) broker or dealer, investment adviser, or investment banking services; (8) legal services and expert services unrelated to the audit; (9) any other service that the Board determines, by regulation, is impermissible. The Board may, on a case-by-case basis, exempt from these prohibitions any person, issuer, public accounting firm, or transaction, subject to review by the Commission. It will not be unlawful to provide other non-audit services if they are pre-approved by the audit committee in the following manner. The bill allows an accounting firm to "engage in any non-audit service, including tax services," that is not listed above, only if the activity is pre-approved by the audit committee of the issuer. The audit committee will disclose to investors in periodic reports its decision to pre-approve non-audit services. Statutory insurance company regulatory audits are treated as an audit service, and thus do not require pre-approval. The pre-approval requirement is waived with respect to the provision of non-audit services for an issuer if the aggregate amount of all such non-audit services provided to the issuer constitutes less than 5% of the total amount of revenues paid by the issuer to its auditor (calculated on the basis of revenues paid by the issuer during the fiscal year when the non-audit services are performed), such services were not recognized by the issuer at the time of the engagement to be non-audit services; and such services are promptly brought to the attention of the audit committee and approved prior to completion of the audit. The authority to pre-approve services can be delegated to 1 or more members of the audit committee, but any decision by the delegate must be presented to the full audit committee. Partner rotation - The rotation of the lead partner and the reviewing partners are required by the SOX Act. Quality Control Standards – Registered firms must maintain the SEC practice requirements:

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AICPA Quality Control Standards for public company audits are summarized at: http://cpcaf.aicpa.org/Resources/