Portfolio Choice #2: The Engagement – Two Parts: Legal Liability and Accepting an Engagement
A. CPA’s Legal Liability when Accepting an Engagement
Reference Case Study 4-42 in the textbook.
You are a partner in the Denver office of a national public accounting firm. During the audit of Mountain Resources, you learn that this audit client is negotiating to sell some of its unproved oil and gas properties to SuperFund, a large investment company. SuperFund is an audit client of your New York office.
Mountain Resources acquired these properties several years ago at a cost of $15 million. The company drilled several exploratory wells but found no developable resources. Last year, you and Mountain Resources agreed that the value of these unproved properties had been “impaired” as defined in Accounting Standards Codification, section 932-360-35-11. The company wrote the carrying value of the properties down to an estimated realizable value of $9 million and recognized a $6 million loss. You concurred with this treatment and issued an unqualified auditor’s report on the company’s financial statements.
You are now amazed to learn that the sales price for these properties being discussed by Mountain Resources and SuperFund is $42 million. You cannot understand why SuperFund would pay such a high price and you wonder what representations Mountain Resources may have made to SuperFund concerning these properties. The management of Mountain Resources declines to discuss the details of the negotiations with you, calling them “quite delicate” and correctly pointing out that the future sale of these properties will not affect the financial statements currently under audit.
- Summarize the arguments for advising SuperFund (through your New York office) that you consider the properties grossly overpriced at $42 million.
- Summarize the arguments for remaining silent and not offering any advice to SuperFund on this matter.
- Express your personal opinion as to the course of action you should take. Indicate which arguments from part (a) or part (b) most influenced your decision.
For Section A, use two outside academic sources other than the textbook, course materials, or other information provided as part of the course materials.
B. Accepting an engagement
Reference Case Study 10-50 in the textbook.
On October 21, Rand & Brink, a CPA firm, was retained by Suncraft Appliance Corporation to perform an audit for the year ended December 31. A month later, James Minor, president of the corporation, invited the CPA firm’s partners, George Rand and Alice Brink, to attend a meeting of all officers of the corporation. Mr. Minor opened the meeting with the following statement:
“All of you know that we are not in a very liquid position, and our October 31 balance sheet shows it. We need to raise some outside capital in January, and our December 31 financial statements (both balance sheet and income statement) must look reasonably good if we’re going to make a favorable impression upon lenders or investors. I want every officer of this company to do everything possible during the next month to ensure that, at December 31, our financial statements look as strong as possible, especially our current position and our earnings.
“I have invited our auditors to attend this meeting so they will understand the reason for some year-end transactions that might be a little unusual. It is essential that our financial statements carry the auditors’ approval, or we’ll never be able to get the financing we need. Now, what suggestions can you offer?”
The vice president for sales was first to offer suggestions: “I can talk some of our large customers into placing some orders in December that they wouldn’t ordinarily place until the first part of next year. If we get those extra orders shipped, it will increase this year’s earnings and also increase our current assets.”
The vice president in charge of production commented: “We can ship every order we have now and every order we get during December before the close of business on December 31. We’ll have to pay some overtime in our shipping department, but we’ll try not to have a single unshipped order on hand at year-end. Also, we could overship some orders, and the customers wouldn’t make returns until January.”
The controller spoke next: “If there are late December orders from customers that we can’t actually ship, we can just label the merchandise as sold and bill the customers with December 31 sales invoices. Also, there are always some checks from customers dated December 31 that don’t reach us until January—some as late as January 10. We can record all those customers’ checks bearing dates of late December as part of our December 31 cash balance.”
The treasurer offered the following suggestions: “I owe the company $50,000 on a call note I issued to buy some of our stock. I can borrow $50,000 from my mother-in-law about Christmastime and repay my note to the company. However, I’ll have to borrow the money from the company again early in January, because my mother-in-law is buying a condo and will need the $50,000 back by January 15.
“Another thing we can do to improve our current ratio is to write checks on December 31 to pay most of our current liabilities. We might even wait to mail the checks for a few days or mail them to the wrong addresses. That will give time for the January cash receipts to cover the December 31 checks.”
The vice president of production made two final suggestions: “Some of our inventory, which we had tentatively identified as obsolete, does not represent an open-and-shut case of being unsalable. We could defer any write-down until next year. Another item is some machinery we have ordered for delivery in December. We could instruct the manufacturer not to ship the machines and not to bill us before January.”
After listening to these suggestions, the president, James Minor, spoke directly to Rand and Brink, the auditors. “You can see I’m doing my best to give you full information and cooperation. If any of these suggested actions would prevent you from giving a clean bill of health to our year-end statements, I want to know about it now so we can avoid doing anything that would keep you from issuing an unqualified audit report. I know you’ll be doing a lot of preliminary work here before December 31, but I’d like for you not to bill us before January. Will you please give us your reactions as to what has been said in this meeting?”
- Put yourself in the role of Rand & Brink, CPAs, and evaluate separately each suggestion made in the meeting. What general term is applicable to most of the suggested actions?
- Could you assure the client that an unqualified audit report would be issued if your recommendations were followed on all the matters discussed? Explain.
- Would the discussion in this meeting cause you to withdraw from the engagement?