AUE2601 - Auditing Theory And Practice Solutions.

AUE2601 - Auditing Theory And Practice Solutions.A NOTE ON ETHICS, FRAUD, AND SOX QUESTIONS The Lakeside Company: Auditing Cases, 11th edition, has been updated in light of the accounting scandals of the early 2000s and the passage of the Sarbanes-Oxley Act of 2002, and the renewed interest in ethics within the accounting and auditing profession. 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. Fraud questions are now specifically identified with a fraud triangle The introduction of Sarbanes-Oxley issues has been accomplished in two ways. First, case content has been altered to include Lakeside’s consideration of financing expansio n 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 SarbanesOxley 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. The following list includes all the questions with the location of the question and a brief learning objective. (Intr-1) The case states that the firm of Abernethy and Chapman is considering the acceptance of clients that are publicly traded. What specific steps would the firm have to take before they could accept an audit client that is publicly traded? Objective – Initial PCAOB registration. (1-1) According to this case, the Lakeside Company is considering a public offering of stock to finance its growth. What steps would the Lakeside Company have to take before issuing stock to the public? In particular, how would the p rovisions of the Sarbanes-Oxley Act impact this decision? How does the possible public sale of stocks impact the Lakeside Company financial reporting requirements? Objective – Public reporting requirements in the PCAOB context. (1-2) Explain how the acceptance of a public company would impact a CPA firm. In particular, how would Roger's decision about offering stock to the public impact Abernethy and Chapman's decision of whether or not to accept Lakeside as a client? Objective – Client 1 acceptance in the PCAOB and in this case the effect of an initial public client. (2-1) According t o Case 1, the Lakeside Company is considering a public offering of stock to finance its growth. The firm of Abernethy and Chapman does not presently have any audit clients that are public companies. How would the Sarbanes-Oxley Act impact the firm's decision to accept such a company as an audit client? What additional requirements are there for a CPA firm that is registered to practice before the SEC compared with a CPA firm that is not registered? Is the firm of Abernethy and Chapman capable of meeting these standards? Objective- Client acceptance in general compared to public clients. (2-2) According to Case 1, the Lakeside Company is considering a public offering of stock to finance its growth. What additional requirements are there for a publicly traded company compared with a nonpublic company? What issues have arisen so far in the case that should be addressed as Lakeside considers going public? Objective- Lakeside issues related to public reporting requirements. (4-1) Lakeside’s consideration of an initial public offering would require significant changes in Lakeside’s organizational structure and governance, including the structure and operation of the board of directors and the need to assess the functioning of the company's internal control systems. Discuss these topics and make specific recommendations to Lakeside. Objective – Corporate governance and internal control in the public reporting context. (4-2) Discuss the assessment of control risk for audit clients that are public companies. If Lakeside were to become a public company, what impact would that have on Abernethy and Chapman's assessment of Lakeside's control risk and the evaluation of internal control? Objective – Internal control both in the public reporting context. Section 404 audits. (5-1) As noted in Case 1, Lakeside in considering the issuance of stock to the public. Write a report discussing tests of controls for clients that are public companies compared with those that are not public companies. If Lakeside were to become a public company, what impact would that have on Abernethy and Chapman's tests of controls? Objective – Comparison of internal auditing in the general case and in the public case. 2 (7-1) The case assumes that tests of controls have been completed and substantive testing in the payroll area has commenced. During the internal control evaluation and testing what options are available to the CPA to document problems and communicate their effect? Write a sample of a “material weakness” in the area of payroll internal control that would be included in the auditor's report. Objective – Material weakness example. (9-1) The Sarbanes-Oxley legislation raised the expectations on the oversight provided by the board of directors and established the role of the “financial expert.” How would these expanded responsibilities affect the financial accounting questions that played a significant part in Case 9? Objective – The role of the audit committee and the financial expert. (9-2) Under Sarbanes-Oxley, management can no longer claim to be unaware of its financial reporting system. In this case, how do the answers provided by Rogers relate to his anticipated plan to take his company public? Objective – Management responsibility, and section 404. (13-1) According to Case 1, the Lakeside Company is considering a public offering of stock to finance its growth. At present, Abernethy and Chapman do not presently have any audit clients that are public companies. Write a report discussing how the SarbannesOxley Act impacts the firm's independence regarding the provision of audit and non-audit services? Objective – The impact of the proscribe non-audit services in general and in Abernathy and Chapman case. 3 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. - 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. - 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 4 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 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. 5 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 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 6 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. - 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. - 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: 7 - 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. - 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. - 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 8 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. -Independence, Integrity, and Objectivity: Abernethy and Chapman requires its employees to sever all financial ties to audit clients. The AICPA's Code of Professional Conduct does not require all employees to sever ties with all audit clients. For example, staff auditors not working on a particular engagement need not sever ties. In this case, the firm exceeds the minimum level of conduct for independence. However, the case does not mention spouses or dependents of the employees. Spouses and dependents must also be independent, as defined by Section 100--Rule 101 of the Code. In this case, the firm should strengthen its requirements. -Personnel Management: The firm considers experience and technical competence in assigning personnel to audit engagements. This appears to be a reasonable quality control. The firm hires only college graduates with a major in accounting and requires that each professional sit for the CPA exam with one year of employment. This seems to be a more than adequate quality control procedure. In fact, many firms hire professionals, such as computer experts, who were not accounting majors. The firm requires 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). Many states require that a minimum number of continuing professional education hours be in accounting- and auditing-related courses. The firm promotion procedures consider seniority and technical competence, which seems to be an adequate control. However, the case does not address the issue of assessment of technical competence. Many firms require a written assessment of performance after each engagement. -Engagement Performance: The firm requires that a consulting partner be assigned to each audit engagement. The consulting partner assures that the work performed by the engagement team meets applicable professional 9 standards and regulatory requirements. This helps to ensure objectivity, as the consulting auditor is not a direct part of the engagement. The firm should have a mechanism for consultation with authoritative literature and other sources, including outside experts, if its professional staff lacks expertise in a particular area. 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-in-charge has an overall supervisory position. -Acceptance and Continuation of Clients and Engagements: This case does not address this control standard. It does note that the firm is attempting to gain more clients through an extensive marketing program. It is important to have many controls when considering a potential client, so that the potential risks of legal exposure are not too great. (Note: This topic is addressed in Case 2.) -Monitoring: The firm has a partner, DeAnna Malott, assigned to monitor the quality control standards. 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. SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTIONS (1) Students should be encouraged to visit the PCAOB website () when answering this question: - Registration – CPA firms must be registered to be associated with public companies. The application for registration is an on-line 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: 10 - 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 an 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 inspection are on a three-year cycle, although smaller firms msay 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. 11 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 Standars – registered firms must maintain the SEC practice requirements: - AICPA Quality Control Standards for public company audits is summarized at: 12 CASE 1 SUGGESTED ANSWERS TO DISCUSSION QUESTIONS (1) Financial statements are frequently relied on by outside parties such as stockholders and banks when making decisions about an enterprise. Should equity securities be bought or sold? Should a long-term loan be given? However, financial statements are the representations of the management of the company. As such, these statements will not necessarily be fairly presented. Material misstatements may exist in the form of errors, irregularities, or illegal acts. The management might, for example, have an insufficient knowledge of generally accepted accounting principles to produce appropriate statements. Human error or bias is also possible in the gathering and reporting of financial information. In addition, the management may have fraudulently manipulated the data in hopes of achieving some objective. Outside parties are aware that the financial information produced by a company and its management may not always be reliable. Hence, to add credibility to this reporting process, independent experts are retained to audit the financial statements and test the underlying accounting records. These auditors then issue an opinion for the benefit of outside parties as to the fair presentation of the financial statements in conformity with generally accepted accounting principles. This added degree of assuredness allows decision-makers to rely on reported financial information. (2) A CPA firm could not be expected to maintain expertise in every potential industry that it might audit. In reviewing a potential client, the firm should evaluate its ability to gain the necessary industry expertise prior to the actual audit, but no requirement exists that this knowledge must be possessed prior to accepting the engagement. Each industry may have its own specific accounting practices. In addition, certain industries frequently offer unique auditing problems. Thus, without a thorough investigation, the auditor cannot ascertain the knowledge that will be needed in examining a potential client. In the consumer electronics business, for example, the methods of distribution as well as credit policies would be significantly different from those found in a car dealership. Damaged or obsolete inventory are other problems that might be more important in this specific industry. Hence, a knowledge of one type of operation does not necessarily mean that the auditor has the expertise needed to examine a client operating in a 13 different industry. Auditing standards require that auditor have the expertise by the completion of the audit, but this expertise need not be in place at the beginning. It would be unethical to misrepresent a firm’s experience, but it need not be volunteered. (3) A profit-sharing bonus plan gives employees an added incentive to seek increases in company income; a larger profit figure will lead to a larger bonus at the end of the year. Consequently, employees may be tempted to inflate income artificially by creating false sales or deferring the recording of expenses. An auditor must always be alert for situations that can promote the possibility of such irregularities. A profit-sharing bonus plan may well have only positive effects on company employees. However, the auditor should not be so naive as to fail to recognize that some individuals may take advantage of such plans by manipulating the financial records. This problem may be especially significant in the Lakeside Company because the bonus plan is new and the stores are geographically located at a distance from the home office. New plans require adaptation by company controls and such separation always increases potential control concerns. In addition, Rogers has already mentioned that some of the internal control systems are no longer adequate. Thus, the possibility of inflated income figures is even more of a possibility. (4) Critics of the auditing profession have argued vehemently for a number of years that advisory services such as those discussed in this question taint the appearance (and possibly the reality) of independence. These services may appear to the public to give the audit firm a financial interest in the success of the company. This argument holds that the firm will now want the client to succeed as proof of the quality of the advice that was given. In addition, the audit team may be less judicious in investigating these systems since they are aware that members of their own firm designed and installed them. Audit firms counter by stating that adequate safeguards have been put into place to ensure continued independence. For example, advisory services are frequently rendered by a separate division of the firm so that no proximity exists between this function and the audit staff. In addition, firms are not allowed to give many types of advice that might jeopardize their independence. Finally, audit firms must make certain that their services are limited to making recommendations, not carrying out management decisions. The firm cannot make decisions for the client. 14 Sarbanes-Oxley specifically proscribes various activities that have traditionally been part of the CPA’s repertoire. Design of accounting systems is prohibited, although helping a client with selection and implementation of off-the-shelf packages would be acceptable. So, in this case, it depends on what the client means by “developing.” In the event the Lakeside goes forward with its public offering Abernathy and Chapman will need to decide whether to remain independent so they can continue as Lakeside’s auditor, or sacrifice independence to do systems consulting. Sarbanes-Oxley prevents trying to do both. (5) In his article "The Initial Audit Engagement Conference" in the Journal of Accountancy for September 1976, Bernard Valek lists a number of steps that can be performed in a plant tour to avoid later "surprises" as well as to assist the firm in establishing an appropriate audit fee. The first three are typical of a plant tour. The others go beyond the typical tour. Students should not be expected to anticipate each of these procedures but the question can be used to emphasize the importance of the auditor's complete understanding of the audit client. These steps include: * Inspect inventory for possible obsolescence and an indication of the major product lines of the company. * Verify the presence or absence of a perpetual inventory system. * Review manufacturing facilities for indication of level of activity as well as any idle machinery. * Review journals for careful preparation. * Review general ledger activity for unusual entries. * Review monthly financial statements for unusual variations. * Review bank reconciliations, and compare to general ledger. * Examine accounts receivable reconciliation to general ledger balance. * Review client physical inventory method. * Discuss with client the policy for valuing inventory and identifying obsolete inventory items. * Discuss with client the procedures for obtaining a proper year-end cut-off. 15 * Review depreciation schedules, and recalculate a sample of the depreciation expense figures. * Review income tax returns. * Examine information relating to any capital stock or retained earnings transactions for the past year. * Review minutes of board of directors' meetings and stockholders' meetings for unusual or material matters. * Read lease agreements. * Review past audit reports. (6) A company may not want its CPAs to audit a client's records because the auditors gain a substantial amount of competitive information during an audit. However, CPAs are bound by confidentiality under the AICPA's Code of Professional Conduct. Also, a CPA's knowledge of the industry gained from having several clients in the same industry provides him or her with insights he/she may not have otherwise had. SUGGESTED ANSWERS TO EXERCISES (1) (a) and (b) The independent auditor must be able to review massive quantities of information and identify the fraud risk factors that may affect the amount of evidence to be gathered or the opinion to be rendered. This question calls upon the judgment abilities of the students. The format used by students for this memo is not important as long as it is clear and understandable. SAS 99 requires use a brainstorming session in the planning stage to be sure that everyone associated with the audit understands the nature of the business and the potential risk of fraud. These sessions can also occur during the audit if additional evidence presents itself. Potential problems that students would be expected to identify are as follows: * Internal Control - The president of the company admits that the company's internal control is antiquated. Control problems may be heightened in that operations extend throughout two states. Since understanding the internal control is one of the prerequisites for ultimately determining the amount of substantive testing that will be required, the weakness of the various controls may require the extensive gathering of evidence, or even preclude an opinion. 16 * Uncertainty Involved with the Sixth Store - A qualified opinion was issued by the predecessor auditor in connection with this store. Abernethy and Chapman must face the question as to whether this issue can be resolved during 2006. * Inventory - The mere size of the inventory of a business like Lakeside would make this account a critical audit area. The auditor will face the problem of verifying the existence, cost, value, presentation, and ownership of the electronic equipment. * Distributorship Sales - The case indicates that these sales have risen dramatically during the past two years. Any sudden change or fluctuation in an account balance will always warrant the auditor's attention. In this instance, the auditor will be especially interested in verifying the validity of these sales figures. * Bonus System - This system has been recently installed by Lakeside, so very little is known about its effects upon the financial results of the company. This factor alone can cause difficulty in the auditor's examination. In addition, any bonus system will provide an incentive for the employees to falsify the company's financial records. The auditor must be aware that employees can benefit from producing falsely inflated income figures. * Related Party Transactions - The case indicates that Lakeside has begun to have financial dealings with the president of the company. Obviously, nothing is wrong with this arrangement, but such related party transactions are often difficult for the auditor to verify. In addition, they require clear disclosure. * Rental Agreements - Five of the stores have been leased and, apparently, Store Seven will be rented from Rogers. Rental agreements pose the question as to the need for capitalizing the lease. Abernethy and Chapman will have to read the various agreements to see if any of them qualify as a capital lease under the criteria established by the Financial Accounting Standards Board. * Accounts Receivable - All distributorship sales are made on credit. Thus, the size of the receivable account and the problem of determining collectibility will be a critical audit area for the auditor. * Loan Agreements - Lakeside has a number of loans outstanding. The auditor will need to study each loan agreement to ascertain that the company is not violating any of the loan covenants. 17 * Inventory Returns - For distributorship sales, up to 20% of the inventory items can be returned within four months. As of the end of the year, Lakeside will have a large contingent liability associated with the inventory items sold during the last four months. Not only is the potential size of this liability a problem but the auditor's ability to estimate the amount must be a concern. * Possible public offering of stock - A public offering raises risk for manipulation of the financial statements in order to attract capital. In addition, the number of potential readers of financial statements has changed dramatically, making the risk associated with this audit much higher. 18 (2) INDEPENDENT AUDITOR'S REPORT To the Board of Directors: We have audited the accompanying balance sheet of the Lakeside Company as of December 31, 2008, and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. During 2007, the company made a $186,000 investment in a retail store located in the eastern sector of Richmond, Virginia. This store has failed to reach a break-even sales point to date and total recovery of the Company's investment is highly uncertain. In our opinion, the chances are reasonably possible that the asset's value has been permanently impaired and should be reduced to the net realizable value in conformity with generally accepted accounting principles. In our opinion, except for the effects of not recording or disclosing the impairment of value of the asset, as discussed in the preceding paragraph, the aforementioned financial statements present fairly, in all material respects, the financial position of the Lakeside Company at December 31, 2008, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.