This suggested solution has been completed by using the template available for this question – note that it is merely an electronic version of Exhibit 2-1 from your Lakeside case book.
You might think about the source of the information you use to complete the questionnaire. Although this is an exercise from Case 2, you will find much of the information in Case 1. Why? Re-read Case 1 and notice how this is your initial meeting with the Lakeside CEO to obtain background information about your potential client. This is what auditors call obtaining oral evidence and the point of the questionnaire is to document (record in the audit work papers) your understanding of such oral evidence obtained from inquiries and discussions like these. This also serves to demonstrate how the evidence you obtain is useful across various stages of the audit … initially with a view to considering Lakeside as a client, now more formally documenting the basis for a decision required by your firm’s quality control processes about client acceptance (ASA 220, APES 320 and ASQC 1).
Exhibit 2-1
Abernethy and Chapman
ANALYSIS OF POTENTIAL LEGAL LIABILITY
Potential Client: The Lakeside Company
Type of Engagement: Audit
Form Completed By: RA Date: 15/06/12
Privately; Rogers has 30%, with the other seven shareholders holding between 6% and 22% of the shares each.
(2) Evaluate the possible liability to the client that Abernethy and Chapman might incur, if the engagement is accepted.
This is about explaining your obligation to exercise “due skill and care” once you decide to audit a client … so at this early stage, based on what you have been told, think about any indicators that might require your “special attention” … remember what Justice Moffit said in the Pacific Acceptance judgement …
Liability (to the client and third parties) for losses if negligence is proven. If performance is that of an average prudent auditor there should be no problems; if not, we may be sued for our fee and losses. A special problem arises due to the notification by the President and corroborated by King & Co that there is weak internal control. This increases the likelihood of fraud and/or errors and makes detection of same more difficult. This increases our risk because there may be a greater chance of proving negligence if we do not appropriately adjust our audit effort.
(3) List the third parties that presently have a financial association with the potential client and could be expected to see the financial statements.
Consider the judgements in relation to liability to third parties as they discuss “proximity” … this area of law remains unclear. Notice how this question and the next ask you to identify third parties for a “worst case” scenario – the widest cast of the net … think about which case law gives the auditor pause to cast their net so widely. This will be “narrowed” when you respond to Q.5 below, again, as the case law has evolved to identify specific circumstances in relation to identified rather than identifiable third parties.
Cypress Products
The two banks financing the inventory
National Insurance Co financing the mortgage loans
Note: current shareholders are not included here – I believe they are the client rather than third parties (they own the company and we report to them).
(4) Discuss the possibility that other third parties will be brought into a position where they would be expected to see the financial statements of the potential client.
Rogers has expressed interest in expansion so it is reasonable that other financiers or investors may be approached. Rogers has indicated the possibility of moving into computing equipment as a new product line so there may be an additional supplier/s.
(5) Evaluate the possible liability to third parties, both present and potential, that Abernethy and Chapman might incur if the engagement is accepted.
Recent case law indicates that named or identified third parties may be successful if negligence is proven. Since it is a requirement of the banks providing finance for an audit the auditor is on notice that the audited financial reports will be used by a third party. Accordingly, there is a clear contractual liability to the client and a liability in tort to specified third parties. Note: if your response here cited relevant cases you will have improved your mark …… if you don’t know what cases I am referring to, I suggest you revisit the topic on legal liability and review the earlier suggested solutions!
Again, pay heed to the fact that some of these responses come from Cases 1 AND 2! Again, think about the fact that you are documenting, using the questionnaire, the oral evidence obtained from various discussions that you have already had. The point of writing it down is to improve the quality (reliability) of the evidence that forms the basis for your firm’s client acceptance decision in accordance with their quality control principles (ASA 220, APES 110, APES 320, ASQC 1). APES 110 is included here because it has a section that deals specifically with contacting a previous auditor (predecessor auditor) when professional appointments are being negotiated.
Exhibit 2-2
Abernethy and Chapman
INFORMATION FROM PREDECESSOR AUDITOR
Potential Client: The Lakeside Company
Form Completed By: RA
Predecessor Auditor: King & Company
Date of Interview: 15/06/12
(1) Discuss the predecessor auditor's evaluation of the integrity of the management of the potential client.
Comfortable working with Rogers and his people; appeared to have integrity although happy to grumble about certain matters.
(2) Did the predecessor auditor reveal any disagreements with management as to accounting principles, auditing procedures, or other similarly significant matters? If so, fully describe these disagreements.
(3) What was the predecessor auditor's understanding as to the reasons for the change in auditors?
The two points listed above plus the level of fees.
(4) Did the predecessor auditor give any indication of other significant audit problems associated with the potential client?
Lakeside’s poor internal controls and Rogers’ unwillingness to spend money to improve same.
(5) Did the predecessor auditor indicate any problem in allowing Abernethy and Chapman to review prior years' working papers for the potential client? If "yes," explain.
No, provided the audit assignment was accepted. (You might like to compare ASA 220.12-13 and A8-A9, APES 110.210.9 to 210.14 pre 2018) or 110.320.5 - R320.8 (post 2018), APES 320.38-46 and ASQC 1.26-28 and A18-A23 for guidance offered in this regard).
(6) Was the predecessor auditor's response limited in any way?
No, appeared quite candid.
NOTE: Hopefully you can appreciate that much of this information corroborates (agrees with) the information documented from the meeting with Rogers (Case 1). What you now have is a solid picture of what Lakeside’s operations and strategy is about from two separate sources. Both have provided oral evidence that you have documented in different ways, but importantly, both sources generally corroborate each other.