Case 2 - Exercise 1

Abernethy and Chapman

ANALYSIS OF POTENTIAL LEGAL LIABILITY

Potential Client: Lakeside Company

Type of Engagement: External Audit

Form Completed By:

Date:

(1) Is the potential client privately held or publicly held? Privately held

(2) Evaluate the possible liability to the client that Abernethy and Chapman
might incur, if the engagement is accepted.
If Abernethy & Chapman performs the engagement as an average, no
problems exist. If not, the client may sue for return of its audit fee as well as
any other resulting losses.
Moreover, the client company has weak internal control; therefore, fraud or
embezzlement can be increased. Proving this company innocent is difficult.

(3) List the third parties that presently have a financial association with the
potential client and could be expected to see the financial statements. These
parties are also called primary and foreseen beneficiaries.
- Cypress Products.
- Two Richmond banks financing the inventory.
- National Insurance Company of Virginia.

(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. These parties are also called foreseeable beneficiaries.
The financial statements could be presented to potential stockholders or
lenders.

(5) Evaluate the possible legal liability to third parties, both present and
potential, that Abernethy and Chapman might incur if the engagement is
accepted.
If the engagement is accepted, the CPA firm should have no liability to third
parties because it is privately held business; this audit firm does not fall
under federal security laws.

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 Abernethy and Chapman

INFORMATION FROM PREDECESSOR AUDITOR

Potential Client: Lakeside Company

Form Completed By:

Predecessor Auditor:

Date of Interview:

(1) Discuss the predecessor auditor's evaluation of the integrity of the

management of the potential client.
Predecessor auditor indicated no problems with the integrity of the
Lakeside management.

(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.
Yes, they have disagreements about one of Lakeside’s stores. Rogers
(Lakeside’s president) refused to write down the reported value of the store
6 (which is proven that made losses).

(3) What was the predecessor auditor's understanding as to the reasons for the
change in auditors?
Predecessor auditor stated that the firm was discharged over the wording
of the previous audit opinion.

(4) Did the predecessor auditor give any indication of other significant audit
problems associated with the potential client?
Yes, the predecessor auditor also mentioned weaknesses in Lakeside's
internal control and Rogers' unwillingness to improve these systems.

(5) Did the predecessor auditor indicate any problem in allowing Abernethy and
Chapman to review prior years' audit documentation for the potential client?
If "yes," explain.
No, the auditor stated that the audit documentation could be reviewed.

(6) Was the predecessor auditor's response limited in any way?

No limitations.

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 Case 2 - Exercise 2

Abernethy and Chapman

Review of Predecessor Auditor's Documentation

Client: Lakeside company

Predecessor Auditor:
Prepared by:
Date:

Prepare a list of the specific contents of the predecessor auditor's documentation

that should be examined by Abernethy and Chapman. Indicate each area that
should be reviewed and the purpose of studying these particular areas of the audit
documentation. Use the following format.

Area that Should be Reviewed Purpose of Review

Proposed Adjusting Entries
The analysis of contingencies
Internal control
Beginning-of-year balances
Specific accounting principles
Slow collection of account receivables
To determine the type and materiality of
the proposed adjustments
To evaluate the obvious weakness and
look for strengths
To look for evidences
To examined that those principles are
applied or not in the fiscal year
To answer the question why the
account receivable is four months.

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 Exhibit 2-3

Abernethy and Chapman

Preliminary Judgment about Materiality

Client: Lakeside Company

Balance Sheet Date:
Prepared by:

Determine the preliminary judgment about materiality for the client as a whole.
Express your answer as a dollar amount. Determine the appropriate level of
materiality based on all analyses completed for the client thus far. Fully support
and discuss the materiality level that you determine.

Quantitative Considerations: Because materiality is relative, it is necessary to

have bases for establishing whether misstatements are material. A base is a
critical item of which users tend to focus while making decisions. The base will
vary depending on the nature of the client’s business. Typical bases may include
net income before taxes, net sales, total assets and stockholders’ equity.
Percentages typically range from 1%-10% depending on the base.

Base (from Dollar Amount of Percentage Base x

previous year) Base Range Percentage
Income before tax 448,000 10% 44,800
Assets 3,186,000 1% 31,860
Stockholders’ 814,000 1% 8,140
equity

Qualitative Considerations: Certain types of misstatements are likely to be more

important to users than others, even if the dollar amounts are the same. For
example, misstatements that involve fraud may be more important to users than
misstatements due to unintentional errors. Fraud reflects on the integrity of
management and other employees of the client.

Item to be Considered Impact on Materiality (Increase or

Decrease)
Sales Increased
Inventory Increased

Preliminary Judgment about Materiality: Combine the quantitative and qualitative

considerations into one overall materiality level.

Materiality level: $ 84,800

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Discussion: Discuss how you arrived at this dollar amount for the preliminary
judgment about materiality. That is, how did you combine the qualitative and
quantitative considerations to arrive at this dollar amount?
Based on three important bases: income before tax, assets and stockholders’
equity. Because when looking at the financial statements, there are a lot of
inappropriate increase (such as inventory store 3 or sales in store 3).

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 Case 2 - Exercise 3

Abernethy and Chapman

PRO FORMA AUDITOR'S REPORT

To the Stockholders:

We have audited the accompanying balance sheet of the Lakeside company as

of December 31, 2011, 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. The financial
statements of Lakeside Company as of December 31, 2010, were audited by
King and Company, on those statements included a qualified opinion because of
inadequate disclosure of an impairment of value. The impairment of value
concerned the Lakeside Company’s investment in one of its stores.

We conducted our audit in accordance with generally accepted auditing

standards 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.

In our opinion, the 2011 financial statements present fairly, in all material
respects, the financial position of the Lakeside Company at December 31, 2011,
and the results of its operations and its cash flows for the year then ended in
conformity with generally accepted accounting principles in the United States of
America.

Abernethy and Chapman

(signed)

Certified Public Accountants

Date: [insert last day of audit fieldwork here]