Question

Joker & Wild LLC has just been sued by its audit client, Canasta, Inc., claiming the audit failed to be conducted in accordance with generally accepted auditing standards, lacked the requisite care expected in an audit, and failed to point out that internal controls were not working as intended. The facts of the case are that the auditors failed to find the accounting manager’s misappropriation of assets when he stole inventory and then improperly, knowingly, wrote down inventory for market declines.

Current market values of inventory were not provided to the auditors despite numerous requests for this information. The auditors relied on management’s representations about these values, which understated inventory by 10 percent. The plaintiff client brought the suit against the CPA firm claiming negligence, asserting the firm’s failure to find the vice president’s misappropriations of inventory and false valuations damaged the company by prematurely recognizing losses and then causing large reversals in the subsequent fiscal year when the inventory was sold for 15 percent above the original cost. The defendant CPA firm sought to blame the client, claiming Canasta did not cooperate on the audit and the vice president overrode internal controls.

1)Are the auditors guilty of malpractice? Explain.

2)What defenses are available to Joker & Wild in this case? Explain what they must prove to successfully assert these defenses.

3)Assume you are not aware of state laws on auditor legal liability. What legal concepts might a court of law use to resolve the lawsuit?

4)Do you believe the auditors should be held legally liable? Why or why not?

Answer 1

ANSWER:

1.

No, audits are not designed to detect fraud. In this case the client did not cooperate with the auditors and provide them with requested information. An engagement letter would have been provided which lays out the responsibilities of both the auditor and the client in relation to the audit. Assuming that the auditor did not breach their contractual obligations with the client, and performed their work in accordance with a standard audit plan, followed GAAS and performed their work with due care, they are not guilty of malpractice. While auditors would prefer to be able to independently verify managements representations, sometimes that is just not possible. In this case the auditors placed too much reliance on managements representations. Had management provided them the information they requested, then perhaps the auditor would have discovered the misappropriation.

2.

The auditors would claim that they performed their work in accordance with professional standards, following GAAS and conducting the audit with due care. They would claim that they performed the work they were contracted for in accordance with the engagement letter, specifically pointing out what they were responsible for versus what management was responsible for. They can demonstrate this by showing that the work they actually performed is consistent with what they perform on all their audits. They would refer to their audit planning process and how they went about it and how it meets the requirements under GAAS.
In addition, the auditors would state that their failure to uncover the fraud, did not cause a loss to the client. The loss existed prior to the audit being conducted.

3.

Privity – Is the auditor contractually obligated to the client?
Extent of Liability – Extent of any liability which should be assigned to the auditor.
Breach of Contract – Did the auditors breach the contract they had with their client? What obligations does the client have to the auditor under the contract?
Negligence – Did the auditors make mistakes during the audit which resulted in a loss to the client?
Gross Negligence - Was the work performed by the auditor so poor that it constituted fraud?

4.

No, the facts given in this case do not appear to indicate that auditors breached their duties to their client. They appear to have been following an audit plan and following GAAS. Auditors must rely on the representations of their clients for many things. If the client does not cooperate then the auditor must make a judgment call as to whether the information requested is needed to be able to complete their work. A question of materiality comes into play with this and whether or not there were other issues they encountered during the audit. The case does not give us this information. So based on what was presented, the auditors do not appear to be liable.