Question

Marshall and Wyatt, CPA’s, has been the independent auditor of Interstate Land Development Corporation for several years. During these years, Interstate prepared and filed its own annual income tax returns.

                  During 20X4, Interstate requested Marshall and Wyatt to audit all the necessary financial statements of the corporation to be submitted to the Securities and Exchange Commission (SEC) in connection with a multistate public offering of 1 million shares of Interstate common stock.

                  This public offering came under the provisions of the Securities Act of 1933. The audit was performed carefully and the financial statements were fairly presented for the respective periods. These financial statements were included in the registration statement filed with the SEC.

                  While the registration statement was being processed by the SEC, but before the effective date, the Internal Revenue Service (IRS) obtained a federal court subpoena directing Marshall and Wyatt to turn over all its working papers relating to Interstate for the years 20X1-20X4. Marshall and Wyatt initially refused to comply for two reasons. First, Marshall and Wyatt did not prepare Interstate’s tax returns. Second, Marshall and Wyatt claimed that the working papers were confidential matters subject to the privileged communications rule. Subsequently, however, Marshall and Wyatt did relinquish the subpoenaed working papers.

                  Upon receiving the subpoena, Wyatt called Dunkirk, the chairman of Interstate’s board of directors, and asked him about the IRS investigation. Dunkirk responded, “I’m sure the IRS people are on a fishing expedition and that they will not find any material deficiencies.”

                  A few days later Dunkirk received a written memorandum from the IRS stating that it was contending Interstate had underpaid its taxes during the period under review. The memorandum revealed that Interstate was being assessed $800,000, including penalties and interest for the three years. Dunkirk forwarded a copy of this memorandum to Marshall and Wyatt. This $800,00 assessment was material relative to the financial statements as of December 31, 20X4. The amount for each year individually, exclusive of penalty and interest, was not material relative to each respective year.  

1. In general terms, discuss the extent to which a CPA firm’s potential liability to third parties is increased in an SEC registration audit.
2. Discuss the implications of the IRS investigation, if any, relative to Marshall and Wyatt’s examination of Interstate’s 20X4 financial statements. Discuss any additional investigative procedures that the auditors should undertake or any audit judgments that should be made as a result of this investigation.
3. Can Marshall and Wyatt validly refuse to surrender the subpoenaed working papers to the IRS? Explain.

Answer 1

Answer:-

a.

In connection with registration audits, auditors may be liable for any losses to persons acquiring the security that are proximately caused by the auditors' ordinary negligence. This is a higher standard of liability than the gross negligence standard existing under common law (Ultramares approach) and under the Securities Exchange Act of 1934. In addition to being liable for losses attributable to ordinary negligence, a considerable portion of the burden of proof is transferred by the 1933 Act to the defendants. Thus, the auditors must prove "due diligence," rather than the plaintiffs having to prove negligence.

b.

The IRS investigation constitutes a subsequent event—that is, information coming to the auditors' attention subsequent to the balance sheet date. As indicated in the text, the Securities Act of 1933 extends the auditors' attention to subsequent events to the effective date of the registration statement. Since this IRS investigation has come to light prior to that date, the auditors are responsible for proper financial statement presentation of these facts.

The $800,000 tax liability is a loss contingency, in that there exists some uncertainty as to whether or not the loss has actually occurred. FASB ASC 450, dealing with contingencies, establishes criteria for accruing, disclosing, or ignoring loss contingencies. If the loss is "probable" and can be "reasonably estimated," it should be accrued in the 20X4 financial statements. If either one of these criteria has not been met, but it is still at least "reasonably possible" that a loss has been incurred, disclosure is required. Only if the prospects of a loss having been incurred are "remote" can this contingency be ignored in the financial statements. Thus, the auditors must make a judgmental decision as to whether it is appropriate to ignore, disclose, or accrue a loss relating to this matter in the 20X4 financial statements.

Prior to making this decision, the CPA firm should investigate the potential tax liability of Interstate, rather than merely relying upon Dunkirk's evaluation. The auditors should review Interstate's tax returns for the years in question. They should also review all correspondence between Interstate and the IRS in order to determine the areas under challenge and to judge the validity of the IRS's assessment. Furthermore, the CPAs should obtain Interstate's legal counsel's evaluation of the situation. In all probability, Marshal and Wyatt should at least insist upon complete disclosure of this situation in the financial statements; they may even need to insist upon accrual of a liability for some or all of the $800,000, depending upon the outcome of their investigation.

c.

No. Although a minority of state courts apply the privileged ­communication rule to the CPA-client relationship, the federal courts do not follow this rule of evidence. Hence, the CPA firm had no choice but to honor the subpoena even though it did not prepare the client's tax returns.