Question

Hide-IT (HI), a family owned business based in Tombstone, AZ, builds custom homes with special features, such as hidden rooms and hidden wall safes. HI has been an audit client for three years.

You are about to sign off on a “clean” opinion on HI’s current AFS when Art Hyde, VP Finance, calls to tell you that the AZ DRS has seized control of a HI bank account that includes about $450,000 of company funds; the account is NOT currently recorded in the accounting system and you had been Unaware of it. In response to your questions about the origin of the funds, Art assures you that the funds, though not recorded a revenue, had been obtained legitimately. He explained that all of the money came from separately billed but unrecorded change orders to items in contracts completed before you became HI’s auditor, and before he or any members of current management became involved with the company. You subsequently determine that there is insufficient evidence to allow you to reconstruct the nature of these cash transactions, although the following analysis is available for the AZ DRS:

                                    Deposits 1.17.02 – 12.3.04          $455,000

                                    Interest Earned 1.02 – 12.08          95,000

                                    Withdrawals 2.12.03 – 4.7.07   (100,000)

                                    Balance 12.31.08   $450,000

Art also informs you that HI has agreed to pay a combined tax and penalty of 12% on the total funds deposited within 120 days as required by a recently enacted rule that provides amnesty for tax evaders. Furthermore, he states that negotiations with the IRS are in process.

ASSIGNMENT:

1. The professional standards define errors as unintentional misstatements or omissions of amounts or disclosures in the F/S. Is this situation described an error?

2. The professional standards state that fraud relates to intentional misstatements or omissions of amounts or disclosures in the financial statements. Misstatements due to fraud may occur due to either (a) fraudulent financial reporting (b) misappropriation of assets. Does the situation appear to be fraud? If so, is it fraudulent financial reporting, misappropriation of assets or both?

3. The professional standards outline certain auditor responsibilities relating to identifying client noncompliance with laws and distinguish between laws with a “direct effect” on the financial statements and other laws. Does the situation herein relate to noncompliance with laws as discussed within the auditing standards? If so, is the noncompliance related to a law with a direct effect on the financial statements or another law?

4. Should the CPA firm resign in this situation? If the decision is not clear-cut, what additional information would you desire before deciding?

Answer 1

(a) As per Auditing standards, Unintentional misstatements or omissions of amounts or omissions of disclosures in the financial statements are considered as committing errors.

For example, errors involve mistakes in collecting or processing data, unreasonable accounting estimated arising from oversight or misinterpretation of facts, or mistakes in the unplanned behavior not exist. There is no evidence about the funds established about $450,000. Mere statement presentation does not give the true picture of the funds arisen in the company. Therefore, it is a case of suppression of facts and unauthorized encouragement of funds.  

(b) This situation does appear to involve misstatements due to the misappropriation of assets. It is a misstatement due to fraudulent financial reporting because of the omission of the information from the financial statements. If the $100,000 withdrawals have been abstracted of assets.

(c) Certain laws have a direct effect on the financial statement amounts and are considered on every audit. An example of income tax law that affects the amount of income tax expense in the financial statements of most clients. This situation involves what appears to a non-compliance with a law that has a "direct effect" since, at a minimum; taxes have not been paid on the income involved.

(d) The auditors will need to consider whether withdrawal is necessary, perhaps after consultation with their attorney. The case suggests that the unrecorded deposits occurred prior to current management involvement with the company. Note, however, that interest was earned during the period this management has been with the company, and withdrawals have been made during this same period. The auditors would wish to consider when current management became aware of the account and the nature of the withdrawals when considering whether to resign from the engagement.