Question

Benjamin M. Rogers is the president of the Lakeside Company, a retailer and distributor of consumer electronics (mainly audio and video equipment) based in Richmond, Virginia. Although King and Company CPAs, a Richmond firm, had previously audited Lakeside, Rogers had recently become aware of the CPA firm of Abernethy and Chapman from reading several advertisements. His interest in the firm was heightened when he discovered that Abernethy and Chapman audited the primary bank with which he did business. During March 2009, Rogers contacted his banker who arranged for Rogers to have lunch with one of the CPA firm’s partners. At that time, a wide-ranging conversation was held concerning Lakeside as well as Abernethy and Chapman. Rogers discussed the history of the consumer electronics company along with his hopes for the future. The partner, in turn, described many of the attributes possessed by his public accounting firm. Subsequently, Rogers requested a formal appointment with Richard Abernethy, the managing partner of Abernethy and Chapman, in hopes of arriving at a final conclusion concerning Lakeside’s 2009 audit engagement.

A June 1 meeting was held at the accounting firm’s Richmond office and was attended by Abernethy, Rogers and Wallace Andrews, an audit manager with the CPA firm who would be assisting in the investigation of this prospective client. Both auditors were quite interested in learning as much as possible about the consumer electronics business. Although a number of similar operations are located in the Richmond area, Abernethy and Chapman has never had a client in this field. Thus, the Lakeside engagement would offer an excellent opportunity to break into a new market.

During a rather lengthy conversation with Rogers, Abernethy and Andrews were able to obtain a significant quantity of data about the Lakeside Company and the possible audit engagement. Included in this information were the following facts:

Rogers originally began Lakeside in 1990 as a single store that sold bargain-priced televisions and stereo equipment. This business did well and the company expanded thereafter at the rate of one new store every two or three years. Presently six stores are in operation, three in Richmond with one in each of three nearby cities: Charlottesville, Fredericksburg and Petersburg. The first five were set up in rented space within small shopping centers. However, the most recent store was located in a building constructed by Lakeside itself, adjacent to a new shopping mall on the east side of Richmond. In addition, Lakeside owns a warehouse that also provides office space for the company’s administrative staff. The growth to date has been slow and has not produced the benefits and profitability that Rogers expected. He is looking for a way to increase the growth rate and taking the company public is beginning to look like the only way that sufficient resources can be amassed.

In 2002, Lakeside reduced the marketing of bargain-priced electronics in a move to concentrate on the sale of high-end audio and video equipment. Several years later, Lakeside became the sole distributor of Cypress Products for the states of Virginia and North Carolina. Cypress is the manufacturer of a quality line of audio and video equipment. Shortly thereafter, the Lakeside stores began to carry Cypress products almost exclusively. Despite the quality of Cypress equipment, the brand was not well known in the Richmond area and store revenues began to decline. Sales did rebound somewhat in 2007 and 2008, although Rogers admitted to Abernethy that all of the stores had suffered from intense competition within the local market. He even indicated that a small audio equipment company, consisting of two stores, had gone bankrupt in Richmond during the past six months. However, he was not certain as to the specific cause of that failure. He believes that a larger organization could take advantage of combined management, purchasing and storage. Geographically there are several cities that Lakeside could enter without dramatically increasing the distances from its current warehouse.

To market the Cypress brand across the states of Virginia and North Carolina, Lakeside had hired a staff of six sales representatives to visit audio, electronics, and appliance stores in their geographic region. These other retailers could then order merchandise from Lakeside by telephoning the Richmond headquarters/warehouse. After a credit check, requested inventory is shipped to these customers and billed at 2/10; NET/45. Up to 20% of the merchandise can be returned to Lakeside within four months as long as the goods have not been damaged. In the past, returns have been low. Rogers indicated that these “distributorship sales” had initially been disappointing but had risen materially in the last two years as the Cypress reputation began to spread. Rogers has only begun to consider what a more comprehensive Southeast strategy would require in terms of sales administration and logistics.

Audio and video equipment inventory is purchased weekly from Cypress. Regional distributors such as Lakeside are allowed 90-day terms but Cypress encourages quick payment by offering large cash discounts. In hopes of maintaining a high profit margin, Rogers has chosen to take all available discounts. To meet the payment terms, Lakeside holds bank credit lines with two Richmond banks totaling $750,000. Interest on this debt is based on the floating prime rate of the respective banks and has averaged just 5% to 9% during recent years. Both banks require that cash in an amount equal to 5% of the outstanding credit line remain on deposit.

The company’s warehouse and the sixth store were constructed with funds provided by loans from the National Insurance Company of Virginia. The first of these obligations was obtained at a 6 ½ % annual interest rate while the second holds a rate of 8%.

Rogers stated that he was quite unhappy with the services of his present CPA firm, King and Company. He enumerated three grievances that he had with that organization:

First, he felt that the firm had provided little assistance in updating Lakeside’s accounting systems. Lakeside was simply outgrowing the control features of its current systems and Rogers asserted that King and Company had not provided the needed input for upgrading them.

Second, Rogers believed that King and Company was charging an excessive fee for its annual audit. He stated that he was no longer willing to pay that much money for what he termed inferior services.

Third, Rogers had an issue with King and Company around the audit opinion that was rendered on Lakeside’s financial statements for the year ending December 31, 2008.

The auditors issued a qualified opinion. King and Company believed that the value of Lakeside’s $186,000 investment in its latest store had been impaired based on guidelines established by FASB. However, Rogers disagreed and refused to write down the reported value of the property. The sixth store, which opened in November 2007, was constructed adjacent to a shopping center that had proven to be very unsuccessful. To date, the shopping center had leased less than 40% of its available space. The Lakeside store, has, consequently, never been able to generate the customer traffic necessary to even come close to its break-even point. The continuing failures of the shopping center made the fate of the Lakeside store appear quite uncertain to King and Company. Furthermore, the CPA firm felt that Lakeside would have considerable trouble in disposing of the store if that became necessary. Because Rogers continued to report this asset based on historical cost, the firm felt that a material misstatement existed and issued a qualified opinion. Rogers expressed annoyance with a firm that would stifle his growth plans and wondered what it would be like if this expansion plans were to become a reality.

Lakeside Company is owned by a group of eight investors. Rogers (who is 46 years old) owns 30% of the outstanding stock while the remaining seven shareholders individually possess between 6% and 22% of the company’s shares. Although all of the investors live in the Richmond area, only Rogers is involved actively in the day-to-day operations of the business. The board of directors is comprised of Rogers, two other owners, and a local lawyer who is not an owner. When the company was first organized, all eight shareholders agreed that an audit by an independent CPA firm would be held annually. This same requirement was also a stipulation made by banks participating in Lakeside’s financing.

A manager and an assistant manager operate each of the six stores. Normally, three to six sales clerks also work at each outlet on a part-time basis. In hopes of stimulating lagging store sales, Rogers initiated a bonus system during 2008, which already appears to be boosting revenues. Under this plan, every manager and assistant manager will receive a cash bonus each January based on the income earned by his or her store during the previous year. The bonus figure is a percentage of the gross profit of the store less any directly allocable expenses.

Lakeside Company is in the process of opening a new (seventh) store, which will begin operations by December 2009. Earlier this year Rogers formed his own separate corporation to construct this latest facility. Upon completion, the building will be leased to Lakeside for its entire life. Although Rogers was confident that this new store would do well, he wanted to avoid any further accounting problems associated with the uncertainty of success. He is also investigating land purchases in at least four other locations in the Southeast.

Rogers indicated to Abernethy that growth was one of his primary business objectives. He stated that the Cypress distributorship offered unlimited opportunity and that, once firmly established, each of the Lakeside stores was a sound financial investment.

To finance its growth, the company is considering a public offering of stock.

The company is strongly contemplating the addition of computer equipment to its product line.

CASE QUESTIONS:

Prepare a one-page executive summary that addresses the following issues related to fraud:

Fraud risk factors are potential problems or indicators of potential fraud.

What are the fraud risk factors that this CPA firm might encounter if it accepts this engagement? The “fraud triangle” of incentives/pressures, opportunities and attitudes/rationalization are more general core concepts for analyzing fraud risk factors and should be used to guide your analysis of fraud risk factors. Please identify fraud risk factors – based on the information provided above – that are specific to Lakeside Company.

In addition, how should a CPA firm follow-up on each potential fraud risk factor that you have identified?

Answer 1

Fraud Risk Factor that Abernethy and Chapman migth encounter if it accept this audit engagement and how they can follow up on each potential fraud risk identified.

Fraud Risk Factor	Follow up by CPA Firm (Abernethy and Chapman)
A potention risk factor could be Lack of Expertise by Abernethy and Chapman. As this would be their first assignment in consumer electronic market, they do not have prior experience of audit in this market. Hence their quality of work might be poor	There is an ethical obligation on the part of audit firm to discuss its lack of expertise to the client and also discussing if the plan to hire someone with expertise specifically for the client. Hence the Abernethy and Chapman could also hire a person with having expertise in consumer elctronic market and providing relevant training to its audit workforce.
Another Risk Factor could be Lack of Independence. As Abernethy and Chapman has been an auditor of the Bank with which Lakeside has financial interest.	If Abernethy and Chapman accept this audit engagement. They need to review all independence and Related Party Transaction. While checking for the primary bank, they would come accross this independence issue and therefore they might nor accept this audit engagement.
Rental or Lease Agreement	Majority of stores of Lakeside is rented and even an upcoming store would alse be leased for a life time. Hence the Abernethy and Chapman sould review all the lease and rental agreement to see if Lakeside has adhered to all the required compliance as per Law.
Since the Lakeside wish to go public in order to get the funding. But there has been similar company which has gone bankrupt in an attempt to go public for addition funding.	Abernethy and Chapman should consider factors with respect to stability of the Lakeside so that they would end up like other firms after going public. Auditors should also consider the fact thar Public offering might temp owner to falsify or misrepreseng financial statement to make it look more profotable in an attemp to attract investors.
Since there is High competition and growth rate is low. The company is looking for a way to increase its revenue	Abernethy and Chapman should keep track on Sales Revenue. This can be done by preparing Trend Analysis of Sales of last 3 to 5 years. Auditors should also consider what are the major cost for Lakeside company
Another Audit Risk Factor could be that Lakeside Company allow 20% inventory could be returned within four month. In other word, Lakeside allowed return after sales	Abernethy and Chapman should consider on testing year end sales and return. Also the Auditor ability to estimate amount of revenue is also a critical concern.
Accounts Receivable are mostly credit	Auditor should review the credit terms of the company in order to determine collectible and non collectible receivlabe of the Lakeside.
Since the Lakeside has tied the Cash Bonus with the revenue, there is an inherent risk that income could be overstated.	If Audit engagement is accepted, Abernethy and Chapman should perform testing and review in all areas with respect to financial statment such as income statement, Balance sheet and Cash flow statement
Qualified opinion by King and Company with respect to impairment of asset.	This issue needs to be resolved as there is a conflict of opinion between previous auditor and Roger. If Audit engagement is accepted, Abernethy and Chapman, they should investigate the matter in the light of guideline provided by the FASB to come to a conclusion whether the asset should be impaired or not
Roger has Started the Seperate Coporation which is doing business with Lakeside	These transaction need to be verified by Abernethy and Chapman as these are Related Party Transactions. Hence Auditor should see that whether these transaction are on Arm's Length basis or not.
Since the Previous Auditor could update the Lakeside Accounting software, they are outdated.	Outdated accounting system implies lessor internal control. Hence the auditor would have to gather extensice evidence in order to make any determination.
Concern with respect to oustanding Laons	Since Lakeside has various outstanding loan at diposal.  Abernethy and Chapman should reveiw its terms and conditons and also see that Lakeside has adhered to all the compliances with respect to the Loan