Question

Herbert McCoy is the president of McCoy Forging Corporation. For the past several years, Donovan & Company, CPAs, has performed the company’s compilation and some other accounting and tax work. McCoy decided to have Donovan & Company conduct an audit. He had recently received a disturbing anonymous letter that stated, “Beware; you have a viper in your nest. The money is literally disappearing before your very eyes! Signed: A friend.” He told no one about the letter.

McCoy Forging engaged Donovan & Company, CPAs, to render an opinion on the financial statements for the year ended June 30. McCoy told Donovan he wanted to verify that the financial statements were “accurate and proper.” He did not mention the anonymous letter. The usual engagement letter providing for an audit in accordance with generally accepted auditing standards (GAAS) was drafted by Donovan & Company and signed by both parties.

The audit was performed in accordance with GAAS. The audit did not reveal a clever defalcation plan. Harper, the assistant treasurer, was siphoning off substantial amounts of McCoy Forging’s funds. The defalcations occurred both before and after the audit. Harper’s embezzlement was discovered by McCoy’s new internal auditor in October after Donovan had delivered the auditors’ opinion. Although the scheme was fairly sophisticated, it could have been detected if Donovan & Company had performed additional procedures. McCoy Forging demands reimbursement from Donovan for the entire amount of the embezzlement, some $40,000 of which occurred before the audit and $65,000 after. Donovan has denied any liability and refuses to pay.

Required:

Discuss Donovan’s responsibility in this situation. Do you think McCoy Forging could prevail in whole or in part in a lawsuit against Donovan under common law? Explain your conclusions.

Answer 1

Answer:-

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Donovan’s responsibility under generally accepted auditing standards is to plan the audit to detect errors and frauds that would have a material effect on the financial statements.

Whether McCoy would prevail depends upon two questions: (1) The materiality of the undiscovered embezzlement and whether it was concealed by falsifying the financial statements and (2) Donovan’s planning and performance of appropriate audit procedures. If the amount is material, Donovan is potentially liable. If Donovan performed a careful audit exercising the appropriate level of professional care, liability probably would not attach. If not, Donovan might be found guilty of ordinary negligence and liable to McCoy with whom he had a privity relationship. All the common law features (damage, reliance, cause, failure to perform with the appropriate level of professional care, and privity) are present. The actual resolution of liability is only a matter of their degree.

McCoy, however, can be faulted (although probably not in a contributory negligence sense) for not informing Donovan about the anonymous letter. Donovan should have obtained signed representations in which McCoy asserted he knew of no errors or frauds that he had not told Donovan. With such signed representations, Donovan might not be found liable at all.

Even if Donovan is judged liable, McCoy could probably recover only the embezzled amounts after the audit ($65,000) but not the amounts embezzled prior to the audit ($40,000).