CASE 1

INTRODUCTION

Many recent auditor liability cases have resulted from a failure to exercise due professional care
and sound professional judgment; failure to complete required audit procedures was not at fault.
In this setting, the thrust of this case is to emphasize the role of audit judgment in the application
of fundamental auditing concepts, standards, and procedures.

The case consists of seven integrated units, each relating to a specific phase of the audit
engagement of Lone Star Western Apparel Co., a manufacturer of western-style hats. Each unit
contains a set of requirements to be completed using the working papers and other documents
provided in the back of this case book.

Throughout the case you are expected to assume a professional role within the public accounting
firm of Harer & Jones, CPAs. At various time you will make decisions at the partner or manager
level, and at other times perform staff functions. The firm is well respected in the region, noted
for a quality practice and exceptional professional staff. It has been operating in the region for 30
years and presently has offices located in three cities approximately 100 miles apart. Present
plans do not call for immediate expansion, although future mergers may be considered as long as
the firm’s quality can be maintained

The professional staff consists of 20 partners, 30 managers, and 100 staff accountants. The firm
has grown to the extent that in-house continuing professional education courses are offered at
central locations for most staff-training needs.

Harer & Jones is structured so that an administrative partner is responsible for the overall
management of the practice, although management is decentralized in the sense that each office
has a managing partner responsible for general operations. The firm generates 75 percent of its
revenues from audit services and the remaining 25 percent from tax and management advisory
services (MAS) functions, both of which operate from the main office in Big City, USA. On all
audit engagement engagements, the partner in charge or manager is expected to consult with the
tax and MAS professionals when planning the engagement and in coordinating their involvement
during the examination
The firm has several SEC clients and therefore has joined both the SEC Practice Section and the
Private Companies Practice Section of the AICPA Division for CPA Firms. Quality control
documentation has been developed, and the firm has requested a peer review for the following
year. The administrative partner has indicated that a favorable peer review report is expected by
the firm.

Harer & Jones Policy

The firm has adopted procedures for the acceptance and retention of clients in accordance with
the AICPA guidelines for quality control in an accounting practice. Regarding prospecting
clients, the firm requires that a partner (called the contact partner) interview the prospective
client to determine the nature of the desired services and the firm’s ability to provide services.
The firm has developed a prospective client questionnaire to be completed during the interview.

Following the interview the contact partner checks references, corresponds with the predecessor
auditor, if any, and consults with the managing partner of the office. At this time the needs of the
client and the firm’s ability to service the client are considered, and an overall evaluation of the
prospective client, including management integrity, is undertaken. Assuming agreement, both
partners sign the completed questionnaire. If agreement is not reached concerning acceptance,
additional partners may be consulted regarding the proposed engagement.

When an engagement is accepted, the contact partner prepares an engagement letter. When an
engagement is declined, the contact partner personally notifies the party and follows up with a
letter setting forth the reasons for not accepting the engagement.

Interview

In early April, James R. Wiggings, president and chairman of the board of Lone Star Western
Apparel Co., telephoned you, a partner with Harer & Jones concerning an appointment to discuss
possible professional services for his company. Wiggins explained that he was not personally
acquainted with anyone in your firm, and that he had been referred to you by a local attorney,
Jane Kindman, who is a friend of yours. You arranged to meet with Wiggins and Donna Wiles,
Lone Star’s controller, in your office on April 12, 19x2. A summary of the facts revealed during
the April 12 interview follows.
The annual audit of Lone Star has been performed by a local CPA, Carl Moore, since the
company’s inception. Although Moore’s work has been satisfactory, Lone Star’s rapid growth
and plans for the future necessitate an auditor change. Wiggins and Wiles have discussed the
matter with Moore and would give permission for Harer & Jones to contact Moore and review
his working papers.

Lone Star was incorporated and commenced operations in January, 19W8. The company
presently has executive offices and manufacturing operations located in a leased 300,000 square
feet facility at 3810 Longhorn Drive, Blg City. The company has 110 employees involved in
manufacturing operations and 35 in the executive offices. At the present time Lone Star
purchases raw materials and converts the materials into western-type felt hats. The company had
facilities to produce hats in a wide variety of styles and sizes. Although operations are currently
limited to a single product line, the board of directors anticipates that as business continues to
expand, other items, such as boots and belts, will be added to the product line. The company
distributes its hats to retail chain and western apparel shops throughout the country. The
company’s sales representatives attend buyers’ conventions and fashion shows nationwide. In
addition, company representatives contact buyers directly concerning the company’s products in
certain high-volume regions.

Wiggins stated that sales and profits have increased significantly each year since the company
began operations. In addition to long range plans for expansion into other items of western
apparel, the company has considered acquiring western apparel retail outlets in selection major
cities in the region; the first would be located in Big City, Wiggins was previously associated
with a large manufacturer of western boots, and he believes this experience will prove valuable
in implementing Lone Star’s plans for expansion.

Wiggins owns 65 percent of the outstanding stock of Lone Star. The remaining 35 percent is held
by three individuals who are also officers of the corporation. Catherine Meyer, vice president and
secretary-treasurer, 15 percent ownership; Ross Crothers, vice president – manufacturing, 10
percent ownership; and Claire McCartin, vice president – marketing, 10 percent ownership. The
attorney for Lone Star is Warren Ramsay, Wiggins’ brother in law. Neither Ramsey nor Wiles,
the controller, has any ownership interest in Lone Star at the present time.
Wiggins stated that all of the shareholders recognize the need for annual audits and the
importance of audited financial statements in obtaining additional capital and perhaps “going
public” some time in the near future. In addition to auditing services, the company requires tax
planning, tax return preparation, and consulting in the electronic data processing (EDP) area. The
company currently utilizes EDP in the processing of cash disbursements and customer billings
and would like to expand the EDP function as growth and resources permit.

Wiles presented a copy of the company’s latest financial statements and audit report (pages 3-6) ,
noting that the CPA rendered an unqualified opinion. She also stated that the company is not
involved in any litigation and that the corporate tax returns have never been audited by the IRS.
Wiles indicated that the accounting records are in good condition and that she and her staff
would cooperated with the auditors and would assist in the preparation of schedules and in other
areas in order to maintain a reasonable fee for the engagement.

Following the discussion of the nature of Lone Star’s operations, organizational structure, and
professional services desired, you explained to Wiggins and Wiles the independent auditor’s
responsibilities for detection of errors, irregularities, illegal acts. Regarding independence, Wiles
mentioned that her daughter is a staff accountant for Harer & Jones, stating that she hope this
would not impair the independence. You noted this fact for future operations with the managing
partner.

You proceeded to describe the firm’s procedure for new client acceptance, stating that you would
have to review the financial statements in more detail, correspond with Moore, consult with
references, and discuss the engagement with the managing partner. Wiggins suggested that you
contact lone star’s attorney and the company’s bank, First National Bank of Big City, adding that
he was confident that both parties would give good references.

Concluding the interview, you indicated that you would contact Wiggins if additional questions
arise and that you would notify him as soon as a decision has been made, probably in a week or
two. Upon leaving, Wiggins commented on the quality reputation of Harer & Jones and
expressed confidence that the engagement would be of a continuing nature and rewarding for
both parties.
 Lone Star Western Apparel Co.

Notes to Financial Statements

Note 1 – Summary of Significant Accounting Policies

Accounts Receivable – Management expects that receivable are fully collectible, thus the
Company uses the direct charge-off method of accounting for bad debts for both financial
reporting and income tax purposes.

Inventories – Finished goods inventory is valued at the lower of cost (determined on the first in,
first out basis) or market. Raw materials inventory is valued at the lower of cost (average) or
market. Due to an annual plant closing for maintenance and vacation, there is no year-end work-
in-process inventory.

Equipment and Leasehold improvements – all assets are stated at cost, improvements and
betterments are capitalized, and maintenance and repairs are charged to expense as incurred. The
policy of the company is to provide annual depreciation on equipment and leasehold
improvements at rates to amortize the cost over their estimated useful lives. Depreciation is
provided for both financial reporting and income tax purposes primarily on the declining balance
method. When assets are fully depreciated or disposed of, the cost and related accumulated
depreciation are removed from the respective accounts, and any gain or loss arising from the
disposition is reflected in income.

Investment Tax Credit – The investment tax credit is accounted for under the “flow-through”
method, which recognizes the tax benefits in the year the asset is place in service.
Note 2 – Provision for Income Taxes

The company’s federal and state income taxes are summarized as follows.

19x1 19x0

Federal income tax 291,000 284,500

Investment tax credit (net) (114,000) (19,000)

State income tax 33,000 32,000

Total provision for income taxes 210,000 297,500

Note 3 – Inventories

Year-end inventory balances are summarized as follows:

19x1 19x0

Raw materials 310,000 50,900

Finished goods 468,500 198,100

778,500 249,000

Note 4- Stock Repurchase Agreement

In September, 19x0, the Company executed a stock repurchase agreement wherein it has the first
right of refusal to purchase the stockholders’ shares. The purchase price is stated as 150 percent
of book value if the purchase takes place during the stockholder’s lifetime and is the greater of
book value or the proceeds of the corporate life insurance if the shares are purchased from the
estate of a deceased stockholder. The purchase price of the stock is to be paid in twelve quarterly
in installments from the date of sale and will bear interest of 12 percent on the unpaid balance
Note 5 – Lease Commitments

The facilities in which the company operates are leased from a partnership owned by the
shareholders of the Corporation. The lease agreement is for a five-year period effective March 1,
19W9. The annual payments under the terms of the lease are 90,000. The lease may be renewed
at the option of the Company for an additional five-year period at a negotiated monthly rental.

Follow-Up

You are impressed with Wiggins, and on the surface you are inclined to believe that the
engagement would be beneficial for Harer & Jones. Your beliefs are confirmed by contacts with
the bank and Lone Star’s attorney. You also contact Kindman, who gives a favor able
recommendation regarding the character and integrity of Lone Star’s management. Also, your
communication with Moore confirms the explanation given by Wiggins for the auditor change.

At your meeting with the managing partner of office, you are able to resolve the potential
independence problem and are given authorization to proceed with the engagement. You contact
Wiggins on April 25, 19x2, stating that Harer & Jones is interested pursuing the engagement. At
this time you explain that the fee for the engagement will be based on the firm’s regular billing
rates. You expect it to range between 10,000 and 15,000 plus out-of-pocket expenses. This
estimate covers only the audit-related fees; additional services for tax planning and return
preparation and EDP consulting would be on a separate, through similar, fee arrangement.

You also point out that the firm would expect Wiles and her staff to provide the following for the
year ended December 31, 19x2 financial statements or a trial balance of the general ledger; a
reconciliation of the bank account; an aged listing of accounts receivables as of December 31,
19X2; a listing of bad debts written off during the year, a completed copy of the physical
inventory sheets; a schedule of insurance coverage; a schedule of property and equipment
additions and retirements; a depreciation schedule, and a list of accounts payable as of December
31, 19X2. In addition, you request copies of the minutes of the board of directors’ meetings for
the past five years and copies of lease agreements, employment contracts, and the corporate
charter and by-laws.
Wiggins concurs with your request, and you state an engagement letter detailing the arrangement
will be prepared immediately. You request that Wiggins, upon receipt of this letter, sign and
return a copy for the permanent files. You also note that a separate letter will be mailed detailing
the schedules and other information to be supplied by Lone Star.
 REQUIREMENTS

1. Discuss the policies and procedures you would expect Harer & Jones to list in its quality
control document as important considerations when accepting new clients. For each
policy and procedure, indicate why you believe it is an important consideration
2. Complete the prospective client questionnaire based on the information provided in the
unit narrative.
3. How would you resolve the potential independence problem with the staff accountant?
For documentation purposes, briefly describe your resolution of the matter on the
questionnaire in the special comments section.
4. Prepare an engagement letter for Lone Star.
5. Prepare an appropriate letter to the predecessor auditor
6. Prepare a supplemental letter to be sent to Wiggins which specifies your expectations of
client assistance on the engagement