Case Study--On Scope of Engagement

Source: Of Mutual Interest

The following includes excerpts from the article cited below, reproduced with permission.

A group of investors loaned $40 million to a now-defunct company. The loan covenants required an unqualified audit by a big 4 accounting firm. However, the 2003 financial statements did not certify the audit as "unqualified" until 2005.

In 2004 the company changed an accounting method--it provided a reserve for obsolescence only for inventory that remained unsold for two years. Previously the company used one year.

An improvement in the business resulted from the change in accounting method.

The company issued an unaudited and unfootnoted report for 2004 showing a dramatic improvement over 2003. The investor group relied on this statement in making the loan. The big 4 firm examined the unaudited and unfootnoted statement for 2004 before completing the audit of the 2003 statements. It did not prepare a "subsequent events" footnote, or conduct a "going concern" analysis relating to the 2004 statements, and it did not require disclosure of the accounting change in the 2003 statements.

The borrower went bankrupt shortly after the loan was made.

The investor group sued the auditor. The court noted that by the time the 2003 audit was issued, the borrower had continued as a going concern for more than a year, and the auditor had no obligation to make a going concern determination beyond one year under GAAS.

The court also found that the auditor was not obligated to include a subsequent events note about the changes in the 2004 statements since that information had no effect on any part of the task they were hired to complete (i.e., an unqualified audit of the 2003 financial statements).

The claims against the auditor were dismissed. But what if the "task" the auditor was retained to perform had not been clearly defined in advance?

A clear, defined scope of engagement, and staying within that scope in your audit work, can protect you in a third-party lawsuit. Some auditors have gone so far as to include in the bound audited financial statements a separate page that makes third-party users subject to the terms of the engagement letter.

Click here for the complete article.

From Of Mutual Interest, "Investor claim against auditor dismissed where investor's own carelessness caused the loss," June 2009, CPA Mutual Insurance Company of America, Alachua, FL, http://www.cpamutual.com/.

The borrower went bankrupt shortly after the loan was made.

The investor group sued the auditor. The court noted that by the time the 2003 audit was issued, the borrower had continued as a going concern for more than a year, and the auditor had no obligation to make a going concern determination beyond one year under GAAS.

The court also found that the auditor was not obligated to include a subsequent events note about the changes in the 2004 statements since that information had no effect on any part of the task they were hired to complete (i.e., an unqualified audit of the 2003 financial statements).

The claims against the auditor were dismissed. But what if the “task” the auditor was retained to perform had not been clearly defined in advance?

A clear, defined scope of engagement, and staying within that scope in your audit work, can protect you in a third-party lawsuit. Some auditors have gone so far as to include in the bound audited financial statements a separate page that makes third-party users subject to the terms of the engagement letter.

Click here for the complete article.

From Of Mutual Interest, “Investor claim against auditor dismissed where investor's own carelessness caused the loss,” June 2009, CPA Mutual Insurance Company of America, Alachua, FL, http://www.cpamutual.com/.