The Lakeside Company:

Auditing Cases
SOLUTIONS MANUAL 12e
Table of Contents
John M. Trussel and J. Douglas Frazer
A Note on Ethics, Fraud and SOX Questions
2
A Note on Research Assignments
3
Introductory Case
5
Case 1

14

Case 2

22

Case 3

33

Case 4

44

Case 5

58

Case 6

74

Case 7

82

Case 8

92

Case 9

101

Case 10

110

Case 11

116

Case 12

125

Case 13

136

A NOTE ON ETHICS, FRAUD, AND SOX QUESTIONS

The Lakeside Company: Auditing Cases, 12th edition, has been updated
in light of the accounting scandals of the early 2000s, the passage of the
Sarbanes-Oxley Act of 2002, and the renewed interest in ethics within
the accounting and auditing profession.
Sarbanes-Oxley issues have been incorporated in two ways. First, case
content has been altered to include Lakesides consideration of financing
expansion through an initial public offering, and the resulting impact
such a decision would have on Lakeside and on Abernathy and
Chapman, CPAs. Second, the discussion questions and exercises have
been expanded to include consideration of Sarbanes-Oxley and new
auditing and independence standards, both by adding a section in the
end-of-chapter material and by reference in the other questions where
appropriate.
Ethics questions are now specifically identified with an ethics logo. The
ethics questions are often open ended, and this solutions manual does
not try to give exact answers to these questions. Rather, we intend to
give some ideas for classroom discussion, and to help with student
research on these questions.
Fra
Fra
ud
ud

Fraud questions are now specifically identified with a fraud triangle.

A NOTE ON RESEARCH ASSIGNMENTS

The "Apply Your Research" and "Consulting Partner Review" assignments
included at the end of several cases do not lend themselves to definitive
solutions that could be included in an instructor's manual. The assignments are
simply not intended to be exercises in arriving at a predetermined answer.
Rather, the applications of the suggested readings have the following objectives:
-

To provide a means for improving the writing skills of students. From all
reports, accounting majors too often leave college lacking in the basic
ability to compose and construct sentences and paragraphs. Accounting
and auditing (especially as one moves up in an organization) obviously
require skills other than the purely quantitative.
Memos, reports,
footnotes, audit and accounting guides, etc., all require accountants and
auditors to be effective communicators of the written word. Indeed, the
instructor may want to team up with a member of the school's English or
communications department to enhance the effectiveness of these
assignments. The auditing instructor can then evaluate the technical and
research portions of the assignment, while the English instructor would
make suggestions as to grammar, syntax, construction of sentences and
paragraphs, logic of the thought process, etc. As a preliminary step, the
instructor may want to assign articles such as "Word Crunching: A Primer
for Accountants" from the March 1990 issue of the Journal of
Accountancy.

To introduce students to accounting and business journals as well as other

important publications. After college, students must be able to "keep
current" or their effectiveness will quickly decline. In most cases, this
continuation of their education is provided by the regular reading of
publications such as The Wall Street Journal, Journal of Accountancy,
CPA Journal, and Forbes. These assignments require the students to
begin reading these journals prior to graduation. The students should
become comfortable with their ability to understand and use the materials
in professional publications. In addition, real-world aspects of many
accounting issues are presented through these various readings.

To develop the students' ability to derive viable solutions to auditing

problems. Unfortunately, students in college often come to the belief that
all auditing issues can be resolved simply by applying the
pronouncements of various authoritative bodies. Textbooks too often
present problems that have one ultimate answer. However, in many real
cases, no definitive solutions actually exist. Thus, when faced with such
problems, students must be capable of reviewing the available literature
and then using that information as a basis for arriving at a workable

decision.
-

To promote auditing research. In most of these library assignments,

students are provided with one or more resources as starting points for their
research. However, the instructor should always push the students to look
for more and different types of information. The ultimate purpose of these
assignments is to force the students into the library and online sources to do
the searching for themselves. One excellent method of introducing the
assignments is to use some class time to illustrate the various methods of
research that are available to them, including electronic resources, such as
the following:
o http://www.sec.gov
o http://www.PCAOBUS.org
o http://www.AICPA.org
o http://www.FASB.org
o Your state society of CPAs also operates sites.
If possible, a business librarian or a research librarian may be enlisted to
discuss the various search techniques that can be used at the school's
library for research purposes. Developing the ability to find information is
one of the most important skills that can be achieved by an accounting
major.

INTRODUCTORY CASE
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
(1)
The staff auditor performs many of the detailed audit procedures, such as
preparing and controlling accounts receivable confirmations. In general the work
of the staff auditor is controlled by the audit program and supervised by the
senior auditor.
The senior auditor coordinates the audit at the client's location and performs
many of the more difficult audit procedures, such as analytical review
procedures. Usually the detailed work performed by the audit senior is more
sophisticated and requires the experience gained by someone holding that rank.
The audit senior is supervised by the manager.
The manager and the partner have supervisory roles. Managers and partners
often have more than one audit team under supervision at any given time.
The partner is the person who has responsibility for determining whether the
firms signature can be attached to audit report.
(2)
The partner-in-charge of an audit is the definitive decision-making position on the
audit team. Although the manager and senior auditor make several decisions,
they must get ultimate approval from the partner-in-charge of the audit. The
consulting partner's role is to add a further degree of objectivity to the audit. The
consulting partner reviews and critiques certain crucial decisions made by the
audit team, such as the final audit report. The partners should be rotated to
assure independence.
Sarbanes-Oxley (SOX-S203) requires the identification of a Leading Partner and
a Reviewing Partner. Both partners must be rotated every five years.
(3)
An accounting firm is a business like any other, and its management must
recognize that a marketing strategy is probably necessary to generate a
continual flow of sufficient operating revenues. However, in the accounting
profession, disagreement exists as to the extent that such marketing should take.
In the past, overt marketing was not permitted since it was considered to be
unprofessional. This position was supported based on the reasoning that a firm

should be selected based solely on the quality of its service. No reliable system
existed, though, for conveying such information to potential clients. Hence, firms
with many clients tended to remain large, while smaller firms often found growth
to be nearly impossible. In the free market system espoused by the United
States, restrictions on such practices as advertising and solicitation were
inevitably overturned. Over the past three decades, attitudes toward marketing
have changed dramatically as competition has become much more intense.
Advertisements by CPA firms in newspapers and magazines are now common.
Newsletters such as that distributed by Abernethy and Chapman are also
frequently used to increase a firm's name recognition in the business community.
In the current world of business, some type of marketing strategy seems
imperative if an accounting firm is to compete. Whether that marketing should
extend to formal advertising is often a question of firm policy. Most importantly,
the firm must ensure that potential clients know of its presence and the services
that it offers. A client will probably not select a CPA firm based on advertising.
However, the client may initially become aware of the firm only through some
type of marketing.
Interestingly, some members of the accounting profession view marketing as
having had a negative impact on the profession as a whole. Price competition for
new clients is often associated with the marketing of a firm. These critics assert
that lowered fees result in sloppy and hurried audit work that can decrease the
overall reputation of the profession. (Additional resources discussing this issue
can be found in the "Suggested Readings" at the end of this case.)
(4)
A national or international CPA firm might consider acquiring Abernethy and
Chapman for several reasons:
-

Although only a regional firm, Abernethy and Chapman apparently has a

client base that includes a number of large clients in several different
industries. By acquiring the local firm, the larger organization will
frequently be able to retain these customers, thus increasing its own client
list.

The larger firm may be interested in moving into this geographical region,
and buying the local firm will provide an instant base on which to build a
practice in the area.

The larger firm may already have an office in this location and feels that
combining the practices will reduce expenses.

Abernethy and Chapman might have several reasons for viewing an acquisition
in a favorable light:

Frequently, the purchase price will be a considerable amount of money

because of the goodwill inherent in an established accounting firm. The
offer to sell may be especially tempting if the partners are nearing
retirement age and the future of the firm appears uncertain.

The smaller firm may have trouble dealing with increased competition from
bigger firms. Often clients may decide that a change to a nationally known
CPA firm should be made to add extra stature to the audit report. If a local
organization has only a few large clients, it cannot economically afford to
lose a significant amount of revenue in this way. A merger may help the
firm to keep its clients.
-

The regional firm may also desire the additional backup services offered by
large organizations. National CPA firms usually have experts in many
industries as well as in specific audit areas who are available for
consultation. In a smaller firm, this degree of assistance is not always
available when a difficult accounting or auditing problem is encountered.

PCAOB registration and SEC practice presents hurdles that might be

overcome through a merger with a larger firm.

Many mergers have occurred in the auditing profession during recent years.
Critics assert that this trend has reduced competition and will inevitably lead to a
decrease in audit quality. Proponents counter by stating that mergers lead to
more efficient operations and, thus, improve audit quality. Obviously, mergers
will create a drastic change in the profession as more of the smaller firms
disappear. Audit work in this country may possibly become concentrated within
the largest CPA firms. Whether this result is good for the auditing profession may
be merely a question of perspective. To the smaller firms struggling to survive
and grow, the mergers are usually considered a threat as the bigger firms
become more competitive. To the larger firms, the chance for continued growth
and more efficient operations is always an important objective.
See the Sarbanes-Oxley section below for a follow-up question related to the
impact of SOX on the auditing profession.
(5)
Moving staff from one area of a CPA firm to another can cause the perception of
an independence problem. For example, the appearance of independence may
be in question if a member of the consulting staff helps to install a new
accounting system for a client and then she moves to the audit staff to audit this
same client.
See the Sarbanes-Oxley section below for a follow-up question/answer related to

the impact of SOX, in particular the list of proscribed activities for registered CPA
firms.
SUGGESTED ANSWERS TO EXERCISE
(1)
The question requires students to address all the elements of a quality control
system, as included in Statement on Quality Control Standards No. 2. In some
cases, students should recognize the need for additional information.
To:
DeAnna Malott
From:
Date:
Re: Quality Control Standards at Abernethy and Chapman
Overview: I was employed by the firm of Abernethy and Chapman to review the
quality control standards within the firm. The following represents my evaluation of
these standards according to the six elements required by the AICPA.
Evaluation:
Standard
Leadership
responsibilities

Relevant
ethical
requirements

Existing
Procedures

Recommendations

The case does

The firm should have
not explicitly
policies in place that
address this
establish the tone at
standard.
the top for quality
However, the firm within the firm.
has some items
in place, such as
a partner
dedicated to
monitoring the
system.
Firm requires its The AICPA's Code of
employees to
Professional
sever all
Conduct does not
financial ties to
require all
audit clients.
employees to sever
ties with all audit
clients. For
example, staff
auditors not working
on a particular

Additional
Information
Needed
What specific
policies does the
firm have to
demonstrate
leadership
responsibilities for
quality within the
firm?

The case does

not mention
spouses or
dependents of
the employees.
Spouses and
dependents must
also be
independent, as
defined by

Acceptance
and
continuation of
clients

Human
resources

engagement need
Section 100-not sever ties. In this Rule 101 of the
case, the firm
Code. In this
exceeds the
case, the firm
minimum level of
should
conduct for
strengthen its
independence.
requirements.
The case does not
How does the
address other ethical
firm meet other
requirements.
ethical
requirements?
This case does
It is important to

not address this

have many controls
control standard.
when considering a
It does note that
potential client, so
the firm is
that the potential
attempting to
risks of legal
gain more clients exposure are not too
through an
great. (Note: This
extensive
topic is addressed in
marketing
Case 2.)
program.
The firm
This appears to be a
considers
reasonable quality
experience and
control.
technical
competence in
assigning
personnel to
audit
engagements.
The firm hires
This seems to be a
only college
more than adequate
graduates with a
quality control
major in
procedure. In fact,
accounting and
many firms hire
requires that
professionals, such
each
as computer experts,
professional sit
who were not
for the CPA
accounting majors.
exam within one
year of
employment.
The firm requires Many states require

40 hours of
continuing
education per
year; however,
the case does
not address the
issue of the type
of education
(e.g., accounting
and auditing
versus other
courses).
The firm
promotion
procedures
consider
seniority and
technical
competence,
which seems to
be an adequate
control.

Engagement
performance

that a minimum
number of continuing
professional
education hours be
in accounting- and
auditing-related
courses.

The firm requires The firm should have

that a consulting
a mechanism for
partner be
consultation with
assigned to each authoritative
audit
literature and other
engagement.
sources, including
The consulting
outside experts, if its
partner assures
professional staff
that the work
lacks expertise in a
performed by the particular area.
engagement
team meets
applicable
professional
standards and
regulatory
requirements.
This helps to
ensure
objectivity, as the
consulting

The case does

not address the
issue of
assessment of
technical
competence.
Many firms
require a written
assessment of
performance
after each
engagement.
It is not clear from
the case how the
team documents
the work
performed on an
audit
engagement. An
evaluation of
audit
documentation is
necessary for
complete
evaluation of the
quality controls.

auditor is not a
direct part of the
engagement.
The firm seems
to have a clear
chain of
command and
adequate
supervision on
the audit. The
staff auditors
report to the
senior auditor,
who in turn
reports to the
manager. The
partner-incharge has an
overall
supervisory
position.
Monitoring

The firm has a

partner, DeAnna
Malott, assigned
to monitor the
quality control
standards.

A comprehensive
system of
documentation of the
quality controls
should be developed.

The case does

not mention what
types of
documents are
required to
support these
controls, but
documentation is
extremely
important. For
example, many
firms require
employees to
submit a listing of
all financial ties
to companies so
that the firm can
monitor its
independence.

Conclusion: The firm has many policies related to quality control standards.
However, the firm has room for improvement in many of the areas, particularly in
the acceptance and continuation of clients.

SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTIONS

(1)
Students should be encouraged to visit the
(http://www.pcaobus.org) when answering this question:

PCAOB

website

Registration CPA firms must be registered to be associated with public

companies. The application for registration is an online process. There is a fee, it
is small relative to other costs of maintaining the registered status and changing
the nature of the firm to comply with PCAOB rules. Here is the fee structure from
their website:

Inspection - The PCAOB operates a system of inspections and publicizes

the results, per its authority under the SOX Act:
The Act provides that an inspection shall include at least the
following three general components:
An inspection and review of selected audit and review
engagements of the firm, performed at various offices and by
various associated persons of the firm;
An evaluation of the sufficiency of the quality control system of
the firm, and the manner of the documentation and
communication of that system by the firm; and
Performance of such other testing of the audit, supervisory,
and
quality control procedures of the firm as are necessary or
appropriate in light of the purpose of the inspection and the
responsibilities of the Board.
Regular inspections are on a three-year cycle, although smaller
firms may be less frequent. Special inspections can be required by the
PCAOB.
-

Maintenance of independence under PCAOB rules and SOX-

proscribed activities:
Proscribed activities under SOX (section 201):
Section 201: Services Outside The Scope Of Practice Of Auditors; Prohibited
Activities.
It shall be "unlawful" for a registered public accounting firm to provide any nonaudit service to an issuer contemporaneously with the audit, including: (1)
bookkeeping or other services related to the accounting records or financial
statements of the audit client; (2) financial information systems design and
implementation; (3) appraisal or valuation services, fairness opinions, or
contribution-in-kind reports; (4) actuarial services; (5) internal audit outsourcing
services; (6) management functions or human resources; (7) broker or dealer,
investment adviser, or investment banking services; (8) legal services and expert
services unrelated to the audit; (9) any other service that the Board determines,
by regulation, is impermissible. The Board may, on a case-by-case basis, exempt
from these prohibitions any person, issuer, public accounting firm, or transaction,
subject to review by the Commission.
It will not be unlawful to provide other non-audit services if they are pre-approved
by the audit committee in the following manner. The bill allows an accounting firm
to "engage in any non-audit service, including tax services," that is not listed
above, only if the activity is pre-approved by the audit committee of the issuer.
The audit committee will disclose to investors in periodic reports its decision to
pre-approve non-audit services. Statutory insurance company regulatory audits
are treated as an audit service, and thus do not require pre-approval.
The pre-approval requirement is waived with respect to the provision of non-audit
services for an issuer if the aggregate amount of all such non-audit services
provided to the issuer constitutes less than 5% of the total amount of revenues
paid by the issuer to its auditor (calculated on the basis of revenues paid by the
issuer during the fiscal year when the non-audit services are performed), such
services were not recognized by the issuer at the time of the engagement to be
non-audit services; and such services are promptly brought to the attention of the
audit committee and approved prior to completion of the audit.
The authority to pre-approve services can be delegated to 1 or more members of
the audit committee, but any decision by the delegate must be presented to the
full audit committee.
Partner rotation - The rotation of the lead partner and the reviewing partners
are required by the SOX Act.
Quality Control Standards Registered firms must maintain the SEC
practice requirements:

AICPA Quality Control Standards for public company audits are summarized
at: http://cpcaf.aicpa.org/Resources/