Problem 4 3 Page 116 Scope Limitation Auditor

Problem 4 -3, Page 116 Scope Limitation, Auditor Independence Crow Corporation, a public company, has set up a number of limited partnerships to pursue some risky development projects. The limited partnerships borrow money form various financial intuitions to support the development projects, and Crow guarantees these loans. Crow’s interest in each limited partnership is set at a level just below the percentage that would require the partnerships, and their debts to be included in Crow’s consolidated financial statements. Theses percentages are set specifically in the professional accounting recommendations that form the basis of GAAP for the purpose of Crow’s financial reporting. Zilch Zulch, LLP (ZZ) has been the auditor of Crow since its incorporation thirty years ago. The current CFO of Crow was formerly and audit partner in ZZ and was in charge of the Crow audit for five years before Crow hired her as its CFO. Because of her familiarity with ZZ’s approach to setting materiality for its audits, the CFO was able to suggest the amount of a loan that could be guaranteed in each limited partnership without being material. If an individual loan was material, it would need to be disclosed as a contingency in Crow’s consolidated financial statements even if the partnership was not required to be consolidated. Approximately 1000 limited partnerships were set up, since a large sum of money was required to fund Crow’s development activities. Because of the way the limited partnerships were structured, none of them was consolidated and no disclosure of Crow’s loan guarantees to the partnerships was made in Crow’s 2000 financial statements, despite the fact that in total they exceeded the reported long-term debt and shareholder’s equity of Crow. Zero Mustbe, the audit partner in charge of the audit of Crow’s 2000 consolidated financial statements, was somewhat puzzled as to why there were so many limited partnerships, since only one development project was being undertaken. However, he was assured by Crow’s CFO that the structure was appropriate and in accordance with GAAP because, in her words, “It was all set up by financial engineers with Ph. D. s in ZZ’s accounting group. These people know all about GAAP and are much smarter that you are, Zero, so there is nothing to be concerned about. ” As a result of his audit work, Zero provided a clean audit opinion on Crow’s 20 X 0 consolidated financial statements, During 20 X 1, adverse events resulted in Crow’s being unable to meet its obligations under loan guarantees and it went bankrupt. Required: Comment on the adequacy of Zero’s audit, the independence and scope issues raised, and the appropriateness of issuing a clean audit report in this scenario. 1

The facts of the case are based on the Enron/Andersen situation. The accounting standards for "variable interest" entities have subsequently been expanded in both Canada and the US to close the "loopholes" that allowed Enron to avoid reporting material liabilities. Key issues raised in the case: • whether the auditor was qualified and technically proficient enough to assess the complex transactions and structures that Crow Corp. was entering into and how they were being accounted for • whether adequate audit procedures were performed to assess the impact of the limited partnership’s loan guarantees on the financial position of Crow Corp. is the Company's transactions and partnerships were "too complex" for the auditor to assess this would constitute a limitation on the scope of the auditors work, affecting the auditor's ability to issue a clean audit opinion • whether the auditor met the standard of due care. Though the financial reporting complies with the letter of GAAP, the auditor would still have a duty to assess whether or not the financial reports presented the substance of these transactions and commitments. The key principle of accounting for "substance over form" is relevant here, since it is the substance of the Company's financial transactions that is relevant to users of its financial statements. • on a broader level, what responsibilities do auditors have in situations where the requirements of GAAP are deficient in that they allow materially misleading information to be produced that technically complies with GAAP requirements. The auditors opinion is that the financial statements "present fairly in accordance with generally accepted accounting principles". Is it possible for statements to be "in accordance with generally accepted accounting principles" when they omit significant information that would very likely change users decisions and assessments? . Is the onus only on accounting standard setters to ensure the following GAAP always provides full and "fair" presentation? Or do auditors also have a duty to consider, even if the letter of GAAP has been complied with, whether the financial statements are still potentially incomplete or otherwise misleading to users? • there is a question about the auditor’s ability to independently assess management’s representations when the CFO is a former ZZ partner who was in charge of the Crow Co. audit for many years and knows the intimate details of the procedures that ZZ will be performing its audit • the auditors independence is also called into question when the auditor appears to need to rely on the expertise of client company personnel to establish whether companies reporting practices comply with generally accepted accounting principles. This becoming an important issue in the audit of accounting estimates including fair values. 2

Problem 4 -6, Page 117 Scope Limitation, Auditor Independence The following audit report was drafted by an assistant at the completion of the audit of Cramdon Inc. , on March 1, 20 X 5. The partner in charge of the engagement has decided the opinion on the 20 X 4 financial statements should be modified only with reference to the change in method of computing sales. Also, because of a litigation uncertainty, an uncertainty paragraph was included in the audit report on the 20 X 3 financial statements, which are included for comparative purposes. The 20 X 3 audit report (same audit firm) was dated March 5, 20 X 4, and on October 15, 20 X 4, the litigation was resolved in favour of Cramdon Inc. Auditor’s Report To the Board of Directors of Cramdon Inc. ; We have audited the accompanying financial statements of Cramdon Inc. , as of December 31, 20 X 4 and 20 X 3. These financial statements are the responsibility of the Company’s Management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. As discussed in Note 7 to the financial statements, our previous report on the 20 X 3 financial statements contained an explanatory paragraph regarding a particular litigation uncertainty. Because of our lawyer’s meritorious defence in this litigation, our current report on these financial statements does not include such an explanatory paragraph. In our opinion, based on the preceding, the financial statements referred to above present fairly, in all material respects, the financial position of Cramdon Inc. , as of December 31, 20 X 4, and the results of its operations and its cash flows for the period then ended in conformity with generally accepted accounting principles consistently applied, except for the changes in the method of computing sales as described in Note 14 to the financial statements. /s/ PA Firm March 5, 20 X 5 Required: Identify the deficiencies and errors in the draft report and write an explanation of the reasons they are errors and deficiencies. Do not 3 write the report.

Deficiencies and Errors in Audit Report 1. The audited financial statements are not identified by the proper names of the statements and the proper dates. 2. The date of the previous audit report is not given. 3. The description of the reason for the report change should not refer to "our attorney's meritorious defense. " 4. The substantive reason for changing the opinion is not given. 5. The phrase "based upon the preceding" in the opinion introduction is not appropriate and may be misinterpreted as some sort of qualification. 6. The opinion refers only to 2004 financial statements, but should refer to both 2004 and 2003. 7. The consistency phrase is based on the language superseded in 1990. A separate consistency paragraph is no longer required. 4

Problem 4 -18, Page 118 Going Concern Issue: PA is the auditor of Jayhawk Inc. Jayhawk’s revenues and profitability have decreased in each of the past three years and, as of this year end, 20 X 3, its retained earnings will fall into a deficit balance. Jayhawk's long-term debt comes due in 20 X 4, and its management is currently renegotiating the repayment date and terms with its bondholders. According to PA’s discussions with management, the renegotiation is not going well and there is a significant risk that the bondholders will put Jayhawk into receivership and liquidate its assets. Jayhawk’s CFO has provided draft 20 X 3 financial statements to PA that are prepared in accordance with GAAP. Required: a) Discuss the audit reporting implications of the preceding situation. b) Assume the long-term debt repayment date was not until 20 X 5. Would your response differ? 5

a) The case facts suggest considerable risk that the company is not a going concern. Preparation of financial statements in accordance with GAAP makes the assumption that the company is a going concern This means that it will be able to realize its assets and discharge its obligations under normal conditions and terms, without undue duress. When issuing the audit report, the auditor needs to be satisfied that presenting financial statements in accordance with GAAP is not misleading and that's disclosure regarding the going concern issues is adequate. In this case, the long term debt coming due in the following year would make difficult for the auditor to agree to financial statements prepared in accordance with GAAP Unless assurances can be obtained that the terms of repayment will be altered or extended so that the company has reasonable probability of meeting them. If there's a high probability that the company will go bankrupt, preparing financial statements on liquidation basis is more appropriate than GAAP. b) If the long term debt were not due until 20 X 5 there may be more probability that the company can survive through the current year, making presentation of financial statements under liquidation basis unnecessary. 6