Hide-It (HI), a family-owned business based in Tombstone, Arizona, builds custom homes with special features, such as hidden rooms and hidden wall safes. Hide-It has been an audit client for three years. You are about to sign off on a “clean” opinion on HI’s current annual financial statements when Art Hyde, the VP-Finance, calls to tell you that the Arizona Department of Revenue has seized control of a Hide-It bank account that includes about $450,000 of company funds; the account is not currently recorded in the accounting system and you had been unaware of it. In response to your questions about the origin of the funds, Art assures you that the funds, though not recorded as revenue, had been obtained legitimately. He explains that all of the money came from separately billed but unrecorded change orders to items in contracts completed before you became HI’s auditor, and before he or any members of current management became involved with the company. You subsequently determine that there is insufficient evidence to allow you to reconstruct the nature of these cash transactions, although the following analysis is available from the Arizona Department of Revenue:
Deposits 1/17/X2–12/3/X4 ...... $455,000
Interest earned 1/2/X2–12/31/X8 .... 95,000
Withdrawals 2/12/X3–4/7/X7 ....... (100,000)
Balance 12/31/X8 ........... $450,000
Art also informs you that HI has agreed to pay a combined tax and penalty of 12 percent on the total funds deposited within 120 days as required by a recently enacted rule that provides amnesty for tax evaders. Furthermore, he states that negotiations with the Internal Revenue Service are in process.
a. The professional standards define errors as unintentional misstatements or omissions of amounts or disclosures in the financial statements. Is the situation described an error?
b. The professional standards state that fraud relates to intentional misstatements or omissions of amounts or disclosures in the financial statements. Misstatements due to fraud may occur due to either (a) fraudulent financial reporting or (b) misappropriation of assets.
Does the situation appear to be fraud? If so, is it fraudulent financial reporting, misappropriation of assets, or both?
c. The professional standards outline certain auditor responsibilities relating to identifying client noncompliance with laws and distinguish between laws with a “direct effect” on the financial statements and other laws. Does the situation herein relate to noncompliance with laws as discussed within the auditing standards? If so, is the noncompliance related to a law with a direct effect on the financial statements or another law.
d. Should the CPA firm resign in this situation? If the decision is not clear-cut, what additional information would you desire before deciding?