Question

Jones, CPA, audits a number of public-companies. During the past year, some deficiencies with respect to audits conducted for two of Jones’s clients in the software industry (SoftWare and ExternalDrive) were identified. These deficiencies related to Jones’s audit procedures used to evaluate the revenue recognized by these clients. Some pertinent facts in each of these audits are summarized as follows:
SoftWare. In 2014, SoftWare issued securities to investors in an initial public offering with an average offering price of $ 50 per share. Jones audited the financial statements, which were later determined to have overstated revenues through premature revenue recognition. The net effect on SoftWare’s operations was an overstatement of revenue by 25 percent and an overstatement of net income by 63 percent. Following the issuance, the market value of SoftWare’s shares declined to $ 15 per share.
ExternalDrive. ExternalDrive has been a client of Jones for five years and has been pub-licly traded throughout that entire period. In 2014, ExternalDrive’s Form 10- K revealed revenues of $ 25 million, net income of $ 8.5 million, and earnings per share of $ 1.40, all of which exceeded prior- years’ results and analysts’ estimates. ExternalDrive’s financial statements were subsequently found to have overstated revenues by $ 2.25 million, which reduced reported revenues and earnings per share by 11 percent and 24 percent, respectively. Following the revelation of these misstatements, ExternalDrive’s stock price declined from $ 18 per share to $ 9 per share.
You have been asked to defend Jones in legal actions involving shareholders of both companies and have engaged an auditing expert to evaluate Jones’s performance. After reviewing the audit documentation and related professional literature, she concluded that Jones’s performance was likely in violation of generally accepted auditing standards; how-ever, it did not rise to the level of being considered “reckless” and it does not appear that Jones was aware of the departures from GAAP. In addition, although unrelated to Jones’s audit, she observed that the market price of software companies had declined in a similar manner to that of SoftWare and ExternalDrive because of overall economic conditions.

Required:
a. Which statute would govern Jones’s liability to shareholders of SoftWare? ExternalDrive?
b. What would shareholders of SoftWare and ExternalDrive need to demonstrate prior to bringing suit against Jones?
c. Based on the case facts as described, what possible defense(s) would you recommend to Jones in each of these situations?
d. Assume that these two cases went to trial and Jones’s performance was deemed to be “reckless” in nature and that Jones possessed scienter. How does this change the likelihood of a favorable outcome for Jones?



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  • CreatedOctober 27, 2014
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