Consider the following situation. The board of directors of a major airline promotes one of its marketing vice presidents to the position of president and CEO. Included in the compensation package is a large salary increase and a bonus based on accounting ratios such as return on equity. Before accepting the job, the vice president consults the audited financial statements of the company to determine the prospects for bonuses. Seeing a reasonably well-performing company, the vice president accepts the job and promptly puts a down payment on a large home in a wealthy part of town and signs a hefty mortgage for the remainder.

About nine months into the new president's tenure, the airline undergoes a severe cash shortage due to soaring fuel prices and cutthroat competition at its major hub airports. Having already missed one interest payment, the bondholders are threatening to force the company into liquidation if it misses another. The executives face the following dilemma: Reduce fares and operate the airline at an accounting loss to preserve cash flow and to keep the airline afloat until conditions improve (even though doing so means they will see no bonus), or keep fares high and stretch payables (including the bond interest payments) to the limit so that they will get a bonus but will run the risk of bankrupting the airline.

The new president now realizes that buying an expensive home at this particular time may not have been a wise decision. In fact, when the board overrules the president and votes to lower fares, the president loses the bonus for the year and is forced to sell the new home at a large loss. However, on the advice of an attorney, the president sues the airline's auditors for not disclosing the extent of the company's vulnerability in the last set of financial statements and for allowing misleading financial data-the airline's supposed profitability-to appear in the company's annual report.

If you were the senior partner of the audit firm for this airline, how would you defend against the lawsuit? Specifically, discuss the merits of the defense strategies available to your firm that are noted in the text. Suggest a new defense.