Crow Corporation, a public company, has set up a number of limited partnerships to pursue some risky development projects. The limited partnerships borrow money from various financial institutions 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. These percentages are set out 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 an 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 shareholders’ 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 consulting 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 20X0 consolidated financial statements. During 20X1, adverse events resulted in Crow’s being unable to meet its obligations under the loan guarantees and it went bankrupt.
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.