XYZ Oil Co. had been a problem for its auditor, Joe Jones, CPA, for several years. The company's stock was traded in the over-the-counter market, and management was concerned with keeping net income as high as possible to support the stock price. Each year, the controller would refuse to record any of Jones's proposed entries if he could establish that they were not material. Accordingly, each year's net income was generally overstated by 5 to 10 percent, which Jones accepted on the basis that it was not material.
Of particular concern to Jones was a \(\$ 10\) million investment in an oil venture in South America; however, he had been unsuccessful to date in proving to the controller's satisfaction that a loss should be recorded on this investment.
During the current year's audit, Jones discovered a report indicating that the South American oil venture was worthless and had been for two years. When he discussed this report with the controller, the controller suggested that the investment be written off in equal amounts over the next 10 years to prevent a significant effect in any year and to prevent embarrassment or liability to Jones from disclosing that past financial statements were misstated. The controller stated that recognition of the loss in the current year would mean bankruptcy for XYZ Oil Co. and certain liability for Jones.

Required:

Answer the following questions.

a. Assume that the stock is being offered for the first time and the provisions of the Securities Act of 1933 apply. If the investment was written off in 10 installments and the company went bankrupt in one year, what case would investors who lost money have against the auditor?

b. Assume the same situation as in (a) above. How might the auditor prove that the investor losses were caused by other factors?

c. Assume the same situation as in (a) above. In your opinion, would the auditor have a due diligence defense against the charge of ordinary negligence? Give reasons for your answers.

d. Assume that the stock has been on the market for several years and that the provisions of the Securities Exchange Act of 1934 apply. If the investment was written off in 10 installments and the company went bankrupt in two years, what conditions would have to exist for investors who lost money to prove scienter?

e. Taking the case situation as stated, give reasons why the auditor should accept the controller's solution. What liability does he face if he does accept it? Give reasons why the auditor should not accept the controller's solution. What liability does he face if he does not accept it?

f. What should the auditor do? Give reasons for your answer.