Ronnie Maloney, an audit partner for Forrester and Loomis, a registered public accounting firm in Boston, just received a meeting request from Jack McDuff, the chairman of the audit committee of Digital Solutions, one of his clients. The audit committee wants to discuss the draft communication the firm prepared to meet its obligations under PCAOB AS 1301. Digital Solutions, a Fortune 1000 client, has expressed concerns over the skepticism raised by the firm over accounting policies. Moreover, McDuff was worried about the impact of critical audit matters included in the draft of the December 31, 2021, audit report. He claimed that publicly disclosing the critical audit matter would muddy the waters for investors as the financial statements for the year-ended December 31, 2021, were found to fairly represent the financial condition of the company in all material respects.

Maloney is the lead engagement partner on the Digital Solutions audit. He arranges a meeting with Haley Stone, another audit partner on the engagement team, to discuss McDuff’s request. They review the audit team’s findings about accounting policies. It seems there was concern about a related party transaction between the CEO of Digital and a vendor whereby Digital paid about 20 percent above market price for components received from the vendor. As a result, Digital’s net earnings for the year declined rather than increased, and earnings per share were $0.10 less than it would have been had the transaction been at arm’s length.

As to the critical audit matters, Maloney and Stone discussed an estimate Digital made of imputed interest on a noninterest-  bearing note from the same vendor for a piece of machinery that was recorded on December 30, 2021. The company used a 2 percent rate on the $400,000 five-year note and calculated the present value as $362,292. The entry recorded was:

Debit—Machinery .....................................           362,292
Debit—Discount   .....................................              37,708
Credit—Note Payable ..............................           400,000

Based on an analysis of the rate Digital would incur if it borrowed funds from another source, Maloney and Stone determined that 6 percent should have been used. That would have led to the following entry:

Debit—Machinery ...................................             298,904
Debit—Discount ......................................             101,096
Credit—Note Payable .............................             400,000

The future interest expense would be $63,388 less given the 2 percent rate, which had a material effect on future earnings. Furthermore, the difference was close to the amount of the “premium” Digital Solutions paid to the vendor for the components.

Questions

1. Given the facts of the case, what communications do you believe Forrester and Loomis should have made with the audit committee with regard to the transactions with the vendor to comply with PCAOB AS 1301?
2. How should Forrester and Loomis have determined whether to communicate the critical audit matter with the audit committee under PCAOB AS 1301?
3. Are the differences discussed in the case a matter of judgment or are there other factors at work? What concerns do you have about the audit risk and ICFR?
4. Do you believe financial statement fraud exists in this case? Explain why or why not.