Case Analysis

The Case Analysis should be typed & single spaced. Each student must submit his/her own Case Analysis. The Analysis will be graded based upon the strength of the positions presented. Please provide references to any appropriate materials including course handouts, the textbook and professional pronouncements. There are 4 separate parts to this assignment: (Assume all companies are privately held)

Going Concern

Subsequent Events

Loss Contingencies

Related Parties, Whistleblower and Fraud

Other Comments:

All 4 parts above are equally weighted

Please start your response to each of the 4 parts on a separate page

Please do not copy the facts I presented in this Case Analysis and merely type your response below each part. Your case analysis should represent your response to the stated requirements of each of the 4 parts.

Part 1. Going Concern

Facts:

There are two affiliated Companies: a Plumbing Supplies Wholesaler (PS) and a Heating and Air Conditioning Wholesaler (HVAC); HVAC is 51% owned by Sister A (A) and 49% owned by Sisters B (B) and C (C); PS is 51% owned by B and C and 49% owned by A. Both PS & HVAC have December 31st year-ends.

HVAC has been in business for over 30 years and has always been very profitable.

PS sells imported merchandise which is at the low end of the market. PS has been in business for 10 years. For the first 7 years PS operated about breakeven; since then, PS has had increasing losses 2018 had a modest loss while 2019 and 2020 had very significant losses. PS has been losing money because of intense competition in the plumbing supply industry. In addition, PS has sustained a much higher than normal rate of return of defective merchandise. For calendar 2019 and calendar 2020 PS suffered recurring losses from operations and had a net capital deficiency.

Starting in 2018, PS received significant financial support from HVAC in the form of cash advances.

PS and HVAC have a joint asset-based lending agreement with a strong prominent Bank. Borrowing capacity fluctuates based upon eligible collateral of each Company (primarily inventories and accounts receivable). PS has only modest borrowing capacity remaining on its portion of the lending arrangement.

Your Audit Firm is currently auditing both PS and HVAC for the year ended December 31, 2021. Preliminary numbers per the August, 2021 client prepared financial statements show HVAC is quite profitable again but PS has significant losses and a net capital deficiency.

Sisters B & C the majority owners of PS -- have been working to put its products in two additional home improvement chains to bolster its sales and improve profit margins.

Sisters B & C have also hired a new Quality Control Manager and established improved Quality Control procedures to reduce returns of defective merchandise.

Sister A has expressed concern over the ongoing necessity of HVAC providing financial support to PS. All 3 Sisters acknowledge that PS can only survive in 2022 and beyond if it continues to receive financial support from HVAC.

The audited financial statements for both PS and HVAC are due 90 days after the 12/31/2021 year end i.e., 3/31/2022. Your audit firm intends to release both sets of these audited financial statements on or prior to this due date.

Substantially all of the work for the 2021 audits will be completed by February 15, 2022.

Part 1 Going Concern (continued)

Required:

State whether you believe there is or is not substantial doubt about PSs ability to continue as a Going Concern. Provide your supporting arguments, specifically addressing:

Conditions and Events

Managements Plans

Stating that you believe there is substantial doubt means that your Audit Firms Independent Auditors Report for the year ended December 31, 2021 will include an emphasis of a matter paragraph with the supporting footnote. (There is no need to formally draft the paragraph & supporting footnote.)

Stating that you believe there is not substantial doubt means that your Audit Firms Independent Auditors Report for the year ended December 31, 2021 will not include an emphasis of a matter paragraph but the Audited Financial Statements will include a footnote describing the conditions and events and how managements plans alleviated the conditions and events. (There is no need to formally draft the footnote.)

Part 2. Subsequent Events

Facts:

You are performing an annual audit of a company with a December 31, 20X1 year-end. Your firm is planning to complete the audit on March 1, 20X2 and release the report on March 31, 20X2. On March 15, 20X2, two material subsequent events occur:

A fire caused extensive damage to the Companys manufacturing plant in New York.

A large customer went bankrupt. At December 31, 20X1, the Company had a receivable of $3,000,000 from this customer; at December 31, 20X1 the Company had established an allowance for doubtful accounts of $1,200,000 for this customer.

Required:

Explain whether each subsequent event is a Type 1 or Type 2 Subsequent Event.

What is the impact of each subsequent event on the companys audited financial statements for the year ended December 31, 20X1? Be specific as to whether (a) there will be an adjustment which will cause the companys balance sheet and / or income statement to change plus footnote disclosure, (b) there will only be footnote disclosure, or (c) there will be no impact to either the financial statements or the footnote disclosures.

How should your Audit Firm date its audit report?

Part 3. Loss Contingencies

Facts (Each of the two dots concern different Companies):

Before year end, a Companys truck driver is involved in a three-vehicle wreck. One of the injured passengers in a separate vehicle is suing everyone involved. The Company is being sued for $2 million. The Company has $1 million of liability insurance. The Companys outside legal counsel states in writing to the Company that it is unable either to express an opinion as to the likelihood of an unfavorable outcome or the amount of any potential loss.

A different Company has been involved in ongoing litigation with one of its competitors for many years. Before the end of the year being audited, the outside legal counsel sends a letter to the Companys owners stating that it is probable that the Company will have to make a payment to the plaintiff to settle the litigation. However, the law firm could only say that it is probable the Company will have to pay somewhere between $100,000 and $300,000 in the settlement.

Required: For both of the Companies discussed above, answer two questions:

Should the Company record a loss contingency in its year end balance sheet and income statement, and if so, for how much?

Should the Company disclose this matter in the footnotes to the Companys financial statements at year end?

Part 4. Related Parties, Whistleblower and Fraud

Facts:

A not-for-profit foundation (ABC) was formed many years ago to invest in real estate in resort areas (e.g., Las Vegas, Arizona, California, etc.). It sells investment agreements and mortgage-backed securities to its members. ABC also gained approval to serve as a trustee for individual retirement accounts (IRAs). A director of ABC incorporated an affiliated entity, (DEF). Since DEF is simply an affiliate, it is not consolidated into ABCs financial statements.

Unfortunately, the real estate market begins to decline significantly; to hide its losses, ABC begins selling overvalued land to DEF at inflated amounts (the sales are financed by intercompany receivables and payables between the two entities). The bottom line is that DEF was formed to buy and hold ABCs nonproducing and overvalued investments in real estate so that ABC could avoid recording losses (write-downs) on its real estate.

The Audit Firm (AF) of ABC has conducted the annual audits of ABC since it was formed.

AF has been retained again to audit ABCs financial statements for calendar 20X1.

During July, 20X1, Joe Green, the client chief accountant for ABC resigns over his concerns about the overvalued real estate and inability of DEF to pay ABC the millions of dollars it owes for the purchase of real estate.

AF commences the planning phase of its audit of ABC in October, 20X1. During the preliminary fieldwork in October, 20X1 Joe Green arranges to have lunch with the Audit Firms Manager and Senior Auditors. Joe expresses his concerns to the Auditors (see prior bullet point); Joe also urges the Auditors to obtain copies of the unaudited financial statements of DEF as well as much other documentation from the management in order to get the big picture of the risk associated with the two entities.

The Auditors met with the engagement Partner; the team dismisses Joe Greens concerns as merely those of a disgruntled former employee.

The Audit team expanded its procedures and asked the management of ABC for significant amounts of documentation; the management provided only a portion of the requested information.

The Audit Firm eventually releases the audited financial statements in March, 20X2, without thoroughly addressing the concerns Joe Green raised.

During September, 20X2, the ABC Foundation declares bankruptcy, investors lose millions of dollars and there is a significant lawsuit against the Audit Firm.

Part 4. Related Parties, Whistleblower and Fraud (continued)

Required:

What are the major things the Audit Firm did wrong? Provide your supporting arguments, specifically addressing:

Risk presented by significant related party transactions

Did the Auditors address the whistleblowers concerns properly?

Assuming the Auditors concluded that the whistleblowers concerns had merit, who should they have met with?

Do you believe there was fraud?

How would you characterize the tone at the top?

Did Audit Firm personnel conduct themselves with the attitude of professional skepticism?