Case 6-6 Kay & Lee, LLP

Case 6-6 Kay & Lee, LLP 1.What would the bank have to prove to successfully bring a lawsuit against Kay & Lee? The bank would have to prove that there was a false representation by Kay & Lee, that the firm had knowledge of the falsehood, that the bank relied on the false information, and it suffered damages. These are the common law standards for asserting legal liability against auditors. The principle of auditor liability for ordinary negligence to third parties is expanded by the American Law Institute's Second Restatement of the Law of Torts. Restatements of law are compilations of the majority view of the common law of the states on various topics such as contracts and torts and are meant to serve as guides for judges when they are issuing opinions in which there are common law issues. The Restatement approach to third-party liability, also known as the foreseen third-party approach, expands auditor liability for ordinary negligence to include third parties who are foreseen users of the audited financial statements. Under the Restatement ruling the bank is a foreseen third-party user and the auditors have an ordinary negligence liability beyond privity. 2.What defenses might the auditors use to rebut any charges made about their (deficient) audit? The auditors would need to assert due diligence, but it seems a stretch given the facts of the case. The auditors asserted that there was no way for them to know that the client included in the inventory account $1 millions of merchandise in transit to a customer on December 31, 2015. The shipping terms were unclear, so the auditors accepted management's representations in that regard (FOB Destination). Auditors should not accept management's representations in lieu of documentary evidence to support the in-transit inventory. One way to do this is look for subsequent data to verify the FOB terms. It should appear on a receiving report from the customer. The auditors can also contact the customer directly to confirm the shipping terms. In no circumstances should an auditor allow $1 million to be included in inventory when it is not physically observed unless the client can demonstrate with documentation the FOB terms. As for the receivables, the auditors claimed the client falsified confirmations by sending them to a post office address, retrieving them, and then confirming the stated balances. The auditors seem to have weak internal controls with respect to the confirmations. The use of a post office address is a red flag. Moreover, the client should not be allowed to process the confirmations. The auditor should send them out with a confirmation letter under its own letterhead. 3.Critically evaluate the auditors' statements about the inventory and receivables with respect to generally accepted auditing standards and the firm's ethical responsibilities. In addition to the discussion above, the auditors lacked the proper level of care to meet generally accepted auditing standards. This includes the failure to exercise the appropriate level of skepticism that would be expected in an audit under GAAS. As for ethical responsibilities, the auditors violated the due care standard; they lacked objectivity in examining evidence and drawing conclusions about the inventory and receivables; and they compromised their integrity by not critically examining management's representations. The auditors have violated the public trust by placing the client's interest ahead of the public interest.