Question

in preparing the Audit Inquiry Letter to Legal Counsel, the auditor can either work with Management to prepare & include a summary of pending or threatened litigation for counsel to review or simply ask the Legal Counsel to prepare the summary and evaluation of pending and threatened litigation. In professional practice, which is generally better and why? During class, we discussed the case involving Verity Distillery Company and Veritas Corporation (Related Parties). The President of Verity Distillery Company engineered a series of transactions between these two related entities. What was he trying to accomplish from a financial statement standpoint?

need all the answers

Answer 1

Answer to 1st Question :

In preparing the audit inquiry letter to Legal counsel, it is always better to work with the management to prepare & include a summary of pending or threatened litigation for counsel to review.

One of the most important reasons for it is that if a summary of cases for the legal counsel's reviews is not present, then the external legal counsel may not be encouraged to give an appropriate response to the auditors. What we have to understand is that it is not compulsory or mandated by the law for legal counsel to respond to the audit inquiry letter. Hence for convincing them to provide an appropriate and correct response, it becomes necessary to involve a list of cases on which we require their opinion.

Also it is more professional to include such a list which depicts the professionalism and attitude of organization. However one thing which is required to be ensured while preparing such a letter is that there should always be a sentence included in the letter which states as follows : "If there is any legal counsel you might have provided to the client for any case which is not mentioned in the aforesaid list, do let us know". This is very important because the management might hide some cases from the auditor involving huge litigation potential in order to hide such cases from the stakeholders.

Answer to 2nd Question :

Related party transactions are transactions which involve a high level of fraud risk. Since the parties are related, there is a high risk of manipulation in the entries for various reasons.

In the current scenario, the president of Verity Distillery Company has engineered a series of transactions between these two related parties. This could be a very serious indicator of potential fraud in the company. He could be trying to accomplish a number of things by making such transactions such as :

a) Increasing the revenue to improve profitability by showing sales from one related party to another related party at higher than fair value of goods/services provided.

b) Increasing the amount of expenses by charging more than the fair value in order to reduce the tax payable by any company.

c) Laundering money by engineering such transactions is also a possibility.

d) Evasion of taxes by hiding certain assets by engaging in transactions which in substance involves transfer of assets but the same has been made under some cover to hide the same.

All these transactions as mentioned above can have the motive of showing a better image of the company as it actually is or for evasion of taxes or for manipulation of accounts in any manner. ]

Such transactions are an important area for the auditor and the same should be given adequate consideration for testing. The auditor should test related party transactions in detail to ensure that they are at arms length value and there is no manipulation involved.