Question

Hide-It (HI), a family-owned business based in Tombstone, Arizona, builds custom homes
with special features, such as hidden rooms and hidden wall safes. Hide-It has been an audit
client for three years.
You are about to sign off on a “clean” opinion on HI’s current annual financial statements
when Art Hyde, the VP-Finance, calls to tell you that the Arizona Department of Revenue
has seized control of a Hide-It bank account that includes about $450,000 of company funds;
the account is not currently recorded in the accounting system and you had been unaware of
it. In response to your questions about the origin of the funds, Art assures you that the funds,
though not recorded as revenue, had been obtained legitimately. He explains that all of the
money came from separately billed but unrecorded change orders to items in contracts completed
before you became HI’s auditor, and before he or any members of current management
became involved with the company. You subsequently determine that there is insufficient evidence
to allow you to reconstruct the nature of these cash transactions, although the following
the analysis is available from the Arizona Department of Revenue:
Deposits 1/17/X2–12/3/X4 $455,000
Interest earned 1/2/X2–12/31/X8 95,000
Withdrawals 2/12/X3–4/7/X7 (100,000)
Balance 12/31/X8 $450,000
Art also informs you that HI has agreed to pay a combined tax and penalty of 12 percent on
the total funds deposited within 120 days as required by a recently enacted rule that provides
amnesty for tax evaders. Furthermore, he states that negotiations with the Internal Revenue
Service are in process.
a. The professional standards define errors as unintentional misstatements or omissions of
amounts or disclosures in the financial statements. Is the situation described an error?
b. The professional standards state that fraud relates to intentional misstatements or omissions
of amounts or disclosures in the financial statements. Misstatements due to fraud
may occur due to either (a) fraudulent financial reporting or (b) misappropriation of assets.
Does the situation appear to be fraud? If so, is it fraudulent financial reporting, misappropriation
of assets, or both?
c. The professional standards outline certain auditor responsibilities relating to identifying
client noncompliance with laws and distinguish between laws with a “direct effect” on
the financial statements and other laws. Does the situation herein relate to noncompliance
with laws as discussed within the auditing standards? If so, is the noncompliance related to
a law with a direct effect on the financial statements or another law.
d. Should the CPA firm resign in this situation? If the decision is not clear-cut, what additional
information would you desire before deciding?

Answer 1

Q.1 : The professional standards define errors as unintentional misstatements or omissions of
amounts or disclosures in the financial statements. Is the situation described an error?

Q.2 : Q.2 :The professional standards state that fraud relates to intentional misstatements or omissions of amounts or disclosures in the financial statements. Misstatements due to fraud my occur due to either (a) fraudulent financial reporting or (b) misappropriation of assets. Does the situation appear to be fraud? If so, is it fraudulent financial reporting, misappropriation of assets, or both?

Answer :

Ans: 1 : Not an Error

Ans 2 : fraudulent financial reporting

Fraud is a broad legal concept and auditors do not make legal determinations of whether fraud has occurred. Rather, the auditor's interest specifically relates to acts that result in a material misstatement of the financial statements. The primary factor that distinguishes fraud from error is whether the underlying action that results in the misstatement of the financial statements is intentional or unintentional. For purposes of the section, fraud is an intentional act that results in a material misstatement in financial statements that are the subject of an audit.

As stated by VP Finance this has been done prior to current management of the company however withdrawal has been carried out in the audit period of current management. Hence based on circumstance that this is getting reveled only after tax inquiry indicates that this were intentional act hence the misstatement is not due to error but it is due to fraud

Misstatements arising from fraudulent financial reporting are intentional misstatements or omissions of amounts or disclosures in financial statements designed to deceive financial statement users where the effect causes the financial statements not to be presented, in all material respects, in conformity with generally accepted accounting principles (GAAP).

Misstatements arising from misappropriation of assets (sometimes referred to as theft or defalcation) involve the theft of an entity's assets where the effect of the theft causes the financial statements not to be presented, in all material respects, in conformity with GAAP. Misappropriation of assets can be accomplished in various ways, including embezzling receipts, stealing assets, or causing an entity to pay for goods or services that have not been received. Misappropriation of assets may be accompanied by false or misleading records or documents, possibly created by circumventing controls.

In view of above it is fraudulent financial reporting

Q.3 : The professional standards outline certain auditor responsibilities relating to identifying client noncompliance with laws and distinguish between laws with a “direct effect” on the financial statements and other laws. Does the situation herein relate to noncompliance with laws as discussed within the auditing standards? If so, is the noncompliance related to a law with a direct effect on the financial statements or another law

AU-C Section 250 provides guidance on this.

The situation herein relates to non compliance with law as discussed within the auditing standards.This non compliance seems to be related to law with a direct effect on the financial statement because it seems that it is done to save the tax

Q.4 : Should the CPA firm resign in this situation? If the decision is not clear-cut, what additional
information would you desire before deciding?

Ans :

As per the case,the deposits were made when none of the members were involved in the company but the interest earned and the withdrawals were done during that period when they were all involved in the management which indicate that to some extent current management is intentionally party to the misreporting. However the management assures that they will pay combined tax and penalty as per required law.Therefore both these conditions should be considered before resigning.

; $100,000 might be misappropriation Direct effect b/c there is an adjusting entry If don’t trust client, could resign