Question

You are a partner in the Denver office of a national public accounting firm. During the audit of Mountain Resources, you learn that this audit client is negotiating to sell some of its unproved oil and gas properties to SuperFund, a large investment company. SuperFund is an audit client of your New York office Mountain Resources acquired these properties several years ago at a cost of $15 million. The company drilled several exploratory wells but found no developable resources. Last year, you and Mountain Resources agreed that the value of these unproved properties had been "impaired” as defined in Accounting Standards Codification, section 932-360-35-11. The company wrote the carrying value of the properties down to an estimated realizable value of $9 million and recognized a $6 million loss. You concurred with this treatment and issued an unqualified auditors' report on the company's financial statements. You are now amazed to learn that the sales price for these properties being discussed by Mountain Resources and SuperFund is $42 million. You cannot understand why SuperFund would pay such a high price and you wonder what representations Mountain Resources may have made to SuperFun concerning these properties. The management of Mountain Resources declines to discuss the details of the negotiations with you, calling them "quite delicate and correctly pointing out that the future sale of these properties will not affect the financial statements currently under audit.

Answer 1

This case is closely modeled after the case of The Fund of Funds, Ltd., v. Arthur Andersen & Co. We did not suggest

reference material relating to this case because we have found that it totally dominates their conclusions; they

opt to avoid the $80 million judgment at all costs.There are several significant differences between our case and the Fund of Funds case, which may well affect the decision were our case brought before the same court. The most important difference is that our client companies have not signed any agreement regarding the prospective sales price of the properties. Hence, Mountain Resources cannot be deemed in violation of a contract. Also, the same key audit personnel audited Fund of Funds and King Resources Company. In our case, the two clients are audited by different offices of the same firm and, therefore, by entirely different personnel. Finally, in our case the auditors have previously approved a write-down of the carrying value of the unproved properties under FASB ASC 932-360-35. King Resources had not recognized any "impairment" of the properties involved in the Fund of Funds case.

a. The following arguments might be advanced in favor of advising Super Fund as to our opinion of the value of the properties:

• Mountain Resources may be perpetrating a fraud upon Super Fund. If we say nothing, we may appear to be aiding and abetting that fraud.
• If Super Fund pays an excessive price for the properties and subsequently must write them down to an estimated recoverable value, it will sustain a large loss. We have information that may prevent our client (Super Fund) from incurring such a loss. Remaining silent would constitute a lack of professional care with respect to Super Fund.
• Super Fund knows that we, as auditors for Mountain Resources, have information as to the fair value of these properties. Our silence may be viewed as tacit approval of the transaction.

In this situation, we have considerable evidence that the properties do not contain significant oil and gas reserves. This evidence was sufficient for us to agree that Mountain Resources should write these properties down to a carrying value of $9 million to avoid overstatement of assets. As we have knowledge of the impaired value of these properties, it would be difficult for us to allow Super Fund to not write the asset down to a similar amount.

• If we insist that Super Fund write these properties down to, say, $9 million, Super Fund will probably sue us and allege that our silence was the proximate cause of their loss.Our exposure appears to be approximately $33 million ($42 million – $9 million).

b. The following arguments might be advanced in favor of not offering advice to Super Fund:

• Giving Super Fund any information about these properties would violate our ethical responsibilities to Mountain Resources for confidentiality.
• The transaction price in the purchase or sale of assets is a managerial prerogative. It is inconsistent with the role of the independent auditors to intervene because they believe one or the other of the transacting parties is receiving a bad deal.
• We are not experts in the value of oil and gas properties, which is highly speculative by any standards. It may turn out that these properties are a bargain at $42 million.
• As far as we know, Mountain Resources has not made any misrepresentations of fact or violated any laws. We have no right to intervene in a transaction merely because we believe that our client is about to earn a surprisingly large profit.
• If we offer our opinion of the value of the properties to Super Fund, Mountain Resources will probably sue us for breach of confidentiality.
• There is a certain autonomy between offices of a national firm. Mountain Resources is a client of the Denver office, while Super Fund is not. If Super Fund were the client of another CPA firm, it is doubtful that we would even consider the possibility of alerting the other auditors or their client as to our opinion of the economic value of the properties.

c.  Our opinion:

We consider it to be totally inconsistent with the role of an independent auditor to intervene in a transaction between a company and its customers on the premise that the auditors have a"greater wisdom" than the transacting parties. Mountain Resources is not, to the auditors' knowledge, doing anything illegal.Furthermore, all of the information at the auditors'disposal is confidential. Barring a flagrant violation of the law by one of the transacting parties, we do not believe that auditors have either the legal responsibility or the right to interject their unsolicited opinion into the business transaction of audit clients.If the auditors had become aware that the client was fraudulently overcharging for the property (as was the case in Funds of Funds) our solution would of course, be different.