Accounting Chapter 4 Homework May Exist Unless Interpretation The

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Ethical Obligations and Decision Making in Accounting, 4/e 1

Case 4-5 Han, Kang & Lee, LLC

Joe Kang is an owner and audit partner for Han, Kang & Lee, LLC. As the audit on Frost

Systems was reaching its concluding stages on January 31, 2016, Kang met with Kate Boller, the

CFO, to discuss the inventory measurement of one its highly valued products as of December 31,

2015. Kang told Boller that a write-down of 20 percent had to be made because the net realizable

value of the inventory was 20 percent less than the original cost recorded on its books. That

meant the earnings for the year would be reduced by $2 million and the client would show a loss

for the year. In a heated exchange with Boller, Kang was told to use the January 31, 2016, value,

Questions

1. Do you think the client’s accounting approach to the market valuation of the

inventory was acceptable under GAAP? Include in your discussion a brief

explanation of why fair value measurements are difficult.

On the surface it appears the accounting was not in conformity with GAAP. However,

consideration of the “subsequent event” rules explained in #4 below may be sufficient to

accept the client’s accounting. In this question we review the basic accounting rules for

inventory valuation.

Inventory should be accounted for under the lower of cost or market method. The

challenge is to properly evaluate what is market value. It starts with the replacement cost,

which can be challenging as well. Is it what the original vendor would charge for the

same or similar goods? What if technological changes have occurred? The replacement

cost is then compared to an upper and lower limit. If it exceeds the upper limit, then the

2. Evaluate the professional judgment used by Kang and the firm in assessing the

client’s accounting and reaching its own decision to accept it.

The discussion is provided assuming the subsequent event consideration has not yet been

made.

The decision to accept the client’s position reflects egoism. The firm has not adequately

considered the effects of their decision on investors and creditors, a more enlightened

egoism perspective and one that might be evaluated using Utilitarianism. The costs to the

firm are significant. It is risking its reputation. Individual CPAs and the firm are in

3. Would independence be impaired if the firm were offered, and accepted, the

consulting arrangements? Consider whether any threats to independence would

exist and, if so, how they might be reduced to an acceptable level.

Remind students of the restrictions on nonaudit services for audit clients that are

publicly-owned. Here are the prohibitions under the Sarbanes-Oxley Act.

1. Financial information systems design and implementation

3. Actuarial services

5. Management functions or human resources

7. Legal services and expert services unrelated to the audit

8. Any other service that the board of directors determines, by regulation, is impermissible.

SOX allows an accounting firm to “engage in any non-audit service, including tax

services,” that is not listed above, only if the activity is pre-approved by the audit

committee of the issuer company. The pre-approval requirement is waived if the

Ethical Obligations and Decision Making in Accounting, 4/e 3

1.295.040 General Requirements for Performing Nonattest Services

When a member (CPA) performs a nonattest service for an attest client, threats to

the member’s compliance with the “Independence Rule” [1.200.001] may exist.

Unless an interpretation of the “Nonattest Services” subtopic [1.295] under the

“Independence Rule” states otherwise, threats would be at an acceptable level, and

independence would not be impaired, when all the following safeguards are met:

• The member determines that the attest client and its management agree to

o assume all management responsibilities as described in the

“Management Responsibilities” interpretation [1.295.030].

4. What would you do at this point if you were Joe Kang and why?

Ethical Obligations and Decision Making in Accounting, 4/e 4

An interesting aspect of this case, and one that students may not be aware of, is that the

change in December 31, 2015, inventory valuation, if it is made, may conform to the

“subsequent event” rules under generally accepted auditing standards. Instructors should

go over the PCAOB rules below on this matter. Use this question to emphasize to

students that subsequent events can be the trickiest of all year-end adjustments when

auditing a client and a difference of opinion that can become quite contentious with

management.

Extended Discussion

AU Section 560

Subsequent Events

Auditing Procedures in the Subsequent Period

Source: SAS No. 1, section 560; SAS No. 12; SAS No. 98.

An independent auditor’s report ordinarily is issued in connection with historical financial

statements that purport to present financial position at a stated date and results of

operations and cash flows for a period ended on that date. However, events or

transactions sometimes occur subsequent to the balance-sheet date, but prior to the

Two types of subsequent events require consideration by management and evaluation by

the independent auditor.

The first type consists of those events that provide additional evidence with respect to

conditions that existed at the date of the balance sheet and affect the estimates inherent in

the process of preparing financial statements. All information that becomes available

Ethical Obligations and Decision Making in Accounting, 4/e 5

Identifying events that require adjustment of the financial statements under the criteria

stated above calls for the exercise of judgment and knowledge of the facts and

circumstances. For example, a loss on an uncollectible trade account receivable as a

result of a customer’s deteriorating financial condition leading to bankruptcy subsequent

to the balance-sheet date would be indicative of conditions existing at the balance-sheet

date, thereby calling for adjustment of the financial statements before their issuance. On

Examples of events of the second type that require disclosure to the financial statements

(but should not result in adjustment) are:

a. Sale of a bond or capital stock issue.

b. Purchase of a business.

c. Settlement of litigation when the event giving rise to the claim took place subsequent to

the balance-sheet date.