Ethical Obligations and Decision Making in Accounting, 4/e 1
Case 6-3 Richards & Co: Year-end Audit Engagement
Paul Lewis is the quality review partner on the Richards & Co. engagement. He was reviewing
the workpapers prior to the December 31, 2015, annual audit when he came across transactions
that caused him a great deal of concern. He wondered if the firm’s auditors had handled them
properly. The following information appeared in a memo to the file that prompted his concern.
Memo to File: Supplier Credits for Returned Product
For the last three quarters of the year, Richards has engaged in last-minute transactions that are
questionable. The facts are, according to the client, that Richards received credits from a cellular
phone supplier and promised to repay the supplier by purchasing cellular telephone and repair
services at inflated prices in the subsequent quarter. The client has been unable to produce any
supporting documents with respect to the promised purchases, and we have not been able to trace
any such payments to cash disbursements.
EXHIBIT 1
Net Income Amounts
Quarters for 2015
March 31
June 30
September 30
December 31
Reported net income
$36 million
$32 million
$33 million
$34 million
Net income w/o credits
$36 million
$28 million
$26 million
$24 million
Difference
—–$0—–
$ 4 million
$ 7 million
$10 million
Questions
Ethical Obligations and Decision Making in Accounting, 4/e 2
1. Does it seem from the limited data that the credit memo transactions can be justified
as adjustments to reported net income amounts? Explain.
It does not seem justifiable since the client is unable to produce any documents to support
promises to repay the supplier by purchasing cellular telephone and repair services “at
inflated prices” in the subsequent quarter. Given these circumstances, recording the credit
memos as reported net income in 2015 rather than offsetting the promised purchases
against these amounts, is not justifiable from a GAAP perspective. What exists here is a
2. From an audit perspective, do you think the firm followed generally accepted
auditing standards? Explain.
The key issue here is the firm is relying on management’s representations with respect to
the promised purchase of future services to offset the current credit memos. Auditors
must gather sufficient competent evidential matter to justify the amounts recorded in the
financial statements. The auditors have not met this standard. This means they failed to
meet the due care standard as well. They also failed to exercise the proper degree of
Ethical Obligations and Decision Making in Accounting, 4/e 3
3. Based on the limited facts presented, do you think the firm violated any provisions
of the Securities Exchange Act of 1934? Explain with reference to the auditors’ legal
liability.
The Securities Exchange Act of 1934 regulates the ongoing reporting by companies
whose securities are listed and traded on stock exchanges. The Act requires ongoing
filing of quarterly (10-Q) and annual (10-K) reports and the periodic filing of an 8-K
form whenever a significant event takes place affecting the entity, such as a change in
auditors. Entities having total assets of $10 million or more and 500 or more stockholders
are required to register under the Securities Exchange Act. The form and content of 10-K
and 10-Q filings are governed by the SEC through Regulation S-X (which covers annual
and interim financial statements) and Regulation S-K (which covers other supplementary
disclosures).