Ethical Obligations and Decision Making in Accounting, 4/e 1
Case 6-6 Kay & Lee, LLP
Kay & Lee LLP was retained as the auditor for Holligan Industries to audit the financial
statements required by prospective banks as a prerequisite to extending a loan to the client. The
auditor knows whichever bank lends money to the client is likely to rely on the audited
statements.
After the audit report is issued, the bank that ultimately made the loan discovers that the audit
client’s inventory and accounts receivable were overstated. The client subsequently went
bankrupt and defaulted on the loan. The bank alleged that the auditor failed to communicate
Questions
1. What would the bank have to prove to successfully bring a lawsuit against Kay &
Lee?
The bank that made the loan would seemingly be considered a reasonably foreseeable
third party user since the auditors knew about the intended use of the client’s financial
statements so that the auditor could be liable for ordinary negligence. It would depend on
the legal principle applied by the court. The bank would have to prove that there was a
false representation by Kay & Lee, that the firm had knowledge of the falsehood, that the
bank relied on the false information and it suffered damages. These are the common law
standards for asserting legal liability against auditors.
Ethical Obligations and Decision Making in Accounting, 4/e 2
2. What defenses might the auditors use to rebut any charges made about their
(deficient) audit?
The auditors would need to assert due diligence but it seems a stretch given the facts of the
case. The auditors asserted that there was no way for them to know that the client included in
the inventory account $1 million of merchandise in transit to a customer on December 31,
2015. The shipping terms were unclear so the auditors accepted management’s
representations in that regard (FOB Destination). Auditors should not accept management’s
representations in lieu of documentary evidence to support the in-transit inventory. One way
to do this is look for subsequent data to verify the FOB terms. It should appear on a receiving
3. Critically evaluate the auditors’ statements about the inventory and receivables with
respect to generally accepted auditing standards and the firm’s ethical
responsibilities.
In addition to the discussion above, the auditors lacked the proper level of care to meet
generally accepted auditing standards. This includes the failure to exercise the appropriate
level of skepticism that would be expected in an audit under GAAS.