Your audit firm is auditing your client Jo-Jo Jolly Products. The company is a small regional manufacturing firm located in Rye, New York. The company manufactures and sells crayons and pencils directly to retail stores.
Your firm is auditing the financial statements of this company as of the year ended December 31, 2006. During the audit your senior auditor has brought to your attention that the company is a defendant in legal case with one of the company's major suppliers.
Your firm has received a letter from the Company's independent attorney, which is under retainer for this legal case, and has performed legal services for the company in the past.
The facts are as follows:
· Jo-Jo Jolly Products is the defendant in a law suite with major packing supplier, Pack-Pack and Go.
· The supplier claims that a major order was cancelled in the amount of USD 100,000 and that Jo-Jo Jolly Products is in breach of contract due to this cancellation.
· Your senior auditor has reviewed the contract and there is a clause that allows the Jo-Jo to cancel the orders at any time as long as written notice is provided 30 days prior to cancellation.
· Mr. Peter Parker, Director of Legal Services for Jo-Jo Jolly Products indicated that a letter was provided to the supplier, but the letter can not be located as the company recently moved to a new location and several boxes were lost in the move.
· The independent law firm's letter indicates that it is probable that Jo-Jo Products will lose the case due to the fact that the letter can not be located and therefore could not be presented as evidence in the legal case.
· Mr. Jaime Zaga, CFO of Jo-Jo Jolly Products has indicated that the company did not record a liability on the balance sheet as of December 31, 2006, but rather, documented the facts of the legal case in the footnotes to the financial statements.
· You are the Partner in charge of the engagement and have a meeting tomorrow with Mr. Zaga to discuss this issue.
Prepare a memo to Mr. Zaga relative to the legal case stating your firm's position on the required accounting treatment based upon the facts provided. It is important to note that Mr. Zaga is not a CPA, but has more than 20 years of accounting and finance experience. He has indicated if the accounting treatment is different than what is currently in the financial statements as of December 31, 2006 he would like your arguments to based upon US GAAP requirements. (Hint: access the FASB website and review FAS 5 Accounting for Contingencies)
MEMO: Mr Zaga
FROM: the audit firm
RE: Accounting treatment of pending litigation
Included with this memo is a copy of the response from your attorney to our letter of inquiry. The primary purpose of the letter of inquiry was to obtain a professional opinion from your attorney as to the possible outcome of the pending litigation by Pack-Pack and Go. Of course, you have provided detailed information about the issue ...
The solution discusses SFAS No. 5, "Accounting for Contingencies", and summarizes the conditions under which disclosure and recording a loss are required.