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Audit Case study 1.7

Lincoln Savings and Loan Association

1. Arthur Young was criticized for not encouraging Lincoln to invoke the substance-over-form principle when accounting for its large real estate transactions. Briefly describe the substance over form concept and exactly what it requires. What responsibility, if any, do auditors have when a client violates this principle?

2. Explain how the acceptance of large, high-risk audit clients for relatively high audit fees may threaten an audit firm's de facto and perceived independence. Under what circumstances such prospective clients should be avoided?

3. How is an auditors' examination affected when a client has engaged in significant related party transactions? What measures should an auditor take to determine that such transactions have been properly recorded by a client?

4. Professional standards require auditors to consider a client's "control environment." Define control environment. What weaknesses, if any, were evident in Lincoln's control environment?

5. What was the significance of Lincoln receiving nonrecourse notes rather than recourse notes as payment or partial payment on many of the properties it sold?

6. SAS No.31, "Evidential Matter," identifies five key management assertions that underlie a set of financial statements. What are the key assertions that Arthur Young should have attempted to substantiate for the Hidden Valley transaction? What procedures should Arthur Young have used for this purpose, and what types of evidence should have been collected?

7. DO you believe that Jack Atchison's close relationship with Lincoln and Charles Keating prior to his leaving Arthur Young was proper? Why or why not? After joining Lincoln's parent company, ACC, should Atchison have "interfaced" with the Arthur Young auditors assigned to the Lincoln and ACC engagements? Again, support your answer.

8. Does the AICPA Code of Professional Conduct discuss the collegial responsibilities of CPA firms? In your opinion, were representatives of either Ernst & Young or Kenneth Leventhal & Company unprofessional in this regard during their congressional testimony?

9. What responsibility does an auditor have to uncover fraud perpetrated by client management? Discuss factors that mitigate this responsibility and actors that compound it. Relate this discussion to Arthur young's audits of Lincoln.

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1. Arthur Young was criticized for not encouraging Lincoln to invoke the substance-over-form principle when accounting for its large real estate transactions. Briefly describe the substance over form concept and exactly what it requires. What responsibility, if any, do auditors have when a client violates this principle?

The form is the paperwork specifics but the substance is the economic impact or effect of the transaction, not the legal or paperwork form. Think about a capital lease. It "looks" like rent but is really a financed purchase. The form is a lease but the substance is a purchase. Auditors have a duty to be sure the economic substance is reported, not just the formal paperwork structure of the deal. The substance is the "reality" of what was exchanged and the real rights and obligations. This is the only "fair" presentation - the economic reality.

2. Explain how the acceptance of large, high-risk audit clients for relatively high audit fees may threaten an audit firm's de facto and perceived independence. Under what circumstances should such prospective clients should be avoided?

The presence of high fees, while attractive to partners and firms, can be intimidating to the audit staff. First, the best audit staff are assigned to the prestigious and lucrative clients. They know this. They also know that if they mess up, they are coming off quickly. So, they have to be extra careful not to irritate the client or create trouble. While it is an honor to be assigned to these clients, it is a bit more risky from the low level staff point of view.

In addition to perhaps compromising the staff's willingness to "push back" on procedures or transactions that might be questionable, the lucrative nature of a client that dominates the firm's overall profits, is the partner's need to keep the client happy. That means that the partner might try to help the client with tough issues rather than challenge them. While it is understandable that you want to be perceived as a "value added" vendor, when you start "helping the client" with their accounting issues, you start stepping over the line between being objective and reviewing their approaches and helping them with their approaches and so acting with management. When you "act with management," you have lost your independent. So, management must decide how to report and then the auditor should review it. The audit should not be in the position of suggesting a reporting method and then basically reviewing their own work.

You should avoid prospective clients who are not forth-coming about their business, who seem to be cutting corners or aggressive about circumventing regulations ...

Solution Summary

Your tutorial is 1,368 words (no references) responding to the questions posed. Example from the case and from other experiences are given.

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