Smuckers & Nudge, CPAs, have previously been engaged by Gerrimander Corporation

Question

Smuckers & Nudge, CPAs, have previously been engaged by Gerrimander Corporation to perform compilations and tax returns. Harry Gerrimander, the company’s president, indicated to the accountants that he needed “something more” than they previously provided. Mr. Gerrimander told Jenny Holt, the partner in-charge of the engagement, that the resulting nancial statements from this proposed engagement would be used primarily for management’s purposes internally as well as short-term bank loans. Holt recommended that a review of the nancial statements be performed and work be commenced without an engagement letter. As Holt proceeded with the work, she indicated uneasiness about certain gures and conclusions but said she would take the client’s word about the validity of some entries since the review was primarily for internal use and was not an audit. If Holt had not relied on the representations of management, she would have detected a material act of fraud committed by management.

(a) Explain the role that an engagement letter could have played in this scenario and indicate what should have been covered in the letter.

(b) What was Holt’s duty in this review? What is the potential liability faced by Smuckers & Nudge, CPAs? Who may assert claims against the rm?

Explanation / Answer

a. The engagement letter’s should play a critical role in highlighting the nature and limitations of the engagement and define the arrangement between the CPAs and the client. This may cover type and scope of the engagement. It should also enlist the procedures and tests to be undertaken during the review. The client should acknowledge these conditions by signing the letter. In case of disputes, the engagement letter can be used in court to avoid misunderstandings and litigation.

b. Holt has violated the AICPA code of conduct along with the duty to enquire about the suspicious transactions. Intead of trusting the management versio, he should have taken some initiative to understand the issue in detail. Depending on the nature of who was involved in the fraud and their ownership of stock, Garrison Corporation may bring an action along with a derivative action of shareholders against the CPA firm for negligence. Also fraud may be asserted against the firm because of negligient conduct of Holt.  

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