Hide-It (HI), a family-owned business based in Tombstone, Arizona builds custom homes with special features, such as hidden rooms and hidden wall safes. Hide-It has been an audit client for three years.
You are about to sign off on a "clean" opinion on HI's current annual financial statements when Art Hyde, the VP-Finance, calls to tell you that the Arizona Department of Revenue has seized control of a Hide-It bank account that includes $450,000 of company funds; the account is not currently recorded in the accounting system and you had been unaware of it. In response to your questions about the origin of the funds, Art assures you that the funds, thought not recorded as revenue, had been obtained legitimately. He explains that all of the money came from separately billed but unrecorded change orders to items in contracts completed before you became HI's auditor, and before he or any other members of current management became involved with the company. You subsequently determine that there is insufficient evidence to allow you to reconstruct the nature of these cash transactions, although the following analysis is available from the Arizona Department of Revenue:
Deposits 1/17/2002 - 12/31/2004 $455,000
Interest earned 1/2/2002 - 12/31/2008 95,000
Withdrawals 2/12/2003 - 4/7/2007 (100,000)
Balance 12/31/2008 $450,000
Art also informs you that HI has agreed to pay a combined tax and penalty of 12 percent on the total funds deposited within 120 days as required by a recently enacted rule that provides amnesty for tax evaders. Furthermore, he states that the negotiations with the Internal Revenue Service are in process.
Prepare a memo to the firm's audit work paper file outlining the answers to items (a) through (c) and a proposed course of action (item (d)).
a) The professional standards define errors as unintentional misstatements of omissions of amounts or disclosures in the financial statements. Is the situation described an error?
b) The professional standards state that fraud relates to intentional misstatements or omissions of amounts or disclosures in the financial statements. Misstatements de to fraud may occur due to either (a) fraudulent financial reporting or (b) misappropriation of assets. Does the situation appear to be fraud? If so, is it fraudulent financial reporting, misappropriation of assets, or both?
c) The professional standards outline certain responsibilities relating to illegal acts and distinguish between direct effect and indirect effect illegal acts. Is the situation described herein an illegal act as discussed within the auditing standards? Is so, is it direct or indirect?
d) Should the CPA firm resign in this situation? If the decision is not clear-cut, what additional information would you desire before deciding?