Accounting Chapter 5, Problem 21

ACT 451: Auditing Spring 2007

Problem 5-21 February 5, 2007

The CPA firm of Sparks, Watts, and Wilcox has a responsibility under common law to fulfill implied or expressed contracts with clients. Liability occurs if the accountant fails to perform as agreed under contract. The CPA is not, however, an insurer of financial statements, and thus does not provide a guarantee against losses and irregularities.

The "normal" audit is not intended to uncover fraud, shortages, defalcations, or irregularities in general, but it is meant to provide audit evidence to express an opinion of fairness of the financial statements. The CPA is normally not liable for failure to detect fraud, irregularities, etc. unless the "normal" audit would have detected it or if the accountant, by agreement, has undertaken greater responsibility such as defalcation audit.

In this example situation, Sparks, Watts, and Wilcox are not liable to their clients for breach of contract for failure to find the fraud and for negligence because they did exercise due care in their performance. Donald Sharpe discovered and documented the exceptions he uncovered, and he followed up on the exceptions he found. Sharpe noted the exceptions he found in his working papers and called them to the attention of the in-charge accountant, but the exceptions were dismissed by the in-charge accountant.

In a court of law, it will be easier to defend this argument if Sparks, Watts, and Wilcox detailed their responsibilities to the client in an engagement letter signed by both parties. The engagement letter should include the limitations of the audit and the fact that the audit will not necessarily uncover fraud, mistakes, defalcations, or illegal actions. Another defense