The Lakeside Company:

Auditing Cases

SOLUTIONS MANUAL 12e

Table of Contents

John M. Trussel and J. Douglas Frazer

A Note on Ethics, Fraud and SOX Questions 2

A Note on Research Assignments 3

Introductory Case 5

Case 1 14

Case 2 22

Case 3 33

Case 4 44

Case 5 58

Case 6 74

Case 7 82

Case 8 92

Case 9 101

Case 10 110

Case 11 116

Case 12 125

Case 13 136
 A NOTE ON ETHICS, FRAUD, AND SOX QUESTIONS

The Lakeside Company: Auditing Cases, 12th edition, has been updated in light
of the accounting scandals of the early 2000s, the passage of the Sarbanes-
Oxley Act of 2002, and the renewed interest in ethics within the accounting
and auditing profession.

Sarbanes-Oxley issues have been incorporated in two ways. First, case content
has been altered to include Lakeside’s consideration of financing expansion
through an initial public offering, and the resulting impact such a decision
would have on Lakeside and on Abernathy and Chapman, CPAs. Second, the
discussion questions and exercises have been expanded to include
consideration of Sarbanes-Oxley and new auditing and independence
standards, both by adding a section in the end-of-chapter material and by
reference in the other questions where appropriate.

Ethics questions are now specifically identified with an ethics logo. The ethics
questions are often open ended, and this solutions manual does not try to give
exact answers to these questions. Rather, we intend to give some ideas for
classroom discussion, and to help with student research on these questions.

Fraud questions are now specifically identified with a fraud triangle.

Fra
Fra
ud
ud
 A NOTE ON RESEARCH ASSIGNMENTS

The "Apply Your Research" and "Consulting Partner Review" assignments included at
the end of several cases do not lend themselves to definitive solutions that could be
included in an instructor's manual. The assignments are simply not intended to be
exercises in arriving at a predetermined answer. Rather, the applications of the
suggested readings have the following objectives:

- To provide a means for improving the writing skills of students. From all reports,
accounting majors too often leave college lacking in the basic ability to compose
and construct sentences and paragraphs. Accounting and auditing (especially as
one moves up in an organization) obviously require skills other than the purely
quantitative. Memos, reports, footnotes, audit and accounting guides, etc., all
require accountants and auditors to be effective communicators of the written
word. Indeed, the instructor may want to team up with a member of the school's
English or communications department to enhance the effectiveness of these
assignments. The auditing instructor can then evaluate the technical and
research portions of the assignment, while the English instructor would make
suggestions as to grammar, syntax, construction of sentences and paragraphs,
logic of the thought process, etc. As a preliminary step, the instructor may want
to assign articles such as "Word Crunching: A Primer for Accountants" from the
March 1990 issue of the Journal of Accountancy.

- To introduce students to accounting and business journals as well as other

important publications. After college, students must be able to "keep current" or
their effectiveness will quickly decline. In most cases, this continuation of their
education is provided by the regular reading of publications such as The Wall
Street Journal, Journal of Accountancy, CPA Journal, and Forbes. These
assignments require the students to begin reading these journals prior to
graduation. The students should become comfortable with their ability to
understand and use the materials in professional publications. In addition, real-
world aspects of many accounting issues are presented through these various
readings.

- To develop the students' ability to derive viable solutions to auditing problems.

Unfortunately, students in college often come to the belief that all auditing issues
can be resolved simply by applying the pronouncements of various authoritative
bodies. Textbooks too often present problems that have one ultimate answer.
However, in many real cases, no definitive solutions actually exist. Thus, when
faced with such problems, students must be capable of reviewing the available
literature and then using that information as a basis for arriving at a workable
decision.

- To promote auditing research. In most of these library assignments, students are

provided with one or more resources as starting points for their research. However,
the instructor should always push the students to look for more and different types
of information. The ultimate purpose of these assignments is to force the students
into the library and online sources to do the searching for themselves. One
excellent method of introducing the assignments is to use some class time to
illustrate the various methods of research that are available to them, including
electronic resources, such as the following:
o http://www.sec.gov
o http://www.PCAOBUS.org
o http://www.AICPA.org
o http://www.FASB.org
o Your state society of CPAs also operates sites.

If possible, a business librarian or a research librarian may be enlisted to discuss

the various search techniques that can be used at the school's library for research
purposes. Developing the ability to find information is one of the most important
skills that can be achieved by an accounting major.
 INTRODUCTORY CASE

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

(1)

The staff auditor performs many of the detailed audit procedures, such as preparing and
controlling accounts receivable confirmations. In general the work of the staff auditor is
controlled by the audit program and supervised by the senior auditor.

The senior auditor coordinates the audit at the client's location and performs many of
the more difficult audit procedures, such as analytical review procedures. Usually the
detailed work performed by the audit senior is more sophisticated and requires the
experience gained by someone holding that rank. The audit senior is supervised by the
manager.

The manager and the partner have supervisory roles. Managers and partners often
have more than one audit team under supervision at any given time.

The partner is the person who has responsibility for determining whether the firm’s
signature can be attached to audit report.

(2)

The partner-in-charge of an audit is the definitive decision-making position on the audit

team. Although the manager and senior auditor make several decisions, they must get
ultimate approval from the partner-in-charge of the audit. The consulting partner's role
is to add a further degree of objectivity to the audit. The consulting partner reviews and
critiques certain crucial decisions made by the audit team, such as the final audit report.
The partners should be rotated to assure independence.

Sarbanes-Oxley (SOX-S203) requires the identification of a Leading Partner and a

Reviewing Partner. Both partners must be rotated every five years.

(3)

An accounting firm is a business like any other, and its management must recognize
that a marketing strategy is probably necessary to generate a continual flow of sufficient
operating revenues. However, in the accounting profession, disagreement exists as to
the extent that such marketing should take. In the past, overt marketing was not
permitted since it was considered to be unprofessional. This position was supported
based on the reasoning that a firm should be selected based solely on the quality of its
service. No reliable system existed, though, for conveying such information to potential
clients. Hence, firms with many clients tended to remain large, while smaller firms often
found growth to be nearly impossible. In the free market system espoused by the
United States, restrictions on such practices as advertising and solicitation were
inevitably overturned. Over the past three decades, attitudes toward marketing have
changed dramatically as competition has become much more intense. Advertisements
by CPA firms in newspapers and magazines are now common. Newsletters such as
that distributed by Abernethy and Chapman are also frequently used to increase a firm's
name recognition in the business community.

In the current world of business, some type of marketing strategy seems imperative if an
accounting firm is to compete. Whether that marketing should extend to formal
advertising is often a question of firm policy. Most importantly, the firm must ensure that
potential clients know of its presence and the services that it offers. A client will
probably not select a CPA firm based on advertising. However, the client may initially
become aware of the firm only through some type of marketing.

Interestingly, some members of the accounting profession view marketing as having

had a negative impact on the profession as a whole. Price competition for new clients is
often associated with the marketing of a firm. These critics assert that lowered fees
result in sloppy and hurried audit work that can decrease the overall reputation of the
profession. (Additional resources discussing this issue can be found in the "Suggested
Readings" at the end of this case.)

(4)

A national or international CPA firm might consider acquiring Abernethy and Chapman
for several reasons:

- Although only a regional firm, Abernethy and Chapman apparently has a client
base that includes a number of large clients in several different industries. By
acquiring the local firm, the larger organization will frequently be able to retain
these customers, thus increasing its own client list.

- The larger firm may be interested in moving into this geographical region, and
buying the local firm will provide an instant base on which to build a practice in
the area.

- The larger firm may already have an office in this location and feels that
combining the practices will reduce expenses.

Abernethy and Chapman might have several reasons for viewing an acquisition in a
favorable light:

- Frequently, the purchase price will be a considerable amount of money because

of the goodwill inherent in an established accounting firm. The offer to sell may
be especially tempting if the partners are nearing retirement age and the future of
the firm appears uncertain.
- The smaller firm may have trouble dealing with increased competition from
bigger firms. Often clients may decide that a change to a nationally known CPA
firm should be made to add extra stature to the audit report. If a local
organization has only a few large clients, it cannot economically afford to lose a
significant amount of revenue in this way. A merger may help the firm to keep its
clients.

- The regional firm may also desire the additional backup services offered by large
organizations. National CPA firms usually have experts in many industries as well
as in specific audit areas who are available for consultation. In a smaller firm, this
degree of assistance is not always available when a difficult accounting or auditing
problem is encountered.

- PCAOB registration and SEC practice presents hurdles that might be overcome
through a merger with a larger firm.

Many mergers have occurred in the auditing profession during recent years. Critics
assert that this trend has reduced competition and will inevitably lead to a decrease in
audit quality. Proponents counter by stating that mergers lead to more efficient
operations and, thus, improve audit quality. Obviously, mergers will create a drastic
change in the profession as more of the smaller firms disappear. Audit work in this
country may possibly become concentrated within the largest CPA firms. Whether this
result is good for the auditing profession may be merely a question of perspective. To
the smaller firms struggling to survive and grow, the mergers are usually considered a
threat as the bigger firms become more competitive. To the larger firms, the chance for
continued growth and more efficient operations is always an important objective.

See the Sarbanes-Oxley section below for a follow-up question related to the impact of
SOX on the auditing profession.

(5)

Moving staff from one area of a CPA firm to another can cause the perception of an
independence problem. For example, the appearance of independence may be in
question if a member of the consulting staff helps to install a new accounting system for
a client and then she moves to the audit staff to audit this same client.

See the Sarbanes-Oxley section below for a follow-up question/answer related to the
impact of SOX, in particular the list of proscribed activities for registered CPA firms.

SUGGESTED ANSWERS TO EXERCISE

(1)
The question requires students to address all the elements of a quality control system,
as included in Statement on Quality Control Standards No. 2. In some cases, students
should recognize the need for additional information.

To: DeAnna Malott

From:
Date:
Re: Quality Control Standards at Abernethy and Chapman

Overview: I was employed by the firm of Abernethy and Chapman to review the quality
control standards within the firm. The following represents my evaluation of these
standards according to the six elements required by the AICPA.

Evaluation:
Standard Existing Recommendations Additional
Procedures Information Needed
Leadership The case does not The firm should have What specific
responsibilities explicitly address policies in place that policies does the
this standard. establish the “tone at firm have to
However, the firm the top” for quality demonstrate
has some items in within the firm. leadership
place, such as a responsibilities for
partner dedicated to quality within the
monitoring the firm?
system.
Relevant ethical Firm requires its The AICPA's Code of The case does not
requirements employees to Professional Conduct mention spouses or
sever all financial does not require all dependents of the
ties to audit clients. employees to sever employees.
ties with all audit Spouses and
clients. For example, dependents must
staff auditors not also be
working on a particular independent, as
engagement need not defined by Section
sever ties. In this 100--Rule 101 of
case, the firm exceeds the Code. In this
the minimum level of case, the firm
conduct for should strengthen
independence. its requirements.
The case does not How does the firm
address other ethical meet other ethical
requirements. requirements?
Acceptance and This case does not It is important to have 
continuation of address this many controls when
clients control standard. It considering a potential
does note that the client, so that the
 firm is attempting potential risks of legal
to gain more exposure are not too
clients through an great. (Note: This
extensive topic is addressed in
marketing Case 2.)
program.

The firm considers This appears to be a

Human experience and reasonable quality
resources technical control.
competence in
assigning
personnel to audit
engagements.
The firm hires only
college graduates
with a major in This seems to be a
accounting and more than adequate
requires that each quality control
professional sit for procedure. In fact,
the CPA exam many firms hire
within one year of professionals, such as
employment. computer experts, who
The firm requires were not accounting
40 hours of majors.
continuing
education per year;
however, the case
does not address Many states require
the issue of the that a minimum
type of education number of continuing
(e.g., accounting professional education
and auditing hours be in
versus other accounting- and
courses). auditing-related
 The firm courses.
promotion
procedures
consider seniority
and technical
competence, which
seems to be an The case does not
adequate control. address the issue
of assessment of
technical
 competence. Many
firms require a
written assessment
of performance
after each
engagement.

Engagement The firm requires The firm should have a It is not clear from
performance that a consulting mechanism for the case how the
partner be consultation with team documents
assigned to each authoritative literature the work performed
audit engagement. and other sources, on an audit
The consulting including outside engagement. An
partner assures experts, if its evaluation of audit
that the work professional staff lacks documentation is
performed by the expertise in a necessary for
engagement team particular area. complete evaluation
meets applicable of the quality
professional controls.
standards and
regulatory
requirements. This
helps to ensure
objectivity, as the
consulting auditor
is not a direct part
of the engagement.
The firm seems to
have a clear chain
of command and
adequate
supervision on the
audit. The staff
auditors report to
the senior auditor,
who in turn reports
to the manager.
The partner-in-
charge has an
overall supervisory
position.

The firm has a A comprehensive The case does not

Monitoring partner, DeAnna system of mention what types
Malott, assigned to documentation of the of documents are
monitor the quality quality controls should required to support
 control standards. be developed. these controls, but
documentation is
extremely
important. For
example, many
firms require
employees to
submit a listing of
all financial ties to
companies so that
the firm can monitor
its independence.

Conclusion: The firm has many policies related to quality control standards. However, the
firm has room for improvement in many of the areas, particularly in the acceptance and
continuation of clients.

SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTIONS

(1)

Students should be encouraged to visit the PCAOB website (http://www.pcaobus.org)

when answering this question:

- Registration – CPA firms must be registered to be associated with public

companies. The application for registration is an online process. There is a fee, it is
small relative to other costs of maintaining the registered status and changing the
nature of the firm to comply with PCAOB rules. Here is the fee structure from their
website:

- Inspection - The PCAOB operates a system of inspections and publicizes the

results, per its authority under the SOX Act:

- The Act provides that an inspection shall include at least the following
three general components:
• An inspection and review of selected audit and review
 engagements of the firm, performed at various offices and by
various associated persons of the firm;
• An evaluation of the sufficiency of the quality control system of the
firm, and the manner of the documentation and communication of that
system by the firm; and
• Performance of such other testing of the audit, supervisory, and
quality control procedures of the firm as are necessary or
appropriate in light of the purpose of the inspection and the
responsibilities of the Board.

- Regular inspections are on a three-year cycle, although smaller firms

may be less frequent. Special inspections can be required by the PCAOB.

- Maintenance of independence under PCAOB rules and SOX-proscribed

activities:

Proscribed activities under SOX (section 201):

Section 201: Services Outside The Scope Of Practice Of Auditors; Prohibited Activities.

It shall be "unlawful" for a registered public accounting firm to provide any non-audit
service to an issuer contemporaneously with the audit, including: (1) bookkeeping or
other services related to the accounting records or financial statements of the audit
client; (2) financial information systems design and implementation; (3) appraisal or
valuation services, fairness opinions, or contribution-in-kind reports; (4) actuarial
services; (5) internal audit outsourcing services; (6) management functions or human
resources; (7) broker or dealer, investment adviser, or investment banking services; (8)
legal services and expert services unrelated to the audit; (9) any other service that the
Board determines, by regulation, is impermissible. The Board may, on a case-by-case
basis, exempt from these prohibitions any person, issuer, public accounting firm, or
transaction, subject to review by the Commission.

It will not be unlawful to provide other non-audit services if they are pre-approved by the
audit committee in the following manner. The bill allows an accounting firm to "engage in
any non-audit service, including tax services," that is not listed above, only if the activity
is pre-approved by the audit committee of the issuer. The audit committee will disclose
to investors in periodic reports its decision to pre-approve non-audit services. Statutory
insurance company regulatory audits are treated as an audit service, and thus do not
require pre-approval.

The pre-approval requirement is waived with respect to the provision of non-audit

services for an issuer if the aggregate amount of all such non-audit services provided to
the issuer constitutes less than 5% of the total amount of revenues paid by the issuer to
its auditor (calculated on the basis of revenues paid by the issuer during the fiscal year
when the non-audit services are performed), such services were not recognized by the
issuer at the time of the engagement to be non-audit services; and such services are
promptly brought to the attention of the audit committee and approved prior to
completion of the audit.

The authority to pre-approve services can be delegated to 1 or more members of the

audit committee, but any decision by the delegate must be presented to the full audit
committee.

- Partner rotation - The rotation of the lead partner and the reviewing partners are
required by the SOX Act.

- Quality Control Standards – Registered firms must maintain the SEC practice
requirements:

- AICPA Quality Control Standards for public company audits are summarized at:
http://cpcaf.aicpa.org/Resources/
 CASE 1

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

(1)

Financial statements are frequently relied on by outside parties such as stockholders

and banks when making decisions about an enterprise. Should equity securities be
bought or sold? Should a long-term loan be given? However, financial statements are
the representations of the management of the company. As such, these statements will
not necessarily be fairly presented. Material misstatements may exist in the form of
errors, irregularities, or illegal acts. The management might, for example, have an
insufficient knowledge of generally accepted accounting principles to produce
appropriate statements. Human error or bias is also possible in the gathering and
reporting of financial information. In addition, the management may have fraudulently
manipulated the data in hopes of achieving some objective.

Outside parties are aware that the financial information produced by a company and its
management may not always be reliable. Hence, to add credibility to this reporting
process, independent experts are retained to audit the financial statements and test the
underlying accounting records. These auditors then issue an opinion for the benefit of
outside parties as to the fair presentation of the financial statements in conformity with
generally accepted accounting principles. This added degree of assuredness allows
decision-makers to rely on reported financial information.

(2)

A CPA firm could not be expected to maintain expertise in every potential industry that it
might audit. In reviewing a potential client, the firm should evaluate its ability to gain the
necessary industry expertise prior to the actual audit, but no requirement exists that this
knowledge must be possessed prior to accepting the engagement.

Each industry may have its own specific accounting practices. In addition, certain
industries frequently offer unique auditing problems. Thus, without a thorough
investigation, the auditor cannot ascertain the knowledge that will be needed in
examining a potential client. In the consumer electronics business, for example, the
methods of distribution as well as credit policies would be significantly different from
those found in a car dealership. Damaged or obsolete inventory are other problems
that might be more important in this specific industry. Hence, a knowledge of one type
of operation does not necessarily mean that the auditor has the expertise needed to
examine a client operating in a different industry.

Auditing standards require that auditor to have the expertise by the completion of the
audit, but this expertise need not be in place at the beginning. It would be unethical to
misrepresent a firm’s experience, but it need not be volunteered.

(3)

A profit-sharing bonus plan gives employees an added incentive to seek increases in

company income; a larger profit figure will lead to a larger bonus at the end of the year.
Consequently, employees may be tempted to inflate income artificially by creating false
sales or deferring the recording of expenses. An auditor must always be alert for
situations that can promote the possibility of such irregularities. A profit-sharing bonus
plan may well have only positive effects on company employees. However, the auditor
should not be so naive as to fail to recognize that some individuals may take advantage
of such plans by manipulating the financial records.

This problem may be especially significant in the Lakeside Company because the
bonus plan is new and the stores are geographically located at a distance from the
home office. New plans require adaptation by company controls and such separation
always increases potential control concerns. In addition, Rogers has already mentioned
that some of the internal control systems are no longer adequate. Thus, the possibility
of inflated income figures is even more of a possibility.

(4)

Critics of the auditing profession have argued vehemently for a number of years that
advisory services such as those discussed in this question taint the appearance (and
possibly the reality) of independence. These services may appear, to the public, to give
the audit firm a financial interest in the success of the company. This argument holds
that the firm will now want the client to succeed as proof of the quality of the advice that
was given. In addition, the audit team may be less judicious in investigating these
systems since they are aware that members of their own firm designed and installed
them.

Audit firms counter by stating that adequate safeguards have been put into place to
ensure continued independence. For example, advisory services are frequently
rendered by a separate division of the firm so that no proximity exists between this
function and the audit staff. In addition, firms are not allowed to give many types of
advice that might jeopardize their independence. Finally, audit firms must make certain
that their services are limited to making recommendations, and are not for carrying out
management decisions. The firm cannot make decisions for the client.

Sarbanes-Oxley specifically proscribes various activities that have traditionally been

part of the CPA’s repertoire. Design of accounting systems is prohibited, although
helping a client with selection and implementation of off-the-shelf packages would be
acceptable. So, in this case, it depends on what the client means by “developing.” In
the event that Lakeside goes forward with its public offering Abernathy and Chapman
will need to decide whether to remain independent so they can continue as Lakeside’s
auditor, or sacrifice independence to do systems consulting. Sarbanes-Oxley prevents
trying to do both.

(5)

In his article "The Initial Audit Engagement Conference" in the Journal of Accountancy
for September 1976, Bernard Valek lists a number of steps that can be performed in a
plant tour to avoid later "surprises" as well as to assist the firm in establishing an
appropriate audit fee. The first three are typical of a plant tour. The others go beyond the
typical tour. Students should not be expected to anticipate each of these procedures
but the question can be used to emphasize the importance of the auditor's complete
understanding of the audit client. These steps include:

* Inspect inventory for possible obsolescence and an indication of the major

product lines of the company.

* Verify the presence or absence of a perpetual inventory system.

* Review manufacturing facilities for indication of level of activity as well as any idle
machinery.

* Review journals for careful preparation.

* Review general ledger activity for unusual entries.

* Review monthly financial statements for unusual variations.

* Review bank reconciliations, and compare to general ledger.

* Examine accounts receivable reconciliation to general ledger balance.

* Review client physical inventory method.

* Discuss with client the policy for valuing inventory and identifying obsolete
inventory items.

* Discuss with client the procedures for obtaining a proper year-end cutoff.

* Review depreciation schedules, and recalculate a sample of the depreciation

expense figures.

* Review income tax returns.

* Examine information relating to any capital stock or retained earnings

transactions for the past year.
* Review minutes of board of directors' meetings and stockholders' meetings for
unusual or material matters.

* Read lease agreements.

* Review past audit reports.

(6) A company may not want its CPAs to audit a client's records because the
auditors gain a substantial amount of competitive information during an audit.
However, CPAs are bound by confidentiality under the AICPA's Code of
Professional Conduct. Also, a CPA's knowledge of the industry gained from
having several clients in the same industry provides him or her with insights
he/she may not have otherwise had.

SUGGESTED ANSWERS TO EXERCISES

(1)

(a) and (b) The independent auditor must be able to review massive quantities of
information and identify the fraud risk factors that may affect the amount of evidence to
be gathered or the opinion to be rendered. This question calls upon the judgment
abilities of the students. The format used by students for this memo is not important as
long as it is clear and understandable. SAS 99 requires use of a brainstorming session
in the planning stage to be sure that everyone associated with the audit understands the
nature of the business and the potential risk of fraud. These sessions can also occur
during the audit if additional evidence presents itself. Potential problems that students
would be expected to identify are as follows. Additional fraud risk factors may also be
identified by the students.

Fraud Risk Factors Auditor Follow Up

Internal Control - The president of the
company admits that the company's
internal control is antiquated. Control
problems may be heightened in that
operations extend throughout two
states.
Uncertainty Involved with the Sixth
Store - A qualified opinion was issued
by the predecessor auditor in
connection with this store.
Inventory - The mere size of the
inventory of a business like Lakeside
would make this account a critical audit
area.
Since understanding the internal
control is one of the prerequisites for
ultimately determining the amount of
substantive testing that will be required,
the weakness of the various controls
may require the extensive gathering of
evidence, or even preclude an opinion.
Abernethy and Chapman must face the
question as to whether this issue can
be resolved during 2009.
The auditor will face the problem of
verifying the existence, cost, value,
presentation, and ownership of the
electronic equipment.
Fraud Risk Factors
Distributorship Sales - The case
indicates that these sales have risen
dramatically during the past two years.
Bonus System - This system has been
recently installed by Lakeside, so very
little is known about its effects upon the
financial results of the company.
Related Party Transactions - The case
indicates that Lakeside has begun to
have financial dealings with the
president of the company.
Rental Agreements - Five of the stores
have been leased and, apparently,
Store Seven will be rented from
Rogers. Rental agreements pose the
question as to the need for capitalizing
the lease.
Accounts Receivable - All
distributorship sales are made on
credit.
Loan Agreements - Lakeside has a
number of loans outstanding.
Inventory Returns - For distributorship
sales, up to 20% of the inventory items
can be returned within four months. As
of the end of the year, Lakeside will
have a large contingent liability
associated with the inventory items
sold during the last four months.
Possible public offering of stock
Auditor Follow Up
Any sudden change or fluctuation in an
account balance will always warrant the
auditor's attention. In this instance, the
auditor will be especially interested in
verifying the validity of these sales
figures.
This factor alone can cause difficulty in
the auditor's examination. In addition,
any bonus system will provide an
incentive for the employees to falsify
the company's financial records. The
auditor must be aware that employees
can benefit from producing falsely
inflated income figures.
Obviously, nothing is wrong with this
arrangement, but such related party
transactions are often difficult for the
auditor to verify. In addition, they
require clear disclosure.
Abernethy and Chapman will have to
read the various agreements to see if
any of them qualify as a capital lease
under the criteria established by the
Financial Accounting Standards Board.
The size of the receivable account and
the problem of determining collectibility
will be a critical audit area for the
auditor.
The auditor will need to study each
loan agreement to ascertain that the
company is not violating any of the loan
covenants.
Not only is the potential size of this
liability a problem, but the auditor's
ability to estimate the amount must be
a concern.
A public offering raises risk for
manipulation of the financial statements
in order to attract capital. In addition,
the number of potential readers of
financial statements has changed
Fraud Risk Factors Auditor Follow Up
dramatically, making the risk
associated with this audit much higher.
(2)

INDEPENDENT AUDITOR'S REPORT

To the Board of Directors:

We have audited the accompanying balance sheet of the Lakeside Company as

of December 31, 2011, and the related statements of income, retained earnings, and
cash flows for the year then ended. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audit.

We conducted our audit in accordance with auditing standards generally

accepted in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audit provides a reasonable basis for our opinion.

During 2010, the Lakeside Company made a large investment in a retail store
located in the eastern sector of Richmond, Virginia. This store has failed to reach a
break-even sales point to date, and total recovery of the Company's investment is highly
uncertain. In our opinion, the chances are reasonably possible that the asset's value
has been permanently impaired and should be reduced to the net realizable value in
conformity with generally accepted accounting principles. Management of the company
has refused to recognize this impairment loss.

In our opinion, except for the effects of not recording or disclosing the impairment
of value of the asset, as discussed in the preceding paragraph, the aforementioned
financial statements present fairly, in all material respects, the financial position of the
Lakeside Company at December 31, 2011, and the results of its operations and its cash
flows for the year then ended in conformity with accounting principles generally
accepted in the United States of America.

King and Company (signed), Certified Public Accountants

Date: (last day of audit fieldwork)
 SUGGESTED ANSWERS TO SARBANES-OXLEY QUESTIONS

(1)

The issuance of stock is regulated by the Securities and Exchange Commission and the
accounting, auditing and reporting is regulated by the PCAOB since 2002. A summary
of the regulations follows:

Issuance of stocks are regulated primarily under the SEC acts of 1933 and 1934.
Registration with the SEC is required, which includes financial reporting. The laws are
summarized at: http://www.sec.gov/about/laws.shtml.

The financial reporting and auditing for public companies has been regulated by the
PCAOB since 2002. The PCAOB registers, inspects and disciplines the auditors of
public companies. Its effect on the public companies is indirect, through the regulation
of the auditors.

Encourage students to visit the SEC EDGAR site to understand the nature of electronic,
public financial information.

(2)

CPA firms wishing to be associated with public companies must be registered firms,
accept the inspection process, and be subject to the discipline of the the PCAOB. CPAs
in public practice ofhave three choices. It is not only public vs. private, because some
CPA firms are choosing to give up the requirement for independence and perform
accounting, tax, and consulting services that are not possible for registered CPA firms.
Thus their clients have two CPA firms, one for the non-independent services and one for
the audit. In the case of Abernathy and Chapman, they will need to choose the nature of
their practice. This is a major strategic choice. Most CPA firms do not perform public
company audits. Large international and national firms handle almost all of the
companies on the exchanges.