Case 6-3 Richards & Co: Year-end Audit Engagement Paul Lewis is the quality review partner on the Richards & Co. engagement. He was reviewing the

Case 6-3 Richards & Co: Year-end Audit Engagement Paul Lewis is the quality review partner on the Richards & Co. engagement. He was reviewing the workpapers prior to the December 31, 2015, annual audit when he came across transactions that caused him a great deal of concern. He wondered if the firm’s auditors had handled them properly. The following information appeared in a memo to the file that prompted his concern. Memo to File: Supplier Credits for Returned Product For the last three quarters of the year, Richards has engaged in last-minute transactions that are questionable. The facts are, according to the client, that Richards received credits from a cellular phone supplier and promised to repay the supplier by purchasing cellular telephone and repair services at inflated prices in the subsequent quarter. The client has been unable to produce any supporting documents with respect to the promised purchases, and we have not been able to trace any such payments to cash disbursements. The client has produced credit memos in the amount of $10 million, $7 million, and $4 million for December 31, 2015, September 30, 2015, and June 30, 2015, respectively, which is about 15 percent of the reported net income for 2015. The memos are marked to indicate that the credit was being provided in connection with defective telephone components. However, we could not identify any shipping documents to confirm that the components were returned to the supplier. Quarters for 2015: March 31 June 31 Sept 31 Dec 31 Reported net income 36 million 32 million 33 million 34 million Net income w/o credits 36 million 28 million 26 million 24 million Difference 0 4 million 7 million 10 million Percentage 14.3% 26.9% 41.7% Reported net income: (3/31): 36 Million (6/30): 32 million (9/30): 33 million (12/31): 34 million Net income w/o credits: (3/31): 36 Million (6/30): 28 million (9/30): 26 million (12/31): 24 million Difference: 0 4 million 7 million 10 million Percentage: 14.3% 26.9% 41.7% We have filed 10-Q quarterly reports to the SEC based on the reported net income. We recommend, however, the firm conduct due diligence prior to publishing the 10-K annual report. The client assures us that the promised purchases will be made and the only reason for not doing so is a cash flow problem. We are relying on management/€™s representations in that regard. Richards is currently negotiating a loan for $20 million. QUESTIONS Does it seem from the limited data that the credit memo transaction can be justified as adjustments to reported net income amounts? explain. From an audit perspective, do you think the firm followed generally accepted accounting standards? explain. Based on the limited facts presented, do you think the firm violated any provisions of the Securities Exchange Act of 1934? Explain with reference to the auditors’ legal liability.

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