Question

Smith, CPA, is the auditor for Juniper Manufacturing Corporation, a nonpublic entity that has a June 30 fiscal year. Juniper arranged for a substantial bank loan, which depended on the bank receiving audited financial statements showing a debt-to-equity ratio of no more than 2 to 1. The bank's deadline for receiving these financial statements was September 30. On September 25, just before the auditors' opinion was to be issued, Smith received an anonymous letter on Juniper's letterhead indicating that Juniper's five-year lease of a factory building that was classified in the financial statements as an operating lease was in fact a capital lease. The letter stated that Juniper had a secret written agreement with the lessor modifying the lease and creating a capital lease. Smith confronted the president of Juniper, who admitted that a secret agreement existed but said it was necessary to treat the lease as an operating lease to meet the debt-to-equity ratio requirement of the pending loan and that nobody would ever discover the secret agreement with the lessor. The president said that if Smith did not issue a report by September 30, Juniper would sue Smith for substantial damages that would result from not getting the loan. Under this pressure and because the audit documentation contained a copy of the five-year lease agreement supporting the operating lease treatment, Smith issued the report with an unmodified opinion on September 29. In spite of the fact that it received the loan, Juniper went bankrupt. The bank is suing Smith to recover its losses on the loan, and the lessor is suing Smith to recover uncollected rents.

a. Is Smith liable to the bank?

b. Is Smith liable to the lessor?

c. Was Smith independent?

Answer 1

(a) Yes,Smith is liable to the bank as bank has relied upon his report to give loan to Juniper. Therefore, knowing the fact that the lease agreement was not of operating nature, it was the professional duty of auditior to report this fact in his report and to bank.Hence, Smith is liable to bank

(b) No, Smith is not liable to lessor as no contractual or duty obligation exist between lessor and Smith.

(C) No, Smith was not independent as he his opinion was subordinate to the wishes of Juniper. It was his duty to give a qualified opinion of he was aware of the fact of Nature of agreement entered by Juniper.

Therefore as per explanation cited above, Smith was not independent.