Question

Infinity Corporation, a public company, has set up a number of limited partnerships to pursue some risky development projects. The limited partnerships borrow money from various financial institutions to support the development projects, and Infinity guarantees these loans. Infinity’s interest in each limited partnership is set at a level just below the percentage that would require the partnerships, and their debts, to be included in Infinity’s consolidated financial statements. These percentages are set out specifically in the professional accounting recommendations that form the basis of GAAP for the purpose of Infinity’s financial reporting.

Zilch Zippo, LLP (ZZ) has been the auditor of Infinity since its incorporation thirty years ago. The current CFO of Infinity was formerly an audit partner in ZZ and was in charge of the Infinity audit for five years before Infinity hired her as its CFO. Because of her familiarity with ZZ’s approach to setting materiality for its audits, the CFO was able to suggest the amount of a loan that could be guaranteed in each limited partnership without being material. If an individual loan was material, it would need to be disclosed as a contingency in Infinity’s consolidated financial statements even if the partnership was not required to be consolidated. Approximately 1000 limited partnerships were set up, since a large sum of money was required to fund Infinity’s development activities. Because of the way the limited partnerships were structured, none of them were consolidated and no disclosure of Infinity’s loan guarantees to the partnerships were made in Infinity’s 20X0 financial statements, despite the fact that in total they exceeded the reported long-term debt and shareholders’ equity of Infinity.

Andy Auditor, the audit partner in charge of the audit of Infinity’s 20X0 consolidated financial statements, was somewhat puzzled as to why there were so many limited partnerships, since only one development project was being undertaken. However, he was assured by Infinity’s CFO that the structure was appropriate and in accordance with GAAP because, in her words, “It was all set up by financial engineers with PhD’s in ZZ’s consulting group. These people know all about GAAP and are much smarter that you are, Andy, so there is nothing to be concerned about.” As a result of his audit work, Andy provided a clean audit opinion on Infinity’s 20X0 consolidated financial statements. During 20X1, adverse events resulted in Infinity’s being unable to meet its obligations under the loan guarantees and it went bankrupt.

Required Comment on the adequacy of Andy’s audit, the independence and scope issues raised, and the appropriateness of issuing a clean audit report in this scenario (max 1 page, single spaced, bullet points are acceptable).

Answer 1

Andy has not conducted the audit with objectivity and professional competence. He did not dig deeper into the cause for formation of partnerships even though something was apparently wrong on the surface.

Further, since Zippo was a partner of the audit firm in which Andy is currently working, he was influenced by his opinion. Further, his opinion was suppressed by Zippy's remarks of everyone being smarter than him.

The limited partnerhsips were used as a clever ploy to raise money but not put the debt on the face of infinity's balance sheet. In substance, the limited partnerships were very much a part of Infinity. Thus, issuance of a clean audit report was inappropriate.