Auditor Legal Liability

You are the auditor of Jehello Inc., a public company with a December year end. Your firm has audited Jehello for the past three years. The following issues were documented in the working paper files for the prior year audit:

The company had incurred expenditures of $400,000 related to the development of a new music format for electronic media. The large majority of the costs were related to development of software, hardware, and presentation of the results to customers who participated in focus groups. Management had been optimistic that the new sound system would work well, even though focus group results had been poor. These costs had been fully capitalized.

About 40% of the company's revenues were from one customer. That contract had been due for renewal on May 15, thirty days after the audit report had been issued. Documents on file indicated that the customer seemed likely to renew the contract, although quality control disputes were escalating. On May 14, Jehello was informed that the contract would not be renewed.

Jehello has defaulted on its bank loans and the bank is suing you, saying that the financial statements presented last year were false and misleading.

Required:

A) Which defences should the auditor use? Please consider and discuss all possible defences. In order to be awarded marks, please ensure that you use case facts to discuss the appropriateness of each defence.

B) Do you believe that the auditor will lose the suit? Why or why not?

C) With the newspapers constantly reporting bankruptcies, corporate scandals, management fraud and lawsuits against auditors, it is very important for an auditor to minimize audit risk and legal liability. Discuss 3 steps an individual public accountant or a public accounting firm can take to minimize its exposure/risk to legal liability.