Marshall and Wyatt, CPAs, has been the independent auditor of Interstate Land Development Corporation for several years. During these years, Interstate prepared and filed it's own income tax returns.

During 20X4 Interstate requested Marshall and Wyatt to audit all the necessary financial statements of the corporation to be submitted to the SEC in connection with a multistate public offering of 1 million shares of Interstate common stock. This public offering came under the provisions of the Securities Act of 1933. The audit was performed carefully and the financial statements were fairly presented for the respective periods. These financial statements were included in the registration statement filed with the SEC.

While the registration statement was being processed by the SEC, but before the effective date, the IRS obtained a federal court subpoena directing Marshall and Wyatt to turn over all its working papers relating to Interstate for the years 20X1-20X4. Marshall and Wyatt initially refused to comply for two reasons. First, Marshall and Wyatt did not prepare Interstate's tax returns. Second, Marshall and Wyatt claimed that the working papers were confidential matters subject to the privileged communications rule. Subsequently, however, Marshall and Wyatt did relinquish the subpoenaed working papers.

Upon receiving the subpoena, Wyatt called Dunkirk, the Charmain of Interstate's board of directors, and asked him about the IRS investigation. Dunkirk responded, "Im sure the IRS people are on a fishing expedition and that they will not find any material deficiencies."

A few days later Dunkirk received a written memo from the IRS stating that it was contending Interstate had underpaid its taxes during the period under review. The memo revealed that Interstate was being assessed $800,000, including penalties and interest for the three years. Dunkirk forwarded a copy of this memo to Marshall and Wyatt. This $800,000 assessment was material relative to the financial statements as of December 31, 20X4. The amount for each year individually, exclusive of penalty and interest, was not material relative to each respective year.

a. In general terms discuss the extent to which a CPA firm's potential liability to third parties is increased in an SEC registration audit.

b. Discuss the implications of the IRS investigation , if any, relative to Marshall and Wyatt's examination of Interstate's 20X4 financial statements. Discuss any additional investigative procedures that the auditors should undertake or any audit judgements that should be made as a result of this investigation.

c. Can Marshall and Wyatt validly refuse to surrender the subpoenaed working papers to the IRS? Explain.

Suggested References:

- AICPA, Professional Standards, Statements on Auditing Standards, AU section 560

- FASB Statement No. 5, "Accounting for Contingencies:

- Principles of Auditing and other Assurance Services, 17E, Whittington/Pany