Ducks ‘R' Us ("Ducks") (a non-public company), was founded in 2001 by three brothers, Huey, Dewey, and Louie. Ducks manufactures rubber ducks for use in bathtubs. Until recently, Ducks has been very profitable.
In recent years, however, sales have been sliding. It appears the market is now flooded with other bathtub novelties. In addition, recent surveys have indicated fewer adults find the time to take a relaxing bath and are more frequently running for a quick shower. A further damper on the sales occurred in the second quarter of 2015 when a lawsuit was filed against the company. The lawsuit claims that ducks produced in the first quarter of 2015 lost their squeak when immersed in water for an extended period of time.
After the audit of its 2014 financial statements, Ducks decided to change auditors. The predecessor auditor's had issued an unmodified auditor's report dated February 16, 2015 on Ducks' 2014 financial statements. Your firm was engaged to audit Ducks' 2015 financial statements.
In connection with your audit of Ducks'2015 financial statements, Huey called you on January 23, 2016 and informed you of the following:
During a family reunion on January 10, 2016, an argument broke out between the brothers regarding their contributions to the current operations of the company. Specifically, Huey and Louie claimed that Dewey had been spending too much time trying to improve his golf game instead of trying to improve sales. During 2015, Huey and Louie watched Dewey fly south to play golf as sales headed south. After a heated argument the three brothers mutually agreed that Dewey did not earn the $500,000 salary he received for the year ended December 31, 2015. Dewey agreed to accept $400,000 as compensation for 2015, and agreed to give back to Ducks the $100,000 difference. Furthermore, the brothers agreed that Dewey's 2016 salary would not be affected by this decision and Dewey agreed to spend more time concentrating on the company in the current year.
On January 21, 2016, the lawsuit regarding the defective ducks had been settled. Unfortunately, the $1.5 million that Ducks anticipated it would settle for (and accrued in its balance sheet as of December 31, 2015) was underestimated by $300,000. Ducks' total liability would be $1.8 million based on the settlement.
You completed your audit of Ducks' 2015 financial statements and issued your unmodified opinion thereon, dated February 7, 2016. Ducks' 2015 and 2014 financial statements and your opinion on Ducks' 2015 financial statements will be included in Ducks' 2015 annual report. The predecessor auditor's report on Ducks' 2014 financial statements has not been reissued and will not be included in Ducks' 2015 annual report.
Required: (1) Answer the following questions and support your conclusions by referencing to applicable professional pronouncements
How should the change in Dewey's compensation be dealt with in Ducks' 2015 financial statements (should compensation expense in 2015 be $500,000 or $400,000?)?
How should the settlement of the lawsuit be dealt with in Ducks' 2015 financial statements (should the liability related to the lawsuit as of December 31, 2015 be $1.5 million or $1.8 million?)?
(2) Prepare the independent auditor's report related to your audit of Ducks' 2015 financial statements that will be included in Ducks' 2015 annual report. Assume the financial statements conform with GAAP, including the matters referred to in the previous two bullet points. Support the wording of your report by referencing to applicable professional pronouncements.