Reference no: EM133108974

Case - Big Logging Ltd has $35,000,000 in share capital and is listed on the TSX. During August 2015, the company issued a press release stating that their financial statements for the years ended December 31, 2014 and 2013 had been misstated and were being restated and re-issued. As a result of this, the press release also announced that the Chief Financial Officer (CFO) had resigned effective immediately. For both 2013 and 2014 expenditures made to maintain the logging & cutting equipment were capitalized to logging & cutting equipment asset accounts. These expenditures are required to be made annually to ensure the safety of the tree cutting and sawmill equipment. In addition some royalty expenses were classified as operating expenses. The company must pay a royalty to the government based on sales. The required royalty is 15% of sales for each of the years 2013 and 2014.

RTMC are the auditors for Big Logging and they performed the audit for both 2013 and 2014. A standard audit opinion was issued for both years. As a result of the press release the partners of RTMC are concerned that they are at risk of being sued by Big Logging's shareholders as the share price has dropped substantially and by their bankers who recently lent $20,000,000 to them on the basis of a far superior level of profitability. You are a senior partner of the firm and have conducted a review of the audit working papers for the 2013 and 2014 audits. You have also interviewed staff to determine if RTMC are at risk of losing a law suit in the event the firm is sued.

Through your review of the working paper files and your discussions with staff, you have determined the following:

1. Big Logging was a new client in 2013. Mick Merciless was the partner on the audit. As RTMC is in a period of growing the public accounting firm, it admitted Mick to the partnership February 2012. During 2012 and 2013 Mick successfully acquired several new clients including Big Logging. Mick's brother in law, Chris, was the Chief Financial Officer of Big Logging from 2010. From conversations with Chris, Mick was aware that Big Logging planned to seek additional bank financing in 2014 after the 2013 audited financial statements were issued. Mick approached Big Logging management in December 2013 and said that RTMC would charge $250,000 for the audit and in the event that Big Logging was not successful in obtaining the financing the audit fee would be reduced to $125,000.

2. There was no documentation in the 2013 working file that indicated RTMC had contacted Big Logging's previous auditors, FMZ LLP. When questioned, Mick said it was not necessary to contact the previous auditors as Chris had always spoken very highly about all the executive team at Big Logging and that he told Chris that RTMC would always do a good job at a value-for-money price.

3. In January 2014 Mick met with the manager at Big Logging's bank, MOB Bank, to answer questions about the financial statements. Although the bank had some concerns about the amount of debt Big Logging already had, Mick convinced them that the company was a good credit risk. The bank approved the loan at a very low interest rate.

4. As Big Logging was considered a low risk client and the audit was conducted during RTMC's busiest weeks Mick assigned Sean as the senior on the engagement. Sean had just been promoted to senior in December 2013 and Big Logging was the first job he supervised. RTMC's two newest assistants were also assigned to Big Logging.

5. A review of the audit working paper file and discussions with the staff indicated that the two new assistants were assigned to the property plant and equipment and royalty sections of the audit. Most of their university accounting and auditing courses used manufacturing and merchandising operations examples. They were not familiar with the key accounting issues in the natural resource industries.

6. The assistants found that the company had capitalized some annual expenditures made to maintain the safety of the logging & cutting equipment. They concluded that this was the appropriate accounting treatment for these expenditures (15% of the profit each year) as maintaining the safety of the equipment created a future benefit.

7. The assistants used a small sample to the test the royalty expenses and had found one royalty expense that had been classified as an operating expense. They concluded that it was immaterial and in addition concluded that it was just classified into the wrong expense account. Therefore the financial statement users would not care as profit would have been the same had it been properly classified. The assistants were surprised to learn through the press release that royalties were materially understated due to the misclassification.

8. During your discussions with the assistants, you discovered that when one of the assistants was auditing the employee expense accounts she discovered that both Chris, the CFO, and Mr. Pine, the Chief Executive Officer (CEO) had claimed some personal expenses that were not allowed under the company's policy. When the assistant questioned Chris about the expenses she was told she should not question the executives as they are the decision makers and that the policy was for the all the other employees. Chris reminded the assistant auditors are easily replaced. The assistant indicated she had mentioned this to Mick, the partner on the audit, and he said to forget about the issue and not to include anything about the expenses in the working paper file as it was irrelevant to the audit.

9. The supervisor on the audit had indicated in the working paper file that he agreed with the conclusions reached by the assistants with respect to the operating expenses classified as royalties and the accounting for the expenditures made to maintain the safety of the logging & cutting equipment.

10. There was no indication in the working paper file that Mick had reviewed the logging & cutting equipment and royalty sections of the file. In addition you could not find evidence that the technical partner in the firm had reviewed the file.

Question - Does the bank have privity of contract with the auditors? Explain.