Kay and Lee LLP has just been retained as the auditor for Holligan Industries to audit the financial statements required by a bank, Second National Bank & Trust, as a prerequisite to extending a loan to the client. The auditor knows the bank is the client's principal lender and is aware of the bank's reliance on the financial statements, particularly the valuation of inventory and accounts receivable. Additionally, the bank and auditor have direct oral and written communication during the lending period and even meet to discuss the client's financial statements.
After the audit report is issued, the bank discovers that the client's inventory and accounts receivable were overstated. The client subsequently goes bankrupt and defaults on the loan. The bank alleges that the auditor failed to communicate about the inadequacy of the client's internal recordkeeping and inventory control.
Questions
1. What would the bank have to prove to successfully bring
2. Changing the facts of the case, assume the client hired Kay & Lee to audit the financial statements, explaining that the purpose of the audit is to negotiate a loan. The name of the bank is unknown to the auditors. Under which legal principle could the auditors be held legally liable for the ordinary negligence? Which case(s) in the book support your opinion?
3. From an ethical perspective why is it important for an auditor to properly audit inventory and accounts receivable when it knows a bank may rely on the audited financial statements?