Benjamin M. Rogers is the president of the Lakeside Company, aretailer and distributor of consumer electronics (mainly audio andvideo equipment) based in Richmond, Virginia. Although King andCompany CPAs, a Richmond firm, had previously audited Lakeside,Rogers had recently become aware of the CPA firm of Abernethy andChapman from reading several advertisements. His interest in thefirm was heightened when he discovered that Abernethy and Chapmanaudited the primary bank with which he did business. During March2009, Rogers contacted his banker who arranged for Rogers to havelunch with one of the CPA firmΓ’ΒΒs partners. At that time, awide-ranging conversation was held concerning Lakeside as well asAbernethy and Chapman. Rogers discussed the history of the consumerelectronics company along with his hopes for the future. Thepartner, in turn, described many of the attributes possessed by hispublic accounting firm. Subsequently, Rogers requested a formalappointment with Richard Abernethy, the managing partner ofAbernethy and Chapman, in hopes of arriving at a final conclusionconcerning LakesideΓ’ΒΒs 2009 audit engagement.
A June 1 meeting was held at the accounting firmΓ’ΒΒs Richmondoffice and was attended by Abernethy, Rogers and Wallace Andrews,an audit manager with the CPA firm who would be assisting in theinvestigation of this prospective client. Both auditors were quiteinterested in learning as much as possible about the consumerelectronics business. Although a number of similar operations arelocated in the Richmond area, Abernethy and Chapman has never had aclient in this field. Thus, the Lakeside engagement would offer anexcellent opportunity to break into a new market.
During a rather lengthy conversation with Rogers, Abernethy andAndrews were able to obtain a significant quantity of data aboutthe Lakeside Company and the possible audit engagement. Included inthis information were the following facts:
Rogers originally began Lakeside in 1990 as a single store thatsold bargain-priced televisions and stereo equipment. This businessdid well and the company expanded thereafter at the rate of one newstore every two or three years. Presently six stores are inoperation, three in Richmond with one in each of three nearbycities: Charlottesville, Fredericksburg and Petersburg. The firstfive were set up in rented space within small shopping centers.However, the most recent store was located in a buildingconstructed by Lakeside itself, adjacent to a new shopping mall onthe east side of Richmond. In addition, Lakeside owns a warehousethat also provides office space for the companyΓ’ΒΒs administrativestaff. The growth to date has been slow and has not produced thebenefits and profitability that Rogers expected. He is looking fora way to increase the growth rate and taking the company public isbeginning to look like the only way that sufficient resources canbe amassed.
In 2002, Lakeside reduced the marketing of bargain-pricedelectronics in a move to concentrate on the sale of high-end audioand video equipment. Several years later, Lakeside became the soledistributor of Cypress Products for the states of Virginia andNorth Carolina. Cypress is the manufacturer of a quality line ofaudio and video equipment. Shortly thereafter, the Lakeside storesbegan to carry Cypress products almost exclusively. Despite thequality of Cypress equipment, the brand was not well known in theRichmond area and store revenues began to decline. Sales didrebound somewhat in 2007 and 2008, although Rogers admitted toAbernethy that all of the stores had suffered from intensecompetition within the local market. He even indicated that a smallaudio equipment company, consisting of two stores, had gonebankrupt in Richmond during the past six months. However, he wasnot certain as to the specific cause of that failure. He believesthat a larger organization could take advantage of combinedmanagement, purchasing and storage. Geographically there areseveral cities that Lakeside could enter without dramaticallyincreasing the distances from its current warehouse.
To market the Cypress brand across the states of Virginia andNorth Carolina, Lakeside had hired a staff of six salesrepresentatives to visit audio, electronics, and appliance storesin their geographic region. These other retailers could then ordermerchandise from Lakeside by telephoning the Richmondheadquarters/warehouse. After a credit check, requested inventoryis shipped to these customers and billed at 2/10; NET/45. Up to 20%of the merchandise can be returned to Lakeside within four monthsas long as the goods have not been damaged. In the past, returnshave been low. Rogers indicated that these Γ’ΒΒdistributorship salesΓ’ΒΒhad initially been disappointing but had risen materially in thelast two years as the Cypress reputation began to spread. Rogershas only begun to consider what a more comprehensive Southeaststrategy would require in terms of sales administration andlogistics.
Audio and video equipment inventory is purchased weekly fromCypress. Regional distributors such as Lakeside are allowed 90-dayterms but Cypress encourages quick payment by offering large cashdiscounts. In hopes of maintaining a high profit margin, Rogers haschosen to take all available discounts. To meet the payment terms,Lakeside holds bank credit lines with two Richmond banks totaling$750,000. Interest on this debt is based on the floating prime rateof the respective banks and has averaged just 5% to 9% duringrecent years. Both banks require that cash in an amount equal to 5%of the outstanding credit line remain on deposit.
The companyΓ’ΒΒs warehouse and the sixth store were constructedwith funds provided by loans from the National Insurance Company ofVirginia. The first of these obligations was obtained at a 6 ΓΒ½ %annual interest rate while the second holds a rate of 8%.
Rogers stated that he was quite unhappy with the services of hispresent CPA firm, King and Company. He enumerated three grievancesthat he had with that organization:
First, he felt that the firm had provided little assistance inupdating LakesideΓ’ΒΒs accounting systems. Lakeside was simplyoutgrowing the control features of its current systems and Rogersasserted that King and Company had not provided the needed inputfor upgrading them.
Second, Rogers believed that King and Company was charging anexcessive fee for its annual audit. He stated that he was no longerwilling to pay that much money for what he termed inferiorservices.
Third, Rogers had an issue with King and Company around theaudit opinion that was rendered on LakesideΓ’ΒΒs financial statementsfor the year ending December 31, 2008.
The auditors issued a qualified opinion. King and Companybelieved that the value of LakesideΓ’ΒΒs $186,000 investment in itslatest store had been impaired based on guidelines established byFASB. However, Rogers disagreed and refused to write down thereported value of the property. The sixth store, which opened inNovember 2007, was constructed adjacent to a shopping center thathad proven to be very unsuccessful. To date, the shopping centerhad leased less than 40% of its available space. The Lakesidestore, has, consequently, never been able to generate the customertraffic necessary to even come close to its break-even point. Thecontinuing failures of the shopping center made the fate of theLakeside store appear quite uncertain to King and Company.Furthermore, the CPA firm felt that Lakeside would haveconsiderable trouble in disposing of the store if that becamenecessary. Because Rogers continued to report this asset based onhistorical cost, the firm felt that a material misstatement existedand issued a qualified opinion. Rogers expressed annoyance with afirm that would stifle his growth plans and wondered what it wouldbe like if this expansion plans were to become a reality.
Lakeside Company is owned by a group of eight investors. Rogers(who is 46 years old) owns 30% of the outstanding stock while theremaining seven shareholders individually possess between 6% and22% of the companyΓ’ΒΒs shares. Although all of the investors live inthe Richmond area, only Rogers is involved actively in theday-to-day operations of the business. The board of directors iscomprised of Rogers, two other owners, and a local lawyer who isnot an owner. When the company was first organized, all eightshareholders agreed that an audit by an independent CPA firm wouldbe held annually. This same requirement was also a stipulation madeby banks participating in LakesideΓ’ΒΒs financing.
A manager and an assistant manager operate each of the sixstores. Normally, three to six sales clerks also work at eachoutlet on a part-time basis. In hopes of stimulating lagging storesales, Rogers initiated a bonus system during 2008, which alreadyappears to be boosting revenues. Under this plan, every manager andassistant manager will receive a cash bonus each January based onthe income earned by his or her store during the previous year. Thebonus figure is a percentage of the gross profit of the store lessany directly allocable expenses.
Lakeside Company is in the process of opening a new (seventh)store, which will begin operations by December 2009. Earlier thisyear Rogers formed his own separate corporation to construct thislatest facility. Upon completion, the building will be leased toLakeside for its entire life. Although Rogers was confident thatthis new store would do well, he wanted to avoid any furtheraccounting problems associated with the uncertainty of success. Heis also investigating land purchases in at least four otherlocations in the Southeast.
Rogers indicated to Abernethy that growth was one of his primarybusiness objectives. He stated that the Cypress distributorshipoffered unlimited opportunity and that, once firmly established,each of the Lakeside stores was a sound financial investment.
To finance its growth, the company is considering a publicoffering of stock.
The company is strongly contemplating the addition of computerequipment to its product line.
CASE QUESTIONS:
Prepare a one-page executive summary that addresses thefollowing issues related to fraud:
Fraud risk factors are potential problems or indicators ofpotential fraud.
What are the fraud risk factors that this CPA firm mightencounter if it accepts this engagement? The Γ’ΒΒfraud triangleΓ’ΒΒ ofincentives/pressures, opportunities and attitudes/rationalizationare more general core concepts for analyzing fraud risk factors andshould be used to guide your analysis of fraud risk factors. Pleaseidentify fraud risk factors Γ’ΒΒ based on the information providedabove Γ’ΒΒ that are specific to Lakeside Company.
In addition, how should a CPA firm follow-up on each potentialfraud risk factor that you have identified?
