Cases Relating to Legal Liability of Auditor5-20 Lauren Yost & Co, a medium sized CPA firm, was engaged to audit Stuart Supply Company. Severalstaff were involved in the audit, all of whom had attended the firm's in house training program oneffective auditing methods. Throughout the audit, Yost spent most of her time in the field planning theaudit, supervising the staff, and reviewing their work.A significant part of the audit entailed verifying the physical count, cost, and summarization of inventory.Inventory was highly significant to the financial statements, and Yost knew the Inventory was pledged ascollateral for a large loan to First City National Bank. In reviewing t's inventory count procedures, Yosttold the president she believed the method of counting inventory at different locations on different dayswas highly undesirable. The president stated that it was impractical to count all inventory on the sameday because of personnel shortages and customer preference. After considerable discussion. Yost agreedto permit the practice if the president would sign a statement that no other method was practical. TheCPA firm had at least one person at each site to audit the inventory count procedures and actual count.There were more than 40 locations.Eighteen months later, Yost found out that the worst had happened. Management below the president'slevel had conspired to materially overstate inventory as a means of covering up obsolete Inventory andInventory losses resulting from mismanagement. The misstatement occurred by physically transportinginventory at night to other locations after it had been counted in a given location. The accountingrecords were inadequate to uncover these illegal transfersAnswer the following questions, setting forth reasons for any conclusions stated:a. What defense should Lauren Yost & Co. use in the suit by Stuart?b. What defense should Lauren Yost & Co. use in the suit by First City National Bank?c. Is Most likely to be successful in her defenses?d. Would the issues or outcome be significantly different if the suit was brought under the SecuritiesExchange Act of 1934?Solution:a. Yost and Co. should use the defenses of meeting auditing standards and contributory negligence. Thefraud perpetuated by Stuart Supply Company was a reasonably complex one and difficult to uncoverexcept by the procedures suggested by Yost.
In most circumstances it would not be necessary to physically count all inventory at different locations onthe same day. Furthermore the president of the company contributed to the failure of finding the fraudby refusing to follow Yost's suggestion. There is evidence of that through his signed statement.b. There are two defenses Yost and Company should use in a suit by First City National Bank First there isa lack of privity of contract. Even though the bank was a known third party, it does not necessarily meanthat there is any duty to that party in this situation. That defense is unlikely to be successful in most