Herbert McCoy is the president of McCoy Forging Corporation.For the past several years, Donovan & Company, CPAs, hasperformed the company’s compilation and some other accounting andtax work. McCoy decided to have Donovan & Company conduct anaudit. He had recently received a disturbing anonymous letter thatstated, “Beware; you have a viper in your nest. The money isliterally disappearing before your very eyes! Signed: A friend.” Hetold no one about the letter.
McCoy Forging engaged Donovan & Company, CPAs, to renderan opinion on the financial statements for the year ended June 30.McCoy told Donovan he wanted to verify that the financialstatements were “accurate and proper.” He did not mention theanonymous letter. The usual engagement letter providing for anaudit in accordance with generally accepted auditing standards(GAAS) was drafted by Donovan & Company and signed by bothparties.
The audit was performed in accordance with GAAS. The audit didnot reveal a clever defalcation plan. Harper, the assistanttreasurer, was siphoning off substantial amounts of McCoy Forging’sfunds. The defalcations occurred both before and after the audit.Harper’s embezzlement was discovered by McCoy’s new internalauditor in October after Donovan had delivered the auditors’opinion. Although the scheme was fairly sophisticated, it couldhave been detected if Donovan & Company had performedadditional procedures. McCoy Forging demands reimbursement fromDonovan for the entire amount of the embezzlement, some $40,000 ofwhich occurred before the audit and $65,000 after. Donovan hasdenied any liability and refuses to pay.
Required:
Discuss Donovan’s responsibility in this situation. Do youthink McCoy Forging could prevail in whole or in part in a lawsuitagainst Donovan under common law? Explain your conclusions.
