MURCHISON TECHNOLOGIES, INC.

Evaluating an Attorney’s Response and Identifying the Proper Audit

Report
INTRODUCTION
Murchison Technologies, Inc. recently developed a patient-billing software system that it markets
to physicians and dentists. Jim Archer and Janice Johnson founded the company in Austin, Texas
five years ago after working at IBM for more than 15 years. Jim worked as a software programmer
and Janice worked as a sales representative, frequently calling on stand-alone medical practices.
Together, they identified a need for software to help physician and dental offices track charges
for patient services provided by doctors and their staff. With the initial backing of three local
venture capitalists, they left IBM, created Murchison Technologies, and devoted their full-time
efforts to the development of the billing system software.

For more than three years, they worked on developing the software. After extensive pilot testing,
the company shipped its first product to customers in early 2012. Sales have been surprisingly
strong for the product, which is marketed as MEDTECH Software. Feedback from physicians and
dentists has been extremely positive. Most note that billing clerks and office staff find the system
quite flexible in tracking numerous types of services for large numbers of patients. Most are
pleased with the ability to customize system features for their unique practice needs. Another
key to the product’s success is the relative cost of the software and the minimal upgrades
required of the office microcomputers and networks to operate the software.

The company has gradually added employees to its staff. Currently, Murchison employs about 60
people, including software programmers who continually update the software for emerging
technological developments. Janice serves as chief executive officer (CEO), and Jim serves as
president. While both serve on the board of directors, they ultimately are accountable to the
board, which also includes representatives from the three venture capitalists and two local
bankers who financed company expansions through commercial loans issued three years ago.
Murchison continues to be privately held.

Your firm, Custer & Custer, LLP, was first engaged by Murchison to perform a review of its
December 31, 2011 financial statements. In the subsequent year, the company engaged your
firm to conduct the audit of its December 31, 2012 financial statements to fulfill requirements of
the loan agreements. Custer & Custer issued standard, unqualified reports on both the 2012 and
2013 annual financial statements.

BACKGROUND
Your firm is in the process of completing the audit of the December 31, 2014 financial statements.
Currently it is February 17, 2015 and most of the detailed audit testing is complete. As audit
senior, you are wrapping up the review of staff audit files. The partner anticipates performing

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the review and signing off on audit files tomorrow. This should provide plenty of time for the
audit team to complete the gathering and evaluation of audit evidence in the next day or two.
In preparation for completion of the audit, you recently worked with the client to send requests
to outside legal counsel asking them to provide the standard attorney letter response regarding
material outstanding claims against the company. You sent requests for attorney confirmations
to three law firms providing legal representation for the company.

Based on all the audit work performed, you do not expect any substantive issues related to
outstanding litigation claims against Murchison. Your only concern relates to an alleged copyright
infringement claim against Murchison that apparently was filed in October 2014. You learned
about this case during your review of the November 2014 minutes of the board of directors’
meeting. The minutes made reference to the case being filed; however, based on notations about
the board’s discussion it appeared to you that the probability of an unsuccessful outcome related
to this case is extremely low. Apparently, another software development company, Physicians
Software, Inc., claims that Murchison’s MEDTECH software violates a copyright held by Physicians
Software. They are suing Murchison for $420,000.

Your subsequent inquiries of management about the case confirmed your expectation of a very
low likelihood of unfavorable outcome. In addition, management believes the claim is immaterial
relative to the December 31, 2014 financial statements. Those financial statements indicate that
Murchison’s total assets as of December 31, 2014 were $15.8 million, with revenues of $32.4
million and pretax income of $3.9 million for the year then ended.

You received two of the attorney confirmation letters in the mail yesterday. Your review of the
attorney responses produced no surprises. Most of the issues being handled by those attorneys
relate to collection efforts on delinquent receivables. Those same firms also helped management
develop contracts for special sales agreements with two new customers.

One of your audit staff members just delivered mail from the office after running by the office
during lunch to pick up a few supplies. You are pleased to see that today’s mail includes the
attorney confirmation from the third law firm. You quickly open the envelope to make sure
everything is okay. You begin reading the letter, which is presented in the pages that follow.

You are a little surprised to read the attorney’s assessment of the case, and some of the language
referencing American Bar Association (ABA) policies puzzles you. You quickly link to professional
standards stored on your laptop to review the relevant ABA policy statements. An excerpt of
those statements, which are presented as an exhibit to the auditing standard that addresses
inquiries of the client's lawyer, is presented in Exhibit 1 on the pages that follow.

You want to closely evaluate the information contained in the letter to prepare for a meeting
with the partner regarding possible accounting treatments and audit reporting issues. It is also
likely that the partner will want to discuss those issues with Murchison’s management. In order
to properly prepare, please complete the items noted on the next page.

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REQUIRED

1. Review the requirements in the Accounting Standards Codification (ASB) that address the
accounting for contingencies. Describe the three ranges of loss contingencies outlined in the
accounting standards and summarize briefly the accounting and disclosure requirements for
each of the three ranges.

2. Based on your review of the attorney’s confirmation, which of the three ranges of probability
of loss do you think the Physicians Software Inc., claim falls? How does that assessment differ
from management’s assessment of the loss probability?

3. Assume that Dunn & King's letter did not include their assessment that the outcome "...in this
case, is more than remote but less than likely" but instead included one of the following
statements. What action would you take in response to each scenario (consider each
statement independently)?
a. "We believe the plaintiff's case against the company is without merit."
b. "We believe that a negative outcome for Murchison is most likely, but we are unable to
assess the amount of damages that might be imposed."
c. "This action involves unusual circumstances where there is no prior legal precedent. We
think the Physicians Software will have difficulty establishing liability for Murchison;
however, if Physicians Software is successful, the settlement would be substantial."

4. Discuss why the attorney’s letter is being received so close to the completion of the audit.
Was the request for the attorney’s response an oversight that should have been taken care
of closer to December 31, 2014, or was Custer & Custer appropriate in not requesting the
response until close to the end of the audit?

5. Assuming that management and the attorney’s assessments differ, how would you resolve
such differences when assessing the potential for an unfavorable outcome associated with
the claim? What are the pros and cons of relying on the attorney’s assessment versus
management’s assessment?

6. In preparation for tomorrow’s meeting with the partner and likely subsequent meeting with
Murchison management, develop recommended responses to the following possible
scenarios. In developing your responses, assume that each scenario is independent of the
others:
a. If generally accepted accounting principles require disclosure of this contingency, how
would you respond to management’s decision against disclosure because they view the
claim as immaterial to the December 31, 2014 financial statements? Do you believe the
potential loss is material? Why or why not?
b. Assume that even though you convince management that the claim is material, they
refuse to provide any disclosure that might be required. Prepare a draft of the auditor’s
report that would be issued in that scenario.

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 c. Assume that you determine, through subsequent discussions with the attorney, that a
more likely estimate of the range of loss falls between $50,000 and $75,000. What type
of financial statement disclosure do you believe is required in that case? Prepare a draft
of the auditor’s report that you would issue in that scenario.
d. Assume that you determine, through subsequent discussions with the attorney, that a
more likely estimate of the range of loss falls between $90,000 and $115,000. What type
of financial statement disclosure do you believe is required in that case?
e. What if you learn that management has pertinent information available about the case
(and the case is deemed material) but refuses to share that information with you? Prepare
a draft of the auditor’s report that you would issue in that scenario.
f. Assume that you convinced management to disclose the contingency in the footnotes to
the December 31, 2014 financial statements and that your audit report on those financial
statements was a standard, unqualified audit report. What would your responsibilities be
if you learned two months after the issuance of the report that Murchison settled the
case for $340,000?
g. Assume that the settlement of the litigation prohibits future sales of MEDTECH software.
What implication would that have on the auditor’s report on the December 31, 2014
financial statements?
h. Assume that Custer & Custer was delayed a month in completing the collection of audit
evidence. What actions would be appropriate relating to gathering evidence about
potential contingencies?

7. Review the ABA policy statement excerpts in Exhibit 1. What limitations exist as it relates to
the attorney’s response? To what extent should auditors rely solely on attorney responses to
identify outstanding claims against audit clients?

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