Auditing and Assurance Services 9th Edition by Alvin Arens,Mark Beasley,Randy Elder

Exercise 28

Conan Doyle Associates (CD A), CPAs, served as the auditors for Lestrad Corporation and Watson Corporation, publicly held companies traded on NASDAQ. Watson recently acquired Lestrad Corporation in a merger that involved swapping 1.75 shares of Watson for 1 share of Lestrad. In connection with that merger, CD A issued an unqualified report on the financial statements and participated in the preparation of the pro forma unaudited financial statements contained in the combined prospectus and proxy statement circulated to obtain shareholder approval of the merger and to register the shares to be issued in connection with the merger. Watson prepared a Form 8-K and Form 10-K in connection with the merger. Shortly thereafter, financial disaster beset the merged company, resulting in large losses to the shareholders and creditors. A class action suit on behalf of shareholders and creditors has been filed against Watson and its management. In addition, it names CD A as a codefendant, challenging the fairness, accuracy, and truthfulness of the financial statements.
Required:
Discuss the various bases of CD A's potential civil liability to the shareholders and creditors of Watson as a result of issuing an unqualified report on the audited financial statements of Watson and Lestrad and having participated in preparing the unaudited financial statements required in connection with the merger under
a. State common law.
b. The federal securities acts.
(AICPA, adapted)