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 2016. 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 computers 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, 2015 financial statements. In the subsequent year, the company engaged your firm to conduct the audit of its December 31, 2016 financial statements to fulfill requirements of the loan agreements. Custer & Custer issued standard, unmodified reports on both the 2016 and 2017 annual financial statements.
Your firm is in the process of completing the audit of the December 31, 2018 financial statements. Currently it is February 17, 2019 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 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 2018. You learned about this case during your review of the November 2018 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 $550,000.
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, 2018 financial statements. Those financial statements indicate that Murchison’s total assets as of December 31, 2018 were $20.5 million, with revenues of $42.1 million and pretax income of $5.1 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 and discover that the ABA policy statement is included as an Exhibit in both AU-C Section 501, "Audit Evidence - Specific Considerations for Selected Items," and in PCAOB AS 2505, "Inquiry of a Client's Lawyer Concerning Litigation, Claims, and Assessments."
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.
REQUIRED  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.
 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?
 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."
 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, 2018, or was Custer & Custer appropriate in not requesting the response until close to the end of the audit?
 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?
 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, 2018 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.
[c] Assume that you determine, through subsequent discussions with the attorney, that a more likely estimate of the range of loss falls between $65,000 and $100,000. 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 $120,000 and $150,000. 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, 2018 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 $445,000?
[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, 2018 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?
 Locate the ABA policy statement, which you can find as an Exhibit in both AU-C Section 501, "Audit Evidence - Specific Considerations for Selected Items," and in PCAOB AS 2505, "Inquiry of a Client's Lawyer Concerning Litigation, Claims, and Assessments." Review the ABA policy statement to answer these questions. 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?
 In June 2017, the PCAOB adopted a new auditing standard to enhance the relevance and usefulness of the auditor's report. Visit the PCAOB website (www.pcaobus.org) and locate the final approved standard, which you can find by searching for PCAOB Release No. 2017-001 (June 1, 2017), "The Auditor's Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards." The final standard now requires public company auditors to include discussion of "critical audit matters (CAMs)" in the auditor's report. What is a critical audit matter? Do you think this litigation case would be deemed a critical audit matter? If so, how would that impact the auditor's report, if Murchison were a public company?
PROFESSIONAL JUDGMENT QUESTIONS It is recommended that you read the Professional Judgment Introduction found at the beginning of this book prior to responding to the following questions.
 The first two steps in the judgment process are "Clarify Issues and Objectives" and "Consider Alternatives." Evaluate the circumstances affecting Murchison and identify the issues at hand and alternatives that need to be considered in making a judgment about the potential legal liability associated with this case.
 One of the tendencies that can bias judgments is the "anchoring tendency." Briefly describe the "anchoring tendency" and how it might impact judgment about this liability assessment.