Solution Manual for Contemporary Auditing 11th Edition by Michael C. Knapp

Solution Manual - for Contemporary Auditing 11th Edition by Michael C. Knapp

Solution Manual - for Contemporary Auditing 11th Edition by Michael C. Knapp

Case 1.1 Enron Corporation 1

CASE 1.1

ENRON CORPORATION

Synopsis Arthur Edward Andersen built his firm, Arthur Andersen & Company, into one of the largest and most respected accounting firms in the world through his reputation for honesty and integrity.

“Think straight, talk straight” was his motto and he insisted that his clients adopt that same attitude when preparing and issuing their periodic financial statements. Arthur Andersen’s auditing philosophy was not rule-based, that is, he did not stress the importance of clients complying with specific accounting rules because in the early days of the U.S. accounting profession there were few formal rules and guidelines for accountants and auditors to follow. Instead, Andersen invoked a substance-over-form approach to auditing and accounting issues. He passionately believed that the primary role of the auditor was to ensure that clients reported fully and honestly to the public, regardless of the consequences for those clients.

Ironically, Arthur Andersen & Co.’s dramatic fall from prominence resulted from its association with a client known for aggressive and innovative uses of “accounting gimmicks” to window dress its financial statements. Enron Corporation, Andersen’s second largest client, was involved in large, complex transactions with hundreds of special purpose entities (SPEs) that it used to obscure its true financial condition and operating results. Among other uses, these SPEs allowed Enron to download underperforming assets from its balance sheet and to conceal large operating losses. During 2001, a series of circumstances, including a sharp decline in the price of Enron’s stock, forced the company to assume control and ownership of many of its troubled SPEs. As a result, Enron was forced to report a large loss in October 2001, restate its earnings for the previous five years, and, ultimately, file for bankruptcy in December 2001.

During the early months of 2002, Andersen became the focal point of attention among law enforcement authorities searching for the parties responsible for Enron’s sudden collapse. The accusations directed at Andersen centered on three key issues. The first issue had to do with the scope of professional services that Andersen provided to Enron. Critics charged that the enormous consulting fees Enron paid Andersen impaired the audit firm’s independence. The second issue stemmed from Andersen’s alleged role in Enron’s aggressive accounting and financial reporting treatments for its SPE-related transactions. Finally, the most embarrassing issue was the massive effort of Andersen’s Houston office to shred Enron audit documents, which eventually led to the demise of the firm. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.1 Enron Corporation 2 Enron Corporation--Key Facts 1.

Throughout Arthur E. Andersen’s life, “Think Straight, talk straight” served as a guiding principle for himself and Arthur Andersen & Co., the accounting firm that he founded.

2.

Arthur Andersen’s reputation for honesty and integrity resulted in Arthur Andersen & Co. gaining stature in the business community and growing into one of the nation’s leading accounting firms by the time of his death in 1947.

3.

Leonard Spacek succeeded Arthur Andersen as managing partner of Arthur Andersen & Co. in 1947 and continued Andersen’s legacy of lobbying for more rigorous accounting, auditing, and ethical standards for the public accounting profession.

4.

When Spacek retired in 1973, Arthur Andersen & Co. was one of the largest and, arguably, the most prominent accounting firm worldwide

5.

The predecessor of Enron Corporation was an Omaha-based natural gas company created in 1930; steady growth in profits and sales and numerous acquisitions allowed Enron to become the largest natural gas company in the United States by the mid-1980s.

6.

During the 1990s, Kenneth Lay, Enron’s CEO, and his top subordinate, Jeffrey Skilling, transformed the company from a conventional natural gas supplier into an energy trading company.

7.

Lay and Skilling placed a heavy emphasis on “strong earnings performance” and on increasing Enron’s stature in the business world.

8.

Enron executives used hundreds of SPEs (special purpose entities) to arrange large and complex related party transactions that served to strengthen Enron’s reported financial condition and operating results.

9.

During 2001, Enron’s financial condition deteriorated rapidly after many of the company’s SPE transactions unraveled; in December 2001, Enron filed for bankruptcy.

10. Following Enron’s collapse, the business press and other critics began searching for parties to hold responsible for what, at the time, was the nation’s largest corporate bankruptcy.

11. Criticism of Andersen’s role in the Enron debacle focused on three key issues: the large amount of consulting revenue the firm earned from Enron, the firm’s role in many of Enron’s SPE transactions, and the efforts of Andersen personnel to destroy Enron audit documents.

12. Andersen’s felony conviction in June 2002 effectively ended the firm’s long and proud history in the public accounting profession. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.1 Enron Corporation 3 Instructional Objectives 1.

To provide students with a brief overview of the history and development of the public accounting profession in the United States.

2.

To examine the “scope of services” issue, that is, the threats to auditor independence posed by audit firms providing consulting services to their audit clients.

3.

To examine the extent to which independent auditors should be involved in their clients’ decisions regarding important accounting and financial reporting issues.

4.

To review recent recommendations made to strengthen the independent audit function.

5.

To review auditors’ responsibilities regarding the preparation and retention of audit workpapers.

Suggestions for Use

I typically begin an auditing course by discussing a major and widely publicized audit case.

Clearly, the Enron case satisfies those criteria. The purpose of presenting such a case early in the semester is not only to acquaint students with the nature of auditing but also to make them aware of why the independent audit function is so important. Many accounting students are not well acquainted with the nature of the independent auditor's work environment, nor are they generally familiar with the critical role the independent audit function plays in our national economy.

Hopefully, cases such as this one provide students with a "reality jolt" that will stimulate their interest in auditing and, possibly, make them more inclined to pursue a career in the auditing field.

The Enron case also serves as a good starting point for an auditing course since it provides students with an overview of how the auditing profession developed and evolved in the United States over the past century. The vehicle used to present this overview is the history of Arthur Andersen & Co. You will find that the case attempts to contrast the “Think straight, talk straight” philosophy of Arthur E. Andersen, the founder of the Andersen firm, with the more business-oriented approach to auditing that his predecessors adopted in the latter decades of the twentieth century.

Consider asking one or more of your students to interview former Andersen personnel who are graduates of your school. I have found that many former Andersen partners and employees are more than willing to discuss their former employer and the series of events that led to the firm’s sudden collapse. These individuals typically suggest that federal prosecutors’ efforts to “bring down” the entire Andersen firm as a result of the document-shredding incident was not only unnecessary but also inequitable, an argument that many members of the accounting profession—including academics— find difficult to refute.

Suggested Solutions to Case Questions 1. A large number of parties bore some degree of responsibility for the problems that the Enron fiasco ultimately posed for the public accounting profession and the independent audit function. The © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.1 Enron Corporation 4 following bullet items identify several of these parties [see bold-facing] and the role they played in the Enron drama.

• The leadership of the Andersen firm that allegedly focused too much attention on practice

development activities at the expense of the public service ideal embraced by Arthur E. Andersen and other early leaders of the profession.

• Impertinent corporate executives who insisted on aggressive, if not illegal, accounting and financial reporting treatments.

• Individual auditors who made shortsighted and/or unprofessional decisions that tainted the perceived integrity of all auditors.

• Regulatory authorities that failed to take proactive measures to limit the ability of rogue corporate executives, accountants, and auditors to circumvent their professional responsibilities.

2. One approach to answering this question is to review with your students the eight specific types of non-audit services that the Sarbanes-Oxley Act of 2002 prohibited auditors of public companies from providing to their clients. Listed next are those eight non-audit services.

• Bookkeeping or other services related to the accounting records or financial statements of the

audit client • Financial information systems design and implementation • Appraisal or valuation services, fairness opinions, or contribution-in-kind reports • Actuarial services • Internal audit outsourcing services • Management functions or human resources functions • Broker or dealer, investment adviser, or investment banking services • Legal services and expert services unrelated to the audit Many of these services would eventually place auditors in situations in which they had to effectively audit their own work. For example, auditors providing “financial information systems design services” could be forced to evaluate the integrity of an accounting system they had designed for an audit client. Likewise, providing “human resources” functions, such as executive search services, to audit clients could threaten auditors’ independence by causing them to evaluate the work product of high-ranking client employees who they had recommended that a client hire.

3. Given the assumption that the Powers Report excerpts included in Exhibit 3 are accurate, one could plausibly argue that Andersen’s involvement in Enron’s accounting and financial reporting decisions violated several of the ten generally accepted auditing standards that were in effect at the time. The specific standards violated would have included, at a minimum, those involving, independence, due professional care, planning and supervision, audit evidence, and audit reporting.

Each of the latter standards are now integrated into the PCAOB’s auditing standards. Next, I list these standards, indicating parenthetically where they can be found in the PCAOB’s auditing standards, and then briefly review how each was likely or possibly violated by the Andersen auditors.

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.1 Enron Corporation 5 • Independence (AS 1005): by becoming too involved in Enron’s decisions for important

accounting and financial reporting treatments, the Andersen auditors may have forfeited some degree of objectivity when they reviewed those decisions during the course of subsequent audits.

• Due professional care (AS 1015): any violation of another auditing standard, by definition, results in a violation of this broad-brush standard.

• Planning (AS 2101) and supervision (AS 1201): a reliable quality control function, including proper audit planning decisions and effective supervision/review during an audit, should result in the identification of problematic situations in which auditors have become too involved in client accounting and financial reporting decisions.

• Audit evidence (AS 1105): many critics suggest that Andersen’s deep involvement in Enron’s aggressive accounting and financial reporting treatments may have precluded the firm from collecting sufficient appropriate evidence to support the audit opinions issued on the company’s financial statements (that is, the Andersen auditors may have been less than objective in reviewing/corroborating the client’s aggressive accounting and financial reporting treatments).

• Reporting (AS 3101): If Andersen did not maintain its independence and objectivity while auditing Enron, the audit firm should have issued a disclaimer of opinion on the company’s periodic financial statements.

4. Note: The PCAOB has established the documentation requirements for the audits of publicly owned companies in AS 1215, “Audit Documentation.” The documentation requirements that pertain to audits of other organizations can be found in AU-C Section 230, “Audit Documentation,” of the AICPA Professional Standards.

AU-C Section 230: Paragraph .08 of AU-C Section 230 provides the following general guidance to independent auditors regarding audit workpapers or “audit documentation.”

“The auditor should prepare audit documentation that is sufficient to enable an experienced auditor, having no previous connection with the audit, to understand a. b. c.

the nature, timing and extent of the audit procedures performed to comply with GAAS and applicable legal and regulatory requirements; the results of the audit procedures performed, and the audit evidence obtained; and significant findings or issues arising during the audit, the conclusions reached thereon, and significant professional judgments made in reaching those conclusions.”

Paragraphs 15-19 of AU-C Section 230 discuss the “assembly” and “retention” of audit workpapers. For example, paragraph 17 notes that the “retention period” for audit documentation “should not be shorter than five years from the report release date.”

AS 1215: This standard defines audit documentation as “the written record of the basis for the auditor’s conclusions that provides the support for the auditor’s representations, whether those representations are contained in the auditor’s report or otherwise” (para. .02). “Examples of audit documentation © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.1 Enron Corporation 6 include memoranda, confirmations, correspondence, schedules, audit programs, and letters of representation. Audit documentation may be in the form of paper, electronic files, or other media” (para. .04).

AS 1215 notes that there are three key objectives of audit documentation: “demonstrate that the engagement complied with the standards of the PCAOB, support the basis for the auditor’s conclusions concerning every major relevant financial statement assertion, and demonstrate that the underlying accounting records agreed or reconciled with the financial statements” (para. .05).

Similar to AU-C Section 230, AS 1215 establishes an explicit benchmark that auditors can use to determine whether audit documentation is “sufficient.” “Audit documentation must contain sufficient information to enable an experienced auditor, having no previous connection with the engagement: a) to understand the nature, timing, extent, and results of the procedures performed, evidence obtained, and conclusions reached, and b) to determine who performed the work and the date such work was completed as well as the person who reviewed the work and the date of such review” (para. .06).

AS 1215 generally requires auditors to retain audit documentation for seven years from the date the auditor gave the client permission to use the relevant audit report in connection with the issuance of a set of financial statements.

Regardless of whether an audit client is a publicly owned company or another type of organization, the audit workpapers are the property of the audit firm.

5. During and following the Enron debacle, wide-ranging recommendations were made by many parties to strengthen the independent audit function. Listed next are several of these recommendations, including certain measures that were incorporated in the Sarbanes-Oxley Act of 2002.

• Establish an independent audit agency. Some critics have suggested that to “cure” the

paradoxical nature of the auditor-client relationship (that is, to eliminate the economic leverage that clients have on their auditors), the independent audit function should be performed by a government agency comparable to the Internal Revenue Service.

• Permit audit firms to provide only audit, reviews, compilations, and other “pure” attestation services to their clients, that is, prohibit the provision of all non-audit services to audit clients.

(As mentioned in the suggested solution to Question 2, Sarbanes-Oxley prohibits audit firms from providing eight specific consulting services to their audit clients.)

• Require that audit clients periodically rotate or change their independent audit firms.

(Sarbanes-Oxley requires that engagement and review partners be rotated every five years on audit engagements involving public companies.)

• Establish an independent board to oversee the audits of public companies. (Sarbanes-Oxley resulted in the creation of the Public Company Accounting Oversight Board “to oversee the audit of public companies that are subject to the securities laws . . .”)

• Require independent auditors to work more closely with their clients’ audit committees.

(Section 204 of Sarbanes-Oxley is entitled “Auditor Reports to Audit Committees” and delineates the information that auditors should exchange with a client’s audit committee, including any alternative accounting treatments “preferred” by the auditors.)

• Establish more explicit statutory requirements that prohibit client executives from interfering with the work of their independent auditors. (Section 303 of Sarbanes-Oxley is entitled © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.1 Enron Corporation 7 “Improper Influence on Conduct of Audits.” This section of the federal law makes it unlawful for corporate executives “to fraudulently influence, coerce, manipulate, or mislead” their company’s independent auditors.”)

6. Many critics of our profession suggest that beginning in the latter part of the twentieth century certain accounting firms gradually turned away from the public service ideal embraced by Arthur E. Andersen and other early pioneers within the profession and, instead, adopted a somewhat mercenary attitude toward the independent audit function. A key factor that certainly accelerated this trend was the profession’s decision in the 1970s, with the goading of the Federal Trade Commission and the courts, to drop bans on competitive bidding, client solicitation, and other ethical rules that effectively restrained competition among audit firms. The elimination of those rules enticed audit firms to begin competing against each other for the finite number of large corporate audits. Practices such as “lowballing” to gain such clients allegedly resulted in audit firms “cutting corners” on audits.

Likewise, audit firms began vigorously marketing non-audit services to supplement their suddenly low-margin audit services.

A related factor that allegedly contributed to the move away from the public service ideal was the growing tendency for large audit firms to consider marketing skills, as opposed to technical skills, as the key criterion in determining which individuals would be promoted to partner. Finally, pure and simple greed is a factor that motivates most of us. The large and lucrative market for business consulting services over the past few decades may have enticed audit firms to focus more on becoming “strategic business advisers” to their clients rather than placing an unrelenting emphasis on the quality of their audits of those clients’ financial statements.

7. In the spring of 2000, the SEC began requiring public companies to have their quarterly financial reports (typically included in Form 10-Q filings) reviewed by their independent auditors.

Should quarterly reports be audited? In fact, many parties have advocated an even more extreme measure, namely, that independent auditors continually monitor and report on the integrity of their clients’ financial disclosures. In the current environment when information is distributed so readily and widely to millions of investors and other decision makers, the validity or utility of independent audits that focus on discrete time periods has been challenged. As recent history has proven, by the time that auditors issue their reports on a client’s financial statements for some discrete period, the “horse may already be out of the barn”—the “horse” in this case being the damage to investors and other parties resulting from oversights and other misrepresentations in the given financial statements.

This problem could be cured, or, at least, mitigated to some extent, by requiring auditors to provide real-time disclosures of potential problems in their clients’ financial records.

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.2 Lehman Brothers Holdings, Inc. 8

CASE 1.2

LEHMAN BROTHERS HOLDINGS INC.

Synopsis Wall Street was stunned in September 2008 when this iconic investment banking firm filed for bankruptcy. Two years later, there was a similar reaction within the investment community when Lehman’s court-appointed bankruptcy examiner released his 2200-page report, the purpose of which was to identify the parties that could possibly be held civilly liable for the enormous losses suffered by Lehman’s investors and creditors.

The focus of the bankruptcy examiner’s report was hundreds of billions of dollars of allegedly “accounting-motivated” transactions that Lehman had used to enhance its apparent financial condition. Lehman’s Repo 105s were short-term repurchase agreements that the company had chosen to record as “true sales” of securities under the auspices of the relevant accounting standard, namely, SFAS No. 140. The normal accounting treatment for repos is for the “seller” to record them as short-term loans. Why? Because most repos are, in substance, short-term loans in which the securities being “sold” are, in reality, simply the collateral for the given loan.

An exception to SFAS No. 140 permits repo borrowers (sellers) to record these transactions as true sales of securities if they can demonstrate that they have “surrendered” control of the securities involved in the transactions. Lehman’s management used this “loophole” in SFAS No. 140 to significantly reduce its “net leverage ratio” and its reported liabilities by engaging in a huge volume of Repo 105 transactions. At the time, the most important metric that analysts used in monitoring the financial health of large investment banks was their degree of financial leverage—Lehman touted its net leverage ratio as the best measure of its financial leverage.

This case provides a brief historical overview of Lehman Brothers and then dissects the accounting and financial reporting issues related to the company’s controversial use of Repo 105s.

Of course, the principal purpose of this case is to examine the auditing issues raised by the Lehman debacle. The company’s audit firm, Ernst & Young, was among the parties most criticized by Lehman’s bankruptcy examiner. The bankruptcy examiner identified three “colorable claims” involving professional malpractice or negligence that could potentially be pursued in lawsuits filed against Ernst & Young. This case examines the auditing issues embedded in each of those claims.

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.2 Lehman Brothers Holdings, Inc. 9 Lehman Brothers Holdings, Inc.--Key Facts 1.

Lehman Brothers, one of Wall Street’s most prominent investment banking firms, became the largest corporate failure in U.S. history when it filed for bankruptcy in September 2008.

2.

The release in March 2010 of a report by Lehman’s court-appointed bankruptcy examiner prompted a public outcry when it revealed that Lehman had used multi-billion dollar “accounting-motivated” transactions to embellish its apparent financial condition during 2007 and 2008.

3.

Similar to other investment banks, a key business risk factor for Lehman was the high degree of financial leverage that it employed; Lehman management persuaded financial analysts and other third parties that its “net leverage ratio” was the best measure of its degree of financial leverage.

4.

The business risk faced by Lehman and the other major investment banks was amplified duringt the 1990s and beyond when they became heavily involved in the rapidly evolving and highrisk financial derivatives markets.

5.

When housing prices began plummeting in the U.S. in 2007, Lehman’s financial condition worsened dramatically since it had large investments in RMBS (residential mortgage-backed securities).

6.

To enhance its reported financial condition and its net leverage ratio, Lehman developed a plan to engage in a large volume of Repo 105s, which were repurchase agreements accounted for as sales of securities (the customary accounting treatment for repos was to record them as shortterm loans).

7.

Accounting for repos as sales of securities was permitted under certain restrictive conditions identified by the relevant accounting standard, SFAS No. 140; however, Lehman could not find a U.S. law firm that would issue an opinion confirming that Repo 105s could be treated as sales.

8.

Lehman executed the Repo 105s in Great Britain after finding a British law firm that would issue an opinion that they qualified as sales of securities; the Repo 105s allowed Lehman to reduce its net leverage ratio by as much as 10 percent and its reported liabilities by as much as $50 billion.

9.

Among the parties that were most heavily criticized by Lehman’s bankruptcy examiner in his report was the company’s audit firm, Ernst & Young.

10. The bankruptcy examiner concluded that E&Y could potentially be held liable for failing to properly investigate a whisteblower’s allegations that Lehman’s financial statements were materially misstated and for allegedly failing to properly investigate the impact of Repo 105s on Lehman’s quarterly and annual financial statements. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.2 Lehman Brothers Holdings, Inc. 10 11. Numerous lawsuits stemming from Lehman’s collapse named E&Y as a defendant or codefendant; to date, E&Y has made more than $100 million in payments to settle such lawsuits.

Instructional Objectives 1.

To examine the responsibility of auditors when a client implements a new and controversial accounting policy that has significant financial statement implications.

2.

To examine the responsibility of auditors when clients have engaged in significant “accountingmotivated” transactions.

3.

To identify auditors’ responsibility to review or otherwise evaluate important “other information” that accompanies a client’s audited financial statements.

4.

To identify factors that should influence key materiality decisions made by auditors.

5.

To identify the responsibilities of auditors when the integrity of a client’s financial statements is challenged by a whistleblower.

6.

To examine auditors’ differing legal exposure in lawsuits filed in state courts versus federal courts.

Suggestions for Use

Here’s another case that you could use as a launching pad for an undergraduate or graduate auditing course. This case will readily demonstrate to your students the huge challenges that auditors can face in carrying out their responsibilities and the critical importance of independent audits for not only individual companies but the national economy as well. Ernst & Young’s audits of Lehman Brothers literally had economic implications for practically every U.S. citizen. In sum, I believe a case such as this can be used as an “attention grabber” for auditing students by conveying to them the importance of the professional responsibilities that they will soon be assuming.

The focal point of this case involves a critically important issue for accountants and auditors alike, namely, the bottom line objective of accounting and financial reporting standards. Lehman Brothers engaged in hundreds of billions of dollars of complex transactions that apparently had no express business purpose. Instead, the transactions were used ostensibly to window dress the company’s financial statements, that is, to improve Lehman’s critical net leverage ratio at a point in time when the company was literally coming apart at the seams. Although there is still some disagreement on this matter, there seems to be a general consensus that the “accounting loophole” that Lehman used to “pull off” this accounting charade was “legal” or permissible under SFAS No. 140, which was the relevant accounting standard. In fact, I tell my students to make that assumption prior to addressing the following question, which I use to kickoff the discussion of this case: Is it permissible for reporting entities to use accounting standards to intentionally misrepresent their financial statements? It is surprising to me that there is not complete consensus within the profession or even among academics within our profession on this issue—as pointed out in the case. As a point © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.2 Lehman Brothers Holdings, Inc. 11 of information, I have found that the majority of my students typically express the view that entities should be allowed to apply a given accounting or financial reporting rule even if their express intent is to use that rule to embellish their apparent financial condition and/or operating results.

You may want to point out to your students that U.S. accounting standards do not currently include a rule equivalent to the “true and fair override” rule embedded in IFRS—that rule requires reporting entities to not apply an accounting standard if it would result in the given financial statements being misleading. However, the AICPA Code of Professional Conduct, “Accounting Principles,” effectively includes such an “override” rule—see “Accounting Principles Rule,” ET 1.320.001.

Suggested Solutions to Case Questions 1. No, auditors do not have an explicit responsibility to be involved in an audit client’s process of developing new accounting policies. In the PCAOB’s auditing standards, AS 1001.03 notes that “The financial statements are management’s responsibility . . . [and] that management is responsible for adopting sound accounting policies. . .” AS 2110.07 requires auditors to obtain an understanding of “the company’s selection and application of accounting principles.” AU-C 315.12 of the AICPA Professional Standards observes that “The auditor should obtain an understanding of the . . . entity’s selection and application of accounting policies, including the reasons for changes thereto.” In addition to obtaining an understanding of a client’s accounting policies, auditors should consider whether each accounting policy is “appropriate” as noted by AS 2110.12 and AU-C 315.12.

Recognize that auditors’ need to obtain an understanding of a given accounting policy is enhanced when the policy involves “unusual” transactions or when a “significant” accounting policy involves “controversial” or “emerging” areas for which there is a lack of authoritative guidance or consensus [see AS 2110.13]. These circumstances certainly seem to apply to the situation that existed when Lehman was developing its Repo 105 accounting policy.

2. Again, for me, this question or issue is the focal point of the case—from both an accounting/financial reporting point of view and from an auditing perspective. In my view, the economic reality of a given transaction should be reflected in the accounting treatment applied to it.

That is, I believe that “intent does matter” and that the underlying intent of the accounting treatment applied to a given transaction should be to ensure that the economic substance of the transaction is properly reflected in the given entity’s financial statements and accompanying notes.

The principal conceptual basis for the argument outlined in the previous paragraph is the FASB’s conceptual framework, that is, the Statement of Financial Accounting Concepts, in particular, SFAC No. 8, “Conceptual Framework for Financial Reporting.” For example, SFAC No. 8 notes that “To be useful, financial information not only must represent relevant phenomena, but it also must faithfully represent the phenomena that it purports to represent. To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral, and free from bias.”

[QC12] Of course, as pointed out by E&Y’s legal counsel in lawsuits filed against the firm, the conceptual framework is not considered a component of GAAP. So, a violation of the “faithful representation” requirement is technically not considered a GAAP violation. [Note: SFAC No. 8 was issued in September 2010. SFAC No. 8 replaced SFAC No. 2 which included a discussion of © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.2 Lehman Brothers Holdings, Inc. 12 “representational faithfulness” that paralleled the “faithful representation” concept presented in SFAC No. 8.]

3. Recall that the SEC has specifically defined “accounting-motivated structured transactions” as follows: ‘Accounting-motivated structured transactions’ are ‘transactions that are structured in an attempt to achieve reporting results that are not consistent with the economics of the transaction, and thereby impair the transparency of financial reports.’ [Attempts] to portray the transactions differently from their substance do not operate in the interests of investors, and may be in violation of the securities laws.

Auditors have an explicit responsibility to investigate whether the key management assertions underlying a given account balance, transaction, or financial disclosure is consistent with the presentation of that item in the relevant financial statements. By definition, accounting-motivated transactions would almost definitely violate one or more of those management assertions. For example, the classification assertion mandates that transactions and events be recorded in the proper accounts. You can imagine that a large proportion of accounting-motivated transactions would result in violations of the classification assertion.

So, my answer to this case question would be that auditors do have a responsibility to investigate whether client transactions are accounting-motivated. However, that responsibility is simply a byproduct of applying an assertion-based audit strategy.

4. There was not a specific auditing standard that mandated that Schlich or one of his subordinates review the legal opinion issued by the British law firm. Having said that, given the critical importance of the Repo 105 transactions to Lehman’s financial statements, it certainly seems that doing so would have been a “good idea.” Reviewing that legal opinion would certainly have provided Ernst & Young with an enhanced “understanding” of the Repo 105 transactions [see answer to Question No. 1].

Granted, this observation is being made ex post. Recognize that Lehman developed the Repo 105 accounting policy shortly after SFAS No. 140 was adopted in 2000. The company didn’t begin engaging in a large volume of the Repo 105 transactions until several years later. So, even though it may not have seemed imperative for Ernst & Young to have reviewed the Linklaters’ legal opinion when it was originally issued, years later when the volume of the Repo 105s increased dramatically, it seems reasonable to suggest that Ernst & Young should have at least considered reviewing that document.

On a large engagement involving multiple practice offices of an accounting firm, the engagement audit partner has the responsibility for overseeing the division of responsibilities on that engagement.

In this case, that individual would have been William Schlich. Of course, on a large audit the engagement partner may delegate that administrative task to a subordinate. Nevertheless, the key point here is that the ultimate responsibility for administering the 2007 Lehman audit, including the allocation of the specific audit procedures to the practice offices involved in that audit, apparently rested with Schlich.

Notes: AU-C 600, “Special Considerations—Audits of Group Financial Statements (Including the Work of Component Auditors)” is relevant for audits of non-public companies. That relatively © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.2 Lehman Brothers Holdings, Inc. 13 new auditing standard discusses the division of responsibilities on audits of “group financial statements,” including the overarching responsibilities of the “group engagement partner.” In the PCAOB’s auditing standards, AS 1205, “Part of the Audit Performed by Other Independent Auditors,” addresses circumstances in which multiple accounting firms are involved in an audit of an SEC registrant. AI 10 of the PCAOB’s auditing standards includes “Interpretations” of AS 1205.

5. The relevant section of the PCAOB’s auditing standards in this context is AS 2710, “Other Information in Documents Containing Audited Financial Statements.”

AS 2710.04: “Other information in a document may be relevant to an audit performed by an independent auditor or to the continuing propriety of his report. The auditor’s responsibility with respect to information in a document does not extend beyond the financial information identified in his report, and the auditor has no obligation to perform any procedures to corroborate other information contained in a document. However, he should read the other information and consider whether such information, or the manner of its presentation, is materially inconsistent with information, or the manner of its presentation, appearing in the financial statements. If the auditor concludes that there is a material inconsistency, he should determine whether the financial statements, his report, or both require revision.”

AS 2710 goes on to discuss additional responsibilities that auditors have for “other information.”

For example, paragraph .05 discusses an auditor’s responsibility when he or she discovers a “material misstatement” in “other information.”

In the AICPA Professional Standards, AU-C Section 720, “Other Information in Documents Containing Audited Financial Statements,” would be relevant to this question in the context of audits of entities other than public companies. AU-C Section 720 imposes responsibilities on auditors that are very similar to those included in AS 2710.

6. Since there isn’t a “definitive” answer to this question, one objective you may want to accomplish in addressing it is to acquaint your students with the principal materiality “rules” or guidelines in the technical literature. Following are multiple viewpoints on materiality.

NOTE: SFAC No. 2 was in effect when the key events in the Lehman case transpired. Included below is the FASB’s reference to materiality in SFAC No. 2 and in SFAC No. 8, which superseded SFAC No. 2. Finally, recognize that in early 2016, the FASB indicated that it might shift to a more legalistic definition of materiality, that is, one more consistent with U.S. Supreme Court rulings. Of course, the SEC’s views on materiality parallel those of the Supreme Court.

FASB, SFAC No. 2: Statement of Financial Accounting Concepts No. 2 defines materiality as follows: “the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.”

FASB, SFAC No. 8: “Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude or both of the items to which the information relates in the context of an individual entity’s financial report.” © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.2 Lehman Brothers Holdings, Inc. 14 SEC: The SEC’s principal statement regarding materiality can be found in Staff Accounting Bulletin No. 99 issued in 1999. From the SEC’s standpoint, an item is generally material if there is a “substantial likelihood” that a “reasonable investor” would “attach importance” to it in deciding whether or not to purchase a given security. Here’s a key excerpt from SAB No. 99.

An assessment of materiality requires that one views the facts in the context of the “surrounding circumstances,” as the accounting literature puts it, or the “total mix” of information in the words of the Supreme Court. In the context of a misstatement of a financial statement item, while the “total mix” includes the size in numerical percentage terms of the misstatement, it also includes the factual context in which the user of the financial statements would view the financial statement item. The shorthand in the accounting and auditing literature for this analysis is that financial management and the auditor must consider both “quantitative” and “qualitative” factors in assessing an item’s materiality.

AICPA Professional Standards: AU-C Section 320, “Materiality in Planning and Performing an Audit,” notes that “misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users made on the basis of the financial statements” (paragraph .02).

PCAOB auditing standards: In AS 2105.02, the PCAOB embraces the Supreme Court and the SEC’s definition of materiality.

For Lehman Brothers, there was no doubt that the company’s apparent degree of leverage was a key issue being monitored closely by the parties tracking that company’s financial data. So, it certainly seems reasonable for E&Y to have placed a disproportionate focus on that facet of Lehman’s financial condition in arriving at key materiality benchmarks—apparently, the E&Y auditors did just that since they had an explicit materiality threshold related to Lehman’s net leverage ratio.

7. Allegations of financial statement misrepresentations by a whistleblower are not one of the “standard” types of audit evidence identified professional auditing standards. Nevertheless, such allegations will nearly always relate to one or more of the management assertions around which auditors design their audit program or audit plan. For example, in this case, the whistleblower’s allegations challenged the reliability of the “accuracy” assertion for total assets and liabilities as well as several other management assertions identified in the PCAOB’s auditing standards and the AICPA Professional Standards. When whistleblower allegations challenge the reliability of management assertions for a given audit client, then certainly auditors have a responsibility to investigate those allegations.

No doubt, the first task of the auditor in this type of scenario will be to “consider the source.” It may well be that the individual making the allegation is not credible and/or does not have access to information on which to base such an allegation. In such cases, the auditor will likely expend little time and effort investigating the given allegation. (By the way, the whistleblower in the Lehman case was very credible and had access to the company’s accounting records since he was a member of the company’s accounting staff.) © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.2 Lehman Brothers Holdings, Inc. 15 8. Most elements of proof do not vary between civil lawsuits filed against audit firms in the state and federal courts. For example, in either level of the court system, the plaintiff has to prove “damages,” otherwise there is no basis for a lawsuit. The key factor that influences the legal exposure that audit firms face in state versus federal courts is the level of misconduct or malfeasance that the plaintiff must prove in order to prevail in a civil lawsuit filed against such a firm. When suing an audit firm under the Securities Exchange Act of 1934, the plaintiff has to prove that the audit firm was more than negligent in performing the given audit. Federal courts require a plaintiff to establish that the defendant audit firm was either reckless or that scienter (intent to deceive) was present (this element of proof varies across individual federal courts—approximately one-half of the federal district courts require plaintiffs to establish at least recklessness, while the other one-half invoke the higher “scienter” standard).

The level of misconduct that plaintiffs must establish in the state courts to prevail in a civil lawsuit against an audit firm varies. For example, in some state courts, only primary beneficiaries (of a given audit) can sue an audit firm for negligence, while in other state court systems primary, foreseen, and reasonably foreseeable beneficiaries can sue auditors for negligence. If a state court system does not allow a plaintiff to sue an audit firm for negligence, then the plaintiff must file such a lawsuit predicated on gross negligence, recklessness, or fraud. As you can imagine, plaintiff legal counsel often engage in so-called “venue shopping” to find a court where their client is most likely to prevail.

Notes: recognize that very few civil lawsuits against audit firms are tried in the federal courts under the Securities Act of 1933. Why? Because that statute imposes a severe level of legal liability on third parties, such as auditors, associated with S-1 registration statements that contain material misrepresentations. So, audit firms nearly always settle such lawsuits out of court. (Of course, the 1933 Act doesn’t apply in this case since that statute deals with initial SEC registration statements for companies going public.)

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Case 1.3 Just for Feet, Inc. 16

CASE 1.3

JUST FOR FEET, INC.

Synopsis Harold Ruttenberg emigrated to the United States from South Africa in 1976. In his early thirties at the time and the father of three small children, Ruttenberg wanted to escape the political and economic troubles brewing in South Africa. Over the previous decade, Ruttenberg had created a successful retail business in his home country. However, South Africa’s emigration laws allowed the young businessmen to take only $30,000 of his considerable net worth with him to the U.S. Not to be deterred, the industrious Ruttenberg quickly resurrected his business career in his new homeland.

In 1988, Ruttenberg sold his existing business and founded Just for Feet, Inc., a retail “superstore” that sold principally athletic shoes. Over the next decade, Just for Feet opened more than 300 retail outlets across the United States and became the second largest retailer of athletic shoes in the nation. Ruttenberg took his company public in 1994. During the late 1990s, Just for Feet’s common stock was one of the “hottest” securities on Wall Street, thanks to the company’s impressive operating results, which included 21 straight quarterly increases in same-store sales.

Those operating results were even more impressive when one considers the fact that the athletic shoe “sub-industry” was suffering from severe over-saturation during that time frame.

Just for Feet shocked Wall Street in mid-1999 by announcing that it would post its first-ever quarterly loss and that it might default on the interest payment that was coming due on its outstanding bonds. The potential default was particularly stunning since the company had just sold the bonds two months earlier. When Harold Ruttenberg resigned as the company’s CEO in July 1999, Just for Feet’s board hired a corporate turnaround specialist. Unfortunately, there was no turnaround in the company’s future. In November 1999, the company filed for bankruptcy and was eventually liquidated.

Federal and state law enforcement authorities who investigated Just for Feet’s sudden collapse discovered that management had orchestrated a large scale accounting fraud to conceal the company’s deteriorating financial condition in the late 1990s. The principal features of the fraud included improper accounting for so-called vendor allowances, the company’s refusal to provide an appropriate reserve for inventory obsolescence, and the recording of millions of dollars of fictitious “booth” income. Eventually, regulatory authorities turned their attention to Just for Feet’s independent audit firm, Deloitte & Touche. Investigations of Deloitte’s audits of Just for Feet © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.3 Just for Feet, Inc. 17 revealed serious deficiencies in those audits that resulted in the prominent audit firm being sanctioned by the SEC and being named as a defendant in multiple civil lawsuits.

Just For Feet, Inc.--Key Facts 1. In 1976, Harold Ruttenberg, a successful entrepreneur in South Africa, chose to emigrate to the U.S. because of the economic and political turmoil in his home country.

2. Ruttenberg, who was forced to leave nearly all of his net worth in South Africa, quickly created a thriving retail business in Birmingham, Alabama.

3. In 1988, Ruttenberg founded Just for Feet, Inc., a retail company that marketed sports apparel, principally athletic shoes, from large “superstores.”

4. From 1988 through 1998, Just for Feet’s revenues and profits grew dramatically; by 1998, the company operated 300 retail outlets in the U.S. and was the nation’s second largest retailer of athletic shoes.

5. In mid-1999, Just for Feet shocked the investing public by announcing that it would report its first-ever quarterly loss and that it might default on the interest payment coming due on its outstanding bonds.

6. Just for Feet’s financial condition continued to deteriorate, causing the firm to file for bankruptcy in November 1999.

7. A series of investigations by state and federal authorities revealed that Just for Feet’s impressive operating results during the 1990s had been the product of a large-scale accounting fraud.

8. The three principal elements of the accounting fraud were improper accounting for vendor allowances, refusing to record an appropriate reserve for inventory obsolescence, and booking millions of dollars of fictitious “booth” income.

9. An SEC investigation revealed numerous deficiencies in Deloitte & Touche’s audits of Just for Feet during the late 1990s.

10. The principal criticisms of Deloitte’s audits included the improper application of confirmation procedures, failure to properly audit Just for Feet’s inventory valuation reserve, and the failure to thoroughly investigate the company’s suspicious booth income transactions.

11. Deloitte was fined $375,000 by the SEC for its deficient Just for Feet audits; the SEC suspended the 1998 audit engagement partner for two years and the audit manager for one year.

12. At the same time that the SEC announced the sanctions imposed on Deloitte for its Just for Feet © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.3 Just for Feet, Inc. 18 audits, the federal agency revealed that it was fining the accounting firm $50 million for its flawed audits of the scandal-ridden telecommunications company, Adelphia Communications.

Instructional Objectives 1. To demonstrate the need for auditors to employ analytical procedures during the planning phase of an audit to identify high-risk accounts.

2. To help students identify key inherent and control risk factors present during an audit.

3. To understand the nature and purpose of audit confirmations.

4. To demonstrate the importance of auditors thoroughly investigating unusual and suspicious circumstances uncovered during an audit.

5. To understand the SEC’s oversight role for the financial reporting and independent audit functions.

Suggestions for Use This case can be integrated with the coverage of several different topics in an undergraduate or graduate auditing course. Exhibits in this case present Just for Feet’s financial statements for the final three years that it was fully operational, namely, fiscal 1996 through fiscal 1998. Instructors can use those financial statements as the basis for a major analytical procedures assignment—see the first case question. The second and third case questions provide an opportunity for instructors to introduce the audit risk model and/or to provide a real-world application of that model. Finally, since much of the criticism of Deloitte in this case involved the confirmation procedures that firm applied to Just for Feet’s receivables, you could integrate this case with your coverage of that important topic.

You might consider making the fourth case question a group assignment. After each group has completed the ranking exercise, collect the resulting lists and post them on the board or overhead.

Then, identify the “outliers” in those rankings and ask the given groups to justify/explain those items.

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Case 1.3 Just for Feet, Inc. 19 Suggested Solutions to Case Questions 1. Common-sized balance sheets for Just for Feet’s 1996-1998 fiscal years: [Note: each fiscal year ended on January 31 of the following year. For example, fiscal 1998 ended on January 31, 1999.]

1998

1997

1996

Current assets: Cash Marketable securities Accounts receivable Inventory Other current assets Total current assets

.02 .00 .03 .58 .03 .66

.19 .00 .04 .46 .01 .70

.37 .09 .02 .35 .01 .84

Property and equipment Goodwill, net Other Total assets

.23 .10 .01 1.00

.21 .08 .01 1.00

.14 .00 .02 1.00

Current liabilities: Short-term borrowings Accounts payable Accrued expenses Income taxes payable Current maturities of LT debt Total current liabilities

.00 .14 .04 .00 .01 .19

.20 .12 .02 .00 .01 .35

.27 .10 .01 .00 .01 .39

Long-term debt and obligations Total liabilities

.34 .53

.05 .40

.03 .42

Shareholders’ equity: Common stock Paid-in capital Retained earnings Total shareholders’ equity

.00 .36 .11 .47

.00 .49 .11 .60

.00 .51 .07 .58

Total liabilities and shareholders’ equity

1.00

1.00

1.00

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Case 1.3 Just for Feet, Inc. 20

Common-sized income statements for Just for Feet: Net sales Cost of sales Gross profit

1998 1.00 .58 .42

1997 1.00 .58 .42

1996 1.00 .58 .42

Operating expenses: Store operating Store opening costs Amortization of intangibles General and administrative Total operating expenses

.30 .02 .00 .03 .35

.30 .01 .00 .04 .35

.27 .04 .00 .03 .34

Operating income

.07

.07

.08

Interest expense Interest income Earnings before income taxes and cumulative effect Provision for income taxes Earnings before cumulative effect

(.01) .00

.00 .00

.00 .01

.06 .02 .04

.07 .03 .04

.09 .03 .06

Cumulative effect Net earnings

-.04

-.04

(.01) .05

Financial Ratios for Just for Feet: 1998

1997

Liquidity: Current Quick

3.39 .37

2.00 .67

Solvency: Debt to assets Times interest earned Long-term debt to equity

.53 6.38 .71

.40 24.67 .09

Activity: Inventory turnover Age of inventory Accounts receivable turnover Age of accounts receivable Total asset turnover

1.49 1.65 242 days 218 days 44.6 42.75 8.1 days 8.4 days 1.36 1.26

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Case 1.3 Just for Feet, Inc. 21 Gross margin Profit margin on sales Return on total assets Return on equity

41.6% 3.4% 6.1% 9.0%

41.5% 4.5% 5.5% 8.8%

Equations: Current ratio: current assets / current liabilities Quick ratio: (current assets - inventory) / current liabilities Debt to assets: total debt / total assets Times interest earned: earnings before interest and taxes / interest charges Long-term debt to equity: long term debt / shareholders’ equity Inventory turnover: cost of goods sold / avg. inventory Age of inventory: 360 days / inventory turnover A/R turnover: net sales / average accounts receivable Age of A/R: 360 days / accounts receivable turnover Total asset turnover: net sales / average total assets Gross margin: total gross margin / net sales Profit margin on sales: net income / net sales Return on total assets: (net income + interest expense) / avg. total assets Return on equity: net income / avg. shareholders' equity Selected industry norms as of 1998 (these norms were taken from a Dun & Bradstreet publication; each industry norm is a mean for the given ratio): Current ratio: Quick ratio: Debt to assets: L-T debt to equity: Inventory turnover: Age of inventory: A/R turnover: Age of A/R: Total asset turnover: Gross margin: Profit margin on sales: Return on total assets: Return on equity:

3.0 .75 .37 .14 2.15 167 days 52.7 6.8 days 2.11 36.7% 4.6% 9.7% 15.3%

Following, in bullet form, are the key financial statement items and other issues that are “brought to the surface” by the common-size financial statements, financial ratios, and other available information regarding Just for Feet as of the end of fiscal 1998.

•

Clearly, inventory had to be a major focus of the fiscal 1998 audit. At January 31, 1999, inventory was easily Just for Feet’s largest asset, accounting for almost 60% of

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Case 1.3 Just for Feet, Inc. 22

•

the company’s total assets. In addition, inventory was growing at a rapid pace relative to other financial statement items. Notice that at the end of fiscal 1996 inventory accounted for only 35% of the company’s total assets. Given the increasing age of inventory, proper valuation of that asset should have been a major concern at the end of 1998. This concern should have been heightened by the fact that the average age of Just for Feet’s inventory was approximately 45% higher than the average age of inventory in the industry.

Cash is a financial statement item that is not particularly challenging to audit; however, auditors must closely monitor a client’s cash and near-cash assets to assess the entity’s liquidity. A client that has limited cash resources may pose a goingconcern issue for its auditors. Notice the dramatic decline in Just for Feet’s cash resources, both on an absolute and relative basis, from the end of fiscal 1996 through the end of fiscal 1998. More insight on Just for Feet’s liquidity can be obtained by reviewing the company’s statements of cash flows, which are included in Exhibit 2 of this case. Notice that over the three-year period in question, Just for Feet’s operations were producing negative cash flows. In fact, in fiscal 1998, the company’s negative operating cash flows were more than three times greater than its reported net income. The major source of cash for Just for Feet from 1996 through 1998 was borrowed funds. Recall that shortly after the end of fiscal 1998, the company borrowed an additional $200 million by selling “junk” bonds. Another indication that Just for Feet’s liquidity was substandard at the end of fiscal 1998 was its quick ratio of .37, which had declined from .67 at the end of fiscal 1997. Notice that the average quick ratio in Just for Feet’s industry at the time was .75.

•

Related to the previous item was the sharp increase in Just for Feet’s long-term debt during 1998. Notice that the company’s long-term debt to equity ratio spiked from .09 at the end of fiscal 1997 to .71 at the end of fiscal 1998. Although the company’s interest coverage ratio was at a reasonable level at the end of fiscal 1998, the auditors should have been aware that it was unlikely that Just for Feet’s operations would “fund” the interest payments on that debt during the following year.

•

Just for Feet’s financial data suggest that accounts payable may have merited more attention than normal at the end of fiscal 1998. As a general rule, the growth rates of inventory and accounts payable should parallel each other. That was not true with Just for Feet. Inventory increased by approximately 200% from the end of fiscal 1996 through the end of fiscal 1998, while accounts payable increased approximately 157% over that time frame. [Note: of course the “netting” of the questionable vendor allowances reduced Just for Feet’s reported accounts payable.]

•

A final issue that is raised by an analysis of Just for Feet’s 1996-1998 financial data is the seemingly improbable consistency of certain of the company’s key financial ratios.

In particular, notice how stable the company’s gross margin (profit) percentage was over that period. Likewise, the company’s operating margin percentage (operating © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.3 Just for Feet, Inc. 23 income / net sales) was effectively unchanged over that period. Executives in the retail industry are aware that analysts pay particular attention to certain financial statistics. Among these latter items are the year-over-year percentage change in same store sales, the gross profit percentage, and the operating margin percentage. In many financial frauds, executives have “sculpted” their financial data to produce impressive appearing trend lines for those items. Finally, notice that Just for Feet’s gross margin percentage was considerably higher than that of the industry during fiscal 1998, which should have raised some level of concern on the part of Deloitte.

2. (The second part of this question will be addressed first.) The audit risk model suggests that there is a direct relationship between control risk and audit risk. That is, as the level of control risk posed by a client increases, ceteris paribus, there is a greater chance that an auditor will issue a “clean” opinion when some other type of audit report is appropriate in the circumstances. Thus, as assessed control risk increases, auditors typically counterbalance that increased risk by increasing the overall rigor of their audit NET (nature, extent, and timing of their audit tests), thereby reducing detection risk.

Listed next are examples of specific control risk factors that are common to companies such as Just for Feet.

• • • • • •

A significant amount of cash changes hands daily.

Inventory is exposed to a high risk of customer and employee theft.

The large volume of transactions increases the likelihood that some transactions will be processed incorrectly.

The decentralized nature of the organization’s operations increases the likelihood that mid- or lower-level managers may attempt to take advantage of the organization.

The decentralized nature of the organization increases the difficulty of monitoring its control functions.

The high degree of employee turnover typically experienced by such organizations tends to diminish the effectiveness of their internal controls.

3. This is a “sister” question to Question #2. Again, there is a direct correlation between inherent risk and overall audit risk. As assessed inherent risk increases, ceteris paribus, overall audit risk increases as well. To mitigate an increased level of inherent risk, auditors will typically increase the rigor of their audit NET (nature, extent, and timing of their audit tests), thereby reducing detection risk.

Listed next are examples of specific inherent risk factors that are common to companies operating in a highly competitive industry.

•

Rapid changes in products and customer preferences for those products increase the risk of obsolete inventory.

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Case 1.3 Just for Feet, Inc. 24 • • • • •

Price competition due to companies “chasing” a finite set of customers may undermine.

Declining or negative operating cash flows may induce management to begin “window-dressing” their financial statements to increase the likelihood of obtaining additional debt and equity capital.

Declining or negative operating cash flows may increase the likelihood of violating debt covenants, which, in turn, may induce window-dressing behavior on the part of management.

Subtle or overt pressure exerted by financial analysts to maintain revenue and profit trends may induce window-dressing behavior on the part of management.

Unusually high turnover within management due to competitors “raiding” each others’ talent pool may result in a higher frequency of inadvertent errors in a company’s accounting records due to a “learning curve” effect.

4. As a point of information, the phrase “audit risk factor” is apparently never explicitly defined in the professional standards. A related phrase, “fraud risk factors” is defined in AU-C 240.A28 of the AICPA Professional Standards: “. . . the auditor may identify events or conditions that indicate an incentive or pressure to commit fraud or provide opportunity to commit fraud (fraud risk factors), such as . . .” In this context, the phrase “audit risk factor” is intended to be more inconclusive. For example, certain of the items identified in the suggested solutions to Questions #2 and #3 may qualify as “generic” audit risk factors but not necessarily fraud risk factors.

The following list identifies key audit risk factors evident during the 1998 Just for Feet audit.

This list is not intended to be all-inconclusive, nor are these factors ranked in order of importance.

Finally, recognize that many of these factors overlap. As a statistician would say, these factors are not “orthogonal.”

• • • • • • • • •

the high-risk business strategies applied by management the “significant” emphasis that management placed on achieving earnings goals management’s aggressive application of accounting standards management’s “excessive” interest in maintaining the company’s stock price at a high level “unique and highly complex” transactions engaged in by the company near year-end the domineering management style of Harold Ruttenberg the large increase in vendor allowance receivables from the end of 1997 to the end of 1998 the large increase in the company’s inventory from the end of 1997 to the end of 1998 the over-saturation and thus extremely competitive nature of the athletic shoe segment of the shoe industry the dwindling cash resources of the company

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Case 1.3 Just for Feet, Inc. 25 • • • • • • • • •

the consistent trend of negative operating cash flows the large increase in long-term debt in 1998 and the resulting increase in financial leverage the disproportionately slow growth rate of accounts payable (vis-à-vis inventory) the unusually steady gross margin and operating margin percentages from 1996 through 1998 the considerable risk of inventory and cash theft given the nature of the company’s operations the decentralized nature of the company’s operations the large volume of transactions processed daily the complex nature of the vendor allowance transactions (for example, Just for Feet’s vendors had considerable discretion in determining the timing and size of the allowances) the unusual, if not unique, nature of the booth income transactions

As suggested previously, you might consider having your students complete Question #4 as a group exercise. After each group has developed its “top five” list, collect those lists and make each of them available to the entire class. Next, challenge individual groups to defend obvious “outliers” and/or obvious omissions in their individual rankings.

Did the Deloitte auditors identify and respond appropriately to the audit risk factors just listed?

First of all, the Deloitte auditors apparently identified most, if not all, of these factors. Granted, the information available in the public domain does not explicitly confirm this assertion. For example, the sources that were the basis for the development of this case do not indicate that Deloitte explicitly considered the potential implications for the 1998 audit of Just for Feet’s negative operating cash flows. However, almost certainly Deloitte recognized this issue since it was so blatantly obvious.

Second, it seems apparent that Deloitte did not respond appropriately to these risk factors. Certainly, that was the conclusion of the SEC. In the course of addressing this case question, you might ask your students what other audit procedures Deloitte should have applied or should have considered applying in responding to the audit risk factors present during the 1998 audit.

5. There was a wide range of parties who stood to be affected by the decision of Thomas Shine regarding whether or not to send a false confirmation to Deloitte & Touche. These parties included, among others, Just for Feet’s stockholders and potential stockholders, Just for Feet’s lenders and potential lenders, Just for Feet’s independent auditors, Shine’s own company and the stakeholders in that organization, his family, and, of course, himself.

A common feature of the various ethical decision-making models that can be applied to ethical dilemmas, such as that faced by Thomas Shine, is identifying the alternatives that are available to the given individual. Too often, individuals facing an ethical dilemma succumb to tunnel vision, that is, they become focused on only one or two possible decision alternatives without taking the time to consider the full range of such alternatives that are available to them. Another common mistake that individuals face in such situations is to act too hastily. This is a natural reaction, of course. By definition, an ethical dilemma imposes some degree of pressure or stress on the given individual. One strategy for eliminating that stress is to make a hasty decision that resolves the dilemma. Finally, another common oversight in such situations is to place too much weight on the short-term consequences that the given individual will face following his or her decision. In these situations, © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.3 Just for Feet, Inc. 26 individuals should force themselves to “look” well into the future and consider how each decision alternative, if chosen, may eventually affect their careers, their feelings of self-worth, and other stakeholders.

An effective approach to addressing this question is to ask students to suggest different ways that Thomas Shine could have responded to the ethical dilemma he faced. Then, you can engage students in an open discussion or debate regarding the advantages and disadvantages, propriety and impropriety of each given suggestion. Too often when faced with this type of question, students will suggest that the given individual should have “stood his or her ground” and simply refused to cooperate in any way with the party who was pressuring him or her to behave unethically. That simplistic suggestion ignores the complexity of most ethical dilemmas that arise in a business context.

So, before asking students to respond to this question, consider requiring them to identify specific contextual factors that may have complicated Thomas Shine’s decision. These factors may have included . . . Shine was aware that Just for Feet had numerous vendors and may have been able to reduce or even eliminate purchases from any one vendor; Shine was in the process of attempting to sell his company to a larger shoe manufacturer (in fact, that is exactly what happened); or, Shine was aware that many of his colleagues with other vendors routinely signed audit confirmations without considering the accuracy of the amounts reported in them.

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Case 1.4 Health Management, Inc. 26

CASE 1.4

HEALTH MANAGEMENT, INC.

Synopsis This case profiles an imaginative accounting fraud orchestrated by two top executives of Health Management, Inc. (HMI), a New York-based pharmaceuticals distributor. The HMI fraud is noteworthy because it led to the first major test of an important federal statute, the Private Securities Litigation Reform Act of 1995 (PSLRA), that was intended to alleviate the growing burden of classaction lawsuits filed against accounting firms and other third parties under the Securities Exchange Act of 1934. (The PSLRA amended key provisions of the 1934 Act.) The PSLRA made it more difficult for plaintiffs to successfully “plead” a case under the 1934 Act, that is, to have such a lawsuit proceed to trial. Among other provisions in the PSLRA is a proportionate liability rule. Under this liability standard, a defendant that is guilty of no more than “recklessness” is generally responsible for only a percentage of a plaintiff’s losses, the percentage of those losses produced by the defendant’s reckless behavior.

HMI’s former stockholders filed a class-action lawsuit against BDO Seidman, HMI’s former audit firm. The plaintiff attorneys attempted to prove that the BDO Seidman auditors had been reckless during the 1995 HMI audit, which prevented them from discovering the large inventory fraud carried out by Clifford Hotte, HMI’s CEO, and Drew Bergman, the company’s CFO. The plaintiff attorneys repeatedly pointed to a series of red flags that the BDO Seidman auditors had allegedly overlooked or discounted during the 1995 audit. Additionally, the plaintiff attorneys charged that a close relationship between Bergman and Mei-ya Tsai, the audit manager assigned to the 1995 HMI audit engagement team, had impaired BDO Seidman’s independence during the 1995 audit. Bergman had previously been employed by BDO Seidman and had served as the audit manager on prior HMI audits.

Following a jury trial in federal court, BDO Seidman was absolved of any responsibility for the large losses that HMI’s stockholders had suffered as a result of the 1995 inventory fraud. BDO Seidman’s lead attorney attributed that outcome of the case to the PSLRA. Absent the proportionate liability rule incorporated in the PSLRA, the attorney suggested that BDO Seidman would likely have chosen to pay a sizable settlement to resolve the lawsuit rather than contest it in the federal courts.

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Case 1.4 Health Management, Inc. 27 Health Management, Inc.--Key Facts 1.

Clifford Hotte and Drew Bergman engineered an accounting fraud to allow HMI to reach its 1995 earnings target.

2.

The key element of the HMI fraud was an elaborate in-transit inventory sham that resulted in a material overstatement of HMI’s year-end inventory.

3.

The HMI fraud triggered the first major test of an important federal statute, the Private Securities Litigation Reform Act (PSLRA) of 1995, which amended the Securities Exchange Act of 1934.

4.

Congress intended the PSLRA to alleviate the burdensome legal liability that accounting firms and other defendants faced under the 1934 Act by raising the “pleading standard” for lawsuits filed under that law and by establishing proportionate liability for defendants found liable in such lawsuits.

5.

The key objective of the plaintiff attorneys in the HMI lawsuit filed by the company’s former stockholders against BDO Seidman was to convince the jury that the BDO Seidman auditors, at a minimum, had been reckless during the 1995 HMI audit.

6.

BDO Seidman’s attorneys used a three-pronged defense strategy: (1) insisting that the auditors were victims of the fraud, (2) arguing that there was no evidence of specific violations of auditing standards by the auditors, and (3) contending that the auditors had made a good faith effort to investigate HMI’s suspicious financial statement items.

7.

A key issue during the trial was whether the BDO Seidman auditors should have performed an inventory rollback to corroborate the year-end in-transit inventory.

8.

Another key issue that arose during the trial was whether a relationship between Bergman and the audit manager assigned to the HMI engagement, who was his former co-worker at BDO Seidman, had undermined BDO Seidman’s independence.

9.

Eventually, the jurors ruled in favor of BDO Seidman after deciding that the auditors had not been reckless.

10. BDO Seidman’s lead attorney suggested that the PSLRA’s proportionate liability rule was a key factor that gave his client the courage to contest and ultimately defeat the HMI lawsuit.

Instructional Objectives 1.

To examine the implications that the Private Securities Litigation Reform Act of 1995 has had, and is expected to have, for the public accounting profession.

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.4 Health Management, Inc. 28 2. To illustrate key strategies that plaintiff and defense attorneys use in lawsuits filed against auditors.

3.

To define “recklessness” as it relates to audit-related lawsuits filed under the Securities Exchange Act of 1934.

4.

To examine the impact that close relationships between auditors and client personnel can have on independent audits.

5.

To demonstrate that auditor judgment is the ultimate determinant of the specific audit procedures applied during an audit engagement.

Suggestions for Use

This case includes dialogue excerpted from the transcripts of the HMI trial in late 1999. When possible, I attempt to incorporate such dialogue into cases because it results in a heightened sense of realism. The dialogue in the case also provides an opportunity for instructors to set up realistic roleplaying exercises. For example, you might consider having one student assume the role of the plaintiff attorney who interrogated Jill Karnick, the BDO Seidman semi-senior who audited HMI’s inventory, while another student “steps into the shoes” of Ms. Karnick. Instruct the attorney to quiz Ms. Karnick regarding the audit procedures she applied to inventory, in particular her aborted effort to complete an inventory rollforward. Likewise, you could use role-playing to recreate some of the testy exchanges that took place between Michael Young, BDO’s lead attorney, and Mr. Moore, the plaintiff’s expert witness. Although many students are hesitant at first to participate in such exercises, I have found that most of them quickly “warm” to the role they are asked to assume.

A feature of this case that typically spawns considerable discussion is the close friendship that existed between Drew Bergman and Mei-ya Tsai. The professional auditing standards do not prohibit auditors from being friends with client personnel, but such friendships can be very problematic. To extend Question 1, you might ask students to develop a set of general rules or guidelines that audit firms should include in their policy and procedures manual to ensure that auditor-client relationships do not jeopardize the independence of an audit team or the independence/ objectivity of individual auditors.

Suggested Solutions to Case Questions 1. The two dimensions of auditor independence are relevant to this context: appearance of independence and de facto independence. A close friendship between an auditor and a client employee can jeopardize the auditor’s appearance of independence (and that of the entire audit team) even though the auditor scrupulously protects his or her de facto independence. If third parties lose confidence in an auditor’s independence, then the purpose of the audit is undermined, period.

I would suggest that the de facto independence of an auditor has been compromised by a relationship with a client employee when that relationship begins to influence important decisions of the auditor. For example, if an auditor decides not to fully investigate a suspicious transaction or other item because doing so might result in negative consequences for his or her friend, clearly the © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.4 Health Management, Inc. 29 actual independence of the auditor has been compromised. Likewise, loss of independence may result in an auditor failing to gain a proper understanding of a client’s internal controls, ignoring pertinent fraud risk factors that are present, or even issuing an inappropriate audit opinion for the given client.

2. Interpretation 1.279.010, “Considering Employment or Association with an Attest Client,” of the AICPA Code of Professional Conduct addresses the situation in which an auditor is considering the possibility of employment with an audit client during the course of an audit engagement. In such situations, the given individual faces an unacceptable threat of violating his or her independence. To mitigate that threat, four “safeguard” conditions have to be met: a.

“The individual promptly reports such consideration or offer to an appropriate person in the firm. b.

The individual immediately ceases participation in the engagement and does not provide any services to the attest client until the employment or offer is rejected or employment is no longer sought. c.

If a covered member becomes aware that an individual is considering employment or association with an attest client, the covered member should notify an appropriate person in the firm. d.

The appropriate person in the firm should consider whether, based on the nature of the engagement and the individual involved, the firm should perform any additional procedures to provide reasonable assurance that any work that the individual performed for the attest client was performed in compliance with the ‘Integrity and Objectivity Rule.’” [ET 1.279.010.02] 3. The most common situation in which an inventory rollback is performed is when an audit firm has been retained to audit a company following that company’s year-end physical inventory. If the inventory is a material item in the client’s financial statements, the audit firm must devise a test or series of tests to corroborate the key management assertions for that inventory. Since re-taking the physical inventory may not be feasible or may be too costly, auditors in such situations will typically use the client’s purchases and sales documentation during the intervening period since the physical inventory to “rollback” the existing inventory quantities and dollar amounts to the corresponding amounts on the inventory date.

AS 1105.08 of the PCAOB auditing standards discusses the factors that impact the reliability or validity of audit evidence. Following is a brief excerpt from that discussion. “Evidence obtained from a knowledgeable source that is independent of the company is more reliable than evidence obtained only from internal company sources.” (A similar statement is found in AU-C Section 500.A8 of the AICPA Professional Standards.) This observation would suggest that the documentary evidence provided by an inventory rollback is not as persuasive as the physical evidence that auditors obtain by observing a client’s physical inventory.

4. As Michael Young noted during the HMI trial, the decision of what audit procedures to apply in a given context is ultimately a matter of professional judgment on the part of individual auditors. So, Jill Karnick and the other members of the HMI audit engagement team were well within their rights to decide whether to complete an inventory rollback or rollforward. One troubling aspect of Karnick’s © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.4 Health Management, Inc. 30 decision not to complete the inventory rollforward was that the decision was apparently not approved or even reviewed by her superiors. Given the importance of that decision, it would seem that Karnick’s superiors would have been involved in, or, at a minimum, reviewed that decision.

[Certainly, it is possible that Tsai and/or Bornstein were involved in that decision and that the trial transcripts simply failed to comment on their involvement.]

AU-C Section 200.A52 of the AICPA Professional Standards notes that cost considerations are a valid issue for auditors to weigh when deciding on the specific audit procedures to apply in a given setting. However, that same paragraph also explicitly states that cost considerations should not be the ultimate factor in such decisions. “The matter of difficulty, time, or cost involved is not in itself a valid basis for the auditor to omit an audit procedure for which there is no alternative or to be satisfied with audit evidence that is less than persuasive. Appropriate planning assists in making sufficient time and resources available for the conduct of the audit. Notwithstanding this, the relevance of information, and thereby its value, tends to diminish over time, and there is a balance to be struck between the reliability of information and its cost . . . Therefore, there is an expectation by users of financial statements that the auditor will form an opinion on the financial statements within a reasonable period of time and so as to achieve a balance between benefit and cost, recognizing that it is impracticable to address all information that may exist or to pursue every matter exhaustively on the assumption that information is fraudulent or erroneous until proved otherwise.” (AS 1105, “Audit Evidence,” in the PCAOB auditing standards does not contain an equivalent discussion of the tradeoff between the costs and benefits of audit evidence.)

5. AU-C Section 230.A6 of the AICPA Professional Standards includes the following statement: “The auditor need not include in audit documentation superseded drafts of working papers and financial statements, notes that reflect incomplete or preliminary thinking, previous copies of documents corrected for typographical or other errors, and duplicates of documents.” This statement suggests that the results of inconclusive audit tests do not have to be included in audit workpapers.

Paragraph 230.A17 reinforces this conclusion by noting that auditors do not need to “retain documentation that is incorrect or superseded.”

AS 1215, “Audit Documentation,” of the PCAOB auditing standards does not include a discussion directly comparable to that just highlighted in AU-C Section 230 of the AICPA Professional Standards. However, AS 1215.06 includes the following blanket statement: “The auditor must document the procedures performed, evidence obtained, and conclusions reached with respect to relevant financial statement assertions.” AS 1215.12 also observes that audit documentation should include a discussion of “circumstances that cause significant difficulty in applying auditing procedures.” This latter statement would certainly have been relevant to Ms. Karnick’s aborted attempt to perform an inventory rollforward.

6. The term “red flags” is generally used to refer to various factors, variables, or other items that suggest there is a higher than normal risk that a given audit client’s financial statements have been distorted by intentional misstatements. The term “fraud risk factors” is essentially interchangeable with “red flags.” The Appendix to AS 2401, “Consideration of Fraud in A Financial Statement Audit,” of the PCAOB’s auditing standards lists numerous examples of fraud risk factors. Examples of these items include “high degree of competition or market saturation accompanied by declining margins,” “high vulnerability to rapid changes . . . in technology . . . or interest rates,” “operating © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.4 Health Management, Inc. 31 losses making the threat of bankruptcy, foreclosure, or hostile takeover imminent.” A comparable list of fraud risk factors can be found in the AICPA Professional Standards at AU-C 240.A75.

During the planning phase of an audit, auditors will consider the existence of red flags in developing the planned nature, extent, and timing of their audit tests. Red flags identified by auditors during the planning phase will typically result in more extensive and rigorous tests applied by auditors during the substantive testing phase of an audit. In the internal control evaluation phase of an audit, auditors should consider whether given red flags have resulted in a client’s internal controls being undercut or subverted. Finally, during the “wrap-up” phase of an audit, an audit engagement team must consciously weigh once more the potential impact of existing red flags or fraud risk factors on a client’s financial statements. In this final stage of an audit, auditors can step back and make a “big picture” assessment of the given client’s financial statements. During the course of an audit, an audit team may overlook individual hints or signals that something is amiss in the client’s accounting records and financial statements. Near the end of the audit, however, an audit manager or partner should be able to link such items together to make a more informed judgment regarding the likelihood that fraud has affected the client’s financial data.

7. Section 10A, “Audit Requirements,” of the Securities Exchange Act of 1934 discusses auditors’ responsibilities for investigating and reporting illegal acts by an audit client. Section 10A provides the following cryptic definition of an illegal act: “the term illegal act means an act or omission that violates any law, or any rule or regulation having the force of law.” The key issue in this context is that an illegal act discovered by an audit team must have a “material effect on the financial statements” of the given company to trigger required disclosure to the SEC [again, such disclosure is not necessary if the given company informs the SEC of the matter]. Listed next are three (hypothetical) illegal acts and my judgment of whether the given audit team should insist that client management report each item to the SEC. • A retail company “holds open” its sales records at the end of a fiscal year to ensure that it reaches its

sales and earnings target for that year. Analysis: this is an illegal act that almost certainly should be reported to the SEC. Two issues that would be relevant in determining whether SEC disclosure would be necessary are the level of management involved in the fraud and the magnitude of the fraud’s impact on the company’s sales and earnings. The more important issue is the fraud’s impact on sales and earnings. For example, if absent the fraudulent scheme the given company would not have achieved its sales and earnings targets, then it would be difficult to sustain an argument that the scheme did not have a material effect on the company’s financial statements, regardless of the absolute magnitude of the amounts involved. In today’s capital markets a small revenue or earnings “miss” can result in a company’s stock being battered by investors.

• A company admits that a racial discrimination charge filed against a production-line supervisor by a minority worker is valid. Analysis: Unless racial discrimination is seemingly rampant within the given organization, this is an illegal act that likely would not have to be reported to the SEC. • A manufacturing company violates legally enforceable regulations issued by the Environmental Protection Agency. Analysis: Unless the violation is indicative of a pervasive problem and unless the monetary sanctions to be imposed on the company are material, this item would likely not have to be reported to the SEC. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

32 Companies

Case 1.5 The Leslie Fay

CASE 1.5

THE LESLIE FAY COMPANIES

Synopsis Fred Pomerantz founded Leslie Fay in the mid-1940s and built the company into one of the leading firms in the highly competitive women’s apparel industry over the next four decades. Fred’s son, John, took over the company in 1982 after his father’s death. Over the next ten years, the younger Pomerantz added to his father’s legacy by maintaining Leslie Fay’s prominent position in its industry. In January 1993, John Pomerantz’s world was rocked when his company’s CFO, Paul Polishan, told him of a large accounting fraud that had inflated Leslie Fay’s operating results during the previous few years. Polishan had learned of the fraud from his top subordinate, Donald Kenia, Leslie Fay’s controller. Kenia revealed the fraud to Polishan and, at the same time, reportedly confessed that he was the mastermind behind the fraud.

Public disclosure of the large-scale fraud sent Leslie Fay’s stock price into a tailspin and prompted the press to allege that Pomerantz and Polishan must have either participated in the various accounting scams or, at a minimum, been aware of them. Within a few months, Leslie Fay was forced to file for protection from its creditors in federal bankruptcy court. In the meantime, investigations by law enforcement authorities corroborated Pomerantz’s repeated denials that he was involved in, or aware of, the fraud. However, those same investigations implicated Polishan in the fraud. Another party tainted by the investigations was Leslie Fay’s former audit firm, BDO Seidman. One investigative report noted that negligence on the part of the accounting firm had likely prevented it from uncovering the fraud.

In July 1997, BDO Seidman contributed $8 million to a settlement pool to resolve several lawsuits stemming from the Leslie Fay fraud. In the summer of 2000, federal prosecutors obtained an 18-count felony conviction against Paul Polishan. The key witness who sealed Polishan’s fate was his former subordinate, Donald Kenia. During the contentious criminal trial, Kenia admitted that Polishan was the true architect of the Leslie Fay fraud. Kenia had initially accepted responsibility for the fraud only after being coerced to do so by Polishan. In early 2002, Polishan began serving a nineyear sentence in a federal prison. Kenia received a two-year sentence for helping his superior perpetrate and conceal the fraud. Leslie Fay emerged from bankruptcy court in 1997 but was bought out by another firm in 2001. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.5 The Leslie Fay

33

Companies The Leslie Fay Companies--Key Facts 1.

2.

Under the leadership of Fred and John Pomerantz, Leslie Fay ranked as one of the leading firms in the very competitive women’s apparel industry during the latter decades of the twentieth century.

One of John Pomerantz’s closest associates was Paul Polishan, Leslie Fay’s CFO who ruled the company’s accounting function with an iron fist.

3.

John Pomerantz insisted on doing business the “old-fashioned way,” which meant that the company’s accounting function was slow to take advantage of the speed and efficiency of computerized data processing.

4.

A growing trend toward more casual fashions eventually created financial problems for Leslie Fay, its principal customers (major department stores), and its leading competitors, problems that were exacerbated by a nationwide recession in the late 1980s and early 1990s.

5.

Despite the slowdown experienced by much of the women’s apparel industry in the late 1980s and early 1990s, Leslie Fay continued to report impressive sales and earnings during that time frame.

In January 1993, Paul Polishan informed John Pomerantz of a large-scale accounting fraud over the previous three years that had materially inflated Leslie Fay’s reported sales and earnings, a fraud allegedly masterminded by Donald Kenia.

6.

7.

Upon learning of the accounting fraud, BDO Seidman withdrew its unqualified audit opinions on Leslie Fay’s 1990 and 1991 financial statements and subsequently resigned as the company’s audit firm after being named as a co-defendant in civil lawsuits filed against Leslie Fay’s executives.

8.

The centerpiece of the Leslie Fay fraud was intentional overstatements of period-ending inventories, although several other financial statement items were also intentionally distorted.

9.

John Pomerantz was never directly implicated in the fraud, although many critics, including BDO Seidman, insisted that he had to share some degree of responsibility for it.

10. BDO Seidman ultimately agreed to pay $8 million to a settlement pool to resolve numerous civil lawsuits stemming from the Leslie Fay fraud that named the accounting firm as a defendant.

11. Due principally to Donald Kenia’s testimony, Paul Polishan was convicted in 2000 of masterminding the Leslie Fay fraud.

12. Leslie Fay emerged from federal bankruptcy court in 1997 but disappeared a few years later when it was purchased by a large investment firm. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

34 Companies

Case 1.5 The Leslie Fay

Instructional Objectives 1.

To provide students with an opportunity to use analytical procedures as an audit planning tool.

2.

To demonstrate the need for auditors to monitor key trends affecting the overall health of a client’s industry and to assess the resulting implications for a client’s financial condition and operating results.

3.

To highlight the internal control issues posed for an audit client when its accounting function is dominated by one individual.

Suggestions for Use

This case contains multi-year financial statement data for The Leslie Fay Companies. These data provide students an opportunity to apply analytical procedures as a planning tool. Although a central theme of this casebook is the “people” aspect of independent audits, I believe it is also important that students be exposed to the more mundane, number-crunching aspects of an independent audit. One way that you can extend Question 1 is to require different groups of students to collect and present (for the same time frame) the financial ratios shown in Exhibit 2 for several of Leslie Fay’s key competitors. Quite often, auditors can learn more about the plausibility (or implausibility) of apparent trends in a client’s financial data by comparing those data with financial information for a key competitor rather than with industry norms. For example, Leslie Fay’s gross margin percentage was generally consistent with that of its overall industry. However, if you compared the company’s gross margin percentages over the time frame of the accounting fraud with those of its direct competitors, it would have been apparent that the margins being reported by Leslie Fay were “out of line” with those companies.

A key feature of this case is the impact that Paul Polishan’s domineering personality had on the accounting function of Leslie Fay. This “red flag” is among the most common associated with problem audit clients. Published reports never indicated exactly how Polishan was able to psychologically control and manipulate Donald Kenia and his other subordinates in “Poliworld.”

Apparently, Polishan was one of those individuals who had an innate and enormous ability to impose his will on subordinates. You might ask students how they would deal with such a domineering superior. Since many of our students will have an “opportunity” to work for one or more strongwilled individuals during their careers, they need to have appropriate coping mechanisms to ensure that they do not find themselves in the unfortunate situation that faced Donald Kenia, that is, spending two years in a federal correctional facility. (You might discourage students from taking the “easy way out” by suggesting that they would simply choose not to work for such an individual. Seldom do we have the freedom to choose the disposition and personality traits of our boss.)

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.5 The Leslie Fay

35

Companies

Suggested Solutions to Case Questions 1. Following are common-sized financial statements and the requested financial ratios for Leslie Fa y for the period 1987-1991.

1991

1990

1989

1988

1987

Current Assets: Cash Receivables (net) Inventories Prepaid Expenses, etc.

Total Current Assets

1.2 30.0 32.0 5.0 68.2

1.1 31.8 33.7 5.1 71.7

1.4 30.3 31.3 5.0 68.0

1.5 30.3 29.5 4.5 65.8

1.3 27.1 27.2 5.2 60.8

PP&E Goodwill Deferred Charges, etc.

Total Assets

9.9 20.5 1.4 100.0

6.8 20.1 1.4 100.0

7.0 23.5 1.5 100.0

7.1 25.9 1.2 100.0

7.9 29.6 1.7 100.0

Current Liabilities: Notes Payable Current Portion--LTD Accounts Payable Acc. Int. Payable Accrued Compensation Acc. Expenses, etc.

Income Taxes Payable Total Curr. Liabs.

8.8 0.0 8.1 .8 4.3 1.1 .4 23.4

10.9 0.0 9.9 .9 3.4 1.5 .5 27.1

5.9 0.0 10.0 1.1 5.0 1.5 1.3 24.8

8.0 0.0 12.6 1.1 4.6 2.0 1.6 29.9

5.1 .5 10.3 1.2 3.5 2.4 .6 23.6

Long-term Debt Deferred Credits, etc.

21.3 .7

29.6 .6

33.2 .7

32.0 1.2

38.2 1.6

Stockholders’ Equity: Common Stock Capital in Excess of PV Retained Earnings Other Treasury Stock Total Stock. Equity Total Liab. & SE

5.1 4.6 5.2 5.5 6.6 20.8 18.7 21.2 22.6 26.9 39.6 29.1 25.4 20.1 16.5 (8.7) (7.2) (8.3) (8.8) (10.4) (2.2) (2.5) (2.2) (2.5) (3.0) 54.6 42.7 41.3 36.9 36.6 100.0 100.0 100.0 100.0 100.0

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

36 Companies

Net Sales Cost of Sales Gross Profit Operating Expenses: SWG&A Amortization Total Operating Exp. Operating Income Interest Expense Income Bef. NR Charges Non-recurring Charges Inc. Before Taxes Income Taxes Net Income

Case 1.5 The Leslie Fay

1991 100.0 69.9 30.1

1990 100.0 68.6 31.4

1989 100.0 68.3 31.7

1988 100.0 68.3 31.7

1987 100.0 69.3 30.7

22.3 .3 22.6 7.5 2.2 5.3 0.0 5.3 1.8 3.5

23.2 .3 23.5 7.9 2.2 5.7 0.0 5.7 2.3 3.4

23.4 .3 23.7 8.0 2.4 5.6 0.0 5.6 2.3 3.3

22.9 .5 23.4 8.3 2.6 5.7 0.0 5.7 2.4 3.3

22.8 .6 23.4 7.3 2.8 4.5 (.9) 5.4 2.0 3.4

Financial Ratios for Leslie Fay: 1991

1990

1989

1988

1987

Liquidity: Current Quick

2.9 1.5

2.6 1.4

2.7 1.5

2.2 1.2

2.6 1.4

Solvency: Debt to Assets Times Interest Earned Long-term Debt to Equity

.45 3.4 .39

.57 3.6 .69

.59 3.3 .81

.63 3.1 .87

.63 2.6 1.04

Activity: Inventory Turnover Age of Inventory* Accts Receivable Turnover Age of Accts Receivable* Total Asset Turnover

4.26 84.5 6.48 55.5 2.1

4.38 82.2 6.69 53.8 2.0

4.71 76.4 6.92 52.0 2.0

4.91 73.3 7.08 50.8 1.9

Profitability: Gross Margin 30.1% 31.4% 31.7% 31.7% 30.7% Profit Margin on Sales 3.5% 3.4% 3.3% 3.3% 3.4% Return on Total Assets 12.1% 10.9% 11.6% 11.2% 11.8% Return on Equity 14.6% 16.8% 17.6% 18.2% © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.5 The Leslie Fay

37

Companies *In days Note: Certain ratios were not computed for 1987 given the lack of data.

Equations: Current Ratio: current assets / current liabilities Quick Ratio: (current assets - inventory) / current liabilities Debt to Assets: total debt / total assets Times Interest Earned: operating income / interest charges Long-term Debt to Equity: long term debt / stock. equity Inventory Turnover: cost of goods sold / avg. inventory Age of Inventory: 360 days / inventory turnover A/R Turnover: net sales / average accounts receivable Age of A/R: 360 days / accounts receivable turnover Total Asset Turnover: net sales / total assets Gross Margin: gross profit / net sales Profit Margin on Sales: net income / net sales Return on Total Assets: (net income + interest expense) / total assets Return on Equity: net income / avg. stockholders' equity Discussion: In comparing Leslie Fay’s 1991 financial ratios with the composite industry norms shown in Exhibit 2, we do not find many stark differences. Overall, Leslie Fay’s liquidity ratios were stronger than the industry averages, while their solvency ratios were generally a little weaker. Leslie Fay’s profitability ratios were also reasonably consistent with the corresponding industry averages. The key differences between the industry norms and Leslie Fay’s 1991 financial ratios involve the age of inventory and receivables measures. Leslie Fay’s inventory was nearly 60% “older,” on average, than the inventory of its competitors, while Leslie Fay’s receivables were more than 20% older than those of competitors. These results suggest that the valuation and existence assertions for both inventory and receivables should have been major concerns for the company’s auditors.

We can use the common-sized financial statements and financial ratios included in this solution to perform longitudinal analysis on the company’s financial data. Here again, the only potential “smoking guns” that we find involve the steadily rising ages of Leslie Fay’s inventory and receivables over the period 1988 through 1991. Notice that Leslie Fay’s liquidity ratios steadily improved—of course, the “improvement” in the current ratio was largely due to the increasing ages of receivables and inventory, while the improving quick ratio was largely attributable to the increasing age of receivables. Leslie Fay’s solvency ratios generally improved during the late 1980s and early 1990s, while most of the company’s profitability ratios were remarkably consistent over that time frame.

Leslie Fay’s common-sized financial statements for 1987-1991 do not reveal any major structural changes in the company’s financial position or operating results over that period. Two accounts that I would mention that had “interesting” profiles in the common-sized balance sheets were accounts payable and accrued expenses. Notice that the relative balances of those two items steadily declined © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.5 The Leslie Fay Companies 38 between 1988 and 1991. Since those two items can be fairly easily manipulated by client management, Leslie Fay’s auditors might have been well advised to focus more attention on the completeness assertions for those items.

In summary, I would suggest that applying analytical procedures to Leslie Fay’s financial data did not reveal any major potential problems, with the exception of inventory and receivables. Then again, Polishan’s subordinates were sculpting those data in an attempt to make them reasonably consistent with industry norms. Auditors should recognize when they are performing analytical procedures that they should search for two types of implausible relationships: unexpected relationships apparent in the client’s financial data and expected relationships that are not apparent in those data. For example, given the problems facing the women’s apparel industry during the late 1980s and early 1990s, Leslie Fay’s auditors probably should have expected some deterioration in the company’s gross margin and profit margin percentages. The fact that Leslie Fay’s profitability ratios were “holding up” very well over that period could have been taken as a “red flag” by the company’s auditors. [Note: As pointed out in the Suggestions for Use section, Leslie Fay’s gross margin percentages were generally consistent with the industry norm during the time frame of the accounting fraud. However, the company’s gross margin percentages during that time frame were considerably more impressive that those being reported by its direct competitors.]

2. Listed next are examples of other financial information, in addition to that shown in Exhibits 1 and 2, that might have been of considerable interest to Leslie Fay’s auditors.

• Backlog of orders • Composition of inventory over the previous several years (that is, did one particular component of

inventory, such as, work-in-process or finished goods, account for the increasing age “issue”?)

• Financial ratios and common-sized financial statements for those companies most comparable to Leslie Fay • Sales data by the company’s major product lines (these data might have revealed developing problems for some of the company’s product lines) • Aging schedule for accounts receivable (this schedule might have revealed that the increasing age of Leslie Fay’s receivables was due to one type of customer, such as, the company’s department store clients) • Sales forecasts and production cost data 3. Listed next are fraud risk factors that relate to the condition of a given audit client’s industry.

Each of these factors is included in the Appendix to AS 2401, “Consideration of Fraud in a Financial Statement Audit,” of the PCAOB’s auditing standards. Similar fraud risk factors are reported in AUC Section 240.A75 of the AICPA Professional Standards.

• New accounting, statutory, or regulatory requirements: audit clients are more likely to misapply

new rules and regulations (having accounting implications) than rules and regulations that have been in effect for some time.

• High degree of competition or market saturation: highly competitive market conditions may induce client management to adopt relatively high-risk strategies, resulting in more volatile operating results. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.5 The Leslie Fay Companies 39 (Significant and/or sudden changes in a client’s operating results complicate the selection and application of audit procedures.)

• Declining industry with increasing business failures: by definition, clients in financially distressed industries pose a higher than normal going-concern risk; this higher risk must be evaluated by auditors and considered when they choose the appropriate type of audit report to issue.

• Rapid changes in the industry, such as changes in technology: sudden technological changes can pose major valuation concerns for a client’s inventory and other assets.

4. When one individual dominates a client’s accounting and financial reporting, the reliability of those systems depends upon the integrity and competence of that individual. In such circumstances, the inherent risk and control risk posed by a client must be carefully assessed by auditors. Even if the assessments of those risks do not yield any evidence of specific problems, the given audit team should likely apply a more rigorous audit NET (nature, extent, and timing of audit procedures) to the client’s financial statement data. Why? Because an individual who dominates a client’s accounting function can readily perpetrate and conceal irregularities.

5. Co-defendants in a lawsuit often have diverging interests that may eventually result in them becoming adversaries as the given case develops (which is exactly what happened in the Leslie Fay case). It is doubtful that auditors can retain their de facto and apparent independence under such circumstances. ET 1.290.010.04-.07, “Litigation Between the Attest Client and Member,” of the AICPA Code of Professional Conduct addresses this issue.

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.6 Le-Nature’s Inc. 40

CASE 1.6

Le-NATURE’S INC.

Synopsis Gregory Podlucky organized a water-bottling business in 1989. Three years later, the company’s product line had expanded to include flavored water, fruit, and tea drinks. Despite operating in the hypercompetitive beverage industry, the company’s revenues grew rapidly. By 2005, the company’s audited income statement reflected sales of nearly $280 million. That same year, Podlucky rejected a $1.2 billion offer for his company. Podlucky, the company’s CEO and sole common stockholder, insisted that figure was too low and decided instead to take the company public the following year.

A common nemesis of a rapidly growing company is a shortage of capital. Throughout LeNature’s existence, Podlucky relied almost exclusively on debt to finance Le-Nature’s expanding operations. During its existence, the company borrowed almost $1 billion via long-term leasing arrangements, high-yield or “junk” bonds, and a large revolving line of credit. Podlucky raised a relatively nominal $30 million of equity capital by selling convertible preferred stock to two investment funds. The conversion feature of the preferred stock effectively gave the investment funds a 45 percent equity interest in Le-Nature’s. Each of the two investment funds was allowed to appoint an “outside” member to Le-Nature’s board of directors—that body was dominated by Podlucky and his fellow officers who were family members or close friends.

In late 2003, Le-Nature’s CFO and two other senior company officials suddenly resigned. Each of them informed the company’s Ernst & Young (EY) audit engagement partner that they had serious doubts regarding the reliability of Le-Nature’s accounting records. In particular, they doubted the accuracy of the company’s reported sales figures. In his resignation letter, the CFO reported that Podlucky had repeatedly refused to provide him with documentation supporting major transactions recorded by the company. The EY audit partner immediately insisted that Le-Nature’s retain an external law firm to oversee an independent investigation of its accounting records. Podlucky did just that and the resulting report cleared the company of any wrongdoing.

Three years later, allegations of an accounting fraud surfaced again. The company’s outside directors were successful in having a court-appointed custodian placed in charge of Le-Nature’s operations. A few days later, the custodian reported that Le-Nature’s financial statement data were fraudulent. In 2005, for example, nearly $250 million of the company’s reported sales had been fabricated by Podlucky. Subsequent criminal charges resulted in Podlucky and several of his family members and fellow executives receiving prison sentences. In addition to focusing on key corporate © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.6 Le-Nature’s Inc. 41 governance issues raised by the Le-Nature’s scandal, the case questions explore the professional roles and responsibilities of the company’s accountants and independent auditors.

Le-Nature’s Inc.--Key Facts 1.

Gregory Podlucky served as the CEO and sole common stockholder of Le-Nature’s Inc., a beverage company with a product line that included flavored water, fruit, and tea drinks.

2.

Podlucky faced a recurring need to raise additional capital for his rapidly growing company.

3.

In 2000 and 2002, Podlucky sold convertible preferred stock to two investment funds.

4.

The convertibility feature of the preferred stock effectively gave the investment funds a 45 percent equity interest in the company; each of the funds also had the right to appoint an “outside” member to the company’s board.

5.

Despite the sale of the convertible preferred stock, Podlucky relied almost exclusively on borrowed capital to fund his company’s expanding operations.

6.

Collectively, Le-Nature’s borrowed almost $1 billion over its existence; among the methods used to raise those funds were long-term leasing arrangements, the sale of high-yield or “junk” bonds, and a large revolving line of credit.

7.

In 2003, three senior company officials, including the CFO, suddenly resigned; the three officials informed Le-Nature’s EY audit engagement partner that they doubted the reliability of the company’s accounting records, particularly its recorded sales figures.

8.

The audit engagement partner immediately insisted that Podlucky retain an outside law firm to investigate the allegations of fraudulent accounting; the resulting report cleared the company of any wrongdoing, allowing Podlucky to refocus his efforts on raising debt capital for the company.

9.

In 2005, Podlucky rejected a $1.2 billion offer for his company and decided instead to take it public the following year; the company’s preferred stockholders charged that Podlucky sabotaged the sale of the company by refusing to allow the potential buyer to access its accounting records.

10. Allegations of a large-scale accounting fraud surfaced again in 2006; a court-appointed custodian discovered that the company’s accounting data were mostly fraudulent which resulted in a federal judge appointing a bankruptcy trustee to liquidate the company.

11. Gregory Podlucky and seven of his co-conspirators pleaded guilty or were convicted of various fraud charges and received prison sentences—Podlucky received the longest sentence of 20 years. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.6 Le-Nature’s Inc. 42 12. Among the parties that made large financial settlements with Le-Nature’s bankruptcy trustee was BDO Seidman—the audit firm that replaced EY when it was dismissed by Le-Nature’s in 2003, Wachovia—the company’s principal lender, and the law firm that oversaw the 2003 fraud investigation.

Instructional Objectives 1.

To identify the corporate governance responsibilities of corporate executives.

2.

To identify corporate governance safeguards that are mandatory for SEC registrants.

3.

To examine the corporate governance-related responsibilities of independent auditors and corporate accountants.

4.

To identify safeguards intended to promote the credibility and preserve the integrity of the independent audit function.

5.

To examine the key differences between a quarterly review and an independent audit.

6.

To identify the professional standards relevant to forensic accounting services.

Suggestions for Use

Corporate governance has been a controversial and “hot” topic in both the front page and business press in recent years. Consider requiring your students to briefly “bone up” on the topic of corporate governance before reading this case. There are several relatively brief overviews or summaries of corporate governance that are available online. In fact, the Wikipedia entry for “corporate governance” provides a reasonable overview of the topic.

This case focuses on Gregory Podlucky who is one of the best examples of what a corporate CEO should not be. Consider asking students to research recent highly publicized accounting frauds and to compare/contrast the CEOs of those organizations with Podlucky. Have them identify the personality traits that those individuals shared with Podlucky as well as apparent differences between them and Podlucky. The more students study major accounting frauds, the more likely it is that they will identify the red flags commonly associated with such frauds. Easily among the most common of those red flags is the presence of a CEO who is brash, bombastic, self-interested, and a self-promoter.

You might also consider asking your students to review a series of recent articles that appeared in major publications which suggest that there are a disproportionate number of CEOs who have a psychopathic personality profile. Here are two examples of such articles: C. Chumley, “Top 10 Psychopathic Professions: CEO, Lawyer -- then Media, Twice,” The Washington Times, 21 March 2014; J. Bercovici, “Why (Some) Psychopaths Make Great CEOs,” Forbes, 14 June 2011.

Although listed as the third “learning objective,” the key goal of this case is to focus students on the critical roles that accountants play in an organization’s corporate governance system. As noted in the case, Gregory Podlucky, himself, was an accountant by training and a CPA—at some point early © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.6 Le-Nature’s Inc. 43 in his business career he apparently gave up his certificate. Role playing is an effective way for students to gain a better understanding and appreciation of the challenges they may face in the professional roles that they occupy during their careers. Consider setting up a role playing scenario involving a stormy confrontation between Gregory Podlucky and John Higbee. The confrontation stems from Higbee’s insistence that Podlucky provide him access to critical documentation for LeNature’s major sales transactions. Recall that Higbee, Le-Nature’s CFO who resigned in 2003 after being repeatedly “stonewalled” by Podlucky, had 20 years experience as a prominent audit partner with Arthur Andersen & Co. You could also set up the following role-playing scenarios: Richard Lipovich, the EY audit engagement partner for Le-Nature’s, and Gregory Podlucky that involves Lipovich quizzing the CEO regarding the allegations made by John Higbee; Tammy Andrecyak, the apparently browbeaten confidante of Gregory Podlucky who was “in” on the accounting fraud, and a persistent audit senior attempting to pry information out of her regarding some suspicious sales transactions; and Gregory and Jesse Podlucky in a situation that revolves around Jesse’s reluctance to record questionable sales transactions for Le-Nature’s large tea subsidiary.

Suggested Solutions to Case Questions 1. Investopedia defines corporate governance as “the system of rules, practices and processes by which a company is directed and controlled.” As such, corporate governance involves the interests and “balancing the interests” of a wide range of stakeholders. Those stakeholders include management, employees, stockholders, debtholders and other creditors, vendors, relevant government agencies, the business community, and the communities in which a given entity’s business operations are located. A major challenge that corporate executives face in carrying out their corporate governance responsibilities is the conflict of interests that exist between and among different classes of those stakeholders. For example, taking actions that are in the best interests of stockholders may disadvantage customers or other stakeholder groups.

Several organizations have published treatises on the topic of corporate governance. Among the most notable of those publications is the “OECD Principles of Corporate Governance” released initially in 1999 by the Organization for Economic Cooperation and Development (OECD). [Note: The OECD is an international organization with 34 member nations. Those member nations include primarily European countries, the United States, Canada, and Australia.]

Typically, the obligation to promote and protect the interests of a company’s shareholders is deemed to be the preeminent responsibility of corporate executives. Of secondary but still great importance is the obligation of corporate executives to consider the interests of the other classes of stakeholders. In considering and acting on behalf of the interests of these stakeholders, corporate executives have an obligation to conduct themselves with integrity, competence, and transparency.

2. As noted in the suggested solution to the previous question, corporate governance involves “the system of rules, practices and processes by which a company is directed and controlled.” Corporate accountants play an essential role in corporate governance by providing the information needed by management to “direct” and “control” their organizations. To properly “direct” their company, corporate executives need a wide range of financial and nonfinancial information that is collected, processed, formatted, and reported by the entity’s accountants. For example, to make informed capital budgeting decisions, corporate executives rely on their accountants to provide a wide range of © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.6 Le-Nature’s Inc. 44 historical and pro forma information for individual capital budgeting projects that are under consideration. To properly “control” their company, corporate executives rely heavily on the internal control mechanisms developed, implemented, and monitored by their accountants. Accountants are delegated the latter responsibility because they are “experts” when it comes to such issues as the proper segregation of key responsibilities in each accounting cycle.

Independent auditors play a secondary but nevertheless critical role in corporate governance.

Similar to corporate accountants, auditors help ensure that critical information needed to exercise effective corporate governance is conveyed to corporate executives, boards of directors, and audit committees. For example, auditors have the responsibility to identify deficiencies in an entity’s internal control processes that have been overlooked or discounted by that entity’s accounting staff.

Plus, auditors have a responsibility to report certain adverse information to the investing and lending public (in their audit opinions) and to regulatory authorities (such as when they discover “illegal acts that client management refuses to report) that effectively keeps corporate executives “on their toes” and serves to enhance the effectiveness of corporate governance.

Forensic accountants are experts in searching for and identifying fraudulent schemes that undermine the operations, accounting systems, and financial reporting functions of organizations.

Given their professional training, corporate accountants and independent auditors have some level of forensic expertise but not to the extent of that possessed by professional forensic accountants. So, forensic accountants can buttress corporate governance by “rooting out” fraud and other malfeasance overlooked by an entity’s accountants and independent auditors. Forensic accountants also serve to enhance corporate governance by identifying circumstances in which an organization’s accountants and/or auditors are complicit in an ongoing fraudulent scheme overseen by corporate executives.

3. The COSO internal control framework identifies five components of a given company’s internal control system or structure: control environment, risk assessment, control activities, information and communication, and monitoring. Listed next are examples of corporate governance flaws that were apparent in each of these components of Le-Nature’s internal control framework.

Control environment: The overarching feature of internal control is the control environment which refers to the degree of control consciousness within an organization. An organization’s leaders establish the “tone at the top” in terms of control consciousness. If those leaders have little interest in or respect for the importance of internal controls, then their subordinates will almost certainly follow suit. As the dominant executive of Le-Nature’s, Gregory Podlucky clearly did not have proper respect for the importance of internal controls and obviously failed to establish a proper degree of control consciousness within the organization.

Related to Podlucky’s domination of Le-Nature’s is another flaw in the control environment element of the company’s corporate governance system, namely, the fact that he nearly always selected family members or close business associates to staff key positions within the company. (A notable exception would be John Higbee.) Another corporate governance flaw that is again related to Podlucky’s domination of the company was assigning individuals responsibilities for which they were not competent to perform. Here the perfect example is Tammy Andrecyak who held the position of Director of Accounting when, in fact, she was his personal secretary. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.6 Le-Nature’s Inc. 45 Risk assessment: COSO defines “risk” as “the possibility that an event will occur and adversely affect the achievement” of one or more entity-level objectives. Risk assessment is a “dynamic and iterative process” intended to ultimately determine how an organization’s risks will be managed and controlled. It seems apparent that the major “risk” that Podlucky and his fellow conspirators continually assessed and actively managed was the risk that their massive fraud would be discovered.

In fact, Podlucky seemed to pay little attention to such “normal” entity-level objectives as establishing a profitable and growing business, meaning that conventional “risk assessment” activities related to such objectives was effectively a non-issue.

Control activities: “Control activities” within the COSO internal control framework refer to “actions established through policies and procedures” to mitigate an organization’s risks. According to COSO, control activities may be “preventive or detective.” Podlucky only made superficial efforts to establish proper control activities for Le-Nature’s. For example, he did have in place an accounting system to capture financial data to be used for decision-making purposes and for external reporting purposes, he established a board of directors for the organization and included external or independent members on that board, he hired a competent CFO, and he retained an independent accounting firm to audit LeNature’s periodic financial statements. However, each of these high-level control activities was, in reality, a smokescreen intended to help Podlucky conceal his fraud rather than to assist him in managing the business-related risks faced by his company. Take the case of the company’s accounting system. Le-Nature’s actually had two accounting systems: one that captured the company’s actual financial data and another that included the huge amount of bogus data that he and his conspirators were fabricating. Podlucky used the latter accounting system as the source for LeNature’s financial statements and only allowed the company’s CFO, independent auditors, and independent directors to access data from that system.

Information and communication: The COSO internal control framework notes that “information is necessary” for an organization to establish and properly carry out its internal control policies and procedures. COSO defines “communication” as the “continual, iterative process of providing, sharing and obtaining necessary information.” Again, this element of Le-Nature’s internal control was completely flawed. Instead of communicating reliable, useful information, Le-Nature’s information and communication systems were designed to deliberately communicate “misinformation” intended to serve the self-interested objectives of Podlucky and his conspirators.

Monitoring: This component of the COSO framework refers to the need for an organization to continually monitor its internal controls to provide the board of directors and senior management timely information on the status of those controls. Again, the concept of “monitoring” as alluded to by COSO was a non-issue for Le-Nature’s since the company’s primary objective was to conceal a massive and ongoing fraud. No doubt, Podlucky and his conspirators routinely and vigorously engaged in “monitoring” activities, but the purpose of those activities was driven by those individuals’ misdirected self-interests. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.6 Le-Nature’s Inc. 46 Note to Instructors: You may want to point out to your students that Podlucky, given his accounting background (he was formerly a CPA), was particularly well-suited to orchestrate a largescale accounting fraud. In particular, his accounting background made him aware of all of the “pressure points” that had to be addressed in managing and concealing such an elaborate ruse.

The fraud triangle is discussed in both the AICPA’s and the PCAOB’s professional auditing standards. The three components or elements of the fraud triangle include incentives/pressures, opportunities, and attitudes/rationalizations. “Incentives/pressures” refer to a given reason to commit fraud; “opportunities” refer to the existence of a set of circumstances that makes the commission of fraud possible; while “attitudes/rationalizations” refer to the ability of a given individual or group of individuals to justify or rationalize fraudulent conduct.

Listed next are specific examples of “fraud risk factors” relevant to each component of the fraud triangle.

Incentives/pressures: • Need to obtain additional debt or equity capital to remain competitive • Management has a significant equity interest in the company • Recurring negative operating cash flows • Highly competitive industry conditions • Excessive revenue or profit expectations by third parties Opportunities: • Significant related party transactions • Key financial statement amounts are based on estimates • Significant, unusual, or highly complex transactions • Domination of management by a single individual • High turnover within senior management • Significant deficiencies or material weaknesses in internal controls Attitudes/rationalizations: • History of violations of securities laws or other regulations by management • Excessive interest by management in company’s stock price • History of management making firm commitments regarding sales or profit forecasts • Management’s failure to remedy known internal control problems • Frequent auditor-client disputes In terms of the fraud triangle, Podlucky’s apparent personal goal was to become wealthy and influential—he reportedly had political ambitions. That goal gave him a tremendous incentive to take unfair advantage of his company, its creditors, the preferred stockholders, and other stakeholders of the company. (Note: Consider pointing out to students that simple greed is the most common motive for perpetrating a financial fraud). Podlucky’s ability to dictate Le-Nature’s internal controls gave him the opportunity to commit fraud. Even when legitimate controls were in place, he was able to undercut them. For example, he was able to intercept the initial draft version of the Special © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.6 Le-Nature’s Inc. 47 Committee report and influence its content before it was actually provided to the Special Committee.

Finally, Podlucky was obviously able to rationalize or justify his bad behavior.

4. Many of the corporate governance safeguards for SEC registrants are a direct consequence of the Sarbanes-Oxley Act of 2002. SOX gave more power, authority, and accountability to corporate boards of directors. For example, the audit committee, which is a subset of the corporate board, has a responsibility under SOX to interact directly with a company’s independent auditors regarding key internal control and financial reporting matters. SOX effectively mandated or forced companies to establish a corporate code of ethics—if a SEC registrant doesn’t have such a code, it must explain and justify that “oversight.” SOX resulted in the creation of the PCAOB which serves as a regulatory watchdog for auditors of public companies thereby strengthening the independent audits of those companies and reinforcing their importance. SOX mandated that public companies have their ICFR (internal controls over financial reporting) audited each year, a requirement that has clearly strengthened the internal controls and corporate governance of public companies.

An example of a corporate governance safeguard implemented for public companies prior to the adoption of SOX was the SEC’s decision to mandate that SEC registrants report changes in auditors and the circumstances surrounding such changes (such as whether or not an auditor change was preceded by a dispute over accounting or auditing issues). This policy strengthens corporate governance by holding corporate executives accountable for a decision to replace their company’s independent auditors.

5. As a sidebar, the information available for this case does not reveal why EY was dismissed in late 2003 by Le-Nature’s. Consequently, it is difficult to address the question of whether or not EY was dismissed for a legitimate reason. Having said that, one could safely argue that EY’s forceful approach to addressing the fraud allegations was a key factor in that dismissal. If the purpose of the dismissal was to “punish” EY for insisting on a fraud investigation, then that would not have been a proper reason for the auditor change.

Both the AICPA and PCAOB auditing standards mandate predecessor-successor auditor communications. These mandatory communications serve to limit the ability of audit clients to conceal adverse information that their auditors uncover—which, of course, would serve to undermine the credibility and integrity of the independent audit function. As pointed out in the suggested solution to the prior case question, when SEC registrants change audit firms they must file an 8-K statement that discloses the change and the circumstances surrounding it, for example, whether a disagreement over an accounting or auditing issue preceded the change. Again, this requirement promotes the credibility and integrity of the independent audit function.

6. The purpose of a review engagement is to obtain a reasonable basis for providing limited assurance that a given client's financial statements have been prepared in conformity with generally accepted accounting principles. More precisely, a “clean” review report provides negative assurance, that is, it discloses only that the auditor (CPA) did not discover any evidence suggesting that the relevant financial statements are materially misstated. Of course, the objective of an audit is much more affirmative in nature. A full-scope independent audit is designed to provide a reasonable basis for expressing an "opinion" concerning whether or not a client's financial statements have been prepared in accordance with generally accepted accounting principles. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.6 Le-Nature’s Inc. 48 There is also a critical difference between a review and an audit in terms of the scope of work performed. In a review engagement, the primary (mandatory) evidence collection techniques are analytical procedures and inquiries of client personnel. Alternatively, in an audit, the full range of evidence collection techniques available to an auditor is likely to be used including, but not limited to, confirmation procedures, physical observation of assets, and inspection of documents.

7. Pascarella & Wiker’s engagement was a non-audit attestation service. (Of course, because all attestation services are also assurance services, the engagement qualified as an assurance service engagement as well.) The attestation standards would be the principal standards that governed P&W’s conduct during its Le-Nature’s engagement. AT Section 101.01 notes that attestation services generally involve those circumstances in which a CPA is retained to issue a report on “subject matter” or “an assertion about the subject matter” that is “the responsibility of another party.” In this case, P&W was hired to investigate and report on whether there was any evidence of an ongoing accounting fraud at Le-Nature’s. So, P&W’s responsibility was effectively to investigate and report on the assertion by Le-Nature’s management team (primarily Gregory Podlucky) that the company wasn’t engaging in an accounting fraud.

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.7 Navistar International Corporation 48

CASE 1.7

NAVISTAR INTERNATIONAL CORPORATION

Synopsis Navistar International Corporation traces its roots back to Cyrus McCormick, the famous 19th century American inventor. This case, however, begins in the 21st century when Navistar fired its longtime audit firm, Deloitte, in early 2006. “Longtime” is an understatement since the relationship between the two organizations lasted 98 years.

As Deloitte’s 2005 audit of Navistar was nearing completion, the firm suddenly replaced the audit engagement partner. The new engagement partner effectively started the audit over, refusing to accept or rely upon any of the work supervised by his predecessor. Not surprisingly, Navistar management was less than happy with the unpleasant turn of events. In April 2006, well after Navistar had missed its filing deadline for its annual Form 10-K with the SEC, Deloitte was fired and replaced by KPMG. More than 18 months would pass before KPMG completed its audit and Navistar filed its 10-K with the SEC. KPMG’s audit was extended by a series of large accounting misstatements and internal control weaknesses discovered by the audit team.

During the midst of Navistar’s accounting scandal, the company sued its former audit firm, Deloitte, for $500 million. The harsh allegations included in the 134-page complaint filed against Deloitte included the suggestion that the prominent audit firm was incompetent. Deloitte was less than happy with that allegation and similar statements made by Navistar’s attorneys and blamed the company’s accounting scandal on the senior executives who were sanctioned by the SEC as a result of it.

Eventually, the PCAOB stepped into the nasty fray involving Navistar and Deloitte and launched a formal investigation of Deloitte’s 2003 audit of the company. That probe was the first formal investigation of a Big Four accounting firm by the PCAOB. Ultimately, two Deloitte audit partners who had been assigned to the Navistar engagement were fined and suspended by the PCAOB. In addition to unraveling the Navistar accounting scandal and Deloitte’s role in it, this case focuses on the regulatory role and responsibilities of the PCAOB. The Navistar case was apparently a key factor that prompted the PCAOB to suggest that mandatory audit firm rotation might be necessary to enhance auditor independence. That proposal, as discussed in the epilogue of the case, was rejected by the U.S. Congress.

Navistar International Corporation--Key Facts 1. Deloitte replaced the audit engagement partner on the 2005 Navistar audit as that engagement was © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.7 Navistar International Corporation 49 nearing completion; the replacement audit partner effectively began the audit over, refusing to “accept any of the work” that had been supervised by the previous audit partner.

2. Five months later, in April 2006, Navistar fired Deloitte and hired KPMG as its audit firm; due to the company’s pervasive “improper accounting practices” and internal control problems, more than 18 months passed before KPMG completed Navistar’s 2005 audit.

3. Navistar ultimately restated its 2003-2004 financial statements and disclosed 15 material weaknesses in internal controls in its 2005 Form 10-K; as a result of Navistar’s accounting scandal, the SEC sanctioned several of the company’s top executives.

4. In 2005, the SEC inadvertently disclosed that the PCAOB was investigating Deloitte’s 2003 Navistar audit; that was the first formal investigation of a Big Four firm by the PCAOB. 5. A few months earlier, the SEC had fined Deloitte $50 million for its audits of Adelphia, a large telecommunications firm that had collapsed into bankruptcy.

6. In addition to investigating alleged audit failures, the PCAOB periodically inspects the audit practices of all accounting firms that audit companies with securities traded on U.S. stock exchanges.

7. The purpose of PCAOB inspections is to “identify and address weaknesses and deficiencies” in how a firm conducts audits.

8. Part I of PCAOB inspection reports identifies deficiencies specific to individual audits, while Part II of those reports identifies quality control defects in accounting firms’ audit practices—only Part 1 is disclosed to the public unless a firm fails to “remediate” the Part II deficiencies within 12 months of the date of the given inspection report.

9. The PCAOB fined and suspended two audit partners involved in the 2003 audit of Navistar; the two partners allegedly worked together to increase a materiality threshold for that audit so that Navistar would not have to adjust its financial statements for a known accounting error.

10. In October 2011, the PCAOB surprised the accounting profession by releasing Part II of Deloitte’s 2007 inspection report; the most serious allegation leveled against Deloitte in that section of the report was that the firm’s “culture” was flawed.

11. Navistar eventually filed a $500 million lawsuit against Deloitte; among other harshallegations, the lawsuit charged Deloitte with “lying” as to the competency of its audit and accounting services.

12. The Navistar-Deloitte debacle apparently contributed to the PCAOB’s decision to propose mandatory audit firm rotation for SEC registrants in 2011.

Instructional Objectives 1. To examine the advantages and disadvantages of mandatory auditor rotation. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.7 Navistar International Corporation 50 2. To consider the nature of material weaknesses in internal control and their impact on independent audits.

3. To examine the nature of the auditor-client relationship and how that relationship may influencethe performance of independent audits.

4. To identify factors that influence the materiality thresholds established by auditors.

5. To identify the nature and importance of quality controls for audit firms.

6. To examine the regulatory role and responsibilities of the PCAOB. Suggestions for Use This is another case that I have used as an initial assignment for my graduate auditing course. This case provides students who have a limited understanding of the independent audit function in the U.S. with a “big picture” view of independent auditing in a free market economy—I typically have several foreign students in my graduate auditing class from “controlled economy” nations.

The Navistar case provides insight on both the internal and external environments of independent auditing. That is, the case highlights important factors that complicate specific audit engagements, while at the same time demonstrating how the external environment, most notably, legal liability issues and regulatory oversight, impact audit firms and auditors. Given the case’s major focus on the PCAOB and its role and responsibilities, in an undergraduate auditing course you might consider assigning this case when you cover the “auditing profession” chapter, which is typically either the first or second chapter of an undergraduate auditing text.

Suggested Solutions to Case Questions 1. The key disadvantage of mandatory auditor rotation is the “learning curve effect.” That is, a new audit firm will automatically have less understanding of a client’s business practices, internal control system, and accounting methods than the “old” audit firm. Several years may pass before the learning curve “deficit” is overcome and then it may be time to change auditors again. Another disadvantage of mandatory auditor rotation is an alleged increase in audit costs—this is an unsubstantiated argument typically used by opponents of auditor rotation. Empirical researchers have documented so-called “spillover effects” that a client benefits from as a result of having an experienced auditor. For example, an experienced auditor should be more likely to identify factors that would enhance the operating effectiveness and efficiency of a client’s operations. Obviously, these positive spillover effects are lost when a new auditor is appointed.

The principal alleged advantage of mandatory audit firm rotation is that a long-tenured auditor may become somewhat “stale” and/or complacent thus diminishing the likelihood that it will identify material errors in a client’s accounting records. Another important advantage of mandatory auditor rotation is an enhanced degree of perceived auditor independence that, in turn, should result in a higher measure of financial statement credibility for the given client.

The Sarbanes-Oxley Act of 2002 mandates a form of auditor rotation in the U.S. The general rule is that the “lead” and “concurring” partners assigned to an audit engagement must be rotated every five © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.7 Navistar International Corporation 51 years. Another five years must elapse before those individuals can be reassigned to the given audit engagement.

Consider having your students research auditor rotation rules around the world and present their findings in class. Australia, for example, implemented an audit partner rotation rule before the SOXimposed rule in the U.S. 2. Notes: PCAOB Auditing Standard No. 2 was the initial internal control standard adopted by the PCAOB (this standard went into effect for large SEC registrants in late 2004). AS No. 2 introduced the terms “material weakness” and “significant deficiency” in internal controls. In 2007, the PCAOB replaced AS No. 2 with AS No. 5. The title of AS No. 5 is, “An Audit of Internal Control Over Financial Reporting That is Integrated with an Audit of Financial Statements.” Earlier in 2007, the SEC had issued new interpretative guidance to streamline and reduce the cost of SOX-mandated assessments of internal control by the management of public companies. The PCAOB followed suit by adopting AS No. 5, which was intended to reduce the cost of SOX-mandated internal control audits by a company’s auditors. In the reorganized PCAOB auditing standards, AS No. 5 is integrated into AS 2201. [An excellent summary of AS No. 5 is included in the following article: S.L. Fogelman, B.H. Peterson, W.G. Heninger, and M.B. Romney, “Opportunity Detected: New SEC Interpretive Guidance and AS5 Give Companies and Auditors A Chance to Make Internal Controls More Efficient,” Journal of Accountancy, December 2007, 62-65.]

Following are definitions of three key terms that were taken directly from AS 2201.

Internal control deficiency: “A deficiency in internal control over financial reporting exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis.”

Significant deficiency in internal control: “A significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the company’s financial reporting.”

Material weakness in internal control: “A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis.”

In fact, it appears that Navistar listed the 15 material weaknesses in descending order of importance.

That is, the most critical weakness is the initial one, while the second weakness is the next most critical, and so on. Your students almost certainly won’t realize that the items are presented in a descending order of importance until they review the entire list. You might consider requiring your students to access Navistar’s Form 10-K on the edgar.gov website and review the complete narrative discussion of the 15 internal control weaknesses. Recognize that the excerpts in Exhibit 1 typically represent only a small portion of the narrative discussion for each item.

Certainly, a client can have such inadequate internal controls that it is not “auditable.” In such cases, an audit team might be effectively forced to reconstruct the client’s accounting records, which means that they would not have the necessary independence to then audit those records. The weaknesses © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.7 Navistar International Corporation 52 in Navistar’s internal controls were so extensive that it does make one wonder how Deloitte was capable of auditing the company’s financial statements in the years prior to 2005.

3. Absolutely not. Because of a lack of independence, an accounting firm cannot audit accounting records that it effectively maintained.

Regarding the second question, the point here is to focus students’ attention on the fact that both Deloitte and Navistar bore some portion of the responsibility for Deloitte’s dismissal in April 2006. In my view, Deloitte clearly had a responsibility to apprise the client earlier than late 2005 that their accounting records were “in a mess” and that a massive reconstruction or refurbishing job would be necessary on those records before they were “auditable.” Having said that, Navistar had the ultimate responsibility for maintaining accounting records that were auditable.

4. AS 2105, “Consideration of Materiality in Planning and Performing an Audit,” in the PCAOB’s auditing standards is the authoritative standard in this context for audits of SEC registrants. The phrase “planning materiality threshold” is not found in AS 2105. The phrase that the PCAOB uses that is most equivalent to “planning materiality threshold” is “materiality level for the financial statements as a whole.” AS 2105.06 provides the following discussion of that phrase.

“To plan the nature, timing, and extent of audit procedures, the auditor should establish a materiality level as a whole that is appropriate in light of particular circumstances. This includes consideration of the company’s earnings and other relevant factors. To determine the nature, timing, and extent of audit procedures, the materiality level for the financial statements as a whole needs to be expressed as a specified amount.”

Among the factors that may influence the planning materiality level for a given client, according to AS 2105, are the existence of related-party transactions and conflicts of interests. “Other relevant factors” that may influence planning materiality decisions would include an usually low amount for an important materiality benchmark (such as net income) in a given year, external circumstances that draw particular attention to the given entity’s financial statements such as a planned offering of securities, and changes in laws or regulations or industry conditions that impact investors’ expectations for the entity.

AS 2105 acknowledges that an auditor may reevaluate the materiality levels he or she has established during the course of an engagement “because of changes in the particular circumstances or additional information that comes to the auditor’s attention” (paragraph 11). An example of such a “change in circumstances” provided by AS 2105 is the following: “The materiality level or levels and tolerable misstatement were established initially based on estimated or preliminary financial statement amounts that differ significantly from actual amounts” (paragraph 11).

Clearly, the change in circumstances that prompted the Deloitte partners to revise the planning materiality threshold for the 2003 Navistar audit would not be considered an appropriate justification for a change in a materiality level under AS 2105.

5. The decision not to sanction Deloitte does not seem consistent with the logic of the former PCAOB official (apologies for the double negative). In my view, it appears that there was a “failure of oversight or supervision.” No doubt, we can criticize the oversight or supervision that Linden provided to Anderson. Likewise, where was the concurring or review partner? It seems that individual should have “weighed in” on the decision to revise the materiality threshold at the last moment.

In fact, the PCAOB in its 2007 Deloitte inspection report criticized the “consultation” function © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.7 Navistar International Corporation 53 within the firm (see Exhibit 2). When necessary, auditors, including audit engagement partners, should consult with experts within or outside the firm to ensure that they make the proper decision. Here’s a relevant excerpt from the PCAOB’s quality control standards: “Policies and procedures should also be established to provide reasonable assurance that personnel refer to authoritative literature or other sources and consult, on a timely basis, with individuals within or outside the firm, when appropriate (for example, when dealing with complex, unusual, or unfamiliar issues)” [QC 20.19]. It is the responsibility of a firm as a whole, not individual partners, to ensure that the firm has proper “consultation” policies and procedures.

6. QC Section 20, “System of Quality Control for a CPA Firm’s Accounting and Auditing Practice” in the PCAOB’s quality control standards provides an overview of the nature and purpose of a CPA firm’s quality control system. (Note: the quality control standards in the AICPA Professional Standards are very similar to the PCAOB’s quality control standards.) QC 20.02 notes that CPAs “should practice in firms that have in place internal quality-control procedures to ensure that services are competently delivered and adequately supervised.” QC 20.07 identifies the following five elements of quality control for a CPA firm registered with the PCAOB: a. b. c. d. e.

Independence, Integrity, and Objectivity Personnel Management Acceptance and Continuance of Clients and Engagements Engagement Performance Monitoring

The key factor that influences an accounting firm’s culture is the “tone at the top,” that is, the overall competence, integrity, and professionalism of the organization’s leaders. As noted in the case, the PCAOB reported that Deloitte’s “senior leadership” had apparently embraced the need to make changes in the firm’s audit practices. For whatever reason, the PCAOB was not convinced that change in attitude had “trickled down” to the rank and file employees of the firm. What this suggests is that the communication element of the firm may need to be improved. [Note: You might draw parallels between the COSO framework for internal control and accounting firms’ quality control systems. Of course, in the COSO framework the tone at the top or “control environment” is the most important element of an entity’s internal control system. Likewise, adequate “communication” is another necessary element of an entity’s internal control system.”] The quality of accounting firms’ training programs and their overall ability to quickly and thoroughly “acculturate” new employees into the public accounting profession are other key factors that influence the culture of those firms.

7. The PCAOB has faced considerable controversy since it was established in 2003. As you are well aware, a legal challenge to the new agency’s constitutionality was ultimately resolved in the federal courts, including a ruling issued in 2010 by the U.S. Supreme Court. As a prologue to discussing this case question, you might provide your students with the PCAOB’s “mission” and “vision” statements that are presented on the organization’s website: “Our Mission: The PCAOB mission is to oversee the audits of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports. The PCAOB also oversees the audits ofbroker-dealers, including compliance reports filed pursuant to federal securities laws, to promote investor protection.” © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.7 Navistar International Corporation 54 “Our Vision: The PCAOB seeks to be a model regulatory organization. Using innovative an d cost-effective tools, the PCAOB aims to improve audit quality, reduce the risks of auditingfailuresin the U.S. public securities market and promote public trust in both the financial reportingprocess and auditing profession.”

Not being an attorney or a governmental affairs expert, I am less than confident in providing affirmative answers to this case question. Then again, even the so-called “experts” quarrel over the proper scope and nature of the PCAOB’s regulatory role and responsibilities. The key goal in having students respond to this question is raising their awareness of the PCAOB and the controversy over its regulatory role and responsibilities.

In my view, triggering a dialogue on the topic of mandatory audit firm rotation seems to be well within the purview of the PCAOB’s “mission” statement. Then again, it would seem to me that the government agency that would have to make the final decision regarding audit firm rotation would be the SEC. Congressman Garrett would likely challenge that assertion since he is of the opinion, apparently, that important policy issues involving the capital markets, such as audit firm rotation, should be addressed directly by Congress.

8. This question is related to the prior one in that it addresses the nature and scope of the PCAOB’s regulatory role and responsibilities. I believe there is a definitive answer to this question, however. In my view, the PCAOB inspection teams have the right, as well as a responsibility, to “second guess” judgments of the professionals whose work they are reviewing. In fact, if the PCAOB did not have that right or responsibility, what purpose would be served in having the regular inspections of audit firms? I also understand the point being made by Deloitte, namely, that two skilled and seasoned professionals may arrive at different decisions when faced with an identical set of circumstances. That fact, however, does not preclude the possibility that one of those “professionals” made a judgment error.

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.8 Livent,

55

Inc.

CASE 1.8

LIVENT, INC.

Synopsis Similar to most financial frauds, the Livent, Inc. fraud was masterminded by a few individuals, primarily Garth Drabinsky and Myron Gottlieb. However, numerous individuals were eventually drawn into Livent’s fraudulent schemes by its principal architects, including Maria Messina, the company’s chief financial officer (CFO). Messina, a former partner with Deloitte & Touche’s Canadian affiliate, had previously served as Livent’s audit engagement partner. The fraud unraveled following Livent’s takeover by an investment group led by Hollywood mogul Michael Ovitz. The new management team installed by Ovitz soon found that “massive, systematic irregularities” permeated the company’s accounting records. Subsequent investigations by various regulatory authorities, including the SEC, resulted in numerous civil lawsuits and criminal indictments being filed against Drabinsky and his former associates.

Two features of the Livent fraud were particularly disturbing to SEC officials. First, Livent’s accounting staff helped further the fraud by developing computer software that allowed senior management to track the company’s “real” financial data and the data that had been distorted by fraudulent manipulations. The accounting software also allowed Livent’s executives to more readily conceal the fraud from the company’s Deloitte auditors. The second troubling feature of the Livent fraud was the matter-of-fact manner in which the company’s executives organized and carried out the fraud.

Following the collapse of Livent, the company’s independent auditors were criticized for failing to discover that the company’s financial statements had been grossly misstated. Much of this criticism stemmed from the fact that the Livent fraud had features common to several “classic” financial frauds.

These features included an extremely aggressive, growth-oriented management team, a history of prior financial reporting indiscretions by top company officials, a constant and growing need for additional capital, and the existence of related-party transactions. The presence of these “red flags” should cause auditors to recognize that there is a higher than normal risk that the given client’s financial statements contain material misstatements.

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56 Inc.

Case 1.8 Livent, Livent, Inc.--Key Facts

1.

Garth Drabinsky and Myron Gottlieb founded Livent in 1989 after they had been forced to relinquish control of Cineplex Odeon following charges of irregularities in that company’s accounting records.

2.

Drabinsky was the creative genius behind Livent’s impressive string of Tony Award-winning theatrical productions during the 1990s but also dominated, with the help of Gottlieb, every other important facet of Livent’s operations.

3.

Livent was based in Toronto but the company received SEC approval to begin trading its stock on the NASDAQ stock exchange in 1995.

4.

Serious financial problems stemming from huge cost overruns on Livent’s extravagant productions forced Drabinsky to allow Michael Ovitz to acquire a controlling interest in the company in 1998.

5.

Ovitz’s new management team quickly found that Livent’s previous financial data had been grossly distorted by pervasive accounting irregularities.

6.

Subsequent investigations by the SEC and other law enforcement authorities revealed that Drabinsky and Gottlieb had apparently masterminded a far-reaching and multi-faceted financial fraud to conceal Livent’s deteriorating financial health.

7.

Livent employees who participated in the fraud included several accountants who had previously served on Deloitte’s audit engagement team for the company, most notably Maria Messina, Livent’s CFO who had previously been the company’s audit engagement partner.

8.

The SEC discovered that Livent’s accounting staff had developed computer software that tracked the company’s “real” and bogus financial data; this software was also used to conceal the fraud from the Deloitte auditors.

9.

Another disturbing feature of the fraud was that company executives regularly met with their accounting staff to discuss “adjustments” needed to improve Livent’s financial data.

10. The “accounting manipulations” used by Livent officials included simply erasing expenses and liabilities from the company’s accounting records, improper deferrals of major production costs, and capitalizing common operating expenses.

11. In August 1998, Messina and four of her subordinates revealed the fraud to a Livent executive who had been appointed by Michael Ovitz.

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Case 1.8 Livent, 57 Inc. 12. Deloitte was named as a defendant in multiple civil lawsuits stemming from the Livent fraud; to settle one such case, Deloitte reportedly made a multimillion dollar payment to a restitution fund established for Livent’s former creditors.

Instructional Objectives 1.

To emphasize the need for auditors to identify the key inherent risk factors posed by an audit client.

2.

To illustrate the lengths to which client executives will sometimes go to misrepresent their company’s operating results and financial position.

3.

To examine the issues raised when independent auditors accept key accounting positions with former clients.

4.

To illustrate the difficulty of uncovering financial frauds masterminded by top client executives that involve the collusion of key members of the given entity’s accounting staff.

5.

To emphasize the need for auditors to thoroughly investigate suspicious circumstances and transactions discovered during an audit engagement.

Suggestions for Use

In responding to Question 1, students are required to identify the audit risk factors posed by companies in the entertainment industry. Consider expanding Question 1 and making it a more comprehensive exercise. After organizing your class into groups of four to six students, require each group to investigate and prepare a five- to ten-minute oral report on the audit risk factors posed by a specific industry. Industries that I have selected for this purpose in similar exercises include gaming (casino), brokerage, trucking, mining, and computer peripherals. The key to this exercise is choosing a set of industries that are quite different in nature. Following this exercise, students should have a better understanding of the risk factors that tend to be common to a wide range of industries and those that are unique to individual industries.

In discussing Maria Messina’s plight (while responding to Question 6), some students are prone to suggest that she should have simply reported the fraud to the appropriate officials as soon as she became aware of it. I attempt to goad my students into recognizing that although revealing the fraud would certainly have been the best decision for Messina to make, it certainly would not have been an easy decision. Encourage students to place themselves in Messina’s position. The young, single mother faced a classic Catch 22 situation. By revealing the fraud, she would be raising doubts regarding the quality of the prior Livent audits that she had supervised. Making matters worse, she faced the prospect of losing the large salary she received from Livent, forfeiting the comfortable lifestyle that she had enjoyed since becoming a Deloitte partner, and suffering enormous embarrassment. By dissecting historically “bad” decisions made by auditors and accountants in the past, students will hopefully be less prone to make such decisions during their professional careers. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

58 Inc.

Case 1.8 Livent, Suggested Solutions to Case Questions

1. The “entertainment industry” is very diverse and fragmented. In fact, there is little consensus among financial analysts on which specific companies belong to this industry. Video game manufacturers, movie production companies, publicly-owned sports franchises, and sporting goods manufacturers are a just a few examples of the types of companies that are involved in “entertaining” the public. Nevertheless, I would suggest that many companies in the entertainment industry pose the following general inherent risk factors: • Entertainment companies tend to have more volatile operating results than more generic

companies. Why? Because most companies in this industry rely heavily on discretionary spending by consumers, which fluctuates with changes in the overall health of the economy.

• Likewise, the demand for products and services of entertainment companies tend to be more subject to sudden changes in the tastes/interests of the consuming public. For example, the most recent “hot” video game may suddenly fall out of favor with teens and pre-teens when a newer, more “hip” game is released by a competing company. In such situations, companies can be “stuck” with a large amount of obsolete inventory.

• Because of the more volatile operating results of entertainment companies, one could certainly argue that their management teams may be more inclined to attempt to “smooth” their periodic earnings by using various earnings management techniques.

• Because of the generally high-risk nature of entertainment companies’ business models, I would suggest that the executives who self-select themselves into this industry are prone to be more risk-seeking, or, at least, less conservative, in their business strategies than the executives who enter electric utilities, banking, and other (historically) low-risk industries.

Listed next are a few examples of “non-standard” audit procedures that might be applied during an audit of a company involved in live theatrical productions.

• Internal control tests would be necessary to ensure that cash receipts generated by live shows

are being processed properly. Likewise, related tests would be needed to reconcile head counts with cash receipts—to investigate the possibility that ticket-takers/ticker-sellers are being “generous” with their friends and relatives.

• Theatrical companies typically sign contracts with the theatres in which their productions are to appear—which was true of Livent when one of its shows appeared in a theatre that wasn’t owned by the company. These contracts have various stipulations that allow the theatre to cancel the show if it is a “bust.” Essentially, these contract stipulations are comparable to covenants commonly included in long-term debt agreements. Auditors would need to develop audit tests to make sure that such contractual stipulations are being satisfied and will likely be satisfied in the near future.

• Theatrical companies defer development costs for new productions. These deferred assets can accumulate to material amounts. Auditors would need to develop appropriate tests to ensure that these deferred costs are, in fact, assets and are properly valued. Such tests might include

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Case 1.8 Livent,

59

Inc. corresponding with industry experts or analysts to investigate the likelihood that the given shows will ultimately “open” and have a reasonable “run.”

• Theatrical companies often have long-term contracts with actors that produce large assets and liabilities in their balance sheets (these long-term contracts are comparable to capital leases).

Auditors would need to develop audit tests to address the key assertions underlying these amounts. For example, a potentially career-ending injury or illness to an actor who has been signed to a long-term contract might have material balance sheet implications for a theatrical company. In such a case, auditors would need to correspond with the appropriate physicians and/or insurance carriers to determine whether the given situation should trigger an accounting adjustment and/or a footnote disclosure in the client’s financial statements.

2. The work roles of an audit partner and CFO of a large public company are probably more similar than they are different. Both an audit engagement partner and a CFO have to “sign off” on financial statements. An audit partner attests to the material accuracy of a client’s financial statements when he or she signs an audit report. Since the passage of the Sarbanes-Oxley Act in the summer of 2002, the SEC has required CEOs and CFOs to sign an oath attesting to the accuracy of financial statements filed by their companies with the SEC under the Securities Exchange Act of 1934. Both audit partners and CFOs supervise numerous subordinates and assume responsibility for the work product of those subordinates, have an obligation to “stay current” regarding key technical developments within the accounting and financial reporting domain, and face potential civil and criminal sanctions if they fail to carry out their responsibilities. Despite holding high-ranking positions within their organizations, both audit partners and CFOs must “answer” to superiors. An audit partner’s performance is regularly reviewed and evaluated by his or her managing partner and/or a committee of peers, while a CFO’s performance is typically reviewed by the CEO and/or the board of directors.

One responsibility that audit partners assume that CFOs do not is practice development, that is, audit partners typically spend a significant amount of their time attempting to obtain new clients for their firms.

Which role is more stressful? My answer would be that both are stressful and that the specific circumstances faced by individuals occupying those roles dictate how much stress they are forced to absorb. For example, a CFO of a high-profile company that is “treading water” financially almost certainly faces a significant amount of stress, as would the audit engagement partner for such a company. On the other hand, the CFO and audit engagement partner of a financially strong company may seldom feel pressure related to their job roles.

Which job role is more important? Your students’ responses will likely vary. One reasonable argument is that the audit partner’s role is more important since the individuals occupying that role have some degree of responsibility for ensuring that several companies’ financial statements are reliable. CFOs, on the other hand, focus their energy and attention on only one company’s financial statements.

3. Most corporate executives are honest and insist that their accounting subordinates be honest and diligent in maintaining a company’s accounting records and in preparing its periodic financial statements. As a result, corporate executives often perceive that an audit contributes nothing to the quality or reliability of their companies’ financial statements. In other words, they conclude that the annual independent audit is effectively a “waste of time.” Of course, the reality is that independent © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

60 Case 1.8 Livent, Inc. audits are necessary. Even scrupulously honest and diligent executives and accountants sometimes make mistakes that result in material financial misstatements. Likewise, there is the occasional dishonest corporate executive whose intent is to mislead and take advantage of investors, creditors, and other third parties who rely on published financial statements to make a wide range of economic decisions.

One effective way for auditors to create a value-added dimension to their audits in the minds of corporate executives is to prepare a management letter or other formal communication at the conclusion of each audit to alert client executives of developing problems in their company’s operations, inefficiencies in production processes, emerging human resource issues, and related matters that were discovered during the course of an audit. Likewise, in the post-Enron, postWorldCom era, auditors should be better equipped to point out to client executives why independent audits—although a potential nuisance to individual companies—are extremely necessary and useful from a society-wide or economy-wide perspective.

4. The relevant technical material in this context is included in AS 6105, “Reports on the Application of Accounting Principles,” of the PCAOB’s auditing standards. Recognize that when the technical material included in AS 6105 was originally adopted in 1986, the PCAOB did not exist. At that time, that technical material was included in AU Section 625 which was a part of the AICPA Professional Standards. In the “clarified” AICPA Professional Standards, the technical material previously included in AU 625 has been reorganized and placed in AU-C Section 915. AU Section 625 was amended in 2002 well after the key events in the Livent case took place. The key change made to AU 625 in 2002 was to prohibit accountants from issuing reports on “the application of accounting principles to a hypothetical situation.” Bottom line, post-2002, the types of reports discussed in AS 6105—and AU-C 915—must now involve specific situations and specific entities.

The simple answer to this question is that the “reporting accountant” must “get the facts” before issuing a report on the given issue. More specifically, AS 6105.08 lists the following four general procedures that a reporting accountant should perform before forming a judgment regarding the given issue.

• Obtain an understanding of the form and substance of the transaction(s) • Review applicable generally accepted accounting principles • If appropriate, consult with other professionals or experts • If appropriate, perform research or other procedures to ascertain and consider the existence of credible precedents or analogies Note: AS 6105.10 describes in detail the form and content of a “report on the application of accounting principles,” while AS 6105.11 provides an example of such a report.

5. At the time, the revenue recognition principle dictated that revenue had to be both “earned” and “realized” before it could be recorded. “Earned” meant that the relevant earnings process was complete or substantially complete, while “realized” meant that an exchange had taken place.

Applying that revenue recognition principle to a generic retail sale was easy to do. But applying the rule to non-standard or unusual revenue transactions was more of a challenge.

In retrospect, the decision to allow Livent to book the full $12.5 million of naming rights revenue seems odd, at a minimum. Particularly troubling was the decision to allow Livent to book naming © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.8 Livent, 61 Inc. rights revenue on the yet-to-be-built theatre since one could easily argue that the earnings process for that revenue was not complete. But, in defense of Deloitte’s decision, neither Ernst & Young or PWC specifically indicated that the $12.5 million should not be recorded.

As a class project, you may want your students to research the “new” revenue recognition standard that will soon go into effect and have them determine whether the naming rights revenue booked by Livent would be justified under that new standard. I would suggest that the “performance obligations” feature of the new revenue recognition standard would pose a problem for Livent to overcome in justifying the “early” booking of the naming rights revenue.

6. Messina did not feel directly responsible for the accounting irregularities. However, because she had chosen to work for an organization that was replete with fraudulent conduct, she apparently “absorbed” some measure of guilt or responsibility for those irregularities.

After discovering the fraudulent schemes, Messina had several options. These options included, among others, simply ignoring the fraud and hoping that the matter would somehow resolve itself or simply “go away,” confronting her superiors who were apparently involved in the fraud, immediately resigning, reporting the fraud to Deloitte officials and/or to law enforcement authorities, and becoming a willing accomplice to the fraud.

One approach to addressing this type of open-ended question is to ask a student to explain what he or she would have done in such circumstances and then immediately ask another student to evaluate the wisdom and morality of that choice. After several rounds of this exercise, a consensus point-of-view among students will likely be evident, namely, that accountants and auditors involved in these types of situations must “bite the bullet” and take aggressive measures, regardless of the personal consequences, to ensure that the fraud is ended.

7. AS 6101 of the PCAOB’s auditing standards provides general guidance for accountants to follow when performing a wide range of due diligence engagements, including such engagements that involve common “acquisition transactions.” (AS 6101.05). [Note: Since due diligence investigations are not audits, the term “accountants” is used to refer to the individuals completing these engagements.] A key thrust of AS 6101 is that the accountants and the client should reach a firm understanding regarding the nature and scope of the engagement. AS 6101.16 suggests that early in a due diligence investigation the accountants should provide the client with a draft of the report that is expected to be issued at the completion of the engagement. Most importantly, this report should indicate the procedures that the accountants expect to complete during the engagement. After being provided a copy of the draft report, the client should be able to determine whether its objective will be met by the due diligence investigation. In general, the procedures performed during a due diligence investigation will be very similar, in some cases, identical, to the procedures performed during a standard independent audit. (Note: In the “clarified” AICPA Professional Standards, AU-C Section 920 is comparable to AS 6101.)

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62 Inc.

Case 1.9 ZZZZ Best Company,

CASE 1.9

ZZZZ BEST COMPANY, INC.

Synopsis Barry Minkow founded ZZZZ Best Company, a carpet cleaning concern, in 1982 at the age of 16. Within a matter of months, Minkow was engaging in several fraudulent schemes to raise working capital for his small company, including credit card forgeries and bogus insurance claims. Minkow soon became even bolder and began reporting fictitious revenues from "insurance restoration" contracts in ZZZZ Best's financial statements to induce local banks to grant him loans. Eventually, the revenues from ZZZZ Best's insurance restoration "business" became the dominant line item in the company's financial statements. In fact, by 1987, the insurance restoration contracts accounted for 90% of ZZZZ Best's annual revenues.

In 1986, Minkow took ZZZZ Best public. On the strength of the impressive, but bogus, earnings and revenues figures reported for the company by Minkow, ZZZZ Best’s stock price increased dramatically during the first several months it was publicly traded. At one point in early 1987, the collective market value of the company's outstanding stock, approximately one-half of which Minkow owned, exceeded $200,000,000. In July 1987, a few months after ZZZZ Best was exposed as a fraud, the tangible assets of the company were sold for $62,000 at a public auction. In reality, Minkow ran a complex Ponzi scheme for five years. The huge amount of funds ZZZZ Best raised from banks, private investors, and finally through public offerings of stock were squandered by Minkow and his associates on illicit expenditures of all types.

In addition to the investors and creditors that Minkow swindled, among the parties most victimized by his elaborate scam were ZZZZ Best's independent auditors. In a congressional investigation into the collapse of ZZZZ Best, the company's auditors were criticized for their failure to expose Minkow's fraudulent schemes. The investigative subcommittee that sponsored the ZZZZ Best hearings was particularly interested in why the company's auditors failed to discover that the numerous multimillion-dollar insurance restoration contracts reported by Minkow were totally bogus.

ZZZZ Best's auditors were also questioned extensively regarding their decision to sign a confidentiality agreement that precluded them from obtaining evidence from independent third parties to corroborate the insurance restoration contracts. Among the other auditing-related issues raised during the course of the hearings was the subject of predecessor-successor auditor communications.

Members of the congressional subcommittee were concerned that there had been a lack of candor in © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.9 ZZZZ Best Company,

63

Inc. the communications between ZZZZ Best's predecessor and successor auditors following both changes in auditors made by the company.

ZZZZ Best Company--Key Facts 1.

ZZZZ Best Company, which was initially a small rug-cleaning business, was founded by Barry Minkow when he was 16-years-old.

2.

Minkow transformed ZZZZ Best into a leading company in the small and highly fragmented insurance restoration industry by including bogus insurance restoration revenues in ZZZZ Best’s financial statements.

3.

The daring and resourceful Minkow eventually took ZZZZ Best public.

4.

Despite the fact that the company effectively existed only on paper, ZZZZ Best’s market capitalization at one point exceeded $200 million.

5.

Minkow spent huge sums to conceal his fraud from third parties, including ZZZZ Best’s independent auditors, Ernst & Whinney.

6.

Ernst & Whinney eventually insisted on visiting some of ZZZZ Best’s insurance restoration job sites.

7.

Minkow carried out elaborate and expensive “sting” operations to convince the auditors that the job restoration sites actually existed.

8.

Minkow demanded that Ernst & Whinney representatives sign a confidentiality agreement prior to visiting the bogus insurance restoration sites; these agreements prevented the auditors from properly investigating the insurance restoration contracts.

9.

Because the auditors were not familiar with the insurance restoration industry, they failed to discover that the company’s gross profit margins greatly exceeded the industry norm and that the number and size of ZZZZ Best's insurance restoration contracts were unrealistically large.

10. Ernst & Whinney avoided being held civilly liable for the losses resulting from the ZZZZ Best raud because the accounting firm never completed an audit of the company.

Instructional Objectives 1.

To stress the importance of professional skepticism on the part of independent auditors.

2.

To demonstrate to students the importance of "assertion-based" auditing.

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64 Inc.

Case 1.9 ZZZZ Best Company,

3.

To emphasize the hazards of allowing a client to impose significant constraints on the scope of an audit.

4.

To emphasize the importance and necessity of candid communications between predecessor and successor auditors.

5.

To introduce students to the SEC's auditor-change disclosure requirements.

6.

To acquaint students with the form and content of audit engagement letters.

7.

To contrast the nature of audits with that of review engagements.

Suggestions for Use

I often assign the ZZZZ Best case during the first week of the semester, using it as an introduction to the auditing profession for my students. The outrageousness of Minkow's scam and the lengths to which he went to deceive his company's auditors impress upon students the need for auditors to enter each audit engagement with a high degree of skepticism. The case also serves as good introductory material for an auditing course because it illustrates to students that the independent audit function plays a critical role in our economy and society. I stress to students in presenting this case that auditors are often the most (if not only) effective defense that investors and creditors have against massive fraudulent schemes similar to Minkow's. If students are convinced early in the semester that auditing is an important activity, it has been my experience that they are more likely to approach the subject with a high level of interest and enthusiasm.

This case can also be integrated into an auditing course during the coverage of the AICPA’s Code of Professional Conduct. Most of the ethical issues raised in the case involve the conduct or misconduct of Minkow and his subordinates. However, the case also raises ethical issues directly relevant to the independent auditor's role, such as, client confidentiality and the collegial responsibilities of auditors. The case could also be assigned during coverage of the following topics: client acceptance and continuance, evaluation of audit evidence, and reviews and compilations.

At some point in the presentation of this case, the instructor will want to emphasize that Ernst & Whinney, the audit firm that is the focus of much of this case, never completed an audit of ZZZZ Best. The audit firm did complete a review of the company's quarterly financial statements for the three months ending July 31, 1986; however, the firm resigned in the late spring of 1987 prior to completing its audit of ZZZZ Best's fiscal 1987 financial statements.

One final pedagogical suggestion concerns the exhibits incorporated in this case. Unlike many auditing cases, the ZZZZ Best case provides an opportunity for students to review actual audit documents since certain of Ernst & Whinney's audit workpapers became public domain material during the course of the congressional investigation. Included in the exhibits, for example, are the memorandum that an audit partner wrote following his visit to one of ZZZZ Best's bogus restoration sites and the actual engagement letter obtained by Ernst & Whinney from ZZZZ Best. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.9 ZZZZ Best Company,

65

Inc. Suggested Solutions to Case Questions 1. The purpose of a review engagement is to obtain a reasonable basis for providing "limited assurance" that a given client's financial statements have been prepared in conformity with generally accepted accounting principles. Essentially, a “clean” review report provides negative assurance, that is, it discloses only that the auditor (CPA) did not discover any evidence suggesting that the financial statements are materially misstated. The objective of an audit is much more affirmative in nature. A full-scope independent audit is designed to provide a reasonable basis for expressing an "opinion" concerning whether or not a client's financial statements have been prepared in accordance with generally accepted accounting principles.

There is also a critical difference between a review and an audit in terms of the scope of work performed. In a review engagement, the primary evidence collection techniques are analytical procedures and inquiries of client personnel. Alternatively, in an audit, the full range of evidence collection techniques available to an auditor is likely to be used including, but not limited to, confirmation procedures, physical observation of assets, and inspection of source documents.

Because reviews are generally not as rigorous as audits, considerably less evidence is typically collected in a review engagement than in a comparable audit engagement.

2. Third party confirmations, in most cases, yield reliable evidence in support of the occurrence assertion. However, the quality of such evidence is largely dependent upon the nature of the relationship, if any, that exists between the client and the third party providing the confirmation.

Confirmations provide the highest quality evidence when the third party is independent of the client.

Unfortunately, in the ZZZZ Best case, the individuals who confirmed that the company’s insurance restoration transactions had “occurred” were not independent of the client. In fact, unknown to Ernst & Whinney, the parties who returned the confirmations were confederates of Minkow. [Note: The second stipulation of the confidentiality agreement signed by Ernst & Whinney precluded the audit firm from obtaining written confirmations from certain key parties allegedly associated with the job sites visited by Ernst & Whinney. However, the auditors did obtain confirmations from the two bogus companies, Assured Property Management and Interstate Appraisal Services, regarding insurance restoration jobs that these companies had allegedly contracted out to ZZZZ Best. It is these latter confirmations that are referred to in this question.]

In evaluating the competence of documentary evidence, such as the contracts ZZZZ Best furnished Ernst & Whinney in support of the company's insurance restoration revenues, an auditor should consider whether the documents are internally or externally prepared. Documents prepared external to the client's internal control system by an independent third party are generally considered to provide a high quality of audit evidence. However, externally prepared documents in the possession of the client, which was the case with the ZZZZ Best insurance restoration contracts, provide a lower quality of audit evidence than documents that originate and remain outside a client's internal control system. Internally prepared documents nearly always yield a lower quality of evidence than either type of externally prepared documents.

The evidence provided by analytical procedures is generally considered to be somewhat tenuous in nature, regardless of which assertion is being tested, and should be corroborated with other audit procedures if possible. For instance, the results of analytical tests may suggest that there is a proper © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

66 Inc.

Case 1.9 ZZZZ Best Company,

relationship between bad debts and credit sales. However, one or both of the account balances may be materially misstated, meaning that any conclusions drawn from such a comparison are invalid.

Physical evidence is generally considered to be a very reliable source of audit evidence since it involves the auditor actually observing and/or inspecting a given asset—of course, in this case, the auditors were observing the job restoration sites to confirm the occurrence assertion for the insurance restoration revenues. Nevertheless, auditors should realize that even physical evidence has limitations. For example, auditors may not have the proper experience or expertise to gather or interpret physical evidence. Likewise, similar to other forms of audit evidence, physical evidence may be fabricated by dishonest client personnel.

3. Payments received by a client on an account receivable do not establish, necessarily, that the receivable actually existed at some point in time. A client with sufficient funds can easily create what appears to be a normal operating cycle on paper even though no arm's length transactions are taking place. In ZZZZ Best's fraudulent scheme, management generated fake receivables and then arranged for payments on those receivables to make it appear that a normal cycle of transactions was occurring. Of course, the absence of a normal operating cycle would have been an immediate tip-off to the auditors that something was awry. Again, an instructor can comment on the need for auditors to maintain a skeptical attitude even when faced with a seemingly "normal" set of circumstances.

4. Note: At the time the key events in this case transpired, SAS No. 7, “Communications between Predecessor and Successor Auditors,” was in effect. In 1998, SAS 7 was superseded by SAS No. 84, which has the same title. There are only minor differences between these two standards. SAS No. 84 is now integrated into AU-C Sections 210 and 510 of the AICPA’s “clarified” Professional Standards.

In the PCAOB’s auditing standards, SAS No. 84 is integrated into AS 2610.

Predecessor-successor auditor communications are intended to help ensure that successor auditors receive all relevant information they need to make a client acceptance decision and to help them design an appropriate audit for the new client following that decision. The prospective successor auditor is responsible for initiating predecessor-successor auditor communications. Prior to accepting a client, the successor auditor should request permission from the prospective client to communicate with the former auditor. Additionally, the successor auditor should ask the client to authorize the former auditor to respond fully to that request.

A successor auditor should request from the predecessor auditor: 1) information that might bear on the integrity of management, 2) disagreements with management as to accounting principles, auditing procedures, or other similar matters, 3) communications with the client’s audit committee (or other parties with similar authority) regarding fraud, illegal acts, and internal control-related matters, 4) the predecessor auditor’s understanding as to the reasons for the change in auditors, and 5) the predecessor’s understanding of the client’s related party relationships and transactions and significant unusual transactions (Item #5 applies only to public company clients.) (Note: AU-C 210.A31 and AS 2610.09 of the AICPA Professional Standards and the PCAOB’s auditing standards, respectively, are the relevant sources in this context.) Following the acceptance of the client by the successor auditor, the latter should ask the client to authorize the predecessor to allow it (the successor) to review the predecessor’s workpapers. It is customary for the predecessor auditor to provide the successor auditor with copies of key workpapers prepared during the prior year's audit. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.9 ZZZZ Best Company,

67

Inc. According to the congressional testimony of ZZZZ Best's initial auditor, George Greenspan, Ernst & Whinney did not attempt to communicate with him either prior to or after that firm accepted ZZZZ Best as an audit client. If that testimony was correct, Ernst & Whinney failed to comply with the existing provisions of SAS 7 since it was the successor auditor and thus had the responsibility to initiate contact with Greenspan. (Of course, theoretically, Minkow could have denied Ernst & Whinney permission to make the standard SAS 7 inquiries of Greenspan.) As pointed out in the case, Ernst & Whinney representatives subsequently disputed Greenspan's testimony by reporting that they, in fact, had communicated with him prior to accepting ZZZZ Best as a client. However, the Ernst & Whinney representatives did not testify as to the content or results of those communications.

Following the resignation of Ernst & Whinney, Price Waterhouse contacted that firm and apparently made the standard inquiries suggested by SAS 7 prior to accepting ZZZZ Best as an audit client. The congressional testimony documents that Congressman Wyden was concerned that Ernst & Whinney failed to respond candidly to Price Waterhouse's request for information regarding ZZZZ Best. In responding to Price Waterhouse's SAS 7 inquiries, Ernst & Whinney reported no prior disagreements with ZZZZ Best management. Regarding the reason for the auditor change, Ernst & Whinney representatives simply informed Price Waterhouse that their firm did not want to be associated with the ZZZZ Best financial statements. Finally, Ernst & Whinney reported to Price Waterhouse that it had no concerns regarding the integrity of management, pending the results of an ongoing board of directors' investigation. Despite this latter communication, the transcripts of the congressional hearings suggest that, at the time of its resignation, Ernst & Whinney did appear to have concerns regarding the integrity of ZZZZ Best management. Ernst & Whinney apparently did not believe it was appropriate to disclose those concerns to Price Waterhouse prior to the conclusion of the board of directors' investigation (which was intended to determine whether allegations of fraudulent conduct involving Minkow were true).

5. The confidentiality agreement certainly imposed restrictions on the ability of Ernst & Whinney to corroborate the evidence collected during the site visitations. The second stipulation of that agreement, shown in Exhibit 3, was particularly limiting. The inability of Ernst & Whinney to contact the building owner, the insurance company, and other companies or individuals allegedly involved in, or associated with, the restoration projects precluded the auditors from obtaining evidence from independent third parties to resolve any questions or issues raised as a result of the site visitations.

Whether the confidentiality agreement improperly limited the scope of Ernst & Whinney's audit is a matter of professional judgment. Apparently, members of the audit engagement team did not believe that the scope of the ZZZZ Best audit was improperly restricted by the agreement, otherwise they would not have complied with it.

Many companies are concerned that confidential information may be leaked to external parties, competitors, in particular, as a result of an independent audit. For example, following the merger of Ernst & Whinney and Arthur Young & Company in 1989, Coca-Cola executives insisted that the merged firm retain only their company or PepsiCo as an audit client. Prior to the merger, Coca-Cola had been a client of Ernst & Whinney, while PepsiCo had been a client of Arthur Young. Coca-Cola officials were reportedly concerned that key operating data might be inadvertently passed to their major competitor if Ernst & Young audited both companies. When an audit firm serves competing companies, one obvious precaution that can be taken is to have different audit teams assigned to the © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

68 Inc.

Case 1.9 ZZZZ Best Company,

engagements.

Another situation in which confidentiality concerns on the part of a client may affect an independent audit is when the client has new products or services in development. Although auditors are bound by the Code of Professional Conduct to not disclose such information to third parties, the client may still be concerned about the possible leakage of information. In such cases, the client may insist that a limited number of auditors be given access to the confidential information. In addition, the client may insist that only partners or managers assigned to the audit be provided that information.

When constraints imposed by a client prevent auditors from complying in material respects with the relevant auditing standards, a scope limitation has occurred. Most often, the standard affected in such cases is the auditor’s responsibility to obtain sufficient appropriate evidence to support the opinion rendered on the client's financial statements. If the auditor decides that a client's confidentiality concerns have resulted in a scope limitation, then client management should be informed that the auditor will be required to issue either a disclaimer of opinion or a qualified opinion on the company's financial statements. At that point, client management can decide whether to modify the constraints that they have chosen to impose on the audit or to accept the impact of those constraints on the auditor's report.

6. Professional standards do not require that auditors attest to the material accuracy of pre-audit earnings press releases that many public companies make. However, it is customary that client executives consult with their independent auditors before making such announcements. Typically, the pre-audit earnings release is not made until the net income number is considered "firm" by both parties.

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Case 1.10 DHB Industries,

69

Inc.

CASE 1.10

DHB INDUSTRIES, INC.

Synopsis David Brooks founded DHB Industries in the early 1990s. Throughout its existence, the principal operating unit of DHB was its Point Blank subsidiary that manufactured bullet-resistant vests for use by law enforcement and military personnel. Sales of protective vests accounted for more than 95 percent of DHB’s revenues each year.

DHB and its free-spirited founder were often in the media spotlight. In 2005, a large number of the company’s protective vests were recalled due to alleged “life-threatening flaws.” A few months earlier, Brooks and his top two subordinates, the company’s COO and CFO, were widely criticized when they realized huge stock market gains after selling the majority of their DHB stock. Brooks, alone, realized a stock market gain of more than $180 million when he sold two-thirds of his total ownership interest in DHB, an interest that he had acquired for a small fraction of that amount.

In July 2006, Brooks was ousted as DHB’s CEO by the company’s board. Over the following year, a forensic investigation of DHB’s accounting records revealed that the company’s impressive operating results from 2003 through 2005 had been the product of a massive accounting fraud.

Brooks and his senior subordinates had routinely and blatantly altered DHB’s accounting records to achieve the earnings targets that he had established for the company. The primary account manipulated by the co-conspirators was DHB’s inventory.

A major problem faced by the conspirators was concealing their misdeeds from the company’s independent auditors. Accomplishing that objective was made easier by the fact that between 2001 and 2005 the company had four different accounting firms serve as its independent auditors. Frequent clashes between management and the company’s auditors were responsible for the almost annual changes in auditors during that period.

DHB’s former CFO accepted a plea bargain deal in exchange for testifying against Brooks and DHB’s former COO during their criminal trial on multiple fraud charges. The eight-month trial in a New York federal court took on a circus atmosphere when the details of Brooks’ scandalous lifestyle and management methods were documented by federal prosecutors. Brooks was ultimately found guilty of all 17 charges filed against him including corporate fraud, insider trading, conspiracy and obstruction of justice. DHB’s former COO was found guilty on 14 of 16 similar charges filed against her. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

70 Inc.

Case 1.10 DHB Industries,

DHB Industries, Inc.--Key Facts 1.

David Brooks was sanctioned in 1992 by the SEC for failing to establish proper internal control procedures for a brokerage firm owned and operated by his brother.

2.

A few months before being sanctioned by the SEC, Brooks organized a small company that would ultimately be named DHB Industries, Inc.

3.

The principal product sold by DHB throughout its existence was bullet-resistant vests used by law enforcement and military personnel.

4.

DHB’s sales of protective vests increased dramatically after the turn of the century due to the 9/11 terrorist attacks and the Second Gulf War.

5.

Despite record revenues and earnings, DHB’s net operating cash flows were very weak; in 2004, the company reported a net income of $30 million and a negative net operating cash flow of $10 million.

6.

Brooks ruled DHB with a dictatorial and intimidating management style; the company’s independent auditors were among the parties that were a common target of Brooks’ angry demeanor and threats.

7.

Repeated clashes between DHB’s management and its auditors resulted in frequent auditor changes; between 2001 and 2005, four different accounting firms served as DHB’s auditors.

8.

At the conclusion of the fiscal 2005 audit, DHB’s auditors refused to issue an opinion on the company’s financial statements in time for DHB to meet the SEC filing deadline.

9.

Following Brooks’ dismissal as DHB’s CEO and chairman of the board, a year-long forensic investigation revealed that the company’s impressive operating results for the period 2003-2005 had been the product of a massive accounting fraud orchestrated by Brooks and DHB’s COO and CFO.

10. The forensic investigators found that DHB’s inventory accounts were the principal source of the material overstatements of the company’s operating results.

11. Law enforcement authorities filed a 17-count federal indictment against Brooks in late 2007 that included, among other charges, allegations of corporate fraud, insider trading, and conspiracy.

12. In late 2011, Brooks was found guilty by a federal jury of all 17 charges filed against him, while DHB’s former COO was found guilty of 14 similar charges; DHB’s former CFO had previously pled guilty to two fraud charges in exchange for testifying against her two former colleagues. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.10 DHB Industries,

71

Inc. Instructional Objectives 1.

To illustrate the lengths to which dishonest executives will go to misrepresent their company’s reported financial data.

2.

To examine the internal control reporting responsibilities of auditors and client management.

3.

To identify fraud risk factors.

4.

To provide students an opportunity to apply the materiality construct.

5.

To examine the impact of frequent auditor changes on the quality of independent audit services.

6.

To examine auditors’ responsibilities for identifying and investigating related party transactions.

Suggestions for Use

One method I use in covering large cases is to require students, in groups of three or four, to complete a case template. After the students have met in their groups and completed the templates (one per group), we then reconvene and discuss the case by going over the completed templates. I use a variety of templates for this purpose. Listed next are the narrative items included in one such template: 1.

2.

3.

4.

5.

6.

Identify the three most important facts of this case.

Identify three other facts or circumstances regarding this case that you would have liked to have known.

What was the key auditing issue raised or addressed by this case?

Why is this case relevant to future auditors?

What is the most important take-away or learning point of this case?

Write a potential essay exam question based upon this case.

This exercise provides students with an opportunity to discuss and debate a given case in a relatively non-threatening (small group) environment. In addition, it has been my experience that the use of a template is an effective way to cover a lengthy case in a relatively short period of time.

Suggested Solutions to Case Questions 1. Before responding to this question, you may want to have your students discuss some of the general benchmarks that are used in making materiality decisions, such as, five percent of net income or one percent of net assets or net revenues. Of course, the authoritative professional literature does not include any “official” or definitive quantitative materiality guidelines. Likewise, you may want to refer your students to the definitions of materiality included in professional accounting and auditing © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

72 Inc.

Case 1.10 DHB Industries,

standards. The PCAOB, for example, relies on the SEC’s definition of materiality, which, in turn, was taken from a U.S. Supreme Court decision: “A fact is material if there is a substantial likelihood that the . . . fact would have been viewed by [a] reasonable investor as having significantly altered the ‘total mix’ of information made available.” [Note: At press time for this casebook, the FASB had under consideration a proposal to effectively embrace the PCAOB/SEC/U.S. Supreme Court definition of materiality.]

Listed next are examples of differences in DHB’s original and restated 2004 financial statements that I would consider to be material (the balance sheet items are listed first followed by the income statement items): • The $47 million difference in “Inventories” • The $18.5 million difference in the current asset “Deferred Income Tax Assets” • The $6.5 million difference in the current liability “Notes Payable” (granted, this was a

classification difference since this figure was included as a long-term liability in the original financial statements) • The $10 million difference in the current liability “Income Taxes Payable” • The fact that the original financial statements did not include the $30 million liability for employment withholding taxes or the offsetting expense item • The $28 million difference in Additional Paid-in Capital • The huge difference in Retained Earnings (Retained Deficit) • The $18 million difference in Net Sales • The $20 million difference in Cost of Goods Sold • The $38 million difference in Gross Profit • The large differences in operating expenses reported in the two income statements • The differences in the tax expense items between the two income statements • The difference in the Net Income/Net Loss reported in the two income statements Although this case question does not require students to explain the specific factors or circumstances that accounted for the material differences between the original and restated 2004 DHB financial statements, you may want to provide them with an overview of some of the major sources of those differences. The 2006 Form 10-K for DHB, which was issued in late 2007, presents a detailed analysis of the company’s restated financial statements for 2003 and 2004 in a footnote appended to the 2006 financial statements (see “Note 2, Restatements.”) That very lengthy footnote documents dozens of reconciling items that account for the significant differences between the original financial statement balances reported in the 2004 Form 10-K and the restated balances included in the 2006 Form 10-K. The sheer volume of those items precluded including them in the case or in this case solution. Listed next are examples of some of the sources of those reconciling items (in addition to the sources mentioned in this case): • The failure of DHB to apply the lower of cost or market rule to inventories in preparing the

original financial statements.

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Case 1.10 DHB Industries,

73

Inc. • Purchase rebates were recorded as revenues rather than as reductions to cost of goods sold in

the original financial statements.

• By 2003, DHB had disclosed that TAP was a related party, which explains why related party amounts were reported in the original 2003-2004 financial statements. These related party items are not included in the restated financial statements because they were treated as inter-company transactions for purposes of those financial statements.

• Certain property and equipment assets reported in DHB’s original 2003-2004 financial statements were actually owned by other entities or individuals even though they were being used in the company’s operations.

• ”During the years ended December 31, 2004 and 2003, withholding taxes for bonuses paid and the exercise of stock options and warrants were not withheld and paid to the taxing authorities as required. The Company has now recorded liabilities for its potential obligations for federal and state payroll withholding taxes, plus penalties.” This explanation that was included in the 2006 Form 10-K accounts for the large employment tax withholding liability and expense reflected in the 2004 restated financial statements.

Rather than providing this information directly, you might consider having your students or a group of your students review the Restatements footnote in DHB’s 2006 Form 10-K and present an in-class overview of the major reconciling items documented in that footnote.

2. AS 2401, “Consideration of Fraud in a Financial Statement Audit,” of the PCAOB’s auditing standards has a lengthy appendix that identifies “Examples of Fraud Risk Factors.” These risk factors are sorted by the three components or “angles” of the fraud triangle: incentives/pressures, opportunities, and attitudes/rationalizations. Listed next are fraud risk factors included in the appendix to AS 2401. (Note: A comparable list of fraud risk factors is included in the AICPA Professional Standards at AU-C Section 240.A75.)

Incentives/pressures: • High degree of competition • High vulnerability to rapid changes in technology, which, in turn may result in obsolete inventory • Recurring negative operating cash flows • Excessive pressure for management to meet the requirements or expectations of third parties • Significant financial interests in the entity by management Opportunities: • Significant related-party transactions • Significant financial statement amounts are based on estimates • Domination of management by a single person or a small group • Ineffective board of directors or audit committee oversight Attitudes/rationalizations: © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

74 Inc.

Case 1.10 DHB Industries, • Ineffective communication, implementation or support, or enforcement of the entity’s values or

ethical standards by management • Nonfinancial management’s excessive participation in, or preoccupation with, the determination of significant accounting estimates • Known history of violations of securities laws • Excessive interest by management in maintaining or increasing the entity’s stock price and/or earnings trend • Commitments by management to achieve aggressive earnings forecasts issued by financial analysts or other parties • Management failure to correct significant internal control problems on a timely basis • A strained relationship between management and independent auditors Which of these fraud risk factors should have been of primary concern to DHB’s auditors? There is certainly room for considerable debate when it comes to this question. At the top of my list I would include, in no particular order, the following items, each one of which had very significant implications for the integrity of DHB’s financial statements and, in turn, for DHB’s auditors. .

• Domination of management by a single person or a small group • Ineffective board of directors or audit committee oversight • Significant related-party transactions • Excessive interest by management in maintaining or increasing the entity’s stock price and/or earnings trend • Commitments by management to achieve aggressive earnings forecasts issued by financial analysts or other parties • Management failure to correct significant internal control problems on a timely basis • A strained relationship between management and independent auditors 3. Note: in effect, the only evidence that DHB’s auditors collected regarding the existence of the $7 million of vest components was a management representation that those items existed. Of course, this “evidence” was subsequently revealed to be patently false by another member of management, namely, David Brooks. As pointed out in the case, the controversy over the $7 million of “missing” vest components was a factor that contributed to DHB’s auditors refusing to issue an audit opinion on the company’s 2005 financial statements. (The background information used in preparing this case did not reveal what David Brooks told DHB’s auditors after he admitted that the “hurricane” explanation—that is, the alleged destruction of the vest components by a hurricane—was a falsehood.)

When auditing a public company, the rules that dictate the quantity and quality of evidence that must be collected are found in AS 1105, “Audit Evidence.” AS 1105.03: “The objective of the auditor is to plan and perform the audit to obtain appropriate audit evidence that is sufficient to support the opinion expressed in the auditor’s report.” AS 1105.05 discusses both the quantitative (sufficiency) and qualitative (appropriateness) dimensions of audit evidence. AS 1105.07-08 provide

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Case 1.10 DHB Industries,

75

Inc. a more in-depth discussion of the two key criteria (relevance and reliability) used in assessing the appropriateness of audit evidence.

AS 1105.29 addresses those circumstances in which auditors have doubts regarding the overall integrity of certain audit evidence. “If audit evidence obtained from one source is inconsistent with that obtained from another, or if the auditor has doubts about the reliability of information to be used as audit evidence, the auditor should perform the audit procedures necessary to resolve the matter and should determine the effect, if any, on other aspects of the audit.” If auditors conclude that they cannot obtain sufficient appropriate evidence to “sign off” on a given financial statement item, then they must consider how that conclusion impacts the audit opinion they will issue on the overall financial statements. If the financial statement item in question is a significant item, then the auditors will likely have to consider issuing either a qualified opinion or a disclaimer of opinion. [Note: The section of the AICPA Professional Standards that is comparable to AS No. 15 is AU-C 500, “Audit Evidence.”]

4. Note: AS 2410, “Related Parties,” presents the PCAOB’s auditing standards for related parties and related-party relationships and transactions. AU-C Section 550, “Related Parties,” includes the comparable auditing standards of the AICPA. The overall audit objective for a client’s related parties, related party relationships, and transactions with related parties is expressed in AS 2410.02: “The objective of the auditor is to obtain sufficient appropriate audit evidence to determine whether related parties and relationships and transactions with related parties have been properly identified, accounted for, and disclosed in the financial statements.”

Auditors must first identify and obtain an understanding of a client’s related parties and the relationships and transactions with those parties. To achieve this goal, auditors should study the client’s “process” for identifying those items, inquire of management regarding the existence of related parties (and consequent relationships and transactions), and make the members of the audit engagement team aware of the client’s related parties.

Among other procedures, auditors must also “identify and assess” the “risks of material misstatements” stemming from the client’s related parties, related party relationships, and related party transactions [AS 2410.10]. AS 2410.12 identifies five specific measures that auditors should apply “for each related party transaction that is either required to be disclosed in the financial statements or determined to be a significant risk.” These five measures are summarized below: a.

“Read the underlying documentation and evaluate whether the terms and other information about the transaction are consistent with explanations from inquiries and other audit evidence about the business purpose (or lack thereof) of the transaction.” b.

“Determine whether the transaction has been authorized and approved in accordance with the company’s established policies and procedures . . .” c.

“Determine whether any exceptions to the company’s established policies or procedures were granted.” d.

“Evaluate the financial capability of the related parties with respect to significant uncollected balances, loan commitments, supply arrangements, guarantees, and other obligations, if any.” © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

76 Inc.

Case 1.10 DHB Industries,

e.

“Perform other procedures as necessary to address the identified and assessed risks of material misstatement.”

Among other auditor responsibilities for related parties, related party relationships, and related party transactions identified by AS 2410 is the need to “communicate to the audit committee the auditor’s evaluation of the company’s identification of, accounting for, and disclosure of its relationships and transactions with related parties” [AS 2410.19].

5. The Sarbanes-Oxley Act of 2002 dramatically changed the nature of internal control reporting responsibilities. For the first time, that federal statute mandated that the management of public companies report on the effectiveness of their organizations’ internal controls. These reports must indicate whether a company’s internal controls have been properly implemented and whether they are operating as intended. In assessing their internal controls, company management must use some reasonable benchmark or model. The internal controls model used by the great majority of public companies is the COSO framework. Most importantly, management reports on internal control must identify any “material weaknesses” in the given organization’s internal controls.

The current internal control standard of the PCAOB, which is the enforceable standard for audits of public companies, is AS 2201, “An Audit of Internal Control Over Financial Reporting That is Integrated with an Audit of Financial Statements.”

AS 2201.03 notes that “The auditor’s objective in an audit of internal control over financial reporting is to express an opinion on the effectiveness of the company’s internal control over financial reporting.” This paragraph goes on to indicate that “a company’s internal control cannot be considered effective if one or more material weaknesses exist.” As a result of this latter premise, “the auditor must plan and perform the audit to obtain appropriate evidence that is sufficient to obtain reasonable assurance about whether material weaknesses exist as of the date specified in management’s assessment [of internal control].” If an auditor discovers one or more material weaknesses in internal control, then he or she cannot issue an unqualified or “clean” opinion on the given client’s internal controls.

Paragraphs 78-84 of AS 2201 address the specific “communication” responsibilities of auditors, other than the overall opinion that an auditor must issue on the client’s internal controls over financial reporting. Listed next are the auditors’ principal responsibilities in this regard: • “The auditor must communicate, in writing, to management and the audit committee all material

weaknesses identified during the audit.”

• “If the auditor concludes that the oversight of the company’s external financial reporting and internal control over financial reporting by the company’s audit committee is ineffective, the auditor must communicate that conclusion in writing to the board of directors.”

• “The auditor also should consider whether there are any deficiencies, or combinations of deficiencies, that have been identified during the audit that are significant deficiencies and must communicate such deficiencies, in writing, to the audit committee.”

• “The auditor also should communicate to management, in writing, all deficiencies in internal control over financial reporting (i.e., those deficiencies in internal control over financial reporting that are of a lesser magnitude than material weaknesses) identified during the audit and inform the © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.10 DHB Industries,

77

Inc. audit committee when such a communication has been made.”

6. Empirical research has demonstrated that there is somewhat of a “learning curve” effect in independent audits. That is, auditors generally become more proficient in detecting material errors in a client’s financial statements the longer their “tenure” with that client. Frequent auditor changes undercut the learning curve effect and thus tend to diminish the overall quality of a given company’s independent audit services.

The principal objective of the SEC’s 8-K auditor change disclosure rule is to inform financial statement users of important contextual circumstances surrounding a change in auditors by a public company, such as, whether technical disagreements between the two parties preceded the auditor change. Given this information, financial statement users can reach their own conclusions regarding whether a given auditor change was made for valid reasons. A second and implicit objective of the 8-K auditor change disclosure rule is to discourage public companies from changing auditors for improper reasons. In fact, the 8-K auditor change disclosure rule was adopted by the SEC in the 1970s in response to widespread allegations of "opinion shopping" by public companies. That is, in some cases when major technical disputes arose between auditors and client management the latter would allegedly dismiss the auditors and then "shop" for a more compliant or flexible audit firm, i.e., one that shared its view regarding the issue in dispute.

AS 2610, “Initial Audits—Communications between Predecessor and Successor Auditors,” of the PCAOB’s auditing standards discusses the communications that should take place between a former and replacement audit firm. These communications are intended to help ensure that successor auditors receive all the relevant information they need to make a client acceptance decision, to help them design an appropriate audit for the new client following that decision, and (implicitly) to diminish the “opinion shopping’ capability of public company audit clients. AS 2610 identifies five specific items of information that the successor auditor should request from the predecessor auditor: 1) information that might bear on the integrity of management, 2) disagreements with management as to accounting principles, auditing procedures, or other similar matters, 3) communications with the client’s audit committee (or other parties with similar authority) regarding fraud, illegal acts, and internal control-related matters, 4) the predecessor auditor’s understanding as to the reasons for the change in auditors, and 5) the predecessor auditor’s understanding of related party relationships, related party transactions, and “significant unusual transactions.”

AS 2610 also points out that following the acceptance of the client by the successor auditor, the latter should ask the client to authorize the predecessor auditor to allow it (the successor) to review the predecessor’s workpapers. It is customary for the predecessor auditor to provide the successor auditor with copies of key workpapers prepared during the prior year's audit. (Note: The technical standards relevant to predecessor-success auditor communications for non-public entities is presented in sections AU-C 210 and AU-C 510 of the AICPA Professional Standards.)

7. Clearly, auditors should not be subject to verbal abuse, intimidation, or other types of harassment by client management or employees. If lower-level auditors are the target of abusive treatment by client management or employees, they should immediately contact their immediate superior and explain the nature of that abuse. Then, it would be incumbent on the senior members of the audit engagement team to deal appropriately with the matter. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

78 Inc.

Case 1.10 DHB Industries,

Senior members of an audit engagement team who are the victims of inappropriate behavior by client personnel should probably deal with the matter directly by confronting the given individual or individuals and explaining that the given behavior will not be tolerated. When senior members of an audit engagement team are subject to extreme verbal abuse, including direct or indirect threats of physical abuse, they should probably refer the matter to the appropriate members of the audit firm’s legal counsel.

8. “Yes,” the SEC does have a responsibility to protect the investing public from self-interested corporate executives. According to the SEC’s website, its mission “is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” Professional auditing standards are not as explicit, but independent auditors’ overall responsibilities certainly include protecting the investing public from short-sighted corporate executives. By issuing opinions on the material fairness of audited financial statements, independent auditors provide the equivalent of a Good Housekeeping Seal of Approval for such financial statements. Investors rely on that seal of approval to make a wide array of decisions.

9. The Sarbanes-Oxley Act revolutionized the audit committee function for public companies. SOX effectively mandates that every SEC registrant establish an audit committee. If a registrant does not have an audit committee, then the board of directors, as a whole, must provide the mandated functions of an audit committee. In a set of rules that became effective in April 2003, the SEC spelled out in elaborate detail the “Standards Relating to Listed Company Audit Committees” (SEC Release Nos. 33-8220; 34-47564; IC-26001; File No. S7-02-03). The primary responsibilities of audit committees of public companies include the following: • The audit committee must retain and supervise the given company’s independent auditors and,

in doing so, determine that the audit engagement team is competent to conduct the audit.

• The audit committee must ensure that the company’s auditors are independent.

• The audit committee must approve all professional services provided to the company by its independent auditors and ensure that auditors do not provide to the company any of the specifically prohibited services identified by SOX, such as bookkeeping services.

• The audit committee must receive and analyze key items of information from the independent auditors. These items of information include auditors’ analysis of critical accounting policies adopted by the company. Other items of information that must be communicated to the audit committee by independent auditors include, among others, all significant deficiencies and material weaknesses in internal controls, significant audit adjustments, disputes with management over important items that have a potentially significant financial statement impact, and any serious problems that the auditors encountered in conducting the audit.

• The audit committee must establish procedures that effectively create an internal “whistle blowing” mechanism for the company. That is, the audit committee must ensure that procedures are in place to provide for the receipt, retention, and consideration of complaints regarding accounting, internal control, and auditing matters. In addition, there must be a structure in place that provides for the confidential and anonymous submission of such complaints by company employees. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.10 DHB Industries,

79

Inc. Note: AS 1301, “Communications with Audit Committees,” of the PCAOB auditing standards requires auditors of SEC registrants to discuss a wide range of matters with a client’s audit committee. These matters include the terms of the audit engagement, the overall audit strategy, the quality of the company’s financial reporting, among others. Because the PCAOB has no jurisdiction over audit committees, all of the mandates include in AS 1301 are directed toward auditors.

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.11 New Century Financial Corporation 79

CASE 1.11

NEW CENTURY FINANCIAL CORPORATION

Synopsis New Century Financial Corporation’s bankruptcy filing in April 2007 was the initial incident in a series of events that would eventually plunge the U.S. and global economies into full-fledged panics.

Within a few years of its founding in 1995, New Century had become one of the largest subprime mortgage lenders in the U.S. New Century and other major subprime lenders such as Wells Fargo, Countrywide, and HSBC catered to potential home buyers who had poor or “subprime” credit histories. The subprime lenders prospered throughout the late 1990s and following the turn of the century because of steadily rising housing prices. Those rising prices allowed large numbers of subprime mortgagees to routinely refinance their homes to raise the cash needed to make their monthly mortgage payments. Other subprime borrowers purchased homes with the intention of “flipping” them in a few years, that is, selling them at a significant gain and then using a portion of the proceeds to purchase a larger home—with an even larger mortgage than their previous home.

This new age, real estate Ponzi scheme came to a screeching halt when housing prices began declining. Suddenly, subprime lenders were flooded with loan repurchase requests. These repurchase requests came primarily from institutional investors that had purchased large blocks of mortgagebacked securities or MBS that the subprime lenders had sold “upstream” via the securitization process. As one observer noted, securitization effectively spread the “cancer” of subprime mortgages around the globe. The resulting worldwide financial crisis imposed huge losses on investors and claimed many former stalwarts of the financial services industries including Merrill Lynch, Bear Stearns, Lehman Brothers, Fannie Mae, and Freddie Mac. This case provides a brief history of the subprime sector of the mortgage industry and the massive financial crisis triggered by the collapse of that industry. The bulk of this case examines allegations that independent auditors played a major role in the subprime lending fiasco. In early 2008, the courtappointed bankruptcy examiner for New Century Financial Corporation released a nearly 600-page autopsy of that company. Much of that report focused on the alleged malfeasance of New Century’s audit firm, KPMG. Among other charges, the bankruptcy examiner maintained that the New Century audits were not properly staffed, that KPMG failed to adequately consider pervasive weaknesses in the company’s internal controls, and that the audit firm failed to properly audit New Century’s critical loan repurchase loss reserve. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.11 New Century Financial Corporation 80 New Century Financial Corporation--Key Facts 1. New Century Financial Corporation was one of the leading firms in the subprime sector of the mortgage industry until it suddenly collapsed into bankruptcy in April 2007; New Century’s collapse contributed to the onset of a worldwide financial crisis in late 2008.

2. New Century’s financial health was undermined by rapidly declining housing prices that resulted in a large number of subprime mortgagees defaulting on their loans.

3. Despite its deteriorating financial condition and operating results, New Century continued to insist that it was financially healthy until late 2006.

4. KPMG served as New Century’s audit firm from the company’s inception in 1995.

5. New Century’s court-appointed bankruptcy examiner maintained that because KPMG failed to comply with “professional standards,” investors and other third parties failed to learn of the company’s deteriorating financial condition and operating results.

6. The bankruptcy examiner alleged that the New Century audit engagements were improperly staffed and that the independence of certain KPMG auditors may have been impaired.

7. The bankruptcy examiner also charged that the KPMG auditors failed to adequately consider serious internal control problems within New Century’s accounting system and that the auditors failed to properly audit the company’s critically important loan repurchase loss reserve.

8. Among other allegations, the bankruptcy examiner maintained that a KPMG senior manager recommended an improper accounting change for New Century’s loan repurchases that resulted in large understatements of the company’s loan repurchase loss reserve.

9. KPMG officials insisted that their firm properly audited New Century and that the bankruptcy examiner’s report was unfair and “one-sided.”

10. Other parties also came to the defense of KPMG, including an accounting professor who suggested that New Century’s high-risk business model doomed the company to bankruptcy and “not anything that KPMG did.”

11. At a minimum, the New Century bankruptcy report added to a series of embarrassing public relations incidents experienced by KPMG. 12. In response to the massive financial crisis triggered at least partially by the huge losses in the subprime sector of the mortgage industry, the U.S. Congress passed a $700 billion bailout plan in October 2008 to shore up the nation’s crumbling financial infrastructure. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.11 New Century Financial Corporation 81

Instructional Objectives 1. To illustrate the critical importance of independent auditing to the proper functioning of a free market economy.

2. To examine the importance of proper staffing of an audit engagement team.

3. To demonstrate how auditors’ perceived independence can be impaired when significant auditorclient conflicts arise.

4. To examine key responsibilities of independent auditors under Section 404 of the Sarbanes-Oxley Act. 5. To identify the general principles auditors should employ when auditing important “accounting estimates” of a client.

Suggestions for Use This case clearly establishes that independent auditors play a critical, if underappreciated, role in the nation’s economy. Likewise, the case documents that auditors of high profile clients may find themselves involuntarily thrust into the spotlight and be asked to justify, in minute detail, key decisions that they made on previous engagements for such a client. You can use these observations to convince your students of 1) the critical importance of the professional role that many of them are about to assume and 2) the need for them to take their professional responsibilities as independent auditors very seriously.

During the 2004 through 2006 New Century audit engagements, PCAOB Auditing Standard No. 2 was in effect. As you are probably aware, AS No. 2 was very controversial and was replaced in short order by PCAOB AS No. 5—which was subsequently integrated into AS 2201 of the PCAOB auditing standards. Consider having a group of your students report on why the PCAOB chose to replace AS No. 2 with AS No. 5. You might also have the students briefly discuss the key differences between those two standards. (In fact, the SEC issued a statement profiling those differences.)

Finally, consider asking another group of students to provide an in-class summary of the technical requirements of Section 404 of the Sarbanes-Oxley Act that are in addition to those that are the subject of case question No. 3.

Suggested Solutions to Case Questions 1. Several academic studies have found that the major international accounting firms have historically specialized, that is, have had heavy concentrations of clients, in certain industries. For example, Arthur Edward Andersen built his namesake firm into a powerhouse in large part by focusing on the electric utility industry. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.11 New Century Financial Corporation 82 The obvious advantage of having client concentrations in certain industries is economies of scale.

An accounting firm that has a sizable market share of a given industry can justify devoting significant resources to developing a customized audit model for companies in that industry and intensive training programs intended to develop expertise in auditing such companies. Because those costs can be “amortized” over a large number of clients, the accounting firm in question should be able to establish itself as the “low cost” supplier of audit services for that industry. Even more important, that accounting firm should develop a reputation for being the highest quality auditor for the industry.

An obvious disadvantage of establishing an audit practice that specializes in certain industries is the difficulty that such a firm may have obtaining clients outside of those industries. For example, earning a reputation as the “banking industry’s auditor” would probably diminish the chances of “picking up” clients that become available in lines of business unrelated to banking. Another disadvantage of specialization is that a large portion of a firm’s clientele may be lost if the industry or sub-industry in which it specializes is undermined by foreign competition, regulatory or legislative changes, or unexpected economic conditions—similar to what happened to the subprime sector of the mortgage industry in recent years.

2. The PCAOB’s quality control standards provide broad guidelines and recommendations that accounting firms can use to ensure that the professional services they provide are competent. QC 20.01 mandates that a CPA firm “shall have a system of quality control for its accounting and auditing practice.” QC 20.07 notes that an accounting firm’s quality control system should include policies and procedures that address the following five elements: independence, integrity, and objectivity; personnel management; acceptance and continuance of clients and engagements; engagement performance; and monitoring.” (Note: the quality control standards included in the AICPA Professional Standards are closely related to those of the PCAOB. There are differences, however.

For example, the AICPA’s quality control standards identify the following six elements that should be integrated into an accounting firm’s quality control system: leadership responsibilities within the firm, relevant ethical requirements, acceptance and continuance of client relationships and specific engagements, human resources, engagement performance, and monitoring. See the “QC” sections of the AICPA Professional Standards.)

The quality control element of “Engagement Performance” is discussed at QC 20.17-19. These paragraphs identify general principles that accounting firms should invoke in performing audits and other professional service engagements. Arguably the principle most relevant in the present context is “consultation.” For example, QC 20.19 observes that, “Policies and procedures should also be established to provide reasonable assurance that personnel refer to authoritative literature or other sources and consult, on a timely basis, with individuals within or outside the firm, when appropriate (for example, when dealing with complex, unusual, or unfamiliar issues).” Given the almost complete turnover of the New Century audit engagement team from the 2004 audit to the 2005 audit and the lack of experience that certain members of the new team had with the client’s industry, it seems reasonable to suggest that KPMG should have emphasized the need for the 2005 engagement team to make full use of the large firm’s considerable “consultation” resources. In fact, as pointed out in the case, certain “specialists” were brought in to review some of New Century’s most complex transactions.

Other quality control measures that could be implemented when there is a large turnover in the © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.11 New Century Financial Corporation 83 members of an audit engagement team would include a more rigorous review of audit workpapers and more input from a “concurring” or “review” partner who has experience with the given client’s industry.

No doubt, some of your students will also suggest that audit firms should simply avoid such situations altogether—that is, situations in which there is wholesale turnover of an audit engagement team from one year to the next. You may want to remind your students that in the “real world” such simple solutions are not always feasible. In fact, during the time frame that the 2004 and 2005 New Century audits were being performed, the major international accounting firms were facing large personnel shortages. The huge amount of SOX Section 404 work that was necessary beginning with calendar-year 2004 audits consumed an enormous amount of those firms’ manpower and other resources. In addition to requiring their employees to work an inordinate amount of overtime, the major firms implemented other unconventional measures in an effort to provide at least minimal staffing for all audit engagements. These latter measures included tracking down former employees and offering them attractive salaries to return to work and “borrowing” staff from international affiliates. KPMG used both of these latter measures to staff the 2005 New Century audit. As indicated in the case, Debbie Biddle, who oversaw the 2005 SOX internal control audit, was recruited from KPMG’s UK affiliate. Mark Kim, the senior manager assigned to the 2005 New Century audit, was a former KPMG auditor who had left the firm several years earlier.

3. As pointed out in the Suggestions for Use, PCAOB Auditing Standard No. 2 was in effect during the time frame that the 2004 through 2006 New Century audits were being performed by KPMG. In 2007, the PCAOB replaced AS No. 2 with AS No. 5, which was subsequently integrated into AS 2201 of the PCAOB auditing standards. The title of AS No. 5 and AS 2201 is, “An Audit of Internal Control Over Financial Reporting That is Integrated with an Audit of Financial Statements.”

[Sidebar: You may want to point out that in 2007 the SEC issued new interpretative guidance to streamline and reduce the cost of SOX-mandated assessments of internal control by the management of public companies. PCAOB followed suit by adopting AS No. 5, which was intended to streamline and reduce the cost of SOX-mandated internal control audits.]

Following are definitions of three key terms that were taken directly from Appendix A of AS 2201.

Internal control deficiency: “A deficiency in internal control over financial reporting exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis.”

Significant deficiency in internal control: “A significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the company’s financial reporting.”

Material weakness in internal control: “A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.11 New Century Financial Corporation 84 or detected on a timely basis.”

AS 2201.03 notes that “The auditor’s objective in an audit of internal control over financial reporting is to express an opinion on the effectiveness of the company’s internal control over financial reporting.” This paragraph goes on to indicate that “a company’s internal control cannot be considered effective if one or more material weaknesses exist.” As a result of this latter premise, “the auditor must plan and perform the audit to obtain reasonable assurance about whether material weaknesses exist as of the date specified in management’s assessment [of internal control].” (AS 2201.62 indicates expressly that “the auditor is not required to search for deficiencies that, individually or in combination, are less severe than a material weakness.”) In summary, if an auditor discovers one or more material weaknesses in internal control, then he or she cannot issue an unqualified or “clean” opinion on the given client’s internal controls. So, in a nutshell, the key operational responsibility of auditors under AS 2201 is to “plan and perform the [internal control] audit to obtain reasonable assurance about whether material weaknesses exist.” Likewise, the key reporting responsibility of auditors is to disclose whether or not material weaknesses are present in the client’s internal control over financial reporting.

AS 2201.78-84 address the “communication” responsibilities of auditors, other than the overall opinion that an auditor must issue on the client’s internal controls over financial reporting. Listed next are these responsibilities: • “The auditor must communicate, in writing, to management and the audit committee all material

weaknesses identified during the audit.”

• “If the auditor concludes that the oversight of the company’s external financial reporting and internal control over financial reporting by the company’s audit committee is ineffective, the auditor must communicate that conclusion in writing to the board of directors.”

• “The auditor also should consider whether there are any deficiencies, or combinations of deficiencies, that have been identified during the audit that are significant deficiencies and must communicate such deficiencies, in writing, to the audit committee.”

• “The auditor should also communicate to management, in writing, all deficiencies in internal control over financial reporting (i.e., those deficiencies in internal control over financial reporting that are of a lesser magnitude than material weaknesses) identified during the audit and inform the audit committee when such a communication has been made.”

4. For audits of SEC registrants, AS 2501, “Auditing Accounting Estimates,” of the PCAOB’s auditing standards is the authoritative source most relevant to this question. AS 2501.04 summarizes the “macro” level responsibilities of auditors regarding client accounting estimates.

“The auditor is responsible for evaluating the reasonableness of accounting estimates made by management in the context of the financial statements taken as a whole . . . when planning and performing procedures to evaluate accounting estimates, the auditor should consider, with an attitude of professional skepticism, both the subjective and objective factors [that were relied on by management in arriving at those estimates].” © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.11 New Century Financial Corporation 85 AS 2501.07 defines the key operational responsibilities of auditors vis-à-vis a client’s accounting estimates: “The auditor’s objective when evaluating accounting estimates is to obtain sufficient appropriate evidential matter to provide reasonable assurance that— a. All accounting estimates that could be material to the financial statements have been developed. b. Those accounting estimates are reasonable in the circumstances. c. The accounting estimates are presented in conformity with applicable accounting principles and are properly disclosed.”

The remaining two sections of AS 2501 provide guidance to auditors that is intended to assist them in “Identifying Circumstances that Require Accounting Estimates” and “Evaluating Reasonableness [of accounting estimates].” Listed next are examples of procedures that AS 2501 recommends auditors use in evaluating the reasonableness of management accounting estimates.

• “Review and test the process used by management to develop the estimate.”

• “Develop an independent expectation of the estimate to corroborate the reasonableness of

management’s estimate.”

• “Review subsequent events or transactions occurring prior to the date of the auditor’s report.”

• “Consider whether changes in the business or industry may cause other factors to become significant to the [underlying] assumptions.”

• “Consider using the work of a specialist regarding certain [underlying] assumptions.”

• “Test the calculations used by management to translate the [underlying] assumptions and key factors into accounting estimates.”

Clearly, several of the recommended procedures for auditing accounting estimates would have been relevant to auditing the period-ending balance of New Century’s loan repurchase loss reserve.

Arguably most relevant would have been the recommendation that auditors consider “changes in the business or industry” in analyzing the reasonableness of an accounting estimate. The rapid changes that were taking place in New Century’s industry during 2005 and 2006 had a huge impact on the company’s loan repurchase loss reserve.

Note: the AICPA Professional Standards discuss the topic of auditing accounting estimates within AU-C Section 540, “Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures.”

5. The most effective way to address this question is to simply “walk through” the various sections of the PCAOB auditing standards and identify apparent oversights made by the KPMG auditors of New Century. The following list is not intended to be all-inclusive. Instead, what I have done is focus on the overarching or “macro” auditing principles or standards slighted by the KPMG auditors.

[Note: Realize, of course, that the following PCAOB auditing standards were not in effect when the New Century audits were performed. Nevertheless, the auditing standards that were in effect at that time included the principles underlying the following list of PCAOB auditing standards.]

1. AS 1005, “Independence.” As mentioned in the case, the bankruptcy examiner “speculated” © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.11 New Century Financial Corporation 86

2.

3.

4.

5.

6.

that the 2005 10-K “incident” impaired the independence of Donovan and Kim. After that awkward and embarrassing incident for KPMG, the two senior members of the audit team may have attempted to “bend over backwards” to get back “in the good graces” of client management.

AS 1010, “Training and Proficiency of the Independent Auditor.” Certainly, the bankruptcy examiner’s report raised legitimate concerns regarding the issue of whether the 2005 New Century audit engagement team was properly staffed. As noted in the case, even New Century management questioned the appointment of Donovan as the new audit engagement partner given his lack of familiarity with the mortgage industry. Likewise, the appointment of Debbie Biddle to oversee the 2005 SOX internal control audit seemed to be a questionable decision since she had no prior SOX experience and “virtually no experience auditing U.S. clients.” Making matters worse was the fact that nearly all of the subordinate members of the audit team were new to the New Century engagement.

AS 1015, “Due Professional Care in the Performance of Work.” This standard is a “catch-all” professional standard. If it is proven that an auditor violated another auditing standard, then it would be easy to maintain that this standard was violated as well.

AS 1105, “Audit evidence.” Whether KPMG obtained sufficient appropriate audit evidence to support the period-ending balances of the loan repurchase loss reserve is a question that will likely be debated ad nauseam in coming years. Based upon the information available in the bankruptcy examiner’s report, it is easy to question the adequacy and propriety of that evidence.

AS 2101, “Audit planning.” The bankruptcy examiner alleged that the 2005 audit team did not properly review the prior year workpapers, at least with regard to the internal control deficiencies discovered by the 2004 audit team. AS 2201 notes specifically that “In subsequent years’ audits, the auditor should incorporate knowledge obtained during past audits he or she performed of the company’s internal control over financial reporting into the decision-making process for determining the nature, timing, and extent of testing necessary” (AS 2201.57). Again, this general audit planning principle was apparently not invoked by the KPMG auditors.

AS 2201, “An Audit of Internal Control Over Financial Reporting That Is Integrated with an Audit of Financial Statements.” The discussion included in the previous item is also relevant to this standard. By not reviewing the internal control “problems” discovered by the prior year’s audit team, the KPMG auditors undercut the integrity of their audit of New Century’s internal control over financial reporting.

6. You can find a slag pile of articles in recent years that have debated the role that mark-to-market accounting played in the serious financial crisis that engulfed the national and global economies in late 2008. The principal (pre-codification) technical standard relevant to mark-to-market accounting is Statement of Financial Accounting Standard No. 157, “Fair Value Measurement.” That standard defines “fair value” as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” [Note: In the FASB’s codification of accounting standards, “Fair Value Measurement” is Topic 820.]

Critics of the mark-to-market rule insist that it is disruptive to the capital markets because it © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.11 New Century Financial Corporation 87 introduces more uncertainty and volatility into those markets. Many financial institutions were “trapped” with large investments in MBS and other more exotic financial instruments when the financial crisis erupted in 2008. The mark-to-market rule forced those institutions to take large, if not massive, write-downs on those investments. Critics of the rule maintained that those involuntary write-downs created more havoc in the markets by panicking investors, which, in turn, forced more mark-to-market write-downs. These same critics argued that many, if not most, of the write-downs being taken were unnecessary and inappropriate since it was difficult, if not impossible, to determine the true fair value of the given investments given the illiquid and sometimes “disorderly” nature of the markets in question. To calm the capital markets, many parties, including respected members of the investment community, called for the mark-to-market rule to be repealed or at least temporarily suspended. One critic of the rule succinctly summarized his position by stating that, “SFAS 157 Is Worse than Al Qaeda.”

Prominent members of the accounting profession forcefully defended the mark-to-market rule and insisted that critics of the rule had adopted a “kill-the-messenger” attitude. Among the most vocal defenders of the rule were former SEC Chairman Arthur Levitt and former SEC Chief Accountant Lynn Turner who addressed the need to retain the rule in an editorial appearing in the Wall Street Journal (September 26, 2008).

Ultimately, those who blame fair-value accounting for the current crisis are guilty of the financial equivalent of shooting the messenger. Fair value does not make markets more volatile; it just makes the risk profile more transparent. We should be pointing our fingers at those at Lehman Brothers, AIG, Fannie Mae, Freddie Mac, and other institutions who made poor investment and strategic decisions and took on dangerous risks. Blame should not be placed on the process by which the markets learned about them.

7. I commonly conclude the discussion of a case by asking students to identify the key “take-aways” for that case. In fact, in pre-coverage, in-class quizzes I frequently ask students to list and rank the most important take-aways for the cases to be discussed in the given class and require them to defend their choices. Listed next is a sample of what I consider to be important take-aways for this case.

• The independent audit function is critically important to the proper functioning of a free market

economy.

• When planning an audit, auditors should pay extremely close attention to important industry developments that may impact the integrity of the client’s financial statements.

• Accounting estimates that are critical to the reported health of the client should be audited rigorously.

• Companies with high-risk business models generally make high-risk audit clients.

• To properly plan an audit, auditors must review prior year workpapers and identify key accounts, internal control deficiencies, and other factors or circumstances that could potentially influence the outcome of the audit.

• Auditors should consider internal control deficiencies when determining the nature, extent, and timing of substantive audit procedures. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.11 New Century Financial Corporation 88 • Proper staffing of an audit engagement is critical to the performance of a high quality audit.

• Perceived auditor independence can be just as important as de facto auditor independence.

• Poor relationships between auditors and client personnel, particularly high-level accounting

personnel, can have an adverse impact on the quality of an audit.

• Client representations are a weak form of audit evidence.

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.12 Madoff Securities 88

CASE 1.12

MADOFF SECURITIES

Synopsis A childhood friend summed up the driving force in Bernie Madoff’s life: “Bernie wanted to be rich.” As a youngster growing up in New York City, Bernie realized that Wall Street was the greatest wealth creation machine the world had ever known. So, after graduating from college in 1960, he set his sights on joining the exclusive fraternity that ran Wall Street by organizing his own one-man brokerage firm, Madoff Securities.

Madoff was one of the first individuals to recognize that computer technology provided the means to “democratize” Wall Street by establishing a system that made securities trading much more efficient and much cheaper. In the early 1970s, Madoff and several other individuals organized the NASDAQ exchange, which was destined to become the world’s largest electronic stock market.

Years later, the NYSE would be forced to follow suit and switch to electronic securities trading.

Literally hundreds of millions of investors have benefitted from the lower transaction costs of electronic securities trading that were in large part a result of the pioneering efforts of Bernie Madoff.

Unfortunately, Bernie Madoff will not be remembered as a pioneer of electronic securities trading. Instead, the word “Madoff” will always be associated with the phrase “Ponzi scheme.”

Although his stock brokerage firm was extremely lucrative, Madoff eventually established a parallel business, investment advisory services. Over a period of several decades, Madoff became known as the “Wizard of Wall Street” for the incredibly consistent and impressive returns that he earned on the billions of dollars entrusted to him by investors. However, those returns and Madoff’s secretive investment strategy that produced them were fraudulent.

This case documents the Madoff fraud with a particular focus on its implications for the nation’s financial reporting system. Many critics have insisted that the ineffectiveness of the SEC was a major factor that allowed Madoff to sustain his fraud for so long. Likewise, those critics insist that Madoff’s independent auditor played a major role in allowing the fraud to go unchecked for decades.

Throughout most of its existence, Madoff Securities was audited by a small accounting firm with one professional accountant. That accountant, David Friehling, would become the second individual arrested by federal prosecutors investigating Madoff’s massive fraud. Friehling was charged with “flouting” the accounting profession’s auditor independence rules and with performing “sham audits” of Madoff Securities. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.12 Madoff Securities 89 Madoff Securities--Key Facts 1.

The driving force in Bernie Madoff’s life was his desire to become wealthy.

2.

Madoff founded Madoff Securities, which was one of the first brokerage firms to employ computer technology to reduce the cost of securities transactions; Madoff is also credited as one of the founders of the NASDAQ, the world’s largest electronic stock exchange.

3.

The investment advisory division of Madoff Securities grew dramatically over the life of the firm due to the incredibly consistent and impressive rates of return that it earned for investors.

4.

In early December 2008, Madoff confessed to family members that his firm’s impressive investment results were fraudulent, the product of a massive Ponzi scheme that he had carried out over decades.

5.

News of the massive fraud prompted an angry public to question why the nation’s “watchdogs” for the capital markets, particularly the independent audit function, had failed once again.

6.

Madoff’s auditor had been a tiny CPA firm, Friehling & Horowitz, with one professional accountant, David Friehling.

7.

Accounting and auditing experts insisted that it was “preposterous” that one person could audit a firm the size of Madoff Securities.

8.

In March 2009, Friehling was arrested and charged with securities fraud and aiding and abetting an investment fraud due to his allegedly “sham audits” of Madoff Securities; federal prosecutors also revealed that Friehling and his firm had a large amount of funds invested with Madoff Securities.

9.

The SEC was the target of harsh criticism when it was revealed that Harry Markopolos, a Boston-based financial analyst, had repeatedly told the federal agency that Madoff was operating the “world’s largest Ponzi scheme” and had provided evidence apparently proving that allegation.

10. In March 2009, Madoff pleaded guilty to eleven counts of fraud, money laundering, perjury, and theft; in June 2009, Madoff was sentenced to 150 years in federal prison.

11. KPMG became the first of the Big Four firms to be sued as a result of the Madoff fraud; the lawsuit alleged that KPMG failed to properly investigate Friehling & Horowitz while auditing the financial statements of a large “feeder firm” in which the plaintiff was an investor.

12. The SEC announced a series of reforms to prevent or detect future frauds similar to Madoff’s; one of those measures subjects investment advisers to annual “surprise audits” to ensure that customer funds are properly safeguarded. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.12 Madoff Securities 90 Instructional Objectives 1.

To identify the principal precursors of financial fraud.

2.

To identify “red flags” or risk factors typically indicative or symptomatic of fraud.

3.

To demonstrate the critical importance of a vigorous independent audit function for a free market economy.

4.

To examine the regulatory role and responsibilities of the Securities and Exchange Commission.

5.

To identify the nature and purpose of peer reviews.

Suggestions for Use

This case is well suited to “kick off” an auditing course, particularly an undergraduate auditing course. The case is high profile, fairly brief, not highly technical, and most importantly documents how vital the independent audit function is to our economy. After studying this case, students should have a crystal clear understanding of why it is so necessary that every large company, both private and public, undergo a truly independent and vigorous financial statement audit each year. No doubt, almost every business in the United States was affected directly or indirectly by Bernie Madoff’s massive fraud. The “sham audits” that David Friehling performed on Madoff Securities’ financial statements played a central role in allowing Madoff to sustain his fraud for as long as he did.

If you don’t choose to launch your auditing course with this case, you could use it to compliment your coverage of several important auditing topics including internal controls, auditor independence, and fraud. This case also provides an opportunity to discuss a technical topic that doesn’t arise in many alleged audit failures, namely, the audit procedures that should be applied to a client’s major stock market investments. Another technical topic in this case that is seldom addressed in other audit cases is peer reviews.

As with all of the “live” cases in this text, you will likely want to have your students research recent developments in this case—see the initial case question. No doubt, there will be interesting revelations and new developments in this case for years to come.

Suggested Solutions to Case Questions 1. Consider having individual students or individual student groups provide updates on the following facets of this case: additional criminal charges filed in the case, developments or additional revelations relating to Friehling and his audits of Madoff Securities, litigation involving the auditors of Madoff’s “feeder firms,” additional recoveries made by the firm’s court-appointed trustee, news items focusing on Harry Markopolos, and additional regulatory reforms emanating from the Madoff fraud.

2. The principal authoritative source in the PCAOB’s auditing standards vis-à-vis the auditing of investments is AS 2503, “Auditing Derivative Instruments, Hedging Activities, and Investments in © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.12 Madoff Securities 91 Securities.” The comparable technical material in the AICPA Professional Standards can be found in in AU-C Section 501, “Audit Evidence—Specific Considerations for Selected Items.” The AICPA has also issued an accounting and audit guide for investment companies. Understandably, the increasing complexity of securities investments in recent years has greatly complicated the auditing of investments, particularly investments involving options and other “exotic” transactions—as noted in the case, the buying and selling of put and call options was a central feature of Bernie Madoff’s alleged investment strategy. Listed next are examples of suggested audit procedures for material investments that are included in AS 2503.

• “Confirmation of settled transactions with the broker-dealer or counterparty.”

• “Confirmation of unsettled transactions with the broker-dealer or counterparty.”

• “Inspecting underlying agreements and other forms of supporting documentation, in paper

or electronic form.”

• “Inspecting supporting documentation for subsequent realization or settlement after the end of the reporting period.

• “Performing analytical procedures” to determine, for example, whether recorded interest revenue or expense is reasonable.

• “Inspecting financial instruments and other agreements to identify embedded derivatives.”

• “Inspecting documentation in paper or electronic form for activity subsequent to the reporting period.”

• “Confirming significant terms” [of the given investment with the third party investee]. •“Reading other information, such as minutes of meetings of the board of directors or finance, asset/liability, investment, or other committees.”

• “Assessing the reasonableness and appropriateness of the [fair value] model” used to determine the reported value of the security.

• “Calculating the [fair] value” of the given investment.

• “Comparing the fair value with subsequent or recent transactions.”

• Ascertaining whether “the accounting principles selected and applied have general acceptance.”

• Determining whether the client’s “financial statements, including the related notes, are informative of matters that may affect their use, understanding, and interpretation.”

Were these and other audit procedures performed by the auditors of Madoff’s “feeder firms”? I have no idea. To date, there has been no public disclosure of the specific audit procedures applied by those feeder firms to their clients’ Madoff-held investments. As a point of information, there has also been no public disclosure regarding specific details of the Friehling & Horowitz’s “sham audits” of Madoff Securities. Hopefully, the resolution of the pending lawsuits in this case will provide us with some insight on the nature and scope of the feeder firm audits and Friehling & Horowitz’s audits of Madoff Securities.

3. A “peer review” is an examination of an accounting firm’s quality control system and its compliance with the requirements of that system by one or more accounting professionals. You may want to point out to your students that the PCAOB has established its own inspection program to ensure that auditors of public companies have established and are applying appropriate quality control © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.12 Madoff Securities 92 policies and procedures. Of course, the PCAOB inspection program is technically not a “peer” review program but it serves the same general purpose.

Assuming that Friehling & Horowitz’s audits of Madoff Securities were, in fact, “sham audits” as alleged by federal prosecutors, then it seems reasonable to conclude that a thorough peer review would have revealed that those audits were substandard. The resulting peer review report filed with the relevant regulatory or oversight body would very likely have resulted in Friehling & Horowitz being disqualified as Madoff’s audit firm.

As discussed in the case, New York adopted a peer review requirement following the Madoff fraud. However, as pointed out in a footnote to the case, a firm the size of Friehling & Horowitz would be exempt from that requirement!

4. AS 2401, “Consideration of Fraud in a Financial Statement Audit” in the PCAOB’s auditing standards, is an authoritative source to refer to in responding to this question. (The corresponding section in the “clarified” AICPA Professional Standards is AU-C Section 240.) AS 2401.07 lists the three “angles” of the so-called fraud triangle: the existence of an incentive and/or pressure to commit a fraud, the opportunity to commit a fraud is present (typically due to ineffective internal controls), and the ability to rationalize fraudulent conduct on the part of the given or potential fraudster. These three “conditions” are effectively precursors to fraud. The presence of these factors does not necessarily mean that fraud will occur but an environment in which these conditions are present is much more likely to spawn fraud.

AS 2110.65 notes that “fraud risk factors” are “events or conditions that indicate” that one or more of the three elements of the fraud triangle are present. [The use of the term “conditions” within the professional auditing standards to refer to both the precursors of fraud and the symptoms or indicators of those precursors is somewhat problematic.] Appendix A of AS 2401 identifies dozens of individual “fraud risk factors.” A few examples: a high degree of competition or market saturation in a client’s industry (incentive/pressure), negative cash flows (incentive/pressure), need to obtain additional debt or equity capital (incentive/pressure), significant related party transactions (opportunity), and known history of violating securities laws or other laws (ability to rationalize).

Each of the three elements of the fraud triangle were present in the Madoff scandal. The principal incentive for Bernie Madoff to commit the fraud was apparently his need to “be somebody,” that is, to become a prominent member of the Wall Street community. Madoff developed an organization that he apparently exercised almost complete control over, which gave him the opportunity to perpetrate and conceal his massive fraud. Finally, Madoff testified ex post that he expected that his scheme would be short-lived and that he would eventually be able to “extricate” himself from it. That “storyline” is among the most common that fraudsters use to justify or rationalize their misconduct.

Listed next are fraud risk factors that were present during the Madoff scandal: • Excessive pressure exists to meet the requirements or expectations of third parties • Management has a significant financial interest in the given entity • Domination of management by a single person • Ineffective oversight over the financial reporting process and internal control by those

charged with governance • Ineffective accounting and information control systems © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.12 Madoff Securities 93 • A practice by management of committing to third parties to achieve aggressive or

unrealistic financial results • Domineering management behavior in dealing with external auditor 5. Financial fraud, including fraudulent accounting, has plagued our nation recently. This question provides your students with an opportunity to come up with their own “answers” to this perplexing problem—maybe their solutions would be more effective than the preventative measures implemented in recent years by so-called experts. Consider placing your students in groups to come up with their recommendations and then have each group present and defend their choices.

Listed next are a few random reforms that regulatory authorities could consider adopting to address the fraud “problem”: • •

• • •

Requiring independent auditors to immediately report suspected fraud to regulatory and/or law enforcement authorities. (This measure has been implemented recently in South Africa.)

Establishing a government audit agency to “take over” the independent audit function. In the 1930s, Congress initially considered creating a government agency to perform the independent audit function when it passed the federal securities laws.

More rigorous training programs to ensure that government regulators, such as SEC personnel, have the proper background to carry out their oversight responsibilities.

Educational programs intended to help investors spot investment opportunities that are “too good to be true.”

Longer prison sentences for convicted fraudsters to serve as a deterrent for potential fraudsters.

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

94 Inc.

Case 1.13 AA Capital Partners,

CASE 1.13

AA CAPITAL PARTNERS, INC.

Synopsis In February 2002, John Orecchio and Paul Oliver teamed together to establish an investment advisory firm, AA Capital Partners, Inc. The two Chicago businessmen had all of the necessary credentials for their new venture. Orecchio had helped manage a $5 billion private equity fund for Bank of America, while Oliver had served as the chief financial officer of a large bank, ABN AMRO. The two men used their network of connections in Chicago to quickly attract $200 million of customer accounts that represented the pension funds of six labor unions.

Unfortunately, AA Capital proved to be a less than trustworthy steward of its customers’ funds.

Within four years, Orecchio was responsible for his customers losing nearly one-fourth of their investments due to embezzlement and mismanagement. Orecchio, who was married with three children, squandered a large portion of the $24 million that he embezzled on his mistress, a young exotic dancer.

This case focuses on Ernst & Young’s 2004 audits of AA Capital Partners and the four private equity funds organized by that firm. During those audits, the Ernst & Young audit team discovered $1.92 million of suspicious cash payments made to John Orecchio that were characterized as “tax transfers” or “tax loans” by the client. In fact, those payments represented a small slice of the $24 million of funds that Orecchio had embezzled. Both the SEC and a federal judge concluded that inadequate audit procedures prevented the AA Capital audit team from discovering the true nature of the alleged “tax transfers.” Surprisingly, the federal judge who issued a 41-page opinion in this case ruled that the AA Capital audit engagement partner was not culpable because the audit manager on the engagement had failed to properly inform him of the suspicious “tax transfers.” After dismissing the sanctions that the SEC had recommended for the audit partner, the judge suspended the audit manager from practicing before the SEC for one year.

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.13 AA Capital Partners,

95

Inc. AA Capital Partners, Inc.--Key Facts 1. John Orecchio and Paul Oliver founded AA Capital Partners in 2002; due to Orecchio’s strong credentials in investment management, he took responsibility for the firm’s day-to-day operations.

2. By the end of 2004, Orecchio had persuaded six labor unions to place their collective $200 million of pension fund assets under the management of AA Capital.

3. The Chicago office of Ernst & Young audited AA Capital and the four private equity funds that it established; during the 2004 AA Capital audits, Gerard Oprins served as the audit engagement partner, while Wendy McNeely served as the audit manager.

4. McNeeley and her subordinates discovered $1.92 million of unusual cash payments made to John Orecchio during 2004; AA Capital’s chief accounting officer told the auditors that the cash payments were “tax transfers” made to Orecchio to allow him to pay taxes levied in error on him by the IRS. 5. McNeeley attempted to obtain more information regarding the suspicious payments but the chief accounting officer would not cooperate; ultimately, McNeeley relied on the client’s journal entries and other internal audit evidence in deciding that the payments had been accounted for properly.

6. McNeeley discovered additional suspicious payments to Orecchio during the subsequent period review; however, she did not mention those payments or the original $1.92 million of payments in the Summary Review Memorandum (SRM) prepared for the 2004 AA Capital engagement.

7. The client’s 2004 financial statements and accompanying financial statement footnotes failed to adequately disclose the “related party” nature of the $1.92 million of payments made to Orecchio.

8. During the 2005 AA Capital audits, the audit manager who replaced McNeeley discovered the $5.7 million of “tax transfers” that had been made to Orecchio during 2004 and 2005; the audit manager refused to “sign off” on those items because she “didn’t have anything to audit.”

9. In February 2010, John Orecchio pleaded guilty to embezzling approximately $24 million from his clients’ funds, which included the bogus $5.7 million of alleged tax transfer payments made to him; Orecchio had spent a large portion of the stolen funds on his mistress.

10. The SEC identified numerous oversights that the auditors had made during the 2004 AA Capital audits; those oversights included failing to properly investigate the suspicious tax transfers and failing to ensure that the client made appropriate related-party disclosures for those transactions. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Case 1.13 AA Capital Partners,

11. A federal judge ultimately ruled that Gerard Oprins was not responsible for the audit “failures” during the 2004 engagement because Wendy McNeeley had not properly apprised him of the suspicious tax transfers; McNeeley received a one-year suspension from practicing before the SEC. 12. John Orecchio received a prison sentence of nine years and four months for his indiscretions; his sentence was significantly shortened because he agreed to cooperate in a “sting operation” intended to implicate other parties allegedly involved in his fraudulent scheme.

Instructional Objectives 1. To examine the responsibility of auditors to thoroughly investigate large and unusual client transactions.

2. To identify the audit procedures that should be applied to related-party transactions.

3. To determine the nature and purpose of “subsequent period” audit procedures.

4. To understand the division of responsibilities on an audit engagement team.

5. To determine the circumstances under which auditors can choose not to rely on a client’s internal controls.

Suggestions for Use An instructional case is only as “good” as the sources from which it is developed. For this case, there was an excellent source of insightful and “inside” information regarding Ernst & Young’s AA Capital audits. This latter source was the 41-page opinion written by Judge Robert Mahony. That opinion was effectively a summary of the two-week hearing presided over by Judge Mahony that was intended to determine whether the sanctions recommended by the SEC for Gerard Oprins (AA Capital’s audit engagement partner) and Wendy McNeeley (the audit manager on the 2004 AA Capital audits) were appropriate. If you are using this case in a graduate class, you might consider having your students read that opinion and/or have a group of students provide an in-class report on it. Judge Mahony does an excellent job of summarizing the “nitty-gritty” details of the 2004 AA Capital engagement. Just as intriguing in his opinion are the views expressed by the expert witnesses regarding key technical issues that arose during the AA Capital audits. No doubt, your students will find it surprising that two “big time” experts could have such divergent views on major auditing issues. The divergence between the experts’ opinions serves to confirm that independent auditing is much more an “art” than a “science.”

Suggested Solutions to Case Questions 1. A)

The fact that both McNeeley and Oprins were “new” to the AA Capital engagement almost certainly resulted in a learning curve effect for each of them. For example, because McNeeley

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.13 AA Capital Partners,

97

Inc. didn’t have a “history” with Mary Beth Stevens, she did not have a baseline against which to evaluate Stevens’ competence, candor, and willingness to cooperate.

B) The fact that Ernst & Young was auditing five entities (AA Capital and its four private equity funds) simultaneously, no doubt, complicated matters for McNeeley and her subordinates. [Note: In fact, Ernst & Young performed ten audits simultaneously! Although not pointed out in the case, the 2003 and 2004 audits (five each) were conducted during the same time frame in early 2005. I didn’t address this aspect of the case because it wasn’t a major issue raised by either the SEC or Judge Mahony. To keep my cases to a reasonable length, I have to eliminate as many marginal issues/facts as possible.]

C) As suggested in the case, the lack of client cooperation was a critical factor in determining the outcome of the 2004 audits.

D) Because the audit team “busted” the assigned budget of 600 hours by 200 hours, McNeeley may have felt pressure near the end of the engagement to “wrap it up” as quickly as possible—in other words, she may have felt the need to give the “tax transfers” issue the short shrift.

E) During the time frame that the 2004 audits was being performed, AA Capital was still in its infancy—recall that it was organized in February 2002. Most likely, the firm was still getting its “legs underneath itself,” meaning that there was probably some degree of confusion, if not chaos, in the firm’s operations.

F) Related to the previous item was the horrific “tone at the top” established by John Orecchio for this audit client. The available sources for this case suggest that Orecchio spent most of his time “on the road” attempting to attract new customers and pursuing various prurient interests. This lack of leadership for AA Capital, no doubt, created, or added to, the confusion and chaos within the organization.

QC Section 20, “System of Quality Control for a CPA Firm’s Accounting and Auditing Practice” in the PCAOB’s quality control standards provides an overview of the nature and purpose of a CPA firm’s quality control system. (Note: the quality control standards in the AICPA Professional Standards are very similar to the PCAOB’s quality control standards.) QC 20.02 notes that CPAs “should practice in firms that have in place internal quality-control procedures to ensure that services are competently delivered and adequately supervised.” QC 20.07 identifies the following five elements of quality control for a CPA firm registered with the PCAOB: a. b. c. d. e.

Independence, Integrity, and Objectivity Personnel Management Acceptance and Continuance of Clients and Engagements Engagement Performance Monitoring

In the AA Capital case, the two quality control elements that were particularly relevant were “acceptance and continuance of clients and engagements” and “engagement performance.” Given Mary Beth Stevens’ failure to cooperate with Wendy McNeeley (when the latter was investigating the tax transfers) one could certainly suggest that Ernst & Young should have considered ending, or at © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

98 Inc.

Case 1.13 AA Capital Partners,

least suspending, the 2004 audits. Of course, during the 2005 engagement, Ernst & Young did suspend the AA Capital audits after the new audit manager (Jennifer Aquino) suggested that sufficient information had not been provided by the client to audit the suspicious tax transfers.

In terms of engagement performance, there are several measures that might have mitigated the impact of the six “problem” facets of the 2004 AA Capital audits listed previously. For example, given that long list of problems, it seems reasonable to suggest that the 600-hour time budget for the 2004 AA Capital engagement should not have been considered a major constraint for the auditors.

Here was a situation where the auditors were probably justified in taking as much time as necessary to complete the audits and saying “to heck” with the time budget. (Note: another facet of the case that I didn’t mention in the case narrative was the fact that AA Capital was pressuring Ernst & Young to complete the audits—quite possibly, the client was hoping that if the auditors were “rushed,” they would be less likely to uncover the fraud.) Another quality control measure that could have been implemented by Ernst & Young, given the “problem” nature of the 2004 AA Capital engagement, was to have had more frequent and timely involvement of Oprins (the audit partner) in the engagement. In fact, one of the expert witnesses complained of the disproportionately few hours that Oprins spent working on the engagement.

2. Both the AICPA and PCAOB auditing standards mandate that auditors obtain an understanding of an audit client’s internal controls and then document that understanding in their workpapers.

However, in either an audit of a private entity or a public company, auditors may decide not to rely on the client’s internal controls. What circumstances would justify such a decision? One obvious example would be that the auditors determine that a client’s internal controls are not reliable.

Likewise, auditors may decide that it is not cost-effective to rely on a client’s internal controls, that is, it would be more efficient to use a strictly substantive testing audit strategy for the given client.

3. Note: AS 2410, “Related Parties,” presents the PCAOB’s auditing standards for related parties and related-party relationships and transactions. AU-C Section 550, “Related Parties,” includes the comparable auditing standards of the AICPA. [Note: AS 2410 did not become effective until late 2014, well after the events documented in this case took place. At the time of the AA debacle, the organization’s auditors were subject to the related-party auditing rules included in AU-C Section 550.

However, going forward, the auditors of an organization such as AA Capital would be subject to the related-party audit requirements included in AS 2410, consequently, this solution will focus on those requirements.]

The overall audit objective for a client’s related parties, related party relationships, and transactions with related parties is expressed in AS 2410.02: “The objective of the auditor is to obtain sufficient appropriate audit evidence to determine whether related parties and relationships and transactions with related parties have been properly identified, accounted for, and disclosed in the financial statements.”

Auditors must first identify and obtain an understanding of a client’s related parties and the relationships and transactions with those parties. To achieve this goal, auditors should study the client’s “process” for identifying those items, inquire of management regarding the existence of related parties (and consequent relationships and transactions), and make the members of the audit engagement team aware of the client’s related parties. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 1.13 AA Capital Partners,

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Inc. Among other procedures, auditors must also “identify and assess” the “risks of material misstatements” stemming from the client’s related parties, related party relationships, and related party transactions [AS 2410.10]. AS 2410.12 identifies five specific measures that auditors should apply “for each related party transaction that is either required to be disclosed in the financial statements or determined to be a significant risk.” These five measures are summarized below: a.

“Read the underlying documentation and evaluate whether the terms and other information about the transaction are consistent with explanations from inquiries and other audit evidence about the business purpose (or lack thereof) of the transaction.” b.

“Determine whether the transaction has been authorized and approved in accordance with the company’s established policies and procedures . . .” c.

“Determine whether any exceptions to the company’s established policies or procedures were granted.” d.

“Evaluate the financial capability of the related parties with respect to significant uncollected balances, loan commitments, supply arrangements, guarantees, and other obligations, if any.” e.

“Perform other procedures as necessary to address the identified and assessed risks of material misstatement.”

Would any of the above audit procedures if applied to Orecchio’s “tax transfers” have resulted in the auditors discovering that the transactions were fraudulent? Probably—if not almost certainly. For example, the auditors obviously did not “read the underlying documentation” for the alleged tax transfers—granted, given the nature of those transactions it is unlikely that there was extensive “documentation” of them. In fact, because of a lack of client cooperation, the Ernst & Young auditors never obtained a complete understanding of the transactions. If auditors fail to obtain a thorough understanding of related party transactions or potential related party transactions, then the usefulness of any subsequent audit procedures [including items “a” through “e” listed above] applied to such transactions is severely diminished if not undercut completely. (For whatever reason, recall that the auditors never directly inquired of Orecchio regarding the nature and purpose of the alleged tax transfers. In retrospect, that appears to be a major oversight since he was the party most knowledgeable of those suspicious transactions.) A full investigation of the transactions would have also revealed that they were not “in accordance with the company’s established policies and procedures.” McNeeley reported having reviewed the “partnership agreement” for AA Capital early in the 2004 audit and she recalled that the agreement permitted “tax distributions and tax advances” to the two partners. However, the funds transferred to Orecchio were not “tax distributions,” “tax advances,” or “tax transfers” for that matter—a fact that almost certainly would have been revealed by a rigorous investigation of the transactions. Likewise, as indicated in the SEC enforcement release, the auditors did not take any steps to determine the “financial capability” of Orecchio to repay the alleged loans. That investigation would likely have revealed that Orecchio could not repay the amounts.

4. Note: AS 2801, “Subsequent Events,” includes the PCAOB’s technical audit requirements for subsequent events. AU-C Section 560, “Subsequent Events and Subsequently Discovered Facts,” presents the AICPA Professional Standards for “subsequent period” audit procedures. These two © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

100 Inc.

Case 1.13 AA Capital Partners,

sets of requirements are very similar.

The key audit objective associated with subsequent period audit procedures is to identify any events, circumstances, or other information that may reflect on the integrity of the management assertions embedded in the given client’s audited financial statements. Once such information is identified, then the auditor must take steps to determine its impact, if any, on the client’s financial statements.

Among other procedures applied to identify relevant subsequent period “information,” auditors may review minutes of post-balance sheet board of directors meetings, inquire of client legal counsel regarding such information, determine whether there have been any “significant new” related party transactions since the balance sheet date, and simply scan the accounting records for evidence of such information. Once important subsequent period information is identified, then the auditors must assess its potential financial statement impact. In some circumstances, the new information may dictate adjustments to the audited financial statements and/or disclosure in the accompanying financial statement footnotes.

In the case at hand, McNeeley discovered the additional “tax transfers” made to Orecchio during the first few months of 2005. However, for whatever reason, she apparently didn’t consider that information important since she didn’t characterize those transactions as unusual or comment on them in the Summary Review Memorandum.

5. When I first read that statement, I was surprised because I had always assumed that audit engagement partners had such a responsibility. However, after some reflection, Ellingsen’s assertion seems reasonable (recall that he was Deloitte’s senior audit technical partner and that he served on the Auditing Standards Board for several years).

Given the fact that the audit engagement partner is not “in the trenches” and in many cases is only deeply involved in an audit on the “front end” and “back end,” it is not reasonable to hold him or her responsible for every decision made during the course of an audit. In truth, the responsibility for many audit decisions is delegated by the audit partner to his or her key subordinates, principally, the lead audit manager and lead audit senior assigned to the given engagement. Of course, an accounting firm must have appropriate controls in place to ensure that the “field lieutenants” on each audit engagement have the proper training and experience to make “good” decisions and to ensure that they communicate all critical decisions to the audit engagement partner. Likewise, a rigorous workpaper review process should increase the likelihood that subpar decisions by the field lieutenants—which were not communicated on a real-time basis to the audit engagement partner—are ultimately brought to the attention of, or discovered by, the audit engagement partner or independent review partner.

Nevertheless, there is always some residual risk that certain “bad” decisions by an audit partner’s subordinates will not be detected.

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Case 2.1 Jack Greenberg, Inc. 101

CASE 2.1

JACK GREENBERG, INC.

Synopsis In the mid-1980s, Emanuel and Fred Greenberg each inherited a 50 percent ownership interest in a successful wholesale business established and operated for decades by their father. Philadelphiabased Jack Greenberg, Inc., (JGI) sold food products, principally meat and cheese, to restaurants and other wholesale customers up and down the eastern seaboard. The company’s largest product line was imported meat products. Following their father’s death, Emanuel became JGI’s president, while Fred accepted the title of vice-president. In the latter role, Fred was responsible for all decisions regarding the company’s imported meat products. When JGI purchased these products, they were initially charged to a separate inventory account known as Prepaid Inventory, the company’s largest account. When these products were received weeks or months later, they were transferred to the Merchandise Inventory account.

In 1986, the Greenberg brothers hired Steve Cohn, a former Coopers & Lybrand employee, to modernize their company’s archaic accounting system. Cohn successfully updated each segment of JGI’s accounting system with the exception of the module involving prepaid inventory. Despite repeated attempts by Cohn to convince Fred Greenberg to “computerize” the prepaid inventory accounting module, Fred resisted. In fact, Fred had reason to resist since he had been manipulating JGI’s periodic operating results for several years by overstating its prepaid inventory.

From 1986 through 1994, Grant Thornton audited JGI’s annual financial statements, which were intended principally for the benefit of the company’s three banks. Grant Thornton, like Steve Cohn, failed to persuade Fred Greenberg to modernize the prepaid inventory accounting module. Finally, in 1994, when Fred refused to make certain changes in that module that were mandated by Grant Thornton, the accounting firm threatened to resign. Shortly thereafter, Fred’s fraudulent scheme was uncovered. Within six months, JGI was bankrupt and Grant Thornton was facing a series of allegations filed against it by the company’s bankruptcy trustee. Among these allegations were charges that the accounting firm had made numerous errors and oversights in auditing JGI’s Prepaid Inventory account. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.1 Jack Greenberg, Inc. 102 Jack Greenberg, Inc.--Key Facts 1.

Emanuel and Fred Greenberg became equal partners in Jack Greenberg, Inc., (JGI) following their father’s death; Emanuel became the company’s president, while Fred assumed the title of vice-president.

2.

JGI was a Philadelphia-based wholesaler of various food products whose largest product line was imported meat products.

3.

Similar to many family-owned businesses, JGI had historically not placed a heavy emphasis on internal control issues.

4.

In 1986, the Greenberg brothers hired Steve Cohn, a former Coopers & Lybrand auditor and inventory specialist, to serve as JGI’s controller.

5.

Cohn implemented a wide range of improvements in JGI’s accounting and control systems; these improvements included “computerizing” the company’s major accounting modules with the exception of prepaid inventory—Prepaid Inventory was JGI’s largest and most important account.

6.

Since before his father’s death, Fred Greenberg had been responsible for all purchasing, accounting, control, and business decisions involving the company’s prepaid inventory.

7.

Fred stubbornly resisted Cohn’s repeated attempts to modernize the accounting and control decisions for prepaid inventory.

8.

Fred refused to cooperate with Cohn because he had been manipulating JGI’s operating results for years by systematically overstating the large Prepaid Inventory account.

9.

When Grant Thornton, JGI’s independent auditor, threatened to resign if Fred did not make certain improvements in the prepaid inventory accounting module, Fred’s scheme was discovered.

10. Grant Thornton was ultimately sued by JGI’s bankruptcy trustee; the trustee alleged that the accounting firm had made critical mistakes in its annual audits of JGI, including relying almost exclusively on internally-prepared documents to corroborate the company’s prepaid inventory.

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Case 2.1 Jack Greenberg, Inc. 103

Instructional Objectives 1.

To introduce students to the key audit objectives for inventory.

2.

To demonstrate the importance of auditors obtaining a thorough understanding of a client’s accounting and internal control systems.

3.

To examine the competence of audit evidence yielded by internally-prepared versus externallyprepared client documents.

4.

To identify audit risk issues common to family-owned businesses.

5.

To demonstrate the importance of auditors fully investigating suspicious circumstances they discover in a client’s accounting and control systems and business environment.

Suggestions for Use

One of my most important objectives in teaching an auditing course, particularly an introductory auditing course, is to convey to students the critical importance of auditors maintaining a healthy degree of skepticism on every engagement. That trait or attribute should prompt auditors to thoroughly investigate and document suspicious circumstances that they encounter during an audit.

In this case, the auditors were faced with a situation in which a client executive stubbornly refused to adopt much needed improvements in an accounting module that he controlled. In hindsight, most of us would view such a scenario as a “where there’s smoke, there’s likely fire” situation.

Since the litigation in this case was resolved privately, the case does not have a clear-cut “outcome.” As a result, you might divide your students into teams to “litigate” the case themselves.

Identify three groups of students: one set of students who will argue the point that the auditors in this case were guilty of some degree of malfeasance, another set of students who will act as the auditors’ defense counsel, and a third set of students (the remainder of your class?) who will serve as the “jury.”

Suggested Solutions to Case Questions 1. AS 1101.04, “Audit Risk,” of the PCAOB auditing standards defines audit risk as the “risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated, i.e., the financial statements are not presented fairly in conformity with the applicable financial reporting framework.” “Inherent risk,” “control risk,” and “detection” risk are the three individual components of audit risk, according to AS 1101. Following are brief descriptions of these components that were also taken that standard: © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.1 Jack Greenberg, Inc. 104 • Inherent risk: refers to the susceptibility of an assertion to a misstatement, due to error or fraud, that

could be material, individually or in combination with other misstatements, before consideration of any related controls.

• Control risk: the risk that a misstatement due to error or fraud that could occur in an assertion and that could be material, individually or in combination with other misstatements, will not be prevented or detected on a timely basis by the company’s internal control. Control risk is a function of the effectiveness of the design and operation of internal control.

• Detection risk: the risk that the procedures performed by the auditor will not detect a misstatement that exists and that could be material, individually or in combination with other misstatements.

Detection risk is affected by (1) the effectiveness of the substantive procedures and (2) their application by the auditor, i.e., whether the procedures were performed with due professional care.

According to the AICPA Professional Standards, the phrase “audit risk” refers to the likelihood that “the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated” (AU-C 200.14). “Inherent risk,” “control risk,” and “detection” risk are also the three individual components of audit risk within the AICPA Professional Standards. Following are brief descriptions of these components that were taken from AU-C 200.14: • Inherent risk: the susceptibility of an assertion about a class of transaction, account balance, or

disclosure to a misstatement that could be material, either individually or when aggregated with other misstatements, before consideration of any related controls.

• Control risk: the risk that a misstatement that could occur in an assertion about a class of transaction, account balance, or disclosure and that could be material, either individually or when aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely basis by the entity’s internal controls.

• Detection risk: the risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a misstatement that exists and that could be material, either individually or when aggregated with other misstatements.

(Note: Both AS 1101 and the AICPA Professional Standards point out that the product of inherent risk and control risk is commonly referred to as the “risk of material misstatement.)

Listed next are some examples of audit risk factors that are not unique to family-owned businesses but likely common to them.

Inherent risk: • I would suggest that family-owned businesses may be more inclined to petty infighting and other interpersonal “issues” than businesses overseen by professional management teams. Such conflict may cause family-owned businesses to be more susceptible to intentional financial statement misrepresentations.

• The undeniable impact of nepotism on most family-owned businesses may result in key accounting and other positions being filled by individuals who do not have the requisite skills for those positions. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.1 Jack Greenberg, Inc. 105 • Many family-owned businesses are small and financially-strapped. Such businesses are more

inclined to window-dress their financial statements to impress bankers, potential suppliers, and other third parties.

Control risk: • The potential for “petty infighting” and other interpersonal problems within family-owned businesses may result in their internal control policies and procedures being intentionally subverted by malcontents.

• Likewise, nepotism tendencies in small businesses can affect the control risk as well as the inherent risk posed by these businesses. A business that has a less than competent controller or accounts receivable bookkeeper, for that matter, is more likely to have control “problems.”

• The limited resources of many family-owned businesses means that they are less likely than other entities to provide for a comprehensive set of checks and balances in their accounting and control systems. For example, proper segregation of duties may not be possible in these businesses.

• I would suggest that it may be more difficult for family-owned businesses to establish a proper control environment. Family relationships, by definition, are typically built on trust, while business relationships require a certain degree of skepticism. A family business may find it difficult to establish formal policies and procedures that require certain family members to “look over the shoulder” and otherwise monitor the work of other family members.

Detection risk: • The relatively small size of many family-owned businesses likely requires them to bargain with their auditors to obtain an annual audit at the lowest cost possible. Such bargaining may result in auditors “cutting corners” to complete the audit.

• Independent auditors often serve as informal business advisors for small, family-owned audit clients. These dual roles may interfere with the ability of auditors to objectively evaluate such a client’s financial statements.

How should auditors address these risk factors? Generally, by varying the nature, extent, and timing of their audit tests. For example, if a client does not have sufficient segregation of key duties, then the audit team will have to take this factor into consideration in planning the annual audit. In the latter circumstance, one strategy would be to perform a “balance sheet” audit that places little emphasis or reliance on the client’s internal controls. (Note: Modifying the nature, extent, and timing of audit tests may not be a sufficient or proper response to the potential detection risk factors identified above. Since each of those risk factors involves an auditor independence issue, the only possible response to those factors may simply be asking the given client to retain another audit firm.)

Final note: Recall that the federal judge in this case suggested that “subjecting the auditors to potential liability” is an appropriate strategy for society to use to help ensure that family-owned businesses prepare reliable financial statements for the benefit of third-party financial statement users.

You may want to have your students consider how this attitude on the part of judges affects audit firms and the audits that they design and perform for such clients. In my view, this factor is not a component of “audit risk” but clearly poses a significant economic or “business” risk for audit firms. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.1 Jack Greenberg, Inc. 106 2. The primary audit objectives for a client’s inventory are typically corroborating the “existence” and “valuation” assertions (related to account balances). For the Prepaid Inventory account, Grant Thornton’s primary audit objective likely centered on the existence assertion. That is, did the several million dollars of inventory included in the year-balance of that account actually exist? Inextricably related to this assertion was the issue of whether JGI management had achieved a proper “cutoff” of the prepaid inventory transactions at the end of each fiscal year. If management failed to ensure that prepaid inventory receipts were properly processed near the end of the year, then certain prepaid inventory shipments might be included in the year-end balances of both Prepaid Inventory and Merchandise Inventory. For the Merchandise Inventory account, both the existence and valuation assertions were likely key concerns of Grant Thornton. Since JGI’s inventory involved perishable products, the Grant Thornton auditors certainly had to pay particularly close attention to the condition of that inventory while observing the year-end counting of the warehouse.

3. The controversial issue in this context is whether Grant Thornton was justified in relying on the delivery receipts given the “segregation of duties” that existed between JGI’s receiving function and accounting function for prepaid inventory. In one sense, Grant Thornton was correct in maintaining that there was “segregation of duties” between the preparation of the delivery receipts and the subsequent accounting treatment applied to those receipts. The warehouse manager prepared the delivery receipts independently of Fred Greenberg, who then processed the delivery receipts for accounting purposes. However, was this segregation of duties sufficient or “adequate”? In fact, Fred Greenberg had the ability to completely override (and did override) that control.

You may want to reinforce to your students that the validity of the delivery receipts as audit evidence was a central issue in this case. Clearly, the judge who presided over the case was dismayed

by Grant Thornton’s decision to place heavy reliance on the delivery receipts in deciding to “sign off” on the prepaid inventory balance each year. The problem with practically any internally-generated document, such as the delivery receipts, is that they are susceptible to being subverted by two or more client employees who collude with each other or by one self-interested executive who has the ability to override the client’s internal controls. On the other hand, externally-prepared documents (such as contracts or external purchase orders) provide stronger audit evidence since they are less susceptible to being altered or improperly prepared.

4. The phrase “walk-through audit test” refers to the selection of a small number of client transactions and then tracking those transactions through the standard steps or procedures that the client uses in processing such transactions. The primary purpose of these tests is to gain a better understanding of a client’s accounting and control system for specific types of transactions. Likewise, walk-through tests can be used by auditors to confirm the accuracy of flowchart and/or narrative depictions of a given transaction cycle within a client’s accounting and control system. (Note: as pointed out by the expert witness retained by JGI’s bankruptcy trustee, if Grant Thornton had performed a walk-through audit test for JGI’s prepaid inventory transactions, the audit firm almost certainly would have discovered that the all-important Form 9540-1 documents were available for internal control and independent audit purposes.)

PCAOB Auditing Standard No. 2, “An Audit of Internal Control Over Financial Reporting © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.1 Jack Greenberg, Inc. 107 Performed in Conjunction with an Audit of Financial Statements,” mandated that auditors of SEC registrants perform a walk-through audit test for “each major class of transactions”—see paragraph 79 of that standard. However, that standard was subsequently superseded by PCAOB Auditing Standard No. 5, “An Audit of Internal Control Over Financial Reporting That is Integrated with An Audit of Financial Statements”—which is now integrated into AS 2201. AS 2201 does not require walk-throughs. The AICPA Professional Standards have never mandated the performance of walkthroughs.

5. As a point of information, I have found that students typically enjoy this type of exercise, namely, identifying audit procedures that might have resulted in the discovery of a fraudulent scheme. In fact, what students enjoy the most in this context is “shooting holes” in suggestions made by their colleagues. “That wouldn’t have worked because . . .,” “That would have been too costly,” or “How could you expect them to think of that?” are the types of statements that are often prompted when students begin debating their choices. Of course, such debates can provide students with important insights that they would not have obtained otherwise.

• During the interim tests of controls each year, the auditors could have collected copies of a

sample of delivery receipts. Then, the auditors could have traced these delivery receipts into the prepaid inventory accounting records to determine whether shipments of imported meat products were being recorded on a timely basis in those records. For example, the auditors could have examined the prepaid inventory log to determine when the given shipments were deleted from that record. Likewise, the auditors could have tracked the shipments linked to the sample delivery receipts into the relevant reclassification entry prepared by Steve Cohn (that transferred the given inventory items from Prepaid Inventory to Merchandise Inventory) to determine if this entry had been made on a timely basis. (Granted, the effectiveness of this audit test would likely have been undermined by Fred’s fraudulent conduct.)

• Similar to the prior suggestion, the auditors could have obtained copies of the freight documents (bills of lading, etc.) for a sample of prepaid inventory shipments. Then, the auditors could have tracked the given shipments into the prepaid inventory records to determine whether those shipments had been transferred on a timely basis from the Prepaid Inventory account to the Merchandise Inventory account. (There would have been a lower risk of Fred’s misconduct undercutting the intent of this audit test.)

• During the observation of the physical inventory, the auditors might have been able to collect identifying information for certain imported meat products and then, later in the audit, traced that information back to the prepaid inventory log to determine whether the given items had been reclassified out of Prepaid Inventory on a timely basis. This procedure may have been particularly feasible for certain seasonal and low volume products that JGI purchased for sale only during the year-end holiday season.

• In retrospect, it seems that extensive analytical tests of JGI’s financial data might have revealed implausible relationships involving the company’s inventory, cost of goods sold, accounts payable, and related accounts. Of course, the judge who presided over this case suggested that the auditors should have been alerted to the possibility that something was awry by the dramatic increase in prepaid inventory relative to sales. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.1 Jack Greenberg, Inc. 108 6. An audit firm (of either an SEC registrant or another type of entity) does not have a responsibility to “insist” that client management correct internal control deficiencies. However, the failure of client executives to do so reflects poorly on their overall control consciousness, if not integrity. Similar to what happened in this case, an audit firm may have to consider resigning from an engagement if client management refuses to address significant internal control problems. (Of course, in some circumstances, client management may refuse to address internal control deficiencies because it would not be cost-effective to do so.)

Note: AS 2201, “An Audit of Internal Control Over Financial Reporting That is Integrated with An Audit of Financial Statements,” provides guidance to auditors charged with auditing a public client’s financial statements while at the same time auditing the client’s internal control over financial reporting. AS 2201.78 mandates that auditors report all “material weaknesses” in writing to client management and to the audit committee. Likewise, auditors must report to the client’s audit committee all “significant deficiencies” in internal controls that they discover (AS 2201.80). But, again, AS 2201 does not require auditors to “insist” that their clients eliminate those material weaknesses or significant deficiencies.

Final note: in the AICPA Professional Standards, the reporting responsibilities of auditors for internal control related matters are discussed in AU-Section 265, “Communicating Internal Control Related Matters Identified in an Audit.”

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Case 2.2 Golden Bear Golf, Inc. 109

CASE 2.2

GOLDEN BEAR GOLF, INC.

Synopsis According to one sports announcer, Jack Nicklaus became “a legend in his spare time.” Nicklaus still ranks as the best golfer of all time in the minds of most pasture pool aficionados—granted, he may lose that title soon if Tiger Woods conquers his health problems and resumes his onslaught on Jack’s golfing records. Despite his prowess on the golf course, Nicklaus has had an up and down career in the business world. In 1996, Nicklaus spun off a division of his privately-owned company to create Golden Bear Golf, Inc., a public company whose primary line of business was the construction of golf courses. Almost immediately, Golden Bear began creating headaches for Nicklaus. The new company was very successful in obtaining contracts to build golf courses. However, because the construction costs for these projects were underestimated, Golden Bear soon found itself facing huge operating losses. Rather than admit their mistakes, the executives who negotiated the construction contracts intentionally inflated the revenues and gross profits for those projects by misapplying the percentage-of-completion accounting method.

This case focuses principally on the audits of Golden Bear that were performed by Arthur Andersen & Co. An SEC investigation of the Golden Bear debacle identified numerous “audit failures” allegedly made by the company’s auditors. In particular, the Andersen auditors naively relied on feeble explanations provided to them by client personnel for a series of suspicious transactions and circumstances that they uncovered.

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Case 2.2 Golden Bear Golf, Inc. 110 Golden Bear Golf, Inc.--Key Facts 1.

Jack Nicklaus has had a long and incredibly successful career as a professional golfer, which was capped off by him being named the Player of the Twentieth Century.

2.

Like many professional athletes, Nicklaus became involved in a wide range of business interests related to his sport.

3.

In the mid-1980s, Nicklaus’s private company, Golden Bear International (GBI), was on the verge of bankruptcy when he stepped in and named himself CEO; within a few years, the company had returned to a profitable condition.

4.

In 1996, Nicklaus decided to “spin off” a part of GBI to create a publicly owned company, Golden Bear Golf, Inc., whose primary line of business would be the construction of golf courses.

5.

Paragon International, the Golden Bear subsidiary responsible for the company’s golf course construction business, quickly signed more than one dozen contracts to build golf courses.

6.

Paragon incurred large losses on many of the golf course construction projects because the subsidiary’s management team underestimated the cost of completing those projects.

7.

Rather than admit their mistakes, Paragon’s top executives chose to misrepresent the subsidiary’s operating results by misapplying the percentage-of-completion accounting method.

8.

In 1998, the fraudulent scheme was discovered, which resulted in a restatement of Golden Bear’s financial statements, a class-action lawsuit filed by the company’s stockholders, and SEC sanctions imposed on several parties, including Arthur Andersen, Golden Bear’s audit firm.

9.

The SEC charged the Andersen auditors with committing several “audit failures,” primary among them was relying on oral representations by client management for several suspicious transactions and events discovered during the Golden Bear audits.

10. The Andersen partner who served as Golden Bear’s audit engagement partner was suspended from practicing before the SEC for one year.

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.2 Golden Bear Golf, Inc. 111

Instructional Objectives 1.

To demonstrate the need for auditors to have an appropriate level of skepticism regarding the financial statements of all audit clients, including prominent or high-profile audit clients.

2.

To demonstrate that management representations is a weak form of audit evidence.

3.

To examine audit risks posed by the percentage-of-completion accounting method.

4.

To illustrate the need for auditors to thoroughly investigate suspicious transactions and events that they discover during the course of an engagement.

5.

To examine the meaning of the phrase “audit failure.”

Suggestions for Use

Many, if not most, of your students will be very familiar with Jack Nicklaus and his sterling professional golf career, which should heighten their interest in this case. One of the most important learning points in this case is that auditors must always retain their professional skepticism.

Encourage your students to place themselves in Michael Sullivan’s position. Sullivan had just acquired a new audit client, the major stockholder of which was one of the true superstars of the sports world. I can easily understand that an audit engagement partner and his or her subordinates might be inclined to grant that client the “benefit of the doubt” regarding any major audit issues or problems that arise. Nevertheless, even in such circumstances students need to recognize the importance of auditors’ maintaining an appropriate degree of professional skepticism.

You may want to point out to your students that because of the subjective nature of the percentage-of-completion accounting method, it is easily one of the most abused accounting methods.

Over the years, there have been numerous “audit failures” stemming from misuse or misapplication of this accounting method.

Suggested Solutions to Case Questions 1. Notes: I have not attempted to identify every management assertion relevant to Paragon’s construction projects. Instead, this suggested solution lists what I believe were several key management assertions for those projects. When auditing long-term construction projects for which the percentage-of-completion accounting method is being used, the critical audit issue is whether the client’s estimated stages of completion for its projects are reliable. As a result, most of the following audit issues that I raise regarding Paragon’s projects relate directly or indirectly to that issue. In this suggested solution, I apply the set of assertions included in AU-C Section 315.A128 of the AICPA Professional Standards. Recall that rather than 13 assertions spread across three categories (classes © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.2 Golden Bear Golf, Inc. 112 of transactions and events, account balances, and presentation and disclosure), AS 1105, “Audit Evidence,” of the PCAOB’s auditing standards identifies only five types of financial statement assertions, namely, existence or occurrence, completeness, valuation or allocation, rights and obligations, and presentation and disclosure (AS 1105.11). (Of course, these latter assertions were the “official” assertions recognized by the AICPA at the time this case transpired. Recognize also that the PCAOB permits auditors to apply the AICPA’s “assertions map” in planning and performing audits of public companies. That is, audit firms of SEC registrants are free to choose which of the two mappings of management assertions in the professional auditing standards that they will apply.)

• Existence/occurrence: According to AU-C 315.A128, “existence” is an “account balance-related”

assertion that refers to whether specific assets or liabilities exist at a given date. “Occurrence,” on the other hand, is a “transaction-related” assertion that refers to whether a given transaction or class of transactions actually took place. On the Golden Bear audits, these two assertions were intertwined.

The existence assertion pertained to the unbilled receivables, while the occurrence assertion related to the corresponding revenue linked to those receivables, each of which Paragon booked as a result of overstating the stages of completion of its construction projects. To investigate whether those unbilled receivables actually existed and whether the related revenue transactions had actually occurred, the Andersen auditors could have made site visitations to the construction projects.

Andersen could also have contacted the given owners of the projects to obtain their opinion on the stages of completion of the projects—if the stages of completion were overstated, some portion of the given unbilled receivables did not “exist” while the corresponding revenues had not “occurred.”

(Of course, this procedure was carried out for one of the projects by subordinate members of the Andersen audit team.) The auditors could have also discussed the stages of completion directly with the onsite project managers and/or the projects’ architects.

• Valuation (and allocation): This account balance assertion relates to whether “assets, liabilities, and

equity interests are included in the financial statements at appropriate amounts” and whether “any resulting valuation or allocation adjustments are appropriately recorded” (AU-C 315.A128). This assertion was relevant to the unbilled receivables that Paragon recorded on its construction projects and was obviously closely linked to the existence assertion for those receivables. Again, any audit procedure that was intended to confirm the reported stages of completion of Paragon’s construction projects would have been relevant to this assertion. Michael Sullivan attempted to address this assertion by requiring the preparation of the comparative schedules that tracked the revenue recorded on Paragon’s projects under the earned value method and the revenue that would have been recorded if Paragon had continued to apply the cost-to-cost method. Of course, client management used the $4 million ruse involving the uninvoiced construction costs to make it appear that the two accounting methods produced effectively the same revenues/unbilled receivables.

• Occurrence: The occurrence assertion was extremely relevant to the $4 million of uninvoiced

construction costs that Paragon recorded as an adjusting entry at the end of fiscal 1997. The uninvoiced construction costs allowed Paragon to justify booking a large amount of revenue on its construction projects. To test this assertion, the Andersen auditors could have attempted to confirm some of the individual amounts included in the $4 million figure with Paragon’s vendors. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.2 Golden Bear Golf, Inc. 113 • Classification and understandability: This presentation and disclosure-related assertion was relevant

to the change that Paragon made from the cost-to-cost to the earned value approach to applying the percentage-of-completion accounting method. By not disclosing the change that was made in applying the percentage-of-completion accounting method, Golden Bear and Paragon’s management were making an assertion to the effect that the change was not required to be disclosed to financial statement users. This assertion could have been tested by researching the appropriate professional standards and/or by referring the matter to consultants in Andersen’s national headquarters office.

• Completeness: Although not addressed explicitly in the case, the SEC also criticized Andersen for not attempting to determine whether Paragon’s total estimated costs for its individual construction projects were reasonable, that is, “complete”—understating a project’s total estimated cost allowed Golden Bear to “frontload” the revenue recorded for that project. To corroborate the completeness assertion for the estimated total construction costs, Andersen could have discussed this matter with architects and/or design engineers for a sample of the projects. Alternatively, Andersen could have reviewed cost estimates for comparable projects being completed by other companies and compared those estimates with the ones developed for Paragon’s projects.

2. The term “audit failure” is not expressly defined in the professional literature. Apparently, the SEC has never defined that term either. One seemingly reasonable way to define “audit failure” would be “the failure of an auditor to comply with one or more professional auditing standards.” A more general and legal definition of “audit failure” would be “the failure to do what a prudent practitioner would have done in similar circumstances.” The latter principle is commonly referred to as the “prudent practitioner concept” and is widely applied across professional roles to determine whether a given practicing professional has behaved negligently.

“No,” Sullivan alone was clearly not the only individual responsible for ensuring the integrity of the Golden Bear audits. Sullivan’s subordinates, particularly the audit manager and audit senior assigned to the engagement, had a responsibility to ensure that all important issues arising on those audits were properly addressed and resolved. This latter responsibility included directly challenging any decisions made by Sullivan that those subordinates believed were inappropriate. Audit practitioners, including audit partners, are not infallible and must often rely on their associates and subordinates to question important “judgment calls” that are made during the course of an engagement. The “concurring” or “review” partner assigned to the Golden Bear audits also had a responsibility to review the Golden Bear audit plan and audit workpapers and investigate any questionable decisions apparently made during the course of the Golden Bear audits. Finally, Golden Bear’s management personnel, including Paragon’s executives, had a responsibility to cooperate fully with Sullivan to ensure that a proper audit opinion was issued on Golden Bear’s periodic financial statements.

3. Most likely, Andersen defined a “high-risk” audit engagement as one on which there was higher than normal risk of intentional or unintentional misrepresentations in the given client’s financial statements. I would suggest that the ultimate responsibility of an audit team is the same on both a “high-risk” and a “normal risk” audit engagement, namely, to collect sufficient appropriate evidence to arrive at an opinion on the given client’s financial statements. However, the nature of the © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.2 Golden Bear Golf, Inc. 114 operational responsibilities facing an audit team on the two types of engagements are clearly different.

For example, when a disproportionate number of “fraud risk factors” are present, the planning of an audit will be affected. Likewise, in the latter situation, the nature, extent, and timing of audit procedures will likely be affected. For example, more extensive auditing tests are typically necessary when numerous fraud risk factors are present.

4. “Yes,” auditors do have a responsibility to refer to any relevant AICPA Audit and Accounting Guide when planning and carrying out an audit based upon the AICPA Professional Standards. These guides do not replace the authoritative guidance included in AICPA Professional Standards but rather include recommendations on how to apply those standards in specific circumstances. What about audits of public companies that are guided by the PCAOB’s auditing standards? After considerable research, I could not find any reference to the AICPA Audit and Accounting Guides in the PCAOB’s auditing standards. As a result, those guides, apparently, are not considered authoritative literature vis-à-vis audits of public companies.

5. The following footnote was included in Accounting and Auditing Enforcement Release No. 1676, which was a primary source for the development of this case. “Regardless of whether the adoption of the ‘earned value’ method was considered a change in accounting principle or a change in accounting estimate, disclosure by the company in its second quarter 1997 interim financial statements and its 1997 annual financial statements was required to comply with GAAP.” In the text of the enforcement release, the SEC referred to the switch from the cost-to-cost method to the earned value method as a change in “accounting methodology,” which seems to suggest that the SEC was not certain how to classify the change. However, APB Opinion No. 20, “Accounting Changes,” which was in effect during the relevant time frame of this case, and SFAS No. 154, “Accounting Changes and Error Corrections,” the FASB standard that replaced APB No. 20, point out that the phrase “accounting principle” refers to accounting principles or practices and “to the methods of applying them.” This statement implies, to me at least, that Paragon’s switch from the cost-to-cost approach to the earned value approach of applying the percentage-of-completion accounting method was a “change in accounting principle.”

Under SFAS No. 154, a change in accounting principle “shall be reported by retrospective application unless it is impracticable to determine either the cumulative effect or the period-specific effects of the change.” [Note: SFAS No. 154 is now integrated into Topic 250, “Accounting Changes and Error Corrections,” in the FASB Accounting Standards Codification.] This is an important difference with the prior standard, APB No. 20, that required a “cumulative effect of a change in accounting principle” to be reported by the given entity in its income statement for the period in which the change was made. SFAS No. 154 requires that a change in accounting estimate “shall be accounted for in the (a) period of change if the change affects that period only or (b) the period of change and future periods if the change affects both.”

In terms of financial statement disclosure, SFAS No. 154 mandates that the “nature of and justification for the change in accounting principle shall be disclosed in the financial statements of the period in which the change is made.” Regarding changes in accounting estimates, this standard notes that, “When an entity makes a change in accounting estimate that affects several future periods (such as a change in service lives of depreciable assets), it shall disclose the effect on . . . net income, and © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.2 Golden Bear Golf, Inc. 115 related per-share amounts of the current period.”

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Case 2.3 Take-Two Interactive Software, Inc.115

CASE 2.3

TAKE-TWO INTERACTIVE SOFTWARE, INC.

Synopsis Grand Theft Auto is the sixth best-selling video game “franchise” of all time and easily ranks among the most controversial as well. The game’s “adult” content has resulted in caustic and unrelenting criticism by prominent politicians, public service organizations, and major media outlets.

Despite that criticism, Grand Theft Auto has been hugely profitable for Take-Two Interactive Software, Inc., its maker and distributor. Take-Two was founded in 1993 by 21-year-old Ryan Brant, the son of a billionaire businessman.

An SEC investigation of Take-Two’s financial statements resulted in the company being forced to issue restated financial statements twice in two years shortly after the turn of the century. Then, just a few years later, Take-Two was caught up in the huge “options backdating” scandal and forced to restate its financial statements a third time. This case focuses on the underlying cause of the initial restatement, which was primarily a series of fraudulent sales transactions booked by the company in 2000 and 2001. Take-Two executives recorded those sham sales transactions to ensure that the company met or surpassed its consensus quarterly earnings forecasts established by Wall Street analysts.

Take-Two’s longtime audit firm, PwC, was also caught up in the company’s financial reporting scandal. One of many SEC enforcement releases issued regarding that scandal focused on the alleged misconduct of Robert Fish, the PwC partner who had supervised the 1994 through 2001 Take-Two audits. In particular, the SEC criticized the audit tests applied to Take-Two’s domestic receivables by Fish and his subordinates. In addition, the PwC auditors were chastised by the SEC for their alleged failure to properly audit Take-Two’s reserve for sales returns.

An interesting feature of this case is the close relationship between Robert Fish and Ryan Brant.

In addition to serving as the Take-Two audit engagement partner, Fish was apparently the much younger Brant’s most trusted business advisor. In fact, in an interview with a business publication Fish suggested that he and Brant effectively had a father-son type relationship. Also interesting is the fact that PwC sharply discounted the professional fees that it charged Take-Two. Those discounted fees almost certainly helped to cement PwC’s relationship with the rapidly growing company.

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116

Case 2.3 Take-Two Interactive Software, Inc. Take-Two Interactive Software, Inc.--Key Facts

1.

In 1993, when he was only 21-years-old, Ryan Brant organized Take-Two Interactive Software, a company that produced and distributed video games.

2. Robert Fish, a PwC audit partner, supervised the annual audits of Take-Two from 1994-2001; Fish also served as one of Brant’s principal business advisors and, when interviewed, suggested that he had a father-son type relationship with the much younger Brant.

3. While Take-Two was in a developmental stage, PwC sharply discounted the professional fees that it charged the company.

4.

Brant took his company public in 1997 to obtain the funding necessary to fuel Take-Two’s growth-by-acquisition strategy.

5. A video game produced by a company acquired by Take-Two would become Grand Theft Auto, one of the most controversial but best-selling video games of all time.

6. An SEC investigation revealed that Take-Two executives recorded a large volume of bogus sales transactions during 2000 and 2001 to ensure that the company achieved its consensus earnings forecasts each quarterly reporting period.

7.

Take-Two would ultimately be required to restate its financial statements three times over a fiveyear period to correct material misrepresentations resulting from the bogus sales transactions and improper “backdating” of stock option grants.

8.

The SEC issued an enforcement release that criticized PwC’s 2000 Take-Two audit; the enforcement release focused on improper decisions allegedly made by Robert Fish during that engagement.

9. Fish identified “revenue recognition” and “accounts receivable reserves” as areas of “higher risk” for the 2000 audit, according to the SEC, but failed to properly respond to those high-risk areas during the engagement.

10. The “alternative audit procedures” that PwC applied after realizing an extremely low response rate on its accounts receivable confirmation requests were flawed and inadequate.

11. PwC also failed to properly audit Take-Two’s reserve for sales returns, which may have prevented the firm from discovering the bogus sales recorded by the company.

12. The SEC sanctioned Fish, Brant, and three other Take-Two executives; Brant resigned from Take-Two during the SEC’s investigation of the company’s scheme to backdate its stock option grants, a scheme that he had masterminded. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.3 Take-Two Interactive Software, Inc.117

Instructional Objectives 1.

To provide students with an opportunity to use analytical procedures as an audit planning tool.

2.

To examine the nature of, and key audit objectives associated with, accounts receivable confirmation procedures and related “alternative audit procedures.”

3.

To examine the meaning of “negligent,” “reckless,” and “fraudulent” as those terms relate to auditor misconduct or malfeasance.

4.

To identify circumstances that may threaten the de facto and apparent independence of auditors.

Suggestions for Use

You might begin class coverage of this case by asking for a show of hands of those students who have played one or more versions of Grand Theft Auto. If you have “age appropriate” college students, you will likely find that most of your male students have played the game, while just a smattering of your female students have experienced the game. After asking for the show of hands, I typically single out individual students and ask them to comment on whether or not they believe the game is morally objectionable. More often than not, I receive a reply similar to the following: “It’s only a game!” [By the way, I have never played the game myself, although I was well aware of it and its controversial content before I developed this case.] Next, I tend to segue into a discussion of the final case question, namely, whether audit firms should accept “ethically-challenged” companies and organizations as clients. That issue often spawns a far-ranging, if not raucous, debate among students. I have found that students also enjoy debating and discussing the two auditor independence issues raised in this case: the question of whether the “father-son” relationship between the client CEO and the audit engagement partner was problematic and the question of whether PwC’s independence was in any way impaired by the heavy discounting of fees charged to Take-Two when it was in a developmental stage.

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Case 2.3 Take-Two Interactive Software, Inc.

Suggested Solutions to Case Questions 1. Following are the requested financial ratios for Take-Two for the period 1998-2000. Notice that the accounts receivable turnover and inventory turnover ratios are also provided.

Financial Ratios for Take-Two:

Age of Accts Receivable* Age of Inventory* Gross Profit Percentage Profit Margin Percentage Return on Assets Return on Equity Current Ratio Debt to Equity Ratio Quality of Earnings Ratio

2000

1999

1998

114.4 63.5 36.0% 6.5% 8.6% 18.3% 1.41 .88 -2.21

93.6 57.2 29.7% 5.3% 9.6% 27.1% 1.28 1.72 -1.03

80.4 57.9 24.0% 3.7% 8.7% 30.2% 1.30 2.08 -1.12

3.19 5.75

3.90 6.38

4.54 6.30

* In days Accts Receivable Turnover Inventory Turnover

Equations: A/R Turnover: net sales / average accounts receivable Age of A/R: 365 days / accounts receivable turnover Inventory Turnover: cost of goods sold / average inventory Age of Inventory: 365 days / inventory turnover Gross Profit Percentage: gross profit / net sales Profit Margin Percentage: net income / net sales Return on Assets: net income / average total assets Return on Equity: net income / average stockholders' equity Current Ratio: current assets / current liabilities Debt to Equity: total liabilities / total stockholders’ equity Quality of Earnings: net operating cash flows / net income Discussion: The most prominent red flag revealed by these ratios is the extremely poor “quality of earnings” being produced by Take-Two over this three-year time frame. Investors want and expect a company to have a quality of earnings ratio higher than 1.0. Simply from a mathematical standpoint, you would expect a company to have a greater than 1.0 quality of earnings ratio because of noncash © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.3 Take-Two Interactive Software, Inc.119 expenses, principally depreciation expense. A large number of factors may collectively or individually produce a negative quality of earnings ratio for a given company. One such factor is the recording of fraudulent sales—the bogus accounts receivable due to fraudulent sales simply “pile up” on the given company’s balance sheet in such circumstances and cause net income to be higher than net operating cash flows. Notice that the negative quality of earnings ratios being experienced over the time frame 1998-2000 was accompanied by a telltale slowdown in accounts receivable turnover (which, in turn, caused Take-Two’s age of receivables to increase significantly).

Notice also that Take-Two’s age of inventory was increasing between 1998 and 2000 but not as consistently or dramatically as the company’s age of receivables. One cause of an increasing age of inventory is the fact that a company is overstating its period-ending inventory. Consequently, an increasing age of inventory should prompt auditors to focus more attention on the existence and valuation assertions for that account. Note: The SEC did not allege that Take-Two was overstating its inventories. However, given that the company was recording bogus sales/receivables, it is certainly a possibility that it was also overstating its period-ending inventory, particularly given the slowing inventory turnover.

Another key red flag that suggested something may have been awry in Take-Two’s reported operating results was the significant increases in the company’s gross profit percentage and profit margin percentage during the year 2000. As noted in the case, many of Take-Two’s competitors went out of business as a direct result of the challenging economic conditions that accompanied the “tech crash” that began in early 2000. Auditors of a company that is “bucking” such a trend by reporting impressive financial data should definitely consider the possibility that the client is somehow window-dressing its financial statements.

2. "Existence” and “valuation” are the primary management assertions that auditors hope to corroborate when confirming a client’s accounts receivable. Confirmation procedures are particularly useful for supporting the existence assertion. A client’s customer may readily confirm that a certain amount is owed to the client (existence assertion), however, whether that customer is willing and/or able to pay the given amount (valuation assertion) is another issue.

The key difference between positive and negative confirmation requests is that the given third party is asked to respond to a positive confirmation request whether or not the information to be confirmed is accurate, while for a negative confirmation request the third party is asked to respond only if the information to be confirmed is not accurate. Auditors must perform other audit procedures (alternative audit procedures) in those instances in which the third party does not return a positive confirmation request. No follow-up procedures are necessary when the auditor does not receive a response to a negative confirmation request. Given the fundamental difference between positive and negative confirmation requests, the audit evidence yielded by the former is of much higher quality (much more reliable) than audit evidence yielded by the latter.

AS 2310, “The Confirmation Process,” of the PCAOB’s auditing standards is the authoritative source in this context for audits of SEC registrants, such as Take-Two. AU-C Section 505, “External Confirmations,” of the AICPA Professional Standards discusses at length the use of confirmation procedures to collect audit evidence in audits of other types of entities. Both of these sections of the respective standards suggest that negative confirmations provide less persuasive audit evidence than positive confirmations. AS 2310.20 notes that negative confirmation requests may be used by auditors when the following three circumstances are present: “(a) the combined assessed level of © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Case 2.3 Take-Two Interactive Software, Inc.

inherent risk and control risk is low, (b) a large number of small balances is involved, and (c) the auditor has no reason to believe that the recipients of the requests are unlikely to give them consideration.”

3. AS 2310.32 of the PCAOB’s auditing standards identifies the following “alternative procedures” that may be applied by an auditor when a positive confirmation request has failed to produce a response: “examination of subsequent cash receipts (including matching such receipts with the actual items being paid), shipping documents, or other client documentation.” Notice the parenthetical statement which is very relevant to the Take-Two case. The SEC specifically criticized the PwC auditors for failing to “match up” subsequent cash receipts with the actual amounts being paid.

Likewise, PwC only examined $18 million of subsequent cash receipts when the total recorded value of the unconfirmed receivables was approximately $100 million. (Note: Paragraph A24 of AU-C Section 505, “External Confirmations,” of the AICPA Professional Standards identifies the same “alternative procedures” in this context as AS 2310.)

Ironically, the results of alternative audit procedures may, in fact, yield stronger audit evidence than that yielded by a properly returned and signed positive confirmation. This is particularly true when the auditor examines subsequent cash collections and is able to trace those cash receipts to the specific items that were included in the given receivable. Despite this possibility, however, auditors typically prefer that the client’s customers confirm their period-ending balances by signing and returning a positive confirmation request. Why? Because considerably less audit effort is required in such circumstances and the quality of the audit evidence provided is almost always deemed acceptable.

4. The following list of alleged and/or potential deficiencies in the 2000 PwC audit of Take-Two will be helpful in responding to this question: failing to properly respond to high audit risk areas identified during the planning phase of the engagement, failing to investigate why such a modest response rate was received from the positive confirmation requests, failing to determine that the one positive confirmation request received was invalid (see footnote 18), accepting as audit evidence for the unconfirmed receivables subsequent cash receipts that could not be traced to specific invoiced sales amounts, identifying and reviewing only a modest amount of subsequent cash receipts related to the unconfirmed accounts receivable, failing to track the sample of five sales returns to specific invoiced sales transactions or otherwise investigate the validity of those sales returns. Of course, more general, broad-brush allegations were included in the SEC enforcement release. The case notes, for example, that the SEC charged that Fish “failed to exercise due professional care and professional skepticism.”

Following are definitions/descriptions that I have found very useful in helping students distinguish among the three key types of auditor misconduct. These definitions were taken from the following source: D.M. Guy, C.W. Alderman, and A.J. Winters, Auditing, Fifth Edition (San Diego: Dryden, 1999), 85-86.

Negligence. "The failure of the CPA to perform or report on an engagement with the due professional care and competence of a prudent auditor." Example: An auditor fails to test a client's reconciliation of the general ledger controlling account for © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.3 Take-Two Interactive Software, Inc.121 receivables to the subsidiary ledger for receivables and, as a result, fails to detect a material overstatement of the general ledger controlling account.

Recklessness (a term typically used interchangeably with gross negligence and constructive fraud). "A serious occurrence of negligence tantamount to a flagrant or reckless departure from the standard of due care." Example: Evidence collected by an auditor suggests that a client's year-end inventory balance is materially overstated.

Because the auditor is in a hurry to complete the engagement, he fails to investigate the potential inventory overstatement and instead simply accepts the account balance as reported by the client.

Fraud. “Fraud differs from gross negligence [recklessness] in that the auditor does not merely lack reasonable support for belief but has both knowledge of the falsity and intent to deceive a client or third party." Example: An auditor accepts a bribe from a client executive to remain silent regarding material errors in the client's financial statements.

We can certainly conclude that the PwC auditors were not fraudulent in this case because they were unaware of the client’s indiscretions and there was no effort on their part to deceive third-party users of Take-Two’s financial statements. Regarding the question of whether the auditors were negligent or reckless, recognize that the SEC enforcement release that focused on that audit and, in particular, Robert Fish’s role in that audit, did not characterize the mistakes made as negligent or reckless. (Note: The issue of whether or not given auditors were negligent or reckless is often the central issue in a civil lawsuit filed against those auditors but is typically not addressed directly within an SEC enforcement release.) However, the SEC’s enforcement release did strongly criticize Fish’s conduct. For example, the SEC charged that “he failed to exercise due professional care and professional skepticism, and failed to obtain sufficient competent evidential matter” (taken from quote in case). This summary statement suggests that Fish was at least negligent in auditing Take-Two given the above definition of “negligence.”

Was Fish reckless? Since we don’t have access to all of the pertinent information for this case, it is difficult to decide whether or not his misconduct rose to the level of recklessness. Consider having your students debate this issue. What I often do in this type of setting is to have one group of students take one side of such a debate and another group of students take the other side. After a lively give and take between the two competing camps, I then have a third set of students vote (anonymously) to choose the “winner.”

5. Professional auditing standards do not address this issue. Rule-making bodies in the auditing discipline apparently believe that the level of audit fees to be charged on any given audit engagement is an issue that will be properly resolved by the interplay of supply and demand forces in the audit market. It has been alleged in the past that major audit firms attempted to expand their client bases by discounting their fees. In the 10th edition of my casebook, Case 1.7, “Lincoln Savings and Loan Association,” notes that Arthur Young & Company expanded its client base by more than 100 clients in the mid-and late 1980s. Although not mentioned in that case, third parties alleged that Arthur Young used “aggressive pricing” during that “marketing campaign” to significantly increase its client © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Case 2.3 Take-Two Interactive Software, Inc.

portfolio.

I would suggest that, ceteris paribus, it is permissible to discount the audit fees charged to developmental stage companies. Having said that, this practice may create independence issues for the given audit firm. For example, if the audit fee for such a client does not allow the audit firm to recover its costs on the given engagement, then the audit firm might attempt to retain the client over a sufficient period of time to recover those costs and ultimately earn a profit on the relationship with that client. This mindset of needing or wanting to retain the client might induce the audit firm to be less than strict in auditing the client. Why? Because the audit firm may fear that employing a rigorous audit strategy would result in the client severing the relationship.

6. The central issue here is whether Robert Fish maintained his objectivity and independence while supervising the Take-Two audits, given his close relationship with Ryan Brant. The AICPA Code of Professional Conduct provides the following overview of those two important and related traits that auditors should possess.

Objectivity is a state of mind, a quality that lends value to a member’s services. It is a distinguishing feature of the profession. The principle of objectivity imposes the obligation to be impartial, intellectually honest, and free of conflicts of interests. Independence precludes relationships that may appear to impair a member’s objectivity in rendering attestation services (ET 0.300.050.02).

As the AICPA notes, objectivity, which is the underpinning of independence, is a “state of mind.”

Consequently, it is impossible for third parties to discern whether or not an auditor performs a given audit objectively. On the other hand, a close relationship between an auditor and his or her client may cause third parties to question the auditor’s independence. This latter possibility is sufficient to undercut the credibility of the auditor regardless of whether or not he or she maintains an objective mindset during the given engagement.

So, was Fish’s relationship with Brant improper? Given the information conveyed during the interview of Fish that is reported in this case, I believe that at least some professional accountants would respond with a resounding “Yes.” The suggestion that there was a father-son type relationship between the two individuals would likely cause third-party financial statement users to question whether Fish could objectively and independently assess Take-Two’s financial statements that were ultimately the responsibility of Brant.

7. This is a question that I have used as an essay question on many in-class exercises and, occasionally, on the final exam for my graduate auditing seminar. As you might expect, I don’t focus much on the “yes” or “no” answers provided by students but instead analyze the overall quality of the logical reasoning that they provide to support their answers. This question is certainly pertinent to this case because of the wide-ranging criticism that Take-Two has garnered for its Grand Theft Auto game. One strategy that I hope my students apply in responding to this question is to examine the issue it raises from the standpoint of the following six ethical “principles” included in the AICPA Code of Professional Conduct: Responsibilities, The Public Interest, Integrity, Objectivity and Independence, Due Care, and Scope and Nature of Services. Those students who use this strategy typically focus on the Integrity and/or Public Interest principles. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.3 Take-Two Interactive Software, Inc.123

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Case 2.4 General Motors Company 123

CASE 2.4

GENERAL MOTORS COMPANY

Synopsis Billy Durant created General Motors Corporation in 1908 when he merged several automobile manufacturers that he had acquired over the previous few years. For most of the 20th century, GM reigned as the largest automobile producer worldwide and one of the U.S.’s most prominent corporations. By the early years of the 21st century, however, GM’s dominance of the automotive industry was waning in the face of stiff competition from several foreign carmakers. In 2009, Toyota supplanted GM as the world’s largest automotive company in terms of annual sales. That same year, GM filed for bankruptcy after being caught in the undertow of the massive financial crisis that crippled the U.S. economy beginning in late 2008.

Many critics had argued for decades that GM’s executives routinely “doctored” the company’s periodic financial statements to conceal its deteriorating financial health. This case focuses on one feature of the window-dressing efforts of GM. In early 2009, the SEC released the results of a lengthy investigation of GM’s accounting and financial reporting decisions over the previous decade.

A major focus of that investigation was GM’s questionable accounting for its massive pension liabilities and expenses. Among other allegations, the SEC claimed that for fiscal 2002 GM applied an inflated discount rate to its pension liabilities that resulted in those liabilities being materially understated. This case examines the controversy surrounding GM’s pension-related accounting decisions and the role of the company’s longtime audit firm, Deloitte, in those decisions. The case questions require students to consider the types of auditing procedures that should be applied to a client’s pension-related financial statement items.

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Case 2.4 General Motors Company 124

General Motors Company--Key Facts 1.

Billy Durant, who worked as an itinerant salesman as a young man, became extremely wealthy after organizing General Motors in 1908; however, Durant lost his fortune in the stock market and spent the final few years of his life in poverty and relative obscurity.

2.

GM reigned as the world’s largest automobile manufacturer for nearly eight decades until 2009 when it filed for bankruptcy during the midst of a severe economic crisis gripping the U.S. economy.

3.

A key factor that contributed to GM’s downfall was the company’s significant pension and other postretirement benefit expenses that made its cars more costly than those of foreign competitors.

4.

In the decades prior to GM’s bankruptcy filing, critics accused GM executives of “juggling” the company’s reported financial data to conceal its deteriorating financial health; GM’s pensionrelated financial statement amounts were among the items allegedly misrepresented.

5.

Accounting for pension-related financial statement items has long been a controversial issue within the accounting profession; in 1985, the FASB finally adopted a new accounting standard that moved the profession toward accrual basis accounting for those items.

6.

The FASB’s new standard still allowed companies to manipulate their pension-related financial statement amounts because of several key assumptions that had to be made in accounting for them, including the discount rate used to determine the present value of pension liabilities.

7.

For fiscal 2002, GM chose to apply a 6.75% discount rate to determine its pension liability when most available evidence suggested that a considerably lower discount rate should have been applied.

8.

After initially contesting the 6.75% discount rate, GM’s audit firm, Deloitte, eventually acquiesced and accepted that rate.

9.

Deloitte agreed to approve the 6.75% discount rate after GM officials indicated that they would include a “sensitivity analysis” in their company’s 2002 financial statements demonstrating the financial statement impact of a range of different discount rates including 6.75%.

10. In a subsequent complaint filed against GM, the SEC maintained that the company’s pensionrelated amounts and disclosures within its 2002 financial statements were “materially misleading,” including the sensitivity analysis. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.4 General Motors Company 125 11. In January 2009, the SEC sanctioned GM for several abusive accounting and financial reporting practices including its accounting and financial reporting decisions for its pension liabilities and related items.

12. In July 2009, the “new General Motors” (General Motors Company) emerged from bankruptcy proceedings; the federal government was the new company’s principal stockholder.

Instructional Objectives 1.

To identify key audit risks and issues posed by an important long-term liability, namely, the liability stemming from an organization’s defined benefit pension plan.

2.

To identify specific audit procedures appropriate for long-term accrued liabilities such as pension liabilities.

3.

To identify circumstances under which auditors should retain outside experts to assist them in completing an audit.

4.

To demonstrate the importance of insisting that audit clients include appropriate disclosures in their financial statement footnotes regarding significant accounting estimates.

Suggestions for Use

While developing this case, I reviewed several auditing textbooks to gain insight on the type and extent of the textbook treatment typically given to the topic of pension liabilities and related financial statement items. I was surprised to find almost no coverage of that topic. Given the materiality of pension-related financial statement amounts for many companies, it seems reasonable that we should, at a minimum, provide auditing students with an overview or “brief taste” of the key audit issues for those items. This case addresses that need. [Sidebar: No doubt, the auditing of pension-related financial statement items is among the more complex assignments on most audit engagements.

Consequently, this task is typically assigned to more experienced auditors, which likely explains why this topic is not dealt with extensively in standard introductory-level auditing textbooks.]

As you probably know, to demonstrate the real-world significance of audit issues, I present those issues in the context of real-world circumstances or dilemmas. One downside to this strategy is that students sometimes are “derailed” by peripheral issues that are not directly audit-related. In covering this case, for example, students enjoy debating the factors that contributed to GM’s demise.

You may find it necessary to direct students’ attention away from such issues and back to the central accounting and auditing issues highlighted by the case.

Suggested Solutions to Case Questions 1. Listed next are examples of general audit procedures that could be applied to a company’s reported pension obligation or liability and/or its related pension expense. This list is not intended to © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.4 General Motors Company 126 be comprehensive by any stretch of the imagination. The purpose of this question is simply to force students to think in general terms of the key issues that should be addressed in auditing these items.

Notice that I list the audit objective first followed by the specific audit procedure. You may want to instruct your students to use that conventional “horse before the cart” strategy for this question as well. Sidebar: you may want to point out to your students that pension amounts are accounting estimates and thus AS 2501, “Auditing Accounting Estimates,” of the PCAOB’s auditing standards can be used as a general framework for developing appropriate audit procedures for those items.

(The corresponding section in the AICPA Professional Standards is AU-C Section 540, “Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related Disclosures.”) a.

1. Audit objective: To determine whether the client’s pension obligation is recorded in the financial statements at the appropriate amount. [“Valuation and allocation” assertion regarding period-ending account balances.]

2. Audit procedure: Identify discount rates applied by comparable companies to determine their pension liabilities. Given those discount rates, evaluate the reasonableness of the client’s chosen discount rate. b.

1.

2.

c.

1.

d.

1.

Audit objective: To determine whether the client’s pension obligation is recorded in the financial statements at the appropriate amount. [“Valuation and allocation assertion regarding period-ending account balances.]

2. Audit procedure: Test the mathematical accuracy of the client’s computations of the pension obligation and pension expense amounts.

2.

e.

Audit objective: To determine whether the client’s pension obligation is recorded in the financial statements at the appropriate amount. [“Valuation and allocation” assertion regarding period-ending account balances.]

Audit procedure: Have an independent actuary review the key actuarial assumptions used by the client in arriving at its reported pension obligation. (For example, the actuary would likely review the reasonableness of mortality assumptions applied by the client.)

1.

2.

Audit objective: To determine that all disclosures that should have been included in the client’s financial statements have been included. [“Completeness” assertion concerning presentation and disclosure issues.]

Audit procedure: Read client financial statement footnotes to determine whether the client has made all necessary and appropriate disclosures regarding its pension liability.

Audit objective: To determine that financial information is appropriately presented and described and disclosures are clearly expressed. [“Classification and understandablity” assertion regarding presentation and disclosure issues.]

Audit procedure: Read client financial statement footnotes to determine whether its pension-related disclosures are explained precisely and clearly.

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Case 2.4 General Motors Company 127 2. AS 1210, “Using the Work of a Specialist,” of the PCAOB’s auditing standards discusses the general circumstances under which auditors should consider retaining the services of an independent expert during the course of an audit engagement. This section identifies several types of specialists or experts that auditors may need to consult on specific engagements including actuaries, appraisers, engineers, environmental consultants, and geologists. AS 1210.06 provides the following general guidance for auditors to follow in deciding whether the services of a specialist should be retained: “The auditor’s education and experience enable him or her to be knowledgeable about business matters in general, but the auditor is not expected to have the expertise of a person trained or qualified to engage in the practice of another occupation or profession. During the audit, however, an auditor may encounter complex or subjective matters potentially material to the financial statements. Such matters may require special skill or knowledge and in the auditor’s judgment require using the work of a specialist to obtain appropriate audit evidential matter.”

In auditing pension-related financial statement items, an auditor may find it necessary to retain the services of an actuary to assess the reasonableness of key assumptions made by the client in arriving at those accounting estimates. For example, assumptions regarding the projected life spans of retirees have a significant impact on those amounts. Auditors typically do not have the experience or training to properly evaluate such mortality assumptions and thus should consider relying on the services of an independent actuary to assess their reasonableness.

(Note: AU-C Section 620, “Using the Work of an Auditor’s Specialist,” is the section of the AICPA Professional Standards that corresponds with AS 1210. The responsibilities imposed on auditors by the two sections are very similar.)

3. In retrospect, it appears that there was significant evidence suggesting that the 6.75% discount rate was a poor choice by GM. However, as always, the information that was available in the public domain in developing this case was certainly only a fraction of the information that was likely relied upon by Deloitte in arriving at the decision to accept the 6.75% discount rate. So, one should be careful in criticizing that decision—you might point out to your students that, as indicated in the case, the SEC has yet to criticize Deloitte for its role in this matter.

The principal purpose of this question is not to criticize Deloitte but rather to prompt students to identify additional audit tests or procedures that should have been applied by the audit firm—and possibly were. Those audit procedures could have included performing analytical tests to determine whether the use of the 6.75% discount rate had a material impact on relevant financial statement benchmarks (see next question), reviewing past choices of discount rates made by GM to determine whether the company had a “track record” of questionable decisions in this regard, and inquiring of client personnel as to why an unconventional method was used to select the pension discount rate for the year in question and then analyzing the rationality or reasonableness of those explanations.

4. Notice that a footnote to this case provides several key financial benchmarks that would be relevant in assessing whether GM’s chosen discount rate had a material impact on its 2002 financial statements. I think most of us would answer a resounding “yes” to that question.

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Case 2.5 Lipper Holdings, LLC 128

CASE 2.5

LIPPER HOLDINGS, LLC

Synopsis Media reports described Kenneth Lipper as a “bon vivant” and “renaissance man.” Lipper, the son of a shoe salesman, grew up in a modest working-class neighborhood in the South Bronx. A childhood friend of Al Pacino and a contemporary of Bernie Madoff, Lipper made a name for himself on both Wall Street and in Hollywood. Lipper served as a partner of Lehman Brothers and then Salomon Brothers during the 1970s and 1980s before becoming a pioneer of the emerging hedge fund industry. After collaborating on Oliver Stone’s popular film Wall Street in the late 1980s, Lipper adopted a bicoastal lifestyle. Lipper capped his Hollywood career by winning an Oscar for a documentary film that he produced. In addition to his careers in high finance and films, Lipper also served as deputy mayor of New York City for three years under Ed Koch.

Kenneth Lipper’s reputation as a Wall Street maven was dashed in February 2002 when his company, Lipper Holdings, LLC, reported that the collective market values of the investments held by three hedge funds that it managed had been grossly overstated. The hedge funds were subsequently liquidated resulting in huge losses for many of Lipper’s prominent investors.

Investigations by regulatory and law enforcement authorities revealed that the market values of the hedge funds’ investments had been intentionally overstated by one of Lipper’s top subordinates who had served as the portfolio manager for those funds.

Another target of the investigations into the collapse of the Lipper hedge funds was PricewaterhouseCoopers (PwC), the longtime auditor of Lipper Holdings and its hedge funds. PwC was criticized for failing to uncover the fraudulent scheme used by the hedge funds’ portfolio manager to materially inflate the market values of their investments. Particularly galling to those parties familiar with the fraud was the fact that the portfolio manager had used patently simple methods to overstate those market values. This case focuses on the alleged flaws in PwC’s audits of the three Lipper hedge funds.

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Case 2.5 Lipper Holdings, LLC 129

Lipper Holdings, LLC--Key Facts 1.

Kenneth Lipper, the son of a shoe salesman, was raised in a modest working-class neighborhood in the South Bronx community within New York City.

2.

In addition to establishing a prominent Wall Street investment firm and serving several years as a deputy mayor of New York City, Lipper had a successful career in Hollywood as a screenwriter and film producer.

3.

Lipper was a leader of the rapidly growing hedge fund industry during the 1990s; his firm, Lipper Holdings, managed three hedge funds, the largest of which was Lipper Convertibles.

4.

One of Lipper’s top subordinates, Edward Strafaci, served as the portfolio manager for the three Lipper hedge funds.

5.

To inflate the reported rates of return earned by the three Lipper hedge funds Strafaci began overstating the year-end market values of the investments they held.

6.

Following Strafaci’s sudden and unexpected resignation in January 2002, an internal investigation revealed his fraudulent scheme.

7.

Lipper Holdings’ longtime audit firm, PwC, became a focal point of the SEC’s investigation of Strafaci’s fraud.

8.

The SEC’s investigation revealed that PwC had collected considerable evidence indicating that the collective market values of the three hedge funds’ investments were materially overstated.

9.

Despite that audit evidence, PwC issued unqualified audit opinions on the hedge funds’ financial statements throughout its tenure as their independent auditor.

10. The SEC suspended the former partner who had supervised the Lipper hedge fund audits after ruling that he had been a “cause” of their violations of federal securities laws.

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Case 2.5 Lipper Holdings, LLC 130

Instructional Objectives 1.

To identify audit risk factors posed by sophisticated financial services clients such as hedge funds.

2.

To identify audit objectives and related audit procedures for a client’s securities investments.

3.

To examine factors that may contribute to poor or deficient decisions by independent auditors.

Suggestions for Use

As the opening prologue for this case suggests, hedge funds are easily among the most controversial investment vehicles in today’s capital markets. They are also among the most mysterious and least understood Wall Street “creatures.” For those reasons, alone, I believe this case will pique your students’ interests. Consider having a student or group of students provide a fiveminute in-class report on the “state of the hedge fund industry.” By the time you discuss this case, there may have been important changes in the regulatory environment for hedge funds that would have at least indirect implications for those entities’ independent auditors.

AS 2501, “Auditing Derivative Instruments, Hedging Activities, and Investments in Securities,” of the PCAOB’s auditing standards discusses specific audit strategies, audit objectives, and audit procedures to apply to securities investments and related transactions (see suggested solution to second case question). Also relevant to this case is AS 2502, “Auditing Fair Value Measurements and Disclosures.” Consider having a student or group of students present an in-class report on these sections prior to discussing this case. Warning: this won’t be an easy assignment! (Note: The sections in the AICPA Professional Standards that would be relevant to the audit of a non-SEC registrant are AU-C Section 501, “Audit Evidence—Specific Considerations for Selected Items,” paragraphs .04-.10 and .A1-.A19, and AU-C Section 540, “Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures.”)

Suggested Solutions to Case Questions 1. The three categories of fraud risk factors discussed in AS 2401, “Consideration of Fraud in A Financial Statement Audit,” in the PCAOB’s Interim Standards are “incentives/pressures,” “opportunities,” and “attitudes/rationalizations” (of course, collectively these three categories of fraud risk factors are often referred to as the “fraud triangle.”) The appendix to AS 2401 provides numerous examples of fraud risk factors in each category. Listed next are examples of specific fraud risk factors faced by the PwC auditors assigned to the Lipper hedge fund audits. (Note: AU-C Section 240, “Consideration of Fraud in a Financial Statement Audit,” is the section in the AICPA Professional Standards that corresponds to AS 2401 in the PCAOB’s auditing standards.) © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.5 Lipper Holdings, LLC 131 Incentives/pressures: • “High degree of competition” (the Lipper hedge funds were competing against literally thousands of other investment alternatives that investors could choose) • “Perceived or real adverse effects of reporting poor financial results” (as noted in the case, Strafaci believed that the hedge funds had to report impressive rates of return to continue attracting new investors) • “Significant financial interests in the entity” (the restitution that the courts forced Strafaci to pay was due to the large profits that he had earned from his investments in the hedge funds) Opportunities: • “Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate” (as noted in a footnote to the case, many of the hedge funds’ investments were in “thinly-traded” securities that often did not have readily determinable market values) • “Domination of management by a single person” (in this case, Strafaci) “Ineffective oversight over the financial reporting process and internal control by those charged with governance” (one could argue that Kenneth Lipper should have exercised more effective oversight of the hedge funds including Strafaci’s role in managing the funds) Attitudes/rationalizations: • “Known history of violations of securities laws or other laws” (as noted in the case, Kenneth Lipper had been previously accused of aiding and abetting violations of federal securities laws) • “Excessive interest by management in maintaining or increasing the entity’s stock price or earnings trend” (again, Strafaci’s zealous interest in ensuring that the hedge funds achieved impressive rates of return was consistent with this fraud risk factor) • “Management failing to correct known significant deficiencies or material weaknesses in internal control on a timely basis” (if Larry Stoler was aware of the significant internal control weaknesses within the hedge funds’ operations, client management was almost certainly aware of those problems also) How should PwC have responded to these and other risk factors posed by the audits of the Lipper hedge funds? By making proper adjustments in the audit NET for those audits, that is, the nature, extent and timing of the audit procedures to be applied during those engagements. Granted, in some cases, audit firms may simply choose not to be associated with an audit client for which an extensive number of fraud risk factors is present.

Note: In the SEC enforcement release for this case, the federal agency reported that the auditors prepared an annual risk analysis for the Lipper hedge fund engagements. Among the “high risk” factors identified during those risk analyses was “management governance and oversight of management.” Although the auditors identified that critical issue as a “high risk” factor during the © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.5 Lipper Holdings, LLC 132 planning phase of those audits, the SEC suggested that the auditors did not respond appropriately to that risk factor during later phases of the audits.

2. AS 1105.11 identifies five management assertions that are relevant to independent auditors. The “audit objectives” on audits of SEC registrants involve collecting sufficient appropriate evidence to corroborate these assertions for specific financial statement line items or disclosure items. [Note: the AICPA Professional Standards identify 13 specific management assertions that are closely related to the “original” five management assertions incorporated in AS 1105. See AU-C Section 315.A128 for a list of those assertions.]

AS 2503, “Auditing Derivative Instruments, Hedging Activities, and Investments in Securities,” is replete with examples of audit objectives for “complex financial instruments and transactions” which is the focus of this case question. Listed next are examples of such audit objectives and corresponding audit procedures suggested by AS 2503.

Audit objective: Audit objectives related to “assertions about the valuation of derivatives and securities address whether the amounts reported in the financial statements through measurement or disclosure were determined in conformity with generally accepted accounting principles.” AS 2503.26 Example of a relevant audit procedure: “If quoted market prices are not available for the derivative or security, estimates of fair value frequently can be obtained from broker-dealers or other third-party sources based on proprietary valuation models or from the entity based on internally or externally developed valuation models.” AS 2503.38 Audit objective: Audit objectives related to “assertions about rights and obligations address whether the entity has the rights and obligations associated with derivatives and securities, including pledging arrangements, reported in the financial statements.” AS 2503.25 Example of a relevant audit procedure: “Confirming significant terms with the counterparty to a derivative or the holder of a security, including the absence of any side agreements.” AS 2503.25 Audit objective: Audit objectives related to “completeness assertions address whether all of the entity’s derivatives and securities are reported in the financial statements through recognition or disclosure.” AS 2503.22 Example of a relevant audit procedure: The auditor should request “counterparties or holders who are frequently used, but with whom the accounting records indicate that there are presently no derivatives or securities, to state whether they are counterparties to derivatives with the entity or holders of its securities.” AS 2503.22 Audit objective: “The auditor should evaluate whether the presentation and disclosure of derivatives and securities are in conformity with generally accepted accounting principles.” AS 2503.49 Example of a relevant audit procedure: The auditor should determine whether “the information presented in the financial statements is classified and summarized in a reasonable manner, that is, neither too detailed nor too condensed.” AS 2503.49

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Case 2.5 Lipper Holdings, LLC 133 3. Listed next are examples of specific factors that may have contributed to the alleged flaws in the audit procedures applied by the PwC auditors while testing the year-end market values of the Lipper hedge funds’ investments.

•

• • •

• •

Kenneth Lipper’s prominence and influence in the hedge fund industry and the investment community (History has proven that auditors are sometimes prone to give prominent audit clients or audit client executives the “benefit of the doubt.”

Auditors may do so because they don’t want to jeopardize losing the given client and/or because they believe that a prominent client or client executive is not likely to jeopardize its/his/her prominence by being associated with misrepresented financial statements.)

Improper planning (This is arguably the most common factor associated with “busted audits.”)

Inadequate supervision (This was one of the specific allegations levied against Stoler by the SEC.) Lack of proper expertise on the part of members of the audit engagement team (Hedge funds are just one example of a type of audit client that almost certainly requires that one or more auditors assigned to the engagement team have specific “industry” expertise or knowledge.)

Inadequate time budgets (There was no indication that this factor was relevant to the Lipper hedge fund audits; nevertheless, this factor appears to have been a contributing factor to many alleged audit failures.)

Overbearing client executives who interfere with the audit (This is another factor commonly associated with alleged audit failures. Again, there was no indication that Strafaci or other Lipper personnel attempted to divert the attention of the PwC auditors or otherwise disrupt their work.)

What measures can audit firms take to lessen the likelihood that the factors just identified (and many other factors, as well) will undercut the quality of their audits? The easy (and proper) answer is for audit firms to have rigorous quality control mechanisms in place to ensure that the relevant professional auditing standards are complied with on each and every audit engagement. Examples of such quality controls include a thorough workpaper review process for every audit, the assignment of a review or concurring partner to audits, participation in peer review programs in which auditors from other firms are allowed to peruse and criticize the workpapers prepared for certain clients, and establishment of a risk management function to “weed out” audit clients that pose excessive audit risks.

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Case 2.6 CBI Holding Company, Inc. 134

CASE 2.6

CBI HOLDING COMPANY, INC.

Synopsis Ernst & Young audited the pharmaceutical wholesaler CBI Holding Company, Inc., in the early 1990s. In 1991, Robert Castello, CBI’s owner and chief executive, sold a 48% stake in his company to TCW, an investment firm. The purchase agreement between Castello and TCW identified certain “control-triggering” events. If one such event occurred, TCW had the right to take control of CBI. In CBI’s fiscal 1992 and 1993, Castello orchestrated a fraudulent scheme that embellished the company’s reported financial condition and operating results. The scheme resulted in Castello receiving bonuses for 1992 and 1993 to which he was not entitled. A major feature of the fraud involved the understatement of CBI’s year-end accounts payable. Castello and several of his subordinates took steps to conceal the fraud from CBI’s Ernst & Young auditors and from TCW (two of CBI’s directors were TCW officials). Concealing the fraud was “necessary” to ensure that Castello did not have to forfeit his bonuses. Likewise, the fraud had to be concealed because it qualified as a “control-triggering” event.

This case examines the audit procedures that Ernst & Young applied to CBI’s year-end accounts payable for fiscal 1992 and 1993. The principal audit test that Ernst & Young used in auditing CBI’s accounts payable was a search for unrecorded liabilities. Although Ernst & Young auditors discovered unrecorded liabilities each year that resulted from Castello’s fraudulent scheme, they did not properly investigate those items and, as a result, failed to require CBI to prepare appropriate adjusting entries for them. A subsequent civil lawsuit focused on the deficiencies in Ernst & Young’s accounts payable-related audit procedures during the 1992 and 1993 CBI audits. Following a 17-day trial, a federal judge ruled that Ernst & Young’s deficient audits were the proximate cause of CBI’s bankruptcy and the resulting losses suffered by TCW and CBI’s creditors.

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Case 2.6 CBI Holding Company, Inc. 135 CBI Holding Company, Inc.--Key Facts 1.

In 1991, TCW purchased a 48 percent ownership interest in CBI from Robert Castello, the company’s owner and chief executive.

2.

The TCW-CBI agreement identified certain “control-triggering events;” if one of these events occurred, TCW would take control of CBI.

3.

During CBI’s fiscal 1992 and 1993, Castello oversaw a fraudulent scheme that resulted in him receiving year-end bonuses to which he was not entitled.

4.

A major feature of the fraud was the understatement of CBI’s year-end accounts payable.

5.

Castello realized that the fraudulent scheme qualified as a control-triggering event.

6.

Castello and his subordinates attempted to conceal the unrecorded liabilities by labeling the payments of them early in each fiscal year as “advances” to the given vendors.

7.

Ernst & Young auditors identified many of the alleged advances during their search for unrecorded liabilities.

8.

Because the auditors accepted the “advances” explanation provided to them by client personnel, they failed to require CBI to record adjusting entries for millions of dollars of unrecorded liabilities at the end of fiscal 1992 and 1993.

9.

The federal judge who presided over the lawsuit triggered by Castello’s fraudulent scheme ruled that Ernst & Young’s deficient audits were ultimately the cause of the losses suffered by TCW and CBI’s creditors.

10. The federal judge also charged that several circumstances that arose during Ernst & Young’s tenure as CBI’s auditor suggested that the audit firm’s independence had been impaired.

Instructional Objectives 1.

To illustrate methods that client management may use to understate accounts payable.

2.

To examine the audit objectives related to accounts payable and the specific audit tests that may be used to accomplish those objectives.

3.

To illustrate the need for auditors to rigorously investigate questionable items discovered during an audit. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.6 CBI Holding Company, Inc. 136 4.

To examine circumstances arising during an audit that can jeopardize auditors’ independence.

Suggestions for Use

This case focuses on accounts payable and, consequently, is best suited for coverage during classroom discussion of the audit tests appropriate for that account. Alternatively, the case could be integrated with coverage of audit evidence issues. Finally, the case also raises several interesting auditor independence issues.

As a point of information, you will find that this case doesn’t fully examine all facets of the fraudulent scheme perpetrated by CBI’s management. The cases in this section purposefully focus on high-risk accounts and auditing issues related to those accounts. If I fully developed all of the issues posed by the cases in this text, each case would qualify as a “comprehensive” case. [I make this point because many adopters have raised this issue with me. By the way, I greatly appreciate such comments and concerns!]

Suggested Solutions to Case Questions 1. "Completeness" is typically the management assertion of most concern to auditors when investigating the material accuracy of a client's accounts payable. Generally, clients have a much stronger incentive to violate the completeness assertion for liability and expense accounts than the other management assertions relevant to those accounts. Unfortunately for auditors, a client's financial controls for accounts payable are typically not as comprehensive or as sophisticated as the controls established in accounting for the analogous asset account, accounts receivable. Clients have a strong economic incentive to maintain a reliable tracking system for amounts owed to them by their customers. This same incentive does not exist for payables since the onus for keeping track of these amounts and ensuring that they are ultimately paid rests with a company's creditors. Granted, a company needs sufficient records to ensure that their vendors are not overcharging them.

Nevertheless, the relatively weak accounting and control procedures for payables often complicate auditors' efforts to corroborate the completeness assertion for this account.

In my view, the two primary audit procedures that Ernst & Young applied to CBI’s accounts payable would likely have yielded sufficient appropriate evidence to corroborate the completeness assertion—if those procedures had been properly applied. The search for unrecorded liabilities is almost universally applied to accounts payable. This search procedure provides strong evidence supporting the completeness assertion because audit clients in most cases have to pay year-end liabilities during the first few weeks of the new fiscal year. [Of course, one feature of the search procedure is examining the unpaid voucher file to uncover any year-end liabilities that remain unpaid late in the audit.] The reconciliation procedure included in Ernst & Young’s audit programs for accounts payable provides additional evidence pertinent to the completeness assertion. In particular, that audit test helps auditors nail down the “timing” issue for payables that arose near a client’s yearend. Vendor statements should identify the shipping terms and shipment dates for specific invoice items and thus allow auditors to determine whether those items should have been recorded as liabilities at the client’s year-end. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.6 CBI Holding Company, Inc. 137 2. Before answering the explicit question posed by this item, let me first address the “explanation” matter. In most circumstances, auditors are required to use confirmation procedures in auditing a client's accounts receivable. Exceptions to this general rule are discussed in AS 2310, “The Confirmation Process,” of the PCAOB’s auditing standards and include cases in which the client's accounts receivable are immaterial in amount and when the use of confirmation procedures would likely be ineffective. On the other hand, confirmation procedures are not generally required when auditing a client's accounts payable. Accounts receivable confirmation procedures typically yield evidence supporting the existence, valuation/allocation, and rights & obligations assertions related to period-ending accounts receivable balances. However, the key assertion corroborated most directly by these tests is existence. When performing confirmation procedures on a client's accounts payable, the auditor is most often concerned with the completeness assertion (as pointed out in the answer to the prior question). [Note: AU-C Section 505, “External Confirmations,” is the section in the AICPA Professional Standards that corresponds with AS 2310.]

The differing objectives of accounts payable and accounts receivable confirmation procedures require an auditor to use different sampling strategies for these two types of tests. For instance, an auditor will generally confirm a disproportionate number of a client's large receivables. Conversely, because completeness is the primary concern in a payables confirmation procedure, the auditor may send out confirmations on a disproportionate number of accounts that have relatively small balances or even zero balances. Likewise, an auditor may send out accounts payable confirmations to inactive vendor accounts and send out confirmations to vendors with which the client has recently established a relationship even though the client’s records indicate no outstanding balance owed to such vendors.

A final technical difference between accounts payable and accounts receivable confirmation procedures is the nature of the confirmation document used in the two types of tests. A receivable confirmation discloses the amount reportedly owed by the customer to the client, while a payable confirmation typically does not provide an account balance but rather asks vendors to report the amount owed to them by the client. Auditors use blank confirmation forms in an effort to identify any unrecorded payables owed by the client.

Should the Ernst & Young auditors have applied an accounts payable confirmation procedure to CBI’s payables? No doubt, doing so would have yielded additional evidence regarding the completeness assertion and, in fact, likely have led to the discovery of Castello’s fraudulent scheme.

One could certainly suggest that given the fact that the 1992 and 1993 audits were labeled by Ernst & Young as high-risk engagements, the audit firm should have considered erring on the conservative side by mailing confirmations—at least to CBI’s major vendors. On the other hand, since payable confirmations are seldom used and since the two procedures that Ernst & Young applied to CBI’s accounts payable would yield, in most circumstances, sufficient appropriate evidence to support the completeness assertion, most auditors would likely not criticize Ernst & Young for not using payable confirmations.

3. AS 2905 of the PCAOB’s auditing standards discusses auditors’ responsibilities regarding the “subsequent discovery of facts” existing at the date of an audit report. That section of the professional standards suggests that, as a general rule, when an auditor discovers information that would have affected a previously issued audit report, the auditor has a responsibility to take © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.6 CBI Holding Company, Inc. 138 appropriate measures to ensure that the information is relayed to parties who are still relying on that report. In this particular case, AS 2905 almost certainly required Ernst & Young to inform CBI’s management, TCW officials, and other parties of the advances ruse orchestrated by Castello that was not uncovered by Ernst & Young during the 1992 and 1993 audits. In my view, the obligation to inform CBI management (including the TCW representatives sitting on CBI’s board) of the oversights in the prior audits was compounded by the fact that Ernst & Young was actively seeking to obtain the reaudit engagement. (Note: AU-C Section 560, “Subsequent Events and Subsequently Discovered Facts,” of the AICPA Professional Standards corresponds with AS 2905.)

Generally, auditors do not have a responsibility to inform client management of “mistakes” made on earlier audits. On practically every audit engagement, simple mistakes or oversights are likely to be made. However, if such mistakes trigger auditors’ responsibilities under AS 2905—for example, the mistakes involve gaffes by auditors that resulted in an improper audit opinion being issued— certainly the given audit firm has a responsibility to comply with AS 2905 and ensure that the appropriate disclosures are made to the relevant parties.

4. The key criterion in assigning auditors to audit engagements should be the personnel needs of each specific engagement. Certainly, client management has the right to complain regarding the assignment of a particular individual to an audit engagement if that complaint is predicated on the individual's lack of technical competence, poor interpersonal skills, or other skills deficiencies. On the other hand, a client request to remove a member of an audit team simply because he or she is too “inquisitive” is certainly not a valid request. Castello’s request was particularly problematic because it involved the audit manager assigned to the engagement. The audit manager on an engagement team often has considerable client-specific experience and expertise that will be forfeited if he or she is removed from the engagement.

5. Determining whether high-risk audit clients should be accepted is a matter of professional judgment. Clearly, “economics” is the overriding issue for audit firms to consider in such circumstances. An audit firm must weigh the economic benefits (audit fees and fees for ancillary services, if any) against the potential economic costs (future litigation losses, harm to reputation, etc.) in deciding whether to accept a high-risk client. Complicating this assessment is the fact that many of the economic benefits and the economic disincentives related to such decisions are difficult to quantify. For example, quite often one of the best ways for an audit firm to establish a foothold in a new industry is to accept high-risk audit clients in those industries (such clients are the ones most likely to be “available” in a given industry). Likewise, audit firms must consider the important “utilization” issue. An audit firm will be more prone to accept a high-risk audit client if rejecting that client would result in considerable “down time” for members of the given office’s audit staff. In any case, the decision of whether to accept or reject a high-risk audit client should be addressed deliberately, reached with the input of multiple audit partners, and ultimately reviewed at a higher level than the practice office. (Most large accounting firms have a “risk management” group that reviews each client acceptance/rejection decision.)

As a point of information, after Ernst & Young issued an unqualified opinion on CBI’s 1993 financial statements, the audit engagement partner recommended that Ernst & Young dissociate itself from CBI. In the partner’s view, the audit risk posed by CBI was simply too high. Despite this © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.6 CBI Holding Company, Inc. 139 recommendation, the audit partner was overruled by his fellow partners in his practice office. (The decision to retain CBI as an audit client proved inconsequential since the company went “belly up” before the 1994 audit was commenced.)

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Case 2.7 Bankrate, Inc. 140

CASE 2.7

BANKRATE, INC.

Synopsis Bankrate, Inc. is an Internet-based company that aggregates and then publishes on its websites financial data needed by U.S. consumers. Those data include information regarding the financial products offered by approximately 5,000 banks, insurance companies, and other financial services providers. For example, consumers can search the relevant Bankrate website to obtain comparative data regarding the interest rates that banks across the U.S. are offering on certificates of deposit.

In June 2011, Bankrate re-emerged as a public company after having been a private company for two years. Financial analysts tracking the company wrote glowing reports concerning the company’s future prospects. Those reports were predicated on Bankrate being the dominant aggregator of financial data needed by U.S. consumers and on the proven business model that the company had developed over the previous several decades.

Bankrate settled a large class-action lawsuit in August 2014 by agreeing to pay $18 million to a group of its stockholders who alleged that the company had improperly embellished its potential revenues shortly after it went public in 2011. Just one month after the announcement of that settlement, Bankrate issued a press release revealing that it was the subject of an SEC investigation.

That investigation focused on Bankrate’s reported operating results for the second quarter of 2012.

The SEC announced in September 2015 that it had reached an agreement to settle fraud charges that it had filed against the company. That settlement included a $15 million fine to be paid by Bankrate. At the same time, the SEC announced that it had settled fraud charges filed against a former Bankrate executive, Hyunjin Lerner. The SEC fined Lerner approximately $180,000 and suspended him from practicing before the SEC for five years. (Both Bankrate and Lerner neither admitted nor denied the charges filed against them.)

On the same date that the settlements with Bankrate and Lerner were announced, the SEC reported that it was continuing to pursue “litigation” against two of Lerner’s former colleagues, Edward DiMaria and Matthew Gamsey. DiMaria had served as Bankrate’s CFO, while Gamsey had served as Bankrate’s director of accounting. The SEC spelled out the charges filed against those two men in a 43-page legal complaint.

The complaint alleged that DiMaria had orchestrated an accounting scam—with the assistance of Lerner and Gamsey—to ensure that Bankrate’s operating results for the second quarter of 2012 did not fall short of the company’s consensus earnings forecasts for that quarter. This case documents © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.7 Bankrate, Inc. 141 the specific measures allegedly used by DiMaria and his subordinates to misrepresent Bankrate’s reported operating results. Those measures included tactics to conceal the accounting scam from Grant Thornton, the company’s audit firm.

Bankrate, Inc.--Key Facts 1. In June 2011, Bankrate re-emerged as a public company; financial analysts predicted that the company would be very successful because it was the dominant aggregator of financial information needed by U.S. consumers and because it had a proven business model.

2.

Bankrate’s two primary revenue streams include payments for leads (referrals) delivered to the approximately 5,000 financial services providers whose products are profiled on its websites and the sale of display advertising on those same websites.

3. In August 2014, Bankrate paid $18 million to a group of its stockholders who claimed that the company had improperly embellished its potential leads revenue shortly after going public in 2011.

4. One month later, in September 2014, Bankrate revealed that the SEC was investigating its reported operating results for the second quarter of 2012.

5. In September 2015, Bankrate and Hyunjin Lerner, the company’s former vice president of finance, settled fraud charges filed against them by the SEC without either admitting or denying those charges; Bankrate paid a $15 million fine while Lerner paid a fine of $180,000 and agreed to a five-year ban from practicing before the SEC. 6. At the same time that the settlements with Bankrate and Lerner were announced, the SEC reported that it was continuing to pursue charges filed against Edward DiMaria and Matthew Gamsey, Bankrate’s former CFO and director of accounting, respectively.

7. In a 43-page legal complaint, the SEC alleged that DiMaria had “fostered a corporate culture within Bankrate’s accounting department that condoned using improper accounting techniques to achieve financial targets.”

8. In July 2012, Bankrate’s preliminary adjusted EBITDA and adjusted EPS for the second quarter of 2012 came up short of analysts’ consensus earnings estimates for that quarter.

9. To eliminate the earnings shortfall, DiMaria allegedly instructed Lerner and Gamsey to make several improper entries in Bankrate’s accounting records.

10. Those improper entries included recording approximately $800,000 of bogus revenue and reducing a marketing expense account and the corresponding accrued liability account by $400,000. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.7 Bankrate, Inc. 142 11. The conspirators took explicit measures to conceal the accounting fraud from the company’s Grant Thornton auditors.

12. In June 2015, following the conclusion of the SEC’s investigation, Bankrate issued restated financial statements for the second quarter of 2012.

Instructional Objectives 1. To determine what responsibilities auditors have to search for fraudulent misstatements during a quarterly review of a public company’s financial statements.

2. To identify the factors that should be considered by accountants and auditors when deciding whether a given financial statement amount is “material.”

3. To determine which parties should bear some degree of responsibility when an entity’s financial statements are materially impacted by fraud.

4. To identify the primary audit objectives for a client’s accrued liabilities.

5. To identify circumstances that complicate the auditing of a client’s accrued liabilities.

Suggestions for Use When assigning this case you may want your students or a subset of your students to research and identify any recent developments that are relevant to the case. In particular, your students should attempt to determine if the fraud charges filed against Edward DiMaria, Bankrate’s former CFO, and Matthew Gamsey, Bankrate’s former director of accounting, have been resolved. You might also consider requiring your students to do a brief update on the recent financial performance of Bankrate.

Public companies’ rampant use of “non-GAAP performance measures” is a controversial topic in the financial reporting domain. This case provides an excellent opportunity to discuss that important financial reporting topic. In particular, you might ask your students to identify the key issues embedded in that topic. Arguably, the most important of those issues is the lack of comparability across the non-GAAP performance measures used by public companies. A closely related issue is the fact that some (many?) public companies use non-GAAP performance measures to direct investors’ attention away from GAAP-based measures of financial performance.

Another financial reporting topic central to this case is the required quarterly reporting of financial results by public companies. Many critics have suggested that quarterly reporting imposes a significant burden on SEC registrants and prompts a non-trivial number of such companies to take drastic measures (including fraudulent accounting) to reach or surpass the consensus quarterly earnings forecasts issued by Wall Street analysts. In fact, a prominent Wall Street executive recently suggested that quarterly financial reporting by SEC registrants should be discontinued.

Of course, you can link the two financial reporting topics discussed in the two previous © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.7 Bankrate, Inc. 143 paragraphs to the auditing domain. For example, there is no doubt that the accounting gimmicks or outright fraudulent accounting that corporate executives sometimes use to window-dress their quarterly financial reports pose significant challenges for auditors who review those reports.

Suggested Solutions to Case Questions 1. AS 4105, “Reviews of Interim Financial Information,” of the PCAOB’s auditing standards is the authoritative source in this context. According to AS 4105.07, “The objective of a review of interim financial information pursuant to this section is to provide the accountant [auditor] with a basis for communicating whether he or she is aware of any material modifications that should be made to the interim financial information for it to conform with generally accepted accounting principles.” This paragraph goes on to clearly distinguish between the nature and scope of an interim review and a fullscope financial audit. For example, the paragraph notes that a review “consists principally of performing analytical procedures and making inquiries of persons responsible for financial and accounting matters . . .”

The first reference to “fraud” can be found in AS 4105.11. That paragraph instructs an accountant [auditor] performing a review “to update his or her knowledge of the entity’s business and internal controls . . .” During such an update, the accountant should “specifically consider” several factors including “(c) identified risks of material misstatement due to fraud . . .” While inquiring of “members of management who have responsibility for financial and accounting matters” an accountant performing a review should ask such individuals about “Their knowledge of any fraud or suspected fraud affecting the entity involving (1) management, (2) employees who have significant roles in internal control, or (3) others where the fraud could have a material effect on the financial statements. (AS 4105.18) At any point during a review, if an accountant becomes aware of “information that leads him or her to believe that the interim financial information may not be in conformity with generally accepted accounting principles,” the interim review procedures must be “extended.” (AS 4015.22) This requirement would mandate that an accountant pursue any apparent indications of financial statement fraud having a material impact on the client’s accounting data.

So, must auditors [accountants] search for fraud while “reviewing” a public company’s quarterly financial statements? I suppose the answer to that question depends on how you interpret the relevant directives included in AS 4105. I believe the best answer is that “yes” auditors [accountants] have a responsibility to search for fraud during such a review . . . but they don’t have to search “very hard.” Granted, if they trip across indications of fraud during the performance of review procedures, then they have a more onerous responsibility to determine whether fraud has impacted the given financial statements.

The fraud risk factors that the Grant Thornton auditors should have considered during the review of Bankrate’s quarterly financial statements include: (1) the preoccupation of DiMaria with reaching or surpassing Bankrate’s consensus quarterly earnings forecasts (this “preoccupation” may not have been readily apparent to the auditors); (2) the fact that the compensation of Bankrate’s top executives, including DiMaria, was directly linked to the EBITDA reported by the company—see footnote 7 in the case; (3) the suspicious nature of the $300,000 of revenue recorded by the Insurance division (the revenue was recorded after the close of the quarter and helped the company reach its © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.7 Bankrate, Inc. 144 earnings target for that quarter); and (4) the fact that the company’s management team had an incentive to fulfill the high expectations that had been established for Bankrate by financial analysts when it re-emerged as a public company (fiscal 2012 was Bankrate’s first full fiscal year after going public again).

2. Generally, the SEC defines earnings management as a “material and intentional misrepresentation” of a given entity’s reported operating results. Because that definition could be used interchangeably with “fraudulent accounting,” the two expressions are effectively equivalent to the SEC. Other parties, however, typically define earnings management less ominously than fraudulent accounting.

For example, the online business encyclopedia, Investopedia, defines earnings management as “The use of accounting techniques to produce financial reports that may paint an overly positive picture of a company’s business activities and financial position.” This latter definition is less severe than the SEC’s definition because it doesn’t include a reference to materiality. Although the Investopedia definition of earnings management appears to be more widely accepted, there is no doubt that the SEC’s definition of earnings management should “carry more weight” among corporate executives, auditors, etc. given the critical oversight role that the federal agency plays in the accounting and financial reporting domain.

Under what conditions is earnings management acceptable? If we define that termas “painting an overly positive picture” of an entity’s operating results, one set of circumstances that could qualify as “acceptable” earnings management is when a company defers discretionary expenditures near the end of a financial reporting period to reach a target earnings number. Then again, the deferral of many, if not most, discretionary expenditures, such as maintenance costs on production line equipment, is not in the best interests of a given entity over the long term, meaning that company management may be violating their fiduciary responsibility to stockholders and other parties when they do so. Another possible case when earnings management is “acceptable” is when there is considerable “wiggle room” in a given accounting or financial reporting rule. That is, the given rule is quite subjective and a company’s executives “take advantage” of that subjectivity by interpreting the rule in the most beneficial way for their entity. Although many parties may suggest this type of earnings management is “acceptable,” I believe the majority of professional accountants would disagree.

3. The best strategy for answering this question is to first define the phrase “materiality.” Ironically, the SEC does not have its own “materiality standard.” Instead, the SEC invokes the following definition of materiality applied by the U.S. Supreme Court: “Information is material if there is a substantial likelihood that a reasonable investor would consider the information in making an investment decision or if the information would significantly alter the total mix of available information.”

The FASB’s definition of materiality can be found in Statement of Financial Accounting Concepts No.8: “Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude or both of the items to which the information relates in the context of an individual entity’s financial report.” [Note: At press time, the FASB was considering a proposal to adopt the Supreme Court/SEC definition of materiality.] © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.7 Bankrate, Inc. 145 Both AS 2105, “Consideration of Materiality in Planning and Performing an Audit,” of the PCAOB auditing standards and the relevant AICPA Professional Standards effectively embrace the U.S. Supreme Court/SEC definition of materiality. (The relevant discussion of materiality in the AICPA Professional Standards can be found at AU-C Section 320.02.) The AICPA Professional Standards, however, have also introduced the concept of “performance materiality” to the professional auditing literature. That term is defined as follows: “The amount or amounts set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole. If applicable, performance materiality also refers to the amount or amounts set by the auditor at less than the materiality level or levels for particular classes of transactions, account balances, or disclosures. Performance materiality is to be distinguished from tolerable misstatement.”

[AU-C 320.09] In turn, AU-C 530.05 defines “tolerable misstatement as follows: “A monetary amount set by the auditor in respect of which the auditor seeks to obtain an appropriate level of assurance that the monetary amount set by the auditor is not exceeded by the actual misstatement in the population.”

In summary then, from an accounting and financial reporting standpoint “materiality” refers to an amount or item or set of circumstances that would “make a difference” in the minds of a reasonably informed user of financial statements. The auditing domain embraces this general definition or concept but is more concerned with “applying” the materiality construct in the context of auditing a set of financial statements.

To finally address Question #3, we have to identify the factors that determine whether a specific financial statement amount is “material.” There are two general sets of such factors: quantitative and qualitative factors. (See paragraph 17 of AS 2810, “Evaluating Audit Results.”) Quantitatively speaking, accountants and auditors typically identify “material” items in reference to some given financial statement benchmark such as net income or change in net income from one period to the next. The old “5 percent rule” is probably the most widely used (if not abused) quantitative materiality standard, that is, an amount is material if it would change the given base or benchmark amount by 5 percent or more. For example, Bankrate’s net income for the second quarter of 2012 was overstated by approximately 5 percent. The SEC ruled that overstatement was material.

DiMaria, financial analysts tracking the company’s stock, and the SEC apparently all agreed that the most relevant financial benchmarks for the company were adjusted EBITDA and adjusted EPS. Understand that although Bankrate’s adjusted EPS was misstated by a little more than 5 percent by the company’s accounting gimmicks ($.18 / $.17), the corresponding misstatement of adjusted EBITDA was less than 4 percent ($37.5 million / $36.2 million). This is where the issue of “qualitative” materiality came into play. The SEC apparently believed that when it came to an overall global decision of whether Bankrate’s EBITDA was materially misstated due to its fraudulent accounting, it was really a question of whether or not the fraudulent accounting decisions allowed the © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.7 Bankrate, Inc. 146 company to reach its earnings target for the given quarter. In other words, in this important context, materiality determination became a qualitative or “nominal” (yes/no) measurement. More generally, a misstatement due to fraud has a lower qualitative materiality threshold than a misstatement due to some unintentional cause.

4. The key audit objective for accrued liabilities is to determine whether those amounts are “complete.” Unlike assets and revenues, audit clients have an incentive to understate liabilities and expenses. Just by their nature, understatements are more challenging to uncover than overstatements.

For example, when it comes to accrued liabilities, auditors may be searching for liabilities/expenses that have never been recorded. For overstatements, on the other hand, auditors have an explicit “starting point,” namely, the amount recorded for the given item by the client.

Another factor that complicates the auditing of accrued liabilities (and their offsetting expenses) is the discretionary nature of those amounts. Many, if not most, accrued liabilities are “guesstimates” which are heavily influenced by key assumptions made by the client. When auditing accrued liabilities, auditors are often forced to challenge the rigor or reliability of those assumptions. In effect, this creates a variation of the “he said, she said” dilemma—in this context, the dilemma would be “I believe, you believe.” Because clients typically have a better understanding of all the parameters relevant to the determination of the dollar amount for a given accrued liability, they have some degree of leverage to prod, cajole, or coerce auditors into accepting the amount that has been recorded for the given item.

5. (a) Audit committees play a critical oversight role in the financial reporting domain. Those committees have a proactive responsibility to “ride herd” on corporate executives to prevent the types of abusive accounting practices evident in this case. Having said that, DiMaria and his subordinates apparently took measures to conceal their “creative accounting” from not only Bankrate’s independent auditors but also from the company’s audit committee and other corporate executives.

(Recall that DiMaria warned Lerner to keep certain improper accounting adjustments “under the radar.”) (b) The Grant Thornton auditors were apparently never criticized by the SEC, PCAOB, or other third parties. Nevertheless, auditors should always be cognizant of, and investigate, red flags indicative of accounting fraud. There were several red flags in this case, most noteworthy was the approximately $800,000 of additional revenue for the second quarter of 2012 that Bankrate suddenly “found” a week or so following the end of that quarter. Making that red flag redder was the fact that the bogus revenue (and other questionable accounting decisions) made by Bankrate ex post allowed the company to reach the two earnings targets that had been previously established by financial analysts. (Again, it is important to reinforce the fact that the conspirators in this case took explicit measures to hide their fraudulent actions from the company’s independent auditors.) (c) There were likely several individuals within Bankrate—other than DiMaria, Gamsey, and Lerner—who were aware of the accounting shenanigans. Those individuals may have included some lower-ranking members of the company’s accounting staff. Those accountants had a responsibility to report any misconduct that they observed by their superiors. Such misconduct could have been reported to the audit committee. Alternatively, those individuals could have reported the misconduct directly to the SEC. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.7 Bankrate, Inc. 147 (d) One could argue that some measure of responsibility for cases such as this must be borne by the regulatory authorities that require public companies to report financial results on a quarterly basis.

This requirement places a significant degree of pressure on corporate executives each quarter to at least reach their company’s consensus earnings estimate.

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.8 Belot Enterprises 147

CASE 2.8

BELOT ENTERPRISES

Synopsis David Robinson, an audit senior assigned to the audit engagement team for Belot Enterprises, faces a dilemma common to auditors. Client management has taken an aggressive position regarding the period-ending balances of several large discretionary expense accruals, including the company’s allowances for bad debts and inventory obsolescence. Robinson discovered the client’s new accrual strategy while performing review procedures on the company’s financial statements for the recently ended second quarter. The end of that quarter coincided with the end of the “Nail the Number” campaign organized by Belot’s new chief operating officer (COO). The goal of the corporate-wide campaign was to significantly improve Belot’s year-over-year operating results for the second quarter.

Zachariah Crabtree, Belot’s longtime accounting general manager, came up with the idea to “tighten” the quarter-ending accruals as his contribution to the Nail the Number campaign. Crabtree is the primary client contact person for Robinson at Belot. Over the past several years, Crabtree has been very generous with his time to Robinson, resulting in a strong friendship developing between the two accountants. That friendship is complicating Robinson’s decision regarding how to deal with the aggressive accruals. In fact, Crabtree has attempted to convince Robinson to simply “pass” on those accruals and not bring them to the attention of the audit manager and audit partner assigned to the review engagement.

Complicating Robinson’s decision even further is that recently he has become more intent on pursuing a long-term career with his Big Four employer as the result of a meeting with the Belot audit engagement partner. The partner told Robinson that he is “partner material” and should become more focused on planning his career with the firm. Robinson realizes that he could “score points” with the partner by dealing firmly with the controversy over Belot’s accruals. The case ends with Robinson considering how he plans to deal with the dilemma that he faces.

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.8 Belot Enterprises 148 Belot Enterprises--Key Facts 1.

David Robinson is an audit senior assigned to the audit engagement team for Belot Enterprises, a wholly-owned subsidiary of a large public company, Helterbrand Associates.

2.

Robinson is in the process of completing the review of Belot’s financial statements for the company’s second quarter.

3.

Robinson has discovered that five of the client’s discretionary expense accruals, including the allowances for bad debts and inventory obsolescence, are lower than he expected them to be.

4.

Zachariah Crabtree, Belot’s accounting general manager, explained to Robinson that the June 30th balances of the accruals are lower because of a new “precise point estimate” method that he used in determining them.

5.

In the past, Belot established the five accruals at a conservative level, that is, the accruals were overstated somewhat.

6.

For the current quarter, Crabtree chose to eliminate the “fat” from the accruals to help Belot reach the target operating income figure for the three-month corporate-wide “Nail the Number” campaign.

7.

Six months earlier, Helterbrand placed a new COO in charge of Belot’s operations; that individual, Kyle Allen, is responsible for reviving the company’s sagging operating results.

8.

Allen’s Nail the Number Campaign included several measures, such as incentive-based compensation programs for the company’s sales staff, intended to produce a significant increase in Belot’s year-over-year operating results for the second quarter of the current year.

9.

Allen was pleased with Crabtree’s decision to lower the discretionary accruals; in fact, the Nail the Number campaign reached its financial goal principally because of the lower accruals at the end of the second quarter.

10. Robinson’s decision on how to deal with the accruals “issue” is complicated by the fact that over the past four years he and Crabtree have become good friends—Crabtree has asked Robinson to “pass” on the accruals and not bring the matter to the attention of the audit manager and partner.

11. Further complicating Robinson’s decision is the fact that he was recently told by the Belot audit engagement partner that he is partner “material.

12. Robinson is conflicted by his loyalty to Crabtree and his desire to impress the audit partner by “standing up” to Crabtree.

Instructional Objectives © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.8 Belot Enterprises 149 1.

To help students understand the dynamics of the relationships that develop between auditors and client personnel.

2.

To examine the ethical principle of “integrity” as it relates to auditors and client personnel.

3.

To identify key audit objectives for discretionary expense accruals.

4.

To identify auditors’ responsibilities when reviewing a client’s quarterly financial statements.

Suggestions for Use

A key objective of this casebook is to introduce students to the “real world” of the auditing discipline. This case provides students with a window on that that world by demonstrating how a relationship between a senior auditor and a key client contact person (accounting general manager) affects the dynamics of the given engagement. To make this case even more “real” for your students consider setting up a role-playing exercise involving David Robinson (the audit senior) and Zachariah Crabtree (the accounting general manager). There are two “scenes” that students can role play. The first scene involves the discussion that took place between Robinson and Crabtree shortly after the former discovered the “tightening” of the period-ending discretionary accruals. The second scene would focus on the end of the case when Robinson encounters Crabtree at the company picnic.

Students’ creativity will be tested by the latter scene since the case ends just as the two individuals come face to face with each other at the picnic.

Suggested Solutions to Case Questions 1. What I hope students recognize in addressing this issue is that Robinson’s suggested compromise does not appear to be based upon a thoughtful analysis of the underlying accounting and financial reporting issues or concepts. For example, Robinson’s compromise does not explicitly address the question of whether the change to the “precise point estimate” method had a material impact on Belot’s operating results for the second quarter [granted, it seems fairly obvious that it did]. Even more important, his suggested compromise does not address the question of whether the change to the “precise point estimate” method is a change in accounting method or a change in accounting estimate. [I would suggest that it is a change in accounting estimate and thus should be dealt with prospectively, which it effectively was.] Instead of being “driven” by accounting issues or concepts, Robinson’s suggested compromise appears to simply be a “meet-you-about-halfway” sort of offer intended to settle the matter with as little acrimony as possible. I believe students should recognize that the audit process should not be reduced to a bargaining process between client management and auditors.

You might use the disagreement over the accruals to initiate a general discussion of materiality.

In a situation such as the one posed by the accruals dispute, I sometimes ask students to individually decide what the given materiality threshold should be. In this case, consider asking students what minimum percentage of the year-over-year increase in Belot’s operating income would have to be due to the change in the accruals estimation method for that change to have a material impact on the © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.8 Belot Enterprises 150 company’s operating income. The most obvious choice would be approximately 29%, which would cause the company’s second quarter operating income to fall just below the target goal of a 100% increase. During this discussion, one or more students will likely point out that Crabtree made an invalid argument when he insisted that none of the changes in the accruals individually would be “material.” Of course, the key issue is what was the collective impact of the change in estimation methods on Belot’s operating income.

2. You may want to point out to your students that “integrity” is one of the ethical principles included in the AICPA Code of Professional Conduct. The discussion of that ethical principle within the Code provides a context in which to address the questions of whether or not Crabtree and Robinson possess integrity. According to ET 0.300.040.03-.04.: Integrity requires a member to be, among other things, honest and candid within the constraints of client confidentiality. Service and the public trust should not be subordinated to personal gain and advantage. Integrity can accommodate the inadvertent error and the honest difference of opinion; it cannot accommodate deceit or subordination of principle.

Integrity is measured in terms of what is right and just. In the absence of specific rules, standards, or guidance, or in the face of conflicting opinions, a member should test decisions and deeds by asking: “Am I doing what a person of integrity would do? Have I retained my integrity?” Integrity requires a member to observe both the form and the spirit of technical and ethical standards; circumvention of those standards constitutes subordination of judgment.

Given the information in the case, it is difficult to build a strong argument that Crabtree lacks integrity. Nevertheless, there are certainly some “issues” that can be raised regarding his ethical fiber.

Students typically suggest that Crabtree’s integrity is brought into question by the fact that he “violated” the chain of command rule when he discussed the accruals issue directly with Allen rather than raising the matter first with his immediate superior, Travis Logan. Other students typically use an “end justifies the means” argument to defend Crabtree’s conduct. Crabtree was almost certainly aware that Logan would quash the idea of tightening the accruals, so, in the interests of the “greater good,” he bypassed Logan and went directly to Allen. Another “minus” in evaluating Crabtree’s integrity is that his conduct could be considered self-serving. He stands to benefit personally by reducing the accruals, that is, doing so may help him keep his job and possibly “win” a promotion if Logan resigns. [Granted, as the case points out, Robinson doesn’t believe that Crabtree is attempting to replace Logan, but who knows.] A final demerit for Crabtree is the fact that he didn’t apprise Robinson of the switch to the precise point estimate method of computing the accruals. It is possible that Crabtree hoped that Robinson wouldn’t uncover the fact that the accruals had been systematically “tightened.” In rebuttal to this latter point, some students typically suggest that Crabtree did not have an obligation to inform Robinson of the change in the method used to compute the accruals.

Is Robinson a “person of integrity”? Students are typically more critical of Robinson than Crabtree. Given the facts of the case, Robinson seems to be strongly motivated by “personal gain.”

Again, as pointed out in the solution to Question 1, Robinson’s compromise proposal is not predicated on “good” accounting but rather on helping him both appease his friend (Crabtree) and © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.8 Belot Enterprises 151 “score points” with his superior (Hansen). In sum, Robinson seems to be “subordinating” his role as the public’s financial watchdog to his own personal gain or interests.

Does Robinson have an inappropriate relationship with Crabtree? It is certainly not unusual for friendships to develop between client personnel and independent auditors. However, the issue is at what point do such friendships become dysfunctional? I would suggest that they become dysfunctional when they begin influencing the performance of the given engagement, that is, undermining or potentially undermining the quality of the engagement. In this case, it appears that the relationship between Crabtree and Robinson is doing just that.

3. As a point of information, two of the “accruals” referred to in this case are not accrued liabilities but rather “accrued” valuation accounts. These two accounts are the allowances for bad debts and for inventory obsolescence. The other three discretionary accruals referred to in this case (the accruals for coupon redemptions, employee vacations, and product warranties) are accrued liabilities.

The offsetting debits for each of these period-ending “accruals,” however, all have a downward effect on an entity’s earnings since they involve expense accounts.

The key audit objective for an asset valuation account, an accrued liability, and an expense account is to determine whether the period-ending balances of those accounts are “complete,” that is, the auditor is most concerned with understatements of those accounts. A secondary audit objective for these accounts stems from the “existence” assertion. In some cases, dishonest clients may have an incentive to overstate the period-ending balances of those accounts, for instance, to accomplish a “big bath” agenda. Likewise, an honest audit client may consistently be too conservative in establishing the period-ending balances of those accounts. In either case, the existence assertion would be violated. The bottom line is that auditors must at least consider the possibility that those accounts’ period-ending balances are overstated, that is, that a portion of those balances do not “exist.”

The FASB’s Conceptual Framework identifies “conservatism” as a “constraint,” similar to the cost-benefit principle and the concept of materiality. The Conceptual Framework does NOT suggest that reporting entities routinely overstate valuation accounts, accrued liabilities, and expenses.

Instead, the purpose of the conservatism constraint is to provide a simple rule for reporting entities to follow when there is significant doubt regarding the proper amount of a given financial statement item. That rule is to resolve such doubt by recording the given transaction or event in such a way that the entity’s net assets and/or net income are understated rather than overstated.

4. The purpose of a review engagement is to obtain a reasonable basis for providing limited assurance that a given client's financial statements have been prepared in conformity with generally accepted accounting principles. Essentially, a “clean” review report provides negative assurance, that is, it discloses only that the auditor (CPA) did not discover any evidence suggesting that the financial statements are materially misstated. Of course, the objective of an audit is much more affirmative in nature. A full-scope independent audit is designed to provide a reasonable basis for expressing an "opinion" concerning whether or not a client's financial statements have been prepared in accordance with generally accepted accounting principles.

There is also a critical difference between a review and an audit in terms of the scope of work performed. In a review engagement, the primary evidence collection techniques are analytical procedures and inquiries of client personnel. Alternatively, in an audit, the full range of evidence collection techniques available to an auditor is likely to be used including, but not limited to, © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.8 Belot Enterprises 152 confirmation procedures, physical observation of assets, inspection of documents, etc. Because reviews are generally not as rigorous as audits, considerably less evidence is typically collected in a review engagement than in a comparable audit engagement.

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Case 2.9 Powder River Petroleum International, Inc. 152

CASE 2.9

POWDER RIVER PETROLEUM INTERNATIONAL, INC.

Synopsis Brian Fox, a Canadian with a background in the oil and gas industry, took control of Powder River in late 2003. Fox became not only the principal stockholder of the small company but also its CEO and CFO. Prior to Fox’s arrival, Powder River had posted large losses each year. Thanks to a new strategy implemented by Fox, Powder River became an “overnight” success. Well, not literally.

But in 2006, only three years after Fox assumed control of the company, Powder River posted a $5.7 million net income on total revenues of $13.2 million.

Fox’s turnaround business strategy for the small oil and gas exploration company involved marketing minority “working interests” in oil and gas properties owned by the company to wellheeled Asian investors, primarily citizens of Singapore. With the help of a business associate with whom he had worked in the past, Fox produced more than $43 million of gross revenue from “Property and Working Interest Sales” in a little more than four years. The gross profit margin on those revenues was enormous. For example, Powder River’s 2006 federal tax return reported $17.7 million of taxable revenues from sales of working interests that had a cost basis of less than $150,000.

In 2007, Powder River’s “bubble” burst when the company disclosed in its annual Form 10-K filed with the SEC that there was a “catch” to the working interest sales contracts. The company had promised to repay the Asian investors their investments in eleven years or less. More specifically, the sales contracts obligated Powder River to repay, on an annual basis, 9 percent of the purchase price of each working interest until the investors had fully recovered their investments. Fox had concealed this critical feature of the sales contracts from the SEC, his fellow stockholders, and his independent audit firm. By 2007, the company was using the proceeds from new “sales” of working interests to meet its obligation to repay the investments of earlier investors. In the words of the SEC, Fox was operating a Ponzi scam. The SEC also ruled that the “sales” transactions were, in reality, loans from the investors to Powder River.

This case focuses primarily on the independent auditors of Powder River. Both the SEC and the PCAOB castigated the two partners who had supervised the 2004-2007 audits of Powder River. The two agencies reported a litany of oversights made by the partners. In addition, the PCAOB reported that the partners’ audit firm had a seriously deficient quality control system that had contributed to the busted audits of Powder River. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.9 Powder River Petroleum International, Inc. 153 Powder River Petroleum International, Inc.--Key Facts 1.

In 2003, Brian Fox, a Canadian citizen with experience in the oil and gas industry, became the principal stockholder, CEO, and CFO of Powder River, a small and unprofitable oil and gas exploration company.

2.

Fox quickly “turned around” Powder River by implementing a strategy of selling minority working interests in the company’s oil and gas properties to Asian investors; Powder River realized a gross profit margin of up to 99% on these sales.

3.

Fox concealed a key feature of the working interest sales contracts from the SEC, his fellow stockholders, and the company’s auditors, namely, the fact that Powder River was obligated to repay 9% of those “sales” each year until the individual investors had recovered their investments.

4.

Even after disclosing the 9% repayment clause, Powder River continued to report the working interest transactions as revenues in its annual financial statements filed with the SEC.

5.

Following an investigation, the SEC alleged that Fox was operating a Ponzi scheme and that he had grossly overstated Powder River’s reported assets, revenues, and profits.

6.

The results of the SEC’s investigation and a parallel investigation by the PCAOB revealed numerous deficiencies in the annual audits of Powder River.

7.

The SEC charged that the two partners who supervised the 2004-2007 Powder River audits had relied on Brian Fox’s characterization of the working interest transactions as sales despite their knowledge of the 9% guaranteed payments being made to the investors annually.

8.

The SEC also charged that the two partners failed to discover that Powder River did not own certain oil and gas properties included in its annual balance sheets and failed to properly review the engineering reports that Powder River used to corroborate its reported “proved reserves.”

9.

In addition to reiterating the SEC’s criticisms of the Powder River audit partners, the PCAOB alleged that the partners’ audit firm had a seriously flawed quality control system.

10.

The SEC suspended Powder River’s former audit engagement partners for five years and banned their audit firm from servicing SEC registrants.

11. one

The PCAOB prohibited Powder River’s audit firm from auditing public companies, banned of the former audit engagement partners from being associated with a PCAOB-registered audit firm for five years, and permanently banned the other partner from associating with such a firm.

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.9 Powder River Petroleum International, Inc. 154 12. In 2010, Powder River’s Chapter 11 bankruptcy petition was converted to a Chapter 7 or involuntary bankruptcy filing, meaning that the company would be liquidated; in 2011, the SEC filed a civil fraud complaint against Brian Fox. Instructional Objectives 1.

To demonstrate the importance of auditors’ obtaining a thorough understanding of new, large and/or unusual client transactions.

2.

To demonstrate the limitations of client representations as audit evidence.

3.

To help students identify fraud risk factors.

4.

To document auditors’ responsibilities when relying on audit evidence produced by a “specialist.”

5.

To examine the nature and purpose of an audit firm’s quality control system.

Suggestions for Use

This case focuses on several consecutive audits of an oil and gas exploration company. The case is not highly technical and does not require any background in, or prior knowledge of, the oil and gas industry. Having said that, the case does revolve around accounting and financial reporting decisions for “working interests” in oil and gas properties; however, your students will have no problem grasping the nature of working interests and the related revenue recognition and financial disclosure issues. Certainly, if you want, you could have your students or a group of your students research the key accounting and financial reporting issues for oil and gas companies and then present the results of that research in class prior to covering this case. No doubt, such an assignment would provide your students with a deeper appreciation of the “ticklish” technical accounting and financial reporting issues posed by oil and gas audit clients.

A common caveat that I offer for many of my cases is that they don’t necessarily address every significant technical accounting, financial reporting, or auditing issue that was relevant in the given context. That is certainly true for this case. To keep the length of the case manageable, I didn’t attempt to address every facet of the Powder River debacle. For example, I didn’t address at length Powder River’s restatement of its quarterly financial statements for the first three quarters of 2007— which the company bungled, according to the SEC. If you have an interest in addressing financial statement restatements and/or “corrections of errors,” you might consider having your students research this facet of the case.

Another interesting issue that you may want to raise in covering this case is auditors’ responsibilities vis-à-vis an oil and gas client’s supplementary reserve disclosures. An important aspect of this case was the failure of Powder River to include reliable disclosures in its financial statements regarding its oil and gas reserves. The first and only “interpretation” of AS 2705, © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.9 Powder River Petroleum International, Inc. 155 “Required Supplementary Information,” addresses the nature of auditors’ responsibilities in this context. That interpretation is entitled “Required Supplementary Information” (AI 19.01-06).

Suggested Solutions to Case Questions 1. In the PCAOB’s report in which it disciplined CBN, Todd Chisholm, and Troy Nilson (see PCAOB Release No. 105-2011-003), the agency noted that, “Chisholm and the Firm also failed to consider, or exercise professional skepticism in evaluating, whether information obtained during the audit represented risk factors for fraud.” The report went on to identify the following three specific items of information that were fraud risk factors: a. b. c.

the high percentage of revenues (95%) from the sale of working interests in contrast to the minor amount of revenue realized through petroleum production (the remaining 5%); the issuer’s [Powder River’s] commitment to pay a 9% return to the Third Parties [Asian investors] irrespective of success or failure in the development of oil fields; and the ambiguous roles of the parties involved in the purchases and sales of working interests.

Notes: Item “c” is not discussed in the case and revolves around the fact that there was conflicting evidence regarding exactly how the “sales” to the Asian investors were consummated. Certain “audit evidence” indicated that Fox’s business associate who was involved in arranging the working interest sales actually purchased the working interests from Powder River and resold them to the Asian investors. Other “audit evidence” suggested that Fox’s business associate simply acted as Powder River’s sales agent in helping to arrange the transactions. The PCAOB report does not explain the exact nature or source of the conflicting audit evidence, nor how it came into Chisholm’s possession; however, the report suggested that Chisholm should have investigated that evidence. Instead, the report notes that Chisholm “relied on uncorroborated representations by management in understanding the” nature of the transactions with the Asian investors. As a point of information, Fox’s business associate received a hefty (20 percent) commission on the “sales” to the Asian investors.

In addition to the three fraud risk factors specifically identified by the PCAOB, there were clearly other fraud risk factors present during the Powder River audit engagements. The appendix, “Examples of Fraud Risk Factors,” that follows AS 2401, “Consideration of Fraud in a Financial Statement Audit,” in the PCAOB’s auditing standards categorizes fraud risk factors into the three “angles” of the fraud triangle. Following are paraphrased versions of selected fraud risk factors from that appendix that were particularly relevant to the Powder River audits.

Incentives/Pressures: • High degree of competition (the oil and gas industry is very competitive—this is especially true for “small-time” oil and gas firms such as Powder River) • Operating losses making the threat of bankruptcy, foreclosure or hostile takeover imminent (prior to Fox’s arrival, Powder River was mired in large operating losses) • Management has significant financial interests in the entity (as pointed out in the case, Fox owned 40% of Powder River’s outstanding common stock) © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.9 Powder River Petroleum International, Inc. 156 •

Management compensation is contingent on strong operating results (Powder River’s impressive reported operating results were used to justify Fox’s exorbitant compensation)

Opportunities: • Key financial statement amounts are based on estimates (among the most critical items in Powder River’s financial statements and accompanying footnotes were the estimates of the company’s oil and gas reserves) • Significant, unusual transactions (that is, the transactions with the Asian investors) Attitudes/Rationalizations: • Fox’s prior “run-in” with Canadian regulatory authorities suggests that he may have not been predisposed to “following rules” The fraud risk factors identified by the PCAOB and the additional AS 2401 fraud risk factors identified above had significant implications for the CBN auditors. In particular, these risk factors should have prompted the auditors to adjust the NET (nature, extent and timing) of the audit procedures that they applied during the Powder River engagements. (Note: AU-C 240 is the section of the AICPA Professional Standards that corresponds to AS 2401.)

2. This question can be addressed without requiring your students to explore the sometimes tedious accounting and financial reporting rules for oil and gas companies. In fact, the proper accounting for the sales of the working interests and the guaranteed payments to the Asian investors was not particularly challenging. Assume, for example, that Powder River “sold” a working interest to an investor for $100 for which it was paid immediately. [Note: the impact of the sales commissions on the transactions will be ignored.] Also, assume that the cost basis of the working interest was $5.

Finally, assume that the net present value of the guaranteed (9%) annual payments to the investors was $74. The proper accounting entry for this transaction would have been: Cash Oil and Gas Properties Loan Revenue

$100 $ 5 74 21

Granted, we could quibble over the specific account titles to use for the “Loan” and “Revenue” accounts, but the basic nature of the transaction is captured by this journal entry.

Regarding the annual guaranteed payment to this investor, the proper accounting entry would have been of the following general nature (assuming that $9 was repaid each year): Loan Interest Expense Cash

$5 4 $9

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Case 2.9 Powder River Petroleum International, Inc. 157 Of course, the “divvying up” of the $9 between Loan and Interest Expense would be a mathematical exercise. Likewise, the amount debited to each account over the 11-year repayment period would change annually.

Note: You might consider referring your students to the audit and accounting guide that the AICPA has issued for oil and gas companies if you want them to analyze in more depth audit-related issues for such companies. That guide is entitled, “Audits of Entities with Oil and Gas Producing Activities.” The PCAOB referred to this publication in the release it issued regarding Chisholm, Nilson, and the CBN firm. [Note: Despite the PCAOB’s express reference to the latter document, I have not found any statement in the PCAOB’s auditing standards indicating that the AICPA’s audit and accounting guides are considered authoritative literature by the PCAOB.] 3. AS 1105, “Audit Evidence,” of the PCAOB auditing standards identifies five general categories of management assertions embedded in any given set of financial statements: existence/occurrence, completeness, valuation/allocation, rights and obligations, and presentation and disclosure (see AS 1105.11): “Existence or occurrence—Assets or liabilities of the company exist at a given date, and recorded transactions have occurred during a given period.”

“Completeness—All transactions and accounts that should be presented in the financial statements are so included.”

“Valuation or allocation—Asset, liability, equity, revenue, and expense components have been included in the financial statements at appropriate amounts.”

“Rights and obligations—The company holds or controls rights to the assets, and the liabilities are obligations of the company at a given date.”

“Presentation and disclosure—The components of the financial statements are properly, classified, described, and disclosed.”

The management assertions that were particularly relevant to the “sales” of working interests to the Asian investors were: Completeness, Valuation or Allocation, and Presentation and Disclosure.

Powder River violated the completeness assertion by not recording the liabilities stemming from those transactions. Likewise, the company failed to record the revenues resulting from those transactions in the proper amounts and thus violated the valuation/allocation assertion. Finally, the failure of Powder River to provide complete disclosure of the true nature of the working interest transactions in the company’s financial statement footnotes violated the presentation and disclosure assertion. (Note: granted, in 2007, Powder River finally referred to the existence of the 9% guaranteed payments to the Asian investors in a financial statement footnote.)

The management assertions that were particularly relevant to the guaranteed payments made to the purchasers of working interests were: Valuation/Allocation and Presentation and Disclosure.

Powder River violated the Valuation/Allocation assertion by improperly recording the guaranteed payments as a contra revenue—of course, during the first three quarters of 2007, the company debited those payments to a prepaid expense (asset) account before restating the quarterly financial statements for those three periods and returning to debiting the payments to a contra revenue account. (Note: of course, this latter accounting treatment was patently wrong, as pointed out by the © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.9 Powder River Petroleum International, Inc. 158 SEC.) The company violated the Presentation and Disclosure assertion for the guaranteed payments by failing to disclose them prior to 2007. As noted in a footnote to the case, Powder River also improperly referred to the guaranteed payments as a “future commitment” rather than a current and ongoing commitment.” (Note: Within the AICPA Professional Standards, the management assertions that underlie the audit objectives developed for specific audit engagements are discussed in AU-C Section 315.A128. Of course, the AICPA’s assertion “list” includes 13 items that were derived from the “original” five assertions introduced in the “old” AICPA Professional Standards.

Those “old” assertions are retained in the PCAOB’s auditing standards.)

4. The definitions of negligence, recklessness, and fraud presented here are found in the following source: D.M. Guy, C.W. Alderman, and A.J. Winters, Auditing, Fifth Edition (San Diego: Dryden, 1999), 85-86.

Negligence. "The failure of the CPA to perform or report on an engagement with the due professional care and competence of a prudent auditor." Example: An auditor fails to test a client's reconciliation of the general ledger controlling account for receivables to the subsidiary ledger for receivables and, as a result, fails to detect a material overstatement of the general ledger controlling account.

Recklessness (a term typically used interchangeably with gross negligence and constructive fraud). "A serious occurrence of negligence tantamount to a flagrant or reckless departure from the standard of due care." Example: Evidence collected by an auditor suggests that a client's year-end inventory balance is materially overstated.

Because the auditor is in a hurry to complete the engagement, he fails to investigate the potential inventory overstatement and instead simply accepts the account balance as reported by the client.

Fraud. “Fraud differs from gross negligence [recklessness] in that the auditor does not merely lack reasonable support for belief but has both knowledge of the falsity and intent to deceive a client or third party." Example: An auditor accepts a bribe from a client executive to remain silent regarding material errors in the client's financial statements.

Determining the “level” of malfeasance of the oversights made by CBN is a task for a court of law. (Note: I am not aware of any civil lawsuits that have been filed against CBN as a result of this case.) The purpose of this question is to give students an opportunity to “try” CBN in their own court of justice. For what it is worth, my students have generally suggested that CBN’s failure to discover that Powder River was including bogus assets in its oil and gas properties qualified as “reckless” behavior.

5. Paragraph .03 of AS 1210, “Using the Work of a Specialist,” in the PCAOB’s auditing standards identifies the following three scenarios when auditors should consider retaining the services of an © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.9 Powder River Petroleum International, Inc. 159 independent expert during the course of an audit engagement. (Note: AU-C Section 620, “Using the Work of an Auditor’s Specialist,” is very similar but not identical to AS 1210.) a. b. c.

“Management engages or employs a specialist and the auditor uses that specialist’s work as evidential matter in performing substantive tests to evaluate a material financial statement assertion.”

“Management engages a specialist employed by the auditor’s firm to provide advisory services and the auditor uses that specialist’s work as evidential matter in performing substantive tests to evaluate material financial statement assertions.”

“The auditor engages a specialist and uses that specialist’s work as evidential matter in performing substantive tests to evaluate material financial statement assertions.”

The first scenario was relevant to the CBN auditors during their audits of Powder River. AS 1210.06 provides the following general guidance for auditors to follow in deciding whether the services of a specialist (of their own) should be retained in that scenario: “The auditor’s education and experience enable him or her to be knowledgeable about business matters in general, but the auditor is not expected to have the expertise of a person trained or qualified to engage in the practice of another occupation or profession. During the audit, however, an auditor may encounter complex or subjective matters potentially material to the financial statements. Such matters may require special skill or knowledge and in the auditor’s judgment require using the work of a specialist to obtain appropriate evidential matter.”

Once an auditor has decided to retain the services of a specialist, AS 1210 identifies the following general steps that the auditor should take: 1.

2.

3.

4.

Review the qualifications of the specialist to determine whether he or she “possesses the necessary skill or knowledge in the particular field.” (AS 1210.08) Obtain a general understanding of the work performed by the specialist.

“Evaluate the relationship of the specialist to the client, including circumstances that might impair the specialist’s objectivity.” (AS 1210.10) Most important, the auditor should: “(a) obtain an understanding of the methods and assumptions used by the specialist; (b) make appropriate tests of data provided to the specialist, taking into account the auditor’s assessment of control risk; and (c) evaluate whether the specialist’s findings support the related assertions in the financial statements.”

(AS 1210.12)

6. QC Section 20, “System of Quality Control for a CPA Firm’s Accounting and Auditing Practice” in the PCAOB’s quality control standards provides an overview of the nature and purpose of a CPA firm’s quality control system. (Note: the quality control standards are somewhat different for private company auditors. See the “QC” sections of AICPA Professional Standards.) QC 20.07 identifies the following five elements of quality control for a CPA firm registered with the PCAOB: a.

Independence, Integrity, and Objectivity

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Case 2.9 Powder River Petroleum International, Inc. 160 b. c. d. e.

Personnel Management Acceptance and Continuance of Clients and Engagements Engagement Performance Monitoring

In the PCAOB’s report focusing on CBN, the agency criticized the audit firm’s quality control system with regard to three of the quality control elements, namely, “personnel management,” “acceptance and continuance of clients and engagements,” and “engagement performance.”

Regarding “personnel management,” the PCAOB alleged that CBN failed to ensure that audit engagement teams were staffed with individuals having the necessary “technical training and proficiency.” In terms of “acceptance and continuance of clients and engagements,” the PCAOB criticized CBN for “accepting more engagements than the Firm’s partners and staff could appropriately conduct and manage.” In terms of “engagement performance,” audit assistants assigned to CBN audit engagements were often poorly supervised and, in some cases, had to “decide for themselves” what audit procedures they should apply.

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

160 Corporation

Case 2.10 LocatePlus Holdings

CASE 2.10

LOCATEPLUS HOLDINGS CORPORATION

Synopsis The management team of LocatePlus developed a New Age business model but relied on an oldfashioned fraud scheme to burnish their company’s financial statements. LocatePlus collected a massive database that consisted of information profiles for 98 percent of all U.S. citizens. The company sold access to the database to a wide range of parties that wanted to investigate the backgrounds of job candidates, future business partners, or possibly a prospective son-in-law. By 2004, the company had accumulated an accumulated deficit of $30 million. To improve its operating results, LocatePlus’s CEO and CFO developed an imaginary customer. During 2005 and 2006, the two executives relied on this fictitious customer to boost LocatePlus’s revenues by more than $6 million. Despite the bogus revenues, the company continued to post large losses each year.

This case focuses on the failure of LocatePlus’s independent auditors to uncover their client’s less than artful accounting fraud. During both the 2005 and 2006 LocatePlus audits, the company’s auditors identified red flags indicative of fraud but failed to properly investigate them. Two partners involved in those audits, the audit engagement partner and the concurring partner, were charged with engaging in “highly unreasonable conduct” by the SEC. In addition to three-year suspensions for each partner, their firm was fined and was required to provide CPE to employees that focused on such topics as fraud detection and risk assessment.

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.10 LocatePlus Holdings

161

Corporation LocatePlus Holdings Corporation--Key Facts 1.

The business model of LocatePlus involved selling access to its huge database of information profiles on U.S. citizens to a wide range of parties, including government agencies, corporations, and individuals.

2.

To enhance LocatePlus’s 2005 and 2006 operating results, the company’s CEO and CFO fabricated more than $6 million of revenues from an imaginary customer, Omni Data; the conspirators used fraudulent cash transfers and journal entries to conceal the fraud from their independent auditors.

3.

Livingston & Haynes (L & H) accepted LocatePlus as an audit client in early 2005 despite information they obtained from the prior audit firm that suggested the company’s management was not trustworthy.

4.

During 2005, L & H discovered several red flags that raised serious doubt regarding the reliability of LocatePlus’s accounting records; the most critical of these red flags were unsolicited statements from a former board member who maintained that Omni Data was a bogus entity.

5.

“Overstated and/or fictitious revenues/accounts receivable” from Omni Data were identified by the L & H auditors as a fraud risk factor during their fraud “brainstorming session” for the 2005 audit.

6.

Despite the fraud risk identified for the Omni Data revenues and receivable during the 2005 audit, the key audit evidence collected by L & H to corroborate those material financial statement items was a questionable confirmation obtained from the alleged president of Omni Data.

7.

Among other oversights, L & H did not complete a “fraud risk assessment” template for the 2005 LocatePlus audit and failed to reach “any conclusion about the merits” of the allegations made by the company’s former board member.

8.

The 2006 LocatePlus audit suffered from the same general deficiencies evident during the 2005 audit; in addition, during the 2006 audit, L & H failed to investigate a state agency’s claim that “many aspects” of LocatePlus’s business “were either highly exaggerated or fictitious.”

9.

The 2005 and 2006 LocatePlus audit opinions were unqualified but contained a fourth explanatory paragraph that questioned whether the company was a going concern.

10. The SEC accused the LocatePlus audit engagement partner and concurring partner with “highly unreasonable conduct;” both partners were suspended while L & H was fined $130,000 and required to provide CPE for its audit staff members that focused on fraud detection and related topics. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

162

Case 2.10 LocatePlus Holdings Corporation Instructional Objectives

1. To obtain an understanding of auditors’ responsibilities when they are considering the possibility that fraud has impacted a public company’s financial statements.

2. To demonstrate the importance of auditors thoroughly investigating unusual and suspicious circumstances uncovered during an audit.

3. To demonstrate the importance of candid predecessor-successor auditor communications.

4. To examine the role of concurring partners on audit engagements.

5. To understand the nature and purpose of a letter of representations.

Suggestions for Use This is a case that could be used by instructors to provide a comprehensive review of the requirements of AS 2401, “Consideration of Fraud in a Financial Statement Audit,” of the PCAOB’s auditing standards. The first case question focuses on that important section of the PCAOB’s auditing standards and is easily the most challenging of the case questions. To properly answer that question, students must review AS 2401 and relate the specific requirements of that section to the oversights made by the LocatePlus auditors.

Suggested Solutions to Case Questions 1. Listed next is a bullet list of specific requirements included in AS 2401 of the PCAOB’s auditing standards that L & H apparently failed to complete or complete adequately. This bullet list was drawn from the major subsections of AS 2401. A longer list could be compiled by “drilling down” into the detailed requirements of each of these major subsections. (Note: AU-C Section 240 in the AICPA Professional Standards corresponds with AS 2401.)

Paragraph 13: Failure to exercise sufficient professional skepticism. This deficiency was apparent in numerous instances during the 2005 and 2006 audits, particularly with regard to considering/investigating the allegations of the former board member of LocatePlus.

Paragraph 52: Failure to “design and perform audit procedures in a manner that addresses the assessed risks of material misstatement due to error or fraud.” In 2005, L & H identified the fraud risks associated with the large receivable from Omni Data and the related revenues, however, as pointed out in the case they apparently failed to apply rigorous audit procedures to adequately address those fraud risks.

Paragraph 57: Apparent failure to adequately investigate the possibility that client management had overridden internal controls. This issue is not addressed in the case and was not addressed explicitly © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.10 LocatePlus Holdings Corporation163 in the SEC Accounting and Auditing Enforcement Release on which the case is based. Nevertheless, given the identified fraud risk for the Omni Data receivable and revenues, it seems that L & H should have focused considerable attention on the question of whether LocatePlus management had circumvented the company’s internal controls for the purpose of concealing fraudulent errors in the company’s accounting records. As pointed out in the case, fraudulent cash transfers and accounting entries were used to help conceal the fraud from the L & H auditors. (Note: Paragraphs 58-67A of AS 2401 include a long list of specific audit tests and procedures that can be used by auditors to identify instances in which client management may have overridden the given company’s internal controls.)

Paragraph 79: Possible failure to adequately communicate with the client’s audit committee regarding potential management fraud. One could argue that L & H satisfied its responsibility to inform LocatePlus’s audit committee regarding the possibility of management fraud when Howley forwarded the allegations of the former board member to the chairman of the company’s audit committee. However, given the seemingly extreme nature of the fraud risks uncovered by L & H (and/or communicated to them by the former board member), it seems reasonable to argue that the audit firm should have insisted on having the face-to-face meeting with the audit committee that Howley called for during 2005.

Paragraph 83: Failure to properly document the auditor’s consideration of fraud. During the 2005 audit, the L & H audit team failed to complete the “Fraud Risk Assessment Form” for that engagement. Even more seriously, the SEC noted that L & H’s 2005 workpapers did not document “any conclusions about the merits” of the former board member’s allegations of fraud within LocatePlus.

2. For audits of public companies, the relevant auditing standards in this context are presented in AS 2610, “Initial Audits—Communications Between Predecessor and Successor Auditors,” of the PCAOB’s auditing standards. The comparable auditing standards for audits of other entities can be found in AU-C 210 and AU-C 510 of the AICPA Professional Standards.

Predecessor-successor auditor communications are intended to help ensure that successor auditors receive all relevant information they need to make a client acceptance decision and to help them design an appropriate audit for the new client following that decision. The prospective successor auditor is responsible for initiating predecessor-successor auditor communications. Prior to accepting a client, the successor auditor should request permission from the prospective client to communicate with the former auditor. Additionally, the successor auditor should ask the client to authorize the former auditor to respond fully to that request.

AS 2610 identifies five specific items of information that the successor auditor should request from the predecessor auditor: 1) information that might bear on the integrity of management, 2) disagreements with management as to accounting principles, auditing procedures, or other similar matters, 3) communications with the client’s audit committee (or other parties with similar authority) regarding fraud, illegal acts, and internal control-related matters, 4) the predecessor auditor’s understanding as to the reasons for the change in auditors, and 5) the predecessor auditor’s understanding of related party relationships, related party transactions, and “significant unusual transactions.” © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Case 2.10 LocatePlus Holdings Corporation

Following the acceptance of the client by the successor auditor, the latter should ask the client to authorize the predecessor auditor to allow it (the successor) to review the predecessor’s workpapers.

It is customary for the predecessor auditor to provide the successor auditor with copies of key workpapers prepared during the prior year's audit.

3. Note: the source for this suggested solution is AS 1220, “Engagement Quality Review,” of the PCAOB’s auditing standards.

AS 1220.01 notes that, “An engagement quality review and concurring approval of issuance are required for the following engagements conducted pursuant to the standards of the Public Company Accounting Oversight Board (PCAOB): (a) an audit engagement; (b) a review of interim financial information; and (c) an attestation engagement performed pursuant to Attestation Standard No. 1, Examination Engagements Regarding Compliance Reports of Brokers and Dealers, or Attestation Standard No. 2, Review Engagements Regarding Exemption Reports of Brokers and Dealers. (Note: Prior to AS 1220, an “engagement quality review” was typically referred to as a “concurring partner review” or some similar expression.)

AS 1220.09 notes that “In an audit engagement, the engagement quality reviewer should evaluate the significant judgments made by the engagement team and the related conclusions reached in forming the overall conclusion on the engagement and in preparing the engagement report.” AS 1220.10 identifies a litany of individual tasks that an engagement quality reviewer must perform on an audit engagement. Examples of these tasks include “evaluate the significant judgments that relate to engagement planning . . .; “evaluate the significant judgments made about materiality . . .;” and “review the financial statements, management’s report on internal control, and the related engagement report.”

In sum, an engagement quality reviewer serves as an overall quality control mechanism for an independent audit.

The ultimate responsibility of the engagement quality reviewer is to decide whether or not to provide “concurring approval of issuance” of the audit report. AS 1220.12 notes that the engagement quality reviewer may not issue “concurring approval” if he or she is aware of any “significant engagement deficiency.” That paragraph defines the latter term as follows: A significant engagement deficiency in an audit exists when (1) the engagement team failed to obtain sufficient appropriate evidence in accordance with the standards of the PCAOB, (2) the engagement team reached an inappropriate overall conclusion on the subject matter of the engagement, (3) the engagement report is not appropriate in the circumstances, or (4) the firm is not independent of its client.

4. AS 2805 of the PCAOB’s auditing standards documents the nature and purpose of a letter of representations (“management representation letter” is the actual phrase used in this context). The corresponding section of the AICPA Professional Standards is AU-C Section 580, “Written Representations.”

AS 2805 mandates that U.S. auditors obtain “written representations from management” (Paragraph 1) and notes that such representations are “part of the evidential matter” (Paragraph 2) that auditors obtain to support the opinion they render on a given client’s financial statements. Such representations must be obtained “for all financial statements and periods covered” (Paragraph 5) by the given auditor’s report. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.10 LocatePlus Holdings Corporation165 Written management representations are obtained to confirm explicit or implicit representations that client management makes to auditors during the course of an audit and also serve to “reduce the possibility of misunderstanding” (Paragraph 2) between the two parties. Among the most important observations made in AS 2805 is the fact that written representations obtained from management are intended to “complement other auditing procedures” (Paragraph 3), meaning that these representations are generally not intended to serve as the primary evidence collected to support key management assertions embedded in a set of financial statements. However, if client management refuses to furnish appropriate written representations to their auditors, such refusal “constitutes a limitation on the scope of the audit sufficient to preclude an unqualified opinion and is ordinarily sufficient to cause an auditor to disclaim an opinion or withdraw from the engagement” (Paragraph 13). (Notes: Appendix A of AS 2805 includes an illustrative letter of representations. An implicit objective of obtaining a letter of representations is to mitigate an audit firm’s legal liability if it becomes involved in litigation subsequent to completing an audit.)

AS 1105 requires an auditor to collect sufficient appropriate evidence to support his or her opinion. In evaluating the quality of audit evidence, a key issue that the auditor considers is the source of the given evidence. Because client executives are not objective parties, representations they make may be biased, which, of course, devalues the quality or strength of this evidence. [Note: AS 2805 observes that when other evidence obtained by an auditor contradicts representations made by client management, the auditor should investigate the relevant circumstances and consider the reliability of the representations made. “Based on the circumstances, the auditor should consider whether his or her reliance on management’s representations relating to other aspects of the financial statements is appropriate and justified” (Paragraph 4).]

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

CASE 2.11

OVERSTOCK.COM, INC.

Synopsis In 1999, Patrick Byrne, the son of a wealthy associate of Warren Buffett, purchased a controlling interest in a small online retailer specializing in “excess” and “closeout” merchandise. Byrne renamed the company Overstock.com and invested several million dollars to expand its operations. Ironically, the bursting of the “dot.com bubble” in 2000 was the trigger that fueled the rapid growth of Overstock. When hundreds of other online companies began falling by the wayside, Overstock stepped in and liquidated their merchandise at fire sale prices. In 2002, Byrne took his company public with an IPO that raised $40 million.

This case revolves around an accounting dispute involving Overstock and the company’s audit firm Grant Thornton. In March 2009, Overstock retained Grant Thornton after dismissing its longtime auditor, PwC. In October 2009, the SEC sent a letter to Overstock inquiring about several accounting decisions made by the company. The key focus of the SEC inquiry was the accounting treatment that had been applied to a $785,000 transaction involving one of Overstock’s business partners—the company served as an intermediary or sales agent for more than 3,000 other businesses which it referred to as “partners.” The accounting treatment applied to the transaction had effectively transferred $785,000 of gross profit from fiscal 2008 to fiscal 2009. When Grant Thornton became aware of this transaction after the SEC inquiry, the audit firm recommended that Overstock restate its prior financial statements to properly account for the transaction. However, Overstock’s accounting staff and PwC believed that the original accounting treatment applied to the transaction was reasonable.

The dispute between Grant Thornton and Overstock resulted in Grant Thornton’s dismissal in November 2009. Because Overstock did not have sufficient time to retain another audit firm to review its Form 10-Q for the third quarter of 2009, the company made the extremely unusual decision to file its 10-Q with the SEC despite the fact that the company’s quarterly financial statements had not been reviewed by an independent audit firm. Adding to the ensuing controversy was a series of contentious exchanges between Overstock’s management and Grant Thornton. Each party accused the other of misrepresenting the series of events that had preceded Grant Thornton’s dismissal in November 2009. Overstock, for instance, alleged that Grant Thornton had acquiesced to the questionable accounting treatment applied to the $785,000 transaction when it agreed to serve as the company’s auditor in March 2009. In an exhibit letter filed with the Form 8-K announcing its dismissal as Overstock’s auditor, Grant Thornton insisted that it had been unaware of that questionable accounting treatment when it accepted the Overstock engagement. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.11 Overstock.com, Inc. 167 Overstock.com, Inc.--Key Facts 1. Warren Buffett launched Patrick Byrne’s career in corporate management when he appointed him the interim CEO of a struggling company owned by Berkshire Hathaway; 18 months later, Byrne struck out on his own when he purchased a controlling interest in a small, online retailer that marketed “excess” and “closeout” merchandise.

2. Byrne’s company, which became Overstock.com, received a kickstart in 2000 with the bursting of the “dot.com bubble” that produced a huge increase in business for online liquidators such as itself.

3. After going public in 2002, Overstock’s revenues grew rapidly, but the company struggled to become profitable; by 2008, the company had yet to report a profit for a full year.

4. In addition to the persistent losses and Patrick Byrne’s overbearing public persona, Overstock’s multiple financial restatements caused investors to shy away from the company’s common stock.

5. In October 2009, Overstock received a letter of inquiry from the SEC that requested information regarding several accounting decisions made by the company including the accounting treatment applied to a $785,000 overpayment made by the company in 2008 to one of its business partners.

6. The accounting treatment applied to the $785,000 overpayment resulted in Overstock’s cost of goods sold for 2008 being overstated by that amount; the company’s cost of goods sold for the first quarter of 2009 was understated by that same amount when the overpayment was recovered.

7. In fiscal 2008, Overstock and PwC, its audit firm at the time, chose not to record a correcting entry for the overpayment because of uncertainty regarding whether the $785,000 would be recovered.

8. In March 2009, Overstock retained Grant Thornton as its new audit firm; according to Overstock’s management, Grant Thornton agreed with the accounting treatment that had been applied to the $785,000 overpayment.

9. In November 2009, following an inquiry by the SEC regarding the accounting treatment applied to the $785,000 overpayment, Grant Thornton informed Overstock that it had never agreed with that accounting treatment; shortly thereafter, Overstock dismissed Grant Thornton.

10. Overstock and Grant Thornton traded combative accusations in a series of Form 8-K’s filed with the SEC following the dismissal of Grant Thornton.

11. Because Overstock did not have sufficient time to hire a replacement audit firm, the company filed an “unreviewed” Form 10-Q for the third quarter of fiscal 2009 with the SEC.

168 Case 2.11 Overstock.com, Inc. 12. In 2010, after hiring KPMG as its new audit firm, Overstock restated its prior financial statements for fiscal 2008 and for the first three quarters of 2009; in 2012, the SEC decided not to file an enforcement action against Overstock for the improper accounting treatment applied to the $785,000 overpayment and related accounting misstatements.

Instructional Objectives 1. To examine the nature and purpose of SEC disclosure requirements for auditor changes.

2. To examine the implications and consequences of auditor-client disagreements.

3. To review the SEC’s quarterly reporting requirements.

4. To compare and contrast the nature of audit and review engagements.

5. To identify quantitative and qualitative considerations that impact materiality judgments.

6. To review revenue recognition issues.

Suggestions for Use This case is ideally suited to be integrated with class coverage of SEC reporting requirements, including those incorporated in the Sarbanes-Oxley statute—recognize that the SEC requirement mandating that quarterly financial statements be reviewed preceded SOX by two years. The case also “fits” well with corporate governance topics and how the independent audit function relates to corporate governance.

There is a “mystery” component of this case, namely, why the SEC didn’t respond publicly to Overstock’s decision to file an “unreviewed” Form 10-Q for the third quarter of its 2009 fiscal year.

In fact, the SEC occasionally accepts “incomplete” filings and defers taking any action if a registrant has a plan to “cure” the deficient filing (you might consider having a group of students research this issue and provide an oral in-class report). Nevertheless, I thought that the SEC would at least make a public statement when a high profile company files “suspect” financial statements for public consumption. It seemed as if the SEC deferred to the relevant stock exchange, the NASDAQ in this case, to serve as the oversight body that ensured that Overstock eventually provided proper financial statement data to the investing public.

Suggested Solutions to Case Questions 1. The dispute between Overstock and Grant Thornton was not that unusual. Given the nature of their relationships, public companies and their independent auditors are commonly involved in disagreements that can range from minor differences of opinion to emotional, tension-packed confrontations. What was unusual was the fact that the Overstock-Grant Thornton dispute was made available for public consumption. No doubt, the finger pointing and caustic allegations diminished, to some degree, the public’s respect for the financial reporting domain and the independent audit function. Granted, the most caustic, if not childish, statements were made by Overstock officials.

Although Grant Thornton officials candidly expressed their disagreement with statements made by Overstock, they did so with a degree of professionalism and civility. Overstock officials were

Case 2.11 Overstock.com, Inc. 169 seemingly less than civil in their attacks on the accounting firm. For example, here is one of the “jabs” that Overstock management directed at Grant Thornton after retaining KPMG as the company’s new audit firm (this statement was not included in the case): “It’s nice to be back with a Big Four accounting firm” (Overstock.com press release, 29 December 2009). That statement certainly seems unnecessary and somewhat childish.

You might point out to your students that in the past auditors and their former clients have been criticized for being less than forthcoming or candid in 8-K auditor-change announcements. The SEC adopted the disclosure rules for auditor changes to provide the investing public with meaningful insight on the factors or circumstances that may have contributed to a given change in audit firms.

Such disclosures can, in particular, reveal situations in which public companies may be engaging in apparent “opinion shopping.” Whatever the circumstances, however, that led to a given change in auditors, the two parties should strive to retain their professionalism and civility to maintain the credibility of, and the public’s respect for, the financial reporting domain and the independent audit function.

2. Let me begin with a prologue or overview of what professional standards have to say regarding the critical materiality concept in an accounting context.

The FASB’s definition of materiality can be found in Statement of Financial Accounting Concepts No. 8: “Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude or both of the items to which the information relates in the context of an individual entity’s financial report.” [Note: At press time, the FASB was considering a proposal to adopt the Supreme Court/SEC definition of materiality.]

The SEC’s principal statement regarding materiality can be found in Staff Accounting Bulletin No. 99 issued in 1999. From the SEC’s standpoint, an item is generally material if there is a “substantial likelihood” that a “reasonable investor” would “attach importance” to it in deciding whether or not to purchase a given security. Here’s a key excerpt from SAB No. 99.

An assessment of materiality requires that one views the facts in the context of the “surrounding circumstances,” as the accounting literature puts it, or the “total mix” of information in the words of the Supreme Court. In the context of a misstatement of a financial statement item, while the “total mix” includes the size in numerical percentage terms of the misstatement, it also includes the factual context in which the user of the financial statements would view the financial statement item. The shorthand in the accounting and auditing literature for this analysis is that financial management and the auditor must consider both “quantitative” and “qualitative” factors in assessing an item’s materiality.

Patrick Byrne, himself, suggested on more than one occasion that he didn’t understand why so much controversy had arisen over a relatively small transaction involving $785,000. During the November 2009 conference call with financial analysts, for example, he pointed out that the amount of the overpayment was equal to less than .1% of the company’s 2008 revenues. Granted, the SEC inquiries and subsequent investigation resulted in a financial restatement of $1.7 million—apparently, other accounting misstatements were discovered as a result of the investigation prompted by the SEC

170 Case 2.11 Overstock.com, Inc. inquiries in the fall of 2009.

Comparing the $785,000 overpayment to the data points presented in Exhibit 1, the issue of quantitative materiality would be most relevant to Overstock’s reported Net Loss amounts. If a proper correction had been recorded for the $785,000 overpayment, the 2008 Net Loss would have been reduced by approximately 6% while the Net Loss for the first quarter of 2009 would have been increased by more than 35%. Consequently, it seems reasonable to conclude that the improper accounting treatment initially applied to the overpayment had a material impact on those two amounts. When one considers the fact that the eventual restatement involved $1.7 million of profit being “moved” from 2009 to 2008, the overpayment “issue” was even more material to the 2008 and first quarter 2009 operating results. Note: The Epilogue to the case reveals that Overstock’s Net Income for 2009 was $7.7 million. Again, either the $785,000 amount that was central to the Overstock-Grant Thornton dispute or the eventual restatement amount of $1.7 million would have been clearly material to that reported Net Income figure.

As the SEC has observed, “qualitative” factors are particularly relevant to materiality determinations. In the context of this case, one of the most important, if not the most important, qualitative consideration was the fact that Overstock was laser-focused on reporting a profit in 2009 for the first time in the company’s history. Under such circumstances, auditors should be aware that the given client may take extraordinary measures to enhance their operating results. Likewise, the fact that Overstock had multiple accounting restatements in the past was certainly relevant to the materiality judgments to be made by the company’s auditors. If a company has had multiple accounting restatements in the past, this seems to suggest that it plays “fast and loose” with its key accounting decisions. A final qualitative factor that Overstock’s auditors should have considered in their materiality determinations was the fact that the company was the focus of inordinate attention on the part of regulatory authorities. If regulatory authorities are expected to go over a client’s financial statements with “a fine tooth comb,” auditors should be particularly cautious when assessing the materiality judgments of that client.

3. The purpose of a review engagement is to obtain a reasonable basis for providing limited assurance that a given client's financial statements have been prepared in conformity with generally accepted accounting principles. Essentially, a “clean” review report provides negative assurance, that is, it discloses only that the auditor (CPA) did not discover any evidence suggesting that the financial statements are materially misstated. Of course, the objective of an audit is much more affirmative in nature. A full-scope independent audit is designed to provide a reasonable basis for expressing an "opinion" concerning whether or not a client's financial statements have been prepared in accordance with generally accepted accounting principles.

There is also a critical difference between a review and an audit in terms of the scope of work performed. In a review engagement, the primary evidence collection techniques are analytical procedures and inquiries of client personnel. Alternatively, in an audit, the full range of evidence collection techniques available to an auditor is likely to be used including, but not limited to, confirmation procedures, physical observation of assets, inspection of documents, etc. Because reviews are generally not as rigorous as audits, considerably less evidence is typically collected in a review engagement than in a comparable audit engagement.

4. The fact that Form 10-Q financial statements are not accompanied by a “review” report although they are subjected to a review comes as a surprise to most students. The SEC mandates that a review report accompany 10-Q financial statements only if the given SEC registrant refers to the fact that the

Case 2.11 Overstock.com, Inc. 171 financial statements were reviewed. This was a major issue in the Warnaco securities fraud case in which Deloitte, the company’s former audit firm, was named as a defendant. The given federal court ruled that Deloitte could not be held “primarily” liable for any misstatements in Warnaco’s quarterly financial statements because the given 10-Q financial statements were not accompanied by a review report. (The plaintiff argued that because third parties were generally aware that Warnaco was required to have Deloitte review its quarterly financial statements, Deloitte should be held responsible for material misstatements in those financial statements.)

The SEC apparently doesn’t require SEC registrants to include review reports with their quarterly financial statements because of concern that investors will misinterpret the degree of assurance that the given auditors (“accountants” is the proper term in this context) are providing. No doubt, many investors, or, at least, naïve investors, would simply glance at a review report and assume that the accompanying financial statements had been audited.

5. The SEC website provides the following general description of the nature and purpose of Form 8-K filings.

“Form 8-K provides investors with current information to enable them to make informed decisions. The types of information required to be disclosed on Form 8-K are generally considered to be ‘material.’ That means that, in general, there is a substantial likelihood that a reasonable investor would consider the information important in making an investment decision.”

Companies generally have four business days to file an 8-K once the “triggering event” takes place. The SEC lists a wide range of disclosure “items” for which a Form 8-K filing is necessary.

Following are some examples.

Entry into a “material definitive agreement” Bankruptcy or receivership proceedings Completion of a major acquisition or a major disposition of assets The issuance of an earnings press release A material impairment of assets Notice of the delisting of a company’s stock by a stock exchange An unregistered sale of equity securities A material modification to the rights of security holders A change in a registrant’s certifying accountant Obviously, the SEC considers a change in auditors to be a “material” event that could impact a reasonable investor’s decisions. The mandated disclosures for auditor changes include whether the auditor resigned or was dismissed, the date of the auditor change, whether the former auditor’s reports for the prior two years included any qualifications or adverse opinions, whether the given company’s audit committee approved the change in auditors, and whether any disagreements took place between the company and the former auditor over the two most recent years.

6. “Grossing” up revenue is a controversial practice. Generally, companies that act as intermediaries

172 Case 2.11 Overstock.com, Inc. or sales agents for other businesses should record only the net amount they receive from their clients or “partners” (Overstock’s term) as revenue. Grossing up revenue obviously enhances a company’s operating results by making the entity appear more substantial. Enron was among the most notable companies in the past that used this method to enhance its “top line”—Enron insisted on grossing up the revenue on the energy contracts that it traded. Many other e-commerce companies—Enron was primarily an online company—have also been criticized for enhancing their total revenues by using this accounting method (Priceline is another prominent example).

The notes accompanying Overstock’s financial statements identify the conditions that must be met before the company records revenues on a gross basis. “When we are the primary obligor in a transaction, are subject to inventory risk, have latitude in establishing prices and selecting suppliers, or have several but not all of these indicators, revenue is recorded gross. If we are not the primary obligor in the transaction and amounts earned are determined using a fixed percentage, revenue is recorded on a net basis” (Overstock, 2014 Form 10-K). [Note: In March 2016, the FASB issued Accounting Standards Update (ASU) 2016-08, “Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net).” This update provides additional guidance to companies, such as Overstock, that must decide whether they qualify as the “principal” or “agent” in revenue transactions involving multiple parties.]

Grossing up revenue is not only controversial from an accounting standpoint but also from an auditing point of view. The PCAOB specifically addressed this topic in Staff Audit Practice Alert No. 12, “Matters Related to Auditing Revenue in an Audit of Financial Statements” (September 9, 2014).

In that practice alert, the PCAOB reported that the “Inspections staff observed instances in which auditors failed to perform sufficient procedures to evaluate whether a company’s presentation of revenue on a gross basis (as a principal) versus a net basis (as an agent) was in conformity with the applicable financial reporting framework” (p. 9). The PCAOB went on to warn auditors that they had a responsibility to determine whether a client recording revenues on a gross basis was truly the “principal” in the given transaction rather than simply serving as an “agent” for the actual seller.

Case 2.12 Parker-Halsey Corporation 173

CASE 2.12

PARKER-HALSEY CORPORATION

Synopsis Katelyn Light, a Big Four audit manager, unexpectedly finds herself supervising an awkward Saturday morning inventory observation. Katelyn was notified of the assignment just one day earlier

by Juan Suarez, an audit partner with whom she works. The assignment is awkward because it is cloaked in secrecy. Suarez’s largest audit client, Volterra Chemicals, is in the early stages of negotiations to acquire Parker-Halsey Corporation (PHC), an agrichemicals manufacturer. Volterra’s senior management was “burned” on a recent corporate acquisition because the company that was acquired overstated its final year-end inventory prior to the takeover, resulting in its assets, revenues, and profits being significantly overstated. Volterra’s executives want to minimize the risk that PHC’s management does something similar.

Suarez was asked by Volterra’s management to send a team of his “best” auditors to observe PHC’s year-end physical inventory. Because Volterra doesn’t want other parties to discover its interest in PHC, Suarez’s auditors have been instructed to conceal their identities during the physical inventory observation—the only parties aware of the auditors’ true identities and purpose are a few members of PHC’s accounting staff who are present during the physical inventory.

Katelyn Light’s two subordinates on the PHC assignment are an audit senior, Dani Morgan, and an audit associate, Tyler Christian. The three auditors encounter challenges commonly faced during an inventory observation assignment including less than cooperative client personnel and unexpected tactical problems in taking their test counts. Even more challenging, however, is concealing their true identities from the curious team of PHC’s independent auditors who are also observing the company’s physical inventory.

The major focus of the case is a significant disagreement that arises when Katelyn insists on reweighing a sample of large inventory storage bins that were allegedly weighed earlier in the week in the presence of PHC’s independent auditors. Given the nature of the assignment, Katelyn believes that she must insist that some of the bins be re-weighed. During the course of the disagreement, Katelyn and her subordinates’ “cover” is blown, which leads to a heated exchange between her and PHC’s audit engagement partner.

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.12 Parker-Halsey Corporation 174 Parker-Halsey Corporation—Key Facts 1. Volterra Chemicals, a large public company, is in the early stages of negotiating a buyout of Parker-Halsey Corporation (PHC), a smaller private company that specializes in agrichemicals.

2. Because Volterra’s executives are concerned that PHC may intentionally overstate its year-end inventory, they ask their audit engagement partner, Juan Suarez, to send a team of his “best” auditors to observe PHC’s year-end physical inventory.

3. The auditors chosen by Suarez for the PHC assignment are Katelyn Light, an audit manager; Dani Morgan, an audit senior and Katelyn’s close personal friend; and Tyler Christian, an audit associate who has worked in the past with both Katelyn and Dani.

4. The PHC assignment is complicated for the three auditors because Volterra insists that they conceal their true identities and the nature of their assignment; Volterra’s executives don’t want any third parties to learn that they are interested in acquiring PHC. 5. During the PHC assignment, the three auditors encounter problems commonly posed by inventory observations including less than cooperative client personnel.

6. The most awkward problem the three auditors face is concealing their true identities and the nature of their assignment from the other parties present during the taking of the physical inventory.

7. The individuals who are most curious about the presence of Katelyn, Dani, and Tyler are the PHC independent auditors who are also observing the physical inventory.

8. Katelyn and her two subordinates inform PHC’s employees and independent auditors that they are inventory “consultants”—a few members of PHC’s accounting staff, including the company’s controller, who are present during the physical inventory are aware of, and participate in, this subterfuge.

9. The “cover” of Katelyn, Dani, and Tyler is blown when a heated disagreement arises; Katelyn insists that certain inventory storage bins must be re-weighed in her presence despite the fact that the bins were allegedly weighed earlier in the week in the presence of two of PHC’s independent auditors.

10. PHC’s audit engagement partner becomes angry when he discovers that Katelyn and her subordinates are auditors themselves; he is angered even more when Katelyn refuses to rely on the audit procedures that his two subordinates completed earlier in the week.

11. Eventually, PHC’s controller agrees to re-weigh a sample of the inventory storage bins in © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.12 Parker-Halsey Corporation 175 question; the recorded weights of the majority of the bins that are re-weighed are found to be significantly inflated.

12. As a result of the evidence collected by Katelyn’s team, Volterra terminates it buyout negotiations with PHC. Instructional Objectives 1. To examine quasi-audit professional service engagements and the professional standards applicable to such engagements.

2. To identify the audit objectives associated with inventory observation assignments and the audit procedures typically performed during such assignments.

3. To identify the circumstances in which auditors can rely on the results of audit procedures performed by other auditors.

4. To identify internal control weaknesses in a client’s physical inventory procedures and the resulting implications for auditors.

5. To examine interpersonal dynamics that may influence the outcome of audits and related professional services.

6. To examine the responsibility of auditors to treat client personnel and professional colleagues with dignity and respect on all engagements.

Suggestions for Use Public accountants are typically assigned to numerous physical inventory observations during their first few years within the profession. If you “hang around” former auditors long enough, they will eventually begin sharing “war stories” regarding challenging, awkward, or even disastrous inventory observations to which they were assigned. In fact, I have begun coverage of this case by sharing several such anecdotes of my own with my students. If you have such experiences, you might consider sharing them with your students to kick off the coverage of this case. If you are teaching a graduate auditing course, it is very likely that you have students who have been involved in physical inventory observations as interns. Consider asking such students to share their experiences with their classmates.

This case involves several named individuals. Consider developing a roster of these individuals and then using that roster in an exercise to initiate coverage of the case. For example, after posting a roster of the individuals involved in this case on the board or overhead, consider requiring students to rank the professionalism, integrity, and/or “likeability” of each of those individuals (this exercise would overlap somewhat with case question #6). At the very least, having such a roster readily accessible will facilitate and expedite the discussion of the case.

I often remind my students that interpersonal dynamics are critical when it comes to the success © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.12 Parker-Halsey Corporation 176 or failure of individual audit engagements or individual audit assignments. Interpersonal dynamics can be particularly critical during physical inventory observations. Quite often, these assignments produce “perfect storm” type circumstances in which anything that can go wrong, does go wrong.

Two factors, in particular, account for those perfect storm circumstances, namely, uncooperative client personnel who wish they were somewhere else and overworked auditors who, likewise, wish they were somewhere else. Complicating matters even more is the fact that entry-level auditors are typically given these assignments. Unlike this case, the norm is that entry-level auditors do not have supervisory personnel present during a physical inventory observation. Consequently, when issues arise, these inexperienced auditors are often “on their own” and subject to pressure imposed on them by the given client’s supervisory personnel who are present. In other words, auditors can sometimes find themselves “bullied” in these circumstances.

The unanswered question in this case is who was responsible for the apparently systematic overstatement of the recorded weights for the majority of the Section B storage bins. The individual who provided the information on which this case is based did not know the answer to that question.

As noted in the epilogue to the case, the company identified as Volterra Chemicals immediately ended its buyout negotiations with the company identified as Parker-Halsey Corporation when the inventory “issue” (overstatement of the Section B inventory weights) was uncovered. The most likely “candidate” in this context was Kenneth Aska, although he appeared to be genuinely shocked by the significant overweights that were discovered during PHC’s physical inventory. You might ask your students to develop alternative theories that could explain how the overweights occurred. (The individual who provided the information for this case did report that approximately 10-15% of the Section B storage bins had been weighed correctly. He also reported that these bins were randomly scattered, that is, they were not “clustered together” in the storage area.)

Suggested Solutions to Case Questions 1. In fact, the individual who provided the key information for this case was not aware of how the hours spent on the inventory observation assignment were billed to the client identified as Volterra Chemicals. That individual speculated that since a limited number of hours were involved, they were most likely included in the standard billing for the upcoming Volterra audit, that is, there likely was not a separate engagement letter or agreement prepared for the inventory observation assignment.

That individual did suggest that he/she viewed the engagement as a “consulting service” for Volterra that effectively involved forensic-type accounting services.

The AICPA Professional Standards define “consulting services” as follows: “Professional services that employ the practitioner’s technical skills, education, observations, experiences, and knowledge of the consulting process. Consulting services may include one or more of the following “ consultations . . . advisory services . . . implementation services . . . transaction services . . . staff and support services . . . product services” (CS 100.05). Paragraph CS 100.05 provides detailed descriptions of each of these latter services. The applicable professional standards for consulting engagements are the Statements on Standards for Consulting Services that are issued by the AICPA Management Consulting Services Executive Committee (see the CS Section in the AICPA Professional Standards, Volume 2.) © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.12 Parker-Halsey Corporation 177 One could question whether the inventory observation assignment qualified as an “attest” engagement, which would mean that the Attestation Standards applied to the assignment. Paragraph AT Section 101.01 makes the following statement regarding the applicability of the profession’s attestation standards: “This section applies to engagements, except for those services discussed in paragraph .04, in which a certified public accountant in the practice of public accounting (hereinafter referred to as a practitioner) is engaged to issue or does issue an examination, a review or an agreedupon procedures report on subject matter, or an assertion about the subject matter (hereinafter referred to as the assertion), that is the responsibility of another party.” The five specific exceptions referred to in the previous statement are audits, reviews, consulting engagements (as defined by the profession’s consulting standards), advocacy engagements, and tax preparation or tax advisory engagements. The exception regarding consulting engagements includes the following verbiage: “Services performed in accordance with the Statements on Standards for Consulting Services, such as engagements in which the practitioner’s role is solely to assist the client (for example acting as the company’s accountant in preparing information other than financial statements), or engagements in which a practitioner is engaged to testify as an expert witness in accounting, auditing, taxation, or other matters, given stipulated facts.”

As the case suggests, a verbal or possibly written report was prepared for Volterra Chemicals— that “report” prompted Volterra to end its buyout negotiations with PHC. But the information available in the case (and from the party who provided the central information for the case) suggests that the given report was not an “attest report.” Again, the individual who was the principal source of the information for this case viewed the assignment as involving the provision of forensic consulting services.

Note: If the inventory observation assignment was treated as a “consulting” engagement by Juan Suarez’s firm, then that assignment may have posed an independence problem for his firm.

“The performance of Consulting Services for an attest client does not, in and of itself, impair independence. However, members and other firms performing attest services for a client should comply with applicable independence standards, rules, and regulations issued by AICPA, the state boards of accountancy, state CPA societies, and other regulatory agencies” (CS 100.09). You might consider extending this question by asking your students to identify the independence-related issues that the inventory observation assignment might have raised for the given firm’s Volterra audit team. I would suggest that the engagement effectively placed Katelyn Light and her subordinates in the position of being advocates for Volterra, which is inconsistent with serving as the company’s independent auditors. (Granted, Katelyn and her subordinates were not assigned to the Volterra audit team but they were employed by Volterra’s audit firm and, even more importantly, their “boss” Juan Suarez headed up the Volterra audit engagement team.)

2. The key audit objective for the Dulin & Jensen auditors was to confirm the “existence” assertion for Volterra’s inventory. The principal audit procedure applied to accomplish that goal is the taking of tests counts during a physical inventory observation. Those test counts are then tracked into the client’s final inventory records. Other existence-related audit procedures are reviewing the client’s physical inventory instructions to determine whether they are sufficient and observing the implementation of those procedures to determine that they were properly applied by client personnel involved in the physical inventory. Another concern of auditors during a client’s physical inventory is © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.12 Parker-Halsey Corporation 178 the “valuation” assertion. While observing the client’s physical inventory procedures and taking their own test counts, auditors should identify and record any indications that the inventory may be overvalued due to obsolescence, damage, or other circumstances. A secondary concern of auditors during an inventory observation is typically the “ownership” assertion. Auditors should attempt to determine that the inventory items they are counting are actually owned by the given client. For example, the auditors should determine that any consigned inventory on hand is not included in the physical inventory and that inventory in-transit is properly dealt with by the client during the physical inventory.

Katelyn Light and her two subordinates were also focused on the existence, valuation, and ownership assertions. However, as documented in the answer to Question #1, Katelyn’s team was not addressing those assertions from the standpoint of independent auditors. Instead, Light’s team was present during the physical inventory observation as surrogates for their firm’s audit client, Volterra Chemicals. As such, Katelyn, Dani, and Tyler were effectively serving as forensic investigators. Compared to independent auditors, forensic investigative teams generally require more extensive and rigorous evidence. Why? Because their clients demand a higher level of certainty than that yielded by an independent audit.

In addition to searching for violations of the existence, valuation, and ownership assertions, Katelyn’s team was also instructed to search for internal control problems and any indications of “hanky panky” on the part of PHC. During the course of an inventory observation, independent auditors would certainly take note of internal control problems and any aberrant behavior on the part of client employees that they encounter. However, Katelyn and her subordinates, no doubt, were much more focused on searching for such circumstances given Juan Suarez’s instructions to them.

3. The issue of whether or not to rely on the work of another audit firm most commonly arises in the context of an audit of “group financial statements.” Such audits are discussed in AU-C Section 600, “Special Considerations—Audits of Group Financial Statements (Including the Work of Component Auditors).” In such engagements, individual “components” of the given entity being audited are examined by different audit firms. That situation does not apply to the case at hand. Nevertheless, we can extrapolate from the context of AU-C Section 600 to the setting of this case: “An auditor may find this section, adapted as necessary in the circumstances, useful when that auditor involves other auditors in the audit of financial statements that are not group financial statements. For example, an auditor may involve another auditor to observe the inventory count or inspect physical fixed assets at a remote location” (AU-C Section 600.02). Granted, Katelyn and her two subordinates were not technically “involved” in the PHC audit, but, nevertheless, her team was providing an audit-related professional service in which they had a choice of whether or not to rely on the work of another audit firm.

When deciding whether or not to rely on the work of another audit firm, the audit firm in question must consider several factors per AU-C Section 600. In the situation at hand, arguably the most important of those issues would have been the “professional competence” and “independence” of the Dulin & Jensen auditors. [Note: See AU-C Section 600.22 for a list of other factors that should be considered when deciding whether to rely on the work of another audit firm.] Given the statement made by Kenneth Aska, the Section B foreman, there was certainly some reason to doubt the © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.12 Parker-Halsey Corporation 179 competence of the Dulin & Jensen auditors, at least the two auditors who had witnessed the earlier weighing of the large storage bins in Section B. If Katelyn Light had decided to rely on those auditors’ work, she would have had, at a minimum, a responsibility to investigate the veracity of the statement made by Kenneth Aska which suggested that the auditors had not properly completed their observation of the Section B inventory weighing process. (Of course, Katelyn, chose not to rely on the audit procedures performed by the Dulin & Jensen auditors—which she certainly had a right to do. Why did she choose not to rely on the work of those auditors? Most likely because regardless of what audit procedures were actually performed by Dulin & Jensen for the Section B inventory, she didn’t consider those procedures adequate given the specific instructions she had received from Juan Suarez.)

In the PCAOB’s auditing standards, AS 1205, “Part of the Audit Performed by Other Independent Auditors,” addresses circumstances in which multiple accounting firms are involved in an audit of an SEC registrant. Again, although not directly relevant to this case, we can extrapolate from the context of AS 1205 to the setting of this case. AS 1205.10 provides insight on what steps should be taken when one audit firm is deciding whether or not to rely on the work of another audit firm: “Whether or not the principal auditor decides to make reference to the audit of the other auditor [in the relevant audit opinion], he should make inquiries concerning the professional reputation and independence of the other auditor.” So, again, the overall competence and independence of the “other auditor” are key issues that should be addressed by an auditor when deciding whether to rely on the work of another auditor.

4. Listed next are weaknesses that were evident in PHC’s inventory-taking procedures. (a) The most glaring weakness was the company’s decision to continue shipping operations during the physical inventory. A cardinal rule of physical inventories is that shipping operations should be suspended while the inventory is being counted. (b) The instructions given to the inventory count teams were apparently inadequate (given Katelyn’s observations regarding those instructions). (c) The poor organization of the inventory in the toxic section (a weakness observed by Dani). (d) The lack of familiarity of at least some count teams with the inventory items they were counting. (e) The lack of cooperation with Katelyn’s audit team that was evident on the part of certain PHC employees, in particular, Kenneth Aska. (f) The significant differences in the “pre-weights” and the “re-weights” of the Section B storage bins. This condition cast doubt on not only the integrity/competence of PHC’s inventorytaking procedures but also on the integrity/competence of its employees (and officers).

These significant weaknesses in PHC’s inventory-taking procedures had significant implications for both sets of auditors. Given these weaknesses, the auditors should have expanded the rigor (“nature”) and scope (“extent”) of the audit tests they applied during and after the physical inventory.

In fact, given the severity of the weaknesses, the auditors might have considered suggesting that the physical inventory be delayed until those weaknesses had been remedied. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.12 Parker-Halsey Corporation 180 5. This particular issue is not addressed in the professional auditing standards. However, one could easily argue that the job performance of lower-level auditors is enhanced by “keeping them in the loop,” that is, by fully informing them of the purpose of the tasks that they have been assigned.

Failure to do so, at a minimum, signals some degree of distrust on the part of their superiors.

Although entry-level auditors are just that, they are also professionals and should be treated as such by their superiors. Having said that, there were certainly extenuating circumstances in this particular case. The most importance of those circumstances was the extreme degree of secrecy demanded by Volterra’s management.

6. Consider listing each of the auditors and accountants involved in this case on the board or overhead and then lead an in-class discussion of the professionalism of each of those individuals and/or rank these individuals in terms of their overall professionalism (see the “Suggestions for Use” section). Listed next are the relevant individuals in this case and selected comments for each. (You might consider adding Kenneth Aska to this list. Although he wasn’t an accountant, he had controlrelated responsibilities. I didn’t list Mitch, the PHC assistant controller, or Kevin, the D&J auditor mentioned briefly in the case, since there was not sufficient information to assess their professionalism.)

Katelyn Light: This audit manager has to be given high marks for professionalism given the capable way in which she dealt with a particularly challenging set of circumstances. She not only was an effective and considerate supervisor, but she also exhibited considerable grace and integrity “under fire” while dealing with the “storage bins” debacle.

Dani Morgan: Her temper tantrum during the early morning meeting with Katelyn and Tyler was not what one would expect of an audit senior with three years of experience. During the actual inventory observation, however, she did exhibit tenacity in completing her responsibilities. Granted, she was somewhat overbearing with Kenneth Aska and seemed to go out of her way to agitate him.

Tyler Christian: As the lowest-ranking member of the audit team, Tyler demonstrated a willingness to defer to his two superiors, which was admirable. But he seemed somewhat “cowed” by the overly aggressive Kenneth Aska. He also could have been more “focused” during the inventory observation assignment. The “slips of tongue” that he made during the assignment could have been impeded its successful completion.

Juan Suarez: We don’t have much information to assess this individual’s professionalism. One concern that could be raised is whether he consulted with his peers or someone in the regional or national office regarding his decision to accept the PHC inventory observation engagement. As noted in the suggestion solution to Question #1, that engagement may have posed an independence “problem” for the Volterra audit engagement.

Wade Cooper: Cooper, PHC’s corporate controller, comes across as a thoughtful and level-headed individual in the case. He interceded when the exchange between Katelyn and Herzberger became heated; he made a seemingly proper decision to re-weigh some of the storage bins; and then, when the re-weighing procedure resulted in significant differences, he made the very reasonable decision to reweigh all of the bins and provide the results to Katelyn on an ASAP basis. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 2.12 Parker-Halsey Corporation 181 Hayden Herzberger: His interaction with Katelyn did not present him in a favorable light. He attempted to “bully” her, interceded between Cooper and Katelyn when he should not have, and came across as an overall “hothead.” Plus, he had to be held responsible, to some degree, for the apparent unprofessionalism of his two lower-level subordinates who apparently failed to properly complete their assignment to observe the original weighing of the storage bins.

“Tony”: This Dulin & Jensen auditor is only mentioned in passing in the case. But that mention was not favorable. He was portrayed as overly inquisitive and as a “weak-kneed” auditor, that is, an auditor who capitulated to the demands or wishes of his client.

Two unnamed D&J auditors assigned to observe the original weighing of the Section B storage bins: If true, these individuals’ failure to complete their assigned task (and to report that failure to their superiors) causes them to be squarely placed in the “unprofessional” camp.

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 3.1 The Trolley Dodgers

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CASE 3.1

THE TROLLEY DODGERS

Synopsis In this brief case, a longtime and trusted employee of the Los Angeles Dodgers engaged in a large scale payroll fraud to embezzle funds from the organization. Over a period of several years, this fraudulent scheme cost the owners of the Dodgers several hundred thousand dollars. Contributing to the success of the fraud was the laxity of the Dodgers' internal controls. Eventually, the fraud was exposed when the individual who masterminded the scheme was hospitalized on an emergency basis and thus unable to "cover his tracks" for a period of time.

The Trolley Dodgers--Key Facts 1.

The top executives of the Dodgers organization placed a great deal of trust in their subordinates.

2.

Campos, the Dodgers' operations payroll chief, was a respected and trusted member of the Dodgers organization.

3.

The Dodgers' payroll system was not only supervised by Campos but had also been designed by him.

4.

Campos was involved in such menial tasks in the payroll function as preparing employees' weekly payroll cards.

5.

Campos would return to oversee the preparation of the Dodgers' payroll even when he was on vacation.

6.

The lax control over the Dodgers’ payroll function allowed Campos and his confederates to embezzle hundreds of thousands of dollars from the organization.

Instructional Objectives © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Case 3.1 The Trolley Dodgers

1. To identify key internal control issues for an organization’s payroll function.

2. To identify audit procedures that may result in the discovery of fraudulent payroll schemes.

3. To emphasize the need for auditors and client management to exhibit some degree of skepticism regarding the motives and integrity of even the most trusted client employees.

Suggestions for Use This case deals with an organization’s payroll function and thus would articulate well with classroom coverage of the payroll transaction cycle. Alternatively, the case could be used to introduce students to key internal control concepts including: the need for management to resist placing too much trust in any one employee, the need for periodic rotation of accounting responsibilities, the need for mandatory annual vacations for all accounting employees, and the old truism that an internal control system is only as good as the people operating it (or is only as reliable as the least reliable person within it).

Suggested Solutions to Case Questions 1. An auditor's principal objective in performing tests of controls on a payroll transaction cycle, as with any transaction cycle, is to assess the level of control risk latent within that cycle. An auditor assesses control risk for a transaction cycle to obtain the evidence needed to determine the nature, extent, and timing of the year-end substantive tests to be applied to the account balances produced by that transaction cycle.

The two most important account balances yielded by a payroll transaction cycle are typically accrued payroll and payroll expense. As for most liability and expense accounts, the auditor's principal concern regarding these two accounts is violation of the "completeness" assertion. In assessing the reasonableness of periodic payroll expense, an auditor usually makes extensive use of analytical procedures. For instance, an auditor typically develops an expectation regarding the client's payroll expense for a given period by reviewing the payroll expense reported by the client in a comparable prior period and by considering such factors as the most recent average employee pay raise granted by the client. If the client's recorded payroll expense varies significantly from the auditor's expectation, additional substantive tests will be required to investigate this difference. Regarding the year-end accrued payroll, the auditor must first determine the length of time over which payroll, both hourly and salaried, should have been accrued by the client. Then the auditor must determine whether the accrued payroll expense reported by the client is reasonable given the length of that time period.

2.

The following internal control weaknesses were apparent in the Dodgers' payroll system:

a. the extent of control that one person had over the payroll system, which began with that individual's design of the system and included his involvement in the system’s operational details, b. the lack of enforced vacations for key personnel, and c. an apparent lack of periodic testing of the payroll transaction cycle by internal auditors or a similar control group, testing that should have resulted in the discovery of the fraudulent scheme. © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Case 3.1 The Trolley Dodgers

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3. Listed next are examples of audit tests that might have led to the discovery of Campos' embezzlement scheme. a. A surprise distribution of payroll checks for selected departments might have resulted in unclaimed checks and thus discovery of Campos' fraud. b. Manual or computer-based "limit tests" should have disclosed instances of employees being paid for an excessive number of hours. c. Analytical procedures to assess the reasonableness of the Dodgers' periodic payroll expense by department might have revealed that certain departments' payroll expenditures were "out of line."

© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.