Solution Manual Cases for Contemporary Auditing 12th Edition by Michael Knapp

SOLUTION MANUAL

SOLUTION MANUAL

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Contemporary Auditing 12th Edition by Michael C. Knapp.

ISBN-10 0357515404 ISBN-13 978-0357515402

Test bank for Contemporary Auditing 12th Edition by Michael C. Knapp

ISBN-10 0357515404 ISBN-13 978-0357515402

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TABLE OF CONTENTS Section 1: Comprehensive Cases Case Study:1.1 Wells Fargo & Company Case Study:1.2 Weatherford International Case Study:1.3 Caterpillar Inc Case Study:1.4 Gemstar Case Study:1.5 Enron Corporation Case Study:1.6 Lehman Brothers Holdings, Inc Case Study:1.7 Just for FEET, Inc Case Study:1.8 Health Management, Inc Case Study:1.9 The Leslie Fay Companies Case Study:1.10 Le-Nature’s Inc Case Study:1.11 Navistar International Corporation Case Study:1.12 Livent, Inc Case Study:1.13 ZZZZ Best Company, Inc Case Study:1.14 DHB Industries, Inc Case Study:1.15 New Century Financial Corporation Case Study:1.16 Madoff Securities Case Study:1.17 AA Capital Partners, Inc

Section 2: Audits of High-Risk Accounts Case Study:2.1 Jack Greenberg, Inc Case Study:2.2 Golden Bear Golf, Inc Case Study:2.3 Take-Two Interactive Software, Inc Case Study:2.4 General Motors Company Case Study:2.5 Lipper Holdings, LLC Case Study:2.6 CBI Holding Company, Inc Case Study:2.7 Bankrate, Inc

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Case Study:2.8 Belot Enterprises Case Study:2.9 Powder River Petroleum International, Inc Case Study:2.10 LocatePlus Holdings Corporation Case Study:2.11 Overstock.com, Inc Case Study:2.12 Parker-Halsey Corporation Case Study:2.13 Hampton & Worley

Section3: Internal Control Issues Case Study:3.1 The Trolley Dodgers Case Study:3.2 Howard Street Jewelers, Inc Case Study:3.3 Avon Products, Inc Case Study:3.4 First Keystone Bank Case Study:3.5 Goodner Brothers, Inc Case Study:3.6 Buranello’s Ristorante Case Study:3.7 Saks Fifth Avenue Case Study:3.8 The Boeing Company Case Study:3.9 Walmart de Mexico Case Study:3.10 Blakely Markets Case Study:3.11 Equifax Inc

Section 4: Ethical Responsibilities of Accountants Case Study:4.1 Creve Couer Pizza, Inc Case Study:4.2 F&C International, Inc Case Study:4.3 Suzette Washington, Accounting Major Case Study:4.4 Aaron Elrod, Sole Practitioner Case Study:4.5 Wiley Jackson, Accounting Major Case Study:4.6 Arvel Smart, Accounting Major Case Study:4.7 Zane Corbin, Accounting Major

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Case Study:4.8 Dell Inc

Section 5: Ethical Responsibilities of Independent Auditors Case Study:5.1 AmTrust Financial Services, Inc Case Study:5.2 Herbalife International Case Study:5.3 Antoine Deltour Case Study:5.4 Universal American Corporation Case Study:5.5 Zero Tolerance Case Study:5.6 Cardillo Travel Systems, Inc Case Study:5.7 American International Group, Inc Case Study:5.8 Caesars Entertainment Corporation Case Study:5.9 IPOC International Growth Fund, Ltd Case Study:5.10 Le-Nature’s Inc., Part II Case Study:5.11 Richard Grimes, Staff Accountant

Section 6: Professional Roles Case Study:6.1 Kayleigh Caudell, Audit Senior Case Study:6.2 Brian Reynolds, Audit Senior Case Study:6.3 Madison Wells, Audit Manager Case Study:6.4 Tillman Rollins, Office Managing Partner Case Study:6.5 Leigh Ann Walker, Staff Accountant Case Study:6.6 Bill DeBurger, In-Charge Accountant Case Study:6.7 Hamilton Wong, In-Charge Accountant Case Study:6.8 Tommy O’Connell, Audit Senior Case Study:6.9 Avis Love, Staff Accountant Case Study:6.10 Charles Tollison, Audit Manager

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Section 7: Professional Issues Case Study:7.1 Ligand Pharmaceuticals Case Study:7.2 Sarah Russell, Staff Accountant Case Study:7.3 Washington Council Ernst & Young Case Study:7.4 Internet Infamy Case Study:7.5 Fred Stern & Company, Inc. (Ultramares Corporation v. Touche et al) Case Study:7.6 First Securities Company of Chicago (Ernst & Ernst v. Hochfelder et al) Case Study:7.7 Texas Drug Warehouse Case Study:7.8 Frank Coleman, Staff Accountant Case Study:7.9 Olivia Thomas, Audit Senior Case Study:7.10 The Red Carpet

Section 8: International Cases Case Study:8.1 Longtop Financial Technologies Limited Case Study:8.2 Kaset Thai Sugar Company Case Study:8.3 Republic of Somalia Case Study:8.4 Republic of the Sudan Case Study:8.5 Shari’a Case Study:8.6 Olympus Corporation Case Study:8.7 Razia Case Study:8.8 The Bank of Tokyo

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.

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 high-risk 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 short-term 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.

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 “accounting-motivated” 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 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

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.

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.)

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.)

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 1.2

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.

Lehman Brothers Holdings, Inc.--Key Facts

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 “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 accountingmotivated. However, that responsibility is simply a by-product 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 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.”

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

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.)

© 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, Inc.

69

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.

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Case 1.10 DHB Industries, Inc. 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, Inc.

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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 standards. The PCAOB, for example, relies on the SEC’s definition 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 1.10 DHB Industries, Inc.

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.

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

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• 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 intercompany 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: •Ineffective communication, implementation or support, or enforcement of the entity’s values or ethical standards by management © 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 1.10 DHB Industries, Inc. •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 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 © 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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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.” 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 © 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 1.10 DHB Industries, Inc.

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 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 © 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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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.

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 © 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 1.10 DHB Industries, Inc.

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.

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 © 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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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 1.3 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: 3.0 Quick ratio: .75 Debt to assets: .37 L-T debt to equity: .14 Inventory turnover: 2.15 Age of inventory: 167 days A/R turnover: 52.7 Age of A/R: 6.8 days Total asset turnover: 2.11 Gross margin: 36.7% Profit margin on sales: 4.6% Return on total assets: 9.7% Return on equity: 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.

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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 Fay 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. © 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

Navistar International Corporation--Key Facts 1. Deloitte replaced the audit engagement partner on the 2005 Navistar audit as that engagement was 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 harsh allegations, the lawsuit charged Deloitte with “lying” as to the competency of its audit and accounting © 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 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.

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 influence the 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 © 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 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 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 © 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 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 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’ © 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 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 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, © 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 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 of broker-dealers, including compliance reports filed pursuant to federal securities laws, to promote investor protection.”

“Our Vision: The PCAOB seeks to be a model regulatory organization. Using innovative and cost-effective tools, the PCAOB aims to improve audit quality, reduce the risks of auditing failures in the U.S. public securities market and promote public trust in both the financial reporting process 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 © 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 55 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,

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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.

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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.

© 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, Inc.

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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.

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Case 1.10 DHB Industries, Inc. 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, Inc.

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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 standards. The PCAOB, for example, relies on the SEC’s definition 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 1.10 DHB Industries, Inc.

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.

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

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• 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 intercompany 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: •Ineffective communication, implementation or support, or enforcement of the entity’s values or ethical standards by management © 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 1.10 DHB Industries, Inc. •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 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 © 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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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.” 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 © 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 1.10 DHB Industries, Inc.

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 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 © 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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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.

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 © 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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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.

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 © 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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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 mortgage-backed 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 court-appointed 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 auditor-client conflicts arise.

4. To examine key responsibilities of independent auditors under Section 404 of the SarbanesOxley 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.

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 © 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 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 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. © 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 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 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 © 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 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].”

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. © 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 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” 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.

2. 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 © 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

3.

4.

5.

6.

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 “catchall” 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 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 © 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 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 “takeaways” 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.

•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.

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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.

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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.

96 Inc.

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

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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,

99

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.

© 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. 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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118

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.

120

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.

122

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.

© 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 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.

2.

d.

1.

2.

e.

1.

2.

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.)

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: Test the mathematical accuracy of the client’s computations of the pension obligation and pension expense amounts.

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.

© 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 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 term as “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.

© 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. 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 Corporation 163 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.

164

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 Corporation 165 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).]

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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

181

Dodgers

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.

© 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.

182 Dodgers

Case 3.1 The Trolley

Instructional Objectives 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 © 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

183

Dodgers 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.

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.

184 Inc.

Case 3.2 Howard Street Jewelers,

CASE 3.2

HOWARD STREET JEWELERS, INC.

Synopsis A common nemesis of small businesses is employee theft. Small business owners who place too much trust in their employees can suffer significant financial losses at the hands of apparently hard-working and trustworthy employees. Such was the case for the husband and wife team who owned the Howard Street Jewelers. For20 years, the owners, Julius and Lore Levi, had worked side by side with Betty, their cashier and part-time accounting clerk. Unfortunately for the Levis, the industrious and well-liked employee "ripped off" the business for years by stealing from its cash receipts. Law enforcement authorities estimated the total theft loss at approximately $350,000.

At one point, Mrs. Levi suggested to the firm's accountant that Betty might be stealing from the business. The accountant responded that he had noticed cash shortages that were higher than normal for a small business. He then encouraged the owners to closely monitor Betty’s work. However, it was two years later that Betty’s embezzlement scheme was discovered and then it was uncovered accidentally by the Levis’ son.

© 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 3.2 Howard Street Jewelers,

185

Inc.

Howard Street Jewelers, Inc.--Key Facts 1. Betty was a trusted and longtime employee of Howard Street Jewelers.

2. Betty's job responsibilities placed her in a position where she could take cash from the business and conceal the theft by altering the business's accounting records.

3. Long before the theft scheme was discovered, Lore Levi suspected that Betty was stealing from the business.

4. Julius Levi refused to seriously consider the possibility that Betty was embezzling funds.

5. Lore Levi subsequently informed the firm’s accountant that Betty might be stealing from the business; at that point, the accountant recommended that the Levis observe Betty closely.

6. Betty's embezzlement scheme was discovered accidentally by the Levis' son approximately two years after Lore Levi suggested that Betty might be responsible for the business’s cash shortages.

Instructional Objectives 1. To demonstrate to students that employee theft is an important internal control issue for small businesses.

2. To emphasize the importance of "compensating controls" for a small business when there is inadequate segregation of key functional responsibilities within the business.

3. To demonstrate to students that a small business's accountant often serves as a "control" consultant for the business’s owners.

4. To discuss an external accountant or auditor's responsibility when he or she suspects that a client may be experiencing theft losses due to weak or nonexistent internal controls.

5. To provide students with an opportunity to comprehensively analyze internal control issues for a small business.

Suggestions for Use The principal focus of this case is internal control, particularly internal control issues related to small businesses. Consequently, this case is well suited to be discussed in connection with internal control topics in an auditing or other accounting course. I use this case to reinforce the fact that even when organizations have apparently trustworthy and competent employees, they need a comprehensive set of internal control policies and procedures. Another important point to make © 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.

186 Inc.

Case 3.2 Howard Street Jewelers,

when covering this case is that small businesses often do not have sufficient resources to operationalize some of the most basic internal control concepts such as segregation of key functional responsibilities. Nevertheless, small businesses can implement compensating controls to mitigate these internal control weaknesses as discussed in the suggested solution to case question #3.

Suggested Solutions to Case Questions 1. The Levis overlooked several important internal control concepts. First, one of the most important control procedures within an organization is the segregation of key functional responsibilities or duties. Three types of duties, authorization, recordkeeping, and custodianship, should be segregated within each transaction cycle of a business if at all possible. The Levis allowed Betty access to both cash and the cash receipts and sales records, thus providing her with an opportunity to pocket cash and alter the accounting records to cover up her theft. In addition, the Levis apparently did not have adequate "detection" controls in place requiring periodic comparisons or reconciliations of existing assets with the related accounting records. For example, on a daily basis one of the owners should have compared/reconciled the cash receipts reflected by the cash register tape to the cash in the register, the cash receipts journal entry, the total of the day’s sales invoices or sales slips, and the daily deposit slip. [Note: The available facts for this case did not indicate whether Betty "rang up" sales and then stole the cash or stole cash from sales that had not been "rung up."]

Finally, the Levis violated a fundamental internal control concept by placing excessive trust in one employee. History has proven repeatedly that an employer, particularly a small business owner, cannot afford to place absolute trust in any one employee.

2. First of all, regardless of the specific type of service that a CPA is providing, when a client approaches him or her with a question, a request, or a problem, it is incumbent on the CPA as a professional to respond and, in doing so, to act in the best interests of the client. In fact, in my view, in the situation at hand it makes very little difference what specific type of service the CPA is providing. Regardless of whether the CPA is providing audit, review, or compilation services to the client, the CPA has a responsibility to sit down with the client and effectively say, “Let me help you solve this problem.” What is a professional? In one very real sense, a professional is simply a problem solver. Individuals go to professionals almost exclusively because they have some “issue” or “problem” that they need addressed. Because CPAs are trained “control” experts, it would only make sense for a small business owner, such as Lore Levi, to turn to her CPA for advice to help solve the problem that she had identified.

So, Ms. Levi’s CPA should have sat down with her and developed a strategy to solve the problem that she faced. There are many systematic problem-solving “models” that have been developed and many, if not most, of them are similar. The first step in effective problem-solving is “putting your finger” on the problem, that is, defining what the problem is. In this first step, you obtain as much information about the problem and the surrounding circumstances as you can. Next, one should attempt to determine the possible causes of the problem. Third, develop a set of potential solutions.

Fourth, study the alternative solutions and ultimately choose the one that appears most likely—given your professional expertise. The final two steps in my universal problem-solving model is to implement the solution and then subsequently evaluate the outcome to that solution ex post.

No doubt, there are constraints that impact problem-solving strategies, the primary one in most © 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 3.2 Howard Street Jewelers,

187

Inc. circumstances being cost. Early in the problem-solving process, it would be incumbent on Ms. Levi’s CPA to identify the likely cost of the service that he will provide. In retrospect, there’s almost no doubt that the benefits of this service, that is, identifying the cause of the recurring cash shortages, would enormously outweigh the costs. The fraud being perpetrated by Betty was not complex.

Almost certainly, an investment of a few hours of intense detective work by the CPA would have revealed her scheme and resulted in it being terminated very quickly.

Those of you who have used past editions of my casebook realize that this suggested answer is much different than the one I have offered in the past. Typically, I discuss the differing nature of auditing, review, and compilation services and examine how the given CPA would address the problem raised by Ms. Levi in the context of the provision of one of those types of professional services. But, honestly, I believe that I misread my own question. Given the nature of the question, in my view, it doesn’t really matter whether the CPA is auditing, reviewing, or compiling the Howard Street Jewelers’ financial statements. What matters is that the client has come to you, the CPA, with a very specific problem. And you, as the expert in such matters, should offer to solve that problem regardless of the “contracted service” that you happen to be providing the client at the time.

3. Small businesses often cannot implement extensive control activities due to resource constraints.

Particularly problematic for small businesses is an inability to achieve complete segregation of key duties (custodianship, authorization, and recordkeeping) within each transaction cycle. To mitigate the problems posed by limited resources available for control purposes, it is important for small businesses to establish "compensating controls." These controls typically require the active participation of business owners in the day-to-day operations of their business. For example, in a jewelry store, safeguarding cash and inventory are among the primary control objectives. By becoming involved in control activities intended to accomplish those two objectives, the Arbeitmans can compensate, to some degree, for their inability to provide adequate segregation of the key duties related to those objectives. Following are several control activities that may be implemented to safeguard cash and inventory in a small merchandising business: a. The cashier should not have access to the accounting records; the clerk maintaining the accounts receivable accounting records should not have access to cash. b. Incoming checks should be restrictively endorsed when received. c. Cash receipts should be deposited in the bank on a daily basis by the owner. d. The owner should compare the daily deposit ticket for agreement with the daily cash receipts journal entry and the corresponding sum of the daily cash register tapes and any other listing of daily cash receipts. e. The owner should prepare a monthly bank reconciliation. g. The owner should approve all write-offs of accounts receivable. f. The owner should test count inventory periodically and compare the resulting counts with the inventory records. g. And, definitely, the owner should determine the optimal insurance coverage for all facets of his or her business, including its inventory, real property, etc.

© 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 3.3 Avon Products, Inc. 189

CASE 3.3

AVON PRODUCTS, INC.

Synopsis During the mid-1880s, David McConnell sold books door-to-door. To entice prospective customers, nearly all of whom were housewives, McConnell gave them samples of rose-scented perfume. After realizing that housewives were much more enamored with his homemade perfume than his books, McConnell dropped the books and began peddling his fragrance products. By the end of the twentieth century, McConnell’s company, Avon Products, had more than three million sales representatives and nearly one billion customers in 140 countries worldwide.

In 1999, Andrea Jung became Avon’s first female CEO. Over the first five years of her tenure as CEO, Jung gave Avon a makeover that involved several key strategic initiatives. Those initiatives included giving Avon a sleeker, more “hip” image to make its products appealing to younger women and expanding the company’s operations in several large and relatively untapped markets, principal among them China. Jung, the daughter of Chinese immigrants, took a personal interest in developing the Chinese market and, in doing so, providing employment opportunities to large numbers of Chinese women.

A key stumbling block to the success of Jung’s Chinese initiative was a ban on direct selling adopted by China in 1998—door-to-door or direct selling was the principal method Avon used to market its products. For several years, Jung and several of her subordinates lobbied the Chinese government to lift the ban on direct selling. In 2005 when the ban was finally lifted, Avon was granted the first direct selling license in the nation. More than a year passed before other foreign companies received direct selling licenses.

In 2008, Jung received a letter from a former executive of Avon’s Chinese subsidiary. The former executive claimed that the Chinese subsidiary had effectively “bought” its direct selling license from Chinese government officials. After notifying the SEC and U.S. Department of Justice (USDOJ) of the allegations, Jung launched an internal investigation. That investigation and parallel investigations by the SEC and USDOJ revealed that executives of the Chinese subsidiary had violated the Foreign Corrupt Practices Act (FCPA) by giving gifts and cash totaling $8 million to Chinese government officials. The fines ultimately levied against Avon totaled almost $135 million. During the course of the investigations, four Avon executives were dismissed and Jung was replaced as CEO

by Avon’s board. This instructional case and the accompanying case questions focus on the ethical, accounting, and internal control issues posed by the Avon FCPA scandal. © 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 3.3 Avon Products, Inc. 190 Avon Products, Inc.--Key Facts 1.

Direct or door-to-door selling was the key element of Avon Products’ business model that made the company a highly successful, global merchandising company.

2.

In 1999, Andrea Jung, whose parents immigrated to the United States from China, became Avon’s first female CEO.

3.

Among Jung’s key initiatives for Avon was significantly expanding the company’s presence in several large and relatively untapped markets, principal among them China.

4.

Jung’s China initiative faced an enormous roadblock, namely, that nation’s ban on direct selling.

5.

For several years, Jung and Avon’s Chinese subsidiary, Avon Products China (APC), lobbied Chinese government officials to lift the ban on direct selling and grant APC a direct selling license in the country.

6.

In 2005, the direct selling ban was lifted and Avon was granted the first direct selling license in China; more than a year would pass before other foreign companies received such a license.

7.

In 2008, a former APC executive wrote a letter to Jung in which he alleged that APC had spent large sums in an effort to influence the decisions of Chinese government officials involved in the direct selling controversy.

8.

After Jung forwarded the whistleblower’s letter to Avon’s corporate audit committee, it launched an investigation of the potential FCPA violations; the USDOJ and SEC initiated their own parallel investigations after Jung informed them of the allegations.

9.

Avon’s investigation and the parallel investigations by the USDOJ and SEC determined that APC had made expenditures of approximately $8 million to improperly influence Chinese government officials; those expenditures violated the Foreign Corrupt Practices Act (FCPA).

10. Avon paid fines totaling nearly $135 million to settle the FCPA charges leveled against it by the USDOJ and SEC; in addition, the company spent $350 million on its internal FCPA investigation.

11. Three APC executives and one Avon executive were dismissed as a result of the FCPA scandal.

12. Avon’s board announced that it was replacing Jung in 2011; the decision to dismiss Jung was reportedly due to both the enormous FCPA scandal and Avon’s poor operating results over the final few years of her tenure with the company.

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 3.3 Avon Products, Inc. 191 1.

To examine the responsibilities imposed on SEC registrants and their executives by the Foreign Corrupt Practices Act.

2.

To illustrate the serious implications that the absence of an adequate degree of control consciousness can have on a company.

3.

To examine the ethical and internal control-related responsibilities of internal auditors.

4. To examine the impact that cultural factors may have on a multinational company’s ability to establish and maintain proper internal controls over its operations.

5. To identify material weaknesses in internal control.

6. To review the COSO’s internal control framework.

Suggestions for Use Consider requiring your students or a subset of them to research and provide a brief in-class report on the enforcement history of the FCPA. That research would reveal that for several years following the passage of the FCPA there were very few FCPA enforcement cases. External pressure by activist groups—and activist law enforcement officials—resulted in a gradual increase in the number of FCPA enforcement cases. In recent years, there have typically been dozens of active FCPA investigations ongoing at any point in time. [Note: you might also ask your students to research the amendments that have been made to the FCPA since it was adopted. One of those amendments involved the controversial issue of whether so-called “grease payments” or “facilitating payments” violated the anti-bribery provision of the FCPA—those payments were deemed not to be violations of the FCPA by that amendment.]

The key issue raised by this case is the poor control environment evident within Avon. Consider initiating the discussion of this case by requiring your students to identify and briefly explain the five components of COSO’s internal control framework. Of course, the control environment is the overarching component of that framework. After examining the COSO internal control framework, you could segue into a discussion of the three different levels of internal control deficiencies with the ultimate goal of identifying apparent material weaknesses in Avon’s internal control system.

Role-playing is an effective strategy for identifying or emphasizing key features of a case. For this particular case, consider setting up a role-playing scenario that involves a hypothetical face-toface meeting between the APC Corporate Affairs official who insisted that his department sometimes had to play “dirty” and an official in Avon’s corporate headquarters committed to ensuring that the company comply with both the spirit and the substance of the FCPA.

Suggested Solutions to Case Questions © 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 3.3 Avon Products, Inc. 192 1. Andrea Jung stated that, “Look, the buck stops with me” when asked in 2011 about Avon’s evolving FCPA scandal (see, D. Rushe, “SEC Investigates Allegations that Avon Reps Bribed Foreign Officials,” www.theguardian.com, 27 October 2011). So, was Jung “responsible” for the improper payments made by Avon’s Chinese subsidiary? The best way to answer that question is to point out that she, herself, seemingly accepted personal responsibility for those payments.

2. The nature and scope of an internal audit staff’s responsibilities vary significantly from organization to organization. But one or more of the key facets of those responsibilities always involves the given organization’s internal controls. Arguably the most precise, if not concise, statement regarding an internal audit staff’s key internal control-related responsibilities can be found in AS 2605, “Consideration of the Internal Audit Function,” in the PCAOB auditing standards. AS 2605.04 notes that “An important responsibility of the internal audit function is to monitor the performance of an entity’s controls.” Given this statement, one could argue that an internal audit staff is the key control mechanism within the “monitoring” component of an organization’s internal control system.

Listed next is the COSO’s detailed description of the monitoring component of internal control (see www.coso.org).: “Internal control systems need to be monitored—a process that assesses the quality of the system's performance over time. This is accomplished through ongoing monitoring activities, separate evaluations or a combination of the two. Ongoing monitoring occurs in the course of operations. It includes regular management and supervisory activities, and other actions personnel take in performing their duties. The scope and frequency of separate evaluations will depend primarily on an assessment of risks and the effectiveness of ongoing monitoring procedures. Internal control deficiencies should be reported upstream, with serious matters reported to top management and the board.”

Recognize that in many, if not most, large organizations, the “separate evaluations” referred to in the COSO’s description of the monitoring component of internal control would be performed by the internal audit staff.

As a point of information, the website of the Institute of Internal Auditors provides the following definition of “internal auditing:” “Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organization's operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes.”

3. Note: You might consider reviewing the specific features of “competence,” “confidentiality,” and “integrity” as those traits are defined by the IMA Statement of Professional Practice with your students. For example, in terms of “integrity,” the latter document identifies three specific responsibilities of IMA members including “abstain from engaging in or supporting any activity that might discredit the profession.” In terms of “competence,” the four specific responsibilities of IMA members include “maintaining an appropriate level of professional expertise by continually developing © 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 3.3 Avon Products, Inc. 193 knowledge and skills.” Finally, in terms of confidentiality, the three specific responsibilities of IMA members include “refrain from using confidential information for unethical or illegal advantage.”

This case includes the following quote from a representative of the USDOJ in which the overall “integrity of [Avon’s] internal audit process” was questioned: “Avon lacked sufficient controls to ensure the integrity of its internal audit process, particularly with regard to its review of allegations of, and testing for, improper payments made to government officials. Avon’s internal audit group also failed to devote adequate funding, staffing, and resources to Avon China.” In this context, the USDOJ representative was likely using the term “integrity” as a synonym for “reliability” rather than in reference to the underlying morality of the decisions made by individual Avon internal auditors.

Having said that, there is other evidence that would cause one to question the “moral integrity” of Avon’s internal audit staff. For example, recall that Avon internal auditors followed the instructions given to them to remove all of the FCPA-related conclusions from the initial report they prepared that documented the improper expenditures being made by Avon’s Chinese subsidiary. Likewise, the internal auditors apparently complied with the instructions to “destroy all hard copies” of that initial draft report and “delete any e-mail to which that draft report was attached.”

In terms of “competence,” it appears that Avon’s internal audit staff possessed the necessary professional expertise to carry out their assigned responsibilities—for example, the internal auditors uncovered the improper expenditures made by Avon’s Chinese subsidiary and communicated the results of their work to the individuals to whom they were apparently instructed to do so. (Note: if those results had been communicated directly to the corporate audit committee, the improper expenditures would likely have been dealt with appropriately from the beginning).

Finally, in terms of confidentiality, there was no available evidence which suggested that the Avon internal auditors violated this feature of the IMA Statement of Professional Practice. In fact, by rigorously enforcing the confidentiality of the improper expenditures that they uncovered, the internal auditors did a disservice to themselves and their employer.

4. Most laymen in this context (including professional accountants) would almost certainly suggest that the potential FCPA violations involved “legal” issues. However, the fact that the potential FCPA violations raised legal issues does not preclude them from raising “internal audit” issues as well. The overarching question in this context appears to be which domain within Avon’s corporate hierarchy should have had the ultimate responsibility for addressing potential FCPA violations. It seems reasonable—and most functional—for both a corporation’s legal staff and internal audit staff to be involved in the resolution of such an issue. Each of those professional groups has a unique point of view when it comes to assessing such matters and it seems that an organization would want the two groups to work together to ultimately arrive at the overall best resolution.

5. The five components of internal control, according to the COSO framework, are control environment, risk assessment, control activities, information and communication, and monitoring (www.coso.org). One could argue that each of these components of Avon’s internal control was flawed. First, the control environment was flawed because at the corporate level there apparently was not a proper or adequate degree of control consciousness as evidenced by the absence of an “anticorruption policy” within the company (see footnote #5 in the case). Second, the absence of an anticorruption policy suggests that the company had done an inadequate job of “assessing” the internal control risks that it faced (recall that the company operated in numerous countries within which © 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 3.3 Avon Products, Inc. 194 “corruption risk” was significant). Third, because of the absence of a proper degree of control consciousness and proper risk assessment activities, Avon did not establish necessary control activities to prevent or detect bribes and related payments. Related to this latter weakness was the failure of Avon to have proper accounting procedures in place to ensure that all expenditures (including illicit payments to government officials) were adequately documented in the company’s accounting records. Fourth, it seems apparent that the “information and communication” component of Avon’s internal control was flawed since the serious internal control deficiencies discovered by the company’s internal audit staff during 2005 and 2006 were not communicated to the corporate audit committee at that point. If the audit committee had been made aware of those deficiencies at that point, it is very likely that a timely and thorough investigation would have short-circuited the Avon FCPA scandal. Finally, as pointed out in the solution to Question #2, a key responsibility of an organization’s internal audit function is the “monitoring” component of the entity’s internal control system. It is apparent ex post that Avon’s internal auditors did not properly carry out that function— that was certainly the opinion of the USDOJ representative who questioned the “integrity of [Avon’s] internal audit process” (see complete quote in case).

Arguably the most serious flaw in Avon’s internal control system was the absence of a proper degree of control consciousness. An organization’s control environment sets the “tone at the top” when it comes to control consciousness. If a proper degree of control consciousness is not exhibited by an organization’s leaders, the remaining components of the organization’s internal control will be undermined as well—if not made completely irrelevant.

6. Although not mentioned in the case question or discussed in the case, there are three levels of internal control “problems”: internal control deficiency, significant deficiency in internal control, and material weakness in internal control. Following are definitions of those terms that were taken directly from AS 2201, “An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements,” in the PCAOB’s auditing standards. (Note: as a point of information, these definitions from AS 2201 are consistent with the comparable definitions included in the AICPA Professional Standards at AU-C Section 265.7).

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.”

There were several instances or circumstances which suggest that Avon had serious internal © 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 3.3 Avon Products, Inc. 195 control “issues.” For example, one could easily argue that the absence of adequate internal controls to prevent and detect violations of the FCPA qualified as a material weakness in internal control. In this same vein, Avon’s absence of any “anti-corruption policy” despite the company operating in numerous countries that posed a high degree of ‘corruption risk’” [see footnote #5 in case] could have been considered a material weakness in internal control. Another potential material weakness that overlaps with the two prior items was the company’s failure to properly follow up and resolve apparent violations of the FCPA that were discovered by its internal auditors.

7. Even when doing business in other countries, U.S. companies and their employees and other representatives must uphold U.S. laws and the legal responsibilities imposed on them by U.S. citizenship. By upholding those laws and responsibilities, U.S. companies and their employees are not “challenging” the business practices deemed acceptable in other countries. In most circumstances, U.S. companies and citizens can uphold the laws of their country while still respecting the laws, cultural norms, and business practices of foreign countries. (Granted, if business practices in a foreign country routinely violate U.S. laws, U.S. companies should likely consider suspending operations in that country.)

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Case 3.4 First Keystone Bank 196

CASE 3.4

FIRST KEYSTONE BANK

Synopsis In January 2010, three tellers of a small branch of First Keystone Bank were arrested by local law enforcement authorities and charged with embezzling more than $100,000 from the branch’s ATM over a period of two years. During that same time frame, the three tellers also allegedly stole more than $20,000 of parking funds collected by the local municipality—municipal employees periodically dropped off at the First Keystone branch large bags of coins collected from parking meters, money that was supposed to be deposited in the municipality’s bank account.

The initial case question requires students to identify internal control procedures for a financial institution’s ATM operations. The second case question requires students to identify general factors that should influence the audit approach or strategy that independent auditors apply to a bank client’s operations, while the final case question requires students to identify specific audit procedures that might have resulted in the First Keystone embezzlement scheme being uncovered by the bank’s independent auditors.

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Case 3.4 First Keystone Bank 197 First Keystone Bank--Key Facts 1.

In 2006, Jean Moronese was promoted to head teller of the Swarthmore, Pennsylvania, branch of First Keystone Bank; Moronese had been an employee of the branch for four years.

2.

In 2008, Moronese began taking cash from the branch’s ATM to pay her credit card bills, rent, and day care expenses.

3.

Moronese eventually began taking cash from the ATM “just to spend” because she “got greedy.”

4.

In the fall of 2008, Moronese convinced a subordinate, Kelly Barksdale, to conceal her embezzlement scheme while she was on vacation; Moronese told Barksdale that “she didn’t want her children to see her go to jail.”

5.

Barksdale agreed to help Moronese and subsequently became an active participant in the embezzlement scheme as did a third teller.

6.

The conspirators easily concealed the embezzlement thefts by simply changing the ledger control sheets that were supposed to reflect the amount of cash in the ATM.

7.

The branch’s internal control procedures mandated that two employees be involved in resupplying the ATM with cash and in maintaining the ATM ledger control sheets; however, either Moronese or Barksdale completed those tasks by themselves.

8.

An internal audit eventually uncovered the embezzlement scheme; the audit revealed that slightly more than $100,000 was missing from the branch’s ATM.

9.

Barksdale confessed that she and her two co-workers also embezzled parking meter funds collected by the local municipality, funds that were supposed to be deposited by the tellers in a municipal bank account.

10. In commenting on the embezzlement scheme, the local district attorney observed, “The case is yet another example of the importance of not only implementing internal accounting safeguards, but ensuring that those safeguards are being followed by all employees at all levels of the business.”

Instructional Objectives 1.

To identify control risks relevant to cash maintained on a client’s premises.

2.

To identify internal control procedures relevant to cash.

3.

To identify audit procedures applied to cash maintained on a client’s premises.

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Case 3.4 First Keystone Bank 198 Suggestions for Use Here’s another case that your students can relate to personally. ATM-related theft is a serious problem facing both the general public and banks and other financial institutions that operate ATMs. The first case question asks students to identify internal control procedures for ATM operations.

Consider expanding that question to address internal control procedures for cash processing operations and cash funds maintained by other types of businesses, such as convenience stores, jewelry stores, and casinos. Consider doing the same for the final case question that requires students to identify audit procedures that should be applied to a client’s ATM operations.

Suggested Solutions to Case Questions 1. Internal controls for ATM operations is obviously not a topic covered by an undergraduate auditing text. Nevertheless, given a general understanding of the nature and purpose of internal controls and their own first-hand experience with ATMs, students should be able to identify several control policies and procedures relevant to ATM operations. Listed next is a sample of both low-tech and high-tech control policies and procedures for ATMs.             

Use of video surveillance systems.

Including microchips in ATM cards to make them more difficult to duplicate.

Use of biometric control systems to permit access to ATMs—such as a fingerprint identification system.

Mailing PINs separately from ATM cards.

Encouraging customers to report stolen ATM cards immediately.

Encrypting the electronic storage files for PINs. Imposing maximum withdrawal limits for individual transactions and maximum daily cumulative withdrawal limits.

Notifying law enforcement authorities immediately when suspicious ATM activity occurs.

Encouraging customers to closely monitor their cash accounts and to immediately report any unauthorized transactions in those accounts.

Installing ATMs in secure locations.

Requiring that multiple employees be involved in the resupplying of ATM cash funds.

Prohibiting employees who have direct access to ATM cash funds from also being involved in the maintenance of ATM control sheets and related accounting records.

Bonding all employees involved in ATM operations.

2. The general conditions or factors that influence the nature, extent, and timing (NET) of audit procedures applied to a client’s ATM operations are not at all unique. For example, the materiality of a bank’s ATM operations (relative to its overall operations) is almost certainly the most critical factor that will dictate how much “attention” or resources auditors allocate to them on a given engagement.

Inherent and control risk factors are also critical considerations in determining how much audit effort to allocate to the ATM operations of a bank client. For example, if a client has experienced a higher than normal frequency of ATM “issues”—disputed withdrawals, etc.—there must be specific inherent © 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 3.4 First Keystone Bank 199 or control risk factors that account for that problem. After identifying those factors, the members of an audit engagement team will make the appropriate modifications in their audit NET. As a sidebar, practically every ATM-related fraud involves misappropriations of assets rather than instances of fraudulent financial reporting. As a result, ATM frauds are generally not a major concern of auditors of banks and other financial institutions. However, if the misappropriation losses are material in either a quantitative or qualitative sense, then clearly they merit considerable attention by independent auditors.

3.

The bulk of the audit procedures applied to a financial institution’s ATM operations will typically involve internal control tests. As is true with internal controls in other areas, auditors will focus on two dimensions of the effectiveness of ATM-related internal controls: design effectiveness and operating effectiveness. Since internal controls for ATM operations are increasingly high-tech, auditors may very likely require the services of an IT expert in reviewing and documenting the design effectiveness of ATM-related controls. Once the design effectiveness of those controls have been assessed, then auditors will go about the task of testing their operating effectiveness.

Listed next is a sample of audit procedures that could be applied to a client’s ATM operations:     

A “surprise” cash count of ATM funds and then reconciling the resulting amounts with the amounts reflected in the client’s accounting records.

Observation of physical ATM controls—such as controls related to the replenishment of an ATM’s cash funds—to ensure that the client’s controls are being properly implemented.

Determining whether the client has properly segregated key functional responsibilities for its ATM operations, such as, separating custodianship and recordkeeping responsibilities.

Transaction walk-throughs (to corroborate auditors’ understanding of a client’s ATMrelated controls).

Reviewing the client’s “dispute resolution” files relating to its ATM operations to determine whether there appears to be any evidence of systemic problems in those operations (most banks have a dispute resolution process/unit/officer to deal with disputed ATM withdrawals).

Obviously, in the First Keystone case a “surprise” cash count of the ATM funds would have resulted in discovery of the ongoing embezzlement scheme. It is unlikely that observation of the ATM-related controls would have uncovered the fraud since the employees, no doubt, would have made sure that the required controls were operational when they were being observed by the auditors.

It is unlikely as well that the other audit procedures listed above would have uncovered the fraud.

As a point of information, First Keystone’s independent auditors were never mentioned in the many media reports of this fraud. Nor were those auditors referred to in the much larger embezzlement scheme involving that bank that is referred to in the final footnote of the case.

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200 Inc.

Case 3.5 Goodner Brothers,

CASE 3.5

GOODNER BROTHERS, INC.

Synopsis Woody Robinson and Al Hunt were lifelong friends. Following graduation from college, Al went to work for his father-in-law, who owned Curcio’s Auto Supply, a retail business located in Huntington, West Virginia. With the help of Al, Woody landed a job with one of Curcio’s major suppliers, Goodner Brothers, Inc., a tire wholesaler. Goodner Brothers sold tires from 14 sales offices scattered across the Midwest and the eastern seaboard. Woody worked as a sales representative for the Goodner sales office in Huntington.

“Volume, volume, volume” was Goodner’s operating philosophy. Company management consistently undercut competitors’ prices to increase sales and market share. The company’s thin profit margin forced Goodner’s executives to scrimp on operating expenses, including expenditures on accounting and control systems. Goodner attempted to compensate for its weak internal controls by hiring only honest and reliable employees. The company generally considered only prospective employees referred by someone associated with Goodner Brothers. Goodner also routinely obtained thorough background checks on prospective employees from detective agencies.

In 2006, Woody Robinson faced a personal crisis brought on by a gambling addiction. Woody began stealing tires from his employer to pay off his sizable gambling debts. Goodner’s lax internal controls allowed him to steal tires almost at will from an inventory site of the Huntington sales office.

Woody sold these tires and pocketed the proceeds. Among his principal “customers” was Al Hunt, who by this time owned Curcio’s Auto Supply.

Robinson’s theft scheme went undetected for more than one year. Eventually, a physical inventory taken by Goodner’s internal auditors revealed a large inventory shortage at the Huntington sales office. A subsequent investigation by Goodner’s independent auditors led to criminal charges being filed against Woody Robinson. When Robinson confessed to his misdeeds, he implicated his best friend, Al Hunt, in the theft scheme. This case focuses principally on the porous controls at Goodner’s Huntington sales office. Among other requirements, the case questions instruct students to identify the key weaknesses in that unit’s internal controls and to suggest specific control activities to remedy those weaknesses.

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Case 3.5 Goodner Brothers,

201

Inc.

Goodner Brothers, Inc.--Key Facts 1. Goodner Brothers’ principal management strategy was to undermine competitors by selling tires in large volumes at cut rate prices.

2. Goodner’s executives did not stress the importance of internal controls, choosing instead to rely heavily on the honesty, integrity, and competence of their subordinates.

3. A key factor that caused Woody Robinson to decide to steal from Goodner Brothers was the weak and often nonexistent internal controls at the company’s Huntington sales office.

4. Eventually, Woody began selling stolen tires to his best friend, Al Hunt, who owned and operated a retail auto supply business.

5. The failure of Felix Garcia, the manager of the Huntington sales office, to follow up on the disproportionate number of customer complaints filed against Woody Robinson prevented him from discovering Woody’s inventory thefts.

6. During their annual audits of Goodner Brothers, the company’s independent auditors paid little attention to Goodner’s internal controls, choosing instead to perform a “balance sheet” audit.

7. A physical inventory taken by Goodner’s internal auditors eventually led to the discovery of the large inventory shortage at the Huntington sales office.

8. Woody ultimately served seven months of a five-year prison term for stealing an estimated $185,000 of tires from Goodner Brothers.

9. After reimbursing Goodner Brothers for $130,000 of theft losses, Goodner’s insurer recovered $98,000 of that amount from Curcio’s (Al Hunt’s business), which Woody implicated in his scheme.

10. Al Hunt sued Woody Robinson in an unsuccessful attempt to recover the payment made by Curcio’s to Goodner’s insurer.

Instructional Objectives 1. To stress the importance of rigorous internal controls for companies that have heavy investments in inventory.

2. To demonstrate that a policy of hiring only “honest and reliable” employees cannot compensate for a company’s otherwise weak or nonexistent internal controls. © 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.

202 Inc.

Case 3.5 Goodner Brothers,

3. To demonstrate the significant losses that one dishonest employee can impose on a company that has weak internal controls.

4. To illustrate how the management style and operating philosophy of a company’s top executives influence the degree of control consciousness within the firm.

5. To highlight the need for management personnel to follow up on potential internal control problems coming to their attention.

Suggestions for Use An effective means of initiating classroom discussion of this case is to develop a role-playing scenario involving Woody Robinson and Al Hunt. In this scenario, ask two students to recreate the meeting in which Al questions Woody regarding the source of the tires he has been selling. Ethical issues are not stressed explicitly in this case. However, here is an opportunity for students to reacquaint themselves with a sensitive situation that almost certainly each one of them has experienced, namely, confronting a desperate friend exercising poor judgment in the face of a personal crisis. The Al Hunt character is the critical “player” in this setting. By this point, Al almost certainly knew that something was awry. On the other hand, he was benefiting handsomely from his friend’s apparent misconduct. By exposing students to difficult ethical dilemmas, particularly in a role-playing exercise, they can “flesh out” their own personal ethical codes of conduct. Such exercises may help students “do the right thing” later in life when they experience similar dilemmas in an accounting or auditing context.

Another common method I use to introduce a case such as this is to provide students with a “responsibility ballot” that lists each person or group of persons who played a significant role in the case. In this case, those individuals would include Woody Robinson, Al Hunt, Felix Garcia, the two company owners, Goodner’s CFO, and Goodner’s independent audit firm. In my graduate class, I then assign students to small groups. Each group must complete the responsibility ballot by assigning a percentage of responsibility or culpability to each individual or group listed on the ballot. (The total allocated responsibility must equal 100% on each group’s ballot.) In this case, students would allocate responsibility for Woody’s theft losses to the parties listed on the ballot. Clearly, most of us would assign the major portion of blame to Woody in this case. However, other individuals involved in this case were not blame-free. For example, one could argue that the two Goodner brothers, themselves, should shoulder some of the responsibility for the theft losses given their failure to establish adequate internal controls within their company. As a point of information, I typically leave one blank line on the responsibility ballots to allow groups to include “write-in” candidates who I have overlooked. After students spend several minutes arriving at a group consensus, I then post the results for each group on the board. The exercise ends with a lively discussion/debate among the groups in which they must justify their responsibility “scores” in light of the generally much different scores of at least one other group.

The narrative of this case does not heavily emphasize the role played by Goodner Brothers’ independent auditors in the theft scheme perpetrated by Woody Robinson. The exercise just described and/or the fourth case question provides an opportunity for instructors to focus students’ © 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 3.5 Goodner Brothers,

203

Inc. attention on Goodner’s independent auditors. The key issue in this context, in my view, is what degree of responsibility, if any, should the company’s independent auditors have assumed for the inventory theft losses? If they choose, instructors can explicitly raise the question of whether professional standards permit auditors to essentially ignore a client’s internal controls (or, in this case, absence of internal controls) and strictly perform a “balance sheet” audit.

Suggested Solutions to Case Questions 1.

(a) (b) (c) (d) (e)

2. (a) (b) (c) (d) 3. (a)

(b)

(c)

Provide adequate physical security for inventory to minimize losses due to customer and employee theft.

Identify inventory shortages on a timely basis.

Ensure that inventory purchases, purchase returns, sales returns, and other inventory transactions are authorized by the proper level of management.

Establish controls to ensure that inventory purchases, sales, and related transactions are recorded properly and on a timely basis.

To the extent possible, segregate the custodianship, authorization, and recordkeeping responsibilities for inventory.

Physical security controls for inventory were extremely lax.

Custodianship, authorization, and recordkeeping responsibilities were not properly segregated across the sale office’s employees.

Sales office personnel often neglected to use pre-numbered accounting documents for transactions and failed to process transactions on a timely basis.

A weak control environment prevailed in the Huntington sales office.

One sales office employee could have been assigned “warehouseman” responsibilities for the remote storage area. This individual would have maintained on-site inventory records, checked in shipments from vendors, checked out shipments to customers, maintained a log of individuals entering the storage area, etc. In addition, management could have installed electronic surveillance equipment to deter and detect theft during non-business hours.

The limited number of employees assigned to each sales office made it difficult to provide for proper segregation of key functional responsibilities. However, Goodner’s management could have made an effort to separate the most important responsibilities. For example, sales personnel should not have had access to the accounting records, nor should the sales reps have had unlimited access to the inventory storage areas in the absence of warehousing controls similar to those listed in the previous item. Additionally, someone other than the sales reps—probably the sales manager—should have monitored the creditworthiness of existing clients.

Because they worked on a commission basis, sales reps had an incentive to continue extending credit to existing clients regardless of their ability to pay.

Company policy should have required the use of pre-numbered accounting documents for all transactions and mandated timely recording of all transactions. (Note: Besides

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204 Inc.

Case 3.5 Goodner Brothers,

(d)

taking intra-year inventory counts at the company’s sales offices, Goodner’s internal auditors could have been required to perform periodic “compliance” audits at each sales office. The legal opinion that provided the background information for this case did not reveal the scope or nature of the responsibilities assigned to Goodner’s internal audit staff.)

To remedy the poor control consciousness at the Huntington sales office— presumably a lax control environment existed at all of Goodner’s operating units, top management first needed to recognize the necessity and importance of a rigorous and comprehensive system of internal controls. Mid-level managers typically follow the example established by their superiors when it comes to acknowledging the importance of internal controls to an organization. In turn, employees occupying the lowest rungs of an entity’s employment hierarchy typically adopt middle management’s attitude toward controls. So, if an organization is to have an effective control environment, top-level management must evidence a strong commitment to creating and maintaining a reliable system of internal controls.

4. Refer to the “Suggestions for Use” section for an overview of a group assignment that may be used with this case question.

Listed next are parties that may have been at least partially responsible for the theft losses suffered

by Goodner Brothers at the hands of Woody Robinson.

T.J. and Ross Goodner: The management style and operating philosophy of Goodner’s two owners created a weak control environment within the company. The existence of a weak control environment may eventually tempt employees to take unfair advantage of a company. In fact, the ease with which inventory could be stolen from Goodner’s was a key factor that prompted Woody Robinson to begin stealing from his employer.

Felix Garcia: As Woody’s immediate superior, Garcia should be held partially responsible for the large inventory losses suffered by the Huntington sales office. One might question Garcia’s assertion that he was unaware of the disproportionate number of customer complaints filed against Robinson. If he was truly unaware of the number of complaints filed against Robinson, his competence must be questioned. As the on-site manager of the Huntington sales office, he should have recognized the implications for his unit of such customer complaints and evidenced some interest in following up on those complaints.

Goodner’s CFO: As the chief financial executive for Goodner Brothers, the company’s CFO should have been aware of the need for, and importance of, reliable internal controls, particularly for the company’s large investment in inventory.

Goodner’s independent auditors: Independent auditors must obtain a sufficient understanding of a client’s internal controls to plan the audit and to determine the nature, timing, and extent of tests to be performed. As noted in the case, when the independent auditors were brought in to investigate the missing inventory, they were shocked at the Huntington unit’s weak controls. 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 3.5 Goodner Brothers,

205

Inc. revelation makes one question whether the auditors obtained a “sufficient understanding” of Goodner’s internal controls to plan their annual audits. Obtaining a thorough understanding of those controls might have prompted the auditors to discuss Goodner’s pervasive control weaknesses with top management.

Al Hunt: Al Hunt should have considered what was in the best interests of his close friend, Woody Robinson, when it became apparent that Woody was involved in illicit activity.

Additionally, Al should have recognized that he and his business were not entitled to benefit financially from apparently illicit actions of his best friend.

Rachelle Robinson: Similar to Al, if Rachelle suspected that her husband was involved in some illicit activity, she had a moral responsibility to intercede. For example, she might have discussed the matter with him directly, raised the issue or apparent problem with family members or the clergy, or approached his best friend Al regarding the situation.

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Case 3.6 Buranello’s Ristorante 206

CASE 3.6

BURANELLO’S RISTORANTE

Synopsis Employee theft is a widespread and serious problem facing the multitude of small businesses that play such a critical role in the U.S. economy, which is the key reason that phenomenon is a focal point of several of the “internal controls” cases that I have written, including this one. This case demonstrates the extreme lengths to which small businesses may go to thwart dishonest employees.

The general manager of Buranello’s Ristorante set up a “sting” operation—with the owner’s approval—to test the honesty of the employee who he believed was stealing from the business. But the plan backfired and Buranello’s eventually found itself on the wrong end of a “malicious prosecution” lawsuit.

© 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 3.6 Buranello’s Ristorante 207 Buranello’s Ristorante--Key Facts 1.

Buranello’s recently faced a problem that plagues many, if not most, small businesses, namely, employee theft.

2.

Michael Barnes, Buranello’s general manager, believed that Aaron O’Neil, one of the restaurant’s three shift managers, was the individual most likely stealing from the business.

3.

The key evidence pointing to O’Neil was the fact that the cash shortages began occurring shortly after he was hired by Buranello’s.

4.

With the approval of Buranello’s owner, Barnes set up a sting operation to test O’Neil’s honesty.

5.

At the close of business one evening, Barnes intentionally understated the cash receipts reported on the deposit slip prepared for that day knowing that O’Neil would be the individual who would be responsible for making the deposit the following morning.

6.

The next day, O’Neil discovered the excess cash not reported on the deposit slip; O’Neil hid the cash in Buranello’s safe because he believed that he was being “set up.”

7.

When O’Neil didn’t report the excess cash, Barnes assumed that he had stolen it and contacted the local police who subsequently arrested O’Neil.

8.

After being taken into custody, O’Neil told the police that he hadn’t stolen the excess cash but instead had hidden it in Buranello’s safe; after finding the cash, the police released O’Neil.

9.

O’Neil didn’t return to work at Buranello’s but one month later filed a “malicious prosecution” civil lawsuit against the business; at the conclusion of a jury trial, O’Neil was awarded a $66,000 judgment against Buranello’s.

10. The judgment was later overturned by an appellate court that ruled because Buranello’s had “probable cause” to file theft charges against O’Neil, it could not be accused of malicious prosecution.

Instructional Objectives 1. To demonstrate that employee theft is an important internal control issue for many, if not most, small businesses.

2.

To identify appropriate measures that can be implemented to remedy internal control weaknesses.

3.

To identify the internal control objectives for specific control activities.

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Case 3.6 Buranello’s Ristorante 208 4. To demonstrate to students that internal control issues and ethics issues are often closely related.

Suggestions for Use Even novice accountants can appreciate the importance of providing controls over cash and cash processing activities. This case allows students to discuss control risks related to cash that are present in a setting with which most of them will be very familiar, namely, a restaurant. An important point to make when covering this case is that small businesses often do not have sufficient resources to operationalize some of the most basic internal control concepts, such as adequate segregation of key functional responsibilities. Nevertheless, there is nearly always some cost-effective measure that a small business can implement to mitigate, to some degree, a given internal control weakness, as demonstrated by the suggested solution to case question #2.

This case also provides an opportunity for instructors to raise important ethical issues that are often intertwined with internal control issues. For example, “Just how far should a company go to protect its assets?” is a question that involves both internal control and ethics issues for businesses. In covering this case, it is likely that a debate will arise among students regarding whether the sting operation used by Michael Barnes was legal—my research suggests that it was, as I point out in the suggested solution to case question #4. Although it was apparently legal, was that ploy ethical?

Consider posing the latter question to your students—if one of them doesn’t raise it during the discussion of case question #4.

Suggested Solutions to Case Questions 1. Listed next are specific internal control weaknesses evident in Buranello’s operations followed by a brief discussion of the given control risks. Your students will likely come up with additional control weaknesses, most of which will be closely related to one of these items. a.

b.

c.

d.

Weak control environment: Michael Barnes’ attitude toward his “back office” responsibilities suggests that he is not setting a good “tone at the top” for Buranello’s. His subordinates, no doubt, perceive that he does not place a sufficient emphasis on his control-related responsibilities, which may result in them following suit.

Rapid employee turnover: This poses a wide range of control risks for a business. Because of the learning curve effect involved in the training of new employees, rapid turnover creates an environment in which internal control breakdowns (and other mistakes or oversights) are more likely. This problem is especially critical when it comes to turnover of management staff.

Ineffectiveness of daily sales reconciliation procedure: By Barnes’ own admission, this important control activity does not appear to be accomplishing its objective; that is, this procedure may actually be used as a tool to conceal rather than uncover cash shortages.

Failure to develop a standard procedure for dealing with or classifying unusual reconciling items encountered during the daily sales reconciliation procedure: This weakness forces shift managers when preparing daily sales reconciliation worksheets (and Barnes when reviewing those worksheets) to continually “reinvent the wheel.” The likely result is that the same type of reconciling item may be dealt with differently by the shift managers.

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Case 3.6 Buranello’s Ristorante 209 e. Failure to review daily sales reconciliation worksheets on a timely basis: An effort should be made to identify and then investigate significant cash shortages as quickly as possible so they can be properly addressed and investigated. Since Barnes allows the daily sales reconciliation worksheets to “pile up” on his desk, this control objective is not being accomplished. f. Lack of accountability for cash (can’t trace cash shortages to one individual): This control weakness is closely related to the three previous items. This weakness may actually encourage or induce employees to steal cash. g Leaving daily cash deposits on business premises overnight: This policy exposes cash receipts to some risk of being stolen. h. Failure to contact an attorney or legal expert prior to implementing a policy or measure that may impinge upon an employee’s civil rights: this internal control weakness exposes a business to significant legal liability. i. Lack of a petty cash fund: A control risk posed by this weakness in the context of this case is the increased likelihood that the daily sales reconciliation procedure will be ineffective, meaning that cash shortages due to theft or other causes are less likely to be detected.

2. Here are proposed remedial measures for the control weaknesses identified in the suggested solution to case question #1, including a discussion of their apparent cost-effectiveness. a.

b.

c.

Other than hiring a new general manager, there is not an easy “fix” for this control weakness.

One suggestion: Marta Giordano could have a heart-to-heart discussion regarding the importance of internal controls with Michael Barnes or appoint a proxy (such as a representative of Buranello’s accounting firm) to do so. Would this measure be cost effective? The monetary cost of this measure would be effectively zero, while the resulting benefits could be enormous.

(This latter assertion stems from the fact that the control environment is easily the most important element of an internal control system. Improving that feature of a control system can have pervasive positive consequences for the remaining internal control elements.)

Here again is a difficult internal control weakness to resolve, at least, it would be difficult to resolve on a cost-effective basis. Almost certainly, Buranello’s could reduce its employee turnover by enhancing its compensation packages, but the cost of that solution might very well exceed the resulting benefits.

The solution to this internal control weakness is readily apparent. The daily sales reconciliation procedure could be and should be streamlined and strengthened. One approach would be for Barnes to consult with a sample of other restaurants and select what appears to be the most effective and efficient daily sales reconciliation procedure within that sample. Another possibility is to ask Buranello’s accounting firm to retool this procedure. Probably the most expensive “fix” would be to retain a consultant within the restaurant industry to design a new reconciliation procedure. The importance of this daily control activity and the current weaknesses evident within it suggest that any one of the recommended remedial measures would likely be costeffective. NOTE: As pointed out in the case, there are several reconciliation templates that are used within the restaurant industry. The size and overall complexity of a restaurant’s operations apparently dictates which particular template is most appropriate.

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Case 3.6 Buranello’s Ristorante 210 d. Solution: develop a standard template or legend for shift managers to reference when addressing unusual reconciling items. This template would briefly indicate exactly how to deal with any given type of reconciling item. Cost-effective: absolutely. e. Here again, the issue is changing Michael Barnes’ mindset. The cash shortages experienced by Buranello’s should reinforce to him the need and importance of “clearing” the daily sales reconciliation worksheets as quickly as possible. Cost: effectively zero. Benefit: significant. f. If the three previous internal control weaknesses are properly resolved (in particular item “c”), then this problem should be mitigated to some degree, if not a significant degree. The benefit of remedying this internal control weakness makes the suggested solutions to the three previous weaknesses even more cost-effective. g. Placing the daily deposit in the overnight deposit box at the bank would eliminate the risk that an overnight break-in would result in the theft of the deposit (granted, there is some risk that the shift manager could be robbed late at night on the streets of Boston!). Cost-effective? Difficult to assess. In all seriousness, the risk that the shift manager may be robbed late at night on the way to the bank may result in the cost of this solution being greater than the expected benefits. h. Although the sting operation implemented by Barnes was apparently legal (see solution to case question #4), several online websites for small businesses suggest that before employing such measures (or related measures) business managers should first contact an attorney to determine that no laws would be broken by the given plan and that it would not violate employees’ civil rights. I would suggest that this control procedure would likely be cost-effective. In the Buranello’s case, the trial jury award was eventually overturned but the business still incurred significant legal expenses. Those expenses possibly could have been mitigated or eliminated if an attorney had been consulted. That is, even though the sting was legal, an attorney may have been able to provide advice on how Buranello’s could minimize its legal exposure (including the likelihood of being sued) in carrying out that plan. i. Creating a petty cash fund will cause some logistical headaches but it is a relatively low cost control that should pay significant benefits by streamlining the daily sales reconciliation procedure and standardizing the process for dealing with miscellaneous daily cash expenditures.

3. Consider converting this question into a group project in which small groups of students visit different local restaurants and develop a list of internal controls evident within each one. Students could then compare, contrast, and discuss their findings in class. Recognize that the control activities observed by students will likely vary as a function of the size and sophistication of the restaurants they visit. Nationally franchised restaurants, for example, typically have more formalized control procedures than local, family-owned restaurants. Note: prior to such a group project, you might want to remind students of the three overarching internal control objectives: enhancing the reliability of financial reports, increasing the effectiveness and efficiency of an organization’s operations, and ensuring compliance with all applicable laws and regulations. [Recall that the old “safeguarding of assets” internal control objective is now subsumed by the “financial reporting” and “efficiency and effectiveness of operations” objectives.]

Listed next is a small sample of internal controls (some of which are “offbeat”) that students might observe at a restaurant and the specific goal or objective of each: a. Voiding or cancelling of coupons after they are used: the objective being to ensure that each coupon is used only once. b. Visual inspection of large bills (such as $50’s and $100’s) by the cashier: to lower the likelihood © 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 3.6 Buranello’s Ristorante 211 c.

d.

e.

f.

that customers will use invalid currency to pay their bills.

Disclaimers or caveats appearing in the restaurant menu, such as, whether or not peanut oil is used in cooking certain items: restaurants, similar to other businesses, attempt to limit their legal liability with public disclaimers when a product or service poses certain risks or potential risks to customers.

A member of the management staff asking patrons (during or after their meal) if everything was cooked to their satisfaction: repeat customers are the lifeblood of most businesses so restaurant managers have a strong incentive to ensure that their customers leave happy. [Note: This control measure is linked to the “efficiency and effectiveness” of operations objective.]

“Sneeze shields” over salad bars: restaurants are subject to a litany of health department requirements with which they must comply (these vary by state, of course)—the overarching internal control objective here would be to comply with applicable laws and regulations.

Using “servers” rather than waiters or waitresses to deliver meals: the overarching internal control objective here is to enhance the efficiency and effectiveness of operations (having servers deliver the food helps ensure that customers receive their meals as quickly as possible and thus enhances their satisfaction).

4. In responding to this question, students should first attempt to place themselves in Barnes’ position. Recognize that Barnes was both infuriated and extremely embarrassed by the recurring cash shortages. [Note: unfortunately, there was no indication in the legal opinion as to the absolute size of the cash shortages.] Someone who is desperate is more inclined to use desperate measures, which is why he apparently came up with the idea of a sting operation. Was the sting operation “appropriate”? This is a good question to ask your students to discuss and debate. But, again, it is difficult to answer that question as a bystander. No doubt, Barnes, himself, would be the best individual to provide the response to that question. (You may want to point out that the sting operation actually accomplished its intended objective, namely, ending the abnormally large cash shortages.)

As a sidebar, there doesn’t seem to be any doubt that the sting operation was legal, at least, given the results of my research. Business owners must tread a very fine line between giving their employees an opportunity to commit a theft (or other crime) versus “entrapping” them in a crime.

“Providing an opportunity” to commit a crime apparently does not qualify as entrapment. On the other hand, if there is some degree of goading or “pushing” the employee into committing a crime, then it is very likely that entrapment has taken place.

An important ethical responsibility that a business's managers and owners have when they suspect an employee of theft is protecting that individual’s legal rights. In the United States, a person is presumed innocent until proven guilty of a crime. Accusing an individual of theft can have very adverse consequences for that person, even if the accusations prove to be unwarranted. From a business standpoint, it is also critical that an employee's legal rights not be violated when he or she is suspected of theft. A false accusation of theft could have serious economic consequences for a business—a lesson learned by the owner and manager of Buranello’s in this case.

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Case 3.7 Saks Fifth Avenue 212

CASE 3.7

SAKS FIFTH AVENUE

Synopsis In the early 1990s, Joseph Fierro accepted a part-time sales position with the Men’s Polo Department of a Saks Fifth Avenue store. The hard-working Fierro received excellent performance appraisals from his immediate supervisor, Robert Perley. After being rewarded with a full-time position, Fierro continued to impress his supervisor and was soon promoted to Clothing Specialist so that Perley could justify giving him a 20 percent raise.

Fierro’s tenure with Saks Fifth Avenue ended abruptly and unpleasantly in 1996. Saks dismissed Fierro after discovering that he had forged co-workers’ signatures and used a co-worker’s identification number to receive an illicit discount of approximately $10 on a shirt that he purchased from another Saks department. After Saks refused to give Fierro a positive employment reference, he sued his former employer. Fierro charged that Perley discriminated against him because of his ethnic background. Fierro also alleged that he was subjected to a “hostile work environment” at Saks.

The judge who presided over Fierro’s lawsuit dismissed both claims. The judge ruled that Perley did not discriminate against Fierro and that Fierro’s work environment at Saks was not hostile but “merely offensive.” The judge also ruled that Saks was entitled to dismiss Fierro for a “relatively trivial” theft. The questions appended to this case focus on various internal control issues and concepts posed by the circumstances surrounding Fierro’s employment with, and dismissal from, Saks Fifth Avenue. In particular, this case reinforces to students that one of the key objectives of an entity’s internal control process should be to ensure “compliance with applicable laws and regulations.”

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Case 3.7 Saks Fifth Avenue 213 Saks Fifth Avenue--Key Facts 1. Joseph Fierro’s hard work and creativity earned him excellent performance appraisals and promotions from his departmental supervisor, Robert Perley.

2. Fierro forged two signatures and used a co-worker’s employee identification number to obtain an improper sales discount of approximately $10 on a shirt he purchased from another Saks department.

3. Saks internal auditors uncovered the forged documents and the improper discount that Fierro obtained.

4. Perley appealed to Saks’ Loss Prevention and Human Resources departments in an effort to save Fierro’s job.

5. Saks dismissed Fierro, invoking its zero tolerance policy for employee theft.

6. Fierro subsequently sued Saks, alleging that Perley discriminated against him because of his ethnic background.

7. Fierro also alleged that he was subjected to a hostile work environment at Saks.

8. The judge who presided over Fierro’s lawsuit ruled that Perley did not discriminate against his former employee and that Saks was well within its right to dismiss Fierro for a relatively trivial theft.

9. In considering Fierro’s allegation that he was subjected to a hostile work environment, the presiding judge noted that among a company’s most credible defenses to such an allegation is the existence of an explicit anti-harassment policy such as that of Saks.

10. The presiding judge dismissed Fierro’s hostile work environment allegation by ruling that the work environment at Saks was not hostile but “merely offensive.”

Instructional Objectives 1. To illustrate an important internal control risk for businesses that is typically not emphasized in the professional literature, namely, the threat of employee lawsuits stemming from substandard working conditions.

2. To document employee theft as an important control risk for retail businesses.

3. To identify control activities that retail businesses can implement to cope effectively with key control risks they face. © 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 3.7 Saks Fifth Avenue 214

Suggestions for Use Consider launching the discussion of this case with a group exercise that articulates with case question #3. Prior to classroom coverage of this case, divide your students into small groups and then assign each group an easily accessible (and preferably large) retail business in the local community. Require each group to visit their assigned business and prepare an oral report listing five or more control activities that they observed at that business. In addition, require each group to identify the three most significant internal control deficiencies that were apparent at their assigned business.

Suggested Solutions to Case Questions 1. Many students maintain that Saks’ zero tolerance policy is unreasonable or extreme. These same students typically argue that Fierro’s theft--taking an undeserved employee discount of $10--did not merit him being fired, especially since he was such a productive employee. In fact, the most significant cost associated with that policy is likely the loss of very productive employees who fall victim to the temptation to take unfair advantage of their employer. To evaluate the costeffectiveness of the zero tolerance policy, Saks must weigh the loss of productive employees against the almost certainly sizable--but very difficult to measure--benefits produced by that policy. In particular, that policy likely serves as a very effective deterrent to employee theft, thus preventing significant inventory losses in the future.

Note: Some students question whether Fierro’s “theft” qualified as a true theft. The argument here is that Fierro likely could have asked another employee in the department from which he purchased the shirt to make the purchase for him. Then, he could have reimbursed that employee for the cost of the shirt, thus receiving the employee discount. By taking the discount “directly,” Fierro simply expedited matters and saved time and effort for both himself and members of the other department--so these students’ argument goes. This argument then raises another question: Would Saks consider such a subterfuge unacceptable? I don’t know the answer to that question.

2. AU-C Section 315.04 defines internal control as follows: Internal control: A process effected by those charged with governance, management, and other personnel that is designed to provide reasonable assurance about the achievement of the entity’s objectives with regard to the reliability of financial reporting, effectiveness and efficiency of operations, and compliance with applicable laws and regulations. Internal control over safeguarding of assets against unauthorized acquisition, use, or disposition may include controls relating to financial reporting and operations objectives.

This definition of internal control would certainly include Saks’ anti-harassment policy and related complaint procedure. Since discriminating against employees on a racial basis and forcing them to work in a hostile environment violate “applicable laws and regulations,” Saks’ anti-harassment policy would be relevant to the third category of control objectives included in the definition of internal © 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 3.7 Saks Fifth Avenue 215 control.

3. Listed next are control activities that a men’s clothing department in a retail store might implement. The related control objective for each activity is also listed. a) Assigning responsibility for the maintenance of each distinct area within the department to one employee. Objective: To ensure that the merchandise in each area of the department is adequately stocked, organized, properly displayed, and that any apparent inventory shortages and/or theft losses are discovered and reported on a timely basis. b) Periodic counts of inventory to reconcile quantities on hand with quantities reflected by inventory records. Objective: To identify inventory shortages on a timely basis and to provide accurate inventory counts for financial statement purposes. c) Requiring that customer returns, employee discounts, and other unusual and/or infrequent transactions be approved by management personnel. Objective: To reduce the risk of inventory theft losses and other invalid transactions. d) Merchandise shipments from vendors are unpacked, inspected, and checked against the packing slip, purchase order, or other appropriate document on a timely basis. Objective: To ensure that merchandise received from vendors is not defective and that quantities received agree with quantities ordered. e) Periodic reviews of inventory by management personnel. Objective: To identify potential inventory obsolescence, excessive inventory, inventory shortages, and improper displays of inventory. f) Inventory purchases are authorized by management personnel. Objective: To reduce the risk that excessive or inadequate amounts of inventory will be ordered and to minimize the risk of subordinates ordering inventory and then diverting subsequent inventory shipments for their own use.

4. Auditors do not report on the quality of the work environment that a client provides for its employees. However, the existence of a hostile work environment within a company provides definite signals regarding the mindset of the entity’s management. If an audit client maintains a “hostile work environment” for its employees, almost certainly the company’s control environment is inadequate. Technical standards suggest that the control environment is the “foundation” for all other elements of internal control. The standards also suggest that an entity’s control environment provides the discipline and structure for the organization. Consequently, an inadequate control environment has direct implications for the company’s independent auditors. A weak control environment typically translates into a higher control risk for key management assertions underlying an entity’s financial statements, thus requiring more extensive testing of those assertions by independent auditors.

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Case 3.8 The Boeing Company 216

CASE 3.8

THE BOEING COMPANY

Synopsis In January 2007, Matthew Neumann and Nicholas Tides, two Boeing employees, transferred to the large aerospace company’s internal audit department. The two men expected that their new jobs would put them on a “fast track” for career advancement within the company. Unfortunately, just the reverse was true. A few months later, both Neumann and Tides were “former” Boeing employees after being fired for communicating with a Seattle newspaper reporter and providing her with company documents.

A few months after being dismissed, Neumann and Tides filed a whistleblowing lawsuit against Boeing, that is, the two men alleged that Boeing had improperly retaliated against them for providing adverse information regarding Boeing’s internal controls to the newspaper reporter. Neumann and Tides filed their lawsuits under the Sarbanes-Oxley Act, which provides for legal remedies for corporate whistleblowers. The two men went “0 for 3” in the federal courts: their case was dismissed on a summary judgment in a federal district court, the U.S. Court of Appeals refused to overturn the district court’s decision, and the U.S. Supreme Court refused to review the two earlier decisions involving their case.

This case revolves around the internal control and whistleblowing provisions of the SarbanesOxley Act. Among other topics, the case questions require students to review the five components of the COSO internal control framework, to explain the difference between a “significant deficiency” and a “material weakness” in internal controls, and to consider the interaction between internal auditors and external auditors in “Section 404” engagements.

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Case 3.8 The Boeing Company 217

The Boeing Company--Key Facts 1. Matthew Neumann and Nicholas Tides transferred to Boeing’s internal audit department in January 2007 to advance their careers with the large aerospace company.

2. The primary responsibility of Neumann and Tides’ internal audit team (IT SOX) was to assist company management in assessing and reporting on the effectiveness of the company’s financial reporting controls as mandated by the Sarbanes-Oxley Act. 3. Shortly after joining the IT SOX audit team, Neumann and Tides identified several serious weaknesses in Boeing’s IT controls that were integrated into the company’s financial reporting function.

4. On more than two dozen occasions, Neumann and Tides reported internal control weaknesses they uncovered to their superiors.

5. Despite the internal control problems identified by Neumann and Tides, Boeing’s management and Deloitte, Boeing’s independent audit firm, issued SOX-mandated reports indicating that the company’s financial reporting controls were effective.

6. Neumann and Tides discussed Boeing’s IT internal control weaknesses with a Seattle newspaper reporter without obtaining prior approval from their employer; the subsequent newspaper article was extremely critical of Boeing’s internal controls.

7. Following an investigation that included monitoring Neumann and Tides’ e-mails and computers, the two internal auditors were fired.

8. Neumann and Tides filed whistleblower lawsuits against Boeing under Section 806 of the Sarbanes-Oxley Act; that section provides for legal remedies for corporate whistleblowers who are punished by their employers.

9. Neumann and Tides’ lawsuit was unsuccessful because Section 806 of the Sarbanes-Oxley Act does not provide for legal remedies for corporate whistleblowers who communicate adverse information regarding their employers to members of the news media.

10. Several parties criticized the legal rulings handed down in the Neumann-Tides case and suggested that those rulings would have a chilling effect on corporate whistleblowing in the future.

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Case 3.8 The Boeing Company 218

Instructional Objectives 1. To introduce students to the key internal control initiatives for public companies mandated by the Sarbanes-Oxley Act. 2. To examine ethical and internal control issues related to corporate whistleblowing.

3. To identify the differences between a significant deficiency and material weakness in internal control.

Suggestions for Use This case is ideally suited to be used as an introduction to coverage of internal controls within an auditing course. The case will help students understand the nature and importance of the key internal control initiatives mandated for public companies by the Sarbanes-Oxley Act of 2002. Alternatively, if you have a self-contained module within your course that focuses on Sarbanes-Oxley, you could use this case as a prologue to that module.

As pointed out by the case, the legal remedies extended to corporate whistleblowers under the SOX Act have proven to be fairly ineffective. You can expand on case question No. 5 by requiring your students to research and report on legal remedies provided for whistleblowers under other federal statutes, in particular, the False Claims Act and the Whistleblower Protection Act. Encourage your students to explain the rationale (or apparent rationale) for the differing legal remedies for whistleblowers that were incorporated in those three statutes by Congress.

Suggested Solutions to Case Questions 1. The five components of internal control, according to the COSO framework, are control environment, risk assessment, control activities, information and communication, and monitoring.

Different arguments can be made as to which of these five components is most relevant to the SOXmandated whistleblowing procedures. Having said that, the most directly relevant component in this context seems to be “monitoring” because the creation of an internal whistleblowing mechanism contributes to the ability of an organization’s management to “monitor” the entity’s internal control system. Note: COSO provides the following overview of the monitoring component of internal control (www.coso.org): “Internal control systems need to be monitored—a process that assesses the quality of the system's performance over time. This is accomplished through ongoing monitoring activities, separate evaluations or a combination of the two. Ongoing monitoring occurs in the course of operations. It includes regular management and supervisory activities, and other actions personnel take in performing their duties. The scope and frequency of separate evaluations will depend primarily on an assessment of risks and the effectiveness of ongoing monitoring procedures. Internal 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 3.8 The Boeing Company 219 deficiencies should be reported upstream, with serious matters reported to top management and the board.”

2.

Although not mentioned in the case question or discussed in the case, there are three levels of internal control “problems”: internal control deficiency, significant deficiency in internal control, and material weakness in internal control. Following are definitions of those terms that were taken directly from AS 2201 of the PCAOB auditing standards. (Note: as a point of information, these definitions are consistent with the comparable definitions included in the AICPA Professional Standards at AU-C Section 265.7).

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.”

Example of an internal control deficiency: an organization does not have a proper petty cash voucher system, that is, the petty cash vouchers do not identify the explicit nature of the given disbursements being paid with petty cash. [In most cases, the resulting financial misstatements due to this deficiency would be immaterial, if not nominal.]

Example of a significant deficiency in internal control: an organization does not have proper segregation of the inventory warehousing function and the purchasing function for inventory. [This would probably not qualify as a material weakness in internal control if inventory and inventory transactions are not typically “material.” On the other hand, most accountants would likely view this violation of the cardinal “segregation of duties” principle as more than simply a “deficiency in internal control.”] Note: it is “tricky” to provide perfect examples of significant deficiencies in internal control given the way they are defined. The given control problem has to rise to the level of “significance” but not reach the level of “material.”

Example of a material weakness in internal control: the prior example can be repeated here except that we change the underlying premise, that is, the given organization typically has a material amount of inventory and the dollar volume of its inventory transactions is also material.

3. The most obvious “problem” that this would have posed for Boeing would have been violating the SEC rule mandating that a public company’s internal auditors be controlled by the entity’s audit committee. But, more to the point, what operational problem is posed by having parties other than an organization’s audit committee control the entity’s internal auditors? Under SOX, audit committees shoulder a significant number of important responsibilities including overseeing the effectiveness 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 3.8 The Boeing Company 220 entity’s internal controls. Granted, company management and an entity’s independent auditors are charged with assessing and reporting on internal controls, but the day-to-day oversight responsibility for those controls rests with the audit committee. To carry out this mission, an audit committee will typically rely heavily on the given organization’s internal auditors. So, if an organization’s internal auditors are not “controlled” by the audit committee, then the latter body will have difficulty exercising its oversight responsibility for internal control.

4. Boeing’s corporate policies make it clear that the proper channels of communication should be used by company employees who want to report a significant problem they have uncovered. For example, Boeing’s policies explicitly prohibit employees from making unauthorized disclosures to “non-Boeing persons.” The company would almost certainly interpret “non-Boeing persons” as including members of the company’s independent audit firm.

In the post-SOX era, a company’s audit committee serves as the liaison between company management and its independent auditors. As a result, if Deloitte had received a whistleblower-type communication from a Boeing employee, the proper course of action would almost certainly have been to forward that information to the company’s audit committee. [Granted, in such circumstances, independent auditors may choose to consult their legal counsel before deciding which specific course of action to take.]

5. In the legal opinion handed down by the appellate court for the Neumann-Tides case, the court observed that if Congress had intended to “protect reports to the media” under SOX Section 806, it would have provided legal remedies to whistleblowers under that section for “any disclosure” as it did under the Whistleblowers Protection Act. The opinion went on to observe that it was obvious that in SOX Section 806 Congress intended to protect whistleblower reports only to parties that had “the capacity or authority to act effectively on the information provided.” The media aren’t included in the latter category since they have no official avenue to remedy corporate wrongdoings or other circumstances disclosed by corporate whistleblowers.

Although not mentioned in the Neumann-Tides appellate court decision, other parties have noted that extending legal protection to whistleblower reports made by corporate employees to the media could potentially place companies in a situation where disgruntled employees or former employees could effectively hold those companies hostage by threatening to leak embarrassing information to the news media. Potential whistleblowers could routinely use such leverage to extract pay raises, severance payments, or other concessions from their employers or former employers.

6. It is no doubt “legal” for Boeing to monitor the computers and e-mail systems that its employees use in carrying out their work-related responsibilities. Those items are the property of Boeing and the company has a legal right to ensure that they are being properly utilized by employees. In fact, companies can face legal liability if they do not take steps to ensure that employees are properly utilizing the company assets at their disposal.

Just because some course of action is “legal” does not mean, necessarily, that it is ethical.

However, in this setting, I can’t imagine a strong argument for maintaining that Boeing’s action was unethical. Company officials insisted that the actions of the two internal auditors exposed Boeing to reputational harm and other potential losses. Assuming that was true, those officials would not have © 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 3.8 The Boeing Company 221 been fulfilling their fiduciary responsibilities if they had not invoked their right to monitor the activities and work product of those 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 3.9 Walmart de Mexico 221

CASE 3.9

WALMART DE MEXICO

Synopsis When Congress passed the Foreign Corrupt Practices Act (FCPA) in 1977, corporate accountants and independent auditors feared that the new law would create major headaches for them. That fear was unwarranted . . . at least for several years. During the first two decades that the FCPA was in effect, the Securities and Exchange Commission (SEC) initiated only a handful of enforcement cases related to that federal statute. During the mid-1990s, however, growing concern that U.S. multinational companies were routinely paying bribes and kickbacks to officials of foreign governments refocused the SEC’s attention on the FCPA. Arguably, the FCPA investigation that has received more attention than any other to date involves Walmart’s Mexican subsidiary, Walmart de Mexico. In 2005, Walmart executives allegedly learned that officials of their Mexican subsidiary were routinely paying bribes to governmental officials to expedite building permits and other business licenses. An internal investigation was launched immediately. However, that investigation was abruptly ended when a Walmart de Mexico executive who had allegedly authorized the bribes was placed in charge of the investigation. A Pulitzer Prize-winning article in the New York Times published in April 2012 accused Walmart executives of concealing the bribery. A year earlier, those executives had reopened their investigation of the bribery allegations after learning of the ongoing independent investigation of them by the prominent newspaper.

This case raises internal control, auditing, and ethical issues stemming from Walmart’s alleged violations of the FCPA. Specific issues addressed by the case questions include, among others, internal control activities that may be effective in minimizing the risk of FCPA violations by public companies, the responsibility of auditors to detect and report illegal acts, and the impact of differing cultural values on the ability of multinational companies to maintain proper internal control over their operations.

© 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 3.9 Walmart de Mexico 222 Walmart de Mexico--Key Facts 1. Under the leadership of Sam Walton, Walmart became the largest retailer in the United States due largely to the hypercompetitive business model that he adopted, a business model that many critics have labeled as “predatory.”

2. In the early 1990s, Walmart became an international company when it moved into Canada and Mexico; Walmart quickly became the dominant retailer in Mexico and that nation’s largest private employer.

3. A Pulitzer Prize-winning article published in 2012 by the New York Times alleged that Walmart’s Mexican subsidiary, Walmart de Mexico, had used widespread bribery to establish its market dominance in that country.

4. The New York Times article, and a follow-up article published later in 2012, alleged that the bribery payments by Walmart violated the Foreign Corrupt Practices Act (FCPA) of 1977 and that Walmart officials had concealed the bribery payments from U.S. law enforcement authorities.

5. The FCPA prohibits U.S. firms from making bribes, kickbacks and similar payments to officials of foreign governments to initiate or maintain business relationships and requires U.S. firms to maintain internal control systems that provide reasonable assurance of discovering such payments.

6. After learning of the ongoing investigation by the New York Times in 2011, Walmart officials reopened their investigation of the alleged bribery payments by Walmart de Mexico.

7. Shortly after the publication of the initial article in the New York Times that reported the bribery allegations, Walmart officials organized a network of international FCPA compliance directors and created a new executive position, Global FCPA Compliance Officer.

8. To date, several parties have speculated that if the bribery allegations are proven, the fines imposed on Walmart may be the largest ever FCPA-related fines handed down by U.S. law enforcement authorities.

9. During the first two decades after the passage of the FCPA, the SEC rarely filed charges against U.S. companies under that federal statute; the federal agency became much more aggressive in pursuing FCPA violators in the late 1990s.

10. In 2012, when the SEC was investigating the alleged FCPA violations by Walmart, the federal agency reported that it had more than 70 FCPA investigations under way.

Instructional Objectives 1. To acquaint students with accounting and control issues relevant to the Foreign Corrupt Practices © 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 3.9 Walmart de Mexico 223 Act. 2. To make students aware that client executives may take extreme—and illegal—measures to sidestep governmental regulations.

3. To examine auditors’ responsibility to detect and report illegal acts by a client.

4. To examine the impact that cultural factors may have on a multinational company’s ability to establish and maintain proper internal controls over its operations.

Suggestions for Use In my auditing courses, I integrate this case with coverage of internal control issues. The FCPA prohibits SEC registrants from making illicit payments (bribes, kickbacks, etc.) to officials of foreign governments to either establish or maintain business relationships. This federal statute also requires SEC registrants to establish internal control systems that provide reasonable assurance of detecting such payments. The increasing trend toward multinational operations by U.S. firms and the SEC’s commitment to pursing alleged violators of the FCPA mandate that accountants and auditors be aware of the important accounting, control, and ethical issues related to this federal statute. This case provides students with such an awareness.

An overriding issue in this case is the critical importance of a high degree of control consciousness within an organization. As the COSO has emphasized, the element of internal control systems that has the most far-reaching implications for an organization is its control environment, that is, it’s “tone at the top.” In a case that has an exclusive or heavy internal control focus, I often revisit the five elements of internal control per the COSO framework and discuss/describe (or challenge my students to discuss/describe) how they are relevant in the context of that case. You might consider doing that for this case.

By the time you use this case in your course, there may be an “official” resolution to the SEC’s investigation of the Walmart bribery allegations. You might consider having a group of students provide an update on any new/important developments involving those allegations since the publication of this case.

Suggested Solutions to Case Questions 1. In retrospect, the most important control policy Walmart could have established for its foreign subsidiaries would have been to inform those subsidiaries’ executives and employees that the payment of bribes was strictly prohibited and that anyone who violated that policy would be fired immediately. Reports to date suggest that Walmart’s top management was initially unaware that their Walmart de Mexico subordinates were making unlawful payments to Mexican governmental officials. However, because those executives apparently did not sternly discourage those types of payments, they created an environment in which they were more likely to occur, particularly since bribery tends to be endemic to Mexico’s business environment. Walmart’s executives also should have insisted that each subsidiary’s disbursements be supported by appropriate documentation and authorized by the appropriate level of management. To reinforce this control policy, Walmart could © 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 3.9 Walmart de Mexico 224 have required periodic tests of disbursements by internal auditors. Deviations from operating policies and procedures discovered by the internal auditors should have been dealt with decisively and appropriately by Walmart’s management.

Another control policy or activity that Walmart could have implemented when it began moving into international markets was the control policy that it ultimately adopted in 2012 after the initial bribery allegations were reported by the New York Times. That policy involved the creation of a FCPA compliance office in the company’s corporate headquarters. The establishment of this office and the accompanying network of international FCPA compliance directors signaled that Walmart’s top management took their FCPA-related responsibilities very seriously. If this control mechanism had been in place during the development of Walmart de Mexico, the management team of that subsidiary would have been less inclined to engage in activities that violated the FCPA. The cost-effectiveness of control activities is difficult to assess. Complicating such an assessment is the fact that many of the costs and benefits associated with specific control activities cannot be measured strictly in dollars. For example, one of the “costs” incurred by Walmart as a result of its foreign payments scandal was a loss of credibility. On the other hand, an “opportunity cost” associated with having a strict policy against illicit payments to officials of foreign governments is lost business revenues and relationships in those countries. Hopefully, corporate executives recognize that, over the long run, the benefits of controls intended to deter and detect illegal activities almost certainly far outweigh the related costs of those controls. [Note: You might point out to your students that following the first report of the bribery allegations by the New York Times, Walmart’s stock price declined sharply. However, the stock price quickly recovered in the following weeks. So, it appears that investors quickly “forgave” the company for its apparent indiscretions.]

2. The accountant’s first responsibility is to report the illegal act to his or her superior. Hopefully, that superior will then take the proper steps to ensure that the situation is dealt with correctly.

However, what if the superior does not take appropriate action? Alternatively, what if the accountant does not feel “comfortable” informing his or her superior of the matter? Possibly, the accountant’s discomfort stems from the involvement or potential involvement of his or her superior in the illegal act. Depending upon the severity of the illegal act, the accountant should probably consider several alternative courses of action. Clearly, one of these alternatives would be obtaining external legal counsel if the situation so warrants. (The accountant should certainly consider this option when he or she is directly or indirectly linked to the illegal act.) External legal counsel could identify the employee’s specific legal responsibilities given the specific circumstances. Another possibility would be to inform the company’s legal counsel and/or outside members of the board of directors of the matter. In most cases, the least preferred alternative would be doing nothing, that is, completely “shirking” any responsibility for disclosing the illegal act.

The responsibility of an accountant to address an illegal act perpetrated by his or her company increases the higher that individual’s position on the firm’s employment hierarchy. For example, a controller or chief financial officer of a public company assumes more responsibility for taking appropriate action to deal with an illegal act perpetrated by the company than does an assistant controller or a low-level accounting clerk.

Except in unusual circumstances, the primary responsibility of an auditor of a public company who discovers that the client has violated a law is simply to report the infraction to his or 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.

Case 3.9 Walmart de Mexico 225 immediate superior. If the superior or the other higher-ranking individuals on the audit engagement team do not deal with the matter properly, the auditor is faced with several alternative courses of action, such as, doing nothing (probably the least preferable option), discussing the matter with an audit partner not assigned to the engagement, or discussing the matter with external legal counsel.

Similar to private accountants, the employment rank of independent auditors impacts the degree of responsibility they assume for dealing with illegal acts perpetrated by a client. The suggested solution to Question 3 discusses auditors’ general responsibility for detecting illegal acts by a client.

For any given audit, the ultimate responsibility in that context rests with the audit engagement partner. Recognize that in certain cases an audit engagement partner and/or his or her proxy may be required to disclose the illegal act to the Securities and Exchange Commission. Finally, AS 2405.23 of the PCAOB’s auditing standards identifies four other situations in which an auditor may be required to divulge an illegal act by a client to a third party: in an 8-K statement reporting an auditor change, in response to a successor auditor’s inquiries regarding the client, in response to a subpoena, or to a government agency from which the client receives financial assistance.

NOTE: In the February 2012 edition of the Journal of Accountancy, the “What’s Your Fraud IQ” feature by Dawn Taylor and Andi McNeal (www.journalofaccountancy.com) included a question addressing the responsibility of auditors when they uncover a client violation of the FCPA (see Question 7). Potential answers included (a) “consider the illegal act’s effect on the amounts presented in [the client’s] financial statements, (b) “evaluate the adequacy of disclosure in the financial statements of the illegal act’s potential effects on [the client’s] operations,” and (c) “consider the implications of the illegal act in relation to other aspects of the audit.” The only incorrect answer to this question was (d) “disclose the illegal act to the SEC.” In the May 2012 edition of the Journal of Accountancy, the chief accountant of the SEC’s Division of Enforcement and the chief of the SEC’s FCPA unit “clarified” the suggestion that option “d” was not a correct answer to the given question. Here is an excerpt from that “clarification”: “Specifically, the answer does not address an auditor’s duties to make disclosure to the SEC under Section 10A of the Securities Exchange Act of 1934. Section 10A(b) requires an audit firm that detects or otherwise becomes aware that an illegal act has, or may have, occurred to determine whether the company has taken appropriate remedial measures and, if not, to report to the SEC in certain situations.”

3. Violations of the FCPA would likely qualify as “illegal acts” by an audit client. The degree of responsibility that an auditor assumes for detecting illegal acts by a client depends upon the nature of those acts as discussed by AS 2405, “Illegal Acts by Clients,” of the PCAOB’s auditing standards.

That section distinguishes between an auditor's responsibility to detect illegal acts that have a "direct and material" effect on a client's financial statements and illegal acts that have a "material indirect" effect on a client's financial statements.

Auditors generally have much less responsibility to detect illegal acts that have a material indirect effect on a client’s financial statements. AS 2405.06 observes that an auditor “ordinarily does not have sufficient basis for recognizing” such violations by clients. AS 2405.07 adds: “If specific information comes to the auditor’s attention that provides evidence concerning the existence of possible illegal acts that could have a material indirect effect on the financial statements, the auditor should apply audit procedures specifically directed to ascertaining whether an illegal act has © 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 3.9 Walmart de Mexico 226 occurred.”

AS 2405.05 notes that an auditor’s responsibility to detect and report “misstatements resulting from illegal acts having a direct and material effect on the determination of financial statement amounts is the same as that for misstatements caused by error or fraud as described in AS 1001.” In turn, AS 1001.02 notes that an auditor “has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.”

4. Even when doing business in other countries, U.S. companies and employees of those companies must uphold U.S. laws and the legal responsibilities imposed on them by U.S. citizenship. By upholding those laws and responsibilities, U.S. companies and their employees are not “challenging” the business practices deemed acceptable in other countries. In most circumstances, U.S. companies and citizens can uphold the laws of their country while still respecting the laws, cultural norms, and business practices of foreign countries. (Granted, if business practices in a foreign country routinely violate U.S. laws, U.S. companies should likely consider suspending operations in that country.)

© 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 4.1 Creve Couer Pizza, Inc.

227

CASE 4.1

CREVE COUER PIZZA, INC.

Synopsis In the early 1990s, the accounting profession was shocked when the news media revealed that for several years a Missouri CPA had funneled confidential financial information regarding a client to the IRS. The CPA had been recruited as a "controlled informant" by the IRS when he was under investigation by that federal agency for failing to file a federal tax return for several years. After the CPA began spying on his client, the IRS dropped its case against him—suggesting a classic quid pro quo scenario.

When a federal indictment was filed against the CPA's client by the IRS, the client subpoenaed the information the IRS had used to build its case against him. At this point, the individual discovered that his accountant had provided the IRS with the information used to incriminate him.

When the facts of this case were publicly reported, the accounting profession was subjected to considerable embarrassment and criticism. This case raised doubts as to whether CPAs could be trusted to protect the confidentiality of their clients' key financial and nonfinancial information. The federal indictment filed against the Missouri CPA's client was eventually dropped, apparently because the judge hearing the case was planning to disallow the evidence collected by the CPA while acting as a controlled informant for the IRS. In 1990, the Missouri State Board of Accountancy revoked the license of the CPA for disclosing confidential client information to a third party without the client's permission.

© 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.

228

Case 4.1 Creve Couer Pizza, Inc. Creve Couer Pizza, Inc.--Key Facts

1. The IRS has operated a controlled informant program since 1939.

2. In the early 1990s, the IRS revealed that more than 40 of its controlled informants were CPAs. 3. James Checksfield was recruited to become a controlled informant by the IRS when he was under investigation by that agency for allegedly failing to file federal tax returns.

4. At the same time the IRS was recruiting Checksfield, one of his clients, the owner of Creve Couer Pizza, was under investigation by the IRS for allegedly "skimming" cash receipts from his business.

5. From 1982 through 1985, Checksfield secretly provided financial information regarding Creve Couer Pizza to the IRS. 6. While Checksfield was providing incriminating evidence regarding his client to the IRS, the f ederal agency dropped its case against him.

7. The IRS and the accounting profession were widely criticized following the well-publicized revelations that Checksfield had provided confidential information to the IRS regarding his client.

8. In 1990, the Missouri State Board of Accountancy revoked Checksfield's CPA license for disclosing confidential client information without the permission of the client.

Instructional Objectives 1. To illustrate the importance of CPAs maintaining the confidentiality of client financial data.

2. To illustrate an unusual but important type of ethical dilemma that accountants in public practice may encounter.

3. To raise the issue of whether communications between accountants and their clients should be privileged similar to attorney-client communications.

Suggestions for Use This case is ideally suited to be integrated with coverage of the confidentiality rule of the AICPA Code of Professional Conduct. Like many of the ethical cases included in this section of the casebook, the Creve Couer case can also be used at practically any point in an auditing course to provide students a "break" from coverage of technical auditing issues.

Be prepared for a lively debate among your students when you address the third case question. © 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 4.1 Creve Couer Pizza, Inc.

229

My experience has been that most students have no qualms admitting that in a similar situation they would cooperate with the IRS to "save their own skin." Then again, a minority of students typically insist that they would refuse to cooperate with the IRS regardless of the personal consequences they would face for not doing so.

Recognize that Checksfield did not provide auditing services to Creve Couer. Instead, he was retained to provide taxation and various accounting services. Nevertheless, the circumstances he faced are easily extrapolated to an auditing context—which is what I attempt to do by posing the hypothetical scenarios early in the case.

Suggested Solutions to Case Questions 1. Most of us have heard anecdotes related by business owners or other taxpayers regarding how their accountants allegedly helped them, or actually encouraged them, to underreport their taxable income. These anecdotes always disturb me. (Granted, these anecdotes may be fabricated or at least wildly embellished in many cases.) As professionals, I believe that public accountants have a responsibility, at the very least, to caution their clients when they engage in, or intend to engage in, unethical or illegal acts. Whether accountants have a responsibility to serve as the "moral conscience" of their clients is a broader and more difficult issue to resolve.

This is an example of a question that often generates considerable "pro" and "con" arguments on the part of students. I believe these types of debates are healthy for students because they allow young men and women to "flesh out" their attitudes regarding important ethical issues and concepts.

2. Here's another example of an ethics-related question that tends to generate considerable debate, if not controversy, among students. The client confidentiality rule expressly prohibits auditors from disclosing confidential client information to third parties. Nevertheless, given the view expressed by the Supreme Court, a reasonable argument could be made that auditors have a responsibility to the public that "transcends" that rule. Then again, if the client confidentiality rule was rescinded, it would likely be very difficult for auditors to obtain the information they need from their clients to complete their audits.

3. Listed next are examples of parties that would be affected by Jess's decision and the related obligation he has to each. a.

Members of the firm: Jess has a responsibility to consider how the individuals in his firm would be affected by his decision to serve as an informant for the IRS. If his involvement with the IRS is revealed publicly, his colleagues may suffer embarrassment and are likely to suffer financially due to a loss of clients. b.

Accounting profession: The actions of one member of a profession can affect the public image and/or credibility of the entire profession. As a result, the individual members of a profession have an obligation to behave in a manner that will not bring discredit to their colleagues. c.

Client: A client of a medical doctor, attorney, or accountant places a high 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 4.1 Creve Couer Pizza, Inc.

d.

trust in the competence and integrity of the given professional. In the hypothetical scenario discussed in this case, Jess has a responsibility to fulfill the commitments he has made to his client to provide a high quality of professional service and to act with integrity in all matters involving the client.

Members of his family: Too often professionals overlook the implications of their job-related decisions for members of their family. In the scenario presented, Jess certainly has a responsibility to consider how his decision would affect the members of his family on several different levels including emotionally and financially.

© 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 4.2 F&C International, Inc. 231

CASE 4.2

F&C INTERNATIONAL, INC.

Synopsis Over two centuries, the Fries family of northern Kentucky and southern Ohio built a dynasty of sorts in the flavor industry. Alex Fries, a German immigrant with a background in chemistry, settled in Cincinnati during the early nineteenth century and a few years later established a flavor company.

Throughout the nineteenth and twentieth centuries, Fries and his descendants owned, operated, or oversaw several flavor companies, the last of which was F&C International. In the early 1990s, F & C’s chief executive, Jon Fries, orchestrated a large-scale financial fraud that proved to be the undoing of the company and the family’s proud history in the flavor industry.

This case examines the role of three F&C officials in Jon Fries’ fraudulent scheme. Those individuals include the company’s chief operating officer who became F&C’s president and chief executive following Jon Fries’ departure, the company’s chief financial officer, and a controller of F&C’s important Flavor Division. Each of these individuals uncovered or stumbled across various evidence that indicated or at least strongly suggested that top management was manipulating the company’s financial records. The company’s chief operating officer failed to heed the warning of a subordinate, an F&C cost accountant, who insisted that the company had a multi-million dollar inventory “problem.” When a subordinate attempted to hand the division controller a document that contained written evidence of Jon Fries’ fraudulent scheme, the controller refused to accept the item.

Finally, F&C’s frustrated chief financial officer resigned after discovering extensive irregularities in the company’s accounting 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 4.2 F&C International, Inc. 232 F&C International, Inc.--Key Facts 1. The Fries family of Cincinnati had a long and proud history in the flavor industry that Alex Fries founded during the nineteenth century.

2. At least ten F&C executives or high-level employees participated in a fraudulent scheme to misrepresent the company’s operating results, principally by overstating revenues and periodending inventories.

3. F&C’s officers used the firm’s misrepresented financial statements to sell equity securities and obtain significant bank loans.

4. Company officials went to great lengths to conceal the fraud, including establishing a fictitious warehouse for accounting purposes and creating false documents to mislead the company’s independent auditors.

5. The controller of F&C’s Flavor Division ignored and avoided subordinates’ efforts to make her aware of evidence indicating the existence of an ongoing fraudulent scheme within the company.

6. F&C’s COO instructed the controller of the Flavor Division not to tell him why she believed the company’s financial records were misleading.

7. F&C’s CFO resigned from the company after realizing that the company’s financial records were unreliable.

8. The SEC subsequently sanctioned F&C’s CFO, COO, and the controller of its Flavor Division for not disclosing the company’s “significant accounting problems.”

9. The SEC permanently banned Jon Fries from serving as an officer or a director of a public company; Fries also forfeited $2 million he realized from the sale of F&C securities and was sentenced to 15 months in federal prison for his role in the F&C fraud.

10. F&C filed for bankruptcy in 1993 and was liquidated the following year.

Instructional Objectives 1. To confirm the critical role of corporate accountants in the financial reporting domain and the SEC’s recognition of the importance of that role.

2. To illustrate ethical dilemmas that corporate accountants may face when a company’s executives are dishonest and to examine accountants’ professional responsibilities in such situations.

3. To demonstrate the adverse consequences that corporate accountants may face if they fail to respond appropriately to ethical crises they encounter. © 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 4.2 F&C International, Inc. 233 4. To illustrate common methods used by corporate executives to inflate their company’s reported profits.

Suggestions for Use Here is another case that lends itself well to a role-playing exercise. Individuals involved in an ethical dilemma often do not have sufficient “distance” from the situation to identify and understand the key factors or dimensions underlying the problem or to grasp its unfolding dynamics. Reaching out to a friend or trusted associate can be extremely beneficial since that individual may be able to provide a more complete and objective point of view regarding the given situation. In this case, I ask two students to assume the roles of Catherine Sprauer and Craig Schuster. In the role-playing exercise, Sprauer approaches Schuster to confide in him regarding her suspicions of an ongoing fraud within F&C. At this point, Sprauer is unaware that Schuster shares her suspicions. Hopefully, the dialogue between the two parties (students) quickly turns to a productive how-can-we-solve-thisproblem discussion. (If you have used role-playing exercises in your classes, you recognize the critical importance of an instructor’s “casting” skills—to prevent such exercises from flopping badly!)

During class discussion of this case, I require students to complete the second case question as a group assignment. After each group arrives at a consensus ethics score for the four key individuals involved in the case, I collect these scores and post them on the board. Then I ask the individual groups to defend those scores. Typically, at least some of the scores vary markedly across the groups—which triggers considerable debate and discussion.

As a point of information, you might remind your students that the Sarbanes-Oxley Act of 2002 (specifically, Section 302 of that statute) requires a public company’s “principal executive officer or officers and the principal financial officer or officers” to “sign off” on each quarterly and annual report filed with the SEC. In effect, these officers must provide a written warranty that the given reports, including the financial statement data included therein, do not contain any “untrue statement” involving a material fact.

Suggested Solutions to Case Questions 1. Chief executive officer: In most companies, the CEO ranks as the ultimate decision maker within the firm. This is where the “buck stops” in terms of long-range policy issues facing a company.

Granted, in most companies, the CEO seeks and obtains input from fellow officers, the board of directors, and various other parties before making decisions on important matters facing a company. Independent auditors may occasionally question a client’s CEO regarding key accounting or financial reporting issues. Generally, though, auditors will direct their questions to lower-level company officials and employees. (For example, when a potential merger or similar development has important financial reporting implications for a company, auditors may need to discuss the given matter with the client’s CEO.) Chief operating officer: The COO is responsible for implementing decisions made by the CEO and other policy makers within a company. That is, he or she generally oversees the day-to-day operations of the company, while the CEO maps out its future. Again, auditors may occasionally © 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 4.2 F&C International, Inc. 234 question the COO on issues that arise during an engagement but will typically direct those inquiries to other client personnel.

Chief financial officer: The CFO in most companies has responsibility for both the financial management and accounting/financial reporting functions of the organization. As the chief financial manager, the CFO oversees the raising of capital and the delegation of that capital to various uses within the company. The CFO also ensures that his or her company has adequate accounting and financial reporting systems to collect the information needed for internal decision making purposes, to maintain control over the entity’s operations, and to accumulate the information needed to prepare periodic financial reports for the SEC, banks, and other parties. Auditors spend much of their time within the CFO’s area of responsibility. In large corporations, auditors will typically question the CFO’s key subordinates on important financial reporting and accounting issues. But, when major issues arise during an audit, the audit engagement partner may find it necessary to communicate directly with the client’s CFO. Division controller: The controllers for individual operating units of an organization typically oversee those units’ accounting, control, and financial reporting functions. Top management relies on division controllers to provide them with timely and accurate data regarding the financial condition and operating results of those units. A division controller’s immediate superior is generally the division manager or president. Division controllers are much closer than high-ranking corporate executives to the “nuts and bolts” accounting and control issues that are of major interest to auditors. As a result, auditors rely heavily on these individuals and their supporting staffs to help them document a client’s internal control systems, to obtain documents needed to complete substantive tests, and to obtain at least initial insights or opinions on important accounting or financial reporting issues facing the company.

2. As pointed out in the Suggestions for Use section, my students complete this item as a group assignment. Students meet in groups to arrive at a consensus ethics score for each of the individuals listed. Then, I post these consensus scores on the board and initiate a discussion/debate among the groups regarding the typically significant differences in at least some of the scores. One interesting (fun) technique I have used to “spice up” this assignment is to include two or three high-profile public personalities in the ethics scoring, typically politicians or individuals in the entertainment industry. Including such individuals in the assignment provides some personal reference points for the students—and typically sparks more debate among students.

3. Students typically want to answer this question by indicating what Sprauer “should” have done, rather than what they, personally, would have done. We all recognize that she had a professional responsibility to investigate the allegations made by the F & C employees. What I want students to consider are the difficult circumstances that Sprauer faced. And I want students to make an effort to place themselves in that context before responding to this question. As noted previously, one measure she could have taken was to discuss the matter with someone in the organization who she trusted, hopefully someone occupying a higher position within the company. The “strength in numbers” concept is particularly valid when it comes to dealing with a moral or ethical dilemma.

4. The SEC ruled that, while employed by F&C, Schuster failed to disclose in F&C’s financial reports the company’s “significant accounting problems” and failed to ensure that the company © 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 4.2 F&C International, Inc. 235 issued ”accurate” financial statements to the investing public. Following his resignation, Schuster remained associated with prior financial statements issued by F&C that were being relied upon by investors, creditors, and other parties. Given this “association” Schuster had a responsibility to make some effort to inform those third parties of the errors in the financial statements they were using.

Schuster could have discussed this problem with F&C’s independent auditors, raised the matter with the SEC, or taken a more direct route and asked F&C’s executives to “fix” and reissue the offending financial statements. In any case, Schuster would have been well advised before taking any action to obtain sound advice from legal counsel. [Note: As pointed out in the Suggestions for Use section, you will likely want to remind your students that the Sarbanes–Oxley Act requires a company’s “principal executive officer” and “principal financial officer” to attest to the material accuracy of the company’s periodic SEC reports.]

5. Here again, the issue is not what Fletcher Anderson “should” have done but what the given student “would” have done given the circumstances. Anderson certainly had a responsibility to investigate and resolve the matter by either confirming F&C’s inventory problem or discrediting that alleged problem. Surprisingly to me, some students when responding to this question adopt an avoidance strategy by suggesting that they would have resigned their position with the firm. I hope that classroom discussion of this question eventually convinces those students that simply “walking away” from this type of situation does not terminate the given individual’s responsibility for, or association with, the problem. Recall that Craig Schuster resigned as F&C’s CFO but was still sanctioned by 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.

236 Case 4.3 Suzette Washington, Accounting Major

CASE 4.3

SUZETTE WASHINGTON, ACCOUNTING MAJOR

Synopsis Here is a case that many of your students may be able to relate to personally. Two close friends work together in a clothing store to help defray the cost of their college educations. Paula is a marketing major and is employed as a salesclerk, while Suzette is an accounting major and works as an inventory clerk for the store. Near the end of their senior year, Paula hears rumors about a theft ring operating within the store. Over lunch one day, she tells Suzette of the rumor. The two friends have very differing opinions on how they should proceed. Paula's view is that she doesn't want to become involved by informing store management of the rumor, while Suzette believes that they should inform management. Paula attempts to convince her friend not to bring the matter to management's attention, at least not before they graduate. She maintains that store management expects to suffer employee theft losses and compensates by "jacking up" merchandise prices. One week following the two friends' conversation, an anonymous message received by store management prompts an investigation that ultimately results in criminal charges being filed against two employees of the store. In responding to the case questions, students must address ethics and internal control issues raised by this brief case.

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237 Case 4.3 Suzette Washington, Accounting Major Suzette Washington, Accounting Major--Key Facts 1. After telling Suzette about the rumored theft ring operating in the retail store where they worked, Paula insisted that Suzette not repeat any of the information since it was only a rumor.

2. Paula did not want to become involved in the matter because of the potential personal repercussions she might face.

3. Paula maintained that store management expected to lose merchandise to employee theft and compensated by increasing the mark-up on merchandise.

4. Suzette believed that the rumored information should be passed on to management personnel.

5. After learning of the rumor, Bertolini’s management immediately acted on it by retaining a detective.

6. The two young men involved in the theft ring were criminally prosecuted.

7. Weaknesses in Bertolini’s internal controls apparently allowed the two individuals to easily steal merchandise from the store.

Instructional Objectives 1. To illustrate an ethical dilemma that college students may face during their college careers.

2. To require students to analyze an ethical dilemma and to determine how they would have responded to it.

3. To discuss control activities intended to prevent employee theft in a retail business.

Suggestions for Use In this case, students are exposed to an ethical dilemma involving someone in their current role— “college student.” In discussing this case, I like to focus students' attention on the fact that they will be entering a profession that places considerable emphasis on ethics. Since they will be held to a high standard of ethical conduct during their careers, it is my contention that they should be aware of, and begin preparing themselves to cope with, the important ethical issues that they may face. This case can be discussed at practically any point during an auditing course. However, the case is best suited to be integrated with coverage of the AICPA Code of Professional Conduct or during class discussion of internal controls, particularly internal controls relevant to inventory.

Suggested Solutions to Case Questions 1. Occasionally, debate on this question can become quite intense. If you recognize this up front, © 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.

238 Case 4.3 Suzette Washington, Accounting Major you will be better prepared to manage students' interaction. It has been my experience that accounting majors typically agree with Suzette's apparent decision to pass the rumored information on to store management. Nevertheless, some students will forcefully maintain that Suzette should not have become involved in this matter. These latter students typically point out that management already suspected that merchandise was being stolen by employees and thus should have been taking steps to deal with this problem.

2. Again, here students are faced with an open-ended question involving ethics. Some students believe that Suzette had a responsibility to report the matter to store management, while others express the opposing view. The fact that Suzette was not certain that the rumor was true is typically an important point of contention in students' debate over this matter. Many students use an "innocent until proven guilty" argument to support their view that Suzette should not have become involved in the matter and instead have allowed management to deal with the problem.

At some point during the discussion of Question 2, I attempt to turn students' attention to a comparable setting in an auditing environment. "Assume that you are a staff accountant (auditor) in the near future for a public accounting firm. You hear rumors that a colleague has been signing off on audit procedures that he or she did not perform. What would you do at that point?" This is a productive strategy to use for this case since it focuses students' attention back on the professional auditor's role and helps them realize that ethical dilemmas in their personal or “pre-professional” lives often have analogues in their professional work roles.

3. I have a personal view on this matter, like most instructors. However, I make every effort not to voice that view to my students. I believe that it is important for students to "hash out" these types of questions in class. When evaluating students' responses to questions such as this that are included on quizzes or exams, I analyze the quality of the students' reasoning rather than whether they arrived at the "correct" answer—or what I may believe to be the correct answer.

Generally, the class consensus is that accounting majors do not have a responsibility to behave more ethically than other business majors. The most common view expressed by students is that everyone, regardless of their vocation or planned vocation, has a responsibility to behave ethically.

In addressing this question, I eventually attempt to focus students’ attention on the fact that auditors are often faced with ethical issues or dilemmas that have implications for a wide range of parties including potential investors, creditors, corporate stockholders, etc. As a result, although auditors may have no more responsibility to behave ethically than other professionals (or nonprofessionals, for that matter), auditors should recognize that they do have an obligation to carefully evaluate ethical issues they face since the resolution of those issues often affects a wide range of parties.

4. Following are examples of control activities that might have prevented or detected the theft losses experienced by Bertolini's: a. b.

The use of anti-theft tags on merchandise. Granted, store employees would likely have known how to deactivate these mechanisms.

Hidden surveillance cameras are an effective means to deter customer theft.

However, if employees understand the operations of these cameras, they may be able

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239 Case 4.3 Suzette Washington, Accounting Major

c.

d.

to steal merchandise when the cameras are not "watching."

Store management could have taken more frequent counts of inventory in the departments being affected by the theft losses. This procedure might have discouraged the employees from stealing since it would have "clued them in" that management was aware of the problem and taking measures to monitor it.

Store management could have developed a comprehensive strategy for dealing with this problem. For example, a meeting of departmental managers may have been needed to focus their attention on the problem and to require them to take special precautions to observe and document any unusual or suspicious behavior on the part of employees. In this same vein, it may have been appropriate to meet with the employees, either en masse or on a one-on-one basis, to apprise them of the problem or suspected problem. Again, this would have alerted the culprits to the risk they faced of being caught and thus may have prompted them to stop stealing merchandise.

© 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 4.4 Freescale Semiconductor, Inc. 240

CASE 4.4

FREESCALE SEMICONDUCTOR, INC.

Synopsis Partners and employees of major accounting firms often have access to confidential client information that they could use to gain an unfair advantage over other stock market investors.

Although the accounting profession’s ethical code prohibits such conduct, in recent years several insider trading cases have been filed against public accountants by law enforcement authorities. This case focuses on an insider trading scandal involving James Gansman, a former E&Y partner.

Gansman was assigned to E&Y’s Transaction Advisory Services department that provides a wide range of consulting services related to mergers and acquisitions (M&A). Gansman provided confidential information concerning a pending buyout of Freescale Semiconductor to a close friend who then used that information to earn windfall profits in the stock market. Gansman also passed on confidential information regarding at least six other M&A deals to his friend. After Gansman’s friend pleaded guilty to fraud charges filed against her by federal law enforcement authorities she testified against him in court. Gansman was eventually convicted on six counts of engaging in securities fraud and was sentenced to serve a prison term of one year and one day.

The epilogue to this case briefly summarizes other insider trading incidents involving employees or partners of major accounting firms, including a case involving the former vice chairman of Deloitte.

This individual bought and sold securities of numerous Deloitte audit clients while he served as the “advisory” partner to those clients’ audit engagement teams.

© 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 4.4 Freescale Semiconductor, Inc. 241 Freescale Semiconductor, Inc.--Key Facts 1.

During the 1990s, the Big Four accounting firms became heavily involved in the investment banking industry, although they typically consulted on only modestly-sized investment banking transactions.

2.

In 2006, E&Y was retained as a consultant on a huge M&A transaction involving The Blackstone Group’s planned takeover of Freescale Semiconductor.

3.

James Gansman, an E&Y partner in the firm’s Transaction Advisory Services (TAS) department, was assigned to that engagement.

4.

Despite being told that the engagement was “super confidential,” Gansman passed “inside information about the pending transaction” to a close friend who worked in the investment banking industry.

5.

Gansman’s friend used the confidential information to earn windfall profits in the stock market; she passed that information on to three other individuals who also used it to earn significant stock market profits.

6.

Gansman was subsequently convicted of six counts of securities fraud for passing the confidential information to his friend; that friend was the principal witness who testified against him during his criminal trial.

7.

A federal judge sentenced Gansman to a prison term of one year and one day.

8.

Several other recent insider trading cases have involved partners or employees of Big Four accounting firms including a highly publicized case involving the former vice chairman of Deloitte.

Instructional Objectives

1.

To discuss the purpose and importance of the profession’s client confidentiality rule.

2.

To examine auditors’ responsibilities when they become aware that colleagues are violating ethical principles or rules of the accounting profession.

3.

To compare and contrast CPAs’ professional responsibilities on consulting and audit engagements.

Suggestions for Use

This case documents several insider trading scandals that have involved the accounting profession in recent years. In fact, some of the more scandalous facts of the Gansman scandal are not included © 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 4.4 Freescale Semiconductor, Inc. 242 in this case. Published reports go into quite some detail regarding the romantic relationship between Mr. Gansman and his “close friend” who he established a relationship with initially over the Internet.

My students often research assigned cases to learn more about them. If your students do the same, you might be prepared to address the more “offbeat” facets of this case—or be prepared to tell your students that those facets of the case are simply not relevant to the issues that you want to address.

Suggested Solutions to Case Questions 1. Here is the actual text of the “Confidential Client Information Rule” that is included in the AICPA Code of Professional Conduct at ET 1.700.001.01. “A member in public practice shall not disclose any confidential client information without the specific consent of the client.” The following paragraph goes on to identify the following four exceptions to this rule: The rule shall not be construed (1) to relieve a member of his or her professional obligations of the “Compliance With Standards Rule” [1.300.001] or the “Accounting Principles Rule” [1.320.001], (2) to affect in any way the member’s obligation to comply with a validly issued and enforceable subpoena or summons, or to prohibit a member’s compliance with applicable laws and government regulations, (3) to prohibit review of a member’s professional practice under AICPA or state CPA society or Board of Accountancy authorization, or (4) to preclude a member from initiating a complaint with, or responding to any inquiry made by, the professional ethics division or trial board of the Institute or a duly constituted investigative or disciplinary body of a state CPA society or Board of Accountancy. [ET 1.700.001.02] 2. I have found that students are often surprisingly (and refreshingly) honest when addressing hypothetical scenarios such as those included in this question. In Scenario 1, the key question is does the auditor have a responsibility to remind the consultant of his or her professional responsibility to not provide confidential client information to a third party? Some students typically argue that since the auditor has an obligation to maintain the confidentiality of such information, the consultant has technically not breached the client confidentiality rule. However, one could easily argue that the “Responsibilities” principle of the Code of Professional Conduct mandates that the auditor inform the consultant that he or she shouldn’t be passing along such information to third parties even colleagues working in other divisions of his or her firm: “Members also have a continuing responsibility to cooperate with each other to improve the art of accounting, maintain the public’s confidence, and carry out the profession’s special responsibilities for self-governance.” [ET 0.300.020.02] Notice the key term in this latter statement is “self-governance.” All professions must rely heavily on their individual members to enforce their specific ethical responsibilities.

In the second scenario, the auditor has a more burdensome responsibility. (Recall that in one of the insider trading incidents briefly referred to in the case epilogue a PwC partner was the individual who reported the PwC employee engaged in insider trading.) The auditor in this second scenario certainly has a responsibility to discourage his or her friend from following through on the plan to use the confidential information to make a “quick buck” in the stock market. What if the friend point blank refuses to follow that advice? Does the auditor have a responsibility to report the friend? My answer is “Yes” for the reasons outlined in the prior paragraph. Obviously, this latter situation places © 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 4.4 Freescale Semiconductor, Inc. 243 the auditor in one of those unhappy Catch 22 situations in which there is not going to be a pleasant outcome to the dilemma he or she faces.

3. The key difference between an auditor’s and a consultant’s “professional responsibilities” involves the “General Standards” that must be complied with on auditing versus consulting engagements. ET 1.300.001.01, “General Standards Rule,” identifies four general responsibilities that CPAs must comply with on professional engagements. First, a CPA must provide only those services that he or she has the “professional competence” to provide. Second, a CPA must exercise “due professional care” on all professional engagements. Third, on each professional engagement a CPA must ensure that the “planning and supervision” are adequate. Finally, a CPA must obtain “sufficient relevant data” to provide a reasonable basis for the conclusions reached or recommendations made on all professional engagements.

The AICPA’s consulting standards identify three additional “general standards” that a CPA must comply with on consulting engagements: Client interest: Serve the client interest by seeking to accomplish the objectives established by the understanding with the client while maintaining integrity and objectivity.

Understanding with the client: Establish with the client a written or oral understanding about the responsibilities of the parties and the nature, scope, and limitations of services to be performed, and modify the understanding if circumstances require a significant change during the engagement.

Communication with client: Inform the client of (a) conflicts of interests that may occur pursuant to the “Integrity and Objectivity Rule” of the code (ET 1.100.001 and 2.100.001), (b) significant reservations concerning the scope or benefits of the engagement, and (c) significant engagement findings or events. [CS 100.07] Note: You might refer your students to 1.140.010, “Client Advocacy,” of the AICPA Code of Professional Conduct. That section discusses CPAs’ responsibilities to maintain their integrity and objectivity when providing consulting services that do not require them to be independent of their clients. Following is a particularly impactful warning included in that section of the code.

“Some professional services involving client advocacy may stretch the bounds of performance standards, go beyond sound and reasonable professional practice, or compromise credibility, thereby creating threats to the member’s compliance with the rules and damaging the reputation of the member and the member’s firm. If such circumstances exist, the member and member’s firm should determine whether it is appropriate to perform the professional service.” [ET 1.140.010.03]

© 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 4.5 Wiley Jackson, Accounting Major 245

CASE 4.5

WILEY JACKSON, ACCOUNTING MAJOR

Synopsis Similar to many recent accounting graduates, Wiley Jackson served an internship with a major accounting firm while he was completing his undergraduate accounting degree. On the final day of his internship, Wiley was offered a full-time position with the firm, an offer contingent on him completing his master’s degree. Wiley enthusiastically accepted the job offer.

A few months later, Wiley received a packet of documents from his future employer that he was supposed to complete and return. One of those documents was an “Arrests and Convictions” form.

Wiley faced an ethical dilemma in deciding how to complete this form. Shortly after finishing his internship, he had received a minor-in-possession citation when a graduation party that he attended was “busted” by the police. (At the time, Wiley was three days short of his 21st birthday.) The dilemma Wiley faces in this case is whether to disclose the pending criminal citation on the Arrests and Convictions form and risk having his future employer rescind his job offer.

© 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 4.5 Wiley Jackson, Accounting Major 246 Wiley Jackson, Accounting Major--Key Facts 1.

Wiley Jackson served an internship on the audit staff of a major accounting firm while completing his undergraduate accounting degree.

2.

On the final day of the internship, Wiley was offered a full-time position with the firm that was contingent on him completing his master’s degree in accounting, an offer that he accepted.

3.

Shortly after finishing the internship, Wiley received a “minor-in-possession” citation when the local police busted a graduation party he was attending—at the time, Wiley was three days short of his 21st birthday.

4.

Before the pending criminal citation was resolved, Wiley received a set of documents from his future employer that he was to complete and return.

5.

These documents included an “Arrests and Convictions” form that required him to disclose pending criminal citations, such as the minor-in-possession citation.

6.

An attorney told Wiley not to worry about the citation since he (the attorney) could almost certainly convince a local judge to approve “deferred adjudication” for that citation, meaning that it would be expunged from Wiley’s record if he stayed out of trouble for the next two years.

Wiley must decide whether to disclose the minor-in-possession citation on the Arrests and Convictions form and risk not only embarrassment but also the possible forfeiture of his future job.

7.

Instructional Objectives 1.

To examine an ethical dilemma that accounting majors may face, namely, deciding whether or not to report unfavorable biographical information in job application and/or post-employment documents.

2.

To examine the responsibilities of accountants when they observe irresponsible and/or unprofessional behavior on the part of colleagues (or future colleagues).

Suggestions for Use

I often cover multiple smaller cases such as this one simultaneously. This can be a particularly effective strategy for highlighting an ethical issue or dilemma that is common to the assigned cases.

You might consider discussing this case simultaneously with the Leigh Ann Walker case. The question of whether and/or when it is proper to “tattle” on a colleague is common to the two cases, although the context in which that issue arises is very different between the cases.

You might also use this case to prompt a general discussion of “disclosure” issues for accounting majors who are involved in the job search process. In recent years, there have been a number of situations in which individuals have padded their vitas to enhance their chances of landing a “plum” © 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 4.5 Wiley Jackson, Accounting Major 247 position only to subsequently have that “padding” revealed by inquisitive journalists. No doubt, some of your students have been tempted to inflate their reported job skills and/or job experiences in their employment vitas. [Note: The Zane Corbin case, Case 4.7, focuses on a situation in which a college accounting major submitted an embellished vita to an awards committee—and then wound up winning the given award!] A related issue that you might want to raise is what right do future employers have to “pry” into the backgrounds of prospective employees. For example, consider asking students whether it is appropriate for future employers to access and review the Facebook profiles of job applicants.

Suggested Solutions to Case Questions 1.

Listed next are examples of decision alternatives available to Wiley.  Report the incident on the Arrests and Convictions form.  Contact the OMP (office managing partner) and fully explain the minor-in-possession incident to him and ask for his advice in completing the form.  Ask Sally Jones for advice on how to complete the form and/or whether he should discuss the matter with the OMP.  Fail to report the minor-in-possession citation and hope that the future employer never discovers it.  Claim that the question is an invasion of privacy and refuse to answer it—of course, choosing this alternative would almost certainly trigger other “issues” for Wiley.

2. In “Suggestions for Use,” I recommended covering this case simultaneously with the Leigh Ann Walker case. Given the additional assumption posed by this question, this case closely parallels the Leigh Ann Walker case in that both deal with dishonesty on the part of an employee (or future employee), dishonesty that is subsequently discovered by the employer. If you have discussed the Leigh Ann Walker case already or if you are covering that case and this case simultaneously, you might begin discussion of this question by asking your students to compare and contrast the severity of the misconduct in each case. Once some degree of consensus has been reached on which individual’s misconduct was more egregious, the students will be better equipped to determine how to mete out justice in each case.

Listed next are examples of issues or factors that the OMP might consider in determining how, or if, to discipline Wiley:    

Wiley’s previously “clean” police record.

The need to impress upon Wiley that integrity is a critically important attribute for a professional auditor to possess.

A perceived need to “set an example” by disciplining Wiley. The point here is that other individuals in the practice office may learn of the incident. If Wiley is not punished in some way, this may set a poor precedent for those individuals.

The OMP’s perception of whether or not Wiley has “learned his lesson.” After discussing the matter with Wiley, the OMP will likely be in a better position to gauge

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Case 4.5 Wiley Jackson, Accounting Major 248



whether Wiley feels remorse regarding the incident, whether he is simply upset “over getting caught,” etc. This additional insight would likely be a key factor for the OMP to consider in resolving the matter.

The OMP might consider asking Sally Jones to comment on Wiley’s behavior at the graduation party—assuming that the OMP knows that Sally was at the party.

3. Here is another discussion question for which the proper response depends on the eye/heart/mind of the answerer. A key issue in this context is whether or not Sally knew if Wiley reported the incident on the Arrests and Convictions form. If we assume that Sally knew Wiley did not report the incident, then she certainly had some justification for doing so herself. As a sidebar, a majority of my students typically suggest that reporting the incident to the OMP would be extremely petty on Sally’s part under any circumstances since Wiley was effectively a victim of bad luck, that is, having the beer shoved into his hand shortly before the police arrived at the party.

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Case 4.6 Arvel Smart, Accounting Major 249

CASE 4.6

ARVEL SMART, ACCOUNTING MAJOR

Synopsis This brief case involves an ethical issue that many future accounting graduates have faced in recent years. Internship programs are an important facet of the recruiting efforts of large accounting firms. Those firms typically offer internships to students they hope to hire on a permanent basis when they graduate. Accounting majors enrolled in five-year accounting programs may have an opportunity to take two internships before they graduate.

In this case, Arvel Smart served an internship with a Big Four accounting firm during the summer between his third and fourth years in a five-year accounting program. By the end of his fourth year of college, Arvel had decided to accept the job offer that firm had given him at the conclusion of his internship. But Arvel delayed accepting the job offer so that he could take a second internship with another firm during the summer between his fourth and fifth years in college. The key issue in this case is whether Arvel acted unethically by accepting the second internship when he intended to accept the offer for a permanent position that he had received as a result of his first internship.

Arvel Smart, Accounting Major--Key Facts © 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 4.6 Arvel Smart, Accounting Major 250 1.

Arvel Smart’s parents were CPAs who had their own accounting firm in a small town in southeastern Missouri.

2.

Like his parents, Arvel attended the University of Missouri at Columbia and majored in accounting.

3.

During the summer between his third and fourth years in Missouri’s five-year accounting program, Arvel served an auditing internship with a Big Four practice office in Kansas City.

4.

At the conclusion of that internship, Arvel was offered a permanent position with the Big Four firm; the job offer would be open until the end of the following summer.

5.

Because he wanted to spend the summer between his fourth and fifth years in college with his girl friend who had accepted an internship with a Big Four practice office in St. Louis, Arvel interviewed for an internship that summer with two regional accounting firms based in St. Louis.

6.

Before accepting an internship offer from one of the two St. Louis firms, Arvel decided that he would accept the Big Four job offer at the conclusion of the second internship.

7.

Arvel experienced some degree of guilt when he accepted the internship with the St. Louis firm because he realized there was only a remote chance that he would consider accepting a full-time position with that firm.

8.

Arvel cleared his guilty conscience by rationalizing that it was the responsibility of the St. Louis firm to demonstrate that it offered more opportunities for him than the Big Four firm from which he had an outstanding job offer.

Instructional Objectives

1.

To expose students to an ethical dilemma that many accounting majors face during their college careers.

2.

To provide students with an opportunity to discuss their job search activities.

Suggestions for Use

For the past several years, the job market within the accounting profession has been a sellers’ market. Many large accounting firms have desperately tried to hire new accounting graduates to “staff up.” The ethical dilemma raised by this case is one that many of my students have faced in recent years. Some students may find this case “strikes too close to home” and, as a result, may be reluctant to share their personal views on the central issue in the case. To overcome this problem, consider preparing a brief anonymous survey form that your students can use to respond to the 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.

Case 4.6 Arvel Smart, Accounting Major 251 case questions. After you have collected the forms, collate the students’ responses and post them on the board or overhead to initiate discussion of the case.

When discussing this case, you might consider adding additional hypothetical facts or circumstances to those included in the case. For example, some of my students in the past have asked whether Arvel disclosed his first internship in the vita that he used while interviewing for the second internship—I don’t know the answer to that question. You might also consider telling students to assume that Arvel was aware that one or more other students had not received offers for a second internship after it had become known that they were intending to accept an outstanding offer for a permanent position made by the firm with which they had served their first internship.

Quite often, I have students in my class who have not yet been involved in the recruiting process.

This case provides an opportunity for students to discuss that process, to share “war stories,” and to provide helpful hints to each other.

Suggested Solutions to Case Questions 1.

No doubt, your students, like my students, will have differing opinions regarding this issue.

Several of my students indicated that unless Arvel was specifically asked whether he had such an offer, he did not have a responsibility to provide that information to the two St. Louis accounting firms. A follow-up question you might pose to your students is whether recruiters for the two St. Louis accounting firms had the right to ask Arvel—or any other interviewees, for that matter— whether they had outstanding job offers as a result of previous internships they had served.

2.

The majority of my students generally express the viewpoint that Arvel did not behave unethically by accepting the second internship when he ultimately intended to accept the job offer that was a result of his first internship. Several students typically adopt Arvel’s mindset by maintaining that it was the St. Louis firm’s responsibility to demonstrate to him that it offered more opportunities than the Big Four firm from which he had an outstanding job offer.

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252

Case 4.7 Zane Corbin, Accounting Major

CASE 4.7

ZANE CORBIN, ACCOUNTING MAJOR

Synopsis In recent years, there have been numerous high-profile cases of “resume padding” that have come to light in the business world, coaching profession, political arena, and other domains. This case examines a resume-padding case involving Zane Corbin, an accounting major. Near the end of the annual spring awards luncheon for the Hopkins College of Business, Zane Corbin is announced as the winner of the prestigious Upchurch Medal, which is awarded annually to the college’s outstanding senior. As Zane is approaching the dais to receive his award and the accompanying check of $1,000, the dean mentions the student organizations to which he belongs. Those organizations were listed on the vita that Zane had submitted to the Undergraduate Awards Committee charged with selecting the winner of the Upchurch Medal—“involvement in student organizations” was one of the key criteria applied by the committee to select the winner. One of the organizations mentioned by the dean is Beta Alpha Psi, the college’s honors organization for accounting majors. However, Professor Ann Herrick, the faculty advisor for the college’s Beta Alpha Psi chapter is sitting in the audience and she is well aware that Zane was never a member of that chapter.

Shortly after the awards luncheon, Herrick tracks down Professor John Goggans who chairs the Undergraduate Awards Committee. The somewhat overbearing Herrick insists that the matter should be referred to Associate Dean Marilyn McGrew who chairs the college’s Academic Misconduct Council. After some testy exchanges between Goggans and Herrick, Goggans agrees. Later that same day, Goggans and Herrick meet with Dean McGrew. As a result of that meeting, McGrew decides to file a charge of academic misconduct against Zane. Because the semester is rapidly coming to an end, McGrew arranges a meeting involving herself, Zane, Goggans, and Herrick. She is hoping that Zane will admit his guilt and allow her to expedite the resolution of the messy situation. But Zane refuses to admit any wrongdoing and instead maintains that he is only guilty of an “honest mistake” in reporting on his vita that he was a member of Beta Alpha Psi. During the subsequent hearing before a panel of two faculty members and three students, Zane is acquitted of the charge of academic misconduct when that panel cannot reach a majority decision— the panel is deadlocked repeatedly with two votes in favor of finding Zane guilty, two votes in favor of acquitting him, and one abstention. Following the outcome of the hearing, Dean McGrew decides that, despite the erroneous vita Zane submitted to the awards committee, the Upchurch Medal he won © 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 4.7 Zane Corbin, Accounting Major 253

will not be rescinded.

Zane Corbin, Accounting Major--Key Facts 1. The Upchurch Medal, and an accompanying prize of $1,000, is awarded each year to the outstanding senior in the Hopkins College of Business.

2. At the annual spring awards luncheon, Zane Corbin, an accounting major, is announced as the winner of the Upchurch Medal.

3. As Zane is approaching the dais to receive his award, the dean lists the student organizations to which Zane belongs—“involvement in student organizations” is one of the criteria applied by the Undergraduate Awards Committee in selecting the winner of the Upchurch Medal.

4. One of the student organizations mentioned by the dean—which were included on the vita Zane submitted to the awards committee—is Beta Alpha Psi, the college’s honors organization for accounting majors.

5. After the luncheon, Professor Ann Herrick, the faculty advisor for the college’s Beta Alpha Psi chapter, informs Professor John Goggans, who chaired the awards committee, that Zane has never been a member of Beta Alpha Psi. 6. After some testy exchanges between Goggans and Herrick, Goggans agrees to report the matter to Associate Dean Marilyn McGrew who chairs the college’s Academic Misconduct Council.

7. Dean McGrew decides to file a charge of academic misconduct against Zane; in an ad hoc meeting arranged by McGrew, Zane insists that he made an honest mistake in listing membership in Beta Alpha Psi on his vita.

8. Because Zane refuses to admit guilt, McGrew arranges to have a five-person panel of two faculty members and three students drawn from the college’s Academic Misconduct Council to preside over a hearing to decide the allegation of academic misconduct filed against him.

9. The hearing panel becomes hopelessly deadlocked in a series of 2-2-1 votes taken to determine Zane’s guilt or innocence.

10. As a result of the outcome of the hearing panel, Dean McGrew dismisses the charge of academic misconduct filed against Zane and allows him to retain the prestigious Upchurch Medal.

Instructional Objectives 1. To document the serious consequences that academic misconduct may have for accounting majors and other college students. © 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 4.7 Zane Corbin, Accounting Major

2. To demonstrate the importance of ensuring that one’s vita properly reports his or her credentials.

3. To analyze the factors and circumstances that should be considered when resolving allegations of dishonest or otherwise unethical conduct.

4. To acquaint or reacquaint students with the process used to resolve allegations of academic misconduct at their institution.

Suggestions for Use This case highlights a decision context that practically every accounting major will face prior to graduation, namely, developing a vita to be used for searching for employment and for other purposes. Consider initiating the discussion of this case by mentioning or highlighting some of the recent high profile cases of “resume padding” and the resulting consequences for the guilty parties. In 2014, General James Amos, the commandant of the United States Marine Corps, was heavily criticized when it was revealed that he had misrepresented a key element of his military training on his vita. Amos retired shortly after the resume controversy erupted. In 2012, Yahoo! CEO Scott Thompson was forced to leave the company after it was determined that he had embellished his vita— Thompson’s bio and multiple SEC registration statements filed by Yahoo! indicated that he had earned a computer science degree, which was not the case. In 2001, George O’Leary, who had just been named the head football coach at Notre Dame, was forced to resign when it was determined that he had not earned a master’s degree that was listed on his vita.

I like to begin coverage of this case by focusing on the initial case question. Consider passing out ballots for your students to indicate (privately) whether they would have voted to “convict” or “acquit” Zane Corbin of the academic misconduct charge. Collect those ballots and then ask for volunteers to indicate how they voted and why. Typically, a freewheeling debate will be initiated as students defend their own position and attempt to undermine the opposing position taken by other students. When the debate begins abating, pass out another identical ballot and ask students to vote again. Tally and report the results of the two votes. My experience has been that the breakdown of the votes between the two positions typically changes—in at least one case, it changed dramatically.

Consider asking students who changed their vote to explain why they did so—which often re-ignites the debate between the two opposing camps.

Suggested Solutions to Case Questions 1. See the “Suggestions for Use” for one approach to launching the discussion of this case that is centered on this question.

2. Zane: I believe a key question for Zane would be to follow up on the question posed to him by Professor Goggans, namely, whether Zane believed that he “somehow” had been accidentally added to the membership roll of Beta Alpha Psi. As noted in the case, he answered “No” to that question, but that seems to be a disingenuous answer. If he is even faintly familiar with the membership © 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 4.7 Zane Corbin, Accounting Major 255

requirements of Beta Alpha Psi—which he should be given the information provided by Professor Herrick, he should be aware that he never fulfilled the membership requirements of the organization.

If he, in fact, believes that he had actually joined Beta Alpha Psi, then he should be able and willing to explain exactly how be accomplished that. Along the same lines, Zane almost certainly knows and interacts with Beta Alpha Psi members in his classes. One would think that as a result of that interaction over an extended period of time he would have come to realize that he was not an official member of Beta Alpha Psi. For example, surely at some point there was some mention or discussion of the mandatory meetings that pledges had to attend. Likewise, it is not unreasonable to think that one or more of his Beta Alpha Psi friends or acquaintances asked him directly why he wasn’t attending those mandatory meetings, why he wasn’t present at the meeting where they were initiated into the organization, or, conversely, why he had apparently chosen not to join the organization.

[Note: In preparing for the hearing, individual panel members could have obtained a list of Beta Alpha Psi members who were in classes with Zane or were members with him in other organizations.

That information would have been useful in pursuing the line of questioning mentioned here.]

Professor Herrick: Panel members would likely ask Professor Herrick to explain in detail the process that accounting majors went through to become members of Beta Alpha Psi. In addition, they would likely ask her to comment on how likely it was that Zane Corbin could have made the mistake of thinking that he had somehow become a member of Beta Alpha Psi—and if she had encountered similar incidents in the past. They would also likely ask her the same question that had been posed to her by Professor Goggans, namely, whether she had any prior interaction with Zane. [Note: As pointed out in the case, Herrick indicated that although Zane “looked familiar” when she saw him at the awards luncheon, she had not interacted with him in the past. The fact that Herrick did not know Zane was not unusual given the size of the accounting faculty at her university and the number of accounting majors.]

Professor Goggans: As noted in the case, the role of the hearing panel did not include rendering a decision on whether Zane Corbin should forfeit the Upchurch Medal. Nevertheless, the panel members would want to understand the circumstances under which a vita was requested from the nominees for that award. For example, when contacted, were those individuals specifically told why the vita was being requested? Likewise, were the nominees given any explicit instructions on what should be included in the vita? No doubt, the members of the hearing panel would also quiz Professor Goggans on how important the nominees’ vitas (“vitae”) were to their deliberations, and, even more specifically, how impactful the organizational membership information reported on those vitas was to those deliberations.

3. Despite the outcome of the hearing, all parties involved, including Zane himself, realized that the vita he had submitted to the awards committee contained an error, namely, his reported membership in Beta Alpha Psi. Almost certainly, Zane benefited from that error to some degree, even if it was to only a nominal degree. Given the fact that the awards committee had difficulty choosing between Zane and Alisha Buchanan, many students express the view that Alisha was “robbed” and that, at a minimum, the College of Business, ex post, should have named her as a “co-winner” of the Upchurch Medal. Other students suggest that, given the circumstances, Zane should have offered to forfeit 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.

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Case 4.7 Zane Corbin, Accounting Major

award and the accompanying monetary prize, while still other students bluntly insist that the College of Business should have rescinded the award and monetary prize and named Alisha as the Upchurch Medal winner.

Typically, students raise another question in addressing this case question, namely, why didn’t the College of Business rescind the award. I don’t have “the” answer to that question. Given the information available, it certainly seems that expediency and/or the need/desire to put this messy situation in the rear view mirror, so to speak, prompted Dean McGrew’s decision to allow Zane to retain the Upchurch Medal.

4. The general consensus of the parties involved in this case—including apparently the majority of the members of the hearing panel—was that Zane Corbin knew he was not a member of Beta Alpha Psi but, nevertheless, decided to list membership in that organization on his vita. For his part, Zane clung tenaciously to the largely indefensible position that he had staked out: he thought he was a member of Beta Alpha Psi and that was why he had listed that membership on his vita. If he was, in fact, guilty of blatantly lying on his vita, that decision appeared to be extremely inconsistent with his conduct otherwise. He was very hard-working, courteous, well-liked by his peers, and was an excellent member of the four student organizations he listed on his vita in addition to BAP. In fact, as pointed out in the case, he held leadership positions in two of those organizations.

The fact that Zane’s conduct appeared to be exemplary other than his one apparent (and egregious?) mistake in judgment placed the five members of the hearing panel in a very difficult situation. As noted in this question, one of the panel members reportedly argued that the sanctions Zane would face if he was found guilty far outweighed the seriousness of the “crime” he had committed. Forfeiting the Upchurch Medal would be a sanction equivalent to the infamous “scarlet letter” was the argument allegedly made by that member of the panel. (Again, the hearing panel had no authority to rescind the Upchurch Medal, but the presumption was that the award would be rescinded if Zane was found guilty by the panel.) Because this member believed that the punishment did not fit the crime, he/she refused to vote to convict Zane despite believing that he was likely guilty of the charge filed against him. So, was this rationale a sufficient justification for voting to acquit Zane? You will probably find that your students are sharply divided when it comes to that question.

Rather than share my personal view on this matter, I allow the students to reach their own conclusions. A key objective in this type of context, in my opinion, is for students to come away from a healthy and possibly highly charged debate respecting opposing points of view expressed by their colleagues, even if they profoundly disagree with those views.

5. This justification for finding Zane “not guilty” seems more defensible than the position described in the previous question. In this case, the panel member allegedly reported that he also believed Zane was guilty but that the college/university had a responsibility to prove his guilt “beyond a reasonable doubt.” (Apparently, the panel members were not given explicit instructions on what burden of proof had to be established to find Zane guilty.) The member argued that there was sufficient doubt regarding Zane’s culpability that the appropriate decision was acquittal—the member pointed out that a vote of “not guilty” was totally different from reaching the conclusion that Zane was actually innocent of the charge filed against him. © 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 4.7 Zane Corbin, Accounting Major 257 Note: I have no “grapevine” information to report regarding the panel member who abstained from voting.

6. Consider assigning the responsibility for this question to a group of students. Another strategy would be to invite a representative of the relevant organization within your university to your class to give a brief overview of the process used to adjudicate a charge of academic misconduct and to explain the severe consequences of being found guilty of such conduct. (I have an administrator from my university’s “Integrity Council” make such a presentation to undergraduate classes that I teach in a given semester because I have found that undergraduate students typically are, at most, only faintly familiar with this critically important topic.)

© 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 4.8 Dell Inc. 258

CASE 4.8

DELL INC.

Synopsis Dropping out of college is a decision that most people ultimately live to regret. Michael Dell is clearly one of the exceptions to that rule. Dell left the University of Texas after his freshman year so that he could concentrate his time and effort on a new business that he had organized. That business would ultimately become Dell Inc. By 2001, Dell Inc. was the largest PC maker in the world.

Michael Dell’s ownership interest in his company allowed him to accumulate a net worth of nearly $15 billion by 2012, a figure that landed him in 22nd place on the Forbes 400.

Dell Inc.’s financial success was largely a function of the “Dell Direct” strategy of selling customized PCs directly to individuals who submitted their purchase orders to a Dell sales rep over the phone or the Internet. Unlike other PC manufacturers, Dell invested very little in research and development activities and instead focused its efforts on emphasizing operating efficiencies throughout its supply chain.

By 2002, Dell’s business model was being undermined by the intense competition among PC makers. Between 2002 and 2007, Dell concealed its deteriorating operating results with more than $4 billion of “exclusivity payments” from Intel Corporation, the company that supplied the allimportant microprocessors for its PCs. Intel was more than willing to make those payments to Dell in exchange for its commitment not to purchase microprocessors from any other company. Instead of disclosing the nature and magnitude of the exclusivity payments in its periodic financial statements, Dell simply netted those payments against its operating expenses. The exclusivity payments allowed Dell to reach or surpass its consensus Wall Street earnings forecasts for 20 consecutive quarters.

An SEC investigation eventually uncovered the improper accounting and financial statement treatment applied to the exclusivity payments. In 2010, the SEC fined Dell Inc. $100 million for failing to account properly for those payments and for using “cookie jar reserves” to smooth its periodic earnings. Several Dell officers, including Michael Dell, were also fined by the SEC. For his role in the scam, Michael Dell was required to pay a $4 million fine.

In addition to exploring ethical issues relevant to the Dell accounting scandal, the case questions address multiple auditing issues raised by that scandal. PricewaterhouseCoopers, Dell’s longtime audit firm, was named as a defendant in a large class-action lawsuit filed by the company’s stockholders. That lawsuit was eventually thrown out of the courts by a federal judge who ruled that © 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 4.8 Dell Inc. 259 the allegations filed against PwC by the plaintiffs were too “vague.”

Dell Inc.—Key Facts 1. In 1984, 19-year-old Michael Dell dropped out of the University of Texas after his freshman year to focus his time and energy on a business that he had created, a business that would eventually become Dell Inc. 2. In 1992, Michael Dell became the youngest CEO of a Fortune 500 company; by 2001, Dell Inc. was the largest PC maker in the world.

3. By 2012, Michael Dell’s personal wealth was estimated at nearly $15 billion, placing him 22nd on the Forbes 400.

4. The critical feature of Dell Inc’s business model was its “Dell Direct” strategy of selling customdesigned PCs directly to consumers who placed their purchase orders over the phone or the Internet.

5. Dell Inc. invested only modest amounts in research and development and instead focused on delivering state-of-the-art computer technology developed by other companies at the lowest possible cost by emphasizing operating efficiencies throughout its supply chain.

6. By 2002, the increasingly competitive PC industry was undercutting Dell Inc.’s business model, which caused the company to face the unpleasant prospect of reporting disappointing earnings to its stockholders.

7. Intel Corporation, which supplied microprocessors for Dell’s computers, offered to make up Dell’s earnings shortfall with “exclusivity payments;” in exchange for these payments, Dell pledged to purchase all of the microprocessors it required from Intel.

8. From 2002 to 2007, Intel made $4.3 billion of exclusivity payments to Dell; those payments allowed Dell to reach or surpass its consensus earnings forecasts for 20 consecutive quarterly reporting periods.

9. Dell did not disclose the nature or magnitude of the exclusivity payments; for accounting and financial reporting purposes, Dell treated the exclusivity payments as reductions of its operating expenses.

10. An SEC investigation revealed the exclusivity payments made by Intel to Dell and the improper accounting treatment applied to them; the SEC investigation also determined that Dell had used “cookie jar reserves” to smooth its earnings from 2002 through 2005.

11. In 2010, the SEC fined Dell Inc. $100 million for its improper accounting and 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 4.8 Dell Inc. 260 Michael Dell was fined $4 million for his role in the accounting scam.

12. PricewaterhouseCoopers, Dell’s longtime audit firm, was named as a defendant in a class-action lawsuit filed by Dell’s stockholders that stemmed from the company’s accounting scandal; a federal judge threw out the lawsuit after ruling that the plaintiffs’ allegations were too “vague.”

Instructional Objectives 1. To identify auditors’ responsibilities to search for evidence of “earnings management” on the part of their clients.

2. To identify management assertions violated by improper accounting and financial reporting treatments applied by clients.

3. To examine auditors’ responsibilities to analyze and monitor a client’s business model and key developments in the client’s industry.

4. To examine ethical issues posed for audit firms by the economic relationship between them and their clients.

Suggestions for Use The major accounting “scam” in this case is an unusual one in that it did not impact Dell Inc.’s “bottom line.” The accounting treatment Dell applied to the exclusivity payments received from Intel impacted operating earnings and the key financial measures related to that item, such as the operating margin ratio, but it did not affect Dell’s reported net income for the given reporting periods. Given the nature of this scam, this case provides an excellent opportunity to address one of the most important “hot button” financial reporting issues, namely, earnings management. This is a controversial topic for several reasons including the difficulty of precisely defining what earnings management entails and which earnings management techniques are acceptable or ethical. Clearly, the method used by Dell management was improper since its purpose was to convince investors and other third parties that the company’s basic business model was resilient to the changing competitive conditions in the PC industry. On the other hand, one could certainly argue that curtailing discretionary expenditures (such as maintenance or advertising expenses) near the end of a reporting period for the purpose of reaching a predetermined earnings forecast is “okay.” Another controversial feature of earnings management is what role should auditors should play in limiting the window-dressing activities of clients, particularly those earnings management tactics that are “legal.”

Students should be made aware that earnings management is an important issue for the SEC. Generally, the SEC defines earnings management as a “material and intentional misrepresentation” of a given entity’s reported operating results. Given this definition, you might initiate discussion of this case by having your students or groups of your students develop an array of different earnings management scenarios and then debate which of these meet the SEC’s definition of earnings management. For example, if a company defers year-end advertising expenditures to increase its EPS © 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 4.8 Dell Inc. 261 from $1.24 to $1.28, does that qualify as a “material and intentional misrepresentation” of its reported operating results? Extending the previous scenario, if the given company is planning a secondary offering of common stock in the next few weeks and the company’s consensus earnings forecast was $1.25, do those two additional facts cause this situation to qualify as “earnings management”? Next, you could segue into a discussion of what auditors should do when they uncover instances of earnings management by their clients. This latter discussion will often revolve around the two key dimensions of earnings management according to the SEC, namely, the quantitative impact (materiality) of the given tactic and the underlying intent or motive of management in engaging in the given tactic.

Suggested Solutions to Case Questions 1. As noted in the Suggestions for Use, the SEC defines earnings management as a “material and intentional misrepresentation” of a given entity’s reported operating results. In some sense, that may be the “best” definition of “earnings management” given the SEC’s position of authority in the financial reporting domain, however, many parties define that phrase less restrictively. 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 restrictive than the SEC’s definition because it doesn’t include a reference to materiality. I would suggest that the latter definition of earnings management is the more widely accepted definition. Nevertheless, the phrase is not explicitly defined by professional accounting standards.

Regardless of which definition of earnings management one accepts, it is difficult to identify a set of circumstances under which it is “acceptable.” One exception might be in those circumstances in which a company defers discretionary expenditures near the end of a financial reporting period in order to reach a target earnings number. However, the deferral of many discretionary expenditures, such as maintenance costs on production line equipment, is not in the best interests of the given entity over the long term, meaning that company management may be violating their fiduciary responsibility to stockholders and other parties. Another possible exception is those circumstances in which 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. Again, although many parties may suggest this type of earnings management is “acceptable,” I believe the majority of professional accountants would disagree.

Do auditors’ responsibilities include actively searching for instances of earnings management on the part of clients? My answer would be “Definitely” if we apply the SEC’s definition of earnings management. That is, auditors clearly have a responsibility to search for intentional and material misrepresentations of a client’s accounting data. If we accept the less restrictive definition of earnings management, then it becomes more problematic to define auditors’ responsibility for the given misrepresentations since they are not necessarily material. An important consideration in the latter context is the fact that the cumulative impact of an earnings management philosophy on the part of a given client may be to distort its overall financial statements, although it may be difficult to pinpoint one specific item that is materially misstated. © 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 4.8 Dell Inc. 262 2. Under the auditing standards of the PCAOB, the “completeness” assertion for liabilities and operating expenses [see note below] and “presentation and disclosure” assertions relevant to the company’s accounting principles disclosures would be the key management assertions violated by Dell. [See AS 1105.11 of the PCAOB auditing standards.]

There are several audit procedures that might have resulted in the discovery of the improper accounting treatment applied to the exclusivity payments made by Intel to Dell. For example, many of the large exclusivity payments [see note below] occurred near the end of quarterly reporting periods. A standard or generic audit test is to scan large transactions occurring near the end of a reporting period because history suggests that such transactions have a disproportionately large likelihood of being fraudulent. Analytical tests of Dell’s financial data should have revealed that the company had an amazing record of just barely reaching or surpassing its quarterly consensus Wall Street earnings forecasts. One could certainly argue that such a discovery should probably prompt auditors to investigate a client’s earnings history in more depth to determine whether the client is somehow sculpting its earnings. Finally, a standard audit test for major accounts payable items is to reconcile the client’s year-end balance for those items to the year-end statements sent to the client by the given vendors. This reconciliation procedure should have resulted in the auditors discovering the large “spikes” in transaction activity between Dell and Intel near the end of financial reporting periods. [Again, refer to the note below.] One could argue that the discovery of those spikes should have prompted an investigation of them.

Note: Although the term “exclusivity payments” was used almost exclusively within the business press and in SEC releases in referring to the Intel-Dell transactions referred to in this case, in reality those “payments” were mostly “credits” extended by Intel to Dell. That is, in most cases, cash was not paid by Intel to Dell. Instead, Intel simply reduced the outstanding receivable balance at the time owed to it by Dell—in turn, Dell debited accounts payable and credited its operating expenses. I didn’t believe this technicality was important enough to point out in the case. However, an industrious student of yours may discover this fact and report it during your in-class discussion of the case.

3. Here’s an example of a case question that you may perceive to be too “easy.” Obviously, auditors have a responsibility to consider the overall integrity of a client’s business model and any major developments within the client’s industry that may impact the integrity of that business model. For example, in performing analytical tests, the professional auditing standards repeatedly suggest that auditors must continually revisit their “understanding” of the client and its external environment in interpreting the results of those tests. [Granted, I don’t believe I have ever discovered the explicit phrase “client business model” in any version of the professional auditing standards.] Likewise, the “fraud” standards require auditors to consciously and repeatedly consider the nature of a client’s business and its industry when identifying and evaluating fraud risk factors that may be relevant to a given engagement—review the fraud risk factors listed in the Appendix to AS 2401 of the PCAOB auditing standards I believe that it is important to occasionally remind students of the need for auditors to consciously consider a client’s business model and industry during the course of an audit engagement because history proves that auditors frequently don’t. Auditors apparently often get “lost” in the day© 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 4.8 Dell Inc. 263 to-day performance of audit tests without consciously thinking of what those audit tests may reveal about “big picture” issues, such as the integrity of the client’s business model and, ultimately, the integrity of the client’s overall financial statements. Bottom line, auditors have to avoid “tunnel vision” when they are performing their audit tests. Likewise, it is the responsibility of the audit engagement partner and the concurring partner to “step back” and make global assessments of what the results of a wide range of audit tests may “say” about the integrity of a client’s financial statements. Particularly relevant in making such assessments are the results of audit tests that reflect on the viability of the client’s business model and industry.

4. The key ethical issue raised by exclusivity payments is that they may be anticompetitive. For example, many parties argue that the exclusivity payments made by Intel to Dell diminished the degree of competition in the microprocessor market by limiting or denying companies like AMD access to the massive Dell account. Ultimately, exclusivity payments may create a monopoly that is harmful to the consumers of the given product or service. In this case, for example, the higher quality microprocessors allegedly being produced by AMD were not incorporated in Dell’s PCs because of the exclusivity payments made by Intel to Dell.

Recall that PwC had served as Dell’s auditor since 1986. In 2011, the PCAOB reported that the average tenure of large public companies and their auditors was 28 years, a fact that added to that agency’s interest in pursuing mandatory auditor rotation. The long tenure between Big 4 audit firms and their major public clients suggests that those are effectively “exclusive” relationships that prevent smaller audit firms from gaining access to those clients. Obviously, the Big 4 firms are not making “exclusivity payments” to retain their large public company clients, but one could argue that to maintain their relationships with those companies the Big 4 audit firms may make “implicit” exclusivity payments. For example, the Big 4 firms could lower the quality of their audit services to limit the likelihood of discovering material misrepresentations in those clients’ financial statements.

Or, the Big 4 firms could simply “look the other way” when they discover material errors in the financial statements of their large public clients. Granted, this is simply conjecture. But similar arguments have been made in other contexts. For example, banks, brokerages, and other businesses also take steps to “protect” their portfolio of clients, that is, to maintain an exclusive relationship with them and, in doing so, to limit the degree of competition that they face.

Students should recognize that exclusive relationships are not all bad. Exclusivity agreements tend to lead to stable business relationships that allow both parties to predict and control their operating costs. But, as already suggested, they may also stymie the development of new and superior products and services that would ultimately be beneficial to the consumers in the given market.

© 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.

264

Case 5.1 Cardillo Travel Systems, Inc.

CASE 5.1

CARDILLO TRAVEL SYSTEMS, INC.

Synopsis Auditors and accountants are frequently forced to resolve ethical dilemmas in their professional roles. There is often a significant price to be paid by the accountant or auditor who chooses the ethically "correct" resolution to such a dilemma. For instance, an auditor may lose a lucrative engagement as a result of complying with the profession's ethical principles. Of course, if an ethical dilemma is resolved improperly, the consequences can also be very serious for the individual and his or her employer. In this case, a controller and two audit partners were faced with ethical dilemmas.

An overbearing and somewhat desperate CEO needed to increase the stockholders' equity of his company, Cardillo Travel Systems, Inc., to satisfy a court order issued in a civil lawsuit filed against the company. To accomplish this objective, the CEO attempted to convince the company's controller and the two audit partners to accept an illicit journal entry that significantly increased the stockholders' equity of Cardillo. To their credit, the controller and both of the audit partners resisted the CEO's efforts to influence their professional judgment.

© 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 5.1 Cardillo Travel Systems, Inc. 265 Cardillo Travel Systems, Inc.--Key Facts 1. During the early 1980s, Cardillo incurred significant operating losses even though it was experiencing rapid growth in revenues as a result of Rognlien's aggressive franchising strategy.

2. The court order outstanding against Cardillo required the company to maintain total stockholders' equity of at least $3 million.

3. The $203,000 payment by United Airlines to Cardillo was intended to reimburse the latter for expenses incurred in changing to the United Airlines reservation system.

4. Recording the $203,000 United Airlines payment as commission revenue allowed Cardillo management to maintain stockholders' equity above $3 million.

5. Cardillo's executives attempted to conceal the true nature of the United Airlines payment from the company's controller and from its independent auditors.

6. The company's controller refused to misrepresent the nature of the United Airlines payment when pressured to do so by Rognlien.

7. The two audit engagement partners involved in this case refused to accept the incomplete and suspicious explanations for the United Airlines payment that were provided by Rognlien and his subordinates.

8. In early 1986, Cardillo's weak financial condition was made even worse by a $685,000 civil judgment imposed on the company.

9. Rognlien sold a large block of Cardillo stock prior to the company publicly disclosing the large civil judgment.

10. In 1988, the SEC sanctioned three of Cardillo's executives for violating several provisions of the federal securities laws.

Instructional Objectives 1. To illustrate the types of ethical dilemmas that accountants and auditors face in their professional roles.

2. To illustrate the personal costs that accountants and auditors may be forced to absorb when they behave ethically.

3. To illustrate the lengths to which client executives will sometimes go to misrepresent their company's financial condition. © 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.

266

Case 5.1 Cardillo Travel Systems, Inc.

4. To emphasize the need for auditors not to accept incomplete or inadequate explanations from client personnel for questionable transactions discovered during an audit.

Suggestions for Use This case focuses upon ethical issues and is thus best suited for coverage during class discussion of the AICPA Code of Professional Conduct. Unlike most cases investigated by the Securities and Exchange Commission (SEC), in this case the federal agency found that the relevant accountants and auditors had fulfilled their professional responsibilities—at some personal cost to themselves. I believe that it is important to expose students to cases such as this since most situations that are well suited for "case treatment" involve the exercise of poor professional judgment on the part of auditors and/or accountants.

One specific facet of this case that I emphasize in particular is the effort of Cardillo's management to control their auditors' access to information regarding the United Airlines contractual agreement with Cardillo. Any time that auditors perceive that client management is limiting their access to key financial information, the auditors' suspicions should be aroused. Another aspect of this case that I emphasize are the personal sacrifices that auditors and accountants must often make simply for “doing the right thing.” I believe that students need to recognize that such sacrifices are one of the prices to be paid by those choosing to enter a profession.

Suggested Solutions to Case Questions 1. The three accountants in this case who faced ethical dilemmas were Russell Smith, Cardillo's controller, and the two audit engagement partners, Helen Shepherd and Roger Shlonsky. The dilemma facing Smith was whether to violate his personal ethical norms of conduct as well as those of his profession or to risk losing his job by refusing to cooperate with Rognlien. The dilemma facing each of the two audit partners was whether to accept their client's "half-baked" explanations for a very material and suspicious transaction or to risk losing the client by insisting on thoroughly investigating that transaction. The principal parties who had a stake in the resolution of these ethical dilemmas were the general public, which would include potential stockholders and creditors of Cardillo, the actual stockholders and creditors of Cardillo, Cardillo's executives, members of the accounting profession, and the three individuals facing the dilemmas.

Smith, Shepherd, and Shlonsky's primary responsibility was to the "public interest." As professionals, these individuals had an obligation to ensure that financial data provided to the general public, for whatever use, were materially accurate. If companies disseminate inaccurate financial data to the public, the eventual result will be less than optimal allocation of scarce economic resources within our economy. These individuals also had a responsibility to ensure that Cardillo's stockholders and creditors received accurate information regarding the company's financial position and results of operations. A firm's creditors need such information to make informed credit-granting and lending decisions. Corporate stockholders need such information so that they can determine whether to retain or increase their ownership interests in a given firm.

The three accountants also had an obligation to the Cardillo executives who were attempting to influence their professional judgment. Corporate executives are frequently subjected to very significant pressures to misrepresent the financial condition of their companies. History tells us that © 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 5.1 Cardillo Travel Systems, Inc. 267 all too often these pressures become so great that executives capitulate to them. When this happens, it is the responsibility of other professionals, such as auditors and accountants, who work with corporate executives, to remind these individuals of their responsibility to report fully and honestly regarding their company's financial condition. Finally, Smith, Shepherd, and Shlonsky had a responsibility to themselves and their colleagues in the public accounting profession. If individuals compromise the profession's ethical norms of conduct, they will likely subject themselves and their colleagues in the profession to second-guessing and possibly to a loss of some degree of credibility.

Additionally, on a personal level, self-imposed guilt and anxiety resulting from unethical behavior may eventually prove disruptive to not only an individual's professional career but to his or her personal life as well.

Each of the three accountants fulfilled their professional and personal responsibilities. Particularly noteworthy was the courage of Smith to accept the loss of his job as a consequence of "doing the right thing" and Shepherd's courage to disclose in the 8-K exhibit letter the nature of the problems that preceded Cardillo's decision to terminate its relationship with Touche Ross.

2. According to AS 4105, "Interim Financial Information," of the PCAOB auditing standards, an auditor should employ primarily analytical procedures, inquiries of management, and “other procedures that address significant accounting and disclosure matters relating to the interim financial information” [AS 4105.15] when performing a review of a client's interim financial statements. Listed next are examples of specific procedures that AS 4105 suggests auditors should consider applying when reviewing a client's interim financial statements (there are literally dozens of other specific procedures identified in AS 4105 that are not listed below!). [Note: AU-C Section 930, “Interim Financial Information,” of the AICPA Professional Standards suggests similar procedures for use during a review of interim financial information.] a. b. c. d. e.

Use of analytical procedures to identify any unusual relationships in the interim financial statements.

Reading the minutes of board of directors meetings.

Inquiry of client management as to whether the interim financial statements have been prepared in accordance with GAAP. Inquiry of management concerning unasserted claims or assessments.

Inquiry of client management regarding compliance with key contractual agreements.

In retrospect, it is always easy to criticize decisions that subsequent events suggest were questionable. Given the fact that the adjusting entry posted in late June 1985 to Cardillo's accounting records allowed the company to maintain its stockholders' equity above the critical $3 million level, the Touche Ross auditors probably should have been very skeptical regarding its authenticity. At the very least, the field auditors probably should have brought the entry to the attention of Shepherd who then would have had an opportunity to determine what additional procedures, if any, were appropriate to corroborate the entry.

3. Following is the evidence collected by Touche Ross that supported the material accuracy of the $203,000 adjusting entry. © 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.

268

Case 5.1 Cardillo Travel Systems, Inc. a. b. c. d.

Lawrence's initial representation that the adjusting entry was valid (made to the Touche Ross auditors during their review of Cardillo's 2nd quarter 10-Q).

Lawrence's second representation that the adjusting entry was valid, which was made in response to Shepherd's inquiry in November 1985.

Rognlien's representation to Shepherd in November 1985 that the adjusting entry was valid.

Rognlien's representation to Shepherd in December 1985 that he and the chairman of the board of United Airlines had secretly agreed that the $203,000 would not have to be refunded to the airline under any conditions.

Listed next is the evidence which suggested that the $203,000 adjusting entry was suspicious. a.

b. c.

Shepherd's review of information regarding the United Airlines-Cardillo agreement that suggested the $203,000 was refundable to United Airlines under certain conditions.

The confirmation returned to Touche Ross by United Airlines that indicated the $203,000 was refundable to the airline under certain conditions.

Rognlien's refusal to allow Shepherd to contact the chairman of the board of United Airlines regarding the alleged "secret" agreement between the two men.

Auditors are required to obtain sufficient appropriate evidence to support their opinion on a set of financial statements. The sufficiency of audit evidence is a matter of professional judgment on the part of the auditor. That is, each auditor must decide when he/she has collected sufficient (appropriate) evidence to support a decision regarding the fairness of an account balance or the overall fairness of a set of financial statements. The professional standards suggest that “reliability” is a key trait that determines whether or not audit evidence is “appropriate.” In turn, a critical issue in evaluating the reliability of audit evidence is the source of the evidence. Evidence collected from an independent third party, for instance, tends to be more reliable than evidence supplied by the client.

Reliability was the central issue that Touche Ross should have considered when assessing the appropriateness of the evidence collected for the $203,000 adjusting entry. The evidence that supported that entry consisted strictly of oral client representations. Conversely, the primary audit evidence that disputed the accuracy of the adjusting entry was provided by an objective third party, United Airlines, and by Shepherd's review of certain information apparently drawn directly from the contractual agreement between the two parties. Given the greater degree of reliability of the latter evidence versus that of the evidence which supported the authenticity of the adjusting entry, Touche Ross certainly had reason to insist that the entry be reversed.

4. The principal objective of the 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 apparently to discourage public companies from changing auditors 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 5.1 Cardillo Travel Systems, Inc. 269 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. According to these allegations, when major technical disputes arose between auditors and client management the latter would often dismiss its audit firm and then "shop" for a more compliant or flexible audit firm, i.e., one that shared its view regarding the issue in dispute.

Shepherd did not violate the client confidentiality rule by discussing in the 8-K exhibit letter the controversy regarding the United Airlines payment to Cardillo. The AICPA Code of Professional Conduct identifies several exceptions to the client confidentiality rule that permit auditors to disclose confidential client information to regulatory authorities or other official bodies.

Shepherd did not have a responsibility to inform Cardillo management of the information she intended to disclose in the 8-K exhibit letter. Nevertheless, some practitioners might suggest that, as a matter of professional courtesy, she should have informed Cardillo of her intentions even though the contractual relationship between Cardillo and Touche Ross had been over for quite some time. By doing so, Shepherd would have given Cardillo's executives early warning of the criticism they would receive once the exhibit letter was released to the public as well as an opportunity to prepare in advance a response to that criticism.

5. The profession’s quality control standards—both those of the AICIPA and those of the PCAOB—require CPA firms to establish policies and procedures that minimize the likelihood of accepting a client that lacks integrity. Among the specific quality control procedures that may be used by CPA firms when deciding whether or not to accept a prospective audit client are the following: a. b.

c.

d.

Inquire of the predecessor audit firm whether it has any reason to question the integrity of the prospective client's management.

Inquire of business associates of the prospective client, including bankers, legal counsel, underwriters, and officials of competing companies, regarding the competence and trustworthiness of the prospective client's key executives.

Contact regulatory authorities that have oversight responsibilities for the prospective client's industry to determine whether disciplinary or legal measures have been taken in the past against the company's key executives.

Retain an investigative agency to perform "background checks" on all key officials of the prospective 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.

Case 5.2 American International Group, Inc. 270

CASE 5.2

AMERICAN INTERNATIONAL GROUP, INC.

Synopsis AIG has a long and proud history in the global insurance and financial services industry.

However, that proud history was easily overshadowed by the adverse publicity received by the huge company during the massive financial crisis that gripped the U.S. economy in the fall of 2008. This case focuses on a series of events several years before that crisis.

In 2001, AIG management came up with an idea for a new financial service, namely, developing customized special purpose entities (SPEs) for large corporations. AIG’s executives had witnessed how several companies, including Enron, had used SPEs to “clean up” their balance sheets. These companies had created SPEs to “download” nonperforming or underperforming assets and related liabilities to them. Since SPEs were typically unconsolidated subsidiaries, many companies used them to effectively “hide” such assets and liabilities from the investing and lending public.

To enhance the credibility of this new product, AIG retained a senior partner of Ernst & Young, Michael Joseph, who was a nationally recognized expert in the creation and operation of SPEs. Joseph wrote SAS No. 50 reports to validate the acceptability of the accounting treatment for transactions involving AIG-created SPEs and AIG used those reports in marketing its new service.

[Note: the technical material in SAS No. 50 has been integrated into AS 6105 of the PCAOB’s auditing standards and AU-C Section 915 of the AICPA Professional Standards.]

Among the first companies to express an interest in AIG’s SPE service was PNC, which at the time owned and operated the nation’s fifth largest bank. PNC management was concerned that their independent auditors might object to the SPEs that the company was considering “purchasing” from AIG. Ironically, PNC was audited by Ernst & Young, Michael Joseph’s firm. Not surprisingly, Joseph was the individual given the responsibility to persuade the PNC auditors that the SPEs and related transactions would be in compliance with GAAP. Joseph easily accomplished that objective.

Throughout 2001, PNC downloaded a large portion of its distressed loan portfolio to its new SPEs. In late 2001, the Federal Reserve reviewed PNC’s SPE transactions and forced the company to reverse them. Next, the SEC launched an investigation of PNC’s SPEs. The SEC concluded that the SPEs did not qualify for treatment as unconsolidated subsidiaries, meaning that the financial data for the SPEs should have been included in PNC’s consolidated financial statements. The SEC also concluded that AIG officials, PNC management, and Michael Joseph were aware or should have been aware that the SPEs were not GAAP “certified.” In addition to sanctions imposed on AIG and PNC, © 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 5.2 American International Group, Inc. 271 Michael Joseph was suspended from practicing before the SEC for three years while E&Y was fined $1.6 million by the federal agency.

American International Group, Inc.--Key Facts 1.

AIG, a global provider of insurance and other financial services, was one of the 10 largest c ompanies in the U.S. and among the 20 largest companies in the world by 2000.

2.

In early 2001, AIG executives came up with the idea for a new financial service: developing customized special purpose entities (SPEs) for large corporations.

3.

The principal selling point for this new service was its ability to help companies “manage their balance sheets” by downloading or transferring underperforming assets and related liabilities to an unconsolidated subsidiary (SPE).

4.

AIG realized that its new SPE service would be more credible if one of the major accounting firms was involved with the service; to help develop and market the new SPE service AIG retained Michael Joseph, a national partner with Ernst & Young and a recognized SPE expert.

5.

Among the first companies to express an interest in AIG’s SPE service was PNC, a large financial services firm that operated the nation’s fifth largest bank.

6.

During negotiations with AIG, PNC consulted with its audit firm to determine whether the accounting treatment for AIG’s SPEs complied with GAAP; ironically, PNC’s audit firm was Ernst & Young.

7.

Joseph informed PNC’s auditors that AIG’s SPEs were GAAP-compliant; PNC would eventually transfer more than $200 million of nonperforming loans to SPEs created for it by AIG.

8.

In early 2002, the Federal Reserve forced PNC to reverse its SPE transactions and include the $200 million of nonperforming loans in its consolidated financial statements.

9.

In July 2002, the SEC ruled that PNC’s SPE transactions had violated GAAP and ordered the company to cease and desist from violating federal securities laws; in July 2003, the U.S. Justice Department fined PNC $115 million.

10. In December 2006, the SEC ruled that Michael Joseph had been a “cause of PNC’s violations” of federal securities laws and suspended his right to practice before it for three years.

11. In 2004, AIG agreed to pay $126 million in fines and restitution for its role in the PNC accounting scandal; the following year, AIG agreed to pay a $1.6 billion fine to settle charges that it had intentionally misrepresented its own 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 5.2 American International Group, Inc. 272 12. In late 2008 during the sudden and massive economic crisis that gripped U.S. and global capital markets, the federal government seized control of AIG to prevent the company from collapsing; AIG would ultimately be the largest recipient of federal bailout funds intended to stymie that crisis.

Instructional Objectives 1.

To demonstrate the importance of accountants and auditors avoiding conflict of interest situations in which their apparent and/or de facto independence and integrity may be impaired.

2.

To demonstrate how “creative” accounting can be used to manage or distort an entity’s reported earnings and financial condition.

3.

To illustrate the risks that accounting firms face when they accept aggressive, high profile companies as audit clients.

4.

To examine the nature and purpose of “SAS No. 50” reports by accounting firms.

Suggestions for Use

This case documents the recent trials and tribulations of AIG, the large insurance and financial services company that became the “poster child” for the massive federal bailout plan implemented by Congress in the fall of 2008. You might consider packaging this case with the New Century and Madoff Securities cases to provide your students with an overview of three companies that played key and infamous roles in the recent crisis that severely disrupted the U.S. economy.

This case provides you with an opportunity to discuss with your students where accounting firms should “draw the line” in terms of deciding what types of professional services they should provide.

In this case, a partner of a major accounting firm was involved in developing and marketing customized SPEs that helped companies “manage”—some would say “distort”—their reported financial condition. Current ethical rules do not prevent accounting firms from providing services or being involved in the provision of services similar to that offered by AIG in this case. To initiate coverage of this case, consider polling your students on the question of whether they believe it is appropriate for accounting firms to provide any type of professional service that is not specifically prohibited by the profession’s ethical standards.

Note: In this case, the phrase “SAS No. 50 report” is used although SAS No. 50 has effectively been “swallowed up” or integrated into AS 6105 of the PCAOB auditing standards and AU-C Section 915 of the AICPA Professional Standards. During the time frame that the key events in this case transpired, the phrase “SAS No. 50” report was commonly used.

Suggested Solutions to Case Questions 1. Regardless of the specific service (auditing, consulting, taxation, etc.) that they happen to be providing, as professionals CPAs have an obligation to serve the public interest. In my view, it is not in the public interest to help companies conceal or obscure their true profitability or financial © 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 5.2 American International Group, Inc. 273 condition even if professional standards do not specifically prohibit them from doing so. The ethical standards most relevant in this context are “public interest” and “integrity,” which are the second and third “principles” included in the AICPA Code of Professional Conduct. Following are selected excerpts from the Code’s discussion of those two principles that you may want to refer to during inclass discussion of this case.

Public Interest: “A distinguishing mark of a profession is acceptance of its responsibility to the public . . . The public interest is defined as the collective well-being of the community of people and institutions that the profession serves . . . In discharging their professional responsibilities, members may encounter conflicting pressures from among each of those groups. In resolving those conflicts, members should act with integrity, guided by the precept that when members fulfill their responsibility to the public, clients’ and employers’ interests are best served.” [ET 0.300.030.02-.03] Integrity: “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.” [ET 0.300.040.04] 2. Let’s begin with a little background information on SAS No. 50 that you may find helpful. SAS No. 50, “Reports on the Application of Accounting Principles,” was initially incorporated into AU Section 625 of the AICPA Professional Standards. SAS No. 97, “Amendment to Statement No. 50, Reports on the Application of Accounting Principles,” issued in June 2002, was also integrated into AU 625. Recognize that SAS No. 97 became effective after the key events in this case took place.

The key change that SAS No. 97 made to the earlier SAS No. 50 requirements was to prohibit accountants from issuing reports on “the application of accounting principles to a hypothetical situation.” That is, SAS 50-type reports must now involve specific situations and specific entities.” In the PCAOB auditing standards, the technical material embedded in SAS No. 50 and SAS No. 97 is included in AS 6105 “Reports on the Application of Accounting Principles.” AS 6105.10 describes in detail the form and content of a SAS No. 50-type report, while AS 6105.11 provides an example of such a report. Final note: in the clarified AICPA Professional Standards, the SAS No. 50/97 technical material is integrated into AU-C Section 915.

The principal responsibility imposed on a “reporting accountant” by AS 6105/AU-C Section 915 is simply to “get the facts” before issuing a report on a given issue. Among the principal sources of information that the reporting accountant should rely upon in “getting the facts” is the given company’s “continuing accountant,” typically its existing audit firm.

Many companies have used SAS No. 50 engagements to effectively “interview” replacement auditors for their existing audit firm or, to be more blunt, to “opinion shop.” When a disagreement arises between an audit client and its audit firm regarding the proper accounting treatment for a transaction, particularly, a new or unusual transaction, the audit client may retain another accounting firm to provide a SAS No. 50 report on the proper accounting treatment for that transaction. The principal ethical dilemma posed by this scenario is the fact that the accounting firm retained to issue the SAS No. 50 report has an economic incentive to “side” with the potential client regarding the proper accounting treatment to be applied to the given transaction. Why? Because doing so may result in that accounting firm being retained as the given company’s new auditor. © 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 5.2 American International Group, Inc. 274 A related ethical dilemma is the incentive of the “reporting accountant” to not obtain a full understanding of the transaction on which it is being asked to report. By failing to properly investigate the given transaction that firm may be able to more readily justify the accounting treatment favored by the potential audit client. This is a key reason why AS 6105/AU-C Section 915 stresses the importance of the reporting accountant obtaining a thorough understanding of the transaction in question.

© 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 5.3 Caesars Entertainment Corporation 274

CASE 5.3

CAESARS ENTERTAINMENT CORPORATION

Synopsis In May 2013, Caesars Entertainment, the nation’s largest gaming company, reported that the SEC was investigating a former partner of its audit firm, Deloitte & Touche (Deloitte). The former partner, James T. Adams, had served as the “advisory partner” on Deloitte’s 2008 and 2009 audits of Caesars. The SEC was reportedly investigating “gaming activities” by Adams in one of Caesars’ casinos during 2009. (At the time, Adams was not only an audit partner for Deloitte but also the chief risk officer for Deloitte LLP, Deloitte’s parent firm.) Deloitte carried out its own independent investigation and concluded that Adams’ actions “did not at any time impair Deloitte’s independence, because among other considerations, these activities were not inconsistent with the SEC’s independence rules and furthermore he had no substantive role in any audit or review concerning the company.” A similar conclusion was reached by Caesars following its own independent investigation.

In an SEC filing, however, Caesars disclosed that “there might be a material adverse effect on our business and financial condition” if the SEC ruled that Adams’ actions had impaired Deloitte’s independence.

In May 2014, the SEC reported the results of its investigation of James Adams in AAER No. 3554. The agency’s report focused on loans that Adams had obtained from a Caesars casino. (The SEC didn’t specifically identify the audit client, but numerous parties, including Caesars itself, identified Caesars as the audit client.) In 2009, Adams obtained multiple loans from the casino.

Three of the loans obtained by Adams remained outstanding for more than one month before he repaid them. In December 2009, while still a member of the Caesars audit engagement team, Adams borrowed $110,000 from the Caesars casino. The SEC reported that Adams defaulted on that loan.

In AAER No. 3554, the SEC ruled that Adams had engaged in “improper professional conduct” by violating its auditor independence rules. The SEC suspended Adams from practicing before the SEC for two years, a penalty that was inconsequential since he had retired four years earlier. Adams’ actions had also caused Deloitte to violate both the SEC’s regulations and the PCAOB’s auditing standards that “require an auditor to be independent of its client.” Finally, without specifically naming Caesars, the SEC ruled that Adams’ actions had caused the given audit client to violate the provisions of the federal securities laws that require public companies to have their financial statements audited by an independent accounting firm. Despite its rulings, the SEC did not sanction either Deloitte or Caesars or require Caesars to have its 2009 financial statements re-audited. © 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 5.3 Caesars Entertainment Corporation 275

Caesars Entertainment, Inc.--Key Facts 1. In May 2013, Caesars Entertainment, the nation’s largest gaming company, reported that the SEC was investigating James T. Adams, a former partner of its audit firm, Deloitte & Touche (Deloitte); according to Caesars, the SEC was investigating Adams’ “gaming activities” in one of its casinos during 2009.

2. Adams had served as the “advisory partner” on Deloitte’s 2008 and 2009 audits of Caesars; in that role Adams’ principal duties included attending Caesars’ audit committee meetings and reviewing the information used by the audit committee members in carrying out their responsibilities 3. Adams was not only a Deloitte audit partner at the time but also the chief risk officer of Deloitte LLP, Deloitte’s parent firm.

4. Prior to the completion of the SEC’s investigation, independent investigations by Caesars and Deloitte suggested that Adams’ actions had not impaired the audit firm’s independence during the 2008 and 2009 audits.

5. In May 2014, the SEC reported the results of its investigation in AAER No. 3554; the primary focus of that AAER was multiple loans obtained by Adams during 2009 from a Caesars casino.

6. Three of Adams’ loans from Caesars were outstanding for more than one month before he repaid them.

7. In December 2009, Adams borrowed $110,000 from the Caesars casino; the SEC reported that the audit partner defaulted on that loan.

8. In commenting on Adams’ actions, the SEC noted that “Public faith in the reliability of a corporation’s financial statements depends upon the public perception of the outside auditor as an independent professional.”

9. The SEC went on to observe that “any loan . . . to or from an audit client” is “inconsistent” with auditor independence.

10. The SEC ruled that Adams had engaged in “improper professional conduct;” Adams was suspended from practicing before the SEC for two years which was an inconsequential penalty since he had retired from public accounting in May 2010.

11. Adams’ actions caused Deloitte to violate the SEC regulations and PCAOB auditing standards that require auditors to be independent of their clients; in addition, he caused Caesars to violate the federal mandate that requires SEC registrants to have their financial statements audited by an independent accounting 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 5.3 Caesars Entertainment Corporation 276

12. Despite its rulings, the SEC did not sanction either Deloitte or Caesars nor did the federal agency require Caesars to have its 2009 financial statements re-audited.

Instructional Objectives 1. To demonstrate the critical importance of auditors maintaining independence from their audit clients.

2. To identify the four guiding principles that the SEC invokes to protect the independence of auditors.

3. To identify the circumstances under which auditors of SEC registrants can have outstanding loans from audit clients.

Suggestions for Use Consider assigning this short case during your coverage of the AICPA’s Code of Professional Conduct. Because the exclusive focus of this case is on auditor independence, you could integrate inclass discussion of this case with that important topic. Probably more than any other “independence” case, the Caesars-Deloitte debacle demonstrates the critical importance of auditor independence to the credibility of the financial reporting domain and does so in an easily understood, if not shocking, context.

Suggested Solutions to Case Questions 1. In my view, the advisory partner’s role in the Caesars audits—as described by the SEC in AAER No. 3554—was a substantive role. Audit committees of SEC registrants play a very important role in the audits of those companies. The primary feature of that role is to serve as a liaison between the client’s management team and the team of auditors. Given Adams’ experience and expertise, it seems only reasonable to conclude that audit committee members would have routinely relied on him when they were addressing audit-related issues, including issues raised by Caesars management team and those raised by the auditors. As a result, Adams likely had the ability to shape the audit committee’s discussion of those issues, if not the manner in which they were resolved.

2. Here are the four general principles applied by the SEC to promote the independence of auditors. a. An auditor is not independent when he or she has a mutual or conflicting interest with a client. b. An auditor is not independent when he or she audits his or her own firm’s work. c. An auditor is not independent when he or she functions as a member of management or as an employee of a client. d. An auditor is not independent when he or she acts in an advocacy role for a 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.

Case 5.3 Caesars Entertainment Corporation 277 3. I would suggest that, technically, Adams would not have violated any ethical or professional standards by using his private resources to finance gambling sprees in a Caesars casino. In this particular case, the SEC’s concern was not with Adams’ gambling activities in a client’s casino but rather the fact that he borrowed the funds from the client to gamble. Although there are exceptions, auditors are generally not precluded from purchasing or utilizing business services or products of audit clients. Having said that, it is arguably not a good idea for auditors to gamble large sums in an audit client’s casino because doing so could cause third parties to question their independence and professionalism. Understand that if a given auditor is gambling sums that are clearly material to the given gaming client and/or himself or herself, that would certainly call in to question the auditor’s independence. Such conduct would violate the SEC’s auditor independence principle involving conflicts of interest—see answer to Question #2. Likewise, such conduct would qualify as a conflict of interest under the AICPA Code of Professional Conduct—see Section ET 1.100, “Conflicts of Interest.”

4. The revised AICPA Code of Professional Conduct identifies specific circumstances in which auditors can have outstanding loans from an audit client. Such loans include, among others, home mortgages, secured loans, immaterial unsecured loans, automobile loans, and loans fully collateralized by the cash surrender value of an insurance policy. For a detailed discussion of the specific circumstances under which such loans are acceptable, see Section ET 1.260, “Loans, Leases, and Guarantees” of the AICPA code.

As a general rule, the SEC’s auditor independence rules for outstanding loans from audit clients are consistent with those of the AICPA. (The PCAOB does not have separate auditor independence rules relating to outstanding loans from audit clients and instead invokes the relevant SEC rules.) The fact that the SEC permits certain auditor-client loans begs the question of why the SEC representative would state in AAER No. 3554 that “any loan . . . to or from an audit client” is “inconsistent” with auditor independence. Most likely, the SEC representative was simply reinforcing the general principle that auditors should avoid having loans from audit clients.

© 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.

278

Case 5.4 IPOC International Growth Fund, Ltd.

CASE 5.4

IPOC INTERNATIONAL GROWTH FUND, LTD.

Synopsis Guy Enright, a KPMG employee, unwittingly became a pawn in an international chess match of corporate espionage. Representatives of Diligence, Inc., a London-based “business intelligence” firm, persuaded Enright to give them copies of “confidential audit documents” obtained during a KPMG audit of IPOC International Growth Fund, a Bermuda-based company with ties to an important Russian bureaucrat who was also a close ally of Vladimir Putin. Those documents and other information that Enright provided regarding IPOC were relayed to a Russian company, Alfa Group.

At the time, IPOC and Alfa were battling each other in court to acquire a 25 percent ownership interest in MegaFon, one of Russia’s largest cell phone companies.

The “sting operation” used by Diligence to pry information out of Enright was eventually disclosed to KPMG, which then promptly sued Diligence. The lawsuit was reportedly settled by a $1.7 million payment to KPMG by Diligence. Enright, who received a Rolex watch for his role in the international intrigue, left KPMG and accepted a job with Deloitte during the general time frame when the details of the sting operation were leaked to the press. After a multi-year and multinational court battle between IPOC and Alfa, the two combatants mutually agreed to drop the lawsuits and counter-lawsuits that they had filed against each other. Although the matter was settled out of court, one of the key individuals involved in the IPOC-Alfa legal battle, an American citizen of Russian descent who was an outspoken critic of Vladimir Putin, wound up missing after he was apparently abducted while on a business trip to Latvia. Skeletal remains of that individual were discovered in a remote area of Latvia in late 2012.

© 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 5.4 IPOC International Growth Fund, Ltd. 279 IPOC International Growth Fund, Ltd.--Key Facts 1. In late 2003, IPOC, a Bermuda-based investment company, and Alfa Group, a Russian conglomerate, became involved in a legal battle to gain control of a 25 percent ownership interest in MegaFon, a large Russian cell phone company.

2. Leonid Rozhetskin, an American citizen of Russian descent and an outspoken critic of Russian president Vladimir Putin, owned the 25 percent stake in MegaFon and had allegedly agreed to sell that stake to IPOC before he unexpectedly sold it to Alfa Group in August 2003.

3. As a result of allegations stemming from the conflict between IPOC and Alfa Group, the Bermuda government retained KPMG to audit the business affairs of IPOC to determine whether that firm was a legitimate business entity or a criminal enterprise.

4. Diligence, Inc., a London-based “business intelligence” firm, recruited Guy Enright, a KPMG auditor assigned to the IPOC engagement, to provide inside information regarding IPOC’s operations that Alfa Group could use to prevail in its legal battle with that company.

5. Enright, a British citizen, was led to believe by Nick Day, the founder of Diligence, that he was being recruited by a British intelligence service to participate in a mission that had national security implications for Great Britain.

6. Enright agreed to provide Nick Day with “confidential audit documents” from the IPOC engagement.

7. When KMPG learned of the “sting operation” used to persuade Enright to give IPOC audit documents to Nick Day, the firm sued Diligence; the case was reportedly settled by Diligence paying KPMG $1.7 million.

8. The Bermuda government forced IPOC to disband its operations in Bermuda after various sources, including KPMG’s audit of IPOC, suggested that the firm was a money-laundering operation linked to Russia’s Telecommunications Minister who was a close ally of Vladimir Putin.

9. During the same time frame that the details of the covert sting operation used by Diligence to obtain audit documents from Enright were leaked to the press, Enright left KPMG and accepted a position with Deloitte & Touche in London.

10. IPOC and Alfa Group mutually agreed to end their legal battle over the 25 percent ownership interest in MegaFon in July 2007.

11. In early 2008, Leonid Rozhetskin disappeared while on a business trip to Latvia; Rozhetskin’s mother blamed his mysterious disappearance on Vladimir Putin.

12. In November 2013, DNA tests revealed that skeletal remains discovered in a remote region 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 5.4 IPOC International Growth Fund, Ltd.

Latvia were those of Rozhetskin.

Instructional Objectives 1. To identify the moral, ethical and professional responsibilities that CPAs owe their clients with a particular focus on the obligation to maintain the confidentiality of client information.

2. To distinguish between, and among, the types of professional services marketed by accounting firms.

Suggestions for Use This case provides a unique set of circumstances in which to examine the client confidentiality obligation of auditors and other CPAs. This is also another case that you can use to convince your students of the importance and far-ranging impact of professional audit and audit-related services.

In my view, this case is ideal for a role-playing exercise. Consider drafting three students to reenact the original meeting involving Guy Enright, Nick Hamilton (Nick Day), and “Liz” (Gretchen King). If you have some students in your class with a “flair for the dramatic,” this role-playing exercise can be educational as well as entertaining given its James Bond-esque elements. After the original role-playing exercise, consider choosing three more students to re-enact the meeting but this time “flip” the genders of each character: Guy Enright becomes Gigi Enright, Nick Hamilton becomes Nicole Hamilton, and “Liz” is now “Lance.” I think you will find that this gender switch significantly alters the dynamics of the encounter.

Suggested Solutions to Case Questions 1. Although the various media outlets reporting on this case and the parties involved in it commonly used the phrases “audit” and “auditors,” KPMG’s IPOC engagement was not an independent audit.

The media reports used in developing this case did not comment on the contractual details of the KPMG engagement, but it appears that we could best characterize the engagement as a non-audit attestation service. (Of course, because all attestation services are also assurance services, KPMG’s IPOC engagement qualified as an assurance service engagement as well.)

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, KPMG was hired by the Bermuda government to report on the credibility of IPOC’s assertion that it was operating in a manner consistent with its business charter when the company was established in Bermuda in 2000. Recall that the company was supposedly a mutual fund investment company when it was organized. The rumors that IPOC was essentially a “criminal enterprise” caused the Bermuda government to question the nature of IPOC’s assertion that it was a mutual fund. So, KPMG was hired to investigate and report on that assertion.

2. Note: Because Enright was a British Chartered Accountant, he was subject to the Code of Ethics of the ICAEW (Institute of Chartered Accountants in England and Wales). As you might expect, that © 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 5.4 IPOC International Growth Fund, Ltd. 281 code is fairly consistent with the AICPA’s Code of Professional Conduct. For comparison purposes, the six ethical principles of the AICPA’s Code of Professional Conduct are Responsibilities (“in carrying out their responsibilities as professionals, members should exercise sensitive professional and moral judgments in all their activities”), The Public Interest, Integrity, Objectivity and Independence, Due Care, and Scope and Nature of Services (this principle essentially requires that CPAs provide only those services that they are qualified to provide and that would not result in conflicts of interests or other circumstances that might discredit themselves or their profession). The five “fundamental principles” included in the ICAEW Code of Ethics are Integrity, Objectivity, Professional Competence and Due Care, Confidentiality, and Professional Behavior (this latter principle refers to the responsibility of Chartered Accountants to “comply with relevant laws and regulations and to avoid any action that discredits the profession”). [Notes: I will answer this question by relying principally on the AICPA’s Code of Professional Conduct despite the fact that Enright was a Chartered Accountant. You might consider having your students research and report on the commonalities shared by, and the differences between, the AICPA and ICAEW codes.]

Listed next are examples of key responsibilities that were imposed on Enright during the IPOC engagement by his profession’s moral, ethical, and professional framework: a) b) c) d) e)

A responsibility to uphold the overall credibility of his profession and the public’s confidence in that profession.

As a professional, Enright had a responsibility to act in the public’s interest, that is, to promote the welfare and well-being of the public.

Enright had a responsibility to maintain the confidentiality of client information.

During the IPOC engagement, Enright had an obligation to be impartial and intellectually honest.

Enright had a responsibility to perform his assigned tasks with competence and in compliance with all applicable technical and ethical standards.

The question in this context is which of the above responsibilities did Enright “violate” and which did he “uphold.” You might consider placing this list, or a comparable list that you or your students develop, on the overhead and then having your students discuss each item. Following are some observations regarding each of the “responsibilities” in my list. a.

One could certainly argue that Enright violated item “a” by causing some third parties familiar with the case to doubt the commitment of professional accountants to uphold the confidentiality of their clients’ business records and other private information.

b.

This item typically fosters a healthy debate among students. Enright apparently believed that he was serving a “greater good” by turning over the confidential documents to Nick Day. One could easily develop hypothetical scenarios in which the “greater good” (such as, preventing a nuclear holocaust) would easily justify violating explicit professional standards. The problem here is that individual auditors should not be making such weighty decisions on their own. At a minimum, it seems that Enright should have discussed the dilemma he faced with a superior or some other person of authority (legal or otherwise) before he decided to hand over the

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Case 5.4 IPOC International Growth Fund, Ltd. client documents. (In fairness to Enright, he very well may have had such a discussion with one or more trusted friends or acquaintances.) c.

Of course, Enright clearly violated the client confidentiality mandate referenced in this item.

d.

Because only Enright was privy to the given circumstances, it is impossible for us to have a complete understanding of those circumstances or to evaluate how “believable” was the scenario and alleged facts presented to him by Nick Day. It may very well be that he truly believed that his actions were necessary given the national security implications presented to him by Day. That is, he was being “intellectually honest” with himself.

e.

We don’t know how competently Enright performed his assignments on the IPOC engagement given the absence of any “inside” information regarding that issue.

However, we obviously know that he violated the client confidentiality standard by turning over the audit documents to Nick Day. One could also argue that his conduct constituted a “discreditable act” as that term is defined by the profession’s ethical code. [Again, these statements assume that Enright was subject to the AICPA Code of Professional Conduct, which he clearly wasn’t.]

3. Before deciding which individual (Enright or Day) was most ethical/least unethical it seems that we should first consider the contextual circumstances faced by each person. For example, because Enright was a professional accountant, it was incumbent on him to consider the constraints imposed on his conduct by his profession’s ethical principles and other professional standards. Likewise, we should consider what ethical or professional or moral responsibilities Day was subject to given his role as a “business intelligence” professional. This is another way of suggesting that there was a different ethical benchmark or yardstick to apply in evaluating the “ethicality” of each individual.

My students typically suggest that Day was easily the least ethical of the two individuals. Day used “sleight of hand” tactics, at a minimum, to mislead Enright. And, he stood to profit significantly from his deception. Enright, on the other hand, apparently was acting in “good faith,” that is, he apparently believed that he was acting in the public interest by turning over the audit documents.

Likewise, unlike Day, Enright apparently had no expectation of financially benefiting from his actions.

4. In addressing this question, I typically ask a few students to indicate how they would have dealt with the set of circumstances faced by Enright. Another approach that I have used in addressing questions such as this is to ask students how they believe their “typical” classmate would respond in such a scenario. As you might expect, this latter tactic often sparks a lively debate among students.

5. This is a question best suited for an attorney since it deals with legal issues. Nevertheless, from a layman’s perspective, it appears that Diligence engaged in a “tort” or wrongful act when it perpetrated the sting operation on Guy Enright and KPMG. The aggrieved party in such circumstances generally has the right to recover the economic damages that it suffered as a result of such an act, which suggests that KPMG would likely have been successful if it had pursued 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.

Case 5.4 IPOC International Growth Fund, Ltd. 283 in court instead of accepting an out-of-court settlement. There are at least two reasons that KPMG may have decided to settle out of court. Most importantly, this was a very embarrassing incident for the prominent accounting firm. The major accounting firms, like most high profile organizations, prefer not to have their “dirty laundry” made available for public inspection. So, it is very likely that the firm wanted to resolve the matter as quickly and quietly as possible to remove it from the “public spotlight.” Likewise, KPMG may have decided that the $1.7 million settlement was the maximum amount that it could expect to extract from Diligence even if it was successful in court.

© 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 5.5 Le-Nature’s Inc., Part II 283

CASE 5.5

Le-NATURE’S INC., PART II

Synopsis In late 2003, three senior executives of Le-Nature’s Inc., a Pennsylvania-based beverage company suddenly resigned. The three men, who included the company’s former CFO, suggested that Le-Nature’s founder and CEO, Gregory Podlucky, was inflating the company’s reported sales. A subsequent investigation that was mandated by Ernst & Young (EY), Le-Nature’s audit firm, found no evidence of “fraud or malfeasance.” Following that investigation, EY was dismissed and replaced

by BDO Seidman. For 2003 through 2005, BDO Seidman issued unqualified opinions on LeNature’s annual financial statements.

In 2006, allegations of accounting fraud surfaced again within Le-Nature’s. A court-appointed custodian discovered a massive ongoing accounting fraud within the company. In 2005, for example, more than 85 percent of the company’s reported revenues of $287 million were determined to be fictitious. Le-Nature’s CEO and seven other individuals received jail sentences for their roles in the huge fraud.

BDO Seidman was among the parties caught up in the civil litigation stemming from the LeNature’s fraud. Most of those lawsuits were settled privately, however, Le-Nature’s bankruptcy trustee reported that he received a $12 million settlement from BDO Seidman—the trustee had alleged that the firm had been negligent in auditing Le-Nature’s. Unfortunately, that settlement was arguably not the most embarrassing outcome of BDO Seidman’s three-year relationship with LeNature’s.

While investigating Le-Nature’s CEO for tax evasion, the IRS launched a parallel investigation of the federal income tax returns of George Mark, the BDO Seidman audit partner for Le-Nature’s.

That investigation revealed that Mark had included $128,000 of fraudulent travel expenses in his 2004 through 2006 income tax returns. The U.S. Justice Department insisted that Mark receive a prison sentence for his criminal behavior. However, the federal judge presiding over Mark’s case chose to fine the former audit partner $30,000 and give him a two-year probationary sentence. Apparently, Mark’s expressed remorse for his misdeeds and the fact that he had a prior history of work with charities deterred the judge from giving him a prison sentence.

© 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 5.5 Le-Nature’s Inc., Part II 284

Le-Nature’s Inc., Part II--Key Facts 1.

In 2003, three senior officials of Le-Nature’s Inc., a Pennsylvania-based beverage company, suddenly resigned and alleged that the company’s CEO had inflated the company’s recorded sales figures.

2.

A subsequent investigation mandated by Ernst & Young (EY), Le-Nature’s audit firm, found no evidence of fraud; shortly after that investigation was concluded, Le-Nature’s retained BDO Seidman to replace EY.

3.

BDO Seidman issued unqualified opinions on Le-Nature’s annual financial statements from 2003 through 2005.

4.

Allegations of improprieties within Le-Nature’s 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.

5.

Among the parties that made large financial settlements with Le-Nature’s bankruptcy trustee were BDO Seidman which paid the trustee $12 million.

6.

While investigating Le-Nature’s former CEO for tax evasion, the IRS launched a parallel investigation of the federal income tax returns of George Mark, the BDO Seidman audit partner who had been assigned to the Le-Nature’s engagement.

7.

The IRS investigation of Mark revealed that the audit partner had included $128,000 of fraudulent travel expenses in his 2004 through 2006 federal income tax returns.

8.

According to the IRS, the Philadelphia-based Mark lived a “lavish lifestyle” that included maintaining an apartment in New York City, extensive travel, and ownership of several luxury automobiles.

9.

The U.S. Justice Department asked the federal judge presiding over Mark’s case to give him a prison sentence to send a message to “wealthy people” that they cannot avoid jail time if they cheat on their taxes.

10. The federal judge fined Mark and gave him a two-year probationary sentence; apparently, the judge’s decision was influenced by the former audit partner’s expressed remorse and the fact that he had an extensive history of working with charities.

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Case 5.5 Le-Nature’s Inc., Part II 285

Instructional Objectives 1. To illustrate the legal exposure that accounting firms may face when they are associated with corporate executives who are ethically challenged.

2. To illustrate the negative consequences that one partner’s poor decisions can have on his or her firm.

3. To raise the question of whether CPAs have a higher moral or ethical responsibility than other citizens to comply with societal norms of conduct.

4. To identify the factors or issues that should be considered when determining the appropriate sanctions for individuals who violate societal norms of conduct.

Suggestions for Use Here’s another brief case that can be used as a “utility infielder” in a graduate or undergraduate auditing course. That is, you can insert this case at almost any point in an auditing course. For example, since you can easily cover this case in 20-25 minutes, you could use it to segue from one major module of a course to another and, in doing so, give your students a brief break from “big” auditing topics that may require multiple class periods to cover—such as internal control, audit planning, or the fraud triangle. Alternatively, you may want to cover this case in conjunction with the Le-Nature’s Inc., case. That strategy would result in students being very familiar with the “background story” for this case, which should expedite and enrich coverage of the case.

Suggested Solutions to Case Questions 1. As professionals, I believe that CPAs do have a responsibility to serve as “role models” for clients, potential clients, and the general public. By definition, individuals who choose to enter a professional field accept a “higher calling,” namely, serving the public interest. If professionals do not hold themselves to a higher standard, then they and their colleagues will almost certainly forfeit a significant measure of their respect and credibility in the eyes of the general public.

2. Here's another example of a question that tends to generate considerable debate, if not controversy, among students. My students typically suggest that “remorse” is not a proper or reasonable criterion to consider when deciding on the proper punishment for someone who has misbehaved. Ex post, we nearly always experience some degree of remorse when our misconduct is revealed, but often that remorse stems from the fact that we were “caught” rather than from the fact that we are ashamed of, or regret, our misconduct. More controversial is the question of whether the judge should have considered Mark’s prior history of having worked extensively with charities as sufficient justification for not incarcerating him. Typically, the majority of my students argue that 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 5.5 Le-Nature’s Inc., Part II 286 judge should not have taken Mark’s charitable work into consideration in deciding upon his punishment. One strategy that I often use in a context such as this is to ask for a show of hands— here, for example, I would ask which students disagree with the judge’s apparent decision to consider Mark’s prior charitable work in arriving at his sentence. Then I ask one or more of the students who express that point of view to play the role of devil’s advocate, that is, I ask them to defend the judge’s decision. This approach forces students to address an ethical or otherwise “sensitive” issue from a different perspective and often results in them having a better understanding or appreciation of that issue and its various dimensions.

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Case 5.6 Richard Grimes, Staff Accountant 287

CASE 5.6

RICHARD GRIMES, STAFF ACCOUNTANT

Synopsis This brief case revolves around a set of circumstances involving a staff accountant with a Big Four audit firm who unintentionally “eavesdropped” on a conversation involving two client executives. The young auditor happened to be retrieving documents he needed to complete an audit test while the executives were discussing a financial reporting issue that had significant audit implications. Because he was hidden from their view, the auditor received an “earful” of important information that the client intended to withhold from the audit team. After their conversation ended, the two executives discovered that the auditor had overheard them discussing the sensitive issue. The dilemma facing the auditor is what to do with the information that he inadvertently but surreptitiously obtained.

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Case 5.6 Richard Grimes, Staff Accountant 288

Richard Grimes, Staff Accountant--Key Facts 1. Richard Grimes is a staff accountant assigned to the annual audit of McCaleb Medical Corporation (MMC), a public company.

2. While retrieving documents that he needed to complete an audit procedure, Grimes unintentionally overheard a conversation between MMC’s COO and the company’s controller.

3. During the conversation, the COO informed the controller that a customer would be declaring bankruptcy in the near future and, as a result, would default on the large receivable that it owed MMC. 4. The controller told the COO that the expected loss on the receivable had to be “addressed somehow” in MMC’s financial statements that would be included in the company’s Form 10-K to be filed in the coming weeks with the SEC. 5. The COO sternly told the controller that MMC would not “borrow trouble” by referring to the loss in the upcoming Form 10-K; according to the COO, the customer’s bankruptcy would not be “widely known” until after MMC had filed the 10-K with the SEC. 6. After the conversation between the COO and controller ended, the COO discovered that Grimes had overheard the conversation because he had been just a few feet away, although he had been hidden from their view.

7. The COO angrily accosted Grimes and accused him of intentionally eavesdropping on the conversation between himself and the controller.

8. After being “dressed down” by the angry COO, Grimes had to decide what to do next.

Instructional Objectives 1. To illustrate an ethical dilemma faced by an auditor.

2. To examine auditors’ responsibilities when they identify material “subsequent events.”

3. To examine the nature and applicability of the client confidentiality rule.

Suggestions for Use This is a brief case that you can “slip” into an undergraduate or graduate auditing course at almost any point. I often use cases such as this to give my students a 20-30 minute “break” from covering arduous technical topics in an auditing course. Notice that the first instructional objective suggests © 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 5.6 Richard Grimes, Staff Accountant 289 that this case can be used to introduce students to a type of “ethical dilemma” that auditors may face in their professional roles. You may disagree that the dilemma faced by Richard Grimes in this case involves an “ethical” issue—refer to the suggested solution for case questions #2 and #3. I think you will agree that whether or not the situation in which he finds himself is an “ethical dilemma,” it is definitely an awkward set of circumstances.

You may consider expanding case question #1 by requiring your students to report on the responsibilities of auditors to identify and audit subsequent events. The final case question raises the issue of whether the client COO involved in this case would have reacted differently if Richard Grimes had instead been Rachel Grimes. Consider exploring that issue by using role-playing exercises in which you rotate the genders of both client executives and the auditor.

Suggested Solutions to Case Questions 1. The topic of “subsequent events” is addressed in AS 2801 of the PCAOB’s auditing standards and AU-C Section 560 of the AICPA Professional Standards. Generally, there are two types of subsequent events: a. Those that provide evidence of conditions that existed at the date of the financial statements. b. Those that provide evidence of conditions that arose after the date of the financial statements.

The first category of subsequent events should be considered by management in arriving at the proper amounts to be presented in a given set of financial statements. The second category of subsequent events should be considered for disclosure only in a given set of financial statements. In fact, when a type “b” subsequent event is extremely material, the given financial statements may be misleading if the event is not disclosed in those financial statements. In certain cases, it may be appropriate to include pro forma financial data in the given financial statements for type “b” subsequent events.

The case does not provide sufficient information to determine whether the pending bankruptcy of MMC’s customer is a type “a” or type “b” subsequent event. If the bankruptcy was brought on by an incident, such as an earthquake, that occurred following the close of MMC’s fiscal year, then it would qualify as a type “b” subsequent event. In most cases, a corporate bankruptcy results from an entity’s deteriorating financial condition over a considerable period of time. If that was the case with MMC’s customer, then the pending bankruptcy would be considered a type “a” subsequent event.

2.

Following are the principal decision alternatives that Richard has: a.Immediately convey the information regarding the customer bankruptcy to his superiors. b. Ask the COO and/or controller for permission to convey the information regarding the customer bankruptcy to his superiors. c.Choose to “sit” on the information, that is, do not convey the information to his superiors.

An interesting facet of this case that typically surfaces when it is being discussed is whether or not Richard Grimes is facing an “ethical dilemma.” Some of your students may suggest that he 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 5.6 Richard Grimes, Staff Accountant 290 facing an ethical dilemma because he must decide whether or not to convey the sensitive information that he has stumbled upon (by way of serendipity) to his superiors on the audit engagement team.

Students voicing this point of view maintain that by passing on the “secret” information to his superiors, Richard would be violating the expectation of privacy that the two executives had when they were discussing the given matter. These students also recognize that by not passing the information on to his superiors, Richard would be effectively concealing critical audit evidence from them—thus the dual nature of the ethical dilemma he faces. [Note: in this context, the client confidentiality rule is often mentioned by one or more students. The argument here is that the information being discussed by the two executives was “confidential” and thus should not be disclosed by Richard to other parties. This argument is tenuous, at best. Why? Because the public interest “rule” would almost definitely mandate that Richard pass the information on to his superiors—and, even more pertinently, the client confidentiality rule does not apply in this set of circumstances. A stronger but still fragile argument can be made that the two executives’ expectation of privacy dictates that Richard not pass along the information he inadvertently heard. But, again, the public interest rule would seemingly override that argument.]

Most students do not view the “quandary” that Richard faces as an ethical dilemma. They argue that because he acquired that information innocently, he is entitled to freely pass it on to his superiors.

These students typically argue that Richard, in fact, would be acting unethically if he did not pass the information on to his superiors.

3. This issue often arises when the previous question is being addressed. Some students maintain that Richard was “at fault” for not making his presence known to the two executives. A related point of view is that Richard should have left the alcove when he realized that the two executives were discussing “sensitive” information. Other students disagree and maintain that he was not at fault and thus he was blameless. (Note: the fact that Richard intentionally “slipped” by the open office door as quietly as possible and retrieved the documents from the file cabinet as quietly as possible typically causes some students to suggest that he was somewhat at fault, that is, his conduct might be construed as intentional “eavesdropping.” Other students maintain that if the two executives wanted to carry on a “private” conversation, they should have closed the office door—then again, it was so early in the morning that neither of them likely expected to have any “company.”)

4. As I suggested in the “Suggestions for Use,” you might explore this possibility by engaging in a “gender-swapping” role-playing exercise where multiple sets of students recreate the scene involving the two executives and Richard.

© 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 6.1 Leigh Ann Walker, Staff Accountant 291

CASE 6.1

LEIGH ANN WALKER, STAFF ACCOUNTANT

Synopsis In this case, a staff accountant of a large, international accounting firm is dismissed by her employer when her integrity is questioned by a senior auditor. The staff accountant had told the senior auditor, who at the time was her immediate supervisor on an audit engagement, that she had not taken the CPA exam the month prior to joining the firm. In fact, the staff accountant had taken the exam but did not want to disclose that fact to her co-workers because she believed that she had not done well on the exam. After learning that she had passed all parts of the exam, the staff accountant informed the senior. The senior immediately brought the matter to the attention of the office managing partner. The senior insisted that since the staff accountant had been untruthful, she could not be trusted in the future and, as a result, was not suited for the independent auditor role.

After consulting other audit partners in the practice office, the office managing partner agreed with the senior and dismissed the staff accountant. In addition to the ethical issues implicit in this case, the case also provides insights on the work role and work environment of a newly-hired staff accountant.

Leigh Ann Walker, Staff Accountant--Key Facts © 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.

292

Case 6.1 Leigh Ann Walker, Staff Accountant

1.

Leigh Ann was well qualified for an entry-level position in public accounting given her college credentials.

2.

According to Leigh Ann's college friends, she was sometimes too "intense."

3.

Leigh Ann performed very well on her first job assignment.

4.

Leigh Ann was dishonest with her supervisor, Jackie Vaughn, when Jackie asked her if she had taken the CPA exam.

5.

Leigh Ann was dishonest with Jackie because she was afraid that she had not done well on the CPA exam and wanted to avoid the embarrassment of admitting that fact when she received her grades on the exam.

6.

Following the discovery of Leigh Ann's dishonesty, Jackie told the office managing partner that she did not want Leigh Ann assigned to any of her jobs in the future.

7.

After consulting with the other audit partners in the office, the office managing partner informed Leigh Ann that she was being dismissed.

Instructional Objectives

1.

To illustrate the critical importance of independent auditors possessing personal integrity.

2. To demonstrate the importance of supervisors on audit engagements being able to trust their subordinates.

3. To illustrate the nature of the newly-hired staff accountant's work role and the frustrations and job-related pressures that individuals occupying that role often experience.

Suggestions for Use I typically assign this case early in the semester to give students insight into the staff accountant's work role and work environment. Given the ethical issues raised in this case, it could be assigned as well during discussion of the AICPA Code of Professional Conduct. The key point that I believe should be stressed in this case is the critical need for auditors to be able to trust their colleagues. This is particularly important for auditors in supervisory positions who have to "sign off" on the work of their subordinates. A common reaction to this case by students is that Jackie Vaughn over-reacted to the "white lie" told by Leigh Ann. In the past, several of my students have pointed out that the dishonesty exhibited by Leigh Ann was not directly job-related. When students express that view, I encourage them to look at this issue from the standpoint of Jackie. Ironically, Jackie was apparently a very "intense" person, similar to Leigh Ann, and committed to advancing as rapidly as possible within © 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 6.1 Leigh Ann Walker, Staff Accountant 293 the firm. From her perspective, she simply did not want to assume the risk of taking responsibility for the work of an individual who had proven that she could rationalize or justify dishonesty.

Another lesson that I hope students learn from this case is the need for them to have a "balanced" perspective when they assume that first professional role in their careers. For professionals to be "successful" in the fullest sense of that word, they need to recognize that their work roles should not consume their entire existence. As proven by this case, individuals with excellent credentials and an extremely high level of motivation sometimes fail because they place too much emphasis on succeeding and on being perceived as successful.

Suggested Solutions to Case Questions 1. Students tend to react quite differently to this series of questions. Following are summaries of some of my former students' responses to these questions. a.

Jackie should have given Leigh Ann a chance to prove that she could be trusted. If I had been Jackie, I would have watched her very closely on her next few assignments. If I saw any indication of a lack of integrity on those assignments, I would have gone to the office managing partner at that point and asked that she be dismissed. Roberts was placed in a very difficult situation. He probably trusted the judgment of Jackie, given her reputation within the office, and likely did not want to offend her by going against her wishes.

Apparently, the other audit partners sided with Jackie, so Roberts probably had no choice other than to dismiss Leigh Ann.

b.

I believe that Jackie treated Leigh Ann unfairly since she did not even discuss the matter with her. Jackie should have taken into consideration the fact that Leigh Ann was a newlyhired employee who simply wanted to make a good first impression. At the very least, Jackie should have sat down with Leigh Ann and explained her view of the matter and then given Leigh Ann an opportunity to defend herself. Rather than immediately taking the matter to the other audit partners in the office, the office managing partner should have spoken with Leigh Ann first and then arranged a meeting with Leigh Ann, Jackie, and himself to discuss the situation. Since Leigh Ann was apparently a very bright individual, she almost certainly would have understood the mistake that she had made and been very careful to avoid making similar errors of judgment in the future.

c.

I believe that Jackie was justified in insisting that Leigh Ann be fired. Leigh Ann's ability to "lie on the spot" about a fairly trivial matter indicated that she could not be trusted regarding more serious matters. If she had not been fired, then this situation would probably have leaked out eventually and damaged her credibility with the other members of the audit staff in her office. Consequently, it was probably best that Roberts took the action that he did.

Of course, he could have been much more harsh and not given her two months to find a job, and he could have disclosed the real reason that she was dismissed to prospective employers that she subsequently contacted. So, in a sense, she was not penalized that heavily for her dishonesty. [Note: According to the placement counselor who provided much of the information for this case, the reason given for Leigh Ann's dismissal by the office managing

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294

Case 6.1 Leigh Ann Walker, Staff Accountant partner to prospective employers she contacted was overstaffing, i.e., his office had hired too many staff accountants that particular year.]

Note: This case has easily been among the most popular cases in the various editions of my casebook. Several adopters have sent me comments regarding this case. I appreciate all such feedback. Bob Eskew, Purdue University, sent me a note reporting that his students were much more supportive of Leigh Ann’s dismissal than were my students. Additionally, Bob noted that his students were “unanimously critical” of the office managing partner: “They felt that he fired someone for lying and then engaged in exactly the same behavior when explaining externally the reason for Ms. Walker’s departure from the firm.” That’s an excellent point and one that instructors might consider raising if their students do not.

2. Again, this is a very subjective question that evokes quite different responses from students.

Following are summaries of some of the general points made by former students of mine in response to this question. a.

Independence and integrity are the two key traits that auditors should possess. If an auditor lacks either one of these traits, his or her work cannot be trusted. Granted, an individual such as Leigh Ann may not do something very "dumb" like lying about whether or not she completed an audit procedure. But, she probably would be inclined to under-report the number of hours she worked so that she could come in under budget on her assignments and do other somewhat dishonest things to impress her supervisors. Overall, I believe that having her on the audit staff of an office would be disruptive to the operations of that office.

b.

The AICPA Code of Professional Conduct says nothing about the need for integrity on the part of auditors while they are not in their professional role. I do not believe that it is the responsibility or right of CPA firms to attempt to monitor the "personal" integrity of their employees. I can see where one might argue that a person who is dishonest or "immoral" in some sense away from work would likely engage in similar behavior while at work.

However, until an employer demonstrates that a lack of personal integrity causes an individual to be a poor employee, I do not believe the employer has a right to penalize such an employee in any way.

c.

It is impossible to distinguish between one's personal integrity and his or her professional integrity. If someone is dishonest, they will be dishonest in all phases of their life.

Note: It is quite interesting that most students express the view that Jackie Vaughn and Don Roberts overreacted to the dishonest statement made by Leigh Ann. However, in response to the second question, the majority of students tend to imply that an individual such as Leigh Ann is unsuited for the auditor's professional role.

© 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.

296 Accountant

Case 6.2 Bill DeBurger, In-Charge

CASE 6.2

BILL DEBURGER, IN-CHARGE ACCOUNTANT

Synopsis Bill DeBurger is an in-charge accountant with a large national accounting firm. Within Bill's firm, an in-charge accountant is typically an individual with one to three years' experience in public accounting. Bill has just completed auditing the inventory account of Marcelle Stores, a retail client.

The year under audit was a difficult one for Marcelle. A poor economy and aggressive competition caused the company's net income to fall from almost $8 million in the previous year to a pre-audit net income of approximately $500,000 for the year under audit. Bill realizes that inventory is easily the most important item in Marcelle’s financial statements. A material error discovered in the company's inventory account could easily wipe out the firm's meager pre-audit net income.

Bill has one remaining task related to the inventory account, namely, writing a summary memo that must conclude with his opinion regarding whether the account's year-end balance is materially accurate. After realizing that he simply does not know whether the inventory account balance is materially accurate, Bill decides to inform the audit engagement partner that he will be unable to write the inventory memo. The audit partner becomes livid when Bill confesses that he cannot reach an overall conclusion regarding the inventory account despite the fact that almost 1,000 man-hours have been spent auditing the account. Immediately, the audit partner demands that Bill return to his office and write the memo, although he does not tell Bill what to include in the memo.

© 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 6.2 Bill DeBurger, In-Charge

297

Accountant

Bill DeBurger, In-Charge Accountant--Key Facts 1.

In Bill DeBurger's firm, an in-charge accountant is an individual with one to three years of experience; in-charges are expected to complete their assigned tasks with little supervision.

2. In the current audit of Marcelle Stores, Bill has been assigned the responsibility of auditing inventory, which is clearly the most important account each year on the Marcelle engagement.

3. The year under audit has been a difficult one for Marcelle; the previous year the company reported a profit of nearly $8 million, while in the current year its pre-audit net income is approximately $500,000.

4. A material error discovered in Marcelle's inventory account could potentially wipe out the company's pre-audit net income and force the firm to report its first-ever net loss.

5. After completing the audit of the inventory account, Bill must write a memo that concludes with an opinion indicating whether the account balance is materially accurate.

6. Although considerable audit evidence has been collected for the inventory account, Bill eventually admits to himself that he does not know whether the balance of the account is materially accurate.

7. After some soul-searching, Bill decides not to "sign off" on the inventory account.

8. When Bill informs the audit partner of his decision, the partner becomes visibly upset and orders Bill to write the inventory memo although he does not tell Bill what to include in the memo.

Instructional Objectives 1. To provide students with insight on the nature of the professional role and responsibilities of auditors with one to three years’ experience in public accounting.

2. To illustrate one type of interpersonal conflict that may arise between the subordinates on an audit engagement team and their superiors.

3. To allow students to place themselves in the professional role of an auditor who is facing a difficult decision that may influence his future with his employer.

Suggestions for Use This is one in a series of cases intended to introduce students to the work role and responsibilities of public accountants occupying various positions on the typical employment hierarchy of a public accounting firm. One approach to covering these cases is to discuss them (one at a time) at regular © 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 6.2 Bill DeBurger, In-Charge Accountant

intervals during the course of the semester. My experience has been that students particularly enjoy and look forward to discussing the role-related cases since these cases provide them with important insights on professional work roles that many of them will eventually assume.

Suggested Solutions to Case Questions 1. Most students believe that Bill DeBurger indicated in his memo that the inventory account balance was materially accurate--which was the actual decision made by the”real” Bill DeBurger. My experience has been that students generally report they would have done exactly the same thing.

Students often justify this decision by suggesting that it was obviously the decision the audit partner wanted Bill to reach.

2. If at all possible, Bill should have raised this issue with the audit partner much earlier in the audit.

By waiting until near the end of the audit, Bill placed the audit partner in a very difficult position.

Nevertheless, Bill did act on his conscience. After reviewing the inventory workpapers, he did not believe that he could sign off on the account. So, he took the courageous action of informing the partner of this decision.

Once he decided that he couldn’t sign off on the inventory account, did Bill take the proper approach in discussing the matter with the partner? I think so. He took a direct approach, no equivocating, which is probably the best strategy in a "touchy" situation, such as the one he faced.

3. I believe it is important to continually remind students that when evaluating the behavior of an auditor (or anyone else for that matter) involved in a difficult situation, they must attempt to put themselves in that person's shoes, so to speak. Typically, students do not believe that the audit partner reacted professionally to Bill's revelation. Anger, even veiled anger, is certainly unwarranted in most settings. However, recognize that the audit partner was probably under tremendous stress himself. Here was a client of his, possibly his largest and most important client, that was having serious financial problems. No doubt, client management was exerting pressure on him to provide as many "breaks" on key accounting issues as possible so that the company would not have to report a loss for the first time in its history. On the other hand, the audit partner's superiors—the office managing partner and/or other senior audit partners in the practice office—were likely reminding him at every opportunity that this was a high-risk engagement that had to be handled with extreme care.

So, there he sits in his office, attempting to wrap up this difficult audit when in walks Bill, his trusted and competent in-charge. In a matter of moments, Bill turns Sam’s world upside down with his bombshell revelation. Most of us, if placed in this situation, would likely have had a difficult time controlling our emotions as well as Sam Hakes did.

Given the circumstances, I believe that it is difficult to fault Sam Hakes for how he dealt with this matter—granted, many of you may disagree. Although he was clearly angry, he did not ask Bill to do anything unethical or unprofessional. He simply instructed Bill to write the inventory memo, which Bill had an obligation to do one way or the other.

4. Most large accounting firms would likely assign a senior to the inventory account of a client similar to Marcelle Stores, if at all possible. However, a key fact of life for major accounting firms is rapid turnover among their professional employees. As a result, on many engagements, it simply 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 6.2 Bill DeBurger, In-Charge Accountant 299 not possible to assign "seasoned" auditors to important client accounts.

Just because relatively inexperienced auditors are assigned to key client accounts does not mean that the audit work on those accounts is substandard. The critical quality control element of an independent audit engagement is an extensive and multi-layered review process. When a relatively inexperienced auditor is assigned to an important client account, the auditor's superiors should intensely review and question that individual's work throughout the 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 6.3 Hamilton Wong, In-Charge Accountant 300

CASE 6.3

HAMILTON WONG, IN-CHARGE ACCOUNTANT

Synopsis “Eating time” is a taboo subject among public accountants. However, empirical research suggests that auditors, particularly individuals near the bottom of the employment hierarchy of major accounting firms, commonly underreport the time that they spend working on their assigned audit tasks. Why do auditors underreport the time they work? No doubt, to impress their superiors. In fact, so-called “impression management” has been a major topic of research in the organizational behavior field in recent years.

This case allows students to identify and discuss the key issues related to the underreporting of time by auditors. Hamilton Wong is currently working on the audit of Wille & Lomax, the largest audit client of his office—his employer is one of the major accounting firms. Among his responsibilities on the engagement are collecting the time worked by each member of the audit team and preparing a weekly progress report for his superiors. Hamilton’s friend, Lauren Hutchison, is also assigned to the Wille & Lomax audit. Both Hamilton and Lauren are in their second year in public accounting and both have their “eye on” the expected vacancy in the senior slot for next year’s Wille & Lomax audit. Some tension has recently developed between the two in-charge accountants.

Hamilton is convinced that Lauren is significantly underreporting the time that she works on her Wille & Lomax assignments. In Hamilton’s mind, Lauren is attempting to impress the audit manager and audit partner on the engagement to persuade them that she is the right person to assume the senior position on the job. As the case ends, Hamilton is wrestling with the decision of whether he too should begin underreporting the time that he has worked on his Wille & Lomax assignments.

Hamilton Wong, In-Charge Accountant--Key Facts © 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 6.3 Hamilton Wong, In-Charge Accountant 301 1.

Hamilton Wong is an in-charge accountant on the audit staff of a large international accounting firm.

2.

Wong’s administrative duties on the Wille & Lomax audit to which he is assigned include keeping track of the time worked by each member of the audit team.

3.

Another member of the Wille & Lomax audit team is Lauren Hutchison, who is also an incharge accountant.

4.

Hutchison and Wong are the top candidates to fill the expected vacancy in the senior position on the Wille & Lomax audit, which is the largest audit client of their office.

5.

Wong is certain that Hutchison has been consistently underreporting the time that she spends each week working on her Wille & Lomax assignments.

6.

Wong believes that Hutchison, who has a “fast-track” image in their office, is underreporting her time to impress her superiors who will choose the next senior for the Wille & Lomax audit.

7.

The “competition” between Hutchison and Wong has created tension between the two friends.

8.

The key issue facing Wong is whether he will begin underreporting the time that he spends working on the Wille & Lomax engagement.

Instructional Objectives

1.

To illustrate an ethical dilemma--whether or not to accurately report the time spent working on audit tasks--that auditors commonly face, particularly auditors near the bottom of their firm’s employment hierarchy.

2.

To demonstrate how competition for promotion opportunities within public accounting can influence the work environment of auditors and potentially affect the quality of independent audits.

3.

To allow students to place themselves in the professional role of an auditor who must make an important decision that will likely influence his future with his employer.

Suggestions for Use

The key question posed by this case is whether it is improper for auditors to underreport the time that they spend working on their assignments. You might launch the discussion of the case by asking students to respond to that question with a show of hands. My experience has been that most students believe that “eating time” is wrong since it is dishonest. On the other hand, the typical student, at least initially, sees this offense as no more than a “white lie” that has few consequences 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 6.3 Hamilton Wong, In-Charge Accountant 302 auditors and the independent audit function. I would encourage you to explore that common observation or belief with your students.

Consider asking students to identify the potential consequences of underreporting time for (1) individual auditors assigned to a specific engagement, (2) those individuals who will be assigned to that engagement in the future, and (3) the overall quality of independent audits, in general.

Students often overlook the “zero sum” feature of promotion opportunities in public accounting. In this case, Hamilton and Lauren are vying for one position. By underreporting her time and enhancing her image with her superiors, Lauren is automatically harming Hamilton’s chance of winning the senior job for the important Wille & Lomax engagement. Likewise, Lauren is “hurting” individuals who will be assigned to the Wille & Lomax audit in the future. Because she has underreported the time that she has worked on her tasks, individuals who are assigned those tasks the following year will likely be given time budgets that are inadequate. In addition, her dishonesty may negatively impact other key audit planning decisions made for the following year’s engagement. As you pursue this topic, I think students will eventually recognize that underreporting time, although it seems to be only a “white lie,” does have important implications for individual auditors and for the overall independent audit function. By the time you complete this discussion, your students will likely have covered many, if not most, of the issues raised by the case questions.

Suggested Solutions to Case Questions 1. Require students to fully explain the choice they make, whether it is a “yes” or a “no.” Students responding with a “yes” typically suggest that they would be justified in underreporting their time since Hutchison had obviously done so, which raises the classic “Do two wrongs make a right” question. These students may also make the interesting observation that Hamilton has already underreported the time he has worked on the engagement by “eating” the time that he spent helping Lauren on her accounts. So, why shouldn’t he do the same thing to benefit himself?

Is underreporting time “unethical”? I believe that the simple—and proper—answer to that question is “yes.” Certainly, the practice is dishonest. Additionally, underreporting time is almost always an act of unilateral self-interest that places someone at a disadvantage. Typically, that “someone” is the individual assigned the same task on the following year’s engagement. In this case, Hamilton Wong is also a victim of Lauren’s malfeasance.

2. Performance appraisal is clearly one key objective of tracking the number of hours worked by individual audit assignment. Auditors realize that both the quality and quantity of their work is evaluated. An auditor who does an “excellent” job in “ticking and tying,” putting together organized and well-formatted workpapers, and writing an articulate and logical memo documenting the work performed will not receive an “excellent” rating on the given assignment if he or she “busts” the budget allocated for the task in question. Budgets also serve a quality control function. During the audit planning function, members of the audit team decide how the scarce resources available to them (primarily manpower) should be allocated. A key input into that decision is the number of hours required on individual assignments during past audits. If hours worked are not reported accurately during the current year’s engagement, the planned allocation of hours for subsequent audits will likely be adversely affected. Finally, tracking hours worked by individual audit tasks is necessary for billing purposes. The audit firm and its client typically agree that the audit fee will be some approximate © 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 6.3 Hamilton Wong, In-Charge Accountant 303 amount. However, there is usually an “out” in that agreement that allows the audit firm to bill the client for additional charges if unexpected problems or circumstances arise that require more time than was expected to complete certain tasks. Even if excess hours required for given tasks are not billed to the client, that information is needed to adjust the audit fee for the following year’s engagement.

Underreporting time can enhance the performance appraisals of individual auditors. Then again, these “high marks” come at a price. The individuals who underreport their time are likely to experience some degree of stress and possibly regret as a result of their questionable conduct. For example, these individuals may question their own competence since they realize that their glossy appraisals are not totally deserved. As already noted, the underreporting of time worked on audit tasks typically poses a problem for individuals assigned those same tasks on subsequent audits. These individuals will likely be given an insufficient time budget for their assigned tasks, meaning that they will either have to “eat” hours or be downgraded for their inability to complete the tasks in the allotted hours. Underreporting of time can also impact “zero sum” type decisions made regarding promotion opportunities within an office—which was an issue in this case since Hamilton and Lauren were competing for one job opening. Finally, as suggested in the prior paragraph, underreporting of time has overall audit quality implications. Inaccurate reporting of hours worked by individual audit assignments will likely result in improper resource allocation decisions on subsequent audits, meaning that the quality of those audits may be adversely affected.

3. A naïve answer to this question is that accounting firms should not place too much emphasis on time budgets in making performance appraisal decisions. In reality, however, time budgets are among the few objective measures or benchmarks that can be used to assess the performance of auditors.

Granted, the most important measure of an auditor’s performance should be the “quality” of the work performed as reflected by the content of the relevant workpapers and by the subjective evaluations of that work by the individual’s superiors. Another strategy for mitigating the dysfunctional nature of time budgets is for audit firms to rigorously review and challenge all time budget allocations during the planning phase of each engagement. Too often, the number of hours charged to a given task during an audit becomes the de facto time budget for that task on the following year’s audit.

4. Because of the “up or out” policy that accounting firms, in particular, the major accounting firms, have historically invoked, the public accounting profession has long been known as having a “dogeat-dog” or highly competitive work environment. The most effective measure that accounting firms can take to mitigate the negative consequences of this policy is to periodically remind lower-level auditors that there is always “room at the top,” or, at least, plenty of “room” at the next job rank. In other words, an individual who does high quality work will nearly always be rewarded with promotion opportunities. This axiom is particularly true in public accounting since the high turnover rate at each employment rank quickly thins out the number of competitors for promotion opportunities. In the context of this case, for example, Hamilton Wong was being shortsighted.

Instead of worrying about the supposed threat posed to him by Lauren Hutchison’s aberrant behavior, he should have dedicated himself to doing the best job that he could. If he performed his assignments well, he would eventually receive another opportunity if he was not the individual tabbed for the senior position on the Wille & Lomax 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 6.4 Tommy O’Connell, Audit Senior 305

CASE 6.4

TOMMY O’CONNELL, AUDIT SENIOR

Synopsis A few weeks after being promoted to audit senior, Tommy O'Connell is assigned to supervise the fieldwork on a difficult engagement, the annual audit of Altamesa Manufacturing Company. At first, Tommy is pleased. His new assignment demonstrates that Tommy's superiors have confidence in his ability to handle a tough audit engagement although he's only a "light" senior. On the other hand, the out-of-town assignment creates problems in Tommy's personal life. His wife of less than one year has already expressed dissatisfaction with the amount of overtime he works and now he has to tell her that he will be spending much of the next few months away from home. Later, Tommy is upset when he learns that the staff accountant assigned to work under him on the Altamesa audit is Carl Wilmeth.

Tommy and Carl have little in common. In fact, Tommy doesn't appreciate Carl's cocky attitude and probably resents the fact that Carl is from a wealthy family. Tommy is also upset because of rumors that Carl signs off on audit procedures without completing them. Challenges, problems, frustrations.

Such is the life of an audit senior.

This case introduces students to the professional role of an audit senior by "observing" Tommy O'Connell's work on the Altamesa engagement. By providing a window on several months in the life of an audit senior, this case allows students to obtain a better appreciation of the audit senior's professional responsibilities, work environment, and related professional and personal issues and problems.

© 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 6.4 Tommy O’Connell, Audit Senior

Tommy O'Connell, Audit Senior--Key Facts 1. Tommy O'Connell had been a senior for only a short time before being assigned to the Altamesa audit engagement.

2. Tommy wanted to impress his superiors and advance as rapidly as possible within his firm.

3. Tommy was pleased when he learned of his assignment to the difficult Altamesa engagement because it signaled that his superiors highly regarded his work.

4. The Altamesa audit was a difficult engagement in part because the company's management took aggressive positions on key accounting issues.

5. The Altamesa assignment required Tommy to be out of town for several weeks, which did not make his wife happy—she had already complained of the long hours he had to work.

6. Tommy apparently did not like Carl Wilmeth and, as a result, was upset when he learned that Carl would be his subordinate on the Altamesa engagement.

7. The two seniors who Carl had worked for previously suspected that he had signed off on audit procedures that he had not completed.

8. During the course of the Altamesa engagement, Tommy suspected that Carl was not completing all of his assigned tasks.

9. Because he was so busy working on other matters during the Altamesa engagement, Tommy did not take the time to investigate his suspicions regarding Carl's work.

10. Tommy never discussed his suspicions regarding Carl's work with the Altamesa audit engagement partner.

Instructional Objectives 1. To illustrate the nature of the audit senior's work role, including frustrating and problematic facets of that role.

2. To compare and contrast the nature of the work roles of audit seniors and staff accountants.

3. To discuss the phenomenon of "premature sign-off" of audit procedures and the resulting implications for independent audits and the auditing profession.

4. To demonstrate that interpersonal issues or problems, including those involving members 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 6.4 Tommy O’Connell, Audit Senior 307

audit engagement team and those involving auditors and client personnel, often influence the performance of audits.

Suggestions for Use The work roles assumed by independent auditors are very important and challenging; however, these roles also pose frustrations and disappointments for the individuals who occupy them. I believe that it is important to make students aware of the opportunities they will encounter in an auditing career but also to expose them to the difficult aspects of such a career. Some of you may be familiar with the extensive work of the behavioral researcher John Wanous. Wanous has found repeatedly that "realistic job previews" enhance the degree of job satisfaction and the length of tenure of individuals entering a given field. In a sense, this case, and the related cases in this section, provide students with a realistic introduction to the work roles they may eventually assume in public accounting. These role-related cases can be covered at practically any point during a semester. Since these cases all raise ethical issues, they could be integrated into classroom coverage of the AICPA Code of Professional Conduct. This particular case could be easily integrated with discussion of audit evidence issues since the competence of much of the evidence collected during the course of the Altamesa engagement was suspect.

Suggested Solutions to Case Questions 1. One could easily argue that audit seniors occupy the most critical role on an audit engagement.

On most audit engagements, audit seniors personally oversee the fieldwork. In this role, seniors supervise, monitor, and review the work of staff accountants, who typically collect most of the audit evidence on an engagement. In addition, seniors are usually required to complete the audit procedures for the most important and/or complex financial statement items of a client. In carrying out their responsibilities, seniors interact almost daily with key client executives and employees.

Seniors must often gently persuade, cajole, or otherwise convince client personnel to provide requested documents, respond to important inquiries, and generally facilitate the performance of an audit with their cooperation. Seniors must also continually interact with their superiors on an engagement, typically an audit manager and an audit partner. These superiors may occasionally have unreasonable demands, at least from the senior's perspective. "You haven't finished the inventory file?

Well then, I suggest that you spend Saturday wrapping up that account." If an audit senior does not successfully manage the many challenges that typically arise during an audit engagement, the result is often a sloppy audit--or worse.

The professional role of a staff accountant, or at least a newly-hired staff accountant, is much different from that of an audit senior. Staff accountants generally have one assignment at a time. A staff accountant may spend several days or weeks completing the audit procedures for one specific and typically straightforward account--such as cash. Although time budget and deadline pressures certainly complicate the role of staff accountants, they are not subject to the extent of pressure imposed on audit seniors by client personnel and by the engagement audit manager and partner.

Which role is more important? It would be difficult to sustain an argument that the audit senior's professional role is less important than that of a staff accountant. Likewise, it is generally accepted that the audit senior's role is very stressful, on balance much more so than that of the staff accountant. © 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 6.4 Tommy O’Connell, Audit Senior

Having said this, however, both roles are important to the successful completion of an audit. And, both roles are stressful, generally for different reasons.

Note: Questions 2-5 require students to assume the role of either Tommy (Questions 2-4) or Jack Morrison (Question 5). Students' responses to these questions will vary. For each question, I identify a few relevant issues or points that students may--or may not--raise.

2. Recognize that Tommy is not in a powerful position in this situation. As a newly-promoted audit senior, Tommy probably feels reluctant to express his wishes regarding the staffing of the Altamesa engagement. A "heavy" senior, on the other hand, might simply tell Jack Morrison, "I don't think I want to work with that guy, Jack. If you want to know why, then we can talk about it in your office."

If Tommy is honest with himself, he may also recognize that his doubts regarding Carl's integrity are likely being fueled, to some degree, by his personal dislike of Carl. Given this fact, Tommy's professional and personal integrity may cause him to be reluctant to discuss the matter with Jack Morrison. Finally, as in most situations, the path of least resistance is always the easiest one to take.

Ignoring a problem, while keeping your fingers crossed and hoping it goes away, is a common way of coping with life's frustrating twists and turns.

3. What would you do? Again, in reality, I would suggest that many people—audit seniors, in this context—would traipse down that path of least resistance. Recognize that Tommy has many problems to cope with, the least important of which may be Carl's malfeasance or suspected malfeasance. His wife back in Fort Worth is unhappy. Jack Morrison calls him every day or so to inquire about the status of the audit and to subtly goad him to speed up the engagement. Finally, there's Scrooge and his stonewalling behavior.

Apparently, Carl is a "smart" cookie and would make every effort to conceal his malfeasant behavior—assuming that he is guilty as charged. Consequently, Tommy would have to spend considerable time attempting to prove his suspicions regarding Carl. Probably the only effective way for Tommy to investigate Carl's integrity would be to tediously re-perform much of his work. For example, if Carl had audited a client's cash processing controls, Tommy might be forced to have the client retrieve dozens of documents—or retrieve those documents himself—and then apply the appropriate procedures to them.

4. I believe most audit professionals would maintain that Tommy has a responsibility to raise this matter with Morrison.

5. Another tough judgment call. Although this case suggests that Carl is guilty as charged, the most defensible position for Morrison to take would be to assume that Carl is innocent until proven otherwise. Given this operating assumption, the next step that Morrison should probably take is to discuss the matter with other audit partners in the office or to seek the advice of a close colleague in another office or in the national office. For example, a human resources partner or a member of the firm's legal counsel may be able to provide invaluable advice to Morrison regarding how he should proceed. At some point, Morrison should discuss this matter with the other seniors who have intimated that Carl has not completed assigned audit procedures in the past. The information © 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 6.4 Tommy O’Connell, Audit Senior 309

provided by these seniors and by Tommy, when compiled and studied, may provide new insights on the allegations against Carl.

© 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 6.5 Avis Love, Staff Accountant 310

CASE 6.5

AVIS LOVE, STAFF ACCOUNTANT

Synopsis While completing a cash receipts cutoff test, Avis Love, a staff accountant employed by one of the large, international accounting firms, discovered several year-end cutoff errors in her client’s cash receipts and sales accounts. The client, Lowell, Inc., operated a chain of retail sporting goods stores in the South. Lowell had sponsored a sales promotion for the final quarter of the year under audit.

The promotion, which was intended to jump-start Lowell’s sagging sales, included bonuses for store managers who exceeded their quarterly sales quota. Of the 20 stores included in the sample that Avis chose for her cutoff test, three stores had backdated cash receipts and sales for the first several days of the new year, meaning that the sales in question had been recorded in the year under audit. Almost certainly, the store managers had backdated the sales to inflate their annual bonuses. Of course, their deceptive accounting scheme had also served to overstate Lowell’s sales for the year being audited.

Over the past several months, Avis had become well acquainted with several of Lowell’s store managers while performing interim tests of controls and observing physical inventories at individual stores. One of those store managers was Mo Rappelle, who had been particularly helpful and gracious to Avis during her visit to his store. Unfortunately, Mo’s store was among the three stores that had cutoff errors at year-end.

After discovering the cutoff errors at Mo’s store, Avis agonized over what to do. She considered dropping Mo’s store from her sample and replacing it with another of Lowell’s retail outlets.

Eventually, Avis chose to include Mo’s store in her cutoff test results. When Lowell’s CEO learned of the results of Avis’s cutoff tests, he ordered the company’s internal auditors to perform a similar test for all of Lowell’s remaining stores. Each manager who held open his or her store’s cash receipts and sales at year-end was fired by the CEO.

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Case 6.5 Avis Love, Staff Accountant 311 Avis Love, Staff Accountant--Key Facts 1. Avis Love, a staff accountant for one of the major accounting firms, was assigned to the annual audit of Lowell, Inc., which operated a chain of retail sporting goods stores in the South.

2. While performing a year-end cutoff test, Avis discovered that three Lowell stores had held open their cash receipts and sales accounts at year-end.

3. The motive of the three store managers was apparently to inflate the bonuses they would receive as a result of a fourth-quarter sales promotion.

4. Avis was initially excited by the prospect of uncovering a fraud.

5. Avis’s excitement turned to concern when she realized that the store managers involved in the scheme would likely be fired by Lowell’s hard-nosed CEO. 6. One of the store managers who Avis had gotten to know quite well, Mo Rappelle, was among the managers who had manipulated their cash receipts and sales records.

7. Avis considered dropping Mo’s store from her cutoff test results but then relented.

8. Lowell’s CEO dismissed Mo Rappelle and the other store managers involved in the accounting scheme.

Instructional Objectives 1. To examine an ethical dilemma commonly faced by staff accountants, namely, reporting audit test results that reflect poorly on a client employee with whom the accountant has developed a personal relationship.

2. To discuss the purpose of year-end cash receipts and sales cutoff tests.

3. To examine auditors’ sample selection methods for small, nonstatistical tests.

4. To review factors that auditors should consider, and methods they may use, in arriving at materiality decisions.

Suggestions for Use Poor Mo, poor Avis. Mo, an underpaid and overworked store manager, has “ripped off” his company for $100. Avis, a staff accountant for the audit firm of Mo’s employer and a new friend of Mo’s, must turn her buddy into the authorities, i.e., the company’s “hardnosed” CEO. This case provides future auditors with a dose of reality. My experience has been that accounting majors © 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 6.5 Avis Love, Staff Accountant 312 planning to join the auditing staff of a public accounting firm do not have a good appreciation of the adversarial nature of the independent auditor’s work role, nor the “little things” that may complicate that role—the “little thing” in this case is developing friendships with client personnel. I do not see my role as discouraging these bright-eyed auditors-to-be, but I believe that a “realistic job preview” [see extensive research into the effectiveness of RJP’s by management scholar John Wanous] will likely serve my students well.

This case can easily be integrated into class coverage of audit tests appropriate for an audit client’s revenue cycle. Alternatively, instructors could use this case while discussing ethics, the purpose being to raise an ethics issue that is not given much “press” by the profession.

An effective method of initiating discussion of this case is to take a confidential poll of students using plain paper ballots. I simply ask each student to write “yes” or “no” on the ballot: “yes” he or she would have “turned in” Mo Rappelle; “no” he or she would have let Mo off the proverbial hook.

After collecting and counting the ballots, I post the results on the board and begin probing students’ attitudes toward auditor-auditee friendships and the issues/problems stemming from such relationships. In my classes, a sometimes significant minority of the students choose the “no” option.

Occasionally, “no” students will even suggest that they would have contacted Mo and made him aware of the jeopardy he faced. Other students typically counter that such an action (1) would have placed Avis’s job in jeopardy and (2) would not have saved Mo’s job since Lowell’s CEO subsequently ordered year-end cutoff tests for all Lowell stores.

A facet of this case that students sometimes raise is that by turning in her friend, Avis became a celebrated hero, both within her firm and with client executives. Thus, Avis’s guilt was doubleedged: she turned in her friend and received kudos for doing so.

Suggested Solutions to Case Questions 1. No. Once Avis selected the sample of 20 stores, she should have applied her audit procedures to each of those stores. AS 2315.25 of the PCAOB’s auditing standards discusses auditors’ responsibilities in this context. “Audit procedures that are appropriate to the particular audit objective should be applied to each sample item.” (A similar statement is found in AU-C Section 530.09 of the AICPA Professional Standards.) The professional standards go on to note that it may not be practical for an auditor to examine all sample items selected for testing and discuss the steps that an auditor should consider taking in such circumstances: “In some circumstances the auditor may not be able to apply the planned audit procedures to selected sample items because, for example, supporting documentation may be missing. If the auditor’s evaluation of the sample results would not be altered by considering those unexamined items to be misstated, it is not necessary to examine the items . . .” (AS 2315.25). However, the professional standards never suggest that it is acceptable for an auditor to replace a sample item for a reason similar to that considered by Avis Love in this case.

2. Listed next are individuals potentially affected by the ethical dilemma that Avis faced. a. Herself: Students often overlook the responsibility that an accountant has to herself or himself. An individual who exercises poor ethical or moral judgment may lose not only the respect of others, but more importantly, his or her self-respect. © 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 6.5 Avis Love, Staff Accountant 313 b. Teddy Tankersley: As Avis’s immediate superior, any improper or unethical decision that Avis made would reflect poorly on Teddy . . . the guilt by association syndrome. Avis had a responsibility to complete tasks assigned to her by Teddy in an effective, expedient, and professionally proper manner. c. Partners & employees of her firm: Recent history suggests that unethical or otherwise unprofessional conduct by a public accountant can cost his or her employer considerable prestige and credibility and impose huge monetary losses on the firm. Again, Avis had a responsibility to exercise the competence and ethical judgment expected of a professional accountant. d. Other members of the accounting profession: Poor judgment by an individual accountant, if widely publicized, can serve as a “black eye” for the entire profession. [Here a good example can be drawn from Case 4.1, Creve Couer Pizza, Inc. Review the circumstances surrounding James Checksfield’s decision to serve as an informant for the IRS in a tax fraud case involving one of his clients.] Avis had an obligation to consider the impact of her decisions and actions on her colleagues in the profession and on the future of the profession. e. Officers, employees, stockholders, creditors and other parties with a direct or indirect financial interest in Lowell, Inc.: These individuals and entities rely on independent auditors to ferret out misrepresentations in their clients’ financial statements. Auditors who intentionally conceal, or make an effort to conceal, such misrepresentations fail to satisfy their societal mandate as independent auditors. f. Mo Rappelle: As a friend of Mo Rappelle’s, Avis had an obligation to consider his best interests and the best interests of his family. Reporting Mo’s bad behavior may not appear to be acting in “his best interest;’ however, if Mo “gets away” with this relatively minor indiscretion, it could lead to a series of more serious bad decisions on his part that could have even worse consequences for him in the long run.

3. No, the AICPA Code of Professional Conduct does not prohibit auditors from developing friendships with client personnel. However, auditors must recognize that such friendships can prove troubling during the course of an audit engagement since they may pose a potential conflict-ofinterest for an auditor.

To prevent client friendships from interfering with their professional responsibilities, auditors must exercise good judgment. For example, a staff accountant who becomes a close personal friend of a key member of a client’s accounting staff should likely request that he or she no longer be assigned to that client’s audit engagement team. Put simply, auditors must place their professional responsibilities and obligations over any personal obligations or commitments stemming from friendships with client personnel.

4. The principal objective of such tests is to determine whether the client has violated the transactionrelated “cutoff” assertion discussed in AU-C Section 315.A128 of the AICPA Professional Standards.

“Transactions and events have been recorded in the correct accounting period.” That is, the auditor is searching for evidence of sales/cash receipts that occurred in the new fiscal year but that were recorded in the prior year (the year under audit). Likewise, auditors use such tests to determine whether sales/cash receipts near the end of the year under audit were “pushed forward” and recorded © 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 6.5 Avis Love, Staff Accountant 314 in the following year. Under certain circumstances, a client may attempt to shift sales from the "old" year to the "new" year, that is, to close its sales journal prematurely. For instance, if record sales and profits have already been achieved for a given year, the client may attempt to get a "head start" on the new year by recording sales made during the last few days of the fiscal year as sales of the following year. [Note: The “cutoff” assertion is included in the “existence or occurrence” assertion of the PCAOB auditing standards—see AS 1105.11.]

5. Notice in the case that Avis apparently assessed the materiality of the backdated sales/cash receipts for Mo’s store independently of other similar errors in Lowell’s accounting records. That method of evaluating errors discovered in a client’s accounting records is inappropriate. Instead, an auditor should attempt to project or extrapolate the misstatements found in his or her sample to the entire client population. [Note: This latter requirement can be found in AU-C Section 530.A24 of the AICPA Professional Standards: “For tests of details, the auditor is required . . . to project misstatements observed in an audit sample to the population in order to obtain a likely misstatement.”

A similar requirement can be found in AS 2315.26 of the PCAOB auditing standards: “The auditor should project the misstatement results of the sample to the items from which the sample was selected.”]

In this case, Avis could have projected the sales cutoff errors discovered in her sample to the client’s total population in several ways. [Note: Here, we focus on the sales cutoff errors since they had the most significant impact on Lowell’s financial statements. Additionally, this analysis assumes that Avis used nonstatistical sampling.] One method would have been to add the total sales cutoff errors and divide by 20, the number of stores in her sample. After multiplying this “average cutoff error per store” by the number of stores Lowell operated, Avis would have had an estimate of the total sales cutoff error for the client. Possibly a more precise method of projecting the error would have been to divide the total sales cutoff errors for the three stores in her sample by the total sales revenues for all 20 stores in the sample. Avis would then have multiplied this percentage by Lowell’s total sales to arrive at the predicted sales overstatement across all of Lowell’s stores. After arriving at a reasonable estimate of the total sales cutoff error, Avis or a superior should have compared this figure with the tolerable misstatement for the account balance or class of transactions. If the estimated sales cutoff error was equal to or higher than the tolerable misstatement, the auditor would likely have concluded that a material error existed in the sales account. (Recognize that after arriving at the projected sales cutoff error, Avis’s firm should have considered the impact of that error on not only sales but other relevant financial statement items as well, including net income.)

A key issue in the preceding analysis is the level of “tolerable misstatement” selected by Avis or her superior. Factors that accounting firms commonly consider in establishing the tolerable misstatement (materiality threshold) for a given account include the importance of the account, for example, would errors in the account impact several financial statement items? Most accounting firms establish at least general quantitative guidelines to follow in making materiality judgments.

For example, any error that changes pre-tax earnings by five percent or more might be deemed a material error. Finally, auditors must consider qualitative factors when reaching tolerable misstatement/materiality judgments. For example, auditors will typically establish lower materiality thresholds for errors involving fraud and/or illegal acts by client personnel.

Note: Recognize that since Lowell’s CEO required a 100 percent test of the company’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 6.5 Avis Love, Staff Accountant 315 sales and cash receipts cutoff, the discussion of materiality for this setting is moot. That is, any error projected from Avis’s sample would have been overridden by the actual error determined (and hopefully booked) by the client.

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316

Case 6.6 Charles Tollison, Audit Manager

CASE 6.6

CHARLES TOLLISON, AUDIT MANAGER

Synopsis Charles Tollison was in the midst of completing a tough audit engagement when he was told by his office managing partner that he had been passed over for promotion to audit partner. This was the second consecutive year that Tollison, an audit manager, had failed to be promoted to partner by his employer, a large international accounting firm. Although the office managing partner promised to “call in all favors” to win a promotion for him the following year, Tollison realized that he had little chance of being promoted to partner after having been rejected twice. One option available to Tollison was accepting a position as a permanent senior manager with his employer. In Tollison’s mind, that option was comparable to having “career failure” stenciled on his office door.

Like many hard-working auditors who rise through the employment ranks of their firms, Tollison was primarily a “technician” instead of a “rainmaker.” Tollison could be counted on to answer the most contentious technical accounting and auditing issues that arose on engagements in his office.

But, unlike his friend Craig Allen, who had been promoted to partner, Tollison was not proficient at obtaining new clients for his firm. Clearly, his employer valued client development skills much more than technical skills. And why not? If partners do not obtain new clients for their firms, those firms will not thrive economically. Then again, without the technical skills of individuals such as Tollison, how can accounting firms offer the highest quality professional services to their clients?

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Case 6.6 Charles Tollison, Audit Manager 317 Charles Tollison, Audit Manager--Key Facts 1. Charles Tollison was an audit manager with a large international accounting firm who had just learned that he had been passed over for promotion to audit partner for the second consecutive year.

2. Tollison was a “technician,” that is, an individual with an extensive knowledge of technical accounting and auditing issues.

3. Tollison also had a reputation as a “micro-manager” on his engagements and for often working excessive amounts of overtime to complete his jobs on time.

4. Craig Allen, Tollison’s friend and fellow audit manager who was promoted to audit partner, had a reputation as a “rainmaker”—an individual proficient in client development.

5. Several years before Tollison was nominated for promotion to partner, his mentor, an audit partner in the firm, had resigned and accepted a position with a client.

6. One option available to Tollison was remaining with his firm as a permanent senior audit manager.

7. Tollison viewed accepting a permanent manager position with his employer as equivalent to stamping “career failure” on his office door.

Instructional Objectives 1. To examine the professional work role of an audit manager with a large international accounting firm.

2. To identify the key factors that large accounting firms consider when making partner promotion decisions.

3. To examine the trade-offs that public accountants must make between their professional work roles and personal lives.

4. To identify the advantages and disadvantages of the “up or out” promotion policy of most large accounting firms.

Suggestions for Use The key issue in this case is whether technical skills or client development skills should be the most important factor in determining whether an audit manager is promoted to audit partner. My students typically come down in favor of technical skills. They generally overlook the fact that a public accounting firm, although a professional endeavor, is also a business. During auditing courses, instructors tend to focus heavily or almost exclusively on the technical and ethical dimensions of public accountants’ work roles. This case provides an opportunity to introduce students 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.

318

Case 6.6 Charles Tollison, Audit Manager

important “business side” of public accounting.

Suggested Solutions to Case Questions 1. Students typically have strong and often conflicting opinions on this issue. The majority of my students generally maintain that Tollison was qualified to be promoted to partner given his strong work ethic, dedication to the firm, and excellent technical skills. However, these students are, of course, slighting the “business side” of public accounting. One or more students will typically suggest that the ultimate survival of an accounting firm depends on its ability to obtain new clients. Thus, Tollison may have been a questionable choice for promotion since he apparently did not have the skills or, possibly, desire necessary to “carry his own weight” in the client development area.

2. Tollison even admitted to himself that he probably did not have the profile that partners in his firm were looking for in candidates for promotion. Thus, Tollison apparently was aware of the “rules of the game” for promotion to partner. In some respects, he had only himself to blame if he did not focus sufficient time and effort on client development. I believe this is an important point to raise with students. As professionals, they will have to assume personal responsibility for taking the proper steps to ensure that they accomplish their career goals.

Some of my students have suggested that Tollison was possibly being “strung along” by his firm.

In particular, students question whether Tollison’s office managing partner was simply attempting to get one more year of hard work out of Tollison by encouraging him to “go up” for partner the following year. On the other hand, the office managing partner did raise the possibility that Tollison could remain with the firm as a permanent senior manager, which gave Tollison a reasonable alternative to leaving the firm and seeking employment elsewhere.

3. Following are criteria that my students have identified as being relevant to partner promotion decisions with large international accounting firms: (Note: Many of these criteria overlap.) a. b. c. d. e. f. g. h. i. j. k.

Client development skills Technical skills Interpersonal skills Dedication to the firm Willingness to accept difficult assignments The degree to which the individual is a “team player” Personal integrity Ability to complete assignments on time and within budget Reputation in the business community Willingness to adapt to changing circumstances within the firm and the profession Creativity and innovation

What I like to do in class is have students identify a list of criteria relevant to partner promotion decisions, such as the list just presented. After listing these criteria on the board, then we have a roundtable discussion (debate) in which we rank order these criteria in terms of their importance.

This exercise forces students to make conscious decisions regarding which of these factors are most important in partner promotion decisions and to defend those choices. © 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 6.6 Charles Tollison, Audit Manager 319 One would expect smaller accounting firms to place different weights on the factors relevant to partner promotion decisions. For example, being a “team player” is an important attribute for any partner candidate but probably more so for a partner candidate in a small firm. Likewise, smaller firms may face unique circumstances that impact their partner promotion decisions. For example, if the existing partners of a small firm all have excellent client development skills, that firm may place a disproportionate emphasis on ensuring that the next individual promoted to partner has strong technical skills.

4. The key advantage of an “up or out” promotion policy, at least theoretically, is the vitality that it creates within an organization. That is, the members of an organization realize that to remain with the organization they have to continually strive to improve, to continually make progress toward the “next level.” This environment tends to spawn energy, creativity, and hard work on the part of an organization’s members. Individuals who do not “carry their own weight” become designated as “dead weight” and are eventually culled from the organization.

An up or out promotion policy also has several drawbacks. For example, this policy may spawn excessive competition among employees. That is, employees may perceive that the most effective way to win a promotion is to “backstab” a peer by undercutting his or her work in some way. This policy may also demoralize certain employees, particularly those who are overly stressed by a competitive or, at least, intense work environment. Clearly, demoralized employees are less likely to perform up to their potential. Probably the biggest drawback of an up or out promotion policy is that it forces certain employees who have skills that are extremely important to an organization to leave that organization. A perfect example is Charles Tollison. Tollison, although not a perfect audit manager, was an extremely important resource for his firm and his office. Tollison’s firm had invested heavily in his professional skills and ultimately saw those skills simply “walk out the door.”

[Note: Tollison accepted a position as a controller with a client a few months after being rejected for promotion to partner the second time.]

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Case 6.7 Madison Wells, Audit Manager 320

CASE 6.7

MADISON WELLS, AUDIT MANAGER

Synopsis In early March, Madison Wells and her subordinates were wrapping up the audit of Le Prix Oil & Gas, a publicly-owned company based in Texas. The Le Prix engagement was the first audit on which Madison had served as an audit manager. A few days earlier, Le Prix had issued its earnings press release and filed its Form 10-K with the SEC. Daniel Alanis, the Le Prix audit engagement partner and Madison’s immediate superior on the Le Prix audit team, signed the unqualified audit opinion included in Le Prix’s 10-K. The Le Prix audit was challenging for Madison for several reasons in addition to the fact that it was her first as an audit manager. Le Prix was a new audit client of Madison’s firm, which meant that everyone on the audit team, including herself and Alanis, were unfamiliar with the company.

Madison had only been assigned to two oil and gas clients during the five years that she had been with her firm and those assignments had been early in her career when she was an entry-level auditor. During mid-January, Madison’s principal subordinate on the audit team, William Blackwell, the supervising audit senior, had shocked her and Daniel Alanis by resigning. Because of Blackwell’s resignation, Madison had been forced to step in and serve as the audit manager and the de facto audit senior during the final six weeks of the audit.

Even more problematic for Madison was the fact that Le Prix was a high-risk audit client. A sudden drop in oil prices had slashed Le Prix’s revenues and forced the company to downsize its operations. The downturn in the company’s operating results was particularly troublesome since Le Prix was highly leveraged. A final factor that enhanced the audit risk posed by Le Prix was the management team’s aggressive stances on accounting and financial reporting issues. Over the prior seven years, Le Prix had twice found it necessary to issue financial restatements.

Madison discovered during the wrap-up phase of the Le Prix audit that Blackwell had signed off on an audit procedure that had not been totally completed, namely, reviewing the minutes of Le Prix’s post-year-end board of directors meetings. She then learned that the minutes of the February board meeting reported a “technical violation” of certain long-term debt covenants. That violation meant that the company’s large long-term loan should have been classified as a current liability in its financial statements that had been filed a few days earlier with the SEC. When Madison informed Alanis of this problem, the partner exploded in a fit of angry expletives directed at her. Madison understood Alanis’s anger but resented his abusive language. The pressing issue faced by Madison and Alanis was what to do regarding the major flaw in Le Prix’s financial statements that were now © 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 6.7 Madison Wells, Audit Manager 321 in the public domain. In fact, Alanis refused to discuss the issue with Madison and she never found any evidence that Le Prix disclosed the debt covenant violations or remedied them in any way.

Madison Wells, Audit Manager--Key Facts 1. Madison Wells served as the audit manager on the audit engagement team for Le Prix Oil & Gas; in early March, Madison and her subordinates were wrapping up the audit.

2. A few days earlier, Le Prix had filed its Form 10-K for the year under audit with the SEC; that 10-K included financial statements and an accompanying unqualified audit opinion signed by Daniel Alanis, the audit engagement partner.

3. This was the first year that Madison’s Big Four employer had served as Le Prix’s audit firm; Le Prix’s primary lender had required the company to replace its regional audit firm with a Big Four firm.

4. Le Prix was a high-risk audit client; the company was highly leveraged and its operating results during the year under audit had been adversely impacted by a sudden drop in oil prices.

5. Le Prix was also very aggressive when it came to accounting and financial reporting issues; twice in the previous seven years the company had been forced to issue financial restatements.

6. A final factor that complicated the Le Prix engagement for Madison was the unexpected resignation of William Blackwell, the supervising audit senior; for the final six weeks of the audit, Madison had to serve as both the audit manager and audit senior on the engagement.

7. Shortly before completing the wrap-up phase of the Le Prix audit, Madison discovered that Blackwell had signed off on an audit step that had not been totally completed; that step involved reviewing the minutes of Le Prix’s post-year-end board of directors meetings.

8. After reviewing the minutes of an early February board meeting, Madison discovered that Le Prix had violated certain long-term debt covenants at the end of the year; those violations should have caused the debt to be reflected as a current liability in the company’s year-end financial statements.

9. Madison then determined that Blackwell had failed to properly test Le Prix’s compliance with its long-term debt covenants which had prevented him from discovering the violations of those covenants.

10. When Madison informed Daniel Alanis of Le Prix’s debt covenant violations, the young partner exploded in anger and directed a series of expletives at her because he held her responsible for the audit team’s failure to uncover those violations.

11. Madison understood why Alanis was so upset, namely, because Le Prix’s audited financial statements filed with the SEC were, in his words, “wronger than wrong;” nevertheless, Madison © 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 6.7 Madison Wells, Audit Manager 322 resented the abusive language directed at her by the audit partner.

12. Alanis subsequently refused to discuss the debt covenant violations with Madison and she never found any evidence that Le Prix disclosed or otherwise remedied that problem; several months later, Madison resigned and accepted a financial analyst position with a major downtown bank.

Instructional Objectives 1. To illustrate the need for auditors at all levels to treat their colleagues with respect and civility.

2. To identify the measures that auditors must take when they discover circumstances unknown to them at the audit report date that might have affected the audit report they issued.

3. To distinguish between and among “honest mistakes,” negligence, and recklessness on the part of auditors.

4. To review the nature and purpose of the workpaper review process.

5. To examine the responsibility of individual auditors to ensure that all appropriate steps have been taken to address and resolve material misrepresentations discovered ex post in a client’s audited financial statements.

Suggestions for Use The key issue raised by this case is the need for auditors to treat each other with a proper measure of dignity and respect even when—or especially when—extremely problematic and stressful circumstances arise during an audit. Unfortunately, because auditors are human, they sometimes fall prey to their baser instincts during such circumstances. That was certainly true in this case. This case presents an ideal set of circumstances in which to use a role playing exercise among your students. Consider having two of your students recreate the telephone conversation between Madison Wells and Daniel Alanis in which she informs him of Le Prix’s debt covenant violations— instead of a telephone conversation, you might have Madison tell Alanis the bad news during a faceto-face meeting in the audit conference room. To help students better understand the interpersonal dynamics of such heated confrontations, repeat this exercise with multiple pairs of your students by changing the gender of the two auditors. Set up role play scenarios involving Madison vs. Danielle, Mark vs. Danielle, and Mark vs. Daniel.

Another important issue addressed by this case is the measures auditors must take when they discover circumstances that existed at the audit report date that, if known at the time, might have impacted that report. In this case, this issue is posed by the year-end debt covenant violations by Le Prix that Madison discovered three days after the company filed its annual Form 10-K—and the enclosed audited financial statements—with the SEC. As spelled out in the suggested solution to the first case question, the professional standards are very explicit on what is required of auditors in such circumstances. The case doesn’t identify what Daniel Alanis did, if anything, to address the debt covenants violation by Le Prix. Consider surveying your students and asking them to identify what © 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 6.7 Madison Wells, Audit Manager 323 they believe Alanis did after learning of the debt covenant violations. For example, did he discuss the problem with Le Prix’s senior management? Alternatively, did he consult with his office managing partner, other partners in his practice office, or with technical experts in his firm’s headquarters office? Or, did he simply “sit tight” and accept the resolution to the problem adopted

by Le Prix’s board? Ask students to identify and evaluate the advantages and disadvantages of each of these alternatives.

Suggested Solutions to Case Questions 1. AS 2905, “Subsequent Discovery of Facts Existing at the Date of the Auditor’s Report,” of the PCAOB’s auditing standards is the relevant section of the professional standards for an SEC registrant. AS 2905.06 describes auditors’ responsibilities when dealing with a cooperative client in this context, while AS 2905.08 discusses auditors’ responsibilities when dealing with an uncooperative client.

When the client cooperates with the auditors, the auditors should first determine the impact of the newly-discovered facts on the relevant financial statements. Then, if deemed necessary, those financial statements and the accompanying audit report should be revised and reissued as promptly as possible. If the impact on the financial statements cannot be promptly determined, the client should contact third parties known to be relying on those financial statements. Those parties should be informed that the financial statements and accompanying audit report should no longer be relied upon and that the revised financial statements and a revised audit report will be issued as soon as possible. In addition, the client should be advised to discuss the matter with the SEC and other relevant regulatory authorities.

If the client refuses to cooperate with the auditors in making disclosure of the subsequently discovered facts (assuming that the auditors have deemed that disclosure necessary), the auditors should first notify each member of the client’s board of directors of that refusal and the steps the auditors are required to take to prevent future reliance on the audit report that accompanied the given financial statements. AS 2905.08 observes that the auditors’ next course of action will depend “upon the degree of certainty of the auditor’s knowledge that there are persons who are currently relying or who will rely on the financial statements and the auditor’s report, and who would attach importance to the information, and the auditor’s ability as a practical matter to communicate with them.”

Generally, the auditors should notify the client and relevant regulatory agencies that the audit report on the relevant financial statements should no longer be relied upon. The auditors should also take steps to notify “each person” known by the auditors to be relying upon the financial statements that the accompanying audit report should no longer be relied upon. In the disclosures made to these parties, the auditors should “describe the effect the subsequently acquired information would have had on the auditor’s report if it had been known to him at the date of his report and had not been reflected in the financial statements.”

2. Aren’t we all entitled to make “honest mistakes” occasionally? Even professionals? Granted, at some point if an individual, particularly a practicing professional, is making “honest mistakes” routinely, then we have to question that individual’s competence. [Note: The following question is closely related to this question.] © 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 6.7 Madison Wells, Audit Manager 324 3. There are multiple questions in my casebook that address the general issue of auditor mistakes, negligence, and intentional misconduct. For many years, I have used the following definitions of negligence, recklessness, and fraud in responding to those questions. Granted, in the context of this question, fraud on the part of the auditors was not an issue. Notice that following each of the definitions, I provide an example of the given malfeasance or 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 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 often 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, he doesn’t investigate that apparent 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.

A key issue in this context is whether professionals are “entitled” to make “honest mistakes.”

The concept of “due care” addressed in the well-known legal treatise Cooley on Torts is often applied to answer that question. According to Cooley on Torts, a professional “assumes the duty to exercise” his or her skills “with reasonable care and diligence.” However, professionals are not “infallible” and should not be held liable for “pure errors of judgment.” I take the “infallible” reference to suggest that professionals are entitled to make “honest mistakes” . . . occasionally.

Likewise, auditors are entitled to make (occasional) “pure” errors in judgment.” No doubt, at some point, if a professional routinely makes “honest mistakes” and/or “errors in judgment,” then we have to consider whether his or her conduct could be characterized as “negligent.”

Now, how should we characterize the mistakes made by William Blackwell and Madison Wells?

Turning first to Blackwell, his failure to use the wrong loan agreement to test Le Prix’s compliance with its key debt covenants was not an “error in judgment” but rather a mistake. Would we refer to it as an “honest mistake”? Almost certainly. Blackwell didn’t gain anything by using the wrong loan agreement since he would have been required to exert the same amount of effort regardless of which loan agreement he used for this test. Was he guilty of not exercising “due care”? (Ultimately, judges and juries are often called on to answer such questions.) One could certainly make an argument that he was, in laymen’s terms, “careless” in choosing the wrong loan agreement for the purposes of that test. But mitigating this carelessness, to some degree, was the fact that the permanent workpaper files included both the old and the new loan agreements. Someone—possibly Blackwell, himself— © 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 6.7 Madison Wells, Audit Manager 325 should have defaced the old agreement to lower the likelihood of the mistake that he made. The other “mistake” Blackwell made was signing off on the given audit program step prior to ensuring that the minutes of all post-year-end board meetings had been reviewed. Was this simply an “honest mistake”? Was it “careless” on his part? Students have pointed out that one mistake is a mistake, while two mistakes is a trend. Other students have also pointed out that because Blackwell had “one foot out the door” his overall professionalism and attention to detail may have been affected. It seems that the “prudent practitioner” in such circumstances would have, at a minimum, included a written note in the audit program indicating that the minutes of all post-year-end board meetings through a certain date had been reviewed and that if there were any subsequent board meetings prior to the issuance of the client’s financial statements, those minutes would have to be reviewed as well.

Now, what about Madison Wells? We can identify two “mistakes” that she made as well. First, prior to the filing of Le Prix’s audited financial statements with the SEC, she failed to recognize that William Blackwell had “prematurely” signed off on the audit step referred to previously. Was that an “honest mistake,” “carelessness,” or negligence? Given the circumstances, I would suggest that the oversight was at least somewhat understandable—particularly given the level of stress that she was under due to the high-risk nature of the Le Prix audit. (Amplifying this stress, no doubt, were the “tight” time budgets faced by the Le Prix auditors—which were likely a consequence of the “lowballed” audit fee for the engagement.) Would other audit managers have “caught” this mistake?

Almost certainly some percentage would have, but, again, I would suggest that because of the circumstances this was an understandable mistake on her part. [Note: In reviewing this case, one instructor pointed out that the audit procedure in question, namely, reviewing the minutes of postyear-end board of directors’ meetings, is an extremely important procedure. As a result, the senior members of an audit engagement team should be particularly focused on ensuring that this procedure was performed and performed properly. This observation not only enhances Madison’s culpability or responsibility for the given oversight but that of Daniel Alanis as well.]

What about Madison’s failure to identify the serious mistake made by Blackwell when he was testing Le Prix’s compliance with the bond covenants? That “mistake,” at a minimum, should be labeled an “error in judgment,” in my view. Madison consciously decided not to do a detailed review of Blackwell’s work given her respect for him. Was that a reasonable decision? One could argue that this was also a particularly important audit test and that its level of importance was magnified by Le Prix’s deteriorating operating results and the company’s high degree of leverage.

Given these circumstances, it seems that a reasonable argument could be made that Madison was negligent.

Note: One could also argue that the audit partner, Daniel Alanis, should have been “dinged” for failing to review the details of Blackwell’s test. For insight on the level of responsibility of audit managers versus audit partners for audit-related oversights, you might refer to the AA Capital Partners case (Case 1.13). In that case, a federal judge ruled that the onus for an oversight during an audit fell on the audit manager not the audit engagement partner. The judge specifically noted that the audit manager, not the audit partner, was the individual “primarily responsible” for ensuring that the given audit “complied with GAAS.” The judge based that conclusion on the fact that the audit partner was entitled to rely on the work and judgment of the audit manager since the latter individual was more directly involved in the audit.

4. The audit review process is the primary quality control mechanism for an independent audit. AS © 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 6.7 Madison Wells, Audit Manager 326 1201, “Supervision of the Audit Engagement,” of the PCAOB auditing standards requires the audit engagement partner (and other engagement team members having supervisory responsibilities) to “review the work of engagement team members to evaluate whether: (1) The work was performed and documented; (2) The objectives of the procedures were achieved; and (3) The results of the work support the conclusions reached” (AS 1201.05). AS 1201.06 identifies four factors that should be considered in determining the “extent of supervision necessary for engagement team members to perform their work as directed.” (These four factors would also certainly impact how thoroughly supervisors should review a given subordinate’s work.) The four factors are the “nature of the company, including its size and complexity,” “the nature of the assigned work,” “the risks of material misstatement,” and “the knowledge, skill, and ability of each engagement member.” Notice that the final factor was certainly relevant to the Le Prix case. Because Madison Wells respected William Blackwell’s audit skills, she apparently decided that a detailed review of the debt covenants workpaper was not necessary. In turn, in reviewing the debt covenants workpaper, Daniel Alanis likely relied on Blackwell’s apparent audit skills as well and the fact that Madison had already signed off (approved) the workpaper.

5. Students will have different responses to this question. But the key issue in this context that I want students to address is that auditors—even when they make serious blunders on an engagement—should not be verbally or psychologically abused by their superiors. It is certainly in the interest of accounting firms to “train” their partners to treat subordinates civilly because the lack of proper civility by partners toward subordinates could result in serious legal liability for those firms. [Note: Almost certainly, Alanis was angry with himself in addition to being angry with Madison and William Blackwell. As pointed out in a suggested solution to a prior question, reviewing the minutes of post-year-end board of directors minutes is a critical audit procedure. That procedure is so important, in fact, that each senior member of the audit engagement team should consider independently ensuring that it was properly performed. Obviously in this case, Alanis did not do that. Likewise, testing a client’s compliance with long-term debt covenants is a significant audit procedure. Again, the senior members of an audit team, at a minimum, should pay particularly close attention to the results of that test when reviewing the relevant workpapers.]

6. Madison had a responsibility to ensure that the matter was dealt with properly given the key role that she played during the Le Prix audit. In particular, she should have been more insistent that Alanis tell her how the matter was resolved. If he continued to refuse to tell her how or whether the matter was resolved, she had other options, one being to raise the issue with the office managing partner. Another possibility was for her to formally dissociate herself from that matter by documenting the relevant circumstances in a workpaper that was then included in the Le Prix workpaper files.

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Case 6.8 Tillman Rollins, Office Managing Partner 327

CASE 6.8

TILLMAN ROLLINS, OFFICE MANAGING PARTNER

Synopsis Tillman Rollins serves as the OMP and director of the auditing practice for a small and remote Big Four office somewhere in the Mountain Time Zone. The major challenges faced by Rollins are ensuring that his office operates profitably and building/maintaining a high degree of morale among his 40 or so subordinates, two-thirds of whom are auditors. A personal goal that is interwoven with those two challenges is retaining his position. The 57-year-old Rollins and his wife spend most of their weekends on their working ranch which is some 70 miles from his practice office. If Rollins loses his OMP position, he will almost certainly be forced to transfer far from his beloved ranch.

The case opens in early December just as busy season is beginning. Rollins faces a staffing crisis for his small office. The office unexpectedly picked up a new year-end audit client during October; in late November, the office’s largest audit client, Harsha Manufacturing, requested Rollins’ office to perform an “acquisition audit” on a company that it was planning to acquire. That acquisition audit will overlap with the busy season since it must be completed by March 15.

At an impromptu meeting of his office’s recruiting committee, Rollins bemoans the fact that the audit staff is probably short by two entry-level auditors, which is a significant shortage given the modest size of that staff. The recruiting committee consists of Rollins; Sophie White Eagle, an audit manager; and Jerry Martin, a “heavy” audit senior. Rollins informs White Eagle and Martin that a young man by the name of Larry Smith, who just graduated from a nearby state college, has recently inquired regarding a job. Rollins asks White Eagle and Martin to have lunch with Smith a few days later and to provide him feedback regarding their assessment of Smith.

After meeting with Smith, both White Eagle and Martin advise Rollins not to offer the young man a job. Despite Smith’s impressive grades and industriousness—he personally financed most of his college degree, White Eagle and Martin don’t believe he is “cut out” for a career in the Big Four “world.” Why? Because he is undersocialized—among other red flags, he wore white athletic socks to his job interview. Rollins tells White Eagle and Martin that the overriding need for a “warm body” justifies hiring Smith. Rollins also maintains that hiring Smith would give him an opportunity to prove that he belongs in the Big Four and that even if Smith doesn’t “hack it,” his resume will forever reflect that he worked for one of the world’s leading accounting firms. In fact, before receiving the requested feedback regarding Smith, Rollins had already hired the young man.

Smith performs admirably during the long busy season—he was assigned to the Harsha audit that © 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 6.8 Tillman Rollins, Office Managing Partner 328 was overseen by White Eagle and Martin. Despite White’s job performance, Rollins fires him in late April on the brink of the summer when chargeable hours are “scarce.” That decision infuriates White Eagle who believes that Smith was treated unfairly by Rollins.

Tillman Rollins, Office Managing Partner--Key Facts 1. Tillman Rollins served as the OMP and director of the audit practice for a small and remote Big Four office located in the Mountain Time Zone.

2. On Saturday, December 11, Rollins called an impromptu meeting of the audit staff recruiting committee which included himself; Sophie White Eagle, an audit manager; and Jerry Martin, a “heavy” audit senior.

3. Rollins was concerned about the understaffing of the office’s audit staff that was already causing his subordinates to work an excessive amount of overtime.

4. The following Monday, Rollins planned to interview Larry Smith, a young man who had inquired about a job with the firm; Smith had just graduated from a state college at which Rollins’ office did not recruit because of the small number of accounting graduates the school produced each year.

5. White Eagle and Martin had lunch with Smith on the day of his interview; they recommended to Rollins that Smith not be hired because he was socially backward and not well suited for a career with a Big Four accounting firm.

6. Rollins agreed that Smith was not “polished” but maintained that he should be hired anyway because of the critical understaffing problem faced by the office.

7. In making the case to hire Smith, Rollins argued that doing so would give Smith a chance to prove that he belonged in the “Big Four world” and, at a minimum, allow him to list experience with a Big Four firm on his resume for the remainder of his career.

8. White Eagle was unconvinced by Rollins’ arguments; Rollins then announced that he had already offered Smith a job and that the young man had accepted the offer.

9. Smith was assigned to an audit that was overseen by White Eagle and Martin; he performed admirably on that job.

10. Rollins’ audit staff suddenly went from undermanned to overstaffed when his office lost one of its largest audit clients near the conclusion of the busy season; the overstaffing concerned Rollins because in the summer months chargeable hours were “scarce.”

11. Because of the overstaffing, Rollins decided to dismiss Smith; that decision upset White Eagle who believed that Smith had not been treated fairly. © 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 6.8 Tillman Rollins, Office Managing Partner 329

12. During a testy exchange, Rollins told White Eagle that as OMP he was responsible for making decisions that benefited the entire practice office rather than any one individual; one month later, White Eagle resigned to pursue other employment opportunities.

Instructional Objectives 1. To examine the professional work role and responsibilities of an office managing partner (OMP) of a Big Four practice office.

2. To compare and contrast the work role and responsibilities of an OMP with those of an audit partner.

3. To examine the factors that influence employment decisions made by accounting firms.

4. To examine the responsibility of accounting firms to treat job candidates and existing employees fairly when making hiring and employee retention decisions.

5. To identify measures that accounting firms can take to increase the likelihood that new employees will be successful.

Suggestions for Use Recruiting decisions of Big Four firms have a significant impact on many of our students. This case provides some insight on the recruiting process and subsequent employment decisions of those firms. As a prelude to this case, I like to involve students in a freewheeling discussion of the recruiting process for accounting majors. In my graduate course, approximately 50 percent of my students have already completed the recruiting process and accepted a future job position, but the other one-half of my students have not. An in-depth discussion of the recruiting process is extremely beneficial for these latter students. FYI, the large majority of my graduate students accept positions in public accounting. Of these students, at least 70-80 percent typically “go Big Four.”

I initiate discussion of the recruiting process by asking the “job-accepted” (JA) students to volunteer some of their relevant job-search experiences. I ask them to identify the features of the recruiting process that they most enjoyed and those that were less than enjoyable. I also ask the JA students to address the specific factors in that process which proved to be decisive in their job choices. I discourage students from identifying specific employers when discussing their recruitment experiences, but I do ask them to preface their comments by indicating whether the anecdote or information they are providing relates to a Big Four firm, a non-Big Four accounting firm, or a nonaccounting firm employer. During this discussion, I encourage those students still involved in the recruitment process to ask questions of their more experienced classmates. I refer to this as a freewheeling discussion because once I initiate the discussion, it often takes off in various directions.

Suggested Solutions to Case Questions © 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 6.8 Tillman Rollins, Office Managing Partner 330 1. The third case question for the “Charles Tollison, Audit Manager” case (Case 6.6) requires students to identify the criteria that international accounting firms should use when evaluating individuals for promotion to partner. Listed next are the criteria that I identify in the solution to that case question. These criteria are not necessarily listed in order of importance. (I allow my students to hammer out what they consider to be the proper order of the criteria—if their list proves to be incomplete, I sometimes nudge them to consider other relevant factors from my list.) As indicated in the Tollison solution, what I typically do in addressing the third case question is begin by listing individual criteria identified by students on the board or overhead and then engage the students in a roundtable debate that culminates in a consensus ranking for the entire class. a. b. c. d. e. f. g. h. i. j. k.

Client development skills Technical skills Interpersonal skills Dedication to the firm Willingness to accept difficult assignments and assignments that include considerable travel and/or overtime Being a “team player” Personal integrity Ability to complete assignments on time and within budget Reputation in the business community Willingness to adapt to changing circumstances within the firm and the profession Creativity and innovation

Now, given the above list, let’s address the initial issue raised by this question, which is what personal traits should an OMP possess. I would argue that every entry on this list could be considered an important personal trait, attribute, or skill for an OMP to possess. However, certain of the skills are more important for an OMP to possess than a “generic” audit partner. I would list the following traits or skills as being indispensable for OMP’s.

Client development skills Interpersonal skills Dedication to the firm Being a “team player” Personal integrity Reputation (strong) in the business community Willingness to adapt to changing circumstances within the firm and the profession The remaining traits, such as technical skills, are certainly important but, in my view, not “indispensable.” FYI, some students will typically suggest that strong technical skills are an indispensable trait for OMP’s to possess. My experience suggests that technicians generally aren’t chosen to serve as OMP’s. Instead, the major international accounting firms typically choose partners who have strong client development skills and interpersonal skills to fill 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 6.8 Tillman Rollins, Office Managing Partner 331

2. The AICPA Code of Professional Conduct provides the following comments, among others, regarding the ethical principle of “integrity.”

“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 honest difference of opinion; it cannot accommodate deceit or subordination of principle.” ET 0.300.040.03 A key issue in this case is whether Tillman Rollins was “honest and candid” with Larry Smith when he offered him a job. Most students tend to suggest that Rollins’ behavior did not meet that standard and that he “subordinated” an important ethical principle (integrity/honesty) to personal gain.

Recall that the argument used by Rollins to justify his decision to hire Smith and then to subsequently fire him was “the greater good.” From a strictly utilitarian point of view, one could certainly contend that Rollins’ decision was justified. However, the discussion of integrity in the Code of Professional Conduct does not seem to embrace a utilitarian perspective.

Some students typically point out that although Rollins used a greater good or utilitarian point of view to justify his decisions vis-à-vis Larry Smith, his own personal (selfish?) interest was also served by that decision. By hiring Smith, he was catering to the interests of his existing subordinates; by firing Smith, he was catering to the economic interests of his firm/office. In each case, Rollins directly benefited because the given decision helped him strengthen (retain?) his position as OMP, which was his overriding personal goal.

3. This question is actually a follow-up to the prior question. Typically, the overriding issue that surfaces in students’ discussion of this question is whether one would prefer working for a professional who strictly embraces the integrity/honesty virtue or whether they would prefer an OMP who makes decisions by applying a greater good or utilitarian perspective. Many students strenuously argue that most successful businesses succeed because they have been founded and managed by individuals who apply what may be perceived as a “cutthroat” approach to doing business, that is, individuals who apply a “whatever is best for the business” mentality to making decisions. This latter mentality seems derived from a utilitarian perspective with the exception that the “greater good” is defined as what is in the best interests of the given business.

4. The key term in responding to this question is “mentoring.” Many, if not most, offices of major accounting firms have a formal or informal mentoring program. Such programs can be invaluable for individuals such as Larry Smith. The mentoring that Larry needed, of course, was of the nontechnical variety. Because he had “lived off the grid,” he needed guidance from a close friend or associate on how to adapt to the culture of the Big Four “world.” A key facet of that culture is selfpresentation, that is, proper attire and etiquette. You may recall that in the Ann Hopkins case (Case 7.4 in the 10th edition of my casebook), her personal etiquette or manner was apparently the key factor that blocked her from being promoted to partner. Subsequent to the decision to not promote © 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 6.8 Tillman Rollins, Office Managing Partner 332 her, Hopkins agreed to undergo a “quality control review” to identify deficiencies in specific interpersonal and other job-related skills that she needed to remedy. For whatever reason, that program was not successful. Of course, the punch line to the Hopkins case is that a federal judge ruled that she had been improperly denied a partnership position by her employer, Price Waterhouse.

In this case, Tillman Rollins’ firm/office may not have a legal obligation to provide individuals such as Larry Smith with a “quality control review” and subsequent follow-up program, but it seems reasonable to suggest that the firm/office has a moral and professional responsibility to do so.

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Case 7.1 Ligand Pharmaceuticals 332

CASE 7.1

LIGAND PHARMACEUTICALS

Synopsis In December 2007, the PCAOB sanctioned Deloitte & Touche. The sanctions, which included a $1 million fine, were noteworthy because it was the first time that the new federal agency had punished a Big Four accounting firm. The PCAOB sanctioned Deloitte for its alleged failure to take “meaningful steps to assure the quality of audit work” on the 2003 audit of Ligand Pharmaceuticals, a San Diego-based company. At the time, Ligand described itself as an “emerging R&D and royaltydriven biotechnology company.”

The PCAOB’s principal complaint against Deloitte was that the firm had not taken appropriate measures to ensure that the 2003 Ligand audit was properly staffed. In particular, the PCAOB alleged that the Ligand audit engagement partner was not qualified to serve in that capacity. In fact, before and during the 2003 Ligand audit, several Deloitte executives had considered and taken explicit measures to encourage the Ligand audit engagement partner to resign from Deloitte. These Deloitte executives had included the firm’s National Audit Managing Partner. Because the Deloitte executives failed to force the Ligand audit partner to resign, that individual supervised the entire 2003 audit and signed the unqualified opinion issued on the company’s 2003 financial statements. A subsequent investigation revealed that those financial statements contained material and seemingly obvious errors.

In addition to sanctioning Deloitte, the PCAOB also sanctioned the Deloitte partner who had supervised the 2003 Ligand audit. The PCAOB sanctioned the partner for, among other things, allegedly failing to exercise proper skepticism and due professional care during the course of that audit. In late 2007 when the PCAOB announced these sanctions, the Ligand audit partner was no longer associated with Deloitte.

© 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 7.1 Ligand Pharmaceuticals 333 Ligand Pharmaceuticals--Key Facts 1. The Enron and WorldCom debacles prompted the federal government to pass the SarbanesOxley Act of 2002.

2. Among the reforms resulting from the SOX statute was the creation of the Public Company Accounting Oversight Board (PCAOB) to oversee the independent audit function.

3. The PCAOB’s regulatory mandate includes registering and monitoring accounting firms that audit public companies; establishing auditing, ethical, and quality control standards for those firms; and carrying out disciplinary investigations.

4. The creation of the PCAOB and other regulatory reforms introduced by SOX further complicated the already stressful role of audit partners with major accounting firms.

5. James Fazio, a Deloitte audit partner, served for several years as the audit engagement partner for Ligand Pharmaceuticals, a San Diego-based developmental stage company involved in the biotechnology industry.

6. During the 2003 Ligand audit, Fazio authorized the issuance of an unqualified opinion on Ligand’s financial statements despite considerable evidence indicating that the company’s year-end allowance for sales returns was materially understated.

7. While reviewing Ligand’s 2004 first-quarter financial statements, Fazio obtained additional evidence indicating that the company’s year-end allowance for sales returns had been materially understated but failed to recommend that Ligand recall its 2003 financial statements.

8. Prior to the beginning of the 2003 Ligand audit, members of Deloitte’s management had suggested that Fazio no longer be allowed to supervise audits of public companies.

9. Shortly before the 2003 audit was completed, several top Deloitte partners called on Fazio to resign from the firm because he was perceived as a “quality risk.”

10. Despite the concerns being expressed regarding Fazio’s competence, he was allowed to remain with the firm and continued to serve as Ligand’s audit engagement partner.

11. In May 2005, Ligand announced that it would restate its financial statements for 2002, 2003, and the first three quarters of 2004 due to material errors that resulted principally from improper revenue recognition practices.

12. In late 2007, Deloitte became the first Big Four firm punished by the PCAOB when the agency sanctioned Deloitte for allowing Fazio to remain as Ligand’s audit engagement partner; Fazio was also sanctioned and was barred from being associated with a PCAOB-registered firm for two 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 7.1 Ligand Pharmaceuticals 334 Instructional Objectives 1. To examine the impact that SOX and PCAOB have had on major accounting firms and individual auditors.

2.

To identify the regulatory responsibilities of the PCAOB.

3.

To examine the role and responsibilities of an audit engagement partner.

4. To demonstrate the need for accounting firms to establish an effective quality control system to ensure that high quality audits are performed.

5.

To document the need for auditors to be particularly cautious on high-risk audit engagements.

Suggestions for Use

This is a landmark case in that it was the first in which the PCAOB sanctioned one of the Big Four accounting firms. You can use this case in a variety of ways. First, you can use it to highlight auditing issues related to revenue recognition. Second, you could use it to discuss the role of an audit engagement partner and how that role contributes to the successful outcome of an audit. Finally, the case can be used to discuss the evolving role of the PCAOB within the auditing discipline.

Similar to many of the cases in this text, the information available in the public domain leaves certain issues “dangling.” For example, your students may ask you why Deloitte allowed Fazio to remain as the audit engagement partner for Ligand given the serious concerns that had been raised regarding his competency. The sources I used in developing this case don’t address that issue.

Consider assigning your students a group project in which they are required to identify the traits that an audit partner should possess. Require each group to rank order those traits from most to least important. Use the results of this exercise as the basis for a discussion of the professional qualifications of audit partners. (Note: This same exercise is required by Question 3 of Case 6.6, “Charles Tollison, Audit Manager.”)

Suggested Solutions to Case Questions 1. As a caveat, I did not have access to Deloitte’s policy and procedures manual, which means that I do not know specifically how the firm defined “engagement risk.”

Most likely, Deloitte used (or uses) the term “engagement risk” to refer to the overall economic risk that a specific engagement poses to the firm. The audit risk posed by a given client would be the key source of engagement risk. Of course, audit risk is a multiplicative product of inherent risk, control risk, and detection risk. In turn, each of these components of audit risk is influenced or determined by numerous factors or variables. For example, inherent risk is influenced by general economic conditions, the relative health of a given client’s industry, the ethical “profile” of the client’s management team, whether or not the client intends to raise a significant amount of debt or equity capital in the near future, and so on and so forth. Other “non-audit” factors also influence engagement risk. For example, public companies generally pose a higher level of engagement risk © 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 7.1 Ligand Pharmaceuticals 335 than private companies since there is a much larger pool of potential plaintiffs for a public company client. Likewise, among public company clients, larger and higher profile companies would tend to pose a higher level of engagement risk than other public companies.

“How if at all, are auditors’ professional responsibilities affected when a client poses a higher than normal degree of engagement risk?” This is a question that I have posed for other cases in my casebook. My stock answer to this question is that auditors’ professional responsibilities are generally the same across all types of audit engagements. Regardless of whether a client is public or private, large or small, a well-established company or in a developmental stage, auditors have a responsibility to comply with professional auditing standards in completing a given audit engagement.

Granted, client-specific factors and circumstances will influence the complexity of audit planning, internal control evaluation, confirmation procedures, etc., but, in the final analysis, auditors must design and carry out audits to ensure that all applicable auditing standards are satisfied.

2. QC 10.33-34, “Assignment of Engagement Teams,” of the PCAOB’s quality control standards is directly relevant to this question.

“The firm should assign responsibility for each engagement to an engagement partner and should establish policies and procedures requiring that: a. b. c.

the identity and role of the engagement partner are communicated to management and those charged with governance; the engagement partner has the appropriate competence, capabilities, and authority to perform the role; and the responsibilities of the engagement partner are clearly defined and communicated to that individual.” (QC 10.33)

QC 10.A25-A27, “Assignment of Engagement Teams: Engagement Partners,” provides more detail on the competencies and capabilities that audit engagement partners should possess. For example, paragraph A25 observes that “in most cases” engagement partners will have acquired the “necessary competencies through relevant and appropriate experience.” Other sources of those necessary competencies include actual experience in the given industry and academic training. That same paragraph goes on to indicate that in some circumstances an engagement partner may supplement his or her “necessary competencies” through “CPE related to auditing” and “consultation” (typically with experienced professionals in the given firm). Paragraph A26 observes that “The characteristics of a particular client, industry, and the kind of service being provided determine the nature and extent of competencies established by a firm that are expected of the engagement partner.” Finally, paragraph A27 points out that “In practice, the competencies necessary for the engagement partner are broad and varied in both nature and number.” That paragraph then goes on to identify and describe the six specific categories of competencies that engagement partners should possess. Listed next are those six categories. (Refer to QC 10.A27 for more insight on each of these required competencies.)  Understanding of the role of a system of quality control and the Code of Professional Conduct  Understanding of the service to be performed © 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 7.1 Ligand Pharmaceuticals 336  Technical proficiency  Familiarity with the industry  Professional judgment  Understanding the organization’s IT systems In sum, a firm should have in place some system or set of systems to ensure that engagement partners acquire the six categories of competencies just listed. For the large international accounting firms, those systems typically include extensive “on-the-job” training that involves engagement reviews by more experienced partners and elaborate in-house training programs designed specifically for the “competency” needs of engagement partners. These large firms also provide extensive “consultation” resources for engagement partners. The latter resources include staffs of specialists within the given firm’s national headquarters office and selected regional offices. Smaller firms typically rely more heavily on external training programs, including CPE resources, to provide the proper training and experience for their engagement partners.

3. Note: The FASB’s new revenue recognition standard was not in effect at the time that the events in the Ligand case took place. Consequently, the suggested answer to this case question will focus on the “old” revenue recognition principle. If you want, consider having a group of students apply the general five-step process for revenue recognition embedded in the FASB’s new standard to Ligand’s business model.

The overriding accounting concept in this context is the revenue recognition principle. This principle requires that for revenue to be recognized or recorded it must first be realized and earned.

“Revenues and gains are realized when products (goods or services), merchandise, or other assets are exchanged for cash or claims to cash . . . revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues.” [Statement of Financial Accounting Concepts No. 5, “Recognition and Measurement in Financial Statements of Business Enterprises,” paragraph 83.] Another relevant accounting concept in this context is conservatism. This concept generally dictates that when there is considerable doubt regarding whether or not a revenue should be recognized, the given entity should generally choose to defer the recognition of the revenue.

Ligand violated the revenue recognition principle because the earnings process was not complete.

That is, Ligand’s wholesalers had not sold all of the product that they had purchased from the company and Ligand had not provided a sufficient allowance for the unsold product that the wholesalers would eventually return. Likewise, Ligand violated the conservatism principle because it did not resolve the existing doubt regarding the ultimate magnitude of the sales returns in favor of increasing the allowance for sales returns.

4. AS 2905, “Subsequent Discovery of Facts Existing at the Date of the Auditor’s Report,” in the PCAOB’s auditing standards should have been applied in this context. That section of the auditing standards requires auditors of public companies to encourage a client to inform third parties relying on a previously issued set of financial statements when evidence becomes available indicating that those financial statements contain material errors. If the client refuses to notify those parties, then it is generally incumbent on the auditors to notify those parties of the errors. © 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 7.1 Ligand Pharmaceuticals 337 5. Consider having your students address this case question in an out-of-class group project. Then have the individual groups provide brief oral reports of their findings.

The PCAOB has been operating for only a few years, nevertheless, it has already received its fair share of criticism, both from the accounting firms that it oversees and from third parties external to the accounting profession. Listed next are specific examples of PCAOB criticism that I found by searching online databases.  The PCAOB has failed to prevent audit failures. Since the inception of the PCAOB, there have been numerous alleged audit failures, particularly within the severely distressed financial services industries.  Representatives of major accounting firms have criticized the PCAOB for being overly harsh in its inspection reports. These individuals maintain that the PCAOB has reached broad conclusions regarding the quality of specific firms’ audit processes after having inspected only a small number of audits performed by those firms.  Third parties external to the accounting profession have alleged that the PCAOB’s inspection reports are too vague and that the agency does not provide timely feedback on inspections to the accounting firms that it oversees.

Is this and other criticism of the PCAOB justified? Require individual students or student groups to address this issue and defend/justify their positions.

Listed next are specific examples of measures that the PCAOB could adopt to respond to the criticism listed above and other criticism.   

Easy answer: seek additional government funding to increase the scope of its inspection program.

Work more closely with state boards of public accountancy to identify accounting firms whose audit processes are deficient.

Require more cooperation among the major accounting firms in terms of sharing effective audit strategies and procedures (with the hope of decreasing the frequency of audit failures).

© 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 7.2 Sarah Russell, Staff Accountant 338

CASE 7.2

SARAH RUSSELL, STAFF ACCOUNTANT

Synopsis Like many accounting students, Sarah Russell chose to begin her career in public accounting because of the wide range of opportunities it offered. After a few years of public accounting experience, she realized that she might decide to stay in that field and pursue a partnership position with an accounting firm. On the other hand, several years of public accounting experience would provide her with numerous employment opportunities in the private sector if she decided that becoming a partner was not her primary career goal.

Sarah accepted a staff accountant position with an out-of-state office of a Big Eight accounting firm. Her first year in public accounting was very productive. Not only did she do well on the six audit engagements to which she was assigned, she also passed each section of the CPA exam in her first attempt. One of the individuals who helped Sarah adjust to her new professional role and to the work environment of a large accounting firm was an audit partner, R.J. Bell. At the beginning of her second year in public accounting, Sarah became uncomfortable when Bell began attempting to establish a personal relationship with her. Although she discouraged his advances, Bell persisted.

Eventually, Sarah informed Bell that she wanted to keep their relationship strictly on a professional level. At this point, Bell became upset and told Sarah that she must have misinterpreted his actions.

Bell then told Sarah that she would not be assigned to any audit engagements that he supervised.

Although Bell made no further advances to Sarah, within a few months she decided to leave the accounting firm and return to her home state.

© 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 7.2 Sarah Russell, Staff Accountant 339

Sarah Russell, Staff Accountant--Key Facts 1. Sarah Russell chose to begin her career in public accounting in large part because of the wide range of opportunities it offered.

2. During her first year in public accounting, Sarah received excellent performance evaluations on the six audits to which she was assigned and passed each section of the CPA exam in her first attempt.

3. One of the individuals who was very supportive of Sarah during her first year in public accounting was R.J. Bell, an audit partner of the large accounting firm that was her employer.

4. Early in Sarah's second year in public accounting, R.J. Bell began attempting to establish a personal relationship with her.

5. Over the next several weeks, Sarah became increasingly uncomfortable and distressed as Bell continued to make unwanted advances.

6. Finally, Sarah made an appointment with Bell and informed him that she wanted to keep their relationship strictly on a professional level.

7. Bell refused to acknowledge his actions and implied that Sarah was wrongly accusing him of improper behavior; he then told Sarah that he would make sure that she was not assigned to any of his engagements in the future.

8. Within a few months after her meeting with Bell, a disillusioned Sarah resigned her position with the accounting firm and returned to her home state.

Instructional Objectives 1. To provide students with insight on the professional role and work environment of a staff accountant of a major accounting firm.

2. To demonstrate that the public accounting profession is a microcosm of society and that social problems that affect society also affect the members of this profession.

Suggestions for Use This case focuses on an issue that many of you may not feel is appropriate to address in an accounting course, namely sexual harassment. However, I believe that students should recognize that the public accounting profession is a microcosm of society and, as a result, disconcerting social problems such as racial discrimination, sexual harassment, etc., affect this profession just as they © 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 7.2 Sarah Russell, Staff Accountant 340 affect our society. In a professional setting, these problems cannot only be disconcerting but also dysfunctional since they may adversely affect the quality of services provided by professional firms.

Likewise, these problems may be disruptive to the personal and professional lives of individual members of a profession, which was clearly true in this case. I believe that prospective public accountants will have a richer understanding of their future professional role if they discuss how important social problems may affect that role. Additionally, by discussing these social problems in the context of the public accounting profession, students should be better equipped to address these issues when they face them subsequently in their careers.

Given the nature of this case, I believe it is most appropriate to discuss it later, rather than earlier, in an auditing course. This case may create a certain level of discomfort among students. As a result, an instructor will benefit if he or she has a good understanding of the temperament, attitudinal predispositions, etc., of individual class members. Such an understanding will allow an instructor to better direct and manage classroom discussion of this case.

Suggested Solutions to Case Questions 1. Sarah seemed to deal with this situation very well, given the circumstances. However, she would likely have benefited if she had discussed this problem with either members of her family or her close friends. In these types of situations, it is very important to seek out someone whose judgment you trust and who you can rely on to keep the matter confidential. Not only can these individuals provide an objective assessment of the situation and advice on how to handle it, more importantly they can provide badly needed emotional support. In Sarah's case, since she did not feel she could approach family members or friends about this matter, another alternative would have been to discuss the situation with a member of the clergy or a personal counselor.

What factors should Sarah have considered in dealing with this situation? Students' answers to this question will vary. Clearly, among the key factors that she should have considered was her absolute right to work in an environment that was free of coercion of any type.

In this context, it is much easier to identify the personal and professional responsibilities of R.J. Bell. Bell had an obligation as both a member of society and as a professional to treat Sarah with due dignity, respect, and courtesy. He should have recognized that his infatuation with Sarah was inappropriate and his efforts to unilaterally establish a personal relationship with her totally objectionable. After Sarah discussed the matter with him, Bell had a responsibility to make amends by taking all appropriate measures to ensure that Sarah's personal and professional life returned to normal.

This case does not indicate that other individuals were involved in the unfortunate series of events affecting Sarah. However, we could speculate that certain members of the given accounting firm may have become aware of the efforts of R.J. Bell to establish a personal relationship with Sarah. If true, what professional and personal responsibilities did these individuals have in the given matter? Should these individuals have interceded on Sarah's behalf in some way? Again, students' responses to these sensitive questions will vary.

2. Among the costs and potential costs to Sarah's employer were the following: the loss of Sarah's professional services, litigation losses resulting from the situation, and a loss of prestige 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 7.2 Sarah Russell, Staff Accountant 341 credibility if the matter was publicly disclosed.

Although this term is often disparaged, accounting firms could use "sensitivity seminars" to acquaint partners and employees with important gender-related issues in the workplace. Accounting firms should have a strict and rigorously enforced policy that the type of behavior discussed in this case will not be tolerated. Finally, accounting firms should ensure that their employees clearly understand their rights in such situations and encourage them to exercise those rights. In this vein, a firm could establish an anonymous "hot line" that would be available to individuals facing situations similar to that which Sarah faced.

The office managing partner had a responsibility to deal with this situation with due professional care. In this context, due professional care means that the partner should have made every effort to protect the rights of both parties to this matter. (You may need to remind students that individuals who are being charged with illicit behavior of the type described in this case are innocent until proven guilty.) A lack of personal objectivity or expertise with such matters might have precluded the office managing partner from dealing effectively with the problem. As a result, the office managing partner should have considered referring the matter to the appropriate individual in the firm’s national office, such as the firm's director of human resources.

3. Yes, an episode such as the one described in this case could occur in today’s work environment.

Hopefully, the intense attention focused on sexual harassment in the workplace in recent years has diminished the frequency of this problem. But it would be unrealistic to expect this problem to disappear.

© 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 7.3 Washington Council Ernst & Young 342

CASE 7.3

WASHINGTON COUNCIL ERNST & YOUNG

Synopsis In early 2012, three investigative reporters for Reuters, the London-based international news agency, stumbled across some interesting information while sifting through quarterly reports filed by registered U.S. lobbying firms. The Lobbying Disclosure Act of 1995 requires such firms to file publicly available quarterly reports of their lobbying activities with both the U.S. House and the U.S. Senate. The three Reuters reporters discovered that Washington Council Ernst & Young (WCEY), a registered lobbying firm owned by Ernst & Young (EY), was apparently providing lobbying services to multiple EY audit clients that were SEC registrants. The SEC, the PCAOB, and other U.S. regulatory authorities, no doubt, were unaware of this fact. Subsequent disclosures in a Reuters article of the simultaneous provision of lobbying and audit services by the EY organization to several large public companies triggered a joint investigation by the SEC and PCAOB. That investigation resulted in significant sanctions, including a $4 million fine, being imposed on EY. Although the EYWCEY controversy provides the “jumping off point” for this case, its major focus is the perplexing “scope of services” issue that continues to plague the public accounting profession. This case provides a chronological history over the past four decades of the key developments relevant to the scope of services 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 7.3 Washington Council Ernst & Young 343 Washington Council Ernst & Young--Key Facts 1.

Three investigative reporters for Reuters, an international news agency, discovered in 2012 that multiple EY public company audit clients were also clients of WCEY, a registered lobbying firm and division of EY.

2.

The subsequent Reuters article prompted an investigation of the joint EY-WCEY clients by the SEC and PCAOB.

3.

The Reuters article also refocused attention on the “scope of services” issue within the public accounting profession, that is, the question of what types of non-audit services audit firms should be permitted to provide to their audit clients.

4.

The scope of services issue was a major topic of the two mid-1970s congressional hearings that focused on the Big Eight accounting firms and their dominance of the U.S. accounting profession.

5.

“The Accounting Establishment,” the report produced by the Metcalf Committee hearings in the U.S. Senate, charged that the Big Eight firms had “seriously impaired” their independence by “advocating their [audit] clients’ interests on controversial issues” facing the profession.

6.

The Metcalf Committee maintained that such “lobbying” activities by Big Eight firms was “highly improper.”

7.

During the early 1990s, the major accounting firms were berated for joining with their large public company clients to defeat a proposed FASB standard intended to improve the accounting for executive and employee stock options.

8.

The SEC’s Chief Accountant questioned whether the major accounting firms could reasonably argue that they were independent of their large public company audit clients when they were “subordinating” their views on proposed accounting standards to positions favored by those clients.

9.

In 2000, SEC Chairman Arthur Levitt reported that “conflict-of-interest violations” were “widespread at all of the large accounting firms” and proposed reforms to limit the non-audit services that auditors of SEC registrants could provide to those clients.

10. According to Levitt, an “intensive and venal lobbying campaign” by the major accounting firms resulted in the defeat of most of his proposed reforms; ironically, many of Levitt’s reforms were incorporated in the Sarbanes-Oxley Act of 2002 that was hurriedly passed by Congress subsequent to the Enron and WorldCom debacles.

© 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 7.3 Washington Council Ernst & Young 344 11. In July 2014, the SEC ruled that the lobbying services that WCEY had provided to EY public company audit clients had undermined EY’s independence by placing the audit firm in the position of being an advocate for those clients.

12. In addition to a public censure and a cease and desist order, EY was fined $4.1 million by the SEC. Instructional Objectives 1.

To provide a historical perspective on the important “scope of services” issue facing the public accounting profession.

2.

To identify non-audit services that are incompatible with the provision of audit services.

3.

To consider types of non-audit services that accounting firms should be allowed to provide to non-audit clients.

4. To understand the approval process that an SEC registrant should follow when purchasing nonaudit services from its audit firm.

Suggestions for Use The scope of services issue is like the proverbial bad penny that keeps showing up in our pocket change. The public accounting profession has been wrestling with the question of what types of nonaudit services are permissible for accounting firms to provide to audit clients since . . . well, since independent audits were “invented.” Students planning to enter the auditing discipline should have an understanding of this issue since it poses some of the most perplexing and enduring challenges facing independent auditors and their employers.

In years past, I have required students in my graduate auditing seminar to read the excellent twopart retrospective history of the U.S. accounting profession written by Professor Stephen Zeff. A footnote in this case references the first part of that “series” which was published in September 2003 in Accounting Horizons. (The second part was published in the December 2003 edition of that same journal.) Zeff’s retrospective tracks the various stages of the “life cycle” of the scope of services issue. You might consider having a group of your students provide an in-class report on Zeff’s classic work.

This case is well suited to be integrated with classroom coverage of the AICPA Code of Professional Conduct, in particular, the sections of that code that focus on auditor independence issues. The case could also be integrated with coverage of a comprehensive case in which the scope of services issues is prominent—such as the Enron case.

Suggested Solutions to Case Questions 1. The fact that the EY-WCEY “problem” was discovered and reported initially by Reuters reporters who “stumbled” upon the relevant information apparently while researching another story line is somewhat troubling. No doubt, both the SEC and PCAOB have so much “on their plates” that © 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 7.3 Washington Council Ernst & Young 345 they can’t be held responsible for searching in every nook and cranny for potential ethical violations or other professional shortcomings committed by accounting firms. To be honest, I had no idea that any of the major accounting firms had registered lobbying firms within their organizations—in addition to EY, PwC had a registered lobbying firm for a short time before deciding to dispose of it.

Likewise, I was unaware that lobbying firms were required to file quarterly reports with Congress regarding their activities.

This question provides an opportunity for instructors to raise and discuss the critical importance of “self-regulation” within the public accounting profession. The parties best positioned to provide effective oversight of a given profession are the actual members of that profession. To protect the integrity and credibility of their profession, individual accountants should be constantly vigilant for potentially abusive or otherwise inappropriate practices or actions by their fellow professionals. Just as importantly, individual accountants must have the fortitude or resolve to report such activity to the proper authorities—it seems highly likely that members of the profession (other than EY’s work force) were aware of the lobbying that WCEY was doing for EY audit clients.

Of course, it is also incumbent on individual accounting firms to “police” themselves to ensure that they are not providing non-audit services that are incompatible with the provision of audit services. As a sidebar, AAER No. 3566, which is referenced in this case, pointed out that EY “issued a written policy to provide guidance on the provision of legislative advisory services to audit clients.”

However, the firm did not “provide WCEY with formal, in-person training specifically tailored to the policy.”

2. First of all, developing such a list would be difficult, if not impossible. Besides, the constant change in information technology, business practices, regulatory policies, and other factors would render such a list obsolete almost as soon as it was published. Second, as professional organizations, accounting firms—particularly the massive, international firms—should have self-regulatory policies and processes in place that serve to preclude the development and provision of non-audit services that are clearly inconsistent with the relevant guidelines and policy directives that have been established by regulatory authorities. Likewise, the self-regulatory processes of the profession—such as peer review—should significantly reduce the likelihood that accounting firms will provide audit clients with inappropriate non-audit services. Finally, in those circumstances in which an accounting firm has reason to doubt the propriety of a given non-audit service that it intends to provide to an audit client, the most judicious strategy would be to simply contact the SEC, PCAOB, or other regulatory authority and obtain a “ruling” on the given matter.

3. This first question should prompt a lively debate among your students. Because there is not a definitive answer to this question, consider organizing a three-way debate exercise: one group of students in favor of the provision of lobbying services by accounting firms, a second group that disapproves the provision of such services by accounting firms, and a third group that serves as the “jury,” that is, decides which of the first two groups has the most persuasive argument.

One reason to allow such services is that when it comes to legislative issues pertinent to the financial reporting domain, the accounting profession, or other topics relevant to accounting firms’ areas of expertise the major accounting firms are likely the parties most knowledgeable of the given issues or topics and thus best positioned to “educate” legislators regarding those issues and topics.

On the downside, allowing accounting firms to provide lobbying services to non-audit clients may © 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 7.3 Washington Council Ernst & Young 346 result in those firms tailoring lobbying positions that serve as “magnets” to attract potential audit clients.

The PCAOB, Financial Accounting Standards Board and Auditing Standards Board routinely invite comments on proposed new standards. “Calls for comment” from those rule-making bodies regarding proposed new standards effectively institutionalizes “lobbying” by accounting firms in this context. This practice clearly places accounting firms in potential conflict-of-interest situations. For example, a client that becomes aware that their audit firm is lobbying against a proposal which it supports might retaliate by retaining a new audit firm. The risk of a conflict-of-interest in this context would be reduced if the identity of the authors of “comment letters” was kept strictly confidential.

But that is not currently being done. Plus, even if such a policy was in place, the authors of comment letters would have a vested interest in opportunistically (and surreptitiously) revealing their authorship of such letters in many circumstances. Likewise, as suggested in the prior paragraph, accounting firms might tailor lobbying positions or arguments regarding proposed new standards solely for the purpose of attempting to indirectly recruit new audit clients.

4.

Section 201 of the Sarbanes-Oxley Act includes the following clause:

(h) PREAPPROVAL REQUIRED FOR NON-AUDIT SERVICES- A registered public accounting firm may engage in any non-audit service, including tax services, that is not described in any of paragraphs (1) through (9) of subsection (g) for an audit client, only if the activity is approved in advance by the audit committee of the issuer, in accordance with subsection (i).

Paragraphs 1 through 9 referenced in this clause refer to the narrative in the SOX statute that lists the non-audit services that auditors of SEC clients are specifically prohibited from providing to those clients.

© 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 7.4 Internet Infamy 347

CASE 7.4

INTERNET INFAMY

Synopsis The first “killer app” of the Internet was email. In fact, email is the Internet application that was most responsible for the rapid, worldwide growth of the information superhighway. Email quickly became the primary communication medium in the business world. By 2015, an estimated 200 billion emails were being sent on a daily basis and more than one-half of those messages involved businesses.

On a typical day, a business professional receives 88 emails and sends 34.

The seemingly indestructible and timeless nature of emails has posed problems for many business professionals, including none other than Bill Gates. During the course of the historic anti-trust lawsuit against Microsoft, federal prosecutors retrieved emails sent by Gates years earlier to demonstrate that, despite his contention to the contrary, he had been aware of abusive business practices that Microsoft had used against its key competitors This short case demonstrates the need for accountants new to the profession to be discreet and considerate when they choose to communicate via email. Embedded in this case are four anecdotes involving problematic email messages sent by novice accountants—each of the emails quickly went “viral” on the Internet. A soon-to-graduate accounting major at a university in the Midwest sent an awkward and tactless email to a Big Four female recruiter who he had met at a career fair. The email not only killed his chances of landing a job with the given Big Four firm but also reportedly resulted in his three pending job offers being rescinded.

Two of the vignettes in this case involve college-type pranks. Three entry-level employees of a Big Four firm were suspended after they circulated an email to male colleagues in their practice office that included photos of 13 newly-hired females. The email requested the recipients to rate those new employees for the purpose of developing a top ten list of the most attractive female new hires. The prank quickly got out of hand after recipients began making rude comments regarding several of those new hires. Ironically, less than one year earlier, an entry-level female employee of another Big Four firm had sent out a comparable email to her female colleagues. That email asked the recipients to rate the men in their practice office on nine traits, one which was “most likely to sleep his way to the top.”

Arguably the most notorious email gaffe within the ranks of the accounting profession was made by a young lady who circulated an email that doubled as her resignation letter. In the email, 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 7.4 Internet Infamy 348 young lady carpet bombed her former co-workers, partners in the practice office, and the auditing discipline as a whole. Her email garnered so much attention that she received numerous interview requests from the media—one of which she granted.

Internet Infamy--Key Facts 1. Email was the original “killer app” of the Internet and was largely responsible for the rapid growth of the information superhighway.

2. More than one-half of the 200 billion emails sent daily involve the business world; the typical business professional receives 88 emails each day and sends 34.

3. Many business professionals, including none other than Bill Gates, have learned the hard way that email messages are seemingly indestructible and live on in perpetuity.

4. A soon-to-graduate accounting major at a large Midwestern university sent an awkward email to a female recruiter of a Big Four firm; not only did the young man fail to receive a job offer from the recruiter’s firm, he reportedly had his three pending job offers rescinded when his email went viral.

5. Three male employees of a Big Four practice office circulated an email to their male colleagues which instructed them to rate the attractiveness of the office’s 13 new female employees; the prank “blew up” when unseemly comments regarding the young ladies were posted to the forwarded email.

6. The three male employees were suspended by their employer.

7. A female employee of another Big Four firm had lost her job approximately one year earlier when she circulated a similar email to female colleagues in her practice office.

8. After leaving her Big Four employer, the naïve young lady told a newspaper reporter that “It’s a complete shock that one email could spread like this and who would think that it could get this out of hand.”

9. After becoming disillusioned with her job, a young Big Four auditor sent an email to her coworkers that doubled as her resignation letter.

10. In the email, the young lady disparaged her co-workers, the partners in her office, and the auditing discipline as a whole.

11. Many auditors and former auditors contested the observations made in the emailed resignation letter; an individual who had spent four years with the same Big Four firm reported that her experience there had been “unparalleled” in terms of how it had advanced and benefited her career.

12. In a subsequent interview, the young lady stood by the remarks that she had made in the email, © 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 7.4 Internet Infamy 349 although she did admit that she never had a strong interest in auditing and had chosen to enter public accounting because her parents had insisted that she pursue a professional career.

Instructional Objectives 1. To document the need for accounting professionals to be discreet and considerate when using email.

2. To illustrate the adverse consequences that accountants may face if they distribute improper email messages.

3. To identify the specific ethical and professional standards that apply to accountants when they use email and other electronic media for communication purposes.

4. To examine the meaning of “low expectation of privacy” in the context of email communications.

5. To reinforce the need for prospective accountants to thoroughly research the work role or roles that they intend to pursue before making a commitment to the accounting profession.

Suggestions for Use This brief case can be used at almost any point in an undergraduate or graduate auditing course to provide your students a short “break” from more challenging or rigorous auditing topics.

Alternatively, consider integrating the case with in-class coverage of ethical and professional standards of conduct.

Despite the non-technical nature of this case, I believe that the subject matter is extremely relevant to auditing students who want to pursue a long and productive career in public accounting. Granted, most students have been made aware of the problems that can ensue if they send improper emails, however, this case provides crisp and vivid examples of the adverse consequences that young accounting professionals have faced by doing so.

I like to begin coverage of this case by asking for volunteers from among my students to share email gaffes that they have made in the past. Almost certainly, most of the shared anecdotes will provide some measure of comic relief. But they typically also reinforce the central theme of this case, namely, the critical importance of properly using email as a communication medium.

Suggested Solutions to Case Questions 1. The phrase “low expectation of privacy” is not cryptic or otherwise difficult to interpret. In certain contexts, individuals have a “high expectation of privacy,” for example, in their homes. In public settings, one’s expectation of privacy is generally much lower. When using email for communication purposes, one should be aware of the risk that a given email will be forwarded to other parties, that is, generally you shouldn’t expect email messages to be private communications.

When using an employer’s computer network, one’s expectation of privacy is minimal since employers generally have a right to review email messages sent by employees and other parties via © 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 7.4 Internet Infamy 350 their computer network. Consequently, individuals should maintain a high level of decorum and professionalism when crafting emails that will travel through an employer’s information system. The same is true of emails that will not be distributed via an employer’s information system but which are written or otherwise initiated on a computer or other device that is the property of an employer.

[Note: you may want to consider informing your students that privacy is not an explicit “right” of U.S. citizens—the issue of privacy, for example, is not addressed directly by the Bill of Rights. Of course, the advent of the Internet era, drones, and other technological advancements have raised increasingly problematic privacy issues for individuals and businesses.]

2. The ethical and professional standards included in the AICPA Code of Professional Conduct are the most relevant standards in this context. [Note: Of course, the “actionable” ethical code for a CPA in the U.S. is the code of ethics of his or her state board of accountancy.] The standard that is arguably the most pertinent to CPAs when they are using either “old school” or “new age” communication media is the requirement that they maintain the confidentiality of their clients’ accounting records, operations, and other critical information. CPAs should understand that email and the modes of communicating on social media networks pose major challenges when it comes to complying with the confidentiality standard, in large part because of the low expectation of privacy associated with those communication platforms (see answer to Question #1). [Note: Recognize that in the four vignettes profiled in this case, client confidentiality was not an issue.]

In the vignettes included in this case, the overarching ethical principle of “integrity” embedded in the Code of Professional Conduct was extremely relevant. The litmus test “Am I doing what a person of integrity would do?” is a benchmark that CPAs should routinely consider when communicating in any medium with peers, subordinates, superiors, and external third parties. This case demonstrates the adverse consequences that prospective accountants and accounting practitioners may face if they fail to act with integrity and/or fail to apply “common sense” when communicating via email. A common “penalty” is the loss of a job (or job offer)—and the difficulty of obtaining a replacement job. Other adverse consequences that CPAs may face include a wide range of sanctions that could be imposed by the relevant state board of accountancy such as a reprimand, suspension of one’s CPA certificate and/or license to practice, and, in extreme cases, the revocation of one’s CPA certificate and license to practice. Probably the most common sanction for violating a given ethical standard is the requirement that the given CPA successfully complete a continuing education course that addresses the context in which he or she violated a particular ethical norm. [Note: As a point of information, at least some of the vignettes in this case could be considered “acts discreditable to the profession.” See ET 1.400.001, “Acts Discreditable Rule.”]

3. No doubt, most accounting professors (including myself) have had terrific students who graduate and enter the accounting profession only to soon discover that they are ill-suited for that profession.

These young men and women face a very high opportunity cost, namely, “retooling” themselves for entry into another field. To avoid this problem, I encourage my students (accounting and nonaccounting majors alike) to gather as much information as possible regarding the profession or field that they intend to pursue. A major source of such information for accounting majors is the lectures that accounting professionals present at Beta Alpha Psi meetings or other accounting club meetings.

At my university, we always reserve time at the end of those presentations for a Q&A session with © 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 7.4 Internet Infamy 351 the given professional. Each semester in my graduate auditing course, I invite two or three auditing practitioners to come to class and provide an overview of their work roles and responsibilities. I also encourage my students to ask in-depth questions of these presenters. Finally, internships are a great way for students to acquire an in-depth understanding of the profession that they are about to enter.

4. Practically every one of our students at multiple points in their careers will face the awkward task of informing an employer that he or she has decided to “move on.” Because prospective employers usually insist on contacting one’s prior employers, it is imperative, if at all possible, to not “burn any bridges” when changing jobs. So, it is very important that students be properly schooled when it comes to the task of transitioning from one professional position to another.

In responding to this question, students typically suggest that Glory should not have attacked her former co-workers. In most work environments, one will encounter co-workers who have strikingly different points of view regarding their jobs, proper social etiquette in the workplace, political issues, religious beliefs, and on and on. And who among us has not occasionally encountered co-workers who have unusual, quirky, or even bizarre peccadilloes. Acceptance of co-workers’ different belief structures and personal idiosyncrasies is a modus operandi that will pay huge dividends as one progresses through his or her career. (Granted, in some cases, it may be necessary to take action when a co-worker’s personal habits or quirks are disruptive in the workplace. In such circumstances, it is probably best to privately refer the matter to someone at a higher level in the organization rather than attempting to change the behavior of the offbeat co-worker.)

My students generally suggest that Glory had every right to express her dissatisfaction with her former work role when she decided to leave her Big Four employer. Some students maintain that Glory had a responsibility to raise those concerns with her employer for the benefit of future employees of that firm. However, the proper context in which to raise those concerns is a private exit interview—not a mass email. Such interviews are typically performed by the given employer’s human resources department. Given the strong personal convictions that Glory had regarding her former position, she could have insisted on speaking directly to one or more partners in her practice office, if not the office managing partner. There is no doubt that those individuals would have been appreciative of Glory’s candor and may have actually taken affirmative measures to address some of the issues she raised. For example, Glory’s feedback regarding the office’s mentoring program may have resulted in some aspects of that program being “fine-tuned.”

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352

Case 7.5 Fred Stern & Company, Inc.

CASE 7.5

FRED STERN & COMPANY, INC. (ULTRAMARES)

Synopsis The 1930 legal opinion written by Judge Benjamin Cardozo in the Ultramares vs. Touche et al. case would influence, if not shape, the legal liability of public accountants for decades to come. Prior to the Ultramares case, parties external to the audit contract, such as investors and creditors, could only bring lawsuits against auditors predicated upon fraudulent conduct. In the Ultramares case, the plaintiff, which was not a party to the audit contract, maintained that it should be allowed to recover losses it suffered as a result of alleged negligence on the part of Touche, Niven & Company, the predecessor of Touche Ross. On this key issue, Judge Cardozo ruled in favor of Touche—and the public accounting profession. According to Judge Cardozo, non-privity third parties could not recover damages from a negligent auditor; however, the judge made an important exception to that general rule. If a third party is specifically designated as the primary beneficiary of an audit, the courts may essentially grant that party implied privity of contract and allow it to recover damages suffered as a result of auditor negligence. Judge Cardozo also raised the possibility that third parties, other than primary beneficiaries, might be entitled to recover damages from "grossly negligent" auditors.

As a result of the Ultramares case, audit firms experienced a sudden and significant increase in their potential legal exposure. Auditors faced the possibility of being sued for negligence by primary beneficiaries of an audit and for "gross negligence” by all other parties who relied to their detriment on audited financial statements that contained material errors. Besides discussing the central legal issues in the Ultramares suit, this case documents the alleged deficiencies in Touche's 1923 audit of Fred Stern & Company that were the basis for Ultramares' legal claim against Touche. This case also provides a brief overview of the evolution of auditors' legal liability since the resolution of the Ultramares case.

© 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 7.5 Fred Stern & Company, Inc. 353 Fred Stern & Company, Inc.--Key Facts 1. Before the passage of the federal securities laws in the early 1930s, the financial reporting practices of companies were not subject to significant government oversight.

2. Ultramares, a finance company, extended Fred Stern & Company a large loan after requesting and then reviewing a Stern balance sheet that had been audited by Touche, Niven & Company.

3. Unknown to Ultramares and Touche, Stern's balance sheet contained large errors that were principally the result of fraudulent journal entries made by an employee of that company.

4. After Stern declared bankruptcy, Ultramares sued Touche, alleging that the accounting firm should have discovered the errors in Stern's balance sheet.

5. Ultramares’ lawsuit charged Touche with both fraud and negligence.

6. The fraud charge against Touche was dismissed, but the jury found in favor of Ultramares on the negligence claim.

7. After a reversal of the jury's decision by the trial judge and a subsequent reversal of the trial judge's decision by an appellate court, Judge Cardozo of the New York Court of Appeals issued the final judgment in the case, a decision in favor of Touche.

8. Judge Cardozo ruled that if Ultramares had been a primary beneficiary of the Stern audit, Ultramares could have recovered on its negligence claim even though it was a non-privity third party.

9. Judge Cardozo also suggested that third parties other than primary beneficiaries should be allowed to recover damages resulting from an audit firm’s gross negligence.

Instructional Objectives 1. To provide a historical overview of the evolution of the independent auditor's legal liability.

2. To provide insight on how the independent audit function of the 1920s differed from the present-day independent audit function.

3. To provide students with a more in-depth understanding of the key contextual circumstances of a landmark legal case for the auditing profession.

Suggestions for Use This case can be used as the starting point for discussing auditors' legal liability. The Ultramares case is the most important of all litigation cases involving independent auditors since it established © 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 7.5 Fred Stern & Company, Inc.

two key legal precedents that would influence auditors' legal liability under the common law for the remainder of the twentieth century. This case provides information regarding key contextual circumstances of the Ultramares litigation that is typically not included in textbook treatments of this matter. Although some of this information does not bear directly upon the legal issues that are central to the case, it should make those issues less abstract by providing the context in which they arose.

This case can also be used by instructors to provide students with a historical perspective on the independent audit function. I particularly enjoy challenging students to explain the evolution of the standard audit opinion from the format used in the 1920s to the format in use today.

Suggested Solutions to Case Questions 1. The key cost of this phenomenon for audit firms is the increased business risk it imposes upon them. On an individual level, the ever-present potential for litigation can impose a significant amount of stress and anxiety on auditors and may be a contributing factor to the high turnover rate within the public accounting profession. Audit clients also suffer as a result of the apparent trend for federal and state courts to socialize investment losses by imposing large legal judgments on audit firms. No doubt, the costs associated with such judgments are eventually passed on to financially viable audit clients in the form of higher audit fees. The parties most likely to benefit from this trend are investors and creditors, particularly investors and creditors who make poor or, at least, very speculative investment and lending decisions. Of course, this raises the question of whether investors and creditors should be protected from their own poor decisions. A basic tenet of a free market economy is that investment risk should be mitigated not by an "insurance" function, but rather by the collective wisdom and prudence of individual investors and creditors.

In a democratic society, elected officials are vested with the authority to make important decisions regarding such matters as how investment losses should be distributed within the economy.

Conversely, it is the responsibility of the judicial branch of government to determine whether the laws passed by elected officials violate the fundamental tenets of a given society. In the United States, these fundamental tenets are documented in the Constitution. Although there is clearly not a consensus on this issue, many vocal critics of the judiciary maintain that federal and state judges do not have the right to "socialize" investment losses since such authority is not vested in them by the Constitution. [An instructor can expect students to express a wide range of differing opinions on this subjective issue. Although this question is not closely related to the subject matter of auditing, I believe it is important to force students on occasion to look at the "big picture." That is, I want my students to occasionally sit back and consider exactly how the independent audit function articulates with broad social issues of our time.]

2. Auditors are faced with much more litigation risk when they audit financial statements included in a registration statement filed under the 1933 Act compared to when they audit financial statements included in a registration statement filed under the 1934 Act. When filing suit against an auditor under the 1933 Act, a plaintiff must establish only two general elements of proof to make a prima facie case. The plaintiff must prove that he or she has suffered damages and that the financial statements in question contain one or more material errors. Conversely, in a suit filed under the 1934 Act, a plaintiff must establish the following points: © 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 7.5 Fred Stern & Company, Inc. 355 a. there was a material error or material omission in the financial statements included in the registration statement, b. he or she relied on the false financial statements, c. he or she suffered damages as a result of that reliance, and d. the CPA's conduct during the examination of the given financial statements was characterized by scienter (intent to deceive) or recklessness (reckless disregard for the truth).

Congress intentionally imposed more legal responsibility on parties associated with financial statements filed under the 1933 Act than on parties associated with financial statements filed under the 1934 Act. Companies file S-1 registration statements under the 1933 Act only when they are selling new securities, while 10-K registration statements filed under the 1934 Act contain the financial data and other information that public companies are required to provide annually to the SEC. If new securities are to be marketable, potential investors must have confidence in the financial data included in the given S-1 registration statement since there will be little, if any, other information available regarding those securities or the companies issuing them. Conversely, investors (and creditors) acting upon financial statements included in a 10-K registration statement typically have a wealth of other data to use in making investment (lending) decisions. For instance, these parties often have several years (if not decades) of financial data to peruse in the given company's previous financial statements. Since investors and other third parties do not have to rely exclusively on the financial statements included in a given company's current year 10-K, auditors do not have as great a responsibility to detect and correct errors in a 10-K registration statement as they do in an S-1 registration statement.

The key difference in the auditor's civil liability under the 1934 Act and the common law is the degree of malfeasance on the part of the auditor that must be proven by the plaintiff. Since the U.S. Supreme Court handed down its ruling in the Hochfelder case in the late 1970s, plaintiffs must establish more than negligence on the part of a CPA firm to recover damages in a suit filed under the 1934 Act. Specifically, plaintiffs must either prove scienter (intent to deceive) or reckless disregard for the truth on the part of the auditor. In most cases, it is difficult for plaintiffs to establish explicit scienter since CPAs very seldom engage in blatant fraudulent conduct. Consequently, plaintiff legal counsel, in most cases, attempt to prove that the auditor(s) in question exhibited "reckless" behavior.

In suing an audit firm under the common law, the degree of auditor malfeasance that must be proven varies from jurisdiction to jurisdiction. In a jurisdiction that applies the primary beneficiary rule of the Ultramares case, third parties that qualify as primary beneficiaries of a given audit only have to prove that the auditor in question was negligent, all other third parties have to prove at least gross negligence on the part of the auditor to recover damages. In a jurisdiction that applies the legal precedent found in the Rusch Factors case, primary beneficiaries and "foreseen" beneficiaries can recover from a negligent auditor. Finally, in very liberal jurisdictions that apply the so-called Rosenblum Rule, primary, foreseen, and "reasonably foreseeable" or "ordinary" beneficiaries are allowed to recover from a negligent auditor.

3. Listed next are some of the key differences between the audit report form shown in Exhibit 1 of this case and the standard audit report form being used presently by non-SEC registrants. © 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 7.5 Fred Stern & Company, Inc. a. No longer do auditors use the term "certify" in their reports; instead, the phrase "in our opinion" is used. b. Rather than using the phrase "true and correct" to describe the status of the client's financial condition, the current audit report uses the phrase "presents fairly, in all material respects." c. The audit report shown in Exhibit 1, like many audit reports of the 1920s, focused exclusively on the client's balance sheet. d. The standard audit report of the 1920s made no reference to generally accepted accounting principles [in the United States] as the benchmark used in assessing the fairness of the client's financial statements. e. The 1920s audit report did not refer to professional auditing standards, nor did it contain a scope paragraph describing the nature of an independent audit. f. The 1920s audit report did not state that the primary responsibility for the client's financial statements rested with client management.

During the early part of the twentieth century, the auditing profession, at least in the United States, was still in its infancy. During that time frame, independent audits were much more mechanical in nature than they are today. That is, the auditor of the 1920s was more concerned with clerical accuracy, the format of a client’s financial data, and related issues and less focused on whether the client's accounting policies captured the substance rather than simply the form of the entity's transactions. As companies grew in size and complexity, highly "mechanical" audits became outmoded. At some point, it simply was no longer possible for auditors to perform clerical tests on all or large portions of clients' accounting data. More importantly, auditors came to recognize that accounting decisions for many transactions and accounts were inherently subjective and, consequently, that it was not appropriate to comment on the "correctness" of the data yielded by such decisions. As a result, auditors gradually redefined their principal responsibility as being to assess whether a client's accounting policies resulted in financial data that were "fairly presented," that is, in financial data that were free of material bias that might result from management's self-interest or other factors.

Two other factors also contributed significantly to the profession’s decision to make major changes in the standard audit report. These factors were extensive criticism of the auditing profession by congressional investigative committees of the 1970s and 1980s and a dramatic increase in the number of lawsuits filed against audit firms during that same time frame. These factors likely contributed to the Auditing Standards Board’s decision to include the important caveat in the current audit report that the financial statements being reported upon are the primary responsibility of client management, a caveat that, at least theoretically, should mitigate auditors’ legal liability for misrepresented financial statements. The expanded scope paragraph, which contains caveats not included in the prior version of the standard audit report, was also likely intended to mitigate auditors' litigation problems by making the public expressly aware of the limitations of independent audits.

4. In the early part of the twentieth century, the principal focus of financial reporting and, consequently, independent auditing, was on the financial condition of companies rather than the results of their operations. During that time frame, the principal purpose of financial reports was to provide third parties with information useful in evaluating the degree to which management had protected or conserved a company's assets. That is, the perceived purpose of financial reports was 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 7.5 Fred Stern & Company, Inc. 357 evaluate management's stewardship of company assets. Gradually, the users of financial statements came to recognize that management's principal responsibility should not be simply to conserve or maintain assets but rather to increase a company's assets and net worth through profitable operations.

Consequently, annual financial reports of public and private companies gradually began placing greater emphasis on periodic operating results and eventually on periodic cash flows.

5. Auditing standards do not specifically identify the type or number of third-party financial statement users as factors that an audit firm should consider when attempting to determine the level to which overall audit risk should be reduced (or, more appropriately, the level to which an audit firm will attempt to reduce overall audit risk). However, each of those factors does influence the level of business risk that an audit firm will face on a given engagement. (For instance, an audit firm will generally face more litigation risk for a public company with a large number of stockholders than for a private or closely-held company of the same size that relies heavily on one or a small number of banks for its financing needs.) In turn, the level of business risk an audit firm faces on a given engagement will typically have a significant impact on the level of audit risk the firm is willing to assume on that engagement. Consequently, the number and type of third parties relying on a client's financial statements affects, at least indirectly, the auditor's decision regarding the level to which overall audit risk should be reduced. [Note: The type and number of third parties relying on a client’s financial statements may impact the “inherent risk” component of audit risk. For example, executives of a public company may feel pressure to meet earnings targets established by external financial analysts, which might tempt the executives to “window dress” their company’s financial statements.]

Requiring clients or prospective clients to disclose, prior to the beginning of an audit, the parties to whom audited financial statements will be provided would certainly help auditors assess the degree of business risk posed by each engagement. Additionally, such disclosures would serve to limit auditors' legal exposure in some jurisdictions to certain nonprivity third parties. For instance, to qualify as a primary beneficiary of an audit in jurisdictions that invoke the legal precedents established by the Credit Alliance case, a third party must satisfy certain restrictive conditions. One of these conditions is that the auditor must have known that the third party would be using the audited financial statements for a specific purpose. If this condition is not satisfied, the third party does not qualify as a primary beneficiary and thus must prove more than negligence on the part of the auditor to prevail in a civil lawsuit filed against the auditor. Recognize that if an auditor is guilty of more than negligence, such as gross negligence or recklessness, essentially any nonprivity third party can sue the auditors for damages resulting from his or her malfeasance. So, in summary, identifying “up front” the third parties who are “entitled” to rely on a set of audited financial statements in a given legal jurisdiction may mitigate an auditor’s legal liability to certain nonprivity parties but certainly doesn’t eliminate all potential legal liability to those 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.

358

Case 7.6 First Securities Company of Chicago

CASE 7.6

FIRST SECURITIES COMPANY OF CHICAGO (HOCHFELDER)

Synopsis Prior to the Supreme Court's ruling in the Hochfelder case, it was unclear exactly what degree of malfeasance on the part of auditors had to be proven for them to be held civilly liable under the Securities Exchange Act of 1934. For many years, plaintiff legal counsel had maintained that if an audit firm was found to have been negligent in auditing financial statements included in a registration statement filed under the 1934 Act, third parties who relied on those statements to their detriment were entitled to recover damages from the audit firm. Conversely, attorneys representing audit firms in such cases maintained that plaintiffs should be allowed to recover damages only if they could prove that an audit firm had engaged in fraudulent conduct. The 1978 Hochfelder (First Securities) ruling by the U.S. Supreme Court addressed this important issue.

The Supreme Court ruled in the Hochfelder case that plaintiffs seeking recovery of damages under the 1934 Act from an audit firm were required to establish "scienter" or intent to deceive on the part of the audit firm rather than simply negligence. However, the court also noted that in certain cases "reckless disregard for the truth" might be construed as equivalent to scienter. That is, a plaintiff unable to establish explicit fraud on the part of an audit firm might be allowed to recover damages by proving that the audit firm had engaged in reckless behavior. In summary, although the Hochfelder case established that audit firms were not liable under the 1934 Act for negligence, the case left open the question of whether they could be held liable for "recklessness" under that statute. In addition to discussing the central legal issues in the First Securities lawsuit, this case provides background information regarding the fraud from which this important lawsuit stemmed.

© 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 7.6 First Securities Company of Chicago 359 First Securities Company of Chicago--Key Facts 1. Leston Nay was well respected and trusted by his customers.

2. Despite his reputation as a prudent and conservative stockbroker, Nay had a well concealed history of unscrupulous business practices.

3. The alleged escrow syndicate was an investment fund personally managed by Nay and not an asset of First Securities.

4. Nay's "mail rule" allowed him to conceal the existence of the escrow syndicate from his subordinates at First Securities.

5. After failing to recover their losses from the Midwest Stock Exchange and First Securities, the escrow investors filed a lawsuit against Ernst & Ernst, the longtime audit firm of First Securities.

6. The escrow investors alleged that negligence on the part of Ernst & Ernst had prevented the audit firm from discovering Nay's mail rule and, as a result, the escrow syndicate fraud.

7. The investors filed their lawsuit against Ernst & Ernst under Rule 10b-5 of the Securities Exchange Act of 1934.

8. At the time of the First Securities scandal it was unclear whether plaintiffs had to prove fraudulent conduct on the part of auditors in a lawsuit filed under the 1934 Act or whether negligence was a sufficient basis for such a suit.

9. The Supreme Court ruled that negligence was not a sufficient basis for a civil lawsuit filed against an audit firm under the 1934 Act; instead, a plaintiff must prove either intent to deceive (scienter) or possibly reckless disregard for the truth on the part of an audit firm to recover damages.

Instructional Objectives 1. To define auditors' legal liability under the Securities Exchange Act of 1934.

2. To demonstrate that auditors must be skeptical of even well respected and apparently trustworthy client executives.

Suggestions for Use This case is best suited for coverage during discussion of auditors' legal liability, specifically auditors' liability under the federal securities laws. The key learning points in this case focus on what I like to refer to as auditors' "culpability standard" under the Securities Exchange Act of 1934.

Although the Hochfelder ruling clearly established that negligence is an insufficient basis for a civil lawsuit filed against an auditor under the 1934 Act, it was much less definitive regarding when © 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 7.6 First Securities Company of Chicago

"reckless disregard for the truth" or, more simply, recklessness, qualifies as sufficient grounds for such a suit. Almost certainly, future litigation related to the 1934 Act will resolve this latter issue.

This is another case that instructors can use to impress upon students the importance of maintaining a healthy degree of skepticism during every audit engagement. Leston Nay was well known and respected in both the Chicago business and civic communities and had a seemingly spotless reputation as a prudent investment advisor. Despite this reputation, Leston Nay was, to put it mildly, dishonest. As pointed out in the case, Ernst & Ernst served as First Securities' audit firm for more than two decades. Audit engagement personnel may become complacent when assigned to a long-term client that has never presented any major problems for the audit firm. Whether such complacency was a factor in this case is impossible to determine. Nevertheless, I believe that possibility is certainly a valid point for instructors to raise when discussing this case.

Suggested Solutions to Case Questions 1. [Note: Because First Securities was an SEC registrant, an audit of the brokerage firm at the present time would be governed by the PCAOB’s auditing standards.] The mail rule would likely qualify as a "material weakness” under AS 2201, “An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements,” of the PCAOB’s auditing standards. “A material weakness is a deficiency, or 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” (AS 2201.98). AS 2201 requires auditors to communicate material weaknesses that they discover to client management and the entity’s audit committee. Likewise, AS 2201 requires auditors to issue an adverse opinion on an SEC registrant’s internal control over financial reporting when a material weakness is present and to identify that weakness in its internal control report. Such disclosure may very well have resulted in the discontinuance of the mail rule and, possibly, to the discovery of Nay’s fraud.

2. The mail rule clearly had important financial implications for First Securities. In one of the legal cases prompted by the First Securities fraud, the court pointed out that while engaging in the fraud Nay was acting as an agent of First Securities. " . . . First Securities also provided Nay with the printed letterhead, printed safekeeping receipts, rubber stamps, and other supplies and other accoutrements which enabled him to perpetrate and perpetuate his frauds." [Securities and Exchange Commission vs. First Securities Company of Chicago, 466 F.2d 1035 (1972), p.

1040.]

In fact, in another court case, First Securities was found liable for the investment losses suffered by the participants in the escrow syndicate. This finding was essentially a moot point, however, since First Securities was insolvent.

The mail rule also had significant implications for the brokerage firm's internal controls. If Ernst & Ernst had discovered the mail rule, it would have vigorously questioned Nay as to its purpose. In this vein, Ernst & Ernst apparently did not contest the testimony of expert witnesses who suggested © 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 7.6 First Securities Company of Chicago 361 that had the mail rule been discovered, the Ernst & Ernst auditors should have considered its existence to be a very serious control deficiency. [See Exhibit 2 for portions of the expert testimony on this issue.]

3. There are multiple questions in my casebook that address the general issue of auditor mistakes, negligence, and intentional misconduct. For many years, I have used the following definitions of negligence, recklessness, and fraud in responding to those questions. Granted, in the context of this question, fraud on the part of the auditors was not an issue. Notice that following each of the definitions, I provide an example of the given malfeasance or 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 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.

4. Most likely, the escrow investors would have been successful in recovering their losses from Ernst & Ernst if they had been entitled to file their suit under the Securities Act of 1933. Auditors are faced with much more litigation risk when they audit financial statements included in a registration statement filed under the 1933 Act compared with financial statements included in a registration statement filed under the 1934 Act. A “qualified” plaintiff who files suit under the 1933 Act is not required to establish any type or degree of malfeasance on the part of the given audit firm. In fact, when filing suit against an audit firm under the 1933 Act, a plaintiff must establish only two general elements of proof to make a prima facie case. The plaintiff must prove that he or she suffered damages and that the financial statements in question contain one or more material errors. (In this case, the material error in First Securities' financial statements was the lack of disclosure regarding the firm's contingent liability for Nay’s fraudulent actions.) © 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 7.6 First Securities Company of Chicago

5. In a jurisdiction that invokes the legal precedent established by the Restatement of Torts, both "primary" and "foreseen" beneficiaries are allowed to recover damages resulting from the actions of a negligent audit firm. Foreseen beneficiaries include a reasonably small or limited group of individuals or other parties that the given audit firm was aware would be relying on the financial statements in question. [Key point: The auditor is aware of the given group of intended financial statement users but is not necessarily aware of the specific individuals or other parties that belong to that group.] If the escrow investors could have established that they qualified as foreseen beneficiaries, they likely would have been able to recover their losses in a “Restatement of Torts” jurisdiction.

© 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 7.7 Texas Drug Warehouse 363

CASE 7.7

TEXAS DRUG WAREHOUSE

Synopsis They key issue posed by this short case is whether audit firms should notify clients of key planning decisions affecting the scope and nature of an audit. Prior to the beginning the 1995 audit of TDW, a drugstore chain headquartered in Dallas, KPMG decided to reduce the number of hours budgeted for the engagement and to assign less experienced personnel to the audit. Neither of these decisions was communicated to the client. The following year, TDW dismissed KPMG after the audit firm told client management that the audit fee would be increased for the 1997 engagement. When TDW’s new audit firm discovered material errors that had existed in the company’s accounting records since 1995, TDW sued KPMG for negligence during the 1995 and 1996 audits—KPMG did not contest the fact that the material errors were present in TDW’s accounting records. When TDW learned of the decisions that KPMG had made prior to the 1995 audit, the company added a “deceptive business practices” complaint to its lawsuit against the audit firm. This complaint alleged that KPMG had a responsibility to inform TDW management of the decision to reduce the “quality of its services.”

An interesting twist in the case is an argument that KPMG attorneys made in attempting to defeat the negligence claim filed against their firm. The attorneys argued that wording in the TDW-KPMG engagement letter required TDW officials to disclose any material errors in the company’s accounting records to KPMG—including errors unknown to those officials. KPMG maintained that TDW’s failure to disclose the material errors (which were subsequently discovered by the successor audit firm) effectively released KPMG from any obligation to find and report the errors. Surprisingly, a lower court agreed with this argument and issued a summary judgment in favor of KPMG, but an appellate court subsequently rejected that argument and scolded the firm’s attorneys for using such weak reasoning in their effort to refute the negligence claim. The appellate court then remanded the negligence claim to a lower court. Since no further public report of the lawsuit was found, the matter was likely resolved privately by the two parties. The appellate court dismissed the deceptive business practices complaint filed against KPMG by TDW. According to the appellate judges, audit firms have the right to make changes in the planned scope of an audit and changes in personnel assigned to an audit without notifying the client.

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Case 7.7 Texas Drug Warehouse 364 Texas Drug Warehouse--Key Facts 1. During the mid-1990s, KPMG served as the audit firm for Texas Drug Warehouse (TDW), a small drugstore chain based in Dallas.

2. Before the 1995 TDW audit, KPMG decided to reduce the budgeted hours for that engagement and to assign less experienced personnel to the engagement—without notifying the client of those decisions.

3. Following the 1996 audit, TDW officials dismissed KPMG after the accounting firm indicated tha it would be increasing the audit fee for the following year’s audit.

4. TDW’s new audit firm discovered material errors in the company’s accounting records during the 1997 audit of the company—errors which had existed in those records during prior years audited

by KPMG. 5. TDW officials sued KPMG for negligence during the 1995 and 1996 audits and for engaging in deceptive business practices by failing to inform them of changes made in the nature and scope of the TDW audit prior to the 1995 engagement.

6. To refute the negligence claim, KPMG argued that client executives had falsely represented in the audit engagement letter that there were no material errors in TDW’s accounting records.

7. An appellate court rejected KPMG’s response to the negligence claim by pointing out that the engagement letter signed by TDW officials did not require them to inform KPMG of unknown material errors in the company’s accounting records; the negligence claim was apparently settled privately by the two parties after it was remanded to the lower court.

8. The appellate court dismissed the deceptive business practices claim by ruling that KPMG had not been required to notify the client of changes made in the nature and scope of the annual TDW audits.

9. According to the appellate court, the number of hours and level of professional expertise necessary to complete an audit are “questions of professional judgment” that an audit firm has the right to make without consulting or notifying the client.

10. The appellate court pointed out that TDW could have sued KPMG for professional malpractice if the accounting firm had failed to budget sufficient hours for the TDW audits or assigned auditors to those engagements that had insufficient experience.

Instructional Objectives 1. To demonstrate that key audit planning decisions, such as time budget and staffing decisions, are © 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 7.7 Texas Drug Warehouse 365 the sole responsibility of the given independent audit firm.

2. To identify factors and circumstances that may influence resource allocation decisions on audit engagements.

3. To examine the nature and content of audit engagement letters.

Suggestions for Use The major issue in this case involves audit planning decisions, namely, whether audit firms should consult their clients when important changes are made in the planned scope of an audit and in personnel assigned to the audit engagement team. Likewise, three of the four case questions are directly or indirectly linked to audit planning, so you might consider integrating this brief case with your coverage of that topic. Another “front-end” activity during an audit engagement, namely, obtaining an engagement letter, is a secondary topic in this case—the first case question addresses that topic. This case does not include the actual engagement letter between KPMG and TDW. If you want to expose your students to an actual audit engagement letter, see Case 1.9, ZZZZ Best Company, Inc. Suggested Solutions to Case Questions 1. AU-C Section 210, “Terms of Engagement,” addresses “the auditor’s responsibilities in agreeing upon the terms of the audit engagement with management.” Paragraph .10 notes that “the agreedupon terms of the audit engagement should be documented in an audit engagement letter or other suitable form of written agreement.” Paragraph .10 then lists, in a bullet format, the following key matters that should be addressed in an engagement letter. a. b. c. d.

The objective and scope of an audit of the financial statements.

The responsibilities of the auditor.

The responsibilities of management.

A statement that because of the inherent limitations of an audit, together with the inherent limitations of internal control, an unavoidable risk exists that some material misstatements may not be detected, even though the audit is properly planned and performed in accordance with GAAS. e. Identification of the applicable financial reporting framework for the preparation of the financial statements. f. Reference to the expected form and content of any reports to be issued by the auditor and a statement that circumstances may arise in which a report may differ from its expected form and content.

Yes, the courts have consistently recognized that an engagement letter between an audit firm and a client is a legally binding contract. © 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 7.7 Texas Drug Warehouse 366 2. Listed next are examples of factors or circumstances that may have influenced KPMG’s decision to reduce the budgeted hours for the 1995 audit and to assign less experienced personnel to that engagement. (a) KPMG believed that the audit fee was not sufficient. Rather than attempt to increase the fee, the accounting firm was attempting to reduce the cost of the audit. Over the long run, audits must be profitable for audit services to be a viable professional service. But, rather than “cut corners” by reducing costs on low-margin or unprofitable engagements, audit firms should attempt to renegotiate the audit fee. [Invalid reason] (b) Changes in technology. The personal computer, statistical sampling software applications, the Internet, and other technological advances in recent years have allowed audit firms to reduce the time required to complete many audits and to use less experienced audit personnel on those engagements. [Valid reason] (c) Additional clients. When a practice office of an audit firm is successful in acquiring a healthy crop of new clients, one result may be that there are insufficient personnel in the office, particularly experienced personnel, to properly staff all new and recurring audit engagements.

[Invalid reason] (d) Periodic reevaluation of resources needed for a given engagement. Each year, the audit engagement partner for a given client routinely reviews and assesses the resources needed to successfully complete the current year audit for that client. Prior to the 1995 audit, the TDW audit engagement partner may have decided that fewer resources would be required to complete that audit. Examples of factors that might have led him or her to reach that conclusion include a new and more efficient accounting system acquired by the client or the closure by the client of several of its retail outlets. [Valid reason] 3. My answer to both of these questions would be “not necessarily.” In fact, the two “valid reasons” listed in the response to Question 2 identify specific factors or circumstances that would allow an audit firm to reduce the time budget for an audit and assign less experienced personnel to that engagement without impairing or diminishing the overall quality of the audit service for the engagement. [I would speculate that among the most common reasons for an audit firm to reduce the planned hours for an audit is the fact that the audit engagement team for the prior year returns intact—or nearly so—for the current year’s audit. The significant learning curve effect on most audits generally allows audit firms to reduce the time budget for an engagement if the prior year’s audit team returns intact.]

4. By definition, professionals have the responsibility and obligation to decide the proper type and scope of services to provide to their clients or customers. [Few of us would want to be directly involved in our heart surgeon’s decision of whether a triple or quadruple bypass operation is necessary!] On the other hand, one could easily argue that professionals should inform a client when dramatic changes are to be made in the nature and scope of services to be provided to that client.

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Case 7.8 Frank Coleman, Staff Accountant 367

CASE 7.8

FRANK COLEMAN, STAFF ACCOUNTANT

Synopsis Overtime is one of those “touchy” subjects that public accounting firms are not prone to discuss at length with prospective employees. This case examines the overtime issue in the public accounting profession from the standpoint of an individual who, after resigning his position with one of the Big Four accounting firms, was asked to become a party to one of the many “overtime” lawsuits pending against those firms.

Each of the Big Four firms faces multiple lawsuits that charge them with failing to pay overtime to thousands of current and former “non-exempt” employees. State and federal labor laws exempt employers from paying overtime wages to certain individuals. The major accounting firms in the United States have maintained for years that even entry-level employees are not entitled to overtime wages under those laws. The most common justification used by these accounting firms to sustain that argument is that entry-level employees are “professionals” who do not require close supervision and who exercise “independent discretion and judgment.” Not surprisingly, the plaintiff attorneys who have filed the overtime lawsuits wholeheartedly reject that argument.

In addition to exploring the major headache that the overtime lawsuits pose for the “Big” accounting firms, this case provides students with an opportunity to openly discuss how the overtime issue will affect their future job choices. The case also provides those students who are already committed to entering public accounting upon graduation an opportunity to discuss how they intend to cope with this negative aspect of their future job roles.

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368

Case 7.8 Frank Coleman, Staff Accountant Frank Coleman, Staff Accountant--Key Facts

1. Like most auditors employed by Big Four accounting firms, a significant amount of overtime was a fact of life for Frank Coleman.

2. While a staff accountant with a Big Four firm, Frank was required to work 70 hours per week during the summer or “off-season” to complete an audit engagement for a client that was going public.

3. A key factor responsible for the significant amount of overtime that Frank was required to work was the high turnover rate experienced by his practice office.

4. Despite frequent reassurances from his superiors that his commitment to the firm and personal sacrifices would eventually be rewarded, Frank decided to leave his employer and accept a position on the consulting staff of another Big Four firm.

5. A key factor that influenced Frank’s decision was a commitment by his new employer that he would have much more reasonable work hours.

6. In recent years, each of the Big Four firms has been sued for failing to pay overtime to “nonexempt” entry-level employees, that is, employees mandated to be paid overtime by applicable labor laws.

7. State and federal labor laws generally mandate that employers pay overtime to employees who require close supervision and who do not exercise “independent discretion and judgment” in their work roles.

8. In response to the overtime lawsuits, the Big Four firms have typically asserted that even their entry-level employees are “professionals” who do not require close supervision and who exercise “independent discretion and judgment” in their work roles.

9. Recently, the Canadian affiliates of the Big Four firms have all agreed to begin paying overtime to their entry-level employees.

10. To date, there has been a “mixed bag” of outcomes to the overtime lawsuits that have been resolved against the major accounting firms.

Instructional Objectives 1. To provide students with a better understanding of the nature of the work roles in the public accounting profession.

2. To examine a major economic problem that the Big Four accounting firms presently face. © 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 7.8 Frank Coleman, Staff Accountant 369 3. To give students an opportunity to discuss the factors that determine whether or not a given job role qualifies for “professional” status.

4. To give students an opportunity to discuss factors that will influence their job choices.

Suggestions for Use By the time that you cover this case in class, there may be some significant developments in the pending overtime lawsuits facing the large accounting firms. As noted in the case, the Canadian affiliates of the Big Four firms who were facing similar lawsuits each capitulated and began paying overtime wages to their entry-level employees. In fact, as also noted in the case, KPMG Canada issued a formal apology to its current and former employees who had been improperly denied overtime wages. Consider having your students or a group of your students research recent developments regarding the overtime lawsuits and then provide a brief in-class report of their findings.

The purpose of this case is two-fold: to explore the impact of overtime on the work roles of lower-level audit staff employees and to examine the implications, principally economic implications, of the numerous overtime lawsuits for the major accounting firms. These lawsuits have been filed in state and federal courts across the nation and are based upon a variety of different state and federal laws and legal precedents. This case was not intended to, and does not, document the many technical differences across the numerous overtime lawsuits or explore the various idiosyncrasies of the state and federal labor laws that mandate the payment of overtime to certain employees.

Suggested Solutions to Case Questions 1. This is a discussion question for students that doesn’t have a definitive answer. For a question such as this, I often draft two groups of students and then have those groups debate the given issue.

As a point of information, state and federal labor laws typically permit employers to avoid paying overtime wages to “professional” employees. This exclusion, as you might expect, has generated intense debate over which employees qualify as professionals. In at least some of the overtime lawsuits, employees of public accounting firms are automatically considered to be “professionals” when they become licensed CPAs regardless of their job title.

2. As suggested in the case, a key element of the defense “strategy” used by the major accounting firms in responding to the overtime lawsuits is to maintain that audit staff below the level of audit senior do not require close supervision and have the ability to exercise independent discretion and judgment. If those two conditions are met, among others, then, at least in certain jurisdictions, the given audit staff are “exempt” employees and it is not mandatory for employers to pay them overtime compensation. Plaintiff attorneys have vigorously maintained that audit staff accountants or associates, in fact, are not allowed to exercise independent judgment and must be closely supervised.

The professional auditing standards don’t take a definitive stance on this issue.

AU Section 220.A14 of the AICPA Professional Standards suggests that several factors must be considered in determining the extent and nature of “supervision” provided to members of an audit engagement team. These factors include the “competence and capabilities of individual members 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.

370

Case 7.8 Frank Coleman, Staff Accountant

the engagement team” and the need to identify those issues that arise during an audit engagement that may require “consultation or consideration by qualified engagement team members” (emphases added). This statement certainly implies that the degree of expertise of engagement team members will likely vary and that some of those members will be more “qualified” than others to address or resolve important technical issues that arise on an engagement. However, that excerpt and the accompanying text does not refer to the need to “closely supervise” inexperienced staff assigned to an audit team nor does it suggest explicitly that inexperienced audit team members are prohibited from exercising “independent discretion and judgment.” Having said that, my reading of this technical material suggests that lower-level auditors do not have the ability to exercise “independent discretion and judgment” at least in certain circumstances.

The PCAOB devoted an entire auditing standard to the topic of supervision, namely, Auditing Standard No. 10, “Supervision of the Audit Engagement,” which is now integrated into AS 1201.

AS 1201.03 of this standard notes that, “The engagement partner is responsible for proper supervision of the work of engagement team members” (emphasis added). AS 1201.06 of this standard observes that in determining the “extent of supervision necessary for engagement team members” the engagement audit partner and other senior members of the engagement team should take into account, among other factors, “the knowledge, skill, and ability of each engagement team member.” Again, this standard does not specifically indicate that inexperienced team members have to be closely supervised nor does it indicate that such auditors should not be allowed to exercise “independent discretion and judgment.” Nevertheless, these excerpts and the accompanying text imply that certain audit team members require closer supervision than others. Finally, AS 1201.05 suggests that in certain contexts lower-level auditors should not be allowed to resolve “significant accounting and auditing issues.” Instead, lower-level auditors should bring such issues to the “attention of the engagement partner or other engagement team members performing supervisory activities so they can evaluate those issues and determine that appropriate actions are taken in accordance with PCAOB standards.” Similar to my conclusion re the relevant sections of the AICPA Professional Standards, my reading of this technical material suggests to me that lower-level auditors do not have the carte blanche authority to exercise “independent discretion and judgment.” No doubt, plaintiff attorneys have reached a similar conclusion in pursuing the overtime lawsuits they have filed against the major accounting firms.

3. Another discussion question for your students. Surprisingly, I have found that many students are unaware that the “Big” accounting firms tend to require entry-level audit staff to work a considerable amount of overtime. Unfortunately, there is not much in the way of empirical evidence regarding the “typical” amount of overtime worked annually by entry-level auditors of the major accounting firms.

My case reports the results of two nationwide surveys that provide insight on that issue but, unfortunately, both of those studies are somewhat dated. In discussing this question, students can share the insights that they have gathered during their interviewing processes regarding this issue. I have found that students often obtain the most reliable (or, at least, what they perceived to be the most reliable) “overtime” data from their former colleagues who graduated a year or so before and from friends or acquaintances that were former Big Four employees. An open forum where students share these “data points” serves to provide them with a more robust understanding of what is widely considered to be the most negative aspect of their future job roles. © 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 7.9 Olivia Thomas, Audit Senior 372

CASE 7.9

OLIVIA THOMAS, AUDIT SENIOR

Synopsis This case focuses on a sensitive but seldom discussed phenomenon or issue in the public accounting profession, namely, the topic of intra-office dating. In the “old” days when I was in public accounting, I believe that most major accounting firms had an anti-fraternization policy. However, as noted in this case, the major accounting firms’ views on that issue have evolved over the years, meaning that they have become more “liberal.” Based upon an informal survey of several major accounting firms as I was writing this case, those firms generally take a neutral position when it comes to intra-office dating, that is, they neither encourage nor discourage it. Having said that, these firms do discourage or prohibit personal relationships among partners and employees that might pose a “conflict of interest” for the given individuals or the firm as a whole.

In this case, two employees of a major accounting firm, Olivia Thomas, an audit senior, and Eli Arezzo, a staff accountant, begin dating. This case examines the issues and problems that the personal relationship between the two auditors poses for them. Complicating matters dramatically for the two individuals is Eli’s unexpected transfer to an audit being supervised by Olivia.

The case questions provide students with an opportunity to explore a sensitive subject that has growing implications for the major accounting firms and their partners/employees. Why? Because empirical research has demonstrated in recent years that, for better or worse, there is a definite upswing in “office romances.”

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Case 7.9 Olivia Thomas, Audit Senior 373

Olivia Thomas, Audit Senior--Key Facts 1. Olivia Thomas, an audit senior for a major accounting firm, and Eli Arezzo, a staff accountant for the same firm, became involved in a personal relationship shortly after meeting each other in their practice office.

2. Their employer neither encouraged nor discouraged intra-office dating; however, the firm required partners and employees to avoid any and all relationships that might “impair or influence their judgment” or otherwise pose a “conflict of interests” for them or the firm.

3. Olivia’s father, a former public accountant, encouraged her to keep her personal and professional lives separate after she decided to enter public accounting.

4. In the past when her father was in public accounting, most major accounting firms had a policy against fraternization; over the years, those firms moved away from that policy and now have generally taken a neutral stance on the topic of intra-office dating.

5. Olivia and Eli’s relationship was complicated when he was unexpectedly transferred to an audit that she was supervising.

6. Olivia and Eli did their best to keep their personal relationship a secret from their co-workers, including their superiors.

7. While they were working together on the same engagement, their personal relationship interfered on occasion with their professional relationship.

8. At one point, Eli became upset with Olivia for treating him as she would any other subordinate; later in the engagement, Olivia became upset when she observed one of her female subordinates flirting with Eli. 9. At the conclusion of the engagement, Olivia completed a performance evaluation report for Eli without disclosing the personal relationship between them.

10. The relationship between Olivia and Eli ended shortly after he left the firm to enroll in an MBA program in a distant city.

Instructional Objectives 1. To make students aware of how major accounting firms’ view of intra-office dating has evolved over the years.

2. To help students understand the personal and professional issues that may arise as a consequence © 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 7.9 Olivia Thomas, Audit Senior 374 of intra-office dating.

3. To provide students with an opportunity to examine and discuss the question of whether public accountants should keep their professional and personal lives strictly separate.

Suggestions for Use Some instructors may not be comfortable using this case in their auditing courses given its sensitive nature. My view is that any issue or phenomenon that has significant implications for the quality of independent audits is fair game in an auditing course. Likewise, I believe we do our students a disservice if we do not make them aware of important non-technical facets of their future job roles that have the potential to adversely affect, if not derail, their professional careers.

I think you will find that students enjoy discussing this case. At some point, I encourage students to consider how the dynamics of this case might have been affected if the genders of Olivia and Eli had been reversed, that is, if Eli had been the audit senior and Olivia had been the staff accountant.

Another “curve” that you can throw at your students is to ask them how the dynamics of the interaction between the two auditors would likely have been affected had the staff accountant rather than the audit senior initiated a relationship with the other individual. Again, you can encourage your students to examine this latter issue from both gender perspectives, that is, assuming that the “initiating” staff accountant is a male in one context and a female in the other.

Suggested Solutions to Case Questions 1. Notice that the case indicates that both Olivia and Eli were aware of their firm’s formal policy regarding “personal relationships,” namely, that partners and employees were required to avoid any and all relationships that might “impair or influence their judgment” or otherwise pose a “conflict of interests” for them or the firm. With regard to the specific issue of intra-office dating, although not specifically prohibited, the firm’s culture effectively deemed it “unprofessional.” As a sidebar, I believe it is important that students recognize that accounting firms have explicit rules that govern personal and professional conduct, but there are also typically a bevy of unwritten rules embedded in those firms’ culture that members must absorb. In some cases, unwritten or informal rules of conduct are given as much or possibly even more weight by an organization’s members.

Given the general understanding within the firm that intra-office dating was considered “unprofessional,” students tend to conclude that both Olivia and Eli behaved unprofessionally by dating each other. A relevant point in this context is that unwritten rules of conduct within an organization are not necessarily accepted or internalized to the same degree by all organizational members. Having said that, it appears that both Olivia and Eli had internalized their formal’s informal rule against dating since they each made an effort to conceal their relationship from their co-workers from its inception. That is, one can likely conclude that both of them considered their behavior unprofessional or inappropriate, to some degree. Independent of Olivia’s and Eli’s attitudes or opinions regarding intra-office dating, the majority of my students typically suggest that such conduct is “cheesy,” gauche, childish, and/or “unprofessional.” In the case at hand, students typically suggest that the behavior of Olivia and Eli during the engagement to which they were jointly assigned © 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 7.9 Olivia Thomas, Audit Senior 375 smacked of “unprofessionalism.”

If Eli had not been transferred to work under Olivia’s supervision, it would be difficult to credibly argue that either had behaved “unethically.” Prior to that point, there was little likelihood that their relationship would “impair or influence their judgment” or pose a “conflict of interests” for them or the firm. However, once Olivia became Eli’s supervisor, both of them were clearly in violation of their employer’s policy regarding “personal relationships.” More to the point, neither of them was acting with “integrity,” which is the overriding ethical principle included in the AICPA Code of Professional Conduct. Given that Olivia was in the supervisory position, students typically maintain that she was more unethical than Eli. Notice that in this context I do not equate the terms “unprofessional” and “unethical.” Some students contend that those two terms are interchangeable. My view is that the term “unethical” clearly brings into play the AICPA Code of Professional Conduct, while the term “unprofessional” does not necessarily, despite the fact that term is included in the title of the AICPA’s code.

2. Eli’s close relationship with Olivia meant that he was highly likely to receive the benefit of the doubt when she completed his performance evaluation report, meaning that his fellow staff accountants on the DuClaux audit were potentially disadvantaged when it came to having their performance assessed. Abby Edzards, in particular, faced the greatest risk of being disadvantaged given Olivia’s belief that there was a budding relationship between Abby and Eli. More globally, the relationship between Olivia and Eli had the potential for undercutting the quality of the DuClaux audit. For example, Olivia may have been disinclined to rigorously or thoroughly review Eli’s work product. The potential reduction in the overall quality of the DuClaux audit could have had adverse consequences for everyone in the practice office and the entire firm if the ultimate result was an “audit failure” or even alleged audit failure.

3. There are a number of factors that may account for the liberalization of major accounting firms’ policies regarding intra-office dating. I will mention three. First, in decades past, major accounting firms were male-dominated with women accounting for only a small fraction of their professional workforces. During those “Medieval” times, there may have been a perception that the few female professionals in those firms had to be, in some sense, protected from their male counterparts, even those at the same employment level. That is, because of their small numbers, women public accountants potentially faced some disproportionate degree of unwanted attention from opposite gender suitors. As the number of men and women employed by the major accounting firms has become more balanced, particularly within the lower and middle employment levels of those firms, that risk has dissipated. Second, based upon my anecdotal research, all types of organizations in the business world have liberalized their workplace dating policies in recent years. This trend has resulted in a “spillover effect” to the generally more conservative work environments such as public accounting. Finally, in recent years, the courts have begun frowning upon organizational rules that strictly forbid consensual relationships, particularly consensual relationships among employees at the same level within an organization. Such rules tend to impose a “guilty until proven innocent” mindset when it comes to workplace relationships, a mindset that an increasing number of courts find objectionable. © 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 7.9 Olivia Thomas, Audit Senior 376 4. This is an open-ended question that overlaps, to some degree, with the three preceding questions.

There is, of course, no clear-cut answer to this question. My experience has been that students enjoy debating this issue. The most common point of view tends to be that it is in one’s own interest, both professionally and personally, to avoid romantic workplace relationships.

© 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 8.1 Longtop Financial Technologies Limited 377

CASE 8.1

LONGTOP FINANCIAL TECHNOLOGIES LIMITED

Synopsis Longtop, an information technology (IT) company, was founded by two Chinese friends in the late 1990s. The company’s business model was oriented around providing IT services to China’s rapidly growing banking industry. Because Longtop’s common stock was listed on the New York Stock Exchange, it was subject to the regulatory overview of the SEC. From 2004 to 2011, the company’s audit firm was Deloitte Touche Tohmatsu CPA Ltd. (D & T Shanghai), the Chinese affiliate of U.S.-based Deloitte & Touche.

In the spring of 2011, just as D & T Shanghai was completing its fiscal 2011 audit of Longtop, allegations surfaced that company officials were fraudulently misrepresenting the company’s financial data. The most serious allegation was that much, if not most, of the $400 million of cash reported on the company’s pre-audit 2011 balance sheet did not exist—the company’s reported cash accounted for nearly 60% of its total assets.

Upon learning of the allegations, D & T Shanghai chose to extend its audit of Longtop’s 2011 financial statements with a particular focus on re-confirming the company’s year-end cash balances.

Almost immediately, Longtop officials interfered with the planned extension of D & T Shanghai’s cash confirmation procedures. In fact, the Longtop officials confiscated certain of D & T’s audit workpapers. A few days later, D & T Shanghai resigned as Longtop’s auditor.

During the same timeframe that the Longtop debacle was taking place, there were other comparable cases in which affiliates of Big Four accounting firms resigned as the auditors of Chinese companies due to concerns over the reliability of the financial data they were auditing. Similar to the Longtop case, the banks of these Chinese companies were apparently complicit in the frauds.

The Longtop incident focused greater attention on an issue that had been simmering in the United States for several years, namely, the refusal of the Chinese government to allow the PCAOB to inspect accounting firms, such as D & T Shanghai, that audit non-U.S. companies that have securities traded on U.S. stock exchanges. The international brouhaha stemming from the Longtop case escalated when D & T Shanghai refused to cooperate with the SEC’s investigation of the Longtop accounting fraud. D & T Shanghai officials insisted that an important Chinese federal statute precluded them from cooperating with the SEC’s investigation. © 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 8.1 Longtop Financial Technologies Limited 378

Longtop Financial Technologies Limited--Key Facts 1. Longtop was founded in 1996 by two Chinese friends, Jia Xiao Gong and Weizhou Lian.

2. Longtop’s business plan involved providing IT services to China’s rapidly growing banking industry.

3. D & T Shanghai, the Chinese affiliate of U.S.-based Deloitte & Touche, served as the auditor of Longtop from 2004 through 2011.

4. Near the completion of the fiscal 2011 Longtop audit, allegations surfaced that company officials were engaging in an accounting fraud to embellish the company’s financial statements.

5. When D & T Shanghai attempted to extend its 2011 audit, Longtop officials interfered and confiscated some of the firm’s audit workpapers.

6. Longtop was subject to the regulatory oversight of the SEC since the company’s common stock was listed on the NYSE. 7. Because of a mandate included in the Sarbanes-Oxley Act, the PCAOB is required to inspect all accounting firms that audit companies that have securities traded on U.S. stock exchanges.

8. By mid-2012, the PCAOB had yet to inspect any of the several dozen Chinese accounting firms that audited companies with securities traded on U.S. stock exchanges; the Chinese government refused to allow such inspections, maintaining that its own audit regulatory system was sufficient.

9. The Longtop case and several other Chinese accounting scandals during the same timeframe refocused attention on the Chinese government’s refusal to allow the PCAOB to inspect Chinese accounting firms.

10. Adding to the controversy was the refusal of D & T Shanghai to provide its Longtop audit workpapers to the SEC, which, at the time, was investigating the Longtop accounting fraud.

Instructional Objectives 1. To demonstrate how cultural and political values can influence a nation’s financial reporting system and independent audit function.

2. To provide students with a better understanding of the global accounting profession, including the role that the major international accounting firms play in that profession.

3. To examine the regulatory responsibilities of the SEC and PCAOB that are relevant 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 8.1 Longtop Financial Technologies Limited 379 independent audit firms.

4. To examine the responsibilities of U.S. accounting firms when a major portion of an audit client’s operations are audited by a foreign accounting firm.

Suggestions for Use By the time you assign this case, there may have been additional significant developments in the ongoing tete-a-tete involving the SEC/PCAOB and the Chinese government. Consider having your students research such developments and provide brief in-class reports on them.

Previous editions of this casebook included a fairly lengthy case entitled Zuan Yan that provided a historical overview of the evolution of China’s financial reporting system, accounting profession, and independent audit function. You might refer to that case to obtain a more complete understanding of the nature and structure of the independent audit function in China. If you are fortunate enough to have Chinese students in your class, you might ask them if they are willing to share any particular insights they may have on the history of their country’s accounting profession, in general, and its independent audit function, in particular.

Suggested Solutions to Case Questions 1. Note: None of the professional standards include a discussion of “auditability”—which may or may not be an actual word. To address the issue of what conditions or circumstances must be present for a company to be “auditable,” a good starting point is the formal definition of “auditing” presented decades ago by the AAA Committee on Basic Accounting Concepts.

Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between the assertions and established criteria and communicating the results to interested users.

Notice that to audit a given entity, an auditor must be able to “obtain” and “evaluate” evidence.

Implicit in this definition are a number of premises such as the fact that the audit evidence collected must be reliable. If an auditor cannot obtain reliable audit evidence regarding a given entity, then by definition there is no basis for an audit. For example, given the amount of audit evidence that must be collected directly from client management, an entity is certainly not auditable if an auditor distrusts management. Likewise, if other sources of audit evidence are not trustworthy, such as, third parties responding to audit confirmations, the auditability of an entity is placed in doubt. An auditor must also, of course, be able to obtain “enough” reliable audit evidence as well as obtain reliable audit evidence that is relevant (“appropriate”) to the assertions being tested. Bottom line, in my view, the issue of auditability revolves around the availability of reliable, relevant, sufficient, etc. audit evidence.

There are a number of other second-order conditions or circumstances that one could identify as precursors to auditability. For example, auditor independence is clearly a precondition for performing a proper audit of a given entity. If an auditor is not independent, then, by definition, it is impossible © 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 8.1 Longtop Financial Technologies Limited 380 for him or her to collect audit evidence that meets the criteria of reliability, relevance, sufficiency, etc.

Regarding the auditability of Chinese companies, if key third parties, such as client banks, actively collude with audit clients to help them subterfuge the purpose of an independent audit, then clearly those clients are not “auditable.” Under such conditions, it would not be possible for an audit firm to collect the evidence necessary to render an objective opinion on a client’s financial statements.

Likewise, if audit clients refuse to cooperate with their independent auditors in providing access to the necessary types of audit evidence, then an audit is not possible. In the case of the People’s Republic of China, it seems also that the central government itself may have erected barriers that make it difficult to perform Western-style audits. For example, the broad definition of “state secrets” may prevent independent auditors in certain circumstances from accessing the information they need to complete an audit of a given entity.

2. The answer to this question seems to turn on the key term “uniform.” No doubt, cultural and political differences across individual nations and regions of the world impact how independent audits are performed. For example, in Islamic countries religious law or shari’a has a significant, if not pervasive, impact on independent audits (see Case 8.5, Shari’a). Likewise, as suggested by this case, one could certainly argue that the nature of independent audits in communist countries is affected by the overriding social or political dogmas of the central government. So, technically, I believe the most appropriate answer to this question is “No.” Certainly, international accounting firms have a responsibility to provide high quality “professional” audit services worldwide but the specific nature of those services will be impacted to some degree by extant political, social, cultural, and ethical norms and business practices specific to the country or region of the world where a given audit is being performed.

3. Assuming that Acme is an SEC registrant, which most large multinational companies are, AS 1205, “Part of Audit Performed by Other Independent Auditors,” of the PCAOB’s auditing standards would be the relevant U.S. auditing standards in this context. Acme’s U.S. audit firm would qualify as the “principal auditor” in this set of circumstances. As the principal auditor, the U.S. audit firm would have to decide whether to assume responsibility for the work of its Chinese affiliate. In most such cases, the U.S. auditor would assume responsibility for the work of that affiliate. AS 1205.05a suggests that a principal auditor will typically assume responsibility for the work performed by another independent auditor if that auditor is an “associated or correspondent firm . . . whose work is acceptable to the principal auditor based on his knowledge of the professional standards and competence of the firm.”

If the U.S. audit firm does not assume responsibility for its affiliate’s work, then the audit report ultimately issued must refer to the affiliate and document the division of responsibility between the two audit firms (AS 1205.07). AS 1205.06 notes that this option may be taken by the principal auditor when it is “impracticable for the principal auditor to review the other auditor’s work or to use other procedures which in the judgment of the principal auditor would be necessary for him to satisfy himself” as to the work performed by the other auditor.

Whether or not the principal auditor chooses to refer to the work of the affiliate in its audit report, the principal auditor must make certain inquiries of the affiliate (“the other auditor”). For example, © 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 8.1 Longtop Financial Technologies Limited 381 the principal auditor should inquire of the affiliate to determine if it is familiar with U.S. accounting principles and auditing standards (see AS 1205.10). In those circumstances where the principal auditor decides not to refer to the affiliate in its audit report, AS 1205 mandates that a series of additional “procedures” be performed by the principal auditor (AS 1205.12-13). These additional procedures include, for example, obtaining and reviewing the affiliate’s “engagement completion document,” “letters of representations from management,” “all matters to be communicated to the audit committee,” among other items.

If Acme was not an SEC registrant, then the AICPA Professional Standards would be relevant in this context and define the responsibilities of the company’s U.S.-based audit firm. The principal section of those standards that would be relevant is AU-C Section 600, “Special Considerations— Audits of Group Financial Statements (Including the Work of Component Auditors).” This section of the AICPA Professional Standards defines in detail the responsibilities of the “group engagement partner” and the “group engagement team” under varying sets of circumstances. An excellent summary of this relatively new section of the AICPA Professional Standards can be found in the following article: Thomas, C.E., and P.D. Wedemeyer, “Clarifying the Standard for Group Audits,” Journal of Accountancy, March 2013. Similar to AS 1205 of the PCAOB’s auditing standards, a key issue addressed by AU-C Section 600 is whether “the group engagement partner should decide to make reference to a component auditor in the auditor’s report on the group financial statements” (AU-C 600.24). If the group engagement partner decides to “assume responsibility for work of a component auditor, no reference should be made to the component auditor in the auditor’s report on the group financial statements” (AU-C 600.31). If the group engagement partner chooses not to assume responsibility for the work of a component auditor, then a series of disclosures must be made in the auditor’s report on the group financial statements focusing on the work performed by the given component auditor (see AU-C 600.28-30). AU-C 600 does effectively require component auditors to be supervised by the group engagement partner and his or her staff regardless of whether the work of the component auditors is referenced in the audit opinion: “The group engagement partner is responsible for the direction, supervision, and performance of the group audit engagement” (AU-C 600.05).

Section 600, “Special Considerations—Audits of Group Financial Statements (Including the Work of Component Auditors)” is the relevant section of the ISA’s in this context. Section 600.04 notes that “the group engagement partner is required to be satisfied that those performing the group audit engagement, including component auditors, collectively have the appropriate competence and capabilities. The group engagement partner is also responsible for the direction, supervision, and performance of the group audit engagement.” Note: Under ISAs, the audit report on “group financial statements” may not refer to one or more “component auditors” that were involved in the group audit engagement—of course, this is a significant difference between ISAs and the corresponding sections of the AICPA Professional Standards (principally AU-C Section 600) and AS 1205 of the PCAOB auditing standards.

4. As a point of information, China was not the only country that “arched its back” in opposition to the PCAOB’s insistence on “inspecting” foreign accounting firms. The PCAOB, for example, encountered considerable resistance in this respect from Japan.

Given the importance of the independent audit function to the free flow of capital 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 8.1 Longtop Financial Technologies Limited 382 increasingly global economy of the modern age, it seems reasonable to suggest that the need for high quality independent audits should be addressed at the highest level. That is, one could argue that U.S. regulatory agencies (SEC/PCAOB) should consider encouraging an international organization such as the WTO (World Trade Organization) to become involved in establishing general guidelines for independent audits worldwide. One could argue that the IFAC/IAASB that issues ISAs (International Standards of Auditing) could potentially provide this role. However, that organization, at least at the present time, doesn’t have the authority or credibility to mediate disputes such as those involving the U.S. and China over the issue of the PCAOB’s mandate to inspect non-U.S. audit firms. [Note: another organization that comes to mind in this context is the United Nations. However, that agency may have too much “on its plate” to take up the issue of independent audits.]

Clearly, there is no one “correct” answer to this case question. This is another example of a case question for which the quality of the support that a student provides for a given position is probably more important than the position he or she actually takes.

5. There is no disputing that ethical and moral values vary across cultures and nations.

Whistleblowing is considered ethical in some cultures and not in others; some cultures consider large disparities in salaries between corporate executives and their lower-level subordinates to be unethical, while others do not; and so on, and so forth. As a result, it seems unlikely that the global accounting profession could ever agree on one universal code of ethics. [As a point of information, you might point out to your students that even within the United States, there have often been differences of opinion across individual state boards of accountancy on what constitutes ethical and/or unethical conduct. For example, in recent years we have seen differences of opinion on issues such as competitive bidding, client solicitation, and the receipt of commissions by CPAs.] Since it is not feasible to develop a uniform ethical code for the global accounting profession, possibly the next best alternative is to attempt to identify those “big” ethical principles that should be and could be embraced by accountants across the globe. Consider asking your students to develop a set of such principles. Or, you might ask your students to discuss the six broad ethical principles included in the AICPA Code of Professional Conduct. Have them identify which of those principles they believe should and could be uniformly adopted by the global accounting profession. Listed next are those six principles: 1.

2.

3.

4.

5.

6.

Responsibilities The public interest Integrity Objectivity and independence Due care Scope and nature of services

For the most part, it seems that these principles would not be controversial in most societies.

However, consider the “public interest” principle. The definition of “public interest” almost certainly differs between a communist country and a democratic nation. In both types of countries, there is a wide range of parties that rely on accountants and auditors. Generally, in the United States, the interests of investors and creditors are of paramount concern to accountants and auditors. 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 8.1 Longtop Financial Technologies Limited 383 other hand, in a communist nation, the central government is likely to be considered the most important beneficiary of accounting and auditing services.

Likewise, consider the “objectivity and independence” principle. This principle requires professional accountants to be free of conflicts of interest. In a communist society, accountants and auditors may routinely face situations in which the interests of the central government are at odds with the interests of investors, lenders, or other users of accounting and auditing services. Such conflicts of interests may, in turn, produce conflicts of interests, or, at least, sizable ethical dilemmas, for individual auditors and accountants.

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Case 8.2 Kaset Thai Sugar Company 384

CASE 8.2

KASET THAI SUGAR COMPANY

Synopsis Many public accountants, particularly recent graduates, relish the possibility of an “overseas” assignment. An international assignment may provide an opportunity to see and experience another part of the world, potentially further one’s career, or simply provide a much needed “break” from the “same old, same old.” However, as the practices of the major international accounting firms have expanded into third-world countries, certain international assignments available to the employees of those firms have posed some degree of risk to their personal safety.

Michael Wansley, a senior partner with Deloitte Touche Tohmatsu who was based in that firm’s Melbourne, Australia, practice office, was a well-known debt restructuring specialist. In the late 1990s, the services of such specialists was in great demand in Thailand. After a decade of impressive economic growth from 1985 through 1995, the Thai economy imploded, causing a large number of Thai companies to default on loans that they had secured, principally from foreign banks and other international lenders. These creditors began hiring debt restructuring experts to help them collect these loans. Among the principal suppliers of debt restructuring services were the major international accounting firms, including Deloitte.

The Kaset Thai Sugar Company was a prime example of a Thai company that had overextended itself during Thailand’s “boom” days. In the late 1990s, the company defaulted on nearly $500 million of loans. Wansley was sent to Thailand to help Kaset Thai Sugar’s creditors recover those loans. During the course of that engagement, Wansley discovered that $150 million of the funds obtained from those loans had been siphoned off by the company’s owners into “shell” companies that they controlled. Shortly after this discovery, Wansley was murdered in an ambush in a remote region of Thailand north of Bangkok.

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Case 8.2 Kaset Thai Sugar Company 385 Kaset Thai Sugar Company--Key Facts 1.

A financial crisis in the late 1990s within Thailand caused many large Thai companies to default on their outstanding loans, including Kaset Thai Sugar Company.

2.

Major lenders to Thai companies retained debt-restructuring experts to help recover all or a significant portion of their “non-performing” loans.

3.

Among the major suppliers of debt-restructuring services are the international accounting firms.

4.

Michael Wansley, a senior partner with Deloitte Touche Tohmatsu and a well-known debtrestructuring expert, was retained by the lenders of Kaset Thai Sugar Company when it defaulted on nearly $500 million of outstanding loans.

5.

In early 1999, Wansley discovered that Kaset Thai Sugar had transferred approximately $150 million of the funds obtained from lenders to “shell” companies controlled by owners of the company.

6.

In March 1999, Wansley was ambushed and murdered as he arrived at a sugar mill owned by Kaset Thai Sugar in a remote region of Thailand.

7.

Six individuals eventually faced criminal charges for Wansley’s murder, including the sugar mill owner who was a member of one of Thailand’s most wealthy and powerful families.

8.

Four of the defendants in the case were convicted for their role in Wansley’s murder; however, the sugar mill owner was acquitted despite significant evidence linking him to the crime.

9.

Ex post, Deloitte was criticized for not providing adequate security for Wansley who had expressed concern regarding his and his subordinates’ personal safety.

Instructional Objectives

1.

To increase students’ awareness of the personal risks that public accountants may face on certain professional services engagements.

2.

To examine the responsibility of accounting firms to provide for the personal safety and wellbeing of their employees.

Suggestions for Use

Because this case focuses on the murder of a public accountant, some instructors may believe it is inappropriate for their courses. Another caveat: if you have one or more Thai students in your course, you may want to avoid this case since such students might find the case embarrassing and/or unpleasant to discuss. © 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 8.2 Kaset Thai Sugar Company 386 Many employees and partners of the major international accounting firms have either been assigned to engagements that require international travel or have spent a part of their careers in a foreign practice office of their firm. Consider requiring one or more groups of students to contact and interview such individuals in local practice offices and to present an oral report of these interviews to their classmates. The principal purpose of these interviews would be to provide students with first-hand insight on the “plusses” and “minuses” of international work assignments in public accounting.

Suggested Solutions to Case Questions 1. I am not aware of the specific policies, if any, that the major international accounting firms may have with respect to this particular issue. Since many of your students will likely have at least initiated the job interview process, consider asking them to raise this issue with the recruitment personnel of those firms.

Listed next are specific actions or decisions that an individual could take in responding to such a situation:  Determine whether the firm has a specific policy regarding such situations. If there is such a policy, determine how it is applied by the firm. To obtain this latter information, it may be necessary to contact an HR person in the local office or, possibly, an HR person in the firm’s headquarters office.  Once the firm’s policy is fully understood, then the individual will be able to make a much more informed decision on how to proceed. In fact, the firm’s policy may allow an individual to simply refuse such an assignment without any repercussions.  If the firm does not have a specific policy addressing this situation or if that policy requires or effectively requires employees to accept assignments with which they are uncomfortable, the next step will likely be to discuss the matter with an immediate supervisor or other mentor within the individual’s practice office.

Note: Audit engagements in hostile foreign countries are not the only type of objectionable job assignment that students may encounter during their public accounting careers. For example, many organizations that have strident positions on sensitive political or social issues must be audited.

Consider asking students what they would do if they found themselves assigned to the audit of an organization that takes strong positions that conflict with their own personal values or views.

2. You may have heard the cliché, “Someone has to cross the Delaware,” in reference to General Washington’s daring and risky decision to cross the Delaware River in the middle of a bitterly cold Christmas night. It is probably unreasonable to compare the dilemma faced by General Washington with the decision by an accountant of whether or not to accept a risky (personally speaking) audit engagement; nevertheless, it is true that such engagements must be completed by someone. At a minimum, it seems that accounting firms have a moral obligation to take all reasonable and necessary steps to protect individuals that they have asked to accept assignments to engagements that pose some degree of danger. It also seems reasonable to suggest that accounting firms should © 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 8.2 Kaset Thai Sugar Company 387 seriously consider a given employee’s request to be removed from an engagement that he or she believes is too dangerous.

No doubt, the murder of Michael Wansley made the major international accounting firms and their partners and employees starkly aware of the risk to one’s personal safety posed by certain engagements. As a result, these firms reportedly have implemented strong security measures to protect individuals in such cases. Apparently, the major firms do not publicly discuss these precautions; however, an Australian accounting firm did reveal security measures that it takes to protect individuals assigned to high-risk engagements in hostile or potentially hostile countries.

[Consider referring your students to the following article: F. Balfour, “Fixing Thailand’s Debt Mess, Business Week (www.businessweek.com) 12 February 2001.] Despite such measures, many public accountants may still choose not to accept such assignments. The question then becomes whether an individual should face any repercussions, explicit or otherwise, for rejecting a given assignment.

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Case 8.3 Republic of Somalia

388

CASE 8.3

REPUBLIC OF SOMALIA

Synopsis Among the most vexing problems facing the United States and other major democracies is the threat posed by terrorists around the globe. In recent years, Somalia has become a major breeding ground for one of the highest profile terrorist organizations, namely, al Qaeda. In 1991, Somalia’s federal government collapsed, plunging the country into anarchy. Al Qaeda took advantage of the resulting power vacuum to set up military training operations in the arid country that wraps around the “Horn of Africa,” the large African peninsula along the continent’s eastern coast. Shortly after the turn of the century, every major country in the world was drawn into the Somalia crisis when Somali pirates began commandeering commercial ships plying the heavily trafficked ocean trade routes that parallel the Horn of Africa.

In 2004, the United Nations collaborated with the African Union and the United States to establish the Transitional Federal Government (TFG) for Somalia. This new entity was intended to re-establish some degree of civil law and rudimentary social functions within Somalia with a long range goal of mediating the differences among the nation’s warring tribes. Nearly all of the TFG’s financial support would be provided by foreign aid. At the time, an estimated one billion dollars of foreign aid was flowing into Somalia each year. The absence of a central banking system and financial accountability on the part of the TFG resulted in much of that aid being embezzled by corrupt TFG officials.

In 2009, the United Nations brokered an arrangement to establish accounting and control functions for the TFG that would be overseen by an outside organization. That organization was the world’s largest accounting firm, PricewaterhouseCoopers (PwC). This case focuses on this very lucrative, very unusual, and very controversial engagement accepted by PwC. The case questions require students to consider the significant risks and thorny ethical issues that the engagement poses for PwC.

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Case 8.3 Republic of Somalia

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Republic of Somalia--Key Facts 1. The Republic of Somalia’s central government collapsed in 1991 plunging the country into anarchy that resulted in a massive humanitarian crisis for its citizens.

2. The Somali crisis impacts the United States and other western powers because of the significant influence of al Qaeda in the war-torn country and the strategic importance of Somalia to Middle Eastern oil fields and important oceanic trade routes.

3. In 2004, the United Nations, the African Union, and the United States organized the Transitional Federal Government (TFG) for Somalia; this new entity was intended to re-establish some degree of civil law and basic social functions in the country.

4. The primary source of financial support for the TFG was expected to be foreign aid; at the time, an estimated $1 billion of foreign aid was pouring into the country each year.

5. Since Somalia did not have a functioning banking system, TFG found it difficult to perform some of the most fundamental administrative functions, such as, disbursing payroll funds to its workforce.

6. The absence of a banking system and the lack of reliable accounting and control procedures resulted in corrupt TFG officials embezzling much, if not most, of the foreign aid intended to support its operations.

7. In 2009, the U.N. brokered an agreement between TFG and PricewaterhouseCoopers (PwC) under which the large accounting firm would manage TFG’s cash receipts and disbursements; PwC would receive a commission of 2-4 percent for those funds that were used for legitimate purposes.

8.

The TFG-PwC agreement was controversial and resulted in criticism of both parties.

9. Critics maintained that the largely confidential nature of the agreement would provide TFG officials with a continued ability to embezzle much of the funds intended to support its operations.

10. Other parties questioned PwC’s ability to provide for the physical safety of those individuals who would staff the engagement.

11. Allegations that Somalia governmental officials and other parties were embezzling much of the foreign aid pouring into the country each year continued largely unabated after PwC was retained to help manage the nation’s cash resources.

12. Somalia continues to be victimized by violent confrontations between and among warring tribes, al Qaeda (al Shabaab) guerillas, and government troops.

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Case 8.3 Republic of Somalia

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Instructional Objectives 1. To make students aware that professional service engagements in the accounting profession may involve a wide range of unusual responsibilities and risks, particularly for the major international accounting firms.

2. To require students to identify the professional standards that apply to specific types of professional service engagements.

3. To examine the responsibility of accounting firms to provide for the personal safety and wellbeing of their employees.

4. To identify the unconventional ethical issues and challenges accounting firms may face when they accept high-profile engagements that have political implications or consequences for government agencies and other parties.

Suggestions for Use Here is another case that can be somewhat sensitive or “ticklish” to discuss since the peripheral issues in the case have political and ethnic undertones. If you have students of the Islamic faith in your classes, you may want to make a special effort to ensure that the focus of the case discussion remains on the accounting and ethics-related issues rather than those peripheral issues.

When it comes to headline-grabbing international affairs and controversies, the general public, including students, typically don’t expect accountants and auditors to be “front and center” in those situations. This case—and several other cases in this text—demonstrate that accountants and auditors often play an important role in those matters. My experience has been that students enjoy discussing and debating this case not only because it involves such a high-profile context but also because it gives them an opportunity to address important ethical issues, such as confidentiality and integrity, in a “fresh” setting.

Before discussing this case, consider asking a student or a group of students to do some background research on recent developments relevant to the case and then report their findings in class.

Suggested Solutions to Case Questions 1. In general, the PwC-TFG engagement was an assurance services engagement. [Note: I am using the past tense here because technically the PwC-TFG relationship has ended, as noted in the case epilogue. However, as also noted in the case, PwC is apparently providing the same type of services to the new Somali government.] The AICPA’s Special Committee on Assurance Services defined those services as follows: “independent professional services that improve the quality of information, or its context, for decision makers.” The principal assurance being provided by PwC was the fact that TFG funds were being used for a legitimate purpose. A relevant question was whether the PwC engagement also qualified as an “attestation service”? Attestation services involve engagements in which there is a report by the accountant or accounting firm to a third party. 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 8.3 Republic of Somalia

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information available regarding the PwC-TFG engagement did not indicate whether PwC prepared a report for a third party and, if so, who that party was. I would suggest that the PwC-TFG engagement also qualified as a “consulting service.” CS Section 100.05 identifies six general types of consulting services provided by CPAs including “staff and other support services.”

“Staff and other support services, in which the practitioner’s function is to provide appropriate staff and possibly other support to perform tasks specified by the client. The staff provided will be directed by the client as circumstances require. Examples of staff and other support services are data processing facilities management, computer programming, bankruptcy trusteeship, and controllership activities.”

Auditing standards, of course, apply only to audit engagements, so they would not be relevant to the PwC-TFG engagement. If that engagement qualified as an attestation engagement, then obviously the attestation standards issued by the AICPA would have applied. The broadest set of professional standards applicable to the PwC-TFG engagement would have been those included in the AICPA Code of Professional Conduct. ET 0.300 identifies the six “principles of professional conduct” which include Responsibilities, The Public Interest, Integrity, Objectivity and Independence, Due Care, and Scope and Nature of Services. The AICPA’s standards for consulting services identify seven “general standards” that apply to consulting engagements: “professional competence,” due professional care,” “planning and supervision,” “sufficient relevant data,” “client interest,” “understanding with the client,” and “communication with client” (CS Section 100.07).

For example, the “client interest” standard requires a CPA to “serve the client interest by seeking to accomplish the objectives established by the understanding with the client while maintaining integrity and objectivity.”

2. Certainly, the “Confidential Client Information Rule” of the AICPA Code of Professional Conduct, prevented PwC from disclosing contractual details of its agreement with TFG. The key text of that rule reads: “A member in public practice shall not disclose any confidential client information without the specific consent of the client.” [ET 1.700.001.01.] Note: Actually, the prior version of the AICPA Code of Professional Conduct was in force during the time frame that the relevant circumstances took place in this case. However, that version of the code had an identical client confidentiality rule.

3. The nature of PwC’s compensation presented an ethical challenge for the firm. Recall that PwC received a percentage commission of all funds disbursed for a legitimate purpose. Consequently, there was an incentive for PwC to approve cash disbursements and characterize them as having been used for a legitimate purpose to increase its compensation. Students typically also suggest that the need for PwC to send certain of its employees into “harm’s way,” i.e., war-torn Mogadishu, in order to earn lucrative fees posed an ethical dilemma for the accounting firm. A final ethical challenge faced by PwC was the need for the firm to do business with senior TFG officials, many of whom had proven to be less than trustworthy or ethical.

4.

Listed next are key “risks” that PwC faced on the Somalia engagement:

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Case 8.3 Republic of Somalia  





392

The high-profile nature of the engagement meant that any mistakes or perceived mistakes made by PwC would cause the resulting negative publicity to be magnified by the international media.

Some degree of litigation risk is present on every professional services engagement. Given the highly sensitive nature of the TFG engagement, it almost certainly posed a higher than normal degree of litigation risk. This risk was heightened by the fact that the prior dishonesty of senior TFG officials increased the likelihood that something untoward might occur during the engagement.

As established in the Shari’a case (Case 8.5) in this textbook, each of the Big Four accounting firms has made a strong effort in recent years to establish a presence in the rapidly developing “Islamic sector” of the world economy. One could reasonably argue that by interjecting itself into the volatile and highly political Somali “situation,” PwC may have offended one or more factions within the Islamic world, which could pose a barrier to client development activities in the Islamic sector of the world economy.

The Kaset Thai Sugar Company case (Case 8.2) in this textbook documents the criticism suffered by Deloitte when one of its partners was murdered during a dangerous engagement in Thailand. No doubt, PwC would have faced similar criticism if one or more of its employees was harmed during the TFG engagement.

Did PwC properly consider and mitigate each of these risks? Almost certainly PwC officials weighed the inordinate risks posed by the TFG engagement prior to accepting it. We don’t know what efforts the firm made to mitigate those risks, but it is highly likely that the prominent firm took every reasonable precaution to limit each of those risks to the greatest extent possible. For example, as suggested in the case, the PwC staffers assigned to that engagement almost certainly received some type of survivalist training.

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Case 8.4 Republic of the Sudan 393

CASE 8.4

REPUBLIC OF THE SUDAN

Synopsis Since the 8th century, the large central African country of Sudan has been a battleground between Christian and Muslim fundamentalists. The country has been ruled since 1989 by Omar Hassan alBashir. [Note: as pointed out in the case epilogue, southern Sudan seceded and became the Republic of South Sudan in July 2011.] Allegedly, al-Bashir’s government has perpetrated atrocities on a massive scale in Sudan. As many as two million citizens of southern Sudan and the large western region of the country known as Darfur may have perished under al-Bashir’s regime. Another four million Sudanese have been displaced under that regime. The atrocities in Sudan resulted in the U.S. State Department placing that nation on its list of state sponsors of terrorism (SSTs) and in President Clinton imposing a broad trade embargo on the country.

In 2004, the U.S. House issued a report calling for the SEC to require domestic and foreign companies with securities listed on U.S. stock exchanges to disclose any business operations within, or other relationships with, Sudan and the handful of other countries identified as SSTs. In 2007, the SEC “one-upped” the U.S. House by developing a webpage on its EDGAR website that listed all such companies. This SEC “blacklist” proved to be extremely controversial. Several large and prominent multinational companies appeared on that list including Deutsche Bank, Nokia, Reuters, and Siemens.

The SEC justified its new policy by maintaining that any links between SEC registrants and SSTs was particularly “material” information that should be highlighted for the benefit of investors. This position triggered an outcry by many critics of the policy who insisted that the SEC’s regulatory mandate did not extend to identifying which disclosures in SEC registration statements were more material than other disclosures. The “punchline” to this controversy was that the SEC closed the SST webpage on its EDGAR website less than two months after the webpage first appeared. This case examines the financial reporting issues related to the SEC’s controversial SST disclosure policy.

Republic of the Sudan--Key Facts © 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 8.4 Republic of the Sudan 394 1.

The Republic of Sudan is among those countries identified by the U.S. State Department as a state sponsor of terrorism (SST).

2.

In 2004, the U.S. House recommended that SEC registrants be required to disclose any business operations within, or other business relationships with, nations identified as SST’s; the SEC adopted the U.S. House recommendation.

3.

The SEC established the Office of Global Security Risk to monitor SEC registrants’ compliance with the new SST disclosure policy.

4.

In June 2007, the SEC created an Internet search tool to identify companies with links to SSTs.

5.

Companies with links to SSTs were included on a list posted by the SEC to a Web page on the EDGAR website.

6.

Many prominent third parties in the investment community were extremely critical of the SEC’s new SST disclosure policy.

7.

A common criticism of the SST disclosure policy was that other SEC registrants engaging in questionable activities were not being “singled out” by the federal agency.

8.

A focal issue of the controversy stemming from the SST disclosure policy was whether the SEC’s regulatory mandate included deciding which disclosures of SEC registrants were so “material” that they should be highlighted for the benefit of the investing public.

9.

After only five weeks, the SEC bowed to critics of its SST disclosure policy and eliminated the SST Web page on the EDGAR website.

10. In late 2007, the SEC issued a “request for comment” asking whether SST-related financial disclosures should be highlighted for the benefit of the investing public; responses to the request for comment were largely opposed to such a disclosure policy.

Instructional Objectives 1.

To examine an important financial reporting issue in the current global economy, namely, the disclosure of reporting entities’ links to state sponsors of terrorism (SSTs).

2.

To examine the regulatory mandate of the SEC.

3.

To identify the materiality standard applied by the SEC.

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Case 8.4 Republic of the Sudan 395 Since September 2001, terrorism has been a major concern, if not preoccupation, of U.S. citizens, politicians, and government officials. No doubt, your students will be aware of the terrorism phenomenon and the impact that it has had on our nation, which should heighten their interest in this case. Surprisingly, the SEC’s effort to contribute to the “war against terrorism”—the focus of this case—has not received much press. Because this is a “live” case, consider requiring students to research and report on recent developments relevant to the case. You might initiate coverage of the case by having your students report their findings.

If you have foreign students in your class, recognize that those students may have very different views of terrorism than domestic students. In this context, it may serve you well to recall the following observation: “One man’s terrorist is another’s freedom fighter.” In fact, this case may generate heated debates between and among domestic students as well—that has certainly been true when I have covered this case in my graduate auditing seminar.

Suggested Solutions to Case Questions 1. 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.]

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: © 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 8.4 Republic of the Sudan 396 “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.

One observation that you may want to make for your students’ benefit is that accountants of reporting entities are charged with making initial materiality decisions, while auditors have the task of analyzing the reasonableness or acceptability of those decisions ex post. Quite often intervening circumstances or events will provide auditors with considerably more information or insight on materiality issues than that which was available to the accountants who made the original materiality determinations.

Sidebar: Your students are probably not aware that the profession in the not too distant past “wrestled’ with the idea of developing more rigorous and/or precise materiality guidelines. In 1975, the FASB issued a “discussion memorandum” that addressed the possibility of establishing explicit materiality guidelines for accountants and auditors to apply. Despite spending several years working on the project, the materiality task force failed to reach a consensus and the project was abandoned.

Ever since, the profession has been “stuck” with “rubbery” definitions of materiality.

2. These questions may trigger unruly debates between and among your students. Of course, the purpose here is not to arrive at definitive answers to these questions—since there are no such answers—but rather to allow students to explore and debate the overall purpose and nature of financial reporting.

3. The catch phrase most commonly associated with the SEC’s overall role in the U.S. economy is “full and fair disclosure.” Since its inception, the watchdog agency for the capital markets has focused on ensuring that registrants disclose all “material” information to investors, lenders, and other interested third parties. For the most part, the agency has not attempted to identify disclosures that are more (or less) “material” than other disclosures, leaving that assessment to individual users of those disclosures. In fact, the SEC’s stated mission is to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation” (SEC website). Because that mission statement is open-ended it provides an opportunity for activist SEC commissioners to go beyond simply requiring “full and fair disclosure” from SEC registrants.

One reasonable argument in favor of the SEC instituting policies such as its controversial SST disclosure policy is the “information overload” that has adversely affected financial statement users in recent years. Most 10-K and S-1 registration statements are so “dense” with information that it is difficult for users to “wade” through and decipher that information. One could argue that financial statement users, particularly relatively naïve users, need help in identifying which disclosures are particularly relevant for their purposes. © 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 8.4 Republic of the Sudan 397 Despite this latter argument, the general consensus among participants in the U.S. capital markets seems to be [this is my armchair assessment] that the laissez faire regulatory model that has been used for decades by the SEC works well and should be maintained. Consider polling your students on the issue of whether the SEC should invoke a “hands-off” or a “hands-on” philosophy to regulating the financial reporting function. To prompt a lively discussion, ask individual students to defend their positions.

Sidebar: Since SEC commissioners are political appointees each new presidential administration can easily “tweak” the SEC’s regulatory model by selectively choosing commissioners. In fact, there were more than subtle changes in many SEC policies and public points-of-view after the transition from President George W. Bush’s administration to the administration of President Barrack Obama.

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Case 8.5 Shari’a 398

CASE 8.5

SHARI’A

Synopsis This case examines a unique feature of the accounting and financial reporting function in Islamic countries, namely, Shari’a audits. Islamic businesses are prohibited from engaging in any economic ventures, contracts, or transactions that violate Shari’a, that is, Islamic religious law. To ensure that they have complied with Shari’a, Islamic businesses must have their operations subjected to a Shari’a compliance audit each year.

This case focuses on Shari’a auditing within the Islamic economy’s largest and fastest growing sector, namely, banking. Presently, there is a wide range of audit “models” that are used by large Islamic banks to carry out the mandatory Shari’a compliance function. This case describes two of those models and presents in accompanying exhibits two different types of Shari’a audit reports—a standalone Shari’a audit report and a Shari’a audit report that is merged with a conventional audit report on a large Islamic bank’s financial statements.

The final section of this case discusses the recent and significant efforts of each of the Big Four accounting firms to establish a “toehold” in the lucrative financial services market for the Islamic banking industry. In 2007, Ernst & Young became the first of the Big Four firms to begin offering Shari’a audits to Islamic banks.

© 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 8.5 Shari’a 399 Shari’a--Key Facts 1.

The Middle East “oil boom” over the past several decades has created a vibrant and rapidly growing “Islamic economy.”

2.

Banking is the largest and most rapidly growing industry within the Islamic economy, which, in turn, is the most rapidly growing sector of the global economy.

3.

Devout Muslims are prohibited by Shari’a or Islamic religious law from having investments in, or being otherwise associated with, certain lines of business, such as the production or distribution of alcoholic drinks.

4.

Islamic companies, including Islamic banks, must also have their operations “audited” each year to ensure that they are Shari’a-compliant.

5.

There are several different Shari’a audit “models” being applied within the approximately 60 predominantly Muslim countries.

6.

In some cases, Islamic companies include a separate Shari’a audit report in their annual financial report, while in other cases a report on Shari’a compliance is integrated in a given Islamic company’s audit report on its annual financial statements.

7.

A key weakness of the Shari’a compliance function in the Islamic economy is that the religious scholars principally responsible for that function generally have little or no formal training in auditing concepts and methodologies.

8.

An Islamic academic has suggested that a new “breed” of Islamic accountants and auditors with expertise in both Shari’a and “Western” accounting and auditing methods needs to be developed.

9.

In recent years, the Big Four accounting firms have begun aggressively marketing financial services to the Islamic banking industry.

10. In 2007, Ernst & Young became the first Big Four firm to begin offering Shari’a audit services.

Instructional Objectives 1.

To demonstrate how cultural norms and values can impact the development and evolution of a nation’s or geographic region’s financial reporting system, accounting profession, and independent audit function.

2.

To provide students with a better understanding of the global accounting profession.

3.

To introduce students to unique challenges faced by independent auditors around the globe.

Suggestions for Use

© 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 8.5 Shari’a 400 Several topics are generally taboo in accounting courses. One that comes to mind is religion.

However, that topic is relevant when it has a pervasive impact on a nation’s or geographic region’s accounting profession.

In the Islamic world—approximately one-fourth of the world’s population is Muslim—Shari’a or Islamic religious law permeates every facet of everyday life and society including financial reporting, accounting, and independent auditing. Although many instructors may be uncomfortable covering this case, I believe that we do our students a great service by introducing them to cultural differences and nuances that are impacting the increasingly global profession that they will be joining. In the current day and age, it seems particularly imperative to acquaint U.S. students with evolving professional issues in the Middle East and other Islamic regions of the world.

Some of you may not have Muslim students in your classes on a regular basis, but I am guessing that most of you do have such students. It goes without saying—as I prepare to say it anyway—that it is important for students to be respectful of strongly held beliefs of their classmates, particularly, those classmates that are a product of a different set of social and cultural values. You may want to explicitly address that issue before discussing this case in your class.

I did not include this particular issue in the case questions, but consider asking your students how Judeo-Christian beliefs have impacted the development of financial reporting, accounting, and auditing practices within the United States. My students typically do not believe that religious customs or beliefs have affected or influenced our nation’s accounting profession—a point of view that I don’t share necessarily. As you can imagine, discussing this sensitive topic as well as the key issues raised in this case may require an instructor to be an effective and proactive moderator.

Suggested Solutions to Case Questions 1. One approach to answering this question is to simply walk through the ten auditing concepts or premises that long served as the “Ten Commandments” of auditing, that is, the ten generally accepted auditing standards—which of course, are still embedded in U.S. professional auditing standards. a. b.

c. d.

e.

Adequate training and proficiency in auditing: This standard would certainly be applicable to Shari’a audits—once we substitute “Shari’a” for “auditing.”

Independence: This standard or general concept also certainly applies to Shari’a audits. In fact, several Islamic academics have questioned the independence of SSB board members.

These critics have suggested that SSB board members sometimes sanction business practices that are questionable in terms of their compliance with Shari’a. Why? Allegedly because of pressure to do so by company management—sounds familiar, huh?

Exercise of due professional care: This standard or concept could be applied to practically any professional or “blue-collar” discipline and it certainly applies to Shari’a audits.

Proper planning and supervision: Any type of examination, such as a financial statement audit or a Shari’a compliance audit, should be thoroughly planned and any relatively inexperienced subordinates should be properly supervised.

Obtaining an understanding of internal control: This standard, as worded, is not directly relevant to Shari’a audits but the general concept certainly is. Those charged with assessing

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Case 8.5 Shari’a 401 Shari’a compliance should first obtain an understanding of the policies and procedures established by the given Islamic entity to ensure Shari’a compliance. f. Obtaining sufficient appropriate audit evidence: Another example of an auditing standard directly relevant to Shari’a audits. g. Determining whether financial statements are GAAP-compliant: Not relevant—a Shari’a report indicates whether a given company complied with Shari’a and any relevant Fatwa issued by its SSB. h. Determining whether accounting principles have been applied consistently: Again, this general concept applies to Shari’a audits. Shari’a principles or concepts should be applied consistently throughout the period in question. i. Determining whether financial statement disclosure is adequate: I have not read any Shari’a reports that disclosed Shari’a violations by the given entity. But, clearly, if such violations are discovered, they should be disclosed to all relevant parties. j. Issuance of an opinion: Shari’a reports should indicate explicitly whether the given entity has complied with Shari’a during the period in question.

In terms of specific audit procedures, most audit tests—such as, accounts receivable confirmation, search for unrecorded liabilities, testing of bank reconciliations, physical inventory counts, etc.—would not be directly relevant to Shari’a audits. Then again, there are certainly many generic audit techniques that could be employed in Shari’a audits, such as, client inquiry, observation, and, probably more so than other, inspection of documents.

2. As suggested in the case, the key problem with implementing that proposal presently is that no one possesses the dual qualifications necessary to complete joint Shari’a-financial statement audits.

Shari’a scholars do not have relevant audit training, while independent auditors do not have the necessary qualifications to analyze compliance with Shari’a. Even if the “new breed” of Islamic accountants and auditors referred to in the case was developed, it is unclear whether those individuals would be recognized as Shari’a “experts” and thus qualified to render decisions regarding Shari’a compliance. In fact, given my research, it seems quite certain that such individuals would not be recognized as Shari’a experts in the most conservative Islamic nations. [Refer to footnote 14 in the case.]

Until a higher degree of Shari’a consensus emerges across the Islamic world, it is unlikely that the ultimate goal of enhancing uniformity across Shari’a audits will be accomplished. Having said that, however, there is still a “market” for Shari’a audits to be performed by independent accounting firms, including the Big Four. As noted in the case, joint Shari’a-financial statement audits are being performed presently, although the Shari’a element of those joint audits is still the domain of Islamic religious scholars.

3. The quote “accounting can lead to perceptions of reality” included in the case was made by an Islamic accounting scholar. There seems to be little doubt that statement is accurate. In fact, isn’t that the purpose of accounting rules in the first place? Hopefully, accounting standards provide an accurate perception of the economic realities facing reporting entities. What the scholar was actually suggesting—which was apparent from the remaining portion of that quote—is that accounting can induce financial statement users to engage in inappropriate behavior, that is, behavior inconsistent with the Islamic religion. © 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 8.5 Shari’a 402 In the United States, rule-making bodies are charged with issuing professional standards consistent with the relevant conceptual framework. The FASB’s conceptual framework that was developed several decades ago has long been used as the principal “guiding light” for that rule-making body. Likewise, the “Ten Commandments” of auditing, that is, the ten generally accepted auditing standards, long served as the conceptual foundation for new auditing standards. [Note: of course, the “Ten Commandments” of auditing are no longer “spiked out” explicitly in U.S. auditing standards.

Nevertheless, the concepts embedded in those standards still serve as operational guidelines for auditing rule-making bodies.] Rule-making authorities in the U.S., to the best of my knowledge, do not consider whether proposed new standards might induce “socially irresponsible” behavior by economic decision makers. Again, those rule-makers simply address the issue of whether proposed standards are conceptually sound. Underlying the “full and fair disclosure” doctrine for the U.S. financial reporting function is the premise that economic decision makers are entitled to use published financial information to make whatever economic decisions they believe to be in their best interests.

4. There is no denying that there is a certain level of distrust between the “Anglo” world and the Islamic world. The Anglo Big Four firms must overcome that distrust if they are to make major inroads into the financial services market within the Islamic banking industry. A related challenge faced by the Big Four firms is obtaining a thorough knowledge of the cultural norms and nuances unique to the Islamic world. Aggressive client development activities that produce results, that is, a client base in the Islamic world, will be meaningless if the Big Four firms cannot establish a strong rapport and mutual understanding with their new Islamic clients.

The major service that the Big Four firms are marketing in Islamic countries is independent audits. As demonstrated in this case, to perform audits of Islamic banks the Big Four firms must modify their audit models to include the issue of Shari’a compliance. The wide divergence in the nature of Shari’a audits across the Islamic world will actually require the Big Four firms, for the foreseeable future, to have multiple audit models that include a Shari’a component.

The dramatic impact that Shari’a has on business practices in the Islamic world will obviously require the Big Four firms to invest resources in developing in-house expertise in those practices.

The unique nature of those business practices also means that the Big Four firms will have to modify the consulting services they presently market and, in many cases, develop totally new consulting services to meet the needs of Islamic clients.

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Case 8.6 Olympus

403

Corporation

CASE 8.6

OLYMPUS CORPORATION

Synopsis Michael Woodford spent 30 years working his way up the employment hierarchy of Olympus Corporation, the Tokyo-based company best known for its digital cameras. In early October 2011, Woodford finally made it to the “top” when he was promoted to CEO of the company. Woodford’s tenure as Olympus’s chief executive lasted all of two weeks. On October 14, 2011, Woodford, the first foreign-born CEO of a Nikkei 225 company, was fired by a unanimous vote of Olympus’s board.

The motion to dismiss Woodford was made by none other than his longtime mentor, Tsuyoshi Kikukawa, the chairman of Olympus’s board of directors.

Prior to being fired, Woodford and Kikukawa had been quarreling over a series of large and suspicious transactions that Woodford had discovered in Olympus’s accounting records. Kikukawa effectively told Woodford that the given transactions were “old news” and that Woodford should plan for the future of the company rather than digging into its past. In fact, the transactions discovered by Woodford involved a decades-long accounting fraud that Kikukawa and other senior Olympus executives had concealed from the investing public.

Within days of being dismissed, Woodford became a corporate whistleblower when he relayed his concerns regarding the suspicious transactions to the media and law enforcement authorities. Less than one month later, Olympus called a news conference and disclosed the accounting fraud, which was one of the largest in Japanese history and easily the most publicized.

Two years before the fraud was exposed, KPMG Azsa, Olympus’s audit firm, had threatened to resign after the company’s management had refused to cooperate with the auditors’ investigation of a large transaction that was later revealed to have been fraudulent. Following that threat, the auditors “signed off” on the transaction after management provided an “expert” (but phony) report that corroborated the accounting treatment applied to the transaction. Shortly after KPMG Azsa issued an unqualified opinion on the given financial statements of Olympus, Kikukawa fired the audit firm for “interfering” with the company’s decisions.

This case documents the nature of the Olympus accounting fraud, the role that the company’s independent and statutory auditors played in that fraud, and examines alleged systemic weaknesses in Japan’s independent audit function.

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404 Corporation

Case 8.6 Olympus Olympus Corporation--Key Facts

1.

Michael Woodford became the first foreign-born CEO of a Nikkei 225 company in early October 2011; through much of his career, Woodford was mentored by Tsuyoshi Kikukawa, who was chairman of the company’s board of directors when Woodford was promoted to CEO.

2.

Before being promoted to CEO, Woodford had been quarreling with Kikukawa for months over a series of transactions that Woodford had discovered in Olympus’s accounting records, transactions that Woodford believed had been recorded improperly and that possibly involved criminal activity.

3.

Two weeks after Woodford was promoted to CEO, Kikukawa made a motion at an Olympus board meeting to dismiss Woodford; the motion was unanimously approved.

4.

After Woodford reported the questionable transactions to the media and law enforcement authorities, Olympus publicly disclosed the long-running accounting fraud and fired Kikukawa.

5.

Olympus’s accounting fraud was intended to conceal more than $1.5 billion of losses Olympus incurred as a result of an unsuccessful zaiteku (high-risk) investment strategy implemented by the company to compensate for an earnings shortfall.

6.

The investment losses were initially concealed from the public simply by maintaining the investments at their historical-cost basis in the company’s accounting records; however, when Japan adopted mark-to-market accounting for investments that concealment plan was no longer viable.

7.

Olympus management devised a tobashi accounting scheme that involved the company writing off the investment losses over an extended period of time; that scheme, which revolved around recording excess goodwill on corporate acquisitions, allowed the company to conceal the actual source of the losses and the fact that they had occurred more than a decade earlier.

8.

KPMG Azsa, Olympus’s audit firm, threatened to resign in 2009 when the client refused to cooperate with the auditors’ investigation of a transaction that was actually a product of the fraud.

After management provided an “expert”—but phony—report to the auditors that corroborated the suspicious transaction, the auditors issued a clean audit opinion on Olympus’s financial statements; a short time later, Kikukawa fired KPMG Azsa for “interfering” with company decisions.

10. KPMG Azsa failed to inform the new audit firm, Ernst & Young ShinNihon, of the disagreement that had preceded Olympus’s decision to change auditors.

9.

11. Critics suggested that systemic weaknesses in Japan’s independent audit function contributed to the failure of Olympus’s auditors to discover the large and long-running 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 8.6 Olympus 405 Corporation 12. Olympus’s auditors were not sanctioned by Japan’s regulatory authorities because the accounting fraud had been so complex and because the company’s executives had went to such great lengths to conceal the fraud from the auditors.

Instructional Objectives 1.

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

2.

To illustrate the lengths to which client management will sometimes go to misrepresent a company’s operating results and financial condition.

3.

To examine how cultural nuances may impact the performance of independent audits, corporate governance, and the regulation of the financial reporting domain in different countries.

4.

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

Suggestions for Use

This case provides students with an opportunity to compare and contrast the accounting profession and independent audit function of two of the world’s major economic powers, namely, Japan and the United States. If you are fortunate enough to have international students in your class, you might ask them to identify and discuss unique social norms in their cultures that have a significant impact on their home countries’ business practices (you could coordinate this exercise with discussion of case question no. 6). If they feel comfortable doing so, ask individual students to compare and contrast those norms with the corresponding norms in the U.S. Also ask them to comment on how the differing social norms in the U.S. and their home country affect the economic productivity of the two countries, the “quality” or attractiveness of each country’s workplace environment, and the likely impact they have on each country’s accounting profession and independent audit function.

Suggested Solutions to Case Questions 1.

Listed next are examples of measures that have been taken in the U.S. and other countries to strengthen the independence of auditors: a. b.

Rotation of audit engagement partners after a given period of time Restrictions on the types of consulting services audit firms are allowed to provide to their clients c.

Public disclosure of audit and non-audit fees d.

Prohibiting auditors from having direct financial interests in clients e.

Prohibiting auditors from having material indirect financial interests in their clients f.

Requiring audit committees to hire the independent auditors for their given companies; requiring audit committees to pre-approve consulting services provided to their companies © 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.

406 Corporation g. h.

i. j. k.

Case 8.6 Olympus Prohibiting auditors from having more than one year of unpaid audit fees outstanding from a client Requiring auditors to resign from an audit engagement when there is an “adverse interest threat” between the two parties, such as, the expressed intent of the client to sue its auditors (or vice versa) Sanctioning auditors for violating the profession’s independence standards Preventing former auditors from accepting “audit sensitive” positions with clients for a given period of time Mandatory rotation of audit firms after a given length of tenure with a client

Next are examples of other measures that have been suggested by various parties to further strengthen the independence of auditors: a. b. c.

Establishing a government agency [patterned after the IRS] that would audit the financial statements of public companies Strictly prohibiting auditors from accepting employment positions with former clients Prohibiting audit firms from providing any type of non-audit services, including taxation services, to their audit clients

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. In this particular case, it doesn’t appear that “specialized” assistance would have been necessary (had the events taken place in the U.S.) since the given issue was apparently the proper accounting treatment for a fairly routine transaction, namely a corporate acquisition. [Note: Recognize that the content of the “experts” report was not discussed in the press. Consequently, we do not know exactly what was included in that report or how that information was presented.]

If you want to further explore the circumstances under which auditors should seek the input of an “expert,” consider discussing paragraph AS 1210.06. That paragraph 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.”

(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.) © 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 8.6 Olympus 407 Corporation 3.

Note: AS 2410, “Related Parties,” within the PCAOB’s auditing standards discusses that agency’s auditing standards for related parties and related-party transactions. AU-C Section 550, “Related Parties,” includes the AICPA’s auditing standards for related parties and related-party transactions. These two sets of standards are similar.

The overarching responsibility of auditors vis-à-vis a client’s related parties 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.” [AS 2410.02] AS 2410 includes an impressive list of audit procedures that should be applied to related party transactions (and relationships). Listed next are a sample of those procedures.

1.

2.

3.

4.

5.

6.

Obtain an understanding of a client’s process for identifying related parties, relationships with related parties, and related party transactions.

Obtain an understanding of a client’s process for accounting for and disclosing relationships and transactions with related parties.

Obtain a list of the client’s related parties.

Investigate the underlying business purpose for related party transactions.

Identify circumstances in which exceptions or exemptions to the client’s policies and procedures were granted to related parties.

Inquire of the client’s audit committee members regarding whether they have concerns regarding specific related party transactions and the nature of those concerns, if any.

4. Note: AS 2805, “Management Representations,” 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 AUC Section 580, “Written Representations.”

AS 2805 mandates that U.S. auditors obtain “written representations from management” (AS 2805.01) and notes that such representations are “part of the evidential matter” (AS 2805.02) 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” (AS 2805.05) by the given auditor’s report.

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” (AS 2805.02) 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” (AS 2805.03), 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” (AS 2805.13). [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.] © 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.

408 Case 8.6 Olympus Corporation Auditors must collect sufficient appropriate evidence to support their opinions. 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” (AS 2805.04).]

5. 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.

For an audit client that is an SEC registrant, a successor auditor should request from the predecessor auditor information regarding: 1) 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 relationships and transactions with related parties (AS 2610.09). [Note: See AU-C 210.A31 of the AICPA Professional Standards for the information items that a successor auditor of a non-SEC registrant should request from a predecessor auditor.] 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.

6. This question could potentially make some students uncomfortable, particularly given the politically correct world in which we live. You might consider pointing out to your students that to identify cultural differences is not the same as identifying which given cultural norm or nuance is superior in any given sense. If you are particularly concerned that this question might result in offending some of your students, then maybe the wisest choice is to “skip it.”

Instead of identifying specific countries here, I will identify specific regions of the world—this lowers somewhat the likelihood of offending students from specific countries. Recognize that I gleaned the following cultural tidbits from various websites rather than from personal observation or “research.”

Nordic countries (Scandinavia): Egalitarianism is considered very important and is typically a cultural norm in these countries. Nordics tend to be brief (tight-lipped) and to the point, which may be considered an indication of aloofness by non-Nordics. Punctionality is considered very important in both social and business settings by Scandinavians. © 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 8.6 Olympus 409 Corporation Islamic countries: Obviously, there are major differences in the religious practices in these countries versus, say, Judeo-Christian cultures. Religious precepts in Islamic countries tend to have a significant impact on business practices, more so than in other regions of the world. For example, the payment or receipt of interest is not permitted by Islamic businesses, which clearly has a pervasive impact on Islamic finance. Frugality, a major tenet of the Islamic religion, also has a major impact on Islamic business practices.

Hindu countries: In Hindu countries, differences in social status are reportedly accepted and ingrained into society. Professional titles are considered very important and commonly used in this culture. Hindus tend to be more open-minded than individuals from other cultures when it comes to considering new ideas, new technology, etc. In these countries, conflict is generally considered impolite and inappropriate in most settings. For example, rather than saying “no,” individuals from these countries are inclined to give vague, indirect answers that the other party should then interpret as a negative response.

After identifying cultural nuances or norms specific to individual countries or regions of the world, you can then engage your students in a discussion of how those traits likely impact the independent audit function across the globe. For example, challenge your students to consider how auditors in a Hindu country might be impacted by that culture’s “politeness” creed. Likewise, prompt them to discuss how the use of the “inquiry” audit collection technique might be affected by Nordics’ alleged curtness or brevity.

7.

Advantages of an oligopolistic market structure for audit services: a.

The major accounting firms should have sufficient economic resources [manpower, etc.] to audit the largest companies in the economy. b.

The significant economic resources of the major accounting firms should allow them ample opportunity to design effective audit strategies, to develop effective quality control mechanisms, to develop excellent training programs for their employees, and to exploit new technologies that become available. c.

The size of the major accounting firms should minimize the amount of economic leverage that individual audit clients have on them. [That is, auditor independence should be enhanced.]

Disadvantages of an oligopolistic market structure for audit services: a.

The small number of major accounting firms means that companies, particularly large companies, that want to change auditors will have few replacement auditors to choose from. b.

In an oligopolistic market structure, suppliers may engage in informal price-fixing and/or other anti-competitive practices to promote their self-interests at the expense of audit clients and the general public. c.

If one of the major accounting firms is forced to disband, the problems previously identified will be compounded.

© 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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Preface

PREFACE

Contemporary Auditing: Real Issues and Cases, Eleventh Edition can be used as either a supplemental text for an undergraduate auditing course or as a primary text for a graduate-level course in auditing. I typically use cases instead of textbook homework assignments when I am teaching undergraduate auditing. Over the more than 35 years that I have taught auditing, one of the most common complaints that I have heard from students in my courses is the lack of practical examples of auditing problems and decision contexts. The cases included in this text overcome this limitation of the standard undergraduate auditing course by requiring students to address actual, not contrived, situations that auditing practitioners have been forced to cope with in the past.

Cengage Learning’s customized publishing capability makes it possible for instructors to select any combination of cases from this text for integration into their auditing courses. To facilitate the selection of cases by instructors, I have included two topical indices in the casebook. The first index, Summary of Topics by Case, lists each of the more than 70 cases in this text and the primary auditing or auditing-related topics addressed in each case. The second index lists, in alphabetical order, the more than 150 key auditing topics addressed in this text and the specific cases in which those topics are raised. The "Suggestions for Use" section of each case solution also contains recommendations regarding the point at which each case should or could be integrated into an auditing course. At the graduate level, I have designed a one-semester course modeled around a selection of the cases presented in Contemporary Auditing: Real Issues and Cases, Eleventh Edition. A syllabus for that course is included in this preface.

Each case solution includes the following five sections: Synopsis, Key Facts, Instructional Objectives, Suggestions for Use, and Suggested Solutions to Case Questions. The purpose of the Synopsis is to provide a concise summary of, and identify the principal issues raised by, each case so that instructors can quickly decide which cases are most appropriate for their particular purposes. I included the listing of Key Facts for each case as a pedagogical tool. If instructors use a pure case method approach to teaching the cases in this text, they will likely want their students to identify the key facts of each case during the classroom discussion. Alternatively, to facilitate covering individual cases as quickly as possible, instructors may choose to use the Key Facts listing as an overhead template. [Note: The key facts for each case are also included in a PowerPoint file available on the Cengage Learning website for my casebook. Instructors can use those files to quickly cover the key facts for assigned cases in PowerPoint slide shows.] The Instructional Objectives section of each solution lists what I perceive to be the key learning objectives that an instructor will accomplish for each case. In addition to recommending at which point to incorporate individual cases in an auditing course, the Suggestions for Use sections provide helpful hints regarding the issues to emphasize 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.

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each case, strategies for focusing students’ attention on those vi issues, and other suggestions to enhance the learning experience afforded by each case. Finally, the Suggested Solutions to Case Questions provide answers that I have personally written for each case question. Past experience suggests that many instructors will disagree with some of my answers.

Please recognize that the answers I provide are only suggested solutions. I am always more than happy to hear from instructors who can provide different viewpoints on the issues posed by the case questions.

Historically, cases have not been utilized extensively in accounting curricula, particularly at the undergraduate level. Consequently, auditing instructors may not be familiar with pedagogical issues related to the use of cases. In fact, many auditing and accounting instructors may not use cases in their courses because of pedagogical concerns. To mitigate such concerns, I recommend that instructors refer to the following excellent source regarding the integration of case materials into accounting courses: J.E. Campbell and W.F. Lewis, "Using Cases in Accounting Courses," Issues in Accounting Education, Fall 1991, pp. 276-283. Campbell and Lewis identify several different approaches available to accounting instructors for utilizing cases in their courses.

As Campbell and Lewis point out, a pure case method approach is not required when using cases as instructional materials and, in fact, may not be appropriate in many instructional contexts. As an example, because of the severe time constraints posed by the amount of technical material that must be covered in the undergraduate auditing course, I utilize one of two approaches in presenting my cases in that course. For certain cases, I require students to have read the case material and to have prepared written solutions to the case questions prior to class. During class, I focus exclusively on the case questions, calling on students randomly to obtain their views on the issues raised by the questions.

For other cases, I typically use a modified case method approach in which I serve as a moderator for an in-class discussion. I initiate this discussion by using one of several “launch strategies” that I have developed for my cases (see next paragraph). Generally, most of the issues posed by the case questions are adequately addressed by the completion of the class discussion. If not, any remaining issues raised by the case questions can be dealt with in fairly short order. The greater flexibility afforded by most graduate courses provides sufficient time to utilize a more conventional case method approach to presenting case materials. Campbell and Lewis note that as an instructor uses cases more extensively over a period of time, he or she will gradually develop an instructional mode for cases that is most "comfortable" for him or her.

One of the biggest challenges that I have faced in using cases extensively in my courses is a simple one, namely, “getting started.” I have found that one way to keep students interested and focused in a case course is to use a variety of different strategies for launching in-class discussions of cases. A sure recipe for quelling students’ interest is using the same “launch strategy” for each case.

So, I would like to share with you a variety of different strategies or tactics that I have used to initiate in-class coverage or discussion of individual cases. As a point of information, many of these ideas are integrated into the Suggestions for Use sections included in the case solutions. As a caveat, some of these strategies are better suited for certain cases than they are for others. In fact, some of these strategies, such as the role-playing suggestion, would not “work” at all for certain cases in this text.

One more caveat: several of these strategies overlap to a degree. © 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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Preface 1. Open a class discussion with a “quickie” group project. For example, several of the cases in this text involve auditors who made poor judgments in responding to ethical dilemmas or other decision contexts. Give students 10 to 15 minutes to meet in groups. Require each group to reach a consensus on the key mistakes made by the given auditor and to develop a list of alternative decisions that auditor could have or should have considered. Each group can then present and defend their conclusions.

2. Choose two or more outgoing students to recreate a key event in a given case, an event that resulted in a face-to-face meeting of two or more individuals involved in the case. In this re-creation, allow the “actors” to change the outcome of that meeting.

3. Use a lottery of some type to choose students to answer specific case questions or to prompt them to participate in some other way in a case discussion. For example, I often write the number of each case question on a piece of paper and then insert those slips into envelopes. If there are seven questions and 12 students, five of the slips will be blank. Students randomly choose an envelope. “Winners” are required to answer the question they “selected.” To liven up this suggestion, you can convert it into a “Dirty Santa” type exercise in which students have the option of passing a tough or otherwise undesirable question to an unsuspecting classmate.

4. Ask individual students for a personal experience or anecdote relevant to the given case.

5. Use a handout that requires each class member to assign a numerical rating or ordinal ranking to some facet of the case. Examples of items that can be rated: ethical conduct of an individual involved in the given case, top three key facts or issues in the case, the jail term that should be or should have been assigned to a given scoundrel, students’ degree of confidence in a key but unsubstantiated assertion or allegation made by a party in the case, etc. Collect the individual ratings/rankings and either post selected student responses on the board or post all of the measures to a “scorecard,” which you then copy and circulate. This is one of my favorite types of case-opening exercises. For whatever reason, students seem to really enjoy these exercises. More important, these exercises tend to trigger considerable discussion and interaction among students.

6. Begin a case by requiring individual students to respond to an open-ended prompt such as, “This case is important because . . .” or “The most important thing I learned from this case was . . .”

7. Walk into your classroom, put your books down, single out a student, and inform that individual that he or she has exactly 60 seconds to provide a concise summary of the case to be discussed.

8. Ask students to relate the case to a recent event highlighted in the front-page press or business press.

9. In a case that poses an ethical dilemma, begin the case by asking students to identify the decision alternatives that were available to the key individual involved in that dilemma.

After listing these alternatives on the board, take a poll to determine the alternatives that individual students would have selected. Have individual students defend their choice.

10. Choose a contentious issue in a given case and organize a three-group debate exercise.

One group must defend one “side” of the given issue, the second group defends the other “side” of that issue, while the third group serves as the jury by voting on which group eventually prevails in the debate. Students in the first two groups will have to meet 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.

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class or outside of class to develop their arguments.

11. Call on a few students and ask them, in turn, one of the following questions: “What’s missing from this case?” “What else did you want to know about the given company, individuals, or other features of the case that was not revealed?” Even for lengthy cases, students typically identify additional information that they would have liked to have had in analyzing the given issues or aspects of the case.

12. Ask individual students, in turn, to identify a key fact or issue in the given case—a timehonored, if not time-worn, strategy for opening a case discussion.

13. Begin a case with your own monologue or lecture highlighting the key issues or facts in the case. This is a strategy I seldom use. But, when “time is of the essence,” an instructor has to do what an instructor has to do.

© 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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Preface

Suggested Syllabus for a Graduate Auditing Course Modeled Around Contemporary Auditing: Real Issues and Cases The following syllabus is intended for a 15-week, one-semester graduate auditing course with an enrollment of 10 to 35 students. At the University of Oklahoma, we refer to this course as Contemporary Auditing Issues. Most of the students in this course are enrolled in the Master of Accountancy program or in our dual Bachelor of Accountancy/Master of Accountancy five-year program. All of these students have completed the undergraduate auditing course and are well versed in the "nuts and bolts" auditing issues. A set of cases that highlight a specific auditing issue or topic is presented during each module of the Contemporary Auditing Issues course. (Approximately one week is required to cover each module.) For instance, in Module 3, two cases requiring students to make extensive use of analytical procedures, Leslie Fay and Just for Feet, are discussed. Although analytical procedures are the focal topic of that module, each of those cases addresses several other auditing topics as well.

You will notice that the “Interlude” segment between Modules 4 and 5 in the following syllabus refers to an "Audit Risk Analysis" project. This in-class project is intended to help prepare students for a similar project that each of them will be required to complete individually. Early in the semester, each student is assigned a public company for which he or she will perform an extensive audit risk analysis. Each student is required to analyze the most recent financial data for his or her assigned company, which is typically obtained from the company's most recent annual report, the EDGAR web site, or any of several on-line financial databases. Students also obtain other pertinent financial and non-financial data regarding their assigned companies. These latter data would include information gleaned from articles appearing in the Wall Street Journal, major metropolitan newspapers, and various business publications concerning the company or its industry; peer group data provided for the company's industry or sub-industry by such investment services as RMA, Dun & Bradstreet, Moody's, etc.; and financial disclosure documents filed with the SEC, such as 8-K auditor change announcements.

Each student is required to prepare a written report and make an oral presentation, accompanied

by PowerPoint slides, describing the key audit risks posed by the company assigned to him or her.

Typically, these reports begin with a historical overview of the given company and its industry. Next, students generally discuss the potentially problematic non-financial items that they identified for the assigned company, such as, a management compensation scheme tied to reported earnings, an upcoming merger, restrictive bond covenants, etc. Next, I suggest that the students present the results of the analytical procedures they applied to their company's financial data to identify “red flag” financial statement items. I require that these procedures be performed on both a longitudinal and cross-sectional basis. Students make use of trend analysis, common-sized financial statements, and key financial ratios prepared on a comparative basis for their assigned company and its peer group.

Each student completes his or her 15 to 20 minute in-class presentation with a summary recommendation regarding whether the given company appears to be an acceptable audit client or, © 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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alternatively, whether the company would pose an unacceptably high level of audit risk and/or business risk for an audit firm. The key purpose of the Audit Risk Analysis project is to require students to integrate and operationalize the important concepts and issues they have studied during the semester.

Syllabus for Contemporary Auditing Issues Course Objectives 1.

2.

3.

To discuss and analyze problematic situations that auditors have dealt with in the past so that students can obtain a better understanding of how to cope constructively with such scenarios in the future.

To enhance students' understanding of the fundamental technical concepts of the auditing discipline.

To increase students' awareness of the key ethical issues that accounting practitioners face and to acquaint them with key ethics models and ethical reasoning strategies.

Text M.C. Knapp, Contemporary Auditing: Learning, 2017).

Real Issues and Cases, Eleventh Edition (Cengage

Course Grades Course grades will be a function of the following items and their respective weights: Midterm Exam Final Exam Audit Risk Analysis Project Class participation, including quizzes

20% 35% 20% 25%

Examinations The midterm and final examinations will consist primarily of short answer and essay questions. No make-up exams or quizzes will be given. If an exam or quiz is missed due to a university-excused absence, the points on that item will be added to the final. The comprehensive final exam will be given during the final class period of the semester.

Quizzes & Class Participation This course is designed to be a seminar and thus requires the active participation of all enrolled students. Each class period we will discuss specific auditing cases. Students are expected to have © 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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Preface

read each assigned case and be prepared to discuss the key concepts and issues raised by those cases.

In addition, students are expected to be able to respond to the set of questions at the end of each case. On occasion, in-class, closed-book quizzes may be given on assigned cases prior to class discussion of those cases.

Audit Risk Analysis Project During the first few weeks of the semester, each student will be assigned a public company for which he or she will complete an audit risk analysis project—no two students will be assigned the same company. Each student will assume the role of an audit manager of a public accounting firm who has been asked by an audit partner to assess the acceptability of the given company as an audit client and to write a memo summarizing this assessment. This is an "open-ended" assignment, which means that you can choose to structure your memorandum in any way you deem appropriate. However, at a minimum, your memorandum should cover the following points.

1. The memorandum should present a brief company profile that comments on, among other items, the history of the firm, its major products, its principal officers, recent developments concerning the firm (such as a merger, planned merger, or new products or technological advancements), etc.

2. Of particular interest to the partner will be what some audit firms refer to as "key items." These are potential "hot spots" that may demand special attention during the course of the audit. Examples: existence of a management compensation plan (bonus scheme) tied to reported profits; a significant number of related parties and related-party transactions; new, high-risk projects/products; important technological advancements or changes in the company's industry; a significant increase in bad debts over the past year, etc.

3. Somewhere within the memorandum you will need to discuss the apparent financial condition of the firm and highlight key financial ratios, such as, the current ratio, return on assets, inventory turnover, etc. In particular, you should bring to the partner's attention the ratios and trends that may be indicative of the future prospects of the firm (good or bad). For instance, if the return on sales percentage has plummeted in recent years, that fact should probably be brought to the attention of the partner (and, of course, you should provide some explanation as to why this sharp downturn has occurred). Both cross-sectional and longitudinal analyses will be appropriate. Additionally, tabular summaries and exhibits (graphs, pie charts, time-series charts, etc.) will be useful means to present quantitative data regarding the firm.

4. Finally, you should conclude your memo with a recommendation for the partner. For example, the recommendation may be that the firm appears to be an acceptable client although it does pose a fairly high level of audit risk and business risk, you may recommend that the company not be considered any further as an audit client, or your recommendation may be that more information is needed before an acceptance/rejection decision is made. (If this latter conclusion is reached, you should identify 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.

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additional information you believe needs to be obtained before an acceptance/rejection decision can be made).

Feel free to use all reference sources available in the library or online, such as, Disclosure, Dun & Bradstreet, Moody's, Robert Morris & Associates, Standard & Poor’s, Value Line, WSJ Index, etc., in preparing your memorandum. Those online sources that supply comparative industry data will be particularly helpful. For a discussion of other factors to consider when evaluating a potential client, refer to any undergraduate auditing text. I would expect that coverage of the above (minimum) items will require a memorandum of approximately six to eight pages doubled-spaced, not including all appropriate exhibits [maximum length = 10 pages (not including exhibits)]. Grading criteria: thoroughness, accuracy (in interpreting the given firm's factual data), coherent structure, conciseness, the degree to which your conclusion is supported by your analysis, grammar, and neatness.

Class Presentation and Discussion of Audit Risk Projects: During the final two weeks of the semester, each student will be required to make a 15-20 minute PowerPoint presentation regarding his or her audit risk project. This presentation should provide an overview of the numbered items identified above and/or other appropriate information.

Due Date: Students will turn in a copy of their type-written memo to the instructor at the beginning of the class in which they discuss their audit risk project. In addition to the type-written memo, students should provide the instructor with the file of information from which the financial data for their report was drawn (e.g., an annual report, peer group data, etc.).

© 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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Preface

Tentative Class Schedule Module 1 Key Topic:

Introduction/Icebreaker

Cases:

Enron, DHB Industries, Navistar

Module 2 Key Topic:

The Professional Roles of Independent Auditors

Cases:

Leigh Ann Walker, Bill DeBurger, Tommy O'Connell, Charles Tollison, Madison Wells, Tillman Rollins

Module 3 Key Topic:

Use of Analytical Procedures and Audit Planning

Cases:

Leslie Fay, Just for Feet

Module 4 Key Topic:

Auditing High-Risk Accounts

Cases:

Parker-Halsey (inventory), Take-Two (receivables), CBI (accounts payable), Golden Bear (revenues), Ligand Pharmaceuticals (sales returns)

Interlude: Subject:

In-class Audit Risk Analysis project

Cases:

None

SupplementaryMost recent annual report of a public company and other pertinent © 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.

Preface Material:

xv

data, including peer group data.

Module 5 Key Topic:

Social Issues and the Auditing Profession

Cases:

Sarah Russell, Olivia Thomas, Frank Coleman, Internet Infamy

Module 6 Key Topic:

Internal Control Issues

Cases:

Buranello’s, Goodner Brothers, Saks Fifth Avenue, Avon Products,

Mid-Term Examination Module 7 Key Topic:

Coping with Complex or Unique Client Transactions

Cases:

Lehman Brothers, Dell, Powder River, LocatePlus

Ethics Models Module Key Topic: Key Topic:

Principal ethical paradigms that underlie applied business ethics Discussion of the nature, content, and purpose of the AICPA Code of Professional Conduct

Cases:

None

Module 8 Key Topic:

Ethics: General Topics

Cases:

Zane Corbin, Suzette Washington, Wiley Jackson, Arvel Smart

Module 9 Key Topic:

Ethics and the Independent Auditor

Cases:

Richard Grimes, Le-Nature’s (Part II), IPOC, Cardillo

© 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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Module 10 Key Topic:

Auditor Independence

Cases:

Caesars, AIG, Belot Enterprises

Module 11 Key Topic:

Evolution of Auditors' Civil Liability

Cases: Module 12

Fred Stern, First Securities Company of Chicago, Health Management

Key Topic:

International Cases: Auditing Around the World

Cases:

Olympus, Shari’a, Longtop

Module 13 Key Topic:

International Cases: Special Topics

Cases:

Republic of Somalia, Republic of the Sudan, Kaset Thai Sugar Company

Presentations Final Exam

© 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.

TABLE OF CONTENTS, 11th Ed. Preface

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SECTION 1 Comprehensive Cases 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11 1.12 1.13

Enron Corporation …………………………………………………………………….. 1 Lehman Brothers Holdings Inc………………………………………………………… 8 Just for FEET, Inc.……………………………………………………………………... 16 Health Management, Inc………………………………………………………………. 26 The Leslie Fay Companies ……………………………………………………………. 32 Le-Nature’s Inc………………………………………………………………………… 40 Navistar International Corporation ……………………………………………………. 48 Livent, Inc……………………………………………………………………………… 55 ZZZZ Best Company, Inc……………………………………………………………… 62 DHB Industries, Inc……………………………………………………………………. 69 New Century Financial Corporation…………………………………………………… 79 Madoff Securities………………………………………………………………………. 88 AA Capital Partners, Inc……………………………………………………………….. 94

SECTION 2 Audits of High-Risk Accounts 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 2.12

Jack Greenberg, Inc…………………………………………………………………… 101 Golden Bear Golf, Inc……………………………………………………………….... 109 Take-Two Interactive Software, Inc………………………………………………….. 115 General Motors Company…………………………………………………………….. 123 Lipper Holdings, LLC……………………………………………………………….... 128 CBI Holding Company, Inc…………………………………………………………… 134 Bankrate, Inc………………………………………………………………………...... 140 Belot Enterprises……………………………………………………………………… 147 Powder River Petroleum International, Inc…………………………………………... 152 LocatePlus Holdings Corporation…………………………………………………….. 160 Overstock.com, Inc…………………………………………………………………… 166 Parker-Halsey Corporation…………………………………………………………… 173

© 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.

iii SECTION 3 Internal Control Issues 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9

The Trolley Dodgers…………………………………………………………………... 181 Howard Street Jewelers, Inc. …………………………………………………………. 184 Avon Products, Inc. …………………………………………………………………... 189 First Keystone Bank ………………………………………………………………….. 196 Goodner Brothers, Inc. ………………………………………………………………. . 200 Buranello’s Ristorante………………………………………………………………… 206 Saks Fifth Avenue…………………………………………………………………….. 212 The Boeing Company…………………………………………………………………. 216 Wal-Mart de Mexico ………………………………………………………………… . 221

SECTION 4 Ethical Responsibilities of Accountants 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8

Creve Couer Pizza, Inc………………………………………………………………... 227 F&C International, Inc………………………………………………………………… 231 Suzette Washington, Accounting Major………………………………………………. 236 Freescale Semiconductor, Inc…………………………………………………………. 240 Wiley Jackson, Accounting Major…………………………………………………….. 245 Arvel Smart, Accounting Major……………………………………………………….. 249 Zane Corbin, Accounting Major………………………………………………………. 252 Dell Inc………………………………………………………………………………… 258

SECTION 5 Ethical Responsibilities of Independent Auditors 5.1 5.2 5.3 5.4 5.5 5.6

Cardillo Travel Systems, Inc………………………………………………………….. 264 American International Group, Inc……………………………………………………. 270 Caesars Entertainment Corporation…………………………………………………… 274 IPOC International Growth Fund, Ltd………………………………………………… 278 Le-Nature’s Inc., Part II………………………………………………………………. 283 Richard Grimes, Staff Accountant…………………………………………………….. 287

SECTION 6 Professional Roles 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8

Leigh Ann Walker, Staff Accountant…………………………………………………. 291 Bill DeBurger, In-Charge Accountant………………………………………………… 296 Hamilton Wong, In-Charge Accountant………………………………………………. 300 Tommy O'Connell, Audit Senior……………………………………………………… 305 Avis Love, Staff Accountant…………………………………………………………... 310 Charles Tollison, Audit Manager……………………………………………………… 316 Madison Wells, Audit Manager………………………………………………………. . 320 Tillman Rollins, Office Managing Partner…………………………………………….. 327

© 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.

iv SECTION 7 Professional Issues 7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9

Ligand Pharmaceuticals………………………………………………………………. 332 Sarah Russell, Staff Accountant……………………………………………………… 338 Washington Council Ernst & Young…………………………………………………. 342 Internet Infamy………………………………………………………………………... 347 Fred Stern & Company, Inc. (Ultramares Corporation v. Touche et al.)…………….. 352 First Securities Company of Chicago (Ernst & Ernst v. Hochfelder et al.)…………... 358 Texas Drug Warehouse……………………………………………………………….. 363 Frank Coleman, Staff Accountant…………………………………………………….. 367 Olivia Thomas, Audit Senior…………………………………………………………. 372

SECTION 8 International Cases 8.1 8.2 8.3 8.4 8.5 8.6

Longtop Financial Technologies Limited…………………………………………….. 377 Kaset Thai Sugar Company…………………………………………………………… 384 Republic of Somalia…………………………………………………………………... 388 Republic of the Sudan………………………………………………………………… 393 Shari’a………………………………………………………………………………… 398 Olympus Corporation…………………………………………………………………. 403

v © 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.