Solution Manual with All cases for Contemporary Auditing University Of Southern Indiano 7th Edition Michael C. Knap
Case 1-8 with all section CASE 1.1 to Case 1.11 CASE 2.1 to Case 2.8 CASE 3.1 to Case 3.6 CASE 4.1 to Case 4.9 CASE 5.1 to Case 5.6 CASE 6.1 to Case 6.7 CASE 7.1 to Case 7.9 CASE 8.1 to Case 8.11
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
2 Case 1.2 Just for Feet, Inc. 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. 1
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 SPE‘s (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.
Case 1.2 Just for Feet, Inc. 3 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.
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
4 Case 1.2 Just for Feet, Inc. 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 hard to refute.
Suggested Solutions to Case Questions 1. A large number of parties bear some degree of direct or indirect responsibility for the problems that the Enron fiasco ultimately posed for the public accounting profession and the independent audit function. The 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. Academics who failed to goad their students into internalizing the accounting profession‘s high ethical principles. 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.
Case 1.2 Just for Feet, Inc. 5 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. An audit firm that provided some type of ―expert service unrelated to the audit‖ could find itself in a dicey situation if the given service proved to be less than expert quality. For example, if an audit firm recommended to a client a strategy for dealing with a labor strike or other work stoppage and that strategy proved ineffective, client executives would potentially have some degree of leverage to extract concessions from the audit firm during subsequent audit engagements. 3. Given the assumption that the Powers Report excerpts included in Exhibit 3 are accurate, one could plausibly argue that Arthur Andersen violated several of the ten generally accepted auditing standards, including the following: Independence (second general standard): by becoming too involved in Enron‘s decisions for important accounting and financial reporting treatments, the Arthur Andersen auditors may have forfeited some degree of objectivity when they reviewed those decisions during the course of subsequent audits. Due professional care (third general standard): any violation of one of the other nine GAAS effectively results in a violation of the catchall due professional care standard. Planning and supervision (first fieldwork standard): 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. Internal control evaluation (second fieldwork standard): one could argue that given the critical and seemingly apparent defects in Enron‘s internal controls, Andersen auditors failed to gain a ―sufficient understanding‖ of the client‘s internal control system. Sufficient competent evidential matter (third fieldwork standard—under the current third fieldwork standard the auditor must obtain ―sufficient appropriate‖ audit evidence): 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 competent 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 (fourth reporting standard): 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 PCAOB Auditing Standard No. 3, ―Audit Documentation.‖ The documentation requirements that pertain to audits of other organizations can be found in Statement on Auditing Standards No. 103, ―Audit Documentation,‖ that became effective for audits of financial statements for periods ending on or after December 15, 2006. SAS No. 103: This standard has been integrated into AU Section 339. Paragraph .03 of AU 339 provides the following general guidance to independent auditors.
6 Case 1.2 Just for Feet, Inc. ―The auditor must prepare audit documentation in connection with each engagement in sufficient detail to provide a clear understanding of the work performed (including the nature, timing, extent, and results of audit procedures performed), the audit evidence obtained and its source, and the conclusions reached. Audit documentation: a. b.
Provides the principal support for the representation in the auditor‘s report that the auditor performed the audit in accordance with generally accepted auditing standards. Provides the principal support for the opinion expressed regarding the financial information or the assertion to the effect that an opinion cannot be expressed.‖
Paragraph .32 of AU 339 notes that the ―auditor should adopt reasonable procedures to retain and access audit documentation for a period of time sufficient to meet the needs of his or her practice and to satisfy any applicable legal or regulatory requirements for records retention.‖ This paragraph goes on to note that the retention period for audit documentation ―should not be shorter than five years from the report release date.‖ PCAOB No. 3: 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 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). PCAOB No. 3 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). This standard 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 to: a) understand the nature, timing, extent, and results of the procedures performed, evidence obtained, and conclusions reached, and b) 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). [Note: SAS No. 103 has a similar requirement—see AU 339.10.] PCAOB No. 3 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
Case 1.2 Just for Feet, Inc. 7 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 ―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 strong marketing skills, as opposed to strong 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. (Note: AU Section 722, ―Interim Financial Information,‖ provides guidance to auditors on the ―nature, timing, and extent of procedures to be applied‖ to a client‘s interim financial information.)
8 Case 1.2 Just for Feet, Inc. 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.
CASE 1.2
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 twenty-one 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.
Case 1.2 Just for Feet, Inc. 9 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 revealed serious deficiencies in those audits that resulted in the prominent audit firm being sanctioned by the SEC and facing numerous civil lawsuits. 8 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
10 Case 1.2 Just for Feet, Inc. 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 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. Notice that the suggested solution to the first case question includes industry norms for selected financial ratios. Instructors may want to provide those ratios to students when making the assignment, or, alternatively, require students to obtain such data on their own. Jointly, the second and third case questions provide an opportunity for instructors to introduce the audit risk
Case 1.2 Just for Feet, Inc. 11 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. This type of exercise typically produces some lively debate among students and provides them with a better understanding of the latent dimensions of the given issue, in this particular case, the nature and importance of individual audit risk factors.
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
.34
.05
.03
12 Case 1.2 Just for Feet, Inc. Total liabilities
.53
.40
.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
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
Common-sized income statements for Just for Feet:
Financial Ratios for Just for Feet: 1998 Liquidity:
1997
Case 1.5 The Leslie Fay Companies 13 Current Quick
3.39 .37
2.00 .67
.53 6.38 .71
.40 24.67 .09
Activity: Inventory turnover Age of inventory Accounts receivable turnover Age of accounts receivable Total asset turnover
1.49 242 days 44.6 8.1 days 1.36
1.65 218 days 42.75 8.4 days 1.26
Profitability: 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%
Solvency: Debt to assets Times interest earned Long-term debt to equity
Equations: Current ratio: current assets / current liabilities Quick ratio: (current assets - inventory) / current liabilities Debt to assets: total debt / total assets Times interest earned: earnings before interest and taxes / interest charges Long-term debt to equity: long term debt / shareholders‘ equity Inventory turnover: cost of goods sold / avg. inventory Age of inventory: 360 days / inventory turnover A/R turnover: net sales / average accounts receivable Age of A/R: 360 days / accounts receivable turnover Total asset turnover: net sales / average total assets Gross margin: total gross margin / net sales Profit margin on sales: net income / net sales Return on total assets: (net income + interest expense) / avg. total assets Return on equity: net income / avg. shareholders' equity Selected industry norms as of 1998 (these norms were taken from a Dun & Bradstreet publication; each industry norm is a mean for the given ratio): Current ratio: Quick ratio: Debt to assets: L-T debt to equity: Inventory turnover: Age of inventory: A/R turnover:
3.0 .75 .37 .14 2.15 167 days 52.7
14
Case 1.5 The Leslie Fay Companies Age of A/R: Total asset turnover: Gross margin: Profit margin on sales: Return on total assets: Return on equity:
6.8 days 2.11 36.7% 4.6% 9.7% 15.3%
Following, in bullet form, are the key financial statement items and other issues that are ―brought to the surface‖ by the common-size financial statements, financial ratios, and other available information regarding Just for Feet as of the end of fiscal 1998. 1.
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 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.
2. 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 going-concern 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. 3. 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. 4. 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
Case 1.5 The Leslie Fay Companies 15 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.] 5. 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 is over that period. Likewise, the company‘s operating margin percentage (operating 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, as discussed in AU Section 312, 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.
16
Case 1.5 The Leslie Fay Companies
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 increases the risk of obsolete inventory. --Declining or negative operating cash flows may induce management to begin ―windowdressing‖ 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 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 316.31 as follows: ―. . . the auditor may identify events or conditions that indicate incentives/pressures to perpetrate fraud, opportunities to carry out the fraud, or attitudes/rationalizations to justify a fraudulent action. Such events or conditions are referred to as ‗fraud risk factors.‘‖ In this context, the phrase ―audit risk factor‖ is intended to be more inconclusive. For example, several of the items identified in the suggested solutions to Questions #2 and #3 qualify as ―generic‖ audit 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 certainly 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 --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
Case 1.5 The Leslie Fay Companies 17 --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 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, 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
18
Case 1.5 The Leslie Fay Companies
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.
CASE 1.3
JAMAICA WATER PROPERTIES
Synopsis This case focuses on David Sokol, an executive who has made a ―name‖ for himself in recent years within the energy industries. After becoming recognized as a successful ―turnaround‖ agent for troubled companies, Sokol was hired in 1992 to serve as the chief operating officer of JWP, Inc., a large, New York-based conglomerate. At the time, JWP had an impressive history of sustained profits and revenue growth that was being threatened by the company‘s far-flung operations and unwieldy organizational structure. Unknown to Sokol, JWP‘s impressive operating results over the prior few years had been embellished by the company‘s CFO and several of his top subordinates. Because of Sokol‘s reputation for being a ―hands-on‖ executive who insisted on personally obtaining a thorough understanding of his employer‘s financial affairs, the CFO attempted to conceal misrepresentations in JWP‘s accounting records from Sokol. Despite the efforts of the CFO, Sokol quickly uncovered suspicious items in JWP‘s accounting records after he assumed responsibility for the company‘s day-to-day operations. The diligent and persistent Sokol eventually met with JWP‘s CEO and informed him of the problems he had uncovered. Sokol insisted that an accounting firm other than JWP‘s audit firm be retained to perform a forensic investigation. Sokol questioned whether JWP‘s audit firm could objectively perform that investigation since there were close relationships between key members of the audit engagement team and JWP‘s top accountants, including its CFO. In fact, the CFO and three of his key subordinates had formerly worked for JWP‘s audit firm. Before the second accounting firm could complete its investigation, Sokol discovered additional distortions in JWP‘s accounting records. Sokol rejected a $1 million ―stay‖ bonus offered to him by JWP‘s CEO and resigned as the company‘s COO after turning over the evidence he had collected to the board of directors. The SEC issued a series of accounting and auditing enforcement releases focusing on the JWP accounting fraud. JWP‘s CFO and the three subordinates who had helped him carry out the fraud
Case 1.5 The Leslie Fay Companies 19 were sanctioned by the SEC. JWP‘s audit firm, Ernst & Young, reportedly paid $23 million to settle lawsuits filed by JWP‘s stockholders. Ernst & Young was eventually successful in defeating a large lawsuit filed by JWP‘s former lenders. However, in the latter lawsuit the federal judge who presided over the case severely chastised Ernst & Young for its ―willingness to accommodate‖ JWP‘s former CFO and for its ―spinelessness‖ in performing JWP‘s annual audits.
18
Jamaica Water Properties--Key Facts 1. In 1992, David Sokol accepted an offer to become the COO of JWP, Inc., a large, New Yorkbased conglomerate whose impressive earnings and revenue trends were being threatened. 2. Unknown to Sokol, JWP‘s operating results had been embellished by an accounting fraud directed by the company‘s CFO, Ernest Grendi, and three of his subordinates. 3. Grendi relied on the far-reaching authority granted to him by Andrew Dwyer, JWP‘s CEO, and on his ―intransigent and intimidating‖ personality to gain complete control over JWP‘s accounting function. 4. Because Sokol had a reputation as an effective and hands-on executive, Grendi attempted to conceal misrepresentations in JWP‘s accounting records from Sokol. 5. Sokol discovered suspicious items in JWP‘s accounting records shortly after joining the company, which prompted him to insist that an accounting firm be brought in to perform a forensic investigation of those records. 6. Sokol wanted a firm other than JWP‘s audit firm, Ernst & Young, to perform the investigation because of close, personal relationships that existed between members of the Ernst & Young audit team and JWP‘s key accounting officials, including Ernest Grendi. 7. After discovering additional problems in JWP‘s accounting records, Sokol gave the evidence that he had collected to the company‘s board and resigned. 8. Before he resigned, Sokol was offered a $1 million ―stay‖ bonus by JWP‘s CEO, an offer he declined. 9.
JWP eventually filed for bankruptcy and was reorganized as Emcor Group Inc.
10. Ernest Grendi and the three subordinates who helped him direct the fraud were sanctioned by the SEC.
20
Case 1.5 The Leslie Fay Companies
11. Ernst & Young ultimately paid $23 million to settle lawsuits filed against the firm by JWP‘s former stockholders. 12. In another lawsuit filed against Ernst & Young by JWP‘s former lenders, a federal judge criticized the accounting firm for accommodating Ernest Grendi and for exhibiting ―spinelessness‖ during its annual JWP audits.
Instructional Objectives 1. To provide students with a vivid example of a corporate executive who insisted on ―doing the right thing‖ regardless of the personal consequences he faced. 2. To demonstrate how close personal relationships between auditors and client personnel can jeopardize independent audits. 3. To demonstrate the audit risks posed by a client executive who dominates his or her firm‘s accounting and financial reporting function.
Suggestions for Use This case provides a welcome relief from the ―typical‖ series of events profiled in the majority of cases presented in this text. Because ―bad news‖ scenarios—Enron, WorldCom, Sunbeam, and so on and so forth--are much more likely to surface in the public domain, the majority of my cases involve unethical corporate executives. Not so in this case. Well, at least, the main ―actor‖ in this case, David Sokol, is scrupulously honest. During my courses, I frequently remind students that most corporate executives, accountants, and auditors are honest and ethical. This case provides a stark and powerful example of one such individual. When I discuss a case such as this in my courses, I try to provide other examples of positive role models among corporate executives. Granted, most of these examples do not involve accounting or auditing matters, but, nevertheless, they help to blunt the impression that students may receive from studying my cases that most corporate executives are ―crooks.‖ An implicit theme of this case that I want students to recognize is the contrast between the persistent and vigorous efforts of David Sokol to ―get to the bottom‖ of the suspicious items he uncovered in JWP‘s accounting records versus what Judge William Conner referred to as the ―spinelessness‖ of JWP‘s auditors. The JWP audits were similar to most problem audits in that the auditors encountered numerous red flags and questionable entries in the client‘s accounting records but, for whatever reason, apparently failed to thoroughly investigate those items. On the other hand, Sokol refused to be deterred in his investigation of the troubling accounting issues that he discovered. Clearly, the relationships that existed between members of JWP‘s accounting staff and
Case 1.5 The Leslie Fay Companies 21 the Ernst & Young audit team influenced the outcome of the JWP audits. Of course, the SarbanesOxley Act of 2002 attempts to curb the impact of such relationships on independent audits—for example, by requiring periodic rotation of audit engagement partners.
Suggested Solutions to Case Questions 1. I discourage students from providing casual ―I would have done the same thing that he did‖ type answers to this question. Before they answer this question, encourage your students to obtain a clear ―picture‖ of the situation in which Sokol found himself. He had just given up a terrific position with a company that he had earned widespread acclaim for ―turning around.‖ Plus, he had uprooted his family and moved away from his beloved Nebraska to the unfamiliar and fast-paced atmosphere of New York City. Like anyone who has made such an abrupt change, Sokol likely experienced a certain amount of cognitive dissonance or doubt regarding the wisdom of his decision. No doubt, that dissonance was compounded when he began uncovering the problem items in JWP‘s accounting records. A normal reaction in such circumstances would have been for Sokol to ―pooh-pooh‖ the suspicious accounting issues and to focus his energy and efforts on JWP‘s challenging operating problems. In fact, Sokol did just that, to some extent. Notice that the case points out that Sokol tried to ―convince himself‖ that the suspicious accounting matters were aberrations. Nevertheless, he never dismissed those items completely and continued to investigate them, which he certainly had an obligation to do. 2. One such measure was taken in the summer of 2002 when the SEC began requiring corporate executives to sign a pledge that the financial statements being filed by their company with the federal agency are materially accurate, a requirement that was formalized in Section 302 of the SarbanesOxley Act. Logically, corporate executives should be more likely to ―blow the whistle‖ on an accounting fraud that they discover given this new requirement. By strengthening the audit committee function, the Sarbanes-Oxley Act provides another incentive for corporate personnel to ―come clean‖ when they discover problematic accounting issues or items. More rigorous audit committees should be more likely to eventually uncover problematic items, so corporate executives and employees should be more inclined to ―go ahead‖ and reveal such items as soon as they discover them. In addition to punitive approaches to encouraging corporate executives and employees to report fraudulent accounting schemes, Corporate America could adopt ―kinder and gentler‖ strategies to persuade those individuals to be scrupulously honest and forthright. For example, explicit awards for commendable conduct, such as that exhibited by David Sokol, could be used to recognize ethical
22
Case 1.5 The Leslie Fay Companies
corporate executives. Likewise, boards of directors could choose to incorporate economic incentives for ethical conduct in the compensation packages of corporate executives. 3. The answer to Question 2 suggests that one approach to encouraging ethical conduct by corporate executives would be to reward them monetarily for such behavior. That suggestion was made in response to a ―how to‖ question, while this question raises the ―should‖ or normative issue regarding such a strategy. You may have a different attitude, but my general inclination in responding to this question is ―No.‖ Shouldn‘t ethical behavior or conduct be an implicit and assumed feature of every job role in Corporate America—from janitorial positions to the office of the CEO? In other words, should employees and executives be rewarded for doing what they have been hired to do? On the other hand, I agree that recognizing ethical conduct, such as that of David Sokol, with plaques, public proclamations, and other token gestures is appropriate and likely helps to encourage other individuals to resolve ethical dilemmas by ―doing the right thing.‖ 4. Auditor-client relationships can adversely impact audit quality by undercutting or undermining the independence of auditors. Auditors who lose their objectivity because of close ties to client personnel may be less than rigorous in assessing a client‘s internal controls, may be overly reliant on client representations (as audit evidence), and, ultimately, may issue an inappropriate report on a given client‘s financial statements. Listed next are examples of specific measures that an audit firm could take to limit or mitigate the risk that auditor-client relationships will impair the quality of their audits: Include an explicit policy statement in the firm‘s audit procedures manual alerting auditors to the potential problems posed by friendships with client personnel. During the staffing phase of each audit, require a senior member of the audit engagement team to question other team members regarding any potential conflict of interests stemming from relationships with client personnel. Require the review or concurring partner for each audit to assess the independence of the audit engagement partner vis-à-vis client executives and other key client employees. Encourage audit team members to report, even if anonymously, potentially problematic relationships between their colleagues and client personnel. Rotate assignments of audit team members periodically so that they do not work with the same client personnel each audit. 5. I have never heard of such agreements prior to this case—maybe you have. Clearly, such agreements can prove to be problematic, as Judge Conner suggested, since they may place audit firms in a situation where the budgeted resources for a given engagement are insufficient. Over a three-year timeframe, the financial condition, operating results, and a variety of other factors relevant to a client can change dramatically, resulting in significant changes in the resources needed to complete an audit. If the audit fee is capped, an audit firm may be more prone to ―cut corners‖ on a given engagement, resulting in a decline in audit quality. So, generally, I would suggest that these types of agreements are not appropriate, although they are not expressly prohibited by professional standards.
Case 1.5 The Leslie Fay Companies 23 6. Stockholders are generally in a stronger position than creditors and other parties to sue a company‘s former auditors. In civil cases filed under the common law, stockholders qualify as primary beneficiaries of an audit in all jurisdictions. On the other hand, lenders and other creditors may only qualify as ―foreseen‖ or ―foreseeable‖ beneficiaries of a given audit. This distinction is important because in many jurisdictions only primary beneficiaries can use auditors for negligence. Other parties in the latter jurisdictions must prove that auditors were guilty of something more than negligence during a given engagement. [Note: for a more elaborate discussion of auditors‘ liability under the common law, see the solution to Case 7.8, ―Fred Stern & Company, Inc.‖] Because of the stronger position that stockholders often have under the common law, audit firms are more inclined to settle stockholder lawsuits out of court.
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 class action 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 makes 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
24
Case 1.5 The Leslie Fay Companies
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.
23
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 GAAS violations 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 roll back to corroborate the year-end in-transit inventory.
Case 1.5 The Leslie Fay Companies 25 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. 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 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
26
Case 1.5 The Leslie Fay Companies
to complete an inventory roll forward. Likewise, you could use role-playing to recreate some of the testy exchanges that took place between Michael Young 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. Clearly, 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 pursue a suspicious transaction or other item because doing so might result in negative consequences for his or her friend, clearly the actual independence of the auditor has been compromised. More globally, I would suggest that an auditor‘s de facto independence has been impaired by a client relationship when that relationship results in the auditor violating one or more GAAS. Loss of independence may result in an auditor failing to gain a proper understanding of a client‘s internal controls, deciding not to collect sufficient appropriate evidence to support an audit-related decision, or even issuing an inappropriate audit opinion. 2. Interpretation 101-2, ―Employment or Association with Attest Clients,‖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. ―When a member of the attest engagement team or an individual in a position to influence the attest engagement intends to seek or discuss potential employment or association with an attest client, or is in receipt of a specific offer of employment from an attest client, independence will be impaired with respect to the client unless the person promptly reports such consideration or
Case 1.5 The Leslie Fay Companies 27 offer to an appropriate person in the firm, and removes himself or herself from the engagement until the employment offer is rejected or employment is no longer being sought.‖ As a point of information, Section 206 of the Sarbanes-Oxley Act of 2002 prohibits an audit firm from providing ―audit services‖ to a company that has recently hired an employee of the audit firm to serve in a top accounting position. ―It shall be unlawful for a registered public accounting firm to perform for an issuer any audit service . . . if a chief executive officer, controller, chief financial officer, chief accounting officer, or any person serving in an equivalent position for the issuer, was employed by that registered independent public accounting firm and participated in any capacity in the audit of that issuer during the 1-year period preceding the date of the initiation of the audit.‖ 3. The most common situation in which an inventory roll back 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 ―roll back‖ the existing inventory quantities and dollar amounts to the corresponding amounts on the inventory date. AU Section 326 discusses the factors that impact the reliability or validity of audit evidence. Following is a brief excerpt from that discussion. ―Audit evidence obtained directly by the auditor is more reliable than audit evidence obtained indirectly or by inference‖ (AU 326.08). This observation would suggest that the documentary evidence provided by an inventory roll back 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 roll back or roll forward. One troubling aspect of Karnick‘s decision not to complete the inventory roll forward 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 Section 326.12 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 auditor may consider the relationship between the cost of obtaining audit evidence and the usefulness of the information obtained. However, the matter of difficulty or expense involved is not in itself a valid basis for omitting an audit procedure for which there is no appropriate alternative.‖ 5. AU Section 339, ―Audit Documentation,‖ discusses the form and content of audit workpapers. That section of the auditing standards does not specifically address the question of whether the
28
Case 1.5 The Leslie Fay Companies
results of inconclusive audit tests should be included in audit workpapers. Most directly relevant to this case question may be the suggestion in paragraph .07 that ―superseded‖ or ―preliminary‖ notes or documents need not be retained by auditors. However, paragraph .16 explicitly requires auditors to address in their workpapers the results of any audit procedures that were ―inconsistent‖ with their final conclusions. Note: AU Section 339 addresses the audit documentation standards for audit clients other than publicly owned companies. Please refer to the suggested solution to Question 4 of Case 1.1, Enron Corporation, for a discussion of the PCAOB‘s audit documentation standards. 6. The term ―red flags‖ is 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 AU 316, ―Consideration of Fraud in A Financial Statement Audit,‖ 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 losses making the threat of bankruptcy, foreclosure, or hostile takeover imminent.‖ 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. [Note: This paragraph summarizes the general strategy or approach that AU 316 suggests auditors follow in considering the impact of fraud risk factors on the key phases of an audit. Refer to AU 316 for a much more indepth discussion of this subject.] 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.
Case 1.5 The Leslie Fay Companies 29 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 manufacturing 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.
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
30
Case 1.5 The Leslie Fay Companies
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 eighteen-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 nine-year 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.
29
The Leslie Fay Companies--Key Facts 1. 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. 2. 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 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. 6. In January 1993, Paul Polishan informed John Pomerantz of a large 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.
Case 1.5 The Leslie Fay Companies 31 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 the client‘s management. 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. Paul Polishan was convicted in 2000 of engineering the Leslie Fay fraud, principally due to the testimony of Donald Kenia. 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.
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 Several of the Section 1 or Comprehensive cases in this text, including the Leslie Fay case, contain exhibits that present multi-year financial statement data for a given company. 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
32
Case 1.5 The Leslie Fay Companies
apparent trends in a client‘s financial data by comparing those data with financial information for a key competitor rather than with industry norms. 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.)
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
8.8 0.0 8.1 .8
10.9 0.0 9.9 .9
5.9 0.0 10.0 1.1
8.0 0.0 12.6 1.1
5.1 .5 10.3 1.2
Case 1.5 The Leslie Fay Companies 33 Accrued Compensation Acc. Expenses, etc. Income Taxes Payable Total Curr. Liabs.
4.3 1.1 .4 23.4
3.4 1.5 .5 27.1
5.0 1.5 1.3 24.8
4.6 2.0 1.6 29.9
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
1991 Net Sales 100.0 Cost of Sales 69.9 Gross Profit 30.1 Operating Expenses: SWG&A 22.3 Amortization .3 Total Operating Exp. 22.6 Operating Income 7.5 Interest Expense 2.2 Income Bef. NR Charges 5.3 Non-recurring Charges 0.0 Inc. Before Taxes 5.3 Income Taxes 1.8 Net Income 3.5
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
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
1991
1990
1989
1988
1987
2.9
2.6
2.7
2.2
2.6
Financial Ratios for Leslie Fay: Liquidity: Current
34
Case 1.5 The Leslie Fay Companies Quick
1.5
1.4
1.5
1.2
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 Profit Margin on Sales Return on Total Assets Return on Equity
30.1% 3.5% 12.1% 14.6%
31.4% 3.4% 10.9% 16.8%
31.7% 3.3% 11.6% 17.6%
31.7% 3.3% 11.2% 18.2%
30.7% 3.4% 11.8%
* 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
Case 1.6 Star Technologies, Inc. 35 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 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. 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.)
36
Case 1.6 Star Technologies, Inc.
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 SAS No. 99, ―Consideration of Fraud in a Financial Statement Audit.‖ 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. (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. Interpretation 101-6 (ET Section 101.8) of the AICPA‘s Code of Professional Conduct, ―The Effect of Actual or Threatened Litigation on Independence,‖ addresses this specific situation.
CASE 1.6
Case 1.6 Star Technologies, Inc. 37
STAR TECHNOLOGIES, INC.
Synopsis During the 1980s, Star Technologies, a small, computer manufacturer based in Virginia, experienced the volatile economic swings common to many small firms in its industry. The company plowed millions of dollars into R&D efforts to produce a prototype computer suitable for production. After taking the product to market, Star found that it was soon obsolete. The cycle started over again with huge R&D expenditures. Most small computer manufacturers could not survive this vicious cycle. By the end of the 1980s, Star was barely ―hanging on.‖ Price Waterhouse‘s Washington, D.C., office performed Star‘s 1989 audit. Clark Childers served as the audit engagement partner, while Paul Argy, a senior audit manager to be considered for promotion to partner the following year, planned and coordinated the audit. Near the end of fiscal 1989, Star faced a severe financial crisis. Poor operating results for that year caused the company to violate restrictive covenants included in the debt agreement with its principal bank. This crisis apparently provoked Star‘s management to take aggressive positions regarding several accounting and financial reporting issues raised by the Price Waterhouse auditors during the 1989 audit. These issues included the proper classification of the company‘s long-term debt, the financial statement treatment of R&D expenditures, and the sufficiency of the company‘s allowances for uncollectible receivables and inventory obsolescence. Repeated confrontations with Star management left Paul Argy frustrated. No doubt, even more frustrating to him were the actions of his immediate superior on the engagement, Clark Childers. On many of the contentious issues raised during the 1989 audit, Childers rejected Argy‘s seemingly reasonable and conservative points of view and sided with the aggressive positions advocated by management. Near the end of the audit, Childers instructed Argy to sign off on the ―audit summary‖ for the engagement, signaling successful completion of the audit. At first, Argy refused, but then relented and signed the document. An anonymous letter sent to Price‘s national headquarters alleged that the 1989 Star audit was an audit failure. An investigation by Price eventually led to the firm withdrawing its 1989 audit opinion for Star. A subsequent SEC investigation resulted in Argy and Childers being suspended from practicing before the SEC for eighteen months and five years, respectively.
37
Star Technologies, Inc.--Key Facts 1. During the 1980s, Star Technologies found itself trapped in the vicious business cycle of
38
Case 1.6 Star Technologies, Inc.
computer manufacturers: heavy R&D expenditures, followed by rapid product obsolescence, followed by a need to incur heavy R&D expenditures once more. 2. Near the end of fiscal 1989 (March 31, 1989), Star faced a financial crisis when it violated a debt covenant due to its poor operating results, triggering a default on a large long-term debt. 3. Star‘s 1989 audit posed many contentious issues for the Price Waterhouse engagement team that included Clark Childers, the engagement partner, and Paul Argy, a senior audit manager to be considered for promotion to partner the following year. 4. During the 1989 audit, Childers and Argy clashed repeatedly over aggressive accounting and financial reporting decisions made by Star management; Childers overrode Argy on several of these issues, choosing to side with positions taken by the client. 5. Near the end of the 1989 audit, Childers instructed Argy to sign off on the ―audit summary‖ for the engagement; a reluctant Argy eventually signed off on that document, signaling successful completion of the audit. 6. After Price Waterhouse issued an unqualified opinion on Star‘s 1989 financial statements, an anonymous letter alleging that the 1989 Star audit was an ―audit failure‖ prompted Price to investigate that audit and ultimately to withdraw its 1989 audit opinion. 7. In 1990, Star issued restated financial statements for 1989 that increased the company‘s originally reported loss of $4.4 million to $7.4 million. 8. Shortly after Price Waterhouse issued an unqualified opinion on Star‘s restated financial statements for 1989, Star dismissed Price and retained Coopers & Lybrand as its auditor. 9. Following an investigation, the SEC suspended Argy from practicing before the federal agency for eighteen months; Childers received a five-year suspension. 10. In commenting on Argy, the SEC noted that ―an independent accountant, including an audit manager, cannot excuse his failure to comply with GAAS because of a sense of futility after his proposed approaches to certain accounting issues are repeatedly rejected.‖
Instructional Objectives
Case 1.6 Star Technologies, Inc. 39 1. To demonstrate the importance of auditors being allowed to dissociate themselves from decisions with which they do not approve. 2. To illustrate the impact that economic conditions within a client‘s industry has on the inherent risk component of audit risk. 3. To demonstrate the adverse impact that pressure exerted on auditors by client management can have on the quality of independent audits. 4. To help students analyze a company‘s financial statements with the objective of identifying items in those statements requiring special scrutiny during an audit. 5. To review the nature and purpose of the audit review process. 6. To examine the SEC‘s oversight role for the auditing discipline.
Suggestions for Use I like to kick off coverage of this case by asking students who they believe wrote the anonymous letter charging that the 1989 Star audit was an ―audit failure.‖ Typically, the class quickly narrows the ―candidates‖ down to three members of the 1989 audit engagement team. This exercise typically transitions into a lively debate of whether such a technique (writing an anonymous letter) is a reasonable or professional method for auditors to use in expressing disagreement with important decisions made during an engagement. Eventually, one or more students will mention Price Waterhouse‘s ―disagreement procedure‖ and insist that the ―letter writer‖ in this case should have taken advantage of that procedure rather than using the ―backdoor‖ approach. (The disagreement procedure allows an auditor on an engagement to dissociate herself or himself from a decision with which she or he does not agree.) In my view, these non-technical issues and the related debates they trigger are more important than the technical accounting and auditing issues raised in the case. We all hope to produce competent, independent-minded professionals who ―stick to their guns‖ when an important dispute arises during an audit engagement, a dispute involving either a client representative or a colleague on the audit team. This case provides students with a classroom opportunity to consider, if not vicariously experience, such a situation. Another exercise you might consider using with this case is a role-playing scenario involving Argy and Childers. In this scenario, ask two students to recreate the meeting in which Childers instructs Argy to sign off on the 1989 audit summary for the Star engagement. Alternatively, you could instruct two students to role-play a hypothetical meeting that Argy arranged with Childers during the course of the 1989 Star audit. Argy (allegedly) called this meeting to express his displeasure with Childers‘ decisions regarding several of the problematic issues that had arisen to that point in the engagement.
As a sidebar, just because the two relevant individuals in these scenarios are men doesn‘t
40
Case 1.6 Star Technologies, Inc.
preclude having female students assume one or both of those roles. Sometimes, I will ask a female student to play a given male role ―straight,‖ that is, as if she were that male. Other times, I change the gender of the given role. For example, I might change Paul Argy to Paulette Argy and/or Clark Childers to Clarice Childers. Of course, I have asked male students to make similar ―gender switches‖ when a female played a central role in a case. My experience has been that role-playing scenarios often turn out quite differently if you mix the genders of the students assigned to the roles and the genders of the characters they are asked to assume.
Suggested Solutions to Case Questions 1. AU Section 311, ―Planning and Supervision," notes that when planning an audit, auditors should obtain an understanding of the client‘s ―environment‖ (AU 311.03), which would clearly include the client‘s industry. Later, this section goes on to note that auditors should also consider "significant industry developments‖ (AU 311.A4) when planning an audit. Obviously, the overall health of a client's industry has important implications for the financial health of that company. Likewise, the changes that an industry is undergoing have implications for the future of each company within that industry. For these reasons, auditors must be cognizant of, and explicitly consider, industry-related factors while planning an audit. Listed next are examples of audit risk factors often posed by many companies in high-tech industries: (a) High risk of inventory obsolescence (b) Liquidity concerns stemming from the need for large amounts of capital to finance product development, production, and marketing efforts (c) Need to ensure compliance with industry and/or governmental guidelines or regulations (Note: an ―upstart‖ manufacturer of golf clubs developed a new driver that was well received by customers only to have the club fail to meet the strict specifications imposed on golf clubs by the PGA. As you might expect, the company‘s sales nosedived after the PGA‘s ruling was released.) (d) High management turnover (possibly due to ―raids‖ by competitors) (e) New and/or unusual transactions (f) Absence of historical industry norms or ―comps‖ (to use in analyzing client financial data) 2. To identify key changes in Star‘s financial status between 1988 and 1989, auditors would have found it helpful to develop common-sized financial statements and key financial ratios for each of those years. Following are common-sized balance sheets, common-sized income statements, and selected financial ratios for Star Technologies for the period 1988-1989.
Case 1.6 Star Technologies, Inc. 41 Common-sized balance sheets for Star Technologies: 1989
1988
Current assets: Cash and equivalents Accounts receivables Inventory Other current assets Total current assets
4.6 16.1 41.4 6.2 68.3
6.6 16.2 42.9 2.3 68.0
PP&E Other assets Total assets
22.1 9.6 100.0
20.1 11.9 100.0
Current liabilities: Accounts payable Accrued payroll Other accrued liabilities Deferred revenue Notes payable Total current liabilities
15.1 3.7 .9 .9 3.5 24.1
6.1 3.7 3.0 1.5 .9 15.2
Notes payable, less curr. portion Total liabilities
59.8 83.9
50.9 66.1
0.0 .5 157.6 (142.0) 16.1
0.0 .6 193.2 (159.9) 33.9
100.0
100.0
Stockholders’ equity: Convertible preferred stock Common stock Additional paid-in capital Retained earnings (deficit) Total stockholders’ equity Total liabilities and Stockholders’ equity
42
Case 1.6 Star Technologies, Inc.
Common-sized income statements for Star Technologies: Year ended March 31, 1989 1988 100.0 100.0
Revenue Costs and expenses: Cost of revenue 57.7 Research and development 20.4 Marketing and sales 21.0 General and administrative 7.6 Operating income (loss) (6.7) Interest expense (4.1) Other expense (.5) Income (loss) before income taxes and extraordinary items (11.3) Provision for income taxes -Income (loss) before extraordinary items (11.3) Extraordinary items: Utilization of NOL carryforward -Net income (loss) (11.3)
48.6 13.1 20.7 6.9 10.7 (4.0) (.3) 6.4 (3.6) 2.8 3.4 6.2
Key financial ratios for Star Technologies: Current Quick Debt to assets Long-term debt to equity Gross margin Profit margin on sales
1989 2.84 1.12 .84 3.71 42.3% (11.3)%
1988 4.47 1.65 .66 1.95 51.4% 6.2%
Equations: Current ratio: current assets / current liabilities Quick ratio: (current assets - inventory) / current liabilities Debt to assets: total debt / total assets Long-term debt to equity: long-term debt / stockholders‘ equity Gross margin: (revenue - cost of revenues) / revenue Profit margin on sales: net income / revenue Discussion: Star‘s financial statements reveal three key changes in the company‘s financial status over the two-year period 1988-1989. First, Star‘s liquidity deteriorated significantly as indicated by its current and quick ratios. Much of the erosion in the company‘s liquidity was due to a large increase in accounts payable between the end of 1988 and 1989. Second, Star became much more leveraged during 1989. Notice that the company‘s long-term debt to equity ratio nearly doubled from the end
Case 1.6 Star Technologies, Inc. 43 of 1988 to the end of 1989. The most adverse change in Star‘s financial status was a sharp decline in profitability over the two-year period. Most of this decline was due to a large decrease in the company‘s gross margin percentage in 1989 and much higher R&D expenditures that year. Star‘s deteriorating financial condition should have put Price Waterhouse on notice that the company‘s going concern status might be in doubt. When a client‘s going concern status is doubtful, an auditor will typically make appropriate changes in the nature, extent, and timing of audit procedures. In particular, Price likely would have planned to devote more time and effort to corroborating the key management assertions for the client. (Executives of a company that is facing severe financial problems may be more prone to take inappropriate steps to ―enhance‖ their firm‘s apparent financial condition and operating results.) Additionally, Price should have considered discussing the going concern issue with Star‘s executives to determine whether they had a plan to remedy the company‘s financial problems. Then, Price should have rigorously evaluated the feasibility of any such plan. Finally, Price might have devoted more time and effort than normal during the 1989 Star audit to examining the company‘s compliance with its debt agreements, studying minutes of the company‘s board of directors meetings, and communicating with the company‘s legal counsel regarding pending legal matters that possibly stemmed from Star‘s deteriorating financial condition. (Note: SAS 58, ―The Auditor‘s Consideration of an Entity‘s Ability to Continue as a Going Concern,‖ became effective for audits of financial statements for periods beginning on or after January 1, 1989. Since Star‘s 1989 fiscal year began on April 1, 1988, SAS 58 did not apply to Price‘s 1989 audit of the company. SAS 58, which is incorporated in AU Section 341, discusses methods auditors should use to evaluate a client‘s going concern status and explicit measures auditors should take after deciding there is substantial doubt a client will remain a going concern for a reasonable period of time.) (Note: Although not unusually significant items, notice that there were significant percentage changes between the end of 1988 and 1989 in Star‘s Other Current Assets and its Other Accrued Liabilities. Price might have allocated additional resources during the 1989 audit to examine the key management assertions for those two items.) 3. A series of cash flow statements provides important insight on a company‘s financial health not readily available from the other two major financial statements. Of course, a cash flow statement reveals how a company is raising cash and how it is spending cash. Generally, we expect a financially healthy company to be satisfying most of its cash needs via its operating activities. Companies cannot rely indefinitely on investing and/or financing activities as their primary source or sources of cash. For example, a company that has positive cash flows from investing activities is typically downsizing by selling off assets. Clearly, that is a finite source of cash. Likewise, banks, lenders, and investors will eventually balk at supplying additional capital to a company if it fails to develop and sustain profitable operations. Auditors can use cash flow data to identify important trends affecting a client‘s financial status and key financial statement items. In turn, such trends can help auditors develop appropriate audit strategies and select relevant audit procedures for a client. Notice that Star‘s operating activities produced positive net cash flows each year over the period 1987-1989. However, by 1989, Star‘s net operating cash flow was minimal. The downward spiral of Star‘s operating cash flows had ominous implications for the company‘s short-term liquidity, solvency, and ―survivability‖ that Price should
44
Case 1.6 Star Technologies, Inc.
have taken into consideration in developing an audit plan for this client. For example, the decline in operating cash flows may have prompted Price to focus particular attention on the company‘s ability to raise additional debt and equity capital when evaluating its status as a going concern. 4. Listed next are the key management assertions Star apparently violated in its original 1989 financial statements (a) $900,000 note receivable from Culler: Existence (account balance assertion) and multiple presentation and disclosure assertions (including Completeness and Classification and Understandability) (b) Reserve for inventory obsolescence: Valuation and allocation (account balance assertion) (c) Reserve for bad debts: Valuation and allocation (account balance assertion) (d) ―Mystery‖ assets: Existence, Valuation and Allocation (account balance assertions) and multiple presentation and disclosure assertions (including Completeness) (e) Notes payable: Classification and understandability (presentation and disclosure assertion) 5. Given the circumstances, the large loan was due and payable in five months, that is, at the end of the five-month waiver period. Since current liabilities are generally debts that must be paid in the coming twelve months, the waiver failed to convert the loan from a current to a long-term liability. (If Star‘s bank had no intention of accelerating the loan‘s maturity date, the waiver should have been for the term of the loan.) 6. The audit review process is the primary quality control mechanism for an independent audit. The auditor who assumes final responsibility for the engagement (generally the audit engagement partner) should ensure that the work of each subordinate is reviewed to determine if the assigned procedures were done adequately and whether the results of those procedures are consistent with the audit report to be issued for the entity. On large engagements, the audit review process involves several layers of review. For example, a staff accountant‘s work may be reviewed first by his or her immediate superior, likely the audit senior assigned to the given engagement. After the staff accountant ―clears‖ the senior‘s review comments, that work will be reviewed by the engagement audit manager. When the manager‘s comments are cleared, the audit engagement partner will review the staff accountant‘s work. Work performed by the audit senior would be reviewed by the manager and partner, while the manager‘s work would be reviewed by the partner. Finally, as in this case, most large audit firms require a second partner review for each audit engagement. Typically, this review involves a partner not assigned to the audit who reviews the results of the key audit procedures applied during the engagement and the resolution of key issues or problems that arose during the engagement. The second partner review for the 1989 Star audit led to an extensive discussion of the accounting and financial reporting treatment for the $900,000 note receivable from Culler & Associates. However, that item was improperly reported in Star‘s 1989 financial statements because neither Childers nor, apparently, the review partner referred to the actual contract between Star and Culler. An inspection of that document would have revealed the true nature of the Star-Culler agreement and dictated that the $900,000 be treated as an R&D expenditure. On at least three occasions during the 1989 Star audit, Childers disagreed with a decision reached
Case 1.7 Savings and Loan Association
45
by a subordinate and sided with a client on an important accounting or financial reporting issue. While reviewing subordinates‘ work during the Star audit, Childers seemed predisposed toward agreeing with positions taken by the client rather than siding with the positions supported by his subordinates. Such a predisposition on the part of an engagement audit partner serves to undercut the purpose of the audit review process. (Note: We don‘t know what accounted for Childers‘ predisposition to agree with positions expressed by Star executives, while rejecting the arguments presented by his subordinates. Possibly, Childers was simply giving the ―benefit of the doubt‖ to client executives who, in the past, had taken reasonable and defensible positions regarding important accounting and financial reporting issues.) In summary, the point here is that the audit partner and/or the review partner for an engagement represents the final line of defense in an audit. If these individuals overlook key issues, fail to exercise sound professional judgment regarding such issues, or simply choose to ignore their responsibilities, the audit review process will fail to function as an effective quality control mechanism. 7. Disagreements among members of an audit engagement team are quite common given the subjective nature of many of the judgments that must be made during an audit. Such differences of opinion should be resolved by open, uninhibited discussion of the issues involved. Unfortunately, junior members of an engagement team may often be reluctant to express their views during such discussions. Consequently, it is incumbent on senior members of an engagement team to impress upon their subordinates that they have a right and an obligation to air their views when disputes arise. After an issue has been discussed and there is still a difference of opinion among the members of an audit team, the senior member of that team should take responsibility for resolving the issue. However, any member of the audit team who does not agree with the resolution of the matter should be allowed to dissociate himself or herself from that decision. This dissociation will typically be accomplished by the individual including a memo in the workpapers that expresses his or her viewpoint on the given issue. Argy and Childers had several disagreements during the 1989 Star audit involving contentious issues that arose during that engagement. The SEC‘s enforcement releases in this case do not reveal exactly how Argy and Childers resolved their differences. Assume for argument‘s sake that Childers simply decided what Price Waterhouse‘s position would be on each of the contentious issues and then informed Argy of his decision. Clearly, an audit firm should not condone that approach to resolving differences of opinion between key members of an audit engagement team. At some point, audit partners must assert their authority and make a decision on key issues arising during an engagement. But a unilateral decision-making style on the part of a partner undercuts the key advantage of assigning an engagement ―team‖ to each audit. If an audit partner finds herself or himself continually overriding or ignoring recommendations made by subordinates, the partner should reexamine and rethink her or his management style. (Note: the SEC implied that Argy‘s interest in being promoted to partner may have colored his judgment in this case and contributed to his decision to capitulate to Childers‘ demands or decisions.)
46
Case 1.7 Lincoln Savings and Loan Association
CASE 1.7
LINCOLN SAVINGS AND LOAN ASSOCIATION
Synopsis The collapse of Lincoln Savings and Loan Association in 1989 was one of the most expensive and controversial savings and loan failures in U.S. history. Charles Keating, Jr., is seemingly the perfect example of the aggressive, risk-seeking entrepreneurs who were attracted in large numbers to the savings and loan industry when it was deregulated by the federal government in the early 1980s. Many of these individuals, including Keating, developed innovative, if not ingenious, methods for diverting the insured deposits of their savings and loans into high-risk commercial development projects. A large numgber of these ventures proved unprofitable or were undermined by the greed of their sponsors. The final result was an estimated price tag of $500 billion for the federal bailout of the savings and loan industry. The congressional hearings subsequent to the collapse of Lincoln Savings and Loan resulted in widespread criticism of Lincoln's auditors and the public accounting profession as a whole. The most serious charge leveled at Lincoln's auditors was that they failed to ensure that the economic substance, rather than the legal form, of their client's huge real estate transactions dictated the accounting treatment applied to those transactions. Other important audit issues raised by this case include the responsibility of auditors to detect management fraud, quality control issues related to the acceptance of prospective audit clients, the effect that an extremely competitive audit market may have on client acceptance decisions and ultimately on auditor independence, and the collegial responsibilities of audit firms.
46 Lincoln Savings and Loan Association--Key Facts
Case 1.7 Savings and Loan Association
47
1. Charles Keating had been charged with professional misconduct in the late 1970s by the SEC. 2. Keating dominated the operations of both Lincoln and its parent company, ACC, and was largely responsible for the phenomenal growth experienced by the savings and loan during the 1980s. 3. The principal lending activities of Lincoln involved commercial development projects and other high-risk ventures. 4. Lincoln's real estate transactions were complex and thus difficult for its auditors to understand. 5. Arthur Young accepted Lincoln as an audit client during the course of an intensive marketing effort to attract new clients. 6. Jack Atchison, Lincoln‘s audit engagement partner, developed a close relationship with Charles Keating and lobbied on Keating's behalf with regulatory officials. 7. Arthur Young relied upon real estate appraisals obtained by Lincoln in auditing certain of the savings and loan's large real estate transactions. 8. After joining ACC, Atchison served as an interface between ACC/Lincoln and the Arthur Young auditors. 9. After Janice Vincent assumed control of the Lincoln audit, the Arthur Young auditors apparently became more aggressive in questioning the validity of the savings and loan's large real estate transactions. 10. In October 1988, Arthur Young resigned as Lincoln‘s auditor following several heated disputes involving Vincent and Keating, disputes that focused on Lincoln‘s aggressive accounting treatments. 11. Ernst & Young, Arthur Young‘s successor, eventually paid $400 million to settle several lawsuits filed by the federal government that charged the accounting firm with substandard audits of four savings and loans, including Lincoln. 12. In 1999, Charles Keating finally admitted, in a plea bargain agreement reached with federal prosecutors, that he had committed various fraudulent acts while serving as ACC‘s CEO.
Instructional Objectives
48
Case 1.7 Lincoln Savings and Loan Association
1. To illustrate the impact that excessive competition in the audit market may have on client acceptance and retention policies of audit firms. 2. To demonstrate the legal exposure that audit firms face when they accept high-risk audit clients. 3. To emphasize the importance and necessity of candid communications between predecessor and successor audit firms. 4. To stress the importance of auditors maintaining a high degree of skepticism when dealing with a client whose management has adopted an aggressive, growth-oriented philosophy. 5. To establish that the economic substance of a client's transactions should be the determining factor in choosing how to account for those transactions. 6. To illustrate the pressure that client executives may impose on their auditors to interpret technical issues to the benefit of the client. 7. To illustrate the importance of auditors maintaining both their de facto independence and their appearance of independence. 8. To emphasize the importance of audit firms' collegial responsibilities to each other.
Suggestions for Use This is another case that I often use during the first week of the semester to introduce students to the purpose, nature, and importance of the independent audit function. This case could also be assigned during class discussion of client acceptance and retention decisions [or, more broadly, the discussion of quality control standards for audit firms] since both Arthur Young and Touche Ross were criticized for agreeing to accept Lincoln as an audit client. In this same vein, the case discusses the aggressive client development philosophy adopted by Arthur Young in the mid-1980s that may have been at least partially responsible for the audit firm's decision to accept the high-risk Lincoln engagement. Finally, since several ethical issues are raised in this case, including issues related to collegial responsibilities of audit firms and the de facto and apparent independence of auditors, the case could be assigned during coverage of the AICPA‘s Code of Professional Conduct. This case demonstrates the importance of the independent audit function and the number of third parties who rely upon the professional integrity and competence of independent auditors. I believe it is important for an instructor to point out that, in situations such as this, auditors can make a difference. To help make this point, I like to stress how Arthur Young's approach to the Lincoln audit changed when Janice Vincent became the audit engagement partner. As noted in the case, Vincent's disagreements with Keating over the proper accounting treatment for certain of Lincoln‘s transactions ultimately resulted in Arthur Young resigning as the savings and loan's audit firm.
Case 1.7 Savings and Loan Association
49
A key focus of this case is the substance over form concept. Allegedly, Lincoln abused this concept in accounting for several of its large real estate transactions. Because of their lack of "real world" experience, students often have the misperception that the answer to any technical issue they will face in their careers can simply be ―looked up‖ in the appropriate authoritative source. Unfortunately, that is not the case. Practicing auditors and accountants must be aware of, and be able to apply, the broad conceptual constructs of our profession, such as the substance over form concept, when addressing ambiguous technical problems or issues.
Suggested Solutions to Case Questions 1. The "substance over form" concept dictates that the true nature, that is, economic substance, of a transaction, rather than its legal or accounting form, should determine the manner in which it is reflected in an entity's accounting records. This concept is particularly pertinent for transactions involving related parties. Quite often, such transactions will not have taken place on an arm's length basis. For instance, the underlying purpose of a sale of property between two related entities may be to distort the apparent profitability of one or both entities, rather than being the result of an economic negotiation between the two parties. An entity's accountants, not their independent auditors, are primarily responsible for ensuring that the substance over form concept is not violated. An auditor is responsible for reviewing and testing the client's accounting records to determine that the substance of a client's transactions are reflected in those records. An auditor who discovers that the substance over form concept has been violated must then consider the resulting impact on the material fairness of the client's financial statements. If the violation(s) of this concept causes the financial statements to be materially misstated, the auditor would be required to issue either a qualified or adverse opinion on the client's financial statements. 2. The professional judgment of auditors may be compromised when their firm is overly dependent on one or a few large clients. Auditors, even those at the lower levels of a CPA firm, are likely cognizant of the economic impact that losing such a client would have on their firm and possibly on their own professional careers. This awareness alone may cause auditors to be more ―flexible‖ during such engagements. This problem may be compounded when a large client poses a relatively high audit risk since there is a greater likelihood that problematic issues requiring the exercise of professional judgment will arise on such an engagement. Criticism of the auditing profession has sensitized investors, creditors, and other third-party financial statement users to the paradoxical nature of audit independence. Third parties often find it difficult to accept that auditors can maintain an objective, professional point of view when the client retains and compensates the audit firm. This skepticism is likely heightened in circumstances such as those that existed in the Phoenix audit market in 1985. In a highly competitive audit market, the acceptance of a huge client, such as Lincoln, may cause third parties to assume that the given audit firm will resolve key accounting and auditing issues in the client's favor to ensure retention of the client. Determining whether large, high-risk audit clients should be accepted is a matter of professional judgment. Certainly, a valid factor to consider in such circumstances is whether the size of the audit fee (and other ancillary fees) would fairly compensate the audit firm for the risks that such a client
50
Case 1.7 Lincoln Savings and Loan Association
poses (litigation risk, etc.). Since the risk aversion of individual audit firms likely varies significantly, one audit firm might be willing to accept a given high-risk client, while another audit firm would not. Nevertheless, there are certain conditions that, if present, should cause an audit firm to be reluctant to accept such a client even if the audit fee fairly compensates the audit firm for the risks posed by the client. For instance, if the client would provide a disproportionate share of the audit firm's revenues (or, at least, the revenues of the local office of the audit firm), the threats to the perceived and de facto independence of the audit firm may simply be too great to justify accepting the client. Likewise, an audit firm that has recently suffered adverse publicity as the result of an audit failure or alleged audit failure might choose to avoid risking further damage to its reputation by accepting a large, high-risk audit client. 3. There are two key issues an auditor should consider when a client has engaged in material related-party transactions: 1) whether economic substance, rather than legal form, was the determining factor in the accounting for such transactions, and 2) whether such transactions have been disclosed adequately in the client's financial statements as required by FASB No. 57, "Related Party Disclosures." The latter of these issues does not present any major problems for the auditor since FASB No. 57 is very explicit regarding the disclosures necessary for related party transactions. Determining whether the economic substance of a related party transaction has prevailed over its legal form is generally a much more difficult issue for the auditor to resolve. AU Section 334, "Related Parties," discusses the procedures that an auditor should consider applying to material related party transactions. Listed below are examples of such procedures. a. determine whether the transaction has been approved by the board of directors b. examine invoices, executed copies of agreements, contracts and other pertinent documents, such as receiving reports and shipping documents c. inspect evidence in possession of the other party or parties to the transaction d. confirm or discuss significant information with intermediaries, such as, banks, guarantors, agents, or attorneys e. with respect to material uncollected balances [resulting from related party transactions], obtain information about the financial capability of the other party or parties to the transaction 4. AU Section 319.07 describes the control environment component of an internal control process as follows: ―The control environment sets the tone of an organization, influencing the control consciousness of its people. It is the foundation for all other components of internal control, providing discipline and structure.‖ Examples of factors that auditors should consider when evaluating a client's control environment include management's philosophy and operating style, an entity's organizational structure, and methods used within the organization to assign authority and responsibility. Listed next are weaknesses that were evident in Lincoln's control environment. a. The prior problems of Charles Keating, Jr., with the SEC suggest that the principal member of Lincoln's top management team may not have had the proper degree of control consciousness (this an important observation since subordinates usually look to superiors for guidance on such matters).
Case 1.7 Savings and Loan Association
51
b. The efforts of Lincoln management to obscure the true nature of the Hidden Valley transaction suggest that management may have attempted to subterfuge the controls that were present in the entity‘s accounting system. c. The problems identified by the 1985 FHLBB audit, i.e., file-stuffing, violation of banking laws, and other complaints not mentioned in the case, also tend to suggest that control consciousness was not an important concern of Lincoln management. d. The appointment of Charles Keating, III, as president of Lincoln demonstrates that managerial and technical competence were not factors that top management necessarily considered in making important personnel decisions. 5. The party holding a nonrecourse note resulting from a sales transaction has no legal recourse other than to retake possession of the previously sold asset if the maker of the note defaults. Consequently, an auditor examining sales transactions involving such notes must attempt to determine whether the purchaser intends to complete the transaction by paying the balance of the nonrecourse note. Quite often, this is a difficult assessment to make since future events, such as appreciation in the value of the acquired asset, may ultimately determine whether the purchaser will choose to pay the balance of the note. For a detailed discussion of the accounting rules for real estate transactions, see FASB No. 66, "Accounting for Sales of Real Estate." 6. AU Section 326.15 identifies the following five management assertions regarding classes of transactions and events: occurrence, completeness, accuracy, cutoff, and classification. Of these assertions ―accuracy‖ seems to have been the most relevant to the Hidden Valley transaction. ―Accuracy. Amounts and other data relating to recorded transactions and events have been recorded appropriately.‖ In addition to ―accuracy,‖ several other management assertions identified in AU 326.15 were relevant to some degree to the Hidden Valley transaction including the ―completeness‖ assertion for presentation and disclosure and the ―valuation and allocation‖ assertion for account balances: ―Completeness. All disclosures that should have been included in the financial statements have been included.‖ ―Valuation and allocation: Assets, liabilities, and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded.‖ To corroborate the ―accuracy‖ assertion for the Hidden Valley transaction, Lincoln's auditors should have first attempted to determine whether the transaction was, in terms of economic substance, a valid sales transaction. A cursory investigation of the transaction would likely have revealed that it likely qualified as a related party transaction. At this point, it would have been incumbent on the auditors to apply the audit procedures suggested by AU Section 334, "Related Parties" [see suggested answer to Question 3]. For example, given the size of the transaction and its unusual characteristics (such as, a sales price greatly in excess of the property's appraised value), the auditors, at a minimum, should have confirmed or discussed the transaction with intermediaries and other parties to the transaction. If the auditors concluded that the Hidden Valley transaction was, in fact, a valid related party sales transaction, they should have attempted to determine that the appropriate FASB No. 57 related party disclosures were made in the client's financial statements. (Note: Whether or not E. C. Garcia was a "related party" to Lincoln was not an issue raised during the congressional hearings; however,
52
Case 1.7 Lincoln Savings and Loan Association
the close ties between Keating and Garcia suggest that the latter was, in fact, a related party as defined by FASB No. 57.) To address the ―valuation and allocation‖ assertion regarding the note receivable resulting from the Hidden Valley transaction, among other audit procedures, the auditors should have evaluated the ability and incentive of the maker of that note to pay the balance owed Lincoln. The key forms of audit evidence that Arthur Young should have collected (and may have collected) to support the Hidden Valley transaction include third party confirmations, documentary evidence (copy of the sales contract, copy of board of directors minutes approving the sale, etc.), and representations by client personnel involved in the transaction. NOTE: The actual procedures that Arthur Young used vis-a-vis the Hidden Valley transaction were not discussed at length in the congressional transcripts. The suggested solution to this question is not intended to imply that Arthur Young did not use the most appropriate procedures to audit this particular transaction. Nevertheless, William Gladstone's comment that his firm had to rely upon real estate appraisals provided by Lincoln was somewhat curious. Almost certainly, Arthur Young had the option of retaining independent appraisals of Lincoln's properties. 7. At the time that Atchison served as Lincoln‘s audit engagement partner, there were no explicit rules that forbid auditors from lobbying on behalf of a client‘s interest. Whether such behavior on the part of auditors is "professional" and/or appropriate is a question that has been widely debated both within and outside the profession. Apparently, Atchison did not believe that his lobbying efforts on behalf of Lincoln were inappropriate. In fact, in most ethical dilemmas that arise in an audit context, the audit professional must use his/her own ethical yardstick to determine how to proceed. Again, once Atchison left Arthur Young and joined ACC, there were no explicit rules that prohibited him from interfacing with members of the Arthur Young audit team. So, Atchison had to decide for himself whether his actions were appropriate, that is, whether his interaction with his former Arthur Young subordinates jeopardized their independence or objectivity. As a point of information, Section 206 of the Sarbanes-Oxley Act of 2002 specifically prohibits an accounting firm from providing ―audit services‖ to a company that has recently hired an employee of the firm to serve in a top accounting position. ―It shall be unlawful for a registered public accounting firm to perform for an issuer any audit service . . . if a chief executive officer, controller, chief financial officer, chief accounting officer, or any person serving in an equivalent position for the issuer, was employed by that registered independent public accounting firm and participated in any capacity in the audit of that issuer during the 1-year period preceding the date of the initiation of the audit.‖ 8. The predecessor of the Code of Professional Conduct contained a series of rules entitled "Responsibilities to Colleagues." Presently, there are no such rules in the Code of Professional Conduct. Nevertheless, implicit in the Principles of the Code of Professional Conduct is the responsibility to treat colleagues within the profession with dignity and respect. During the congressional hearings into the collapse of Lincoln Savings and Loan, representatives of the two CPA firms called to testify expressed distinct differences of opinion on a number of issues. At one point in the testimony, one of these individuals suggested that the work of the other
Case 1.7 Savings and Loan Association
53
firm was "unprofessional." Several of the congressmen sitting on the investigative committee perceived this to be an unprovoked and an unjustified attack. Whether the work performed by the audit firm was, in fact, unprofessional, is a matter of judgment. However, it is very important that audit firms in such public forums treat each other with due respect and courtesy, otherwise they may diminish the prestige and credibility of the public accounting profession as a whole. 9. AU Section 110 succinctly summarizes an auditor‘s responsibility for fraud detection. ―The 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‖ (AU 110.02). AU Section 316 discusses how auditors should and can fulfill that responsibility. Among other procedures, that section requires auditors to complete the following general tasks: 1. Discuss [among members of the audit engagement team] the risks of material misstatement due to fraud that are posed by a client 2. Obtain the information needed to identify the risks of material misstatement due to fraud. 3. Identify the risks that may result in a material misstatement due to fraud 4. Assess the identified risks after taking into account an evaluation of the entity‘s programs and controls that address the risks 5. Respond to the results of the risk assessment by, among other ways, making appropriate changes in the nature, extent, and timing of audit procedures to be performed 6. Evaluate audit test results 7. Communicate the results of the relevant fraud-related audit procedures to appropriate client personnel 8. Document fraud-related procedures and their outcomes. Because fraud is often well concealed, auditors do not have an absolute responsibility to discover fraud-related misstatements in a client‘s financial statements, as explicitly noted in AU 316.12: ―However, absolute assurance is not attainable and thus even a properly planned and performed audit may not detect a material misstatement resulting from fraud.‖ For instance, in cases in which forgery and/or collusion among client personnel has occurred, the likelihood that the auditor will uncover the fraud is probably quite low regardless of the nature and extent of the audit procedures employed. Conversely, an auditor's responsibility to detect an obvious fraud, such as the theft of huge amounts of inventory or the kiting of large checks at year-end, is much greater. In the Lincoln audit, Arthur Young was severely criticized by congressional investigators for failing to discover that many of the client's real estate transactions were not properly reflected in the client's financial records. However, the testimony of Lincoln executives subsequent to the congressional hearings strongly suggested that the true nature of those transactions was intentionally obscured to mislead the auditors.
54 Case 1.8 Crazy Eddie, Inc.
CASE 1.8
CRAZY EDDIE, INC.
Synopsis Eddie Antar opened his first retail consumer electronics store in 1969 near Coney Island in New York City. By 1987, Antar's firm, Crazy Eddie, Inc., was a public company with annual sales exceeding $350 million. The rapid growth of the company's revenues and profits after it went public in 1984 caused Crazy Eddie's stock to be labeled as a "can't miss" investment by prominent Wall Street financial analysts. Unfortunately, the rags-to-riches story of Eddie Antar unraveled in the late 1980s following a hostile takeover of Crazy Eddie, Inc. After assuming control of the company, the new owners discovered a massive overstatement of inventory that wiped out the cumulative profits reported by the company since it went public in 1984. Subsequent investigations by various regulatory authorities, including the SEC, resulted in numerous civil lawsuits and criminal indictments being filed against Antar and his former associates. Following the collapse of Crazy Eddie, Inc., in the late 1980s, regulatory authorities and the business press criticized the company's auditors for failing to discover that the company's financial statements had been grossly misstated. This case focuses on the accounting frauds allegedly perpetrated by Antar and his associates and the related auditing issues. Among the topics addressed by this case are the need for auditors to have a thorough understanding of their client's industry and the importance of auditors maintaining a high level of skepticism when dealing with a client whose management has an aggressive, growth-oriented philosophy. This case also clearly demonstrates the need for auditors to consider weaknesses in a client's internal controls when planning the nature, extent, and timing of year-end substantive tests.
54 Crazy Eddie, Inc.--Key Facts
Case 1.8 Crazy Eddie, Inc. 55 1. Most of Crazy Eddie‘s top executives were relatives or close friends of Eddie Antar who lacked the appropriate qualifications for their positions. 2. The consumer electronics industry realized a dramatic increase in sales from 1981 through 1984, which prompted Eddie Antar to convert Crazy Eddie's stores into consumer electronics supermarkets. 3. In 1984, Eddie Antar took Crazy Eddie public to raise capital needed to finance his company's aggressive expansion program. 4. To help market Crazy Eddie's stock, Antar dismissed the company's small accounting firm and retained Main Hurdman, which later merged with Peat Marwick. 5. Antar ordered his subordinates to inflate inventory and understate accounts payable after the company went public in 1984 to enhance Crazy Eddie's operating results and maintain the company's stock price at a high level. 6. Several of Crazy Eddie's top accounting officials cooperated with Antar‘s fraudulent schemes. 7. By 1986, the boom days for the consumer electronics industry had ended, creating financial problems for Crazy Eddie. 8. Following a 1987 hostile takeover of Crazy Eddie, the new owners discovered that the company's inventory was grossly overstated. 9. In 1989, Crazy Eddie filed a bankruptcy petition and then later that year ceased operations and liquidated its assets. 10. Crazy Eddie's auditors allegedly failed to adequately consider several "red flags," including pervasive internal control weaknesses, dominance of the company by one individual, the volatility of the consumer electronics industry, and unusual relationships among key account balances.
56 Case 1.8 Crazy Eddie, Inc. Instructional Objectives 1. To illustrate the lengths to which client management will sometimes go to misrepresent a company's operating results and financial position. 2. To emphasize the importance of auditors having a thorough understanding of the client's industry, including any major changes the industry is undergoing. 3. To demonstrate the need for auditors to employ analytical procedures during the planning phase of an audit to identify high-risk account balances. 4. To stress the need for auditors to maintain a high degree of skepticism when dealing with a client whose management has an aggressive, growth-oriented philosophy. 5. To examine auditors' responsibilities to detect management fraud and to identify specific procedures that may lead to the detection of fraudulent misrepresentations. 6. To emphasize the importance of considering major weaknesses in a client's internal controls when planning the nature, extent, and timing of year-end substantive tests. Suggestions for Use This case could easily be integrated with classroom coverage of analytical procedures. Crazy Eddie's auditors were criticized by third parties for failing to investigate red flags in the company's financial statements that resulted from Antar‘s fraudulent schemes. The first case question requires students to apply analytical procedures to the company's financial statements to identify those red flags. Since a major focus of this case is management fraud and auditors' responsibility to detect fraudulent misrepresentations in clients' financial statements, the case could be assigned in conjunction with classroom discussion of SAS No. 99 "Consideration of Fraud in a Financial Statement Audit.‖ Finally, this is another case that could be used during the first week of an auditing course to acquaint students with the nature of the independent audit function and the problematic circumstances that auditors often encounter.
Case 1.8 Crazy Eddie, Inc. 57
Suggested Solutions to Case Questions 3. On the following pages are common-sized balance sheets and income statements for Crazy Eddie's for the period 1984-1987. Additionally, key financial ratios for the company's 1986 and 1987 fiscal years are presented.
Clearly, Crazy Eddie's inventory account should have been, and almost certainly was, a focal point of attention during the company‘s 1984-1987 audits. Inventory is nearly always the key asset of a retailer: no inventory, no sales . . . no company. In the case of Crazy Eddie's, the inventory account dominated the company's periodic balance sheets. Granted, at the end of fiscal 1987, inventory was only the second largest asset of the company but that was an anomaly due to the company investing proceeds from sales of stock and convertible debentures into short-term marketable securities. Notice that Crazy Eddie's inventory increased dramatically over this time period, from $23 million in 1984 to nearly $110 million in 1987. Also notice that the company's inventory turnover slowed considerably during 1987 resulting in the average age of inventory leaping from 80 days to more than 111 days. When the age of a company's inventory increases significantly, the risk of obsolescence and related valuation problems must be seriously considered by the firm's auditors. Another high-risk account for a retailer is typically accounts receivable. Notice that Crazy Eddie's accounts receivable turnover also slowed considerably during 1987, resulting in the age of receivables nearly doubling. Two other accounts that Crazy Eddie's auditors likely identified as being high-risk accounts were accounts payable and accrued expenses. Generally, auditors expect that changes in inventory and accounts payable will be correlated. The more inventory a company purchases, the higher its yearend accounts payable should be, as a general rule. Notice that although Crazy Eddie's inventory increased by nearly $50 million during fiscal 1987, accounts payable actually decreased over that same time span. [Of course, one factor contributing to inventory increasing more rapidly than accounts payable can be slowing sales of inventory.] Also suspicious is the fact that Crazy Eddie's year-end accrued expenses for 1987 were lower than at the end of the three previous fiscal years, although the company's assets increased by approximately 800% between 1984 and 1987. In summary, Crazy Eddie's 1984-1987 financial statements contain several red flags suggesting that certain key accounts demanded special attention by the firm's auditors. These red flags, when coupled with other factors, such as the company's tremendous growth rate in sales, demonstrate that the Crazy Eddie audits during this time frame likely posed a higher than normal level of overall audit risk.
58 Case 1.8 Crazy Eddie, Inc. Common-sized balance sheets for Crazy Eddie, 1984-1987:
Current assets Cash Short-term investments Receivables Merchandise inventories Prepaid expenses Total current assets
March 1, 1987
March 2, 1986
March 3, 1985
May 31, 1984
3.2 41.4 3.6 37.0 3.6 88.8
10.4 21.1 1.8 47.2 1.9 82.4
34.0 -4.2 40.5 1.0 79.7
3.8 -7.1 63.8 1.4 76.1
Restricted cash Due from affiliates Property, plant and equipment Construction in process Other assets Total assets
---
2.6 --
10.8 --
-15.7
9.0 -2.2 100.0
5.7 4.9 4.4 100.0
5.6 1.8 2.1 100.0
5.0 -3.2 100.0
Current liabilities Accounts payable Notes payable Short-term debt Unearned revenue Accrued expenses Total current liabilities
17.0 -16.8 1.2 1.9 36.9
40.7 -1.8 2.9 13.5 58.9
35.2 -.7 1.8 13.3 51.0
55.0 8.0 .3 2.1 16.6 82.0
2.9
6.1
11.6
.1
27.5 1.1
-1.5
-1.0
-.9
.1 19.5 12.0
.2 13.9 19.4
.2 18.8 17.4
.1 1.6 15.3
31.6
33.5
36.4
17.0
100.0
100.0
100.0
100.0
Long-term debt Convertible subordinated debentures Unearned revenue Stockholders' equity Common stock Additional paid-in capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity
Case 1.8 Crazy Eddie, Inc. 59 Common-sized income statements for Crazy Eddie, 1984-1987: Year Ended March 1, 1987
Year Ended March 2, 1986
100.0 77.2 22.8
100.0 74.1 25.9
100.0 75.9 24.1
100.0 77.9 22.1
17.4 2.1 1.5 6.0 .1 2.9 3.0
16.4 1.2 .3 10.4 .3 5.1 5.0
15.0 .9 .3 9.7 .4 5.0 4.3
16.4 .5 .4 5.8 -3.1 2.7
Net sales Cost of goods sold Gross profit Selling, general and admin. expense Interest and other income Interest expense Income before taxes Pension contribution Income taxes Net income
Nine Months Ended March 3, 1985
Year Ended May 31, 1984
Financial Ratios for Crazy Eddie: 1987
1986
Liquidity: Current ratio Quick ratio
2.41 1.40
1.40 .60
Solvency: Debt to assets Times interest earned Long-term debt to equity
.68 4.94 .96
.66 33.3 .18
3.22 111.8 days
4.50 80.0 days
53.9
105.2
6.7 days
3.4 days
22.8% 3.0% 5.4% 15.6%
25.9% 5.0% 11.1% 39.8%
Activity: Inventory turnover Age of inventory Accounts receivable turnover Age of accounts receivable Profitability: Gross margin Profit margin on sales Return on total assets Return on equity
60 Case 1.8 Crazy Eddie, Inc. 2.
a.
Falsification of inventory count sheets:
1)
Copy all inventory count or compilation sheets following completion of the physical inventory. If this procedure is not feasible because of the number of inventory count sheets, then the auditor may record the numerical sequence of the count sheets used during the physical inventory. To minimize the likelihood that the client will add additional items to partially full count sheets, auditors may draw a slash thorough the unused portion of each count sheet or deface the unused portion in some other fashion. To reduce the likelihood of clients' recording bogus inventory items, auditors must also determine that sufficient control has been established over inventory tags (on which inventory counts are typically recorded before being transferred to count or compilation sheets). Recording the numerical sequence of the tags used during the counting process is one of several relevant audit procedures in this context.
2)
b.
Recording of bogus debit memos for accounts payable:
1)
Mail accounts payable confirmations on selected accounts and follow up on all reported differences. Randomly select a sample of debit memos charged to accounts payable and investigate supporting documentation to determine whether the charges appear reasonable. Review subsequent payments of accounts payable to determine whether amounts deducted from year-end payable balances via client-prepared debit memos were later paid by the client.
2) 3)
c.
Recording transshipping transactions as retail sales:
1)
Review the documentation for large volume retail sales transactions, particularly those recorded near year-end, to determine that the sales are valid and properly recorded. For instance, match sales invoices with shipping documentation for these transactions. Review the client's procedures for recording wholesale transactions to ensure that proper controls exist for these transactions. Perform tests of controls to assess the operating effectiveness of these controls.
2)
d.
Inclusion of consigned merchandise in year-end inventory: When a client has merchandise in its retail outlets that is owned by third parties, the client should have a procedure to ensure that the consigned merchandise is not included in the year-end inventory. Crazy Eddie‘s auditors should have reviewed this procedure, assuming that it existed, and taken steps to determine whether it was implemented properly by client personnel. For example, the auditors could have reviewed inventory count sheets to determine whether consigned merchandise had been included on those sheets.
Case 1.8 Crazy Eddie, Inc. 61 3. AU Section 311, ―Planning and Supervision,‖ notes that auditors should obtain ―an understanding of the entity and its environment‖ (311.02). Clearly, an audit client‘s ―environment‖ includes its industry and major changes that industry is undergoing. The overall health of a client's industry has important implications for the financial health of that company. Likewise, the changes that an industry is undergoing have implications for the future of each company within that industry. For these reasons, auditors must be cognizant of, and explicitly consider, industry-related factors in planning audits. By the late 1980s, the retail consumer electronics industry was experiencing problems, including slackening demand for its products and intense competition among companies within the industry. Both of these factors had immediate and important implications for the financial health of Crazy Eddie. From an auditing standpoint, these factors increased the likelihood that client management might attempt to "window dress" the company's financial statements to downplay the negative effect the industry's problems were having on the firm's operating results. Likewise, the auditors should have realized that the changes the industry was undergoing would gradually diminish Crazy Eddie's ability to extract "sweetheart" deals from its suppliers and to supplement its retail sales with wholesale transactions to its competitors. Collectively, these and other related factors had pervasive implications for the financial health of Crazy Eddie and should have been considered by the auditors during the planning phase of each Crazy Eddie audit. 4. Lowballing" refers to a method used by accounting firms to obtain audit clients, principally in a competitive bidding process. When an audit firm lowballs, it offers to provide an independent audit to a prospective client at an annual fee that is considerably below what other audit firms would charge to provide that audit. In many cases, audit firms that lowball to obtain an audit client hope to sell consulting services or other professional services to that client to compensate for the minimal revenue earned by providing the audit. However, if the audit firm issues other than an unqualified opinion on the client's financial statements, it faces some risk of being dismissed by the client. If the audit firm is dismissed, it will almost certainly be unable to sell other professional services to the former audit client. Net result: the audit firm's strategy of compensating for lost revenue on the audit engagements with revenue from the provision of other professional services doesn't "pan out." So, an audit firm that lowballs to obtain an audit client may be very reluctant to issue other than an unqualified opinion on the client's financial statements out of fear of losing the client. 5. Different auditors would respond in different ways to this scenario. Probably the most common response, and many would argue the most appropriate, would be to significantly expand the year-end substantive tests applied to the client's inventory account. For example, the cutoff test, itself, would likely be expanded significantly. The most troubling feature of such a scenario is the possibility that the client is not providing the requested documentation because it wants to conceal the fact that the year-end inventory cutoff was intentionally or unintentionally "messed up." That is, the client did not record inventory sales and purchase transactions occurring near year-end in the proper fiscal year. 6. This is an important issue that the accounting profession has debated extensively in recent years. Many critics of the profession have suggested that the integrity of an independent audit is undermined when companies hire their former auditors. Why? Because a former auditor, at least
62 Case 1.9 ZZZZ Best Company, Inc. theoretically, could help his or her new employer subvert the purpose of the independent audit. Likewise, the quality of audit services in such situations may be adversely affected because of the personal relationships between the former auditor and his or her former colleagues within the given audit firm. For example, on subsequent audits, the auditors may place too much trust in their former colleague and thus overlook or discount potential problems in the client's financial statements. As a point of information, Section 206 of the Sarbanes-Oxley Act of 2002 prohibits an accounting firm from providing ―audit services‖ to a company that has recently hired an employee of the firm to serve in certain key positions. ―It shall be unlawful for a registered public accounting firm to perform for an issuer any audit service . . . if a chief executive officer, controller, chief financial officer, chief accounting officer, or any person serving in an equivalent position for the issuer, was employed by that registered independent public accounting firm and participated in any capacity in the audit of that issuer during the 1-year period preceding the date of the initiation of the audit.‖
CASE 1.9
ZZZZ BEST COMPANY, INC.
Case 1.9 ZZZZ Best Company, Inc.
63
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 the communications between ZZZZ Best's predecessor and successor auditors following both changes in auditors made by the company. 63 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 sixteen 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.
64 Case 1.9 ZZZZ Best Company, Inc.
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 fraud 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.
3.
To emphasize the hazards of allowing a client to impose significant constraints on the scope of
Case 1.9 ZZZZ Best Company, Inc.
65
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 audit and 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.
Suggested Solutions to Case Questions
66 Case 1.9 ZZZZ Best Company, Inc. 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, vouching and tracing of transactions, 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 the existence of the restoration contracts 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 any written confirmations from certain parties 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 other 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 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.
Case 1.9 ZZZZ Best Company, Inc.
67
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 or existence of the related 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 integrated into AU Section 315.) Under SAS No. 84, ―Communications between Predecessor and Successor Auditors,‖ 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. According to SAS 84, the prospective successor auditor is responsible for initiating predecessor-successor auditor communications. SAS 84 indicates that 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 the SAS 84 inquiries. SAS 84 identifies four 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 [Note: SAS 7 did not require successor auditors to request information regarding this item], and 4) the predecessor auditor‘s understanding as to the reasons for the change in auditors. SAS 84 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. 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
68 Case 1.9 ZZZZ Best Company, Inc. 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 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
Case 1.9 ZZZZ Best Company, Inc.
69
information. In addition, the client may insist that only partners or managers assigned to the audit be provided that information. When constraints of any type imposed by a client prevent auditors from complying, in material respects, with one or more of the generally accepted auditing standards, a scope limitation has occurred. Most often, the standard affected in such cases is the third standard of fieldwork that requires the auditor 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 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.
CASE 1.10
UNITED STATES SURGICAL CORPORATION
Synopsis In less than two decades, Leon Hirsch transformed a small company with four employees and one product into a large and very profitable publicly owned firm that dominated the relatively small, but important, surgical stapling industry. In fact, Hirsch's company, United States Surgical Corporation (USSC), literally created the surgical stapling industry in the 1960s. Like many small companies that experience explosive growth, USSC eventually became a captive of its own success. Faced with the need to maintain the company's rapid growth rates in sales and profits to continue attracting capital from outside investors and creditors, Hirsch and his associates began using several creative accounting techniques to window dress USSC's financial statements. In 1985, the Securities and Exchange Commission (SEC), after a lengthy investigation, concluded that USSC management had deliberately and materially overstated the profits of the company for the period 1979-1982. USSC was ordered to revise and reissue its financial statements for those years, resulting in a $26 million
70 Case 1.10 United States Surgical Corporation reduction in its previously reported earnings. Additionally, Hirsch and other USSC executives were forced to repay large bonuses they had earned on the overstated profits. Ernst & Whinney, USSC's independent audit firm during the late 1970s and early 1980s, was criticized by the SEC for failing to discover the various methods used to manipulate the company's reported operating results. Among these schemes were recording shipments of product to sales employees as consummated sales transactions, improperly capitalizing litigation expenses in a patent account, and retaining the cost of retired assets in the company's financial records. The principal focus of the SEC investigation and its subsequent enforcement release for the USSC case, however, was a complex scheme the company's executives devised to capitalize certain production costs. The SEC charged that Ernst & Whinney personnel had sufficient opportunity to uncover this scheme but, nevertheless, failed to do so.
70
United States Surgical Corporation--Key Facts 1. USSC‘s management was growth-oriented and dominated by an aggressive chief executive. 2. USSC's dominance in the surgical stapling industry was being challenged in the early 1980s by several competitors. 3. In the early 1980s, USSC needed to raise additional capital to fend off the challenges of its competitors and to finance its expansion plans for the future. 4. USSC had an incentive compensation scheme for its key executives that was tied to reported earnings. 5. Between 1980 and 1981, there were significant changes, both on an absolute and relative basis, in the year-end balances of several of USSC's key accounts. 6. Ernst & Whinney apparently failed to obtain and review a copy of the standard employment contract signed by USSC's sales employees, which would have provided important evidence regarding the validity of "sales" made by the company to those employees. 7. USSC improperly accounted for a large amount of production expenses by treating them as ―tooling modification‖ expenditures and capitalizing them in a long-term asset account. 8. Several of USSC's vendors were involved in the fraudulent deferred tooling expenditures
Case 1.10 United States Surgical Corporation 71 scheme. 9. Much of the evidence collected by Ernst & Whinney to support the validity of the questionable deferred tooling costs failed to support the client's position regarding those costs. 10. Although the SEC found that USSC officials had lied repeatedly to the audit engagement partner, the federal agency sanctioned that partner and maintained that he and his subordinates should have discovered USSC‘s fraudulent financial statement misrepresentations.
Instructional Objectives 1. To illustrate that auditor-client disputes can have serious implications for the quality of an audit if not "managed" properly by auditors. 2. To demonstrate the need for auditors to employ analytical procedures during the planning phase of an audit to identify high-risk account balances. 3. To demonstrate the need for auditors to identify contextual variables that influence the level of inherent risk for a given engagement, such as, the existence of a bonus plan for client management tied to reported earnings. 4. To illustrate the confidentiality problems that may arise during an audit engagement when a client has significant business dealings with another client of the audit firm. 5. To illustrate the need for auditors to weigh carefully conflicting evidence collected during an engagement before rendering a decision regarding the material accuracy of the account balance in question. 6. To confirm the need for auditors to investigate thoroughly all potential material misrepresentations discovered during the course of an audit.
Suggestions for Use
72 Case 1.10 United States Surgical Corporation
One of the questions appended to this case requires students to make extensive use of analytical procedures to identify the high-risk financial statement line items for the USSC audits during the early 1980s. Consequently, this case could be integrated into classroom coverage of analytical procedures, particularly the discussion of how such procedures are used during the planning phase of an audit. The case could also be assigned during coverage of the audit risk model since the assessment of inherent risk is an important topic in the case. Finally, since much of the case deals with accounting and auditing issues related to fixed assets, the USSC case could be assigned during coverage of the substantive tests appropriate for various fixed asset accounts. One point I like to stress in this case is that the SEC let USSC and its executives "off the hook" to a certain extent. Despite USSC‘s abusive accounting methods, the company and its executives received relatively light penalties. "Wrist-slap" penalties in such circumstances likely fail to discourage malfeasant behavior in the future on the part of other corporate executives. I raise this point because I believe auditing students should be aware of the need for strong and effective leadership from the SEC in the regulation of financial reporting practices. Another important point to stress during the discussion of this case is the fact that financial frauds involving collusion between a client and an external third party or parties are much more difficult for auditors to discover. For instance, in defense of Ernst & Whinney, the involvement of USSC's vendors in the deferred tooling expenses scam was likely a key factor that prevented the audit firm from discovering that USSC management was manipulating that financial statement item. Finally, this case provides a detailed chronological summary of a lengthy auditor-client dispute. Such technical disputes are typically not discussed at length in auditing textbooks even though they occur commonly during audits and have serious implications for the quality of audits. By studying the chronology of the USSC-Ernst & Whinney dispute (regarding deferred tooling expenses), students should obtain important insights on how auditors' objectivity can be slowly eroded by a persistent client. Suggested Solutions to Case Questions 1. Prior to performing year-end substantive tests on such an account, an auditor should first assess the level of control risk for that account. The two primary considerations in this respect are design effectiveness and operating effectiveness. Regarding the former, the auditor is concerned with whether the controls for a given account are adequately designed to minimize the likelihood of material errors affecting the account balance. When considering operating effectiveness, the auditor attempts to determine whether the controls that have been established by the client are actually operating as intended. In this case, the auditors should have (and possibly did) identify the controls that USSC had established to ensure that the cost of retired Leased and Loaned Assets was removed from the subsidiary ledger. For example, the client should have had a procedure for authorizing the retirement of such assets, a related procedure to ensure that retired assets were disposed of properly (by sale or otherwise), and a control policy or procedure to ensure that retirement transactions triggered the proper accounting entries. The auditors in this case should have reviewed these procedures to determine that they were appropriate in the circumstances and then considered performing tests of controls on a sample of retirement transactions to determine that the controls
Case 1.10 United States Surgical Corporation 73 were operating as intended. Quite often, auditors will employ year-end substantive tests almost exclusively to corroborate the key management assertions underlying asset accounts similar to the Leased and Loaned Assets account of USSC. This strategy is generally very cost-effective given the limited number of transactions recorded in such accounts on an annual basis. There are two options available to auditors if a strict substantive testing strategy is adopted in this context. An auditor may prepare a "roll-forward" schedule for the given asset account that documents the account's beginning balance, all additions and deletions to the account during the year, and the general ledger ending balance. Assuming the beginning balance was audited sufficiently during the prior year, the auditor focuses on collecting evidence to support the activity (additions and deletions) in the account for the year. The second option would be to apply extensive test of balances audit procedures to confirm the material accuracy of the year-end account balance. Typically, this latter option would be selected when the prior year's financial statements were audited by another audit firm or not audited at all. Regardless of which of these two strategies is selected, an auditor would generally apply some or all of the following procedures to identify retirements of assets made during the year: 1. Ask client management about asset retirements occurring during the year. 2. Scan the miscellaneous revenue accounts to identify proceeds from the disposition of retired assets. 3. Obtain and review asset retirement work orders. 4. Obtain and review insurance policies for changes (reductions) in coverage. 5. Identify discontinued facilities and product lines. Following the completion of the above procedures, the auditor should determine that the retirements he/she identified were properly reflected in the client's accounting records. In the USSC case, a specific procedure that might have resulted in the discovery of the overstatement of the Leased and Loaned Assets account balance would have been scanning the subsidiary ledger and comparing the recorded cost of specific assets in the prior year with their recorded cost for the current year. 2. As a point of information, the FASB recently adopted a new standard to replace APB No. 20, Accounting Changes, that was in effect when the events in this case transpired. This new standard, ―Accounting Changes and Error Corrections‖ (Statement on Financial Accounting Standards No. 154) also addresses changes in accounting estimates, which is the subject of this question. The suggested solution to this question assumes that the new accounting standard for accounting changes was in effect during the relevant timeframe of this case. Changes in the estimated useful lives and salvage values of depreciable assets are permissible but only when these changes are justified by the circumstances, such as, when several years after the acquisition of an asset it becomes apparent that the original useful life of that asset was significantly underestimated. Such changes are to be treated as changes in estimates and adopted prospectively with no adjustments to the beginning asset balances. Following is a relevant excerpt from SFAS No. 154 that addresses financial statement disclosure issues for changes in accounting estimates, such as those mentioned in this question. ―When an entity makes a change in estimate that affects several future periods (such as a change
74 Case 1.10 United States Surgical Corporation in service lives of depreciable assets), it shall disclose the effect on income before extraordinary items, net income, and related per-share amounts of the current period. Disclosure of the effect on those income statement amounts is not necessary for estimates made each period in the ordinary course of accounting for items such as uncollectible accounts or inventory obsolescence; however disclosure is required if the effect of a change in estimate is material.‖ If the changes in the salvage values and estimated useful lives of the given assets had a material effect on USSC's financial statements and were justified, then, as just noted in the above excerpt, the footnotes to the financial statements should have disclosed the changes and their effect on income before extraordinary items, net income, and the related earnings per share amounts (this would be the case under both the ―old‖ and ―new‖ rules for accounting changes). In fact, these disclosures were made in the footnotes to USSC's 1981 financial statements although the SEC did not believe the changes were justified because many of those changes were made "arbitrarily." Since the changes were not appropriate, USSC management technically should have disclosed in the financial statement footnotes that the changes were not justified and then explained the resulting effect on the fairness of the financial statements. Assuming the changes were justified (and that the audit reporting rules established by SAS No. 58, "Reports on Audited Financial Statements," were in effect at the time), USSC's auditors should have issued an unqualified opinion. It would not have been necessary for the auditors to include an explanatory paragraph in their report addressing these changes. (See AU 420.15.) If the changes were not justified, they should have qualified their audit report due to a departure from GAAP. 3. Common-sized balance sheets for USSC. Current Assets: Cash Receivables (net) Inventories Finished Goods Work in Process Raw Materials Other Current Assets Total Current Assets Property, Plant, and Equipment: Land Buildings Molds and Dies Machinery and Equipment Allowance for Depreciation Other Assets Total Assets Current Liabilities: Accounts Payable
1981
1980
1979
.2 17.7
1.0 25.6
.9 32.0
14.1 2.5 10.1 3.8 48.4
8.3 2.2 15.8 1.3 54.2
8.0 1.6 10.4 2.6 55.5
1.2 15.6 15.5 19.4 51.7 (7.2) 44.5 7.1 100.0
2.0 15.6 13.4 20.0 51.0 (8.4) 42.6 3.2 100.0
1.5 18.5 12.5 17.5 50.0 (9.0) 41.0 3.5 100.0
5.9
5.8
8.9
Case 1.10 United States Surgical Corporation 75 Notes Payable Accrued Expenses Income Taxes Payable Current Portion--LTD Total Current Liabilities
2.7
2.3 7.3
.4 9.0
4.3 1.4 .6 12.1
.6 19.1
Long-term Debt Deferred Income Taxes
38.9 3.6
39.9 2.5
47.5 2.0
Stockholders’ Equity: Common Stock Additional Paid-in Capital Retained Earnings Translation Allowance Deferred Compensation Total Liab. and St. Eq.
.5 35.0 15.8 (.5) (2.3) 100.0
.8 29.3 17.6
.5 15.2 18.7
(2.2) 100.0
(3.0) 100.0
1981 100.0
1980 100.0
1979 100.0
42.9 40.3 5.3 11.5
37.4 43.8 4.7 14.1
42.1 39.3 5.6 13.0
.7 .3 10.5
4.0 1.0 9.1
3.7 .8 8.5
Common-sized income statements for USSC. Net Sales Costs and Expenses: Cost of Products Sold SG&A Interest Income Before Income Taxes Income Taxes: Federal and Foreign State and Local Net Income Financial Ratios for USSC. 1981
1980
Liquidity: Current Quick
5.37 2.41
4.48 2.31
Solvency: Debt to Assets Times Interest Earned Long-term Debt to Equity
.52 3.19 .80
.55 3.98 .88
76 Case 1.10 United States Surgical Corporation Activity: Inventory Turnover Age of Inventory Accounts Receivable Turnover Age of Accounts Receivable Total Asset Turnover
1.11 324 days 3.33 108 days .54
1.42 253 days 3.25 111 days .72
Profitability: Gross Margin Profit Margin on Sales Return on Total Assets Return on Equity
57.1% 10.5% 8.5% 15.2%
62.5% 9.1% 10.0% 20.6%
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 / 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: total gross margin / 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: The above data suggest that the inventory accounts were the highest risk accounts during the 1981 audit. In particular, the Finished Goods Inventory account nearly doubled as a percentage of total assets from 1980 to 1981. This increase caused USSC's inventory turnover ratio to decline significantly and the average age of the inventory to rise dramatically. These changes suggest that inventory obsolescence may have been (or should have been) a primary concern during the 1981 audit. Another area of concern during the 1981 audit should have been the Molds and Dies account. Although that account balance, as a proportion of total assets, did not increase significantly between 1980 and 1981, it more than doubled in absolute terms during that twelve-month period. Additionally, the accounting decisions made for this account were fairly complex in nature and apparently required the exercise of a significant degree of subjective judgment on the part of USSC's accountants. In sum, the size and sensitive nature of the Molds and Dies account should have caused the auditors to allocate a disproportionately large amount of audit effort to that account during the 1981 audit. Other accounts that should have been the focus of fairly intense scrutiny by Ernst & Whinney
Case 1.10 United States Surgical Corporation 77 during the 1981 USSC audit included Other Current Assets, Income Taxes, and Accrued Expenses. Although less than 4% of total assets, the balance of Other Current Assets more than quadrupled between 1980 and 1981. (Of course, a significant portion of this increase was due to the litigation expenses that USSC improperly deferred.) Regarding Income Taxes, the auditors should have obtained a reasonable explanation for the significant drop in the income tax expense amounts for 1981 versus the comparable amounts for the prior two years. Finally, Accrued Expenses is typically a high risk account given the ease with which it can be manipulated. The balance of that account was fairly stable between 1979 and 1981 even though USSC was growing rapidly during that time frame. As a percentage of total assets, Accrued Expenses decreased more than 60% from the end of 1979 to the end of 1981. This unusual trend should have caused the auditors to expand their year-end substantive tests for this account. For instance, a more extensive search for unrecorded liabilities was likely justified during the 1981 audit. 4. The following factors or variables tend to cause a power imbalance in favor of the client in the auditor-client relationship. a. b. c.
The retention and compensation of auditors by their clients. The purchase of consulting and tax services by clients from their auditors. The ability of a client to affect negatively the reputation of its auditor in the local business community and thereby damage the ability of the auditor to attract other clients.
d. e.
The reliance of the auditor on the client's assistance and cooperation to complete the audit. The subjective nature of technical standards that provides an incentive for client executives to encourage the auditor to interpret subjective issues to the benefit of the client.
Among the measures that the profession could take to mitigate the imbalance of power in the audit context are the following. a.
b.
Decrease management's power to easily dismiss its auditor. Toward this end, the profession adopted SAS No. 50, "Reports on the Application of Accounting Principles," which imposes significant responsibilities on prospective replacement auditors when a client is engaging in apparent "opinion shopping" behavior. [Note: The provisions of SAS 50 were strengthened by SAS No. 97, ―Amendment to Statement on Auditing Standards No. 50, Reports on the Application of Accounting Principles.‖ SAS 50 and SAS 97 are integrated into AU Section 625.] Likewise, the SEC's 8-K disclosure rules, which require public firms to disclose auditor changes and important circumstances surrounding auditor changes, are designed to discourage firms from dismissing their auditors for illicit reasons. Limit the ability of clients to interfere in predecessor-successor auditor communications. Under the current professional standards and ethical rules, clients can prevent a successor auditor or prospective successor auditor from communicating with the predecessor auditor (see, SAS No. 84, "Communications Between Predecessor and Successor Auditors"). As a result, the successor auditor may be deprived of important information regarding the circumstances surrounding the auditor change, management integrity, and technical disputes preceding the auditor change.
78 Case 1.10 United States Surgical Corporation c.
Impose limitations on the amount and type of consulting services that auditors can provide to their audit clients. Granted, this measure is not one that would likely be supported by audit practitioners. However, a limitation on the provision of non-audit services to audit clients would decrease the economic leverage that client management would have on external auditors. Of course, the Sarbanes-Oxley Act of 2002 expressly prohibits audit firms from providing certain types of non-audit services to audit clients that are SEC registrants. These services include: 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
d.
e.
5. a.
1)
Encourage promulgatory authorities to adopt objective accounting and auditing standards. More objective technical standards should diminish, but certainly not eliminate, the likelihood that client managers will attempt to influence the important decisions made by auditors during an engagement. For example, establishing explicit, quantitative materiality standards would eliminate, to a degree, the subjectivity of many audit decisions. With explicit materiality standards, client managers would essentially be asking auditors to "break the rules" rather than "bend" them when they apply pressure on auditors to resolve materiality disputes in favor of the client. No doubt, many members of the profession would find such explicit standards objectionable on the grounds that they would diminish the need for the exercise of professional judgment in auditing and thus negatively affect the professional status of independent auditors. Create an independent audit agency. A more extreme alternative would be to radically change the nature of the independent audit function by establishing a federal audit agency to assume responsibility for the performance of independent audits. Evidence supporting the position that the disputed costs were for tooling modifications:
USSC executives' representations that the costs were for tooling modifications (including their explanations as to why these tooling costs were charged out on a per-unit basis) 2) More's eventual verbal support for the accuracy of the representations made by the USSC executives (which was provided in the presence of one of these executives) 3) The signed confirmation from More indicating that the disputed costs were for tooling modifications 4) The explanation by More that tooling costs were sometimes inadvertently reported as inventory production costs by production personnel
Case 1.10 United States Surgical Corporation 79 5)
Barden's invoices that described the costs as being for tooling modifications
b.
Evidence supporting the position that the disputed costs were generic production expenses:
1)
Yamont's original concern, expressed in his unsolicited phone call to Ernst & Whinney, that the disputed costs were not for tooling modifications The results of the Ernst & Whinney investigation that suggested the disputed costs were not for tooling modifications The results of the independent investigation by Barden's legal counsel that indicated the disputed costs were production expenses The refusal of Yamont to sign a confirmation letter indicating that the disputed costs were for tooling modifications More's original statement, made in the absence of USSC executives, that the disputed costs were production expenses The fact that the disputed costs were charged on a per-unit basis (which suggested that they were production expenses)
2) 3) 4) 5) 6)
The third standard of fieldwork requires an auditor to obtain sufficient appropriate evidence to support his/her 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. Regarding ―appropriateness‖, the professional standards suggest that audit evidence possesses this trait when it is both reliable and relevant. A key consideration 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. Regarding relevance, audit evidence is relevant if it pertains to the management assertion that the auditor is attempting to corroborate. A comparison of the evidence collected to support the assertion that the disputed costs were for tooling modifications versus the evidence collected to support the assertion that the costs were production expenses suggests that the latter evidence was more reliable. That is, the evidence supporting the production expense argument was provided by more objective sources (Ernst & Whinney auditors, Barden's legal counsel, and Barden officials). The evidence supporting the argument that the costs were for tooling modifications was provided either by USSC officials or by parties subject to the influence of USSC officials. A perfect example is the evidence provided by More. Initially, More indicated that the costs were for production work but changed his opinion later when he was in the presence of USSC executives. In sum, given the information provided in the SEC enforcement release, Hope's decision to accept his client's explanation that the disputed costs were for tooling modifications seems somewhat questionable. 6. The facts yielded by the SEC investigation suggest that Hope should have performed a more intensive review of the alleged tooling modification costs charged to USSC by vendors other than Barden Corporation. For instance, Hope probably should not have allowed client management to select the additional vendors to be included in this review. Regarding the additional tooling modification charges he discovered after inquiring of USSC management, he should have considered
80 Case 1.10 United States Surgical Corporation corresponding with these vendors and asking them to describe these charges in detail. His comment in the audit workpapers regarding the "incomplete" nature of the explanations he received for those additional tooling modification charges seems to have left an important issue in the audit unresolved. Also troubling is his conclusion that the amounts involved were immaterial. Granted, the actual amounts he observed on the invoices that he was allowed to review may have been immaterial, but these amounts, if investigated further, may have resulted in his discovering USSC's systematic and large-scale scheme to misrepresent certain inventoriable production costs. AU Section 317, ―Illegal Acts by Clients‖ defines auditors‘ responsibility to detect illegal acts. That section of the professional auditing standards 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. [Note: When the relevant events occurred in this case, the AU 317 requirements described here were not in effect. But, again, for the benefit of students, I ask them to assume that the existing ―illegal act‖ rules were in effect at the time.] Auditors generally have much less responsibility to detect illegal acts that may have a material indirect effect on a client‘s financial statements. AU Section 317.06 succinctly observes that an auditor ―ordinarily does not have sufficient basis for recognizing‖ such violations by clients. Later this section 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 occurred.‖ In the USSC case, the client‘s scheme to misrepresent certain production expenses likely had a direct and material effect on the firm's financial statements. AU 317.05 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 Section 110.‖ In turn, AU Section 110.02 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.‖ If such an illegal act is discovered, the auditor must inform the client's audit committee or the equivalent oversight body and must ask the client to adjust the financial statements and/or disclose the act in the footnotes. If the client refuses to accept the auditor's recommendation, the auditor must qualify the audit report (or issue an adverse opinion depending upon the materiality of the illegal act‘s impact on the client‘s financial statements). AU 317 also suggests that in some circumstances an auditor may need to consider withdrawing from an engagement when client management refuses to cooperate with the auditor‘s recommended course of action. [Note: As discussed in footnote 3 of AU Section 317, auditors may be required to disclose illegal acts by clients to the Securities and Exchange Commission pursuant to the Private Securities Litigation Reform Act of 1995.] Following are specific audit procedures, among others, that AU 317 suggests auditors should consider applying when they suspect that an illegal act may have a material and direct effect on a client‘s financial statements. a.
obtain an understanding of the illegal act or potential illegal act and the circumstances under which it occurred
Case 1.10 United States Surgical Corporation 81 b. c.
discuss the situation with management at a level of responsibility above that at which the act apparently occurred consult with the client's legal counsel regarding the act and its implications for the client and its financial statements
AU 317 suggests that additional audit procedures may be necessary to provide more detailed evidence regarding the illegal act. These additional procedures may include obtaining copies of all pertinent documents related to the illegal act, confirming significant information regarding the act with third parties, and performing tests to determine whether similar transactions have occurred that have not yet been identified. Eventually, an auditor will have to evaluate the potential impact of the illegal act on the client‘s financial statements and his or her audit report as well as make sure that the client‘s audit committee is aware of the given item. 7. The AICPA‘s Code of Professional Conduct does not allow, with the exception of four very specific situations, the disclosure of confidential client information unless the client consents. Certainly, strong arguments can be made that the sharing of information between two audit teams assigned to clients that have significant business dealings with each other would increase the likelihood that the appropriate audit conclusions would be reached on each engagement. However, allowing this free flow of information, even if it is restricted to situations involving audit teams from the same CPA firm, might have a detrimental effect in the long run on the quality of independent audits. If clients knew that their auditors would be sharing information with other audit teams, they might be less candid with their auditors. This would be particularly true for highly sensitive issues such as product cost information, pending litigation claims, and research and development expenditures. If information regarding such sensitive items was inadvertently passed to a company with which a given audit client had significant business dealings, the latter could be irreparably harmed.
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
82 Case 1.12 New Century Financial Corporation 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. To date, the ongoing worldwide financial crisis has resulted in trillions of dollars of losses and has 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 subprime mortgage lending. 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.
8 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
Case 1.12 New Century Financial Corporation 83 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 have insisted that their firm properly audited New Century and that the bankruptcy examiner‘s report was unfair and ―one-sided.‖ 10. Other parties have also come to the defense of KPMG, including an accounting professor who has 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 in recent years. 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 infrastructure. . Instructional Objectives 1. To illustrate the critical importance of independent auditing to the proper functioning of a free market economy. 2. To examine the importance of proper staffing of an audit engagement team. 3. To demonstrate how auditors‘ perceived independence can be impaired when significant auditorclient conflicts arise. 4. To examine key responsibilities of independent auditors under Section 404 of the SarbanesOxley Act. 5. To identify the general principles auditors should employ when auditing important ―accounting estimates‖ of a client.
84 Case 1.12 New Century Financial Corporation
Suggestions for Use This is a very timely case given the current economic environment. The 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 that client. Since this case is still unfolding, consider asking a group of your students to research recent developments involving the case and to report their findings to the rest of the class. 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 2007 by PCAOB AS No. 5. 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. If you believe it is appropriate, you might expand this assignment and require the given students to provide a summary overview of Section 404 of the Sarbanes-Oxley Act. 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 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 AICPA‘s quality control standards provide broad guidelines and recommendations that accounting firms can use to ensure that the professional services they provide are competent. In fact, QC 20.02 mandates that a CPA firm ―have a system of quality controls for its accounting and auditing practice.‖ QC 20.07 identifies the following five elements that an accounting firm‘s quality
Case 2.1 Jack Greenberg, Inc. 85 control system should address: Independence, Integrity, and Objectivity; Personnel Management; Acceptance and Continuance of Clients and Engagements; Engagement Performance; and Monitoring. The quality control element of ―Engagement Performance‖ is discussed at QC 20.17-19. These latter 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:‖ ―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)‖—emphasis added. 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. Unfortunately, those ―FDR‖ specialists did not complete their assigned procedures. 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. 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 took 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. The title of AS No. 5 is, ―An Audit of Internal Control Over Financial Reporting That is Integrated With an Audit of Financial Statements.‖ [Sidebars: 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. 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,
86 Case 2.1 Jack Greenberg, Inc. ―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 No. 5. [As a point of information, the following definitions from AS No. 5 are consistent with the comparable definitions included in SAS No. 115, ―Communicating Internal Control Related Matters Identified in an Audit‖ and SASE No. 15, ―An Examination of an Entity‘s Internal Control Over Financial Reporting That Is Integrated With an Audit of Its Financial Statements.‖ These latter standards were adopted by the Auditing Standards Board to parallel the requirements of AS No. 5.] 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.‖ Paragraph 3 of AS No. 5 notes that ―The auditor‘s objective in an audit of internal control over financial reporting is to express an opinion on the effectiveness of the company‘s internal control over financial reporting‖ This paragraph goes on to indicate that ―a company‘s internal control cannot be considered effective if one or more material weaknesses exist.‖ As a result of this latter premise, ―the auditor must plan and perform the audit to obtain reasonable assurance about whether material weaknesses exist as of the date specified in management‘s assessment [of internal control].‖ 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 No. 5 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 controls over financial reporting. Paragraph No. 62 of AS No. 5 indicates expressly that ―the auditor is not required to search for deficiencies that, individually or in combination, are less severe than a material weakness.‖ Paragraphs 78-84 of AS No. 5 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
Case 2.1 Jack Greenberg, Inc. 87 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 auditors 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. AU Section 342, ―Auditing Accounting Estimates,‖ is the authoritative source most relevant to this question. Paragraph .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].‖ Paragraph .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 audit evidence to provide reasonable assurance that— a. All accounting estimates that could be material to the financial statements have been developed. b. Those accounting estimates are reasonable in the circumstances. c. The accounting estimates are presented in conformity with applicable accounting principles and are properly disclosed.‖ The remaining two sections of AU 342 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 specific procedures that AU 342 recommends that 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 reasonable of management‘s estimate.‖ --―Identify whether there are controls over the preparation of accounting estimates and supporting data that may be useful in the evaluation.‖ --―Evaluate whether the [underlying] assumptions are consistent with each other, the supporting data, relevant historical data, and industry data.‖ --―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.‖
88 Case 2.1 Jack Greenberg, Inc. --―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. 5. The most effective way to address this question is to simply ―walk through‖ the ten generally accepted auditing standards (GAAS) and identify possible violations of each by KPMG. General Standards: 1. Technical training and proficiency in auditing: Certainly, the bankruptcy examiner‘s report raised legitimate concerns regarding the issue of whether the 2005 New Century audit engagement team was properly staffed. As noted in the case, even New Century management questioned the appointment of Donovan as the new audit engagement partner given his lack of familiarity with the mortgage industry. Likewise, the appointment of Debbie Biddle to oversee the 2005 SOX internal 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. 2. Maintaining an independent mental attitude: 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. 3. Exercising due professional care: This standard is a ―catch-all‖ professional standard. If it is proven that an auditor violated one of the other nine GAAS, then it would be easy to maintain that this standard was violated as well. Field Work Standards: 1. Adequate planning and proper supervision of subordinates: The bankruptcy examiner pointed out that the 2005 audit team apparently did not properly review the prior year workpapers, at least with regard to the internal control deficiencies discovered by the 2004 audit team. AS No. 5 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.‖ [Paragraph 57] Although AS No. 5 was not in effect during the 2005 New Century audit, this general audit planning principle would still have applied to that audit. If this general principle was not invoked by the subordinate
Case 2.1 Jack Greenberg, Inc. 89 members of the 2005 audit team, then certainly one could argue as well that those individuals were not properly supervised by their superiors. 2. Obtaining a sufficient understanding of the entity, its environment, and its internal control: The most serious allegations made by the bankruptcy examiner against KPMG involve this field work standard and the next. In retrospect, it does not seem that KPMG fully considered the impact that rapid and dramatic changes in the housing market were having on New Century‘s business model. Likewise, the severity of the internal control problems evident in New Century‘s accounting system may not have been fully understood by the KPMG auditors. In particular, KPMG‘s decision that the internal control problems related to the loan repurchase loss reserve were ―inconsequential‖ seems extremely curious in retrospect. 3. Obtaining sufficient appropriate 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. Reporting: 1. Presentation in accordance with GAAP: KPMG stated in its 2005 audit report that New Century complied with GAAP. Certainly, a reasonable argument can be made that the 2005 year-end balance of the loan repurchase loss reserve may not have been determined in compliance with GAAP. The absence of an adequate system to track loan repurchase requests and the failure of New Century to consider the ―interest recapture‖ issue in the reserve computation cast doubt on the integrity of that account balance. It is important to point out to your students that the improper accounting change made for the loan repurchase loss reserve did not affect the 2005 balance of that account or prior year balances of the account. That improper accounting change only impacted the reserve balance at the end of each of the first three quarterly reporting periods for 2006. Of course, KPMG only ―reviewed‖ the financial statements for those three periods. 2. Consistent application of GAAP: Again, this standard is most directly relevant to the accounting change made in early 2006 for the loan repurchase loss reserve. Since this issue did not affect the pre-2006 audit reports, KPMG was not responsible for commenting on that consistency violation in those audit reports. 3. Assessment of adequacy of disclosure: One could certainly argue that New Century‘s financial statements did not properly disclose the potential impact that rapidly changing conditions in the housing market were having on the material accuracy of the loan loss repurchase reserve and related account balances. 4. Expression of an opinion: Was KPMG‘s 2005 audit opinion the most appropriate opinion? Again, that is an issue that may well be debated for years to come. 6. You can find a slag pile of articles in recent years that have debated the role that mark-to-market accounting has played in the serious financial crisis that engulfed the national and global economies in late 2008. The principal technical standard relevant to mark-to-market accounting is Statement of Financial Accounting Standard No. 157, ―Fair Value Measurement.‖ That standard defines ―fair
90 Case 2.1 Jack Greenberg, Inc. 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.‖ 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 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, ―FAS 157 Is Worse than Al Qaeda.‖ Prominent members of the accounting profession forcefully defended the mark-to-market rule and insisted that critics of the rule had adopted a ―kill-the-messenger‖ attitude. Among the most vocal defenders of the rule were former SEC Chairman Arthur Levitt and former SEC Chief Accountant Lynn Turner who addressed the need to retain the rule in an editorial appearing in the Wall Street Journal (September 26, 2008). Ultimately, those who blame fair-value accounting for the current crisis are guilty of the financial equivalent of shooting the messenger. Fair value does not make markets more volatile; it just makes the risk profile more transparent. We should be pointing our fingers at those at Lehman Brothers, AIG, Fannie Mae, Freddie Mac, and other institutions who made poor investment and strategic decisions and took on dangerous risks. Blame should not be placed on the process by which the markets learned about them. 7. I commonly conclude the discussion of a case by asking students to identify the key ―take-aways‖ for that case. In fact, in pre-coverage, in-class quizzes I frequently ask students to list and rank the most important take-aways for the cases to be discussed in the given class and require them to defend their choices. Listed next is a sample of what I consider to be important take-aways for this case. --The independent audit function is critically important to the proper functioning of a free market economy. --When planning an audit, auditors should pay extremely close attention to important industry developments that may impact the integrity of the client‘s financial statements. --Accounting estimates that are critical to the reported health of the client should be audited rigorously. --Companies with high risk business models generally make high risk audit clients. --To properly plan an audit, auditors must review prior year workpapers and identify key accounts, internal control deficiencies, and other factors or circumstances that could potentially influence the outcome of the audit. --Auditors should consider internal control deficiencies when determining the nature, extent, and timing of substantive audit procedures.
Case 2.1 Jack Greenberg, Inc. 91 --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 is a weak form of audit evidence.
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. Philadelphia-based 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
92 Case 2.1 Jack Greenberg, Inc. Prepaid Inventory account.
83 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 vicepresident. 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.
Case 2.1 Jack Greenberg, Inc. 93
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 uncover in a client‘s accounting and control systems and business environment.
Suggestions for Use This case focuses on audit issues related to inventory. However, you will find that Jack Greenberg, Inc.‘s largest inventory account, namely, Prepaid Inventory, was unconventional and posed several unconventional audit issues and risk factors. So, if you are interested in a conventional inventory case, you might consider one of the other offerings in my casebook that deal with more ―normal‖ or customary inventory accounts. 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. No doubt, 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
94 Case 2.1 Jack Greenberg, Inc. the ―jury.‖
Suggested Solutions to Case Questions 1. The phrase ―audit risk‖ refers to the likelihood that an auditor ―may unknowingly fail to appropriately qualify his or her opinion on financial statements that are materially misstated‖ [AU 312.02]. ―Inherent risk,‖ ―control risk,‖ and ―detection‖ risk are the three individual components of audit risk. Following are brief descriptions of these components that were taken from AU 312 (paragraphs 21 and 24): ►Inherent risk: the susceptibility of a relevant assertion to a misstatement that could be material, either individually or when aggregated with other misstatements, assuming that there are no related controls. ►Control risk: the risk that a misstatement that could occur in a relevant assertion and that could be material, either individually or when aggregated with other misstatements, will not be prevented or detected on a timely basis by the entity‘s internal control. ►Detection risk: the risk that the auditor will not detect a material misstatement that exists in a relevant assertion that could be material, either individually or when aggregated with other misstatements. 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. ►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
Case 2.2 Golden Bear Golf, Inc. 95 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 business 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 complete 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 federal 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. 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
96 Case 2.2 Golden Bear Golf, Inc. 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) the control served by having the delivery receipts prepared and processed by different individuals. 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 internallygenerated 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 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 superceded by PCAOB Auditing Standard No. 5, ―An Audit of Internal Control Over Financial Reporting That is Integrated with An Audit of Financial Statements.‖ PCAOB No. 5 does not require walk-throughs. The ASB has never issued a standard that mandates the performance of walk-throughs.
Case 2.2 Golden Bear Golf, Inc. 97 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. ►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. ►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, have 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 federal 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. 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 deficiencies because it would not be cost-effective to do so.) Note: PCAOB Auditing Standard No. 5, ―An Audit of Internal Control Over Financial Reporting That is Integrated with An Audit of Financial Statements,‖ provides extensive guidance to auditors charged with auditing a public client‘s financial statements while at the same time auditing that client‘s ―management‘s assessment of the effectiveness of internal control over financial reporting.‖
98 Case 2.2 Golden Bear Golf, Inc. For example, PCAOB No. 5 mandates that auditors report all ―material weaknesses‖ in writing to client management and to the audit committee (paragraph 78). Likewise, auditors must report to the client‘s audit committee all ―significant deficiencies‖ in internal controls that they discover (paragraph 80). But, again, PCAOB No. 5 does not require auditors to ―insist‖ that their clients eliminate those material weaknesses or significant deficiencies.
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 continues his onslaught on 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 obtained the construction contracts intentionally inflated the revenues and gross profits for those projects by misapplying the percentageof-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.
Case 2.2 Golden Bear Golf, Inc. 99
90 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 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.
100 Case 2.2 Golden Bear Golf, Inc.
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 oral 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 arguably one of the most easily 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. Note: 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. Additional note: When auditing long-term construction
Case 2.3 Happiness Express, Inc. 101 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. ►Existence/occurrence: In SAS No. 106, ―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 unbilled revenue, 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.‖ (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-related 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 Section 326.15). 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 persuade Sullivan that his analysis was incorrect. ►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. ►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 was making an assertion to the effect that the change was not required to be disclosed to financial statement users. The Andersen auditors could have tested this assertion by researching
102 Case 2.3 Happiness Express, Inc. the appropriate professional standards and/or by referring the matter to technical consultants in their firm‘s national headquarters office. ►Completeness: Although not addressed explicitly in the case, the SEC also briefly criticized Andersen for not attempting to determine whether Paragon‘s total estimated costs for its individual construction projects were reasonable, that is, ―complete.‖ 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 generally accepted 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 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
Case 2.3 Happiness Express, Inc. 103 Guides when planning and carrying out an audit. These guides do not replace the authoritative guidance included in Statements on Auditing Standards but rather include ―recommendations on the application of SASs in specific circumstances.‖ Following is an excerpt from the prologue of one Audit and Accounting Guide. ―Auditing guidance included in an AICPA Audit and Accounting Guide is an interpretive publication pursuant to Statement on Auditing Standards (SAS) No. 95, ‗Generally Accepted Auditing Standards.‘ Interpretive publications are recommendations on the application of SASs in specific circumstances, including engagements for entities in specialized industries. Interpretive publications are issued under the authority of the Auditing Standards Board. The members of the Auditing Standards Board have found this guide to be consistent with existing SASs. The auditor should be aware of and consider interpretive publications applicable to his or her audit. If the auditor does not apply the auditing guidance included in an applicable interpretive publication, the auditor should be prepared to explain how he or she complied with the SAS provisions addressed by such auditing guidance.‖ 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 new 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.‖ 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 income before extraordinary items, net income, and related per-share amounts of the current period.‖
104 Case 2.3 Happiness Express, Inc.
CASE 2.3
HAPPINESS EXPRESS, INC.
Synopsis In 1989, two longtime sales reps in the toy industry, Joseph and Isaac Sutton, founded Happiness Express, Inc. The business model developed by the Sutton brothers involved acquiring the licensing rights to market toys and other merchandise featuring popular characters appearing in movies, television programs, and books and other publications intended principally for children. The company got off to a quick start, thanks to the uncanny ability of the Sutton brothers to identify children‘s characters, such as The Little Mermaid and Barney, that would have tremendous appeal among children. By 1994, the company had annual sales of $40 million. That same year, the Sutton brothers took Happiness Express public with a successful IPO. By 1995, the company‘s ―hottest‖ line of merchandise featured the Mighty Morphin Power Rangers. In fact, 75 percent of the company‘s reported revenues for fiscal 1995 resulted from sales of Power Rangers toys and merchandise. Unfortunately for the Sutton brothers and their fellow stockholders, sales of Power Rangers merchandise began falling dramatically near the end of the company‘s 1995 fiscal year as children‘s interest in the enigmatic crusaders subsided. To sustain their company‘s impressive profit and revenue trends, Happiness Express booked several million dollars of fictitious sales and accounts receivable near the end of fiscal 1995. (Ironically, the fraudulent scheme resulted in Happiness Express being named the ―#1 Hot Growth Company‖ in the United States by Business Week.) Public allegations of insider trading involving Happiness Express‘s executives and hints of financial irregularities in its accounting records prompted an SEC investigation and ultimately resulted in the company filing for bankruptcy in the fall of 1996. A class-action lawsuit by Happiness Express‘s stockholders targeted Coopers & Lybrand, which had issued unqualified opinions on the company‘s financial statements each year through fiscal 1996. The principal thrust of the lawsuit was that Coopers & Lybrand recklessly audited Happiness Express‘s sales and accounts receivable, which prevented the firm from discovering the bogus sales and receivables entered in the company‘s accounting records near the end of fiscal 1995. This case examines the audit procedures that Coopers & Lybrand applied to Happiness Express‘s sales and receivables, with a particular focus on the firm‘s receivables confirmation and sales cut-off procedures.
Case 2.3 Happiness Express, Inc. 105
96 Happiness Express, Inc.--Key Facts 1. In 1989, Joseph and Isaac Sutton founded Happiness Express, Inc., a small toy company that marketed licensed merchandise featuring popular children‘s characters. 2. During the early 1990s, Happiness Express‘s revenues grew rapidly; in May 1995, Happiness Express was named the ―#1 Hot Growth Company‖ in the United States by Business Week. 3. Happiness Express was heavily dependent on the continued popularity of certain children‘s characters for which it had purchased licensing rights; for example, in fiscal 1995, sales of Mighty Morphin Power Rangers merchandise accounted for 75% of the company‘s total revenues. 4. Happiness Express began experiencing financial problems during the spring of 1995 when sales of its Power Rangers merchandise began falling sharply. 5. To conceal Happiness Express‘s deteriorating financial condition, company executives booked several million dollars of fictitious sales near the end of fiscal 1995. 6. When the fraudulent scheme was uncovered, Happiness Express‘s stockholders filed a classaction lawsuit against Coopers & Lybrand, which had issued unqualified opinions on the company‘s financial statements through fiscal 1996. 7. The primary focus of the lawsuit was on the audit procedures that Coopers & Lybrand had applied to Happiness Express‘s sales and year-end receivables for fiscal 1995. 8. Plaintiff attorneys argued that Coopers & Lybrand had overlooked key red flags regarding Happiness Express‘s sales and receivables and, consequently, failed to develop a proper audit plan for the 1995 audit engagement. 9. Coopers & Lybrand was also charged with recklessly performing year-end sales cutoff tests and accounts receivable confirmation procedures during the 1995 audit. 10. In 2002, Coopers & Lybrand agreed to pay $1.3 million to resolve the class-action lawsuit.
106 Case 2.3 Happiness Express, Inc.
Instructional Objectives 1. To make students aware of the need for auditors to identify the unique or atypical audit risks posed by specific industries and client business models. 2. To demonstrate the importance of auditors‘ obtaining a thorough understanding of their client‘s operations and any major changes in those operations that have occurred since the prior year‘s audit. 3. To demonstrate the need for auditors to thoroughly investigate large and/or suspicious year-end transactions recorded by a client. 4. To discuss the nature of, and audit objectives associated with, sales cutoff tests and accounts receivable confirmation procedures.
Suggestions for Use Consider using this case to illustrate the audit objectives related to accounts receivable and sales as well as the audit procedures that can be used to accomplish those objectives. In particular, this case can be used to provide your students with a solid understanding of the nature and purpose of year-end sales cutoff tests and accounts receivable confirmation procedures. Another important feature of this case is that it demonstrates the need for auditors to identify and carefully consider important ―red flags‖ present in their clients‘ accounting records or in key circumstances surrounding those records. No doubt, one of the ―top 10‖ red flags associated with financial frauds is large and unusual year-end transactions. In this case, the auditors apparently did not carefully scrutinize large and unusual sales transactions recorded by the client on the final day of its fiscal year. Another important feature of this case is that it clearly demonstrates that auditors should take a ―big picture‖ view of their client when planning an audit. Key features of a client‘s industry (for example, in this case, the difficulty of predicting children‘s taste in toys) and critical elements of a client‘s business model (in this case, the heavy reliance of Happiness Express on one or a few lines of merchandise) can have significant implications for the successful completion of an audit.
Suggested Solutions to Case Questions 1. "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.
Case 2.4 CapitalBanc Corporation 107 Not surprisingly, year-end sales cutoff tests are used to corroborate the ―cutoff‖ assertion for individual transactions or classes of transactions. These tests are designed to determine whether transactions have been recorded in the proper accounting period. The ―completeness‖ assertion is also a primary focus of year-end cutoff tests, particularly for expense and liability transactions. When examining a client‘s year-end sales cutoff, auditors intend to determine whether the client properly sorted sales transactions near the end of the fiscal year into the proper accounting period— either the fiscal year under audit or the ―new‖ fiscal year. If a sales transaction recorded on the last day of a client‘s fiscal year actually occurred on the following day, then the cutoff assertion has been violated. A sales transaction that was recorded on the first day of the new fiscal year but that was actually a valid transaction of the ―old‖ fiscal year is another example of a violation of the cutoff assertion. [You might point out that both types of errors—when they are ―honest‖ errors--are typically due to client personnel improperly applying the FOB shipping point/FOB destination features of year-end sales or improperly applying other criteria that clients have established to determine when ―a sale is a sale.‖ As a general rule, companies can establish any reasonable cutoff criteria for year-end sales as long as those criteria are applied consistently from period to period.] 2. I would suggest that Coopers & Lybrand made three mistakes or errors in judgment vis-a-vis the Wow Wee confirmation. First, from the facts reported in the legal transcript used to prepare this case, the auditors effectively allowed Goldberg to take control of the confirmation process for the Wow Wee account. Throughout the confirmation process, auditors should maintain control over the confirmation requests and responses to minimize the risk that client personnel will attempt to intercept and/or alter those requests and responses. Second, the auditors apparently did not take all necessary precautions regarding the acceptance of facsimile confirmations. ―Facsimile responses involve risks because of the difficulty of ascertaining the sources of the responses. To restrict the risks associated with facsimile responses and treat the confirmations as valid audit evidence, the auditor should consider taking certain precautions, such as verifying the source and contents of a facsimile response in a telephone call to the purported sender. In addition, the auditor should consider requesting the purported sender to mail the original confirmation directly to the auditor.‖ [AU 330.28] Third, given the circumstances, the auditors likely should have considered performing additional procedures to corroborate the existence assertion for the Wow Wee receivable. For example, the auditors could have reviewed subsequent payments made on that account. 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 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
108 Case 2.4 CapitalBanc Corporation 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. I do not have access to all of the facts pertinent to this case since it never went to trial, as a result, I do not feel comfortable characterizing Coopers & Lybrand‘s misconduct as negligent, reckless, or fraudulent. But, I assure you, your students will be more than happy to complete this task for me. [Note: the information presented in this case was drawn from a preliminary ruling issued by Judge Robert Patterson who had been assigned to preside over the lawsuit filed by Happiness Express‘s former stockholders. Much of the information presented in his ruling was simply a rehash of the key allegations made by the plaintiff legal counsel.] 3. Given the size of the West Coast receivable—it represented approximately 13% of Happiness Express‘s year-end accounts receivable, which, in turn accounted for 32% of the company‘s total assets—it certainly seems reasonable to conclude that the account should have been confirmed. Since this case never went to trial, Coopers & Lybrand did not have an opportunity to give a full accounting for, or justification of, its decision not to confirm the West Coast account. In responding to an early legal brief in the case, Coopers & Lybrand did report, according to Judge Patterson‘s preliminary ruling in the case, that it ―examined cash receipts that West Coast paid after year-end.‖ However, Judge Patterson‘s ruling indicates that the accounting firm did not ―cite workpapers or other evidence to support this claim,‖ nor did the firm challenge plaintiff counsel‘s allegation that the failure to confirm the West Coast account was a violation of a generally accepted auditing procedure. Plaintiff counsel criticized Coopers & Lybrand for not including any of the bogus West Coast sales transactions in its year-end sales cutoff tests. However, apparently none of those sales occurred in the year-end cutoff period defined by Coopers & Lybrand—although the case does not indicate the length of the year-end cutoff period, it typically includes the five business days on either side of the client‘s fiscal year-end. [Note: As pointed out in the case, the bulk of the bogus West Coast sales were booked in the last month of fiscal 1995, but apparently not in the final few days of fiscal 1995—which was the case for the bogus Wow Wee sales. So, you would not have expected any of the bogus West Coast sales to be included in the year-end sales cutoff test.] 4. Examination of subsequent cash receipts and inspection of shipping documents are the two most common ―alternative‖ procedures auditors apply when a confirmation cannot be obtained for a large receivable. Another alternative procedure in such circumstances is simply to sit down with appropriate client personnel and have a heart-to-heart discussion regarding the given receivable. The purpose of this discussion would be to determine whether the client is aware of any unusual risks or circumstances regarding the given receivable that have important audit implications. Generally, a positive confirmation received from an independent third party, such as a client‘s
Case 2.4 CapitalBanc Corporation 109 customer, is considered to be more reliable than the evidence yielded by the alternative procedures identified in the prior paragraph. For example, a deceitful audit client may ―fake‖ shipping documents and subsequent cash receipts to conceal the true nature of bogus sales transactions. 5. You will not find a reference to ―insider trading‖ in the topical index to the professional auditing standards. Nevertheless, insider trading is clearly an ―illegal act‖ that may have significant implications for a client and significant implications for the client‘s independent audit firm. AU Section 317 discusses at length auditors‘ responsibilities regarding illegal acts perpetrated by a client. AU 317.05 notes that auditors‘ responsibilities for illegal acts that have a direct and material effect on a client‘s financial statements are the same as auditors‘ responsibilities for misstatements caused by error or fraud as described in AU Section 110. The principal focus of AU Section 317 is on illegal acts that have a material but indirect effect on a client‘s financial statements. AU 317.06 refers specifically to insider trading as an example of an illegal act that may have such an effect on a client‘s financial statements. According to AU 317.07, auditors ―should be aware of the possibility that such illegal acts [those having a material and indirect effect on financial statement amounts] may have occurred.‖ That paragraph goes on to suggest that if specific information comes to the auditor‘s attention that provides evidence concerning the existence of such illegal acts, ―the auditor should apply audit procedures specifically directed to ascertaining whether an illegal act has occurred.‖ In summary, I would suggest that ―yes‖ auditors do have a responsibility to consider the possibility that client executives have engaged in insider trading. Additionally, if they uncover evidence suggesting that insider trading has occurred, auditors have a responsibility to investigate that possibility. [AU Section 317 lists various audit procedures that can be used to investigate potential illegal acts.]
CASE 2.4
CAPITALBANC CORPORATION
Synopsis This case examines an embezzlement scheme involving CapitalBanc Corporation, a publiclyowned bank holding company based in New York City. The principal operating unit of CapitalBanc was Capital National Bank, a bank that had five branch offices scattered across the New York City metropolitan area. CapitalBanc‘s CEO, Carlos Cordova, embezzled at least $400,000 from the
110 Case 2.4 CapitalBanc Corporation firm‘s 177th Street Branch office. Cordova‘s embezzlement was discovered after the bank was declared insolvent in 1990 and taken over by the Federal Deposit Insurance Corporation (FDIC). Cordova subsequently pleaded guilty to several counts of bank fraud. In 1987, CapitalBanc retained Arthur Andersen to audit the financial statements to be included in its 10-K. Ironically, Arthur Andersen selected the 177th Street Branch to perform a surprise year-end cash count. When the auditors arrived, they discovered that $2.7 million, more than one-half of the branch‘s cash funds, were not accessible. Allegedly, those funds were segregated in a locked cabinet within the branch‘s main vault. According to branch personnel, three keys were required to unlock the cabinet, one of which was in Cordova‘s possession. Since Cordova was out of the country at the time, the employees were unable to unlock the cabinet. After consulting with their superiors on the audit engagement team, the Arthur Andersen auditors informed the branch‘s personnel that they would count the cash funds in the locked cabinet when Cordova returned. Upon returning to New York City, Cordova had cash funds from other CapitalBanc branches transferred to the 177th Street Branch to conceal his embezzlement. When the Arthur Andersen auditors returned to that branch to count the funds in the locked cabinet, they did not count the cash funds of the other branches and thus failed to discover the shortage. Nor did the Arthur Andersen auditors adequately corroborate Cordova‘s explanation regarding why such a large portion of the 177th Street Branch‘s cash funds were segregated in the locked cabinet and thus unavailable for use by the branch. Following the FDIC takeover of CapitalBanc, the SEC investigated Arthur Andersen‘s 1987 audit of the bank holding company. That investigation resulted in the federal agency censuring the Arthur Andersen audit manager and audit partner assigned to the CapitalBanc engagement.
102
CapitalBanc Corporation--Key Facts 1. Shortly after going public, CapitalBanc Corporation retained Arthur Andersen to audit its consolidated financial statements for the fiscal year ending December 31, 1987. 2. On December 29, 1987, during a surprise cash count at CapitalBanc's 177th Street Branch, the Andersen auditors discovered a $2.7 million reconciling item in the branch's cash accounting records. 3. The auditors were told that the $2.7 million had been segregated in a locked cabinet in the bank's main vault and that one of the three keys required to unlock the cabinet was in the possession of the CEO, Carlos Cordova, who was out of the country. 4. The audit manager told the audit staff that they could count the cash in the locked cabinet when Cordova returned and that it was not necessary to secure the cabinet in any way.
Case 2.4 CapitalBanc Corporation
111
5. On January 14, 1988, the locked cabinet was opened in the presence of the Andersen auditors, who accounted for the $2.7 million, although they did not simultaneously count the other cash funds of the 177th Street Branch or the cash funds of the other branches. 6. Cordova explained that the $2.7 million was segregated in the locked cabinet because a customer had previously cashed a large CD and insisted that the funds be available on demand. 7. The Andersen auditors failed to adequately corroborate Cordova's explanation for the $2.7 million of segregated cash. 8. Arthur Andersen issued an unqualified opinion on CapitalBanc's 1987 financial statements. 9. After CapitalBanc was declared insolvent, an SEC investigation revealed that Cordova had misappropriated at least $400,000 of the $2.7 million allegedly stored in the locked cabinet and had intentionally concealed this shortage from the Andersen auditors. 10. The SEC censured the Arthur Andersen audit manager and audit partner assigned to the CapitalBanc engagement.
Instructional Objectives 1. To illustrate the lengths to which dishonest client personnel may go to conceal critical information from auditors. 2. To identify key audit procedures for cash funds maintained on a client's premises. 3. To demonstrate the need for auditors to corroborate important representations made by client management with other forms of audit evidence. 4. To emphasize the need for auditors to follow up thoroughly on all suspicious items noted during the course of an audit.
Suggestions for Use
112 Case 2.4 CapitalBanc Corporation
This case focuses on a cash embezzlement scheme carried out by the CEO of a New York City banking firm and the apparent deficiencies in the audit procedures applied to the firm‘s cash funds. The case is ideally suited to be integrated with coverage of cash-related audit tests. Additionally, this is another case that can be used to impress upon students the importance of auditors having a healthy dose of skepticism when examining client financial statements.
Suggested Solutions to Case Questions 1. The nature of cash makes it more susceptible to theft and other misuses than most assets. As a result, "existence" is typically the financial statement assertion of most concern to auditors when examining a client's cash resources. This is true for both cash funds maintained by a client and those maintained by a third party, such as a bank. Another assertion particularly relevant to cash is the ―rights and obligation‖ assertion (which is one of the ―account balance‖ assertions discussed in SAS No. 106). For example, auditors should ascertain whether there are any significant restrictions on the use of a client‘s cash resources, such as, compensating balance requirements. These restrictions, if any, should be properly disclosed in a client‘s financial statements, an issue relevant to the ―classification and understandability‖ assertion (which is one of the ―presentation and disclosure‖ assertions discussed in SAS No. 106). 2. Following are examples of audit procedures that can be applied to cash funds maintained on a client‘s premises: a) Count the cash. (Note: Cash funds should be counted in the presence of client personnel. Additionally, it may be necessary to count other cash funds and/or securities simultaneously to ensure that the client has not concealed a cash shortage by transferring amounts between cash funds and/or by disposing of securities.) b) Reconcile the total of the cash count to the general ledger cash balance.
c) When counting a petty cash or ―imprest‖ fund, an auditor should review disbursement vouchers included in the fund to determine that they are for appropriate expenditures. d) Determine that adequate controls are in place to safeguard the cash. 3. Following are apparent mistakes or oversights made by Arthur Andersen personnel during their audit of cash funds maintained at CapitalBanc‘s 177th Street Branch: a) While counting the branch‘s cash funds, the auditors apparently did not take steps to establish control over other cash funds and/or securities of the client to prevent a cash shortage from being concealed by transferring cash from another source or by disposing of securities. b) The auditors failed to verify the existence of the three-key security system. c) The auditors failed to place audit seals on the doors of the locked cabinet to prevent client
Case 2.5 SmarTalk Teleservices, Inc. 113 personnel from gaining access to the cabinet before the date it was to be opened. d) The auditors failed to adequately confirm that a liability existed in the branch‘s accounting records to offset the segregated funds (again, those funds allegedly represented a customer‘s proceeds from a cashed CD). e) The auditors did not obtain documentation to support the client‘s assertion that a customer had cashed a large CD and intended to use those proceeds for a specific purpose. f) The auditors failed to ask client representatives why a substantial amount of the branch‘s cash was inaccessible to branch personnel and was not invested in appropriate interestbearing securities.
CASE 2.5
SMARTALK TELESERVICES, INC.
Synopsis
114 Case 2.5 SmarTalk Teleservices, Inc.
Throughout his long tenure as the chairman of the SEC, Arthur Levitt campaigned against ―earnings management‖ practices used by many public companies to window dress their reported operating results. A primary target of his campaign were the restructuring reserves that SEC registrants often established after acquiring another company. Levitt contended that many of the items included in restructuring reserves were actually routine operating expenses that the given companies would incur in future reporting periods. The apparent intent of the companies that used this accounting gimmick was to take a ―big bath‖ in the current reporting period, while setting themselves up for a quick earnings rebound in future periods. This case focuses on a company that used a restructuring reserve in the late 1990s to manage its reported earnings, namely, SmarTalk Teleservices, Inc., a company in the telecommunications industry. In 1997, SmarTalk established a $25 million restructuring reserve that was made up of individual items that did not qualify as restructuring charges, according to a subsequent SEC investigation. The SEC‘s investigation also revealed that SmarTalk‘s audit firm, PwC, had altered its audit workpapers for the 1997 SmarTalk audit after learning of a large class-action lawsuit being filed by the company‘s stockholders. The SEC fined PwC $1 million and required the company to establish quality control procedures to prevent its personnel from making undocumented changes to audit workpapers in the future.
106 SmarTalk Teleservices, Inc.--Key Facts 1. A major focus of Arthur Levitt‘s tenure as SEC Chairman was discouraging public companies from using so-called ―earnings management‖ techniques to distort their reported operating results. 2. ―Restructuring reserves‖ was a primary target of Levitt‘s campaign against earnings management. 3. Companies typically establish a restructuring reserve to accrue various ―exit expenditures‖ after acquiring one or more other companies. 4.
During the 1990s, many companies took a ―big bath‖ in the current reporting period by charging
Case 2.5 SmarTalk Teleservices, Inc. 115 future operating expenses to a restructuring reserve, an accounting gimmick that set those companies up for a quick and impressive profit recovery in future reporting periods. 5. SmarTalk Teleservices, a telecommunications firm, established a $25 million restructuring reserve in 1997 after acquiring several other companies. 6. A subsequent SEC investigation revealed that SmarTalk did not have a formal ―exit plan,‖ which is required by EITF 94-3 before a company can establish a restructuring reserve. 7. Even if SmarTalk had approved a formal exit plan, the items charged to its restructuring reserve would not have qualified as ―exit expenditures.‖ 8. The SEC‘s investigation resulted in the federal agency severely criticizing PwC‘s audit of SmarTalk‘s restructuring reserve. 9. The SEC also criticized PwC for altering its 1997 SmarTalk audit workpapers ex post after learning of a class-action lawsuit filed by the company‘s stockholders. 10. The SEC fined PwC $1 million and required the firm to establish quality control procedures to prevent PwC personnel from making undocumented ex post changes in audit workpapers.
Instructional Objectives 1. To introduce students to the controversial practice of ―earnings management‖ that many large public companies have allegedly used in recent years. 2.
To identify key audit issues posed by restructuring reserves.
3.
To document the need for auditors to maintain the integrity of audit workpapers.
4. To identify the function of the FASB‘s Emerging Issues Task Force in the rule-making process for accounting standards.
116 Case 2.5 SmarTalk Teleservices, Inc.
Suggestions for Use I typically include a module in my graduate case course for cases such as this that involve one ―high-risk‖ account, the objective being to allow students to focus almost exclusively on client accounts that can pose significant problems for auditors. (Of course, Section 2 of my casebook provides instructors with a series of ―high-risk account‖ cases for that specific purpose.) This case could also be integrated into an ethics module in your course. The SmarTalk case brings to mind the Enron debacle involving Arthur Andersen & Co. since it involves the alteration and discarding of workpapers. Notice that case question No. 3 specifically addresses this latter topic. As a point of information, the large class-action lawsuit filed by SmarTalk‘s stockholders apparently prompted PwC personnel to modify ex post the 1997 audit workpapers for that client. However, at the time those modifications were made, PwC had not been named as a defendant in that lawsuit. Even more important, as pointed out by the suggested solution to case question No. 3, the SEC had yet to initiate its investigation of the 1997 SmarTalk audit when PwC modified the workpapers for that engagement. I believe it is important to make these latter points very precisely so that students do not draw too close a parallel between this case and the Enron case.
Suggested Solutions to Case Questions 1. The key objectives for any given audit engagement are linked to one or more of the management assertions identified by SAS No. 106, ―Audit Evidence.‖ Listed next are management assertions that would be relevant to a large restructuring reserve established by an audit client. [Note: this answer is not intended to be comprehensive. In fact, a reasonable argument could be made that each of the thirteen management assertions identified by SAS No. 106 apply to a restructuring reserve. Likewise, many of these assertions would overlap for such a reserve and thus could be corroborated with the same evidence.] ►Existence: ―Assets, liabilities, and equity interests exist.‖ The existence assertion definitely applies to a restructuring reserve given the recent efforts of companies to use these reserves to manage their reported earnings. For a restructuring reserve, an auditor should determine whether the given liabilities represented by that reserve actually exist as of the end of the relevant accounting period. To address this issue, an auditor should first examine the client‘s ―exit plan‖ to determine that the client is committed to the program that resulted in the booking of the restructuring reserve and then discuss the plan with management to obtain further confirmation of that commitment. An auditor would then develop appropriate audit procedures to collect sufficient appropriate evidence supporting the existence assertion for each of the material items charged to the restructuring reserve. For example, an auditor might review employment contracts, board of directors‘ minutes, and external contracts with third parties to corroborate individual components of the reserve. Note: Much of the evidence collected to corroborate the existence assertion for a restructuring reserve would likely corroborate as well the related ―occurrence assertion‖ for the transactions and events that resulted in the recording of the reserve. SAS No. 106 defines the occurrence assertion for transactions and events as follows: ―Transactions and events that have been recorded have occurred
Case 2.6 CBI Holding Company, Inc. 117 and pertain to the entity.‖ ►Completeness: ―All transactions and events that should have been recorded have been recorded‖ [transaction-related assertion]; ―All assets, liabilities, and equity interests that should have been recorded have been recorded‖ [account balance-related assertion]; ―All disclosures that should have been included in the financial statements have been included‖ [presentation and disclosure-related assertion]. Companies engaging in earnings management would not be prone to understate a restructuring reserve. But a company that is attempting to establish a legitimate restructuring reserve might fail to identify all future expenditures that should be charged to such a reserve and thus violate one or more prongs of SAS No. 106’s completeness assertion. As a result, an auditor should attempt to determine whether a given client‘s restructuring reserve includes all future expenditures that relate to the given ―exit activities‖ and that the financial statement footnotes provide adequate or ―complete‖ disclosure of the reserve. Inquiries of management, third-party representations (expert opinions regarding the sufficiency of asset impairment estimates), and documentary evidence (review of a client‘s exit plan) are examples of types of audit evidence that could be collected to support the three-pronged completeness assertion for a restructuring reserve. ►Valuation and allocation: ―Assets, liabilities, and equity interests are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded.‖ This assertion often goes hand in hand with the existence and occurrence assertions, that is, auditors often design audit procedures that address these assertions simultaneously. In the context of a restructuring reserve, an auditor would want to determine that a client‘s restructuring reserve was established in the proper amount and that the related restructuring charges have been allocated properly to the current reporting period. Documentary evidence, representations by third parties, client representations, and mathematical evidence would likely be required to substantiate the valuation assertion for a restructuring reserve and its individual components. For example, mathematical evidence would be needed to substantiate the amount of severance payments charged to the restructuring reserve. To corroborate the amount of future asset impairments charged off to a restructuring reserve, an auditor might obtain third party representations (such as appraisals or other expert opinions). ►Classification and understandability: ―Financial information is appropriately presented and described and disclosures are clearly expressed.‖ An auditor would want to determine that the client has provided an ―understandable‖ description of its restructuring reserve in its financial statement footnotes. To achieve this audit objective, auditors would likely review the client‘s exit plan and any contracts or commitments related to that plan to ensure that the restructuring reserve is properly presented and discussed in the client‘s footnotes. Note: This latter assertion for a restructuring reserve clearly overlaps with the presentation and disclosure-related assertion for such reserves. 2. Here is a brief excerpt taken from the FASB‘s website that describes the EITF and its mission. ―The Emerging Issues Task Force was formed in 1984 in response to the recommendations of the FASB‘s task force on timely financial reporting guidance and an FASB Invitation to Comment on those recommendations. The mission of the EITF is to assist the FASB in improving financial reporting through the timely identification, discussion, and resolution of financial accounting issues within the framework of existing authoritative literature.‖
118 Case 2.6 CBI Holding Company, Inc. Kieso, Weygandt & Warfield (Intermediate Accounting, 11th Edition, John Wiley & Sons) provide the following additional snippet of information regarding the EITF. ―The EITF is composed of 13 members, representing CPA firms and preparers of financial statements. Also attending EITF meetings are observers from the SEC and the AICPA. The purpose of the task force is to reach a consensus on how to account for new and unusual financial transactions that have the potential for creating differing financial reporting practices.‖ (p. 10) ―Yes,‖ EITF pronouncements do have GAAP ―status.‖ In particular, AU Section 411, which was derived principally from SAS No. 69, includes EITF pronouncements in the GAAP hierarchy. See the table, ―GAAP Hierarchy Summary,‖ included in AU 411.18. 3. The key distinction between this case and the Enron case is that the PwC personnel who modified the SmarTalk audit workpapers were not attempting to obstruct any ongoing investigation by a regulatory body or law enforcement agency. I would suggest that PwC violated the overarching ―due professional care‖ standard of the profession, which is embodied directly or indirectly in GAAS (the third general standard). Likewise, one could reasonably argue that PwC violated Rule 102, ―Integrity and Objectivity,‖ and Rule 201, ―General Standards,‖ of the AICPA‘s Code of Professional Conduct. By not clearly documenting and justifying the changes made in the 1997 SmarTalk audit workpapers, PwC likely failed to do what a prudent audit practitioner would have done in such circumstances. Of course, the ―prudent practitioner concept‖ is often applied by the courts in addressing the issue of whether a given professional or professional firm lived up to their responsibilities in a given situation. As a point of information, neither PCAOB Auditing Standard No. 3, ―Audit Documentation,‖ nor SAS No. 103, ―Audit Documentation,‖ were in effect during the time frame in which this case took place. One could reasonably argue that conduct such as PwC‘s in this case would be a clear violation of SAS No.103 since that standard requires auditors to not only adequately document the results of their audit procedures but also to retain and ―protect the integrity‖ of that documentation (AU 339.34).
CASE 2.6
CBI HOLDING COMPANY, INC.
Synopsis Ernst & Young audited the pharmaceutical wholesaler CBI Holding Company, Inc., in the early
Case 2.6 CBI Holding Company, Inc. 119 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 lawsuit examined in detail 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.
111 CBI Holding Company, Inc.--Key Facts 1. In 1991, TCW purchased a 48% 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 be permitted to 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.
120 Case 2.6 CBI Holding Company, Inc.
6. Castello and his subordinates attempted to conceal the unrecorded liabilities by labeling the payments of these items 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. 4.
To examine circumstances arising during an audit that can jeopardize auditors‘ independence.
Case 2.6 CBI Holding Company, Inc. 121 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. 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
122 Case 2.7 Campbell Soup Company client's accounts receivable. Exceptions to this general rule are discussed in SAS No. 67 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 (account balance-related assertions). 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). 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. AU Section 561 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 appropriate measures to ensure that the information is relayed to parties who are still relying on that report. In this particular case, AU Section 561 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. 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 ―rise‖ to the level of AU 561, for example, involve gaffes by auditors that resulted in an improper audit opinion being issued, certainly the given audit firm has a responsibility to comply with AU 561 and ensure that the appropriate
Case 2.7 Campbell Soup Company 123 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 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.)
CASE 2.7
CAMPBELL SOUP COMPANY
124 Case 2.7 Campbell Soup Company
Synopsis The Campbell Soup Company has dominated the soup ―industry‖ since the company developed a cost-effective method of producing condensed soup products in 1899. Throughout most of the twentieth century, Campbell was known as one of the most conservative companies in the United States. In 1980, Campbell startled the business world by selling debt securities for the first time and by embarking on a program to lengthen and diversify its historically ―short‖ product line. Despite a sizable increase in revenues, the diversification program failed to improve Campbell‘s profitability, which prompted the company‘s executives to refocus their attention on their core business, namely, manufacturing and marketing soup products. Unfortunately, by the end of the twentieth century, the public‘s interest in soup was waning. Faced with a shrinking market for its primary product, Campbell‘s management team allegedly began using a series of questionable business practices and accounting gimmicks to prop up the company‘s reported profits. A class-action lawsuit filed in early 2000 by disgruntled Campbell stockholders charged top company executives with misrepresenting Campbell‘s operating results in the late 1990s. The principal allegation was that the executives had used a variety of methods to inflate the company‘s revenues, gross margins, and profits during that time frame. Eventually, PricewaterhouseCoopers (PwC), Campbell‘s independent audit firm, was named as a co-defendant in the case. The plaintiffs in the class-action lawsuit claimed that PwC had recklessly audited Campbell, which effectively allowed Campbell‘s executives to continue their illicit schemes. This case examines the allegations filed against PwC by Campbell‘s stockholders with the primary purpose of illustrating the audit objectives and procedures that can and should be applied to a client‘s revenue and revenue-related accounts. The case also provides students with important insights on how the Private Securities Litigation Reform Act of 1995 has affected auditors‘ civil liability in lawsuits filed under the Securities and Exchange Act of 1934.
117 Campbell Soup Company--Key Facts 1. During much of its history, Campbell Soup was known as one of the most conservative large companies in the U.S. economy. 2. Campbell‘s conservative corporate culture abruptly changed in the 1980s when the company sold debt securities for the first time and embarked on an ambitious program to diversify and expand its product line. 3.
In the late 1990s, after the diversification program had produced disappointing financial results
Case 2.7 Campbell Soup Company 125 and when market data indicated that the public‘s interest in soup was waning, Campbell executives allegedly began using several illicit methods to meet Wall Street‘s earnings targets for the company. 4. A class-action lawsuit filed in 2000 charged that Campbell had offered customers large, periodending discounts to artificially inflate sales, accounted improperly for those discounts, recorded bogus sales, and failed to record appropriate reserves for anticipated sales returns. 5. PwC, Campbell‘s audit firm, was named as a defendant in the class-action lawsuit and was charged with recklessly auditing Campbell‘s financial statements. 6. Because the class-action lawsuit was filed under the Securities Exchange Act of 1934, the federal judge presiding over the case had to decide whether the allegations involving PwC satisfied the new ―pleading standard‖ established by the Private Securities Litigation Reform Act of 1995. 7. The PSLRA‘s pleading standard requires plaintiffs to plead or allege facts suggesting that there is a ―strong inference of scienter‖ on the part of a given defendant. 8. To satisfy the PSLRA pleading standard in the Third Circuit of the U.S. District Court in which the Campbell lawsuit was filed, a plaintiff, at a minimum, must allege that the given defendant acted with ―recklessness.‖ 9. After reviewing PwC‘s audit workpapers, the federal judge ruled that the plaintiffs had failed to satisfy the PSLRA pleading standard, which resulted in PwC being dismissed as a defendant in the case. 10. In February 2003, Campbell settled the class-action lawsuit by agreeing to pay the plaintiffs $35 million, although company executives denied any wrongdoing.
Instructional Objectives 1. To demonstrate that even the largest and highest profile audit clients can pose significant audit risks. 2. To identify discretionary business practices and accounting ―gimmicks‖ that can be used to distort a company‘s reported operating results. 3.
To identify audit procedures that should be applied to a client‘s sales and sales-related accounts.
126 Case 2.7 Campbell Soup Company
4. To examine the implications that the Private Securities Litigation Reform Act of 1995 has for the civil liability of independent auditors in lawsuits filed under the Securities Exchange Act of 1934. 5.
To examine the concepts of recklessness and negligence in the context of auditors‘ civil liability.
Suggestions for Use The ―high-risk‖ accounts that are the focus of this case are sales and sales-related accounts. This case focuses students‘ attention on schemes that companies can use to enhance their reported operating results. These schemes involve both ―discretionary‖ business practices and accounting gimmicks. Auditing textbooks generally ignore the fact that audit clients often manage or manipulate their reported profits by using discretionary business practices—such as delaying advertising or maintenance expenditures. This case requires students to address this possibility and consider the resulting audit implications. After discussing this case, I hope my students recognize that companies that use discretionary business practices to ―rig‖ their profits are likely inclined to use accounting gimmicks for the same purpose. As an out-of-class assignment, you might ask students to find in the business press recent examples of companies that have attempted to manage their earnings without violating any accounting or financial reporting rules. Have students present these examples and then discuss them when addressing case question No. 1. I think you will find that students have very different opinions on whether it is ethical for public companies to ―massage‖ their income statement data while complying with the technical requirements of GAAP. You might consider packaging this case with the Health Management, Inc., case (Case 1.4). The Health Management case provides a general discussion of the PSLRA. The Campbell Soup case contributes to students‘ understanding of the PSLRA by examining in more depth the ―pleading standard‖ established by that federal statute and the impact that standard has on lawsuits filed against auditors under the Securities Exchange Act of 1934.
Suggested Solutions to Case Questions 1. Here are a few examples of discretionary business practices that corporate executives can use to influence their company‘s revenues and/or expenses. ►Deferring advertising, maintenance, or other discretionary expenditures until the following period. ►Slowing down (or accelerating) work on long-term construction projects or contracts for which the percentage-of-completion accounting method is used to recognize revenue. ►Using economic incentives to stimulate sales near the end of an accounting period (a technique used by Campbell). Are the practices just listed ―ethical‖? Typically, students suggest that since these practices do not violate any laws, GAAP, or other ―black and white‖ rules, the practices cannot be considered
Case 2.8 Rocky Mount Undergarment Company, Inc. 127 ―unethical‖—a roundabout way of arguing that they are ethical. That general point-of-view seems consistent with the following comment that Judge Irenas made regarding Campbell‘s period-ending ―trade loading:‖ ―There is nothing inherently improper in pressing for sales to be made earlier than in the normal course . . . there may be any number of legitimate reasons for attempting to achieve sales earlier.‖ For what it is worth, I believe that corporate executives who defer needed maintenance expenses or who postpone advertising programs that would likely produce sizable sales in future periods are not acting in the best interests of their stockholders. In other words, I do not believe such practices are proper or ―ethical.‖ Likewise, corporate executives who take advantage of the inherent flexibility of the percentage-of-completion accounting method, ostensibly to serve their own economic interests, are not individuals who I would want serving as stewards of my investments. In my view, it is a little more difficult to characterize the ―trade loading‖ practices of Campbell as unethical. Why? Because, allegedly, the company‘s competitors were using the same practice. If Campbell chose not to offer large, period-ending discounts to their customers, the company would likely have lost sales to its competitors. [Note: Campbell‘s CEO who resigned in 2000 announced in mid-1999 that his company was discontinuing trade loading.] 2. I would suggest that companies that use various ―legitimate‖ business practices to ―manage‖ their earnings are more prone to use illicit methods (accounting gimmicks, etc.) for the same purpose. As a result, auditors could reasonably consider such business practices as a ―red flag‖ that mandates more extensive and/or rigorous audit tests. [Note: Professional auditing standards suggest that corporate executives who place excessive emphasis on achieving earnings forecasts may be prone to misrepresenting their company‘s financial statement data.] 3. SAS No. 106, ―Audit Evidence,‖ identifies three categories of management assertions implicit in an entity‘s financial statements that independent auditors should attempt to corroborate by collecting sufficient appropriate audit evidence. The third of these categories is ―presentation and disclosure.‖ Included in the latter category is the following item: ―Classification and understandability. Financial information is appropriately presented and described and disclosures are clearly expressed.‖ [AU 326.15] Likewise, one of the five transaction-related assertions is entitled ―Classification.‖ This latter assertion suggests that, ―Transactions and events have been recorded in the proper accounts.‖ Here are examples of ―spin‖ techniques that can be used to enhance income statement data without changing net income: ►Classifying cost of goods sold components as SG&A expenses to inflate gross profit on sales. ►Reporting items that qualify as operating expenses/losses as nonoperating expenses/losses to inflate operating income. (One of the most common variations of this ―trick‖ in recent years has been including legitimate operating expenses in ―restructuring‖ losses.) ►Treating ―other losses‖ as extraordinary losses to inflate income from continuing operations. 4. Shipping to the yard: Year-end sales cutoff tests are intended to identify misclassification of sales occurring near the end of a client‘s fiscal year. Auditors will typically choose a small sample of sales that the client recorded in the final few days of the fiscal year and a comparable sample of sales
128 Case 2.8 Rocky Mount Undergarment Company, Inc. that occurred in the first few days of the new fiscal year. Then, the relevant shipping and other accounting documents for those sales will be inspected to determine that they were recorded in the proper period. This standard test might have revealed the fact that Campbell was booking some unusually large sales near the end of accounting periods. Even though the shipping documents for these sales might have suggested that they were valid period-ending sales, a curious auditor might have investigated the sales further. For example, that auditor might have attempted to determine whether the resulting receivables were collected on a timely basis. During the course of such an investigation, the auditor would likely have discovered that the sales were reversed in the following period or dealt with in some other nonstandard way. Accounts receivable confirmation procedures might also have resulted in the discovery of these ―sales.‖ Customers to whom such sales were charged would likely have identified them as differences or discrepancies on returned confirmations. Subsequent investigation of these items by the auditors may have revealed their true nature. As pointed out by the plaintiffs in this case, during physical inventory counting procedures auditors typically take notice of any inventory that has been segregated and not counted—for example, inventory that is sitting in parked trucks. If there is an unusually large amount of such segregated inventory—which was apparently true in this case, the auditors should have inquired of the client and obtained a reasonable explanation. The old, reliable ―scanning year-end transactions to identify large and/or unusual transactions‖ might also have led to the discovery of Campbell‘s sales ―shipped to the yard.‖ Guaranteed sales: During the first few weeks of a client‘s new fiscal year, auditors should review the client‘s sales returns and allowances account to determine whether there are any unusual trends apparent in that account. Auditors should be particularly cognizant of unusually high sales returns and allowances, which may signal that a client overstated reported sales for the prior accounting period. Accounts receivable confirmation procedures may also result in auditors discovering an unusually high rate of ―charge-backs‖ by the client‘s customers. In some cases, clients will have written contracts that document the key features of sales contracts. Reviewing such contracts may result in the discovery of ―guaranteed sales‖ or similar transactions. Finally, simply discussing a client‘s sales policies and procedures with client personnel may result in those personnel intentionally or inadvertently ―tipping off‖ auditors regarding questionable accounting practices for sales, such as shipping to the yard or guaranteed sales. 5. Here are definitions of ―negligence‖ and ―recklessness‖ that I have referred to in suggested solutions for questions in other cases. 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." Recklessness: "A serious occurrence of negligence tantamount to a flagrant or reckless departure from the standard of due care." After reviewing the definition of ―negligence,‖ ask your students to define or describe a ―prudent auditor.‖ Then, ask them whether they believe that definition/description applies to the PwC auditors assigned to the 1998 Campbell audit. Here are two hypothetical examples drawn from this case involving what I would characterize as ―reckless auditors.‖
Case 2.8 Rocky Mount Undergarment Company, Inc. 129 ►A client employee tells PwC auditors that many year-end sales are ―guaranteed‖ and that no reserve has been established for the large amount of returns that will likely be produced by those sales. PwC decides not to investigate this allegation because of manpower constraints on the engagement. ►While reviewing receivables confirmations returned by Campbell customers, PwC auditors discover that approximately one-fourth of those customers indicate that their balances include charges for large amounts of product purchased near the end of the year, product that they did not order or receive. PwC dismisses this unusually large number of similar reported differences as a ―coincidence.‖ 6. Here is a list of key parties that have been affected by the PSLRA. ►Investors who suffer large losses that they believe were caused by reckless or fraudulent conduct on the part of a given company‘s management team, its auditors, or other parties associated with the company‘s financial statements. At least some of these investors have likely found it more difficult and costly to recover their losses because of the barrier to securities lawsuits erected by the PSLRA. [Note: Granted, the PSLRA has little impact on the ability of investors to recover losses in those cases involving obvious gross fraud or malfeasance by corporate management or other parties.] ►Some parties have argued that the PSLRA diminishes the overall efficiency of the stock market. These parties argue that by making it more difficult for investors to file lawsuits under the 1934 Securities Act, the PSLRA has resulted in a larger portion of scarce investment capital being squandered by irresponsible corporate executives, which, in the long run, diminishes the strength of our economy and our nation‘s standard of living. ►Generally, corporate executives have benefited from the PSLRA since it has reduced, to some degree, their exposure to civil liability. ►As pointed out in the Health Management, Inc., case (Case 1.4), the PSLRA apparently has not been very beneficial to large accounting firms. For whatever reason, in recent years, there has been a general upward trend in federal securities cases alleging accounting irregularities. Not only are independent auditors more likely to be named as defendants in such cases, the settlements in those cases tend to be considerably higher than in other lawsuits filed under the federal securities laws.
CASE 2.8
ROCKY MOUNT UNDERGARMENT COMPANY, INC.
Synopsis
130 Case 2.8 Rocky Mount Undergarment Company, Inc.
Near the end of 1985, the executives of Rocky Mount Undergarment Company (RMUC) faced the unpleasant realization that their firm‘s operating results for that year would be unimpressive. In fact, RMUC‘s 1985 net income would fall short of $500,000, less than one-third of the company‘s reported profit for the previous year. The executives decided that RMUC‘s actual operating results were unacceptable and decided to change them. How? By pressuring three of RMUC‘s accounting clerks to significantly overstate the company‘s year-end inventory. Initially, the three employees did not want to become involved in the fraudulent scheme. However, the employees subsequently changed their minds. What caused them to have a change of heart? The executives told the employees that unless they inflated the company‘s reported net income, the company might cease operations. Later, while the employees were actively involved in the inventory fraud, they had another change of heart. They told RMUC‘s executives that they were unwilling to continue falsifying the company‘s year-end inventory quantities. After renewed coaxing and goading by the executives, the three employees once again became active, if unwilling, participants in the fraud. Following the SEC‘s discovery of RMUC‘s fraudulent scheme, the federal agency sanctioned the two executives responsible for masterminding the fraud. RMUC was also required to issue corrected financial statements for 1985.
123 Rocky Mount Undergarment Company, Inc.--Key Facts 4. The ―success‖ of many, if not most, fraudulent accounting schemes hinges on the willingness of lower-level employees to participate in them. 5. In 1985, RMUC failed to sustain its impressive profit trend as the company‘s actual net income was less than onethird of the previous year amount. 6.
Two RMUC executives decided that the company‘s net income for 1985 was unacceptable and
devised a fraudulent scheme to inflate that figure by more than 100 percent. 7.
The executives instructed three RMUC employees to materially overstate the company‘s year-
Case 2.8 Rocky Mount Undergarment Company, Inc. 131 end inventory for 1985. 8.
The employees were reluctant to cooperate but eventually agreed to do so when the executives
told them that RMUC might otherwise cease operations--and thus lay off its entire workforce. 9. At one point, the three employees informed the executives that they were no longer going to participate in the fraud; however, the executives goaded them into changing their minds once more. 7. RMUC‘s senior executive also convinced one of the company‘s suppliers to submit a false confirmation letter to RMUC‘s audit firm; that confirmation indicated the supplier had $165,000 of RMUC inventory on hand at the end of 1985. 8. RMUC‘s senior executive signed a letter of representations addressed to the company‘s audit firm near the end of the 1985 audit that indicated he was not aware of any irregularities in RMUC‘s financial statements.
9. Following the discovery of the fraudulent inventory scheme, the SEC sanctioned RMUC‘s two executives who masterminded the fraud; RMUC also issued corrected financial statements for 1985.
Instructional Objectives 1. To suggest that the ―success‖ of many, if not most, fraudulent accounting schemes depends on the willingness of lower-level employees to participate in those schemes. 2. To demonstrate the pressure that corporate executives may impose on an organization‘s accountants and clerical personnel to misrepresent the entity‘s financial data.
3. To allow students to assume the role of a corporate accountant who is being pressured to fraudulently overstate an entity‘s year-end inventory. 10. To examine audit procedures that may be effective in preventing or detecting fraudulent overstatements of inventory.
132 Case 2.8 Rocky Mount Undergarment Company, Inc. Suggestions for Use This case examines an inventory fraud in which several lower-level employees were coerced into participating in the fraudulent scheme by two of the given company‘s executives. One of my objectives in an auditing course, particularly an undergraduate auditing course, is to dispel the naivete of my students regarding the ―real world‖ that most of them are about to enter. Although the coercion of lower-level accounting employees that was evident in this case may be rare, it does occur in the real world and I believe that future auditors and corporate accountants should be aware that it occurs. I also believe that it is important to have students ―step into such situations‖ and role play-which I often do with a case such as this one. I have found that such role-playing exercises are extremely thought-provoking and revealing for both the ―actors‖ and the observers.
Suggested Solutions to Case Questions 11. In the United States, we don‘t have any definitive criteria for determining whether a given amount is ―material.‖ However, in this case, the 1985 overstatement of RMUC‘s inventory clearly had a very material impact on the company‘s key financial data. In evaluating an inventory misstatement, the most relevant benchmark is typically a company‘s net income for the given accounting period. In this case, the inventory fraud more than doubled RMUC‘s reported net income. Most accountants would likely conclude that the more than $1 million overstatement of inventory also had a material impact on RMUC‘s total assets, current assets, and stockholders‘ equity, each of which was overstated by approximately 5%.
2. The audit procedures that would have had the highest likelihood of detecting RMUC‘s inventory fraud would have been inventory observation procedures and the related follow-up procedures. As noted in the case, the three RMUC employees involved in the fraud overstated inventory quantities listed on the count sheets prepared during the physical inventory. If RMUC‘s auditors had test counted several of the company‘s inventory items, they might have discovered (later) that their test count quantities for those items did not correspond to the quantities listed in the final inventory compilation prepared by the client. Among other audit procedures that might have uncovered the fraud were standard analytical tests focusing on the client‘s inventory turnover, gross profit margin, net operating margin, and related ratios. Note: The SEC enforcement release did not comment on the inventory audit procedures applied by the company‘s audit firm, nor did that enforcement release criticize RMUC‘s independent auditors. 3. One of the key traits of audit evidence is ―freedom from bias.‖ The existence of the buyout option should have caused RMUC‘s auditors to question whether the Stretchlon executive who signed the confirmation letter was unbiased, that is, unaffected by any pressure or influence potentially exerted by RMUC personnel.
4. Companies are not inclined to be completely forthcoming when they must display their ―dirty laundry.‖ In my view, the footnote disclosure of the inventory overstatement was not adequate. If I was a potential investor in this company or a potential lender to the company, I would certainly be interested in the source of the inventory misstatement. Why? Because that information would influence the degree of credibility I would impute to the company‘s current and future financial disclosures. Note: The information on which this case is based does not reveal whether the SEC formally
Case 3.1 The Trolley Dodgers 133 reviewed and/or approved RMUC‘s footnote disclosure of the inventory misstatement. My guess would be that the SEC did review and approve the disclosure shown in Exhibit 2. 5. Again, I often select students to role play when addressing case questions such as this one. Here, it is appropriate to have two students assume the role of RMUC‘s two executives (one of whom was the company‘s senior executive) and three other students to assume the role of the low-level accounting employees who participated in the inventory fraud. Among the alternative courses of action available to the three employees were resigning, refusing to participate in the fraud and threatening legal action if pressured to do so by the two executives, discussing the matter with other executives or directors of RMUC, and referring the matter to the SEC and/or to RMUC‘s independent audit firm.
CASE 3.1
THE TROLLEY DODGERS
Synopsis In this brief case, a long-time 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.
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.
134 Case 3.1 The Trolley Dodgers
127 The Trolley Dodgers--Key Facts 1. The top executives of the Dodgers organization apparently 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.
Case 3.1 The Trolley Dodgers 135
Suggestions for Use This case deals exclusively 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 following: the need for management to resist placing too much trust or reliance on any one employee, the need for periodic rotation of accounting responsibilities and/or 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
136 Case 3.1 The Trolley Dodgers that time period. 2.
The following internal control weaknesses were apparent in the Dodgers' payroll system:
a. the extent of control that one person had over the payroll system, which began with that individual's design of the system and included his involvement in the system‘s operational details, b. the lack of enforced vacations for key personnel, and c. an apparent lack of periodic testing of the payroll transaction cycle by internal auditors or a similar control group, testing that should have resulted in the discovery of the fraudulent scheme.
3. Listed next are examples of audit tests that might have led to the discovery of Campos' embezzlement scheme. (Note: The auditors who tested the Dodgers' payroll transaction cycle should have recognized that the control risk associated with that cycle was relatively high given the fact that one person had almost complete responsibility for the payroll function--with very little accompanying accountability. Such an assessment of control risk, ceteris paribus, should have dictated a fairly rigorous audit scope for year-end testing of the payroll-related account balances. Regarding these latter tests, the external auditor's principal concern would have been violations of the completeness assertion. However, in this case, the existence (account balance-related) and occurrence (transaction-related) assertions, rather than the completeness assertion, were violated, implying that the auditors may have spent much of their time searching for the wrong type of errors.) 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."
CASE 3.2
HOWARD STREET JEWELERS, INC.
Case 3.2 Howard Street Jewelers, Inc. 137
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. For twenty years, the owners, Mr. and Mrs. 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.
131 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.
138 Case 3.2 Howard Street Jewelers, Inc.
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 form 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.
Case 3.2 Howard Street Jewelers, Inc. 139 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 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. a. AU Section 110 summarizes an auditor‘s responsibility for fraud detection. ―The auditor has
140 Case 3.2 Howard Street Jewelers, Inc. 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‖ (AU 110.02). AU Section 316, ―Consideration of Fraud in A Financial Statement Audit," discusses how auditors should and can fulfill that responsibility: ―This section establishes standards and provides guidance to auditors in fulfilling this responsibility, as it relates to fraud, in an audit of financial statements conducted in accordance with generally accepted auditing standards.‖ AU Section 316 requires auditors to complete the following general tasks: 1. Discuss [among members of the audit engagement team] the risks of material misstatement due to fraud that are posed by a client. 2. Obtain the information needed to identify the risks of material misstatement due to fraud. 3. Identify the risks that may result in a material misstatement due to fraud. 4. Assess the identified risks after taking into account an evaluation of the entity‘s programs and controls. 5. Respond to the results of the risk assessment by, among other ways, making appropriate changes in the nature, extent, and timing of audit procedures to be performed. 6. Evaluate audit test results. 7. Communicate the results of the relevant fraud-related audit procedures to appropriate client personnel. 8. Document fraud-related procedures and their outcomes. Because fraud is often well concealed, auditors do not have an absolute responsibility to discover fraud-related misstatements in a client‘s financial statements, as explicitly noted in AU Section 316: ―However, absolute assurance is not attainable and thus even a properly planned and performed audit may not detect a material misstatement resulting from fraud‖ (paragraph 12). For instance, in cases in which forgery and/or collusion among client personnel has occurred, the likelihood that the auditor will uncover the fraud is probably quite low regardless of the nature and extent of the audit procedures employed. Conversely, an auditor's responsibility to detect an obvious fraud, such as the theft of huge amounts of inventory or the kiting of large checks at year-end, is much greater. As a point of information, AU Section 316 differentiates between two types of fraudulent activities: misstatements arising from fraudulent financial reporting and misstatements arising from misappropriations of assets. Of course, the latter type of fraud is relevant to this case. AU Section 316 provides a brief discussion of specific measures auditors may take to investigate potential financial statement errors due to misappropriation of assets. ―For example, if a particular asset is highly susceptible to misappropriation and a potential misstatement would be material to the financial statements, obtaining an understanding of the controls related to the prevention and detection of such misappropriation and testing the operating effectiveness of such controls may be warranted‖ (paragraph 56). b. A review of a company's financial statements requires the accountant who performs the engagement to express negative assurance regarding the reliability of those financial statements. At the conclusion of a review engagement, an accountant will typically report that nothing came to his or her attention to indicate that the information in the financial statements contained material misstatements. In the current case, if Mrs. Levi expressed suspicions regarding Betty's honesty to the
Case 3.2 Howard Street Jewelers, Inc. 141 CPA, then the CPA would have had reason to doubt the integrity of those financial statements and thus have had a responsibility to investigate this matter further. Otherwise, he would have been unable to provide the negative assurance report at the conclusion of the engagement. c. A compilation differs from an audit and a review in that the accountant performing the engagement does not express any assurance on the financial statements in question. AR Section 100.09 states that in a compilation engagement there is no requirement "to verify, corroborate, or review information." However, that paragraph goes on to state that if the accountant becomes aware that the information he or she is compiling is ―incorrect,‖ ―incomplete,‖ or ―unsatisfactory‖ in any other way, the accountant should obtain additional or revised information. So, in the case at hand, even if the CPA had been retained to perform only a compilation, he likely would have concluded that it was necessary to investigate the issue raised by Mrs. Levi. 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 Trubeys 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 (such as a list of checks received in the mail). 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.
CASE 3.3
SAKS FIFTH AVENUE
142 Case 3.3 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.‖
136 Saks Fifth Avenue--Key Facts 1. Joseph Fierro‘s hard work and creativity earned him excellent performance appraisals and promotions from his supervisor, Robert Perley. 12. Fierro forged two signatures and used another employee‘s identification number to obtain an improper sales discount
Case 3.3 Saks Fifth Avenue 143 of approximately $10 on a shirt he purchased from another Saks department. 13. Saks internal auditors uncovered the forged documents and the improper discount that Fierro obtained. 14. Perley appealed to Saks‘ Loss Prevention and Human Resources departments in an attempt to save Fierro‘s job. 15. Saks dismissed Fierro, invoking its zero tolerance policy for employee theft. 16. Fierro subsequently sued Saks, alleging that Perley discriminated against him because of his ethnic background; Fierro also alleged that he was subjected to a hostile work environment at Saks. 17. 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.
8. 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. 9. The presiding judge eventually dismissed Fierro‘s hostile work environment allegation by observing that his former work environment was not hostile but rather ―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. 18. To identify control activities that retail businesses can implement to cope effectively with key
144 Case 3.3 Saks Fifth Avenue control risks they face.
Suggestions for Use In my auditing courses, I find myself stressing the control risks that businesses have historically faced such as the potential for losses due to uncollectible receivables. In recent years, though, businesses have been exposed to more varied and often more threatening types of control risks not commonly discussed in accounting texts. One such threat is the risk of loss due to employee lawsuits. This case focuses on that control risk issue and on a control risk that has dogged retail businesses from their inception, namely, potential losses due to employee theft. Classroom discussion of this case typically centers on Saks‘ zero tolerance policy for employee theft. Many students disagree with Saks‘ decision to terminate a hard-working and effective employee for a ―relatively trivial‖ theft. One issue that I hope these students eventually consider-sometimes I prod them into considering it--is the need for retail businesses to weigh not only the short-term or immediate implications of employee misconduct but also the longer range implications, particularly if such conduct is not dealt with decisively. Saks must weigh the loss of productive employees due to its zero tolerance policy against the deterrent effect that policy has over the long run in discouraging employee theft. The improper $10 discount taken by Joseph Fierro was clearly not material to Saks. However, the precedent Saks established by dismissing him for that theft may serve to prevent significant employee theft losses in the future.
Suggested Solutions to Case Questions 19. 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. No doubt, that policy 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. 20. AU Section 314.41 defines internal control as follows:
Internal control is a process--effected by those charged with governance, management, and other personnel--designed to provide reasonable assurance about the achievement of the entity‘s objectives with regard to reliability of financial reporting, effectiveness and efficiency of operations, and compliance with applicable laws and regulations.
Case 3.3 Saks Fifth Avenue 145 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‘ antiharassment policy would be relevant to the third category of control objectives identified in the previous definition of internal 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. 21. 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. Of course, 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.
146 Case 3.4 Triton Energy Ltd.
CASE 3.4
TRITON ENERGY LTD.
Synopsis When Congress passed the Foreign Corrupt Practices Act (FCPA) in 1977, corporate accountants and independent auditors feared that the new law would add significantly to their litigation problems. 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, 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. In 1997, the SEC issued a series of enforcement releases involving Triton Energy Ltd., a Dallas-based oil exploration company with operations scattered across the globe. These releases sanctioned the company and several of its executives for making numerous illicit payments to officials of foreign countries. Representatives of the SEC noted that the Triton case was intended to send a ―message‖ to corporate executives. The federal agency pledged to prosecute many more FCPA-related cases in the future. This case raises internal control, auditing, and ethical issues stemming from Triton‘s illegal activities that were
Case 3.4 Triton Energy Ltd. 147 documented in the SEC enforcement releases. Specific issues raised in the case questions include, among others, factors complicating the audits of multinational companies and auditors‘ responsibility to detect and report illegal acts.
141 Triton Energy Ltd.--Key Facts 1. The FCPA of 1977 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. 2. Triton Energy‘s executives employed aggressive strategies to contend with much larger and better financed competitors, including fostering close relationships with officials of foreign countries in which their company had operations. 3. Throughout 1989 and 1990, Triton Indonesia made numerous unlawful payments to Indonesian governmental officials, each of which was ―sanitized‖ by the unit‘s accounting staff. 4. When he was informed of the unlawful payments, Triton Energy‘s president told a Triton Indonesia officer that such payments ―had to be done‖ in certain countries. 5. After being fired for refusing to sign Triton Energy‘s 1989 10-K, the company‘s former controller revealed the illicit payments that Triton had made to officials of foreign governments. 6. Two former Triton accountants, an internal audit director and an accountant with Triton Indonesia, corroborated the allegations made by Triton Energy‘s former controller. 7. During the planning phase of the 1991 Triton audit, a Peat Marwick auditor learned of an internal audit memo that supposedly documented the unlawful activities of Triton Indonesia.
148 Case 3.4 Triton Energy Ltd. 8. Triton officials told Peat Marwick representatives that all copies of the internal audit memo had been destroyed and then refuted the principal allegations reportedly included in that memo. 9. The SEC eventually charged Triton and six of its executives with violating the FCPA‘s antibribery, accounting, and control provisions and fined the company and two Triton Indonesia executives. 10. The SEC announced that the penalties imposed in the Triton case were intended to send a message to corporate executives that violations of the FCPA would not be tolerated.
Instructional Objectives 22. To acquaint students with accounting and control issues posed by the Foreign Corrupt Practices Act. 23. To make students aware that client executives may take extreme--and illegal--measures to sidestep governmental regulations. 24. To examine auditors‘ responsibility to detect and report illegal acts by a client.
4. To illustrate the need for auditors to thoroughly investigate questionable transactions discovered during an audit. 5. To illustrate the serious implications that the absence of an adequate degree of control consciousness in a company's culture can have for the reliability of its financial records. 6. To identify key challenges posed by audits of multinational companies.
Suggestions for Use In my auditing courses, I integrate this case with coverage of internal control issues. This case focuses principally on violations of the Foreign Corrupt Practices Act (FCPA) of 1977 by executives of Triton Energy and its wholly-owned subsidiary, Triton Indonesia. The FCPA prohibits U.S. firms from making illicit payments (bribes, kickbacks, etc.) to officials of foreign governments to either
Case 3.4 Triton Energy Ltd. 149 establish or maintain business relationships. This federal statute also requires all U.S. firms to establish internal controls that provide reasonable assurance of detecting such payments. The increasing trend toward multinational operations by U.S. firms mandates that accountants and auditors be aware of the important accounting, control, and ethical issues posed by such operations. This case provides students with such an awareness. Multinational companies often face a difficult dilemma: ―either pay up or pack up.‖ Triton management chose to ―pay up‖ and to conceal its illicit payments to officials of the Indonesian government. I believe that eye-opening cases such as this can dissolve students‘ natural tendency to be naive when it comes to expectations of financial statement fraud. By discussing these types of cases in class, students should be better prepared to cope with comparable situations later in their own careers. An effective method of initiating class discussion of this case is to have students role play key events within the case. For example, I have had students role play the interaction between Triton Indonesia‘s controller and a senior Triton Indonesia executive who has just been informed of his unit‘s tax deficiencies by the Indonesian auditors. The senior executive wants to contact the company‘s ―liaison,‖ Roland Siouffi, and instruct him to make the appropriate arrangements to resolve the matter. The controller‘s responsibility is to dissuade the senior executive from handling the matter in that unethical and illegal manner. Instructors can also develop a role-playing exercise involving Triton Energy‘s controller and Triton Energy‘s president. As noted in this case, the controller was fired by the company‘s senior management--apparently Triton Energy‘s president— after he refused to sign off on the company‘s 1989 10-K because it failed to disclosed the unlawful foreign payments made by the company. Finally, another role-playing scenario I have used involves Triton‘s independent audit firm, Peat Marwick, and officers of Triton Indonesia. In this scenario, a Peat Marwick auditor questions Triton Indonesia officers regarding the internal audit memo that documented the fraudulent payments made by Triton to government officials. If you have used role playing exercises in your classes, you realize that they provide an excellent opportunity to inject students into a real-world atmosphere in which they have to wrestle directly with important technical and ethical issues. These exercises tend to provide students with a much better appreciation of the types of pressures and challenges that auditors and accountants face in their work environments. There are two facets of this case that I hope arise each time it is discussed. (If students do not raise these items, I try to subtlety direct their attention to them.) The first of these items is the statement by Triton Energy‘s president that illicit payments to officials of foreign governments ―had to be done in certain environments.‖ I believe students need to recognize that at least some corporate executives adopt that fatalistic attitude toward doing business in foreign countries. Such an attitude has a pervasive and negative impact on a given company‘s control environment. The other facet of the case that I want students to explicitly address is the effort of three accountants to ―do the right thing.‖ Triton Energy‘s controller, its internal audit director, and a Triton Indonesia accountant each stood their ground when ―tested.‖ Each of these individuals either resigned or was fired. Hopefully, this case helps convince students that losing a job is a small price to pay for refusing to behave unethically and/or illegally.
Suggested Solutions to Case Questions
150 Case 3.4 Triton Energy Ltd. 1. Listed next are key factors that pose challenging problems on audits of multinational companies. a. Auditors will likely encounter different accounting and financial reporting treatments for similar transactions and accounts. If consolidated financial statements are to be prepared for the given entity, auditors must ensure that the ―home country‘s‖ accounting and financial reporting standards are properly applied to the client‘s consolidated financial statement data. b. A related problem is the need to audit the conversion of transaction and account balance data from one or more currencies to the currency of the home country. c. The audit of a multinational client is also more difficult to administer and control. For example, the audit of a large multinational client may require several teams of auditors assigned to different operating units of the client scattered across several countries. Even with the help of e-mail and other Internet resources, coordinating widely dispersed teams of auditors can be a challenging task. d. Quite often, the most challenging feature of multinational audits is the differences in cultural norms across the countries in which a client‘s operations are located. Cultural and communication barriers between auditors and client personnel can complicate even the simplest audit tasks. Assigning auditors from a local affiliate or a local office of the given audit firm can sometimes eliminate or at least significantly reduce the problems posed by language and cultural differences. 25. In retrospect, the most important control policy Triton Energy could have established for its foreign subsidiaries would have been to inform employees that the payment of bribes was strictly prohibited and that anyone who violated that policy would be fired immediately. Triton Energy‘s executives did not instruct their subordinates to make unlawful payments to Indonesian authorities. However, because the executives apparently did not explicitly discourage such payments, they created an environment in which these payments were more likely to occur. Triton Energy‘s executives also should have insisted that each subsidiary‘s disbursements be made by check, supported by appropriate documentation, and authorized by the appropriate level of management. To reinforce this control policy, Triton Energy should 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 Triton Energy‘s management. [Recognize that Triton Indonesia did vouch disbursements with supporting documentation and that the entity‘s disbursements and other transactions were regularly tested by internal auditors. However, these control activities were ineffective, as documented in the case, principally because of the poor control environment within the company.]
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 Triton Energy as a result of its foreign payments scandal was a loss of credibility. No doubt, the scandal deterred many parties from loaning funds to, or investing in, Triton Energy. 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. 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 AU Section 317, ―Illegal Acts by Clients.‖ That section of the professional auditing standards distinguishes between an auditor's responsibility to detect illegal acts
Case 3.5 Goodner Brothers, Inc. 151 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. AU Section 317.06 observes that an auditor ―ordinarily does not have sufficient basis for recognizing‖ such violations by clients. Later this section 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 occurred.‖ AU 317.05 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 Section 110.‖ In turn, AU Section 110.02 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. Technical standards define inherent risk as the ―susceptibility of a relevant assertion to a misstatement that could be material, either individually or when aggregated with other misstatements, assuming that there are no related controls.‖ [AU 312.21] The fact that a client employs a high-risk business strategy does not necessarily increase the inherent risk component of audit risk posed by that company. However, the aggressive management practices employed by Triton Energy often left the company ―living on the edge,‖ that is, fighting to survive. No doubt, company executives faced with the need to ensure the survival of their firm over the short-term face more temptations to ―cut corners‖ in their accounting system and financial reports than the executives of financially healthy companies. This tendency clearly increases the risk that misrepresentations will be introduced into such a company‘s financial statements. Control risk is defined as ―the risk that a misstatement that could occur in a relevant assertion and that could be material, either individually or when aggregated with other misstatements, will not be prevented or detected on a timely basis by the entity‘s internal control.‖ [AU 312.21] Here again, the high-risk business strategies employed by Triton Energy‘s executives did not necessarily increase the control risk component of audit risk posed by the company. Nevertheless, if a company‘s management invokes a ―devil-may-care‖ approach to its basic operating policies, wouldn‘t you expect that same attitude to adversely influence the control policies those managers establish? 26. 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 seriously consider this alternative 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 absolutely nothing, that is, completely ―shirking‖ any responsibility for disclosing the illegal act.
Certainly, the responsibility of an accountant to address an illegal act perpetrated by his or her
152 Case 3.5 Goodner Brothers, Inc. 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. In this particular case, Triton Energy‘s controller clearly made the correct decision by refusing to sign off on the company‘s 1989 10-K--although that decision cost him his job. Again, when an illegal act has severe or pervasive consequences for a given company, an accountant of that company who is aware of the illegal act would generally be well advised to seek external legal counsel. 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 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, including: 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, AU 317.23 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 certain funding agencies or other government agency when the client receives financial assistance from a government agency. 27. 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.)
CASE 3.5
GOODNER BROTHERS, INC.
Case 3.5 Goodner Brothers, Inc. 153
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 fourteen 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. By the mid-1990s, 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.
148 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. 28. 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. 29. A key factor that caused Woody Robinson to decide to steal from Goodner Brothers was the
154 Case 3.5 Goodner Brothers, Inc. weak and often nonexistent internal controls at the company‘s Huntington sales office. 30. 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. 31. To demonstrate the significant losses that one dishonest employee can impose on a company
that has weak internal controls.
Case 3.5 Goodner Brothers, Inc. 155 32. 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 clearly 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‘ 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 assume for the inventory theft losses? If they choose, instructors can explicitly raise the question of whether professional
156 Case 3.6 Troberg Stores 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)
33. (a)
(b) (c) (d)
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 neglected to routinely use prenumbered accounting documents for all transactions and to process transactions on a timely basis. A weak control environment prevailed in the Huntington sales office.
34. (a)
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.
(b)
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 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
(c)
(d)
Case 3.6 Troberg Stores 157 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. 35. 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: The second field work standard requires auditors to 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 revelation makes one question whether the auditors obtained a ―sufficient understanding‖ of Goodner‘s internal controls, as mandated by the second fieldwork standard. 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
158 Case 3.6 Troberg Stores 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.
CASE 3.6
TROBERG STORES
Synopsis Employee theft ranks among the most serious threats to the profitability of retail businesses. Retailers that fail to develop effective internal controls to curb employee theft face the risk of being driven out of business by opportunistic employees. Potential losses stemming from lawsuits filed by employees and former employees also pose a serious threat to the financial health of retailers and other types of businesses as well. Again, businesses should consider implementing an effective network of internal controls to anticipate and minimize this risk. This case focuses on a recent series of events involving a small grocery chain that suffered a rash of employee thefts. Ironically, a federal court later required the business to make a sizable payment to the former employee implicated in those thefts. The court imposed the judgment on the business because its management violated the suspect‘s civil rights during the investigation of the thefts.
Case 3.6 Troberg Stores 159
154 Troberg Stores--Key Facts 1. Troberg‘s Sixth Street store experienced a rash of cash shortages during 1994 and early 1995. 2. Kirby Jacobson, a longtime employee and assistant store manager, was suspected of the thefts because he was the only employee with access to cash on each occasion. 3. The May 1995 cash shortage, unlike the previous shortages, could be traced to a specific cash register and a specific time frame. 4. A police detective called in to investigate the May 1995 cash shortage decided to administer polygraph examinations to Kirby and Violet Rahal, one of the store‘s cashiers. 5. Kirby‘s polygraph results suggested that he had stolen the cash. 6. Troberg‘s management demoted Kirby to stocker after receiving the polygraph results. 7. After his demotion, Kirby found his work environment intolerable and soon resigned. 8. Two years following his resignation, Kirby filed a civil lawsuit against Troberg Stores for violating his civil rights under the Employee Polygraph Protection Act (EPPA).
160 Case 3.6 Troberg Stores
9. Troberg Stores was forced to pay Kirby $40,000 in damages for failing to comply with the requirements of the EPPA.
Instructional Objectives 1. To illustrate the importance of business owners and managers being familiar with state and federal statutes that may impact their organization. 2. To demonstrate to students that employee theft is an important internal control issue for retail businesses. 3. To discuss internal control activities intended to minimize employee theft in a retail business. 4. To emphasize the importance of ―compensating controls‖ for a small business when proper segregation of key functional responsibilities is not feasible. 5. To demonstrate to students that internal control and ethics issues are often closely related.
Suggestions for Use This case focuses on internal control issues, particularly internal control issues relevant to small businesses. Consequently, this case is well suited to be discussed in connection with internal control
Case 3.6 Troberg Stores 161 topics in an auditing or other accounting course. This case can be used either to introduce students to internal control topics or to reinforce students‘ understanding of basic control concepts by providing them with a ―real-world‖ context in which control issues were paramount. The case involves two sets of internal control issues. 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, the neighborhood grocery store. The second set of control issues woven into this case are not as obvious and typically not dealt with extensively in textbook discussions of internal control. These issues involve the need for a business‘s owners and managers to be familiar with all applicable laws and regulations that may impact the business. Lack of such awareness can pose serious control risks for a business. 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 segregation of key functional responsibilities. Nevertheless, small businesses can implement compensating controls to mitigate these internal control weaknesses, as discussed in the solution to case question #3. Finally, this case provides an opportunity for instructors to raise important ethical issues that are 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. Federal law has largely answered this question regarding the use of polygraphs to investigate employee theft, as discussed in this case. But there are numerous other control activities that, although legal and effective, may be seen by some as infringing on the privacy and/or civil rights of the employees and customers of businesses.
Suggested Solutions to Case Questions 1. Professional auditing standards indicate that an entity‘s internal control process should be designed to achieve objectives in the following three categories: reliability of financial reporting, effectiveness and efficiency of operations, and compliance with applicable laws and regulations (AU 314.41). A truism often heard in legal circles is that ―ignorance of the law is not a valid defense.‖ Thus, it is very important that an entity‘s internal control process address the need to comply with all relevant state and federal statutes. 2. Listed next are examples of control activities that students might observe at a checkout stand of a grocery store. (Recognize that the control activities observed by students may vary considerably as a function of the size and sophistication of the grocery stores they visit.) For most of these activities, the control objective is to prevent or minimize losses of cash and/or inventory due to theft, employee mistakes, and related factors. a. b. c.
Cash registers should have locked-in totals to prevent manipulation of cash receipts. Cashiers should obtain appropriate documentation (driver‘s license, check cashing card, etc.) before accepting a customer check in payment for a purchase. Cash registers should never be left unattended (when a cash till is in a register).
162 Case 3.6 Troberg Stores d. e. f. g. h.
Cash registers should not open unless customer purchases have been rung up. Voided transactions and other corrections should require the approval of a manager. Cashiers should be assigned exclusive responsibility and physical control over their own cash till. Restrictive endorsement of checks should be required immediately upon receipt. Manufacturers‘ coupons should be canceled when presented.
3. Within each transaction cycle of a business, the functions of authorizing transactions, recording transactions, and custodianship of assets should generally be assigned to different individuals. For example, segregating the authorization and record keeping functions generally prevents someone from authorizing a fictitious or illegal transaction and then concealing it by making the necessary entries in the accounting records. Separating record keeping and physical custody of assets is designed to prevent someone with custodial responsibilities from absconding with assets and then concealing the theft with fictitious entries in the accounting records. Small businesses can establish ―compensating controls‖ to mitigate the problems posed by limited resources available for control purposes. These controls typically require the active participation of the given business‘s owner in the entity‘s operations and control functions. For example, the owner of a small business may insist on performing the monthly bank reconciliation. Another simple, obvious, but yet effective compensating control is the active involvement of a business‘s owner in the entity‘s day-to-day operations. Employees are less likely to ―rip off‖ a business when the owner is ―lurking around‖ the premises. 4. The most 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. Falsely 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. Certainly, ethical considerations are important factors for businesses to weigh when developing internal control objectives, policies, and procedures. A commonly shared belief of most businesspeople is that entities that have a strong set of ethical virtues as a part of their culture will be rewarded by the marketplace. Quite often, ethical and legal considerations are so closely intertwined that they cannot be separated. For example, as just noted, a company that falsely accuses an employee of theft may not only be guilty of unethical conduct but also be held accountable for violating the employee‘s civil rights. 5. Students will have differing opinions regarding this question, which addresses the rights of the individual versus the rights of society. Instructors should also recognize that students may have very strong convictions regarding this issue. It is important to allow students to express their personal opinions about such sensitive issues. It is just as important that students appreciate, respect, and quietly listen to the opinions of their classmates, opinions that may be diametrically opposed to their own beliefs. Following are several points that may be raised by students in responding to this question:
Case 4.1 Creve Couer Pizza, Inc.
163
Polygraph examination results are not admissible in court. Polygraph examinations have been found to have a modest percentage of ―false positive" results. Some individuals have an ability to consistently ―outwit‖ a polygraph test. The EPPA was enacted by Congress because many employers were abusing polygraph tests. The EPPA includes the ―ongoing investigation exemption‖ for the benefit of employers. Employees suspected of malfeasance can insist on taking a polygraph test to ―clear their name.‖ Following are a few examples of other federal statutes that have potential control implications for retail businesses: Foreign Corrupt Practices Act Americans with Disabilities Act (ADA) Occupational Safety and Health Act (OSHA) Age Discrimination in Employment Act Family and Medical Leave Act Equal Pay Act
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
164 Case 4.1 Creve Couer Pizza, Inc. 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.
159 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 forty 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 federal 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.
Case 4.1 Creve Couer Pizza, Inc.
165
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--Rule 301 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. 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
166 Case 4.1 Creve Couer Pizza, Inc. 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 under-report 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 them to develop or "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" the client confidentiality 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.
b.
c.
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. 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. Client: A client of a medical doctor, attorney, or accountant places a high level of 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.
Case 4.2 F&C International, Inc. 167 d.
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.
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 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.
168 Case 4.2 F&C International, Inc.
163 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 period-ending inventories. 3. F&C‘s officers used the firm‘s misrepresented financial statements to sell equity securities and obtain significant bank loans. 36. 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 fifteen 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.
Case 4.2 F&C International, Inc. 169
Instructional Objectives 37. To confirm the critical role of corporate accountants in the financial reporting domain and the SEC‘s recognition of the importance of that role. 38. 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. 39. To demonstrate the adverse consequences that corporate accountants may face if they fail to respond appropriately to ethical crises they encounter.
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. When faced with an ethical dilemma, individuals often fail to reach out to close friends and associates to help them resolve the crisis. 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-this-problem 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 case question two 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) now requires a public company‘s ―principal executive
170 Case 4.2 F&C International, Inc. 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 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
Case 4.2 F&C International, Inc. 171 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. 40. 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 at least minimally 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 that 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. 41. 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 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.] 42. 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.
CASE 4.3
Case 4.3 Suzette Washington, Accounting Major 172
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.
168
Suzette Washington, Accounting Major--Key Facts 1. When Paula told Suzette about the rumored theft ring, she insisted that Suzette not repeat any of the information since it was only a rumor.
173 Case 4.3 Suzette Washington, Accounting Major
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.
Case 4.3 Suzette Washington, Accounting Major 174
2. To require students to analyze this ethical dilemma and to indicate how they would have responded to it personally. 3. To discuss control activities intended to prevent employee theft in a retail business.
Suggestions for Use The cases involving ethics in this text focus almost exclusively on situations in which accountants (auditors) are faced with an ethical dilemma. However, 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 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, 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 allows them to see that ethical dilemmas in their personal lives often have analogues in their professional work roles.
175 Case 4.3 Suzette Washington, Accounting Major
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.
c.
d.
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 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, and may have, developed a comprehensive strategy for dealing with this problem. For example, a meeting of departmental managers may have been appropriate 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.
CASE 4.4
176 Case 4.4 Oak Industries, Inc.
OAK INDUSTRIES, INC.
Synopsis Private accountants are frequently faced with ethical dilemmas in their professional careers. In this case, the controller of Oak Industries had to choose between violating his professional responsibilities and losing his job by refusing to cooperate with his superiors. The executives of Oak Industries pressured the controller to participate in an earnings manipulation scheme that initially involved understating the company‘s net income by establishing ―rainy day reserves.‖ When Oak encountered financial difficulties, the executives instructed the controller to reverse those reserves and ultimately to significantly understate several major expense items. The controller challenged his superiors‘ instructions to misrepresent Oak‘s financial data. However, when the executives rebuffed him, he acquiesced and became a central figure in a fraudulent scheme to distort Oak‘s financial statements. Oak‘s controller also misled the company‘s independent audit firm and his former employer, Arthur Andersen. For example, the controller signed a false letter of representations addressed to Arthur Andersen and failed to prevent misleading financial schedules from being forwarded to members of the audit engagement team. An SEC enforcement release harshly criticized the controller‘s conduct. In that release, the SEC noted that following the orders of one‘s superiors, that is, behaving as a corporate ―good soldier,‖ is not a valid defense for involvement in a fraudulent accounting scheme.
172 Oak Industries, Inc.--Key Facts 1. Oak Industries achieved record sales and profits each year from 1978 through 1981.
Case 4.4 Oak Industries, Inc. 177 2. In 1980, company executives established "rainy day reserves" that could be reversed in future years when the company‘s actual earnings were disappointing. 3. Oak‘s executives instructed the company‘s controller to begin reversing the rainy day reserves in 1982 when the company encountered serious financial difficulties. 4. Oak‘s controller participated in the fraudulent earnings manipulation scheme, although he initially recommended to his superiors that the company‘s actual operating results be reported. 5. The controller was an experienced CPA who had worked several years with Oak‘s audit firm, Arthur Andersen. 6. The controller allowed the company‘s independent auditors to be given misleading financial schedules and signed a false letter of representations addressed to the audit firm. 43. In censuring Oak‘s controller, the SEC noted that following the orders of one‘s superiors, that
is, acting as a corporate ―good soldier,‖ is not a valid justification for becoming involved in a fraudulent accounting scheme.
Instructional Objectives 1. To demonstrate that corporate executives may occasionally understate revenues and overstate
178 Case 4.4 Oak Industries, Inc. expenses in an effort to ―manage‖ their firms‘ earnings. 2. To illustrate the pressure that corporate executives may sometimes impose on corporate accountants to misrepresent a company‘s financial condition and operating results. 3. To demonstrate the high ethical standards of conduct to which the SEC holds corporate accountants.
Suggestions for Use This case involves intentional errors introduced into a company‘s allowances for inventory obsolescence and uncollectible receivables and thus could be integrated with coverage of substantive tests applied to those accounts. The key ethical issues in this case revolve around a corporate accountant who was a former employee of his company‘s audit firm. The case demonstrates that honest individuals who are aware of their professional responsibilities may eventually ―cave in‖ to pressure applied by their superiors to misrepresent an entity‘s financial data. I believe that it is important for instructors to point out to students that they may face such pressure during their careers, in public or private accounting, and, consequently, should have a strategy for coping with it. A unique aspect of this case is that Oak‘s executives initially manipulated their company‘s financial statements by understating revenues and by overstating expenses. Students need to be aware that corporate executives sometimes have an incentive to understate their firm‘s net income and that auditors should take this possibility into consideration when designing their audits.
Suggested Solutions to Case Questions 1. Yes, it is unethical for a company to intentionally understate earnings. Third-party financial statement users who make important economic decisions based upon publicly available financial data have a right to expect companies to honestly report their financial condition and operating results. ―Earnings management‖ schemes that deliberately distort a company‘s key financial trends complicate users‘ efforts to accurately analyze the firm‘s financial data and may cause them to make sub-optimal economic decisions. 2. Auditors are required to plan and perform an audit to obtain reasonable assurance that the client‘s financial statements are free of material misstatements. Such misstatements include overstatements and understatements of both revenues and expenses, thus, auditors should be concerned with each of these items. Nevertheless, auditors are clearly more concerned with the possibility that a company‘s revenues are overstated rather than understated and focus more attention on the likelihood that the company‘s expenses are understated rather than overstated. Why? Because a company‘s executives and employees are much more prone to overstate revenues and understate expenses. Additionally, although misrepresentations, revenue understatements and expense overstatements result in financial statements that are less impressive than they would be otherwise. As a result, the decisions that external parties make based upon those financial statements are likely to be biased in a conservative direction. For example, such misrepresentations are likely to cause a lender to not grant a loan
Case 4.4 Oak Industries, Inc. 179 requested by the given company. Probably the most useful strategy for uncovering understatements of revenues and overstatements of expenses is to identify those circumstances when a client may be particularly prone to introduce such errors into its financial records. For example, a company that has easily surpassed key earnings and revenue targets may be inclined to ―stash away‖ some rainy day reserves, similar to Oak Industries. Being aware of situations that may predispose clients to be excessively conservative in their accounting decisions will make it much easier to develop audit plans to uncover such decisions. Analytical procedures are audit techniques particularly useful in uncovering misstatements of revenues and expenses. For example, studying the trend of a company‘s gross profit ratio may reveal that a company‘s cost of goods sold seems to be excessive in a given year. Likewise, a longitudinal (horizontal) examination of a company‘s bad debt expense to sales ratio may reveal that bad debts are disproportionately high (or low) in a given year. In either case, auditors would investigate various plausible hypotheses that would account for the unexpected variance from the client‘s norm. Typically, auditors would begin by inquiring of client management regarding the reason or reasons for a given variance. If management‘s explanation is implausible, the auditor‘s scope of testing for the given item would likely be expanded. Besides financial ratios, more sophisticated statistical techniques, such as multiple regression, can be used to identify potential misstatements of revenues and expenses. Independent variables used in regression models to predict current year sales and related operating expenses, for example, might include operating statistics, such as number of units sold and number of sales presentations made during a given period by a company‘s sales staff. 3. Clearly, the controller should have refused to comply with the demands of the executives. Probably the best course of action would have been for the controller to warn the executives that he would report any fraudulent action on their part to the company‘s board of directors, and if necessary, to the SEC. This decision would have resulted in the controller upholding his professional responsibilities as a CPA. Although he may have lost his job, his reputation would have been intact. Most important, this course of action would have prevented innocent parties, such as potential Oak investors and creditors, from being harmed by the fraudulent scheme. 4. When interacting with independent auditors, a company‘s controller and its other accounting employees have a responsibility to act in the "public interest." As professionals, these individuals have an obligation to ensure that financial data provided to the public, for whatever use, are materially accurate. One facet of this obligation is responding fully and honestly to the inquiries of independent auditors. No, a corporate accountant‘s responsibility to be candid with independent auditors does not conflict with his or her other job-related responsibilities. Granted, in isolated cases, a corporate accountant may be pressured by his or her superiors to misrepresent a company‘s financial data and/or to be deceitful to the company‘s auditors. However, misrepresenting their company‘s financial data is not a valid ―responsibility‖ of corporate accountants. 5. The SEC and other regulatory bodies should hold all corporate accountants to the same high standard of conduct, regardless of whether they are CPAs. All corporate accountants have a professional responsibility to act with honesty and integrity, including resisting pressure from superiors to misrepresent their firms‘ financial data.
180 Case 4.8 Jack Bass, Accounting Professor
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.
Case 4.8 Jack Bass, Accounting Professor 181 176 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 over the next two years. 7. 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.
182 Case 4.8 Jack Bass, Accounting Professor
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 a set of 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 and David Quinn cases. The question of whether and/or when it is proper to ―tattle‖ on a professional colleague is common to those three cases, although the context in which that issue arises is very different across 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‖ 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. 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 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.
Case 4.8 Jack Bass, Accounting Professor 183 2. In ―Suggestions for Use,‖ I recommended covering this case simultaneously with the Leigh Ann Walker and David Quinn cases. 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 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. 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 that Wiley did not report the incident, then there is certainly a much stronger argument that she had a responsibility to report the matter to the OMP. If Sally is not aware of whether or not Wiley reported the incident, then disclosing it to the OMP would appear to be somewhat petty, particularly 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.
CASE 4.6
ARVEL SMART, ACCOUNTING MAJOR
184 Case 4.8 Jack Bass, Accounting Professor
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 accounting 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 4 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 ultimately intended to accept the offer for a permanent position that he had received as a result of his first internship.
180 Arvel Smart, Accounting Major--Key Facts 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.
Case 4.8 Jack Bass, Accounting Professor 185 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 4 practice office in Kansas City. 4. At the conclusion of that internship, Arvel was offered a permanent position with the Big 4 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 4 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 4 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 4 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.
186 Case 4.8 Jack Bass, Accounting Professor
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 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 had already accepted an offer for a permanent position. 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 this 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 4 firm from which he had an outstanding job offer.
CASE 4.7
Case 4.8 Jack Bass, Accounting Professor 187
DAVID QUINN, TAX ACCOUNTANT
Synopsis Debbie Woodruff and David Quinn met in a section of introductory financial accounting at the large public university they each attended. Although the two accounting majors had very different, if not conflicting, personalities, they established a tenuous friendship and became study partners throughout college. The shy but hard-working Debbie breezed through her college career with a 3.9 accounting GPA, while the brash and outgoing David managed to post a 3.2 GPA in his accounting courses, thanks largely to extensive tutoring by Debbie. When they graduated, Debbie accepted an entry-level position on the audit staff of a Big 8 accounting firm, while David accepted a similar position on the tax staff of the same practice office of that firm. Debbie would eventually leave the firm and obtain a doctorate in accounting. After accumulating an impressive publication record, Debbie returned to her alma mater as an accounting professor. David, on the other hand, remained with the Big 8 firm and eventually became the managing partner of the practice office that he and Debbie had joined after completing college. Each fall, David and Debbie met for lunch when he and a group of his subordinates came to campus to recruit accounting majors. The two accountants‘ friendship survived for three decades despite an ―ugly‖ episode that took place during the second year of their employment with the Big 8 firm. Over lunch one day, David and Debbie had a nasty spat over an issue involving client confidentiality. This case focuses principally upon that important ethical issue, namely, the responsibility of public accountants, both tax practitioners and auditors, to maintain the confidentiality of client information that they acquire during the course of a professional engagement.
183 David Quinn, Tax Accountant--Key Facts 1.
Debbie Woodruff and David Quinn met in a section of introductory financial accounting at a large public university.
188 Case 4.8 Jack Bass, Accounting Professor
2.
Debbie was somewhat shy, while David was brash and outgoing; nevertheless, the two accounting majors became friends and study partners during their college careers.
3.
When they graduated from college, Debbie and David accepted entry-level positions with a nearby practice office of a major accounting firm.
4.
Debbie served on the office‘s audit staff, while David joined the office‘s tax staff.
5.
During the second year of their employment with the firm, Debbie and David met for lunch with three other tax professionals of another accounting firm.
6.
During the course of this lunch, David discussed confidential information regarding one of his clients with the other tax professionals.
7.
When Debbie told David that he should not discuss such matters over lunch, an angry confrontation ensued between the two friends.
8.
The two friends later made up and continued their relationship throughout their respective careers.
9.
Debbie eventually left the accounting firm, earned a doctorate in accounting, and returned to her alma mater as an accounting professor; David remained with the firm and subsequently became the managing partner of the practice office that he and Debbie had joined following graduation.
Instructional Objectives
Case 4.8 Jack Bass, Accounting Professor 189 1.
To demonstrate the importance of maintaining the confidentiality of important client information.
2.
To examine the responsibilities of accountants when they observe colleagues violating or potentially violating the profession‘s ethical standards.
3.
To provide students with some perspective on how the career paths of accountants may develop.
Suggestions for Use Maintaining the confidentiality of client information is a critically important responsibility of every profession, including public accounting. This brief case documents that even lower-level accounting professionals need to be aware of the obligations the client confidentiality rule imposes upon them. You might consider using a role-playing exercise to recreate, and examine the dynamics of, the ―spat‖ concerning client confidentiality that took place between Debbie and David in the restaurant. A secondary issue in this case that often triggers considerable discussion is embedded in the third case question, namely, did Debbie have a responsibility to determine whether her practice office‘s tax department was providing appropriate advice to the given tax client. Most students typically suggest that Debbie did not have a responsibility to ―poke her nose‖ in the business of her practice office‘s tax department.
Suggested Solutions to Case Questions 1. Rule 301 of the AICPA Code of Professional Conduct states that ―A member in public practice shall not disclose any confidential client information without the specific consent of the client.‖ However, the code does not expressly define what constitutes ―confidential client information.‖ Given the absence of any such definition, public accountants would be well served to apply a conservative interpretation to that phrase. In other words, public accountants should simply choose not to discuss any client information with third parties or communicate such information in such a way that it might be intercepted by a third party. In my view, David‘s very vocal dialogue regarding his tax client certainly constituted a violation of the profession‘s client confidentiality standard. First, he was communicating confidential information regarding his client directly to the three tax professionals employed by another firm. Second, he was communicating that information in such a manner that it could easily have been intercepted by any of a number of third parties within earshot of him. 2. Of course, students will have different views on how Debbie should have dealt with this matter. In my view, she handled the problematic situation very well. She immediately recognized that a colleague of hers was engaging in unprofessional behavior by discussing confidential client information. Next, she attempted to delicately divert his attention to a different subject. When that tactic failed, she ―took the bull by the horns‖ and simply told David that his behavior was inappropriate. What more could she have done?
190 Case 4.8 Jack Bass, Accounting Professor One strategy to use in responding to this question is to ask students to assume that Debbie was actually Danny. Ask them how they believe that change would have affected the interpersonal dynamics of the restaurant ―spat‖? 3. Debbie could easily have justified reporting David‘s conduct to a superior. In fact, one could argue that a strict interpretation or application of the profession‘s ethical standards dictated that Debbie report David‘s imprudent conduct. In reality, Debbie did not report David‘s conduct, which, I would suggest, is what most individuals would do under similar circumstances. Note: As a point of information, one of my insightful students suggested that, quite possibly, the embarrassing episode in the restaurant made David aware of his responsibilities and prompted him to behave more professionally in the future. Who knows? Maybe Debbie‘s intervention contributed to David‘s successful career and to his eventual promotion to office managing partner. The question of whether Debbie had a responsibility to determine whether her office‘s tax unit was providing appropriate professional advice typically prompts lively debate among students. No doubt, if Debbie was certain that her firm‘s tax department was providing improper advice to its clients, she had a responsibility to follow up on the matter. However, Debbie was not a tax professional and did not have the necessary expertise to evaluate the quality or propriety of the decisions being made by her office‘s tax department. In my view, even after the episode involving David in the restaurant it would have been reasonable for her to assume that the partners, managers, and other supervisory personnel in her office‘s tax department were providing competent professional services to their clients.
CASE 4.8
JACK BASS, ACCOUNTING PROFESSOR
Synopsis Jack Bass completed his PhD in accounting at a Big 10 school and then accepted a faculty position with a large private university on the West Coast. During his first semester at his new school, Jack had to deal with an unpleasant cheating scandal in the large ―megasection‖ of introductory financial accounting that he had been assigned to teach. Making matters even more unpleasant was the fact that one of the students involved in that scandal was D.R. Street, III, a student who Jack had gotten to know well since he often came by his office. Unlike most of the
Case 4.8 Jack Bass, Accounting Professor 191 ethics-related cases in this text, this short case allows students to discuss important ethical issues in a context with which they are very familiar.
187 Jack Bass, Accounting Professor--Key Facts 1. Jack Bass decided to pursue a career in academics because he did not enjoy public accounting; after completing his PhD, Jack‘s first faculty position was with a large private university on the West Coast. 2.
One of the classes Jack taught was a large ―megasection‖ of introductory financial accounting.
3. One of the megasection students who Jack got to know well during his first semester was D.R. Street, III, a student who frequently stopped by his office to talk. 4. After the first exam in the megasection was graded and returned to the students, approximately thirty students reported that they had not been given credit for one or more correct answers on their scantrons. 5. Jack suspected that some of the these students had actually changed answers on their scantrons, but he had no way of corroborating that suspicion since neither he nor his teaching assistants had copied the scantrons before returning them to the students.
192 Case 4.8 Jack Bass, Accounting Professor 6. Prior to returning the graded scantrons for the second exam, Jack instructed his teaching assistants to copy the scantrons. 7. After returning the graded scantrons for the second exam, approximately 35 students returned them and indicated that one or more correct answers had been graded incorrectly; 15 of these students, including D.R. Street, had changed incorrect answers to correct answers. 8. After consulting with his departmental chair, Jack decided to require each student involved in the teaching scandal to drop his course with a WP (withdrawal while passing); a temporary sanction letter would also be placed in each student‘s file. 9. With the exception of D.R. Street, each student accepted the proposed sanction; D.R. refused to accept the sanction, insisting that he had not intended to cheat when he changed his scantron. 10. After D.R.‘s father spoke with the university chancellor, Jack agreed to allow D.R. to drop the class with a WP without having a sanction letter placed in his file.
Instructional Objectives 1. To provide students with an opportunity to examine and discuss important ethical issues in a context with which they are very familiar. 2. To provide students with an opportunity to consider the factors that should be considered in meting out punishment for unethical behavior. 3.
To identify alternative career paths for public accountants.
Suggestions for Use This case could be used in a political science, marketing, anatomy, or accounting course since the central issues are not discipline-specific. If you plan to discuss several ethics-based cases in your course, you might consider using this case as the ―lead-off‖ case since it is simple to digest and analyze. The first case question dealing with entrapment often triggers considerable debate, if not
Case 4.8 Jack Bass, Accounting Professor 193 controversy, among students. You will likely find that some of your students believe that any form of entrapment is inappropriate in an academic setting, while others viscerally disagree. On the other hand, in responding to the final question, you will probably find that every one of your students believes that the special deal ―cut‖ for D.R. Street was not fair. Although that question may not generate the differences of opinion that make for a hearty discussion, it raises a ―real-world‖ variable that commonly influences the resolution of ethical dilemmas, namely, ―power‖ or social influence.
Suggested Solutions to Case Questions 1. Most students express the opinion that Jack Bass did not have a responsibility to tell his students that he had copied the scantrons for the second exam. To fuel more discussion of this general issue, consider developing more ―borderline‖ entrapment methods that professors could use. For example, would it be inappropriate for a professor to assign a topic for a research paper when he or she knows that a ―perfect‖ paper on that given topic is available in one of the online ―pay-for-term-papers‖ websites? At some point in the discussion of this case, expect students to raise the issue of ―honor systems‖ that are used at some universities. You might also be prepared to circulate a copy of your own school‘s honor code and have students debate the rigor and necessity of that code. 2. One possibility was for Jack Bass and/or the Dean of Students to simply ask the potential repeat offenders whether they had also changed answers on the first exam. Those students who responded affirmatively could have been dealt with more harshly. Of course, it is naïve, I suppose, to expect students in this set of circumstances to admit that they were repeat offenders! You might ask your students whether the concept of ―innocent until proven guilty‖ should have been applied to the potential repeat offenders. Some students express the view that if an individual was proven to have cheated on the second exam, it would be fair and appropriate to assume that they cheated on the first exam as well. 3. What I try to accomplish with this question and the previous one is to trigger discussion of the general factors that should be considered in punishing unethical conduct across a wide array of contexts. You will likely have students in your class who have had a recent philosophy or ethics course. Such students are typically more than happy to provide ―expert testimony‖ on matters such as the one posed by this question. For me, personally, the extent of cheating activity is not particularly relevant. Once a student has admitted cheating or once it has been proven that he or she cheated, I am generally not overly concerned by the ―volume‖ of the cheating activity. 4. As noted earlier, most students will express the opinion that it was not fair or appropriate for D.R. to receive preferential or, at least, differential treatment. However, the key issue raised by this question is how to respond to a situation in which the powers-that-be suggest that you resolve an ethical dilemma in a manner that you believe is inappropriate or, at a minimum, somewhat distasteful. Students need to recognize that they may face many comparable scenarios over their careers. Consider asking your students to identify the alternative courses of action that were
194 Case 4.9 Thomas Forehand, CPA available to Jack once the Chancellor made his request. Post the alternatives on the chalkboard or overhead, discuss them, and then ask students to vote for their preferred alternative.
CASE 4.9
THOMAS FOREHAND, CPA
Synopsis CPAs in public practice often find themselves facing challenging, if not troubling, ethical dilemmas. In this case, students have an opportunity to ―step into the shoes‖ of Thomas Forehand, the owner of a small accounting firm. After spending several years working in a major metropolitan area, Forehand and his wife decided that they wanted a different lifestyle for themselves and their children and so he purchased a small accounting practice far removed from the hustle and bustle of the large city. Unfortunately, within a short time, a recession cost Forehand many of his clients and forced him to lay off two of his six employees. Desperate for new clients, Forehand had to decide whether to accept an unusual but lucrative engagement proposed by a new client who suddenly appeared in his office one day. Eventually, Forehand learned that the too-good-to-be-true engagement was just that, too good to be true. Nevertheless, Forehand capitulated, accepted the engagement, and became involved in a criminal enterprise, a series of decisions that would cost him his practice and much more.
Case 4.9 Thomas Forehand, CPA 195
191 Thomas Forehand, CPA--Key Facts 1. Thomas Forehand, who had spent his entire professional career working in a major metropolitan area, decided to purchase an accounting practice in a small suburb because he and his wife wanted a different lifestyle. 2. An economic recession soon cost Forehand one-third of his clients and forced him to lay off two of his six employees. 3. During the midst of the recession, a prospective client, John Jones, approached Forehand; Jones was allegedly searching for an accounting firm for a new business that he intended to create with funds inherited from his grandmother. 4. Shortly after choosing Forehand to serve as his accountant, Jones told Forehand that the funds he had inherited from his grandmother were in the form of cash (that is, currency being held outside of the banking system). 5. Jones then outlined a plan involving Forehand that would allow him to use the cash inherited from his grandmother to finance his new business; Jones‘ intent was to prevent the IRS and other taxing agencies from discovering that he had inherited a substantial amount of cash. 6. Jones‘ plan involved Forehand loaning him $120,000, which Jones would repay over a twelvemonth period from the monthly cash flows of his business. 7. Forehand would earn $12,000 in interest on the loan and a $15,000 ―loan origination fee‖; the loan agreement indicated that the new business‘s assets would serve as the collateral for the loan, but, in fact, the actual collateral would be a $120,000 bundle of $100 bills. 8. After considerable goading from Jones and after having been offered a $5,000 upfront ―bonus,‖ Forehand agreed to cooperate with Jones‘ plan. 9.
In fact, Jones‘ ―business‖ involved the marketing of illicit drugs.
10. Forehand was eventually arrested by FBI agents and charged with conspiracy to commit money laundering and aiding and abetting money laundering; after being convicted of those charges, Forehand received a six-year prison sentence.
196 Case 5.1 Cardillo Travel Systems, Inc.
Instructional Objectives 1. To introduce students to the money laundering phenomenon that diminishes the productivity of the U.S. and worldwide economies and has important implications for current and future generations of business professionals, including accounting practitioners. 2.
To introduce students to the nature and importance of client acceptance decisions.
3. To require students to identify and discuss strategies that accounting professionals can use to avoid becoming entangled in situations that pose ethical and moral hazards.
Suggestions for Use This case is ideally suited for a series of in-class role-playing exercises. Require students to read and study the case before covering it in class. During the class session in which the case is presented, assign the roles of Thomas Forehand and John Jones to two students. Have these students engage in the face-to-face dialogue that takes place between Forehand and Jones during Acts 1, 2, and 3. (Notes: Act 1 presents the initial meeting between Forehand and Jones. In this meeting, the principal interaction revolves around Forehand‘s effort to ―sell‖ his firm to Jones, a prospective client. In Act 2, during the second meeting between the two men, Forehand eventually goads Jones into discussing the nature of the services that he wants Forehand to provide. Finally, in Act 3, Jones reveals the true—and fraudulent--nature of the ―services‖ that he needs.) Here is a ―twist‖ on the role-playing exercise that you might consider using for this case. During each ―act‖ of the case, assign different students to assume the Thomas Forehand and John Jones roles. As you move through Acts 1 through 3, require each successive Forehand and Jones actor to ―live with‖ the decisions made by the individuals who occupied their roles in the prior acts. This requirement can create some degree of discomfort for students as they are forced to sustain a pattern of behavior with which they do not necessarily agree. This strategy forces students to view the developing dilemma faced by Thomas Forehand from their peers‘ predispositions and biases as well as their own. To reduce the stage fright that interferes with role-playing exercises, consider placing your students into small groups. Have the members of each group simultaneously carry out the roleplaying exercise. If you choose this option, recognize that you will have to monitor the progress of the various groups, which means that you will probably not want to create more than three or four groups. If the role-playing exercise is performed in small groups, consider requiring individual group members to swap roles as they proceed through the case.
Case 5.1 Cardillo Travel Systems, Inc. 197 Suggested Solutions to Case Questions 1. The AICPA‘s Statements on Quality Control Standards are the professional standards most relevant to client acceptance decisions. In fact, one of the seven elements of ―quality control‖ for a public accounting practice is ―Acceptance and Continuance of Client Relationships and Specific Engagements‖ (Statement on Quality Control Standards No. 7, ―A Firm‘s System of Quality Control.‖) SQCS No. 7 identifies three general principles or strategies that accounting firms should consider in arriving at client acceptance decisions. First, a firm should closely scrutinize the integrity of the prospective client and the related ―risks associated with providing professional services in particular circumstances‖ (paragraph 27a). Second, a firm should consider accepting only those engagements for which it has the ―capabilities and resources to do so‖ (paragraph 27b). Third, a firm should determine whether it can comply with all ―legal and ethical requirements‖ relevant to a given prospective engagement (paragraph 27c). Listed next are examples of client acceptance policies and procedures that accounting firms should consider adopting. Arguably, the most important of these are the establishment of screening procedures to identify ―problem‖ clients and engagements. a. Accounting firms should use available resources to identify those prospective clients that are particularly high risk and/or problematic. For example, accounting firms should attempt to determine whether a given prospective client has a history of improper or illegal activities, whether the entity has experienced frequent turnover in key management positions, and whether the entity has a history of frequently changing its accounting firm. b. If a potential client is a member of a professional or trade organization, the accounting firm can contact that organization to determine whether complaints or other allegations have been filed against the given business or individual. (Individual offices of the Better Business Bureau maintain a database of complaints filed by consumers against local businesses.) c. Accounting firms should consider whether a potential client poses any conflict-of-interest or independence issues. For example, audit firms are required to avoid potential clients in which they have a direct financial interest. d. Accounting firms should not accept clients that refuse to sign an engagement letter that documents the key conditions and parameters of the engagement. e. Before accepting a potential client, an accounting firm should assess whether the client engagement will benefit the firm economically. To make this determination, the accounting firm must consider not only the tangible revenues and costs associated with the engagement, but also other intangible benefits (and costs) that may result from the engagement. For example, obtaining a prominent bank as a client may provide an accounting firm with considerable credibility and prestige in the local business community, which will likely facilitate the firm‘s future client development activities. f. Accounting firms that are considering accepting a potential audit client are required by professional auditing standards to contact the party‘s former audit firm. Among other issues, an accounting firm is required to ask the predecessor auditor whether it had any major disagreements over accounting or auditing issues with the former client. 2. Students are prone to give the ―politically correct‖ answer to questions involving ethical issues if
198 Case 5.1 Cardillo Travel Systems, Inc. they are singled out in class. For example, in this case, most students will suggest that Forehand should have immediately and strongly voiced an objection to Jones‘ plan. More ―genuine‖ responses are often obtained when students are required to role play sensitive situations such as this. You may want to direct your students to the AICPA‘s Code of Professional Conduct in responding to the issue of whether CPAs have a moral or legal responsibility to report illegal acts committed by clients or potential clients. In particular, you might instruct them to review the six ―principles‖ included in that ethical code. The preamble to those principles contains the following general comments regarding their nature: ―These Principles of the Code of Professional Conduct of the American Institute of Certified Public Accountants express the profession‘s recognition of its responsibilities to the public, to clients, and to colleagues. They guide members in the performance of their professional responsibilities and express the basic tenets of ethical and professional conduct. The Principles call for an unswerving commitment to honorable behavior, even at the sacrifice of personal advantage.‖ [ET 51.02] As a general rule, our profession‘s ethical standards do not specifically require CPAs to report illegal acts committed by clients or potential clients. However, each individual CPA who faces such a decision should likely consider the third principle invoked by the Code of Professional Conduct, namely, ―integrity.‖ Although the code does not instruct CPAs on what course of conduct they should take when they face ethical dilemmas, such as whether to report an illegal act by a client, the code does provide explicit guidance to CPAs in addressing such situations. ―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 54.04] So, the profession‘s ethical standards leave the responsibility for reporting illegal acts by clients or potential clients to the discretion of the individual practitioner. However, given this excerpt from the Code of Professional Conduct, it seems reasonable to conclude that CPAs have an obligation to report illegal acts that have serious consequences for society as a whole. Illicit drug and moneylaundering operations clearly have serious consequences for a wide range of parties. As a result, when CPAs become aware of such activities, they should likely inform the appropriate law enforcement authorities. In this particular case, the profession‘s ethical code and other standards certainly would not preclude CPAs from reporting such activities to the appropriate authorities. At some point, you will likely want to inform your students that there are certain situations in which the profession‘s ethical rules prohibit the disclosure of information obtained from a client. Rule 301 of the Code of Professional Conduct, ―Confidential Client Information,‖ generally prohibits CPAs from disclosing ―any confidential client information without the specific consent of the client.‖ Does this prohibition extend to illegal acts committed by a client? This question has arisen in many lawsuits involving CPA firms, particularly with respect to audit engagements. For example, in the notorious Fund of Funds case, a federal judge ruled that Arthur Andersen & Co. had a responsibility to violate the client confidentiality rule in order to inform an audit client that it was
Case 5.1 Cardillo Travel Systems, Inc. 199 being defrauded by another of its audit clients (The Fund of Funds, Limited v. Arthur Andersen & Co., 545 F. Supp. 1314, 1982). Also, recognize that the Private Securities Litigation Reform Act of 1995 actually imposes a legal responsibility on auditors of public companies to report illegal acts by clients in certain circumstances. (AU 317.23 of the auditing standards refers to this latter responsibility.)
3. Listed next are parties affected by Forehand‘s decision to cooperate with John Jones‘ scheme, the responsibility that Forehand had to each of those parties, and how each of these parties was affected by his misconduct. ►Thomas Forehand: Forehand had a responsibility to himself to make the proper decision and thus protect his mental and spiritual well-being and his ability to earn a livelihood from his chosen vocation. Of course, Forehand paid a high price for his transgressions, including forfeiting the ―human capital‖ he had accrued for more than a decade as a professional accountant. ►Forehand‘s family: Forehand had a responsibility to his spouse and children as their sole ―breadwinner.‖ By cooperating with Jones, Forehand undercut his family‘s economic livelihood ►John Jones: As a professional responsible for promoting the public interest, Forehand had a responsibility to warn Jones that his scheme was not only unethical but illegal as well. There is some (remote?) chance that Jones would have ―corrected the error of his ways‖ if Forehand had dealt with the matter properly. Instead, Jones was convicted of a felony and sentenced to prison. ►Forehand‘s employees: Similar to his family, Forehand had a responsibility to protect the economic interests of his employees. By engaging in a criminal act, Forehand caused his employees to be embarrassed and cost them their jobs as well. ►Accounting profession: Forehand had a responsibility not to behave in such a way that would bring discredit to his profession and the members of that profession, which is exactly what happened when he was convicted. 4. Listed next are four general strategies that should help CPAs avoid becoming drawn into unethical, immoral, and/or illegal activities. ►Have a thorough understanding of the principles, rules, and other elements of the profession‘s ethical code. Regularly review the ethical code and become very familiar with each change in the code. ►Establish a ―support group‖ that includes relatives, friends, professional colleagues, a pastor, or other trusted associates. When an important ethical question or ethical dilemma arises, discuss the matter with multiple members of your support group. Quite likely, those individuals can provide you with important insights on the given issue or dilemma that you have overlooked or downplayed. ►After having decided on a course of action, apply the two questions included in ET 54.04, namely, ―Am I doing what a person of integrity would do? Have I retained my integrity?‖ ►Consider applying one of the many ―ethical decision-making‖ models that have been developed in recent years. For example, Texas Instruments provides each of its employees with
200 Case 5.1 Cardillo Travel Systems, Inc. a business card that contains the following six-point decision-making model (L.E. Boone and D. L. Kurtz, Contemporary Business, Cincinnati: Thomson South-Western, 2005, 49): ►Does it comply with our values? ►If you do it, will you feel bad? ►How will it look in the newspaper? ►If you know it‘s wrong, don‘t do it! ►If you‘re not sure, ask. ►Keep asking until you get an answer.
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.
Case 5.1 Cardillo Travel Systems, Inc. 201
197 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 of 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.
202 Case 5.1 Cardillo Travel Systems, Inc.
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. 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.
Case 5.1 Cardillo Travel Systems, Inc. 203
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 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 AU Section 722, "Interim Financial Information," an auditor should employ primarily analytical procedures and inquiries of management when performing a review of a client's interim financial statements. Listed next are examples of specific procedures that AU 722 suggests
204 Case 5.1 Cardillo Travel Systems, Inc. auditors should consider applying when reviewing a client's interim financial statements. a. b. c. d. e.
Inquiry of client management regarding any significant changes in the entity‘s internal controls since the most recent financial statement audit. 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. Obtaining written confirmation from management regarding its primary responsibility for the material accuracy of the interim financial statements.
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. 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.
Case 5.1 Cardillo Travel Systems, Inc. 205 The third standard of fieldwork requires an auditor to obtain sufficient appropriate evidence to support his/her 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 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 AICPA‘s quality control standards 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:
206 Case 5.2 Mallon Resources Corporation 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.
CASE 5.2
MALLON RESOURCES CORPORATION
Synopsis Duane Knight was happy to receive a job offer from the CEO of Mallon Resources Corporation, a Denver-based company involved in gold mining and the oil and gas industry. The offer was for Knight to become Mallon Resources‘ treasurer and principal accounting officer. At the time, Knight, an audit manager for a Denver accounting firm, was supervising the audit of Mallon Resources‘ 1993 financial statements. When the Mallon Resources‘ CEO initially discussed the possibility of Knight joining the company, Knight did not inform his superiors and continued working on the Mallon Resources audit. However, a few days later, Knight immediately told his superiors when he received a formal job offer. Knight and his superiors jointly decided that he should dissociate himself from the Mallon Resources audit engagement. One week later, Knight formally accepted the job offer. After accepting the job offer from Mallon Resources, Knight remained an employee of Mallon Resources‘ accounting firm for approximately one month. Despite the decision that Knight should not be involved in the ongoing Mallon Resources audit, he continued to participate in that audit during his last few weeks of employment with the company‘s accounting firm. In fact, during that time, Knight worked both for the accounting firm and for Mallon Resources. Knight also continued his dual work responsibilities during the first two weeks of his official employment with Mallon Resources. Several months after Mallon Resources filed its 1993 10-K registration statement with the SEC, which included an unqualified opinion from Knight‘s former accounting firm, the SEC began investigating the dual relationship that Knight had maintained for a time with his former employer and Mallon Resources. Initially, the true nature of that relationship was not divulged to the SEC.
Case 5.2 Mallon Resources Corporation 207 When the SEC investigation revealed that Knight had, in fact, served in dual and conflicting roles with the two entities, Knight and his former accounting firm were sanctioned. Additionally, the SEC ruled that Mallon Resources‘ 10-K registration statement was invalid since the company‘s audit firm had not been independent during the course of the 1993 audit engagement. Mallon Resources then retained Price Waterhouse as its new accounting firm. Several months later, Price Waterhouse issued an unqualified opinion on Mallon Resources‘ 1993 financial statements that were included in an amended 1993 10-K filed by the company.
203 Mallon Resources Corporation--Key Facts 1. Duane Knight was serving as the audit manager on the 1993 Mallon Resources audit when he
was contacted by George Mallon regarding a possible job with Mallon Resources. 2. Although Knight concluded that his conversation with George Mallon created an ―independence problem‖ for him, he did not bring this matter to the attention of his superiors. 3. Knight promptly notified his superiors at Hein + Associates (HA) when he received a formal job offer from George Mallon; Knight was then removed from the Mallon Resources audit engagement. 4. After accepting the job offer from Mallon Resources and being removed from the audit engagement team, Knight continued to be involved in the 1993 audit of the company during his last few weeks of employment with HA. 5. During his last few weeks of employment with HA, Knight also spent time working on accounting and financial reporting matters for Mallon Resources. 6. After Knight formally became an employee of Mallon Resources, the SEC began investigating
whether he had served in dual and conflicting roles with HA and Mallon Resources during March and April 1994. 7. Initially, HA denied that Knight had worked on the 1993 Mallon Resources audit following his acceptance of George Mallon‘s job offer. 8. After learning that Knight had served in dual and conflicting roles with HA and Mallon Resources, the SEC ruled that Mallon Resources‘ 1993 10-K registration statement was deficient since HA‘s independence had been impaired during the 1993 audit. 9. Mallon Resources retained Price Waterhouse to re-audit its 1993 financial statements.
10. The SEC sanctioned Knight and HA for failing to maintain their independence during the 1993 Mallon Resources audit.
208 Case 5.2 Mallon Resources Corporation
Instructional Objectives 44. To examine an auditor‘s responsibilities when he or she is offered a job by a client. 2. To address the ethical and practice issues raised when auditors are hired by former clients to fill key accounting positions. 3. To demonstrate the implications that a lack of independence can have for auditors, their employing firms, and their clients. 4. To demonstrate the importance of auditor independence to the SEC.
Suggestions for Use Because this case demonstrates the importance of auditor independence to practicing auditors, their employers, and their clients, it could be integrated with classroom coverage of the auditor independence rules included in the AICPA Code of Professional Conduct. Alternatively, this case could be presented during discussion of regulatory issues for the auditing discipline since it clearly demonstrates the important oversight role that the SEC provides for the independent audit function. The career paths of many accountants often begin with a tour of duty with a public accounting firm followed by a stint with one of their former audit clients. For this reason, the ethical issues faced by Duane Knight in this case will likely be faced by a significant number of your students. I make this point explicitly when assigning this case to give it added ―real-world‖ significance for my students.
Suggested Solutions to Case Questions 45. ET Section 101.01.06 provides the following definitions of ―independence of mind‖ and ―independence in appearance.‖
―Independence of mind—The state of mind that permits the performance of an attest service without being affected by influences that compromise professional judgment, thereby allowing an individual to act with integrity and exercise objectivity and professional skepticism.‖
Case 5.2 Mallon Resources Corporation 209 ―Independence in appearance—The avoidance of circumstances that would cause a reasonable and informed third party, having knowledge of all relevant information, including safeguards applied, to reasonably conclude that the integrity, objectivity, or professional skepticism of a firm or a member of the attest engagement team had been compromised.‖ Why is independence the ―cornerstone‖ of the auditing profession? The need for an independent audit function stems from managers‘ and/or owners‘ incentives to be less than candid or truthful in financial reports for their organizations. If auditors do not maintain their independence, they may be swayed to overlook misrepresentations in the financial statements prepared by those managers and owners. In simple terms, if auditors are not independent, they will not add any measure of credibility to an organization‘s financial statements. 46. Following are the key violations of the profession‘s ethical code that apparently occurred in this case:
February 15
Duane Knight failed to inform his superiors that he had discussed a possible employment position with Mallon Resources. Reportedly, Knight concluded that the nature of the discussion was such that his independence was subject to question, which suggests that he should have immediately discussed the matter with his superiors. [Note: This situation is discussed in Interpretation 101-2 of the Code of Professional Conduct—see ET Section 101.] An argument could also be made that the colleague with whom Knight discussed this matter had a responsibility to inform HA‘s management when Knight failed to do so.
February 24March 28
Knight, while still employed by HA, prepared client schedules for Mallon Resources, which were then audited by HA. Knight also prepared unaudited exhibits that were later attached to Mallon Resources‘ 10-K registration statement and reviewed by HA auditors. Here, Knight placed HA in a situation in which it was auditing (or reviewing) accounting records prepared by its own personnel.
March 28
Knight, while still an HA employee, discussed the content of the MD&A section of Mallon Resources‘ 1993 annual report with the company‘s general counsel. Again, Knight was apparently serving in an employee capacity with an audit client.
March 29
Clarence Hein asked Knight to review several unresolved issues on the Mallon Resources audit. Since Knight no longer qualified as independent of Mallon Resources, he violated the profession‘s independence rule (Rule 101). Hein‘s conduct, and possibly that of Knight as well, likely violated the profession‘s integrity and objectivity rule--Rule 102. That rule reads: ―In the performance of any professional service, a member shall maintain objectivity and integrity, shall be free of conflicts of interest, and shall not knowingly misrepresent facts or subordinate his or her judgment to others.‖ On this
210 Case 5.2 Mallon Resources Corporation same date, Hein and Knight failed to disclose Knight‘s dual relationship with HA and Mallon Resources during a telephone conversation with SEC personnel, which also likely violated Rule 102. March 30
July 5
August 1
Again, Hein and Knight likely violated the profession‘s independence/integrity rules when Hein asked Knight to write an audit memo regarding the March 29 conversation with the SEC. (Hein made this request on March 30, while Knight actually submitted the memo to Hein on April 14.) Representatives of HA likely violated Rule 102 of the Code by failing to inform the SEC that Knight was involved in the Mallon Resources audit in his last few weeks of employment with HA. Knight and Hein likely violated Rule 102 of the Code by failing to accurately describe to the SEC Knight‘s involvement in the Mallon Resources audit following his acceptance of the job offer from George Mallon.
3. As pointed out in the answer to Question No. 2, there are two dimensions of auditor independence, the perception of an auditor‘s independence by third parties and the de facto independence of an auditor. It is not feasible to measure or assess an auditor‘s de facto independence since that trait refers to whether an auditor possesses the appropriate mental state of mind to behave ―independently‖ of a client. On the other hand, we can easily conclude that Knight‘s appearance of independence was jeopardized. Among the most relevant third-party observers of Knight‘s conduct in this case was the SEC, which unequivocally concluded that Knight lost his appearance of independence by serving in dual and conflicting roles during the 1993 Mallon Resources audit. By definition, if an auditor‘s appearance of independence is undermined, then the integrity of the given audit is undermined as well. 4. As a point of information, Section 206 of the Sarbanes-Oxley Act of 2002 prohibits an audit firm from providing ―audit services‖ to a company that has recently hired an employee of the audit firm to serve in a top executive or accounting position. ―It shall be unlawful for a registered public accounting firm to perform for an issuer any audit service . . . if a chief executive officer, controller, chief financial officer, chief accounting officer, or any person serving in an equivalent position for the issuer, was employed by that registered independent public accounting firm and participated in any capacity in the audit of that issuer during the 1-year period preceding the date of the initiation of the audit.‖ This restriction applies only to a limited number of circumstances, namely, to auditors of public companies (SEC registrants) who accept key positions with their former clients. This restriction will not prevent most auditors from ―changing sides‖ and accepting positions with their clients. Listed next are the potential problems that this practice poses for various parties. a) Auditors ―changing sides‖ presents a public relations problem for the auditing profession. That is, this practice diminishes the public‘s overall confidence in the auditing profession by
Case 5.3 The North Face, Inc. 211 damaging auditors‘ and audit firms‘ appearance of independence. b) The value or credibility of an audit firm‘s audit services may be diminished when one or more of its former employees accept positions with clients. For example, third parties who are aware that a given company regularly hires employees of its audit firm may begin to question whether that company‘s audit firm can maintain its independence while auditing the company. Why? Because of the ―cozy‖ relationship that likely exists between the auditors and their former colleagues who are now employed by the client. Ironically, many large accounting firms have historically made a concerted effort to place their employees with clients. Apparently, this strategy is intended to cement or strengthen the bond between the audit firm and such clients. c) Audit clients may also suffer when auditors change sides. If a company employs several of its former auditors, third parties, such as potential lenders and investors, may begin to question the credibility of the company‘s audited financial statements. Such doubts might make it more difficult or expensive for that company to raise debt and equity capital.
CASE 5.3
THE NORTH FACE, INC.
Synopsis In the winter months, you will often find college students wearing parkas, pullovers, or longsleeved t-shirts that sport the North Face label. Over the past four decades, North Face has established itself as a leading supplier of apparel for the entire spectrum of outdoors ―types.‖ North Face also markets a wide range of equipment needed by mountain climbers, whitewater daredevils, ski bums, and the like. Despite North Face‘s prominence in the two markets that it serves, the company has had an ―up and down‖ history. Various gaffes made by the many management teams that North Face has had over the years have resulted in inconsistent operating results and subjected the company‘s executives to public ridicule. During the late 1990s, a business periodical included North Face among the five ―worst-managed‖ corporations in the United States. A few years later, North Face‘s executives were red-faced once more when the Securities and Exchange Commission (SEC) revealed that the company had embellished its reported operating results. This case examines the accounting gimmicks used by North Face executives to enhance the company‘s revenues and profits. These gimmicks primarily involved violations of the revenue recognition rule for certain barter and consignment transactions arranged by the company‘s chief financial officer and vice-president of sales. Deloitte served as North Face‘s auditors during the
212 Case 5.3 The North Face, Inc. period when the company‘s operating results were manipulated. The SEC‘s investigation revealed that personnel of the prominent accounting firm altered North Face‘s audit workpapers to conceal a critical judgment error made by a Deloitte audit partner.
209 The North Face, Inc.--Key Facts 1. The new team of executives that took over control of North Face in the mid-1990s failed to meet aggressive revenue and earnings goals they had established for the company, which prompted the company‘s CFO and vice-president of sales to book a series of fraudulent sales transactions. 2. In December 1997, North Face‘s CFO negotiated a $7.8 million ―sale‖ of excess merchandise to a barter company in exchange for principally ―trade credits;‖ the CFO knew that the authoritative accounting literature generally precludes the recognition of revenue on such transactions. 3. In late 1998, North Face‘s vice-president of sales arranged two large transactions with small wholesalers, transactions recorded as consummated sales although they were actually consignments. 4. North Face‘s CFO and vice-president of sales took explicit measures to conceal the true nature of the barter and consignment transactions from members of the company‘s Deloitte audit team. 5. Richard Fiedelman served for several years as the ―advisory‖ partner for the North Face audit engagement and during early 1998 served for a brief time as the audit engagement partner. 6. During the 1997 audit, the Deloitte audit engagement partner proposed an adjustment to reverse the portion of the $7.8 million barter transaction recorded in December 1997--he realized the profit could not be recognized on a barter transaction when the seller is paid exclusively in ―trade credits.‖ 7. The Deloitte audit partner ―passed‖ on the proposed adjustment since it did not have a material effect on North Face‘s 1997 financial statements. 8. While supervising the review of North Face‘s financial statements for the first quarter of 1998, Fiedelman allowed the company to improperly recognize profit on a portion of the $7.8 million barter transaction booked in January 1998 for which North Face was paid exclusively in trade
Case 5.3 The North Face, Inc. 213 credits. 9. During the planning phase of the 1998 audit, Fiedelman convinced the new audit engagement partner that the prior year workpapers were wrong and that the previous audit partner had not concluded that it was not permissible for North Face to recognize profit on the 1997 portion of the barter transaction that involved strictly trade credits. 10. As a result of Fiedelman‘s guidance, the new audit partner did not propose an adjustment to reverse the January 1998 portion of the barter transaction that had been approved by Fiedelman. 11. Fiedelman‘s subordinates altered the 1997 workpapers to change the conclusion expressed by the 1997 audit engagement partner that North Face was not entitled to record profit on a sales transaction in which it was paid entirely in trade credits. 12. The SEC sanctioned North Face‘s CFO, the company‘s vice-president of sales, and Richard Fiedelman for their roles in the North Face fraud. Instructional Objectives 1. To demonstrate the need to document each important decision made during an audit engagement in the audit workpapers and to maintain that documentation for the benefit of future audit engagement teams. 2. To demonstrate the need for auditors to thoroughly investigate questionable or suspicious transactions and to not rely exclusively on a colleague‘s opinion regarding the proper treatment of such transactions. 3. To allow students to discuss the application of the revenue recognition rule to nonstandard sales transactions.
Suggestions for Use The importance of maintaining the integrity of audit workpapers and other audit-related documentation is the key theme of this case. Consider having your students discuss the following hypothetical situation: What would they do if a senior audit partner instructed them to alter opinions expressed in a set of prior year audit workpapers and told them not to document that those alterations had been made? Another unusual feature of this case is the exclusive reliance of one audit partner (Will Borden) on the opinion of another (Richard Fiedelman). Fiedelman convinced Borden that the accounting treatment applied by the audit client to a material and unusual transaction was appropriate although the prior year workpapers indicated otherwise. What responsibility did Borden have to investigate this matter? Did he have a responsibility to contact the client‘s previous audit engagement partner, who had been transferred to another office? Did he have a responsibility to corroborate Fiedelman‘s assertion by referring to the relevant authoritative literature himself?
214 Case 5.3 The North Face, Inc. This case focuses on barter and consignment transactions and the related revenue recognition issues. You may want to refer your students to the following authoritative sources for these transactions: Accounting Principles Board Opinion No. 29, ―Accounting for Nonmonetary Transactions;‖ EITF Issue No. 93-11, ―Accounting for Barter Transactions Involving Barter Credits;‖ and Statement of Financial Accounting Standards No. 48, ―Revenue Recognition When Right of Return Exists.‖
Suggested Solutions to Case Questions 1. The professional standards urge auditors to be cautious when they are considering ―uncorrected misstatements‖ in a client‘s financial statements. AU Section 312 discusses such items at length. Following is an excerpt from that discussion. If the auditor concludes that the effects of uncorrected misstatements, individually or in the aggregate, do not cause the financial statements to be materially misstated, they could still be materially misstated because of further misstatements remaining undetected. As the aggregate misstatements approach materiality, the risk that the financial statements may be materially misstated also increases; consequently, the auditor should also consider the effect of undetected misstatements in concluding whether the financial statements are fairly stated. [AU 312.65] AU Section 312 notes that if the auditor concludes that the client‘s financial statements are materially misstated, then ―the auditor should request management to make the necessary corrections‖ (312.64). This section goes on to discuss the documentation standards for ―uncorrected misstatements‖ (see paragraphs 69-70). For example, auditors must document in their workpapers ―whether uncorrected misstatements, individually or in the aggregate, do or do not cause the financial statements to be materially misstated, and the basis for that conclusion.‖ Given the guidance provided by the professional auditing standards, I would suggest that the most reasonable answer to this case question is, ―Yes, except for those misstatements that are clearly immaterial.‖ Having said that, auditors‘ lives would be considerably less complicated if clients would prepare an adjusting entry for each proposed audit adjustment, even those that are immaterial. 2. To the greatest extent possible, auditors should not provide clients with access to the critical parameters or facets of audit engagements, including materiality limits. Similar to what transpired in this case, unethical client personnel can use that information to subvert the intent of individual audit procedures or even the integrity of the entire audit engagement. However, it is often not feasible to conceal information such as materiality limits from client personnel. For example, to mitigate the cost of an audit, auditors typically have client personnel ―pull‖ documents, prepare various schedules to which audit procedures will be applied, and perform other important audit-related tasks. In completing these tasks, client personnel can often determine the auditor‘s intent and/or the scope or materiality limit of a given audit test. Likewise, clients have access to the professional auditing literature and professional publications that discuss the general guidelines that auditors use in making important strategic decisions during the course of an audit, including the selection of materiality limits for individual accounts or financial statement items.
Case 5.5 Koger Properties, Inc.
215
3. Statement of Financial Accounting Concepts No. 5, ―Recognition and Measurement in Financial Statements of Business Enterprises,‖ established a two-part revenue recognition rule for accountants to follow in deciding when to record revenues. Before revenue is recognized (recorded) in an entity‘s accounting records, it should be both realized and earned, according to the following excerpt from SFAC No. 5. 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. The ―Suggestions for Use‖ section identifies the specific accounting standards that apply most directly to barter and consignment transactions. A brief discussion of EITF Issue No. 93-11, ―Accounting for Barter Transactions Involving Barter [trade] Credits,‖ can be found on pages 101102 of the May 1994 edition of the Journal of Accountancy. Generally, barter transactions in which a company receives trade credits in exchange for merchandise should be recorded at the fair value of the merchandise given up since the ultimate realizability or economic value of the trade credits is typically not determinable at the time of the exchange. So, even though the ―exchange‖ element of the revenue recognition principle is satisfied by such a transaction, the ―realized‖ element is not necessarily satisfied, meaning that any profit on the transaction should be deferred. In the case at hand, there was clearly some question as to the fair value of the excess merchandise that was being ―sold‖ to the barter company. A conservative treatment of the transaction might have dictated that a loss or writedown of the merchandise was actually the most appropriate accounting treatment for the transaction. As pointed out in a footnote appended to several of the SEC enforcement releases issued for this case, Statement of Financial Accounting Standards No. 48, ―Revenue Recognition When Right of Return Exists,‖ prohibits a seller from recognizing revenue (or profit, of course) when the given customer can return the product and the ultimate payment to be received by the seller hinges on the customer reselling the product. Both features of the revenue recognition rule were violated by the decision of North Face to record the large consignment sales: there was not a true exchange since the two customers did not pay for the merchandise and the given transactions were not finalized until the customers resold the merchandise. 4. Note: The PCAOB has established the documentation requirements for the audits of publicly owned companies in PCAOB Auditing Standard No. 3, ―Audit Documentation.‖ The documentation requirements that pertain to audits of other organizations can be found in Statement on Auditing Standards No. 103, ―Audit Documentation,‖ that became effective for audits of financial statements for periods ending on or after December 15, 2006. SAS No. 103: This standard has been integrated into AU Section 339. Paragraph .03 of AU 339 provides the following general guidance to independent auditors.
216 Case 5.5 Koger Properties, Inc. ―The auditor must prepare audit documentation in connection with each engagement in sufficient detail to provide a clear understanding of the work performed (including the nature, timing, extent, and results of audit procedures performed), the audit evidence obtained and its source, and the conclusions reached. Audit documentation: a. b.
Provides the principal support for the representation in the auditor‘s report that the auditor performed the audit in accordance with generally accepted auditing standards. Provides the principal support for the opinion expressed regarding the financial information or the assertion to the effect that an opinion cannot be expressed.‖
Paragraph .32 of AU 339 notes that the ―auditor should adopt reasonable procedures to retain and access audit documentation for a period of time sufficient to meet the needs of his or her practice and to satisfy any applicable legal or regulatory requirements for records retention.‖ This paragraph goes on to note that the retention period for audit documentation ―should not be shorter than five years from the report release date.‖ PCAOB No. 3: 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 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). PCAOB No. 3 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). Application to this case: The objectives of obtaining audit documentation (workpapers) identified by the ASB and the PCAOB were undercut by the decision of the Deloitte auditors to alter North Face‘s 1997 audit workpapers. For example, by modifying the 1997 workpapers and not documenting the given revisions in those workpapers, the Deloitte auditors destroyed audit evidence that provided an explicit record of important issues considered and key decisions reached on the 1997 audit. The alteration of the 1997 workpapers also destroyed evidence that demonstrated that the 1997 audit team had complied with professional auditing standards. 5. AU Section 316.07 identifies the three conditions that are generally present when an accounting fraud occurs. One of those conditions is the ―incentive‖ of management or other employees to commit fraudulent acts. Clearly, major strategic blunders by client management can create an environment in which client executives and their key subordinates have a strong incentive to distort their entity‘s accounting records and financial statements. More generally, the overall quality of top management‘s decisions affects the ―inherent risk‖ present during a given audit. For example, a factor that increases inherent risk is the potential for technological developments that would result in a given audit client‘s inventory or other assets becoming obsolete. One would certainly expect that a
Case 5.5 Koger Properties, Inc.
217
―high quality‖ management team would be more capable of forecasting such potential developments and taking the appropriate steps to mitigate the risk posed by those developments than would a ―low quality‖ management team. So, I would suggest that although you will likely not see ―Assess the quality of key decisions made by client executives‖ as an explicit audit procedure within an audit program, auditors need to be cognizant of the competence of top management and the wide-ranging implications of that competence, or lack thereof, to all facets of an audit.
CASE 5.4
NEXTCARD, INC.
Synopsis In November 2001, Arthur Andersen & Co. employees in that firm‘s Houston office shredded certain Enron audit workpapers during the midst of a federal investigation of the large energy company. The decision to destroy those workpapers ultimately proved to be the undoing of the prominent accounting firm. A few years later, a felony conviction for obstruction of justice would effectively put Andersen out of business. Ironically, at the same time that the Andersen personnel were shredding Enron workpapers, three senior members of the NextCard, Inc., audit engagement team were altering the fiscal 2000 audit workpapers of that San Francisco-based company. NextCard was founded during the late 1990s by Jeremy Lent, the former chief financial officer of the large financial services company, Providian Financial Corporation. Lent‘s business model was simple: use a massive Internet-based marketing campaign to quickly grab a large market share of the intensely competitive credit card industry. By 2000, NextCard, which by then was a public company, had signed up one million credit card customers. Unfortunately, NextCard‘s customers tended to be high credit risks, which resulted in the company absorbing much higher than normal bad debt losses. When the company‘s management team attempted to conceal those large credit losses, the SEC and other federal regulatory authorities uncovered the scam. By 2003, the once high-flying Internet company was bankrupt and its former officers were facing a litany of federal charges. The San Francisco office of Ernst & Young audited NextCard‘s periodic financial statements. When the news of the federal investigations of NextCard became public in the fall of 2001, Robert Trauger, the NextCard audit engagement partner, made a poor decision. That decision was to alter the fiscal 2000 audit workpapers for NextCard to make it appear that Ernst & Young had properly considered, investigated, and documented the company‘s bad debt losses and related allowance for bad debts. During two meetings in November 2001, Trauger and his top two subordinates secretly
218 Case 5.5 Koger Properties, Inc. altered the 2000 NextCard audit workpapers. To conceal the alterations of the electronic workpapers, the three auditors reset an internal computer clock to produce an appropriate electronic time stamp on those revised workpapers. Trauger realized that the altered workpapers would be given to federal authorities investigating NextCard and the 2000 audit of that company. As a result, Trauger became the first audit partner of a major accounting firm to be prosecuted under the criminal provisions of the Sarbanes-Oxley Act of 2002. In October 2004, Trauger pleaded guilty to one count of impeding a federal investigation and was sentenced to one year in federal prison and two years of supervised release. 215 NextCard, Inc.--Key Facts 1. Jeremy Lent‘s business model for NextCard, Inc., was predicated on using Internet advertising as a cost-effective tool to recruit high-quality credit card customers. 2. Initially, Lent‘s business model for NextCard seemed to be a financial success, as the company obtained a large customer base and became recognized as a leader of the e-commerce ―revolution.‖ 3. Despite the public perception that NextCard was successful, which was propped up by aggressive statements made by company executives, NextCard‘s business model was seriously flawed. 4. NextCard effectively became a lender of last resort for individuals who could not obtain credit elsewhere; as a result, the company‘s credit losses were much higher than the industry norm. 5. NextCard executives attempted to conceal the company‘s large credit losses by understating its allowance for bad debts and by classifying certain credit losses as losses due to Internet fraud schemes. 6. In the fall of 2001, several federal agencies, among them the SEC, initiated investigations of NextCard‘s financial affairs, including its prior financial statements. 7. The announcements of the federal investigations prompted Robert Trauger, the NextCard audit engagement partner, to alter NextCard‘s 2000 audit workpapers. 8. Trauger‘s intent was to make it appear that the NextCard engagement team had properly audited the company‘s accounting records, including its reported credit losses and allowance for bad debts. 9. Trauger and his subordinates manipulated E&Y‘s computer system to produce an appropriate electronic time stamp on the revised NextCard workpapers. 10. Trauger instructed his subordinates to dispose of any incriminating evidence but Oliver Flanagan, a senior audit manager, failed to comply with those instructions and ultimately provided the evidence that federal authorities used to prosecute Trauger for obstruction of justice.
Case 5.5 Koger Properties, Inc.
219
11. In October 2004, Trauger pleaded guilty to impeding a federal investigation and was sentenced to one year in federal prison; his two subordinates pled guilty to similar charges but did not receive prison sentences. 12. NextCard was liquidated by a federal bankruptcy court in the summer of 2003; five of the company‘s former executives have been indicted on various fraud charges.
Instructional Objectives 1. To examine auditors‘ ethical responsibilities when they are instructed by a superior to violate professional standards. 2. To help students understand the enormous pressures that auditors, particularly audit partners, can face on high-profile audit engagements. 3. To allow students to identify, and discuss the implications of, fraud risk factors that are present on a given audit engagement. 4.
To review auditors‘ responsibilities regarding the preparation and retention of audit workpapers.
5. To demonstrate the impact of the Sarbanes-Oxley Act on the auditing profession and work environment of auditors.
Suggestions for Use This case allows auditing instructors to cover the following three ―hot‖ topics in the auditing profession: (1) ethical responsibilities of auditors, (2) auditors‘ fraud detection responsibilities, and (3) the Sarbanes-Oxley Act. This is a good case to assign early in the semester of an undergraduate auditing course, possibly as a prelude to the ethics and legal liability chapters (which are typically presented back-to-back in an undergraduate auditing text). You might consider using a role-playing exercise to introduce the case. Choose two students to assume the role of Robert Trauger and Oliver Flanagan. Then, set up the meeting in which Trauger informs Flanagan that they will be ―revising‖ the 2000 NextCard workpapers. (Consider choosing ―forceful‖ or headstrong students to assume the Trauger role.) This role-playing exercise can be used to help students obtain a better understanding of the dynamics of evolving ethical dilemmas. After several pairs of students have assumed the roles of Trauger and Flanagan, the class should have plenty of ―ammunition‖ to provide insightful responses to case question no. 6. As a point of information, some of my students have found this case very troubling. Those students find it difficult to believe that an audit partner would so blatantly violate the profession‘s
220 Case 5.5 Koger Properties, Inc. most basic ethical standards and goad his subordinates to do the same. Trauger‘s conduct demonstrates very profoundly the enormous pressure that audit partners face when supervising the audit of a high profile company, pressure that results in large part from the litigious environment in which major audit firms operate.
Suggested Solutions to Case Questions 1. The professional auditing standards do not explicitly require auditors to ―evaluate the soundness‖ of a client‘s business model. Nor do the standards require auditors to document the client‘s business model in their workpapers. Nevertheless, AU Section 311, ―Planning and Supervision,‖ requires an auditor to obtain a thorough understanding of the client‘s business operations: ―Obtaining an understanding of the entity and its environment, including its internal control, is an essential part of planning and performing an audit in accordance with generally accepted auditing standards‖ (AU 311.03). Obtaining a thorough understanding of a client‘s business operations is especially critical when the client operates in a new industry and/or relies on an unproven business model, which was true in this case. Since new businesses have a high failure rate, it is incumbent on auditor to more rigorously consider the going concern status of such a client. AU Section 341, ―The Auditor‘s Consideration of an Entity‘s Ability to Continue as a Going Concern,‖ discusses specific audit procedures that can be used to assess a client‘s going-concern status. 2. When identifying fraud risk factors for a given case, I typically require my students to classify those factors into the A‘s, I‘s and O‘s of fraud. That is, students are required to classify those factors as either ―attitudes,‖ ―incentives‖ (pressures), or ―opportunities.‖ Listed next are specific fraud risk factors that were apparently present during the 2000 NextCard audit. The high degree of subjectivity required to arrive at NextCard‘s allowance for bad debts (opportunities) NextCard‘s management team did not have a proper appreciation of the importance of internal controls and honest financial reporting (attitudes and opportunities) NextCard‘s management had a practice of making firm commitments to financial analysts regarding their company‘s future earnings goals (attitudes and incentives/pressures) NextCard operated in an extremely competitive industry that was dominated by a few financially strong and high profile companies (incentives/pressures) The bursting of the Internet bubble in the stock market limited NextCard‘s access to the debt and equity markets (incentives/pressures) NextCard‘s recurring operating losses weakened the company‘s financial condition (incentives/pressures) NextCard operated in a highly regulated industry, meaning that the company‘s financial affairs and operating policies and procedures were under constant scrutiny by an array of federal regulatory authorities (incentives/pressures)
Case 5.5 Koger Properties, Inc.
221
AU Section 316 points out that auditors have an obligation to obtain ―reasonable assurance‖ regarding whether a client‘s financial statements are ―free of material misstatement, whether caused by error or fraud‖ [AU 316.01]. After having identified specific audit risk factors, an auditor must consider how those factors should impact the nature, extent and timing of his or her subsequent audit procedures. Following are just a few specific examples of how subsequent audit procedures may be changed to take into consideration an audit engagement team‘s fraud risk assessment. Perform audit procedures at locations on a surprise or unannounced basis Request that the client‘s inventories be counted at year-end or as close to year-end as practical Perform substantive analytical procedures using disaggregated data (such as financial data ―broken down‖ by the client‘s individual lines of business) Engage a specialist to arrive at an independent estimate of a key financial statement amount that was estimated by management Review and/or investigate the business rationale for significant unusual transactions that occurred during the period being audited 3. Note: The PCAOB has established the documentation requirements for the audits of publicly owned companies in PCAOB Auditing Standard No. 3, ―Audit Documentation.‖ The documentation requirements that pertain to audits of other organizations can be found in Statement on Auditing Standards No. 103, ―Audit Documentation,‖ that became effective for audits of financial statements for periods ending on or after December 15, 2006. SAS No. 103: This standard has been integrated into AU Section 339. Paragraph .03 of AU 339 provides the following general guidance to independent auditors. ―The auditor must prepare audit documentation in connection with each engagement in sufficient detail to provide a clear understanding of the work performed (including the nature, timing, extent, and results of audit procedures performed), the audit evidence obtained and its source, and the conclusions reached. Audit documentation: a. b.
Provides the principal support for the representation in the auditor‘s report that the auditor performed the audit in accordance with generally accepted auditing standards. Provides the principal support for the opinion expressed regarding the financial information or the assertion to the effect that an opinion cannot be expressed.‖
PCAOB No. 3: 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 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). PCAOB No. 3 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
222 Case 5.5 Koger Properties, Inc. conclusions concerning every major relevant financial statement assertion, and demonstrate that the underlying accounting records agreed or reconciled with the financial statements” (para. .05). This standard 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 to: a) understand the nature, timing, extent, and results of the procedures performed, evidence obtained, and conclusions reached, and b) 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 a point of information, paragraph 17 PCAOB No. 3 notes that, ―audit documentation must not be deleted or discarded after the documentation completion date [which is generally 45 days after the audit report release date], however information may be added.‖ Any additions to audit documentation must indicate the date the given information was added, the identity of the individual who added that information, and the reason why the information was added. 4. An efficient way to address this question is to simply ―walk‖ through the ten generally accepted auditing standards with your students and point out apparent or potential violations of each standard. General Standards 1. Proper technical training and technical proficiency: one could question whether the NextCard audit was properly staffed since a relatively inexperienced individual, Oliver Flanagan, was serving as the senior audit manager on that engagement 2. Independence: N/A (although, one could suggest that given the size and prominence of NextCard, Robert Trauger may have been inclined to be more lenient with that client when addressing and/or interpreting important accounting or auditing issues that arose during audits of the company) 3. Due professional care: This is the ―catch-all‖ professional standard. Any violation of one of the other nine auditing standards results in an automatic violation of this standard. Field Work Standards 1. Adequate planning and proper supervision: Clearly, Robert Trauger failed to provide proper supervision of his two subordinates, Oliver Flanagan and Michael Mullen. Although the SEC did not criticize E&Y‘s planning of the 2000 NextCard audit, in retrospect, it seems apparent that the planning phase of that audit failed to identify the huge audit (inherent) risk posed by the client‘s accounts receivable. 2. Sufficient understanding of internal control: NextCard‘s internal control system failed to prevent the improper accounting decisions for the company‘s receivables and related accounts. As a result, E&Y may have understated the control risk for the sales and collection cycle when analyzing NextCard‘s internal controls. 3. Sufficient appropriate evidence: The NextCard audit engagement team apparently failed to collect appropiate evidential matter to support the unqualified opinion issued on NextCard‘s 2000 financial statements. Reporting Standards
Case 5.5 Koger Properties, Inc.
223
1. Accordance with GAAP: NextCard‘s financial statements were not presented in accordance with GAAP, which means that E&Y should have pointed this out in its 2000 audit opinion. 2. Consistent application of GAAP: N/A 3. Proper disclosures: In retrospect, E&Y likely should have required NextCard to discuss in the footnotes to the company‘s 2000 financial statements the inordinate collectibility risk posed by its credit card receivables. 4. Proper opinion: E&Y failed to issue a proper opinion on NextCard‘s 2000 financial statements. Almost certainly, an adverse opinion, rather than an unqualified opinion, should have been issued on those financial statements. 5. A mentor is defined in Random House Webster’s College Dictionary as ―a wise and trusted counselor or teacher.‖ The professional standards do not refer directly to the term ―mentor;‖ however, the standards seem to suggest that ―mentoring‖ is an important feature of the quality control process within the auditing profession. For example, the first standard of field work requires that ―assistants‖ be ―properly supervised.‖ Likewise, the profession‘s quality control standards refer on several occasions to the importance of proper supervision of the subordinates assigned to professional services engagements. As we all know, much, if not a majority, of the detailed evidence collection procedures on audit engagements are performed by relatively inexperienced auditors. If those individuals are not properly supervised by a ―wise‖ superior (―teacher‖), the quality of an audit will be adversely affected. In this case, of course, Flanagan was not an inexperienced ―assistant‖ or an entry-level accountant but rather a senior-level manager. So, we normally would not expect Trauger to be required to closely supervise or oversee Flanagan‘s work. Nevertheless, Trauger did have a responsibility to serve as a proper role model for Flanagan. Clearly, engaging in behavior that is a blatant violation of professional standards and asking his two subordinates to do the same is not serving as a proper role model or ―mentor.‖ As a point of information, in this case Flanagan indicated that he had hoped that Trauger would serve as his ―mentor.‖ In fact, Flanagan may have actually wanted Trauger to serve as his ―sponsor.‖ In this context, the term ―sponsor‖ is used to refer to a senior member of an accounting firm who takes affirmative steps to help a specific subordinate advance through the employment hierarchy of that firm. An example of a ―sponsorship‖ activity would be making sure that the subordinate in question is given challenging work assignments and/or assignments that will provide him or her with high visibility in the given practice office. Certainly, Trauger did not have a responsibility to serve as Flanagan‘s ―sponsor.‖ 6. We all recognize that Oliver Flanagan had a professional responsibility to not blindly acquiesce to Robert Trauger‘s instructions to alter the 2000 NextCard workpapers. However, the intent of this question is to require students to place themselves in Flanagan‘s situation before responding. For example, students should recognize that Flanagan has a great deal of respect for Trauger and, in fact, apparently hopes that Trauger will help him advance up the employment hierarchy of E&Y. Plus, students should recognize that Flanagan is somewhat of an ―outsider.‖ He has been in the U.S. for only a short time and is probably not entirely familiar with the cultural norms and mores that affect the organizational dynamics and ―politics‖ of the work environment of a U.S. accounting firm. For
224 Case 5.5 Koger Properties, Inc. example, he may not have a good grasp of exactly how ―whistleblowing‖ is viewed within E&Y or, at least, within the firm‘s San Francisco office. Your students will likely identify a wide range of alternative courses of actions that Oliver Flanagan could have pursued. Here, we will examine a small sample of those alternatives. One obvious measure that Flanagan could have and probably should have taken would have been to consult other audit partners within the San Francisco office. Almost certainly, this would have solved Flanagan‘s dilemma. The audit partners he contacted would have discussed the matter with Trauger and very likely convinced him that altering the NextCard workpapers was not a reasonable decision. Granted, there is a high likelihood that if Flanagan had chosen this alternative, his professional relationship with Trauger would have been impaired, if not ended. Another option would have been to discuss the matter directly with Trauger. Flanagan apparently did not view this as a viable alternative because of the forceful nature of Trauger‘s personality. A third option would have been to discuss the matter with Michael Mullen, the other audit manager assigned to the NextCard engagement. He and Mullen could then have approached Trauger together—the ―strength in numbers‖ concept is relevant here. Finally, at least one of the major accounting firms reportedly has an anonymous ―hot line‖ that subordinates can use to discuss ethical dilemmas, such as the one facing Oliver Flanagan, with a senior member of the firm who is in another practice office or the firm‘s headquarters office. Following is a list of individuals who were affected by Oliver Flanagan‘s decision to cooperate with Trauger in altering the NextCard workpapers. (a) Himself: 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. (b) Partners and employees of his 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. (c) 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. (d) Investing and lending public: These individuals and entities rely on independent auditors to carry out their ―public watchdog‖ function rigorously, including reporting honestly and candidly on their clients‘ financial statements. The integrity and efficiency of our nation‘s capital markets are undermined when auditors do not fulfill their professional responsibilities. (e) Robert Trauger: As a colleague of Robert Trauger, Flanagan had an obligation to consider his best interests and the best interests of his family. Just imagine the grief that Trauger would have avoided if Flanagan had convinced the audit partner that it was inappropriate to alter the NextCard workpapers.
CASE 5.5
Case 5.5 Koger Properties, Inc.
225
KOGER PROPERTIES, INC.
Synopsis Michael Goodbread spent several years working his way up the employment hierarchy of Touche Ross & Company. In 1981, Goodbread achieved his career goal when he was promoted to audit partner with that firm. Eight years later, Goodbread became a partner with Deloitte & Touche when Deloitte, Haskins & Sells merged with Touche Ross. Following the merger, Goodbread was assigned to the Jacksonville office of Deloitte & Touche. Previously, Goodbread had been assigned to the Jacksonville office of Touche Ross. One of Goodbread‘s first engagements for Deloitte & Touche was to supervise the 1990 audit of Jacksonville-based Koger Properties, Inc., a real estate development company that had previously been a Deloitte audit client. Koger‘s 1990 fiscal year-end was March 31, 1990. The 1990 audit was completed in June 1990 with an unqualified opinion being issued on Koger‘s financial statements. Apparently unknown to other Deloitte & Touche personnel was the fact that Goodbread had a financial interest in Koger Properties during most of the 1990 audit engagement. Prior to the Deloitte & Touche merger, Goodbread had purchased 400 shares of Koger common stock in December 1988. Goodbread sold those shares in May 1990, while the 1990 Koger audit was in progress. When the SEC discovered that Goodbread had held an equity interest in Koger during the 1990 audit, the federal agency charged that he had violated its independence rules, the AICPA Code of Professional Conduct, and generally accepted auditing standards. The SEC also ruled that Goodbread had caused Deloitte & Touche to issue an improper opinion on Koger‘s 1990 financial statements. Given the circumstances, a disclaimer of opinion, rather than an unqualified opinion, should have been issued on Koger‘s financial statements. Goodbread was eventually censured by the SEC. [Note: Deloitte & Touche did not reissue its audit opinion on Koger‘s 1990 financial statements since the company was no longer in existence when the SEC concluded its investigation of this matter.] In September 1991, Koger filed for bankruptcy. Shortly thereafter, Koger‘s stockholders filed a large class-action lawsuit against Deloitte & Touche that ultimately resulted in an $81 million judgment being awarded to the stockholders by the courts. A subsequent appellate court ruling overturned that large award.
223 Koger Properties, Inc.--Key Facts 47. Michael Goodbread became a partner with Deloitte & Touche following the 1989 merger of Deloitte, Haskins & Sells and Touche Ross.
226 Case 5.5 Koger Properties, Inc. 48. In December 1988, Goodbread purchased 400 shares of common stock of Koger Properties, an audit client of Deloitte, Haskins & Sells. 49. Following the merger, Goodbread became the audit engagement partner for Koger Properties. 50. Goodbread supervised the fiscal 1990 audit of Koger Properties, which began in February 1990 and extended through June 1990. 51. On June 11, 1990, Deloitte & Touche issued an unqualified audit opinion on Koger‘s 1990 financial statements. 52. On May 10, 1990, Goodbread sold his 400 shares of Koger common stock. 53. The SEC censured Goodbread in 1996 for violating the profession‘s auditor independence rules. 54. The SEC also ruled that Goodbread had caused Deloitte & Touche to issue an improper audit opinion on Koger‘s 1990 financial statements. 55. Following Koger‘s bankruptcy, its stockholders sued Deloitte & Touche, alleging that the firm‘s 1989 and 1990 Koger audits were deficient. 56. The $81 million judgment awarded to Koger‘s former stockholders was subsequently overturned by an appellate court.
Instructional Objectives 57. To demonstrate the importance of auditors maintaining strict independence from their clients. 58. To demonstrate the importance of auditor independence to the SEC. 59. To highlight the need for accounting firms created by mergers to take appropriate steps to ensure that their partners and employees comply with the profession‘s independence rules.
Case 5.5 Koger Properties, Inc.
227
Suggestions for Use This case focuses primarily on the importance of practicing auditors maintaining strict independence from clients and thus could be integrated with classroom discussion of the profession‘s independence rules. The Koger case could also be used to introduce regulatory issues relevant to the auditing profession, in particular, the SEC‘s oversight responsibilities for the auditing domain. Most students have one very simple question after reading this case, namely, ―Why did he do it?‖ Unfortunately, I do not have an answer to that question. The SEC‘s discussion of this case and other available materials do not reveal whether Goodbread simply forgot that he had invested in Koger‘s common stock or whether he chose to ignore the profession‘s independence rules.
Suggested Solutions to Case Questions 1. At the time the key events in this case occurred, the SEC‘s independence rules (included in Regulation S-X) specifically precluded auditors of SEC registrants from having any direct or material indirect financial interest in their clients. Clearly, Goodbread‘s ownership interest in Koger violated that rule. Goodbread‘s ownership interest in Koger also violated the comparable independence rule of the AICPA (Rule 101 of the AICPA Code of Professional Conduct). Finally, the second general standard of GAAS requires auditors to be independent of their clients. Thus, Goodbread also violated one of the ―ten commandments‖ of auditing. 2. Most likely, the Koger investment was not material to Goodbread. The total value of that investment was approximately $10,000. Although we do not know what Goodbread‘s net worth was over the period he held this investment, the investment likely represented only a nominal percentage of his net worth.
―No,‖ the materiality of the investment was not an issue in this case. The profession‘s independence rules that were effective when the key events in this case took place and the revised independence rules currently in effect forbid any direct financial interest in an audit client by an audit engagement partner. 3.
Under the AICPA Code of Professional Conduct, Goodbread could have served as Koger‘s
audit engagement partner as long as he disposed of his investment in Koger common stock before the 1990 audit of that company began. That is, just because an individual once owned stock in a company does not disqualify him or her from serving as an independent auditor for that company after that stock has been sold. 4. Apparently, British authorities in the nineteenth century believed that auditors would take their roles more seriously, that is, search more thoroughly for financial statement errors, if they owned stock in their clients. Would this rule ―make sense‖ in today‘s business environment? Certainly, the same argument could be made that a financial interest in clients would motivate auditors to be more thorough. However, there is a countervailing argument that is widely accepted in the U.S. presently. If auditors were allowed to have financial interests in their clients, potential investors and lenders would likely doubt whether auditors would disclose errors they found in clients‘ financial records. Why? Because such disclosure would likely cause the value of an auditor‘s investment in a given client to decline. This argument is particularly relevant to the audits of large, publicly owned
228 Case 5.6 American Fuel & Supply Company, Inc. companies whose stock is widely traded. During the nineteenth century, most companies, even publicly owned companies, had very few stockholders and the ownership interests in companies rarely changed hands. Additionally, few companies relied heavily on borrowed funds. Consequently, auditors of the nineteenth century were more focused on protecting the existing ownership interests of their clients rather than looking out for the interests of potential investors, lenders, and other third parties, which is the primary concern of present-day independent auditors.
Case 5.6
AMERICAN FUEL & SUPPLY COMPANY, INC.
Synopsis American Fuel & Supply Company (AFS) was a wholesaler of automotive supplies, lawn and garden supplies, and related merchandise. In early 1986, Touche Ross issued an unqualified opinion on AFS‘s 1984 and 1985 financial statements. Several months later, Touche discovered that AFS‘s 1985 financial statements contained a material error. What to do, what to do? After considerable discussion, Touche decided to inform AFS‘s management that the company‘s 1985 financial statements should be recalled. But AFS‘s management would not cooperate. AFS threatened to sue Touche if the accounting firm carried through on its stated intention to withdraw its audit opinion on the company‘s 1985 financial statements and to notify third parties that the opinion should no longer be relied upon. Eventually, the two parties reached a compromise. Touche would notify AFS‘s one secured creditor that its audit opinion had been withdrawn on AFS‘s 1985 financial statements. The other parties relying on AFS‘s 1985 financial statements, principally unsecured creditors, would not be notified of the withdrawal of Touche‘s opinion. In April 1987, AFS filed for bankruptcy. Two years later, one of the company‘s unsecured creditors, Chevron Chemical Company, sued Touche. Chevron alleged that Touche was negligent in auditing AFS and that the accounting firm had a responsibility to notify Chevron after withdrawing its opinion on AFS‘s 1985 financial statements. The courts rejected Chevron‘s negligence allegation but agreed that Touche should have notified Chevron of the decision to withdraw its audit opinion on AFS‘s 1985 financial statements. The courts ordered Touche to pay Chevron damages of $1.6 million.
Case 5.6 American Fuel & Supply Company, Inc. 229
227 American Fuel & Supply Company, Inc.--Key Facts 60.
In early 1986, Touche issued an unqualified opinion on AFS‘s 1984 and 1985 financial statements.
61. AFS‘s audited financial statements were distributed to the company‘s creditors, including Chevron Chemical Company, one of its largest suppliers. 62. Several months after completing its 1985 audit of AFS, Touche discovered that the company‘s 1985 financial statements contained a material error. 63. Touche attempted to persuade AFS‘s management to recall the company‘s 1985 financial statements. 64. AFS refused to recall its 1985 financial statements and threatened to sue Touche if the accounting firm notified third parties that it was withdrawing the audit opinion on AFS‘s 1985 financial statements. 65. AFS management and Touche eventually agreed to notify only one party, AFS‘s sole secured creditor, that Touche‘s audit opinion on AFS‘s 1985 financial statements had been withdrawn. 66. The audit manager assigned to the AFS engagement disagreed with the decision to notify only AFS‘s secured creditor that Touche‘s 1985 audit opinion had been withdrawn. 67. AFS filed for bankruptcy in April 1987. 68. Chevron sued Touche alleging that the accounting firm had been negligent in auditing AFS and had a responsibility to fully disclose its decision to withdraw the 1985 audit opinion.
10. The courts ruled that Touche was not negligent in its 1985 audit of AFS but concluded that the accounting firm had been negligent in failing to fully disclose its withdrawal of the 1985 audit opinion.
230 Case 5.6 American Fuel & Supply Company, Inc.
Instructional Objectives 1. To examine an audit firm‘s responsibility when it discovers that it has issued an improper audit opinion on a client‘s financial statements. 69. To demonstrate that members of an audit engagement team sometimes disagree regarding the proper resolution of an important technical issue facing a client. 70. To demonstrate that client pressure may cause audit firms to make improper decisions. 71. To review the profession‘s client confidentiality rule.
Suggestions for Use Like most of the cases in this text, this case can be integrated at several points in an auditing course. Typically, I begin each semester with a ―comprehensive‖ case that introduces students to a wide range of auditing topics and issues. However, this short case can also be used to introduce students to the auditing profession. This case gives students a quick ―reality jolt‖ by exposing them to a contentious auditor-client conflict. Although such conflicts are not a particularly ―appetizing‖ topic of discussion in the profession, they are common and have serious implications for the profession, for individual audit firms, and for individual auditors. This case focuses on the ―subsequent discovery‖ rule. Consequently, it could also be discussed during the segment of an auditing course in which that rule is most relevant. (Typically, the subsequent discovery rule is integrated with a textbook‘s treatment of the wrap-up phase of an audit.) Finally, this case could be used to focus students‘ attention on the profession‘s client confidentiality rule. One facet of this case that tends to stimulate discussion among students is the audit manager‘s disagreement with the compromise reached between Touche and AFS‘s management. Here‘s another example of a situation in which an audit firm could have spared itself considerable expense and embarrassment if it had only taken the advice of a subordinate member of an audit engagement team.
Suggested Solutions to Case Questions 72. AU Section 561 delineates the auditor‘s responsibilities regarding the ―subsequent discovery of facts‖ existing at the
Case 5.6 American Fuel & Supply Company, Inc. 231 date of the audit report. Paragraph 6 of Section 561 describes the auditor‘s responsibility when dealing with a ―cooperative‖ client in this context, while Paragraph 8 of that section discusses the auditor‘s responsibility when dealing with an ―uncooperative‖ client.
When the client cooperates with the auditor, the auditor should first determine the impact of the newly-discovered facts on the relevant financial statements. Then, as promptly as possible, those financial statements and the accompanying audit report should be revised and reissued. If the impact on the given 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 revised financial statements and a revised auditor‘s 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 auditor in making appropriate disclosure of the subsequently discovered facts, the auditor should first notify each member of the client‘s board of directors of this refusal and the steps the auditor is required to take to prevent future reliance on his or her audit report on those financial statements. Section 561 observes that the auditor‘s 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 auditor should notify the client and relevant regulatory agencies that the audit report on the relevant financial statements should no longer be relied upon. The auditor should also take steps to notify ―each person‖ known by the auditor 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 auditor 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.‖ Note: Instructors may want to refer their students to AU Section 711, ―Filings Under Federal Securities Statutes.‖ Paragraph 12 of that section focuses on auditors‘ responsibilities regarding the subsequent discovery of facts relevant to the audited financial statements of an SEC registrant. 73. The comments made by the Touche Ross audit manager indicate that the accounting firm was aware that third parties were using AFS‘s 1985 financial statements. Since only one of those third parties was contacted by Touche Ross, it does not appear that the accounting firm complied fully with the requirements of AU Section 561. 74. No, Touche Ross would not have violated the client confidentiality rule by withdrawing its audit opinion on AFS‘s 1985 financial statements. One exception to the confidentiality rule allows an auditor to disclose confidential client information that he or she is obligated to disclose under ―standards promulgated by bodies designated by Council,‖ which would include Statements on Auditing Standards.
4. This situation is dealt with explicitly by AU Section 9561. That section notes that the subsequent discovery‖ rule discussed in AU Section 561 must be complied with by an auditor ―even when the auditor has resigned or been discharged.‖
232 Case 6.1 Leigh Ann Walker, Staff Accountant
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 consultation with 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 several insights on the work role and work environment of a newly-hired staff accountant.
Case 6.1 Leigh Ann Walker, Staff Accountant
233
231 Leigh Ann Walker, Staff Accountant--Key Facts 1. Leigh was well qualified for an entry-level position in public accounting given her college credentials. 2.
According to Leigh's college friends, she was sometimes too "intense."
3.
Leigh performed very well on her first job assignment.
4. Leigh was dishonest with her supervisor, Jackie Vaughn, when Jackie asked her if she had taken the CPA exam. 5. Leigh 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's dishonesty, Jackie told the office managing partner that she did not want Leigh 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 that she was being dismissed.
234 Case 6.1 Leigh Ann Walker, Staff Accountant
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. In the past, several of my students have pointed out that the dishonesty exhibited by Leigh 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, and committed to advancing as rapidly as possible within 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.
Case 6.1 Leigh Ann Walker, Staff Accountant
235
a.
Jackie should have given Leigh 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.
b.
I believe that Jackie treated Leigh unfairly since she did not even discuss the matter with her. Jackie should have taken into consideration the fact that Leigh was a newly-hired employee who simply wanted to make a good first impression. At the very least, Jackie should have sat down with Leigh and explained her view of the matter and then given Leigh 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 first and then arranged a meeting with Leigh, Jackie, and himself to discuss the situation. Since Leigh 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 be fired. Leigh'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's dismissal by the office managing 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 earlier editions of this textbook. 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‘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.
236 Case 6.1 Leigh Ann Walker, Staff Accountant
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 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. However, in response to the second question, the majority of students tend to imply that an individual such as Leigh is unsuited for the auditor's professional role.
CASE 6.2
BILL DEBURGER, IN-CHARGE ACCOUNTANT
Synopsis
Case 6.2 Bill DeBurger, In-Charge Accountant 237 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 last 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.
236
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
238 Case 6.2 Bill DeBurger, In-Charge Accountant 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.
Case 6.2 Bill DeBurger, In-Charge Accountant
239
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 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 conclude 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. Clearly, Bill should have discussed 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. Having said this, however, 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. 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. The audit partner's superiors 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
240 Case 6.4 Tommy O‘Connell, Audit Senior 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. No doubt, 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 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 these 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.
CASE 6.3
DAVID MYERS, CONTROLLER
Synopsis David Myers served as the controller for WorldCom, Inc., from 1995 until the summer of 2002. In January 2001, Scott Sullivan, Myers‘ superior and WorldCom‘s chief financial officer, instructed him to make bogus entries in the company‘s accounting records to conceal its disappointing operating results. Myers complied with his superior‘s request, a decision he would soon regret. When Cynthia Cooper, a WorldCom internal auditor, discovered the bogus entries and began investigating them, she triggered a series of events that would result in the huge WorldCom fraud becoming one of the most publicized financial scandals in U.S. history. This case, which was originally an article published in The Wall Street Journal, provides a poignant chronological history of the WorldCom scandal from the perspective of David Myers.
Case 6.4 Tommy O‘Connell, Audit Senior 241
240 David Myers, Controller--Key Facts 1. David Myers was hired as WorldCom‘s controller shortly before the telecommunications company realized a huge growth spurt. 2. WorldCom‘s impressive financial results in the late 1990s caused the company‘s stock price to rise dramatically and resulted in huge economic benefits for Myers and his fellow WorldCom executives. 3. When WorldCom failed to meet earnings targets established by financial analysts, Scott Sullivan, the company‘s chief financial officer and Myers‘ immediate superior, decided to conceal the earnings shortfall from the investing public. 4. Sullivan persuaded Myers and his subordinates to record bogus accounting entries to conceal WorldCom‘s disappointing operating results. 5. Myers later testified that he justified the decision to make the fraudulent accounting entries because he believed that WorldCom‘s earnings would soon recover. 6. In fact, WorldCom‘s earnings continued their disappointing trend, which prompted Sullivan and Myers to continue making bogus entries in the company‘s accounting records. 7. The WorldCom fraud was revealed by an internal auditor, Cynthia Cooper, who discovered the fraudulent entries posted to the company‘s accounting records by Myers and his subordinates. 8. Myers believed that he would not be held personally responsible for the fraudulent accounting entries since he had been instructed to make them by his superior, Scott Sullivan.
242 Case 6.4 Tommy O‘Connell, Audit Senior 9. Nevertheless, federal authorities filed securities fraud charges against Myers; a few months later, Myers became the first WorldCom executive to plead guilty to securities fraud. 10. In 2005, a federal judge sentenced Myers to one year in federal prison for his role in the WorldCom fraud.
Instructional Objectives 1.
To illustrate the personal and professional consequences that accountants may face when they behave unethically.
2.
To examine the responsibilities of accountants when they are instructed by their superiors to engage in unethical conduct.
Suggestions for Use When I first read this article in The Wall Street Journal, I knew that I wanted to incorporate it in my casebook. The article does a terrific job of illustrating the destructive consequences that accountants may suffer when they make poor (unethical) decisions. As demonstrated by this case, the WorldCom debacle has literally left the life of David Myers, WorldCom‘s former controller, in shambles. A good way to initiate discussion of this case is to ask students to comment on recent developments in the WorldCom case—see case question No. 1. No doubt, the WorldCom scandal, just like the Enron debacle, will continue to make ―news‖ for several years to come. When discussing this case, there is one point in particular that I hope rises to the surface, namely, the fact that the improper entries in WorldCom‘s accounting records were intended initially to be a one-time ―thing.‖ Myers decided to approve the bogus accounting entries because he believed WorldCom‘s business would soon improve, meaning that the resulting profits would absorb the effect of the illicit entries. As proven repeatedly in financial frauds, once an individual takes that first step onto the ―slippery slope,‖ he or she often loses control of the situation.
Case 6.4 Tommy O‘Connell, Audit Senior 243 Suggested Solutions to Case Questions 1. My students have access to Lexis-Nexis. So, I typically encourage them to use that source to find updates on ―live‖ cases. When all else fails, students can turn to Google. 2. In numerous Accounting & Auditing Enforcement Releases over the past several decades, the SEC has consistently stressed that the ―good soldier‖ defense is not a valid defense in the case of accounting and financial reporting frauds. That is, corporate executives cannot excuse their bad behavior on the fact that a superior instructed them to engage in that conduct. In the postEnron/WorldCom era, corporate executives, accountants, independent auditors and other business professionals must recognize that regulatory authorities will hold them personally responsible and accountable for their involvement in accounting and financial reporting frauds. A question that my students raised in discussing this case is whether Myers actually believed that he would not be held personally accountable for the fraudulent WorldCom accounting entries, as his wife suggested. Students questioned whether an executive of a major corporation could be that naïve. 3. This is a topic or issue that students enjoy debating. My students often disagree on the severity of the punishment meted out to individuals involved in accounting and financial frauds, although the majority of them typically invoke a ―hangman‖ philosophy by suggesting that such individuals deserve more severe punishment. Rather than debating whether or not a given individual‘s sentence was proper, a more productive strategy in addressing a question such as this is to ask students to identify the factors that should be considered by the courts in sentencing parties involved in financial frauds. After asking students to identify those factors, consider listing them on the board or overhead projector. Next, prompt a discussion of those factors by requiring students to rank them (from most to least important in this context). Number of parties affected by a fraud, the degree to which the given fraudster benefited economically, and the duration of the fraudulent activity are examples of factors commonly identified in such an exercise. Another angle you might take in addressing this question is to ask students whether accountants and auditors should be held more responsible than other parties for participating in financial frauds, given the accounting profession‘s explicit code of ethics. My experience is that students typically respond with a resounding ―no‖ to that proposition. 4. Like all federal agencies, the federal law enforcement authorities operate on limited budgets. As a result, ferreting out and punishing every corporate fraudster is not economically feasible. So, to get the most ―bang for their buck,‖ these agencies often invest a disproportionate amount of their resources in high-profile cases, reasoning that the prosecution of the individuals in those cases will serve as a deterrent to other potential lawbreakers. Is such a policy ―fair‖ to those individuals who are singled out for prosecution simply because they are involved in high-profile cases? No doubt, your students, like my students, will disagree on this issue. As always, in evaluating the quality of students‘ positions on such subjective matters, the rigor of their arguments, rather than the actual position they take, is the more important consideration.
244 Case 6.4 Tommy O‘Connell, Audit Senior
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.
244
Case 6.4 Tommy O‘Connell, Audit Senior 245 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 regarding the long hours he worked. 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 audit engagement partner.
246 Case 6.4 Tommy O‘Connell, Audit Senior
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 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 challenges and 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. In 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. On the other end of the spectrum, seniors must continually interact with
Case 6.4 Tommy O‘Connell, Audit Senior 247
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. 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
248 Case 6.4 Tommy O‘Connell, Audit Senior
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 provided by these seniors and by Tommy, when compiled and studied, may provide new insights on the allegations against Carl.
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 twenty stores included in the sample 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.
Case 6.5 Avis Love, Staff Accountant 249 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 was 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.
249 Avis Love, Staff Accountant--Key Facts 1. Avis Love, a staff accountant for a large accounting firm, 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. 75. 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. 76. Avis was initially excited by the prospect of uncovering a fraud. 77. 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. 78. 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. 79. Avis considered dropping Mo‘s store from her cutoff test results but then relented.
250 Case 6.5 Avis Love, Staff Accountant 80. 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. 81. To discuss the purpose of year-end cash receipts and sales cutoff tests. 82. To examine auditors‘ sample selection methods for small, nonstatistical tests. 83. 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 CEO who doubles as a drill instructor. This case provides future auditors with a dose of reality. My experience has been that accounting majors planning to join the auditing staff of a public accounting firm do not have a good
Case 6.5 Avis Love, Staff Accountant 251 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 sizable minority of the students typically 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 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 twenty stores, she should have applied her audit procedures to each of those stores. AU 350.25 discusses auditors‘ responsibilities in this context. ―Audit procedures that are appropriate to the particular audit objective should be applied to each sample item.‖ 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. 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. (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
252 Case 6.5 Avis Love, Staff Accountant 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 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. At the same time, Avis had to weigh the interests of the other parties already listed. Not being an ethicist, I will not suggest that my decision here is ―correct‖ in any sense, but, it seems to me that the ―greater good‖ in this case is served by Avis honestly reporting the results of her audit tests to her immediate superior. In the long run, this may actually be the best outcome for Mo. 3. No, the 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-of-interest for an auditor. Following is the text of Rule 102 of the Code of Professional Conduct: ―In the performance of any professional service, a member shall maintain objectivity and integrity, shall be free of conflicts of interest, and shall not knowingly misrepresent facts or subordinate his or her judgment to others.‖ 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 transaction-related ―cutoff‖ assertion discussed in AU Section 326.14: ―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 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
Case 6.5 Avis Love, Staff Accountant 253 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. 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. 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 twenty, 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 twenty 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‖ (AU 350.26). 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 and inventory.) 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? Another relevant factor is the projected likelihood that the given account will contain errors. A review of prior year workpapers should provide the data needed to make this assessment. 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 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.
254 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?
Case 6.6 Charles Tollison, Audit Manager 255
255 Charles Tollison, Audit Manager--Key Facts 84. 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. 85. Tollison was a ―technician,‖ that is, an individual with an extensive knowledge of technical accounting and auditing issues. 86. 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. 87. One option available to Tollison was remaining with his firm as a permanent senior audit manager. 88. Tollison viewed accepting a permanent manager position with his employer as equivalent to admitting that his career was a failure.
256 Case 6.6 Charles Tollison, Audit Manager
Instructional Objectives 89. To examine the professional work role of an audit manager with a large international accounting firm. 90. To identify the key factors that large accounting firms consider when making partner promotion decisions. 91. To examine the trade-offs that public accountants must make between their professional work roles and personal lives. 92. 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 important ―business side‖ of public accounting.
Suggested Solutions to Case Questions 93. 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. 94. 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.
Case 6.6 Charles Tollison, Audit Manager 257 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 clearly overlap, that is, involve the same skill, talent, or personal attribute.) 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 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. Rationally, 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, a small accounting firm may have more flexibility in varying the weights assigned to these criteria. If the managing partner of a small firm has excellent client development skills, that firm may place a disproportionate emphasis on promoting individuals with strong technical skills. 95. 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
258 Case 7.1 PricewaterhouseCoopers Securities, LLC 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.]
CASE 6.7
HAMILTON WONG, IN-CHARGE ACCOUNTANT
Synopsis ―Eating time‖ is one of those taboo subjects among public accountants. 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. But, this subject is apparently not an acceptable lunch time topic among auditors. 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 is 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 soon-to-be-open senior position on the job. As the case ends, Hamilton is wrestling with the
Case 7.1 PricewaterhouseCoopers Securities, LLC
259
decision of whether he too should begin underreporting the time that he has worked on his Wille & Lomax assignments.
260 Hamilton Wong, In-Charge Accountant--Key Facts 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 for 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.
260 Case 7.1 PricewaterhouseCoopers Securities, LLC
Instructional Objectives 1. To illustrate an ethical dilemma, namely, whether or not to accurately report the time spent working on audit tasks, that commonly faces auditors, 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 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
Case 7.1 PricewaterhouseCoopers Securities, LLC
261
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 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
262 Case 7.1 PricewaterhouseCoopers Securities, LLC 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, 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 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 ―dog-eat-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 lowerlevel 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.
CASE 7.1
Case 7.1 PricewaterhouseCoopers Securities, LLC
263
PRICEWATERHOUSECOOPERS SECURITIES, LLC
Synopsis Contingent fees have always been considered inconsistent with the independent audit function. How could an accounting firm maintain its independence and objectivity if it was compensated based upon the type of audit opinion issued on a client‘s financial statements? Accounting rule-making authorities also prohibit accounting firms from billing audit clients for non-audit services on a contingent fee basis. Rule 302 of the AICPA Code of Professional Conduct serves as the blueprint for the contingent fee ban included in the ethical codes of all state boards of accountancy. During the 1990s, most of the major accounting firms created separate divisions or wholly owned subsidiaries to begin marketing investment banking services. Immediately, these firms faced a major problem in competing head-to-head with existing investment banking firms. This problem stemmed from (1) the investment banking industry‘s routine use of contingent fee arrangements, (2) the fact that the most accessible potential investment banking clients for the major accounting firms were their own audit clients, and (3) the accounting profession‘s ban on contingent fees for non-audit services sold to audit clients. The investment banking arm of Coopers & Lybrand and its successor firm, PricewaterhouseCoopers (PwC), simply ignored the profession‘s ban on contingent fees for non-audit services sold to audit clients, a decision that eventually drew the attention and the ire of the Securities and Exchange Commission.
265 PricewaterhouseCoopers Securities--Key Facts 1. In 1996, Coopers & Lybrand created Coopers & Lybrand Securities (CLS), a wholly owned subsidiary that it registered as a securities brokerage firm with the SEC.
264 Case 7.1 PricewaterhouseCoopers Securities, LLC 2. Following the merger of Coopers & Lybrand with Price Waterhouse, CLS became PricewaterhouseCoopers Securities (PwCS). 3. PwCS was integrated into PwC‘s Financial Advisory Services practice, which provided various investment banking services, including M&A consulting. 4. In 1998, PwCS had 429 M&A consulting engagements, which was the second most in the investment banking industry worldwide (second only to KPMG). 5. In reality, the old-line investment banking firms, such as Morgan Stanley, still dominated the M&A industry since they consulted on the billion-dollar M&A deals in that industry. 6.
PwC and KPMG were most successful in marketing investment banking services in Europe.
7. In Europe, accounting firms are generally not prohibited from charging audit clients contingent fees for non-audit services—contingent fee arrangements are the norm in the investment banking industry. 8. The ethical ban prohibiting accounting firms from charging contingent fees for non-audit services provided to audit clients stymied PwCS‘s effort to expand its investment banking practice in the U.S. 9. In July 2002, the SEC revealed that CLS and PwCS had used contingent fee arrangements for fourteen audit clients of their parent organization. 10. PwC and PwCS were censured by the SEC for violating the ban on contingent fees; in addition, PwC was fined $5 million.
Instructional Objectives 1.
To examine the controversial ―scope of services‖ issue facing the accounting profession.
Case 7.1 PricewaterhouseCoopers Securities, LLC 2.
265
To allow students to discuss fee arrangements used by audit firms for non-audit services.
3. To identify measures that the accounting profession could implement to restore the public‘s trust in the profession.
Suggestions for Use I am speculating here, but I don‘t believe that many of your students will realize that most of the major accounting firms began offering a full line of investment banking services in the late 1990s. To be honest, I wasn‘t fully aware of this ―new frontier‖ in non-audit services until I uncovered and began investigating this case. In my view, the key opportunity this case poses is to allow your students to discuss the widely debated and very controversial ―scope of services‖ issue within the public accounting profession. One question that comes to mind in this context is, ―Where should the major accounting firms draw the line?‖ That is, what types of consulting services should those firms not offer? See the suggested solution to Question No. 2 for a recommended in-class exercise that you can use to address this issue. [Note: As pointed out by the final footnote of this case, the Sarbanes-Oxley Act of 2002 prohibits accounting firms from providing investment banking and related services to SEC registrants.]
Suggested Solutions to Case Questions 1. In my view, the SEC should impose stiff penalties on accounting firms and individual accountants when they deliberately ignore ethical rules or other professional standards. I would suggest that a $5 million fine was a ―stiff‖ penalty but was it a sufficient penalty? Recognize that a key parameter of this case was the fact that PwC was a repeat offender. In 1999, the SEC had penalized PwC for numerous blatant violations of the financial independence rules for auditors. One interesting aspect of the penalty handed down in this case is that the SEC did not single out any individual partners or administrative personnel for admonishment. In my view, for SEC penalties to be as effective as possible in these cases, it may be necessary for the federal agency to single out and punish those individuals who were the apparent ―ringleaders‖ or decision makers. 2. This question alludes to one of the most important issues, if not the most important issue, facing the public accounting profession in the post-Enron era, namely, the ―scope of services issue.‖ With a few exceptions--principally, those imposed by the Sarbanes-Oxley Act, accounting firms can market a ―veritable plethora‖ of non-audit services to existing and potential clients. But, at some point, it seems that accounting firms will cease to be identified as ―accounting‖ firms if they continue to expand their product line of services. By being ―lumped together‖ with a wide array of other ―professional services‖ firms, accounting firms would likely lose their hard-earned identity as society‘s principal purveyor of audit, taxation, and accounting services. This is the type of question that I believe is ideally suited for an in-class debate exercise. Consider dividing your class into three groups: one group that argues in favor of a continually expanding product line of professional services for accounting firms, a second group opposed to that
266 Case 7.2 Stephen Gray, CPA strategy, and a third group that serves as the ―jury‖ by determining which of the first two groups made the most effective argument. [Note: One suggestion is that you poll your class before this exercise by asking them their general position on the scope of services issue. By placing the ―undecideds‖ in the third group, you are likely to have a less biased ―jury‖ for this exercise.] 3. A few years ago, I recall a flurry of articles in accounting and business periodicals that discussed and/or promoted ―value added‖ pricing for accounting firms and business consulting firms. I do not know, empirically speaking, whether value added pricing has become more prevalent among generic consulting firms, but it doesn‘t seem to have ―caught on‖ in the accounting profession. Obviously, there is a key potential problem with these types of fee arrangements. Self-interested and/or unethical clients can easily ―job‖ this type of fee arrangement to benefit themselves. Although I have not seen this proposal discussed, one way to possibly mitigate this problem would be to have some type of third party decide how much ―value‖ a given professional services engagement has yielded. This requirement would have to be included in the contract between the accounting firm and its client. Effectively, this would incorporate an automatic and binding mediation or arbitration feature into those contracts. You might use this question to prompt a freewheeling brainstorming session among your students regarding how accounting firms could and/or should revamp their pricing strategies and fee structures.
CASE 7.2
STEPHEN GRAY, CPA
Synopsis In 1988, the Federal Trade Commission effectively forced the AICPA to allow its members to accept commissions for certain services provided to non-attest clients. By the late 1990s, most state boards of accountancy had grudgingly adopted the AICPA‘s new ethical rule governing the receipt of commissions by CPAs. Stephen Gray, a CPA who owned and operated a small accounting practice in south central Mississippi, found himself swept up in the decade-long controversy over CPAs‘ receipt of commissions. In 1987, Gray obtained a brokerage‘s license and began offering brokerage services through his accounting firm. At the time, Gray realized that the Mississippi State Board of Public Accountancy prohibited CPAs from accepting commissions from their clients. Gray disagreed with
Case 7.2 Stephen Gray, CPA 267 that rule, insisting that the state board did not have the authority to ban CPAs from accepting commissions. Gray also believed that the rule was not in the public‘s interest. After he began offering brokerage services on a commission basis, Gray took several steps to protect the integrity of his CPA status. He prominently displayed his broker‘s license in his office to make clients and potential clients aware of his dual roles, he only accepted commissions from nonattest clients, and he informed his brokerage clients that he would earn commissions on securities trades they placed through him. In 1990, another CPA learned that Gray was offering brokerage services on a commission basis and notified the Mississippi state board. Following a hearing, the state board voted to revoke Gray‘s CPA certificate and license to practice, although he retained both while his case was under review. A state court subsequently overturned the state board‘s revocation decision only to see its decision reversed by the Mississippi Supreme Court. The latter court ruled that the Mississippi state board had the authority to establish practice and ethical standards for Mississippi CPAs. The supreme court also ruled that the ban on commissions was in the public‘s interest and served to protect and promote CPAs‘ independence and objectivity. In 1996, the Mississippi state board adopted the AICPA‘s rule that allows its members to accept commissions from non-attest clients. In that same year, the state board rescinded its decision to revoke Stephen Gray‘s CPA certificate and license to practice. Instead, the state board required Gray‘s accounting practice to undergo one year of supervisory review.
269 Stephen Gray, CPA--Key Facts 1. In 1987, Stephen Gray, a Mississippi CPA, obtained a broker‘s license and began offering brokerage services on a commission basis to non-attest clients, although he realized that doing so violated the ethical code of the Mississippi State Board of Public Accountancy. 2. Gray took several steps to protect the integrity of his CPA status, including informing his brokerage clients that he would earn commissions on the securities trades they placed through him. 3. Shortly after Gray began providing brokerage services, the AICPA voted to allow members to accept commissions for certain services provided to non-attest clients. 4. In late 1990, the Mississippi state board charged Gray with violating its ethical rule prohibiting CPAs from accepting commissions. 96. Gray maintained that the state board exceeded its statutory authority when it adopted the ban
on commissions and insisted that the ban was not in the public‘s interest. 6. The state board rejected Gray‘s arguments and voted to revoke his CPA certificate and license to practice in 1991. 7. The state court that presided over Gray‘s appeal of the state board‘s decision sided with him and
268 Case 7.2 Stephen Gray, CPA overturned the revocation of his CPA certificate and license to practice. 8. The Supreme Court of Mississippi overturned the state court‘s decision and reinstated the revocation of Gray‘s CPA certificate and license to practice, ruling that the ban on CPAs accepting commissions was in the public‘s interest and served to protect CPAs‘ objectivity. 9. In 1996, the Mississippi state board dropped its ban on CPAs receiving commissions from nonattest clients. 10. After the Supreme Court of Mississippi reinstated the state board‘s decision to revoke Gray‘s CPA certificate and license to practice, the state board withdrew that decision, requiring instead that Gray‘s accounting practice undergo one year of supervisory review.
Instructional Objectives 1. To examine ethical issues posed by allowing CPAs to receive commissions from non-attest clients. 2. To examine the role and purpose of professional codes of ethics and the factors that cause these codes to evolve over time. 3. To review the nature and purpose of the regulatory structure within the public accounting profession.
Suggestions for Use This case parallels the Scott Fane (Case 7.3) case in many ways. Fane, a Florida CPA, sued the Florida Board of Accountancy to overturn its ethical rule that prohibited CPAs from employing direct solicitation methods to obtain new clients. Fane‘s lawsuit was eventually decided by the U.S. Supreme Court, which ruled in his favor. In this case, Stephen Gray openly challenged and directly violated the Mississippi State Board of Public Accountancy‘s rule that prohibited CPAs from accepting commissions from non-attest clients. Gray‘s challenge was ultimately unsuccessful. But, when the Mississippi state board adopted the AICPA rule allowing CPAs to receive commissions from non-attest clients, the board reversed its earlier decision to revoke Gray‘s CPA certificate and
Case 7.2 Stephen Gray, CPA 269 license to practice. In short, covering these two cases in tandem would provide students with interesting insights on the evolution of the profession‘s ethical rules and on the nature, purpose, and complexities of the profession‘s regulatory structure.
Suggested Solutions to Case Questions 1. Each profession, medicine, law, the clergy, accounting, among others, lays claims to an exclusive mandate to provide a specific, needed, and highly valued service to society at large. By their nature, professions presume to be, in some sense, a step above or beyond other vocations. This presumption apparently stems from the members of a profession exhibiting some degree of altruism or willingness to engage in self-sacrifice for the greater good of society. A code of ethics helps ensure that members of a profession live up to its high ideals. In the absence of a code of ethics, a profession‘s good name and public image would stand a higher risk of being tarnished by opportunistic and selfserving ―professionals.‖ At some point, a profession might lose its cherished status and be relegated to simply a vocation. If that happened, members of the profession would suffer a loss of prestige, self-respect, and likely economic opportunities. Likewise, society would suffer since the needed or highly valued service would likely be provided from that point on by ―unprofessional‖ or, at least, less qualified individuals. In my view, the key factor that accounts for the dynamic nature of most professional codes of ethics is the ebb and flow within society of what is considered moral or ethical conduct. Over the history of this country, there clearly have been major changes in many important values and attitudes broadly held by members of society. These changes, which typically take place over a long time span, impact the ethical issues faced by individual professions and how professions respond to these issues. Other factors that impact the ethical issues faced by a profession, and thus their ethical codes, include changes in technology (consider the recent heated arguments stemming from scientists‘ newfound ability to clone life), competitive pressures (most professionals believe they have a right to ―earn a living‖), and the morality or ethical judgment exhibited by each generation‘s leaders in political affairs, sports, entertainment, the sciences, and, yes, education. 2. The Mississippi state board dropped its ban on commissions at approximately the same time that the final court opinion was rendered in the Stephen Gray case, the ruling that upheld the state board‘s revocation of his CPA status. The timing of these two events, no doubt, created an ―interesting‖ dilemma for the state board. If it insisted on revoking Gray‘s CPA certificate, the board might lose respect for punishing a CPA for conduct that was now permissible. On the other hand, if it chose not to punish Gray in any way, it might look ―soft‖ on rules violators, thus costing it credibility. The board chose to resolve this dilemma by choosing a ―middle ground‖ option. That is, by (lightly) punishing Gray but allowing him to remain a member of the profession. For what my opinion is worth, I believe the Mississippi state board‘s decision was rational, compassionate, and most likely allowed it to retain the respect of CPAs in the Magnolia State. 3. This situation is dealt with directly by an ethics ruling for the Section 500 rules of the Code of Professional Conduct. The answer is ―no‖ . . . generally. The CPA‘s spouse may provide such services on a commission basis ―if the activities of the spouse are separate from‖ the CPA‘s practice and the CPA is ―not significantly involved in those activities.‖ [See ET Section 591.373]
270 Case 7.3 Scott Fane, CPA
4. The AICPA is the most prominent national organization of CPAs in the public accounting profession. The AICPA plays a key role in the standard-setting processes of the profession, oversees the preparation and grading of the uniform CPA examination, operates an extensive continuing professional education program for CPAs, and actively promotes and implements a wide range of programs to ensure that CPAs provide a high quality of professional services to the public. The AICPA also has the right to discipline its members, including expulsion from the organization; however, the AICPA cannot ban CPAs from practicing public accounting since it is not a governmental agency. All professions, including public accounting, are regulated at the state level. Each state has a state board of accountancy (the actual title of these agencies varies somewhat from state to state). The primary responsibility of these boards is to enforce the statutes that govern the practice of accountancy in a given state. Among other specific duties, a state board of accountancy typically establishes and enforces continuing education requirements, issues CPA certificates and licenses to practice public accounting, and rules on ethical complaints filed against individual CPAs. Unlike the AICPA, a state board of accountancy can impose stiff penalties and sanctions on CPAs, including revoking their CPA certificates and/or licenses to practice. ―State societies‖ of CPAs provide some of the same services as the AICPA except that they limit these services to member CPAs in one state. Sponsoring continuing professional education programs is the most common service provided to CPAs by state societies. Unlike state boards of accountancy, state societies have no regulatory authority over public accountants.
CASE 7.3
SCOTT FANE, CPA
Synopsis In 1985, Scott Fane shut down his New Jersey accounting practice and moved south to sunny Florida. Scott hoped that Florida‘s booming economy would allow him to quickly establish a prosperous accounting practice. After arriving in Florida, Scott, a CPA, filed for a license to practice in Florida with the State Board of Accountancy. After obtaining that license, Scott intended to recruit clients for his new practice using methods that had worked well for him in New Jersey. He planned to use direct solicitation measures, such as, direct mail, telephone calls, and in-person visitations to obtain clients. Scott soon learned that the Florida State Board of Accountancy prohibited CPAs from directly soliciting clients. After several years of frustration, Scott sued the state board in 1990. In his lawsuit, he maintained that the board‘s ban on direct solicitation was
Case 7.3 Scott Fane, CPA 271 unconstitutional. Scott charged that the ban violated his First Amendment rights to freedom of speech, more specifically, his right to commercial speech. After several rounds of legal battles, Scott and the Florida State Board of Accountancy squared off in front of the U.S. Supreme Court. In 1993, the Supreme Court ruled in Scott‘s favor, effectively squelching Florida‘s ban on direct solicitation by CPAs. Within months after the Supreme Court ruling in Scott‘s case, the Florida Supreme Court struck down the Florida Board of Accountancy‘s ban on competitive bidding by CPAs. Similar to the Fane case, the Florida Supreme Court ruled that the ban on competitive bidding improperly restricted CPAs‘ right to commercial speech. In 1994, the Florida state board saw its record fall to 0 and 3 in commercial speech cases. Silvia Ibanez, a practicing attorney who was also a CPA and a CFP, sued the Florida state board for reprimanding her. The reprimand stemmed from Ibanez publicizing her CPA and CFP designations in the yellow pages and on her business cards. The state board ruled that Ibanez‘s use of her CPA designation misled third parties who might conclude that she was a practicing CPA. Additionally, the state board charged that her use of the CFP designation violated its rule that Florida CPAs could publicly display only specifically approved speciality designations. (The CFP designation had not been approved as a specialty designation by the state board.) The U.S. Supreme Court ruled that the state board had improperly infringed on Ms. Ibanez‘s freedom of (commercial) speech and overturned the reprimand imposed on her.
273 Scott Fane, CPA--Key Facts 1. Scott Fane, CPA, moved to Florida from New Jersey in 1985 because he hoped that Florida‘s healthy economy would allow him to develop a successful accounting practice. 2. In New Jersey, Fane used direct solicitation to pursue potential clients, but Florida‘s state board banned direct solicitation efforts by CPAs. 3. Fane sued the Florida Board of Accountancy, alleging that its ban on direct solicitation infringed on his First Amendment rights of freedom of speech. 97. The state board defended its ban on direct solicitation by maintaining that it shielded the public from ―overreaching‖ CPAs and safeguarded auditors‘ independence. 98. A federal district court and the U.S. Court of Appeals ruled in Fane‘s favor, prompting the Florida State Board to appeal the case to the U.S. Supreme Court. 99. In the Fane case, the Supreme Court noted that commercial speech is generally protected as long as it is truthful and not misleading. 100. The Supreme Court ruled in Scott Fane‘s favor, concluding that the Florida state board failed to prove that allowing CPAs to use direct solicitation methods posed a serious harm to the public.
272 Case 7.3 Scott Fane, CPA 101. Justice O‘Connor dissented to the decision in the Fane case, pointing out the adverse impact that ―incremental commercialization‖ has had on professions. 102. In 1993, the Florida Supreme Court struck down the state board‘s ban on competitive bidding,
ruling that the ban improperly restricted Florida CPAs‘ right to commercial speech. 10. In 1994, the U.S. Supreme Court ruled in favor of another Florida CPA who charged that the state board had infringed on her right to commercial speech, including her right to display her CPA designation (she did not publicly practice) and her CFP designation.
Instructional Objectives 1. To examine recent controversies stemming from previous ethical rules that allegedly infringed on CPAs‘ First Amendment rights to freedom of (commercial) speech. 2. To consider the impact that a profession‘s ethical code has on new and potential members of that profession.
3. To consider the impact that recent changes in the accounting profession‘s ethical rules has had on the nature and degree of ―commercialization‖ within the profession. 4. To examine the role of state boards of accountancy and the courts in regulating the public accounting profession.
Suggestions for Use You might consider using this case in the introductory auditing course at the undergraduate level to initiate a classroom discussion of ethics. This case demonstrates the ―state of flux‖ that has characterized the profession‘s ethical code over the past two decades. Probably most important, the case helps students recognize an important dual reality that public accountants face. On the one hand, the public accountant is a professional whose objective is to serve the public interest and the
Case 7.3 Scott Fane, CPA 273 needs of individual clients; on the other hand, the public accountant is a businessperson, dead-set on earning a reasonable livelihood. As we all know, the profession, as a whole, and individual CPAs wrestle daily with the problems posed by this dual reality. This case also provides instructors with an opportunity to demonstrate to students that the public accounting profession is dynamic and is likely to continue undergoing significant changes in the years to come. (To make this point even more vivid, you might include a discussion of the far-ranging effect that the Sarbanes-Oxley Act of 2002 is having—and will will have--on the profession.) Students need to consider the impact that such changes will likely have on their future work environment and the professional roles they will assume. Hopefully, a better understanding of the dynamic nature of the profession will allow our students to have more meaningful input on the future direction the profession takes.
Suggested Solutions to Case Questions 1. As a point of information, the U.S. Court of Appeals that issued a ruling in the Scott Fane case noted that commercial speech involves ―expression that is related exclusively to the economic interests of the speaker and audience.‖ The best or, at least, most expedient approach to responding to this question may simply be to refer to the AICPA Code of Professional Conduct and one-by-one ask students whether each rule infringes on CPAs‘ right to commercial speech. Not being a lawyer by training, my opinion is not binding here, but I do not believe that a reasonable argument could be made that any of the existing ethical rules violates CPAs‘ right to commercial speech. In stretching for potential ―candidates‖ in this context, there are three rules I would mention simply because they refer in some way to communication (speech) by CPAs: Rule 301, ―Confidential Client Information;‖ Rule 503, ―Advertising and Other Forms of Solicitation;‖ and Rule 505, ―Form of Organization and Name.‖ The latter rule, for instance, prohibits accounting firms from using firm names that are misleading. Although this rule imposes definite boundaries on the ―speech‖ or communication efforts of CPA firms, we all know that even the right to ―plain vanilla‖ freedom of speech is limited. (Here, you can make use of the yelling-―fire‖-in-a-crowdedtheater example to reinforce this point.) 2. Ethical codes can drastically limit the ability of ―newcomers‖ to quickly establish an economic beachhead or, at least, economic toehold in a profession. For example, the direct solicitation rule, although defensible in many respects, clearly served to make it more difficult for Scott Fane types to move to Florida and quickly establish robust accounting practices at the expense of native Floridian CPAs. Most of us recall other comparable ethical rules that have fallen by the wayside in recent decades. In the past, an accounting firm that wanted to ―raid‖ a competing firm‘s workforce had to first obtain the competing firm‘s permission to contact its employees. Clearly, that rule imposed economic constraints on accounting firms, particularly small, growth-oriented firms. Likewise, the ban on competitive bidding, intentionally or unintentionally, served to protect accounting firms from losing their existing audit clients to ―lowballing‖ competitors. (In a slightly different vein, many cynics external to the accounting profession have suggested that the new five-year educational requirement is actually intended to protect the economic interests of those individuals who have
274 Case 7.3 Scott Fane, CPA already earned their pass key to the profession.) 3. Since competitive bidding appears to drive down the audit fees paid for independent audits, it likely reduces the profitability of independent audits. Why? Because auditors generally have to expend the same resources to complete an audit regardless of the amount they are being paid. If auditors attempt to ―cut corners‖ and do audits more cheaply in the face of competitive bidding, they may violate generally accepted auditing standards and expose themselves to various sanctions and economic penalties, including monetary losses in civil judgments. In the long run, then, competitive bidding may cause some accounting firms to gradually de-emphasize the importance of audits as a source of revenue and begin focusing on providing other (more profitable) professional services. These latter services would likely include consulting, assurance, or taxation services. Although a few years old at this point, the following article provides an excellent and interesting analysis of the impact of excessive price competition among auditors on the independent audit function: R.H. Hermanson, L.M. Dykes, and D.H. Turner, "Enforced Competition in the Accounting Profession: Does It Make Sense?" Accounting Horizons (December 1987), pp. 13-19. 4. The key advantage or benefit of lowballing for accounting firms is that it allows them to quickly build a client base. From the perspective of audit clients, the key benefit of lowballing is cheaper audits. Generally, the profession views lowballing as a negative phenomenon. Lowballing typically occurs in competitive bidding scenarios, that is, when several accounting firms submit bids to obtain the right to perform a given entity‘s independent audit. In at least some cases, audit firms allegedly submit competitive bids that do not allow them to fully recover the costs of completing an engagement. In such cases, audit firms may be particularly tempted to provide a ―bare bones‖ audit, that is, to cut corners and provide lower quality audits. No doubt, if accounting firms consciously choose to lower the quality of independent audits, the image of the public accounting profession will be tarnished. Likewise, one would expect lower-quality audits to result in heavier litigation losses for accounting firms. Most important, lower-quality audits would adversely impact investors, creditors, and other financial decision makers who rely on independent auditors. Lower-quality audits would likely result in these parties more often arriving at sub-optimal economic decisions. 103. Advantages of having the accounting profession regulated by state agencies:
(a) State regulatory agencies, because they are smaller than federal agencies, can likely respond on a more timely basis to issues and concerns raised by CPAs and users of CPAs‘ services. (b) State agencies can more readily monitor the interests and concerns of their constituents and tailor rules and regulations that ―fit‖ those constituents‘ needs. (The premise here is that the interests, concerns, and needs of CPAs and users of CPAs‘ services vary somewhat from state to state.) Disadvantages of having the accounting profession regulated by state agencies: (a) State regulatory agencies may be more subject to being pressured (successfully) by the parties they regulate than federal regulatory agencies. (b) Because the rules and regulations of state boards of accountancy are not consistent,
Case 7.4 Hopkins v. Price Waterhouse
275
professionals often face certification and licensing problems when they move from one state to another. (c) Having one federal agency oversee a profession would likely result in considerable cost savings. 104. Following are examples of ―creeping commercialization‖ within the accounting profession in recent years, some of which have been alluded to in suggested answers for previous case questions:
(a) Increasingly extensive and elaborate advertising. (Students may not realize that for most of this century CPAs were not allowed to advertise at all.) (b) Competitive bidding for audit engagements and the accompanying lowballing phenomenon. (Allegedly, some accounting firms use an audit as a ―loss leader;‖ that is, these firms acquire an audit engagement with a lowball competitive bid with the hopes of selling extensive consulting and other types of services to the new audit client.) (c) Efforts to develop new markets for CPAs. (Examples include allowing CPAs to offer brokerage services and the relatively new and aggressive move by the profession to offer assurance services, particularly in the healthcare industry and in the field of electronic commerce.) (d) A growing number of specialty designations and specialty services within the profession. (Examples of specialty designations include the CFP, certified financial planner, and the CFE, certified fraud examiner. Forensic accounting is a prime example of a specialty service that many accounting firms now offer exclusively.) The new ―commercial age‖ of the public accounting profession has witnessed a dramatic upswing in litigation problems for accounting firms. Some critics suggest that lower quality professional services, particularly lower quality audits, account for the litigation headaches now suffered by accounting firms. In turn, these critics claim that the lower quality of professional services results from accounting firms placing too much emphasis on economic issues and too little emphasis on complying with professional standards and ethical rules. Other parties maintain that the recent surge in litigation involving accounting firms is unrelated to the increasingly commercial nature of the profession. These parties tend to attribute the litigation crisis in the accounting profession to the increasingly litigious nature of our society--individuals and businesses now seem more prone to rely on the courts to resolve their differences rather than attempting to mutually ―work out‖ those differences. In summary, probably the most noticeable change within the accounting profession that has been brought on by ―creeping commercialization‖ is the extensive marketing efforts undertaken by CPAs, CPA firms, the AICPA, and state societies of CPAs. Faced with increasing competitive pressures from colleagues within the profession and other professional and ―quasi-professional‖ groups external to the profession, CPAs have been forced to ―market‖ themselves extensively for the first time.
276 Case 7.4 Hopkins v. Price Waterhouse
CASE 7.4
HOPKINS V. PRICE WATERHOUSE
Synopsis In 1983, Ann Hopkins was nominated for promotion to partner with Price Waterhouse. Hopkins, a senior manager in the firm at the time, seemed to have excellent credentials for a partnership position. In fact, of the 88 individuals nominated for partner that year, Hopkins had generated by far the most client revenues for the firm. Hopkins was also unique in that she was the only female among the partner candidates. Unfortunately for Hopkins, she was not promoted to partner and was subsequently told that she had little chance of being promoted in the future. After resigning from the firm in 1984, Hopkins began to question why she was denied the promotion to partner. Eventually, she decided to sue Price Waterhouse, claiming that she had been rejected for partnership on the basis of her gender. After a lengthy trial and several appeals, one of which was ruled on by the Supreme Court, Hopkins was awarded $400,000 in compensatory damages. Price Waterhouse was also ordered to offer Hopkins a partnership position, apparently the first time in U.S. history that a court had handed down such an order. The principal purpose of this case is to focus attention on several issues facing women entering the public accounting profession. Probably the most perplexing of these issues is the difficult task of successfully managing a professional career and having a family. Ann Hopkins, an energetic mother of three small children during her tenure at Price Waterhouse, achieved a good balance between her home life and professional work role. Another challenging issue that women public accountants face is the dominant male culture that pervades many CPA firms. In Hopkins' case, she was apparently forced to deal with a work environment in which sexual stereotypes dictated how she was expected to behave. In fact, a court ruled in her civil suit that Price Waterhouse had evaluated her as a
Case 7.4 Hopkins v. Price Waterhouse
277
candidate for becoming a female partner with the firm rather than simply a partner. That is, there was an expectation that female partners and female partner candidates behave in a feminine manner, which was not Hopkins' style. Hopkins, like many other women in the profession, also had to cope with the lack of female mentors. Finally, early in her career, Hopkins had been forced by the nepotism rule of her original employer, Touche Ross, to leave that firm so her husband would have an opportunity to be promoted to partner.
279 Hopkins vs. Price Waterhouse--Key Facts 1. Historically, females and minorities have been under-represented in the large international accounting firms, particularly at the partner level. 2. Early in her career, Ann Hopkins had been forced to resign from Touche Ross because that firm's nepotism rule precluded her and her husband from both being considered for promotion to partner. 3. Hopkins was the only female among the 88 candidates for partner with Price Waterhouse in the year that she was nominated for promotion. 4. Hopkins had generated more revenues for Price Waterhouse than any of the other partner candidates. 5. Hopkins' office managing partner informed her, following the announcement that her nomination for promotion had been placed on hold, that she should behave more "femininely." 6. The trial in Hopkins' suit against Price Waterhouse revealed that several partners had made sexist remarks regarding her qualifications for partner. 7. The trial also revealed that prior female candidates for partner had been the target of sexist remarks by Price Waterhouse partners. 8. Evidence presented during the trial confirmed that Hopkins had deficiencies in her interpersonal skills but that similar deficiencies had not prevented prior male candidates for partner from being promoted. 9. The judge hearing Hopkins' suit ruled that she had been evaluated by Price Waterhouse as a female partner candidate rather than simply as a partner candidate. 10. The judge in the Hopkins case ruled that the sexual discrimination she experienced had not been overt but rather latent in the culture of Price Waterhouse.
278 Case 7.4 Hopkins v. Price Waterhouse
11. In 1990, Hopkins was awarded a judgment of $400,000 against Price Waterhouse; the firm was also ordered to offer Hopkins a partnership position, an offer she accepted. 12. In recent years, an increasing number of women have been promoted to partnership positions with the major accounting firms; nevertheless, women are still significantly underrepresented within the partnership ranks of those firms.
Instructional Objectives 1. To demonstrate the unique challenges that women face in pursuing a public accounting career. 2. To illustrate that discriminatory attitudes against women public accountants may be latent within the culture of their employing firms. 3. To raise the issue of whether public accounting firms have a responsibility to implement measures specifically intended to facilitate the career success of their female employees. 4. To provide insight on the partnership promotion process of large accounting firms. 5. To document the historical under-representation of women and minorities in large accounting firms.
Suggestions for Use This case can be integrated at practically any point in an auditing course. The most obvious point at which to discuss this case would be during coverage of the introductory chapter in the standard auditing text, a chapter that typically provides a broad overview of the public accounting profession, including the changes it is undergoing and the challenges it faces in the future. However, rather than discussing this case early in the semester, I typically defer presenting it until mid-semester. In a sense, I use this case to give my students a brief "break" from the technical aspects of auditing. The key purpose of this case is to sensitize both male and female students to the unique challenges that women public accountants face in their careers. Making both sexes aware of the subtle but often pervasive nature of sexual discrimination is the first step toward remedying this problem. As noted in the case, the presiding judge in the Hopkins suit against Price Waterhouse ruled that the firm‘s partners were not aware they were discriminating against females. In fact, Ann Hopkins, herself, admitted during the trial that she never witnessed any overt discriminatory acts against her while she was with Price Waterhouse. Of course, subtle or latent discrimination is very
Case 7.4 Hopkins v. Price Waterhouse 279 difficult to detect and combat. Hopefully, by making aspiring public accountants aware of this problem they will be more sensitive to it and recognize the constraints and inequities that it imposes on women public accountants. If an instructor wishes to pursue the central issues in this case in more detail, he or she can refer to a number of articles regarding these issues that have appeared in the Journal of Accountancy in recent years. Many of these articles are reports by the AICPA task force that is responsible for monitoring the progress of women in public accounting. Another article that might be of interest is the following one that I co-authored with Soon-Yong Kwon: "Toward a Better Understanding of the Underrepresentation of Women and Minorities in Big Eight Firms," Advances in Public Interest Accounting, Vol. 4 (1991), pp. 47-62.
Suggested Solutions to Case Questions 1. This is a question that typically generates quite different responses from students. Generally, the majority of students suggests that public accounting firms have an obligation to adopt policies designed to help women overcome the barriers to success that they have historically faced in the public accounting profession. However, my experience has also been that a certain proportion of male students will mention the phrase "reverse discrimination" when they respond to this question. These individuals typically suggest that accounting firms should be fair to all employees but do not have a responsibility to "bend over backwards" to accommodate the special needs of any one group of employees. [I would caution instructors to deal with this issue with a great deal of sensitivity since it often evokes emotional responses from both female and male students.] Following is a list of measures, identified by former students of mine, that accounting firms could consider implementing to facilitate the career success of women public accountants (and minority public accountants as well). a. b.
c. d.
e.
f.
Accounting firms could make greater use of females and minorities in their recruiting processes. The large offices of public accounting firms could adopt a policy of having at least one female and/or minority involved in their personnel function. Females and minorities would likely be more comfortable in discussing sensitive issues related to job discrimination with such an individual. Accounting firms could develop a formal mentoring system for their female and minority employees. The executive offices of accounting firms could review their promotion and performance appraisal policies and procedures to make sure that they are gender and color "blind." "Sensitivity" seminars could be developed for partners and employees to make them aware of the subtle discrimination that females and minorities often face within their firms. Accounting firms could give female employees an opportunity to adopt flexible work
280 Case 7.4 Hopkins v. Price Waterhouse schedules to help them meet the dual responsibilities of their professional and family roles. 2. The "old boy network" is a phrase generally used in reference to a small clique of key decision-makers within an organization. As the term implies, typically all of the members of such groups are male. In most cases, this phrase has pejorative connotations. For instance, members of an old boy network are often perceived as protecting and furthering their own economic self-interests and those of their colleagues at the expense of individuals outside their clique. Should professional firms attempt to break down old boy networks? Certainly, it does not appear proper or advantageous for professional firms to encourage the formation and continuation of such cliques since their existence can be very disruptive and counter-productive to an organization's operations. For example, women public accountants are often not included in the informal "power" groups that form within an accounting firm. As a result, they do not benefit from the often very significant influence that these groups can impose on a firm's or practice office's personnel decisions. At the very least, accounting firms should ensure that personnel-related and other key operating decisions are not made "behind closed doors" by self-interested cliques. Instead, these decisions should be made in an open forum in which all appropriate individuals are allowed to participate fully and fairly in the decision-making process. 3. The key criterion in assigning auditors to audit engagements should be the personnel needs of each specific engagement. For instance, one engagement may need an individual with significant EDP auditing experience, another engagement may require an individual with knowledge of sophisticated cash management systems, etc. 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 complaint in this context predicated upon the race, gender, or physical limitations of an auditor are nearly always unjustified. If client management objects to a given auditor being assigned to their company's audit team for an unjustified reason, the individuals responsible for staffing decisions within the given practice office should politely but firmly inform client management that its request is unreasonable. If the client persists, the audit firm should consider resigning from the engagement. Hopefully, over the long run, accounting firms will be rewarded for such a commitment to high ideals and ethical norms by their local business community. [Note: As a point of information, Case 7.6, ―Bud Carriker,‖ focuses on the key issue raised by this question.] 4. Nepotism rules have been adopted in many settings, not just professional firms. Historically, the principal purpose of such rules has been to ensure that the leadership positions within an organization are "earned" rather than "bequeathed." That is, organizations adopting such rules believe that competence should be the key factor in the determination of which individuals are given leadership positions and other organizational rewards. As a general rule, the key benefit of such a policy is that an organization has a better chance to thrive and prosper over time because the most qualified individuals are the ones promoted and, consequently, the ones who generally remain with the organization. The key disadvantage of nepotism rules is that qualified individuals may not be allowed to assume leadership positions in an organization because they happen to be related to another individual in that organization.
Case 7.4 Hopkins v. Price Waterhouse 281 In most employment contexts, nepotism rules have historically been more disadvantageous for females than males. If a married couple is employed by an organization, the husband is more likely to have a longer tenure with the employer (because he is typically older than his wife). Consequently, the wife is generally perceived as having a smaller "investment" in the employer and thus is the spouse who is more likely to resign when the nepotism policy of the firm is invoked. [Quite often, married couples can work together at professional firms until they reach the partner level. At that point, however, only one of the individuals will typically be considered for promotion to partner.] 5. As you might expect, the U.S. Senate and the Big Eight firms had diametrically opposed views on this matter. The U.S. Senate believed that since the major accounting firms had essentially become a part of the regulatory process for the financial reporting sphere (through their role in the rule-making process for accounting and financial reporting), the federal government had an oversight responsibility with respect to these firms. Other critics of public accounting firms suggested that these firms should be the subject of federal oversight since most of them had very large contracts with the federal government or agencies of the federal government. On the other hand, the Big Eight firms argued that they were private partnerships and thus not subject to federal oversight. Were the requests of the U.S. Senate an invasion of the Big Eight firms' privacy? An unequivocal answer can probably not be given to that question since both parties had legitimate views. However, it does seem appropriate that professional firms that become involved in regulatory processes of the federal government and/or that become major suppliers of professional services to the federal government should be subject to federal oversight. Even if the information requested by the U.S. Senate during the Metcalf hearings is strictly "private" information, one could credibly argue that such information should be made available to the public. In 1984, in a case involving Arthur Young & Company, the U.S. Supreme Court noted that the primary responsibility of auditors and audit firms is to the public interest. Consequently, it seems reasonable to suggest that these firms should be responsive to the requests of elected officials who represent the general public. In a nutshell, the issue here is whether or not the public has a right to know if the parties to whom it has delegated a key societal role are maintaining high standards of professional and ethical conduct.
CASE 7.5
SARAH RUSSELL, STAFF ACCOUNTANT
Synopsis
282 Case 7.5 Sarah Russell, Staff Accountant
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 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.
285 Sarah Russell, Staff Accountant--Key Facts 1. Sarah 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 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.
Case 7.5 Sarah Russell, Staff Accountant 283 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. 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
284 Case 7.5 Sarah Russell, Staff Accountant
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 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 all 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
Case 7.7 National Medical Transportation Network 285 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 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 likely should have referred 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.
CASE 7.6
BUD CARRIKER, AUDIT SENIOR
Synopsis Bud Carriker had a plan. After graduating from college with an accounting degree, Bud intended to spend several years in public accounting working as an independent auditor. Then he
286 Case 7.7 National Medical Transportation Network would seek a mid-level accounting position with a firm in the banking or financial services industries. His eventual career objective was to become a controller or chief financial officer in one of those industries. During the first several years that Bud was employed on the audit staff of one of the major accounting firms, he requested an assignment to a bank or financial services audit engagement. Near the beginning of his fifth busy season, Bud finally got his wish. His firm unexpectedly acquired a new bank client. The office managing partner told Bud that he would be assigned to the engagement for two reasons: (1) Bud had requested such an assignment and (2) the high-risk nature of the engagement dictated that a ―heavy‖ senior, such as Bud, be assigned to the job. After completing preliminary internal control work, meeting key client personnel, including the owner of the bank, and working on a draft of the audit program, Bud‘s dream assignment was off to a good start. Then, on a Friday afternoon as he was completing the audit program, Bud‘s office managing partner met with him. The managing partner informed Bud that he was being taken off the bank audit engagement team. A stunned Bud asked why he was being replaced. The partner reluctantly told Bud that he was being removed from the engagement because the bank‘s owner was not ―comfortable‖ with Bud. The owner‘s discomfort stemmed from the fact that Bud was a minority.
289 Bud Carriker, Audit Senior--Key Facts 1. Bud Carriker, a college basketball player, chose to major in accounting because he realized that the accounting profession would provide him with an opportunity to earn a good livelihood. 2. Bud decided to begin his career in public accounting on the audit staff of a major accounting firm. 3. After obtaining several years of experience in public accounting, Bud hoped to obtain a midlevel position in the banking or financial services industries, with the eventual career objective of becoming a controller or chief financial officer in one of those fields. 4. During his first several years in public accounting, Bud requested that he be assigned to audits in the banking or financial services industries.
Case 7.7 National Medical Transportation Network 287
5. Bud finally got his wish when he was chosen to serve as the audit senior on the audit of a bank that his firm unexpectedly acquired as a client shortly before the beginning of his fifth busy season. 6. After completing preliminary work on the engagement, which included meeting the bank‘s owner and other key client personnel, Bud was asked to meet with his office‘s managing partner one afternoon. 7. During that meeting, Bud was shocked when the office managing partner told him that he was being removed from the bank audit. 8.
Initially, the partner was reluctant to tell Bud why he was being removed from the engagement.
9. The partner then admitted that Bud was being removed because the bank‘s owner was not comfortable having a minority assigned to the audit engagement team. 10. A few months after being removed from the bank audit, Bud left his employer for a job in the private sector.
Instructional Objectives 1. To provide students with insight on the professional role and work environment of an audit senior with a major accounting firm. 2. To demonstrate that the public accounting profession is a microcosm of society and that society‘s problems affect the accounting profession and the independent audit function.
Suggestions for Use This case focuses on an issue that you may not feel is appropriate to address in an auditing or accounting course, namely, racial discrimination. However, I believe that students should recognize
288 Case 7.7 National Medical Transportation Network that the public accounting profession is, in fact, a microcosm of society and, as a result, disconcerting social problems such as racial discrimination, sexual harassment, etc., affect this profession just as they 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 the profession, which was certainly true in this case. I believe that prospective public accountants will have a richer understanding of their future professional roles if they discuss how important social problems affect those roles. 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 some level of discomfort among students. As a result, an instructor will benefit if he or she has a good understanding of the temperament, 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. Again, this case focuses on very sensitive issues. As a result, instructors may want to consider the interpersonal dynamics of their given classes before deciding how to address the case questions. In retrospect, we would hope that as soon as Saunders perceived the underlying reason for Charles‘ request, he would simply have told Charles that the race and gender of individual auditors were not legitimate considerations in deciding the makeup of an audit engagement team. Another approach that Saunders could have taken in responding to Charles‘ request would have been to explain that the key factor influencing staffing decisions for any given audit is the specific needs of that engagement. For example, for audits of companies in specialized industries, such as electric utilities or insurance firms, someone on the engagement team, preferably someone in a supervisory position, should have significant experience auditing entities in those industries. In the case of the new bank client, Saunders believed that it was imperative to assign a ―heavy‖ senior to supervise the engagement, which was an important consideration in choosing Bud for that job. Saunders could have explained this rationale to Charles and insisted that to properly complete the audit, it was necessary to have Bud supervise the field work on the engagement. 2. Interpretation 501.2 of the AICPA Code of Professional Conduct is entitled ―Discrimination and Harassment in Employment Practices.‖ According to that interpretation, an AICPA member has committed an ―act discreditable‖ to the profession when a ―court‖ or ―competent jurisdiction‖ determines that he or she has violated ―any of the antidiscrimination laws of the United States or any state or municipality thereof.‖ This interpretation became effective on November 30, 1997, well after the events in this case transpired. Certainly, Bud Carriker was the victim of discrimination in this case and, in my view, Alex Saunders was a party to that discrimination. Despite the fact that the profession‘s ethical code at the time did not expressly prohibit such conduct, in my view, Saunders‘ complicity in the discrimination suffered by Bud qualifies as ―unethical‖ conduct. 3. I will not presume to answer this question since I am not a racial minority. When covering this case, I typically ask minority students if they would consider answering the question.
Case 7.7 National Medical Transportation Network 289
4. Hopefully, the attention that has been focused on racial discrimination within the work environment and the resources that have been dedicated to addressing this social problem have reduced its severity over the past few decades. However, it would be naïve and unrealistic to assume that this phenomenon would be eradicated anytime soon.
CASE 7.7
NATIONAL MEDICAL TRANSPORTATION NETWORK
Synopsis National Medical Transportation Network faced a financial crisis in 1992 after losing its line of credit unexpectedly. Compounding this crisis for MedTrans‘ CEO was the resignation of the company‘s CFO and repeated run-ins with Gordon Johns, the Deloitte & Touche partner who supervised MedTrans‘ annual audits. In June 1992, while Deloitte was nearing completion of its fiscal 1992 audit of MedTrans, the former CFO told Johns that he lacked faith in the integrity of Roberts, MedTrans‘ CEO, and the company‘s financial statements. Deloitte eventually concluded that MedTrans‘ 1992 financial statements contained material errors. The audit firm proposed adjustments that converted the company‘s pre-audit net income of $2 million to a net loss of $500,000. Throughout the summer of 1992, Roberts and Johns butted heads over these proposed adjustments. At one point, Roberts arranged for a $10 million investment in MedTrans by an external party, a deal contingent on MedTrans receiving an unqualified opinion on its 1992 financial statements. The deal collapsed when Deloitte refused to issue such an opinion and resigned. Prompting Deloitte‘s resignation were verbal threats Roberts made to Johns. Johns believed these threats impaired Deloitte‘s independence and obligated the firm to resign as MedTrans‘ auditor. Following Deloitte‘s resignation, Roberts authorized Deloitte to communicate with three potential successor audit firms. In each case, Deloitte informed the potential successor of the circumstances leading to its resignation. In the fall of 1992, MedTrans finally retained another audit firm. Before issuing an unqualified opinion on MedTrans‘ 1992 financial statements, that firm insisted that the company book the adjustments initially proposed by Deloitte. After MedTrans‘ owners sold the company for a loss in 1993, they sued Deloitte, charging that the firm negligently resigned as its auditor, breached its contract by doing so, and defamed MedTrans during communications with potential successor auditors. A California jury sided with MedTrans‘ former owners, awarding them a $9.9 million judgment. An appellate court later overturned that
290 Case 7.7 National Medical Transportation Network verdict, ruling that each of the allegations made by MedTrans‘ former owners was invalid.
293 National Medical Transportation Network--Key Facts 105. In the spring of 1992, near the end of its 1992 fiscal year, MedTrans faced a crisis brought on by a severe cash flow problem and the resignation of its CFO.
2. Following his resignation, MedTrans‘ former CFO told Gordon Johns, the Deloitte partner who served as MedTrans‘ audit engagement partner, that the company‘s accounting records were unreliable and that he doubted the integrity of MedTrans‘ CEO. 3. Throughout the summer of 1992, Johns and Roberts, MedTrans‘ CEO, quarreled over large adjustments Deloitte had proposed to MedTrans‘ fiscal 1992 financial statements. 106. A proposed $10 million investment in MedTrans fell through when Roberts verbally threatened Johns, causing Deloitte to resign as MedTrans‘ audit firm before completing its 1992 audit.
5. Deloitte informed each potential successor auditor of the problems that led to the end of its relationship with MedTrans--Roberts had authorized Deloitte to communicate ―freely‖ with those potential successor audit firms. 107. The audit firm that ultimately replaced Deloitte insisted on MedTrans recording the adjustments initially proposed by Deloitte. 108. After selling MedTrans in 1993, the company‘s former owners sued Deloitte, alleging that the firm had acted negligently when it resigned as MedTrans‘ auditor, breached its contract, and defamed MedTrans in communications with potential successor auditors. 109. In attempting to rebut the key allegation of MedTrans‘ former owners, Deloitte insisted that it was obligated to resign as the company‘s audit firm after Roberts verbally threatened Johns. 110. A California state jury agreed with each allegation that MedTrans‘ former owners had made against Deloitte and ordered the firm to pay the former owners $9.9 million.
10. An appellate court overturned the lower court ruling; this court found that Deloitte had a reasonable basis for resigning from the 1992 audit and discredited the other allegations made by Medtrans‘ former owners against Deloitte.
Case 7.7 National Medical Transportation Network 291
Instructional Objectives 1. To examine the contractual responsibilities of auditors to their clients. 2. To introduce students to sources of auditor-client conflicts, approaches to coping with such conflicts, and the negative impact that such conflicts can have on an auditor-client relationship. 111. To review the nature and purpose of predecessor-successor auditor communications. 112. To illustrate the importance of independent audits to third-party decision makers.
Suggestions for Use I include this case in my pool of potential ―semester openers.‖ In my view, this case gets to the heart of the independent audit function. We have a client that desperately needs to raise new capital. To obtain that capital, the client needs an audit opinion, but not ―any old opinion.‖ The client must have an unqualified opinion or the potential investor will walk. We have an honest CFO who quits because he doubts the integrity of his boss, the CEO. Angry confrontations between the CEO and audit engagement partner fail to budge the latter‘s resolve to insist that the client book large adjustments to correct the company‘s financial statements. The audit firm is fired by the CEO, then the CEO does a quick about-face and insists that the audit firm complete the audit. The audit firm says, ―No way.‖ A lawsuit follows; the audit firm is ordered to pay a $10 million judgment. But, in the end, sanity prevails and the audit firm ―gets off the hook‖ with its pocketbook, credibility, and professionalism intact. In other words, just a common, everyday, run-of-the-mill audit! This case provides several opportunities for role-playing scenarios. You might have two students recreate the meeting between MedTrans‘ former CFO and Gordon Johns. Likewise, the summerlong battle between Johns and Roberts lends itself well to role-playing. (Choose an animated student to play the Roberts role.) Before discussing a case such as this that contains a lot of ―action,‖ I sometimes plot the key events on the board in a time-line graphic. Such a graphic helps ensure that students (and the instructor) stay ―on the same page‖ in terms of discussing the key events of the case.
Suggested Solutions to Case Questions 1 In my view, the CFO did have a professional and personal responsibility to make Gordon Johns aware of the errors in MedTrans‘ financial statements. In discussing this question, you might refer
292 Case 7.7 National Medical Transportation Network students to the first interpretation (Interpretation 102.1) of Rule 102, ―Integrity and Objectivity,‖ of the AICPA Code of Professional Conduct. ―A member shall be considered to have knowingly misrepresented facts in violation of Rule 102 when he or she knowingly (a) makes or permits another to make, materially false and misleading
entries in an entity‘s financial statements or records; or, (b) fails to correct an entity‘s financial statements or records that are materially false and misleading when he or she has the authority to record an entry; or (c) signs, or permits another to sign, a document containing materially false and misleading information.‖ Even more to the point here, is the third interpretation (Interpretation 102.3) of Rule 102: ―In dealing with his or her employer‘s external accountant, a member must be candid and not knowingly misrepresent facts or knowingly fail to disclose material facts.‖ (Note: The legal opinion that provided the facts for this case did not indicate whether the CFO was a CPA. Even if he was not a CPA, he clearly had a responsibility to make relevant parties—such as his former employer‘s independent auditors--aware of his concerns.) 113. Listed next are several options available to Johns after his meeting with the CFO.
(a) (b) (c) (d)
Resign from the engagement. Ask for advice from senior partners in his practice office and/or in the firm‘s regional or national headquarters. Immediately bring the matter to Roberts attention and discuss it with him. Approach the remainder of the audit with extreme caution, that is, make appropriate adjustments in the nature, extent, and timing of planned audit procedures for the client.
Apparently, Johns chose option ―D.‖ Recognize that Deloitte had audited MedTrans for several years and issued an unqualified opinion each of those years on the company‘s financial statements. So, we can speculate that the prominent accounting firm had not encountered significant problems with the client in the past. Quite possibly, Johns intended to investigate the CFO‘s allegations first and then sit down with Roberts and resolve whatever problems were evident in MedTrans‘ accounting records. For whatever reason, Johns apparently chose not to discuss the matter immediately with senior colleagues. Of course, following the July 9th meeting with Roberts, Johns did contact an executive partner in Deloitte‘s New York headquarters. (Note: Of course, we are not privy to all of the ―history‖ involving Roberts and Johns. For instance, we do not know if they had a cordial or stormy relationship prior to 1992. In fact, we don‘t know how long their relationship had existed. The legal opinion did not indicate the number of years Johns had served as MedTrans‘ audit engagement partner. What we do know is that Roberts was under a significant amount of pressure. He may have feared the worst: that MedTrans would soon go ―belly up‖ if external financing was not obtained. I believe it is important for students not to
Case 7.7 National Medical Transportation Network 293 quickly condemn executives--or auditors--who make poor or, at least, questionable decisions. There is always a context to those decisions. Although that context may not excuse the poor or unethical judgment, it may help us better understand the given individual‘s actions or decisions.) 114. During the July 9th meeting between Roberts and Johns, Roberts made a veiled threat of taking
legal action against Deloitte. In the August 13th meeting, Roberts made a more explicit threat to Johns when he indicated that Deloitte might be forced to complete the 1992 audit ―under court order or otherwise.‖ Interpretation 101.6 of the Code of Professional Conduct addresses the impact that actual or threatened litigation has on auditor‘s independence. ―The relationship between the management of the client and a covered member must be characterized by complete candor and full disclosure regarding all aspects of the client‘s business operations. In addition, there must be an absence of bias on the part of the covered member so that he or she can exercise professional judgment on the financial reporting decisions made by management. When the present management of a client company commences, or expresses an intention to commence, legal action against the covered member, the covered member and the client management may be placed in adversarial positions in which the management‘s willingness to make complete disclosures and the covered member‘s objectivity may be affected by self-interest.‖ Numerous ―threats‖ to auditor independence can be found in the interpretations and ethics rulings included in the Code of Professional Conduct. A particularly rich source for such items is ET Section 191, ―Ethics Rulings on Independence, Integrity, and Objectivity.‖ Listed next are three situations impairing an auditor‘s independence that were drawn from ethics rulings under Rule 101. The actual number of the ruling is shown parenthetically. (a)
(b)
(c)
―The mere designation of a covered member as an executor or trustee [of the estate of an individual who owns the majority of a client‘s stock] would not be considered to impair independence, however, if a covered member actually served in such capacity, independence would be considered to be impaired. (11) ―Service as director of an entity constitutes participation in management functions that affect the entity‘s trust. Accordingly, independence would be considered to be impaired if any partner or professional of the firm served in such capacity‖ [―capacity‖ in this context refers to serving as the director of an entity and as the auditor of its profit sharing retirement trust]. (21) ―Independence is considered to be impaired if, when the report on the client‘s current year [financial statements] is issued, billed or unbilled fees, or a note receivable arising from such fees, remain unpaid for any professional services provided more than one year prior to the date of the report.‖ (52)
115. Roberts authorized Deloitte to provide each potential replacement audit firm with the details of Deloitte‘s ―history‖ with MedTrans, including the ―facts and circumstances‖ surrounding the termination of their relationship. After receiving this authorization, Deloitte had a professional responsibility to respond candidly to the inquiries of the potential successor auditors. The relevant professional standard in this context is ―Communications Between Predecessor and Successor Auditors‖ [AU Section 315]. This standard indicates that the ―predecessor auditor should respond promptly and fully, on the basis of known facts, to the successor auditor‘s reasonable inquiries.‖
AU Section 315.09 identifies five items of information that should be obtained from a
294 Case 7.7 National Medical Transportation Network predecessor auditor by a successor auditor: (a) (b) (c)
(d) (e)
Information that might bear on the integrity of management. Disagreements with management as to accounting principles, auditing procedures, or other similarly significant matters. Communications to those charged with governance regarding fraud and illegal acts by clients. Communications to management and those charged with governance regarding significant deficiencies and material weaknesses in control. The predecessor auditor‘s understanding as to the reasons for the change of auditors.
116. Listed next is a hypothetical example of each type of misconduct for your consideration.
(a)
(b)
(c)
Negligent resignation from an audit engagement: After completing two-thirds of the work on XYZ‘s annual audit, Black & Berry, CPAs resigns from that engagement. The resignation is prompted by Black & Berry‘s decision that the XYZ auditors are needed on the audit of ABC. ABC‘s management has insisted that its audit be completed one month earlier than originally planned. ABC needs it audited financial statements to close a deal to acquire a competitor. (The audit fee for ABC is six times larger than the audit fee for XYZ. Additionally, unlike XYZ, ABC makes extensive use of Black & Berry‘s consulting staff on a wide range of consulting projects.) Breach of contract with client: An engagement letter signed by an audit firm and its client indicates that the audit firm will notify the client if it discovers any fraud or related activity during the course of the audit. During the audit, the audit firm discovers a fraudulent misstatement of the client‘s assets. Since the amount of the misstatement is deemed immaterial, the audit firm decides not to inform the client of the matter. Defamatory statements made to successor auditor: During predecessor-successor auditor communications, representatives of the predecessor firm indicate that their former client‘s CEO has a ―drug problem.‖ If this statement is unjustified, then the predecessor has defamed the CEO.
CASE 7.8
FRED STERN & COMPANY, INC. (ULTRAMARES)
Case 7.8 Fred Stern & Company, Inc.
295
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.
299 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.
296 Case 7.8 Fred Stern & Company, Inc. 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 although 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 insights on how the independent audit function of the 1920s differed from the present-day independent audit function.
Case 7.8 Fred Stern & Company, Inc.
297
3. To provide students with a more in-depth understanding of the key contextual circumstances of this 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 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.]
298 Case 7.8 Fred Stern & Company, Inc. 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: 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
Case 7.8 Fred Stern & Company, Inc.
299
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. 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 generally accepted auditing standards [in the United States], 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
300 Case 7.8 Fred Stern & Company, Inc. 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 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 certain jurisdictions. 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. [You might consider having your students review AU Section 311 .08-10, ―Establishing an Understanding With the Client.‖ These paragraphs document the nature, purpose, and content of engagement letters.]
Case 7.9 First Securities Company of Chicago
301
CASE 7.9
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.
305
302 Case 7.9 First Securities Company of Chicago 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 lawsuit against Ernst & Ernst by the investors was filed 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.
Case 7.9 First Securities Company of Chicago
303
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 "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 each and 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. The mail rule would likely qualify as a "material weakness‖ under AU Section 325, ―Communicating Internal Control Related Matters Identified in an Audit:‖ ―A material weakness is a significant [control] deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the financial statements will not be prevented or detected‖ (AU 325.06). In turn, a ―significant deficiency‖ is a ―control deficiency, or combination of control deficiencies, that adversely affects the entity‘s ability to initiate, authorize, record, process, or report financial data reliably in accordance with generally accepted accounting principles such that there is more than a remote likelihood that a misstatement of the entity‘s financial statements that is more than inconsequential will not be prevented or detected‖ (325.06). AU Section 325 requires auditors to communicate material weaknesses that they discover to ―management and those charged with governance as a part of each audit‖ (325.20). Testimony in the various lawsuits triggered by the First Securities fraud did not reveal whether that firm had an audit committee or an equivalent committee. If the organization had such a committee or a comparable committee, Ernst & Ernst would have been required to disclose the mail
304 Case 7.9 First Securities Company of Chicago rule to that committee under the present requirements of AU Section 325 (obviously, this is assuming that Ernst & Ernst had discovered the mail rule). Such disclosure may very well have resulted in the discontinuance of the mail rule and, possibly, to the discovery of Nay‘s fraud. If First Securities did not have such an oversight committee, then Ernst & Ernst would apparently have been required to report the mail rule to Nay, himself. No doubt, Nay would have resisted any suggestion that he alter or eliminate the mail rule, making it unlikely that the material weakness disclosure would have resulted in the escrow syndicate fraud being discontinued. 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 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. 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.
Case 7.9 First Securities Company of Chicago
305
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.) 5. In a jurisdiction that invokes the legal precedent established by the Rusch Factors case, 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. 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 ―Rusch Factors‖ jurisdiction.
CASE 8.1
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
306 Case 1.1 Enron Corporation 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 may contain material misstatements.
310 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.
Case 1.1 Enron Corporation 307 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. A second 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. 12. In June 2001, a U.S. federal judge ruled that a class action lawsuit filed against Deloitte for its failure to uncover the Livent fraud could proceed since there was a reasonable likelihood the audit firm had been reckless in auditing the company. 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 management will sometimes go to misrepresent its 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 sophisticated financial frauds masterminded by top client executives. 5. To emphasize the need for auditors to thoroughly investigate suspicious circumstances and transactions discovered during an audit engagement.
308 Case 1.1 Enron Corporation
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. Maria Messina, the Deloitte audit partner who became Livent‘s CFO, is a key character in this case. At press time, federal authorities in the United States had yet to decide on what punishment Messina would receive for her role in the Livent fraud. Before covering this case, you might do a quick Internet search to determine whether Messina‘s case has been resolved. In discussing 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 in retrospect, it 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 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 examining unfortunate circumstances involving auditors/accountants who have made poor decisions, students will hopefully be less prone to make such decisions during their professional careers. 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,
Case 1.1 Enron Corporation 309 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 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 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
310 Case 1.1 Enron Corporation 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 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 standards in this context are SAS No. 50, ―Reports on the Application of Accounting Principles,‖ and SAS No. 97, ―Amendment to Statement No. 50, Reports on the Application of Accounting Principles.‖ (Notes: Recognize that SAS 97 was issued in June 2002, well after the key events in the Livent case took place. The key change that SAS 97 made to the earlier SAS 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
Case 1.1 Enron Corporation 311 specific situations and specific entities.‖ SAS 50 and SAS 97 have been integrated into AU Section 625.) 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, AU Section 625.08 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: AU 625.10 describes in detail the form and content of a SAS 50-type report, while AU 625.11 provides an example of such a report. 5. The revenue recognition principle is the key accounting concept that is relevant to this context. Generally, the revenue recognition principle dictates that revenue must be both ―earned‖ and ―realized‖ before it can be recorded. ―Earned‖ means that the relevant earnings process must be complete or substantially complete, while ―realized‖ means that an exchange has taken place. Applying the revenue recognition principle to a generic retail sale is easy to do. But applying the rule to non-standard or unusual revenue transactions is 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 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. 6. Messina did not feel directly responsible for the accounting irregularities. Instead, because she had chosen to work for an organization that was replete with fraudulent conduct, she apparently ―absorbed‖ some measure of guilt. 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. AU Section 634 provides general guidance for accountants to follow when performing a wide range of due diligence engagements, including such engagements that involve common ―acquisition transactions.‖ (AU 634.05). [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 AU
312 Case 1.1 Enron Corporation 634 is that the accountants and the client should reach a firm understanding regarding the nature and scope of the engagement. AU 634.16 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.
CASE 8.2
ROYAL AHOLD, N.V
Synopsis Royal Ahold, N.V., is a large multinational company based in The Netherlands that was founded in 1877 by Albert Heijn. Three generations of the Heijn family oversaw the company‘s retail grocery business. In 1989, the company hired a professional management team. The new management team expanded Royal Ahold‘s operations by purchasing grocery chains around the globe, resulting in the company becoming the third largest food retailer in the world. In 2000, the company diversified into the wholesaling segment of the huge food industry when it purchased U.S. Foodservice, a large food wholesaler based in Columbia, Maryland. Royal Ahold‘s professional management team established aggressive earnings and revenue goals for the company each year and pressured their subordinates to achieve those goals. An incentive compensation plan awarded large year-end bonuses to managers of operating units that met or surpassed their financial goals. Royal Ahold‘s decentralized operations when coupled with the strong incentives to achieve unrealistic earnings and revenue goals created an environment in which fraud often flourishes. In early 2003, Royal Ahold‘s independent auditors suspended their fiscal 2002 audit of the company when they discovered numerous potential irregularities in the company‘s accounting records. Subsequent investigations documented that the company had improperly included the operating results of foreign joint ventures in its consolidated financial statements, had accounted improperly for initial acquisition costs related to several of those joint ventures, and had materially overstated ―promotional allowances‖ due from company vendors. The disclosure of the massive accounting fraud resulted in criminal and civil lawsuits being filed against the company and its top
Case 1.1 Enron Corporation 313 executives in both Europe and the United States. Three former Royal Ahold executives, including the company‘s former CEO and CFO, were found guilty by a Dutch court. The three executives were fined and given suspended prison sentences. Fraud charges filed against the company were settled by the payment of a fine of 8 million euros. Several lawsuits stemming from the Royal Ahold case are still pending. This case examines accounting, auditing, and control issues pertinent to multinational companies. In addition, the case examines recent controversies arising between and among international regulatory agencies and rule-making bodies within the accounting and auditing disciplines. Finally, the case illustrates important risk factors commonly associated with financial statement fraud.
317 Royal Ahold, N.V.--Key Facts 1. Royal Ahold was controlled by members of the Albert Heijn family until 1989 when a professional management team was hired. 2. The new management team aggressively pursued an international expansion plan that eventually resulted in Royal Ahold owning retail grocery chains in 27 countries and a large food wholesaling operation in the United States. 3. Differences in cultural norms and expectations adversely impacted Royal Ahold‘s ability to manage its global business operations. 4. The new management team pressured their subordinates to achieve unrealistic earnings goals and rewarded them with large year-end bonuses if they reached those goals. 5. In early 2003, Royal Ahold‘s Deloitte auditors suspended their fiscal 2002 audit after discovering potential irregularities in the company‘s accounting records. 6. Deloitte‘s suspension of its 2002 audit caused significant financial problems for Royal Ahold, including sharp drops in the prices of its outstanding securities and its credit rating. 7. Investigations of Royal Ahold‘s accounting records revealed that the company‘s previous financial statements had been materially misstated. 8. The three principal sources of Royal Ahold‘s financial statement misrepresentations were the improper inclusion of financial data for foreign joint ventures in its consolidated financial statements, improper accounting for purchases of foreign joint ventures, and improper accounting for ―promotional allowances‖ by the company‘s food wholesaling subsidiary. 9. Among the parties blamed for the Royal Ahold scandal were the company‘s top executives, the company‘s Deloitte auditors, and international oversight and rule-making bodies in the accounting and auditing disciplines.
314 Case 1.1 Enron Corporation
10. The Royal Ahold case refocused attention on the lack of cooperation between international oversight and rule-making bodies in the accounting and auditing disciplines. 11. Three of Royal Ahold‘s former executives were convicted of fraud charges by a Dutch court; the company settled fraud charges filed against it by paying a fine of approximately 8 million euros. 12. Several legal actions stemming from the Royal Ahold case are pending, including charges filed by the SEC against two individuals who supervised the audits of U.S. Foodservice before that company was acquired by Royal Ahold.
Instructional Objectives 1. To introduce students to accounting, auditing, and control issues related to multinational corporations. 2. To examine the recent tension between international oversight and rule-making bodies within the accounting and auditing disciplines and the related implications for auditing practitioners. 3.
To identify important risk factors commonly associated with financial statement frauds.
Suggestions for Use Your students will likely be unfamiliar with the Royal Ahold fraud since it was not widely reported in the United States. Nevertheless, the Royal Ahold debacle was a major accounting and auditing scandal in Europe that, as indicated in this case, was referred to as ―Europe‘s Enron‖ by a major European publication (The Economist). The Royal Ahold fraud was particularly embarrassing to the Dutch business community and, in fact, the entire nation of The Netherlands since the company has long been one of the largest and most respected multinational corporations in that country. Although clearly not the most important issue in this case, this case confirms that audit failures are not unique to the United States. In fact, there have been numerous significant audit failures and alleged audit failures involving large companies outside of the United States in recent years including OAO Gazprom (Russia), Parmalat (Italy), Adecco (Switzerland), and Lernout & Hauspie (Belgium), to name just a few. Before discussing this case in your class, ask your students to search online databases for any new developments regarding the case and to provide brief oral reports of their findings. In particular, ask them to search for news reports regarding the settlement of the civil and criminal litigation cases that were pending as of the date this case was completed. Also ask them to research any recent developments involving the requirement that foreign accounting firms register with the PCAOB.
Case 1.1 Enron Corporation 315 Suggested Solutions to Case Questions 1. The equity method is the proper accounting method for U.S. companies to apply to investments representing a 20-50% ownership interest in an investee company. U.S. GAAP generally does not permit full or proportional consolidation of a joint venture company in which the ―parent‖ owns a 50 per cent interest. In arriving at the U.S. GAAP-based net income figures shown in the reconciliations presented in Exhibit 3, Royal Ahold fully consolidated the operating results of the joint ventures in which it had a 50 per cent ownership interest. Since these entities were operating profitably, the result was to overstate the U.S. GAAP-based net income figures shown in Exhibit 3. 2. There isn‘t a universally-accepted definition of ―earnings quality,‖ but, generally, that phrase refers to the degree of correlation between a company‘s reported earnings and its ―true‖ earnings. The term ―earnings quality‖ is also often used when referring to the degree to which a given entity‘s reported earnings can be used to predict its future earnings. Because of the pervasive conservatism principle within the U.S. accounting profession, reported earnings figures that are conservative, that is, that tend to be understated, are often considered to be of high quality. However, consistently understated or overstated earnings are of low quality given the general definition of earnings quality just presented. So, in comparing the earnings produced by two competing sets of accounting principles, such as IFRS and U.S. GAAP, the key issue is which set of accounting principles produces net income figures that are more highly correlated with the given entity‘s stream of actual earnings. Granted, determining ―actual earnings‖ for purposes of this comparison is a difficult assignment. In addressing this question, your students will likely focus on the large differences between the Dutch GAAP-based and U.S. GAAP-based net earnings figures shown in Exhibit 3. Notice that easily the most significant factor accounting for the difference in Royal Ahold‘s Dutch GAAP-based and U.S. GAAP-based net income figures each year was the method used to account for goodwill. As explained in the case, under Dutch GAAP at the time, Royal Ahold charged goodwill directly to owners‘ equity thus bypassing the income statement. During this time frame, U.S. GAAP required companies to capitalize goodwill and amortize it (to expense) over a period not to exceed 40 years. So, the key question in this context is which of the two methods was most defensible or reasonable, that is, which did a better ―job‖ of helping produce a net income figure that was closely correlated with Royal Ahold‘s actual but unknown earnings each year? Posing that question to your students should prompt a lively but difficult to resolve debate. Extend or expand this debate by examining contemporaneous differences in U.S. GAAP and International Financial Reporting Standards (IFRS). For example, you might point out that LIFO is the most widely used inventory cost-flow assumption in the U.S. but it is effectively banned under IFRS. Of course, many economists—and accountants— vigorously contend that LIFO does a better job of determining the true earnings of many, if not, most entities. The purpose of this question is not to resolve the continuing controversy over which competing accounting methods do a better job of producing a ―true‖ earnings figure. Instead, the purpose of the question is to alert students to the fact that there are differences in U.S. GAAP and other accounting standards (the most important ―other‖ being IFRS) and that these differences can sometimes produce significantly different earnings figures. [Note: Of course, over the next few years, many, if not
316 Case 1.1 Enron Corporation most, of these differences may ―go away‖ given recent reports that U.S. GAAP may be ―harmonized‖ with IFRS.] 3. In 2004, after studying the issue for two years, the EITF decided not to make any explicit changes in the recommended accounting for promotional allowances, meaning that the historical method of accounting for those items would be retained. In a press release, the EITF summarized this method by noting that refunds, rebates, and other promotional allowances should be ―recognized as a reduction of the cost of sales based on a systematic and rational allocation of the cash consideration offered to each of the underlying transactions that results in progress by the customer toward earning the rebate or refund, provided the amounts are reasonably estimable.‖ . The EITF effectively ruled that the ―matching‖ concept should be applied to promotional allowances. That is, promotional allowances should be properly ―matched‖ with the corresponding purchase transactions that generated those allowances. Implicit in the EITF‘s policy statement was that food wholesalers and other companies that regularly receive promotional allowances had not been properly accounting for these items if they had not been applying this matching concept. One such company was U.S. Foodservice. 4. Listed next are key factors that pose challenging problems on audits of multinational companies. Each of these factors was present during the Royal Ahold audits. As a point of information, although the annual Royal Ahold audits were complicated by the fact that they involved operating units of the client in literally dozens of countries, the key factor that undermined the quality of the audits was the lack of candor on the part of executive management, certain of their subordinates, and vendors of the company‘s U.S. subsidiary. a. Auditors will likely encounter different accounting and financial reporting treatments for similar transactions and accounts. If consolidated financial statements are to be prepared for the given entity, auditors must ensure that the home country‘s accounting and financial reporting standards are properly applied to the client‘s consolidated financial statement data. b. A related problem is the need to audit the conversion of transaction and account balance data from one or more currencies to the currency of the home country. c. The audit of a multinational client is also more difficult to administer and control. For example, the audit of a large multinational client may require several teams of auditors assigned to different operating units of the client scattered across several countries. Even with the help of e-mail and other Internet resources, coordinating widely dispersed teams of auditors can be a challenging task. d. Quite often, the most challenging feature of multinational audits is the differences in cultural norms across the countries in which a client‘s operations are located. Cultural and communication barriers between auditors and client personnel can complicate even the simplest audit tasks. Assigning auditors from a local affiliate or a local office of the given audit firm can sometimes eliminate or at least significantly reduce the problems posed by language and cultural differences. 5.
AU Section 316.07 identifies the following three elements of the fraud triangle.
Case 1.1 Enron Corporation 317 Incentives/pressures: ―Management or other employees have an incentive or are under pressure, which provides a reason to commit fraud.‖ Opportunities: ―Circumstances exist—for example, the absence of controls, ineffective controls, or the ability of management to override controls—that provide an opportunity for a fraud to be perpetrated.‖ Attitudes/rationalization: ―Those involved are able to rationalize committing a fraudulent act. Some individuals possess an attitude, character or set of ethical values that allow them to knowingly and intentionally commit a dishonest act.‖ The appendix to AU 316 lists a large number of risk factors related to fraudulent financial reporting. Listed next are several fraud risk factors that were particularly relevant to the Royal Ahold audits. --―High degree of competition or market saturation, accompanied by declining margins.‖ --―Rapid growth or unusual profitability, especially compared to that of other companies in the same industry. --―Need to obtain additional debt or equity capital . . .‖ --―There is excessive pressure on management or operating personnel to meet financial targets set up by those charged with governance or management, including sales or profitability incentive goals.‖ --―Significant operations located or conducted across international borders in jurisdictions where differing business environments and cultures exist.‖ AU Section 316 identifies the detailed steps that auditors should take in responding to identified risk factors commonly associated with fraudulent financial reporting. In particular, AU 316.48 suggests that auditors should respond in three ways to the risk of material misstatements due to fraud: 1.
First, the auditor should consider the ―overall effect‖ that the presence of fraud risk factors should have on how the given audit is performed. For example, the staffing of an engagement may need to be changed if there is an inordinate level of fraud risk present. Likewise, the auditor may need to more rigorously analyze how the client has applied specific accounting principles (to determine whether there is any evidence that they have been intentionally misapplied).
2.
Second, the auditor must consider how the presence of given fraud risk factors should affect the application of the audit NET—nature, extent, and timing of specific audit tests—to be applied on the given engagement. For example, physical observation or inspection of client assets may have to be applied extensively in cases in which numerous fraud risk factors are present.
3.
Third, the auditor may have to consider applying additional procedures specifically intended to address the possibility of ―risk of material misstatement due to fraud involving management override of controls.‖ For example, the auditor may find it necessary to closely scrutinize significant accounting estimates made by management. Such estimates
318 Case 1.1 Enron Corporation are particularly susceptible to misstatement when the risk of fraud is disproportionately high. 6. As explained in the case, two audit firms were involved in the U.S. Foodservice audits. For the 1996 through 1999 audits, KPMG served as U.S. Foodservice‘s independent audit firm. Following the acquisition of U.S. Foodservice by Royal Ahold, Deloitte & Touche was appointed to audit that company‘s annual financial statements. The Deloitte auditors were effectively responsible for ―blowing the whistle‖ on the promotional allowances fraud during the course of the 2002 audit. Recognize that although Deloitte has been named as a defendant in lawsuits stemming from the U.S. Foodservice fraud, the SEC has not criticized Deloitte‘s audits of the company. On the other hand, the SEC has filed complaints against two members of the KPMG‘s audit engagement team assigned to the 1999 audit. In February 2006, the SEC issued an administrative order that detailed the specific charges filed against the two former KPMG auditors. This document, which is available on the SEC website, includes a lengthy discussion of the audit procedures applied by the two KPMG auditors to U.S. Foodservice‘s promotional allowances during the 1999 audit. You might consider having your students or a group of your students access this document and provide an oral report of the SEC complaints filed against the KPMG auditors. The principal reason the SEC has filed charges against the two KPMG auditors is because the audit procedures they applied resulted in them discovering a series of suspicious ―exceptions‖ and other circumstances that strongly suggested that U.S. Foodservice had improperly accounted for its promotional allowances. The point here is that the audit procedures applied by the two KPMG auditors were effective in uncovering at least some of the material misstatements related to U.S. Foodservice‘s promotional allowances. Listed next are the four major categories of audit procedures applied by the two KPMG auditors to U.S. Foodservice‘s promotional allowances during the 1999 audit: 1. 2. 3. 4.
―Testing vendor PA [promotional allowances] payments received in fiscal 1999 and applied to reduce fiscal 1998 and 1999 receivables; Testing subsequent PA payments received during early fiscal 2000 and applied to fiscal 1999 receivables; Recalculating selected PA income balances recorded by USF through examination of PA contracts and vendor correspondence; and Seeking third party confirmation from vendors of outstanding PA balances.‖
Of these four audit procedures, the confirmation of the outstanding PA balances should have provided the strongest or most objective evidence regarding the material accuracy of the PA balances. However, as noted in the case, the individuals who completed and returned many of these confirmations to KPMG were coerced by U.S. Foodservice management personnel to report amounts on the confirmations that were consistent with U.S. Foodservice‘s accounting records. Certainly, in such circumstances auditors cannot be held responsible for the failure of their confirmation procedures to uncover material misstatements in given account balances. The SEC‘s criticism of the two KPMG auditors stemmed from those auditors‘ completion of the three other general audit procedures. For example, during the 1999 audit, the two auditors discovered unearned PA ―prepayments‖ made in fiscal 1999 that had been recognized in that year as
Case 1.1 Enron Corporation 319 realized PA income. Even more problematic was the fact that U.S. Foodservice officials had specifically represented to the KPMG auditors that their vendors did not make PA ―prepayments.‖ As a result, the auditors‘ discovery of the PA prepayments should have alerted them to the fact that client management was being less than truthful with them. As a point of information, the two KPMG auditors who performed the PA audit procedures were the audit engagement partner and senior audit manager assigned to the 1999 U.S. Foodservice audit. These two individuals had identified promotional allowances as a ―high risk audit area‖ for the 1999 audit and, as a result, ―assumed responsibility for the detail testing themselves rather than delegating the work to more junior audit staff.‖ In fact, the two auditors were so concerned regarding the promotional allowances that they added an item to the client representation letter that effectively required client management to vouch specifically for the materially accuracy of the promotional allowances. 7. Note: Your students should be at least somewhat familiar with the key differences in the food wholesaling and retail grocery lines of business. If not, you might provide them with a brief overview of those differences before addressing this question. Audit procedures applied to inventory, receivables, and controls would likely be quite different for a food wholesaler versus a retail grocery chain. The inventory of a food wholesaler is typically congregated in a few locations (warehouses), while a retail grocery chain‘s inventory is widely dispersed over its individual retail locations, meaning that the observation of physical inventories can be a more challenging task for a retail grocery chain than for a food wholesaler. On the other hand, a food wholesaler typically has a considerable amount of inventory in-transit at any point in time, which can greatly complicate the taking of an accurate physical inventory and the related audit procedures. Food wholesalers generally have a large amount of receivables, while retail grocery chains have a modest amount. Plus, the nature of the two types of businesses‘ receivables are very different. A large portion of the receivables of food wholesalers are from small retail businesses and thus subject to a moderate to high degree of credit risk. Alternatively, a retail grocery chain‘s receivables are usually credit card receivables, which have little credit risk associated with them. Given this difference, confirmation of accounts receivable would generally be a more time consuming and important audit test for a food wholesaler than for a retail grocery chain. Finally, the very different nature of food wholesaling and retail grocery operations would translate into significant differences in the design and performance of tests of controls. A particular challenge in this respect for a retail grocery chain would be to determine whether controls are being uniformly applied across the large number of individual retail locations.
320 Case 1.1 Enron Corporation
CASE 8.3
KANSAYAKU
Synopsis This case focuses on Japan‘s accounting profession and independent audit function. As this case documents, the accounting profession and independent audit function within the U.S. and Japan are very similar in many respects but very dissimilar in others. Similar to the United States, Japan‘s accounting profession has historically been dominated by a small number of large accounting firms. In fact, each of Japan‘s four largest accounting firms is affiliated with one of the Big Four accounting firms that are principally domiciled in the U.S. The overall role and nature of the independent audit function in the two major industrialized countries are also very similar. One of the major differences between the accounting profession in Japan and the United States is the relatively small number of Japanese CPAs. On a per capita basis, the U.S. has more than ten times as many CPAs as Japan. Likewise, there is a large disparity in audit fees between the two countries. The annual audit fee for a U.S. company is typically ten times the size of the audit fee for a comparable Japanese company.
Case 1.1 Enron Corporation 321 Finally, the nature and structure of the regulatory function for the accounting profession and financial reporting system have historically been very different between the two countries. Similar to the United States, Japanese auditors have faced mounting criticism in recent years as a result of a series of high profile accounting and auditing failures. Much of this criticism stemmed from revelations that several of the large ―mega banks‖ that have dominated Japan‘s post-World War II economy were technically insolvent despite the fact that those banks had received unqualified audit opinions each year on their financial statements. As a result of the major financial crises within Japan‘s banking industry, pervasive changes were made in the country‘s regulatory infrastructure for its financial reporting system. Many of these changes directly impacted Japan‘s accounting profession and independent audit function. The first major test of this new regulatory framework was posed by an accounting and auditing scandal involving a large cosmetics and apparel company, Kanebo Ltd. In fact, the Kanebo affair is often referred to by the Japanese press as ―Japan‘s Enron.‖
325 Kansayaku--Key Facts 1. Similar to the United States, the public accounting profession and independent audit function in Japan are dominated by a small number of large accounting firms. 2. On a per capita basis, Japan has significantly fewer CPAs than any other industrialized country, including the U.S.; likewise, independent audit fees in Japan have historically been a small fraction of those in the U.S. 3. A severe financial crisis that struck Japan‘s banking industry during the late 1990s triggered a major credibility crisis for Japan‘s accounting profession and independent audit function. 4. The criticism of Japan‘s independent audit function focused on allegations that the close relationship between auditors and client management undermined the independence and objectivity of auditors. 5. Allegedly, independent auditors in Japan routinely subordinated their professional judgment to the wishes and demands of client executives. 6. In response to the widespread criticism of independent auditors, Japan‘s federal government overhauled the regulatory structure for the nation‘s financial reporting system.
322 Case 1.1 Enron Corporation 7. The first major test of this new regulatory framework was posed by an accounting and auditing scandal involving Kanebo, Ltd., a large cosmetics and apparel company. 8. Kanebo‘s top executives goaded the company‘s accounting staff to misrepresent Kanebo‘s financial statements throughout the late 1990s and beyond. 9. Kanebo‘s independent auditors not only ignored the material misrepresentations in Kanebo‘s financial statements but also suggested additional methods for improving the company‘s apparent financial condition and operating results. 10. Despite the fact that Kanebo‘s top executives and the company‘s independent auditors either pled guilty or were convicted of various fraud charges, none of the individuals served any time in prison since each received suspended sentences. 11. Among the most significant results of the Kanebo scandal was the two-month suspension imposed on the company‘s independent audit firm, ChuoAoyama. 12. The unprecedented suspension of ChuoAoyama signalled that Japan‘s regulatory authorities were seriously committed to reforming the nation‘s financial reporting system, including its independent audit function.
Instructional Objectives 1. To demonstrate how cultural norms and values can impact a nation‘s financial reporting system, accounting profession, and independent audit function. 2. To demonstrate that independent auditors within different countries face similar challenges in their efforts to satisfy their professional responsibilities.
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. No doubt, by the time you assign this case there will be more ―news items‖ regarding the Japanese accounting profession. To initiate discussion of the case, you might require a group of students to present an oral summary of the latest developments within the Japanese accounting profession—refer to case question #1. 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. 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
Case 1.1 Enron Corporation 323 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 of the differing social norms on each country‘s accounting profession and independent audit function.
Suggested Solutions to Case Questions 1. Consider assigning individual student groups specific issues or topics to investigate and report on in class. For example, you might have one group research recent developments regarding the new Aarata firm founded by PwC. A second group could report on new accounting and auditing pronouncements issued in Japan since this case was written. A third group assignment would be to research and report on important developments regarding the legal liability and exposure of Japanese accounting firms. For this latter assignment, the given group could summarize recent civil and/or criminal cases involving Japanese accounting firms. 2. In any economy, the parties that are the principal source of capital for business organizations will obviously be among the principal stakeholders in that economy‘s financial reporting process. Not surprisingly, individual audit firms, rule-making authorities, and professional organizations will likely feel some pressure or need to cater (or kowtow) to the information needs of those principal stakeholders. No doubt, this pressure will influence decisions made on individual audit engagements, influence the nature of accounting and auditing pronouncements, and influence the agendas and policy initiatives pursued by professional accounting and auditing organizations. The leverage that Japan‘s mega banks had on that nation‘s independent audit function through the late 1990s was manifested primarily by the reluctance of audit firms to issue unfavorable audit opinion on those banks‘ annual financial statements. Of course, large banks and financial institutions in the U.S. have some ability to pressure their independent auditors as well. However, that leverage stems principally from the incentive auditors have to retain any large client, not from the fact that large U.S. banks are the principal ―power merchants‖ in the U.S. economy. 3.
Advantages of high barriers to entry to a given profession: a. b. c. d.
As a general rule, only highly qualified individuals will enter the profession. Each individual who enters the profession will likely have a strong commitment and interest in the profession. The quality of professional services provided should be enhanced by high barriers to entry. The prestige of the profession will be enhanced by high barriers to entry.
Disadvantages of high barriers to entry to a given profession: a. b.
There may not be a sufficient number of professionals to meet the public‘s demand for the given professional service. Individuals who would be productive members of the profession may become discouraged and decide to pursue other occupational opportunities.
324 Case 1.1 Enron Corporation c. d.
4.
The limited number of professionals may drive up the cost of the relevant professional services [of course, this was not true of auditing services in Japan]. Other professional or occupational groups may attempt to co-opt, or move into, the given profession‘s market.
Advantages of an oligopolistic market structure for audit services: a. b.
c.
The major accounting firms should have sufficient economic resources [manpower, etc.] to audit the largest companies in the economy. 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. 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.
b.
c.
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. 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. If one of the major accounting firms is forced to disband, the problems previously identified will be compounded.
5. 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. c. d. e. f.
g. h.
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 Public disclosure of audit and non-audit fees Prohibiting auditors from having direct financial interests in clients Prohibiting auditors from having material indirect financial interests in their clients Requiring audit committees to retain the independent auditors for their given companies; requiring audit committees to pre-approve consulting services provided to their companies Prohibiting auditors from serving in a management capacity with clients Prohibiting auditors from having more than one year of unpaid audit fees outstanding from a client
Case 1.1 Enron Corporation 325 i.
j.
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
Next are examples of other measures that have been suggested by various parties to further strengthen the independence of auditors: a. b. c. d.
Establishing a government agency [patterned after the IRS] that would audit the financial statements of public companies Prohibiting auditors from accepting employment positions with former clients Mandatory rotation of audit firms after a given length of tenure with a client Prohibiting audit firms from providing any type of non-audit services, including taxation services, to their audit clients