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PROFESSIONAL SKEPTICISM

Delphi Corporation (LO 1, 2, 3, 4, 6, 8, 9) Refer to the Focus on Fraud feature “Fraud Risks Related to Debt and Equity: Insights from SEC Accounting and Auditing and Enforcement Releases.” Review the panel related to Delphi Corporation.

-What risks of material misstatement were present in the case?

-What are the auditor’s responsibilities related to auditing retained earnings? What procedures should the auditor have performed?

-Identify ways in which the audit team appeared to have a lack of appropriate professional skepticism.

Focus on Fraud Fraud Risks Related to Debt and Equity: Insights from SEC Accounting and Auditing Enforcement Releases

This feature provides examples of frauds related to debt and equity.

Debt: Federico Quinto Jr., CPA

The client involved in this case, Soyo Group, acted fraudulently by not accurately disclosing violations of its debt covenants.

In August 2012, the SEC issued an Accounting and Auditing Enforcement Release in the matter of Federico Quinto Jr., CPA. Quinto was an audit engagement partner for Soyo Group, Inc., in 2007. During 2007 and the first three quarters of 2008, Soyo booked over $47 million in fictitious revenues. At the same time, Soyo was financing its business with debt from United Commercial Bank (UCB). As of December 31, 2007, Soyo’s debt with UCB was approximately $27.8 million, which represented 63% of Soyo’s total liabilities. Because of Soyo’s struggling business, the company often found itself in violation of its debt covenants with UCB.

Quinto’s audit team conducted an analysis that identified that Soyo was not in compliance with three of its six debt covenants with UCB as of December 31, 2007. Because of the debt covenant violations, UCB could take action that would force Soyo into bankruptcy, as Soyo needed the financing to fund its business operations. The audit team did not follow up on the identified debt covenant violations and did not obtain any evidence indicating whether a waiver had been granted by UCB. The audit workpapers did not provide any evidence that the audit team considered whether these violations could impact the going concern status of Soyo. Further, the audit report for 2007 included an unqualified opinion, although Soyo did not make the required disclosures regarding noncompliance with its debt covenants.

Source: Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 3403, August 31, 2012, available at http://www.sec.gov/litigation/admin/2012/34-67767.pdf

Equity: Delphi Corporation

In this case, members of Delphi’s management and staff acted fraudulently by charging expenses directly to retained earnings rather than to the appropriate expense accounts.

In 2006, the SEC outlined its case of allegations involving Delphi Corporation and certain of its senior officers, accounting staff, and treasury staff. The allegations involve a pattern of violations of federal securities laws from 2000 through 2004. One of the alleged violations related to Delphi improperly accounting for an increase in warranty reserves related to warranty claims made by its former parent company.

Delphi recorded the reserve increase as a direct adjustment to retained earnings rather than as an expense. There was no basis for Delphi to record the reserve adjustment as an adjustment to retained earnings. The SEC further alleged that Delphi disclosed the adjustment in an intentionally and materially misleading way. Specifically, the disclosure suggested, falsely, that the adjustment primarily related to certain pension and other postemployment benefit (OPEB) matters and Delphi failed to disclose highly material information concerning the reserve increase and the former parent company’s warranty claim.

The misclassification of the reserve increase as a direct adjustment to retained earnings, rather than as an expense item, resulted in Delphi materially overstating its net income for 2000 by $69 million. Given that either way, Delphi management was recording this transaction, why would it care about charging it to retained earnings as compared to net income? Some reasons include meeting or beating analysts forecasted earnings expectations, and attempting to focus users’ attention on net income, a very common benchmark in terms of users’ assessments of profitability. In this case, appropriate classification among the financial statement accounts was very important, and management was misleading in its allocation choices.

Source: SEC Accounting and Auditing Enforcement Release No. 2504, October 30, 2006. A related SEC complaint in this matter is available at http://www.sec.gov/litigation/complaints/2006/comp19891.pdf