Auditing Paper, ZZZZ Best Company

CASE 1.10 DHB INDUSTRIES, INC. 143

a security firm at an estimated cost of $3,500 per day to monitor him around the clock. ABC News21 reported that Brooks’ bail terms were more stringent than those imposed years earlier by a federal judge on the infamous mobster John Gotti.

Just as Brooks’ trial was beginning, Judge Seybert revoked his bail and remanded him to jail because of two reports given to her by the FBI. An undercover video for- warded to the FBI by Scotland Yard detectives allegedly showed Jeffrey Brooks and one of his subordinates transferring millions of euros to a large safety deposit box in a London bank. The FBI was convinced that the funds belonged to David Brooks. The FBI also informed Judge Seybert that they had discovered evidence suggesting that Brooks had secretly transferred tens of millions of dollars to bank accounts in the tiny European nation of San Marino. Judge Seybert revoked Brooks’ bail because the two incidents violated the conditions of his bail agreement that mandated that all of his financial assets be “frozen.”

Midway through the trial, Judge Seybert threatened to have David Brooks removed from the courtroom after he was discovered attempting to smuggle anxiety suppres- sion medication into his jail cell. The antianxiety pills were hidden in a ballpoint pen that had been placed at Brooks’ desk during a break in the courtroom pro- ceedings. Following this incident, Judge Seybert barred Jeffrey Brooks and one of David Brooks’ close friends from the courtroom. Brooks’ personal psychiatrist sub- sequently testified that the psychiatrist at the correctional facility where Brooks was being held had prescribed him an insufficient dosage of the antianxiety medication. Brooks reportedly needed larger-than-normal dosages of that medication to ward off the panic attacks that he frequently experienced.

Later in the trial, federal prosecutors revealed that several months earlier David Brooks had allegedly asked a veterinarian who worked in his harness racing opera- tion to obtain a medication administered to horses. If taken by a human, this medica- tion would supposedly wipe out his or her memory. According to the veterinarian, Brooks hoped to somehow administer the medication to Dawn Schlegel, the pros- ecution’s principal witness, prior to the beginning of his criminal trial. This revelation and Brooks’ other antics during the trial caused Comedy Central’s Stephen Colbert to name Brooks his “Alpha Dog of the Week” during the August 2, 2010, airing of the popular television program The Colbert Report.

Andrew Cohen, a senior legal analyst for CBS News who monitored Brooks’ trial, observed that many of its details were so salacious that major publications, such as the New York Times, would not report them.22 One veteran reporter summarized some of the more outrageous events and testimony that took place during the trial.

It’s not an everyday federal trial in which …the defense asserts that the payment of company money to prostitutes might be an acceptable technique to motivate employ- ees. Or in which a defendant says he is entitled to have his company pay for the grave of his mother, camp tuition for his children, [and] family trips to St. Barts and St. Tropez.23

After spending two months studying the massive amount of evidence that prosecu- tors had presented to prove their allegations, a federal jury convicted Brooks on all 17 counts filed against him. Sandra Hatfield, Brooks’ former colleague and codefen- dant, was found guilty on 14 of the 16 counts included in her federal indictment.

21. ABC News, “‘War Profiteer’ Gets ‘Bulletproof’ Bail Terms: Released on $400 Million Bond,” http:// blogs.abcnews.com, 4 January 2008. 22. A. Cohen, “Hurricane Brooks: The Trial of the Century (Finally) Ends,” www.theatlantic.com, 15 September 2010. 23. Ibid.

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144 SECTION ONE COMPREHENSIVE CASES

Questions 1. Exhibits 1 and 4 present DHB’s original 2003–2004 balance sheets and income

statements and the restated balance sheets and income statements for those two years, respectively. Review the original and restated financial statements for 2004 and identify the “material” differences between them. (Note: You are not required to identify the sources of these differences.) Defend your choices.

2. Identify the fraud risk factors posed by DHB for its independent auditors. Which of these factors, in your opinion, should have been of primary concern to those auditors?

3. During the 2004 DHB audit, the company’s independent auditors had considerable difficulty obtaining reliable audit evidence regarding the $7 million of obsolete vest components that allegedly had been destroyed by a hurricane. What responsibility do auditors have when the client cannot provide the evidence they need to complete one or more audit tests or procedures?

4. What responsibility, if any, do auditors have to search for related-party transactions? If auditors discover that a client has engaged in related-party transactions, what audit procedures should be applied to them?

5. Compare and contrast the internal control reporting responsibilities of the management and independent auditors of public companies.

6. What potential consequences do frequent changes in auditors have for the quality of a given entity’s independent audits? Identify professional standards or other rules and regulations that are intended to discourage auditor changes or provide disclosure of the circumstances surrounding them.

E P I L O G U E In April 2010, near the midpoint of David Brooks’ criminal trial, Point Blank Solutions, the succes- sor to DHB Industries, Inc., filed for protection from its creditors in U.S. Bankruptcy Court. The following year, a federal judge approved the sale of the company’s remaining assets to Sun Capital Partners, Inc., a private investment com- pany, for approximately $37 million.

Following the completion of Brooks’ criminal trial, his attorneys immediately appealed his conviction. Among other arguments, the attor- neys maintained that Brooks was incompetent and unable to contribute to his defense during much of the trial because of the antianxiety medication that he was taking. In August 2013,

after losing his appeal, Brooks was sentenced to 17 years in federal prison by Judge Joanna Seybert.

In February 2011, the SEC filed a civil com- plaint against three former members of DHB’s audit committee. The federal agency charged the three individuals with being “willfully blind to numerous red flags signaling account- ing fraud, reporting violations, and misappro- priation at DHB.”24 The civil complaint went on to allege that the three former audit com- mittee members “merely rubber-stamped the decisions of DHB’s senior management while making substantial sums from sales of DHB’s securities.”25

24. Securities and Exchange Commission v. Jerome Krantz, Cary Chasin, and Gary Nadelman, U.S. District Court, Southern District of Florida, Case No. 0:11-cv-60432, 28 February 2011. 25. Ibid.

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CASE 1.10 DHB INDUSTRIES, INC. 145

7. David Brooks apparently made threatening remarks to certain of his company’s independent auditors. What actions should auditors take when they are the target of hostile statements or actions by client executives or employees?

8. Does the SEC have a responsibility to protect the investing public from self- interested corporate executives? Do professional auditing standards or other rules or regulations impose such a responsibility on independent auditors?

9. The audit committee of DHB Industries was criticized for failing to carry out its oversight responsibilities. What are the primary responsibilities of a public company’s audit committee?

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147

CASE 1.11

New Century Financial Corporation

It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.

Henry Ford

From 1962 to 1992, Ed McMahon served as the quintessential sidekick and straight man to Johnny Carson on the long-running and popular television program The Tonight Show. After leaving that program, McMahon stayed in the television spot- light for 12 years by serving as the host of Star Search, a syndicated talent show. McMahon’s résumé also included long stints as cohost of TV Bloopers and Practical Jokes, the annual Macy’s Thanksgiving Day Parade, and the Jerry Lewis Labor Day Telethon and as commercial spokesperson for such companies as Budweiser and American Family Publishing.

McMahon’s 50-year-plus career in television made him one of the most recognized celebrities in that medium. Understandably then, the American public was shocked when press reports in June 2007 revealed that McMahon was more than $600,000 past due on his home mortgage payments. The $5 million mortgage on McMahon’s Beverly Hills mansion was held by Countrywide Financial Corporation.

Unfortunately, millions of everyday Americans with mortgage balances only a fraction of Ed McMahon’s also faced the unhappy prospect of losing their homes due to the worst financial crisis to strike the United States economy since the Great Depression. As that crisis quickly worsened and spread to the global economy, the search began for the parties responsible for it. Among the potential culprits identi- fied by the press was the accounting profession, in particular, independent auditors.

Mortgage Mess Nearly one-half of recent mortgage foreclosure victims obtained their loans from so- called subprime lenders that became dominant forces within the mortgage industry during the past two decades. The largest of those lenders were Countrywide, HSBC, New Century Financial Corporation (New Century), and Wells Fargo, but more than a dozen other large companies provided loans to borrowers with suspect credit his- tories. The implosion of the lucrative but high-risk subprime sector of the mortgage industry in 2007 and 2008 ignited the financial panic in the United States that quickly engulfed the global economy.

The origins of the subprime mortgage debacle in the United States can be traced to the collapse of New Century, the nation’s second largest subprime lender. New Century was founded in 1995 by three friends who had previously worked together at a mortgage banking company. New Century, which was based in Irvine, California, grew dramatically over its brief existence. In 1996, New Century reported total rev- enues of $14.5 million and total assets of $4.4 million. Nine years later, the company reported total revenues of $2.4 billion and total assets of $26 billion.

During the heyday of subprime mortgage lending in 2005 and 2006, New Century funded $200 million of new mortgage loans on a typical business day. In early February 2007, just a few months after company executives insisted that New Century

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148 SECTION ONE COMPREHENSIVE CASES

was financially strong, those same executives unsettled Wall Street when they revealed that the company would be restating previously released financial statements as a result of the misapplication of generally accepted accounting principles (GAAP).

Two months later, New Century declared bankruptcy. A court-appointed bank- ruptcy examiner summarized the far-reaching implications that New Century’s down- fall had for the global economy:

The increasingly risky nature of New Century’s loan originations created a ticking time bomb that detonated in 2007…. The demise of New Century was an early con- tributor to the subprime market meltdown. The fallout from this market catastrophe has been massive and unprecedented. Global equity markets were rocked, credit mar- kets tightened, recession fears spread, and losses are in the hundreds of billions of dollars and growing.1

In fact, New Century would be just the first of many high-profile companies brought down by the turmoil in the mortgage industry. Other longtime stalwarts of the nation’s financial services industries that fell victim to that turmoil included Bear Stearns, Lehman Brothers, and Merrill Lynch.

In September 2008, the federal government assumed control of the Federal National Mortgage Association and the Federal Home Loan Mortgage Company, two “government-sponsored” but publicly owned companies better known as Fannie Mae and Freddie Mac, respectively. At the time, the two organizations owned or guaranteed nearly one-half of the approximately $12 trillion of home mortgages in the United States. For decades, the federal government had used Fannie Mae and Freddie Mac to create an orderly and liquid market for homeowner mortgages, but the enormous losses each suffered in 2007 and 2008 undercut that role and forced the U.S. Department of the Treasury to take over their operations.

Angry investors lashed out at a wide range of parties who they believed bore some measure of responsibility for the massive financial crisis. Those parties included the major subprime mortgage lenders in the United States, such as New Century, and the politicians, regulatory authorities, ratings agencies, and independent auditors who had failed to prevent or rein in the imprudent business practices of those lending institutions.

Only a few years removed from the sweeping reforms prompted by the Enron and WorldCom scandals, the accounting profession was once again forced to defend itself from a wide range of angry and often self-righteous critics. Among these critics was the New York Times. The prominent newspaper castigated the auditors of subprime lenders for stamping those institutions’ financial statements with the accounting pro- fession’s equivalent of the Good Housekeeping Seal of Approval. “While accounting firms don’t exert legal or regulatory authority over their clients, they do bestow seals of approval, the way rating agencies do. People in the financial industry, as well as investors, have reason to believe that a green light from an auditor means that a com- pany’s accounting practices have passed muster.”2

The following section of this case provides a historical overview of subprime mort- gage lending in the United States. Next, the history and operations of New Century Financial Corporation are reviewed with a particular focus on the company’s major role in the subprime mortgage fiasco. The case then examines the criticism of KPMG,

1. “Final Report of Michael J. Missal, Bankruptcy Court Examiner,” In re New Century TRS Holdings, Inc., a Delaware corporation, et al., U.S. Bankruptcy Court for the District Delaware, Case No. 07-10416 (KJC), 29 February 2008. Unless indicated otherwise, the quotations appearing in this case were taken from this source. 2. V. Bajaj and J. Creswell, “A Lender Failed. Did Its Auditor?” New York Times (online), 13 April 2008.

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CASE 1.11 NEW CENTURY FINANCIAL CORPORATION 149

New Century’s longtime independent audit firm, by the federal bankruptcy examiner appointed to investigate the company’s sudden collapse in early 2007.

Subprime Lending: A Historical Perspective Like all businesses, mortgage companies struggle to achieve a proper balance between “risk” and “return” in their operations. The principal risk historically faced by mortgage lenders is the possibility that their clients will be unable or unwilling to pay the principal and interest on their mortgage loans.

Prior to the 1980s, individuals who were poor credit risks effectively had only two choices for obtaining a mortgage to purchase a home. Those alternatives were obtaining a home loan insured by either the Federal Housing Administration (FHA) or the Department of Veteran Affairs (VA). Borrowers with good credit histories, so-called prime borrowers, would typically seek financing for a new loan directly from a bank, savings and loan, or other financial institutions.

The deregulation of the lending industry beginning in the 1980s made it much easier for subprime borrowers to obtain mortgage loans to finance the purchase of a new home. The Depository Institutions Deregulation and Monetary Control Act of 1980 did away with restrictions that imposed a ceiling on the interest rates lending institutions could charge on new mortgage loans. Subsequent legislation allowed mortgage lenders to create a wide array of financing alternatives to compete with the standard 30-year, fixed interest rate mortgage loan that had long been the indus- try’s principal product. Most notably, these nontraditional mortgage loans included ARMs, or adjustable rate mortgages, that would become particularly popular with mortgage borrowers who had impaired or “subprime” credit histories or profiles.

Despite the deregulatory legislation of the 1980s, the subprime sector of the mort- gage industry did not experience explosive growth until the “securitization” of mortgage loans became increasingly common following the turn of the century. Wikipedia defines securitization as “a structured finance process in which assets, receivables, or financial instruments [such as mortgage loans] are acquired, classi- fied into pools, and offered as collateral for third-party investment.”

The securitization option caused many mortgage lenders to adopt an “originate to distribute” business model. This new business model meant that the credit risk posed by new mortgages was no longer exclusively absorbed by lending institutions but rather was shared with investors worldwide who purchased so-called mortgage- backed securities or MBS. By 2006, nearly one-fourth of all new residential mortgage loans in the United States were made to subprime borrowers; three-fourths of those mortgages were securitized and sold to investors in the United States and around the world.

The insatiable demand for high-yield MBS among investors, particularly institu- tional investors such as large banks and hedge funds, caused subprime lenders to ratchet up their marketing efforts. To persuade individuals who were high credit risks to obtain mortgage loans, the subprime lenders developed new products designed specifically for that sector of the mortgage market.

Among the most popular mortgage products developed for the subprime lending market were “stated-income” and “interest-only” mortgages. An applicant for a stated- income loan was simply asked to report his or her annual income during the applica- tion process for the loan. The applicant’s self-reported income was used by the lender to determine the size of the loan that the individual could afford. Not surprisingly, many applicants for stated-income loans, commonly known as “liars’ loans” in the mortgage industry, grossly overstated their annual incomes so that they could purchase a larger home than was economically feasible given their actual annual incomes.

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150 SECTION ONE COMPREHENSIVE CASES

A borrower who obtained an interest-only or IO mortgage loan was required to pay only interest on his or her loan balance for a fixed period of the mortgage term. The IO feature of these loans typically extended over either the first 5 or the first 10 years of the mortgage term. Similar to other mortgage loans, the most common term of an IO loan was 30 years.

Housing prices in those regions of the country where subprime lending was par- ticularly prevalent—such as Arizona; California; south Florida; and Las Vegas, Nevada—rose steeply during the late 1990s and into the early years of the new cen- tury. Many subprime borrowers in those housing markets purchased a home with the express intention of reaping a short-term windfall profit. An individual who obtained a 100 percent loan to acquire a $2 million home could realize a more than $400,000 “profit” on that home in two years if housing prices rose 10 percent each year. After two years, the borrower could extract that profit by refinancing his or her mortgage. That profit could then be used to make the monthly payments on the new mortgage. Or, that individual could sell the home and use the resulting profit to purchase a much larger home—with a much larger mortgage—that he or she could also “flip” in a few years.

Housing prices generally reached their peak in the United States in mid-2006, although they had been declining in some regions of the country over the previ- ous 12 months. By late 2007, prices in several major regional housing markets had declined by 10 percent from their peak levels. By mid-2008, housing prices in those same markets had declined by 20 percent, or more, from their high water marks.

As housing prices steadily fell, a growing number of subprime borrowers began defaulting on their monthly mortgage payments. In fact, many of those individuals quickly became “upside down in their homes,” that is, the unpaid balances of their mortgages exceeded the market values of their homes. By early 2008, an estimated nine million U.S. homeowners had a negative equity in their homes.

The sharp downturn in the housing market had an immediate and drastic impact on mortgage lenders, particularly subprime mortgage lenders such as New Century. Many of the subprime loans originated and packaged for sale by New Century included repurchase clauses. If the default rate on those packages of loans exceeded a certain rate, New Century could be forced to repurchase those loans. As the hous- ing market weakened, New Century and other subprime lenders were flooded with loan repurchase requests.

The financial problems facing the mortgage industry soon spread to other sectors of the economy because of the securitization of subprime mortgage loans. Many high-profile companies in the financial services industry, such as Merrill Lynch, that had no direct connection to the large subprime lenders, suffered huge losses as the market value of MBS plunged. Making matters worse, a large proportion of MBS that originated in the United States was sold worldwide. As one observer of the mortgage market noted, the securitization process effectively “spread the cancer of subprime mortgages to investors throughout the U.S. and the rest of the world.”3

New Century: Poster Child for Subprime Mortgage Lending Bob Cole, Ed Gotschall, and Brad Morrice found themselves without jobs in 1995 when the company for which they had worked for several years, Plaza Home Mortgage, was purchased by a much larger competitor. The three friends decided to pool their resources and establish their own mortgage company, a company that

3. K. Amadeo, “Understanding the Subprime Mortgage Crisis,” About.com (online), 9 October 2008.

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CASE 1.11 NEW CENTURY FINANCIAL CORPORATION 151

would focus on the “low-end” or subprime sector of the mortgage market. Cole served as New Century Financial Corporation’s chief executive officer (CEO), Gotschall was the company’s chief financial officer (CFO), and Morrice oversaw New Century’s lending operations as the company’s chief operating officer (COO). Morrice would eventually replace Cole as New Century’s CEO. In June 1997, the company went pub- lic by listing its stock on the NASDAQ—New Century’s stock would be switched to the New York Stock Exchange in late 2004.

Cole, Gotschall, and Morrice earned relatively modest annual salaries throughout their tenure with the company. For example, in 2005, each of them received a sal- ary of $569,250. However, New Century’s incentive compensation plan rewarded the three cofounders handsomely with significant bonuses and stock option grants when the company met or exceeded its financial goals. During 2005, the three executives received total compensation of approximately $15 million each. In addition, the New York Times reported that, collectively, they realized more than $40 million in trading profits on the sale of New Century stock between 2004 and 2006.4

New Century thrived from its inception thanks largely to three key factors. First, mortgage interest rates, which had spiked during the mid-1990s, stabilized and then generally trended downward for more than a decade—lower mortgage rates serve to fuel the housing and mortgage industries. Second, the economic and reg- ulatory environment at the time made subprime lending the most lucrative sector of the mortgage industry. Finally, the booming housing market in Orange County, California, where the company was located, provided New Century a large and eas- ily accessible market to tap.

Once New Century was well established in Orange County, the company’s ruling troika of Cole, Gotschall, and Morrice began pursuing expansion opportunities for their company in other “hot” real estate markets in the United States. At its zenith, New Century operated more than 200 retail mortgage offices in the United States from which company employees originated new mortgage loans. The company’s wholesale division, which produced the bulk of its loan originations, operated through a far-flung network of more than 35,000 independent mortgage brokers.

New Century’s 2003 Form 10-K filed with the Securities and Exchange Commission (SEC) provided a concise summary of the company’s business model:

We offer mortgage products designed for borrowers who generally do not satisfy the credit, documentation or other underwriting standards prescribed by conventional mortgage lenders and loan buyers, such as Fannie Mae and Freddie Mac. We origi- nate and purchase loans on the basis of the borrower’s ability to repay the mortgage loan, the borrower’s historical pattern of debt repayment and the amount of equity in the borrower’s property (as measured by the borrower’s loan-to-value ratio, or LTV). We have been originating and purchasing these types of loans since 1996 and believe we have developed a comprehensive and sophisticated process of credit evaluation and risk-based pricing that allows us to effectively manage the potentially higher risks associated with this segment of the mortgage industry.

In 2004, New Century’s management reorganized the company as a real estate investment trust (REIT) so that it would qualify for favorable tax treatment under the Internal Revenue Code. This organizational change had little impact on the com- pany’s operations or the underlying nature of its principal line of business, that is, originating subprime mortgage loans.

4. V. Bajaj, “Report Assails Auditor for Work at Failed Home Lender,” New York Times (online), 26 March 2008.

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152 SECTION ONE COMPREHENSIVE CASES

New Century experienced impressive growth from its founding in 1996 through 2001, however, a significant increase in subprime lending activity quadrupled New Century’s revenues from fiscal 2002 to fiscal 2005. In the latter year, New Century originated or purchased more than $56 billion of mortgage loans and securitized $17 billion of those loans, resulting in net earnings of $411 million for the company.

The decision by New Century’s management to focus the company’s marketing efforts principally on stated-income and IO loans contributed significantly to its remarkable growth in revenues beginning in 2002. By 2005, approximately three- fourths of the company’s loan originations involved one of those two products.

Throughout the period that New Century’s revenues were increasing dramatically, company spokespeople repeatedly insisted in press releases and public filings with the SEC that the company had a strong and sophisticated system of internal con- trols. That contention was subsequently questioned by the bankruptcy examiner appointed to investigate the collapse of New Century.

Several interviewees told the Examiner that they thought New Century’s information technology and data entry and processing systems were not “state of the art” and were not sufficient for a business of the size and nature of New Century’s. In particu- lar, New Century’s loan production processes were apparently manual and people- intensive through the fall of 2005. Up until that time, New Century apparently used an outdated DOS-based loan underwriting and appraising operating system, which, according to one Management interviewee, allowed users to “finagle anything.”

The bankruptcy examiner’s report went on to note that the company’s account- ing system was particularly lax with regard to tracking “loan repurchase claims.” According to the examiner, New Century did not develop an “automated system or protocol” for tracking such claims until late 2006. By that time, the company was being swamped by loan repurchase requests due to the weakening housing markets in the principal geographical areas that it served. Besides failing to properly track loan repurchase requests throughout most of its history, New Century “did not have a formal policy spelling out exactly how to calculate reserves”5 for loans that it would be required to repurchase.

By late 2005, several members of New Century’s board of directors were openly challenging top management’s high-risk business strategies as well as questionable accounting and financial reporting decisions made by the company. The most vocal of these critics was Richard Zona, an outside director who also served on the com- pany’s audit committee.

Earlier in his long and distinguished career, Zona had been a senior partner with Ernst & Young (E&Y) and had served for a time as E&Y’s National Director of Financial Services, a position in which he oversaw the firm’s audit, tax, and manage- ment consulting services. In the late 1990s, Zona had also served on an advisory council to the Federal Reserve Board.

In late 2005, Zona drafted a resignation letter, which he addressed to New Century’s board of directors. In that letter, Zona suggested that company management was manipulating reported earnings, employing “aggressive” revenue recognition meth- ods, and failing to provide an adequate allowance for loan losses.6 Excerpts from Zona’s letter are included in Exhibit 1.

5. Bajaj and Creswell, “A Lender Failed.” 6. Zona eventually rescinded the 2005 resignation letter and remained on the company’s board until September 2007.

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CASE 1.11 NEW CENTURY FINANCIAL CORPORATION 153

At the October 25th and 26th [2005] Board meeting, Management informed the Board that its current forecast and analyst consensus for third quarter EPS of $2.24 per share could not be achieved unless Management reversed $.26 per share of loan loss reserves … Obviously, Management’s desire to reverse reserves in the third quarter smacked of earnings manipulation.

Management use of off-balance sheet gain on sale accounting substantially overstates earnings when compared to cash flows, thus generating extremely aggressive income recognition.

Our largest shareholder has questioned the appropriateness of our accounting for loan losses.

As to accounting for loan losses, it is a long-standing accounting maxim that accounting should be designed and applied to match revenues with expenses. Management’s methodology to provide for loan losses based upon their estimate of charge-offs over the next 18 months does not accomplish that objective …Management’s methodology does not result in a proper matching of revenues with costs, (loan loss provisions), because charge-offs are back ended.

Source: “Final Report of Michael J. Missal, Bankruptcy Court Examiner,” In re: New Century TRS Holdings, Inc., a Delaware corporation, et al., U.S. Bankruptcy Court for the District Delaware, Case No. 07-10416 (KJC), 29 February 2008.

EXHIBIT 1

EXCERPTS FROM DRAFT OF 2005 RESIGNATION LETTER SUBMITTED BY RICHARD ZONA TO NEW CENTURY’S BOARD

Throughout 2006, New Century’s financial condition and operating results deterio- rated rapidly. To quell concerns regarding the company’s health, New Century man- agement repeatedly assured Wall Street that the company was financially sound. In August 2006, New Century reported a significant increase in its earnings for the sec- ond quarter of the year compared with that for the same period of the prior year. A company spokesperson noted that those operating results were “evidence of the strength and stability of our franchise.” New Century’s third quarter earnings press release for 2006 admitted that subprime lenders faced “challenging” market condi- tions because of increasing loan delinquencies. Nevertheless, the press release assured the investing public that New Century was “adequately reserved for the expected higher level of loan losses.”

On 31 January 2007, New Century’s management team met with the company’s board of directors and audit committee. At that meeting, management told the board and audit committee that New Century had understated its reserve for loan repurchase losses for each of the first three quarterly reporting periods of 2006. New Century’s controller, David Kenneally, attributed those understatements to an “inadvertent oversight” in the method used to compute the reserve. Members of New Century’s board and audit committee testified that they were “shocked” by this rev- elation and described the 31 January meeting as “ugly” and “very emotional.”

On 7 February 2007, New Century filed a Form 8-K with the SEC, which publicly disclosed the prior understatements of the loan repurchase loss reserve. The 8-K indicated that the understatements were due to the company failing “to account for expected discounts upon the disposition of repurchased loans” and due to its failure to “properly consider the growing volume of repurchase claims outstanding that resulted from the increasing pace of repurchase requests.” The 8-K filing did not disclose to what extent the loan repurchase loss reserve had been understated but instead simply indicated that the previously reported earnings for the first three quar- ters of 2006 “should no longer be relied upon.”

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154 SECTION ONE COMPREHENSIVE CASES

On March 2, 2007, New Century informed the SEC that its 2006 Form 10-K would be delayed and that it would eventually report a loss for the entire year. At the same time, New Century disclosed that KPMG was considering issuing a going-concern opinion on the company’s 2006 financial statements—KPMG resigned as New Century’s audi- tor a few weeks later without having issued an opinion on those financial statements. On 2 April 2007, New Century filed for bankruptcy in a U.S. federal court. At the time, New Century was the ninth largest company to file for bankruptcy in U.S. history.7 In May 2008, company management announced that New Century’s audited financial statements for 2005 should no longer be relied upon.

Within a few days of New Century’s bankruptcy filing, the company’s stock price fell to less than $1 per share, down from more than $30 per share two months ear- lier—the stock had reached its all-time high of $66 per share in 2004. Not surprisingly, stockholders and other parties were enraged by the company’s sudden collapse that mimicked the downfall of Enron and WorldCom a few years earlier. Exhibit 2 pres- ents a sarcastic commentary on New Century’s collapse by one of the company’s many critics. This commentary was in the form of a fictitious letter addressed to the readers of an online banking forum.

7. The five largest companies to file for bankruptcy in 2007 were mortgage lenders. Four of those five companies were subprime lenders.

EXHIBIT 2

FICTITIOUS LETTER SUPPOSEDLY WRITTEN BY FORMER NEW CENTURY CEO FOLLOWING THE COMPANY’S BANKRUPTCY FILING

Dear BankNet360 Readers:

Hi, my name is Brad Morrice and I’ve just bailed out of my sinking ship, the SS New Century Financial.

But don’t feel bad for me; I’ll be doing just fine. I may have bankrupt the company, treated mortgage underwriting like a bad cold, and helped cause more layoffs than a recession, but I should still bank about $25 million. To the creditors I say, “nanee-nanee billy goat.”

Regrets? Sure, I’ve got some. I should have cashed in more of my options when the NEW stock was on a rocket ship fueled by option ARMs and I.O. loans from heaven. Ah, those were the days, when loans fell from the sky—and into the laps of subprime borrowers who can more easily discern Britney from J-Lo than understand all the conditions of their upcoming loan repricings.

You know, I wonder also how I can walk away from New Century with so much dough. This Chief Restructuring Officer, Holly Etlin, I don’t know what planet she is from, but she can come over to my palace, er, place, anytime.

Oh, look at the time. That money’s going to hit my account any moment now, and I’ve got shopping to do. Well, my regards to the subprime mortgage industry. All you Wall Street guys—hope you can handle the risk.

Sincerely yours,

Brad A. Morrice Founder (ret.) New Century Financial Corp. (bankrupt)

Source: BankNet360.com (www.banknet360.com/viewpoints/Discussion.do?discussion_id=191), 13 June 2007.

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CASE 1.11 NEW CENTURY FINANCIAL CORPORATION 155

“Go-To Auditor” The New York Times characterized KPMG as the “go-to auditor” for the subprime sector of the mortgage industry.8 KPMG’s audit clients in that sector included the larg- est subprime lenders, namely, Countrywide, HSBC, New Century, and Wells Fargo. KPMG served as New Century’s auditor from the company’s inception in 1995 until its resignation in April 2007.

New Century’s bankruptcy filing resulted in heated criticism of KPMG. The New York Times drew a parallel between Arthur Andersen’s audits of Enron Corporation that had failed to expose the huge energy company’s aggressive accounting treatments and KPMG’s audits of New Century. According to the newspaper, KPMG had failed to warn investors that New Century’s “mortgage freight train was about to run off the rails.”9

New Century’s accounting methods let it prop up profits, charming investors and allowing the company to continue to tap a rich vein of Wall Street cash that it used to underwrite more mortgages. Without the appearance of a strong bottom line, New Century’s financial lifeline could have been cut earlier than it was.10

The federal bankruptcy examiner appointed for New Century carried out an exhaustive investigation of the large subprime lender’s sudden failure. A major focus of that investigation was KPMG’s 2005 audit of New Century and the accounting firm’s reviews of the financial statements included in the company’s Form 10-Qs for the first three quarters of 2006. KPMG was required to provide the bankruptcy examiner with nearly 2 million pages of documents relating to those engagements. Exhibit 3 pres- ents KPMG’s audit report on New Century’s 2005 financial statements.

In his 560-page report, the bankruptcy examiner alleged that KPMG had failed to perform its New Century engagements “in accordance with professional standards.” The examiner’s specific allegations included charges that the 2005 New Century audit was improperly staffed and that the independence of certain KPMG auditors may have been impaired. The examiner also maintained that KPMG failed to adequately consider serious internal control problems evident in New Century’s accounting and financial reporting system and failed to properly audit the company’s critically important loan repurchase loss reserve.

Staffing Issues on the New Century Engagement In the spring of 2005, shortly after KPMG completed the 2004 audit of New Century, an almost entirely new team of auditors, approximately 15 KPMG employees in total, was assigned to that client. The only two members of the 2004 audit engagement team “held over” for the 2005 audit were two first-year associates. The two key mem- bers of the 2005 audit team, the audit engagement partner and the senior manager, had just joined the Los Angeles office of KPMG, the practice office responsible for servicing New Century.

John Donovan, the engagement partner for the 2005 New Century audit, had served for 17 years as an audit partner with Arthur Andersen prior to that firm being forced to disband in 2002. After Andersen’s demise, Donovan became an audit part- ner with E&Y, which he left in early 2005 to take a similar position with KPMG.

New Century’s audit committee was unhappy with KPMG’s decision to appoint Donovan as the audit engagement partner for the 2005 audit. Members of the audit

8. Bajaj and Creswell, “A Lender Failed.” 9. Ibid. 10. Ibid.

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156 SECTION ONE COMPREHENSIVE CASES

committee believed that Donovan’s lack of experience with the mortgage industry made him a poor choice to supervise that audit and asked KPMG to appoint another partner to oversee the engagement. When KPMG refused, the audit committee con- sidered dismissing KPMG and retaining a different audit firm. “Ultimately, the Audit Committee determined that a switch to a new accounting firm would be tremen- dously disruptive and would send a bad signal to its lenders.”

Mark Kim accepted a position with KPMG in May 2005, shortly before being assigned to serve as the senior manager on the 2005 New Century audit engagement.

EXHIBIT 3

KPMG’S 2005 AUDIT REPORT ON NEW CENTURY’S FINANCIAL STATEMENTS

New Century Financial Corporation and Subsidiaries

Report of Independent Registered Certified Public Accounting Firm

The Board of Directors

New Century Financial Corporation

We have audited the accompanying consolidated balance sheets of New Century Financial Corporation and subsidiaries as of December 31, 2005, and 2004, and the related consolidated statements of income, comprehensive income, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2005. These consolidated financial statements are the responsibility of Company’s Management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of New Century Financial Corporation and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 15, 2006 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

KPMG LLP Los Angeles, California March 15, 2006

Source: New Century’s 2005 10-K.

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CASE 1.11 NEW CENTURY FINANCIAL CORPORATION 157

Kim had several years of prior experience as an auditor and had served for three years as the assistant controller of a small mortgage lending company.

During his tenure on the New Century audit team, Mark Kim complained to John Donovan that it was difficult to recruit a “good team” of auditors to work on the engagement. In an e-mail to Donovan, an exasperated Kim remarked, “We will never get a good team out here because of the reputation that the engagement has.” Another e-mail sent by a New Century accountant to the company’s controller, David Kenneally, seemed to corroborate Kim’s opinion. This latter e-mail noted that KPMG had not assigned the “A team” to the New Century audit.

In fact, Kenneally, a former KPMG employee, was apparently the key reason that the New Century engagement had a negative reputation within KPMG’s Los Angeles office. Evidence collected by the New Century bankruptcy examiner suggested that the company’s accounting function was “weak” and was overseen by Kenneally who was “domineering” and “difficult, condescending, and quick-tempered.” One KPMG subordinate on the New Century audit team testified that Kenneally often berated Donovan and Kim. In another e-mail sent by Kim to Donovan, the KPMG senior man- ager indicated that “Dave [Kenneally] seems to know the answers for everything and anything and the rest of the accounting department is on almost the same boat as the audit team is—little knowledge of what’s going on. This intimidates everyone on the engagement team.”

The tense relationship between the KPMG audit engagement team and New Century’s management, particularly Kenneally, worsened as the 2005 audit neared completion. Two individuals with KPMG’s FDR (Financial Derivatives Resource) Group were brought in to review New Century’s accounting for certain hedges and other financial derivatives during the final phase of the audit. They requested vari- ous documents from New Century that were needed to complete their review of the aforementioned items. When New Century failed to provide that documentation, the two specialists refused to “sign off” on the company’s relevant accounting decisions. This refusal prevented Donovan from releasing the opinion on New Century’s finan- cial statements that were to be included in the company’s 2005 Form 10-K.

Hours before the SEC filing deadline for New Century’s 2005 10-K, an angry Donovan e-mailed one of the FDR specialists. “I am very disappointed we are still discussing this. As far as I am concerned, we are done. The client thinks we are done. All we are going to do is p___ everybody off.” Later that same day, a high-ranking KPMG partner in the firm’s New York headquarters office told Donovan to release the unqualified opinion on New Century’s 2005 financial statements. Donovan was instructed to release the opinion even though the two FDR specialists had not approved the company’s accounting decisions for its financial derivatives.11

The following day, New Century’s audit committee called a meeting with Donovan and Kim. In that meeting, members of the audit committee reportedly “yelled” and “screamed” at the two KPMG auditors. Later, Kenneally told the New Century bank- ruptcy examiner that he had been “furious” over the “near-disaster”—that is, the fact that New Century’s filing of its 2005 10-K with the SEC had almost been delayed.

11. The FDR specialists were allowed to dissociate themselves from the decision to issue the audit opinion on New Century’s 2005 financial statements in a “disagreement memorandum” included in the 2005 workpapers. The following month, New Century finally provided the documentation that had been requested by those specialists. A review of that documentation revealed that New Century had improp- erly accounted for certain of its derivatives, resulting in “a misstatement of several million dollars.” However, KPMG ruled that those errors were immaterial, meaning that it was not necessary to restate the 2005 financial statements.

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158 SECTION ONE COMPREHENSIVE CASES

Because of the incident, New Century’s audit committee deferred the decision of whether to reappoint KPMG as the company’s auditor for the 2006 fiscal year. Donovan later testified that he had been concerned that the audit committee would dismiss KPMG.

Over the following two months, Donovan assured New Century’s audit committee that “a situation like this will never happen again.” After receiving that assurance, the audit committee reappointed KPMG as New Century’s audit firm.

The bankruptcy examiner speculated that the 2005 10-K incident impaired KPMG’s independence during the remainder of the firm’s tenure with New Century. “In par- ticular, it is possible that Donovan and Kim were not as skeptical as they might oth- erwise have been with regard to critical assumptions [underlying New Century’s accounting decisions].” The examiner went on to suggest that “Donovan and Kim may have looked for ways to add unique value in order to salvage KPMG’s reputation, such as by providing proactive (though erroneous) advice in connection with the repurchase reserve calculation methodology.”

In a subsequent interview with the New York Times, the bankruptcy examiner fur- ther questioned KPMG’s independence when he maintained that the New Century auditors had been eager to please the company’s management team. “They acqui- esced overly to the client, which in the post-Enron era seems mind-boggling.”12 In another interview with the Reuters news agency, the examiner expressed a simi- lar point of view. “In the post-Enron era, one of the lessons should have been that accountants need to be skeptical, strong, and independent. You didn’t have any of those attributes here.”13

Inadequate Consideration of Internal Control Problems Section 404 of the Sarbanes–Oxley Act requires auditors of public companies to audit the effectiveness of their clients’ internal controls over financial reporting.14 In both 2004 and 2005, KPMG concluded that New Century maintained effective inter- nal control over its financial reporting function.

During the 2004 internal control audit, the KPMG auditors identified five “significant deficiencies” in internal controls that they reported to New Century’s audit committee. Since the KPMG auditors concluded that those deficiencies did not qualify as “material weaknesses,” the audit firm was able to issue an unqualified opinion on New Century’s internal controls for 2004. No significant deficiencies or material weaknesses in inter- nal controls were identified by KPMG during the 2005 internal control audit.

New Century’s bankruptcy examiner challenged KPMG’s conclusion that the com- pany’s internal controls over financial reporting were effective during 2004 and 2005. The examiner pointed out that throughout its existence New Century did not have an “effective mechanism for tracking, processing and handling [loan] repurchase claims.” This internal control weakness prevented the company from determining the magnitude of loan repurchase requests at any point in time, which, in turn, pre- vented the company from properly considering those requests in arriving at the period-ending balances of the loan repurchase loss reserve.

12. Bajaj, “Report Assails Auditor.” 13. A. Beck, “KPMG Allowed Fraud at New Century, Report Says,” Reuters.com, 27 March 2008. 14. KPMG’s 2004 and 2005 audits of New Century were completed while PCAOB Auditing Standard No. 2, “An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements” was in effect. That standard was subsequently replaced by PCAOB Auditing Standard No. 5, “An Audit of Internal Control Over Financial Reporting That Is Integrated with an Audit of Financial Statements.” The two standards are very similar.

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CASE 1.11 NEW CENTURY FINANCIAL CORPORATION 159

A related internal control weakness was New Century’s failure to adopt “formal policies and procedures” for calculating the loan repurchase loss reserve at the end of each accounting period. The lower-level accountants who were assigned the task of computing the reserve balance each reporting period testified that they simply followed the instructions passed down to them by the individual who had previously been responsible for the reserve computation.

During both the 2004 and 2005 audits, the KPMG auditors discovered the inter- nal control weaknesses related to New Century’s loan repurchase loss reserve. The bankruptcy examiner noted that those control weaknesses had particularly critical implications for New Century in 2005 when the volume of loan repurchase requests was increasing rapidly. Despite those implications, KPMG characterized those weak- nesses as “inconsequential” during the 2005 audit. Since the internal control prob- lems were not deemed significant deficiencies or material weaknesses, KPMG did not communicate them to New Century’s audit committee.

The bankruptcy examiner insisted that for at least the 2005 audit, the inadequate accounting procedures for loan repurchase requests qualified as a material weak- ness in internal control that should have caused KPMG to issue an adverse opinion on New Century’s internal controls. In fact, New Century’s management reached a similar conclusion in early 2007.

The material weaknesses identified [by New Century’s management in early 2007] were: (1) the failure to maintain effective controls over the interpretation and applica- tion of the accounting literature relating to the Company’s critical accounting policies (specifically as to the calculation of repurchase reserves); and (2) the failure to main- tain effective controls to provide reasonable assurances that the Company collected, analyzed, and used information relating to outstanding purchase claims when estab- lishing the allowance for repurchase losses.

Debbie Biddle was the KPMG audit senior principally responsible for the 2005 inter- nal control audit. Similar to John Donovan and Mark Kim, Biddle had joined KPMG’s Los Angeles office shortly before the 2005 New Century audit began. Biddle had trans- ferred to the Los Angeles office from a KPMG affiliate in the United Kingdom. Prior to being assigned responsibility for the 2005 New Century internal control audit, Biddle had “virtually no experience auditing U.S. clients and no prior SOX experience.”

The bankruptcy examiner reported that Biddle and her colleagues failed to thor- oughly review the 2004 audit workpapers for New Century. As a result, they may have been unaware of the internal control problems discovered by KPMG auditors the prior year and thus failed to properly consider those problems in planning and carry- ing out the 2005 audit.

The Examiner found no evidence that the KPMG [2005] engagement team engaged in a formal process to compare year over year deficiency findings in connection with the 2005 SOX 404 audit. Conducting this analysis would have been prudent given the wholesale turnover in the KPMG engagement team. This failure is significant, as it impacted the planning for the 404 audit in 2005, the evaluation of findings in 2005, and the planning for the year-end audits.

Failure to Properly Audit New Century’s Loan Repurchase Loss Reserve In early 2005, the quality of New Century’s loan portfolio, as measured by such objec- tive criteria as delinquency and default rates, began declining rapidly. Internal data collected by New Century revealed that the delinquency rate on loans originated during 2005 was approximately double that of loans originated during the previous

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160 SECTION ONE COMPREHENSIVE CASES

year. The delinquency rate continued to rise throughout 2006 as conditions within the housing market deteriorated.

The increasing delinquency and default rates on loans originated by New Century caused a large increase in the number of loan repurchase claims filed by investors that had purchased large blocks of those loans. Because of the inadequate account- ing procedures and internal controls for loan repurchase claims, New Century’s accounting staff failed to record the needed increases in the loan repurchase loss reserve throughout 2005 and beyond. For example, despite the large increase in loan repurchase requests in 2005, New Century’s loan repurchase loss reserve actually declined from the end of 2004 to the end of 2005.

New Century’s bankruptcy examiner estimated that the understatement of the loan repurchase loss reserve and errors in related accounts inflated New Century’s reported pretax earnings for fiscal 2005 by 14.3 percent or approximately $64 mil- lion. The examiner determined that errors in those same accounts overstated New Century’s reported pretax earnings for the first three quarters of 2006 by approxi- mately $200 million or 59 percent.

New Century’s accountants used a 90-day “look-back” period in determining the adequacy of the loan repurchase loss reserve each financial reporting period. That is, only repurchase requests for loans sold in the 90 days immediately preceding the balance sheet date were considered in arriving at the reserve balance. In fact, the com- pany often received repurchase requests for loans sold more than three months earlier.

The bankruptcy examiner criticized KPMG for not insisting that New Century use a longer than 90-day “window” in computing the loan repurchase loss reserve. In fact, a KPMG workpaper suggested that policy was reasonable. “Based on the review of the Company’s repurchase log and discussions with management, it appears reason- able that the most recent three months sales are at risk for repurchase.” The bank- ruptcy examiner contested the assertion that KPMG had reviewed the log of loan repurchase requests since that accounting record indicated that loans were being reacquired by New Century as long as three years after the date they were sold. The examiner also uncovered evidence suggesting that a New Century executive had informed a KPMG auditor that a significant number of loans older than 90 days were being repurchased by the company.

KPMG’s audit workpapers documented the ominous increase in loan repurchase requests received by New Century beginning in late 2004. In 2005, New Century repurchased $332 million of loans, compared with $135 million the prior year. Despite this large increase, the bankruptcy examiner reported that KPMG “failed to perform any increased procedures or testing of New Century’s repurchase reserves” during the 2005 audit.

A secondary factor that contributed to the understatement of New Century’s loan repurchase loss reserve was the company’s failure to consider an “interest recapture” element in computing that reserve each reporting period. The bankruptcy examiner found this obvious oversight by the company’s accountants “perplexing.”

The failure to include Interest Recapture in the repurchase reserve calculation from the outset is perplexing because the Examiner understands that it was a longtime require- ment under loan repurchase agreements for New Century to pay investors the amount of interest that the borrower had failed to pay.

A workpaper memorandum that summarized the audit tests KPMG applied during the 2005 audit to the loan repurchase loss reserve indicated that interest recapture was a component of the reserve.

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CASE 1.11 NEW CENTURY FINANCIAL CORPORATION 161

A KPMG workpaper from January 2006 notes that estimated losses on future repur- chases “include accrued interest the investor [loan purchaser] would have collected from the borrower, if the loan had performed, that New Century must pay to the inves- tor at the time of repurchase.”

The evidence that KPMG relied on to reach that erroneous conclusion was a state- ment made by David Kenneally. The bankruptcy examiner criticized the KPMG auditors for not corroborating Kenneally’s assertion with other audit evidence. “If KPMG had performed adequate tests and calculations, it would have determined that Interest Recapture was omitted from the repurchase reserve calculation.”

During early 2006, New Century changed the method used to compute the period- ending balance of the loan repurchase loss reserve.15 This change resulted in large increases in the understatements of that account at the end of each subsequent quar- terly reporting period—by the third quarter of 2006, the reserve was understated by approximately 1000 percent.

Kenneally testified that the change in accounting for the reserve account was rec- ommended by Mark Kim, the KPMG senior audit manager. Kim would later testify that he did not explicitly remember making that recommendation. Nevertheless, evidence collected by the bankruptcy examiner caused him to conclude that a KPMG auditor “almost certainly” recommended the change in accounting for the reserve account.

At a time when KPMG was aware, as evidenced by its own workpapers, that market conditions were worsening and repurchases were increasing, KPMG made a recom- mendation to New Century to remove a component of the repurchase reserve that had the effect of decreasing the reserve …and then failed to inform the Audit Committee of the change in this critical accounting policy.

In November 2006, New Century hired a new chief financial officer (CFO) who had 30 years of prior experience in the mortgage industry. The CFO immediately questioned the adequacy of the company’s loan repurchase loss reserve and asked KPMG to provide him with a written statement that the reserve was properly stated. KPMG refused to provide that written assurance.

As a result of the new CFO’s persistent inquiries, New Century’s accounting staff eventually recognized that the accounting change made in early 2006 for the loan repurchase loss reserve had been improper and had materially understated the reserve for each of the first three quarterly reporting periods of 2006. That realization led to the 7 February 2007, 8-K filing in which New Century reported those under- statements. That 8-K disclosure triggered the series of events that resulted in New Century filing for bankruptcy less than two months later.

In Defense of KPMG Representatives of KPMG responded forcefully to the allegations against their firm in the report prepared by New Century’s bankruptcy examiner. Particularly galling to the large accounting firm was the suggestion that KPMG auditors had “deferred excessively”16 to client executives during the course of the New Century

15. The change in the method of computing the loss reserve involved deleting the “inventory severity” component of that reserve. That component involved those losses expected to be incurred by New Century on loans that had already been reacquired as of the given balance sheet date. Kim allegedly suggested dropping this component because he believed that it was considered by New Century in arriving at the balance of a related valuation account for the company’s portfolio of outstanding loans. In fact, that was not the case. 16. Bajaj, “Report Assails Auditor.”

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162 SECTION ONE COMPREHENSIVE CASES

engagements. In response to that allegation, a KPMG spokesperson told a reporter with the New York Times, “There is absolutely no evidence to support that conten- tion.”17 In a subsequent interview with the Times, that same individual suggested that the bankruptcy examiner’s report was unfair and “one-sided.”

The examiner was appointed by the court to identify potential lawsuits in a bank- ruptcy case. Consistent with that charge, he has prepared an advocacy piece, which has many one-sided statements and significant omissions. In the end, the examiner concluded that the bankruptcy estate may be able to file a lawsuit against KPMG for negligence—a claim we strongly dispute—and a claim even the examiner notes in his report for which KPMG has strong defenses.18

Several other parties also came to KPMG’s defense. An accounting professor at the University of Chicago maintained that KPMG was not at fault in the New Century case and instead attributed the company’s bankruptcy to its high-risk business model. “The business model of New Century depended on real estate values that would continue to go up and certainly not go down. The economic model here is what is at fault. It’s the cause of what happened, not anything that KPMG did.”19

At a minimum, the New Century bankruptcy report served to sustain a string of embarrassing public relations incidents for KPMG. In 2005, KPMG had faced poten- tial criminal charges for a series of questionable tax shelters that it had marketed to well-heeled tax clients. In that same year, KPMG had agreed to pay the SEC $22.5 million to settle charges that audits of one of its largest clients, Xerox, were flawed. Subsequent to that announcement, KPMG paid $80 million to settle civil litigation stemming from its Xerox audits.

Even before the New Century bankruptcy report was released, KPMG had been linked to the ongoing crises and scandals in the mortgage industry. Charges of large- scale earnings manipulation by Fannie Mae called into the question the quality of KPMG’s audits of that organization, which for decades had played such a large role in the mortgage industry. Finally, in early January 2008, KPMG was named a codefen- dant in a large class-action lawsuit that charged Countrywide, another KPMG audit client, with perpetrating an accounting fraud.

E P I L O G U E In August 2008, Ed McMahon revealed that he had finally found a buyer for his Beverly Hills mansion that would allow him to pay off his large mortgage.20 Most individuals snared by the financial crisis that overwhelmed the mort- gage industry and housing market in the United States did not share McMahon’s good fortune. By the end of 2008, more than 1.5 million Americans would face foreclosure proceedings on their homes, easily the largest number of residential foreclosures in U.S. history.

In an effort to thwart the nationwide financial panic caused by the meltdowns in the mort- gage and housing industries, the U.S. Congress passed a massive bailout plan in October 2008. The price tag for that plan was measured in hundreds of billions of dollars. Despite that massive effort to shore up the nation’s crum- bling financial infrastructure, most experts expected that the U.S. economy, as well as the global economy, would suffer adverse lingering effects for years, if not decades, to come.

17. Ibid. 18. Bajaj and Creswell, “A Lender Failed.” 19. Ibid. 20. Mr. McMahon passed away in June 2009.

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CASE 1.11 NEW CENTURY FINANCIAL CORPORATION 163

Questions 1. KPMG served as the independent audit firm of several of the largest subprime

mortgage lenders. Identify the advantages and disadvantages of a heavy concentration of audit clients in one industry or subindustry.

2. As noted in the case, there was an almost complete turnover of the staff assigned to the New Century audit engagement team from 2004 to 2005. What quality control mechanisms should accounting firms have in such circumstances to ensure that a high-quality audit is performed?

3. Section 404 of the Sarbanes–Oxley Act requires auditors of a public company to analyze and report on the effectiveness of the client’s internal controls over financial reporting. Describe the responsibilities that auditors of public companies have to discover and report (a) significant deficiencies in internal controls and (b) material weaknesses in internal controls. Include a definition of each item in your answer. Under what condition or conditions can auditors issue an unqualified or clean opinion on the effectiveness of a client’s internal controls over financial reporting?

4. One of New Century’s most important accounts was its loan repurchase loss reserve. Each accounting period, New Century was required to estimate the ending balance of that account. What general principles or procedures should auditors follow when auditing important “accounting estimates”?

5. New Century’s bankruptcy examiner charged that KPMG did not comply with applicable “professional standards” while auditing the company. List specific auditing standards or principles that you believe KPMG may have violated on its New Century engagements. Briefly defend each item you list.

6. Mortgage-backed securities (MBS) produced by New Century and other major subprime lenders were a focal point of attention during the recent financial crisis. Many parties maintain that the mark-to-market rule for investments in securities such as MBS contributed significantly to that crisis and that the rule should be modified, suspended, or even eliminated. Briefly summarize the principal arguments of those parties opposed to the mark-to-market rule. Do you believe that those arguments are legitimate? Why or why not?

7. Identify what you consider to be the three most important “take-aways” or learning points in this case. Rank these items in order of importance (highest to lowest). Justify or defend each of your choices.

New Century’s collapse resulted in numerous criminal investigations by regulatory and law enforcement authorities as well as a barrage of civil litigation. In July 2010, the SEC announced that it had reached a settlement to resolve fraud charges that it had filed against three former New Century officers including Brad Morrice and David Kenneally. In addition to monetary

sanctions of approximately $750,000 for Morrice and $160,000 for Kenneally each was barred from serving as an officer of a public company for five years. Among the civil lawsuits decided to date, KPMG reportedly agreed to contribute $45 million to a settlement pool in late 2010 to resolve a class-action lawsuit filed by New Century’s former stockholders.

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165

CASE 1.12

Madoff Securities

Bernie wanted to be rich; he dedicated his life to it.

John Maccabee, longtime friend of Bernie Madoff

Bernard Lawrence Madoff was born on 29 April 1938, in New York City. Madoff spent his childhood in a lower middle-class neighborhood in the borough of Queens. After graduating from high school, Madoff enrolled in the University of Alabama but trans- ferred to Hofstra College on Long Island, now known as Hofstra University, at the beginning of his sophomore year. Three years later in 1960, he graduated with a polit- ical science degree from Hofstra.

According to a longtime friend, the driving force in Madoff’s life since childhood was becoming wealthy. “Bernie wanted to be rich; he dedicated his life to it.”1 That compelling force no doubt accounted for Madoff’s lifelong fascination with the stock market. As a teenager, Madoff frequently visited Wall Street and dreamed of becoming a “major player” in the world of high finance. Because he did not have the educational training or personal connections to land a prime job on Wall Street after he graduated from college, Madoff decided that he would set up his own one-man brokerage firm.

While in college, Madoff had accumulated a $5,000 nest egg by installing sprinkler systems during the summer months for wealthy New Yorkers living in the city’s afflu- ent suburbs. In the summer of 1960, Madoff used those funds to establish Bernard L. Madoff Investment Securities LLC, which was typically referred to as Madoff Securities. Madoff operated the new business from office space that was provided to him by his father-in-law, who was a partner in a small accounting firm. For nearly five decades, Madoff served as the senior executive of Madoff Securities. During that time, the shy New Yorker who had an occasional stammer and several nervous tics would accumulate a fortune estimated at more than one billion dollars.

Taking on Wall Street Madoff’s brokerage firm initially traded only securities of small over-the-counter com- panies, securities commonly referred to as “penny stocks.” At the time, the securi- ties of most large companies were traded on the New York Stock Exchange (NYSE). The rules of that exchange made it extremely difficult for small brokerage firms such as Madoff’s to compete with the cartel of large brokerage firms that effectively con- trolled Wall Street. Madoff and many other small brokers insisted that the NYSE’s rules were anticompetitive and inconsistent with a free market economy. Madoff was also convinced that the major brokerage firms kept securities transaction costs arti- ficially high to produce windfall profits for themselves to the detriment of investors, particularly small investors.

Because of Madoff’s resentment of the major Wall Street brokerage firms, he made it his mission to “democratize” the securities markets in the United States while at the same time reducing the transaction costs of trading securities. “Bernie was the king of democratization. He was messianic about this. He pushed to automate the [securities trading] system, listing buyers and sellers on a computer that anyone could access.”2

1. J. Maccabee, “Mom and Dad and Ruth and Bernie,” New York Magazine (nymag.com), 22 February 2009. 2. S. Fishman, “The Monster Mensch,” New York Magazine (nymag.com), 22 February 2009.

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166 SECTION ONE COMPREHENSIVE CASES

In fact, Madoff Securities was one of the first brokerage firms to utilize computers to expedite the processing of securities transactions. Bernie Madoff is also credited as one of the founders of the NASDAQ stock exchange that was organized in 1971. The NASDAQ was destined to become the world’s largest electronic stock exchange and the largest global stock exchange in terms of trading volume. In the late 1980s and early 1990s, Madoff served three one-year terms as the chairman of the NASDAQ.

Madoff’s leadership role in the development of electronic securities trading con- tributed significantly to his firm’s impressive growth throughout the latter decades of the twentieth century. By the early years of the twenty-first century, Madoff Securities was the largest “market maker” on the NASDAQ, meaning that the firm accounted for more daily transaction volume on that exchange than any other brokerage.3 By that time, the firm was also among the largest market makers for the New York Stock Exchange, accounting for as much as 5 percent of its daily transaction volume. This market-making service was lucrative with low risk for Madoff Securities and report- edly earned the firm, which was privately owned throughout its existence, annual profits measured in the tens of millions of dollars.

In 1962, Madoff had expanded his firm to include investment advisory services. For several years, most of the individuals who set up investment accounts with Madoff Securities were referred to him by his father-in-law. Although the firm was a pioneer in electronic trading and made sizable profits from its brokerage operations, invest- ment advisory services would prove to be its most important line of business. By late 2008, the total value of customer accounts managed by Madoff Securities reached $65 billion.

The key factor that accounted for the incredible growth in the amount of money entrusted to Madoff’s firm by investors worldwide was the impressive rates of return that the firm earned annually on the funds that it managed. For decades, those funds earned an average annual rate of return generally ranging from 10 to 15 percent. Although impressive, those rates of return were not spectacular. What was spectacu- lar was the consistency of the returns. In 2001, Barron’s reported that some of the Madoff firm’s largest investment funds had never experienced a losing year despite significant stock market declines in several individual years.4 Even when the stock market collapsed in late 2008, individual Madoff funds continued to report net gains for the year-to-date period.

Although Madoff would eventually serve as an investment advisor to dozens of celebrities, professional athletes, and other wealthy individuals, most of the money he managed came from so-called “feeder firms,” which were large hedge funds, banks, and other investment companies. The individuals who had committed their funds to these feeder firms were typically unaware that those funds had been turned over to Madoff.

The reclusive Madoff and his subordinates disclosed as little as possible about the investment strategy responsible for their firm’s success in the stock market. On one occasion, Madoff told an executive of a feeder firm, “It’s no one’s business what goes on here.”5 The Wall Street Journal reported that Madoff commonly “brushed

3. Investopedia, an online encyclopedia of business terms, provides the following description of a “market maker”: “Broker-dealer firm that accepts the risk of holding a certain number of shares of a par- ticular security in order to facilitate trading in that security. Each market maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares. Once an order is received, the market maker immediately sells from its own inventory or seeks an offsetting order.” 4. Barron’s (online), “What We Wrote About Madoff,” 12 December 2008. 5. Ibid.

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CASE 1.12 MADOFF SECURITIES 167

off” skeptics who questioned his firm’s investment results by pointing out that those results had been audited and by insisting that his investment strategy “was too com- plicated for outsiders to understand.”6

The only substantive information Madoff Securities provided regarding its invest- ment policies was that it employed a “split-strike conversion” investment model. In simple terms, this strategy involved purchasing several dozen blue-chip stocks and then simultaneously selling both put options and call options on those securities. Supposedly, this strategy ensured a positive rate of return on those investments whether the stock market went up or went down.

Competitors, financial analysts, and academics repeatedly attempted to replicate the success of Madoff Securities’ investment strategy. None of those attempts were successful, which only added to Bernie Madoff’s stature and mystique on Wall Street. As one industry insider noted in 2001, “Even knowledgeable people can’t really tell you what he’s doing.”7 A CNN reporter observed that by the turn of the century Madoff was widely regarded as a stock market wizard and that “everyone” on Wall Street, including his closest competitors, was “in awe of him.”8

The Bubble Bursts On 10 December 2008, Bernie Madoff asked his two sons, Andrew and Mark, who worked at Madoff Securities, to meet him at his apartment that evening. In this meet- ing, Madoff told his sons that the impressive returns earned for clients of his firm’s investment advisory division over the previous several decades had been fraudulent. Those returns had been produced by an elaborate Ponzi scheme engineered and overseen by Madoff without the knowledge of any of his employees or family mem- bers.9 The following day, an attorney representing Madoff’s sons notified the SEC of their father’s confession. That evening, FBI agents came to Madoff’s apartment. One of the agents asked Madoff “if there was an innocent explanation”10 for the information relayed to the SEC from his sons. Madoff replied, “There is no innocent explanation.”11 The agents then placed Madoff under arrest and within hours filed securities fraud charges against him.

The public announcement of Madoff’s fraudulent scheme in December 2008 stunned investors worldwide. That announcement further undercut the stability of global stock markets that were already reeling from the subprime mortgage crisis in the United States, which had “frozen” the world’s credit markets, caused stock prices to drop precipitously, and threatened to plunge the global economy into a deep depression. Politicians, journalists, and everyday citizens were shocked to learn that a massive investment fraud, apparently the largest in history, could go undetected for decades within the capital markets of the world’s largest economic power. Even more disconcerting was the fact that the Madoff fraud went undetected for several

6. G. Zuckerman, “Fees, Even Returns and Auditor All Raised Flags,” Wall Street Journal (online), 13 December 2008. 7. Ibid. 8. A. Chernoff, “What Drove Bernie Madoff,” CNNMoney.com, 5 January 2009. 9. Investopedia provides the following description of a “Ponzi scheme”: “A fraudulent investing scam promising high rates of return with little risk to investors. The Ponzi scheme generates returns for older investors by acquiring new investors. This scam actually yields the promised returns to earlier investors, as long as there are more new investors. These schemes usually collapse on themselves when the new investments stop.” 10. Fishman, “The Monster Mensch.” 11. Ibid.

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168 SECTION ONE COMPREHENSIVE CASES

years after the implementation of the far-reaching regulatory reforms mandated by the U.S. Congress in the wake of the Enron and WorldCom debacles.

News of the Madoff fraud caused a wide range of parties to angrily demand that the federal government and law enforcement authorities determine why the nation’s “watchdog” system for the capital markets had failed once again. The accounting profession was among the first targets of the public’s anger. On the day that Madoff’s fraud was publicly reported, Floyd Norris, a New York Times reporter acquainted with Madoff, asked a simple question that was on the minds of many people, namely, “Who were the auditors?”12

“Rubber-Stamped” Financial Statements Business journalists quickly determined that the auditor of Madoff Securities was Friehling & Horowitz, an accounting firm located in the small New York City suburb of New City. Friehling & Horowitz had issued unqualified opinions on the financial statements of Madoff Securities since at least the early 1990s, audits for which the small firm was paid as much as $200,000.

Further investigation revealed that Friehling & Horowitz had only one active accountant, one nonprofessional employee (a secretary), and operated from a tiny office occupying approximately two hundred square feet. The active accountant was David Friehling who had performed the annual audits of Madoff’s firm and signed off on the firm’s unqualified audit opinions. Accounting and auditing experts interviewed by the Associated Press insisted that it was “preposterous” to conceive that any one individual could complete an audit of a company the size of Madoff Securities by himself.13

Friehling and his firm were members of the American Institute of Certified Public Accountants (AICPA). A spokesperson for that organization revealed that Friehling had reported to the AICPA each year that he did not perform any audits. As a result, Friehling’s firm was not required to submit to the AICPA’s peer review program for CPA firms. Friehling’s firm was also not required to have a periodic peer review at the state level. At the time, New York was one of six states that did not have a mandatory peer review program for accounting firms.

In March 2009, the New York Times reported that Friehling had maintained dozens of investment accounts with Madoff Securities, according to documents obtained by the court-appointed trustee for that firm. Those same documents indicated that Friehling & Horowitz had another 17 investment accounts with Madoff’s firm. In total, Friehling, his accounting firm, and his family members had nearly $15 million invested in funds managed by Madoff. Federal prosecu- tors noted that these investments had “flouted” the accounting profession’s audi- tor independence rules and “disqualified” Friehling from serving as the auditor of Madoff Securities.14

David Friehling would be the second person arrested by federal law enforcement authorities investigating Madoff’s fraud. Among other charges, federal prosecutors indicted Friehling for securities fraud, aiding and abetting an investment fraud, and obstructing the IRS. The prosecutors did not allege that Friehling was aware of Madoff’s fraudulent scheme but rather that he had conducted “sham audits” of

12. F. Norris, “Bernie Madoff,” New York Times (online), 12 December 2008. 13. Associated Press (online), “Questions Surround Madoff Auditor,” 17 December 2008. 14. New York State Society of Certified Public Accountants, “Madoff Auditor Charged for Role in Massive Fraud,” 19 March 2009 (www.nysscpa.org/ezine/ETPArticles/ML31909a.htm).

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CASE 1.12 MADOFF SECURITIES 169

Madoff Securities that “helped foster the illusion that Mr. Madoff legitimately invested his clients’ money.”15

News reports of Friehling’s alleged sham audits caused him to be berated in the business press. A top FBI official observed that Friehling’s “job was not to merely rubber-stamp statements that he didn’t verify” and that Friehling had betrayed his “fiduciary duty to investors and his legal obligation to regulators.”16 An SEC offi- cial maintained that Friehling had “essentially sold his [CPA] license for more than 17 years while Madoff’s Ponzi scheme went undetected.”17 Many parties found this and other denigrating remarks made by SEC officials concerning Friehling ironic since the federal agency was itself the target of scornful criticism for its role in the Madoff fiasco.

Sir Galahad and the SEC On at least eight occasions, the SEC investigated alleged violations of securities laws by Madoff Securities during the two decades prior to Bernie Madoff’s startling con- fession. In each case, however, the investigation concluded without the SEC charg- ing Madoff with any serious infractions of those laws. Most of these investigations resulted from a series of complaints filed with the SEC by one individual, Harry Markopolos.

On the 1 March 2009, edition of the CBS news program 60 Minutes, investiga- tive reporter Steve Croft observed that until a few months earlier Harry Markopolos had been an “obscure financial analyst and mildly eccentric fraud investigator from Boston.” Beginning in 1999, Markopolos had repeatedly told the SEC that Bernie Madoff was operating what he referred to as the “world’s largest Ponzi scheme.” Between May 2000 and April 2008, Markopolos mailed or hand delivered documents and other evi- dence to the SEC that purportedly proved that assertion. Although SEC officials politely listened to Markopolos’s accusations, they failed to vigorously investigate them.

One lengthy report that Markopolos sent to the SEC in 2005 identified 29 specific “red flags” suggesting that Madoff was perpetrating a massive fraud on his clients. Among these red flags was Madoff’s alleged refusal to allow the Big Four auditor of an investment syndicate to review his financial records. Another red flag was the fact that Madoff Securities was audited by a one-man accounting firm, namely, Friehling & Horowitz. Also suspicious was the fact that Madoff, despite his firm’s leadership role in electronic securities trading, refused to provide his clients with online access to their accounts, providing them instead with monthly account state- ments by mail.

Among the most credible and impressive evidence Markopolos gave to the SEC were mathematical analyses and simulations allegedly proving that Madoff’s split-strike conversion investment strategy could not consistently produce the investment results that his firm reported. Markopolos noted that if such an invest- ment strategy existed, it would be the “Holy Grail” of investing and eventually be replicated by other Wall Street investment advisors. Even if Madoff had discov- ered this “Holy Grail” of investing, Markopolos demonstrated there was not suf- ficient transaction volume in the options market to account for the huge number

15. L. Neumeister, “Federal Appeals Court to Hear Madoff Jail Argument,” Associated Press (online), 19 March 2009. 16. W. K. Rashbaum and D. B. Henriques, “Accountant for Madoff Is Arrested and Charged with Securities Fraud,” New York Times (online), 18 March 2009. 17. Ibid.

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170 SECTION ONE COMPREHENSIVE CASES

of options that his investment model would have required him to buy and sell for his customers’ accounts.

In the months following the public disclosure of Madoff’s fraud, Harry Markopolos reached cult hero status within the business press. Markopolos was repeatedly asked to comment on and explain the scope and nature of Madoff’s scheme. Markopolos’s dissection of Madoff’s fraud suggested that three key factors accounted for it con- tinuing unchecked for decades. First, Madoff targeted investors who were unlikely to question his investment strategy. According to Markopolos, a large number of “smart” investors had refused to invest with Madoff despite his sterling record. “Smart investors would stick to their investment discipline and walk away, refusing to invest in a black-box strategy they did not understand. Greedy investors would fall over themselves to hand Madoff money.”18

The second factor that allowed Madoff’s fraud to continue for decades was his impeccable credentials. Even if his impressive investment results were ignored, Madoff easily qualified as a Wall Street icon. He was a pioneer of electronic securi- ties trading and throughout his career held numerous leadership positions within the securities industry, including his three stints as NASDAQ chairman. Madoff’s stature on Wall Street was also enhanced by his well-publicized philanthropy. He regularly contributed large sums to several charities.

The final and most important factor that allowed Madoff to sustain his fraudulent scheme was the failure of the regulatory oversight function for the stock market. In testimony before Congress and media interviews, Harry Markopolos insisted that the Madoff debacle could have been avoided or at least mitigated significantly if federal regulators, particularly the SEC, had been more diligent in fulfilling their responsibili- ties. According to Markopolos, Madoff knew that the SEC’s accountants, attorneys, and stock market specialists were “incapable of understanding a derivatives-based Ponzi scheme”19 such as the one he masterminded. That knowledge apparently embold- ened Madoff and encouraged him to continually expand the scope of his fraud.

Even after Markopolos explained the nature of Madoff’s fraud to SEC officials, they apparently did not understand it. “I gift wrapped and delivered the largest Ponzi scheme in history to them . . . [but the SEC] did not understand the 29 red flags that I handed them.”20 The outspoken SEC critic went on to predict that “If the SEC does not improve soon, they risk being merged out of existence in the upcoming rewrite of the nation’s regulatory scheme.”21

Markopolos’s pointed criticism of the SEC and additional harsh criticism by sev- eral other parties forced the agency’s top officials to respond. An embarrassed SEC Chairman Christopher Cox admitted that he was “gravely concerned”22 by the SEC’s failure to uncover the fraud.

In an extraordinary admission that the SEC was aware of numerous red flags raised about Bernard L. Madoff Investment Securities LLC, but failed to take them seriously enough, SEC Chairman Christopher Cox ordered a review of the agency’s oversight of the New York securities-trading and investment-management firm.23

18. D. Carozza, “Chasing Madoff,” Fraud Magazine, May/June 2009, 39. 19. Ibid, 57. 20. J. Chung and B. Masters, “SEC ‘Illiteracy’ to Blame for Madoff Affair,” Financial Times (online), 4 February 2009. 21. Carozza, “Chasing Madoff,” 58. 22. A. Lucchetti, K. Scannell, and A. Efrati, “SEC to Probe Its Ties to Madoffs,” Wall Street Journal (online), 17 December 2008. 23. Ibid.

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CASE 1.12 MADOFF SECURITIES 171

E P I L O G U E On March 12, 2009, Bernie Madoff appeared before Judge Denny Chin in a federal court- house in New York City. After Judge Chin read the 11 counts of fraud, money laundering, perjury and theft pending against Madoff, he asked the well-dressed defendant how he pled. “Guilty,” was Madoff’s barely audible one-word reply. Judge Chin then told Madoff to explain what he had done. “Your Honor, for many years up until my arrest on December 11, 2008, I oper- ated a Ponzi scheme through the investment advisory side of my business.”24 Madoff then added, “I knew what I did was wrong, indeed criminal. When I began the Ponzi scheme, I believed it would end shortly and I would be able to extricate myself and my clients …[but] as the years went by I realized this day, and my arrest, would inevitably come.”25

Despite allegations that his two sons, his brother, and his wife were at least knowledge- able of his fraud and possibly complicit in it, Madoff refused to implicate any of them or any of his other subordinates. Madoff claimed that he alone had been responsible for the fraud and that the brokerage arm of his business, which had been overseen by his brother and his two sons, had not been affected by his Ponzi scheme. On 29 June 2009, Madoff appeared once more in federal court. After reprimanding Madoff for his actions, Judge Chin sentenced him to 150 years in federal prison, meaning that the 71-year-old felon would spend the rest of his life incarcerated.26

David Friehling, Madoff’s longtime auditor, pleaded guilty in November 2009 to the nine- count indictment filed against him by federal prosecutors. Through late 2013, Friehling’s sen- tencing hearing had been delayed six times while he cooperated with the ongoing investi- gations of the Madoff fraud. In 2009, the AICPA announced that it had expelled Friehling for not cooperating with its investigation of his audits of Madoff Securities; one year earlier, Friehling had been stripped of his CPA license by the state of New York. The controversy over the failure of Friehling’s firm to undergo any peer reviews persuaded the New York state legislature to pass a law in December 2008 requiring New York accounting firms that provide attest services to be peer reviewed every three years.27, 28

Although none of the Big Four accounting firms were directly linked to Madoff Securities, legal experts speculated that those firms would face civil lawsuits in the wake of Madoff’s fraud. That potential liability stemmed from the Big Four’s audits of the large “feeder firms” that entrusted billions of dollars to Madoff. Lynn Turner, a former chief accountant of the SEC, contended that the auditors of the feeder firms had a responsibility to check out Madoff’s audi- tor. “If they didn’t, then investors will have to hold the auditors [of the feeder firms] accountable.”29

In February 2009, KPMG became the first of the Big Four firms to be named as a defen- dant in a civil lawsuit triggered by the Madoff

24. D. B. Henriques and J. Healy, “Madoff Goes to Jail After Guilty Plea,” New York Times (online), 13 March 2009. 25. Ibid. 26. In August 2009, Frank DiPascali, Madoff Securities’ former chief financial officer, pleaded guilty to complicity in Madoff’s fraudulent scheme. During an appearance in federal court, DiPascali testified that, “It was all fake; it was all fictitious. It was wrong and I knew it at the time” (C. Bray and T. Lauricella, “’All Fake’: Key Madoff Executive Admits Guilt,” Wall Street Journal (online), 11 August 2009). 27. Ironically, the New York law exempts accounting firms that have fewer than three professional accountants, meaning that Friehling & Horowitz would not have been required to undergo a peer review if the law had been in place during the time span covered by Madoff’s fraud. 28. In November 2012, David Friehling’s 23-year-old son, Jeremy, a medical student at Ohio State University, committed suicide. 29. I. J. Dugan and D. Crawford, “Accounting Firms That Missed Fraud at Madoff May Be Liable,” Wall Street Journal (online), 18 February 2009.

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172 SECTION ONE COMPREHENSIVE CASES

fraud. A California charity sued the promi- nent accounting firm to recover the millions of dollars it lost due to Madoff ’s scheme. KPMG had served as the independent auditor of a large hedge fund that had hired Madoff to invest the charity’s funds. Among the criti- cal risk factors allegedly overlooked by the KPMG auditors was the fact that Madoff ’s huge organization was serviced by a tiny accounting firm operating out of a strip mall in a New York City suburb.30

Over the following years, several other major international accounting firms would be named as defendants in civil lawsuits prompted by the Madoff fraud. Those firms included BDO Seidman, Ernst & Young, and PricewaterhouseCoopers.

In early 2009, President Obama appointed Mary Schapiro to replace Christopher Cox as the chairperson of the SEC. In the aftermath of the Madoff fraud, Schapiro reported that her agency would revamp its oversight policies and procedures for investment advisors having physical custody of customer assets. Among the proposals announced by Schapiro were annual “surprise audits” of such firms to ensure that customer funds were being properly safe- guarded. Schapiro also recommended that those firms be required to have internal con- trol audits by independent accounting firms to determine whether they have “the proper con- trols in place.”31 Finally, Schapiro pledged that the SEC would implement specific measures to ensure that credible whistleblowing allega- tions, such as those made by Harry Markopolos

regarding Madoff’s firm, would be investigated on a thorough and timely basis.

Bernie Madoff’s victims included a wide range of prominent organizations and individuals. The large asset management firm Fairfield Greenwich Advisors alone had more than one-half of its invest- ment portfolio of $14 billion invested with Madoff. Other companies and organizations that had sig- nificant funds in the custody of Madoff Securities include the large Dutch bank Fortis Bank, the large British bank HSBC, the International Olympic Committee, Massachusetts Mutual Life Insurance Company, New York University, Oppenheimer Funds, and Yeshiva University.

One media outlet reported that the list of individuals who had investments with Madoff reads like a lineup from Lifestyles of the Rich and Famous, a popular television program of the 1980s. Those individuals include award-win- ning actors and actresses, Hollywood directors and screenwriters, media executives, journal- ists, professional athletes, a Nobel Prize winner, and high-profile politicians. Among these indi- viduals are Kevin Bacon, Zsa Zsa Gabor, Jeffrey Katzenberg, Henry Kaufman, Larry King, Ed Koch, Sandy Koufax, Senator Frank Lautenberg, John Malkovich, Stephen Spielberg, Elie Wiesel, and Mort Zuckerman.32

By late 2013, Ir v ing Picard, the cour t- appointed trustee charged with recovering the billions of dollars stolen or misused by Madoff, had filed more than 1,000 civil lawsuits against a wide range of defendants. To date, he has recouped nearly $10 billion of the losses suf- fered by Madoff’s victims.

30. USLaw.com, “The Madoff Saga Continues as Pomerantz Files the First Derivative Suit Against an Auditor,” 11 February 2009. 31. S. N. Lynch, “SEC to Consider Surprise Audits of Advisers,” Wall Street Journal (online), 14 May 2009. 32. To date, several suicides have been attributed to Madoff’s massive fraud. One of those victims was Mark Madoff. Bernie Madoff’s oldest son took his life on 11 December 2010, two years to the date that his father admitted that he had masterminded a huge investment fraud.

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CASE 1.12 MADOFF SECURITIES 173

Questions 1. Research recent developments involving this case. Summarize these

developments in a bullet format.

2. Suppose that a large investment firm had approximately 10 percent of its total assets invested in funds managed by Madoff Securities. What audit procedures should the investment firm’s independent auditors have applied to those assets?

3. Describe the nature and purpose of a “peer review.” Would peer reviews of Friehling & Horowitz have likely resulted in the discovery of the Madoff fraud? Why or why not?

4. Professional auditing standards discuss the three key “conditions” that are typically present when a financial fraud occurs and identify a lengthy list of “fraud risk factors.” Briefly explain the difference between a fraud “condition” and a “fraud risk factor” and provide examples of each. What fraud conditions and fraud risk factors were apparently present in the Madoff case?

5. In addition to the reforms mentioned in this case, recommend other financial reporting and auditing-related reforms that would likely be effective in preventing or detecting frauds similar to that perpetrated by Madoff.

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175

CASE 1.13

AA Capital Partners, Inc.

A desire to be their “own bosses” and a burning entrepreneurial spirit compelled John Orecchio and Paul Oliver to leave the ranks of well-paid, white-collar employ- ees and strike out on their own. In February 2002, the two friends established a new investment advisory firm, AA Capital Partners, Inc. (AA Capital), on historic LaSalle Street in downtown Chicago. The two men realized that the investment advisory field was extremely competitive but planned to rely on their large network of friends and business associates and their impressive credentials to get their firm off to a fast start. Orecchio was particularly well known in Chicago and was a much sought-after speaker on the banquet circuit within the Windy City’s business community. For sev- eral years, he had managed a $5 billion private equity fund for Bank of America, the nation’s second largest bank holding company. During the same time frame, Paul Oliver served as the chief financial officer (CFO) of ABN AMRO, a large Dutch bank that has a major presence in the United States.

Getting Started Orecchio and Oliver agreed to be equal partners in AA Capital. Orecchio assumed the titles of president and secretary for the new firm, while Oliver took the titles of chairman and treasurer. Because of Orecchio’s extensive experience in investment management, the two partners agreed that he would oversee the firm’s day-to-day operations. Orecchio’s key responsibilities would be recruiting clients and managing AA Capital’s investments. Initially, Orecchio intended to focus his recruiting efforts on key officials of local labor unions. He hoped that he could quickly establish a cus- tomer base by convincing several of those individuals to entrust the management of their unions’ pension funds to AA Capital.

Orecchio’s plan was successful. By the end of 2004, he had persuaded six labor unions to transfer the assets in their pension funds to AA Capital. The collective value of those funds was approximately $200 million. Orecchio allocated the $200 million to four private equity funds organized under the corporate umbrella of AA Capital. The largest of these funds was the AA Capital Equity Fund, which was com- monly referred to as the Equity Fund.

AA Capital’s accounting function was the responsibility of one person, Mary Beth Stevens. Stevens, who was not a CPA but had several years of accounting experi- ence, was eventually given the title of CFO and chief compliance officer, as well. In the latter role, Stevens had the responsibility for complying with the complicated maze of governmental rules and regulations imposed on AA Capital by various fed- eral and state statutes, principal among them the Investment Advisers Act of 1940. Stevens also served as AA Capital’s liaison to the company’s independent auditors. The Investment Advisers Act requires investment advisory firms that manage more than $25 million of assets to register with the Securities and Exchange Commission (SEC) and file annual audited financial statements with that federal agency.

Earnest Auditors The Chicago office of Ernst & Young audited AA Capital and its four private equity funds. In 2004, Gerard Oprins, an Ernst & Young partner since 1995, was asked to

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176 SECTION ONE COMPREHENSIVE CASES

oversee the AA Capital audits. Oprins, who had just returned to Ernst & Young’s Chicago office after spending nearly three years in the firm’s Luxembourg office, was unfamiliar with AA Capital. Before agreeing to serve as the firm’s audit engagement partner, Oprins spoke with several colleagues and business associates who were acquainted with AA Capital and its owners. Based upon his research, Oprins’ deter- mined that AA Capital would be a “legitimate, respectable client.”1

Wendy McNeeley, an audit manager, served as Oprins’ principal subordinate on the 2004 AA Capital engagement. Similar to Oprins, McNeeley was unfamiliar with AA Capital. To prepare for her assignment, McNeeley reviewed prior-year workpa- pers and gained an understanding of the “basic client structure, the nature of the entity, and its industry.” The independent review or concurring partner for the AA Capital engagement was John Kavanaugh. The remaining members of the audit team consisted of two seniors and two staff accountants.

A subsequent report prepared by the SEC provided the following descriptions of the roles and responsibilities of Oprins, McNeeley, and Kavanaugh on the AA Capital engagement.

Oprins was the engagement partner. His role was to set the tone for the audit, staff the audit team adequately, and focus on high-risk areas. His responsibility was to oversee the audit manager and sign the audit report. As engagement partner, Oprins used discretion in reviewing the detailed audit workpapers, but typically reviewed work- papers that involved planning and audit strategy, as well as the GAAP Disclosure Checklist2. . . . [His principal] responsibility was to review and analyze significant auditing issues brought to his attention by McNeeley or the audit team.

McNeeley was the audit manager. She was responsible for the day-to-day oversight of audit planning and execution of the audit strategy. She also supervised the audit staff and reviewed audit workpapers in significant risk areas.

Kavanaugh provided quality control. This required him to read the financial state- ments, to understand the audit approach, and to ensure that the financial statements were stated in accordance with GAAP or any other basis of presentation used.

After an initial planning meeting of the audit engagement team, Oprins and McNeeley met with Orecchio and Stevens in AA Capital’s downtown Chicago office in late April 2005. During this meeting, the four individuals discussed various accounting matters and the procedures that the firm had in place to prevent and detect fraud.

Next, McNeeley outlined the “planning and audit strategy” for the AA Capital engagement in a standard Ernst & Young audit document referred to as the Audit Strategies Memorandum (ASM). In this document, McNeeley noted that she and her subordinates would not “rely on AA Capital’s internal controls.” Instead, the audit team would perform “substantive testing on all account balances.” McNeeley also oversaw the preparation of another standard Ernst & Young audit document for the AA Capital engagement, Internal Control and Fraud Considerations (ICFC). The purpose of this document is to identify “potential risks of material misstatement due to fraud.”

1. Securities and Exchange Commission, In the Matter of Gerard A.M. Oprins, CPA, and Wendy McNeeley, CPA, Initial Decision Release No. 411, 28 December 2010. Unless indicated otherwise, the quotations in this case were taken from this source. 2. This document is used by Ernst & Young auditors to determine whether an audit client has properly applied generally accepted accounting principles (GAAP), including making all appropriate disclosures in its audited financial statements.

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CASE 1.13 AA CAPITAL PARTNERS, INC. 177

The team of auditors spent nearly 800 hours on the 2004 AA Capital engagement, 200 hours more than budgeted. At the conclusion of the engagement, Ernst & Young issued unqualified audit opinions on the financial statements of AA Capital, the Equity Fund, and the three smaller private equity funds established and controlled by AA Capital. According to the SEC, Ernst & Young’s audit procedures focused pri- marily on three key items within the series of financial statements: investments, part- ners’ capital, and management fees paid to AA Capital.

The only major problem that McNeeley and her four subordinates encountered during the audit fieldwork involved the partners’ capital accounts with AA Capital. While testing a client-prepared schedule that detailed the activity in those accounts during 2004, the auditors identified four unusual cash transfers to Orecchio. Those transfers totaled $1.92 million and were described in the client-prepared schedule as “tax payments or tax distributions” to Orecchio. (In other documents and correspon- dence, these transactions were sometimes referred to as “tax advances,” “tax loans,” or “tax transfers.”) In each case, the cash had been transferred from the Equity Fund to AA Capital and ultimately disbursed to John Orecchio. As a result of these trans- actions, the year-end accounting records of the Equity Fund included a $1.92 mil- lion receivable from AA Capital. Likewise, AA Capital’s year-end accounting records included a $1.92 million receivable from John Orecchio and an offsetting $1.92 mil- lion payable to the Equity Fund.

A Taxing Problem A staff accountant assigned to the AA Capital audit team questioned Mary Beth Stevens regarding the nature of the $1.92 million of cash transfers made to John Orecchio from the Equity Fund. The auditor noted on a workpaper that, “The $1,921,150 is essentially a loan made to John Orecchio.” The loan to Orecchio had been necessary, allegedly, because the IRS had levied a $1.92 million tax assessment on Orecchio in error. Stevens told the auditor that the amount would either be repaid to AA Capital by the IRS or Orecchio.

After reviewing the information collected by her subordinate regarding the $1.92 million of cash payments made to Orecchio, McNeeley “initiated a series of e-mails with Stevens in which she attempted to solidify her understanding of the transfers.” McNeeley initially thought that the $1.92 million in cash transfers involved payments made for disputed tax liabilities of AA Capital rather than John Orecchio, despite the workpaper notation made by her subordinate. “Contrary to McNeeley’s assump- tion that the payments were for corporate taxes, Stevens replied that the tax accruals were, in fact, related to Orecchio and that ‘John was dinged by the IRS and incurred multiple fees and tax payments.’” Stevens went on to explain to McNeeley that the IRS had mistakenly assessed Orecchio with the taxes and that the matter would not be resolved until after the 2004 audit was completed. After the series of e-mail exchanges with Stevens, McNeeley made the following notation in the Ernst & Young audit workpapers:

Note: Per the last page of N2 [workpaper reference], the Equity Fund made approxi- mately $1,921,304 of tax payments for John Orecchio during 2004. The Equity Fund has set up a receivable from AA Capital Partners for reimbursement of this amount. E&Y verified that AA Capital Partners has a reciprocal payable balance to Equity. E&Y also noted that AA Capital has an offsetting receivable balance from John Orecchio. Appears proper.

Despite the conclusion by McNeeley that the $1.92 million of cash payments to Orecchio appeared “proper,” Stevens’ explanations did not fully satisfy her. The audit

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178 SECTION ONE COMPREHENSIVE CASES

manager subsequently asked the CFO to provide her with “any and all documen- tation that she had regarding the tax advances.” Stevens never responded to that request.

McNeeley eventually decided that sufficient evidence had been collected for her to sign off on the $1.92 million of tax transfers to Orecchio that she recognized as being “quantitatively material.” This evidence included the information in the client- prepared schedule that reported the amount and timing of each of the four cash transfers, the related entries in the client’s accounting records for those transactions, and the 2004 management representations letters signed by Orecchio and Stevens in which they “represented to E&Y that the accounting records were complete and accurately reflected all of the company’s transactions.”

Years later, McNeeley testified that she had also reviewed the partnership agree- ment of AA Capital at the beginning of the 2004 audit and “understood” as a result of that review that it “permitted tax distributions and tax advances” to Orecchio and Oliver. She could not recall, however, whether she had specifically reviewed the partnership agreement “in connection with her analysis of the transfers.” McNeeley also testified that she “did not recall any member of the audit team speaking with Orecchio or Oliver about the Transfers.” An audit checklist item mandated that the audit team “gain an understanding of the business rationale” for significant transac- tions “outside the normal course of business” that may have been linked to an effort to conceal the “misappropriation of assets.” For that checklist item, McNeeley made the following entry: “None noted.”

Near the end of the 2004 audits of AA Capital and its private equity funds, McNeeley performed the mandatory “subsequent period” audit tests. These tests include reviewing significant events and transactions that occur following the date of the given client’s year-end balance sheet but prior to the issuance of the audit report. McNeeley performed this subsequent period review for the time frame 1 January– 31 March 2005. Ernst & Young’s workpapers “indicated that disbursements during the period . . . were reviewed for significant unusual items.” McNeeley noted in the work- papers that “no unusual items” were found during the review of those disbursements despite the fact that an additional $482,000 of “tax distributions” were made to John Orecchio during the first three months of 2005.

Ernst & Young auditors prepare a Summary Review Memorandum (SRM) near the completion of an audit. The SEC described the SRM as a “document completed by the audit team near the end of the audit that summarizes key accounting and auditing matters that arose during the audit and the core team’s ultimate conclu- sions regarding the audit and the opinion(s) to be issued.” The SRM is reviewed at the conclusion of an audit by both the audit engagement partner and the independent review partner. Neither McNeeley nor her subordinates commented in the SRM on the tax payments made on behalf of John Orecchio during 2004 or the first three months of 2005.

The 2004 year-end audited balance sheet of the Equity Fund reported the $1.92 million of cash transfers made to John Orecchio, by way of AA Capital, on a line item entitled “Accounts Receivable from AA Capital Partners, Inc.” According to the SEC, “There was no disclosure in the ‘Notes to Financial Statements’ regarding the fact that money from the Equity Fund ultimately went to Orecchio for a ‘tax loan’ or ‘tax dis- tribution.’” In AA Capital’s 2004 balance sheet, the $1.92 million receivable from John Orecchio was embedded in a $2.3 million line item labeled “Accounts Receivable from Affiliates,” while the $1.92 million payable to the Equity Fund was embedded in a $2.5 million line item labeled “Fees and Accounts Payable.” AA Capital’s financial

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CASE 1.13 AA CAPITAL PARTNERS, INC. 179

statement footnotes included a “Related-party Note,” but that note did not mention the $1.92 million of transactions involving Orecchio and the Equity Fund.

With one exception, the key members of the 2004 AA Capital engagement team returned to work on the 2005 engagement. Because Wendy McNeeley was on maternity leave, she was replaced on the 2005 audit team by another audit man- ager, Jennifer Aquino. The $1.92 million of tax distributions or loans made to John Orecchio during 2004 had not been repaid by the end of 2005. In fact, by the end of 2005, the amount owed to the Equity Fund by AA Capital on behalf of Orecchio had swelled to $5.7 million because Orecchio had received an additional $3.8 million in “tax loans” from the Equity Fund during 2005.

During the 2005 audit, Jennifer Aquino asked Mary Beth Stevens for “documenta- tion supporting the [$5.7 million of] Transfers, but never received anything.” Aquino noted that “other than the inquiry of Stevens and sending an e-mail to Orecchio, there were no other audit procedures to perform on the Transfers ‘because the audit team didn’t have anything to audit.’” The members of the AA Capital audit team held sev- eral “internal discussions” regarding the tax loans to Orecchio during the 2005 audit. During one of these meetings, “the audit team determined that it would not proceed with the 2005 audit until Orecchio paid back the ‘tax loan’ and they received suffi- cient documentation” to audit the transactions related to that loan. On 30 June 2006, Gerard Oprins informed Mary Beth Stevens and John Orecchio of that decision.

In early August 2006, the SEC launched an investigation of the financial affairs of AA Capital after receiving an anonymous tip that members of the firm were involved in “improprieties.” Six weeks later, a federal judge appointed a receiver to take con- trol of AA Capital. The latter decision prompted Ernst & Young to recall its audit opin- ions on the 2004 financial statements of AA Capital and its four private equity funds.

Oh, Orecchio! In February 2010, John Orecchio pleaded guilty to embezzling approximately $24 million from AA Capital’s Equity Fund. That amount included the $5.7 million that had been labeled as “tax loans.” Instead of using the funds transferred to him from the Equity Fund for tax payments and other allegedly legitimate purposes, Orecchio had used the stolen money to finance a “high roller” lifestyle.

Law enforcement authorities revealed that Orecchio spent millions of dollars to establish and sustain a romantic relationship with a young exotic dancer that he met at a Detroit nightclub. Orecchio reportedly purchased $1.4 million of jewelry for his mistress, bought her a boat and several luxury automobiles, paid for $180,000 in renovations at the club where she worked so that the owner would promote her to a management position, and once rented a small Caribbean island to throw a party for her and her friends. In late 2005, Orecchio convinced his partner, Paul Oliver, that AA Capital should invest $8.7 million of their customers’ funds in a real estate devel- opment project. In fact, Orecchio invested only $1.3 million of that amount in the real estate project and used the bulk of the other $7.4 million to renovate a Michigan horse farm that he had purchased to impress his girlfriend.

Las Vegas was a prime destination for Orecchio while he was embezzling from his clients’ pension funds that were intended to finance the retirements of thousands of carpenters, millwrights, and other skilled tradesmen. Court records revealed that Orecchio spent more than $300,000 in Las Vegas nightclubs, including a one-night extravaganza costing $4,900 at MGM’s Studio 54 and a blow-out party costing $14,000 at Wynn’s Tryst. He also spent $500,000 of his clients’ funds to purchase a Las Vegas condominium.

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180 SECTION ONE COMPREHENSIVE CASES

Orecchio spent large sums attempting to purchase favors from politicians and gov- ernment officials who could influence the investment decisions made by labor union pension funds. One of the politicians he attempted to bribe unsuccessfully was Detroit Mayor Kwame Kilpatrick. Orecchio had hoped that he could convince Kilpatrick to steer the large pension funds of the Detroit police and fire departments to AA Capital.

In addition to the $24 million that he embezzled, Orecchio admitted that he was responsible for more than $30 million in additional losses suffered by his labor union clients. The largest of those losses stemmed from an investment that he had made on behalf of those clients in a sports drink company organized by several of his Las Vegas acquaintances. The venture eventually failed and AA Capital recovered only a small fraction of the large investment.

Auditors Front and Center Once the SEC determined that Orecchio had used AA Capital’s Equity Fund as his personal piggy bank, the federal agency turned its attention to the Ernst & Young auditors who had issued unqualified opinions on the financial statements of that fund and AA Capital. In March 2010, the SEC issued an Accounting and Auditing Enforcement Release in which it maligned Ernst & Young’s audits of those entities. That document included the following statement that summarized the SEC’s princi- pal criticism of Ernst & Young, Gerard Oprins, and Wendy McNeeley.

During the [2004] audits, Oprins, the engagement partner, and McNeeley, the man- ager, learned that … John Orecchio purportedly had borrowed $1.92 million in funds belonging to AA Capital’s clients … to pay a personal tax liability arising from his ownership interest in AA Capital’s private equity funds. In fact, Orecchio had invented the story about the so-called “tax loan” to conceal his ongoing misappropriation of cli- ent assets for his personal use. Despite learning about the [bogus] “tax loan” during the [2004] audits, Oprins and McNeeley failed to review the transaction in accordance with GAAS. Instead of properly evaluating the “tax loan” as a related party transac- tion, Oprins and McNeeley relied solely upon dubious and unsubstantiated informa- tion obtained from AA Capital’s chief financial officer, Mary Beth Stevens. As a result, Oprins and McNeeley caused Ernst & Young to issue unqualified audit reports for AA Capital’s and the Equity Fund’s 2004 financial statements even though Orecchio’s pur- ported “tax loan” was not adequately disclosed in conformity with GAAP and Ernst & Young’s audits were not conducted in accordance with GAAS.3

The Accounting and Auditing Enforcement Release also identified other oversights made by the Ernst & Young auditors.

The audit team did not obtain any documentation reflecting Orecchio’s tax liability or the terms of the ‘tax loan.’

They did not discuss the ‘tax loan’ with Orecchio.

They did not take steps to assess the collectability of the ‘tax loan.’

They also failed to discuss Orecchio’s tax liability with their colleagues in Ernst & Young’s tax department who prepared the tax filings for AA Capital and its affiliated private equity funds.

The SEC’s Enforcement Division recommended that Oprins and McNeeley be sus- pended from practicing before the SEC for three years as a result of their alleged “improper professional conduct” during the 2004 audits of AA Capital and its Equity

3. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 3116A, 1 March 2010.

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CASE 1.13 AA CAPITAL PARTNERS, INC. 181

Fund. The two auditors quickly appealed that decision. A federal judge, Judge Robert Mahony, presided over their appeals in a hearing that extended over two weeks from late July through early August 2010.

Ernst & Young retained two high-profile expert witnesses to testify on behalf of Oprins and McNeeley during the hearing. One of those experts was John Ellingsen who had served for 25 years as an audit partner with Deloitte & Touche, including 6 years in which he was the firm’s senior technical audit partner. Ellingsen had also served for four years on the Auditing Standards Board. The SEC also retained a high- profile expert witness John Barron, who, like Ellingsen, was a former longtime audit partner with Deloitte & Touche.

In a 41-page opinion that he wrote following the conclusion of the hearing for Oprins and McNeeley, Judge Mahony confirmed that the SEC has the authority to sanction accountants and auditors for “improper professional conduct.” The appli- cable federal regulations identify two gradients of improper professional conduct: “reckless conduct” and “negligent conduct.”

To find that an auditor was reckless, the SEC’s Enforcement Division must establish that “the audit amounted to no audit at all, or an egregious refusal to see the obvious, or to investigate the doubtful.” To find that an auditor was negligent, which is the less severe form of improper professional conduct, the SEC must establish that the indi- vidual was guilty of at least one instance of “highly unreasonable conduct.” This mis- conduct involves a violation of the relevant professional standards “in circumstances in which an accountant [auditor] knows that heightened scrutiny is warranted.” Judge Mahony noted that the key benchmark to use in making a determination of whether an auditor is guilty of highly unreasonable conduct is to compare the given individual’s conduct with “the actions a reasonable accountant [auditor] should have taken” in identical circumstances.

In his opinion, Judge Mahony ruled in favor of Gerard Oprins by finding that the audit partner had not engaged in either reckless or highly unreasonable (negligent) conduct. A key factor that influenced Judge Mahony’s decision was the testimony of John Ellingsen that an audit engagement partner is not “responsible for all decisions made in the course of an engagement.” In siding with that argument, Judge Mahony concluded that it was improper for the SEC to hold Oprins responsible for the defi- cient audit procedures applied to the alleged tax transfers to John Orecchio because Wendy McNeeley had failed to adequately inform him of those transactions. ”As the engagement partner, Oprins reasonably relied on McNeeley, a highly regarded audi- tor, to perform the audit in accordance with professional standards and escalate issues, such as the Transfers, to his attention.” The judge maintained that because McNeeley had failed to highlight the transfers in the SRM or discuss those transfers directly with the audit partner, Oprins never realized that they were “outside the nor- mal course of business.”

Judge Mahony did rule that Oprins had sufficient information to determine that the tax transfers qualified as related-party transactions and should have been disclosed as such in the 2004 financial statements of the Equity Fund and AA Capital. However, the judge found that this one oversight did not rise to the level of reckless or highly unreasonable conduct.

Wendy McNeeley, not Gerard Oprins, was the individual “primarily responsible for ensuring that the 2004 audit complied with GAAS,” according to Judge Mahony. The judge ruled that McNeeley had not obtained “sufficient competent evidential matter” to corroborate the alleged tax transfers to John Orecchio during 2004. After characterizing McNeeley’s “failures” as “significant,” Judge Mahony summarized the specific errors in judgment that she had made during the 2004 engagement.

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182 SECTION ONE COMPREHENSIVE CASES

She missed significant warning signs throughout the audit, not the least of which was the increase in the Transfers balance that should have been discovered during the subsequent review testing and investigated. She failed to follow up on her request of Stevens to provide documentary support for the Transfers. And she failed to ensure that the Transfers were disclosed in the financial statements in accordance with GAAP.

Despite his finding that McNeeley had made several significant mistakes during the AA Capital audits, Judge Mahony concluded that a three-year ban from practic- ing before the SEC was too severe of a punishment for her. He based this decision, in part, on the fact that she “has had a distinguished career and no disciplinary his- tory.” McNeeley subsequently appealed the one-year suspension that Judge Mahony imposed on her, however, that appeal was apparently unsuccessful.

E P I L O G U E John Orecchio faced a prison sentence of up to 25 years for the fraud and embezzle- ment charges filed against him. To reduce his sentence, Orecchio agreed to participate in a “sting operation” organized by federal law enforcement authorities. While wearing a “wire” to record his conversations, Orecchio met with 20 different union representatives. The union reps who accepted the bribes offered to them by Orecchio found themselves facing a felony indictment as well. Following his cooperation with the “feds,” Orecchio received a prison term of nine years and four months after pleading guilty to one count of fraud and one count of theft in early 2010. In a largely symbolic move, the federal judge who sentenced Orecchio also ordered him to repay the more than $50 million of losses suffered by AA Capital’s pension fund clients as a result of his theft and mismanagement. When he was formally sentenced, Orecchio had already been stripped of any remaining assets that he had accumulated during his crime spree.

The loss of material possessions was not the most significant price that John Orecchio paid for his indiscretions. At the height of his embez- zlement scheme, while he was still married and clandestinely living a dual existence, Orecchio had asked his mistress to marry him, but that relationship dissolved when his embezzlement scheme surfaced. Then, his wife left him, taking with her their three children. After both rela- tionships had ended, a despondent Orecchio attempted suicide in 2009. Before being sen- tenced in June 2010, Orecchio was living with his mother in New Jersey. His only request at his sentencing was that he be incarcerated in New Jersey so that his three children could visit him in prison during trips to see their grandmother. Orecchio pledged to the judge that, “I’ll do what I can do make it up to them the rest of my days.” 4,5

Gerard Oprins left Ernst & Young in April 2009 and at last report was self-employed as a private consultant. Wendy McNeeley left Ernst & Young in July 2006. At last report she was employed by another major accounting firm.

1,2

4. Daily Herald (online), “Ex-Arlington Heights Man Gets 9 Years in Prison in Pension Fraud,” 18 June, 2010. 5. Mary Beth Stevens did not face criminal charges as a result of her role in John Orecchio’s fraud. However, the SEC barred Stevens from being associated with a registered investment advisory firm and levied monetary penalties of approximately $150,000 on her. The federal agency barred Paul Oliver, Orecchio’s partner, from being associated with an investment advisory firm for 12 months and levied fines and other civil sanctions on him totaling $130,000.

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CASE 1.13 AA CAPITAL PARTNERS, INC. 183

Questions 1. What factors likely contributed to the oversights made by the Ernst & Young

auditors during the 2004 AA Capital engagement? Identify measures that audit firms can implement to minimize the likelihood of such oversights on audit engagements.

2. Was it appropriate for Ernst & Young to decide not to rely on AA Capital’s internal controls during the 2004 audits? Under what circumstances can auditors choose not to rely on a client’s internal controls?

3. What audit procedures do professional auditing standards require that auditors apply to related-party transactions? Would any of these procedures have resulted in Ernst & Young discovering the true nature of the cash transfers made to John Orecchio?

4. What objectives do auditors hope to accomplish in performing “subsequent period” audit tests?

5. Do you agree with the assertion of John Ellingsen that an audit engagement partner is not “responsible for all decisions made in the course of an engagement?” Defend your answer. What quality control implications does that assertion, if true, have for audit firms?

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185

CASE 1.14

Navistar International Corporation

Cyrus McCormick revolutionized American agriculture in the mid-nineteenth century when he invented a mechanical reaper. His horse-drawn harvester would become the primary product marketed by McCormick Harvesting Machine Company. Decades later, Cyrus McCormick II merged his father’s company with three compet- ing firms to create International Harvester Company, the nation’s largest manufac- turer of agricultural equipment.

In addition to being successful businessmen, the McCormicks were pioneers in the field of management science. Each of them realized that modern management techniques were critical to a large company’s success. As an example, to help him maintain control over his rapidly growing company, Cyrus McCormick II retained an independent accounting firm to audit its financial records long before independent audits were mandated for public companies. That accounting firm was the predeces- sor of Deloitte, one of the Big Four firms that now dominate the public accounting profession.

By the late 1980s, International Harvester had been renamed Navistar International Corporation because the company’s principal line of business had migrated away from farming equipment and into the manufacture of trucks, school buses, and auto- motive engines. As the company evolved and changed over the decades, one of its most enduring relationships was with the accounting firm that Cyrus McCormick II retained in 1908. The business community was shocked in 2006 when, after 98 years, Navistar dismissed Deloitte as its independent audit firm. Even more shocking was a $500 million lawsuit subsequently filed by the company against Deloitte. Among other allegations, the lawsuit alleged that Navistar management had been duped into believing that Deloitte provided professional quality accounting and auditing services.1 The dramatic end to Deloitte’s relationship with Navistar caught the atten- tion of the Public Company Accounting Oversight Board (PCAOB), resulting in that agency’s first formal investigation of a Big Four accounting firm.

New Partner . . . New Audit In late 2005, Deloitte’s Navistar audit for the fiscal year ending 31 October 2005, was nearing completion when the audit engagement partner took a “mysterious medi- cal leave”2 and was replaced. Navistar’s new audit engagement partner was a for- mer Arthur Andersen partner who had joined Deloitte after a felony conviction in 2002 drove Andersen out of business.3 The new engagement partner was apparently shocked at the condition of Navistar’s accounting records and the work that had been done to that point on the 2005 audit. “The new lead engagement partner . . . began questioning almost everything that had been done or approved previously

1. J. Stempel, “Navistar Sues Ex-Auditor Deloitte for $500 million,” 26 April 2011, www.reuters.com. 2. F. McKenna, “Navistar Sues Deloitte Proving No Statute of Limitations on Idiocy,” 31 May 2011, www.forbes.com. 3. Arthur Andersen’s felony conviction was overturned in 2005 by the U.S. Supreme Court but it was not practical for the firm to resume operations at that point.

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186 SECTION ONE COMPREHENSIVE CASES

. . . [and] refused to accept any of the work . . . the [audit] team had already done and basically, according to Navistar, started the audit over.” 4

Navistar’s management team was less than happy with the sudden turn of events. The company’s executives were even more dismayed when the delay in the 2005 audit prevented Navistar from meeting the filing deadline for its annual Form 10-K with the Securities and Exchange Commission (SEC). In February 2006, Deloitte advised Navistar management that it could no longer rely on representations made by the company’s controller, which caused Navistar to replace that individual. Deloitte also asked Navistar to reassign a top executive of its large finance subsid- iary, Navistar Financial Corporation, which the company did. The tense relationship between Deloitte and Navistar ended in April 2006 when the company’s audit com- mittee dismissed Deloitte and retained KPMG as the company’s independent auditor.

Over the following 20 months, “Navistar spent more than $200 million to reconduct their 2002–2004 audits, redo and complete their 2005 audit, and reevaluate a never- ending list of material weaknesses and significant deficiencies in internal controls over financial reporting.”5 Navistar hired PricewaterhouseCoopers, Ernst & Young, and two large consulting firms to overhaul its accounting and financial reporting functions. In the meantime, the New York Stock Exchange delisted Navistar’s com- mon stock, which complicated the company’s efforts to raise needed capital. In late 2007, Navistar finally filed its 2005 Form 10-K and restated financial statements for fiscal 2003, fiscal 2004, and the first three quarters of 2005 with the SEC. The restate- ments reduced Navistar’s previously reported profits by nearly $680 million.

Navistar’s 2005 Form 10-K reported 15 material weaknesses in the company’s inter- nal controls over financial reporting. Exhibit 1 provides brief summaries of those material weaknesses that were excerpted from that Form 10-K.

SEC Weighs In The long delay in the filing of Navistar’s 2005 Form 10-K caused the SEC to investigate the company’s financial affairs. In 2010, the federal agency issued a series of enforce- ment and litigation releases focusing on the company and members of its manage- ment team. Despite uncovering circumstances in which financial statement amounts had been intentionally misstated, the SEC concluded that Navistar’s management did not engage in a “coordinated scheme” to misrepresent the company’s financial state- ments. Instead, the SEC reported that the Navistar case primarily involved a “defi- cient system of internal controls.”

These findings do not reflect a coordinated scheme by senior management to manipu- late the Company’s reported results or conduct committed with the intent of personal gain. Instead, these findings reflect misconduct that resulted in large part from a defi- cient system of internal controls, evidenced in part by insufficient numbers of employ- ees with accounting training, a lack of written accounting policies and procedures, and flaws in the Company’s organizational structure.6

The SEC identified several “improper accounting practices” that materially overstated Navistar’s profits in the early 2000s. The fiscal year most affected by the restatements was 2003. Navistar originally reported a net loss of $18 mil- lion for 2003; after restatement, the company reported a net loss for that year of

4. McKenna, “Navistar Sues Deloitte.” 5. Ibid. 6. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 3165, 5 August 2010.

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CASE 1.14 NAVISTAR INTERNATIONAL CORPORATION 187

1. Control Environment: As of October 31, 2005, management was unsuccessful in establishing an adequately strong consciousness regarding the consistent application of ethics across all areas of the company and the importance of internal controls over fi nancial reporting, including adherence to GAAP.

2. Accounting Personnel: We did not have a suffi cient number of accounting personnel with an appropriate level of accounting knowledge, experience and training in the application of GAAP.

3. Accounting Policies: We did not have a formalized process for monitoring, updating, disseminating, and implementing GAAP-compliant accounting policies and procedures.

4. Internal Audit: Our internal audit department was not an effective monitoring control over fi nancial reporting.

5. Segregation of Duties: We did not maintain effective controls to ensure adequate segregation of duties.

6. Information Technology (“IT”): Our IT general controls over computer program development, computer program changes, computer operations and system user access to programs and data were ineffectively designed.

7. Journal Entries: We did not maintain effective controls over the preparation, support, review and approval of journal entries.

8. Account Reconciliations: We did not maintain effective controls over account reconciliations and fi nancial analysis and review.

9. Period End Close: We did not maintain effective controls over the period end close process.

10. Pension Accounting: We did not maintain effective controls to accurately estimate our pension and OPEB obligations.

11. Warranty Accounting: We did not have appropriate warranty cost accounting models and methodologies in place to adequately estimate warranty accruals and we did not perform appropriate fi nancial analyses of the warranty cost estimates on a periodic basis.

12. Income Tax Accounting: We did not have suffi cient modeling tools in place or a process to validate the positive and negative evidence necessary to determine whether valuation allowances were required to reduce the carrying values of deferred tax assets.

13. Inventory Accounting: We did not maintain effective controls over our inventory accounting process.

14. Revenue Accounting: We did not maintain effective controls over the revenue accounting process.

15. Contracts and Agreements: We did not perform effective reviews of contracts and agreements, including customer agreements, supplier agreements, agreements related to variable interest entities, derivatives, debt, and leases to assess the accounting implications related to the contracts and agreements.

Source: Navistar International Corporation’s 2005 Form 10-K.

EXHIBIT 1

MATERIAL WEAKNESSES IN INTERNAL CONTROL REPORTED BY NAVISTAR IN ITS 2005 FORM 10-K

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188 SECTION ONE COMPREHENSIVE CASES

$333 million. Among the largest misstatements was the company’s understate- ment of its reserve for warranty-related expenses on its product line of automotive engines. The company understated that reserve by subtracting “anticipated ven- dor reimbursements” from estimated warranty-related expenses each year. That is, Navistar’s accounting staff anticipated that the company’s suppliers would con- tribute to the cost of repairing or replacing automotive engines that failed due to components purchased from those suppliers. In fact, vendor reimbursements were not contractually required and the vendors did not offer to voluntarily make such reimbursements.

Navistar also improperly accounted for vendor rebates that were dictated by the volume of purchases the company made in a given period. Instead of record- ing rebates strictly when they were earned, Navistar’s accountants began recording “anticipated” rebates to be received from the company’s vendors based upon the volume of purchases expected to be made from them in the future.

Under GAAP, a company could recognize rebates only when they were actually earned, i.e., when the entity had substantially accomplished what was necessary to be entitled to such rebates. Accordingly, Navistar could record the full rebate as income in the then-current period only if no contingencies existed on its right to receive the rebate. Conversely, the Company was prohibited from booking rebates as income in the then-current period if they were based on future business.7

Navistar also improperly deferred “start-up costs” related to a long-term contract being negotiated with one of its major customers. In anticipation of that contract being signed, Navistar spent nearly $60 million, including expenditures to construct a production facility where the engines to be supplied under the contract would be manufactured. When the other party cancelled the contract negotiations, Navistar was forced to absorb those costs. According to the SEC, Navistar was entitled to defer the start-up costs only “if there existed an objectively verified and measured contrac- tual guarantee of reimbursement.”8

The SEC sanctioned several of Navistar’s top executives despite ruling that the com- pany’s misrepresented financial statements were not due to a coordinated scheme. Those executives included Daniel Ustian, Navistar’s chairman of the board and chief executive officer (CEO), and Robert Lannert, the company’s chief financial officer (CFO). In addition to agreeing to “cease and desist” from future violations of federal securities laws, Ustian and Lannert forfeited more than $1 million in bonuses they had each received due to Navistar’s inflated earnings. The SEC did not fine Navistar because the firm had implemented a wide range of measures to remedy its serious accounting and internal control problems. Those measures included hiring 50 addi- tional accountants, a new chief accounting officer, a new vice president of internal audit, and a new chief information officer.

Navistar’s sloppy accounting practices triggered the filing of a class-action lawsuit against the company by investors who had purchased the company’s common stock during the time periods when its financial statements were misrepresented. Navistar settled that lawsuit in 2011 by agreeing to pay the plaintiffs $13 million. Deloitte had previously been dismissed as a defendant in that case by a federal judge who ruled that there was an insufficient basis for the allegations filed against the accounting firm by the plaintiffs’ attorneys. Deloitte would not be so fortunate when it came to the PCAOB’s investigation of its Navistar audits.

7. Ibid. 8. Ibid.

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CASE 1.14 NAVISTAR INTERNATIONAL CORPORATION 189

Deloitte vs. The Feds In June 2005, the SEC, which oversees the PCAOB’s operations, inadvertently revealed that the PCAOB was investigating Deloitte’s 2003 audit of Navistar. The PCAOB had notified the SEC of that investigation the prior month in a document that was not intended to be released to the public. An SEC spokesperson admitted his agency had accidentally included that document with other documents routinely made available to the public. The spokesperson apologized for the error and indicated that steps were being taken to improve the SEC’s administrative procedures. The release of the PCAOB document was newsworthy because it signaled the PCAOB’s first formal investigation of a Big Four accounting firm.

Prior to the SEC’s inadvertent disclosure of the PCAOB’s Deloitte investigation, there was already considerable tension between the SEC and Deloitte. In April 2005, the SEC had fined Deloitte $50 million for its audits of the fraudulent financial state- ments of Adelphia Communications, a large telecommunications company that col- lapsed into bankruptcy in 2002. That fine was easily the largest ever levied against a Big Four firm by the SEC.

Shortly after the SEC announced the $50 million fine, James Quigley, Deloitte’s CEO, issued a press release that infuriated SEC officials. In the press release, Quigley noted that, “Among our most significant challenges is the early detection of fraud, particu- larly when the client, its management and others collude specifically to deceive a company’s auditors.”9 An SEC spokesperson responded harshly to Quigley’s state- ment. “Deloitte was not deceived in this case. The findings in the order show that the relevant information was right in front of their eyes. Deloitte just didn’t do its job, plain and simple. They didn’t miss red flags. They pulled the flag over their head and claimed they couldn’t see.”10

The SEC also suggested that Quigley’s press release violated the terms of the agree- ment the agency had reached with Deloitte in settling the Adelphia case. Under the terms of that agreement, Deloitte was not required to “admit” to the SEC’s find- ings, nor was it allowed to “deny” those findings. Deloitte subsequently rescinded Quigley’s press release and issued another that eliminated some, but not all, of the statements that had offended the SEC.11

A few weeks after the brouhaha involving Deloitte and the SEC, the PCAOB began investigating the accounting firm’s 2003 audit of Navistar. The PCAOB’s investigation of that audit was in addition to the agency’s mandated annual inspections of Deloitte. The Sarbanes–Oxley Act of 2002 requires accounting firms that audit companies with secu- rities traded on U.S. stock exchanges to register with the PCAOB. Accounting firms that audit more than 100 SEC registrants are inspected annually by the PCAOB; accounting firms that audit fewer than 100 SEC registrants are inspected every three years.

PCAOB inspections are intended to “identify and address weaknesses and defi- ciencies related to how a firm conducts audits.”12 The PCAOB identifies two types

9. S. Laub, “Deloitte Statement Irks SEC,” CFO.com, 28 April 2005. 10. S. Hughes, “SEC Rebukes Deloitte over Spin of Adelphia Audit,” The Associated Press State & Local Wire, 27 April 2005. 11. In late 2007, a Deloitte audit partner would become the first individual barred by the PCAOB from being associated with an accounting firm approved by the agency to audit SEC registrants. That indi- vidual, James Lazio, had supervised an audit of the San Diego–based Ligand Pharmaceuticals. The joint SEC–PCAOB investigation of Deloitte’s Ligand audit also resulted in Deloitte being publicly censured and fined $1 million. See Case 7.1, “Ligand Pharmaceuticals.” 12. Public Company Accounting Oversight Board, PCAOB Release No. 104-2008-070A, “Report on 2007 Inspection of Deloitte & Touche LLP,” 19 May 2008.

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190 SECTION ONE COMPREHENSIVE CASES

of such weaknesses and deficiencies: those on specific audits reviewed by PCAOB inspectors and those that involve more pervasive “matters related to the firm’s qual- ity control system.”13 Deficiencies on specific audit engagements are included in the publicly available inspection reports issued by the PCAOB for individual accounting firms, although the disclosures do not reveal the identities of the given audit clients. The more critical quality control deficiencies are excluded, at least initially, from PCAOB inspection reports released to the public. If a firm does not properly resolve or remediate quality control deficiencies observed by PCAOB inspectors within 12 months of the date that an inspection report is released, the PCAOB may subse- quently disclose those quality control matters to the public.

In May 2008, the PCAOB released its 2007 inspection report for Deloitte. In that report, the PCAOB revealed that the inspection team had visited Deloitte’s national headquarters and 18 of the firm’s approximately 70 practice offices in the United States. The inspection team identified audit deficiencies on nine of the 61 Deloitte audits that it reviewed. It was widely believed that one of those clients was Navistar given the SEC’s inadvertent disclosure that the PCAOB was investigating the 2003 Navistar audit.

As dictated by the PCAOB’s policies, the 2007 inspection report did not reference any quality control deficiencies or defects in Deloitte’s audit process. The inspection report included the following statement regarding any such items: “Any defects in, or criticisms of, the Firm’s quality control system are discussed in the nonpublic portion of this report and will remain nonpublic unless the Firm fails to address them to the Board’s satisfaction within 12 months of the date of this report.”14

Navistar Audit Partners Sanctioned by PCAOB In November 2008, the PCAOB released its first public statement regarding the ongo- ing investigation of the 2003 Navistar audit. The agency reported that it had fined Christopher Anderson, an audit partner in Deloitte’s Chicago office, $25,000 and sus- pended him from being associated with a PCAOB-registered accounting firm for one year. This was the first fine ever imposed on an individual by the PCAOB. Anderson had supervised the 2003 audit of Navistar Financial Corporation (NFC), Navistar’s finance subsidiary. NFC’s 2003 financial statements were included in Navistar’s con- solidated financial statements for that year.15

Among other charges, the PCAOB reported that Anderson had accepted a deci- sion made by a member of the Navistar audit engagement team, presumably the Navistar audit engagement partner, to increase the planning materiality threshold for NFC by 50 percent during the final few days of the 2003 Navistar and NFC audits. According to the PCAOB, Anderson “believed that the original threshold remained appropriate and understood that the increased threshold would make it easier to treat known misstatements as immaterial.”16 The “known misstatements” referred to by the PCAOB involved errors discovered in NFC’s accounting records shortly before the completion of the 2003 audit.

13. Ibid. 14. Ibid. 15. Because NFC issued debt securities that were publicly traded, it filed an annual Form 10-K with the SEC in addition to the annual Form 10-K filed by its parent, Navistar. 16. Public Company Accounting Oversight Board, PCAOB Release No. 105-2008-003, “Order Instituting Disciplinary Proceedings, Making Findings and Imposing Sanctions, In the Matter of Christopher E. Anderson, CPA, Respondent,” 31 October 2008.

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CASE 1.14 NAVISTAR INTERNATIONAL CORPORATION 191

Following the announcement of the PCAOB sanctions, a Deloitte spokesperson reported that Anderson was still with the firm “with responsibilities consistent with the settlement [with the PCAOB].”17 A PCAOB official refused to comment on why Deloitte was not sanctioned at the same time that the penalties were handed down against Anderson. “We do not comment on considerations involved in whether to charge firms or persons other than named respondents. The Board’s order only finds violations relating to Mr. Anderson.”18 When asked to comment on the same issue, a former PCAOB official provided a more elaborate response. “The firm tends to be the subject of disciplinary action when there is a failure of oversight or supervision. Where a particular partner simply makes an error but the firm was not negligent, only the party may get named in the proceeding.”19

Less than one year after sanctioning Anderson, the PCAOB issued a second enforcement release focusing on Deloitte’s 2003 Navistar and NFC audits. This sec- ond release centered on Thomas Linden, the Deloitte partner who had supervised the 1997–2003 Navistar audits. In that role, Linden effectively served as Anderson’s supervisor during the 2003 audit. Linden was fined $75,000 by the PCAOB and received a two-year suspension. Published reports indicated that at the time the PCAOB sanctioned Linden in August 2009 he was no longer associated with Deloitte.

On 1 December 2003, Linden participated in a meeting with Navistar’s audit com- mittee in which the company’s 2003 operating results were discussed. The audit com- mittee was reviewing those results in anticipation of releasing them the next day in a telephone conference call to securities analysts who tracked the company’s com- mon stock. During the 1 December meeting, Linden “informed the Audit Committee at that time that Deloitte had substantially completed its audit and expected to issue an unqualified report.”20 The following day, the preaudit operating results, which were “on the top side” of the previous earnings guidance provided by Navistar’s man- agement, were communicated to the company’s securities analysts.

Linden expected Navistar to file its 2003 Form 10-K, including Deloitte’s audit report, with the SEC on 18 December, one week before Christmas, which was the company’s standard practice. Two days prior to that date, on the evening of 16 December, Christopher Anderson told Linden of $20 million of errors in NFC’s accounts that his subordinates had uncovered, errors that had materially overstated NFC’s assets, revenues, and earnings. That figure was also material to the consoli- dated operating results of Navistar.21

17. T. Whitehouse, “PCAOB Suspends Second Deloitte Engagement Partner,” 3 November 2008, www.complianceweek.com. 18. Ibid. 19. Ibid. 20. This quote and the remaining quotes in this case, unless indicated otherwise, were taken from the following source: Public Company Accounting Oversight Board, PCAOB Release No. 105-2009-004, “Order Making Findings and Imposing Sanctions, In the Matter of Thomas J. Linden, CPA, Respondent,” 11 August 2009. 21. For fiscal 2003, Navistar reported a net loss of $18 million. However, the company reported a $77 million profit for the fourth quarter of 2003. For the previous three quarters of 2003, the company had reported a net income (loss) of ($99 million), ($14 million), and $18 million, respectively. Apparently, company management was intent on not reducing the impressive preaudit earnings for the fourth quarter in order to signal to investors that the company was in the midst of a significant turnaround. For fiscal 2002, the company had reported a net loss of $536 million. Although the $20 million in errors were material to NFC’s financial statements, the PCAOB was most concerned by how the treatment of the NFC errors impacted Navistar’s consolidated financial statements.

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192 SECTION ONE COMPREHENSIVE CASES

Executives of both Navistar and NFC were informed of the $20 million of errors. “Because NFC’s financial results were consolidated into NIC’s [Navistar’s] financial statements, correction of the overstatement created the prospect that NIC would have to revise its previously announced earnings.” According to the PCAOB, Linden was aware that Navistar’s executives had a “certain level of anxiety” concerning the errors and that they “would prefer not to revise its [Navistar’s] announced earnings.”

Over the following two days, NFC made a series of accounting adjustments to “neutralize” most of the errors discovered by the NFC audit team. For example, the company recomputed the gains that it had previously recorded on certain securitiza- tion transactions during 2003. The increased gain on those transactions, which were recorded with Linden’s knowledge, “canceled out” approximately $7.2 million of the $20 million in errors discovered by the NFC auditors.

After the “neutralizing” adjustments were made, only $4.5 million in overstate- ments due to the discovered errors remained. NFC’s accounting staff chose to defer the write-off of that amount until the first quarter of 2004. Linden was aware that NFC made the decision to postpone that write-off “without identifying a sufficient basis under GAAP to do so.”

On the morning of 17 December, Linden “initiated, and the NFC engagement part- ner [Anderson] adopted” a 50 percent increase in the “planning materiality thresh- old” for the 2003 NFC audit. Anderson had used a planning materiality threshold of 5 percent of NFC’s pretax income during each of the four years that he had super- vised the NFC audit. Linden increased that threshold to 7.5 percent of NFC’s pretax income. The increase in the materiality threshold allowed the Deloitte auditors to accept NFC’s decision not to record a year-end adjustment for the postponed $4.5 mil- lion write-off. That is, the increase in the materiality threshold made the $4.5 million error “presumptively immaterial” under Deloitte’s policies and procedures. Absent the increase in the materiality threshold, the $4.5 million error would have been “pre- sumptively material.”22

In addition to increasing NFC’s materiality threshold, Linden prepared an audit workpaper justifying that change. “[Linden] authored, with the assistance of the NFC engagement team, an NFC audit workpaper that inaccurately characterized the rea- sons for and circumstances surrounding the increase.”

More Pushback from the PCAOB In October 2011, the PCAOB surprised the public accounting profession by releas- ing “Part II” of its 2007 inspection report for Deloitte. Part II of that report included the discussion of quality control deficiencies the PCAOB had identified during its 2007 inspection of Deloitte but not included in the version of that report made avail- able to the public. This was the first instance in which the PCAOB had released information from Part II of an inspection report for a Big Four accounting firm. The decision to release that information was made because Deloitte allegedly had not properly addressed the issues raised in that section of the report in the 12 months following its release. Exhibit 2 includes statements excerpted from Part II of the 2007 inspection report.

The most pervasive cause for concern that the PCAOB raised in Part II of the 2007 inspection report revolved around Deloitte’s internal “culture.” In particular, the PCAOB questioned whether the rank-and-file employees of that firm had “embraced” the need to change how they performed audits.

22. The original planning materiality threshold was approximately $4.1 million; the revised threshold was approximately $6.1 million.

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CASE 1.14 NAVISTAR INTERNATIONAL CORPORATION 193

These deficiencies may result, in part, from a Firm culture that allows, or tolerates, audit approaches that do not consistently emphasize the need for an appropriate level of critical analysis and collection of objective evidence, and that rely largely on management representations. While it appears that the Firm has instituted positive changes to its audit practice over the years of PCAOB inspections, and that the Firm’s senior leadership has accepted the need to do so, some questions remain about whether the Firm’s audit personnel have embraced the concept that change in audit performance is necessary in order to achieve compliance with PCAOB standards.23

Before the 2007 inspection report was released in May 2008 to the public, Deloitte was given an opportunity to respond to a draft of that report. Deloitte wrote two let- ters to the PCAOB in response to the report: one letter addressing the audit deficien- cies identified by the PCAOB on specific engagements that were reviewed (Part I) and a second letter responding to the observed defects in Deloitte’s quality controls (Part II). Deloitte was aware that the letter written in response to Part II of the report

23. Public Company Accounting Oversight Board, PCAOB Release No. 104-2008-070A, “Report on 2007 Inspection of Deloitte & Touche LLP,” 19 May 2008.

1. The engagement reviews provide cause for concern that the Firm’s system of quality control may not do enough to assure that the Firm performs appropriate procedures to audit signifi cant accounting estimates, including evaluating management’s assumptions and testing the data supporting the estimates.

2. The engagement reviews provide cause for concern about the effectiveness of the Firm’s quality controls with respect to the audit procedures performed on income tax balances.

3. The engagement reviews provide cause for concern about the effectiveness of the Firm’s quality controls with respect to the use of specialists.

4. The inspection results provide cause for concern that the Firm’s system of quality control may not do enough to assure that accounting and auditing issues are evaluated with the objectivity that is contemplated in the auditing standards.

5. The Firm’s apparent failure to appropriately challenge management’s representations occurred in numerous areas, including when the Firm evaluated management’s estimates, considered the valuation of investment securities, performed alternative procedures in connection with confi rmations, and tested income tax accounts and disclosures.

6. The engagement reviews provide cause for concern that the Firm’s quality controls may not result in appropriate and effective consultations when necessary. Further, the Firm’s policy on consultations . . . appears to be defi cient in that it lacks a mechanism reasonably designed to provide that signifi cant, complex matters are raised to the appropriate level in the hierarchy in order to ensure a suffi cient level of rigor in the analysis.

7. Deloitte Touche Tohmatsu (DTT) uses its global internal inspection program to assess and monitor the quality of the audit work of its member fi rms. However, the specifi c results of the inspections of member fi rms or practice offi ces are not disseminated to the Firm’s partners. . . . Accordingly, the global inspection program does not routinely provide a U.S. engagement partner with a basis for assessing a foreign offi ce’s qualifi cations and familiarity with U.S. GAAP, PCAOB standards, and SEC reporting requirements.

Source: Public Company Accounting Oversight Board, “Report on 2007 Inspection of Deloitte & Touche LLP.”

EXHIBIT 2

EXCERPTS FROM PART II, “ISSUES RELATED TO QUALITY CONTROLS,” PCAOB’S 2007 INSPECTION REPORT FOR DELOITTE & TOUCHE

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194 SECTION ONE COMPREHENSIVE CASES

would not be made publicly available unless the PCAOB subsequently released that section to the public.

In its letter addressing Part II of the inspection report, Deloitte strenuously objected to the PCAOB’s suggestion that the firm’s culture needed to change. “We believe that such a broad statement by the Board mischaracterizes our audit approach and our practices. Further, we strongly take exception to the observation that our culture or system of quality control allows or tolerates such audit approaches. . . . We do not believe that the inspection results support such a broad statement by the Board and such statement should not be included in the final report.”24

Deloitte also objected to many of the issues identified in Exhibit 2. Deloitte’s most ardent complaints revolved around the broad-brush statements made by the PCAOB that were based on “limited instances” observed by the inspection team. Deloitte also suggested that the PCAOB was improperly “second-guessing” the judgments of highly skilled professionals. “Professional judgments of reasonable and highly competent people may differ as to the nature and extent of necessary auditing pro- cedures, conclusions reached and required documentation. We believe that reason- able judgments should not be second guessed.”25

Following the PCAOB’s release of Part II of the 2007 Deloitte inspection report, Deloitte’s CEO once again defended his firm’s audit practices. At the same time, though, he admitted that his firm was aware of the need to continually improve the quality of its professional services. “We have complete confidence in our profession- als and the quality of our audits, and agree that there were and always will be areas where we can improve.”26

Navistar Sues Deloitte In August 2011, two months prior to the PCAOB’s release of Part II of Deloitte’s 2007 inspection report, Navistar filed a $500 million lawsuit against its former audit firm.27 Among the company’s harshest allegations against Deloitte was that the auditing ser- vices were seriously flawed due to the inadequate training of its professional staff.28 In the 134-page complaint filed against Deloitte, Navistar’s attorneys also suggested that Deloitte had been much more than Navistar’s independent audit firm. In fact, the attorneys alleged that Deloitte had been so deeply involved in the company’s accounting and financial reporting function that the firm was a “de facto adjunct to Navistar’s accounting department.”

Deloitte provided Navistar with much more than audit services. Deloitte also acted as Navistar’s business consultant and accountant. For example, Navistar retained Deloitte to advise it on how to structure its business transactions to obtain account- ing treatment under Generally Accepted Accounting Principles (GAAP) . . . Deloitte advised and directed Navistar in the accounting treatments Navistar employed for numerous complex accounting issues apart from its audits of Navistar’s financial statements, functioning as a de facto adjunct to Navistar’s accounting department. . . . Deloitte even had a role in selecting Navistar’s most senior accounting personnel by directly interviewing applicants.29

24. Ibid. 25. Ibid. 26. S. Johnson, “PCAOB: Deloitte Trusted Management Too Much,” 17 October 2011, www3.cfo.com. 27. The specific civil charges filed against Deloitte in the complaint included fraud, fraudulent concealment, negligent misrepresentation, professional malpractice, breach of contract, and breach of fiduciary duty. 28. Stempel, “Navistar Sues Ex-Auditor.” 29. McKenna, “Navistar Sues Deloitte.”

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CASE 1.14 NAVISTAR INTERNATIONAL CORPORATION 195

Many parties within the profession came to the defense of Deloitte when the Navistar lawsuit was reported. One widely quoted observer of the profession pointed out that Navistar’s lawsuit against Deloitte ignored two important features of the auditor–client relationship: (1) a company’s financial statements are ultimately the responsibility of senior management; (2) a public company’s audit committee has a “responsibility to certify the independence of the auditor every year and to change or reduce the services they perform, or fire them, if their independence and objectivity becomes compromised.”30

The most visceral reaction to the lawsuit within the profession was, not surpris- ingly, from Deloitte itself. Deloitte representatives vigorously defended their firm in the business press. A Deloitte spokesperson told Accounting Today that Navistar’s lawsuit was a “cynical and baseless attempt to shift responsibility for the wrongdoing of Navistar’s own management.”31 The spokesperson added that, “Several members of Navistar’s past or present management team were sanctioned by the SEC for the very matters alleged in the complaint. This claim is without merit and we will defend ourselves vigorously.”32

E P I L O G U E In June 2008, Navistar’s common stock regained its listing on the New York Stock Exchange, sig- naling to many observers that the company had recovered from the embarrassing accounting scandal that had tarnished its reputation. Over the next several years, the company posted impressive profits, culminating in a record net income of $1.7 billion for fiscal 2011. Bad news returned in August 2012 when the SEC launched another investigation of the compa- ny’s accounting records. The announcement of that investigation caused the company’s stock price to drop sharply. Less than four weeks later, Navistar’s board of directors fired Daniel Ustian as the company’s CEO and chairman of the board. In December 2012, the company reported a massive $3 billion loss. Over the next several months, unhappy investors filed several class-action lawsuits against Navistar charging the company and its management team with issuing misleading financial reports.

As Navistar’s troubles mounted, the company quietly announced in its Form 10-Q for the first quarter of 2013 that it had settled the lawsuit

filed against Deloitte in 2011. Neither Navistar nor Deloitte publicly commented on the finan- cial aspects, if any, of that settlement.

In October 2013, the PCAOB announced that it was fining Deloitte $2 million for permitting Christopher Anderson to perform audit services during the time that he was serving his one-year suspension. According to published reports, in anticipation of his suspension, Anderson had resigned as a Deloitte partner and accepted a salaried position as a director with the firm. In that role, Anderson had interacted with, and provided advice on auditing matters to, three different Deloitte audit engagement teams.33

The PCAOB has continued to vigorously pur- sue its legislative mandate to strengthen the independent audit function for SEC registrants. The agency made mandatory audit firm rota- tion the hottest topic within the public account- ing profession when it issued a concept release in August 2011 to solicit input from the public on ways to strengthen auditor independence. One of the measures mentioned prominently by the PCAOB was limiting the tenure of public

1234

30. Ibid. 31. M. Cohn, “Navistar Sues Deloitte Over Audits,” 28 April 2011, www.accountingtoday.com. 32. Ibid. 33. S. Strahler, “Deloitte Fined $2 Million for Letting Suspended Exec Work on Audit,” www .chicagobusiness.com, 23 October 2013.

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196 SECTION ONE COMPREHENSIVE CASES

company auditors to a discrete number of years. James Doty, the chairman of the PCAOB, raised this possibility while discussing the problems posed by long-term auditor–client relationships.

The PCAOB’s efforts to address these prob- lems through inspections and enforcement are ongoing. But considering the disturbing lack of skepticism we continue to see, and because of the fundamental importance of indepen- dence to the performance of quality audit work, the Board is prepared to consider all possible methods of addressing the problem of audit quality—including whether manda- tory audit firm rotation would help address the inherent conflict created because the auditor is paid by the client.34

Although PCAOB officials never referred to Deloitte’s 98-year tenure as Navistar’s auditor or the allegedly “cozy” relationship that developed between the two organizations over that time, many parties believed that relationship was a key factor that prompted the agency’s interest in mandatory audit firm rotation.35

In March 2012, Chairman Doty was asked to testify before the U.S. House Subcommittee on Capital Markets and Government Sponsored Enterprises. The principal topic that the subcom- mittee wanted to pursue with Doty was the issue of mandatory audit firm rotation. The open- ing remarks made by U.S. Representative Scott Garrett set the tone for the hearing. “I do think it is important to remind the PCAOB that it is not a policy-making entity; Congress and this commit- tee are the policy makers. The PCAOB’s job is to regulate and oversee the accounting profession. I am very concerned about some of the recent activist proposals put forth by the PCAOB.”36

Representative Garrett and other members of the subcommittee then grilled Doty on why mandatory audit firm rotation was the major agenda item being pursued by his agency. At one point, Representative Garrett challenged Doty to provide “data” other than “anecdotal” circumstances to demonstrate that lengthy tenure between auditors and clients impairs auditors’ independence. Doty could not pro- vide such data but noted that the lack of audi- tor skepticism in such situations “recurs in our findings over the years. It is not an isolated issue.”37

Instead of mandatory audit firm rotation, members of the congressional subcommittee suggested that other strategies for strengthening auditor independence might be less costly and more fruitful to consider. One such recommen- dation was limiting the percentage of revenue that a PCAOB-registered accounting firm could receive from any one client.

In 2013, the U.S. Congress once more took up the topic of mandatory audit firm rotation. On 19 June 2013, the U.S. House Financial Services Committee voted unanimously to approve a bill that would prohibit mandatory audit firm rotation for SEC registrants. In commenting on that bill, U.S. Representative Jeb Hensarling, the chairman of the congressional committee, observed that, “It is boards of directors, manage- ment and shareholders who should ultimately make the decision about which accounting firms should audit a company’s financial statements— not the PCAOB.”38 Three weeks later, on 8 July 2013, the U.S. House of Representatives voted 321 to 62 in favor of the bill and sent it to the U.S. Senate for its consideration.

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34. F. McKenna, “Two Wildly Different Stories About Deloitte: Or Are They?” 8 June 2011, http:// retheauditors.com. 35. The record for the longest auditor–client relationship involving a Big Four accounting firm and a public company belongs to Deloitte and Procter & Gamble. That relationship began in 1890. 36. J. Hamilton, “‘Mission Creep’ Replaced ‘Increased Skepticism’ as the Word of the Day,” 30 March 2012, Accounting News Report (http://accountingnewsreport.com). 37. Ibid. 38. S. Lynch, “House Panel OKs Bill to Prohibit Mandatory Auditor Rotation,” 19 June 2013, Reuters (www.reuters.com).

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CASE 1.14 NAVISTAR INTERNATIONAL CORPORATION 197

Questions 1. Identify the advantages and disadvantages of mandatory audit firm rotation.

What, if any, auditor rotation rules are in effect in the United States?

2. What is the formal definition of a “material weakness” in internal control? How do material weaknesses in internal control differ from “significant deficiencies” in internal control? Identify the three material weaknesses in Exhibit 1 that you believe were most critical. Defend your choices. Can an organization’s internal controls be so inadequate that it is not possible for the entity to be audited? Defend your answer.

3. Is it appropriate for an audit firm “to function as a de facto adjunct” to a client’s accounting department? Why or why not? Which party or parties were primarily responsible for Deloitte being dismissed as Navistar’s independent auditor in April 2006? Defend your answer.

4. Define what is meant by the phrase “planning materiality threshold”? What factors should be considered in establishing such thresholds? Are there any conditions under which it is appropriate for auditors to change a planning materiality threshold after the given audit has begun?

5. This case includes the following quote from a former PCAOB official: “The [audit] firm tends to be the subject of disciplinary action when there is a failure of oversight or supervision. Where a particular partner simply makes an error but the firm was not negligent, only the party may get named in the proceeding.” Do you believe that Deloitte, in addition to Linden and Anderson, should have been sanctioned by the PCAOB in connection with the 2003 Navistar audit? Justify your answer.

6. What professional standards require accounting firms to develop quality controls for their audit practices? What key issues should such quality controls address? In commenting on Deloitte’s quality controls, the PCAOB referred to the “culture” of that firm. What are the key factors or conditions that influence the “culture” within an accounting firm’s audit practice?

7. Do you believe that the PCAOB overstepped its regulatory role and responsibilities by beginning a dialogue regarding the possible need for mandatory audit firm rotation? Why or why not? Do you agree with U.S. Representative Garrett that the PCAOB is not a policy-making body? Explain.

8. Deloitte maintained that it was not appropriate for PCAOB inspection teams to “second-guess” the “reasonable judgments” of skilled professionals. Do you agree? Defend your answer.

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199

CASE 1.15

Livent, Inc.

The structure of a play is always the story of how the birds came home to roost.

Arthur Miller

In 1995, Canadian native Maria Messina achieved one of the most sought-after career goals in the public accounting profession when she was promoted to partner with Deloitte & Touche, Chartered Accountants, the Canadian affiliate of the U.S.-based Deloitte & Touche LLP. In an interview she granted to an accounting trade publica- tion shortly after receiving that promotion, Ms. Messina noted that “Becoming a part- ner is exciting because you are a part of everything.” 1 Messina’s promotion earned her the respect and admiration of her family, her friends, and her colleagues and catapulted her to a much higher tax bracket and a more comfortable standard of living. But another opportunity soon arose, an opportunity that promised even more intrinsic and extrinsic rewards for Messina.

Throughout the 1990s, Livent, Inc., was the only publicly owned company whose primary line of business was live theatrical productions. Livent’s cofounder and the individual recognized as the creative genius responsible for the company’s impres- sive string of Tony Award–winning shows was Garth Drabinsky. Livent’s audit firm was Deloitte & Touche, Chartered Accountants. Maria Messina served as the engage- ment partner for the 1996 audit, after having been the audit manager on several prior audits of the company. Following the completion of the 1996 Livent audit, Drabinsky asked Messina to leave Deloitte & Touche and become Livent’s chief financial officer (CFO). After carefully weighing the challenges, opportunities, and potential drawbacks of making the job change, Messina gave up the partnership position with Deloitte & Touche that she had coveted for years in exchange for a “back office” but high-paying and high-profile position in the glitzy and glamorous world of show business.

Within a few weeks of signing on with Livent, Maria Messina was questioning the wisdom of her decision. Time budgets, out-of-town travel, inexperienced subordi- nates, and an array of other common “stressors” faced by partners of major account- ing firms had complicated Messina’s professional and personal life when she was at Deloitte. But, at Livent, the pressures she faced were much more intense, much more difficult to manage and control, even physically debilitating at times. Each passing month imposed a heavier emotional burden on Messina. By the late summer of 1998, Messina’s life was in complete disarray. A few months later, in January 1999, Messina pleaded guilty to a felony for her role in a massive financial fraud. Following that plea, the single mother of a 10-year-old daughter faced up to 5 years in prison and a $250,000 fine.

There Is No Business Like Show Business The entertainment industry had fascinated Garth Drabinsky from an early age. Unlike many of his colleagues in the industry, Drabinsky did not benefit from a network of

1. T. Frank, “Opportunity Knocks,” CA Magazine, March 1997, 27.

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200 SECTION ONE COMPREHENSIVE CASES

family members and friends in show business. Instead, Drabinsky relied on his own drive, inspiration, and indomitable work ethic to claw his way to the top of the vola- tile and fickle entertainment industry. Born in Toronto in 1947, Drabinsky was struck down by polio at age three, leaving him with a severe limp for the remainder of his life. The young Canadian refused to allow his physical limitations to prevent him from reaching his goals. In fact, Drabinsky freely admits that his physical problems and his modest upbringing—his father sold air conditioners—were key factors that motivated him to “aim for the stars.”

During his college years, Drabinsky made his first foray into show business by pub- lishing a free magazine that provided critiques of movies appearing in local theaters. After graduating from law school, where he concentrated his studies on the entertain- ment industry, Drabinsky became involved in real estate development. The young attorney hoped to accumulate a nest egg that he could use to begin producing mov- ies and live plays. A successful condominium project provided him with the funds he needed to begin dabbling in motion pictures and Broadway productions. By age 30, Drabinsky had produced three feature-length movies and one Broadway musical, none of which were particularly well received by critics or the ticket-buying public.

In 1979, Drabinsky and a close friend, Myron Gottlieb, decided to enter the show business world via the “back door.” The two young entrepreneurs persuaded a prom- inent Toronto businessman to invest nearly $1 million in a “cinema complex” proj- ect they had conceived.2 This project involved converting the basement of a large shopping mall into a multiscreen theater. The design for the “cineplex” included plush interiors for each theater, luxurious seats, and cappuccino bars in the lobby. Drabinsky intended to make a trip to the local movie theater the captivating experi- ence that it had been several decades earlier in the halcyon days of Hollywood.

Most industry insiders predicted that Drabinsky’s blueprint for his cineplex con- cept would fail, principally because the large overhead for his theaters forced his company to charge much higher ticket prices than competitors. But the critics were wrong. Toronto’s moviegoers were more than willing to pay a few extra dollars to watch a film in Drabinsky’s upscale theaters. Over the next several years, Drabinsky and Gottlieb expanded their company with the help of well-heeled investors whom they convinced to pony up large sums to finance the development of multiscreen theater complexes throughout Canada and the United States. By the mid-1980s, their company, Cineplex Odeon, controlled nearly 2,000 theaters, making it the second- largest theater chain in North America.

Several major investors in Cineplex Odeon eventually began complaining of Drabinsky’s unrestrained spending practices. The company’s rapid expansion and the increasingly sumptuous designs Drabinsky developed for new theaters required Cineplex Odeon to borrow enormous amounts from banks and other lenders. An internal investigation in 1989 uncovered irregularities in the company’s accounting records that wiped out a large profit for the year and resulted in Cineplex Odeon reporting a significant loss instead. The controversy sparked by the discovery of the accounting irregularities gave Cineplex Odeon’s major investors the leverage they needed to force Drabinsky and Gottlieb to resign. During the negotiations that led to their departure from the company, Drabinsky and Gottlieb acquired the Pantages Theatre, a large live production theater in Toronto, as well as the Canadian rights to certain Broadway plays.

Within a few weeks after severing their ties with Cineplex Odeon, Drabinsky and Gottlieb had organized Live Entertainment Corporation to produce Broadway-type

2. The key financial amounts reported in this case are expressed in Canadian dollars.

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CASE 1.15 LIVENT, INC. 201

shows in their hometown of Toronto. Drabinsky’s concept for this new company, which he coaxed several large investors and lenders to bankroll, was to bring “corporate management” to the notoriously freewheeling and undisciplined show business industry. Following a series of widely acclaimed productions, the company—renamed Livent, Inc.—went public in 1993.3 In May 1995, Livent filed an application with the Securities and Exchange Commission (SEC) to sell its stock in the United States. The SEC approved that application, and Livent’s stock began trad- ing on the NASDAQ stock exchange. Within two years, U.S. investors controlled the majority of Livent’s outstanding stock.

By early 1998, Livent owned five live production theaters in Canada and the United States, including a major Broadway theater in New York. The company’s produc- tions, among them Fosse, Kiss of the Spider Woman, Ragtime, Show Boat, and The Phantom of the Opera, had garnered a total of more than 20 Tony Awards. Show busi- ness insiders attributed Livent’s rapid rise to prominence to Garth Drabinsky. After organizing Livent, Drabinsky quickly developed a keen sense of the types of shows that would appeal to the public. Even more important, he was able to identify and recruit talented directors, actors, set designers, and the array of other skilled artisans needed to produce successful Broadway shows. The domineering Drabinsky micro- managed not only the creative realm of Livent’s operations but every other major facet of the company’s operations as well, although he relied heavily on his friend and confidant, Myron Gottlieb—who had an accounting background—to help him oversee the company’s accounting and financial reporting functions.

Despite the artistic success enjoyed by several Livent productions and the com- pany’s increasing stature in the entertainment industry, Garth Drabinsky was dogged by critics throughout the 1990s. The enigmatic Drabinsky had a well-deserved repu- tation as flamboyant and charming with Wall Street analysts, metropolitan bankers, and fellow corporate executives. But critics were prone to point out that Drabinsky also had a darker side to his personality. “He is—by his own admission—complex and difficult, cranky and litigious, breathtakingly ambitious, singled-minded and self-centered.”4 According to company insiders, Drabinsky could be “tyrannical and abusive”5 to his subordinates, berating them when they failed to live up to his per- fectionist standards or when they questioned his decisions. Maria Messina subse- quently revealed that Livent’s accountants were common targets of verbal abuse by Drabinsky and other Livent executives. “They [Livent’s accountants] were told on a very regular basis that they are paid to keep their [expletive] mouths shut and do as they are [expletive] told. They are not paid to think.”6

Critics also charged that Drabinsky failed to live up to his pledge of bringing a disci- plined style of corporate management to Broadway. In reality, Drabinsky was anything but disciplined in managing Livent’s finances. Because he demanded that the com- pany’s live productions be “motion-picture perfect,” most of Livent’s shows, particularly those that were box-office successes, incurred huge cost overruns. By 1998, Livent was

3. Drabinsky and Gottlieb’s company was not affiliated with the California-based Live Entertainment, Inc. Jose Menendez organized the latter company in 1988 but was murdered along with his wife, Kitty, in August 1989. In one of the many “trials of the century,” the Menendez’s sons, Lyle and Erik, were subsequently convicted of murdering their parents. 4. K. Noble, “The Comeback King: Garth Drabinsky Is Back, and Creating a Lot of Showbiz Buzz,” MacLean’s (online), 4 June 2001. 5. M. Potter and T. Van Alphen, “Livent Charges $7.5 Million Kickback Scam,” Toronto Star (online), 19 November 1998. 6. Profit, “Backstage at Livent,” May 1999, 29.

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202 SECTION ONE COMPREHENSIVE CASES

buckling under the huge load of debt Drabinsky had incurred to finance the com- pany’s lavish productions. In early 1998, Roy Furman, a Wall Street investment banker and close friend, persuaded Drabinsky to accept a $20 million investment from for- mer Disney executive Michael Ovitz to alleviate Livent’s financial problems. A con- dition of Ovitz’s investment was that he be granted sufficient common stock voting rights to allow him to control the company’s board of directors.

During the 1980s, Ovitz had reigned as Hollywood’s top talent agent. When he became chairman of the Creative Artists Agency, show business periodicals tagged him with the title of “Hollywood’s most powerful man.” In late 1995, Disney chief executive officer (CEO) Michael Eisner chose Ovitz to serve as his top lieutenant and gave him the title of company president. A little more than one year later, repeated personality clashes between the two Hollywood heavyweights resulted in Eisner dis- missing Ovitz. No doubt, Ovitz hoped that Livent would provide him with an oppor- tunity to refurbish his reputation in the entertainment industry, a reputation that had been tarnished during his brief and turbulent stint with Disney. Just as important, taking control of Livent would allow Ovitz to compete head-to-head with his former boss. At the time, Disney’s The Lion King was a colossal hit on Broadway.

Before agreeing to invest in Livent, the cautious Ovitz retained the Big Five account- ing firm KPMG to scrutinize the company’s accounting records. After KPMG’s “due diligence” investigation yielded a clean bill of health for Livent, Ovitz became the company’s largest stockholder in early June of 1998 and took over effective control of the company. Ovitz took a seat on the company’s board and became chairman of the board’s executive committee, while Furman assumed Drabinsky’s former titles of chairman of the board and CEO. Drabinsky was given the titles of vice chairman and chief creative director. In the latter role, Drabinsky continued to oversee the all-impor- tant creative facets of Livent’s operations. To provide a second opinion on artistic matters, Ovitz appointed the noted producer and songwriter Quincy Jones to Livent’s board.

Ovitz also demoted Myron Gottlieb to a vice president position. A former Disney executive who left that company along with Ovitz assumed Gottlieb’s former posi- tion as Livent’s president. Among other changes that Ovitz made in Livent’s corporate management structure was the hiring of former KPMG audit partner Robert Webster to serve as an executive vice president of the company. Webster, who had supervised KPMG’s due diligence investigation of Livent’s accounting records, was given a broad range of responsibilities, but his principal role was to monitor Livent’s accounting and finance functions for Ovitz’s new management team.

Webster’s Summer of Discontent Like Maria Messina, Robert Webster quickly discovered that the work environment within Livent was much less than ideal. After joining Livent in the early summer of 1998, Webster found that the accounting staff, including Messina, who remained Livent’s CFO, was reluctant to discuss accounting matters with him. Webster later tes- tified that some of the Livent accountants “told him that Mr. Drabinsky had warned them not to provide certain financial information until [Drabinsky] had reviewed and approved it.”7 Even more troubling to Webster was Drabinsky’s management style. Webster testified that, “I had never before experienced anyone with Drabinsky’s

7. M. Petersen, “The Roar of the Accountants: The Strange Last Days of a Theater Impresario’s Reign,” New York Times (online), 10 October 1998.

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CASE 1.15 LIVENT, INC. 203

abusive and profane management style.”8 He was shocked to find that Livent’s execu- tives often screamed and swore at the company’s accountants. Webster reported that after meeting with Drabinsky, Livent’s accountants were often in tears or even nause- ated. Following one such meeting, Webster recalled Messina “shaking like a leaf.”9

When Webster demanded that Livent’s accountants provide him with unrestricted access to the company’s accounting records, the former KPMG partner became the target of Drabinsky’s wrath. Drabinsky accused Webster of attempting to “tear the company” apart with his persistent inquiries and told him that he was there to “ser- vice his [Drabinsky’s] requirements.”10 Webster refused to be deterred by Drabinsky’s bullying tactics. In early August 1998, after Webster began asking questions regard- ing a suspicious transaction he had uncovered, Messina and four of her subordi- nates secretly met with him. The five accountants admitted to Webster that Livent’s accounting records had been distorted by a series of fraudulent schemes initiated and coordinated by Drabinsky and other top Livent executives.

Webster relayed the disturbing revelations to Livent’s board. On 11 August 1998, Roy Furman issued a press release announcing that “significant financial irregular- ities” adversely affecting Livent’s financial statements for the past three years had been discovered. The press release also indicated that Drabinsky and Gottlieb had been indefinitely suspended pending the outcome of a forensic investigation by KPMG. During the fall of 1998, company officials issued successive press releases suggesting that the impact of the accounting irregularities would be more severe than initially thought. Adding to Livent’s problems was the suspension of all trading in the company’s stock and a series of large class-action lawsuits filed against the company and its officers. In August 1998 alone, 12 such lawsuits were filed.

On 18 November 1998, Livent’s board announced that KPMG’s forensic investiga- tion had revealed “massive, systematic, accounting irregularities that permeated the company.”11 The press release issued by Livent’s board also disclosed that Deloitte & Touche had withdrawn its audit opinions on the company’s 1995–1997 financial statements. Finally, the press release reported that Drabinsky and Gottlieb had been dismissed and that Livent had simultaneously filed for bankruptcy in Canada and the United States. A few weeks later, a federal grand jury in New York issued a 16-count fraud indictment against Drabinsky and Gottlieb. When the former Livent executives failed to appear for a preliminary court hearing, a U.S. federal judge issued arrest warrants for the two Canadian citizens and initiated extradition proceedings.

A “Pervasive and Multifaceted” Fraud Details of the fraud allegedly conceived by Garth Drabinsky and Myron Gottlieb were eventually revealed to the public by the SEC, the Ontario Securities Commission—a Canadian agency comparable to the SEC, and publicly available records of various court proceedings in civil lawsuits. In numerous enforcement and litigation releases, SEC officials repeatedly used the descriptive phrase “pervasive and multifaceted” when referring to the Livent fraud. One of the earliest elements of the fraud was a large kickback scheme.

8. A. Clark, “An Epic from Livent: Executive Accuses Drabinsky of Bullying Tactics,” MacLean’s (online), 1 March 1999. 9. Ibid.

10. Ibid. 11. In re Livent, Inc. Noteholders Securities Litigation, 151 F. Supp. 2d 371 (2001).

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204 SECTION ONE COMPREHENSIVE CASES

“As early as 1990, and continuing through 1994, Drabinsky and Gottlieb operated a kickback scheme with two Livent vendors designed to siphon millions of dollars from the company directly into their own pockets.”12 Gottlieb reportedly instructed the two vendors to include in the invoices that they submitted to Livent charges for services that they had not provided to the company. After Livent paid the inflated invoice amounts, Drabinsky and Gottlieb received kickbacks equal to the payments for the bogus services. According to the SEC, over a four-year period in the 1990s, Drabinsky and Gottlieb received approximately $7 million in kickbacks from the two Livent vendors. The fake charges billed to Livent by the vendors were capitalized in “preproduction” cost accounts for the various shows being developed by the com- pany. Legitimate costs charged to those accounts included expenditures to produce sets and costumes for new shows, costs that were amortized over a maximum period of five years.

By the mid-1990s, the kickback scheme and large losses being registered by sev- eral of Livent’s plays made it increasingly difficult for the company to achieve quar- terly earnings targets that Drabinsky and Gottlieb had relayed to Wall Street analysts. The two conspirators realized that if Livent failed to reach those earnings targets, the company’s credit rating and stock price would fall, jeopardizing the company’s abil- ity to raise the additional capital needed to sustain its operations. Faced with these circumstances, the SEC reported that beginning in 1994 Drabinsky and Gottlieb directed Livent’s accounting staff to engage in an array of “accounting manipula- tions” to obscure the company’s financial problems.

These manipulations included such blatant subterfuges as simply erasing from the accounting records previously recorded expenses and liabilities at the end of each quarter. A particularly popular accounting scam within Livent involved the transfer of preproduction costs from a show that was running to a show still in production. Such transfers allowed the company to defer, sometimes indefinitely, the amortiza- tion of those major cost items. To further reduce the periodic amortization charges for preproduction costs, Livent’s accountants began charging such costs to various fixed asset accounts. These assets were typically depreciated over 40 years, com- pared with the five-year amortization period for preproduction costs. Eventually, the company’s accountants began debiting salary expenses and other common operat- ing expenses to long-term fixed asset accounts.

The SEC estimated that the accounting manipulations understated Livent’s expenses by more than $30 million in the mid-1990s. Despite the resulting favorable impact on Livent’s financial statements, Drabinsky and Gottlieb eventually realized that additional efforts were needed to embellish the company’s financial data. So, beginning in 1996, Drabinsky and Gottlieb organized and carried out what the SEC referred to as a “fraudulent revenue-generating” scheme.

This new scam involved several multimillion-dollar transactions arranged by Drabinsky and Gottlieb. The specific details of these transactions varied somewhat, but most of them involved the sale of production rights owned by Livent to third par- ties. For example, Livent sold the rights to produce Ragtime and Show Boat in various U.S. theaters to a Texas-based company. The contract for this transaction indicated that the $11.2 million fee paid to Livent by the Texas company was not refundable under any circumstances. However, a secret side agreement arranged by Livent’s executives shielded the Texas company from any loss on this deal and, in fact, guar- anteed it a reasonable rate of return on its large investment. Despite the considerable

12. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 1095, 19 May 1999.

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CASE 1.15 LIVENT, INC. 205

uncertainty regarding the actual profit, if any, that would ultimately be earned on this and similar transactions, Livent’s accounting staff included at least $34 million of revenues on those transactions in the company’s 1996 and 1997 income statements.

A final Livent scam documented by the SEC involved inflating reported box-office results for key productions. In late 1997, Livent opened Ragtime in a Los Angeles the- ater. The agreement with that theater allowed it to close the show if weekly ticket sales fell below $500,000. Livent’s executives planned to open Ragtime on Broadway in January 1998. Those executives realized that if the show fared poorly in Los Angeles, its Broadway opening could be jeopardized. To inflate Ragtime’s ticket sales during its Los Angeles run, Livent executives arranged to have two of the company’s vendors—the same individuals involved in the fraudulent kickback scheme alluded to previously—purchase several hundred thousand dollars of tickets to the show. Livent reimbursed the vendors for these ticket purchases and charged the payments to various fixed asset accounts.

The fraudulent schemes engineered by Livent’s executives caused the company’s periodic financial statements to be grossly misrepresented. For example, in 1992, the company reported a pretax profit of $2.9 million when the actual figure was approxi- mately $100,000. Four years later, Livent reported a pretax profit of $14.2 million, when it actually incurred a loss of more than $20 million. By 1997, the company’s total fixed assets of $200.8 million were overstated by nearly $24 million due to the various accounting schemes.

SEC officials found two features of the Livent fraud particularly disturbing. As the scope of the fraud steadily grew throughout the 1990s, the company’s accounting staff found it increasingly difficult to provide meaningful financial data to top man- agement. “Because of the sheer magnitude and dollar amount of the manipulations, it became necessary for senior management to be able to track both the real and the phony numbers.”13 Gordon Eckstein, the company’s senior vice president of finance and administration and Maria Messina’s immediate superior, allegedly instructed a subordinate to develop computer software that would solve this problem. This soft- ware could be used to filter the bogus data out of the company’s accounting records. The secret software also served a second purpose, namely, allowing Livent’s accoun- tants to record fraudulent transactions “without leaving a paper trail that Livent’s out- side auditors might stumble across.”14 The accountants processed in a batch mode the fraudulent changes in the accounting records demanded by Livent’s executives. When these so-called “adjustments” were processed, they replaced the initial journal entries for the given transactions, making the adjustments appear as if they were the original transactions, thus duping the company’s Deloitte auditors.

The second extremely troubling feature of the Livent fraud, according to the SEC, was the matter-of-fact manner in which the company’s management team organized and carried out the fraud. Reportedly, Drabinsky, Gottlieb, and Robert Topol, Livent’s chief operating officer (COO), regularly met with Eckstein, Messina, and other mem- bers of the company’s accounting staff to discuss the details of the fraud. At these meetings, the three top executives reviewed preliminary financial reports prepared by the accounting staff and instructed the accountants on the “adjustments” needed to improve or embellish those reports. As suggested earlier, Livent’s top execu- tives relied on coercion and intimidation to browbeat their accountants, including Messina, into accepting these illicit changes. Once the adjustments were processed,

13. Ibid. 14. M. A. Hiltzik and J. Bates, “U.S. Indicts Stage Producer Drabinsky,” Los Angeles Times (online), 14 January 1999.

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206 SECTION ONE COMPREHENSIVE CASES

“the bogus numbers were presented to Livent’s audit committee, the auditors, inves- tors, and eventually filed with the Commission [SEC].”15

Keeping the Auditors in the Dark Press reports of a large accounting fraud involving a public company often prompt scathing criticism of the company’s independent audit firm. The disclosure of the Livent fraud in the late summer and fall of 1998 caused Deloitte & Touche to become a target of such criticism. A Canadian financial analyst observed that investors depend on auditors to clamp down on their clients and force them to prepare reli- able financial reports. “They [auditors] are the only ones in a position to question the policies, to question the numbers, to make sure they’re right.”16

Critics could readily point to several red flags or fraud risk factors during Deloitte’s tenure with Livent that should have placed the accounting firm on high alert regard- ing the possible existence of financial statement misrepresentations. Among those factors were an extremely aggressive, growth-oriented management team; a history of prior financial reporting indiscretions by Drabinsky and Gottlieb; a constant and growing need for additional capital; and the existence of related-party transactions. Regarding the latter factor, several of Livent’s fraudulent “revenue-generating transac- tions” that were documented by the SEC involved companies or corporate executives affiliated with Livent or its management team.

In Deloitte’s defense, a massive collusive fraud that involves a client’s top execu- tives and the active participation of its accountants is difficult to detect. Making mat- ters worse for Deloitte was the contemptuous attitude that Livent’s executives had toward independent auditors. At one point, a top Livent officer told a subordinate that independent auditors were a “necessary evil and that it was no one’s business how they [Livent’s executives] ran their company.”17 Also complicating the Livent audits for Deloitte was the fact Maria Messina and Christopher Craib, two former members of the Livent audit engagement team, had accepted key accounting positions with the company. The personal relationships the auditors had with Messina and Craib may have impaired their objectivity during the Livent engagements.

Christopher Craib replaced Maria Messina as the audit manager assigned to the Livent audit engagement team following Messina’s promotion to partner in 1995. After the 1996 audit was completed, Drabinsky hired Craib to serve as Livent’s senior controller for budgeting. Not long after joining Livent, Craib, a chartered accoun- tant, became involved in the ongoing effort to segregate Livent’s “real” account- ing data from its bogus data. In subsequent testimony, Craib recalled meeting with Gordon Eckstein to discuss Livent’s schizoid accounting system. Eckstein explained to Craib why it was imperative to track both the real and bogus accounting data: “I have to keep all the lies straight. I have to know what lies I’m telling these people [outside auditors]. I’ve told so many lies to different people I have to make sure they all make sense.”18

Like Craib, Maria Messina realized that concealing the Livent fraud from the Deloitte auditors was among her primary responsibilities. During a meeting shortly after Messina joined Livent, she became aware of the adversarial attitude that Livent’s top executives had toward the company’s independent auditors. During this meeting,

15. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 1095. 16. J. McCarten, “Auditors Taking the Heat after Financial Scandals,” Toronto Star (online), 18 August 1998. 17. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 1096, 19 May 1999. 18. Ibid.

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CASE 1.15 LIVENT, INC. 207

Topol became angry when Messina raised an issue involving what documents to turn over to Deloitte. Topol responded with an angry outburst. “[Expletive] you and your auditors…. I don’t care what they see or don’t see.”19

Despite the efforts of Livent officials to sabotage their independent audits, the com- pany’s Deloitte auditors focused considerable attention on several suspicious trans- actions that they uncovered. The Deloitte auditors became increasingly skeptical of Livent’s accounting records in 1996 and 1997 when Drabinsky and his colleagues were scrambling to conceal the deteriorating financial condition of their company while, at the same time, attempting to raise much needed debt and equity capital.

Near the end of the 1996 audit, Deloitte & Touche LLP, the U.S.-based branch of the firm, initially refused to allow its Canadian affiliate to issue an unqualified audit opinion on Livent’s financial statements that were to be filed with the SEC. Deloitte’s top technical partners in the United States believed that Livent had been much too aggressive in recognizing revenue on a few large transactions—transactions that, unknown to partners of both the firm’s Canadian and U.S. affiliates, included fraudu- lent elements. After a series of meetings between Livent officials and representatives of Deloitte & Touche LLP, a compromise was reached. Livent agreed to defer the recognition of revenue on one of the two large transactions in question until 1997. In return, Deloitte allowed the company to record the full amount of the revenue for the other disputed transaction.

During 1997, a major transaction with a real estate firm triggered another conflict between Deloitte and Livent management. In the second quarter of that year, the real estate firm purchased for $7.4 million the development rights to a valuable parcel of land owned by Livent. The contract between the two companies included a stipula- tion or “put agreement” allowing the real estate firm to cancel the transaction prior to the date that it began developing the property. When the Deloitte audit engage- ment partner learned of the put agreement, he insisted that no revenue could be recorded for the transaction. Complicating matters was the fact that the transaction involved a related party since Myron Gottlieb served on the board of directors of the real estate firm’s parent company.

To quell the audit partner’s concern, Gottlieb arranged to have an executive of the real estate firm send the partner a letter indicating that the put agreement had been cancelled—which it had not. After receiving the letter, the Deloitte partner told Gottlieb that the revenue resulting from the transaction could be recorded during Livent’s third quarter when the put agreement had allegedly been cancelled. At this point, a frustrated Gottlieb ignored the partner’s decision and included the disputed revenue in Livent’s earnings press release for the second quarter of 1997.

When Deloitte officials learned of the press release, they demanded a meeting with Livent’s board of directors. At this meeting, Deloitte threatened to resign. After considerable discussion, Livent’s board and the Deloitte representatives reached a compromise. According to a subsequent legal transcript, the board agreed to reverse the journal entry for the $7.4 million transaction in the second quarter, recording it instead during the third quarter. The board also agreed to issue an amended earn- ings release for the second quarter. In exchange for these concessions, Deloitte offi- cials purportedly agreed to allow Livent to reverse certain accrued liabilities that had been recorded at the end of the second quarter. The reversal of those accrued liabili- ties and the corresponding expenses reduced by approximately 20 percent the profit

19. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 1097, 19 May 1999.

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208 SECTION ONE COMPREHENSIVE CASES

“correction” reported by Livent in the amended earnings press release for the second quarter.20

Another serious disagreement arose between Livent executives and Deloitte audi- tors shortly after the dispute just described was resolved. During the third quarter of 1997, Livent’s management arranged to sell for $12.5 million the naming rights for one of its existing theaters and a new theater that the company was planning to build. Neither Maria Messina nor the Deloitte auditors assigned to the Livent engage- ment believed that the $12.5 million payment should be recorded immediately as revenue since the contract between Livent and the other party, AT&T, was strictly an oral agreement at the time and since one of the theaters was yet to be built. Gottlieb retained Ernst & Young (E&Y) to review the matter.

The report E&Y submitted to Gottlieb did not take a firm position on the revenue recognition issue. Instead, E&Y’s report simply suggested that the $12.5 million pay- ment for the naming rights could be “considered” for recording during the third quar- ter. After receiving a copy of E&Y’s report, Deloitte hired Price Waterhouse to review the transaction. When Price Waterhouse reached the same conclusion as E&Y, Deloitte allowed Livent to book the $12.5 million as revenue during the third quarter.

Don’t Blame Me, Blame… Resolving the legal implications of a major accounting and financial reporting fraud can require years. However, one Canadian journalist suggested that in the Livent case the legal wrangling could continue even longer, possibly for decades.21 From its inception, a key factor complicating the resolution of this case was its “cross-border” nature.

Beginning in late 1998, officials from several federal agencies in Canada and the United States became embroiled in a tedious and often contentious struggle to determine which agency would be the first to prosecute the key parties involved in the Livent fraud. Those agencies included the Royal Canadian Mounted Police, the Ontario Securities Commission, the SEC, and the U.S. Department of Justice, among others. Law enforcement authorities in the United States failed to win the cooperation of their Canadian counterparts in attempting to extradite Garth Drabinsky and Myron Gottlieb to face a series of federal fraud charges filed against them in U.S. courts. Even more frustrating to U.S. authorities was the snail’s pace at which Canadian authorities moved in pursuing legal action against the two alleged fraudsters.

While Canadian and U.S. law enforcement authorities tangled over jurisdictional matters, the leading actors in the final Livent “production” waged a public rela- tions war against each other in major metropolitan newspapers and in the courts. Drabinsky and Gottlieb were the most vocal of these individuals. They repeatedly insisted that they were not responsible for the various fraudulent schemes that had been uncovered within Livent. At a press conference held in early 1999, Drabinsky suggested that he had been too busy overseeing Livent’s creative operations to become involved in any creative bookkeeping.22 In his typical Shakespearean manner, Drabinsky declared: “The final act of this tragedy has yet to be played out

20. In re Livent, Inc. Noteholders Securities Litigation. As a point of information, this legal transcript did not include any commentary from Deloitte’s perspective regarding the nature and outcome of these negotiations. 21. Noble, “The Comeback King.” 22. M. Lewyckyj, “Livent’s Accounting Designed to Deceive,” Toronto Sun (online), 15 January 1999.

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CASE 1.15 LIVENT, INC. 209

and, when it is, Myron Gottlieb and I have complete confidence that we will be vindicated.”23

In January 1999, Myron Gottlieb filed a civil lawsuit against Maria Messina, Christopher Craib, Gordon Eckstein, and three other former Livent accountants; the lawsuit charged those six individuals with responsibility for the Livent accounting fraud. In court documents filed with this lawsuit, Gottlieb alleged that he was not “an expert on accounting practices” and that he had relied on Livent’s accounting staff to ensure that the company’s financial statements were accurate.24 In responding to that lawsuit, the six named defendants, with the exception of Eckstein, claimed that they had been coerced into participating in the fraud by its principal architects.25 These defendants also rejected Gottlieb’s assertion that he was unfamiliar with accounting practices. “Gottlieb was and remains an experienced businessman with a sophis- ticated and comprehensive grasp of accounting and auditing issues and intimate knowledge of the details of Livent’s accounting practices.”26

When Eckstein eventually responded to Gottlieb’s lawsuit, he charged the Livent cofounder with being a key architect of the accounting fraud.27 Eckstein also insisted that Maria Messina had played a key role in the fraudulent scheme. In particular, Eckstein claimed that Messina had used her relationship with the Deloitte auditors to ensure that they approved Livent’s fraudulent financial statements.28

Messina answered Eckstein and other critics by maintaining that she had attempted to dissuade Livent’s executives from using accounting gimmicks to boost the compa- ny’s revenues and profits. She insisted that she had “begged” her former colleagues at Deloitte to crack down on the aggressive revenue recognition policies being used by Livent’s management.29 To support her claim that she had not been a willing mem- ber of the Livent conspiracy, Messina pointed out that she had refused to sign the letters of representations for the 1996 and 1997 audits, each of which indicated that there were no material inaccuracies in Livent’s financial statements. In fact, near the end of the 1997 audit, Messina had redrafted Deloitte’s preformatted letter of repre- sentations to remove her name from it.30

After firing Drabinsky and Gottlieb, Michael Ovitz and the members of the new management team he installed at Livent in June 1998 sued the company’s cofound- ers for $325 million for their alleged role in the fraudulent accounting schemes. That lawsuit prompted Drabinsky and Gottlieb to file a $200 million defamation-of-charac- ter lawsuit against Ovitz and his colleagues.

In September 1998, Drabinsky sued KPMG, the accounting firm that Ovitz had retained to perform a due diligence investigation earlier in the year and the firm retained by Livent’s board of directors in August 1998 to investigate the charges of

23. C. Brodesser and M. Peers, “U.S. Indicts Duo in Liventgate,” Variety, 18 January 1999, 137. 24. The Gazette (online), “Livent Co-Founder Sues 6 Employees,” 19 February 1999. 25. V. Menon, “Livent Whistle-Blowers File Defence,” Toronto Star (online), 1 April 1999. 26. B. Bouw, “Livent Employees Fight Back: ‘Gottlieb to Blame,’” National Post (online), 1 April 1999. 27. B. Shecter, “Drabinsky’s Assertions Refuted,” National Post (online), 26 June 1999. 28. Ibid. 29. Profit, “Backstage at Livent.” In a deposition filed in one of the many lawsuits triggered by the Livent fraud, Messina described Deloitte’s audits of the company as “inadequate.” See D. Francis, “Livent: A Bean Counter Scandal,” National Post (online), 10 May 2001. 30. In a court document, Messina reported that she did not reveal the various Livent fraudulent schemes prior to August 1998 because she feared Drabinsky and Gottlieb and because she believed that she would be “implicated by association.” See B. Bouw, “Livent Employees Fight Back: ‘Gottlieb to Blame,’” National Post (online), 1 April 1999.

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210 SECTION ONE COMPREHENSIVE CASES

accounting irregularities revealed by Maria Messina and her subordinates. That law- suit, which requested damages of more than $26 million, was predicated on the fact that Drabinsky had been a client of KPMG over the past two decades. Drabinsky charged that by agreeing to perform the forensic audit requested by Livent’s board in August 1998, KPMG had placed itself in a conflict of interest between two clients.31

Deloitte & Touche was a primary target of the various plaintiffs attempting to hold someone responsible for the Livent debacle and the resulting financial losses. In December 1999, a U.S. federal judge dismissed Deloitte as a defendant in one of those lawsuits filed by Livent’s former stockholders. The judge concluded that the plaintiffs had not made a reasonable argument that Deloitte was at least “reckless” in auditing Livent. For lawsuits filed under the Securities and Exchange Act of 1934, as amended by the Private Securities Litigation Reform Act (PSLRA) of 1995, plaintiffs must allege or “plead” that the given defendant was at least “reckless.”

In another class-action lawsuit filed by Livent creditors, a federal judge ruled in June 2001 that the plaintiffs had met the pleading standard of recklessness, mean- ing that the lawsuit could proceed. This judge observed that Livent’s “accounting manipulations” were so flagrant that there was a reasonable likelihood Deloitte was reckless in failing to discover them. “Deloitte & Touche’s actions and omissions in connection with Livent’s manipulations of its books and records display acqui- escence and passivity that, in this Court’s reading of the pleadings, cross over the boundary of ordinary breaches of reasonable care into the zone of recklessness.”32 Published reports indicate that Deloitte & Touche was dropped as a defendant in this case after it agreed to pay $5.5 million to a restitution fund established for Livent’s former creditors.

E P I L O G U E As predicted, Canadian law enforcement authorities were extremely methodical in pursuing their investigation and prosecution of Garth Drabinsky, Myron Gottlieb, and the other key individuals involved in the Livent scandal. In late 2002, the Royal Mounted Canadian Police finally filed a fraud indict- ment against Drabinsky and Gottlieb that contained 19 individual charges. Five years later, Gordon Eckstein pleaded guilty to one count of fraud and agreed to testify against Drabinsky and Gottlieb. Eckstein’s testimony and the testimony of Maria Messina would prove to be pivotal evidence in the 11-month

long criminal trial of Drabinsky and Gottlieb. That trial ended in late March 2009 with both Drabinsky and Gottlieb being convicted of fraud and forgery.

The Canadian judge who presided over the lengthy trial rejected Drabinsky and Gottlieb’s principal argument that they had been unaware of the massive accounting fraud and that it had been orchestrated by their subordinates. In handing down her verdict, the judge con- cluded that the two executives “had initiated the improper accounting system” that had “systemically manipulated” Livent’s reported operating results and financial condition.33,34

1234

31. Drabinsky and KPMG ultimately settled this lawsuit out of court. Although the settlement’s financial terms were not disclosed, KPMG acknowledged that it had breached its “fiduciary duty” to Drabinsky by agreeing to perform the forensic audit requested by Livent’s board. 32. In re Livent, Inc. Noteholders Securities Litigation. 33. Reuters (online), “Former Broadway Impresario Drabinsky Found Guilty,” 25 March 2009. 34. Robert Topol, Livent’s former COO, had faced charges similar to those for which Drabinsky and Gottlieb were prosecuted. However, those charges were dismissed in 2008 when his attorneys con- vinced the judge that he had been denied his right to a speedy trial.

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CASE 1.15 LIVENT, INC. 211

In August 2009, the judge sentenced Drabinsky and Gottlieb to prison sentences of seven years and six years, respectively.

Drabinsky and Gottlieb lost the appeals of their convictions, but the appellate court reduced their prison sentences to five years and four years, respectively. The two men began serving their sentences in 2011. After serving approximately one-third of his sen- tence, Gottlieb was paroled in early 2013. After serving 17 months of his sentence, Drabinsky received a “day parole” in February 2013, meaning that he would be free to leave the half- way house where he was serving his sentence during daytime hours but would be required to return to that facility each night. Drabinsky was expected to receive a full parole in early 2014. The double jeopardy provisions in Canada’s criminal statutes prevented the two men from being extradited to the United States where they would be subject to prosecution for the same crimes for which they had been con- victed in Canada.

In July 1999, SFX Entertainment purchased the remaining assets of Livent, ending the company’s dramatic and turbulent existence after only 10 years. In June 2000, the disciplin- ary committee of the Institute of Chartered Accountants of Ontario (ICAO) sanctioned the former Livent accountants who had publicly admitted some degree of involvement in the Livent fraud. Maria Messina, who pleaded guilty to three charges of professional misconduct, was fined $7,500 and suspended from practic- ing as a chartered accountant for two years. Christopher Craib received a six-month suspen- sion and a $1,000 fine.

In 2007, the ICAO found three of the Deloitte auditors who had been assigned to the 1997 Livent audit engagement team guilty of profes- sional misconduct, publicly reprimanded them, and levied fines against them and Deloitte totaling $1.55 million. In early 2010, a Canadian appellate court overturned those sanctions. The court ruled that the ICAO had failed to prove that the Deloitte auditors were guilty of a “sig- nificant departure” from professional standards during the 1997 Livent audit.

The SEC sanctioned Craib and three other Livent accountants who had confessed to some role in the Livent accounting fraud. Craib received a three-year suspension from practicing before the SEC. During the criminal trial of Drabinsky and Gottlieb, their defense attorneys revealed that Maria Messina was being paid $325,000 annually by Livent’s bankruptcy receiver to testify in the various Livent-related lawsuits. Those attorneys also reported that law enforcement authorities in the United States had privately agreed to drop all charges against Messina if Drabinsky and Gottlieb were ultimately sent to prison. Subsequent to the imprisonment of Drabinsky and Gottlieb, neither the SEC nor the U.S. Justice Department has publicly commented on Messina’s status. In 1999, after pleading guilty to violating U.S. federal securities laws, Messina’s sentencing had been delayed pending the resolution of the criminal charges filed against Drabinsky and Gottlieb.

The criminal convictions and subsequent imprisonment of Drabinsky and Gottlieb did not end the long-running Livent legal ordeal. As of late 2013, a $450 million civil lawsuit against Deloitte stemming from the firm’s Livent audits was still in process in a Toronto court.

Questions 1. Identify common inherent risk factors that companies involved in the

entertainment industry pose for their independent auditors. List and briefly describe specific audit procedures that would not be used on “typical” audit engagements but would be required for audits of companies involved in live theatrical productions, such as Livent.

2. Compare and contrast the responsibilities of an audit partner of a major accounting firm with those of a large public company’s CFO. Which work role do you believe is more important? Which is more stressful? Which role would you prefer and why?

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212 SECTION ONE COMPREHENSIVE CASES

3. Explain why some corporate executives may perceive that their independent auditors are a “necessary evil.” How can auditors combat or change that attitude?

4. When auditor–client disputes arise during an audit engagement, another accounting firm is sometimes retained by the client and/or the existing auditor to provide an objective report on the issue at the center of the dispute—as happened during Deloitte’s 1997 audit of Livent. Discuss an accounting firm’s responsibilities when it is retained to issue such a report.

5. Do you believe Deloitte & Touche should have approved Livent’s decision to record the $12.5 million “naming rights” payment as revenue during the third quarter of 1997? Defend your answer. What broad accounting concepts should be considered in determining the proper accounting treatment for such transactions?

6. Maria Messina testified that when she learned of the accounting irregularities at Livent shortly after becoming the company’s CFO she felt “guilty by association,” which prevented her from revealing the fraud to regulatory or law enforcement authorities. Explain what you believe she meant by that statement. Place yourself in Messina’s position. What would you have done after discovering the fraudulent schemes affecting Livent’s accounting records?

7. What professional standards apply to “due diligence” investigations performed by accounting firms?

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2 SECTION 2

AUDITS OF HIGH-RISK ACCOUNTS

Case 2.1 Jack Greenberg, Inc.

Case 2.2 Golden Bear Golf, Inc.

Case 2.3 Take-Two Interactive Software, Inc.

Case 2.4 General Motors Company

Case 2.5 Lipper Holdings, LLC

Case 2.6 CBI Holding Company, Inc.

Case 2.7 Geo Securities, Inc.

Case 2.8 Belot Enterprises

Case 2.9 Powder River Petroleum International, Inc.

Case 2.10 LocatePlus Holdings Corporation

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215

CASE 2.1

Jack Greenberg, Inc.

Auditors commonly find themselves facing situations in which they must persuade cli- ent executives to do something they absolutely and resolutely do not want to do. When all else fails, auditors may be forced to use a tactic that clinical psychologists, mar- riage counselors, parents of toddlers, and other interpersonal experts typically frown upon; namely, the old-fashioned “if you don’t cooperate, I will punish you” threat. In the mid-1990s, an exasperated team of Grant Thornton auditors resorted to threaten- ing a stubborn client executive to goad him into turning over key documents that had significant audit implications. The executive eventually capitulated and turned over the documents—which resulted in even more problems for the auditors.

The Brothers Greenberg For decades, Jack Greenberg oversaw a successful wholesale meat company, a com- pany that he eventually incorporated and named after himself.1 Jack Greenberg, Inc., marketed a variety of meat, cheese, and other food products along the Eastern Seaboard of the United States from its Philadelphia headquarters. Jack Greenberg’s failing health in the early 1980s prompted him to place his two sons in charge of the company’s day-to- day operations. After their father’s death, the two brothers, Emanuel and Fred, became equal partners in the business. Emanuel assumed the title of company president, while Fred became the company’s vice president. The two brothers and their mother made up the company’s three-person board of directors. Several other members of the Greenberg family also worked in the business.

Similar to many family-owned and -operated businesses, Jack Greenberg, Inc. (JGI), did not place a heavy emphasis on internal control. Like their father, the two Greenberg brothers relied primarily upon their own intuition and the competence and integrity of their key subordinates to manage and control their company’s opera- tions. By the mid-1980s, when the privately owned business had annual sales mea- sured in the tens of millions of dollars, Emanuel realized that JGI needed to develop a more formal accounting and control system. That realization convinced him to begin searching for a new company controller who had the expertise necessary to revamp JGI’s outdated accounting function and to develop an appropriate network of internal controls for the growing company. In 1987, Emanuel hired Steve Cohn, a CPA and former auditor with Coopers & Lybrand, as JGI’s controller. Cohn, who had extensive experience working with a variety of different inventory systems, immedi- ately tackled the challenging assignment of creating a modern accounting and con- trol system for JGI.

Among other changes, Cohn implemented new policies and procedures that pro- vided for segregation of key responsibilities within JGI’s transaction cycles. Cohn also integrated computer processing throughout most of JGI’s operations, including the payroll, receivables, and payables modules of the company’s accounting func- tion. One of the more important changes that Cohn implemented was developing an internal reporting system that produced monthly financial statements the Greenbergs

1. The facts of this case and the quotations included in it were taken from the following court opinion: Larry Waslow, Trustee for Jack Greenberg, Inc., v. Grant Thornton LLP; United States Bankruptcy Court for the Eastern District of Pennsylvania, 240 B.R. 486; 1999 Bankr. LEXIS 1308.

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216 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

could use to make more timely and informed decisions for their business. Cohn’s new financial reporting system also allowed JGI to file more timely financial statements with the three banks that provided the bulk of the company’s external financing. By the early 1990s, JGI typically had a minimum of $10 million in outstanding loans from those banks.

One area of JGI’s operations that Cohn failed to modernize was the company’s accounting and control procedures for prepaid inventory. Since the company’s early days, imported meat products had accounted for a significant portion of JGI’s annual sales. Because foreign suppliers required JGI to prepay for frozen meat items, the company maintained two inventory accounts: Prepaid Inventory and Merchandise Inventory. Prepayments for imported meat products were debited to the Prepaid Inventory account, while all other merchandise acquired by the company for resale was debited to the Merchandise Inventory account. Prepaid inventory typically accounted for 60 percent of JGI’s total inventory and 40 percent of the company’s total assets.

Long before Cohn became JGI’s controller, Jack Greenberg had given his son Fred complete responsibility for the purchasing, accounting, control, and other decisions affecting the company’s prepaid inventory. Following their father’s death, the two brothers agreed that Fred would continue overseeing JGI’s prepaid inventory. When Cohn attempted to restructure and computerize the accounting and control proce- dures for prepaid inventory, Fred refused to cooperate. Despite frequent and ada- mant pleas from Cohn over a period of several years, Emanuel refused to order his younger brother to cooperate with Cohn’s modernization plan for JGI’s accounting system.

Accounting for Prepaid Inventory Fred Greenberg processed the purchase orders for meat products that JGI bought from foreign vendors. The items purchased were inspected by the appropriate authority in the given country and then loaded into refrigerated lockers to be trans- ported by boat to the United States. When a vendor provided documentation to JGI that a shipment was in transit, Fred Greenberg approved payment of the vendor’s invoice. Again, these payments were debited to JGI’s Prepaid Inventory account. Fred Greenberg maintained a handwritten accounting record known as the prepaid inventory log to keep track of the items included in the Prepaid Inventory account at any point in time.

When a shipment of imported meat products arrived at a U.S. port, a customs bro- ker retained by JGI arranged for the individual items to be inspected and approved for entry into the United States by customs officials. After a shipment had cleared customs, the customs broker sent a notification form to that effect to Fred Greenberg. When the product arrived by truck at JGI’s warehouse, a U.S. Department of Agriculture (USDA) official opened and inspected the items included in the order. The USDA official completed a document known as Form 9540-1 to indicate that the items had passed inspection. Each Form 9540-1 also indicated the date that the given products had arrived at JGI’s warehouse.

Upon completion of the USDA inspection process, the prepaid inventory items were turned over to the manager of JGI’s warehouse. The warehouse manager stamped the items to indicate that they had passed the USDA inspection and then completed a document known as a delivery receipt that listed the date of arrival, the vendor, the type of product, and the quantity of the product. The warehouse man- ager sent the delivery receipt form to Fred Greenberg, who matched the form with the appropriate vendor invoice. Fred then deleted the given inventory items from the

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CASE 2.1 JACK GREENBERG, INC. 217

prepaid inventory log and forwarded the matched invoice and delivery receipt to Steve Cohn, who processed an accounting entry that transferred the product from the Prepaid Inventory account to the Merchandise Inventory account. At the end of each year, JGI took a physical inventory of the company’s warehouse and adjusted the balance of the Merchandise Inventory account to agree with the results of the physical inventory.

Because of the accounting procedures used for JGI’s two inventory accounts, there was some risk that certain inventory items would be “double-counted” at year-end. That is, certain inventory items might be included in both the Prepaid Inventory and Merchandise Inventory accounts if there was any delay in processing the delivery receipt forms. For example, suppose that a shipment of imported meat products arrived at JGI’s warehouse on 29 December, two days before the close of the com- pany’s fiscal year. If Fred Greenberg failed to delete the items in the shipment from the prepaid inventory log and failed to forward the delivery receipt and invoice for the shipment to Steve Cohn on a timely basis, the items in the shipment would be included in both inventory accounts at the end of the year.2 To reduce the risk of such errors, Cohn reconciled the prepaid inventory log maintained by Fred to the year-end bal- ance of the Prepaid Inventory account. Cohn also asked Fred to allow him to review any delivery receipts that arrived during the last few days of the fiscal year.

Fred’s Fraud Steve Cohn realized that the accounting procedures for prepaid inventory increased the risk that JGI’s year-end inventory would be misstated. In early 1992, Cohn, who by this time had been given the title of chief financial officer, designed a computer- ized accounting system for JGI’s prepaid inventory. Cohn then called a meeting with the two Greenberg brothers to illustrate the system and demonstrate the important information and control advantages that it would provide over the “sloppy” manual system that Fred had used for years to account for prepaid inventory. Several years later, Cohn would recount how the Greenberg brothers reacted to his proposal.

I told Fred how this was a great idea and how I believed that this would be a big step forward in being able to monitor the [prepaid] inventory and determine what was open. . . . And I showed it to Fred, looked at it and said, “Isn’t this great? We can do this.” And I said, “Don’t you want to do this?” And he looked at me and said, “No.”

I was flabbergasted. I looked over to Manny [Emanuel]. He just sat there. And I was furious. I didn’t talk to Fred for weeks. I was—I was having a hard time dealing with it. I couldn’t imagine why he wouldn’t want me to do this. It was such a good thing for the company. And he didn’t want to do it.

Later in 1992, the persistent Cohn decided to personally collect the information needed to maintain a computerized accounting system for JGI’s prepaid inventory. Cohn would watch for delivery trucks arriving at JGI’s warehouse, which was adja- cent to the company’s administrative offices. When a truck arrived, either he or a subordinate would go to the shipping dock and make copies of the delivery receipt and other documents for each shipment of imported meat products. “We used to run back and forth trying to get these receivings [delivery receipts] that [the warehouse manager] was preparing and it became a game. I became a laughingstock because it was a joke that I was trying to get this information.” After several weeks, an exasper- ated Cohn gave up his futile effort.

2. Because such items would be present during the year-end physical inventory of JGI’s warehouse, the book-to-physical inventory adjustment would cause them to be included in the 31 December balance of the Merchandise Inventory account.

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218 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

Fred Greenberg had reason not to cooperate with Cohn’s repeated attempts to overhaul the accounting and control procedures for JGI’s prepaid inventory. Since the mid-1980s, Fred had been intentionally overstating the company’s prepaid inven- tory. Those overstatements had materially understated JGI’s annual cost of goods sold as well as overstated the company’s gross profit and net income each year. In subsequent court testimony, Fred reported that his father’s failing health had com- pelled him to begin manipulating JGI’s reported operating results. “To avoid aggra- vating his illness, I started the practice [inflating prepaid inventory] so he would feel better about his business.”

Fred also testified that following his father’s death “significant changes occurring in the market which adversely affected us” caused him to continue his fraudulent scheme. During the late 1980s and early 1990s, Fred and his brother found it increas- ingly difficult to compete with larger wholesalers that were encroaching on their com- pany’s market. To compete with these larger companies, JGI was forced to reduce the gross margins on the products that it sold. To mitigate the impact of this competi- tive pressure on JGI’s operating results, Fred routinely overstated prepaid inventory to produce gross margins that approximated those historically realized by the company.

Fred manipulated the dates upon which the prepaid inventory was received in order to make it appear that the company’s operations generated the same general financial performance from period to period. He did this by determining how much inventory needed to be prepaid inventory so that the percentages of gross profit and net income would remain consistent.

To overstate prepaid inventory, Fred destroyed delivery receipts forwarded to him by JGI’s warehouse manager and neglected to update the prepaid inventory log for the given shipments. Weeks or even months later, he would prepare new delivery receipts for those shipments, delete the items in the shipments from the prepaid inventory log, and then forward the receipts along with the corresponding vendor invoices to Cohn. This practice resulted in inventory items being included in the Prepaid Inventory account well after they had arrived at JGI’s warehouse.

Auditing Prepaid Inventory Grant Thornton served as JGI’s independent audit firm from 1986 through 1994. Because prepaid inventory was JGI’s largest asset and because it posed significant audit risks, the engagement audit team allocated a disproportionate amount of audit resources to that item. Several weeks before the end of each fiscal year, Grant Thornton provided Steve Cohn with an “Engagement Compliance Checklist” that identified the documents and other information needed by the audit engagement team to complete the audit. Many of these requested items involved JGI’s prepaid inventory, including “government forms, bills of lading, insurance information, and the delivery receipts prepared by the warehouse personnel evidencing the date upon which the [prepaid] inventory was received at the warehouse.” Each year, Grant Thornton also requested a copy of Fred Greenberg’s prepaid inventory log and Cohn’s reconciliation of the information in that record to JGI’s general ledger control- ling account for prepaid inventory.

One key item that Grant Thornton did not request from Cohn was the Form 9540-1 prepared for each shipment of imported meat products delivered to JGI’s warehouse. Grant Thornton auditors later testified that they became aware in 1988 that a Form 9540-1 was prepared for each prepaid inventory shipment received by JGI. However, the audit team did not learn until 1993 that the USDA official who completed the 9540-1 gave a copy of that document to a JGI warehouse clerk.

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CASE 2.1 JACK GREENBERG, INC. 219

Each year, Cohn diligently collected the information requested by Grant Thornton and gave it to the accounting firm well before the date the audit was to begin, with one exception. Because Fred Greenberg failed to give the prepaid inventory log, delivery receipts, and other information he maintained for JGI’s prepaid inventory to Cohn on a timely basis, Grant Thornton received that information well after the audit had begun each year.

Grant Thornton audited all of JGI’s prepaid inventory transactions each year. “Grant Thornton tested 100 percent of the prepaid inventory transactions which meant that Grant Thornton examined every invoice for prepaid inventory and reviewed the delivery receipts to confirm if and when a delivery had been made.” By examining the invoices and delivery receipts, the auditors could determine which prepaid inven- tory purchases were apparently “still open” at year-end, that is, the prepaid inventory shipments that were properly included in JGI’s year-end Prepaid Inventory account.

Because Fred Greenberg had destroyed many of the delivery receipts prepared by the warehouse manager, the Grant Thornton auditors failed to discover that much of JGI’s year-end prepaid inventory was “double-counted.” A critical issue in subse- quent litigation stemming from this case was whether Grant Thornton was justified in relying on the delivery receipts to audit JGI’s year-end prepaid inventory. Members of the audit engagement team maintained that because JGI’s warehouse manager prepared the delivery receipts independently of the company’s accounting function for prepaid inventory, those documents provided sufficient competent evidence to corroborate prepaid inventory. “Grant Thornton believed it was acceptable to rely on the Delivery Receipt to verify the date of delivery because JGI’s internal control procedures for inventory were based on a system of ‘segregation of duties.’” A Grant Thornton representative provided the following explanation of exactly what was implied by the phrase “segregation of duties.”

Question: You speak of segregation of duties. What do you mean by that? Answer: Somebody is separate—you know, the purchasing function is separate

from the receiving function and the approval function is different from the person who executes the transactions.

Question: Does that mean that there are separate people that do these different functions?

Answer: Yes. Separate people or departments.

1993 and 1994 JGI Audits During the 1992 JGI audit, members of the Grant Thornton audit team told Steve Cohn and Emanuel Greenberg they were concerned by the large increase in pre- paid inventory over the previous three years.3 The auditors also expressed concern regarding the haphazard accounting procedures applied to prepaid inventory. These con- cerns caused the auditors to include the following comments in a report entitled “Internal Control Structure Reportable Conditions and Advisory Comments” that was submitted to Emanuel Greenberg at the conclusion of the 1992 audit. “Prepaid inventory should be set up on a personal computer and updated daily from purchases. This would identify a prob- lem much sooner and reduce the risk of loss should such a problem occur.” Cohn later testified that he had encouraged Grant Thornton to include this recommendation in the report filed with Emanuel Greenberg. Despite this recommendation, Emanuel would not

3. The dollar value of JGI’s prepaid inventory increased by 303 percent from the end of 1989 to the end of 1992.

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220 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

pressure his brother to cooperate with Cohn’s effort to strengthen the accounting proce- dures for prepaid inventory.

Grant Thornton auditors had access to the notification forms JGI’s customs broker sent to Fred Greenberg when a prepaid inventory shipment arrived in a U.S. port. During the 1993 audit, a Grant Thornton auditor noticed that for several prepaid inventory shipments an abnormally long period of time had elapsed between the date the customs broker inspected the merchandise and the date that merchandise arrived at JGI’s warehouse. When asked about this issue, Fred Greenberg explained that “floods in the Midwest” had slowed down many shipments en route to the East Coast from ports on the West Coast. A Grant Thornton auditor contacted JGI’s cus- toms broker regarding Fred’s explanation. The customs broker told the auditor that Fred’s explanation was valid.

Near the end of the 1993 audit, a Grant Thornton auditor stumbled across a large stack of Form 9540-1 documents in the receiving office of JGI’s warehouse. Following this discovery, the Grant Thornton audit team attempted to match individual delivery receipts with the corresponding Form 9540-1 documents to verify the dates reported on the delivery receipts. Because the latter documents were in no particular alpha- betical, chronological, or numerical order, the “task proved insurmountable and was abandoned.” In explaining why the auditors did not insist on JGI providing those forms in a usable condition, a Grant Thornton representative noted that the 1993 audit program did not require the delivery receipts to be matched with the Form 9540-1 documents. “However, Grant Thornton decided that since JGI had access to the forms, it wanted them produced for the 1994 audit so that it could use them to verify the date recorded on the delivery receipts.”

Following the completion of the 1993 audit, Grant Thornton once again submit- ted a report entitled “Internal Control Structure Reportable Conditions and Advisory Comments” to Emanuel Goldberg. In this report, Grant Thornton included several specific recommendations regarding improvements needed in the accounting proce- dures applied to prepaid inventory. One of these recommendations was to maintain an orderly file of the Form 9540-1 documents that could be used for internal con- trol purposes and during the annual independent audit. A second recommendation called for JGI to begin using a specific set of computer-based accounting and inter- nal control procedures and documents for prepaid inventory. These latter items were the same procedures and documents that Steve Cohn had developed and presented to the Greenberg brothers in 1992.

Throughout 1994, Fred Greenberg continued to refuse to adopt Grant Thornton’s recommendations for improving the accounting for, and control over, prepaid inven- tory. In the fall of 1994, Cohn contacted Grant Thornton and told members of the audit engagement team that Fred had not complied with their recommendations. A Grant Thornton representative then met with Fred and told him that, at a mini- mum, JGI would have to provide the Form 9540-1 documents to Grant Thornton if the accounting firm was to complete the 1994 audit. Still, Fred refused to comply.

Shortly after Grant Thornton began the 1994 audit, a senior member of the audit engagement team advised Fred that unless the Form 9540-1 documents were pro- vided, the accounting firm would likely resign as JGI’s independent auditor. Within a few days, Fred turned over the documents to Grant Thornton. “However, before he did so, he altered the dates on them. Apparently, the alterations were so obvious that after reviewing the forms for only 10 seconds, Grant Thornton knew there was a prob- lem. Grant Thornton informed Emanuel and Cohn that the dates were falsified and terminated the audit.” When Emanuel confronted his brother regarding the altered documents, the suddenly remorseful Fred “admitted everything.”

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CASE 2.1 JACK GREENBERG, INC. 221

E P I L O G U E

Following Fred’s confession, JGI retained Grant Thornton to determine the impact of the fraudulent scheme on the company’s prior financial statements and to develop a set of current financial statements that were reliable. The Greenbergs provided this information to their company’s three banks. Within six months, JGI filed for bank- ruptcy and ceased operations.

JGI’s sudden collapse sparked a spate of law- suits. In February 1997, JGI’s court-appointed bankruptcy trustee filed a civil action that contained eight specific charges against Grant Thornton. These charges included, among oth- ers, breach of contract, negligence, and fraud. A primary defense Grant Thornton used in attempting to rebut those allegations was con- tributory negligence on the part of JGI and its management.

Grant Thornton argued that JGI had a respon- sibility to implement internal controls that would have been effective in uncovering Fred Greenberg’s fraudulent scheme. In particu- lar, Grant Thornton contended that Emanuel Greenberg should have required his brother to adopt the computer-based accounting and control procedures initially proposed by Steve Cohn in 1992. The accounting firm also main- tained that Emanuel Greenberg had been neg- ligent in failing to discover Fred’s subterfuge since he had never taken any steps to check or verify his brother’s work for the all-important Prepaid Inventory account.

The federal judge who presided over the lawsuit filed against Grant Thornton by JGI’s bankruptcy trustee responded to the firm’s con- tributory negligence defense by first suggesting that the accounting firm, rather than JGI’s man- agement, had more “leverage” to force Fred Greenberg to adopt Cohn’s recommendations. “Cohn could not insist that Fred implement tighter controls over the prepaid inventory, but Grant Thornton, as JGI’s auditor, could. Indeed, that is how the fraud was finally discovered in 1994.” Additionally, the judge pointed out that Grant Thornton had failed to present any

compelling evidence that Emanuel Greenberg had suspected his brother was misrepresenting JGI’s prepaid inventory. “Accordingly, Emanuel had no reason to check or verify his brother’s work in matching up the delivery receipts with the other prepaid inventory documenta- tion.” The judge went even further in absolving Emanuel of responsibility for his brother’s mis- conduct by suggesting that independent audi- tors are the parties primarily responsible for discovering such schemes.

Given Fred’s equal ownership in the com- pany and his apparent control, not only is there no evidence that Emanuel was “slip- shod,” there is no evidence that he could have prevented Fred’s wrongful acts. Rather, in the unique circumstances where a corporation is owned and operated by family members, the goal of deterring wrongdoing is best served by subjecting the auditors to potential liabil- ity, thereby encouraging greater diligence by them in such situations in the future.

After responding to Grant Thornton’s argu- ments, the federal judge criticized several aspects of the firm’s JGI audits. Although Grant Thornton identified the large increase in prepaid inventory during the late 1980s and early 1990s as an audit risk factor, the judge suggested that the accounting firm did not thoroughly investigate the underlying cause of that dramatic increase. Likewise, the judge maintained that during the 1993 audit Grant Thornton did not adequately investigate the abnormally long time lag between the date that certain imported meat shipments arrived at a U.S. port and the date they were delivered to JGI’s warehouse.4 The judge also referred to

4. Recall that JGI’s customs broker had confirmed Fred Greenberg’s assertion that floods in the Midwestern states during 1993 were responsible for this time lag. Apparently, that assertion was not valid.

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222 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

criticism of Grant Thornton that was included in a report prepared by an expert witness retained by JGI’s bankruptcy trustee. Among other issues, this repor t cr iticized Grant Thornton for not discovering until 1993 that JGI had copies of the Form 9540-1 documents. According to the expert witness, if the auditors had performed a routine “walk-through” audit procedure to document their understanding of JGI’s important accounting and control pro- cedures, they would have immediately discov- ered that “third-party documentation [Form 9540-1] existed to verify the arrival dates of the inventory.”

The federal judge was most critical of Grant Thornton’s decision near the end of the 1993 audit to continue relying on the internally gen- erated delivery receipts when the firm had access to externally generated documenta- tion to vouch the prepaid inventory transac- tions and year-end balance. In the judge’s opinion, that decision could be construed as “reckless.”

According to Grant Thornton, although it now knew that third-party verification of the delivery dates existed, it considered it unnec- essary to have the USDA forms for the 1993 audit because of its reliance on JGI’s segre- gation of duties. Yet, Grant Thornton refused to rely upon JGI’s segregation of duties for its 1994 audit. Rather, it demanded that JGI pro- duce the USDA forms for the 1994 audit. . . . If Grant would not issue an unqualified opinion in 1994 relying solely upon JGI’s segregation of duties, then why did it do so in 1993?

In October 1999, the federal judge issued a 36-page opinion weighing the merits of the allegations filed by JGI’s trustee against Grant Thornton and the validity of the accounting firm’s rebuttals of those allegations. After striking down one of the charges filed against Grant Thornton, the judge ruled that the other charges would be addressed in a subsequent trial. Since no fur- ther mention of this case can be found in public records, Grant Thornton and JGI’s bankruptcy trustee apparently settled the case privately.

Questions 1. Identify important audit risk factors common to family-owned businesses. How

should auditors address these risk factors?

2. In your opinion, what primary audit objectives should Grant Thornton have established for JGI’s (a) Prepaid Inventory account and (b) Merchandise Inventory account?

3. Assess Grant Thornton’s decision to rely heavily on JGI’s delivery receipts when auditing the company’s prepaid inventory. More generally, compare and contrast the validity of audit evidence yielded by internally prepared versus externally prepared client documents.

4. Describe the general nature and purpose of a “walk-through” audit procedure. Are such tests required by professional auditing standards?

5. Identify audit procedures, other than a walk-through test, that might have resulted in Grant Thornton discovering that Fred Greenberg was tampering with JGI’s delivery receipts.

6. Once an audit firm has informed client management of important internal control weaknesses, what further responsibility, if any, does the audit firm have regarding those items? For example, does the audit firm have a responsibility to insist that client management correct the deficiencies or address them in some other way?

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223

CASE 2.2

Golden Bear Golf, Inc.

Jack Nicklaus electrified sports fans worldwide in 1986 when he won the prestigious Masters golf tournament at the ripe old age of 46. Over the previous several years, the “Golden Bear” had been struggling to remain competitive with the scores of talented young players who had earned the right to play in the dozens of golf tournaments sponsored each year by the Professional Golfers’ Association (PGA).

Regaining his golden touch on the golf course was not the only challenge that Nicklaus faced during the mid-1980s. In 1985, Richard Bellinger, an accountant employed by Golden Bear International, Inc. (GBI), the private company that over- saw the famous golfer’s many business interests, mustered the courage to approach his employer. Bellinger told Nicklaus that his company was on the verge of bank- ruptcy. Nicklaus, who had allowed subordinates to manage his company’s opera- tions, was startled by the revelation. In a subsequent interview with the Wall Street Journal, Nicklaus admitted that after a brief investigation he realized that he had allowed his company to become a tangled knot of dozens of unrelated businesses. “We were an accounting nightmare . . . I didn’t know what any of them did and neither did anyone else.”1

Nicklaus immediately committed himself to revitalizing his company. The first step that he took to turn around his company was naming himself as its chief executive officer (CEO). Nicklaus then placed Bellinger in charge of GBI’s day-to-day opera- tions. Within a few years, the two men had returned GBI to a profitable condition by focusing its resources on lines of business that Nicklaus knew best, such as golf course design, golf schools, and the licensing of golf equipment.

In the late 1990s, Jack Nicklaus, however, once again found himself coping with an “accounting nightmare.” This time, Nicklaus could not blame himself for the predicament he faced. Instead, the responsibility for the new crisis rested squarely on the shoulders of two of Nicklaus’s key subordinates who had orches- trated a fraudulent accounting scheme that jeopardized their employer’s corpo- rate empire.

Player of the Century Jack Nicklaus began playing golf as a young boy and had mastered the game by his mid-teens. After graduating from high school, the golf prodigy accepted a schol- arship to play collegiately for Ohio State University in his hometown of Columbus. At the age of 21, Nicklaus joined the professional golf tour and was an instant suc- cess, racking up more than one dozen victories within a few years.

Shortly after joining the professional golf tour, the business-minded Nicklaus real- ized that winning golf tournaments was not the most lucrative way to profit from his enormous skills. At the time, the undisputed “king” of golf was Arnold Palmer, who endeared himself to the golfing public with his easy smile and affable manner on the golf course. Adoring legions of fans known as “Arnie’s Army” tracked Palmer’s every move during a tournament. Palmer’s popularity with the public translated into a

1. R. Lowenstein, “A Golfer Becomes an Executive: Jack Nicklaus’s Business Education,” Wall Street Journal, 27 January 1987, 34.

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224 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

series of high-profile and profitable endorsement deals. On the other hand, golf fans generally resented Nicklaus’s no-nonsense approach on the golf course. Those same fans resented Nicklaus even more when it became evident that the burly Ohioan with the trademark crew cut would likely replace Palmer as the world’s best golfer, which he did. Nicklaus would ultimately win a record 18 major golf championships and edge out Palmer for the “Player of the Century” award in the golfing world.

With the help of a professional sports agent, Nicklaus worked hard to develop a softer, more appealing public image. By the mid-1970s, Nicklaus’s makeover was complete and his popularity rivaled that of Palmer. As his popularity with the public grew, Nicklaus was able to cash in on endorsement deals and other business oppor- tunities. Eventually, Nicklaus founded GBI to serve as the corporate umbrella for his business interests.

In 1996, Nicklaus decided to expand his business operations by spinning off a sub- sidiary from GBI via an initial public offering (IPO). Nicklaus named the new public company Golden Bear Golf, Inc. (Golden Bear). One of Golden Bear’s principal lines of business would be the construction of golf courses. GBI would remain a privately owned company that would continue to manage Nicklaus’s other business ventures. Because Nicklaus planned to retain more than 50 percent of Golden Bear’s common stock, he and his subordinates would be able to completely control the new com- pany’s operations.

Nicklaus chose his trusted associate Richard Bellinger to serve as Golden Bear’s CEO. Bellinger then appointed John Boyd and Christopher Curbello as the two top execu- tives of Paragon International, Golden Bear’s wholly owned subsidiary that would be responsible for the company’s golf course construction business. Boyd became Paragon’s president and principal operating officer, while Curbello assumed the title of Paragon’s vice president of operations. On 1 August 1996, Golden Bear went public. The company’s stock traded on the NASDAQ exchange under the ticker symbol JACK.

Triple Bogey for Golden Bear Shortly after Golden Bear’s successful IPO, Paragon International’s management team was inundated with requests to build Jack Nicklaus–designed golf courses. In a few months, the company had entered into contracts to build more than one dozen golf courses. Wall Street analysts, portfolio managers, and individual investors expected these contracts to translate into sizable profits for Golden Bear. Unfortunately, those profits never materialized.

Less than one year after Golden Bear’s IPO, Boyd and Curbello realized that they had been much too optimistic in forecasting the gross profit margins Paragon would earn on its construction projects. Instead of earning substantial profits on those projects, Paragon would incur large losses on many of them. To avoid the embar- rassment of publicly revealing that they had committed Paragon to a string of unprof- itable construction projects, the two executives instructed Paragon’s accounting staff to embellish the subsidiary’s reported operating results.

A key factor that may have contributed to Boyd and Curbello’s decision to conceal Paragon’s financial problems was the incentive compensation package each had received when they signed on with the company. The two executives could earn sizable bonuses if Paragon met certain operating benchmarks. In addition, Boyd had been granted a large number of Golden Bear stock options.

Because Paragon’s construction projects required considerably more than one year to complete, the company used percentage-of-completion accounting to recog- nize the revenues associated with those projects. Initially, Paragon applied the widely used “cost-to-cost” percentage-of-completion method that requires a company to

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CASE 2.2 GOLDEN BEAR GOLF, INC. 225

determine the percentage of a project’s total estimated construction costs incurred in a given accounting period. Then, the same percentage of the total revenue (and gross profit) to be earned on the project is booked that period.

During the second quarter of fiscal 1997, Boyd and Curbello determined that Paragon would have a large operating loss if the cost-to-cost method was used to recognize revenue on the golf course construction projects. At that point, the two executives instructed Paragon’s controller to switch to what they referred to as the “earned value” percentage-of-completion accounting method. “In developing its percentage-of-completion estimates under the earned value method, Paragon relied not on objective criteria, such as costs incurred, but instead relied on management’s subjective estimates as to its [a project’s] progress.”2

Throughout the remainder of fiscal 1997 and into fiscal 1998, Paragon’s manage- ment routinely overstated the percentage-of-completion estimates for the company’s golf course construction projects each quarter. To further enhance Paragon’s operat- ing results, the company’s accounting staff inflated the contractual revenue amounts for most of the company’s construction projects. These increased revenue amounts were allegedly attributable to “change orders” that amended the original construc- tion contracts between Paragon and the company’s clients. A final window-dressing scheme used by Paragon was recording revenue for potential construction projects.

In some cases, Paragon recognized revenue in connection with potential projects that Paragon had identified while looking for new work, even though Paragon had no agreements in connection with these projects. In other cases, Paragon recognized rev- enue in connection with projects where the project’s owners were either entertaining bids from Paragon and other contractors or were negotiating with Paragon regarding a project yet to be awarded.3

During the spring of 1998, John Boyd and several of his top subordinates, includ- ing Christopher Curbello, attempted to purchase Paragon International from Golden Bear. When that effort failed, Boyd and Curbello resigned their positions with Paragon. After their departure, Paragon’s new management team quickly discovered that the subsidiary’s operating results had been grossly misrepresented.

A subsequent investigation carried out jointly by Arthur Andersen & Co. (Paragon’s audit firm), PricewaterhouseCoopers, and Golden Bear’s external legal firm resulted in Golden Bear issuing restated financial statements in October 1998 for fiscal 1997 and for the first quarter of fiscal 1998. For fiscal 1997, Golden Bear had initially reported a $2.9 million net loss and golf course construction revenues of $39.7 million; the restated amounts included a $24.7 million net loss for fiscal 1997 and golf course construction revenues of only $21.8 million. For the first quarter of fiscal 1998, Golden Bear had reported an $800,000 net loss and golf course con- struction revenues of $16.0 million. Those amounts were restated to a $7.2 million net loss and golf course construction revenues of $8.3 million.

“Audit Failures” The Securities and Exchange Commission (SEC) launched its own investigation of Golden Bear shortly after the company issued the restated financial statements. A primary target of the SEC investigation was Michael Sullivan, the Arthur Andersen

2. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 1604, 1 August 2002. 3. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 1603, 1 August 2002.

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226 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

audit partner who served as the Golden Bear engagement partner. Sullivan had been employed by Andersen since 1970 and had been a partner in the firm since 1984.

The SEC enforcement release that disclosed the results of its investigation of Andersen’s Golden Bear audits included a section entitled “Sullivan’s Audit Failures.” According to the SEC, Sullivan was well aware that the decision to use the earned value method “accelerated revenue recognition by material amounts” for Paragon.4

In fact, Sullivan was very concerned when Paragon decided to switch from the cost-to- cost method to the “new and untested” earned value method. This concern prompted him to warn Paragon’s management, at the time the switch was made, that the earned value method should produce operating results approximately in line with those that would have resulted from the continued application of the cost-to-cost method. To monitor the impact of the earned value method on Paragon’s operating results, Sullivan required the client’s accounting staff to “provide detailed schedules showing Paragon’s project-by-project results under both methods for each reporting period from the second quarter of 1997 through the first quarter of 1998.”

By the end of fiscal 1997, the comparative schedules prepared by Paragon’s accoun- tants clearly revealed that the earned value method was allowing Paragon to book much larger amounts of revenue and gross profit on its construction projects than it would have under the cost-to-cost method. When Sullivan questioned Paragon’s executives regarding this issue, those executives maintained that “uninvoiced” con- struction costs had caused the cost-to-cost method to significantly understate the stages of completion of the construction projects. To quell Sullivan’s concern, in early fiscal 1998 Paragon’s management recorded $4 million of uninvoiced construc- tion costs in a year-end adjusting entry for fiscal 1997. These costs caused the rev- enue that would have been recorded under the cost-to-cost method to approximate the revenue that Paragon actually recorded by applying the earned value method. Unknown to Sullivan, the $4 million of uninvoiced construction costs booked by Paragon were fictitious.5

The SEC criticized Sullivan and his subordinates for failing to adequately inves- tigate the $4 million of uninvoiced construction costs that materialized at the end of fiscal 1997. According to the SEC, Sullivan relied almost exclusively on manage- ment’s oral representations to corroborate those costs.

Sullivan knew that Paragon booked costs for which no invoices had been received and which were not reflected in the company’s accounts payable system, and that recording these uninvoiced costs would have substantially reduced the gap between the results produced by the two estimation methods. . . . While procedures with respect to invoiced and paid costs were performed, Sullivan did not employ any procedures to determine whether the uninvoiced costs had actually been incurred as of year-end.

Paragon’s scheme to overstate its reported revenues and profits by applying the earned value method resulted in a dramatic increase in unbilled revenues by the end of 1997. Approximately 30 percent of the revenues reported in Golden Bear’s 1997 income statement had not been billed to its customers. When Paragon’s executives switched to the earned value method, they had assured Sullivan that they would bill their customers on that basis. Despite that commitment, Paragon continued to bill

4. The remaining quotations in this case were taken from Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 1676, 26 November 2002. 5. Recognize that the $4 million of uninvoiced construction costs that were accrued in the adjusting entry did not reduce Golden Bear’s gross profit that it had recognized for fiscal 1997 under the earned value method. The $4 million of construction costs simply replaced an equal amount of expenses that had been recorded to produce the “proper” amount of gross profit under the earned value method.

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CASE 2.2 GOLDEN BEAR GOLF, INC. 227

their customers effectively on a cost-to-cost basis. (Paragon could not bill custom- ers for the full amount of revenue that it was recording on the construction projects since those customers were generally aware of the actual stages of completion of those projects.)

The SEC maintained that Sullivan and his subordinates should have rigorously tested Paragon’s large amount of unbilled revenues at the end of 1997. “A significant unbilled revenue balance requires adequate testing to determine the reason that the company is not billing for the work it reports as complete and whether unbilled amounts are properly recognized as revenue.” Instead, the SEC charged that Sullivan relied “excessively” on oral representations from Paragon management to confirm the unbilled revenues and corresponding receivables.

In at least one case, the SEC reported that members of the Golden Bear audit team asked the owner of a Paragon project under construction to comment on the rea- sonableness of the $2 million unbilled receivable that Paragon had recorded for that project at the end of 1997. The owner contested that amount, alleging that Paragon had overestimated the project’s stage of completion. “Despite this significant evi- dence that a third party with knowledge of the project’s status disputed Paragon’s estimated percentage-of-completion under the contract, the audit team did not properly investigate this project or otherwise expand Andersen’s scope of testing of Paragon’s unbilled revenue balances.” According to the SEC, Sullivan did not believe the unbilled revenue posed major audit issues but instead was a “business issue” that Paragon had to resolve with its clients.

A second tactic Paragon used to inflate its reported profits was to overstate the total revenues to be earned on individual construction projects. During the 1997 audit, Andersen personnel selected 13 of Paragon’s construction projects to corrobo- rate the total revenue figures the company was using in applying the earned value percentage-of-completion accounting method to its unfinished projects. For 11 of the 13 projects selected, the Andersen auditors discovered that the total revenue being used in the percentage-of-completion computations by Paragon exceeded the rev- enue figure documented in the construction contract. Paragon’s management attrib- uted these differences to unsigned change orders that had been processed for the given projects “but could not produce any documents supporting these oral rep- resentations.” Sullivan accepted the client’s representations that the given revenue amounts were valid. “In each instance, Sullivan failed to properly follow up on a single undocumented amount; instead, Sullivan relied solely on Paragon manage- ment’s oral representations that the estimated revenue amounts accurately reflected the economic status of the jobs.”

Another scam used by Paragon to inflate its revenues and profits was to record rev- enue for nonexistent projects. In the enforcement release that focused on Sullivan’s role in the Paragon scandal, SEC officials pointed out that the publication AICPA Audit and Accounting Guide—Construction Contracts is clearly relevant to the audits of construction companies such as Paragon. This publication recommends that audi- tors visit construction sites and discuss the given projects with project managers, architects, and other appropriate personnel. The purpose of these procedures is to assess “the representations of management (for example, representations about the stage of completion and estimated costs to complete).” Despite this guidance, the Andersen auditors did not visit any project sites during the 1997 audit.6 Such visits may have resulted in Andersen discovering that some of Paragon’s projects were purely

6. As a point of information, most of Paragon’s golf construction projects were outside of the United States. During 1996, auditors employed by foreign affiliates of Andersen visited some of these sites.

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228 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

imaginary. In addition, Andersen would likely have determined that Paragon was overstat- ing the stages of completion of most of its existing projects.

The SEC reprimanded Andersen for not visiting any of Paragon’s jobsites or dis- cussing those projects with knowledgeable parties. “Failing to discuss project status, including percentage-of-completion estimates, with project managers and other on-site operating personnel was, under the circumstances, a reckless departure from GAAS.”

The SEC also criticized Sullivan for not insisting that Golden Bear disclose in its 1997 financial statements the change from the cost-to-cost to the earned value method of applying percentage-of-completion accounting. Likewise, the SEC contended that Sullivan should have required Golden Bear to disclose material related-party transac- tions involving Paragon and Jack Nicklaus, Golden Bear’s majority stockholder.

Finally, the SEC noted that Sullivan failed to heed his own concerns while planning the 1997 Golden Bear audit. During the initial planning phase of that audit, Sullivan had identified several factors that prompted him to designate the 1997 Golden Bear audit a “high-risk” engagement. These factors included the subjective nature of the earned value method, Paragon’s large unbilled revenues, the aggressive revenue rec- ognition practices advocated by Golden Bear management, and severe weaknesses in Paragon’s cost accounting system. Because of these factors, the SEC maintained that Sullivan and his subordinates should have been particularly cautious during the 1997 Golden Bear audit and employed a rigorous and thorough set of substantive audit procedures.

E P I L O G U E In August 1998, angry Golden Bear stockhold- ers filed a class-action lawsuit against the com- pany, its major officers, and its principal owner, Jack Nicklaus. That same month, the NASDAQ delisted the company’s common stock, which was trading for less than $1 per share, dramati- cally below its all-time high of $20. Richard Bellinger resigned as Golden Bear’s CEO two months later to “pursue other interests.” In December 1999, Golden Bear announced that it had reached an agreement to settle the class- action lawsuit. That settlement required the company to pay its stockholders $3.5 million in total and to purchase their shares at a price of $0.75. In 2000, Golden Bear, by then a private company, was folded into Nicklaus Companies, a new corporate entity that Jack Nicklaus cre- ated to manage his business interests.

In November 2002, Michael Sullivan was suspended from practicing before the SEC

for one year. Sullivan’s employer, Andersen, had effectively been put out of business a few months earlier when a federal jury found it guilty of obstruction of justice for destroy- ing audit documents pertaining to its bank- rupt client Enron Corporation.7 In August 2002, Paragon’s former controller received a two-year suspension from practicing before the SEC. At the same time, the SEC sanctioned three former Golden Bear executives by ordering them to “cease and desist” from any future violations of the federal securities laws. One of those execu- tives was Richard Bellinger. The SEC maintained that Bellinger approved Paragon’s change from the cost-to-cost to the earned value method. Additionally, the SEC charged that Bellinger knew the change would materially increase Golden Bear’s reported revenues and gross profit but failed to require that the change be disclosed in the company’s financial statements.

7. As discussed in Case 1.1, Andersen’s conviction was subsequently overturned by the U.S. Supreme Court.

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CASE 2.2 GOLDEN BEAR GOLF, INC. 229

Questions 1. Professional auditing standards identify the “management assertions” that commonly

underlie a set of financial statements. Which of these assertions were relevant to Paragon’s construction projects? For each of the assertions that you listed, describe an audit procedure that Arthur Andersen could have employed to corroborate that assertion.

2. The SEC referred to several “audit failures” that were allegedly the responsibility of Michael Sullivan. Define what you believe the SEC meant by the phrase “audit failure.” Do you believe that Sullivan, alone, was responsible for the deficiencies that the SEC noted in Andersen’s 1997 audit of Golden Bear? Defend your answer.

3. Sullivan identified the 1997 Golden Bear audit as a “high-risk” engagement. How do an audit engagement team’s responsibilities differ, if at all, on a high-risk engagement compared with a “normal” engagement? Explain.

4. The AICPA has issued several Audit and Accounting Guides for specialized industries. Do auditors have a responsibility to refer to these guides when auditing clients in those industries? Do these guides override or replace the authoritative guidance included in the professional auditing standards?

5. Was the change that Paragon made in applying the percentage-of-completion accounting method a “change in accounting principle” or a “change in accounting estimate”? Briefly describe the accounting and financial reporting treatment that must be applied to each type of change.

Finally, in March 2003, a federal grand jury indicted John Boyd and Christopher Curbello on charges of securities fraud and conspir- acy to commit securities fraud. Curbello was arrested in San Antonio, Texas, on 14 March 2003, while Boyd was apprehended in Bogota, Colombia, a few days later by Secret Service

and FBI agents who immediately flew him to the United States. In June 2003, Curbello pleaded guilty to conspiracy to commit securi- ties fraud and was sentenced to three and one- half years in prison. A few months later, Boyd pleaded guilty to similar charges and was given a five-year prison sentence.

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231

CASE 2.3

Take-Two Interactive Software, Inc.

Grand Theft Auto ranks among the best-selling video games of all time as well as one of the most controversial.1 By the time Grand Theft Auto V was released in 2013, over 125 million copies of the video game had been sold worldwide since the original ver- sion of the game was introduced in 1997. Wikipedia provides the following general description of the game.

Game play focuses on an open world where the player can choose missions to prog- ress an overall story, as well as engaging in side activities, all consisting of action- adventure, driving, occasional role-playing, stealth, and racing elements. The subject of the game is usually a comedic satire of American culture, but the series has gained controversy for its adult nature and violent themes.

Prominent public officials, major media outlets, and public service organizations have condemned Grand Theft Auto. Senator Hillary Clinton urged the Federal Trade Commission (FTC) to assign a rating of “Adults Only” to the game because of its “pornographic and violent content,” which includes one setting that “encourages them [game players] to have sex with prostitutes and then murder them.”2 Senator Joseph Lieberman denounced the game as “gruesome, and grotesque.”3 The mayor of New York City, Michael Bloomberg, bluntly noted that the game “Teaches chil- dren to kill.”4

In fact, law enforcement authorities have linked the commission of serious crimes to Grand Theft Auto. A teenager killed three police officers in Alabama in June 2003 in a set of circumstances similar to a scene in the game. The teenager, who played the game “day and night” and had no previous criminal record, calmly told his captors that, “Life is like a video game. Everybody’s got to die sometime.”5 In referring to that case, a CNN commentator branded Grand Theft Auto a “cop kill- ing simulator.”6

Mothers Against Drunk Driving (MADD) have criticized the game for encouraging drunk driving. “Drunk driving is not a game, and it is not a joke.”7 A spokesperson for Take-Two Interactive Software, Inc., the producer of the game, responded by main- taining that MADD’s criticism was unfair since the given version of Grand Theft Auto involved only one drunk driving scene. “For the same reason that you can’t judge an entire film or television program by a single scene, you can’t judge Grand Theft Auto IV by a small aspect of the game.”8

1. Wikipedia reports that Grand Theft Auto ranks as the sixth best-selling video game franchise of all time. The best-selling video game franchise is Mario followed by Super Mario, Pokemon, Wii, and The Sims. 2. USA Today (online) “Clinton Seeks ‘Grand Theft Auto’ Probe,” 14 July 2005. 3. B. McLean, “Sex, Lies, and Videogames,” Fortune (money.cnn.com), 22 August 2005. 4. PC World, “Rants Begin Against Grand Theft Auto IV,” www.pcworld.com, 3 May 2008. 5. R. Leung, “Can A Video Game Lead To Murder?” www.cbsnews.com, 11 February 2009. 6. CNN Headline News, 8 May 2008. 7. D. Lang, “MADD Attacks ‘Grand Theft Auto IV ’,” www.nbcnews.com, 1 May 2008. 8. Ibid.

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232 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

Take-Two’s executives have been the target of most of the emotionally charged criti- cism of Grand Theft Auto. A Wall Street analyst who tracked Take-Two’s stock for years suggested that, “You’d be hard-pressed to find a worse set of guys.”9 Despite repeated challenges to the suitability of Grand Theft Auto filed with the FTC by various parties, the federal agency that eventually posed the most significant challenge for the compa- ny’s management team was the Securities and Exchange Commission (SEC). The SEC sanctioned several of Take-Two’s top executives for issuing a series of financial state- ments that contained fraudulent misrepresentations. Those sanctions resulted in Take- Two restating its financial statements three separate times between 2001 and 2004.

Striking Out on His Own In 1992, Ryan Brant graduated from the University of Pennsylvania’s Wharton School of Business with a degree in economics. The 20-year-old Brant began his business career by working for a company owned by his father, Peter Brant, a billionaire busi- nessman. Eighteen months later, Brant decided to leave that company and establish his own business. After raising $1.5 million from family members and “angel” inves- tors, Brant organized Take-Two Interactive Software, Inc., in late 1993.

Robert Fish, a partner with Price Waterhouse, Take-Two’s audit firm, served as one of Brant’s principal business advisors from the inception of his company. Following the merger of Price Waterhouse with Coopers & Lybrand in 1998 to form PricewaterhouseCoopers (PwC), Fish became the Senior Managing Partner of the Venture Capital Practice of PwC’s New York City office. That unit provided a wide range of professional services to developmental stage companies.

In addition to serving as a general business advisor to the much younger Brant, Fish supervised the annual audits of Take-Two’s financial statements from 1994 through 2001. In a 1998 interview with Crain’s New York Business, Fish suggested that he and Brant had a father–son type relationship. In discussing PwC’s relation- ship with Take-Two, Fish noted that, “We [PwC] make an investment of our time in growth-oriented companies.”10 He went on to observe that, “Most start-ups coming to larger accounting firms know they don’t just want the accountants to handle debits and credits, but to focus on the structure of the enterprise.”11

PwC’s “investment” in Take-Two included initially discounting the fees that it charged the company for its professional services. According to Brant, PwC billed Take-Two “a mere $20,000” for the services provided annually to the newly formed company, a figure that was “roughly one-third what the firm would have charged had it applied its standard hourly rate.”12

For the first few years of Take-Two’s existence, the company realized modest suc- cess with several video games including Ripper and Hell: A Cyberpunk Thriller. To sur- vive in the ultra-competitive video gaming industry, Brant realized that his company had to grow, and quickly. Brant decided that the best strategy for achieving that goal was to acquire other video game companies, which would require a considerable amount of external financing. To raise those funds, Brant took his company public in 1997 with an initial public offering (IPO). Brant relied heavily on Fish for professional advice regarding accounting and financial reporting issues related to the IPO and the subsequent series of acquisitions made by the company.

9. McLean, “Sex, Lies, and Videogames.” 10. L. Aron, “Fatherly Advice on Facts of Financial Life,” Crain’s New York Business, 12 October 1998, 34. 11. Ibid. 12. Ibid.

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CASE 2.3 TAKE-TWO INTERACTIVE SOFTWARE, INC. 233

Among the nearly 20 acquisitions that Take-Two made in the late 1990s was a small operating unit of Bertelsmann, a large German mass media company. The video games owned by that entity included the game that would become Grand Theft Auto, which would prove to be Take-Two’s first major gaming “franchise.” Every few years, Take-Two releases a new version of the game. On 29 April 2008, the date that Grand Theft Auto IV was released, the game established the single-day sales record for the video gaming industry, selling 3.6 million units with a total revenue of $180 million.13

Grand Theft Auto resulted in Take-Two becoming one of the leading worldwide developers and distributors of video games. The successful game also allowed Take- Two to survive the “tech crash” that began in early 2000 with the bursting of the “dot- com bubble” in the stock market. That financial crisis proved to be the death knell for many of Take-Two’s competitors. Despite the challenging circumstances faced by Take-Two during that time frame, the company continued to post surprisingly strong operating results.

Exhibit 1 presents key financial data for Take-Two that document the company’s rapid growth from 1998 through 2000, the first three full fiscal years that it was a public company. A footnote to that exhibit includes selected amounts included in Take-Two’s 1997 financial statements.

“Parking” Violations In 2000 and 2001, a stock analyst who tracked Take-Two’s financial statements and pub- lic earnings releases noted apparent discrepancies between the company’s reported sales and data reported by the NDP Group, a market research company that moni- tors video game sales. That analyst’s concerns prompted an SEC investigation of Take- Two’s 2000 and 2001 financial statements. The federal agency’s investigation revealed that Take-Two executives had recorded millions of dollars of sham sales transactions to inflate their company’s reported operating results, transactions that involved Take- Two temporarily “parking” large amounts of inventory with its customers.

On October 31, 2000, the final day of Take-Two’s fiscal year 2000, the company’s chief operating officer (COO) and chief financial officer (CFO) arranged a bogus sale of $5.4 million of video games to Capitol Distributing, a video game distribu- tor based in Virginia. The transaction was the largest individual sale ever recorded by Take-Two. To make the sale appear legitimate to the company’s PwC auditors, Take-Two shipped 230,000 video games to Capitol. Both parties agreed prior to the shipment that the games would be returned by Capitol to Take-Two over the follow- ing few months. When the video games were returned to Take-Two in fiscal 2001, the two parties forged various documents to make the returns appear as if they were purchases of new product inventory by Take-Two from another company—this latter company was an affiliate of Capitol.

In 2001, Take-Two recorded three additional fictitious sales of video games to Capitol that totaled more than $9 million. Similar to the $5.4 million transaction, the merchandise shipped to Capitol as a result of these “sales” was returned to Take-Two under the guise of inventory purchases.

During fiscal 2000 and 2001, Take-Two recorded dozens of smaller bogus sale trans- actions to four other video game distributors. Nearly all of this merchandise was sub- sequently reacquired by Take-Two—some of these transactions were camouflaged as purchases of new inventory, while others were processed and recorded as normal sales returns. Take-Two also recorded sales during 2000 and 2001 for video games

13. C. Feldman, “Grand Theft Auto IV Steals Sales Records,” www.cnn.com, 8 May 2008.

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234 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

that were still in production and that would not be delivered to the given customers until a subsequent quarterly reporting period.14

Take-Two’s fraudulent accounting during 2000 allowed the company to meet or sur- pass its consensus quarterly earnings forecasts for that year. For the fourth quarter of 2000, for example, Take-Two reported earnings of $.42 per share, slightly higher than the company’s consensus earnings forecast of $.41 per share and considerably higher than the company’s actual earnings per share of $.27. The accounting fraud also allowed Take-Two to report a net income for that quarter that was higher than the figure reported for the prior quarter. This fact was significant to Take-Two’s CFO since his bonus each quarterly reporting period was contingent on the company increasing its net income over the previous quarter.

In February 2002, Take-Two issued restated financial statements for fiscal 2000 and for the first three quarters of fiscal 2001 to eliminate the fraudulent sales transactions recorded during those periods and to correct other instances of improper account- ing treatments. Two years later, in February 2004, Take-Two issued restated financial statements for fiscal years 1999 through 2003 after additional improper accounting

14. Take-Two also improperly accounted for acquisitions that it made of other companies and failed to record a proper reserve for “price protection guarantees” that it made to its customers.

EXHIBIT 1

TAKE-TWO INTERACTIVE SOFTWARE, INC. FINANCIAL HIGHLIGHTS 1998–2000 (000S OMITTED)

2000 1999 1998

Sales $387,006 $305,932 $194,052 Gross Profit 139,210 90,810 46,496 Operating Income 45,061 27,381 10,690 Net Income 24,963 16,332 7,181 Accounts Receivable 134,877 107,799 49,139 Inventories 44,922 41,300 26,093 Total Current Assets 214,908 187,970 95,302 Total Assets 351,641 231,712 109,385 Current Liabilities 152,023 146,531 73,505 Total Liabilities 164,639 146,609 73,820 Net Operating Cash Flows (55,259) (16,748) (8,022) Net Investing Cash Flows (12,906) (21,540) (727) Net Financing Cash Flows 71,564 46,780 9,017

Note: The following financial statement amounts for 1997 were included in Take-Two’s 1999 Form 10-K.

Sales $97,341 Gross Profit 15,862 Operating Income (895) Net Income (2,904) Accounts Receivable 36,369 Inventories 20,784 Total Assets 56,395 Total Stockholders’ Equity 11,935 Net Operating Cash Flows (14,460) Net Investing Cash Flows (2,583) Net Financing Cash Flows 18,809

Source: Form 10-K’s filed with the Securities and Exchange Commission by Take-Two Interactive Software, Inc.

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CASE 2.3 TAKE-TWO INTERACTIVE SOFTWARE, INC. 235

decisions were discovered for those years. The two restatements materially reduced Take-Two’s revenues and earnings from 1999 through 2003, but the company’s reported operating results for 2000 bore the brunt of those restatements. Take-Two’s 2000 sales were reduced from $387 million to $358 million, while its net income for that year was lowered from $25 million to $4.6 million.

PwC’s 2000 Audit of Take-Two Despite the fact that Take-Two actively concealed its fraudulent schemes from PwC, the SEC alleged that PwC failed to comply with generally accepted auditing standards (GAAS) while auditing the company’s financial statements. The SEC’s allegations cen- tered on the role that Robert Fish had played in supervising PwC’s 2000 audit of Take-Two.

In preparing for the 2000 engagement, Fish identified “revenue recognition” and “accounts receivable reserves” as “areas of higher risk” that would be given “special attention” during that audit.15 Following its investigation of the 2000 audit, the SEC concluded that, “Fish did not properly respond to those risks as he failed to exercise due professional care and professional skepticism, and failed to obtain sufficient com- petent evidential matter.”16 The SEC ruled that as a result of Fish’s poor decisions, PwC improperly issued an unqualified opinion on Take-Two’s 2000 financial statements.

A major focus of the 2000 audit was the $104 million of “domestic” accounts receiv- able that represented the majority of Take-Two’s total receivables at the end of fiscal 2000.17 The principal audit test applied to the domestic receivables was the mailing of positive confirmation requests to 15 of Take-Two’s customers that accounted for approximately 70 percent of those receivables. The PwC auditors received only one confirmation from that sample of customers, a confirmation that represented less than 2 percent of the company’s domestic receivables.18 Capitol Distributing was among the 14 customers that failed to respond to PwC’s confirmation requests.

Because of the poor response rate to the confirmation requests, Fish decided that PwC would apply alternative audit procedures to Take-Two’s domestic receivables. The principal alternative audit procedure employed by Fish and his subordinates was reviewing payments that Take-Two received in the new fiscal year from the 14 customers who had failed to return a confirmation.

The PwC auditors identified $18 million of cash payments received by Take-Two from those 14 customers over the first 6 weeks of the new fiscal year. During its inves- tigation, the SEC determined that the auditors had failed to track many of those pay- ments to specific invoiced sales transactions because Take-Two’s accounting records often reflected only “aggregate” cash collections for individual customers.

As a result, Fish knew, or should have known, that he could not be certain whether the cash he examined from November 1 through December 8, 2000, related to the accounts receivable balances that existed as of October 31, 2000, or to sales recorded after that date. . . . The fact that Take-Two’s records often showed only aggregate cash collected was a red flag to Fish that any subsequent cash receipts testing relying on this data would prove ineffective.19

15. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 2783, 11 February 2008. 16. Ibid. 17. The SEC enforcement releases that focused on the Take-Two fraud did not discuss the company’s more than $30 million of receivables from nondomestic customers as of fiscal year-end 2000, or PwC’s audit of those receivables. Presumably, those receivables were not affected by the fraud. 18. The SEC reported that the one returned confirmation was “false” but did not elaborate on how or why the confirmation was not authentic. 19. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 2783.

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236 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

The SEC also harshly criticized the audit procedures PwC used to test the suffi- ciency of the client’s reserve for sales returns. One of these tests involved examin- ing five sales returns received by Take-Two during the first few days of fiscal 2001. Because Fish and his subordinates did not track these returns to the original sales invoices, they failed to discover evidence suggesting that Take-Two was grossly underestimating its year-end reserve for sales returns.

Of the five specific returns tested, Fish did not compare the returns with the origi- nal sales invoices. Had he done so, he would have discovered that in four of the five instances, much more than 75% of the games purportedly purchased had been returned . . . when Take-Two only reserved for returns at the rate of 5%. Fish deter- mined, nonetheless, that Take-Two’s reserves were adequate without, for instance, examining other returns from fiscal year 2000, or inquiring of the customers regarding these particular sales.20

The SEC went on to point out that the four sales returns in question involved “parking transactions” that Take-Two had used to inflate its 2000 sales and earnings.21

E P I L O G U E

In June 2005, the SEC sanctioned Take-Two’s vice president of sales and three of its former executives for their role in the company’s accounting fraud. These latter individuals included Ryan Brant, Take-Two’s former chief executive officer, as well as the company’s for- mer COO, and former CFO. Take-Two was fined $7.5 million, while the four executives paid fines ranging from $50,000 for the vice presi- dent of sales to $500,000 for Brant. Brant was also ordered to forfeit $3.1 million of stock mar- ket gains he had earned on Take-Two’s com- mon stock. The company’s former CFO, who was a CPA, was also suspended from practicing before the SEC for 10 years.

In Febr uar y 2008, the SEC is sued an Accounting and Auditing Enforcement Release focusing on Robert Fish’s role as Take-Two’s audit engagement partner. The federal agency imposed a one-year suspension on Fish, who had previously resigned from PwC.

In 2007, the SEC filed dozens of civil cases against companies and individual executives

involved in the “backdating” of stock option grants. Over the previous two decades, these defendants had identified specific dates on which a given company’s stock price was at a relatively low level and then retrospectively issued stock option grants on those dates. This retrospective dating of stock option grants allowed the grantees to receive “in the money” stock options that they subsequently exercised, resulting in large stock market gains. Take-Two and Ryan Brant were among the parties that the SEC filed charges against in the huge options backdating scandal.

The SEC alleged that Brant was the mas- termind of Take-Two’s options backdating scheme. “From 1997 to September 2003, Brant awarded himself 10 backdated option grants, representing a total of approximately 2.1 mil- lion shares of Take-Two common stock.”22 Brant exercised all of those options before he left the company during the midst of the SEC’s investigation of Take-Two’s stock option grants. The SEC fined Brant $1 million for his role in

20. Ibid. 21. Recall that when some of the merchandise involved in “parking” transactions was returned to Take- Two it was disguised as purchases of new inventory. The other merchandise involved in parking trans- actions was processed as normal sales returns when it was subsequently shipped back to Take-Two. 22. Securities and Exchange Commission, Litigation Release No. 20003, 14 February 2007.

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CASE 2.3 TAKE-TWO INTERACTIVE SOFTWARE, INC. 237

Questions 1. Analyze Take-Two’s 1998-2000 financial data included in Exhibit 1. Compute the

following financial ratios for each of those years: age of accounts receivable, age of inventory, gross profit percentage, profit margin percentage, return on assets, return on equity, current ratio, debt-to-equity ratio, and the quality-of-earnings ratio. What major “red flags,” if any, were present in Take-Two’s financial statements given these ratios? Explain.

2. Identify the primary audit objectives that auditors hope to accomplish by confirming a client’s year-end accounts receivable. Explain the difference between “positive” and “negative” confirmation requests and discuss the quality of audit evidence yielded by each.

3. Identify audit tests that may be used as alternative audit procedures when a response is not received for a positive confirmation request. Compare and contrast the quality of audit evidence yielded by these procedures with that produced by audit confirmation procedures.

4. In your opinion, did the apparent mistakes made by the PwC auditors in auditing Take-Two’s receivables and reserve for sales returns involve “negligence” on their part? Would you characterize the mistakes or errors as “reckless” or “fraudulent”? Justify your answers.

5. Is it appropriate for audit firms to sharply discount their professional fees for developmental stage companies? Why or why not? What problems, if any, may this practice pose for audit firms?

6. Do you believe that the relationship between Robert Fish and Ryan Brant was inappropriate? Explain.

7. Should audit firms accept “ethically challenged” companies and organizations as audit clients? Defend your answer.

the scheme and required him to forfeit more than $5 million in stock market gains that he realized as a result of it. In a related criminal case, Brant pleaded guilty to a felony charge filed by a New York state prosecutor and paid a $1 million fine.

In April 2009, Take-Two reached an agree- ment with the SEC to settle the charges filed against it for the backdating of options by pay- ing a $3 million fine. Prior to reaching that settlement, the company had restated its finan- cial statements for the third time in five years

to correct the misrepresentations linked to the improper stock option grants.

Take-Two weathered the fraudulent finan- cial reporting and options backdating scan- dals and retained its prominent position in the video gaming industry. In 2008, Electronic Arts, the largest video gaming company in the U.S., launched a $2 billion hostile takeover bid for Take-Two. Electronic Arts dropped that take- over bid in late 2008 after it met with fierce resistance from the management team that had replaced Ryan Brant and his former colleagues.

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239

CASE 2.4

General Motors Company

As long as the unwritten rule stands that the best way to achieve success at GM is to be a good finance man, the bad habit of juggling numbers in order to present the picture people want to see cannot be broken.

Maryann Keller, analyst for the automotive industry, September 1990

The Great Depression dealt a devastating blow to Billy Durant. During the depths of the Depression in 1936, Durant, a high school dropout who was born a few months after the outbreak of the Civil War in 1861, was forced to declare bankruptcy. Like mil- lions of Americans, the tough-minded and resilient Durant survived the Depression by becoming a jack-of-all-trades, a “job” that he had mastered as a young man. During his early 20s, the free-spirited Durant had worked as an itinerant salesman traveling from town to town peddling patent medicines. During the latter days of the Depression, Durant, who was in his late 70s by this time, made ends meet by manag- ing a bowling alley. After suffering a stroke in 1942, he and his wife subsisted on a pension provided to him by a company that he had once managed. Durant died a few years later in 1947.

If one considered only the early and later years of Durant’s life, his life story would not be particularly compelling. However, in the 50-year span between working as a traveling medicine man and managing a bowling alley, William C. “Billy” Durant cre- ated an organization that would become the United States’ biggest corporation and have the largest workforce of any company worldwide.

Durant made a fortune in the late 1880s and 1890s manufacturing horse-drawn car- riages, a business that he had launched in 1886 on $3,000 of borrowed money. In the early days of the twentieth century, Durant realized that the horseless carriage would soon supplant his company’s product. Over the next few years, Durant invested much of his personal wealth in several automobile manufacturers, most notably the Buick Motor Company. In 1908, Durant merged those companies to create General Motors Corporation (GM).

For 77 years, from 1931 through 2008, GM reigned as the number one automobile manufacturer worldwide. Only a few months after that long run ended, GM, just like Billy Durant some seven decades earlier, filed for bankruptcy.1 GM’s bankruptcy fil- ing in June 2009 had been foreshadowed by the going-concern audit opinion issued on its 2008 financial statements a few months earlier by Deloitte & Touche, its long- time audit firm.

Pensions & Panic Similar to many companies, GM was victimized by the economic crisis triggered in late 2008 by collapsing housing prices and the implosion of the subprime sec- tor of the mortgage industry. That crisis quickly spread to other sectors of the U.S.

1. After losing control of General Motors in the early 1920s, Billy Durant became preoccupied with “playing” the stock market. The stock market crash of 1929 wiped out Durant’s massive wealth and eventually forced him to file for bankruptcy.

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240 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

economy, including the large automotive industry. Panic and fear caused millions of distraught U.S. consumers to delay or cancel “big-ticket” discretionary expenditures, such as purchases of new automobiles.

Well before the economic crisis that gripped the country in 2008 and 2009, GM’s finan- cial condition had been deteriorating. The generous pensions that the company histori- cally paid to its former workers and executives, such as Billy Durant, were a key factor that contributed to GM’s declining health. Wage freezes implemented during World War II by the federal government had prompted many companies, including GM, to estab- lish an employee pension plan—or expand an existing one—to give their employees a legal pay “raise.” The retirement benefits provided by those pension plans became increasingly lucrative during the latter half of the twentieth century due largely to the effective negotiation skills of such labor unions as the United Auto Workers (UAW).

The large expenses stemming from GM’s pension plan and other postretirement benefit plans added significantly to the company’s cost of producing automobiles. Because foreign competitors such as Toyota paid more modest wages and provided their employees with less liberal pension and other postretirement benefits, they could produce automobiles more cheaply than GM. Over time, this economic disadvantage caused the annual sales of GM to shrink as car buyers gravitated to foreign models. In 2009, Toyota finally overtook GM as the world’s largest automobile producer.

Easily one of the most controversial issues surrounding GM’s financial problems in early 2009 was what would happen to the company’s huge and significantly under- funded pension plan if the company failed. Nearly 500,000 GM retirees or surviv- ing spouses received monthly pension payments financed by the company. The majority of those individuals relied on their GM pension as the principal source of their retirement income. Likewise, the approximately 250,000 active GM employees had built their retirement plans around the pension benefits promised to them by their employer. What frightened GM’s retirees and employees was that the present value of the liabilities associated with GM’s pension plan were estimated to exceed $100 billion while the pension plan had total assets of only $85 billion. As the company tottered on the verge of bankruptcy, it was unclear how, or whether, the pension plan would be salvaged if the company filed for bankruptcy.

Pension Accounting: A Brief History GM’s impending bankruptcy in early 2009 refocused attention on long-standing alle- gations that top management manipulated the company’s financial data to conceal its deteriorating financial condition and operating results. The company’s critics included Maryann Keller, a longtime analyst of the automotive industry who two decades earlier had published a book entitled Rude Awakening: The Rise, Fall, and Struggle for Recovery of General Motors (HarperCollins, 1990). Keller suggested that GM management routinely “juggled” the company’s accounting numbers to conceal its serious financial problems. Among the financial statement items that GM man- agement allegedly distorted were the expenses and liabilities associated with the company’s enormous pension plan.

In fairness to GM, a large number of companies have faced similar allegations, that is, charges that they “manage” their reported earnings and apparent financial condi- tion by improperly accounting for their employee pension plans. In fact, accounting for pension-related financial statement items has long been one of the most complex and controversial issues facing the accounting profession.

Prior to the mid-1960s, most companies accounted for their pension plan expenses on a pay-as-you-go or cash basis. In addition to simply ignoring the long-term liabili- ties associated with pension plans, a major drawback to this accounting method was

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CASE 2.4 GENERAL MOTORS COMPANY 241

that it allowed companies to readily and legally manipulate their reported earnings by varying the amounts they contributed each year to their pension plans. For example, if a company was having a poor year profit-wise, it could simply reduce its pension plan contribution and thus reduce its pension expense for the year.

Accounting for pension plan–related expenses and liabilities did not change dra- matically until 1985 when the Financial Accounting Standards Board (FASB) adopted a new accounting standard that moved the profession toward accrual basis account- ing for those items. However, this new standard, Statement on Financial Accounting Standards No. 87 (SFAS No. 87), “Employers’ Accounting for Pensions,” still provided opportunities for companies to window-dress their financial statements.

SFAS No. 87 required companies for the first time to make several key assumptions in accounting for financial statement items associated with a defined-benefit pen- sion plan, similar to the one that GM provided to its employees.2 Critics of the new standard argued that since these assumptions were “discretionary,” they could be easily “manipulated” by corporate executives hoping to make their company’s finan- cial statements more impressive.3 Among the most important of these assumptions was the discount rate used to determine the present value of a company’s pension liability. This choice had important financial statement implications, particularly for labor-intensive companies with huge pension plans, such as GM. For example, a company could raise or lower—most likely the latter—the present value of its pension liability by varying the discount rate it applied to those liabilities.4

Rate Debates In late 2002, GM faced an unpleasant predicament. Falling stock market prices were driving down the value of the assets held by its pension plan, while falling interest rates were increasing the present value of its pension liability. These two conditions were causing the unfunded portion of GM’s pension liability and the company’s pro- jected pension expense under SFAS No. 87 to increase dramatically.

During the final few months of 2002, several GM executives, including the com- pany’s chief financial officer (CFO), chief accounting officer (CAO), and controller, agonized over the decision of which discount rate to apply to the company’s pen- sion liability. Those executives recognized that the choice of that discount rate would have a material impact on GM’s reported operating results and financial condition. SFAS No. 87 obligated GM to choose the most reasonable discount rate to apply in computing the present value of its pension liability but did not specify how that discount rate was to be chosen. The mathematical method historically used by the company produced a discount rate of 6.0 percent. As in years past, the company also asked its actuarial firm to develop an independent estimate of the appropriate discount rate to apply to its pension liability. GM’s actuarial firm reported that its mathematical modeling suggested that a 6.18 percent discount rate was appropriate.

2. Recognize that a company’s pension plan is nearly always a legal entity independent of the company that created it. The issue in this context is not the actual accounting for a pension plan but rather the accounting for pension plan–related financial statement amounts of the given employer or “sponsor” of that plan. 3. Audit Integrity (www.auditintegrity.com), “Pension Liabilities: The Elephant in the Room,” March 2009. 4. Addressing the specific features and requirements of pension accounting is beyond the scope of this case. Refer to any intermediate accounting text for a comprehensive treatment of that topic. In 2006, the FASB replaced SFAS No. 87 with SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” Following the issuance of SFAS No. 158, the FASB has continued to debate and consider additional modifications to its pension accounting guidelines and rules.

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242 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

Instead of using either a 6.0 percent or 6.18 percent discount rate, GM’s executives chose a discount rate of 6.75 percent to apply to the company’s pension liability. This latter discount rate was not produced by a rigorous mathematical model but rather by simply averaging the interest rates on a relatively small sample of high-quality corporate bonds tracked by the Moody’s investment service. In fact, the actual aver- age interest rate of the sample used by the executives to arrive at the 6.75 percent discount rate was 6.63 percent. (When choosing a discount rate, GM “rounded” the given estimate of that rate to the nearest quarter of a percent.)

By the first week of January 2003, Deloitte’s audit of GM’s 2002 financial statements was well under way. On 7 January 2003, Deloitte auditors met with representatives of the GM department responsible for developing the discount rate to apply to the com- pany’s pension liability. At that meeting, the GM representatives presented the three point estimates of the discount rate that had been considered and the source of each of those estimates. Their principal justification for choosing the 6.75 percent point estimate was that “most companies”5 were relying on the Moody’s database of inter- est rates to choose the discount rate to apply to their pension liability. The Securities and Exchange Commission (SEC) subsequently challenged that assertion. The federal agency also maintained that GM officials had made no effort to determine whether the companies actually using the Moody’s data were “demographically similar to GM” and thus a valid sample to use in supporting the company’s decision to rely on that source.

Following the 7 January 2003, meeting, the Deloitte auditors informed client per- sonnel that they would begin their review of the company’s decision to apply the 6.75 percent discount rate. The auditors also informed the client that a second meet- ing to discuss the issue would be necessary. Finally, the auditors noted that their initial impression was that the 6.75 percent discount rate was too high.

A few days later, the Deloitte auditors asked to meet again with the client to discuss the 6.75 percent discount rate. Deloitte insisted that representatives of GM’s actu- arial firm attend this second meeting. GM’s controller also attended this meeting. Following this second meeting, the controller told GM’s CFO and CAO that the Deloitte auditors were “now resigned to our use of 6.75%.”

GM personnel at this second meeting apparently convinced the Deloitte auditors to accept the 6.75 percent rate by pledging to include a “sensitivity analysis in the com- pany’s 2002 Form 10-K.” This supplemental disclosure would supposedly illustrate the impact of an array of discount rates on GM’s pension-related financial statement items. In an intercompany communication, GM’s controller told the CFO and CAO that a Deloitte audit partner accepted this compromise as a “reasonable although imperfect solution or compromise to his concerns.” Despite agreeing to the com- promise solution proposed by GM, the Deloitte partner believed that a 6.50 percent discount rate would have been a “better choice.” Deloitte subsequently issued an unqualified audit opinion on GM’s 2002 financial statements.

GM filed its 2002 Form 10-K with the SEC on 13 March 2003. As the company had pledged to Deloitte, it included a sensitivity analysis in the 10-K relevant to its choice of the 6.75 percent discount rate. That analysis disclosed what GM’s pension expense and total pension liabilities would have been for both a 6.5 percent and 7.0 percent dis- count rate. If the 6.5 percent discount rate had been applied, the company’s pension expense for 2002 would have increased by $120 million, which would have lowered its pretax earnings by approximately 6 percent. Likewise, the choice of a 6.5 percent

5. The remaining quotes in this case were taken from the following source: Securities and Exchange Commission v. General Motors Corporation, Case 1:09-cv-00119, U.S. District Court for the District of Columbia, 22 January 2009.

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CASE 2.4 GENERAL MOTORS COMPANY 243

discount rate would have increased GM’s total pension liability reported on its bal- ance sheet by approximately 10 percent or $1.8 billion and would have reduced the company’s stockholders’ equity by approximately 16 percent or $1.1 billion.6

In a subsequent complaint filed against GM by the SEC in January 2009, the fed- eral agency maintained that the pension-related amounts and disclosures within the company’s 2002 financial statements were “materially misleading.” The SEC was par- ticularly concerned by GM’s lack of candor in the sensitivity analysis that it presented for its selected pension discount rate. Since that analysis disclosed the financial state- ment impacts of using 6.5 and 7.0 percent discount rates, it implied that the selected discount rate of 6.75 percent was near the midpoint of the discount rates that had been considered by the company, which was not the case. The SEC also criticized GM for failing to disclose that an unconventional method had been used to select the 2002 discount rate.

6. In its 2002 Form 10-K, GM reported total assets of $370.8 billion, total liabilities of $364 billion, and total stockholders’ equity of $6.8 billion. 7. On 17 November 2010, General Motors Company went public. On that day, trading in GM’s stock accounted for nearly 10 percent of the trading volume on the New York Stock Exchange. The federal gov- ernment eventually recovered the majority of the funds invested in GM by selling its ownership interest in the company.

E P I L O G U E In late January 2009, the SEC issued Accounting and Auditing Enforcement Release No. 3033 that disclosed a litany of accounting and financial reporting abuses by GM over the previous sev- eral years. The principal focus of that document was the improper decisions that the company had made in accounting for its pension-related expenses and liabilities. Without admitting or denying the charges, GM agreed to a consent decree under which the SEC enjoined the com- pany from any future violations of federal secu- rities laws. The SEC did not sanction Deloitte for its role in GM’s pension accounting debacle.

Six months after being sanctioned by the SEC, GM emerged from bankruptcy as the “new” General Motors or “General Motors Company.” Following GM’s reorganization, the

federal government was its largest stockholder as a result of investing nearly $60 billion in the company through the Troubled Asset Relief Program (TARP).7 Fortunately for GM’s retir- ees and workforce, the bankruptcy reorgani- zation plan left the company’s huge pension plan intact. In 2012, GM announced a series of measures to reduce its pension plan liabili- ties. Those measures included offering a lump sum settlement to certain former employees to liquidate GM’s pension obligation to them and purchasing a group annuity from Prudential Insurance Company to cover the future pen- sion payments to a group of existing and for- mer employees. These two measures alone reduced GM’s outstanding pension obligations by approximately 25 percent.

Questions 1. Auditing standards don’t specifically discuss the audit procedures that should

be applied to a client’s pension-related financial statement amounts. Identify five audit procedures that would be relevant to those items. For each audit procedure that you list, identify the related audit objective.

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244 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

2. Under what general circumstances should auditors retain outside experts to assist them in completing an audit? How could an expert be useful in auditing a client’s pension-related financial statement items?

3. Do you believe that Deloitte behaved properly by accepting GM’s decision to apply a 6.75 percent discount rate to its pension liabilities? What, if any, other steps or measures should Deloitte have taken under the circumstances?

4. Did the choice of the 6.75 percent discount rate in 2002 have a material impact on GM’s financial statements? Defend your answer.

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245

CASE 2.5

Lipper Holdings, LLC

Over the past few decades, hedge funds have become among the most controversial and largest investment vehicles on Wall Street. Critics of hedge funds argue that their high-risk investment strategies contributed significantly to the economic crisis that gripped the world’s capital markets beginning in late 2008. Prior to that crisis, the total market value of investments held by hedge funds was estimated to be a stagger- ing $2.5 trillion.

In fact, pegging the total value of hedge funds at any point in time is a difficult task since there is a lack of consensus among even Wall Street experts on exactly which investment funds qualify as “hedge funds.” Hedge funds are generally thought of by lay investors as investment funds that use sophisticated risk management techniques to limit the downside risk of the investments that they hold. Many hedge funds, how- ever, do just the reverse. These latter funds employ investment strategies, such as buying and selling a wide range of exotic financial derivatives, that serve to increase, rather than decrease, the overall risk of their investment portfolios.

The two traits that most commonly cause an investment fund to be labeled a “hedge fund” are minimal regulatory oversight and the payment of “performance fees” to the fund managers. Many hedge funds are domiciled in offshore tax havens, such as the Cayman Islands, that impose little regulatory oversight on investment companies, banks, and related entities. Hedge funds headquartered in the United States typically have a legal structure that allows them to avoid intense scrutiny by the Securities and Exchange Commission (SEC) and other federal and state regulatory authorities.

In addition to the annual management fees that most investment fund managers are paid, the managers of hedge funds collect performance fees equal to a certain percentage of their fund’s profit each year. These performance fees vary consider- ably from fund to fund but range as high as 20 percent. Critics of hedge funds, such as renowned investor Warren Buffett, maintain that performance fees encourage fund managers to adopt high-risk, if not reckless, investment strategies, which would explain why many hedge funds specialize in “junk bonds” and “distressed” corpo- rate securities.1

Hedge Funds and Hollywood During the 1990s, Kenneth Lipper emerged as a leader of the rapidly growing hedge fund “industry” in the United States. Born in 1941, Lipper, the son of a shoe sales- man, spent his childhood in a modest working-class neighborhood in New York City’s South Bronx. As an adolescent, he enjoyed a wide range of interests, including sports, movies, and the stock market. Unlike his childhood friend, Alfredo “Sonny” Pacino, Lipper decided as a young adult to pursue a career on Wall Street rather than in Hollywood—at least initially.

Lipper was a brilliant student who relied on academic scholarships to finance an undergraduate degree at Columbia, a law degree at Harvard, and a master’s degree from the New York University School of Law before pursuing postgraduate studies

1. Increasing the risk preference of hedge fund managers is the fact that they do not absorb any portion of a net loss suffered in a given year by a fund that they manage.

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246 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

at the University of Paris. The charismatic Lipper developed an impressive list of wealthy and well-connected friends and acquaintances during his college years.

In 1966, when he was 25 years old, Lipper married the daughter of one of New York’s richest philanthropists. That marriage placed Lipper’s Wall Street career on the “fast track, according to Business Week.”2 Shortly thereafter, he joined the presti- gious Wall Street firm of Lehman Brothers; by the age of 32, Lipper was among that firm’s youngest partners.

Lipper left Lehman in 1975 to become a partner and managing director of a com- peting firm, Salomon Brothers. His bright career was briefly derailed when the SEC accused him of aiding and abetting violations of the federal securities laws in a covert attempt to take over a large public company. Lipper settled those charges without admitting or denying any wrongdoing and escaped with only mild sanctions being imposed on him by the federal agency.

In 1983, one year after settling the SEC charges, Lipper took a sabbatical from the world of high finance to serve as deputy mayor of New York City. After three years in New York City’s rough-and-tumble political arena, Lipper became involved in a Hollywood film project being developed by Oliver Stone. The famous movie director tapped Lipper to serve as a technical advisor for the film Wall Street starring Michael Douglas and Charlie Sheen. Following the release of the Academy Award–winning movie, Lipper wrote a novel of the same name based upon the film’s screenplay.

Over the next two decades, Lipper lived a high-profile, bicoastal lifestyle in which he was a mainstay in both the West Coast’s glitzy movie industry and Wall Street’s economic powerhouse some 3,000 miles away. In Hollywood, Lipper enjoyed a suc- cessful career as a screenwriter and film producer and even collaborated with his old friend Al Pacino on a major film project.3 At the same time, Lipper oversaw a burgeoning financial empire on the East Coast through his investment firm, Lipper Holdings, LLC, that he organized in the late 1980s. Lipper’s firm, for which he served as both president and chief executive officer (CEO), would eventually manage invest- ments having a total market value exceeding $4 billion dollars.

Lipper’s network of influential friends on both coasts served as a pipeline of cli- ents to his Wall Street firm. Julia Roberts, Sylvester Stallone, and Disney CEO Michael Eisner were among the many Hollywood luminaries for whom Lipper served as a financial advisor. One-time presidential candidate U.S. Senator Fritz Hollings, for- mer Federal Reserve Chairman Paul Volcker, and Lipper’s former boss Ed Koch, the longtime and very popular mayor of New York City, were among the political heavyweights that entrusted much of their wealth to Lipper’s firm. As Business Week reported, “The flashy pitchman [Kenneth Lipper] with his fancy connections and wealth was a magnet for investors who never questioned his ability to manage their money. . . . These were . . . people who were wowed by his blue-chip Wall Street credentials.”4

Lipper delegated the day-to-day responsibility of managing his firm’s investment funds to subordinates. One of his principal subordinates was Edward Strafaci, an executive vice president of Lipper Holdings. Strafaci served as the portfolio man- ager for three large hedge funds within the family of Lipper investment funds. Those three hedge funds were Lipper Convertibles, Lipper Convertibles Series II, and Lipper

2. M. Vickers, “The Fallen Financier,” Business Week (online), 9 December 2002. 3. In 1999, Lipper received an Oscar for his role as the producer of The Last Days, a documentary film focusing on the Holocaust. Al Pacino played the lead role in City Hall, a 1996 feature film produced by Lipper. 4. Vickers, “The Fallen Financier.”

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CASE 2.5 LIPPER HOLDINGS, LLC 247

Fixed Income Fund. Each of the funds had been legally structured so that they were not required to register with the SEC as investment companies under the Investment Company Act of 1940. Because Lipper Convertibles and Lipper Convertibles Series II were legally “broker-dealers,” however, they were required to file annual audited financial statements with the SEC pursuant to the requirements of the Securities Exchange Act of 1934.

Strafaci used financial leverage to enhance the rates of return earned by the investors in the three hedge funds, that is, he arranged for the funds to borrow large amounts of cash that were then invested along with the equity capital of the investors. This financial leverage caused the rates of return earned by investors to be considerably higher than the returns earned on the funds’ investment portfo- lios. Of course, the use of financial leverage also meant that when the funds suf- fered losses in a given year, the corresponding losses of the funds’ investors were magnified.

The marketing materials Lipper’s firm used to promote his hedge funds reported that 70 percent of their holdings were high quality, “investment grade” securities. In fact, the actual percentage of investment grade securities held by the three hedge funds was considerably lower than that figure. To ensure that the funds contin- ued to attract new investors, Strafaci believed it was imperative for them to earn impressive rates of return. Because investment grade securities didn’t yield such returns, he invested an increasingly large percentage of the hedge funds’ assets in high-risk, high-return securities. These securities were typically convertible bonds and convertible preferred stocks issued by companies experiencing financial problems.

“Recipe for Fraud” When the volatile securities that Strafaci purchased for Lipper’s hedge funds failed to produce the rates of return that he wanted, he began intentionally overstating their reported market values to achieve those desired returns. In January 2002, Strafaci resigned his lucrative position with Lipper Holdings. His unexpected resignation prompted an internal investigation over the following several weeks that led to the discovery of his fraudulent scheme.

In late February 2002, Lipper Holdings publicly reported that the market values of the investments held by the three hedge funds formerly managed by Strafaci had been overstated. When those investments were reflected at their true market values, the investors in the largest of the three funds, Lipper Convertibles, realized a nearly 50 percent reduction in their equity capital. More modest but still significant losses were suffered by the investors in Lipper’s two other hedge funds.

Subsequent investigations by regulatory and law enforcement authorities revealed that Strafaci had personally supervised the “marking to market” of the investments held by the three hedge funds that he managed.5 This revelation caused a prominent Wall Street money manager to point out that most hedge fund managers use an inde- pendent third party to value their investment portfolios and that allowing “insiders” to do so was a “recipe for fraud.”6

When the overstatements of the Lipper hedge funds’ investments were initially reported, Edward Strafaci vehemently denied any involvement in, or knowledge of, them. Instead, Strafaci laid the blame for the misstatements squarely on the shoulders

5. Many of these securities were “thinly traded” securities for which readily determinable market values were not available. 6. Vickers, “The Fallen Financier.”

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248 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

of his former boss, Kenneth Lipper. “We [Strafaci and his subordinates] don’t bear any responsibility at all. Clients have to go to Ken Lipper if they’re mad—he was the CEO.”7

In August 2004, Strafaci did a sudden about-face. Strafaci pleaded guilty to fraudu- lently overstating the collective value of the investments he had managed for Lipper’s hedge funds and subsequently received a six-year prison sentence. He was also ordered by a federal judge to pay restitution of nearly $90 million. Despite Strafaci’s guilty plea, many parties, including former Lipper investors, maintained that Kenneth Lipper was ultimately responsible for the huge losses suffered by the Lipper hedge funds.

Lipper most likely knew these traders were mispricing the portfolio and juicing the returns all along. But he was so concerned with his reputation and impressing his celeb- rity clients that he allowed it, until they just got too deep to recover. It was pure hubris.8

Auditors Miss the “Mark” While federal prosecutors dogged Edward Strafaci and Kenneth Lipper, PricewaterhouseCoopers (PwC), Lipper’s longtime audit firm, was being investigated by the SEC for failing to uncover the grossly overstated values of the investments held by the Lipper hedge funds. Particularly galling to the hedge fund investors was the allegation that those overstatements should have been readily apparent to the auditors. Making the situation even less palatable for the investors was the fact that Lipper Holdings had cho- sen PwC to audit its three hedge funds in part because of that firm’s “touted expertise with respect to hedge funds and valuation of hard-to-price securities.”9,10

The principal focus of the SEC’s investigation of PwC was the firm’s 2000 audits of the three Lipper hedge funds, the final audits completed by PwC prior to the discov- ery of the accounting fraud. The primary individual targeted by the federal agency during that investigation was Larry Stoler. Stoler became a partner with PwC’s prede- cessor firm, Price Waterhouse, in 1980 and retired from the firm in 2002, shortly after the Lipper scandal surfaced. With the exception of two years in the mid-1990s, Stoler served as the audit engagement partner for each of the three Lipper hedge funds from 1989 through the collapse of those funds in early 2002. During the two years that he was not the audit engagement partner, Stoler had served as the concurring partner on the audits of those funds.

During its investigation of PwC’s 2000 audits, the SEC discovered that Stoler had for several years been aware of internal control weaknesses that should have “height- ened [PwC’s] scrutiny of the valuation of their [the hedge funds’] investments.” Most importantly, Stoler had been aware that Edward Strafaci personally supervised the marking to market of the hedge funds’ investments each year and that there was no “formal review” of that process by another credible party.

The most important audit procedures applied by PwC during its 2000 audit of the Lipper hedge funds were the audit tests intended to determine whether the funds’ major investments were appropriately valued at year-end.11 According to the SEC,

7. Ibid. 8. Ibid. 9. Lipper actually retained the predecessor firm of PwC, Price Waterhouse, as the auditor of the three hedge funds. In 1998, Price Waterhouse merged with Coopers & Lybrand to create PwC. 10. This and all subsequent quotations, unless indicated otherwise, were taken from the following source: Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 2470, 31 July 2006. 11. These audit procedures were applied to the investments held by the Lipper Convertibles hedge fund, the largest of the three Lipper hedge funds. The investment portfolios of the other two hedge funds consisted of subsets of the securities held by Lipper Convertibles.

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CASE 2.5 LIPPER HOLDINGS, LLC 249

the basis for the values assigned to those investments by Strafaci was allegedly 31 December 2000, price quotes that he had received directly from a sample of the brokers that executed securities trades for the three hedge funds. PwC’s audit work- papers, however, did not include copies of the documents containing those alleged price quotes or any evidence that the auditors had reviewed those documents.

The initial audit procedure applied to the year-end securities prices of the hedge funds’ investments involved a review of the 31 December 2000, statements obtained by the auditors from the brokers actually holding those investments on that date on behalf of the funds. These prices were inconsistent with the market prices that had been applied to the investments by Strafaci. According to the SEC, Stoler did not discuss these inconsistencies “with anyone at Lipper Holdings,” nor did the PwC workpapers indicate how these inconsistencies were resolved.

PwC’s workpapers documented the fact that the year-end market values of the hedge funds’ investments appeared to be overstated given the results of the initial audit test. For Lipper Convertibles the apparent overstatement was approximately 13 percent. However, this amount “ignored the impact of leverage on the portfolio” of that fund. If the auditors had considered the impact of that leverage, they would have determined that the apparent errors made by Strafaci in marking to market Lipper Convertibles’ investments had overstated the equity capital of the fund’s investors “by approximately 48%.”

The PwC auditors also used year-end market prices reported by the Bloomberg investment service “to obtain an independent price for 65% of the total market value positions held at 12/31/00” by the Lipper hedge funds. This audit procedure resulted in the auditors once again discovering apparent overstatements in the year-end mar- ket values of the hedge funds’ investments. PwC’s audit program called for the inves- tigation of any “significant variances” between the year-end Bloomberg prices and the prices applied by Strafaci to those investments.

Any Bloomberg prices that were “greater than 2% of what Lipper Convertibles has recorded” were to be “independently confirmed” by “directly contacting” the brokers with whom Convertibles traded and from whom Strafaci purportedly obtained the quotes on which he based his values for the securities “so that they may confirm the price of the positions.”

This follow-up audit procedure involved a junior auditor assigned to the PwC audit team sending faxes to salespersons at five broker-dealers used by the Lipper hedge funds. These faxes included a schedule of all the securities prices used by Strafaci to mark the hedge funds’ investments to market at 31 December 2000. The faxes asked the recipients to “Please verify the attached schedule of broker quotes as of 12/31/00 were [sic] provided by you to Lipper Convertibles.” The faxes also instructed the recipients to sign the schedules and fax them back to the auditor.

Representatives of four of the five brokers signed the schedules and faxed them back to the junior auditor “without any notation or comments.” PwC considered these four returned faxes to be “clean confirmations” of the year-end market prices applied by Strafaci. The fifth returned fax was unsigned and included notations indi- cating that several of the market prices were significantly higher than the actual year- end prices of the given securities.

The SEC charged that PwC’s confirmation audit procedure was “flawed in sev- eral significant respects.” For example, the faxed confirmations did not specifically instruct the recipients to “provide quotes for the specified securities or ask them to attest to the reasonableness of the values listed on the schedules.” As a result, with the exception of the one broker-dealer representative who questioned several of the market prices included in the confirmation, there was no evidence “that the

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250 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

salespeople who returned signed confirmations had actually ascertained the broker- dealer’s quote or valued the security.” In fact, in some cases, the given broker-dealers did not make a market in certain securities listed on the confirmation and thus had no basis for attesting to the year-end market prices of those securities.

12. Although Stoler had retired in 2002, in its 2006 enforcement release the SEC suspended his right to practice before it for one year. 13. Kirby McInerney LLP, “Lipper Convertibles, L.P.,” http://kmslaw.us/news.asp?type=cases&id=32. 14. Kenneth Lipper was not sanctioned by the SEC following its investigation of Edward Strafaci’s fraud- ulent scheme nor was he criminally indicted for any role in that scheme. 15. SmartPros (online), “SEC Votes to Force Public Disclosures from Hedge Funds,” 23 June 2011, http://accounting.smartpros.com/x72218.xml. 16. Ibid.

E P I L O G U E In a July 2006 enforcement release, the SEC reported that “most” of the relevant audit evi- dence collected by PwC during its 2000 audit of Lipper’s hedge funds “indicated that Strafaci’s valuation of the Funds’ assets were substan- tially overstated.” For that reason, the federal agency ruled that the unqualified audit reports on the funds’ financial statements, reports signed by Larry Stoler, were unjustified.

Stoler ignored, discounted, or failed to apprise himself of, the evidence produced by the audit tests. . . . Thus, he ailed to obtain sufficient competent evidential matter concerning the valuation of the Funds’ assets, and failed to adequately supervise the assistants working on the audit.

Accompanying the 2000 audited financial statements filed with the SEC by the Lipper Convertibles and Lipper Convertibles Series II hedge funds were supplemental reports on their internal controls prepared by PwC, reports mandated at the time for broker-dealers reg- istered with the federal agency. The reports, signed by Stoler, indicated that PwC had uncov- ered no material weaknesses in the two hedge funds’ internal controls. In its 2006 enforcement release, the SEC ruled that the latter conclusion was “inaccurate.”

The SEC sanctioned Larry Stoler for failing to comply with generally accepted auditing stan- dards (GAAS) during the 2000 audits of Lipper Holdings’ three hedge funds.12 According to the

SEC, Stoler was “a cause” of the funds’ viola- tions of the federal securities laws.

The Funds’ audited financial statements for the year ended December 31, 2000, were dis- seminated to investors/clients and prospective investors/clients, along with PwC’s unquali- fied audit reports on those statements. PwC’s unqualified audit reports on those statements gave comfort to investors/clients, among others, that the Funds were being properly valued. Investors/clients who received those audited financial statements were solicited to make, and in some cases made, investments or additional investments in the Funds.

The three Lipper hedge funds audited by Stoler and his subordinates were liquidated by Lipper Holdings beginning in 2002. Those forced liqui- dations resulted in hundreds of millions of dollars of losses for the funds’ investors. Numerous civil lawsuits stemming from the Lipper scandal were filed by the investors or their representatives. One of the largest of those lawsuits was filed against PwC by a court-appointed bankruptcy trustee. According to published reports, that lawsuit was settled in 2010 when PwC agreed to pay $29.9 million to the former Lipper investors.13,14

In 2011, the SEC adopted measures to make hedge funds “a bit less mysterious.”15 The new measures required many hedge funds to dis- close “potential conflicts of interest,” “general information about their size and ownership,” and the identity of their independent auditors.16

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CASE 2.5 LIPPER HOLDINGS, LLC 251

Questions 1. Identify specific fraud risk factors present during PwC’s audits of the Lipper

hedge funds. Explain how PwC should have responded to the fraud risk factors that you identified.

2. Provide examples of important audit objectives for complex financial instruments and transactions. For each audit objective that you identify, list one or more audit procedures that could be used to accomplish that objective.

3. Identify the factors that may have contributed to the alleged flaws in the audit procedures that PwC applied in testing the year-end market values of the Lipper hedge funds’ investments. Discuss specific measures that audit firms can employ to reduce the likelihood that such factors will undercut the quality of their audits.

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253

CASE 2.6

CBI Holding Company, Inc.

During the 1980s, CBI Holding Company, Inc., a New York–based firm, served as the parent company for several wholly owned subsidiaries, principal among them Common Brothers, Inc. CBI’s subsidiaries marketed an extensive line of pharmaceuti- cal products. The subsidiaries purchased these products from drug manufacturers, warehoused them in storage facilities, and then resold them to retail pharmacies, hospitals, long-term care facilities, and related entities. CBI’s principal market area stretched from the northeastern United States into the upper Midwest.

In 1991, Robert Castello, CBI’s president and chairman of the board, sold a 48 percent ownership interest in his company to Trust Company of the West (TCW), a diversified investment firm. The purchase agreement between the two parties gave TCW the right to appoint two members of CBI’s board; Castello retained the right to appoint the three remaining board members. The purchase agreement also identi- fied several so-called “control-triggering events.” If any one of these events occurred, TCW would have the right to take control of CBI. Examples of control-triggering events included CBI’s failure to maintain certain financial ratios at a specified level and unauthorized loans to Castello and other CBI executives.

Castello engaged Ernst & Young (E&Y) as CBI’s independent audit firm several months before he closed the TCW deal. During this same time frame, Castello was named “Entrepreneur of the Year” in an annual nationwide promotion cosponsored by E&Y. From 1990 through 1993, E&Y issued unqualified opinions on CBI’s annual financial statements.

Accounting Gimmicks Castello instructed several of his subordinates to misrepresent CBI’s reported oper- ating results and financial condition for the fiscal years ended 30 April 1992, and 1993.1 Those misrepresentations allowed Castello to receive large, year-end bonuses to which he was not entitled. CBI actively concealed the fraudulent activities from TCW’s management, from TCW’s appointees to CBI’s board, and from the company’s E&Y auditors because Castello realized that the scheme, if discovered, would qualify as a control-triggering event under the terms of the 1991 purchase agreement with TCW. Several years later in a lawsuit prompted by Castello’s fraud, TCW executives testified that they would have immediately seized control of CBI if they had become aware of that scheme.

Understating CBI’s year-end accounts payable was one of the methods Castello and his confederates used to distort CBI’s 1992 and 1993 financial statements. At any point in time, CBI had large outstanding payables to its suppliers, which included major pharmaceutical manufacturers such as Burroughs-Wellcome, Schering, and FoxMeyer. At the end of fiscal 1992 and fiscal 1993, CBI understated payables due to its large vendors by millions of dollars. Judge Burton Lifland, the federal magistrate who presided over the lawsuit stemming from Castello’s fraudulent scheme, ruled that the intentional understatements of CBI’s year-end payables were very material to the company’s 1992 and 1993 financial statements.

1. Due to a change in CBI’s fiscal year, the company’s 1992 fiscal year was only 11 months.

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254 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

E&Y’s 1992 and 1993 CBI Audits In both 1992 and 1993, E&Y identified the CBI audit as a “close monitoring engage- ment.” The accounting firm’s audit manual defined a close monitoring engagement as “one in which the company being audited presents significant risk to E&Y . . . there is a significant chance that E&Y will suffer damage to its reputation, monetarily, or both.”2 E&Y’s workpapers for the 1992 and 1993 audits also documented several “red flags” suggesting that the engagements posed a higher-than-normal audit risk.

Control risk factors identified for the CBI audits by E&Y included the dominance of the company by Robert Castello,3 the absence of an internal audit function, the lack of proper segregation of duties within the company’s accounting department, and aggressive positions taken by management personnel regarding key accounting estimates. These apparent control risks caused E&Y to describe CBI’s control envi- ronment as “ineffective.” Other risk factors identified in the CBI audit workpapers included the possible occurrence of a control-triggering event, an “undue” emphasis by top management on achieving periodic earnings goals, and the fact that Castello’s annual bonus was tied directly to CBI’s reported earnings.

For both the 1992 and 1993 CBI audits, the E&Y engagement team prepared a document entitled “Audit Approach Plan Update and Approval Form.” This document described the general strategy E&Y planned to follow in completing those audits. In 1992 and 1993, this document identified accounts payable as a “high risk” audit area. The audit program for the 1992 audit included two key audit procedures for accounts payable:

a. Perform a search for unrecorded liabilities at 30 April 1992, through the end of fieldwork.

b. Obtain copies of the 30 April 1992, vendor statements for CBI’s five largest vendors, and examine reconciliations to the accounts payable balances for such vendors as shown on the books of CBI.

The 1993 audit program included these same items, although that program required audit procedure “b” to be applied to CBI’s 10 largest vendors.

During the 1992 audit, the E&Y auditors discovered numerous disbursements made by CBI in the first few weeks of fiscal 1993 that were potential unrecorded liabilities as of 30 April 1992. The bulk of these disbursements included payments to the company’s ven- dors that had been labeled as “advances” in the company’s accounting records. CBI per- sonnel provided the following explanation for these advances when questioned by the auditors: “When CBI is at its credit limit with a large vendor, the vendor may hold an order until they receive an ‘advance.’ CBI then applies the advance to the existing A/P balance.”

In truth, the so-called advances, which totaled nearly $2 million, were simply pay- ments CBI made to its vendors for inventory purchases consummated on, or prior to, 30 April 1992. Castello and his confederates had chosen not to record these transac- tions—their purpose being to strengthen key financial ratios of CBI at the end of fiscal 1992 and otherwise embellish the company’s apparent financial condition. The conspirators developed the advances ruse because they feared that E&Y would dis- cover the material understatements of accounts payable at year-end.

Subsequent court testimony revealed that after reviewing internal documents sup- porting the advances explanation—documents that had been prepared to deceive

2. This and all subsequent quotes were taken from the following court opinion: In re CBI Holding Company, Inc., et al., Debtors; Bankruptcy Services, Inc., Plaintiff— against—Ernst & Young, Ernst & Young, LLP, Defendants; 247 B.R. 341; 2000 Bankr. LEXIS 425. 3. The CBI audit engagement partner noted during the 1993 audit that the company’s CFO appeared to be “afraid of his boss, Castello.” When questioned by an auditor regarding an important issue, the CFO typically responded by telling the individual to “ask Castello.” In the audit partner’s view, this raised an “integrity red flag.”

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CASE 2.6 CBI HOLDING COMPANY, INC. 255

E&Y—the E&Y auditors readily accepted that explanation and chose not to treat the items as unrecorded liabilities. This decision prompted severe criticism of the audit firm by Judge Lifland.

The federal judge pointed out that the auditors had failed to rigorously investigate the alleged advances and consider the veracity of the client’s explanation for them. For exam- ple, the auditors did not investigate the “credit limit” feature of that explanation. The E&Y auditors neglected to determine the credit limit that the given vendors had established for CBI or whether CBI had “maxed out” that credit limit in each case as maintained by client personnel. Nor did the auditors attempt to analyze the given vendors’ payable accounts or contact those vendors directly to determine if the alleged advances applied to specific invoice amounts, particularly invoice amounts for purchases made on or before 30 April 1992. Instead, the auditors simply chose to record in their workpapers the client’s feeble explanation for the advances, an explanation that failed to address or resolve a critical issue. “The advance explanation recorded in E&Y’s workpapers, even if it were true, did not tell the E&Y auditor the essential fact as to whether the merchandise being paid for by the advance had been received before or after April 30, 1992.”

Because of the lack of any substantive investigation of the advances, the E&Y audi- tors failed to determine “whether a liability should have been recorded for each such payment as of fiscal year-end, and whether, in fact, a liability was recorded for such payment as of fiscal year-end.” This finding caused Judge Lifland to con- clude that E&Y had not properly completed the search for unrecorded liabilities. The judge reached a similar conclusion regarding the second major audit procedure for accounts payable included in the 1992 audit program for CBI.

The 1992 audit program required the E&Y auditors to obtain the year-end state- ments sent to CBI by the company’s five largest vendors and to reconcile the bal- ances in each of those statements to the corresponding balances reported in CBI’s accounting records. E&Y obtained year-end statements mailed to CBI by five of the company’s several hundred vendors and completed the reconciliation audit proce- dure. However, the vendors involved in this audit test were not the company’s five largest suppliers. In fact, E&Y never identified CBI’s five largest vendors during the 1992 audit. The federal judge scolded E&Y for this oversight and maintained that the “minimal” amount of testing applied by E&Y to the small sample of year-end vendor statements was “not adequate.”

The audit procedures that E&Y applied to CBI’s year-end accounts payable for fis- cal 1993 suffered from the same flaws evident during the firm’s 1992 audit. Similar to the previous year, CBI’s management attempted to conceal unrecorded liabili- ties at year-end by labeling subsequent payments of those amounts as “advances” to the given vendors. Once more, Judge Lifland noted that the “gullible” auditors readily accepted the explanation for these advances that was relayed to them by CBI personnel. As a result, the auditors failed to require CBI to prepare appropriate adjusting entries for approximately $7.5 million of year-end payables that the client’s management team had intentionally ignored.

The 1993 audit program mandated that E&Y obtain the year-end statements for CBI’s 10 largest vendors and reconcile the balances in those statements to the corre- sponding accounts payable balances in CBI’s accounting records. Again, E&Y failed to identify CBI’s largest vendors and simply applied the reconciliation procedure to a sample of 10 CBI vendors.4

4. The court opinion that provided the background information for this case did not indicate what cri- teria E&Y used to select the vendor accounts to which the reconciliation procedure was applied in the 1992 and 1993 audits.

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256 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

One of CBI’s 10 largest vendors was Burroughs-Wellcome. If the E&Y auditors had reconciled the balance due Burroughs-Wellcome in its year-end statement with the corresponding account payable balance in CBI’s accounting records, the auditors would have discovered that a $1 million “advance” payment made to that vendor in May 1993 was actually for an inventory purchase two weeks prior to 30 April 1993. This discovery would have clearly established that the $1 million amount was an unrecorded liability at year-end.

E&Y Held Responsible for CBI’s Bankruptcy In March 1994, E&Y withdrew its opinions on CBI’s 1992 and 1993 financial state- ments after learning of the material distortions in those statements that were due to Castello’s fraudulent scheme. Almost immediately, CBI began encountering difficulty obtaining trade credit from its principal vendors. A few months later in August 1994, the company filed for bankruptcy. In early 2000, Judge Lifland presided over a 17-day trial in federal bankruptcy court to determine whether E&Y would be held respon- sible for the large losses that CBI’s collapse inflicted on TCW and CBI’s former credi- tors. Near the conclusion of that trial, Judge Lifland ruled that E&Y’s conduct during the 1992 and 1993 CBI audits was the “proximate cause” of those losses.

The demise of CBI was a foreseeable consequence of E&Y’s failure to conduct its audits in fiscal 1992 and 1993 in accordance with GAAS, which was the cause of its failure to detect the unrecorded liabilities, which in turn foreseeably caused it to with- draw its opinions in March 1994. As direct and reasonably foreseeable consequences thereof, CBI’s vendors restricted the amount of credit available, CBI’s inventory and sales declined, its revenues declined, its value as a going concern diminished, and ultimately it filed for bankruptcy and was liquidated.

Judge Lifland characterized E&Y’s conduct as either “reckless and/or grossly negli- gent” and identified several generally accepted auditing standards that the account- ing firm violated while performing the 1992 and 1993 CBI audits. Although the bulk of the judge’s opinion dealt with the audit procedures E&Y applied to CBI’s accounts payable, his harshest criticism focused on the firm’s alleged failure to retain its inde- pendence during the CBI engagements.

Several circumstances that arose during E&Y’s tenure as CBI’s audit firm called into question its independence. For example, Judge Lifland referred to an incident in 1993 when Robert Castello demanded that E&Y remove the audit manager assigned to the CBI engagement. Apparently, Castello found the audit manager’s inquisitive and probing nature disturbing. The CBI audit engagement partner “submissively acquiesced” to Castello’s request and replaced the audit manager.

Shortly after the completion of the 1993 audit, Castello hired a new chief financial officer (CFO). This individual resigned eight days later. The CFO told members of the E&Y audit team he was resigning because of several million dollars of “grey account- ing” he had discovered in CBI’s accounting records. Judge Lifland chided E&Y for being slow to pursue this allegation. Nearly five months passed before the CBI audit engagement partner contacted the former CFO. By that point, E&Y had already discov- ered Castello’s fraudulent scheme and withdrawn its 1992 and 1993 audit opinions.

In February 1994, the audit engagement partner met with Castello to discuss sev- eral matters. E&Y’s unpaid bill for prior services provided to CBI was the first of those matters, while the second issue discussed was E&Y’s fee for the upcoming audit. The last topic on the agenda was the allegation by CBI’s former CFO regarding the com- pany’s questionable accounting decisions. According to Judge Lifland, the audit part- ner “wanted to speak to [the former CFO] in order to ask him whether his leaving the

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CASE 2.6 CBI HOLDING COMPANY, INC. 257

post of chief financial officer and his allegations of ‘grey accounting’ had anything to do with the financial statements that E&Y had just certified; however, [the audit partner] obligingly allowed himself to be put off.” In Judge Lifland’s opinion, the E&Y audit partner was “more concerned about insuring E&Y’s fees than he was about speaking to [the former CFO].”

The final matter Judge Lifland discussed in impugning E&Y’s independence was the accounting firm’s effort to retain CBI as an audit client after discovering that the 1992 and 1993 audits had been deficient. Judge Lifland charged that E&Y officials realized, when they withdrew the audit opinions on CBI’s 1992 and 1993 financial statements, that the CBI audits had been flawed. In the days prior to withdrawing those opinions, two individuals, a former CBI accountant and CBI’s controller at the time, informed E&Y that the “advances” discovered during the 1992 and 1993 audits had been for payment of unrecorded liabilities that existed at the end of CBI’s 1992 and 1993 fiscal years. After investigating these admissions, E&Y determined that they were true. E&Y also determined that the CBI auditors “had failed to detect the unrecorded liabilities because they had failed to properly perform the search [for unrecorded liabilities].”

E&Y failed to notify CBI’s board of directors of the flaws in the 1992 and 1993 audits.5 According to Judge Lifland, E&Y did not inform the board members of those flaws because the accounting firm realized that doing so would lower, if not elimi- nate, its chance of landing the “reaudit” engagement for CBI’s 1992 and 1993 finan- cial statements. “E&Y’s egocentric desire to get the reaudit work is illustrated by the fact that it prepared an audit program for the reaudit two days before E&Y met with the CBI board of directors and one day before they withdrew their opinion.”

CBI’s board ultimately selected E&Y to reaudit the company’s 1992 and 1993 finan- cial statements. Given the circumstances under which E&Y obtained that engage- ment, Judge Lifland concluded that the accounting firm’s independence was likely impaired. “Thus, E&Y knew prior to agreeing to perform the reaudit work that it had not complied with GAAS. E&Y also knew that CBI’s board of directors did not know of E&Y’s failure to comply with GAAS. It is reasonable to infer that if CBI’s board of directors knew of such failure, E&Y and CBI would be in adversarial positions.”6

Questions 1. Most of Judge Lifland’s criticism of E&Y focused on the firm’s audit procedures

for CBI’s accounts payable. Generally, what is the primary audit objective for accounts payable? Do you believe that E&Y’s two principal audit tests for CBI’s accounts payable would have accomplished that objective if those tests had been properly applied? Why or why not?

2. Do you believe that the E&Y auditors should have used confirmations in auditing CBI’s year-end accounts payable? Defend your answer. Briefly explain the differing audit objectives related to accounts receivable and accounts payable confirmation procedures and the key differences in how these procedures are applied.

5. At this point, the TCW representatives on CBI’s board were apparently the company’s principal decision-makers. 6. The plaintiffs in this case were initially awarded a judgment of approximately $70 million. E&Y appealed that judgment, an appeal that prompted what one legal expert referred to as a decade-long “epic battle” in the appellate courts. In late 2010, Judge Lifland brokered a settlement to end that court battle. The amount paid by E&Y to the plaintiffs to settle the case was apparently never reported publicly.

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258 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

3. In early 1994, E&Y officials discovered that the CBI auditors had failed to determine the true nature of the “advances” they had uncovered during the 1992 and 1993 audits. In your view, did E&Y have an obligation to inform CBI management of this oversight prior to seeking the “reaudit” engagement? More generally, does an auditor have a responsibility to inform client management of mistakes or oversights made on earlier audits?

4. Under what circumstances, if any, should an audit engagement partner acquiesce to a client’s request to remove a member of the audit engagement team?

5. E&Y officials believed that the CBI audits were high-risk engagements. Under what general circumstances should an audit firm choose not to accept a high- risk engagement?

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259

CASE 2.7

Geo Securities, Inc.

In 1980, Frank Sinopoli, a 27-year-old accountant, accepted a job offer from a CPA firm based in Dallas, Texas. Four years later, Sinopoli became a partner with the firm. Perkins, Dexter, Sinopoli & Hamm (PDSH) provided accounting and account- ing-related services to small and medium-sized businesses located principally in the Dallas-Fort Worth metroplex. During his long tenure with PDSH, Sinopoli supervised a wide range of engagements. Those engagements included the 2000 through 2005 audits of a small brokerage firm, Geo Securities, Inc.

Geo Companies of North America (GCNA), a Dallas-based oil and gas exploration company, organized Geo Securities as a wholly owned subsidiary in June 1996. The sole business purpose of Geo Securities was to market interests in oil and gas proper- ties owned or controlled by GCNA. Similar to GCNA, Geo Securities was not a public company. However, because Geo Securities was a registered broker-dealer with the Securities and Exchange Commission (SEC), its annual financial statements had to be audited by an independent accounting firm.

Throughout the six-year period that Sinopoli supervised the annual audits of Geo Securities, the company was entangled in two civil lawsuits filed in a federal dis- trict court in Georgia. The two principal defendants in these lawsuits were GCNA and Geo Securities. The primary allegation filed against the defendants was that they had “fraudulently offered and sold”1 joint partnership interests in oil and gas properties.

In 2004, the Georgia federal court ordered the defendants to pay a nominal amount of damages, approximately $217,000, to the plaintiffs to settle the two civil lawsuits. The court also appointed an arbitrator to determine whether the plaintiffs would be entitled to recover some or all of their sizable attorneys’ fees from the defendants. In April 2005, three months before Geo Securities’ 2005 fiscal year-end of 31 July 2005, the arbitrator ruled that GCNA, Geo Securities, and the other defendants in the civil lawsuits—who were individuals affiliated with the two companies—would be required to reimburse the plaintiffs for $949,688 of legal fees they had incurred in pursuing the case. The defendants were jointly and severally liable for those legal fees. GCNA had informed Geo Securities and the other defendants that it would pay the $217,000 settlement but did not make such a commitment regarding the much larger arbitration award.

GCNA, Geo Securities, and the other defendants appealed the 2004 court-ordered settlement and filed a challenge to the 2005 arbitration decision. Because Geo Securities’ management believed that GCNA would pay the full amount of the arbi- tration award—if it was not overturned—the company did not record a contingent liability or loss related to that award in its accounting records. Instead, the company disclosed the arbitration award in a financial statement footnote accompanying its 2005 financial statements (see Exhibit 1).

1. This and all subsequent quotes were taken from the following source: Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 2979, 27 May 2009.

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260 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

Geo Securities reported total assets of $155,183, total liabilities of $12,441, and total stockholder’s equity of $142,742 in its 31 July 2005, balance sheet. The compa- ny’s income statement for the year ended 31 July 2005, reflected total revenues of $551,131 and a net loss of $100,167. The unqualified opinion that PDSH issued on Geo Securities’ 2005 financial statements is shown in Exhibit 2.

NOTE EIGHT—LOSS CONTINGENCIES

During 2000 and 2002, two separate lawsuits were filed against the Company (Geo Securities), GCNA, and other related parties by individuals in Georgia. The suits allege that the Company violated applicable security laws. During the fiscal year ended July 31, 2005, the trial judge granted a motion to enforce a contested settlement and ordered the issue of the plaintiffs’ attorney fees to be resolved at arbitration. The arbitrator determined that $949,688 in attorney fees should be paid by the Company, GCNA, and the other related parties. The judge construed that a settlement agreement had been reached. This settlement agreement is currently being appealed. Additionally, the Company, GCNA, and other related parties have sued the plaintiffs and their attorneys for unrelated claims not related to the Georgia lawsuits. Management believes that the original suits are without merit and are vigorously defending its position in both lawsuits. The Company, GCNA, and the other related parties feel the original claims have no merit.

EXHIBIT 1

LOSS CONTINGENCIES FOOTNOTE ACCOMPANYING GEO SECURITIES’ 2005 FINANCIAL STATEMENTS

To the Board of Directors

GEO SECURITIES, INC.

Dallas, Texas

Independent Auditors’ Report

We have audited the accompanying statement of financial condition of GEO SECURITIES, INC. as of July 31, 2005, and the related statements of income, changes in stockholder’s equity, and cash flows for the year then ended that you are filing pursuant to Rule 17a-5 under the Securities Exchange Act of 1934. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of GEO SECURITIES, INC. at July 31, 2005, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.

Our audit was conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental information presented in Schedule

EXHIBIT 2

AUDIT REPORT ISSUED BY PDSH ON GEO SECURITIES’ 2005 FINANCIAL STATEMENTS

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CASE 2.7 GEO SECURITIES, INC. 261

1 – Computation of Net Capital Pursuant to Rule 15c3-1 and Schedule 2 – Exemptive Provision of Rule 15c3-3 is presented for the purposes of additional analysis and is not a required part of the basic financial statements, but is supplementary information required by Rule 17a-5 under the Securities Exchange Act of 1934. Such information has been subjected to the audit procedures applied in the examination of the basic financial statements, and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.

Perkins, Dexter, Sinopoli & Hamm, PC [signed]

Richardson, Texas

September 30, 2005

In May 2009, the SEC ruled that Geo Securities’ 2005 financial statements were mate- rially misstated because they “failed to include a material liability for the Arbitrator’s award.” The SEC pointed out that generally accepted accounting principles (GAAP) require companies to record a loss and a liability in their accounting records for a loss contingency that is both probable and subject to reasonable estimation. Since the arbitration award met both criteria and since the defendants in the lawsuit were jointly and severally liable, the SEC deemed that Geo Securities should have reported a loss and corresponding liability of $949,688 in its 2005 financial statements.

Compounding this error was Geo Securities’ failure to consider the arbitration award when computing its “net capital.” Registered broker-dealers must include a “computation of net capital” schedule with their audited financial statements that they file each year with the SEC. The purpose of this schedule is to demonstrate that a broker-dealer has sufficient equity to sustain its operations. In this schedule, broker- dealers must make certain adjustments to the stockholders’ equity reported in their audited balance sheets to arrive at a more conservative (lower) net capital figure.2 In computing its net capital, Geo Securities did not consider the large contingent loss stemming from the arbitration award, which was not surprising given the accounting treatment it applied to that award.3

The SEC also sanctioned Frank Sinopoli for failing to properly audit Geo Securities’ 2005 financial statements and the net capital schedule that accompanied those state- ments. According to the SEC, Sinopoli was fully aware of the arbitration award when he planned and performed the 2005 Geo Securities audit. In fact, Sinopoli “assisted” Geo Securities management when it was deciding whether to record the award as a loss and liability in the company’s 2005 financial statements or simply disclose the arbitration award in the accompanying financial statement footnotes.

Despite Sinopoli’s awareness of Geo Securities’ litigation problems, he did not identify “litigation, claims, and assessments as an area of significant risk” while plan- ning the 2005 audit. Sinopoli also did not identify the attorneys representing Geo Securities in those legal matters, nor did he request that Geo Securities “send an audit inquiry letter” to those attorneys.

The SEC also criticized Sinopoli for relying on a representation made by Geo Securities’ president that GCNA, Geo Securities’ parent company, would ultimately pay the arbitration award in full if the effort to overturn that award proved unsuccessful.

2. Among many other items, these adjustments include reductions for “non-allowable” or illiquid assets. 3. Geo Securities did include a supplementary disclosure in its net capital schedule that referred to “contingent indebtedness” equal to the full amount of the arbitration award.

EXHIBIT 2– continued

AUDIT REPORT ISSUED BY PDSH ON GEO SECURITIES’ 2005 FINANCIAL STATEMENTS

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262 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

That representation was particularly relevant to Geo Securities’ status as a going con- cern. In fact, the SEC reported that during the 2005 audit Sinopoli did not explicitly consider whether Geo Securities was a going concern. Sinopoli “failed to evaluate GSI’s ability to continue as a going concern, failed to obtain additional information about the conditions raising the concerns and failed to evaluate management’s plans for dealing with the adverse effects of the conditions raising the concerns, as required by GAAS.”

The SEC maintained that, at a minimum, Sinopoli should have corresponded with GCNA to determine whether it intended to pay the arbitration award, as claimed by Geo Securities’ president. Since GCNA was also a client of PDSH, Sinopoli could have easily contacted the company regarding that matter. The SEC noted that when Geo Securities subsequently disclosed its net capital deficiency in January 2006, GCNA failed to intervene, resulting in Geo Securities being forced out of business.

A final complaint lodged against Sinopoli by the SEC was his failure to identify the impact of the arbitration award on Geo Securities’ net capital computation in the supplemental schedule accompanying its 2005 financial statements. As reflected in Exhibit 2, Sinopoli’s 2005 audit opinion indicated that the information in that sched- ule was “fairly stated in all material respects in relation to the basic financial state- ments taken as a whole.” In contrast to Sinopoli’s conclusion, the SEC ruled that Geo Securities’ net capital computation was “materially misstated” since it ignored the large contingent loss due to the arbitration award.

In a May 2009 Accounting and Auditing Enforcement Release, the SEC summarized its overall conclusions regarding Sinopoli’s 2005 audit of Geo Securities.

Sinopoli failed to conduct the 2005 GSI [Geo Securities] audit in accordance with GAAS. Among other things, he failed to exercise professional skepticism and failed to obtain sufficient evidential matter to evaluate adequately and report properly the Arbitrator’s award in GSI’s financial statements. Furthermore, Sinopoli’s work papers fail to evaluate GSI’s ability to continue as a going concern. Nonetheless, Sinopoli signed, on behalf of PDSH, an audit report dated September 30, 2005, containing an unqualified opinion incorrectly claiming that PDSH’s audit of GSI’s July 31, 2005, financial statements had been conducted in accordance with GAAS. The opinion also incorrectly claims that GSI’s audited financial statements present fairly, in all material respects, the financial position of GSI in conformity with GAAP.

The sanctions imposed on Sinopoli included a cease and desist order prohibiting him from any future violations of the federal securities laws and a one-year suspen- sion from practicing before the SEC.

E P I L O G U E The Dodd–Frank Act that was passed by Con- gress in 2010 required the Public Company Accounting Oversight Board (PCAOB) to over- see the audits of SEC-registered broker-dealers. Congress included this provision in the Dodd– Frank Act as a direct consequence of the Madoff Securities4 scandal that contributed to the

financial crisis that paralyzed the U.S. and global economies beginning in late 2008. In April 2012, the PCAOB released a report on its initial review of brokerage audits. The agency reported find- ing “deficiencies” in each of the 23 brokerage audits that it reviewed. A PCAOB spokesperson noted that the auditors of the brokerage firms

4. See Case 1.12, Madoff Securities.

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CASE 2.7 GEO SECURITIES, INC. 263

Questions 1. When auditing contingent liabilities, which of the management assertions

discussed in professional auditing standards are of primary concern to an auditor? Explain.

2. The SEC criticized Frank Sinopoli for not sending an “audit inquiry letter” to Geo Securities’ external legal counsel. Describe the nature and purpose of such a letter. Do you agree with the SEC that Sinopoli should have contacted Geo Securities’ external legal counsel?

3. Under what circumstances must audit procedures be applied to supplemental information accompanying a client’s financial statements? Describe the responsibilities auditors have when auditing such information.

4. Under what circumstances, if any, are auditors required to assess the going- concern status of an audit client? What procedures should auditors apply when performing such an assessment?

5. F. Norris, “Regulator Says Broker Audits Fail to Include Required Work,” New York Times (online), 20 August 2012. 6. Ibid.

“were not properly fulfilling their responsi- bilities to provide an independent check on brokers’ and dealers’ financial reporting and

compliance with SEC rules.”5 Lynn Turner, for- mer chief accountant of the SEC, characterized the PCAOB report as “mind-boggling.”6

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265

CASE 2.8

Belot Enterprises

As David Robinson works his way through the large, festive crowd, he keeps bump- ing into people he knows. All the while, Robinson is hoping that he will avoid the one person he doesn’t want to meet face to face.1

Belot Enterprises’ several hundred employees and their family members are celebrating the Fourth of July with a corporate picnic. For the occasion, the com- pany reserved a municipal park perched on the bank of the Mississippi River in a Minneapolis suburb. The corporate picnic actually serves two purposes. In addition to celebrating the Fourth of July, Belot’s employees are marking the end of the suc- cessful corporate-wide “Nail the Number” campaign.

The campaign was the brainchild of Kyle Allen, Belot’s chief operating officer (COO) who joined the company six months ago. Allen was handpicked for the COO position by the top management of Helterbrand Associates, Belot’s parent company. Helterbrand is a large, publicly owned conglomerate with five wholly owned subsid- iaries that operate in five diverse industries.

Belot, a consumer products company, accounts for approximately one-third of Helterbrand’s annual revenues and consolidated assets. During the previous several years, however, Belot has never accounted for more than 10 percent of Helterbrand’s consolidated operating income. Two decades ago, Belot was the flagship of the Helterbrand corporate family. Declining profit margins in Belot’s mature and intensely competitive industry have caused the company’s profitability to gradually erode despite low but persistent growth in its annual revenues.

Allen, a 38-year-old Harvard MBA who established himself as a corporate turn- around specialist in the automotive supplies industry, was hired to reinvigorate Belot. After spending several weeks studying all facets of Belot’s operations, Allen organized the Nail the Number campaign for the company’s second quarter—1 April through 30 June. The goal of the campaign was to increase Belot’s year- over-year quarterly operating income by 100 percent. Although that goal seemed impressive, it was not earthshaking since the company had earned a very modest, even by recent historical standards, operating income during the previous year’s second quarter.

The tactics employed by Allen during the three-month campaign were also not earthshaking. They included focusing Belot’s marketing efforts on products with relatively high profit margins, incentive-based compensation programs for the com- pany’s sales staff, and a variety of corporate-wide cost-cutting initiatives.

When David Robinson learned of the details of the Nail the Number campaign, he was not impressed. In his mind, the company should have implemented each of those strategic measures long ago. Then again, as a member of Belot’s audit engage- ment team, Robinson recognized that his responsibilities did not include openly cri- tiquing corporate management or its policies.

1. This case was developed from an actual series of events. Certain background information has been changed to conceal the identities of the individuals involved in the case.

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266 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

Detox and Grizz In two months, David Robinson will mark his fourth anniversary with the Big Four account- ing firm that serves as the independent auditor of Helterbrand Associates and each of its five subsidiaries, including Belot Enterprises. During the past spring, Robinson com- pleted his fourth busy season assigned to the Belot engagement. Since joining the firm after graduating with bachelor’s and master’s degrees in accounting from the University of Minnesota, 60 percent of Robinson’s chargeable hours have been spent working at Belot.

Robinson has spent so much time at Belot’s headquarters office on the northern edge of Minneapolis that he often feels as if he is an employee rather than an indepen- dent auditor of the firm. As he surveys the large throng of people attending the compa- ny’s Fourth of July picnic, Robinson isn’t sure that it is appropriate for him to be there. But the Belot audit engagement partner, R. B. Hansen, insisted that he attend the event.

The person that Robinson is hoping to avoid at the picnic is Belot’s accounting gen- eral manager, Zachariah Crabtree. As the current in-charge senior on the audit team, Robinson interacts with Crabtree on an almost daily basis. The two men have an excellent relationship. In fact, over the previous few years, Robinson and Crabtree have become good friends, so much so that they regularly refer to each other using the nicknames— Detox and Grizz, respectively, that each was tagged with at the University of Minnesota.

Crabtree is a huge man, six-feet five-inches tall with a sturdy frame and girth. In his early 40s, he wears old-fashioned, black plastic-framed glasses that have lenses as thick as the bottom of a Coke bottle and sports an unruly head of bushy, prematurely gray hair. Making Grizz—short for “grizzly bear”—stand out even more in a crowd is his Johnny Cash–like insistence on wearing black. His standard workday attire is a pair of black cowboy boots, black denim jeans, a black button-down shirt, and a gar- ish tie—the maroon and gold colors of the University of Minnesota’s Golden Gophers are his favorite hues when it comes to ties.

Topping off Grizz’s imposing persona is a dour expression that seems to convey that he is perpetually unhappy, if not chronically sociopathic. In truth, Crabtree is a kind and likable person with a dry sense of humor, who despite his unconventional appearance is well respected by both his superiors and subordinates.

Unlike Crabtree, Robinson could easily be mistaken for a Ralph Lauren model. The audit senior is a tall, handsome, athletically built 27-year-old who wears a stylish suit to work each day along with a starched, white button-down Polo shirt that is accessorized with a matching Polo tie. Robinson has a gregarious, outgoing personality. As for as his nickname, “Detox” is not a reference to any personal shortcomings but simply a jazzed-up version of the initials of his first and middle names given to him by his fraternity brothers.

Despite being so different in appearance and temperament, Robinson and Crabtree share one interest that binds them together. Both are certified sports fanatics. Each is a long-suffering fan of the various athletic teams fielded by the Golden Gophers and the local professional sports franchises, most notably the purple-clad Minnesota Vikings. The two sports aficionados typically start each conversation with the latest sports controversy being fueled by ESPN.

Nailing the Number the Easy Way During his time at Belot, there have been few disputes between Robinson and Crabtree over accounting matters. Sit-down discussions involving the two accoun- tants have centered on topics such as dollar-value LIFO, foreign currency transla- tions, and impairment of long-lived assets. Robinson is grateful to Crabtree for his patience and willingness to explain the finer points of complex accounting issues despite his busy work schedule.

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CASE 2.8 BELOT ENTERPRISES 267

Robinson and Crabtree recently experienced their first truly unpleasant confron- tation over an accounting issue, which explains why Robinson is hoping that he doesn’t encounter Crabtree at the picnic. The dispute stemmed from Kyle Allen’s Nail the Number campaign.

Crabtree is extremely loyal to Belot. He is concerned that if Belot’s operating results don’t improve soon, Helterbrand’s top management may decide to sell the company outright or, even worse, split it up and sell it on a piecemeal basis. Crabtree once confided in Robinson that if the company is jettisoned by Helterbrand, he will prob- ably lose his job and have difficulty finding a comparable position in the area. Like Robinson, Crabtree has strong family and emotional ties to the state of Minnesota and to the Minneapolis–St. Paul metroplex.

Over the past three months, Crabtree wore one of the promotional stickers for the Nail the Number campaign on his shirt pocket each day. The stickers, which feature a cartoonish icon of a large hammer posed over a dollar sign, were distributed to all of Belot’s employees but few actually wore them.

Crabtree came up with his own personal contribution to the Nail the Number campaign by deciding to tighten the company’s major discretionary accruals as of June 30. Those accruals include the allowances for bad debts, coupon redemptions, employee vacations, inventory obsolescence, and product warranties. Crabtree defends his decision by pointing out that in the past Belot’s controller, Travis Logan, instructed him to err on the side of conservatism in establishing the accruals, mean- ing that each of them have been routinely overstated by a modest amount. Crabtree maintains that he is simply reducing the accruals to their appropriate levels.

Robinson rarely speaks with Logan who, like Crabtree, has spent his entire profes- sional career with Belot. Only a few years away from retirement, Logan is a straitlaced, no-nonsense accountant who can quote specific passages from key accounting stan- dards. Robinson particularly admires Logan because of his exemplary personal life. Logan spends hundreds of hours each year working as a volunteer and fund-raiser for a local charity that operates a private school for disabled children.

Crabtree’s decision to record relatively modest 30th June balances for the five dis- cretionary accruals has created a rift between himself and Logan. When he made that decision, Crabtree did something very uncharacteristic for him, namely, bypass- ing Logan, his immediate superior, and discussing the matter directly with Kyle Allen. Allen responded enthusiastically to Crabtree’s proposal and agreed that all of the “fat” should be cut out of the accruals. He then sent an e-mail to Logan telling him that he approved Crabtree’s decision.

After receiving the e-mail, Logan immediately met with Allen and voiced his disap- proval. At that point, Allen reportedly told Logan point-blank that the accruals would be reduced whether he liked it or not. When Logan continued to object, Allen told him that Crabtree would have complete authority for establishing the period-ending balances of the accruals for the foreseeable future. Not surprisingly, Allen’s decision made Logan livid. Robinson had heard rumors that Logan is considering submitting his resignation as a result of the incident.

Allen’s actions have confirmed Robinson’s perception that Belot’s new COO is its de facto chief executive officer (CEO). Allen apparently has carte blanche authority from the top management of Helterbrand Associates to do whatever is necessary to improve Belot’s operating results.

The controversy over the period-ending accruals has cast a tense pall over Belot’s corporate accounting staff. Each member of that staff has effectively been forced to side with either Logan or Crabtree who are barely speaking to each other. Robinson feels as if he is being forced to make the same choice. Although he seldom interacts

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268 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

with Logan, he does sit down with him during each audit and quarterly review to discuss the major “hot spots” in Belot’s financial statements.

Robinson realizes that if Logan resigns, Crabtree will likely be chosen to replace him. He is also convinced that Crabtree’s decision to reduce the accruals was not motivated by his desire to replace Logan. Robinson believes that Crabtree is a man of honesty and integrity and that his actions were motivated strictly by his desire to help save Belot.

The most troubling aspect of the accrual controversy for Robinson is its impact on Belot’s second-quarter operating results. Kyle Allen’s Nail the Number campaign was successful. In fact, just yesterday, the day before the corporate picnic, Allen cir- culated an e-mail to all Belot employees thanking them for making the campaign an “unmitigated, flabbergasting success”—his exact words. Belot’s operating income for the just-completed quarter is 140 percent higher than the corresponding figure for the prior year’s second quarter. Granted, Allen included a brief caveat in the e-mail indicating that the second-quarter numbers are not yet “official,” meaning that the auditors have not yet signed off on them.

Robinson has determined that the reductions in the five discretionary accruals at the end of the second quarter account for approximately 70 percent of the improve- ment in Belot’s year-over-year operating results. If Travis Logan’s “conservative” strat- egy was used in establishing those accruals, Robinson estimates that Belot would post a modest 40 percent increase in its second-quarter operating income, considerably less than the 100 percent goal targeted by Allen for the Nail the Number campaign.

Conservatism vs. Precision Robinson reviewed Belot’s major discretionary accruals while performing analytical procedures on the company’s preliminary second-quarter financial statements. It was then that he found that each of the accruals was smaller than expected given the rele- vant benchmark amount. For example, the allowance for bad debts is a smaller-than- normal percentage of the period-ending balance of accounts receivable. Robinson immediately went to Crabtree’s office to ask him about the unexpectedly modest dis- cretionary accruals. In response to Robinson’s inquiry, Crabtree told him of a new “precise point estimate” method that he had used to establish those accruals.

“‘Precise point estimate’? What’s that?” Robinson had asked. “Just what it implies. We’re using the best available information we have to arrive at

a precise point estimate of each of those accruals.” “So, Grizz, you’re saying that the method you used the previous 419 quarters was

wrong?” Robinson had used his normal lighthearted style in posing the question to Crabtree. He was surprised when Crabtree seemed offended.

“Yeah, they were wrong. Just like the rest of the numbers we feed you high and mighty and holier-than-thou auditors constantly,” Crabtree had snapped.

“Well, hey, Grizz, there’s no reason to bite my head off. You know, I have a job to do.” “Detox, I know what your job is. Your job is to scan the second-quarter numbers

during a coffee break, rack up a few hours of chargeable time, and then call your bosses and tell them that everything looks okay. Right?”

“Well, I think a quarterly review is a little more involved than that.” Before Robinson could continue, Crabtree had cut him off.

“There you are. Key word ‘review.’ All you have to do is ‘review’ those numbers. You don’t have to rip them apart or audit them. Right?”

Crabtree’s impertinence had caused Robinson to adopt a more professional demeanor. Over the following 10 to 15 minutes, the two men had an evenhanded, frank discussion of the method Belot had used in the past to compute the

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CASE 2.8 BELOT ENTERPRISES 269

discretionary accruals, the method that had been used to compute them at the end of the just-completed second quarter, and the reason for the change.

During their discussion, Crabtree had repeatedly defied Robinson to prove that the “precise point estimate” method he had used to determine the accruals was improper in any way or resulted in a violation of generally accepted accounting prin- ciples. Crabtree insisted that all he had done was eliminate what Travis Logan had always referred to as the “add-ons” to “fudge” those numbers a little higher than they should be. The tone of the discussion became tense when Robinson asked Crabtree about the connection between Kyle Allen’s Nail the Number campaign and the more modest accrual balances.

“Allen didn’t have anything to do with this. This didn’t start with him. This was my idea. Everyone around here has been busting their behind over the past three months to keep this ship from sinking. I thought I should do my part too.”

Near the end of his meeting with Crabtree, Robinson had mentioned matter-of- factly that he would have to discuss the accruals with Anna Bledsoe, the audit man- ager for the Belot engagement, and, ultimately, with R. B. Hansen, both of whom were out of town but would be returning on 5th July. Crabtree had grimaced at that point and shook his head in disgust.

“Come on, Detox. There’s no reason to try to score some points for yourself by bring- ing this up with either of them. Why make trouble for yourself, for them, and for me? This is a nonissue. We haven’t done anything wrong. The numbers are okay.” When Robinson didn’t reply immediately, Crabtree had continued. “Hey, if you pass on these accruals, no one will ever be the wiser. There is no way you can argue that any of them are indi- vidually ‘wrong’ or ‘materially inaccurate’ or whatever. So, just drop it and go play golf this afternoon.” Ironically, the more desperate Crabtree had become in defending the accruals, the more worried Robinson had become that the accruals were a problem.

Crabtree was unaware that his comment regarding “scoring points” had struck close to home for Robinson. Over the past four years, Robinson seldom gave much thought to any career planning initiatives. Instead, he simply plodded along, com- pleting each assignment given to him. Robinson reserved most of his energy and enthusiasm for his principal “outside” interest, namely, sports. When he wasn’t root- ing for the Golden Gophers or the Vikings, he was playing golf or tennis or managing one of his many fantasy sports teams.

Two recent incidents, however, have made Robinson dwell at length for the first time on his future in the accounting profession. First, he realized that as his four-year anniversary with his employer approached, he was one of the few members of his “start class” still with the firm. Nearly all of his former colleagues have moved on to other jobs, most of them higher-paying positions with clients. The second and more important event that caused him to think of his future was a lunch meeting a few weeks ago with R. B. Hansen.

During that lunch, Hansen encouraged Robinson to become more focused on his career and to devote himself more fully to his job. According to Hansen, Robinson’s strong interpersonal skills are just what the firm is looking for in partner candidates. Hansen told Robinson he could use those skills to recruit new clients to the firm, a talent that is highly valued by existing partners, many of whom are not “natural com- municators” or “marketing types.”

Hansen’s pep talk caused Robinson to seriously consider for the first time that he may be partner “material.” Robinson has always possessed a remarkable degree of self-confidence. When he commits himself to accomplishing a goal, he always rises to the occasion. In his mind, there is no reason why he cannot become a partner with his firm if he adopts that objective as a personal and career goal.

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270 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

Prior to his meeting with Hansen, Robinson would very likely have just “gone along” with Zachariah Crabtree’s suggestion that he “pass” on the 30th June discre- tionary accruals. But now that he realizes he is potential partner material, his outlook on his job has changed suddenly and dramatically.

Robinson doesn’t want to do anything that would cause R. B. Hansen to perceive that he is “coasting” along as usual. In fact, standing up to Grizz, who Hansen knows he is very close to, would provide Robinson an opportunity to demonstrate to the part- ner that he has adopted a more professional mindset to his job and responsibilities.

Grizzly Sighting Prior to the Belot company picnic, Robinson spent much of the two previous days stewing over his dilemma. He eventually settled on a compromise plan that would possibly appease Crabtree while at the same time allowing him to impress R. B. Hansen. His compromise, which he intends to discuss with Hansen before relaying it to Crabtree, involves requiring Belot to increase the 30th June balances of the allow- ances for bad debts and inventory obsolescence to more normal levels, while allow- ing the company to use the “precise point estimates” for the other three discretionary accruals. Robinson realizes that Hansen is most concerned with the bad debts and inventory obsolescence accruals since they have a “higher profile” in Belot’s finan- cial statements than the other accruals.

Robinson’s compromise plan would reduce the year-over-year increase in Belot’s operating income for the just-completed quarter from 140 percent to approximately 103 percent—slightly above the target figure that Allen established for the Nail the Number campaign. Although Robinson believes his compromise is reasonable, he is worried that Crabtree will react negatively to it.

Because he wants to avoid discussing the accruals issue with Crabtree at the pic- nic, Robinson has been scanning the clusters of people in front of him trying to spy Grizz’s hulking figure as he works his way across the large park. Suddenly, Robinson feels a large hand clamp down on his shoulder from behind. As he turns around, he finds himself standing face to face with Zachariah Crabtree. Plastered across Grizz’s chest are three creased and crinkled Nail the Number stickers.

Questions 1. Is David Robinson’s suggested compromise appropriate? Why or why not?

2. Do you believe that Zachariah Crabtree is a person of integrity? What about David Robinson? Defend both of your answers. Does Robinson have an inappropriate relationship with Crabtree? Explain.

3. Identify the primary audit objectives for a client’s year-end discretionary expense accruals. Is it permissible for companies to overstate period-ending expense accruals to make their financial statements more “conservative”?

4. Discuss the scope and nature of an auditor’s responsibilities during a review of a client’s quarterly financial statements.

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271

CASE 2.9

Powder River Petroleum International, Inc.

In 1999, a group of private investors founded Celebrity Sports Network, Inc., a com- pany that retained professional athletes and former professional athletes to sponsor “fringe” sporting events such as professional wrestling, competitive dancing, and roller derby. When that business plan proved less than successful, the company was reorganized in 2001. The business model of the new company, Powder River Basin Corporation, ultimately evolved into purchasing and developing oil and gas proper- ties. In 2007, the company was renamed Powder River Petroleum International, Inc.

Brian Fox, a Canadian citizen, became the principal stockholder of Powder River in 2003 when he acquired 40 percent of its outstanding common stock. Fox assumed the titles of chief executive officer (CEO) and chief financial officer (CFO) for the small company that had only eight full-time employees, two of whom were his daughters. Although initially incorporated in Colorado and later reincorporated in Oklahoma, Powder River’s de facto headquarters were in Calgary, Alberta, the home of the Fox family.

In 2002, prior to Fox’s arrival, Powder River reported total revenues of only $15,000 and a net loss of $1.3 million. Because Fox had considerable experience in Canada’s oil and gas industry, the company’s other stockholders hoped that he could trans- form it into a profitable operation. But Fox also came with a certain amount of unde- sirable “baggage.” In 2000, the Alberta Securities Commission, a Canadian regulatory agency, had barred him from serving as a corporate officer or director for 18 months. The agency alleged that Fox had sold unregistered securities of a company for which he served as a senior executive.

Marketing Miracle Brian Fox quickly “turned around” Powder River. In 2006, the company reported a net income of $5.7 million on revenues of $13.2 million. The company’s balance sheet for that year reported nearly $25 million of assets, the bulk of which consisted of investments in oil and gas properties. Thanks to the company’s profitable operations in 2006, Fox’s compensation for the following year approached $1.5 million.

Powder River’s rapid turnaround was due to a new business strategy that Fox imple- mented for the company. In 2004, Fox began marketing minority “working interests”1 in oil and gas properties owned by Powder River to foreign investors through a busi- ness associate that he had worked with in the past. Fox arranged for the company to purchase oil and gas properties in several southern states, including Louisiana, Oklahoma, and Texas, and then, with the help of his business associate, sold work- ing interests in those properties to Asian investors, principally well-heeled citizens

1. The online dictionary, Investopedia, defines a working interest as follows: “a form of investment in oil and gas drilling operations in which the investor is directly liable for a portion of the ongoing costs asso- ciated with exploration, drilling and production. In a similar fashion, working interest owners also fully participate in the profits of any successful wells. This stands in contrast to royalty interests, in which an investor’s cost is usually limited to their initial investment, also resulting in a lower potential for large profits.”

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272 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

of Singapore. The company reported that it intended to use the proceeds from the sale of the working interests to develop its oil and gas properties and to purchase additional properties.

A key factor in the initial success of this strategy was the huge difference between the amounts paid for the oil and gas properties by Powder River and the prices at which the company sold working interests in those properties to the Asian investors. For example, Powder River’s 2006 federal tax return reported $17.7 million of tax- able revenue from the sale of working interests in oil and gas properties that it had purchased over the previous 12 months. The cost basis of those working interests for Powder River was less than $150,000.

During the time frame that the company was selling the working interests, Brian Fox repeatedly maintained that the company’s “primary focus” was “oil and gas exploration and development,” while its “secondary focus” was the marketing of minority working interests in those properties.2 In fact, the $13.2 million of revenue reported in the company’s 2006 income statement consisted of $12.6 million of rev- enue from “Property and Working Interest Sales” and only $554,000 of revenue from “Oil and Gas Sales.”3 Following is the description of Powder River’s revenue recogni- tion policy for the sales of working interests that was included in the company’s 2006 financial statement footnotes.

As the Company finds and purchases new properties, it makes arrangements to sell partial working interests to various individuals referred to by [sic] the Singapore Group. The revenues are recorded as operating revenues, net of any commission or other costs associated with earning the revenues. The related percentage of capital- ized cost of the property sold is also removed from the oil and gas property account and offset against the proceeds to calculate the net revenue recorded in the operating revenues.

Powder River’s common stock traded over the counter on what was known at the time as the “Pink Sheets” network, a nationwide network of stock brokers that shared bid and ask prices for small publicly owned companies. Because Powder River’s securities were registered with the SEC, the company filed audited financial state- ments annually with that federal agency.

Bountiful Audit Firm Throughout its history, Powder River was audited by Chisholm, Bierwolf & Nilson4 (CBN), an accounting firm based in Bountiful, Utah, a suburb of Salt Lake City. In 2003, CBN registered with the Public Company Accounting Oversight Board (PCAOB) to enable it to audit financial statements of publicly owned companies. From 2003 through 2007, CBN had two audit partners, Todd Chisholm and Troy Nilson, and five to nine other auditors on its professional audit staff. Chisholm also served as CBN’s managing partner.

CBN’s audit clientele included dozens of small public companies whose securities were traded on over-the-counter networks such as the Pink Sheets network. In 2006 and 2007, CBN issued 52 and 49 audit reports, respectively. Chisholm and Nilson swapped roles on CBN’s audit engagements. For those clients that Chisholm served as the audit engagement partner, Nilson was the concurring partner, and vice versa.

2. Securities and Exchange Commission v. Brian D. Fox, U.S. District Court, Northern District of Oklahoma, Civil Action No. 11-CV-211-CVE-PJC, 8 April 2011. 3. Not surprisingly, the total revenues reported in Powder River’s GAAP-based income statement differed from the total revenues reported in its federal tax return. 4. The accounting firm’s name changed over time but it was known by this name in both 2006 and 2007.

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CASE 2.9 POWDER RIVER PETROLEUM INTERNATIONAL, INC. 273

Chisholm served as Powder River’s audit engagement partner through 2006, while Nilson assumed that role beginning in 2007.

Powder River paid CBN $39,712 for the 2006 audit and $38,251 for the 2007 audit, according to the company’s 2007 Form 10-K filed with the SEC. The accounting firm also prepared Powder River’s 2006 and 2007 tax returns, charging the company less than $2,000 for that service each year. In neither year did Powder River pay CBN any “audit related” fees for professional services.

SEC Investigation A footnote to Powder River’s 2007 financial statements reported a previously undis- closed stipulation of the contracts with the Asian investors who had purchased work- ing interests in oil and gas properties owned by the company.

Powder River’s contracts with Asian investors provided that they would receive guar- anteed payments yielding an annual minimum of 9%, and in some cases more, begin- ning approximately six months after the date of investment until investors reached the “break-even” point, i.e., when their principal had been repaid (the “guaranteed payments”). Thereafter, investors received lease production payments based on their respective [percentage] working interests.5

The disclosure of this feature of the working interest contracts prompted a compre- hensive investigation of Powder River’s accounting records and prior financial state- ments by the SEC.

In April 2011, the SEC filed a civil complaint against Brian Fox in a federal district court in Oklahoma. The central feature of the complaint was that from 2004 through early 2008, Fox had fraudulently misrepresented the nature of Powder River’s operat- ing results in its periodic filings with the SEC. The SEC charged that the company’s alleged sales of working interests to Asian investors were, in substance, loans to Powder River since the company “guaranteed” to pay back those investments over a period of approximately 11 years.

Beginning in early 2007, Powder River had been forced to use the proceeds from new “sales” of working interests to “fulfill its ongoing guaranteed minimum payment obligations to prior investors,” which created a “Ponzi-style” fraud.6 “Although Fox was aware of the Ponzi-style payments, he nonetheless caused the company to con- tinue to represent in Commission filings that Asian investor proceeds would be used to purchase and develop oil and gas properties.”7

The SEC’s investigation of Powder River uncovered a laundry list of other alleged accounting and financial reporting abuses by the company. From 2005 through 2007, the company included as assets in its balance sheets oil and gas properties that it did not own. While negotiating to purchase a $5 million leasehold in New Mexico during 2005, Powder River made a nonrefundable $500,000 down payment on that property. In August 2005, the negotiations ended and Powder River forfeited the down payment. Despite not completing the purchase, the company included the $5 million leasehold in “Oil and Gas Properties” reported on its 2005 through 2007 balance sheets. Similarly, in 2006, Powder River made a $1.5 million nonrefundable down payment on a $6.5 million oil and gas lease in Texas. Because the transaction

5. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 3266, 8 April 2011. 6. Securities and Exchange Commission v. Brian D. Fox, U.S. District Court, Northern District of Oklahoma. 7. Ibid.

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274 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

was never consummated, Powder River forfeited the down payment. Nevertheless, in 2006 and 2007, the $6.5 million leasehold was included in the company’s reported oil and gas properties.

In 2006 and 2007, oil and gas properties accounted for 67 percent and 82 per- cent, respectively, of Powder River’s total assets on its annual balance sheets. In a footnote appended to the company’s 2006 and 2007 financial statements, Powder River reported that the “proved reserves” related to those properties could have a value as high as $382 million.8 The SEC subsequently determined that the com- pany’s reserve estimates were unreliable and did not meet its definition of “proved reserves.”

Fox obtained reserve reports for Powder River and oversaw its reserve-reporting process. At least some of the company’s reserve reports were prepared by a Texas engineer, an individual Fox knew, or was severely reckless in not knowing, was a convicted felon and securities fraud recidivist. Powder River, however, represented in its annual and quarterly reports from 2004 to 2007 that the company’s proved reserves were based on evaluations prepared by a certain Oklahoma petroleum engineer. In fact, the Oklahoma engineer performed no services for Powder River after 2005, and his earlier reports were not intended for use in SEC filings. . . . By 2007, Powder River had still not obtained bona fide historical or updated reserve reports, despite the fact that oil and gas properties represented approximately 82% of its total reported assets.9

These items and other misstatements in Powder River’s annual and quarterly finan- cial statements caused those financial statements to grossly misrepresent the com- pany’s financial condition and operating results. For 2006, the SEC ruled that Powder River’s assets, revenues, and net income were overstated by 40 percent, 638 percent, and 324 percent, respectively. The corresponding overstatements for 2007 were 45 percent, 301 percent, and 114 percent. Despite these huge misstatements, Powder River received unqualified opinions for both 2006 and 2007 from its independent audit firm, CBN. Exhibit 1 presents the 2006 audit opinion.

8. Ibid. 9. Ibid.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of Powder River Basin Corp.

We have audited the accompanying balance sheet of Powder River Basin Corp. as of December 31, 2006, and the related statement of operations, stockholders’ equity, and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with the standards of the PCAOB (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial

EXHIBIT 1

AUDIT OPINION ON POWDER RIVER’S 2006 FINANCIAL STATEMENTS

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CASE 2.9 POWDER RIVER PETROLEUM INTERNATIONAL, INC. 275

Calling Out the Auditors During CBN’s 2006 audit of Powder River, Todd Chisholm, the audit engagement part- ner, learned for the first time of the 9 percent repayment clause in Powder River’s working interest contracts with the Asian investors. In a subsequent Accounting and Auditing Enforcement Release, the SEC reported that Chisholm “failed to inquire further about them [guaranteed payments] or consider how those payments might affect Powder River’s revenue recognition or whether the company should disclose its payment obligation in its 2006 financial statements.”10 Instead, Chisholm simply relied on Brian Fox’s characterization of the amounts paid to Powder River by the Asian investors as “sales.”

During both the 2005 and 2006 Powder River audits, the CBN audit team failed to discover that Powder River had included in its reported assets oil and gas properties that it did not own. The SEC held Chisholm responsible for this oversight because he “failed to review the oil-and-gas lease purchase documents” for those alleged assets.11 The SEC also criticized Chisholm’s review of the oil and gas reserve reports that Powder River supplied him to corroborate the impressive proved reserves reported in the company’s financial statement footnotes.

In auditing Powder River’s 2005 and 2006 financial statements, Respondent [CBN] and Chisholm obtained and relied upon brief excerpts from oil-and-gas reserve reports. He did little, if anything, to: a) evaluate the qualifications of the petroleum engineer who prepared the oil-and-gas reserve reports; b) understand the nature of the work performed in preparing the oil-and-gas reserve reports; and c) evaluate the petroleum engineer’s relationship to Powder River.12

10. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 3266. 11. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 3267, 8 April 2011. 12. Ibid.

reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Powder River Basin Gas Corp. at December 31, 2006, and the results of its operations and cash flows for the year then ended in conformity with U.S. generally accepted accounting principles.

/s/Chisholm, Bierwolf & Nilson Chisholm, Bierwolf & Nilson, LLC Bountiful, UT March 7, 2007

Source: Powder River’s 2006 Form 10-K.

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276 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

According to the SEC, Chisholm should have been alerted to the possibility that Powder River’s reserve estimates were suspect because in 2005 the federal agency had questioned the qualifications of the engineer who had prepared the 2004 esti- mate and the method used to arrive at that estimate. In fact, during the 2005 audit of Powder River, Chisholm had participated in a conference call with the SEC in which a company representative had responded to those concerns.

Todd Nilson assumed the role of audit engagement partner for Powder River in 2007. During early 2007, Powder River had begun charging (debiting) the guaran- teed payments made to the Asian investors to an asset account, “Prepaid Production Payments.”13 After reviewing the working interest contracts, Nilson determined that this accounting treatment was improper. As a result of that decision, Powder River issued restated financial statements for the first three quarters of 2007 that eliminated that accounting treatment for the guaranteed payments. In addition, apparently because of concern expressed by Nilson, Powder River disclosed for the first time in the footnotes to its 2007 financial statements that the guaranteed payments were being made to the Asian investors.14

Despite investigating the working interest contracts and questioning the account- ing treatment applied to the guaranteed payments, Nilson failed to consider whether the cash received from the Asian investors “should have been reported as borrow- ings rather than sales”15 in Powder River’s 2007 financial statements. “As a result, the company continued to improperly report the proceeds from its working interest con- veyances as revenues.”16 The SEC also criticized Nilson for failing to include a “going concern” paragraph in the unqualified audit opinion issued on Powder River’s 2007 financial statements. Because the guaranteed payments due to the Asian investors in 2008 would almost certainly exceed the company’s oil and gas revenues by a wide margin, the SEC maintained that there was “substantial doubt” that Powder River would remain a going concern.

Similar to Todd Chisholm during the 2005 and 2006 Powder River audits, Nilson, during the 2007 audit, failed to discover that the company was including in its reported assets large oil and gas properties that it did not own. The SEC reported that CBN did not perform any audit procedures to verify the existence and ownership of the $5 million New Mexico and $6.5 million Texas leaseholds during the 2007 audit “despite the size of the assets and the fact that the company had not paid any signifi- cant development costs or taxes on the properties in 2007.”17

The SEC also reported that, similar to Chisholm, Nilson failed to properly investigate Powder River’s reserve reports that the company used to corroborate its proved reserves disclosures in its 2007 financial statements. In fact, during

13. Prior to 2007, the company had recorded these payments as a contra revenue item to “Oil and Gas Sales.” For income statement purposes, Powder River reported only net “Oil and Gas Sales,” that is, the guaranteed payments were not reported separately. 14. The company characterized the obligation to make these guaranteed payments as a “future commit- ment,” a characterization disputed by the SEC which maintained that the guaranteed payments should have been reported as a “current and ongoing—not future—commitment.” After the restatement, Powder River returned to netting the guaranteed payments to the Asian investors against its revenues. However, rather than netting them directly against oil and gas revenues, the company reported a sepa- rate contra revenue line item for these payments in the subsequent comparative income statements for 2006 and 2007 included in its 2007 Form 10-K. That line item was entitled “Production Payment to Working Interest Owners.” 15. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 3267. 16. Ibid. 17. Ibid.

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CASE 2.9 POWDER RIVER PETROLEUM INTERNATIONAL, INC. 277

2007, the company failed to update those reports and instead simply relied on the inadequate prior year reserve reports for financial statement disclosure purposes.

The SEC’s investigation of the Powder River fraud and the deficient audits of the company prompted a parallel investigation of CBN by the PCAOB. In addition to investigating CBN’s Powder River audits, the PCAOB reviewed audits performed by the firm during the same time frame for three other companies.

In reviewing CBN’s Powder River audits, the PCAOB reiterated and, in some instances, expanded on the SEC’s criticisms of those engagements. The PCAOB also addressed firm-wide deficiencies in CBN’s audit practice.

The large number of [CBN audit] clients severely limited the amount of time and atten- tion that Chisholm and Nilson, the Firm’s only audit partners, could spend providing supervision to audit assistants. As a result, planning for many audits consisted of little more than referring audit assistants to standardized audit programs and checklists, which failed to take into account, among other things, specific audit risks for each engagement.

The Firm’s typical practice with respect to staffing audit engagements entailed one audit assistant teaming up with either Chisholm or Nilson. . . . The large number of issuer audit engagements prevented Chisholm or Nilson from providing appropri- ate supervision of audit procedures. Audit assistants with limited experience were often left to decide for themselves what audit procedures should be performed in an audit. Further, Chisholm and Nilson failed to properly evaluate whether the audit reports issued by the Firm were supported by sufficient competent evidential matter.18

The PCAOB also reprimanded Chisholm for failing to establish a proper “tone at the top” of his firm. “Chisholm was the managing partner of the Firm during the relevant time period and was principally responsible for setting the tone at the top. As the managing partner, Chisholm was responsible for designing, implementing and monitoring the Firm’s system of quality control. Accordingly, Chisholm had overall responsibility for ensuring that the Firm complied with PCAOB rules and standards.”19

Some of PCAOB’s harshest criticism of Chisholm and Nilson was reserved for their decision to make undocumented changes in the audit workpapers for engage- ments that were subject to inspection by the agency, including the workpaper files for the 2006 Powder River audit. During the summer of 2007, the PCAOB notified CBN that it would be inspecting the firm’s audit practice. “In preparation for the Board’s inspection, Chisholm and Nilson, and at their instruction, Firm assistants, created and added audit documentation to the audit files [to be inspected].”20 The alterations included several instances in which information was added to the given workpaper files “to create the appearance that Firm auditors had performed cer- tain audit procedures that had not, in fact, been performed during the audits.”21 According to the PCAOB, “hundreds of hours” were spent revising the given work- paper files.

18. Public Company Accounting Oversight Board, PCAOB Release No. 105-2011-003, 8 April 2011. 19. Ibid. 20. Ibid. 21. Ibid.

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278 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

22. M. Caswell, “SEC Target Fox Denies Inflating Revenue,” Stockwatch.com (online), 7 July 2011. 23. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 3469, 28 June 2013.

E P I L O G U E Powder River filed for Chapter 11 bankruptcy reorganization in a federal district court in December 2008. Court records in the case revealed that the company had sold working interests in its oil and gas properties to more than 2,000 individual investors; collectively, the investors had paid more than $43 million for those working interests. An independent appraisal of Powder River’s oil and gas proper- ties obtained by the company’s court-appointed bankruptcy receiver in late 2008 assigned them a value of approximately $1.2 million. Just a few months earlier, the company’s 2007 bal- ance sheet had reported a value of $23 mil- lion for those properties. In November 2010, Powder River’s Chapter 11 bankruptcy petition was converted to a Chapter 7 bankruptcy filing, meaning that the company’s assets would be involuntarily liquidated and the proceeds dis- tributed to the company’s creditors.

In April 2011, the SEC filed a civil complaint against Brian Fox. Among other charges, the complaint alleged that Fox had used various accounting and financial reporting schemes to defraud purchasers and sellers of Powder River’s common stock. Fox responded to the SEC charges filed against him in an interview with a representative of an online investment news service. In that interview, Fox insisted that the transactions involving Powder River and its Asian investors had been bona fide sales transactions and not loans. He also claimed that Powder River had been a “viable operating

entity”22 when a federal judge appointed a bankruptcy receiver to take over the company’s operations in 2008. According to Fox, the bank- ruptcy receiver had destroyed the company by curtailing its business operations. Fox also criti- cized his former business associate who had been involved in arranging the working inter- est transactions. He claimed that individual improperly withheld some of the proceeds from those transactions from Powder River.

In November 2012, a federal judge issued an order banning Fox from serving as an officer or director of an SEC registrant. Three months later, the SEC issued an enforcement order in which it ruled that Fox “had misled the invest- ing public by fraudulently inflating the rev- enues and assets of Power River Petroleum International, Inc . . . and by making other false and misleading public disclosures.”23 The order suspended Fox’s right to “appear or practice” before the SEC.

Todd Chisholm and Troy Nilson were sus- pended from practicing before the SEC for five years beginning in April 2011. The federal agency also indefinitely suspended CBN. At the same time, the PCAOB permanently revoked CBN’s registration, meaning that the firm was prohibited from providing audit services to pub- lic companies. The PCAOB also permanently banned Chisholm from being associated with a PCAOB-registered accounting firm. Nilson was barred from being associated with such a firm for five years.

Questions 1. Identify the primary audit risk factors that were evident within Powder River’s

operations. Briefly explain the significance of each.

2. How should Powder River have recorded the sales of the working interests and the guaranteed payments made to the purchasers of those working interests in its accounting records?

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CASE 2.9 POWDER RIVER PETROLEUM INTERNATIONAL, INC. 279

3. U.S. auditing standards identify the principal “management assertions” that underlie a set of financial statements. What management assertions were particularly relevant to (a) the “sales” of working interests and (b) the guaranteed payments made annually by Powder River to the purchasers of those working interests?

4. The SEC and PCAOB criticized CBN for failing to discover that Powder River did not own certain assets included in its reported oil and gas properties. How would you characterize that oversight? That is, did this oversight constitute negligence, recklessness, or fraud on the part of those auditors or none of these? Defend your answer.

5. Powder River relied on the expertise of a “specialist” in arriving at the estimates of its proved reserves. What responsibilities, if any, do U.S. auditing standards impose on auditors when a client has used the services of a “specialist” for accounting or financial reporting purposes?

6. The PCAOB criticized Todd Chisholm for failing to establish a proper “quality control” system for CBN. What are the primary issues that should be addressed by the quality control system of an audit firm that has public company clients? Provide examples of circumstances in which Chisholm and/or CBN violated the PCAOB’s quality control standards for audit firms.

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281

CASE 2.10

LocatePlus Holdings Corporation

In August 2004, an Internet-based investment advisory service included the com- mon stock of LocatePlus Holdings Corporation in its “Stocks to Watch”1 alert. The advisory service touted the New Age business model of LocatePlus, a company whose headquarters were in a Boston suburb. That business model included pro- viding government agencies, business entities, and individuals access to a mas- sive online database that LocatePlus had collected and organized, a database that included information profiles on 98 percent of all U.S. citizens. Customers of LocatePlus purchased access to the company’s database for a wide array of inves- tigative uses, including antiterrorism initiatives by law enforcement agencies, crimi- nal background checks by prospective employers, and identity theft investigations by private individuals.

Ironically, LocatePlus, a company that developed an important tool to com- bat fraud and other criminal activities in the Internet Age, found itself the focus of a fraud investigation in late 2010. That investigation, which involved the Federal Bureau of Investigation (FBI), the Internal Revenue Service (IRS), and the Securities and Exchange Commission (SEC), resulted in the downfall of the company, criminal prosecutions of its top executives, and harsh regulatory sanctions for the company’s independent audit firm.

Channeling Fraud LocatePlus had two principal revenue streams. Slightly more than one-half of the company’s annual revenue was generated by selling direct, one-time access to its large database. The company’s other major revenue source involved so-called “chan- nel partner” arrangements. A channel partner paid LocatePlus a fixed monthly roy- alty in exchange for unlimited access to its database. Channel partners were typically large government agencies or corporations.

To enhance their company’s disappointing operating results, two LocatePlus executives created a bogus channel partner in 2005. Those two executives were James Fields, the company’s chief financial officer (CFO), and Jon Latorella, the company’s chief executive officer (CEO). The fictitious company, Omni Data Services, allegedly paid several hundred thousand dollars in monthly royalties to LocatePlus. These royalties accounted for $3.6 million of LocatePlus’s 2005 rev- enues of $11.6 million and $2.7 million of the company’s 2006 revenues of $12.2 million. Despite these bogus revenues, LocatePlus continued to post large losses each year. In 2004, the company had reported a net loss of $7.5 million. In 2005 and 2006, the company reported net losses of $5.6 million and $5.9 million, respectively.

LocatePlus used a series of sham transactions, including fraudulent cash transfers, to make it appear that the Omni Data revenues were genuine. The principal purpose of these sham transactions and the corresponding fraudulent journal entries was to

1. Wall Street Capital Funding LLC, “Wall Street Alert’s U.S. Hot Stock Highlights,” GlobeNewswire (online), 24 August 2004.

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282 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

deceive LocatePlus’s independent auditors. Because LocatePlus was a public com- pany, it had to file audited financial statements annually with the SEC.

Predecessor–Successor Auditor Communications In early 2005, LocatePlus contacted Livingston & Haynes (L & H), a Massachusetts- based accounting firm. LocatePlus needed a new independent auditor because its previous one had abruptly resigned. The Form 8-K that LocatePlus filed with the SEC to disclose that resignation included the resignation letter. In that letter, the former audit firm noted that it had “concerns about the timeliness of information we received and about the reliability of certain representations of your company’s management.”2

Before making a decision to accept or reject LocatePlus as an audit client, two L & H audit partners met with the individual who had served as the company’s previous audit engagement partner. These two L & H partners were William Wood and Kevin Howley. Wood was the senior technical partner on L & H’s audit staff.

In his meeting with Wood and Howley, LocatePlus’s former audit engagement part- ner identified several factors that had contributed to his firm’s decision to resign as the company’s independent auditor: “difficulty getting information from manage- ment, management providing contradictory information, management providing unsigned contracts as audit evidence, and difficulty getting management to accept its proposed audit adjustments.” The former audit engagement partner also provided Wood and Howley access to his firm’s audit workpapers for LocatePlus. Included in these workpapers was a letter that the former audit firm had received from an indi- vidual who had previously served as a member of LocatePlus’s management team. This letter alleged that a LocatePlus business partner with whom it had engaged in a multimillion-dollar transaction was “not a legitimate entity.” Despite the informa- tion obtained from LocatePlus’s former audit engagement partner, L & H accepted LocatePlus as an audit client.

After accepting LocatePlus as an audit client, L & H designated the company a “high-risk audit client.” The planning workpapers for the engagement required the audit team to “use extensive care” in auditing the company. Howley was appointed to serve as the audit engagement partner, while Wood served as the concurring part- ner on the engagement.

Red Flags Discovered During 2005 During their 2005 reviews of LocatePlus’s quarterly financial statements, L & H audi- tors “became aware of multiple red flags concerning the revenue recognized from Omni Data and the resulting receivable on LocatePlus’s balance sheet.” In June 2005, Howley noted in an e-mail that he sent to James Fields that Omni Data was not included on a government website that supposedly listed all corporations domiciled in its home state. More troubling was the fact that the L & H auditors could not find a website for that company “despite the fact that Omni Data was purportedly a business doing data sales over the Internet.” Fields subsequently told Howley that Omni Data did not have a website because the company was “trying to keep a low profile.”

In August 2005, a former member of LocatePlus’s board of directors contacted Howley and made disturbing allegations regarding the reliability of the company’s accounting records. Over the next several months, this individual contacted Howley on “numerous occasions” and made similar statements to him. The individual’s most

2. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 3288, 6 June 2011. The remaining quotations in this case were taken from this source.

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CASE 2.10 LOCATEPLUS HOLDINGS CORPORATION 283

serious allegation was that Omni Data did not exist. Among other evidence to sup- port this claim, he pointed out that the alleged President of Omni Data knew “noth- ing” about the company and that she was a ballet teacher who had previously been Latorella’s girlfriend. Howley informed Wood of each of the successive communica- tions he received from the former board member.

Wood discussed the allegations of LocatePlus’s former board member with L & H’s president and forwarded them to the chairman of the company’s audit committee. Wood recommended that the audit committee chairman arrange a meeting of the audit committee with the former board member and Howley to address the allega- tions. Such a meeting never took place.

During the fraud “brainstorming session” for the 2005 LocatePlus audit, the L & H audit team identified “overstated and/or fictitious revenues/accounts receivable” related to Omni Data as a fraud risk factor. For the revenues LocatePlus received from its channel partners other than Omni Data, the L & H auditors compared the “amounts billed and recognized as revenue to LocatePlus’s data usage logs to ensure that the customer had agreed to purchase the product and had actually used it.” This critical audit test was not applied to the Omni Data revenues despite those revenues accounting for nearly one-third of LocatePlus’s 2005 revenues. If the auditors had applied this test to the Omni Data revenues, they would have discovered that Omni Data never accessed the company’s online database in 2005.

In auditing the Omni Data revenues, L & H “relied on the executed agreement between LocatePlus and Omni Data and a confirmation received from Omni Data regarding the monies earned and owed.” In fact, both the executed agreement (con- tract) between the two parties as well as the confirmation received from Omni Data were fraudulent.

As of 31 December 2005, LocatePlus’s accounting records included a $3.3 mil- lion receivable from Omni Data that accounted for 75 percent of the company’s net receivables and represented nearly 40 percent of its total assets. The confirmation for this large receivable was sent to the alleged president of Omni Data. That initial confirmation was returned as “undeliverable” by the U.S. Postal Service. After being provided with a new address for Omni Data’s president, L & H mailed a second con- firmation that was signed and returned without any exceptions being noted.

The L & H auditors documented the allegations made by the former board mem- ber of LocatePlus in their 2005 workpapers but failed to rigorously investigate those allegations. For example, the SEC discovered that the “Fraud Risk Assessment Form” included in the 2005 LocatePlus workpapers was left blank by the L & H auditors. In fact, according to the SEC, the auditors failed to reach “any conclusion about the merits” of the former board member’s disturbing allegations.

Lingering concern about the validity of the Omni Data revenues and receivable prompted the L & H auditors to include specific statements regarding those items in the 2005 letter of representations that was signed by Fields and Latorella. In the let- ter of representations, Fields and Latorella maintained that they had “no knowledge of any fraud or suspected fraud” and that they were unaware of any “allegations of fraud or suspected fraud” related to the Omni Data transactions.

2006 Audit By 31 December 2006, the receivable from Omni Data totaled $5.1 million. In late 2006, LocatePlus had supposedly amended Omni Data’s payment terms. These amended terms resulted in most of the large receivable being reclassified from cur- rent assets to long-term assets on LocatePlus’s 31 December 2006, balance sheet. The company also reduced the gross amount of the long-term portion of the receivable

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284 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

to its net present value and recorded an allowance of nearly $600,000 against the receivable. After these adjustments, the net reported value of the Omni Data receiv- able was approximately $3 million, an amount that represented slightly more than one-half of LocatePlus’s total assets as of 31 December 2006.

The principal evidence collected by L & H to support the Omni Data receivable during the 2006 audit was once again a confirmation. As in the prior year, the ini- tial mailing of the confirmation resulted in it being returned as “undeliverable.” After informing LocatePlus that the original confirmation had not been delivered, Howley was told that Omni Data was operating under a new name and had a new president. L & H mailed the confirmation a second time with the corrected address informa- tion, which resulted in the confirmation being returned signed without any reported exceptions.

While investigating the 2006 LocatePlus audit, the SEC obtained a document from Howley that was entitled “LocatePlus Memorandum—Gallagher Allegations.” This memo summarized the fraud allegations made by the former LocatePlus board member. In the memo, Howley reported that he had discussed the allegations with the chairman of LocatePlus’s audit committee who had “indicated that he did not believe there was any basis” for them. The memo also noted that Howley had dis- cussed the allegations with LocatePlus’s outside legal counsel who also “found no basis for them.” The outside legal counsel suggested that the former board member had made the allegations out of vengeance because he and Latorella were no longer on good terms. Although the memo included evidence pertinent to the Omni Data receivable, it was not included in the LocatePlus workpapers, nor was it dated.

The 2006 workpapers did include a document that referenced an investigation car- ried out in September 2006 by the Massachusetts Securities Division, an investigation that involved LocatePlus. The state agency’s report on that investigation indicated that “even the most cursory review of LocatePlus’s business would reveal that many aspects of its business were either highly exaggerated or fictitious.” This report was readily available on the state agency’s website, however, Howley apparently never accessed the report.

In the 2006 letter of representations, Fields and Latorella once again indicated that they were unaware of any suspected fraud or fraudulent allegations involving Omni Data. Near the conclusion of the 2006 audit, William Wood approved Kevin Howley’s decision to issue an unqualified opinion on LocatePlus’s 2006 financial statements. Wood, who had been involved in the planning for both the 2005 and 2006 audits, had also approved the unqualified opinion issued on the company’s 2005 financial statements.

Both the 2005 and 2006 audit opinions on LocatePlus’s financial statements included a fourth explanatory paragraph. In that paragraph, L & H reported that there was substantial doubt that LocatePlus would remain a going concern. Exhibit 1 includes the 2006 audit opinion.

“Highly Unreasonable Conduct” In June 2011, the SEC issued an Accounting and Auditing Enforcement Release sum- marizing its investigation of L & H’s 2005 and 2006 audits of LocatePlus. The SEC accused Howley and Wood of engaging in “highly unreasonable conduct.”

In light of the specific allegations that the [Omni Data revenue and receivable] . . . were fictitious. . . . The failure of L & H and Howley to properly plan the audits, ade- quately test the Omni Data revenue, obtain sufficient competent evidence to serve as a basis for L & H’s audit reports, exercise due professional care, apply skepticism,

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CASE 2.10 LOCATEPLUS HOLDINGS CORPORATION 285

INDEPENDENT AUDITORS’ REPORT

To the Stockholders and Board of Directors of LocatePlus Holdings Corporation Beverly, Massachusetts

We have audited the accompanying consolidated balance sheet of LocatePlus Holdings Corporation as of December 31, 2006, and the related consolidated statements of operations, stockholders’ equity (deficit) and cash flows for the year ended December 31, 2006, and December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of LocatePlus Holdings Corporation and its subsidiaries as of December 31, 2006, and the results of its consolidated operations and its consolidated cash flows for the years ended December 31, 2006, and December 31, 2005, in conformity with accounting principles generally accepted in the United States of America.

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As disclosed in the financial statements, the Company has an accumulated deficit at December 31, 2006, and has suffered substantial net losses in each of the last two years, which raise substantial doubt about the Company’s ability to continue as a going concern. Management’s plans in regard to these matters are disclosed in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

/s/LIVINGSTON & HAYNES, P.C. Livingston & Haynes, P.C. Wellesley, Massachusetts May 1, 2007

Source: LocatePlus’s 2006 Form 10-K.

EXHIBIT 1

AUDIT OPINION ISSUED BY L & H ON LOCATEPLUS’S 2006 FINANCIAL STATEMENTS

and properly assess the risks of material misstatement due to fraud, and the failure of Wood to address these deficiencies . . . constituted highly unreasonable conduct that resulted in a violation of applicable professional standards in circumstances in which each knew, or should have known, that heightened scrutiny was warranted.

Both Howley and Wood were suspended from practicing before the SEC for three years. L & H was fined $130,000, prohibited from accepting any new SEC clients for one year, and required to undergo an extensive quality control review. Each profes- sional staff member of L & H who served public clients was also required to undergo 24 hours of training involving audit documentation standards, fraud detection, assess- ing the risk of material misstatements, and obtaining and evaluating audit evidence.

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286 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS

Questions 1. The PCAOB’s Interim Standards identify auditors’ responsibilities when

addressing the possibility that fraud has materially impacted a public company’s financial statements. Identify in a bullet format the key instances in which the L & H auditors apparently failed to comply with these responsibilities during the 2005 and 2006 LocatePlus audits.

2. What is the purpose of predecessor–successor auditor communications? Which party, the predecessor or successor auditor, has the responsibility for initiating those communications? Briefly summarize the information that a successor auditor should obtain from the predecessor auditor.

3. What are the primary responsibilities of a “concurring partner” under current U.S. auditing standards?

4. What is the nature and purpose of a “letter of representations”? Comment on the quality or strength of the audit evidence yielded by a letter of representations.

E P I L O G U E In November 2010, the SEC announced that James Fields and Jon Latorella were being charged with criminal violations of the fed- eral securities laws. In March 2012, Latorella pleaded guilty to conspiring to commit securi- ties fraud and related charges, including mak- ing false statements to his former company’s independent auditors. Three months later, Latorella was sentenced to five years in prison. In November 2012, a federal jury found James

Fields guilty of 29 criminal charges, including securities fraud, money laundering, and mak- ing false statements to his former company’s independent auditors. A federal judge sen- tenced Fields to five years in prison in February 2013.

LocatePlus filed for bankruptcy in June 2011. The company’s assets, including its name and website, were sold to a private investment firm in November 2011.

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SECTION 3

INTERNAL CONTROL ISSUES

Case 3.1 The Trolley Dodgers

Case 3.2 Howard Street Jewelers, Inc.

Case 3.3 United Way of America

Case 3.4 First Keystone Bank

Case 3.5 Goodner Brothers, Inc.

Case 3.6 Buranello’s Ristorante

Case 3.7 Foamex International, Inc.

Case 3.8 The Boeing Company

Case 3.9 Walmart de Mexico

3

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289

CASE 3.1

The Trolley Dodgers

In 1890, the Brooklyn Trolley Dodgers professional baseball team joined the National League. Over the following years, the Dodgers would have considerable difficulty competing with the other baseball teams in the New York City area. Those teams, principal among them the New York Yankees, were much better financed and gener- ally stocked with players of higher caliber.

After nearly seven decades of mostly frustration on and off the baseball field, the Dodgers shocked the sports world by moving to Los Angeles in 1958. Walter O’Malley, the flamboyant owner of the Dodgers, saw an opportunity to introduce professional baseball to the rapidly growing population of the West Coast. More important, O’Malley saw an opportunity to make his team more profitable. As an inducement to the Dodgers, Los Angeles County purchased a goat farm located in Chavez Ravine, an area two miles northwest of downtown Los Angeles, and gave the property to O’Malley for the site of his new baseball stadium.

Since moving to Los Angeles, the Dodgers have been the envy of the baseball world: “In everything from profit to stadium maintenance . . . the Dodgers are the prototype of how a franchise should be run.”1 During the 1980s and 1990s, the Dodgers reigned as the most profitable franchise in baseball with a pretax profit margin approaching 25 percent in many years. In late 1997, Peter O’Malley, Walter O’Malley’s son and the Dodgers’ princi- pal owner, sold the franchise for $350 million to media mogul Rupert Murdoch. A spokes- man for Murdoch complimented the O’Malley family for the long-standing success of the Dodgers organization: “The O’Malleys have set a gold standard for franchise ownership.”2

During an interview before he sold the Dodgers, Peter O’Malley attributed the success of his organization to the experts he had retained in all functional areas: “I don’t have to be an expert on taxes, split-fingered fastballs, or labor relations with our ushers. That talent is all available.”3 Edward Campos, a longtime accountant for the Dodgers, was a seemingly perfect example of one of those experts in the Dodgers orga- nization. Campos accepted an entry-level position with the Dodgers as a young man. By 1986, after almost two decades with the club, he had worked his way up the employment hierarchy to become the operations payroll chief.

After taking charge of the Dodgers’ payroll department, Campos designed and implemented a new payroll system, a system that only he fully understood. In fact, Campos controlled the system so completely that he personally filled out the weekly payroll cards for each of the 400 employees of the Dodgers. Campos was known not only for his work ethic but also for his loyalty to the club and its owners: “The Dodgers trusted him, and when he was on vacation, he even came back and did the payroll.”4

Unfortunately, the Dodgers’ trust in Campos was misplaced. Over a period of sev- eral years, Campos embezzled several hundred thousand dollars from his employer. According to court records, Campos padded the Dodgers’ payroll by adding fictitious

1. R. J. Harris, “Forkball for Dodgers: Costs Up, Gate Off,” Wall Street Journal, 31 August 1990, B1, B4. 2. R. Newhan, “Dodger Sale Heads for Home,” Los Angeles Times, 5 September 1997, C1, C12. 3. Harris, “Forkball for Dodgers,” B1. 4. P. Feldman, “7 Accused of Embezzling $332,583 from Dodgers,” Los Angeles Times, 17 September 1986, Sec. 2, 1, 6.

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290 SECTION THREE INTERNAL CONTROL ISSUES

employees to various departments in the organization. In addition, Campos routinely inflated the number of hours worked by several employees and then split the result- ing overpayments 50-50 with those individuals.

The fraudulent scheme came unraveled when appendicitis struck down Campos, forcing the Dodgers’ controller to temporarily assume his responsibilities. While com- pleting the payroll one week, the controller noticed that several employees, includ- ing ushers, security guards, and ticket salespeople, were being paid unusually large amounts. In some cases, employees earning $7 an hour received weekly paychecks approaching $2,000. Following a criminal investigation and the filing of charges against Campos and his cohorts, all the individuals involved in the payroll fraud confessed.

A state court sentenced Campos to eight years in prison and required him to make restitution of approximately $132,000 to the Dodgers. Another of the conspirators also received a prison sentence. The remaining individuals involved in the payroll scheme made restitution and were placed on probation.

5. A. Burack, “Former Giants’ Payroll Manager Sentenced to 21 Months in Prison for Embezzlement,” San Francisco Examiner (online), 26 March 2012. 6. Ibid. 7. Ibid.

E P I L O G U E The San Francisco Giants are easily the most heated, if not hated, rival of the Dodgers. In March 2012, a federal judge sentenced the Giants’ former payroll manager to 21 months in prison after she pleaded guilty to embezzling $2.2 million from the Giants organization. An attorney for the Giants testified that the payroll manager “wreaked havoc” on the Giants’ play- ers, executives, and employees. The attorney said that the embezzlement “included more than 40 separate illegal transactions, includ- ing changing payroll records and stealing employees’ identities and diverting their tax payments.”5 A federal prosecutor reported that

the payroll manager used the embezzled funds to buy a luxury car, to purchase a second home in San Diego, and to travel.

When initially confronted about her embezzle- ment scheme, the payroll manager had “denied it completely.”6 She confessed when she was shown the proof that prosecutors had collected. During her sentencing hearing, the payroll man- ager pleaded with the federal judge to sentence her to five years probation but no jail term. She told the judge, “I cannot say how sorry that I am . . . that I did this, because it’s not who I am. I have no excuse for it. There is no excuse in the world for taking something that doesn’t belong to you.”7

Questions 1. Identify the key audit objectives for a client’s payroll function. Comment on

objectives related to tests of controls and substantive audit procedures.

2. What internal control weaknesses were evident in the Dodgers’ payroll system?

3. Identify audit procedures that might have led to the discovery of the fraudulent scheme masterminded by Campos.

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291

CASE 3.2

Howard Street Jewelers, Inc.

Lore Levi was worried as she scanned the most recent monthly bank statement for the Howard Street Jewelers.1 For decades, she and her husband, Julius, had owned and operated the small business that they had opened after fleeing Nazi Germany during World War II. Certainly the business had experienced ups and downs before, but now it seemed to be in a downward spiral from which it could not recover. In pre- vious times when sales had slackened, the Levis had survived by cutting costs here and there. But now, despite several measures the Levis had taken to control costs, the business’s cash position continued to steadily worsen. If a turnaround did not occur soon, Lore feared that she and her husband might be forced to close their store.

Lore had a theory regarding the financial problems of Howard Street Jewelers. On more than one occasion, she had wondered whether Betty the cashier, a trusted and reliable employee for nearly 20 years, might be stealing from the cash register. To Lore, it was a logical assumption. Besides working as a part-time sales clerk, Betty handled all of the cash that came into the business and maintained the cash receipts and sales records. If anybody had an opportunity to steal from the business, it was Betty.

Reluctantly, Lore approached her husband about her theory. Lore pointed out to Julius that Betty had unrestricted access to the cash receipts of the business. Additionally, over the previous few years, Betty had developed a taste for more expensive clothes and more frequent and costly vacations. Julius quickly dismissed his wife’s speculation. To him, it was preposterous to even briefly consider the possibility that Betty could be stealing from the business. A frustrated Lore then raised the subject with her son, Alvin, who worked side by side with his parents in the family business. Alvin responded simi- larly to his father and warned his mother that she was becoming paranoid.

Near the end of each year, the Levis met with their accountant to discuss various matters, principally taxation issues. The Levis placed considerable trust in their CPA because for years he had given them solid, professional advice on a wide range of accounting and business matters. So, it was only natural for Lore to confide in him about her suspicions regarding Betty the cashier. The accountant listened intently to Lore and then commented that he had noticed occasional shortages in the cash receipts records that seemed larger than normal for a small retail business. Despite Julius’s protestations that Betty could not be responsible for any cash shortages, the accountant encouraged the Levis to closely monitor her work.

Embezzlements are often discovered by luck rather than by design. So it was with the Howard Street Jewelers. Nearly two years after Lore Levi had suggested that Betty might be stealing from the business, a customer approached the cash register and told Alvin Levi that she wanted to make a payment on a layaway item. Alvin, who was working the cash register because it was Betty’s day off, searched the file of layaway sales tickets and the daily sales records but found no trace of the customer’s layaway purchase. Finally, he apologized and asked the customer to return the next day when Betty would be back at work.

1. Most of the facts of this case were reconstructed from information included in several legal opinions. The following two articles served as additional sources for this case: Securities Regulation and Law Report, “Accounting & Disclosure: Accounting Briefs,” Vol. 23, No. 21 (24 May 1991), 814; Securities Regulation and Law Report, “Accounting & Disclosure: Accounting Briefs,” Vol. 24, No. 19 (8 May 1992), 708.

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292 SECTION THREE INTERNAL CONTROL ISSUES

The following day, Alvin told Betty that he was unable to find the layaway sales ticket. Betty expressed surprise and said she would search for the ticket herself. Within a few minutes, Betty approached Alvin, waving the sales ticket in her hand. Alvin was stumped. He had searched the layaway sales file several times and simply could not accept Betty’s explanation that the missing ticket had been there all along. Suspicious, as well, was the fact that the sale had not been recorded in the sales records—a simple oversight, Betty had explained.

As Alvin returned to his work, a troubling and sickening sensation settled into the pit of his stomach. Over the next several weeks, Alvin studied the daily sales and cash receipts records. He soon realized that his mother had been right all along. Betty, the trusted, reliable, longtime cashier of the Howard Street Jewelers, was steal- ing from the business. The estimated embezzlement loss suffered by Howard Street Jewelers over the term of Betty’s employment approached $350,000.

Questions 1. Identify the internal control concepts that the Levis overlooked or ignored.

2. When Lore Levi informed the CPA of her suspicions regarding Betty, what responsibilities, if any, did the CPA have to pursue this matter? Alternately, assume that, in addition to preparing tax returns for Howard Street Jewelers, the CPA (a) audited the business’s annual financial statements, (b) reviewed the annual financial statements, and (c) compiled the annual financial statements.

3. Assume that you have a small CPA firm and have been contacted by a husband and wife, Chris and Brooke Arbeitman, who are in the final stages of negotiating to purchase a local jewelry store. Chris will prepare jewelry settings, size jewelry for customers, and perform related tasks, while Brooke will be the head salesclerk. The Arbeitmans intend to retain four of the current employees of the jewelry store—two salesclerks, a cashier, and a college student who cleans the store, runs errands, and does various other odd jobs. They inform you that the average inventory of the jewelry store is $300,000 and that annual sales average $1,400,000, 30 percent of which occur in the six weeks prior to Christmas.

The Arbeitmans are interested in retaining you as their accountant should they purchase the store. They know little about accounting and have no prior experience as business owners. They would require assistance in establishing an accounting system, monthly financial statements for internal use, annual finan- cial statements to be submitted to their banker, and all necessary tax returns. Chris and Brooke are particularly concerned about control issues—given the dollar value of inventory that will be on hand in the store and the significant amount of cash receipts that will be processed daily.

You see this as an excellent opportunity to acquire a good client. However, you have not had a chance to prepare for your meeting with the Arbeitmans because they came in without an appointment. You do not want to ask them to come back later since that may encourage them to check out your competitor across the street.

Required: Provide the Arbeitmans with an overview of the key internal control issues they will face in operating a jewelry store. In your overview, identify at least five control activities you believe they should implement if they acquire the store. You have never had a jewelry store as a client but you have several small retail clients. Attempt to impress the Arbeitmans with your understanding of internal control issues for small retail businesses.

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293

CASE 3.3

United Way of America

In 1887, several of Denver’s community and religious leaders established the Charity Organization Society. During its first year of operation, the organization raised a little more than $20,000, which it then distributed to several local charities. The charity- of-charities fundraising concept spread across the United States over the following decades. After several name changes, the original Denver-based organization adopted the name United Way in 1963.

United Way grew rapidly during the latter decades of the twentieth century, even- tually becoming the nation’s largest charitable organization. In 2006, United Way raised four billion dollars, more than double the charitable donations received that year by the Salvation Army, the nation’s second largest charitable organization. Each year, approximately 40,000 charities across the United States receive cash distribu- tions from United Way.

Football & Fraud For more than two decades beginning in the early 1970s, William Aramony served as the president of United Way of America. The Virginia-based United Way of America serves as the umbrella organization for the almost 1,400 local United Way chapters scattered across the United States. An alliance that Aramony negotiated with the National Football League (NFL) resulted in huge nationwide exposure for the United Way during every Sunday afternoon and Monday night NFL game. That exposure was largely responsible for the explosive growth that United Way realized during Aramony’s tenure as president.

In recent years, United Way has faced two major challenges that threaten its lead- ership position in the charitable sector. Over the past several decades, the number of charitable and other not-for-profit organizations in the United States has skyrock- eted. Currently, there are nearly two million registered tax-exempt organizations in the United States, the majority of which are charities. Collectively, these organiza- tions employ one of every ten working Americans. Registered charities alone raise more than $300 billion each year in donations from the public and private sector. The intense and growing competition for Americans’ charitable donations has made it increasingly difficult for United Way to sustain the impressive growth that it real- ized under William Aramony’s leadership.

The second major challenge facing United Way is a loss of credibility suffered by the organization due to a series of embarrassing and highly publicized embezzle- ment schemes. In the early 1990s, federal prosecutors indicted William Aramony for embezzling millions of dollars of United Way funds. In 1995, a federal jury found Aramony guilty of more than two dozen of the individual fraud charges that had been filed against him. Aramony was later sentenced to serve seven years in federal prison. Testimony during his trial revealed that he had squandered United Way funds on lavish trips to Las Vegas, Europe, Africa, and other destinations. The 68-year-old Aramony reportedly used United Way funds to finance multiple romantic relation- ships as well.

Shortly before Aramony went to trial, another United Way executive in Westchester, New York, admitted to embezzling several hundred thousand dollars of her chapter’s

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294 SECTION THREE INTERNAL CONTROL ISSUES

funds. This individual, Evol Sealy, who oversaw the Westchester chapter’s account- ing and finance functions, was later sentenced to a three-year prison term. In 2003, Jacquelyn Allen-MacGregor, the former vice president of finance of a United Way chapter in East Lansing, Michigan, pleaded guilty to stealing $1.9 million from the organization. Allen-MacGregor revealed that she had used the stolen funds to sup- port her hobby, namely, horses—over the course of her embezzlement scheme she purchased more than 70 quarter horses. In June 2004, Allen-MacGregor was sen- tenced to four years in prison to be followed by three years of supervised probation.

In 2004, Aramony’s friend and former associate, Oral Suer, who served for almost three decades as the president of a large United Way chapter in Washington, D.C., pleaded guilty to embezzling $1.5 million of United Way funds. The evidence collected by federal prosecutors against Suer included testimony documenting that Suer and Aramony had spent time together at a local racetrack. That evidence also docu- mented that Suer used cash taken from his chapter to make good on the generous and well-publicized personal contribution pledges that he made during annual United Way fundraising campaigns. At his sentencing hearing, a contrite Suer told the presid- ing judge, “This is a very sad day for me, for the community and for the United Way. What I feel is embarrassment, shame and guilt.”1 The judge then handed Suer a three- year prison sentence, the maximum permissible under federal sentencing guidelines.

United Way’s reported theft losses have had a chilling effect on the organization’s fundraising efforts nationwide in recent years. Individual chapters impacted directly by the embezzlement losses have experienced the most dramatic declines in their annual receipts. For example, adverse publicity resulting from the embezzlement loss at the United Way chapter in the Washington, D.C., area caused that chapter’s annual donations to plummet from $45 million to $18 million.

Other major charities have also been victimized by organizational insiders. In 1989, former television evangelist Jim Bakker was sentenced to 18 years in federal prison. Bakker was convicted of diverting millions of dollars for his personal use from the PTL Club, a religious broadcasting network that he and his wife, Tammy Faye, founded in the 1970s. The Bakkers had used passionate and persistent tele- vised fundraising campaigns to convince the faithful and mostly shallow-pocketed viewers of their network to send them donations.

In 1997, John G. Bennett, the founder of the New Era Philanthropy Foundation, was sentenced to 12 years in prison after embezzling an estimated $8 million from that charitable organization. In California, seven employees of Goodwill Industries, all of whom were related, operated a large-scale “fencing” operation from the early 1970s through 1998 in which they sold furniture, clothing, and other goods donated to that charity. Law enforcement authorities estimate that the seven relatives stole more than $25 million from that organization over the course of the fraudulent scheme.

To date, the largest fraud impacting a charity was a Ponzi scheme involving the Baptist Foundation of Arizona. In 2006, William Crotts, the chief executive of that charitable religious organization, received an eight-year prison sentence for defraud- ing an estimated 10,000 individuals of nearly $160 million. Making matters worse, most of the victims of Crotts’ fraud were elderly individuals, many of whom lost a sizable portion of their retirement nest eggs as a result of the fraud.

Empirical research has confirmed that fraud is a major problem plaguing the chari- table sector. A recent study by four accounting professors suggests that approximately one of every eight dollars contributed to charitable organizations in the United States

1. J. Markon, “Ex-Chief of Local United Way Sentenced,” Washington Post (online), 15 May 2004.

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CASE 3.3 UNITED WAY OF AMERICA 295

is stolen each year, resulting in annual losses to those organizations of $40 billion.2 That study found that 95 percent of the losses suffered by charities result from the theft of cash and that the culprits are typically involved in the charity’s financial func- tions. “They’re usually done by someone in the financial area—the treasurer, the bookkeeper, the signer of checks—who knows how to avoid getting caught.”3

Recipe for Theft: Weak Controls and Ineffective Regulatory Oversight A common theme of the frauds that have plagued charities in recent years has been inadequate or nonexistent internal controls. Understandably, charitable organizations make every effort to minimize their administrative expenses, including their account- ing and control-related expenditures. For example, an internal study by United Way of America in 2002 found that fewer than 15 percent of the organization’s local chapters had invested the time and other resources to develop written policies to address fun- damental accounting and control issues.4 No doubt, the porous nature of charities’ internal control systems not only encourages opportunistic individuals to take advan- tage of those organizations but also makes it difficult to detect ongoing frauds.

In 2004, PricewaterhouseCoopers released a 200-page report that detailed the results of a seven-month investigative audit of the embezzlement loss suffered by the East Lansing, Michigan, chapter of United Way. That report castigated United Way for failing to implement some of the most rudimentary control procedures intended to prevent thefts by organizational insiders. “The audit, more than seven months in the making, gives a scathing review, depicting the charity as a place where top managers were per- mitted to dip into the millions of dollars in public donations with little or no oversight.”5

According to the New York Times, the individual who embezzled the funds from the East Lansing chapter “did not need to be a criminal mastermind to succeed in the theft.”6 Instead, that individual took advantage of the chapter’s lack of proper internal controls and stole the funds at will. “She simply wrote checks to herself, forging the signatures of the required cosigners and destroying the canceled checks when the bank mailed them back. No one noticed this because she also kept the organization’s books.”7

Similar to the other United Way fraudsters, the executive who embezzled several hundred thousand dollars from the Westchester, New York, United Way chapter used a simple scam to “rip off” her organization. The executive endorsed checks made payable to United Way from local donors and then deposited those checks in her personal bank account. The fraud was uncovered when a bank teller reported her to local authorities. In commenting on the embezzlement scheme, the local district attorney noted, “There was most certainly a total lack of supervision which permit- ted this to occur.”8 The president of that chapter expressed a different point of view:

2. S. Strom, “Report Sketches Crime Costing Billions: Theft From Charities,” New York Times (online), 29 March 2008. 3. Ibid. 4. S. Strom, “Questions Arise on Accounting at United Way,” New York Times (online), 19 November 2002. 5. J. Salmon and P. Whoriskey, “Audit Excoriates United Way Leadership,” Washington Post (online), 25 June 2004. 6. S. Strom, “Guilty Plea Due Today in Big United Way Theft,” New York Times (online), 6 February 2003. 7. Ibid. 8. J. Steinberg, “United Way Accountant Admits $282,500 Theft,” New York Times (online), 19 May 1992.

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296 SECTION THREE INTERNAL CONTROL ISSUES

“As in the case of virtually any organization, our system of internal control proce- dures, no matter how strong, is based on trust.”9

Compounding the weakness of the internal control systems of charities such as United Way is the absence of strong regulatory oversight for the charitable sector. The regulatory infrastructure for charities is weak and enforcement is inconsis- tent. Unlike public companies that are overseen by the Securities and Exchange Commission (SEC), charitable organizations are not subject to direct oversight by a federal agency. Federal oversight of charities involves principally an annual informa- tion filing with the Internal Revenue Service (IRS).

Similar to other tax-exempt organizations, most charities are required to submit a Form 990 to the IRS each year. Among many other required disclosures in Form 990, charities must report their total annual revenues and the principal sources of those revenues, fundraising expenses, the salaries of highly paid executives, and losses due to theft, embezzlement, and other fraudulent activities. The latter disclosure was added to Form 990 beginning in 2008 as a direct consequence of the mounting theft losses being incurred by charities. A searchable database of the approximately two million Form 990’s filed each year with the IRS is available at www.guidestar.org.

Although there is no federal agency with a direct responsibility to regulate chari- ties, many states have established such an agency. Nevertheless, these state agen- cies tend to be underfunded and are ineffectual as a result. “While most states have agencies [overseeing charitable organizations], most are inactive, ineffective or significantly understaffed.”10

Bring in the Auditors? Following the passage of the Sarbanes–Oxley Act in 2002, some charities adopted inter- nal control reforms and other provisions included in that federal statute. Not satisfied, prominent members of the philanthropic community have lobbied state and federal legislators to pass legislation that would require charities to implement a comprehen- sive reform agenda similar to that mandated by Sarbanes–Oxley. “The American gov- ernment can no longer make a plausible argument that charities don’t deserve the type of scrutiny that the for-profit sector warrants. Quite simply, the charitable sector is much too large to warrant the continued disinterest our government has shown it.”11

One proponent of regulatory reform has suggested that charities be required to obtain a “seal of approval” of some type to reassure donors that their contributions are not being misused.12 In fact, a common measure included in proposed regulatory reforms for charities is a requirement that they be subject to an annual independent audit by an accounting firm.

Only a few states currently require annual financial audits of nonprofit corporations. . . . Independent financial audits have become such a fundamental and essential test of the financial soundness of any corporate enterprise that all best practice codes of nonprofit governance require that every nonprofit corporation with substantial assets or annual revenue should be audited annually by an independent auditing firm.13

9. Ibid. 10. A. Rothschild, “Public Scrutiny of Exempt Organizations,” www.abanet.org/rppt/publications/ estate/2004/2/Rothschild-PublicScr.pdf. 11. T. Stamp, “Why Does Our Government Ignore Charities?” Charity Navigator (online), 14 October 2002. 12. W. Muller, “Charities and Anti-Money Laundering: Is a ‘Seal of Approval’ the Answer?” Trusts and Trustees, 14 (May 2008): 259–271. 13. T. Silk, “Good Governance Practices for 501 (c)(3) Organizations: Should the IRS Become Further Involved?” International Journal of Not-for-Profit Law, 2007 (Vol. 10), 40.

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CASE 3.3 UNITED WAY OF AMERICA 297

California and Massachusetts are examples of states that have passed legisla- tion in recent years to require certain charities to be audited annually. California’s Nonprofit Integrity Act of 2004 requires charities with annual gross revenues exceed- ing $2   million to be audited. The comparable state statute in Massachusetts requires charities with annual revenues exceeding $500,000 or total assets greater than $5  million to be audited. These same charities are also required by the Massachusetts law to establish an audit committee.

Not all charity reform advocates believe that mandatory independent audits would remedy the problems facing the charitable sector. These parties point out that sev- eral of the charities that suffered large losses due to embezzlement and other fraudu- lent schemes had been audited by accounting firms. One such charity was United Way of America, which was audited by Arthur Andersen during the time frame that Aramony was embezzling from the organization. Andersen was widely criticized for failing to detect Aramony’s fraud. The managing partner of the Andersen office that audited the organization responded to that criticism by insisting that United Way offi- cials had intentionally concealed the fraudulent activities from the auditors.14

The auditors of the East Lansing, Michigan, United Way chapter that suffered an embezzlement loss of $1.9 million were also criticized for failing to uncover that fraud. The audit partner who supervised the annual audits of that chapter staunchly defended himself and his subordinates. “This [embezzlement scheme] went on prior to our being engaged in 1999, and when you have fraud going on a long time, it’s hard to find because it has become the norm [within the organization].”15

Questions 1. Identify and briefly describe fundamental and cost-effective internal controls

that charitable organizations could implement to reduce their exposure to theft losses.

2. Do CPA firms have a responsibility to perform audits of charitable organizations for reduced or lower-than-normal audit fees? Defend your answer. Other than audit fees, what other benefits do accounting firms accrue by auditing a charity?

3. Identify unique or uncommon audit risk factors posed by a charity. How should accounting firms modify their audits to address these risk factors?

14. J. Garnatz, “United Way Cleaning House Nationally, Doing Well Locally,” St. Petersburg Times, 17 April 1992, 11. 15. Strom, “Guilty Plea Due Today.”

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299

CASE 3.4

First Keystone Bank

A Japanese bank introduced the concept of around-the-clock access to cash in the 1960s when it installed the world’s first cash-dispensing machine. In 1968, the first networked ATM appeared in Dallas, Texas.1 Two generations later, there are more than two million “cashpoints,” “bancomats,” and “holes-in-the-wall” worldwide, including one in Antarctica.

Not surprisingly, ATMs have been a magnet for thieves since their inception. In 2009, an international gang of racketeers used a large stash of counterfeit ATM cards to steal $9 million from hundreds of ATMs scattered around the globe in a well-planned and coordinated 30-minute crime spree. Several high-tech thieves have hacked into the computer networks of banks and modified their ATM software. One such miscreant reprogrammed a network of ATMs to change the denomination of bills recognized by the brainless machines—the ATMs treated $20 bills as if they were $5 bills. High-powered video cameras and miniature electronic devices attached to ATMs have been used to steal personal identification numbers (PINs) from a count- less number of unsuspecting bank customers.

A variety of low-tech schemes have also been used to rip off banks and their cus- tomers via ATMs, including forced withdrawals and post-withdrawal armed rob- beries. “Ram-raiding” involves using heavy-duty equipment to rip an ATM from its shorings. The ram-raiders then haul the ATM to a remote location and blast it open with explosives. The most common and lowest-tech type of ATM pilfering involves the aptly named tactic of “shoulder-surfing.”

Many banks have suffered losses from their ATM operations due to embezzle- ment schemes perpetrated by employees. One such bank was the Swarthmore, Pennsylvania, branch of First Keystone Bank. Swarthmore, a quiet suburb of Philadelphia, is best known for being home to one of the nation’s most prestigious liberal arts colleges. In 2013, Forbes Magazine ranked Swarthmore College as the sixth best institution of higher learning in the United States—two slots below Yale, but two slots higher than Harvard.

In January 2010, three tellers of First Keystone’s Swarthmore branch were arrested and charged with stealing more than $100,000 from its ATM over the previous two years. The alleged ringleader was Jean Moronese, who had worked at the branch since 2002 and served as its head teller since 2006. According to media reports, Moronese told law enforcement authorities that she initially began taking money from the branch’s ATM in 2008 to pay her credit card bills, rent, and day care expenses.

No doubt emboldened by the ease with which she could steal the money, Moronese reportedly began taking cash from the ATM “just to spend” because she “got greedy.”2 Prior to taking a vacation in the fall of 2008, a tearful Moronese approached one of her subordinates and fellow tellers, Kelly Barksdale, and confessed that she had been stealing from the ATM. Moronese “begged” Barksdale to help her conceal her

1. In the United States, “ATM” generally refers to an “automated teller machine” or “automated transac- tion machine.” In some English-speaking countries, however, “ATM” refers to “all-time-money.” 2. C. Scharr, “Bank Employees Charged in Embezzlement Scheme,” Delaware County Daily Times (online), 12 January 2010.

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300 SECTION THREE INTERNAL CONTROL ISSUES

thefts “because she didn’t want her children to see her go to jail.”3 Barksdale was apparently persuaded by Moronese’s tearful plea and agreed to help her cover up the embezzlement scheme.

In fact, the cover-up was easily accomplished. According to the local police, Moronese and Barksdale simply changed the ledger control sheets that were supposed to report the amount of cash stored in the ATM and in the locked vault within the ATM. First Keystone’s internal control procedures mandated that two employees be involved in resupplying the ATM and its locked vault and in maintaining the ATM ledger control sheets. However, either Moronese or Barksdale completed those tasks by themselves.

In early 2009, a third teller, Tyneesha Richardson, overheard Moronese and Barksdale discussing the embezzlement scheme. Richardson then reportedly asked Moronese for money to pay off her car loan. Moronese agreed to give Richardson the money and told her that she shouldn’t worry because “the bank had a lot of money and they would never miss it.”4,5 After telling Barksdale that she had given money to Richardson, Moronese told Barksdale that if she ever needed any money “to let her know.”6 Not long thereafter, Barksdale allegedly asked Moronese for $600 to pay her rent.

An internal audit eventually uncovered the embezzlement scheme at First Keystone’s Swarthmore branch. That internal audit revealed that $40,590 was miss- ing from the branch’s ATM, while another $60,000 was missing from the locked vault within the ATM’s interior.

While being interrogated by law enforcement authorities, Barksdale reportedly confessed that she and her colleagues had also stolen money from the local munici- pality. City employees periodically dropped off at the First Keystone branch large bags of coins collected from Swarthmore’s parking meters. Tellers at the branch were supposed to feed the coins into a coin-counting machine and then deposit the receipts printed by the machine into the city’s parking account. According to Barksdale, she and her two fellow conspirators diverted money from Swarthmore’s parking funds and split it among themselves. The police estimated that the three tell- ers stole approximately $24,000 of the parking funds.

In January 2010, when the three tellers were arrested, they did not have far to go since the Swarthmore police station was across the street from the First Keystone branch where they worked. In commenting on the case, the local district attorney observed that Barksdale and Richardson had a choice to make when they learned of Moronese’s embezzlement scheme and that each had made the wrong choice. “So, the lesson is you can either be a witness or you can be a defendant. These two chose to be defendants.”7

The district attorney also commented on the branch’s failure to require employees to comply with internal control procedures. “The case is yet another example of the importance of not only implementing internal accounting safeguards, but ensuring that those safeguards are being followed by all employees at all levels of the business.”8,9

3. M. Schaefer, “Ex-tellers at Swarthmore Bank Charged in Theft,” www.philly.com, 12 January 2010. 4. Scharr, “Bank Employees Charged.” 5. While at work, the three coworkers reportedly used the code word “Todd” to refer to “their friend” when they needed or wanted to take money from the ATM. 6. Scharr, “Bank Employees Charged.” 7. Schaefer, “Ex-tellers at Swarthmore Bank.” 8. Press release issued 11 January 2010, by G. Michael Green, District Attorney, Delaware County, Media, Pennsylvania (http://www.delcoda.com/documents/FirstKeystoneStatement byMikeGreen.pdf). 9. In March 2010, an employee of First Keystone’s branch in Berwick, Pennsylvania, pleaded guilty to embezzling $750,000 over the 17 years that she had worked for that branch. According to published reports, the employee routinely “skimmed” money received by the bank and deposited the stolen funds into bank accounts that she controlled.

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CASE 3.4 FIRST KEYSTONE BANK 301

Questions 1. Prepare a list of internal control procedures that banks and other financial

institutions have implemented, or should implement, for their ATM operations.

2. What general conditions or factors influence the audit approach or strategy applied to a bank client’s ATM operations by its independent auditors?

3. Identify specific audit procedures that may be applied to ATM operations. Which, if any, of these procedures might have resulted in the discovery of the embezzlement scheme at First Keystone’s Swarthmore branch? Explain.

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303

CASE 3.5

Goodner Brothers, Inc.

“Woody, that’s $2,400 you owe me. Okay? We’re straight on that?” “Yeah, yeah. I got you.” “And you’ll pay me back by next Friday?” “Al, I said I’d pay you back by Friday, didn’t I?” “Just checkin’.” Borrowing money from a friend can strain even the strongest relationship. When

the borrowed money will soon be plunked down on a blackjack table, the impact on the friendship can be devastating.

Woody Robinson and Al Hunt were sitting side by side at a blackjack table in Tunica, Mississippi. The two longtime friends and their wives were spending their summer vacations together as they had several times. After three days of loitering in the casi- nos that line the banks of the Mississippi River 20 miles south of Memphis, Woody found himself hitting up his friend for loans. By the end of the vacation, Woody owed Al nearly $5,000. The question facing Woody was how he would repay his friend.1

Two Pals Named Woody and Al Woodrow Wilson Robinson and Albert Leroy Hunt lived and worked in Huntington, West Virginia, a city of 60,000 tucked in the westernmost corner of the state. The blue- collar city sits on the south bank of the Ohio River. Ohio is less than one mile away across the river, while Kentucky can be reached by making a 10-minute drive westward on Interstate 64. Woody and Al were born six days apart in a small hospital in eastern Kentucky, were best friends throughout grade school and high school, and roomed together for four years at college. A few months after they graduated with business man- agement degrees, each served as the other’s best man at their respective weddings.

Following graduation, Al went to work for Curcio’s Auto Supply on the western out- skirts of Huntington, a business owned by his future father-in-law. Curcio’s sold lawn- mowers, bicycles, and automotive parts and supplies, including tires and batteries, the business’s two largest revenue producers. Curcio’s also installed the automotive parts it sold, provided oil and lube service, and performed small engine repairs.

Within weeks of going to work for Curcio’s, Al helped Woody land a job with a large tire wholesaler that was Curcio’s largest supplier. Goodner Brothers, Inc., sold tires of all types and sizes from 14 locations scattered from southern New York to northwestern South Carolina and from central Ohio to the Delaware shore. Goodner concentrated its operations in midsized cities such as Huntington, West Virginia; Lynchburg, Virginia; Harrisburg, Pennsylvania; and Youngstown, Ohio, home to the company’s headquarters.

Founded in 1979 by two brothers, T. J. and Ross Goodner, nearly three decades later Goodner Brothers’ annual sales approached $40 million. The Goodner family dominated the company’s operations. T. J. served as the company’s chairman of the

1. The central facts of this case were drawn from a legal opinion. The names of the actual parties involved in the case and the relevant locations and dates have been changed. Additionally, certain of the factual circumstances reported in this case are fictionalized accounts of background material disclosed in the legal opinion.

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304 SECTION THREE INTERNAL CONTROL ISSUES

board and chief executive officer (CEO), while Ross was the chief operating officer (COO). Four second-generation Goodners also held key positions in the company.

Goodner purchased tires from several large manufacturers and then sold those tires at wholesale prices to auto supply stores and other retailers that had auto supply depart- ments. Goodner’s customers included Sears, Walmart, Kmart, and dozens of smaller retail chains. The company also purchased discontinued tires from manufacturers, large retailers, and other wholesalers and then resold those tires at cut-rate prices to school districts, municipalities, and to companies with small fleets of automobiles.

Goodner Brothers hired Woody to work as a sales rep for its Huntington location. Woody sold tires to more than 80 customers in his sales region that stretched from the west side of Huntington into eastern Kentucky and north into Ohio. Woody, who worked strictly on a commission basis, was an effective and successful salesman. Unfortunately, a bad habit that he acquired during his college days gradually developed into a severe problem. A gambling compulsion threatened to wreck the young salesman’s career and personal life.

Woody bet on any and all types of sporting events, including baseball and football games, horse races, and boxing matches. He also spent hundreds of dollars each month buying lottery tickets and lost increasingly large sums on frequent gambling excursions with his friend Al. By the summer of 2006 when Woody, Al, and their wives visited Tunica, Mississippi, Woody’s financial condition was desperate. He owed more than $50,000 to the various bookies with whom he placed bets, was falling behind on his mortgage payments, and had “maxed out” several credit cards. Worst of all, two bookies to whom Woody owed several thousand dollars were demanding payment and had begun making menacing remarks that alluded to his wife, Rachelle.

Woody Finds a Solution Upon returning to Huntington in early July 2006, Woody struck upon an idea to bail him out of his financial problems: he decided to begin stealing from his employer, Goodner Brothers. Other than a few traffic tickets, Woody had never been in trouble with law enforcement authorities. Yet, in Woody’s mind, he had no other reasonable alternatives. At this point, resorting to stealing seemed the lesser of two evils.

One reason Woody decided to steal from his employer was the ease with which it could be done. After several years with Goodner, Woody was very familiar with the company’s sloppy accounting practices and lax control over its inventory and other assets. Goodner’s executives preached one dominant theme to their sales staff: “Volume, volume, volume.” Goodner achieved its ambitious sales goals by undercutting competitors’ prices. The company’s dominant market share in the geographical region it served came at a high price. Goodner’s gross profit margin averaged 17.4 percent, considerably below the mean gross profit margin of 24.1 percent for comparable tire wholesalers. To compensate for its low gross profit margin, Goodner scrimped on oper- ating expenses, including expenditures on internal control measures.

The company staffed its 14 sales outlets with skeletal crews of 10 to 12 employees. A sales manager supervised the other employees at each outlet and also worked a sales district. The remaining staff typically included two sales reps, a reception- ist who doubled as a secretary, a bookkeeper, and five to seven employees who delivered tires and worked in the unit’s inventory warehouse. Goodner’s Huntington location had two storage areas: a small warehouse adjacent to the sales office and a larger storage area two miles away that had previously housed a discount grocery store. Other than padlocks, Goodner provided little security for its tire inventory, which typically ranged from $300,000 to $700,000 for each sales outlet.

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CASE 3.5 GOODNER BROTHERS, INC. 305

Instead of an extensive system of internal controls, T. J. and Ross Goodner relied heavily on the honesty and integrity of the employees they hired. Central to the com- pany’s employment policy was never to hire someone unless that individual could provide three strong references, preferably from reputable individuals with some connection to Goodner Brothers. Besides following up on employment references, Goodner Brothers obtained thorough background checks on prospective employees from local detective agencies.

For almost three decades, Goodner’s employment strategy had served the com- pany well. Fewer than 10 of several hundred individuals employed by the company had been terminated for stealing or other misuse of company assets or facilities.

Each Goodner sales outlet maintained a computerized accounting system. These systems typically consisted of an “off-the-shelf” general ledger package intended for a small retail business and a hodgepodge of assorted accounting documents. Besides the Huntington facility’s bookkeeper, the unit’s sales manager and two sales reps had unrestricted access to the accounting system.

Because the large volume of sales and purchase transactions often swamped the bookkeeper, sales reps frequently entered transactions directly into the system. The sales reps routinely accessed, reviewed, and updated their customers’ accounts. Rather than completing purchase orders, sales orders, credit memos, and other accounting documents on a timely basis, the sales reps often jotted the details of a transaction on a piece of scrap paper. The sales reps eventually passed these “source documents” on to the bookkeeper or used them to enter transaction data directly into the accounting system.

Sales reps and the sales manager jointly executed the credit function for each Goodner sales outlet. Initial sales to new customers required the approval of the sales manager, while the creditworthiness of existing clients was monitored by the appropriate sales rep. Sales reps had direct access to the inventory storage areas. During heavy sales periods, sales reps often loaded and delivered customer orders themselves.

Each sales office took a year-end physical inventory to bring its perpetual inven- tory records into agreement with the amount of inventory actually on hand. One concession that T. J. and Ross Goodner made to the policy of relying on their employ- ees’ honesty was mandating one intra-year inventory count for each sales office. Management used these inventories, which were taken by the company’s two-person internal audit staff, to monitor inventory shrinkage at each sales outlet.

Goodner’s inventory shrinkage significantly exceeded the industry norm. The com- pany occasionally purchased large shipments of “seconds” from manufacturers; that is, tires with defects that prevented them from being sold to major retailers. The tires in these lots with major defects were taken to a tire disposal facility. A sales office’s accounting records were not adjusted for these “throwaways” until the year-end physical inventory was taken.

Selling Tires on the Sly Within a few days after Woody hatched his plan to pay off his gambling debts, he visited the remote storage site for the Huntington sales office. Woody rummaged through its dimly lit and cluttered interior searching for individual lots of tires that apparently had been collecting dust for several months. After finding several stacks of tires satisfying that requirement, Woody jotted down their specifications in a small notebook. For each lot, Woody listed customers who could potentially find some use for the given tires.

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306 SECTION THREE INTERNAL CONTROL ISSUES

Later that same day, Woody made his first “sale.” A local plumbing supply dealer needed tires for his small fleet of vehicles. Woody convinced the business’s owner that Goodner was attempting to “move” some old inventory. That inventory would be sold on a cash basis and at prices significantly below Goodner’s cost. The owner agreed to purchase two dozen of the tires. After delivering the tires in his large pickup, Woody received a cash payment of $900 directly from the customer.

Over the next several months, Woody routinely stole inventory and kept the proceeds. Woody concealed the thefts in various ways. In some cases, he would charge merchandise that he had sold for his own benefit to the accounts of large volume customers. Woody preferred this technique since it allowed him to reduce the inventory balance in the Huntington facility’s accounting records. When custom- ers complained to him for being charged for merchandise they had not purchased, Woody simply apologized and corrected their account balances. If the customers paid the improper charges, they unknowingly helped Woody sustain his fraudulent scheme.

Goodner’s customers frequently returned tires for various reasons. Woody com- pleted credit memos for sales transactions voided by his customers, but instead of returning the tires to Goodner’s inventory, he often sold them and kept the proceeds. Goodner occasionally consigned tires to large retailers for promotional sales events. When the consignees returned the unsold tires to Goodner, Woody would sell some of the tires to other customers for cash. Finally, Woody began offering to take throw- aways to the tire disposal facility in nearby Shoals, West Virginia, a task typically assigned to a sales outlet’s delivery workers. Not surprisingly, most of the tires that Woody carted off for disposal were not defective.

The ease with which he could steal tires made Woody increasingly bold. In late 2006, Woody offered to sell Al Hunt tires he had allegedly purchased from a manu- facturer (by this time, Al owned and operated Curcio’s Tires). Woody told Al that he had discovered the manufacturer was disposing of its inventory of discontinued tires and decided to buy them himself. When Al asked whether such “self-dealing” vio- lated Goodner company policy, Woody replied, “It’s none of their business what I do in my spare time. Why should I let them know about this great deal that I stumbled upon?”

At first reluctant, Al eventually agreed to purchase several dozen tires from Woody. No doubt, the cut-rate prices at which Woody was selling the tires made the decision much easier. At those prices, Al realized he would earn a sizable profit on the tires.

Over the next 12 months, Woody continued to sell “closeout” tires to his friend. After one such purchase, Al called the manufacturer from whom Woody had report- edly purchased the tires. Al had become suspicious of the frequency of the closeout sales and the bargain basement prices at which Woody supposedly purchased the tires. When he called the manufacturer, a sales rep told Al that his company had only one closeout sale each year. The sales rep also informed Al that his company sold closeout merchandise directly to wholesalers, never to individuals or retail establishments.

The next time Al spoke to Woody, he mentioned matter-of-factly that he had con- tacted Woody’s primary supplier of closeout tires. Al then told his friend that a sales rep for the company indicated that such merchandise was only sold to wholesalers.

“So, what’s the point, Al?” “Well, I just found it kind of strange that, uh, that . . .” “C’mon, get to the point, Al.” “Well, Woody, I was just wondering where you’re getting these tires that you’re

selling.”

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CASE 3.5 GOODNER BROTHERS, INC. 307

“Do you want to know, Al? Do you really want to know, Buddy? I’ll tell you if you want to know,” Woody replied angrily.

After a lengthy pause, Al shrugged his shoulders and told his friend to “just forget it.” Despite his growing uneasiness regarding the source of the cheap tires, Al contin- ued to buy them and never again asked Woody where he was obtaining them.

Internal Auditors Discover Inventory Shortage On 31 December 2006, the employees of Goodner’s Huntington location met to take a physical inventory. The employees treated the annual event as a prelude to their New Year’s Eve party. Counting typically began around noon and was finished within three hours. The employees worked in teams of three. Two members of each team climbed and crawled over the large stacks of tires and shouted out their counts to the third member who recorded them on preformatted count sheets.

Woody arranged to work with two delivery workers who were relatively unfamiliar with Goodner’s inventory since they had been hired only a few weeks earlier. He made sure that his team was one of the two count teams assigned to the remote storage facility. Most of the inventory he had stolen over the previous six months had been taken from that site. Woody estimated that he had stolen approximately $45,000 of inventory from the remote storage facility, which represented about 10 percent of the site’s book inventory. By maintaining the count sheets for his team, Woody could easily inflate the quantities for the tire lots that he and his team members counted.

After the counting was completed at the remote storage facility, Woody offered to take the count sheets for both teams to the sales office where the total inventory would be compiled. On the way to the sales office, he stopped in a vacant parking lot to review the count sheets. Woody quickly determined that the apparent shortage remaining at the remote site was approximately $20,000. He reduced that shortage to less than $10,000 by altering the count sheets prepared by the other count team.

When the year-end inventory was tallied for Goodner’s Huntington location, the difference between the physical inventory and the book inventory was $12,000, or 2.1 percent. That percentage exceeded the historical shrinkage rate of approximately 1.6 percent for Goodner’s sales offices. But Felix Garcia, the sales manager for the Huntington sales office, did not believe that the 2006 shrinkage was excessive. As it turned out, neither did the accounting personnel and internal auditors at Goodner’s corporate headquarters.

Woody continued “ripping off” Goodner throughout 2007. By midyear, Woody was selling most of the tires he stole to Al Hunt. On one occasion, Woody warned Al not to sell the tires too cheaply. Woody had become concerned that Curcio’s modest prices and its increasing sales volume might spark the curiosity and envy of other Huntington tire retailers.

In late October 2007, Goodner’s internal audit team arrived to count the Huntington location’s inventory. Although company policy dictated that the internal auditors count the inventory of each Goodner sales outlet annually, the average interval between the internal audit inventory counts typically ranged from 15 to 20 months. The internal auditors had last counted the Huntington location’s inventory in May 2006, two months before Woody Robinson began stealing tires. Woody was unaware that the internal auditors periodically counted the entire inventory of each Goodner operating unit. Instead, he understood that the internal auditors only did a few test counts during their infrequent visits to the Huntington sales office.

After completing their inventory counts, the two internal auditors arrived at an inventory value of $498,000. A quick check of the accounting records revealed a book inventory of $639,000. The auditors had never encountered such a large

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308 SECTION THREE INTERNAL CONTROL ISSUES

difference between the physical and book inventory totals. Unsure what to do at this point, the auditors eventually decided to take the matter directly to Felix Garcia, the Huntington sales manager.

The size of the inventory shortage shocked Garcia. He insisted that the auditors must have overlooked some inventory. Garcia, the two internal auditors, and three delivery workers spent the following day recounting the entire inventory. The result- ing physical inventory value was $496,000, $2,000 less than the original value arrived at by the auditors.

Following the second physical inventory, the two internal auditors and Garcia met at a local restaurant to review the Huntington unit’s inventory records. No glaring trends were evident in those records to either Garcia or the auditors. Garcia admitted to the auditors that the long hours required “just to keep the tires coming and going” left him little time to monitor his unit’s accounting records. When pressed by the auditors to provide possible explanations for the inventory shortage, Garcia erupted. “Listen. Like I just said, my job is simple. My job is selling tires. I sell as many tires as I can, as quickly as I can. I let you guys and those other suits up in Youngstown track the numbers.”

The following day, the senior internal auditor called his immediate superior, Goodner’s chief financial officer (CFO). The size of the inventory shortage alarmed the CFO. Immediately, the CFO suspected that the inventory shortage was linked to the Huntington unit’s downward trend in monthly profits over the past two years.

Through 2005, the Huntington sales office had consistently ranked as Goodner’s second or third most profitable sales outlet. Over the past 18 months, the unit’s slump- ing profits had caused it to fall to the bottom one-third of the company’s sales outlets in terms of profit margin percentage. Tacking on the large inventory shortage would cause the Huntington location to be Goodner’s least profitable sales office over the previous year and one-half.

After discussing the matter with T. J. and Ross Goodner, the CFO contacted the company’s independent audit firm and arranged for the firm to investigate the inven- tory shortage. The Goodners agreed with the CFO that Felix Garcia should be suspended with pay until the investigation was concluded. Garcia’s lack of a reason- able explanation for the missing inventory and the anger he had directed at the inter- nal auditors caused Goodner’s executives to conclude that he was likely responsible for the inventory shortage.

Within a few days, four auditors from Goodner’s independent audit firm arrived at the Huntington sales office. Goodner’s audit firm was a regional CPA firm with six offices, all in Ohio. Goodner obtained an annual audit of its financial statements because one was demanded by the New York bank that provided the company with a line of credit. Goodner’s independent auditors had never paid much attention to the internal controls of the client’s sales offices. Instead, they performed a “balance sheet” audit that emphasized corroborating Goodner’s year-end assets and liabilities.

During their investigation of the missing inventory, the auditors were appalled by the Huntington unit’s lax and often nonexistent controls. The extensive control weaknesses complicated their efforts to identify the source of the inventory shortage. Nevertheless, after several days, the auditors’ suspicions began settling on Woody Robinson.

A file of customer complaints that Felix Garcia kept in his desk revealed that over the past year an unusually large number of customer complaints had been filed against Woody. During that time, 14 of his customers had protested charges included on their monthly statements. Only two customers serviced by the other sales rep had filed similar complaints during that time frame.

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CASE 3.5 GOODNER BROTHERS, INC. 309

When questioned by the auditors, Garcia conceded that he had not discussed the customer complaints with Woody or the other sales rep. In fact, Garcia was unaware that a disproportionate number of the complaints had been filed against Woody. When Garcia received a customer complaint, he simply passed it on to the appropri- ate sales rep and allowed that individual to deal with the matter. He maintained a file of the customer complaints only because he had been told to do so by the previous sales manager whom he had replaced three years earlier.

After the independent auditors collected other incriminating evidence against Woody, they arranged for a meeting with him. Also attending that meeting were Goodner’s CFO and Felix Garcia. When the auditors produced the incriminating evidence, Woody disclaimed any knowledge of, or responsibility for, the inventory shortage. Woody’s denial provoked an immediate and indignant response from Goodner’s CFO. “Listen, Robinson, you may have fooled the people you’ve been working with, but you’re not fooling me. You’d better spill the beans right now, or else.” At this point, Woody stood, announced that he was retaining an attorney, and walked out of the meeting.

2. Ironically, Woody’s confession also implicated his wife, Rachelle. After Woody revealed that Rachelle had typically deposited the large checks written to him by Al Hunt, the district attorney reasoned that Rachelle must have been aware of Woody’s fraudulent scheme and was thus an accessory to his crime. However, Woody insisted that he had told his wife the checks were for gambling losses owed to him by Al. After interrogating Rachelle at length, the district attorney decided not to prosecute her.

E P I L O G U E Goodner Brothers filed a criminal complaint against Woody Robinson two weeks after he refused to discuss the inventory shortage at the Huntington sales office. A few weeks later, Woody’s attorney reached a plea bargain agree- ment with the local district attorney. Woody received a five-year sentence for grand larceny, four years of which were suspended. He even- tually served seven months of that sentence in a minimum-security prison. A condition of the plea bargain agreement required Woody to pro- vide a full and candid written summary of the fraudulent scheme that he had perpetrated on his employer.

Woody’s confession implicated Al Hunt in his theft scheme. Over the 15 months that Woody had stolen from Goodner, he had “fenced” most of the stolen inventory through Curcio’s Tires. Although the district attorney questioned

Al Hunt extensively, he decided not to file crimi- nal charges against him.2

Goodner Brothers filed a $185,000 insurance claim to recoup the losses resulting from Woody’s thefts. The company’s insurer eventually paid Goodner $130,000, which equaled the theft losses that Goodner could document. After settling the claim, the insurance company sued Curcio’s Tires and Al Hunt to recover the $98,000 windfall that Curcio’s allegedly realized due to Al Hunt’s involvement in the theft ring. The case went to federal district court where a judge ordered Hunt to pay $64,000 to Goodner’s insurer. Al Hunt then sued Woody Robinson to recover that judgment. The judge, who had presided over the earlier case, quickly dismissed Al Hunt’s lawsuit. According to the judge, Al Hunt’s complicity in the fraudulent scheme vacated his right to recover the $64,000 judgment from his former friend.

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310 SECTION THREE INTERNAL CONTROL ISSUES

Questions 1. List what you believe should have been the three to five key internal control

objectives of Goodner’s Huntington sales office.

2. List the key internal control weaknesses that were evident in the Huntington unit’s operations.

3. Develop one or more control policies or procedures to alleviate the control weaknesses you identified in responding to Question 2.

4. Besides Woody Robinson, what other parties were at least partially responsible for the inventory losses Goodner suffered? Defend your answer.

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311

CASE 3.6

Buranello’s Ristorante

In 1983, Marta Giordano inherited the restaurant that her grandfather, Alberto Buranello, had established shortly after returning to his hometown of Boston after serving in World War I.1 For nearly a century, the restaurant, Buranello’s Ristorante, has been a landmark and favorite gathering spot for generations of families in Boston’s historic North End neighborhood.

Over the years, the large corner restaurant, which has a staff of approximately 40 employees, has been essentially recession-proof. But Giordano’s business recently faced two major challenges. Three local, formerly family-owned restaurants that Giordano considers to be her primary competitors were purchased by private inves- tors who then renovated their interiors and facades and refurbished their kitchens. Although Buranello’s breakfast and lunchtime traffic were largely unaffected by the competitors’ upgrades, its dinner traffic fell by 20 percent. Making matters worse for Giordano during this same time span was another problem that was plaguing the restaurant, namely, abnormally large cash shortages apparently resulting from employee theft. These shortages were typically discovered at the close of business when the daily sales reconciliation worksheet was prepared.

The Suspect Michael Barnes, Buranello’s general manager, was just as frustrated by the cash shortages as his boss, Marta Giordano. Barnes had worked at Buranello’s for more than 20 years and was practically a member of the Giordano family. His first position with the restaurant was as a busboy when he was 14 years old. During college he worked as a waiter at the restaurant. When he graduated from Northeastern University with a management degree, Barnes turned down an offer from Giordano to become a member of Buranello’s manage- ment staff, choosing instead to work for a large, nationally franchised restaurant chain that had an extensive management trainee program. Five years later, though, Barnes returned to Buranello’s when Giordano offered him the position of general manager.

Barnes eventually called a meeting of the restaurant’s management staff—himself, three shift managers, three assistant managers, and the chef—to address the cash shortages being experienced by Buranello’s. At the meeting, which Giordano also attended, Barnes informed his subordinates that the cash shortages were becom- ing larger and more frequent. He pledged that he would catch the culprit or culprits and prosecute them to the fullest extent of the law. Barnes did not discuss specific measures that he planned to take to determine the source of the cash shortages. Why? Because he suspected that the thief was a member of the management staff. The prime suspect in Barnes’ mind was Aaron O’Neil, one of the three shift managers.

Barnes rotates the work assignments for the shift managers so that each of them works the closing shift, which is 3 p.m. to 11 p.m., only twice per week.2 Buranello’s

1. This case was developed from a recent legal opinion. The names of the actual parties involved in the case and the location have been changed. In addition, certain of the background details presented in the case are fictionalized accounts of information disclosed in the legal opinion. 2. The opening shift runs from 7 a.m. to 3 p.m. Shift managers supervise four eight-hour shifts each week. During their fifth eight-hour shift each week, they serve as an assistant manager to the shift manager on duty.

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312 SECTION THREE INTERNAL CONTROL ISSUES

is closed on Sundays when it often hosts private parties such as family reunions and wedding receptions. One of the responsibilities of the shift manager at closing is to prepare the daily sales reconciliation. To perform this task the shift manager com- pletes one of the standard reconciliation templates used for that purpose within the restaurant industry. The final task of the closing shift manager each night is to pre- pare the bank deposit for that day’s sales. The day’s receipts along with the com- pleted deposit slip are left overnight in the restaurant’s safe. The following morning, the shift manager who opens the restaurant recounts the receipts, traces the resulting total to the deposit slip, and then takes both to Buranello’s bank a few blocks away.

The purpose of the daily sales reconciliation is to reconcile the day’s sales reflected by the cash register printout to the total cash and cash items in the cash register at the close of business. The final line item on the reconciliation worksheet is entitled “Variance.” A negative variance reflects a cash shortage, while a positive variance indicates a cash overage. Similar to most restaurants and retail businesses, Buranello’s typically has a modest cash shortage at the end of each business day.

After Buranello’s began experiencing abnormally large cash shortages, Barnes engaged the business’s accounting firm to analyze the restaurant’s daily sales reconciliations. The accounting firm attempted to correlate the cash shortages with the shifts worked by the management staff and the cashiers but the results of that analysis were inconclusive.3 The accounting firm also attempted to determine whether the cash shortages were correlated with the presence of a specific shift manager during the closing shifts—Barnes believed that cash was most likely being stolen during the nightly closing procedures. Again, the results were inconclusive. There was no definite trend that linked the shortages to the closing shifts worked by specific shift managers. In Barnes’ mind, the results of the accounting firm’s analyses suggested that the thief or thieves were sufficiently clever to make it difficult for the cash shortages to be traced directly to them.

The only evidence that linked Aaron O’Neil to the cash shortages was the fact that they began occurring within a few weeks of the date that he began working at Buranello’s. But there was another reason that Barnes suspected O’Neil. During the 20 years prior to accepting a position with Buranello’s, O’Neil had been employed by seven different restaurants or restaurant chains. That unstable employment his- tory  had concerned Barnes when he interviewed him. The reference letters provided by O’Neil’s former employers had also posed some degree of concern since they had been lukewarm, at best, in their endorsement of him. Despite the fact that O’Neil was a marginal job candidate, Barnes had hired him because Buranello’s management team was chronically understaffed. Similar to most restaurants, management and employee turnover is a constant problem faced by Buranello’s.

The Opportunity The cash shortages infuriated Barnes not only because of the adverse financial impact they had on the restaurant but also because they reflected poorly on his manage- ment style and overall performance as the caretaker of the business for the Giordano family. Barnes much prefers “pressing the flesh” with customers and the restaurant’s waitstaff rather than taking care of his back-office responsibilities. He often allows his paperwork, which includes health inspection reports, tax reporting schedules, and the daily sales reconciliation worksheets, to pile up on his desk.

3. Five individuals have access to Buranello’s cash register during each shift: the cashier, the shift manager, the assistant manager, Barnes, and Giordano, who typically spends a few hours each day in the restaurant.

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CASE 3.6 BURANELLO’S RISTORANTE 313

Barnes finds the daily sales reconciliation worksheets particularly wearisome. He would never admit as much to Marta Giordano or any of his subordinates, but even after having completed hundreds of daily sales reconciliations, it is still a challenging task for him on the infrequent occasions when he closes the restaurant.

The objective of a daily sales reconciliation is obvious to Barnes, but the task itself is tedious and frustrating. The process of completing the worksheet at the end of a busy day requires properly analyzing a wide array of nonstandard transac- tions. These items typically include a variety of coupons redeemed by customers, discounted meals purchased by employees, unpaid meal tickets of “deadbeat” customers who slipped out of the restaurant without paying, duplicate meal tickets issued to replace lost or misplaced tickets, refunds for overcharges, purchases or redemptions of meal cards given as gifts, petty cash expenditures such as modest charitable contributions, discounts or rain checks given to unhappy patrons whose pasta was not cooked to order, and so on and so forth. Each time that he completes a daily sales reconciliation worksheet, Barnes is reminded why he switched his major from accounting to management during his sophomore year of college.

Barnes also finds the task of reviewing completed daily sales reconciliation work- sheets unpleasant, which is why he often has a stack of them sitting on his desk. Ironically, despite his accounting “dyslexia,” he is the person responsible for the final approval of the reconciliations. The most challenging facet of reviewing the reconcil- iations is deciphering, comprehending, and then clearing the numerous comments printed or scrawled haphazardly in the margins of the worksheet form. On a typical day, there are six to eight “problem” reconciling items that the closing shift manager must explain in a written comment on the worksheet form—the template used by Buranello’s does not have a “comments” section.

The intricate nature of the reconciliation worksheets has convinced Barnes that an unscrupulous shift manager could easily use them as a tool to conceal amounts embezzled from the daily sales receipts. This ever-present opportunity, if not invita- tion, to steal from the restaurant means that the larger-than-normal cash shortages recently experienced by Buranello’s may have been significantly understated.

The Sting The day following the management meeting in which he addressed Buranello’s recurring cash shortages, Barnes met with Marta Giordano. He had developed a plan to address the problem, and he wanted her approval before he went forward with it. Barnes told Giordano that he wanted to carry out a “sting” operation to test the hon- esty of Aaron O’Neil—Giordano was aware that Barnes considered O’Neil to be the most likely source of the cash shortages.

The plan called for Barnes to replace the closing shift manager on an evening before O’Neil was scheduled to open the restaurant the following day. During the closing procedures, Barnes would prepare a deposit slip that understated the amount of cash receipts by several hundred dollars—Giordano would be present to verify the understatement. Barnes expected, actually hoped, that O’Neil would steal the excess cash prior to making the morning bank deposit. Barnes then planned to con- tact the police and file theft charges against O’Neil. Giordano reluctantly approved Barnes’ plan, although she thought it smacked of entrapment and considered it to be distasteful.

Barnes executed his plan the following week and it seemed to work to perfection. Neither O’Neil nor the bank reported the difference between the cash receipts and the dollar amount reflected on the given deposit slip. In Barnes’ mind that meant that O’Neil had stolen the excess cash in the deposit, which amounted to $360.

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314 SECTION THREE INTERNAL CONTROL ISSUES

The following day, Barnes contacted the police and reported the incident. He and Giordano met the police detective assigned to investigate the apparent embezzle- ment. Barnes told the officer that he believed O’Neil had stolen the $360 and wanted to press charges against him on behalf of Buranello’s. Barnes also told the detec- tive that he suspected O’Neil was responsible for the rash of abnormally large cash shortages experienced by the restaurant over the past several months. The detective informed Barnes that it would be necessary for him to provide evidence to support that allegation.

That afternoon, the detective went to O’Neil’s apartment with two uniformed offi- cers—O’Neil had not been scheduled to work that day. After the detective explained the circumstances of the alleged embezzlement, O’Neil indicated that he wanted to contact his attorney. The uniformed officers then arrested O’Neil, handcuffed him, and marched him through the large courtyard of his apartment complex on the way to the patrol car.

O’Neil’s attorney arrived at the police station to consult with his client later that afternoon. At approximately 5 p.m., the attorney arranged a meeting involving him- self, O’Neil, and the detective in charge of the case. During this meeting, the attor- ney told the detective that O’Neil had not stolen the $360. When counting the cash before making the deposit, O’Neil had discovered that the cash receipts exceeded the amount reported on the deposit slip by $360. O’Neil had then taken that amount and placed it in Buranello’s safe in an envelope marked to the attention of Michael Barnes.

The detective telephoned Michael Barnes, passed along the information provided by O’Neil, and asked him to search the safe. Barnes and Giordano went through the safe but could not find the envelope. When the detective told O’Neil that the enve- lope could not be found, O’Neil asked to be taken to the restaurant to search for it himself. The detective refused to do that.

O’Neil then asked the detective to send a police officer to search the safe. After the detective agreed to send an officer to the restaurant, O’Neil told the detective exactly where the envelope containing the $360 could be found. According to O’Neil, he had placed the letter-sized envelope containing the $360 in a larger envelope that was labeled “Equipment Leases.” When the detective asked O’Neil why he had hidden the cash so well, he replied that he believed he was being “set up” by Barnes. O’Neil explained that he had been hoping to “buy some time” to figure out exactly what to do, which also explained why he had not called Barnes immediately and reported the excess cash.

The police officer sent to Buranello’s found the hidden cash in a matter of minutes. The charges filed against O’Neil were immediately dropped, and he was released from police custody.

The Lawsuit Aaron O’Neil never returned to Buranello’s, choosing instead to resign immediately, but Michael Barnes and Marta Giordano had not heard the last of him.4 One month later, O’Neil filed a “malicious prosecution” civil lawsuit that named Buranello’s, Barnes, and Giordano as defendants. Following a brief trial, the jury ruled in O’Neil’s favor and awarded him a judgment of $66,000. The defendants immediately appealed the jury’s ruling. One year later, an appellate court overturned the jury’s decision and voided the judgment. The appellate court ruled that because Barnes and Giordano had “probable cause” to file theft charges against O’Neil, they could not be accused of “malicious prosecution.”

4. The abnormally large cash shortages experienced by Buranello’s ended abruptly when O’Neil termi- nated his employment.

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CASE 3.6 BURANELLO’S RISTORANTE 315

Questions 1. Identify internal control weaknesses evident in Buranello’s operations. What

risks are posed by these internal control problems?

2. For each internal control weakness you listed in responding to the previous question, identify a measure that Buranello’s could implement to remedy that weakness. Indicate whether these measures would be cost-effective.

3. Prepare a list of internal control procedures for a restaurant other than the controls referred to in this case. For each control that you list, identify its underlying objective.

4. Do you believe that Barnes’ plan to test Aaron O’Neil’s honesty was appropriate? Was it ethical? What ethical responsibilities does a business’s senior management or owner have when an employee is suspected of theft?

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317

CASE 3.7

Foamex International, Inc.

In 1937, Otto Bayer, a research scientist for the large German chemical company IG Farben, discovered a new chemical compound that would become known as polyurethane. During World War II, polyurethane was used principally in the manu- facture of military equipment and supplies. Following the war, IG Farben was disman- tled by the Allied Forces as punishment for its collaboration with the Nazis. Certain of the company’s products had been used by the Nazis to perpetrate unconscionable atrocities on innocent civilians.

During the latter one-half of the twentieth century, polyurethane was used in the manufacture of a wide range of consumer goods, including automotive trims and moldings, batteries, carpet padding, and diapers. Among the most important poly- urethane derivatives was a compound initially referred to as “imitation Swiss cheese.” Polyurethane foam was “invented” in a research laboratory in the early 1950s when water was accidentally added during the production process for polyurethane.

One of the initial manufacturers of polyurethane foam was the Firestone Tire and Rubber Company. The Firestone division that produced the product would eventu- ally become a freestanding company, Foamex International, Inc. Foamex became the United States’ largest producer of polyurethane foam due to an ambitious acqui- sition program initiated by the company’s management during the 1980s. By 2001, Foamex owned and operated more than 50 manufacturing and distributing facilities in the United States, Canada, and Mexico.

An unanticipated by-product of Foamex’s acquisition program was a chaotic accounting system. The companies acquired by Foamex continued to use the accounting systems that they had previously employed. As a result, by the year 2000, Foamex’s corporate accounting system was an amalgamation of dozens of geograph- ically dispersed “legacy” systems that relied on a haphazard assortment of computer hardware and software components.

Foamex’s failure to develop a coherent, integrated corporate account- ing system complicated the annual audits of the company. In August 1999, PricewaterhouseCoopers (PwC), Foamex’s independent audit firm, notified the com- pany’s audit committee that Foamex needed to improve its internal controls. “The auditor reported that Foamex’s systems for the preparation of interim financial infor- mation did not provide an adequate basis for the auditor to complete, prior to certain filing deadlines, its reviews of Foamex’s interim financial statements.”1 In May 2000, following the completion of the 1999 Foamex audit—the company’s fiscal year coin- cided with the calendar year—PwC issued a “Report to Management.” This report identified several serious internal control problems or “reportable conditions”2 and

1. This and all subsequent quotes, unless indicated otherwise, were taken from the following source: Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 2274, 11 July 2005. 2. At the time, professional auditing standards defined “reportable conditions” as “matters coming to the auditor’s attention that, in his judgment, should be communicated to the audit committee because they represent significant deficiencies in the design or operation of internal control, which could adversely affect the organization’s ability to initiate, record, process, and report financial data consistent with the assertions of management in the financial statements” (AU Section 325.02 [superseded]).

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318 SECTION THREE INTERNAL CONTROL ISSUES

recommended that Foamex take the following specific actions to remedy these problems:

(1) make significant improvements in the control environment and reporting prac- tices of Foamex’s foreign operations;

(2) conduct a comprehensive analysis of financial results on a quarterly basis; (3) improve inventory reporting; and (4) develop a comprehensive information technology strategy, including an enter-

prise-wide security program.

During the 2000 audit of Foamex, PwC informed the company’s audit commit- tee on multiple occasions of reportable conditions similar to those included in the Report to Management issued in May 2000. After completing the 2000 audit, PwC resigned in June 2001. The following month, Foamex retained Deloitte & Touche as its independent audit firm.

Foamex’s management informed the SEC in 2002 that the company was in the process of resolving the internal control problems previously identified by PwC. Nevertheless, in early 2003, during its 2002 audit, Deloitte identified five reportable conditions that it communicated to Foamex’s audit committee.3 These conditions involved the following areas of concern:

(1) oversight of financial reporting by international subsidiaries; (2) inventory procedures, processes, and systems; (3) integration of IT systems; (4) access and security for IT systems; and, (5) process for reviewing and approving journal entries.

In January 2004, Foamex restated the financial statements included in its Form 10-Qs filed with the SEC for the first three quarterly reporting periods of 2003. These restatements were necessary because of a major glitch discovered in the process- ing of inventory transactions. After completing its 2003 audit of Foamex in March 2004, Deloitte notified the company’s audit committee of four reportable conditions. Three of these items involved control issues identified in Deloitte’s 2003 report to the audit committee. The fourth reportable condition concerned control weaknesses in Foamex’s quarterly financial reporting system.

After receiving Deloitte’s internal control report in March 2004, Foamex’s audit committee dismissed Deloitte and retained KPMG as the company’s new audit firm. Over the following few months, Foamex made several changes in its senior manage- ment. One of those changes involved appointing a former Ernst & Young partner to the company’s board of directors and audit committee. Foamex’s new management team also hired a “special consultant on internal accounting controls” to remedy the company’s pervasive internal control problems.

Foamex’s efforts in 2004 to improve its internal controls were “too little and too late” to satisfy the SEC. In 2005, Foamex became the first SEC registrant to be sanc- tioned by the federal agency solely for having inadequate internal controls. In the Accounting and Auditing Enforcement Release summarizing its investigation of Foamex, the SEC defended the decision to sanction the company despite its belated attempt to improve its internal controls.

The repeated observations of the auditors and Foamex’s history of restating its interim financial reports show that Foamex did not devote the appropriate managerial effort

3. The SEC enforcement release for this case did not reveal whether Deloitte discovered reportable conditions in Foamex’s internal controls during its 2001 audit.

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CASE 3.7 FOAMEX INTERNATIONAL, INC. 319

and other resources to remediate its deficient internal controls, which were identified as reportable conditions in 1999.

The cease and desist order issued to Foamex by the SEC included a road map for the company to follow to improve its internal controls. During the 2005 audit, the SEC ordered Foamex to “cooperate fully” with KPMG’s review and evaluation of the company’s internal controls pursuant to Section 404 of the Sarbanes–Oxley Act of 2002. Following the 2005 audit, the SEC instructed KPMG to issue a “Section 404 Report” to Foamex’s audit committee. That report would document any “significant deficiencies” in Foamex’s internal controls. The audit committee would then forward the report to Foamex’s special consultant on internal controls.

Within 90 days, the special consultant would issue a report to Foamex’s audit com- mittee and the SEC that identified specific recommendations for eliminating the internal control deficiencies. The SEC mandated that Foamex adopt those recommen- dations or propose alternative measures that would be equally effective. The special consultant was also instructed to issue quarterly reports to Foamex’s audit committee and the SEC until all of the reported internal control deficiencies were eliminated.

The SEC’s decision to sanction Foamex was interpreted as a “message”4 being sent by the federal agency to public companies. The intended message was that the SEC would rigorously enforce the new internal control initiatives included in the Sarbanes– Oxley Act. Ironically, absent the SEC’s specific directive that required KPMG to per- form a Section 404 review and evaluation of Foamex’s internal controls, the company would have been exempt from that requirement because it was a “non-accelerated filer.”5 Due to widespread concern that Section 404 audit and internal control reme- diation costs would be onerous for small public companies, the SEC had delayed the implementation of the principal Section 404 requirements for those registrants. In late 2010, Congress passed a law that permanently exempted non-accelerated filers from being required to obtain Section 404 reports on their internal controls.6

Questions 1. Who has the final responsibility for the integrity of an SEC registrant’s internal controls:

its audit committee, its management team, or its independent auditors? Explain.

2. Under the professional standards currently in effect, what responsibility do auditors have to identify internal control problems within their clients’ accounting systems? To whom must auditors communicate such problems? In responding to these questions, indicate how auditors’ responsibilities differ, if at all, between public and nonpublic clients.

3. Under what conditions is a public company allowed to dismiss its independent audit firm? Under what conditions is an independent audit firm allowed to resign as the auditor of a public company? What disclosures, if any, does the SEC mandate when a public company experiences a change in its independent auditors?

4. Should the SEC selectively prosecute companies, organizations, or individuals to encourage compliance with legal or professional standards? Defend your answer.

4. P. J. Martinek, “SEC Probe into Foamex Internal Controls Won’t Be Last,” Compliance Week (online), 12 April 2006. 5. Non-accelerated filers are generally SEC registrants that have a market capitalization of $75 million or less. 6. The Wall Street Journal reported in July 2013 that 5,549 public companies in the United States are exempt from obtaining Section 404 internal control reports. See, E. Chasan, “The Big Number,” Wall Street Journal (online), 23 July 2013.

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321

CASE 3.8

The Boeing Company

We say in this nation that we are looking for people with honesty integ- rity, drive and dedication, and then when we find such people, we take them out and whip them.

Anonymous whistleblower

In January 2007, Matthew Neumann and Nicholas Tides, two Boeing employees, transferred to the company’s internal audit department. Neumann, who worked in Boeing’s Seattle headquarters, and Tides, who was based in St. Louis, believed that the move would advance their careers with the large aerospace company.

Neumann and Tides were assigned to one of Boeing’s two internal audit groups. Their 10-member audit team monitored Boeing’s information technology (IT) con- trols within the company’s financial reporting function.1 The overall mission of their team was to assist company management in its effort to comply with the inter- nal control mandates for public companies included in the Sarbanes–Oxley (SOX) Act of 2002. An important responsibility imposed on corporate executives by SOX is to annually report on the effectiveness of their company’s financial reporting controls.

Boeing contracted with PricewaterhouseCoopers (PwC) to obtain the additional manpower needed to help Neumann and Tides’ audit team accomplish its mission. Approximately 70 PwC contract auditors worked with the IT SOX internal audit team.

As mandated by SOX, Deloitte, Boeing’s independent audit firm, also prepared an annual report on the effectiveness of the company’s internal controls over financial reporting. The Deloitte auditors reviewed and relied on the work of Boeing’s IT SOX audit team in completing that task each year.

IT Isn’t Good Neumann and Tides quickly found that their new work roles were tension-packed. The source of the tension was management’s concern that Deloitte, which at the time was completing its 2006 audit of Boeing’s financial statements, would report one or more “material weaknesses” in the company’s IT financial reporting controls. Management realized that Boeing would face significant adverse consequences if such weaknesses were reported, including a likely drop in the company’s stock price.

By early February 2007, Neumann and Tides had decided, independently of each other, that there were major problems in Boeing’s IT financial reporting controls. The two internal auditors, again independently of each other, repeatedly voiced those concerns over the next few months. Collectively, Neumann and Tides notified their superiors of the apparent internal control weaknesses on more than two dozen occasions.

Neumann and Tides identified seven potential problems in Boeing’s IT financial reporting controls. Their primary concerns, however, revolved around two of those issues. First, Neumann and Tides believed that the PwC contract auditors were being

1. According to Boeing, an IT control “is a policy or procedure implemented by a company to ensure the confidentiality and integrity of its IT functions, such as a procedure requiring the testing and approval of software before installation on a company computer.”

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322 SECTION THREE INTERNAL CONTROL ISSUES

given “managerial authority over Boeing employees,”2 including the company’s inter- nal auditors. The SEC’s rules for corporate audit committees expressly require that a company’s internal auditors be controlled by its audit committee.

Second, and more importantly, Neumann and Tides questioned the overall integrity of Boeing’s control environment that had been established by the company’s top execu- tives. In particular, they charged that those executives were intentionally undermining the annual SOX-mandated assessment of the company’s financial reporting controls. Among specific allegations, the two internal auditors suggested that Boeing manage- ment was “potentially misleading the external auditors” by permitting  company insid- ers to “change audit results,” was “permitting other tampering with the official internal audit records,” and had concealed “failed controls.”3

Despite the concerns expressed by Neumann and Tides, Boeing management rated the company’s internal controls over financial reporting as effective for the company’s fiscal years ending 31 December 2006, and 2007. Likewise, for both years, Deloitte issued an unqualified opinion on Boeing’s internal controls, meaning that the Deloitte auditors found no indication of one or more material weaknesses in those controls during either of those years.

Paper Tiger During the spring of 2007, Andrea James, a reporter for the Seattle Post-Intelligencer, the city’s oldest newspaper, began investigating unpublished reports that Boeing, easily Seattle’s largest employer, had serious internal control problems. James con- tacted numerous Boeing employees, including Matthew Neumann and Nicholas Tides. Neither Neumann nor Tides responded to James’ requests for interviews. The two men subsequently reported that, at the time, they had hoped to resolve their con- cerns regarding Boeing’s control problems internally. Both of the internal auditors were also well aware of a Boeing policy that “required employees to refer inquiries of any kind from the news media to the Communications department and also prohib- ited the release of company information without prior review by that department.”

James went to Neumann’s home uninvited in May 2007 and asked him to dis- cuss Boeing’s internal controls and the company’s compliance with SOX. Neumann agreed to speak with James. “[Neumann] described the pressure he felt to render positive audit results and detailed a recent meeting where he and other IT SOX audi- tors expressed concerns over the role of PricewaterhouseCoopers contractors in audits of Boeing’s internal controls.” A few days after interviewing Neumann, James e-mailed him an excerpt from the article that she intended to publish in the Post- Intelligencer. Neumann responded by noting that the excerpt “looked good.” Along with his response to James, Neumann attached an e-mail that he and other IT SOX auditors had been sent by a superior. This e-mail reminded the auditors of Boeing’s policy regarding the release of information to the news media.

In July 2007, a week or so prior to James’ article being published, Nicholas Tides contacted her. Tides was prompted to contact James by what he believed was an undeserved negative performance evaluation that he had received for the second quarter of 2007. In his e-mail, Tides disclosed the various concerns that he had pre- viously raised with his superiors regarding Boeing’s IT-related control weaknesses.

2. The following legal opinion is the primary source for this case: Tides and Neumann v. The Boeing Company, U.S. Court of Appeals for the Ninth Circuit, 644 F.3d 809; 2011 App. LEXIS 8980. Unless indi- cated otherwise, the quotations in this case were taken from this source. 3. J. J. Tollefsen, “Tides and Neumann v. The Boeing Company, Petition for Writ of Certiorari filed with the U.S. Supreme Court,” October 2011.

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CASE 3.8 THE BOEING COMPANY 323

Tides also forwarded to James copies of various Boeing documents that were relevant to those weaknesses.

The Post-Intelligencer published the article coauthored by Andrea James regarding Boeing’s internal controls, “Computer Security Faults Put Boeing at Risk,”4 on 17 July 2007. James and her coauthor described how the company had failed to establish proper controls to protect its “computer systems against manipulation, theft and fraud” and referred to a “threatening company culture” that influenced the work of its internal auditors. In an internal Boeing e-mail that James had obtained, Boeing’s chief finan- cial officer (CFO) told certain subordinates that the performance of the company’s internal controls was “unacceptable.” James also reported that Boeing’s external audi- tor, Deloitte, was aware that “many of Boeing’s computer system controls were failing.”

James’ article revealed that Deloitte had identified a “significant deficiency” in Boeing’s internal controls during each of the previous three years. That deficiency involved the company’s failure to eliminate “database and software development security holes.” This pervasive control weakness created some level of risk that Boeing would suffer significant asset losses due to fraud or theft and increased the likelihood that the company’s financial statements would contain material errors. Because Deloitte had concluded that the control problem did not rise to the level of a material weakness, the firm was able to issue an unqualified opinion on Boeing’s internal controls during each of those years.

A Boeing spokesperson interviewed by James insisted that the company was work- ing toward remedying the persistent significant deficiency in internal controls identified by Deloitte. The spokesperson also insisted that the company’s overall controls were “strong.” To demonstrate the company’s commitment to improving its internal controls, the spokesperson told James that in 2006 alone the company had spent $55 million in its efforts to comply with the SOX-mandated internal control initiatives.

Termination for Tattling Prior to the publication of James’ article, Boeing’s management had come to suspect that one or more employees were communicating with journalists regarding alleged problems in the company’s internal controls. That suspicion had caused company officials to initiate an investigation. During that investigation, management began monitoring the computers and e-mail communications of Neumann and Tides and apparently other employees as well.

In September 2007, members of the investigative team interviewed Neumann and Tides. During these separate interviews, both individuals admitted to speaking with James and providing her with company documents. After reviewing the evidence collected during the investigation, including Neumann and Tides’ own admissions, an employee review board voted unanimously to terminate them. The following explanation, which accompanied the termination notice delivered to each of them, identified the specific company “PRO” [procedure] policies that they had violated.

It has been determined that you created an unacceptable liability for the Company. Specifically, you violated PRO-2227, Information Protection, by disclosing Boeing information5 to non-Boeing persons without following appropriate procedures, obtain- ing necessary approvals and putting in place appropriate safeguards. In addition, you

4. A. James and D. Lathrop, “Computer Security Faults Put Boeing at Risk,” Seattle Post-Intelligencer (online), 17 July 2007. 5. Boeing’s corporate policy statement PRO-2227 defined “Boeing information” as “all nonpublic infor- mation that is owned by Boeing.” Under this corporate policy, “all Boeing information is presumed to have value and be proprietary, confidential, and/or trade secret information.”

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324 SECTION THREE INTERNAL CONTROL ISSUES

violated PRO-3439 by not referring inquiries from the news media to Communications, and by releasing information without approval in accordance with the requirements of the said PRO. Your actions are aggravated by the fact that the information had an adverse effect on the Company’s reputation and its relations with its employees, cus- tomers, shareholders, suppliers and other important constituents, causing significant liability. The company deems your behavior in this incident as unacceptable and in violation of its expectations as defined in PRO-1909.

Fighting Back in the Courts In late December 2007, three months after they were terminated, Neumann and Tides filed separate “whistleblower” complaints challenging their dismissals. These complaints were filed under SOX Section 806, “Protection for Employees of Publicly Traded Companies Who Provide Evidence of Fraud.” In fact, at the time, several federal statutes in addition to SOX provided protection for whistleblowers that subsequently faced some type of retaliation by their employer or another entity. The most prominent of these statutes are the False Claims Act and the Whistleblower Protection Act that deal primarily with whistleblowing incidents involving the federal government or its agencies.

Following the Enron and WorldCom debacles in 2001 and 2002, Congress hurriedly passed the SOX statute in an attempt to strengthen the nation’s financial reporting function and reduce the frequency of large-scale corporate frauds that were under- mining the credibility of the capital markets. Among the centerpieces of this legisla- tion were the SOX mandates to strengthen public companies’ internal controls and to provide more transparency regarding those controls. This enhanced transparency was manifested principally by requiring corporate management teams and indepen- dent auditors to annually report on the effectiveness of public companies’ financial reporting controls.

Not nearly as well publicized were the whistleblower mandates included in SOX. Section 301 of the statute requires audit committees of public companies to establish procedures for processing “complaints . . . regarding accounting, internal accounting controls, or auditing matters.” This section also mandates that public company audit committees establish procedures to provide for the “confidential, anonymous sub- mission by employees . . . of concerns regarding questionable accounting or auditing matters.” In addition, Section 806 of the federal statute provides legal remedies for employees who are fired or otherwise punished after making whistleblower reports.

Two Strikes In February 2010, a federal district court dismissed Neumann and Tides’ whistleblower lawsuits against Boeing. Their attorney immediately appealed that decision to the U.S. Court of Appeals. In May 2011, the appellate court affirmed the lower court’s ruling.

The appellate court ruled that the whistleblowing protections included in SOX Section 806 did not apply to the circumstances surrounding Neumann and Tides’ dismissals. In particular, the court noted that Section 806 provides for legal reme- dies for corporate whistleblowers only when they are punished after communicating complaints or other adverse information to one or more of the following three par- ties: a federal regulatory or law enforcement agency, the U.S. Congress, or a “person with supervisory authority over the employee (or such other person working for the employer who has the authority to investigate, discover, or terminate misconduct).” Because Neumann and Tides had been fired by Boeing for communicating adverse information to a member of the news media, they were not entitled to legal remedies under SOX Section 806.

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CASE 3.8 THE BOEING COMPANY 325

Neumann and Tides’ attorney argued before the appellate court that disclosing Boeing’s internal control problems to the news media was equivalent to reporting those problems to the U.S. Congress since one or more members of Congress no doubt became aware of those issues as a result of James’ highly publicized article. The attorney also argued that because the overall purpose of the SOX statute is to protect investors and other third parties from self-interested corporate executives, the courts should interpret and apply the protections extended to corporate whistle- blowers under the statute as liberally as possible.

The appellate justices seriously considered and analyzed the arguments made by Neumann and Tides’ attorney. However, because of the lack of ambivalence in the SOX statute regarding the parties to whom corporate employees may communicate whistleblower complaints, the justices chose not to overturn the lower court’s deci- sion to dismiss the lawsuits of Neumann and Tides.

Next, the attorney of the two former Boeing employees filed a petition with the U.S. Supreme Court asking that body to review the decisions handed down by the district and appellate courts. In that petition, the attorney quoted Senator Patrick Leahy, a strong proponent of extending legal remedies for corporate whistleblowers. Senator Leahy contends that the “corporate code of silence” that is pervasive among large public companies damages the integrity of the nation’s capital markets and that providing extensive legal remedies for corporate whistleblowers is an effective means to counter that code of silence.

This ‘corporate code of silence’ not only hampers investigations, but also creates a cli- mate where ongoing wrongdoing can occur with virtual impunity. The consequences of this corporate code of silence for investors in publicly traded companies, in particular, and the stock market, in general, are serious and adverse, and they must be remedied.6

6. J. J. Tollefsen, “Tides and Neumann v. The Boeing Company, Petition for Writ of Certiorari.” 7. National Whistleblowers Center, “9th Circuit Whistleblowers Barred from Talking to the Press,” www.whistleblowers.org, 4 May 2011. 8. The Economist, “Sacked for Telling Tales,” www.economist.com, 7 July 2011.

E P I L O G U E In October 2011, the Supreme Court refused to review the prior rulings handed down in Neumann and Tides’ whistleblower lawsuits, meaning that those rulings would stand. Several groups that advocate for enhanced transparency on the part of public corpora- tions were dismayed by the Supreme Court’s decision. A representative of the National Whistleblowers Center argued that the out- come of the Neumann–Tides case would have a “chilling effect”7 on corporate whistleblow- ers in the future. Other critics of the Supreme Court’s decision and the earlier rulings in the case pointed out that many large-scale frauds,

including the Enron and Madoff Securities scandals, surfaced only after persistent jour- nalists reported allegations communicated to them by corporate insiders or other parties.

Following the Supreme Court’s refusal to review Neumann and Tides’ case, the promi- nent business publication The Economist sug- gested that the whistleblowing protections included in the SOX statute are largely ineffec- tive and need to be strengthened. According to that publication, of nearly 1,900 whistleblow- ing complaints filed under SOX by mid-2012, only 317 had been resolved in favor of the complainants.8

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326 SECTION THREE INTERNAL CONTROL ISSUES

Questions 1. The COSO internal control framework identifies five internal control

components. Which of those components is most relevant to the procedures that SOX mandates public companies establish to enable, if not encourage, whistleblowing by corporate employees?

2. Explain the difference between a “significant deficiency” and “material weakness” in internal control. Provide an example of each.

3. Assume that the PwC contract auditors did, in fact, exert “managerial authority” over Boeing employees? What internal control problems or issues would that have posed for Boeing?

4. Would it have been unethical or otherwise inappropriate for Neumann and Tides to have directly communicated their concerns regarding Boeing’s IT controls to the company’s Deloitte auditors? Explain. Assuming that Neumann and Tides had done just that, how should the Deloitte auditors have responded?

5. Why do you believe that SOX does not provide legal remedies for corporate whistleblowers who are punished by their employers after communicating with members of the news media?

6. Was it ethical for Boeing to monitor the computers and e-mail of Neumann and Tides during the investigation to determine whether one or more employees were communicating with members of the news media? Defend your answer.

9. P. Murphy, “Whistleblowers and Sarbanes–Oxley Fallout,” www.tollefsenlaw.com, 17 May 2011. 10. Ibid. 11. Ibid. 12. Ibid. 13. The Dodd–Frank Wall Street Reform and Consumer Protection Act was signed into law in July 2010 by President Barack Obama. That statute “allows the SEC to pay financial awards to whistleblowers who provide information that leads to a successful SEC enforcement action with more than $1 million in sanctions” (K. Tysiac, “Hot Tips: SEC Fields 3,000 Whistleblower Complaints in 12 months,” www.journalofaccountancy.com, 15 November 2012).

Similar to many, if not most, corporate whistleblowers, Neumann and Tides had diffi- culty obtaining jobs after they were dismissed by their employer. In May 2011, their attorney noted on his website that they “both are finally working again, but at significantly reduced salaries.”9

When asked to comment on the Boeing whistleblowing incident following the dismissal of Neumann and Tides’ lawsuit, Andrea James

expressed regret that they were fired as a result of her newspaper article. “It is hard for me to talk about because I feel bad. And . . . there’s nothing I can do.”10 James also revealed that her article was based upon “discussions with dozens of people”11 and she was unsure why Neumann and Tides were singled out for pun- ishment by Boeing. “That’s always puzzled me. But it’s clear that they [Boeing] made an exam- ple out of them.”12, 13

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327

CASE 3.9

Walmart de Mexico

Sam Walton was born on 29 March 1918, in Kingfisher, Oklahoma, a small town 50 miles northwest of Oklahoma City. Sam’s father, a farmer, struggled to support his family during the Great Depression. The Walton family hopscotched around the country before finally settling in Missouri where Sam graduated from high school. After obtaining a degree in economics from the University of Missouri, Sam went to work as a management trainee with J.C. Penney Company at a monthly salary of $75. Following the outbreak of World War II, Sam enlisted in the U.S. Army and served until 1945.

Upon returning to civilian life, Sam Walton borrowed money from his father-in-law to purchase a small retail store in northern Arkansas. Walton purchased additional stores in Arkansas, Kansas, and Missouri over the following years. In 1962, Walton opened the first store branded as a “Wal-Mart” in Rogers, Arkansas, 10 miles from Bentonville, which would become the company’s corporate headquarters. Walmart expanded its operations across the continental United States over the next three decades. In 1992, the year Sam Walton died, Walmart surpassed Sears to become the largest retailer in the United States.

By 2012, Walmart employed over two million people, making it the world’s largest private employer. In that same year, four members of Sam Walton’s family ranked among the top 10 of the Forbes 400, the 400 wealthiest individuals in the United States.1 Those individuals, with a collective wealth of more than $100 billion, included his three surviving children and the widow of his son, John Walton, a former Green Beret who was awarded the Silver Star for heroism during the Vietnam War.

The Lowest Prices Anytime, Anywhere! Walmart’s incredible growth was due to the hypercompetitive business model devel- oped by Sam Walton. The central tenet of Walton’s business plan was the motto that he adopted for his company, “The Lowest Prices Anytime, Anywhere!” Walton rea- soned that if he undercut the prices charged by his competitors, his company would generate sufficient sales volume to realize significant economies of scale. The most important of those economies of scale would be purchasing merchandise in bulk quantities at discounted wholesale prices that were not available to other retailers.

Walton’s simple business plan worked to perfection as Walmart routinely domi- nated the geographical markets that it entered. The ultimate result of Walmart’s alleged “predatory” business model was to drive large numbers of small retailers, including pharmacies, groceries, and general merchandise stores, out of business. In an op-ed piece written for the New York Times, Robert Reich, former Secretary of the U.S. Department of Labor, observed that Walmart “Turns main streets into ghost towns by sucking business away from small retailers.”2

In the early 1990s, Walmart became an international company when it opened retail outlets in Mexico and Canada. After replicating its successful business model in

1. From 1982 through 1988, Sam Walton topped the Forbes 400 as the richest individual in the United States. 2. R. Reich, “Don’t Blame Wal-Mart,” New York Times (online), 28 February 2005.

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328 SECTION THREE INTERNAL CONTROL ISSUES

those countries, Walmart extended its operations outside of North America. Within two decades, approximately one-fourth of the company’s sales were produced by its 6,000 retail stores in more than two dozen countries scattered around the globe.

To date, Mexico has easily been Walmart’s most successful international venture. Walmart quickly seized control of the retail industry in that country by taking away large chunks of market share previously held by domestic retailers that had oper- ated in the country for decades. By 2012, Walmart’s Mexican subsidiary, Walmart de Mexico, was Mexico’s largest retailer and that nation’s largest private employer.

Bribery Allegations In April 2012, an article published by the New York Times, “Vast Mexico Bribery Case Hushed Up by Wal-Mart After Top-Level Struggle,” reported that Walmart had rou- tinely bribed governmental officials to obtain building permits and other business licenses required by Mexican law. A former Walmart de Mexico officer testified that the bribes allowed the Mexican subsidiary “to build hundreds of new stores so fast that competitors would not have time to react.”3 The Pulitzer Prize–winning article in the New York Times, which was the culmination of an 18-month long investigation, insisted that the bribes violated the Foreign Corrupt Practices Act of 1977 (FCPA). The article also accused Walmart’s senior management of concealing those bribes from U.S. law enforcement authorities.

Walmart’s senior executives learned of the bribes being paid by their company’s Mexican subsidiary in late 2005 and immediately launched an investigation. “Wal- Mart dispatched investigators to Mexico City, and within days they unearthed evi- dence of widespread bribery. . . . They also found documents showing that Wal-Mart de Mexico’s top executives not only knew about the payments, but had taken steps to conceal them from Wal-Mart’s headquarters in Bentonville, Ark.”4

Following the discovery of the bribes, Walmart’s senior executives disagreed on how to address the problem. The New York Times article reported that Walmart’s management ultimately decided to resolve the matter quietly and internally. That goal was achieved by placing the Walmart de Mexico executive who had allegedly authorized the bribes in charge of the ongoing investigation of them. The investiga- tion ended shortly thereafter. The subsequent internal report noted that “There is no clear evidence or clear indication of bribes paid to Mexican government authorities with the purpose of wrongfully securing any licenses or permits.”5

The former FBI agent who served as Walmart’s director of corporate investigations found the internal report inadequate. “The report was nonetheless accepted by Wal- Mart’s leaders as the last word on the matter.”6 Walmart’s senior executives informed the U.S. Department of Justice that their company may have violated the FCPA only after they had learned of the ongoing investigation by the New York Times.

The author of the New York Times article charged that Walmart’s “relentless pur- suit of growth” had compromised its commitment to the “highest moral and ethi- cal standards.”7 A follow-up article in the New York Times in December 2012, “How Wal-Mart Used Payoffs to Get Its Way in Mexico,” described the methods used by

3. D. Barstow, “Vast Mexico Bribery Case Hushed Up by Wal-Mart After Top-Level Struggle,” New York Times (online), 21 April 2012. 4. Ibid. 5. Ibid. 6. Ibid. 7. Ibid.

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CASE 3.9 WALMART DE MEXICO 329

Walmart de Mexico to gain an unfair advantage over its competitors. That article also dismissed the suggestion that Walmart was a “victim” of a corrupt business culture in Mexico that obligated companies to bribe governmental officials.

The Times’ investigation reveals that Wal-Mart de Mexico was not the reluctant victim of a corrupt culture that insisted on bribes as the cost of doing business. Nor did it pay bribes merely to speed up routine approvals. Rather, Wal-Mart de Mexico was an aggressive and creative corrupter, offering large payoffs to get what the law otherwise prohibited. It used bribes to subvert democratic governance—public votes, open debates, transparent procedures. It used bribes to circumvent regulatory safeguards that protect Mexican citizens from unsafe construction. It used bribes to outflank rivals.8

After reporting the potential FCPA violations to the U.S. Department of Justice in December 2011, Walmart instructed its audit committee to use “all resources nec- essary” to “aggressively” investigate the company’s “FCPA compliance” not only in Mexico but worldwide.9 The audit committee hired KPMG and a major law firm to assist in the forensic investigation.10 Walmart’s board also created a network of international “FCPA compliance directors” that would report to a Bentonville-based “Global FCPA Compliance Officer.” In an April 2012 press release that addressed the bribery allegations made by the New York Times, Walmart officials declared that, “We will not tolerate noncompliance with the FCPA anywhere or at any level of the company.”11

Walmart included an interim report of the ongoing FCPA investigation in its Form 10-K for the fiscal year ending 31 January 2013. Company officials reported it was “probable” Walmart would “incur a loss from these matters” but could not “reasonably estimate” the amount of that loss. Nevertheless, they expected that the loss would not have a “material adverse effect on our business.” They also disclosed that the company had already spent $157 million on the FCPA investi- gation. Finally, the interim report revealed that additional “potential FCPA viola- tions” had been uncovered within the company’s operations in Brazil, China, and India.

There was widespread speculation in the business press concerning the ultimate outcome of the joint SEC and U.S. Department of Justice investigation of Walmart’s alleged FCPA violations. Much of that speculation focused on the magnitude of the monetary fines the federal agencies might levy on Walmart. Many observers believed that those fines could surpass the $450 million in FCPA-related fines imposed on the German engineering and electronics firm Siemens AG in 2008.

The FCPA: From Watergate to Walmartgate Walmart’s widely publicized FCPA problems refocused attention on the origins and nature of that federal statute. The FCPA was a by-product of the scandal-ridden Watergate era of the 1970s. During the Watergate investigations, the Office of the Special Prosecutor uncovered large bribes, kickbacks, and other payments made by U.S. corporations to officials of foreign governments to initiate or maintain business relationships. Widespread public disapproval compelled Congress to pass the FCPA,

8. D. Barstow and A. Xanic von Bertrab, “How Wal-Mart Used Payoffs to Get Its Way in Mexico,” New York Times (online), 17 December 2012. 9. Walmart.com, News release issued 24 April 2012. 10. Ernst & Young was Walmart’s audit firm at the time. 11. Walmart.com, News release issued 24 April 2012.

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330 SECTION THREE INTERNAL CONTROL ISSUES

which criminalizes most such payments.12 The FCPA also requires U.S. companies to maintain internal control systems that provide reasonable assurance of discovering improper foreign payments. In a 1997 Accounting and Auditing Enforcement Release, the Securities and Exchange Commission (SEC) highlighted the importance and need for the accounting and internal control requirements embedded in the FCPA.

The accounting provisions [of the FCPA] were enacted by Congress along with the antibribery provisions because Congress concluded that almost all bribery of foreign officials by American companies was covered up in the corporations’ books and that the requirement for accurate records and adequate internal controls would deter bribery.13

In the two decades following the passage of the FCPA, the SEC seldom charged U.S. companies with violating its provisions. In fact, in 1997 when the SEC filed FCPA- related charges against Triton Energy Ltd., an international oil and gas exploration company, more than 10 years had elapsed since the federal agency’s prior FCPA case. At the time, the SEC conceded that the filing of the FCPA charges against Triton Energy was intended to send a “message” to U.S. companies that “it’s not O.K. to pay bribes as long as you don’t get caught.”14 At the same time, an SEC spokesperson predicted that his agency would be filing considerably more FCPA charges in the future.15

The SEC was true to its word. While investigating the suspected FCPA violations by Walmart in 2012, the federal agency reported that it was also investigating potential violations of that federal statute by more than 70 other public companies. Those com- panies included such prominent firms as Alcoa, Goldman Sachs, Hewlett-Packard, and Pfizer. The World Bank has reinforced the need for the SEC and other global law enforcement agencies to rein in corporate bribery since it estimates that more than $1 trillion in bribes are paid annually to government officials worldwide.16

The FCPA is not without its critics. Many corporate executives have complained that the federal statute places U.S. multinational companies at a significant competi- tive disadvantage to multinational firms based in countries that have do not have a comparable law. Those same executives also find the recent “overzealousness” in prosecuting alleged FCPA violators inappropriate. “We are seeing companies getting scooped up in aggressive enforcement actions and investigations. A culture of over- zealousness has grabbed the Justice Department. The last time I checked, we were not living in a police state.”17 In response to that complaint, a representative of the U.S. Department of Justice observed, “This is not the time for the United States to be

12. The FCPA was initially unclear regarding whether or not so-called “facilitating payments” qualified as bribes and thus were illegal under that federal statute. Generally, bribes are significant amounts paid to governmental officials, while facilitating or “grease” payments are modest or nominal payments made to lower-ranking governmental officials to expedite or “facilitate” an already authorized or con- summated transaction. In 1988, the FCPA was amended to address that issue. As amended, facilitating payments made to encourage “routine governmental action” are not covered by the FCPA. 13. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 889, 27 February 1997. 14. L. Eaton, “Triton Energy Settles Indonesia Bribery Case for $300,000,” New York Times, 28 February 1997, D2. 15. Securities Regulation and Law Report, “SEC Official Predicts More FCPA Cases in Near Future,” Vol. 29, No. 18 (2 May 1997), 607. 16. L. Wayne, “Hits, and Misses, in a War on Bribery,” New York Times (online), 10 March 2012. 17. Ibid.

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CASE 3.9 WALMART DE MEXICO 331

condoning corruption. We are a world leader and we want to do everything to make sure that business is less corrupt, not more.”18

To date, the FCPA has not had a significant impact on the auditors of SEC regis- trants. An audit firm has been named in only one FCPA complaint filed by the SEC. In that case, a representative of KPMG’s Indonesian affiliate was charged with paying a bribe to a governmental official to reduce the tax bill of its client. The KPMG affiliate settled the charge by agreeing to a cease and desist order but was not fined.19 As the FCPA complaint against Walmart unfolded, a reporter for the Reuters international news service noted that it was unlikely that Ernst & Young, Walmart’s longtime audi- tor, would become a target of that investigation.20

In fact, the FCPA has created a new revenue stream for the major accounting firms that serve as the auditors of most SEC registrants. For example, Deloitte’s website lists “Foreign Corrupt Practices Act Consulting” as an ancillary service that it provides to public companies.

Our Foreign Corrupt Practices Act (FCPA) Consulting practice helps organiza- tions navigate FCPA risk and respond to potential violations. Utilizing the network of Deloitte member firms and their affiliates including their forensic resources in the United States, Canada, Europe, Russia, Africa, Latin America and Asia, we have worked on a variety of FCPA engagements including investigations, acquisition due diligence, and compliance program implementation and assessments in over fifty countries for some of the world’s leading companies.21

Questions 1. Identify control activities that Walmart could have implemented for Walmart de

Mexico and its other foreign subsidiaries to minimize the likelihood of illegal payments to government officials. Would these control activities have been cost-effective?

2. What responsibility, if any, does an accountant of a public company have when he or she discovers that the client has violated a law? How does the accountant’s position on the company’s employment hierarchy affect that responsibility, if at all? What responsibility does an auditor of a public company have if he or she discovers illegal acts by the client? Does the auditor’s position on his or her firm’s employment hierarchy affect this responsibility?

3. Does an audit firm of an SEC registrant have a responsibility to apply audit procedures intended to determine whether the client has complied with the FCPA? Defend your answer.

4. If the citizens of certain foreign countries believe that the payment of bribes is an acceptable business practice, is it appropriate for U.S. companies to challenge that belief when doing business in those countries? Defend your answer.

18. Ibid. 19. Securities and Exchange Commission, Litigation Release No. 17127, 12 September 2001. 20. N. Byrnes, “Wal-Mart Auditor Unlikely to Suffer in Bribery Case,” Reuters.com, 4 May 2012. 21. Deloitte, “Foreign Corrupt Practices Act Consulting,” www.deloitte.com.

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4

SECTION 4

ETHICAL RESPONSIBILITIES OF ACCOUNTANTS

Case 4.1 Creve Couer Pizza, Inc.

Case 4.2 F&C International, Inc.

Case 4.3 Suzette Washington, Accounting Major

Case 4.4 Freescale Semiconductor, Inc.

Case 4.5 Wiley Jackson, Accounting Major

Case 4.6 Arvel Smart, Accounting Major

Case 4.7 David Quinn, Tax Accountant

Case 4.8 Dell, Inc.

Case 4.9 AccuHealth, Inc.

Case 4.10 Wichita Falls

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335

CASE 4.1

Creve Couer Pizza, Inc.

Imagine this scenario. A few years after graduating from the University of Miami, New Mexico State University, or Ohio Wesleyan University with an accounting degree, you find yourself working as an audit senior with an international accounting firm. Your best friend, Rick, whom you have known since kindergarten, is a special agent with the Internal Revenue Service (IRS). Over lunch one day, Rick mentions the IRS’s informant program.

“You know, Jess, you could pick up a few hundred dollars here and there working as a controlled informant for us. In fact, if you would feed us information regarding one or two of those large corporate clients of yours, you could make a bundle.”

“That’s funny, Rick. Real funny. Me, a double agent, spying on my clients for the IRS? Have you ever heard of the confidentiality rule?”

Sound far-fetched? Not really. Since 1939, the IRS has operated an informant pro- gram. Most individuals who participate in this program provide information on a one-time basis; however, the IRS also retains hundreds of “controlled informants” who work in tandem with one or more IRS special agents on a continuing basis. Controlled informants provide the IRS with incriminating evidence regarding indi- viduals and businesses suspected of cheating on their taxes. In the early 1990s, the IRS revealed that more than 40 of these controlled informants were CPAs.

Now consider this scenario. You, the audit senior, are again having lunch with your friend Rick, the IRS special agent. Rick knows that the IRS is investigating you for large deductions taken in recent years on your federal income tax returns for a ques- tionable tax shelter scheme. The additional tax assessments and fines you face signif- icantly exceed your net worth. Your legal costs alone will be thousands of dollars. To date, you have been successful in concealing the IRS investigation from your spouse, other family members, and your employer, but that will not be possible much longer.

“Jess, I know this investigation is really worrying you. But I can get you out of this whole mess. I talked to my supervisor. She and three other agents are working on a case involving one of your audit clients. I can’t tell you which one right now. If you agree to work with them as a controlled informant and provide them with information that you can easily get your hands on, they will close the case on you. You will be off the hook. No questions. No fines or additional taxes. Case closed . . . permanently.”

“Rick, come on, I can’t do that. What if my firm finds out? I’d lose my job. I would probably lose my certificate.”

“Yeah, but face these facts. If the IRS proves its case against you, you are going to lose your job and your certificate . . . and probably a whole lot more. Maybe even your marriage. Think about it, Jess. Realistically, the agency is looking at a maximum recovery of $50,000 from you. But if you cooperate with my supervisor, she can prob- ably squeeze several million out of your client.”

“You’re sure they would let me off . . . free and clear?” “Yes. Free and clear. Come on, Jess, we need you. More important, you need us.

Plus, think of it this way. You made one mistake by becoming involved in that phony tax shelter scam. But your client has been ripping off the government, big time, for years. You would be doing a public service by turning in those crooks.”

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336 SECTION FOUR ETHICAL RESPONSIBILITIES OF ACCOUNTANTS

Returning to reality, consider the case of James Checksfield. In 1981, Checksfield, a Missouri CPA, became a controlled informant for the IRS. The IRS special agent who recruited Checksfield had been his close friend for several years and knew that Checksfield was under investigation by the IRS. Reportedly, Checksfield owed back taxes of nearly $30,000 because of his failure to file federal income tax returns from 1974 through 1977.

At the same time the IRS recruited Checksfield, the federal agency was also inves- tigating a Missouri-based company, Creve Couer Pizza, Inc. The IRS believed that the owner of this chain of pizza restaurants was “skimming receipts” from his business— that is, failing to report on his federal income tax returns the total sales revenue of his eight restaurants. Checksfield had served as Creve Couer’s CPA for several years, although both the IRS and Checksfield denied that he was recruited specifically to provide information regarding that company.

From 1982 through 1985, Checksfield funneled information to the IRS regarding Creve Couer Pizza. Based upon this information, federal prosecutors filed a six- count criminal indictment against the owner of that business in 1989. This indict- ment charged the owner with underreporting his taxable income by several hundred thousand dollars. The owner faced fines of nearly $1 million and a prison term of up to 24 years if convicted of the charges. Meanwhile, the IRS dropped its case against Checksfield. Both the IRS and Checksfield maintained that there was no connection between the decision to drop the case against him and his decision to provide the IRS with information regarding Creve Couer Pizza.

Following the indictment filed against the owner of Creve Couer Pizza, the owner’s attorneys subpoenaed the information that the IRS had used to build its case against him. As a result, the owner discovered the role played by his longtime friend and accountant in the IRS investigation. Quite naturally, the owner was very upset. “What my accountant did to me was very mean and devious. He sat here in my home with me and my family. He was like a member of the family. On the other hand, he was working against me.”1 Contributing to the owner’s anger was the fact that he had paid Checksfield more than $50,000 in fees for accounting and taxation services during the time the CPA was working undercover for the IRS.

The print and electronic media reported the case of the “singing CPA” nation- wide, prompting extensive criticism of the IRS. The case also caused many clients of CPAs to doubt whether they could trust their accountants to protect the confiden- tiality of sensitive financial information. When questioned concerning the matter, the IRS expressed no remorse for using Checksfield to gather incriminating evidence regarding the owner of Creve Couer Pizza. An IRS representative also rejected the contention that communications between accountants and their clients should be “privileged” under federal law similar to the communications between attorneys and their clients. In fact, that representative insisted that accountants had an ethical responsibility to turn over to the IRS any incriminating information that suggests a cli- ent has violated federal tax laws.2

The accounting profession was appalled by the Checksfield case and tried to mini- mize the damage it had done to the public’s trust in CPAs. In particular, the profes- sion condemned the actions of the IRS and attempted to reassure the public that individual CPAs did not share the IRS’s views regarding matters involving client confidentiality.3

1. “Accountant Spies on Client for IRS,” Kansas City Star, 18 March 1992, 2. 2. “The Case of the Singing CPA,” Newsweek, 17 July 1989, 41. 3. “IRS Oversteps with CPA Stoolies,” Accounting Today, 6 January 1992, 22.

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CASE 4.1 CREVE COUER PIZZA, INC. 337

Questions 1. Do CPAs who provide accounting, taxation, and related services to small

businesses have a responsibility to serve as the “moral conscience” of those clients? Explain.

2. In a 1984 opinion handed down by the U.S. Supreme Court, Chief Justice Warren Burger noted that “the independent auditor assumes a public responsibility transcending any employment relationship with the client.” If this is true, do auditors have a moral or professional responsibility to turn in clients who are cheating on their taxes or violating other laws?

3. Assume that you were Jess in the second hypothetical scenario presented in this case. How would you respond to your friend’s suggestion that you become a controlled informant for the IRS? Identify the parties that would be affected by your decision and the obligations you would have to each.

4. J. Novack, “Boomerang,” Forbes, 7 July 1997, 42–43. 5. L. Saunders and R. Sidel, “Whistleblower Gets $104 Million,” Wall Street Journal (online), 11 September 2012.

E P I L O G U E In August 1990, the Missouri State Board of Accountancy revoked James Checksfield’s CPA license for violating a state law that pro- hibits CPAs from disclosing confidential client information without the client’s permission. In November 1991, the U.S. Department of Justice suddenly announced that it was dropping the tax evasion charges against the owner of Creve Couer Pizza, although pretrial arguments had already been presented for the case. The Justice Department had little to say regarding its decision. Legal experts speculated that fed- eral prosecutors dropped the charges because the judge hearing the case was expected to dis- allow the evidence that the IRS had collected with the assistance of Checksfield.

Despite the negative publicity produced by the Creve Couer case, the IRS continues to use accoun- tants both in public practice and private industry as informants. In the late 1990s, Forbes magazine

reported a case in which a disgruntled control- ler of a retail electronics chain got even with his boss.4 Shortly before leaving the firm, the control- ler copied accounting and tax records document- ing a large-scale tax fraud perpetrated by the chain’s owner. Thanks to this information, the IRS collected a nearly $7 million fine from the owner and sent him to jail for 10 months. The former con- troller received a significant but undisclosed “find- er’s fee” from the IRS for his “cooperation.”

In 2007, the IRS Whistleblower Office was established. This office administers a provision of a 2006 federal law that guarantees individu- als who report significant tax deficiencies owed by other parties a minimum payment equal to 15 percent of the delinquent taxes collected. Among the largest payments made to date under this program was a $104 million distribu- tion made in 2012 to a former employee of UBS, a large Swiss banking company.5

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339

CASE 4.2

F&C International, Inc.

Alex Fries emigrated to the United States from Germany in the early nineteenth century.1 The excitement and opportunity promised by the western frontier fas- cinated thousands of new Americans, including the young German, who fol- lowed his dreams and the Ohio River west to Cincinnati. A chemist by training, Fries soon found a job in the booming distillery industry of southern Ohio and northern Kentucky. His background suited him well for an important need of dis- tilleries, namely, developing flavors to make their products more palatable for the public. Alex Fries eventually established his own flavor company. Thanks largely to Fries, Cincinnati became the home of the small but important flavor industry in the United States. By the end of the twentieth century, the flavor industry’s annual revenues approached $5 billion.

Alex Fries’ success in the flavor industry became a family affair. Two of his grand- sons created their own flavor company, Fries & Fries, in the early 1900s. Several decades later, another descendant of Alex Fries, Jon Fries, served as the presi- dent and CEO of F&C International, Inc., a flavor company whose common stock traded on the NASDAQ stock exchange. F&C International, also based in Cincinnati, reigned for a time during the 1980s as Ohio’s fastest-growing corporation. Sadly, the legacy of the Fries family in the flavor industry came to a distasteful end in the early 1990s.

The Fraud Jon Fries orchestrated a large-scale financial fraud that led to the downfall of F&C International. At least 10 other F&C executives actively participated in the scam or allowed it to continue unchecked due to their inaction. The methods used by Fries and his cohorts were not unique or even innovative.

Fries realized that the most effective strategy for embellishing his company’s peri- odic operating results was to inflate revenues and overstate period-ending inventories. Throughout the early 1990s, F&C systematically overstated sales revenues by backdat- ing valid sales transactions, shipping customers product they had not ordered, and recording bogus sales transactions. To overstate inventory, F&C personnel filled bar- rels with water and then labeled those barrels as containing high-concentrate flavor products. The company also neglected to write off defective goods and included waste products from manufacturing processes in inventory. Company officials used F&C’s misleading financial statements to sell equity securities and to obtain signifi- cant bank financing.

As F&C’s fraud progressed, Jon Fries and his top subordinates struggled to develop appropriate sales and inventory management strategies since the company’s account- ing records were unreliable. To help remedy this problem, F&C created an imaginary warehouse, Warehouse Q.

1. The facts in this case were taken from several SEC enforcement releases and a series of articles that appeared in the Cincinnati Enquirer. The key parties in this case neither admitted nor denied the facts reported by the SEC. Those parties include Jon Fries, Catherine Sprauer, Fletcher Anderson, and Craig Schuster.

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340 SECTION FOUR ETHICAL RESPONSIBILITIES OF ACCOUNTANTS

Warehouse Q became the accounting repository for product returned by customers for being below specification, unusable or nonexistent items, and items that could not be found in the actual warehouses.2

Another baffling problem that faced Fries and his confederates was concealing the company’s fraudulent activities from F&C’s independent auditors. The executives continually plotted to divert their auditors’ attention from suspicious transactions and circumstances uncovered during the annual audits. Subversive measures taken by the executives included creating false documents, mislabeling inventory counted by the auditors, and undercutting subordinates’ attempts to expose the fraud.

The size and complexity of F&C’s fraud eventually caused the scheme to unravel. Allegations that the company’s financial statements contained material irregularities triggered an investigation by the Securities and Exchange Commission (SEC). The investigation revealed that F&C had overstated its cumulative pretax earnings during the early 1990s by approximately $8 million. The company understated its pretax net loss for fiscal 1992 alone by nearly 140 percent, or $3.8 million.

The Division Controller Catherine Sprauer accepted an accounting position with F&C International in July 1992, shortly after the 30 June close of the company’s 1992 fiscal year. Sprauer, a CPA, drafted the Management’s Discussion and Analysis (MD&A) section of F&C’s 1992 Form 10-K registration statement. In October 1992, the 28-year-old Sprauer became the controller of F&C’s Flavor Division. Following that promotion, Sprauer continued to help prepare the MD&A sections of F&C’s periodic financial reports submitted to the SEC.

In early January 1993, an F&C employee told Sprauer that he saw company employ- ees filling inventory barrels with water in the final few days of June 1992. This indi- vidual also advised Sprauer that he had documentation linking two F&C executives to that incident, which was apparently intended to overstate the company’s year-end inventory for fiscal 1992. According to the SEC, Sprauer abruptly ended the conversa- tion with this employee and did not discuss his allegations with anyone.

Later that same day, another F&C employee approached Sprauer and confessed that he was involved in the episode recounted to her earlier in the day. This indi- vidual told Sprauer that he had acted under the direct instructions of Jon Fries. The employee then attempted to hand Sprauer a listing of inventory items affected by the fraud. Sprauer refused to accept the list. The persistent employee placed the list in Sprauer’s correspondence file. The document detailed approximately $350,000 of nonexistent inventory in F&C’s accounting records. Sprauer reportedly never showed the list of bogus inventory to her superiors, to other F&C accountants, or to the com- pany’s independent auditors. However, she subsequently warned F&C’s chief operat- ing officer (COO), Fletcher Anderson, that the company had “significant inventory problems.”

The Chief Operating Officer Fletcher Anderson became the COO of F&C International in September 1992 and joined the company’s board of directors a few days later. On 23 March 1993, Anderson succeeded Jon Fries as F&C’s president and CEO. During the fall of 1992, Anderson stumbled across several suspicious transactions in F&C’s accounting records.

2. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 605, 28 September 1994. All subsequent quotations are taken from this source.

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CASE 4.2 F&C INTERNATIONAL, INC. 341

In late September 1992, Anderson discovered sales shipments made before the given customers had placed purchase orders with F&C. He also learned that other sales shipments had been delivered to F&C warehouses rather than to customers. Finally, in early October 1992, Anderson uncovered a forged bill of lading for a customer shipment. The bill of lading had been altered to change the reported month of shipment from October to September. Each of these errors inflated F&C’s reported earnings for the first quarter of fiscal 1993, which ended 30 September 1992.

More direct evidence that F&C’s financial data were being systematically distorted came to Anderson’s attention during the second quarter of 1993. In November, a subordinate told Anderson that some of the company’s inventory of flavor concen- trate was simply water labeled as concentrate. The following month, Anderson learned of Warehouse Q and that at least $1.5 million of the inventory “stored” in that warehouse could not be located or was defective.

Catherine Sprauer submitted her resignation to Fletcher Anderson in late January 1993. Among the reasons Sprauer gave for her resignation were serious doubts regard- ing the reliability of the company’s inventory records. Anderson insisted that Sprauer not tell him why she believed those records were unreliable because he wanted to avoid testifying regarding her concerns in any subsequent litigation.

In February 1993, shortly before Anderson replaced Jon Fries as F&C’s top execu- tive, an F&C cost accountant warned him that the company had an inventory problem “in the magnitude of $3–4 million.” Anderson later told the SEC that although the cost accountant had access to F&C’s inventory records and its actual inventory, he believed the accountant was overstating the severity of the company’s inventory problem.

The Chief Financial Officer Craig Schuster served as the chief financial officer (CFO) of F&C International during the early 1990s. As F&C’s CFO, Schuster oversaw the preparation of and signed the company’s registration statements filed with the SEC, including the company’s Form 10-K reports for fiscal 1991 and 1992.

Throughout 1992, Schuster became aware of various problems in F&C’s account- ing records, most notably the existence of Warehouse Q. In March 1992, Schuster learned that his subordinates could not locate many items listed in F&C’s perpetual inventory records. A few months later, Schuster discovered that customer shipments were being backdated in an apparent attempt to recognize sales revenue prema- turely. In late 1992, Schuster determined that approximately $1 million of F&C’s work- in-process inventory was classified as finished goods.

On 17 December 1992, a frustrated Schuster prepared and forwarded to Fletcher Anderson a 23-page list of $1.5 million of inventory allegedly stored in Warehouse Q. The memo indicated that the inventory could not be located or was defective. The SEC’s enforcement releases focusing on the F&C fraud did not reveal how or whether Anderson responded to Schuster’s memo.

Because he supervised the preparation of F&C’s financial reports filed with the SEC, Schuster knew that those reports did not comment on the company’s inventory prob- lems. On 1 January 1993, Craig Schuster resigned as the CFO of F&C International. The final F&C registration statement Schuster signed was the company’s Form 10-Q for the first quarter of fiscal 1993, which ended 30 September 1993.

The Rest of the Story In a 28 September 1994, enforcement release, the SEC criticized Catherine Sprauer, Fletcher Anderson, and Craig Schuster for failing to ensure that F&C’s financial reports “filed with the Commission and disseminated to the investing public were

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342 SECTION FOUR ETHICAL RESPONSIBILITIES OF ACCOUNTANTS

accurate.” The federal agency also chastised the three individuals for not disclos- ing in F&C’s financial reports “significant accounting problems of which they were aware.” Finally, the SEC scolded Anderson and Schuster for not establishing adequate internal controls to provide for the proper recognition of revenue and the proper val- uation of inventory. In an agreement reached with the SEC to settle the allegations pending against them, the three former F&C executives pledged to “permanently cease and desist” from committing or causing violations of federal securities laws.

A second enforcement release issued by the SEC on 28 September 1994, contained a series of allegations directed at Jon Fries and seven other senior F&C executives. The SEC charged that these executives were primarily responsible for F&C’s fraudu- lent earnings scheme. To settle these charges, each executive pledged not to violate federal securities laws in the future. The settlement agreement permanently banned Jon Fries from serving as an officer or director of a public company. Several of the individuals agreed to forfeit proceeds received from earlier sales of F&C securities. Fries relinquished more than $2 million he had realized from the sale of F&C com- mon stock. Finally, the SEC imposed civil fines on four of the executives that ranged from $11,500 to $20,000.

F&C International filed for bankruptcy in April 1993 shortly after the fraud became public. The following year, a competitor purchased F&C’s remaining assets. In March 1995, Jon Fries began serving a 15-month sentence in federal prison for his role in the F&C fraud.

Questions 1. Jon Fries (CEO), Fletcher Anderson (COO), Craig Schuster (CFO), and Catherine

Sprauer (division controller) were the four central figures in this case. Identify the key responsibilities associated with the professional roles these individuals occupied. Briefly describe the type and extent of interaction each of these individuals likely had with F&C’s independent auditors.

2. Using the scale shown below, evaluate the conduct of the four key individuals discussed in this case. Be prepared to defend your answers.

−100 . . . . . . . . . 0 . . . . . . . . . 100 Highly Highly Unethical Ethical

3. For a moment, step into the shoes of Catherine Sprauer. What would you have done during and following each of the confrontations she had with the two employees who insisted that F&C executives were involved in a fraudulent scheme to misrepresent the company’s financial statements?

4. Craig Schuster resigned as F&C’s CFO on 1 January 1993. Apparently, Schuster did not reveal to any third parties the concerns he had regarding F&C’s accounting records and previous financial statements. In your opinion, did Schuster have a responsibility to inform someone of those concerns following his resignation? Defend your answer.

5. Assume that you, rather than Fletcher Anderson, were F&C’s COO in December 1992. What would you have done upon receiving the list of Warehouse Q inventory from Craig Schuster?

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343

CASE 4.3

Suzette Washington, Accounting Major

Suzette Washington financed her college education by working as an inventory clerk for Bertolini’s, a clothing store chain located in the southeastern United States.1 Bertolini’s caters primarily to fashion-conscious young men and women. The com- pany’s stores carry a wide range of clothing, including casual wear, business suits, and accessories. The Bertolini’s store for which Suzette worked is located a few blocks from the campus of the large state university that she attended. Except for management personnel, most of Bertolini’s employees are college students. Suzette’s best friend and roommate, Paula Kaye, worked for Bertolini’s as a sales clerk. Paula majored in marketing, while Suzette was an accounting major.

During Suzette’s senior year in college, Bertolini’s began experiencing abnormally high inventory shrinkage in the store’s three departments that stocked men’s apparel. Suzette’s supervisor, an assistant store manager, confided in her that he believed one or more of the sales clerks were stealing merchandise. Over lunch one day in the student union, Suzette casually mentioned the inventory problem to Paula. Paula quickly changed the subject by asking Suzette about her plans for the weekend.

“Paula, rewind for just a second. Do you know something that I don’t?” “Huh? What do you mean?” “Missing inventory . . . shrinkage . . . theft?” After a few awkward moments, Paula stopped eating and looked squarely into her

friend’s eyes. “Suzette, I don’t know if it’s true, but I’ve heard a rumor that Alex and Matt are stealing a few things each week. Polo shirts, silk ties, jeans. Occasionally, they take something expensive, like a hand-knit sweater or sports jacket.”

“How are they doing it?” “I’ve heard—and don’t repeat any of this now—I’ve heard that a couple of times

per week, Alex stashes one or two items at the bottom of the trash container beneath the number two cash register. Then Matt, you know he empties the trash every night in the dumpster out in the alley, takes the items out and puts them in his car.”

“Paula, we can’t let them get away with this. We have to tell someone.” “No ‘we’ don’t. Remember, this is just a rumor. I don’t know that it’s true. If you tell

a manager, there will be questions. And more questions. Maybe the police will be brought in. You know that eventually someone’s going to find out who told. And then . . . slashed tires . . . phone calls in the middle of the night.”

“So, don’t get involved? Don’t do anything? Just let those guys keep stealing?” “Suze, you work in inventory. You know the markup they put on those clothes.

They expect to lose a few things here and there to employees.” “Maybe the markup wouldn’t be so high if theft wasn’t such a problem.” Now, there was no doubt in Paula’s mind that Suzette was going to report the

alleged theft scheme to management. “Two months, Suze. Two months till we gradu- ate. Can you wait till then to spill the beans? Then we can move out of state before our cars are spray-painted.”

1. This case was developed from information provided by a former college student who is now a CPA. The names, location, and certain other background facts have been changed.

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344 SECTION FOUR ETHICAL RESPONSIBILITIES OF ACCOUNTANTS

One week following Suzette and Paula’s conversation, a Bertolini’s store manager received an anonymous typed message that revealed the two-person theft ring rumored to be operating within the store. Bertolini’s immediately retained a private detective. Over a four-week period, the detective documented $500 of merchandise thefts by Alex and Matt. After Bertolini’s notified the police, the local district attor- ney filed criminal charges against the two young men. A plea bargain agreement arranged by their attorneys resulted in suspended prison sentences for Alex and Matt. The terms of that agreement included making restitution to Bertolini’s, complet- ing several hundred hours of community service, and a lengthy period of probation.

Questions 1. What would you do if you found yourself in a situation similar to that faced by

Suzette in this case?

2. Do you believe that it was appropriate for Suzette to report the alleged theft ring to a store manager? Would it have been unethical for Suzette not to report the rumored theft ring?

3. Accounting majors are preparing to enter a profession recognized as having one of the strongest and most rigorously enforced ethical codes. Given this fact, do you believe that accounting majors have a greater responsibility than other business majors to behave ethically?

4. Briefly discuss internal control activities that might have prevented the theft losses suffered by Bertolini’s.

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345

CASE 4.4

Freescale Semiconductor, Inc.

Who will guard the guardians?

Juvenal

During the summer of 2006, a syndicate of investors led by The Blackstone Group, one of Wall Street’s largest private equity investment firms, initiated a secret plan to acquire Freescale Semiconductor. Based in Austin, Texas, Freescale is among the world’s largest producers of semiconductors and for decades was a subsidiary of Motorola, Inc., the large electronics company. In July 2004, Motorola spun off Freescale in one of that year’s largest initial public offerings.

Blackstone retained Ernst & Young (E&Y) to serve as a consultant for the planned buyout of Freescale. Among other services, Blackstone wanted E&Y to review Freescale’s human resource functions and to make recommendations on how to streamline and strengthen those functions following the acquisition. James Gansman, a partner in E&Y’s Transaction Advisory Services (TAS) division, was responsible for overseeing that facet of the engagement.

Similar to the other Big Four accounting firms, E&Y became involved in the invest- ment banking industry during the 1990s. In fact, by the late 1990s, the small fraternity of accounting firms could boast of having two of the largest investment banking prac- tices in the world, at least in terms of the annual number of consulting engagements involving merger and acquisition (M&A) deals. In 1998, KPMG consulted on 430 M&A transactions, exactly one more than the number of such engagements that year for PricewaterhouseCoopers (PwC). Despite those impressive numbers, KPMG and PwC had not established themselves as dominant firms in the investment banking industry.

In 1998, the total dollar volume of the M&A engagements on which KPMG and PwC consulted was $1.65 billion and $1.24 billion, respectively. Those numbers paled in comparison to the annual dollar value of M&A transactions for industry giants such as Goldman Sachs, which was involved in M&A deals valued collectively at nearly $400 billion in 1998. At the time, Goldman Sachs, Lehman Brothers, Morgan Stanley, and the other major investment banking firms consulted exclusively on “mega” or multibillion-dollar M&A engagements. By contrast, the “low end” of the M&A market—in which the Big Four firms competed—typically involved transac- tions measured in a few million dollars.

E&Y’s involvement in the huge Freescale M&A deal was a major coup for the Big Four firm. When the transaction was consummated in December 2006, the price paid for the company by the investment syndicate led by The Blackstone Group approached $18 billion. That price tag made it the largest private takeover of a tech- nology company to that point in time as well as one of the 10 largest corporate take- overs in U.S. history.

Not surprisingly, Blackstone demanded strict confidentiality from E&Y and the other financial services firms that it retained to be involved in the planned acquisi- tion of Freescale. James Gansman, for example, was told that Blackstone wanted the transaction to be “super confidential” and was instructed in an internal E&Y e-mail to “not breathe the name of the target [Freescale] outside of the [engagement] team.”1

1. U.S. Department of Justice, “Former Ernst & Young Partner and Investment Banker Charged in Insider Trading Scheme,” 29 May 2008 (http://newyork.fbi.gov).

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346 SECTION FOUR ETHICAL RESPONSIBILITIES OF ACCOUNTANTS

During June and July 2006, while he was working on the Freescale engagement, Gansman passed “inside information about the pending transaction”2 to Donna Murdoch, a close friend who worked in the investment banking industry. An FBI investigation revealed that Gansman and Murdoch “communicated over 400 times via telephone and text messages”3 in the weeks leading up to the 11 September 2006, announcement that the Blackstone investment syndicate intended to acquire Freescale. In that time span, Murdoch purchased hundreds of Freescale stock options, which she cashed in on 11–12 September 2006, realizing a windfall profit of $158,000.

The FBI also determined that between May 2006 and December 2007 Gansman provided Murdoch with information regarding six other M&A transactions on which E&Y consulted. In total, Murdoch used that inside information to earn nearly $350,000 in the stock market. Murdoch gave that information to three other individuals, includ- ing her father, who also used it to produce significant stock market profits.

Published reports indicate that Murdoch became involved in the insider trading scheme to help make the large monthly payments on a $1.45 million subprime mort- gage on her home. The funds she initially used to “play the market” were provided to her by one of the individuals to whom she disclosed the inside information given to her by James Gansman. In addition, Gansman at one point loaned her $25,000.

The Securities and Exchange Commission (SEC) uses sophisticated software pro- grams to detect suspicious trading activity in securities listed on stock exchanges. In early 2007, the SEC placed Murdoch on its “watch list” of individuals potentially involved in insider trading and began scrutinizing her stock market transactions. Information collected by the SEC resulted in criminal charges being filed against Murdoch. In December 2008, she pleaded guilty to 15 counts of securities fraud and two related charges.

In May 2009, Murdoch served as one of the prosecution’s principal witnesses against Gansman in a criminal trial held in a New York federal court. During the trial, Gansman testified that he had been unaware that Murdoch was acting on the information he had supplied her. Defense counsel also pointed out that Gansman had not personally profited from any of the inside information that he had been privy to during his tenure with E&Y. Nevertheless, the federal jury convicted Gansman of six counts of securities fraud. A federal judge later sentenced him to a prison term of one year and one day.

2. Ibid. 3. Ibid. 4. A. Rappeport, “Ex-PwC Pals Were Inside Traders, SEC Says,” CFO.com, 15 January 2009.

E P I L O G U E Personnel at all levels of the Big Four account- ing firms routinely gain access to highly confi- dential inside information, information that can be used to gain an unfair advantage over other stock market investors. Unfortunately for the accounting profession, James Gansman is not the only partner or employee of one of those firms who has been implicated recently in a major insider trading scandal.

In January 2008, the SEC charged two for- mer PwC employees with using confidential client information to earn large profits in the stock market. One of the individuals was on PwC’s audit staff, while the other was assigned to PwC’s Transaction Services group, the PwC division comparable to E&Y’s TAS department.4 The individual in the Transactions Services group accessed the confidential information

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CASE 4.4 FREESCALE SEMICONDUCTOR, INC. 347

5. P. Lattman, “Couple Accused of Trading Insider Tips,” New York Times (online), 30 November 2010. 6. E. Stevens, “Pacific Heights Socialites Charged in Elaborate Insider-Trading Scheme,” Bay Citizen (online), 9 January 2011. 7. A Deloitte “advisory” partner is typically a senior audit partner who has significant industry exper- tise relevant to a given client. In addition to consulting with members of an audit engagement team on important issues arising during an audit, an advisory partner typically reviews the audit workpapers before the engagement is completed. 8. S. Johnson, “Deloitte Insider Case Sparked Doubts About Audits,” CFO.com, 10 November 2008. 9. B. Carton, “21-Month Sentence Just One of the Consequences of Former Deloitte Partner’s Insider Trading” www.complianceweek.com, 30 October 2012.

while working on several M&A consulting engagements for PwC. He then provided that information to his friend on PwC’s audit staff, who used it to purchase securities of compa- nies that were acquisition targets. This latter individual’s name was recognized by a PwC audit partner when he was reviewing a list of securities transactions for a client that another company was attempting to acquire. The audit partner informed the SEC, which then filed insider trading charges against the two friends.

In November 2010, the U.S. Department of Justice filed insider trading charges against a former Deloitte tax partner and his wife, who had also been employed by that firm.5 The couple allegedly obtained confidential informa- tion regarding seven Deloitte clients that were involved in M&A transactions. According to the SEC, the couple communicated that informa- tion to family members living in Europe who then engaged in securities trades involving the companies that were parties to those transac- tions. The SEC reported that more than $20 mil- lion in illicit stock market gains were earned as a result of the scheme.6 The case was ultimately resolved with the charges being dropped against the tax partner when his wife admitted that she was solely responsible for passing the inside information to relatives. The partner’s wife obtained the information by eavesdrop- ping on her husband’s telephone conversations. She was subsequently sentenced to 11 months in prison by a federal judge.

In the 38 years that he spent with Deloitte, Thomas Flanagan worked his way up the employment hierarchy of the Big Four account- ing firm from staff accountant to vice chairman. In October 2008, Deloitte announced that it was

suing Flanagan for trading in the securities of multiple Deloitte audit clients for which he had served as an “advisory”7 partner.

Deloitte claims that Flanagan held and traded securities of his own clients for the past three years. The firm alleges he bought one of his client’s stock one week before it announced an acquisition of a public company. He is also accused of violating the firm’s indepen- dence and conflict-of-interest policies and hiding his personal securities holdings from Deloitte. In his role as an advisory partner, he attended the audit committee meetings of seven of the twelve clients affected.8

The Deloitte clients involved in Flanagan’s insider trading scheme included Allstate, Berkshire Hathaway, Best Buy, Sears, and Walgreens.

In August 2010, the SEC announced that it had settled the insider trading charges that it had filed against Flanagan. The terms of the settlement required Flanagan to pay more than $1 million in fines and penalties. Flanagan consented to the settlement without admitting or denying the SEC’s allegations. Flanagan’s son, who had allegedly made securities trades based upon inside information given to him by his father, reached a similar settlement with the SEC and paid fines and penalties of approximately $120,000. In October 2012, a fed- eral judge sentenced Thomas Flanagan to 21 months in federal prison after he pleaded guilty to insider trading. During the sentencing hear- ing, Flanagan remarked that his conduct “was stupid, it was arrogant and it was wrong.”9 In addition to the 21-month prison sentence and the SEC fines, Flanagan will reportedly forfeit more than $14 million in pension benefits and

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348 SECTION FOUR ETHICAL RESPONSIBILITIES OF ACCOUNTANTS

Questions 1. Identify the specific circumstances under which auditors are allowed to provide

confidential client information to third parties.

2. Suppose that you and a close friend are employed by the same accounting firm. You are assigned to the firm’s audit staff, while your friend is a consultant who works on M&A engagements. What would you do under the following circumstances: (1) your friend discloses to you highly confidential “market- moving” information regarding a soon-to-be announced merger; (2) your friend not only discloses such information to you but also informs you that he or she plans to use it to make a “quick” profit in the stock market? In your responses, comment on your ethical responsibilities in each scenario.

3. E&Y was providing a consulting service to The Blackstone Group in connection with its planned acquisition of Freescale Semiconductor. Explain how a CPA’s professional responsibilities differ between consulting engagements and audit engagements.

10. S. Pfeifer, “Former KPMG Partner Scott London Pleads Guilty to Insider Trading,” Los Angeles Times (online), 1 July 2013. 11. P. Lattman, “Ex-KPMG Partner Is Charged in Insider Case,” New York Times (online), 11 April 2013. 12. Ibid.

deferred compensation as a result of settling the civil lawsuit filed against him by Deloitte.

To date, the most publicized case of insider trading by an independent auditor involved Scott London, a longtime and high-profile audit partner with KPMG. In addition to super- vising the audit practice of KPMG’s large Los Angeles office, London served on Los Angeles’ Chamber of Commerce and chaired the Los Angeles Sports Council. In June 2013, London pleaded guilty to insider trading, “admitting he revealed secret information about his company’s clients to a friend who used the tips to make more than $1 million from result- ing trades.”10 In exchange for the stock tips, which took place over several years, London received gifts and cash payments from his friend.

In a statement issued through his attorney, London indicated that “What I have done

was wrong and against everything that I had believed in. I spent nearly 30 years at KPMG and I dedicated my entire life to that firm.” During an appearance on CNBC, London’s attorney reported that his client had realized that he was violating federal laws when he pro- vided the inside information to his friend. “But he just can’t understand why he did it, and it’s hard to understand why he did it. It makes no sense. . . . It made no sense from a dollar- and-cents point of view; it made no sense in terms of his ethics.”11 The attorney added that London’s personal and professional lives had been ruined by the scandal. “He’s 50 years old, he’s lost his career, he’ll probably lose his license, he’s been disgraced. . . . It’s a very grim reminder of the consequences for any- one who wants to leak insider information.”12 London has yet to be sentenced for his crimi- nal conduct.

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349

CASE 4.5

Wiley Jackson, Accounting Major

Wiley Jackson spent three months as an audit intern with a local practice office of a major accounting firm while he was earning an undergraduate accounting degree at the University of Wisconsin–Milwaukee.1 Wiley thoroughly enjoyed the three-month internship. He made several friends and, more importantly, gained valuable work experience and insight into the nature and work environment of independent audit- ing. On the final day of his internship, Wiley had an exit interview with the office managing partner (OMP). The OMP told Wiley that he had impressed his superiors and coworkers. Wiley’s performance reviews indicated that he had strong technical and interpersonal skills and always conducted himself in a professional and ethical manner. At the end of the exit interview, the OMP offered Wiley a full-time position with the firm once he completed his master’s degree in accounting at UWM. Wiley was thrilled by the offer and accepted it immediately.

While working on his graduate degree, Wiley received a packet of documents from his future employer that he was to complete and return. The packet contained standard insurance forms, 401-K elections, a W-4 form, a personal investments work- sheet for independence-compliance purposes, and a “Statement of Arrests and Convictions” form. Wiley recalled having completed an earlier version of the latter document before beginning his internship. Among the questions included in this form was the following:

Have you ever been convicted of a misdemeanor (excluding minor traffic violations) or a felony, or driving while intoxicated in this or any other state, or are criminal charges currently pending against you?

The form required a full explanation if this question was answered “Yes.” Wiley had previously responded “No” to this question because, at the time, he had a “clean” record, except for a few parking tickets and one speeding violation. But now, as he sat at his desk staring at the form, he was not sure how to respond to the question.

After completing his internship, Wiley had been invited to a graduation party at an off-campus location. Although he was not a “party animal,” Wiley had decided to accept the invitation since it would likely be his final opportunity to see many of his friends who were graduating from UWM. When he arrived at the site of the party, Wiley was surprised by the large number of people there. In fact, because the older, two-story home could not accommodate all the partygoers, several dozen of them were congregated in the front yard and on the residential street on which the house was located.

As he made his way through the boisterous crowd, Wiley suddenly came face to face with Sally Jones. Sally, a UWM alumna, had been the audit senior assigned to Wiley’s largest client during his internship. While Wiley was talking to Sally, an acquaintance thrust a cold beer into his hand and slapped him on the shoulder. “No talking business here, Dude. It’s party time!” As luck would have it, just a few minutes later, the party was “busted” by the local police. Before Wiley realized exactly what

1. This case was written by Brian Daugherty, associate professor at the University of Wisconsin– Milwaukee. The facts of this case were developed from an actual series of events. Certain background information has been changed to conceal the identities of the individuals involved in the case.

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350 SECTION FOUR ETHICAL RESPONSIBILITIES OF ACCOUNTANTS

was happening, a policeman approached him and asked for his I.D. As he handed over his driver’s license, Wiley, who was three days short of his 21st birthday, realized that he was in trouble. Moments later, the stone-faced policeman began writing out a minor-in-possession citation. The citation ordered Wiley to appear before a local judge the following month.

Wiley was distraught and had a difficult time sleeping that night. The next morn- ing, he called an attorney and told him what had happened. The attorney informed Wiley that he had dealt with many similar situations involving college students and that Wiley should not be “stressed out” by the incident. For first-time offenders, like Wiley, the attorney had always been successful in persuading a judge to approve “deferred adjudication.” As long as Wiley stayed out of trouble over the following two years, the minor-in-possession charge would be expunged from his record, “just like it never happened,” according to the attorney.

Questions 1. Place yourself in Wiley’s position. How would you respond to the “Arrests and

Convictions” question? Before responding, identify the decision alternatives available to you.

2. Suppose that Wiley does not disclose the citation he received. A few weeks after going to work for his new employer, Wiley is called into the OMP’s office. The OMP tells Wiley that he recently learned of the minor-in-possession citation that Wiley had been given. The OMP then hands Wiley a copy of the Arrest and Convictions form that he completed after receiving the job offer from the firm. How should the OMP deal with this matter? How, if at all, should Wiley be disciplined? Defend your answer.

3. Assume that Sally Jones was the individual who told the OMP that Wiley had been given a police citation at the graduation party. Do you believe Sally had a moral or ethical responsibility to inform the OMP of that matter? Why or why not?

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351

CASE 4.6

Arvel Smart, Accounting Major

Arvel Ray Smart was born in Lebanon, Missouri, and grew up in the small town of Bolivar, 40 miles west of Lebanon in southeastern Missouri.1 Arvel’s mother and father graduated from the University of Missouri with accounting degrees in the mid-1970s. The Smarts spent three years working on the tax staff of a Big Eight prac- tice office in Kansas City before deciding to establish their own accounting firm in Bolivar. Arvel helped out in his parents’ office during high school, especially when they were facing tax deadlines. He enjoyed the work, which is why he decided to major in accounting when he enrolled at the University of Missouri following gradua- tion from high school. Arvel realized that he would most likely have the opportunity to take over his parents’ accounting firm when they retired. His only sibling, an older sister, was a performing arts major at Washington University in St. Louis and had no interest in becoming involved in the family business.

During his junior year at Mizzou, Arvel was admitted into the five-year program in the School of Accountancy. Arvel would receive Bachelor of Science and Master of Accountancy degrees when he completed the 150-hour program. After completing his junior year, Arvel accepted an internship with a Big Four practice office in Kansas City. Because he wanted to gain a better understanding of auditing, Arvel chose to intern on the audit staff of that office. Arvel was surprised by the number of interest- ing assignments he was given that summer. In fact, by the end of the summer he was reconsidering the decision he had made earlier to choose the tax track of Mizzou’s five-year accounting program.

On the final day of Arvel’s internship, the office managing partner met with him and offered him an entry-level auditing position. Arvel thanked the partner for the job offer and told him that he would seriously consider accepting it. He explained to the partner that he had not made a final decision about whether to focus on auditing or taxation early in his career. The partner was very understanding and told Arvel that he had plenty of time to make up his mind and then added that the job offer would remain open for 12 months, until the end of the following summer.

Arvel enrolled in the undergraduate auditing course during the spring semester of his fourth year in college. He enjoyed the course so much that he made up his mind to begin his career as an auditor and to accept the job offer from the firm with which he had interned the previous summer. He planned to delay accepting that offer, how- ever, until the end of the summer. Arvel’s girlfriend, who was also an accounting major at Mizzou, had accepted an offer for a summer internship with a Big Four prac- tice office in St. Louis. Arvel was hoping to spend the summer in St. Louis, so he had interviewed earlier in the year with two regional accounting firms based in that city. Both of the firms had offered him an internship.

During the final week of the spring semester of his fourth year, Arvel accepted an internship offer from one of the two St. Louis–based accounting firms. Arvel realized that both regional and national accounting firms use internships as a tool to recruit

1. This case is based on factual circumstances involving a recent accounting graduate. Key facts, including the individual’s name and relevant locations, have been changed to obscure his or her identity.

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352 SECTION FOUR ETHICAL RESPONSIBILITIES OF ACCOUNTANTS

permanent employees and that they typically offer internships to students who they believe have an interest in eventually accepting a permanent position with them. That realization caused Arvel to experience some degree of guilt when he called and accepted the internship with the St. Louis firm. He quickly cleared his guilty con- science by convincing himself that there was some remote chance he would change his mind and accept a job with the St. Louis accounting firm. In fact, in Arvel’s mind, that firm had a responsibility to prove to him that it offered more opportunities than the Big Four accounting firm from which he had already received a job offer.

Questions 1. Before interviewing with the two St. Louis accounting firms, did Arvel have an

obligation to inform them that he had an outstanding job offer from a Big Four practice office in Kansas City? Why or why not?

2. Did Arvel Smart behave unethically by accepting the internship with the St. Louis accounting firm when he intended to accept the outstanding job offer from the Big Four accounting firm at the completion of that internship? Defend your answer.

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353

CASE 4.7

David Quinn, Tax Accountant

We have all had that friend, an individual who attaches himself or herself to us without our encouragement—or approval, for that matter.1 For Debbie Woodruff, that friend was David Quinn. Debbie met David in the very first college accounting class that either of them took at the large public university they attended. Shortly before the instructor entered the room, David had rushed in and taken the seat to Debbie’s left. Moments later, an out-of-breath David had leaned over and asked Debbie, “Is this Accounting 201?” That question was the beginning of a relationship that would last for decades.

Debbie had little trouble grasping the revenue recognition rule, accrual account- ing, straight-line depreciation, and the other fundamental concepts and topics in the introductory financial accounting course. David, on the other hand, struggled to earn a “B” in the course. Debbie never questioned David’s intelligence. The problem was that David simply had too many outside interests—campus politics, his social fraternity, and weekend parties—to devote sufficient time to studying for the rigorous departmental exams in ACCT 201.

Before each exam, David would ask Debbie if they could study together. Debbie was not particularly fond of David, but she agreed to tutor him while she prepared for each exam because explaining an accounting concept or principle to someone else made the given item “gel” in her own mind. During two of these tutoring sessions, David asked Debbie for a date. The second time, Debbie told him that she did not mind studying together but that their “chemistry” made dating out of the question. David’s outspoken and opinionated manner was the principal source of the chem- istry problem between the two accounting majors. On most subjects—politics and economics, in particular—David had an opinion, an expert opinion, which he was more than willing to share with anyone who would listen. Debbie was much more reserved and preferred to spend her time focusing on her studies rather than debat- ing whatever happened to be the front-page issue of the day.

Over the remainder of their college careers, Debbie and David sat side by side in most of their accounting courses and several other business courses, as well. Eventually, Debbie came to accept David’s brash personality and considered him a friend—just not a close friend. Debbie maintained a near-perfect 3.9 GPA in her accounting courses, while David finished with a 3.2 GPA in his accounting major. During her final year of college, Debbie accepted an audit staff position with a nearby office of a Big Eight accounting firm. As fate would have it, David accepted a job on the tax staff of that same office.

Debbie wasn’t thrilled by the fact that she and David would be working for the same firm. But she expected that they would seldom see each other since she would be working primarily at client locations, while David would likely be “stuck” in the office completing tax returns and doing tax research. Debbie was right. During their first year in public accounting, she saw David only on the rare occasions when she was in the office, which was typically during the wrap-up phase of an audit to which she was assigned.

1. The key facts of this case were provided by a former public accountant who is now an accounting professor. The names of all parties and locations have been changed.

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354 SECTION FOUR ETHICAL RESPONSIBILITIES OF ACCOUNTANTS

Each time she was in the office, David would ask Debbie to go to lunch with him. Debbie always accepted. She didn’t like to admit it, but the lunches served a useful purpose, namely, catching up on all the office scuttlebutt. David seemingly made it his business to know everyone else’s business. He would joyfully tell Debbie which tax manager had not received a recommendation for promotion, which audit senior was interviewing for a position on a client’s accounting staff, and which intra-office relationship was not “working out.”

One Friday in early April, Debbie and David met for lunch to celebrate the end of her second busy season. Debbie was in the office tying up loose ends on the soon- to-be-completed audit of her largest client. She was looking forward to the lunch because she hadn’t spoken to David since the office Christmas party almost four months earlier.

On their way to a nearby restaurant, David told Debbie that three of his friends on the tax staff of another Big Eight accounting firm would be meeting them for lunch. Debbie realized that the presence of those individuals would likely divert David’s attention and deprive her of the latest news from the office grapevine. So, she resigned herself to having a boring lunch. She could not have been more wrong.

During lunch, the four tax professionals swapped war stories regarding the latest returns on which they had worked. Debbie found the topic of the conversation inap- propriate. In her mind, it was best to never discuss professional engagements, audit or otherwise, over lunch in a public setting. You just never knew who might be eaves- dropping at an adjoining table. Debbie became particularly uncomfortable when David began discussing the tax return of a wealthy local businessman who had pre- viously served several terms on the city council.

“Yeah, you wouldn’t believe the investments this guy has,” David said to the friend on his left. “The guy is loaded. And I mean . . . loaded!” Debbie cringed. Anyone within 20 feet could have heard David’s emphatic pronouncement. She attempted to change the subject of the conversation, but David refused to yield the floor.

“No, wait, Debbie, I gotta tell these guys about the latest racket this dude is run- ning.” Debbie cringed once more. “You wouldn’t believe what he wants us to do. He wants to write off the cost of his daughter’s wedding as an entertainment expense. And, you know what? I think we are going to let him do it!”

Debbie couldn’t take it anymore. “David, you shouldn’t be talking about this at lunch. You don’t know who is listening.”

“Come on, Debbie. No one’s listening.” “David. I’m serious. This is inappropriate.” “What?” David was obviously surprised that his normally meek friend was chal-

lenging him. Over the five years that he had known Debbie, she had never behaved in this manner. He was not only surprised but also somewhat miffed that Debbie was running the risk of embarrassing him in front of three fellow tax professionals. “Look around us, Debbie. These people aren’t listening to us. Besides, they are all strangers.”

“David, that’s the point. These people are strangers. And how do you know that they aren’t listening? Isn’t it possible that one of them might call up your client and tell him what they heard?”

David leaned back in his chair and shook his head. “Oh yeah, I’m sure Grandma over there wrote down every word I just said.”

Debbie was flabbergasted at her friend’s flippant attitude toward what she consid- ered a very important topic. “David, does the phrase ‘client confidentiality’ mean anything to you? Surely you tripped across it when studying for the CPA exam?”

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CASE 4.7 DAVID QUINN, TAX ACCOUNTANT 355

“Oh, so you are going to bring up the CPA exam? I guess you are trying to embar- rass me in front of my friends. Just because you passed that stupid thing the first time and I am still working on it doesn’t make you an expert on ethics issues.”

“David. You know that’s not what I meant,” Debbie responded indignantly. “Even if ‘Grandma’ isn’t listening, you are talking about sensitive issues regarding a tax client with three guys from a competing office.”

“Oh, I see. My buddies here are going back to their office to report me to the state board, right?” David was no longer miffed; he was angry. “Now, you’ve gone too far, Debbie. My friends would never do anything to get me into trouble.” He then added in a sarcastic tone, “If anyone ‘reports me,’ it will be you, Miss Self-Righteous.”

Debbie reached into her purse and counted out the money for her part of the bill. She then laid the cash on the table in front of her and, without speaking to David or his friends, left the restaurant.

David and Debbie did not speak again until their office’s annual Fourth of July golf tournament. To his credit, David approached Debbie and said that he hoped they could put their unpleasant encounter behind them.

“I’m sorry it happened. Why don’t we just forget it, Debbie? We’ve been friends for a long time. There’s no reason we can’t get over this.”

Debbie stepped forward and gave David a light hug and told him that they could be friends once more. Despite the nice overture by David, in the future Debbie made every effort to avoid him when she was working in the office.

E P I L O G U E Debbie sat waiting in the college placement office to meet the managing partner of the practice office where she had worked as a staff accountant and senior auditor. After almost five years in that office, Debbie had decided that public accounting was not for her. Instead, she had decided to pursue a Ph.D.—with the even- tual career objective of becoming an account- ing professor. Debbie subsequently spent five years earning her doctoral degree, including a stressful 18 months fretting over her dissertation. Ten years later, after accumulating an impres- sive portfolio of publications, she returned to her alma mater to accept a tenured position in its accounting department. After 15 years at her alma mater, Debbie was a full professor and just a few years away from retirement.

Each fall semester, representatives of the major accounting firms came to Debbie’s cam- pus to interview the latest crop of soon-to-be accounting graduates. Today was her former

employer’s opportunity to attempt to impress her students. Debbie realized that she had a responsibility to interact with the recruiters who came to campus—but she always dreaded meeting with the recruiters from her former employer. She knew that throughout lunch David Quinn, her old friend who was now the managing partner of the office in which she had worked, would tell story after story of their college and coworker days, stories that she had heard repeatedly, stories that became more embellished each year.

In Debbie’s mind, the annual lunch with David and his subordinates was a small price to pay to help her students land a job with her former employer. Besides, this year, she had a course to teach immediately after lunch, so she had an excuse to leave early. As she sat waiting for David, she suddenly realized that her course that after- noon was in the same classroom where she had met him for the first time more than 30 years earlier.

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356 SECTION FOUR ETHICAL RESPONSIBILITIES OF ACCOUNTANTS

Questions 1. Explain the meaning of the phrase “client confidentiality” in the context of

a CPA’s ethical responsibilities. In your opinion, did David Quinn violate the accounting profession’s client confidentiality rule?

2. Assume the role of Debbie Woodruff. How would you have handled the situation that arose in the restaurant?

3. Did Debbie have a responsibility to report David’s behavior to a superior in her practice office or to anyone else? Why or why not? Did Debbie have a responsibility to determine whether her firm’s tax department was providing appropriate professional advice regarding the deductibility of the entertainment expenses being claimed by David’s client?

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357

CASE 4.8

Dell, Inc.

Accuracy and completeness are the touchstones of public company disclosures under the federal securities laws.

Robert Khuzami, Director, SEC Division of Enforcement

Like most high school graduates, Michael Dell had a sense of anticipation, if not exhilaration, when he left home to begin his college career. Because Dell planned to become a doctor, like his father, he declared premed as his major when he enrolled in the University of Texas in the fall of 1983. Over the next few months, Dell’s interest in college waned as he began spending most of his time and energy on a hobby that he had pursued in high school, namely, tinkering with computers. By the end of his first semester at UT, Dell’s dorm room had become a workshop in which he and a few friends tore apart, reconfigured, and then reassembled per- sonal computers (PCs).

In the spring of 1984, Dell decided to go into business for himself. By the end of the spring semester, Dell’s small business was producing more than $10,000 in revenues each month from the sale of PCs and PC-related products. The success of his business convinced him to drop out of college and create Dell Computer Corporation. Less than a decade later, Michael Dell, at age 27, became the young- est chief executive officer (CEO) of a Fortune 500 company. Dell’s company, which had been renamed Dell, Inc., surpassed Compaq in 2001 as the world’s largest manufacturer of PCs. By 2012, Dell’s personal worth was estimated at nearly $15 billion, which placed him 22nd on the Forbes 400 list of the wealthiest Americans.

The critical feature of Dell, Inc.’s business model that allowed it to grow so rapidly was the “Dell Direct” strategy of selling custom-designed PCs. The company’s sales force took purchase orders over the phone or the Internet and then transmitted those orders to a production facility that assembled the PCs and shipped them in a matter of days. Unlike competitors, Dell spent only modest amounts on research and devel- opment. Instead, Dell focused its operations on delivering state-of-the-art computer technology developed by other companies at the lowest cost possible by emphasiz- ing operating efficiencies throughout its supply chain.

Increasing competition that caused profit margins to narrow dramatically on PC sales began undermining Dell’s business model during the late 1990s. In 2002, Dell faced the unhappy prospect of reporting disappointing earnings to its investors. At that point, Intel Corporation, which provided the microprocessors for Dell’s PCs, stepped into the breach and offered Dell “exclusivity payments” that would wipe out its earnings shortfall. Intel made these payments in exchange for a commitment from Dell that it would not purchase microprocessors from other suppliers, including Intel’s principal competitor, Advanced Micro Devices, Inc. (AMD). Because AMD was developing microprocessors that were reportedly superior to those of Intel, Intel’s management had become increasingly concerned that Dell would choose AMD as its primary supplier of microprocessors.

Over the next several years, Dell executives often asked Intel for additional exclu- sivity payments when it appeared that their company would fall short of its con- sensus Wall Street earnings forecast for a given quarter. According to the Securities

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358 SECTION FOUR ETHICAL RESPONSIBILITIES OF ACCOUNTANTS

and Exchange Commission (SEC), Dell management was “quite open with Intel”1 about the reason it was requesting those payments. Officials of Intel and Dell used the tongue-in-cheek acronym MOAP (mother of all programs) to refer to their mutu- ally beneficial arrangement that resulted in Intel paying Dell more than $4 billion between fiscal 2002 and fiscal 2007.

The exclusivity payments from Intel allowed Dell to meet or surpass its consen- sus earnings forecasts for 20 consecutive quarterly reporting periods. For fiscal 2003, Intel’s exclusivity payments accounted for 10 percent of Dell’s reported operating earnings. That figure rose to 38 percent for fiscal 2006 and to 76 percent for the first quarter of fiscal 2007. Dell’s impressive earnings trend produced sizable stock mar- ket gains for the company’s executives. During the time frame that Intel was making exclusivity payments to Dell, Michael Dell earned more than $450 million in compen- sation, most of which came in the form of gains on stock options granted to him by the company’s board.2

Dell’s management failed to disclose the exclusivity payments and their impact on the company’s reported earnings in its periodic earnings news releases and registration statements filed with the SEC. For accounting and financial report- ing purposes, Dell netted those payments against its operating expenses with- out disclosing the payments separately. Instead of disclosing that the exclusivity payments were responsible for the company consistently achieving or surpassing its consensus earnings forecasts, company executives attributed Dell’s remarkable earnings record to its “ultra-efficient supply chain and direct-sales strategy.”3 In the company’s 2005 annual report, for example, Michael Dell boasted of the compa- ny’s “best-ever operating results” and alluded to the company’s superior business model: “Dell’s exceptional performance again demonstrated the . . . superb execu- tion of a better way of doing business. . . . Our business is a model for customer focus, growth, and profitability.”

When Dell announced that it would purchase microprocessors from Intel and AMD beginning in the second quarter of 2007, Intel slashed the exclusivity payments, which caused Dell’s earnings to drop sharply. Instead of disclosing the true cause of the earnings decline, Dell attributed the decline to evolving competitive issues within its industry. Over the next two years, Dell’s stock price drifted downward. An SEC investigation eventually revealed the exclusivity payments made by Intel to Dell and the undisclosed impact those payments had on the company’s reported earn- ings from 2002 through early 2007.

The SEC investigation also revealed that Dell had used so-called “cookie jar reserves” to “smooth” its earnings from 2002 through 2005. Company officials inten- tionally overstated period-ending reserves for expenses such as warranty-related costs on the products it sold and then “withdrew” those reserves to “cover shortfalls in operating results” for subsequent periods.4 Dell ultimately issued restated finan- cial statements to properly reflect its operating results for the periods that had been affected by the improper accounting for the Intel exclusivity payments and period- ending reserves.

1. E. Wyatt, “Dell to Pay $100 Million Settlement,” New York Times (online), 22 July 2010. 2. E. Hess, “Stark Lessons from the Dell Fraud Case,” Forbes.com, 13 October 2010. 3. A. Jones, “’A Bad Way to Run a Railroad’: Dell Pays Big to Settle Fraud Charges,” WSJ.com, 23 July 2010. 4. Securities and Exchange Commission, SEC Charges Dell and Senior Executives with Disclosure and Accounting Fraud, www.sec.gov, 22 July 2010.

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CASE 4.8 DELL, INC. 359

In July 2010, the SEC revealed that it had charged Dell and several of its top execu- tives, including Michael Dell, with routinely misleading the investing public by issu- ing misleading financial statements.

Dell manipulated its accounting over an extended period to project financial results that the company wished it had achieved, but could not. Dell was only able to meet Wall Street targets consistently during this period by breaking the rules.5

Dell agreed to pay a $100 million fine to settle the charges filed against it by the SEC. Several Dell officials also agreed to pay significant fines. Michael Dell paid a $4 million fine for his alleged role in the earnings manipulation scheme, while the company’s former chief financial officer paid $3 million. In settling the case and agreeing to the fines, each of the parties, including the company as a whole and Michael Dell, stipulated that they neither “admitted nor denied” those charges.

Revelations of Dell’s brazen earnings management schemes angered a wide range of parties and made many critics question how pervasive such schemes are among large public companies. One business professor suggested that their root cause is the pressure on public companies to consistently report impressive quarterly earnings.

The Dell case illustrates the perverse short-term view prevalent on Wall Street that dictates that growth must occur continuously, smoothly, and linearly every quarter. . . . Too often, the maniacal focus on creating ever-increasing quarterly earnings drives bad corporate behavior, as it apparently did at Dell. That behavior produces non- authentic earnings that obscure what is really happening in a business. Short-termism can result in a range of corporate and financial games that may enrich management at the expense of market integrity and efficient investor capital allocation.6

5. Ibid. 6. Hess, “Stark Lessons from the Dell Fraud Case.” 7. Amalgamated Bank et al. vs. Dell, Inc. et al., U.S. District Court for the Western District of Texas, Civ. Action No. 1: 07-CA-00077-LY, 30 January 2007, 222–223. 8. S. Howard, “Court Flings Dell Shareholder Class Action Aside,” www.law360.com, 10 October 2008.

E P I L O G U E In 2007, a group of Dell, Inc.’s stockholders filed a class-action lawsuit against Michael Dell, other Dell executives, Intel Corporation, and Dell’s audit firm PricewaterhouseCoopers (PwC), which had served as Dell ’s audi- tor since 1986. The stockholders alleged that the defendants were responsible for the large stock market losses they had suffered as a result of Dell’s earnings management schemes.

The class-action lawsuit charged PwC with turning a “blind eye” to the “improper account- ing” of Dell and with violating a wide range of “fundamental concepts of GAAS.”7 These alleged violations included failing to maintain

a proper attitude of independence during the Dell audits, failing to properly plan those audits, and failing to issue the appropriate audit opin- ions on Dell’s periodic financial statements. In October 2008, a federal judge dismissed the lawsuit after ruling that the plaintiffs’ allegations of scienter on the part of the defendants was “too vague.”8

In February 2013, Michael Dell announced that he and a group of investors planned to pur- chase the outstanding shares of Dell, Inc. and take the company private. Industry analysts and business journalists speculated that the move was being made to allow Michael Dell and his fellow Dell executives to escape the intense

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360 SECTION FOUR ETHICAL RESPONSIBILITIES OF ACCOUNTANTS

Questions 1. Define the phrase “earnings management.” Under what conditions, if any, is

earnings management acceptable? Do auditors’ responsibilities include actively searching for instances of earnings management by clients? Defend your answers.

2. Dell recorded the exclusivity payments as an offset or reduction to its operating expenses. What “management assertion” did that accounting treatment violate? What audit procedure or procedures might have resulted in the discovery of that accounting treatment?

3. During the time frame that Intel was making exclusivity payments to Dell, Dell’s business model was being adversely affected by the increasingly competitive nature of the PC industry. What responsibility, if any, do auditors have to analyze a client’s business model? Do auditors have a responsibility to track and analyze key developments in a client’s industry? Defend your answers.

4. What ethical issues do exclusivity agreements such as that between Dell and Intel raise? Are there analogous ethical issues faced by audit firms and their clients? Explain.

scrutiny and regulatory oversight faced by the management teams of public companies. Six months later, in August 2013, billionaire investor and Dell stockholder Carl Icahn filed a lawsuit to thwart Michael Dell’s effort to take the com- pany private. Icahn insisted that the per share

buyout price being offered to Dell’s stockhold- ers by Michael Dell was too low. One month later, however, a majority of Dell’s stockhold- ers approved that buyout price, meaning that Michael Dell’s plan to take the company private had succeeded.

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361

CASE 4.9

Accuhealth, Inc.

One morning in early 1990, William Makadok opened the door to the office occupied by one of his colleagues, a fellow officer of Accuhealth, Inc.1 Scattered across the individual’s desk were large piles of cash and several empty envelopes. Makadok quickly closed the door and returned to his office. Later that day, Makadok observed the officer casually distributing the envelopes, bulging with cash, to executives and senior employees of Accuhealth.

The two scenes just described startled Makadok. Those scenes added to, if not confirmed, Makadok’s suspicion that Accuhealth’s top executives were embezzling cash from the company. A few weeks earlier, Makadok had discovered a suspicious alteration to a weekly “cash report sheet” prepared for one of Accuhealth’s retail drug stores. Each Accuhealth store reported its weekly cash sales to headquarters on this document. On the altered cash report sheet the original cash sales figure had been crossed out and replaced with a lower figure. The difference between the two amounts had been reported on a line item labeled “Office.”

William Makadok had been hired in the summer of 1989 to serve as vice presi- dent and chief accounting officer of Accuhealth, a New York–based firm that oper- ated a chain of drug stores and a home healthcare business. The fact that his fellow executives were involved in a large-scale and well-organized embezzlement scheme deeply troubled the CPA. In his early 50s at the time, Makadok had more than two decades of professional experience, including several years in public accounting. Never before in his career had he encountered a fraudulent scheme apparently mas- terminded by a company’s top executives. The situation posed a simple question for William Makadok: What would he do?

Accuhealth: A Brief History Stanley Lepelstat founded Leroy Pharmacies in 1981. Lepelstat, who had more than two decades of work experience with retail drug store chains before he established his own firm, took Leroy Pharmacies public in 1988 and then changed its name to Accuhealth, Inc. two years later. Initially, the company owned and operated a small chain of retail stores that sold prescription drugs, cosmetics, small kitchen appliances, and related merchandise. Lepelstat added a home healthcare line of business to his firm in 1987. In this new line of business, Accuhealth sold and rented home medical equipment and provided in-home infusion (intravenous) therapy for the critically ill. Exhibit 1 summarizes key financial data of Accuhealth for the period 1987–1991.

During the 1980s and early 1990s, Lepelstat, his family, and a few close friends dom- inated the day-to-day operations of Leroy Pharmacies and its successor, Accuhealth, Inc. Lepelstat served as the firm’s president, chief executive officer (CEO), and chair- man of the board, while his wife, Sheila, was the company’s personnel director and held the titles of vice president, secretary, and treasurer. The Lepelstats’ son, Lawrence, joined the firm in 1990 and was placed in charge of its home healthcare

1. The facts reported in this case were taken from several enforcement releases issued by the Securities and Exchange Commission, various annual reports of Accuhealth, Inc., and numerous newspaper articles.

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362 SECTION FOUR ETHICAL RESPONSIBILITIES OF ACCOUNTANTS

subsidiary. Both Lawrence and his mother sat on Accuhealth’s board of directors. Another Lepelstat also served on the company’s board of directors in the early 1990s. Mark Lepelstat, Lawrence’s brother, was appointed to the board of directors although he was not an employee or otherwise involved with Accuhealth. Other members of the board of directors included several longtime associates of Stanley Lepelstat who held executive positions with the company.

Accuhealth’s 1991 annual report disclosed that the company’s top executives had modest compensation packages. The average salary of Accuhealth’s seven top execu- tives, which included the two senior Lepelstats, averaged only $51,000. Those seven executives easily controlled the bulk of Accuhealth’s outstanding common stock. The senior Lepelstats alone owned more than 53 percent of the company’s common stock.

In“Accu”rate Financial Statements In 1993, law enforcement agencies, including the Securities and Exchange Commission (SEC), began investigating rumors that Accuhealth’s officers were engaging in a massive fraud. The SEC’s investigation revealed that Stanley Lepelstat had directed a systematic cash-skimming operation within his business since its inception in 1981. Lepelstat and his colleagues embezzled funds primarily from cash sales of two of the company’s retail drug stores. Each week, a company official called an accounting clerk at one of those two stores to specify the amount of cash to be forwarded to corporate headquarters.

The store manager segregated the cash and bundled it separately in a paper bag for pickup by either Miszke [a senior pharmacist with Accuhealth] or an officer. The diverted cash was then taken to the company headquarters where Miszke and/or an officer would divide it up and put it into plain white envelopes for distribution. . . . No particular effort was made to conceal the distribution.2

A store manager typically recorded the amount of cash embezzled each week from his or her store on the given store’s cash report sheet. The manager listed the funds on a line labeled “Office,” as William Makadok eventually discovered. At headquar- ters, the sales and cash receipts recorded for the store was the net figure, that is, the actual weekly sales less the embezzled funds. Accuhealth officials kept meticulous records on an electronic spreadsheet documenting the funds embezzled each week and the weekly cash payments made to individuals within the firm. Stanley Lepelstat reviewed a weekly printout of these cash payments. The company’s chief financial officer (CFO) also received a monthly report of the cash receipts stolen from indi- vidual stores. Most likely, Accuhealth’s officers used the embezzlement data to arrive at compensation adjustments (pay raises) for given employees and to determine the “true” profitability of stores affected by the cash-skimming scheme.

2. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 589, 8 September 1994.

1991 1990 1989 1988 1987

Net Sales $35,152 $33,797 $32,747 $27,677 $23,207 Gross Profit 10,988 10,350 9,576 7,944 6,756 Net Income 301 (783) (96) 441 466 Total Assets 12,139 12,033 12,147 8,860 6,892 Total Liabilities 9,349 9,590 8,950 5,720 6,680

Source: Accuhealth’s 1987 Form 10-K filed with the Securities and Exchange Commission.

EXHIBIT 1

SELECTED FINANCIAL DATA REPORTED BY ACCUHEALTH, 1987–1991 (000’S OMITTED)

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CASE 4.9 ACCUHEALTH, INC. 363

Regulatory authorities estimated that Accuhealth’s senior management embez- zled between $500,000 and $900,000 annually from 1986 through 1992.3 The cash- skimming operation negatively impacted Accuhealth’s apparent profitability since it reduced the company’s reported sales. Beginning in 1989, senior management decided to correct this “problem.”

Inflating year-end inventory ranks among the easiest methods to intentionally over- state profits in a retail environment. From 1989 through 1992, Accuhealth executives ordered subordinates to fraudulently increase the company’s year-end pharmaceu- ticals inventory. The employees responsible for counting pharmaceuticals at retail stores simply overstated the quantities of selected items on inventory count sheets for stores where the counting procedures were not observed by the company’s indepen- dent auditors. Stanley Lepelstat also ordered subordinates to double-count certain high-priced inventory items maintained in Accuhealth’s warehouse. One of those subordinates was George Miszke, Accuhealth’s senior pharmacist who also partici- pated in the cash-skimming operation.

After those drugs were counted in the company’s warehouse, Miszke, under orders from the CEO [Stanley Lepelstat], transported them at night or over the weekend to drugstores where they were included in inventory and counted again. This surrepti- tious inventory movement was possible because the physical inventory counts were conducted over several days.4

Numerous Accuhealth officers and employees knew of the company’s fraudulent schemes and/or participated in them. These individuals apparently had a nonchalant attitude toward the schemes, treating them as just another company policy or proce- dure. This nonchalant attitude did not prevail when it came to concealing the frauds from the company’s independent auditors. Besides the flagrant efforts to conceal the inventory irregularities just described, Accuhealth personnel repeatedly and system- atically misled the auditors when they raised questions regarding accounts affected by the fraudulent schemes.

William Makadok Revisited When we left William Makadok, he faced an unpleasant dilemma: what to do given the nearly irrefutable evidence that his employer was engaging in a large-scale fraud. After considering his options, Makadok decided to avoid the issue.

Makadok did not take any steps to investigate any of these incidents nor did he bring them to the attention of Accuhealth’s independent auditors. He consciously avoided undertak- ing any effort that would confirm any doubts or concerns caused by his observations.5

Makadok made another important decision after stumbling across Accuhealth’s embezzlement scam during mid-1990. The chief accountant resolved not to sign off on Accuhealth’s 1990 10-K, which would be prepared for the company’s fiscal year ending 31 December 1990. True to his conviction, Makadok resigned his position with Accuhealth one month before the company filed its 1990 10-K with the SEC. When Accuhealth’s independent auditors learned of Makadok’s resignation, they wanted to know why he was leaving the company. Makadok did not reply candidly

3. For certain periods, the actual amount of embezzled funds could not be determined because Accuhealth personnel destroyed the relevant documents. 4. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 589, 8 September 1994. 5. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 588, 8 September 1994.

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364 SECTION FOUR ETHICAL RESPONSIBILITIES OF ACCOUNTANTS

to the auditors. Instead, he told them that his decision to leave Accuhealth was moti- vated purely by another “opportunity.”

Although Makadok did not sign off on Accuhealth’s 1990 10-K, he did prepare and sign off on the company’s financial reports filed with the SEC for the second and third quarters of 1990. Those quarterly financial reports, similar to Accuhealth’s annual financial reports, misrepresented the company’s operating results and finan- cial condition. The SEC subsequently revealed that company officials stole more than $200,000 of cash receipts during each of those quarters.

An important focus of the SEC’s investigation of Accuhealth was the conduct of its key accounting personnel, including William Makadok. In examining Makadok’s conduct, a central issue addressed by the SEC was whether he violated Rule 10b-5 of the Securities Exchange Act of 1934. That rule prohibits an individual from making material misstatements in, or omitting material information from, a registration state- ment filed under the 1934 Act that would cause the document to be misleading to purchasers or sellers of the relevant securities.

In 1984, the U.S. Supreme Court established a major precedent relevant to Rule 10b-5 when it handed down a decision in the Ernst & Ernst v. Hochfelder et al. case.6 Under the Hochfelder ruling, scienter must be present for an individual to violate Rule 10b-5—scienter being “a mental state embracing intent to deceive, manipulate or defraud.” However, the Supreme Court also noted that in some jurisdictions “reck- less disregard for the truth” or “recklessness” satisfies the scienter requirement. That is, although the individual did not have a conscious intent to deceive third parties, he or she recklessly allowed material representations to be included in a registration statement filed under the 1934 Act without obtaining a reasonable basis for determin- ing whether those representations were true. For purposes of the SEC, an accountant, auditor, or other party associated with an SEC registration statement who engages in “reckless conduct” is subject to severe sanctions by the federal agency.7

In deciding if Makadok had breached Rule 10b-5, the SEC first addressed the issue of whether the misrepresentations in Accuhealth’s quarterly financial reports that he prepared qualified as “material facts.” Earlier court rulings had established the following definition of a material fact in the context of the 1934 Act: “A fact is material if there is a substantial likelihood that a reasonable investor would consider the infor- mation to be important.”8 The SEC ruled that the embezzlement scheme Makadok discovered was clearly a material fact that would have been of interest to a “reason- able investor” in Accuhealth’s common stock.

The second issue faced by the SEC in deciding if Makadok had violated Rule 10b-5 was whether he had acted recklessly in signing off on Accuhealth’s 1990 quarterly financial reports. The SEC correctly observed that Makadok “did not actively par- ticipate in the fraud or benefit from it financially.” Nevertheless, the federal agency maintained that his conduct qualified as reckless.

Makadok signed two Form 10-Qs that contained materially false financial information. Makadok signed these reports in reckless disregard of whether the information con- tained in them was materially misstated. By engaging in such conduct, Makadok directly violated Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder.9

6. Exhibit 1 in Case 7.6, First Securities Company of Chicago, contains Rule 10b-5. That case also includes a discussion of the Supreme Court ruling in the Ernst & Ernst v. Hochfelder et al. case. 7. The SEC may also punish individuals who engage in negligent or “highly unreasonable conduct,” which is misconduct somewhat less severe than recklessness. 8. Basic, Inc. v. Levinson, 485 U.S. 224 (1988), 231–232. 9. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 588, 8 September 1994.

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CASE 4.9 ACCUHEALTH, INC. 365

Questions 1. Identify the parties who had a stake in, or would be affected by, the outcome of

the ethical dilemma faced by William Makadok in 1990. What obligation, if any, did Makadok have to each of these parties?

2. Place yourself in William Makadok’s position. Would you have responded differently than he did to the circumstances he faced? Explain.

3. The SEC did not criticize Accuhealth’s independent auditors in the various enforcement releases issued concerning the company’s fraudulent schemes. Under what general circumstances should auditors not be held at least partially responsible for such schemes? Defend your answer.

4. What specific audit procedures might have led to the detection of Accuhealth’s fraudulent cash and inventory schemes?

5. The “control environment” is generally considered the most important component of any organization’s internal control process. Defend that generalization. Use examples from this case to support your answer.

E P I L O G U E In February 1993, shortly after the SEC pub- licly announced that it was investigating Accuhealth, Arthur Andersen, Accuhealth’s audit firm, withdrew its opinion on the compa- ny’s most recent financial statements. Trading in Accuhealth’s common stock was also sus- pended following the SEC’s announcement and several of the company’s directors resigned, including Stanley and Sheila Lepelstat.

The SEC wrapped up its lengthy investigation of Accuhealth’s financial affairs in mid-1994 and published the key findings of that investi- gation in a series of enforcement releases over the next several months. William Makadok received a three-year suspension from practic- ing before the SEC. Other parties sanctioned included Stanley and Sheila Lepelstat and George Miszke. Several of Accuhealth’s former executives, including Stanley Lepelstat, were

permanently barred from serving as an officer or director of a public company. The SEC also ordered Stanley Lepelstat to surrender $100,000 of profits that he had realized from selling Accuhealth common stock during the embez- zlement scheme. Lepelstat later pleaded guilty to fraud charges filed against him in a U.S. district court.

In October 1994, Accuhealth settled legal claims against several of its former executives that stemmed from the cash-skimming scheme. Stanley Lepelstat agreed to the cancellation of a $600,000 note receivable from Accuhealth. Stanley Lepelstat, Sheila Lepelstat, and several other former Accuhealth executives also agreed to return to the company the Accuhealth com- mon stock they owned. Accuhealth received more than 300,000 shares of common stock as a result of this restitution agreement.

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367

CASE 4.10

Wichita Falls

I have had, and may have still, a thousand friends, as they are called in life, who are like one’s partners in the waltz of the world/not much remembered when the ball is over.

Lord Byron

In September 1872, several businessmen platted a new town site on a barren stretch of prairie in northwest Texas, just a few miles south of the Red River. The entre- preneurs chose “Wichita Falls” as the name of the new town because of a natural waterfall in the nearby Wichita River. Wichita Falls was strategically located between the Chisholm Trail to its east and the Dodge City Trail to its west. Crews of cowboys headed northward to the railheads of those two trails during the great cattle drives of the 1870s and 1880s created a Wild West atmosphere in the small town. Jesse and Frank James, the leaders of the infamous James-Younger Gang, spent considerable time in the area. Ironically, their sister Susan was one of the founders of the First Baptist Church of Wichita Falls—the father of the three siblings was a Baptist minis- ter. Several decades later, the devil-may-care duo of Bonnie and Clyde hid out from law enforcement authorities in a small, second-story apartment above a popular Wichita Falls grocery store.

The discovery of the nearby Electra oil field in 1911 transformed Wichita Falls from a backwater, frontier-era cow town into an oil boom town. An enterprising accoun- tant recognized that Wichita Falls’ rapidly expanding business community needed a wide range of accounting services. The firm that individual organized, which became known as Freemon, Shapard & Story (FSS), lays claim to being the account- ing firm that has been registered for the longest period of time with the Texas State Board of Public Accountancy. In addition to its headquarters in Wichita Falls, the firm ultimately opened practice offices in Austin, Dallas, Denton, Marble Falls, and Windthorst over its long history.

By the late 1990s, the ownership interest of FSS was divided equally among three senior partners who had worked together at the firm for more than 25 years. Those gentlemen included two brothers, Mac and Dennis Cannedy, and John Barfield. All three men had obtained their accounting degrees from Midwestern State University in Wichita Falls between 1967 and 1972. The Cannedy brothers chose John Barfield to serve as the managing partner of FSS in 1996.

Originally from the nearby small town of Olney, Barfield was involved in a wide range of civic activities in Wichita Falls, including leadership positions with the local United Way chapter, the Wichita Falls Museum and Art Center, the Wichita General Hospital, and several other community organizations. Unfortunately, Barfield’s career ended prematurely when he died of brain cancer on 18 March 2008. His survivors included Ann, his wife of more than 30 years, and their daughter Amber.

The FSS partnership agreement specified that the legal survivor of a partner would receive the “fair value” of his interest in the firm at the date of his death. In October 2009, FSS offered Ann Barfield $602,000 for her late husband’s one-third ownership interest in the firm. Ms. Barfield did not believe the offer was reasonable, which prompted her to file a lawsuit six months later against FSS. The lawsuit alleged that

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368 SECTION FOUR ETHICAL RESPONSIBILITIES OF ACCOUNTANTS

FSS had refused to “negotiate a proper redemption price” and had not acted in “good faith” in resolving Ms. Barfield’s claim against the firm.1

In a December 2011 trial, a jury in a Texas state court ruled that the fair value of John Barfield’s one-third interest in FSS at the time of his death was $4.59 million. “The jury drew its value from a personal financial statement by Mac Cannedy one month before Barfield died that represented his one-third interest in the firm.”2 The market value estimate of Cannedy’s ownership interest in FSS had been included in a confidential loan application that he filed in February 2008 with Wells Fargo Bank.3

During the trial, the Cannedy brothers retained an appraisal expert to testify regarding the fair value of each partner’s ownership interest in FSS at the time of John Barfield’s death. That expert established an appraisal value for those owner- ship interests that was considerably lower than the $4.59 million figure included in Mac Cannedy’s February 2008 loan application.4 Ms. Barfield’s attorney suggested that the members of the jury rejected that appraised value because they believed the value included in Cannedy’s loan application was more credible. “Giving false infor- mation to a federally insured lending institution for the purpose of getting or keeping or guaranteeing a loan is a federal crime, so the jury apparently thought Mr. Cannedy would not falsify his financial statement.”5

On 21 May 2012, one day before the jury’s ruling in the case was to be certified by the presiding judge, FSS filed for Chapter 11 bankruptcy in a federal court. The Chapter 11 bankruptcy filing allowed FSS to continue operating and servicing its clients while it worked toward resolving the dilemma that it faced.

In commenting on the litigation between FSS and Ms. Barfield, her attorney referred to a meeting between her client and the Cannedy brothers following John Barfield’s death. “In a conversation with them shortly after John died, one of the Cannedy brothers assured her that they were going to treat her ‘just like we’d want our own wives treated.’ We are pretty sure that this is not how they would want their own wives treated.”6

Questions 1. The AICPA’s Code of Professional Conduct includes six broad ethical principles.

Which of those ethical principles are most relevant to this case? Which of the specific “rules” in the Code of Professional Conduct are most applicable to this case? Defend your answers.

2. Identify specific factors that may influence the market value of a given accounting firm. Relying on publicly available sources, identify common methods used to assign a market value to an accounting firm or practice.

3. Define what is meant by the phrase “succession planning.” How was succession planning relevant to this case?

1. A. Work, “Chapter 11 Filed by Local Business,” TimesRecordNews.com, 7 June 2012. 2. Ibid. 3. The various published reports concerning this case do not reveal how Ms. Barfield’s attorney obtained a copy of the confidential loan application or how Cannedy arrived at the $4.59 million value. 4. Published reports did not disclose the specific amount of this appraisal value, although it was appar- ently in the range of $1 million. 5. Work, “Chapter 11 Filed by Local Business.” 6. Ibid.

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SECTION 5

ETHICAL RESPONSIBILITIES OF INDEPENDENT AUDITORS

Case 5.1 Cardillo Travel Systems, Inc.

Case 5.2 American International Group, Inc.

Case 5.3 The North Face, Inc.

Case 5.4 IPOC International Growth Fund, Ltd.

Case 5.5 Phillips Petroleum Company

Case 5.6 Ryden Trucking, Inc.

Case 5.7 Richard Grimes, Staff Accountant

5

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371

CASE 5.1

Cardillo Travel Systems, Inc.

If virtue is not its own reward, I don’t know any other stipend attached to it.

Lord Byron

Act 1 Russell Smith knew why he had been summoned to the office of A. Walter Rognlien, the 74-year-old chairman of the board and chief executive officer (CEO) of Smith’s employer, Cardillo Travel Systems, Inc.1 Just two days earlier, Cardillo’s in-house attorney, Raymond Riley, had requested that Smith, the company’s controller, sign an affidavit regarding the nature of a transaction Rognlien had negotiated with United Airlines. The affidavit stated that the transaction involved a $203,000 payment by United Airlines to Cardillo but failed to disclose why the payment was being made or for what specific purpose the funds would be used. The affidavit included a state- ment indicating that Cardillo’s stockholders’ equity exceeded $3 million, a state- ment that Smith knew to be incorrect. Smith also knew that Cardillo was involved in a lawsuit and that a court injunction issued in the case required the company to maintain stockholders’ equity of at least $3 million. Because of the blatant misrep- resentation in the affidavit concerning Cardillo’s stockholders’ equity and a sense of uneasiness regarding United Airlines’ payment to Cardillo, Smith had refused to sign the affidavit.

When Smith stepped into Rognlien’s office on that day in May 1985, he found not only Rognlien but also Riley and two other Cardillo executives. One of the other executives was Esther Lawrence, the firm’s energetic 44-year-old president and chief operating officer (COO) and Rognlien’s wife and confidante. Lawrence, a long- time employee, had assumed control of Cardillo’s day-to-day operations in 1984. Rognlien’s two sons by a previous marriage had left the company in the early 1980s following a power struggle with Lawrence and their father.

As Smith sat waiting for the meeting to begin, his apprehension mounted. Although Cardillo had a long and proud history, in recent years the company had begun experiencing serious financial problems. Founded in 1935 and purchased in 1956 by Rognlien, Cardillo ranked as the fourth-largest company in the travel agency industry and was the first to be listed on a national stock exchange. Cardillo’s annual revenues had steadily increased after Rognlien acquired the company, approach- ing $100 million by 1984. Unfortunately, the company’s operating expenses had increased more rapidly. Between 1982 and 1984, Cardillo posted collective losses of nearly $1.5 million. These poor operating results were largely due to an aggressive franchising strategy implemented by Rognlien. In 1984 alone that strategy more than doubled the number of travel agency franchises operated by Cardillo.

Shortly after the meeting began, the overbearing and volatile Rognlien demanded that Smith sign the affidavit. When Smith steadfastly refused, Rognlien showed him the first page of an unsigned agreement between United Airlines

1. The events discussed in this case were reconstructed principally from information included in Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 143, 4 August 1987. All quotations appearing in this case were taken from that document.

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372 SECTION FIVE ETHICAL RESPONSIBILITIES OF INDEPENDENT AUDITORS

and Cardillo. Rognlien then explained that the $203,000 payment was intended to cover expenses incurred by Cardillo in changing from American Airlines’ Sabre computer reservation system to United Airlines’ Apollo system. Although the payment was intended to reimburse Cardillo for those expenses and was refund- able to United Airlines if not spent, Rognlien wanted Smith to record the payment immediately as revenue.

Not surprisingly, Rognlien’s suggested treatment of the United Airlines payment would allow Cardillo to meet the $3 million minimum stockholders’ equity threshold established by the court order outstanding against the company. Without hesitation, Smith informed Rognlien that recognizing the United Airlines payment as revenue would be improper. At that point, “Rognlien told Smith that he was incompetent and unprofessional because he refused to book the United payment as income. Rognlien further told Smith that Cardillo did not need a controller like Smith who would not do what was expected of him.”

Act 2 In November 1985, Helen Shepherd, the audit partner supervising the 1985 audit of Cardillo by Touche Ross, stumbled across information in the client’s files regard- ing the agreement Rognlien had negotiated with United Airlines earlier that year. When Shepherd asked her subordinates about this agreement, one of them told her of a $203,000 adjusting entry Cardillo had recorded in late June. That entry, which follows, had been approved by Lawrence and was apparently linked to the United Airlines–Cardillo transaction:

Dr Receivables–United Airlines $203,210 Cr Travel Commissions and Fees $203,210

Shepherd’s subordinates had discovered the adjusting entry during their second- quarter review of Cardillo’s Form 10-Q statement. When asked, Lawrence had told the auditors that the entry involved commissions earned by Cardillo from United Airlines during the second quarter. The auditors had accepted Lawrence’s explana- tion without attempting to corroborate it with other audit evidence.

After discussing the adjusting entry with her subordinates, Shepherd ques- tioned Lawrence. Lawrence insisted that the adjusting entry had been properly recorded. Shepherd then requested that Lawrence ask United Airlines to provide Touche Ross with a confirmation verifying the key stipulations of the agreement with Cardillo. Shepherd’s concern regarding the adjusting entry stemmed from information she had reviewed in the client’s files that pertained to the United Airlines agreement. That information suggested that the United Airlines payment to Cardillo was refundable under certain conditions and thus not recognizable immediately as revenue.

Shortly after the meeting between Shepherd and Lawrence, Walter Rognlien contacted the audit partner. Like Lawrence, Rognlien maintained that the $203,000 amount had been properly recorded as commission revenue during the second quarter. Rognlien also told Shepherd that the disputed amount, which United Airlines paid to Cardillo during the third quarter of 1985, was not refundable to United Airlines under any circumstances. After some prodding by Shepherd, Rognlien agreed to allow her to request a confirmation from United Airlines concerning certain features of the agreement.

Shepherd received the requested confirmation from United Airlines on 17 December 1985. The confirmation stated that the disputed amount was refund- able through 1990 if certain stipulations of the contractual agreement between the

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CASE 5.1 CARDILLO TRAVEL SYSTEMS, INC. 373

two parties were not fulfilled.2 After receiving the confirmation, Shepherd called Rognlien and asked him to explain the obvious difference of opinion between United Airlines and Cardillo regarding the terms of their agreement. Rognlien told Shepherd that he had a secret arrangement with the chairman of the board of United Airlines. “Rognlien claimed that pursuant to this confidential business arrangement, the $203,210 would never have to be repaid to United. Shepherd asked Rognlien for permission to contact United’s chairman to confirm the confidential business arrangement. Rognlien refused. In fact, as Rognlien knew, no such agreement existed.”

A few days following Shepherd’s conversation with Rognlien, she advised William Kaye, Cardillo’s vice president of finance, that the $203,000 amount could not be recognized as revenue until the contractual agreement with United Airlines expired in 1990. Kaye refused to make the appropriate adjusting entry, explaining that Lawrence had insisted that the payment from United Airlines be credited to a rev- enue account. On 30 December 1985, Rognlien called Shepherd and told her that he was terminating Cardillo’s relationship with Touche Ross.

In early February 1986, Cardillo filed a Form 8-K statement with the Securities and Exchange Commission (SEC) notifying that agency of the company’s change in auditors. SEC regulations required Cardillo to disclose in the 8-K statement any disagreements involving accounting, auditing, or financial reporting issues with its former auditor. The 8-K, signed by Lawrence, indicated that no such disagreements preceded Cardillo’s decision to dismiss Touche Ross. SEC regulations also required Touche Ross to draft a letter commenting on the existence of any disagreements with Cardillo. This letter had to be filed as an exhibit to the 8-K statement. In Touche Ross’s exhibit letter, Shepherd discussed the dispute involving the United Airlines payment to Cardillo. Shepherd disclosed that the improper accounting treat- ment given that transaction had resulted in misrepresented financial statements for Cardillo for the six months ended 30 June 1985, and the nine months ended 30 September 1985.

In late February 1986, Raymond Riley, Cardillo’s legal counsel, wrote Shepherd and insisted that she had misinterpreted the United Airlines–Cardillo transaction in the Touche Ross exhibit letter filed with the company’s 8-K. Riley also informed Shepherd that Cardillo would not pay the $17,500 invoice that Touche Ross had submitted to his company. This invoice was for professional services Touche Ross had rendered prior to being dismissed by Rognlien.

Act 3 On 21 January 1986, Cardillo retained KMG Main Hurdman (KMG) to replace Touche Ross as its independent audit firm. KMG soon addressed the accounting treatment Cardillo had applied to the United Airlines payment. When KMG personnel discussed the payment with Rognlien, he informed them of the alleged secret arrangement with United Airlines that superseded the written contractual agreement. According to Rognlien, the secret arrangement precluded United Airlines from demanding a refund of the $203,000 payment under any circumstances. KMG refused to accept this explanation. Roger Shlonsky, the KMG audit partner responsible for the Cardillo

2. Shepherd apparently never learned that the $203,000 payment was intended to reimburse Cardillo for expenses incurred in switching to United Airlines’ reservation system. As a result, she focused almost exclusively on the question of when Cardillo should recognize the United Airlines payment as revenue. If she had been aware of the true nature of the payment, she almost certainly would have been even more adamant regarding the impropriety of the $203,000 adjusting entry.

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374 SECTION FIVE ETHICAL RESPONSIBILITIES OF INDEPENDENT AUDITORS

engagement, told Rognlien that the payment would have to be recognized as reve- nue on a pro rata basis over the five-year period of the written contractual agreement with United Airlines.3

Cardillo began experiencing severe liquidity problems in early 1986. These prob- lems worsened a few months later when a judge imposed a $685,000 judgment on Cardillo to resolve a civil suit filed against the company. Following the judge’s ruling, Raymond Riley alerted Rognlien and Lawrence that the adverse judgment qualified as a “material event” and thus had to be reported to the SEC in a Form 8-K filing. In the memorandum he sent to his superiors, Riley discussed the serious implications of not disclosing the settlement to the SEC: “My primary concern by not releasing such report and information is that the officers and directors of Cardillo may be subject to violation of Rule 10b-5 of the SEC rules by failing to disclose information that may be material to a potential investor.”

Within 10 days of receiving Riley’s memorandum, Rognlien sold 100,000 shares of Cardillo stock in the open market. Two weeks later, Lawrence issued a press release disclosing for the first time the adverse legal settlement. However, Lawrence failed to disclose the amount of the settlement or that Cardillo remained viable only because Rognlien had invested in the company the proceeds from the sale of the 100,000 shares of stock. Additionally, Lawrence’s press release underestimated the firm’s expected loss for 1985 by approximately 300 percent.

Following Lawrence’s press release, Roger Shlonsky met with Rognlien and Lawrence. Shlonsky informed them that the press release grossly understated Cardillo’s estimated loss for fiscal 1985. Shortly after that meeting, KMG resigned as Cardillo’s independent audit firm.

3. Cardillo executives also successfully concealed from the KMG auditors the fact that the United Airlines payment was simply an advance payment to cover installation expenses for the new reserva- tion system.

E P I L O G U E In May 1987, the creditors of Cardillo Travel Systems, Inc., forced the company into involun- tary bankruptcy proceedings. Later that same year, the SEC concluded a lengthy investigation of the firm. The SEC found that Rognlien, Lawrence, and Kaye had violated several provisions of the federal securities laws. These violations included making false representations to outside auditors, failing to maintain accurate financial records, and failing to file prompt financial reports with the SEC. In addition, the federal agency charged

Rognlien with violating the insider trading provisions of the federal securities laws. As a result of these findings, the SEC imposed perma- nent injunctions on each of the three individu- als that prohibited them from engaging in future violations of federal securities laws. The SEC also attempted to recover from Rognlien the $237,000 he received from selling the 100,000 shares of Cardillo stock in April 1986. In January 1989, the two parties resolved this matter when Rognlien agreed to pay the SEC $60,000.

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CASE 5.1 CARDILLO TRAVEL SYSTEMS, INC. 375

Questions 1. Identify the accountants in this case who faced ethical dilemmas. Also identify

the parties who would be potentially affected by the outcome of each of these dilemmas. What responsibility did each accountant owe to these parties? Did the accountants fulfill these responsibilities?

2. Describe the procedures an auditor should perform during a review of a client’s quarterly financial statements. In your opinion, did the Touche Ross auditors who discovered the $203,000 adjusting entry during their 1985 second-quarter review take all appropriate steps to corroborate that entry? Should the auditors have immediately informed the audit partner, Helen Shepherd, of the entry?

3. In reviewing the United Airlines–Cardillo agreement, Shepherd collected evidence that supported the $203,000 adjusting entry as booked and evidence that suggested the entry was recorded improperly. Identify each of these items of evidence. What characteristics of audit evidence do the profession’s technical standards suggest auditors should consider? Analyze the audit evidence that Shepherd collected regarding the disputed entry in terms of those characteristics.

4. What are the principal objectives of the SEC rule that requires Form 8-K statements to be filed when public companies change auditors? Did Shepherd violate the client confidentiality rule when she discussed the United Airlines– Cardillo transaction in the exhibit letter she filed with Cardillo’s 8-K auditor change statement? In your opinion, did Shepherd have a responsibility to disclose to Cardillo executives the information she intended to include in the exhibit letter?

5. Do the profession’s technical standards explicitly require auditors to evaluate the integrity of a prospective client’s key executives? Identify the specific measures auditors can use to assess the integrity of a prospective client’s executives.

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377

CASE 5.2

American International Group, Inc.

Cornelius Vander Starr wanted to see the world. In 1918, the 26-year-old Californian emptied his bank account to purchase a one-way ticket to the Far East on a steam- ship. After “bumming around” Japan for several months, Vander Starr traveled to Shanghai, China, where he landed a job working for an insurance company. Within a short period of time, Vander Starr realized that selling insurance was a low overhead business that was ideally suited for a young entrepreneurial type like himself, so he quit his job and set up his own insurance agency, American Asiatic Underwriters.

Vander Starr’s business grew rapidly. By the time of his death in the late 1960s, Starr’s one-man firm had become a multibillion-dollar international conglomerate with operating units in Europe, Latin America, the Middle East, and the United States. The Starr Foundation that he created before his death ranks among the world’s larg- est philanthropic organizations.

In 1948, the Chinese civil war forced Vander Starr to relocate his company’s head- quarters from Shanghai to New York City. As he neared retirement, Vander Starr chose his protégé, Maurice “Hank” Greenberg, to replace him as his company’s chief executive officer. During the early 1960s, Greenberg had revamped the company’s business model. Instead of focusing on selling life insurance and other insurance products for individuals, Greenberg convinced Starr that the company’s principal line of business should be insurance and other financial services products designed for large corporations. In 1969, Greenberg took the company, which had been renamed American International Group, Inc. (AIG), public by listing its stock on the New York Stock Exchange.

Greenberg would serve as AIG’s top executive for nearly four decades. Under his leadership, the company became known worldwide for the new and innovative financial services products that it continually developed and the aggressive methods that it used to market those products. These efforts produced impressive financial results for the company. By the turn of the century, AIG was one of the 10 largest companies in the United States and among the 20 largest companies worldwide.

In early 2001, a group of AIG executives came up with an idea for a new financial service that they believed would appeal to a wide range of large corporations. This service would involve AIG creating customized “special purpose entities” or SPEs for such companies. An SPE is typically a limited partnership that two or more compa- nies join together to form. Since an SPE is an unconsolidated subsidiary, a company can download or transfer underperforming assets and related liabilities to that entity to improve its apparent financial condition. This “balance sheet management fea- ture” of SPEs was the principal selling point that AIG intended to rely on in marketing its new service.

In fact, many large corporations were already using SPEs “to perform cosmetic surgery on their balance sheets.”1 Enron Corporation, a large Houston-based energy company, was among the most prolific users of SPEs.2 Enron had significantly improved its apparent financial condition by “hiding” distressed assets and much of

1. J. Kahn, “Off Balance Sheet—And Out of Control,” Fortune, 18 February 2002, 84. 2. See Enron Corporation, Case 1.1.

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378 SECTION FIVE ETHICAL RESPONSIBILITIES OF INDEPENDENT AUDITORS

its outstanding debt in hundreds of SPEs that it had created. AIG’s management was convinced that, unlike Enron, most companies did not have the in-house expertise to develop their own SPEs.

AIG’s executives realized that their new SPE service, which was effectively an accounting mechanism, would be more credible if one of the major accounting firms was involved in its development and marketing. For that reason, AIG retained Michael Joseph, a partner in the national office of Ernst & Young (E&Y) and a “nationally recognized expert on the accounting for structured financial vehicles and SPEs,”3 to help develop and market the new service. “To assist AIG in its marketing” of the new SPE service “Joseph caused E&Y to issue reports pursuant to Statement on Auditing Standards No. 50, ‘Reports on the Application of Accounting Principles.’”4 These SAS No. 50 reports indicated that the “nonconsolidation accounting treatment” for the assets and liabilities transferred to an SPE that had been designed by AIG “was an appropriate application of GAAP.” In promoting its new SPE service, “AIG referred to E&Y’s advice in its marketing materials and referred potential buyers directly to Joseph to answer accounting-related questions.”

Among the first companies to express an interest in purchasing AIG’s SPE service was PNC Financial Services Group, Inc. (PNC), a large financial services firm that operated the fifth-largest bank in the United States. During the negotiations with AIG, PNC consulted with its independent auditors to determine whether the account- ing treatment for AIG’s SPE product complied with GAAP. In fact, PNC’s audit firm was E&Y, which meant that the company’s auditors contacted Joseph to determine whether PNC’s proposed SPE would be GAAP-compliant.

Joseph gave the PNC auditors a copy of a SAS No. 50 report that he had written for AIG. The auditors relied on that report “without performing any meaningful separate analysis” in deciding that the accounting treatment for the proposed SPE was accept- able. Joseph billed the time that he spent interacting with the PNC auditors to the PNC audit engagement.

During July 2001, PNC transferred nearly $100 million of nonperforming loans to an SPE that was created by AIG. A few months later, the company downloaded more than $100 million of additional nonperforming loans to another AIG-created SPE. In an earnings press release in late 2001, PNC reported that it had $361 million of non- performing loans. That figure did not include more than $200 million of such loans that had been transferred to its SPEs.

Federal Reserve officials contacted PNC in November 2001 and inquired regarding the company’s nonperforming loans. When those officials reviewed the transactions that had resulted in $207 million of PNC’s nonperforming loans being transferred to SPEs, they questioned whether those transfers were appropriate. At this point, PNC executives asked Michael Joseph to intercede on their behalf with the Federal Reserve. Joseph discussed the matter with the Federal Reserve and defended the accounting and financial reporting treatment for the loans that had been transferred to SPEs. The Federal Reserve disagreed with Joseph and in January 2002 ordered PNC to reverse the SPE transactions and include the $207 million of nonperforming loans in the company’s consolidated financial statements.

3. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 2523, 11 December 2006. Unless indicated otherwise, subsequent quotes in this case were taken from this source. 4. Accounting firms typically prepare such reports to provide a third party, other than an audit client, with technical guidance on how to apply existing accounting principles to a new type of transaction. SAS No. 50 has been integrated into AU Section 625 of the PCAOB’s Interim Standards and AU-C Section 915 of the AICPA Professional Standards.

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CASE 5.2 AMERICAN INTERNATIONAL GROUP, INC. 379

The Federal Reserve’s decision to force PNC to reverse its SPE transactions triggered an investigation of the company by the Securities and Exchange Commission (SEC). In reviewing PNC’s SPE transactions, the SEC discovered that they were not in compli- ance with GAAP. For a company to treat an SPE as an unconsolidated subsidiary, an external entity must have a minimum capital investment of 3 percent in the SPE. The external entity that had invested in PNC’s SPEs was AIG. However, AIG’s investments in the SPEs had not met the required 3 percent threshold, meaning that the finan- cial data for PNC’s SPEs should have been included in the company’s consolidated financial statements.

E P I L O G U E

In July 2002, PNC executives agreed to cease and desist from any future violations of federal securities laws to settle charges pending against the company by the SEC. One year later, PNC agreed to pay $115 million to settle related fraud charges filed against the company by the U.S. Justice Department.

In December 2006, the SEC issued an accounting and auditing enforcement release focusing on Michael Joseph’s role in PNC’s SPE transactions. In this release, the SEC reported that “Joseph was a cause of PNC’s violations” of federal securities laws. The SEC maintained that Joseph should have known that PNC’s SPE transactions were not in compliance with GAAP. In this same enforcement release, the SEC alleged that Joseph’s dual role with AIG and PNC had been improper and had posed a conflict of interest for him.

Joseph was involved in the development and marketing of the AIG [SPE] accounting prod- uct. He advised AIG on the structure, he pre- pared several SAS 50 letters used in marketing the product, he participated in conference calls with potential purchasers. . . . Consequently, Joseph was invested both financially and rep- utationally in the success of the [SPE] product and therefore had a conflict of interest when he later evaluated the accounting for the prod- uct by E&Y’s audit client, PNC.

The SEC went on to observe that Joseph’s conduct was “highly unreasonable” and undermined the

independence of E&Y’s PNC audit engagement team. An accounting professor interviewed by the Los Angeles Times used an analogy to describe the likely impact that Joseph’s conduct had on the PNC audit engagement team. “Did it bias the individual auditors in this particular case? It’s like asking whether 40 years of smoking led to some- one’s lung cancer.”5

The SEC suspended Joseph for three years from being involved with audits of public com- panies. In March 2007, the SEC fined E&Y $1.6 million for the firm’s independence violations stemming from Joseph’s conduct. The follow- ing month, E&Y agreed to pay approximately $9 million to settle a class-action lawsuit filed against it for its role in the PNC accounting scandal.

In late 2004, AIG agreed to pay $126 million in fines and restitution for its involvement in PNC’s improper SPE accounting. That amount would be dwarfed by the $1.6 billion fine that AIG agreed to pay in late 2005 to settle charges that it had intentionally misrepresented its own accounting records. Among many other allega- tions, AIG had reportedly recorded bogus sales of insurance policies to inflate its earnings and understated its loss reserves. In addition to the huge fine, Hank Greenberg was forced to resign as AIG’s chief executive as a result of the mas- sive accounting fraud.6

AIG was front and center in news head- lines once more in late 2008 when the largest

5. Los Angeles Times (online), “Ernst & Young in SEC Probe of PNC’s Books,” 8 December 2004. 6. In August 2009, Greenberg agreed to pay a $15 million fine to settle civil fraud charges filed against him by the SEC. The settlement also prohibited Greenberg from serving as an officer of a public company for three years.

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380 SECTION FIVE ETHICAL RESPONSIBILITIES OF INDEPENDENT AUDITORS

Questions 1. Is it ethical for a CPA or CPA firm to help companies “manage” their reported

earnings and financial condition? In responding to this question, first assume that the CPA or CPA firm is serving as a consultant, and then assume that the CPA or CPA firm is serving as the given entity’s independent auditor. Defend your answers.

2. When a dispute arises between an audit client and its auditor regarding the proper accounting treatment for a transaction or other item, the audit client will sometimes retain another accounting firm to issue a report, previously known as a SAS No. 50 report, on the proper accounting treatment for the given item [see AU Section 625 and AU-C Section 915]. Identify the potential ethical dilemmas that may result from allowing accounting firms to issue such reports to nonaudit clients.

economic crisis since the Great Depression erupted in the United States and quickly spread around the globe. In September 2008, the federal government seized control of AIG to prevent the company from collapsing. The com- pany had such an extensive role in global credit and insurance markets that financial experts maintained that its collapse would cause a worldwide economic calamity. In exchange

for approximately $85 billion of capital, the federal government received an 80 percent equity interest in the company. In the following months, tens of billions of dollars of additional federal “bailout” money was invested in AIG to keep the company afloat. AIG would ultimately receive more federal bailout funds than any other U.S. company during the historic eco- nomic crisis of 2008–2009.

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381

CASE 5.3

The North Face, Inc.

Executives of The North Face, Inc., faced a troubling dilemma during the 1990s.1 For decades, those executives had struggled to develop and maintain an exclusive brand name for their company’s extensive line of outdoor apparel and sporting equipment products. By positioning those products for the “high-end” segment of the retail mar- ket, North Face’s management had consciously chosen to ignore the much larger and more lucrative mainstream market. This decision kept the company’s primary customers happy. Those customers, principally small, independent specialty sporting goods stores, did not want North Face to market its merchandise to major discount retailers such as Walmart and Costco.

Economic realities eventually forced North Face’s executives to begin selling the company’s products to the mainstream market via backdoor marketing channels. Unfortunately, the company’s relatively high-priced merchandise did not compete effectively with the mass-market brands sold by the major discount retailers. Making matters worse, as the company’s merchandise began appearing on the shelves of discount retailers, those products quickly lost their exclusive brand name appeal, which caused North Face’s sales to its principal customers to drop sharply.

North Face’s change in marketing strategies, the company’s decision to spend mil- lions of dollars to relocate its headquarters from northern California to Colorado, and other gaffes by its management team caused Chief Executive magazine to include North Face among the nation’s five “worst-managed” corporations. A short time later, North Face’s public image and reputation on Wall Street would be damaged even more by public revelations that the company’s reported operating results had been embellished with various accounting and marketing gimmicks.

Adventurers, Inc. Hap Klopp founded North Face in the mid-1960s to provide a ready source of hik- ing and camping gear that he and his many free-spirited friends and acquaintances needed to pursue their “back to nature” quest. Initially, the business operated from a small retail store in San Francisco’s North Beach neighborhood. The company quickly added a mail-order sales operation. In 1970, North Face began designing and manu- facturing its own line of products after opening a small factory in nearby Berkeley.

Over the next decade, North Face endeared itself to outdoor enthusiasts by sponsoring mountain-climbing expeditions across the globe, including successful attempts to scale Mount Everest, Mount McKinley, China’s K-2, and the highest peaks in South America. The name recognition and goodwill generated by these expedi- tions allowed North Face to establish itself as the premier supplier of top- quality parkas, tents, backpacking gear, and other apparel and equipment demanded by “professional” mountain climbers. Adding even more credibility to North Face’s merchandise was the lifetime warranty that Hal Klopp attached to each item his company sold and the fact that the United States Marine Corps purchased tents and other bivouac supplies from North Face.

1. The development of this case was funded by Glen McLaughlin. I would like to thank Mr. McLaughlin for his generous and continuing support of efforts to integrate ethics into business curricula.

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382 SECTION FIVE ETHICAL RESPONSIBILITIES OF INDEPENDENT AUDITORS

North Face’s sterling reputation for rugged and durable hiking, camping, and mountaineering gear prompted company management to begin marketing related lines of apparel and sporting equipment for skiers, whitewater daredevils, and other outdoor types. Among the most popular items marketed by the company were its Mountain Jacket, Snow Leopard Backpack, and Tadpole Tent. The company’s expanding product line triggered rapid sales growth during the 1970s and 1980s. Similar to the management teams of many growth companies, North Face’s execu- tives confronted several imposing challenges that could undermine their company’s financial success. The most critical of those challenges was maintaining quality con- trol in North Face’s cramped production facilities.

Company executives prided themselves on producing only the highest-quality out- door sporting equipment and apparel. To maintain the quality of that merchandise, they insisted on manufacturing all of North Face’s products in-house, rather than out- sourcing some of the company’s manufacturing operations to third parties. By the mid-1980s, North Face’s overburdened manufacturing facilities could not satisfy the steadily growing demand for the company’s merchandise or maintain the high-quality production standards established by management. North Face’s limited production capacity and mounting quality control problems caused the company to routinely deliver merchandise to retail stores after the peak selling seasons for its highly sea- sonal products. The quality control problems also caused North Face to accumulate a large inventory of “seconds,” that is, merchandise items having minor flaws.

In the late 1980s, North Face’s management made a decision it would soon regret. The company opened several outlet stores to dispose of obsolete and second-grade merchandise. This decision angered the specialty sporting goods stores that had been North Face’s primary customers since the company’s inception. To pacify those customers, North Face did a quick about-face and closed the outlet stores.

Over the next several years, North Face continued to struggle with maintaining its image as the leading producer of high-quality outdoor apparel and sporting equip- ment, while at the same attempting to gradually ease into the mainstream retail mar- ket. By this time, Hap Klopp had left the company to become an author—one of his books was entitled The Complete Idiot’s Guide to Business Management. In fact, the company experienced several changes in company management and ownership during the late 1980s and throughout the 1990s.

In July 1996, a new management team took North Face public, listing the com- pany’s common stock on the NASDAQ exchange. Sold initially at $14 per share, the company’s stock price peaked at nearly $30 per share in February 1998, fueled by the company’s steadily increasing sales and profits. In fiscal 1994, North Face reported total sales of $89 million; four years later in fiscal 1998, the company’s sales had nearly tripled, rising to approximately $250 million.

Despite the company’s strong operating results, by early 1999 North Face’s stock price had plunged from its all-time high. Persistent rumors that North Face’s man- agement had enhanced the company’s reported revenues and profits by “channel stuffing” and other questionable, if not illegal, practices caused the sharp decline in the stock price. To squelch those rumors, North Face’s board of directors attempted to purchase the company in a leveraged buyout underwritten by a large investment banking firm. That effort failed in March 1999 when NASDAQ officials halted public trading of North Face’s stock following an announcement that the company would be restating its previously reported operating results due to certain “bad bookkeeping.”2

2. D. Blount, “Shares of Colorado-Based Outdoor Clothing Maker Slump,” Denver Post (online), 11 May 1999.

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CASE 5.3 THE NORTH FACE, INC. 383

In May 1999, North Face officials publicly revealed that their company’s audited financial statements for 1997 and the company’s preaudited operating results for 1998, which had been released in January 1999, had been distorted by fraudulent accounting schemes. The principal schemes involved violations of the revenue recognition principle. For 1997, North Face’s reported revenues of $208.4 million had been overstated by approximately $5 million, while the company’s net income of $11.2 million had been overstated by $3.2 million. In January 1999, the company had reported unaudited revenue and net income of $263.3 million and $9.5 million, respectively, for fiscal 1998. The company’s actual 1998 revenues were $247.1 million, while the company’s actual net income for the year was $3.6 million.

Bartering for Success at North Face The management team that took over North Face in the mid-1990s established a goal of reaching annual sales of $1 billion by 2003. Many Wall Street analysts believed North Face could reach that goal, given the company’s impressive operating results over the previous several years. When the actual revenues and profits of North Face failed to meet management’s expectations, the company’s chief financial officer (CFO) and vice president of sales took matters into their own hands, literally.

In December 1997, North Face began negotiating a large transaction with a barter company. Under the terms of this transaction, the barter company would purchase $7.8 million of excess inventory North Face had on hand near the end of fiscal 1997. In exchange for that inventory, North Face would receive $7.8 million of trade cred- its that were redeemable only through the barter company. Historically, companies have used such trade credits to purchase advertising or travel services.

Before North Face finalized the large barter transaction, Christopher Crawford, the company’s chief financial officer, asked North Face’s independent auditors how to account for the transaction. The auditors referred Crawford to the appropriate authoritative literature for nonmonetary exchanges. That literature generally pre- cludes companies from recognizing revenue on barter transactions when the only consideration received by the seller is trade credits. To circumvent the authoritative literature, Crawford restructured the transaction. The final agreement with the barter company included an oral “side agreement” that was concealed from North Face’s independent auditors.

Crawford, however, structured the transaction to recognize a profit on the trade cred- its. First, he required the barter company to pay a portion of the trade credits in cash. Crawford agreed that The North Face would guarantee that the barter company would receive at least 60 percent recovery of the total purchase price when it resold the prod- uct. In exchange for the guarantee, the barter company agreed to pay approximately 50 percent of the total purchase price in cash and the rest in trade credits. This guar- antee took the form of an oral side agreement that was not disclosed to the auditors.3

To further obscure the true nature of the large barter transaction, Crawford split it into two parts. On 29 December 1997, two days before the end of North Face’s fiscal 1997 fourth quarter, Crawford recorded a $5.15 million sale to the barter company. For this portion of the barter deal, North Face received $3.51 million in cash and trade credits of $1.64 million. Ten days later, during North Face’s first quarter of fiscal 1998, the company’s accounting staff booked the remaining $2.65 million portion of the barter transaction. North Face received only trade credits from the barter company

3. U.S. District Court, Northern District of California, Securities and Exchange Commission v. Christopher F. Crawford and Todd F. Katz, February 2003.

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384 SECTION FIVE ETHICAL RESPONSIBILITIES OF INDEPENDENT AUDITORS

for this final portion of the $7.8 million transaction. North Face recognized its normal profit margin on each segment of the barter transaction.

Crawford, who was a CPA, realized that Deloitte & Touche, North Face’s auditors, would not challenge the $3.51 million portion of the barter transaction recorded dur- ing the fourth quarter of fiscal 1997. There was no reason for the auditors to chal- lenge that component of the transaction since North Face was being paid in cash. Crawford also realized that Deloitte would disagree with the company’s decision to recognize revenue for the $1.64 million component of the barter transaction for which North Face would be paid exclusively in trade credits. However, Crawford was aware of the materiality thresholds that Deloitte had established for North Face’s key financial statement items during the fiscal 1997 audit. He knew that the gross profit of approximately $800,000 on the $1.64 million component of the barter transaction fell slightly below Deloitte’s materiality threshold for North Face’s collective gross profit. As a result, he believed that Deloitte would propose an adjustment to reverse the $1.64 million item but ultimately “pass” on that proposed adjustment since it had an immaterial impact on North Face’s financial statements. In fact, that is exactly what Deloitte did.

In early January 1998, North Face recorded the remaining $2.65 million portion of the $7.8 million barter transaction. Again, Crawford instructed North Face’s accoun- tants to record the full amount of profit margin on this “sale” despite being aware that accounting treatment was not consistent with the authoritative literature. Crawford did not inform the Deloitte auditors of the $2.65 million portion of the barter transac- tion until after the 1997 audit was completed.

The barter company ultimately sold only a nominal amount of the $7.8 million of excess inventory that it purchased from North Face. As a result, in early 1999, North Face reacquired that inventory from the barter company.

In the third and fourth quarters of fiscal 1998, Todd Katz, North Face’s vice presi- dent of sales, arranged two large sales to inflate the company’s revenues, transac- tions that were actually consignments rather than consummated sales. The first of these transactions involved $9.3 million of merchandise “sold” to a small apparel wholesaler in Texas. During the previous year, this wholesaler had purchased only $90,000 of merchandise from North Face. The terms of this transaction allowed the wholesaler to return any of the merchandise that he did not resell and required North Face to pay all of the storage and handling costs for that merchandise. In fact, North Face arranged to have the large amount of merchandise stored in a warehouse near the wholesaler’s business. Katz negotiated a similar $2.6 million transaction with a small California wholesaler a few months later.

During a subsequent internal investigation, North Face’s audit committee ques- tioned the validity of the large transaction with the Texas wholesaler. North Face paid for the Texas customer to fly to North Face’s new corporate headquarters in Aspen, Colorado, to discuss that transaction with members of the audit committee and the company’s CEO, who were not aware of the true nature of the transaction. The night before the customer met with North Face officials, Katz went to his hotel room and had him sign a fake purchase order for the $9.3 million transaction—a purchase order had not been prepared for the bogus sale when it was originally arranged by Katz.

Several months later, Katz instructed a North Face sales representative to ask the Texas customer to sign an audit confirmation letter sent to him by Deloitte. By signing that letter, the customer falsely confirmed that he owned the $9.3 million of merchan- dise as of 31 December 1998, North Face’s fiscal year-end. The California wholesaler involved in the bogus $2.6 million sale signed a similar confirmation after having

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CASE 5.3 THE NORTH FACE, INC. 385

been asked to do so by a North Face sales representative. In May 1999, following the completion of North Face’s 1998 audit, the Texas customer returned the $9.3 million of merchandise that he had supposedly purchased from North Face.

Erasing the Past Richard Fiedelman served for several years as the Deloitte “advisory” partner assigned to the North Face audit engagements. Within Deloitte, an advisory partner is typically a senior audit partner who has significant industry expertise relevant to a given audit client. Fiedelman was the advisory partner on the North Face engage- ment team because he was in charge of Deloitte’s “consumer retail group” in the firm’s northern California market area. In addition to consulting with members of an audit engagement team on important issues arising during an audit, an advisory partner typically reviews the audit workpapers before the engagement is completed.4

Pete Vanstraten was the audit engagement partner for the 1997 North Face audit.5 Vanstraten proposed the adjusting entry near the end of the 1997 audit to reverse the $1.64 million barter transaction that North Face had booked in the final few days of fiscal 1997. Vanstraten proposed that adjustment because he was aware that the authoritative literature generally precludes companies from recognizing revenue on barter transactions when the only consideration received by the seller is trade credits. Vanstraten was also the individual who “passed” on that adjustment after determin- ing that it did not have a material impact on North Face’s 1997 financial statements. Richard Fiedelman reviewed and approved those decisions by Vanstraten.

Shortly after the completion of the 1997 North Face audit, Pete Vanstraten was transferred from the office that serviced North Face. In May 1998, Will Borden was appointed the new audit engagement partner for North Face.6 In the two months before Borden was appointed the North Face audit engagement partner, Richard Fiedelman functioned in that role.

Fiedelman supervised the review of North Face’s financial statements for the first quarter of fiscal 1998, which ended on 31 March 1998. While completing that review, Fiedelman became aware of the $2.65 million portion of the $7.8 million barter trans- action that Christopher Crawford had instructed his subordinates to record in early January 1998. Recall that North Face received only trade credits from the barter company for this final portion of the large barter transaction. Despite being familiar with the authoritative literature regarding the proper accounting treatment for barter transactions involving trade credits, Fiedelman did not challenge North Face’s deci- sion to record its normal profit margin on the January 1998 “sale” to the barter com- pany. As a result, North Face’s gross profit for the first quarter of 1998 was overstated by more than $1.3 million, an amount that was material to the company’s first-quarter financial statements. In fact, without the profit margin on the $2.65 million transac- tion, North Face would have reported a net loss for the first quarter of fiscal 1998 rather than the modest net income it actually reported that period.

In the fall of 1998, Will Borden began planning the 1998 North Face audit. An important element of that planning process was reviewing the 1997 audit workpa- pers. While reviewing those workpapers, Borden discovered the audit adjustment

4. The information regarding the nature and role of a Deloitte advisory partner was obtained from a senior audit manager with that firm. 5. “Pete Vanstraten” is a fictitious name assigned to the 1997 North Face audit engagement partner. The SEC enforcement releases issued in this case and other available sources did not identify that partner’s actual name. 6. “Will Borden” is also a fictitious name.

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386 SECTION FIVE ETHICAL RESPONSIBILITIES OF INDEPENDENT AUDITORS

that Pete Vanstraten had proposed during the prior-year audit to reverse the $1.64 million barter transaction. When Borden brought this matter to Fiedelman’s atten- tion, Fiedelman maintained that the proposed audit adjustment should not have been included in the prior-year workpapers since the 1997 audit team had not con- cluded that North Face should not record the $1.64 million transaction with the barter company. Fiedelman insisted that, despite the proposed audit adjustment in the 1997 audit workpapers, Pete Vanstraten had concluded that it was permissible for North Face to record the transaction as a consummated sale and recognize the $800,000 of profit margin on the transaction in December 1997.

Fiedelman could not offer any viable explanation to Borden as to why the 1997 workpapers included the proposed audit adjustment for the $1.64 million transac- tion. Borden could have easily addressed that issue by simply contacting Vanstraten; however, he apparently chose not to do so. Nor did he refer to the authoritative literature to determine whether North Face was entitled to record that transaction as a finalized sale. Instead, Borden simply accepted Fiedelman’s assertion that North Face was entitled to recognize profit on a “sales” transaction in which the only con- sideration received by the company was trade credits. Borden also relied on this assertion during the 1998 audit. As a result, Borden and the other members of the 1998 audit team did not propose an adjusting entry to require North Face to reverse the $2.65 million sale recorded by the company in January 1998.

After convincing Borden that the prior-year workpapers misrepresented the deci- sion that Pete Vanstraten had made regarding the $1.64 million barter transaction, Fiedelman “began the process of documenting this revised conclusion in the 1997 working papers.”7 According to a subsequent investigation by the Securities and Exchange Commission (SEC), Deloitte personnel “prepared a new summary mem- orandum and adjustments schedule reflecting the revised conclusion about profit recognition, and replaced the original 1997 working papers with these newly created working papers.” The Deloitte personnel who revised the 1997 workpapers did not document the revisions in those workpapers. “In the end, the 1997 working papers, as revised, did not indicate that the 1997 audit team had originally reached a different conclusion concerning the company’s accounting for the 1997 barter transaction.”

The SEC requires that a partner not assigned to an engagement team review the audit workpapers for an SEC registrant. The Deloitte “concurring” partner who reviewed the 1998 workpapers questioned Will Borden’s decision to allow North Face to recognize revenue on a sales transaction for which it had been paid exclu- sively in trade credits. The partner then referred to the prior-year workpapers and discovered that the workpapers pertaining to the December 1997 transaction with the barter company had been altered.

Because of concerns raised by the concurring partner, Deloitte investigated the 1997 and 1998 North Face transactions with the barter company. The concurring partner’s concerns also prompted North Face’s audit committee to retain a second accounting firm to investigate the company’s 1997 and 1998 accounting records. These investigations ultimately revealed the true nature of the transactions with the barter company, including the previously undisclosed “side agreement” that Christopher Crawford had made with officials of that company. The investigations also led to the discovery of the two bogus consignment sales that Crawford had arranged during 1998.

7. This and all remaining quotes in this case were taken from the following source: Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 1884, 1 October 2003.

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CASE 5.3 THE NORTH FACE, INC. 387

Questions 1. Should auditors insist that their clients accept all proposed audit adjustments,

even those that have an “immaterial” effect on the given financial statements? Defend your answer.

2. Should auditors take explicit measures to prevent their clients from discovering or becoming aware of the materiality thresholds used on individual audit engagements? Would it be feasible for auditors to conceal this information from their audit clients?

3. Identify the general principles or guidelines that dictate when companies are entitled to record revenue. How were these principles or guidelines violated by the $7.8 million barter transaction and the two consignment sales discussed in this case?

E P I L O G U E The SEC sanctioned Richard Fiedelman for failing to document the changes that his sub- ordinates had made in the 1997 North Face workpapers. In commenting on the North Face case, the federal agency stressed the important function of audit workpapers and the need for any ex post changes in those workpapers to be clearly and fully documented.

The auditor’s working papers provide the principal support for the auditor’s report, including his representation regarding the observance of the standards of field work, which is implicit in the reference in his report to generally accepted auditing standards. It therefore follows that any addition, deletion, or modification to the working papers after they had been finalized in connection with the completion of the audit may be made only with appropriate supplemental documenta- tion, including an explanation of the justifica- tion for the addition, deletion, or modification.

The SEC also criticized Fiedelman for fail- ing to exercise due professional care while reviewing North Face’s financial statements for the first quarter of 1998. According to the SEC, Fiedelman allowed North Face to record the January 1998 barter transaction “directly con- trary to the conclusion reached by Deloitte in its 1997 year-end audit.” In October 2003, the SEC imposed a three-year suspension on Fiedelman

that prevented him from being involved in the audits of SEC clients.

In Februar y 2003, the SEC suspended Christopher Crawford for five years, which pro- hibited him from serving as an officer or director of a public company or being associated with any financial statements filed with the federal agency over that time frame. The SEC also fined Crawford $30,000 and required him to disgorge approximately $30,000 of trading profits he had earned on the sale of North Face stock. The SEC also denied Todd Katz, the former vice presi- dent of sales who had helped Crawford manip- ulate North Face’s reported operating results, the privilege of serving as an officer of a public company for five years and fined him $40,000. The two former North Face customers involved in the bogus consignment sales arranged by Katz were reprimanded by the SEC.

In May 2000, VF Corporation, the world’s larg- est apparel company, more commonly known as Vanity Fair, made North Face a wholly owned subsidiary by purchasing the company’s out- standing common stock for $2 per share. VF immediately installed a new management team to take over North Face’s operations. Under the leadership of that new management team, North Face quickly returned to profitability and rees- tablished itself as one of the nation’s premier suppliers of outdoor equipment and apparel.

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388 SECTION FIVE ETHICAL RESPONSIBILITIES OF INDEPENDENT AUDITORS

4. Identify and briefly explain each of the principal objectives that auditors hope to accomplish by preparing audit workpapers. How were these objectives undermined by Deloitte’s decision to alter North Face’s 1997 workpapers?

5. North Face’s management teams were criticized for strategic blunders that they made over the course of the company’s history. Do auditors have a responsibility to assess the quality of the key decisions made by client executives? Defend your answer.

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389

CASE 5.4

IPOC International Growth Fund, Ltd.

And thus I clothe my naked villainy With odd old ends stolen out of holy writ; And seem a saint, when most I play the devil.

William Shakespeare

No doubt, Guy Enright was apprehensive as he talked to the mysterious stranger on the phone. At the time, Enright, a British citizen and Chartered Accountant, was working on an unusual engagement for his employer, KPMG.1,2 The Big Four account- ing firm had been appointed by Bermuda’s Minister of Finance to review and report on the financial affairs of a large investment fund, IPOC International Growth Fund, Ltd. (IPOC). Although based in Bermuda, a Danish attorney, Jeffrey Galmond, served as the company’s chief executive and was reportedly its principal stockholder.

The individual who had called Enright identified himself as Nick Hamilton. During the phone call, Hamilton told Enright that he needed to speak to him about a mat- ter that had “national security implications for Britain.” Hamilton, who had a strong British accent, “led Enright to believe he was a British intelligence officer” and appar- ently asked Enright not to tell his superiors that he had contacted him.

After considering the strange request for a few moments, Enright agreed to meet with Hamilton in a public place. Hamilton then arranged for the two of them to have lunch a few days later at Little Venice, a popular Bermuda restaurant.

Bermuda Shell Game A former Merrill Lynch executive organized IPOC in 2000 after the Bermuda govern- ment issued a license to the company to operate as a mutual fund. Three years later, after Bermuda regulatory authorities discovered that the company’s founder was a convicted felon, he was dismissed and Jeffrey Galmond took control of the company.

Over the next few years, IPOC grew dramatically. The company’s principal invest- ments were in Russian telecommunications companies that were a product of the Russian Federation’s “privatization programme” during the 1990s. That program converted thousands of state-owned agencies within the former Soviet Union into privately owned companies and was intended to distribute the ownership interests of those new companies to millions of Russian citizens. The majority of those own- ership interests, however, were usurped by individuals who had held high-ranking positions in the former Soviet government or who were friends, family members, and business associates of such individuals.

By 2004, the Bermuda government was alarmed by rampant rumors and allegations that IPOC was not operating as a mutual fund but rather was a money-laundering

1. This case was coauthored by Carol A. Knapp and was originally published in the Journal of Forensic & Investigative Accounting, Vol. 6, No. 1 (January–June 2014). I would like to thank D. Larry Crumbley, the editor of the Journal of Forensic & Investigative Accounting, for granting permission to include this case in this edition of Contemporary Auditing: Real Issues and Cases. 2. Much of the background information for this case and the quotes, unless indicated otherwise, were taken from the following source: Bloomberg Businessweek, “Spies, Lies & KPMG,” www.businessweek .com, 25 February 2007.

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390 SECTION FIVE ETHICAL RESPONSIBILITIES OF INDEPENDENT AUDITORS

“criminal” enterprise. Critics of the company insisted that Jeffrey Galmond and other IPOC executives served only as figureheads and that IPOC was actually owned and controlled by Leonid Reiman, Russia’s Telecommunications Minister.

Reiman was a longtime friend and close ally of Russian president Vladimir Putin who had appointed him to oversee Russia’s emerging telecommunications industry. Allegedly, Reiman had used his position to take control of Russia’s key telecommu- nications companies and place them under the IPOC corporate umbrella. Reiman disputed such claims and insisted that he was not involved with IPOC and that Galmond was the company’s principal executive and owner.

To squelch the controversy, IPOC’s executives hired Ernst & Young to “audit” their company’s business affairs and issue a report on its findings. Copies of the Ernst & Young report obtained by third parties caused even more questions to be raised about IPOC’s legitimacy. The E&Y report documented a number of suspicious cash transfers that appeared to have no credible business purpose.

For decades, Bermuda’s political leaders have taken strenuous measures to pre- vent their country, which is technically a British territory, from becoming a headquar- ters for companies controlled by organized crime syndicates. Several small nations in the nearby Caribbean, on the other hand, have bank secrecy laws that serve as an invitation to such enterprises. Increasing concern regarding the true nature of IPOC’s operations goaded Bermuda’s Minister of Finance in 2004 to retain KPMG to inves- tigate the company. Two years would pass before the investigation and its findings would be publicly reported. In the meantime, another headline-grabbing controversy involving IPOC erupted.

Cell Phone Mania In late 2003, IPOC filed a lawsuit against the Alfa Group, a Russian-based company that was attempting to become a major competitor in Russia’s mobile phone indus- try. At the time, IPOC owned, directly or indirectly, a 40 percent interest in one of Russia’s largest cell phone companies, MegaFon. Over the previous few years, IPOC had attempted to gain a majority ownership interest in MegaFon by purchasing the 25 percent stake in the company held by Leonid Rozhetskin, a U.S. citizen of Russian descent. IPOC also named Leonid Rozhetskin as a defendant in the lawsuit it filed.

In 1992, Rozhetskin, a 26-year-old Harvard Law School graduate, accepted a job with the Moscow office of a U.S. law firm. Rozhetskin soon left his legal career behind to become a venture capitalist. In 1996, he was involved in registering VimpelCom, a Russian telecommunications company, on the New York Stock Exchange—the first Russian company to be listed on the “Big Board.”

Among Rozhetskin’s investment partners were George Soros, a billionaire American financier, and Mikhail Fridman, one of Russia’s wealthiest businessmen. Both Soros and Fridman were longtime antagonists of Vladimir Putin. In 2000, Putin, a former agent in the Soviet Union’s notorious intelligence agency, the KGB, had been elected president of the Russian Federation. Putin succeeded his mentor Boris Yeltsin, the Federation’s first president.

Unlike his two wealthy colleagues, Rozhetskin, was openly critical of President Putin and his economic policies. The controversial and ambitious Rozhetskin also maintained a high profile in Russia’s nascent investment community. Because of his aggressive persona, the Russian version of Forbes magazine placed him on its cover under the caption, “The Most Dangerous Shark in Our Waters.”3

3. PRNewswire (online), “Russian Oligarch Fridman, Corporation Sued for Racketeering, Fraud that Used U.S. Banks and Exchanges,” 9 June 2006.

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CASE 5.4 IPOC INTERNATIONAL GROWTH FUND, LTD. 391

IPOC officials sued Alfa Group and Rozhetskin because they insisted that they had negotiated a binding agreement with Rozhetskin that required him to sell his 25 percent ownership interest in MegaFon to their company. Rather than selling his stake in MegaFon to IPOC, Rozhetskin unexpectedly sold it to the Alfa Group in August 2003. Rozhetskin’s decision would ultimately trigger the filing of a series of lawsuits and countersuits over the next several years involving IPOC, Alfa Group, and Rozhetskin in British, Russian, Swedish, Swiss, and Russian courts. The bruising legal battle eventually convinced Bermuda’s Minister of Finance to hire KPMG to investigate IPOC.

Lunch and Lies When Guy Enright showed up at the Little Venice restaurant in Bermuda for his luncheon meeting with Nick Hamilton, he was greeted not only by Hamilton but also by an attractive young lady who introduced herself as “Liz from Langley.” No doubt, Enright took “Langley” to mean Langley, Virginia, the headquarters of the U.S. Central Intelligence Agency (CIA). Hamilton explained to Enright that he was needed to assist in a “top secret” mission that “involved Britain’s national security.”

[Hamilton] . . . told the accountant he would have to undergo a British government background check to ensure that he was up to the task. [Hamilton] produced an official-looking—but fake—questionnaire with a British government seal at the top and asked for information about Enright’s parents, his professional background, any criminal history, and political activities.

A few weeks later, Hamilton and Enright met again at a Bermuda bar. During this meeting, Hamilton told Enright he was being recruited to provide information about KPMG’s investigation of IPOC. Hamilton convinced Enright to begin “handing over confidential audit documents, including transcripts of interviews KPMG had con- ducted in the IPOC investigation.” Enright was instructed to place those documents in a plastic container hidden under a large rock in a secluded area on Bermuda. Hamilton would then retrieve those documents.

In fact, Nick Hamilton was not a British intelligent officer, and “Liz” was not a CIA agent as they had led Enright to believe. Instead, Nick Hamilton was actually Nick Day and “Liz” was Gretchen King, one of Day’s subordinates. Day was a senior executive of Diligence, Inc., a London-based “business intelligence” firm that he had founded in 2000; King was assigned to Diligence’s New York City office. Day did have a background in government intelligence, having served with the United Kingdom Special Forces, a secretive agency of the British government that deals with counter- terrorism and other threats to Britain’s national security.4

During the legal battle over Leonid Rozhetskin’s 25 percent ownership inter- est in MegaFon, the Alfa Group had hired Barbour Griffith & Rogers (BGR),5 a Washington, D.C.–based lobbying firm. In turn, BGR had hired Diligence, which maintained an office in Washington, D.C., two blocks from the White House. BGR wanted Diligence to obtain information regarding IPOC that would help Alfa Group retain the 25 percent ownership interest in MegaFon that had been purchased from Rozhetskin.

4. Day also served for a time as a special consultant to the popular British TV series Spooks, a drama that revolves around the trials and tribulations of a British domestic intelligence organization. 5. BGR was cofounded by the prominent politician Haley Barbour. In 2000, Fortune Magazine tabbed BGR as the nation’s most powerful lobbying firm.

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392 SECTION FIVE ETHICAL RESPONSIBILITIES OF INDEPENDENT AUDITORS

On its website, Diligence states that it is a “business intelligence firm that helps its clients confront difficult business challenges.” The website goes on to note that, “In this role, we provide companies with both the intelligence and analysis to enable them to identify, manage and mitigate risks stemming either from the normal flow of business or from unanticipated contingencies.” In laymen’s terms, a major focus of Diligence’s business model is helping multinational companies deal with threats posed by corporate espionage, real or imagined.

William Webster, the only individual to have served as the head of both the Federal Bureau of Investigation (FBI) and the CIA, was for many years on Diligence’s Advisory Board and reportedly helped Nick Day organize the firm in 2000. In 2006, Michael Howard was appointed Diligence’s chairman. For several years, Howard had served as the leader of Britain’s Conservative Party and would have become the nation’s Prime Minister if his party had been successful in defeating the Labour Party headed by Tony Blair.

Unknown to Guy Enright, he had been the focal point of a months-long effort by agents of Diligence to gain inside information regarding IPOC. Diligence’s manage- ment intended to complete this assignment, which it referred to as Project Yucca, in secrecy to avoid any embarrassment or legal repercussions for itself, Alfa Group, or BGR. An internal memo of Diligence obtained by Bloomberg Businessweek noted that, “We are doing it [Project Yucca] in a way which gives [us] plausible deniability, and therefore virtually no chance of discovery.”

After being retained by BGR, Diligence went to great lengths to identify one or more individuals who might cooperate in its effort to gain access to IPOC’s inner sanctum. When Diligence learned that KPMG was involved in a government-sponsored investi- gation of IPOC, they contacted staff members of KPMG’s Bermuda office. While pos- ing as organizers of a legal conference in Bermuda, two Diligence employees were successful in eliciting from KPMG’s secretarial staff the names of the individuals assigned to the IPOC engagement.

Next, Diligence developed psychological profiles to identify the KPMG employ- ees most likely to participate in the agency’s covert plan. According to Bloomberg Businessweek, the female profile suggested that Diligence should target “a young female who is insecure . . . not honest. Someone who spends money on her looks, clothes, gadgets. Has no boyfriend, and only superficial friends. Has a strong rela- tionship with her mother.” The similarly unflattering male profile involved a ”male in his mid-20s who is somewhat bored . . . has a propensity to party hard, needs cash, enjoys risk, likes sports, likes women, is disrespectful of his managers, fiddles his expenses, but is patriotic.”

After determining that none of the KPMG employees assigned to the IPOC engage- ment was a good “fit” for the ideal male or female personality profiles that they had developed, the Diligence officials decided to focus their attention on Guy Enright. Throughout the several months required to carry out Project Yucca, the intelligence firm went to great lengths to insure that Enright was not a “double agent” acting on behalf of IPOC. The counter-intelligence measures they employed included tracking Enright as he traveled around Bermuda and searching his garbage.

For its efforts, Diligence was paid $280,000 by BGR and was reimbursed for $30,000 of expenses it incurred. Included in the $280,000 figure was a $60,000 “bonus” paid to Diligence when Nick Day convinced Enright to hand over an early draft of KPMG’s report on its IPOC investigation. For his role in the clandestine operation, Enright was given a Rolex watch valued at “thousands of dollars” by Diligence and “was led to believe that it [the watch] was a thank-you gift from the British government.”

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CASE 5.4 IPOC INTERNATIONAL GROWTH FUND, LTD. 393

6. N. Buckley, “Russian Phone Feud Peace Deal,” Financial Times (online), 30 July 2007. 7. Ibid. 8. J. Kent, “The Rise and Fall of IPOC,” The Royal Gazette (online), 9 May 2008. 9. Ibid. 10. Ibid. 11. Several parties have speculated that a disgruntled former employee of Diligence, Inc. was the indi- vidual who delivered these documents to KPMG. 12. S. Fidler, A. Ostrovsky, and N. Buckley, “MegaFon Diplomacy: A Disputed Stake Pits an Oligarch against a Putin Ally,” Financial Times (online), 24 April 2006.

E P I L O G U E In July 2007, IPOC and Alfa Group announced that they were ending their long-running and costly legal battle. The two companies agreed to “end all court actions and renounce legal claims against each other,”6 which meant that the Alfa Group would retain the 25 percent ownership interest in MegaFon that it had pur- chased from Leonid Rozhetskin. By this time, however, IPOC’s cover “had been blown.” The year before, a Swiss arbitration panel had corroborated one of the key allegations made by Alfa Group against IPOC, namely, that Leonid Reiman, Russia’s Telecommunications Minister and Vladimir Putin’s close ally, was IPOC’s “beneficial owner.”7 A similar conclu- sion was reached by a law enforcement agency in the British Virgin Islands that also had been investigating IPOC. That agency reported that IPOC “was a front for the laundering of the proceeds of crime of, amongst others, Russian Telecommunications Minister Mr. Leonid Reiman.”8

In May 2008, after reviewing KPMG’s report on IPOC and information culled from other sources, the Bermuda Supreme Court ruled that IPOC had to disband its business opera- tions in Bermuda. In commenting on that rul- ing, Bermuda’s Finance Minister observed that, “We were committed to protecting Bermuda and sending a signal to the world that Bermuda does not trifle with its reputation.”9 The relieved and happy official then added that the “long and complicated case” had “more angles and twists and turns than a James Bond novel.”10

In late 2005, a bundle of documents that revealed the details of Diligence’s “sting oper- ation” involving Guy Enright had been left anonymously at a New Jersey office of KPMG.11 After reviewing those documents, the Big Four accounting firm filed a civil lawsuit against the British intelligence firm. Although that lawsuit was settled privately between the two parties, numerous sources reported that Diligence paid KPMG $1.7 million to resolve the matter. Despite that settlement, Diligence officials insisted that they had done nothing wrong during the infa- mous Project Yucca. Those officials reported that they had “obtained information [regarding IPOC] from a whistleblower worried that the inquiry [of IPOC by KPMG] might bury some uncomfortable facts.”12

The details of Diligence’s sting operation were leaked to the press in late 2006 and early 2007. By this time, Guy Enright had left the employment of KPMG and joined the consult- ing staff of Deloitte & Touche in London.

During the drawn-out legal battle involv- ing himself, Alfa Group, and IPOC, Leonid Rozhetskin continued to be an outspoken critic of the Russian government, particularly Vladimir Putin. In late 2006, a Russian fed- eral prosecutor filed criminal charges against Rozhetskin and issued an arrest warrant for him. The prosecutor alleged that Rozhetskin had engaged in wide-ranging fraudulent activi- ties related to the sale of his 25 percent own- ership interest in MegaFon to Alfa Group. After the arrest warrant was issued, “Rozhetskin

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394 SECTION FIVE ETHICAL RESPONSIBILITIES OF INDEPENDENT AUDITORS

Questions 1. Bermuda’s Minister of Finance retained KPMG to “audit” the business affairs

of IPOC to determine whether the company was a criminal enterprise or a legitimate business operation. What type of professional service was KPMG providing during this engagement? Did the engagement qualify as an assurance, attestation, audit, or consulting engagement? Defend your answer.

2. What moral, ethical, and professional responsibilities did Guy Enright face when he was asked to turn over confidential documents to the individuals who were representing themselves as intelligence agents for the British and the U.S. governments? Which of those responsibilities did he violate and which did he uphold?

3. Compare and contrast the conduct of Guy Enright and Nick Day. Which of these individuals was most ethical (or least unethical)? Defend your answer.

4. How would you respond if you faced a set of circumstances similar to those faced by Guy Enright?

5. KPMG filed a civil lawsuit against Diligence, Inc., in 2005 after learning of the “sting operation” that firm had perpetuated on Guy Enright. What rationale or legal principles would have been the basis for that lawsuit? Do you believe that KPMG would have been successful if it had pursued that lawsuit rather than settling it out of court? Assuming that KPMG believed it would ultimately win a civil judgment against Diligence, why would the accounting firm choose to settle the lawsuit out of court? Explain.

maintained that his life was in danger for seek- ing to expose corruption of President Putin’s government.”13

In March 2008, Rozhetskin disappeared while making a business trip to Latvia. Over the next few years, Russian law enforcement authorities insisted that Rozhetskin had been placed in the federal witness protection program by the U.S. law enforcement authorities and was living under an assumed name in California where he had become involved in the movie industry as

a producer. Rozhetskin’s mother dismissed that rumor and maintained instead that her son had been abducted by Putin allies. She claimed that he had been abducted because of his public criticism of Putin and because he was planning “a documentary film that would expose gov- ernment and business corruption in Russia.”14 Four years later, in September 2012, DNA tests revealed that skeletal remains discovered in a remote area of Latvia were those of Leonid Rozhetskin.

13. B. Gain, “Missing American’s Body a DNA Match in Latvia,” www.trutv.com, 5 September 2012. 14. Ibid.

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395

CASE 5.5

Phillips Petroleum Company

Bill Grant sat in the middle of a large jail cell with 12 other inmates as the long October night dragged on.1 To pass the time, Grant and several other inmates played cards and talked about their hopes of being reunited with their families. The accom- modations of the Tulsa County Jail were not unlike those of most jails: dirty, no lid on the toilet, and 12 beds for 13 inmates. What made this scene unusual was not the less-than-glamorous, overcrowded condition of the jail cell, but rather the presence of Grant, a Big Eight audit partner and graduate of the Harvard Business School. At the time, Grant served as the managing partner of the Tulsa office of Arthur Young & Company, but he was destined to become Arthur Young’s comanaging partner in 1988 shortly before that firm merged with Ernst & Whinney to form Ernst & Young.

Earlier that day, Grant had appeared in a Tulsa federal courthouse at a hearing presided over by Judge Allan Barrow. Judge Barrow had ordered Grant to produce certain audit workpapers that had been subpoenaed by a federal grand jury. Those workpapers had been prepared during an audit of the large oil company, Phillips Petroleum Company, a client of Arthur Young’s Tulsa office. When Grant respectfully denied the judge’s request, he was cited for civil contempt, handcuffed, and led away to jail. Apparently, the judge hoped that an overnight stay in a crowded jail cell would convince Grant to change his mind.

The federal grand jury’s interest in the Arthur Young workpapers stemmed from an ongoing investigation of Phillips. That investigation focused on possible tax fraud related to a secret, multimillion-dollar fund that Phillips’ executives had established to make political contributions. One contribution made from the secret fund, which was maintained in a Swiss bank account, was an illegal donation of $100,000 to the Committee to Reelect the President (Richard Nixon). Under the terms of an earlier plea bargain agreement with Watergate special prosecutor Archibald Cox, Phillips’ chairman of the board had admitted to the $100,000 contribution to President Nixon’s 1972 reelection campaign and pleaded guilty to one misdemeanor.2 Following that plea bargain agreement, federal prosecutors indicted Phillips for filing false federal tax returns that failed to report interest revenue earned on the secret Swiss bank account.

Prior to Bill Grant’s appearance before Judge Barrow, Arthur Young had turned over to the federal grand jury approximately 12,000 pages of Phillips audit workpa- pers. Arthur Young, however, had refused to give the grand jury several workpapers relating to two key items: (1) certain tax accruals made by Phillips and (2) attorneys’ letters that Arthur Young had obtained from Phillips’ law firms. Among other top- ics, these attorneys’ letters were known to include discussions of “unasserted claims”

1. The facts of this case were drawn principally from the following articles: “Arthur Young Aide Cited for Contempt and Jailed in Tulsa,” Wall Street Journal, 8 October 1975, 10; F. Andrews, “Arthur Young Faces Test on Protecting Client Audit Secrets,” Wall Street Journal, 14 October 1975, 23; “Arthur Young & Co. Gives Grand Jury Data on Phillips Petroleum,” Wall Street Journal, 15 October 1975, 28; “Pleas by Phillips Petroleum Filed on U.S. Charges,” Wall Street Journal, 23 November 1977, 2. 2. Phillips’ chairman also revealed that he had delivered $50,000 to Nixon in a New York City apartment during the 1968 presidential campaign in which Nixon eventually defeated Senator Hubert Humphrey.

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396 SECTION FIVE ETHICAL RESPONSIBILITIES OF INDEPENDENT AUDITORS

by Phillips’ attorneys. The federal grand jury believed that both sets of workpapers might provide important insight on the tax fraud allegations involving Phillips.

Arthur Young had refused to provide the contested workpapers to the grand jury on the grounds that they contained confidential information that, if disclosed, would be potentially damaging to Phillips. Tax accrual audit workpapers, for example, typi- cally contain an audit firm’s analysis of tax-related decisions made by their clients. Access to such workpapers would make it much easier for the Internal Revenue Service (IRS) to “build a case” against a given company.

Bill Grant was released from the Tulsa County Jail on 7 October 1975, but was ordered to make an appearance the following week before Judge Barrow. If Grant again refused to produce the workpapers subpoenaed by the grand jury, he faced the risk of being cited for criminal contempt and receiving a 17-month jail term. During the week between Grant’s two court appearances, Arthur Young’s attorneys worked out a compromise with Judge Barrow. Under the terms of the agreement, Arthur Young turned over copies of the requested tax accrual workpapers. All matters other than those specifically identified by the subpoena were masked in the copies of the workpapers given to the grand jury. Judge Barrow also granted Arthur Young the right to contest any subsequent court order to provide the original “unmasked” tax accrual workpapers to the grand jury.

Judge Barrow did not relent with respect to the contested attorneys’ letters. He ordered Arthur Young to provide copies of those letters to the grand jury. Phillips filed a motion to appeal this order, but that appeal was denied.

E P I L O G U E The Watergate-related problems of Phillips Petroleum continued to plague the company following the resolution of the dispute involv- ing the Arthur Young workpapers. In early 1976, Phillips’ executives temporarily turned over control of the company to its outside directors. This decision was spurred by the filing of a large class-action lawsuit against Phillips linked to the charges of illegal campaign contribu- tions. In November 1977, Phillips settled these charges by pleading guilty to engaging in a con- spiracy to make illegal campaign contributions,

pleading no contest to four related tax evasion charges, and paying a fine of $30,000.

Ironically, Arthur Young’s tax accrual work- papers for another audit client, the large oil company Amerada Hess, became the focal point of another major litigation case. The issue in this case was whether the IRS had the right to review copies of auditors’ tax accrual work- papers. In 1984, the Supreme Court decided the case by unanimously ruling that the IRS has the right to review tax accrual workpapers pre- pared during an independent audit.

Questions 1. Do you believe that Bill Grant was justified in refusing to provide the requested

workpapers to the grand jury? Explain.

2. What responsibility, if any, does a public accounting firm have to its partners and employees when they are subpoenaed to testify regarding a client?

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CASE 5.5 PHILLIPS PETROLEUM COMPANY 397

3. What is the purpose of “attorneys’ letters” obtained during the course of an audit? If attorneys are aware that these letters can be routinely subpoenaed, how does this fact likely affect the quality of the audit evidence yielded by the letters?

4. Do you believe the documentation included in tax accrual audit workpapers is likely affected by auditors’ knowledge that those workpapers can be obtained by the IRS? Explain.

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399

CASE 5.6

Ryden Trucking, Inc.

Jermell Marshall graduated with an accounting degree from the University of Washington in 1990 and immediately accepted a job with a regional accounting firm based in Seattle.1 After spending four and one-half years on the auditing staff of that firm, Marshall decided he had worked for someone else long enough and resigned to establish his own accounting practice.

Fifteen years later, Marshall’s firm included two other partners, 15 professional employees, and a support staff of 10 paraprofessionals and clerical workers. Marshall served as the managing partner of his firm and supervised most audit, accounting services, and consulting engagements. The firm’s audit and accounting services clients were primarily small to moderately sized businesses in the Seattle area that required annual audits or reviews of their financial statements for their banks or other lenders.

In August 2009, Marshall hired Lola Rojas, a 28-year-old accountant who had moved to Seattle from southern California a few weeks earlier to be near her ailing mother. Rojas had earned an accounting degree in 2005 but after several attempts had not passed the CPA exam. Following graduation, Rojas had held three different jobs, two as a staff accountant with small accounting firms and one as an entry-level accountant with a bank. Before hiring Rojas, Marshall asked for letters of recommen- dation from two of her former employers. Each of those recommendation letters indi- cated that the cheerful and outgoing Rojas had been a dependable, competent, and hard-working employee.

Marshall assigned Rojas to several audit and accounting services engagements that he supervised during her first six months with the firm. He was very pleased with her performance on those assignments. She was typically the first individual to arrive for work each morning, quickly established friendships with her peers, and was well liked by client personnel. Marshall’s impression of Rojas changed abruptly in March 2010 when he received a phone call from Carson Caddell, the principal owner of Ryden Trucking, Inc., a trucking firm that serviced agricultural businesses in Washington and neighboring states. Ryden was easily the largest client of Marshall’s firm. Caddell informed Marshall that one of his bookkeepers had discovered com- pelling evidence that Rojas had embezzled approximately $32,000 during the three weeks she had spent in Ryden’s office in early 2010.

Since establishing his firm, Marshall had dealt with several “problem” employ- ees, but a client had never accused one of his employees of theft. Extremely upset, Marshall called Rojas into his office and informed her of the alleged theft reported by Carson Caddell. Within moments, Rojas began weeping and confessed to embez- zling the funds. She explained that she needed the cash to pay for the medical expenses incurred over the previous year by her terminally ill mother who had no health insurance. Rojas then pleaded with Marshall to help her. She insisted that she had intended to somehow repay the stolen funds. If Marshall or Caddell reported her to law enforcement authorities, there would be no one to care for her mother.

1. This case was developed from an actual legal opinion. The names of the parties involved in the case and the relevant locations have been changed. In addition, certain of the factual circumstances reported in this case are fictionalized accounts of the actual facts disclosed in the legal opinion.

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400 SECTION FIVE ETHICAL RESPONSIBILITIES OF INDEPENDENT AUDITORS

Marshall discussed the situation with his subordinate for more than an hour. Gradually, his anger subsided and he began to feel sorry for the emotionally dis- traught Rojas. In his mind, here was a young lady who had faced a tragic set of cir- cumstances and made a foolish decision that stood to wreck her personal life and professional career. Finally, Marshall told Rojas that he wanted to discuss the matter with an attorney. In the meantime, he told her that he had no choice but to terminate her employment since he could no longer trust her.

Later that same day, Marshall drove to the law office of Andrew Tao. The two men had been friends since high school and fraternity brothers in college. After explain- ing the situation to Tao, Marshall asked if there was any way that the matter could be resolved without Rojas facing criminal charges. Tao responded that the decision of whether or not to file charges against Rojas rested with Carson Caddell.

The following morning, Marshall and Tao met with Caddell. During the meeting, Caddell repeatedly insisted that Rojas should be reported to law enforcement author- ities. Even after Marshall explained the sad circumstances facing Rojas, Caddell was unmoved. “You can’t let something like this slide, Jermell. Come on, she stole more than $30,000 from us. She deserves what she gets.”

Marshall made one final attempt to change Caddell’s mind. He offered to repay one- half of the stolen funds immediately and sign a promissory note obligating him to repay the remainder within two years if Caddell would agree not to press charges. After sev- eral moments, Caddell responded by indicating that he “would think about it.”2

Three days later, Marshall and Tao met with Rojas. When Marshall told Rojas of his offer to reimburse Ryden for the embezzlement loss, she burst into tears and prom- ised to repay him. After she regained her composure, Marshall reminded Rojas that Caddell had not yet accepted his offer. Before Rojas left Marshall’s office a few min- utes later, he asked her how she expected to support herself over the coming weeks. Rojas told Marshall that, thanks to a recommendation from a friend, she had found a bookkeeping job with a small manufacturing firm in a nearby Seattle suburb. She was scheduled to begin the job the following Monday.

Marshall telephoned Caddell regarding Lola Rojas each of the next two weeks. During those two conversations, Caddell indicated that he appreciated Marshall’s offer but still firmly believed that Rojas should be held accountable for her actions. A few days following the second conversation with Caddell, Marshall was surprised when Rojas walked into his office and told him that she had convinced an uncle to loan her the $32,000 to repay Ryden Trucking. She then handed Marshall an enve- lope that contained a cashier’s check for that amount. Marshall told Rojas that he would give the check to Caddell but warned her that Caddell was still likely to insist on pressing charges. He told her that he would talk with Caddell one more time and try to persuade him to change his mind.

The following day, Marshall, accompanied by Tao, delivered the cashier’s check to Caddell. As Marshall had expected, the check did not change Caddell’s mind. But, after Marshall made one final, heartfelt plea that Rojas deserved a second chance, Caddell agreed to drop the matter in exchange for Rojas pleading guilty to a misdemeanor.

Two days later, Marshall, Tao, and Rojas met with an assistant district attorney who was a friend of Tao. After reviewing the matter and discussing it with his superiors, the assistant district attorney refused to accept Rojas’s misdemeanor plea, explaining that the substantial size of the embezzlement warranted that she be charged with more than a misdemeanor.

2. As a point of information, the legal opinion from which this case was developed did not indicate whether Ryden Trucking had insurance that would reimburse the company for the embezzlement loss.

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CASE 5.6 RYDEN TRUCKING, INC. 401

A frazzled and frustrated Marshall reported the decision of the assistant district attorney to Caddell. On hearing the news, an equally frazzled and frustrated Caddell told Marshall, “Let’s just forget the whole mess right now. I am sick and tired of this. I just hope that she has learned her lesson.”

Less than one month after Caddell decided not to press criminal charges against Lola Rojas, the young accountant was back in court—in handcuffs. Rojas was arrested for embezzling approximately $41,000 from her new employer. Rojas had used the bulk of that amount to repay the funds she had embezzled from Ryden Trucking.

3. This lawsuit also named Lola Rojas and Andrew Tao as codefendants, although the complaints filed against them differed from those filed against Jermell Marshall.

E P I L O G U E The insurance company that reimbursed Rojas’s second victim for the $41,000 embez- zlement loss filed a lawsuit against Jermell Marshall to recover that payment. The lawsuit included various charges of negligence and gross negligence against Marshall. But, the cen- tral premise of the lawsuit was that Marshall had been negligent in failing to warn Rojas’s new employer of her prior criminal activity.3

The judge who presided over this lawsuit referred to several broad legal principles in reaching his decision, including his jurisdic- tion’s definition of what constitutes negligence: the doing of that which an ordinarily prudent person would not have done under the same or similar circumstances, or the failure to do that which an ordinarily prudent person would have done under the same or similar circum- stances. A second legal principle central to the case was the general rule that a person has no legal duty to protect another from the criminal acts of a third party. However, the judge noted that this latter rule is not absolute. For example,

employers who can reasonably foresee that an employee under their control may commit crim- inal acts harming third parties generally have a responsibility to warn those parties of the impending criminal behavior.

After a brief trial, the judge ruled, and an appellate court later concurred, that Jermell Marshall had not been negligent in failing to warn Rojas’s new employer of her prior crimi- nal conduct. According to the judge, Marshall could not have foreseen or predicted that Lola Rojas would embezzle from future employers. In fact, it was just as likely, reasoned the judge, that Rojas “had learned her lesson” and thus was very unlikely to commit a similar act in the future. Additionally, once Marshall dismissed Rojas as an employee, he had no control over her future conduct. The appellate judge who reviewed the lower court opinion did sug- gest, however, that despite not having a legal responsibility to warn Rojas’s new employer of her prior criminal conduct, Marshall may have been “morally obligated” to do so.

Questions 1. The legal opinion in this case did not indicate how Lola Rojas actually used

the funds she embezzled from Ryden Trucking. Suppose that she did use those funds to pay medical expenses of her mother. Given this assumption, would you describe her behavior as “unethical”? Defend your answer.

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402 SECTION FIVE ETHICAL RESPONSIBILITIES OF INDEPENDENT AUDITORS

2. What factors may have motivated Jermell Marshall to go to such great lengths to help Rojas? Do you believe that Marshall acted “prudently” in dealing with Rojas?

3. Although not mentioned in this case, the plaintiff that sued Marshall maintained that he had been negligent in supervising Rojas while she was assigned to the Ryden engagement. That negligence, according to the plaintiff, had contributed to Rojas’s decision to embezzle funds from Ryden. Briefly describe the supervisory responsibilities that the U.S. auditing standards impose on senior personnel assigned to an audit or accounting services engagement. To what extent does a supervisor on such engagements have a responsibility to prevent his or her subordinates from engaging in criminal activity?

4. The appellate judge who reviewed the lower court opinion in this case observed that Marshall may have been “morally obligated” to warn Rojas’s new employer of her prior criminal conduct. Explain the difference between a “moral obligation” and a “legal obligation.” If someone fails to honor a moral obligation, has he or she behaved “unethically”?

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403

CASE 5.7

Richard Grimes, Staff Accountant

Richard Grimes glanced at his wristwatch as he pulled into the nearly deserted park- ing lot of the corporate headquarters of McCaleb Medical Corporation (MMC).1 It was 6:25 a.m. on a cold and overcast Friday morning in February. Based in a suburb on the south side of Pittsburgh, Pennsylvania, MMC was a conglomerate whose princi- pal line of business was manufacturing diagnostic instruments used in medical labo- ratories. The company’s common stock traded on one of the major stock exchanges. Richard, a staff accountant with a Big Four accounting firm, was a member of the MMC audit team. He and his colleagues were auditing MMC’s financial statements for the company’s fiscal year that had ended several weeks earlier on 31 December.

Gwen Tomlinson, the audit senior who was supervising the fieldwork for the MMC audit, had given Richard permission to leave at 4 p.m. that day so that he could attend a family get-together in his hometown of Cumberland, Maryland, a two-hour drive from Pittsburgh. To compensate somewhat for his early departure, Richard had arrived at MMC’s headquarters an hour or so before he and his colleagues typically began their workday.

Richard flipped on the lights as he entered a conference room on the third floor of the client’s headquarters building that served as the home base for the MMC audit team. One end of the conference room was dominated by a large oval desk where Gwen could typically be found pounding away on her laptop computer, reviewing a file of audit workpapers, or wading through large stacks of client documents. The remaining two-thirds of the conference room was partitioned into cubicle worksta- tions for Richard and the three other staff accountants assigned to the MMC engage- ment. Two of those staff accountants were “rookies” who had less than three months experience. Similar to Richard, the other staff accountant was beginning her second busy season in public accounting.

After spending a few minutes organizing his workstation for the day, Richard picked up a notepad on which he had jotted down identifying information for six equipment lease contracts that he needed to review. He then headed for a bank of file cabinets in a far corner of the third floor. The file cabinets were tucked in an L-shaped alcove adjacent to the office of MMC’s controller, Alva Russell.

As Richard approached Russell’s office, he was surprised to see the controller and Daniel Slater, MMC’s president and chief operating officer (COO), leaning forward over Russell’s desk with their backs to the open door of the office. The two men were having an animated conversation as they studied a large spreadsheet that was unfolded on the desk. Because he didn’t want to interrupt them, Richard walked softly past the open door and then made an immediate left into the small alcove containing the file cabinets.

As quietly as possible, Richard opened the file cabinet drawer that contained MMC’s equipment lease contracts. As he stood there, he alternately referred to his notepad and then leafed through the open drawer of the file cabinet to retrieve each of the contracts that he intended to review.

1. This case is based upon a similar set of circumstances involving a staff accountant of a large audit firm. The names of the individuals involved in the case and other background information have been changed.

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404 SECTION FIVE ETHICAL RESPONSIBILITIES OF INDEPENDENT AUDITORS

While standing there, Richard could clearly hear every word being said by the two MMC executives since they were standing just a few feet away, although he was totally hidden from their view. Slater was informing Russell that the day before he had learned MMC’s largest customer would be filing for Chapter 7 bankruptcy sometime within the next several weeks. The receivable from that customer, which was a private company, accounted for 28 percent of MMC’s outstanding receivables. Slater told Russell that MMC would be “lucky” to collect a “few pennies on the dollar” from the receivable.

Russell responded to the bad news by telling Slater that the expected loss on the large receivable had to be “addressed somehow” in the company’s financial state- ments to be filed with the SEC in the coming two weeks. Slater quickly replied that MMC was not going to “borrow trouble” by referring to the loss in MMC’s upcoming Form 10-K. Besides, he reasoned, the bankruptcy almost certainly would not become “public information” until after the Form 10-K was filed with the SEC.

As the conversation between the two men continued, it was obvious that Russell strongly disagreed with Slater’s decision. Near the end of the conversation, an exas- perated Russell asked Slater, “What am I supposed to tell the auditors?”

“Don’t tell them anything,” Slater snapped. “What they don’t know, doesn’t concern them.”

A few moments later, Richard was startled when Daniel Slater strode out of Alva Russell’s office and passed within a few feet of him. Richard had anticipated that Slater would turn to the right when he left Russell’s office—in which case he would not have walked past the alcove where Richard was standing. As he was walking away, Slater glanced over his shoulder and noticed Richard standing in front of the bank of file cabinets. Slater immediately turned and approached him.

“How long have you been standing there?” Slater snarled. When Richard didn’t respond immediately, Slater added, “Aren’t you one of the auditors?”

Richard nodded his head affirmatively. “What’s wrong with you? You think you can stand out here and listen to a private

conversation?” Slater was angry, very angry. After taking a deep breath, he continued his harangue. “How did you sneak by the office door without us noticing you?” By this time, Alva Russell had stepped out of his office and was standing shoulder to shoulder with Slater.

Richard stood silently before the two men with his mouth slightly ajar, not sure whether he should try to explain his presence or offer an apology or both.

After a long awkward pause, Slater uttered an expletive under his breath and walked away. Russell stood facing Richard for a few additional moments before shrugging his shoulders and returning to his office.

Questions 1. How, if at all, should MMC report the expected loss on the large receivable in its

Form 10-K financial statements? Explain.

2. Place yourself in Richard Grimes’ position. What decision alternatives does he have after overhearing the conversation between Alva Russell and Daniel Slater? Which of these alternatives should he choose? Why?

3. Did Richard have a responsibility to make the two client executives aware of his presence when he was outside of Russell’s office? Why or why not?

4. Do you believe that Daniel Slater would have reacted differently if the auditor in question had been a female rather than a male? Explain.

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6

SECTION 6

PROFESSIONAL ROLES

Case 6.1 Leigh Ann Walker, Staff Accountant

Case 6.2 Bill DeBurger, In-Charge Accountant

Case 6.3 Hamilton Wong, In-Charge Accountant

Case 6.4 Tommy O’Connell, Audit Senior

Case 6.5 Avis Love, Staff Accountant

Case 6.6 Charles Tollison, Audit Manager

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407

CASE 6.1

Leigh Ann Walker, Staff Accountant

Leigh Ann Walker graduated from a major state university with a bachelor’s degree in accounting.1 During her college career, Walker earned a 3.9 grade point average and participated in several extracurricular activities, including three student busi- ness organizations. Her closest friends often teased her about the busy schedule she maintained and the fact that she was, at times, a little too “intense.” During her final year of college, Walker interviewed with several public accounting firms and large corporations and received six job offers. After considering those offers, she decided to accept an entry-level position on the auditing staff of a major interna- tional accounting firm. Walker was not sure whether she wanted to pursue a partner- ship position with her new employer. But she believed that the training programs the firm provided and the breadth of experience she would receive from a wide array of client assignments would get her career off to a fast start.

Walker’s “start date” was 4 June, exactly one month following her graduation date. She spent the first two weeks on her new job at her firm’s regional audit staff training school. On returning to her local office in mid-June, she was assigned to work on the audit of Saint Andrew’s Hospital, a large sectarian hospital with a 30 June fiscal year-end. Walker’s immediate superior on the Saint Andrew’s engagement was Jackie Vaughn, a third-year senior. On her first day on the Saint Andrew’s audit, Walker learned that she would audit the hospital’s cash accounts and assist with accounts receivable. Walker was excited about her first client assignment and pleased that she would be working for Vaughn. Vaughn had a reputation as a demanding supervisor who typically brought her engagements in under budget. She was also known for having an excellent rapport with her clients, a thorough knowledge of technical stan- dards, and for being fair and straightforward with her subordinates.

Like many newly hired staff auditors, Walker was apprehensive about her new job. She understood the purpose of independent audits and was familiar with the work per- formed by auditors but doubted that one auditing course and a two-week staff-training seminar had adequately prepared her for her new work role. After being assigned to work under Vaughn’s supervision, Walker was relieved. She sensed that although Vaughn was demanding, the senior would be patient and understanding with a new staff auditor. More important, she believed that she could learn a great deal from work- ing closely with Vaughn. Walker resolved that she would work hard to impress Vaughn and had hopes that the senior would mentor her through the first few years of her career.

Early in Walker’s second week on the Saint Andrew’s engagement, Jackie Vaughn casually asked her over lunch one day whether she had taken the CPA examination in May. After a brief pause, Walker replied that she had not but planned to study intensively for the exam during the next five months and then take it in November.2

1. This case is based upon a true set of facts; however, the names of the parties involved have been changed. An employee of a job placement firm provided much of the information incorporated in this case. This firm had been retained by the student identified in this case as Leigh Ann Walker. 2. At the time, the CPA examination was offered twice annually, in November and May. In most states, including Leigh Ann’s home state, an individual who sat for the exam for the first time was required to take all four parts.

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408 SECTION SIX PROFESSIONAL ROLES

Vaughn indicated that was a good strategy and offered to lend Walker a set of CPA review manuals—an offer Walker declined. In fact, Walker had returned to her home state during the first week of May and sat for the CPA exam, but she was convinced that she had failed it. Fear of failure, or, rather, fear of admitting failure, caused Walker to decide not to tell her coworkers that she had taken the exam. She realized that most of her peers would not pass all sections of the exam on their first attempt. Nevertheless, Leigh Ann wanted to avoid the embarrassment of admitting through- out the remainder of her career that she had not been a “first timer.”

Walker continued to work on the Saint Andrew’s engagement throughout the summer. She completed the cash audit within budget, thoroughly documenting the results of the audit procedures she applied. Vaughn was pleased with Walker’s work and frequently complimented and encouraged her. As the engagement was winding down in early August, Walker received her grades on the CPA exam in the mail one Friday evening. To her surprise, she had passed all parts of the exam. She immedi- ately called Vaughn to let her know of the impressive accomplishment. To Walker’s surprise, Vaughn seemed irritated, if not disturbed, by the good news. Walker then recalled having earlier told Vaughn that she had not taken the exam in May. Walker immediately apologized and explained why she had chosen not to disclose that she had taken the exam. Following her explanation, Vaughn still seemed annoyed, so Walker decided to drop the subject and pursue it later in person.

The following week, Vaughn spent Monday through Wednesday with another cli- ent, while Walker and the other staff assigned to the Saint Andrew’s engagement con- tinued to wrap up the hospital audit. On Wednesday morning, Walker received a call from Don Roberts, the office managing partner and Saint Andrew’s audit engagement partner. Roberts asked Walker to meet with him late that afternoon in his office. She assumed that Roberts simply wanted to congratulate her on passing the CPA exam.

The usually upbeat Roberts was somber when Walker stepped into his office that afternoon. After she was seated, Roberts informed her that he had spoken with Jackie Vaughn several times during the past few days and that he had consulted with the three other audit partners in the office regarding a situation involving Walker. Roberts told Walker that Vaughn was very upset by the fact that she (Walker) had lied regarding the CPA exam. Vaughn had indicated that she would not be comfortable having a subordinate on future engagements that she could not trust to be truthful. Vaughn had also suggested that Walker be dismissed from the firm because of the lack of integrity she had demonstrated.

After a brief silence, Roberts told a stunned Walker that he and the other audit partners agreed with Vaughn. He informed Walker that she would be given 60 days to find another job. Roberts also told Walker that he and the other partners would not disclose that she had been “counseled out” of the firm if they were contacted by employers interested in hiring her.

Questions 1. In your opinion, did Vaughn overreact to Walker’s admission that she had been

untruthful regarding the CPA exam? If so, how would you have dealt with the situation if you had been in Vaughn’s position? How would you have dealt with the situation if you had been in Roberts’ position?

2. Vaughn obviously questioned Walker’s personal integrity. Is it possible that one can fulfill the responsibilities of a professional role while lacking personal integrity? Why or why not?

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409

CASE 6.2

Bill DeBurger, In-Charge Accountant

“Bill, will you have that inventory memo done by this afternoon?”1

“Yeah, Sam, it’s coming along. I should have it done by five, or so.” “Make it three . . . or so. Okay, Bub?” Bill responded with a smile and a nod. He had a good relationship with Sam

Hakes, the partner supervising the audit of Marcelle Stores. Bill DeBurger was an in-charge accountant who had 18 months experience with

his employer, a large national accounting firm. Bill’s firm used the title “in-charge” for the employment position between staff accountant and audit senior. Other titles used by accounting firms for this position include “advanced staff” and “semi-senior.” Typically, Bill’s firm promoted individuals to in-charge after one year. An additional one to two years’ experience and successful completion of the CPA exam were usu- ally required before promotion to audit senior.

The title “in-charge” was a misnomer, at least in Bill’s mind. None of the in-charges he knew had ever been placed in-charge of an audit, even a small audit. Based upon Bill’s experience, an in-charge was someone a senior or manager expected to work with little or no supervision. “Here’s the audit program for payables. Go spend the next five weeks completing the 12 program steps . . . and don’t bother me,” seemed to be the prevailing attitude in making work assignments to in-charges.

As he turned back to the legal pad in front of him, Bill forced himself to think of Marcelle Stores’ inventory—all $50 million of it. Bill’s task was to summarize, in a two-page memo, 900 hours of work that he, two staff accountants, and five internal auditors had done over the past two months. Not included in the 900 hours was the time spent on eight inventory observations performed by other offices of Bill’s firm.

Marcelle Stores was a regional chain of 112 specialty stores that featured a broad range of products for do-it-yourself interior decorators. The company’s most recent fiscal year had been a difficult one. A poor economy, increasing competition, and higher supplier prices had slashed Marcelle’s profit to the bone over the past 12 months. The previous year, the company had posted a profit of slightly less than $8 million; for the year just completed, the company’s preaudit net income hovered at an anemic $500,000.

Inventory was the focal point of each audit of Marcelle’s financial statements. This year, inventory was doubly important. Any material overstatement discovered in the inventory account would convert a poor year profit-wise for Marcelle into a disas- trous year in which the company posted its first-ever loss.

Facing Bill on the small table that served as his makeshift desk were two stacks of workpapers, each two feet tall. Those workpapers summarized the results of exten- sive price tests, inventory observation procedures, year-end cutoff tests, an analysis of the reserve for inventory obsolescence, and various other audit procedures. Bill’s task was to assimilate all of this audit evidence into a conclusion regarding Marcelle’s inventory. Bill realized that Sam Hakes expected that conclusion to include the

1. The source for this case was a former public accountant who is now a college instructor. The names of the parties involved in the case and certain other background facts have been changed.

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410 SECTION SIX PROFESSIONAL ROLES

key catch phrases “present fairly, in all material respects” and “in accordance with accounting principles generally accepted in the United States of America.”

As Bill attempted to outline the inventory memo, he gradually admitted to himself that he had no idea whether Marcelle’s inventory dollar value was materially accu- rate. The workpaper summarizing the individual errors discovered in the inventory account reflected a net overstatement of only $72,000. That amount was not material even in reference to Marcelle’s unusually small net income. However, Bill realized that the $72,000 figure was little more than a guess.

The client’s allowance for inventory obsolescence particularly troubled Bill. He had heard a rumor that Marcelle intended to discontinue 2 of the 14 sales depart- ments in its stores. If that were true, the inventory in those departments would have to be sold at deep discounts. The collective dollar value of those two departments’ inventory approached $6 million, while the client’s allowance for inventory obsoles- cence had a year-end balance of only $225,000. Earlier in the audit, Bill had asked Sam about the rumored closing of the two departments. The typically easygoing partner had replied with a terse “Don’t worry about it.”

Bill always took his work assignments seriously and wanted to do a professional job in completing them. He believed that independent audits served an extremely important role in a free market economy. Bill was often annoyed that not all of his colleagues shared that view. Some of his coworkers seemed to have an attitude of “just get the work done.” They stressed form over substance: “Tic and tie, make the workpapers look good, and don’t be too concerned with the results. A clean opinion is going to be issued no matter what you find.”

Finally, Bill made a decision. He would not sign off on the inventory account regardless of the consequences. He did not know whether the inventory account balance was materially accurate, and he was not going to write a memo indicating otherwise. Moments later, Bill walked into the client office being used by Sam Hakes and closed the door behind him.

“What’s up?” Sam asked as he flipped through a workpaper file. “Sam, I’ve decided that I can’t sign off on the inventory account,” Bill blurted out. “What?” was Sam’s stunned, one-word reply. Bill stalled for a few moments to bolster his courage as he fidgeted with his tie.

“Well . . . like I said, I’m not signing off on the inventory account.” “Why?” By this point, a disturbing crimson shade had already engulfed Sam’s ears

and was creeping slowly across his face. “Sam . . . I just don’t think I can sign off. I mean, I’m just not sure whether the inven-

tory number is right.” “You’re . . . just not sure?” After a brief pause, Sam continued, this time pronounc-

ing each of his words with a deliberate and sarcastic tone. “You mean to tell me that you spent almost 1,000 hours on that account, and you’re just not sure whether the general ledger number is right?”

“Well . . . yeah. Ya know, it’s just tough to . . . to reach a conclusion, ya know, on an account that large.”

Sam leaned back in his chair and cleared his throat before speaking. “Mr. DeBurger, I want you to go back into that room of yours and close the door. Then you sit down at that table and write a nice, neat, very precise and to-the-point inventory memo. And hear this: I’m not telling you what to include in that memo. But you’re going to write that memo, and you’re going to have it on my desk in two hours. Understood?” Sam’s face was entirely crimson as he completed his short speech.

“Uh, okay,” Bill replied.

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CASE 6.2 BILL DEBURGER, IN-CHARGE ACCOUNTANT 411

Bill returned to the small conference room that had served as his work area for the past two months. He sat in his chair and stared at the pictures of his two-year-old twins, Lesley and Kelly, which he had taped to the wall above the phone. After a few minutes, he picked up his pencil, leaned forward, and began outlining the inventory memo.

Questions 1. What conclusion do you believe Bill DeBurger reached in his inventory memo?

Put yourself in his position. What conclusion would you have expressed in the inventory memo? Why?

2. Would you have dealt with your uncertainty regarding the inventory account differently than Bill did? For example, would you have used a different approach to raise the subject with Sam Hakes?

3. Evaluate Sam Hakes’ response to Bill’s statement that he was unable to sign off on the inventory account. In your view, did Sam deal with the situation appropriately? Was Sam’s approach “professional”? Explain.

4. Is it appropriate for relatively inexperienced auditors to be assigned the primary responsibility for such critical accounts as Marcelle Stores’ inventory? Explain.

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413

CASE 6.3

Hamilton Wong, In-Charge Accountant

After spending much of the previous three months working elbow-to-elbow with as many as six colleagues in a cramped and poorly ventilated conference room, Hamilton Wong was looking forward to moving on to his next assignment.1 Wong was an in-charge accountant on the audit staff of the San Francisco office of a large international accounting firm, the firm that had offered him a job two years earlier as he neared completion of his accounting degree at San Jose State University. His current client, Wille & Lomax, Inc., a public company and the second largest client of Wong’s office, owned a chain of retail stores in the western United States that stretched from Seattle to San Diego and as far east as Denver and Albuquerque.

Although Wille & Lomax’s stores operated under different names in different cit- ies, each stocked the same general types of merchandise, including briefcases and other leather goods, luggage and travel accessories, and a wide range of gift items, such as costume jewelry imported from Pacific Rim countries. The company also had a wholesale division that marketed similar merchandise to specialty retailers throughout the United States. The wholesale division accounted for approximately 60 percent of the company’s annual sales.

A nondescript building in downtown San Francisco, just one block from bustling Market Street, served as Wille & Lomax’s corporate headquarters. The company’s fis- cal year-end fell on the final Saturday of January. With the end of March just a few days away, Hamilton and his fellow “Willies”—the nickname that his office assigned to members of the Wille & Lomax audit engagement team—were quickly running out of time to complete the audit. Wong was well aware that the audit was behind schedule because he collected, coded, and input into an electronic spreadsheet the time worked each week by the individual Willies. He used the spreadsheet package to generate a weekly time and progress report that he submitted to Angela Sun, the senior who supervised the fieldwork on the Wille & Lomax audit.

In addition to Wong and Sun, another in-charge accountant, Lauren Hutchison, and four staff accountants had worked on the Wille & Lomax audit since early January. Wong and Hutchison knew each other well. They shared the same start date with their employer and the past two summers had attended the same weeklong staff and in-charge training sessions at their firm’s national education headquarters. Hutchison’s primary responsibility on the current year’s audit was the receivables account, but she also audited the PP&E (property, plant, and equipment) and leases accounts. Besides his administrative responsibilities, which included serving as the engagement timekeeper and maintaining the correspondence file for the audit, Wong supervised and coordinated the audit procedures for inventory, accounts pay- able, and a few smaller accounts.

Hamilton was thankful that it was late Friday afternoon. In recent weeks, with the audit deadline looming, Angela Sun had required the Wille & Lomax crew to work

1. This case is based upon the experiences of an individual previously employed by one of the major accounting firms. The names of the parties involved in this case and other background information, such as locations, have been changed.

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414 SECTION SIX PROFESSIONAL ROLES

until at least 7 p.m. each weekday except Friday, when she allowed them to leave “early” at 5 p.m. The engagement team had spent three consecutive Saturdays in the client’s headquarters and would be spending both Saturday and Sunday of the com- ing weekend hunched over their workpapers. Wong had just completed collecting and coding the hours worked during the current week by the other members of the engagement team. Now it was time for him to enter in the electronic spreadsheet his chargeable hours, which he dutifully recorded at the end of each work day in his little “black book.”

Before entering his own time, Wong decided to walk across the hall and purchase a snack in the employees’ break room. In fact, he was stalling, trying to resolve a matter that was bothering him. Less than 30 minutes earlier, Lauren Hutchison had told him that during the current week, which included the previous weekend, she had spent 31 hours on the receivables account, 18 hours on the leases account, and 3 hours on PP&E. What troubled Wong was the fact that he knew Hutchison had worked several additional hours on the Wille & Lomax audit during the current week.

This was not the first time Hutchison had underreported her hours worked. On several occasions, Wong had noticed her secretively slipping workpaper files into her briefcase before leaving for home. The next morning, those files included polished memos or completed schedules that had not existed the previous day. Wong was certain that Hutchison was not reporting the hours she spent working at home on her audit assignments. He was just as certain that each week she consciously chose to shave a few hours off the total number she had spent working at the client’s head- quarters. Collectively, Wong estimated that Hutchison had failed to report at least 80 hours she had worked on the audit.

“Eating time” was a taboo subject among auditors. Although the subject was not openly discussed, Wong was convinced that many audit partners and audit man- agers subtly encouraged subordinates to underreport their time. By bringing their jobs in near budget, those partners and managers enhanced their apparent ability to manage engagements. The most avid time-eaters among Wong’s peers seemed to be the individuals who had been labeled as “fast-track” superstars in the office.

After Hutchison had reported her time to Wong that afternoon, he had noncha- lantly but pointedly remarked, “Lauren, who are you trying to impress by eating so much of your time?” His comment had caused the normally mild-mannered Hutchison to snap back, “Hey, Dude, you are the timekeeper, not the boss. So just mind your own business.” Immediately, Wong regretted offending Hutchison, whom he considered his friend. But she stomped away before he could apologize.

Wong knew who Hutchison was trying to impress. Angela Sun would almost cer- tainly be promoted to audit manager in the summer and then become the audit man- ager on the Wille & Lomax engagement, meaning that there would be a vacancy in the all-important senior position on the engagement team. Both Hutchison and Wong also anticipated being promoted during the summer. The two new seniors would be the most likely candidates to take over the job of overseeing the fieldwork on the Wille & Lomax audit.

The in-charge accountant who handled the administrative responsibilities on the Wille & Lomax engagement was typically the person chosen to take over the senior’s role when it came open. But Wong worried that the close friendship that had devel- oped between Lauren Hutchison and Sun might affect his chances of landing the coveted assignment. Almost every day, Hutchison and Sun went to lunch together without extending even a token invitation to Wong or their other colleagues to join them. John Berardo, the audit engagement partner, would choose the new senior for

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CASE 6.3 HAMILTON WONG, IN-CHARGE ACCOUNTANT 415

the Wille & Lomax engagement, but Angela Sun would certainly have a major influ- ence on his decision.

There was little doubt in Wong’s mind that Hutchison routinely underreported the time she worked on the Wille & Lomax audit to enhance her standing with Sun and Berardo. Not that Hutchison needed to spruce up her image. She had passed the CPA exam shortly after joining the firm, had a charming personality that endeared her to her superiors and client executives, and, like both Sun and Berardo, was a Stanford graduate. Wong, on the other hand, had struggled to pass the CPA exam, was shy by nature, and had graduated from a public university.

What irritated Wong the most about his subtle rivalry with Hutchison was that during the past two weekends he had spent several hours helping her research con- tentious technical issues for Wille & Lomax’s complex lease contracts on its retail store sites. Earlier in the engagement, Hutchison had also asked him to help analyze some tricky journal entries involving the client’s allowance for bad debts. In each of those cases, Wong had not charged any time to the given accounts, both of which were Hutchison’s responsibility.

Before entering his time for the week, Wong checked once more the total hours that he had charged to date to his major accounts. For both inventory and accounts payable, he was already over budget. By the end of the audit, Wong estimated that he would “bust” the assigned time budgets for those two accounts by 20 to 25 percent each. On the other hand, Hutchison, thanks to her superior “time management” skills, would likely exceed the time budget on her major accounts by only a few hours. In fact, she might even come in under budget on one or more of her accounts, which was almost unheard of, at least on the dozen or so audits to which Wong had been assigned.

After finishing the bag of chips he had purchased in the snack room, Wong reached for the computer keyboard in front of him. In a few moments, he had entered his time for the week and printed the report that he would give to Angela Sun the following morning. After briefly glancing at the report, he slipped it into the appropriate work- paper file, turned off the light in the empty conference room, and locked the door behind him as he resolved to enjoy his brief 16-hour “weekend.”

Questions 1. Place yourself in Hamilton Wong’s position. Would you report all of your time

worked on the Wille & Lomax audit? Why or why not? Do you believe that Lauren Hutchison behaved unethically by underreporting the time she worked on that engagement? Defend your answer.

2. Academic research suggests that underreporting time on audit engagements is a common practice. What are the key objectives of tracking hours worked by individual accounts or assignments on audit engagements? What implications does the underreporting of time have for individual auditors, their colleagues, and the overall quality of independent audits?

3. What measures can accounting firms take to ensure that time budgets do not interfere with the successful completion of an audit or become dysfunctional in other ways?

4. What measures can accounting firms take to reduce the likelihood that personal rivalries among auditors of the same rank will become dysfunctional?

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417

CASE 6.4

Tommy O’Connell, Audit Senior

Tommy O’Connell had been a senior with one of the major international account- ing firms for less than one month when he was assigned to the audit engagement for the Altamesa Manufacturing Company.1 Tommy worked out of his firm’s Fort Worth, Texas, office, while Altamesa was headquartered in Amarillo, the “capital” of the Texas Panhandle. The young senior realized that being assigned to the tough Altamesa engagement signaled that Jack Morrison, the Altamesa audit partner and the office managing partner, regarded his work highly. Serving as the audit senior on the Altamesa job would allow Tommy to become better acquainted with Morrison. Despite the challenges and opportunities posed by his new assignment, Tommy did not look forward to spending three months in Amarillo, a five-hour drive from Fort Worth. This would be his first assignment outside of Fort Worth since his marriage six months earlier. He dreaded breaking the news to his wife, Suzie, who often com- plained about the long hours his job required.

Altamesa manufactured steel girders used in the construction and renovation of bridges in West Texas, New Mexico, Colorado, and Oklahoma. The company’s busi- ness was very cyclical and linked closely to the funding available to municipalities in Altamesa’s four-state market area. To learn more about the company and its per- sonnel, Tommy arranged to have lunch with Keri Hansel, the audit senior on the Altamesa job the two previous years. According to Keri, Altamesa’s management took aggressive positions regarding year-end expense accruals and revenue recogni- tion. The company used the percentage-of-completion method to recognize revenue since its sales contracts extended over two to five years. Keri recounted several dis- putes with the company’s chief accountant regarding the estimated stage of comple- tion of jobs in progress. In an effort to “front-load” as much of the profit on jobs as possible, the chief accountant typically insisted that jobs were further along than they actually were.

Speaking with Keri made Tommy even more apprehensive about tackling the Altamesa engagement. But he realized that the job gave him an excellent chance to strengthen his fast-track image within his office. To reach his goal of being promoted to manager by his fifth year with the firm, Tommy needed to prove himself on diffi- cult assignments such as the Altamesa engagement.

An Unpleasant Surprise for Tommy It was late May, just two weeks before Tommy would be leaving for Amarillo to begin the Altamesa audit—the company had a 30 June fiscal year-end. Tommy, Jack Morrison, and an audit manager were having lunch at the Cattleman’s Restaurant in the Cowtown district of north Fort Worth.

“Tommy, I’ve decided to send Carl with you out to Amarillo. Is that okay?” asked Jack Morrison.

“Uhh . . . sure, Jack. Yeah, that’ll be fine,” Tommy replied.

1. This case is based upon an actual series of events. Names and certain background information have been changed to conceal the identities of the individuals involved in the case.

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418 SECTION SIX PROFESSIONAL ROLES

“Of all people,” Tommy thought, “he would send Carl Wilmeth to Amarillo with me.” Carl was a staff accountant with only a few months’ experience, having been hired in the middle of the just-completed busy season. Other than being auditors and approximately the same age, the two young men had little in common. Tommy was from Lockettville, a small town in rural West Texas, while Carl had been raised in the exclusive Highland Park community of north central Dallas. Texas Tech, a large state-supported university, was Tommy’s alma mater. Carl had earned his accounting degree from a small private college on the East Coast.

Tommy did not appreciate Carl’s cocky attitude, and his lack of experience made him a questionable choice in Tommy’s mind for the Altamesa engagement. As he tried to choke down the rest of his prime rib, Tommy recalled the complaints he had heard about Carl’s job performance. Over the past three months, Carl had worked on two audits. In both cases, he had performed admirably—too admirably, in fact, com- ing in well under budget on his assigned tasks.

On one engagement, Carl had completed an assignment in less than 60 hours when the audit budget allotted 100 hours; the previous year, 110 hours had been required to complete that same task. Both seniors who had supervised Carl suspected that he had not completed all of his assigned audit procedures, although he signed off on those procedures on the audit program. The tasks assigned to Carl had been large-scale tests of transactions that involved checking invoices, receiving reports, purchase orders, and other documents for various attributes. Given the nature of the tests, the seniors would have had difficulty confirming their suspicions.

“Boss” Tommy Six weeks later, in early July, the Altamesa audit was in full swing. Carl had just fin- ished his third assigned task on the job, in record time, of course. “Boss, here’s that disbursements file,” Carl said as he plopped a large stack of workpapers in front of Tommy. “Anything else you want me to do this afternoon? Since I’m way ahead of schedule, maybe I should take off and work on my tan out on the golf course.”

“No, Carl. I think we have plenty to keep you busy right here.” Tommy was agitated but he tried not to let it show. “Why don’t you pull out the contracts file and then talk to Rachel Simpson in the sales office. Get copies of any new contracts or proposals over the past year and put them in the contracts file.”

At this point, Tommy simply did not have time to review Carl’s cash disbursements workpapers. He was too busy trying to untangle Altamesa’s complex method of allo- cating overhead costs to jobs in process. Later that afternoon, he had an appoint- ment to meet with the chief accountant and a production superintendent to discuss the status of a large job. Tommy and the chief accountant had already butted heads on two occasions regarding a job’s stage of completion. Keri had been right: the chief accountant clearly meant to recognize profit on in-progress jobs as quickly as possible.

With four decades of experience, Scrooge—a nickname Keri had pinned on the chief accountant—obviously considered the young auditors a nuisance and did not appreciate their probing questions. Each time Tommy asked him a question regard- ing an important issue, the chief accountant registered his disgust by pursing his lips and running his hand through his thinning hair. He then responded with a rambling, convoluted answer intended to confuse rather than inform.

To comprehend Altamesa’s accounting decisions for its long-term contracts, Tommy spent several hours of nonchargeable time each night in his motel room flip- ping through copies of job order worksheets and contracts. Occasionally, he referred

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CASE 6.4 TOMMY O’CONNELL, AUDIT SENIOR 419

to prior-year workpapers, his firm’s policy and procedures manual, and even his tat- tered cost accounting textbook from his college days. Carl, on the other hand, spent most of his evenings in the motel’s club being taught the Texas Two-step and Cotton- eyed Joe by several new friends he had acquired.

During July and August, Tommy and Carl worked 50 to 60 hours per week on the Altamesa engagement. Several times, Tommy wondered whether it was worthwhile to work so hard to earn recognition as a “superstar” senior. He was also increas- ingly concerned about the impact of his fast-track strategy on his marriage. When he tried to explain to Suzie that the long hours and travel would pay off when he made partner, she was unimpressed. “Who cares if you make partner? I just want to spend more time with my husband,” was her stock reply.

To Tell or Not to Tell Finally, late August rolled around and the Altamesa job was almost complete. Jack Morrison had been in Amarillo for the past three days combing through the Altamesa workpapers. Nothing seemed to escape Morrison’s eagle eye. Tommy had spent 12 hours per day since Morrison had arrived, tracking down missing invoices, check- ing on late confirmations, and tying up dozens of other loose ends. Carl was already back in Fort Worth, probably working on his golf swing. Morrison had allowed Carl to leave two days earlier after he had finished clearing the review comments in his workpaper files.

“Tommy, I have to admit that I was a little concerned about sending a light senior out to run this audit. But, by golly, you have done a great job.” Morrison did not look up as he signed off on the workpapers spread before him on Altamesa’s conference table. “You know, this kid Carl does super work. I’ve never seen cleaner, more orga- nized workpapers from a staff accountant.”

Tommy grimaced as he sat next to Morrison at the conference table. “Yeah, right. They should look clean, since he didn’t do half of what he signed off on,” Tommy thought. Here was his opportunity. For the past several weeks, Tommy had planned to sit down with Morrison and talk to him regarding Carl’s job performance. But now he was reluctant to do so. How do you tell a partner that you suspect much of the work he is reviewing may not have been done? Besides, Tommy realized that as Carl’s immediate supervisor, he was responsible for that work. Tommy knew that he was facing a no-win situation. He leaned back in his chair and remained silent, hoping that Morrison would hurry through the last few workpaper files so they could make it back to Fort Worth by midnight.

E P I L O G U E Tommy never informed Jack Morrison of his suspicions regarding Carl’s work. Thankfully, no problems—of a legal nature—ever arose on the jobs to which Carl was assigned. After passing the CPA exam on his first attempt, Carl left the accounting firm and enrolled in a prestigious MBA program. Upon graduation,

Carl accepted a job on Wall Street with one of the large investment banking firms. Tommy reached his goal of being promoted to audit manager within five years. One year later, he decided that he was not cut out to be a partner and resigned from the firm to accept a position in private industry.

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420 SECTION SIX PROFESSIONAL ROLES

Questions 1. Compare and contrast the professional roles of an audit senior and a staff

accountant. In your analysis, consider the different responsibilities assigned to each role, the job-related stresses that individuals in the two roles face, and how each role contributes to the successful completion of an audit engagement. Which of these two roles is (a) more important and (b) more stressful? Defend your choices.

2. Assume that you are Tommy O’Connell and have learned that Carl Wilmeth will be working for you on the Altamesa audit engagement. Would you handle this situation any differently than Tommy did? Explain.

3. Again, assume that you are Tommy. Carl is badgering you for something to do midway through the Altamesa job. You suspect that he is not completing all of his assigned procedures, but at the time you are wrestling with an important accounting issue facing the client. What would you do at this point? What could you do to confirm your suspicions that Carl is not completing his assignments?

4. Now, assume that Jack Morrison is reviewing the Altamesa workpapers. To date, you (Tommy) have said nothing to Morrison about your suspicions regarding Carl. Do you have a professional responsibility to raise this matter now with Morrison? Explain.

5. Assume that at some point Tommy told Morrison that he suspected Carl was not completing his assigned tasks. The only evidence Tommy had to support his theory was the fact that Carl had come in significantly under budget on every major task assigned to him over a period of several months. If you were Jack Morrison, how would you have handled this matter?

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421

CASE 6.5

Avis Love, Staff Accountant

“Oh no, not Store 51,” Avis Love moaned under her breath. For the third time, Avis compared the dates listed in the cash receipts journal with the corresponding dates on the bank deposit slips. Avis shook her head softly and leaned back in her chair. There was no doubt in her mind now. Mo Rappelle had definitely held open Store 51’s cash receipts journal at the end of October.1

Avis Love was a staff accountant with the Atlanta office of a large international accounting firm. Several months earlier, Avis had graduated with an accounting degree from the University of Alabama at Birmingham. Although she did not plan to pursue a career in public accounting, Avis had accepted one of the several job offers she received from major accounting firms. The 22-year-old wanted to take a two- or three-year “vacation” from college, while at the same time accumulating a bankroll to finance three years of law school. Avis intended to practice law with a major firm for a few years and then return to her hometown in eastern Alabama and set up her own practice.

For the past few weeks, Avis had been assigned to the audit engagement for Lowell, Inc., a public company that operated nearly 100 retail sporting goods stores scattered across the South. Avis was nearing completion of a year-end cash receipts cutoff test for a sample of 20 Lowell stores. The audit procedures she had performed included preparing a list of the cash receipts reported in each of those stores’ accounting records during the last five days of Lowell’s fiscal year, which ended 31 October. She had then obtained the relevant bank statements for each of the stores to determine whether the cash receipts had been deposited on a timely basis. For three of the stores in her sample, the deposit dates for the cash receipts ranged from three to seven days following the dates the receipts had been entered in the cash receipts journal. The individual store managers had apparently backdated cash receipts for the first several days of the new fiscal year, making it appear that the receipts had occurred in the fiscal year under audit by Avis’s firm.

Avis had quickly realized that the objective of the store managers was not to over- state their units’ year-end cash balances. Instead, the managers intended to inflate their recorded sales. Before Avis began the cutoff test, Teddy Tankersley, the senior assigned to the Lowell audit and Avis’s immediate superior, had advised her that there was a higher-than-normal risk of cash receipts and sales cutoff errors for Lowell this year. The end of Lowell’s fiscal year coincided with the end of a three-month sales promotion. This campaign to boost Lowell’s sagging sales included bonuses for store managers who exceeded their quarterly sales quota. This was the first time that Lowell had run such a campaign and it was a modest success. Fourth-quarter sales for the fiscal year just ended topped the corresponding sales for the previous fiscal year by 6 percent.

When Avis uncovered the first instance of backdated cash receipts, she had felt a noticeable surge of excitement. In several months of tracing down invoices and receiving reports, ticking and tying, and performing other mundane tests, the young

1. This case was developed from an actual series of events. Names, locations, and certain other back- ground information have been changed to conceal the identities of the individuals involved in the case.

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422 SECTION SIX PROFESSIONAL ROLES

accountant had occasionally found isolated errors in client accounting records. But this was different. This was fraud.

Avis had a much different reaction when she uncovered the second case of back- dated cash receipts. She had suddenly realized that the results of her cutoff test would have “real world” implications for several parties, principally the store man- agers involved in the scheme. During the past few months, Avis had visited six of Lowell’s retail stores to perform various interim tests of controls and to observe physi- cal inventory procedures. The typical store manager was in his or her early 30s, mar- ried, with one or two small children. Because of Lowell’s miserly pay scale, the stores were chronically understaffed, meaning that the store managers worked extremely long hours to earn their modest salaries.

No doubt, the store managers who backdated sales to increase their bonuses would be fired immediately. Clay Shamblin, Lowell’s chief executive officer (CEO), was a hard-nosed businessman known for his punctuality, honesty, and work ethic. Shamblin exhibited little patience with subordinates who did not display those same traits.

When Avis came to the last store in her sample, she had hesitated. She realized that Mo Rappelle managed Store 51. Three weeks earlier, Avis had spent a long Saturday afternoon observing the physical inventory at Store 51 on the outskirts of Atlanta. Although the Lowell store managers were generally courteous and accommodating, Mo had gone out of his way to help Avis complete her tasks. Mo allowed Avis to use his own desk in the store’s cramped office, shared a pizza with her during an after- noon break, and introduced her to his wife and two small children who dropped by the store during the afternoon.

“Mo, what a stupid thing to do,” Avis thought after reviewing the workpapers for the cutoff tests a final time. “And for just a few extra dollars.” Mo had apparently backdated cash receipts for only the first two days of the new year. According to Avis’s calcula- tions, the backdated sales had increased Mo’s year-end bonus by slightly more than $100. From the standpoint of Lowell, Inc., the backdated sales for Mo’s store clearly had an immaterial impact on the company’s operating results for the year just ended.

After putting away the workpapers for the cutoff test, a thought dawned on Avis. The Lowell audit program required her to perform cash receipts cutoff tests for 20 stores . . . any 20 stores she selected. Why not just drop Store 51 from her sample and replace it with Store 52 or 53 or whatever?

E P I L O G U E Avis brooded over the results of her cutoff test the remainder of that day at work and most of that evening. The following day, she gave the workpa- per file to Teddy Tankersley. Avis reluctantly told Teddy about the backdated cash receipts and sales she had discovered in three stores: Store 12, Store 24, and Store 51. Teddy congratulated Avis on her thorough work and told her that Clay Shamblin would be very interested in her findings.

A few days later, Shamblin called Avis into his office and thanked her for uncovering the

backdated transactions. The CEO told her that the company’s internal auditors had tested the year-end cash receipts and sales cutoff for the remaining 72 stores and identified seven ad- ditional store managers who had tampered with their accounting records. As Avis was leaving the CEO’s office, he thanked her once more and assured her that the store managers involved in the scam “would soon be looking for a new line of work . . . in another part of the country.”

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CASE 6.5 AVIS LOVE, STAFF ACCOUNTANT 423

Questions 1. Would it have been appropriate for Avis to substitute another store for Store 51

after she discovered the cutoff errors in that store’s accounting records? Defend your answer.

2. Identify the parties potentially affected by the outcome of the ethical dilemma faced by Avis Love. What obligation, if any, did Avis have to each of these parties?

3. Does the AICPA’s Code of Professional Conduct prohibit auditors from developing friendships with client personnel? If not, what measures can auditors take to prevent such friendships from interfering with the performance of their professional responsibilities?

4. Identify the key audit objectives associated with year-end cash receipts and sales cutoff tests.

5. What method would you have recommended that Avis or her colleagues use in deciding whether the cutoff errors she discovered had a material impact on Lowell’s year-end financial statements? Identify the factors or benchmarks that should have been considered in making this decision.

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425

CASE 6.6

Charles Tollison, Audit Manager

“No, that’s okay, Bea. I’ll write that memo this weekend and send it to Mr. Fielder. You go on home.”1

“Are you sure, Chuck? I don’t mind staying a while longer.” “Thanks, Bea, but you’ve already put in too much overtime this week.” After he sent his secretary home, Charles Tollison spent several minutes shuffling

through the audit workpapers and correspondence stacked on his desk, trying to decide what work he would take home over the weekend. Finally, only one deci- sion remained. Tollison couldn’t decide whether to take the inventory file with him. Compulsive by nature, Tollison knew that if he took the inventory file home, he would have to complete his review of that file, which would increase his weekend workload from 6 hours to more than 12 hours. As he stewed over his decision, Tollison stepped to the window of his office and idly watched the rush-hour traffic on the downtown streets several stories below.

It was nearly 6:30 on a Friday evening in early August. Charles Tollison, an audit manager for a large international accounting firm, had suffered through a tough week. His largest audit client was negotiating to buy a smaller company within its industry. For the past two months, Tollison had supervised the fieldwork on an intensive acquisition audit of the competitor’s accounting records. The client’s chief executive officer (CEO) suspected that the competitor’s executives had embellished their firm’s financial data in anticipation of the proposed buyout. Since the client was overextending itself financially to acquire the other firm, the CEO wanted to be sure that its financial data were reliable. The CEO’s principal concern was the valuation of the competitor’s inventory, which accounted for 45 percent of its total assets.

The client’s CEO had requested that Tollison be assigned to the acquisition audit because she respected Tollison and the quality of his work. Normally, an audit man- ager spends little time “in the trenches” supervising day-to-day audit procedures. Because of the nature of this engagement, however, Tollison had felt it necessary to spend 10 hours per day, six and seven days per week, poring over the accounting records of the takeover candidate with his subordinates.

As Tollison stared at the gridlocked streets below, he was relieved that the acquisi- tion audit was almost complete. After he tied up a few loose ends in the inventory file, he would turn the workpapers over to the audit engagement partner for a final review.

Tollison’s tough week had been highlighted by several contentious meetings with client personnel, a missed birthday party for his eight-year-old daughter, and an early breakfast Thursday morning with his office managing partner, Walker Linton. During that breakfast, Linton had notified Tollison that he had been passed over for promo- tion to partner—for the second year in a row. The news had been difficult for Tollison to accept.

For more than 13 years, Tollison had been a hard-working and dedicated employee of the large accounting firm. He had never turned down a difficult assignment, never

1. This case was developed from information obtained from a CPA employed for many years with a large international accounting firm.

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426 SECTION SIX PROFESSIONAL ROLES

complained about the long hours his work required, and made countless personal sacrifices, the most recent being the missed birthday party. After informing Tollison of the bad news, Linton had encouraged him to stay with the firm. Linton promised that the following year he would vigorously campaign for Tollison’s promotion and “call in all favors” owed to him by partners in other offices. Despite that promise, Tollison realized that he had only a minimal chance of being promoted to partner. Seldom were two-time “losers” ticketed for promotion.

Although he had been hoping for the best, Tollison had not expected a favor- able report from the Partner Selection Committee. In recent weeks, he had gradu- ally admitted to himself that he did not have the profile for which the committee was searching. Tollison was not a rainmaker like his friend and fellow audit man- ager, Craig Allen, whose name appeared on the roster of new partners to be for- mally announced the following week. Allen was a member of several important civic organizations and had a network of well-connected friends at the local country club. Those connections had served Allen well, allowing him to steer several new clients to the firm in recent years.

Instead of a rainmaker, Tollison was a technician. If someone in the office had a difficult accounting or auditing issue to resolve, that individual went first to Tollison, not to one of the office’s six audit partners. When a new client posed complex tech- nical issues, the audit engagement partner requested that Tollison be assigned to the job. One reason Tollison was a perfect choice for difficult engagements was that he micromanaged his jobs, insisting on being involved in every aspect of them. Tollison’s management style often resulted in his “busting” time budgets for audits, although he seldom missed an important deadline. To avoid missing deadlines when a job was nearing completion, Tollison and the subordinates assigned to his engage- ments would work excessive overtime, including long weekend stints.

Finally, Tollison turned away from his window and slumped into his chair. As he sat there, he tried to drive away the bitterness that he was feeling. “If Meredith hadn’t left the firm, maybe I wouldn’t be in this predicament,” Tollison thought. Three years earlier, Meredith Oliveti, an audit partner and Tollison’s closest friend within the firm, had resigned to become the chief financial officer (CFO) of a large client. Following Oliveti’s resignation, Tollison had no one within the firm to sponsor him through the tedious and political partner selection process. Instead, Tollison had been “lost in the shuffle” with the dozens of other hard-working, technically inclined audit manag- ers within the firm who aspired to a partnership position.

Near the end of breakfast Thursday morning, Walker Linton had mentioned to Tollison the possibility that he could remain with the firm in a senior manager posi- tion. In recent years, Tollison’s firm had relaxed its “up or out” promotion policy. But Tollison was not sure he wanted to remain with the firm as a manager with no pos- sibility of being promoted to partner. Granted, there were clearly advantages associ- ated with becoming a permanent senior manager. For example, no equity interest in the firm meant not absorbing any portion of its future litigation losses. On the other hand, in Tollison’s mind accepting an appointment as a permanent senior manager seemed equivalent to having “career failure” stenciled on his office door.

Ten minutes till seven, time to leave. Tollison left the inventory file lying on his desk as he closed his bulging briefcase and then stepped toward the door of his office. After flipping off the light switch, Tollison paused momentarily. He then grudg- ingly turned and stepped back to his desk, picked up the inventory file, and tucked it under his arm.

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CASE 6.6 CHARLES TOLLISON, AUDIT MANAGER 427

Questions 1. Do you believe Charles Tollison was qualified for a partnership position with his

firm? Explain.

2. Did Tollison’s firm treat him “fairly”? Why or why not?

3. Identify the criteria you believe large international accounting firms should use when evaluating individuals for promotion to partner. In your opinion, which of these criteria should be most heavily weighted by these firms? Should smaller accounting firms establish different criteria for evaluating individuals for promotion to partner? Explain.

4. Discuss the advantages and disadvantages of the “up or out” promotion policy followed by many accounting firms.

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7

SECTION 7

PROFESSIONAL ISSUES

Case 7.1 Ligand Pharmaceuticals

Case 7.2 Sarah Russell, Staff Accountant

Case 7.3 Bud Carriker, Audit Senior

Case 7.4 Hopkins v. Price Waterhouse

Case 7.5 Fred Stern & Company, Inc. (Ultramares Corporation v. Touche et al.)

Case 7.6 First Securities Company of Chicago (Ernst & Ernst v. Hochfelder et al.)

Case 7.7 Elizabeth Wallace, Audit Senior

Case 7.8 Frank Coleman, Staff Accountant

Case 7.9 Olivia Thomas, Audit Senior

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431

CASE 7.1

Ligand Pharmaceuticals

In the late 1990s, James Fazio reached what many CPAs consider the pinnacle of suc- cess in the accounting profession, namely, partnership in one of the Big Four public accounting firms. For more than a decade, Fazio served as an audit partner with Deloitte & Touche in that firm’s San Diego, California, practice office. Similar to his colleagues within Deloitte and the other major accounting firms, Fazio’s professional life was disrupted by the Enron and WorldCom debacles. The sudden collapse of those two large companies following the turn of the century prompted a public out- cry to impose more rigorous regulatory controls over the financial reporting func- tion for publicly owned companies. The federal government’s response to that outcry would further complicate the already complex and stressful nature of James Fazio’s professional role as an audit partner with a Big Four accounting firm.

Peek-A-Boo In the summer of 2002, the U.S. Congress hurriedly passed the Sarbanes–Oxley Act (SOX). The SOX legislation contained the most far-reaching financial reporting reforms at the federal level since the passage of the Securities Act of 1933 and the Securities Exchange Act of 1934. The reforms included a requirement that public companies have their internal controls over financial reporting audited by an inde- pendent accounting firm. That requirement, which became effective for most com- panies in 2004, forced U.S. companies to spend billions of dollars to rethink and, in many cases, completely overhaul their internal control systems.

The SOX legislation was an economic boon for Deloitte and the other Big Four accounting firms since those firms were ideally suited to provide the thousands of internal control audits mandated by SOX. To take full advantage of this large new revenue stream, these firms redesigned their audit processes, retooled their organi- zational structures, and hired a large number of new employees.

SOX also established a new regulatory structure for the independent audit func- tion that had far-reaching implications for the major accounting firms. The role of the new Public Company Accounting Oversight Board (PCAOB) was to strengthen and improve the independent audit function for public companies and thereby mini- mize the likelihood of “audit failures.” Many parties have alleged that the Enron and WorldCom fiascoes could have been avoided, or at least mitigated, if those compa- nies’ financial statements had been audited more rigorously.

Based in Washington, D.C., the PCAOB, commonly referred to as “Peek-a-boo” by auditing practitioners, falls under the regulatory purview of the Securities and Exchange Commission (SEC). The PCAOB’s operations are overseen by five board members appointed by the SEC; it has several hundred employees and an annual operating budget exceeding $100 million. The agency’s regulatory mandate includes registering and monitoring accounting firms that audit public companies required to file periodic financial statements with the SEC. Other responsibilities of the PCAOB include establishing auditing, ethical, and quality control standards for those firms and carrying out disciplinary investigations.

The years immediately following the passage of SOX presented exciting and profit- able opportunities for the Big Four accounting firms but posed enormous challenges

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432 SECTION SEVEN PROFESSIONAL ISSUES

for them as well. No one knew exactly how the new regulatory agenda and infra- structure would impact the nature of financial reporting and the independent audit function in the United States. Despite the uncertainty they faced, James Fazio and other Big Four audit partners had more pressing concerns at the time, namely, the everyday “business” of, and professional responsibilities associated with, supervising the audits of their clients.

Deloitte’s 2003 Ligand Audit In early 2004, the 43-year-old Fazio was overseeing the 2003 audit of Ligand Pharmaceuticals, a San Diego–based company whose stock was traded on the NASDAQ exchange. As the audit engagement partner for Ligand, Fazio had a wide range of responsibilities. The following excerpts from Deloitte’s Accounting and Auditing Practice Manual at the time addressed the role and responsibilities of an audit engagement partner.

It is the responsibility of the Engagement Partner to form the audit opinion, or to dis- claim an opinion, on the financial statements.

The Engagement Partner has the final responsibility for the planning and performance of the audit engagement, including the assignment, on-the-job training, and audit work of professional staff, and the implementation of the decisions concerning mat- ters that have been the subject of consultation . . .

The knowledge and skills of an Engagement Partner should be matched with the needs and characteristics of the engagement.

For several years, James Fazio had been involved in his office’s “High Technology Group.” Because of his experience with emerging growth companies, Fazio seemed well suited to serve as the audit engagement partner for Ligand, which was still in a developmental stage. In company press releases, Ligand described itself as an “emerging R&D and royalty-driven biotechnology company.” The company’s princi- pal products included a painkiller and several cancer treatment drugs. The company also had several new products under development. Rising expectations for the com- pany’s future prospects had caused its stock price to soar from under $4 per share in early 2003 to nearly $24 per share in early 2004, despite the company never having reported an operating profit.

Deloitte requires each audit engagement team to assess the degree of “engagement risk” posed by a given audit.1 Fazio and his subordinates concluded that the 2003 Ligand audit posed a “greater than normal” degree of engagement risk due to ques- tions surrounding Ligand’s accounting for sales returns. Ligand’s distribution channel consisted principally of three large drug wholesalers. These wholesalers purchased Ligand’s products and then marketed them to pharmacies and other healthcare facili- ties throughout the United States. Ligand recorded product shipments made to the three wholesalers as consummated sales transactions although the wholesalers had the right to return any products that they did not “sell through” to their customers. Because of this revenue recognition policy, Ligand was required to record a reserve (allowance) for expected future sales returns at the end of each accounting period.

By early 2004 when Deloitte was auditing Ligand’s 2003 financial statements, the company had been marketing its major products for only a short period of time, which meant that Ligand’s accountants had limited historical experience on which

1. The three levels of engagement risk that can be assigned to a given audit include “normal,” “greater than normal,” and “much greater than normal.”

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CASE 7.1 LIGAND PHARMACEUTICALS 433

to base their estimates of future sales returns. Complicating matters was the difficulty Ligand had in obtaining sales and inventory data from its three wholesalers.

Ligand typically shipped product to those wholesalers 12 months before the expi- ration date of the given product. The wholesalers generally had the right to return product received from Ligand in a 12-month window that extended 6 months on either side of a product’s expiration date. To properly assess the quantity of future sales returns, Ligand’s accounting staff needed up-to-date “sell-through” data from its wholesalers. However, the three wholesalers frequently failed to provide that data on a timely basis. In fact, Ligand often received large and unexpected shipments of product returns from the three wholesalers.

The limited sales returns data available to Ligand during 2003 suggested that the company was significantly underestimating its rate of product returns. For example, one product had experienced rates of return ranging from 13 percent to as high as 20 percent on “open lots.”2 Company management was convinced that those return rates were not representative of the overall return rate that product would eventually experience. As a result, management instructed the company’s accountants to apply a much more modest 2.5 percent return rate when determining the product’s 2003 year-end allowance for future sales returns.

Shortly before Deloitte completed the 2003 Ligand audit in early March 2004, Ligand received additional information from its wholesalers regarding the return rates being experienced by its major products. Although this information was available from the company’s accounting staff, the Deloitte auditors did not review it. The updated sales returns data, similar to the earlier data that had been reviewed by the Deloitte auditors, indicated that the 31 December 2003, allowance for future sales returns was inadequate. In some cases, the returns received in early 2004 for products sold in 2003 exceeded those products’ total 2003 year-end provision for sales returns.

Fazio was aware of the difficulty Ligand had in estimating its future sales returns and the fact that the projected return rates being applied by the company appeared insufficient given the actual sales returns data available from the company’s whole- salers. Despite this knowledge, Fazio authorized the issuance of an unqualified opin- ion on Ligand’s 2003 financial statements on 10 March 2004.

The following month, Fazio supervised Deloitte’s interim review of Ligand’s financial statements for the first quarter of 2004. During that engagement, Fazio and his subor- dinates obtained Ligand’s sales returns data for the first two months of fiscal 2004. Those data alone demonstrated that the year-end allowance for sales returns was significantly understated. However, Ligand’s accounting staff also provided forecast data to the auditors indicating that the company would experience a large amount of additional product returns from fiscal 2003 sales during the remaining months of 2004. Despite the considerable evidence that Ligand’s 2003 year-end allowance for sales returns was materially understated, Fazio failed to recommend that the com- pany recall and restate its 2003 financial statements.

The Trials and Tribulations of James Fazio The contentious accounting issues posed by Ligand were not the only challenges that James Fazio faced during the 2003 audit of that company. Several months before that audit began, Fazio’s immediate superior, the partner in charge of Deloitte’s San

2. Ligand used the term “lot” in reference to a given quantity of items of the same product that were manufactured at the same time and had the same expiration date. The term “open lot” referred to a product shipment for which the given wholesaler still had a right to return the unsold inventory from that shipment.

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434 SECTION SEVEN PROFESSIONAL ISSUES

Diego audit practice, asked to meet with him. During that meeting, Fazio was told that concerns were being expressed about his job performance. In fact, members of Deloitte’s management had suggested that Fazio no longer be allowed to supervise audits of public companies.

In February 2004, during the course of the 2003 Ligand audit, Fazio’s immediate superior met with him once more. During this meeting, Fazio was told that he was perceived as a “quality risk” and was “counseled to resign from the firm.”3 Several of Deloitte’s top partners had been involved in the decision to ask for Fazio’s resigna- tion. These partners included the director of Deloitte’s Risk Management Program, the regional audit managing partner for Deloitte’s Pacific Southwest Region, and Deloitte’s national audit managing partner.

On 5 March 2004, the San Diego audit managing partner and the regional audit managing partner met with Fazio. Following that meeting, the regional audit manag- ing partner sent an e-mail to the national audit managing partner that summarized the discussions that took place during the meeting. The e-mail documented the rea- sons why Fazio was being asked to resign from Deloitte.

Among the reasons given were the views of certain members of Deloitte’s manage- ment that the Engagement Partner [Fazio] did not have the skills to adequately super- vise public company engagements and other engagements with above-average risk profiles and that the Engagement Partner [Fazio] was not suited to handling complex or risky engagements.4

Five days later, on 10 March 2004, Fazio signed the unqualified audit opinion issued by Deloitte on Ligand’s 2003 financial statements. Fazio remained the audit engage- ment partner for Ligand following the issuance of that audit report.

On 5 August 2004, Deloitte resigned as Ligand’s independent auditor. The price of Ligand’s stock declined sharply following Deloitte’s abrupt and unexpected resigna- tion. From its high-water mark of nearly $24 per share in April 2004, the stock would eventually fall to under $1.50 per share by late 2008.

3. PCAOB, “Order Instituting Disciplinary Proceedings, Making Findings and Imposing Sanctions: In the Matter of Deloitte & Touche LLP,” PCAOB Release No. 105-2007-005, 10 December 2007, 7. 4. Ibid. 5. J. McEntee, “Ligand to Restate Financials Back to 2002,” sandiego.com, 20 May 2005. 6. Ibid.

E P I L O G U E In May 2005, Ligand’s management announced that the company would be restating its finan- cial statements for 2002, 2003, and the first three quarters of 2004. Management reported that a joint investigation by the company’s audit committee and new audit firm, BDO Seidman, had revealed material errors in those finan- cial statements. The errors resulted principally from “improperly recognizing revenue on prod- uct shipments to distributors.”5 The financial restatement released by Ligand later in 2005

reduced the company’s previously reported rev- enues for 2003 by 52 percent or $59 million in total. The company also increased its reported operating loss for 2003 by 250 percent.

Ligand insisted that the joint investigation by its audit committee and BDO Seidman had “found no evidence of improper or fraudulent actions or practices by any member of manage- ment or that management acted in bad faith in adopting and administering the company’s historical revenue recognition policies.”6 The

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CASE 7.1 LIGAND PHARMACEUTICALS 435

7. Although the PCAOB issued the disciplinary reports in this case, SEC and PCAOB personnel were involved in the related investigations. In 2005, the SEC had announced that it was launching an independent investigation of Ligand. The federal agency apparently completed that investigation with- out imposing sanctions on Ligand or any Ligand executive or employee. 8. PCAOB, “PCAOB Issues Disciplinary Orders against Deloitte & Touche LLP and a Former Audit Partner,” www.pcaobus.org/News_and_Events/2007/12-10.aspx, 10 December 2007. 9. Ibid. 10. Ibid. 11. Ibid.

company also reported that it intended to adopt a new revenue recognition model based upon sell-through accounting under which revenue would not be recognized until the company’s wholesalers had sold Ligand’s products to their customers.

On 10 December 2007, the PCAOB issued joint disciplinary releases announcing sanc- tions imposed on James Fazio and Deloitte & Touche. These sanctions stemmed from Fazio’s involvement in the 2003 Ligand audit.7 The PCAOB barred James Fazio from being associ- ated with a PCAOB-registered public account- ing firm for two years. In a PCAOB press release also issued on 10 December 2007, an agency spokesperson reported that Fazio had violated several professional auditing standards during the 2003 Ligand audit.

Mr. Fazio failed to perform appropriate and adequate audit procedures related to Ligand’s reported revenue from sales of products for which a right of return existed and failed to supervise others adequately to ensure the performance of such procedures.

Mr. Fazio neither performed nor ensured the performance of procedures that adequately took into account the existence of factors indi- cating that Ligand’s ability to make reason- able estimates of product returns may have been impaired.

Mr. Fazio neither performed nor ensured the performance of procedures that adequately took into account the extent to which Ligand had consistently and substantially underesti- mated its product returns.

In auditing Ligand’s reported revenues, Mr. Fazio failed to [exercise] . . . the due care and professional skepticism required under the circumstances.

He also failed to identify and appropriately address issues concerning Ligand’s policy of excluding certain types of returns from its esti- mates of future returns and the adequacy of Ligand’s disclosure of this accounting policy.8

The PCAOB publicly censured Deloitte and fined the firm $1 million for failing to take “meaningful steps to assure the quality of the audit work”9 on the 2003 Ligand audit engage- ment. According to the PCAOB spokesperson, prior to and during the 2003 Ligand audit, “Certain members of Deloitte’s management concluded that Mr. Fazio should be removed from public company audits” and that “he should be asked to resign from the firm.”10 The spokesperson went on to note that despite the grave concerns expressed regarding Mr. Fazio’s competence, he was allowed to continue as the engagement partner for the 2003 Ligand audit.

The PCAOB’s Director of Enforcement and Investigations issued a separate statement on the responsibility of registered accounting firms to ensure that their partners are competent to perform public company audits.

Registered public accounting firms must take reasonable steps to assure that their audit partners and other audit professionals are competent to conduct public audits. When concerns about an auditor’s competency rise, a firm must act with dispatch to protect audit quality. The firm [Deloitte] failed to meet the Board’s auditing standards in the audit led by Mr. Fazio.11

The sanctions imposed on Deloitte were the first levied on a Big Four accounting firm by the PCAOB. A former SEC official noted that the Ligand case was a milestone in the new agen- cy’s short regulatory history. “It shows that the PCAOB’s Enforcement Division is fully mature and also that we should expect to see within

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436 SECTION SEVEN PROFESSIONAL ISSUES

Questions 1. Describe what you believe is implied by the term “engagement risk.” What

are the key factors likely considered by Deloitte and other audit firms when assessing engagement risk? How, if at all, are auditors’ professional responsibilities affected when a client poses a higher-than-normal degree of engagement risk?

2. What quality control mechanisms should major accounting firms have in place to ensure that audit partners have the proper training and experience to supervise audit engagements?

3. Identify the accounting standards and concepts that dictate the proper accounting treatment for sales returns. How were these standards and concepts violated by Ligand?

4. During the review of Ligand’s first-quarter financial statements for 2004, the Deloitte auditors learned that the company had significantly underestimated its future sales returns at the end of 2003. What responsibility, if any, did this discovery impose on the Deloitte auditors?

5. Since its inception, the PCAOB has been criticized by many parties. Summarize the principal complaints that have been directed at the PCAOB. Do you believe this criticism is justified? Explain. What measures could the PCAOB take to improve its effectiveness and efficiency as a regulatory body?

12. C. Johnson, “Deloitte Settles in Key Case over Faulty Audit,” Washington Post, 11 December 2007, D01. 13. F. Norris, “Deloitte Agrees to Pay $1 Million Fine,” New York Times (online), 11 December 2007. 14. Ibid.

a short period of time additional cases against not only other Big Four firms, but against the so-called second four firms as well.”12

Deloitte issued a public statement respond- ing to the sanctions imposed on it by the PCAOB. In that statement, a Deloitte official reported that the firm had “established and

implemented changes to its quality-control policies that directly address the PCAOB’s con- cerns.”13 The Deloitte spokesperson went on to insist that the firm was “confident that its audit policies and procedures were among the very best in the profession and that they meet or exceed all applicable standards.”14

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437

CASE 7.2

Sarah Russell, Staff Accountant

Sarah Russell grew up in a small town in the flatlands of western Kansas where she was born.1 In high school, she was homecoming queen, valedictorian of her graduat- ing class, point guard on her basketball team for two years, and a candy striper (vol- unteer) at the local hospital. Since her parents had attended the University of Kansas, Sarah was off to Lawrence at age 18.

After spending her freshman year posting straight A’s in 30 hours of college courses, Sarah settled on accounting as her major after seriously considering journalism, pre- law, and finance. Although Sarah had yet to take any courses in accounting, she had been impressed by a presentation that a female partner of a large accounting firm had made at a career fair. Sarah was excited by the challenges and opportunities presented by public accounting, as described by the partner. Here was a field in which she could learn a great deal in a short period of time and advance rapidly to a position where she had important responsibilities. Plus, public accounting provided a wide range of career paths. If she really enjoyed public accounting, she could pursue a partnership position with a large accounting firm. Then again, she might “hang out her shingle” in her hometown, see the world on the internal audit staff of a large corporation, or return to college after a couple of years of real-world experience to earn an MBA.

Sarah completed the tough accounting courses at the University of Kansas with only two small blemishes on her transcript—B’s in individual and corporate taxa- tion. During the fall semester of her senior year, Sarah accepted a position as a staff accountant with a Big Eight accounting firm. Sarah considered staying in her home state but decided instead to request an assignment in her new employer’s Chicago office. She believed that exposure to big-city life would allow her to arrive at a more informed decision when it was time to make a long-term commitment to a career path and a lifestyle.

During her first year on the job, Sarah served on six audit engagements. Her clients included a pipeline company, a religious foundation, and a professional sports team. She worked hard on those assignments and earned impressive performance apprais- als from each of her immediate supervisors. Somehow Sarah also squeezed a CPA review course into her hectic schedule that first year. And she was glad she did. She was among the few rookies in her large office to pass each section of the CPA exam on her first attempt. With that barrier out of the way, Sarah focused her energy on being promoted to audit senior as quickly as possible.

Several individuals provided Sarah with much-needed moral support during her first year, including R. J. Bell, an audit partner. Bell was 40 years old and had been a partner for eight years. According to the office grapevine, he was in line to become the new office managing partner within the next year or so. Bell tried to get to know the new staff accountants assigned to the audit staff and to help them adjust to their jobs in any way he could. Several times during the year, Bell invited small groups of staff accountants to his home to have dinner with him and his family. Recognizing

1. This case was authored by Carol Knapp, an assistant professor at the University of Oklahoma. This case is based upon experiences related by a young woman previously employed by a large accounting firm. The names of the individuals involved in this case and other background facts, such as locations, have been changed.

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438 SECTION SEVEN PROFESSIONAL ISSUES

that Sarah was new to Chicago, he made a special effort to include her in such social gatherings and to give her complimentary tickets to cultural and sporting events. When Sarah’s old car from college died, Bell arranged for her to obtain a loan from a local bank. Sarah appreciated Bell’s help and guidance. She considered the firm to be very lucky to have an audit partner so supportive of staff accountants.

Shortly after her first anniversary with the firm, Sarah received a telephone call from Bell at home one Saturday afternoon. At first, Sarah thought there must be a client emergency that required her assistance, but Bell did not bring up any client business during the conversation. Instead, he told Sarah that he had just called to chat. Sarah felt mildly uncomfortable with the situation but spoke with Bell for a few minutes before making up an excuse to get off the phone.

The following day, Sarah, an avid jogger, had just completed a four-mile run on her regular jogging trail in a city park when Bell pulled up as she was walking toward her car. “Hi, Sarah. How was your run?” Bell asked nonchalantly. “I was just driving by and thought you might like to get a Coke after your workout.”

As Sarah approached Bell’s car she felt awkward but tried to act natural, as if his unexpected appearance was only a coincidence. “Thanks, R. J. But I really need to get back to my apartment. I’ve got several errands to run and phone calls to make.”

“You sure? I’m buying.” “Yeah, I’d better get home.” “Well, okay.” Over the next several weeks, Bell made a concerted effort to develop a personal

relationship with Sarah. Eventually, Bell, who was known for working long hours, was calling her nearly every evening from his office just “to chat.” Once or twice per week, he invited her to get a drink with him after work. On a couple of occasions, she accepted, hoping that by doing so he would stop asking her. No such luck. Finally, she began avoiding him in the office and stopped answering her home phone when she thought it was him calling. Twice, Bell dropped by her apartment in the eve- ning. Panic-stricken both times, Sarah refused to answer the door, hoping he would quickly decide that she was not home.

Bell’s persistence caused Sarah to feel increasing levels of stress and powerless- ness. She did not know what to do or to whom she could turn. She was reluctant to discuss the matter with her friends in the office since she did not want to start a rumor mill. Embarrassment prevented her from discussing the matter with her parents or other family members. Worst of all, Sarah began wondering whether she had some- how encouraged Bell’s behavior. She racked her brain to recall each time that she had spoken or met with him during her first year on the job. She could not remember saying anything that could have been misconstrued by him. But maybe she had inad- vertently said something that had given him the wrong impression. Maybe he had mistaken the sense of respect and admiration she had for him as affection. Maybe she had asked him an inappropriate question. Maybe . . .

E P I L O G U E After more than six weeks of enduring Bell’s advances, Sarah summoned the courage to make an appointment with him one Friday afternoon in his office. When Sarah informed

Bell that she wanted to keep their relationship on a strictly professional level, he failed to respond for several tense moments. Finally, he remarked that Sarah must have misinterpreted

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CASE 7.2 SARAH RUSSELL, STAFF ACCOUNTANT 439

Questions 1. In your opinion, how should Sarah have handled this matter? Identify the factors

that Sarah should have considered in dealing with the situation. Also, identify the professional and personal responsibilities of Sarah, R. J. Bell, and other relevant individuals in this matter.

2. What were the costs and potential costs to Sarah’s employer in this case? How should accounting firms attempt to prevent these types of situations from occurring? Assume that rather than speaking to Bell, Sarah had told the office managing partner about the problem she faced. How should the office managing partner have dealt with the matter?

3. This case took place several years ago. Do you believe that events similar to those that took place in this case could occur now? Explain.

his actions over the past several weeks. He was simply trying to make her feel more com- fortable with her job. “I go out of my way to be as friendly and sociable with as many mem- bers of the audit staff as I can.” Bell then told Sarah that, given the circumstances, he would see to it that she was not assigned to any of his engagements in the future. After another few moments of tense silence, he tersely asked,

“Is there anything else I can do for you, Miss Russell?” Sarah shook her head softly and then got up and left his office.

Sarah had no further contact or conversations with Bell following that Friday afternoon meet- ing. A few months later, she decided to return to Kansas to be closer to her family. At last report, Sarah was the chief financial officer (CFO) of a charitable organization.

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441

CASE 7.3

Bud Carriker, Audit Senior

During childhood, Louis Armstrong Carriker had been tagged with the nickname “Bud” by his paternal grandmother.1 Bud’s father, a New Orleans native, was a life- long fan of the famous blues musician after whom he had named his only son. After graduating from high school, Elliot Carriker joined the military. In April 1951, Elliot, an African-American, married Bud’s mother, a Mexican-American, while he was sta- tioned at a military base in Texas. Two years later, Bud arrived. Sadly, Bud’s mother died during childbirth. As a result, Bud spent most of his childhood in New Orleans being raised by his grandmother.

When he was a young teenager, Bud was reunited with his father in Dallas, Texas. Bud’s new family included a stepmother and one-year old twin sisters. In high school, Bud excelled in both academics and athletics and earned a scholarship to play bas- ketball at a small Division 1 school. Bud realized that his athletic career would end after college, so he dedicated himself to obtaining a degree that would provide him with an opportunity to earn a good livelihood following graduation. After leaving the military, Elliot Carriker had relied on the GI Bill to earn a college degree in finance. Because of his experience in the business world as a senior loan officer for a major metropolitan bank, Elliot encouraged his son to consider majoring in either account- ing or finance. After several sessions with his high school career counselor, Bud decided to take his father’s advice and pursue an accounting degree in college.

During his senior year in college, Bud interviewed with several of the interna- tional accounting firms and with two large Houston-based oil companies. After dis- cussing his job offers with his father, Bud decided to begin his career in the public accounting profession. Bud realized that a few years’ experience on the audit staff of a major accounting firm would provide him with a strong background in financial accounting. He intended to use that background to obtain a mid-level position on the accounting staff of a bank with an eventual career goal of becoming either a corpo- rate controller or chief financial officer (CFO) in the financial services industry.

Bud launched his career in public accounting in June 1975 and was promoted to audit senior in the late fall of 1977, just prior to the beginning of his third busy season. By the time his fifth busy season arrived in late 1979, Bud had decided that he would begin searching for a job in the private sector when he was promoted to audit manager, which he expected would be sometime during the following 18 months. Although he enjoyed public accounting, Bud was anxious to get his “real” career started.

In mid-November 1979, Alex Saunders, the managing partner of the practice office that Bud had been assigned to throughout his career, asked Bud to meet with him one afternoon. Saunders informed Bud that the firm had unexpectedly acquired a new client. The new client was a privately owned bank in a midsized city in central Texas. Since accepting a position with his employer, Bud had made it known that he wanted to be assigned to a client in the banking or financial services industries. The acquisition of the new client provided Saunders an opportunity to finally grant Bud’s request.

1. This case is based upon factual circumstances. Although the key events occurred in the approximate time frame identified in the case, the names of all parties and the locations have been changed.

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442 SECTION SEVEN PROFESSIONAL ISSUES

“Bud, when we picked up this client, I immediately thought of you since you have expressed an interest in gaining some experience in the banking industry. Plus, this is one of those clients where we really need an experienced audit senior to run the engagement.”

“Thank you, sir. I am looking forward to this opportunity.” Bud’s practice office was quite large. As a result, he did not have a close relationship with Alex Saunders. Nevertheless, Bud had considerable respect for Saunders. Saunders, a native of Lubbock, was an imposing man physically, towering well over six feet. He spoke with a distinctive west Texas twang and often wore a bolo tie and cowboy boots to work. Saunders had spent his entire 35-year career in the practice office that he now managed and was well known and respected within the business community. Bud particularly appreciated Saunders’ blunt, no-nonsense management style. He had a reputation for candor with his subordinates and with clients. You always knew where you stood with “Big Alex,” as he was often referred to by his subordinates.

“Eric Jones will be the audit engagement partner. But I am going to shadow Eric on this job. Just like you, Eric doesn’t have any past experience with a bank client. Since I have had a slew of bank clients, he can use me as a sounding board if problems develop. K. T. Wilson will be the audit manager. He’s worked on a couple of savings and loan audits.”

“Sounds great,” Bud commented when Saunders paused. “Of course, I have worked with Eric and K. T. on a couple of audits in the past.”

“Let me give you a little background on this client,” Saunders continued as he leaned back in his chair and folded his arms across his chest. “This guy, Jim Charles, who owns the bank, is one of those ‘self-made’ millionaires who is more than happy to tell you his success story. He prides himself on being a ‘good ol’ boy’ from west Texas. Kind of like me, I guess,” he added with a smile. “Ya know, he doesn’t have a college degree.”

“Wow, that is interesting,” Bud responded. “Well, that’s what he claims, at least. He got lucky about 15 years ago and brought

in a couple of wildcat wells in the Permian Basin. He used that money to buy a small bank in his hometown. In the past few years, the bank has grown by leaps and bounds because of the deregulation of the banking industry. I have reviewed his loan portfolio and it seems to me that he specializes in funding commercial real estate projects and high-risk oil and gas ventures.” Bud listened intently as Saunders continued. “That’s why I want an experienced audit senior running this engagement. I want you to spend a lot of time in the field. Ya know, in the past, bank clients were always considered extremely low risk. But that has totally changed in the past few years with the new legislation.”

“Well, sir, I will do my best.” “I know you will, Bud. What I would like you to do is meet with Eric this afternoon.

As luck would have it, the firm has a three-day seminar on bank auditing next week in Houston. I want you and Eric to attend that seminar. K. T.’s schedule won’t allow him to make it.”

“Okay. Sir, what about the Garrett audit? Will I continue to work on that job?” For the past three years, Bud had spent the majority of the winter months assigned to the audit engagement team for Garrett Manufacturing, a local prefabricated housing company.

“No. You’re gonna be too busy with this new client. I have already made arrange- ments to have Zach Payne take your spot on that job.”

When Bud left Saunders’ office he felt a surge of excitement. This was just the type of assignment he had been hoping to land. Given the nature of the

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CASE 7.3 BUD CARRIKER, AUDIT SENIOR 443

engagement and his required hands-on role, he would learn a great deal about the banking industry in a short time. Bud realized that this experience would posi- tion him well to obtain the type of job he wanted in the banking industry when he left public accounting.

In the two weeks following his meeting with Alex Saunders, Bud attended the banking seminar with Eric Jones and spent several days reviewing copies of the new client’s prior-year workpapers that had been obtained from the previous auditor. On a Monday morning in early December, Bud made his first trip to the client’s head- quarters. He and K. T. Wilson planned to introduce themselves to key client person- nel and to do some preliminary internal control work.

The meetings with client personnel went well, at least until they met with Jim Charles, who was not only the principal owner of the bank but also its chief execu- tive officer (CEO). During that meeting, Charles seemed annoyed for some reason. In fact, the meeting lasted no more than a few minutes. Charles told the two auditors that he had several important phone calls to make and rushed them out of his office. Although Charles had been less than cordial, Bud quickly dismissed the episode. He realized that as the audit senior he would have little interaction with Charles.

Bud and K. T. Wilson completed their initial work at the client’s headquarters and returned to their firm’s office late on Tuesday afternoon. Over the next three days, Bud planned to draft a preliminary copy of the audit program and have it ready for a meeting that he and K.T. had scheduled with Eric Jones and Alex Saunders the fol- lowing Monday afternoon.

Just as Bud was completing a draft of the audit program on Friday afternoon, Alex Saunders unexpectedly dropped by the cubicle in which he was working. Alex asked Bud to come to his office.

“Do you want me to bring the draft of the audit program? It’s almost done.” “No. That won’t be necessary,” Saunders replied. As they walked silently down the hall together, Bud suspected that something was

wrong. Although he didn’t know Saunders well, Bud sensed that the partner was upset. Bud’s suspicions were heightened when Saunders turned and closed the door behind them after they entered his office.

“Please sit down, Bud,” Saunders said quietly as he motioned to the chair posi- tioned directly in front of his desk. After sitting down himself, Saunders fumbled with a couple of overstuffed workpaper files on his desktop and then spent several moments reviewing a small stack of handwritten telephone messages. Finally, he spoke.

“Bud, I have decided to place you back on the Garrett audit. I have already spoken with Zach Payne. Zach will be taking your place on the bank engagement.”

Bud was stunned, too stunned to speak. The sudden and unexpected announce- ment was both startling and extremely disappointing. Here was the assignment that he had literally coveted and now it was being taken away from him. For several awk- ward moments, Bud sat facing Saunders, who refused to look at him. Not making eye contact with whomever he was speaking to was uncharacteristic of Saunders.

When Bud realized that Saunders did not intend to provide an explanation for removing him from the bank engagement, he took the initiative. “Sir, I don’t under- stand. I was really looking forward to this assignment. I’m not sure why you believe Zach Payne is more qualified than me to run this job.”

Saunders cleared his throat as he turned to the right and gazed out the large plate window that overlooked a busy street several blocks below. Saunders then turned back and faced Bud. “This is not about Zach Payne, Bud. I have decided that you are

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444 SECTION SEVEN PROFESSIONAL ISSUES

not the right person for this engagement. I’m sorry, but that’s my decision.” Saunders paused momentarily and then added, “Thanks for your time, Bud,” signaling that the brief meeting had ended.

Still in shock, Bud rose slowly from the chair in which he had been sitting and turned toward the door. After taking a few steps, Bud turned back toward Saunders. “Mr. Saunders, I consider myself a professional. I work hard, I enjoy my work, and I believe I do a good job. I typically don’t challenge the decisions of those above me. But I believe that I deserve an explanation for why you are taking me off this job.” After speaking, Bud stood his ground, staring directly at Saunders who was once again nervously shuffling papers on his desktop.

After more awkward silence, Saunders rose to his feet and made direct eye con- tact with Bud as he spoke. “You’re right, young man. You deserve an explanation. I’m sorry that I wasn’t more to the point. Avoiding issues is not my style.” Saunders paused and cleared his throat again before speaking. “Jim Charles called me Wednesday afternoon and told me that he wanted a different senior assigned to the audit. He said that he wouldn’t be comfortable working with you.” After one final pause, Saunders continued. “That’s why we are taking you off the job.”

“Comfortable? What does that mean?” Bud blurted out. Saunders shoved his hands into the pockets of his trousers and shrugged his shoul-

ders in exasperation. “You know what I mean. Charles . . . Charles wants another . . . another type of person assigned to the audit.”

Now Bud understood. He had a crystal clear understanding of why he was being removed from the bank audit. As he stood there staring at Saunders, Bud felt several emotions, principally anger. He wanted to respond to Saunders, but he wasn’t sure exactly what to say. Bud had always been aware that he was different from his col- leagues. He was one of a handful of non-Caucasians in his office. In fact, it had been that way throughout his career. But he had never considered his race to be an issue of any kind. At least, not until this moment.

Finally, after an extended period of silence, Saunders turned away from Bud and walked over to his window and stared down at the Friday afternoon traffic. Bud shook his head in disgust, let out a deep breath, and then left Saunders’ office. It was the last time that Bud would speak to, or meet with, Alex Saunders.

Bud Carriker spent his final busy season with his employer supervising the fieldwork on the Garrett Manufacturing engagement. Shortly after that engagement was completed, he received a brief letter from Alex Saunders con- gratulating him on his promotion to audit man- ager that would take effect a few months later on 1 July. However, Bud never officially became an audit manager with the firm.

In June of that year, Bud resigned from the firm and accepted a position as an assistant

controller with a large healthcare facility in Dallas.

The banking empire of Jim Charles col- lapsed suddenly in the early 1980s. Charles’ bank was one of hundreds that regula - tor y authorities closed down during that time period for operating in an “unsafe and unsound” manner. Charles’ equity in the bank, along with that of the bank’s other investors, was wiped out by huge losses in the bank’s loan portfolio.

E P I L O G U E

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CASE 7.3 BUD CARRIKER, AUDIT SENIOR 445

Questions 1. How do you believe Alex Saunders should have reacted when Jim Charles

insisted that Bud be removed from the bank’s audit engagement team? What would you have done under similar circumstances if you had been Saunders?

2. In your opinion, did Saunders’ decision to comply with Charles’ request violate any professional or ethical standards? Defend your answer.

3. How do you believe that Bud should have reacted when Saunders told him why he had been removed from the audit engagement team?

4. The key events in this case transpired during the late 1970s. Do you believe that such a series of events could occur now? Explain.

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447

CASE 7.4

Hopkins V. Price Waterhouse

In 1978, at the age of 34, Ann Hopkins faced a dilemma that a growing number of pro- fessional women are being forced to confront. Hopkins had to make a difficult choice involving her family and her career. Both Hopkins and her husband were employed by Touche Ross & Company. Because of the firm’s nepotism rules, she realized that either she or her husband would have to leave the firm. Otherwise, neither would be considered for promotion to partner. Although comfortable with her position, Hopkins chose to make the personal sacrifice. She resigned from Touche Ross and within a few days accepted a position in the consulting division of Price Waterhouse.

Four years later, Hopkins was among the 88 individuals nominated for promo- tion to partner with Price Waterhouse. Hopkins, a senior manager in the firm’s Washington, D.C., office, was the only woman in that group. Hopkins stood out from the other nominees in another respect. She had generated the most business for Price Waterhouse of all the partner candidates. Over the previous four years, clients obtained by Hopkins had produced $40 million of revenues for the firm. Because cli- ent development skills generally rank as the most important criterion in partnership promotion decisions, Hopkins appeared to be a shoo-in for promotion.

Strengthening Hopkins’ case even more was the unanimous and strong backing her nomination received from the seven partners in the Washington, D.C., office. The extent of home office support for a candidate’s nomination was another key factor Price Waterhouse considered in evaluating individuals for promotion to partner.

Much to her surprise, Hopkins was not awarded a partnership position. Instead, the senior manager was told that she would be considered for promotion the follow- ing year. A few months later, Hopkins was surprised again when her office manag- ing partner informed her that she was no longer considered a viable candidate for promotion to partner. The firm’s top executives did invite her to remain with Price Waterhouse in a nonpartner capacity. Disenchanted and somewhat bitter, Hopkins resigned from Price Waterhouse in January 1984 and accepted a position with the World Bank in Washington, D.C. Eventually, nagging uncertainty regarding her failure to make partner caused Hopkins to file a civil lawsuit against Price Waterhouse.

Prior Criticism of Personnel Practices of Big Eight Firms The lawsuit Ann Hopkins filed against Price Waterhouse drew attention to an issue simmering within the public accounting profession for years. During a 1976 investiga- tion of the profession by a U.S. Senate subcommittee, several parties charged that Big Eight firms’ personnel practices discriminated against females and minorities.1 At one point during its hearings, the Senate subcommittee requested each of the Big Eight firms to disclose the average compensation of their partners and the number of females and nonwhite males in their partner ranks.

The Senate subcommittee’s request evoked uncooperative responses from several of the Big Eight firms. Exhibit 1 presents two of those responses. Exhibit 2 contains

1. U.S. Congress, Senate Subcommittee on Reports, Accounting and Management of the Committee on Government Operations, The Accounting Establishment (Washington, D.C.: U.S. Government Printing Office, 1977).

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448 SECTION SEVEN PROFESSIONAL ISSUES

a letter that Senator Lee Metcalf, chairman of the investigative subcommittee, wrote to Ernst & Ernst after that firm questioned the Senate’s authority to investigate the personnel practices of private partnerships. Six of the Big Eight firms provided the requested information regarding the number of females and minority males among their partners. Collectively, these firms had seven female partners and four partners who were African-American males out of a total of more than 3,500 partners.

EXHIBIT 1

SELECTED RESPONSES TO U.S. SENATE REQUEST FOR INFORMATION REGARDING BIG EIGHT FIRMS’ PERSONNEL PRACTICES

June 11, 1976

The Honorable Lee Metcalf, Chairman Subcommittee on Reports, Accounting, and Management Committee on Government Operations United States Senate Washington, D.C. 20510

Dear Senator Metcalf:

I acknowledge receipt of your letter of June 7, 1976. As you know, this firm has responded and in considerable detail to the Committee’s earlier requests. However, we consider the information sought in this letter to exceed the scope of the Committee’s investigative authority. Moreover, the information sought includes data proprietary to this firm and its individual members. As a result, we respectfully decline to provide the requested data.

Very truly yours,

Russell E. Palmer Managing Partner and Chief Executive Officer Touche Ross & Company

June 30, 1976

The Honorable Lee Metcalf, Chairman Subcommittee on Reports, Accounting, and Management United States Senate Washington, D.C. 20510

Dear Senator Metcalf:

This will acknowledge your letter of June 7 which was received during the period I was away from my office.

We find it difficult to understand why the compensation of our partners is a matter of valid interest to a subcommittee of the Committee on Government Operations. We are even more perplexed with the suggestion that this could be a matter of importance in an assessment of our professional performance.

Along with these reservations we also confess to a deep-rooted belief that members of a private partnership have a right to maintain privacy over such matters if they wish to do so. Therefore, absent an understanding of its justification, we respectfully decline to furnish the compensation information you have requested.

Two partners (.5% of the total number of our partners) are female. None of our partners are blacks.

Yours very truly,

William S. Kanaga Arthur Young & Company

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CASE 7.4 HOPKINS V. PRICE WATERHOUSE 449

June 28, 1976

Mr. R.T. Baker Managing Partner Ernst & Ernst Union Commerce Building Cleveland, Ohio 64115

Dear Mr. Baker:

In your letter of June 24, you question the authority of this subcommittee to request information from your firm on various subjects. You note that our authority is primarily directed to the accounting practices of Federal departments and agencies.

Our requests for information from your firm are based on the unusual and substantial relationship which has developed between certain Federal agencies and influential segments of the accounting profession. This relationship has led to official recognition by Federal agencies of judgments on binding standards which have been made entirely within the private sector. The Securities and Exchange Commission has even formalized its acceptance of private decision-making through Accounting Series Release 150. The Moss amendment to the Energy Policy and Conservation Act also contemplates Federal recognition of private decisions on the manner of uniform accounting to be developed for the oil and gas industry.

The substantial reliance by Federal agencies upon decisions made in the private sector represents a significant delegation of the statutory authority vested in those agencies. This arrangement involves important decisions affecting the policies of the Federal government and other segments of our society.

Decisions made by Federal agencies are subject to review by Congress and the public. Much progress has been made both in Congress and the Federal government in opening the processes of decision-making to public scrutiny. The public has a right to know the identity and interests of those who act under the public’s authority to determine the directions which this nation shall take.

When public decision-making authority is delegated to the private sector, the public has an even greater interest in knowing who is directing important national policies. As you are well aware, little information is available to Congress or the public concerning the activities of accounting firms. That is why it is necessary for this subcommittee to request information on various activities of accounting firms.

Your firm is substantially involved in the private decision-making process which develops accounting standards that are recognized by Federal agencies. The information which has so far been requested by this subcommittee is only a small fraction of the information that is publicly available regarding the identity and interests of Federal officials, or even major corporate officials. Yet, the decision-making area in which your firm is involved influences public policy as much or more than do many companies for which the requested information is publicly available.

This subcommittee has a responsibility to ensure that Federal accounting practices are responsive to the public interest. We must be informed on matters which are relevant to Federal accounting practices. That is why your firm has been requested to provide information to this subcommittee.

Very truly yours,

Lee Metcalf, Chairman Subcommittee on Reports, Accounting, and Management

EXHIBIT 2

U.S. SENATE RESPONSE TO ERNST & ERNST’S RELUCTANCE TO PROVIDE REQUESTED PERSONNEL INFORMATION

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450 SECTION SEVEN PROFESSIONAL ISSUES

The criticism of the Big Eight firms’ personnel practices spawned by the 1976 Senate investigation spurred academic researchers and the business press to begin monitoring the progress of women and minorities within Big Eight firms. By the late 1980s, when the Hopkins suit against Price Waterhouse was working its way through the courts, neither group had made significant inroads into the top hierarchy of the Big Eight firms. For instance, in 1988, women held approximately 3.5 percent of the partnership positions with Big Eight firms, although those firms had been hiring women in considerable numbers since the mid-1970s.2

Continued concern regarding the progress of women and minorities within Big Eight firms focused the accounting profession’s attention on Ann Hopkins’ civil suit against Price Waterhouse. Although the Hopkins case provides only anecdotal evi- dence regarding the personnel practices of large international accounting firms, it is noteworthy for several reasons. First, the case yielded revealing insights into the partnership selection process employed by large accounting firms. Second, the case pointed to the need to rid performance appraisal methods of gender-based criteria in all disciplines, including professional fields. Finally, Hopkins v. Price Waterhouse stimulated discussion of measures that professional firms could take to facilitate the career success of their female employees.

Price Waterhouse’s Consideration of Ann Hopkins for Promotion to Partner During the 1980s, the partners of Price Waterhouse annually identified and then nominated for promotion to partner those senior managers whom they considered to be partner “material.” Price Waterhouse’s admissions committee collected these nominations and then provided a list of the nominees to each partner in the firm. The admissions committee invited partners to provide either a “long form” or “short form” evaluation of the individual candidates.

Typically, a partner well acquainted with a nominee provided a long form evalua- tion. Partners having had little or no contact with a given nominee submitted a short form evaluation or no evaluation at all. Both forms required the partners to assess the partnership potential of the nominees on several scaled dimensions, includ- ing client development abilities, interpersonal skills, and technical expertise. After responding to the scaled items, the partners indicated whether the given individual should be promoted, whether he or she should be denied promotion, or whether the promotion decision should be deferred for one or more years. The partners also provided a brief written explanation documenting the key reasons for their overall recommendation for each candidate.

After studying and summarizing the evaluations, the admissions committee pre- pared three lists of candidates: those recommended for admission to partnership, those not recommended for promotion, and those who had received a “hold” rec- ommendation. These latter candidates typically included individuals having part- ner potential but also one or more weaknesses that needed to be addressed before they were considered again for promotion. The admissions committee submitted its recommendations to the firm’s policy board, which reviewed them and selected the final slate of candidates to be voted on by the entire partnership.3

2. E. Berg, “The Big Eight,” New York Times, 17 December 1977, D1; “Women Comprise Half of 1986–87 Graduates,” Public Accounting Report, 1 February 1988, 7. 3. This description of Price Waterhouse’s partnership selection process was summarized from informa- tion presented in the 1985 court opinion Hopkins v. Price Waterhouse, 618 F. Supp. 1109 (D.C.D.C. 1985).

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CASE 7.4 HOPKINS V. PRICE WATERHOUSE 451

The admissions committee received 32 evaluation forms commenting on Ann Hopkins’ nomination for partner. Thirteen partners submitted positive recommenda- tions, eight recommended she not be promoted, three suggested she be held over for consideration the following year, and eight did not include a recommendation in their evaluation forms.

The most common criticism of Hopkins by partners who recommended she not be promoted was that she had poor interpersonal skills and an abrasive personal- ity. These individuals criticized her for being too demanding of her subordinates, for using profanity, and for being generally harsh and overly aggressive. Two partners used gender-specific terms when commenting on Hopkins. One partner referred to her as “macho,” while another observed that “she may have overcompensated for being a woman.”4

After reviewing Hopkins’ evaluations, the admissions committee recommended that she be held over for consideration, a recommendation accepted by the policy board. The admissions committee decided that her interpersonal skills needed to be strengthened to allow her to function effectively as a partner.

To improve her chances of promotion the following year, Hopkins agreed to undergo a “quality control review” to help her identify specific interpersonal and other job-related skills needing improvement. Subsequent to the quality control review, several partners indicated they would give her opportunities to demonstrate that she was remedying the deficiencies in her interpersonal skills. These partners never followed through on their commitments. Four months after Hopkins com- pleted the quality control review, her office managing partner informed her that she would not be nominated for partner that year. Hopkins was also told that she prob- ably would never be considered again for promotion to partner.

Ann Hopkins’ Civil Suit against Price Waterhouse Ann Hopkins learned of the “hold” recommendation given to her nomination for partner in mid-1983. At that time, her office managing partner discussed with her some of the reservations partners expressed regarding her nomination. In particu- lar, he told Hopkins that several partners believed her appearance and interpersonal manner were overtly masculine and that these traits caused her to be less appealing as a partner candidate.

The office managing partner suggested that she could improve her chances for pro- motion if she would “walk more femininely, wear makeup, have her hair styled, and wear jewelry.” Following her resignation from Price Waterhouse, Hopkins recalled these suggestions and began to question why she had been denied promotion to partner. She began to suspect that Price Waterhouse had denied her promotion not because she was perceived as unqualified to be a partner with the firm but, rather, because she was perceived as unqualified to be a female partner with the firm.

Eventually, Hopkins concluded that Price Waterhouse, in fact, did apply dif- ferent standards for promoting females and males to partner. This issue became the focal point of the civil trial in the Hopkins v. Price Waterhouse case. Hopkins included the following four specific allegations in the lawsuit she filed against Price Waterhouse:

1. The criticisms of her interpersonal skills were fabricated by the Price Waterhouse partners.

4. This and all subsequent quotations, unless indicated otherwise, were taken from Hopkins v. Price Waterhouse, 618 F. Supp. 1109 (D.C.D.C. 1985).

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452 SECTION SEVEN PROFESSIONAL ISSUES

2. Even if the criticisms of her interpersonal skills were valid, Price Waterhouse had promoted male candidates to partner having similar deficiencies in their interpersonal skills.

3. The criticisms of her interpersonal skills resulted from sexual stereotyping by Price Waterhouse partners.

4. Price Waterhouse’s partnership selection process did not discount the sexually discriminatory comments made regarding her candidacy.

The judge who presided over the civil trial dismissed Hopkins’ first allegation. According to the judge, the defense counsel clearly proved that Hopkins did have poor interpersonal skills, particularly when dealing with subordinates. The judge ruled that Price Waterhouse was well within its rights to deny an individual a partner- ship position who did not possess adequate interpersonal skills. However, the judge then pointed to court testimony documenting that Price Waterhouse had previously promoted male partner candidates described as “crude, abrasive, and overbearing.” These comments were very similar to criticisms of Hopkins’ interpersonal skills made during the partner selection process.

A review of the firm’s past promotion decisions also revealed that two earlier female partner candidates may have been denied admission to the partnership for reasons identical to those that cost Hopkins her promotion. Evaluation comments made for those candidates criticized them for acting like “Ma Barker” or for trying to be “one of the boys.”

An earlier legal case established the precedent that an employer who evaluates a woman with an aggressive or abrasive personality differently than a man with similar personality traits is guilty of sex discrimination. After reviewing all of the evidence pre- sented during the trial, the judge ruled that Price Waterhouse had evaluated Hopkins as a candidate for becoming a female partner rather than simply a partner with the firm.

[Female] candidates were viewed favorably if partners believed they maintained their femininity while becoming effective professional managers. To be identified as a “women’s libber” was regarded as a negative comment. Nothing was done to discour- age sexually biased evaluations. One partner repeatedly commented that he could not consider any woman seriously as a partnership candidate and believed that women were not capable of functioning as senior managers—yet the firm took no action to dis- courage his comments and recorded his vote in the overall summary of the evaluations.

Although Hopkins was found to have been the victim of sex discrimination, the judge deemed that the discrimination was not overt or intentional. In fact, Hopkins freely admitted during the trial that she never perceived she was being discrimi- nated against because of her gender while employed with Price Waterhouse. Instead, sexually discriminatory attitudes latent within the culture of Price Waterhouse vic- timized Hopkins’ candidacy for partner. That is, the partners who made the sexu- ally biased remarks regarding Hopkins were unaware that they were evaluating her unfairly relative to male candidates for partner. Nevertheless, the judge ruled that Price Waterhouse perpetuated an evaluation system that allowed sexual stereotypes to undermine the promotion opportunities of female employees.

There is no direct evidence of any determined purpose to maliciously discriminate against women, but plaintiff appears to have been a victim of “omissive and subtle” discriminations created by a system that made evaluations based on “outmoded” atti- tudes. . . . Price Waterhouse should have been aware that women being evaluated by male partners might well be victims of discriminatory stereotypes. Yet the firm made no efforts . . . to discourage comments tainted by sexism or to determine whether they were influenced by stereotypes.

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CASE 7.4 HOPKINS V. PRICE WATERHOUSE 453

5. A 2012 report indicated that 18.1 percent of Big Four partners are women (D. McClure, “Celebrating Women in the Profession,” www.cpapracticeadvisor.com, 5 July 2012). 6. AccountingWEB.com, “PricewaterhouseCoopers Faces Discrimination Suit,” 29 July 2004. 7. Ibid. 8. B. Van Voris, “KPMG Gender-Discrimination Suit Can Proceed, Judge Rules,” www.businessweek .com, 7 February 2013. 9. Sanford Heisler, LLP, “KPMG Gender Discrimination Lawsuit,” www.sanfordheisler.com, 7 February 2013.

E P I L O G U E In May 1990, six years after Ann Hopkins filed suit against Price Waterhouse, a federal judge ordered the firm to pay her $400,000 of com- pensatory damages. More important, the judge ordered the CPA firm to offer Hopkins a part- nership position. During a party to celebrate the court’s decision, Hopkins maintained that she had no reservations joining a firm that had unfairly rejected her for partnership seven years earlier. She also joked with her male coworkers at the World Bank regarding several less-than- complimentary remarks made regarding her during the trial. In particular, she questioned the assertion of one Price Waterhouse part- ner that she needed to enroll in charm school. Moments later, Hopkins took a long and noisy slug of champagne—straight from the bottle.

In 1996, five years after rejoining Price Waterhouse, Ann Hopkins documented her dif- ficult road to becoming a partner in a book pub- lished by the University of Massachusetts Press that was entitled So Ordered: Making Partner the Hard Way. Despite the ordeal that she experi- enced, Hopkins insists that she has no “hard feel- ings” toward her fellow partners. In fact, Hopkins’ daughter joined PricewaterhouseCoopers (PwC), the successor firm to Price Waterhouse, when she graduated from college in 1998.

Growing numbers of women have obtained partnership positions with the large interna- tional accounting firms since the resolution of the Hopkins case. But women still remain signifi- cantly underrepresented in the partnership ranks of those firms.5 That fact was a key issue raised by Melissa Page, a former PwC tax manager, when she filed a lawsuit against PwC that was reminis- cent of Ann Hopkins’ lawsuit two decades earlier. In her complaint, Page alleged that the firm was

guilty of “systematically discriminating” against women and suggested that an “old boy network” still pervaded PwC’s culture.

[Page] claims her career was derailed by a corporate culture that kept women away from the very opportunities that led to part- nership—including informal networking events, golf outings, and other activities that would have given her more access to clients and company executives.6

Page’s lawsuit prompted other women in the profession to speak out. One of those individu- als was Barbara Hufsmith, who reported that she had chosen to establish her own account- ing firm after being a victim of gender discrimi- nation in a male-dominated accounting firm.

I too have been discriminated against in an old boys CPA firm. It has forced me to start my own firm, for which I am grateful, but it should not have been such a painful and expensive experience. I truly believe that only a couple of partners from my old firm knew what they were doing to me was not fair. The rest of the partners were blind, stupid, and arrogant.7

In 2011, several former female employees of KPMG filed a class-action lawsuit alleging that the firm systematically discriminates against female professional employees. The plaintiffs asked for damages of nearly $400 million. In February 2013, a New York federal judge ruled that the lawsuit could proceed after denying KPMG’s request that the case be dismissed.8

Among other allegations, the complaint filed by the plaintiffs reported that a KPMG partner justified the firing of a female on the day she returned from maternity leave by suggesting that she “should be fine without a job” because her husband makes “a lot of money.”9

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454 SECTION SEVEN PROFESSIONAL ISSUES

Questions 1. Do public accounting firms have a responsibility to facilitate the career success

of female employees? Why or why not? Identify policies accounting firms could implement to increase the retention rate of female employees.

2. In business circles, one frequently hears references to the “old boy network.” Many women in professional firms complain that their gender precludes them from becoming a member of the old boy network within their firm. Define, in your own terms, the phrase old boy network. Should professional firms attempt to break down these networks?

3. Suppose that an audit client objects to a given auditor because of his or her gender or race. Identify the alternative courses of action the auditor’s employer should consider taking in such a case. Which of these alternatives do you believe the accounting firm should take? Defend your answer.

4. The nepotism rules of many professional firms pose a major inconvenience for married couples who work for, or would like to work for, those firms. Discuss the costs and benefits of these rules in a public accounting setting. In practice, do you believe these rules are equally fair (or unfair) to both sexes?

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455

CASE 7.5

Fred Stern & Company, Inc. (Ultramares Corporation v. Touche et al.)

In the business world of the Roaring Twenties, the schemes and scams of flim- flam artists and confidence men were legendary. The absence of a strong regula- tory system at the federal level to police the securities markets—the Securities and Exchange Commission was not established until 1934—aided, if not encouraged, financial frauds of all types. In all likelihood, the majority of individuals involved in business during the 1920s were scrupulously honest. Nevertheless, the culture of that decade bred a disproportionate number of opportunists who adopted an “anything goes” approach to transacting business. An example of a company in which this self- serving attitude apparently prevailed was Fred Stern & Company, Inc. During the mid-1920s, Stern’s executives duped three of the company’s creditors out of several hundred thousand dollars.

Based in New York City, Stern imported rubber, a raw material demanded in huge quantities by many industries in the early twentieth century. During the 1920s alone, industrial demand for rubber in the United States more than tripled. The nature of the rubber importation trade required large amounts of working capital. Because Stern was chronically short of funds, the company relied heavily on banks and other lenders to finance its day-to-day operations.

In March 1924, Stern sought a $100,000 loan from Ultramares Corporation, a finance company whose primary line of business was factoring receivables. Before consider- ing the loan request, Ultramares asked Stern’s management for an audited balance sheet. Stern had been audited a few months earlier by Touche, Niven & Company, a prominent accounting firm based in London and New York City. Touche had served as Stern’s independent auditor since 1920. Exhibit 1 presents the unqualified opin- ion Touche issued on Stern’s 31 December 1923, balance sheet. Stern’s management obtained 32 serially numbered copies of that audit report. Touche knew that Stern intended to use the audit reports to obtain external debt financing but was unaware of the specific banks or finance companies that might receive the audit reports.

After reviewing Stern’s audited balance sheet, which reported assets of more than $2.5 million and a net worth of approximately $1 million, and the accompany- ing audit report, Ultramares granted the $100,000 loan requested by the company. Ultramares later extended two more loans to Stern totaling $65,000. During the same time frame, Stern obtained more than $300,000 in loans from two local banks after providing them with copies of the 31 December 1923, balance sheet and accompany- ing audit report.

Unfortunately for Ultramares and the two banks that extended loans to Stern, the company was declared bankrupt in January 1925. Subsequent courtroom testimony revealed that the company had been hopelessly insolvent at the end of 1923 when its audited balance sheet reported a net worth of $1 million. An accountant with Stern, identified only as Romberg in court records, concealed Stern’s bankrupt status from the Touche auditors. Romberg masked Stern’s true financial condition by making sev- eral false entries in the company’s accounting records. The largest of these entries

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456 SECTION SEVEN PROFESSIONAL ISSUES

involved a debit of more than $700,000 to accounts receivable and an offsetting credit to sales.

Following Stern’s bankruptcy, Ultramares sued Touche to recover the $165,000 loaned to Stern. Ultramares alleged that the audit firm had been both fraudulent and negligent in auditing Stern’s financial records. The New York Times noted that the res- olution of the negligence claim in the Ultramares case would likely establish a legal precedent for future plaintiffs hoping to recover losses from audit firms.1 The novel aspect of the negligence claim stemmed from the absence of a contractual relationship between Touche and Ultramares. Touche’s contract to audit Stern’s 31 December 1923, balance sheet was made solely with Stern’s management. At the time, a well- entrenched legal doctrine dictated that only a party in privity with another—that is, having an explicit contractual agreement with another—could recover damages resulting from the other party’s negligence.

Another interesting facet of the Ultramares lawsuit involved the founder of Touche, Niven & Company, Sir George Alexander Touche. George Touche, who served for two years as the sheriff of London during World War I, merged his accounting practice in the early 1900s with that of a young Scottish accountant, John B. Niven, who had immigrated to New York City. The new firm prospered, and George Touche, who was knighted in 1917 by King George V, eventually became one of the most respected lead- ers of the emerging public accounting profession. John Niven also became influential within the profession. Ironically, Niven was serving as the president of the American Institute of Accountants, the predecessor of the American Institute of Certified Public Accountants, when Fred Stern & Company was declared insolvent. An issue posed by the Ultramares lawsuit was whether George Touche and his fellow partners who were not involved in the Stern audit could be held personally liable for any improper con- duct on the part of the Touche auditors assigned to the Stern engagement. Ultramares raised that issue by naming each of the Touche partners as codefendants.

Ultramares Corporation v. Touche et al.: A Protracted Legal Battle The Ultramares civil suit against Touche was tried before a jury in a New York state court. Ultramares’ principal allegation was that the Touche auditors should have eas- ily discovered the $700,000 overstatement of receivables in Stern’s 31 December 1923,

1. “Damages Refused for Error in Audit,” New York Times, 27 June 1929, 50.

February 26, 1924

Touche, Niven & Co. Public Accountants Eighty Maiden Lane,

New York

Certificate of Auditors

We have examined the accounts of Fred Stern & Co., Inc., for the year ended December 31, 1923, and hereby certify that the annexed balance sheet is in accordance therewith and with the information and explanations given us. We further certify that, subject to provision for federal taxes on income, the said statement in our opinion, presents a true and correct view of the financial condition of Fred Stern & Co., Inc., as at December 31, 1923.

EXHIBIT 1

TOUCHE, NIVEN & COMPANY’S AUDIT OPINION ON STERN’S DECEMBER 31, 1923, BALANCE SHEET

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CASE 7.5 FRED STERN & COMPANY, INC. 457

balance sheet. That error, if corrected, would have slashed Stern’s reported net worth by nearly 70 percent and considerably lessened the likelihood that Ultramares would have extended the company a sizable loan.

A young man by the name of Siess performed most of the fieldwork on the Stern audit. When Siess arrived at Stern’s office to begin the audit in early February 1924, he discovered that the company’s general ledger had not been posted since the prior April. He spent the next few days posting entries from the client’s journals to its general led- ger. After Siess completed that task, Stern’s accounts receivable totaled approximately $644,000. Stern’s accountant, Romberg, obtained the general ledger the day before Siess intended to prepare a trial balance of the company’s accounts. After review- ing the ledger, Romberg booked an entry debiting receivables and crediting sales for approximately $706,000. Beside the entry in the receivables account, he entered a number cross-referencing the recorded amount to the company’s sales journal.

The following day, Romberg notified Siess of the entry he had recorded in the gen- eral ledger. Romberg told Siess that the entry represented Stern’s December sales that had been inadvertently omitted from the accounting records. Without question- ing Romberg’s explanation for the large entry, Siess included the $706,000 in the receivables balance. In fact, the receivables did not exist and the corresponding sales never occurred. To support the entry, Romberg or one of his subordinates hast- ily prepared 17 bogus sales invoices.

In subsequent testimony, Siess initially reported that he could not recall whether he reviewed any of the 17 invoices allegedly representing Stern’s December sales. Plaintiff counsel then demonstrated that “a mere glance” at the invoices would have revealed that they were forged. The invoices lacked shipping numbers, cus- tomer order numbers, and other pertinent information. Following this revelation, Siess admitted that he had not examined any of the invoices.2 Touche’s attorneys attempted to justify this oversight by pointing out that audits involve “testing and sampling” rather than an examination of entire accounting populations.3 Thus, it was not surprising or unusual, the attorneys argued, that none of the fictitious December sales invoices were among the more than 200 invoices examined during the Stern audit.

The court ruled that auditing on a sample basis is appropriate in most cases. But, given the suspicious nature of the large December sales entry recorded by Romberg, the court concluded that Touche should have specifically reviewed the December sales invoices.

Verification by test and sample was very likely a sufficient audit as to accounts regu- larly entered upon the books in the usual course of business. . . . [However], the defen- dants were put on their guard by the circumstances touching the December accounts receivable to scrutinize with special care.4

Ultramares’ attorneys noted during the trial that Touche had even more reason than just the suspicious nature of Romberg’s December sales entry to question the integrity of the large year-end increase in receivables. While auditing the compa- ny’s inventory, Touche auditors discovered several errors that collectively caused the inventory account to be overstated by more than $300,000, an overstatement of 90 percent. The auditors also uncovered large errors in Stern’s accounts payable and discovered that the company had improperly pledged the same assets as collateral

2. Ultramares Corporation v. Touche et al., 255 N.Y. 170, 174 N.E. 441 (1930), 449. 3. Ibid. 4. Ibid.

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458 SECTION SEVEN PROFESSIONAL ISSUES

for several bank loans. Given the extent and nature of the problems revealed by the Touche audit, the court ruled that the accounting firm should have been particu- larly skeptical of the client’s accounting records. This should have been the case, the court observed, even though Touche had not encountered any reason in previous audits to question the integrity of Stern’s management.

No doubt the extent to which inquiry must be pressed beyond appearances is a ques- tion of judgment, as to which opinions will often differ. No doubt the wisdom that is born after the event will engender suspicion and distrust when old acquaintance and good repute may have silenced doubt at the beginning.5

The jury in the Ultramares case dismissed the fraud charge against Touche. The jurors ruled that the company’s attorneys failed to establish that the audit firm had intentionally deceived Ultramares—intentional deceit being a necessary condition for fraud. Regarding the negligence charge, the jury ruled in favor of Ultramares and ordered Touche to pay the company damages of $186,000.

The judge who presided over the Ultramares case overturned the jury’s ruling on the negligence charge. In explaining his decision, the judge acknowledged that Ultramares’ attorneys had clearly established that Touche had been negligent during its 1923 audit of Stern. Nevertheless, the judge ruled that the jury had overlooked the long-standing legal doctrine that only a party in privity could sue and recover dam- ages resulting from a defendant’s negligence.6

Ultramares’ attorneys quickly appealed the trial judge’s decision. The appellate division of the New York Supreme Court reviewed the case. In a 3 to 2 vote, the appel- late division decided that the trial judge erred in reversing the jury’s verdict on the negligence charge. As appellate Justice McAvoy noted, the key question in the case centered on whether Touche had a duty to Ultramares “in the absence of a direct contractual relation.”7 Justice McAvoy concluded that Touche did have an obligation to Ultramares, and to other parties relying on Stern’s financial statements, although the accounting firm’s contract was expressly and exclusively with Stern.

One cannot issue an unqualified statement [audit opinion] . . . and then disclaim responsibility for his work. Banks and merchants, to the knowledge of these defen- dants, require certified balance sheets from independent accountants, and upon these audits they make their loans. Thus, the duty arises to these banks and merchants of an exercise of reasonable care in the making and uttering of certified balance sheets.8

Justice McAvoy and two of his colleagues were unwavering in their opinion that Touche had a legal obligation to Ultramares. Nevertheless, the remaining two judges on the appellate panel were just as strongly persuaded that no such obliga- tion existed. In the dissenting opinion, Justice Finch maintained that holding Touche responsible to a third party that subsequently relied upon the Stern financial state- ments was patently unfair to the accounting firm.

If the plaintiff [Ultramares] had inquired of the accountants whether they might rely upon the certificate in making a loan, then the accountants would have had the opportunity to gauge their responsibility and risk, and determine with knowledge how thorough their verification of the account should be before assuming the respon- sibility of making the certificate run to the plaintiff.9

5. Ibid., 444. 6. “Damages Refused for Error.” 7. Ultramares Corporation v. Touche et al., 229 App. Div. 581, 243 N.Y.S. 179 (1930), 181. 8. Ibid., 182. 9. Ibid., 186.

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CASE 7.5 FRED STERN & COMPANY, INC. 459

Following the appellate division’s ruling in the Ultramares case, Touche’s attorneys appealed the decision to the next highest court in the New York state judicial sys- tem, the Court of Appeals. That court ultimately handed down the final ruling in the lengthy judicial history of the case. The chief justice of New York’s Court of Appeals, Benjamin Cardozo, was a nationally recognized legal scholar whose opinions were given great weight by other courts.

Justice Cardozo and his six associate justices ruled unanimously that the judge who presided over the Ultramares trial had properly reversed the jury’s decision on the negligence claim. Justice Cardozo reiterated the arguments made by Justice Finch. He maintained that it would be unfair to hold Touche legally responsible to a third party, unknown to Touche when its audit was performed, that happened to obtain and rely upon Stern’s audited balance sheet. However, Justice Cardozo went on to suggest that had Ultramares been clearly designated as a beneficiary of the Stern–Touche contract, his ruling would have been different.

Unfortunately for the accounting profession, Justice Cardozo’s opinion did not end with his commentary on the negligence question in the Ultramares case. After resolv- ing that issue, he sharply criticized Touche’s audit of Stern. The judge implied that Ultramares might have been successful in suing Touche on the basis of gross negli- gence: “Negligence or blindness, even when not equivalent to fraud, is none the less evidence to sustain an inference of fraud. At least this is so if the negligence is gross. . . . [In the Ultramares case] a jury might find that . . . [the Touche auditors] closed their eyes to the obvious, and blindly gave assent.”10

The Ultramares Decision: Implications for the Accounting Profession In retrospect, the Ultramares decision had two principal implications for the pub- lic accounting profession. First, Justice Cardozo’s opinion established the precedent that certain direct beneficiaries of an audit, generally referred to as primary benefi- ciaries, are entitled to recover damages from a negligent auditor. Subsequent to the Ultramares ruling, very few plaintiffs were successful in establishing themselves as primary beneficiaries of an audit.11 Consequently, this “expansion” of the auditor’s legal exposure proved to be fairly insignificant.

The second key implication of the Ultramares case was that it provided a new strategy for plaintiff counsel to use in suing auditors on behalf of nonprivity parties. Following the Ultramares ruling, attorneys representing such plaintiffs began predi- cating lawsuits against auditors on allegations of gross negligence. Before that ruling, nonprivity third parties faced the heavy burden of proving fraud if they wanted to recover losses resulting from auditor misconduct. Because establishing gross negli- gence is much easier than proving intent to defraud, the Ultramares decision signifi- cantly increased auditors’ legal exposure to nonprivity third parties.

A secondary issue addressed by Justice Cardozo in the Ultramares case was whether Sir George Touche and his fellow partners who had no direct connection with the Stern engagement could be held liable for the deficient Stern audit. This issue was moot regarding the negligence allegation since that charge had already been dismissed. But, the issue was still pertinent to the fraud charge since Justice Cardozo ruled that Ultramares was entitled to a retrial to determine whether Touche’s

10. Ultramares Corporation v. Touche et al., 255 N.Y. 170, 174 N.E. 441 (1930), 449. 11. Decades later, the Credit Alliance case established several restrictive conditions that third parties must satisfy to qualify as primary beneficiaries. See Credit Alliance Corporation v. Arthur Andersen & Company, 483 N.E. 2d 110 (N.Y. 1985).

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460 SECTION SEVEN PROFESSIONAL ISSUES

negligence was severe enough to infer fraudulent conduct or gross negligence.12

Because the auditors assigned to the Stern engagement were acting as agents of the accounting firm’s partners, Justice Cardozo ruled that all of Touche’s partners were legally responsible for the actions of those individuals.

12. For whatever reason, Ultramares chose not to file an amended lawsuit against Touche that was predicated upon an allegation of gross negligence. 13. Accounting firms have other defenses available to them when sued under the Securities Act of 1933. These defenses include, among others, expiration of the statute of limitations, establishing that the plaintiff knew the relevant financial statements were misleading when he or she purchased the securi- ties, and proving that the plaintiff’s damages were not caused by the misleading financial statements. 14. Case 7.6, “First Securities Company of Chicago (Ernst & Ernst v. Hochfelder et al.),” examines the legal implications posed for public accounting firms by the Securities Exchange Act of 1934, which is the “sister” statute to the 1933 Act. 15. American Law Institute, Restatement of the Law, Second: Torts (Philadelphia: American Law Institute, 1965). 16. H. Rosenblum, Inc. v. Adler, 461 A. 2d 138 (N.J. 1983).

E P I L O G U E In the years following the Ultramares case, the legal exposure of public accountants to third- party financial statement users was gradually extended. The first extension came on the heels of the Ultramares case with the passage of the Securities Act of 1933. That federal stat- ute imposed on auditors a very significant legal obligation to initial purchasers of new securi- ties marketed on an interstate basis.

Under the 1933 Act, plaintiffs do not have to prove fraud, gross negligence, or even neg- ligence on the part of auditors. Essentially, plaintiffs must only establish that they suffered investment losses and that the relevant finan- cial statements contain material errors or omis- sions. If a plaintiff establishes those elements of proof, the defendant accounting firm assumes the burden of proving that its employees were “duly diligent” in performing the audit.13 To sustain a due diligence defense, an account- ing firm must show that, following a “reason- able investigation,” it had “reasonable ground to believe and did believe” that the audited financial statements were materially accurate. Federal courts have not been receptive to the due diligence defense if the plaintiffs have clearly established that the financial statements in question contain material errors.14

Auditors’ legal exposure has also expanded under the common law over the past several decades. In 1965, the American Law Institute issued Restatement of Torts, a legal compen- dium relied on heavily in many jurisdictions. This source suggests that “foreseen” beneficia- ries, in addition to primary beneficiaries, should have a right to recover damages from negligent auditors.15 Foreseen beneficiaries are members of a limited group or class of third-party finan- cial statement users. Auditors are typically aware of this distinct group of potential finan- cial statement users but unaware of the specific individuals or entities who make up that group.

The 1983 Rosenblum ruling went beyond the boundary established by the Restatement of Torts. That judicial ruling suggested that even “reasonably foreseeable” or “ordinary” third-party financial statement users should be allowed to recover damages from negligent auditors.16 Reasonably foreseeable third parties include a much larger population of potential financial statement users than “foreseen” third parties. The most liberal definition of “reason- ably foreseeable third parties” includes individ- ual investors who happen to obtain a copy of audited financial statements and make a deci- sion based upon them.

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CASE 7.5 FRED STERN & COMPANY, INC. 461

Questions 1. Observers of the accounting profession suggest that many courts attempt to

“socialize” investment losses by extending auditors’ liability to third-party financial statement users. Discuss the benefits and costs of such a policy to public accounting firms, audit clients, and third-party financial statement users, such as investors and creditors. In your view, should the courts have the authority to socialize investment losses? If not, who should determine how investment losses are distributed in our society?

2. Auditors’ legal responsibilities differ significantly under the Securities Exchange Act of 1934 and the Securities Act of 1933. Briefly point out these differences and comment on why they exist. Also comment on how auditors’ litigation risks differ under the common law and the 1934 Act.

3. The current standard audit report differs significantly from the version issued during the 1920s. Identify the key differences in the two reports and discuss the forces that accounted for the evolution of the audit report into its present form.

4. Why was it common in the 1920s for companies to have only an audited balance sheet prepared for distribution to external third parties? Comment on the factors that, over a period of several decades, resulted in the adoption of the financial statement package that most companies presently provide to external third parties.

5. When assessing audit risk, should auditors consider the type and number of third parties that may ultimately rely on the client’s financial statements? Should auditors insist that audit engagement letters identify the third parties to whom the client intends to distribute the audited financial statements? Would this practice eliminate auditors’ legal liability to nonprivity parties not mentioned in engagement letters?

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463

CASE 7.6

First Securities Company of Chicago (Ernst & Ernst v. Hochfelder et al.)

Ladislas Nay immigrated to the United States from Hungary in 1921 at the age of 18. The opportunities offered by his new land excited the industrious young immigrant and he promised himself that he would make the most of them. Shortly after arriving in the United States, Nay made his way to Chicago and landed a job in the boom- ing securities industry with a small brokerage firm. For the next several years, Nay worked long and hard hours learning the brokerage business.

Unfortunately for Nay, the Great Depression hit the securities industry particu- larly hard. Young stockbrokers like him were the first to be laid off by their firms when personnel cuts were necessary. During the bleak 1930s, Nay, who by this time had Americanized his first name to Leston, endured several job changes and two failed marriages. In 1942, as World War II began to pull the United States out of the Depression, Nay landed a permanent job with the brokerage firm of Ryan-Nichols & Company.

Within two years of joining Ryan-Nichols, Nay was promoted to president. He even- tually became the firm’s principal stockholder, accumulating more than 90 percent of its outstanding common stock. In 1945, the firm successfully applied for member- ship to the Midwest Stock Exchange and was renamed First Securities Company of Chicago. Over the next two decades, Nay’s career and personal life flourished. Nay and his wife, Elizabeth, participated in a wide range of community affairs, includ- ing serving on several prominent civic boards, and eventually purchased a home in the upper-class neighborhood of Hyde Park. Nay made numerous friends among the faculty and staff of nearby University of Chicago. In fact, many of his best customers were associated with the prestigious school.

Nay’s personal attention to the financial needs of his customers earned him their respect and admiration. One of his customers described him as a kind and considerate man, much “like an old-fashioned English solicitor who took care of a family’s affairs.”1 His conservative investment strategies particularly appealed to his retired clients and those nearing retirement. Nay offered many of these customers an opportunity to invest in a lucrative fund that he personally man- aged. This fund was not an asset of First Securities, nor were any other First Securities personnel aware it existed. Nay referred to this fund as the “escrow syndicate.”

Nay loaned funds invested in the escrow syndicate to blue chip companies that developed sudden and unexpected working capital shortages. These companies paid interest rates well above the prevailing market rates. Individuals who invested in the escrow syndicate earned 7 to 12 percent on their investments, considerably more than the interest rates paid at the time by banks on savings accounts.

One of Nay’s closest friends, Arnold Schueren, entrusted him with more than $400,000 over three decades and granted him a power of attorney to make invest- ment decisions regarding those funds. Nay invested a large portion of Schueren’s

1. J. M. Johnston, “How Broker Worked $1 Million Swindle,” Chicago Daily News, 13 December 1968, 42, 43.

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464 SECTION SEVEN PROFESSIONAL ISSUES

savings in the escrow syndicate. Another individual who relied heavily on Nay for investment advice was the widow of a close associate of the famed University of Chicago scientist Enrico Fermi. This woman later testified that Nay had managed her family’s investments for many years but did not offer her the opportunity to invest in the escrow syndicate until after her husband’s death. Nay told her that he only offered this investment opportunity to his “nearest and dearest friends.”2 Following the death of another of his customers, Norman Moyer, Nay convinced Moyer’s widow to invest her husband’s estate of $90,000 in the escrow syndicate. In total, 17 of Nay’s friends and/or their widows invested substantial sums in the escrow syndicate.

Dr. Jekyll and Mr. Hyde: A Tragic Ending On the morning of 4 June 1968, Leston Nay drove to St. Luke’s Hospital in Chicago to pick up his wife, who had fallen and broken her hip the previous week. Earlier that morning, Nay had telephoned his secretary to tell her that he would not be in the office that day because he had a stomach virus. Shortly before noon, as his wife, who was still on crutches, made her way to the kitchen of their apartment, Nay retrieved his 12-gauge shotgun and shot her in the upper back from close range. Nay then laid a suicide note on a dressing table in his bedroom, sat down on his bed, put the muzzle of the gun in his mouth, and pulled the trigger.

News of the murder-suicide shocked the Nays’ friends and associates. These same people were shocked again when the Chicago police released the contents of Nay’s suicide note. The note revealed that the kindly stockbroker had led a Dr. Jekyll–Mr. Hyde existence for decades. In the note, addressed “To whom it may concern,” Nay admitted stealing from his customers for more than 30 years. The escrow syndicate in which his closest friends had invested did not exist—police speculated that Nay had lost the investors’ funds in the stock market. Nay had successfully concealed the miss- ing funds for as long as he did because he periodically mailed checks to the investors for interest supposedly earned by the escrow syndicate. These periodic interest pay- ments deterred the victims of the scam from questioning the safety of their investments.

In the suicide note, Nay displayed some remorse when he referred to the 80-year- old Mrs. Moyer, who was penniless as a result of his actions. He also explained why he had decided to take his life. After Arnold Schueren died in 1967, the executor of his estate had demanded that Nay return Schueren’s investment in the escrow syndi- cate. Nay indicated in the suicide note that he had “stalled” as long as he could but that the executor would not be put off any longer. So he took his life. Most likely, Nay murdered his wife to “save” her from the shame she would feel when his fraudulent scheme, of which she was apparently unaware, was disclosed.

Defrauded Customers Sue to Recover Their Investments The investors in Nay’s escrow syndicate filed civil lawsuits against several parties in an effort to recover their collective investments of more than $1 million. Initially, the investors sued the Midwest Stock Exchange. In that suit, the investors alleged that the stock exchange failed to adequately investigate Nay’s background before admitting his firm to membership. According to the investors, a more thorough investigation might have revealed that Nay had a history, although well concealed, of unscrupu- lous business practices. The investors suggested that the discovery of Nay’s past unethical conduct would have forced the exchange to deny his firm’s membership application and may have prevented him from engaging in the escrow syndicate

2. Ibid.

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CASE 7.6 FIRST SECURITIES COMPANY OF CHICAGO 465

fraud. The court hearing the suit quickly dismissed the investors’ claims, conclud- ing that the stock exchange had sufficiently investigated Nay’s background before approving his firm’s membership application.

Nay’s 17 escrow participants or their estates also sued First Securities Company of Chicago. The court ruled that the brokerage firm had clearly facilitated Nay’s fraud- ulent activities. But, since the brokerage firm was bankrupt, the escrow investors found themselves thwarted again.

Finally, Nay’s former customers filed suit against Ernst & Ernst, the accounting firm that audited First Securities Company for more than two decades. The lawsuit alleged that Ernst & Ernst’s negligence had prevented the firm from detecting what became known throughout the lengthy judicial history of the First Securities case as Nay’s “mail rule.” According to the plaintiffs’ legal counsel, “Nay had forbidden anyone other than himself to open mail addressed to him, and in his absence all such mail was simply allowed to pile up on his desk, even if it was addressed to First Securities for his attention.”3 Nay’s mail rule allowed him to conceal the escrow syn- dicate scam from his subordinates at First Securities and from the brokerage’s inde- pendent auditors. Had Ernst & Ernst discovered the mail rule, the plaintiffs alleged, an investigation would have been warranted. Such an investigation would very likely have led to the discovery of Nay’s escrow investment scam.

Ernst & Ernst v. Hochfelder et al. The defrauded investors filed their lawsuit against Ernst & Ernst under the Securities Exchange Act of 1934. That federal statute does not expressly provide civil reme- dies to stockholders of companies registered with the Securities and Exchange Commission (SEC). However, since the adoption of the 1934 Act, federal courts have allowed stockholders to use the statute as a basis for civil suits against company offi- cers, investment brokers, auditors, and other parties associated with false financial statements filed with the SEC. Most of these suits allege one or more violations of Rule 10b-5 of the 1934 Act, shown in Exhibit 1.

In the First Securities case, the plaintiffs charged that Ernst & Ernst’s alleged negli- gence in failing to discover Nay’s mail rule constituted a violation of Rule 10b-5.

The premise [of the investors’ suit] was that Ernst & Ernst had failed to utilize “appro- priate auditing procedures” in its audits of First Securities. . . . Respondents [investors] contended that if Ernst & Ernst had conducted a proper audit, it would have discov- ered this “mail rule.” The existence of the rule then would have been disclosed to the

3. Securities and Exchange Commission v. First Securities Company of Chicago, 463 F.2d 981 (1972), 985.

Employment of manipulative and deceptive devices. It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact

necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

EXHIBIT 1

RULE 10B-5 OF THE SECURITIES EXCHANGE ACT OF 1934

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466 SECTION SEVEN PROFESSIONAL ISSUES

Exchange [Midwest Stock Exchange] and to the Commission [SEC] by Ernst & Ernst as an irregular procedure that prevented an effective audit.4

To support their claim that the mail rule qualified as a critical internal control weakness having important audit implications, the escrow investors submitted affidavits from three expert witnesses with impressive credentials in the accounting profession. Exhibit 2 lists a portion of one of those affidavits.

The federal district court that initially presided over the Hochfelder et al. v. Ernst & Ernst case quickly dismissed the lawsuit.5 This court deemed that there was no sub- stantive evidence to support the allegation that Ernst & Ernst had negligently audited First Securities. When the investors appealed this decision, the U.S. Court of Appeals reversed the lower court decision and ordered that the case go to trial. In its decision, the appeals court ruled that sufficient doubt existed regarding the negligence claim against Ernst & Ernst to have the case heard. The appeals court also suggested that if the plaintiffs established negligence on the part of Ernst & Ernst, the accounting firm could be held civilly liable to the defrauded investors under Rule 10b-5 of the 1934 Act.

Before the Hochfelder case went to trial in a federal district court, Ernst & Ernst appealed the ruling of the U.S. Court of Appeals to the U.S. Supreme Court. Ernst & Ernst argued before the Supreme Court that the negligence allegation of the escrow investors was insufficient, even if proved, to constitute a violation of Rule 10b-5. This issue had surfaced in many previous civil cases filed under the Securities Exchange Act of 1934. In these earlier cases, the federal courts had generally ruled or suggested that negligence constituted a violation of Rule 10b-5. That is, fraud or gross negli- gence, either of which is much more difficult for a plaintiff to prove than ordinary negligence, did not have to be established for a defendant to be held civilly liable to a plaintiff under Rule 10b-5.

Ernst & Ernst contested these earlier rulings by arguing that Rule 10b-5, as worded, could not be construed to encompass negligent behavior. Given the long-standing controversy surrounding this issue, the Supreme Court decided to rule on the issue in the Hochfelder case. This ruling would then establish a precedent for future law- suits filed under Rule 10b-5.

Before the Supreme Court heard Ernst & Ernst’s appeal, the SEC filed a legal brief with the Court. This brief supported the defrauded investors’ argument that Rule 10b-5 encompassed both fraudulent and negligent conduct. The SEC pointed out that the

4. Ernst & Ernst v. Hochfelder et al., 425 U.S. 185 (1976), 190. (One of the investors defrauded by Nay was Olga Hochfelder.) 5. Hochfelder et al. v. Ernst & Ernst, 503 F.2d 1100 (1974).

Expert Witness No. 3:

If I had discovered in making an audit of a security brokerage business that its president had established an office rule that mail addressed to him at the business address, or to the company for his attention should not be opened by anyone but him, even in his absence; and that whenever he was away from the office such mail would remain unopened and pile up on his desk I would have to raise the question whether such rule or practice could possibly have been instituted for the purpose of preventing discovery of irregularities of whatever nature; would, at a minimum, have to undertake additional audit procedures to independently establish a negative answer to the latter question; also failing such an answer either withdraw from the engagement or decline to express an opinion on the financial statements of the enterprise.

EXHIBIT 2

EXCERPT FROM EXPERT WITNESS TESTIMONY REGARDING NAY’S MAIL RULE

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CASE 7.6 FIRST SECURITIES COMPANY OF CHICAGO 467

end result of investors’ acting on false financial statements is the same whether the errors in the statements result from fraud or negligence. Because a central purpose of the federal securities laws is to ensure that investors receive reliable information, the SEC argued that the ambiguity in Rule 10b-5 should be resolved in favor of investors.

Surprisingly, the bulk of the Supreme Court’s opinion in the Hochfelder case responded to the SEC’s legal brief rather than the arguments of the defrauded inves- tors or those of Ernst & Ernst. The Court rejected the SEC’s largely philosophical argument and instead focused on the question of whether the authors of Rule 10b-5 intended it to encompass both negligent and fraudulent behavior. In addressing this issue, the Court reviewed the legislative history of the 1934 Act and did a painstaking analysis of the semantics of Rule 10b-5.

The Supreme Court eventually concluded that the key signal to the underlying meaning of Rule 10b-5 was the term manipulative. As shown in Exhibit 1, the heading of the rule clearly indicates that it pertains to “manipulative and deceptive” devices. According to the Court, negligence on the part of independent auditors or other par- ties associated with false financial statements could not be construed as manipula- tive behavior. The Court suggested that, in most cases, for behavior to qualify as manipulative, intent to deceive—the legal term being scienter—had to be present.

When a statute speaks so specifically in terms of manipulation and deception, and of implementing devices and contrivances—the commonly understood terminology of intentional wrongdoing—and when its history reflects no more expansive intent, we are quite unwilling to extend the scope of the statute to negligent conduct.6

Two of the nine Supreme Court justices dissented to the Hochfelder decision, while one justice abstained. In disagreeing with the majority decision, Justice Harry Blackmun sided with the view expressed by the SEC. He noted that although the decision was probably consistent with the semantics of the Securities Exchange Act of 1934, the decision clashed with the underlying intent of that important federal statute. He wrote: “It seems to me that an investor can be victimized just as much by negligent conduct as by positive deception, and that it is not logical to drive a wedge between the two, saying that Congress clearly intended the one but certainly not the other.”7 Justice Blackmun went on to comment on the “critical importance” of the independent auditor’s role and the ultimate responsibility of the auditor to serve the “public interest.”8 Given this societal mandate, Justice Blackmun argued, negligent auditors should be held accountable to investors who rely to their detriment on false financial statements.

An Unresolved Issue At first reading, the Supreme Court’s Hochfelder opinion appeared to establish, once and for all, the culpability standard for determining Rule 10b-5 violations. Unfortunately, the opinion is not as precise or definitive as it first appeared. A footnote

6. Ernst & Ernst v. Hochfelder et al., 214. A particularly troublesome issue for the Supreme Court to resolve was the underlying meaning of Subsection b of Rule 10b-5. Subsections a and c of that rule refer explicitly to fraud, implying that negligence is not a severe enough form of misconduct to constitute a violation of Rule 10b-5. However, Subsection b contains no explicit reference to fraudulent conduct. The SEC construed this omission to suggest that Subsection b covers both fraudulent and negligent misconduct. The Supreme Court rejected this argument, maintaining instead that the explicit references to fraud in Subsections a and c signaled that fraudulent conduct was the implied, although unstated, culpability standard in Subsection b as well. 7. Ernst & Ernst v. Hochfelder et al., 216. 8. Ibid., 218.

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468 SECTION SEVEN PROFESSIONAL ISSUES

to the opinion suggests that in certain cases, scienter, or intent to deceive, may not be a necessary element of proof for a plaintiff to establish in a civil suit alleging a Rule 10b-5 violation. The Court noted that some jurisdictions equate scienter with willful or reckless disregard for the truth or, more simply, “recklessness.”9 When engaging in reckless behavior, a party does not possess conscious intent to deceive; that is, sci- enter is not present. For whatever reason, the Court refused to rule on the question of whether reckless behavior would be considered equivalent to scienter and thus consti- tute a violation of Rule 10b-5. This omission caused subsequent plaintiffs to predicate alleged Rule 10b-5 violations by independent auditors on reckless behavior, since that type of professional misconduct is much easier to prove than actual scienter.

9. Ibid., 194.

E P I L O G U E Congressional critics of the Supreme Court’s decision in the Hochfelder case insisted that the alleged “flaw” in Rule 10b-5 should be corrected legislatively. In late 1978, legisla- tors introduced a bill in the U.S. House of

Representatives to hold negligent auditors civ- illy liable to investors who relied on false finan- cial statements filed with the SEC. Fortunately for independent auditors, Congress rejected that bill.

Questions 1. Under present technical standards, would auditors be required to disclose a

company policy similar to Nay’s mail rule that they discover during an audit? Explain. Assuming such disclosure had been required at the time this case took place, would that disclosure have resulted in the mail rule being discontinued?

2. Ernst & Ernst argued that the mail rule was not relevant to its audits of First Securities since that rule only involved personal transactions of Nay and the escrow investors. Do you agree? Why or why not?

3. Define negligence as that term has been used in legal cases involving independent auditors. What is the key distinction between negligence and fraud? Between recklessness and fraud? For all three types of professional misconduct, provide an example of such behavior in an audit context.

4. Assume that the investors defrauded by Nay could have filed their lawsuit against Ernst & Ernst under the Securities Act of 1933. How, if at all, do you believe the outcome of their suit would have been affected?

5. The Restatement of Torts is a legal compendium issued by the American Law Institute. This compendium is relied on by courts in many jurisdictions as the basis for legal rulings. Under the Restatement of Torts, courts have ruled that negligent auditors can be held liable to unknown third parties if those parties belonged to a known group of financial statement users who the auditors were aware would likely rely on the audited financial statements. If this legal principle had been invoked in the Hochfelder case, would the defrauded investors have been successful in pursuing a negligence claim against Ernst & Ernst under the common law? Why or why not?

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469

CASE 7.7

Elizabeth Wallace, Audit Senior

Elizabeth Wallace graduated from a large state university with dual undergraduate and graduate accounting degrees.1 Following graduation, she accepted an entry- level position on the audit staff of a major international accounting firm. Five years later, Elizabeth is a “heavy” senior with hopes of being promoted soon to audit man- ager. Elizabeth’s largest client is Burnham Manufacturing, an auto parts manufac- turer that supplies automotive components to factories operated by one of the Big Three domestic auto companies.

Elizabeth is presently supervising the fieldwork on the current year’s audit of Burnham. Her subordinates include Anton Nikolov who has two years’ experience and was just promoted to audit senior, two staff accountants who each have one year of public accounting experience, and two “rookie” staff accountants who have less than three months’ experience. Anton serves as Elizabeth’s “first lieutenant” on the Burnham audit. In addition to helping supervise the four staff accountants, Anton is responsible for certain administrative tasks on the engagement, such as preparing the weekly progress reports that are filed each Monday morning with Julius Shen, the Burnham audit engagement partner. Anton is also responsible for Burnham’s large inventory account—nearly 35 percent of the time budget for the Burnham audit is allocated to inventory. Two staff accountants and three of Burnham’s internal audi- tors are assisting Anton with the inventory account.

Today is Friday, 19 January, and the Burnham audit should be approximately one- half complete. Unfortunately, the engagement has not gone smoothly and the audit team has fallen well behind schedule. Julius Shen estimates that to complete all of the critical audit procedures by the sign-off date of 14 February, his subordinates on the Burnham audit team will have to work at least 70 hours per week over the next four weeks. Elizabeth, Anton, and Julius each have a somewhat different perspective on the Burnham engagement and why it has become a “problem audit.”

Friday Morning, January 19 Anton had looked forward to beginning the Burnham audit because it would be his first as an audit senior. He realized that he would not be “running the job,” that would be Elizabeth Wallace’s responsibility, but it would be the first assignment on which he had significant supervisory responsibilities.

Prior to beginning the Burnham audit, Anton had not interacted with Elizabeth. Their practice office includes more than 300 professionals, two-thirds of whom are on the audit staff, and the two of them had never been assigned to the same engage- ment team. Although he had not worked with Elizabeth, several of the individuals from Anton’s “start class” with whom he is well acquainted had been assigned to one or more audits that she had supervised. None of those individuals was compli- mentary of Elizabeth’s management style. Terms they used to describe her included “detail-oriented,” “stern,” and “impetuous.”

1. This case is based upon a series of events and circumstances disclosed by an audit senior of a major accounting firm who ultimately sought and received treatment for an addiction to prescription drugs. The names of the individuals involved and other background information have been changed.

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470 SECTION SEVEN PROFESSIONAL ISSUES

Despite the generally unpleasant opinions of Elizabeth, Anton had decided to go into the Burnham audit with an open mind. He enjoyed public accounting and real- ized that if he was to reach his goal of becoming an audit partner, he would occa- sionally have to deal with “difficult” personalities.

By the end of his first week on the Burnham audit, Anton was wondering why his colleagues who had worked previously with Elizabeth had been so kind in describ- ing her. Instead of “detail-oriented,” “stern,” and “impetuous,” Elizabeth was obses- sive-compulsive, insensitive, and perpetually angry. Now that he is several weeks into the Burnham audit, Anton wonders if he can make it to the sign-off date without “blowing up” at Elizabeth. He understands that she is his immediate superior, but he doesn’t believe that gives her the right to routinely berate and belittle him, including in the presence of the other members of the audit engagement team. The only saving grace is that he is not being singled out for harsh treatment. Elizabeth treats all of her subordinates on the Burnham audit team with disrespect and contempt.

Making matters worse is the fact that Elizabeth is unreliable. At the beginning of the audit, she made it clear that the standard workweek on the Burnham engage- ment would be 60 hours. The members of the audit team would work ten-hour days, 8 a.m. to 7 p.m., Monday through Saturday. Despite that mandate, Elizabeth often shows up for work at 10 a.m., and sometimes disappears during the day for several hours without telling Anton how he can reach her. On one occasion, Julius Shen called and asked for Elizabeth when she was nowhere to be found. Shen had been annoyed, if not exasperated, that Elizabeth had not told Anton or her other subordi- nates how she could be contacted.

Anton has gradually decided over the past few weeks that the source of Elizabeth’s unpleasant persona is a serious personal problem, namely, a drug problem. During college, he witnessed firsthand the unraveling of a close friend who had developed an addiction to prescription drugs. He sees in Elizabeth many of the behavioral traits and idiosyncrasies that he observed in that friend.

In addition to her abrasive management style and her habit of disappearing for hours at a time, Elizabeth has random temper tantrums. Any small inconvenience or problem may spark her anger and cause her to suddenly “lose it.” During such episodes, Elizabeth typically directs her anger at her nearest subordinate. After her tirade ends, she stomps out of the conference room and disappears for 30 minutes or longer. When she returns, her emotions are under control and she goes back to work- ing as if nothing happened.

Also very telling is Elizabeth’s personal appearance. She is a very attractive young woman and wears the latest business fashions, but she sometimes arrives at work disheveled and unkempt. On one occasion, she arrived at the client’s conference room wearing shoes that did not match.

Despite her “issues,” Elizabeth is somehow able to be civil with client personnel, although it is apparent to Anton that she minimizes her contact with them, especially with client executives. Plus, she is always on her best behavior on Fridays when Julius Shen or Laura Bishop, the audit manager assigned to the Burnham engage- ment, drops by to check on the status of the audit. Anton is convinced that Elizabeth prepares for those Friday meetings by “over medicating” herself. On Fridays she is often manic, overly effusive, and, most telling, she is almost “human” to Anton and her other subordinates.

Anton is so upset with Elizabeth that he just did something that would have been unthinkable for him a few weeks earlier: he called Julius Shen and asked that they meet and discuss Elizabeth’s management style and overall demeanor. To Anton’s

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CASE 7.7 ELIZABETH WALLACE, AUDIT SENIOR 471

surprise, the audit partner did not seem the least bit annoyed by his request and arranged for the two of them to have lunch today.

Friday Afternoon, January 19 Elizabeth is livid. She is so distraught that she finds it almost impossible to con- centrate on the workpaper file that she is reviewing as she sits at her worksta- tion in the conference room shared by the members of the Burnham audit team. Earlier this morning, Julius Shen came to the conference room. The two of them discussed the Burnham audit for an hour or so. Julius expressed concern over how far behind schedule the audit is and told Elizabeth that she and her team will have to begin working 70-hour weeks to complete the bulk of the audit by the sign-off date.

Elizabeth is not upset by the increased workload. What has upset her is the fact that Julius took Anton Nikolov to lunch without inviting her. It was obvious to Elizabeth that the two of them had made plans to go to lunch together. And, they had obviously planned to exclude her. No doubt, the two of them had discussed her over lunch. In fact, Elizabeth is certain that Anton asked to go to lunch with Julius alone so that they could talk about her privately.

Over the past several weeks, Elizabeth has grown increasingly distrustful of Anton. He is like most of the light seniors or experienced staff accountants who have worked for her on previous engagements. He is self-centered and takes every opportunity to ingratiate himself to the audit engagement partner and audit manager.

A few months ago, Elizabeth was passed over for promotion to audit manager, a decision that had infuriated her. Everyone in her practice office knows that the nor- mal time period for promotion to manager is five years with the firm. She is convinced that she was not promoted because some of her subordinates have complained about her in-your-face management style. Elizabeth realizes that she is demanding of her subordinates, but she is convinced that pushing them to the limit and refusing to coddle them “toughens them up” and makes it more likely that they will succeed in the challenging work environment of public accounting.

Elizabeth also suspects that some of her subordinates are rumormongers. She sus- pects that they are making up lies about her personal life, which is absolutely none of their business. In college, Elizabeth and a couple of her close friends began tak- ing a stimulant known as Adderall to help them pull “all-nighters” before important exams. At one point, she tried to convince her family doctor to give her a prescrip- tion for the drug but he refused. So, she resorted to buying the drug from friends of friends who somehow had access to it.

For the past eight years, she has been taking Adderall off and on . . . mostly on. But, she is convinced that she doesn’t have a “problem” with the drug. Anytime she wants, she can quit taking it. Besides, in her mind, because Adderall is a prescription drug, it has to be safe. Otherwise, doctors wouldn’t prescribe it for their patients.

After learning that she was being passed over for promotion this past fall, Elizabeth’s anger and frustration caused her to become depressed. One of her longtime friends from her college days offered to give her a few Xanax, a prescrip- tion drug used to treat anxiety disorders and depression. Elizabeth took her friend up on the offer. It is amazing to Elizabeth how one of the pills can quickly lift her spirits and help her cope with the day-to-day stress imposed on her by ungrateful and backbiting subordinates such as Anton. Over the past several months, she has become a steady user of Xanax, although she has never bothered to obtain a pre- scription for it.

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472 SECTION SEVEN PROFESSIONAL ISSUES

Occasionally, Elizabeth worries that the two drugs may somehow interact with each other—quite often, she takes both of the drugs on the same day. But, again, because they are both prescription drugs, she reasons that they must be “safe” even if taken together.

Friday Evening, January 19 It is 7:25 p.m. on Friday evening and Julius Shen is still sitting at his office desk. A few minutes earlier, he called his wife and told her that he would be heading home soon. Julius is troubled. Earlier in the day, he went to lunch with Anton Nikolov, the new audit senior assigned to the Burnham audit. Anton voiced serious complaints about his immediate supervisor on the engagement, Elizabeth Wallace. It is not the first time that Julius has heard such complaints.

Julius is well acquainted with Elizabeth because she serves as the lead senior for the audits of two of his largest clients. In terms of technical competence, Elizabeth is unsurpassed. She has a special knack for identifying, thoroughly documenting, and aggressively investigating “hot spots” in client financial statements. Just as important, Julius never has to worry about Elizabeth giving a client the benefit of the doubt when it comes to a questionable accounting or financial reporting issue. She ada- mantly refuses to allow clients to “fudge” their numbers or loosely apply accounting standards. In sum, she is an “auditor’s auditor,” a terrific technician who exudes pro- fessional skepticism.

Despite her technical skills, Elizabeth, unfortunately, has a “bedside manner” that leaves much to be desired. Elizabeth is much tougher on her subordinates than she is on her clients. On several occasions, Julius has counseled her during performance appraisal sessions to be more considerate of her subordinates. For whatever reason, though, she always reverts back to her standard “drill instructor” mentality.

Julius had hoped that Elizabeth’s failure to be promoted to manager would serve as a wake-up call for her and make her realize that she has to develop a more per- sonable approach to dealing with the individuals that she supervises. But, given the statements of Anton Nikolov, Elizabeth has obviously not changed her manage- ment style. If anything, it appears that Elizabeth has become even harsher with her subordinates.

More upsetting to Julius was Anton’s suggestion that Elizabeth may have a serious “personal problem.” Despite the fact that Anton did not explain what he meant, Julius knew exactly what he was implying. On the previous audit engagement that Elizabeth had served as the audit senior for Julius, one of her subordinates had made a simi- lar insinuation. Plus, in interacting with Elizabeth over the past two years, Julius has personally witnessed several telltale signs typically associated with drug abuse. Most troubling to Julius is the fact that she sometimes disappears for several hours without telling other members of her audit team where she is or how they can reach her.

As an audit partner, Julius has faced many stressful circumstances, nearly all of which have involved complex auditing or accounting issues. The situation he faces now, though, is even more stressful. He isn’t sure exactly how he should deal with Elizabeth. Should he confront her directly and speak to her as a “friend”? Julius doesn’t relish that option because he and Elizabeth have exclusively a professional relationship. Unlike his other subordinates, Elizabeth has never shown any interest in “letting her guard down” and discussing her career aspirations, private life, or any other non–job related issue with him.

Another option is for Julius to refer the matter to his office’s human resources coordinator and take the risk that Elizabeth will be removed from the Burnham

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CASE 7.7 ELIZABETH WALLACE, AUDIT SENIOR 473

engagement, if not dismissed from the firm. That option is also unappealing. Despite her obvious shortcomings, Elizabeth makes his job much easier for him. In sum, Julius’ 20 years of experience in public accounting and the countless continuing edu- cation seminars that he has taken over that time have not prepared him to deal with this unpleasant and baffling predicament.

Julius glances at his wristwatch one more time. Almost 30 minutes have passed since he spoke with his wife. It’s time to go home. Over the weekend, he will decide what to do about Elizabeth.

Questions 1. Do you believe that Anton Nikolov has dealt with his concerns regarding

Elizabeth Wallace appropriately? Did he behave ethically in discussing that matter with Julius Shen? Defend your answer.

2. How should Julius respond to the matter involving Elizabeth? Identify the key factors that he should consider in deciding how to proceed.

3. Do public accounting firms have a responsibility to monitor their employees for the purpose of identifying individuals who have substance abuse problems? Do these firms have a responsibility to help their employees address such problems? Defend your answers.

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475

CASE 7.8

Frank Coleman, Staff Accountant

For the better part of three hours, Frank Coleman pounded away at his calculator as he tried in vain to reconcile his number for the LIFO reserve to the figure recorded by the client.1 Frustrated and fatigued, Frank finally glanced at his wristwatch. Frank couldn’t believe that it was 9:40 p.m. The “official” workday for Frank and the other members of the audit engagement team to which he was assigned was 8 a.m. to 8 p.m. However, it was not unusual for individual team members to remain at work well past 8 p.m. Frank typically chose to leave whenever he reached a suitable stop- ping point for the given task on which he was working.

After glancing at his wristwatch, Frank stood and began shuffling together the workpapers spread out before him on his desk. He realized that if he hurried, he could make it home by 10 p.m. No doubt, Maggie, his wife of two months, would be upset that he had stayed so late at work, again. Fortunately, Frank and Maggie’s home was only a 15-minute drive from his client’s corporate headquarters in down- town Dallas.

Frank was assigned to an S-1 audit engagement for a longtime client of his employer that had decided to go public. Because the company’s management team had devel- oped an overly optimistic schedule for filing its S-1 registration statement with the SEC, Frank and the other members of his audit team were putting in 70-hour work- weeks in the middle of summer, the supposed “slow season” in public accounting.

Since graduating from Texas Christian University a little more than two years ear- lier and accepting an entry-level position on the audit staff of one of the Big Four accounting firms, Frank had worked on several audit engagements. His clients had included a brokerage firm, a discount retailer, a bank holding company, and a software firm that developed video games for the Xbox generation. Frank enjoyed almost every facet of public accounting, including the challenging assignments, the in-depth exposure to the “real world” of financial accounting and reporting, and the camaraderie of working closely with other professional accountants to achieve a common goal. There was only one aspect of Frank’s job that he did not enjoy: the large amount of overtime that he was required to work.

Over the previous two years, Frank’s practice office had experienced a steady stream of turnover, most notably among audit staff employees with two or fewer years of experience. Frank was certain that much, if not most, of that turnover was a direct result of the long hours of overtime required in public accounting. The turn- over experienced by Frank’s office was so relentless that he was surprised when a week passed without someone that he knew leaving the firm. In fact, a group of Frank’s coworkers created a “dead pool” to wager on who among them would be the last to leave the firm.

Because of the excellent training and experience they receive in such a short period of time, Big Four auditors are valuable and highly sought-after commodi- ties in the private sector. Overworked auditors suffering from the burnout that is a chronic condition of their jobs are easy targets of corporate headhunters looking to

1. This case was developed, in part, from information obtained from a CPA employed for several years with a large international accounting firm.

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476 SECTION SEVEN PROFESSIONAL ISSUES

fill accounting positions in the private sector. Those positions typically come with not only a more reasonable workload but considerably higher salaries and fringe benefits than those offered by Big Four firms.

The long hours required by Frank’s job were made somewhat more tolerable by the moral support that he received from his superiors. The audit partner on the S-1 engagement often reminded Frank that, ultimately, he would be rewarded by the firm for his diligence and long overtime hours. But Frank came to seriously question whether the personal sacrifices necessary to make partner were worth the corner office, prestige, and large salary that accompanied the position. Plus, he realized that pursuing and achieving partnership meant an ever-increasing commitment to his firm. Client development activities, entertaining clients, and other “after hours” obligations effectively required one to “live and breathe” the firm. In Frank’s mind, being a Big Four partner was not a job, it was an all-consuming lifestyle.

The major international accounting firms recognize that the significant amount of overtime required of their employees is a key factor responsible for the high turnover rates they experience. The accounting profession’s leading firms consistently experi- ence turnover rates approaching, if not exceeding, 20 percent each year in their non- management ranks. In recent years, the grueling workload faced by the employees of major accounting firms has become an even more important issue for those firms, but for a different reason.

The U.S. Department of Labor estimates that labor laws entitle 86 percent of U.S. workers to be compensated for the overtime they work, including the majority of white-collar employees.2 Business Week reported in 2007 that there had been an “explosion” in “overtime” lawsuits over the previous few years and that such lawsuits were “the biggest problem” for companies “in the employment area by far.”3 Even corporate defense attorneys, according to Business Week, privately admitted that companies and professional firms were routinely violating the state and federal laws that mandate the payment of overtime.

Initially, the primary targets of the plaintiff attorneys who specialize in overtime lawsuits were financial services firms, including the major Wall Street brokerages. Several of those firms paid settlements approaching $100 million to resolve such law- suits. Plaintiff attorneys next turned their attention to a set of potential defendants from which they could potentially wrest settlements several times that size, namely, the large international accounting firms.

Since 2006, each of the Big Four firms and at least one of the second-tier firms have been named as defendants in class-action lawsuits alleging that they have violated statutory mandates that require them to compensate entry-level employees for the overtime hours they work. In 2008, a federal judge in California “certified” a class- action lawsuit filed against PricewaterhouseCoopers (PwC) by former employees of that firm. This was the first lawsuit in which a federal judge had issued such a certifi- cation, which means that the plaintiffs are allowed to collectively pursue their legal claims in court. In 2012, a federal judge certified a similar lawsuit filed against KPMG by former employees of that firm.

Ironically, in 2008, each of the four Big Four–affiliated firms in Canada agreed to begin paying overtime to certain lower-level employees.4 At the time, overtime

2. M. Orey, “Wage Wars,” Business Week (online), 30 September 2007. 3. Ibid. 4. Generally, the Canadian firms pay overtime to staff accountants and seniors who are not Chartered Accountants. Two to three years is typically required for an individual to become a Chartered Accountant after entering public accounting.

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CASE 7.8 FRANK COLEMAN, STAFF ACCOUNTANT 477

lawsuits similar to those filed in the United States were pending against those firms. Reportedly, the Canadian firms chose to change their overtime policies because they feared that they would be forced to pay not only compensatory damages but sub- stantial punitive damages, as well, if the plaintiffs prevailed in those lawsuits.

KPMG Canada implemented an “Overtime Redress Plan” that would retroactively pay qualifying employees for the overtime they had worked since 1 January 2000. When that program was announced, firm officials also issued an apology to the indi- viduals they had slighted. “We very much regret that we did not pay overtime when it was earned by current and former employees. While this was an error of omis- sion, not commission, it should not have happened. The principles of the [Overtime Redress] Plan will be reflected in all KPMG’s remuneration in the future.”5

To date, the Big Four firms in the United States have shown no willingness to settle the overtime lawsuits that have been filed against them. Instead, the Big Four firms have vigorously contested those lawsuits in state and federal courts across the nation. Each of the firms maintains that it was justified in not paying overtime to the former and current employees who are the plaintiffs in those lawsuits because the given individuals were “exempt” employees.

State and federal labor laws do not require employers to compensate employees for the overtime they work if one or more exemptions apply to those individuals. The specific conditions that cause an employee to qualify as exempt from overtime payments vary from jurisdiction to jurisdiction. For professional firms, a common requirement for exempt status for a given employee is the fact that the individual is not closely supervised and, instead, carries out his or her job-related responsibilities with a significant degree of autonomy.

In the state of California where many of the overtime lawsuits have originated, a professional firm is generally not required to pay an employee overtime if that employee routinely exercises “independent discretion and judgment” in carrying out his or her work role.6 “Professional” employees who require close supervision, on the other hand, are typically considered nonexempt employees and must be paid for overtime.

The large accounting firms that have been sued in California for the nonpayment of overtime maintain that entry-level employees do not require close supervision and, in fact, exercise “independent discretion and judgment” in their work assignments. The plaintiff attorneys counter by insisting that it is common knowledge that audit staff employees below the level of audit senior are required to be closely supervised and are limited in their ability to exercise independent judgment while completing their assigned tasks.

In addition to demanding compensation for prior qualifying overtime worked by the plaintiffs, the overtime lawsuits filed against the major accounting firms typically request that employees be paid for “rest breaks” to which they were entitled as non- exempt employees and call for significant punitive damages. The overtime lawsuits do not specify the total monetary awards being sought by the plaintiffs’ legal coun- sel. That figure will ultimately depend upon two variables: the number of individuals who will agree to be included as plaintiffs in the lawsuits and the number of qualify- ing overtime hours worked by those individuals.

Once an overtime lawsuit is certified by a judge, the defendant firm is typically ordered to provide the plaintiff attorneys the names and addresses of all potential

5. Consultant-News.com (online), “KPMG Canada Implements Unpaid Overtime Compensation Plan,” www.consultant-news.com, 20 February 2008. 6. Public Accounting Report, “BDO Hit with Overtime Class Action Lawsuit,” 30 November 2007, 3–4.

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478 SECTION SEVEN PROFESSIONAL ISSUES

plaintiffs. Plaintiff attorneys have not reported how many current and former Big Four employees may qualify for compensation under those lawsuits. Nor have those attorneys revealed what percentage of those potential plaintiffs they believe will ulti- mately “join” the overtime lawsuits. Just as difficult to quantify is the number of over- time hours that have been worked by those potential plaintiffs. Not surprisingly, the Big Four firms do not report the average annual number of overtime hours worked by their employees; however, two nationwide surveys collected that information directly from Big Four employees. According to those surveys, “audit staff” of Big Four firms typically average 250 hours of overtime per year, compared to approximately 345 overtime hours worked each year by audit seniors who are exempt from the payment of overtime wages.7

One law firm representing plaintiffs in the Big Four overtime lawsuits has released its own “conservative estimate” of the payments to which their clients may be enti- tled. That estimate is approximately $19,000 for each year of qualifying employment.8 Another source reports that the total damages sought in a single overtime lawsuit filed in California against Ernst & Young may approach $100 million in total.9

7. R. Guinn, S. Bhamornsiri, and C. Blanthorne, “Promotion to Partner in Big Firms: Truths and Trends,” The CPA Journal (online), April 2004. 8. Public Accounting Report, “BDO Hit with Overtime Class Action Lawsuit.” 9. N. Moody, “North American Big Four Firms Face Lawsuits over Unpaid Overtime,” The Accountant (online), 15 February 2008.

E P I L O G U E Within a year of being promoted to audit senior, Frank Coleman left his Big Four employer and accepted a position on the consulting staff of another Big Four firm. His new position came with a large salary increase and a commitment from his new employer that he would have much more reasonable work hours. One month later, Frank was contacted by a plaintiff attorney

involved in a class-action overtime lawsuit filed against his former employer. The attor- ney encouraged Frank to join the lawsuit as a plaintiff. After considering the matter for several days, Frank chose not to become a party to the lawsuit. Among his concerns was that his new employer, which was also a target of multiple overtime lawsuits, would be offended.

Questions 1. As a general rule, do you believe that “professionals” should be compensated for

the overtime they work? Defend your answer.

2. At what level within an accounting firm do accountants qualify as “professionals”? Which employment levels (staff accountant—that is, an employee below the rank of audit senior; audit senior; audit manager; audit partner) do you believe should be compensated for overtime that they work? Explain.

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CASE 7.8 FRANK COLEMAN, STAFF ACCOUNTANT 479

3. A key issue in the overtime lawsuits is whether audit staff below the position of audit senior require close supervision and have the ability and authority to exercise “independent discretion and judgment.” Do professional auditing standards mandate that these employees be closely supervised? Likewise, do those standards prohibit these employees from exercising independent discretion and judgment?

4. Will the overtime policy of prospective employers influence your job choice? Why or why not?

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481

CASE 7.9

Olivia Thomas, Audit Senior

October 1 “Excuse me, are you Jake Tadlock?”1

“No, my name is Eli. Eli Arezzo.” “Hello, Eli. My name is Olivia. Olivia Thomas. I’m sorry. I was told that this was

Jake’s cubicle.” “No need to be sorry. Jake’s cubicle is around the corner,” Eli replied as he pointed

to his left. “Thanks,” Olivia responded as she extended her right hand. “I’m assuming that you

are new to the firm, so welcome aboard.” “Yes, I’m a rookie alright. Thanks for the welcome, Olivia,” Eli replied as he shook

Olivia’s hand before she turned and walked away. Like most relationships, Eli and Olivia’s relationship began with a simple exchange

of greetings. They met each other in the “bullpen” of their office. The bullpen was a large room consisting of 20 cubicles. Unassigned staff accountants of the practice office of the Big Four accounting firm that was their employer “hung out” in the bull- pen. Eli and Olivia’s practice office was located in a large Midwestern city and had more than 400 professional employees.

1 October was Eli’s “start” date with the firm. He and a dozen other recent account- ing graduates in the bullpen that day were only a few hours into their public account- ing careers. Unlike Eli, Olivia was a seasoned professional. She had been with the firm for more than two and one-half years and had been promoted to audit senior three months earlier.

Despite the difference in their employment rank, Olivia and Eli were both 25 years old. Olivia had fast-tracked her way through a five-year joint undergraduate and mas- ter’s degree program in four years. Eli had initially majored in journalism but had switched his major to accounting during his junior year in college after discovering that a degree from j-school provided limited job opportunities upon graduation. The switch in majors added one and one-half years to his college career.

October 12 “Olivia, I would like you to meet Eli Arezzo.”

“Hey, no need to introduce us, Luke. We are old pals, right Eli?” “Oh yeah, we go way back!” Olivia and Eli shared a laugh at the expense of Luke Stotts, an audit manager who

had attempted to introduce the two of them as all three stood in line at the corner Starbucks near their office. After Olivia explained how she and Eli had met, Luke paid for his drink and excused himself.

“Well, Eli, would you like to join me?” Olivia asked casually as she stepped away from the counter with her latte in hand. “We can kill a little time here while the traffic dies down if you want.”

1. This case is based upon an actual series of events. Names and background information have been changed to conceal the identities of the individuals involved in the case.

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482 SECTION SEVEN PROFESSIONAL ISSUES

“Sure, why not?” Eli replied. For more than an hour, Olivia and Eli sat together at a small table discussing topics

ranging from the coming weekend’s “big” college football game to global warming to their upcoming client assignments.

“Wow, it’s after six!” Olivia exclaimed after glancing at her wristwatch. “I guess time flies when you’re having fun.” Olivia laughed off the awkward but candid statement before adding as she stood to leave, “Eli, I hope to see you around the office soon.”

“Uh, sure. I would like that,” Eli replied awkwardly as he fidgeted with his necktie. The parting exchange was awkward for two reasons. First, the two young auditors

each realized that there was a mutual attraction between the two of them. Second, they both realized that although intra-office dating was not prohibited by their employer, there was a general understanding within the firm that it was not consid- ered “professional.” The firm’s formal written policy regarding personal relationships required partners and employees to avoid any and all such relationships that might “impair or influence their judgment” or otherwise pose a “conflict of interests” for them or the firm.

November 2 On a Friday morning, three weeks after Olivia and Eli bumped into each other in Starbucks, Olivia did something that she had pledged to herself she would never do: she invited a coworker on a date. Because she had been in a client’s office for most of the previous three weeks, Olivia had not had an opportunity to drop by the bullpen to say “Hi” to Eli. So, that morning, she sent Eli a brief e-mail asking him if he wanted to join her and a couple of her friends from her hometown at a free concert that eve- ning in a local city park.

Olivia was not desperate for a date. She was very attractive and outgoing and had more than her fair share of “ask-outs.” But most of the guys who asked her out were either boring, not her type, or, even worse, employees of one of her audit clients. Eli was none of those, but the handsome and articulate young man was a coworker and she was well aware that she was treading on thin ice by asking him to meet her at the concert.

Olivia’s apprehension dissipated a few minutes later when Eli replied to her e-mail message. “Sounds great! Should I meet you guys there? Or do you want me to come by your place and pick you up?”

Olivia quickly replied, giving Eli directions to her apartment and letting him know when he could pick her up.

After the concert, Olivia, Eli, and her friends shared a couple of pizzas. Later, when he took her home, she hesitated briefly after opening the car door to leave.

“Would you like to come up and try those chocolate chip cookies I was bragging about?” A few minutes later, the two of them were sitting on Olivia’s couch drinking milk and eating cookies. An hour later when there was a lull in their conversation, Eli decided that it was time to excuse himself. He certainly didn’t want to overstay his welcome.

“Well, it’s getting a little late, I guess I’d better be hitting the road.” “Hey, I had a great time. Thanks for joining us tonight,” Olivia said warmly, before

adding, “my friends really liked you.” “Yeah, that was a great band and you have some really cool friends. Thanks for

inviting me,” Eli responded. As the two of them sat smiling at each other, they both realized it was that uncom-

fortable point near the end of a first date. Who was going to make a move? Would either of them make a move?

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CASE 7.9 OLIVIA THOMAS, AUDIT SENIOR 483

Finally, Olivia leaned over and kissed Eli lightly on his left cheek. “Well, again, thanks, Eli. I really enjoyed the evening.”

Eli wasn’t sure what to do, but he decided that caution rather than courage was the best choice and so he stood and stepped toward the door. Olivia followed him and then opened the door for him, but before Eli stepped out, she grabbed his left arm lightly.

“We both know this is . . . a little weird,” she said tentatively after Eli turned to face her. “You know, because of, well, the fact that the firm kind of frowns on . . .” Olivia paused before continuing, “but, I just thought you were a neat guy and that we had a lot in common.”

At this point, Eli threw caution to the wind as he wrapped his arms around Olivia’s waist, leaned over, and kissed her squarely on the lips.

December 24 Meeting your boyfriend’s or girlfriend’s parents is always a stressful event, but the ten- sion is compounded when that meeting takes place during a major family gathering. As the Christmas holidays approached, Eli and Olivia were spending the bulk of their weekends together. They realized that it was time to take the next big step in their relationship, namely, meeting each other’s family. They decided to spend Christmas Eve with Olivia’s family and Christmas Day with Eli’s.

As the big day approached, Olivia became increasingly anxious. There was no doubt in her mind that her family would like Eli because he had a charming Italian personality—Eli’s parents had emigrated from Italy to the United States shortly before he was born. And, she knew that her mother and younger sister would be awestruck by his stunning good looks. The problem was that her father was also an accoun- tant who had spent several years in public accounting at the beginning of his career. He had once told Olivia that in the “old days” most major accounting firms had a strict policy against “fraternization.” He realized that those firms had moved away from that policy and now, at least publicly, had taken a neutral stance on the issue of intra-office dating. Despite that change in policy, he had suggested to Olivia when she accepted a job in public accounting that she keep her personal and professional lives totally separate.

The previous several weeks, Olivia and Eli had played a game of cat and mouse with their coworkers. They had gone to great lengths to avoid restaurants and other public places where they might encounter someone from their firm, which meant that they spent most of their time together at their apartments. Most stressful for Olivia was sidestepping questions from her two best friends in the office who were also audit seniors. As time passed, both of them had become increasingly suspicious why she was typically unavailable when they asked her to go out with them.

The big question was finally popped by Olivia’s father 30 minutes after she and Eli stepped through the front door of her parents’ home on Christmas Eve morning.

“Eli, Olivia mentioned to her mother a couple of weeks ago that you are also an accountant. Do you work in private accounting?”

Eli took a deep breath as he glanced at Olivia. “No, Sir, I’m in public accounting just like Olivia.”

“Oh, that’s interesting,” Olivia’s father replied. “Are you with a Big Four firm or did you sign on with a local or regional firm?”

When Eli paused to clear his throat, Olivia interceded. “Dad, Eli went to work for my office this past October,” Olivia paused momentarily to allow her father to pro- cess the news bulletin. “He’s on the audit staff, but, of course, we don’t work on any of the same clients.”

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484 SECTION SEVEN PROFESSIONAL ISSUES

After an extended pause, Olivia’s father nodded as he tried to maintain a smile on his face. “That is interesting.”

January 22 Because of unexpected turnover in her office the previous few months and the new responsibilities that she had to assume as an audit senior, Olivia’s busy sea- son proved to be much more demanding than she had anticipated. During the first week of January, Olivia and the four staff accountants she was supervising on the audit of DuClaux Brothers, a manufacturing company in the electronics industry, had begun working 65 hours each week. The only “day off” they had was Sunday afternoon.

Early one Tuesday morning, Sarah Tolbert, the audit manager on the DuClaux engagement, told Olivia that she planned to ask the office’s personnel manager to transfer two additional staff accountants to the DuClaux audit. Sarah wanted the staff accountants to help Olivia complete several tedious and time-consuming audit tests for DuClaux’s large inventory of electronic components.

Several hours later, Olivia was startled when Sarah walked into the client confer- ence room that served as the workspace for the DuClaux audit team followed by Eli and another staff accountant. “Olivia, I want you to meet Abby Edzards and Eli Arezzo,” Sarah announced. “They are going to be helping you knock out those inven- tory price tests and fill in wherever else you need them over the next few weeks.” After gesturing to Abby and Eli, Sarah stepped aside as Olivia rose stiffly from the chair in which she had been seated. Olivia extended her right hand, first to Abby and then to Eli.

After regaining some semblance of composure, Olivia finally spoke. “Well, uh, we certainly can use you guys out here. Welcome to, uh, welcome to the DuClaux job.”

Over the next 30 minutes, Olivia sat at the conference room table explaining in detail the nature of the audit procedures that Abby and Eli would be working on jointly. Then, she took them to the office of the assistant controller from whom they would obtain the documents needed to complete those procedures. After introduc- ing them, Olivia turned to head back to the conference room. As she was leaving, Eli followed her.

“Olivia, could I ask you a question real quickly about how Abby and I should charge our hours today?” Eli asked as he rushed to catch up to Olivia as she hurried down the hallway outside the assistant controller’s office. When they were safely out of earshot of anyone, Eli leaned forward and whispered,” I’m sorry that I couldn’t warn you that I was coming. Sarah rode over here with me and so I never had a chance to text you.”

Olivia arched her eyebrows nervously as she glanced both directions in the hall- way to make sure that no one was near. “Okay, okay,” she replied tensely. “We’ll just have to make the best of it,” she added before instructing Eli to return to the assistant controller’s office.

Late that evening, shortly before 7 p.m., Olivia told Eli, Abby, and the four other staff accountants on the DuClaux audit team that they could leave for the night. Eli dawdled while the other staff accountants organized their cubicles and one by one left the conference room. Finally, only he and Olivia remained.

“Whew,” Olivia said with a shake of her head. “I think we both deserve an Academy Award nomination for the acting jobs that we did.”

“Forget the nomination, you deserve to win the Oscar, hands down,” Eli replied sharply.

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CASE 7.9 OLIVIA THOMAS, AUDIT SENIOR 485

Taken back by the tone of Eli’s voice, Olivia walked to the door of the conference room and closed it and then turned and faced him. “Are you upset about something?”

Eli shrugged his shoulders indifferently as he put on his jacket and prepared to leave.

Olivia stepped forward and placed her hand on Eli’s shoulder. “Eli, what’s wrong?” “Nothing, nothing. Just forget it.” “No, I won’t ‘just forget it.’ Now what is this all about?” “Wait a minute, you may be my supervisor, but you’re not my mother,” Eli

responded. “If I don’t want to talk about what’s bothering me, I don’t have to.” For the first time in their relationship, Olivia and Eli were at odds. Because she was

not one to allow a problem to simmer, Olivia decided to make one final attempt to persuade Eli to discuss what was bothering him.

“No, I’m not your mother, but I am your girlfriend. And, I don’t like seeing you upset.” Olivia paused to make sure that her next words were spoken without any anger. “And, the fact that you’re upset, has made me upset. So, can we sit down and discuss this?”

While Olivia was speaking, Eli had refused to face her. After her brief speech, he cleared his throat and turned toward her. “Uh, well, it was just . . . just tough to, to, uh, have you treat me so coldly. It was just a little too strange for me, I guess,” he added sheepishly.

As she often did, Olivia attempted to defuse a tense moment with humor. “Oh, okay. Tomorrow, each time I ask you to do something, I will give you a big fat kiss and say, ‘Honey, would you do this for me?’”

When Eli did not laugh or even smile in response, Olivia quickly added, “Oh, come on, now, I was just teasing you.” She then reached up and kissed him on the cheek as she ran her hand through his hair.

Eli finally smiled and reciprocated with a light kiss to Olivia’s forehead. “You know what? All of this ticking and tying and tension have made me hungry. What say we head to my apartment and I’ll whip us up a big plate of my grandmother’s famous rigatoni?” Before Olivia could respond, Eli added in an improvised sarcastic tone, “Boss!”

Olivia and Eli recovered nicely from their squabble. Over the next few weeks, they carried on their charade on the DuClaux Brothers audit without raising the least bit of suspicion on the part of their colleagues.

February 10 As the 15 February deadline for completing all major audit tests on the DuClaux Brothers engagement loomed ever nearer, Olivia began “stressing out.” Neither the audit manager nor the audit partner paid much attention to the fact that there were dozens of loose ends that needed to be tied down before the 15th. They seemed to believe that all of the pending issues would be magically resolved somehow by that date. It was also strangely disturbing to Olivia that her two superiors placed total con- fidence in her ability to wrap up the audit on time despite the fact that the DuClaux engagement was the first major audit on which she had supervised the fieldwork.

As the pressure on Olivia to complete the audit had mounted, the pressure on the staff accountants, including Eli, had subsided. During the hectic last week of a large audit, much of the work that remains is critical wrap-up procedures that must be completed by the audit senior, audit manager, and audit engagement partner. In fact, because Olivia had found it increasingly difficult to keep her subordinates busy, she began sending them home each day at 5 p.m. to get them “out of her hair.”

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486 SECTION SEVEN PROFESSIONAL ISSUES

On the evening of 9 February, she had arrived home at her apartment at 9 p.m. expecting Eli to be there. During the previous few weeks, the two of them had met at her apartment after work, but that night her apartment was empty when she got home. When she called and asked where he was, Eli responded that he was “out with some of the guys” from the DuClaux audit. Eli told her that they were celebrating the end of the audit, which was upsetting to Olivia because from her perspective the end of the engagement was still not in sight. Although she didn’t raise the issue with Eli, she thought that he should have been more supportive of her given the heavy burden of work and responsibility that she was facing over the next several days.

Even more troubling to Olivia was the fact that one of the “guys” on the DuClaux audit who was likely out partying with Eli was Abby Edzards, the former college cheerleader who had joined the DuClaux audit team on the same day as Eli. Over the previous week, it had become apparent to Olivia that Abby was becoming a little too “chatty” with Eli. On a couple of occasions when she had walked past the cubicle the two of them shared in the client’s conference room, she had overheard Abby ask Eli questions that had nothing to do with the audit tests they were completing. One of those questions involved Eli’s interest in tennis. Prior to joining the college cheer- leading squad, Abby had been a member of the university’s tennis team. There was no doubt in Olivia’s mind that Abby would soon be challenging Eli, a well-rounded athlete in his own right, to a tennis match—if she hadn’t already.

Shortly before 10 a.m. on the morning of 10 February, Olivia told Eli in front of the other members of the audit team that she would like to have lunch with him so they could discuss his performance appraisal for the DuClaux audit. Because she was the immediate supervisor of the staff accountants assigned to the engagement team, Olivia was responsible for completing a performance evaluation report for each of them. She had decided to have lunch individually with her subordinates to discuss their evaluation reports. Eli would be the first to receive his report. In truth, Olivia had less interest in discussing Eli’s on-the-job performance than in discussing his off- the-job activities the previous night.

“Okay, Mr. Arezzo, here’s your report,” Olivia said with a forced smile as she handed Eli his signed performance evaluation report as they sat facing each other at a restau- rant a few blocks from DuClaux Brothers’ headquarters.

After glancing at the excellent scaled scores that Olivia had given him, Eli responded happily, “Wow, I guess it does help to be buddy-buddy with the boss!”

Olivia was in no mood to be teased so she ignored Eli’s lighthearted response. Instead, she decided to subtly raise the issue that was at the forefront of her mind. “You guys must have partied hardy last night. How late did you stay out?”

“Oh, we were out to midnight or so, I guess,” Eli replied without looking up from his performance report that he had spread out on the table in front of him.

“Who did ‘we’ include?” Olivia asked as she picked at her salad. “Oh, just the guys on the audit team, like I told you last night,” Eli responded mat-

ter-of-factly without giving much thought to the question. Olivia reminded herself to stay cool as she tried to come up with an artistic way

to get the information she wanted. “You mean Max, Kirk, and Andrew?” she asked as she ticked off the names of the three other male staff accountants assigned to the DuClaux audit team.

“Huh?” Eli replied as he looked up to catch Olivia staring at him. “Were you out with Max, Kirk, and Andrew?” There was a definite but unintended

gritty edge to Olivia’s question. The tone of her words immediately caught Eli’s attention.

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CASE 7.9 OLIVIA THOMAS, AUDIT SENIOR 487

Eli folded the performance report neatly and then laid it aside. He then clasped his hands together and leaned forward before replying. “In other words, was Abby with us last night?”

Olivia realized that she had been exposed. There was no reason to tiptoe around the subject any longer. “Yeah, I guess that’s what I’m asking.” She paused to choke down a bite of salad before continuing, “I was just wondering if you went out for a late-night tennis match.” She immediately regretted the catty remark as soon as the final word left her mouth. Olivia was candid, frank, to-the-point, but being “snide” was not in her repertoire of personality traits.

Eli leaned back in his chair. It was his time to respond in kind, but he thought the better of it. Instead, he chose to respond civilly without a hint of sarcasm or anger in his voice. “Olivia, there were five of us at O’Connell’s last night. Myself, Max, Kirk, Andrew, and . . . Charlotte. Abby had told us the day before that she had other plans and couldn’t make it.”

E P I L O G U E Olivia and Eli continued to date over the next 12  months. Eventually, their relationship became a “hot ticket” item on the office grape- vine. Even after their relationship was no longer a secret, they never acknowledged it publicly and only discussed it with their closest friends within the office.

As the end of Eli’s second busy season approached, he decided that public account- ing was not for him. A few months later, he was

accepted into an MBA program on the East Coast, several hundred miles from the metro- politan area where he and Olivia lived. That August, before he moved away, Eli and Olivia committed to making their long-term relation- ship work. But, it didn’t. The two of them mutu- ally decided to “call it quits” a few months later. After completing one more busy season, Olivia left public accounting and accepted a mid-level accounting position with a major oil firm.

Questions 1. Do you believe that either Olivia or Eli acted “unprofessionally” or “unethically”?

Defend your answer.

2. Did Olivia and Eli’s relationship likely affect other individuals within their office? Explain.

3. Why do you believe that major accounting firms have become more accepting of intra-office dating over the years? Do you believe that shift in policy is appropriate? Why or why not?

4. Do you agree or disagree with Olivia’s father that public accountants should keep their professional and personal lives strictly separate? Explain.

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8

SECTION 8

INTERNATIONAL CASES

Case 8.1 Longtop Financial Technologies Limited

Case 8.2 Kaset Thai Sugar Company

Case 8.3 Republic of Somalia

Case 8.4 Republic of the Sudan

Case 8.5 Shari’a

Case 8.6 Mohamed Salem El-Hadad, Internal Auditor

Case 8.7 Tae Kwang Vina

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491

CASE 8.1

Longtop Financial Technologies Limited

In 1996, two friends and business partners, Jia Xiao Gong and Weizhou Lian, founded Longtop Financial Technologies Limited in Beijing. Gong served as Longtop’s chair- man of the board, while Lian assumed the title of chief executive officer (CEO). The two men developed a business model intended to make Longtop the leading provider of information technology services to the booming banking industry of the People’s Republic of China. China’s “Big Four” banks dominate the nation’s bank- ing industry. In turn, the powerful Ministry of Finance, the government agency that oversees China’s economic and fiscal policies, controls the Big Four banks.

By 2010, Longtop had achieved its goal of becoming the leading provider of information technology services to China’s banking industry, including three of the nation’s Big Four banks. The company’s audited financial statements for fiscal 2010 reported a $59 million profit, total revenues of $169 million, and net assets of $600 million. Although modest by U.S. standards, Longtop’s profits, revenues, and net assets were growing rapidly and were expected to continue to do so over the years to come. Similar to the previous five years, Deloitte & Touche Shanghai (D & T Shanghai), the Chinese affiliate of U.S.-based Deloitte Touche Tohmatsu, issued an unqualified audit opinion on Longtop’s 2010 financial statements.

“Faked” Cash and Red-Faced Auditors The rapidly expanding Chinese economy has captured the attention of investors worldwide over the past two decades. Companies such as Longtop sought to capi- talize on the growing interest in the Chinese economy by listing their securities on international stock exchanges, including the leading exchanges in the United States.

In October 2007, Longtop went public with an initial public offering (IPO) managed by Goldman Sachs and Deutsche Bank. The company’s common stock, which was listed on the New York Stock Exchange (NYSE), nearly doubled in price during its first day of trading. By late 2010, Longtop’s stock had a total market value of $2.5 billion. Similar to the more than 200 other Chinese companies whose securities have traded on U.S. stock exchanges, Longtop became subject to the regulatory oversight of the Securities and Exchange Commission (SEC) when it listed its common stock on the NYSE.

In the late spring of 2011, Longtop was rocked by allegations that management had recorded bogus revenues to inflate the company’s reported operating results and financial condition. Those allegations surfaced just as D & T Shanghai was near- ing completion of its Longtop audit for the company’s 2011 fiscal year, which ended 31 March 2011.

The source of the claims of fraudulent accounting was a small U.S.-based investment advisory firm that specializes in exposing companies that are “cooking their books.” Among other allegations, that firm maintained that much, if not most, of the more than $400 million of cash reported in Longtop’s preaudit 2011 financial statements—which accounted for almost 60 percent of the company’s total assets—did not exist.

D & T Shanghai responded to the allegations of the investment advisory firm by extending its audit of Longtop’s 2011 financial statements. In particular, the audit firm

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492 SECTION EIGHT INTERNATIONAL CASES

decided to revisit the audit procedures that had been applied to the company’s cash accounts. In the past, the principal evidence the auditors had collected to corrobo- rate Longtop’s cash balances had been confirmations obtained from local branches of the company’s banks.

On 17 May 2011, D & T Shanghai attempted to confirm Longtop’s 2011 year-end cash balances by contacting the headquarters offices of the company’s banks. Those extended cash confirmation tests were abruptly halted by Longtop officials, as reported by the New York Times.

“Within hours” of beginning the new round of confirmations on May 17, the confirma- tion process was stopped . . . the result of “intervention by the company’s officials, including the chief operating officer.” . . . Despite the company’s efforts, Deloitte learned that Longtop did not have the cash it claimed and that there were “significant bank borrowings” not reflected in the company’s books.1

A few days following D & T Shanghai’s aborted attempt to reconfirm Longtop’s cash balances, Jia Xiao Gong admitted to a partner of that firm that the company had “faked” cash and revenues in its financial statements. That admission prompted D & T Shanghai to resign as Longtop’s auditor. Exhibit 1 presents the resignation letter that D & T Shanghai sent to Longtop’s audit committee and filed with the SEC on 22 May 2011.

1. F. Norris, “The Audacity of Chinese Frauds,” New York Times (online), 26 May 2011.

EXHIBIT 1

DELOITTE RESIGNATION LETTER

22 May 2011

The Audit Committee Longtop Financial Technologies Limited No. 61 Wanghai Road, Xiamen Software Park Xiamen, Fujian Province People’s Republic of China

Attention: Mr. Thomas Gurnee, Chairman of the Audit Committee

Dear Sirs:

Longtop Financial Technologies Limited (the “Company”) and together with its subsidiaries (the “Group”) Audit for the Year Ended 31 March 2011

We hereby give you formal notice of our resignation as auditor of the Company.

Background and significant issues encountered by Deloitte Touche Tohmatsu CPA Ltd. (China) (“Deloitte”)

As part of the process for auditing the Company’s financial statements for the year ended 31 March 2011, we determined that, in regard to bank confirmations, it was appropriate to perform follow-up visits to certain banks. These audit steps were recently performed and identified a number of very serious defects including: statements by bank staff that their bank had no record of certain transactions; confirmation replies previously received were said to be false; significant differences in deposit balances reported by the bank staff compared with the amounts identified in previously received confirmations (and in the books and records of the Group); and significant bank borrowings reported by bank staff not identified in previously received confirmations (and not recorded in the books and records of the Group).

In light of this, a formal second round of bank confirmations was initiated on 17 May. Within hours, however, as a result of intervention by the Company’s officials including the Chief

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CASE 8.1 LONGTOP FINANCIAL TECHNOLOGIES LIMITED 493

Operating Officer, the confirmation process was stopped amid serious and troubling new developments including: calls to banks by the Company asserting that Deloitte was not their auditor; seizure by the Company’s staff of second round bank confirmation documentation on bank premises; threats to stop our staff leaving the Company premises unless they allowed the Company to retain our audit files then on the premises; and then seizure by the Company of certain of our working papers.

In that connection, we must insist that you promptly return our documents.

Then on 20 May the Chairman of the Company, Mr. Jia Xiao Gong, called our Eastern Region Managing Partner, Mr. Paul Sin, and informed him in the course of their conversation “that there was fake revenue in the past so there was fake cash recorded on the books.” Mr. Jia did not answer when questioned as to the extent and duration of the discrepancies. When asked who was involved, Mr. Jia answered : “senior management.”

We bring these significant issues to your attention in the context of our responsibilities under Statement on Auditing Standards No. 99, “Consideration of Fraud in a Financial Statement Audit” issued by the American Institute of Certified Public Accountants.

Reasons for our Resignation

The reasons for our resignation include: (1) the recently identified falsity of the Group’s financial records in relation to cash at bank and loan balances (and also now seemingly in the sales revenue); (2) the deliberate interference by the management in our audit process; and (3) the unlawful detention of our audit files. These recent developments undermine our ability to rely on the representations of management which is an essential element of the audit process; hence our resignation.

Prior periods’ financial reports and our reports thereon

We have reached the conclusion that we are no longer able to place reliance on management representations in relation to prior financial reports. Accordingly, we request the Company take immediate steps to make the necessary 8-K filing to state that continuing reliance should no longer be placed on our audit reports on the previous financial statements and moreover that we decline to be associated with any of the Company’s financial communications during 2010 and 2011.

Our consent

We hereby consent to a copy of this letter being supplied to the SEC and the succeeding auditor to be appointed.

Section 10A of the Securities Exchange Act of 1934 (U.S.)

In our view, without providing any legal conclusion, the circumstances mentioned above could constitute illegal acts for purposes of Section 10A of the Securities Exchange Act of 1934. Accordingly, we remind the Board of its obligations under Section 10A of the Securities Exchange Act, including the notice requirements to the U.S. Securities and Exchange Commission. You may consider taking legal advice on this.

Yours faithfully, /s/ Deloitte Touche Tohmatsu CPA Ltd. c.c.: The Board of Directors

Source: www.sec.gov/Archives/edgar/data/

EXHIBIT 1— continued

DELOITTE RESIGNATION LETTER

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494 SECTION EIGHT INTERNATIONAL CASES

“The Law on Guarding State Secrets” Following D & T Shanghai’s resignation, published reports from several sources, including the New York Times, revealed that employees of Longtop’s banks had conspired with company management to conceal the company’s fraudulent account- ing scheme. For years, those individuals had apparently returned confirmations to D & T Shanghai that vouched for the accuracy of the company’s materially overstated cash balances.

In fact, a month before resigning as Longtop’s auditor, D & T Shanghai had stepped down as the auditor of China MediaExpress because of concerns regard- ing the reliability of cash confirmations obtained from that company’s banks. A few months earlier, KPMG’s Chinese affiliate reported the same concern upon resigning as the auditor of ShengdaTech. Similar to Longtop, both China MediaExpress and ShengdaTech had securities listed on U.S. stock exchanges.

Reports that Chinese banks were complicit in the Longtop accounting fraud stunned the global investment community. An Australian hedge fund official noted that, “Given the centrality of Chinese banks to the global economy . . . [this] is a story much bigger than Deloitte or Longtop.”2

Floyd Norris, a prominent reporter for the New York Times, noted that the inci- dents involving Longtop, China MediaExpress, and ShengdaTech raised the question of whether “defrauding foreign investors is deemed to be a serious crime in China.”3 Norris went on to observe that although accounting frauds and audit failures were a worldwide problem, “the audacity of these frauds, as well as the efforts to intimidate auditors, stand out.”4

The SEC banned Longtop’s securities from U.S. stock exchanges in December 2011. The move was largely symbolic since the company’s stock was essentially worth- less by that time. Fraud Magazine reported that Longtop was among more than two dozen China-based companies whose securities had been banned or suspended from trading on U.S. or European stock markets by late 2011 due to “accounting discrepancies,” auditor resignations, or related issues.5

In June 2011, the SEC asked D & T Shanghai to turn over the Longtop work papers that it had in its possession. The SEC believed the workpapers would provide important insights relevant to its ongoing investigation of the Longtop fraud. SEC officials were shocked when D & T Shanghai refused to provide the workpapers. A subsequent subpoena and court order obtained by the SEC failed to persuade D & T Shanghai to comply with the agency’s request.

D & T Shanghai reported that it had decided not to give the workpapers to the SEC because doing so would violate an important Chinese law, the Law on Guarding State Secrets, that China’s central government had enacted in 1988. According to D & T Shanghai, that law prohibits Chinese citizens and firms from providing documents or other information to foreign entities that relate to “the national economy.”6

2. Ibid. 3. Ibid. 4. Ibid. 5. R. Hurley and T. Harvey, “Chinese Stock Investment Fraud: Separating Fact from Fiction,” Fraud Magazine, January/February 2012, 59. 6. F. McKenna, “Deloitte Hides From SEC Behind Chinese Wall Over Longtop,” Forbes (online), 9 September 2011.

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CASE 8.1 LONGTOP FINANCIAL TECHNOLOGIES LIMITED 495

Skeptics believed that it was highly unlikely that any “state secrets” were con- tained in the Longtop audit workpapers. However, an attorney of a major U.S. law firm explained to a Wall Street Journal reporter that the Chinese government invokes a “sufficiently broad” definition of “state secret” to routinely blunt the efforts of foreign regulatory bodies to obtain information from Chinese companies and other entities.7

Chinese Standoff The controversy spawned by the Longtop fraud focused greater attention on an issue that the Public Company Accounting and Oversight Board (PCAOB) had been wres- tling with for years. The Sarbanes–Oxley Act of 2002 requires the PCAOB to inspect all accounting firms that audit companies that have securities traded on U.S. stock exchanges. This requirement extends to foreign accounting firms that audit such companies, including the foreign affiliates of major international accounting firms based in the United States.

Since the inception of the PCAOB in 2004, nearly 2,400 accounting firms that audit companies having securities traded on U.S. markets have registered with the agency, including more than 900 non-U.S. accounting firms from 85 countries. The latter number includes several dozen Chinese accounting firms. By late 2013, the PCAOB had yet to inspect any of those Chinese accounting firms.

Chinese government officials refused to allow the PCAOB to inspect China-based accounting firms because they insisted that their nation’s “own regulatory system was adequate.”8 The failure of China to permit PCAOB inspections of Chinese accounting firms when coupled with the growing list of Chinese accounting scandals caused one U.S. accounting professor to question “whether Chinese companies are audit- able in the current regulatory environment.”9

In November 2011, Senator Charles Schumer slammed the PCAOB for allowing Chinese accounting firms to continue auditing companies with securities traded in the United States. “The board’s failure to do what it was created to do—particularly in the face of Chinese corporate accounting scandals that have already cost U.S. investors billions—is deeply troubling.”10

James Doty, the chairman of the PCAOB, deflected much of the criticism of his agency to the Big Four accounting firms. In particular, Chairman Doty maintained that global accounting firms needed “to improve their quality control over far-flung affiliates” such as D & T Shanghai.11 Doty observed that “many people are unaware that an audit report signed by a large U.S. firm may be based largely on the work of affiliates in other countries that are completely separate legal entities.”12 He went on to note that in many of those instances the U.S. firms fail to review the work of their foreign affiliates.

7. I. Steger, “How Should Auditors Handle China’s State Secrets Law?” Wall Street Journal (online), 2 November 2011. 8. D. Aubin, “U.S. Auditor Watchdog Hopeful of Access to China,” Reuters (online), 5 May 2011. 9. P. Gillis, “China Accounting Blog: State Secrets and Auditing,” www.chinaccountingblog.com/ weblog/state-secrets-and-auditing.html, 3 November 2011. 10. M. Rapoport, “Sen. Schumer Urges Audit Watchdog to Act on China,” Wall Street Journal (online), 22 November 2011. 11. Aubin, “U.S. Auditor Watchdog Hopeful.” 12. Ibid.

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496 SECTION EIGHT INTERNATIONAL CASES

Questions 1. What are the key conditions or circumstances that must be present for a

company to be “auditable”? What uncommon challenges to “auditability” are posed by Chinese companies?

2. Do the major international accounting firms have a responsibility to ensure that their individual national practice units provide independent audit services that are uniform worldwide? Defend your answer.

3. Acme, Inc., a multinational company based in the United States, has a large subsidiary located in Beijing, China. Acme is audited by an international accounting firm headquartered in the United States; its subsidiary is audited by the Chinese affiliate of that firm. Under U.S. auditing standards, what responsibilities, if any, does Acme’s U.S. audit firm have to supervise or oversee the audit of the Chinese subsidiary? Would these responsibilities be different under International Standards of Auditing?

4. What alternative strategies or approaches could U.S. regulatory agencies consider invoking to ensure that the audits of non-U.S. companies with securities traded on U.S. markets are adequate?

5. Since ethical and moral values vary from culture to culture and nation to nation, does this mean that a global profession, such as the accounting profession, cannot have a uniform ethical code? Explain.

13. U.S. Securities and Exchange Commission, “SEC Charges China Affiliates of Big Four Accounting Firms with Violating U.S. Securities Laws in Refusing to Produce Documents,” www.sec.gov, 3 December 2012. 14. M. Cohn, “PCAOB Signs Enforcement Cooperation Agreement with Chinese Regulators,” www .accountingtoday.com, 24 May 2013. 15. Although not publicly confirmed by the SEC, Chinese governmental officials reportedly turned over to the SEC certain Longtop audit workpapers in August 2013.

E P I L O G U E In December 2012, the SEC charged the Chinese affiliates of BDO Seidman, Deloitte, Ernst & Young, KPMG, and PricewaterhouseCoopers with violating the Securities Exchange Act of 1934 and the Sarbanes–Oxley Act of 2002. These charges stemmed from the refusal of those firms to comply with the SEC’s request to turn over audit workpapers for selected clients that were SEC registrants. The director of the SEC’s Division of Enforcement observed that “Only with access to workpapers of foreign pub- lic accounting firms can the SEC test the quality of the underlying audits and protect investors from the dangers of accounting fraud.”13 As of

December 2013, the charges filed against the five firms were not yet resolved.

In May 2013, the PCAOB signed a “memoran- dum of understanding” (MOU) with China’s Ministry of Finance and another Chinese regu- latory agency that established a “cooperative framework between the parties for the pro- duction and exchange of audit documents relevant to investigations in both countries’ respective jurisdictions.”14, 15 The MOU, how- ever, did not grant the PCAOB the right to inspect Chinese accounting firms that audit companies with securities registered on U.S. stock exchanges.

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497

CASE 8.2

Kaset Thai Sugar Company

The black Toyota minivan made slow but steady progress down the narrow, unpaved road as it approached the village of Takhli in south central Thailand, approximately 150 miles north of Bangkok. On either side of the bumpy road were fields of sugarcane, dense thickets of scrub brush, and an occasional rice paddy. Seated in a rear window seat of the minivan was Michael Wansley, a senior partner with Deloitte Touche Tohmatsu, who was based in that firm’s Melbourne, Australia, practice office. The vehicle’s four other occupants were Thai nationals and employ- ees of the Kaset Thai Sugar Company. No doubt, the five weary travelers who had spent several hours in the cramped minivan were overjoyed when they finally caught a glimpse of the large sugar mill in the distance that was their final destina- tion. The sugar mill was one of many owned and operated by the Kaset Thai Sugar Company.

For the past several weeks, Michael Wansley had been supervising a debt-restructuring engagement for the company’s banks and other lenders. Kaset Thai Sugar had defaulted on nearly $500 million of loans to those lenders. Wansley and the 14 subordinates on his engagement team were to study the company’s accounting records and business operations and then make recommendations about how the lenders should proceed in attempting to collect all—or, at least, a significant portion—of the outstanding loans.

Wansley, a well-known debt-restructuring expert, had become all too familiar with remote Thailand communities, such as Takhli, over the previous several months because the services of debt-restructuring specialists were much in demand within Thailand during the late 1990s. In March 1999 when Wansley visited the sugar mill on the outskirts of Takhli, the nation of Thailand was mired in a financial crisis. From 1985 through 1995, Thailand had boasted the highest economic growth rate in the world, averaging almost 9 percent annually over that time span. That trend prompted billions of dollars of foreign direct investment in Thailand companies, the bulk of which was in the form of loans.

Thailand’s impressive economic growth came to a jarring halt in 1997, undercut by speculative investments, mismanagement, and extensive fraud on the part of business owners and corporate executives. According to one critic of Thailand’s free-wheeling economic system, “cronyism, collusion, corruption, and complacency” had long been the “four modern horsemen of the apocalypse” in that economy.1 By the late 1990s, hundreds of Thai companies faced bankruptcy, unable to pay back the loans they had secured over the previous decade. In 1999, nearly one-half of the $150 billion in outstanding loans to large Thai companies was classified as “nonperforming”—and it was estimated that $50 billion of that total would never be collected.2

As Thailand’s financial crisis deepened, the foreign banks and other lenders that had pumped billions of dollars of debt capital into Thai companies began retain- ing debt-restructuring specialists in Australia, the United States, and other developed countries to help them determine how to deal best with their mounting portfolios

1. U. Parpart, “Restructuring East Asia: A Progress Report,” The Milken Institute Review, Third Quarter 1999, 42. 2. Ibid., 40.

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498 SECTION EIGHT INTERNATIONAL CASES

of nonperforming loans. Among the major providers of these debt-restructuring services were the large international accounting firms, including Deloitte, Michael Wansley’s firm.

The nature of debt-restructuring services varies significantly, but such engage- ments often begin with an intense study or “audit” of the given entity’s accounting records. This examination is intended to uncover any evidence of embezzlement or other malfeasance by management or other parties. These engagements also com- monly include an in-depth analysis of the debtor company’s business model to deter- mine whether the entity appears to be economically viable. A debt-restructuring engagement typically concludes with the engagement team developing a series of recommendations intended to help the lenders of the financially troubled company minimize their loan losses. These recommendations may involve replacing the exist- ing management team, having the lender or lenders forgive their outstanding loans in exchange for equity interests in the given company, or liquidating the company to raise funds that can be used to repay or partially repay its outstanding loans.

Not surprisingly given their nature and purpose, debt-restructuring engagements can be rife with tension. Business Week noted that Thailand’s financial crisis spawned “Debt Wars” in that country that pitted representatives of the large international accounting firms, such as Michael Wansley, against Thai business owners and exec- utives.3 Thai business owners and executives resented the probing and relentless investigations of the “farangs” (foreigners) who did not appreciate or fully understand the informal and low-key culture of the Thai business community, a culture in which “handshake” contracts were common, disagreements were considered impolite, and face-to-face confrontations were rare. Making matters worse, Thai companies were not accustomed to having their financial records and business operations scrutinized by third parties since the nation’s independent audit function was still evolving and was not nearly as rigorous as in developed countries around the world.

The investigative work of debt-restructuring specialists was particularly galling to members of the wealthy Thai families that had long dominated their nation’s econ- omy. Until the late 1990s, 15 Thai families controlled networks of businesses that accounted for more than one-half of Thailand’s annual gross domestic product.4 Among these families was the Siriviriyakul family that owned the Kaset Thai Sugar Company. For centuries, these families had operated their business empires with only minimal oversight or regulation from the Thai government or other parties. Suddenly, these prominent families found themselves being forced to respond to embarrassing questions and accusations posed by a small army of foreign accountants.

In January 1999, Business Week interviewed the 58-year-old Wansley regarding the difficult and stressful nature of his work in Thailand. Wansley noted that the most frus- trating facet of debt-restructuring engagements in Thailand was the belligerent atti- tude of company owners. “Once you become grossly insolvent you’re not supposed to be in a position of great strength, but here they think they are.”5 In a subsequent interview, Wansley also admitted that the hostile nature of the debt-restructuring engagements caused him to sometimes question his and his subordinates’ safety. That concern was not unwarranted.

As the black minivan carrying Wansley and the four employees of Kaset Thai Sugar Company rolled to a stop outside the firm’s Takhli sugar mill, two men on a

3. F. Balfour, “Fixing Thailand’s Debt Mess,” Business Week (www.businessweek.com), 12 February 2001. 4. Parpart, “Restructuring East Asia,” 41. 5. R. Corben, M. Clifford, and B. Einhorn, “Thailand: Bring Your Spreadsheet—and Bulletproof Vest,” Business Week (www.businessweek.com), 29 March 1999.

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CASE 8.2 KASET THAI SUGAR COMPANY 499

motorcycle pulled up beside the vehicle. The man sitting on the rear of the motor- cycle leaped off and within a matter of seconds fired eight bullets from an automatic pistol into the interior of the minivan. The bullets struck Michael Wansley in the head, killing him instantly. The four other passengers in the minivan were left unharmed as the gunman and his confederate sped away on the motorcycle.

The murder of Michael Wansley triggered outrage in Australia and the interna- tional business community. Australian government officials demanded that Thailand law enforcement authorities vigorously investigate the crime and apprehend those responsible. Eventually, six individuals would face criminal charges for Wansley’s murder. These individuals included the gunman, the motorcyclist, the owner of the motorcycle, two employees of Kaset Thai Sugar Company who had allegedly been involved in the conspiracy to kill Wansley, and the owner of the Takhli sugar mill who was a member of the powerful Siriviriyakul family. This latter individual was charged with masterminding Wansley’s murder.

The motorcyclist, who was arrested shortly after the incident, was convicted for his role in the crime and given a life sentence. A human resources manager of Kaset Thai Sugar and the owner of the motorcycle, a retired policeman, were convicted of conspiring to murder Wansley and received death sentences. The brother of the human resources manager, who was also a Kaset Thai Sugar employee, was con- victed of conspiracy to commit murder but received a life sentence. In July 2008, the individual who allegedly shot Wansley was acquitted of that crime by a Thai court. The only witnesses who identified that individual as the gunman were two of his alleged co-conspirators; however, their testimony was dismissed by the court. The court ruled that the witnesses were not credible since they were convicted felons.

The most controversial outcome in the criminal cases emanating from Wansley’s death was the acquittal of the owner of the Takhli sugar mill despite seemingly strong evidence linking him to the crime. During this individual’s trial, a witness testified that the defendant had paid him approximately $1,000 to dispose of the motorcycle used in the Wansley murder. Another individual, a senior law enforcement official, revealed that the sugar mill owner had offered him $4 million in exchange for not filing charges against him in the case. Phone records introduced as evidence during the trial documented that prior to the shooting the defendant had frequent telephone conversations with the three individuals convicted of conspiring to kill Wansley.

Court testimony also revealed that shortly before his death, Michael Wansley dis- covered that approximately $150 million loaned to the Kaset Thai Sugar Company had been secretly transferred to small companies controlled by the sugar mill owner and other members of his family. This testimony established that the defendant had a strong motive to harm Wansley. In fact, a Kaset Thai Sugar employee testified that following Wansley’s death, the sugar mill owner had told him, “It’s very good the far- ang is dead; now we can all live comfortably.”6 Despite such evidence, the three-judge tribunal that presided over the trial handed down a “not guilty” verdict, clearing the sugar mill owner of any involvement in Wansley’s murder.7, 8

6. J. Pollard, “Death Penalty for Aussie Auditor’s Killers,” The Australian (www.theaustralian.news.com .au), 6 September 2006. 7. One of the judges initially assigned to the case had been replaced when allegations surfaced that he had been paid a large bribe by the defendant’s family. 8. The Siriviriyakul family maintained control of the Kaset Thai Sugar Company following Michael Wansley’s death. When the debt-restructuring plan eventually developed by Deloitte was rejected by the company’s creditors, a Thai court refused to liquidate the company and instead allowed the Siriviriyakul family to continue operating it.

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500 SECTION EIGHT INTERNATIONAL CASES

The six individuals who faced criminal charges stemming from the murder of Michael Wansley were not the only parties blamed for his death. A journalist sug- gested that Wansley’s employer, Deloitte, should shoulder some of the blame for his untimely death. Deloitte officials “should have known that they were send- ing the locally inexperienced Wansley into a dangerous situation without taking precautions.”9 The journalist pointed out that among the major international account- ing firms, Deloitte had established a reputation as a leader in risk assessment and risk management. “These days, expertise in risk assessment—on which D. T. T. [Deloitte Touche Tohmatsu] prides itself—cannot be prudently limited to financial risk.”10

Deloitte apparently did not respond directly to such criticism. However, several years later, Keith Skinner, the chief operating officer (COO) of Deloitte Touche Tohmatsu and a close friend of Michael Wansley, agreed to be interviewed regarding Wansley’s death. In that interview, Skinner indicated that Wansley’s murder “has had a lasting impact” on Deloitte’s operations in regions of the world that are “culturally different.”11 When asked what specific changes Deloitte had made in response to the incident, Skinner reported that Deloitte was placing a higher priority on “security” issues for professional services engagements in high-risk countries.

During this same interview, Skinner noted that Michael Wansley had not only been a well-respected professional but also an individual who was known for his extraordinary personal integrity and humanitarian efforts. In particular, Wansley had devoted considerable time to working with the International Red Cross.

Questions 1. Suppose in the future you are assigned to an audit engagement that requires

you to travel to a foreign country openly hostile to the United States. Because of that hostility, you are uncomfortable with the assignment. What would you do? Before responding, identify the alternatives you have.

2. Do you believe it is appropriate for a professional services firm to ask employees to serve on engagements in which their personal safety is at risk? Defend your answer.

9. Parpart, “Restructuring East Asia,” 39. 10. Ibid. 11. A. Caldwell, “Murdered Accountant’s Son Welcomes Sentences,” www.abc.net.au, 5 September 2006.

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501

CASE 8.3

Republic of Somalia

Accounting has a reputation as a fairly unexciting line of work. That won’t be the case in Mogadishu.

Frank James, National Public Radio

The Horn of Africa has long played an important role in world history. Most histori- ans believe that the large triangular peninsula that juts into the Indian Ocean along the east coast of Africa was the home of the legendary Kingdom of Punt, an impor- tant trading partner of ancient Egypt during the time of the pharaohs. Centuries later, the tribes that occupied the Horn of Africa played a pivotal role in the development of a strategic trade route linking the East and West. Those tribes patrolled the narrow mouth of the Red Sea that served as a passageway for merchant ships transporting goods to and from the Far East and Eurasia.

In modern times, the Horn of Africa has been home to the Republic of Somalia, a country that gained its independence from Italy and Great Britain in 1960. For most of the past five decades, the arid country with approximately ten million residents has been plagued by a bloody civil war. In 1991, the nation’s central government collapsed, resulting in Somalia being carved up into lawless fiefdoms controlled by tribal warlords. In addition to being ravaged by civil war, Somalia has suffered greatly due to frequent military raids launched within its borders by neighboring Ethiopia and Kenya, each of which views the anarchy in Somalia as a threat to its own politi- cal and economic stability. Humanitarian organizations estimate that more than one million Somalis have been displaced by the two decades of warfare since Somalia plunged into anarchy. One-third of those Somalis who have not fled their homeland live in abject poverty without access to clean water or the most basic healthcare services.

Somalia has been in the news in recent years because of the gangs of pirates that operate from several camps along its long coastline. Following the turn of the cen- tury, these pirates began commandeering commercial ships that must skirt the coast of Somalia on their way to and from the Red Sea. The New York Times reported that during 2009 Somali pirates attacked 214 ships and successfully hijacked 47 of them.1 According to the Boston Globe, the pirates received approximately $200 million in ransom payments from private companies and other organizations in a period of less than 15 months in 2008 and 2009. These payments were made in exchange for the release of the cargo and crews of the hijacked ships.2

The most pressing international concern posed by the civil unrest in Somalia has been the growing influence of the terrorist organization Al Shabaab within the country. Al Shabaab, which is closely affiliated with Al Qaeda, the terrorist group founded by Osama bin Laden, has established training bases in Somalia and actively recruits large numbers of Somali youths who have few, if any, employment oppor- tunities. Because of Somalia’s strategic importance to ocean trade routes and the Middle Eastern oil fields, the United States and other western powers have attempted to blunt the growing influence of Al Shabaab in the country.

1. M. McDonald, “Record Number of Somali Pirate Attacks in 2009,” New York Times (online), 29 December 2009. 2. A. Taylor, “Pirates of Somalia,” Boston Globe (online), 16 March 2009.

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502 SECTION EIGHT INTERNATIONAL CASES

In 2004, the United Nations and the African Union, with the financial support of the United States, organized the Transitional Federal Government (TFG) for Somalia. This new governmental entity was intended to reestablish some degree of civil law and rudimentary social functions, such as an educational system, within Somalia with a long-range objective of mediating the differences among the nation’s warring tribes. The bulk of the financial support for the TFG was to be provided by foreign countries and by wealthy Somalis who had fled the country and settled elsewhere, principally in Canada, Great Britain, and the United States. In the first few years following its creation, the TFG received an estimated one billion dollars of foreign aid annually from Somali expatriates and other sources.

Shortly after the TFG was created, it faced a troublesome and largely unanticipated problem. When Somalia’s central government disintegrated in 1991, the nation’s bank- ing system collapsed. The absence of a banking system made it difficult for the TFG to perform some of the most basic administrative functions necessary to sustain its oper- ations, such as purchasing equipment and supplies and distributing payroll funds. The absence of a banking system when coupled with the TFG’s failure to establish reliable accounting and control functions resulted in much of the foreign aid pouring into Somalia each year being embezzled. In turn, the reports of rampant embezzle- ment made it increasingly difficult for the TFG to raise funds from foreign sources.

To establish financial accountability for the TFG, representatives of a UN agency were stationed in Mogadishu, the country’s capital. This UN team was to provide banking and related administrative functions for the TFG. Within a short time, however, the UN withdrew those individuals due to enormous safety concerns posed by the frequent street-to-street fighting, mortar attacks, and suicide bombings within Mogadishu.

In 2009, with the TFG in dire financial straits, the UN brokered a private agreement to have an outside organization manage the TFG’s financial affairs. That organization was the world’s largest accounting firm, PricewaterhouseCoopers (PwC). In a brief press release issued in July 2009, a PwC spokesperson confirmed that the firm had been “appointed to hold and manage the pledged and allocated funds for institu- tional capacity building and development [in Somalia].”3 Citing client confidentiality and security concerns, PwC refused to divulge any more information regarding the unusual engagement or the nature of its contract with the TFG.4

Additional details of PwC’s contractual agreement with the TFG were eventually leaked to the press. PwC reportedly had made a commitment to station 20 professional accountants and consultants in Nairobi, Kenya, to staff the engagement. (Nairobi is located approximately 600 miles east of Mogadishu—Kenya and Somalia share a long border.) These PwC staffers were charged with developing orderly cash receipts and disbursements functions for the foreign aid funneled to the TFG each year. Before releasing funds requisitioned by a TFG agency, PwC personnel would audit the requisi- tion and establish that the funds were to be used for a legitimate purpose. After funds were disbursed to an agency, PwC would perform postaudit procedures to ascertain whether the funds had been used for their designated purpose.

Since the PwC staff would be stationed in Nairobi, Somali nationals living in the small sector of Mogadishu controlled by the TFG would be hired and trained by the firm to perform day-to-day administrative duties. PwC apparently agreed, however, that members of the Nairobi-based engagement team would occasionally travel to Mogadishu and remain there for short periods of time.

3. BBC (online), “Somalia Appoints Accountancy Firm,” 8 July 2009. 4. Ibid.

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CASE 8.3 REPUBLIC OF SOMALIA 503

According to published reports, PwC was to be compensated on a commission basis for its services. The commissions earned by the firm would be equal to 2 to 4 percent of the funds that were ultimately spent for their designated purpose. Although PwC stood to earn tens of millions of dollars annually on the engagement, the firm’s compensa- tion was considerably more modest than the 10 to 14 percent commission charged by the UN agency that had previously performed similar services for the TFG.

TFG officials maintained that the services provided by PwC would help them rebuild a social and economic infrastructure for Somalia, as well as strengthen their organi- zation’s credibility around the globe. “This is a big step in reconstructing Somalia. In addition, this will enhance transparency and accountability.”5 Despite those expecta- tions, the TFG’s decision to hire PwC proved to be very controversial for both parties.

One prominent TFG critic claimed that despite public reports that the UN had brought together PwC and the TFG, the agreement between the two parties had been secretly orchestrated by Kenyan and Ethiopian government officials who were acting in the best interests of their countries, not those of Somalia.6 This same critic also chided the TFG for choosing PwC rather than one of the other international account- ing firms. “Of all the international accounting firms that your government could have hired, PwC should have been the last to be considered for the job. Take a look at how many scandals and lawsuits they have been involved in.”7 This individual then identi- fied 10 high-profile incidents that documented PwC’s recent legal troubles, including the firm’s role in the Satyam fraud in India.

Several other parties provided less emotional and thus more credible critiques of the TFG’s decision to retain PwC. The most common complaint involved the lack of transparency surrounding the decision by the TFG to hire PwC and its failure to publicly disclose the specific nature of PwC’s responsibilities. One critic observed that since TFG officials had been involved in previous “illegal agreements,” it was inappropriate for them to engage in “confidential” contracts that could provide them an opportunity to once again use foreign donations for their own personal benefit.8 “The PwC contract will most likely generate windfalls for personal benefit [of TFG officials]. Client confidentiality is a very handy defense for any abuse of power and misappropriation of funds.”9 This same critic noted that Transparency International, a highly regarded organization committed to leading the global fight against cor- ruption, insists that secret contracts such as the TFG–PwC agreement effectively shield corrupt governmental officials from prosecution.10 (In 2009, Somalia topped Transparency International’s list of the most corrupt nations worldwide.)

Certain parties also questioned the judgment of PwC in accepting the Somalia engagement. One concern voiced repeatedly was how the firm could ensure the safety of the individuals assigned to the engagement, particularly when those individuals found it necessary to travel to war-torn Mogadishu. In response to that concern, PwC officials noted that their firm had previously carried out similar but less-publicized engagements in both Afghanistan and Sudan. On its website, PwC disclosed that the individuals who had been assigned to the Sudanese engagement

5. Somalialand Times (online), “Somalia Hires UK Accountancy Firm,” 11 July 2009. 6. Hiiraan (online), “There Is No Circular Logic in Honesty,” 21 January 2010. (Note: Hiiraan is an online Somali news and information service.) 7. Ibid. 8. M. M. Uluso, “PwC’s Contract Empowers ‘The Smartest Guys in the Room,’” Somaliatalk.com, 2 August 2009. 9. Ibid. 10. Ibid.

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504 SECTION EIGHT INTERNATIONAL CASES

had been required to participate in a survivalist program known by the acronym THREAT—The Hostile Region Environment Awareness Training. No doubt, the firm required the staff assigned to the Somalia engagement to undergo similar training.11

11. Those parties who criticized PwC for accepting the lucrative Somalia engagement failed to comment on the prominent firm’s involvement in important humanitarian activities around the globe. In 2008, the firm committed millions of dollars to a program to help educate Sudanese children living in refugee camps in Chad. Among the many other humanitarian activities supported by PwC is the global initiative of the Save the Children program that provides educational and healthcare services to impoverished children around the globe. 12. J. Gettleman, “U.N. Criticizes U.S. Restrictions on Aid for Somalia,” New York Times (online), 18 February 2010. 13. J. Gettleman, “Somalia Food Aid Bypasses Needy, U.N. Study Finds,” New York Times (online), 9 March 2010.

E P I L O G U E Throughout the latter half of 2009 and beyond, Somalia continued to be plagued by violence that often resulted in significant casualties for the TFG militia, Al Shabaab–trained and –financed guerillas, and innocent civilians. Charges of government corruption also con- tinued unabated following the retention of PwC by the TFG. In early 2010, the UN and U.S. government began quarreling over the issue of foreign aid for Somalia. According to the New York Times, the UN was upset because U.S. government officials were stymieing the flow of foreign aid into Somalia due to “unfounded allegations” that much of the aid was being “diverted to terrorists.”12 Two weeks

later, those U.S. officials referred to a report prepared by the UN’s own Security Council to support those “unfounded allegations.” This report indicated that as much as one-half of the foreign aid flowing into Somalia was being embezzled by various parties, includ- ing corrupt TFG officials and “radical Islamist militants.”13

In August 2012, with the help of the UN, the TFG was replaced by the Federal Government of Somalia, a new and democratic governmen- tal infrastructure for Somalia. Published reports indicate that PwC continues to play a key role in managing Somalia’s financial affairs under the new government regime.

Questions 1. What type of professional services was PwC providing to the TFG? What

professional standards apply to such engagements?

2. Do you agree that the client confidentiality rule prohibited PwC from disclosing the contractual details of the TFG engagement? Defend your answer.

3. In addition to client confidentiality, what other ethical issues or challenges did PwC’s contractual relationship with TFG present for the accounting firm?

4. Identify the specific risks that the Somalia engagement posed for PwC as a firm. Do you believe that PwC properly considered and mitigated each of those risks? Explain.

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505

CASE 8.4

Republic of the Sudan

No investor should ever have to wonder whether his or her investments or retirement savings are indirectly subsidizing a terrorist haven or genocidal state.

Christopher Cox, SEC Chairman

In 1956, the Republic of the Sudan obtained its independence from Great Britain. Although unified, Sudan was effectively two countries within one. Northern Sudan, home of the nation’s capital, Khartoum, was controlled by Islamic fundamentalists, while southern Sudan was controlled by Christian fundamentalists. In 1989, a mili- tary coup led by General Omar Hassan al-Bashir, leader of the National Islamic Front, overthrew Sudan’s central government and took control of Khartoum. Almost imme- diately, the new government imposed Islamic law or Shari’a on southern Sudan, trig- gering widespread violence between the Islamic-controlled Sudanese military and rebel forces organized by Christian leaders in southern Sudan. By the early years of the twenty-first century, the primary battleground in Sudan was the large western region of the country known as Darfur.

Over the past several decades, various organizations, including the United Nations and the International Criminal Court, have documented atrocities on a massive scale that have been inflicted on the citizens of Sudan, principally residents of Darfur and southern Sudan. The Christian Science Monitor reported in 2008 that as many as two million Sudanese have died as a result of those atrocities, while four million other Sudanese have been displaced from their homes.1 In June 2004, United Nations Secretary-General Kofi Annan and United States Secretary of State Colin Powell visited the war-torn country. During that visit, Annan referred to the ongoing civil war in Sudan as the worst humanitarian crisis facing the world, while Powell described the situation as a “humanitarian catastrophe.”2

Political leaders in numerous Western countries have insisted that the Republic of the Sudan’s government is responsible for the war crimes committed in Darfur and southern Sudan. Allegedly, that military dictatorship organized large bands of armed mercenaries or janjaweed to attack and wipe out entire villages in those regions of the country. The Sudanese government reportedly used revenues produced by the nation’s large oil industry to finance this campaign of terror against its own citizens.

In recent years, governmental authorities and private interest groups across the globe have undertaken initiatives to end the widespread suffering in Sudan. Many of these efforts have involved economic sanctions intended to limit the Sudanese government’s ability to finance terrorist attacks on its own citizens. In 1998, President Bill Clinton imposed an economic embargo on Sudan that effectively prevented U.S. companies from engaging in commerce with Sudanese companies or the Sudanese government. During President Clinton’s administration, Sudan was also included on the U.S. State Department’s list of “state sponsors of terrorism” (SSTs), a list that

1. J. Adams, “Renewed Sudan Violence Raises Fears of Return to Civil War,” Christian Science Monitor (online), 16 May 2008. 2. CNN.com, “U.S. Circulates U.N. Resolution on Sudan,” 30 June 2004.

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506 SECTION EIGHT INTERNATIONAL CASES

includes such countries as Cuba, Iran, and Syria.3 More recently, several states have passed laws requiring state employee pension funds to divest themselves of invest- ments linked to Sudan.

In 2004, a U.S. House of Representatives committee issued a report calling for the SEC to require companies with securities listed on U.S. stock exchanges to disclose any business operations within, or other relationships with, nations identified as SSTs. The House committee maintained that such information qualified as “material information” under the far-reaching “full and fair disclosure” regulatory mandate of the SEC and thus should be disclosed to investors.

A company’s association with sponsors of terrorism and human rights abuses, no matter how large or small, can have a material adverse effect on a public company’s operations, financial condition, earnings, and stock prices, all of which can affect the value of an investment.4

The SEC responded to this directive by requiring public companies to disclose any and all ties to SST countries. To promote compliance with this new policy, the SEC established the Office of Global Security Risk (OGSR) within its Division of Corporation Finance. The OGSR monitors SEC filings to ensure that SEC registrants make all appropriate SST-related disclosures.

The most controversial measure to date to help investors identify companies with links to SSTs was an Internet search tool created by the SEC in June 2007. This search tool scanned the huge number of documents filed by SEC registrants on the agency’s EDGAR (electronic data gathering and retrieval system) website and tagged compa- nies with ties to one or more SSTs. After these companies were identified, they were included on a list that was posted to a webpage on the EDGAR website. The SEC reported that the intent of this new procedure was to provide investors and other parties with direct access to company disclosures involving “past, current or antici- pated future business activities in one or more of these [SST] countries.”5 In fact, such disclosures were already available to investors and other parties who wanted to search for them by utilizing the existing search tool on the EDGAR website.

Nearly one hundred companies appeared on the initial SST “blacklist” that was generated by the SEC’s Internet search tool. Because of the economic embargo imposed by the U.S. on Sudan, nearly all of these companies were foreign firms that had securities listed on U.S. stock exchanges. Among the more prominent of these companies were Alcatel, Benetton, Cadbury Schweppes, Credit Suisse, Deutsche Bank, HSBC, Nokia, Reuters, Siemens, and Unilever. The SEC reported “exceptional traffic” on the SST webpage. The agency also reported that individuals who visited that webpage typically “clicked” on individual company names to access the relevant financial statement disclosures made by those companies.6

Within a matter of days after the SEC initiated its new disclosure policy, the com- panies affected by that policy began complaining bitterly to the federal agency. Executives of many of these companies insisted that it was unfair for them to be singled out by the SEC since they had only minimal operations in, or some other

3. According to the Encyclopedia Britannica Online, terrorism is the “systematic use of violence to create a general climate of fear in a population and thereby to bring about a particular political objective.” 4. Steptoe & Johnson, “International Law Advisory—SEC Disclosure for Operations in Sensitive Countries,” 17 May 2004 (steptoe.com/publications-3091.html). 5. Securities and Exchange Commission, “Concept Release on Mechanisms to Access Disclosures Relating to Business Activities in or with Countries Designated as State Sponsors of Terrorism,” Release Nos. 33-8860 & 34-56803, 23 November 2007. 6. A. Rappeport, “SEC Removes Terrorism Tool Amid Backlash,” CFO.com, 23 July 2007.

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CASE 8.4 REPUBLIC OF THE SUDAN 507

tenuous connection to, one or more SST countries. For example, a major pharmaceu- tical company in India, Dr. Reddy’s Laboratories, admitted that it marketed several of its products in Sudan. However, the company’s CEO maintained that those sales were not “viewed as material to our business or our overall revenue.”7 Despite that point of view, under the SEC’s disclosure policy any sales to an SST nation quali- fied as “material.” As a result, when such information was disclosed in an SEC regis- tration statement, the federal agency’s search tool ensured that the given company appeared on the webpage listing registrants with SST ties.

Another common complaint voiced by executives of companies appearing on the SEC’s SST list was that many firms avoided being included on that list by not disclos- ing links to terrorist countries in documents filed with the federal agency. One such company was the large U.S.-based investment firm Berkshire Hathaway. In its 2006 annual report, Berkshire Hathaway failed to disclose that it had a large investment in PetroChina, a company with extensive business operations in Sudan. When con- tacted about this matter, Berkshire Hathaway officials insisted that the PetroChina investment was not material to their company’s financial statements and thus did not have to be disclosed as an SST-linked investment in its SEC registration statements. In late 2007, Berkshire Hathaway announced that it had liquidated its PetroChina investment. Warren Buffett, the company’s chief executive officer, reported that the PetroChina investment was sold for economic reasons and not because of pres- sure to do so by parties who had criticized his company for having a Sudan-related investment.8

Other critics of the SST disclosure policy suggested that it was inappropriate for the SEC to “single out” registrants involved in one type of questionable business activity while ignoring companies involved in a wide range of other such activities. An officer of the National Foreign Trade Council noted that, “Providing enhanced access . . . in this particular case is selective and ignores the fact that there are a multitude of other social and political issues that do not receive similar treatment.”9 A similar point of view was expressed by an executive of the American Bankers Association—many large international banks appeared on the SEC’s SST webpage. “Some investors feel strongly about activities supporting gambling enterprises, others oppose those busi- nesses generating excessive greenhouse gases, still other investors avoid companies that are not unionized, while others avoid companies that are unionized. . . . There is simply no basis for the Commission to dedicate special resources to a particular kind of taboo business activity.”10

Finally, two top executives of the Securities Industry and Financial Markets Association maintained that the SST disclosure policy went beyond the SEC’s

7. K. Datta and P. B. Jayakumar, “Dr. Reddy’s in SEC List for Terrorist State Links,” Rediff India Abroad (online), 30 June 2007. 8. In fact, Berkshire Hathaway’s board of directors asked the company’s shareholders to vote on whether the PetroChina investment should be sold. In presenting that proposal to the stockholders, the board indicated that it did not believe that “Berkshire should automatically divest shares of an investee because it disagrees with a specific activity of that investee” (“Shareholder Proposal Regarding Berkshire’s Investment in PetroChina,” www.berkshirehathaway.com/sudan.pdf). The stockholders voted not to require the board to sell the PetroChina shares by a margin of 97.5 percent to 2.5 percent. 9. W. A. Reinsch, Letter filed with the SEC in response to SEC Release Nos. 33-8860 & 34-56803, “Concept Release on Mechanisms to Access Disclosures Relating to Business Activities in or with Countries Designated as State Sponsors of Terrorism” (www.sec.gov) 18 January 2008. 10. S. Behram, Letter filed with the SEC in response to SEC Release Nos. 33-8860 & 34-56803, “Concept Release on Mechanisms to Access Disclosures Relating to Business Activities in or with Countries Designated as State Sponsors of Terrorism” (www.sec.gov) 22 January 2008.

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508 SECTION EIGHT INTERNATIONAL CASES

regulatory mandate by involving the federal agency in “foreign policy and national security matters.”11 These individuals went on to raise the issue that became a focal point of the controversy surrounding the SEC’s new disclosure policy. That issue was whether the SEC should be allowed to decide what information in registration state- ments is particularly “material” and thus should be highlighted or otherwise brought specifically to the attention of the investing public.

We are not aware of the SEC having previously singled out companies based on disclosures that they have made, unless those disclosures were materially misleading or otherwise violated the law. With any website tool designed to draw attention to disclosures involving activities in countries designated as State Sponsors of Terrorism, however, the SEC in effect would determine what information should concern inves- tors. Though this kind of judgment may be well-intentioned . . . it directly conflicts with the SEC’s longstanding disclosure-based regulatory scheme, which is designed to elicit material information and then to let investors evaluate the disclosures for themselves.12

11. D. Preston and D. Strongin, Letter filed with the SEC in response to SEC Release Nos. 33-8860 & 34-56803, “Concept Release on Mechanisms to Access Disclosures Relating to Business Activities in or with Countries Designated as State Sponsors of Terrorism,” (www.sec.gov) 22 January 2008. 12. Ibid. 13. Despite closing the webpage that reported companies with links to SSTs, the SEC continues to require public companies to disclose in their SEC registration statements any relationships they have with SSTs.

E P I L O G U E In July 2007, five weeks after the SEC instituted its new SST disclosure policy, the federal agency yielded to vocal critics of that policy by eliminat- ing the webpage that contained the SST black- list. At the time, the SEC reported that it would possibly reinstitute the SST disclosure policy or an amended version of it in the future.13

Four months later, in November 2007, the SEC issued a “request for comment” release asking for public input regarding the issue of terrorism- linked financial disclosures. The key question raised by the SEC was whether such disclosures in SEC registration statements should be high- lighted in some way on the EDGAR website. The large majority of the responses received by the SEC indicated that the federal agency should not bring special attention to such dis- closures. To date, the SEC has taken no further action on this matter.

Sudan President al-Bashir bowed to intense pressure in 2005 and accepted a peace agreement

brokered by international mediators. The arrangement called for a ceasefire of all hostili- ties, established a semiautonomous government for southern Sudan, and called for a nationwide referendum on independence for that region of the country. That referendum in January 2011 resulted in nearly 99 percent of the electorate in southern Sudan voting for secession. On 9 July 2011, the Republic of South Sudan became an independent country recognized by the United Nations.

The 2005 peace agreement and the subse- quent creation of the Republic of South Sudan did not end the violence between the two dominant Sudanese factions. After South Sudan gained its independence, armed rebels from the Republic of the Sudan began launching orga- nized attacks against military installations in that new country, particularly in South Sudan’s large eastern province of Jonglei. By late 2013, this violence had claimed hundreds of lives and

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CASE 8.4 REPUBLIC OF THE SUDAN 509

Questions 1. Do you agree with the assertion that any and all associations that SEC

registrants have with SSTs qualify as “material information” for financial reporting purposes and thus should be disclosed in their SEC filings? Are there other “sensitive” or questionable business activities that SEC registrants should be required to disclose? Defend your answers.

2. Should the SEC have the authority to highlight or bring special attention to certain disclosures made by SEC registrants? Why or why not?

3. How does the SEC define “materiality”? How does that definition differ, if at all, from the definitions of materiality included in accounting and auditing standards?

delayed the planned return of millions of South Sudanese citizens who had been uprooted by the civil warfare.

In March 2009, the International Criminal Court in The Hague, Netherlands, issued an arrest warrant for President al-Bashir. That court, which is recognized by nearly 150 nations worldwide, indicted al-Bashir for a series of war

crimes and crimes against humanity. The follow- ing year, the court indicted al-Bashir on charges of genocide and issued a second arrest warrant for him. The two arrest warrants were the first ever issued by the court for a national head of state. To date, al-Bashir has ignored the arrest warrants and insisted that the International Criminal Court has no jurisdiction over him.

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511

CASE 8.5

Shari’a

Live together like brothers and do business like strangers.

Arabic proverb

The surging demand for petroleum products in recent decades has produced a wind- fall of revenues for many oil-rich Islamic countries in the Middle East, including, among others, Kuwait, Saudi Arabia, and the United Arab Emirates. Because Islam limits the types of investments and business ventures in which the world’s 1.6 billion Muslims can become involved, the Middle Eastern oil boom has resulted in the emergence of an Islamic economy that is largely distinct from the rest of the global economy.1 In recognition of this new economy, which is the world’s most rapidly growing economic sector, major business publications have established market indices devoted strictly to Islamic business enterprises. These indices include the Dow Jones Islamic Market World Index and the FTSE Global Islamic Index.

Banking ranks among the fastest-growing and most important components of the burgeoning Islamic economy. In the early 1970s, only a few small Middle Eastern banks expressly embraced the restrictive conditions imposed on business transactions and relationships by the Islamic religion and thus qualified as “Islamic” banks. Collectively, the assets of those banks totaled less than $20 million. Four decades later, approxi- mately 300 major banks around the globe cater exclusively or primarily to devout Muslims. Those Islamic banks boast total assets of more than $1.5 trillion dollars.

Although modern Islamic finance is still in its infancy, major Islamic banks have implemented most of the high-tech banking functions and practices used by their Western counterparts. The principal Islamic banking centers are Malaysia, the Middle East, and the United Kingdom, but financial institutions throughout the world have developed aggressive marketing campaigns to attract Muslim clients. By 2013, more than two dozen banks in the United States offered financial services designed exclusively for the estimated six million Muslim-Americans.

Tenets of the Islamic religion dramatically influence the nature of banking prac- tices within the Islamic economy. Easily the biggest difference between Islamic banking and Western banking is the prohibition against interest payments on capital within the Islamic world.

Islamic religious law or Shari’a2 forbids the payment or receipt of riba (interest) in personal or business relationships. Islamic banks have been forced to develop unique and elaborate profit and risk-sharing contracts known as mudarabah to allow them to provide financial services without paying interest on their depositors’ funds or charging interest to their “borrowers.” As noted in a special report on Islamic finance published by the London-based Financial Times, “Islamic finance tries to replicate the conventional [banking] market, but in a structure that uses profits rather than interest.”3

1. For example, Islam generally prohibits Muslims from being associated with companies whose lines of business involve alcoholic drinks, destructive weapons, gambling, illicit drugs, pornography, pork and pork products, and tobacco. 2. Western publications spell this term in several different ways. The most common spellings include Shari’a, Sharia, Shari’ah, and Shariah. 3. Financial Times, “Islamic Finance: An FT Special Report,” ftalphaville.ft.com, 23 May 2007.

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512 SECTION EIGHT INTERNATIONAL CASES

The literal interpretation of the term Shari’a in Arabic is “path to the water source.” Wikipedia defines Shari’a as “the legal framework within which the public and pri- vate aspects of life are regulated for those living in a legal system based on Islamic principles of jurisprudence.” Unlike legal codes in the United States and other Western countries, Shari’a is not a compendium of static laws but rather an evolving set of guiding principles and interpretations derived principally from the Qur’an and teachings of the Prophet Muhammad. The dynamic nature of Shari’a results from numerous religious opinions or Fatwa issued periodically by Islamic religious schol- ars on a wide range of contemporary issues facing Muslims.

Shari’a influences every aspect of day-to-day life in the Islamic world, including politics, family issues, personal hygiene, and business relationships. Within the Islamic economy, the term “Shari’a compliant” is used to refer to business prac- tices, economic ventures, and individual transactions that have been sanctioned by Islamic religious scholars. An audit partner of Ernst & Young Global Limited recently observed that “Shari’a compliance is the essence of Islamic banking and finance.”4 In fact, only those banks that offer Shari’a-compliant financial services and products are considered to be Islamic banks.

The development of mudarabah and other Shari’a-compliant banking practices have contributed significantly to the growth of Islamic finance in recent years. Islamic banks presently account for less than 3 percent of the worldwide financial services market, but economic experts expect that market share to grow significantly in com- ing decades if the Islamic banking industry can overcome several major challenges that it faces. A major European financial publication has reported that “Islamic bank- ing’s long-term ambition”5 is to become a dominant force in international financial markets. This same publication noted that among the biggest obstacles to accom- plishing that goal is the “lack of uniform and consistent accounting and auditing standards”6 within the Islamic economy.

The Islamic View of Accounting Since the inception of the accounting profession, cultural norms have influenced the development of accounting standards within every country, including the United States. Likewise, cultural differences across countries and regions of the world have complicated recent efforts to develop a common set of international accounting stan- dards. Nowhere have cultural nuances had a greater impact on efforts to develop uniform accounting standards than in the Islamic world. Because of its growing size and prominence, the Islamic banking industry has been the principal focus of efforts within Islamic nations to develop domestic accounting standards that cohere with Shari’a, or, alternatively, to modify international accounting standards to achieve the same goal.

Similar to every other aspect of Islamic life, accounting principles are considered subordinate to the dictates of Shari’a. As one Islamic accounting scholar has noted, “Islam accepts the fact that accounting is a social construction and itself constructs social reality but this social reality which the accounting constructs must conform to the dictates of Islamic belief.”7

4. O. Ansari, “Audit & Shari’a Compliance—Issues in Islamic Banking and Finance,” www.icmap.com .pk/ppt/sem_asc_khi.pps, 20 September 2008. 5. N. Dudley, “Islamic Banks Aim for the Mainstream,” Euromoney 349 (May 1998), 113–116. 6. Ibid. 7. B. Maurer, “Anthropological and Accounting Knowledge in Islamic Banking and Finance: Rethinking Critical Accounts,” Journal of Royal Anthropological Institute 8 (2002), 660.

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CASE 8.5 SHARI’A 513

A more blunt point of view was expressed by another Islamic scholar who suggested that accounting principles can induce behavior inconsistent with funda- mental tenets of his religion. “The problem with modern corporate accounting is not a matter of just numbers but a whole philosophy. Accounting can lead to perceptions of reality. . . . Ultimately, what accounting tells us [is that] what makes more money is the best thing. Over time, people will become mesmerized with this infatuation and act accordingly.”8

Auditing in the Islamic World Either because of governmental regulations in their home countries or because of economic necessity brought on by their growing size and involvement in interna- tional commerce, most Islamic banks have their annual financial statements audited by an independent accounting firm. In addition to annual financial statement audits, Islamic banks must also have their business activities “audited” each year to deter- mine whether they are in compliance with Shari’a. An accounting professor provides the following description of Shari’a auditing.

We can define Shari’a auditing as a systematic process of objectively obtaining and evaluating evidence regarding assertions about socio-economic, religious and environmental actions and events in order to ascertain the degree of correspondence between those assertions and Shari’a (Islamic law), and communicating the results to users.9

There is a wide divergence in Shari’a auditing practices across the nearly 60 Asian and African countries that are predominantly Muslim. This variance results principally from diverse interpretations and applications of Shari’a within individual Islamic countries that not only ultimately determine what business practices are acceptable in those nations but also influence how Shari’a audits are performed. Similar to Christianity, there are numerous factions or schools of thought within Islam, each of which share certain fundamental beliefs while disagreeing, often significantly, on other facets of their religion. For example, in certain Islamic countries, the Qur’an tends to be interpreted literally, while in other Islamic countries the Qur’an’s teachings are subject to more expansive or liberal interpretations.

The most common Shari’a auditing “model” applied presently is prevalent in the Middle East. Under this audit model, the principal responsibility for determin- ing whether an Islamic bank has complied with Shari’a rests with the institution’s Shari’a Supervisory Board (SSB). An SSB is typically composed of a minimum of three Islamic religious scholars who are independent of the given bank. When an Islamic bank is considering new business ventures, banking practices, or other major operational changes, its SSB will be asked to determine whether the changes are acceptable under Shari’a. Under the conventional Shari’a audit model, an SSB also reviews the given bank’s financial statements and underlying transactions, accounting records, business contracts, and other relationships at the conclusion of each year to determine that the institution has complied with Shari’a throughout that period.

Exhibit 1 presents a Shari’a audit or compliance report prepared by the SSB of Stehwaz Holding Company, a large Kuwaiti company that has significant investments

8. Ibid. 9. S. Ibrahim, “The Case for Islamic Auditing,” International Accountant 41 (2008), 21, 23.

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514 SECTION EIGHT INTERNATIONAL CASES

in Islamic financial institutions.10 Stehwaz’s annual report in which this Shari’a report was included was very comparable in terms of content and appearance to an annual report of a large U.S. company. For example, Stehwaz’s annual report contained a standard set of financial statements—prepared in accordance with International Financial Reporting Standards (IFRS) rather than U.S. GAAP, an accompanying set of detailed financial statement footnotes, and traditional “front matter” including a letter to the company’s shareholders from Stehwaz’s chairman of the board.

An unqualified audit opinion issued by a Kuwaiti chartered accounting firm pre- ceded Stehwaz’s financial statements in the company’s annual report. Stehwaz’s audit report was comparable to unqualified audit reports issued in the United States with one principal exception—the report indicated that the audit had been performed in accordance with International Standards of Auditing (ISAs). Stehwaz’s audit report did not explicitly address the question of whether the company had complied with Shari’a during the year under audit. Nevertheless, Shari’a compliance is an important issue for independent auditors of Islamic banks and other Islamic entities to con- sider, whether or not they address that issue explicitly in their audit reports. Because violations of Shari’a could have serious financial consequences for an Islamic com- pany, independent auditors in the Islamic economy must consider that possibility in designing and carrying out audit engagements.

A second but less common Shari’a audit model results in the financial statement audit report shown in Exhibit 2. That exhibit presents the independent audit report issued by Ernst & Young on recent financial statements of Al Baraka Banking Group, a large international bank based in the Kingdom of Bahrain. Notice in this report that Ernst & Young’s audit opinion includes an assertion that the bank’s financial state- ments are in compliance with “Shari’a Rules and Principles” as determined by the bank’s Shari’a Supervisory Board.

10. Notice the reference to zakat in Exhibit 1. Zakat is one of the Five Pillars of Islam, that is, the five spe- cific duties of devout Muslims. Under Shari’a, individual Muslims and Muslim businesses are required to contribute a certain percentage of their wealth each year to individuals less fortunate than themselves.

Esteemed Shareholders,

According to our signed contract, we have applied the required auditing for Stehwaz Holding’s achieved transactions and concluded contracts to ensure their compliance to Islamic Shari’ah principles, as already revealed by our submitted reviews, Shari’ah instructions and our decisions during the period ended 31st December, 2008.

The commitment to execute these transactions and contracts in compliance with Shari’ah guidelines is Stehwaz’s liability, whereas our responsibility is restricted to reviewing the submitted models and agreements.

We hereby certify that all Stehwaz’s activities and transactions as well as Zakat calculations were practiced in compliance with the Islamic Shari’ah principles and provisions, and no violations have occurred to the best of our knowledge.

Sheikh Dr. Nayef Hajaj Al Ajmi, Board Member Sheikh Dr. Essam Khalaf Al Inizi, Board Member Sheikh Dr. Essa Zaki Shaqra, Chairman

Source: 2008 Annual Report of Stehwaz Holding Company

EXHIBIT 1

SHARI’A COMPLIANCE AUDIT REPORT ACCOMPANYING RECENT FINANCIAL STATEMENTS OF STEHWAZ HOLDING COMPANY

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CASE 8.5 SHARI’A 515

REPORT ON CONSOLIDATED FINANCIAL STATEMENTS

We have audited the accompanying consolidated financial statements of Al Baraka Banking Group B.S.C. (“the Bank”) and its subsidiaries (“the Group”) which comprise the consolidated statement of financial position as at 31 December 2012 and the consolidated statements of income, cash flows, changes in owners’ equity and changes in off-balance sheet equity of investment accountholders for the year then ended, comprising a summary of significant accounting policies and other explanation information.

Board of Directors’ and Management’s Responsibility for the Consolidated Financial Statements

The Board of Directors and the management are responsible for the preparation and fair presentation of these consolidated financial statements in accordance with the Financial Accounting Standards issued by the Accounting and Auditing Organisation for Islamic Financial Institutions and for such internal control as the Board of Directors and the management determine is necessary to enable the preparation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. In addition, the Board of Directors and the management are responsible for the Group’s undertaking to operate in accordance with Islamic Shari’a rules and principles.

Auditor’s Responsibility

Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with both the Auditing Standards for Islamic Financial Institutions and International Standards of Auditing. Those Standards require that we comply with relevant ethical requirements and plan and perform the audit to obtain reasonable assurance whether the consolidated financial statements are free from material misstatement.

An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend upon our judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, we consider internal control relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by the Board of Directors and management, as well as evaluating the overall presentation of the consolidated financial statements.

We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.

Opinion

In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Group as at 31 December 2012, and its financial performance and cash flows for the year then ended in accordance with Financial Accounting Standards issued by the Accounting and Auditing Organisation for Islamic Financial Institutions.

EXHIBIT 2

ERNST & YOUNG AUDIT REPORT ON 2012 FINANCIAL STATEMENTS OF AL BARAKA BANKING GROUP B.S.C.

(continued)

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516 SECTION EIGHT INTERNATIONAL CASES

REPORT ON OTHER REGULATORY REQUIREMENTS

As required by the Bahrain Commercial Companies Law and the Central Bank of Bahrain (CBB) Rule Book (Volume 2), we report that:

a. the Bank has maintained proper accounting records and the consolidated financial statements are in agreement therewith; and

b. the financial information contained in the Report of the Board of Directors is consistent with the consolidated financial statements.

We are not aware of any violations of the Bahrain Commercial Companies Law, the Central Bank of Bahrain and Financial Institutions Law, the CBB Rule Book (Volume 2 and applicable provisions of Volume 6) and CBB directives, regulations and associated resolutions, rules and procedures of the Bahrain Bourse or the terms of the Bank’s memorandum and articles of association during the year ended 31 December 2012 that might have had a material effect on the business of the Bank or on its financial position. Satisfactory explanations and information have been provided to us by management in response to all our requests. The Bank has also complied with the Islamic Shari’a Rules and Principles as determined by the Shari’a Supervisory Board of the Group.

Ernst & Young 20 February 2013 Manama, Kingdom of Bahrain

Source: 2012 Annual Report of Al Baraka Banking Group B.S.C.

EXHIBIT 2— continued

ERNST & YOUNG AUDIT REPORT ON RECENT FINANCIAL STATEMENTS OF AL BARAKA BANKING GROUP B.S.C.

In addition to approving new business ventures, banking practices, or other major operational changes, Al Baraka Banking Group’s SSB also periodically reviews or “audits” the bank’s compliance with Shari’a. Under this Shari’a audit model, the Shari’a-related procedures performed during an entity’s independent audit effec- tively provide a second layer of assurance that the given entity has complied with relevant Islamic religious principles during the year under audit.

The principal Shari’a-related procedures integrated into a financial statement audit under this second Shari’a audit model are performed by one or more Islamic reli- gious scholars independent of the given audit client. These scholars are retained by the client’s accounting firm. If an accounting firm does not have Shari’a scholars on its professional staff—which most firms do not—then the firm will retain the services of one or more such scholars on an engagement-by-engagement basis.

Just because an Islamic bank fails to issue a separate Shari’a audit report does not mean that the bank’s independent auditors will necessarily refer to the issue of Shari’a compliance in their audit report on the bank’s annual financial statements. Consider Arab National Bank, a large Islamic bank headquartered in Riyadh, Saudi Arabia. Although Arab National Bank has an internal Shari’a compliance function, the only reference to Shari’a compliance in a recent annual report released by the company was a brief narrative statement included in the letter to stockholders by the bank’s chairman. That statement assured the bank’s stockholders that all necessary procedures had been taken during the year in question to ensure that the institu- tion complied with Shari’a. There was no indication in the bank’s annual report of the degree of involvement, if any, of the entity’s independent auditors in the Shari’a compliance audit.

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CASE 8.5 SHARI’A 517

Enhancing the Uniformity of Shari’a Auditing The wide disparity in Shari’a auditing practices has become an increasingly contro- versial issue within the Islamic economy in recent years. KPMG, a leading supplier of professional accounting and auditing services for Islamic banks, reported in 2009 that there was a need for Shari’a compliance audits to be “standardized” since they were highly “subjective” and applied on a “case-by-case basis.”11 Many parties have suggested that the most effective way to accomplish this objective would be to estab- lish a rule-making body that issues authoritative Shari’a auditing standards for all Islamic banks and other Islamic businesses. But the lack of consensus in interpreting and applying Shari’a across Islamic countries has so far prevented that goal from being accomplished.

To date, the most comprehensive effort to develop a body of consistent standards for Shari’a audits has been undertaken by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). The AAOIFI was founded in 1991 in Bahrain by a cartel of large Islamic banks. By 2013, approximately 200 Islamic banks in 45 countries and other prominent business organizations, including major interna- tional accounting firms, were sponsoring members of the AAOIFI.

The AAOIFI employs approximately 20 Islamic religious scholars who review new transactions, contracts, and business structures being considered by Islamic banks. Periodically, the AAOIFI issues “Shari’a standards” to be used by SSBs and other parties, such as independent auditors, involved in the Shari’a compli- ance function of Islamic banks. Shari’a standards issued by the AAOIFI address a wide range of business transactions and circumstances that are impacted by Islamic religious tenets such as insurance contracting, currency trading, and debt collection. These standards are intended to enhance the consistency of Shari’a compliance decisions across the Islamic banking industry. The AAOIFI also has a staff of professional accountants who monitor emerging account- ing and independent auditing issues. When deemed appropriate, the AAOIFI releases “best practices” accounting and independent auditing standards for Islamic banks.

By 2013, the AAOIFI had issued 45 Shari’a standards, 26 accounting standards, and 5 independent auditing standards. These standards are either mandatory or used as the principal regulatory framework by Islamic banks in Bahrain, Dubai, Jordan, Lebanon, Malaysia, Qatar, Saudi Arabia, Singapore, South Africa, Sudan, and Syria. In other Islamic countries, the AAOIFI’s standards are consulted on a regular basis by religious scholars, accountants, and independent auditors of Islamic banks.12

Many Islamic academics have suggested that Shari’a compliance audits and finan- cial statement audits should be merged. This proposal would leave intact SSBs and

11. KPMG.com, “Supporting the Global Islamic Finance Industry’s Aspirations,” 2009. 12. The AAOIFI is the most prominent standard-setting body for the accounting profession within the Islamic global economy. In 2009, officials of the IASB announced that they would be meeting with the AAOIFI to begin a dialogue regarding the possibility of converging or harmonizing IFRS and AAOIFI accounting standards. Presently, most Islamic countries apply IFRS modified to reflect the unique requirements or features of Islamic business. However, within the banking sector of the Islamic economy, financial institutions domiciled in the same country do not necessarily use the same subset or variation of IFRS. In terms of financial statement auditing, International Standards of Auditing (ISAs) are used extensively in the Islamic world. Many Islamic countries have formally adopted ISAs, while in other Islamic countries the relevant government agency has informally endorsed the use of those standards. In countries that embrace the AAOIFI’s auditing standards, such as Bahrain, independent auditors jointly apply the two sets of auditing standards.

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518 SECTION EIGHT INTERNATIONAL CASES

other oversight bodies that are charged with making initial decisions on which eco- nomic ventures, contracts, transactions, and other business practices are Shari’a compliant. However, the responsibility for recurring periodic audits of Shari’a com- pliance by Islamic banks and other Islamic businesses would be delegated to profes- sionally trained Shari’a auditors.

An Islamic academic who supports this proposal suggests that the effectiveness of the Shari’a compliance function is being undercut by the lack of formal training in auditing concepts and auditing methodologies on the part of the religious scholars principally responsible for that function. “While members of the Shari’a Supervisory Boards are preeminently qualified for their role of issuing Fatwa on the Shari’a permissibility of a financial product, they are not qualified auditors because they are not trained in the collecting and evaluating of evidence.”13, 14

This problem could be eliminated, according to the Islamic academic, by develop- ing a “new breed” of Islamic accountants and auditors. “What is required is a new breed of Islamic accountants and auditors who would have both a Western account- ing qualification and possibly a degree or certification in Shari’a.”15 To accomplish this goal, the scholar suggests that intervention by the Organization of Islamic Cooperation (OIC) may be necessary.

The OIC is an organization sponsored by 57 Islamic countries that represents Islamic interests at the United Nations and other global tribunals. Because of its important position in the Islamic world and its financial resources, the OIC may be the only Islamic organization that could eventually persuade differing factions of the Islamic faith to adhere to a common body of Shari’a compliance standards, such as those issued by the AAOIFI. The OIC would also likely have the authority and ability to sponsor or oversee a certification program to train accountants capable of performing joint financial statement and Shari’a compli- ance audits.

The Big Four: Gaining Access to the Islamic World A spokesperson for KPMG recently acknowledged that auditors of Islamic banks require a unique skill set. “It has become evident that the role of the external auditor to Islamic financial institutions requires a different skill set and experience to that possessed by some accounting organizations today.”16 Because of their international credibility and extensive resources, KPMG and the other Big Four accounting firms are well suited to develop accountants who have the skills necessary to perform joint financial statement and Shari’a audits.

In recent years, each of the Big Four firms has established an economic beachhead in the Islamic economy. In 2008, KPMG International issued a marketing brochure entitled Islamic Finance Credentials that identified the wide range of professional services the firm could offer Islamic banks. According to that brochure, “KPMG was one of the first accountancy organizations to meet the needs of Islamic financial insti- tutions across national boundaries and we continue to be one of the industry’s top

13. Ibrahim, “The Case for Islamic Auditing,” 25. 14. Another complicating factor is the lack of consensus within the Islamic world on exactly who qualifies as a “religious scholar” and is thus qualified to be involved in the Shari’a compliance function for Islamic banks and other organizations. Individuals recognized as religious scholars in one Islamic country may not necessarily be recognized as such in other Islamic nations. 15. Ibrahim, “The Case for Islamic Auditing,” 25. 16. KPMG International, Islamic Finance Credentials (New York: KPMG International, 2008), 2.

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CASE 8.5 SHARI’A 519

international advisors.”17 At approximately the same time, PricewaterhouseCoopers (PwC) made a similar bid to attract clients in the Islamic banking sector.18

Both Ernst & Young and Deloitte also claim to be leading providers of professional accounting, auditing, and consulting services to the Islamic finance sector. In late 2007, Deloitte became the first of the Big Four firms to appoint an Islamic religious scholar to its Middle Eastern professional staff. In commenting on this appointment, a Deloitte partner observed that “We hope by this to create a gap big enough to make it difficult [for the other Big Four firms] to compete.”19

An Ernst & Young partner downplayed the significance of Deloitte’s hiring of an Islamic religious scholar. “We have good relationships with a number of scholars and a sound understanding of major Shari’a issues. There are variances of opinion among the scholars and, accordingly, the selection of scholars is particular to every organization.”20 In a subsequent press release, Ernst & Young “one-upped” Deloitte by announcing that it was the first of the Big Four firms to actually begin offering Shari’a audit services.

Ernst & Young was the first professional services firm to establish a dedicated team to service clients in this [Islamic finance] industry and is the only professional services firm to offer Shari’a auditing. . . . We have an unshakeable belief in the future of Islamic Finance. . . . As a reflection of the changing needs of the industry, we currently offer more services in more markets and more industry segments in the Islamic financial services industry than any other professional services firm.21

In 2013, Ernst & Young made further inroads into the rapidly developing market for Shari’a audit services when it signed an exclusive agreement with the AAOIFI. Under the terms of this agreement, Ernst & Young would be working with the AAOFI to develop new Shari’a certification standards for “core banking systems” used by Islamic banks.22 To exploit this new credential, Ernst & Young announced that it was launching a new advisory service to assist Islamic banks in developing Shari’a- compliant core banking systems.

Questions 1. Identify specific financial statement auditing concepts and procedures that

could be applied in determining whether an Islamic bank has been Shari’a compliant during a given financial reporting period. Would these concepts and procedures be applied differently in Shari’a compliance audits compared to conventional financial statement audits? Explain.

2. Do you believe that the proposal to merge Shari’a compliance audits with financial statement audits is feasible? Defend your answer.

17. Ibid., 4. 18. PricewaterhouseCoopers, “Middle East Region: Industries—Islamic Banking & Takaful,” www.pwc .com, September 2008. 19. Islamic Finance News (online), “Deloitte ‘First’ with Shariah Scholar Post: Appoints Mufti Hassan Kaleem,” 28 November 2007. 20. Ibid. 21. Ernst & Young, “Islamic Financial Services Group,” http://www.ey.com/EM/en/Services/Advisory/ Advisory_IFSG-Overview, September 2008. 22. L. Murshid, “Ernst & Young Signs Exclusive Agreement with Global Standard Setting Body to Assist in Shari’a Certification,” www.zawya.com, 5 March 2013.

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520 SECTION EIGHT INTERNATIONAL CASES

3. Do you agree with the assertion that “accounting can lead to perceptions of reality”? Why or why not? In deciding whether to adopt a proposed accounting standard, should accounting rule-making bodies consider whether that standard might induce socially irresponsible behavior on the part of economic decision- makers? Defend your answer.

4. Identify the key challenges that the Big Four firms will likely face in their efforts to establish a major presence in the Islamic banking industry.

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521

CASE 8.6

Mohamed Salem El-Hadad, Internal Auditor

The world is moved along, not only by the mighty shoves of its heroes, but also by the aggregate of the tiny pushes by each honest worker.

Helen Keller

In 1976, Mohamed El-Hadad earned an undergraduate accounting degree in his native Egypt. Before he began his accounting career, El-Hadad completed his com- pulsory service in the Egyptian military forces. El-Hadad accepted an entry-level position with a large hotel in Alexandria after being honorably discharged from the military in 1979. Two years later, El-Hadad immigrated to Abu Dhabi, the capital of the United Arab Emirates (UAE), after he learned that there were excellent employ- ment opportunities for accountants in that small Middle Eastern nation.1

The determined young accountant soon landed a job with the UAE’s Ministry of Education. For 10 years, El-Hadad worked as an auditor with that government agency. Throughout his tenure with the Ministry of Education, El-Hadad regularly received excellent performance appraisals from his superiors.

While on a vacation in the United States in 1992, El-Hadad visited the UAE’s embassy in Washington, D.C. During that visit, he became acquainted with the embassy’s cultural attaché and the deputy cultural attaché. The cultural attaché was impressed with El-Hadad and his employment history and encouraged him to apply for an open auditing position with the embassy. The position involved “the audit and review of all expenditures and accounting methods of the cultural attaché and the educational expenditures for UAE students in the United States, and reconciliation of all bank accounts.”2 The job would require El-Hadad to supervise eight other accoun- tants. El-Hadad’s immediate superior would be the cultural attaché.

El-Hadad was excited by the new job opportunity and the possibility of relocating to the United States. When he returned to the UAE, he informed his superiors in the Ministry of Education of his interest in the Washington, D.C., job. They encouraged him to apply for the position and gave him excellent personal references that were forwarded to the cultural attaché of the UAE’s Washington, D.C., embassy. Among other complimentary remarks, the recommendations indicated that El-Hadad “was an exemplary employee who displayed seriousness and integrity.”

In January 1993, El-Hadad accepted the supervisory audit position in Washington, D.C. El-Hadad enjoyed his new job and the relationships he developed with his supe- riors, his subordinates, and the remainder of the embassy staff. He was certain that the increased scope of responsibilities he assumed in the new position would help him develop professionally. El-Hadad also realized that the cultural, educational,

1. Approximately 95 percent of UAE’s workforce is made up of foreign nationals. For decades, the small, oil-rich country has actively encouraged immigration of foreign nationals to bolster its rapidly growing economy. 2. This and all subsequent quotes were taken from the following source: Mohamed Salem El-Hadad v. The Embassy of the United Arab Emirates, et al., Civil Action No. 96-1943 (RWR), United States District Court for the District of Columbia, 2006. Much of the background information included in this case was drawn from other legal transcripts and news reports.

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522 SECTION EIGHT INTERNATIONAL CASES

and recreational opportunities offered by the dynamic Washington, D.C., metropoli- tan area would be beneficial for himself and his family.

Reluctance and Regret Unfortunately, within a matter of months, El-Hadad’s American “adventure” turned bittersweet. During the performance of routine audit procedures in April 1993, El-Hadad discovered a secret bank account being used by the embassy. Upon further investigation, he determined that his new boss and friend, the embassy’s cultural atta- ché, was maintaining the account with the assistance of the deputy cultural attaché and the embassy’s chief accountant. He also determined that the three individuals were diverting UAE government funds into the secret account.

One method used by the conspirators to embezzle funds involved healthcare payments made by embassy employees. The embassy provided healthcare cover- age for its employees but not for employee dependents. If an employee elected to have dependents covered by the embassy’s healthcare plan, the employee was required to pay the monthly premiums directly to the embassy. The conspirators deposited these payments into the secret bank account and then used UAE govern- ment funds to pay the healthcare premiums for employees’ dependents. In fact, the monthly amounts that El-Hadad paid to the embassy to provide healthcare cover- age for his wife and children were included in the funds diverted into the secret bank account.

Another method used by the conspirators to misappropriate UAE government funds involved tuition refunds that the embassy received from a large number of U.S. universities. The UAE government had established an educational program that paid the college tuition of UAE citizens who chose to attend a U.S. university. The UAE embassy made these tuition payments directly to the given U.S. universities. Not unlike other college students, UAE students frequently dropped courses early in the semester for various reasons. The resulting tuition refunds remitted to the UAE embassy were funneled into the secret bank account discovered by El-Hadad.

Despite harboring feelings of reluctance and regret, El-Hadad knew that he had to “blow the whistle” and report the embezzlement scheme orchestrated by his boss and friend. Instead of informing top officials in the UAE embassy, El-Hadad chose to pass the information to a government official in the Ministry of Education, the agency for which he had worked the past 10 years. This individual in turn notified UAE’s Minister of Finance. The Minister of Finance promptly contacted El-Hadad to question him about the scheme and then traveled to the United States to discuss the matter with him in person. The Minister of Finance then sent a team of auditors from his agency to carry out a comprehensive and secret investigation of the fraud. This team of auditors discovered two additional secret bank accounts used by the conspirators and determined that the three individuals had stolen at least $2 million. In early 1994, the cultural attaché, his deputy, and the embassy’s chief accountant were fired. Three other embassy employees who were aware of the embezzlement scheme were also dismissed.

Prior to learning that El-Hadad had uncovered his embezzlement scheme, the embassy’s cultural attaché completed his annual performance appraisal of El-Hadad for 1993. The cultural attaché indicated that El-Hadad was an “excellent employee” and gave him 99 out of a possible 100 points on the scale used for the performance appraisal. El-Hadad received a similar performance appraisal near the end of 1994 by the embassy’s new cultural attaché. The new cultural attaché recommended that he be promoted, receive a salary increase, and a merit bonus for his excellent

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CASE 8.6 MOHAMED SALEM EL-HADAD, INTERNAL AUDITOR 523

work. During 1994, El-Hadad also received plaudits from numerous UAE government officials, most notably the Minister of Finance, for his role in uncovering the embez- zlement scheme.

Retribution and Recriminations Not surprisingly, the Minister of Finance, the new cultural attaché, and several other UAE government officials were stunned in late 1995 when the UAE State Audit Division announced that Mohamed El-Hadad had been involved in the embezzle- ment scheme that he had reported. The State Audit Division, a government agency that provides audit services for other UAE government agencies, reported that El-Hadad had received several improper payments from the conspirators who had maintained the three secret bank accounts. These improper payments included com- pensation for overtime that he had not worked, expense reimbursements to which he was not entitled, and payment of healthcare premiums for his family.

The State Audit Division investigation that culminated in the charges being filed against El-Hadad had been initiated by another government agency, the Ministry of Higher Education and Scientific Research (HESR). Officials in the latter agency had been embarrassed when the embezzlement scheme at the UAE’s Washington, D.C., embassy was publicly revealed in early 1994 since it involved an educational program that fell under the purview of their agency. These same officials also reportedly had an ongoing feud throughout 1994 and beyond with the embassy’s new cultural attaché, who was a staunch supporter and ally of El-Hadad. Following the startling announcement that El-Hadad had been involved in the embezzle- ment scheme, a top official of the HESR Ministry traveled to the Washington, D.C., embassy and personally told several of El-Hadad’s coworkers that he was dishonest and a poor employee.

In early 1996, the UAE cultural attaché capitulated to relentless pressure from government officials in Abu Dhabi and fired El-Hadad for his alleged role in the embezzlement scheme. El-Hadad, who had consistently and vehemently insisted that he was innocent of the charges, immediately appealed his dismissal. While his case was being reviewed, El-Hadad secured an entry-level auditing job for the UAE’s military attaché in the Washington, D.C., embassy. When the HESR Minister learned of El-Hadad’s new job, he notified government officials in Abu Dhabi. Within a matter of days, El-Hadad was fired once more.

In late 1996, El-Hadad’s appeal of his dismissal from the supervisory audit position with the UAE embassy was denied. His appeal was denied despite several prominent individuals interceding on his behalf with the appellate tribunal. Among the indivi- duals who wrote letters testifying to El-Hadad’s work ethic and integrity were the cultural attaché who had been pressured to fire him, the UAE Minister of Finance, and the U.S. Ambassador to the UAE who was well acquainted with El-Hadad. Despite this impressive show of support for the Egyptian accountant, the appellate tribunal ruled that because El-Hadad’s involvement in the fraudulent scheme had been well documented, his dismissal had been justified. The documents used to corroborate his role in the fraud had been provided by the Ministry of HESR.

Throughout the remainder of 1996 and much of 1997, El-Hadad searched for employment as an auditor or accountant in the Washington, D.C., area. Each time that he applied for a job, however, the prospective employer contacted the UAE embassy and learned that El-Hadad had been terminated because of his role in an embezzle- ment scheme. Economic necessity forced El-Hadad to return with his family to his native Egypt in late 1997 and seek employment there. Similar to his experience in

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524 SECTION EIGHT INTERNATIONAL CASES

Washington, D.C., each time that he applied for an accounting or auditing position, the prospective employer learned of his past history and refused to consider him any further.

Frustrated and disheartened, El-Hadad eventually realized that his career in audit- ing, a career that he had loved and a career to which he had devoted nearly two decades of his life, was over. El-Hadad then decided to pursue a new livelihood. For several years, he sold cosmetics through a small business that he organized. But in 2003 that business failed and El-Hadad was forced to rely on family members for economic support.

Redemption Prior to leaving the United States in 1997, El-Hadad had retained an attorney to file a lawsuit against the UAE’s Washington, D.C., embassy. In this lawsuit, El-Hadad alleged that the embassy had wrongfully terminated him, that he had been defamed, and that his accounting career had been destroyed. Attorneys for the UAE attempted to have El-Hadad’s lawsuit dismissed due to the concept of sovereign immunity. This concept generally prohibits criminal or civil lawsuits from being filed in U.S. courts against foreign embassies in the United States. However, the U.S. federal law that dictates the nature and scope of sovereign immunity, the Foreign Sovereign Immunities Act, includes an exception for lawsuits related to “commercial activity.” Because the U.S. District Court in which El-Hadad filed his lawsuit ruled that his work as an auditor for the UAE embassy had qualified as “commercial activity,” the federal court refused to dismiss the lawsuit.

During El-Hadad’s civil trial in July 2001, his attorneys addressed one by one the allegations of dishonesty that had been filed against him by the UAE State Audit Division. The attorneys presented to the court the documents that had been used as the basis for those allegations and easily established that they had been forged. The attorneys also presented other documents and evidence that had been submitted to the State Audit Division during its investigation of El-Hadad, which clearly dem- onstrated he had not been involved in any way in the embezzlement scheme. For whatever reason, the State Audit Division had ignored that exculpatory evidence. El-Hadad’s attorneys went on to prove that not only had he not been involved in the fraud, he had been known for being scrupulously honest while employed by the UAE embassy. For example, evidence presented by his attorneys demonstrated that when filing for expense reimbursements, El-Hadad had understated the amounts to which he was entitled to reimbursement.

The federal judge who presided over El-Hadad’s civil trial agreed with his attor- neys that he had had been victimized by false and “trumped-up” charges intended to discredit him. The federal judge also ruled that El-Hadad had been defamed by his former employer and that the defamation had ended his career as an accountant and auditor. At the conclusion of the trial, the UAE was ordered to pay El-Hadad $1.25 million for lost wages, $500,000 of damages related to the defama- tion he had suffered, and accrued interest on both amounts since the date of his termination in 1996.

The UAE’s attorneys refused to accept the court’s verdict and filed repeated appeals to have it overturned. At each level of the federal court system, the appeals filed by those attorneys regarding major issues central to the case were rejected. In 2007, the verdict was appealed to the U.S. Supreme Court. When the Supreme Court refused to review the case, Mohamed El-Hadad could finally claim victory. At last report, the UAE had yet to pay El-Hadad the more than $2 million that it owes him.

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CASE 8.6 MOHAMED SALEM EL-HADAD, INTERNAL AUDITOR 525

Questions 1. Identify and briefly describe the legal protections that “whistleblowers” have in

the United States.

2. Should U.S. companies integrate legal protections for internal whistleblowers into their internal control systems? Defend your answer.

3. Suppose that during your career you discover a fraud similar to that uncovered by Mohamed El-Hadad. List specific measures that you could take to protect yourself from recriminations by your employer or other parties.

4. Did El-Hadad face an ethical or moral dilemma when he discovered the fraud being perpetrated by his superior and friend? Before responding, define “ethical dilemma” and “moral dilemma.”

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527

CASE 8.7

Tae Kwang Vina

During the 1970s, the public accounting profession eliminated its bans on competi- tive bidding, advertising, direct solicitation, and related practices that the Federal Trade Commission maintained were restraints of trade. The decision to drop those restrictions contributed to the increasingly competitive nature of the market for independent audits over the following decades. That escalating competition was manifested by a rapid increase in the rate of auditor changes by public companies, “lowballing” on the part of certain accounting firms to obtain new clients, and stag- nant or declining audit fees.

By the late 1990s, many leading accountants suggested that the independent audit “product” was diminishing in value. The American Institute of Certified Public Accountants (AICPA) concurred with that point of view in an article that appeared in its monthly newsletter. To counter the declining value of independent audits, the AICPA recommended that accounting firms begin developing and marketing other services.

The audit—the CPA profession’s core assurance product—has been declining in value over the past few years, becoming a less marketable product. In fact, revenues from traditional accounting and auditing services have been flat for the past seven years. . . . Where challenges exist, however, opportunities abound . . . [nontraditional] assurance services provide a lucrative opportunity to expand [accounting] prac- tices. CPAs are singularly qualified as independent assurance providers to furnish businesses and their customers with the certainty they need to compete in today’s marketplace.1

To identify new professional services that accountants could begin providing, the AICPA created the Assurance Services Special Committee that was chaired by Robert Elliott, a senior audit partner with KPMG. Elliott’s committee recommended a wide range of new services that accounting practitioners could market. Specific examples of such services included the following: ascertaining the quality of home healthcare providers and assisted living (nursing home) facilities, identifying security breaches of Internet-linked information systems, and helping companies and other organiza- tions identify and manage the economic risks they faced. The AICPA believed that these and other nontraditional services would provide accounting firms an opportu- nity to significantly increase their revenues while at the same time enhancing their stature and reputation within the business community.

Among the boldest initiatives taken by the AICPA in the late 1990s to expand the product line of services offered by CPAs was a proposal to create a new professional designation for accountants. This new credential would be awarded to individuals who passed a rigorous examination to demonstrate that they qualified as “multidisci- plinary business advisers and strategic thinkers.”2 The AICPA believed this new pro- fessional designation would help existing CPAs strengthen their credibility as general

1. American Institute of Certified Public Accountants, “Assurance Services: Transforming the Quality of Information,” The CPA Letter (online), May 2001. 2. American Institute of Certified Public Accountants, “Internet Portal, Broad-Based Global Credential Discussed at Regional Council Meetings,” The CPA Letter (online), May 2000.

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528 SECTION EIGHT INTERNATIONAL CASES

business consultants and thereby allow them to gain a larger share of the rapidly expanding market for business consulting services worldwide.

Throughout the 1990s and into the new century, the major international accounting firms began offering an extended product line of nontraditional services. These firms invested heavily in advertising programs and other promotional activities to market these new services. However, as these firms attempted to develop new markets and encroach on existing markets served by other professionals, they encountered unexpected challenges and problems.

Nontraditional professional services marketed by the major accounting firms dur- ing the 1990s included “environmental and labor practices audits.” These engage- ments were not financial statement audits but rather examinations intended to determine whether a given company, organization, or specific production facility was complying with state and federal laws, industry rules and regulations, and other predetermined criteria relevant to environmental issues and labor practices.

The accounting profession’s dominant firms recognized that there was a growing demand for environmental and labor practices audits and similar engagements during the 1990s. This demand sprang from a social activism movement targeting high-profile companies in the United States that allegedly operated, or purchased goods from, “sweatshops” in foreign countries. Ernst & Young and PricewaterhouseCoopers (PwC) were the most prolific providers of environmental and labor practices audits within the accounting profession. In 1998 alone, PwC performed 1,500 such audits in China’s Guangdong province, that nation’s industrial epicenter.3

Wikipedia defines a sweatshop as a “working environment with very difficult or dangerous conditions, usually where the workers have few rights or ways to address the situation.” These conditions may include “exposure to harmful materi- als, hazardous situations, extreme temperatures, or abuse from employers.” Social activists claimed that many large U.S. companies were maximizing their profits by using sweatshops in third-world countries to minimize the production cost of the merchandise they sold.

In 1996, Walmart was blindsided by a firestorm of unfavorable media attention ignited by a social activist organization. This organization revealed that Walmart’s popular line of Kathie Lee Gifford apparel was being manufactured under sweatshop conditions in the Central American nation of Honduras. Over the following several years, many other U.S. companies would face similar charges. The company targeted more than any other by the anti-sweatshop activists was Nike, Inc., the world’s largest producer of athletic shoes.

Nike’s critics insisted that the working conditions in the company’s Far Eastern production facilities were harsh, hazardous, and in violation of the given countries’ labor laws. Those production facilities were located principally in China, Indonesia, Taiwan, and Vietnam. The company was also berated for paying multimillion- dollar endorsement fees to sports celebrities such as Michael Jordan and Tiger Woods while factory workers in its foreign production facilities received weekly wages of $10 or even less for working upwards of 60 hours.

In early 1997, threats of congressional investigations and consumer boycotts per- suaded Nike to hire Andrew Young, a former U.S. Congressman and leading civil rights advocate, to inspect production facilities in countries where the company’s products were being manufactured. After visiting several of those factories, Young submitted a written report to Nike’s board in which he indicated that the workers in those facilities were being treated well. To garner public support and quell its critics,

3. The Economist, “Business Ethics: Sweatshop Wars,” 27 February 1999, 62.

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CASE 8.7 TAE KWANG VINA 529

Nike included favorable comments excerpted from Young’s report in full-page ads that it purchased in several major metropolitan newspapers.

Andrew Young’s report failed to placate Nike’s critics. The company’s detractors claimed that Young’s visits had been brief and less than rigorous and that he was not qualified to assess the working conditions in the given facilities.

The next measure Nike took to silence its critics was to retain Ernst & Young to perform an environmental and labor practices audit of one of its major Far Eastern production facilities. The facility chosen for that audit was a Vietnamese factory oper- ated by Tae Kwang Vina Industrial Company, Limited, one of Nike’s largest manufac- turing contractors. That factory, Nike’s newest and most modern production facility in the Far East, employed 9,200 workers and produced 400,000 pairs of athletic shoes each month. During the 1990s, U.S. companies that outsourced production opera- tions to Vietnam were responsible for much of that nation’s impressive economic growth. In fact, by the late 1990s, Nike’s Vietnamese factories accounted for more than 5 percent of that country’s gross domestic product.

In the spring of 1997, Ernst & Young submitted a 10-page report to Nike management summarizing the principal findings of its Tae Kwang Vina audit. Only a brief excerpt from that confidential report was released to the press. That brief excerpt suggested that Ernst & Young’s overall conclusion regarding the working conditions at the Tae Kwang Vina site was consistent with the conclusion reached by Andrew Young.

The excerpt from the Ernst & Young report provided to the press also indicated that the Tae Kwang Vina facility was complying with Nike’s code of conduct. Among many other stipulations, that code required Nike’s “business partners” to pay no less than the minimum wage mandated in a given country, to fully compensate workers for overtime hours, and to provide a safe working environment for those workers.

Ernst & Young’s conclusion that the Tae Kwang Vina factory was operating in compliance with Nike’s code of conduct infuriated the company’s critics. In November 1997, several months after Ernst & Young submitted its final report to Nike, one of those critics obtained a copy of the complete report and turned it over to the New York Times.

Ernst & Young’s 10-page report painted a much different picture of the working conditions at the Tae Kwang Vina facility than the brief excerpt initially provided to the press. The full Ernst & Young report documented numerous abusive labor prac- tices and hazardous working conditions at the site. The New York Times disclosed some of the more deplorable working conditions that the accounting firm had found at the factory.

Ernst & Young wrote that workers at the factory near Ho Chi Minh City were exposed to carcinogens that exceeded local legal standards by 177 times in parts of the plant and that 77 percent of the employees suffered from respiratory problems. The report also said that employees at the site . . . were forced to work 65 hours a week, more than Vietnamese law allows, for $10 per week.4

Other improper practices or incidents reported by Ernst & Young included inade- quate ventilation systems, excessive noise levels and temperatures within the factory, insufficient safety equipment, inadequate training for employees required to work with dangerous chemicals, failure to provide workers with sufficient water, refusal to pay wages owed to employees after they were terminated, and mistreatment of workers by supervisors.

4. S. Greenhouse, “Nike Shoe Plant in Vietnam is Called Unsafe for Workers,” New York Times (online), 8 November 1997.

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530 SECTION EIGHT INTERNATIONAL CASES

The release of the complete Ernst & Young report to the press provoked an angry public outcry against Nike. In response, the company initially insisted that the prob- lems identified in the report had been largely remedied over the more than six months that had elapsed since Ernst & Young completed its audit of the Tae Kwang Vina facility. That assertion was met with disbelief and ridicule by the company’s critics. Several of those critics banded together and filed a lawsuit against Nike that charged the company with intentionally misrepresenting the working conditions within its foreign production facilities.

Ironically, the release of the full Ernst & Young report also resulted in heated criti- cism of the prominent accounting firm. Although Ernst & Young’s report disclosed serious problems at the Tae Kwang Vina factory, a subsequent investigation by Dara O’Rourke, a consultant to the United Nations and a leader of the anti-sweatshop movement, revealed that the facility’s working conditions were much worse than reported by Ernst & Young.

O’Rourke suggested that the Ernst & Young personnel involved in the Tae Kwang Vina engagement did not have the necessary qualifications and training to perform environmental and labor practices audits, which had resulted in the engagement being seriously flawed. Alleged deficiencies in Ernst & Young’s Tae Kwang Vina engagement included, among others, relying heavily on the factory’s management and other secondary sources for the information collected during the engagement, failing to properly test air quality and other working conditions in the factory, and failing to ensure that employees questioned during the engagement were free to respond candidly without any fear of reprisals from management.

Sweatshop activists also challenged Nike’s claim that Ernst & Young performed the Tae Kwang Vina engagement as an “independent” third party. A governmental health and compliance officer for the state of California maintained that Nike’s hiring of Ernst & Young to complete the Tae Kwang Vina “audit” was equivalent to “putting the fox’s paid consultant in charge of the henhouse.”5 Corporate Watch, an international organization that monitors the social responsibility of multinational organizations, pointed out that rather than being independent of Nike, the Ernst & Young auditors had simply followed specific instructions given to them by Nike management in com- pleting the Tae Kwang Vina engagement. To prove this point, the organization quoted the following statement directed to Nike by Ernst & Young it its 10-page report: “The procedures we have performed were those that you [Nike] specifically instructed us to perform. Accordingly, we make no comments as to the sufficiency of these proce- dures for your purposes.”6

The Corporate Watch organization went on to suggest that accounting firms were not well suited to perform environmental and labor practices audits. “Indeed, Ernst & Young’s incompetence as a social and environmental auditor, combined with Mr. O’Rourke’s own findings inside the plant, present a strong argument against using accounting firms to conduct labor and environmental audits.”7 This latter opinion was seconded by the New York Times, which called for companies such as Nike to use “truly independent monitors” to complete such engagements.8

5. D. Rourke, “Vietnam: Smoke from a Hired Gun,” November 1997, www.corpwatch.org/article .php?id=966%20. 6. Ibid. 7. Ibid. 8. Ibid.

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CASE 8.7 TAE KWANG VINA 531

Questions 1. Define each of the following types of professional services: consulting services,

attestation services, agreed-upon procedures engagements, and assurance services. Explain how, if at all, these services overlap.

2. Visit the websites of the major international accounting firms. Identify nontraditional services currently marketed by these firms. List several of these services and briefly describe their nature. Of the services you identified, are there any that you believe accounting firms should not provide? If so, explain.

3. On what types of engagements must CPAs be “independent”? Identify types of engagements on which CPAs are not required to be independent. What other traits should CPAs possess on professional services engagements?

9. The Guardian (online), “Nike Acknowledges Massive Labor Exploitation in its Overseas Markets,” 14 April 2005.

E P I L O G U E In 2003, the U.S. Supreme Court agreed to hear arguments in the lawsuit filed against Nike that charged the company with falsely deny- ing that it used foreign sweatshops to produce the merchandise that it sold. However, the case was ultimately settled out of court when Nike agreed to pay $1.5 million to help moni- tor and improve factory working conditions in third-world countries. In 2005, Nike published a self-study of the working conditions in 700 factories scattered around the world that manu- factured the merchandise it sold. The report documented that “widespread problems” still existed within those factories.9 Nike executives pledged to work with social activist groups to resolve those problems.

In a nationwide vote in late 2001, the rank- and-file members of the AICPA rejected the

proposal to create a new professional desig- nation to recognize expertise in the field of general business consulting. Several months later, the U.S. Congress passed the Sarbanes– Oxley Act of 2002 in response to the massive losses imposed on investors by the Enron and WorldCom scandals. That statute included a wide range of reforms intended to strengthen independent audits. The Sarbanes–Oxley Act served not only to enhance the perceived importance of the independent audit func- tion in the United States but also refocused the attention of the major accounting firms on the “independent audit product.” Thanks largely to the Sarbanes–Oxley reforms, the audit fees charged to public companies by the major accounting firms rose dramatically over the following several years.

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533

INDEX

A AA Capital Equity Fund, 175, 177–181 AA Capital Partners, Inc., 175–183

embezzlement scheme, 179–180 Ernst & Young, 175–182 generally accepted auditing

standards, 180–181 Internal Revenue Service, 177 John Orecchio, 175, 179–180 Paul Oliver, 175 Securities and Exchange Commission

investigation of, 175–182 ABC News, 143 ABN AMRO, 175 Abu Dhabi, 523 Accountants/accounting. See also

specifi c accountants of Accuhealth, Inc., 361–365 Arvel Smart, 351–352 Avis Love, 421–423 Bill DeBurger, 409–411 Bud Carriker, 441–445 Charles Tollison, 425–427 of Creve Couer Pizza, Inc., 335–337 David Quinn, 353–356 of Dell, Inc., 357–360 Elizabeth Wallace, 469–473 ethical responsibilities of, 333–368 of F&C International, Inc., 339–342 Frank Coleman, 475–479 of Freescale Semiconductor, Inc.,

345–348 Hamilton Wong, 413–415 Islamic, 512–518 Leigh Ann Walker, 407–408 Olivia Thomas, 481–487 Sarah Russell, 437–439 Suzette Washington, 343–344 Tommy O’Connell, 417–420 of Wichita Falls, 367–368 Wiley Jackson, 349–350

Accounting and Auditing Enforcement Release, 180, 262, 275, 284, 318, 330

No. 2238, 51 No. 3033, 243

Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), 517

Accounting and Auditing Practice Manual, 432

Accounting Principles Board (APB), 5 Accounting schemes, 94–97 Accounting Today, 19, 195

ACCT 201, 353 Accuhealth, Inc., 361–365

fi nancial statements of, 362–363 history of, 361–362 Securities and Exchange

Commission, 362–365 William Makadok, 363–364

Acosta, Fernando, 95 Adderall, 471 Adelphia Communications, 51, 189 Adidas, 40 Adjustable rate mortgages (ARMs), 149 “Adults Only” game rating, 231 Advanced Micro Devices, Inc. (AMD),

357–358 Aerosmith, 135 African Union, 502 Akroyd, Dan, 108 Akst, Daniel, 118 Alabama Securities Commission, 44 Al Baraka Banking Group, 514–516 Al-Bashir, Omar Hassan, 505, 508–509 Alberta Securities Commission, 271 Alcatel, 506 Alcoa, 330 Alfa Group, 390–393 Allen, Craig, 426 Allen, Kyle, 265, 267–268 Allen-MacGregor, Jacquelyn, 294 Allenwood Federal Prison Camp, 81 Allied/Federated Department

Stores, 73 Allied Forces, 317 Allstate, 347 Al Qaeda, 501 Al Shabaab, 501–504 Altamesa Manufacturing Company,

417–419 Amazon.com, 83–85 Amerada Hess, 396 American Airlines, 372 American Asiatic Underwriters, 377.

See also American International Group, Inc.

American Bankers Association, 507 American Continental Corporation

(ACC), 93–94, 98–99, 101, 103–104

American Express, 84, 86 American Family Publishing, 147 American Image Awards, 80 American Institute of Accountants, 456 American Institute of Certifi ed Public

Accountants (AICPA), 168, 171, 456, 527, 531

Audit and Accounting Guide— Construction Contracts, 227

Code of Professional Conduct, 67 Tae Kwang Vina Industrial

Company, Limited, 527 American International Group, Inc.

(AIG), 377–380 Cornelius Vander Starr, 377 Ernst & Young, 378–379 generally accepted accounting

principles, 378–379 Maurice “Hank” Greenberg, 377 PNC Financial Services Group, Inc.,

378–379 Securities and Exchange

Commission investigation of, 379 special purpose entities used by,

377–378 American Law Institute, 460 Anarchy, 501 Andersen, Arthur Edward, 3–5, 21 Andersen, Christopher E.,

190–191, 195 Andersen, Delany & Company, 3 Andersen, John and Mary, 3–5 Anderson, Fletcher, 340–342 Annan, Kofi , 505 Antar, Eddie, 107–115 Antar, Sam E., 109, 114–115 AOL, 83 Aquino, Jennifer, 179 Arab National Bank, 516 Aramony, William, 293–294, 297 Arezzo, Eli, 481–487 “Arnie’s Army,” 223 Arthur Andersen & Co., 89

Enron Corporation, 3–5, 8–9, 14–16, 18–20, 155, 228

Federal Bureau of Investigation, 98 Leslie Fay Companies, 77–78 Lincoln Savings and Loan

Association, 97–103 Michael Sullivan, 225–228 Securities and Exchange

Commission investigation of, 365 United Way of America, 296–297

Arthur Young & Company, 97–102, 104, 395–396

Asics-Tiger, 47 Associated Press, 168 Assurance Services Special

Committee, 527 Atchison, Jack, 98–100 Athletic Attic, 41 AT&T, 208

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534 INDEX

Auditing/audits. See also Independent audits; specifi c companies

of Belot Enterprises, 265–270 of CBI Holding Company, Inc.,

253–258 of General Motors Company, 239–244 of Geo Securities, Inc., 259–263 of Golden Bear Golf, Inc., 223–229 of Jack Greenberg, Inc., 215–222 of Lipper Holdings, LLC, 245–251 of LocatePlus Holdings

Corporation, 281–286 of Powder River Petroleum

International, Inc., 271–279 of Take-Two Interactive Software,

Inc., 231–237 Auditing Standards Board, 62, 181 Audit Strategies Memorandum

(ASM), 176 Automated teller machine (ATM),

299–300

B Bacon, Kevin, 172 Baker, Karen, 47–51 Bakker, Jim, 294 Bakker, Tammy Faye, 294 Bank of America, 84 Bankruptcy

of CBI Holding Company, Inc., 256–257

Chapter 7, 50, 278, 404 Chapter 11, 47, 126, 278, 368 of General Motors Corporation,

240–241 of Lehman Brothers Holdings, Inc.,

23–24 Baptist Foundation of Arizona, 294 Barbour Griffi th & Rogers (BGR),

391–392 Barfi eld, Ann, 367–368 Barfi eld, John, 367–368 Barksdale, Kelly, 299–300 Barnes, Michael, 311–314 Barron, John, 181 Barron’s, 28, 166 Barrow, Allan, 395–396 Barry, Steven, 47–51 Bartering, 383–384 Bayer, Otto, 317 BDO Seidman

civil lawsuits by, 172 Clifford Hotte, 56–68 Health Management, Inc., 53–54,

59–68 Leslie Fay Companies, 77–80 Ligand Pharmaceuticals, 434 Sarbanes–Oxley Act, 495–496 Securities Exchange Act, 496

Bear Stearns, 148 Bell, R. J., 437–439 Bellinger, Richard, 223, 224, 228 Belot Enterprises, 265–270

David Robinson, 265–270 fi nancial statements of, 268–270 Nail the Number campaign, 265–268

Benetton, 506 Bennett, John G., 294 Berardino, Joseph, 14–21 Berardo, John, 414–415 Bergman, Drew, 53–54, 57–59, 61–64,

66–68 Bergman, Nancy, 57 Berkshire Hathaway, 347, 507 Bermuda Supreme Court, 389–390, 393 Bernard L. Madoff Investment

Securities LLC. See Madoff Securities

Bertelsmann, 233 Bertolini’s, 343–344 Best Buy, 347 Betty the cashier, 291–292 Bezos, Jeff, 83 B.F. Goodrich, 25 Biddle, Debbie, 159 Big Eight fi rms, 447–450 Big Four fi rms, 518–519 Bin Laden, Osama, 501 Bishop, Laura, 470 Blackmun, Justice, 467 Blackstone Group, The, 345 Black Thursday, 23 Blair, Tony, 392 Bledsoe, Anna, 269 Bloomberg, Michael, 231 Bloomberg BusinessWeek, 392 Boeing Company, The, 321–326

Deloitte & Touche, 321, 323 information technology, 321–322 internal control problems, 322–323 Matthew Neumann, 321, 323–324 Nicholas Tides, 321, 323–324 PricewaterhouseCoopers, 321–322 Securities and Exchange

Commission investigation of, 322 whistleblowing at, 323–325

Bond, James, 393 Bonnie and Clyde, 367 Booth income, 46–47, 49–50 Borden, Will, 385–386 Bornstein, Fred, 59–61 Boston Globe, 501 Boyd, John, 224–225, 229 Boyle, Tom, 58, 59, 66 Brant, Peter, 232 Brant, Ryan, 232, 236–237 Breeden, Richard, 21, 54, 99, 101–102 Bribery, 328–329

Broadcast.com, 83 Brooklyn Trolley Dodgers, 289–290

Edward Campos, 289–290 Walter O’Malley, 289

Brooks, David, 131–144 Brooks, Jeffrey, 131–144 Budweiser, 147 Buffett, Warren, 245, 507 Buick Motor Company, 239 Buranello, Alberto, 311–312 Buranello’s Ristorante, 311–315

“malicious prosecution” civil lawsuit against, 314

Marta Giordano, 311 Michael Barnes, 311–313 sting operation at, 313–314

Burnham Manufacturing, 469–472 Burroughs-Wellcome, 253, 256 Bush, George W., 7, 132 Business model

of Dell, Inc., 357 New Economy, 6–8

Business Week, 11, 246, 476, 498

C Cadbury Schweppes, 506 Caddell, Carson, 399–401 California State Board of

Accountancy, 104 Campbell Soup, 25 Campos, Edward, 289–290 Cannedy, Mac and Dennis, 367–368 Capitol Distributing, 233, 235 Cardillo Travel Systems, Inc., 371–375

A. Walter Rognlien, 371–372 Helen Shepherd, 372–373 KMG Main Hurdman, 373–374 Securities and Exchange Commission

investigation of, 373–374 United Airlines, 371–372

Cardozo, Benjamin, 459–460 Carriker, Elliot, 441 Carriker, Louis Armstrong “Bud,”

441–445 Carson, Johnny, 147 Case, Stephen, 83 Cash, Johnny, 266 Cash-skimming scheme, 362–363 Castello, Robert, 253–254, 256 Casualization, 73–74 Cattleman’s Restaurant, 417 CBI Holding Company, Inc., 253–258

bankruptcy of, 256–257 Ernst & Young, 253–257 fi nancial statements of, 253 generally accepted auditing

standards, 256–257 Robert Castello, 253

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INDEX 535

CBS, 169 CBS News, 143 Celebrity Sports Network, Inc., 271 Chapter 7 bankruptcy, 50, 278, 404 Chapter 11 bankruptcy, 47, 126,

278, 368 Charity frauds, 295–296 Charity Organization Society, 293 Charles, Jim, 443–444 Chartered Accountants, 199 Checksfi eld, James, 336–337 Chief Executive, 381 Chilling effect, 325 Chin, Judge, 171 China MediaExpress, 494 Chisholm, Bierwolf & Nilson (CBN),

272–278 Chisholm, Todd, 272–278 Christian Science Monitor, 505 Cineplex Odeon, 200 Citibank, 84 Citizens for Decency through Law, 93 Civil lawsuits

BDO Seidman, 172 Ernst & Young, 172 First Securities Company of

Chicago, 464–465 “malicious prosecution,” 314

Claiborne, Liz, 72–73, 78 Clinton, Bill, 55, 505 Clinton, Hillary, 231 CMGI, 83 CNBC, 348 CNN, 167, 231 Cohen, Andrew, 143 Cohen, David Jacob Levi, 114 Cohn, Steve, 215–221 Coke, 266, 438 Colbert, Stephen, 143 Colbert Report, The, 143 Cole, Bob, 150–151 Coleman, Frank, 475–479 Coleman, Maggie, 475 Columbia University, 245 Comedy Central, 143 Commission on Pornography, 93 Common Brothers, Inc., 253 Complete Idiot’s Guide to Business

Management, The (Klopp), 382 Cook, Michael, 55 Coopers & Lybrand, 18, 215, 232 Corporate code of silence, 325 Corporate Watch, 530 Costco, 381 Cotton production, 24 Countrywide Financial Corporation,

147, 155, 162 Cox, Archibald, 395 Cox, Christopher, 170, 172

Crabtree, Zachariah, 266–270 Craib, Christopher, 206, 209, 211 Crain’s New York Business, 232 Crawford, Christopher, 383–387 Crazy Eddie, Inc., 107–115

downfall of, 110–111 Eddie Antar, 107–108 initial public offering, 109–110 Main Hurdman, 112–113 Securities and Exchange

Commission investigation of, 107, 112, 114

success of, 108–109 Creative Artists Agency, 202 Credit Suisse, 506 Creve Couer Pizza, Inc., 335–337

Internal Revenue Service, 335–337 James Checksfi eld, 336 tax shelter scam, 335–336

Crotts, William, 294 Cuban, Mark, 83 Cuomo, Andrew, 35–36 Curbello, Christopher, 224–225, 229 Curcio’s Auto Supply, 303, 306, 309 Cutler, Stephen, 90

D Darfur, 505 Day, Nick, 391–392 DeBurger, Bill, 409–411 DeBurger, Lesley and Kelly, 411 Delany, Clarence, 3 Dell, Inc., 357–360

business model of, 357 “Dell Direct” strategy of personal

computers (PCs), 357 exclusivity payments to, 357–358 generally accepted auditing

standards, 359 Intel Corporation, 357–358 Michael Dell, 357 PricewaterhouseCoopers, 359 Securities and Exchange

Commission investigation of, 358–359

Dell, Michael, 357–360 “Dell Direct” strategy of personal

computers (PCs), 357 Deloitte & Touche, 39

Boeing Company, 321, 323 Foamex International, Inc., 318 “Foreign Corrupt Practices Act

Consulting,” 331 General Motors, 239, 242 Guy Enright, 393 Islamic accounting, 519 John Ellingsen, 181 Just For FEET, Inc., 47–51 Ligand Pharmaceuticals, 431–436

Lincoln Savings and Loan Association, 104

Livent, Inc., 205–211 Maria Messina, 199 Michael Cook, 55 Navistar International Corporation,

185–186, 188–196 Price Waterhouse, 208 Richard Fiedelman, 384–386 Securities Exchange Act, 496 Thomas Flanagan, 347–348

Deloitte & Touche Shanghai (D & T Shanghai), 491–495

Deloitte Touche Tohmatsu, 491, 497, 500

Delphi Investments, 41 Department of Veteran Affairs

(VA), 149 Depository Institutions Deregulation

and Monetary Control Act, 149 Deutsche Bank, 491, 506 DHB Capital Group, Inc., 132 DHB Industries, Inc., 131–145

David Brooks, 131–144 initial public offering, 132 Point Blank Body Armor, 132–133 Sandra Hatfi eld, 135–144 Securities and Exchange

Commission investigation of, 131–132

Diligence, Inc., 391–393 Dingell, John D., 117–118 Disney, 202 Division of Corporation Finance, 506 Dr. Reddy’s Laboratories, 507 Dodd–Frank Act, 262–263 Donovan, John, 155–157, 159 Dot-com, 83 Doty, Chairman, 196 Doty, James, 495 Douglas, Michael, 246 Dow Jones Industrial Average (DJIA),

23, 83 Dow Jones Islamic Market World

Index, 511 Drabinsky, Garth, 199–211 DuClaux Brothers, 484–486 Duncan, David, 15, 20 DuPont, 4 Durant, William C. “Billy,” 239–240

E E. C. Garcia & Company, 95 EBay, 83, 85 Eckstein, Gordon, 205, 209–210 E-commerce, 84 Economic crisis of 2008–2009,

239–240, 380 Economist, The, 325

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536 INDEX

EDGAR (electronic data gathering and retrieval system), 506, 508

Edzards, Abby, 484, 486–487 Eisner, Michael, 202, 246 Electra oil fi eld, 367 Electronic Arts, 237 El-Hadad, Mohamed Salem, 521–525 Ellingsen, John, 181 Elliot, Anthony, 103 Elliot, Robert, 527 Embezzlement schemes

AA Capital Partners, Inc., 179–180 Accuhealth, Inc., 365 of First Keystone Bank, 300 of Howard Street Jewelers, Inc.,

291–292 Mohamed Salem El-Hadad, 522–523 United Way of America, 293–294

Energy Wholesale Services, 6 Enright, Guy, 389, 391–393 Enron Broadband Services, 7 Enron Corporation, 3–22, 37, 148, 154

Arthur Anderson & Co., 3–5, 8–9, 14–16, 18–20, 155, 228

downfall of, 20–21 fi nancial statements of, 8–9 history of, 5–6 James Fazio, 431 Joseph Berardino, 14–19 Kenneth Lay, 6 New Economy business model of,

6–8 Public Company Accounting

Oversight Board, 21 regulatory reforms caused by, 168 Sarbanes-Oxley Act, 89,

321–325, 531 Securities and Exchange

Commission investigation of, 11, 16, 18–19, 23

special purpose entities used by, 9–13, 377–378

stock price for, 8–9 Enron Energy Services, 7 EnronOnline, 6–8 Enron Transportation Services, 7 Equity capital, 85–86 Equity Fund, 175, 177–181 Ernst & Ernst, 448, 465–467 Ernst & Ernst v. Hochfelder et al., 364,

463–468 Ernst & Whinney, 120–128, 395 Ernst & Young (E&Y), 496, 514, 519,

528–530 AA Capital Partners, Inc., 175–182 Al Baraka Banking Group, 514 American International Group, Inc.,

378–379

CBI Holding Company, Inc., 253–257

civil lawsuits fi led by, 172 Ernst & Whinney, 395 Freescale Semiconductor, Inc.,

345–346 IPOC International Growth Fund,

Ltd., 390 Islamic accounting, 519 Lehman Brothers Holdings, Inc.,

32–35 Lincoln Savings and Loan

Association, 101–104 Myron Gottlieb, 208 Navistar Financial Corporation, 186 NextCard, Inc., 86–90 Nike, Inc., 528–530 Repo 105 transactions, 32–33 Richard Zona, 152 Securities Exchange Act, 496 Tae Kwang Vina Industrial

Company, Limited, 528–530 William Gladstone, 98

Ernst & Young Global Limited, 512 Escrow syndicate, 463–464 ESPN, 266 Ethical responsibilities

of accountants, 333–368 of independent auditors, 369–404

Ethiopia, 501, 503 Exclusivity payments, 357–358

F Fairfi eld Greenwich Advisors, 172 False Claims Act, 324 Fannie Mae, 148 Fastow, Andrew, 7–9, 12, 14, 20 Fatwa, 512, 518 Fazio, James, 431–435 F&C International, Inc., 339–342

Alex Fries, 339 Catherine Sprauer, 340 Craig Schuster, 341 downfall of, 339–340 Fletcher Anderson, 340–341 Jon Fries, 339–340 Securities and Exchange

Commission investigation of, 340–342

Federal Bureau of Investigation (FBI), 90, 129, 281

Arthur Andersen & Co., 98 Bernie Madoff, 167 David Brooks, 143 David Friehling, 169 Freescale Semiconductor, Inc., 346 John Boyd, 229 Just For FEET, Inc., 44

LocatePlus Holdings Corporation, 281

Thomas Trauger, 88 Walmart, 328 William Webster, 392

Federal Deposit Insurance Corporation (FDIC), 90

Federal Government of Somalia, 504 Federal Home Loan Bank Board

(FHLBB), 93, 97–98 Federal Home Loan Mortgage

Company, 148 Federal Housing Administration

(FHA), 149 Federal National Mortgage

Association, 148 Federal Reserve Board, 97, 152,

378–379 Federal Savings and Loan Insurance

Corporation (FSLIC), 95 Federal securities laws, 54–55 Federal Trade Commission (FTC),

231–232, 527 Feeder fi rms, 166, 171 Fermi, Enrico, 464 Fiedelman, Richard, 385–387 Fields, James, 281, 283–286 Fifth Amendment, 14, 62 50 Cent, 135 Filo, David, 83 Financial Accounting Standards

Board (FASB), 5, 11, 20, 37, 241 Financial derivatives markets, 25–29 Financial statements

of Accuhealth, Inc., 362–363 of Belot Enterprises, 268–270 of CBI Holding Company, Inc., 253 of Enron Corporation, 8–9 of Geo Securities, Inc., 259–262 of Just For FEET, Inc., 42–47 of Leslie Fay Companies, The, 74–78 of Take-Two Interactive Software,

Inc., 233–235 Financial Times, 511 Finch, Justice, 458–459 Firestone Tire and Rubber

Company, 317 First Baptist Church of Wichita

Falls, 367 First Keystone Bank, 299–301

automated teller machines, 299–300

embezzlement schemes of, 300 Swarthmore branch, 299–300

First Securities Company of Chicago, 463–468

Arnold Schueren, 463–464 civil lawsuits fi led against, 464–465

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INDEX 537

Ernst & Ernst v. Hochfelder et al., 465–467

Ladislas Nay, 463–464 Rule 10b-5 violation of, 467–468 Securities and Exchange

Commission investigation of, 465–468

Fish, Robert, 232, 235–236 Fisk, Warren, 59 Flanagan, Oliver, 87–90 Flanagan, Thomas, 347–348 Flynt, Larry, 93 Foamex International, Inc., 317–319

Deloitte & Touche, 318 KPMG, 318–319 Otto Bayer, 317 PricewaterhouseCoopers, 317–318 Securities and Exchange

Commission investigation of, 318–319

Forbes 400, 83, 327 Forbes Internet Index, 83 Forbes Magazine, 299, 337, 390 Foreign Corrupt Practices Act (FCPA),

328–331 “Foreign Corrupt Practices Act

Consulting,” 331 Foreign Sovereign Immunities Act, 524 Form 990, 296 Form 9540-1, 216, 220, 222 Form 8-K, 125–126, 153, 161, 282,

373–374 Form 10-K, 136, 138, 140, 151, 154,

157–158, 186, 191, 242, 273, 329, 340–341, 363–364

Form 10-Q, 139, 195, 318, 372 Fortis Bank, 172 Fortune, 11, 14 Fosse, 201 Fox, Brian, 271–273, 275, 278 FoxMeyer, 253 Fraud Discovery Institute, 129 Fraud Magazine, 494 Freddie Mac, 148 Fred Stern & Company, Inc., 455–461

history of, 455 Securities and Exchange

Commission investigation of, 455 Ultramares Corporation, 455–460 Ultramares Corporation v. Touche

et al., 456–460 Freemon, Shapard & Story (FSS),

367–368 Freescale Semiconductor, Inc.,

345–348 Blackstone Group, 345 Ernst & Young, 345–346 Federal Bureau of Investigation, 346

merger and acquisitions of, 345 PricewaterhouseCoopers, 345–347 Securities and Exchange

Commission investigation of, 346–347

Fridman, Mikhail, 390 Friehling, David, 168–169, 171 Friehling & Horowitz, 168–169 Fries, Alex, 339 Fries, Jon, 339–342 Fries & Fries, 339 FTSE Global Islamic Index, 511 Fuld, Richard, 27–28 Furman, Roy, 202–203 F.W. Woolworth, 25

G Gabor, Zsa Zsa, 172 Galmond, Jeffrey, 389–390 Gansman, James, 345–346 Garcia, Ernie, 95, 104 Garcia, Felix, 307–309 Garrett, Representative, 196 Garrett Manufacturing, 442–443 Generally accepted accounting

principles (GAAP), 31, 36, 46, 148, 188, 192, 194, 261, 378–379, 514

American International Group, Inc., 378–379

Geo Securities, Inc., 261 Just For FEET, Inc., 46 Lehman Brothers Holdings, Inc., 36 Navistar Financial Corporation,

188, 192–194 New Century Financial

Corporation, 148 Repo 105s, 31 Securities and Exchange

Commission, 261 Shari’a, 514

Generally accepted auditing standards (GAAS), 64, 66, 181, 228, 256–257, 359

AA Capital Partners, Inc., 180–181

CBI Holding Company, Inc., 256–257

Dell, Inc., 359 Health Management, Inc., 64, 66 Michael Young, 64, 66 Paragon International, 228

General Motors Corporation (GM), 23, 239–244

bankruptcy of, 240–241 Billy Durant, 239 Deloitte & Touche, 239, 242 economic crisis, 239–240 pension of, 240–243

Securities and Exchange Commission investigation of, 242–243

Geo Companies of North America (GCNA), 259, 261–262

Geo Securities, Inc., 259–263 fi nancial statements of, 259–262 Frank Sinopoli, 259 generally accepted accounting

principles, 261 Securities and Exchange

Commission investigation of, 259–263

GI Bill, 441 Gilburne, Adam, 44–46 Giordano, Marta, 311, 313–314 Gladstone, William, 98–100, 102–103 Glenn, John, 97 Goldberg, Emanuel, 220 Golden Bear Golf, Inc., 223–229

Arnold Palmer, 223–224 initial public offering, 224–225 Jack Nicklaus, 223–224 Richard Bellinger, 223 Securities and Exchange

Commission investigation of, 225–228