Crossing the Finish Line: Latino Students and College Completion
Crossing the line
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Crossing the Line Cases in Financial Statement Fraud and Auditor Deception Publication Date: April 2019
Transcript of Crossing the line
Crossing the Line Cases in Financial Statement Fraud and Auditor Deception
Publication Date: April 2019
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Crossing the Line Cases in Financial Statement Fraud and Auditor Deception
Copyright © 2017 by
Mill Creek Publishing LLC
P.O. Box 11, Zionsville, IN 46077
All rights reserved. No part of this course may be reproduced in any form or by any means, without
permission in writing from the publisher.
The author is not engaged by this text or any accompanying lecture or electronic media in the rendering
of legal, tax, accounting, or similar professional services. While the legal, tax, and accounting issues
discussed in this material have been reviewed with sources believed to be reliable, concepts discussed
can be affected by changes in the law or in the interpretation of such laws since this text was printed. For
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--From a Declaration of Principles jointly adopted by a committee of the American Bar Association and a
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Course Description:
This course is based on two recent financial statement fraud cases; Dewey & LeBouef and ContinuityX. Dewey & LeBouef was a high-profile law firm that, at its peak, had over 3,000 employees and over 1,400 lawyers. It is alleged that personnel at Dewey & LeBouef made inappropriate financial adjustments starting in 2008 to meet its bank lending covenants and planned to conceal these adjustments from its “clueless auditor”. Dewey & LeBouef declared bankruptcy in 2012.
ContinuityX was an internet services reseller that, according to an SEC complaint, fabricated 99% of its revenue. It was audited by a firm that was fined and disciplined by the SEC and the partner responsible for the audit was also fined and permanently suspended from practicing before the SEC. ContinuityX declared bankruptcy in 2013.
Both cases involve financial statement fraud, auditor deception and some lessons to be learned.
Learning Objectives
Upon completion of this course, you should be able to:
• Recognize the primary elements of financial statement fraud in the Dewy & LeBouef and
ContinuityX cases
• Associate the primary elements of financial statement fraud in the cases in this course with
audit procedures that may have detected the fraud
Prerequisites: None
Level: Overview
NASBA Category: Auditing
Recommended CPE: 1 Hour
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Contents Course Overview ........................................................................................................................................... 6
Dewey & LeBouef .......................................................................................................................................... 6
Background ............................................................................................................................................... 6
Principle Administrative Personnel at Dewey & LeBouef ......................................................................... 6
Financial Statement Fraud in 2008 ........................................................................................................... 7
2008 Adjustments ................................................................................................................................. 7
Damaging Emails ................................................................................................................................... 8
Financial Statement Fraud in 2009 ......................................................................................................... 10
2009 Adjustments ............................................................................................................................... 10
More Damaging Emails ....................................................................................................................... 11
Reduction in Covenant ........................................................................................................................ 11
The $150 Million Bond Offering .............................................................................................................. 12
Collapse of Dewey & LeBouef ................................................................................................................. 12
The Auditor ............................................................................................................................................. 12
Criminal Charges and the Outcome ........................................................................................................ 13
Discussion of the Dewey & LeBouef Case ............................................................................................... 13
The Motivation Behind the Adjustments ............................................................................................ 14
How was the Auditor Deceived? ......................................................................................................... 14
Lessons Learned .................................................................................................................................. 15
ContinuityX .................................................................................................................................................. 16
Background ............................................................................................................................................. 16
Principle Personnel ................................................................................................................................. 16
Alleged Financial Statement Fraud ......................................................................................................... 16
The Scheme is Exposed ........................................................................................................................... 20
Source of Funding ................................................................................................................................... 21
The Auditor ............................................................................................................................................. 21
The Outcome .......................................................................................................................................... 24
Discussion of the ContinuityX Case ......................................................................................................... 25
The Motivation .................................................................................................................................... 25
Lessons Learned .................................................................................................................................. 25
Review Questions........................................................................................................................................ 26
Glossary ....................................................................................................................................................... 27
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Index............................................................................................................................................................ 27
Exam Questions .......................................................................................................................................... 28
Answers to Review Questions..................................................................................................................... 29
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Course Overview
This course is based on two recent financial statement fraud cases; Dewey & LeBouef and ContinuityX. Dewey & LeBouef was a high-profile law firm that, at its peak, had over 3,000 employees and over 1,400 lawyers. It is alleged that personnel at Dewey & LeBouef made inappropriate financial adjustments starting in 2008 to meet its bank lending covenants and planned to conceal these adjustments from its “clueless auditor”. Dewey & LeBouef declared bankruptcy in 2012.
ContinuityX was an internet services reseller that, according to an SEC complaint, fabricated 99% of its revenue. It was audited by a firm that was fined and disciplined by the SEC and the partner responsible for the audit was also fined and permanently suspended from practicing before the SEC. ContinuityX declared bankruptcy in 2013.
Both cases involve financial statement fraud, auditor deception and some lessons to be learned.
Dewey & LeBouef
Background
The law firm Dewey & LeBouef was created in October, 2007 by the merger of Dewey Ballantine and
LeBouef, Lamb, Greene & MacRae. Dewey Ballantine started in 1909 and LeBouef, Lamb, Greene &
MacRae started in 1929. Its headquarters was in New York City.
It has been reported that it its peak, Dewey & LeBouef employed approximately 3,000 people and over
1,400 attorneys. The firm was best known for offering attorneys who could generate significant fee
income lucrative guaranteed compensation contracts to lure them away from rival firms.
Dewey & LeBouef filed for Chapter 11 bankruptcy protection in May, 2012.
Principle Administrative Personnel at Dewey & LeBouef
Joel Sanders – CFO
Steven Davis – Chairman
Stephen DiCarmine – Executive Director
Frank Canellas – Finance Director
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Financial Statement Fraud in 2008
The 2007 merger was costly for Dewey & Lebouef and 2008 was the onset of a severe economic
recession. In July, 2008, Dewey & LeBouef entered into a credit agreement with four banks. This line of
credit had a cash flow covenant that required annual cash flow, defined as net income plus depreciation,
of at least $290 million.
“As the end of2008 approached, Dewey's finance group--principally in the form of CFO Sanders and
Finance Director Canellas-informed Davis and DiCarmine that the firm was in serious jeopardy of
breaching the Cash Flow Covenant because the firm's revenue had dried up. “1
“For the year ended December 31, 2008, the firm missed its budgeted revenue by almost $200 million
and its budgeted profitability by over $150 million.”2
“On December 4, 2008 Sanders emailed Canellas: "What revenue number must we hit not to breach our
covenants?" Canellas responded: "The covenant is on Cash Flow, described as net income plus
depreciation. The agreement call [sic] for Cash Flow of 290M. Budgeted expenses are 715 less 11M of
depreciation. Hence, we will need 994M in Revenue to be in compliance." “3
“On December 23,2008, in response to a report that clients were trying to delay their payments to
Dewey to avoid breaching their own bank covenants, Sanders told Davis: "That's precisely what l’m
concerned about. The banks will pull our lines in a heartbeat if we don't satisfy our covenants." Davis
responded: "That's what I {sic) told him {another Dewey partner}." “4
“By December 30, 2008, Dewey was on the cusp of a massive shortfall, with only one business day
remaining in which to collect enough revenue to meet its Cash Flow Covenant. Late on December 30,
2008, Sanders emailed DiCarmine and Davis to inform them the firm needed "$50M [in collections]
tomorrow to meet our covenant." Davis responded: "Ugh." “5
2008 Adjustments
The SEC complaint alleges that financial results in 2008 were inflated by approximately $36 million
through the use of accounting fraud and deception. According to the complaint, fraudulent adjustments
were compiled on a list titled “Master Plan” with each adjustment’s impact on net income detailed on
the list. Some of the specific alleged adjustments are detailed below.
1 Securities and Exchange Commission against Steven H. Davis, Stephen DiCarmine, Joel Sanders, Francis Canellas and Thomas Mullikin. United States District Court, Southern District of New York. 14-CV-1528. 2 Ibid 3 Ibid 4 Ibid 5 Ibid
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• Reclassifying salary expense as a partner distribution – The compensation expense related to
two of counsel attorneys who had no equity ownership in the firm were moved from salary
expense and classified as an equity distribution. This improved net income by approximately
$14.3 million
• Pre-merger credit card expenses – There were $2.5 million of American Express credit card
expenses incurred before the merger, many of which were on the American Express card of Joel
Sanders. These were internally referred to as “Joel’s Amex”. These expenses were originally
capitalized, then classified as expense in November, 2008. In January, 2009, these expenses
were capitalized as “unbilled disbursements”, which is described in the SEC complaint as an
asset related to unbilled client expenses.
• Uncollectible client disbursements – Disbursements on behalf of clients that would be
subsequently collected from the client were recorded as an account receivable. These
receivables were periodically evaluated for collectability and written off as deemed
uncollectible. In early 2009, $3.8 million of previously written off receivables related to client
disbursements were reversed, increasing net income by $3.8 million.
• Double booking income – In 2007, a Dewey lawyer in Saudi Arabia had a client that owed $1.4
million in fees. In order to have these fees count toward the lawyer’s 2007 profit goal, the
lawyer loaned Dewey the $1.4 million in fees, with the understanding that the loan would be
repaid when the client paid its legal bill. This $1.4 million was counted in revenue rather than as
a loan. In August, 2008, the client paid to Dewey approximately $8 million, which included the
$1.4 million previously reported as revenue. The full $8 million was recorded as revenue,
including the $1.4 million previously reported. Dewey did not repay this partner the $1.4 million
until 2010, after a bond offering was completed.
• Amortization of break-up fee – Dewey had vacated office space in London and paid $3.3 million
to cover remaining lease obligations. Dewey personnel were told by their auditor that this fee
could be amortized over the remaining life of the lease if certain conditions were met, one of
which was that Dewey remained a guarantor on the lease. Dewey was not a guarantor on the
lease. This $3.3 million was originally booked as an expense in 2008. However, in early 2009,
the expense was reversed and amortized over the life of the lease. A junior accounting
employee represented to an auditor that the break-up was a consulting fee related to a new
tenant’s assumption of the lease and should be amortized over the life of the lease.
• Amortization of fixed assets - $5.2 million of fixed assets related to the London lease were
amortized over the remaining life of the lease rather than being expensed.
Damaging Emails
One article written about the Dewey & LeBouef case expressed surprise that a large, prestigious law firm
would be so careless with emails. Certain emails between Sanders, Davis, DiCarmine and Canellas
became the basis of the case against them. Here are some of the email exchanges from 2008 used in
the SEC complaint.
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“In a December 4, 2008 email exchange entitled "IT Spend," Sanders vented to Dewey's Chief Operating
Officer, copying DiCarmine on the email, about the firm's cash flow problems and his concern that
someone at Dewey had approved the execution of costly information technology improvements at the
firm without his knowledge or approval. In the course of expressing his anxieties over Dewey being "hit
with a few million worth of bills in January," Sanders told the COO, "I don't know anything about [the
contracts] and I don't want to cook the books anymore. We need to stop doing that." ”6
“Contrary to his professed anxieties about "cooking the books" and the "need to stop doing that," on
December 29, 2008, while in the midst of the mad scramble to meet the covenants, Sanders boasted to
DiCarmine in an email: "We came up with a big one: Reclass the disbursements." “7
“To which DiCarmine responded: "You always do in the last hours. That's why we get the extra 10 or
20% bonus. Tell [Sander's wife], stick with me! We'll buy a ski house next. Just need to keep the ship
afloat [sic] and take care of the top and bottom, the middle can move." “8
“Late on December 31,2008, DiCarmine emailed Sanders: "You certainly cheered the Chairman
[Defendant Davis] up. I could use a dose." “9
“Sanders responded: "I think we made the covenants and I’m shooting for 60%." Sanders cryptically
added: "Don't even ask-you don't want to know." “10
“On January 7, 2009, Mullikin (Controller of Dewey & LeBouef) emailed Canellas: "They didn't do the
entry [reverse the write-off] for Joel's amex. Do you want them to put that entry in?" Canellas
responded: "Maybe we should do it to a pending billable matter." Mullikin then responded: "That would
be less visible." “11
“On January 8, 2009, Sanders emailed Davis and DiCarmine summary financials showing how Dewey
would meet the bank covenants for 2008 and estimating the amount of money it could distribute to
partners. The summary financials pointedly contained line items enumerating certain improper
6 Ibid 7 Ibid 8 Ibid 9 Ibid 10 Ibid 11 Ibid
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adjustments included in the "Master Plan." For example, "Adjusted Bank Income (including equitization
of Of Counsels)" and "Back-Out Disbursement W/0 [Write-Off]." “12
Financial Statement Fraud in 2009
In 2009, the revenues of Dewey & LeBouef continued to decline. In addition to declining revenues, the
firm also had the impact of the improper 2008 accounting adjustments to deal with. If accounted for
properly, there would need to be write off of assets that were created (American Express expenses,
break up cost and fixed assets) as well as recognition of liabilities and reserves (loan to partner and
uncollectible client disbursements).
In March, 2009, while planning a budget for the firm, a PowerPoint presentation was prepared.
According to the SEC complaint, the 2009 budget presentation and subsequent discussions of 2009
projected results included some incriminating items.
“One of the pages marked “Steve's copy" includes a list of accounting entries made for 2008, that
included many of Dewey's fraudulent entries broken down into two categories, "Adjustments (do not
itnpact 09 budget)," including "Equitization of Of Counsel" and "Adjustments (impact 09 budget)"
including "Capitalize London Wall reverse premium" and "Reduction in disbursement write-offs." The
PowerPoint presentation was then forwarded to DiCarmine.”13
“By mid-2009, a culture of accounting fraud had taken root at Dewey under the Defendants' watch. For
example, in an email dated May 28,2009, bearing the subject line ''Confidential-For your eyes only,"
Canellas sent Sanders a schedule containing a list of suggested cost savings to Dewey's budget, among
which included, a $7,500,000 reduction entitled "Accounting Tricks." “14
2009 Adjustments
The SEC complaint alleges that financial results in 2009 were inflated by approximately $23 million.
Some of the specific allegations are detailed below.
• Backdating checks from clients – Clients with outstanding bills were encouraged to backdate
checks to 2009 to help improve reported financial results.
• Retention of client retainer – In November, 2009, Dewey was informed that a client who had
paid a $5 million retainer was leaving the firm. This client requested that $4.6 million of this
retainer be returned. Instead, the retainer was returned in January, 2010 and counted as
revenue in 2009.
12 Ibid 13 Ibid 14 Ibid
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• Pre-merger credit card expenses – These amounts remained capitalized as expenses in 2009.
• Debt to partner – The $1.4 million owed to a partner remained unpaid and unrecognized.
• Uncollectible client disbursements – This practice continued.
More Damaging Emails
“On November 10, 2009, Sanders emailed Davis, DiCarmine, Dewey's chief operating officer, and
Canellas with an update on the firm's efforts to collect revenue in the final months of 2009. “I said at the
Exec Committee meeting that if we can really collect (with no adjustments) between $850 and $875
then we will do between $14k and $15k per point. If we bring $850M in the door (real collections- no
accounting adjustments including constructive receipt or reclassing disbursements) we can get really
aggressive and push the envelope to $14k per point. If we really bring in $875M then we can push to get
to $15k per point. Keep in mind though that at these levels we will not have the cash to pay the partners
by Jan 31 since $25M is fake income.” “15
On December 9, 2009, Sanders emailed Davis and DiCarmine: “I'm really sorry to be the bearer of bad
news but I had a collections meeting today and we can't make our target. The reality is we will miss our
net income covenant by $1OOM and come in at about $7k per point. At this point I can't tell whether
the inventory just isn't really there or our partners just can't convert it but either way I just cannot make
it happen. I can probably come through with enough "adjustments" to get us to miss the covenant by
$50M-$60M and get the points to $10k but that pretty much wipes out any possible cushion we may
have had for next year which was slim at best”. “16
“That same day, DiCarmine emailed Sanders: "should we bring Frank [Canellas] to lunch today? he might
need some reassuring." Sanders responded: "I don't know. He's starting to wig a little. Maybe he's
hearing and seeing too much ....". “17
Note – A point, as referenced in the above emails, was a method to determine partner compensation.
Each point assigned to a partner was worth a certain dollar value, depending on the net income of the
firm.
Reduction in Covenant
15 Ibid 16 Ibid 17 Ibid
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The lenders to Dewey & LeBouef were persuaded to reduce the cash flow covenant at the end of 2009
to $246 million from the previously established $290 million. Dewey reported that the cash flow
covenant was met with $7 million to spare. The SEC complaint contended that this was the result of $23
million of inappropriate adjustments.
The $150 Million Bond Offering
At the end of 2009, Dewey & LeBouef was $206 million in debt with $118 million of the debt due at the
end of 2010. $240 million was needed to pay partners. At 12/31/09, there was only $119 million of
cash in the bank.
In January, 2010, a private bond offering was initiated with the intent to raise $150 million. The bond
offering was oversubscribed. 13 insurance companies participated and the $150 million was raised.
The financial information in the solicitation materials for the private bond offering included audited
2008 results and unaudited 2009 financial results. These financial results included the inappropriate
accounting entries that have been discussed. Accordingly, the financial results for 2008 and 2009 were
misstated. In addition to the discussed misstatements, there were two other significant liabilities that
were not disclosed to bond investors.
• Guaranteed payment contracts with certain partners - Approximately $33 million of
guaranteed compensation to partners was not disclosed.
• Pension obligations – Dewey & LeBouef had stopped paying its pension obligations and former
partners had threatened to file lawsuits.
Collapse of Dewey & LeBouef
Financial conditions continued to deteriorate in 2010 and 2011. On May 28, 2012, a petition for Chapter
11 bankruptcy was filed. Listed assets included $13 million in cash, accounts receivable of $255 million
and $11 million of other investments. Liabilities were reported to be $315 million. The secured
creditors portion of the liabilities was $225 million and included banks and holders of the private bonds
issued in 2010. The largest unsecured creditor was the Pension Benefit Guaranty Corporation in the
amount of $80 million.
The Auditor
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Dewey & LeBouef was audited by Ernst & Young, who provided a clean opinion through 2010. As
indicated by internal emails at Dewey, personnel did not have a high opinion of their auditor. The
following is from the SEC complaint.
“Sanders, Canellas and Mullikin expressed occasional concern that the Auditor would detect their
fraudulent accounting practices, but they took a certain degree of comfort in what they viewed to be
the ineptitude of the auditors.”18
“By spring 2009, the·Auditor fired - for reasons unrelated to the audit work - the partner responsible for
the Dewey audit. On June 27, 2009, the former Auditor partner emailed Sanders his new work contact
information. Sanders forwarded the former Auditor partner's new contact information to Canellas and
added: "I assume you [k]new this but just in case. Can you find another clueless auditor for next year?"
Canellas responded: "That's the plan!. Worked perfect this year." “19
Ernst & Young provided audit and tax services to Dewey & LeBouef since its inception in 2007.
Criminal Charges and the Outcome
The Manhattan District Attorney filed fraud charges against Steven Davis, Stephen DiCarmine and Joel
Sanders. This was in addition to the charges that were brought by the SEC.
The first trial ended in October, 2015 as a mistrial. There were 4 months of testimony and the jury
deliberated for almost a month without reaching a unanimous verdict. During the first trial, Canellas
testified regarding the fraudulent accounting adjustments, the concern that the auditor would discover
the adjustments and the existence of the Master Plan document that listed the adjustments at the end
of 2008.
After this trial, Davis entered into an agreement with prosecutors to avoid a second trial. He agreed to a
five-year ban on practicing law in New York.
The second trial against Sanders and DiCarmine ended in May, 2017. After this second trial, DiCarmine
was acquitted of all charges, but Sanders was convicted and sentenced to a $1 million fine and 750
hours of community service. There was no jail time involved.
Discussion of the Dewey & LeBouef Case
18 Ibid 19 Ibid
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The Motivation Behind the Adjustments
When discussing any fraud, it is important to determine the motivation behind it. There are many motives that can spur unethical conduct. A few possible motives are presented below. Greed – personal financial gain is a strong motive. In an email from DiCarmine to Sanders related to the adjustments that caused the firm to exceed its cash flow covenant in 2008, DiCarmine says "You always do in the last hours. That's why we get the extra 10 or 20% bonus. Tell [Sander's wife], stick with me! We'll buy a ski house next.”20 Self-interest – this can include a promotion, maintaining a position in a firm or company, meeting budget commitments or even personal pride. It, too, is a strong motive. In a 2008 email from Sanders to DiCarmine, Sanders boasts, "We came up with a big one: Reclass the disbursements."21 In another 2008 email, Sanders tells DiCarmine, "I think we made the covenants and I’m shooting for 60%. Don't even ask-you don't want to know." 22 In a 2009 email from Sanders to DiCarmine and Davis, Sanders says, “I'm really sorry to be the bearer of bad news but I had a collections meeting today and we can't make our target. The reality is we will miss our net income covenant by $1OOM and come in at about $7k per point. At this point I can't tell whether the inventory just isn't really there or our partners just can't convert it but either way I just cannot make it happen. I can probably come through with enough "adjustments" to get us to miss the covenant by $50M-$60M and get the points to $10k but that pretty much wipes out any possible cushion we may have had for next year which was slim at best”23 It is unclear whether the motives in this case were greed or self-interest. However, it is likely that one or
both of these were factors behind the adjustments.
How was the Auditor Deceived?
It appears that the primary deception of the auditor, Ernst & Young, was in the form of
misrepresentations. When asked about the London lease break-up fee, it was represented that this was
a consulting fee rather than a break-up fee. Since the auditors were regarded as inept, there were likely
other explanations offered in the event that questions arose.
While client misrepresentation is clearly a bad act, the question is to what extent an auditor should rely
on management representation alone. With the understanding that hindsight is always easy, why
wouldn’t the audit firm confirm the terms of the London lease with the lessor or review the associated
agreement governing the breakup? Perhaps an equity roll forward that was tested or whose beginning
and ending balances were confirmed with partners would have disclosed that salaried partner expense
20 Ibid 21 Ibid 22 Ibid 23 Ibid
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was being classified as an equity distribution. Analytical review of uncollectible client disbursements
from 2007 to 2008 should have shown a large difference between those classified as uncollectible at the
end of 2007 and those classified as uncollectible at the end of 2008.
Lessons Learned
From the standpoint of Dewey & LeBouef, the principle lesson is that once these “accounting
adjustments” begin, it starts a lengthy cycle. Once 2008 had been completed, 2009 was filled with
analysis of the 2008 adjustments. The end of the cycle was Dewey’s bankruptcy in 2012.
At the beginning of this cycle, there is some indication that some of those involved had some remorse.
Sanders wrote in an email, “…I don’t want to cook the books anymore.”24 Another email from
DiCarmine to Sanders referring to finance director Canellas says “should we bring Frank to lunch today?
He might need some reassuring.”25 Sanders responds, “…He’s starting to wig a little. Maybe he’s
hearing and seeing too much…” 26
The problem with permitting this behavior in an organization is that once the behavior is accepted by
the organization, it becomes the new normal. Even though some people know it’s wrong, they allow it
to continue.
24 Ibid 25 Ibid 26 Ibid
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ContinuityX
Background
ContinuityX was a publicly traded company based in Metamora, Illinois. The business claimed to sell
internet services to small and medium sized businesses. However, according to the SEC complaint
against the CEO and CFO of the company, 99% of reported revenues came from fraudulent and fictitious
sales.
ContinuityX was created in March, 2011 after a predecessor firm, Mezolink, Inc. was shut down by a
court appointed receiver. It was formed to carry on the business of Mezolink and became a public
company in November, 2011 through a reverse merger with a shell company called EDUtoons, Inc.
Principle Personnel
David Godwin - CEO
Anthony Roth - CFO
Alleged Financial Statement Fraud
ContinuityX had two major sources of reported revenue:
• A commission sales arrangement with AT&T
• A commission sales arrangement with XO Communications
The internet services sold were to business customers and could cost as much as a hundred thousand
dollars per month.
The original 2011 AT&T agreement called for the entire commission to be paid to ContinuityX after AT&T
accepted a customer’s order for services. If the customer was past due more than 90 days, the
commission would be charged back to AT&T. In April, 2012, this agreement was changed to provide
that 50% of the commission would be paid up front and the remaining 50% would be paid after the
customer paid for three consecutive months of service.
“During the period from April 2011 through September 2012, ContinuityX recorded in its books and
reported in its SEC filings approximately $16.4 million in sales commission revenue attributable to the
sales of AT&T’s internet services.”27
27 United States Securities and Exchange Commission v. David P. Godwin and Anthony G. Roth. United States District Court for the Central District of Illinois, Peoria Division. 15-CV-01414-JES-JEH
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The XO agreement called for commissions to be paid on a monthly basis. However, ContinuityX
recorded the commission on its books as if 100% was earned at the inception of the agreement. The XO
agreement also stated that commissions paid could be charged back to ContinuityX if the customer
failed to pay.
“During the period July 2011 through September 2012, ContinuityX recorded in its books and reported
in its SEC filings approximately $5.9 million in sales commission revenue attributable to sales of XO’s
internet service.”28
The SEC complaint describes the straw buyer transaction that was utilized by ContinuityX to fabricate
revenues. The following is from that complaint:
“III. ContinuityX’s Entire Business Was A Fraud.
41. Throughout its corporate existence, ContinuityX entered into almost no legitimate business
transactions. Over 99% of the revenues it recognized and reported in its public SEC filings were based
on fraudulent sales transactions involving straw buyers or fabricated deals.
A. Straw Buyer Transactions
42. Throughout their respective tenures at ContinuityX, Godwin and Roth used straw buyers to defraud
AT&T and XO and to inflate the revenues ContinuityX reported in its public SEC filings.
43. Godwin and Roth approached certain small companies with an offer to become straw buyers of
internet services provided by AT&T and XO. In return for serving as straw buyers, Godwin and Roth
promised to pay these companies part of the sales commissions ContinuityX received from AT&T and XO
(“Straw Buyer Transactions”).
44. Godwin and Roth often referred to the straw buyers as “resellers” because the straw buyers
purportedly intended to resell the internet services purchased from AT&T and XO to other parties
(hereinafter, “Straw Buyer Transactions”). In reality, the straw buyers never used, paid for, or resold the
internet services. One straw buyer described his company’s role in the transaction as being a “beard,”
meaning his company served to disguise the fraudulent nature of the arrangement.
45. A typical Straw Buyer Transaction worked as follows: a. Godwin and Roth identified a company
willing to serve as straw buyer of internet services from AT&T or XO. b. In return, Godwin and Roth
promised to cause ContinuityX to pay part of the commissions to the straw buyer. c. The straw buyer
submitted, through ContinuityX, an order to purchase internet services to AT&T and XO. In some
instances, Godwin and Roth also prepared and submitted fake financial statements to AT&T to
demonstrate the straw buyer’s supposed creditworthiness. d. After AT&T and XO accepted the order,
ContinuityX claimed entitlement to commissions for the ostensible sales reflected in the order and
recorded those commissions as revenue in its corporate books. e. Unbeknownst to AT&T and XO,
ContinuityX paid the straw buyer a kickback for its role in the transaction.
46. ContinuityX and the straw buyers frequently signed a contract (“Reseller Agreement”) memorializing
the straw purchase. A typical Reseller Agreement provided, among other things: a. The straw buyer
would serve as the “customer” for the contract with AT&T or XO. b. The straw buyer bore “no liability of
28 Ibid
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performance” on the contract with AT&T or XO. c. ContinuityX accepted assignment of the AT&T or XO
contract and would be substituted as the customer no later than nine months after AT&T or XO
accepted the straw buyer’s order for services. d. ContinuityX paid the straw buyer part of the
commission from AT&T or XO.
47. Aside from not intending to pay for the services, the straw buyer could not afford the services they
purchased. In some cases, the straw buyer agreed to purchase internet services that exceeded their
own net worth.
48. AT&T and XO did not know the straw buyer never intended to pay for the services they ordered.
49. To further conceal the true nature of the Straw Buyer Transactions from AT&T and XO, Godwin and
Roth never informed AT&T or XO about the Reseller Agreements.
50. ContinuityX’s first sale of internet services was to AARMG, LLC (“AARMG”). AARMG was shell
company and straw buyer owned and controlled by Roth. During the fiscal year ended June 30, 2011,
commissions from purported sales to AARMG accounted for 40% of ContinuityX’s total reported
commission revenue. During the next fiscal year, ContinuityX recognized and reported in its SEC filings
nearly $700,000 in commission revenue generated from supposed internet sales to AARMG.
51. AARMG never used any of the internet services it purchased and never paid for any of those
services. As AARMG’s owner and manager, Roth knew AARMG was not going to pay for the internet
services it ordered. Godwin also knew AARMG never intended to and did not pay for these services.
52. Another important aspect of the Straw Buyer Transactions involved Godwin and Roth creating and
submitting to AT&T false financial statements for some straw buyers. Before accepting an order from
some prospective customers, AT&T required they demonstrate their creditworthiness.
53. Many of the straw buyers could not meet AT&T’s credit requirements. In these situations, AT&T
asked the straw buyers to provide financial statements to verify their creditworthiness. In some cases,
AT&T required the customer pay a higher security deposit.
54. To help straw buyers get past AT&T’s credit checks and to reduce the amount of any required
security deposits, Godwin and Roth created false financial statements for some straw buyers reflecting
inflated revenues and assets. Godwin and Roth then provided the false financial statements to AT&T.
Based, in part, on these false financial statements, AT&T approved the straw buyers as customers.”29
“58. After a straw buyer was approved by AT&T, ContinuityX typically paid the required security deposit
for the straw buyer. ContinuityX paid the security deposits, which were often over one hundred
thousand dollars, because the straw buyers had no intention of paying for the services and, in most
cases, could not afford to pay the security deposits. To conceal the fact ContinuityX was paying the
security deposits, Godwin had banks issue cashier’s checks to AT&T that listed the straw buyers as the
“remitter.” “30
29 Ibid 30 Ibid
19
The SEC complaint alleges that ContinuityX had a related party as a straw buyer in AARMG, which was
owned by Roth. They were also able to recruit third party straw buyers by promising a portion of the
commission that was paid by either AT&T or XO. ContinuityX recorded the full commission as revenue,
knowing that neither the related party customer or third party “straw buyers” intended to pay for the
service.
The use of straw buyers unraveled when AT&T started to charge back commissions to ContinuityX for
customer non-payment. Originally, the charge back was taken from new sales commissions. Eventually,
the charge-backs exceeded new commission amounts. The SEC complaint summarizes this as follows:
“62. None of the customers who purchased AT&T services through ContinuityX paid for the services.
AT&T tried to collect past due amounts from these customers without success. Because its customers
were not paying, AT&T began charging back ContinuityX’s commissions pursuant to the chargeback
provisions of the AT&T Agreement.
63. AT&T also charged back commissions related to canceled customer orders. AT&T cancelled some
customer orders because it was unable to establish network internet connections at the customer’s
facilities. When AT&T canceled a customer’s order, it charged back the commissions associated with the
order.
65. Initially, when AT&T charged back commissions from ContinuityX, the chargebacks were offset
against commissions from new sales.
66. In July 2012, ContinuityX stopped selling AT&T’s services. That meant ContinuityX stopped
generating new commissions from AT&T. At the same time, ContinuityX’s customers were falling
further behind on their AT&T bills, causing AT&T to charge back more and more commissions.
67. Without new commissions to offset the increasing chargebacks, AT&T demanded ContinuityX repay
previously paid commissions. On or about September 17, 2012, Godwin received a letter from AT&T
demanding ContinuityX repay more than $6 million in commissions (“AT&T Demand Letter”).
68. ContinuityX did not repay any commissions to AT&T.
69. In early October 2012, AT&T notified Godwin in writing that it was terminating its business
relationship with ContinuityX because it violated the terms of the AT&T Agreement (“AT&T Termination
Letter”).
70. In December 2012, AT&T filed a civil suit against ContinuityX in Texas state court seeking repayment
of $9.1 million in commissions.”31
In addition to the commission arrangement with AT&T and XO, Continuity X also signed a joint
marketing agreement in August, 2012 with Hutchison Global Communications Ltd. Under this
agreement, ContinuityX agreed to create a private internet network and Hutchison would market and
sell access to the network. Hutchison would receive 20% of the profit from the joint venture and
ContinuityX would receive 80%.
31 Ibid
20
“During the period from July 1, 2012 through September 30, 2012, ContinuityX recorded in its books and
reported in its SEC filings approximately $4.2 million in revenue from its joint venture with Hutchison in
2012.”32
The SEC complaint contends that all revenue recorded from the Hutchison joint marketing agreement
(JMA) was also fabricated. From the SEC complaint:
“61. For example, the revenue ContinuityX purportedly derived from the Hutchison JMA was based on
phony invoices fabricated by Godwin. No sales had been made under the Hutchison joint venture.
Godwin created fake invoices, forged the signatures appearing on those invoices, and caused
ContinuityX’s accounting personnel to recognize revenue based on the fabricated documents.”33
The Scheme is Exposed
The SEC complaint summarizes the manner in which the financial statement fraud scheme was exposed.
A new CFO was hired who started asking questions. From the SEC complaint:
“71. Roth resigned his positions with ContinuityX on or about September 12, 2012. Shortly before
Roth’s departure, a new CFO, an accountant, was hired in August 2012.
72. During the preparation of the company’s quarterly report for the period ended September 30, 2012,
ContinuityX’s new CFO became concerned about the substantial receivables—over $9 million—due from
AT&T. The new CFO recommended to Godwin that ContinuityX establish a reserve for receivables
greater than 90 days past due. Godwin objected, claiming the establishment of a reserve was not
necessary.
73. During an audit committee meeting held on or about November 20, 2012, Godwin assured
ContinuityX’s audit committee, the new CFO, and ContinuityX’s auditor he knew of no reasons why
ContinuityX would not collect the past due AT&T receivables. As a compromise, Godwin agreed to set a
reserve for receivables over 120 days past due. In its Form 10-Q covering the period ended September
30, 2012, which was filed on or about November 21, 2012, ContinuityX recorded an allowance for
doubtful accounts of $3.5 million.
74. At this time, neither the new CFO nor the company’s auditor was aware of the AT&T Demand Letter
or the AT&T Termination Letter. Godwin hid from them the fact that AT&T had terminated its
relationship with ContinuityX and was demanding repayment of millions of dollars in commissions.
75. On December 12, 2012, the new CFO learned AT&T had filed a lawsuit against ContinuityX on
December 6, 2012, seeking to recoup over $9 million from ContinuityX. The AT&T Demand Letter was
attached as an exhibit to the complaint.
76. The new CFO promptly confronted Godwin and asked why he had not disclosed the AT&T Demand
Letter. Godwin admitted withholding the information and claimed it was a failure in judgment. Even
32 Ibid 33 Ibid
21
then, however, Godwin did not tell the new CFO that AT&T terminated the AT&T Agreement and ended
its relationship with ContinuityX in October 2012.
77. The new CFO also notified ContinuityX’s auditor of the AT&T lawsuit. The next day, on December 13,
2012, ContinuityX filed a Form 8-K disclosing the lawsuit.
78. Upon learning of the AT&T lawsuit, the new CFO grew increasingly suspicious about Godwin’s
conduct and the legitimacy of ContinuityX’s business. A few weeks after discovering the AT&T lawsuit,
the new CFO telephoned his counterpart at Hutchison. During this conversation, the new CFO learned
the Hutchison invoices presented by Godwin were fakes. No sales had been made under the Hutchison
joint venture, and the signatures on the Hutchison invoices presented by Godwin were forgeries.
79. On January 30, 2013, Godwin was terminated from his positions as President and Chief Executive
Officer of ContinuityX. He was removed as a director on February 6, 2013.”34
Source of Funding
If almost all revenues were fabricated, how did ContinuityX fund its operations? Once it recorded the
AT&T and XO commissions as “earned”, the receivables were sold to factoring firms who purchased the
receivables at a discount. This was the principle source of cash to fund operations until a private bond
offering in June, 2012.
“ContinuityX sold approximately $6.9 million in bonds to at least 31 investors. The proceeds from the
bond offering made up approximately 65% of all ContinuityX’s incoming cash from June 15, 2012 until it
declared bankruptcy in February 2013.”35
The Auditor
The auditor of ContinuityX was EFP Rotenberg LLP, a New York CPA firm. Rotenberg acted as the auditor
for the form 10-K filed for the fiscal year ended June 30, 2012.
The SEC issued an administrative order against EFP Rotenberg LLP and the engagement partner,
Nicholas Bottini, CPA. “The SEC’s order finds that during the audits of ContinuityX, EFP Rotenberg and
Bottini failed to perform sufficient procedures to detect the fraudulent sales in the company’s financial
statements. EFP Rotenberg and Bottini also failed to obtain sufficient audit evidence over revenue
recognition and accounts receivable, identify related party transactions, investigate management
representations that contradicted other audit evidence, perform procedures to resolve and properly
document inconsistencies, and exercise due professional care.”36
34 Ibid 35 Ibid 36 SEC Press Release 2016-147. Accountant Suspended for Failing to Spot Fraud in Company Audit
22
The SEC order contains specifics that explain these allegations. These specifics from the SEC order
follow:
“17. During the planning of the ContinuityX Audit, EFP Rotenberg and Bottini deemed accounts
receivable, revenue, and security deposits as areas of the audit with a significant risk of fraud. In
response to this identified risk, to comply with Section 10A(a)(1) and AS No. 13, EFP Rotenberg and
Bottini should have included as part of the ContinuityX Audit procedures designed to address the risk of
material misstatement due to fraud on the determination of the amounts in these accounts.
18. In addition to deeming certain areas of the ContinuityX Audit as a significant risk, EFP Rotenberg and
Bottini were also on notice of potential irregularities in ContinuityX’s accounting. During the ContinuityX
Audit, ContinuityX’s management attempted to limit the scope of EFP Rotenberg’s procedures to obtain
sufficient audit evidence on accounts receivable. Specifically, EFP Rotenberg and Bottini requested that
ContinuityX’s management prepare accounts receivable confirmations for the Internet Providers.
ContinuityX’s management refused to prepare and sign the confirmations. EFP Rotenberg and Bottini
acquiesced to ContinuityX’s management’s scope limitation and instead spoke to people purporting to
be employees of the Internet Providers. However, the engagement team failed to obtain sufficient audit
evidence over the existence of accounts receivable.
19. EFP Rotenberg and Bottini did not plan or perform procedures to obtain sufficient appropriate audit
evidence that ContinuityX’s revenue was legitimate or that it was being recognized correctly. During the
ContinuityX Audit, EFP Rotenberg and Bottini obtained signed agreements between ContinuityX and the
Internet Providers’ customers that showed that the customers who purchased internet services via
ContinuityX did not intend to use or pay for the internet services. These agreements stated that the
customers: (1) were not responsible for paying for the internet services they purchased from the
Internet Providers; (2) ContinuityX was responsible for paying the Internet Providers for the customers’
monthly internet service bills; and (3) Continuity X would pay the customers a one-time commission. In
short, these agreements, when read in light of the agreements between ContinuityX and the Internet
Providers, showed that ContinuityX would pay the customers a kick-back for purchasing internet
services so that ContinuityX could earn a commission from the Internet Providers.
20. ContinuityX received commission payments from the Internet Providers based on the fraudulent
sales. Under Generally Accepted Accounting Principles (“GAAP”), revenue is recognized when it is
realized or realizable and earned. There must be persuasive evidence that an actual arrangement exists
and that the parties are committed to performing their respective obligations. Here, these agreements
clearly showed that the customers had no intention of performing their obligations to the Internet
Providers. EFP Rotenberg and Bottini failed to perform sufficient procedures to detect these fraudulent
sales despite possessing all of the documents necessary to identify them. Furthermore, EFP Rotenberg
and Bottini failed to design or perform sufficient substantive procedures to determine if ContinuityX’s
revenue was legitimately earned.
21. Internet Provider A required that its customers pay security deposits. ContinuityX paid the security
deposits on behalf of its customers and the deposits were held by Internet Provider A in the name of the
customers. When the customers did not pay their bills, Internet Provider A applied the security deposits
to the past due account balance. ContinuityX recorded the security deposits as its own assets. In its
2012 Form 10-K ContinuityX reported $2.1 million of security deposits as an asset. ContinuityX should
not have recorded the security deposits as an asset.
23
22. EFP Rotenberg and Bottini did not plan or perform procedures to evaluate whether ContinuityX had
the rights to or ownership of the security deposits. During the ContinuityX Audit, ContinuityX’s
management represented to EFP Rotenberg and Bottini that the security deposits held by Internet
Provider A were ContinuityX’s assets. To support this assertion ContinuityX’s management provided EFP
Rotenberg and Bottini with cashier’s checks drawn from ContinuityX’s bank account. However, the
cashier’s checks had the customer listed as the remitter. EFP Rotenberg and Bottini accepted the
cashier’s checks as evidence of ContinuityX’s ownership of the security deposits and did not question
why ContinuityX was using cashier’s checks to pay security deposits or why a check drawn from
ContinuityX’s bank would list the customer as the remitter. Furthermore, in an email correspondence
with Internet Provider A, Bottini was told that Internet Provider A held the security deposits for the
customers. EFP Rotenberg and Bottini failed to take further steps or perform additional procedures
after being told by Internet Provider A that the security deposits were ContinuityX customers’ deposits,
and not ContinuityX’s. EFP Rotenberg and Bottini failed to resolve inconsistencies in the audit evidence
obtained to become reasonably assured that ContinuityX was properly recording the security deposits as
assets.
27. EFP Rotenberg and Bottini possessed documents in which the CFO of ContinuityX signed internet
service agreements and a security deposit agreement on behalf of a customer named AARMG, LLC.
During the ContinuityX Audit, the audit manager sent an email to ContinuityX management and Bottini
that noted the CFO signed an internet service contract on behalf of AARMG and inquired if AARMG was
a related party. EFP Rotenberg and Bottini failed to obtain an answer from ContinuityX management
and to conduct additional procedures to determine if AARMG was a related party. ContinuityX
recognized $695,000 in commission revenue purportedly earned from sales to AARMG. However, the
AARMG transactions were not disclosed in the financial statements included in its 2012 Form 10-K as
related party transactions.
32. ContinuityX reported $18.6 million in commission revenue purportedly earned from the Internet
Providers. However, EFP Rotenberg and Bottini did not obtain sufficient evidence to support the
revenue recognized. In fact, the evidence that EFP Rotenberg and Bottini obtained supported a
conclusion that ContinuityX should not have recognized any of these commission payments.
Specifically, EFP Rotenberg and Bottini obtained agreements which showed that ContinuityX’s
customers had no intention of paying for or using the internet services. Thus, under GAAP, the revenue
from these transactions should not have been recognized. EFP Rotenberg and Bottini failed to properly
evaluate these customer agreements despite the fact that accounts receivable and revenue were
deemed significant risk areas. They recalculated the commission payments paid to the customers and
failed to appreciate the significance of the terms of the agreements. ContinuityX recognized $18.6
million in revenue (over 99.8% of ContinuityX’s total revenue) that it had not earned.
34. ContinuityX entered into an agreement with Internet Provider A which specifically outlined how and
when ContinuityX would earn its commission. EFP Rotenberg and Bottini were provided a copy of this
agreement and maintained it in the workpapers. This agreement stated that Internet Provider A could
charge back ContinuityX when customers failed to pay for their internet services. However,
ContinuityX’s management told Bottini that Internet Provider A could not charge back commissions.
Despite possessing the agreement with Internet Provider A that directly contradicted ContinuityX’s
management’s representation, EFP Rotenberg and Bottini did not perform sufficient additional
procedures to resolve the inconsistent evidence. As a result of EFP Rotenberg and Bottini’s failure to
24
obtain sufficient appropriate audit evidence, they failed to detect that the statement that “in these
lump-sum compensation arrangements, the customer may not claw back – unreasonably withhold – or
transfer these orders and must pay the Company per agreement” in the ContinuityX Form 10-K for 2012
was false.
35. ContinuityX’s revenue recognition policy for sales to Internet Provider A was based on the erroneous
premise that Internet Provider A was not able to charge back commissions. Internet Provider A’s ability
to charge back commissions was not consistent with ContinuityX’s policy of recognizing 100% of its
commission revenue upfront. Instead, ContinuityX should have recognized the revenue over the life of
the contract as it was earned, or set up a reserve account to offset potential chargebacks. EFP
Rotenberg and Bottini failed to obtain sufficient appropriate audit evidence to support management’s
assertion that ContinuityX could recognize 100% of the commission revenue upfront. In fact, the
agreement included in the audit documentation stated that Internet Provider A could charge back
commissions.
36. ContinuityX and Internet Provider B also entered into an agreement which outlined how and when
ContinuityX would earn commissions. EFP Rotenberg and Bottini received a copy of this agreement and
maintained it in the workpapers. The agreement with Internet Provider B stated that Internet Provider
B would pay ContinuityX a commission on a monthly pro rata basis after the customer had paid Internet
Provider B for the internet services. ContinuityX’s revenue recognition policy was consistent with the
terms of the agreement with Internet Provider B. However, ContinuityX did not recognize revenue in
accordance with its agreement with Internet Provider B or its own revenue recognition policy. Instead
of recognizing the commissions monthly on a pro rata basis, ContinuityX recognized 100% of the
commission after the customer had signed the sales contract. When EFP Rotenberg and Bottini inquired
about the discrepancy, ContinuityX’s management stated that the terms of the agreement with Internet
Provider B had changed. In fact, ContinuityX and Internet Provider B never changed the terms of their
agreement. EFP Rotenberg and Bottini never requested nor received documentation to support this
purported change. Despite possessing the agreement that contradicted ContinuityX management’s
representation, EFP Rotenberg and Bottini failed to obtain sufficient appropriate evidence to support
the revenue recognized from Internet Provider B.”37
The SEC order permanently suspended Bottini from practicing before the SEC as an accountant, which
includes not participating in the financial reporting or audits of public companies, and required the
payment of a $25,000 fine. EFP Rotenberg was required to pay a $100,000 penalty and cannot accept
new public company clients for one year. The acceptance of new public company clients is contingent
upon the certification of an independent consultant that the firm has corrected the causes of its audit
failures.
The Outcome
37 Securities and Exchange Commission Accounting and Auditing Enforcement Release No. 3790/July 22,2016. Administrative Proceeding File No. 3-17356. In the Matter of EFP Rotenberg, LLP and Nicholas Bottini, CPA, Respondents.
25
Roth pleaded guilty to one count of wire fraud. A sentence has not yet been determined. Godwin has
plead not guilty to 14 counts of wire fraud and is awaiting trial.
Discussion of the ContinuityX Case
The Motivation
The only apparent motive in this case is greed. According to the SEC complaint, Godwin was paid $1.3
million in salary and Roth received $351,800 in salary and $456,098 in profits from the sale of
ContinuityX stock.
Lessons Learned
In this case, the primary lesson learned is from the standpoint of the auditor. To simplify the audit
failings, always confirm and verify. Rather than accepting client representations, read contracts and
resolve inconsistencies. This basic guidance would have helped EFP Rotenberg immensely.
26
Review Questions
1. Which of the following procedures may have detected the $3.8 million of uncollectible client
disbursements in Dewey & LeBouef’s 2008 financial statements?
a. Comparison of uncollectible disbursements to the prior year and to the averages of the
two firms before the merger
b. Discussion with the firm’s Finance Director
c. Discussion with the firm’s accounting staff
d. Relying on management’s representations
2. How did ContinuityX fabricate commission revenue?
a. Generated fake invoices
b. Used straw buyers
c. Factored receivables
d. Used cashier’s checks with the customer name as the remitter
3. What audit procedure may have detected improper revenue recognition at ContinuityX
a. Review of revenue recognition procedures with the CFO
b. Recalculation of commission amounts
c. Reading the associated agreements to ensure that revenue recognition corresponds to
the documents
d. Ask the CEO
27
Glossary
Cash Flow Covenant - A requirement imposed on Dewey & LeBouef by its lenders that originally
mandated annual cash flow, defined as net income plus depreciation, of at least $290 million
Master Plan – A listing of adjustments and adjustment amounts needed to reach a bank imposed cash
flow covenant.
Straw buyer – A person who makes a purchase on behalf of another person who is unable or unwilling
to do so.
Index
cash flow covenant, 7, 12, 14, 28 EFP Rotenberg, 21, 22, 23, 24, 25, 28 Ernst & Young, 12, 13, 14
Master Plan, 7, 10, 13 straw buyers, 17, 18, 19, 26, 28, 29
28
Exam Questions
1. What was the Master Plan at Dewey & LeBouef in 2008?
a. A collections strategy to collect past due client billings
b. A listing of adjustments and adjustment amounts needed to reach a bank imposed cash
flow covenant
c. A strategy of paying lawyers guaranteed amounts to lure them from rival firms
d. Capitalizing Joel’s Amex
2. Which of the following procedures may have uncovered the improper London lease accounting
at Dewey & LeBouef?
a. Discussion with the CFO
b. Discussion with accounting staff
c. Reviewing the terms of the lease breakup document or discussing the terms with the
lessor
d. Recalculating the 2008 portion of the lease amortization over the life of the lease
3. Which of the following is NOT a method to fabricate revenue employed by ContinuityX?
a. Use straw buyers
b. Fabricate documents
c. Alter the dates and amounts of customer purchase orders
d. Create a related entity to use as a customer
4. What did EFP Rotenberg fail to question in the XO Agreement?
a. The XO Agreement made no mention of a commission
b. The XO Agreement did not specify how commissions were to be earned and recognized
by ContinuityX
c. There was no agreement with XO
d. The XO Agreement called for the recognition in revenue of monthly commission
payments, after XO had been paid by the customer, while ContinuityX recognized 100%
of the overall commission after the sales contract was signed
5. Which audit procedure would have detected overstated commissions receivable at June 30,
2012 at ContinuityX?
a. Accounts receivable confirmations
b. Discussion with the CEO
c. Discussion with the CFO
d. Reviewing security deposit cashier checks drawn from ContinuityX’s bank account
29
Answers to Review Questions
1. Which of the following procedures may have detected the $3.8 million of uncollectible client
disbursements in Dewey & LeBouef’s 2008 financial statements?
a. Correct. Comparison of uncollectible disbursements to the prior year and to the
averages of the two firms before the merger may have detected the journal entry to
reverse the write off of $3.8 million of previously uncollectible client disbursements. It
would be logical to assume that the level of uncollectible disbursements would likely
increase at the onset of an economic recession rather than decrease.
b. Incorrect. Discussion with the firm’s Finance Director would likely not have produced an
answer that highlighted the improper journal entry. This is based on SEC complaint
which indicates that there were emails that expressed occasional concern about the
auditors discovering the adjustments as well as a similar concern covered in testimony
at trial.
c. Incorrect. Discussion with the firm’s accounting staff would likely not point out the
improper journal entry. In the case of the London lease breakup fee, a member of the
accounting staff represented to an auditor that it was a consulting fee rather than a
breakup fee.
d. Incorrect. Relying on management’s representations would likely not highlight the
improper journal entry based on the other improper entries that also took place while
management represented that all transactions had been accounted for properly.
2. How did ContinuityX fabricate commission revenue?
a. Incorrect. Fake invoices were used to fabricate revenue under the Joint Marketing
Agreement, but were not used in generating commissions from AT&T and XO.
b. Correct. ContinuityX used straw buyers who signed internet service agreements with
AT&T and XO, but never intended to pay for the service. Straw buyers were induced to
participate in the scheme with the promise of a share of the commission from AT&T or
XO.
c. Incorrect. Factoring the receivables was a means of obtaining immediate cash. The
receivables were sold to a factor at a discount.
d. Incorrect. The use of cashier’s checks with the customer name as the remitter was the
method that ContinuityX used to fund a security deposit with AT&T for the straw buyer.
While ContinuityX recorded this deposit as an asset even though it was owned by AT&T,
it was not part of the scheme to fabricate commission revenue.
3. What audit procedure may have detected improper revenue recognition at ContinuityX
a. Incorrect. A review of revenue recognition procedures with the CFO would be unlikely
to uncover improper revenue recognition as the CFO participated in the scheme. He
also owned one of the entities used as a straw buyer.
b. Incorrect. Recalculation of commission amounts was a method employed by EFP
Rotenberg, the auditor and it did not result in the detection of improper revenue
recognition.
c. Correct. Reading the associated agreements to ensure that revenue recognition
corresponds to the documents would have uncovered the improper revenue
30
recognition. The fundamentals of the recorded transactions did not correspond to the
available documentation.
d. Incorrect. The CEO would likely not have been forthcoming regarding the improper
revenue recognition at ContinuityX as it appears that he participated in the scheme to
fabricate the revenues.
