Section 4 Accounting Fraud And Auditor Legal Liability.pdf

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instructor resource Manual — do not coPy or redistribute

accounting fraud and auditor legal liability4.1 Enron Corporation and Andersen, LLP . . . . . . . . . . . 89 Analyzing the Fall of Two Giants

4.2 Comptronix Corporation . . . . . . . . . . . . . . . . . . . . . . 99 Identifying Inherent Risk and Control Risk Factors

4.3 Cendant Corporation . . . . . . . . . . . . . . . . . . . . . . . . 111 Assessing the Control Environment and Evaluating

Risk of Financial Statement Fraud

4.4 Waste Management, Inc. . . . . . . . . . . . . . . . . . . . . . . 119 Manipulating Accounting Estimates

4.5 Xerox Corporation . . . . . . . . . . . . . . . . . . . . . . . . . . 127 Evaluating Risk of Financial Statement Fraud

4.6 Phar-Mor, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137 Accounting Fraud, Litigation, and Auditor Liability

caSeS included in thiS Section

89copyright © 2009 by Pearson education, inc., upper saddle river, nJ 07458


The case was prepared by Mark S. Beasley, Ph.D. and Frank A. Buckless, Ph.D. of North Carolina State University and Steven M. Glover, Ph.D. and Douglas F. Prawitt, Ph.D. of Brigham Young University, as a basis for class discussion. It is not intended to illustrate either effective or ineffective handling of an administrative situation.

enron corporation and andersen, llPanalyzing the fall of two giantsMark S. Beasley · Frank A. Buckless · Steven M. Glover · Douglas F. Prawitt

To help students understand what happened at [1]

Enron Corporation and how Andersen’s involve-ment with Enron led to the accounting firm’s downfall.To enhance students’ appreciation of the im-[2]

portance of understanding an audit client’s core business strategies.To develop students’ understanding of the role [3]

of confidence, reputation, and trust both in the corporate and auditing professions.

To provide a venue for exploring professional [4]

issues relating to auditor independence and the provision of non-audit services for clients.To introduce students to the current debate on [5]

rules- versus principles-based accounting stan-dards and related implications for the auditing profession.To actively involve students in considering the [6]

challenges facing the accounting profession and in evaluating alternative courses of action for overcoming these obstacles.

inStructional objectiveS

KEY FACTSEnron entered the year 2001 as the seventh largest public company in the U.S., only to exit ��the year as the largest company to ever declare bankruptcy in U.S. history (until WorldCom’s bankruptcy in 2002 later claimed the record).Enron engaged in very aggressive accounting approaches, including the establishment of special ��purpose entities (SPEs), the intent of which appears to have been simply to move debt off the company’s balance sheet and enhance profits.Enron began as a natural gas pipeline company, when Houston Natural Gas and InterNorth of ��Omaha, Nebraska merged in 1985. The company eventually morphed into a speculative energy and commodity trading company, often acting as a “market-maker” in electricity and other markets.A Northwestern University professor established Arthur Andersen, LLP in 1913. The company ��rapidly achieved a reputation for taking tough stands against clients wishing to adopt aggressive reporting strategies. This reputation was key to the early success of the firm.Andersen’s failure was a result of the firm’s loss of reputation as a result of a long string of audit ��failures (including Waste Management, Global Crossing, Sunbeam, Qwest Communications, Enron, and eventually WorldCom) and of the firm’s conviction on federal charges of obstruction of justice.Financial accounting standards played a role in that some of Enron’s questionable accounting ��strategies were in technical compliance with generally accepted accounting principles (GAAP), despite clearly violating the intent of those standards. This ties directly to the current debate on rules-based versus principles-based accounting standards.

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section 4: accounting fraud and auditor legal liability


USE OF CASEThis case vividly illustrates the important role of trust, reputation, and confidence in corporate America, since the fall of both Enron and Andersen resulted from the loss of these critical elements. Because the Enron/Andersen debacle involves one of the largest bankruptcies and perhaps the single most significant audit failure in U.S. history, the level of student interest in this case is high. Thus, the case provides an excellent venue for discussion of many different topics ranging from auditor independence to the nature and intent of financial accounting standards.

This case is ideal for use as an out-of-class written assignment or as a basis for class presentation and/or discussion. Either way, an in-class discussion of the issues is critical to vividly highlight the lessons of this case.

If the case is to be used for an in-class discussion, we recommend having students read it prior to the in-class discussion, as the case is fairly lengthy. In class, students can meet in pairs or small groups to discuss and compare their conclusions. Once all students have had an opportunity to share their ideas and arrive at a group consensus, the instructor can randomly call on individual students to share their group’s answers with the class. Randomly calling on individual students to share their group’s answers with the class helps to ensure that all students take responsibility for learning the material.

If the case is going to be used as an out-of-class writing assignment, we recommend discussing the case requirements with the students prior to having them complete the assignment. In-class, the instructor can call on students to share their answers with the class and discuss current events as described in the current business press.

PROFESSIONAL STANDARDSRelevant professional standards for this assignment are FAS 94, “Consolidation of All Majority-Owned Subsidiaries”, FAS 141R, “Business Combinations”, SEC Release No. 33-8180 “Retention of Records Relevant to Audits and Reviews”, and FIN 46R, “Consolidation of Variable Interest Entities.”

QueStionS and SuGGeSted SolutionS

What were the business risks Enron faced, and how did those risks increase the likelihood of [1]

material misstatements in Enron’s financial statements?

Enron faced most of the risks ordinarily faced by any energy company, including price instability and foreign currency risks. However, the speculative nature of Enron’s business model exposed the company to many additional risks, which created pressure for the company’s executives to adopt aggressive, and perhaps even fraudulent, financial reporting practices. The realization of these risks eventually brought the company down.

Enron acted as a broker of speculative energy (and other) futures, which exposed the company to greatly magnified energy and other commodity price risks. The company also offered financial hedges to its customers, exposing Enron to risks such as interest rate and amplified foreign exchange risks. Enron was a major player in hedging and contracting for supplies of electricity, an extremely competitive business subject to price wars and environmental concerns. Much of Enron’s business was transacted over the Internet, exposing the company to the risk of technological failure. Finally, Enron operated in many different areas of the world with very different regulatory and risk profiles, including Europe and India.

As several of Enron’s business risks were realized, the company’s management experienced real pressure to report healthy financial results. These pressures were particularly intense at Enron for at least two reasons. First, many of Enron’s deals (including the SPEs discussed in the case) depended heavily on a high and rising stock price. This pressure existed

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case 4.1: enron corporation and andersen, llP


because the company had guaranteed its obligations with stock and had contractually agreed that those obligations would become immediately due and payable if the stock price fell below certain levels. Second, the nature of Enron’s business required the confidence of its business partners in the company’s ability meet its future obligations to deliver electricity and other commodities. If the company were to report poor or deteriorating financial results, its partners might begin to question the company’s ability to meet its obligations and consequently refuse to do business with the company. This is, in fact, what eventually happened.

[a][2] What are the responsibilities of a company’s board of directors? [b] Could the board of directors at Enron—especially the audit committee—have prevented the fall of Enron? [c]

Should they have known about the risks and apparent lack of independence with Enron's SPEs? What should they have done about it?

[a] The board of directors is responsible for ensuring that a firm’s management is acting in the best interest of the firm’s owners. As such, directors can be held liable by shareholders and others if they are negligent in their duties.

[b] Although we will never know if the board of directors could have prevented the fall of Enron, the board could have taken several steps to improve corporate governance. In a recent report by the U.S. Senate Permanent Subcommittee of Investigation, the Subcommittee placed a good deal of blame on the board of directors and the audit committee, and recommended that boards take several steps to improve corporate governance. The overall recommendations from that report follow:

“Based upon the evidence before it and the findings made in this report, the U.S. Senate Permanent Subcommittee on Investigations makes the following recommendations:

“(1) Strengthening Oversight. Directors of publicly traded companies should take steps to:(a) prohibit accounting practices and transactions that put the company at high risk of non-compliance with generally accepted accounting principles and result in misleading and inaccurate financial statements; (b) prohibit conflict of interest arrangements that allow company transactions with a business owned or operated by senior company personnel; (c) prohibit off-the-books activity used to make the company’s financial condition appear better than it is, and require full public disclosure of all assets, liabilities and activities that materially affect the company’s financial condition; (d) prevent excessive executive compensation, including by

(i) exercising ongoing oversight of compensation plans and payments; (ii) barring the issuance of company-financed loans to directors and senior officers of the company; and (iii) preventing stock-based compensation plans that encourage company personnel to use improper accounting or other measures to improperly increase the company stock price for personal gain; and

(e) prohibit the company’s outside auditor from also providing internal auditing or consulting services to the company and from auditing its own work for the company.

“(2) Strengthening Independence. The Securities and Exchange Commission and the self-regulatory organizations, including the national stock exchanges, should: (a) strengthen requirements for Director independence at publicly traded companies, including by requiring a majority of the outside Directors to be free of material financial ties to the company other than through Director compensation; (b) strengthen requirements for Audit Committees at publicly traded companies,

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including by requiring the Audit Committee Chair to possess financial management or accounting expertise, and by requiring a written Audit Committee charter that obligates the Committee to oversee the company’s financial statements and accounting practices and to hire and fire the outside auditor; and (c) strengthen requirements for auditor independence, including by prohibiting the company’s outside auditor from simultaneously providing the company with internal auditing or consulting services and from auditing its own work for the company.”1

Many of these calls for change are currently being considered as revisions to listing requirements for NYSE and NASDAQ registrants. Some of these calls have been effectively addressed by Congress in the Sarbanes-Oxley Act.

[c] It appears that the board of directors could have discovered the risks and the lack of independence with Enron’s SPEs. The board may have been able to discover these issues if it had followed the recommendations listed above. However, the inherent limitations of boards of directors must be understood. They meet only periodically, do not have an independent investigative arm (and thus rely on management and internal and external auditors for accurate information), and do not monitor the companies they serve on a full-time basis.

In your own words, summarize how Enron used SPEs to hide large amounts of company debt.[3]

The case explains only how Enron’s SPEs were used to sell under-performing assets, thereby removing related losses and liabilities from the company’s financial statements. Thus, students will need to do outside research for a more complete explanation of the various means Enron used SPEs to hide company debt. In assigning this question, the instructor should clarify whether students are expected to simply summarize the information provided in the case, or whether they are expected to do further outside research.

SPEs are separate legal entities set up to accomplish specific company objectives. Enron created SPEs for the purpose of selling off company assets in order to record a cash inflow and remove the assets and any related liabilities from the balance sheet. Such SPEs were legal as long as Enron secured an outside investment of at least three percent of the value of the assets to be sold to the SPE. In other words, the outside investors were to assume the risk of the investment. However, as an incentive to bear the risk, Enron pledged company stock to the outside SPE investors to remove the risk in the case that the assets were sold for a loss. These obligations were not understood until Enron’s stock began to perform poorly, making the company unable to cover the losses with shares of stock. “Chewco,” “LJM2,” and “Whitewing” were three of Enron’s most prominent SPEs. Enron also allegedly hid debt by working with large investment bankers to take on large loans that appeared like financial hedges rather than debt.

The Wall Street Journal summed up Enron’s use of SPEs to hide large amounts of company debt with the following example:

“The essence of the scam was simple: Let’s say you had a clunker of a car but told your spouse you just sold it for twice what it was worth. You neglect to mention, though, that you basically sold it to yourself because you lent the buyer the money. Unless the car miraculously recovers its value, you’ll still eat a loss when the buyer defaults and you’re forced to repossess. Enron’s shareholders were in the position of the misled spouse. They saw the company shedding questionable or volatile assets and getting paid well for them, but they weren’t told that Enron still bore the risk in the form of various exotic loans to the nominally ‘independent’ buyers.”2

1 http://www.thecorporatelibrary.com/special/070702enronreport.pdf2 The Wall Street Journal, August 22, 2002, p. A12

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What are the auditor independence issues surrounding the provision of external auditing [4]

services, internal auditing services, and management consulting services for the same client? Develop arguments for why auditors should be allowed to perform these services for the same client. Develop separate arguments for why auditors should not be allowed to perform non-audit services for their audit clients. What do you believe?

External auditors are required to be independent of the companies they audit. When auditors begin to perform internal audit and management consulting services for the same companies they audit, the following questions arise: Can auditors be independent in appearance when providing both services? Can auditors be independent in fact when providing both services? How does providing both services affect the judgment of auditors?

Congress recently enacted legislation known as the Sarbanes-Oxley Act of 2002 in order to enhance the independence of public auditors. Section 201 of the Sarbanes-Oxley Act specifically gives guidance relating to independence:

“It shall be ‘unlawful’ for a registered public accounting firm to provide any non-audit service to an issuer contemporaneously with the audit, including : (1) bookkeeping or other services related to the accounting records or financial statements of the audit client; (2) financial information systems design and implementation; (3) appraisal or valuation services, fairness opinions, or contribution-in-kind reports; (4) actuarial services; (5) internal audit outsourcing services; (6) management functions or human resources; (7) broker or dealer, investment adviser, or investment banking services; (8) legal services and expert services unrelated to the audit; (9) any other service that the Board determines, by regulation, is impermissible. The Board may, on a case-by-case basis, exempt from these prohibitions any person, issuer, public accounting firm, or transaction, subject to review by the Commission.

“It will not be unlawful to provide other non-audit services if they are pre-approved by the audit committee in the following manner. The bill allows an accounting firm to ‘engage in any non-audit service, including tax services,’ that is not listed above, only if the activity is pre-approved by the audit committee of the issuer. The audit committee will disclose to investors in periodic reports its decision to pre-approve non-audit services. Statutory insurance company regulatory audits are treated as an audit service, and thus do not require pre-approval.

“The pre-approval requirement is waived with respect to the provision of non-audit services for an issuer if the aggregate amount of all such non-audit services provided to the issuer constitutes less than 5% of the total amount of revenues paid by the issuer to its auditor (calculated on the basis of revenues paid by the issuer during the fiscal year when the non-audit services are performed), such services were not recognized by the issuer at the time of the engagement to be non-audit services; and such services are promptly brought to the attention of the audit committee and approved prior to completion of the audit.

The authority to pre-approve services can be delegated to 1 or more members of the audit committee, but any decision by the delegate must be presented to the full audit committee.”3

Arguments for allowing auditors to perform external audit and other services at the same time include:

Auditors realize efficiencies by completing both external audit and internal audit services. •�They reduce the number of hours required to complete both audits by eliminating overlapping work.

3 http://www.aicpa.org/info/sarbanes_oxley_summary.htm (Section 201: Services Outside the Scope of Practice of Auditors; Prohibited Activities)

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Auditors discover inefficiencies and other weaknesses while performing audit work. •�They use their expertise and knowledge in providing consulting services to management to improve these weaknesses. Auditors already have a relationship established with management. By providing other •�services, they save the company time and money that would be spent in obtaining the services of another organization unfamiliar with company policies and procedures. Auditors can act independently in the external audit when they are performing other •�services.Legislation should not impede the freedom to pursue growth and revenues in different •�lines of business in a free enterprise system.

Arguments for not allowing auditors to perform external audit and other services at the same time include:

Auditors may not act independently in the external audit when they perform other •�services. The incentives to perform consulting and/or audit services may lead to impaired judgment.Internal audit services are best performed by in-house personnel who understand the •�company’s culture and practices. Internal auditors are an important part of corporate governance and should not be replaced by external auditors acting as internal auditors.The company benefits from multiple viewpoints. This includes viewpoints from •�consultants and internal auditors who do not also serve as the company’s external auditors.

Explain how “rules-based” accounting standards differ from “principles-based” standards. [5]

How might fundamentally changing accounting standards from bright-line rules to principle-based standards help prevent another Enron-like fiasco in the future? Some argue that the trend toward adoption of international accounting standards represents a move toward more “principles-based” standards. Are there dangers in removing “bright-line” rules? What difficulties might be associated with such a change?

Rules-based accounting standards are specific and detailed, reading like the tax or criminal law codes. A rules-based system of accounting standards attempts to create a package of pre-fabricated decision models for every imaginable situation. Due to the impossibility of defining every situation, individuals can sometimes justify a violation of the spirit of the law by technically complying with the letter of the law. Principles-based standards are general guidelines that describe how classes of transactions should be reflected in general terms, requiring that the accounting appropriately reflect economic substance. They allow accounting professionals to make judgments when determining specific applications. A principles-based system of accounting standards would require that accounting and auditing professionals possess the integrity and judgment necessary to make appropriate decisions and would involve greater judgment and discretion.

Principles-based rules may prevent another Enron failure by requiring accountants to make judgments regarding the “spirit of the law,” rather than just regarding technical compliance with rules. In the case of Enron’s SPEs, for example, Enron’s managers may have succeeded in pressuring auditors into accepting deceptive financial reporting by pointing to the “bright-line” standard requiring a three percent outside investment. Principles-based standards would require auditors to evaluate the circumstances as a whole in order to determine whether the parent company in fact did not have significant exposure in relation to the unconsolidated SPE.

Removing bright-line rules may also create problems in some circumstances because human judgment and discretion are involved. Auditors and executives may rationalize aggressive financial decisions and then defend themselves when questioned by asserting that accounting standards do not specifically prohibit their actions.

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Enron and Andersen suffered severe consequences because of their perceived lack of integrity [6]

and damaged reputations. In fact, some people believe the fall of Enron occurred because of a form of “run on the bank.” Some argue that Andersen experienced a similar “run on the bank” as many top clients quickly dropped the firm in the wake of Enron’s collapse. Is the “run on the bank” analogy valid for both firms? Why or why not?

The run-on-the-bank analogy is valid for both firms, at least to some extent, in that such runs are triggered by loss of confidence and credibility on the part of investors. Enron may have been able to avoid bankruptcy if customers had been willing to continue use of the company’s services. The debts and other obligations the company revealed were large, but the company also had a large revenue stream of over $100 billion per year. When Enron lost its credibility, however, customers were no longer willing to do business with the company. In Andersen’s case, the firm would have also likely survived if the Enron repercussions had been isolated to the office conducting the actual audit. Andersen was a large, established, multi-national firm and the loss of one client Enron’s size would not likely have proven the end of the firm. Unfortunately, clients all over the world lost confidence in the firm’s credibility—ultimately a public accounting firm’s only significant asset. As a result, many clients in nearly all of Andersen’s many offices subsequently fired the firm as part of an intensifying downward spiral.

A perceived lack of integrity caused irreparable damage to both Andersen and Enron. How [7]

can you apply the principles learned in this case personally? Generate an example of how involvement in unethical or illegal activities, or even the appearance of such involvement, might adversely affect your career. What are the possible consequences when others question your integrity? What can you do to preserve your reputation throughout your career?

Student answers will vary widely, but the following may serve as a guideline: As students begin a career in auditing they need to be aware that they will make many professional judgments and should make these judgments considering the interests of all parties involved – not just themselves or management. If a professional is involved in a decision the ethical appropriateness of which is later called into question by shareholders or regulatory authorities, for example, he or she will run the risk of losing his or her job, and possibly even the ability to obtain work with other firms due to a damaged reputation or loss of professional license. Even if a particular action does not technically break any laws, if others have any reason to question a professional’s integrity there will be a loss of trust that will negatively affect the demand for this person’s services. An auditor can preserve her or his reputation by ensuring that she or he follows her or his conscience and exercises a high level of ethics and professionalism. She or he can also rely on firm resources and personnel, for example by obtaining an objective second opinion, to ensure that personal judgments are accurate and unbiased.

The old parable of a young man and a rattlesnake figuratively illustrates how getting involved in questionable circumstances, whether in fact or in appearance, might adversely affect a person’s career. The young man in the story was climbing in the mountains one day when he saw a rattlesnake that was dying because it was unable to descend the steep cliffs of the mountain on its own and because the weather was too cold at that altitude. The rattlesnake begged the young man to carry him down the mountain and promised that he would not bite the young man. The boy finally consented and carried the rattlesnake down the mountain. When the boy reached the base of the mountain, he stooped down to lay the rattlesnake on the ground. Suddenly, the rattlesnake bit the young man. The boy cried out in horror and cursed the rattlesnake for failing to abide by its promise not to bite him. The rattlesnake responded, “You knew what I was when you picked me up.” Getting involved in unethical or illegal activities, or even the appearance of such, is like picking up a rattlesnake that in the end will bite its carrier. To act in a manner that violates trust or creates

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the appearance of impropriety can be similarly lethal to one’s reputation and credibility. In the business world, trust is difficult to restore once there has been a breach of that trust. It can take months or years to restore . . . or it may be permanently lost.

As another example, recently a four-day leadership conference was held for about 800 students completing an internship at a large public accounting firm. The interns were given instructions to abstain from alcohol during the four-day period of the conference. The firm placed trust in the interns and expected the directive to be followed individually on an honor system. Unfortunately, several of the interns betrayed the trust given them. Due to the drunken actions of one intern, a fellow guest at the conference hotel made a complaint that made its way to the partner responsible for the conference. As a result, the intern’s employment offer was rescinded, and all of the interns felt that their collective reputation had been tarnished to some degree. Despite his attempts to keep his untoward actions private, the intern neglected the basic principle that private actions can often have public consequences for the individual and others.

Why do audit partners struggle with making tough accounting decisions that may be contrary [8]

to their client’s position on the issue? What changes should the profession make to eliminate these obstacles?

This question is a very open one, and students’ responses will reflect a wide variety of ideas. The variety of ideas should allow for a creative and stimulating in-class discussion. However, some of the key points that should be raised include the following.

Public accounting is a highly competitive, service-oriented business. As is the case with most other service-offering enterprises, public accounting firms have a vital interest in pleasing their clients by providing value and excellent customer service. In order to provide excellent client service, partners may sometimes feel pressure to avoid taking tough stands on a client’s accounting choices. Otherwise, partners may run the risk of losing clients to other accounting firms.

Furthermore, public accounting firms are in the business of making money. As owners of a public accounting firm, partners are naturally interested in the financial performance of the firm because, among other reasons, partner income and bonuses depend on annual revenues. Partners are often responsible for revenue targets each year and aggressively attempt to reach these targets. One interesting note is that audit fee revenues from such companies as Enron are very lucrative—Andersen’s audit fee at Enron was about $48 million per year.

Finally, some argue that the provision of consulting, internal auditing, and other services to auditing clients may have compromised the auditors’ ability to be objective and take tough stands on questionable accounting practices. Along these lines, it is interesting to note that in 2000 Andersen earned more from Enron in consulting fees than in auditing fees, with consulting fees topping $50 million in that year alone.

In order to eliminate these obstacles, auditors need to be committed to putting the public interest first. They need to be upfront with each client by affirming that even though the accounting firm desires to add value to the client’s business, difficult decisions that are contrary to management’s position on certain issues may have to be made to protect the interests of the investing public. By laying this foundation, difficult decisions will be easier to make when such circumstances arise. Firms may need to reformulate their performance evaluation and compensation practices to determine whether they provide incentives for local partners to take aggressive stances that may not be in the best interests of the firm as a whole. In addition, most large accounting firms require national approval for local office partners to sign off on certain complex or aggressive accounting positions, mitigating the sometimes strong individual pressures on local partners to please the client. Finally, the Sarbanes-Oxley Act of 2002 now makes it illegal for external auditors to perform internal auditing and a variety of management consulting services for the same company.

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What has been done, and what more do you believe should be done to restore the public trust in [9]

the auditing profession and in the nation’s financial reporting system?

This question is designed to encourage students to think creatively about issues for which there are no uniquely correct answers. Some of the issues students may raise are as follows.

Congress passed the Sarbanes-Oxley Act in 2002, making it illegal for auditors to perform external audit and internal audit or management consulting services at the same time. This bill also introduced other measures that attempt to restore confidence in the country’s capital markets. For instance, the bill mandated the creation of the Public Company Accounting Oversight Board (the PCAOB) that is under the oversight of the SEC, essentially ending the profession’s long-standing tradition of self-regulation. The board has power over accounting firms that audit SEC clients in the U.S. It is clear that these measures ultimately cannot by themselves completely restore confidence in the capital markets, because auditors and auditing were only part of the problem that led to Enron and the other scandals of the early 2000’s. The NYSE and NASDAQ have instituted several reforms to listing requirements to strengthen board of director governance over senior management. In the end, all those with a role in the system must act appropriately. Auditors must put the public interest first. Companies must consistently demonstrate their commitment to accurately disclose financial and operating information, and a continuous process must be established to enhance and maintain the quality of information provided to investors and creditors.




comptronix corporationidentifying inherent risk and control risk factorsMark S. Beasley · Frank A. Buckless · Steven M. Glover · Douglas F. Prawitt

To illustrate a real-world example of fraudulent [1]

financial reporting.To illustrate examples of inherent risk and [2]

control risk factors that are commonly associated with fraudulent financial reporting.To highlight the importance of effective board [3]

of director and audit committee oversight over senior executives.

To illustrate the review of interim financial [4]

statements that CPAs can provide as another attest engagement in conjunction with their audit of annual financial statements.To sensitize students to real-world pressures [5]

that sometimes motivate executives to engage in fraudulent financial reporting.


KEY FACTSComptronix Corporation provided contract manufacturing services to original equipment •manufacturers in the electronics industry.The company was formed in the early 1980s and suffered several years of losses until receiving •an infusion of capital from a venture capitalist in 1987. The company went public in 1989.Three of the senior executives at Comptronix fraudulently issued financial statements for •1989, 1990, and 1991, before confessing in 1992 to their shenanigans.The chief executive officer (CEO), the chief operating officer (COO), and the controller/•treasurer, who were all founders, colluded to record fictitious assets and profits by overriding existing internal controls.Top company executives began the fraud by understating cost of goods sold and overstating •inventory in the interim financial statements filed in Form 10-Qs with the Securities and Exchange Commission (SEC).Due to concerns that the auditors might detect the interim misstatements, the executives •reversed those transactions at year-end but then booked fictitious sales and receivables to overstate annual assets and income.To make the fictitious sales and receivables appear legitimate, top management prepared and •recorded cash payments for fictitious equipment purchases and then re-deposited those cash payments as cash receipts from the fictitious accounts receivable customers.Top executives were able to maintain the fraud by overriding established controls and •recording transactions without required documentation.The fraud scheme allowed Comptronix to show an annual profit in each of the fraud years, •when in actuality Comptronix was incurring net losses. Sales were overstated by as much as 14.9% while stockholders’ equity was overstated by as much as 111.3%.Deficiencies in the oversight provided by the board of directors and audit committee enabled •the fraud to continue for several years.

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Two of the three top executives held significant portions of Comptronix’s common stock, •which provided motivation for them to inflate stock prices by manipulating financial statement results. The CEO was the largest shareholder of the company.The consequences for Comptronix Corporation were severe. Significant portions of its •operations were sold and the company filed for Chapter 11 bankruptcy. Unsecured creditors received less than 10 cents on the dollar.

USE OF CASEThis particular case is appropriate for undergraduate or graduate auditing courses. It can easily be used at several points during the coverage of key audit topics. For example, it would complement class discussion about the audit risk model, internal controls, and the auditor’s responsibility to detect material misstatements due to fraud. The first three questions emphasize identifying both inherent risk and control risk factors that may have indicated a greater likelihood of material misstatements due to fraud. The fourth and fifth questions are particularly relevant for an advanced auditing course as they emphasize the roles of boards of directors and audit committees in preventing management fraud and they provide an overview of AU 722, Interim Financial Information, requirements related to reviews of interim financial statements for public companies. Both of those topics are more likely to be addressed in an advance auditing class. The sixth question focuses on motivations and incentives for managers to engage in fraudulent financial reporting. That question is useful when discussing professional ethics.

We find that students particularly enjoy reading about actual fraud cases involving real-world companies. This case is about an actual company, Comptronix Corporation, based in Guntersville, Alabama. We particularly like this case because it focuses on a relatively small start-up company that is likely to be similar to many clients students will audit when they enter public accounting. In addition, this case highlights that frauds can involve people trained in accounting. By observing that the CEO had a degree in accounting and was a certified public accountant, students are able to see that fraud can involve people who should have an awareness of the inappropriate nature of those activities. It is our hope that exposing students to real cases of fraud involving individuals trained in accounting will make them more aware of the risks and related red flag indicators of fraud enabling them to avoid involvement in similar activities during their professional accounting careers.

The case can be completed by students individually or in groups as an in-class or out-of-class assignment. If the case is going to be used for an in-class discussion, we recommend having students read the case as an out-of-class reading assignment prior to the in-class discussion. A useful cooperative learning technique to use for the in-class discussion is “Roundtable.” The basic process for the Roundtable activity is to have students meet in small groups to state aloud and write down on a single sheet of paper their ideas regarding a case question. Once all students have had an opportunity to state their ideas and arrive at a group consensus, the instructor can randomly call on individual students to share their group’s answers with the class. The class time allocated to the group discussion can be shortened by assigning groups responsibility for different case questions. It is important for the instructor to randomly call on individual students to share their group’s answers to ensure that all students take responsibility for learning the material.

If the case is going to be used as an out-of-class writing assignment, we recommend discussing the case requirements with the students prior to having them complete the assignment. A useful cooperative learning technique to use for the out-of-class writing assignment is “peer editing.” With this approach students first meet in pairs to develop an outline for their written solutions. Once an outline is developed, students individually draft a written response based on the outline. When the drafts are completed, students exchange draft responses and prepare written suggestions on the grammar, organization, and accuracy of the composition. Students then meet to discuss revisions for each draft. Finally, students revise their responses based on the suggestions provided. To ensure the process is followed, students should attach their final draft to the outline and critiqued drafts.

When multiple writing assignments are assigned during the semester, the above approach

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case 4.2: comptronix corporation


can be modified to require students to complete a joint response in place of individual responses. The basic difference is that one student is assigned responsibility to compose and re-write the written response while the other student is assigned responsibility to critique the original draft. Students should still meet to create an outline for the written solution. The responsibilities of writer and reviewer should be alternated for each written assignment.

PROFESSIONAL STANDARDSRelevant professional standards for this assignment include AU Section 312 “Audit Risk and Materiality in Conducting an Audit,” AU Section 314 “Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement,” AU Section 316 “Consideration of Fraud in a Financial Statement Audit,” AU Section 318, “Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained,” AU Section 350 “Audit Sampling,” AU Section 722, “Interim Financial Information,” and ET Section 54, “Article III-Integrity,” and ET Section 102, “Integrity and Objectivity.”


Professional auditing standards present the audit risk model, which is used to determine the [1]

nature, timing, and extent of audit procedures. Describe the components of the model and discuss how changes in each component affect the auditor’s need for evidence.

The audit risk model is used to determine the nature, timing, and extent of substantive audit procedures. The audit risk model used during planning is usually stated as follows:

PDR = AAR/(IR x CR)where:

PDR = planned detection riskAAR = acceptable audit riskIR = inherent riskCR = control risk

Planned detection risk (PDR) represents the likelihood that the auditor’s substantive audit tests will fail to detect material misstatements that actually exist in a financial statement assertion. PDR is a function of the effectiveness of an audit test and of its application by the auditor. Decreases in PDR will require the auditor to increase the competence and/or sufficiency of audit evidence collected.

Acceptable audit risk (AAR) represents the likelihood that the auditor issues an unqualified opinion for financial statements that are materially misstated. AAR should be established at a low level for all audit engagements. In some instances the auditor may want to reduce acceptable audit risk further because of the number of users relying on the financial statements and/or the high level of auditor business risk associated with this engagement. As AAR decreases, PDR decreases, which in turn increases the auditor’s need for stronger evidence.

Inherent risk (IR) represents the auditor’s assessment of the susceptibility of an assertion to a material misstatement assuming there are no related internal controls. See the solution to question 2 for a list of factors that affect the auditor’s assessment of inherent risk. As inherent risk increases, PDR decreases, which in turn increases the auditor’s need for stronger evidence.

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Control risk (CR) represents the auditor’s assessment of the likelihood that a material misstatement could occur and not be prevented or detected on a timely basis by the client’s internal control. See the solution to question 3 for a list of factors that affect the auditor’s assessment of control risk. As the strength of internal control is assessed as decreasing, the auditor’s assessment of control risk increases. That, in turn, decreases PDR, which increases the auditor’s need for stronger evidence.

One of the components of the audit risk model is inherent risk. Describe typical factors that [2]

auditors evaluate when assessing inherent risk. With the benefit of hindsight, what inherent risk factors were present during the audits of the 1989 through 1992 Comptronix financial statements?

As stated in the solution to question 1, inherent risk reflects a measure of the auditor’s assessment of the susceptibility of an assertion to a material misstatement assuming there are no related internal controls. Professional standards note that inherent risk may be greater for some assertions and related account balances than for others. These standards note that certain accounts are inherently more likely to be materially misstated because their balances are based on:

Complex calculations rather than simple calculations.�Subjective data rather than objective factual data.�Non-routine rather than routine transactions.�

Professional standards also note that external factors can influence inherent risk and some of those factors affect more than one account. For example:

Changes in industry economic conditions can directly affect companies in that �industry.Technological developments can affect the demand of the client’s product or services.�Insufficient working capital to continue operations places undue pressure on management �to meet external expectations to satisfy cash flow needs.

Other factors that may affect inherent risk include the following:Transactions with related parties.�Susceptibility of assets to misappropriation. �

Some of the inherent risk factors present during the 1989 through 1992 financial statement audits include the following:

�Initial Public Offering of Stock. Comptronix made its first public offering of stock during 1989. Comptronix had experienced strong operating performance during 1987 and 1988 creating high investor expectations. These high expectations of investors could motivate management to manipulate operating performance should the company’s operations take a turn for the worse. Thus, there was high inherent risk that operating accounts would be manipulated to meet investor expectations.

�Loss of Key Customer. Early after the public offering, Comptronix lost a key customer to SCI. The loss of a key customer could put extreme downward pressure on sales and operating performance. Management would have strong motivation to manipulate operating performance to meet investor expectations. Thus, there was a high inherent risk that operating accounts would be misstated to meet investor expectations.

�Technological Developments. Because Comptronix manufactured circuit boards, their main product was directly affected by technological developments, which continue to rapidly occur in both the technology and healthcare fields. The changing technology could negatively impact sales which could motivate management to manipulate operating performance to meet investor expectations. This would suggest a high inherent risk related to operating accounts.

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�Accounts Based on Estimation. Accounts receivable, inventory, and property, plant, and equipment are very important accounts for manufacturing companies. The estimates related to the collectibility of accounts receivable and obsolescence of inventory and property, plant, and equipment are subjective. Thus, these accounts should have a high inherent risk assessment. The inherent risk of these accounts is accentuated by the rapidly changing technology which increases the likelihood of collectibility and obsolescence problems.

�Pressures of a Start-up Company. By the first year of the fraud (1989), Comptronix had been in existence for less than a decade. Going from a brand new company to employing over 1,800 employees in three locations in less than a decade, meant that top company executives were likely having to continually adjust their oversight of rapidly changing operations. Such demands may have distracted management from sufficiently monitoring company operations. The resulting lackluster performance may have encouraged them to create bogus operating results to camouflage inadequate operations.

�Cash Flow Pressures from Net Losses. From its existence through 1986, Comptronix suffered net losses. It wasn’t until the company attracted a venture capitalist that the company was able to generate strong sales and profits. Prior to 1989, Comptronix had only experienced two consecutive years of profit after several years of net losses. While the company appeared to be going in the right direction, cash flow pressures may have lagged years of recurring losses. Those pressures should have signaled an increased potential for material misstatements of operating accounts. Thus, there was high inherent risk that operating accounts were manipulated so the Comptronix could meet its cash flow needs.

Another component of the audit risk model is control risk. Describe the five components of [3]

internal control. What characteristics of Comptronix’s internal control increased control risk for the audits of the 1989-1992 year-end financial statements?

As stated in the solution to question 1, control risk reflects the auditor’s assessment of the likelihood a material misstatement could occur and not be prevented or detected on a timely basis by the client’s internal control. Internal control is defined by professional standards to be made up of these five interrelated components:

Control environment. � This component sets the tone of an organization, which influences the control consciousness of its people. The control environment is the foundation for all other components of internal control, providing discipline and structure. Control environment factors include management’s integrity and ethical values and its commitment to competence, board of directors and audit committee oversight, management’s philosophy and operating style, the client’s organizational structure, the assignment of authority and responsibility, and human resource policies and procedures.

Risk assessment.� This component reflects the entity’s identification and analysis of relevant risks to the achievement of its objectives, forming a basis for determining how the risks should be managed. This component focuses on how management considers risks relevant to financial reporting and how management decides about actions to address those risks.

Control Activities. � This component reflects the policies and procedures that help ensure that management directives are carried out. Generally, control activities pertain to performance reviews, information processing, physical controls, and segregation of duties.

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Information and Communication. � This component reflects the identification, capture, and exchange of information in a form and time frame that enable people to carry out their responsibilities. This component consists of the methods and records established to record, process, summarize, and report entity transactions and to maintain accountability for the related assets, liabilities, and equity.

Monitoring. � This component reflects the entity’s process of assessing the quality of internal control performance over time. This component involves management’s consideration of whether controls are operating as intended and that they are modified as appropriate for changes in conditions.

Some control risk factors that were present during the 1989 through 1992 financial statement audits include the following:

Management’s Integrity. � Apparently local townspeople observed top executives engaging in activities that may have signaled potential uncertainty about management’s integrity. Executives lived a rather flamboyant lifestyle, and one executive was known to have “led an active bachelor’s life that led to some problems in town.” In addition, there was a major dispute with an executive that led to that executive’s sudden departure from the company. These factors may have increased concern about management’s integrity.

Weak Board and Audit Committee Governance. � As described more fully in the solution to question 4, the oversight of top management by the board of directors and the audit committee was weak. For example, the board was heavily comprised of Comptronix executives and others with close affiliations with those executives. And, the audit committee only met two times during 1991 to review financial reports even though Comptronix was required to issue financial statements to the public four times a year. Given that the primary internal control mechanism over top executives is the board and its audit committee, weaknesses at the board and audit committee level should have indicated that company executives were not being closely monitored at the time.

Domination of the Organizational Structure by a Few Individuals and Lack of �Segregation of Duties. Top executives had the ability to authorize transactions and had the ability to prepare journal entries even though basic internal control guidelines suggest segregating authorization, custody, and record-keeping. Not only did the CEO and the controller/treasurer both have the ability to authorize transactions and record them in the accounting records, they also had the authority to sign checks, giving them custody of cash. Furthermore, the controller/treasurer had the ability to access the on-line shipping department system. While top executives of small companies frequently have these combined responsibilities, auditors should recognize the heightened control risk that results. In these situations, top management’s ability to exercise their power and influence to take advantage of combined duties significantly increases control risk.

Management’s Compensation Incentives. � Some of the top executives had significant personal wealth tied up in Comptronix common stock. The CEO and COO were two of the company’s largest shareholders. In addition, the company tied executive performance to stock options and stock incentive plans. The extent of stock-based compensation should have been recognized as providing increased incentives to overstate assets and income to inflate stock values for personal gain. Additionally, employment agreements with the CEO and the COO even provided a base salary for one year after termination from Comptronix, regardless of the reason for termination. Thus, these two top executives were protected financially even if their actions and behavior were not serving the best interests of the company and shareholders.

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The board of directors, and its audit committee, can be an effective corporate governance [4]

mechanism.

Discuss the pros and cons of allowing inside directors to serve on the board. Describe [a]

typical responsibilities of audit committees.

Professional standards note that the board of directors and its audit committee are an important component of an entity’s control environment. Those standards (e.g., see Appendix B in AU Section 314) note that “an entity’s control consciousness is influenced significantly by the entity’s board of directors or audit committee.” Frequently, the board of directors is viewed as the top internal control mechanism responsible for overseeing the actions of top management on behalf of the shareholders.

Because shareholders are generally not able to monitor management on a day-to-day basis, they delegate that responsibility to the board of directors. The board is responsible for raising and pursuing difficult questions with top management. Because the board is responsible for monitoring entity activities, it is important to include insiders on the board to ensure that the board has the necessary information about company transactions and activities to make decisions that are in the best interests of shareholders. Thus, most company boards of directors include several members from the company’s top executive team as full members of the board. Those members help provide necessary information to the board as it makes key decisions. However, there are risks of including too many top executives on the board. To help prevent the board from becoming an instrument of top management that could be manipulated to management’s versus the shareholders’ best interests, it is important that outsiders (i.e., individuals who are not employed by the company) be included on the board as directors. Representation of outsiders helps increase the board’s objectivity when evaluating key decisions and actions of top management. Outside directors are at a disadvantage, however, because they do not have access to the same amount of information about the company as inside directors. Outside directors often rely on audit committees and auditors (both internal and external) to provide relevant information to assist them in their board responsibilities.

Boards often create audit committees comprised solely of outside directors to interact with both external and internal auditors about financial reporting matters. Audit committees help focus the board and top management on the importance of a strong financial reporting environment. They regularly meet with both internal and external auditors to discuss relevant financial reporting and internal control matters. Effective audit committees do not allow top executives to release financial statements to the public until those statements have been reviewed and discussed by the audit committee.

What strengths and weaknesses were present related to Comptronix’s board of directors [b]

and audit committee?

The Comptronix board did not appear to be heavily represented by inside directors given that only 28.6% of the board consisted of insider directors. And, the board was not unduly large, given that it consisted of seven members. By 1991, most of the directors had served on the board for about five years, which should have increased their familiarity with Comptronix’s operations. While the outside board members did receive cash compensation and options to purchase Comptronix common stock, those types of compensation arrangements are typical for outside director service on boards. And, the board included representatives of the venture capitalist and bank that provided significant funds for Comptronix before it went public. Their inclusion on the board would be considered appropriate, given that they, like other Comptronix shareholders, had a personal stake in insuring that company executives acted in the best interests of the shareholders. Thus, on the surface, the Comptronix board appeared reasonable.

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However, a closer look at the board membership reveals that many of the outside directors had affiliations with top executives outside their role as an outside director. One of the non-management directors served as the company’s general legal counsel, which likely generated significant fees for that director related to professional services rendered. Another non-management director was a significant customer, which meant that Comptronix was a major supplier of parts for that director’s company. These two directors also served on the three-member compensation committee of the board. Both of these relationships may have reduced the directors’ objectivity as they assessed top management actions and compensation. A third director was president of a company based in Taiwan. The location of that director relative to the company’s Alabama headquarters increased the difficulty for that director to effectively monitor management.

Section 301 of the Sarbanes-Oxley Act of 2002 now requires that the audit committee of public companies be composed entirely of independent, outside directors. According to the proxy statement sent to shareholders, Comptronix did have an audit committee that did not include any inside directors. And, the audit committee did meet occasionally. However, one of the audit committee members represented a gray director who had close affiliations with top management. Inclusion of a gray director may have decreased the objectivity of the audit committee. And, the audit committee only met two times in 1991 even though Comptronix issued financial statements four times during 1991. Thus, the audit committee was not as active in monitoring the financial reporting process as might be expected for publicly traded companies.

Public companies must file quarterly financial statements in Form 10-Qs that have been [5]

reviewed by the company’s external auditor. Briefly describe the key requirements of Auditing Standards (AU) Section 722, Interim Financial Information. Why wouldn’t all companies (public and private) engage their auditors to perform timely reviews of interim financial statements?

The SEC requires all public companies to have quarterly financial statements reviewed by the external auditor on a timely basis. AU Section 722, Interim Financial Information, provides guidance on the nature, timing, and extent of procedures to be applied by the independent accountant in conducting a review of interim financial information. The objective of a review of interim financial information is to determine whether material modifications should be made for such information to conform with GAAP. A review of interim financial information consists principally of inquiries and analytical procedures. It does not include (1) tests of accounting records, (2) the evaluation of corroborating evidential matter in response to inquiries, or (3) other normal procedures ordinarily performed during an audit. Thus, the accountant does not obtain reasonable assurance that would serve as the basis for an opinion on that financial information. In performing a review of interim financial information, the accountant needs to have sufficient knowledge of a client’s internal control as it relates to the preparation of both interim and annual financial statements. That knowledge assists the accountant in identifying the likelihood of potential material misstatements in interim financial information and in selecting the inquiries and analytical procedures that will provide the accountant a basis for reporting whether material modifications should be made to the interim financial information in order for it to conform to GAAP. Non-public companies are not required to engage independent accountants to perform a review of interim financial statements. Thus, a private company’s decision to engage an independent accountant to conduct a review of interim financial information is a cost-benefit decision. The services associated with obtaining such a review require time and money. If top executives and the board of directors do not believe the related benefits exceed the costs, then they are not likely to engage independent accountants. The guidance in AU

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Section 722 applies to interim financial information that is included in a note to the audited financial statements of a non-public company. If the interim financial information for the non-public company is presented in a separate complete set of interim financial statements, the accountant should comply with the AICPA’s Statements on Standards for Accounting and Review Services. Recently, there has been increased attention on interim reviews because of alleged financial reporting fraud involving interim financial statements. The SEC requirement for timely interim reviews for public companies was sparked by the February 1999 Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (the Blue Ribbon Report). That report included a recommendation that the SEC require a reporting company’s outside auditor to conduct an interim review in accordance with AU Section 722 prior to the company’s filing of its Form 10-Q with the SEC. According to the Blue Ribbon Panel’s report, the “increased involvement by the outside auditors and the audit committee in the interim financial reporting process should result in more accurate interim reporting.”

Describe whether you think Comptronix’s executive team was inherently dishonest from the [6]

beginning. How is it possible for otherwise honest people to become involved in frauds like the one at Comptronix?

Determining whether the Comptronix executive team was inherently dishonest from the beginning is not possible based on the information provided in this case. Rather, one can only speculate as to their level of dishonesty.

Like many other fraud cases, it is highly likely that the Comptronix executives did not intend to engage in fraudulent activities during the early years of the company’s start. But they, like other executives found guilty of fraud, faced pressures that lured them to take inappropriate action. At Comptronix, the mounting pressures from recurring net losses likely placed undue pressures on these young executives, who had their professional careers and personal finances at stake, to show improvement. Once the company obtained outside funding from the venture capitalists, company executives were faced with meeting not only their expectations but also the expectations of the venture capitalist. When the company went public, pressures to meet the expectations of others rose even further. At some point, those pressures reached a high enough level that the perceived incentives of engaging in fraudulent reporting exceeded the executive’s better judgment about the consequences.

Auditing Standards (AU) Section 316, Consideration of Fraud in a Financial Statement Audit, [7]

notes that three conditions are generally present when fraud occurs. Research the authoritative standards for auditors (which are available for free on the AICPA’s Web site organized by both SAS or AU – www.aicpa.org) and provide a brief summary of each of the three fraud conditions. Additionally, provide an example from the Comptronix fraud of each of the three fraud conditions.

Auditing Standards (AU) Section 316 notes that three fraud conditions are often present when fraud exists. First, management or employees have an incentive or are under pressure, which provides them a reason to commit the fraud act. Second, circumstances exist – for example, absent or ineffective internal controls or the ability for management override of controls – which provide an opportunity for the fraud to be perpetrated. Third, those involved are able to rationalize the fraud as being consistent with their personal code of ethics. Some individuals possess an attitude, character, or set of ethical values that allows them to knowingly commit a fraudulent act.

Several incentives for management to distort financial statements were present at Comptronix. Management was under tremendous pressure as a new publicly traded start-up company to be profitable. Prior periods of recurring net losses only increased pressures

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for management to show improved results for both its shareholders and creditors. The loss of a key customer only added to that pressure. Furthermore, all individuals involved held shares of stock and were subject to stock incentive and stock option plans.

Because of their senior management positions, the executives who engaged in the fraud took advantage of their positions and power to bypass existing processes to manipulate both quarterly and annual financial statements. Internal controls were deficient, given that management had the ability to enter and modify transactions with the accounting system without being detected by other employees. Poor segregation of duties, including tasks assigned to executive management, allowed management to enter the accounting system to record inappropriate entries. And, the ability to make manual accounting entries outside the main accounting system also created opportunities for senior management to alter the accounting records with “top-sided” entries. Furthermore, the lack of effective board and audit committee oversight provided management the opportunity to engage in activities not scrutinized by the board.

Obviously, the executives who perpetrated the fraud were able to rationalize their actions to be within their personal code of conduct. Apparently they convinced themselves that their actions were acceptable. The attitude/rationalization condition is often difficult to observe. However, personal actions (e.g., lifestyle choices, reputation, etc) of top executives provide some indication of their willingness to engage in activities considered by many to be unethical. Additionally, the company’s willingness to engage in related party transactions and the poorly constructed employment agreements provide some indication of the top management attitude about ethics.

Auditing Standards (AU) Section 316, Consideration of Fraud in a Financial Statement Audit, [8]

notes that there is a possibility that management override of controls could occur in every audit and accordingly, the auditor should include audit procedures in every audit to address that risk.

What do you think is meant by the term “management override”?[a]

Management override refers to management’s bypassing of existing internal controls to engage in actions not allowed by those controls. For some unusual transactions, it may be appropriate for internal controls to be overridden, if those controls prevent the transaction from being properly reflected in the financial statements in accordance with GAAP. However, in most instances, override of internal controls by management should be prevented to reduce opportunities for management fraud.

Provide two examples of where management override of controls occurred in the [b]

Comptronix fraud.

The Comptronix case includes several examples of management override of internal control. First, management avoided making standardized entries in the sales and purchases journal as required by internal controls and made manual entries (even though not allowed by existing internal controls) to book the inappropriate transactions. Second, management failed to follow internal controls that required documentation for equipment purchases. No documents were created for the bogus transactions. Third, Mr. Shifflett and Mr. Medlin approved payments based solely on an invoice, even though internal controls required review of the purchase order, receiving report, and invoice before payment could be approved. Fourth, Mr. Medlin took advantage of weaknesses in the shipping department system to record bogus transactions and then he destroyed documentation generated by the system for those transactions so that there no audit trail of those transactions was present.

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Research AU Section 316 to identify the three required auditor responses to further address [c]

the risk of management override of internal controls.

Auditing Standards (AU) Section 316 requires auditors to perform these three mandated procedures in every audit to address the risk of management override:

Examine journal entries and other adjustments for evidence of possible material �misstatement due to fraud.Review accounting estimates for biases that could result in material misstatement due �to fraud.Evaluate the business rationale for significant unusual transactions to determine whether �the transactions may have been entered into to engage in fraudulent financial reporting.




cendant corporationassessing the control environment and evaluating risk of financial statement fraudMark S. Beasley · Frank A. Buckless · Steven M. Glover · Douglas F. Prawitt

To highlight the auditor’s responsibility for [1]

considering a client’s internal controls.To highlight the auditor’s responsibility for [2]

detecting material misstatements due to errors and fraud.To demonstrate that material fraud typically [3]

involves collusion of a number of individuals in the management team who often go to extreme lengths to fool the auditors only to later use their independent auditors as scapegoats when mate-rial errors or frauds are discovered.

To illustrate red flags associated with [4]

management fraud.To illustrate red flags associated with a weak [5]

control environment.To demonstrate the linkage of financial mis-[6]

statements to management assertions and audit procedures.To highlight the importance of maintaining a [7]

healthy degree of professional skepticism during all audit engagements.


KEY FACTSCendant Corporation was created in December 1997 from the all stock merger of CUC •�International, Inc. (CUC) and HFS, Inc. (HFS).CUC was a direct marketing company with shopping, travel, automobile, and entertainment •�clubs serving over 68 million members worldwide.HFS was a franchisor of hotel, rental car, and real estate franchises such as Ramada, Days Inn, •�Avis, and Century 21.At the time of the merger, Cendant had a market capitalization of approximately $29 billion, •�making it one of the 100 largest U.S. corporations.At the time of the merger, Henry Silverman from HFS assumed the position of chief executive •�officer of Cendant while Walter Forbes from CUC assumed the position of the chairman of the board of Cendant. The executives were scheduled to switch their positions after 1999.CUC was audited by Ernst & Young, LLP, while HFS was audited by Deloitte & Touche, LLP. •�Deloitte & Touche, LLP was selected as the successor auditor for Cendant.Cendant’s 8-K filing with the SEC announcing the selection of Deloitte & Touche, LLP noted •�that there were no material disagreements between the company and Ernst & Young, LLP regarding accounting or auditing matters.The fraud occurred at CUC prior to its merger with HFS.•�The CUC fraud was discovered by HFS personnel early in 1998 when they took over accounting •�responsibilities from CUC personnel.Originally it was announced that as a result of the fraud CUC’s 1997 earnings were overstated by •�$100 to $115 million. Later it was disclosed that the fraud covered the period 1995 to 1997 and that the cumulative overstatement of pretax quarterly earnings was approximately $300 million.

4.3c a s e

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CUC’s earnings were allegedly inflated by recording fictitious revenues and reducing expenses •�to meet Wall Street analysts’ expectations.Meeting analysts’ expectations artificially inflated CUC’s stock prices thereby providing •�opportunities to use CUC stock to merge or acquire other companies.CUC’s pretax earnings for the first three quarters of 1995, 1996, and 1997 were misstated by $31 •�million, $87 million, and $176 million, respectively.To cover-up the inflated quarterly earnings at year-end, CUC management allegedly made •�irregular charges against merger reserves, falsely coded cash receipts from membership programs, and delayed recognition of membership cancellations and credit card rejections.After the investigation was completed CUC’s year-end 1995, 1996, and 1997 pretax earnings •�were reduced by $96 million, $159 million, and $245 million, respectively. This amounted to more than one-third of CUC’s reported pretax earnings during the fraud period.Cendant’s total market value declined by more than $20 billion as a result of the announced •�fraud.In 1999 Cendant settled two lawsuits initiated because of the fraud that resulted in a $351 million •�and a 2.83 billion pretax charges to the 1999 financial statements.Over twenty CUC employees were identified as participating in the fraud including Cosmo •�Corigliano, chief financial officer and Anne Pember, controller.Four of CUC’s directors were identified as having personal ties with Walter Forbes, chairman •�and chief executive officer.Four of CUC’s financial managers were previously employed by Ernst & Young, LLP including •�Cosmo Corigliano, chief financial officer and Anne Pember, controller.The audit committee report on the fraud investigation notes that senior management of CUC •�encouraged employees to conceal certain information from the auditors.Prior to the fraud, CUC was required to amend financial statements it filed with the Securities •�and Exchange Commission because of aggressive accounting practices.Walter Forbes, chairman, and ten other members of the Cendant board of directors tendered •�their resignations as a result of the alleged fraud. Forbes was allowed to receive a severance package of $47.5 million.Cosmo Corigliano, chief financial officer and Anne Pember, controller, and Casper Sabatino, •�CUC accountant, pleaded guilty to federal conspiracy and fraud charges.Kirk Sheldon, chief operating officer of CUC was fired for cause eliminating Cendant’s obligation •�to fulfill his previously negotiated severance package.In January 2005, a federal jury convicted Kirk Shelton on federal conspiracy and fraud charges. •�Shelton was sentenced to 10 years in prison and ordered to pay $3.275 billion in restitution to Cendant.After two mistrials in October 2006, a federal jury convicted Walter A. Forbes on federal •�conspiracy and false statement charges. Forbes was sentenced to 12 years, seven months in prison and also ordered to pay $3.275 billion in restitution to Cendant.Cosmo Corigliano, Anne Pember, and Casper Sabatino pleaded guilty to federal conspiracy and •�fraud charges. Cosmo Corigliano was sentenced to 6 months house arrest and 3 years probation while Anne Pember and Casper Sabatino were sentenced to two years probation. These three individuals were given reduced sentences as a result of cooperating with authorities related to the fraud investigation. Cosmo Corigliano agreed to pay civil penalties in excess of $14 million and Anne Pember agreed to pay civil penalties of $100,000.

USE OF CASEThis case involves the hindsight evaluation of management fraud and the control environment at CUC. Lack of attention to the evaluation of factors related to management fraud and factors related to the control environment has contributed to several alleged audit failures. Hindsight evaluations of fraud cases should improve students’ ability to recognize conditions that suggest a higher likelihood

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case 4.3: cendant corporation


of management fraud. The Cendant case provides students with the opportunity to critically evaluate issues surrounding the auditor’s professional judgement.

This assignment works well in an undergraduate or graduate course after discussing the auditor’s responsibility to understand internal controls and to detect material fraud. It provides students the opportunity to apply concepts covered in professional standards and textbooks to a real company that allegedly perpetuated a financial statement fraud. We have found that the use of real companies that have allegedly been involved in fraud generates high levels of student interest and enthusiasm.

The case can be completed by students individually or in groups as an in-class or out-of-class assignment. If the case is going to be used for an in-class discussion, we recommend having students read the case as an out-of-class reading assignment prior to the in-class discussion. A useful cooperative learning technique to use for the in-class discussion is “Roundtable.” The basic process for the Roundtable activity is to have students meet in small groups to state aloud and write down on a single sheet of paper their ideas regarding a case question. Once all students have had an opportunity to state their ideas and arrive at a group consensus, the instructor can randomly call on individual students to share their group’s answers with the class. The class time allocated to the group discussion can be shortened by assigning groups responsibility for different case questions. It is important for the instructor to randomly call on individual students to share their group’s answers to ensure that all students take responsibility for learning the material.

If the case is going to be used as an out-of-class writing assignment, we recommend discussing the case requirements with the students prior to having them complete the assignment. We like to remind students that they have more information than the auditors did at the time of the fraud and that they should focus on the information that was or should have been available before the fraud was discovered. A useful cooperative learning technique to use for the out-of-class writing assignment is “peer editing.” With this approach students first meet in pairs to develop an outline for their written solutions. Once an outline is developed, students individually draft a written response based on the outline. When the drafts are completed, students exchange draft responses and prepare written suggestions on the grammar, organization, and accuracy of the composition. Students then meet to discuss revisions for each draft. Finally, students revise their responses based on the suggestions provided. To ensure the process is followed, students should attach their final draft to the outline and critiqued drafts.

When multiple writing assignments are assigned during the semester, the above approach can be modified to require students to complete a joint response in place of individual responses. The basic difference is that one student is assigned responsibility to compose and re-write the written response while the other student is assigned responsibility to critique the original draft. Students should still meet to create an outline for the written solution. The responsibilities of writer and reviewer should be alternated for each written assignment.

PROFESSIONAL STANDARDSRelevant professional standards for this assignment include AU Section 230, “Due Professional Care in the Performance of Work,” AU Section 314 “Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement,” AU Section 316, “Consideration of Fraud in a Financial Statement Audit,” AU 319, “Consideration of Internal Control in a Financial Statement Audit.”

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QueStionS and SuGGeSted Solution

Professional standards outline the auditor’s consideration of material misstatements due to [1]

errors and fraud. (a) What responsibility does an auditor have to detect material misstatements due to errors and fraud? (b) What two main categories of fraud affect financial reporting? (c) What types of factors should auditors consider when assessing the likelihood of material misstatements due to fraud? (d) Which factors existed during the 1995 through 1997 audits of CUC that created an environment conducive for fraud?

Auditors are required to plan and perform audit engagements to provide reasonable [a]

assurance that the financial statements are free of material misstatement, whether the result of error or fraud. The distinguishing feature between errors and fraud is whether the misstatement was unintentional or intentional. Errors are unintentional misstatements while frauds are intentional misstatements. The auditor provides reasonable assurance of detecting frauds leading to material misstatements by evaluating the likelihood of fraud and expanding audit tests when there is a higher likelihood of fraud.

Fraud misstatements can occur from fraudulent financial reporting or misappropriation [b]

of assets. Financial statement misstatements or omissions intended to deceive users are referred to as fraudulent financial reporting. Thefts of entity assets reported in the financial statements are referred to as misappropriation of assets.

Three broad conditions generally are present when fraud occurs. These broad conditions [c]

are:

Management’s or employees’ “incentive or pressure” to commit fraud��Circumstances exist to provide management or employees the “opportunity” to commit ��fraud (for example, absence of controls, ineffective controls or ability to override controls)Management or employees posses an “attitude” that allows them to commit fraud��

AU Section 316 provides extensive detail about potential indicators for each of these conditions. For example, an “incentive” that would suggest a higher likelihood of fraud would be excessive pressure on management or operating personnel to meet financial targets set up by those charged with governance.

Factors that existed during the 1995 through 1997 audits of CUC that created an [d]

environment conducive to fraud include:

The excessive emphasis of CUC management on meeting analyst expectations��The focus of CUC management on maintaining a strong stock price to provide ��opportunities to use CUC stock to acquire and merge with other companies The use of overly aggressive accounting practices as suggested by the Securities and ��Exchange Commission’s previous requirement that CUC’s financial statements be restated because of aggressive accounting practicesCUC’s rapid growth��Lack of board oversight because of the close financial ties of four of the directors with ��Walter Forbes, chairman and chief executive officer for CUC

Many students will indicate that management did not properly communicate and display an appropriate attitude regarding internal control and the financial reporting process. When this factor is raised, students can be asked to indicate the information that was present at that time that would have suggested this factor. Students normally note the audit committee report as the information source. Students can then be told that in hindsight it appears that management did not communicate and display an appropriate attitude related to controls

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and financial reporting. However, it is helpful to point out that they have the benefit of hindsight that the auditors did not have at the time. Students can then be asked to identify factors that suggested management’s lack of an appropriate attitude about internal control before the fraud was discovered. This last question normally draws the students to the factors listed above.

Professional standards indicate that an entity’s internal controls consist of five interrelated [2]

components. (a) What responsibility does an auditor have related to each of these five components? (b) One component of internal control is the entity’s control environment. What factors should an auditor consider when evaluating the control environment? (c) What red flags were present during the 1995 through 1997 audits of CUC that may have suggested weaknesses in CUC’s control environment?

Internal controls consist of five interrelated components including the control environment, [a]

risk assessment, control activities, information and communication, and monitoring. In all audits, the auditor must obtain a sufficient understanding of internal controls to identify the types of misstatements that can occur, determine the risk of misstatement, and determine the design of substantive tests.

The control environment sets the tone of the organization towards controls. It is the foundation for all other components of internal control. This component has a pervasive effect on internal control. Therefore, auditors should obtain an understanding of this component on all audits to determine the risk of misstatement and the design of substantive tests.

Risk assessment is concerned with the process used by management to identify, analyze, and manage risks relevant to the preparation of the financial statements. Auditors must obtain an understanding of this component on all audits to determine the risk of misstatement and the design of substantive tests.

Control activities are the specific policies and procedures established by management to ensure that management directives are carried out. Auditors need to obtain an understanding of control activities as they relate to identifying the type of misstatements that can occur, determining the risk of misstatement, and determining the design of substantive tests.

The information and communication system consists of the methods and records established to record, process, summarize, and report transactions and events and maintain accountability for assets, liabilities, and equity. Auditors must obtain knowledge of the information system to understand the major classes of transactions, how transactions are initiated, the types of accounting records and documents used, processes from initiation to inclusion in financial statements, and processes used to determine significant account estimates and disclosures. This information is needed to determine the type of misstatements that can occur, risk of misstatement, and design of substantive tests.

Monitoring is concerned with the process used by management to assess the quality of internal controls over time. Auditors must obtain an understanding of the monitoring system on all audits to determine the risk of misstatement and design of substantive tests.

As noted in the professional standards, factors to consider when evaluating the control [b]

environment include:

Integrity and ethical values•Commitment to competence•Board of directors and audit committee participation•Management’s philosophy and operating style•Organizational structure•Assignment of authority and responsibility•Human resource policies and practices•

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Factors present during the CUC audits suggesting a weaker control environment include:[c]

Lack of appropriate board oversight because of the close financial ties of four of CUC’s ��board of directors with Walter Forbes, chairman and chief executive officerThe aggressive management philosophy and operating style of CUC management as ��suggested by the Securities and Exchange Commission’s previous requirement that CUC’s financial statements be restated because of aggressive accounting practicesThe aggressive management philosophy and operating style of CUC management as ��suggested by its emphasis on meeting analyst expectations

Many students will indicate that management lacked integrity and ethical values. When this factor is raised, students can be asked to indicate the information that was present at the time the fraud occurred that would have suggested management lacked integrity and ethical values. Students normally note the fraud as evidence. At this point, students can be told in hindsight it appears that management lacked integrity and ethical values. Again, it is useful to ask students how would the auditor know this before discovery of the fraud?

Professional standards recognize there is a possibility that management may override internal [3]

controls. (a) Provide an example where management override occurred in the Cendant fraud. (b) What are the required auditor responses to further address the risk of management override of internal controls?

The Cendant case includes several examples of management override of internal control. [a]

Some of these examples are:

Recording irregular charges against merger reserves.��Recording cash received from customers for deferred revenue recognition programs as ��cash received from customers for immediate revenue recognition programs.Delaying the recording of membership cancellations and bank rejection of charges made ��to customers’ credit cards.

Auditing Standards (AU) Section 316 requires auditors to perform three mandated [b]

procedures in every audit to address the risk of management override. These three procedures are:

Examine journal entries and other adjustments for evidence of possible material •misstatement due to fraud.Review accounting estimates for biases that could result in material misstatement due •to fraud.Evaluate the business rationale for significant unusual transactions to determine whether •the transactions may have been entered into to engage in fraudulent financial reporting.

Several misstatements were identified as a result of the fraud perpetrated by CUC management. [4]

(a) For each misstatement identified, indicate one management assertion that was violated. (b) For each misstatement identified, indicate one audit procedure the auditor could have used to detect the misstatement.

Irregular charges against merger reserves[a] – occurrence or accuracy of revenues, completeness or accuracy of expenses, and valuation or existence of merger reserves.

False coding of services sold to customers – classification of revenues and valuation of deferred revenues.

Delayed recognition of membership cancellations and bank rejection of charges made to members’ credit card accounts – occurrence of revenues and existence or valuation of cash.

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Irregular charges against merger reserves[b] – scan the journals looking for unusual journal entries or examine the journal entries for the adjustments to the merger reserve account and examine related support for those entries/adjustments.

False coding of services sold to customers – examine documents supporting cash receipts to ascertain proper classification of revenue from various programs.

Delayed recognition of membership cancellations and bank rejection of charges made to members’ credit card accounts – test year-end bank reconciliations.

Some of the members of CUC’s financial management team were former auditors for Ernst & [5]

Young, LLP. (a) Why would a company want to hire a member of its external audit team? (b) If the client has hired former auditors, how might this affect the independence of the existing external auditors?

A company may desire to hire one of its external auditors for a number of reasons: (i) the [a]

auditor is familiar with the company, (ii) the auditor is perceived as being highly motivated and competent with relevant accounting experience, and (iii) management has developed a strong working relationship with the auditor as a result of the audit.

When former auditors go to work for clients, there is the possibility that independence can [b]

be threatened in both fact and in appearance. Current auditors may have a close personal friend working for the client who formerly worked for the audit firm as a result of working for the audit firm for many years. Further, current auditors may consider the former auditor to be a person of competence and high integrity. As a result, current auditors may rely too much on the representations made by their former colleague. Finally, because the former auditor will be intimately familiar with audit procedures and approaches, the potential for successfully hiding an accounting fraud or mismanagement of funds may increase.




waste Management, inc.Manipulating accounting estimatesMark S. Beasley · Frank A. Buckless · Steven M. Glover · Douglas F. Prawitt

To illustrate a real-world example of fraudulent [1]

financial reporting.To illustrate examples of incentives/pressures, [2]

opportunities, and attitudes present in cases involving fraudulent financial reporting.

To highlight inherent risks associated with [3]

accounting estimates.To sensitize students to auditor responsibilities [4]

for assessing the reasonableness of accounting estimates.


KEY FACTSWaste Management, Inc.’s primary core business involved providing solid waste management •services consisting of collection, transfer, resource recovery, and disposal services for commercial, industrial, municipal, and residential customers.The company was formed in the late 1960s and had grown to be a leader in waste management •services.For the year ended December 31, 1996, the company reported consolidated revenues of $9.19 •billion, net income of $192 million, and total assets of $18.4 billion.Despite the success, by 1996 the company was feeling pressures from the effects of changes •occurring in its markets and the environmental industry. Although consolidated revenues were increasing during the three year period ending •December 31, 1996, consolidated net income was decreasing in both dollar and percentage terms.Company disclosures indicated that Waste Management was encountering intense •competition, primarily in the pricing and rendering of services from various sources in all phases of its waste management and related operations. Over half of the company’s assets as of December 31, 1996 involved property and equipment, •consisting of land (primarily disposal sites), buildings, vehicles and equipment, and leasehold improvements. Land and vehicles and equipment represented 20% and 27%, respectively, of the company’s total consolidated assets.Disposal sites included approximately 66,400 total acres, with estimated remaining lives •ranging from one to over 100 years based upon management’s site plans and estimated annual volumes of waste.The vehicles and equipment included approximately 21,400 collection and transfer vehicles, •1.6 million containers, and 25,100 stationary compactors.In January 1998, the company announced that it would file amended reports on Forms 10-K •and 10-Q for the year ended December 31, 1996. By the time the restated financial statements were filed in February 1998, the company had restated earnings for 1992 through 1996.The 1996 restatements alone took the company from a previously reported net income of $192 •million to a restated 1996 net loss of $39 million.

4.4c a s e

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According to management’s press releases, the restatements principally related to the •calculation of vehicle, equipment, and container depreciation expense and capitalized interest costs related to landfills. The company admitted to the use of incorrect vehicle and container salvage values and useful lives assumptions.In the restatements, the company announced that it was adopting new policies that included •shortening the depreciable lives for certain categories of assets to reflect their current anticipated useful lives and had eliminated salvage value for trucks and waste containers.News of the company’s restatements caused the stock price to plummet by more than 33%, •causing a more than $6 billion decline in market value.The SEC alleged that the improper accounting practices were centralized at the corporate •headquarters, involving the chairman and CEO, the president and chief operating officer, and the chief financial officer.The company’s financial statements were audited by Arthur Andersen, LLP. The SEC’s •complaint alleges that the fraud was aided by the auditors who secretly signed an agreement with company management to cover the fraudulent actions over time.Waste Management, Inc. evidentially settled a class action suit for $457 million.•Andersen agreed to pay a penalty of $7 million, which at that time was the largest fine ever •assessed against an accounting firm.

USE OF CASEThis particular case is appropriate for undergraduate or graduate auditing courses. It can easily be used at several points during the coverage of key audit topics. For example, it would complement class discussion about the audit risk model, professional ethics and independence, the auditor’s responsibility to detect material misstatements due to fraud, and accounting estimates. The first question helps students focus on the three conditions present when fraud occurs: incentives/pressures, opportunities, and attitudes. Questions two through five focus on inherent risks associated with accounting estimates and auditor responsibilities for evaluating estimates. The last two questions focus on auditor independence and professional ethics.

We find that students particularly enjoy reading about actual fraud cases involving real-world companies. This case is about an actual company, Waste Management, Inc., located in Oak Brook, Illinois. We particularly like this case because it highlights the significance of accounting estimates in the development of financial statements and the related judgments required in their development. So, often students view accounting for business transactions as “black and white.” This case points out the reality that many financial statement account valuations are dependent on significant management assumptions. In addition, this case highlights a fraud whereby the auditor acquiesced to management pressures to conceal the fraud. Frequently, perpetrators of fraud rationalize their unethical behavior by convincing themselves that they will be able to reverse the fraud effects in the future when actual results improve. This case highlights the snowballing effects of those kinds of rationalizations. It is our hope that exposing students to real cases of fraud will make them more aware of the risks and related red flag indicators of fraud enabling them to avoid involvement in similar activities during their professional accounting careers.

The case can be completed by students individually or in groups as an in-class or out-of-class assignment. If the case is going to be used for an in-class discussion, we recommend having students read the case as an out-of-class reading assignment prior to the in-class discussion. A useful cooperative learning technique to use for the in-class discussion is “Roundtable.” The basic process for the Roundtable activity is to have students meet in small groups to state aloud and write down on a single sheet of paper their ideas regarding a case question. Once all students have had an opportunity to state their ideas and arrive at a group consensus, the instructor can randomly call on individual students to share their group’s answers with the class. The class time allocated to the group discussion can be shortened by assigning groups responsibility for different case questions. It

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case 4.4: waste Management, inc.


is important for the instructor to randomly call on individual students to share their group’s answers to ensure that all students take responsibility for learning the material.

If the case is going to be used as an out-of-class writing assignment, we recommend discussing the case requirements with the students prior to having them complete the assignment. A useful cooperative learning technique to use for the out-of-class writing assignment is “peer editing.” With this approach students first meet in pairs to develop an outline for their written solutions. Once an outline is developed, students individually draft a written response based on the outline. When the drafts are completed, students exchange draft responses and prepare written suggestions on the grammar, organization, and accuracy of the composition. Students then meet to discuss revisions for each draft. Finally, students revise their responses based on the suggestions provided. To ensure the process is followed, students should attach their final draft to the outline and critiqued drafts.


PROFESSIONAL STANDARDSRelevant professional standards for this assignment include AU Section 312 “Audit Risk and Materiality in Conducting an Audit,” AU Section 316 “Consideration of Fraud in a Financial Statement Audit,” AU Section 342 “Auditing Accounting Estimates,” AU Section 380, “The Auditor’s Communication with Those Charged with Governance,” and ET Section 54, “Article III-Integrity,” and ET Section 102, “Integrity and Objectivity.”


Three conditions are often present when fraud exists. First, management or employees have [1]

an incentive or are under pressure, which provides them a reason to commit the fraud act. Second, circumstances exist – for example, absent or ineffective internal controls or the ability for management to override controls – that provide an opportunity for the fraud to be perpetrated. Third, those involved are able to rationalize the fraud as being consistent with their personal code of ethics. Some individuals possess an attitude, character, or set of ethical values that allows them to knowingly commit a fraudulent act. Using 20-20 hindsight, identify factors present at Waste Management that are indicative of each of the three fraud conditions: incentives, opportunities, and attitudes.

Senior management faced several incentives that may have pressured them to engage in issuing fraudulent financial statements. Since commencing operations in 1968, the company had grown to be a leader in the waste management services industry. Recognition as an industry leader and the company’s sheer size, with revenues and assets over $9 billion and $18 billion, respectively, placed tremendous pressure on senior management to maintain the company’s reputation and stature in the industry and business community. With that kind of presence and reputation, management faced even greater pressure as industry competition intensified in the mid-1990s, causing company profits to decline between 1994 and 1996 despite increasing revenues. Internal budgets and earnings targets set by the chairman and CEO, Dean Buntrock, created an internal incentive for other members of the management team to identify ways to satisfy expectations of senior management. As acknowledged in the case, the SEC alleged that the defendants’ fraudulent conduct was also driven by greed and a desire to retain their corporate positions and status in the business and social communities. Buntrock, CEO, posed as a successful entrepreneur and used the inflated

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company stock to make charitable contributions to his alma mater to fund a building in his name. Furthermore, members of the senior management team received bonuses based on company performance targets. These conditions collectively provided numerous incentives that pressured members of senior management to identify creative ways to artificially inflate company performance. Given these incentives, management took advantage of opportunities to engage in fraudulent financial reporting. With a significant portion of the company’s assets tied up in property, plant, and equipment items, management identified an opportunity to inflate company operations by taking advantage of the inherent subjectivity involved in developing key assumptions used to calculate depreciation charges associated with those assets. With the ability to manipulate key assumptions related to asset useful lives and residual values, management was able to modify depreciation expenses so that earnings targets could be met. In addition, they took advantage of other judgment-based estimates by failing to reflect known decreases in the value of landfills as those disposals neared capacity and they failed to write-off costs of unsuccessful and abandoned landfill development projects. Finally, they took advantage of the subjectivity associated with establishing various environmental and other reserve accounts. Many of these fraudulent judgments affected accounting entries that management made outside the traditional accounting system, through the use of last minute, end of period “top-level adjustments” to actual results. To conceal the fraudulent intent of many of these “adjustments,” management often spread the effects of unusual entries across various lines in the financial statements. In some cases, management took advantage of its senior position to override accounting decisions made by others within the company, in order to meet targeted earnings expectations. Management’s attitude towards financial reporting was revealed once the auditors from Andersen presented management the Proposed Adjusting Journal Entries to correct the errors in the financial statements. At that point, management revealed its lack of regard towards quality financial reporting by consistently refusing to make the adjustments. The lack of an ethical attitude became more evident when management approached Andersen with a secret agreement to write off the accumulated errors in future periods. Clearly, management had rationalized their actions and wanted others to accept their scheme. In this case, all the ingredients of fraud were present. Management had tremendous incentives to engage in fraud, and they took advantage of opportunities present to manipulate significant estimates in the financial statements. Finally, their refusal to correct identified errors and their scheme to cover-up the inappropriate accounting reflected their attitude towards the financial reporting process.

Review Waste Management’s Consolidated Balance Sheet as of December 31, 1996. Identify [2]

accounts whose balances were likely based on significant management estimation techniques. Describe the reasons why estimates were required for each of the accounts identified.

Many of the accounts included in Waste Management Inc.’s December 31, 1996 Balance Sheet were likely based on significant management estimation techniques. Here are some of the accounts most likely affected:

Short-term Investments.� The use of management estimation techniques may have impacted the valuation of several of the short-term investment accounts. First, the underlying accounting treatment for the investment as either a trading security or a security available-for-sale would be contingent on management’s assumptions about their intentions related to the holding period for the investment. Second, some of the market valuations needed to value the accounts (e.g., marked to market) may have been dependent on management’s estimation of market values.Accounts Receivable, Net.� The net Accounts Receivable balance would be affected by management’s estimation of the allowance for doubtful accounts.

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Employee Receivables. � The net Employee Receivables would be affected by management’s estimation of the allowance for uncollectible employee receivables. Costs + Estimated Earnings in Excess of Billings. � This account represents the amounts due from waste management services long-term contracts. Management estimation techniques were required to estimate the anticipated earnings on uncompleted contracts netted against billings on uncompleted contracts.Property & Equipment. � To calculate depreciation on depreciable property, plant, and equipment assets, management estimation of the assets’ useful lives and salvage values directly impacted the calculation of annual depreciation expense and the accumulated depreciation end of year balance.Intangible Assets – Goodwill, Net.� Goodwill constitutes the difference between the cost of the acquired assets and their related market values. Thus, the original valuation of the goodwill account was directly impacted by estimates of the underlying market values of the assets acquired. Additionally, the annual amortization expense was dependent on management’s determination of the appropriate amortization period. Finally, management periodically had to evaluate whether goodwill was impaired.Accrued Expenses. � Many of the accounts included in the Accrued Expense financial statement line would have been based on management’s estimation of expenses incurred, but not yet paid. Many of these accruals related to estimated reserves for environmental clean-up costs.Unearned Revenues.� Estimation may have been necessary to determine the value of services that had not yet been performed by the company even though proceeds had already been collected from subscribers.Deferrals. � Most likely, management assumptions and estimations were necessary to establish end-of-period balances for the Deferrals financial statement line item.

Describe why accounts involving significant management estimation are generally viewed as [3]

inherently risky.

Auditing Standards (AU) Section 342, Auditing Accounting Estimates, notes that accounting estimates are often included in financial statements because (1) the measurement of some amounts or the valuation of some accounts is uncertain, pending the outcome of future events, and (2) relevant data concerning events that have already occurred cannot be accumulated on a timely, cost-effective basis. Thus, accounting estimates are associated with uncertainty, future events, and the lack of relevant data, which in turn increases risks. Estimates are based on subjective as well as objective factors, and, as a result, judgment is required to estimate an amount at the date of the financial statements. Management’s judgment is normally based on its knowledge and experience about past and current events and its assumptions about conditions it expects to exist and courses of action it expects to take. Even when management’s estimation process involves competent personnel using relevant and reliable data, there is potential for bias in the subjective factors. The risk of material misstatement of accounting estimates normally varies with the complexity and subjectivity associated with the process, the availability and reliability of relevant data, the number and significance of assumptions that are made, and the degree of uncertainty associated with the assumptions. All these characteristics inherently associated with accounting estimates increase the risks of material misstatements.

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Review Auditing Standards (AU) Section 342, Auditing Accounting Estimates, and describe [4]

the auditor’s responsibilities for examining management-generated estimates. Also, AU 342 provides guidance to assist auditors in examining estimates. Describe the techniques commonly used by auditors to evaluate the reasonableness of management’s estimates.

Auditing Standards (AU) Section 342 notes that the auditor is responsible for evaluating the reasonableness of accounting estimates made by management in the context of the financial statements taken as a whole. The auditor’s objective when evaluating accounting estimates is to obtain sufficient appropriate evidential matter to provide reasonable assurance that:

All accounting estimates that could be material to the financial statements have been a. developed.Those accounting estimates are reasonable in the circumstances.b. The accounting estimates are presented in conformity with applicable accounting c. principles and are properly disclosed.

AU Section 342 notes that in evaluating the reasonableness of management’s estimates, the auditor should use one or a combination of the following approaches:

Review and test the process used by management to develop the estimate.a. Develop an independent expectation of the estimate to corroborate the reasonableness b. of management’s estimate.Review subsequent events or transactions occurring up through the audit report date.c.

The Waste Management fraud primarily centered around inappropriate estimates of salvage [5]

values and useful lives for property and equipment. Describe techniques Andersen auditors could have used to assess the reasonableness of those estimates used to create Waste Management’s financial statements.

First, the auditors could have requested information about the sources of data and factors that management used to form the assumptions about salvage values and useful lives to evaluate the reasonableness of those assumptions. Second, the auditors could have compared information about the useful lives for depreciating classes of assets to similar estimates of useful lives used by competitors in the waste management industry. Third, the auditors could have performed an analysis of recent property and equipment disposals to determine whether asset disposals were consistently occurring within time periods shorter than the estimated useful lives and at disposal amounts less than salvage value assumptions. Such a retrospective analysis of management’s estimates of salvage values and useful lives may have identified a consistent bias in management’s assumptions of those items. Fourth, given the specialized nature of many of the property and equipment items used in the waste management industry, the auditors may have benefited from the judgments of independent specialists knowledgeable of those kinds of assets.

Several of the Waste Management accounting personnel were formerly employed by the company’s [6]

auditor, Arthur Andersen. What are the risks associated with allowing former auditors to work for a client in key accounting positions? Research Section 206 of the Sarbanes−Oxley Act of 2002 and provide a brief summary of the restrictions related to the ability of a public company to hire accounting personnel who were formerly employed by the company’s audit firm.

An audit firm’s independence can become impaired with respect to an audit client that employs a former audit firm professional generally in one of three ways. First, an audit firm professional who resigns to accept a position with the audit client may not have exercised an appropriate level of skepticism during the audit process prior to their departure. Second, the departing audit firm professional may be familiar with the audit firm’s approach and testing strategy, which may enable them to circumvent the auditor’s processes once he or she

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is employed by the audit client. Third, the remaining members of the audit team, who may have been friendly with or respectful of the former audit firm professional, may be reluctant to challenge the decisions of the former audit firm professional and may accept the client’s proposed accounting without exercising appropriate professional skepticism. In response to these concerns, the Sarbanes-Oxley Act of 2002, which was signed into law by President Bush in July 2002, now prohibits an audit firm of a public company from performing audit services if certain key client positions are staffed by individuals formerly employed by the audit firm. Section 206 of the Act prohibits a person who was employed by the audit firm and who participated in any capacity in the audit of that public company during the prior one-year period from serving in the client positions of chief executive officer, controller, chief financial officer, chief accounting officer, or any person serving in an equivalent position for the issuer. Useful guidance of what audit firms can do to address risks associated with the movement of firm personnel to clients was issued in July 2000 by the former Independence Standards Board as Independence Standard No. 3 titled, Employment With Audit Clients. That standard requires firms auditing public company financial statements to establish a program of safeguards to eliminate the risk of independence impairment. The guidance in ISA #3, which is still useful for auditors of both public and private entities, establishes these safeguards:

Pre-Change in Employment Safeguards:Firm professionals are required to promptly report to the firm conversations between �themselves and an audit client about possible employment.Firm professionals engaged in negotiations about possible employment with an audit �client are immediately removed from the audit engagement.Under removal of a professional from the audit engagement as provided above, the �firm reviews the professional’s work to assess whether he or she exercised appropriate skepticism while working on the audit engagement.

Post-Change in Employment Safeguards:If a professional accepts employment with the audit client, the on-going engagement �team gives active consideration to the appropriateness or necessity of modifying the audit plan to adjust for risk of circumvention.When a former firm professional joins an audit client and will have significant interaction �with the audit team, the firm takes appropriate steps to provide that the existing audit team members have the stature and objectivity to effectively deal with the former firm professional and his or her work.When a former firm professional joins an audit client within one year of disassociating �from the firm and the professional has significant interactions with the audit team, the next following annual audit is to be separately reviewed by a firm professional uninvolved in the audit to determine whether the remaining engagement team maintained an appropriate level of professional skepticism when evaluating the representations and work of a former firm professional.The firm requires prompt liquidation of all capital accounts of former partners and �settlement of related retirement balances.

Discuss possible reasons why the Andersen partners allegedly allowed Waste Management [7]

executives to avoid recording the identified accounting errors. How could accounting firms ensure that auditors do not succumb to similar pressures on other audit engagements?

Students’ responses will reflect a wide variety of ideas, which should allow for a creative and stimulating in-class discussion. However, some of the key points that should be raised include the following.

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Public accounting is a highly competitive service-oriented business. As is the case with most other service-offering enterprises, public accounting firms have a vital interest in pleasing their clients by providing value and excellent customer service. In order to provide excellent customer service and please the client, partners may sometimes feel pressure to avoid taking tough stands on a client’s accounting choices. Otherwise, partners may run the risk of losing clients to other accounting firms. That kind of pressure likely led to the auditor’s decision to accept the “Summary of Action Steps,” given management’s pressure for them to do so.

To justify their acceptance of the 32 “must do” steps, the auditors likely convinced themselves that the underlying effects of the misstatements would not be deemed as significantly material to affect decisions of the users of the financial statements. Perhaps, the auditors focused primarily on quantitative assessments of materiality thresholds and ignored the qualitative implications associated with management’s unwillingness to correct known accounting misstatements.

In order to eliminate these obstacles, auditors need to be reminded of the importance of exercising professional skepticism to ensure that they question on an ongoing basis whether the information and evidence obtained suggests that a material misstatement has occurred and that they do not become satisfied with less than persuasive evidence. Additionally, public accounting firms need to emphasize to their personnel the need to be committed to putting the public’s interest first. Auditors need to be up-front with each client by affirming that even though the accounting firm desires to add value to the client’s business, difficult decisions that are contrary to management’s position on certain issues may have to be made to protect the interests of the investing public. By laying this foundation, difficult decisions will be easier to make when such circumstances arise. Firms may need to reformulate their performance evaluation and compensation practices to determine whether they provide incentives for local partners to take aggressive stances that may not be in the best interests of the firm as a whole. In addition, most large accounting firms require national approval for local office partners to sign off on certain complex or aggressive accounting positions, mitigating the sometimes-strong individual pressures on local partners to please the client.

Finally, changes resulting from the issuance of the Sarbanes-Oxley Act and related corporate governance requirements have re-defined the auditor’s view of who represents “the client.” Stricter requirements and higher expectations for audit committee oversight of the hiring and firing of the external auditor reinforce the view that the audit committee, not management, represents the client. The shift from viewing management as the client to viewing the audit committee as the client has helped reduce some of the incentives auditors might face to please management as “the client.” Additionally, AU Section 380, “The Auditor’s Communication with Those Charged with Governance,” requires auditors to communicate to those charged with governance (for example, the audit committee) the auditor’s view about qualitative aspects of the entity’s significant accounting estimates, significant difficulties encountered during the audit, disagreements with management, corrected misstatements that were brought to the attention of management as the result of audit procedures, and uncorrected misstatements, if any. These required communications are designed to ensure that audit committees (or others charged with governance) are informed of matters similar to those highlighted in the Waste Management case.



1 The background information about this case was primarily obtained from 8-K’s and 10-K’s filed by Xerox with the Securities and Exchange Commission and Accounting and Auditing Enforcement Release Nos. 1542, 1796, 2235, 2333, 2379 issued by the Securities and Exchange Commission.


xerox corporationevaluating risk of financial statement fraudMark S. Beasley · Frank A. Buckless · Steven M. Glover · Douglas F. Prawitt

To highlight the auditor’s responsibility for con-[1]

sidering a client’s internal controls.To highlight the auditor’s responsibility for [2]

detecting material misstatements due to errors and fraud.To illustrate risk factors associated with manage-[3]

ment fraud.To illustrate risk factors associated with a weak [4]

control environment.To demonstrate the linkage of financial mis-[5]

statements to management assertions and audit procedures.To demonstrate that material fraud typically [6]

involves collusion among a number of individu-als in the management team who often go to extreme lengths to fool the auditors only to later use their independent auditors as scapegoats when material errors or frauds are discovered.To highlight the importance of maintaining a [7]

healthy degree of professional skepticism during all audit engagements.


KEY FACTS1

Xerox purportedly overstated revenues by $3 billion and pre-tax earnings by $1.5 billion over ��the reporting period 1997 through 2000.The purported accounting manipulations also engulfed KPMG, Xerox’s auditor, in this ��scandal. Xerox was experiencing significant technological change in the document industry (including ��changes from black and white to color capable devices, from stand alone to network-connected devices, from light-lens and analog technology to digital technology, and from paper to electronic documents.)Xerox was experiencing increased competition from foreign competitors.��The investment market exuberance of 1990s created high expectations for all companies to ��report revenue and earnings growth.The credit market and Xerox’s compensation system was creating pressure to report revenues ��and earning growth.The accounting manipulations used by Xerox centered primarily around its lease transactions.��Concerns about the accounting manipulations were raised internally by Xerox managers and ��KPMG.Xerox’s stock dropped from over $60 per share to less than $5 per share after accounting problems ��were announced.Following an SEC investigation, Xerox agreed to pay a $10 million fine and create a committee ��of outside directors to review the company’s material accounting controls and policies.

4.5c a s e

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Following an SEC investigation, KPMG agreed to pay a $22 million fine and institute changes to ��its audit practice. Additionally, four former KPMG partners involved with the Xerox engagement agreed to pay civil penalties from $100,000 to $150,000 and agreed to suspensions from practice before the SEC with rights to reapply from within one to three years. A fifth KPMG partner agreed to be censured by the SEC.Xerox agreed to pay $670 million and KPMG agreed to pay $80 million to settle a shareholder ��lawsuit related to the alleged fraud.

USE OF CASEThis case involves the hindsight evaluation of alleged management fraud at Xerox. Lack of attention to the evaluation of risk factors related to management fraud has contributed to several alleged audit failures. Hindsight evaluations of fraud cases should improve the students’ ability to recognize conditions that suggest a higher likelihood of management fraud. The Xerox case provides students with the opportunity to critically evaluate issues surrounding the auditor’s professional judgement.

This assignment works well in an undergraduate or graduate course after discussing the auditor’s responsibility to detect material misstatement due to fraud. It provides students the opportunity to apply concepts covered in professional standards and textbooks to a real company that allegedly perpetuated a financial statement fraud. We have found that the use of real companies allegedly involved in fraud generates a high level of student interest and enthusiasm.

The case can be completed by students individually or in groups as an “in-class” or “out-of-class” assignment. If the case is going to be used for an “in-class” discussion, we recommend having students read the case as an “out-of-class” reading assignment prior to the “in-class” discussion. A useful active learning technique to use for the “in-class” discussion is “Roundtable.” The basic process for the Roundtable activity is to have students meet in small groups to state aloud and write down on a single sheet of paper their ideas regarding a case question. Once all students have had an opportunity to state their ideas and arrive at a group consensus, the instructor can randomly call on individual students to share their group’s answers with the class. The class time allocated to the group discussion can be shortened by assigning groups responsibility for different case questions. It is important for the instructor to randomly call on individual students to share their group’s answers to ensure that all students take responsibility for learning the material.

If the case is going to be used as an “out-of-class” writing assignment, we recommend discussing the case requirements with the students prior to having them complete the assignment. We like to remind students that they have more information than the auditors did at the time of the fraud and that they should focus on the information that was or should have been available before the fraud was discovered. A useful learning technique to use for the “out-of-class” writing assignment is “peer editing.” With this approach students first meet in pairs to develop an outline for their written solutions. Once an outline is developed, students individually draft a written response based on the outline. When the drafts are completed, students exchange draft responses and prepare written suggestions on the grammar, organization, and accuracy of the composition. Students then meet to discuss revisions for each draft. Finally, students revise their responses based on the suggestions provided. To ensure the process is followed, students should attach their final draft to the outline and critiqued drafts.


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case 4.5: xerox corporation


PROFESSIONAL STANDARDSRelevant professional standards for this assignment include AU Section 230, “Due Professional Care in the Performance of Work,” AU Section 312 “Audit Risk and Materiality in Conducting an Audit,” AU Section 314 “Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement,” AU Section 316 “Consideration of Fraud in a Financial Statement Audit,” and AU Section 342 “Auditing Accounting Estimates.”

QueStionS and SuGGeSted Solution

Financial information was provided for Xerox for the period 1997 through 2000. Go to the [1]

SEC web site (www.sec.gov) and obtain financial information for Hewlett Packard Company for the same reporting periods. How are Xerox’s and Hewlett Packard’s businesses similar and dissimilar? Using the financial information, perform some basic ratio analyses for the two companies. How do the two companies financial performance compare? Explain your answers.

Hewlett Packard Company’s (HP) products include office printers, copiers, fax machines, scanners, multifunction machines, servers, workstations, handhelds, and storage devices. Xerox Company’s products include office printers, production printers, print controllers and servers, office copiers, fax machines, scanners, and multifunction machines. HP offers a wider range of products while Xerox offers more depth of products in the copier and print production area.

Selected HP financial information (similar to the Xerox financial information presented in the case materials) for the period 1997 to 2000 is:

Hewlett Packard CompanySelected Financial Information

For the Year Ended October 312000 1999 1998 1997

(in millions)Revenues $ 48,870 $ 42,371 $ 39,419 $ 35,465 Cost and expenses (excluding income taxes) 44,845 38,553 36,020 32,060 Income/(loss) from continuing operations 3,561 3,104 2,678 2,515 Net income/(loss) 3,697 3,491 2,945 3,119

Cash flows from operating activities 3,705 3,096 4,760 3,386

As of October 312000 1999 1998 1997

Assets (in millions)Cash and cash equivalents $ 3,415 $ 5,411 $ 4,046 $ 3,072 Short-term investments 592 179 21 1,497 Accounts receivable, net 6,394 5,958 5,104 6,142 Finance receivables, net 2,174 1,889 1,494 1,123 Inventory 5,699 4,863 4,699 6,763 Other current assets 4,970 3,342 3,143 2,350

Total current assets 23,244 21,642 18,507 20,947 Land, building, and equipment, net 4,500 4,333 4,877 6,312 Long-term investments and other 6,265 5,789 5,240 4,490 Investment in discontinued operations -- 3,533 3,084 --

Total assets $ 34,009 $ 35,297 $ 31,708 $ 31,749

Liabilities and EquityNotes payable and short-term borrowings $ 1,555 $ 3,105 $ 1,245 $ 1,226 Accounts payable 5,049 3,517 2,768 3,185 Employee compensation and benefits 1,584 1,287 1,195 1,723 Taxes on earnings 2,046 2,152 2,796 1,515 Deferred revenue 1,759 1,437 1,248 1,152 Other accrued liabilities 3,204 2,823 2,622 2,418 Total current liabilities 15,197 14,321 11,874 11,219 Long-term debt 3,402 1,764 2,063 3,158 Other liabilities 1,201 917 852 1,217 Common shareholders’ equity 14,209 18,295 16,919 16,155

Total liabilities and shareholders’ equity $ 34,009 $ 35,297 $ 31,708 $ 31,749

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Selected financial ratios for HP and Xerox are:

Hewlett Packard Company’sSelected Financial Ratios

For the Year Ended October 31HP 2000 1999 1998Return on Equity 0.23 0.20 0.18 Asset Turnover 1.41 1.26 1.24 Profit Margin 0.08 0.08 0.07 Financial Leverage 2.13 1.90 1.92 Current Ratio 1.53 1.51 1.56 Receivables Turnover 7.85 7.61 7.01 Inventory Turnover* 5.75 5.32 4.24 Payables Turnover* 8.13 9.46 9.34

*HP’s inventory and payables turnover ratios cannot be calculated from the information presented on the previous page.

Xerox CorporationSelected Financial Ratios (based on un-restated numbers)

For the Year Ended December 312000 1999 1998

Return on Equity (0.09) 0.29 0.08 Asset Turnover 0.64 0.65 0.67 Profit Margin (0.02) 0.07 0.02 Financial Leverage 6.85 6.02 5.87 Current Ratio 2.08 1.51 1.47 Receivables Turnover 7.60 7.27 8.08 Inventory Turnover* 2.94 1.84 1.87 Payables Turnover* 10.75 10.41 11.45 *Xerox’s inventory and payables turnover ratios cannot be calculated from the information presented in the case. Additionally, Xerox’s 2000 inventory and payables turnover ratios were calculated based on Xerox’s restated financial information as this is the only information that is publicly available.

Xerox’s financial performance during the period 1997 to 2000 was not as strong as HP’s. Xerox was experiencing lower margins and turnovers than HP (based on un-restated numbers). The lower margins and turnovers were putting downward pressure on Xerox’s return on equity. Xerox also was not able to generate a positive cash flow from its operations during the 1997 to 2000 reporting period as compared to the positive cash flow generated by HP. The variation of Xerox’s reported earnings from its operating cash flows should have raised concerns in the investment community about Xerox’s “quality of earnings.” Substantial variation between earnings and operating cash flows is a red flag for earnings manipulation. The above information suggests that Xerox was having a difficult time adjusting its products and product features to the changing business environment in the document industry. The increased overseas competition along with the industry transition to network-connected color capable printing devices, digital technology, and electronic documents was creating significant business challenges for Xerox.

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Professional standards outline the auditor’s consideration of material misstatements due to [2]

errors and fraud. (a) What responsibility does an auditor have to detect material misstatements due to errors and fraud? (b) What two main categories of fraud affect financial reporting? (c) What types of factors should auditors consider when assessing the likelihood of material misstatements due to fraud? (d) Which factors existed during the 1997 through 2000 audits of Xerox that created an environment conducive for fraud?

Auditors are required to plan and perform audit engagements to provide reasonable [a]

assurance that the financial statements are free of material misstatement, whether the result of error or fraud. The distinguishing feature between errors and fraud is whether the misstatement was unintentional or intentional. Errors are unintentional misstatements while frauds are intentional misstatements. The auditor provides reasonable assurance of detecting frauds leading to material misstatements by evaluating the likelihood of fraud and expanding audit tests when there is a higher likelihood of fraud.

Fraud misstatements can occur from fraudulent financial reporting or misappropriation [b]

of assets. Financial statement misstatements or omissions intended to deceive users are referred to as fraudulent financial reporting. Thefts of entity assets reported in the financial statements are referred to as misappropriation of assets.

When assessing the likelihood fraud the auditor should consider:[c]

Management’s incentives (are there industry conditions or operating characteristics ��putting pressure on management to perpetuate a fraud?)Management’s opportunity (are there significant accounts requiring subjective estimates, ��is the control environment weak, are controls inadequate?)Management’s attitude (is or has management exhibited questionable behavior in the past?) ��

Factors that existed during the 1997 through 2000 audits of Xerox that created an [d]

environment conducive to fraud include:

Changing business environment for document processing products (transition to color ��documents, digital technology, network connected devices, and electronic documents),Increasing competition from foreign competitors,��Investment climate of the 1990s for public companies to continuously report revenues ��and earning growth,Need for Xerox to maintain high credit rating to obtain the funds necessary to internally ��finance customer purchases,Linkage of senior management compensation to increasing revenues and earnings,��Negative operating cash flows.��Complexity and subjectivity of accounting related to lease transactions.��Management’s use of aggressive accounting practices to increase revenues and earnings,��Senior management’s view of accounting manipulations as accounting opportunities,��Senior management’s disregard for accounting concerns raised by non-senior managers.��

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Three conditions are often present when fraud exists. First, management or employees have an [3]

incentive or are under pressure, which provides them a reason to commit the fraud act. Second, circumstances exist – for example, absent or ineffective internal controls or the ability for management to override controls – that provide an opportunity for the fraud to be perpetrated. Third, those involved are able to rationalize the fraud as being consistent with their personal code of ethics. Some individuals possess an attitude, character, or set of ethical values that allows them to knowingly commit a fraudulent act. Using hindsight, identify factors present at Xerox that are indicative of each of the three fraud conditions: incentives, opportunities, and attitudes.

Incentive conditions that existed at the time the alleged fraud occurred were:Investment climate of the 1990s for public companies to continuously report revenues and ��earning growth,Need for Xerox to maintain a high credit rating to obtain the capital necessary to internally ��finance customer purchases,Linkage of senior management compensation to increasing revenues and earnings,��Negative operating cash flows.��

An opportunity condition that existed at the time the alleged fraud occurred was:Senior management’s ability to direct and change the accounting methods without audit ��committee or board of director oversight,Complexity and subjectivity of accounting related to lease transactions.��

Attitude conditions that existed at the time the alleged fraud occurred were:Senior management’s view of accounting manipulations as accounting opportunities.��Senior management’s disregard for accounting concerns raised by non-senior managers.��

KPMG has publicly stated that the main accounting issues raised in the Xerox case do not [4]

involve fraud, as suggested by the SEC, rather they involve differences in judgment. (a) Which of the questionable accounting manipulations used by Xerox involved estimates? (b) Based on AU 342, Auditing Accounting Estimates, describe the auditor’s responsibilities for examining management-generated estimates.

Accounting estimates relate to uncertain amounts included in the financial statement because a)

(1) the measurement of some amount or the valuation of some account is contingent on certain future events, and/or (2) relevant data concerning past events cannot be accumulated on a timely and cost-effective basis. Accounting estimates are based on subjective as well as objective factors and thus require judgment to estimate an amount at the date of the financial statements. Management’s estimate judgments are normally based on its knowledge and experience about past and current events and its assumptions about conditions expected to exist and courses of action expected to be taken. The difficulty in generating accounting estimates normally varies with the complexity and subjectivity associated with the process, the availability and reliability of relevant data, the number and significance of assumptions that are made, and the degree of uncertainty associated with the assumptions. Xerox accounting manipulations involving estimation included:

Sales revenue for sales-type leases (bundled leases),��Cost of goods sold for sales-type leases (leased equipment residual values), and��Acquisition reserve.��

AU Section 342 notes that the auditor is responsible for evaluating the reasonableness b)

of accounting estimates made by management in the context of the financial statements taken as a whole. The auditor’s objective when evaluating accounting estimates is to obtain sufficient competent evidential matter to provide reasonable assurance that:

All accounting estimates that could be material to the financial statements have been ��developed,

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Those accounting estimates are reasonable in the circumstances,��The accounting estimates are presented in conformity with applicable accounting ��principles and are properly disclosed.

AU Section 342 further notes that in evaluating the reasonableness of management’s estimates, the auditor should use one or a combination of the following three approaches:

Review and test the process used by management to develop the estimate,��Develop an independent expectation of the estimate to corroborate the reasonableness ��of management’s estimate, and/orReview subsequent events or transactions occurring prior to completion of fieldwork.��

Some will argue that KPMG inappropriately subordinated its judgments to Xerox preferences. [5]

How could accounting firms ensure that auditors do not subordinate their judgments to client preferences on other audit engagements?

Some policies and procedures audit firms could consider instituting to reduce the likelihood of audit firm personnel subordinating their judgments to client preferences include:

Emphasizing to firm personnel on a regular basis the importance of placing the investing ��public first and maintaining a questioning mind and critical evaluation of evidence throughout the audit. Regularly re-affirming with executives, audit committees, and board of directors of audit ��clients the audit firm’s responsibilities to the investing public. Establishing appropriate client/auditor expectations will make it easier for the auditor to make difficult decisions when such circumstances arise. Use a performance evaluation and promotion system that places integrity and competence as ��the most important elements in personnel decisions. Establishing integrity and competence as corner stones of personnel evaluations should help to minimize the incentives for engagement partners to inappropriately accept aggressive client accounting practices.Require non-engagement partner review and approval of complex or aggressive accounting ��positions taken by clients. Non-engagement partner review should mitigate pressures on engagement partners to please the client.

Several questionable accounting manipulations were identified by the SEC. (a) For each [6]

accounting manipulation identified, indicate the financial statement accounts affected. (b) For each accounting manipulation identified, indicate one audit procedure the auditor could have used to assess the appropriateness of the practice.

Acceleration of Lease Revenue Recognition from Bundled Leases��Sales Revenue, Service Revenue, Finance Revenue, and Finance Receivables.a)

The auditor could look at practices followed by Xerox in the past and others in the b)

industry related to bundled lease allocations and compare that to the current practice. Should there be a change in practice, the auditor should evaluate whether the change is a change in principle or estimate and determine what type of disclosure would be necessary to ensure financial statement readers are not mislead. The auditor could also consider looking at recent non-bundled sales of equipment and services to evaluate the reasonableness of the bundled lease allocations.

Acceleration of Lease Revenue from Lease Price Increases and Extensions.��Sales Revenue and Finance Receivables.a)

The auditor could look at practices followed by Xerox in the past related to changes b)

in lease terms and compare that to the current practice. Should there be a change in practice, the auditor should evaluate whether the change is a change in principle or estimate and determine what type of disclosure would be necessary to ensure financial statement readers are not mislead. Another procedure would be to examine on a

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retrospective basis prior year assumptions used to identify any potential management bias in the assumptions. Also the auditor could review the accounting literature to identify acceptable accounting practices.

Increases in the Residual Values of Leased Equipment��Cost of Sales.a)

The auditor could look at practices followed by Xerox in the past related to changes in b)

residual values of leased equipment and compare that to the current practice. Should there be a change in practice, the auditor should evaluate whether the change is a change in principle or estimate and determine what type of disclosure would be necessary to ensure the financial statements are not misleading. Also the auditor could review the accounting literature to identify acceptable accounting practices.

Acceleration of Revenues from Portfolio Asset Strategy Transactions��Sales Revenue, Rental Revenue, Equipment on Operating Leases, and Cost of Sales.a)

The auditor could review the accounting literature to identify acceptable accounting b)

practices for the new business practice. The auditor could also review the management disclosures accompanying the financial statements to ensure the financial statements are not misleading.

Manipulation of Reserves��Selling, General, and Administrative Expenses, Cost of Sales, or Cost of Services and a)

Other Liabilities.The auditor could review journal entries recorded in reserve accounts to evaluate the b)

appropriateness of the adjustment. Also the auditor could perform a retrospective review of actual expenses incurred related to various reserve accounts to evaluate whether management judgments and assumptions were reasonable.

Manipulation of Other Incomes.��Interest (Other) Income and Interest Receivable.a)

The auditor could review the documentation supporting the interest income from tax b)

refunds due Xerox to ascertain the periods covered.

Failure to Disclose Factoring Transactions��Finance Receivables or Accounts Receivable.a)

The auditor could review the cash receipts journal for large unusual transactions, make b)

inquires of management, and review supporting documentation for any transactions noted. The auditor could also send written inquiries regarding the factoring of receivables to financial institutions doing business with Xerox.

In its complaint, the SEC indicated that Xerox inappropriately used accounting reserves to inflate [7]

earnings. … What responsibility do auditors have regarding accounting reserves established by company management? How should auditors test the reasonableness of accounting reserves established by company management?

Accounting reserves are established for expenses expected to be incurred in the future as a result of past business activities. Accounting reserves are an example of an accounting estimate and thus the auditor is responsible for evaluating the reasonableness of accounting estimates made by management in the context of the financial statements taken as a whole (see AU Section 342). The auditor needs to obtain reasonable assurance that the accounting reserve amount is reasonable and that its presentation and disclose is appropriate. The reasonableness of the accounting reserve amount can be evaluated by one or a combination of the following approaches:

Review and test the process used by management to develop the accounting reserve ��amount,

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Develop an independent expectation of the accounting reserve amount to corroborate the ��reasonableness of management’s estimate,Review subsequent events or transactions occurring prior to completion of fieldwork.��

Note that AU Section 316 requires auditors to perform a retrospective review of actual expenses incurred related to reserve accounts to evaluate whether management judgments and assumptions are reasonable.

In 2002 Andersen was convicted for one felony count of obstructing justice related to its [8]

involvement with the Enron Corporation scandal (this conviction was later overturned by the United States Supreme Court). Read the “Enron Corporation and Andersen, LLP” case included in this casebook. (a) Based on your reading of that case and this case, how was Enron Corporation’s situation similar or dissimilar to Xerox’s situation? (b) How did the financial and business sectors react to the two situations when the accounting issues became public? (c) If the financial or business sectors reacted differently, why did they react differently? (d) How was KPMG’s situation similar or dissimilar to Andersen’s situation?

Students’ responses to this question can create a stimulating “in-class” discussion. Both Enron and Xerox were large publicly traded companies that were required to restate their financial statements because of massive accounting manipulations. Xerox’s earning were reportedly overstated by $1.5 billion while Enron’s earnings were reportedly overstated by 0.5 billion. The accounting manipulations for Xerox centered around its accounting for lease transactions (specifically its estimates of lease revenues) while Enron’s centered around its accounting for investment transactions (specifically its accounting for Special Purpose Entities). Announcement of the restatements resulted in significant declines to the stock prices of both companies. Xerox’s stock value dropped from over $60 per share to less than $5 per share while Enron’s stock value dropped from over $100 per share to less than $10 per share. Enron was eventually forced to file for bankruptcy protection as a result of the reported accounting manipulations. Enron’s collapse resulted in substantial losses to both investors and employees who had significant portions of the retirements tied-up in Enron stock.

An interesting question to ask is, “why did Enron eventually collapse because of the alleged fraud while Xerox did not?” Both companies were heavily financed with debt obligations and were experiencing significant challenges to their core business operations. The major difference is in the nature of their core business. At the time of the restatement, Enron was predominately a speculative energy and commodity trading company while Xerox was the producer of copier and printing devices. At the end, Enron no longer had physical products it produced and sold. Rather, Enron acted as an intermediary service provider between producers and buyers. Buyers and sellers were no longer interested in using Enron’s services when the integrity of management was brought into question, causing its business to basically disappear over night. Xerox on the other hand, was still perceived to produce quality products it could sell to its customers.

Enron’s restatement of its financial statements had a much more profound effect on Andersen than did Xerox’s restatements of its financial statements on KPMG. The number of high profile fraud cases Andersen was involved with (Waste Management, Global Crossing, Sunbeam, Qwest Communications, and Enron) helped it to quickly lose its credibility with the investment markets and federal government. More importantly, Andersen’s criminal conviction for document shredding in the midst of an SEC investigation forced Andersen to stop performing audits of public companies. In the end, Andersen’s loss of public trust rendered its services useless. KPMG fortunately, has not been involved in as many high profile fraud cases. Nevertheless, the demise of Andersen has brought about a significant re-evaluation and re-structuring of all public accounting firms to prevent similar situations in the future.

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On April 19, 2005, KPMG agreed to pay $22 million to the SEC to settle its lawsuit with the [9]

SEC in connection with the alleged fraud. Go to the SEC’s web site to read about the settlement of this lawsuit with the SEC (try, “http:// www.sec.gov/news/press/2005-59.htm”). Do you agree or disagree with the findings? Explain your answer.

The SEC litigation release regarding KPMG’s settlement of the Xerox case indicates that KPMG consented to the entry of the order without admitting or denying the SEC’s findings. The SEC’s findings note that KPMG failed to comply with generally accepted auditing standards (GAAS) and allowed Xerox to utilize accounting actions that did not comply with generally accepted accounting principles (GAAP). These accounting actions permitted Xerox to close a $3 billion “gap” between actual equipment revenues and reported revenues during the period 1997 through 2000. The SEC further noted that KPMG did not demand evidence sufficient to establish that the accounting actions and related assumption made by Xerox were in fact grounded in business realities or fairly reflected the company’s performance.

Without reviewing the audit work performed by KPMG it is difficult to agree or disagree with the SEC findings. Some students may argue that the accounting actions taken by Xerox were complex and subjective and that the SEC findings actually highlight a difference in judgment not a violation of GAAS or GAAP. Other students may argue that given the fraud factors present and the one sided nature of the accounting actions taken by Xerox that KPMG should have been more skeptical and required stronger evidence from the client to support the accounting actions taken. This question should highlight to students the importance for auditors to take a step back from the details of the audit to question whether the accounting actions taken by a client in combination fairly represent the economic performance of the company. An auditor should not allow clients to employ accounting actions that technically comply with reporting standards if the substance is misleading.

A 2002 editorial in BusinessWeek raised issues with compensation received by corporate [10]

executives even when the company does not perform well. In 1980 corporate executive compensation was 42 times the average worker compensation while in 2000 it was 531 times the average worker compensation. (a) Do you believe executive compensation levels are reasonable? (b) Explain your answer. (c) What type of procedures could corporations establish to help ensure the reasonableness of executive compensation?

Students’ responses to this question can be very divergent, which can create a stimulating “in-class” discussion. Some students will argue that corporate executive compensation is reasonable because the labor market for corporate executives is very tight and thus companies must pay high salaries to attract executives with the necessary skills. Other students will argue that high corporate executive salaries are reasonable for executives whose companies achieve superior performance. These students likely believe that the executives are reaping the benefits of their hard work (as are the stockholders) and are achieving the “American Dream.” Yet, other students will argue that corporate executive compensation is not in line with corporate executives’ contributions. Today’s large corporations are much less hierarchical and more team oriented. Therefore, corporate executive compensation should be closer to other employee compensation. These students will argue that superior corporate performance is the result of positive teamwork and not solely attributable to corporate executives.

An interesting analogy to consider raising with the students is the relationship between professional coaches' and athletes' salaries. Students generally will note that professional coaches are not paid substantially more than professional athletes. When questioned why coaches are not paid substantially more, some students will fall back on the team concept for why coaches are not paid substantially more. Others students will argue that coaches are not paid substantially more because athletic teams are not as complex as today’s business corporations.




Phar-Mor, inc.accounting fraud, litigation, and auditor liabilityMark S. Beasley · Frank A. Buckless · Steven M. Glover · Douglas F. Prawitt

To illustrate the degree of legal exposure [1]

professional accountants face.To define auditors’ legal liability under common [2]

and statutory law.To demonstrate that massive fraud typically [3]

involves collusion of a number of individuals in the management team. Further, those involved in the fraud will go to extreme lengths to fool the auditors only to later attempt to use their independent auditors as scapegoats when material errors or fraud are discovered.

To illustrate the potential independence [4]

problems that can arise when a client generates large audit and other service revenue.To illustrate the importance of maintaining a [5]

healthy degree of professional skepticism during all audit engagements.To illustrate the need for auditors to identify [6]

key red flags by conducting “smell tests” both on their client’s financial statements and top management’s personal integrity.


After completing and discussing this case you should be able to

KEY FACTSPhar-Mor had grown from 1 store in 1982 to 310 stores in 1992, with sales exceeding $3 ��billion.The deep discount drug store retail business is extremely competitive.��Mickey Monus was found guilty in December 1995 of embezzling more than $10 million and ��sentenced to nearly 20 years in prison.Nearly $1.14 billion were invested in this privately-held company by Westinghouse Credit ��Corp., Sears Roebuck & Co., Edward J. de Bartolo, and Lazard Freres & Co. Corporate Partners Investment Fund, among others.Monus was an original equity investor in the Colorado Rockies baseball franchise. Although not ��discussed in the students’ case he was also the founder of the World Basketball League, a league for players 6’ 5’’ and under, and continued to financially (sometimes with Phar-Mor funds) support franchises that were losing money until the WBL’s demise. It was noted later that only a man who was supremely confident (or arrogant) would dare take on the NBA.Monus and his CFO, Patrick Finn, manipulated income statement accounts, overstated inventory, ��and manipulated accounting rules in order to carry out this fraud for nearly six years.The total loss to investors and creditors reached over $1.1 billion, making it one of the largest ��corporate frauds in U.S. history.The fraud was facilitated by many factors, including lack of adequate management information ��systems poor internal controls, the CFO’s hands-off style, inadequate internal auditing, collusion among upper management, and the existence of related parties.The fraud was discovered when a travel agent received a check from Phar-Mor for WBL expenses ��

4.6c a s e

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signed by Monus. She showed the check to her landlord, who happened to be a Phar-Mor investor. The landlord then called David Shapira, CEO.After the fraud was uncovered, Phar-Mor laid off more than 16,000 employees, closed 200 stores, ��and filed for bankruptcy.Phar-Mor emerged from Chapter 11 in 1995, its common stock traded on NASDAQ, and in ��2001 it operated 139 stores in 24 states under the names Phar-Mor Rx Place, and Pharmhouse. However, on September 24, 2001, Phar-Mor filed again for Chapter 11 bankruptcy to restructure their operations in an effort to return to profitability. Phar-Mor’s securities have been delisted from the NASDAQ. In late 1995, Coopers & Lybrand, LLP settled with Phar-Mor as well as many investors and ��creditors banks who together were seeking in excess of $1 billion (the terms were not disclosed). Several investors and creditors did not settle at that time and in February 1996, a federal jury found Coopers guilty of having a “knowing or reckless disregard for material problems in the condition of Phar-Mor,” which is paramount to fraud. The student case indicates only that the auditors were found liable, it does not specify that the plaintiffs had to prove fraud to be successful.

PROFESSIONAL STANDARDSRelevant professional standards for this assignment include AU Section 230, “Due Professional Care in Performance of Work,” AU Section 316, “Consideration of Fraud in a Financial Statement Audit,” AU 318, “Performing Audit Procedures in Response to Assessed Risks and Evaluating the Audit Evidence Obtained.”

USE OF THE CASEThis is a rich comprehensive case that can be used in an undergraduate or graduate auditing class. An important point to stress is that financial frauds that involve collusion of top management are very difficult to detect. Some of the topics that can be addressed with this case are legal liability, auditor independence, analytical procedures, inventory valuation, and revenue recognition. When going over the case, consider showing all or part of the 57-minute PBS video called “How to Steel $500 million.” The video is excellent and includes interviews with members of Phar-Mor’s management team and a Coopers & Lybrand representative. To order the video, call PBS Video at (800) 328-7271.

Legal Liability. This case can be used in a legal liability module as it points to the large dollar amounts involved in lawsuits against professional accountants. It can also be used to effectively discuss the differences between statutory (e.g., U.S. Federal Securities Acts of 1933 and 1934) and common law. Within common law, the case can facilitate discussions about the differences in liability to third parties between jurisdictions and countries. The attorney for Sears, Sarah Wolff, of Chicago’s Sachnoff & Weaver, said under U.S. federal securities law and Pennsylvania State common law, a plaintiff alleging fraud must prove that the defendant made a misrepresentation or omission of a material fact, and that the plaintiff relied substantially on that misrepresentation or omission in making investment decisions. She added that scienter—which includes recklessness—is an element of both causes of action. However, while U.S. federal securities laws require that recklessness be proved by a preponderance of the evidence, Pennsylvania state common law requires proof by a clear and convincing standard, a higher hurdle. The jury concluded that under either standard, Coopers had been reckless. Ms. Wolff added that the case could prove to be the model for getting a jury to find that a respected accounting firm behaved “recklessly.” Other legal liability issues that can be addressed include the trend to “socialize losses” by holding external auditors liable for losses incurred by investors and creditors. Coopers & Lybrand’s attorney, Robert J. Sisk, chairman of New York’s Hughes Hubbard & Reed, said:

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case 4.6: Phar-Mor, inc.


“The jury [rightly] saw that a corporate fraud had been committed, but it mistakenly blamed the outside auditor for not uncovering something no one but the perpetrators could have known about.” He added, “It’s a first . . . that effectively turns outside auditors into insurers against crooked management.”

The verdict is significant because Coopers claimed the investors did not rely on the audited financial statements—and that Coopers never expected investors to rely on those reports—in making investment decisions, Wolff observed. A clean opinion by an independent outside auditor, however, is relied upon by investors like Sears because it contains information about the company’s history, an “extremely important” factor in investment decisions, Wolff said. Cases such as the Phar-Mor and Waste Management frauds, as well as the savings and loan debacles in the U.S. have put independent auditors under considerable pressure to do more than certify that a company’s books meet accepted accounting principles. Major accounting firms, as well as major law firms and other professional consultants, frequently are targets of people with grievances against their clients, in part because the professional firms may have more money to pay claims than the primary miscreants. In February 1997 the American Institute of Certified Public Accountants (AICPA) issued SAS 82, “Consideration of Fraud in a Financial Statement Audit,” outlining new guidelines to help auditors spot fraud and determine how they should treat the information. “We want auditors to focus more on suspicious situations and carry a healthy skepticism with them when they do their job,” Richard Miller, the AICPA’s general counsel, told the Wall Street Journal.1 SAS No. 82 was superseded in 2002 by SAS 99. The current guidance on the auditor’s responsibility to detect fraud is located in AU 316, “Consideration of Fraud in a Financial Statement Audit.” At the writing of this edition, the PCAOB has on its agenda an initiative to further improve the guidance relative to auditor’s responsibilities to detect fraud.

Auditor Independence. This case can also be used to discuss auditor independence. Auditor independence has received significant attention in the U.S. Walter Schuetze, then Chief Accountant to the Securities and Exchange Commission (SEC), wrote a pointed commentary, “A Mountain or a Molehill?”2 Several other SEC speeches and commentaries followed until November 2000 when the SEC adopted new rules governing the auditor’s independence. The amendments modernize the Commission’s rules for determining whether an auditor is independent in light of investments by auditors or their family members in audit clients, employment relationships between auditors or their family members and audit clients, and the scope of services provided by audit firms to their audit clients. The amendments also identify certain non-audit services that, if provided by an auditor to public company audit clients, impair the auditor’s independence. For all annual proxy statements filed after February 5, 2001, a public company is required to disclose information related to the non-audit services provided by the auditor during the most recent fiscal year. In 2003 Title II of the Sarbanes-Oxley Act required additional independence restrictions but left the final determinations and ruling regarding restrictions to the SEC and the PCAOB. For example in July 2005 the PCAOB issued Release No. 2005-014, “Ethics and Independence Rules Concerning Independence, Tax Services, and Contingent Fees.” The PCAOB’s “Ethics and Independence Rules Concerning Independence, Tax Services and Contingent Fees” was approved by the SEC on April 19, 2006. In addition, in April 2008, PCAOB adopted rule 3526 concerning communication with audit committees regarding independence. In addition, the SEC cites the PCAOB’s 2005-014 release in its brochure on Audit Committees and Auditor Independence released May of 2007.

1 Berton, Lee, “Auditors Face Stiffer Rules for Finding, Reporting Fraud at Client Companies,” The Wall Street Journal, February 5, 1996.2 Schuetze, Walter P., “A Mountain or a Molehill?” Accounting Horizons, Vol. 8 No. 1, 1994, pp. 69-75.

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The AICPA has revised their ethics rulings and interpretations related to auditor independence to conform, for the most part, with the new SEC and PCAOB rules.

Screening New and Existing Clients. This case provides an excellent opportunity to discuss the reasons why auditors should evaluate potential clients for any client-specific risks before accepting a new engagement. The same principle of evaluation can also be applied to existing clients. An good reference for evaluating clients is an article by Mark Murray published in the Journal of Accountancy.3 One of the screening steps suggested in this article is to check all potential client’s references to determine such things as “reputation,” “cooperativeness,” “management quality,” and “personality.” Mickey Monus spent most of his life in Youngstown, Ohio. This is also where he located the main office for Phar-Mor. As a result of spending the majority of his personal and professional life in the same town, he was well known in the area and many people could comment on his reputation in both his personal and professional activities. After discussing the questions assigned to students, the instructor can focus on the information about Mickey Monus that is contained in Exhibit 1 at the end of these teaching notes. Have students assume the identity of the auditors and ask them how this information might influence their thoughts about a new or existing client. The information about Pat Finn contained in Exhibit 2 can also provide a good opportunity to discuss the integrity of existing management. Pat Finn was a trained auditor who spent time working for Arthur Anderson before becoming the CEO at Phar-Mor. The comments in Exhibit 2, most from Pat Finn himself, give insight into his personality and his feelings about operations at Phar-Mor. Throughout the entire case materials, there is no evidence to suggest Pat Finn intended to become involved in a fraud of the magnitude that developed at Phar-Mor. The comments suggest Finn had some remorse and guilt about fraud and was drawn into scheme by Monus’ dominant personality. Exhibit 2 provides an opportunity to discuss the fact that participants in management and employee frauds often have a personality that provides no visible clues of danger to auditors. The auditors must be willing to perform their own screening evaluations of management for both new and existing clients.

Auditor’s potential response to improve ability to detect fraud or avoid associating with high-risk client. The case can also be used to discuss firm’s response to cases such as Phar-Mor. Firms should follow quality control guidelines as set forth in the professional standards. These include correct hiring, development, supervision and advancement practices, peer and quality reviews, partner rotation, consultation on difficult matters with other partners, and appropriate attention to auditor independence. The response of Coopers & Lybrand to audit and litigation risk is useful in answering how firms can reduce the likelihood of being associated with management fraud and resulting litigation. In an address to the American Accounting Association in August 1996, Vin O’Reilly, a leading partner with C&L spoke about some of Coopers new methods of assessing and managing audit and litigation risk. These methods have been carried over to the merged firm PricewaterhouseCoopers (PwC). Mr. O’Reilly indicated that:

The Firm has a firm-wide department of risk management. All new clients with risk factors ��must be approved by this department prior to acceptance, preferably prior to the proposal. One major advantage of using this approval system is that the client acceptance decision is more objective. In the late 1980s, 25 percent of the clients the Firm accepted had experienced problems with the previous auditor. By the mid 1990s, that percentage was down to four percent.Partners are continuously reminded they are not alone. Difficult matters should be discussed ��with other partners at the local and national levels.Each year the Firm identifies the 200 highest risk continuing clients. These engagements go ��

3 Murray, Mark F., “When a Client is a Liability,” Journal of Accountancy, September 1992, pp. 54-58. See also, “Assessing Fraud Risk, Journal of Accountancy, October 2007.

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through intense scrutiny as the firm challenges whether the client should be retained. The Firm has “fired” several high-risk clients in the last few years. Partners are taught that it is cause for celebration when they lose a “bad” client.The Firm’s engagement planning process specifically identifies factors that might indicate ��incentive, or the existence of management fraud.Based on a study of auditor litigation, the Firm has found that 85 percent of lawsuits against ��auditors are initiated when the client company fails. Therefore, the Firm runs prospective and continuing clients through viability screens including sophisticated quantitative failure prediction models. In addition to the quantitative measures, the Firm considers several qualitative factors such as industry risk, company risk, management risk, corporate governance, oversight risk, etc.The Firm studies the personality factors of the client and the engagement team to ensure a ��proper match. The Firm has found that most audit failures have resulted because partner objectivity is compromised. With this in mind, they conducted studies of partners who have been highly successful as well as those who have had problems with former audits to begin to understand the warning signs. They now monitor more closely partner traits and situations that may compromise objectivity.When necessary, the Firm provides objectivity counseling to the auditors. For example, an ��audit team may need counseling before an audit of a high-risk client that has aggressive and domineering management.The Firm demands better documentation of audit decisions. They have found they can ��defend decisions that are written in the working papers easier than they can defend auditors’ recollections stated years after the fact.

CURRENT INFORMATION ABOUT PHAR-MORNew management of Phar-Mor faced the task of restructuring its accounting records and strengthening the control systems. New management developed and implemented a strict internal control regimen designed specifically to avoid a situation in which a member of management could override controls and avoid detection. In Phar-Mor’s 1997 10-K management indicated that they “(i) implemented three major information system improvements, each of which supports the accurate reporting of inventory and facilitates stricter accounting controls: point-of-sale scanning equipment, a pharmacy software system and a Distribution Control System warehousing system (these systems provide greater merchandising data, facilitate pharmacy processing and track and coordinate inventory purchasing and warehouse volume), (ii) undertook a review of various existing systems which included an operations and control enhancement project on the accounts payable system and a vendor correspondence and relations review and (iii) enhanced an internal audit department that assembled extensive protocols to follow in conducting audits of internal controls.”

The 10-K also indicated that “in order to further enhance the control process, new management regularly generates numerous internal reports which are distributed to a wide variety of senior, middle and lower level management on a daily, weekly and monthly basis. In addition, operational and financial planning meetings are now attended by members of all levels of management.”

In September of 2001, Phar-Mor operated 139 stores in 24 states under the names of Phar-Mor, Rx Place, and Pharmhouse. However, on September 24, 2001, Phar-Mor and certain of its affiliates filed voluntary petitions under Chapter 11 of the United States Bankruptcy Code to restructure their operations in an effort to return to profitability. Management determined that the reorganization was necessary to address operational and liquidity difficulties resulting from factors such as the slowing economy, increased competition from larger retail chains, the reduction of credit terms by vendors and the service of high-cost debt. Phar-Mor’s securities were delisted from the NASDAQ. Phar-Mor was not able to recover from these problems and liquidated the last of its assets in 2002.

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QueStionS and SuGGeSted SolutionSSome of the members of Phar-Mor’s financial management team were former auditors for [1]

Coopers & Lybrand. (a) Why would a company want to hire a member of its external audit team? (b) If the client has hired former auditors, would this affect the independence of the existing external auditors? (c) How did the Sarbanes-Oxley Act of 2002 and related rulings by the PCAOB, SEC or AICPA affect a public company’s ability to hire members of its external audit team? (d) Is it appropriate for auditors to trust executives of a client?

A company may desire to hire a member of its audit teams for a number of reasons: (i) [a]

the auditor is familiar with the company, (ii) the auditor is typically highly competent and has experience with a number of financial matters, and (iii) management has had the opportunity to work closely with the auditor and probably has developed a strong relationship.

When former auditors become clients, there is the possibility that independence can be [b]

threatened in both fact and in appearance. Current auditors may be close personal friends with the former auditor as a result of working on the same team for years. Further, the current auditors likely consider the former auditor to be a person of competence and high integrity. As a result, the current auditors may overrely on the representation of their former colleague. Finally, because the former auditor will be intimately familiar with the audit approach, the potential for successfully hiding an accounting fraud or mismanagement of funds may increase.

Section 206 of the Sarbanes-Oxley Act of 2002 states that the CEO, CFO, Chief Accounting [c]

Officer or person in an equivalent position cannot have been employed by the external audit firm during a one year “cooling off ” period preceding the audit. The SEC rules extend this position to prohibit the employment of such persons “in an accounting or financial reporting oversight role.” Also PCAOB Rule 3600T, “Interim Independence Standards,” adopt the independence standards as described in the AICPA Code of Professional of Conduct and Standards 1-3 of the Independence Standards Board.

No, auditors should maintain healthy professional skepticism. AU Section 230, “Due [d]

Professional Care in the Performance of Work,” indicates that professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. Section 230 also indicates that, “The auditor neither assumes that management is dishonest nor assumes unquestioned honesty. In exercising professional skepticism, the auditor should not be satisfied with less than persuasive evidence because of a belief that management is honest” (paragraph .09). Therefore, an audit team must objectively evaluate observed conditions and audit evidence, and follow up any potentially negative indicators to determine whether or not financial statements are free of material misstatement.

(a) What factors in the auditor-client relationship can put the client in a more powerful [2]

position than the auditor? (b) What measures has and/or can the profession take to reduce the potential consequences of this power imbalance?

The following factors can lead to a power imbalance between the client and the auditor:[a]

Clients, typically financial management, select the auditor, determine the compensation, ��and have the authority to terminate the auditor.To conduct an effective audit, the auditor must maintain a good working relationship with ��the client. In fact, the auditor must have the client’s assistance, and the auditor is often in a position where the auditor must rely on the client to provide needed information.Many disputes between auditor and clients involve professional judgment. Because of ��the subjective nature of the professional standards, the client can pressure the auditors

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to accept aggressive stances.

To reduce the power imbalance between the client and the auditor, the profession requires [b]

the following:

AU 315, “Communications Between Predecessor and Successor Auditors,” in the U.S. ��requires communication between the predecessor and successor auditors. All firms listed on the New York Stock Exchange are required to have audit committees ��made up of outside directors. The SEC prohibits national securities associations from listing any security of an issuer that doesn’t have properly established audit committee. The AICPA considers it a best practice, but has no audit committee requirements. In the U.S., the Securities and Exchange Commission requires an 8-K disclosure when ��there is a change in auditors. The disclosure describes important circumstances surrounding auditor changes, and the auditors are required to report any disagreements they may have with the client’s purported reason for switching. AU 625, “Reports on the Application of Accounting Principles,” in the U.S. imposes ��significant responsibilities on prospective auditors who are contacted by a client that may be involved in “opinion shopping” behavior. Students commonly come up with several other alternatives. Alternatives like, “have the ��government or SEC hire and pay the auditors,” “prohibit the audit firm from selling other services to audit clients,” “change partner compensation models away from rewarding selling of new services,” are common.

(a) Assuming you were an equity investor, would you pursue legal action against the auditor? [3]

Assuming the answer is yes, under what law(s) would you bring suit and what would be the basis of your claim? (b) Define negligence as it is used in legal cases involving independent auditors. (c) What is the primary difference between negligence and fraud; between fraud and recklessness?

Not surprisingly, the investors and creditors did sue Coopers & Lybrand. In late 1995, [a]

Coopers & Lybrand settled with Phar-Mor, Corporate Partners, and a number of banks who together were seeking in excess of $1 billion. The terms were not disclosed. Several creditors/investors did not settle and their cases went to trial. The plaintiffs brought claims under both Pennsylvania common law and the Securities Exchange Act of 1934 (even though Phar-Mor was a private company their securities and debt issues were covered under this Act). However, these third party creditors/investors were not considered primary beneficiaries (see question 4), which meant that in order to be successful under both common law and the Securities Exchange Act of 1934 these plaintiffs had to prove the auditors were guilty of more than mere ordinary negligence (defined below). On February 14, 1996, a federal jury found Coopers & Lybrand, LLP guilty of fraud under both state and federal law because they had a “knowing or reckless disregard for material problems in the condition of Phar-Mor.” Coopers faced over $176 million in claimed damages to the creditors/investors under federal securities and state common law fraud charges (the accounting firm was expected to have professional liability insurance to cover most damages awarded).

Plaintiff attorneys explained to the jury that they understood Coopers did not have a responsibility to detect the management fraud. However, they asserted Coopers absolutely had the obligation to perform a GAAS audit. The plaintiffs’ case against Coopers basically was that Coopers was grossly negligent in their performance of the audit. Plaintiffs argued that a GAAS audit would have easily uncovered the fraud in a number of audit areas.

Attorneys representing the creditors believed Coopers’ credibility with the jury was hurt by the firm’s apparent conflict of interest. In particular, attorneys were critical of the actions

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of Gregory Finerty, the Coopers & Lybrand partner who oversaw audits of Phar-Mor. They note that while Coopers & Lybrand was raising red flags concerning Phar-Mor’s accounting practices, it was encouraging its auditors to sell additional services to the retailer. As stated in the case, Monus was the source of significant new business for Finerty. Because of his relationship with Monus, plaintiff attorneys argued Finerty could not maintain the professional skepticism necessary to perform an independent audit.

When the verdict was handed out, Coopers & Lybrand’s chairman Nicholas G. Moore stated that the Phar-Mor fight is far from over. Moore said,

“We believe the jury has erred and may have believed that an audit is intended to discover fraud. This is a dangerous message to send to those who seek to recoup business losses on the backs of innocent and well-meaning professional advisors.”4

Coopers pointed out that the fraud was carried out by the top management via a sophisticated conspiracy wrought with lies, forgery, and cover-up aimed at fooling the external auditors. Coopers & Lybrand maintains it followed generally accepted auditing standards, which the firm claims have never been interpreted to require auditors to be trained detectives specializing in uncovering the collusive fraud of senior management.

Ordinary Negligence[b] : The absence of reasonable care that can be expected of a person in a set of circumstances. When negligence of an auditor is being evaluated, it is in terms of what other competent auditors would have done in the same situation.

Fraud[c] occurs when a misstatement is made and there is both the knowledge of its falsity and the intent to deceive. The primary difference between fraud and negligence or recklessness is the intent to deceive. Recklessness or constructive fraud is the existence of extreme or unusual negligence even though there was no intent to deceive or do harm. It can also mean the lack of even slight care, tantamount to reckless behavior, that can be expected of a competent auditor. While U.S. common law and U.S. statutory law do suggest intent is necessary, the courts will find defendants guilty of fraud if the plaintiffs can prove recklessness, which is exactly what happened in the Phar-Mor trial.

Coopers & Lybrand was sued under both federal statutory and state common law. The judge [4]

ruled that under Pennsylvania law the plaintiffs were not primary beneficiaries. Pennsylvania follows the legal precedent inherent in the Ultramares Case. (a) In jurisdictions following the Ultramares doctrine, under what conditions can auditors be held liable under common law to third parties who are not primary beneficiaries? (b) How do jurisdictions that follow the legal precedent inherent in the Rusch Factors case differ from jurisdictions following Ultramares?

In jurisdictions that follow the Ultramares doctrine, only primary beneficiaries can [a]

successfully sue for ordinary negligence. However, even third parties who do not have privity of contract or who are not primary beneficiaries can successfully sue for gross negligence, recklessness, and fraud. In fact, the creditors in the Phar-Mor case were not considered primary beneficiaries and therefore faced the more difficult burden of proof of knowing recklessness or fraud. In fact, while U.S. federal securities laws require that recklessness be proved by a preponderance of the evidence, Pennsylvania state common law requires proof by a clear and convincing standard, a higher hurdle.

Jurisdictions that follow the Rusch Factors case (or the Restatement of Torts) have [b]

broadened the Ultramares doctrine to allow recovery by third parties who are considered foreseen users. Generally, a foreseen user is a member of a limited class of users who the

4 “Jury Finds C&L Liable,” Public Accounting Report, February 29, 1996, p. 1.

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auditor is aware will rely on the financial statements. For example, a bank with loans outstanding to a client at the balance sheet date is a foreseen user.

Coopers was also sued under the Securities Exchange Act of 1934. The burden of proof is not [5]

the same under the Securities Acts of 1933 and 1934. Identify the important differences and discuss the primary objective behind the differences in the laws (1933 and 1934) as they relate to auditor liability?

The burden of proof is very different for cases brought under the 1933 and 1934 Securities Acts. For cases brought under the 1933 Securities Act, the plaintiff must prove only that the audited financial statements contained a material misrepresentation or omission and that the plaintiff suffered a loss. However, the auditor faces an unusual burden of proof. The auditor must demonstrate as a defense that (1) an adequate audit was conducted in the circumstances, or (2) that all or a portion of the plaintiff ’s loss was caused by factors other than the misleading financial statements. The 1933 Security Act is the only common or statutory law where the burden of proof is on the defendant.

For actions brought under the 1934 Securities Exchange Act, the plaintiff must prove reliance on financial statements that were materially misstated that thereby resulted in a loss. Furthermore, the plaintiff must prove the auditor acted knowingly or with recklessness.

1933 exposes the auditor to more litigation risk than 1934 Act. The primary objective behind the differences is to protect the purchasers of new securities. Often on an original issue the only information publicly available is the prospectus whereas with an existing issue there are many sources of information (Internet, previous financial statements, analysts’ reports, industry publications, etc.).

Even though neither Phar-Mor’s management, the plaintiffs’ attorneys, nor anyone else associated with the case ever alleged the auditors knowingly participated in the Phar-Mor fraud, a jury found Coopers liable under a fraud claim. The crux of this fraud charge, as unfolded in the trial, was the plaintiffs’ allegation that Coopers made representations recklessly without regard to whether they were true or false, which legally enabled plaintiffs to sue the auditors for fraud.

The popular press has indicated that inventory fraud is one of the biggest reasons for the [6]

proliferation of accounting scandals. (a) Name two other high profile cases where a company has committed fraud by misstating inventory. (b) What makes the intentional misstatement of inventory difficult to detect? How was Phar-Mor successful in fooling Coopers & Lybrand for several years with overstated inventory? (c) To help prevent or detect the overstatement of inventory, what are some audit procedures that could be effectively employed?

A classic case that has influenced auditing standards in several countries was the discovery [a]

of a major fraud in the McKesson & Robbins Company in the U.S. in the 1937 financial statements. Other high profile inventory frauds have taken place at Leslie Fay Company, Inc. (1990-1992), Comptronix Corporation (1992), Rite Aid (1999).

Reasons why auditors have failed to detect the overstatement of inventory in the past [b]

include the following:5

Auditors who showed up at plants were fresh out of college; there was little continuity ��of assigned staff.

5 Groveman, Howard, “How Auditors Can Detect Financial Statement Misstatement,” Journal of Accountancy, October 1995. See also, “Ghost Goods: How to spot phantom inventory,” Journal of Accountancy, June 2001, by Joseph Wells, and the Crazy Eddie White Collar Fraud internet site, www.whitecollarfraud.blogspot.com.

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Partners or managers rarely attended audit team observance of inventory counts.��Auditors were fooled because they checked only small samples of management’s tallies.��Auditors permitted company officials to follow them and record where they made test ��counts, making it easy for officials to falsify counts for inventory not being tested.Auditors who did identify a situation indicating possible fraud—such as a barrel filled ��with floor sweepings whose contents management had valued at thousands of dollars—would then force the company to subtract the amount from inventory, but neglect to recognize the possibility of intentional and pervasive fraud.Auditors gave a client advance notice of specific locations where they would observe ��the inventory count. As a result, the client refrained from making adjustments at locations where it knew the inventories would be observed, and instead made fraudulent adjustments at other locations.

Regarding Phar-Mor’s ability to fool Coopers, Generally Accepted Auditing Standards (GAAS) do not require the auditor of a retail chain to physically examine the inventory in every store. In fact, in 1989, Coopers & Lybrand physically examined inventory counts in only four stores out of 129. In 1991, only five of the 200 Phar-Mor stores’ inventories were examined. (One explanation for this seemingly low number of stores checked by Coopers is that the audit firm wanted to limit its cost since it had won the Phar-Mor account with a very low bid.6 Another explanation is that Coopers was able to rely on the physical observation of an independent inventory control firm.) It appears one reason Phar-Mor was successful in hiding the inventory fraud from the auditors is they were able to obtain a listing of the sample of stores selected by the auditors for physical observation well in advance. With this information, Phar-Mor was able to insure that the stores sampled by the auditors were “clean.” To rectify this, Coopers & Lybrand could have made additional surprise visits for physical observations to several locations at random times of the year, not only at year end. With these increased test counts coupled with price testing of these items, Coopers would have had a higher probability of identifying the overstatement. Also, the auditors could have contacted major suppliers to investigate the relationship between the supplier and Phar-Mor and to verify shipments.

Some observation procedures that can be followed to help prevent or detect the overstatement [c]

of inventory include:7

The audit team assigned to observe inventories should be led by capable, experienced ��personnel who are familiar with the client and its operations. When less experienced personnel participate, they should be adequately supervised and encouraged to bring anything out of the ordinary to the attention of the partner, manager, or other auditor in charge at that location.If not all locations will be visited, or if counts are made cyclically, the auditors should ��be certain the locations and cycles do not follow an easily predictable pattern and then advise the client as late as possible about locations or cycles to be observed.Be skeptical of large or unusual test count differences or of client personnel taking notes ��or displaying particular interest in audit procedures or test counts. If there are more than occasional differences, ensure that they are not systematic, or worse, systemic.Be alert for inventory that appears not to have been used for some time or that is stored in ��unusual locations or fashions. If not already so identified, such conditions may indicate

6 “How To Steal $500 Million,” Frontline, Video No. 1304, aired on PBS, November 8, 1994.7 Groveman, Howard, “How Auditors Can Detect Financial Statement Misstatement,” Journal of Accountancy, October 1995, pp. 83-86. See also, “Ghost Goods: How to spot phantom inventory,” Journal of Accountancy, June 2001, by Joseph Wells, and the Crazy Eddie White Collar Fraud internet site, www.whitecollarfraud.blogspot.com.

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damage, obsolescence, or excess quantities.Ensure that intercompany and interplant movement is kept to an absolute minimum. ��Establish control of the inventory before the audit team leaves—satisfy that any items added to it after the count is completed are proper and reasonable.Coopers may have been able to identify a higher degree of risk that inventory was misstated ��with extensive use of analytical procedures. For example, by artificially inflating ending inventory, the inventory turnover ratio would have indicated a slow down. It is also possible that analytical audit procedures would have identified the increase to inventory balances on a per store basis (at least for the stores not visited by the auditors). The increase in inventory should have increased the inherent risk associated with inventory, which would require more audit testwork. Evidence presented in the trial indicated that the auditors were aware of the large “spikes” discussed in the case. Surprise visits by auditors to various retail locations would likely have raised questions ��about empty shelf space. Accounts payable confirmation with some of Phar-Mor’s largest vendors would have identified the large overdue balances. Auditors could have informally or formally interviewed operations management and store personnel to identify any unusual situations.If the auditors had identified that vendors were not being paid and therefore withholding ��shipments, they may have discerned (1) the severe cash shortage Phar-Mor was having as well as (2) the overvaluation of inventory by employing an analytical procedure of same-store inventory levels. Then, understanding that actual physical inventory at the stores was lower than previous years, the inventory accounting records should have also shown a lower ending balance.

(a)The auditors considered Phar-Mor to be an inherently “high risk” client. List several factors [7]

at Phar-Mor that would have contributed to a high inherent risk assessment. (b) Should auditors have equal responsibility to detect material misstatements due to errors and fraud? (c) Which conditions, attitudes, and motivations at Phar-Mor that created an environment conducive for fraud could have been identified as red flags by the external auditors?

Some of the factors that would have contributed to a high inherent risk assessment include [a]

the following:

Phar-Mor was competing in a highly competitive industry (too good to be true).��Phar-Mor was rapidly expanding the number of stores; however, the accounting system ��was not keeping pace.Management was highly motivated to meet budgets and maintain growth. ��Previous audits had identified misstatements and system weaknesses.��Phar-Mor was extensively involved with a number of related parties.��Judgment was required for many of the accounting transactions (e.g., Tamco, inventory ��valuation, exclusivity payments).Inventory was a significant account. Physical observation occurred at times other than ��year-end, and valuation was based on cost complement.

It is obviously more difficult to uncover frauds because of their intentional nature. [b]

Professional auditing standards around the globe recognize that the function of the auditor is not to prevent and detect all irregularities or fraud. However, an audit is considered to have the responsibility to act as a deterrent. Professional standards do require auditors to plan and perform an audit with professional skepticism and standards require that an audit be designed and conducted to provide a reasonable assurance of detecting material misstatements (AU 316, “Consideration of Fraud in a Financial Statement Audit,” in the US, internationally, other standards include ISA 240 International, SAS 110 U.K., AUS 210 Australia). Interestingly, while international standards and standards of many other

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countries have explicitly described auditors’ responsibility for assessing the risk of fraud, the U.S. standards did not use the word “fraud” until SAS 82 which was issued in February 1997. SAS 82 was superseded by SAS 99 and the guidance on the auditors responsibility to detect fraud is found in AU 316. AU 316 requires auditors to have fraud “brainstorming” meetings and to add additional inquiries, as well as some additional audit procedures related to fraud detection. Auditors are required to document their assessment of the risk of fraud; and when the risk is high, to tailor the audit plan to address the risk. The U.S. standards are now similar to standards in Australia, the U.K. and Canada. At the writing of this edition, the PCAOB has on its agenda a project to further to improve the guidance relative to auditor’s responsibilities to detect fraud.

Some of the [c] conditions and attitudes at Phar-Mor that made it conducive to the commission of fraud are provided in the following list.8 Items preceded by a flag appear to have been identifiable “red flags” to the auditors:

Decisions were dominated by one person (Monus).�3Key executive involved in significant speculation (Monus’ investment in the now defunct �3World Basketball League). Key executive involved in excessive or habitual gambling.�� Key executive exhibits greed as evidenced by overwhelming desire for self-enrichment ��and fame. Key executive is a “wheeler dealer” who enjoys feeling of power, influence, social status, �3and excitement associated with financial transactions involving large sums of money. Key executives had low moral character and lacked personal code of honesty.�� Key executive created overly optimistic expectations for the company��Significant related-party transactions exist.�3 An attitude that success is more important than ethics.��Rapid expansion of company.�3Heavy competition experienced.�3Inadequate internal control system, and/or failure to enforce existing internal controls.�3 Assets subject to misappropriation (money to WBL and Monus).��Inexperienced management. (non-financial management’s participation in accounting �3and finance)Inventory increases on paper, with empty shelf space.�3Key executive have close association with suppliers.�3 Too much trust placed in key employees (Shapira’s hands-off style).�� Liberal accounting practices (exclusivity fees booked up front).�� Weak internal audit function��

Some of the (c) motivations at Phar-Mor that made it conducive to the commission of fraud are listed below. Items those preceded by a pointing finger appear to have been identifiable “red flags” to the auditors:

Inadequate profits relative to past performance and budgets.��Rapid growth of company.�3Management job threatened by poor performance.�3Strong emphasis on earnings growth.�3 Management believes there is a need to gloss over “temporarily bad situations” in order ��to maintain management position and prestige.

8 The items in the suggested solutions section listed as indicators are consistent with Fraud Risk Factors listed in AU 316 (see p. 31-33, 85).

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exhibit 1Additional Information on Mickey Monus9

The descriptions below were applied to Monus from people in the Youngstown area, or people who knew him professionally. All of this information would have potentially been available to auditors, or possible business associates, who did a little checking in Monus’ background.

Reputation in Community

Brash exterior with an inspiring ability to create jobs and make money.•�Often found on the front lines at public celebrations, inviting people to believe in whatever enterprise he •�pushed.“The Monus family has done more good for this valley than any harm to this valley.” (Radio Talk Show •�Caller)To the folks back home, Mickey Monus had become a legend who breathed new life into their old town.•�Monus, the local boy made good, would occasionally stop by Kim’s Cafe to serve as guest bartender.•�“He became almost like a cult figure. He was bigger than life. He could do no wrong. He had the •�Midas touch. However you want to say it, he was a very, very important person for the psyche of the Youngstown area.” (Anthony Cafaro, Phar-Mor Investor)

Business Philosophy

“There’s no stopping us now to being a national retailer and to having a store in every major market •�across the country.” (Mickey Monus)Monus committed Phar-Mor to underselling Wal-Mart.•�“Power buying” was Monus’s catch phrase.•�Monus would squeeze up-front payments from vendors in return for not selling their competitors’ •�products.“There’s a lot of people who lose a lot of money in minor league sports, so yeah, it was a challenge •�because he was going to, again, do something that nobody had done. He was going to be a success where others had failed.” (Tom Zawistowski, former Director of Broadcasting for the World Basketball League)Monus had this attitude: “If we’re going to create a new basketball league from scratch and we’re going •�to make money on it when no one else has, well, hey, we’re the people who started Phar-Mor. We can do these kinds of things.” (Tom Zawistowski, former Director of Broadcasting for the World Basketball League)

Personal traits and Lifestyle Observations

Monus’s salary and bonus was half a million dollars and he lived accordingly. He loved West Palm •�Beach. He lived in a big house where he had spent large amounts ($500,000) to add rooms. His second marriage took place at the Ritz-Carlton Hotel, pool side where his second wife wore an 18-carat gold mesh gown donated for the wedding day by a vendor.“He had the ability to motivate all of his- everyone who worked with him to have that same type of fire and •�that same type of dedication towards Phar-Mor.” (Pat Finn)

9 Many of the facts in Exhibit 1 were obtained from the PBS video called “How to Steel $500 million.” As noted earlier in the instructor’s notes, the video is excellent. To order the video, call PBS Video at (800) 328-7271.

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Monus had a gambling spirit—“Mickey’s personality is he’s in essence a gambler. If he loses a bet, he’s •�going to double up on the bet, and hope- hopefully, the next time he can recover his funds.” (Pat Finn)Monus loved the high life, loved to be where the action was. “It would be 3:00 o’clock in the afternoon and •�he’d say, ‘Let’s go to Vegas and we’re going now. Just take your wallet and let’s go.’ And we would fly into Las Vegas and there would be a limo from Caesar’s Palace that would meet the plane on the tarmac and we would get taken to Caesar’s Palace and there would be a suite for Mickey, 24 hours a day, seven days a week. It did not matter when we came there. There was always a suite.” (Tom Zawistowski, former Director of Broadcasting for the World Basketball League)“Life was a game. Life was just this ride you’re on. You know, you’re working hard and you’ve got all this •�money, you know, coming through your hands. Whether you own it or not, you know, that’s for someone else to decide, but you have the power, the ability to do anything. The gambling was insane. I mean, my coaches would come back and say, ‘Yeah, Mickey game me $4,000 to gamble with last night and I lost it all.’” (Tom Zawistowski, former Director of Broadcasting for the World Basketball League)

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exhibit 2Additional Information on Pat Finn10

“Pat Finn always had an aggressive approach to accounting and call it aggressive or call it creative, that’s •�the way it was done ever since I remember.” (John Anderson, former Accounting Manager)“You could see yourself going after problems, challenging yourself, solving problems. In accounting, you •�know, you worked through a problem. There was a right answer and a wrong answer. Things were, things were black and white. And that’s probably part of my personality. Things are black and white. Things are either right or wrong.” (Pat Finn)“You knew you were doing something wrong, but you never understood how wrong. I think he- he •�(Monus) helped me believe that, you know, starting it for him was being a team ballplayer. Give him time and he’ll fix the problem.” (Pat Finn)“My energy, and people who worked for me, was going to cover up a situation and it really wasn’t going •�towards making Phar-Mor a better company and that really hurt. And I think we all longed for the day that we could just kiss this good-bye and just dedicate ourselves to making the company better.” (Pat Finn)“I felt like I was almost in quicksand. I kept sinking deeper and deeper and deeper. But I always had a •�belief that we could fix it. I never wanted to tell myself that we couldn’t fix it because if we couldn’t fix it, there was nothing but bad.” (Pat Finn)“It’s okay to be loyal. It’s okay to, as I did, try to build a company, to nurture something from the beginning. •�But never, never lose sight of yourself. Never compromise yourself for that. It’s not worth it. No matter how much of a team ballplayer you think you are, you’re just destroying yourself and destroying things that are important to you.” (Pat Finn)

10 Many of the facts in Exhibit 2 were obtained from the PBS video called “How to Steel $500 million.”

Section 4 Accounting Fraud And Auditor Legal Liability.pdf

Documents

Transcript of Section 4 Accounting Fraud And Auditor Legal Liability.pdf