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![Case 2.2 Golden Bear Golf, Inc. 114
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4. “Yes,” auditors do have a responsibility to refer to any relevant AICPA Audit and Accounting
Guide when planning and carrying out an audit based upon the AICPA Professional Standards.
These guides do not replace the authoritative guidance included in AICPA Professional Standards
but rather include recommendations on how to apply those standards in specific circumstances.
What about audits of public companies that are guided by the PCAOB’s auditing standards? After
considerable research, I could not find any reference to the AICPA Audit and Accounting Guides in
the PCAOB’s auditing standards. As a result, those guides, apparently, are not considered
authoritative literature vis-à-vis audits of public companies.
5. The following footnote was included in Accounting and Auditing Enforcement Release No. 1676,
which was a primary source for the development of this case. “Regardless of whether the adoption
of the ‘earned value’ method was considered a change in accounting principle or a change in
accounting estimate, disclosure by the company in its second quarter 1997 interim financial
statements and its 1997 annual financial statements was required to comply with GAAP.” In the text
of the enforcement release, the SEC referred to the switch from the cost-to-cost method to the earned
value method as a change in “accounting methodology,” which seems to suggest that the SEC was
not certain how to classify the change. However, APB Opinion No. 20, “Accounting Changes,”
which was in effect during the relevant time frame of this case, and SFAS No. 154, “Accounting
Changes and Error Corrections,” the FASB standard that replaced APB No. 20, point out that the
phrase “accounting principle” refers to accounting principles or practices and “to the methods of
applying them.” This statement implies, to me at least, that Paragon’s switch from the cost-to-cost
approach to the earned value approach of applying the percentage-of-completion accounting method
was a “change in accounting principle.”
Under SFAS No. 154, a change in accounting principle “shall be reported by retrospective
application unless it is impracticable to determine either the cumulative effect or the period-specific
effects of the change.” [Note: SFAS No. 154 is now integrated into Topic 250, “Accounting
Changes and Error Corrections,” in the FASB Accounting Standards Codification.] This is an
important difference with the prior standard, APB No. 20, that required a “cumulative effect of a
change in accounting principle” to be reported by the given entity in its income statement for the
period in which the change was made. SFAS No. 154 requires that a change in accounting estimate
“shall be accounted for in the (a) period of change if the change affects that period only or (b) the
period of change and future periods if the change affects both.”
In terms of financial statement disclosure, SFAS No. 154 mandates that the “nature of and
justification for the change in accounting principle shall be disclosed in the financial statements of
the period in which the change is made.” Regarding changes in accounting estimates, this standard
notes that, “When an entity makes a change in accounting estimate that affects several future periods
(such as a change in service lives of depreciable assets), it shall disclose the effect on . . . net income,
and related per-share amounts of the current period.”](https://image.slidesharecdn.com/10909-250212142520-2d23bbb0/75/Get-Contemporary-Auditing-11th-Edition-Knapp-Solutions-Manual-Free-All-Chapters-Available-18-2048.jpg)
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Case 2.3 Take-Two Interactive Software, Inc. 117
12. The SEC sanctioned Fish, Brant, and three other Take-Two executives; Brant resigned from
Take-Two during the SEC’s investigation of the company’s scheme to backdate its stock option
grants, a scheme that he had masterminded.
Instructional Objectives
1. To provide students with an opportunity to use analytical procedures as an audit planning tool.
2. To examine the nature of, and key audit objectives associated with, accounts receivable
confirmation procedures and related “alternative audit procedures.”
3. To examine the meaning of “negligent,” “reckless,” and “fraudulent” as those terms relate to
auditor misconduct or malfeasance.
4. To identify circumstances that may threaten the de facto and apparent independence of auditors.
Suggestions for Use
You might begin class coverage of this case by asking for a show of hands of those students who
have played one or more versions of Grand Theft Auto. If you have “age appropriate” college
students, you will likely find that most of your male students have played the game, while just a
smattering of your female students have experienced the game. After asking for the show of hands, I
typically single out individual students and ask them to comment on whether or not they believe the
game is morally objectionable. More often than not, I receive a reply similar to the following: “It’s
only a game!” [By the way, I have never played the game myself, although I was well aware of it
and its controversial content before I developed this case.] Next, I tend to segue into a discussion of
the final case question, namely, whether audit firms should accept “ethically-challenged” companies
and organizations as clients. That issue often spawns a far-ranging, if not raucous, debate among
students. I have found that students also enjoy debating and discussing the two auditor independence
issues raised in this case: the question of whether the “father-son” relationship between the client
CEO and the audit engagement partner was problematic and the question of whether PwC’s
independence was in any way impaired by the heavy discounting of fees charged to Take-Two when
it was in a developmental stage.](https://image.slidesharecdn.com/10909-250212142520-2d23bbb0/75/Get-Contemporary-Auditing-11th-Edition-Knapp-Solutions-Manual-Free-All-Chapters-Available-21-2048.jpg)
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Case 2.3 Take-Two Interactive Software, Inc. 121
Negligence. "The failure of the CPA to perform or report on an engagement with the
due professional care and competence of a prudent auditor." Example: An auditor
fails to test a client's reconciliation of the general ledger controlling account for
receivables to the subsidiary ledger for receivables and, as a result, fails to detect a
material overstatement of the general ledger controlling account.
Recklessness (a term typically used interchangeably with gross negligence and
constructive fraud). "A serious occurrence of negligence tantamount to a flagrant or
reckless departure from the standard of due care." Example: Evidence collected by
an auditor suggests that a client's year-end inventory balance is materially overstated.
Because the auditor is in a hurry to complete the engagement, he fails to investigate
the potential inventory overstatement and instead simply accepts the account balance
as reported by the client.
Fraud. “Fraud differs from gross negligence [recklessness] in that the auditor does
not merely lack reasonable support for belief but has both knowledge of the falsity
and intent to deceive a client or third party." Example: An auditor accepts a bribe
from a client executive to remain silent regarding material errors in the client's
financial statements.
We can certainly conclude that the PwC auditors were not fraudulent in this case because they
were unaware of the client’s indiscretions and there was no effort on their part to deceive third-party
users of Take-Two’s financial statements. Regarding the question of whether the auditors were
negligent or reckless, recognize that the SEC enforcement release that focused on that audit and, in
particular, Robert Fish’s role in that audit, did not characterize the mistakes made as negligent or
reckless. (Note: The issue of whether or not given auditors were negligent or reckless is often the
central issue in a civil lawsuit filed against those auditors but is typically not addressed directly
within an SEC enforcement release.) However, the SEC’s enforcement release did stronglycriticize
Fish’s conduct. For example, the SEC charged that “he failed to exercise due professional care and
professional skepticism, and failed to obtain sufficient competent evidential matter” (taken from
quote in case). This summary statement suggests that Fish was at least negligent in auditing Take-
Two given the above definition of “negligence.”
Was Fish reckless? Since we don’t have access to all of the pertinent information for this case, it
is difficult to decide whether or not his misconduct rose to the level of recklessness. Consider
having your students debate this issue. What I often do in this type of setting is to have one group of
students take one side of such a debate and another group of students take the other side. After a
lively give and take between the two competing camps, I then have a third set of students vote
(anonymously) to choose the “winner.”
5. Professional auditing standards do not address this issue. Rule-making bodies in the auditing
discipline apparently believe that the level of audit fees to be charged on any given audit engagement
is an issue that will be properly resolved by the interplay of supply and demand forces in the audit
market. It has been alleged in the past that major audit firms attempted to expand their client bases
by discounting their fees. In the 10th
edition of my casebook, Case 1.7, “Lincoln Savings and Loan](https://image.slidesharecdn.com/10909-250212142520-2d23bbb0/75/Get-Contemporary-Auditing-11th-Edition-Knapp-Solutions-Manual-Free-All-Chapters-Available-25-2048.jpg)
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Case 2.4 General Motors Company 125
11. In January 2009, the SEC sanctioned GM for several abusive accounting and financial reporting
practices including its accounting and financial reporting decisions for its pension liabilities and
related items.
12. In July 2009, the “new General Motors” (General Motors Company) emerged from bankruptcy
proceedings; the federal government was the new company’s principal stockholder.
Instructional Objectives
1. To identify key audit risks and issues posed by an important long-term liability, namely, the
liability stemming from an organization’s defined benefit pension plan.
2. To identify specific audit procedures appropriate for long-term accrued liabilities such as
pension liabilities.
3. To identify circumstances under which auditors should retain outside experts to assist them in
completing an audit.
4. To demonstrate the importance of insisting that audit clients include appropriate disclosures in
their financial statement footnotes regarding significant accounting estimates.
Suggestions for Use
While developing this case, I reviewed several auditing textbooks to gain insight on the type and
extent of the textbook treatment typically given to the topic of pension liabilities and related financial
statement items. I was surprised to find almost no coverage of that topic. Given the materiality of
pension-related financial statement amounts for many companies, it seems reasonable that we
should, at a minimum, provide auditing students with an overview or “brief taste” of the key audit
issues for those items. This case addresses that need. [Sidebar: No doubt, the auditing of pension-
related financial statement items is among the more complex assignments on most audit
engagements. Consequently, this task is typically assigned to more experienced auditors, which
likely explains why this topic is not dealt with extensively in standard introductory-level auditing
textbooks.]
As you probably know, to demonstrate the real-world significance of audit issues, I present
those issues in the context of real-world circumstances or dilemmas. One downside to this strategy
is that students sometimes are “derailed” by peripheral issues that are not directly audit-related. In
covering this case, for example, students enjoy debating the factors that contributed to GM’s demise.
You may find it necessary to direct students’ attention away from such issues and back to the central
accounting and auditing issues highlighted by the case.
Suggested Solutions to Case Questions](https://image.slidesharecdn.com/10909-250212142520-2d23bbb0/75/Get-Contemporary-Auditing-11th-Edition-Knapp-Solutions-Manual-Free-All-Chapters-Available-30-2048.jpg)
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Case 2.4 General Motors Company 126
1. Listed next are examples of general audit procedures that could be applied to a company’s
reported pension obligation or liability and/or its related pension expense. This list is not intended to
be comprehensive by any stretch of the imagination. The purpose of this question is simply to force
students to think in general terms of the key issues that should be addressed in auditing these items.
Notice that I list the audit objective first followed by the specific audit procedure. You may want to
instruct your students to use that conventional “horse before the cart” strategy for this question as
well. Sidebar: you may want to point out to your students that pension amounts are accounting
estimates and thus AS 2501, “Auditing Accounting Estimates,” of the PCAOB’s auditing standards
can be used as a general framework for developing appropriate audit procedures for those items.
(The corresponding section in the AICPA Professional Standards is AU-C Section 540, “Auditing
Accounting Estimates, Including Fair Value Accounting Estimates and Related Disclosures.”)
a. 1. Audit objective: To determine whether the client’s pension obligation is recorded
in the financial statements at the appropriate amount. [“Valuation and allocation”
assertion regarding period-ending account balances.]
2. Audit procedure: Identify discount rates applied by comparable companies to
determine their pension liabilities. Given those discount rates, evaluate the
reasonableness of the client’s chosen discount rate.
b. 1. Audit objective: To determine whether the client’s pension obligation is recorded
in the financial statements at the appropriate amount. [“Valuation and allocation”
assertion regarding period-ending account balances.]
2. Audit procedure: Have an independent actuary review the keyactuarial assumptions
used by the client in arriving at its reported pension obligation. (For example, the
actuary would likely review the reasonableness of mortality assumptions applied by
the client.)
c. 1. Audit objective: To determine whether the client’s pension obligation is recorded
in the financial statements at the appropriate amount. [“Valuation and allocation
assertion regarding period-ending account balances.]
2. Audit procedure: Test the mathematical accuracyof the client’s computations of the
pension obligation and pension expense amounts.
d. 1. Audit objective: To determine that all disclosures that should have been included
in the client’s financial statements have been included. [“Completeness” assertion
concerning presentation and disclosure issues.]
2. Audit procedure: Read client financial statement footnotes to determine whether the
client has made all necessary and appropriate disclosures regarding its pension
liability.
e. 1. Audit objective: To determine that financial information is appropriatelypresented
and described and disclosures are clearly expressed. [“Classification and
understandablity” assertion regarding presentation and disclosure issues.]
2. Audit procedure: Read client financial statement footnotes to determine whether its
pension-related disclosures are explained precisely and clearly.](https://image.slidesharecdn.com/10909-250212142520-2d23bbb0/75/Get-Contemporary-Auditing-11th-Edition-Knapp-Solutions-Manual-Free-All-Chapters-Available-31-2048.jpg)
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Case 2.5 Lipper Holdings, LLC 132
planning phase of those audits, the SEC suggested that the auditors did not respond appropriately to
that risk factor during later phases of the audits.
2. AS 1105.11 identifies five management assertions that are relevant to independent auditors. The
“audit objectives” on audits of SEC registrants involve collecting sufficient appropriate evidence to
corroborate these assertions for specific financial statement line items or disclosure items. [Note:
the AICPA Professional Standards identify13 specific management assertions that are closelyrelated
to the “original” five management assertions incorporated in AS 1105. See AU-C Section 315.A128
for a list of those assertions.]
AS 2503, “Auditing Derivative Instruments, Hedging Activities, and Investments in Securities,”
is replete with examples of audit objectives for “complex financial instruments and transactions”
which is the focus of this case question. Listed next are examples of such audit objectives and
corresponding audit procedures suggested by AS 2503.
Audit objective: Audit objectives related to “assertions about the valuation of derivatives and
securities address whether the amounts reported in the financial statements through measurement or
disclosure were determined in conformity with generally accepted accounting principles.” AS
2503.26
Example of a relevant audit procedure: “If quoted market prices are not available for the derivative
or security, estimates of fair value frequentlycan be obtained from broker-dealers or other third-party
sources based on proprietary valuation models or from the entity based on internally or externally
developed valuation models.” AS 2503.38
Audit objective: Audit objectives related to “assertions about rights and obligations address whether
the entity has the rights and obligations associated with derivatives and securities, including pledging
arrangements, reported in the financial statements.” AS 2503.25
Example of a relevant audit procedure: “Confirming significant terms with the counterparty to a
derivative or the holder of a security, including the absence of any side agreements.” AS 2503.25
Audit objective: Audit objectives related to “completeness assertions address whether all of the
entity’s derivatives and securities are reported in the financial statements through recognition or
disclosure.” AS 2503.22
Example of a relevant audit procedure: The auditor should request “counterparties or holders who
are frequently used, but with whom the accounting records indicate that there are presently no
derivatives or securities, to state whether they are counterparties to derivatives with the entity or
holders of its securities.” AS 2503.22
Audit objective: “The auditor should evaluate whether the presentation and disclosure of derivatives
and securities are in conformity with generally accepted accounting principles.” AS 2503.49
Example of a relevant audit procedure: The auditor should determine whether “the information
presented in the financial statements is classified and summarized in a reasonable manner, that is,
neither too detailed nor too condensed.” AS 2503.49](https://image.slidesharecdn.com/10909-250212142520-2d23bbb0/75/Get-Contemporary-Auditing-11th-Edition-Knapp-Solutions-Manual-Free-All-Chapters-Available-37-2048.jpg)
![Case 2.6 CBI Holding Company, Inc. 136
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Suggestions for Use
This case focuses on accounts payable and, consequently, is best suited for coverage during
classroom discussion of the audit tests appropriate for that account. Alternatively, the case could be
integrated with coverage of audit evidence issues. Finally, the case also raises several interesting
auditor independence issues.
As a point of information, you will find that this case doesn’t fully examine all facets of the
fraudulent scheme perpetrated by CBI’s management. The cases in this section purposefully focus
on high-risk accounts and auditing issues related to those accounts. If I fully developed all of the
issues posed by the cases in this text, each case would qualify as a “comprehensive” case. [I make
this point because many adopters have raised this issue with me. By the way, I greatly appreciate
such comments and concerns!]
Suggested Solutions to Case Questions
1. "Completeness" is typically the management assertion of most concern to auditors when
investigating the material accuracy of a client's accounts payable. Generally, clients have a much
stronger incentive to violate the completeness assertion for liability and expense accounts than the
other management assertions relevant to those accounts. Unfortunately for auditors, a client's
financial controls for accounts payable are typically not as comprehensive or as sophisticated as the
controls established in accounting for the analogous asset account, accounts receivable. Clients have
a strong economic incentive to maintain a reliable tracking system for amounts owed to them by their
customers. This same incentive does not exist for payables since the onus for keeping track of these
amounts and ensuring that they are ultimately paid rests with a company's creditors. Granted, a
company needs sufficient records to ensure that their vendors are not overcharging them.
Nevertheless, the relatively weak accounting and control procedures for payables often complicate
auditors' efforts to corroborate the completeness assertion for this account.
In my view, the two primary audit procedures that Ernst & Young applied to CBI’s accounts
payable would likely have yielded sufficient appropriate evidence to corroborate the completeness
assertion—if those procedures had been properly applied. The search for unrecorded liabilities is
almost universally applied to accounts payable. This search procedure provides strong evidence
supporting the completeness assertion because audit clients in most cases have to pay year-end
liabilities during the first few weeks of the new fiscal year. [Of course, one feature of the search
procedure is examining the unpaid voucher file to uncover anyyear-end liabilities that remain unpaid
late in the audit.] The reconciliation procedure included in Ernst & Young’s audit programs for
accounts payable provides additional evidence pertinent to the completeness assertion. In particular,
that audit test helps auditors nail down the “timing” issue for payables that arose near a client’s year-
end. Vendor statements should identify the shipping terms and shipment dates for specific invoice
items and thus allow auditors to determine whether those items should have been recorded as
liabilities at the client’s year-end.
2. Before answering the explicit question posed by this item, let me first address the “explanation”
matter. In most circumstances, auditors are required to use confirmation procedures in auditing a](https://image.slidesharecdn.com/10909-250212142520-2d23bbb0/75/Get-Contemporary-Auditing-11th-Edition-Knapp-Solutions-Manual-Free-All-Chapters-Available-41-2048.jpg)
![Case 2.6 CBI Holding Company, Inc. 137
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client's accounts receivable. Exceptions to this general rule are discussed in AS 2310, “The
Confirmation Process,” of the PCAOB’s auditing standards and include cases in which the client's
accounts receivable are immaterial in amount and when the use of confirmation procedures would
likely be ineffective. On the other hand, confirmation procedures are not generally required when
auditing a client's accounts payable. Accounts receivable confirmation procedures typically yield
evidence supporting the existence, valuation/allocation, and rights & obligations assertions related to
period-ending accounts receivable balances. However, the key assertion corroborated most directly
by these tests is existence. When performing confirmation procedures on a client's accounts payable,
the auditor is most often concerned with the completeness assertion (as pointed out in the answer to
the prior question). [Note: AU-C Section 505, “External Confirmations,” is the section in the
AICPA Professional Standards that corresponds with AS 2310.]
The differing objectives of accounts payable and accounts receivable confirmation procedures
require an auditor to use different sampling strategies for these two types of tests. For instance, an
auditor will generally confirm a disproportionate number of a client's large receivables. Conversely,
because completeness is the primary concern in a payables confirmation procedure, the auditor may
send out confirmations on a disproportionate number of accounts that have relativelysmall balances
or even zero balances. Likewise, an auditor may send out accounts payable confirmations to inactive
vendor accounts and send out confirmations to vendors with which the client has recentlyestablished
a relationship even though the client’s records indicate no outstanding balance owed to such vendors.
A final technical difference between accounts payable and accounts receivable confirmation
procedures is the nature of the confirmation document used in the two types of tests. A receivable
confirmation discloses the amount reportedly owed by the customer to the client, while a payable
confirmation typically does not provide an account balance but rather asks vendors to report the
amount owed to them by the client. Auditors use blank confirmation forms in an effort to identify
any unrecorded payables owed by the client.
Should the Ernst & Young auditors have applied an accounts payable confirmation procedure to
CBI’s payables? No doubt, doing so would have yielded additional evidence regarding the
completeness assertion and, in fact, likely have led to the discovery of Castello’s fraudulent scheme.
One could certainly suggest that given the fact that the 1992 and 1993 audits were labeled byErnst &
Young as high-risk engagements, the audit firm should have considered erring on the conservative
side by mailing confirmations—at least to CBI’s major vendors. On the other hand, since payable
confirmations are seldom used and since the two procedures that Ernst & Young applied to CBI’s
accounts payable would yield, in most circumstances, sufficient appropriate evidence to support the
completeness assertion, most auditors would likelynot criticize Ernst & Young for not using payable
confirmations.
3. AS 2905 of the PCAOB’s auditing standards discusses auditors’ responsibilities regarding the
“subsequent discovery of facts” existing at the date of an audit report. That section of the
professional standards suggests that, as a general rule, when an auditor discovers information that
would have affected a previously issued audit report, the auditor has a responsibility to take
appropriate measures to ensure that the information is relayed to parties who are still relying on that
report. In this particular case, AS 2905 almost certainly required Ernst & Young to inform CBI’s
management, TCW officials, and other parties of the advances ruse orchestrated byCastello that was
not uncovered by Ernst & Young during the 1992 and 1993 audits. In my view, the obligation to](https://image.slidesharecdn.com/10909-250212142520-2d23bbb0/75/Get-Contemporary-Auditing-11th-Edition-Knapp-Solutions-Manual-Free-All-Chapters-Available-42-2048.jpg)
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Case 2.7 Bankrate, Inc. 143
Suggested Solutions to Case Questions
1. AS 4105, “Reviews of Interim Financial Information,” of the PCAOB’s auditing standards is the
authoritative source in this context. According to AS 4105.07, “The objective of a review of interim
financial information pursuant to this section is to provide the accountant [auditor] with a basis for
communicating whether he or she is aware of any material modifications that should be made to the
interim financial information for it to conform with generally accepted accounting principles.” This
paragraph goes on to clearly distinguish between the nature and scope of an interim review and a
full-scope financial audit. For example, the paragraph notes that a review “consists principally of
performing analytical procedures and making inquiries of persons responsible for financial and
accounting matters . . .”
The first reference to “fraud” can be found in AS 4105.11. That paragraph instructs an
accountant [auditor] performing a review “to update his or her knowledge of the entity’s business
and internal controls . . .” During such an update, the accountant should “specifically consider”
several factors including “(c) identified risks of material misstatement due to fraud . . .” While
inquiring of “members of management who have responsibilityfor financial and accounting matters”
an accountant performing a review should ask such individuals about “Their knowledge of anyfraud
or suspected fraud affecting the entity involving (1) management, (2) employees who have
significant roles in internal control, or (3) others where the fraud could have a material effect on the
financial statements. (AS 4105.18)
At any point during a review, if an accountant becomes aware of “information that leads him or
her to believe that the interim financial information may not be in conformity with generally
accepted accounting principles,” the interim review procedures must be “extended.” (AS 4015.22)
This requirement would mandate that an accountant pursue any apparent indications of financial
statement fraud having a material impact on the client’s accounting data.
So, must auditors [accountants] search for fraud while “reviewing” a public company’s quarterly
financial statements? I suppose the answer to that question depends on how you interpret the
relevant directives included in AS 4105. I believe the best answer is that “yes” auditors
[accountants] have a responsibility to search for fraud during such a review . . . but they don’t have
to search “very hard.” Granted, if they trip across indications of fraud during the performance of
review procedures, then they have a more onerous responsibility to determine whether fraud has
impacted the given financial statements.
The fraud risk factors that the Grant Thornton auditors should have considered during the review
of Bankrate’s quarterly financial statements include: (1) the preoccupation of DiMaria with reaching
or surpassing Bankrate’s consensus quarterly earnings forecasts (this “preoccupation” may not have
been readily apparent to the auditors); (2) the fact that the compensation of Bankrate’s top
executives, including DiMaria, was directly linked to the EBITDA reported by the company—see
footnote 7 in the case; (3) the suspicious nature of the $300,000 of revenue recorded bythe Insurance
division (the revenue was recorded after the close of the quarter and helped the company reach its
earnings target for that quarter); and (4) the fact that the company’s management team had an
incentive to fulfill the high expectations that had been established for Bankrate by financial analysts
when it re-emerged as a public company (fiscal 2012 was Bankrate’s first full fiscal year after going
public again).](https://image.slidesharecdn.com/10909-250212142520-2d23bbb0/75/Get-Contemporary-Auditing-11th-Edition-Knapp-Solutions-Manual-Free-All-Chapters-Available-47-2048.jpg)
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Case 2.7 Bankrate, Inc. 144
2. Generally, the SEC defines earnings management as a “material and intentional
misrepresentation” of a given entity’s reported operating results. Because that definition could be
used interchangeably with “fraudulent accounting,” the two expressions are effectively equivalent to
the SEC. Other parties, however, typically define earnings management less ominously than
fraudulent accounting. For example, the online business encyclopedia, Investopedia, defines
earnings management as “The use of accounting techniques to produce financial reports that may
paint an overly positive picture of a company’s business activities and financial position.” This latter
definition is less severe than the SEC’s definition because it doesn’t include a reference to
materiality. Although the Investopedia definition of earnings management appears to be more
widely accepted, there is no doubt that the SEC’s definition of earnings management should “carry
more weight” among corporate executives, auditors, etc. given the critical oversight role that the
federal agency plays in the accounting and financial reporting domain.
Under what conditions is earnings management acceptable? If we define that term as “painting
an overly positive picture” of an entity’s operating results, one set of circumstances that could qualify
as “acceptable” earnings management is when a company defers discretionary expenditures near the
end of a financial reporting period to reach a target earnings number. Then again, the deferral of
many, if not most, discretionary expenditures, such as maintenance costs on production line
equipment, is not in the best interests of a given entity over the long term, meaning that company
management may be violating their fiduciary responsibility to stockholders and other parties when
they do so. Another possible case when earnings management is “acceptable” is when there is
considerable “wiggle room” in a given accounting or financial reporting rule. That is, the given rule
is quite subjective and a company’s executives “take advantage” of that subjectivity by interpreting
the rule in the most beneficial way for their entity. Although many parties may suggest this type of
earnings management is “acceptable,” I believe the majority of professional accountants would
disagree.
3. The best strategy for answering this question is to first define the phrase “materiality.”
Ironically, the SEC does not have its own “materiality standard.” Instead, the SEC invokes the
following definition of materiality applied by the U.S. Supreme Court: “Information is material if
there is a substantial likelihood that a reasonable investor would consider the information in making
an investment decision or if the information would significantly alter the total mix of available
information.”
The FASB’s definition of materiality can be found in Statement of Financial Accounting
Concepts No.8: “Information is material if omitting it or misstating it could influence decisions that
users make on the basis of the financial information of a specific reporting entity. In other words,
materiality is an entity-specific aspect of relevance based on the nature or magnitude or both of the
items to which the information relates in the context of an individual entity’s financial report.”
[Note: At press time, the FASB was considering a proposal to adopt the Supreme Court/SEC
definition of materiality.]
Both AS 2105, “Consideration of Materiality in Planning and Performing an Audit,” of the
PCAOB auditing standards and the relevant AICPA Professional Standards effectively embrace the
U.S. Supreme Court/SEC definition of materiality. (The relevant discussion of materiality in the
AICPA Professional Standards can be found at AU-C Section 320.02.) The AICPA Professional](https://image.slidesharecdn.com/10909-250212142520-2d23bbb0/75/Get-Contemporary-Auditing-11th-Edition-Knapp-Solutions-Manual-Free-All-Chapters-Available-48-2048.jpg)
![© 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part.
Case 2.7 Bankrate, Inc. 145
Standards, however, have also introduced the concept of “performance materiality” to the
professional auditing literature. That term is defined as follows:
“The amount or amounts set by the auditor at less than materiality for the financial statements as
a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected
and undetected misstatements exceeds materiality for the financial statements as a whole. If
applicable, performance materiality also refers to the amount or amounts set by the auditor at
less than the materiality level or levels for particular classes of transactions, account balances, or
disclosures. Performance materiality is to be distinguished from tolerable misstatement.”
[AU-C 320.09]
In turn, AU-C 530.05 defines “tolerable misstatement as follows:
“A monetary amount set by the auditor in respect of which the auditor seeks to obtain an
appropriate level of assurance that the monetary amount set bythe auditor is not exceeded bythe
actual misstatement in the population.”
In summary then, from an accounting and financial reporting standpoint “materiality” refers to
an amount or item or set of circumstances that would “make a difference” in the minds of a
reasonably informed user of financial statements. The auditing domain embraces this general
definition or concept but is more concerned with “applying” the materiality construct in the context
of auditing a set of financial statements.
To finally address Question #3, we have to identify the factors that determine whether a specific
financial statement amount is “material.” There are two general sets of such factors: quantitative
and qualitative factors. (See paragraph 17 of AS 2810, “Evaluating Audit Results.”) Quantitatively
speaking, accountants and auditors typically identify “material” items in reference to some given
financial statement benchmark such as net income or change in net income from one period to the
next. The old “5 percent rule” is probably the most widely used (if not abused) quantitative
materiality standard, that is, an amount is material if it would change the given base or benchmark
amount by 5 percent or more. For example, Bankrate’s net income for the second quarter of 2012
was overstated by approximately 5 percent. The SEC ruled that overstatement was material.
DiMaria, financial analysts tracking the company’s stock, and the SEC apparentlyall agreed that
the most relevant financial benchmarks for the company were adjusted EBITDA and adjusted EPS.
Understand that although Bankrate’s adjusted EPS was misstated by a little more than 5 percent by
the company’s accounting gimmicks ($.18 / $.17), the corresponding misstatement of adjusted
EBITDA was less than 4 percent ($37.5 million / $36.2 million). This is where the issue of
“qualitative” materiality came into play. The SEC apparently believed that when it came to an
overall global decision of whether Bankrate’s EBITDA was materially misstated due to its fraudulent
accounting, it was really a question of whether or not the fraudulent accounting decisions allowed the
company to reach its earnings target for the given quarter. In other words, in this important context,
materiality determination became a qualitative or “nominal” (yes/no) measurement. More generally,
a misstatement due to fraud has a lower qualitative materiality threshold than a misstatement due to
some unintentional cause.](https://image.slidesharecdn.com/10909-250212142520-2d23bbb0/75/Get-Contemporary-Auditing-11th-Edition-Knapp-Solutions-Manual-Free-All-Chapters-Available-49-2048.jpg)
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- 5. Case 2.1 JackGreenberg, Inc. 102 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Thornton, the accounting firm threatened to resign. Shortlythereafter, Fred’s fraudulent scheme was uncovered. Within six months, JGI was bankrupt and Grant Thornton was facing a series of allegations filed against it by the company’s bankruptcy trustee. Among these allegations were charges that the accounting firm had made numerous errors and oversights in auditing JGI’s Prepaid Inventory account.
- 6. Case 2.1 JackGreenberg, Inc. 103 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Jack Greenberg, Inc.--Key Facts 1. Emanuel and Fred Greenberg became equal partners in Jack Greenberg, Inc., (JGI) following their father’s death; Emanuel became the company’s president, while Fred assumed the title of vice-president. 2. JGI was a Philadelphia-based wholesaler of various food products whose largest product line was imported meat products. 3. Similar to many family-owned businesses, JGI had historically not placed a heavy emphasis on internal control issues. 4. In 1986, the Greenberg brothers hired Steve Cohn, a former Coopers & Lybrand auditor and inventory specialist, to serve as JGI’s controller. 5. Cohn implemented a wide range of improvements in JGI’s accounting and control systems; these improvements included “computerizing” the company’s major accounting modules with the exception of prepaid inventory—Prepaid Inventory was JGI’s largest and most important account. 6. Since before his father’s death, Fred Greenberg had been responsible for all purchasing, accounting, control, and business decisions involving the company’s prepaid inventory. 7. Fred stubbornly resisted Cohn’s repeated attempts to modernize the accounting and control decisions for prepaid inventory. 8. Fred refused to cooperate with Cohn because he had been manipulating JGI’s operating results for years by systematically overstating the large Prepaid Inventory account. 9. When Grant Thornton, JGI’s independent auditor, threatened to resign if Fred did not make certain improvements in the prepaid inventory accounting module, Fred’s scheme was discovered. 10. Grant Thornton was ultimately sued by JGI’s bankruptcy trustee; the trustee alleged that the accounting firm had made critical mistakes in its annual audits of JGI, including relying almost exclusively on internally-prepared documents to corroborate the company’s prepaid inventory.
- 7. Case 2.1 JackGreenberg, Inc. 104 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Instructional Objectives 1. To introduce students to the key audit objectives for inventory. 2. To demonstrate the importance of auditors obtaining a thorough understanding of a client’s accounting and internal control systems. 3. To examine the competence of audit evidence yielded by internally-prepared versus externally- prepared client documents. 4. To identify audit risk issues common to family-owned businesses. 5. To demonstrate the importance of auditors fully investigating suspicious circumstances they discover in a client’s accounting and control systems and business environment. Suggestions for Use One of my most important objectives in teaching an auditing course, particularlyan introductory auditing course, is to convey to students the critical importance of auditors maintaining a healthy degree of skepticism on every engagement. That trait or attribute should prompt auditors to thoroughly investigate and document suspicious circumstances that they encounter during an audit. In this case, the auditors were faced with a situation in which a client executive stubbornlyrefused to adopt much needed improvements in an accounting module that he controlled. In hindsight, most of us would view such a scenario as a “where there’s smoke, there’s likely fire” situation. Since the litigation in this case was resolved privately, the case does not have a clear-cut “outcome.” As a result, you might divide your students into teams to “litigate” the case themselves. Identify three groups of students: one set of students who will argue the point that the auditors in this case were guilty of some degree of malfeasance, another set of students who will act as the auditors’ defense counsel, and a third set of students (the remainder of your class?) who will serve as the “jury.” Suggested Solutions to Case Questions 1. AS 1101.04, “Audit Risk,” of the PCAOB auditing standards defines audit risk as the “risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated, i.e., the financial statements are not presented fairly in conformity with the applicable financial reporting framework.” “Inherent risk,” “control risk,” and “detection” risk are the three individual components of audit risk, according to AS 1101. Following are brief descriptions of these components that were also taken that standard: •Inherent risk: refers to the susceptibility of an assertion to a misstatement, due to error or fraud, that could be material, individually or in combination with other misstatements, before consideration of any related controls.
- 8. Case 2.1 JackGreenberg, Inc. 105 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. •Control risk: the risk that a misstatement due to error or fraud that could occur in an assertion and that could be material, individually or in combination with other misstatements, will not be prevented or detected on a timely basis by the company’s internal control. Control risk is a function of the effectiveness of the design and operation of internal control. •Detection risk: the risk that the procedures performed by the auditor will not detect a misstatement that exists and that could be material, individually or in combination with other misstatements. Detection risk is affected by (1) the effectiveness of the substantive procedures and (2) their application by the auditor, i.e., whether the procedures were performed with due professional care. According to the AICPA Professional Standards, the phrase “audit risk” refers to the likelihood that “the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated” (AU-C 200.14). “Inherent risk,” “control risk,” and “detection” risk are also the three individual components of audit risk within the AICPA Professional Standards. Following are brief descriptions of these components that were taken from AU-C 200.14: •Inherent risk: the susceptibility of an assertion about a class of transaction, account balance, or disclosure to a misstatement that could be material, either individuallyor when aggregated with other misstatements, before consideration of any related controls. •Control risk: the risk that a misstatement that could occur in an assertion about a class of transaction, account balance, or disclosure and that could be material, either individually or when aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely basis by the entity’s internal controls. •Detection risk: the risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will not detect a misstatement that exists and that could be material, either individually or when aggregated with other misstatements. (Note: Both AS 1101 and the AICPA Professional Standards point out that the product of inherent risk and control risk is commonly referred to as the “risk of material misstatement.) Listed next are some examples of audit risk factors that are not unique to family-owned businesses but likely common to them. Inherent risk: •I would suggest that family-owned businesses may be more inclined to petty infighting and other interpersonal “issues” than businesses overseen by professional management teams. Such conflict may cause family-owned businesses to be more susceptible to intentional financial statement misrepresentations. •The undeniable impact of nepotism on most family-owned businesses may result in key accounting and other positions being filled by individuals who do not have the requisite skills for those positions. •Many family-owned businesses are small and financially-strapped. Such businesses are more inclined to window-dress their financial statements to impress bankers, potential suppliers, and other third parties.
- 9. Case 2.1 JackGreenberg, Inc. 106 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Control risk: •The potential for “petty infighting” and other interpersonal problems within family-owned businesses may result in their internal control policies and procedures being intentionally subverted by malcontents. •Likewise, nepotism tendencies in small businesses can affect the control risk as well as the inherent risk posed by these businesses. A business that has a less than competent controller or accounts receivable bookkeeper, for that matter, is more likely to have control “problems.” •The limited resources of many family-owned businesses means that they are less likely than other entities to provide for a comprehensive set of checks and balances in their accounting and control systems. For example, proper segregation of duties may not be possible in these businesses. •I would suggest that it may be more difficult for family-owned businesses to establish a proper control environment. Family relationships, by definition, are typically built on trust, while business relationships require a certain degree of skepticism. A family business may find it difficult to establish formal policies and procedures that require certain family members to “look over the shoulder” and otherwise monitor the work of other family members. Detection risk: •The relatively small size of many family-owned businesses likely requires them to bargain with their auditors to obtain an annual audit at the lowest cost possible. Such bargaining mayresult in auditors “cutting corners” to complete the audit. •Independent auditors often serve as informal business advisors for small, family-owned audit clients. These dual roles may interfere with the ability of auditors to objectively evaluate such a client’s financial statements. How should auditors address these risk factors? Generally, by varying the nature, extent, and timing of their audit tests. For example, if a client does not have sufficient segregation of keyduties, then the audit team will have to take this factor into consideration in planning the annual audit. In the latter circumstance, one strategy would be to perform a “balance sheet” audit that places little emphasis or reliance on the client’s internal controls. (Note: Modifying the nature, extent, and timing of audit tests may not be a sufficient or proper response to the potential detection risk factors identified above. Since each of those risk factors involves an auditor independence issue, the only possible response to those factors may simply be asking the given client to retain another audit firm.) Final note: Recall that the federal judge in this case suggested that “subjecting the auditors to potential liability” is an appropriate strategy for society to use to help ensure that family-owned businesses prepare reliable financial statements for the benefit of third-party financial statement users. You may want to have your students consider how this attitude on the part of judges affects audit firms and the audits that they design and perform for such clients. In my view, this factor is not a component of “audit risk” but clearly poses a significant economic or “business” risk for audit firms. 2. The primary audit objectives for a client’s inventory are typically corroborating the “existence” and “valuation” assertions (related to account balances). For the Prepaid Inventory account, Grant Thornton’s primary audit objective likely centered on the existence assertion. That is, did the several
- 10. Case 2.1 JackGreenberg, Inc. 107 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. million dollars of inventory included in the year-balance of that account actually exist? Inextricably related to this assertion was the issue of whether JGI management had achieved a proper “cutoff” of the prepaid inventory transactions at the end of each fiscal year. If management failed to ensure that prepaid inventory receipts were properly processed near the end of the year, then certain prepaid inventory shipments might be included in the year-end balances of both Prepaid Inventory and Merchandise Inventory. For the Merchandise Inventory account, both the existence and valuation assertions were likely key concerns of Grant Thornton. Since JGI’s inventory involved perishable products, the Grant Thornton auditors certainly had to pay particularly close attention to the condition of that inventory while observing the year-end counting of the warehouse. 3. The controversial issue in this context is whether Grant Thornton was justified in relying on the delivery receipts given the “segregation of duties” that existed between JGI’s receiving function and accounting function for prepaid inventory. In one sense, Grant Thornton was correct in maintaining that there was “segregation of duties” between the preparation of the delivery receipts and the subsequent accounting treatment applied to those receipts. The warehouse manager prepared the delivery receipts independently of Fred Greenberg, who then processed the delivery receipts for accounting purposes. However, was this segregation of duties sufficient or “adequate”? In fact, Fred Greenberg had the ability to completely override (and did override) that control. You may want to reinforce to your students that the validity of the delivery receipts as audit evidence was a central issue in this case. Clearly, the judge who presided over the case was dismayed by Grant Thornton’s decision to place heavy reliance on the deliveryreceipts in deciding to “sign off” on the prepaid inventory balance each year. The problem with practically any internally- generated document, such as the delivery receipts, is that they are susceptible to being subverted by two or more client employees who collude with each other or by one self-interested executive who has the ability to override the client’s internal controls. On the other hand, externally-prepared documents (such as contracts or external purchase orders) provide stronger audit evidence since they are less susceptible to being altered or improperly prepared. 4. The phrase “walk-through audit test” refers to the selection of a small number of client transactions and then tracking those transactions through the standard steps or procedures that the client uses in processing such transactions. The primary purpose of these tests is to gain a better understanding of a client’s accounting and control system for specific types of transactions. Likewise, walk-through tests can be used by auditors to confirm the accuracy of flowchart and/or narrative depictions of a given transaction cycle within a client’s accounting and control system. (Note: as pointed out by the expert witness retained by JGI’s bankruptcy trustee, if Grant Thornton had performed a walk-through audit test for JGI’s prepaid inventory transactions, the audit firm almost certainly would have discovered that the all-important Form 9540-1 documents were available for internal control and independent audit purposes.) PCAOB Auditing Standard No. 2, “An Audit of Internal Control Over Financial Reporting Performed in Conjunction with an Audit of Financial Statements,” mandated that auditors of SEC registrants perform a walk-through audit test for “each major class of transactions”—see paragraph 79 of that standard. However, that standard was subsequently superseded by PCAOB Auditing Standard No. 5, “An Audit of Internal Control Over Financial Reporting That is Integrated with An Audit of Financial Statements”—which is now integrated into AS 2201. AS 2201 does not require
- 11. Case 2.1 JackGreenberg, Inc. 108 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. walk-throughs. The AICPA Professional Standards have never mandated the performance of walk- throughs. 5. As a point of information, I have found that students typicallyenjoythis type of exercise, namely, identifying audit procedures that might have resulted in the discovery of a fraudulent scheme. In fact, what students enjoy the most in this context is “shooting holes” in suggestions made by their colleagues. “That wouldn’t have worked because . . .,” “That would have been too costly,” or “How could you expect them to think of that?” are the types of statements that are often prompted when students begin debating their choices. Of course, such debates can provide students with important insights that they would not have obtained otherwise. •During the interim tests of controls each year, the auditors could have collected copies of a sample of delivery receipts. Then, the auditors could have traced these delivery receipts into the prepaid inventory accounting records to determine whether shipments of imported meat products were being recorded on a timely basis in those records. For example, the auditors could have examined the prepaid inventory log to determine when the given shipments were deleted from that record. Likewise, the auditors could have tracked the shipments linked to the sample delivery receipts into the relevant reclassification entry prepared by Steve Cohn (that transferred the given inventory items from Prepaid Inventory to Merchandise Inventory) to determine if this entry had been made on a timely basis. (Granted, the effectiveness of this audit test would likely have been undermined by Fred’s fraudulent conduct.) •Similar to the prior suggestion, the auditors could have obtained copies of the freight documents (bills of lading, etc.) for a sample of prepaid inventory shipments. Then, the auditors could have tracked the given shipments into the prepaid inventory records to determine whether those shipments had been transferred on a timely basis from the Prepaid Inventory account to the Merchandise Inventory account. (There would have been a lower risk of Fred’s misconduct undercutting the intent of this audit test.) •During the observation of the physical inventory, the auditors might have been able to collect identifying information for certain imported meat products and then, later in the audit, traced that information back to the prepaid inventory log to determine whether the given items had been reclassified out of Prepaid Inventory on a timely basis. This procedure may have been particularly feasible for certain seasonal and low volume products that JGI purchased for sale only during the year-end holiday season. •In retrospect, it seems that extensive analytical tests of JGI’s financial data might have revealed implausible relationships involving the company’s inventory, cost of goods sold, accounts payable, and related accounts. Of course, the judge who presided over this case suggested that the auditors should have been alerted to the possibility that something was awry by the dramatic increase in prepaid inventory relative to sales. 6. An audit firm (of either an SEC registrant or another type of entity) does not have a responsibility to “insist” that client management correct internal control deficiencies. However, the failure of client executives to do so reflects poorly on their overall control consciousness, if not integrity. Similar to what happened in this case, an audit firm may have to consider resigning from an engagement if client management refuses to address significant internal control problems. (Of course, in some
- 12. Case 2.1 JackGreenberg, Inc. 109 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. circumstances, client management may refuse to address internal control deficiencies because it would not be cost-effective to do so.) Note: AS 2201, “An Audit of Internal Control Over Financial Reporting That is Integrated with An Audit of Financial Statements,” provides guidance to auditors charged with auditing a public client’s financial statements while at the same time auditing the client’s internal control over financial reporting. AS 2201.78 mandates that auditors report all “material weaknesses” in writing to client management and to the audit committee. Likewise, auditors must report to the client’s audit committee all “significant deficiencies” in internal controls that they discover (AS 2201.80). But, again, AS 2201 does not require auditors to “insist” that their clients eliminate those material weaknesses or significant deficiencies. Final note: in the AICPA Professional Standards, the reporting responsibilities of auditors for internal control related matters are discussed in AU-Section 265, “Communicating Internal Control Related Matters Identified in an Audit.”
- 13. Case 2.2 GoldenBear Golf, Inc. 109 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CASE 2.2 GOLDEN BEAR GOLF, INC. Synopsis According to one sports announcer, Jack Nicklaus became “a legend in his spare time.” Nicklaus still ranks as the best golfer of all time in the minds of most pasture pool aficionados— granted, he may lose that title soon if Tiger Woods conquers his health problems and resumes his onslaught on Jack’s golfing records. Despite his prowess on the golf course, Nicklaus has had an up and down career in the business world. In 1996, Nicklaus spun off a division of his privately-owned company to create Golden Bear Golf, Inc., a public company whose primary line of business was the construction of golf courses. Almost immediately, Golden Bear began creating headaches for Nicklaus. The new company was very successful in obtaining contracts to build golf courses. However, because the construction costs for these projects were underestimated, Golden Bear soon found itself facing huge operating losses. Rather than admit their mistakes, the executives who negotiated the construction contracts intentionally inflated the revenues and gross profits for those projects by misapplying the percentage-of-completion accounting method. This case focuses principally on the audits of Golden Bear that were performed by Arthur Andersen & Co. An SEC investigation of the Golden Bear debacle identified numerous “audit failures” allegedly made by the company’s auditors. In particular, the Andersen auditors naively relied on feeble explanations provided to them by client personnel for a series of suspicious transactions and circumstances that they uncovered.
- 14. Case 2.2 GoldenBear Golf, Inc. 110 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Golden Bear Golf, Inc.--Key Facts 1. Jack Nicklaus has had a long and incredibly successful career as a professional golfer, which was capped off by him being named the Player of the Twentieth Century. 2. Like many professional athletes, Nicklaus became involved in a wide range of business interests related to his sport. 3. In the mid-1980s, Nicklaus’s private company, Golden Bear International (GBI), was on the verge of bankruptcy when he stepped in and named himself CEO; within a few years, the company had returned to a profitable condition. 4. In 1996, Nicklaus decided to “spin off” a part of GBI to create a publicly owned company, Golden Bear Golf, Inc., whose primary line of business would be the construction of golf courses. 5. Paragon International, the Golden Bear subsidiary responsible for the company’s golf course construction business, quickly signed more than one dozen contracts to build golf courses. 6. Paragon incurred large losses on many of the golf course construction projects because the subsidiary’s management team underestimated the cost of completing those projects. 7. Rather than admit their mistakes, Paragon’s top executives chose to misrepresent the subsidiary’s operating results by misapplying the percentage-of-completion accounting method. 8. In 1998, the fraudulent scheme was discovered, which resulted in a restatement of Golden Bear’s financial statements, a class-action lawsuit filed bythe company’s stockholders, and SEC sanctions imposed on several parties, including Arthur Andersen, Golden Bear’s audit firm. 9. The SEC charged the Andersen auditors with committing several “audit failures,” primary among them was relying on oral representations by client management for several suspicious transactions and events discovered during the Golden Bear audits. 10. The Andersen partner who served as Golden Bear’s audit engagement partner was suspended from practicing before the SEC for one year.
- 15. Case 2.2 GoldenBear Golf, Inc. 111 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Instructional Objectives 1. To demonstrate the need for auditors to have an appropriate level of skepticism regarding the financial statements of all audit clients, including prominent or high-profile audit clients. 2. To demonstrate that management representations is a weak form of audit evidence. 3. To examine audit risks posed by the percentage-of-completion accounting method. 4. To illustrate the need for auditors to thoroughly investigate suspicious transactions and events that they discover during the course of an engagement. 5. To examine the meaning of the phrase “audit failure.” Suggestions for Use Many, if not most, of your students will be very familiar with Jack Nicklaus and his sterling professional golf career, which should heighten their interest in this case. One of the most important learning points in this case is that auditors must always retain their professional skepticism. Encourage your students to place themselves in Michael Sullivan’s position. Sullivan had just acquired a new audit client, the major stockholder of which was one of the true superstars of the sports world. I can easily understand that an audit engagement partner and his or her subordinates might be inclined to grant that client the “benefit of the doubt” regarding any major audit issues or problems that arise. Nevertheless, even in such circumstances students need to recognize the importance of auditors’ maintaining an appropriate degree of professional skepticism. You may want to point out to your students that because of the subjective nature of the percentage-of-completion accounting method, it is easily one of the most abused accounting methods. Over the years, there have been numerous “audit failures” stemming from misuse or misapplication of this accounting method. Suggested Solutions to Case Questions 1. Notes: I have not attempted to identify every management assertion relevant to Paragon’s construction projects. Instead, this suggested solution lists what I believe were several key management assertions for those projects. When auditing long-term construction projects for which the percentage-of-completion accounting method is being used, the critical audit issue is whether the client’s estimated stages of completion for its projects are reliable. As a result, most of the following audit issues that I raise regarding Paragon’s projects relate directly or indirectly to that issue. In this suggested solution, I apply the set of assertions included in AU-C Section 315.A128 of the AICPA Professional Standards. Recall that rather than 13 assertions spread across three categories (classes of transactions and events, account balances, and presentation and disclosure), AS 1105, “Audit Evidence,” of the PCAOB’s auditing standards identifies only five types of financial statement assertions, namely, existence or occurrence, completeness, valuation or allocation, rights and
- 16. Case 2.2 GoldenBear Golf, Inc. 112 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. obligations, and presentation and disclosure (AS 1105.11). (Of course, these latter assertions were the “official” assertions recognized by the AICPA at the time this case transpired. Recognize also that the PCAOB permits auditors to apply the AICPA’s “assertions map” in planning and performing audits of public companies. That is, audit firms of SEC registrants are free to choose which of the two mappings of management assertions in the professional auditing standards that theywill apply.) •Existence/occurrence: According to AU-C 315.A128, “existence” is an “account balance-related” assertion that refers to whether specific assets or liabilities exist at a given date. “Occurrence,” on the other hand, is a “transaction-related” assertion that refers to whether a given transaction or class of transactions actually took place. On the Golden Bear audits, these two assertions were intertwined. The existence assertion pertained to the unbilled receivables, while the occurrence assertion related to the corresponding revenue linked to those receivables, each of which Paragon booked as a result of overstating the stages of completion of its construction projects. To investigate whether those unbilled receivables actually existed and whether the related revenue transactions had actually occurred, the Andersen auditors could have made site visitations to the construction projects. Andersen could also have contacted the given owners of the projects to obtain their opinion on the stages of completion of the projects—if the stages of completion were overstated, some portion of the given unbilled receivables did not “exist” while the corresponding revenues had not “occurred.” (Of course, this procedure was carried out for one of the projects by subordinate members of the Andersen audit team.) The auditors could have also discussed the stages of completion directlywith the onsite project managers and/or the projects’ architects. •Valuation (and allocation): This account balance assertion relates to whether “assets, liabilities, and equity interests are included in the financial statements at appropriate amounts” and whether “any resulting valuation or allocation adjustments are appropriately recorded” (AU-C 315.A128). This assertion was relevant to the unbilled receivables that Paragon recorded on its construction projects and was obviously closely linked to the existence assertion for those receivables. Again, any audit procedure that was intended to confirm the reported stages of completion of Paragon’s construction projects would have been relevant to this assertion. Michael Sullivan attempted to address this assertion by requiring the preparation of the comparative schedules that tracked the revenue recorded on Paragon’s projects under the earned value method and the revenue that would have been recorded if Paragon had continued to apply the cost-to-cost method. Of course, client management used the $4 million ruse involving the uninvoiced construction costs to make it appear that the two accounting methods produced effectively the same revenues/unbilled receivables. •Occurrence: The occurrence assertion was extremely relevant to the $4 million of uninvoiced construction costs that Paragon recorded as an adjusting entry at the end of fiscal 1997. The uninvoiced construction costs allowed Paragon to justify booking a large amount of revenue on its construction projects. To test this assertion, the Andersen auditors could have attempted to confirm some of the individual amounts included in the $4 million figure with Paragon’s vendors. •Classification and understandability: This presentation and disclosure-related assertion was relevant to the change that Paragon made from the cost-to-cost to the earned value approach to applying the percentage-of-completion accounting method. By not disclosing the change that was made in
- 17. Case 2.2 GoldenBear Golf, Inc. 113 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. applying the percentage-of-completion accounting method, Golden Bear and Paragon’s management were making an assertion to the effect that the change was not required to be disclosed to financial statement users. This assertion could have been tested by researching the appropriate professional standards and/or by referring the matter to consultants in Andersen’s national headquarters office. •Completeness: Although not addressed explicitly in the case, the SEC also criticized Andersen for not attempting to determine whether Paragon’s total estimated costs for its individual construction projects were reasonable, that is, “complete”—understating a project’s total estimated cost allowed Golden Bear to “frontload” the revenue recorded for that project. To corroborate the completeness assertion for the estimated total construction costs, Andersen could have discussed this matter with architects and/or design engineers for a sample of the projects. Alternatively, Andersen could have reviewed cost estimates for comparable projects being completed by other companies and compared those estimates with the ones developed for Paragon’s projects. 2. The term “audit failure” is not expressly defined in the professional literature. Apparently, the SEC has never defined that term either. One seemingly reasonable way to define “audit failure” would be “the failure of an auditor to comply with one or more professional auditing standards.” A more general and legal definition of “audit failure” would be “the failure to do what a prudent practitioner would have done in similar circumstances.” The latter principle is commonlyreferred to as the “prudent practitioner concept” and is widely applied across professional roles to determine whether a given practicing professional has behaved negligently. “No,” Sullivan alone was clearly not the only individual responsible for ensuring the integrity of the Golden Bear audits. Sullivan’s subordinates, particularly the audit manager and audit senior assigned to the engagement, had a responsibility to ensure that all important issues arising on those audits were properly addressed and resolved. This latter responsibility included directlychallenging any decisions made by Sullivan that those subordinates believed were inappropriate. Audit practitioners, including audit partners, are not infallible and must often rely on their associates and subordinates to question important “judgment calls” that are made during the course of an engagement. The “concurring” or “review” partner assigned to the Golden Bear audits also had a responsibility to review the Golden Bear audit plan and audit workpapers and investigate any questionable decisions apparently made during the course of the Golden Bear audits. Finally, Golden Bear’s management personnel, including Paragon’s executives, had a responsibility to cooperate fully with Sullivan to ensure that a proper audit opinion was issued on Golden Bear’s periodic financial statements. 3. Most likely, Andersen defined a “high-risk” audit engagement as one on which there was higher than normal risk of intentional or unintentional misrepresentations in the given client’s financial statements. I would suggest that the ultimate responsibility of an audit team is the same on both a “high-risk” and a “normal risk” audit engagement, namely, to collect sufficient appropriate evidence to arrive at an opinion on the given client’s financial statements. However, the nature of the operational responsibilities facing an audit team on the two types of engagements are clearly different. For example, when a disproportionate number of “fraud risk factors” are present, the planning of an audit will be affected. Likewise, in the latter situation, the nature, extent, and timing of audit procedures will likely be affected. For example, more extensive auditing tests are typically necessary when numerous fraud risk factors are present.
- 18. Case 2.2 GoldenBear Golf, Inc. 114 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4. “Yes,” auditors do have a responsibility to refer to any relevant AICPA Audit and Accounting Guide when planning and carrying out an audit based upon the AICPA Professional Standards. These guides do not replace the authoritative guidance included in AICPA Professional Standards but rather include recommendations on how to apply those standards in specific circumstances. What about audits of public companies that are guided by the PCAOB’s auditing standards? After considerable research, I could not find any reference to the AICPA Audit and Accounting Guides in the PCAOB’s auditing standards. As a result, those guides, apparently, are not considered authoritative literature vis-à-vis audits of public companies. 5. The following footnote was included in Accounting and Auditing Enforcement Release No. 1676, which was a primary source for the development of this case. “Regardless of whether the adoption of the ‘earned value’ method was considered a change in accounting principle or a change in accounting estimate, disclosure by the company in its second quarter 1997 interim financial statements and its 1997 annual financial statements was required to comply with GAAP.” In the text of the enforcement release, the SEC referred to the switch from the cost-to-cost method to the earned value method as a change in “accounting methodology,” which seems to suggest that the SEC was not certain how to classify the change. However, APB Opinion No. 20, “Accounting Changes,” which was in effect during the relevant time frame of this case, and SFAS No. 154, “Accounting Changes and Error Corrections,” the FASB standard that replaced APB No. 20, point out that the phrase “accounting principle” refers to accounting principles or practices and “to the methods of applying them.” This statement implies, to me at least, that Paragon’s switch from the cost-to-cost approach to the earned value approach of applying the percentage-of-completion accounting method was a “change in accounting principle.” Under SFAS No. 154, a change in accounting principle “shall be reported by retrospective application unless it is impracticable to determine either the cumulative effect or the period-specific effects of the change.” [Note: SFAS No. 154 is now integrated into Topic 250, “Accounting Changes and Error Corrections,” in the FASB Accounting Standards Codification.] This is an important difference with the prior standard, APB No. 20, that required a “cumulative effect of a change in accounting principle” to be reported by the given entity in its income statement for the period in which the change was made. SFAS No. 154 requires that a change in accounting estimate “shall be accounted for in the (a) period of change if the change affects that period only or (b) the period of change and future periods if the change affects both.” In terms of financial statement disclosure, SFAS No. 154 mandates that the “nature of and justification for the change in accounting principle shall be disclosed in the financial statements of the period in which the change is made.” Regarding changes in accounting estimates, this standard notes that, “When an entity makes a change in accounting estimate that affects several future periods (such as a change in service lives of depreciable assets), it shall disclose the effect on . . . net income, and related per-share amounts of the current period.”
- 19. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.3 Take-Two Interactive Software, Inc. 115 CASE 2.3 TAKE-TWO INTERACTIVE SOFTWARE, INC. Synopsis Grand Theft Auto is the sixth best-selling video game “franchise” of all time and easily ranks among the most controversial as well. The game’s “adult” content has resulted in caustic and unrelenting criticism by prominent politicians, public service organizations, and major media outlets. Despite that criticism, Grand Theft Auto has been hugely profitable for Take-Two Interactive Software, Inc., its maker and distributor. Take-Two was founded in 1993 by 21-year-old Ryan Brant, the son of a billionaire businessman. An SEC investigation of Take-Two’s financial statements resulted in the companybeing forced to issue restated financial statements twice in two years shortly after the turn of the century. Then, just a few years later, Take-Two was caught up in the huge “options backdating” scandal and forced to restate its financial statements a third time. This case focuses on the underlying cause of the initial restatement, which was primarily a series of fraudulent sales transactions booked by the companyin 2000 and 2001. Take-Two executives recorded those sham sales transactions to ensure that the company met or surpassed its consensus quarterly earnings forecasts established by Wall Street analysts. Take-Two’s longtime audit firm, PwC, was also caught up in the company’s financial reporting scandal. One of many SEC enforcement releases issued regarding that scandal focused on the alleged misconduct of Robert Fish, the PwC partner who had supervised the 1994 through 2001 Take-Two audits. In particular, the SEC criticized the audit tests applied to Take-Two’s domestic receivables by Fish and his subordinates. In addition, the PwC auditors were chastised by the SEC for their alleged failure to properly audit Take-Two’s reserve for sales returns. An interesting feature of this case is the close relationship between Robert Fish and Ryan Brant. In addition to serving as the Take-Two audit engagement partner, Fish was apparently the much younger Brant’s most trusted business advisor. In fact, in an interview with a business publication Fish suggested that he and Brant effectively had a father-son type relationship. Also interesting is the fact that PwC sharply discounted the professional fees that it charged Take-Two. Those discounted fees almost certainly helped to cement PwC’s relationship with the rapidly growing company.
- 20. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 116 Case 2.3 Take-Two Interactive Software, Inc. Take-Two Interactive Software, Inc.--Key Facts 1. In 1993, when he was only 21-years-old, Ryan Brant organized Take-Two Interactive Software, a company that produced and distributed video games. 2. Robert Fish, a PwC audit partner, supervised the annual audits of Take-Two from 1994-2001; Fish also served as one of Brant’s principal business advisors and, when interviewed, suggested that he had a father-son type relationship with the much younger Brant. 3. While Take-Two was in a developmental stage, PwC sharply discounted the professional fees that it charged the company. 4. Brant took his company public in 1997 to obtain the funding necessary to fuel Take-Two’s growth-by-acquisition strategy. 5. A video game produced by a company acquired by Take-Two would become Grand Theft Auto, one of the most controversial but best-selling video games of all time. 6. An SEC investigation revealed that Take-Two executives recorded a large volume of bogus sales transactions during 2000 and 2001 to ensure that the company achieved its consensus earnings forecasts each quarterly reporting period. 7. Take-Two would ultimately be required to restate its financial statements three times over a five-year period to correct material misrepresentations resulting from the bogus sales transactions and improper “backdating” of stock option grants. 8. The SEC issued an enforcement release that criticized PwC’s 2000 Take-Two audit; the enforcement release focused on improper decisions allegedly made by Robert Fish during that engagement. 9. Fish identified “revenue recognition” and “accounts receivable reserves” as areas of “higher risk” for the 2000 audit, according to the SEC, but failed to properly respond to those high-risk areas during the engagement. 10. The “alternative audit procedures” that PwC applied after realizing an extremely low response rate on its accounts receivable confirmation requests were flawed and inadequate. 11. PwC also failed to properly audit Take-Two’s reserve for sales returns, which may have prevented the firm from discovering the bogus sales recorded by the company.
- 21. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.3 Take-Two Interactive Software, Inc. 117 12. The SEC sanctioned Fish, Brant, and three other Take-Two executives; Brant resigned from Take-Two during the SEC’s investigation of the company’s scheme to backdate its stock option grants, a scheme that he had masterminded. Instructional Objectives 1. To provide students with an opportunity to use analytical procedures as an audit planning tool. 2. To examine the nature of, and key audit objectives associated with, accounts receivable confirmation procedures and related “alternative audit procedures.” 3. To examine the meaning of “negligent,” “reckless,” and “fraudulent” as those terms relate to auditor misconduct or malfeasance. 4. To identify circumstances that may threaten the de facto and apparent independence of auditors. Suggestions for Use You might begin class coverage of this case by asking for a show of hands of those students who have played one or more versions of Grand Theft Auto. If you have “age appropriate” college students, you will likely find that most of your male students have played the game, while just a smattering of your female students have experienced the game. After asking for the show of hands, I typically single out individual students and ask them to comment on whether or not they believe the game is morally objectionable. More often than not, I receive a reply similar to the following: “It’s only a game!” [By the way, I have never played the game myself, although I was well aware of it and its controversial content before I developed this case.] Next, I tend to segue into a discussion of the final case question, namely, whether audit firms should accept “ethically-challenged” companies and organizations as clients. That issue often spawns a far-ranging, if not raucous, debate among students. I have found that students also enjoy debating and discussing the two auditor independence issues raised in this case: the question of whether the “father-son” relationship between the client CEO and the audit engagement partner was problematic and the question of whether PwC’s independence was in any way impaired by the heavy discounting of fees charged to Take-Two when it was in a developmental stage.
- 22. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 118 Case 2.3 Take-Two Interactive Software, Inc. Suggested Solutions to Case Questions 1. Following are the requested financial ratios for Take-Two for the period 1998-2000. Notice that the accounts receivable turnover and inventory turnover ratios are also provided. Financial Ratios for Take-Two: 2000 1999 1998 Age of Accts Receivable* 114.4 93.6 80.4 Age of Inventory* 63.5 57.2 57.9 Gross Profit Percentage 36.0% 29.7% 24.0% Profit Margin Percentage 6.5% 5.3% 3.7% Return on Assets 8.6% 9.6% 8.7% Return on Equity 18.3% 27.1% 30.2% Current Ratio 1.41 1.28 1.30 Debt to Equity Ratio .88 1.72 2.08 Quality of Earnings Ratio -2.21 -1.03 -1.12 * In days Accts Receivable Turnover 3.19 3.90 4.54 Inventory Turnover 5.75 6.38 6.30 Equations: A/R Turnover: net sales / average accounts receivable Age of A/R: 365 days / accounts receivable turnover Inventory Turnover: cost of goods sold / average inventory Age of Inventory: 365 days / inventory turnover Gross Profit Percentage: gross profit / net sales Profit Margin Percentage: net income / net sales Return on Assets: net income / average total assets Return on Equity: net income / average stockholders' equity Current Ratio: current assets / current liabilities Debt to Equity: total liabilities / total stockholders’ equity Quality of Earnings: net operating cash flows / net income Discussion: The most prominent red flag revealed by these ratios is the extremely poor “quality of earnings”
- 23. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.3 Take-Two Interactive Software, Inc. 119 being produced by Take-Two over this three-year time frame. Investors want and expect a company to have a quality of earnings ratio higher than 1.0. Simply from a mathematical standpoint, you would expect a company to have a greater than 1.0 quality of earnings ratio because of noncash expenses, principally depreciation expense. A large number of factors may collectively or individually produce a negative quality of earnings ratio for a given company. One such factor is the recording of fraudulent sales—the bogus accounts receivable due to fraudulent sales simply “pile up” on the given company’s balance sheet in such circumstances and cause net income to be higher than net operating cash flows. Notice that the negative quality of earnings ratios being experienced over the time frame 1998-2000 was accompanied by a telltale slowdown in accounts receivable turnover (which, in turn, caused Take-Two’s age of receivables to increase significantly). Notice also that Take-Two’s age of inventory was increasing between 1998 and 2000 but not as consistently or dramatically as the company’s age of receivables. One cause of an increasing age of inventory is the fact that a company is overstating its period-ending inventory. Consequently, an increasing age of inventory should prompt auditors to focus more attention on the existence and valuation assertions for that account. Note: The SEC did not allege that Take-Two was overstating its inventories. However, given that the company was recording bogus sales/receivables, it is certainly a possibility that it was also overstating its period-ending inventory, particularly given the slowing inventory turnover. Another key red flag that suggested something may have been awry in Take-Two’s reported operating results was the significant increases in the company’s gross profit percentage and profit margin percentage during the year 2000. As noted in the case, many of Take-Two’s competitors went out of business as a direct result of the challenging economic conditions that accompanied the “tech crash” that began in early 2000. Auditors of a company that is “bucking” such a trend by reporting impressive financial data should definitely consider the possibility that the client is somehow window-dressing its financial statements. 2. "Existence” and “valuation” are the primary management assertions that auditors hope to corroborate when confirming a client’s accounts receivable. Confirmation procedures are particularly useful for supporting the existence assertion. A client’s customer may readily confirm that a certain amount is owed to the client (existence assertion), however, whether that customer is willing and/or able to pay the given amount (valuation assertion) is another issue. The key difference between positive and negative confirmation requests is that the given third party is asked to respond to a positive confirmation request whether or not the information to be confirmed is accurate, while for a negative confirmation request the third party is asked to respond only if the information to be confirmed is not accurate. Auditors must perform other audit procedures (alternative audit procedures) in those instances in which the third partydoes not return a positive confirmation request. No follow-up procedures are necessary when the auditor does not receive a response to a negative confirmation request. Given the fundamental difference between positive and negative confirmation requests, the audit evidence yielded by the former is of much higher quality (much more reliable) than audit evidence yielded by the latter. AS 2310, “The Confirmation Process,” of the PCAOB’s auditing standards is the authoritative source in this context for audits of SEC registrants, such as Take-Two. AU-C Section 505, “External Confirmations,” of the AICPA Professional Standards discusses at length the use of confirmation procedures to collect audit evidence in audits of other types of entities. Both of these sections of the
- 24. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 120 Case 2.3 Take-Two Interactive Software, Inc. respective standards suggest that negative confirmations provide less persuasive audit evidence than positive confirmations. AS 2310.20 notes that negative confirmation requests may be used by auditors when the following three circumstances are present: “(a) the combined assessed level of inherent risk and control risk is low, (b) a large number of small balances is involved, and (c) the auditor has no reason to believe that the recipients of the requests are unlikely to give them consideration.” 3. AS 2310.32 of the PCAOB’s auditing standards identifies the following “alternative procedures” that may be applied by an auditor when a positive confirmation request has failed to produce a response: “examination of subsequent cash receipts (including matching such receipts with the actual items being paid), shipping documents, or other client documentation.” Notice the parenthetical statement which is very relevant to the Take-Two case. The SEC specifically criticized the PwC auditors for failing to “match up” subsequent cash receipts with the actual amounts being paid. Likewise, PwC only examined $18 million of subsequent cash receipts when the total recorded value of the unconfirmed receivables was approximately $100 million. (Note: Paragraph A24 of AU-C Section 505, “External Confirmations,” of the AICPA Professional Standards identifies the same “alternative procedures” in this context as AS 2310.) Ironically, the results of alternative audit procedures may, in fact, yield stronger audit evidence than that yielded by a properly returned and signed positive confirmation. This is particularly true when the auditor examines subsequent cash collections and is able to trace those cash receipts to the specific items that were included in the given receivable. Despite this possibility, however, auditors typically prefer that the client’s customers confirm their period-ending balances by signing and returning a positive confirmation request. Why? Because considerably less audit effort is required in such circumstances and the quality of the audit evidence provided is almost always deemed acceptable. 4. The following list of alleged and/or potential deficiencies in the 2000 PwC audit of Take-Two will be helpful in responding to this question: failing to properly respond to high audit risk areas identified during the planning phase of the engagement, failing to investigate why such a modest response rate was received from the positive confirmation requests, failing to determine that the one positive confirmation request received was invalid (see footnote 18), accepting as audit evidence for the unconfirmed receivables subsequent cash receipts that could not be traced to specific invoiced sales amounts, identifying and reviewing only a modest amount of subsequent cash receipts related to the unconfirmed accounts receivable, failing to track the sample of five sales returns to specific invoiced sales transactions or otherwise investigate the validity of those sales returns. Of course, more general, broad-brush allegations were included in the SEC enforcement release. The case notes, for example, that the SEC charged that Fish “failed to exercise due professional care and professional skepticism.” Following are definitions/descriptions that I have found very useful in helping students distinguish among the three key types of auditor misconduct. These definitions were taken from the following source: D.M. Guy, C.W. Alderman, and A.J. Winters, Auditing, Fifth Edition (San Diego: Dryden, 1999), 85-86.
- 25. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.3 Take-Two Interactive Software, Inc. 121 Negligence. "The failure of the CPA to perform or report on an engagement with the due professional care and competence of a prudent auditor." Example: An auditor fails to test a client's reconciliation of the general ledger controlling account for receivables to the subsidiary ledger for receivables and, as a result, fails to detect a material overstatement of the general ledger controlling account. Recklessness (a term typically used interchangeably with gross negligence and constructive fraud). "A serious occurrence of negligence tantamount to a flagrant or reckless departure from the standard of due care." Example: Evidence collected by an auditor suggests that a client's year-end inventory balance is materially overstated. Because the auditor is in a hurry to complete the engagement, he fails to investigate the potential inventory overstatement and instead simply accepts the account balance as reported by the client. Fraud. “Fraud differs from gross negligence [recklessness] in that the auditor does not merely lack reasonable support for belief but has both knowledge of the falsity and intent to deceive a client or third party." Example: An auditor accepts a bribe from a client executive to remain silent regarding material errors in the client's financial statements. We can certainly conclude that the PwC auditors were not fraudulent in this case because they were unaware of the client’s indiscretions and there was no effort on their part to deceive third-party users of Take-Two’s financial statements. Regarding the question of whether the auditors were negligent or reckless, recognize that the SEC enforcement release that focused on that audit and, in particular, Robert Fish’s role in that audit, did not characterize the mistakes made as negligent or reckless. (Note: The issue of whether or not given auditors were negligent or reckless is often the central issue in a civil lawsuit filed against those auditors but is typically not addressed directly within an SEC enforcement release.) However, the SEC’s enforcement release did stronglycriticize Fish’s conduct. For example, the SEC charged that “he failed to exercise due professional care and professional skepticism, and failed to obtain sufficient competent evidential matter” (taken from quote in case). This summary statement suggests that Fish was at least negligent in auditing Take- Two given the above definition of “negligence.” Was Fish reckless? Since we don’t have access to all of the pertinent information for this case, it is difficult to decide whether or not his misconduct rose to the level of recklessness. Consider having your students debate this issue. What I often do in this type of setting is to have one group of students take one side of such a debate and another group of students take the other side. After a lively give and take between the two competing camps, I then have a third set of students vote (anonymously) to choose the “winner.” 5. Professional auditing standards do not address this issue. Rule-making bodies in the auditing discipline apparently believe that the level of audit fees to be charged on any given audit engagement is an issue that will be properly resolved by the interplay of supply and demand forces in the audit market. It has been alleged in the past that major audit firms attempted to expand their client bases by discounting their fees. In the 10th edition of my casebook, Case 1.7, “Lincoln Savings and Loan
- 26. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 122 Case 2.3 Take-Two Interactive Software, Inc. Association,” notes that Arthur Young & Company expanded its client base bymore than 100 clients in the mid-and late 1980s. Although not mentioned in that case, third parties alleged that Arthur Young used “aggressive pricing” during that “marketing campaign” to significantlyincrease its client portfolio. I would suggest that, ceteris paribus, it is permissible to discount the audit fees charged to developmental stage companies. Having said that, this practice may create independence issues for the given audit firm. For example, if the audit fee for such a client does not allow the audit firm to recover its costs on the given engagement, then the audit firm might attempt to retain the client over a sufficient period of time to recover those costs and ultimately earn a profit on the relationship with that client. This mindset of needing or wanting to retain the client might induce the audit firm to be less than strict in auditing the client. Why? Because the audit firm may fear that employing a rigorous audit strategy would result in the client severing the relationship. 6. The central issue here is whether Robert Fish maintained his objectivityand independence while supervising the Take-Two audits, given his close relationship with Ryan Brant. The AICPA Code of Professional Conduct provides the following overview of those two important and related traits that auditors should possess. Objectivity is a state of mind, a quality that lends value to a member’s services. It is a distinguishing feature of the profession. The principle of objectivityimposes the obligation to be impartial, intellectually honest, and free of conflicts of interests. Independence precludes relationships that may appear to impair a member’s objectivity in rendering attestation services (ET 0.300.050.02). As the AICPA notes, objectivity, which is the underpinning of independence, is a “state of mind.” Consequently, it is impossible for third parties to discern whether or not an auditor performs a given audit objectively. On the other hand, a close relationship between an auditor and his or her client may cause third parties to question the auditor’s independence. This latter possibility is sufficient to undercut the credibility of the auditor regardless of whether or not he or she maintains an objective mindset during the given engagement. So, was Fish’s relationship with Brant improper? Given the information conveyed during the interview of Fish that is reported in this case, I believe that at least some professional accountants would respond with a resounding “Yes.” The suggestion that there was a father-son type relationship between the two individuals would likely cause third-party financial statement users to question whether Fish could objectively and independently assess Take-Two’s financial statements that were ultimately the responsibility of Brant. 7. This is a question that I have used as an essay question on many in-class exercises and, occasionally, on the final exam for my graduate auditing seminar. As you might expect, I don’t focus much on the “yes” or “no” answers provided by students but instead analyze the overall quality of the logical reasoning that they provide to support their answers. This question is certainly pertinent to this case because of the wide-ranging criticism that Take-Two has garnered for its Grand Theft Auto game. One strategy that I hope my students apply in responding to this question is to examine the issue it raises from the standpoint of the following six ethical “principles” included in
- 27. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.3 Take-Two Interactive Software, Inc. 123 the AICPA Code of Professional Conduct: Responsibilities, The Public Interest, Integrity, Objectivity and Independence, Due Care, and Scope and Nature of Services. Those students who use this strategy typically focus on the Integrity and/or Public Interest principles.
- 28. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.4 General Motors Company 123 CASE 2.4 GENERAL MOTORS COMPANY Synopsis Billy Durant created General Motors Corporation in 1908 when he merged several automobile manufacturers that he had acquired over the previous few years. For most of the 20th century, GM reigned as the largest automobile producer worldwide and one of the U.S.’s most prominent corporations. By the early years of the 21st century, however, GM’s dominance of the automotive industry was waning in the face of stiff competition from several foreign carmakers. In 2009, Toyota supplanted GM as the world’s largest automotive company in terms of annual sales. That same year, GM filed for bankruptcy after being caught in the undertow of the massive financial crisis that crippled the U.S. economy beginning in late 2008. Many critics had argued for decades that GM’s executives routinely“doctored” the company’s periodic financial statements to conceal its deteriorating financial health. This case focuses on one feature of the window-dressing efforts of GM. In early 2009, the SEC released the results of a lengthy investigation of GM’s accounting and financial reporting decisions over the previous decade. A major focus of that investigation was GM’s questionable accounting for its massive pension liabilities and expenses. Among other allegations, the SEC claimed that for fiscal 2002 GM applied an inflated discount rate to its pension liabilities that resulted in those liabilities being materially understated. This case examines the controversy surrounding GM’s pension-related accounting decisions and the role of the company’s longtime audit firm, Deloitte, in those decisions. The case questions require students to consider the types of auditing procedures that should be applied to a client’s pension-related financial statement items.
- 29. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.4 General Motors Company 124 General Motors Company--Key Facts 1. Billy Durant, who worked as an itinerant salesman as a young man, became extremely wealthy after organizing General Motors in 1908; however, Durant lost his fortune in the stock market and spent the final few years of his life in poverty and relative obscurity. 2. GM reigned as the world’s largest automobile manufacturer for nearly eight decades until 2009 when it filed for bankruptcy during the midst of a severe economic crisis gripping the U.S. economy. 3. A key factor that contributed to GM’s downfall was the company’s significant pension and other postretirement benefit expenses that made its cars more costlythan those of foreign competitors. 4. In the decades prior to GM’s bankruptcy filing, critics accused GM executives of “juggling” the company’s reported financial data to conceal its deteriorating financial health; GM’s pension- related financial statement amounts were among the items allegedly misrepresented. 5. Accounting for pension-related financial statement items has long been a controversial issue within the accounting profession; in 1985, the FASB finally adopted a new accounting standard that moved the profession toward accrual basis accounting for those items. 6. The FASB’s new standard still allowed companies to manipulate their pension-related financial statement amounts because of several key assumptions that had to be made in accounting for them, including the discount rate used to determine the present value of pension liabilities. 7. For fiscal 2002, GM chose to apply a 6.75% discount rate to determine its pension liabilitywhen most available evidence suggested that a considerably lower discount rate should have been applied. 8. After initially contesting the 6.75% discount rate, GM’s audit firm, Deloitte, eventually acquiesced and accepted that rate. 9. Deloitte agreed to approve the 6.75% discount rate after GM officials indicated that they would include a “sensitivity analysis” in their company’s 2002 financial statements demonstrating the financial statement impact of a range of different discount rates including 6.75%. 10. In a subsequent complaint filed against GM, the SEC maintained that the company’s pension- related amounts and disclosures within its 2002 financial statements were “materially misleading,” including the sensitivity analysis.
- 30. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.4 General Motors Company 125 11. In January 2009, the SEC sanctioned GM for several abusive accounting and financial reporting practices including its accounting and financial reporting decisions for its pension liabilities and related items. 12. In July 2009, the “new General Motors” (General Motors Company) emerged from bankruptcy proceedings; the federal government was the new company’s principal stockholder. Instructional Objectives 1. To identify key audit risks and issues posed by an important long-term liability, namely, the liability stemming from an organization’s defined benefit pension plan. 2. To identify specific audit procedures appropriate for long-term accrued liabilities such as pension liabilities. 3. To identify circumstances under which auditors should retain outside experts to assist them in completing an audit. 4. To demonstrate the importance of insisting that audit clients include appropriate disclosures in their financial statement footnotes regarding significant accounting estimates. Suggestions for Use While developing this case, I reviewed several auditing textbooks to gain insight on the type and extent of the textbook treatment typically given to the topic of pension liabilities and related financial statement items. I was surprised to find almost no coverage of that topic. Given the materiality of pension-related financial statement amounts for many companies, it seems reasonable that we should, at a minimum, provide auditing students with an overview or “brief taste” of the key audit issues for those items. This case addresses that need. [Sidebar: No doubt, the auditing of pension- related financial statement items is among the more complex assignments on most audit engagements. Consequently, this task is typically assigned to more experienced auditors, which likely explains why this topic is not dealt with extensively in standard introductory-level auditing textbooks.] As you probably know, to demonstrate the real-world significance of audit issues, I present those issues in the context of real-world circumstances or dilemmas. One downside to this strategy is that students sometimes are “derailed” by peripheral issues that are not directly audit-related. In covering this case, for example, students enjoy debating the factors that contributed to GM’s demise. You may find it necessary to direct students’ attention away from such issues and back to the central accounting and auditing issues highlighted by the case. Suggested Solutions to Case Questions
- 31. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.4 General Motors Company 126 1. Listed next are examples of general audit procedures that could be applied to a company’s reported pension obligation or liability and/or its related pension expense. This list is not intended to be comprehensive by any stretch of the imagination. The purpose of this question is simply to force students to think in general terms of the key issues that should be addressed in auditing these items. Notice that I list the audit objective first followed by the specific audit procedure. You may want to instruct your students to use that conventional “horse before the cart” strategy for this question as well. Sidebar: you may want to point out to your students that pension amounts are accounting estimates and thus AS 2501, “Auditing Accounting Estimates,” of the PCAOB’s auditing standards can be used as a general framework for developing appropriate audit procedures for those items. (The corresponding section in the AICPA Professional Standards is AU-C Section 540, “Auditing Accounting Estimates, Including Fair Value Accounting Estimates and Related Disclosures.”) a. 1. Audit objective: To determine whether the client’s pension obligation is recorded in the financial statements at the appropriate amount. [“Valuation and allocation” assertion regarding period-ending account balances.] 2. Audit procedure: Identify discount rates applied by comparable companies to determine their pension liabilities. Given those discount rates, evaluate the reasonableness of the client’s chosen discount rate. b. 1. Audit objective: To determine whether the client’s pension obligation is recorded in the financial statements at the appropriate amount. [“Valuation and allocation” assertion regarding period-ending account balances.] 2. Audit procedure: Have an independent actuary review the keyactuarial assumptions used by the client in arriving at its reported pension obligation. (For example, the actuary would likely review the reasonableness of mortality assumptions applied by the client.) c. 1. Audit objective: To determine whether the client’s pension obligation is recorded in the financial statements at the appropriate amount. [“Valuation and allocation assertion regarding period-ending account balances.] 2. Audit procedure: Test the mathematical accuracyof the client’s computations of the pension obligation and pension expense amounts. d. 1. Audit objective: To determine that all disclosures that should have been included in the client’s financial statements have been included. [“Completeness” assertion concerning presentation and disclosure issues.] 2. Audit procedure: Read client financial statement footnotes to determine whether the client has made all necessary and appropriate disclosures regarding its pension liability. e. 1. Audit objective: To determine that financial information is appropriatelypresented and described and disclosures are clearly expressed. [“Classification and understandablity” assertion regarding presentation and disclosure issues.] 2. Audit procedure: Read client financial statement footnotes to determine whether its pension-related disclosures are explained precisely and clearly.
- 32. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.4 General Motors Company 127 2. AS 1210, “Using the Work of a Specialist,” of the PCAOB’s auditing standards discusses the general circumstances under which auditors should consider retaining the services of an independent expert during the course of an audit engagement. This section identifies several types of specialists or experts that auditors may need to consult on specific engagements including actuaries, appraisers, engineers, environmental consultants, and geologists. AS 1210.06 provides the following general guidance for auditors to follow in deciding whether the services of a specialist should be retained: “The auditor’s education and experience enable him or her to be knowledgeable about business matters in general, but the auditor is not expected to have the expertise of a person trained or qualified to engage in the practice of another occupation or profession. During the audit, however, an auditor may encounter complex or subjective matters potentially material to the financial statements. Such matters may require special skill or knowledge and in the auditor’s judgment require using the work of a specialist to obtain appropriate audit evidential matter.” In auditing pension-related financial statement items, an auditor may find it necessary to retain the services of an actuary to assess the reasonableness of key assumptions made by the client in arriving at those accounting estimates. For example, assumptions regarding the projected life spans of retirees have a significant impact on those amounts. Auditors typicallydo not have the experience or training to properly evaluate such mortality assumptions and thus should consider relying on the services of an independent actuary to assess their reasonableness. (Note: AU-C Section 620, “Using the Work of an Auditor’s Specialist,” is the section of the AICPA Professional Standards that corresponds with AS 1210. The responsibilities imposed on auditors by the two sections are very similar.) 3. In retrospect, it appears that there was significant evidence suggesting that the 6.75% discount rate was a poor choice by GM. However, as always, the information that was available in the public domain in developing this case was certainly only a fraction of the information that was likely relied upon by Deloitte in arriving at the decision to accept the 6.75% discount rate. So, one should be careful in criticizing that decision—you might point out to your students that, as indicated in the case, the SEC has yet to criticize Deloitte for its role in this matter. The principal purpose of this question is not to criticize Deloitte but rather to prompt students to identify additional audit tests or procedures that should have been applied by the audit firm—and possibly were. Those audit procedures could have included performing analytical tests to determine whether the use of the 6.75% discount rate had a material impact on relevant financial statement benchmarks (see next question), reviewing past choices of discount rates made by GM to determine whether the company had a “track record” of questionable decisions in this regard, and inquiring of client personnel as to why an unconventional method was used to select the pension discount rate for the year in question and then analyzing the rationality or reasonableness of those explanations. 4. Notice that a footnote to this case provides several key financial benchmarks that would be relevant in assessing whether GM’s chosen discount rate had a material impact on its 2002 financial statements. I think most of us would answer a resounding “yes” to that question.
- 33. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.5 Lipper Holdings, LLC 128 CASE 2.5 LIPPER HOLDINGS, LLC Synopsis Media reports described Kenneth Lipper as a “bon vivant” and “renaissance man.” Lipper, the son of a shoe salesman, grew up in a modest working-class neighborhood in the South Bronx. A childhood friend of Al Pacino and a contemporary of Bernie Madoff, Lipper made a name for himself on both Wall Street and in Hollywood. Lipper served as a partner of Lehman Brothers and then Salomon Brothers during the 1970s and 1980s before becoming a pioneer of the emerging hedge fund industry. After collaborating on Oliver Stone’s popular film Wall Street in the late 1980s, Lipper adopted a bicoastal lifestyle. Lipper capped his Hollywood career by winning an Oscar for a documentary film that he produced. In addition to his careers in high finance and films, Lipper also served as deputy mayor of New York City for three years under Ed Koch. Kenneth Lipper’s reputation as a Wall Street maven was dashed in February 2002 when his company, Lipper Holdings, LLC, reported that the collective market values of the investments held by three hedge funds that it managed had been grossly overstated. The hedge funds were subsequently liquidated resulting in huge losses for many of Lipper’s prominent investors. Investigations by regulatory and law enforcement authorities revealed that the market values of the hedge funds’ investments had been intentionally overstated by one of Lipper’s top subordinates who had served as the portfolio manager for those funds. Another target of the investigations into the collapse of the Lipper hedge funds was PricewaterhouseCoopers (PwC), the longtime auditor of Lipper Holdings and its hedge funds. PwC was criticized for failing to uncover the fraudulent scheme used by the hedge funds’ portfolio manager to materially inflate the market values of their investments. Particularly galling to those parties familiar with the fraud was the fact that the portfolio manager had used patently simple methods to overstate those market values. This case focuses on the alleged flaws in PwC’s audits of the three Lipper hedge funds.
- 34. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.5 Lipper Holdings, LLC 129 Lipper Holdings, LLC--Key Facts 1. Kenneth Lipper, the son of a shoe salesman, was raised in a modest working-class neighborhood in the South Bronx community within New York City. 2. In addition to establishing a prominent Wall Street investment firm and serving several years as a deputy mayor of New York City, Lipper had a successful career in Hollywood as a screenwriter and film producer. 3. Lipper was a leader of the rapidly growing hedge fund industry during the 1990s; his firm, Lipper Holdings, managed three hedge funds, the largest of which was Lipper Convertibles. 4. One of Lipper’s top subordinates, Edward Strafaci, served as the portfolio manager for the three Lipper hedge funds. 5. To inflate the reported rates of return earned by the three Lipper hedge funds Strafaci began overstating the year-end market values of the investments they held. 6. Following Strafaci’s sudden and unexpected resignation in January 2002, an internal investigation revealed his fraudulent scheme. 7. Lipper Holdings’ longtime audit firm, PwC, became a focal point of the SEC’s investigation of Strafaci’s fraud. 8. The SEC’s investigation revealed that PwC had collected considerable evidence indicating that the collective market values of the three hedge funds’ investments were materially overstated. 9. Despite that audit evidence, PwC issued unqualified audit opinions on the hedge funds’ financial statements throughout its tenure as their independent auditor. 10. The SEC suspended the former partner who had supervised the Lipper hedge fund audits after ruling that he had been a “cause” of their violations of federal securities laws.
- 35. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.5 Lipper Holdings, LLC 130 Instructional Objectives 1. To identify audit risk factors posed by sophisticated financial services clients such as hedge funds. 2. To identify audit objectives and related audit procedures for a client’s securities investments. 3. To examine factors that may contribute to poor or deficient decisions by independent auditors. Suggestions for Use As the opening prologue for this case suggests, hedge funds are easily among the most controversial investment vehicles in today’s capital markets. They are also among the most mysterious and least understood Wall Street “creatures.” For those reasons, alone, Ibelieve this case will pique your students’ interests. Consider having a student or group of students provide a five- minute in-class report on the “state of the hedge fund industry.” By the time you discuss this case, there may have been important changes in the regulatory environment for hedge funds that would have at least indirect implications for those entities’ independent auditors. AS 2501, “Auditing Derivative Instruments, Hedging Activities, and Investments in Securities,” of the PCAOB’s auditing standards discusses specific audit strategies, audit objectives, and audit procedures to apply to securities investments and related transactions (see suggested solution to second case question). Also relevant to this case is AS 2502, “Auditing Fair Value Measurements and Disclosures.” Consider having a student or group of students present an in-class report on these sections prior to discussing this case. Warning: this won’t be an easy assignment! (Note: The sections in the AICPA Professional Standards that would be relevant to the audit of a non-SEC registrant are AU-C Section 501, “Audit Evidence—Specific Considerations for Selected Items,” paragraphs .04-.10 and .A1-.A19, and AU-C Section 540, “Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures.”) Suggested Solutions to Case Questions 1. The three categories of fraud risk factors discussed in AS 2401, “Consideration of Fraud in A Financial Statement Audit,” in the PCAOB’s Interim Standards are “incentives/pressures,” “opportunities,” and “attitudes/rationalizations” (of course, collectively these three categories of fraud risk factors are often referred to as the “fraud triangle.”) The appendix to AS 2401 provides numerous examples of fraud risk factors in each category. Listed next are examples of specific fraud risk factors faced by the PwC auditors assigned to the Lipper hedge fund audits. (Note: AU-C Section 240, “Consideration of Fraud in a Financial Statement Audit,” is the section in the AICPA Professional Standards that corresponds to AS 2401 in the PCAOB’s auditing standards.)
- 36. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.5 Lipper Holdings, LLC 131 Incentives/pressures: • “High degree of competition” (the Lipper hedge funds were competing against literally thousands of other investment alternatives that investors could choose) • “Perceived or real adverse effects of reporting poor financial results” (as noted in the case, Strafaci believed that the hedge funds had to report impressive rates of return to continue attracting new investors) • “Significant financial interests in the entity” (the restitution that the courts forced Strafaci to pay was due to the large profits that he had earned from his investments in the hedge funds) Opportunities: • “Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate” (as noted in a footnote to the case, many of the hedge funds’ investments were in “thinly-traded” securities that often did not have readily determinable market values) • “Domination of management by a single person” (in this case, Strafaci) “Ineffective oversight over the financial reporting process and internal control by those charged with governance” (one could argue that Kenneth Lipper should have exercised more effective oversight of the hedge funds including Strafaci’s role in managing the funds) Attitudes/rationalizations: • “Known history of violations of securities laws or other laws” (as noted in the case, Kenneth Lipper had been previously accused of aiding and abetting violations of federal securities laws) • “Excessive interest by management in maintaining or increasing the entity’s stock price or earnings trend” (again, Strafaci’s zealous interest in ensuring that the hedge funds achieved impressive rates of return was consistent with this fraud risk factor) • “Management failing to correct known significant deficiencies or material weaknesses in internal control on a timely basis” (if Larry Stoler was aware of the significant internal control weaknesses within the hedge funds’ operations, client management was almost certainly aware of those problems also) How should PwC have responded to these and other risk factors posed by the audits of the Lipper hedge funds? By making proper adjustments in the audit NET for those audits, that is, the nature, extent and timing of the audit procedures to be applied during those engagements. Granted, in some cases, audit firms may simply choose not to be associated with an audit client for which an extensive number of fraud risk factors is present. Note: In the SEC enforcement release for this case, the federal agency reported that the auditors prepared an annual risk analysis for the Lipper hedge fund engagements. Among the “high risk” factors identified during those risk analyses was “management governance and oversight of management.” Although the auditors identified that critical issue as a “high risk” factor during the
- 37. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.5 Lipper Holdings, LLC 132 planning phase of those audits, the SEC suggested that the auditors did not respond appropriately to that risk factor during later phases of the audits. 2. AS 1105.11 identifies five management assertions that are relevant to independent auditors. The “audit objectives” on audits of SEC registrants involve collecting sufficient appropriate evidence to corroborate these assertions for specific financial statement line items or disclosure items. [Note: the AICPA Professional Standards identify13 specific management assertions that are closelyrelated to the “original” five management assertions incorporated in AS 1105. See AU-C Section 315.A128 for a list of those assertions.] AS 2503, “Auditing Derivative Instruments, Hedging Activities, and Investments in Securities,” is replete with examples of audit objectives for “complex financial instruments and transactions” which is the focus of this case question. Listed next are examples of such audit objectives and corresponding audit procedures suggested by AS 2503. Audit objective: Audit objectives related to “assertions about the valuation of derivatives and securities address whether the amounts reported in the financial statements through measurement or disclosure were determined in conformity with generally accepted accounting principles.” AS 2503.26 Example of a relevant audit procedure: “If quoted market prices are not available for the derivative or security, estimates of fair value frequentlycan be obtained from broker-dealers or other third-party sources based on proprietary valuation models or from the entity based on internally or externally developed valuation models.” AS 2503.38 Audit objective: Audit objectives related to “assertions about rights and obligations address whether the entity has the rights and obligations associated with derivatives and securities, including pledging arrangements, reported in the financial statements.” AS 2503.25 Example of a relevant audit procedure: “Confirming significant terms with the counterparty to a derivative or the holder of a security, including the absence of any side agreements.” AS 2503.25 Audit objective: Audit objectives related to “completeness assertions address whether all of the entity’s derivatives and securities are reported in the financial statements through recognition or disclosure.” AS 2503.22 Example of a relevant audit procedure: The auditor should request “counterparties or holders who are frequently used, but with whom the accounting records indicate that there are presently no derivatives or securities, to state whether they are counterparties to derivatives with the entity or holders of its securities.” AS 2503.22 Audit objective: “The auditor should evaluate whether the presentation and disclosure of derivatives and securities are in conformity with generally accepted accounting principles.” AS 2503.49 Example of a relevant audit procedure: The auditor should determine whether “the information presented in the financial statements is classified and summarized in a reasonable manner, that is, neither too detailed nor too condensed.” AS 2503.49
- 38. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.5 Lipper Holdings, LLC 133 3. Listed next are examples of specific factors that may have contributed to the alleged flaws in the audit procedures applied by the PwC auditors while testing the year-end market values of the Lipper hedge funds’ investments. • Kenneth Lipper’s prominence and influence in the hedge fund industry and the investment community (History has proven that auditors are sometimes prone to give prominent audit clients or audit client executives the “benefit of the doubt.” Auditors may do so because they don’t want to jeopardize losing the given client and/or because they believe that a prominent client or client executive is not likely to jeopardize its/his/her prominence by being associated with misrepresented financial statements.) • Improper planning (This is arguably the most common factor associated with “busted audits.”) • Inadequate supervision (This was one of the specific allegations levied against Stoler by the SEC.) • Lack of proper expertise on the part of members of the audit engagement team (Hedge funds are just one example of a type of audit client that almost certainly requires that one or more auditors assigned to the engagement team have specific “industry” expertise or knowledge.) • Inadequate time budgets (There was no indication that this factor was relevant to the Lipper hedge fund audits; nevertheless, this factor appears to have been a contributing factor to many alleged audit failures.) • Overbearing client executives who interfere with the audit (This is another factor commonly associated with alleged audit failures. Again, there was no indication that Strafaci or other Lipper personnel attempted to divert the attention of the PwC auditors or otherwise disrupt their work.) What measures can audit firms take to lessen the likelihood that the factors just identified (and many other factors, as well) will undercut the quality of their audits? The easy (and proper) answer is for audit firms to have rigorous quality control mechanisms in place to ensure that the relevant professional auditing standards are complied with on each and everyaudit engagement. Examples of such quality controls include a thorough workpaper review process for every audit, the assignment of a review or concurring partner to audits, participation in peer review programs in which auditors from other firms are allowed to peruse and criticize the workpapers prepared for certain clients, and establishment of a risk management function to “weed out” audit clients that pose excessive audit risks.
- 39. Case 2.6 CBIHolding Company, Inc. 134 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CASE 2.6 CBI HOLDING COMPANY, INC. Synopsis Ernst & Young audited the pharmaceutical wholesaler CBI Holding Company, Inc., in the early 1990s. In 1991, Robert Castello, CBI’s owner and chief executive, sold a 48% stake in his company to TCW, an investment firm. The purchase agreement between Castello and TCW identified certain “control-triggering” events. If one such event occurred, TCW had the right to take control of CBI. In CBI’s fiscal 1992 and 1993, Castello orchestrated a fraudulent scheme that embellished the company’s reported financial condition and operating results. The scheme resulted in Castello receiving bonuses for 1992 and 1993 to which he was not entitled. A major feature of the fraud involved the understatement of CBI’s year-end accounts payable. Castello and several of his subordinates took steps to conceal the fraud from CBI’s Ernst & Young auditors and from TCW (two of CBI’s directors were TCW officials). Concealing the fraud was “necessary” to ensure that Castello did not have to forfeit his bonuses. Likewise, the fraud had to be concealed because it qualified as a “control-triggering” event. This case examines the audit procedures that Ernst & Young applied to CBI’s year-end accounts payable for fiscal 1992 and 1993. The principal audit test that Ernst & Young used in auditing CBI’s accounts payable was a search for unrecorded liabilities. Although Ernst & Young auditors discovered unrecorded liabilities each year that resulted from Castello’s fraudulent scheme, they did not properly investigate those items and, as a result, failed to require CBI to prepare appropriate adjusting entries for them. A subsequent civil lawsuit focused on the deficiencies in Ernst & Young’s accounts payable-related audit procedures during the 1992 and 1993 CBIaudits. Following a 17-day trial, a federal judge ruled that Ernst & Young’s deficient audits were the proximate cause of CBI’s bankruptcy and the resulting losses suffered by TCW and CBI’s creditors.
- 40. Case 2.6 CBIHolding Company, Inc. 135 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. CBI Holding Company, Inc.--Key Facts 1. In 1991, TCW purchased a 48 percent ownership interest in CBI from Robert Castello, the company’s owner and chief executive. 2. The TCW-CBI agreement identified certain “control-triggering events;” if one of these events occurred, TCW would take control of CBI. 3. During CBI’s fiscal 1992 and 1993, Castello oversaw a fraudulent scheme that resulted in him receiving year-end bonuses to which he was not entitled. 4. A major feature of the fraud was the understatement of CBI’s year-end accounts payable. 5. Castello realized that the fraudulent scheme qualified as a control-triggering event. 6. Castello and his subordinates attempted to conceal the unrecorded liabilities by labeling the payments of them early in each fiscal year as “advances” to the given vendors. 7. Ernst & Young auditors identified many of the alleged advances during their search for unrecorded liabilities. 8. Because the auditors accepted the “advances” explanation provided to them byclient personnel, they failed to require CBI to record adjusting entries for millions of dollars of unrecorded liabilities at the end of fiscal 1992 and 1993. 9. The federal judge who presided over the lawsuit triggered byCastello’s fraudulent scheme ruled that Ernst & Young’s deficient audits were ultimately the cause of the losses suffered by TCW and CBI’s creditors. 10. The federal judge also charged that several circumstances that arose during Ernst & Young’s tenure as CBI’s auditor suggested that the audit firm’s independence had been impaired. Instructional Objectives 1. To illustrate methods that client management may use to understate accounts payable. 2. To examine the audit objectives related to accounts payable and the specific audit tests that may be used to accomplish those objectives. 3. To illustrate the need for auditors to rigorously investigate questionable items discovered during an audit. 4. To examine circumstances arising during an audit that can jeopardize auditors’ independence.
- 41. Case 2.6 CBIHolding Company, Inc. 136 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Suggestions for Use This case focuses on accounts payable and, consequently, is best suited for coverage during classroom discussion of the audit tests appropriate for that account. Alternatively, the case could be integrated with coverage of audit evidence issues. Finally, the case also raises several interesting auditor independence issues. As a point of information, you will find that this case doesn’t fully examine all facets of the fraudulent scheme perpetrated by CBI’s management. The cases in this section purposefully focus on high-risk accounts and auditing issues related to those accounts. If I fully developed all of the issues posed by the cases in this text, each case would qualify as a “comprehensive” case. [I make this point because many adopters have raised this issue with me. By the way, I greatly appreciate such comments and concerns!] Suggested Solutions to Case Questions 1. "Completeness" is typically the management assertion of most concern to auditors when investigating the material accuracy of a client's accounts payable. Generally, clients have a much stronger incentive to violate the completeness assertion for liability and expense accounts than the other management assertions relevant to those accounts. Unfortunately for auditors, a client's financial controls for accounts payable are typically not as comprehensive or as sophisticated as the controls established in accounting for the analogous asset account, accounts receivable. Clients have a strong economic incentive to maintain a reliable tracking system for amounts owed to them by their customers. This same incentive does not exist for payables since the onus for keeping track of these amounts and ensuring that they are ultimately paid rests with a company's creditors. Granted, a company needs sufficient records to ensure that their vendors are not overcharging them. Nevertheless, the relatively weak accounting and control procedures for payables often complicate auditors' efforts to corroborate the completeness assertion for this account. In my view, the two primary audit procedures that Ernst & Young applied to CBI’s accounts payable would likely have yielded sufficient appropriate evidence to corroborate the completeness assertion—if those procedures had been properly applied. The search for unrecorded liabilities is almost universally applied to accounts payable. This search procedure provides strong evidence supporting the completeness assertion because audit clients in most cases have to pay year-end liabilities during the first few weeks of the new fiscal year. [Of course, one feature of the search procedure is examining the unpaid voucher file to uncover anyyear-end liabilities that remain unpaid late in the audit.] The reconciliation procedure included in Ernst & Young’s audit programs for accounts payable provides additional evidence pertinent to the completeness assertion. In particular, that audit test helps auditors nail down the “timing” issue for payables that arose near a client’s year- end. Vendor statements should identify the shipping terms and shipment dates for specific invoice items and thus allow auditors to determine whether those items should have been recorded as liabilities at the client’s year-end. 2. Before answering the explicit question posed by this item, let me first address the “explanation” matter. In most circumstances, auditors are required to use confirmation procedures in auditing a
- 42. Case 2.6 CBIHolding Company, Inc. 137 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. client's accounts receivable. Exceptions to this general rule are discussed in AS 2310, “The Confirmation Process,” of the PCAOB’s auditing standards and include cases in which the client's accounts receivable are immaterial in amount and when the use of confirmation procedures would likely be ineffective. On the other hand, confirmation procedures are not generally required when auditing a client's accounts payable. Accounts receivable confirmation procedures typically yield evidence supporting the existence, valuation/allocation, and rights & obligations assertions related to period-ending accounts receivable balances. However, the key assertion corroborated most directly by these tests is existence. When performing confirmation procedures on a client's accounts payable, the auditor is most often concerned with the completeness assertion (as pointed out in the answer to the prior question). [Note: AU-C Section 505, “External Confirmations,” is the section in the AICPA Professional Standards that corresponds with AS 2310.] The differing objectives of accounts payable and accounts receivable confirmation procedures require an auditor to use different sampling strategies for these two types of tests. For instance, an auditor will generally confirm a disproportionate number of a client's large receivables. Conversely, because completeness is the primary concern in a payables confirmation procedure, the auditor may send out confirmations on a disproportionate number of accounts that have relativelysmall balances or even zero balances. Likewise, an auditor may send out accounts payable confirmations to inactive vendor accounts and send out confirmations to vendors with which the client has recentlyestablished a relationship even though the client’s records indicate no outstanding balance owed to such vendors. A final technical difference between accounts payable and accounts receivable confirmation procedures is the nature of the confirmation document used in the two types of tests. A receivable confirmation discloses the amount reportedly owed by the customer to the client, while a payable confirmation typically does not provide an account balance but rather asks vendors to report the amount owed to them by the client. Auditors use blank confirmation forms in an effort to identify any unrecorded payables owed by the client. Should the Ernst & Young auditors have applied an accounts payable confirmation procedure to CBI’s payables? No doubt, doing so would have yielded additional evidence regarding the completeness assertion and, in fact, likely have led to the discovery of Castello’s fraudulent scheme. One could certainly suggest that given the fact that the 1992 and 1993 audits were labeled byErnst & Young as high-risk engagements, the audit firm should have considered erring on the conservative side by mailing confirmations—at least to CBI’s major vendors. On the other hand, since payable confirmations are seldom used and since the two procedures that Ernst & Young applied to CBI’s accounts payable would yield, in most circumstances, sufficient appropriate evidence to support the completeness assertion, most auditors would likelynot criticize Ernst & Young for not using payable confirmations. 3. AS 2905 of the PCAOB’s auditing standards discusses auditors’ responsibilities regarding the “subsequent discovery of facts” existing at the date of an audit report. That section of the professional standards suggests that, as a general rule, when an auditor discovers information that would have affected a previously issued audit report, the auditor has a responsibility to take appropriate measures to ensure that the information is relayed to parties who are still relying on that report. In this particular case, AS 2905 almost certainly required Ernst & Young to inform CBI’s management, TCW officials, and other parties of the advances ruse orchestrated byCastello that was not uncovered by Ernst & Young during the 1992 and 1993 audits. In my view, the obligation to
- 43. Case 2.6 CBIHolding Company, Inc. 138 © 2018 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. inform CBI management (including the TCW representatives sitting on CBI’s board) of the oversights in the prior audits was compounded by the fact that Ernst & Young was actively seeking to obtain the reaudit engagement. (Note: AU-C Section 560, “Subsequent Events and Subsequently Discovered Facts,” of the AICPA Professional Standards corresponds with AS 2905.) Generally, auditors do not have a responsibilityto inform client management of “mistakes” made on earlier audits. On practically every audit engagement, simple mistakes or oversights are likely to be made. However, if such mistakes trigger auditors’ responsibilities under AS 2905—for example, the mistakes involve gaffes by auditors that resulted in an improper audit opinion being issued— certainly the given audit firm has a responsibility to comply with AS 2905 and ensure that the appropriate disclosures are made to the relevant parties. 4. The key criterion in assigning auditors to audit engagements should be the personnel needs of each specific engagement. Certainly, client management has the right to complain regarding the assignment of a particular individual to an audit engagement if that complaint is predicated on the individual's lack of technical competence, poor interpersonal skills, or other skills deficiencies. On the other hand, a client request to remove a member of an audit team simply because he or she is too “inquisitive” is certainly not a valid request. Castello’s request was particularlyproblematic because it involved the audit manager assigned to the engagement. The audit manager on an engagement team often has considerable client-specific experience and expertise that will be forfeited if he or she is removed from the engagement. 5. Determining whether high-risk audit clients should be accepted is a matter of professional judgment. Clearly, “economics” is the overriding issue for audit firms to consider in such circumstances. An audit firm must weigh the economic benefits (audit fees and fees for ancillary services, if any) against the potential economic costs (future litigation losses, harm to reputation, etc.) in deciding whether to accept a high-risk client. Complicating this assessment is the fact that many of the economic benefits and the economic disincentives related to such decisions are difficult to quantify. For example, quite often one of the best ways for an audit firm to establish a foothold in a new industry is to accept high-risk audit clients in those industries (such clients are the ones most likely to be “available” in a given industry). Likewise, audit firms must consider the important “utilization” issue. An audit firm will be more prone to accept a high-risk audit client if rejecting that client would result in considerable “down time” for members of the given office’s audit staff. In any case, the decision of whether to accept or reject a high-risk audit client should be addressed deliberately, reached with the input of multiple audit partners, and ultimately reviewed at a higher level than the practice office. (Most large accounting firms have a “risk management” group that reviews each client acceptance/rejection decision.) As a point of information, after Ernst & Young issued an unqualified opinion on CBI’s 1993 financial statements, the audit engagement partner recommended that Ernst & Young dissociate itself from CBI. In the partner’s view, the audit risk posed by CBI was simply too high. Despite this recommendation, the audit partner was overruled by his fellow partners in his practice office. (The decision to retain CBI as an audit client proved inconsequential since the company went “belly up” before the 1994 audit was commenced.)
- 44. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.7 Bankrate, Inc. 140 CASE 2.7 BANKRATE, INC. Synopsis Bankrate, Inc. is an Internet-based company that aggregates and then publishes on its websites financial data needed by U.S. consumers. Those data include information regarding the financial products offered by approximately 5,000 banks, insurance companies, and other financial services providers. For example, consumers can search the relevant Bankrate website to obtain comparative data regarding the interest rates that banks across the U.S. are offering on certificates of deposit. In June 2011, Bankrate re-emerged as a public company after having been a private companyfor two years. Financial analysts tracking the company wrote glowing reports concerning the company’s future prospects. Those reports were predicated on Bankrate being the dominant aggregator of financial data needed by U.S. consumers and on the proven business model that the company had developed over the previous several decades. Bankrate settled a large class-action lawsuit in August 2014 by agreeing to pay $18 million to a group of its stockholders who alleged that the company had improperly embellished its potential revenues shortly after it went public in 2011. Just one month after the announcement of that settlement, Bankrate issued a press release revealing that it was the subject of an SEC investigation. That investigation focused on Bankrate’s reported operating results for the second quarter of 2012. The SEC announced in September 2015 that it had reached an agreement to settle fraud charges that it had filed against the company. That settlement included a $15 million fine to be paid by Bankrate. At the same time, the SEC announced that it had settled fraud charges filed against a former Bankrate executive, Hyunjin Lerner. The SEC fined Lerner approximately $180,000 and suspended him from practicing before the SEC for five years. (Both Bankrate and Lerner neither admitted nor denied the charges filed against them.) On the same date that the settlements with Bankrate and Lerner were announced, the SEC reported that it was continuing to pursue “litigation” against two of Lerner’s former colleagues, Edward DiMaria and Matthew Gamsey. DiMaria had served as Bankrate’s CFO, while Gamsey had served as Bankrate’s director of accounting. The SEC spelled out the charges filed against those two men in a 43-page legal complaint. The complaint alleged that DiMaria had orchestrated an accounting scam—with the assistance of Lerner and Gamsey—to ensure that Bankrate’s operating results for the second quarter of 2012 did not fall short of the company’s consensus earnings forecasts for that quarter. This case documents the specific measures allegedly used by DiMaria and his subordinates to misrepresent Bankrate’s
- 45. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.7 Bankrate, Inc. 141 reported operating results. Those measures included tactics to conceal the accounting scam from Grant Thornton, the company’s audit firm. Bankrate, Inc.--Key Facts 1. In June 2011, Bankrate re-emerged as a public company; financial analysts predicted that the company would be very successful because it was the dominant aggregator of financial information needed by U.S. consumers and because it had a proven business model. 2. Bankrate’s two primary revenue streams include payments for leads (referrals) delivered to the approximately 5,000 financial services providers whose products are profiled on its websites and the sale of display advertising on those same websites. 3. In August 2014, Bankrate paid $18 million to a group of its stockholders who claimed that the company had improperly embellished its potential leads revenue shortly after going public in 2011. 4. One month later, in September 2014, Bankrate revealed that the SEC was investigating its reported operating results for the second quarter of 2012. 5. In September 2015, Bankrate and Hyunjin Lerner, the company’s former vice president of finance, settled fraud charges filed against them by the SEC without either admitting or denying those charges; Bankrate paid a $15 million fine while Lerner paid a fine of $180,000 and agreed to a five-year ban from practicing before the SEC. 6. At the same time that the settlements with Bankrate and Lerner were announced, the SEC reported that it was continuing to pursue charges filed against Edward DiMaria and Matthew Gamsey, Bankrate’s former CFO and director of accounting, respectively. 7. In a 43-page legal complaint, the SEC alleged that DiMaria had “fostered a corporate culture within Bankrate’s accounting department that condoned using improper accounting techniques to achieve financial targets.” 8. In July 2012, Bankrate’s preliminary adjusted EBITDA and adjusted EPS for the second quarter of 2012 came up short of analysts’ consensus earnings estimates for that quarter. 9. To eliminate the earnings shortfall, DiMaria allegedly instructed Lerner and Gamsey to make several improper entries in Bankrate’s accounting records. 10. Those improper entries included recording approximately $800,000 of bogus revenue and reducing a marketing expense account and the corresponding accrued liability account by $400,000. 11. The conspirators took explicit measures to conceal the accounting fraud from the company’s
- 46. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.7 Bankrate, Inc. 142 Grant Thornton auditors. 12. In June 2015, following the conclusion of the SEC’s investigation, Bankrate issued restated financial statements for the second quarter of 2012. Instructional Objectives 1. To determine what responsibilities auditors have to search for fraudulent misstatements during a quarterly review of a public company’s financial statements. 2. To identify the factors that should be considered by accountants and auditors when deciding whether a given financial statement amount is “material.” 3. To determine which parties should bear some degree of responsibility when an entity’s financial statements are materially impacted by fraud. 4. To identify the primary audit objectives for a client’s accrued liabilities. 5. To identify circumstances that complicate the auditing of a client’s accrued liabilities. Suggestions for Use When assigning this case you may want your students or a subset of your students to research and identify any recent developments that are relevant to the case. In particular, your students should attempt to determine if the fraud charges filed against Edward DiMaria, Bankrate’s former CFO, and Matthew Gamsey, Bankrate’s former director of accounting, have been resolved. You might also consider requiring your students to do a brief update on the recent financial performance of Bankrate. Public companies’ rampant use of “non-GAAP performance measures” is a controversial topic in the financial reporting domain. This case provides an excellent opportunityto discuss that important financial reporting topic. In particular, you might ask your students to identify the key issues embedded in that topic. Arguably, the most important of those issues is the lack of comparability across the non-GAAP performance measures used by public companies. A closely related issue is the fact that some (many?) public companies use non-GAAP performance measures to direct investors’ attention away from GAAP-based measures of financial performance. Another financial reporting topic central to this case is the required quarterly reporting of financial results by public companies. Many critics have suggested that quarterly reporting imposes a significant burden on SEC registrants and prompts a non-trivial number of such companies to take drastic measures (including fraudulent accounting) to reach or surpass the consensus quarterly earnings forecasts issued by Wall Street analysts. In fact, a prominent Wall Street executive recently suggested that quarterly financial reporting by SEC registrants should be discontinued. Of course, you can link the two financial reporting topics discussed in the two previous paragraphs to the auditing domain. For example, there is no doubt that the accounting gimmicks or outright fraudulent accounting that corporate executives sometimes use to window-dress their quarterly financial reports pose significant challenges for auditors who review those reports.
- 47. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.7 Bankrate, Inc. 143 Suggested Solutions to Case Questions 1. AS 4105, “Reviews of Interim Financial Information,” of the PCAOB’s auditing standards is the authoritative source in this context. According to AS 4105.07, “The objective of a review of interim financial information pursuant to this section is to provide the accountant [auditor] with a basis for communicating whether he or she is aware of any material modifications that should be made to the interim financial information for it to conform with generally accepted accounting principles.” This paragraph goes on to clearly distinguish between the nature and scope of an interim review and a full-scope financial audit. For example, the paragraph notes that a review “consists principally of performing analytical procedures and making inquiries of persons responsible for financial and accounting matters . . .” The first reference to “fraud” can be found in AS 4105.11. That paragraph instructs an accountant [auditor] performing a review “to update his or her knowledge of the entity’s business and internal controls . . .” During such an update, the accountant should “specifically consider” several factors including “(c) identified risks of material misstatement due to fraud . . .” While inquiring of “members of management who have responsibilityfor financial and accounting matters” an accountant performing a review should ask such individuals about “Their knowledge of anyfraud or suspected fraud affecting the entity involving (1) management, (2) employees who have significant roles in internal control, or (3) others where the fraud could have a material effect on the financial statements. (AS 4105.18) At any point during a review, if an accountant becomes aware of “information that leads him or her to believe that the interim financial information may not be in conformity with generally accepted accounting principles,” the interim review procedures must be “extended.” (AS 4015.22) This requirement would mandate that an accountant pursue any apparent indications of financial statement fraud having a material impact on the client’s accounting data. So, must auditors [accountants] search for fraud while “reviewing” a public company’s quarterly financial statements? I suppose the answer to that question depends on how you interpret the relevant directives included in AS 4105. I believe the best answer is that “yes” auditors [accountants] have a responsibility to search for fraud during such a review . . . but they don’t have to search “very hard.” Granted, if they trip across indications of fraud during the performance of review procedures, then they have a more onerous responsibility to determine whether fraud has impacted the given financial statements. The fraud risk factors that the Grant Thornton auditors should have considered during the review of Bankrate’s quarterly financial statements include: (1) the preoccupation of DiMaria with reaching or surpassing Bankrate’s consensus quarterly earnings forecasts (this “preoccupation” may not have been readily apparent to the auditors); (2) the fact that the compensation of Bankrate’s top executives, including DiMaria, was directly linked to the EBITDA reported by the company—see footnote 7 in the case; (3) the suspicious nature of the $300,000 of revenue recorded bythe Insurance division (the revenue was recorded after the close of the quarter and helped the company reach its earnings target for that quarter); and (4) the fact that the company’s management team had an incentive to fulfill the high expectations that had been established for Bankrate by financial analysts when it re-emerged as a public company (fiscal 2012 was Bankrate’s first full fiscal year after going public again).
- 48. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.7 Bankrate, Inc. 144 2. Generally, the SEC defines earnings management as a “material and intentional misrepresentation” of a given entity’s reported operating results. Because that definition could be used interchangeably with “fraudulent accounting,” the two expressions are effectively equivalent to the SEC. Other parties, however, typically define earnings management less ominously than fraudulent accounting. For example, the online business encyclopedia, Investopedia, defines earnings management as “The use of accounting techniques to produce financial reports that may paint an overly positive picture of a company’s business activities and financial position.” This latter definition is less severe than the SEC’s definition because it doesn’t include a reference to materiality. Although the Investopedia definition of earnings management appears to be more widely accepted, there is no doubt that the SEC’s definition of earnings management should “carry more weight” among corporate executives, auditors, etc. given the critical oversight role that the federal agency plays in the accounting and financial reporting domain. Under what conditions is earnings management acceptable? If we define that term as “painting an overly positive picture” of an entity’s operating results, one set of circumstances that could qualify as “acceptable” earnings management is when a company defers discretionary expenditures near the end of a financial reporting period to reach a target earnings number. Then again, the deferral of many, if not most, discretionary expenditures, such as maintenance costs on production line equipment, is not in the best interests of a given entity over the long term, meaning that company management may be violating their fiduciary responsibility to stockholders and other parties when they do so. Another possible case when earnings management is “acceptable” is when there is considerable “wiggle room” in a given accounting or financial reporting rule. That is, the given rule is quite subjective and a company’s executives “take advantage” of that subjectivity by interpreting the rule in the most beneficial way for their entity. Although many parties may suggest this type of earnings management is “acceptable,” I believe the majority of professional accountants would disagree. 3. The best strategy for answering this question is to first define the phrase “materiality.” Ironically, the SEC does not have its own “materiality standard.” Instead, the SEC invokes the following definition of materiality applied by the U.S. Supreme Court: “Information is material if there is a substantial likelihood that a reasonable investor would consider the information in making an investment decision or if the information would significantly alter the total mix of available information.” The FASB’s definition of materiality can be found in Statement of Financial Accounting Concepts No.8: “Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude or both of the items to which the information relates in the context of an individual entity’s financial report.” [Note: At press time, the FASB was considering a proposal to adopt the Supreme Court/SEC definition of materiality.] Both AS 2105, “Consideration of Materiality in Planning and Performing an Audit,” of the PCAOB auditing standards and the relevant AICPA Professional Standards effectively embrace the U.S. Supreme Court/SEC definition of materiality. (The relevant discussion of materiality in the AICPA Professional Standards can be found at AU-C Section 320.02.) The AICPA Professional
- 49. © 2018 CengageLearning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Case 2.7 Bankrate, Inc. 145 Standards, however, have also introduced the concept of “performance materiality” to the professional auditing literature. That term is defined as follows: “The amount or amounts set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole. If applicable, performance materiality also refers to the amount or amounts set by the auditor at less than the materiality level or levels for particular classes of transactions, account balances, or disclosures. Performance materiality is to be distinguished from tolerable misstatement.” [AU-C 320.09] In turn, AU-C 530.05 defines “tolerable misstatement as follows: “A monetary amount set by the auditor in respect of which the auditor seeks to obtain an appropriate level of assurance that the monetary amount set bythe auditor is not exceeded bythe actual misstatement in the population.” In summary then, from an accounting and financial reporting standpoint “materiality” refers to an amount or item or set of circumstances that would “make a difference” in the minds of a reasonably informed user of financial statements. The auditing domain embraces this general definition or concept but is more concerned with “applying” the materiality construct in the context of auditing a set of financial statements. To finally address Question #3, we have to identify the factors that determine whether a specific financial statement amount is “material.” There are two general sets of such factors: quantitative and qualitative factors. (See paragraph 17 of AS 2810, “Evaluating Audit Results.”) Quantitatively speaking, accountants and auditors typically identify “material” items in reference to some given financial statement benchmark such as net income or change in net income from one period to the next. The old “5 percent rule” is probably the most widely used (if not abused) quantitative materiality standard, that is, an amount is material if it would change the given base or benchmark amount by 5 percent or more. For example, Bankrate’s net income for the second quarter of 2012 was overstated by approximately 5 percent. The SEC ruled that overstatement was material. DiMaria, financial analysts tracking the company’s stock, and the SEC apparentlyall agreed that the most relevant financial benchmarks for the company were adjusted EBITDA and adjusted EPS. Understand that although Bankrate’s adjusted EPS was misstated by a little more than 5 percent by the company’s accounting gimmicks ($.18 / $.17), the corresponding misstatement of adjusted EBITDA was less than 4 percent ($37.5 million / $36.2 million). This is where the issue of “qualitative” materiality came into play. The SEC apparently believed that when it came to an overall global decision of whether Bankrate’s EBITDA was materially misstated due to its fraudulent accounting, it was really a question of whether or not the fraudulent accounting decisions allowed the company to reach its earnings target for the given quarter. In other words, in this important context, materiality determination became a qualitative or “nominal” (yes/no) measurement. More generally, a misstatement due to fraud has a lower qualitative materiality threshold than a misstatement due to some unintentional cause.
- 50. Discovering Diverse ContentThrough Random Scribd Documents
- 51. "Beaver Tail iswise. But he did not come back into the wigwams of the Sioux to tell them this?" "Not a bit on it. But I had ter go through with what the law-makers of my people call ther preramble fust. What I come back fer war ter whisper in yer ears that yer have bin nussin' a pesky, p'ison sarpint in yer bosom, an' it am a-gittin' ready ter sting yer ter the heart—all on yer." There was a great commotion, and every one pressed still nearer to catch his words, entirely forgetting their recent fears, while the confused old Medicine muttered mysteriously: "I knew there was some great danger coming, from the black circles around the moon, and the rattling of the bones of the dead in their coffins." "Wal, ef yer did, yer took good keer ter keep it ter yerself, old fuss and snake-skins and feathers." "Let Beaver Tail go on," commanded the chief. "And I'll make short work on it, too. The pale-face whom yer trusted an' treated as a brother, are the blackest kind of a traitor." "Ugh!" "He has bin stealin' away, an' has got a great lot of warriors hidden within a few miles, and they intend ter come an' butcher ye all—men an' wimin an' children—jist on ercount of his lies." "How do you know this?" "Wal, I found it out; an' ter show I war yer friend, I scouted around and found whar they am encamped, and got ther best of ther white- skinned devil, and have him jist as safe as yer ever did a wolf in a trap loaded with stones." "Where is he?" "That hain't the question now. In the fust place, yer must know that I speak the truth. Thar's the brave Young Bear, an' Burning Cloud, an' the Leetle Raven, as yer call them. See if all on them don't say the same thing."
- 52. "Beaver Tail speakswell." "And ther truth." The three whom he had designated came forward and gave their testimony, and then Young Bear told of having trailed the party, who were hidden in the forest awaiting the signal of the renegade, Parsons, and that there was quite a force and well armed. "Thar!" exclaimed the scout, triumphantly; "hain't it jist as I said?" "Beaver Tail is our brother!" answered a hundred voices. "An' likely to be more so than yer knows on," with a sly wink at Burning Cloud. "Where is the traitor? Let our brother tell, that we may put him to the torture, and then go and drive our enemies before us as the wolves do the deer." "Now, yer jist hain't a-goin' ter do any thin' of the kind! Yer kin have the traitor fer torture, an' welcome, fer I never saw any one that more desarved it. But, yer hain't a-goin' ter fight the rest. I'll go an' explain it all, an' send them about thar business. Will yer agree ter that?" "There would be many scalps," mused the chief. "An' yer'd be likely ter lose yer own, an' have the hull tribe wiped clean out of the 'arth." A brief discussion followed, and a faithful promise having been given that no one of white skin should be molested but Parsons, the scout gave a signal to the brother of the Burning Cloud, who, with another brave, instantly disappeared. They soon returned, dragging along the renegade, and the shout that then rent the heavens could have been heard for miles. "Now," said the scout, "yer can't expect me ter take er hand in yer punishment. It wouldn't be nateral fer me ter do so. But ef I had my way I'd whip him like er dorg." It was an entirely new idea to the Indians, and immediately seized upon. Despite his struggles and his pleadings, the renegade was dragged to the post of torture—his garments cut away to his waist
- 53. and his nakedback exposed. Then a dozen hands brought tough sprouts of the hickory, and applied them with all the strength of their muscular arms. The scout took advantage of the excitement attending the torture to make a visit to the physician, whom he found among the happiest of mortals. Fearing that something might still happen to him and his beautiful Olive, the old scout secured the Young Bear and Little Raven as guides and protectors, and saw them fairly started to join the party waiting for the renegade. "Yer kin tell them better nor I could," said the honest-hearted fellow, "all erbout it." "And you?" asked the physician. "Wal, I've got ter stay and see the ther thing out." "And then?" "Why," blushing like a school-boy detected in stealing his first kiss, "I'll have ter talk with ther Burning Cloud er leetle erbout that. She hain't got so fair er skin as yer wife that am ter be, doctor, but her heart am jest as white." "I don't doubt it in the least." "Ther fact am we perpose ter travel in double harness ther rest on our lives and stick up er wigwam somewhar, though I can't tell jest yet whar it will be." "She is a good and brave girl." "Yes, all of that, and ther Little Raven am ernuther. It hain't often yer kin find sich squaws. But, yer mustn't stand heah er talkin'. Git ter ther camp of ther white folks as soon as ever yer kin." "But, we shall certainly see you again?" "More'n likely. Yes, we—that am ther Cloud and me—will strike yer trail berfore long, and prehaps keep on with yer till ther end. I've quite er notion ter gi'n up this 'er' jerrymanderin' life and settle down, and I reckon diggin' gold will suit me as well as any thin' else,
- 54. 'specially as itam in er country whar I kin hunt when I have er mind ter." He wrung both their hands, went with them as far as possible upon the trail, and then returned to talk to his dusky love about their future. But as the shadows lengthened he was again attracted to the prisoner, and saw that the torture had been renewed. He was standing tied to the fire-blackened post, evidently more dead than alive. Almost entirely stripped of his clothing there was not a spot to be found that did not bear the marks of arrow, hatchet, knife or whip, and the blood that had oozed forth had congealed and gave him the most ghastly appearance that could be imagined. His hair and whiskers were clotted and his face streaked with gore, and between the crimson lines was white as chalk, while the working of the muscles—twitching constantly with pain—made the strong- hearted scout shudder and grow faint even to gaze upon. Night passed, and with every mark of the horrid torture removed, the village rung with notes of joy. It had become known that the white man wished to be adopted into the tribe—that he was to take the Burning Cloud for a wife and that he had already notified the chief to that effect. Great, consequently, were the preparations, especially as the Young Bear and Little Raven would be married at the same time, and the simple ceremony having been performed, the entire tribe feasted— and made gluttons of themselves. Then the newly married couples stole away to pass their honeymoon alone. Such a thing was common, and nothing was thought of it. But though one returned after the lapse of a few days, of the other nothing was ever seen, and the scout and his bride became only a remembrance among the Sioux.
- 55. CHAPTER XVII. AFTER THECLOUDS—THE SUN! The party to which the renegade Parsons had applied for assistance waited a long time for his coming and were about to give him up, when they were surprised by the appearance of the doctor and the beautiful Olive; and when all had been explained they waxed most exceedingly wroth and determined to leave the traitor to his fate. In that they were wise. Notwithstanding all the promises given to the scout, they had numerous spies out, and upon the first symptom of retaliation they would have ambushed, and cut to pieces the entire party—so little faith is there to be put in the word of the generality of Indians. That the renegade would be punished far more effectually than they would have had the heart to carry out they did not doubt, and leaving him to his fate they returned to the waiting wagons, resumed the journey that had been interrupted, and pressed forward to make up for the precious time that had been lost. It was almost as heaven for the doctor and Olive to be together again and in safety, and each had so much to tell that the long summer days were far too short. The sufferings through which they had passed made their love doubly dear, and they longed for the time when they could be joined in marriage. That, however, was denied them until some settlement could be reached. But while thinking thus of their own happiness they never failed to remember the scout and Burning Cloud with tears of gratitude, and as the days lengthened out into a week, they wondered very much what had become of them. One night their suspense was unexpectedly relieved. The couple were found waiting for the train on the banks of a river, and thenceforward the scout resumed his old position of guide, and as they were gathered around the little camp-fire he filled in the outlines of the story that the doctor had merely sketched.
- 56. When the firstfrontier fort was reached there was a double wedding, and though Olive shone in all her wondrous beauty yet the dusky child of the forest almost rivaled her in her semi-savage charms. This proceeding the scout, though more from bashfulness than for any other reason, had somewhat opposed. "We have been married once," he said, "and ther Cloud am satisfied and so am I." "It was a heathen ceremony," suggested Olive, who, womanlike, had her peculiar notions of what constituted the fitness of such things. "Wal, it mought be, but thar hain't no priest nor prayer-book that kin bind us any tighter than we now am, nor make us any more true." "That may be. But remember you come of a Christian people, and must educate your wife." "When I hain't got no edercation myself!" he laughed. Nevertheless he consented after having a talk with the Indian girl, and finding it was her wish to be married by the "Medicine of the Manitou of the pale-faces," and so it was done. "And speakin' of the Medicine," the scout said, a few days afterward, when they were talking over the subject, "reminds me of ther old one of ther Sioux." "What has become of him?" questioned the doctor. "I owe him a deep debt of vengeance, but I fear it will never be paid." "Ef it hain't by this time I am very much mistaken." "You did not kill him?" "Not exactly, but I reckon it resulted in ther same thing." "I do not understand how that can be." "Wal, I'll tell yer, and that puts me in mind that I promised you, Cloud, ter do so some day. Don't yer remember what I said erbout er leetle business?" "She never forgets what her brave tells," was the truthful and characteristic answer of the Indian woman, who looked up to her
- 57. husband as noone of purely white skin would ever have done. "Fust I must give yer er description of what kind of er den the old Satan kept." He proceeded at length to do so, and then described how he had removed the ash and untied the animals so that both they and the terrible serpents could have full play. "He must have met a fearful death," replied the physician, with a shudder. "Thar hain't no doubt on that. Ef he chanced to miss ther sarpints— which I don't think he could—thar b'ar and ther wildcat must have gone fer him savagely and chawed him up in erbout no time." "But his death was as nothing compared to that of the wretched white man." "No, heaven keep us all from sich er one!" The journey was finished without accident, and a few years later both the doctor and the scout had made themselves comfortable— one by practice and the other by patient industry and hunting. But never have they—never will they forget the terrible scenes through which they passed, and their children hear the story told with shudders. What then must have been the reality? THE END. DIME POCKET NOVELS. PUBLISHED SEMI-MONTHLY, AT TEN CENTS EACH. 1—Hawkeye Harry. By Oll Coomes. 2—Dead Shot. By Albert W. Aiken.
- 58. 3—The Boy Miners.By Edward S. Ellis. 4—Blue Dick. By Capt. Mayne Reid. 5—Nat Wolfe. By Mrs. M. V. Victor. 6—The White Tracker. Edward S. Ellis. 7—The Outlaw's Wife. Mrs. Ann S. Stephens. 8—The Tall Trapper. By Albert W. Aiken. 9—Lightning Jo. By Capt. Adams. 10—The Island Pirate. By Capt. Mayne Reid. 11—The Boy Ranger. By Oll Coomes. 12—Bess, the Trapper. By E. S. Ellis. 13—The French Spy. By W. J. Hamilton. 14—Long Shot. By Capt. Comstock. 15—The Gunmaker. By James L. Bowen. 16—Red Hand. By A. G. Piper. 17—Ben, the Trapper. By Lewis W. Carson. 18—Wild Raven. By Oll Coomes. 19—The Specter Chief. By Seelin Robins. 20—The B'ar-Killer. By Capt. Comstock. 21—Wild Nat. By Wm. R. Eyster. 22—Indian Jo. By Lewis W. Carson. 23—Old Kent, the Ranger. Edward S. Ellis. 24—The One-Eyed Trapper. Capt. Comstock. 25—Godbold, the Spy. By N. C. Iron. 26—The Black Ship. By John S. Warner. 27—Single Eye. By Warren St. John. 28—Indian Jim. By Edward S. Ellis. 29—The Scout. By Warren St. John. 30—Eagle Eye. By W. J. Hamilton. 31—The Mystic Canoe. By Edward S. Ellis. 32—The Golden Harpoon. By R. Starbuck. 33—The Scalp King. By Lieut. Ned Hunter. 34—Old Lute. By E. W. Archer. 35—Rainbolt Ranger. By Oll Coomes. 36—The Boy Pioneer. By Edward S. Ellis. 37—Carson, the Guide. By J. H. Randolph. 38—The Heart Eater. By Harry Hazard. 39—Wetzel, the Scout. By Boynton Belknap.
- 59. 40—The Huge Hunter.By Ed. S. Ellis. 41—Wild Nat, the Trapper. Paul Prescott. 42—Lynx-cap. Paul Bibbs. 43—The White Outlaw. By Harry Hazard. 44—The Dog Trailer. By Frederick Dewey. 45—The Elk King. By Capt. Chas. Howard. 46—Adrian, the Pilot. By Col. P. Ingraham. 47—The Man-hunter. By Maro O. Rolfe. 48—The Phantom Tracker. By F. Dewey. 49—Moccasin Bill. By Paul Bibbs. 50—The Wolf Queen. By Charles Howard. 51—Tom Hawk, the Trailer. 52—The Mad Chief. By Chas. Howard. 53—The Black Wolf. By Edwin E. Ewing. 54—Arkansas Jack. By Harry Hazard. 55—Blackbeard. By Paul Bibbs. 56—The River Rifles. By Billex Muller. 57—Hunter Ham. By J. Edgar Iliff. 58—Cloudwood. By J. M. Merrill. 59—The Texas Hawks. By Jos. E. Badger, Jr. 60—Merciless Mat. By Capt. Chas. Howard. 61—Mad Anthony's Scouts. By E. Rodman. 62—The Luckless Trapper. Wm. R. Eyster. 63—The Florida Scout. Jos. E. Badger, Jr. 64—The Island Trapper. Chas. Howard. 65—Wolf-Cap. By Capt. Chas. Howard. 66—Rattling Dick. By Harry Hazard. 67—Sharp-Eye. By Major Max Martine. 68—Iron-Hand. By Frederick Forest. 69—The Yellow Hunter. By Chas. Howard. 70—The Phantom Rider. By Maro O. Rolfe. 71—Delaware Tom. By Harry Hazard. 72—Silver Rifle. By Capt. Chas. Howard. 73—The Skeleton Scout. Maj. L. W. Carson. 74—Little Rifle. By Capt. "Bruin" Adams. 75—The Wood Witch. By Edwin Emerson. 76—Old Ruff, the Trapper. "Bruin" Adams.
- 60. 77—The Scarlet Shoulders.Harry Hazard. 78—The Border Rifleman. L. W. Carson. 79—Outlaw Jack. By Harry Hazard. 80—Tiger-Tail, the Seminole. R. Ringwood. 81—Death-Dealer. By Arthur L. Meserve. 82—Kenton, the Ranger. By Chas. Howard. 83—The Specter Horseman. Frank Dewey. 84—The Three Trappers. Seelin Robins. 85—Kaleolah. By T. Benton Shields, U. S. N. 86—The Hunter Hercules. Harry St. George. 87—Phil Hunter. By Capt. Chas. Howard. 88—The Indian Scout. By Harry Hazard. 89—The Girl Avenger. By Chas. Howard. 90—The Red Hermitess. By Paul Bibbs. 91—Star-Face, the Slayer. 92—The Antelope Boy. By Geo. L. Aiken. 93—The Phantom Hunter. By E. Emerson. 94—Tom Pintle, the Pilot. By M. Klapp. 95—The Red Wizard. By Ned Hunter. 96—The Rival Trappers. By L. W. Carson. 97—The Squaw Spy. By Capt. Chas. Howard. 98—Dusky Dick. By Jos. E. Badger, Jr. 99—Colonel Crockett. By Chas. E. Lasalle. 100—Old Bear Paw. By Major Max Martine. 101—Redlaw. By Jos. E. Badger, Jr. 102—Wild Rube. By W. J. Hamilton. 103—The Indian Hunters. By J. L. Bowen. 104—Scarred Eagle. By Andrew Dearborn. 105—Nick Doyle. By P. Hamilton Myers. 106—The Indian Spy. By Jos. E. Badger, Jr. 107—Job Dean. By Ingoldsby North. 108—The Wood King. By Jos. E. Badger, Jr. 109—The Scalped Hunter. By Harry Hazard. 110—Nick, the Scout. By W. J. Hamilton. 111—The Texas Tiger. By Edward Willett. 112—The Crossed Knives. By Hamilton. 113—Tiger-Heart, the Tracker. By Howard.
- 61. 114—The Masked Avenger.By Ingraham. 115—The Pearl Pirates. By Starbuck. 116—Black Panther. By Jos. E. Badger, Jr. 117—Abdiel, the Avenger. By Ed. Willett. 118—Cato, the Creeper. By Fred. Dewey. 119—Two-Handed Mat. By Jos. E. Badger. 120—Mad Trail Hunter. By Harry Hazard. 121—Black Nick. By Frederick Whittaker. 122—Kit Bird. By W. J. Hamilton. 123—The Specter Riders. By Geo. Gleason. 124—Giant Pete. By W. J. Hamilton. 125—The Girl Captain. By Jos. E. Badger. 126—Yankee Eph. By J. R. Worcester. 127—Silverspur. By Edward Willett. 128—Squatter Dick. By Jos. E. Badger. 129—The Child Spy. By George Gleason. 130—Mink Coat. By Jos. E. Badger. 131—Red Plume. By J. Stanley Henderson. 132—Clyde, the Trailer. By Maro O. Rolfe. 133—The Lost Cache. J. Stanley Henderson. 134—The Cannibal Chief. Paul J. Prescott. 135—Karaibo. By J. Stanley Henderson. 136—Scarlet Moccasin. By Paul Bibbs. 137—Kidnapped. By J. Stanley Henderson. 138—Maid of the Mountain. By Hamilton. 139—The Scioto Scouts. By Ed. Willett. 140—The Border Renegade. By Badger. 141—The Mute Chief. By C. D. Clark. 142—Boone, the Hunter. By Whittaker. 143—Mountain Kate. By Jos. E. Badger, Jr. 144—The Red Scalper. By W. J. Hamilton. 145—The Lone Chief. By Jos. E. Badger, Jr. 146—The Silver Bugle. Lieut. Col. Hazleton. 147—Chinga, the Cheyenne. By Edward S. Ellis. Ready 148—The Tangled Trail. By Major Max Martine. Ready 149—The Unseen Hand. By J. Stanley Henderson. Ready 150—The Lone Indian. By Capt. Chas. Howard. Ready March 23d.
- 62. 151—The Branded Brave.By Paul Bibbs. Ready April 6th. 152—Billy Bowlegs, the Seminole Chief. Ready April 20th. 153—The Valley Scout. By Seelin Robins. Ready May 4. 154—Red Jacket, the Huron. By Paul Bibbs. Ready May 18th. BEADLE AND ADAMS, Publishers, 98 William Street, New York.
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