Deck 5: Fraud in Financial Statements and Auditor Responsibilities

Question 1

Computer Associates
Computer Associates (CA) is a business consulting and software development company that designs, markets, and licenses computer software products that allow businesses to run and manage critical aspects of their information technology efficiently. CA's stock trades on the NYSE and is registered pursuant to Section 12(b) of the Exchange Act, 15 U.S.C. §78l(b).
Between about the fourth quarter of fiscal year (FY) 1998 through the second quarter of FY2001, CA engaged in a widespread practice that allowed for the premature recognition of revenue from software licensing agreements. CA personnel recorded, into the just-elapsed fiscal quarter, revenue from software contracts that were not finalized and signed by both CA and its customers until days or weeks after that quarter ended. The reported revenue was improper because it violated GAAP, which required that license agreements be fully executed by both CA and its customers by quarter end before recognizing revenue. CA's reported revenue and earnings per share (EPS) appeared to meet or exceed Wall Street analysts' expectations, when-in truth and fact-those results were based in part on revenue that CA recognized prematurely and in violation of GAAP. 1
Audit Committee Investigation
In 2003, CA announced that the Audit Committee of its Board of Directors was conducting an investigation into the timing of revenue recognition at the company. On April 26, 2004, CA filed with the SEC a Form 8-K ("Form 8-K") stating, among other things, that:
"The Audit Committee's investigation found accounting irregularities that led to material misstatements of the Company's financial reports for fiscal years 2000 and 2001, and prior periods. The effect of prior period errors which have an impact on fiscal year 2000 have been considered as part of this restatement. The Audit Committee believes that several factors contributed to the improper recognition of revenue in these periods, including a practice of holding the financial period open after the end of the fiscal quarters, providing customers with contracts with preprinted signature dates, late countersignatures by Company personnel, backdating of contracts, and not having sufficient controls to ensure the proper accounting. In addition, the Audit Committee found that certain former executives and other personnel were engaged in the practice of "cleaning up" contracts by, among other things, removing fax time stamps before providing agreements to the outside auditors. These same executives and personnel also misled the Company's outside counsel, the Audit Committee and its counsel and accounting advisers regarding these accounting practices."
Also in the Form 8-K, CA announced that it was restating over $2.2 billion in revenue that CA had recognized improperly in FY2000 and FY2001.
Improper Revenue Recognition at CA
From at least the fourth quarter of FY1998 through the second quarter of FY2001, CA derived its income primarily from licensing software and providing maintenance for that software. CA's software operated and maintained powerful "mainframe" computers, those generally used by businesses and other organizations. Prior to October 2000, CA's contract and licensing model involved entering into long-term licensing contracts, some as long as seven years in duration. Under that business model, customers paid an initial licensing fee for the software, plus subsequent licensing fees for the right to use the software in subsequent years. In addition, customers paid CA for ongoing maintenance, such as technical support. Customers often entered into long-term contracts and spread out the licensing and maintenance fees over the term of the contract.
For contracts under its pre-October 2000 business model, GAAP allowed CA to recognize all the license revenue called for during the duration of the contract up front, during the fiscal quarter in which the software was shipped and the contract was executed and final.
SOP 97-2 , 2 which the AICPA adopted in October 1997, requires the following before revenue can be recognized from a software sale:
• Evidence of an arrangement
• Delivery
• Fixed and determinable fees
• Ability to collect
When a software company uses contracts requiring signatures by the software company and its customer, then SOP 97-2 provides that both signatures-the software company and the customer-are required as "evidence of an arrangement" before the software company may recognize revenue. During the period in question, all CA's license agreements required signatures by both CA and the customer.
Materially False Statements and Omissions in Filings with the SEC
During at least the fourth quarter of FY1998 through the second quarter of FY2001, CA violated GAAP, including SOP 97-2 , by backdating software contracts into prior fiscal quarters expired software contracts that were not executed-and for which "evidence of an arrangement" did not exist-until a subsequent quarter. This extended quarters practice resulted in CA's premature recognition of revenue. As a consequence, CA made material misrepresentations and omissions of fact concerning CA's revenues and earnings for the fourth quarter of FY1998 through the second quarter of FY2001 in various public documents and in connection with the offer, purchase, and sale of securities. CA's reported results for at least the fourth quarter of FY1998 through the fourth quarter of FY2000 appeared to meet or exceed the revenue and earnings estimates of outside analysts when, in fact, those reported results did not comply with GAAP and were false and misleading.
In its Form 8-K, which was not an audited restatement, CA admits that the extended quarters practice resulted in CA prematurely recognizing substantial percentages of revenue for all quarters of FY2000 and the first two quarters of FY2001. The following chart illustrates the impact of the premature revenue recognition in each fiscal quarter:

The greatest amount of prematurely recognized revenue as a result of the extended quarters practice occurred in FY2000, particularly in the third quarter, followed by the second, fourth and first quarters of that fiscal year. If CA had not improperly recognized revenue in each of those fiscal quarters, CA would not have met analysts' revenue and earnings estimates.
The following is a chart which shows the impact of the extended quarters practice on CA's earnings per share in the four quarters of FY2000 and the extent of the material misstatements and misrepresentations in the Forms 10-Q and Form 10-K that CA filed with the SEC which reported each quarterly result, and related public statements made by CA:

A Systemic and Intentional Practice
The premature recognition of revenue at CA during at least the fourth quarter of FY1998 through the second quarter of FY2001 was the result of a systemic, intentional practice by certain CA personnel. To implement and conceal this extended quarters practice, CA personnel employed a variety of improper techniques, many of which rendered the company's books and records false and misleading, including:
• Some employees at CA called the extended quarters practice the "35-day month" practice, because generally most quarters were extended by at least 3 business days, although some quarterly extensions lasted longer.
• Sometimes CA had its customers execute contracts bearing preprinted dates from the just-expired quarter, even though the customer did not actually sign the contract until days or weeks into the new quarter.
CA substantially stopped prematurely recognizing revenue for software contracts signed after quarter end by CA's customers during the first quarter of FY2001 (quarter ended June 30, 2000). That quarter, CA missed its Wall Street earnings estimates. CA issued a press release on July 3, 2000, stating that it would miss the analysts' estimates, specifically citing the fact that the company did not complete several large contracts that they had hoped to conclude before the close of the quarter. This was only the second time in CA's then-recent history that CA missed Wall Street's estimates. The next trading day, July 5, 2000, CA's share price dropped over 43 percent, from $51.12 to $28.50, as the market reacted to the news. The share price has not recovered and closed at $26.26 on June 14, 2013.
CA continued to recognize revenue prematurely from contracts that CA signed after quarter end (although, with a few exceptions, the customer did sign the contract by quarter end) for the first two quarters of FY2001, after which that practice substantially stopped.
Legal Matters Resolved
In September 2004, CA agreed to pay $225 million in restitution to shareholders to settle the civil case brought by the SEC and to defer criminal charges by the U.S. Department of Justice. At the same time, a federal grand jury brought criminal charges against former CA chairman and CEO Sanjay Kumar. Kumar resigned in April 2004 following an investigation into securities fraud and obstruction of justice at CA. A federal grand jury in Brooklyn indicted him on fraud charges on September 22, 2004. Kumar pled guilty to obstruction of justice and securities fraud charges on April 24, 2006. On November 2, 2006, he was sentenced to 12 years in prison and fined $8 million for his role in the massive accounting fraud at CA. Kumar is currently housed at the Federal Correctional Institution in Miami, Florida, with a projected release date of January 25, 2018.
Questions
1. Analyze each revenue recognition technique identified in the audit committee investigation and explain whether each technique violates revenue recognition rules in accounting. Evaluate the practices followed by CA from an ethical perspective.
2. CA executives were not accused of reporting nonexistent deals or hiding major flaws in the business. The contracts that were backdated by a few days were real. Was this really a crime, or should it fall under the heading of "no harm, no foul"? Be sure to use ethical reasoning in responding to the question.
3. In her "Seven Signs of Ethical Collapse," which were discussed in Chapter 3, Marianne Jennings listed "pressure to maintain the numbers" as the number one sign. How can a company like CA resist such pressure?
1 The material in this case is taken from the SEC complaint against CA that can be found at http://www.sec.gov/litigation/complaints/comp18891-cai.pdf.
2 SOPs are pronouncements on specific accounting matters that had been issued by the AICPA's Accounting Standards Division from 1974 to 2009. The FASB GAAP Codification of authoritative accounting standards issued in 2009 supersedes existing sources of US GAAP including Statements of Position.

Answer 1

1. Accrual earnings are income that has been earned but not yet received in cash. For example, a contractor who completed a construction project but not paid yet. These are considered "earned" when the customer finishes the purchases, e.g. contract signed or delivery made. The revenue on the company's financial statements were inflated due to recognizing income that has not been earned. The objectionable practices listed
• 35 month days, extends the revenue recognition period
• Dating contracts with earlier dates that were signed later
The company violated its responsibility to its stockholders to keep accurate records. They also misled stockholders of their earning strength. 2. Just because a crime doesn't hurt anyone doesn't mean that there are no repercussions. By backdating contracts the revenues were inflated, making the company look better financially than it actually was. Investors use this information for their portfolio. But since this information is not accurate this causes losses to investors later on when the revenues have to be corrected for. The company also gives a poor ethical image for its employees to follow by condoning such practices. 3. These companies need to realize that the numbers are only allocated, shifted. By reporting revenues earned say in December when it's actually earned in January, it only shifts the numbers down. The company will have to keep up this practice. Furthermore, shifting numbers doesn't help the company financially in the long run. In the long run, their revenue are determined by their products and services not by shifting numbers.

Question 2

What is the purpose of audit "risk assessment"? What are its objectives, and why is it important in assessing the likelihood that fraud may occur?

Answer 2

Risk assessment is the identification of risk factors that will negatively impact a business. For auditing the important risk are fraud. Fraud is a deliberate attempt to deceive, such as lying about business expenses or misreporting the actual revenue earned. By identifying fraud risk, auditors can advise management on safeguards to prevent it. Doing so improves internal control.

Question 3

ZZZZ Best 1
The story of ZZZZ Best is one of greed and audaciousness. It is the story of a 15-year-old boy from Reseda, California, who was driven to be successful regardless of the costs. His name is Barry Minkow.
Minkow had high hopes to make it big-to be a millionaire very early in life. He started a carpet cleaning business in the garage of his home. But Minkow realized early on that he was not going to become a millionaire cleaning other people's carpets. He had grander plans than that. Minkow was going to make it big in the insurance restoration business. In other words, ZZZZ Best would contract to do carpet and drapery cleaning jobs after a fire or flood. Because the damage from the fire or flood probably would be covered by insurance, the customer would be eager to have the work done, and perhaps not be all that concerned with how much it would cost. The only problem with Minkow's insurance restoration idea was that it was all a fiction. There were no insurance restoration jobs-at least not for ZZZZ Best. Allegedly, over 80 percent of his revenue was from this work. In the process of creating the fraud, Minkow was able to dupe the auditors, Ernst Whinney (one of the predecessor firms of Ernst Young), into thinking the insurance restoration business was real. The auditors never caught on until it was too late.
How Barry Became a Fraudster
Minkow wrote a book, Clean Sweep: A Story of Compromise, Corruption, Collapse, and Comeback , 2 that provides some insights into the mind of a 15-year-old kid who was called a "wonder boy" on Wall Street until the bubble burst. He was trying to find a way to drum up customers for his fledgling carpet cleaning business. One day, while he was alone in his garage-office, Minkow called Channel 4 in Los Angeles. He disguised his voice so he wouldn't sound like a teenager and told a producer that he had just had his carpets cleaned by the 16-year-old owner of ZZZZ Best. He sold the producer on the idea that it would be good for society to hear the success story about a high school junior running his own business. The producer bought it lock, stock, and carpet cleaner. Minkow gave the producer the phone number of ZZZZ Best and waited. It took less than five minutes for the call to come in. Minkow answered the phone and when the producer asked to speak with Mr. Barry Minkow, Minkow said: "Who may I say is calling?" Within days, a film crew was in his garage shooting ZZZZ Best at work. The story aired that night, and it was followed by more calls from radio stations and other television shows wanting to do interviews. The calls flooded in with customers demanding that Barry Minkow personally clean their carpets.
As his income increased in the spring of 1983, Minkow found it increasingly difficult to run the company without a checking account. He managed to find a banker that was so moved by his story that the banker agreed to allow an underage customer to open a checking account. Minkow used the money to buy cleaning supplies and other necessities. Even though his business was growing, Minkow ran into trouble paying back loans and interest when due.
Minkow developed a plan of action. He was tired of worrying about not having enough money. He went to his garage-where all his great ideas first began-and looked at his bank account statement, which showed that he had more money than he thought he had based on his own records. Minkow soon realized it was because some checks he had written had not been cashed by customers, so they didn't yet show up on the bank statement. Voila! Minkow started to kite checks between two or more banks. He would write a check on one ZZZZ Best account and deposit it into another. Because it might take a few days for the check written on Bank #1 to clear that bank's records (back then, checks weren't always processed in real time the way they are today), Minkow could pay some bills out of the second account and Bank #1 would not know-at least for a few days-that Minkow had written a check on his account when, in reality, he had a negative balance. The bank didn't know it because some of the checks that Minkow had written before the visit to Bank #2 had not cleared his account in Bank #1.
It wasn't long thereafter that Minkow realized he could kite checks big time. Not only that, he could make the transfer of funds at the end of a month or a year and show a higher balance than really existed in Bank #1 and carry it onto the balance sheet. Because Minkow did not count the check written on his account in Bank #1 as an outstanding check, he was able to double-count.
Time to Expand the Fraud
Over time, Minkow moved on to bigger and bigger frauds, like having his trusted cohorts confirm to banks and other interested parties that ZZZZ Best was doing insurance restoration jobs. Minkow used the phony jobs and phony revenue to convince bankers to make loans to ZZZZ Best. He had cash remittance forms made up from nonexistent customers with whatever sales amount he wanted to appear on the document. He even had a co-conspirator write on the bogus remittance form, "Job well done." Minkow could then show a lot more revenue than he was really making.
Minkow's phony financial statements enabled him to borrow more and more money and expand the number of carpet cleaning outlets. However, Minkow's personal tastes had become increasingly more expensive, including purchasing a Ferrari with the borrowed funds and putting a down payment on a 5,000-square-foot home. So, the question was: How do you solve a perpetual cash flow problem? You go public! That's right, Minkow made a public offering of stock in ZZZZ Best. Of course, he owned a majority of the stock to maintain control of the company.
Minkow had made it to the big leagues. He was on Wall Street. He had investment bankers, CPAs, and attorneys all working for him-the now 19-year-old kid from Reseda, California, who had turned a mom-and-pop operation into a publicly owned corporation.
Barry Goes Public
Minkow's first audit was for the 12 months ended April 30, 1986. A sole practitioner performed the audit. (There are eerie similarities in the Madoff fraud, with its small practitioner firm-Friehling Horowitz-conducting the audit of a multibillion-dollar operation, and that of the sole practitioner audit of ZZZZ Best.)
Minkow had established two phony front companies that allegedly placed insurance restoration jobs for ZZZZ Best. He had one of his cohorts create invoices for services and respond to questions about the company. There was enough paperwork to fool the auditor into thinking the jobs were real and the revenue was supportable. However, the auditor never visited any of the insurance restoration sites. If he had done so, there would have been no question in his mind that ZZZZ Best was a big fraud.
Pressured to get a big-time CPA firm to do his audit as he moved into the big leagues, Minkow hired Ernst Whinney to perform the April 30, 1987, fiscal year-end audit. Minkow continued to be one step ahead of the auditors-that is, until the Ernst Whinney auditors insisted on going to see an insurance restoration site. They wanted to confirm that all the business-all the revenue-that Minkow had said was coming in to ZZZZ Best was real.
The engagement partner drove to an area in Sacramento, California, where Minkow did a lot of work-supposedly. He looked for a building that seemed to be a restoration job. Why he did that isn't clear, but he identified a building that seemed to be the kind that would be a restoration job in progress.
Earlier in the week, Minkow had sent one of his cohorts to find a large building in Sacramento that appeared to be a restoration site. As luck would have it, Minkow's associate picked out the same site as had the partner later on. Minkow's cohorts found the leasing agent for the building. They convinced the agent to give them the keys so that they could show the building to some potential tenants over the weekend. Minkow's helpers went up to the site before the arrival of the partner and placed placards on the walls that indicated ZZZZ Best was the contractor for the building restoration. In fact, the building was not fully constructed at the time, but it looked as if some restoration work was going on at the site.
Minkow was able to pull it off in part due to luck and in part because the Ernst and Whinney auditors did not want to lose the ZZZZ Best account. It had become a large revenue producer for the firm, and Minkow seemed destined for greater and greater achievements. Minkow was smart and used the leverage of the auditors not wanting to lose the ZZZZ Best account as a way to complain whenever they became too curious about the insurance restoration jobs. He would even threaten to take his business from Ernst and Whinney and give it to other auditors.
Minkow also took a precaution with the site visit. He had the auditors sign a confidentiality agreement that they would not make any follow-up calls to any contractors, insurance companies, the building owner, or other individuals involved in the restoration work. This prevented the auditors from corroborating the insurance restoration contracts with independent third parties. The auditors clearly dropped the ball here as the firm failed to gather the evidence necessary to support the existence of the work and revenue-production from the insurance restoration contracts.
The Fraud Starts to Unravel
It was a Los Angeles housewife who started the problems for ZZZZ Best that would eventually lead to the company's demise. Because Minkow was a well-known figure and flamboyant character, the Los Angeles Times did a story about the carpet cleaning business. The Los Angeles housewife read the story about Minkow and recalled that ZZZZ Best had overcharged her for services in the early years by increasing the amount of the credit card charge for its carpet cleaning services.
Minkow had gambled that most people don't check their monthly statements, so he could get away with the petty fraud. However, the housewife did notice the overcharge and complained to Minkow, and eventually he returned the overpayment. She couldn't understand why Minkow would have had to resort to such low levels back then if he was as successful as the Times article made him out to be. So, she called the reporter to find out more, and that ultimately led to the investigation of ZZZZ Best and future stories that weren't so flattering.
Because Minkow continued to spend lavishly on himself and his possessions, he always seemed to need more and more money. It got so bad over time that he was close to defaulting on loans and had to make up stories to keep the creditors at bay, and he couldn't pay his suppliers. The complaints kept coming in, and eventually the house of cards that was ZZZZ Best came crashing down.
During the time that the fraud was unraveling, Ernst and Whinney decided to resign from the ZZZZ Best audit. The firm never did issue an audit report. It had started to doubt the veracity of Minkow and his business at ZZZZ Best.
The procedure to follow when a change of auditor occurs is for the company being audited to file an 8-K form with the SEC and the audit firm to prepare an exhibit commenting on the accuracy of the disclosures in the 8-K. The exhibit is attached to the form that is sent to the SEC within 30 days of the change. 3 Ernst Whinney waited the full 30-day period, and the SEC released the information to the public 45 days after the change had occurred. Meanwhile, ZZZZ Best filed for bankruptcy. During the period of time that had elapsed, Minkow had borrowed more than $1 million, and the lenders never were repaid. Bankruptcy laws protected Minkow and ZZZZ Best from having to make those payments.
Legal Liability Issues
The ZZZZ Best fraud was one of the largest of its time. ZZZZ Best reportedly settled a shareholder class action lawsuit for $35 million. Ernst Whinney was sued by a bank that had made a multimillion-dollar loan based on the financial statements for the three-month period ending July 31, 1986. The bank claimed that it had relied on the review report issued by Ernst Whinney in granting the loan to ZZZZ Best. However, the firm had indicated in its review report that it was not issuing an opinion on the ZZZZ Best financial statements. The judge ruled that the bank was not justified in relying on the review report because Ernst Whinney had expressly disclaimed issuing any opinion on the statements.
Barry Minkow was charged with engaging in a $100 million fraud scheme. He was sentenced to a term of 25 years.
Questions
1. Do you believe that auditors should be held liable for failing to discover fraud in situations such as ZZZZ Best, where top management goes to great lengths to fool the auditors? Answer this question with respect to the ethical and professional responsibilities of audit professionals when conducting an audit.
2. Discuss the red flags that existed in the ZZZZ Best case and evaluate Ernst Whinney's efforts with respect to fraud risk assessment. Do you think Ernst Whinney's relationship with ZZZZ Best influenced risk assessment and the work done on the audit?
3. These are selected numbers from the financial statements of ZZZZ Best for fiscal years

4. Evaluate Minkow's actions using the fraud triangle.
What calculations or analyses would you make with these numbers that might help you assess whether the financial relationships are "reasonable"? Given the facts of the case, what inquiries might you make of management based on your analysis?
Barry: The Afterlife
After being released from jail in 1995, Minkow became a preacher and a fraud investigator, and he spoke at schools about ethics. This all came to an end in 2011, when he admitted to helping deliberately drive down the stock price of Lennar, a home-building company, and was sent back to prison. The facts below explain what happened to Barry since 1995.
In 1997, Minkow became the senior pastor of Community Bible Church in San Diego. Soon after his arrival, a church member asked him to look into a money management firm in nearby Orange County. Suspecting something was not right, Minkow used his "fraud-sniffing" abilities to alert federal authorities, who discovered the firm was a $300 million pyramid scheme. This was the beginning of the Fraud Discovery Institute, a for-profit investigative firm. Minkow managed to dupe the investment community again; several Wall Street investors liked what they saw and sent him enough money to go after bigger targets. By Minkow's estimate, he had uncovered $1 billion worth of fraud over the years.
We assume that Minkow missed the adrenalin rush of committing fraud that kept him going for so long in the 1990s, and in 2009 he issued a report accusing the major homebuilder Lennar of massive fraud. Minkow claimed that irregularities in Lennar's off-balance-sheet debt accounting were evidence of a massive Ponzi scheme. He accused Lennar of not disclosing enough information about this to its shareholders, and also claimed that a Lennar executive took out a fraudulent personal loan. Minkow denounced Lennar as "a financial crime in progress" and "a corporate bully." From January 9, 2009 (when Minkow first made his accusations) to January 22, Lennar's stock tumbled from $11.57 a share to only $6.55. Minkow issued the report after being contacted by Nicholas Marsch, a San Diego developer who had filed two lawsuits against Lennar for fraud. One of Marsch's suits was summarily thrown out of court, while the other ended with Marsch having to pay Lennar $12 million in counterclaims.
Lennar responded by adding Minkow as a defendant in a libel-and-extortion suit against Marsch. According to court records, Minkow had shorted Lennar stock, buying $20,000 worth of options in a bet that the stock would fall. Minkow also forged documents alleging misconduct on Lennar's part. He went forward with the report even after a private investigator he had hired for the case could not substantiate Marsch's claims. (In an unrelated development, it was also revealed that Minkow operated the Fraud Discovery Institute out of the offices of his church and even used church money to fund it-something which could have potentially jeopardized his church's tax-exempt status.)
On December 27, 2010, Florida circuit court judge Gill Freeman issued terminating actions against Minkow in response to a motion by Lennar. Freeman found that Minkow had repeatedly lied under oath, destroyed or withheld evidence, concealed witnesses, and deliberately tried to "cover up his misconduct." According to Freeman, Minkow had even lied to his own lawyers about his behavior. Freeman determined that Minkow had perpetuated "a fraud on the court" that was so egregious that letting the case go any further would be a disservice to justice. In her view, "no remedy short of default" was appropriate for Minkow's lies. She ordered Minkow to reimburse Lennar for the legal expenses it incurred while ferreting out his lies. Lennar estimates that its attorneys and investigators spent hundreds of millions of dollars exposing Minkow's lies.
On March 16, 2011, Minkow announced through his attorney that he was pleading guilty to one count of insider trading. According to his lawyer, Minkow had bought his Lennar options using "nonpublic information." The plea, which was separate from the civil suit, came a month after Minkow learned that he was the subject of a criminal investigation. Minkow claimed not to know at the time that he was breaking the law. The SEC had already been probing Minkow's trading practices. On the same day, Minkow resigned his position as senior pastor, saying in a letter to his flock that because he was no longer "above reproach," he felt that he was "no longer qualified to be a pastor." Six weeks earlier, $50,000 in cash and checks was stolen from the church during a burglary. Though unsolved, it was noted as suspicious due to Minkow's admitted history of staging burglaries to collect insurance money.
The nature of the "nonpublic information" became clear a week later, when federal prosecutors filed a criminal information action against Minkow, with one count of conspiracy to commit securities fraud. Prosecutors charged that Minkow and Marsch conspired to extort money from Lennar by driving down its stock. The complaint also revealed that Minkow had sent his allegations to the Federal Bureau of Investigation (FBI), Internal Revenue Service (IRS), and SEC, and that the three agencies found his claims credible enough to open a formal criminal investigation into Lennar's practices. Minkow then used confidential knowledge of that investigation to short Lennar stock, even though he knew he was barred from doing so. Minkow opted to plead guilty to the conspiracy charge rather than face charges of securities fraud and market manipulation, which could have sent him to prison for life.
On March 30, 2011, Minkow pleaded guilty and was eventually sent to jail for five years and ordered to pay Lennar $584 million in damages-roughly the amount the company lost as a result of the bear raid. The ruling stated that Minkow and Marsch had entered into a conspiracy to wreck Lennar's stock in November 2008. With interest, the bill could easily approach $1 billion-far more than he stole in the ZZZZ Best scam.
Questions ( continued )
5. What factors do you think motivated Minkow to return to his evil ways after becoming a respected member of the community following his release from prison in the ZZZZ Best fraud?
6. Using Kohlberg's stages of moral development, how would you characterize Minkow's actions after being released from prison in the ZZZZ Best fraud? Explain the effects of Minkow's actions on the stakeholders who relied on him to act in a professional manner.
1 The facts are derived from a video by the ACFE, Cooking the Books: What Every Accountant Should Know about Fraud.
2 Barry Minkow, Clean Sweep: A Story of Compromise, Corruption, Collapse, and Comeback (Nashville, TN: Thomas Nelson, 1995).
3 Under current SEC rules, Item 4.01 of Form 8-K requires a company to request the former accountant to furnish a letter stating whether the former accountant agrees with the company's statements concerning the reasons for the change. Where the former accountant declines to provide such a letter, the company should indicate that fact in the Form 8-K. The company must file the 8-K report for the change in accountant within five business days of notification.

Answer 3

1. Yes, the auditors should be held liable for failing to discover fraud. This is the duty of auditor to detect and prevent fraud and any failure to detect fraud and reporting to the board of directors will hold them responsible. There must be an effective system of internal controls and an independent audit function for defense against fraud. While conducting audit, it is the ethical and moral duties of an audit professional that auditor must perform his work with due diligence, exercise reasonable care, must be loyal and honest and work in obedience. The auditors applied all the reasonable care and due diligence to find the proper financial accounts of the corporation but failed to do so. E W was loyal towards their work and was abiding all the laws and regulations but when B tries to pull everything off then the auditor did not act against them as they did not want to lose the ZZZZ best account. This shows that auditor should be made liable as he divert from their ethical obligations. 2. There was enough paper work of the accounts of ZZZZ but there were no actual reports of the restoration sites by the previous auditors. The E W wanted to confirm all the revenues and property of the company. When the auditor inspected the restoration sites, they failed to take the reasonable steps to find out the actual papers of the site to check out to whom the site belong. E W also did not want to lose their client because of good accounts of the company. This shows that E W's relationship with ZZZZ influenced the work done on audit. The auditor came to know about some red flags and they have to work to find the true story behind the accounts of the company. Instead, they supported the company to pursue with the illegal accounting and frauds just to have good records with the company. 3. After looking into the data, we can see that there is sudden increase in the volume of sales from the year 1985 to 1986 which is up to three times more than in the year 1985. Not only sales, the current liabilities, cost of goods sold, accounts receivable were also increased three times more than in year 1985. The inquiries must be made regarding the documents, bank account statements and all the revenues that the company has earned in the financial year 1986. However, increase in the sales is normal phenomenon in this process but the enormous increase would be checked properly by the auditors honestly with due diligence. 4. The fraud triangle describes three conditions requires to be present when fraud occurs. The conditions are as follows:
a. Incentive/ pressure
b. Opportunity
c. Rationalization. The sum up of all these condition is that when the employee has an incentive or pressure then this provides an opportunity to commit fraud or act as a perpetrator. Those involved employee are able to rationalize committing a fraudulent act. In this case, B received incentives for work as carpet cleaner. He has the pressure to become the multi millionaire and started with a fiction idea of insurance restoration job. The opportunity to execute its plan was given by the bank process of clearing the checks. From there B got an idea to kite checks. B started working on the fraud ideas over the phone with the banks to obtain loans by falsifying accounts and revenue. B found one way from another to fraud banks, auditors and other third parties. 5. The Min started working as fraud detector and became the senior pastor after releasing from the jail. But his work of fraud detector provides him the opportunity to involve into the evil ways of fraud. When Min finds the fraud of L, he told Mar about it. Mar then instituted the lawsuit against L which results into the decline in the value of the share of his company. Min bets on the fall in stock and also forged the document to allege the misconduct upon the L in order to win the bet. This betting provides him the opportunity. 6. Kohlberg has six stages of moral development. They are as follows:
i. Obedience and punishment orientation. ii. Self interest orientation. iii. Interpersonal accord and conformity. iv. Authority and social order maintaining orientation. v. Social contract orientation. vi. Universal ethical principles. Min's action after being released from the jail is similar to the stage two of the K's stages of moral development. Stage two is the self interest orientation which means that individual is only concerned about himself and little care about the needs of other. Similarly is the case of Min, who only cares about his money and earnings and does not care about the other's loss because of his behavior as he done to the L. Min fraudulently forged the document to allege fraud against the Lennar in order to win the bet in which huge amount was involved. This shows that Min's behavior satisfied the second stage of moral development.

Question 4

Distinguish between an auditor's responsibilities to detect and report errors, illegal acts, and fraud. What role does materiality have in determining the proper reporting and disclosure of such events?

Question 5

Imperial Valley Thrift Loan
Bill Stanley, of Jacobs, Stanley Company, started to review the working paper files on his client, Imperial Valley Thrift Loan, in preparation for the audit of the client's financial statements for the year ended December 31, 2013. The bank was owned by a parent company, Nuevo Financial Group, and it serviced a small western Arizona community near Yuma that reached south to the border of Mexico. The bank's preaudit statements are presented in Exhibit 1.
Bill Stanley knew there were going to be some problems to contend with during the course of the audit, so he decided to review several items in the file in order to refresh his memory about the client's operations.
Background
The first item Stanley reviewed was the planning memo that he had prepared about two months earlier. This memo is summarized in Exhibit 2.
The next item he reviewed was an internal office communication on potential audit risks. This communication described three areas of particular concern:
1. The client charged off $420,000 in loans in 2012 and had already charged off $535,000 through July 31, 2013. Assuming that reserve requirements by law are a minimum of 1.25 percent of loans outstanding, this statutory amount probably would not be large enough for the loan loss reserve. This, in combination with the prior auditors' concerns about proper loan underwriting procedures and documentation, indicates that the audit engagement team should carefully review loan quality.
2. The audit report issued on the 2012 financial statements contained an unmodified opinion with an emphasis-of- matter paragraph describing the uncertainty about the client's ability to continue as a going concern. The concern was caused by the "capital impairment" declaration by the Arizona Department of Corporations.
3. The client had weak internal controls according to the prior auditors. Some of the items to look out for, in addition to proper loan documentation, were whether the preaudit financial statement information provided by the client was supported by the general ledger, whether the accruals were appropriate, and whether all transactions were properly authorized and recorded on a timely basis.
Audit Findings
Stanley conducted the audit during January and February 2014. Based on information gathered during the audit, the following were the areas of greatest concern to him:
1. Adequacy of Loan Collateral. A review of 30 loan files representing $2,100,000 of total loans outstanding (33.3 percent of the portfolio) indicated that much of the collateral for the loans was in the form of second or third mortgages on real property. This gave the client a potentially unenforceable position due to the existence of very large senior liens. For example, if foreclosure became necessary to collect Imperial Valley's loan, the client would have to pay off these large senior liens first. Other collateral often consisted of personal items such as jewelry and furniture. In the case of jewelry, often there was no effort made by the client after granting the loan to ascertain whether the collateral was still in the possession of the borrower. The jewelry could have been sold without the client's knowledge. It was difficult to obtain sufficient audit evidence about these amounts.
2. Collectibility of Loans. Many loans were structured in such a way as to require interest payments only for a small number of years (two or three years), with a balloon payment for principal due at the end of this time. This structure made it difficult to evaluate the payment history of the borrower properly. Although the annual interest payments may have been made for the first year or two, this was not necessarily a good indication that the borrower would come up with the cash needed to make the large final payment, and the financial statements provided no additional disclosures about this matter.
3. Weakness in Internal Controls. Internal control weaknesses were a pervasive concern. The auditors recomputed certain accruals and unearned discounts, confirmed loan and deposit balances, and reconciled the preaudit financial information provided by the client to the general ledger. Some adjustments had to be made as a result of this work. A material weakness in the lending function was identified. Loans were too frequently granted merely because the borrowers were well known to Imperial Valley officials, who believed that they could be counted on to repay their outstanding loans. An ability to repay these loans was based too often on "faith" rather than on clear indications that the borrowers would have the necessary cash available to repay their loans when they came due. This was of great concern to the auditors, especially in light of the inadequacy of the loan reserve, as detailed in item 5 that follows.
4. Status of Additional Capital Infusion. The audit engagement team is working under the assumption that under Arizona regulatory requirements, a thrift and loan institution must maintain a 6:1 ratio of thrift certificates to net equity capital. Based on the financial information provided by Imperial Valley, the capital deficiency was only $32,000 below capital requirements (preaudit), as follows:

Audit adjustments explained in Exhibit 3 increased the capital deficiency to $622,000, as follows:

There was a possibility that the parent company, Nuevo Financial Group, would contribute the additional equity capital. Also, management had been in contact with a potential outside investor about the possibility of investing $600,000. This investor, Manny Gonzalez, has strong ties to the Imperial Valley community and to the family ownership of Imperial Valley.
5. Adequacy of General Reserve Requirement. The general reserve requirement of 1.25 percent had not been met.
Based on the client's reported outstanding loan balance of $6,300,000, a reserve of $78,750 would be necessary. However, audit adjustments for the charge-off of uncollectible loan amounts significantly affected the amount actually required. In addition, the auditors felt that a larger percentage would be necessary because of the client's history of problems with loan collections; initially, a 5 percent rate was proposed. Management felt this was much too high, arguing that the company had improved its lending procedures in the last few months and that it expected to have a smaller percentage of charge-offs in the future. A current delinquent report received in February 2014 showed only two loans from 2013 still on the past due list. The auditors agreed to a 2 percent reserve, and an adjusting entry (AJE #3, shown in Exhibit 3) was made.
Regulatory Environment
Imperial Valley Thrift Loan was approaching certain regulatory filing deadlines during the course of the audit. Stanley had a meeting with the regulators at which representatives of management were present. Gonzalez also attended the meeting because he had expressed some interest in possibly making a capital contribution. There was a lot of discussion about the ability of Imperial Valley to keep its doors open if the loan losses were recorded as proposed by the auditors. This was a concern because the proposed adjustments would place the client in a position of having net equity capital significantly below minimum requirements.
The regulators were concerned about the adequacy of the 2 percent general reserve because of the prior collection problems experienced by Imperial Valley. The institution's solvency was a primary concern. At the time of the meeting, the regulators were quite busy trying to straighten out problems caused by the failure of two other savings and loan (S L) institutions in Arizona. Many depositors had lost money as a result of the failure of these S Ls. The regulators were concerned that a domino effect might occur, as had happened in the early 1990s, and that Imperial Valley would get caught up in the mess. Also, the regulators were unable to make a thorough audit of the company on their own, so they relied quite heavily on the work of Jacobs, Stanley, Company. In this sense, the audit was used as leverage on the institution to get more money in as a cushion to protect depositors. The regulators viewed this as essential in light of the other S L failures and the fact that the insurance protection mechanism for thrift and loan depositors was less substantial than depository insurance available through the Federal Deposit Insurance Corporation (FDIC) in commercial banks and in S Ls.
Summary of the Client's Position
The management of Imperial Valley Thrift Loan placed a great deal of pressure on the auditors to reduce the amount of the loan write-offs. It maintained that the customers were "good for the money." Managers pointed out the payments to date on most of the loans had been made on a timely basis. The client felt that the auditors did not fully understand the nature of its business. Managers contend that a certain amount of risk had to be accepted in their business because they primarily made loans that commercial banks and S Ls did not want to make. "We are the bank of last resort for many of our customers," commented bank president Eddie Salazar. Salazar then commented that the auditors' inability to understand and appreciate this element of the thrift and loan business was the main reason why the auditors were having trouble evaluating the collectibility of the outstanding loans. Management informed the auditors that they vouched for the collectibility of the outstanding loans.
Outstanding Loans
The auditors' contended that the payments to date, which were mostly annual interest amounts, were not necessarily a good indication that timely balloon principal payments would be made. They felt it was very difficult to evaluate the collectibility of the balloon payments adequately, primarily because the borrowers' source of cash for loan repayment had not been identified. They could not objectively audit or support borrowers' good intentions to pay or undocumented resources as represented by client management.
To ensure that they were not being naive about the thrift and loan industry, the auditors checked with colleagues in another office of the firm who knew more about this type of business. One professional in this office explained that the real secret of this business is to follow up ruthlessly with any nonpayer. The auditors certainly did not believe that this was being done by Imperial Valley management.
The auditors knew that Manny Gonzalez was a potential source of investment capital for Imperial Valley. They believed it was very important to give Gonzalez an accurate picture because if a rosier picture were painted than actually existed, and Gonzalez made an investment, then the audit firm would be a potential target for a lawsuit.
Board of Trustees
The auditors approached the nine-member board of trustees that oversaw the operations of Imperial Valley, three of whom also served on the audit committee. Of the nine board members, four were officers with the banks and five were outsiders. All members of the audit committee were outsiders. The auditors had hoped to solicit the support of the audit committee in dealing with management over the audit opinion issue, as detailed in the next section. However, the auditors were concerned about the fact that all five outsiders had loans outstanding from Imperial Valley that carried 2 percent interest payments until the due date in two years. Perhaps not coincidentally, all five had supported management with respect to the validity of collateral and loan collectibility issues with customers.
Auditor Responsibilities
The management of Imperial Valley Thrift Loan was pressuring the auditors to give an unmodified opinion. If the auditors decided to modify the opinion, then in the client's view, this would present a picture to their customers and the regulators that their financial statements were not accurate. The client maintained that this would be a blow to its integrity and would shake depositors' confidence in the institution.
On one hand, the auditors were very cognizant of their responsibility to the regulatory authority, and they were also concerned about providing an accurate picture of Imperial Valley's financial health to Manny Gonzalez or other potential investors. On the other hand, they wondered whether they were holding the client to standards that were too strict. After all, the audit report issued in the preceding year was unmodified with an emphasis-of-matter paragraph on the capital impairment issue. They also wondered whether the doors of the institution would be closed by the regulators if they gave a qualified or adverse opinion. What impact could this action have on the depositors and the economic health of the community? Bill Stanley wondered whose interests they were really representing-depositors, shareholders, management, the local community, or regulators, or all of these.
Stanley knew that he would soon have to make a recommendation about the type of audit opinion to be issued on the 2013 financial statements of Imperial Valley Thrift Loan. Before approaching the advisory partner on the engagement, Stanley drafted the memo on the next page to file.
Questions
1. What is the role of professional skepticism in auditing financial statements? Do you think that the auditors were skeptical enough in evaluating the operations of Imperial Valley?
2. a. Assume that the auditors decide to support man
agement's position and reduce the amount of loan write-offs. The decision was made in part because of concerns that regulators might force the bank to close its doors, and then many customers would have nowhere else to go to borrow money. Evaluate the auditors' stage of moral reasoning in making this decision.
b. Assume instead that the auditors insist on a higher level of loan write-offs and allowance for uncollectibles to reserve for loan losses. What level of reasoning are they at in making this decision?
3. Evaluate the facts of the case from the perspective of materiality and risk assessment. How does your evaluation help in determining the appropriate audit opinion to give in the Imperial Valley case? What opinion do you think is appropriate in this case? Why?
Optional Question
4. Assume that you were asked to review the information in this case as the advisory partner on the audit of Imperial Valley Thrift Loan. Using the relevant steps in the Integrated Ethical Decision-Making Process explained in Chapter 2, analyze the case and come up with a decision on what type of opinion to recommend to management.

Question 6

AU-C 240 points to three conditions that enable fraud to occur. Briefly describe each condition. How does one's propensity to act ethically, as described by Rest's model of morality, influence each of the three elements of the Fraud Triangle?

Question 7

Audit Client Considerations and Risk Assessment
Lanny Beaudean joined Cardinal Coyote LLP in 2011 after working for two years for the IRS in Phoenix, Arizona. Cardinal Coyote is a second-tier CPA firm just below the Big Four in size. Beaudean had passed all four parts of the CPA Exam in Arizona and decided to work for a locally based CPA firm with international clients to gain a broad base of experience that might help him become a CFO at a public company in the future. Beaudean has been advancing rapidly and just became a senior auditor at Cardinal Coyote.
Yancy Corliss is a new audit partner at Cardinal Coyote. One day, Corliss was summoned to the office of Sharon Rules, the managing partner of the firm. Rules told Corliss that she had been approached by a new client, Jerry Jost of Jost Furniture International. Jost Furniture (Jost) is a large chain of home furniture rental companies in the Southwest catering to young, upscale individuals who might live in a city for two years or so and then move on. It recently opened an office in Canada and plans to expand to Europe in the not- too-distant future. Top management at Jost seemed to imply that the firm would get the audit so long as it submitted a reasonable bid.
Rules asked Corliss to do background checks on Jost and make whatever inquiries were necessary to assess the potential business risk of Jost as a future client, including an assessment of the integrity of management. Corliss was given three days to do the work and report back to Rules with a recommendation. If the decision was to go ahead, then Cardinal Coyote would submit a bid and compete with one other CPA firm for the account. The firm believes that it will be a lucrative account, especially because the company has been in expansion mode and will require advisory services in the future including advice on acquisitions and other consulting services.
Corliss assembled his team to review the background and other information about Jost, and he asked Beaudean to head up the assessment and report back to Corliss in two days. During that time, Beaudean would have two other staff members to help with the assignment. Beaudean was excited about his first opportunity to work on new client assessment.
Beaudean met with Vinnie Gabelli, a transplanted Brooklyn native who had graduated from Arizona State University (ASU) at Phoenix. Gabelli was like a fish out of water in Arizona, even though he had spent 16 months in the Master's of Accounting program at ASU. Gabelli thought a prickly pear was someone who could not make it in Staten Island and moved to Brooklyn for a better life.
Gabelli told Beaudean that he welcomed the opportunity to work with a native of Phoenix and learn about its colorful history. Beaudean also asked Jackie Oloff, a native of Minneapolis, to join the team. Jackie had moved to Phoenix two years ago with her husband, who is a professor of accounting at ASU. The team discussed mutual responsibilities, data sources for the information, and key areas of risk, and then they broke up to start their work. At the end of the day, the team reassembled to share information. Here is a brief list of the findings:
1. The predecessor audit firm had helped Jost Furniture with its initial public offering (IPO) and audited the financial statements of the company for five years. The firm resigned the account in 2010 following the issuance of a qualified (i.e., modified) opinion on the 2009 financial statements. The firm had issued this opinion because of differences with management over the proper accounting for inventories.
2. A second firm audited the financial statements for 2010. That firm also issued a qualified opinion.
3. Jost's financial statements for 2011 and 2012 were audited by a third firm, which was dismissed after two years for reasons that were unclear.
4. The financial statements for 2013 had not been audited, and on March 19, 2014, the CEO of Jost Furniture, Jerry Jost, approached Sharon Rules at a community event and asked her to submit a bid for the Jost audit. Jost asked that the bid be submitted by March 23.
5. A memorandum to the file prepared by Rules indicated that Jost had admitted to Rules that the company had past problems with various auditors, but Jost assured Rules that the accounting issues had been resolved. He also told Rules that the company's controller had recently quit-the third time in four years there had been a turnover in that position. Jost told Rules that the company had two candidates to replace the controller, and he wanted her to help with the final decision because the CPA firm would work closely with the controller.
6. Beaudean, with the help of Gabelli and Oloff, reviewed the financial statements of Jost Furniture for the past four years, during which time the qualified opinions had been issued. They went through a checklist of risk assessment issues for new clients and stopped when they came to the following: Verify the circumstances of any prior auditor dismissal or withdrawal by first asking the client for permission to approach the predecessor auditor(s).
One final discovery that gave the auditors pause with respect to taking on Jost Furniture as a client was a statement in the report on internal control over financial reporting for 2012. That statement indicated the existence of a material weakness in internal control that had not been mentioned in management's internal control assessment.
At the meeting at the end of the first day, the auditors discussed the unusual number of auditor changes in a short period of time, apparently due to the accounting differences that were raised in the audit reports for the years 2009 through 2012. Beaudean asked Gabelli to contact Jerry Jost and ask permission to speak with the auditors for the 2011 and 2012 financial statements. Gabelli was also asked to contact the two banks where the company does business and check into its payment record. Oloff had a past business relationship with Miles Frazer, the attorney for Jost Furniture. Oloff agreed to contact Frazer to determine whether there are any outstanding litigation issues or other legal matters that the firm should know about. They all agreed to get these matters done by the end of the second day, and a meeting was set for 5:00 p.m. With respect to the material weakness in internal controls, the decision was made to ask Sharon Rules to discuss the matter directly with Jerry Jost.
Gabelli found out that a $1 million loan payable to Phoenix Second National Bank had been overdue before payment was made on March 15, 2014. The president of the bank told Gabelli that Jost had been in violation of a debt covenant agreement that obligated Jost to maintain a current ratio of 1.5:1 at all times, and that the bank was concerned about Jost's ability to continue as a going concern, pointing out that Jost had gone below the ratio twice. The first time that Jost violated the covenant, the bank accepted the explanation of a temporary cash flow problem. The bank granted the company a three-month extension to meet the requirements of the debt covenant. It subsequently found out that the cash flow problem had happened because Jerry Jost withdrew $500,000 from the Jost Furniture cash account at Second National Bank to help put a down payment on a mortgage to buy an upscale house in Scottsdale. The second time that it occurred, the bank began foreclosure on the loan on January 31, 2014, but by the time the process completed, Jost had paid off the entire $1 million balance.
Oloff had no luck with Frazer, the attorney for Jost. When she called his office, the secretary always told Oloff that Frazer was on another line and she'd take a message. When Oloff asked to leave a voicemail message, she was told Frazer did not have voicemail. How about leaving an e-mail message? She asked. No, the secretary said, no e-mail either. Can I text him, tweet him, or just do it the old-fashioned way and set up an appointment? No, no, and no were the answers.
Oloff had left five messages for Frazer by the time of the team's second meeting, and she had nothing to report except to make an editorial comment about lawyer responsiveness (or lack thereof).
As for permission to speak with the predecessor auditor, Jerry Jost was indignant with the request. Gabelli wasn't sure why or whether it meant problems existed with the 2011-2012 audits. He reported to the audit team that Jost asked for more time to consider the request.
At 5:00 p.m. on March 22, the auditors met in the firm's conference room to discuss their findings. After hearing about Gabelli's concerns, the internal control issue, and Oloff's lack of success with Frazer, Beaudean expressed serious concerns about taking on Jost as a client.
Questions
1. From an ethical perspective, why do auditors evaluate business risk before deciding whether to accept a new client?
2. Integrity is an essential element in the relationship between client management and the auditor. Evaluate the issue of integrity from the perspective of possibly taking on Jost Furniture as a new client. Use Josephson's Six Pillars of Character to support your decision whether to submit a bid for the Jost Furniture audit.
3. Some CPA firms have started to add an indemnification clause to their engagement letters that provides that the client would release, indemnify, defend, and hold the auditor harmless from any liability and costs resulting from knowing misrepresentations by management. Would inclusion of such an indemnification clause in engagement letters impair independence? Why or why not? What if, as a condition to retaining an auditor to perform an audit engagement, a prospective client requests that the firm enter into an agreement providing that the firm indemnify the client for damages, losses, or costs arising from lawsuits, claims, or settlements that relate directly or indirectly to client acts. Would entering into such an agreement impair independence?

Question 8

Explain the content of each section of the audit report. Evaluate the importance of each section with respect to the users of financial reports.

Question 9

Krispy Kreme Doughnuts, Inc. 1
On March 4, 2009, the SEC reached an agreement with Krispy Kreme Doughnuts, Inc., and issued a cease-and- desist order to settle charges that the company fraudulently inflated or otherwise misrepresented its earnings for the fourth quarter of its FY2003 and each quarter of FY2004. By its improper accounting, Krispy Kreme avoided lowering its earnings guidance and improperly reported earnings per share (EPS) for that time period; these amounts exceeded its previously announced EPS guidance by 1 cent. 2
The primary transactions described in this case are "round-trip" transactions. In each case, Krispy Kreme paid money to a franchisee with the understanding that the franchisee would pay the money back to Krispy Kreme in a prearranged manner that would allow the company to record additional pretax income in an amount roughly equal to the funds originally paid to the franchisee.
There were three round-trip transactions cited in the SEC consent agreement. The first occurred in June 2003, which was during the second quarter of FY2004. In connection with the reacquisition of a franchise in Texas, Krispy Kreme increased the price that it paid for the franchise by $800,000 (i.e., from $65,000,000 to $65,800,000) in return for the franchisee purchasing from Krispy Kreme certain doughnut- making equipment. On the day of the closing, Krispy Kreme debited the franchise's bank account for $744,000, which was the aggregate list price of the equipment. The additional revenue boosted Krispy Kreme's quarterly net income by approximately $365,000 after taxes.
The second transaction occurred at the end of October 2003, four days from the closing of Krispy Kreme's third quarter of FY2004, in connection with the reacquisition of a franchise in Michigan. Krispy Kreme agreed to increase the price that it paid for the franchise by $535,463, and it recorded the transaction on its books and records as if it had been reimbursed for two amounts that had been in dispute with the Michigan franchisee. This overstated Krispy Kreme's net income in the third quarter by approximately $310,000 after taxes.
The third transaction occurred in January 2004, in the fourth quarter of FY2004. It involved the reacquisition of the remaining interests in a franchise in California. Krispy Kreme owned a majority interest in the California franchise and, beginning on or about October 2003, initiated negotiations with the remaining interest holders for acquisition of their interests. During the negotiations, Krispy Kreme demanded payment of a "management fee" in consideration of Krispy Kreme's handling of the management duties since October 2003. Krispy Kreme proposed that the former franchise manager receive a distribution from his capital account, which he could then pay back to Krispy Kreme as a management fee. No adjustment would be made to the purchase price for his interest in the California franchise to reflect this distribution. As a result, the former franchise manager would receive the full value for his franchise interest, including his capital account, plus an additional amount, provided that he paid back that amount as the management fee. Krispy Kreme, acting through the California franchise, made a distribution to the former franchise manager in the amount of $597,415, which was immediately transferred back to Krispy Kreme as payment of the management fee. The company booked this fee, thereby overstating net income in the fourth quarter by approximately $361,000.
Additional accounting irregularities were unearthed in testimony by a former sales manager at a Krispy Kreme outlet in Ohio, who said a regional manager ordered that retail store customers be sent double orders on the last Friday and Saturday of FY2004, explaining "that Krispy Kreme wanted to boost the sales for the fiscal year in order to meet Wall Street projections." The manager explained that the doughnuts would be returned for credit the following week-once FY2005 was under way. Apparently, it was common practice for Krispy Kreme to accelerate shipments at year end to inflate revenues by stuffing the channels with extra product, a practice known as "channel stuffing."
Some could argue that Krispy Kreme auditors-PwC-should have noticed a pattern of large shipments at the end of the year with corresponding credits the following fiscal year during the course of their audit. Typical audit procedures would be to confirm with Krispy Kreme's customers their purchases. In addition, monthly variations analysis should have led someone to question the spike in doughnut shipments at the end of the fiscal year. However, PwC did not report such irregularities or modify its audit report.
In May 2005, Krispy Kreme disclosed disappointing earnings for the first quarter of FY2005 and lowered its future earnings guidance. Subsequently, as a result of the transactions already described, as well as the discovery of other accounting errors, on January 4, 2005, Krispy Kreme announced that it would restate its financial statements for 2003 and 2004. The restatement reduced net income for those years by $2,420,000 and $8,524,000, respectively.
In August 2005, a special committee of the company's board issued a report to the SEC following an internal investigation of the fraud at Krispy Kreme. The report states that every Krispy Kreme employee or franchisee who was interviewed "repeatedly and firmly" denied deliberately scheming to distort the company's earnings or being given orders to do so; yet, in carefully nuanced language, the Krispy Kreme investigators hinted at the possibility of a willful cooking of the books. "The number, nature, and timing of the accounting errors strongly suggest that they resulted from an intent to manage earnings," the report said. "Further, CEO Scott Livengood and COO John Tate failed to establish proper financial controls, and the company's earnings may have been manipulated to please Wall Street." The committee also criticized the company's board of directors, which it said was "overly deferential in its relationship with Livengood and failed to adequately oversee management decisions."
Krispy Kreme materially misstated its earnings in its financial statements filed with the SEC between the fourth quarter of FY2003 and the fourth quarter of FY2004. In each of these quarters, Krispy Kreme falsely reported that it had achieved earnings equal to its EPS guidance plus 1 cent in the fourth quarter of FY2003 through the third quarter of FY2004 or, in the case of the fourth quarter of FY2004, earnings that met its EPS guidance.
The SEC cited Krispy Kreme for violations of Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder, which require every issuer of a security registered pursuant to Section 12 of the Exchange Act to file with the commission all the necessary information to make the financial statements not misleading. The company was also sanctioned for its failure to keep books, records, and accounts that, in reasonable detail, accurately and fairly reflect their transactions and dispositions of their assets. Finally, Krispy Kreme was cited for failing to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP.
On March 4, 2009, the SEC reached agreement with three former top Krispy Kreme officials, including onetime chair, CEO, and president Scott Livengood. Livengood, former COO John Tate, and CFO Randy Casstevens all agreed to pay more than $783,000 for violating accounting laws and fraud in connection with their management of the company.
Livengood was found in violation of fraud, reporting provisions, and false certification regulations. Tate was found in violation of fraud, reporting provisions, recordkeeping, and internal controls rules. Casstevens was found in violation of fraud, reporting provisions, recordkeeping, internal controls, and false certification rules. Livengood's settlement required him to pay about $542,000, which included $467,000 of what the SEC considered as the "disgorgement of ill-gotten gains and prejudgment interest" and $75,000 in civil penalties. Tate's settlement required him to return $96,549 and pay $50,000 in civil penalties, while Casstevens had to return $68,964 and pay $25,000 in civil penalties. Krispy Kreme itself was not required to pay a civil penalty because of its cooperation with the SEC in the case.
Questions
1. Why did the round-trip transactions engaged in by Krispy Kreme and its franchisees violate revenue recognition rules? How should they have been recorded under GAAP?
2. Evaluate the corporate governance at Krispy Kreme during its financial statement fraud including management's stewardship responsibility to owners.
3. Krispy Kreme had materially misstated its financial results in an effort to manage its earnings. Subsequently, after the fraud was detected, the company restated its net income for 2003 and 2004. What are an auditor's responsibilities to detect material misstatements in the financial statements? What should an auditor do after discovering material accounting irregularities? In other words, how should an auditor correct for the fact that in the current year it was discovered that a previous years' financial statements were materially misstated?
Optional Question
4. Prime accounting issues with respect to accounting for franchise activities include how to recognize revenue on the individual sale of franchise territories and on the transactions that arise in connection with the continuing relationship between the franchisor and franchisee. The Krispy Kreme case describes three transactions between the company and its franchisees that created false earnings. Review FAS 45, Accounting for Franchise Fee Revenue , and explain specifically how Krispy Kreme's transactions violated FAS 45. (See www.fasb.org/pdf/fas45.pdf.)
1 An article that deals with the intangible asset aspect of the case can be found at Lori Holder-Webb and Mark Kohlbeck, "The Hole in the Doughnut: Accounting for Acquired Intangibles at Krispy Kreme," Issues in Accounting Education , August 2006, Vol. 21, No. 3, pp. 297-312. Available at http://dx.doi.org/10.2308/iace.2006.21.3.297.
2 Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 2941, In the Matter of Krispy Kreme Doughnuts, Inc., March 4, 2009, www.sec.gov/litigation/admin/2009/34-59499.pdf.

Question 10

Give one example each of when an auditor might render an unmodified opinion and include an emphasis-of-matter paragraph and an other-matter paragraph. What is the value of such paragraphs in the audit report?

Question 11

Dunco Industries
The following two cases deal with accounting issues at Dunco Industries.
Part 1-Marcus Yamabuto
Marcus Yamabuto graduated from Washington State University in June 2013. He began his career working for Dunco Industries, a public company that manufactures full HD plasma televisions. Frank Johnson is the CEO of Dunco, and Karen Gross is the CFO. Dunco has a three-person audit committee whose chair is Ken Holden.
Dunco is the original equipment manufacturer (OEM) of 42- through 64-inch plasma screens. The company sells its monitors to major manufacturers in the United States and overseas. Marcus was hired directly by the internal audit department and reports to Francey Gordon, the director of internal auditing. Both Marcus and Gordon are CPAs.
Marcus was assigned to review sale documents and freight bills to determine the amount of freight, the terms of the sale, and the proper cutoff treatment. During the course of his examination, Marcus discovered $2.4 million that was prematurely recognized as revenue by the accountants for the year ended December 31, 2013. He identified the problem by matching the invoices with corresponding freight bills and found that the shipping date of the transaction was January 2, 2014. However, there was a note signed by the freight forwarder: "Picked up for shipment at Dunco warehouse on December 31, 2013."
Marcus went to see Gordon to discuss the matter. They determined that the $2.4 million was material and should have been recorded in 2014. They were concerned about the premature revenue recognition given the impending external audit that will begin next week.
Question
Assume that Francey Gordon goes to Karen Gross and Frank Johnson to discuss the matter. Gordon tells Gross and Johnson that just because the freight forwarder indicates the merchandise is picked up on December 31, that doesn't justify reporting the revenue until the goods are on its way to customers. Gross and Johnson disagree and instruct Gordon to leave the matter alone. What would you do if you were Francey Gordon at this point? Be sure to include your ethical obligations in the discussion.
Part 2-Sandy Cole
Sandy Cole is a staff auditor of Lyons Co., CPAs. She just completed her review of various accrual accounts during a routine audit of one of the firm's clients, Dunco Industries. Sandy uncovered ten manual entries made after the quarter's close that lacked sufficient supporting documentation and that significantly reduced the reserve balance for each account. She reviewed the entries in the system and found the same explanation for each reduction: "Reduce accrual by $1.5 million, per Jim Benson, corporate controller." The total amount of reductions came to $15 million and was material to the financial statements of Dunco.
Sandy brought this information to Joan Franks, the audit manager who was in charge of the engagement. Franks advised Sandy to discuss the entries with the corporate controller. The controller provided verbal support for each entry. Sandy had no reason to disbelieve the controller, so she cited the lack of supporting documentation as an audit finding and completed the report.
Six months later, news came out that the controller was adjusting various accrual accounts to manipulate earnings. Sandy, distraught about the situation, questioned her conduct and the audit procedures. Joan Franks was asked by Grace Wong, the audit partner in charge of the engagement, to explain why the audit team did not pursue the findings and press for supporting documentation.
The controller was terminated, and the company underwent an investigation by the SEC. Sandy continued to wrestle with her conscience: "I'm an auditor, not an investigator... right?" she thought.
Questions
1. What is the role of an external auditor? Is it to simply examine the client's financial statements, or does it involve more-to be an investigator in conducting and completing the audit?
2. Evaluate the actions taken by Sandy Cole and Joan Franks in this case. Were their actions in accordance with ethical and professional standards? Why or why not?

Question 12

The following statement expresses the conclusion of XYZ auditors with respect to the company's investment in ABC. Assume that all amounts are material. What type of audit opinion should be rendered given this statement? Explain the reasoning behind your answer.
XYZ's investment in ABC, a foreign subsidiary acquired during the year and accounted for by the equity method, is carried at xxx on the statement of financial position as at December 31, 2013, and XYZ's share of ABC's net income of xxx is included in XYZ's income for the year then ended. We were unable to obtain sufficient appropriate audit evidence about the carrying amount of XYZ's investment in ABC as at December 31, 2013, and XYZ's share of ABC's net income for the year because we were denied access to the financial information, management, and the auditors of ABC. Consequently, we were unable to determine whether any adjustments to these amounts were necessary.

Question 13

First Community Bank
This case involves the valuation of loan loss estimates of First Community Bank (FCB) and the examination of relevant accounts by the CPA firm of Howard Stacey LLP.
FCB provided mostly residential loans to customers in Las Vegas, Florida, and Arizona. Beginning in about 2004, FCB expanded into high-risk types of lending that were experiencing unusual, rapid escalation in market values. This strategy made the bank particularly vulnerable to the fallout from the financial crisis, as these areas were hardest hit by the precipitous fall in real estate prices, which began in late 2006 and early 2007.
Throughout 2008, FCB was experiencing a dramatic rise in high-risk problem loans, including land and land development and residential construction. Certain of these problem loans were deemed "impaired" pursuant to Statement on Financial Accounting Standards (FAS) No. 114, meaning that it was probable the bank would not recover all amounts as contractually due. FCB reported FAS 114 impaired loan balance had increased from less than $4 million as of December 31, 2006, to nearly $186 million as of December 31, 2008.
In June 2008, Office of Community Bank Regulator (OCBR), the bank regulator, conducted a "risk-focused examination" of the bank that focused on asset quality, credit administration, management, earnings, and the adequacy of all items. As a result of that examination, OCBR downgraded the bank's credit rating from a 1 (indicating a financial institution that was "sound in every respect") to a 4 (indicating a financial institution with "serious financial or managerial deficiencies" that require close supervisory attention).
OCBR provided the bank with a report that deemed the institution to be in troubled condition and board and management performance to be exceptionally poor. OCBR concluded that FCB had experienced a significant deterioration in asset quality due to eroding real estate values in Nevada and Florida, and that poor board and management oversight had exacerbated the problem. OCBR directed FCB to maintain higher minimum capital ratios. Failure to correct the problems identified by OCBR or to meet the heightened capital requirements would result in additional enforcement action by the regulator.
The bank's FAS 114 loans had a negative effect on FCB's ability to meet the heightened capital requirements mandated by the OCBR. Under GAAP, FCB was required to assess probable losses associated with its impaired loans and record those losses. The bank applied the rules in FAS 114, Accounting by Creditors for Impairment of a Loan , and decided to measure impairment using the fair value of the loans in the marketplace.
As loan losses increased, the bank's capital was further eroded, directly affecting the OCBR capital requirements. In order to assess the loan losses for the bank's FAS 114 loans, FCB prepared loan-by-loan spreadsheets that contained estimates of collateral values and loan impairment determinations. The auditors generally based the valuation on the most recent appraisal in FCB's loan files. If the appraisal was aged, as it typically was, FCB would sometimes apply a discount to the appraised value. The rationale for applying any particular discount-or for not discounting an appraisal at all-was not documented. In the limited instances where FCB did get updated appraisals or valuations on the bank's FAS 114 loans during 2008, the collateral value typically showed a significant decline from the amount used by management in the immediately preceding quarter. The auditors' review of the appraisals showed that management's estimates were inflated by twenty to almost fifty times.
With respect to the audit of FCB, Howard was the engagement partner and was responsible for the audit engagement and its performance, for proper supervision of the work of the engagement team members, and for compliance with PCAOB standards. Stacey was more of a hands-on partner and contributed significantly to the planning of the audit, the design of tests of controls, and the design and implementation of substantive procedures. In addition, Stacey was responsible for executing the audit, including directing the audit engagement team on how to conduct the audit. She reviewed the audit work papers and was responsible for on-site supervision of the audit engagement team. She also played a significant role in gathering and evaluating evidential matter to support the loan loss reserve, and specifically the valuation of collateral underlying the bank's FAS 114 loans. Both partners were responsible for compliance with PCAOB standards with respect to the supervisory responsibilities that were assigned to Stacey.
Prior to and during their 2008 audit of FCB, Howard Stacey auditors were aware of the valuation issues with the bank's loan loss reserve. The FCB loans subject to impairment were individually material to the financial statements and presented a significant risk of material misstatement. It far exceeded the $1.9 million materiality threshold established for the 2008 audit. It was reasonably possible that even a relatively small change in the value of the bank's FAS 114 loans would cause a material error in the financial statements. The audit planning document mentioned the significant risk, including a risk of fraud.
At the completion of the audit, both Howard and Stacey signed off that "all necessary auditing procedures were completed," that "support for conclusions was obtained," and that "sufficient appropriate audit evidence was obtained." Further, Howard specifically signed off on the audit checklist's requirement that the audit engagement team had "performed and documented its work in compliance with... applicable auditing standards... and the working papers demonstrate this compliance."
In the summer of 2009, when the OCBR began its annual exam, the bank was forced to get a significant number of updated appraisals and to use those appraisals in its loan loss calculations. In the fall of 2009, FCB disclosed over $130 million in additional loan loss provisions. FCB was shut down by bank regulators on June 4, 2010 and filed for bankruptcy later that month.
In April 2010, Howard Stacey LLP resigned as FCB's auditor. Howard Stacey withdrew its audit opinion relating to FCB's 2008 financial statements on the basis that they were materially misstated with respect to certain out- of-period adjustments for loan loss reserves. The firm also withdrew its opinion relating to FCB's internal control over financial reporting as of year-end 2008 due to a material weakness in internal control over financial reporting related to the material misstatements.
In the aftermath of the FCB fraud, a forensic auditor was called in to look at the work of the auditors. A review of the audit documents showed concerns on the part of Howard Stacey after receiving the report from OCBR indicating an inadequacy in the loan loss reserve of $5 million, a material amount. Concern also existed about the value of the collateral supporting the outstanding loans.
The forensic auditor also discovered that valuation adjustments on the collateral underlying the bank's FAS 114 loans were inconsistent with independent market data. Third-party market data indicated that real estate values were declining precipitously in many of the markets where the bank's
FAS 114 collateral was located, including Las Vegas, Nevada, and Phoenix, Arizona. At year-end 2008, FCB had prepared spreadsheets analyzing more than fifty borrower relationships, totaling approximately $255 million in loans, for evaluation for impairment under FAS 114. Approximately $186 million of these loans were actually deemed impaired by the bank. The majority of the loans that the bank evaluated for impairment under FAS 114 were collateralized by property with appraisals more than a year old; over half of those stale appraisals were not discounted. Critically, when management did discount appraisals, those discounts were typically inconsistent with-and more favorable to the bank than-the declines indicated by the independent market data.
Questions
1. Explain the rules for accounting for impairment of loans under Statement of Financial Accounting Standards (FAS) No. 114, Accounting by Creditors for Impairment of a Loan. Did FCB apply these rules properly?
2. Evaluate the audit work of Howard Stacey with respect to PCAOB audit standards discussed in the text and any other standards you choose to review. In particular comment on the auditors risk assessment in the audit of First Community Bank.
3. Evaluate the actions of the auditors using the AICPA ethics rules discussed in Chapter 4 and the GAAS discussed in this chapter.

Question 14

Rationalization for fraud can fall under two categories: "no harm" and "no responsibility." Assume an employee is directed by management to reduce recorded expenses at year-end by insignificant amounts individually, but which are material in total. How might the employee justify her actions if questioned by the auditor with respect to no harm and no responsibility? What stage of moral development in Kohlberg's model is best illustrated by the employee's actions? Why?

Question 15

Fannie Mae: The Government's Enron
Background
The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) are government-sponsored entities (GSEs) that operate under congressional charters to "help lower- and middle- income Americans buy homes." Both entities receive special treatment aimed at increasing home ownership by decreasing the cost for homeowners to borrow money. They do this by purchasing home mortgages from banks, guaranteeing them, and then reselling them to investors. This helps the banks eliminate the credit and interest rate risk, as well as lengthen the mortgage period. Fannie Mae and Freddie Mac receive advantages over commercial banks, including the following:
(1) the U.S. Treasury can buy $2.25 billion of each company's debt; (2) Fannie Mae and Freddie Mac receive exemption from state and local taxes; and (3) the implied government backing gives them the ability to take on large amounts of home loans without increasing their low cost of capital.
Fannie Mae makes money either by buying, guaranteeing, and then reselling home mortgages for a fee or by buying mortgages, holding them, and then taking on the risk. By selling the mortgages, Fannie Mae eliminates the interest rate risk. There is less profit from this conservative approach than by holding the mortgages they buy. By holding the mortgages, Fannie Mae can make money on the spread because it has such a low cost of capital. In 1998, Fannie Mae's holdings hit a peak of $375 billion of mortgages and mortgage-backed securities on its own books, not to mention the more than $1 trillion of mortgages that it guaranteed. This process of holding mortgages on its books helped Fannie Mae expand rapidly. It also stimulated unprecedented profit growth because there was more profit to be made by keeping the mortgages than by guaranteeing them and then reselling them to other investors.
The reasons for growth in the telecommunications sector in the 1990s were, in part, the building of overcapacity in telecommunications equipment inventory based on the belief the economic growth bubble of the early 1990s would never end. Fannie Mae was similarly affected by the bubble in making and holding home mortgage loans. Just as telecommunication companies such as Global Crossing and Qwest were motivated to keep revenue and net income increasing quarter after quarter, the pressure also was on the top management of Fannie Mae to keep up the pace of growth. Fannie Mae's CEO, Franklin Raines, was so optimistic that he claimed at an investor conference in May 1999, "The future is so bright that I am willing to set as a goal that our earnings per share will double over the next five years." 1
As growth pressures continued, Fannie Mae began to use more derivatives to hedge interest rate risk. Critics looked at Fannie Mae's portfolio and expressed concern that with the risk involved in using derivatives, it may be at risk of defaulting. They pointed out that unlike federally guaranteed commercial bank deposits and the partial government guarantee of pension obligations through the Pension Benefit Guaranty Corporation (PBGC), there was no federal guarantee of Fannie Mae. Behind the scenes, Fannie Mae encouraged the concept that if it did default, the government would back it. This belief in the government as a back-stop if Fannie Mae got into financial trouble raised the specter of "moral hazard." Moral hazard is the idea that a party that is protected in some way from risk will act differently than if they didn't have that protection. This "too big to fail" philosophy turned out to be true later on, after the initial crisis in the 1990s, when the government bailed out Fannie Mae during the 2007-2008 financial crisis. 2
In the 1990s, Fannie Mae was growing, and the market loved it. Top executives were receiving large bonuses for the growing profits. The growth was due to increased risk but people believed that, at the end of the day, the government would come to the rescue of Fannie Mae if that became necessary.
The Accounting Scandal
The discovery of Fannie Mae's accounting scandal began in 2001, when Freddie Mac fired its auditor, (Arthur) Andersen, right after Enron's scandal exploded and the firm's existence seemed untenable. Freddie Mac then hired PwC.
PwC looked very closely at Freddie Mac's books and found that it had understated its profits in an attempt to smooth earnings. Freddie Mac agreed to a $5 billion restatement and fired many of its top executives. Meanwhile, Fannie Mae continued on its course and accused Freddie Mac of causing "collateral damage." The Fannie Mae Web site even included the statement, "Fannie Mae's reported financial results follow [GAAP] to the letter. There should be no question about our accounting." To a cynic, that statement may have had the unintended consequence of raising suspicion about Fannie Mae's accounting. After all, the markets had already been through it with Enron.
The government agency that regulated Fannie Mae and Freddie Mac at the time, the Office of Federal Housing Enterprise Oversight (OFHEO), had stated days before Freddie Mac's restatement that its internal controls were "accurate and reliable." Once the restatement was made public, OFHEO had no choice but to look deeper into Fannie Mae's accounting to make sure that such a serious misjudgment did not happen again.
OFHEO was much weaker than most regulatory agencies such as the SEC and Justice Department that went after Enron in the obstruction of justice case. Fannie Mae essentially established OFHEO in 1992 as the regulatory agency that oversaw its operations and accounting. Fannie Mae was able to control its own regulator because it had enough influence in Congress to have OFHEO's budget cut. Fannie Mae had political influence because of its connections with realtors, homebuilders, and trade groups. Fannie Mae also made large contributions to various organizations and gained political clout.
After the Enron debacle, the White House wanted to make sure to avoid another scandal. The government provided the funding needed to bring in an independent investigator, Deloitte Touche, that uncovered massive accounting irregularities. In September 2004, OFHEO released results of its investigation and "accused Fannie of both willfully breaking accounting rules and fostering an environment of 'weak or nonexistent' internal controls."
The investigation focused on the use of derivatives and Fannie Mae's deferring derivative losses on the balance sheet, thus inflating profits. OFHEO and Deloitte believed that the derivative losses should be recorded on the income statement. The dispute involved the application of FAS 133, Accounting for Derivative Instruments and Hedging Activities. The SEC's chief accountant determined that Fannie Mae failed to comply with the requirements for hedge accounting-including FAS 133's rigorous documentation requirements. Fannie Mae was required by law to document its derivative use and file with the SEC. But "Fannie Mae's application of FAS 133 (and its predecessor standards, FAS 91) did not comply in material respects with the accounting requirements" of GAAP. In particular, Fannie Mae's practice of putting losses on the balance sheet rather than on the income statement resulted in overstated earnings and excess executive compensation. 3
OFHEO issued a report charging that in 1998, Fannie Mae recognized only $200 million in expenses when it was supposed to recognize $400 million. The underreporting of expenses led to an earnings per share (EPS) value of $3.23 and a total of $27 million in executive bonuses. These charges prompted investigations by the SEC and the Justice Department. 4
Two weeks after the OFHEO report and charges against Fannie Mae, the House of Representatives Subcommittee on Capital Markets called a hearing. Raines initially deflected criticisms by saying, "These accounting standards are highly complex and require determinations on which experts often disagree." Raines was quite convincing in his defense of OFHEO charges that Fannie Mae executives had manipulated earnings in an attempt to increase bonuses. In the end, Raines won because the tone of the OFHEO reports made it seem as though the regulator was out to get Fannie Mae.
Perhaps feeling his oats after the victory in the House, Raines demanded that the SEC review OFHEO's findings. On December 15, 2004, the SEC announced that "Fannie did not comply 'in material respects' with accounting rules, and that as a result, Fannie would have to restate its results by more than $9 billion." Other than the $11-13 billion WorldCom fraud, the Fannie Mae fraud has the "dubious" honor of being the next largest fraud during the dark days of the late 1990s and early 2000s.
The OHFEO had been vindicated. The Fannie Mae board was told that both Raines and CFO Tim Howard had to be fired. Soon after, both resigned, and Fannie Mae fired KPMG and appointed Deloitte Touche as the new auditor. Deloitte was asked to audit the 2004 statements of Fannie Mae and reaudit previous statements from 2001.
OFHEO Report of May 23, 2006
On May 23, 2006, OFHEO issued a more extensive report of a comprehensive three-year investigation that officially charged senior executives at Fannie Mae with manipulating accounting to collect millions of dollars in undeserved bonuses and to deceive investors. The fraud led to a $400 million civil penalty against Fannie Mae, more than three times the $125 million penalty imposed on Freddie Mac for understating its earnings by about $5 billion from 2000 to 2002 to minimize large profit swings. The $400 million is one of the largest penalties ever in an accounting fraud case. Of this amount, $350 million will be returned to investors damaged by the alleged violations as required by the Fair Funds for Investors provision of SOX. 5
The OFHEO review involves nearly 8 million pages of documents and details what the agency calls an arrogant and unethical corporate culture. The report, which concluded an 18-month investigation led by former senator Warren Rudman, was commissioned by Fannie Mae's board of directors. The final 2,600 page report charges Fannie Mae executives with perpetrating an $11 billion accounting fraud in order to meet earnings targets that would trigger $25 million in bonuses for top executives. The report charged former CFO Tim Howard and former controller Leanne G. Spencer as the chief culprits. Along with former chair and CEO Franklin Raines, who earned $20 million (including $3 million in stock options) in 2003 and $17.7 million in 2002, these executives created a "culture that improperly stressed stable earnings growth." Rudman told reporters that the management team Raines hired was "inadequate and in some respects not competent." 6
Criticisms of Internal Environment
From 1998 to mid-2004, the smooth growths in profits and precisely hit earnings targets each quarter reported by Fannie Mae were illusions deliberately created by senior management using faulty accounting. The report shows that Fannie Mae's faults were not limited to violating accounting standards but included inadequate corporate governance systems that failed to identify excessive risk taking and poor risk management. Randal Quarles, U.S. Treasury undersecretary for domestic finance at the time, said in a statement, "OFHEO's findings are a clear warning about the very real risk the improperly managed investment portfolios of [Fannie Mae and Freddie Mac] posed to the greater financial system." 7
Fannie Mae agreed to make these changes in its operations:
• Limit the growth of its multibillion-dollar mortgage holdings, capping them at $727 billion.
• Make top-to-bottom changes in its corporate culture, accounting procedures, and ways of managing risk.
• Replace the chair of the board's audit committee. The board named accounting professor Dennis Beresford to replace audit committee chair Thomas Gerrity.
The report also faulted Fannie Mae's board of directors for failing to discover "a wide variety of unsafe and unsound practices" at the largest buyer and guarantor of home mortgages in the country. It signaled out senior management for failing to make investments in accounting systems, computer systems, other infrastructure, and staffing needed to support a sound internal control system, proper accounting, and GAAP-consistent financial reporting.
KPMG's Audits
As for the role of KPMG as Fannie Mae's auditors, the report alleges that external audits performed by the firm failed to include an adequate review of Fannie Mae's significant accounting policies for GAAP compliance. KPMG also improperly provided unqualified opinions on financial statements even though they contained significant departures from GAAP. The failure of KPMG to detect and disclose the serious weaknesses in policies, procedures, systems, and controls in Fannie Mae's financial accounting and reporting, coupled with the failure of the board of directors to oversee KPMG properly, contributed to the unsafe and unsound conditions at Fannie Mae.
SEC Civil Action
The SEC filed a civil action against Fannie Mae on May 23, 2006, charging that it engaged in a financial fraud involving multiple violations of GAAP in connection with the preparation of its annual and quarterly financial statements. These violations enabled Fannie Mae to show a stable earnings growth and reduced income statement volatility, and-as of year-end 1998-Fannie Mae was able to maximize bonuses and meet forecasted earnings. The SEC action thoroughly details a variety of deficiencies in accounting and financial reporting. Four of the more serious situations are described below. 8
Improper Accounting for Loan Fees, Premiums, and Discounts
FAS 91 requires companies to recognize loan fees, premiums, and discounts as an adjustment over the life of the applicable loans, to generate a "constant effective yield" on the loans. Because of the possibility of loan prepayments, the estimated life of the loans may change with changing market conditions. FAS 91 requires that any changes to the amortization of fees, premiums, and discounts caused by changes in estimated prepayments be recognized as a gain or loss in its entirety in the current period's income statement. Fannie Mae referred to this amount as the "catch-up adjustment." In the fourth quarter of 1998, Fannie Mae's accounting models calculated an approximate $439 million catch-up adjustment, in the form of a decrease to net interest income. Rather than book this amount consistent with FAS 91 , senior management of Fannie Mae directed employees to record only $240 million of the catch-up amount in that year's income statement. By not recording the full catch-up adjustment, Fannie Mae understated its expenses and overstated its income by a pretax amount of $199 million. The unrecorded catch-up amount represented 4.3 percent of the 1998 earnings before taxes and 4.9 percent of 1998 net interest income for the fiscal year 1998. 9
Improper Hedge Accounting
Fannie Mae used debt to finance the acquisition of mortgages and mortgage securities and it turned to derivative instruments to hedge against the effect of fluctuations in interest rates on its debt costs. Application of FAS 133 required that Fannie Mae adjust the value of its derivatives to changing market values. Critics contended that this standard opened the door to earnings volatility, and it would appear that Fannie's desire to create earnings stability was used as the motivation for the application of the standards in FAS 133. 10
Accounting for Loan Loss Reserve
During the period 1997 through 2003, management failed to provide any quantitative estimate of losses in their loan portfolio, instead relying on a qualitative judgment. The failure to establish and implement an appropriate model for determining the size of the loan loss reserve was a violation of the GAAP rules in FAS 5. 11
Fannie Mae maintained an unjustifiably high level of loan loss reserve in case it was needed to compensate for possible future changes in the economic environment. This violates the GAAP requirement that the estimate of loss reserves should be based on losses currently inherent in the loan portfolio. At year-end 2002, Fannie Mae's reserve was overstated by at least $100 million. This overstatement resulted in a $100 million understatement of earnings before tax, which represented 1.6 percent of the earnings before tax and $.08 of additional EPS on the year-end 2002 figure of $4.52.
Classifications of Securities Held in Portfolio
FAS 115 requires the classification of securities acquired as either trading, available for sale, or held to maturity at the time of acquisition. Rather than follow the FAS 115 rules, Fannie Mae initially classified the securities that it acquired as held to maturity and then, at the end of the month of acquisition, decided on the ultimate classification. 12
GAAP requires that the accounting classification be made at the time of acquisition. Once a security is classified, it can be reclassified only in narrow circumstances. Both trading and available-for-sale securities are valued at current market value, with any declines over time (or recaptures) in trading securities reported as a loss (or gain) in the income statement and as other comprehensive income in the equity section of the balance sheet for available-for-sale securities.
Postscript
On October 27, 2008, Congress formed the Federal Housing Finance Agency (FHFA) by a legislative merger of OFHEO, the Federal Housing Finance Board (FHFB), and the U.S. Department of Housing and Urban Development (HUD) government-sponsored enterprise mission team. FHFA now regulates Fannie Mae, Freddie Mac, and the 12 Federal Home Loan Banks.
The meltdown in the mortgage-backed securities market that occurred during the financial crisis of 2007-2008 took place after the facts of this case. One can only wonder how bad things would have been for Fannie Mae had the entity been exposed to huge market losses in the mortgages that it held in addition to the financial fraud discussed in the case.
During the financial crisis, the market prices of many securities, particularly those backed by subprime home mortgages, had plunged to fractions of their original prices. That forced banks to report hundreds of billions of dollars in losses during 2008. The business community turned its attention to the accounting standards established by FASB for some relief. Bankers bitterly complained that the current market prices were the result of distressed sales and that they should be allowed to ignore those prices and value the securities instead at their value in a normal market.
At first, FASB resisted making changes, but that changed within a few days of a congressional hearing at which legislators from both parties demanded that the board act. FASB approved three changes to the rules, one of which would allow banks to keep some declines in asset values off their income statements. Reluctant FASB board members rationalized going along with this change by stating that improved disclosures would help investors. The American Bankers Association, which pushed legislators to demand the board make changes, praised the board stating that the "decision should improve information for investors by providing more accurate estimates of market values." The change that met with the most dissent was to allow banks to write down these investments to market value only if they conclude that the decline is "other than temporary." This change will now enable banks to keep many losses off the income statements, although the declines will still show up in the institutions' balance sheets.
A class action lawsuit was filed in 2005 on behalf of approximately 1 million Fannie Mae shareholders who incurred losses after regulators identified pervasive accounting irregularities at the company. Government investigators found that between 1998 and 2004, senior executives at Fannie had manipulated its results to hit earnings targets and generate $115 million in bonus compensation. The company had to restate its earnings, reducing them by $6.3 billion.
In 2006, the government sued three former executives, seeking $100 million in fines and $115 million in restitution from bonuses that it maintained they had not earned. Without admitting wrongdoing, former CEO Franklin Raines and two other members of top management paid $31.4 million to settle the matter in 2008. In September of that year, the federal government stepped in to rescue Fannie Mae, which was struggling under a mountain of bad mortgages.
Costs spent defending the three former executives against the shareholder suit recently totaled almost $100 million, according to a report in February 2012 by the inspector general of the FHFA. Since Fannie was taken over by the government in September 2008, the inspector general said, taxpayers have borne $37 million in legal outlays on behalf of the three executives.
On September 21, 2012, the federal judge overseeing the class action against Fannie Mae and its management ruled that the investors' lawyers had not proved that Raines knowingly misled shareholders about the company's accounting and internal controls, a necessary hurdle for the case against him to continue. The judge ruled that at best, evidence submitted by the shareholders showed that Raines "acted negligently in his role as the company's chief executive and negligently in his representations about the company's accounting and earnings management practices."
Questions
1. An eight-month investigation by OFHEO concluded that slack standards at Fannie Mae created a corporate culture "that emphasized stable earnings at the expense of accurate financial disclosures." What is wrong with having stable earnings over time? Answer this question with respect to stakeholder interests.
2. Fannie Mae's corporate governance system failed to identify excessive risk taking. Describe those risks and the mechanisms that should have been used by Fannie Mae and KPMG to enhance risk assessment. To what extent do you think the risk taking at Fannie Mae was due to moral hazard?
3. According to the case, KPMG failed to review Fannie Mae's significant accounting policies for GAAP compliance. One item in particular was the failure of Fannie Mae to make a quantitative estimate of losses on its loan portfolio. In the end, KPMG gave an unqualified (now unmodified) opinion even though the financial statements contained significant departures from GAAP. What ethical and professional standards did KPMG violate in taking that position?
1 Bethany McLean, "Fannie Mae: The Fall of Fannie Mae," Fortune , January 10, 2005.
2 With a growing sense of crisis in U.S. financial markets, Fannie Mae and Freddie Mac were placed into conservatorship and the U.S. government committed to backstop the two-government-sponsored enterprises (GSEs) with up to $200 billion in additional capital.
3 Securities and Exchange Commission, SEC Form 8-K for Federal National Mortgage Association (Fannie Mae), December 28, 2004.
4 Office of the Federal Housing Oversight, Report of the Findings to Date: Special Examination of Fannie Mae, September 17, 2004, www.ofheo.gov/media/pdf/FNMfindingstodate17septo4.pdf.
5 OFHEO, Report of the Findings to Date: Special Examination of Fannie Mae , September 17, 2004, www.fanniemae.com/media/pdf/newsreleases/FNMSPECIALEXAM.pdf.
6 Stephen Labaton and Eric Dash, "Report on Fannie Mae Cites Manipulation to Secure Bonus," New York Times , February 23, 2006, www.nytimes.com/2006/02/23/business/23cnd-fannie.htm.
7 Under Secretary Randal K. Quarles Statement on Treasury Reaction to OFHEO Report , May 23, 2006, www.ustreas.gov/press/releases/js4278.htm.
8 Securities and Exchange Commission, Case Number 1:06CV00959, Securities and Exchange Commission v. Federal National Mortgage Association , May 23, 2006.
9 Financial Accounting Standards Board, Statement of Financial Accounting Standards (FAS) No. 91 , Accounting for Non- refundable Fees and Costs Associated with Origination or Acquiring Loans and Initial Direct Costs of Leases (Norwalk, CT: FASB, 1982).
10 Financial Accounting Standards Board, Statement of Financial Accounting Standards (FAS) No. 133 , Accounting for Derivatives Instruments and Hedging Activities (Norwalk, CT: FASB, 1998).
11 Financial Accounting Standards Board, Statement of Financial Accounting Standards (FAS) No. 5 , Accounting for Contingencies (Norwalk, CT: FASB, 1975).
12 Financial Accounting Standards Board, Statement of Financial Accounting Standards (FAS) No. 115 , Accounting for Certain Investments in Debt and Equity Securities (Norwalk, CT: FASB, 1993).

Question 16

Some criticize the accounting profession for using expressions in the audit report that seem to be building in deniability should the client commit a fraudulent act. What expressions enable the CPA to build a defense should the audit wind up in the courtroom? How does your analysis relate to the opening statement in the chapter by Abe Briloff?

Question 17

Royal Ahold N.V. (Ahold)
Summary of the Charges against Ahold
On October 13, 2004, the SEC charged Royal Ahold N.V. (Ahold) with multiple violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Exchange Act Rule 10b-5. Charges were also filed against three former top executives: Cees van der Hoeven, the former CEO and chair of the executive board; A. Michael Meurs, the former CFO and executive board member; and Jan Andreae, the former executive vice president and executive board member. The commission also filed a related administrative action charging Roland Fahlin, a former member of Ahold's supervisory board and audit committee, with causing violations of the reporting, books and records, and internal control provisions of the securities laws. 1
As a result of two frauds and other accounting errors and irregularities that are described in the following text, Ahold made materially false and misleading statements in SEC filings and in other public statements for at least fiscal years 1999 through 2001 and for the first three quarters of 2002. The company failed to adhere to the requirements of the Exchange Act and related rules that require each issuer of registered securities to make and keep books, records, and accounts that, in reasonable detail, accurately and fairly reflect the business of the issuer. The company also failed to devise and maintain a system of internal controls sufficient to provide reasonable assurances that, among other things, transactions are recorded as necessary to permit preparation of financial statements and to maintain the accountability of accounts.
About the Company
Ahold is a publicly held company organized in the Netherlands with securities registered with the SEC pursuant to Section 12(b) of the Exchange Act. Ahold's securities trade on the NYSE and are evidenced by American Depositary Receipts (ADRs). 2
As a foreign issuer, Ahold prepared its financial statements pursuant to Dutch accounting rules and included, in its filings with the commission, a reconciliation to U.S. GAAP and condensed financial statements prepared pursuant to U.S. GAAP. 3
U.S. Foodservice (USF), a food service and distribution company with headquarters in Columbia, Maryland, is a wholly owned subsidiary of Ahold. USF was a publicly held company with securities registered with the SEC pursuant to Section 12(b) of the Exchange Act prior to being acquired by Ahold in April 2000.
Summary of Complaint
The SEC's complaints, filed in the U.S. District Court for the District of Columbia, alleged that, as a result of the fraudulent inflation of promotional allowances at USF, the improper consolidation of joint ventures through fraudulent side letters, and other accounting errors and irregularities, Ahold's original SEC filings for at least fiscal years 2000 through 2002 were materially false and misleading. For fiscal years 2000 through 2002, Ahold overstated net sales by approximately $30 billion. Ahold overstated its operating income and net income by approximately $3.3 billion and $829 million, respectively, in total for fiscal years 2000 and 2001 and the first three quarters of 2002.
Ahold agreed to settle the commission's action, without admitting or denying the allegations in the complaint, by consenting to the entry of a judgment permanently enjoining the company from violating the antifraud and other provisions of the securities laws. Various officers of the company also settled charges, without admitting or denying the allegations in the complaint, by consenting to permanent injunctions and officer and director bars.
The SEC did not seek penalties in the enforcement actions because the Dutch Public Prosecutor's Office, which conducted a parallel criminal investigation in the Netherlands, requested that the commission not seek penalties against the individuals because of potential double jeopardy issues under Dutch law. Because of the importance of this case in the Netherlands and the need for continued cooperation between the SEC and regulatory authorities in other countries, the commission agreed to the Dutch prosecutor's request.
The commission did not seek a penalty from Ahold because of, among other reasons, the company's extensive cooperation with the commission's investigation. Ahold self-reported the misconduct and conducted an extensive internal investigation. On its own initiative, Ahold expanded its internal investigation beyond the fraud at USF and the improper joint venture accounting to analyze accounting practices and internal controls at 17 operating companies. Ahold promptly provided the staff with the internal investigative reports and the supporting information and waived the attorney-client privilege and work product protection with respect to its internal investigations. Ahold also made its current personnel available for interviews or testimony and significantly assisted the staff in arranging interviews with, or testimony from, former Ahold personnel located in the United States and (of even greater importance) abroad. Ahold promptly took remedial actions including, but not limited to, revising its internal controls and terminating employees responsible for the wrongdoing.
In a separate action, on June 17, 2009, Ahold reached a final settlement with plaintiffs in a class action securities lawsuit that requires the company to pay the lead plaintiffs $1.1 billion to resolve all claims against Ahold. The settlement applies to all qualifying common shareholders around the world and covers Ahold, its subsidiaries and affiliates, the individual defendants, and the underwriters. 4
Statement of Facts
The following summarizes the main facts of the case with respect to transactions between Ahold and USF.
Budgeted Earnings Goals
From the time that it acquired USF in April 2000, Ahold and USF budgeted annual earnings goals for USF. Compensation for USF executives was based on, among other things, USF's meeting or exceeding budgeted earnings targets. USF executives each received a substantial bonus in early 2002 because USF purportedly satisfied earnings goals for FY2001. USF executives were each eligible for a substantial bonus if USF met earnings targets for FY2002. Certain USF executives engaged in or substantially participated in a scheme whereby USF reported earnings equal to or greater than the targets, regardless of the company's true performance.
Promotional Allowances
A significant portion of USF's operating income was based on payments by its vendors, referred to in various ways such as "promotional allowances," "rebates," "discounts," and "program money" (referred to below only as "promotional allowances"). During at least FY2001 and FY2002, USF made no significant profit on most of its end sales to its customers. Instead, the majority of USF's operating income was derived from promotional allowances.
In a typical promotional allowance agreement, USF committed to purchasing a minimum volume from a vendor. The vendor in turn paid USF a per-unit rebate of a portion of the original price that it charged USF, according to an agreed- upon payment schedule.
Sometimes the volume-based promotional allowances were paid as they were earned, but it was a common practice for the vendor to "prepay" on multiyear contracts at least some portion of the amounts that would be due if USF met all the projected purchase volume targets in the contract. Promotional allowances were critical to USF's financial results-without them, USF's operating income for FY2001 and FY2002 would have been materially reduced.
False Confirmations and Statements to Auditors
USF executives engaged in or substantially participated in a scheme whereby USF reported earnings equal to or greater than its earnings targets, regardless of the company's true performance. The primary method used to carry out this fraudulent scheme to "book to budget" was to inflate USF's promotional allowance income improperly. USF executives booked to budget by, among other things, causing USF to record completely fictitious promotional allowances that were sufficient to cover any shortfall to budgeted earnings.
USF executives covered up the false earnings by making it appear that the inflated promotional allowance income had been earned by (1) inducing vendors to confirm false promotional allowance income, payments, and receivable balances; (2) manipulating the promotional allowance accounts receivable from vendors and manipulating and misapplying cash receipts; and (3) making false and misleading statements and material omissions to the company's independent auditors, other company personnel, and/or Ahold personnel.
USF executives falsely represented to the company's independent auditors that there were no written promotional allowance contracts for the vast majority of promotional allowance agreements when in fact they knew, or were reckless in not knowing, that such written contracts existed. These executives falsely represented that USF had only handshake deals with its vendors that a USF executive would renegotiate at the end of each year to arrive at a mutually agreed-upon final amount due from each vendor for the year. They knew, or were reckless in not knowing, that these representations were false when they were made.
Nonexistent Internal Controls
USF had no comprehensive, automated system for tracking the amounts owed by the vendors pursuant to the promotional allowance agreements. Instead, USF, for purposes of interim reporting, purported to estimate an overall "promotional allowance rate" as a percentage of sales and recorded periodic accruals based on that rate. Information provided by USF executives caused the estimated rate to be inflated. The intended and actual result of inflating USF's promotional allowance income was that USF, and Ahold, materially overstated their operating incomes.
Corrupting the Audit Process
USF executives participated in a systematic effort to corrupt the audit process to keep the fraud from being discovered. Ahold's auditors attempted at the end of each fiscal year to confirm with the vendors that they actually paid, or still owed, the promotional allowances recorded by USF. To satisfy the auditors, USF executives successfully convinced vendors to sign audit confirmation letters even though they knew that the letters were false.
For each vendor subject to the confirmation process, USF executives prepared a schedule purportedly reflecting the promotional allowances earned by USF for the year, the amount paid by the vendor, and the balance due. USF executives grossly inflated the figures contained in these schedules. The schedules were used both by USF to support the related amounts recorded in its financial statements and by its auditors to perform the year-end audit.
USF executives provided information used to prepare confirmation request letters that they signed and that were sent to major vendors reflecting the inflated aggregate promotional allowances purportedly paid or owed to USF during the year. The promotional monies earned, paid, and receivable that were stated in the confirmations were grossly inflated and in many cases were simply fictitious, having no relationship to the actual promotional allowances earned, paid, or receivable.
Fraudulent Acts by Management
As a further part of the fraud, USF executives contacted or directed subordinates to contact vendors to alert them that they would receive confirmation letters and to ask them to sign and return the letters without objection. If a vendor balked at signing the fraudulent confirmation, USF executives pressed the vendor by, for example, falsely representing that the confirmation was just "an internal number" and that USF did not consider the receivable reflected in the confirmation to be an actual debt that it would seek to collect. USF executives sent, or directed subordinates to send, side letters to vendors who continued to object to the fraudulent confirmations. The side letters assured the vendors that they did not, in fact, owe USF amounts reflected as outstanding in the confirmation letters.
USF executives attempted to prevent the discovery of the fraudulent scheme by making accounting entries that unilaterally deducted material amounts from the balances that USF owed to certain vendors for the products USF had purchased, and simultaneously credited the promotional allowance receivable balance for the amount of such deductions. These "deductions" were made at the end of the year and had the net effect of making it appear that USF had made material progress in collecting promotional allowance payments allegedly due.
The large year-end deductions facilitated the fraudulent recording of promotional allowance income because these deductions made it appear that the amounts recorded had been earned and paid. The USF executives concealed the fact that the deductions were not authorized, were not legitimate, and that a substantial percentage of the deductions were reversed in the early part of the following fiscal year.
USF executives also knew, or were reckless in not knowing, that the amounts paid by some vendors included prepayments on multiyear contracts. But they falsely represented to USF personnel, Ahold personnel, and/or the company's independent auditors that none of the promotional allowance agreements included such prepayments. As a result, USF treated the prepayments by vendors as if they were payments for currently owed promotional allowances. This made it falsely appear that USF was making material progress in collecting the inflated promotional allowance income that it had recorded.
Role of the Auditors
Deloitte Touche had been Ahold's group (the consolidated entity) auditor since the company went public. A few years after Ahold had acquired USF and the accounting fraud surfaced, investors sued the firm for engaging in deceptive conduct and recklessly disregarding misstatements in Ahold's financial statements. The charges were dismissed because it was concluded that Deloitte was being deceived by Ahold executives, many of whom went to great lengths to conceal the fraud.
When Deloitte took over the auditing of USF after being taken over by Ahold, the firm uncovered multiple accounting errors that not only had a material effect on USF's profits, but materially distorted the net income of Ahold as well.
Financial Statement Misstatements and Restatements
As a result of the schemes already described, USF materially overstated its operating income during at least FY2001 and FY2002. On February 24, 2003, Ahold announced that it would issue restated financial statements for previous periods and would delay filing its consolidated 2002 financial statements as a result of an initial internal investigation based, in part, on the overstatement of income at USF. Ahold announced in May 2003 that USF's income had been overstated by more than $800 million since April 2000. Ahold's stock price plummeted from approximately $10.69 per share to $4.16 per share.
On or about October 17, 2003, Ahold filed its Form 20-F (filing with the SEC for foreign entities) for the fiscal year ended December 29, 2002, which contained restatements for FY2000 and FY2001, corrected accounting adjustments for FY2002, and restated amounts for FY1998 and FY1999 included in the five-year summary data. The restatements indicated that in its original SEC filings and other public statements, Ahold had overstated (1) net income by approximately 17.6, 32.6, and 88.1 percent for FY2000, FY2001, and the first three quarters of FY2002, respectively; (2) operating income by approximately 28.1, 29.4, and 51.3 percent for FY2000, FY2001, and the first three quarters of FY2002, respectively; and (3) net sales by approximately 20.8, 18.6, and 13.8 percent for FY2000, FY2001, and the first three quarters of FY2002, respectively. Ahold and three of the individual defendants agreed to settlements with the commission.
Ahold Today
Ahold operates a number of grocery chains throughout the United States and Europe. Its common shares are listed and traded on the NYSE Euronext. 5
Questions
1. Explain how Ahold used promotional allowances to manipulate earnings. Refer to the Fraud Triangle described in this chapter and analyze the incentives, pressures, and opportunities to commit fraud at Ahold.
2. Use the COSO Integrated Framework and discussion of risk assessment in the chapter and evaluate the deficiencies in the internal control system at Ahold. Include in your discussion whether you believe Ahold adequately monitored its internal controls as suggested in COSO's Guidance on Monitoring Internal Control Systems discussed earlier in this chapter.
3. The court ruled that Deloitte was not responsible for the fraud at Ahold because its management deceived the auditors and hid information from the firm. How does such deception relate to the Deloitte auditors' obligations to identify material misstatements in the financial statements of Ahold and provide an opinion that the statements present fairly financial position, results of operations, and changes in cash flows? Do you believe auditors should be left off the hook with respect to their ethical and professional obligations because of management deception?
Optional Questions
4. In addition to the deficiencies in accounting for promotional allowances, Ahold engaged in joint venture transactions that materially misstated the financial statements. Review the litigation referred to in the case and the nature and scope of the joint venture transactions and the problems that existed with the company's accounting and financial reporting and answer the following two questions.
a. Evaluate the operation of internal controls with respect to accounting for the joint venture transactions. How might the company have strengthened its controls?
b. From a corporate governance perspective, what were the deficiencies that seem to have contributed to the fraud in accounting for and reporting the joint venture transactions? Can you identify corporate governance mechanisms that might have helped prevent or detect the fraud at Ahold but that were nonexistent?
1 U.S. Securities and Exchange Commission, Litigation Release No. 18929, October 13, 2004, www.sec.gov/litigation/litreleases/lr18929.htm.
2 An ADR represents ownership in the shares of a non-U.S. company and trades in U.S. financial markets. The stocks of many non-U.S. companies trade on U.S. stock exchanges through the use of ADRs. ADRs enable U.S. investors to buy shares in foreign companies without the hazards or inconveniences of cross-border and cross-currency transactions. ADRs carry prices in U.S. dollars, pay dividends in U.S. dollars, and can be traded like the shares of U.S.-based companies.
3 Starting in 2005, members of the European Union (EU), including the Netherlands, adopted IFRS as the only acceptable standards for EU companies when filing statements with securities commissions in the European Union. Subsequent to the adoption, the SEC in the United States announced it would accept IFRS-based financial statement filings for foreign companies listing their stock on the NYSE and NASDAQ without reconciliation to U.S. GAAP. The United States has not adopted IFRS, although the SEC has established a method known as "condorsement" that calls for IFRS to be examined for conformity with U.S. GAAP and determination whether to endorse IFRS as a part of GAAP. These issues are discussed in Chapter 8.
4 Securities and Exchange Commission, U.S. District of Columbia, December 5, 2009, www.sec.gov/litigation/complaints/comp19034-6.pdf.
5 NYSE Euronext is the result of a merger on April 4, 2007, between the NYSE and stock exchanges in Paris, Amsterdam, Brussels, and Lisbon, as well as the NYSE Liffe derivatives markets in London, Paris, Amsterdam, Brussels, and Lisbon. NYSE Euronext is a U.S. holding company that operates through its subsidiaries. NYSE Euronext is a listed company. NYSE Euronext common stock is dually listed on the NYSE and Euronext Paris under the symbol "NYX." Each of the Euronext exchanges holds an exchange license granted by the relevant national exchange regulatory authority and operates under its supervision. Each market operator is also subject to national laws and regulations in its jurisdiction in addition to the requirements imposed by the national exchange authority and, in some cases, the central bank and/or the finance ministry in the relevant European country. Regulation of Euronext and its constituent markets is conducted in a coordinated fashion by the respective national regulatory authorities pursuant to memoranda of understanding relating to the cash and derivatives markets.

Question 18

The audit report on General Motors for 2008 issued by Deloitte Touche included the following statement: "The corporation's recurring losses from operations, stockholders' deficit, and inability to generate sufficient cash flow to meet its obligations and sustain its operations raise substantial doubt about its ability to continue as a going concern." Are you surprised to learn of this going-concern alert at a company such as General Motors? What signs might the auditors look for prior to issuing their report on the 2009 financial statements that help them reevaluate the going-concern assessment?

Question 19

Groupon
Introduction
The Groupon case was first discussed in Chapter 3. Here, we expand on the discussion of internal controls and the risk of material misstatement in the financial statements. Groupon is a deal-of-the-day recommendation service for consumers. Launched in 2008, Groupon-a fusion of the words group and coupon -combines social media with collective buying clout to offer daily deals on products, services, and cultural events in local markets. Promotions are activated only after a certain number of people in a given city sign up.
Groupon pioneered the use of digital coupons in a way that created an explosive new market for local business. Paper coupon use had been declining for years. But when Groupon made it possible for online individuals to obtain deep discounts on products in local stores using emailed coupons, huge numbers of people started buying. Between June 2009 and June 2010, revenues grew to $100 million. Then, between June 2010 and June 2011, revenues exploded tenfold, reaching $1 billion. In August 2010, Forbes magazine labeled Groupon the world's fastest growing corporation. And that did not hurt the company's valuation when it went public in November 2011.
On November 5, 2011, Groupon took its company public with a buy-in price of $20 per share. Groupon shares rose from that IPO price of $20 by 40 percent in early trading on NASDAQ, and at the 4 p.m. market close, it was $26.11, up 31 percent. The closing price valued Groupon at $16.6 billion, making it more valuable than companies such as Adobe Systems and nearly the size of Yahoo!
But after trading up for a couple of months, at the beginning of March 2012, Groupon's stock price turned downward, and the company has since lost 75 percent of its market capitalization. Groupon is now valued at about $3.6 billion-approaching half of what Google offered to pay for the company in 2011 before Groupon leadership decided to go public.
The problem seems to be growing competition from sites such as LivingSocial and AmazonLocal. Also, the leadership of the company has come under scrutiny for some of their practices. But the main reason Groupon seems to be struggling is concern over its reported numbers.
Problems with Financial Results
Less than five months after its IPO on March 30, 2012, Groupon announced that it had revised its financial results, an unexpected restatement that deepened losses and raised questions about its accounting practices. As part of the revision, Groupon disclosed a "material weakness" in its internal controls saying that it had failed to set aside enough money to cover customer refunds. The accounting issue increased the company's losses in the fourth quarter to $64.9 million from $42.3 million. These amounts were material based on revenue of $500 million in the prior year. The news that day sent shares of Groupon tumbling 6 percent, to $17.29. Shares of Groupon had fallen by 30 percent since it went public, and the downward trend continues today.
In its announcement of the restatement, Groupon explained that it had encountered problems related to certain assumptions and forecasts that the company used to calculate its results. In particular, the company said that it underestimated customer refunds for higher-priced offers such as laser eye surgery.
Groupon collects more revenue on such deals, but it also carries a higher rate of refunds. The company honors customer refunds for the life of its coupons, so these payments can affect its financials at various times. Groupon deducts refunds within 60 days from revenue; after that, the company has to take an additional accounting charge related to the payments.
Groupon's restatement is partially a consequence of the "Groupon Promise" feature of its business model. The company pledges to refund deals if customers aren't satisfied. Because it had been selling those deals at higher prices-which leads to a higher rate of returns-it needed to set aside larger amounts to account for refunds, something it had not been doing. It is an example of Groupon failing to account accurately for a part of its business that reduces its financial performance.
The financial problems escalated after Groupon released its third-quarter 2012 earnings report, marking its first full- year cycle of earnings reports since its IPO in November 2011. While the net operating results showed improvement year- to-year, the company still showed a net loss for the quarter. Moreover, while its revenue had been increasing in fiscal 2012, its operating profit had declined over 60 percent. This meant that its operating expenses were growing faster than its revenues, a sign that trouble may be lurking in the background. The company's stock price on NASDAQ went from $26.11 per share on November 5, 2011, the end of the IPO day, to $4.14 a share on November 30, 2012, a decline of more than 80 percent in one year. The company did not meet financial analysts' expectations for the third quarter of 2012.
Groupon's fourth quarter 2012 results show a revenue increase to $638.8 million but with an operating loss of $12.9 million and a loss per share of 12 cents, falling short of analyst expectations on the EPS front-they had predicted $638.41 million in revenue and EPS of $0.03. The Groupon share price has recovered somewhat to $7.65 per share on June 14, 2013.
Groupon blamed the disappointing results on its European operations. Some analysts took solace in the fact that Groupon reported that it has 39.5 million active customers, an increase of 37 percent from the previous year. But what good does it do to have a larger customer base if it also leads to larger-than-expected operating costs?
Problems with Internal Controls
As Groupon prepared its financial statements for 2011, its independent auditor, Ernst Young (EY), determined that the company did not accurately account for the possibility of higher refunds. By the firm's assessment, that constituted a "material weakness." Groupon said in its annual report, "We did not maintain effective controls to provide reasonable assurance that accounts were complete and accurate." This means other transactions may be at risk because poor controls in one area tend to cause problems elsewhere. More important, the internal control problems raise questions about the management of the company and its corporate governance. But Groupon blamed EY for the admission of the internal control failure to spot the material weakness.
In a related issue, on April 3, 2012, a shareholder lawsuit was brought against Groupon accusing the company of misleading investors about its financial prospects in its IPO and concealing weak internal controls. According to the complaint, the company overstated revenue, issued materially false and misleading financial results, and concealed the fact that its business was not growing as fast and was not nearly as resistant to competition as it had suggested. These claims bring up a gap in the sections of SOX that deal with companies' internal controls. There is no requirement to disclose a control weakness in a company's IPO prospectus.
The red flags had been waving even before the company went public in 2011. In preparing its IPO, the company used a financial metric that it called "Adjusted Consolidated Segment Operating Income." The problem was that that figure excluded marketing costs, which make up the bulk of the company's expenses. The net result was to make Groupon's financial results appear better than they actually were. After the SEC raised questions about the metric-which The Wall Street Journal called "financial voodoo"-Groupon downplayed the formulation in its IPO documents.
In an updated filing with the SEC, Groupon said that it is working to "remediate the material weakness," in its internal financial reporting controls, and will hire "additional finance personnel." But it warned: "If our remedial measures are insufficient to address the material weakness, or if additional material weaknesses or significant deficiencies in our internal control over financial reporting are discovered or occur in the future, our consolidated financial statements may contain material misstatements and we could be required to restate our financial results."
Questions
1. What is the responsibility of management and the auditor with respect to the internal controls of a client?
2. Groupon disclosed a "material weakness" in its internal controls saying that it had failed to set aside enough money to cover customer refunds. Do you believe the company engaged in fraud with respect to customer refunds? Why or why not?
3. Groupon blamed EY for the admission of the internal control failure to spot the material weakness. Do you agree that EY should have spotted the internal control weakness earlier and taken appropriate action? Include in your response the role that risk assessment should have played in EY's actions.
Optional Question
4. According to Groupon, the merchants are responsible for fulfilling the obligation to deliver the goods and services. Groupon disclosed that fact and the following statement in its restated financial statements:"We record the gross amount received from Groupon, excluding taxes where applicable, as the Company is the primary obligor in the transaction, and records an allowance for estimated customer refunds on total revenue primarily based on historical experience... the Company also records costs related to the associated obligation to redeem the award credits granted as issuance as an offset to revenue."
Review SEC Staff Accounting Bulletin 101 (Question 10) and Emerging Issues Task Force (EITF) pronouncement 99-19 using the links provided below and evaluate whether Groupon's accounting for the allowance referred to in this scenario met GAAP requirements.
Staff Accounting Bulletin 101- Revenue Recognition in Financial Statements
http://www.sec.gov/interps/account/sab101.htm
EITF No. 99-19 Reporting Revenue Gross as a Principal versus Net as an Agent
http://www.fasb.org/csZBlobServer?blobkey=id blobwhere=1175820914023 blobheader=application%2Fpdf blobcol=urldata blobtable=MungoBlobs

Question 20

Do you think the concept of materiality is incompatible with ethical behavior? Why or why not?

Question 21

How do materiality judgments affect risk assessment in an audit of financial statements?

Question 22

According to GAAS, the auditor must evaluate the control deficiencies that he has become aware of to determine whether those deficiencies, individually or in combination, are significant deficiencies or material weaknesses. What is the purpose of the auditor's evaluation of internal controls in these contexts with respect to conducting an audit in accordance with established auditing standards?

Question 23

In 2005, the IMA reported the results of a survey of business, academic, and regulatory leaders conducted by the Center for Corporate Change that found the corporation's culture to be the most important factor influencing the attitudes and behavior of executives. The results indicate that 88 percent of the representatives who took part in the survey believe that companies devote little management attention to considering the effect of the culture on their executives. What are the elements of the corporate culture? How do the standards in COSO's Integrated Framework help define a strong control environment?

Question 24

Kinetics, Inc., included the following footnote in its December 31, 2013, financial statements:
We corrected the misstatement of capitalized advertising costs recorded in 2012 by adjusting operating expenses for 2013, and crediting the asset account. The result of this correction is to reduce income by $500,000 for 2013 [a material amount] and reduce recorded assets by a like amount.
How would you determine whether to include reference to the correction in the audit report? If reference is needed, how should it affect the type of audit opinion given?

Question 25

What do you think is meant by the term ethical auditing with respect to the principles and rules of professional conduct in the AICPA Code?

Question 26

Mr. Arty works for Smile Accounting Firm as a senior accountant. Currently, he is doing a review of rental property compliance testing completed by the staff accountants. He is testing rental receipts and expenses of the property owned by the client. Arty realizes that the staff accountants tested only two tenants per property, instead of the three required by the audit program based on materiality considerations. However, to request more information from the client would cause massive delays, and the manager on the engagement is pressing hard for the information before Christmas vacation. Assume that the manager approaches the client, who states that she does not want any additional testing: "I needed the report yesterday." The manager points out to Arty that no problems were found from the testing of the two properties. Moreover, the firm has never had any accounting issues with respect to the client. Assume that the firm decides that it is not necessary to do the additional testing. What would you do if you were Arty? Consider in your answer the ethics of the situation, your ethical obligations as a CPA, and the reporting obligations of the firm.

Question 27

What are the auditor's responsibilities to communicate information to the audit committee under PCAOB standards? If the auditor discovers that the audit committee routinely ignores such communications especially when they are critical of management's use of GAAP in the financial statements, what step(s) might the auditor take at this point?

Question 28

In Europe, the audit reports use the expression "true and fair view" to characterize the results of the audit. Do you think there is a meaningful difference between that language and the "present fairly" statement made in U.S. audit reports? As a user of the financial statements in each instance, does one expression more than the other give you a greater comfort level with respect to the conformity of the financial statements with GAAP? Why or why not?

Question 29

"Accounting firms and their personnel must continually evaluate their clients' accounting and related disclosures, putting themselves in investors' shoes." This statement was made on February 8, 2012, by Claudius B. Modesti, director of the PCAOB Division of Enforcement and Investigations, in reporting on PCAOB's audits of Medicis Pharmaceutical Corporation's fiscal 2005 through 2007 financial statements. Medicis was a client of Ernst Young that was undergoing an inspection in accordance with PCAOB's enforcement program. The board found that EY and its partners failed to audit key assumptions sufficiently and placed undue reliance on management's representation that those assumptions were reasonable. Further, the firm failed to evaluate properly a material departure from GAAP in the company's financial statements-its sales returns reserve. 75
PCAOB chairman James R. Doty was quoted as saying: "The auditor's job is to exercise professional skepticism in evaluating a public company's accounting and in conducting its audit to ensure that investors receive reliable information, which did not happen in this case."
Following the audits and PCAOB inspection of EY's audit of Medicis, the company corrected its accounting for its sales returns reserve and filed restated financial statements with the SEC.
What is the link between professional skepticism and Josephson's Six Pillars of Character that were discussed in Chapter 1? Given the limited information, which rules of professional conduct in the AICPA Code were violated by EY? Explain why.

Question 30

Audit morality includes moral sensitivity, moral judgment, moral motivation, and moral character. Explain how audit morality plays a key role in determining best audit practices that influence audit performance.