Instructions 5-1 Case Study 3: Financial Statement Fraud (Please see attachment for the Assignment) Paper must be original because it will be submitted in Turnitin (APA format) Assignment The thir
Instructions
5-1 Case Study 3: Financial Statement Fraud (Please see attachment for the Assignment)
Paper must be original because it will be submitted in Turnitin (APA format)
Assignment
The third case study in the course gives you the opportunity to evaluate and select your own case to analyze. Be sure that the case you chose provides you with enough of a framework to answer the questions for the assignment. Check the module resources for assistance with evaluating a case study.
Misstatements
Misstatements in financial statements are the result of either errors or fraud. Errors are unintentional mistakes, while fraud results from an intentional act. The AICPA is concerned with errors or fraud that result in material misstatements in a company’s financial statements (AICPA, 2012). Company management and others in the corporate governance system are primarily responsible for the prevention and detection of fraud as well as creating and maintaining an ethical corporate environment. Auditors must realize that although the risk of fraud can be reduced, it cannot be eliminated. Therefore, auditors must understand the nature of fraud and be aware of potential fraud schemes that are characteristic of the industry for each company they audit. In addition, acts such as collusion make it difficult to detect the existence of fraud.
The Fraud Triangle
Donald Cressey (1952) developed the framework for understanding how fraud occurs, now called the fraud triangle. Three conditions need to be present in order for the fraud to take place: incentive or pressure to commit the fraud, opportunity, and rationalization for the fraud. Without each component of the fraud triangle, fraud could not occur. The AICPA has adopted the theory of the fraud triangle in AU 240, Consideration of Fraud in a Financial Statement Audit. Examples of illustrations of risk factors for each component of the fraud triangle are shown in Exhibit 5.3 of the textbook (Mintz & Morris, 2013). Additionally, AU 240 lists 10 areas auditors can consider to increase the detection of fraud during an audit.
This document also discusses the difficulties of detecting fraud when management overrides the internal controls that are in place or colludes with others to conceal fraud. Revenue recognition is the area that has produced the greatest fraud losses. Because of their position, management is able to manipulate revenue through estimates and allowances.
Internal Controls
The studies performed by the Committee of the Sponsoring Organizations of the Treadway Commision (COSO) and its resulting reports have served as the framework for the development of an effective internal control system. Additionally, its reports have stressed the significance in top management’s role in misleading financial statements, whether in actually perpetrating the fraud or shopping for an audit firm willing to support management’s decisions (Mintz & Morris, 2013).
Understanding the psychological components of fraud as depicted in the fraud triangle and being aware of red flags that may signal fraud can greatly assist auditors and accountants. Auditors have missed many of these fraud indicators in the past. Following audit standards and applying the fraud triangle increases auditors’ ability to evaluate the risk of fraud. Users of financial information rely on auditors’ reports to make decisions, and auditors must keep this responsibility in mind at all times.
References
American Institute of Certified Public Accountants (AICPA). (2012). AU-C Section 240:Consideration of fraud in a financial statement audit. New York, NY: AICPA.
Cressey, D. (1952). Application and verification of the differential association theory. Journal of Criminal Law & Criminology, 43(1), 43–52.
Mintz, S., & Morris, R. (2013). Ethical obligations and decision making in accounting (3rd ed.). New York, NY: McGraw-Hill.
For additional details, please refer to the Case Study 3 Rubric document.
(Please select one of the cases below)
Cases – choose one of the cases highlighted in green below.
Chapter 5 Cases
Case 5-1 Loyalty and Fraud Reporting (a GVV case)
Assume Vick and Ethan are CPAs. Ethan Lester was seen as a “model employee” who deserved a promotion to CFO, according to Kelly Fostermann, the CEO of Fostermann Corporation, a Maryland-based, largely privately held company that is a prominent global designer and marketer of stereophonic systems. Kelly considered Lester to be an honest employee based on performance reviews and his unwillingness to accept the promotion, stating that he wasn’t ready yet for the position. Little did she know that Lester was committing a $50,000 fraud during 2015 by embezzling cash from the company. In fact, no one seemed to catch on because Lester was able to override internal controls. However, the auditors were coming in and to solidify the deception, he needed the help of Vick Jensen, a close friend who was the accounting manager. Lester could “order” Jensen to cover up the fraud but hoped he would do so out of friendship and loyalty. Besides, Lester knew Jensen had committed his own fraud two years ago and covered it up by creating false journal entries for undocumented sales, returns, transactions, and operating expenses.
Lester went to see Jensen and explained his dilemma. He could see Jensen’s discomfort in hearing the news. Jensen had thought he had turned the corner on being involved in fraud after he quietly paid back the $20,000 he had stolen two years ago. Here is how the conversation went.
“Vick, I need your help. I blew it. You know Mary and I split up 10 months ago.”
“Yes,” Vick said.
“Well, I got involved with another woman who has extravagant tastes. I’m embarrassed to say she took advantage of my weakness and I wound up taking $50,000 from company funds.”
“Ethan, what were you thinking?”
“Don’t get all moral with me. Don’t you recall your own circumstances?”
Vick was quiet for a moment and then asked, “What do you want me to do?”
“I need you to make some entries in the ledger to cover up the $50,000. I promise to pay it back, just as you did. You know I’m good for it.”
Vick reacted angrily, saying, “You told me to skip the bank reconciliations—that you would do them yourself. I trusted you.”
“I know. Listen, do this one favor for me, and I’ll never ask you again.”
Vick grew increasingly uneasy. He told Ethan he needed to think about it … his relationship with the auditors was at stake.
Questions
Analyze the facts of the case using the Fraud Triangle. Include a discussion of the weaknesses in internal controls.
Which rules of professional conduct should Vick consider in deciding on a course of action? Explain. What are Vick’s ethical obligations in this matter?
Use the “Giving Voice to Values” framework to help Vick decide on his next course of action. Why do you recommend it?
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Case 5-2 ZZZZ Best1
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. Although this case dates back over 30 years, it does serve as an example of what can happen when auditors do not look too hard to find fraud.
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. Minkow realized early on that he was not going to become a millionaire cleaning other people’s carpets, but that he could 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. 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 (now EY), 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. Voilá! 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.
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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
Pressured to get a big-time CPA firm to do his audit by the underwriting firm selling his stock, 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 & 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 & Whinney and give it to other auditors. To get on their good side, he would wine and dine the auditors and even invite them to his house.
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 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.
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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 & Whinney decided to resign from the ZZZZ Best audit. It had started to doubt the veracity of Minkow and his business at ZZZZ Best. Of course, by then it mattered little because the firm had been a party to the cover-up for some time.
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. The firm lucked out in that the judge understood that a review engagement only provides limited assurance rather than the reasonable assurance of the audit.
Barry Minkow was charged with engaging in a $100 million fraud scheme. He was sentenced to a term of 25 years.
Questions
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? Explain.
Discuss the red flags that existed in the ZZZZ Best case and evaluate Ernst & Whinney’s efforts with respect to fraud risk assessment. Criticize the firm’s approach to the audit from a professional judgment perspective.
These are selected numbers from the financial statements of ZZZZ Best for fiscal years 1985 and 1986:
1985 1986
Sales $1,240,524 $4,845,347
Cost of goods sold 576,694 2,050,779
Accounts receivable 0 693,773
Cash 30,321 87,014
Current liabilities 2,930 1,768,435
Notes payable—current 0 780,507
What is the purpose of performing analytical review procedures in an audit performed under GAAS? 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 1997, Minkow became a preacher and a fraud investigator, and he spoke at schools about ethics. He had established a reputation of trust as a pastor in the Community Bible Church in San Diego that he had served after being released from prison. However, over time his greedy nature got the better of him. He admitted that he tricked a widower into making a $75,000 donation for a hospital in Sudan to honor his wife after she died of cancer. Only there was no hospital, and Minkow pocketed the money. Minkow also admitted, among others things, that he stole $300,000 from a widowed grandmother who was trying to raise her teenage granddaughter. In addition, Minkow confessed to diverting church member donations for his own benefit and embezzling money intended as church donations. In all, Minkow admitted stealing—and concealing from the IRS—at least $3 million from church parishioners and lenders. As described in court documents, Minkow’s conduct continued for over a decade. On April 28, 2014, he was sentenced to five years in prison for his crimes that will be tacked on to the five-year term in the Lennar scheme, described below.
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Soon after his arrival at Community Bible Church, 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.
Once again, Barry’s true self got the better of him 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, 2009, 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. Prosecutors had charged that Minkow and Marsch conspired to extort money from Lennar by driving down its stock. According to his lawyer, Minkow had bought his Lennar options using “nonpublic information.” The complaint also revealed that Minkow had sent his allegations to the FBI, 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.
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.”
Questions (continued)
4. Why do you think Minkow was able to pull off the fraud at the church for so long and not be detected?
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Case 5-3 Imperial Valley Community Bank
Bill Stanley, of Jacobs, Stanley & Company, started to review the working paper files on his client, Imperial Valley Community Bank, in preparation for the audit of the client’s financial statements for the year ended December 31, 2016. 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.
EXHIBIT 1
IMPERIAL VALLEY COMMUNITY BANK
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Background
Bill Stanley knew there were going to be some problems to contend with during the course of the audit, so he decided to review the planning memo that he had prepared about two months earlier. This memo is summarized in Exhibit 2.
EXHIBIT 2
Planning Memo
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The next item he reviewed was an internal office communication on potential audit risks. This communication described three areas of particular concern:
The client charged off $420,000 in loans in 2015 and had already charged off $535,000 through July 31, 2016. 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.
The audit report issued on the 2015 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.
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
Jacobs, Stanley & Company conducted the audit of the financial statements for the year ended December 31, 2016, and the following were the areas of greatest concern to Stanley:
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.
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.
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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.
Status of Additional Capital Infusion. The audit engagement team is working under the assumption that under Arizona regulatory requirements, a community bank 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:
Thrift certificates
Net equity capital required $1,232,000
Net equity capital reported $1,200,000
Deficiency $ 32,000
Audit adjustments explained in Exhibit 3 increased the capital deficiency to $622,000, as follows:
Net equity capital required $1,232,000
Net equity capital (postaudit)
($1,200,000–$590,000) $ 610,000
Deficiency $ 622,000Page 323
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.
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 showed only two loans from 2016 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.
EXHIBIT 3
Audit Adjustments
Regulatory Environment
Imperial Valley Community Bank 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 community banks in Arizona. Many depositors had lost money as a result of the failure of these banks. 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 bank 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 savings and loans (S&Ls).
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Summary of the Client’s Position
The management of Imperial Valley Community Bank 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 contended that a certain amount of risk had to be accepted in their business because they primarily made loans that commercial banks 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 naïve about the community bank, 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 was 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 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.
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Stanley knew that he would soon have to make a recommendation about the type of audit opinion to be issued on the 2016 financial statements. Before approaching the engagement review partner on the engagement, Stanley drafted the following memo to file.
Memo: Going-Concern Question
The question of the going-concern status of Imperial Valley Community Bank is being raised because of the client’s continuing operating losses and high level of loan losses that has resulted in a “capital impairment” designation by the Arizona Department of Corporations. The client lost $920,000 after audit adjustments in 2016. This is in addition to a loss of $780,000 in 2015. Imperial Valley has also reported a loss of $45,000 for the first two months of 2017.
Imperial Valley is also out of compliance with regulatory capital requirements. After audit adjustments, the client has net equity capital of $610,000 as of December 31, 2016. The Arizona Department of Corporations requires a 6:1 ratio of thrift certificates to capital. As of December 31, 2016, these regulations would require net equity capital of $1,232,000. Imperial Valley was therefore undercapitalized by $622,000 at that date, and no additional capital contributions have been made subsequent to December 31. It is possible, however, that either the parent company, Nuevo Financial Group, or a private investor, Manny Gonzalez, will contribute additional equity capital.
We have been unable to obtain enough support for the value of much of the collateral backing outstanding loans. We also have concluded that there is a substantial doubt about the bank’s ability to continue in business. The reasons for this conclusion include the following:
The magnitude of losses, particularly loan losses, implies that Imperial Valley is not well managed.
The losses are continuing in 2017. Annualized losses to date, without any provision for loan losses, are $270,000.
Additional equity capital has not been contributed to date, although Gonzalez has $600,000 available.
Our review of client loan files and lending policies raises an additional concern that loan losses may continue. If this happens, it would only exacerbate the conditions mentioned herein.
We also believe that it is not possible to test the liquidation value of the assets at this time should Imperial Valley cease to operate. The majority of client assets are loans receivable. These would presumably have to be discounted in order to be sold. In addition, there is some risk that the borrowers will simply stop making payments.
In conclusion, it is our opinion that a going-concern question exists for Imperial Valley Thrift & Loan at December 31, 2016.
Questions
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? Explain.
What is the role of assessing risk including materiality in an audit? Do you think the auditors did an adequate job in this regard? Explain.
Assume that the auditors decide to support management’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 ethics of the auditors’ decision.
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Assume that you were asked to review the information in this case as the engagement review partner on the audit of Imperial Valley Community Bank. How would you assess the quality of the audit? Include an assessment of internal controls in your analysis.
Case 5-4 Busy Season Planning
Romello Accounting LLP is a small CPA firm consisting of three partners and seven other professional staff. The firm offers full attestation and assurance services. Most of the work is for small and medium-sized nonpublic companies. The firm is registered with the PCAOB and does audits of about 30 penny stock or pink sheet companies and broker-dealers each year.
Tony Romello, the managing partner of the firm, has been the review partner on all audits for the last several years. Unfortunately, Tony encountered major health concerns in the last month and will not be available for the upcoming busy season. Michelle Thompson and Max King, the two remaining partners, are discussing staffing during the busy season.
“I am sorry that Tony is so ill, but I am concerned about our staff needs over the next three months. With two senior auditors and five staff auditors, we are all going to be very busy. I guess it is too late to hire experienced staff and get them trained quickly,” Michelle stated.
“Don’t forget that we will need a review partner,” Max mused. “Hey, I could be the review partner for your audits and you can be review partner on my audits.”
“I almost forgot that,” Michelle said. “But don’t we need to get a review partner who hasn’t worked on the audits the last two years? That would exclude both of us, since we are switching off audits every five years. . . . Hey, maybe we can get Tom Mullins, CPA, to be our review partner on a contract basis?”
Max immediately objected. “You know that, as a retired Big Four audit partner, he would eat up our slim profits with his contract rate. Let’s just make do this year and start planning to have a new partner by this time next year.”
“We can’t do that,” Michelle countered. “When we have the PCAOB inspections, we will get penalized. We would also be cited in our peer reviews. No, no, I’m not comfortable thinking of not having a review partner. Also, without Tony this year, you and I will be busy supervising the staff without the added responsibilities of being review partner.”
“Oh brother, you are such a rule follower!”
Questions
Consider the staffing of audits in responding to the following questions.
Identify the stakeholders of audits and their interests. Is there a difference between stakeholders and interests of public versus nonpublic companies?
What are a firm’s considerations in having review partners? Does it really matter from a professional judgment perspective whether review partners rotate off after a prescribed number of years? Explain.
Assume Max convinces Michelle to let him serve as the review partner for all audits and Michelle will serve as the engagement partner on all audits. Do you see any problems with this approach from an ethical perspective?
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Case 5-5 Tax Inversion (a GVV case)
Jamie Keller was pleased with his new job position as director of international consolidation for Gamma Enterprises. Gamma Enterprises was a consolidation of high-tech gaming companies, with subsidiaries of Alpha, Beta, Gamma, Delta, and Epsilon. This past year Gamma had completed a tax inversion with Epsilon, which is headquartered in Ireland, becoming the parent company. Gamma was the oldest company of the group and the only subsidiary with material inventory.
Jamie was preparing for a meeting with Jason Day, the CFO of the group, as well as the senior manager on the audit of Gamma. The discussion was planning for the year-end and issues with the tax inversion and consolidation with Epsilon as the parent company.
Jamie and Jason were in the conference room when Thomas Stein, the senior auditor, arrived. Jamie was surprised as Thomas was an accounting classmate from State University.
“Thomas, what a surprise! I did not know that we would be working together on the annual financial statements. Long time, no see,” Jamie said.
“Yes, it’s good to see you. We did many a team project together in school. Congratulations on your new position. Jason told me what a great job you were doing.”
Jason cleared his throat and said, “I see we all know each other. Let’s get started as I think there are a lot of year-end issues with this tax inversion. First, the company will keep the corporate physical headquarters here in Philadelphia, but many of the governance meetings will be at Epsilon headquarters in Dublin, Ireland. Jamie, I need you to prepare a study for the board to consider at the next meeting as to whether all the subsidiaries should change to IFRS for the consolidation or not. Thomas, can you briefly explain the issues with such a change?”
“Under IFRS most assets will be revalued to fair market values. That will increase the values on the balance sheet. The biggest drawback will be the taxes the company will owe with changing from LIFO to weighted average for Gamma’s inventory,” Thomas began.
“Hold on, a minute,” Jason jumped in. “This tax inversion is to be a tax savings or tax-neutral situation, particularly this year when the stockholders are expecting profits. The U.S. government has allowed LIFO inventory for tax and financial reporting purposes so that is what Gamma is going to do.”
Jamie asked, “Are you suggesting that Gamma continue using U.S. GAAP while the other subsidiaries change to the IFRS basis? If I remember correctly from school, a company must pick one financial reporting format and follow the principles in those standards. Besides, LIFO is not acceptable under IFRS.”
“I don’t see why it is a big deal to use IFRS for all but Gamma’s inventory, Jason said. Thomas, what do you think?”
“I’m sure something can be worked out,” Thomas replied.
The discussion changed to other issues. After the meeting, Jamie and Thomas went to lunch to catch up on old times. At lunch, Jamie commented, “Thomas, do you really mean to let Jason and Gamma Enterprises pick and choose which accounting standards to follow, using a mixed-bag approach?”
“No, you were right, Jamie. However, I could see that the issue was upsetting Jason. It may take time to convince him.”
“I was just surprised that you seemed open to it at all. Aren’t the auditors suppose to be the watchdogs of business?”
“Jamie, I am up for partner this next year. I need to keep Gamma as a happy client. The pressure to keep revenues coming into the accounting firm is a big weight on my shoulders.”
“Well, just don’t forget your values.”
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Questions
Assume you are Thomas’s position and know that you have to let Jason know the correct way to convert to IFRS accounting.
What will be the objections or pushback from Jason?
What would you say next? What data and other information do you need to make your point and counteract the reasons and rationalizations you will likely have to address?
Consider whether Jamie and Thomas could work together to convince Jason (and the board) to change accounting methods. Identify the stakeholders in this case and their interests in addressing the following questions.
What are the main arguments you are trying to counter? That is, what are the reasons and rationalizations you need to address?
What is at stake for the key parties, including those who disagree with you?
What levers can you use to influence those who disagree with you?
What is your most powerful and persuasive response to the reasons and rationalizations you need to address? To whom should the argument be made? When and in what context?
Case 5-6 Rooster, Hen, Footer, and Burger
Barry Yellen, CPA, is a sole practitioner. The largest audit client in his office is Rooster Sportswear. Rooster is a privately owned company in Chicken Heights, Idaho, with a 12-person board of directors.
Barry is in the process of auditing Rooster’s financial statements for the year ended December 31, 2016. He just discovered a related-party transaction that has him worried. For one thing, the relationship has existed for the past two years, but Barry did not discover it. What’s just as troubling is that the client hid it from him.
Rooster bought out Hen Sportswear two years ago but still operates it as a separate entity, and since then has systematically failed to disclose to the private investors related-party transactions involving the CEO of Rooster, Frank Footer. It seems that Footer is borrowing money from Hen and is deeply in debt to the CEO of that company, who is his brother-in-law. Also, Hen has hired relatives of Footer, most of whom are unqualified for their jobs, and pays them an above-market salary. This has been hidden from Barry as well.
Barry was informed by an anonymous tipster that Rooster operates a secret off-balance-sheet cash account to pay for cash bonuses to senior officers, travel and entertainment expenses and an apartment rental for Footer, and cash and noncash gifts to local government officials to “grease the wheels” when permits need to be expedited in favor of Rooster. Barry doesn’t know what to make of it, because he is too focused right now on the related-party transactions with Hen Sportswear.
Barry is in the process of questioning Hans Burger, CPA, who is the CFO of Rooster, about these transactions. Burger explains that he had raised these issues with Footer but was instructed in no uncertain terms to leave them alone. He did just that. Burger told Barry he needed this job and wouldn’t jeopardize it out of a sense of “ethics.”
Barry is in his office back at the firm and reflecting on how best to handle this matter.
Questions
What are related-party transactions and the obligations of Barry as the auditor of Rooster Sportswear? Why are related-party transactions a particularly sensitive area?
What are Barry’s ethical obligations in this matter? Include in your discussion the issues of concern from an audit perspective and why they should be of concern to Barry in deciding what to do.
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Assume you are Barry’s best friend and he asks for your advice. What would you tell Barry and why? Use ethical reasoning in developing the advice.
Case 5-7 Diamond Foods: Accounting for Nuts1
Diamond Foods, based in Stockton, California, is a premium snack food and culinary nut company with diversified operations. The company had a reputation of making bold and expensive acquisitions. Due to competition within the snack food industry, Diamond developed an aggressive company culture that placed high emphasis upon performance. The company’s slogan was “Bigger is better.” However, without strong ethical oversight, questionable behavior started to persist at Diamond Foods in 2009. Serious allegations of fraud against top management led to a restructuring of leadership. Here is the story we dub: “Accounting for Nuts.”
On November 14, 2012, Diamond Foods Inc. disclosed restated financial statements tied to an accounting scandal that reduced its earnings during the first three quarters of 2012 as it took significant charges related to improper accounting for payments to walnut growers. The restatements cut Diamond’s earnings by 57 percent for FY2011, to $29.7 million, and by 46 percent for FY2010, to $23.2 million. By December 7, 2012, Diamond’s share price had declined 54 percent for the year.
Diamond Foods, long-time maker of Emerald nuts and subsequent purchaser of Pop Secret popcorn (2008) and Kettle potato chips (2010), became the focus of an SEC investigation after The Wall Street Journal raised questions about the timing and accounting of Diamond’s payments to walnut growers. The case focuses on the matching of costs and revenues. At the heart of the investigation was the question of whether Diamond senior management adjusted the accounting for the grower payments on purpose to increase profits for a given period.
The case arose in September 2011, when Douglas Barnhill, an accountant who is also a farmer of 75 acres of California walnut groves, got a mysterious check for nearly $46,000 from Diamond. Barnhill contacted Eric Heidman, the company’s director of field operations, on whether the check was a final payment for his 2010 crop or prepayment for the 2011 harvest. (Diamond growers are paid in installments, with the final payment for the prior fall’s crops coming late the following year.) Though it was September 2011, Barnhill was still waiting for full payment for the walnuts that he had sent Diamond in 2010. Heidman told Barnhill that the payment was for the 2010 crop, part of FY2011, but that it would be “budgeted into the next year.” The problem is under accounting rules, you cannot legitimately record in a future fiscal year an amount for a prior year’s crop. That amount should have been estimated during 2010 and recorded as an expense against revenue from the sale of walnuts.
An investigation by the audit committee in February 2012 found payments of $20 million to walnut growers in August 2010 and $60 million in September 2011 that were not recorded in the correct periods. The disclosure of financial restatements in November 2012 and audit committee investigation led to the resignation of former CEO Michael Mendes, who agreed to pay a $2.74 million cash clawback and return 6,665 shares to the company. Mendes’s cash clawback was deducted from his retirement payout of $5.4 million. Former CFO Steven Neil was fired on November 19, 2012, and did not receive any severance. The SEC brought a lawsuit against Diamond Foods, Mendes and Neil. It settled with the company and Mendes on January 9, 2014. In a separate action Neil settled charges that he had directed the effort to fraudulently underreport money paid to walnut growers by delaying the recording of payments into later fiscal periods.
As a result of the audit committee investigation and the subsequent analysis and procedures performed, the company identified material weaknesses in three areas: control environment, walnut grower accounting, and accounts payable timing recognition. The company announced efforts to remediate these areas of material weakness, including enhanced oversight and controls, leadership changes, a revised walnut cost estimation policy, and improved financial and operation reporting throughout the organization.
An interesting aspect of the case is the number of red flags, including unusual timing of payments to growers, a leap in profit margins, and volatile inventories and cash flows. Moreover, the company seemed to push hard on every lever to meet increasingly ambitious earnings targets and allowed top executives to pull in big bonuses, according to interviews with former Diamond employees and board members, rivals, suppliers and consultants, in addition to reviews of public and nonpublic Diamond records.
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Nick Feakins, a forensic accountant, noted the relentless climb in Diamond’s profit margins, including an increase in net income as a percent of sales from 1.5 percent in FY2006 to more than 5 percent in FY2011. According to Feakins, “no competitors were improving like that; even with rising Asian demand.” Reuters did a review of 11 companies listed as comparable organizations in Diamond’s regulatory filings and found that only one, B&G Foods, which made multiple acquisitions, added earnings during the period.
Another red flag was that while net income growth is generally reflected in operating cash flow increases, at Diamond, the cash generation was sluggish in FY2010, when earnings were strong. This raises questions about the quality of earnings. Also, in September 2010, Mendes had promised EPS growth of 15 percent to 20 percent per year for the next five years. In FY2009, FY2010, and FY2011, $2.6 million of Mendes’s $4.1 million in annual bonus was paid because Diamond beat its EPS goal, according to regulatory filings.
Diamond Foods fraudulent actions also stretched to falsely disclosing its strong overall financial performance in conference calls with financial analysts. In its call for the third quarter FY 2011, Mendes said: “Earnings per share had increased 73 percent to 52 cents, exceeding the top end of the company’s guidance range. Strong operating cash flow for the period helped fund a significant increase in new product and advertising investment as EBITDA [Earnings before interest, taxes, depreciations and amortization] of $31 million was more than double the same period in the prior year.”
As for the role of Deloitte in the fraud, the SEC charged that Neil misled them by giving false and incomplete information to justify the unusual accounting treatment for the payments. The SEC’s order against Mendes found that he should have known that Diamond’s reported walnut cost was incorrect because of information he received at the time, and he omitted facts in certain representations to Deloitte about the special walnut payments. One problem was Neil did not document accounting policies or design the process for which walnut grower payments and the walnut cost estimates were determined. This was exacerbated by the fact that management did not communicate the intent of the payments effectively.
Questions
Use the fraud triangle to analyze the business and audit risks that existed at Diamond Foods during the period of its accounting fraud.
Answer the following:
Did Diamond Foods commit an illegal act? Explain.
Evaluate the control environment at Diamond Foods.
Based on the facts of the case, do you think the auditors from Deloitte could have done more to identify the fraud at Diamond Foods? Were there any apparent deficiencies in their audit procedures and evaluation of the risk of material misstatement in the financial statements of Diamond Foods? Explain.
Case 5-8 Bill Young’s Ethical Dilemma
Bill Young felt uneasy but good about downloading hundreds of pages of documents about Infant Products Inc., an audit client of his former CPA firm, Rogers & Autry, which involved the bribery of foreign government officials to gain favored treatment—a crime under the Foreign Corrupt Practice Act. He had stumbled upon the information while looking for other files online. Bill had already decided to quit his job and was in the process of cleaning up his office and boxing personal items. He thought about it but did not see anything wrong with the downloading. Besides, the bribery case involved selling tainted infant formula in China. Payments were made to government officials to look the other way.
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Bill pondered what his options were. Should he inform management of the company even though he had handed in his official resignation letter? Should he disclose the matter to an investigative reporter who had been sniffing around the company for months following up on a tip he had received about improper foreign payments by the company? Or should he report the matter to the authorities? He also considered remaining silent. Bill carefully weighed these options by reflecting on the harms and benefits of his alternative courses of action.
Questions
You are Bill’s best friend. Assume he asks for your advice about what he should do. What would you say and why? Support your answer with reference to relevant auditing and/or ethics requirements.
Bill is at home now having already spoken to you about the matter. He decides to carefully consider the consequences of his actions. What are the harms and benefits of the alternatives identified by Bill?
Assume Bill decides not to follow your advice but calls you again to let you know about his decision. If you sense an opportunity to provide additional input during the conversation, what would your advice be to Bill at this point and why?
Case 5-9 Royal Ahold N.V. (Ahold)
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).1 Today its common shares are sold on NYSE Euronext.
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.2 Those were the rules at that time. However, today foreign companies listed on U.S. stock exchanges are allowed to submit their financial statements to the U.S. SEC using International Financial Reporting Standards (IFRS).
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 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 10(B-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.3
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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.
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.
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.
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False Confirmations and Statements
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.
Interaction With Deloitte Auditors
Because USF lacked an internal auditing department, Ahold hired Deloitte to perform internal auditing services at USF, a practice permitted for the same external audit firm prior to SOX. Deloitte reported to the internal audit director of the company. In auditing the promotional allowances and internal control processes, a number of documents were requested from USF management, including the vendor contracts. Management refused to produce many of the requested documents. Several members of management refused to meet with the internal auditors, making the completion of internal audit objectives virtually impossible.
Deloitte conducted confirmations of the promotional allowances to verify income. Management had already induced vendors to falsely report promotional allowances to income amounts and receivables to the auditors and had concealed the existence of written contracts with USF vendors. Deloitte accepted confirmation letters via fax and from brokers and sales executives instead of financial officers.
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 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. Deloitte did not detect this in its audit.
Fraudulent Acts by Management
As previously noted, 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.
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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 nor 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 multi-year 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.
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.
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.
Questions
Evaluate the facts and circumstances of the case using the Fraud Triangle. Discuss how auditors perform an audit and assess risk when red flags exist that the financial statements may be materially misstated.
Evaluate the role of Deloitte from the perspective of professional judgment by referring to the discussions in Chapters 4 and 5. Do you think Deloitte compromised its professional responsibilities in accepting evidence and explanations provided by the client for the joint venture and promotional allowance transactions? Explain.
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. Do you think Deloitte compromised its ethical responsibilities in this case? Identify any such deficiencies and why you believe compromises existed.
Case 5-10 Groupon
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.
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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 e-mailed 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. However, after disclosures of fraud and increased competition from the likes of AmazonLocal and LivingSocial, its value had dropped to about $6 billion.
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.
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. 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 might 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.
There had been other oddities with Groupon’s accounting that reflected a culture of indifference toward GAAP and its obligations to the investing public.
It reported a 1,367 percent increase in revenue for the three months ending March 31, 2011 versus the same period in 2010
It admitted to recognizing as revenue commissions received on sales of coupons/gift certificates, but also recognized the total value of the coupons and gift certificates at the date of sale.
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 meant that other transactions could be at risk because poor controls in one area tend to cause problems elsewhere. More important, the internal control problems raised 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.
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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 identified 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. In fact, a reported $81.6 million profit would have been a $98.3 million loss had the marketing costs been included. After the SEC raised questions about the metric—which The Wall Street Journal called “financial voodoo”—Groupon downplayed the formulation in its IPO documents.
Groupon reported the weakness in its internal controls through a Section 302 provision in SOX that requires public companies’ top executives to evaluate each quarter whether their disclosure controls and procedures are effective. The company seems to have concluded that the internal control shortcoming was serious enough to treat as an overall deficiency in disclosure controls rather than pointing it out in its report on internal controls that is required under Section 404. EY expressed no opinion on the company’s internal controls in its audit report, which makes us wonder whether it was willing to stand up to Groupon’s management on the shortcomings in its internal controls and governance. In fact, the firm signed clean audit opinions for four years.
Questions
Prompted by frauds such as at Groupon, which was carried out in part by creating a metric that is not recognized in the accounting literature, although not specifically prohibited either, the PCAOB has issued a release requesting comments on a proposal to include either in the audit report or as a separate document an Auditor’s Discussion and Analysis (AD&A). It would be an analog of the management’s discussion and analysis (MD&A) currently required in certain filings under the federal securities laws. The idea is to give users a more detailed view both of the auditor’s work and impressions and concerns about the entity being audited.
Do you think the AD&A is a good idea? Should it comment on the audit, the company’s financial statements, or both? Should it comment on any other information? Explain.
The role of Ernst & Young in the Groupon fraud is somewhat unclear. The firm did render unmodified opinions for four years. Do you believe it is possible that an audit firm can render an unmodified opinion and have no responsibility for detecting and reporting a financial fraud? Explain in general and specifically with reference to the fraud at Groupon.
According to a 2012 survey of 192 U.S. executives conducted by Deloitte & Touche LLP and Forbes Insights, social media was identified as the fourth-largest risk on par with financial risk.1 This ranking derives from social media’s capacity to accelerate to other risks, such as financial risk associated with disclosures in violation of SEC rules, for example. Other risks inherent to social media include information leaks, reputational damage to brand, noncompliance with regulatory requirements, third-party, and governance risks.Page 337
Why is it important for a firm such as EY, in a case such as Groupon, to fully understand the nature of risk when a company conducts its business online?
What role can internal auditors play in dealing with such risks?
How should external auditors adapt their risk assessment procedures for social media/networking clients?
