Contemporary auditing real issues and cases

Cases from prior editions of Michael C. Knapp’s Contemporary Auditing are available exclusively online
via www.CengageBrain.com. In addition to the option to purchase the current edition in multiple formats,
CengageBrain.com offers the following cases from prior editions for purchase as an eBook or as individual
eChapters. This range of options allows you the flexibility to choose the content that best fits your needs!

Comprehensive Cases
1A Jamaica Water Properties
1B AMRE, Inc.
1C United States Surgical Corporation

audits of high-risk aCCounts
2A
2B
2C
2D
2E
2F
2G

CapitalBanc Corporation
Dollar General Stores, Inc.
General Technologies Group Ltd.
SmarTalk Teleservices, Inc.
Campbell Soup Company
Perry Drug Stores, Inc.
Rocky Mount Undergarment
Company, Inc.

internal Control issues
3A Saks Fifth Avenue

3B Triton Energy Ltd.
3C Troberg Stores

ethiCal responsibilities
of aCCountants
4A
4B
4C
4D

Oak Industries, Inc.
Thomas Forehand, CPA
Laurel Valley Estates
Jack Bass, Accounting Professor

ethiCal responsibilities
of independent auditors
5A
5B
5C
5D

Mallon Resources Corporation
The PTL Club
Zaveral Boosalis Raisch
Koger Properties, Inc.

professional roles
6A David Myers, WorldCom Controller

professional issues
7A
7B
7C
7D
7E

HealthSouth Corporation
PricewaterhouseCoopers Securities, LLC
Stephen Gray, CPA
Scott Fane, CPA
National Medical Transportation Network

international Cases
8A
8B
8C
8D

Royal Ahold, N.V.
Australian Wheat Board
Tata Finance Limited
Baan Company, N.V.

ClassiC litigation Cases
9A National Student Marketing Corporation
9B Equity Funding Corporation of America

Discover why CengageBrain.com is your one-stop solution!
CengageBrain.com offers students a wealth of options in both price and format of their course materials. To access

additional course materials, visit www.cengagebrain.com. At the CengageBrain.com home page, fill in the author
or ISBN of your textbook. This will take you to the product page where you will find various purchasing options
and access to free companion study resources.


This page intentionally left blank


This page intentionally left blank


Contemporary auditing�
Real Issues

and

Ninth Edition

Cases


This is an electronic version of the print textbook. Due to electronic rights restrictions,
some third party content may be suppressed. Editorial review has deemed that any suppressed
content does not materially affect the overall learning experience. The publisher reserves the right
to remove content from this title at any time if subsequent rights restrictions require it. For
valuable information on pricing, previous editions, changes to current editions, and alternate
formats, please visit www.cengage.com/highered to search by ISBN#, author, title, or keyword for
materials in your areas of interest.

Contemporary auditing�
Real Issues

and

Cases

Ninth Edition

Michael C. Knapp
University of Oklahoma

Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States


Contemporary Auditing: Real Issues
and Cases, Ninth Edition
Michael C. Knapp
Vice President of Editorial, Business:
Jack W. Calhoun
Editor-in-Chief: Rob Dewey
Acquisitions Editor: Matt Filimonov
Developmental Editor: Ann Loch
Editorial Assistant: Ann Loch
Marketing Manager: Heather Mooney
Content Project Management:
PreMediaGlobal
Media Editor: Bryan England
Manufacturing Planner: Doug Wilke

© 2013, 2011 South-Western, Cengage Learning
ALL RIGHTS RESERVED. No part of this work covered by the copyright
herein may be reproduced, transmitted, stored, or used in any form
or by any means graphic, electronic, or mechanical, including but not
limited to photocopying, recording, scanning, digitizing, taping, web
distribution, information networks, or information storage and retrieval
systems, except as permitted under Section 107 or 108 of the 1976
United States Copyright Act, without the prior written permission of
the publisher.
For product information and technology assistance, contact us at
Cengage Learning Customer & Sales Support, 1-800-354-9706
For permission to use material from this text or product,
submit all requests online at www.cengage.com/permissions
Further permissions questions can be emailed to


Marketing Communications Manager:
Libby Shipp

Library of Congress Control Number: 2011941655

Production Service: PreMediaGlobal

ISBN-13: 978-1-133-18789-9

Art Director: Kristina Mose-Libon

ISBN-10: 1-133-18789-7

Internal Designer: PreMediaGlobal

Cover Designer: PreMediaGlobal
Cover Image: ©Sailorr/Shutterstock; Bottom
photo (background graph): ­©Photoredaktor/
Dreamstime.com; Small photos: Left small
photo (gold map and pen): ­©ronfromyork/
Shutterstock; 2nd photo from left (man
at computers): ©Steve Cole Images/­
iStockphoto.com; 3rd photo from left (gavel
and paper): ©Chris Reed/ iStockphoto;
4th photo from left: (blue money and men
in circle): ©Photos.com/Getty Images/
Thinkstock
Rights Acquisitions Specialist: Sam Marshall

South-Western
5191 Natorp Boulevard
Mason, OH 45040
USA
Cengage Learning is a leading provider of customized learning solutions
with office locations around the globe, including Singapore, the United
Kingdom, Australia, Mexico, Brazil, and Japan. Locate your local office at:
international.cengage.com/region
Cengage Learning products are represented in Canada by
Nelson Education, Ltd.
For your course and learning solutions, visit www.cengage.com.
­ urchase any of our products at your local college store or at our
P
­preferred online store www.cengagebrain.com.

Printed in the United States of America

1 2 3 4 5 6 7 15 14 13 12 11


DEDICATION�

To Paula, Suzie, and Becky�


This page intentionally left blank


BRIEF CONTENTS�
Preface
SECTION

xxi
1

Comprehensive Cases
Enron Corporation
Lehman Brothers Holdings, Inc.
Just for FEET, Inc.
Health Management, Inc.
The Leslie Fay Companies
NextCard, Inc.
Lincoln Savings and Loan Association
Crazy Eddie, Inc.
ZZZZ Best Company, Inc.
Gemstar-TV Guide International, Inc.
New Century Financial Corporation

Madoff Securities

2

Audits of High-Risk Accounts
Jack Greenberg, Inc.
Golden Bear Golf, Inc.
Happiness Express, Inc.
General Motors Company
Lipper Holdings, LLC
CBI Holding Company, Inc.
Geo Securities, Inc.
Belot Enterprises
Regina Company, Inc.

171�
173�
181�
189�
197�
203�
211�
217�
221�
227�

3

Internal Control Issues
The Trolley Dodgers

Howard Street Jewelers, Inc.
United Way of America
First Keystone Bank
Goodner Brothers, Inc.
Buranello’s Ristorante
Foamex International Inc.

235�
237�
239�
241�
247�
251�
259�
265�

4

Ethical Responsibilities of Accountants
Creve Couer Pizza, Inc.
F&C International, Inc.
Suzette Washington, Accounting Major
Freescale Semiconductor, Inc.
Wiley Jackson, Accounting Major
Arvel Smart, Accounting Major
David Quinn, Tax Accountant

269�
271�
275�

279�
281�
285�
287�
289�

1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
1.10
1.11
1.12
SECTION

2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
SECTION

3.1
3.2
3.3
3.4
3.5
3.6
3.7
SECTION

4.1
4.2
4.3
4.4
4.5
4.6
4.7

1�
3�
23�
39�
53�
71�
83�
93�
107�
117�
131�
143�

161�

ix


x

Brief Contents
SECTION 5

Ethical Responsibilities of Independent Auditors
Cardillo Travel Systems, Inc.
American International Group, Inc.
The North Face, Inc.
Waverly Holland, Audit Senior
Phillips Petroleum Company
American Fuel & Supply Company, Inc.

293�
295�
301�
305�
313�
319�
323�

6

Professional Roles
Leigh Ann Walker, Staff Accountant

Bill DeBurger, In-Charge Accountant
Hamilton Wong, In-Charge Accountant
Tommy O’Connell, Audit Senior
Avis Love, Staff Accountant
Charles Tollison, Audit Manager

327�
329�
331�
335�
339�
343�
347�

7

Professional Issues
Ligand Pharmaceuticals
Sarah Russell, Staff Accountant
Bud Carriker, Audit Senior
Hopkins v. Price Waterhouse
Fred Stern & Company, Inc.�
(Ultramares Corporation v. Touche et al.)
First Securities Company of Chicago�
(Ernst & Ernst v. Hochfelder et al.)

351�
353�
359�
363�

369�

International Cases
Livent, Inc.
Parmalat Finanziaria, S.p.A.
Kansayaku
Registered Auditors, South Africa
Zuan Yan
Kaset Thai Sugar Company
Republic of Somalia
OAO Gazprom
Societe Generale
Institute of Chartered Accountants of India
Republic of the Sudan
Shari’a
Mohamed Salem El-Hadad, Internal Auditor
Tae Kwang Vina

391�
393�
407�
421�
431�
443�
455�
459�
463�
477�
493�
505�

511�
521�
527�

5.1
5.2
5.3
5.4
5.5
5.6
SECTION

6.1
6.2
6.3
6.4
6.5
6.6
SECTION

7.1
7.2
7.3
7.4
7.5
7.6

SECTION

8.1

8.2
8.3
8.4
8.5
8.6
8.7
8.8
8.9
8.10
8.11
8.12
8.13
8.14

8

Index
Summary of Topics by Case
Summary of Cases by Topic

377�
385�

533�
543�
555�


CONTENTS�
Preface

SECTION

xxi
1

Case 1.1

Comprehensive Cases

1

Enron Corporation

3

Arthur Edward Andersen established a simple motto that he required his subordinates
and clients to invoke: “Think straight, talk straight.” For decades, that motto served Arthur
Andersen & Co. well. Unfortunately, the firm’s association with one client, Enron Corporation,
abruptly ended Andersen’s long and proud history in the public accounting profession.
Key topics: history of the public accounting profession in the United States, scope of
professional services provided to audit clients, auditor independence, and retention
of audit workpapers.

Case 1.2

Lehman Brothers Holdings Inc.

23

Wall Street was stunned in September 2008 when this iconic investment banking firm

filed for bankruptcy. Lehman’s bankruptcy examiner charged that the company had en�
gaged in tens of billions of dollars of “accounting-motivated” transactions to enhance
its apparent financial condition.
Key topics: “accounting-motivated” transactions, materiality decisions by auditors,
responsibility of auditors to investigate whistleblower allegations, auditors’ legal
exposure, communications with audit committee.

Case 1.3

Just for FEET, Inc.

39

In the fall of 1999, just a few months after reporting a record profit for fiscal 1998, Just
for FEET collapsed and filed for bankruptcy. Subsequent investigations by law enforce�
ment authorities revealed a massive accounting fraud that had grossly misrepresented
the company’s reported operating results. Key features of the fraud were improper
accounting for “vendor allowances” and intentional understatements of the company’s
inventory valuation allowance.
applying analytical procedures, identifying inherent risk and control risk
factors, need for auditors to monitor key developments within the client’s industry,
assessing the health of a client’s industry, and receivables confirmation procedures.

Key topics:

Case 1.4

Health Management, Inc.

54

The Private Securities Litigation Reform Act (PSLRA) of 1995 amended the Securities
Exchange Act of 1934. This new federal statute was projected to have a major impact
on auditors’ legal liability under the 1934 Act. The first major test of the PSLRA was
triggered by a class-action lawsuit filed against BDO Seidman for its 1995 audit of
Health Management, Inc., a New York–based pharmaceuticals distributor.
inventory audit procedures, auditor independence, content of audit workpapers, inherent risk factors, and auditors’ civil liability under the federal securities laws.

Key topics:

Case 1.5

The Leslie Fay Companies

71

Paul Polishan, the former chief financial officer of The Leslie Fay Companies, received
a nine-year prison sentence for fraudulently misrepresenting Leslie Fay’s financial
xi


xii

Contents

statements in the early 1990s. Among the defendants in a large class-action lawsuit
stemming from the fraud was the company’s audit firm, BDO Seidman.
applying analytical procedures, need for auditors to assess the health
of a client’s industry, identifying fraud risk factors, control environment issues, and
auditor independence.

Key topics:

Case 1.6

NextCard, Inc.

83

In January 2005, Thomas Trauger became the first partner of a major accounting firm to
be sent to prison for violating the criminal provisions of the Sarbanes-Oxley Act of 2002.
identifying fraud risk factors, nature and purpose of audit workpapers,
understanding a client’s business model, criminal liability of auditors under the
Sarbanes-Oxley Act, and collegial responsibilities of auditors.

Key topics:

Case 1.7

Lincoln Savings and Loan Association

93

Charles Keating’s use of creative accounting methods allowed him to manufacture
huge paper profits for Lincoln.
Key topics: substance-over-form concept, detection of fraud, identification of key
management assertions, collegial responsibilities of auditors, assessment of control
risk, and auditor independence.

Case 1.8

Crazy Eddie, Inc.

107

“Crazy Eddie” Antar oversaw a profitable chain of consumer electronics stores on the
East Coast during the 1970s and 1980s. After new owners discovered that the com�
pany’s financial data had been grossly misrepresented, Antar fled the country, leaving
behind thousands of angry stockholders and creditors.
Key topics: auditing inventory, inventory control activities, management integrity, the
use of analytical procedures, and the hiring of former auditors by audit clients.

Case 1.9

ZZZZ Best Company, Inc.

117

Barry Minkow, the “boy wonder” of Wall Street, created a $200,000,000 company that
existed only on paper.
Key topics: identification of key management assertions, limitations of audit evi�
dence, importance of candid predecessor successor auditor communications, client
confidentiality, and client imposed audit scope limitations.

Case 1.10

Gemstar-TV Guide International, Inc.

131

In 2000, U.S. News and World Report predicted that Henry Yuen, the chief executive
of Gemstar-TV Guide International, would become the “Bill Gates of television” thanks
to the innovative business model that he had developed for his company. When that
business model proved to be a “bust,” Yuen used several accounting gimmicks to em�
bellish his company’s reported operating results.
Key topics: conditions commonly associated with “audit failures,” revenue recognition
principle, quantitative and qualitative materiality assessments, and “legal” vs.“ethical”
conduct.


Contents
Case 1.11

New Century Financial Corporation

143

The collapse of New Century Financial Corporation in April 2007 signaled the
beginning of the subprime mortgage crisis in the United States, a crisis that would
destabilize securities and credit markets around the globe. A federal bankruptcy exam�
iner has maintained that New Century’s independent audits were inadequate.
Key topics: auditing loan loss reserves, Section 404 audit procedures, material inter�
nal control weaknesses, auditor independence, and audit staffing issues.

Case 1.12

Madoff Securities

161

As an adolescent, Bernie Madoff dreamed of becoming a “key player” on Wall Street.
Madoff realized his dream by overseeing the world’s largest and possibly longest run�
ning Ponzi scheme. Madoff’s auditor pled guilty to various criminal charges for his role
in that fraud.
factors common to financial frauds, regulatory role of Securities and
Exchange Commission (SEC), nature and purpose of peer reviews, audit procedures
for investments, and the importance of the independent audit function.

Key topics:

SECTION

2

Case 2.1

Audits of High-Risk Accounts
Jack Greenberg, Inc.

171
173

A federal judge criticized Greenberg’s independent auditors for failing to realize the
impact that pervasive internal control problems had on the reliability of the company’s
inventory accounting records.
Case 2.2

Golden Bear Golf, Inc.

181

Jack Nicklaus, the “Golden Bear,” endured public embarrassment and large financial
losses when key subordinates misapplied the percentage-of-completion accounting
method to numerous golf course development projects.
Case 2.3

Happiness Express, Inc.

189

To compensate for flagging sales of their Mighty Morphin Power Rangers toys, this
company’s executives booked millions of dollars of bogus sales. Deficiencies in the
audit procedures applied by Happiness Express’s auditors resulted in the bogus sales
and receivables going undetected.
Case 2.4

General Motors Company

197

In early 2009, the SEC released the results of a lengthy investigation of GM’s accounting
and financial reporting decisions over the previous decade. A major focus of that investiga�
tion was GM’s questionable accounting for its massive pension liabilities and expenses.
Case 2.5

Lipper Holdings, LLC

203

Lipper’s auditors were criticized for failing to uncover a fraudulent scheme used by

a portfolio manager to materially inflate the market values of investments owned by
three of the company’s largest hedge funds.

xiii


xiv

Contents
Case 2.6

CBI Holding Company, Inc.

211

This case focuses on audit procedures applied to accounts payable, including the
search for unrecorded liabilities and the reconciliation of year-end vendor statements to
recorded payables balances.
Case 2.7

Geo Securities, Inc.

217

The SEC sanctioned GEO Securities’ audit engagement partner for failing to apply
proper audit procedures to a material loss contingency faced by the company.
Case 2.8

Belot Enterprises

221

Understating discretionary expense accruals is a common method used by selfinterested corporate executives to enhance their company’s financial statements. In this
case, Belot “juggled” the period-ending balances of five major expense accruals to
achieve an earnings goal established by the company’s new chief operating officer.
Case 2.9

Regina Company

227

To reach forecasted sales and earnings targets, Regina executives used several
accounting gimmicks that violated the revenue recognition principle.
SECTION

3

Case 3.1

Internal Control Issues
The Trolley Dodgers

235
237

Control deficiencies in the Dodgers’ payroll transaction cycle allowed an accounting
manager to embezzle several hundred thousand dollars.
Case 3.2

Howard Street Jewelers, Inc.

239

Given the susceptibility of cash to theft, retail companies typically establish rigorous
internal controls for their cash processing functions. This case documents the high
price of failing to implement such controls.
Case 3.3

United Way of America

241

Weak or nonexistent internal controls have resulted in this prominent charitable orga�
nization, as well as numerous other charities nationwide, being victimized by opportu�
nistic employees.
Case 3.4

First Keystone Bank

247

Three tellers of a First Keystone Bank branch embezzled more than $100,000 from the
branch’s ATM. The district attorney who prosecuted the tellers commented on the need
for businesses to not only establish internal controls to protect their assets but also on
the importance of ensuring that those controls are operational.
Case 3.5

Goodner Brothers, Inc.

251

An employee of this tire wholesaler found himself in serious financial trouble. To
remedy this problem, the employee took advantage of his employer’s weak internal


Contents

controls by stealing a large amount of inventor y, which he then sold to other
parties.
Case 3.6

Buranello’s Ristorante

259

The general manager of Buranello’s set up a “sting” operation–with the owner’s
approval–to test the honesty of the employee who he believed was stealing from the
business. But the plan backfired, and Buranello’s eventually found itself on the wrong
end of a “malicious prosecution” lawsuit.
Case 3.7

Foamex International Inc.

265

Foamex’s auditors repeatedly reported internal control problems to the company’s
management and audit committee. Because the company’s management refused to
adopt effective and timely measures to remediate those problems, Foamex became
the first public company sanctioned by the SEC solely for having inadequate internal
controls.

SECTION

4

Case 4.1

Ethical Responsibilities of Accountants
Creve Couer Pizza, Inc.

269
271

Intrigue and espionage seem far removed from accounting . . . but not in this case.
Creve Couer’s CPA was actually a double agent. While providing accounting ser�
vices to his client, the CPA also supplied incriminating evidence regarding the client
to the IRS.
Case 4.2

F&C International, Inc.

275

A financial fraud spelled the end of a company with a proud history and tested the
ethics of several of its key management and accounting personnel.
Case 4.3

Suzette Washington, Accounting Major

279

Suzette Washington was a college senior majoring in accounting when she came
face-to-face with an important ethical decision. Since accounting majors are entering
a profession with a rigorous code of ethics, do they have a greater responsibility than
other students to behave ethically?
Case 4.4

Freescale Semiconductor, Inc.

281

Partners and employees of accounting firms often have access to confidential client
information that they could use to gain an unfair advantage over other investors. In
recent years, law enforcement authorities have filed insider trading charges against
several public accountants, including a partner assigned to a professional services
engagement for Freescale.
Case 4.5

Wiley Jackson, Accounting Major

285

“To tell or not to tell” was the gist of an ethical dilemma faced by Wiley Jackson
while completing a pre-employment document for his future employer, a major
accounting firm.

xv


xvi

Contents
Case 4.6

Arvel Smart, Accounting Major

287

Should an accounting major accept an internship position with one firm when he has
already decided to accept a job offer for a permanent position with another firm upon
graduation?
Case 4.7

David Quinn, Tax Accountant

289

The responsibility to maintain the confidentiality of client information obtained during
a professional services engagement is at the center of a nasty disagreement that arises
between two friends employed by a major accounting firm.

SECTION

5

Case 5.1

Ethical Responsibilities of Independent Auditors

293

Cardillo Travel Systems, Inc.

295

A top executive of Cardillo pressured and manipulated three accountants, the compa�
ny’s controller and two partners of public accounting firms, in an unsuccessful attempt
to conceal the true nature of a fraudulent entry in the company’s accounting records.
Case 5.2

American International Group, Inc.

301

AIG is best known as the company that received more federal “bailout” funds than any
other during the economic crisis that engulfed the U.S. economy beginning in the fall of
2008. Several years earlier, AIG had been widely criticized for marketing customized
special purpose entities (SPEs). Surprisingly, Ernst & Young helped AIG develop and
market this controversial service.
Case 5.3

The North Face, Inc.

305

North Face’s independent auditors altered prior-year workpapers to conceal question�
able decisions made by an audit partner, decisions that involved several large barter
transactions that inflated the company’s reported operating results.
Case 5.4

Waverly Holland, Audit Senior

313

A few months after leaving public accounting, “Dutch” Holland is pressured to
become involved in a class-action lawsuit involving a former audit client of his. If
he cooperates with the plaintiff attorneys, he will alienate his former colleagues. If he
doesn’t cooperate, he may be named as a defendant in that lawsuit. What will Dutch
choose to do?
Case 5.5

Phillips Petroleum Company

319

Rather than compromise the confidentiality of his client’s accounting records, the part�
ner in charge of the annual Phillips audit was found in contempt of court and jailed.
Case 5.6

American Fuel & Supply Company, Inc.

323

This case focuses on the responsibility of auditors to recall an audit report when they
discover previously undetected errors in a client’s audited financial statements.


Contents

SECTION

6

Case 6.1

Professional Roles

327

Leigh Ann Walker, Staff Accountant

329

A staff accountant employed by a large accounting firm is dismissed after serious questions arise regarding her integrity.
Case 6.2

Bill DeBurger, In-Charge Accountant

331

To “sign off” or “not sign off” was the issue Bill DeBurger wrestled with after he
completed the audit procedures for a client’s most important account. An angry
confrontation with the audit engagement partner made Bill’s decision even more
difficult.
Case 6.3

Hamilton Wong, In-Charge Accountant

335

“Eating time,” or underreporting time worked on audit engagements, has serious
­implications for the quality of audit services and for the quality of auditors’ work
­environment. Hamilton Wong came face-to-face with these issues when a colleague
insisted on understating the hours she worked on her assignments.
Case 6.4

Tommy O’Connell, Audit Senior

339

A new audit senior is quickly exposed to the challenging responsibilities of his professional work role when he is assigned to supervise a difficult audit engagement. During
the audit, the senior must deal with the possibility that a staff accountant is not completing his assigned audit procedures.
Case 6.5

Avis Love, Staff Accountant

343

Auditors sometimes develop close friendships with client personnel. Such friendships
can prove problematic for auditors, as demonstrated in this case.
Case 6.6

Charles Tollison, Audit Manager

347

Audit managers occupy an important role on audit engagements and are a critical link
in the employment hierarchy of public accounting firms.

SECTION

7

Case 7.1

Professional Issues

351

Ligand Pharmaceuticals

353

Ligand’s auditor was the first Big Four firm sanctioned by the Public Company
­Accounting Oversight Board (PCAOB).
Case 7.2

Sarah Russell, Staff Accountant

359

Sexual harassment is a sensitive subject that many companies and professional firms
have been forced to contend with in recent years. This case recounts the experiences of
a staff accountant who was harassed by an audit partner.

xvii

xviii

Contents
Case 7.3

Bud Carriker, Audit Senior

363

An executive of an audit client informs the audit partner that he is not “comfortable”
working with the senior assigned to the engagement. Why? Because the senior is a
member of a minority group. Will the partner assign another senior to the engagement?
Case 7.4

Hopkins v. Price Waterhouse

369

This case explores the unique problems faced by women pursuing a career in public
accounting.
Case 7.5

 red Stern & Company, Inc.
F
(Ultramares Corporation v. Touche et al.)

377

This 1931 legal case established the Ultramares Doctrine that decades later has a pervasive influence on auditors’ civil liability under the common law.
Case 7.6

 irst Securities Company of Chicago
F
(Ernst & Ernst v. Hochfelder et al.)

385

In this case, the Supreme Court defined the degree of auditor misconduct that must be
present before a client can recover damages from an auditor in a lawsuit filed under
the Securities Exchange Act of 1934.

SECTION

8

Case 8.1

International Cases

391

Livent, Inc.

393

Garth Drabinsky built Livent, Inc., into a major force on Broadway during the 1990s.
A string of successful Broadway productions resulted in numerous Tony Awards for
the Canadian company. Despite Livent’s theatrical success, its financial affairs were in
disarray. Drabinsky and several of his top subordinates used abusive accounting practices to conceal Livent’s financial problems from their independent auditors.
Case 8.2

Parmalat Finanziaria, S.p.A.

407

Parmalat’s executives used a simple accounting ruse, a “double-billing scheme,” to
produce billions of dollars of bogus receivables, sales, and profits for the company.
The fraud unraveled in a matter of weeks after the company admitted that it would
have difficulty paying off a small bond issue that was coming due. Lawsuits filed in
this case raised a troubling legal issue that could potentially threaten the financial viability of major accounting firms.
Case 8.3

Kansayaku

421

Like the United States, Japan has recently made significant changes in the regulatory
infrastructure for its financial reporting system. Many of these changes have directly
impacted Japan’s accounting profession and independent audit function. An accounting and auditing scandal involving a large cosmetics and apparel company, Kanebo
Limited, posed the first major challenge of that new regulatory framework.


Contents



Case 8.4

Registered Auditors, South Africa

431

The South African economy was rocked in recent years by a series of financial reporting scandals. To restore the credibility of the nation’s capital markets, the South African
Parliament passed a controversial new law, the Auditing Profession Act (APA). The
APA established a new auditing regulatory agency and a new professional credential
for independent auditors. The APA also mandated that independent auditors immediately disclose to the new auditing agency any “reportable irregularities” committed by
an audit client.
Case 8.5

Zuan Yan

443

The Big Four accounting firms view China as one of the most lucrative markets for
accounting and auditing services worldwide. However, those firms face major challenges in that market. Among these challenges are an increasing litigation risk and the
difficulty of coping with the often heavy-handed tactics of China’s authoritarian central
government.
Case 8.6

Kaset Thai Sugar Company

455

This case focuses on the 1999 murder of Michael Wansley, a partner with Deloitte
­Touche Tohmatsu. Wansley was supervising a debt-restructuring engagement in
a ­remote region of Thailand when he was gunned down by a professional assassin.
Case 8.7

Republic of Somalia

459

PricewaterhouseCoopers (PwC) accepted a lucrative, unusual, and very controversial
engagement for the transitional government established for Somalia by the United Nations. The case questions require students to consider the significant risks and thorny
ethical issues that engagement poses for PwC.
Case 8.8

OAO Gazprom

463

Business Week referred to the huge Gazprom debacle as “Russia’s Enron.” For the
first time in the history of the new Russian republic, a Big Four accounting firm was
sued for allegedly issuing improper audit opinions on a Russian company’s financial
statements.
Case 8.9

Societe Generale

477

This case addresses the surprising decision made by Societe Generale, France’s ­second
largest bank, to backdate a 6.4 billion euro loss that resulted from unauthorized securities trades made by one of its employees. Although that huge loss occurred in 2008,
the bank included the loss in its audited financial statements for 2007. To justify that
decision, the bank’s management invoked a controversial provision of International
Financial Reporting Standards (IFRS).
Case 8.10

Institute of Chartered Accountants of India

493

The Institute of Chartered Accountants of India (ICAI) is the federal agency that
oversees India’s accounting profession. In 2002, the ICAI commissioned a study of
the alleged takeover of that profession by the major international accounting firms.

xix


x x

Contents

The ­resulting 900-page report charged that those firms had used a variety of illicit and
even illegal methods to “colonize” India’s market for accounting, auditing, and related
services to the detriment of the nation’s domestic accounting firms.
Case 8.11

Republic of the Sudan

505

In 2004, the SEC began requiring domestic and foreign registrants to disclose any business operations within, or other relationships with, Sudan and other countries identified as state sponsors of terrorism. Three years later, the SEC included a Web page on
its EDGAR website that listed all such companies. This SEC “blacklist” proved to be
extremely controversial and triggered a contentious debate over the federal agency’s
regulatory mandate and its definition of “materiality.”
Case 8.12

Shari’a

511

Islamic companies are prohibited from engaging in transactions that violate Shari’a,
that is, Islamic religious law. To ensure that they have complied with Shari’a, Islamic
companies have their operations subjected to a Shari’a compliance audit each year.
Recently, Big Four firms have begun offering Shari’a audit services.
Case 8.13

Mohamed Salem El-Hadad, Internal Auditor

521

Accountants sometimes find themselves in situations in which they must report
­unethical or even illegal conduct by other members of their organization. This case
examines the trials and tribulations of an internal auditor who “blew the whistle” on
his immediate superior for embezzling large sums of cash from their employer, the
Washington, D.C., embassy of the United Arab Emirates.
Case 8.14

Tae Kwang Vina

527

“Environmental and labor practices” audits are one of many nontraditional services that
major accounting firms have begun offering in recent years to generate new ­revenue
streams. Ernst & Young provided such an audit for Nike, which had been accused of
operating foreign “sweatshops” to produce its footwear products. This case documents
the unexpected challenges and problems that accounting firms may face when they
provide services outside their traditional areas of professional expertise.

Index
Summary of Topics by Case
Summary of Cases by Topic

533
543
555


PREFACE
The past decade has arguably been the most turbulent and traumatic in the history
of the accounting profession and the independent audit function. Shortly after the
turn of the century, the Enron and WorldCom fiascoes focused the attention of the
investing public, the press, Wall Street, and, eventually, Congress on our profession.
Those scandals resulted in the passage of the Sarbanes-Oxley Act of 2002 (SOX) and
the creation of the Public Company Accounting Oversight Board (PCAOB).
Next came the campaign to replace U.S. generally accepted accounting principles
(GAAP) with International Financial Reporting Standards (IFRS). That campaign
stalled when the subprime mortgage crisis in the United States caused global stock
markets to implode and global credit markets to “freeze” during the fall of 2008. Many
parties insisted that inadequate audits were a major factor that led to the onset of the
most severe global economic downturn since the Great Depression. That economic
downturn claimed many companies that had been stalwarts of the U.S. economy,
most notably Lehman Brothers. The huge investment banking firm filed for bankruptcy in September 2008 just a few months after having had its annual financial
statements “blessed” by its audit firm.
As Congress and regulatory authorities struggled to revive the U.S. economy, news of
the largest Ponzi scheme in world history grabbed the headlines in early 2009. Investors worldwide were shocked to learn that Bernie Madoff, an alleged “wizard of Wall
Street,” was a fraud. Law enforcement authorities determined that billions of dollars
of client investments supposedly being held by Madoff’s company, Madoff Securities,
did not exist. The business press was quick to report that for decades Madoff Securities’ financial statements had been audited by a New York accounting firm and had

received unqualified audit opinions each year from that firm. The auditing discipline
absorbed another body blow in 2010 when a court-appointed bankruptcy examiner
publicly singled out Lehman Brothers’ audit firm as one of the parties most responsible for the Lehman Brothers debacle.
As academics, we have a responsibility to help shepherd our profession through these
turbulent times. Auditing instructors, in particular, have an obligation to help restore
the credibility of the independent audit function that has been adversely ­impacted by
the events of the past decade. To accomplish this latter goal, one strategy we can use
is to embrace the litany of reforms recommended several years ago by the ­Accounting
Education Change Commission (AECC). Among the AECC’s recommendations was
that accounting educators employ a broader array of instructional resources, particularly experiential resources, designed to stimulate active learning by students. In fact,
the intent of my casebook is to provide auditing instructors with a source of such
­materials that can be used in both undergraduate and graduate auditing courses.
This casebook stresses the “people” aspect of independent audits. If you review a
sample of recent “audit failures,” you will find that problem audits seldom result from
xxi


x xii

Preface

inadequate audit technology. Instead, deficient audits typically result from the presence of one, or both, of the following two conditions: client personnel who intentionally subvert an audit and auditors who fail to carry out the responsibilities assigned
to them. Exposing students to problem audits will help them recognize the red flags
that often accompany audit failures. An ability to recognize these red flags and the
insight gained by discussing and dissecting problem audits will allow students to
cope more effectively with the problematic situations they are certain to encounter
in their own careers. In addition, this experiential approach provides students with
context-specific situations that make it much easier for them to grasp the relevance
of important auditing topics, concepts, and procedures.
The cases in this text also acquaint students with the work environment of auditors.

After studying these cases, students will better appreciate how client pressure, peer
pressure, time budgets, and related factors complicate the work roles of independent
auditors. Also embedded in these cases are the ambiguity and lack of structure that
auditors face each day. Missing documents, conflicting audit evidence, auditors’ dual
obligations to the client and to financial statement users, and the lack of definitive
professional standards for many situations are additional aspects of the audit environment woven into these cases.
The ninth edition of my casebook contains the following eight sections of cases:
Comprehensive Cases, Audits of High-Risk Accounts, Internal Control Issues, ­Ethical
Responsibilities of Accountants, Ethical Responsibilities of Independent ­Auditors,
Professional Roles, Professional Issues, and International Cases. This organizational
structure is intended to help adopters readily identify cases best suited for their particular needs.
In preparing this edition, I retained those cases that have been among the most
widely used by adopters. These cases include, among many others, Crazy Eddie,
Enron Corporation, Golden Bear Golf, Leigh Ann Walker, Lincoln Savings and Loan
Association, Livent, The Trolley Dodgers, and ZZZZ Best Company. You will find that
many of the “returning” cases have been updated for relevant circumstances and
events that have occurred since the publication of the previous edition.
New To This Edition  This edition features 13 new cases. Two of these cases are
included in the international section. Easily the most dramatic trend in the business
world over the past few decades has been the “globalization” of markets, including
the market for professional accounting services. Business schools have responded to
this dramatic trend by establishing new international majors, study-abroad programs,
and a slew of international courses across all business disciplines. Accounting may
very well be the business discipline that has been the slowest to “internationalize”
its curriculum. The 14 international cases in this edition provide auditing ­instructors
with an efficient and cost-effective way to introduce their students to a wide range of
important issues within the global accounting profession that will have far-reaching
implications for their careers.

Preface

The new Parmalat Finanziaria case provides an opportunity for students to compare
and contrast the independent audit functions of Italy and the United States. This case
demonstrates the significant impact that cultural norms and influences can have on
the nature and effectiveness of a nation’s independent audit function. Another important focus of the Parmalat case is a legal issue that has become very troublesome for
the major international accounting firms in recent years. This issue is whether those
firms’ global organizations should face joint and several liability for the malfeasance
of any one national practice unit.
The other international case new to this edition is The Republic of Somalia, which
transports students to one of the most troubled “hotspots” in the world. For more than
20 years, anarchy has reigned in Somalia, a country that sits astride one of the
world’s most important oceanic trade routes. In 2009, the world’s largest accounting
firm, PricewaterhouseCoopers (PwC), accepted a controversial professional services
­engagement in Somalia. Under the terms of that engagement, PwC serves as an overseer of the financial affairs for the provisional government that the United Nations
established for the war-torn country. The Somalia case requires students to consider
the significant risks and thorny ethical issues that engagement poses for PwC.
Eight of the new cases in this edition are included in two sections of my casebook that
historically have been among the most popular: Audits of High-Risk Accounts and Internal Control Issues. New cases in the Audits of High-Risk Accounts section include
­General Motors Company, Lipper Holdings, Geo Securities, Belot Enterprises, and
­Regina Company. The General Motors case examines the controversy surrounding GM’s
pension-related accounting decisions and the role of the company’s longtime audit firm,
Deloitte, in those decisions. Hedge funds have been among the most controversial and
mysterious investment vehicles on Wall Street over the past ­decade and have presented
major challenges for the firms that audit them. In the ­Lipper Holdings case, the organization’s audit firm was criticized for failing to uncover a fraudulent scheme that materially
inflated the market values of investments held by three Lipper hedge funds.
In the present business environment, many, if not most, companies routinely deal with
the worrisome problems posed by material loss contingencies. Loss contingencies also

pose major challenges for independent auditors. Geo Securities’ audit engagement partner faced SEC sanctions for the decisions he made regarding a pending loss contingency
for that company. Client executives who face pressure to meet unrealistic earnings goals
are often tempted to understate period-ending expense accruals. A senior auditor assigned to the audit engagement team for Belot Enterprises faced the unpleasant task of
challenging the client’s decision to implement a new approach for estimating its periodending discretionary expense accruals. That decision by client management coincided
with the end of a promotional campaign intended to boost Belot’s sagging operating
­results. The final new “High-Risk” case, Regina Company, is actually a ­refurbished
version of a case that appeared in earlier editions of my casebook. This case, which
­focuses on a high-profile financial fraud involving revenue recognition issues, was not
previously available in the custom publishing database for my casebook.

x xiii