Soution manual for auditing cases 9th international edition by knapp

Soution Manual for Auditing Cases 9th International Edition by Kna
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CASE 1.1

AMRE, INC.

Synopsis
During the mid-1980s, AMRE, Inc., was a rapidly growing company in the competitive home
siding industry. In 1987, the company went public and immediately began to fall short of optimistic
revenue and profit projections made by its executives. To prevent the company’s stock price from
declining, AMRE’s executives began misrepresenting the company’s operating results and financial
condition in its periodic financial statements. Among the principal means used by the executives to
distort AMRE’s financial status was overstating deferred advertising costs and inflating inventory.
AMRE’s executives convinced the firm’s independent auditors to bypass EDP tests that might have
uncovered the overstatement of deferred advertising costs and also persuaded the auditors to limit
their inventory observation procedures.
In March 1989, AMRE hired Mac Martirossian, a former manager with their audit firm, to serve
as the company’s chief accounting officer. Shortly after hiring Martirossian, AMRE’s executives
revealed their fraudulent scheme to him. Martirossian insisted that AMRE’s accounting records be
immediately corrected. The executives involved in the fraud acquiesced to his demands but refused
to publicly disclose their fraudulent scheme by issuing corrected financial statements for the affected
years. Instead, the errors were largely eliminated through the preparation of year-end adjusting
entries. When AMRE’s auditors questioned these adjustments, Martirossian’s superiors provided
false explanations for the adjustments in the presence of Martirossian, who remained silent.
Martirossian was uncomfortable with misleading the auditors and eventually arranged a secret
meeting with them. During this meeting, Martirossian subtly hinted that AMRE’s accounting
records had been manipulated. However, the auditors failed to grasp what Martirossian was
attempting to communicate to them and thus failed to learn the true nature of the large period-ending
adjustments.
In 1990, the SEC began an investigation of AMRE’s financial statements for the previous few
years. Ultimately, each of the executives who participated in the fraud was sanctioned by the SEC.

The SEC was especially critical of Martirossian for his “silent” role in the fraud. The SEC also
sanctioned the audit partner and audit manager who had been assigned to the AMRE engagements
for failing to comply with generally accepted auditing standards.

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2 Case 1.1 AMRE, Inc.

AMRE, Inc.--Key Facts
1.

AMRE, Inc., was a rapidly growing company in a very competitive industry.

2.

AMRE routinely capitalized advertising expenditures related to "unset leads."

3. After going public in 1987, AMRE's financial results fell short of earlier projections, which
prompted company executives to begin inflating AMRE's earnings.
4. AMRE executives persuaded their auditors, Price Waterhouse, to eliminate selected audit tests
and to reduce the scope of other tests.
5. In the spring of 1989, AMRE’s top executives revealed their fraudulent scheme to the
company’s new chief accounting officer, Mac Martirossian, a former Price Waterhouse manager.
6. Near the end of fiscal 1989, AMRE’s executives decided to correct the company’s accounting
records, principally with several large adjustments during the fourth quarter of that year.

7. During Price Waterhouse’s 1989 AMRE audit, Martirossian met secretly with the auditors and
suggested to them that the large fourth-quarter adjustments did not pass the "smell test."
8. The Price Waterhouse auditors failed to grasp what Martirossian was suggesting and thus
did not discover the true nature of the fourth-quarter adjustments.
9. Martirossian and other AMRE executives signed a letter of representations indicating that they
were not aware of any irregularities in the company’s 1989 financial statements.
10. The SEC ruled that the audit engagement partner and the senior audit manager who oversaw the
annual AMRE audits had failed to comply with GAAS during the 1988 and 1989 engagements.

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Case 1.1 AMRE, Inc. 3
Instructional Objectives
1. To stress the importance of auditors maintaining a high degree of skepticism when dealing with
client executives who have strong incentives to manipulate their company's financial statements.
2.

To emphasize the hazards of allowing a client to influence key audit planning decisions.

3.

To illustrate the potential for abuse of the percentage-of-completion accounting method.

4.

To illustrate the critical importance of auditors remaining strictly independent of their clients.

5. To demonstrate the need for auditors to test a client's EDP controls and to consider the resulting
implications for year-end substantive audit procedures.
6. To demonstrate the SEC’s willingness to impose sanctions on private accountants for failing to
satisfy their ethical and professional responsibilities.
7. To examine the auditor’s responsibility for quarterly financial data included in a client’s audited
financial statements.

Suggestions for Use
This case could be assigned during coverage of the AICPA’s Code of Professional Conduct.
One of the most important aspects of this case, in my view, is Martirossian’s role in the cover up of
the fraud. This case clearly demonstrates that even an individual with integrity may not respond
appropriately to an ethical dilemma. I believe that it is important for instructors to point out to
students that they may face these types of situations during their careers and, consequently, should
have a strategy for coping with such scenarios.
Since a major focus of this case is management fraud, the case could be assigned during
classroom discussion of auditors’ responsibilities for uncovering fraudulent misrepresentations. In
addition, this is another case that could be used during the first week of an auditing course to
acquaint students with the nature of the independent audit function and the problematic
circumstances that auditors often encounter. This case is also well suited for discussion during
classroom coverage of audit evidence. Key features of this case include Price Waterhouse’s failure
to obtain sufficient competent evidence to corroborate AMRE’s deferred advertising costs and the
weak evidence collected to support the large write-offs recorded by AMRE during fiscal 1989.

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the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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4 Case 1.1 AMRE, Inc.
Suggested Solutions to Case Questions
1. Generally, ethics refer to moral principles and values. Random House Webster’s College
Dictionary notes that ethics are “the rules of conduct recognized in respect to a particular class of
human actions or governing a particular group, culture, etc.” An individual's ethics generally define

what that individual believes to be right and wrong. Professional ethics are typically expressed by a
code of conduct adopted by an organization that represents a profession. Professions adopt such
codes to encourage moral conduct among their members.
Following is a list of the individuals involved in the AMRE case:
Robert Levin, Chief Operating Officer
Dennie Brown, Chief Accounting Officer
Walter Richardson, Vice President of Data Processing
Steven Bedowitz, Chief Executive Officer
Mac Martirossian, Chief Financial Officer
Edward Smith, audit engagement partner
Joel Reed, senior audit manager
My experience has been that students differ markedly in their assessments of the ethics of these
individuals. In particular, students generally have difficulty arriving at a consensus assessment of
Martirossian’s conduct in this case. I believe that the lively debate typically produced by this
exercise is healthy for students since such debates allow them to begin developing or "fleshing out"
their attitudes regarding important ethical issues and concepts.
2. The executives involved in the AMRE fraud agreed in a consent order to refrain from violating
federal securities laws in the future. In addition, Robert Levin and Dennie Brown forfeited funds
they realized from sales of AMRE stock during the fraud. Levin also paid $1.8 million to the federal
government, including a $500,000 fine for insider trading. Finally, Levin and Steven Bedowitz
contributed approximately $9 million to a settlement pool to resolve a large class-action lawsuit.
Most students conclude that the AMRE executives who participated in the fraud were appropriately

punished. Their actions were motivated by greed and self-interest and they paid a heavy price for
their indiscretions.
The two auditors involved in this case, Edward Smith and Joel Reed, were prohibited from being
assigned to audits of SEC registrants for nine months. Again, students typically find that this
punishment was appropriate given the apparent mistakes made during the AMRE audits. These
mistakes included failing to adequately test the computerized lead bank, allowing AMRE personnel
to observe certain inventory sites, accepting client explanations without applying sufficient audit
procedures, and failing to require the client to disclose large and suspicious period-ending accounting
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Case 1.1 AMRE, Inc. 5
adjustments in the financial statements.
The SEC issued a separate enforcement release criticizing Martirossian for his failure to take
appropriate measures upon learning about the fraud. Students frequently disagree with the SEC’s
criticism of Martirossian. Many of them view him as an ethical person who just happened to be in
the wrong place at the wrong time. It is important to point out to students that it is not unusual for
accountants to find themselves in these types of ethical dilemmas. Martirossian’s experience
provides an excellent example of the potential consequences an accountant may face if he or she
violates the Code of Professional Conduct.
3.

Among the alternative courses of action available to Martirossian were the following:
a.
b.
c.

d.
e.

Aid in the cover up of the fraud.
Demand that the executives involved disclose the fraud to the auditors. If they refused
to comply, report the fraud to the SEC.
Report the fraud to the auditors and to the Board of Directors immediately.
Secretly report the fraud to the auditors.
Resign his position with AMRE, Inc.

Probably the best course of action for Martirossian would have been to demand that the
executives disclose the fraud to the auditors. If they refused, Martirossian should have considered
disclosing the fraud directly to the SEC. This action would have resulted in Martirossian upholding
his professional responsibilities as a CPA. Although he may have lost his job, he would have
avoided being sanctioned by the SEC. Most important, this course of action would have prevented
innocent parties, such as potential AMRE investors and creditors, from being harmed by the
fraudulent scheme.
4. The relevant accounting concept in this context was the matching principle. The matching
principle requires that expenses be matched with the revenues they produce. A cost can be deferred-treated as an asset--when it is expected that the cost will produce future economic benefits
(generally, revenue). It seems reasonable that a portion of AMRE’s advertising costs benefited
future periods and, thus, could be appropriately deferred. Nevertheless, AMRE’s policy of deferring
all of the advertising costs related to unset leads was very aggressive and probably resulted in the
booking of assets that would provide no future benefits for the company.
5. Listed next are key audit risk factors that were present during the 1988 and 1989 AMRE
audits.
a.
b.
c.

AMRE's management had a strong incentive and desire to maintain the company's stock

price at a high level.
AMRE’s unset leads increased dramatically during 1988.
The company’s inventory also increased significantly during 1988 and increased much
more rapidly than the company’s sales.

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6 Case 1.1 AMRE, Inc.
d.
e.

f.
g.

The efforts of AMRE’s executives to influence important audit planning decisions should
have been of concern to the auditors.
The percentage-of-completion accounting method was an unusual method to apply to
AMRE’s installation jobs since those jobs typically required only four to ten days to
complete.
AMRE had several large and unusual fourth-quarter adjusting entries in 1989.
Martirossian’s secret meeting with the AMRE auditors should have caused them to
question the integrity of the client’s financial statements.

When taken together, these items suggest that the overall audit risk for the AMRE audits was
relatively high. Most of these risk factors were discovered by Price Waterhouse or were apparent to

the audit firm. For example, the audit planning memo for the 1988 audit identified the large increase
in inventory as a key risk factor and called for an increase in the number of inventory observation
sites. Likewise, the AMRE audit partner originally requested that the company disclose the large
period-ending adjustments in its 1989 10-K.
Although the auditors identified these risk factors, it appears that they failed to adequately
consider them during the performance of fieldwork. For example, company executives convinced
the auditors to allow client personnel to observe several of the inventory sites selected for
observation at the end of 1988. During the 1989 audit, client management persuaded the auditors not
to require disclosure of the large fourth-quarter adjustments in AMREs financial statements. Why
did the auditors apparently defer to AMRE’s executives in several situations and fail to adequately
question their decisions in others? Possibly, the auditors simply succumbed to client pressure in
each of these instances. During the 1989 audit, the auditors may have relied too their detriment on
Martirossian, a former colleague, to inform them of any major problems in AMRE’s financial
statements.
6. Whether Price Waterhouse was justified during the 1988 audit in agreeing to allow client
personnel to observe the physical counts at certain inventory sites is a matter of professional
judgment. Apparently, members of the audit team did not believe that the client’s request posed a
major problem--that is, did not result in a material scope limitation, otherwise they would not have
agreed to it.
Client management should not be allowed to influence key audit decisions such as sample size
determinations, assignments of auditors to given areas of the audit, and the types of audit tests
applied to specific accounts. Generally, any time a client request would prevent an auditor from
satisfying the requirements of the third standard of fieldwork--obtaining sufficient competent
evidential matter to support his or her audit opinion, that request should be denied.
7. Note: the relevant U.S. auditing standards presently for audits of public companies are those
issued/endorsed by the Public Company Accounting Oversight Board (PCAOB). Although SAS No.
31 has been superseded by a new standard issued by the Auditing Standards Board, the PCAOB still
endorses the regime of management assertions included in that standard. In particular, the SAS No.
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Case 1.1 AMRE, Inc. 7
31 list of management assertions is now embedded in Auditing Standard No. 15 issued by the
PCAOB.
In most situations, the key management assertion for an expense item is the completeness
assertion. That is, auditors are generally concerned that a client may attempt to understate expenses.
However, in this case the fourth-quarter write-offs in 1989 were initiated by AMRE management.
When management voluntarily recognizes a large and unusual expense item, an auditor may want to
consider the possible motives underlying management’s decision. Certainly, an auditor in such a
case will want to investigate the completeness assertion, but the existence/occurrence assertion
should also be examined by the auditor in such circumstances. In recent years, many large firms
have taken “big bath” write-offs to improve their chances of returning to a profitable or more
profitable position in the near future.
In fact, the management assertion of most concern to Price Waterhouse regarding the 1989
fourth-quarter write-offs may have been the “presentation and disclosure” assertion. This assertion
addresses whether particular components of the financial statements “are properly classified,
described, and disclosed” (AS No. 15, paragraph 11). The large year-end adjustments that resulted in
AMRE reporting a net loss for 1989 were clearly not adequately described in the company’s financial
statements.
8. Listed next are the key responsibilities an auditor assumes for quarterly financial information
included in the footnotes to a client's audited financial statements. Refer to AU Section 722 for a
more detailed discussion of these responsibilities.
a.
b.
c.

The auditor should apply “review” procedures to the interim financial information. (Such
procedures consist principally of inquiries of client personnel and analytical procedures.)
The auditor should ensure that the quarterly data are presented as supplementary
information and that each page of the data is clearly marked as unaudited.
If the results of the review procedures are satisfactory, the auditor does not need to modify
his or her report on the audited financial statements to make reference to the review of the
interim financial information. However, if the interim financial information does not
appear to be in conformity with generally accepted accounting principles, including
adequate disclosure, the auditor’s report should generally be expanded to address this issue.
[Note: See AU 722.50b for an exception to the latter general requirement.]

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