case #2.1 enron: independence - college test...

Case #2.1 – Enron: Independence

I. Technical Audit Guidance

To maximize the knowledge acquired by students, this book has been designed to be read inconjunction with the post-Sarbanes-Oxley technical audit guidance. All of the PCAOB AuditingStandards that are referenced in this book are available for free at:http://pcaobus.org/Standards/Pages/default.aspx.

In addition, the AU Sections that are referenced in this book are available for free at:http://pcaobus.org/Standards/Auditing/Pages/default.aspx. Finally, a summary of the provisionsof the Sarbanes-Oxley Act of 2002 is available for free at:http://thecaq.aicpa.org/Resources/Sarbanes+Oxley/Summary+of+the+Provisions+of+the+Sarbanes-Oxley+Act+of+2002.htm.

II. Recommended Technical Knowledge

The Sarbanes-Oxley Act of 2002

Section 201Section 203Section 206Section 301

III. Classroom Hints

This case provides students with the opportunity to understand what is meant by auditor

independence and why it is important to the audit profession. In addition, the case provides

students with an opportunity to understand how a lack of independence may impact the

objectivity of auditors and potentially lead to biased professional judgments. To meet these

objectives, this case illuminates a number of relevant issues about the business relationship that

existed between Arthur Andersen and Enron in the years leading up to the Enron business

failure.

We believe it is essential for students to carefully read over the recommended technical

knowledge, along with this case reading. The educational psychology literature suggests that the

acquisition of technical/factual type knowledge increases dramatically when such knowledge can

Full file at http://collegetestbank.eu/Solution-Manual-Auditing-and-Accounting-Cases-3rd-Edition-Thibodeau

be applied in a realistic context. Thus, we urge instructors to use this case as a mechanism to

impart the relevant post-Sarbanes technical audit knowledge, outlined above.

This case assignment will work best if is scheduled to coincide with the auditors'

professional responsibilities/conduct topic or the independence topic in the auditing course. We

do believe that it is helpful to introduce the notion of an auditor's responsibility to financial

statement users before discussing how a lack of independence can potentially bias an auditor's

professional judgments. Specifically, we suggest that instructors do everything possible to

illustrate the tension that auditors face when attempting to maintain an attitude of independence

during the financial statement audit. Students need to realize that the nature of the auditing

process sometimes makes it difficult to remember that your primary responsibility when

completing an audit is to financial statement users, not to client personnel.

The difficulty starts with the nature of the business relationship, in particular prior to the

Sarbanes-Oxley Act of 2002. The audit firm is hired and is paid by the audit client. Thus, the

audit client can also fire the audit firm. This is a nontrivial dynamic that can make it difficult to

maintain your independence and an attitude of professional skepticism throughout the audit.

Another aspect that adds to this tension is the reality that auditors need the client’s cooperation in

order to complete their work at the audit client. This reality forces the auditor to build a strong

rapport with client personnel. Such a rapport also just makes life more enjoyable for the auditor,

who is forced to work with client personnel on a daily basis. Each of these examples can add to

the tension that auditors face on a daily basis but they must always remember that their primary

responsibility is to the financial statement users. Thus, they must always maintain their

independence and their professional skepticism throughout the audit.


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IV. Assignment Questions & Suggested Answers

1. What is auditor independence, and what is its significance to the audit profession?What is the difference between independence in appearance and independence infact?

The second general standard of generally accepted auditing standards (GAAS) is, “In all

matters relating to the assignment, an independence in mental attitude is to be maintained by the

auditor or auditors.” If the auditor is not independent, the financial statements are considered

unaudited for all practical purposes. In case where the SEC has found that a CPA firm was not

independent, it has required that the financial statements be re-audited by another firm. A lack of

independence can result in disciplinary action by regulators and/or professional organizations

and litigation by those who relied on the financial statements (e.g., clients and investors). The

profession, as a whole, depends on the value of independence in that the auditor’s opinion on the

financial statements loses its value if the auditor is not considered to be substantially independent

from the management of the firm.

Article IV of the AICPA’s Professional Code of Conduct requires that “a member in public

practice should be independent in fact and appearance when providing auditing and other

attestation services.” To be independent in fact, an auditor must have integrity, a character of

intellectual honesty and candor; and objectivity, a state of mind of judicial impartiality that

recognizes an obligation of fairness to management and owners of a client, creditors, prospective

owners or creditors, and other stakeholders. To be independent in appearance, the auditor must

not have any obligations or interests (in the client, its management, or its owners) that could

cause others to believe the auditor is biased with respect to the client, its management, or its

owners. Even if the auditor does not have any direct or indirect financial interest or obligation

with the client in fact, they must assure that no part of their behavior or actions appear to affect



their independence in the opinion of the public. When behavior seems to affect independence it

has a similar effect on public opinion as a breach of independence in fact.

The facts of the case reveal numerous issues that suggest that Andersen's independence may

have been compromised. For example, Enron was one of Andersen’s biggest audit clients. It

paid Arthur Andersen $46.8 million in fees for auditing, business consulting, and tax work for

the fiscal year ended August 31, 1999; $58 million in 2000; and more than $50 million in 2001.

At Andersen, the compensation of partners depended on their ability to cross-sell other services

to its audit clients. More than half of the fees for Enron were charged for non-audit services. By

2001, Duncan was earning more than $1 million a year. The size of the fees would likely have

made it hard for Duncan and his fellow auditors to challenge Enron's management team on

difficult accounting issues.

In addition, the substantial amount of non-audit work completed by Andersen provided

incentives to work as an advocate on behalf of Enron. For example, Arthur Andersen boasted

about the closeness of their relationship in a promotional video. “We basically do the same types

of things…We’re trying to kinda cross lines and trying to, you know, become more of just a

business person here at Enron,” said one accountant.

In addition, Since 1993 Andersen had performed Enron’s internal audit function in addition

to performing the audit on its financial statements. Performing both the internal and external

auditing functions meant that Andersen was auditing its own work and thus would not be

unbiased. In addition, more than eighty former Arthur Andersen accountants were working at

Enron. Several were in senior executive positions, including Jeffrey McMahon, who served in

the positions of treasurer and president; and vice president Sherron Watkins; and chief

accounting officer Richard Causey.



Article IV of the AICPA Code of Conduct (Objectivity and Independence) states: “A

member in public practice should be independent in fact and appearance when providing

auditing and other attestation services.” Close relationships might affect independence in

appearance, even if independence in fact is maintained. Clearly there was cause for concern at

Enron. Causey was good friends with Andersen’s global engagement partner, David Duncan. In

fact, their families had even gone on vacations together. Andersen employees often attended

Enron-sponsored events and office parties. The nature of Causey and Duncan’s close

relationship violated the AICPA Code of Conduct’s requirements for independence in

appearance.

2. Refer to Section 201 of SARBOX. Identify the services provided by ArthurAndersen that are no longer allowed to be performed. Do you believe that Section201 was needed? Why or why not?

Section 201 says that it shall be unlawful for a registered public accounting firm to provide

any non-audit service to an issuer contemporaneously with the audit, including: (1) bookkeeping

or other services related to the accounting records or financial statements of the audit client; (2)

financial information systems design and implementation; (3) appraisal or valuation services,

fairness opinions, or contribution-in-kind reports; (4) actuarial services; (5) internal audit

outsourcing services; (6) management functions or human resources; (7) broker or dealer,

investment adviser, or investment banking services; (8) legal services and expert services

unrelated to the audit; (9) any other service that the Board determines, by regulation, is

impermissible.

Arthur Andersen provided services to Enron that would be prohibited today by SOX

Section 201. “More than half of that amount (more than $50 million) was for fees that were

charged for non-audit services… $27 million for consulting and other services, such as internal



audit services.” Andersen had been providing internal audit services to Enron for eight years.

The non-audit services that Andersen provided were encouraged by the structure of partner

compensation.

Importantly, the bill allows an accounting firm to “engage in any non-audit service,

including tax services,” that is not listed above, only if the activity is pre-approved by the audit

committee of the issuer. The audit committee is required to disclose to investors in its periodic

filings its decision to pre-approve non-audit services.

Most observers now agree that Section 201 was needed. The rise of non-audit services

has been a common trend in the public accounting profession. In 1993, 31% of the fees in the

industry came from consulting. By 1999, that number had jumped to 51%. In fact, the AICPA

released a publication in 1999 titled “Make Audits Pay: Leveraging the Audit Into Consulting

Services.” The book advised the auditor to think of himself as a “business advisor.” It did note

that conflicts could arise from performing the role of business advisor (which was a client

advocate) and the auditor (which had to be independent). It advised erring on the side of looking

out for the public interest. Other striking examples include KPMG, which billed Motorola $3.9

million for auditing and $62.3 million for other services; Ernst & Young, which billed Sprint

Corp. $2.5 million for auditing and $63.8 million for other services; and

PricewaterhouseCoopers, which billed AT&T $7.9 million for auditing and $48.4 million for

other services.

3. Refer to Sections 203 and 206 of SARBOX. How would these sections of the lawhave impacted the Enron audit? Do you believe that these sections were needed?Why or why not?

Section 203 says that “the lead audit or coordinating partner and the reviewing partner must

rotate off of the audit every 5 years.” Section 206 says that the CEO, Controller, CFO, Chief



Accounting Officer or person in an equivalent position cannot have been employed by the

company’s audit firm during the 1-year period ("the cooling off period) preceding the audit.

Section 203 could have impacted the Enron audit. David Duncan, lead partner for the Enron

engagement, had formed a close personal relationship with Enron’s Chief Accounting Officer,

Richard Causey. “…and their families had even gone on vacations together.” The nature of this

close relationship put Duncan in a position that he might not be able to challenge management. A

key point to raise in this response is that David Duncan would not have been the lead audit

partner after 5 years of service because of the establishment of Section 203. It is important to

point out that the relationship that develops among professionals is interrupted by regulation to

help insure independence.

Section 206 requires a “one year cooling off period” for former Andersen employees to

accept a position as CEO, CFO, Controller, or Chief Accounting Officer. “Causey was

responsible for recruiting many Andersen alumni to work at Enron. Over the years, Enron hired

at least 86 Andersen accountants. Several were in senior executive positions.” Section 206 of

SOX would have prevented some of these hirings before the cooling off period had expired.

Since both of these laws help to ensure independence in appearance and in fact, most

students are likely to agree that they were needed. Both Section 203 and Section 206 would have

impacted the Enron engagement.

4. Refer to Section 301 of SARBOX. Do you believe that Section 301 was important tomaintaining independence between the auditor and the client? Why or why not?

Section 301 of SARBOX requires that the “audit committee of an issuer shall be directly

responsible for the appointment, compensation, and oversight of the work of any registered

public accounting firm employed by that issuer.” As a result, the relationship between the audit

firm and the CFO and/or Controller at an audit client has changed dramatically. In the past, it



may have been difficult for an auditor to challenge the CFO and/or the Controller on difficult

accounting issues because the auditor knew that these individuals had the authority to fire the

audit firm from the job. At a minimum, this was a major threat to independence in appearance.

Now, the auditor reports directly to the audit committee. As a result, the independence between

the auditor and client has improved.



Case #2.2 – Waste Management: Due Care






Section 203Section 206

III. Teaching Hints

This case provides students with the opportunity to understand what is meant by an audit

firm exercising due professional care in completing the audit and the consequences associated

with a failure to do so. In addition, the case provides a mechanism to illustrate auditor

independence and why it is important to the audit profession. More specifically, the case

provides students with an opportunity to understand how a lack of independence may impact the

objectivity of auditors and potentially lead to biased professional judgments. Finally, the case

provides a context to discuss what is meant by an adjusting journal entry proposed by an auditor.

To meet these objectives, this case illuminates a number of relevant issues about the business

relationship that existed between Arthur Andersen and Waste Management, the quality control

review process at Arthur Andersen and Waste Management’s refusal to record adjusting journal

entries proposed by Arthur Andersen.







impart the relevant technical audit knowledge, as outlined above.


professional responsibilities topic or the independence topic in the auditing course. The case can

also be used in conjunction with a discussion of the importance of quality control at an audit

firm. Alternatively, the case could be used when discussing the completion of the audit topic to

illustrate the issues involved in forcing the clients to record adjusting journal entries.

Overall, we believe that it is helpful for students if instructors introduce the notion of an

auditor's responsibility to financial statement users before discussing how a lack of independence

can potentially bias an auditor's professional judgments. Specifically, we suggest that instructors

do everything possible to illustrate the tension that auditor's face when attempting to maintain an

attitude of independence during the financial statement audit. Students need to realize that the

nature of the auditing process sometimes makes it difficult to remember that your primary

responsibility when completing an audit is to financial statement users, not to client personnel.

We recommend that instructors spend time in class discussing the nature of the quality

assurance at an audit firm. This discussion can be accomplished quite effectively while going

over the response to question number two in the case. In addition, depending on the point of the

semester that this case is used, instructors should also consider spending class time explaining

the nature of the adjusting journal entries proposed by auditors. Again, this can be accomplished

quite effectively while going over the response to question three in the case. Finally, the subject



of materiality can be raised in class when discussing whether Andersen should have forced

Waste Management to record the adjusting journal entries.

Each of these points can also be used to help discuss the difficulties associated with

professional judgments made by auditors and just how important it is to be unbiased in making

all decisions. Indeed, what makes this tension more pronounced is the subjectivity that is

inherent in many professional judgments made be auditors. The overriding objective of this

discussion is to get students to think about the types of professional judgments that auditors

make (e.g., requiring the client to record adjusting journal entries) and then to demonstrate how a

lack of independence can impact the final professional judgment. To facilitate class discussion

in this regard, it is useful to talk about the subjectivity that is inherent in an auditor's application

of Generally Accepted Auditing Standards. In addition, it may also be useful to talk about the

subjectivity inherent in the application of Generally Accepted Accounting Principles. Both

aspects of subjectivity characterize the environment that auditors make decisions within and it

absolutely essential that auditors are independent in all areas.


1. What is auditor independence, and what is its significance to the audit profession?

In what ways, if any, was Arthur Andersen’s independence potentially impacted on

the Waste Management audit?

According to the second general standard of Generally Accepted Auditing Standards, “In all

matters relating to the assignment, an independence in mental attitude is to be maintained by the

auditor or auditors.” Unfortunately, the facts of the case reveal numerous issues that suggest that

Andersen's independence may have been compromised on the Waste Management audit.



For example, at Andersen, the compensation of partners depended on their ability to cross-

sell other services to its audit clients. More than half of the fees for Waste Management were

charged for non-audit services. The size of the nonaudit fees would likely have made it hard for

the Andersen partners to challenge Waste Management's team on the difficult accounting issues.

In addition, more than fourteen former Arthur Andersen accountants were working at

Waste Management. Several were in senior executive positions, including Thomas Hau, the

chief accounting officer. Another concern is how Robert Allgyer was chosen for the engagement.

He was chosen based on his personal style that fit well with the Waste Management officers.





Waste Management.

2. Considering the example in the Waste Management case, please explain why a

review by the practice director and audit division head is important in the

operations of a CPA firm. In your opinion, was this review effective at Waste

Management? Why or why not?

A review by the Practice Director and Audit Division Head serves as a quality control

mechanism for the audit as the work of the engagement partner and concurring partner are

reviewed. Since the practice director and audit division head are not directly involved with the

engagement, each professional is in a position to provide an unbiased opinion on all work

completed.



This type of review is important because of the specialized knowledge possessed by each

professional. Thus, this review, if conducted effectively, can reduce the exposure of the firm to

financial loss resulting from litigation, customer complaints and loss of reputation due to

intentional or unintentional errors in an individual engagement. Indeed, an effective control of

this type helps to ensure that individual partners conform with a firm’s “best practices” and that

GAAP was properly and consistently applied on the engagement.

In this case, the review does not appear to have been effective as Andersen issued an

unqualified opinion on Waste Management when misstatements of $128 million or 12% of net

income were not deemed material by Andersen.

3. What is meant by an auditor’s proposed adjusting journal entries (PAJEs). Do you

believe that Andersen’s final decision regarding the PAJE’s was appropriate, under

the circumstances? Would your opinion change if you knew that all of the

adjustments were based on subjective differences (such as a difference in the

estimate of the allowance for doubtful accounts), as compared to objective

differences (such as a difference in the account receivable balance of their biggest

customer)?

PAJEs or Proposed Adjusting Journal Entries refer to the adjustments recommended by

the auditors for the client’s financial statements to comply with GAAP. These entries are used as

a mechanism to correct an account balance that is not recorded in accordance with GAAP. The

decision made by Andersen regarding the PAJEs was inappropriate under the circumstances

because the differences would likely have mattered to financial statement users. Andersen

partners had a high level of professional training and experience in adhering to professional

standards. As a result, it is surprising that they did not require the adjustments to be recorded.



Because of the magnitude of the adjustments, taken together, it probably would not have

mattered if the adjustments were based on subjective as compared to objective differences

discovered by Andersen. It is important to point out that the PAJE’s resulted in an overstatement

of net income by 12 percent. So, regardless of subjective differences or objective differences,

the proposed adjustments were material in nature and would have resulted in a change in

earnings per share. It is however important to point out that the subjective differences often lead

to negotiation between the auditors and the client, where the objective difference typically do

not. And, it is during these negotiations where an auditor’s independence is truly put to the test.

This is a terrific opportunity to bring up this tension in class and illustrate the difficulties of

maintaining an independent and objective mind as an auditor.

4. Refer to Sections 203 and 206 of SOX. How would these sections of the law have

impacted the Waste Management audit? Do you believe that these sections were

needed? Why or why not?

Section 203 of the Sarbanes-Oxley Act requires audit partners to rotate off an audit

engagement after five years. Section 206 says that the CEO, Controller, CFO, Chief Accounting

Officer or person in an equivalent position cannot have been employed by the company’s audit

firm during the 1-year period (“the cooling off period”) proceeding the audit.

Many believe that this law goes far enough, and that the audit firm itself should not have to

rotate off an audit engagement every five years. Arguments against the rotation of the audit firm

argue that forcing audit firm rotation every five years would be too chaotic and the costs for both

audit firms and clients would be significant. Audit firms incur substantial costs in the first

couple years of an audit engagement as they are acquiring information about the firm, its

industry and its internal control system for the first time. Requiring audit firms to switch every



five years would inflate audit costs as firms would constantly be in the process of performing due

diligence and researching their clients. The inflated costs of performing the audit would

undoubtedly be passed onto clients. Another argument against audit firm rotation is that

requiring firms to switch may be counterproductive in that fraud may actually be harder to find

as the new audit firm is not as familiar with the client’s business processes, risks, and attitude of

management.

Waste Management had several employees who were formed employees of Arthur Andersen.

In addition, every chief financial officer and chief accounting officer at Waste Management until

1997 was a former auditor of Andersen. Section 206 of SOX would have affected Waste

Managements chief officers since the former Andersen employees would have had to wait at

least one year before stepping into the position.

Arguments supporting section 203 and 206 believe these sections are needed in order to keep

a respectable distance between the client and audit firm. Rotating partners every 5 years will

make it harder for employees of the audit firm to create close relationships with employees at the

client company. This distance helps create an image of independence. Section 206 also supports

the argument of independence. By requiring former audit employees to wait one year before

stepping into a “C” position it creates an image of independence. The former employee can take

time off the engagement and employees still on the engagement have time to make changes to

procedures and such; this way the former employee does not know every procedure being done

and is at a far enough distance to be “out of the loop.” If the former employee stepped into the

position right away he would know all of the audit procedures being used and could inform other

members of management of how to hide fraud and other scandals from the auditors.



The key arguments against section 203 and 206 support the overarching belief that rotating

partners is too costly. A student may argue that if partners are rotated every 5 years there will

always be a learning curve which will slow down the audit, creating higher costs for clients and

audit firms. A student may also argue that making a former employee wait at least one year

before stepping into an influential position at the former client is costly to the client. In addition,

a student may argue that it is better for the former audit employee to be in the position right away

this way no current knowledge of the company is lost.



Case #2.3 – WorldCom: Professional Responsibility





PCAOB Auditing Standard No. 5

Paragraph # 14Paragraphs #A8 (in Appendix A)


This case provides students with an opportunity to understand that an auditor’s

professional responsibility includes exercising due professional care and maintaining an attitude

of professional skepticism on every audit engagement. The case also provides a mechanism to

show how a perceived lack of independence might impact an auditor carrying out his/her

professional duties. In addition, the case provides a context to introduce the difference between

substantive analytical review and substantive test of details as a means to gather evidential

matter. Finally, the case allows for the introduction of what is meant by a “top-side” adjusting

journal entry and why such an entry poses special risk to an auditor. In fact, since this may be

the first time students have been exposed to a “top-side” entry, we recommend that instructors

spend time discussing this topic in class. This can be accomplished when reviewing the answer

to question #4.








We believe that this case assignment will work best if is scheduled to coincide with a

discussion of the auditor professional responsibilities topic. However, the case can also be used

to introduce the evidential matter topic as a way to illustrate the difference in competence

between the evidence gathered by substantive analytical review versus substantive test of details.

We believe it is critical to stress the importance of having open access to all relevant evidence

when completing the financial statement audit. In addition, it is critical to point out that

substantive analytical review is not as effective as substantive test of details. Of course, audit

firms will often opt to complete a substantive analytical review because it is a more efficient.

However, it is typically not as effective.

The case also provides a mechanism to help discuss how a lack of independence can

possibly impact the professional judgments made by the auditors. For example, WorldCom was

one of Andersen’s biggest audit clients nationwide, and was the biggest client in the Jackson, MI

office. The size of the client and the importance of its fees to the Jackson, MI office would

likely have made it hard for Andersen to challenge WorldCom on difficult issues, including the

lack of access to evidence. The overriding objective of this discussion is to get students to think

about the types of professional judgments that auditors make and then to demonstrate how a lack

of independence can impact the final professional judgment of an auditor.




1. What is auditor independence, and what is its significance to the audit profession?Based on the case information, do you believe that Andersen violated the secondgeneral standard? Why or why not?

According to the second general standard of Generally Accepted Auditing Standards, “In all

matters relating to the assignment, independence in mental attitude is to be maintained by the

auditor or auditors.” If the auditor is not independent, the financial statements are considered

unaudited for all practical purposes. In case where the SEC has found that a CPA firm was not

independent, it has required that the financial statements be re-audited by another firm. A lack of






Unfortunately, the facts of the case reveal several issues that suggest that Andersen’s

independence may have been compromised. For example, WorldCom was one of Andersen’s

biggest audit clients. In terms of the total amount of fees charged to clients, WorldCom was one

of Andersen’s top 20 engagements in 2000, and the largest client of its Jackson, Mississippi,

office. From 1999 through 2001, WorldCom paid Andersen $7.8 million in fees to audit the

financial statements of WorldCom, Inc.; $6.6 million for other audits required by law in other

countries; and about $50 million for consulting, litigation support, and tax services.

At Andersen, the compensation of partners depended on their ability to cross-sell other

services to its audit clients. The fees charged to WorldCom for non-audit services were highly



significant. The size of the fees would likely have made it hard for Andersen auditors to

challenge WorldCom’s management team on difficult accounting issues.

In addition, the substantial amount of non-audit work completed by Andersen provided

incentives to work as an advocate on behalf of WorldCom. For example, in a presentation to the

Audit Committee on May 20, 1999, Andersen stated that it viewed its relationship with

WorldCom as a “long-term partnership,” in which Andersen would help WorldCom improve its

business operations and grow in the future. In its Year 2000 Audit Proposal, Andersen told the

Audit Committee that it considered itself “a committed member of [WorldCom’s] team” and that

WorldCom was “a flagship client and a ‘Crown jewel’” of its firm.1





WorldCom.

2. Refer to the responsibilities principle of Generally Accepted Auditing Standards(GAAS). Given the reluctance of WorldCom’s management team to communicatewith Andersen, do you believe that Andersen exercised due care and professionalskepticism in completing the audit? Why or why not?

The reluctance of WorldCom’s management team to communicate with Andersen was a

major issue and reveals a lack of professional skepticism and/or due professional being exercised

by Andersen. Indeed, there are a number of specific observations that indicated a lack of

professional skepticism and/or due professional being exercised by Andersen. The observations

include:

A failure to demand supporting evidence for certain recorded transactions;

1 Board of Directors’ Special Investigative Committee Report, June 9, 2003, 225.



Top management tried to intimidate and often silenced its division managers and

employees in order to prevent them from revealing information to Andersen. This

was evidenced by several requests for information and interviews by Andersen

being denied by WorldCom;

The failure of WorldCom to disclose the maximum risk classification to the Audit

Committee at WorldCom;

Top management prevented the auditors from gaining access to the computerized

General Ledger;

Finallly, The failure to adequately respond to the maximum risk classification by not

requiring adequate evidence for “top-side” journal entries and a reliance on substantive analytical

review instead of tests of details to gather evidence was an inadequate audit response.

3. In terms of audit effectiveness and efficiency, briefly explain the difference betweensubstantive analytical procedures and substantive test of details. Do you believe itwas appropriate for Andersen to rely primarily on substantive analyticalprocedures? Why or why not?

A substantive test is used to gather evidence that substantiates whether an account balance

and/or an economic transaction was recorded in accordance with generally accepted accounting

principles (GAAP). There are two primary ways of conducting substantive tests: 1) substantive

analytical review and 2) test of details.

When applying substantive analytical reviews to gather evidence, the auditor must develop

an independent expectation of what he/she thinks the account balance should be. Once this is

developed, the expectation is compared to the recorded amount. Analytical procedures are used

to study the relationships between accounts within client information to identify possible



material misstatements. Any significant differences must be investigated and corroborated with

evidence. In order to be effective, the procedure must be conducted with exacting precision and

high degree of rigor.

When applying substantive test of details, the auditor must seek to understand the account

balance and/or economic transaction to ensure, based on valid and reliable evidence, that the

amount was recorded in accordance with GAAP.

In general, a substantive analytical review is more efficient, while the test of details is more

effective. However, there are a number of situations where the substantive analytical procedures

can be equally effective. Thus, many auditors rely substantially on substantive analytical

reviews.

Since WorldCom was considered a maximum risk client, Andersen should have relied on

more than just substantive analytical procedures. When a client is categorized as maximum risk

this requires the audit team to gather more evidence than is normally necessary. Andersen

should have accumulated more factual evidence such as test of details and not relied on

relationships of data; especially since the client was maximum risk and the numbers in the data

could have been skewed and manipulated. If WorldCom was rated at a lower level of risk, the

use of substantive analytical procedures may have been sufficient. It is the increased risk which

really made tests of details necessary on this audit engagement.

4. Consult Paragraphs 14 and A8 (in Appendix A) of PCAOB Auditing Standard No.5. Provide an example of both a preventive control and a detective control thatcould address the risk that a fraudulent top-side adjusting journal entry could bemade by a member of management.

Paragraph #14 of Auditing Standard #5 focused on the importance of auditors utilizing the

results of their fraud risk assessments as part of the audit. Specifically, according to the

paragraph, “the auditor should evaluate whether the company's controls sufficiently address



identified risks of material misstatement due to fraud and controls intended to address the risk of

management override of other controls.” Since top-side entries are a mechanism used by upper

managers to circumvent the internal control system, paragraph #14 of Standard No. 5 clearly

identifies the danger of unusual journal entries and entries made late in the reporting process

explicitly, in the standard.

In paragraph #A8, the standard explicitly discussed the types of controls. That is,

“controls over financial reporting may be preventive controls or detective controls. Effective

internal control over financial reporting often includes a combination of preventive and detective

controls.” Specifically, “preventive controls have the objective of preventing errors or fraud that

could result in a misstatement of the financial statements from occurring” while “detective

controls have the objective of detecting errors or fraud that has already occurred that could result

in a misstatement of the financial statements.”

Clearly, there are a number of allowable answers to this question. This question is also

designed to help the students understand the differences between preventive controls and

detective controls and the importance of each in a well-functioning internal control system.

And, it would be difficult to design control procedures that are likely to be effective against top-

side entries at WorldCom because of the weak control environment and the lack of ethics and

integrity exhibited by top management. This point should be made because it illustrates the

pervasiveness of the control environment. The bottom line is how effective are control

procedures if management has the power to override internal controls?

With that said, one specific control procedure that could be designed to prevent a

misstatement related to a top-side adjusting entry from occurring would be to involve

management from the operating units in the decisions to make all top-side adjusting entries



related to their own operating units. For example, the company can implement a policy that both

the top corporate executives and the management from the operating units must sign off on the

entries. Another specific control procedure that could be designed to detect a misstatement that

originated from a top-side adjusting entry would be to require that all significant top-side entries

be reviewed by the audit committee.



Case #2.4 – Enron: Quality Assurance








This case provides students with an opportunity to understand what is meant by quality

control in the financial statement audit process and to understand why a quality control

mechanism is an important internal control procedure for an audit firm. Further, the case

provides a terrific example for students to see what can actually happen when quality control

breaks down at an audit firm. In the case of Arthur Andersen, the breakdown in quality control

ultimately led to the demise of the firm. To meet these objectives, this case illuminates the role

of the professional standards group (PSG) at Arthur Andersen and the dialogue that occurred for

several technical issues between Andersen’s PSG and the lead partner on the Enron engagement,

David Duncan.








This case assignment will work best if is scheduled to coincide with a discussion of an

auditor firm’s quality control process or the auditors' professional responsibilities topic. We

believe that it is critical to stress the importance of quality control at an audit firm. This will

naturally lead to a discussion of the quality control process at audit firms. Instructors should

point out that each of the largest audit firms has a group that is comparable to Andersen’s PSG,

usually located at the national office.

The need for a quality control process is particularly salient when considering the

incentives of the lead audit partner (at least during this period of time). Indeed, it is important to

point out the tension that auditor's face when attempting to maintain an attitude of independence

while completing the financial statement audit and also generating additional revenue for the

firm. We recommend that you stress that David Duncan's substantial salary at Andersen was due

in large part to his role generating revenue as the lead partner on the Enron account. When

framed in this manner, it is likely that students will see the danger of allowing the

recommendations of the national office quality control function to be overruled by the lead

partner at an audit client.

The case may also provide a mechanism to help discuss the difficulties associated with

professional judgments made by auditors and just how important it is to be unbiased in making

all decisions. Indeed, what makes this tension more pronounced is the subjectivity that is

inherent in many of the professional judgments made by an auditor. The overriding objective of

this discussion is to get students to think about the types of professional judgments that auditors



make and then to demonstrate how a lack of independence can impact the final professional

judgment.


1. Explain why an accounting and auditing research function (like Andersen’s PSG) isimportant in the operations of a CPA firm. What role does the function play incompleting the audit?

In order to mitigate their risk of an audit failure, CPA firms must implement their own

system of internal controls to ensure that professional standards (and their own standards) of

audit quality are being met. Stated simply, a firm must have assurance that the work being

completed by its audit professionals is being completed in accordance with professional

standards set forth by the firm.

The accounting and auditing research function (like Andersen’s PSG) is an instrumental part

of a firm’s quality assurance process. Typically, the group is comprised of a CPA firm’s leading

technical experts on accounting, auditing and industry-specific professional standards. Thus, if

an engagement partner (like Andersen’s David Duncan) encounters a difficult technical issue,

he/she has the necessary technical support that may be necessary to reach the correct conclusion

in the field.

2. Consult Section 103 of SARBOX. Do you believe that the engagement leader of anaudit (like David Duncan on the Enron audit) should have the authority to overrulethe opinions and recommendations of the accounting and auditing research function(like the PSG)? Why or why not?

According to Section 103 of SOX, the “PCAOB shall: 1) register public accounting firms; 2)

establish, or adopt, by rule, “auditing, quality control, ethics, independence, and other standards

relating to the preparation of audit reports for issuers; 3) conduct inspections of accounting firms;

4) conduct investigations and disciplinary proceedings, and impose appropriate sanctions; 5)

perform such other duties or functions as necessary or appropriate; 6) enforce compliance with



the Act, the rules of the Board, professional standards, and the securities laws relating to the

preparation and issuance of audit reports and the obligations and liabilities of accountants with

respect thereto; 7) set the budget and manage the operations of the Board and the staff of the

Board.”

In essence, this section of SOX provides for government regulation of the audit profession

and it represents one of most dramatic changes mandated by the new law. Indeed, this section

requires the PCAOB to perform detailed inspections of the audit process employed by each audit

firm. In addition, PCAOB inspectors have the authority to review the audit work completed at

any publicly traded corporations. Considering that the audit profession has relied solely on peer

evaluation for decades, this represents a dramatic change.

Considering these sweeping changes, there is no way that an engagement partner should be

allowed to overrule the firm’s technical experts on an accounting or auditing matter. The role of

the technical experts is to provide information needed to make a correct decision on a technical

or complex matter. By the very nature of the expert’s role, they are used at a time when the

auditing professionals do not have the knowledge to make a correct decision. To overrule the

expert would defeat the objective of the technical experts entirely.

In addition, in the post-Sarbanes environment, it is not likely that the PCAOB would agree

that the engagement partner on a particular audit should have the authority to overrule the firm’s

auditing and accounting research group. The bottom line is that since the function is in place to

insure a quality audit, it is likely that a PCAOB inspector would note this as an egregious

violation of a firm quality control procedure and may even issue some type of sanction against

the firm.



3. After Carl Bass was removed from the Enron account, he indicated to his boss thathe did not believe Enron should have known about internal discussions regardingaccounting and auditing issues. Do you agree with Bass’s position? Why or whynot?

In general, it is hard not to agree with Carl Bass’s position that Enron should not have known

about the internal discussions regarding accounting and auditing treatments. There are a number

of different points that can be made to support this view. They include:

The firm has an obligation to maintain independence and objectivity per therequirements of Rule 102 of the AICPA Code of Conduct. In order to maintainindependence and objectivity, the firm should have a policy that prevents this type ofcommunication with the client about the treatment of complex accounting or auditingtransactions. Collaboration with the client on these types of issues is comparable toasking “their opinion,” which of course would be a violation of independencestandards.

It is absolutely not acceptable to allow the client to know about any internaldiscussions related to a complex accounting and/or auditing issue. The firm’sposition needs to be unified to the client in all cases. If employees of Enron knewabout such conversations, they may be able to understand the “thinking” behindcertain audit procedures and perhaps take actions to circumvent other auditprocedures that might be considered by the audit firm. Additionally, sharing thisinternal information violates independence in appearance.

4. Consult Section 203 of SARBOX. Do you believe that this provision of the law goesfar enough? That is, do you believe the audit firm itself (and not just the partner)should have to rotate off an audit engagement every five years? Why or why not?

According to Section 203, “the lead audit or coordinating partner and the reviewing partner

must rotate off of the audit every 5 years.” Again, it is hard not to agree that some type of

auditor rotation should be required. However, there may be differences in opinion on whether

this provision goes far enough. Some thoughts raised by students may include:

The current provision is sufficient to maintain independence. There is no need to rotatethe entire firm from the audit. Doing so would be too costly to both CPA firms and auditclients. If the entire audit firm was required to rotate off, the tradeoff is that the new CPAfirm would not have the benefit of the experience and knowledge gained by the staff on



prior audits. Previous knowledge proves beneficial for analytical procedures and duringsubstantive testing. As a result, the overall cost of performing the audit would increase.

The current provision is not enough. Instead, Section 203 of SOX should require that theaudit firm should rotate off the engagement every five years. The fact is that the longer afirm is involved with a client, the greater the chance that the firm’s objectivity willbecome compromised as evidenced by the relationship between Andersen and Enron.



Case #2.5– Sunbeam: Due Care








Paragraph #69



firm exercising due professional care in completing the audit and the consequences associated

with a failure to do so. It is important to emphasize to students that the consequences attach to

both the firm and the individual auditor. In addition, the case provides a context to discuss what

is meant by an adjusting journal entry proposed by an auditor and the issues associated with an

auditor’s decision about whether to require that such entries be recorded. Finally, the case

provides an opportunity for instructors to discuss the role of the audit committee in helping to

prevent these types of situations. To meet these objectives, this case illuminates a number of



relevant accounting issues that surfaced during the audits of Sunbeam and the client’s refusal to

record the adjusting journal entries proposed by Arthur Andersen.







professional responsibilities topic in the auditing course. Alternatively, the case can be used in

connection with a discussion of quality control at an audit firm. Or, this case could be used when

discussing the completion of the audit topic as a way to illustrate the issues involved when

asking clients to record adjusting journal entries.

We recommend that instructors spend time explaining the nature of adjusting journal

entries proposed by auditors. Depending on the point of the semester where this case is used,

students may need to gain an understanding of what is meant by an auditor’s proposed adjusting

journal entry. This can be accomplished quite effectively while going over question number one

and two. Interestingly, Sunbeam’s first year improprieties were designed to decrease net income,

while Sunbeam’s second year improprieties were designed to increase net income. So, the case

provides a mechanism to explain the different motivations of managers in different years.

We also recommend that instructors spend time discussing the nature of the quality

control process at an audit firm. This discussion can be accomplished quite effectively while

going over the response to question number three in the case. That is, it is useful to ask students

how they think Harlow was able to justify his decision to the concurring review partner. This



may provide an opportunity to discuss materiality and the subjectivity associated with estimating

materiality. Finally, question four provides instructors with an opportunity to discuss the

increased role of the audit committee in the post-Sarbanes environment and whether that would

have made a difference on the Sunbeam audit.


1. Consider the alleged accounting improprieties related to increased expenses from the 1996 audit. If you

were auditing Sunbeam, what type of evidence would you like to review to determine whether Sunbeam

had recorded the litigation reserve amount and the cooperative advertising amount in accordance with

GAAP?

In 1996, Sunbeam failed to comply with GAAP by recording a $12 million reserve for a

lawsuit that alleged Sunbeam’s potential obligation to cover a portion of the cleanup costs for a

hazardous waste site. Sunbeam’s management did not take appropriate steps to determine

whether the amount should be recorded in accordance with FASB Statement #5. Had they done

so, the reserve would not have passed either of the criteria.

According to FASB statement #5, an accrual and related expense needs to be recorded if the

loss is probable and the amount of the loss is able to be reasonably estimated. Thus, the auditor

would need to determine whether each of these criteria had been met for the $12 Million

litigation reserve. Thus, among other factors, the auditor would want to be sure that the cleanup

costs for the hazardous waste represented a reasonable estimate of the cleanup costs. In order to

be assured of this, the auditor must obtain sufficient and competent evidential matter. According

to the generally accepted auditing standards of field work number three, “Sufficient, competent

evidential matter is to be obtained through inspection, observation, inquiries, and confirmations

to afford a reasonable basis for an opinion regarding the financial statements under audit.”



Andersen did not obtain sufficient, competent evidential matter regarding the hazardous waste

contingency. This could be accomplished in part by reviewing documents such as the following:

Statements made by Sunbeam’s lawyers about the range of estimated liability, including

the most likely amount. One of the primary substantive tests to obtain comfort over the

valuation of an estimated liability is to obtain written, third party confirmation from the

client’s attorneys. If the attorney refuses access to the information on basis of

attorney/client privilege, the auditor should consider this a scope restriction.

Review all independent estimates of the cleanup costs obtained by management. If an

independent estimate has not been obtained by management, it may be appropriate for the

auditor to hire a valuation expert to provide an estimate of the cleanup costs.

Review copies of all correspondence with pertinent regulatory agencies regarding the

hazardous waste sight. The auditor should confirm the correspondence with pertinent

regulatory agencies in order to confirm the document validity.

Review any board of director meeting minutes that relate to the cleanup process.

Review the process that management follows to determine whether a liability and related

expense need to be recorded in accordance with FASB #5.

Any other evidence that may help to determine whether the criteria in FASB Statement

#5 has been met.

In 1996, Sunbeam also recognized an excessive figure for a “cooperative advertising” reserve

that was established to fund a portion of its retailers’ costs of running local promotions. The

amount recorded, $21.8 million, was approximately 25% higher than the prior year’s accrual

amount. Andersen should have identified the increase during a horizontal analysis of the

financial statements during the analytical procedures.



Under GAAP, the matching principle does require that an estimate be made for all expenses

incurred that relate to revenue of that period. Thus, the recording of an estimated “cooperative

advertising” reserve would have been reasonably expected by the auditor. However, the auditor

must determine that the estimate that was recorded as an accrual and related expense must be a

close approximation of the expected actual costs. In order to test the estimate recorded by

Sunbeam, the auditor would need to fully understand the causal factors associated with this

expense. By understanding the causal factors, the auditor can then determine whether the

estimate made is appropriate under GAAP. For example, given the nature of “cooperative

advertising” expenses, it is likely that sales volume would be a key determinant for the expense

amount. However, in 1996, while the sales volume did not change drastically, the “cooperative

advertising” amount increased by 25%. Andersen should have identified that there was not a

correlation in the change of “cooperative advertising” and sales volume during the analytical

procedures of the audit engagement.

Sufficient and competent evidential matter to assess the valuation of “cooperative

advertising” expense could be accomplished in part by reviewing the following documents:

Contractual agreements between Sunbeam and retailers that outlined the agreement

related to “cooperative advertising”.

Board of Director meeting minutes that relate to Sunbeam’s policy regarding

“cooperative advertising”.

Internal documentation of management’s existing policy and procedures regarding

“cooperative advertising”.



2. For the excessive litigation reserves and excessive cooperative advertising amount, identify the journal

entry that is likely to have been proposed by Andersen to correct each of these accounting improprieties.

Why would Sunbeam be interested in recording journal entries that essentially reduced its income before

tax in 1996?

For the excessive litigation reserve, Andersen is likely to have proposed a journal entry to

reduce the amount of the reserve and the related expense account. So, the journal entry proposed

would be:

Debit Litigation Reserve (Liability) XXXXCredit Litigation Expense (Expense) XXXX

For the excessive “cooperative advertising” amount, Andersen is likely to have proposed a

journal entry to reduce the amount of the accrual and the related expense account. So, the

journal entry proposed would be:

Debit Cooperative Advertising Accrual (Liability) XXXXCredit Advertising Expense (Expense) XXXX

In this particular situation, since Sunbeam’s new upper management team was hired during

1996, it is likely that they were interested in trying to make themselves look the best that they

could during 1997. Thus, by overstating the liability accounts in 1996, the upper management

team created a mechanism to reduce the amount of recorded expenses in 1997. As a result of

reducing recorded expenses in 1997, this provided the opportunity for management to look better

in 1997 by sacrificing the “bottom line” in 1996 for which they were not responsible.



3. As discussed in the case, during both the 1996 and 1997 audit, Phillip Harlow allegedly discovered a

number of different accounting entries made by Sunbeam that were not compliant with Generally

Accepted Accounting Principles (GAAP). Speculate about how Harlow might have explained his decision

not to require Sunbeam to correct these alleged misstatements in the audit working papers.

This question is designed to get the students to think about documenting their rationale in the

working papers for professional judgments. Since Mr. Harlow discovered these accounting

entries that were not compliant with GAAP, he would have had to document his rationale for

passing on the audit adjustments in the working papers. He might have used any or all of the

following explanations:

He may have argued that the journal entries were each immaterial and thus would not be

of interest to the readers of the financial statements. By doing so, Mr. Harlow would

have to argue that the journal entry would not change or influence the judgment of a

reasonable person. To do so, he may have arbitrarily increased the assessed materiality

level in the work papers and tried to justify the increase in a number of different ways.

He may have argued that he relied on management’s assessments as probable and

reasonable (with regard to the reserve) or by trying to find “independent” experts that

would essentially support management’s conclusions. In addition, he may have argued

that the procedure management used to reasonably estimate the amount of the reserve

was appropriate.

He may have argued that management’s refusal to record the proposed adjustments was

based on the notion that the proposed adjustments were based upon subjective estimates,

as opposed to objective factors and that management’s subjective estimates were

appropriate.



4. Consult Paragraph 69 of PCAOB Auditing Standard No. 5 and Sections 204 and 301 of SARBOX. In the

post-Sarbanes audit environment, which of the issues that arose in 1996 and 1997 would have to be

reported to the audit committee at Sunbeam? Do you believe that communication to the audit committee

would have made a difference in Harlow’s decision not to record the adjusting journal entries? Why or

why not?

It is important to note that paragraph #69 of Auditing Standard No. 5 explicitly notes that

“ineffective oversight of the company's external financial reporting and internal control over

financial reporting by the company’s audit committee” is an indicator of a material weakness in

internal control over financial reporting. This of course has elevated the importance of the audit

committee. In addition, the audit committee plays an important role as a liaison with a

company’s auditor.

According to Section 301 of SOX, the “audit committee of an issuer shall be directly

responsible for the appointment, compensation, and oversight of the work of any registered

public accounting firm employed by that issuer.” Moreover, according to Section 204, the

auditing firm must report all “critical accounting policies and practices” and “all alternative

treatments of financial information within [GAAP] that have been discussed with management”

as well as the “ramifications of the use of such alternative disclosures and treatments, and the

treatment preferred” by the auditing firm. This is an important component of the oversight role

played by the audit committee. Based on the revised technical guidance, for Sunbeam,

communication of each of these proposed adjustments to the audit committee would have likely

led to the recording of these adjustments in the financial statements.



Case #2.6 – The Fund of Funds: Independence






Section 201Section 203Section 206


This case provides students with the opportunity to understand what is meant by auditor

independence and why it is important to the audit profession. In addition, the case provides

students with an opportunity to understand how a lack of independence may impact the

objectivity of auditors and potentially lead to biased professional judgments. To meet these

objectives, this case illuminates a number of relevant issues about the relationship that existed

between Arthur Andersen, the Fund of Funds (FOF), and King Resources Corporation (KRC).

In particular, the case focuses on the issues that can arise when the same audit firm conducts the

audit of two different organizations that share an important business relationship.









professional responsibilities/conduct topic or the independence topic in the auditing course. We

do believe that it is helpful to introduce the notion of an auditor's responsibility to financial

statement users before discussing how a lack of independence can potentially bias an auditor's

professional judgments. Specifically, we suggest that instructors do everything possible to

illustrate the tension that auditors face when attempting to maintain an attitude of independence

during the financial statement audit. Students need to realize that the nature of the auditing

process sometimes makes it difficult to remember that your primary responsibility when

completing an audit is to financial statement users, not to the audit client.

The difficulty starts with the nature of the business relationship, particularly prior to the

Sarbanes-Oxley Act of 2002. The audit firm is hired and is paid by the audit client. Thus, the

audit client can also fire the audit firm. This is a nontrivial dynamic that can make it difficult to

maintain your independence and an attitude of professional skepticism throughout the audit.

Another aspect that adds to this tension is the reality that auditors need the client’s cooperation in

order to complete their work at the audit client. This reality forces the auditor to build a strong

rapport with client personnel. Such a rapport also just makes life more enjoyable for the auditor,

who is forced to work with client personnel on a daily basis. Each of these examples can add to

the tension that auditors face on a daily basis but they must always remember that their primary

responsibility is to the financial statement users. Thus, they must always maintain their

independence and their professional skepticism throughout the audit.



Overall, the case questions are designed to demonstrate how important it is for auditors to

maintain an independent and objective attitude at all times. By making sure that the firm is

independent and objective, this helps to unsure that auditors will always make audit judgments

without any bias whatsoever. Indeed, we believe that it is helpful to remind students that they

have a professional responsibility to maintain an attitude of skepticism throughout the audit

process. One of the primary goals of the Sarbanes-Oxley Act of 2002 was to take steps to

improve the independence and objectivity of the audit process (e.g., Section 201).


1. What is auditor independence, and what is its significance to the audit profession?What is the difference between independence in appearance and independence infact? Based on the case information, do you believe that Arthur Andersen violatedany principles of auditor independence? Why or why not?

The second general standard of generally accepted auditing standards (GAAS) provides that,

“In all matters relating to the assignment, an independence in mental attitude is to be maintained

by the auditor or auditors.” If the auditor is not independent, the financial statements are

considered unaudited for all practical purposes. In cases where the SEC has found that a CPA

firm was not independent, in the meaning provided by the second general standard, it has

required that the financial statements be re-audited by another CPA firm. A lack of






Article IV of the AICPA’s Professional Code of Conduct requires that “a member in public

practice should be independent in fact and appearance when providing auditing and other



attestation services.” To be independent in fact, an auditor must have integrity, a character of

intellectual honesty and candor; and objectivity, a state of mind of judicial impartiality that

recognizes an obligation of fairness to current and prospective management and owners of a

client, creditors and other stakeholders. To be independent in appearance, the auditor must not

have any obligations or interests in the client, its management, or its owners, that could cause

others to believe the auditor is biased with respect to the client, its management, or its owners. It

is important that even if an auditor maintains independence in fact, that independence in

appearance is also maintained. Without being independent in appearance, the value that the audit

function has to the public is weakened or lost. Given the facts and circumstances of the case,

there are some concerns.

2. Consider that both KRC and FOF, including its NRFA, were audited by ArthurAndersen. In addition, Arthur Andersen audited King’s personal accounts. Do youbelieve these relationships impaired the independence of Arthur Andersen? Why orwhy not?

While it may be possible for the Arthur Andersen auditors to remain objective and unbiased

(unless the auditor was auditing his/her own work), the interrelationships among the entities

would make it very difficult to do so. Indeed, while the AICPA Code of Professional Conduct

does not specifically preclude auditors from performing audit services for clients that are

interrelated, it is absolutely essential that auditors perform all of their duties in an objective,

unbiased manner.

In this case, the public may perceive the interdependency of KRC and FOF (since essentially

NRFA’s financial statements rely upon information generated from KRC) as a violation of

independence in appearance. This is particularly true since the partner and manager assigned to

the KRC audit also had the same responsibilities on the NRFA audit. The bottom line is that



students need to consider whether the interrelationship would possibly impair the professional

judgments of the partner and/or manager.

3. Would your answer change if different partners were assigned to both the KRCaudit and the NRFA audit? Assume that both audit teams were completelydifferent. Why or why not would your answer be different?

The answer might be different. As stated previously, the relationships do not explicitly

violate independence in fact (unless the auditor was auditing his/her own work). However, there

is still a question as to whether independence in appearance has been violated. The fact that

there would now be completely different audit teams does help to mitigate the possible

independence in appearance concern. However, the dependency of NRFA’s financial statements

on the information presented by KRC still poses a potential issue of concern. It is certainly

possible that the investing public would still believe that this interdependency might impair

Arthur Andersen’s ability to be objective and unbiased in performing its duties. The bottom line,

again, is that students must consider whether the interdependency would impair the professional

judgments of the auditors.

4. Refer to Sections 201, 203, and 206 of SARBOX. Based on your understanding ofthe FOF audit, do you believe these sections were needed? Why or why not? Bespecific.

Section 201 says that “it shall be unlawful for a registered public accounting firm to provide

any non-audit service to an issuer contemporaneously with the audit, including: (1) bookkeeping

or other services related to the accounting records or financial statements of the audit client; (2)

financial information systems design and implementation; (3) appraisal or valuation services,

fairness opinions, or contribution-in-kind reports; (4) actuarial services; (5) internal audit

outsourcing services; (6) management functions or human resources; (7) broker or dealer,

investment adviser, or investment banking services; (8) legal services and expert services



unrelated to the audit; (9) any other service that the Board determines, by regulation, is

impermissible.” Importantly, the bill allows an accounting firm to “engage in any non-audit

service, including tax services,” that is not listed above, only if the activity is pre-approved by

the audit committee of the issuer. The audit committee is required to disclose to investors in its

periodic filings its decision to pre-approve non-audit services. Section 203 says that “the lead

audit or coordinating partner and the reviewing partner must rotate off of the audit every 5

years.”

Based on the case information provided, Section 201 would not have had much of an impact

on the Fund of Funds audit. However, Section 203 of the Sarbanes-Oxley Act would clearly

apply to the FOF audit as the lead audit partner and the concurring review audit partner would

have to rotate off of the audit after five years of serving in this capacity. It is likely that this

provision would have indirectly reduced the likelihood that the same partner would have been

auditing both FOF and KRC, depending on the rotation schedule.

Given the importance for auditors to remain objective and unbiased in completing their

professional duties, most would agree that these sections of the law were needed. For example,

Section 201 prevents accounting firms from offering audit services in conjunction with certain

non-audit services, such as human resources. The intent is to make sure that the audit firm is

only focused on the audit and does not have to worry about whether judgments made on the audit

may impact the ability of the firm to “win” other professional service contracts from the audit

client. In addition, by requiring audit partners to rotate, Section 203 helps to mitigate the

possibility of audit partners becoming too “close” with management at their clients. The law is

therefore designed to ensure that auditors are always unbiased and independent in completing

their audit duties.



Case #2.7– Bernard L. Madoff Investment and Securities: A Focus onAuditors’ Legal Liability and Due Care





The Securities Act of 1933

Section 24

The Securities Exchange Act of 1934

Section 32



firm exercising due care in completing the audit and the consequences associated with a failure

to do so. It is important to emphasize to students that such the consequences attach to both the

firm and to the individual auditors involved. To meet these objectives, this case illuminates a

number of relevant issues that have surfaced about the audits of Bernie Madoff’s company,

Bernard L. Madoff Investment and Securities (BLMIS) by the accounting firm Friehling &

Horowitz.







impart the relevant technical knowledge about the Securities Act of 1933 and Section 32 of the

Securities Exchange Act of 1934, outlined above. In our opinion, this case assignment will work

best if is scheduled to coincide with the auditors’ legal liability and/or auditors' professional

responsibilities topic in the auditing course. Alternatively, the case can be used in connection

with a discussion of quality control at an audit firm.

We recommend that instructors begin the case discussion with an overview of what is

meant be a “Ponzi” scheme. In our experience, students are likely to have heard this term, but

are not likely to fully understand what is meant by the term. A Ponzi scheme is any fraudulent

investment plan that pays its returns to an investor from either that investor’s own funds or those

paid by other investors in the future. Next, we believe that instructors should take the time to

reinforce the Responsibilities principle under Generally Accepted Auditing Standards. This can

be accomplished quite effectively while going over question number one and two. We also

recommend that instructors spend time explaining the nature of an auditor’s legal liability under

both common law and statutory law. Thus, we believe that this case can be an effective tool to

help students understand the differences between common law and statutory law which can often

be difficult for students. We believe that this discussion can be accomplished quite effectively

while going over question number three and four.


1. Refer to the Fundamental Prinicples governing an audit. Under the ResponsibilitiesPrinciple, auditors are required to exercise due care and maintain professionalskepticism throughout the audit. Based on the case information, do you believe that theauditors from Friehling & Horowitz exercised due care and maintained professionalskepticism throughout the audit? Why or why not?



Based on the case information, due care was not exercised during the audit of BLMIS.

According the Responsibilities Principle, auditors are responsible for “maintaining professional

skepticism and exercising professional judgment throughout the planning and performance of the

audit. This was clearly not exhibited by the auditors at Friehling & Horowitz on the BLMIS

audit.

Friehling & Horowitz did not conduct any independent confirmations of BLMIS’s assets,

liabilities, sales and other revenues during the audit. Thus the existence and validity of these line

items was never tested. In addition, the auditors did not test to determine whether any internal

controls were in place at BLMIS to prevent fraud. Finally, Friehling & Horowitz neglected to

send independent confirmations for BLMIS’s bank statements. The bottom line is that that the

auditors did not gather and then objectively evaluate enough evidence to render an opinion,

based on the case information. So, they did not fulfill the Responsibilities Principle under

GAAS.

2. Consider the charges brought against the BLMIS auditor, Friehling regarding hisfailure to complete certain audit steps. If you were auditing BLMIS, what type ofevidence would you like to review to determine whether BLMIS had truly purchased,sold and maintained proper custody of investment securities?

According to paragraph #21 of AU Section 326, “To be competent, evidence, regardless of

its form, must be both valid and relevant.” Indeed, “the validity of evidential matter is so

dependent on the circumstances under which it is obtained that generalizations about the

reliability of various kinds of evidence are subject to important exceptions.” So, the competence

of audit evidence refers to the quality of the evidence gathered for a financial statement assertion

about a financial statement account balance and/or an economic transaction(s). And, as indicated

in the standard, there are two aspects to evidence quality that are most important: relevance and

reliability. The relevance of audit evidence specifically relates to whether the evidence gathered



actually relates to the financial statement assertion being tested. That is, will the evidence allow

the auditor to reach conclusions related to that financial statement assertion?

The reliability of the evidence specifically relates to whether the evidence gathered can truly

be relied upon as providing a true indication about the financial statement assertion being tested.

There are a number of factors that should influence an auditor’s conclusions about reliability, the

most important of which is the source (e.g., is it from a third party?) of the audit evidence.

According to paragraph #22 of AU Section 326, “The amount and kinds of evidential

matter required to support an informed opinion are matters for the auditor to determine in the

exercise of his or her professional judgment after a careful study of the circumstances in the

particular case.” So, the sufficiency of audit evidence refers directly to the quantity of the audit

evidence gathered about a financial statement assertion. All things being equal, the greater the

risk of material misstatement related to the financial statement assertion, the more audit evidence

will be gathered by the auditor.

Of course, auditors need to gather evidence that explicitly relates to the relevant assertion

being tested. Thus, the answer to this question may vary depending on the specific assertion

being tested in the circumstances. When auditing the purchase of securities, an auditor would

likely seek to vouch a sample of the purchases to external supporting documentation. When

auditing the custody of securities, an auditor would likely seek to confirm directly with the

financial institution that was serving as the custodian for the securities.

3. Consider an auditor’s common law liability to third parties. Please describe thedifference between the three levels of failure to exercise professional care, ordinarynegligence, gross negligence and fraud. Based on the case information, please commenton the possible level of failure that was seemingly exhibited by Friehling & Horowitz.Are there any mitigating factors to help defend the actions of the auditing firm?



Ordinary negligence can be defined as “an unintentional breach of duty owed to another

party” due to the lack of reasonable care. Gross negligence can be defined as a “breach of duty

owed to another party” due to the lack of even minimal care. Finally, fraud can be defined as

wholly misrepresenting the facts that an auditor knows is a false misrepresentation. So, with

fraud, there is intent to deceive.

The BLMIS auditor, Friehling & Horowitz, failed to conduct, examine, and test certain

aspects of BLMIS’s financials which ultimately resulted in the continuation of BLMIS’s fraud.

At the present level of understanding, there is not enough information to know whether this is an

example of gross negligence or fraud. Stated simply, at the present time, we cannot be

absolutely sure that deception was intentional here, but fraud is clearly possible, depending on

the final facts and circumstances that come to light.

4. Consider Section 24 of the Securuties Act of 1933 and Section 32 of the SecuritiesExchange Act of 1934. Do you believe an auditing firm should be held criminallyresponsible for a fraud committed by its client’s management team? Next, based on thecase information, do you believe that the BLMIS auditor, Friehling, should be facingcriminal charges? Why or why not?

According to Section 24 of the Securities Act of 1933, there can be criminal penalties

imposed on an auditor. In order for an auditor to be subject to criminal penalties, there must be a

willful violation by the auditors. That is, they must have “willfully” caused material misstated

financial statements to be filed. As a result, this is very difficult to prove.

According to Section 32 of the Securities Exchange Act of 1934, there can be criminal

penalties imposed on the auditor. In order for the auditor to be subject to criminal penalties, the

critical test is whether the auditor “willfully and knowingly” knew about the misstatement in the

financial statements.



In the case of Friehling & Horowitz, we do not have enough facts to know if the criteria for

criminal penalties has been met as of yet. However, it is certainly possible that the auditor could

be held criminal responsible. Consider that since 1993, Friehling & Horowitz intentionally told

the AICPA that he was not performing audits, which was not true. It is certainly possible that the

firm lied about completing audits to avoid peer review. But, at this point, we just do not know

all of the facts. So, it is not yet clear if the auditors should be held criminally responsible.



Case #2.8 – Enron: Audit Documentation






Paragraph 2Paragraphs 4-6Paragraphs 14-15


Section 103


This case provides students with an opportunity to understand what is meant by audit

documentation in the financial statement audit process and to understand why the retention of

audit documentation is an important quality control mechanism for an audit firm. Further, the

case provides a terrific example for students to see what can actually happen when a quality

control mechanism breaks down at an audit firm. In the case of Arthur Andersen, the breakdown

in quality control ultimately led to the demise of the firm. To meet these objectives, this case

illuminates the circumstances surrounding the shredding of evidence related to the Enron audit

that occurred in the fall of 2001 by auditors at Arthur Andersen.








This case assignment will work best if is scheduled to coincide with a discussion of audit

documentation and/or an auditor firm’s quality control process. We believe that it is critical to

stress the importance of maintaining adequate audit documentation at an audit firm. This will

naturally lead to a discussion of the quality control process at audit firms.

Of course, in January 2002, Arthur Andersen fired Duncan for his lead role in the

shredding of documents. After Duncan pled guilty to the crime of obstruction of justice, the US

Justice Department filed a criminal indictment against Arthur Andersen in March 2002. The

entire firm was indicted because of the several offices that had worked on the Enron account and

that had been involved with shredding documents.1 The indictment signaled the beginning of the

end for Enron’s auditor Arthur Andersen LLP, one of the five largest international public

accounting firms.

In May 2002, Andersen was convicted on one charge of obstruction of justice in

connection with the shredding of documents related to the Enron audit. And although this

conviction was overturned in May 2005 by the United States Supreme Court, Andersen’s

decision to destroy evidence cast suspicion on whether Andersen was trying to cover up any guilt

related to a failure to perform its professional responsibilities.

1 Susan E. Squires, Cynthia J. Smith, Lorna McDougal, William R. Yeack, Inside Arthur Andersen (Upper SaddleRiver, NJ: Prentice Hall, 2003), p. 127-128.




1. Consult Paragraph 2 of PCAOB Auditing Standard No. 3. Define auditdocumentation. Why is it important for an auditor to retain audit documentationfor a specific period of time?

According to Paragraph #2 of PCAOB Auditing Standard No. 3 audit documentation is

“the written record of the basis for the auditor's conclusions that provides the support for the

auditor's representations, whether those representations are contained in the auditor's report or

otherwise.” Audit documentation aids in the, “planning, performance, and supervision of the

engagement.” As a result audit documentation can be used as the basis in reviewing the quality

of the work because it is a written documentation that can be used as evidence for the audit

conclusion. Audit documentation can be a, “record of the planning and performance of the work,

the procedures performed, evidence obtained, and conclusions reached by the auditor. Audit

documentation is also known as work papers or working papers.” It is important for an auditor

to retain documentation for a specific period of time because it represents the written evidence

that the auditor has completed his/her work in accordance with generally accepted auditing

standards.

2. Refer to Section 103 of SARBOX. Do you believe that this provision of the law goesfar enough; that is, do you believe that the law is adequate related to auditdocumentation requirements? Why or why not?

According to Section 103 of SOX, the “PCAOB shall: 1) register public accounting firms; 2)

establish, or adopt, by rule, “auditing, quality control, ethics, independence, and other standards

relating to the preparation of audit reports for issuers; 3) conduct inspections of accounting firms;

4) conduct investigations and disciplinary proceedings, and impose appropriate sanctions; 5)

perform such other duties or functions as necessary or appropriate; 6) enforce compliance with

the Act, the rules of the Board, professional standards, and the securities laws relating to the



preparation and issuance of audit reports and the obligations and liabilities of accountants with

respect thereto; 7) set the budget and manage the operations of the Board and the staff of the

Board.” In addition, the Board must require registered public accounting firms to “prepare, and

maintain for a period of not less than 7 years, audit work papers, and other information related to

any audit report, in sufficient detail to support the conclusions reached in such report.” There are

a number of allowable answers to the second part of the question. The absolute key is for a

student to try and justify his or her position.

3. Consult Paragraphs 4-6 of PCAOB Auditing Standard No. 3. In your own words,describe what is expected to be documented in the audit workpapers for eachrelevant financial statement assertion.

There are a number of allowable answers to this question as each student will be answering

the question in his/her own words. The absolute key is that the student’s responses reflect an

understanding of the relevant paragraphs from the standard. Please consider the following.

According to Paragraph #4 of Auditing Standard No. 3, “the auditor must prepare audit

documentation in connection with each engagement conducted pursuant to the standards of the

PCAOB. Audit documentation should be prepared in sufficient detail to provide a clear

understanding of its purpose, source, and the conclusions reached. Also, the documentation

should be appropriately organized to provide a clear link to the significant findings or issues.

Examples of audit documentation include memoranda, confirmations, correspondence,

schedules, audit programs, and letters of representation. Audit documentation may be in the form

of paper, electronic files, or other media.”

According to Paragraph #6 of Auditing Standard No. 3, the “auditor must document the

procedures performed, evidence obtained, and conclusions reached with respect to relevant

financial statement assertions. Audit documentation must clearly demonstrate that the work was



in fact performed. This documentation requirement applies to the work of all those who

participate in the engagement as well as to the work of specialists the auditor uses as evidential

matter in evaluating relevant financial statement assertions. Audit documentation must contain

sufficient information to enable an experienced auditor, having no previous connection with the

engagement: a) To understand the nature, timing, extent, and results of the procedures

performed, evidence obtained, and conclusions reached; and b) To determine who performed the

work and the date such work was completed as well as the person who reviewed the work and

the date of such review.”

4. Consult Paragraphs 14-15 PCAOB Auditing Standard No. 3. Do you believe thatthe shredding of documents acquired during the audit process still occurs? Why orwhy not?

According to Paragraph 14 of PCAOB Auditing Standard No. 3, “The auditor must retain

audit documentation for seven years from the date the auditor grants permission to use the

auditor's report in connection with the issuance of the company's financial statements (report

release date), unless a longer period of time is required by law.”

According to paragraph 15 of PCAOB Auditing Standard No. 3, “Prior to the report release

date, the auditor must have completed all necessary auditing procedures and obtained sufficient

evidence to support the representations in the auditor's report. A complete and final set of audit

documentation should be assembled for retention as of a date not more than 45 days after the

report release date (documentation completion date).”

Yes, as long as the documentation is not needed to support the auditor’s conclusion on a

particular audit, the shredding of documentation still likely occurs. However, if the evidence is

necessary to support an auditor’s conclusion, the shredding of audit documentation should not

occur.



5. Consider the actions of Andersen lawyer Nancy temple and practice directorMichael Odom. Do you believe that their actions were appropriate under thecircumstances? Why or why not?

Clearly, there are a number of allowable answers to this question. The absolute key is for a

student to try and justify his or her position. However, it must be made clear to students that as

soon as the SEC announced its decision to investigate the Enron matter, it was entirely

unacceptable for any employee at Andersen to shred any documentation related to the Enron

audit.



case #2.1 enron: independence - college test...

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