BRIEF CONTENTS SECTION 1 COMPREHENSIVE CASES 1 Case 1.1 Enron Corporation 3 Case 1.2 — Livent, Inc. 25 Case 13 Health Management, Inc. 41 Case14 AMRE, Inc. 61 Case1.5 The Leslie Fay Companies 71 Case 1.6 Star Technologies, Inc. 83 Case 1.7 Lincoln Savings and Loan Association 95 Case 18 Crazy Eddie, Inc. 109 Case 1.9 ZZZZ Best Company, Inc. 119 Case 1.10 ESM Government Securities, Inc. 135 Case 1.11 United States Surgical Corporation 149 Case 1.12 The Fund of Funds, Ltd. 161 SECTION 2 AupiTs OF HiGH-Risk ACCOUNTS 175 Case 2.1 Doughtie’s Foods, Inc. 177 Case 2.2 Flight Transportation Corporation 181 Case 2.3 J.B. Hanauer & Co. 187 Case 2.4 CapitalBanc Corporation 193 Case 2.5 General Technologies Group Ltd. 197 Case 2.6 Giant Stores Corporation 207 SECTION 3 INTERNAL CONTROL IssuEs 213 Case 3.1 The Trolley Dodgers 215 Case 3.2 Howard Street Jewelers, Inc. 217BRIEF CONTENTS: Case 3.3 Saks Fifth Avenue 221 Case 3.4 Triton Energy Ltd. 227 Case 3.5 Goodner Brothers, Inc. 237 Case 3.6 = Troberg Stores 245 SECTION 4 ETHICAL RESPONSIBILITIES OF ACCOUNTANTS 253 Case 4.1 Creve Couer Pizza, Inc. 255 Case 4.2. Jamaica Water Properties 259 Case 4.3 Suzette Washington, Accounting Major 269 Case 4.4 Oak Industries, Inc. 271 Case 4.5 F&C International, Inc. 277 Case 4.6 Laurel Valley Estates 283 Case 4.7 Rocky Mount Undergarment Company, Inc. 287 SECTION 5 ErHicaL RESPONSIBILITIES OF INDEPENDENT AUDITORS 291 = Case 5.1 Cardillo Travel Systems, Inc. 293 Case 5.2 The PTL Club 299 Case 5.3 Zaveral Boosalis Raisch 303 Case 5.4 Mallon Resources Corporation 307 Case 5.5 Ryden Trucking, Inc. 313 Case 5.6 Koger Properties, Inc. 317 Case 5.7. American Fuel & Supply Company, Inc. 321 SECTION 6 PROFESSIONAL ROLES 325 —————————— Case 6.1 Leigh Ann Walker, Staff Accountant 327 Case 6.2 Bill DeBurger, In-Charge Accountant 331 Case 6.3 Sarah Russell, Staff Accountant 335 Case6.4 Tommy O’Connell, Audit Senior 339 Case 6.5 Avis Love, Staff Accountant 343 Case 6.6 Charles Tollison, Audit Manager 347 Case 6.7 Hamilton Wong, In-Charge Accountant 351 SECTION 7 PROFESSIONAL IssUES 355 Oe Case 7.1 CPA2Biz.com 357 Case 7.2. National Medical Transportation Network 369 Case 7.3 Texas Drug Warehouse 377BRIEF CONTENTS Case 7.4 Case 7.5 Case 7.6 Case 7.7 Case 7.8 Hopkins v. Price Waterhouse Taxing Transactions Scott Fane, CPA Stephen Gray, CPA Stock Option Mania SECTION 8 CLassic LITIGATION CASES Case 8.1 Case 8.2 Case 8.3 Case 8.4 Case 8.5 Fred Stern & Company, Inc. (UItramares Corporation v. Touche et al.) First Securities Company of Chicago (Ernst & Ernst v. Hochfelder et. al) 1136 Tenants Corporation Equity Funding Corporation of America National Student Marketing Corporation 381 397 403 409 419 421 429 441 447CONTENTS SECTION 1 COMPREHENSIVE CASES 1 Rene ee a EEE Case 1.1 Enron Corporation 3 Arthur Edward Andersen established a simple motto that he required his subor- dinates and clients to invoke: “Think straight, talk straight.” For decades, that motto served Arthur Andersen & Co. well. Unfortunately, the firm’s association with one client, Enron Corporation, abruptly ended Andersen's long and proud history in the public accounting profession. Key topics: history of the public accounting profession in the United States, scope of professional services provided to audit clients, auditor independence, retention of audit workpapers, and auditors’ responsibilities for a client’s quarterly finan- cial data. Case 1.2 Livent, Inc. 25 Garth Drabinsky built Livent, Inc., into a major force on Broadway during the 1990s. A string of successful Broadway productions resulted in numerous Tonys for the company. Despite Livent’s theatrical success, the financial affairs of the Canadian company were in disarray. Drabinsky and several of his top subordi- nates concealed Livent's financial problems from their independent auditors with a wide range of abusive accounting practices, Key topics: inherent risk factors unique to given industries, resolution of auditor- client disputes, revenue recognition, and criminal liability of auditors. Case 1.3 Health Management, Inc. 4 The Private Securities Litigation Reform Act (PSLRA) of 1995 amended the Securities Exchange Act of 1934. This new federal statue was projected to have a major impact on auditors’ legal liability under the 1934 Act. One of the first majortests of the PSLRA was triggered by a class-action lawsuit filed against BDO Seidman for its 1995 audit of Health Management, Inc., a New York-based phar- maceuticals distributor. Key topics: inventory audit procedures, auditor independence, audit workpa- pers, inherent risk factors, and auditors’ civil liability under the federal securities laws. Case 1.4 AMRE, Inc. 61 AMRE’s chief financial officer arranged a secret meeting with the company’s in- dependent auditors in a subtle but unsuccessful attempt to focus their attention on a fraudulent scheme masterminded by his superiors. Key topics: hiring of former auditors by audit clients, client-imposed audit scope limitations, auditors’ responsibility for unaudited quarterly financial data, and auditing large and suspicious write-offs by clients. Case 1.5 The Leslie Fay Companies 71 In January 2002, Paul Polishan, the former chief financial officer of The Leslie Fay Companies, began serving a nine-year prison sentence for fraudulently misrepre- senting Leslie Fay’s financial statements in the early 1990s. Among the defendants ina large class-action lawsuit stemming from the fraud was the company’s audit firm, BDO Seidman. Key topics: applying analytical procedures to a client's financial data, need for auditors to assess the health of a client's industry, identifying and assessing “red flags,” control environment issues, and auditor independence. Case 1.6 Star Technologies, Inc. 83 This computer manufacturer found itself trapped in its industry's short product life cycle. The company incurred heavy R&D expenditures to develop new prod- ucts only to have those products soon become obsolete. Management began tampering with the company’s accounting records to conceal its deteriorating fi- nancial condition. Key topics: auditor-client conflict, conflict between auditors, audit review process, auditing inventory, auditing the allowance for bad debts, classification of liabilities, and intercompany transactions. Case 1.7. Lincoln Savings and Loan Association 95 Charles Keating’s use of creative accounting methods allowed him to manufac- ture huge paper profits for Lincoln. Key topics: substance-over-form concept, detection of fraud, identification of key management assertions, collegial responsibilities of auditors, assessment of con- trol risk, and auditor independence. Case 1.8 Crazy Eddie, Inc. 109 “Crazy Eddie" Antar oversaw a profitable chain of consumer electronics stores on the East Coast during the 1970s and 1980s. After new owners discovered that the company’s financial data had been grossly misrepresented, Antar fled the coun- try, leaving behind thousands of angry stockholders and creditors.CONTENTS Key topics: auditing inventory, inventory control activities, management in- tegrity, the use of analytical procedures, and the hiring of former auditors by audit clients. Case 1.9 ZZZZ Best Company, Inc. ng Barry Minkow, the "boy wonder" of Wall Street, created a $200,000,000 company that existed only on paper. Key topics: identification of key management assertions, limitations of audit ev- idence, importance of candid predecessor-successor auditor communications, client confidentiality, and client-imposed audit scope limitations. Case 1.10 ESM Government Securities, Inc. 135 The ESM scandal rocked the international financial markets and resulted in one state imposing the first "banking holiday" in the United States since the Depression. Key topics: performance pressure exerted on auditors, the use of audit confirma- tion procedures, quality control in an auditing practice, and discovery of financial statement errors following the issuance of an audit report. Case 1.11 United States Surgical Corporation 149 An SEC investigation revealed that officials of this company went to great lengths to conceal irregularities in the company’s accounting records from its indepen- dent auditors. Key topics: the use of analytical procedures, accounting for revenue and capital expenditures, implications of the imbalance of power in the auditor-client rela- tionship, and evaluation of conflicting audit evidence. Case 1.12 The Fund of Funds, Ltd. 161 Bernie Cornfeld, John McCandish King, and Robert Vesco were among the parties associated with this once high-flying mutual fund. Key topics: detection of fraud, client confidentiality, materiality of financial state- ment errors, and auditors’ legal exposure under the Securities Exchange Act of 1934. SECTION 2 Aupits oF HicH-Risk ACCOUNTS 175 oan Case 2.1 Doughtie’s Foods, Inc. 177 Inadequate inventory observation procedures prevented this company’s auditors from discovering a materially overstated inventory balance. Case 2.2 Flight Transportation Corporation 181 This company’s auditors failed to investigate major weaknesses in its internal controls, which prevented them from uncovering a fraudulent scheme conceived by the firm’s top executives to inflate revenues.CONTENTS Case 2.3. J.B. Hanauer & Co. 187 This case focuses on the audit objectives for accounts receivables and accounts payable and illustrates inappropriate methods of applying confirmation proce- dures to both types of accounts. Case 2.4 CapitalBanc Corporation 193 What is the most important asset of a bank? Cash, of course. This case examines an audit that failed to uncover a large embezzlement scheme perpetrated by a bank’s chief executive officer. Case 2.5 General Technologies Group Ltd. 197 Inadequate audit planning, poor execution of audit procedures, and an ineffective quality review function resulted in General Tech’s audit firm failing to uncover material errors in the client’s work-in-process inventory. Case 2.6 Giant Stores Corporation 207 An SEC investigation revealed that Giant Stores’ top executives used a variety of methods to understate their company's accounts payable and to conceal those un- derstatements from their auditors. SECTION 3 INTERNAL CONTROL ISSUES 213 _M MM... Case 3.1 The Trolley Dodgers 215 Control deficiencies in the Dodgers’ payroll transaction cycle allowed an ac- counting manager to embezzle several hundred thousand dollars. Case 3.2. Howard Street Jewelers, Inc. 217 Given the susceptibility of cash to theft, companies typically establish rigorous in- ternal controls for their cash processing functions. This case documents the high price of failing to implement such controls. Case 3.3 Saks Fifth Avenue 221 Saks “zero tolerance” policy for employee theft was tested in this case by a sales clerk. After being dismissed, the employee tested Saks again by suing the firm for wrongful termination. Case 3.4 Triton Energy Ltd. 227 Recent years have witnessed a renewed interest by regulatory authorities in en- forcing the Foreign Corrupt Practices Act of 1977 (FCPA). Key executives of Triton Energy ignored the FCPA, including its internal control provisions. Case 3.5 Goodner Brothers, Inc. 237 An employee of this tire wholesaler found himself in serious financial trouble. To remedy this problem, the employee took advantage of his employer’s weak in-CONTENTS ternal controls by stealing a large amount of inventory, which he then sold to other parties. Case 3.6 Troberg Stores 245 An important but commonly overlooked internal control objective is ensuring “compliance with applicable laws and regulations.” The management of this company violated the provisions of a federal statute, imposing a heavy monetary cost on the company in the process. SECTION 4 _ ETHICAL RESPONSIBILITIES OF ACCOUNTANTS 253 eS Case 4.1 Creve Couer Pizza, Inc. 255 Intrigue and espionage seem far removed from accounting . . . but not in this case. Creve Couer’s CPA was actually a double agent. While providing accounting ser- vices to his client, the CPA also supplied incriminating evidence regarding the client to the IRS. Case 4.2 Jamaica Water Properties 259 Shortly after accepting an executive position with JWP, David Sokol discovered several suspicious items in the company’s accounting records. Sokol insisted on thoroughly investigating those items. When that investigation uncovered evi- dence of a pervasive fraud, Sokol resigned and turned over that evidence to the company’s board of directors. Case 4.3 Suzette Washington, Accounting Major 269 Suzette Washington was a college senior majoring in accounting when she came face-to-face with an important ethical decision. Since accounting majors are en- tering a profession with a rigorous code of ethics, do they have a greater respon- sibility than other students to behave ethically? Case 4.4 Oak Industries, Inc. 271 Top management of this company systematically misrepresented its operating results and financial condition. The company’s controller often questioned his su- periors’ decisions before acting as a “good soldier” and following their instructions. Case 4.5 F&C International, Inc. 277 A financial fraud spells the end of a company with a proud history and tests the ethics of several of its key management and accounting personnel. Case 4.6 Laurel Valley Estates 283 A young staff accountant wrongfully accused a client executive of criminal con- duct, The false accusation resulted in the accountant’s firm being sued by that executive.CONTENTS: Case 4.7. Rocky Mount Undergarment Company, Inc. 287 ‘You are the accountant of a corporation experiencing severe financial problems. Top company officials suggest that several hundred employees will lose their jobs unless you embellish the company’s financial data. Three employees of Rocky Mount faced this unpleasant dilemma during the mid-1980s. SECTION 5 ETHICAL RESPONSIBILITIES OF INDEPENDENT AUDITORS 291 ——_ $$ Case 5.1 Cardillo Travel Systems, Inc. 293 A top executive of Cardillo pressured and manipulated three accountants, the company’s controller, and two partners of public accounting firms, in an unsuc- cessful attempt to conceal the true nature of a fraudulent entry in the company’s accounting records. Case 5.2 The PTL Club 299 PTL officials convinced a partner of their independent audit firm to maintain a se- cret check register in his office to record illicit disbursements being made by the organization. Case 5.3 Zaveral Boosalis Raisch 303 Should auditor-client communications be “privileged”? In the late 1990s, a Colorado accounting firm fought a protracted legal battle over that issue with the Colorado State Board of Accountancy. Case 5.4 Mallon Resources Corporation 307 The common practice of auditors “changing sides” by accepting positions with clients raises several difficult-to-resolve issues for the public accounting profes- sion, Many of these issues are posed by this case that involves Mallon hiring one of its independent auditors for a key management position. Case 5.5 Ryden Trucking, Inc. 313 What responsibility, if any, does the management of an accounting firm have to an employee charged with criminal activity while working on a client engage- ment? That question is a central issue in this case that focuses on an employee of a Seattle-based accounting firm who embezzled thousands of dollars from one of her employer’s clients. Case 5.6 Koger Properties, Inc. 317 An audit partner’s firm obtains a client in which he has a small but direct finan- cial interest. The partner is then assigned to supervise the annual audit of that company. What should he do?CONTENTS Case 5.7 American Fuel & Supply Company, Inc. 321 This case focuses on the responsibility of auditors to recall an audit report when they discover previously undetected errors in a client’s audited financial state- ments. SECTION 6 PROFESSIONAL ROLES 325 Case 6.1 Leigh Ann Walker, Staff Accountant 327 In this case, a staff accountant employed by a large accounting firm is dismissed after serious questions arise regarding her integrity. Case 6.2 Bill DeBurger, In-Charge Accountant 331 "To sign off" or "not sign off" was the issue facing Bill DeBurger after he com- pleted the audit procedures for a client's most important account. An angry con- frontation with the audit engagement partner made Bill’s decision even more difficult. Case 6.3 Sarah Russell, Staff Accountant 335 Sexual harassment is a sensitive subject that many companies and professional firms have been forced to contend with in recent years. This case recounts the ex- periences of a staff accountant who was harassed by an audit partner. Case 6.4 Tommy O'Connell, Audit Senior 339 A new audit senior is quickly exposed to the challenging responsibilities of his professional work role when he is assigned to supervise a difficult audit engage- ment. During the audit, the senior must deal with the possibility that a staff ac- countant is not completing his assigned audit procedures. Case 6.5 Avis Love, Staff Accountant 343 Auditors often develop close friendships with client personnel. Such friendships can prove problematic for auditors, as demonstrated by this case. Case 6.6 Charles Tollison, Audit Manager 347 Audit managers, such as Charles Tollison, occupy an important role on audit en- gagements and are a critical link in the employment hierarchy of public account- ing firms. Case 6.7 Hamilton Wong, In-Charge Accountant 351 “Eating” or underreporting time worked on audit engagements has important implications for the quality of audit services and for the quality of auditors’ work environment. Hamilton Wong came face-to-face with these issues when a col- league insisted on understating the hours she worked on her assignments.CONTENTS SECTION 7 PROFESSIONAL ISSUES 355 OO ——————— Case 7.1 CPA2Biz.com 357 Many parties, including prominent CPAs, have criticized top officials of the AICPA in recent years. The harshest of this criticism resulted from the AICPA’s decision to allow Barry Melancon, the organization’s president and chief execu- tive officer, to purchase—at an alleged bargain basement price—a substantial ownership interest in the profession’s new Internet portal. Case 7.2 National Medical Transportation Network 369 Under what circumstances does an accounting firm have a right and responsibil- ity to withdraw from an audit engagement? After Deloitte resigned as Med Trans’ independent auditor, the accounting firm was sued for not completing the audit that was in progress. Case 7.3. Texas Drug Warehouse 377 In the late 1990s, KPMG found itself a defendant in a lawsuit filed by a former client. Among other allegations, the former client charged that KPMG had en- gaged in “deceptive business practices” by failing to inform client management that it planned to change the scope and nature of its annual audit of the company. Case 7.4 Hopkins v. Price Waterhouse 381 This case explores the unique problems faced by women pursuing a career in public accounting. Case 7.5 Taxing Transactions 391 Major accounting firrns have been criticized recently for some of the innovative services they have begun offering to their clients. This case examines one such service, namely, the provision of creative tax shelter or tax avoidance plans. Case 7.6 Scott Fane, CPA 397 Scott Fane moved from New Jersey to Florida in hopes of establishing a success- ful accounting practice. Scott soon found that differing ethics rules for CPAs in the two states had important implications for his new firm. Case 7.7 Stephen Gray, CPA 403 This practicing CPA challenged an ethical rule that banned CPAs from receiving commissions. Although the CPA lost in court, the state board of accountancy later changed the controversial rule. Case 7.8 Stock Option Mania 409 Some of the largest public accounting firms have been charged with “kowtow- ing” to the economic interests of their clients when it comes to new accounting tules proposed by the FASB. This case examines this issue in the context of the firestorm of controversy that has surrounded the new accounting standard for compensatory stock options.CONTENTS SECTION 8 CLassic LITIGATION CASES 419 ———— Case 8.1 Fred Stern & Company, Inc. (Ultramares Corporation v. Touche et al.) 421 This 1931 legal case established the Ultramares Doctrine that seven decades later still has a pervasive influence on auditors’ civil liabilities under the common law. Case 8.2 First Securities Company of Chicago (Ernst & Ernst v. Hochfelder et al.) 429 In reviewing this case, the Supreme Court defined the degree of auditor miscon- duct that must be present before a client can recover damages from an auditor in a lawsuit filed under the Securities Exchange Act of 1934. Case 8.3 1136 Tenants Corporation 437 The need for an explicit contractual agreement between a client and audit firm was made clear in this landmark case. Case 8.4 Equity Funding Corporation of America 441 The huge Equity Funding scandal demonstrated the critical need for auditors to maintain a high level of skepticism when planning and carrying out an audit. Case 8.5 National Student Marketing Corporation 447 ‘Two Big Eight accountants faced a long and grueling jury trial following their in- dictment on criminal fraud charges that stemmed from their audits of this once high-profile company.