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Case 4-4 Threats to Audit Independence
Katy Carmichael, CPA, was just promoted to audit manager in the technology sector at a large public accounting firm.
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She started at the firm six years ago and has worked on a number of the same client audits for multiple years. She prefers being placed on same client audits year over year as she believes her knowledge about the client grows each year, resulting in a better audit. Public accounting firms tend to do this as it provides continuity between the firm and the client and often results in a more efficient (less costly) audit as well.
Katy was thrilled to learn that she would be retaining three of her prior audit clients, including what she considers her favorite client (DGS – Drako Gaming Solutions). She has friendships with those in the financial reporting area including the CFO with whom she has makes joint business investments.
The audit planning for DGS’s next audit is about to begin. As is common practice with all audits, each member of the audit engagement team is asked to fill out a questionnaire about any type of relationship (personal, business, or financial) they might have (or any other member of the engagement team might have with the client company, any of its customers, suppliers, employees, or direct family members of their employees. Katy will soon be meeting with the firm’s compliance partner assigned to the DGS audit to go through the completed questionnaire. In that regard, answer the following questions.
1. Identify any potential threats to independence that exists based on the facts of the case. [150 words]
Assume Vick and Ethan are CPAs. Ethan Lester was seen as a “model employee” who deserved a promotion to CFO, according to Kelly Fostermann, the CEO of Fostermann Corporation, a Maryland-based, largely privately held company that is a prominent global designer and marketer of stereophonic systems. Kelly considered Lester to be an honest employee based on performance reviews and his unwillingness to accept the promotion, stating that he wasn’t ready yet for the position. Little did she know that Lester was committing a $50,000 fraud during 2015 by embezzling cash from the company. In fact, no one seemed to catch on because Lester was able to override internal controls. However, the auditors were coming in and to solidify the deception, he needed the help of Vick Jensen, a close friend who was the accounting manager. Lester could “order” Jensen to cover up the fraud but hoped he would do so out of friendship and loyalty. Besides, Lester knew Jensen had committed his own fraud two years ago and covered it up by creating false journal entries for undocumented sales, returns, transactions, and operating expenses.
Lester went to see Jensen and explained his dilemma. He could see Jensen’s discomfort in hearing the news. Jensen had thought he had turned the corner on being involved in fraud after he quietly paid back the $20,000 he had stolen two years ago. Here is how the conversation went.
“Vick, I need your help. I blew it. You know Mary and I split up 10 months ago.”
“Yes,” Vick said.
“Well, I got involved with another woman who has extravagant tastes. I’m embarrassed to say she took advantage of my weakness and I wound up taking $50,000 from company funds.”
“Ethan, what were you thinking?”
“Don’t get all moral with me. Don’t you recall your own circumstances?”
Vick was quiet for a moment and then asked, “What do you want me to do?”
“I need you to make some entries in the ledger to cover up the $50,000. I promise to pay it back, just as you did. You know I’m good for it.”
Vick reacted angrily, saying, “You told me to skip the bank reconciliations—that you would do them yourself. I trusted you.”
“I know. Listen, do this one favor for me, and I’ll never ask you again.”
Vick grew increasingly uneasy. He told Ethan he needed to think about it … his relationship with the auditors was at stake.
2. Analyze the facts of the case using the Fraud Triangle. Include a discussion of the weaknesses in internal controls. [150 words]
Case 6-2 Solutions Network, Inc. (a GVV case)
“We can’t recognize revenue immediately, Paul, since we agreed to buy similar software from DSS,” Sarah Young stated.
“That’s ridiculous.” Paul Henley replied. “Get your head out of the sand, Sarah, before it’s too late.”
Sarah Young is the controller for Solutions Network, Inc., a publicly owned company headquartered in Sunnyvale, California. Solutions Network has an audit committee with three members of the board of directors that are independent of management. Sarah is meeting with Paul Henley, the CFO of the company on January 7, 2019, to discuss the accounting for a software systems transaction with Data Systems Solutions (DSS) prior to the company’s audit for the year ended December 31, 2018. Both Young and Henley are CPAs.
Young has excluded the amount in contention from revenue and net income for 2018, but Henley wants the amount to be included in the 2018 results. Without it, Solutions Network would not meet earnings expectations. Henley tells Young that the order came from the top to record the revenue on December 28, 2018, the day the transaction with DSS was finalized. Young points out that Solutions Network ordered essentially the same software from DSS to be shipped and delivered early in 2019. Therefore, according to Young, Solutions Network should delay revenue recognition on this “swap” transaction until that time. Henley argues against Sarah’s position, stating that title had passed from the company to DSS on December 31, 2018, when the software product was shipped FOB shipping point.
Solutions Network, Inc., became a publicly owned company on March 15, 2014, following a successful initial public offering (IPO).
Solutions Network built up a loyal clientele in the three years prior to the IPO by establishing close working relationships with technology leaders, including IBM, Apple, and Dell Computer. The company designs and engineers systems software to function seamlessly with minimal user interface. There are several companies that provide similar products and consulting services, and DSS is one. However.
DSS operates in a larger market providing IT services management products that coordinate the entire business infrastructure into a single system.
Solutions Network grew very rapidly during the past five years, although sales slowed down a bit in 2018. The revenue and earnings streams during those years are as follows:
On December 28, 2018, Solutions Network offered to sell its Internet infrastructure software to DSS for its internal use. In return, DSS agreed to ship similar software 30 days later to Solutions Network for that company’s internal use. The companies had conducted several transactions with each other during the previous five years, and while DSS initially balked at the transaction because it provided no value added to the company, it did not want to upset one of the fastest-growing software companies in the industry. Moreover, Solutions Network might be able to help identify future customers for DSS’s IT service management products.
The $15 million of revenue would increase net income by $1.0 million. For Solutions Network, the revenue from the transaction would be enough to enable the company to meet targeted goals, and the higher level of income would provide extra bonus money at year-end for
Young, Henley, and Ed Fralen, the CEO.
In her discussions with Henley. Young points out that the auditors will arrive on January 15, 2019; therefore, the company should be certain of the appropriateness of its accounting before that time. After all, says Young, “the auditors rely on us to record transactions properly as part of their audit expectations.” At this point Henley reacts angrily and tells Young she can pack her bags and go if she doesn’t support the company in its revenue recognition of the DSS transaction. Young is taken aback. Henley seems unusually agitated.
Perhaps he was under a lot more pressure to “meet the numbers” than she anticipated. To defuse the matter. Young makes an excuse to end the meeting prematurely and asks if they could meet on Monday morning, after the weekend. Henley agrees.
Over the weekend, Sarah Young calls her best friend, Shannon McCollough, for advice. Shannon is a controller at another company and Sarah would often commensurate with Shannon over their mutual experiences. Shannon suggests that Sarah should explain to Paul Henley exactly what her ethical obligations are in the matter. Shannon thinks it might make a difference because Paul is a CPA as well.
After the discussion with Shannon, Sarah considers whether she is being too firm in her position. On the one hand, she knows that regardless of the passage of title to DSS on December 31. 2018, the transaction is linked to Solutions Network’s agreement to take the DSS product 30 days later. While she doesn’t anticipate any problems in that regard, Sarah is uncomfortable with the recording of revenue on December 31 because DSS did not complete its portion of the agreement by that date. She has her doubts whether the auditors would sanction the accounting treatment.
On the other hand, Sarah is also concerned about the fact that another transaction occurred during the previous year that she questioned but, in the end, went along with Paul’s accounting for this transaction. On December 28, 2017, Solutions Network sold a major system for $20 million to Laramie Systems but executed a side agreement with Laramie on that date which gave Laramie the right to return the product for any reason within 30 days. Even though Solutions Network recorded the revenue in 2017 and Sarah felt uneasy about it, she did not object because Laramie did not return the product; her acceptance was motivated by the delay in the external audit until after the
30-day period had expired. Now, however, Sarah is concerned that a pattern may be developing.
3. Evaluate whether the actions of Paul Henley of Solutions Network represent ethical or unethical earnings management. [150 words]
4. Describe the basic features of the Revised AICPA Code of Professional Conduct. [120 words]
5. Campus Fast is a new audit client. Campus Fast uses public WiFi to place and deliver restaurant take out for students at the Up and Coming State University. Campus Fast was founded by three highly ambitious MBA students at the university. The business plan is to find a buyer or place an IPO of the company by graduation in two years. The founders expect to pay off all student loans, take a tour around the world, and then start another company. In order for the business plan to work on the timeline for graduation, the business must meet highly ambitious earnings numbers. Additionally, the company is dealing with two situations that the founders would like to keep from the auditors: [120 words]
6. Categorize the financial shenanigans in the fraud case at Lucent. [120 words]