Beauda Medical Center Lance Popperson woke up in a sweat. He felt an anxiety attack coming on. Popperson popped two anti-anxiety pills, laid down to try and sleep for the third time that night, and thought once again about his dilemma. Popperson is an associate with the accounting firm of Scoop and Shovel LLP. He recently discovered, through a casual conversation with Brad Snow, a friend of his on the audit staff, that one of the firm’s clients managed by Snow recently received complaints that its heart monitoring equipment was malfunctioning. Cardio-Systems Monitoring, Inc. (CSM) called for a meeting of the lawyers, auditors, and top management to discuss what to do about the complaints from health care facilities that had significantly increased between the first two months of 2010 and the last two months of that year. Doctors at these facilities claim the systems shut off for brief periods and, in one case, the hospital was unable to save a patient that went into cardiac arrest. Popperson got out of bed, went for a glass of water, looked at the clock that said 2:58am, and tried to sleep for the fourth time. He tossed and turned and wondered what he should do about the fact that Beauda Medical Center, his current audit client, plans to buy 20 units of Cardio-Systems heart monitoring equipment for its brand new medical facility in the outskirts of Beauda. This case discusses when and how to keep confidentiality of a client. Ethical Issues The CPA promises confidentiality to his clients so the client will trust him with information needed to perform an audit of the financial statements taken as a whole. Clients have a right to expect accountants to honor the promise of confidentiality. If the CPA should tell Beauda Medical Center confidential information about CSM, why would Beauda trust the CPA not to tell Beauda’s confidential information? The threat of harm or death to patients may be significant so Popperson should try to get CSM to correct or disclose the problem. If Popperson discloses the confidential information to Beauda, Beauda would probably cancel the order of 20 units. Would that cancellation cause financial distress or bankruptcy for CSM? Using virtue theories, the values of trustworthiness, respect, responsibility, fairness, caring and citizenship are challenged by the dilemma. Using utilitarianism theories, Popperson and the firm will have to decide whether keeping confidentiality or telling of harm to patients provides the greatest good. Questions Assume both Popperson and Snow are CPAs. Do you think Snow violated his confidentiality obligation under the AICPA Code of Professional Conduct by informing Popperson about the faulty equipment at CSM? Why or why not?Popperson has not told anyone connected to the Beauda Medical Center audit about the situation at CSM. What do you think he should do with the information? Be sure to consider are Popperson’s ethical obligations in answering this question. Assume Popperson informs the senior in charge of the Beauda audit and the senior informs the manager, Kelly Korn. A meeting is held the next day with all parties in the office of Iceman Cometh, the managing partner of the firm. Here’s how it goes: Iceman: If we tell Beauda about the problems at CSM, we will have violated our confidentiality obligation as a firm to CSM. Moreover, we may lose both clients. Kelly: Lance, you are the closest to the situation. How do you think Beauda’s top hospital administrators would react if we told them? Lance: They wouldn’t buy the equipment. Iceman: Once we tell them, we’re subject to investigation by our State Board of Accountancy for violating the confidentiality obligation we have to CSM. We don’t want to alert the board and have it investigate our actions. What’s worse is we may be flagged for the confidentiality violation in our next peer review. Kelly: Who would do that? I mean, CSM won’t know about it and the Beauda people are going to be happy we prevented them from buying what may be faulty equipment. Senior: I agree with Kelly. They are not likely to say anything. Iceman: I don’t like it. I think we should be silent and find another way to warn Beauda Medical without violating confidentiality. Lance: What about contacting the state board for advice? Follow-up questions 3 (a) Discuss all ethical and professional matters of concern for the firm of Scoop and Shovel LLP, in deciding whether to do as Iceman Cometh suggests and not tell the administrators at Beauda Medical Center? (b) What do you think about Lance’s suggestion to contact the state board for advice on the matter? Is that the function of a state board of accountancy? First Community Church First Community Church is the largest church in the city of Perpetual Happiness. Yes, it’s in California! A meeting was held on Friday, November 16 to address the fact that money had been stolen from the weekly collection box during the course of the year and church leaders were getting quite concerned. At first, no one paid much attention as the amounts were small and could have been attributed to inadvertent errors due to discrepancies between the actual count and what really was collected. However, after 45 weeks of the continuous discrepancies, the total amount of differences had become alarming. Eddie Wong, the controller for the church, estimated the total was now $23,399. That represents well over 5 percent of their annual collections from church members totaling about $400,000. The meeting began at 9am, a time that was early for the church leaders who often had late evening calls to make. The church staff brought donuts, bagels and coffee to help get the meeting off to a good start. But that’s not the way it happened. “I want an explanation,” said Allen Yuen, the executive director of the church. “The boards of trustees are on my back about this matter. Some of them talk about this Sarbanes-Oxley Act and our lack of internal controls. All it’s foreign to me but I know indignation when I see it!” “I can’t explain it, Allen,” responded Eddie Wong. “Jennie. How about you?” Yuen asked. He was addressing Jennie Lin, the member of the executive committee of the board of trustees who was directly responsible for the count each week. Jennie seemed uncomfortable. She hesitated before saying: “I think my count is correct. I take the money given to me by Joey, put it in the safe, and then Eddie opens the safe on Monday morning. He records the cash receipts and makes a bank deposit.” Eddie said, “That’s right. My deposit always matches the amount of money reported by Jennie.” “That doesn’t make sense,” Yuen said. “Someone is getting his or her hands on the money between the collection process and recording of the amount. I trust you, Jennie, to watch over these things and the internal control matter.” “Perhaps the tally amount record independently submitted by the church volunteers has been overstated.” Jennie said. “Why would that happen?” Yuen asked. “I mean, while it could happen and it would be an honest mistake, it seems unlikely.” Jennie was starting to sweat. She decided a diversion was in order. “Maybe someone gets their hands on the collection box after the tally and before Joey gives it to me.” Joey Ching is the accounting manager who delivers the collection box and tally sheet to Jennie after each service. Joey goes to church on a regular basis and volunteered to do the job in order to establish a control in the process. At this point Jennie lowered her head while she waited for a response. It came from Alex Yuen. “Jennie, are you accusing Joey of stealing money from the church collection box?” Jennie shook her head as if to say no. She was visibly upset. A phone call came in for Yuen and the meeting had to break up. The group agreed to continue the discussion in two days. In the meantime, Alan Yuen said he’d call Joey Ching and ask him to attend the next meeting. Jennie went back to her office, closed the door, and started to reflect on what she had just done. The truth is that Jennie had been taking the money each week and giving it to a homeless shelter two blocks from the church. Some of the homeless attend church services and Jennie has befriended many of them. She knew it was wrong to take money from the collection box, but she thought it was for a very good cause and that the church clergy would approve. She never thought about getting caught since she told the bookkeeper to record the lower amount. Now, she feels guilty about bringing Joey into the picture. This case looks at challenges facing many non-profits, using volunteers to provide internal controls. Ethical Issues Jennie has succumbed to the fraud triangle. Jennie is not fulfilling her fiduciary duty. By stealing monies, fraud and deceit, Jennie has committed acts discreditable to the profession. From the rights perspective, the church has a right to determine its donation to the shelter through the normal process. The church members have a right to expect the staff to uphold their fiduciary duties. From the deontology perspective, Jennie has a duty not to steal or take money without permission of the church. From a utilitarian perspective not all the constituencies of the church may have been considered. Questions Assume Jennie Lin is a CPA. Evaluate her actions from an ethical perspective. Jennie believed her actions were proper because taking the money from the church and giving it to the homeless served a greater good. Do you agree with her position from an ethical perspective? As a member of the board of trustees of the church, what are Jennie’s ethical obligations to the church? Do you think it is more difficult to establish strong internal controls in a nonprofit such as First Community Church as compared to a public or privately-owned company? Why or why not? (a) Assume Jennie calls Joey and explains the situation. She tells Joey about the impending call from Alex Yuen and, as a friend, asks him not to come to the meeting so she could explain what she has done without his involvement. If you were Joey, would you stay away from the meeting? Why or why not? 4. (b) Assume Joey stays away, Jennie explains why she did what she did, and, after due deliberation, Yuen fires Jennie and tells her she must replace the money she “stole” from the collection box. How would you evaluate Yuen’s actions from an ethical perspective? ZZZZ Best* The story of ZZZZ Best is one of greed and audaciousness. It is the story of a 15-year old boy from Reseda, California who was driven to be successful regardless of the costs. His name is Barry Minkow. Minkow had high hopes to make it big – to be a millionaire very early in life. He started a carpet cleaning business in the garage of his home. Minkow realized early on that he was not going to become a millionaire cleaning other people’s carpets. He had bigger plans than that. Minkow was going to make it big in the insurance restoration business. In other words, ZZZZ Best would contract to do carpet and drapery cleaning jobs after a fire or flood. Since the damage from the fire or flood probably would be covered by insurance, the customer would be eager to have the work done. The only problem with Minkow’s insurance restoration idea was that it was all a fiction. There were no insurance restoration jobs, at least for ZZZZ Best. In the process of creating the fraud, Minkow was able to dupe the auditors, Ernst & Whinney into thinking the insurance restoration business was real. In fact, over 80 percent of his revenue was allegedly from this work. The auditors never caught on until it was too late. How Barry Became a Fraudster Minkow wrote a book, Clean Sweep: A Story of Compromise, Corruption, Collapse, and Comeback** that provides some insights into the mind of a 15-year old kid __________________ * The facts are derived from a video by the ACFE, Cooking the Books: What Every Accountant Should Know about Fraud. **Barry Minkow, Clean Sweep: A Story of Compromise, Corruption, Collapse, and Comeback (Nashville, TN: Thomas Nelson, 1995). who was called a “wonder boy” on Wall Street until the bubble burst. He was trying to find a way to drum up customers for his fledgling carpet cleaning business. One day, while he was alone in the garage-office, Minkow called Channel 4 in Los Angeles. He disguised his voice to sound not like a teenager and told a producer that he had just had his carpets cleaned by the 16-year owner of ZZZZ Best and was very impressed that a high school junior was running his own business. He sold the producer on the idea that it would be good for society to hear the success story about a high school junior running his own business. The producer bought it lock, stock and carpet cleaner. Minkow gave the producer the phone number of ZZZZ Best and waited. It took less than five minutes for the call to come in. Minkow answered the phone and when the producer asked to speak with Mr. Barry Minkow, Minkow said: “Who may I say is calling?” Within days a film crew was in his garage shooting ZZZZ Best at work. The story aired that night and it was followed by more calls from radio stations and other television shows wanting to do interviews. People called demanding that Barry Minkow personally clean their carpets. As his income increased in the spring of 1983, Minkow found it increasingly difficult to run the company without a checking account. He managed to find a banker that was so moved by his story that the banker would agree to allow someone under-aged to open a checking account. Minkow used the money to buy cleaning supplies and other necessities. Even though his business was growing, Minkow ran into trouble paying back loans and interest when due. Minkow developed a plan of action. He was tired of worrying about not having enough money. He went to his garage – where all his great ideas first began – and he looked at his bank account statement which showed that he had more money than he thought he had based on his own records. Minkow soon realized it was because some checks he had written had not been cashed by customers so it didn’t yet shown up on the bank statement. Voila! Minkow started to kite checks between two or more banks. He would write a check on one ZZZZ Best account and deposit it into another. Since it might take a few days for the check written on bank number one to clear that banks’ records, at least back then when checks weren’t always processed in real time, Minkow could pay some bills out of the second account and the first bank would not know – at least for a few days – that Minkow had written a check on his account when, in reality, he had a negative balance. The bank didn’t know it because some of the checks that Minkow had written before the visit to bank number two had not cleared his account in bank number one. It wasn’t long thereafter that Minkow realized he could kite checks big-time. Not only that, he could make the transfer of funds at the end of a month or a year and show a higher balance than really existed in bank number one and carry it on to the balance sheet. Since Minkow did not count the check written on his account in bank one as an outstanding check, he was able to double-count. Time to Expand the Fraud Over time, Minkow moved on to bigger and bigger frauds like having his trusted cohorts confirm to banks and other interested parties that ZZZZ Best was doing insurance restoration jobs. Minkow used the phony jobs and phony revenue to convince bankers to make loans to ZZZZ Best. He had cash remittance forms made up from non-existent customers with whatever sales amount he wanted to appear on the document. He even had a co-conspirator write on the bogus remittance form, “job well done.” Minkow could then show a lot more revenue that he was really making. Minkow’s phony financial statements enabled him to borrow more and more money and expand the number of carpet cleaning outlets. However, Minkow’s personal tastes had become increasingly more expensive including purchasing a Ferrari with the borrowed funds and putting a down payment on a 5,000-square foot home. So, the question was: How do you solve a perpetual cash flow problem? You go public! That’s right, Minkow made a public offering of stock in ZZZZ Best. Of course he owned a majority of the stock to maintain control of the company. Minkow had made it to the big leagues. He was on Wall Street. He had investment bankers, CPAs and attorneys all working for him -- the 15-year old kid from Reseda who had turned a mom and pop operation into a publicly-owned corporation. Barry Goes Public Minkow’s first audit was for the twelve months ended April 30, 1986. A sole practitioner performed the audit. (There are eerie similarities in the Madoff fraud with its small practitioner firm – Frichling & Horowita – conducting the audit of a multi-billion dollar operation and that of the sole practitioner audit of ZZZZ Best). Minkow had established two phony front companies that allegedly placed insurance restoration jobs for ZZZZ Best. He had one of his cohorts make out invoices for services and respond to questions about the company. There was enough paperwork to fool the auditor into thinking the jobs were real and the revenue was supportable. However, the auditor never visited any of the insurance restoration sites. If he had done so, there would have been no question in his mind that ZZZZ Best was a big fraud. Pressured to get a big-time CPA firm to do his audit as he moved into the big leagues, Minkow hired Ernst &Whinney to perform the April 30, 1987 fiscal year-end audit. Minkow continued to be one step ahead of the auditors. That is until the Ernst & Whinney auditors insisted on going to see an insurance restoration site. They wanted to confirm that all the business – all the revenues --- that Minkow had said was coming in to ZZZZ Best, was real. The engagement partner drove to an area in Sacramento, California where Minkow did a lot of work – supposedly. He looked for a building that seemed to be a restoration job. Why he did that isn’t clear but he identified a building that seemed to be the kind that would be a restoration job in process. Earlier in the week, Minkow sent one of his cohorts to find a large building in Sacramento that appeared to be a restoration site. As luck would have it, Minkow’s associate picked out the same site as had the partner later on. Minkow’s cohorts found the leasing agent for the building. They convinced the agent to give them the keys so that they could show the building to some potential tenants over the weekend. Minkow’s helpers went up to the site before the arrival of the partner and placed placards on the walls that indicated ZZZZ Best was the contractor for the building restoration. In fact, the building was not fully constructed at the time but it looked as if some restoration work would have been going on at the site. Minkow was able to pull it off in part due to luck and in part because the Ernst and Whinney auditors did not want to lose the ZZZZ Best account. It had become a large revenue producer for the firm and Minkow seemed destined for greater and greater achievements. Minkow was smart and he used the leverage of the auditors not wanting to lose the ZZZZ Best account as a way to complain whenever they became too curious about the insurance restoration jobs. He would even threaten to take his business away from Ernst and Whinney and give it to other auditors. Minkow also took a precaution with the site visit. He had the auditors sign a confidentiality agreement that they would not make any follow-up calls to any contractors, insurance companies, the building owner, or other individuals involved in the restoration work. This prevented the auditors from corroborating the insurance restoration contracts with independent third parties. The Fraud Starts to Unravel It was a Los Angeles housewife that started the problems for ZZZZ Best that would eventually lead to the demise of the company. Since Minkow was a well known figure and flamboyant character, the Los Angeles Times did an expose about the carpet cleaning business. The Los Angeles housewife read the story about Minkow and recalled that ZZZZ Best had overcharged her for services in the early years by increasing the amount of the credit card charge for carpet cleaning services. Minkow had gambled that most people don’t check their monthly statements so he could get away with the petty fraud. However, the housewife did notice the overcharge, complained to Minkow, and eventually he returned the overpayment. She couldn’t understand why Minkow would have had to resort to such low levels back then if he was as successful as the L.A. Times article made him out to be. So, she called the reporter to find out more and that ultimately led to the investigation of ZZZZ Best and future stories that weren’t so flattering. Since Minkow continued to spend lavishly on himself and his possessions, he always seemed to need more and more money. It got so bad over time that he was to close to defaulting on loans and had to make up stories to keep the creditors at bay, and he couldn’t pay his suppliers. The complaints kept coming in and eventually the house of cards that was ZZZZ Best came crashing down. During the time that the fraud was unraveling, Ernst and Whinney decided to resign from the ZZZZ best audit. The firm never did issue an audit report. It had started to doubt the veracity of Minkow and the reality of business at ZZZZ Best. The procedure to follow when a change of auditor occurs is for the company to file an 8-K form with the SEC and the audit firms prepares an exhibit commenting on the accuracy of the disclosures in the 8-K. The exhibit is attached to the form that is sent to the SEC within 30 days of the change. Ernst & Whinney waited the full 30-day period and the SEC released the information to the public 45 days after the change had occurred. Meanwhile, ZZZZ Best had filed for bankruptcy. During the period of time that had elapsed, Minkow had borrowed more than $1 million dollars and the lenders never were repaid. The Bankruptcy laws protected Minkow and ZZZZ Best from having to make those payments. Legal Liability Issues The ZZZZ Best fraud was one of the largest of its time. ZZZZ Best reportedly settled a shareholder class action lawsuit for $35 million. Ernst & Whinney was sued by a bank that had made a multimillion-dollar loan based on the financial statements for the three-month period ending July 31, 1986. The bank claimed that it had relied on the review report[1] issued by Ernst & Whinney in granting the loan to ZZZZ Best. However, the firm had indicated in its review report that it was not issuing an opinion on the ZZZZ Best financial statements. The judge ruled that the bank was not justified in relying on the review report since Ernst & Whinney had expressly disclaimed issuing any opinion on the statements. Barry Minkow was charged with engaging in a $100 million fraud scheme. He was sentenced to a term of 25 years. Minkow was paroled after serving eight years in jail. During his time in prison, Minkow became involved in Christian ministry, which continued after his probationary release from prison in April 1995. Today he is senior pastor of the Community Bible Church in San Diego, California, having renounced his felonious acts. Minkow is recognized as an expert on fraud, and speaks on the subject to university students and the business community in an effort to prevent fraud. This case discusses the actual case of ZZZZ Best and Barry Minkow. The auditors ignored common sense and did not use due care in the audit. Ethical Issues This case shows how auditors did not use due care or skepticism in the audit of ZZZZ Best. The auditors lost independence and became bedazzled by Barry Minkow, the whiz kid of Wall Street. Due care requires that an auditor discharges professional responsibilities with competence and diligence. It imposes the obligation to perform professional services to the best of the auditor’s ability with concern for the best interest of the public. Questions Do you believe that auditors should be held liable for failing to discover fraud in situations such as ZZZZ Best where top management goes to great lengths to fool the auditors? Why or why not? 2. The AICPA Code obligates CPAs to follow specific standards of conduct in conducting audits. Answer the following questions with respect to those standards and the related ethical expectations. (a) Why is it important to exercise sensitive moral judgments when conducting an audit? Did Ernst & Whinney meet its obligations in this regard? If not, describe why it failed to meet its obligations. (b) What are the criteria for audit independence? Comment on the independence of Ernst & Whinney in conducting its audit of ZZZZ Best. (c) ) Auditors are expected to exercise due care in the performance of professional services. Explain the purpose of the due care standard. Based on the facts of the case, do you think Ernst & Whinney met their due care obligations? Why or why not? These are selected numbers from the financial statements of ZZZZ Best for fiscal years 1985 and 1986: 1985 1986 Sales $1,240,524 $4,845,347 Cost of goods sold 576,694 2,050,779 Accounts receivable 0 693,773 Cash 30,321 87,014 Current liabilities 2,930 1,768,435 Notes payable-current 0 780,507 What calculations or financial analyses would you make with these numbers that might help you assess whether the financial relationships are “reasonable?” Given the facts of the case, what inquiries might you make of management based on your analysis? HealthSouth The HealthSouth case is unique because the CEO, Richard Scrushy, was initially acquitted on all accounts while five former HealthSouth employees were sentenced by a federal judge for their admitted roles in a scheme to inflate revenues and reported earnings of the company from 1999 through mid-2002. These amounts are presented in Exhibit 1. You may want to review the facts of the case presented in the text before reading on. HealthSouth was the nation’s largest provider of outpatient surgery, diagnostic imaging and rehabilitative services. In 2003, the SEC filed a complaint against the company and Scrushy for violating provisions of the Securities Act of 1933 and the Securities and Exchange Act of 1934[1] The complaint alleges that HealthSouth, under Scrushy’s direction and with the help of key employees, falsified its revenue to inflate earnings and “meet their numbers.” Specifically, false accounting entries were made to an account called “contractual adjustment.” The contractual adjustment account is a revenue allowance account that estimates the difference between the gross amount billed to the patient and the amount that various healthcare insurers will pay for a specific treatment. HealthSouth deducted this account from gross revenues to derive net revenues, which were disclosed on the company’s periodic reports filed with the SEC. The allowances were deliberately understated to help meet financial analyst earnings estimates. The SEC contends that in mid-2002, certain senior officers of Health South discussed with Scrushy the impact of the scheme to inflate earnings because they were concerned about the consequences of the August 14, 2002 financial statement certification required under Section 302 of the Sarbanes-Oxley Act of 2002. Allegedly, “Scrushy agreed that, going forward, he would not insist that earnings be inflated to meet Wall Street analysts’ expectations.” The filing also alleges that Scrushy received at least $6.5 million from Health South during 2001 in “Bonus/Annual Incentive Awards.” Also, from 1999 through 2002, HealthSouth paid Scrushy $9.2 million in salary. Approximately $5.3 million of this salary was based on the company’s achievement of certain budget targets. On December 10, 2003, U.S. District Judge Inge P. Johnson sentenced former vice president of finance Emery Harris, who pleaded guilty in March 2003 to a charge of conspiracy and willfully falsifying books and records, to a term of five months in prison on each count to run concurrently, three years of supervised release with five months of unsupervised house detention, and payment of a $3,000 fine and a $200 special assessment. Harris was also ordered to pay $106,500 in forfeiture.[2] The Judge also sentenced each of the following to four years of probation with six months unsupervised home confinement and payment of a $2,000 fine: (1) former Accounting Department vice presidents Angela C. Ayers and Cathy C. Edwards; (2) group vice president Rebecca Kay Morgan; and (3) assistant vice president Virginia B. Valentine. Ayers and Valentine were also ordered to pay a $100 special assessment, and Edwards and Morgan, a $200 special assessment. Morgan was also ordered to pay $235,000 in forfeiture. The four officers all pleaded guilty in April 2003 to conspiracy to commit wire and securities fraud, and Edwards and Morgan also pleaded guilty to wire fraud. Ayers, Edwards, Morgan and Valentine all made false entries into the accounts of HealthSouth during the fraud period. Harris admitted falsifying the company’s finances to generate false entries, knowing that those entries would be included in the company’s filings with the SEC. On June 28, 2005, Richard Scrushy, the former CEO of HealthSouth, was acquitted on all charges despite the testimony of more than a half-dozen former lieutenants who said he had presided over a $2.7 billion accounting fraud while running the Health South national hospital chain. The jury had even heard secretly recorded conversations between Scrushy and a chief financial officer, William T. Owens, in March 2003 discussing balance sheet problems, with Scrushy asking “You’re not wired, are you?” In an ironic twist in the HealthSouth saga, the key prosecution witness in the government’s case against Scrushy, William Owens, was sentenced on December 9, 2005, to five years in prison for his role in the accounting fraud at HealthSouth. Owens had manipulated the company’s books and instructed subordinates to make phony accounting entries. He also falsely certified the 2002 financial statements filed with the 10-K Report to the SEC. U.S. District Judge Sharon Lovelace Blackburn knocked three years from the prosecutors sentencing request stating to Owens: “I believe you told the truth.” Blackburn called Scrushy’s acquittal a “travesty.” Nonetheless, Blackburn said white collar criminals merit stiff sentences, if only to send a message of deterrence to other business executives. “Corporate offenders are nothing more than common thieves wearing suits and wielding pens,” Blackburn said.[3] The Fraud Investigation –Implications of Whistleblowing HealthSouth said a forensic audit by PricewaterhouseCoopers found fraudulent entries to raise the total to a range of $3.8 billion to $4.6 billion, up from $3.5 billion, the government's original estimate. The fraud included $2.5 billion in fraudulent accounting entries from 1996 to 2002, $500 million in incorrect accounting for goodwill and other items involved in acquisitions from 1994 to 1999, and $800 million to $1.6 billion in ''aggressive accounting'' from 1992 to March 2003. Allegedly, HealthSouth's auditors—and maybe even government regulators—were tipped off to a possible massive accounting fraud at the company five years before it became public knowledge, or at least that's the takeaway from a shareholder's memo that was released by a congressional committee during its investigation. The memo, dated November 1998, was apparently written by an anonymous HealthSouth shareholder and sent to auditor Ernst & Young. In it, the shareholder alerts the audit firm to alleged bookkeeping violations at the rehabilitation-services company. Reportedly HealthSouth's top lawyer assured its independent auditor that it would conduct an internal investigation of the allegations. The committee notes no record of such an inquiry, however. "You bring the smoke, I'll bring the mirrors," the unnamed shareholder wrote in the memo. The shareholder's list of alleged violations at HealthSouth included an assertion that the company booked charges to outpatient clinic patients before checking that insurers would reimburse the claims. The shareholder also alleged that HealthSouth continued to record these charges as revenue even after payments were denied. "How can the company carry tens of millions of dollars in accounts receivable that are well over 360 days?" the shareholder asked in the letter. More questions followed: "How can some hospitals have NO bad debt reserves? How did the E&Y auditors in Alabama miss this stuff? Are these clever tricks to pump up the numbers, or something that a novice accountant could catch?" In a statement issued by E&Y, the firm stated it had conducted a review at the time the allegations were made and "determined the issues raised did not affect the presentation of HealthSouth's financial statements.”You people and I have been hoodwinked," the shareholder concluded in the memo. "This note is all that I can do about it. You all can do much more, if all you do is look into it to see if what I say is true." At 10:06 a.m. on Feb. 13, 2003, someone made a sensational claim on the Yahoo bulletin board devoted to discussion of HealthSouth Corp."What I know about the accounting at HealthSouth will be the blow that will bring the company to its knees." Michael Vines, a former bookkeeper in HealthSo uth's accounting department, tried to spread the word about alleged questionable practices while at HealthSouth but was turned away at every turn. According to Vine’s testimony at the April 2002 federal court hearing, he came to believe that people in the department were falsifying assets on the balance sheet. The accountants, he testified, would move expenses from the company’s income statement – where the expenses would have to be deducted from profits immediately – to its balance sheet, where they wouldn’t have to be deducted all at one time. Thus, the company’s expenses looked lower than they should have been, which helped artificially boost net income. The individual expenses were relatively small – between $500 and $4,999 a piece, according to Vines’ testimony – because E&Y examined expenses over $5,000. Overall, according to the SEC complaint, about $1 billion in fixed assets were falsely entered. In his testimony, Vines identified about $1 million in entries he believed were fraudulent. He told his immediate superior, Cathy C. Edwards, a vice president in the accounting department, that he wouldn’t make such entries unless she first initialed them. “I wanted her signature on it,” Vines testified. Edwards, according to Vine’s testimony, signed off on the entries and he logged them. Vines also testified that he saw Edwards falsifying an invoice, which according to his testimony was a way to cover up the larger fraud involving the accounts. On April 3, Edwards pleaded guilty to conspiracy to commit wire and securities fraud. As part of the plea, she admitted to falsifying records, although the plea didn’t mention specific incidents. Over time, Vines had grown more concerned about the accounting practices, particularly in light of the scandal that had recently erupted at Enron Corp. He quit his job and moved to the accounting office of a Birmingham country club. Not long afterward, he sent an e-mail to E&Y alleging fraudulent transactions between the company's accounts and identifying three account numbers that Ernst should investigate. The accounts covered expenses for "minor equipment," "repairs and maintenance" and "public information," which included costs for temporary workers and advertising job openings, he said in an interview and in court testimony. Vines's e-mail was passed on to James Lamphron, a partner in Ernst's Birmingham office. Lamphron testified that he had contacted William T. Owens, who was then president and chief operating officer at HealthSouth, and George Strong, who served as chairman of the audit committee of HealthSouth's board. A HealthSouth spokesman said Strong felt the matter was being resolved. According to Mr. Lamphron's testimony, Owens defended the company's accounting practices. He acknowledged that the company had moved expenses from one category to another, but he argued that the company had done it for several years and that it was an acceptable practice. Lamphron testified that Owens called Vines a "disgruntled employee." On March 26, 2004, Owens pleaded guilty to wire and securities fraud and certifying a false financial report to the SEC. Lamphron testified that E&Y conducted "audit-related procedures" with the accounts Vines pointed out. The result: Ernst "reached a point where we were satisfied with the explanation that the company had provided to us ... We then closed the process." According to Lamphron's testimony, Vines never specified that invoices were being falsified -- only that there was a problem with the three accounts he mentioned. So E&Y never investigated the falsified invoices and didn't find any evidence of fraud. Ernst defended itself by stressing the difficulty of detecting accounting fraud in the midst of a conspiracy involving senior executives and allegedly false documentation. Ernst wasn’t named or charged as a defendant in the government cases and the firm cooperated with investigators. This case discusses the HealthSouth scandal, which was one of the first cases under the Sarbanes Oxley required that the CEO and CFO of a company certify the financial statements as non misleading. Ethical Issues The ethical issue of this case is whether it is fair that the former CEO of HealthSouth was acquitted of certifying misleading and false financial statements while the CFO is serving a five years for the same act. Questions Do you think lower level employees should be excused from any liability for their actions that contribute towards financial statement fraud when the person in charge of the fraud is found not guilty in a court of law? Use ethical reasoning to support your answer. 2- What is the nature of the contractual allowance account? Can you equate it to other allowance accounts? Explain the rules under GAAP to account for such allowances 3-EY wasn’t named or charged as a defendant in the government case against HealthSouth. Based on the limited facts of the case, do you think EY should have been charged for its failure to exercise due care in the audit of HealthSouth? Be specific. Independence Violations at PricewaterhouseCoopersOn January 6, 2000, the SEC made public the report by independent consultant Jess Fardella, who was appointed by the Commission in March 1999 to conduct a review of possible independence rule violations by the public accounting firm PricewaterhouseCoopers (PwC) arising from ownership of client- issued securities. The report found significant violations of the firm's, the profession's, and the SEC's auditor independence rules.BackgroundOn January 14, 1999, the Commission issued an Opinion and Order Pursuant to Rule 102(e) of the Commission's Rules of Practice In the Matter of PricewaterhouseCoopers LLP (Securities Exchange Act of 1934 Release No. 40945) ("Order"),[4] which censured PwC for violating auditor independence rules and improper professional conduct. Pursuant to the settlement reached with the Commission, PwC agreed to, among other things, complete an internal review by Fardella to identify instances in which the firm’s partners or professionals owned securities of public audit clients of PwC in contravention of applicable rules and regulations concerning independence. The independent consultant's report discloses that a substantial number of PwC professionals, particularly partners, had violations of the independence rules, and that many had multiple violations. The review found excusable mistakes, but also attributed the violations to laxity and insensitivity to the importance of independence compliance. According to Fardell’s report, PwC acknowledged that the reviewdisclosed widespread independence non-compliance that reflected serious structural and cultural problems in the firm.Results of Independent Consultant’s Report The report summarizes results of the internal review at PwC, which included two key parts: PwC professionals were requested in March 1999 to self-report independence violations; and the independent consultant randomly tested a sample of the responses for completeness and accuracy. The results are as follows.1. Almost half of the PwC partners -- 1,301 out of a total of 2,698 -- self-reported at least one independence violation. The 1,301 partners who reported a violation reported an average of five violations; 153 partners had more than ten violations each. Of 8,064 reported violations, 81.3% were reported by partners and 17.4% by managers; 45.2% of the violations were reported by partners who perform services related to audits of financial statements. 2. Almost half of the reported violations involved direct investments by the PwC professional in securities, mutual funds, bank accounts, or insurance products associated with a client. Almost 32% of reported violations, or 2,565 instances, involved holdings of a client's stock or stock options.3. Six out of eleven partners at the senior management level who oversaw PwC's independence program self-reported violations. Each of the 12 regional partners who help administer PwC's independence program reported at least one violation; one reported 38 violations and another reported 34 violations.4. Thirty-one of the 43 partners who comprise PwC's Board of Partners and its U.S. Leadership Committee self-reported at least one violation. Four of these had more than 20 violations; one of these partners had 41 violations and another had 40 violations. The random tests of the self-reporting process summarized above indicated that a far greater percentage of individuals had independence violations than were reported. Despite clear warnings that the SEC was overseeing the self-reporting process,the random tests of those reports indicated that 77.5% of PwC partners failed to self-report at least one independence violation. The combined results of the self-reporting and random tests of those reports indicated that approximately 86.5% of PwC partners and 10.5% of all other PwC professionals had independence violations. The independent consultant's report identifies key weaknesses in the systems PwC had used to prevent or detect independence violations. These include:1. Reporting systems relied on the individuals themselves to sort through their own investments and interests for violations;2. Efforts to educate professionals about the independence rules and their responsibilities to the client to comply with the rules were insufficient;3. Resolution of reported violations were not adequately documented; and4. Reporting systems did not focus on the reporting of violations that were deemed to be resolved before annual confirmations were submitted. The consultant’s report concludes that . . . the numbers of violations alone, as PwC acknowledged, reflect serious structural and cultural problems that were rooted in both its legacy firms [Price Waterhouse and Coopers & Lybrand]. Although a large percentage of the reported and unreported violations is attributable solely to the Merger, an even larger portion is not; thus, the situation revealed by the internal investigation is not a one-time breakdown explained solely by the Merger. Nor can the magnitude of the reported and unreported violations be attributed simply to less familiar Independence Rules such as those pertaining to brokerage, bank and sweep accounts. At least half of the reported and unreported violations consisted of interests held by a reporting PwC professional himself or herself, and most of the violations arose from either mutual fund or stock holdings . . . .Independence compliance at PwC and its legacy firms was dependent largely on individual initiative. This system failed, as PwC has acknowledged . . . .Changes Needed As accounting firms have grown larger, acquired more clients and provided more services, and as investment opportunities and financial arrangements have increased in number and complexity, well-designed and extensive controls are needed both to facilitate Independence compliance and to discourage and detect non-compliance. The violations discussed in the consultant's report had come to light as a result of a Commission-ordered review after professional self-regulatory procedures failed to detect such violations. As a result, the SEC's requested the then current Public Oversight Board (largely replaced by PCAOB), to sponsor similar independent reviews at other firms and oversee development of enhancements to quality control and other professional standards. The firm also agreed in a settlement to conduct the review and create a $2.5 million education fund after the SEC alleged that some of its accountants compromised their independence by owning stock in corporations they audited. PricewaterhouseCoopers promised at the time to take steps to ensure that it didn’t happen again. As a result of the inquiry, five partners of the firm and a slightly larger number of other employees had been dismissed, and other employees were disciplined but not fired. Two changes that resulted from the problems at PwC were: (1) to clearly define family members and other close relatives of members of the attest engagement team that might create an independence impairment for the auditors because of the formers ownership interests in a client and/or their position within the client including having a financial reporting oversight role (Interpretation 101-1); and (2) to restrict the ability of audit personnel from having loans to or from banks and other financial institution clients (Interpretation 101-5). This case describes the need for independence during an audit. Without it, the audit would be compromised. Ethical IssuesA lack of independence violates the rights theory because the stakeholders have a right to trust that the external auditors remain independent when conducting their audit so they avoid a bias. Under the fairness theory, all the stakeholders deserve that a fair audit be conducted. The theory of deontology requires that the auditor has a duty to report accurate information to the public and adhere to independence requirements. Questions1. In commenting on the findings in the consultant’s report, the then-chief-accountant of the SEC, Lynn E. Turner said, "This report is a sobering reminder that accounting professionals need to renew their commitment to the fundamentalprinciple of auditor independence." Why is it so important for auditors to be independent of their clients? Explain the nature of the independence impairments at PwC with respect to the threats to independence impairments discussed in the chapter. Review question 19 at the end of the chapter and the PeopleSoft case in the chapter. What are the commonalities between the facts of these two cases with respect to independence violations and the facts of PwC’s independence violations? How might the independence violations in these cases negatively affect the ability of an auditor to be objective in performing professional services and maintain her integrity 3- We have discussed the need for an ethical tone at the top and strong internal controls at public companies to help prevent and detect fraud. In Chapter 2 we point out that studies have shown most CPAs reason at stages 3 or 4 in Kohlberg’s model. Given the independence violations at PwC, do you think it is indicative of a stage 3 or 4 reasoning capacity? Or is it stage 1 or 2? Explain. [1] Securities and Exchange Commission, Civil Action No. CV-03-J-0615-S, U.S. District Court Nirthern District of Alabama, SEC v. HealthSouth Corporation and Richard M. Scrushy, Defendants. [2] Department of Justice, “Five Defendants Sentenced in HealthSouth Fraud Case,” www.usdov.gov. [3] Carrie Johnson, “5 Years for HealthSouth Fraud: Former Chief Financial Officer was Key Witness,” Washington Post, December 10, 2005, D1. [4] Available at: http://www.sec.gov. CLICK HERE TO GET THE ANSWER !!!! Beauda Medical Center Lance Popperson woke up in a sweat. He felt an anxiety attack coming on. Popperson popped two anti-anxiety pills, laid down to try and sleep for the third time that night, and thought once again about his dilemma. Popperson is an associate with the accounting firm of Scoop and Shovel LLP. He recently discovered, through a casual conversation with Brad Snow, a friend of his on the audit staff, that one of the firm’s clients managed by Snow recently received complaints that its heart monitoring equipment was malfunctioning. Cardio-Systems Monitoring, Inc. (CSM) called for a meeting of the lawyers, auditors, and top management to discuss what to do about the complaints from health care facilities that had significantly increased between the first two months of 2010 and the last two months of that year. Doctors at these facilities claim the systems shut off for brief periods and, in one case, the hospital was unable to save a patient that went into cardiac arrest. Popperson got out of bed, went for a glass of water, looked at the clock that said 2:58am, and tried to sleep for the fourth time. He tossed and turned and wondered what he should do about the fact that Beauda Medical Center, his current audit client, plans to buy 20 units of Cardio-Systems heart monitoring equipment for its brand new medical facility in the outskirts of Beauda. This case discusses when and how to keep confidentiality of a client. Ethical Issues The CPA promises confidentiality to his clients so the client will trust him with information needed to perform an audit of the financial statements taken as a whole. Clients have a right to expect accountants to honor the promise of confidentiality. If the CPA should tell Beauda Medical Center confidential information about CSM, why would Beauda trust the CPA not to tell Beauda’s confidential information? The threat of harm or death to patients may be significant so Popperson should try to get CSM to correct or disclose the problem. If Popperson discloses the confidential information to Beauda, Beauda would probably cancel the order of 20 units. Would that cancellation cause financial distress or bankruptcy for CSM? Using virtue theories, the values of trustworthiness, respect, responsibility, fairness, caring and citizenship are challenged by the dilemma. Using utilitarianism theories, Popperson and the firm will have to decide whether keeping confidentiality or telling of harm to patients provides the greatest good. Questions Assume both Popperson and Snow are CPAs. Do you think Snow violated his confidentiality obligation under the AICPA Code of Professional Conduct by informing Popperson about the faulty equipment at CSM? Why or why not? Popperson has not told anyone connected to the Beauda Medical Center audit about the situation at CSM. What do you think he should do with the information? Be sure to consider are Popperson’s ethical obligations in answering this question. Assume Popperson informs the senior in charge of the Beauda audit and the senior informs the manager, Kelly Korn. A meeting is held the next day with all parties in the office of Iceman Cometh, the managing partner of the firm. Here’s how it goes: Iceman: If we tell Beauda about the problems at CSM, we will have violated our confidentiality obligation as a firm to CSM. Moreover, we may lose both clients. Kelly: Lance, you are the closest to the situation. How do you think Beauda’s top hospital administrators would react if we told them? Lance: They wouldn’t buy the equipment. Iceman: Once we tell them, we’re subject to investigation by our State Board of Accountancy for violating the confidentiality obligation we have to CSM. We don’t want to alert the board and have it investigate our actions. What’s worse is we may be flagged for the confidentiality violation in our next peer review. Kelly: Who would do that? I mean, CSM won’t know about it and the Beauda people are going to be happy we prevented them from buying what may be faulty equipment. Senior: I agree with Kelly. They are not likely to say anything. Iceman: I don’t like it. I think we should be silent and find another way to warn Beauda Medical without violating confidentiality. Lance: What about contacting the state board for advice? Follow-up questions 3 (a) Discuss all ethical and professional matters of concern for the firm of Scoop and Shovel LLP, in deciding whether to do as Iceman Cometh suggests and not tell the administrators at Beauda Medical Center? (b) What do you think about Lance’s suggestion to contact the state board for advice on the matter? Is that the function of a state board of accountancy? First Community Church First Community Church is the largest church in the city of Perpetual Happiness. Yes, it’s in California! A meeting was held on Friday, November 16 to address the fact that money had been stolen from the weekly collection box during the course of the year and church leaders were getting quite concerned. At first, no one paid much attention as the amounts were small and could have been attributed to inadvertent errors due to discrepancies between the actual count and what really was collected. However, after 45 weeks of the continuous discrepancies, the total amount of differences had become alarming. Eddie Wong, the controller for the church, estimated the total was now $23,399. That represents well over 5 percent of their annual collections from church members totaling about $400,000. The meeting began at 9am, a time that was early for the church leaders who often had late evening calls to make. The church staff brought donuts, bagels and coffee to help get the meeting off to a good start. But that’s not the way it happened. “I want an explanation,” said Allen Yuen, the executive director of the church. “The boards of trustees are on my back about this matter. Some of them talk about this Sarbanes-Oxley Act and our lack of internal controls. All it’s foreign to me but I know indignation when I see it!” “I can’t explain it, Allen,” responded Eddie Wong. “Jennie. How about you?” Yuen asked. He was addressing Jennie Lin, the member of the executive committee of the board of trustees who was directly responsible for the count each week. Jennie seemed uncomfortable. She hesitated before saying: “I think my count is correct. I take the money given to me by Joey, put it in the safe, and then Eddie opens the safe on Monday morning. He records the cash receipts and makes a bank deposit.” Eddie said, “That’s right. My deposit always matches the amount of money reported by Jennie.” “That doesn’t make sense,” Yuen said. “Someone is getting his or her hands on the money between the collection process and recording of the amount. I trust you, Jennie, to watch over these things and the internal control matter.” “Perhaps the tally amount record independently submitted by the church volunteers has been overstated.” Jennie said. “Why would that happen?” Yuen asked. “I mean, while it could happen and it would be an honest mistake, it seems unlikely.” Jennie was starting to sweat. She decided a diversion was in order. “Maybe someone gets their hands on the collection box after the tally and before Joey gives it to me.” Joey Ching is the accounting manager who delivers the collection box and tally sheet to Jennie after each service. Joey goes to church on a regular basis and volunteered to do the job in order to establish a control in the process. At this point Jennie lowered her head while she waited for a response. It came from Alex Yuen. “Jennie, are you accusing Joey of stealing money from the church collection box?” Jennie shook her head as if to say no. She was visibly upset. A phone call came in for Yuen and the meeting had to break up. The group agreed to continue the discussion in two days. In the meantime, Alan Yuen said he’d call Joey Ching and ask him to attend the next meeting. Jennie went back to her office, closed the door, and started to reflect on what she had just done. The truth is that Jennie had been taking the money each week and giving it to a homeless shelter two blocks from the church. Some of the homeless attend church services and Jennie has befriended many of them. She knew it was wrong to take money from the collection box, but she thought it was for a very good cause and that the church clergy would approve. She never thought about getting caught since she told the bookkeeper to record the lower amount. Now, she feels guilty about bringing Joey into the picture. This case looks at challenges facing many non-profits, using volunteers to provide internal controls. Ethical Issues Jennie has succumbed to the fraud triangle. Jennie is not fulfilling her fiduciary duty. By stealing monies, fraud and deceit, Jennie has committed acts discreditable to the profession. From the rights perspective, the church has a right to determine its donation to the shelter through the normal process. The church members have a right to expect the staff to uphold their fiduciary duties. From the deontology perspective, Jennie has a duty not to steal or take money without permission of the church. From a utilitarian perspective not all the constituencies of the church may have been considered. Questions Assume Jennie Lin is a CPA. Evaluate her actions from an ethical perspective. Jennie believed her actions were proper because taking the money from the church and giving it to the homeless served a greater good. Do you agree with her position from an ethical perspective? As a member of the board of trustees of the church, what are Jennie’s ethical obligations to the church? Do you think it is more difficult to establish strong internal controls in a nonprofit such as First Community Church as compared to a public or privately-owned company? Why or why not? (a) Assume Jennie calls Joey and explains the situation. She tells Joey about the impending call from Alex Yuen and, as a friend, asks him not to come to the meeting so she could explain what she has done without his involvement. If you were Joey, would you stay away from the meeting? Why or why not? 4. (b) Assume Joey stays away, Jennie explains why she did what she did, and, after due deliberation, Yuen fires Jennie and tells her she must replace the money she “stole” from the collection box. How would you evaluate Yuen’s actions from an ethical perspective? ZZZZ Best* The story of ZZZZ Best is one of greed and audaciousness. It is the story of a 15-year old boy from Reseda, California who was driven to be successful regardless of the costs. His name is Barry Minkow. Minkow had high hopes to make it big – to be a millionaire very early in life. He started a carpet cleaning business in the garage of his home. Minkow realized early on that he was not going to become a millionaire cleaning other people’s carpets. He had bigger plans than that. Minkow was going to make it big in the insurance restoration business. In other words, ZZZZ Best would contract to do carpet and drapery cleaning jobs after a fire or flood. Since the damage from the fire or flood probably would be covered by insurance, the customer would be eager to have the work done. The only problem with Minkow’s insurance restoration idea was that it was all a fiction. There were no insurance restoration jobs, at least for ZZZZ Best. In the process of creating the fraud, Minkow was able to dupe the auditors, Ernst & Whinney into thinking the insurance restoration business was real. In fact, over 80 percent of his revenue was allegedly from this work. The auditors never caught on until it was too late. How Barry Became a Fraudster Minkow wrote a book, Clean Sweep: A Story of Compromise, Corruption, Collapse, and Comeback** that provides some insights into the mind of a 15-year old kid __________________ * The facts are derived from a video by the ACFE, Cooking the Books: What Every Accountant Should Know about Fraud. **Barry Minkow, Clean Sweep: A Story of Compromise, Corruption, Collapse, and Comeback (Nashville, TN: Thomas Nelson, 1995). who was called a “wonder boy” on Wall Street until the bubble burst. He was trying to find a way to drum up customers for his fledgling carpet cleaning business. One day, while he was alone in the garage-office, Minkow called Channel 4 in Los Angeles. He disguised his voice to sound not like a teenager and told a producer that he had just had his carpets cleaned by the 16-year owner of ZZZZ Best and was very impressed that a high school junior was running his own business. He sold the producer on the idea that it would be good for society to hear the success story about a high school junior running his own business. The producer bought it lock, stock and carpet cleaner. Minkow gave the producer the phone number of ZZZZ Best and waited. It took less than five minutes for the call to come in. Minkow answered the phone and when the producer asked to speak with Mr. Barry Minkow, Minkow said: “Who may I say is calling?” Within days a film crew was in his garage shooting ZZZZ Best at work. The story aired that night and it was followed by more calls from radio stations and other television shows wanting to do interviews. People called demanding that Barry Minkow personally clean their carpets. As his income increased in the spring of 1983, Minkow found it increasingly difficult to run the company without a checking account. He managed to find a banker that was so moved by his story that the banker would agree to allow someone under-aged to open a checking account. Minkow used the money to buy cleaning supplies and other necessities. Even though his business was growing, Minkow ran into trouble paying back loans and interest when due. Minkow developed a plan of action. He was tired of worrying about not having enough money. He went to his garage – where all his great ideas first began – and he looked at his bank account statement which showed that he had more money than he thought he had based on his own records. Minkow soon realized it was because some checks he had written had not been cashed by customers so it didn’t yet shown up on the bank statement. Voila! Minkow started to kite checks between two or more banks. He would write a check on one ZZZZ Best account and deposit it into another. Since it might take a few days for the check written on bank number one to clear that banks’ records, at least back then when checks weren’t always processed in real time, Minkow could pay some bills out of the second account and the first bank would not know – at least for a few days – that Minkow had written a check on his account when, in reality, he had a negative balance. The bank didn’t know it because some of the checks that Minkow had written before the visit to bank number two had not cleared his account in bank number one. It wasn’t long thereafter that Minkow realized he could kite checks big-time. Not only that, he could make the transfer of funds at the end of a month or a year and show a higher balance than really existed in bank number one and carry it on to the balance sheet. Since Minkow did not count the check written on his account in bank one as an outstanding check, he was able to double-count. Time to Expand the Fraud Over time, Minkow moved on to bigger and bigger frauds like having his trusted cohorts confirm to banks and other interested parties that ZZZZ Best was doing insurance restoration jobs. Minkow used the phony jobs and phony revenue to convince bankers to make loans to ZZZZ Best. He had cash remittance forms made up from non-existent customers with whatever sales amount he wanted to appear on the document. He even had a co-conspirator write on the bogus remittance form, “job well done.” Minkow could then show a lot more revenue that he was really making. Minkow’s phony financial statements enabled him to borrow more and more money and expand the number of carpet cleaning outlets. However, Minkow’s personal tastes had become increasingly more expensive including purchasing a Ferrari with the borrowed funds and putting a down payment on a 5,000-square foot home. So, the question was: How do you solve a perpetual cash flow problem? You go public! That’s right, Minkow made a public offering of stock in ZZZZ Best. Of course he owned a majority of the stock to maintain control of the company. Minkow had made it to the big leagues. He was on Wall Street. He had investment bankers, CPAs and attorneys all working for him -- the 15-year old kid from Reseda who had turned a mom and pop operation into a publicly-owned corporation. Barry Goes Public Minkow’s first audit was for the twelve months ended April 30, 1986. A sole practitioner performed the audit. (There are eerie similarities in the Madoff fraud with its small practitioner firm – Frichling & Horowita – conducting the audit of a multi-billion dollar operation and that of the sole practitioner audit of ZZZZ Best). Minkow had established two phony front companies that allegedly placed insurance restoration jobs for ZZZZ Best. He had one of his cohorts make out invoices for services and respond to questions about the company. There was enough paperwork to fool the auditor into thinking the jobs were real and the revenue was supportable. However, the auditor never visited any of the insurance restoration sites. If he had done so, there would have been no question in his mind that ZZZZ Best was a big fraud. Pressured to get a big-time CPA firm to do his audit as he moved into the big leagues, Minkow hired Ernst &Whinney to perform the April 30, 1987 fiscal year-end audit. Minkow continued to be one step ahead of the auditors. That is until the Ernst & Whinney auditors insisted on going to see an insurance restoration site. They wanted to confirm that all the business – all the revenues --- that Minkow had said was coming in to ZZZZ Best, was real. The engagement partner drove to an area in Sacramento, California where Minkow did a lot of work – supposedly. He looked for a building that seemed to be a restoration job. Why he did that isn’t clear but he identified a building that seemed to be the kind that would be a restoration job in process. Earlier in the week, Minkow sent one of his cohorts to find a large building in Sacramento that appeared to be a restoration site. As luck would have it, Minkow’s associate picked out the same site as had the partner later on. Minkow’s cohorts found the leasing agent for the building. They convinced the agent to give them the keys so that they could show the building to some potential tenants over the weekend. Minkow’s helpers went up to the site before the arrival of the partner and placed placards on the walls that indicated ZZZZ Best was the contractor for the building restoration. In fact, the building was not fully constructed at the time but it looked as if some restoration work would have been going on at the site. Minkow was able to pull it off in part due to luck and in part because the Ernst and Whinney auditors did not want to lose the ZZZZ Best account. It had become a large revenue producer for the firm and Minkow seemed destined for greater and greater achievements. Minkow was smart and he used the leverage of the auditors not wanting to lose the ZZZZ Best account as a way to complain whenever they became too curious about the insurance restoration jobs. He would even threaten to take his business away from Ernst and Whinney and give it to other auditors. Minkow also took a precaution with the site visit. He had the auditors sign a confidentiality agreement that they would not make any follow-up calls to any contractors, insurance companies, the building owner, or other individuals involved in the restoration work. This prevented the auditors from corroborating the insurance restoration contracts with independent third parties. The Fraud Starts to Unravel It was a Los Angeles housewife that started the problems for ZZZZ Best that would eventually lead to the demise of the company. Since Minkow was a well known figure and flamboyant character, the Los Angeles Times did an expose about the carpet cleaning business. The Los Angeles housewife read the story about Minkow and recalled that ZZZZ Best had overcharged her for services in the early years by increasing the amount of the credit card charge for carpet cleaning services. Minkow had gambled that most people don’t check their monthly statements so he could get away with the petty fraud. However, the housewife did notice the overcharge, complained to Minkow, and eventually he returned the overpayment. She couldn’t understand why Minkow would have had to resort to such low levels back then if he was as successful as the L.A. Times article made him out to be. So, she called the reporter to find out more and that ultimately led to the investigation of ZZZZ Best and future stories that weren’t so flattering. Since Minkow continued to spend lavishly on himself and his possessions, he always seemed to need more and more money. It got so bad over time that he was to close to defaulting on loans and had to make up stories to keep the creditors at bay, and he couldn’t pay his suppliers. The complaints kept coming in and eventually the house of cards that was ZZZZ Best came crashing down. During the time that the fraud was unraveling, Ernst and Whinney decided to resign from the ZZZZ best audit. The firm never did issue an audit report. It had started to doubt the veracity of Minkow and the reality of business at ZZZZ Best. The procedure to follow when a change of auditor occurs is for the company to file an 8-K form with the SEC and the audit firms prepares an exhibit commenting on the accuracy of the disclosures in the 8-K. The exhibit is attached to the form that is sent to the SEC within 30 days of the change. Ernst & Whinney waited the full 30-day period and the SEC released the information to the public 45 days after the change had occurred. Meanwhile, ZZZZ Best had filed for bankruptcy. During the period of time that had elapsed, Minkow had borrowed more than $1 million dollars and the lenders never were repaid. The Bankruptcy laws protected Minkow and ZZZZ Best from having to make those payments. Legal Liability Issues The ZZZZ Best fraud was one of the largest of its time. ZZZZ Best reportedly settled a shareholder class action lawsuit for $35 million. Ernst & Whinney was sued by a bank that had made a multimillion-dollar loan based on the financial statements for the three-month period ending July 31, 1986. The bank claimed that it had relied on the review report[1] issued by Ernst & Whinney in granting the loan to ZZZZ Best. However, the firm had indicated in its review report that it was not issuing an opinion on the ZZZZ Best financial statements. The judge ruled that the bank was not justified in relying on the review report since Ernst & Whinney had expressly disclaimed issuing any opinion on the statements. Barry Minkow was charged with engaging in a $100 million fraud scheme. He was sentenced to a term of 25 years. Minkow was paroled after serving eight years in jail. During his time in prison, Minkow became involved in Christian ministry, which continued after his probationary release from prison in April 1995. Today he is senior pastor of the Community Bible Church in San Diego, California, having renounced his felonious acts. Minkow is recognized as an expert on fraud, and speaks on the subject to university students and the business community in an effort to prevent fraud. This case discusses the actual case of ZZZZ Best and Barry Minkow. The auditors ignored common sense and did not use due care in the audit. Ethical Issues This case shows how auditors did not use due care or skepticism in the audit of ZZZZ Best. The auditors lost independence and became bedazzled by Barry Minkow, the whiz kid of Wall Street. Due care requires that an auditor discharges professional responsibilities with competence and diligence. It imposes the obligation to perform professional services to the best of the auditor’s ability with concern for the best interest of the public. Questions Do you believe that auditors should be held liable for failing to discover fraud in situations such as ZZZZ Best where top management goes to great lengths to fool the auditors? Why or why not? 2. The AICPA Code obligates CPAs to follow specific standards of conduct in conducting audits. Answer the following questions with respect to those standards and the related ethical expectations. (a) Why is it important to exercise sensitive moral judgments when conducting an audit? Did Ernst & Whinney meet its obligations in this regard? If not, describe why it failed to meet its obligations. (b) What are the criteria for audit independence? Comment on the independence of Ernst & Whinney in conducting its audit of ZZZZ Best. (c) ) Auditors are expected to exercise due care in the performance of professional services. Explain the purpose of the due care standard. Based on the facts of the case, do you think Ernst & Whinney met their due care obligations? Why or why not? These are selected numbers from the financial statements of ZZZZ Best for fiscal years 1985 and 1986: 1985 1986 Sales $1,240,524 $4,845,347 Cost of goods sold 576,694 2,050,779 Accounts receivable 0 693,773 Cash 30,321 87,014 Current liabilities 2,930 1,768,435 Notes payable-current 0 780,507 What calculations or financial analyses would you make with these numbers that might help you assess whether the financial relationships are “reasonable?” Given the facts of the case, what inquiries might you make of management based on your analysis? HealthSouth The HealthSouth case is unique because the CEO, Richard Scrushy, was initially acquitted on all accounts while five former HealthSouth employees were sentenced by a federal judge for their admitted roles in a scheme to inflate revenues and reported earnings of the company from 1999 through mid-2002. These amounts are presented in Exhibit 1. You may want to review the facts of the case presented in the text before reading on. HealthSouth was the nation’s largest provider of outpatient surgery, diagnostic imaging and rehabilitative services. In 2003, the SEC filed a complaint against the company and Scrushy for violating provisions of the Securities Act of 1933 and the Securities and Exchange Act of 1934[1] The complaint alleges that HealthSouth, under Scrushy’s direction and with the help of key employees, falsified its revenue to inflate earnings and “meet their numbers.” Specifically, false accounting entries were made to an account called “contractual adjustment.” The contractual adjustment account is a revenue allowance account that estimates the difference between the gross amount billed to the patient and the amount that various healthcare insurers will pay for a specific treatment. HealthSouth deducted this account from gross revenues to derive net revenues, which were disclosed on the company’s periodic reports filed with the SEC. The allowances were deliberately understated to help meet financial analyst earnings estimates. The SEC contends that in mid-2002, certain senior officers of Health South discussed with Scrushy the impact of the scheme to inflate earnings because they were concerned about the consequences of the August 14, 2002 financial statement certification required under Section 302 of the Sarbanes-Oxley Act of 2002. Allegedly, “Scrushy agreed that, going forward, he would not insist that earnings be inflated to meet Wall Street analysts’ expectations.” The filing also alleges that Scrushy received at least $6.5 million from Health South during 2001 in “Bonus/Annual Incentive Awards.” Also, from 1999 through 2002, HealthSouth paid Scrushy $9.2 million in salary. Approximately $5.3 million of this salary was based on the company’s achievement of certain budget targets. On December 10, 2003, U.S. District Judge Inge P. Johnson sentenced former vice president of finance Emery Harris, who pleaded guilty in March 2003 to a charge of conspiracy and willfully falsifying books and records, to a term of five months in prison on each count to run concurrently, three years of supervised release with five months of unsupervised house detention, and payment of a $3,000 fine and a $200 special assessment. Harris was also ordered to pay $106,500 in forfeiture.[2] The Judge also sentenced each of the following to four years of probation with six months unsupervised home confinement and payment of a $2,000 fine: (1) former Accounting Department vice presidents Angela C. Ayers and Cathy C. Edwards; (2) group vice president Rebecca Kay Morgan; and (3) assistant vice president Virginia B. Valentine. Ayers and Valentine were also ordered to pay a $100 special assessment, and Edwards and Morgan, a $200 special assessment. Morgan was also ordered to pay $235,000 in forfeiture. The four officers all pleaded guilty in April 2003 to conspiracy to commit wire and securities fraud, and Edwards and Morgan also pleaded guilty to wire fraud. Ayers, Edwards, Morgan and Valentine all made false entries into the accounts of HealthSouth during the fraud period. Harris admitted falsifying the company’s finances to generate false entries, knowing that those entries would be included in the company’s filings with the SEC. On June 28, 2005, Richard Scrushy, the former CEO of HealthSouth, was acquitted on all charges despite the testimony of more than a half-dozen former lieutenants who said he had presided over a $2.7 billion accounting fraud while running the Health South national hospital chain. The jury had even heard secretly recorded conversations between Scrushy and a chief financial officer, William T. Owens, in March 2003 discussing balance sheet problems, with Scrushy asking “You’re not wired, are you?” In an ironic twist in the HealthSouth saga, the key prosecution witness in the government’s case against Scrushy, William Owens, was sentenced on December 9, 2005, to five years in prison for his role in the accounting fraud at HealthSouth. Owens had manipulated the company’s books and instructed subordinates to make phony accounting entries. He also falsely certified the 2002 financial statements filed with the 10-K Report to the SEC. U.S. District Judge Sharon Lovelace Blackburn knocked three years from the prosecutors sentencing request stating to Owens: “I believe you told the truth.” Blackburn called Scrushy’s acquittal a “travesty.” Nonetheless, Blackburn said white collar criminals merit stiff sentences, if only to send a message of deterrence to other business executives. “Corporate offenders are nothing more than common thieves wearing suits and wielding pens,” Blackburn said.[3] The Fraud Investigation –Implications of Whistleblowing HealthSouth said a forensic audit by PricewaterhouseCoopers found fraudulent entries to raise the total to a range of $3.8 billion to $4.6 billion, up from $3.5 billion, the government's original estimate. The fraud included $2.5 billion in fraudulent accounting entries from 1996 to 2002, $500 million in incorrect accounting for goodwill and other items involved in acquisitions from 1994 to 1999, and $800 million to $1.6 billion in ''aggressive accounting'' from 1992 to March 2003. Allegedly, HealthSouth's auditors—and maybe even government regulators—were tipped off to a possible massive accounting fraud at the company five years before it became public knowledge, or at least that's the takeaway from a shareholder's memo that was released by a congressional committee during its investigation. The memo, dated November 1998, was apparently written by an anonymous HealthSouth shareholder and sent to auditor Ernst & Young. In it, the shareholder alerts the audit firm to alleged bookkeeping violations at the rehabilitation-services company. Reportedly HealthSouth's top lawyer assured its independent auditor that it would conduct an internal investigation of the allegations. The committee notes no record of such an inquiry, however. "You bring the smoke, I'll bring the mirrors," the unnamed shareholder wrote in the memo. The shareholder's list of alleged violations at HealthSouth included an assertion that the company booked charges to outpatient clinic patients before checking that insurers would reimburse the claims. The shareholder also alleged that HealthSouth continued to record these charges as revenue even after payments were denied. "How can the company carry tens of millions of dollars in accounts receivable that are well over 360 days?" the shareholder asked in the letter. More questions followed: "How can some hospitals have NO bad debt reserves? How did the E&Y auditors in Alabama miss this stuff? Are these clever tricks to pump up the numbers, or something that a novice accountant could catch?" In a statement issued by E&Y, the firm stated it had conducted a review at the time the allegations were made and "determined the issues raised did not affect the presentation of HealthSouth's financial statements.”You people and I have been hoodwinked," the shareholder concluded in the memo. "This note is all that I can do about it. You all can do much more, if all you do is look into it to see if what I say is true." At 10:06 a.m. on Feb. 13, 2003, someone made a sensational claim on the Yahoo bulletin board devoted to discussion of HealthSouth Corp."What I know about the accounting at HealthSouth will be the blow that will bring the company to its knees." Michael Vines, a former bookkeeper in HealthSo uth's accounting department, tried to spread the word about alleged questionable practices while at HealthSouth but was turned away at every turn. According to Vine’s testimony at the April 2002 federal court hearing, he came to believe that people in the department were falsifying assets on the balance sheet. The accountants, he testified, would move expenses from the company’s income statement – where the expenses would have to be deducted from profits immediately – to its balance sheet, where they wouldn’t have to be deducted all at one time. Thus, the company’s expenses looked lower than they should have been, which helped artificially boost net income. The individual expenses were relatively small – between $500 and $4,999 a piece, according to Vines’ testimony – because E&Y examined expenses over $5,000. Overall, according to the SEC complaint, about $1 billion in fixed assets were falsely entered. In his testimony, Vines identified about $1 million in entries he believed were fraudulent. He told his immediate superior, Cathy C. Edwards, a vice president in the accounting department, that he wouldn’t make such entries unless she first initialed them. “I wanted her signature on it,” Vines testified. Edwards, according to Vine’s testimony, signed off on the entries and he logged them. Vines also testified that he saw Edwards falsifying an invoice, which according to his testimony was a way to cover up the larger fraud involving the accounts. On April 3, Edwards pleaded guilty to conspiracy to commit wire and securities fraud. As part of the plea, she admitted to falsifying records, although the plea didn’t mention specific incidents. Over time, Vines had grown more concerned about the accounting practices, particularly in light of the scandal that had recently erupted at Enron Corp. He quit his job and moved to the accounting office of a Birmingham country club. Not long afterward, he sent an e-mail to E&Y alleging fraudulent transactions between the company's accounts and identifying three account numbers that Ernst should investigate. The accounts covered expenses for "minor equipment," "repairs and maintenance" and "public information," which included costs for temporary workers and advertising job openings, he said in an interview and in court testimony. Vines's e-mail was passed on to James Lamphron, a partner in Ernst's Birmingham office. Lamphron testified that he had contacted William T. Owens, who was then president and chief operating officer at HealthSouth, and George Strong, who served as chairman of the audit committee of HealthSouth's board. A HealthSouth spokesman said Strong felt the matter was being resolved. According to Mr. Lamphron's testimony, Owens defended the company's accounting practices. He acknowledged that the company had moved expenses from one category to another, but he argued that the company had done it for several years and that it was an acceptable practice. Lamphron testified that Owens called Vines a "disgruntled employee." On March 26, 2004, Owens pleaded guilty to wire and securities fraud and certifying a false financial report to the SEC. Lamphron testified that E&Y conducted "audit-related procedures" with the accounts Vines pointed out. The result: Ernst "reached a point where we were satisfied with the explanation that the company had provided to us ... We then closed the process." According to Lamphron's testimony, Vines never specified that invoices were being falsified -- only that there was a problem with the three accounts he mentioned. So E&Y never investigated the falsified invoices and didn't find any evidence of fraud. Ernst defended itself by stressing the difficulty of detecting accounting fraud in the midst of a conspiracy involving senior executives and allegedly false documentation. Ernst wasn’t named or charged as a defendant in the government cases and the firm cooperated with investigators. This case discusses the HealthSouth scandal, which was one of the first cases under the Sarbanes Oxley required that the CEO and CFO of a company certify the financial statements as non misleading. Ethical Issues The ethical issue of this case is whether it is fair that the former CEO of HealthSouth was acquitted of certifying misleading and false financial statements while the CFO is serving a five years for the same act. Questions Do you think lower level employees should be excused from any liability for their actions that contribute towards financial statement fraud when the person in charge of the fraud is found not guilty in a court of law? Use ethical reasoning to support your answer. 2- What is the nature of the contractual allowance account? Can you equate it to other allowance accounts? Explain the rules under GAAP to account for such allowances 3-EY wasn’t named or charged as a defendant in the government case against HealthSouth. Based on the limited facts of the case, do you think EY should have been charged for its failure to exercise due care in the audit of HealthSouth? Be specific. Independence Violations at PricewaterhouseCoopers On January 6, 2000, the SEC made public the report by independent consultant Jess Fardella, who was appointed by the Commission in March 1999 to conduct a review of possible independence rule violations by the public accounting firm PricewaterhouseCoopers (PwC) arising from ownership of client- issued securities. The report found significant violations of the firm's, the profession's, and the SEC's auditor independence rules. Background On January 14, 1999, the Commission issued an Opinion and Order Pursuant to Rule 102(e) of the Commission's Rules of Practice In the Matter of PricewaterhouseCoopers LLP (Securities Exchange Act of 1934 Release No. 40945) ("Order"),[4] which censured PwC for violating auditor independence rules and improper professional conduct. Pursuant to the settlement reached with the Commission, PwC agreed to, among other things, complete an internal review by Fardella to identify instances in which the firm’s partners or professionals owned securities of public audit clients of PwC in contravention of applicable rules and regulations concerning independence. The independent consultant's report discloses that a substantial number of PwC professionals, particularly partners, had violations of the independence rules, and that many had multiple violations. The review found excusable mistakes, but also attributed the violations to laxity and insensitivity to the importance of independence compliance. According to Fardell’s report, PwC acknowledged that the review disclosed widespread independence non-compliance that reflected serious structural and cultural problems in the firm. Results of Independent Consultant’s Report The report summarizes results of the internal review at PwC, which included two key parts: PwC professionals were requested in March 1999 to self-report independence violations; and the independent consultant randomly tested a sample of the responses for completeness and accuracy. The results are as follows. 1. Almost half of the PwC partners -- 1,301 out of a total of 2,698 -- self-reported at least one independence violation. The 1,301 partners who reported a violation reported an average of five violations; 153 partners had more than ten violations each. Of 8,064 reported violations, 81.3% were reported by partners and 17.4% by managers; 45.2% of the violations were reported by partners who perform services related to audits of financial statements. 2. Almost half of the reported violations involved direct investments by the PwC professional in securities, mutual funds, bank accounts, or insurance products associated with a client. Almost 32% of reported violations, or 2,565 instances, involved holdings of a client's stock or stock options. 3. Six out of eleven partners at the senior management level who oversaw PwC's independence program self-reported violations. Each of the 12 regional partners who help administer PwC's independence program reported at least one violation; one reported 38 violations and another reported 34 violations. 4. Thirty-one of the 43 partners who comprise PwC's Board of Partners and its U.S. Leadership Committee self-reported at least one violation. Four of these had more than 20 violations; one of these partners had 41 violations and another had 40 violations. The random tests of the self-reporting process summarized above indicated that a far greater percentage of individuals had independence violations than were reported. Despite clear warnings that the SEC was overseeing the self-reporting process, the random tests of those reports indicated that 77.5% of PwC partners failed to self-report at least one independence violation. The combined results of the self-reporting and random tests of those reports indicated that approximately 86.5% of PwC partners and 10.5% of all other PwC professionals had independence violations. The independent consultant's report identifies key weaknesses in the systems PwC had used to prevent or detect independence violations. These include: 1. Reporting systems relied on the individuals themselves to sort through their own investments and interests for violations; 2. Efforts to educate professionals about the independence rules and their responsibilities to the client to comply with the rules were insufficient; 3. Resolution of reported violations were not adequately documented; and 4. Reporting systems did not focus on the reporting of violations that were deemed to be resolved before annual confirmations were submitted. The consultant’s report concludes that . . . the numbers of violations alone, as PwC acknowledged, reflect serious structural and cultural problems that were rooted in both its legacy firms [Price Waterhouse and Coopers & Lybrand]. Although a large percentage of the reported and unreported violations is attributable solely to the Merger, an even larger portion is not; thus, the situation revealed by the internal investigation is not a one-time breakdown explained solely by the Merger. Nor can the magnitude of the reported and unreported violations be attributed simply to less familiar Independence Rules such as those pertaining to brokerage, bank and sweep accounts. At least half of the reported and unreported violations consisted of interests held by a reporting PwC professional himself or herself, and most of the violations arose from either mutual fund or stock holdings . . . .Independence compliance at PwC and its legacy firms was dependent largely on individual initiative. This system failed, as PwC has acknowledged . . . . Changes Needed As accounting firms have grown larger, acquired more clients and provided more services, and as investment opportunities and financial arrangements have increased in number and complexity, well-designed and extensive controls are needed both to facilitate Independence compliance and to discourage and detect non-compliance. The violations discussed in the consultant's report had come to light as a result of a Commission-ordered review after professional self-regulatory procedures failed to detect such violations. As a result, the SEC's requested the then current Public Oversight Board (largely replaced by PCAOB), to sponsor similar independent reviews at other firms and oversee development of enhancements to quality control and other professional standards. The firm also agreed in a settlement to conduct the review and create a $2.5 million education fund after the SEC alleged that some of its accountants compromised their independence by owning stock in corporations they audited. PricewaterhouseCoopers promised at the time to take steps to ensure that it didn’t happen again. As a result of the inquiry, five partners of the firm and a slightly larger number of other employees had been dismissed, and other employees were disciplined but not fired. Two changes that resulted from the problems at PwC were: (1) to clearly define family members and other close relatives of members of the attest engagement team that might create an independence impairment for the auditors because of the formers ownership interests in a client and/or their position within the client including having a financial reporting oversight role (Interpretation 101-1); and (2) to restrict the ability of audit personnel from having loans to or from banks and other financial institution clients (Interpretation 101-5). This case describes the need for independence during an audit. Without it, the audit would be compromised. Ethical Issues A lack of independence violates the rights theory because the stakeholders have a right to trust that the external auditors remain independent when conducting their audit so they avoid a bias. Under the fairness theory, all the stakeholders deserve that a fair audit be conducted. The theory of deontology requires that the auditor has a duty to report accurate information to the public and adhere to independence requirements. Questions 1. In commenting on the findings in the consultant’s report, the then-chief-accountant of the SEC, Lynn E. Turner said, "This report is a sobering reminder that accounting professionals need to renew their commitment to the fundamental principle of auditor independence." Why is it so important for auditors to be independent of their clients? Explain the nature of the independence impairments at PwC with respect to the threats to independence impairments discussed in the chapter. Review question 19 at the end of the chapter and the PeopleSoft case in the chapter. What are the commonalities between the facts of these two cases with respect to independence violations and the facts of PwC’s independence violations? How might the independence violations in these cases negatively affect the ability of an auditor to be objective in performing professional services and maintain her integrity 3- We have discussed the need for an ethical tone at the top and strong internal controls at public companies to help prevent and detect fraud. In Chapter 2 we point out that studies have shown most CPAs reason at stages 3 or 4 in Kohlberg’s model. Given the independence violations at PwC, do you think it is indicative of a stage 3 or 4 reasoning capacity? Or is it stage 1 or 2? Explain. [1] Securities and Exchange Commission, Civil Action No. CV-03-J-0615-S, U.S. District Court Nirthern District of Alabama, SEC v. HealthSouth Corporation and Richard M. Scrushy, Defendants. [2] Department of Justice, “Five Defendants Sentenced in HealthSouth Fraud Case,” www.usdov.gov. [3] Carrie Johnson, “5 Years for HealthSouth Fraud: Former Chief Financial Officer was Key Witness,” Washington Post, December 10, 2005, D1. [4] Available at: http://www.sec.gov. CLICK HERE TO GET THE ANSWER !!!!

Beauda Medical Center

            Lance Popperson woke up in a sweat.  He felt an anxiety attack coming on.  Popperson popped two anti-anxiety pills, laid down to try and sleep for the third time that night, and thought once again about his dilemma.

            Popperson is an associate with the accounting firm of Scoop and Shovel LLP.  He recently discovered, through a casual conversation with Brad Snow, a friend of his on the audit staff, that one of the firm’s clients managed by Snow recently received complaints that its heart monitoring equipment was malfunctioning.  Cardio-Systems Monitoring, Inc. (CSM) called for a meeting of the lawyers, auditors, and top management to discuss what to do about the complaints from health care facilities that had significantly increased between the first two months of 2010 and the last two months of that year.  Doctors at these facilities claim the systems shut off for brief periods and, in one case, the hospital was unable to save a patient that went into cardiac arrest.

            Popperson got out of bed, went for a glass of water, looked at the clock that said 2:58am, and tried to sleep for the fourth time.  He tossed and turned and wondered what he should do about the fact that Beauda Medical Center, his current audit client, plans to buy 20 units of Cardio-Systems heart monitoring equipment for its brand new medical facility in the outskirts of Beauda.

 

This case discusses when and how to keep confidentiality of a client.

 

Ethical Issues

The CPA promises confidentiality to his clients so the client will trust him with information needed to perform an audit of the financial statements taken as a whole. Clients have a right to expect accountants to honor the promise of confidentiality. If the CPA should tell Beauda Medical Center confidential information about CSM, why would Beauda trust the CPA not to tell Beauda’s confidential information? The threat of harm or death to patients may be significant so Popperson should try to get CSM to correct or disclose the problem. If Popperson discloses the confidential information to Beauda, Beauda would probably cancel the order of 20 units. Would that cancellation cause financial distress or bankruptcy for CSM? Using virtue theories, the values of trustworthiness, respect, responsibility, fairness, caring and citizenship are challenged by the dilemma. Using utilitarianism theories, Popperson and the firm will have to decide whether keeping confidentiality or telling of harm to patients provides the greatest good.

 

Questions

1. Assume both Popperson and Snow are CPAs.  Do you think Snow violated his confidentiality obligation under the AICPA Code of Professional Conduct by informing Popperson about the faulty equipment at CSM?  Why or why not?
2. Popperson has not told anyone connected to the Beauda Medical Center audit about the situation at CSM.  What do you think he should do with the information? Be sure to consider are Popperson’s ethical obligations in answering this question.

 

3. Assume Popperson informs the senior in charge of the Beauda audit and the senior informs the manager, Kelly Korn.  A meeting is held the next day with all parties in the office of Iceman Cometh, the managing partner of the firm.  Here’s how it goes:

Iceman:  If we tell Beauda about the problems at CSM, we will have violated our confidentiality obligation as a firm to CSM. Moreover, we may lose both clients.

Kelly:  Lance, you are the closest to the situation.  How do you think Beauda’s top hospital administrators would react if we told them?

Lance:  They wouldn’t buy the equipment.

Iceman:  Once we tell them, we’re subject to investigation by our State Board of Accountancy for violating the confidentiality obligation we have to CSM. We don’t want to alert the board and have it investigate our actions. What’s worse is we may be flagged for the confidentiality violation in our next peer review.

Kelly:  Who would do that?  I mean, CSM won’t know about it and the Beauda people are going to be happy we prevented them from buying what may be faulty equipment.

Senior:  I agree with Kelly.  They are not likely to say anything.

Iceman:  I don’t like it.  I think we should be silent and find another way to warn Beauda Medical without violating confidentiality.

Lance:  What about contacting the state board for advice?

Follow-up questions

3 (a)  Discuss all ethical and professional matters of concern for the firm of Scoop and Shovel LLP, in deciding whether to do as Iceman Cometh suggests and not tell the administrators at Beauda Medical Center?

 

 

   (b)  What do you think about Lance’s suggestion to contact the state board for advice on the matter?  Is that the function of a state board of accountancy?

 

 

First Community Church

 

            First Community Church is the largest church in the city of Perpetual Happiness.  Yes, it’s in California! 

A meeting was held on Friday, November 16 to address the fact that money had been stolen from the weekly collection box during the course of the year and church leaders were getting quite concerned.  At first, no one paid much attention as the amounts were small and could have been attributed to inadvertent errors due to discrepancies between the actual count and what really was collected.  However, after 45 weeks of the continuous discrepancies, the total amount of differences had become alarming.  Eddie Wong, the controller for the church, estimated the total was now $23,399.  That represents well over 5 percent of their annual collections from church members totaling about $400,000.

            The meeting began at 9am, a time that was early for the church leaders who often had late evening calls to make.  The church staff brought donuts, bagels and coffee to help get the meeting off to a good start.  But that’s not the way it happened.

            “I want an explanation,” said Allen Yuen, the executive director of the church. “The boards of trustees are on my back about this matter. Some of them talk about this Sarbanes-Oxley Act and our lack of internal controls. All it’s foreign to me but I know indignation when I see it!”

            “I can’t explain it, Allen,” responded Eddie Wong.

            “Jennie.  How about you?” Yuen asked.  He was addressing Jennie Lin, the member of the executive committee of the board of trustees who was directly responsible for the count each week.

            Jennie seemed uncomfortable.  She hesitated before saying:  “I think my count is correct.  I take the money given to me by Joey, put it in the safe, and then Eddie opens the safe on Monday morning.  He records the cash receipts and makes a bank deposit.”

            Eddie said, “That’s right.  My deposit always matches the amount of money reported by Jennie.”

            “That doesn’t make sense,” Yuen said.  “Someone is getting his or her hands on the money between the collection process and recording of the amount. I trust you, Jennie, to watch over these things and the internal control matter.”

“Perhaps the tally amount record independently submitted by the church volunteers has been overstated.”  Jennie said.

            “Why would that happen?” Yuen asked.  “I mean, while it could happen and it would be an honest mistake, it seems unlikely.”

            Jennie was starting to sweat.  She decided a diversion was in order.  “Maybe someone gets their hands on the collection box after the tally and before Joey gives it to me.”

Joey Ching is the accounting manager who delivers the collection box and tally sheet to Jennie after each service.  Joey goes to church on a regular basis and volunteered to do the job in order to establish a control in the process.

At this point Jennie lowered her head while she waited for a response.  It came from Alex Yuen.  “Jennie, are you accusing Joey of stealing money from the church collection box?”

Jennie shook her head as if to say no.  She was visibly upset.  A phone call came in for Yuen and the meeting had to break up. The group agreed to continue the discussion in two days. In the meantime, Alan Yuen said he’d call Joey Ching and ask him to attend the next meeting.

Jennie went back to her office, closed the door, and started to reflect on what she had just done.  The truth is that Jennie had been taking the money each week and giving it to a homeless shelter two blocks from the church.  Some of the homeless attend church services and Jennie has befriended many of them.  She knew it was wrong to take money from the collection box, but she thought it was for a very good cause and that the church clergy would approve.  She never thought about getting caught since she told the bookkeeper to record the lower amount.   Now, she feels guilty about bringing Joey into the picture.

 

This case looks at challenges facing many non-profits, using volunteers to provide internal controls.

 

Ethical Issues

Jennie has succumbed to the fraud triangle. Jennie is not fulfilling her fiduciary duty. By stealing monies, fraud and deceit, Jennie has committed acts discreditable to the profession. From the rights perspective, the church has a right to determine its donation to the shelter through the normal process. The church members have a right to expect the staff to uphold their fiduciary duties. From the deontology perspective, Jennie has a duty not to steal or take money without permission of the church. From a utilitarian perspective not all the constituencies of the church may have been considered.

 

Questions

1. Assume Jennie Lin is a CPA.  Evaluate her actions from an ethical perspective.  Jennie believed her actions were proper because taking the money from the church and giving it to the homeless served a greater good. Do you agree with her position from an ethical perspective?

 

 

2. As a member of the board of trustees of the church, what are Jennie’s ethical obligations to the church? Do you think it is more difficult to establish strong internal controls in a nonprofit such as First Community Church as compared to a public or privately-owned company? Why or why not?

 

 

3. (a) Assume Jennie calls Joey and explains the situation. She tells Joey about the impending call from Alex Yuen and, as a friend, asks him not to come to the meeting so she could explain what she has done without his involvement.  If you were Joey, would you stay away from the meeting? Why or why not?

4.     (b) Assume Joey stays away, Jennie explains why she did what she did, and, after due deliberation, Yuen fires Jennie and tells her she must replace the money she “stole” from the collection box. How would you evaluate Yuen’s actions from an ethical perspective?

 

 

 

ZZZZ Best*

 

            The story of ZZZZ Best is one of greed and audaciousness.  It is the story of a 15-year old boy from Reseda, California who was driven to be successful regardless of the costs.  His name is Barry Minkow.

            Minkow had high hopes to make it big – to be a millionaire very early in life.  He started a carpet cleaning business in the garage of his home.  Minkow realized early on that he was not going to become a millionaire cleaning other people’s carpets.  He had bigger plans than that.  Minkow was going to make it big in the insurance restoration business.  In other words, ZZZZ Best would contract to do carpet and drapery cleaning jobs after a fire or flood.  Since the damage from the fire or flood probably would be covered by insurance, the customer would be eager to have the work done. The only problem with Minkow’s insurance restoration idea was that it was all a fiction.  There were no insurance restoration jobs, at least for ZZZZ Best.  In the process of creating the fraud, Minkow was able to dupe the auditors, Ernst & Whinney into thinking the insurance restoration business was real.  In fact, over 80 percent of his revenue was allegedly from this work.  The auditors never caught on until it was too late.

How Barry Became a Fraudster

            Minkow wrote a book, Clean Sweep: A Story of Compromise, Corruption, Collapse, and Comeback** that provides some insights into the mind of a 15-year old kid

__________________

* The facts are derived from a video by the ACFE, Cooking the Books: What Every Accountant Should Know about Fraud.

**Barry Minkow, Clean Sweep: A Story of Compromise, Corruption, Collapse, and Comeback (Nashville, TN: Thomas Nelson, 1995).

who was called a “wonder boy” on Wall Street until the bubble burst.  He was trying to find a way to drum up customers for his fledgling carpet cleaning business.  One day, while he was alone in the garage-office, Minkow called Channel 4 in Los Angeles.  He disguised his voice to sound not like a teenager and told a producer that he had just had his carpets cleaned by the 16-year owner of ZZZZ Best  and was very impressed that a high school junior was running his own business.  He sold the producer on the idea that it would be good for society to hear the success story about a high school junior running his own business.  The producer bought it lock, stock and carpet cleaner.  Minkow gave the producer the phone number of ZZZZ Best and waited.  It took less than five minutes for the call to come in.  Minkow answered the phone and when the producer asked to speak with Mr. Barry Minkow, Minkow said: “Who may I say is calling?”  Within days a film crew was in his garage shooting ZZZZ Best at work.    The story aired that night and it was followed by more calls from radio stations and other television shows wanting to do interviews.  People called demanding that Barry Minkow personally clean their carpets.

            As his income increased in the spring of 1983, Minkow found it increasingly difficult to run the company without a checking account.  He managed to find a banker that was so moved by his story that the banker would agree to allow someone under-aged to open a checking account.  Minkow used the money to buy cleaning supplies and other necessities.  Even though his business was growing, Minkow ran into trouble paying back loans and interest when due.

            Minkow developed a plan of action.  He was tired of worrying about not having enough money.  He went to his garage – where all his great ideas first began – and he looked at his bank account statement which showed that he had more money than he thought he had based on his own records.  Minkow soon realized it was because some checks he had written had not been cashed by customers so it didn’t yet shown up on the bank statement.  Voila!  Minkow started to kite checks between two or more banks.  He would write a check on one ZZZZ Best account and deposit it into another.  Since it might take a few days for the check written on bank number one to clear that banks’ records, at least back then when checks weren’t always processed in real time, Minkow could pay some bills out of the second account  and the first bank would not know – at least for a few days – that Minkow had written a check on his account when, in reality, he had a negative balance.  The bank didn’t know it because some of the checks that Minkow had written before the visit to bank number two had not cleared his account in bank number one.

            It wasn’t long thereafter that Minkow realized he could kite checks big-time.  Not only that, he could make the transfer of funds at the end of a month or a year and show a higher balance than really existed in bank number one and carry it on to the balance sheet.  Since Minkow did not count the check written on his account in bank one as an outstanding check, he was able to double-count.

Time to Expand the Fraud

            Over time, Minkow moved on to bigger and bigger frauds like having his trusted cohorts confirm to banks and other interested parties that ZZZZ Best was doing insurance restoration jobs.  Minkow used the phony jobs and phony revenue to convince bankers to make loans to ZZZZ Best.  He had cash remittance forms made up from non-existent customers with whatever sales amount he wanted to appear on the document.  He even had a co-conspirator write on the bogus remittance form, “job well done.”  Minkow could then show a lot more revenue that he was really making.

            Minkow’s phony financial statements enabled him to borrow more and more money and expand the number of carpet cleaning outlets.  However, Minkow’s personal tastes had become increasingly more expensive including purchasing a Ferrari with the borrowed funds and putting a down payment on a 5,000-square foot home.  So, the question was: How do you solve a perpetual cash flow problem?  You go public!  That’s right, Minkow made a public offering of stock in ZZZZ Best.  Of course he owned a majority of the stock to maintain control of the company.

Minkow had made it to the big leagues.  He was on Wall Street.  He had investment bankers, CPAs and attorneys all working for him -- the 15-year old kid from Reseda who had turned a mom and pop operation into a publicly-owned corporation.

Barry Goes Public

            Minkow’s first audit was for the twelve months ended April 30, 1986.  A sole practitioner performed the audit. (There are eerie similarities in the Madoff fraud with its small practitioner firm – Frichling & Horowita – conducting the audit of a multi-billion dollar operation and that of the sole practitioner audit of ZZZZ Best).

 Minkow had established two phony front companies that allegedly placed insurance restoration jobs for ZZZZ Best.  He had one of his cohorts make out invoices for services and respond to questions about the company.  There was enough paperwork to fool the auditor into thinking the jobs were real and the revenue was supportable.  However, the auditor never visited any of the insurance restoration sites.  If he had done so, there would have been no question in his mind that ZZZZ Best was a big fraud.

            Pressured to get a big-time CPA firm to do his audit as he moved into the big leagues, Minkow hired Ernst &Whinney to perform the April 30, 1987 fiscal year-end audit.  Minkow continued to be one step ahead of the auditors.  That is until the Ernst & Whinney auditors insisted on going to see an insurance restoration site.  They wanted to confirm that all the business – all the revenues --- that Minkow had said was coming in to ZZZZ Best, was real.

The engagement partner drove to an area in Sacramento, California where Minkow did  a lot of work – supposedly.  He looked for a building that seemed to be a restoration job.  Why he did that isn’t clear but he identified a building that seemed to be the kind that would be a restoration job in process.

Earlier in the week,  Minkow sent one of his cohorts to find a large building in Sacramento that appeared to be a restoration site.  As luck would have it, Minkow’s associate picked out the same site as had the partner later on. Minkow’s cohorts found the leasing agent for the building.  They convinced the agent to give them the keys so that they could show the building to some potential tenants over the weekend.  Minkow’s helpers went up to the site before the arrival of the partner and placed placards on the walls that indicated ZZZZ Best was the contractor for the building restoration.  In fact, the building was not fully constructed at the time but it looked as if some restoration work would have been going on at the site.

            Minkow was able to pull it off in part due to luck and in part because the Ernst and Whinney auditors did not want to lose the ZZZZ Best account.  It had become a large revenue producer for the firm and Minkow seemed destined for greater and greater achievements.  Minkow was smart and he used the leverage of the auditors not wanting to lose the ZZZZ Best account as a way to complain whenever they became too curious about the insurance restoration jobs.  He would even threaten to take his business away from Ernst and Whinney and give it to other auditors.  

            Minkow also took a precaution with the site visit.  He had the auditors sign a confidentiality agreement that they would not make any follow-up calls to any contractors, insurance companies, the building owner, or other individuals involved in the restoration work.  This prevented the auditors from corroborating the insurance restoration contracts with independent third parties.

The Fraud Starts to Unravel

            It was a Los Angeles housewife that started the problems for ZZZZ Best that would eventually lead to the demise of the company.  Since Minkow was a well known figure and flamboyant character, the Los Angeles Times did an expose about the carpet cleaning business.  The Los Angeles housewife read the story about Minkow and recalled that ZZZZ Best had overcharged her for services in the early years by increasing the amount of the credit card charge for carpet cleaning services.

Minkow had gambled that most people don’t check their monthly statements so he could get away with the petty fraud.  However, the housewife did notice the overcharge, complained to Minkow, and eventually he returned the overpayment. She couldn’t understand why Minkow would have had to resort to such low levels back then if he was as successful as the L.A. Times article made him out to be.  So, she called the reporter to find out more and that ultimately led to the investigation of ZZZZ Best and future stories that weren’t so flattering.

Since Minkow continued to spend lavishly on himself and his possessions, he always seemed to need more and more money.  It got so bad over time that he was to close to defaulting on loans and had to make up stories to keep the creditors at bay, and he couldn’t pay his suppliers. The complaints kept coming in and eventually the house of cards that was ZZZZ Best came crashing down.

During the time that the fraud was unraveling, Ernst and Whinney decided to resign from the ZZZZ best audit.  The firm never did issue an audit report.  It had started to doubt the veracity of Minkow and the reality of business at ZZZZ Best.

The procedure to follow when a change of auditor occurs is for the company to file an 8-K form with the SEC and the audit firms prepares an exhibit commenting on the accuracy of the disclosures in the 8-K.  The exhibit is attached to the form that is sent to the SEC within 30 days of the change.  Ernst & Whinney waited the full 30-day period and the SEC released the information to the public 45 days after the change had occurred.  Meanwhile, ZZZZ Best had filed for bankruptcy.  During the period of time that had elapsed, Minkow had borrowed more than $1 million dollars and the lenders never were repaid.  The Bankruptcy laws protected Minkow and ZZZZ Best from having to make those payments.

Legal Liability Issues

            The ZZZZ Best fraud was one of the largest of its time.  ZZZZ Best reportedly settled a shareholder class action lawsuit for $35 million.  Ernst & Whinney was sued by a bank that had made a multimillion-dollar loan based on the financial statements for the three-month period ending July 31, 1986. The bank claimed that it had relied on the review report[1] issued by Ernst & Whinney in granting the loan to ZZZZ Best.  However, the firm had indicated in its review report that it was not issuing an opinion on the ZZZZ Best financial statements.  The judge ruled that the bank was not justified in relying on the review report since Ernst & Whinney had expressly disclaimed issuing any opinion on the statements.

            Barry Minkow was charged with engaging in a $100 million fraud scheme.  He was sentenced to a term of 25 years.  Minkow was paroled after serving eight years in jail. During his time in prison, Minkow became involved in Christian ministry, which continued after his probationary release from prison in April 1995. Today he is senior pastor of the Community Bible Church in San Diego, California, having renounced his felonious acts. Minkow is recognized as an expert on fraud, and speaks on the subject to university students and the business community in an effort to prevent fraud.

 

 

This case discusses the actual case of ZZZZ Best and Barry Minkow. The auditors ignored common sense and did not use due care in the audit.

 

Ethical Issues

This case shows how auditors did not use due care or skepticism in the audit of ZZZZ Best. The auditors lost independence and became bedazzled by Barry Minkow, the whiz kid of Wall Street. Due care requires that an auditor discharges professional responsibilities with competence and diligence. It imposes the obligation to perform professional services to the best of the auditor’s ability with concern for the best interest of the public.

 

Questions

1. Do you believe that auditors should be held liable for failing to discover fraud in situations such as ZZZZ Best where top management goes to great lengths to fool the auditors?  Why or why not?

2.     The AICPA Code obligates CPAs to follow specific standards of conduct in conducting audits. Answer the following questions with respect to those standards and the related ethical expectations.

(a)  Why is it important to exercise sensitive moral judgments when conducting an audit? Did Ernst & Whinney meet its obligations in this regard? If not, describe why it failed to meet its obligations.

(b)  What are the criteria for audit independence?  Comment on the independence of Ernst & Whinney in conducting its audit of ZZZZ Best. 

(c)   ) Auditors are expected to exercise due care in the performance of professional services.  Explain the purpose of the due care standard.  Based on the facts of the case, do you think Ernst & Whinney met their due care obligations?  Why or why not?

 

3. These are selected numbers from the financial statements of ZZZZ Best for fiscal years 1985 and 1986:                                    1985                1986

Sales                                             $1,240,524            $4,845,347

Cost of goods sold                            576,694             2,050,779

Accounts receivable                            0                        693,773

Cash                                                    30,321                   87,014

Current liabilities                                 2,930             1,768,435

Notes payable-current                        0                       780,507

            What calculations or financial analyses would you make with these numbers that might help you assess whether the financial relationships are “reasonable?”  Given the facts of the case, what inquiries might you make of management based on your analysis?

 

 

 

 

HealthSouth

 

            The HealthSouth case is unique because the CEO, Richard Scrushy, was initially acquitted on all accounts while five former HealthSouth employees were sentenced by a federal judge for their admitted roles in a scheme to inflate revenues and reported earnings of the company from 1999 through mid-2002.  These amounts are presented in Exhibit 1.

You may want to review the facts of the case presented in the text before reading on.

            HealthSouth was the nation’s largest provider of outpatient surgery, diagnostic imaging and rehabilitative services.  In 2003, the SEC filed a complaint against the company and Scrushy for violating provisions of the Securities Act of 1933 and the Securities and Exchange Act of 1934[1] The complaint alleges that HealthSouth, under Scrushy’s direction and with the help of key employees, falsified its revenue to inflate earnings and “meet their numbers.”  Specifically, false accounting entries were made to an account called “contractual adjustment.”  The contractual adjustment account is a revenue allowance account that estimates the difference between the gross amount billed to the patient and the amount that various healthcare insurers will pay for a specific treatment.  HealthSouth deducted this account from gross revenues to derive net revenues, which were disclosed on the company’s periodic reports filed with the SEC. The allowances were deliberately understated to help meet financial analyst earnings estimates.

            The SEC contends that in mid-2002, certain senior officers of Health South discussed with Scrushy the impact of the scheme to inflate earnings because they were concerned about the consequences of the August 14, 2002 financial statement certification required under Section 302 of the Sarbanes-Oxley Act of 2002.  Allegedly, “Scrushy agreed that, going forward, he would not insist that earnings be inflated to meet Wall Street analysts’ expectations.”

            The filing also alleges that Scrushy received at least $6.5 million from Health South during 2001 in “Bonus/Annual Incentive Awards.”  Also, from 1999 through 2002, HealthSouth paid Scrushy $9.2 million in salary.  Approximately $5.3 million of this salary was based on the company’s achievement of certain budget targets.

            On December 10, 2003, U.S. District Judge Inge P. Johnson sentenced former vice president of finance Emery Harris, who pleaded guilty in March 2003 to a charge of conspiracy and willfully falsifying books and records, to a term of five months in prison on each count to run concurrently, three years of supervised release with five months of unsupervised house detention, and payment of a $3,000 fine and a $200 special assessment.  Harris was also ordered to pay $106,500 in forfeiture.[2]

            The Judge also sentenced each of the following to four years of probation with six months unsupervised home confinement and payment of a $2,000 fine: (1) former Accounting Department vice presidents Angela C. Ayers and Cathy C. Edwards; (2) group vice president Rebecca Kay Morgan; and (3) assistant vice president Virginia B. Valentine.  Ayers and Valentine were also ordered to pay a $100 special assessment, and Edwards and Morgan, a $200 special assessment.  Morgan was also ordered to pay $235,000 in forfeiture.  The four officers all pleaded guilty in April 2003 to conspiracy to commit wire and securities fraud, and Edwards and Morgan also pleaded guilty to wire fraud.

            Ayers, Edwards, Morgan and Valentine all made false entries into the accounts of HealthSouth during the fraud period.  Harris admitted falsifying the company’s finances to generate false entries, knowing that those entries would be included in the company’s filings with the SEC. 

            On June 28, 2005, Richard Scrushy, the former CEO of HealthSouth, was acquitted on all charges despite the testimony of more than a half-dozen former lieutenants who said he had presided over a $2.7 billion accounting fraud while running the Health South national hospital chain.  The jury had even heard secretly recorded conversations between Scrushy and a chief financial officer, William T. Owens, in March 2003 discussing balance sheet problems, with Scrushy asking “You’re not wired, are you?”

            In an ironic twist in the HealthSouth saga, the key prosecution witness in the government’s case against Scrushy, William Owens, was sentenced on December 9, 2005, to five years in prison for his role in the accounting fraud at HealthSouth.  Owens had manipulated the company’s books and instructed subordinates to make phony accounting entries.  He also falsely certified the 2002 financial statements filed with the 10-K Report to the SEC.

            U.S. District Judge Sharon Lovelace Blackburn knocked three years from the prosecutors sentencing request stating to Owens: “I believe you told the truth.”  Blackburn called Scrushy’s acquittal a “travesty.”  Nonetheless, Blackburn said white collar criminals merit stiff sentences, if only to send a message of deterrence to other business executives.  “Corporate offenders are nothing more than common thieves wearing suits and wielding pens,” Blackburn said.[3]

The Fraud Investigation –Implications of Whistleblowing

HealthSouth said a forensic audit by PricewaterhouseCoopers found fraudulent entries to raise the total to a range of $3.8 billion to $4.6 billion, up from $3.5 billion, the government's original estimate. The fraud included $2.5 billion in fraudulent accounting entries from 1996 to 2002, $500 million in incorrect accounting for goodwill and other items involved in acquisitions from 1994 to 1999, and $800 million to $1.6 billion in ''aggressive accounting'' from 1992 to March 2003.

Allegedly, HealthSouth's auditors—and maybe even government regulators—were tipped off to a possible massive accounting fraud at the company five years before it became public knowledge, or at least that's the takeaway from a shareholder's memo that was released by a congressional committee during its investigation. The memo, dated November 1998, was apparently written by an anonymous HealthSouth shareholder and sent to auditor Ernst & Young. In it, the shareholder alerts the audit firm to alleged bookkeeping violations at the rehabilitation-services company. Reportedly HealthSouth's top lawyer assured its independent auditor that it would conduct an internal investigation of the allegations. The committee notes no record of such an inquiry, however. "You bring the smoke, I'll bring the mirrors," the unnamed shareholder wrote in the memo.

The shareholder's list of alleged violations at HealthSouth included an assertion that the company booked charges to outpatient clinic patients before checking that insurers would reimburse the claims. The shareholder also alleged that HealthSouth continued to record these charges as revenue even after payments were denied. "How can the company carry tens of millions of dollars in accounts receivable that are well over 360 days?" the shareholder asked in the letter.

More questions followed: "How can some hospitals have NO bad debt reserves? How did the E&Y auditors in Alabama miss this stuff? Are these clever tricks to pump up the numbers, or something that a novice accountant could catch?" In a statement issued by E&Y, the firm stated it had conducted a review at the time the allegations were made and "determined the issues raised did not affect the presentation of HealthSouth's financial statements.”You people and I have been hoodwinked," the shareholder concluded in the memo. "This note is all that I can do about it. You all can do much more, if all you do is look into it to see if what I say is true." At 10:06 a.m. on Feb. 13, 2003, someone made a sensational claim on the Yahoo bulletin board devoted to discussion of HealthSouth Corp."What I know about the accounting at HealthSouth will be the blow that will bring the company to its knees."

Michael Vines, a former bookkeeper in HealthSo uth's accounting department, tried to spread the word about alleged questionable practices while at HealthSouth but was turned away at every turn. According to Vine’s testimony at the April 2002 federal court hearing, he came to believe that people in the department were falsifying assets on the balance sheet. The accountants, he testified, would move expenses from the company’s income statement – where the expenses would have to be deducted from profits immediately – to its balance sheet, where they wouldn’t have to be deducted all at one time. Thus, the company’s expenses looked lower than they should have been, which helped artificially boost net income.

The individual expenses were relatively small – between $500 and $4,999 a piece, according to Vines’ testimony – because E&Y examined expenses over $5,000. Overall, according to the SEC complaint, about $1 billion in fixed assets were falsely entered. In his testimony, Vines identified about $1 million in entries he believed were fraudulent. He told his immediate superior, Cathy C. Edwards, a vice president in the accounting department, that he wouldn’t make such entries unless she first initialed them. “I wanted her signature on it,” Vines testified. Edwards, according to Vine’s testimony, signed off on the entries and he logged them. Vines also testified that he saw Edwards falsifying an invoice, which according to his testimony was a way to cover up the larger fraud involving the accounts. On April 3, Edwards pleaded guilty to conspiracy to commit wire and securities fraud. As part of the plea, she admitted to falsifying records, although the plea didn’t mention specific incidents. 

Over time, Vines had grown more concerned about the accounting practices, particularly in light of the scandal that had recently erupted at Enron Corp. He quit his job and moved to the accounting office of a Birmingham country club. Not long afterward, he sent an e-mail to E&Y alleging fraudulent transactions between the company's accounts and identifying three account numbers that Ernst should investigate. The accounts covered expenses for "minor equipment," "repairs and maintenance" and "public information," which included costs for temporary workers and advertising job openings, he said in an interview and in court testimony.

Vines's e-mail was passed on to James Lamphron, a partner in Ernst's Birmingham office. Lamphron testified that he had contacted William T. Owens, who was then president and chief operating officer at HealthSouth, and George Strong, who served as chairman of the audit committee of HealthSouth's board. A HealthSouth spokesman said Strong felt the matter was being resolved. According to Mr. Lamphron's testimony, Owens defended the company's accounting practices. He acknowledged that the company had moved expenses from one category to another, but he argued that the company had done it for several years and that it was an acceptable practice. Lamphron testified that Owens called Vines a "disgruntled employee." On March 26, 2004, Owens pleaded guilty to wire and securities fraud and certifying a false financial report to the SEC.

Lamphron testified that E&Y conducted "audit-related procedures" with the accounts Vines pointed out. The result: Ernst "reached a point where we were satisfied with the explanation that the company had provided to us ... We then closed the process." According to Lamphron's testimony, Vines never specified that invoices were being falsified -- only that there was a problem with the three accounts he mentioned. So E&Y never investigated the falsified invoices and didn't find any evidence of fraud. Ernst defended itself by stressing the difficulty of detecting accounting fraud in the midst of a conspiracy involving senior executives and allegedly false documentation. Ernst wasn’t named or charged as a defendant in the government cases and the firm cooperated with investigators.

 

This case discusses the HealthSouth scandal, which was one of the first cases under the Sarbanes Oxley required that the CEO and CFO of a company certify the financial statements as non misleading.

 

Ethical Issues

The ethical issue of this case is whether it is fair that the former CEO of HealthSouth was acquitted of certifying misleading and false financial statements while the CFO is serving a five years for the same act.

 

Questions

1. Do you think lower level employees should be excused from any liability for their actions that contribute towards financial statement fraud when the person in charge of the fraud is found not guilty in a court of law? Use ethical reasoning to support your answer.

2- What is the nature of the contractual allowance account? Can you equate it to other allowance accounts? Explain the rules under GAAP to account for such allowances

 

3-EY wasn’t named or charged as a defendant in the government case against HealthSouth. Based on the limited facts of the case, do you think EY should have been charged for its failure to exercise due care in the audit of HealthSouth? Be specific.

 

 

 

Independence Violations at PricewaterhouseCoopers

On January 6, 2000, the SEC made public the report by independent consultant Jess Fardella, who was appointed by the Commission in March 1999 to conduct a review of possible independence rule violations by the public accounting firm PricewaterhouseCoopers (PwC) arising from ownership of client- issued securities.  The report found significant violations of the firm's, the profession's, and the SEC's auditor independence rules.

Background

On January 14, 1999, the Commission issued an Opinion and Order Pursuant to Rule 102(e) of the Commission's Rules of Practice In the Matter of PricewaterhouseCoopers LLP (Securities Exchange Act of 1934 Release No. 40945) ("Order"),[4] which censured PwC for violating auditor independence rules and improper professional conduct.  Pursuant to the settlement reached with the Commission, PwC agreed to, among other things, complete an internal review by Fardella to identify instances in which the firm’s partners or professionals owned securities of public audit clients of PwC in contravention of applicable rules and regulations concerning independence. 

               The independent consultant's report discloses that a substantial number of PwC professionals, particularly partners, had violations of the independence rules, and that many had multiple violations.  The review found excusable mistakes, but also attributed the violations to laxity and insensitivity to the importance of independence compliance.  According to Fardell’s report, PwC acknowledged that the review

disclosed widespread independence non-compliance that reflected serious structural and cultural problems in the firm.

Results of Independent Consultant’s Report

               The report summarizes results of the internal review at PwC, which included two key parts:  PwC professionals were requested in March 1999 to self-report independence violations; and the independent consultant randomly tested a sample of the responses for completeness and accuracy. The results are as follows.

1.     Almost half of the PwC partners -- 1,301 out of a total of 2,698 -- self-reported at least one independence violation.  The 1,301 partners who reported a violation reported an average of five violations; 153 partners had more than ten violations each. Of 8,064 reported violations, 81.3% were reported by partners and 17.4% by managers; 45.2% of the violations were reported by partners who perform services related to audits of financial statements.  

2.     Almost half of the reported violations involved direct investments by the PwC professional in securities, mutual funds, bank accounts, or insurance products associated with a client.  Almost 32% of reported violations, or 2,565 instances, involved holdings of a client's stock or stock options.

3.     Six out of eleven partners at the senior management level who oversaw PwC's independence program self-reported violations. Each of the 12 regional partners who help administer PwC's independence program reported at least one violation; one reported 38 violations and another reported 34 violations.

4.     Thirty-one of the 43 partners who comprise PwC's Board of Partners and its U.S. Leadership Committee self-reported at least one violation.  Four of these had more than 20 violations; one of these partners had 41 violations and another had 40 violations.

               The random tests of the self-reporting process summarized above indicated that a far greater percentage of individuals had independence violations than were reported.  Despite clear warnings that the SEC was overseeing the self-reporting process,

the random tests of those reports indicated that 77.5% of PwC partners failed to self-report at least one independence violation.  The combined results of the self-reporting and random tests of those reports indicated that approximately 86.5% of PwC partners and 10.5% of all other PwC professionals had independence violations.

               The independent consultant's report identifies key weaknesses in the systems PwC had used to prevent or detect independence violations. These include:

1.     Reporting systems relied on the individuals themselves to sort through their own investments and interests for violations;

2.     Efforts to educate professionals about the independence rules and their responsibilities to the client to comply with the  rules were insufficient;

3.     Resolution of reported violations were not adequately documented; and

4.     Reporting systems did not focus on the reporting of violations that were deemed to be resolved before annual confirmations were submitted.

               The consultant’s report concludes that .  .  .  the numbers of violations alone,  as  PwC acknowledged,  reflect  serious  structural  and cultural  problems that were rooted  in  both  its legacy  firms  [Price  Waterhouse  and  Coopers  & Lybrand].   Although  a large  percentage  of  the reported and unreported violations is attributable solely  to  the Merger, an even larger portion  is not;  thus, the situation revealed by the internal investigation is not a one-time  breakdown explained solely  by  the Merger.  Nor  can  the magnitude of the reported and unreported violations be attributed simply to less familiar Independence Rules such as those pertaining to brokerage, bank and sweep accounts. At least half of the reported and unreported violations consisted of interests held by a  reporting  PwC professional himself or herself, and most of the violations arose from either mutual fund or stock holdings . . . .Independence compliance at  PwC  and  its legacy  firms was dependent largely on individual initiative. This system failed, as PwC  has acknowledged . . . .

Changes Needed

               As accounting firms have grown larger, acquired more clients and  provided  more services, and as investment opportunities and financial arrangements have increased in number and complexity, well-designed and extensive controls are needed both to facilitate Independence compliance and to discourage and detect non-compliance.

               The violations discussed in the consultant's report had come to light as a result of a Commission-ordered review after professional self-regulatory procedures failed to detect such violations.  As a result, the SEC's requested the then current Public Oversight Board (largely replaced by PCAOB), to sponsor similar independent reviews at other

firms and oversee development of enhancements to quality control and other professional standards. The firm also agreed in a settlement to conduct the review and create a $2.5 million education fund after the SEC alleged that some of its accountants compromised their independence by owning stock in corporations they audited. PricewaterhouseCoopers promised at the time to take steps to ensure that it didn’t happen again. As a result of the inquiry, five partners of the firm and a slightly larger number of other employees had been dismissed, and other employees were disciplined but not fired.

               Two changes that resulted from the problems at PwC were: (1) to clearly define family members and other close relatives of members of the attest engagement team that might create an independence impairment for the auditors because of the formers ownership interests in a client and/or their position within the client including having a financial reporting oversight role (Interpretation 101-1); and (2) to restrict the ability of audit personnel from having loans to or from banks and other financial institution clients (Interpretation 101-5).  

This case describes the need for independence during an audit.  Without it, the audit would be compromised.  

Ethical Issues

A lack of independence violates the rights theory because the stakeholders have a right to trust that the external auditors remain independent when conducting their audit so they avoid a bias.  Under the fairness theory, all the stakeholders deserve that a fair audit be conducted.  The theory of deontology requires that the auditor has a duty to report accurate information to the public and adhere to independence requirements. 

Questions

1.     In commenting on the findings in the consultant’s report, the then-chief-accountant of the SEC, Lynn E. Turner said, "This report is a sobering reminder that accounting professionals need to renew their commitment to the fundamental

principle of auditor independence." Why is it so important for auditors to be independent of their clients? Explain the nature of the independence impairments at PwC with respect to the threats to independence impairments discussed in the chapter.

Review question 19 at the end of the chapter and the PeopleSoft case in the chapter. What are the commonalities between the facts of these two cases with respect to independence violations and the facts of PwC’s independence violations? How might the independence violations in these cases negatively affect the ability of an auditor to be objective in performing professional services and maintain her integrity

 

3-     We have discussed the need for an ethical tone at the top and strong internal controls at public companies to help prevent and detect fraud. In Chapter 2 we point out that studies have shown most CPAs reason at stages 3 or 4 in Kohlberg’s model. Given the independence violations at PwC, do you think it is indicative of a stage 3 or 4 reasoning capacity? Or is it stage 1 or 2? Explain.

 

 

---

[1] Securities and Exchange Commission, Civil Action No. CV-03-J-0615-S, U.S. District Court Nirthern District of Alabama, SEC v. HealthSouth Corporation and Richard M. Scrushy, Defendants.

[2] Department of Justice, “Five Defendants Sentenced in HealthSouth Fraud Case,” www.usdov.gov.

 

[3] Carrie Johnson, “5 Years for HealthSouth Fraud: Former Chief Financial Officer was Key Witness,” Washington Post, December 10, 2005, D1.

[4] Available at: http://www.sec.gov.

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