On May 22, 2012, the audit firm of Brock, Schechter & Polakoff LLP (hereafter BSP) was censured and fined $20,000 by the PCAOB in relation to its audits of public companies located in Taiwan and China. These public companies were listed on U.S. stock exchanges. James Waggoner, BSP's Director of Accounting and Auditing, was the BSP auditor responsible for the audits. The charges against BSP and Waggoner include the following:
— BSP failed to develop policies and procedures to assure that the firm undertook only audit engagements that it could expect to conduct with professional competence. Prior to undertaking the audits of the Taiwan and Chinese companies, the firm had no experience auditing public companies in general or companies based in these locations. Further, BSP personnel lacked the ability to communicate in Chinese.
— BSP failed to develop policies and procedures to assure that the personnel assigned to the audits had the requisite technical training and proficiency.
— BSP failed to monitor the audits during its annual internal review process.
— BSP failed to comply with PCAOB standards on the planning, performance, and supervision of the audits.
— BSP failed to gather sufficient evidence, failed to use due care, and failed to exercise professional skepticism on the audits.
— BSP allowed two other audit firms, which were located in Taiwan and China, to plan and perform the audits. BSP had minimal contact with the foreign firms, and inadequately reviewed the working papers of the foreign firms. BSP also failed to obtain and review engagement completion documentation from the foreign firms prior to issuing the audit reports.
— Waggoner failed to comply with professional auditing standards.
Further, he failed to cooperate with PCAOB inspectors, and he falsified documentation relating to the audits. The Kid Castle Audits. Kid Castle is a company located in Taiwan that provides English-language instruction to Chinese-speaking children.
Kid Castle was traded on the OTC Bulletin Board and Pink Sheets. A Taiwanese audit firm approached BSP in June 2006 concerning the Kid Castle audit, and BSP was hired as the auditor on July 26, 2006. BSP expressed unqualified audit opinions on the company's 2006-2008 financial statements.
In addition to the general criticisms detailed above, the PCAOB enforcement release provides detailed information on audit quality deficiencies on the Kid Castle audits, including the following:
— BSP failed to consider the nature, extent, and timing of audit work necessary to audit Kid Castle. Instead, BSP relied completely upon the Taiwan firm to make these considerations and to develop the audit program.
— BSP failed to adequately supervise the auditors of the Taiwan firm, including:
— Failing to assess the technical competence of the Taiwan firm's auditors
— Failing to assign the Taiwan auditors to tasks according to their abilities
— Failing to instruct the Taiwan firm's auditors
— Failing to inform the Taiwan firm's auditors about their responsibilities and the objectives of the audit
— Failing to inform the Taiwan firm's auditors about matters that affected the nature, extent, and timing of audit procedures
— Failing to direct the Taiwan firm's auditors to bring to BSP's attention significant accounting/auditing issues encountered during the audits
— BSP failed to adequately perform a review of the Taiwan firm's audit work, and such a review was the principal involvement required of BSP. In fact, Waggoner assigned the final responsibility for reviewing the audit to a BSP staff member.
— The reviewing staff member did find deficiencies in the audit procedures performed by the Taiwan auditor. Waggoner forwarded those deficiencies to the Taiwan firm's auditors, but they did not address those deficiencies or conduct additional audit work.
— For the 2007 audit, BSP did not receive or review any working papers from the Taiwan auditor, except for a set of worksheets showing consolidation work among Kid Castle's subsidiary accounts. For the 2008 audit, BSP did not receive or review any working papers.
Kid Castle Risk Factors and Financial Condition. In its December 31, 2008, Form 10K, Kid Castle management disclosed the following risk factors relating to its business:
— There is a history of operating losses and difficulty maintaining profitability.
— Demand for products and services is unpredictable.
— The company's operating results are dependent upon the success of its franchises.
— Market competition from established competitors could negatively affect the business.
— International expansion plans may not be successful.
— There exist risks relating to the company's potential inability to defend and protect its intellectual property.
— The Company relies on loans from shareholders and bank loans, which may adversely affect liquidity.
— Because the company's officers and directors are not U.S. persons and because subsidiaries are Taiwanese or Chinese, judgments under the U.S. securities laws may not be able to be enforced.
— Internal controls are not effective in accordance with the requirements of Sarbanes-Oxley Act of 2002 (SOX).
— The Company€™s assets and operations in the People's Republic of China are subject to political, regulatory, and economic uncertainties.
In addition, BSP issued a going-concern audit report, which indicates concern about the company's ability to remain operational. The financial statements of Kid Castle are as follows:

During 2010, Kid Castle stock was no longer trading in any U.S. markets.

KID CASTLE EDUCATIONAL CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS

James Waggoner was censured by the PCAOB and cannot practice on any public company audits in the U.S. for at least three years.
a. Why would the inherent and control risks at Kid Castle be of concern to a potential auditor?
b. Review the financial statements and calculate the commonly used ratios from Exhibit 7.3 for the years ending 2008 and 2007. Assume that the auditor expected the 2008 financial results to be line with the 2007 financial results. Given this expectation, comment on the trends in the financial statements and ratios that would cause the auditor to assess heightened risk.
c. Based on your answers to (a) and (b), for what accounts would you recommend that the auditor plan to conduct more substantive audit procedures?
d. The 10-K discloses the fact that BSP earned total audit fees in 2007 and 2008 of $121,026 and $150,000, respectively. Comment on the motivations of BSP and Waggoner to accept the foreign audits and how those motivations might have affected Waggoner's lack of ethics and how those motivations might have affected his professional skepticism. Presumably, BSP had to pay the Taiwan and Chinese audit firms a portion of the audit fee, and based on the allegations in the PCAOB enforcement release, BSP did virtually no audit work. Comment on your thoughts about the appropriateness of hiring a foreign audit firm to conduct the majority of audit work on an engagement and on BSP's actions (or lack thereof) in this regard.
e. Use the framework for making quality professional decisions from Chapter 4 to identify those steps in the framework where Waggoner went wrong and describe what he should have done differently.
f. Describe the risks that an audit firm faces when it attempts to audit a company in a foreign country.
For additional information on the PCAOB enforcement releases relating to this case, see PCAOB Release Nos. 105-2012-002 and105-2012-003.

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KID CASTLE EDUCATIONAL CORPORATION CONSOLIDATED BALANCE SHEETS December 31, 2008 December 31, 2007 (Expressed in U.S. Dollars) ASSETS Current assets Cash and bank balances Bank fixed deposits-pledged (Note 12 Notes and accounts receivable, net Notes 3 and 20 2,171,768 Inventories, net (Note 4] Other receivables (Notes 5 and 20] Prepayments and other current assets (Note 6) Pledged notes receivable (Note 12) Deferred income tax assets (Note 7 Total current assets Deferred income tax assets (Note 7) Interest in associates (Note 8) Property and equipment, net (Note 9) Intangible assets, net of amortization (Note 10 Long-term notes receivable Pledged notes receivable (Note 12) Other assets Total assets $1,238,212 363,562 2,453,868 2,008 739 88,139 542,794 557,983 $1,985,818 2,847 1,933,153 396,003 475,617 416,238 7 427,061 49,528 68,336 2,775,663 371,056 356,901 283,469 255.288 11,587,302 7,295632 50,481 58,625 2,312,065 572,005 420,636 183,453 268,388 11,161,285 December 31, 2008 December 31, 2007 (Expressed in U.S. Dollars) UABILUTIES AND SHAREHOLDERS EQUITY Current liabilities 242,879 Bank borrowings- shortterm and maturing within one year (Note 12) Notes and accounts payable (Note 19) Accrued expenses (Note 11) $ 1,212,534 1,017,552 1,617,717 389,639 985,764 Amounts due to officers (Note 19) Other payables 270,458 751,151 2,305,980 39.115 6,244,852 1,583,968 1,001,801 839,295 41,775 446,038 10,157,729 Deposits received (Note 13) Receipts in advance (Note 14) 573,237 912,535 2,372,403 Income tax payable (Note 7) Total current liabilities Bank borrowings maturing after one year (Note 12 Receipts in advance (Note 14) Deposits received (Note 13) Deferred liability 6,570,530 1752,776 1,034,260 680,694 38,787 Accrued pension liabilities (Note 15) Total liabilities 10,478,940 Commitments and contingencies (Note 16) Minority interest 162,343 Shareholders' equity Common stock, no par share (Note 17 60,000,000 shares authorized; 25,000,000 shares issued and outstanding at December 31, 2008 and 2007, respedively Additional paid-in capital Legal reserve Accumulated deficit (Note 18) Accumulated other comprehensive loss Net loss not recognized as pension Total shareholders' equity Total liabilities and shareholders' equity 8,592,138 194,021 65,320 6,340,449 1,026713) 271498 1,212,819 8,592,138 194,021 65,320 (7,179418) 932,027) 220,032 520,002 $11,161,285 cost Years Ended December 31 2007 (Expressed in U.S. Dollars) 2008 2006 Operating revenue (Note 21) Sales of goods Franchise income Other operating revenue Net operating revenue $ 7,905,949 $7,671392 $6774,260 2,205668 2,080,551 1359552 85612 11,236612 9711,583 2,380,930 12,845 111 Operating costs Note 21) (3,357,441 (3,154,509) (2,684,650 (451,469 (337,986 91,869 616 1021 Cost of goods sold Cost of franchising Other operating costs Total operating costs Gross profit Advertising costs Other operating expenses Profit from operations (368,061) 17778621 15.503 3641 7,341 747 22,735) 7847 3638 738 7,138765 6,072,845 (21,833) 342216 5.526,3181 524,694 90,299 (179,825) (39,489) 153,803 151,577 29,241) 1,046,259 (89,761) 5,109 1,767,308 t expense, net (Note 12) Share of profit (loss of investments 27,007 Other nonoperating income (loss), net 24789 5520 Profit before income taxes and minority interest income 986,396 2256 627 Income taxes (expense] benehit (Note 71 Income (loss) after income taxes 106215 2781911 173 325 (21,748) ー141,2121-101.2871-1244631 880,181 1,978 436 Minority interest income Net income (loss) Income (lossl per share-basic and diluted 838.969 $1,877,149 0.034 $0.075 $(0.002]