Robert A. Putnam, an engagement partner for Arthur Andersen LLP, was in charge of the audit for HBOC, an Atlanta-based maker of software for the healthcare industry, during the period 1996-1999. HBOC had a fantastic earnings track record. In fact, HBOC's management was so confident of the strength of its financial statements that it made public announcements of the company's revenues, net income, and earnings per share before Andersen's audits or reviews were completed, a practice of which Putnam was aware. However, these financial results reflected the fact that senior officers of HBOC were fraudulently recognizing revenue on transactions that failed to comply with GAAP.

Early in 1997, Putnam learned that HBOC's management was inappropriately recognizing revenue on contracts where a sale was contingent on later approval by a customer's board of directors (such a situation is referred to as a board contingency). Putnam discussed the issue with Jay Gilbertson, the CFO, who claimed that the board contingencies were perfunctory and contained no real risk of cancellation. Gilbertson agreed to provide documentation supporting his claim, but he never did so. Putnam had additional reason to be skeptical concerning HBOC's accounting practices. During the prior year's audit, the auditors identified an instance where HBOC used side letters in its contract negotiations with customers. Auditors were aware of the risks associated with side letters, and Andersen had warned its audit staff that such side letters often are the cause of material revenue misstatements, especially in the software industry.

Putnam also had reason to be skeptical about the integrity of HBOC's management. During 1997, Gilbertson represented to Andersen that HBOC had complied with the latest draft of SOP 97 2, the new software revenue recognition guidelines prohibiting revenue recognition if any board contingency existed. Despite the new standard, HBOC continued to enter into some contracts with board contingencies.

Despite these issues, Putman failed to expand the scope of the audit to address the increased risk of fraud. In January 1999, McKesson Corporation acquired HBOC. On April 28, 1999, McKesson announced that it "had determined that software sales transactions aggregating $26.2 million in the company's fourth quarter ended March 31, 1999, and $16.0 million in the prior quarters of the fiscal year, were improperly recorded because they were subject to contingencies, and have been reversed. The audit process is ongoing and there is a possibility that additional contingent sales may be identified." After the announcement, the company's share price tumbled from approximately $65 to $34 a share (a loss of about $9 billion in market value). Ultimately, the SEC determined that Putnam failed to exercise due professional care, to adequately plan and supervise the audits, and to obtain sufficient appropriate evidence to afford a reasonable basis for an opinion regarding the financial statements. The SEC issued a cease and desist order against Putnam, and denied him the privilege of appearing or practicing before the commission as an accountant for at least five years. In addition, fraud charges were brought against the management of HBOC.

Summarizing the facts from the SEC's Administrative Proceeding against Putnam dated April 28, 2008, we know the following about the quarterly and year-end audits that led to the problems for Arthur Andersen LLP on the HBOC engagement:

● Andersen's Review of HBOC's financial statements-First Quarter 1997 HBOC reported $68 million of software revenue during Q1, and the engagement team tested the account balance and found that $14 million was improperly recorded, which overstated pretax income by 9.4%. Most of the improperly recognized revenue related to board contingencies, and the remainder related to revenue recognized on a contract signed

after quarter end. HBOC management refused to eliminate the improperly recorded revenue, and Putnam did not insist that it does so. Putnam approved an unqualified quarterly review report.

● Andersen's Review of HBOC's financial statements-Second Quarter 1997 The engagement team learned that HBOC continued to improperly recognize revenue on contracts containing board contingencies, and that the company was improperly recording revenue on sales subject to side letter contingencies that allowed for contract cancellation. Further, the engagement team learned that at least one such contract that had been recorded as revenue in Q1 had been canceled during Q2. The engagement team also learned that HBOC had again recognized revenue on a contract signed after quarter end. Putnam recommended to HBOC's management that the revenue from these contracts be reversed, but Gilbertson (the CFO) refused to do so. The errors overstated pretax income by 7%. Despite these facts, Putnam approved an unqualified quarterly review report.

● Andersen's Review of HBOC's financial statements-Third Quarter 1997 The engagement team continued to experience the same difficulties as they had noted in Q2; Putnam continued to do nothing about the problems and continued to approve an unqualified quarterly review report.

● Andersen's Audit of HBOC's financial statements-1997 Year End Andersen's year-end audit included testing of HBOC's revenue recognition and accounts receivable. The engagement team used confirmations as their primary substantive evidence on these accounts. The team sent eight confirmation requests (11

fewer than they sent during the 1996 audit). The confirmations requested customers to confirm amounts owed to HBOC and to confirm that no revenue contingencies existed on software purchased from HBOC. Only three customers responded, and two of those noted contingencies included in side letters. Putman did not direct the team to send any additional confirmations or to perform any additional audit procedures.

In addition, the engagement team learned that HBOC was recognizing too much revenue on maintenance contracts and that material amounts should have been deferred to later periods.

Putnam asked Gilbertson to increase deferred revenue, but Gilbertson refused, promising to do so in later periods. In addition, HBOC acquired other companies during 1997 and recorded acquisition reserves of $95.3 million associated with the expenses of the acquisition. Putnam proposed that HBOC reverse $16 million of the reserves because they were excessive, overstating expenses by 20% (in other words, a cookie jar reserve). Gilbertson refused to make the proposed adjustment.

Despite all these problems, Putnam approved an unqualified audit report and disclosed none of the issues to the audit committee.

● Andersen's Review of HBOC's financial statements-First Quarter 1998 During the review, Putnam discovered that HBOC was misusing the acquisition reserve to offset current period operating expenses, which is in violation of GAAP and had the effect of overstating HBOC's net income. The engagement team also identified another instance of improper revenue recognition associated with a contract involving a side letter.

Once again, Putnam proposed an adjusting entry to correct the problems, but Gilbertson refused to make the entry. Putnam again approved an unqualified quarterly review report.

By April 1998, the engagement manager (Putnam's subordinate) expressed concerns about the earnings management issues occurring at HBOC to Putnam, and Putnam shared the same concerns despite doing nothing to address them. In May 1998, Putnam and the engagement team called a special meeting with Gilbertson and others at HBOC to discuss the issues, and Gilbertson expressed promises to begin properly recording the various transactions.

● Andersen's Review of HBOC's financial statements-Second Quarter 1998 During the quarterly review, the engagement team again noted a variety of errors. These included inappropriate application of acquisition reserves to reduce current period expenses, recognition of excessive revenue from software maintenance agreements, and an understatement of the allowance for doubtful accounts. Putnam informed Gilbertson that if HBOC did not reverse the application of the acquisition reserves, Andersen would not issue its review report. After a heated discussion, Gilbertson reversed the entry related to acquisition reserves but did not correct any of the other errors. Putnam approved the issuance of the quarterly review report.

● Andersen's Review of HBOC's financial statements-Third Quarter 1998 The engagement team again discovered the same types of earnings management issues as in prior quarters, but Putnam did not require HBOC to make corrections. Further, Putnam approved an unusual transaction in which HBOC simultaneously sold to and purchased a product from another company. Putnam advised Gilbertson that the accounting for the transaction would be correct only if the sale and purchase were not linked and if there was a defined end user for the HBOC software. Neither of these conditions was true, and Putnam was aware of this fact (and this transaction ultimately led to a restatement of $30 million about a year later). However, Putnam still approved the issuance of the quarterly review report.

● At the November 1998 meeting of HBOC's audit committee, the CEO informed the audit committee that Gilbertson was resigning as CFO, which was an unexpected event. The CEO asked Putnam if he "had a Cendant on his hands," referring to a widely reported financial fraud case at the time. Putnam responded that he knew of no problems or disagreements with Gilbertson.

In October 1998, McKesson and HBOC announced their merger. Putnam approved the use of Andersen's reports in related filings and made no mention of the associated accounting errors.

● Andersen's Audit of McKesson's financial statements-1998 Year End McKesson hired Andersen to complete the audits, and Putnam and the engagement team continued to discover various accounting errors. Still, Putnam did not require the team to expand the scope of audit testing. Putnam again approved the issuance of an unqualified audit report.

During the spring of 1999, McKesson initially disclosed some of the revenue recognition issues, and by the summer of 1999, McKesson reported restatements of the 1997 and 1998 financial statements. Ultimately, six members of upper management of HBOC were charged with securities fraud. The SEC issued a cease and desist order against Putman and denied him the privilege of appearing or practicing before the commission as an accountant for at least five years. In many instances of fraudulent financial reporting, the auditor is completely unaware of the fraud until it ultimately unravels. That is certainly NOT the case for the HBOC fraud. Rather, it is very clear that Putnam and his Andersen engagement team were well aware of the fraud and possessed detailed knowledge of precisely how it was accomplished. Yet, they did virtually nothing to address the situation.

a. What was Putnam's critical mistake in the review of Q1 1997? How did that critical mistake affect his willingness to take action to address the problems in the HBOC audit in later periods?

b. What do you think could have motivated Putnam to act as he did? Why do you think that after all the problems that he encountered, he was still willing to acquiesce to the obviously inappropriate sale/purchase transaction in Q3 1998?

c. What other elements of corporate governance failed in the HBOC situation?

d. The confirmation process in the 1997 year-end audit was clearly flawed. What did the engagement team and Putnam do wrong?

e. The McKesson acquisition of HBOC provided an opportunity for Putnam to deal with what he knew. Obviously, McKesson management would have been eager to know about the earnings management issues at HBOC prior to acquiring the company. Instead, Putnam did not reveal the problems he had been encountering, even when asked directly by the CEO and the audit committee. Use the professional decision making framework introduced in Chapter 4 to make a recommendation about a course of action that would have enabled Putnam to do the right thing during the acquisition process and alert the other parties involved in corporate governance of HBOC and McKesson about the problematic behaviors he had been encountering. Recall that the framework is as follows:

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