At some point in their careers, every public accountant reaches that crossroads where they must answer the important question: Should I stay in public accounting or should I accept a job offer in the "outside" world? Duane Knight, a CPA employed by the Denver-based accounting firm Hein + Associates (HA), reached that point in his career in February 1994. \({ }^{1}\) Knight graduated with an accounting degree from Colorado State University in 1983 and accepted a job three years later with HA. By 1994, Knight had risen to the position of audit manager, one step from becoming a partner with his firm. On February 15, 1994, George Mallon, the president and chief executive officer (CEO) of Mallon Resources Corporation, telephoned Knight. Mallon asked Knight if he would be interested in becoming the treasurer and principal accounting officer of Mallon Resources, a publicly owned company that operated a gold mine and owned several large oil and gas properties.

Knight was well acquainted with Mallon Resources since HA had served as the company's audit firm for several years. In fact, Knight had been assigned to the audit engagement team for that client since 1991. In February 1994 when George Mallon contacted him, Knight was supervising the fieldwork on the audit of Mallon Resources for its fiscal year ended December 31, 1993.

Following his conversation with George Mallon, Knight became concerned that he had an "independence problem." This concern caused Knight to discuss the matter with a fellow audit manager at HA. After reviewing the applicable professional standards, the two men concluded that Knight indeed had an independence problem. However, Knight did not immediately bring this matter to the attention of his superiors at HA.

George Mallon formally offered Knight the position of treasurer and chief accounting officer of Mallon Resources on February 17, 1994. Knight promptly notified a senior HA audit partner of the job offer. The two men decided that Knight should dissociate himself from the Mallon Resources audit while the job offer was pending. One week later, on February 24, 1994, Knight accepted the job offer extended by George Mallon. Knight immediately informed his superiors at HA of his decision and told them that he would terminate his position with the accounting firm on March 31 and assume his new position with Mallon Resources on April 1. Within the next few days, HA assigned another audit manager to oversee the Mallon Resources audit. Despite the decision to remove Knight from the Mallon Resources audit, he continued to be involved in that engagement during his last few weeks of employment with HA.

Knight's involvement in the Mallon Resources audit after February 24, 1994, included developing several "prepared-by-client" schedules for the company. Among these schedules were analyses of Mallon Resources' tax deferrals. HA audited these schedules and filed them in the Mallon Resources workpapers. Knight also prepared unaudited exhibits included in the 1993 10-K registration statement that Mallon Resources submitted to the Securities and Exchange Commission (SEC). Knight's former subordinates on the HA engagement team reviewed these exhibits. Finally, during March 1994 Knight spent considerable time in the Mallon Resources corporate offices. At least some of this time he spent working on matters related to the company's 1993 audit. For example, on March 28, Knight reviewed the Management's Discussion and Analysis (MD\&A) section that accompanied Mallon Resources' 1993 audited financial statements. He also discussed the content of the MD\&A section with the company's legal counsel.

Clarence Hein contacted Knight on March 29, 1994, two days before Knight formally joined Mallon Resources. Hein, HA's managing partner, served as the audit engagement partner for the Mallon Resources audit. Hein asked Knight to review several important and unresolved issues on the audit, which was nearing completion. Eventually, Hein arranged a conference call with SEC personnel to discuss one of those issues. Knight, Hein, and the new audit manager assigned to the Mallon Resources audit participated in that conference call. During the telephone conversation, Knight was identified simply as a "future Mallon employee."

Although Hein knew that Knight was still a Hein + Associates employee, he told Knight that he should represent Mallon's perspective in the telephone call with the [SEC] staff.

Following the conference call, Hein asked Knight to write a memo on behalf of Mallon Resources that documented the resolution of the issue discussed with the SEC. Two weeks later, after Knight had begun working for Mallon Resources, he sent the memorandum to Hein. The memo was then included in the workpaper file for the 1993 Mallon Resources audit.

Mallon Resources filed its 1993 10-K with the SEC on April 4, 1994. The \(10-\mathrm{K}\) contained the company's audited financial statements for 1993 and HA's unqualified audit opinion on those statements. During the first two weeks of April, Knight, now an employee of Mallon Resources, continued to work on assignments for HA. Knight eventually billed HA for 55 hours of work he performed as an "independent contractor" for the accounting firm during those two weeks.

In June 1994, the SEC began investigating Duane Knight's relationship with HA and Mallon Resources during the company's 1993 audit. The SEC questioned Knight's status after reviewing documents Mallon Resources had submitted to the federal agency. Those documents suggested that Knight had served in dual and conflicting roles during the 1993 Mallon Resources audit. 

QUESTIONS 

1. Define auditor independence. Why is independence often referred to as the cornerstone of the auditing profession?

2. Identify the specific violations of the profession's ethical rules by the parties involved in this case. Relying on the timeline included in Exhibit 1, indicate when each of these violations occurred.
3. Do you agree with the SEC that Knight's conduct following his acceptance of the job offer from George Mallon "tainted" the entire 1993 audit of Mallon Resources? Why or why not?
4. Should auditors be allowed to become employees of their former clients? Defend your answer. What problems does this practice pose for

(a) the auditing profession,

(b) audit firms, and

(c) audit clients?