Orecchio and Oliver agreed to be equal partners in AA Capital. Orecchio assumed the titles of president and secretary for the new firm, while Oliver took the titles of chairman and treasurer. Because of Orecchio's extensive experience in investment management, the two partners agreed that he would oversee the firm's day-to-day operations. Orecchio's key responsibilities would be recruiting clients and managing AA Capital's investments. Initially, Orecchio intended to focus his recruiting efforts on key officials of local labor unions. He hoped that he could quickly establish a customer base by convincing several of those individuals to entrust the management of their unions' pension funds to AA Capital.
Orecchio's plan was successful. By the end of 2004, he had persuaded six labor unions to transfer the assets in their pension funds to AA Capital. The collective value of those funds was approximately $200 million. Orecchio allocated the $200 million to four private equity funds organized under the corporate umbrella of AA Capital. The largest of these funds was the AA Capital Equity Fund, which was commonly referred to as the Equity Fund.
AA Capital's accounting function was the responsibility of one person, Mary Beth Stevens. Stevens, who was not a CPA but had several years of accounting experience, was eventually given the title of CFO and chief compliance officer, as well.
In the latter role, Stevens had the responsibility for complying with the complicated maze of governmental rules and regulations imposed on AA Capital by various federal and state statutes, principal among them the Investment Advisers Act of 1940.
Stevens also served as AA Capital's liaison to the company's independent auditors.
The Investment Advisers Act requires investment advisory firms that manage more than $25 million of assets to register with the Securities and Exchange Commission (SEC) and file annual audited financial statements with that federal agency.
Earnest Auditors
The Chicago office of Ernst & Young audited AA Capital and its four private equity funds. In 2004, Gerard Oprins, an Ernst & Young partner since 1995, was asked to oversee the AA Capital audits. Oprins, who had just returned to Ernst & Young's Chicago office after spending nearly three years in the firm's Luxembourg office, was unfamiliar with AA Capital. Before agreeing to serve as the firm's audit engagement partner, Oprins spoke with several colleagues and business associates who were acquainted with AA Capital and its owners. Based upon his research, Oprins' determined that AA Capital would be a "legitimate, respectable client.^"1
Wendy McNeeley, an audit manager, served as Oprins' principal subordinate on the 2004 AA Capital engagement. Similar to Oprins, McNeeley was unfamiliar with AA Capital. To prepare for her assignment, McNeeley reviewed prior-year workpapers and gained an understanding of the "basic client structure, the nature of the entity, and its industry." The independent review or concurring partner for the AA Capital engagement was John Kavanaugh. The remaining members of the audit team consisted of two seniors and two staff accountants.
A subsequent report prepared by the SEC provided the following descriptions of the roles and responsibilities of Oprins, McNeeley, and Kavanaugh on the AA Capital engagement.
Oprins was the engagement partner. His role was to set the tone for the audit, staff the audit team adequately, and focus on high-risk areas. His responsibility was to oversee the audit manager and sign the audit report. As engagement partner, Oprins used discretion in reviewing the detailed audit workpapers, but typically reviewed workpapers that involved planning and audit strategy, as well as the GAAP Disclosure Checklist2. . . . [His principal] responsibility was to review and analyze significant auditing issues brought to his attention by McNeeley or the audit team.
McNeeley was the audit manager. She was responsible for the day-to-day oversight of audit planning and execution of the audit strategy. She also supervised the audit staff and reviewed audit workpapers in significant risk areas.
Kavanaugh provided quality control. This required him to read the financial statements, to understand the audit approach, and to ensure that the financial statements were stated in accordance with GAAP or any other basis of presentation used.
After an initial planning meeting of the audit engagement team, Oprins and McNeeley met with Orecchio and Stevens in AA Capital's downtown Chicago office in late April 2005. During this meeting, the four individuals discussed various accounting matters and the procedures that the firm had in place to prevent and detect fraud.
Next, McNeeley outlined the "planning and audit strategy" for the AA Capital engagement in a standard Ernst & Young audit document referred to as the Audit Strategies Memorandum (ASM). In this document, McNeeley noted that she and her subordinates would not "rely on AA Capital's internal controls." Instead, the audit team would perform "substantive testing on all account balances." McNeeley also oversaw the preparation of another standard Ernst & Young audit document for the AA Capital engagement, Internal Control and Fraud Considerations (ICFC). The purpose of this document is to identify "potential risks of material misstatement due to fraud."

Questions
1. What factors likely contributed to the oversights made by the Ernst & Young auditors during the 2004 AA Capital engagement? Identify measures that audit firms can implement to minimize the likelihood of such oversights on audit engagements.
2. Was it appropriate for Ernst & Young to decide not to rely on AA Capital's internal controls during the 2004 audits? Under what circumstances can auditors choose not to rely on a client's internal controls?
3. What audit procedures do professional auditing standards require that auditors apply to related-party transactions? Would any of these procedures have resulted in Ernst & Young discovering the true nature of the cash transfers made to John Orecchio?
4. What objectives do auditors hope to accomplish in performing "subsequent period" audit tests?
5. Do you agree with the assertion of John Ellingsen that an audit engagement partner is not "responsible for all decisions made in the course of an engagement?" Defend your answer. What quality control implications does that assertion, if true, have for audit firms?