Case 2 - Pleasant Pasta Overview

Pleasant Pasta (the Company) was the largest dry pasta producer in North America. As a manufacturer and marketer of pasta products, Pleasant competed for market share with many other companies in a low-growth industry. Despite the competitive nature and maturity of the pasta market, Pleasants management team was determined to become a high-growth company. After successfully executing an initial public offering (IPO), Pleasants management team developed a short-term strategy which would allow the Company to achieve the rapid growth promised to its new investors. Specifically, Pleasant decided to focus

on marketing its products under generic brand names owned by several leading grocery chains. While the strategy did allow the Company to initially achieve the sales and earnings growth management desired, it became clear that Pleasant could not continue to rapidly grow its business solely through generic channels of distribution. Aware of this, management devised a long term performance plan that outlined aggressive top and bottom line numbers for fiscal years 2002, 2003, and 2004. The strategic initiative referred to as Extraordinary Performance unambiguously laid out managements primary objective for the next three years: grow revenue, grow earnings, and grow earnings per share (EPS) at all costs.

Achieve the Extraordinary targets

Shortly after the start of fiscal year 2002, it became obvious that Pleasant Pasta was having difficulty meeting the aggressive Extraordinary targets set by management. Due primarily to the increasing popularity of low-carbohydrate diets like the Atkins diet, consumer demand for pasta had dropped, rather dramatically. Plummeting demand coupled with a historically low industry growth rate created a difficult environment for the Company to operate in. Dissatisfied with performance, the CEO assembled a task force to focus on closing the gap between the Extraordinary targets and actual results. In these meetings, the

CEO boldly stressed that their task would only be accomplished when reported results met analysts expectations. As a direct consequence, task force members were committed to the full execution of strategic profit initiatives to enable the Company to meet its Extraordinary targets. Without a doubt, the tone at the top set by the CEO in these meetings had an impact on task force members because most considered the use of improper accounting practices to be part of the plan to achieve the Extraordinary initiatives.

Close the Gap

To start, the task force focused on the trade promotion expense account to help close the gap between actual and targeted profit. For example, the Company had recently acquired several other large pasta brands. A routine aspect of promoting such brands involved product discounts, promotions, advertising, and volume rebates that together made up trade promotion expenses. Based on a detailed financial analysis, it was clear that these types of expenses were consistently greater than the amount accrued for in the budget, which reduced actual profits. To remedy this, the task force decided that Pleasant Pasta was justified in including a portion of promotional expenses into the brand acquisition costs, thereby capitalizing a portion of the costs that had previously been expensed. These unsupported journal entries reduced the trade promotion expenses by greater than 50%, boosting the Companys actual profits.

The second phase of the task forces strategic profit initiative focused on reducing manufacturing expenses. Since its IPO, the Company had grown at a tremendous rate and taken on a number of significant capital projects to expand production lines. Under GAAP, the Company should have separated out internal labor costs from ordinary operating expenses, capitalizing only the labor related to the capital projects. However, the task force determined that it would be best to reduce operating expenses by capitalizing all budgeted internal labor and manufacturing overruns. To further contain rising expenses, the task force refused to write off obsolete assets, which had the effect of reducing reported depreciation expense.

As the pasta market continued to shrink, the task force realized that its efforts to suppress the Companys expenses were simply not enough. Determined to meet the CEOs objectives, the task force began to concentrate on ways to increase Pastas reported sales revenue. Reduced demand for pasta had driven many customer orders well below the contractually agreed upon minimum purchase volume. As such, numerous customers were contractually required to pay the Company a higher price on purchases

until contractual volume numbers were met. Under GAAP, the premiums paid on each order should have been recognized as revenue immediately. However, at the direction of the task force, the Company not only recognized the revenue associated with the actual price increases, but also their projected price increases in order to boost reported earnings. Further, the task force authorized significant promotional discounts that resulted in several material sales in the final days of each period. Unwilling to fall short of the Extraordinary targets, the task force even improperly recognized revenue before shipping the product in many end of year transactions.

Overall, the task forces efforts to improperly reduce costs and inflate revenues resulted in an overstatement of EPS by 23% in 2002, 41% in 2003, and 59% in 2004. Additionally, over the fraudulent years, Pleasant Pastas pretax income was improperly inflated by greater than 66%, which helped to fuel a significant stock price increase for the company.

Fraud Discovery

In 2008, Pleasant Pasta publicly admitted that the Companys 2002, 2003, and 2004 consolidated financial statements were materially misstated due to fraud. In its admission and subsequent restatement, the Company attributed the fraud to an inadequate system of internal controls as well as managements failure to maintain an appropriate tone at the top. The discovery was made through a combination of an internal whistle-blower, significant management turnover, and ultimately an SEC investigation.

Case Questions:

Based on your understanding of fraud risk assessment and the case information, identify at least three specific fraud risk factors related to the Pleasant Pasta Company.

If you were responsible for planning the audit of Pleasant Pasta, how would the fraud risk factors identified in question #1 have influenced the nature, timing, and extent of your audit work?

Please consider the five steps of the KPMG Judgment Framework. For each step, think carefully about what the auditors could have done to help detect the fraudulent activity related to the capitalization of trade promotion and manufacturing expenses at the Pleasant Pasta Company. Please use the following questions to guide your critical thinking about this case:

a) Clarify the issue and the objectives related to auditing whether certain trade promotion and manufacturing expenses should be capitalized at Pleasant Pasta. To do so, please ask yourself what specific problem needs to be solved by the auditor? What assumptions would have the biggest impact on the overall judgment to be made? How does this judgment relate to the overall audit process?

b) Consider the various alternatives that should be thought about when auditing whether certain trade promotion and manufacturing expenses should be capitalized at Pleasant Pasta. To do so, please ask yourself about each of the alternatives that are reasonably possible, even when they might contradict the clients point of view. Are there any external factors that should be considered?

c) Consider the type of information and evidence that should be gathered when completing the audit of entity level controls at Pleasant Pasta. To do so, please ask yourself about the type of information that would be helpful to determine whether entity level controls were operating effectively. How can you be sure that the information is reliable? In addition, how can you be sure that the evidence is appropriate in this situation? Finally, what evidence could be gathered that might reveal that the entity level controls were NOT operating effectively?

d) Consider the type of information and evidence that should be gathered when completing the audit of the internal control activities related to the trade promotion and manufacturing expenses at Pleasant Pasta. To do so, please ask yourself about the type of information that would be helpful to determine whether the internal control activities were operating effectively. How can you be sure that the information is reliable? In addition, how can you be sure that the evidence is appropriate in this situation? Finally, what evidence could be gathered that might reveal that the internal control activities were NOT operating effectively?

e) Consider the type of information and evidence that should be gathered when completing the substantive testing procedures related to the trade promotion and manufacturing expenses at Pleasant Pasta. To do so, please ask yourself about the type of information that would be helpful to determine whether the trade promotion and manufacturing expenses were fairly stated in the financial statements. How can you be sure that the information is reliable? In addition, how can you be sure that the evidence is appropriate in this situation? Finally, what evidence could be gathered that might disconfirm your belief that the trade promotion and manufacturing expenses were fairly stated?

f) Consider the factors that would have to be thought about when reaching a final conclusion about the trade promotion and manufacturing expense accounts at Pleasant Pasta. Although you do not have access to the actual evidence, what big picture issues would have to be considered before reaching a final conclusion? Finally, what could possibly go wrong in this situation?

g) Consider the importance of documenting the rationale for your final conclusion. Why do you think it is important to document your rationale when finalizing your judgment? In addition, describe what is expected to be documented to support an auditors professional judgment.

Describe the availability tendency in your own words, and give an example of how the tendency could result in a lack of audit effectiveness. How can the tendency be mitigated?

Describe the confirmation tendency in your own words, and give an example of how the tendency could result in a lack of audit effectiveness. How can the tendency be mitigated?

Describe the overconfidence bias in your own words, and give an example of how the bias could result in a lack of audit effectiveness. How can the bias be mitigated?

Describe the anchoring bias in your own words, and give an example of how the bias could result in a lack of audit effectiveness. How can the bias be mitigated?

What judgment tendency or bias is most likely to have manifested in the Pleasant Pasta case example? Please provide support for your answer.