CHANGINGAUDITORSTHE CASE OFCALLAWAY

GOLFCOMPANYANDITS FOUR DIFFERENT AUDITORS IN ONEYEAR

CASEDESCRIPTION

Thiscaseexaminesaproposednewauditorwhoisconsideringacceptinganewaudit client.Thestudentthensearchestheprofessionalliteratureregardingauditorchanges.In particular,studentsarerequiredtoresearchGenerallyAccepted AuditingStandards(GAAS) regardingchangingauditorsandtheSecuritiesandExchange Commission(SEC)form8-K disclosure rules for auditor changes.

Thecaseisappropriateforseniorlevelandgraduatelevel auditingcourses. The difficultylevelofthiscaseis3to5.Thecaseisexpected torequirethreehoursofoutside preparationandisdesignedtobetaughtinoneclassperiod.Thesuggestedfinalproductofthis caseisashortmemowherethestudentevaluatesthepossiblereasonswhyacompany may changeauditorsaswellastherequiredresponsesfromtheauditorwhenachangeinauditors occurs.The case also works well as a discussion vehicle to discuss auditor changes.

Thiscaseexposesstudentstoareal-worldsituationderivedfromCallaway Golf Company's(Callaway)8-Kfiling,whichdocumentsadisagreementbetweenCallawayandtheir auditor.(Additional information is taken from Callaway's 10-K and 12B-25 filings.)

CASE SYNOPSIS

Whatcircumstancesinducedawellknown NYSEtradedcompany toemploy four differentauditorsinthespanofapproximately oneyear? Theprincipaleventinthiscaseisa disagreementbetweenCallawayandtheauditingfirmofKPMGPeatMarwick(KPMG) overthe interpretationofandaccountingtreatmentforcertaintransactions.Althoughmostcompanies and auditorsgotogreateffortstokeepanyaccountingdisputeprivate,bothCallawayandthe previousauditorinthiscasemadethedetailsoftheirdisputepublic,providingthepublicwith interestingdetailsonadisputebetween acompanyanditsauditorandhowaccounting standards are often open to different interpretations.

HISTORY

Callawayisknownformakingnumeroustypesofgolfequipment,includingclubs,putters,balls,anddrivers.In1991CallawayintroducedtheBigBerthadriver.TheBigBertha wasthefirstwidebodystainlesssteel"wood"introducedinthegolfmarket. Thefounderof Callaway Golf,ElyReevesCallaway Jr.,iscredited withtheideaofastainlesssteelgolfclub takingitsnamefromaWorldWarIGermancannonknownforitslong-distancecapabilities.In 1991MarkBrookswasthefirstPGATourplayertousetheBigBerthatowinaPGA tournament,theGreater GreensboroOpen.TheBigBerthawasaninstantsuccessandthe followingyearthecompanywentpublicontheNYSEunderthetickersymbolELY(Callaway website).Callaway continuedtoinnovate,andin1995introducedadrivermadepartiallywith titanium.Titaniumislighter andstrongerthansteelanddoesnotrust.Followingthesuccessof thetitaniumdriver,Callawaythenintroducedtitanium fairwaywoodsin1996(Callaway website).Althoughtitanium hasadvantagesoversteel,newmaterialssometimesincrease the riskofproductfailureandacorrespondingincreaseinwarranty costs.In2001RonDrapeauwas hiredtomanagetheOdysseyGolfunit,whichwasacquiredinAugust1997.InMay1998 CallawayacquiredpartialownershipinAll-AmericanGolfandsoldthisinterestinFebruary 1999(TheAlacraStorewebsite).In2001AnnaSorenstam,aCallaway sponsoredprofessional golfer, shot 59 for a sanctioned tournament round record.

InMay2001ElyCallaway,theChiefExecutiveOfficerandPresidentofCallaway resignedduetofailinghealthandwasreplacedbyRonDrapeau.Earlyin2001Callaway'saudit committeerequestedthatthecompanyobtainproposalsfrompotentialnewauditors(Callaway website).AlthoughPricewaterhouseCoopersLLP(PWC)hadbeenthecompany'sauditorsince Callaway'sIPO,PWCwasreleasedinJune2001becauseCallaway'sauditcommitteebelieved thathavinganewauditorwouldenhancetheauditor'sindependence.ArthurAndersenLLPwas appointedasthenewauditorinJune2001.Otherreasonsthatcanprompt thereleaseofan auditorarecompetence ortheneedforspecialtyexpertise,whenacompanyhasoutgrown its auditor,toobtain alower-costaudit,orwhentherearedisagreementswiththeauditor overan accounting treatment.

InJanuary2002ArthurAndersenadmitted todestroyingdocumentsrelatedtoEnronand thenNewYorkandConnecticutannouncedthatAndersen'slicensetopractice wasunder review.InMarch2002ArthurAndersenwasindictedoncriminalchargesrelatedtoEnron (Rezaee,HuntandLukawitz;2004).SubsequentlyinMarch2002,Callaway dismissedArthur Andersen due to concerns about the future of Arthur Andersen and wasreplaced by KPMG.

Concernoverearningsmanagementamongregulatorshadbeenbuildingpriortothe Enrondebacle.In1998ArthurLevitt, ChairmanoftheSecuritiesandExchange Commission expressedgraveconcernsaboutthegrowingproblemofearningsmanagementanditspotential toharmthequalityoffinancialreporting. Mr.Levittdidnotlimithiscriticismtothecompanies tryingtomeetanalysts'forecasts:"Tomanycorporatemanagers,auditors,andanalysts participateinagameofnodsandwinks"(p.2,Mr.Levitt'sspeech).Oneofthefivegimmicks thatMr.Levitt identifiedwas"CookieJarReserves;"reservingliabilitiesingoodtimestobe reversed in bad times (p. 4 Mr. Levitt's speech).

Accountingscandalscharacterized2002,whereasotheryearssawfewwell-publicized problems. Thelistoffirmswithaccountingproblemsin2002included Adelphia Communication,Bristol-MyersSquib,AOLTimeWarner,ImCloneSystems,Qwest Communications,BaptistFoundation,WorldCom,Tyco,Halliburton, NicorEnergy,Merrill Lynch,Mirant,ElPasoCorporation,CMSEnergy,Reliant Energy,Dynegy,DukeEnergy, PeregrineSystemsandGlobalCrossing(Sullivan2006).InresponsetotheEnronfraudand theseotherscandals,congresspassedtheSarbanes-Oxleybillin2002toimprove corporate governance and financial reporting.

CallawayGolfBallCompanywasformedtoproduce golfballsin1996andthefirst

product,theRule35golfballwasproducedinFebruary2000. lost$45.9millionbeforetaxes,muchworsethananticipated.

In2000thegolfballcompany CallawayGolfBallCompany mergedintoCallawayGolfCompanyinDecember2000.Twomoremodelsofgolfballswere developedfor2001whenthelossbeforetaxesdecreaseto$17.9million.Threemoremodelsof golfballsexpandedthisproduct linein2002,buttheproductlinehadyettogenerate thesales volumenecessarytoefficientlyproducethegolfballsandchargesrelatedtotheacquisitionof theproductionequipmentcontributedtoalossof$25.6million beforetaxesforthisproductline in2002.Callawaydisclosedinthe2002annualreportthatfurtherwrite-downsoftheseassets might be necessary if sales volume continued to be inadequate.

InanunusualmoveonNovember14,2002;CallawayfiledwiththeSECaNotification of Late Filing for the September 30, 2002quarterly statements; which stated thefollowing.

'IntheCompany'sOctober17,2002earningsrelease(acopyofwhichisavailable onthe Company'swebsiteatwww.callawaygolf.com),theCompanyannounced thatitwouldbe voluntarilyseekingtheguidanceofthestaffoftheSecuritiesandExchange Commissionwith regardtotheappropriateperiodsinwhichtorecordareductionintheCompany'swarranty reserve.TheCompanyhasinitiatedthisprocessbutitisnotyetcompleted.TheCompany expectstoreceivesuchguidance,andwillfileitsForm10-Q,onorbeforeNovember19,2002' (p. 3 Callaway 12B-25).

InDecember2002,KPMGwasdismissedduetoadisagreementoverthewarranty liabilityaccountingtreatmentandDeloitte&ToucheLLPwasproposedasthenewauditor. Callaway hadalwaysreceivedanunqualifiedauditopiniononitsfinancial statements(Callaway 8-K, 10-K).

ACCOUNTING ISSUE

Attheendof2001Callaway hadanaccruedwarranty liabilityof$34.8million(The discussionoftheaccountingissuepresentedhereistakenfromReed&Rose-Green,2007).In thethirdquarterof2002Callawaycompletedareviewofitswarrantyreservesandimplemented anewmethodologytoestimatefuture warrantyobligations.Baseduponthisnewanalysis, managementdetermined that the warranty liability was overstated by $17 million.

KPMGwhowasthecurrentauditoragreedthatthewarrantyliabilitywasoverstatedby $17million,however,managementandKPMGcouldnotagreeontheappropriatewayto accountforthechange.Managementbelieved thatbecausethewarranty liabilitywasbased uponanestimateoffuturewarranty costs,thechangeintheestimationprocessusedtoestimate the warranty liability should be treated as a change in estimate (Callaway8-K, 10-K).

KPMG,ontheotherhand,determined throughtheiranalysisthatasignificantportionof thereductioninthewarrantyliability relatedtoperiodspriorto2002,andtheCompany'sfinancialstatementsforthesepriorperiodsshouldberestatedforacorrectionofanerrorto reflectthewarrantyliabilitybaseduponinformationthatwasavailabletomanagementatthe timethepriorfinancialstatementswereprepared.Thefollowingquoteindicatesthemagnitude ofthedisagreementovertheaccountingissuethatoccurredbetweenthemanagementof CallawayandKPMG."Despite lengthydiscussionsbetweenmanagementandKPMG,including consultationwiththestaffoftheSecuritiesandExchangeCommission,managementandKPMG couldnotreachagreementonproperaccountingtreatment."(Callaway8-K).Thedisagreement ledtoCallawaydismissingKPMGasthecompany'sauditorandproposingthattheauditingfirm of Deloitte & Touche LLP performthe 2002 audit. (Callaway 8-K, 10-K)..

DECISION

Bobisanauditpartner withtheproposedauditor Deloitte&Touche. TheCFOfrom CallawayhasrequestedameetingwithBobregardingCallaway'sproposaltoretainDeloitte& Toucheasitsauditorfor2002.BobisawareofCallawayandisexcitedabouttheopportunityto obtainsuchahigh-profileclient.However,BobisconcernedthatCallawayhashadthree previousauditorsinthepastyear.

Bobisaware thattheauditingstandardsidentify disagreementswithauditorsasafraudriskfactor. Bobisunsureifheshouldrecommend tohis fellow partners that they accept Callaway as a client.

Requirement:

Read the case and provide summary of the major issues and a point form sketch of your analysis.