Focus on the relationship between the former senior manager, who now works for the client, and the former subordinate who has now been promoted. Although the particular fact pattern of the case has now been eliminated by the "cooling off period" of SOX, many parallels still exist in the current audit environment. Explore the vulnerabilities that may result because of trust built through working relationships. In the current environment, what situations create these vulnerabilities for auditors?

Health Management, Inc. (HMI) was a corporation whose principal offices were located Holbrook, New York. HMI focused on providing integrated health management services to patients with chronic medical conditions and to the general health care industry. Its services included distribution of prescription drugs, drug utilization review, patient compliance monitoring and other services. HMI's common stock was listed and traded on the NASDAQ.

Clifford E. Hotte ("Hotte") was Chairman of the Board and Chief Operating Officer of Health Management and Drew W. Bergman ("Bergman") was Health Management's Chief Financial Officer, Corporate Development Officer, Treasurer and Secretary. Bergman, as an employee of BDO Seidman, had supervised the 1989 and 1990 audits of HMI before being employed by HMI.

Hotte and Bergman issued numerous press releases, financial statements in Form 10-K and 10-Q from June 1995 through early 1996 that contained false information about HMI's accounts receivable and inventories, because they were not accounted for according to Generally Accepted Accounting Principles (GAAP).

During the planning phase of an audit, auditors are to consider the existence of red flags in developing the planned nature, extent, and timing of their audit tests. Red flags identified by auditors during the planning phase will typically result in more extensive and rigorous tests applied by auditors during the substantive testing phase of an audit. In the internal control evaluation phase of an audit, auditors should consider whether red flags have resulted in a client's internal controls being undercut or subverted. Finally, during the "wrap-up" phase of an audit, an audit engagement team must consciously weigh once more the potential impact of existing red flags or fraud risk factors on a client's financial statements. In this final stage of an audit, auditors can step back and make a "big picture" assessment of the given client's financial statements. During the course of an audit, an audit team may overlook individual hints or signals that something is amiss in the client's accounting records and financial statements. Near the end of the audit, however, an audit manager or partner should be able to link such items together to make a more informed judgment regarding the likelihood that fraud has affected the client's financial data.

The auditor is not independent in fact if the auditor has been compromised by a relationship with a client employee such that the relationship influences important decisions of the auditor. For example, if an auditor decides not to pursue a suspicious transaction or other item because doing so might result in negative consequences for his or her friend, clearly the actual independence of the auditor has been compromised. More generally, an auditor's independence in fact has been impaired by a client relationship when that relationship causes the auditor to violate one or more GAAS. Loss of independence may result in an auditor failing to gain a proper understanding of a client's internal controls, deciding not to collect sufficient appropriate evidence to support an audit-related decision (a form of "confirmation bias"), or even issuing an inappropriate audit opinion.

In a press release issued on June 15, 1995, Health Management announced that it expected its revenues for its 1995 fiscal year ending April 30, 1995 to be between $88 million and $90 million. Revenues for the fourth quarter ending 1995 were announced as being between $28 million and $29 million. Revenue increases for both periods would be greater than 100 percent over prior-year similar periods. Net income was expected to be over $7 million for the year, about 75 percent more than in 1994. Fiscal 1995 earnings per share was expected to be between $0.74 and $0.75, an increase of more than 40 percent over the last year. The earnings per share estimates include a one-time charge of $0.03 per share which the Company expected to take in the fourth quarter. The Company said that it had made several investments in the past year which had not yet begun to generate sufficient revenues to offset the capital outlays and overhead necessary to support them.

However, the information contained in the June 15, 1995 press release was false and misleading, because the figures announced were based on financial statements that were not prepared using GAAP. In fact, the assets and earnings of HMI were materially overstated. For example, reported accounts receivable exceeded amounts expected to be collected and thus were not stated at their net realizable value.

According to a new report dated July 10, 1995 based upon an interview with Hotte, the Company's accounts receivable had grown to as many as 150 days outstanding. Hotte was quoted as attributing the Company's growth in accounts receivable to its installation of a new computer system. However, Hotte did not report that HMI's accounts receivable were not reported in accordance with generally accepted accounting principles, and, therefore, were materially overstated.

On August 2, 1995, HMI filed its Form 10-K for the year ended April 30, 1995 with the SEC. The Form 10-K stated that HMI's revenues were a little over $89 million ($89,297,547) for the year ended April 30, 1995, an increase of $45 million ($45,048,031), or 101.8%, over revenues of approximately $44 million ($44,249,516) for the year ended April 30, 1994.

The 10-K stated that "Revenues generated through the Company's recent acquisitions accounted for which approximately $20,000,000 is attributable to the acquisition of the Murray Corp. The balance of the increase in revenues was derived from internal growth, resulting from the expansion of the Lifecare program into new disease states and referral sources."

The financial results for the fourth quarter and fiscal year 1995 reported in the August 2, 1995 Form 10-K were false and misleading and, at the time of the issuance of the August 2, 1995 results, Hotte and Bergman knew that these results were not in accordance with GAAP, and, therefore, that HMI's assets and earnings were overstated. For example, HMI's reported accounts receivable exceeded amounts expected to be collected in violation of GAAP.