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1. List some external and internal pressures on USSC that would cause an increase in business risk and/or inherent risk.

2. What evidence did Ernst and Whinney have that the work done by Lacey Manufacturing was actually tooling modifications? What proof did they have that it wasnt? Do you think their decision to accept the costs as tooling modifications weighted this evidence properly? Why or why not?

3. What was wrong with USSCs application of the revenue recognition principle? How did E & W miss this?
4. What did the SEC site to support its claim that E & W failed to make proper use of analytical procedures? Do you think this criticism is justified?

1) List some external and internal pressures on USSC that would cause an increase in business risk and/or inherent risk.

2) What evidence did Ernst and Whinney have that the work done by Lacey Manufacturing was actually tooling modifications? What proof did they have that it wasnt? Do you think their decision to accept the costs as tooling modifications weighted this evidence properly? Why or why not?

3) What was wrong with USSCs application of the revenue recognition principle? How did E & W miss this?

4) What did the SEC site to support its claim that E & W failed to make proper use of analytical procedures? Do you think this criticism is justified?

CASE 1.3 UNITED STATES SURGICAL CORPORATION Leon Hirsch founded United States Surgical Corporation (USSC) in 1964 with very little capital, four employees, and one product: an unwieldy mechanical de vice that he intended to market as a surgical stapler. In his mid-thirties at the time and lacking a college degree, Hirsch had already tried several lines of business, including frozen foods, dry cleaning, and advertising, each with little success. In fact, the dry cleaning venture ended in bankruptcy. No doubt, few of Hirsch's friends and family members believed that USSC would become financially viable. Despite the long odds against him, by 1980 Hirsch had built the Connecticut- based USSC into a large and profitable public company whose stock was traded on a national exchange. More important, the surgical stapler that Hirsch invented revolutionized surgery techniques in the United States and abroad. During the early years of its existence, USSC dominated the small surgical sta- pling industry that Hirsch had founded in the mid-1960s. By 1980, several com- panies were beginning to encroach on USSC's domestic and foreign sales markets. USSC's principal competitor at the time was a company owned by Alan Blackman. Blackman's company sold its products primarily in foreign countries but was also making an effort to significantly expand its U.S. sales. Hirsch alleged that Blackman, who was a former friend and associate, had infringed on USSC's patents by "reverse-engineering the company's products. Beginning in 1980, USSC began an aggressive counterattack to repel Blackman's intrusion into its markets. First, USSC adopted a worldwide litigation strategy to contest Blackman's right to manufacture and market his competing products. Second, the company initiated a large research and development pro gram to create a line of new products technologically superior to those being manufactured by Blackman. Each of these activities required multimillion dollar commitments by USSC-commitments that threatened the profitable eamings trend of the company and Hirsch's ability to raise additional capital that USSC desperately needed. Hirsch overcame the major challenges facing his company in the early 1980s. USSC maintained its dominant position in the surgical stapling industry while 29 SECTION ONE COMPREHENSIVE CASES continuing to report record profits and sales each year. Ironically, those record profits and sales eventually spelled trouble for the company. Mounting suspicion that USSC's reported operating results were too good to be true spurred the Securities and Exchange Commission (SEC) to launch an investigation of the company's financial affairs. In 1983, the SEC leveled several charges of miscon- duct against key USSC officers, including Leon Hirsch. Within a short time, USSC's audit firm, Ernst & Whinney, resigned and withdrew the unqualified audit opinions it had issued on the company's 1980 and 1981 financial statements. In 1985, the SBC issued a report on its lengthy investigation of USSC. The SEC ruled that the company had used a "variety of manipulative devices to overstate its earnings in its 1980 and 1981 financial statements." (Exhibit 1 contains USSC'S original balance sheets and income statements for the period 1979 to 1981.) To settle the SEC charges, USSC officials signed an agreement with the federal agency that forced the company to reduce its previously reported earnings by $26 million. Additionally, senior executives of USSC were required to return to the company large bonuses they had been paid during 1980 and 1981. Hirsch alone repaid more than $300,000 to USSC. Following the signing of the agreement with ingin mening of the the SEC, Hirsch reported that the criticism of his company and his management decisions was undeserved. Hirsch implied that cost considerations motivated him to accept the SEC sanctions: "It was our opinion that the settlement with the SEC] was pre erable to long, costly and time-consuming litigation. USSC's ABUSIVE ACCOUNTING PRACTICES The enforcement release that disclosed the key findings of the SEC's investigation of USSC charged the company with several abusive accounting and financial re- porting practices. A focal point of the SEC's investigation was an elaborate scheme that USSC executives implemented to charge inventoriable production costs to a long-term asset account, molds and dies. This scheme, which required the cooperation of several of USSC's vendors, was deliberately concealed from the company's audit firm, Ernst & Whinney The SEC investigation also revealed that USSC recorded inventory shipments to its sales force as consummated sales transactions. Until the mid-1970s, USSC had marketed its products through a network of independent dealers. Historically, inventory shipments to these dealers had been treated as arm's length transactions and thus reportable as revenue. By 1980, nearly all of the com- pany's products were marketed by a sales staff consisting of full-time employees working on a commission basis. Everyone on the sales staff maintained an in- ventory of USSC products, which they transported from client to client. When a shipment was made to a salesperson, USSC recorded the inventory as having been sold, although employees could retum unsold items for full credit 1. Thus and subsequent quotations, unless indicated otherwise, were taken from Securities and Exclunge Commission, Accounting and Auditing Enforcement Release No. 109A, 6 August 1936 2. K.B. Noble. US Surgical Settlement to Restate Earnings." The New York Times, 28 February 1984. B2 A subsequent section of this case discusses the details of this scheme, including the measures that USSC executives took to conceal it from Emat & Winney, CASE 13 UNITED STATES SURGICAL CORPORATION U.S. Surgical Corporation: Consolidated Balance sheela 1970 1961 (poor omitted) EXHIBIT 1 United States Surgical Corporation's 1979-1981 Financial Statements es Secebir 1. 1979 Cash 30.670 Current Assets Recavables net Inventoring Work In Process 29,216 Other Currenloop Property, Plant, and Equipment 2.be Buildings Moist and Des 14.0.83) $2,274 114.36 $207,300 sudi 12.278 $10.00 3. 5.873 18,675 80,612 @ 7466 5,130 414326 7.566 2285 5 1453 13,413 3 3497. 1 .394 Current Liabilitlos Accounts Payable Notes Payable Income Taxes Payable Current Portion of Long Term Debt Accrued Expenses Total Curtant Liabilities Long-Term Debt. .. Deferred Income Taxos Stockholder s . Common Stock . Additional Pald-Capitale.. . Retained Earnings . Translation Allowance . . Deferred Compensation from Issuance of Restricted Stock Total Stockholders' Equity Total Liabilities and Stockholders' Equity ibig s . " 1,001 % 72,594 32.665 (1.086) - (6,698) 100,556 $ 207,339 30, 320 434 433 40,736 520831213, 1898 Fry 12,507) (2,078) "54,146 22.226 $119,108 $70,520 In 1980 and 1981, USSC's management ordered that excessive amounts of in- ventory be shipped to salespeople to overstate the company's reported sales and profits. A former USSC sales manager later testified regarding this practice. "It was nothing to come home and find $3,000 worth of product sitting in a box on your front porch from UPS and a note saying, 'We thought you needed a little SECTION ONE COMPREHENSIVE CASES EXHIBIT 1-continued United States Surgical Corporation's 1979-1981 Financial Statements U.S. Surgical Corporation Consolidated Income Statements 1976-1981 (Ooos omitted) Year Ended December 31, 1900 . 1,100 $36,215 1979 560.1876 40 more product. According to the SEC, USSC's policy of recognizing inventory shipments to its sales staff as consummated sales transactions overstated the com- pany's 1980 and 1981 pretax profits by $1,150,000 and $750,000, respectively. The SEC also charged that USSC abused the accounting rule that permits the capitalization of legal expenditures incurred to develop and successfully defend a patent. In 1950, USSC capitalized less than $1 million of such expenditures, the following year, that figure leaped to $5.8 million. The SEC investigation disclosed that a significant portion of the 1981 litigation expenditures was incurred in Australian lawsuits filed against Alan Blackman and his company. However, USSC did not have any registered patents in Australia, meaning that the Australian legal expenditures should not have been deferred in an asset account but instead immediately charged to operations. The SEC did find that approxi- mately $3.7 million of the 1981 litigation expenditures had been incurred by USSC to defend its U.S. patents. However, USSC had chosen to amortize these costs over a ten-year period even though the seventeen-year legal life of most of the patents in question would expire in 1963 or 1984. 4. N.R.Kleinfeld, "US. Surgical's Checkered History." The New York Times, 13 May 1954,4 CASE 1.3 UNITED STATES SURGICAL CORPORATION Many of USSC's surgical tools were not sold but rather leased to customers The cost of each of these assets was recorded in a subsidiary fixed asset ledger leased and loaned assets. USSC periodically retired such assets and removed them from the sub-ledger. However, the SEC discovered that the costs associated with these assets were not removed from the sub-ledger but instead debited to the accounts of other assets still in service. In 1981, USSC also understated depreda tion expense on several fixed assets and thus inflated the balance sheet values of those assets. These misstatements resulted from the company's accounting staff arbitrarily extending the useful lives of selected assets and establishing salvage values for the first time for other assets. ALLEGATIONS OF AUDIT DEFICIENCIES The SEC's investigation of USSC uncovered several alleged flaws in Emst k Whinney's audits of the company, particularly the accounting firm's 1981 audit of USSC. Among these flaws was Emst & Whinney's failure to make proper use of analytical procedures during the planning phase of the 1981 audit. Erst & Whinney apparently overlooked the important implications for its 1981 audit of several material changes in USSC account balances between December 31, 1980, and Decepaber 31, 1981. For example, the balance of the molds and dies account more than doubled from the end of 1980 to the end of 1981. According to the SEC, "This unusually large increase should have caused the auditors to scrutinize care fully the nature and source of the additions, and whether certain costs were prop. erly identified and capitalized under GAAP. Two other USSC accounts that reflected material changes between 1980 and 1981 were research and development expenses and patents. USSC reported a greater than 50 percent decrease in research and development expenses in 1981 compared with the previous year. This decrease occurred even though USSC un dertook a large product development campaign during 1981. USSC's accounting records for 1981 also reflected a significant increase in litigation expenditures that were deferred in its patents account. (USSC included the patents account in non- current "Other Assets" on its balance sheet. See Exhibit 1.) The SEC maintained that the unusually large changes in key USSC account balances between 1980 and 1981 should have placed Ernst & Whinney on alert that the 1981 USSC audit would have a higher-than-normal degree of risk associated with it. The height- ened audit attention was particularly important since the aggregate effect of the changes was material to Surgical's 1981 financial statements... (and) the changes all had the effect of increasing income.". Another important risk factor present during the 1981 USSC audit was the company's strong incentive to reach targeted sales and profit goals that had been communicated to security analysts who tracked the firm's stock. If those targeted figures were not reached, USSC would have difficulty raising the additional cap- ital needed to finance Hirsch's plan to expand the company's product line. A former USSC vice president reported that Hirsch often made firm commitments to security analysts regarding the company's future sales and profits. This 5. Ibid. SECTION ONE COMPREHENSIVE CASES Individual suggested that many of USSC's abusive accounting practices were a direct consequence of Hirsch's efforts to deliver the promised sales and earnings figures. Another incentive for USSC officials to misrepresent the company's fi- nancial data was provided by a management bonus plan that was tied to reported profits. Surgical's executive officers could eam bonuses ranging from 15% to 75% of their base salaries, if the earnings per share growth ranged from 15% to 30% over the previous year. Management therefore had powerful personal incentives to keep the earnings per share high The SEC ruled that Ernst & Whinney made three critical errors when consid- ering the question of whether USSC should be allowed to record inventory ship. ments to its sales staff as valid sales transactions. First, the SEC pointed out that Emst & Whinney failed to recognize that there is a strong presumption that "sales of inventory to employees are not arm's length transactions: "Because the potential for abuse is so great when a 'sale' transaction is between a company and its employee, the presumption is that no 'true' sale has taken place." Second, the SEC maintained that USSC's repurchase of significant amounts of inventory from its salespeople during 1981 should have alerted Ernst & Whinney that the origi- nal inventory shipments to these employees were not bona fide sales transactions. This oversight by Ernst & Whinney was particularly troublesome to the SEC be- cause these repurchases were clearly documented in the audit firm's 1980 and 1981 workpapers. Finally, the SEC criticized Ernst & Whinney for failing to in vestigate a client executive's assertion that USSC was not obligated to repurchase inventory from employees who resigned or were terminated. Ernst & Whinney's 1981 audit program included a procedure to obtain and review a copy of the em- ployment contract signed by USSC's sales employees and to incorporate that con- tract in the permanent workpaper file. Although the Ernst & Whinney audit program indicated that this procedure had been completed, there was no evi. dence to this effect in the firm's 1981 workpapers. The SEC ruled that if the em ployment contract had been obtained and reviewed, Ernst & Whinney would have leamed that USSC not only had a policy of repurchasing inventory from for- mer employees but had a contractual obligation to do so. The SEC's harshest criticism of Ernst & Whinney was reserved for the firm's failure to prevent USSC from capitalizing a material amount of production ex- penses in the molds and dies account. During the last few months of 1980, USSC began systematically charging production costs to that noncurrent asset account, resulting in a significant overstatement of assets and a corresponding understate ment of cost of goods sold. Company executives used a number of methods to conceal this illicit scheme. The most common of these methods was instructing the company's vendors, who did most of the production work on USSC's prod- ucts, to describe generic production costs as capitalizable expenditures on in- voices submitted for payment to USSC. One of USSC's primary vendors was Lacey Manufacturing Company, a divi- sion of Barden Corporation which also happened to be an audit client of Emst Whinney. In late 1980, USSC officials instructed Barden Corporation to begin using the phrase "tooling modifications to describe the work performed for USSC by Lacey Manufacturing. Previously, these invoices had described the ex- penditures incurred for USSC as generic production costs. This change in the CASE 1. UN TED STATES SURGICAL CORPORATION description of the incurred costs was critical, since all tooling costs for new or re- designed products were capitalizable expenditures. CHRONOLOGY OF USSC-ERNST & WHINNEY DISAGREEMENT REGARDING CAPITALIZATION OF ALLEGED TOOLING COSTS For many years, accounting educators have maintained that the quality of audits is often impaired by the imbalance of power in the auditor-client relationship. This imbalance of power favors the client, largely because client executives retain and compensate their company's independent auditors. When technical disputes arise during an audit, dient executives may use their leverage on auditors to ex. tract important concessions from them. A classic example of an audit conflict arose during Emst & Whinney's 1981 audit of USSC. This conflict stemmed from USSC's illicit scheme to charge pro- duction costs to the noncurrent asset account molds and dies. The following chronology lists the key events in this dispute: 1/27/82 The Emst & Whinney audit team completes its fieldwork on the USSC engagement 2/2/82 Paul Yumont, senior vice-president and treasurer of Barden Corporation, makes an unsolicited telephone call to William Burke, the Ernst & Whinney audit engagement partner on the Barden audit. Yamont Informa Burke that Harden accountants have discovered numerous USSC purchase orders and corresponding Barden invoices that do not accurately describe the work that Lacey Manufacturing (a division of Barden Corporation) has been per forming for USSC. According to Yamont, these invoices and purchase or- ders, totaling approximately $1.000.000, indicate that the Lacey work for USSC has been for "tooling modifications. In fact, Lacey has simply been producing and assembling products for USSC. Burke immediately visits Barden to discuss this issue with Yamont. 2/3/82 Ernst & Whinney approves the issuance of a press release by USSC man agement that reports the company's sales and earnings for 1981. (At this point, Michael Hope, the USSC audit engagement partner, is unaware of the problem brought to William Burke's attention by Paul Yamont.) 2/5/82 Burke again visits Yamont to discuss the alleged mislabeled invoices 2/8/82 Barden Corporation's board of directors votes to retain Emat & Whinney to formally investigate the mislabeled invoices 2/10/82 Burke contacts Norman Strauss, regional director of accounting and audit ing for Emst & Whitney's New York region, and informs him of Yamont's concerns. Strauss immediately informs Bruce Dixon, Ernst & Whinney partner in charge of the New York region, of the Barden situation Shortly thereafter, Dixon calls Hope and instructs him not to sign off on the USSC 6 A. Goldman and B. Barley, The Auditor-Firm Conflict of Interests: Its Implications for Independence." Accounting Review 49 (October 1974), 707-718: D.R. Nichols and K. Price, "The Auditor-Firm Conflict An Analysis Using Concepts of Exchange Theory." Accounting Kruire 51 (April 1976), 335-346 M.C. Knapp and B.H. Ward, "An Integrative Analysis of Audit Conflict Sources, Consequences and Resolution," Adrenasit Accounting 4 1987). 267-286. SECTION ONE COMPREHENSIVE CASES 2/13/82 2/15/82 2/18/82 2/20/82 (approx- imately audit until the questionable invoice charges have been fully investigated. Dixon also informs Robert Neary, Emrat & Whinney's chief technical part- ner, of the problem. Burke sends an imst & Whinney audit manager to Barden Corporation to investigate the invoices and purchase orders in question Burke joins the East & Whinney audit manager at Barden Corporation to tour the Lacey Manufacturing facility and to discuss the questionable in- voices and purchase orders with Robert More, the Lacey general manager. More Informa Burke that nearly all of the invoiced charges being reviewed were for generic production work performed for USSC rather than for tool- ing modifications Burke meets with the Barden board of directors and reports that the results of the Ernst & Whirny investigation demonstrate that the USSC purchase orders and the corresponding Barden invoices misrepresent the nature of the work performed by Lacey Manufacturing for USSC. The chairman of Barden's board of directors then reports that an independent investigation by an outside law firm has yielded the same conclusion. The Barden direc- tors vote to require that all future work performed for USSC be properly described in invoices submitted for payment to the company Hope and Dixon are unsure how to proceed on the USSC audit, given the results of Burke's investigation. Because of confidentiality concerns, Hope cannot raise the issue directly with USSC officers. Barden officers are con cerned that if USSC perceives that Barden has brought the problem to the attention of Emst & Whinney, USSC may terminate its relationship with Barden. Finally, Hope and Dixon decide to send a confirmation letter to Yamont and More that asks them to confirm that the disputed $1 million in charges were for tooling modifications. (Hope and Dixon realize that Yamont and More will refuse to sign the confirmation letter.) Yamont contacts Hope and informs him that he cannot sign the confirma- tion letter since he is aware that the disputed charges are not for tooling modifications Following the refusal of Yamont and subsequently, More to sign the confirmation letter, Ernst & Whinney officials discuss the problem with the management of both USSC and Barden. Eventually, executives of each com- pany agree to allow auditors from the two Emst & Whinney teams to have mutual access to their company's accounting records. Hope meets with top USSC executives and asks them to relate their under standing of the costs incurred by Lacey Manufacturing on behalf of USSC. The USSC officials inform Hope that in early 1981, they had instructed More, the Lacey general manager, to make certain tooling changes that would result in improved efficiency in the production of USSC products The executives then provided an elaborate and confusing explanation as to why the tooling modifications were charged out on a per-unit basis. (Earlier, Ernst & Whinney representatives had noted that the disputed costs were billed to USSC based upon the number of units of product manufac tured by Lacey. Intuitively, costs associated with tooling modifications should have been billed in one lump sum or in installments. The fact that the costs were billed on a per-unit basis suggested that they were produc tion costs.) Hope asks USSC's controller for purchase orders that the company had placed with outside contractors other than Barden (Lacey). Hope is look ing for evidence of additional mistabeled costs. In the files that Hope is 2/25/82 3/3/82 CASE 1.3 UNITED STATES SURGICAL CORPORATION Leon Hirsch founded United States Surgical Corporation (USSC) in 1964 with very little capital, four employees, and one product: an unwieldy mechanical de vice that he intended to market as a surgical stapler. In his mid-thirties at the time and lacking a college degree, Hirsch had already tried several lines of business, including frozen foods, dry cleaning, and advertising, each with little success. In fact, the dry cleaning venture ended in bankruptcy. No doubt, few of Hirsch's friends and family members believed that USSC would become financially viable. Despite the long odds against him, by 1980 Hirsch had built the Connecticut- based USSC into a large and profitable public company whose stock was traded on a national exchange. More important, the surgical stapler that Hirsch invented revolutionized surgery techniques in the United States and abroad. During the early years of its existence, USSC dominated the small surgical sta- pling industry that Hirsch had founded in the mid-1960s. By 1980, several com- panies were beginning to encroach on USSC's domestic and foreign sales markets. USSC's principal competitor at the time was a company owned by Alan Blackman. Blackman's company sold its products primarily in foreign countries but was also making an effort to significantly expand its U.S. sales. Hirsch alleged that Blackman, who was a former friend and associate, had infringed on USSC's patents by "reverse-engineering the company's products. Beginning in 1980, USSC began an aggressive counterattack to repel Blackman's intrusion into its markets. First, USSC adopted a worldwide litigation strategy to contest Blackman's right to manufacture and market his competing products. Second, the company initiated a large research and development pro gram to create a line of new products technologically superior to those being manufactured by Blackman. Each of these activities required multimillion dollar commitments by USSC-commitments that threatened the profitable eamings trend of the company and Hirsch's ability to raise additional capital that USSC desperately needed. Hirsch overcame the major challenges facing his company in the early 1980s. USSC maintained its dominant position in the surgical stapling industry while 29 SECTION ONE COMPREHENSIVE CASES continuing to report record profits and sales each year. Ironically, those record profits and sales eventually spelled trouble for the company. Mounting suspicion that USSC's reported operating results were too good to be true spurred the Securities and Exchange Commission (SEC) to launch an investigation of the company's financial affairs. In 1983, the SEC leveled several charges of miscon- duct against key USSC officers, including Leon Hirsch. Within a short time, USSC's audit firm, Ernst & Whinney, resigned and withdrew the unqualified audit opinions it had issued on the company's 1980 and 1981 financial statements. In 1985, the SBC issued a report on its lengthy investigation of USSC. The SEC ruled that the company had used a "variety of manipulative devices to overstate its earnings in its 1980 and 1981 financial statements." (Exhibit 1 contains USSC'S original balance sheets and income statements for the period 1979 to 1981.) To settle the SEC charges, USSC officials signed an agreement with the federal agency that forced the company to reduce its previously reported earnings by $26 million. Additionally, senior executives of USSC were required to return to the company large bonuses they had been paid during 1980 and 1981. Hirsch alone repaid more than $300,000 to USSC. Following the signing of the agreement with ingin mening of the the SEC, Hirsch reported that the criticism of his company and his management decisions was undeserved. Hirsch implied that cost considerations motivated him to accept the SEC sanctions: "It was our opinion that the settlement with the SEC] was pre erable to long, costly and time-consuming litigation. USSC's ABUSIVE ACCOUNTING PRACTICES The enforcement release that disclosed the key findings of the SEC's investigation of USSC charged the company with several abusive accounting and financial re- porting practices. A focal point of the SEC's investigation was an elaborate scheme that USSC executives implemented to charge inventoriable production costs to a long-term asset account, molds and dies. This scheme, which required the cooperation of several of USSC's vendors, was deliberately concealed from the company's audit firm, Ernst & Whinney The SEC investigation also revealed that USSC recorded inventory shipments to its sales force as consummated sales transactions. Until the mid-1970s, USSC had marketed its products through a network of independent dealers. Historically, inventory shipments to these dealers had been treated as arm's length transactions and thus reportable as revenue. By 1980, nearly all of the com- pany's products were marketed by a sales staff consisting of full-time employees working on a commission basis. Everyone on the sales staff maintained an in- ventory of USSC products, which they transported from client to client. When a shipment was made to a salesperson, USSC recorded the inventory as having been sold, although employees could retum unsold items for full credit 1. Thus and subsequent quotations, unless indicated otherwise, were taken from Securities and Exclunge Commission, Accounting and Auditing Enforcement Release No. 109A, 6 August 1936 2. K.B. Noble. US Surgical Settlement to Restate Earnings." The New York Times, 28 February 1984. B2 A subsequent section of this case discusses the details of this scheme, including the measures that USSC executives took to conceal it from Emat & Winney, CASE 13 UNITED STATES SURGICAL CORPORATION U.S. Surgical Corporation: Consolidated Balance sheela 1970 1961 (poor omitted) EXHIBIT 1 United States Surgical Corporation's 1979-1981 Financial Statements es Secebir 1. 1979 Cash 30.670 Current Assets Recavables net Inventoring Work In Process 29,216 Other Currenloop Property, Plant, and Equipment 2.be Buildings Moist and Des 14.0.83) $2,274 114.36 $207,300 sudi 12.278 $10.00 3. 5.873 18,675 80,612 @ 7466 5,130 414326 7.566 2285 5 1453 13,413 3 3497. 1 .394 Current Liabilitlos Accounts Payable Notes Payable Income Taxes Payable Current Portion of Long Term Debt Accrued Expenses Total Curtant Liabilities Long-Term Debt. .. Deferred Income Taxos Stockholder s . Common Stock . Additional Pald-Capitale.. . Retained Earnings . Translation Allowance . . Deferred Compensation from Issuance of Restricted Stock Total Stockholders' Equity Total Liabilities and Stockholders' Equity ibig s . " 1,001 % 72,594 32.665 (1.086) - (6,698) 100,556 $ 207,339 30, 320 434 433 40,736 520831213, 1898 Fry 12,507) (2,078) "54,146 22.226 $119,108 $70,520 In 1980 and 1981, USSC's management ordered that excessive amounts of in- ventory be shipped to salespeople to overstate the company's reported sales and profits. A former USSC sales manager later testified regarding this practice. "It was nothing to come home and find $3,000 worth of product sitting in a box on your front porch from UPS and a note saying, 'We thought you needed a little SECTION ONE COMPREHENSIVE CASES EXHIBIT 1-continued United States Surgical Corporation's 1979-1981 Financial Statements U.S. Surgical Corporation Consolidated Income Statements 1976-1981 (Ooos omitted) Year Ended December 31, 1900 . 1,100 $36,215 1979 560.1876 40 more product. According to the SEC, USSC's policy of recognizing inventory shipments to its sales staff as consummated sales transactions overstated the com- pany's 1980 and 1981 pretax profits by $1,150,000 and $750,000, respectively. The SEC also charged that USSC abused the accounting rule that permits the capitalization of legal expenditures incurred to develop and successfully defend a patent. In 1950, USSC capitalized less than $1 million of such expenditures, the following year, that figure leaped to $5.8 million. The SEC investigation disclosed that a significant portion of the 1981 litigation expenditures was incurred in Australian lawsuits filed against Alan Blackman and his company. However, USSC did not have any registered patents in Australia, meaning that the Australian legal expenditures should not have been deferred in an asset account but instead immediately charged to operations. The SEC did find that approxi- mately $3.7 million of the 1981 litigation expenditures had been incurred by USSC to defend its U.S. patents. However, USSC had chosen to amortize these costs over a ten-year period even though the seventeen-year legal life of most of the patents in question would expire in 1963 or 1984. 4. N.R.Kleinfeld, "US. Surgical's Checkered History." The New York Times, 13 May 1954,4 CASE 1.3 UNITED STATES SURGICAL CORPORATION Many of USSC's surgical tools were not sold but rather leased to customers The cost of each of these assets was recorded in a subsidiary fixed asset ledger leased and loaned assets. USSC periodically retired such assets and removed them from the sub-ledger. However, the SEC discovered that the costs associated with these assets were not removed from the sub-ledger but instead debited to the accounts of other assets still in service. In 1981, USSC also understated depreda tion expense on several fixed assets and thus inflated the balance sheet values of those assets. These misstatements resulted from the company's accounting staff arbitrarily extending the useful lives of selected assets and establishing salvage values for the first time for other assets. ALLEGATIONS OF AUDIT DEFICIENCIES The SEC's investigation of USSC uncovered several alleged flaws in Emst k Whinney's audits of the company, particularly the accounting firm's 1981 audit of USSC. Among these flaws was Emst & Whinney's failure to make proper use of analytical procedures during the planning phase of the 1981 audit. Erst & Whinney apparently overlooked the important implications for its 1981 audit of several material changes in USSC account balances between December 31, 1980, and Decepaber 31, 1981. For example, the balance of the molds and dies account more than doubled from the end of 1980 to the end of 1981. According to the SEC, "This unusually large increase should have caused the auditors to scrutinize care fully the nature and source of the additions, and whether certain costs were prop. erly identified and capitalized under GAAP. Two other USSC accounts that reflected material changes between 1980 and 1981 were research and development expenses and patents. USSC reported a greater than 50 percent decrease in research and development expenses in 1981 compared with the previous year. This decrease occurred even though USSC un dertook a large product development campaign during 1981. USSC's accounting records for 1981 also reflected a significant increase in litigation expenditures that were deferred in its patents account. (USSC included the patents account in non- current "Other Assets" on its balance sheet. See Exhibit 1.) The SEC maintained that the unusually large changes in key USSC account balances between 1980 and 1981 should have placed Ernst & Whinney on alert that the 1981 USSC audit would have a higher-than-normal degree of risk associated with it. The height- ened audit attention was particularly important since the aggregate effect of the changes was material to Surgical's 1981 financial statements... (and) the changes all had the effect of increasing income.". Another important risk factor present during the 1981 USSC audit was the company's strong incentive to reach targeted sales and profit goals that had been communicated to security analysts who tracked the firm's stock. If those targeted figures were not reached, USSC would have difficulty raising the additional cap- ital needed to finance Hirsch's plan to expand the company's product line. A former USSC vice president reported that Hirsch often made firm commitments to security analysts regarding the company's future sales and profits. This 5. Ibid. SECTION ONE COMPREHENSIVE CASES Individual suggested that many of USSC's abusive accounting practices were a direct consequence of Hirsch's efforts to deliver the promised sales and earnings figures. Another incentive for USSC officials to misrepresent the company's fi- nancial data was provided by a management bonus plan that was tied to reported profits. Surgical's executive officers could eam bonuses ranging from 15% to 75% of their base salaries, if the earnings per share growth ranged from 15% to 30% over the previous year. Management therefore had powerful personal incentives to keep the earnings per share high The SEC ruled that Ernst & Whinney made three critical errors when consid- ering the question of whether USSC should be allowed to record inventory ship. ments to its sales staff as valid sales transactions. First, the SEC pointed out that Emst & Whinney failed to recognize that there is a strong presumption that "sales of inventory to employees are not arm's length transactions: "Because the potential for abuse is so great when a 'sale' transaction is between a company and its employee, the presumption is that no 'true' sale has taken place." Second, the SEC maintained that USSC's repurchase of significant amounts of inventory from its salespeople during 1981 should have alerted Ernst & Whinney that the origi- nal inventory shipments to these employees were not bona fide sales transactions. This oversight by Ernst & Whinney was particularly troublesome to the SEC be- cause these repurchases were clearly documented in the audit firm's 1980 and 1981 workpapers. Finally, the SEC criticized Ernst & Whinney for failing to in vestigate a client executive's assertion that USSC was not obligated to repurchase inventory from employees who resigned or were terminated. Ernst & Whinney's 1981 audit program included a procedure to obtain and review a copy of the em- ployment contract signed by USSC's sales employees and to incorporate that con- tract in the permanent workpaper file. Although the Ernst & Whinney audit program indicated that this procedure had been completed, there was no evi. dence to this effect in the firm's 1981 workpapers. The SEC ruled that if the em ployment contract had been obtained and reviewed, Ernst & Whinney would have leamed that USSC not only had a policy of repurchasing inventory from for- mer employees but had a contractual obligation to do so. The SEC's harshest criticism of Ernst & Whinney was reserved for the firm's failure to prevent USSC from capitalizing a material amount of production ex- penses in the molds and dies account. During the last few months of 1980, USSC began systematically charging production costs to that noncurrent asset account, resulting in a significant overstatement of assets and a corresponding understate ment of cost of goods sold. Company executives used a number of methods to conceal this illicit scheme. The most common of these methods was instructing the company's vendors, who did most of the production work on USSC's prod- ucts, to describe generic production costs as capitalizable expenditures on in- voices submitted for payment to USSC. One of USSC's primary vendors was Lacey Manufacturing Company, a divi- sion of Barden Corporation which also happened to be an audit client of Emst Whinney. In late 1980, USSC officials instructed Barden Corporation to begin using the phrase "tooling modifications to describe the work performed for USSC by Lacey Manufacturing. Previously, these invoices had described the ex- penditures incurred for USSC as generic production costs. This change in the CASE 1. UN TED STATES SURGICAL CORPORATION description of the incurred costs was critical, since all tooling costs for new or re- designed products were capitalizable expenditures. CHRONOLOGY OF USSC-ERNST & WHINNEY DISAGREEMENT REGARDING CAPITALIZATION OF ALLEGED TOOLING COSTS For many years, accounting educators have maintained that the quality of audits is often impaired by the imbalance of power in the auditor-client relationship. This imbalance of power favors the client, largely because client executives retain and compensate their company's independent auditors. When technical disputes arise during an audit, dient executives may use their leverage on auditors to ex. tract important concessions from them. A classic example of an audit conflict arose during Emst & Whinney's 1981 audit of USSC. This conflict stemmed from USSC's illicit scheme to charge pro- duction costs to the noncurrent asset account molds and dies. The following chronology lists the key events in this dispute: 1/27/82 The Emst & Whinney audit team completes its fieldwork on the USSC engagement 2/2/82 Paul Yumont, senior vice-president and treasurer of Barden Corporation, makes an unsolicited telephone call to William Burke, the Ernst & Whinney audit engagement partner on the Barden audit. Yamont Informa Burke that Harden accountants have discovered numerous USSC purchase orders and corresponding Barden invoices that do not accurately describe the work that Lacey Manufacturing (a division of Barden Corporation) has been per forming for USSC. According to Yamont, these invoices and purchase or- ders, totaling approximately $1.000.000, indicate that the Lacey work for USSC has been for "tooling modifications. In fact, Lacey has simply been producing and assembling products for USSC. Burke immediately visits Barden to discuss this issue with Yamont. 2/3/82 Ernst & Whinney approves the issuance of a press release by USSC man agement that reports the company's sales and earnings for 1981. (At this point, Michael Hope, the USSC audit engagement partner, is unaware of the problem brought to William Burke's attention by Paul Yamont.) 2/5/82 Burke again visits Yamont to discuss the alleged mislabeled invoices 2/8/82 Barden Corporation's board of directors votes to retain Emat & Whinney to formally investigate the mislabeled invoices 2/10/82 Burke contacts Norman Strauss, regional director of accounting and audit ing for Emst & Whitney's New York region, and informs him of Yamont's concerns. Strauss immediately informs Bruce Dixon, Ernst & Whinney partner in charge of the New York region, of the Barden situation Shortly thereafter, Dixon calls Hope and instructs him not to sign off on the USSC 6 A. Goldman and B. Barley, The Auditor-Firm Conflict of Interests: Its Implications for Independence." Accounting Review 49 (October 1974), 707-718: D.R. Nichols and K. Price, "The Auditor-Firm Conflict An Analysis Using Concepts of Exchange Theory." Accounting Kruire 51 (April 1976), 335-346 M.C. Knapp and B.H. Ward, "An Integrative Analysis of Audit Conflict Sources, Consequences and Resolution," Adrenasit Accounting 4 1987). 267-286. SECTION ONE COMPREHENSIVE CASES 2/13/82 2/15/82 2/18/82 2/20/82 (approx- imately audit until the questionable invoice charges have been fully investigated. Dixon also informs Robert Neary, Emrat & Whinney's chief technical part- ner, of the problem. Burke sends an imst & Whinney audit manager to Barden Corporation to investigate the invoices and purchase orders in question Burke joins the East & Whinney audit manager at Barden Corporation to tour the Lacey Manufacturing facility and to discuss the questionable in- voices and purchase orders with Robert More, the Lacey general manager. More Informa Burke that nearly all of the invoiced charges being reviewed were for generic production work performed for USSC rather than for tool- ing modifications Burke meets with the Barden board of directors and reports that the results of the Ernst & Whirny investigation demonstrate that the USSC purchase orders and the corresponding Barden invoices misrepresent the nature of the work performed by Lacey Manufacturing for USSC. The chairman of Barden's board of directors then reports that an independent investigation by an outside law firm has yielded the same conclusion. The Barden direc- tors vote to require that all future work performed for USSC be properly described in invoices submitted for payment to the company Hope and Dixon are unsure how to proceed on the USSC audit, given the results of Burke's investigation. Because of confidentiality concerns, Hope cannot raise the issue directly with USSC officers. Barden officers are con cerned that if USSC perceives that Barden has brought the problem to the attention of Emst & Whinney, USSC may terminate its relationship with Barden. Finally, Hope and Dixon decide to send a confirmation letter to Yamont and More that asks them to confirm that the disputed $1 million in charges were for tooling modifications. (Hope and Dixon realize that Yamont and More will refuse to sign the confirmation letter.) Yamont contacts Hope and informs him that he cannot sign the confirma- tion letter since he is aware that the disputed charges are not for tooling modifications Following the refusal of Yamont and subsequently, More to sign the confirmation letter, Ernst & Whinney officials discuss the problem with the management of both USSC and Barden. Eventually, executives of each com- pany agree to allow auditors from the two Emst & Whinney teams to have mutual access to their company's accounting records. Hope meets with top USSC executives and asks them to relate their under standing of the costs incurred by Lacey Manufacturing on behalf of USSC. The USSC officials inform Hope that in early 1981, they had instructed More, the Lacey general manager, to make certain tooling changes that would result in improved efficiency in the production of USSC products The executives then provided an elaborate and confusing explanation as to why the tooling modifications were charged out on a per-unit basis. (Earlier, Ernst & Whinney representatives had noted that the disputed costs were billed to USSC based upon the number of units of product manufac tured by Lacey. Intuitively, costs associated with tooling modifications should have been billed in one lump sum or in installments. The fact that the costs were billed on a per-unit basis suggested that they were produc tion costs.) Hope asks USSC's controller for purchase orders that the company had placed with outside contractors other than Barden (Lacey). Hope is look ing for evidence of additional mistabeled costs. In the files that Hope is 2/25/82 3/3/82