- If you were the auditor, what testing would you have wanted to see performed to provide you reasonable assurance there wasn't a misstatement in accounts payable?
During the 1980s, CBI Holding Company. Inc, a New York-based firm, served as the parent company for several wholly owned subsidiaries, principal among them Common Brothers, inc. CBI's subsidiaries marketed an extensive line of pharmaceutical products. The subsidiaries purchased these products from drug manufacturers, warehoused them in storage facilifies, and then resold them to retail pharmacies, hospitals, longterm care facilities, and related entities. CBI's principal market area stretched from the northeastem United States into the upper Midwest. In 1991. Robert Castelto, CBI's president and chairman of the board, sold a 48 percent ownership interest in his company to Thust Company of the West (TCW). a diversified investment firm. The purchase agreement between the two parties gave TCW the right to appoint two members of CBI's board; Castello retained the right to appoint the three remaining board inembers. The purchase agreement also identified several so-called "control-triggering events." If any one of these events occurred, TCW would have the right to take control of CBI. Examples of control-triggering events included CBIs failure to maintain certain financial ratios at a specified level and utauthorised loans to Castello and other CPI executives. Castello engaged Emst \& Young (F\&Y) as CBI's independent audit firm several months before he closed the TCW deal. During this same time frame, Castello was narked "Fintreprencur of the Year" in an anntal nationwide promotion cosponsored by ERY From 1990 through 1993, ERY issued unqualified opinions on CBI's annual fimancial statements. Accounling Gimmicks Castello instructed several of his subardinates to misrepresent CBI's reported operatirg results and tinanciat condition for the fiscal years ended April 30, 1992, and 1993 Those misrepresentations aliowed Castello to recelve large, year-end bonuses to which he was not entitied. CBt actively conceated the fraudulent activities from TCW's management, from TCW's appointees to CBI s board, and trom the company's EAY auditors because Castello realized that the srineme, if discovered, woitd qualify as a control-triggering event under the terms of the 1991 purchase agreement with TCW Several years later in a lawsuit prompted by Castelto's fraud, TCW executives testified that they would have immediately seized control of CBI if they had become awate of that scheme: Understating CBI's year-end accounts payable was one of the methods Castelto and bis confederates used to distort CBI's 1992 and 1993 financial statements. At any point in time, CBI had large outstanding payables to its suppliers, which included inajor phremaceutical manufacturers such as Burroughs-Wellcome, Schering, and firkMeyer. At the end of fiscal 1992 and liscal 1993, CBI understated payables due to its large vendors by millions of dollars. Judge Burton Litland, the lederal magistrate who presided over the lawsuit stemming from Castello's I raudulent scheme, ruled that the intemtional understatements of CBI's year-end payables were very material to the company's 1992 and 1993 tinancial statements. E\&Y's 1992 and 1993 CBI Audits In both 1992 and 1993, E\&Y identified the CBI audit as a "close monitoring engagement." The accounting firm's audit manual defined a close monitoring engagement as "one in which the company being audited presents significant risk to E\&Y ... there is a significant chance that E\&Y will suffer damage to its reputation, monetarily, or both." E\&Y's workpapers for the 1992 and 1993 audits also documented several "red flags" suggesting that the engagements posed a higher-than-normal audit risk. Control risk factors identified for the CBI audits by E&Y included the dominance of the company by Robert Castello, 3 the absence of an internal audit function, the lack of proper segregation of duties within the company's accounting department, and aggressive positions taken by management personnel regarding key accounting estimates. These apparent control risks caused E\&Y to describe CBI's control environment as "ineffective." Other risk factors identified in the CBI audit workpapers included the possible occurrence of a control-triggering event, an "undue" emphasis by top management on achieving periodic earnings goals, and the fact that Castello's annual bonus was tied directly to CBI's reported earnings. For both the 1992 and 1993 CBI audits, the E\&Y engagement team prepared a document entitled "Audit Approach Plan Update and Approval Form." This document described the general strategy E\&Y planned to follow in completing those audits. In 1992 and 1993, this document identified accounts payable as a "high risk" audit area. The audit program for the 1992 audit included two key audit procedures for accounts payable: a. Perform a search for unrecorded liabilities at April 30, 1992, through the end of fieldwork. b. Obtain copies of the April 30, 1992, vendor statements for CBI's five largest vendors, and examine reconciliations to the accounts payable balances for such vendors as shown on the books of CBI. The 1993 audit program included these same items, although that program required audit procedure " b " to be applied to CBl's 10 largest vendors. During the 1992 audit, the E\&Y auditors discovered numerous disbursements made by CBI in the first few weeks of fiscal 1993 that were potential unrecorded liabilities as of April 30, 1992. The bulk of these disbursements included payments to the company's vendors that had been labeled as "advances" in the company's accounting records. CBI personnel provided the following explanation for these advances when questioned by the auditors: "When CBI is at its credit limit with a large vendor, the vendor may hold an order until they receive an 'advance.' CBI then applies the advance to the existing A/P balance." In truth, the so-called advances, which totaled nearly $2 million, were simply payments CBI made to its vendors for inventory purchases consummated on, or prior to, April 30, 1992. Castello and his confederates had chosen not to record these transactions - their purpose being to strengthen key financial ratios of CBI at the end of fiscal 1992 and otherwise embellish the company's apparent financial condition. The conspirators developed the advances ruse because they feared that E\&Y would discover the material understatements of accounts payable at year-end. Subsequent court testimony revealed that after reviewing internal documents supDorting the advances explanation-documents that had been prepared to deceive E\&Y - the E\&Y auditors readily accepted that explanation and chose not to treat the items as unrecorded liabilities. This decision prompted severe criticism of the audit firm by Judge Lifland. The federal judge pointed out that the auditors had failed to rigorously investigate the alleged advances and consider the veracity of the client's explanation for them. For example, the auditors did not investigate the "credit limit" leature of that explanation. The E\&Y auditors neglected to determine the credit limit that the given vendors had established for CBI or whether CBI had "maxed out" that credit limit in each case as maintained by client personnel. Nor did the auditors attempt to analyze the given vendors' payable accounts or contact those vendors directly to determine if the alleged advances applied to specific invoice amounts, particularly invoice amounts for purchases made on or before April 30, 1992. Instead, the auditors simply chose to record in their workpapers the client's feeble explanation for the advances, an explanation that failed to address or resolve a critical issue. "The advance explanation recorded in E\&Y's workpapers, even if it were true, did not tell the E\&Y auditor the essential fact as to whether the merchandise being paid for by the advance had been received before or after April 30, 1992." Because of the lack of any substantive investigation of the advances, the E\&Y auditors failed to determine "whether a liability should have been recorded for each such payment as of fiscal year-end, and whether, in fact, a liability was recorded for such payment as of fiscal year-end." This finding caused Judge Lifland to conclude that E\&Y had not properly completed the search for unrecorded liabilities. The judge reached a similar conclusion regarding the second major audit procedure for accounts payable included in the 1992 audit program for CBI. The 1992 audit program required the E\&Y auditors to obtain the year-end statements sent to CBI by the company's five largest vendors and to reconcile the balances in each of those statements to the corresponding balances reported in CBI's accounting records. E\&Y obtained year-end statements mailed to CBI by five of the company's several hundred vendors and completed the reconciliation audit procedure. However, the vendors involved in this audit test were not the company's five largest suppliers. In fact, E\&Y never identified CBI's five largest vendors during the 1992 audit. The federal judge scolded E\&Y for this oversight and maintained that the "minimal" amount of testing applied by E\&Y to the small sample of year-end vendor statements was "not adequate." The audit procedures that E\&Y applied to CBI's year-end accounts payable for fiscal 1993 suffered from the same flaws evident during the firm's 1992 audit. Similar to the previous year, CBl's management attempted to conceal unrecorded liabilities at year-end by labeling subsequent payments of those amounts as "advances" to the given vendors. Once more, Judge Lifland noted that the "gullible" auditors readily accepted the explanation for these advances that was relayed to them by CBI personnel. As a result, the auditors failed to require CBI to prepare appropriate adjusting entries for approximately $7.5 million of year-end payables that the client's management team had intentionally ignored. The 1993 audit program mandated that E\&Y obtain the year-end statements to CBI's 10 largest vendors and reconcile the balances in those statements to the corr sponding accounts payable balances in CBl's accounting records. Again, E\&Y faile to identify CBI's largest vendors and simply applied the reconciliation procedure to sample of 10CBI vendors. 4
