Kid Castle Educational Corporation, Brock, Schechter & Polakoff LLP, PCAOB LO 2, 3, 4 General Background. On May 22, 2012, the audit firm of Brock, Schechter & Polakoff LLP (hereafter BSP) was censured and fined $20,000 by the PCAOB in relation to its audits of public companies located in Taiwan and China. These public companies were listed on U.S. stock exchanges. James Waggoner, BSPs director of accounting and auditing, was the BSP auditor responsible for the audits. The charges against BSP and Waggoner include: BSP failed to develop policies and procedures to assure that the firm undertook only audit engagements that it could expect to conduct with professional competence. Prior to undertaking the audits of the Taiwan and Chinese companies, the firm had no experience auditing public companies in general or companies based in these locations. Further, BSP personnel lacked the ability to communicate in Chinese. BSP failed to develop policies and procedures to assure that the personnel assigned to the audits had the requisite technical training and proficiency. BSP failed to monitor the audits during its annual internal review process. BSP failed to comply with PCAOB standards on the planning, performance, and supervision of the audits. BSP failed to gather sufficient evidence, failed to use due care, and failed to exercise professional skepticism on the audits. BSP allowed two other audit firms, which were located in Taiwan and China, to plan and perform the audits. BSP had minimal contact with the foreign firms, and inadequately reviewed the working papers of the foreign firms. BSP also failed to obtain and review engagement completion documentation from the foreign firms prior to issuing the audit reports. Waggoner failed to comply with professional auditing standards. Further, he failed to cooperate with PCAOB inspectors, and he falsified documentation relating to the audits. The Kid Castle Audits. Kid Castle is a company located in Taiwan that provides English-language instruction to Chinese-speaking children. Kid Castle was traded on the OTC Bulletin Board and Pink Sheets. A Taiwanese audit firm approached BSP in June 2006 concerning the Kid Castle audit, and BSP was hired as the auditor on July 26, 2006. BSP expressed unqualified audit opinions on the companys 20062008 financial statements. In addition to the general criticisms detailed previously, the PCAOB enforcement release provides detailed information on audit quality deficiencies on the Kid Castle audits, including the following: BSP failed to consider the nature, extent, and timing of audit work necessary to audit Kid Castle. Instead, BSP relied completely upon the Taiwan firm to make these considerations and to develop the audit program. BSP failed to adequately supervise the auditors of the Taiwan firm, including: Failing to assess the technical competence of the Taiwan firms auditors Failing to assign the Taiwan auditors to tasks according to their abilities Failing to instruct the Taiwan firms auditors Failing to inform the Taiwan firms auditors about their responsibilities and the objectives of the audit Failing to inform the Taiwan firms auditors about matters that affected the nature, extent, and timing of audit procedures Failing to direct the Taiwan firms auditors to bring to BSPs attention significant accounting/auditing issues encountered during the audits. BSP failed to adequately perform a review of the Taiwan firms audit work, and such a review was the principal involvement required of BSP. In fact, Waggoner assigned the final responsibility for reviewing the audit to a BSP staff member. The reviewing staff member did find deficiencies in the audit procedures performed by the Taiwan auditor. Waggoner forwarded those deficiencies to the Taiwan firms auditors, but they did not address those deficiencies or conduct additional audit work. For the 2007 audit, BSP did not receive or review any working papers from the Taiwan auditor, except for a set of worksheets showing consolidation work among Kid Castles subsidiary accounts. For the 2008 audit, BSP did not receive or review any working papers. Kid Castle Risk Factors and Financial Condition. In its December 31, 2008, Form 10-K, Kid Castle management disclosed the following risk factors relating to its business: There is a history of operating losses and difficulty maintaining profitability. Demand for products and services is unpredictable. The companys operating results are dependent upon the success of its franchises. Market competition from established competitors could negatively affect the business. International expansion plans may not be successful. There exist risks relating to the companys potential inability to defend and protect its intellectual property. The company relies on loans from shareholders and bank loans, which may adversely affect liquidity. Because the companys officers and directors are not U.S. persons and because subsidiaries are Taiwanese or Chinese, judgments under the U.S. securities laws may not be able to be enforced. Internal controls are not effective in accordance with the requirements of Sarbanes-Oxley Act of 2002 (SOX). The companys assets and operations in the Peoples Republic of China are subject to political, regulatory, and economic uncertainties. In addition, BSP issued a going-concern audit report, which indicates concern about the companys ability to remain operational. The financial statements of Kid Castle are as follows: KID CASTLE EDUCATIONAL CORPORATION CONSOLIDATED BALANCE SHEETSEnlarge Image LIABILITIES AND SHAREHOLDERS EQUITYEnlarge Image KID CASTLE EDUCATIONAL CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONEnlarge Image During 2010, Kid Castle stock was no longer trading on any United States market. The PCAOB censured James Waggoner and prohibited him from practicing on any public company audits in the U.S. for at least three years. Why would the inherent and control risks at Kid Castle be of concern to a potential auditor? Review the financial statements and calculate the commonly used ratios from Exhibit 7.3 for the years ending 2008 and 2007. Assume that the auditor expected the 2008 financial results to be in line with the 2007 financial results. Given this expectation, comment on the trends in the financial statements and ratios that would cause the auditor to assess a heightened risk of material misstatement. Would the auditor likely conclude that there was a heightened risk of fraud? Based on your answers to (a) and (b), for what accounts would you recommend that the auditor plan to conduct more substantive audit procedures? The 10-K discloses that BSP earned total audit fees in 2007 and 2008 of $121,026 and $150,000, respectively. Comment on the motivations of BSP and Waggoner to accept audit clients in international locations. How might those motivations have affected Waggoners lack of ethics? Furthermore, how might those motivations might have affected his professional skepticism? Presumably, BSP had to pay the Taiwanese and Chinese audit firms a portion of the audit fee, and based on the allegations in the PCAOB enforcement release, BSP did virtually no audit work. Comment on your thoughts about the appropriateness of hiring a foreign audit firm to conduct the majority of audit work on an engagement and on BSPs actions (or lack thereof) in this regard. Use the framework for making quality professional decisions from Chapter 1 to identify those steps in the framework where Waggoner went wrong and describe what he should have done differently. Describe the risks that an audit firm faces when it attempts to audit a company in an international location. For additional details, see PCAOB Release Nos. 105-2012-002 and 105-2012-003.