Miller Energy, Incorporated was a thinly traded, penny stock, oil and gas company headquartered in Knoxville, TN.Miller won a competitive bid to purchase assets of a company filing for bankruptcy for $2.25 million in cash, along with assuming liabilities of about $2 million.A California based energy company in the process of legally abandoning those assets.The assets consisted of leases covering 602,000 acres of land in Alaska that contained mostly unproven exploratory oil and gas reserves.The assets also included five oil and gas wells, two production facilities, and an offshore oil platform, hereafter the "Alaska Assets."

This case highlights both financial reporting, fraud by Miller, as a well as audit failures on the part of its auditor, KPMG, and the audit engagement partner, John Riordan.Ultimately, the SEC fined Miller $5 million, KPMG $1 million and Riordan $25,000.

KPMG issued unqualified audit opinions on the financial statements throughout the fraudulent period, and remained Miller's auditor even after the fraud was discovered.On March 12, 2015, Miller submitted a NT-10-K, which is a notification of its ability to file its 10-K in a timely fashion.KPMG issued an adverse opinion on the company's internal controls, and the company was trying to remediate those hiring more internal accounting staff.Ultimately, the SEC delisted the company's stock and on march 29, 2016, its series registration was terminated.KPMG's audit fees during 2011 through 2014 were:

FYE 2014: $1,214,000

FYE 2013: $890,000

FYE 2012: $578,000

FYE 2011: $451,005

Miller reported the assets that it had purchased at an overstated value of $480 million, and recognized a bargain purchase gain of $277 million.To justify this fraudulent valuation, the CFO used a fair value reserve report that a petroleum-engineering firm produced.Shortly after the purchase, Miller filed its 10-Q for its fiscal third quarter year ending January 31, 2010.That report asserted that the company's fixed assets were comprised of $368 million of oil and gas properties, and $110 million of long-lived assets.Of particular interest, the SEC AAER states that the following occurred with respect to fraud relating to long-lived assets:

"In a February 8, 2010 email, the CFO informed the Alaska CEO that he needed an amount to use as fair value for the fixed assets obtained as part of the Alaska acquisition.He noted that, ideally, the value should be what a willing buyer would pay for the assets, but in the absence of that, replacement values or something similar would probably work.Two days later, the CFO sent an "asset replacement cost study" purportedly provided by an independent insurance broker, which appeared to list the replacement cost for the assets as $110 million.The study was dated September 5, 2008, but "revised" on February 9, 2010.Without any additional analysis, the CFO recorded the amount in the revised insurance study on Miller Energy's balance sheet.The recording of the assets at a value of $110 million was improper for several reasons.Miller Energy's use of the values in the insurance study resulted in counting the value of the fixed assets twice, thereby overstating the value of the such assets.The reverse report Miller Energy relied on to value the acquired oil and gas properties used a discounted cash flow model.Valuation specialists use such models the estimate the value of an enterprise's "operating assets" - the assets employed to generate future cash flows - by converting future benefit streams into net present value.In Miller Energy's case, the fixed assets in the insurance study were the very same operating assets that were expected to generate the future cash flows in the reverse report.Accordingly, they should not have been separately valued."

Miller also reported a bargain purchase gain of $277 million, which was a material improvement over its prior fiscal year end loss of $556,097.Because of this fraudulent reporting, Miller's stock rose from $0.61 per share to $6.60 per share.After achieving that fraudulent performance, Miller's stock started trading on the NASDAQ, and then the NYSE a year later; the all-time high price of the stock occurred on December 9, 2013 at a value of $8.83 per share!

AAER No. 3888 details the following failures by KPMG and the engagement partner: with regard to client acceptance: The engagement partner, John Riordan, had no experience in the oil and gas industry.Only one of two senior managers on the engagement had such experience; KPMG assigned her to the engagement specifically because of that experience.The AAER states the following: KPMG's client acceptance procedures also failed to adequately address the audit team's lack of industry experience.Although a client acceptance evaluation form completed by Riordan noted that the assigned engagement partner and senior manager had no prior experience with oil and gas companies like Miller Energy, it stated that there were no concerns regarding the overall skills and experience of the engagement team.Consequently, KPMG assigned to the engagement team personnel who had insufficient expertise to appropriately address the risks presented by Miller Energy.Riordan lacked the necessary experience to serve as the partner-in-charge of the engagement, resulting in departures from professional standards.

KPMG and Riordan failed to obtain sufficient competent evidence regarding the impact of the opening balances on the current-year financial statements, despite knowing that no proper fair value assessment had been performed by management in the prior year.Although KPMG and Riordan did undertake some audit procedures relating to the opening balances, these procedures failed to appropriately consider the facts leading to Miller Energy's acquisition of the Alaska Assets, including the multiple offers received for those assets and the "abandonment" of the assets by the prior owner.In applying these procedures, KPMG and Riordan also failed to sufficiently review certain forecasted costs associated with the estimation of the fair value of the Alaska Assets, which were understated, and to detect that certain fixed assets were double counted in the company's valuation.

KPMG and Riordan failed to properly assess the risks associated with accepting Miller Energy as a client and to properly staff the audit.KPMG and Riordan also overlooked evidence that indicated a possible overvaluation of the Alaska Assets and failed to exercise the requisite degree of due professional care and skepticism.And while KPMG management and national office personnel became aware of the unusual and highly material prior-year transaction, the firm did not take sufficient action to determine that an appropriate response was taken by the engagement team regarding the risk of overvaluation of the Alaska Assets.

KPMG and Riordan agreed with Miller Energy's accounting treatment for the fixed assets without performing sufficient procedures to obtain the necessary evidence to properly assess the reasonableness of that accounting treatment.Although EVS was aware of potential double-counting and made inquires of the core engagement team about the relationship between the fixed assets and the reserve report's cash flows, the discussion and the resolution of this issue were not documented in KPMG's workpapers.

There was also insufficient competent evidence to support the $110 million valuation of the fixed assets.Despite workpapers that state the opposite, KPMG and Riordan knew that the insurance broker was not a valuation specialist and that the insurance report was not sufficient evidential matter to support the value of the fixed assets.

To corroborate the $110 million number listed in the insurance report, Miller Energy, at KPMG's request, created a second estimate in 2011, without the assistance of any valuation professionals.In preparing this analysis, Miller Energy adjusted its original estimates of the replacement costs for the various fixed assets - increasing the values for some assets and reducing the value of others - and made further adjustments to these replacement costs for depreciation and for functional obsolescence.KPMG and Riordan accepted the new replacement cost values from this analysis as reasonable without obtaining adequate corroboration, and they did so even though the values were based on management's own internal cost estimates and included miles of additional pipelines.Based mostly on this additional analysis, EVS determined that the overall replacement cost estimate in the insurance report was a "reasonable proxy" for fair value.

A. What is a penny stock?Why does the SEC care about such a small and thinly traded stock?Do you think that the fact that this was a relatively small company within minimal stock capitalization might have played into the engagement partner's relative lack of skepticism regarding management's assertions?Explain.

B. What audit procedures should KPMG have conducted with regard to the valuation of the oil and gas reserves?