What is meant by maintaining control of confirmation procedures when collecting audit evidence? In the case of Sky, Inc., what were some of the mistakes made related to the confirmation of the Russian CDs?

Sky Scientific, Inc.: An Auditing Minefield Stephen M. BeMiller, Randy Wirtz, and Deborah L. Lindberg ABSTRACT: In 1994, Sky Scientific, Inc. dramatically overstated assets and under- stated expenses in its financial statements. A Securities and Exchange Commission (SEC) investigation into those financial statements led to charges being filed against both the company and its auditors. This case takes a detailed look into the independent audit of Sky's financial statements for the purpose of understanding how the auditors failed to see the extent to which Sky's financial reporting was misleading and to ade- quately challenge the assertions presented in the financial statements before Sky filed them with the SEC. This case provides an opportunity to examine numerous issues related to the audit engagement process, including audit planning, the evaluation of management representations, the audit evidence process, and auditors' going-concern judgments. The roles and responsibilities of the concurring auditor and an outside specialist are also discussed. Keywords: Sky Scientific; mining, auditing standards; audit failures; overstatement of assets. S INTRODUCTION ky Scientific, Inc. (Sky) was founded by William Dorow in 1991 as a privately held mining and processing company, which purportedly operated five mining properties in the western United States (SEC 1999). In 1993 the company went public with a market capitalization of $2 million. At that time American Capital Network (ACN), the firm hired to promote Sky's stock, began circulating tout sheets under the titles "Wall Street Watch" and "Chicago Financial Services, Inc." to generate interest in the company and its stock. These efforts were successful as its stock price increased 600 percent, from $0.75 to $4.50 per share, and its market capitalization rose to $80 million. Sky reported assets of $69.7 million and estimated revenues of $31 million in 1994 (SEC 1999). The reality of Sky's financial position was much different than what was reported. Assets reported on the balance sheet in 1994 were overstated by at least 95 percent, since in reality Sky was a company with little to no cash, questionable investments in certificates of deposit (CDs), no revenues, and substantial doubt about its ability to continue as a going concern. Moreover, none of the mines would be operating for several years. Barry Stephen M. BeMiller is a Junior Auditor at the Illinois Agricultural Auditing Association, Randy Wirtz is a Staff Accountant at Caterpillar, Inc., and Deborah L. Lindberg is a Pro- fessor at Illinois State University. C. Scutillo, CPA of Fort Lauderdale, Florida, served as Sky's independent auditor for 1994. Scutillo retained Mark Jensen, a CPA who was not a member of Scutillo's firm, to serve as the concurring reviewer for the engagement. Scutillo's firm (Scutillo & Blake) issued a 1994 audit report with a going-concern paragraph, but failed to identify many of the prob- lems with Sky's financial statements presentation (SEC 1999). The United States Securities and Exchange Commission (SEC) initiated an investigation of Sky Scientific, Inc. in August 1994, and eventually charged management officials with fraudulent accounting practices and the broker-dealers of Sky stock with violations of sev- eral federal securities laws (SEC 1999). In a separate action, the SEC brought charges against Scutillo and Jenson for engaging in improper professional conduct for failing to conduct the 1994 audit in accordance with generally acceptable auditing standards (GAAS). The charges resulted in an array of penalties for all parties involved, including bans from practicing before the SEC, monetary fines, and cease-and-desist orders. Sky's Operating Activities, Financing Activities, and Financial Statement Presentation Sky Scientific owned and purported to operate as many as five mines with millions of dollars worth of mineral reserves in the western United States. According to press releases issued by the company, the mines were in full production, operating as many as ten hours per day, seven days per week. In reality the mines did not operate at all. While Sky did own the mining properties, it was expressly prohibited by law from conducting any mining activities, since they had met neither the regulatory nor the environmental requirements to operate the mines (SEC 1999). Indeed, it would be several years before the necessary studies would be completed and the permissions granted. Few, if any, of the mining sites had equipment sufficient to conduct regular mining operations, nor was there any scrap or other evidence of recent mining activities. Moreover, Sky never completed any geological analyses of whether or not there were any actual reserves on their sites. In short, the reserves did not appear to be either economically or legally extractable (SEC 1999). Burdened with nonproductive assets and essentially no operating revenues, Sky turned to a number of fraudulent activities and accounting practices, apparently in an effort to maintain the price of Sky Scientific's stock. These schemes were largely the work of the Sky chief executive officer W. A. Dorow, Jr., the principal financial officer Jerry Foster, and Robert Schlien of American Capital Network, the company that promoted and sold Sky's stock. Dorow worked out of Sky's corporate headquarters in Florida while Foster was located in West Virginia (SEC 1999). The 1994 financial statements reported assets of nearly $70 million, consisting of $30 million in mining properties, $40 million in Russian certificates of deposit (CDs), and remarkably, only $3,000 in cash. With limited cash on hand, Sky issued a large number of shares of preferred and common stock, and used it to make acquisitions and carry out operations. Sky acquired its mining properties by paying for them with preferred shares of stock, issued at $10 par value per share (SEC 1999). Sky reported the mining properties on its balance sheet using one of two methodologies: (1) it booked the assets based on the estimated net present value of future revenues expected to be generated by mining activities, or (2) by multiplying the par value ($10 per share) of the preferred stock by the number of shares issued. The future revenue estimates were based on assumptions that the mines contained significant mineral deposits and would be operating in full production within one or two months, instead of one to three years. At the same time, the preferred stock had no market value. In short, the properties were overvalued. Sky's financial statements indicated it acquired $40 million in Russian CDs from the Bank of Sinektika of Moscow, Russia, on February 28, 1994, the last day of its fiscal year, in exchange for four million shares of preferred stock. The CDs were recorded as assets on the Sky books and represented more than 50 percent of Sky's assets (SEC 1999). Dorow worked with his good friend Hillel Sher, who served as an agent of the Russian bank, to complete the transaction and three provisions of the deal. First, the deal included a provision that Sky could rescind the transaction at its own discretion at any time for any reason without penalty or payment. Second, the transaction could be revoked if the Sky auditors did not approve the transaction or allow for its full valuation on the balance sheet. Third, the agreement stated that Sky would receive an annual interest rate of 11.25 percent on the CDs, payable at the end of four years, even though the dividend rate on the preferred stock was only 4.25 percent or less (SEC 2001a). It was also Sky's practice to use both common and preferred stock to compensate its employees and consultants to cover operating expenses. Sometimes Sky would issue com- mon stock to consultants in excess of the value of the services rendered and treated the transaction as a financing activity rather than as an expense (SEC 1999). This failure to properly report expenses related to the acquisition of assets and ongoing operations caused the company to under-report its losses by $35 million, or 700 percent, in 1994. Because Sky had no positive cash flows resulting from operating activities, it focused its attention on its financing activities as a mechanism to bring cash into the company. Robert Schlien of American Capital Network (ACN) and a cadre of broker-dealers were responsible for promoting and selling Sky stock in the marketplace. ACN distributed 350,000 tout sheets using the fictitious title Wall Street Watch during the period June 1993 to August 1994. These tout sheets communicated misleading information, including claims that the mines were currently in full production. These marketing efforts successfully generated new investments into the company. In addition to distributing the fraudulent tout sheets, Schlien and his associates performed a series of wash trades and other activities to stimulate market demand for the stock. Schlien and his colleagues were able to profit by charging undisclosed markups on the sale of the stock to unsuspecting customers (SEC 1999). Dorow and Foster worked with ACN to return cash to the company. As previously noted, Sky issued stock to pay for services it received from consultants, primarily ACN. The preferred stock issued by Sky included a contract provision through which ACN held the right to liquidate (sell) the shares of the preferred stock at any time. Schlien would exercise this right on a regular basis in order to generate cash for himself and his colleagues, who would get a portion of the proceeds upon sale of the stock. In addition, some of the proceeds of stock sales were given to Sky in an effort to continue to generate cash flows for its operations. Schlien alone made $2.6 million on these transfers and subsequent sales of stock. To prevent rapid dilution of the stock's value from driving down its market price, Schlien executed a series of wash trades and engaged in other manipulative behavior to artificially maintain the price of Sky's common stock (SEC 1999). In sum, the financial statements for Sky Scientific, Inc. for the year ending February 28, 1994, were misleading. There were substantial issues related to the valuation of its assets and questions about whether period expenses had been properly recorded. In addition, Sky had limited cash on hand and regularly paid its management, employees, and consult- ants with common and/or preferred stock. Finally, there was substantial evidence that its agents were fraudulently manipulating Sky's valuation in the marketplace by various stock transactions. Sky Finds a New Auditor Sky had substantial difficulty retaining outside audit firms. In fact, Sky contracted with six firms during a very short time span (SEC 1999; SEC 2001a). BDO Seidman audited Sky for the period ending July 31, 1992, when Sky was still a privately held company. As early as April 1993, Ernst & Young added a going-concern paragraph to its audit opinion and was immediately dismissed by Sky. The successor auditor, Weinberg & Company, initially released an unqualified opinion, but soon thereafter modified it to include a going- concern reference. Another auditor, Norman Cutler, was dismissed in December 1993 after only three weeks on the job. Joel S. Baum served as Sky auditor following the dismissal of Cutler through May 16, 1994, only to be dismissed two weeks before the SEC filing deadline (SEC 1999; SEC 2001a). Exhibit 1 provides a timeline summarizing the auditors and CPAs associated with Sky Scientific during the 19921994 periods. Scutillo learned of Sky's need for accounting services from Richard Greene, an attorney he had known for several years. At the time, Greene served as outside corporate and securities counsel for Sky (SEC 2001a). In May 1994, Barry Scutillo, CPA, was offered the job of being Sky's next independent auditor. Scutillo had been a CPA for 13 years and his career included audit work at Peat, Marwick & Co. where he had reached the level of senior manager. Scutillo was a certified fraud examiner and had taught a number of ac- counting courses. At the time he was offered the Sky audit job he was a partner in the firm of Scutillo & Blake (SEC 2001a). Scutillo knew that Sky had engaged three prior audit firms in the last year and that Sky's financial records were not in good shape. Before accepting the engagement, Scutillo spoke with Jacobs, a subcontracted temporary auditor hired by Cutler, Jacobs did not ex- press any concerns about the integrity of management or point to any disagreements with EXHIBIT 1 CPA Firms and CPAs Associated with Sky Scientific, Inc. Period Ending 7/31/92 BDO Seidman Sky Was Still Privately-Held April 1993 Ernst & Young Going-concern paragraph in opinion A portion of 1993 Weinberg & Company Initially released unqualified opinion; Subsequently issued going-concem paragraph in opinion December 1993 Norman Cutler Dismissed after three weeks Lasted until May 16, 1994 Joel S. Baum Dismissed two weeks before SEC filing deadline May 1994 Scutillo & Blake Audit firm in this case management. Scutillo did not contact Baum and did not contact Cutler, reasoning that Cutler had never rendered an opinion on Sky's financial statements (SEC 2001a). Scutillo sent an associate at his firm to review Weinberg's work papers; again, no auditing disagreements or concerns about the integrity of Sky's management surfaced (SEC 2001a). In addition, before accepting the job with Sky, Scutillo made several things clear to Dorow about what he could expect from the audit. First, he let him know that he would need help auditing a mining company because he had no experience with this type of firm. Second, Scutillo let Dorow know that he would need more than a month to complete the audit, and would not be able to meet the SEC deadline, which at the time was only two weeks away; therefore, an extension would need to be filed with the SEC. Finally, and perhaps most importantly, Scutillo indicated that a going-concern qualification on the 1994 financial statements was likely (SEC 2001a). In spite of the problems Scutillo accepted the audit engagement on May 16, 1994. To assist him on the audit he selected two accountants from his firm. Both had only been with Scutillo & Blake for about one year, but each had several years of prior public auditing experience. Scutillo, who had no previous experience auditing mining companies, decided to go outside the firm to retain Mark Jensen to serve as concurring reviewer for the Sky audit. Mark Jensen was a partner in a CPA firm that had six professional employees and earned about two-thirds of its income from auditing (SEC 2001a). Jensen was supposedly retained primarily to provide the experience needed for auditing mining companies, al- though his previous experience was limited to only one mining company engagement. Scutillo began his audit of Sky, Inc. by identifying several critical audit areas. These in- cluded valuation of Sky's transaction with the Russian bank, the valuation of Sky's mineral properties, and Sky's issuance of preferred stock. A materiality threshold of $468,000 was established for the audit (SEC 2001a). Jensen was directly involved in the audit, having contributed approximately 20 percent of the total billable services on the audit. Jensen never did receive, nor did he review, a full set of the original audit work papers.? Valuing the Russian Bank Assets on Sky's Balance Sheet The transaction involving Russian certificates of deposit was very unusual. The trans- action had occurred on the last day of the fiscal year and, based on the interest rate differ- ences, was disproportionately beneficial to Sky. Further, the Russian bank was not required to pay interest or principal to Sky for four years, with accrued amounts put into an escrow account for payment at the time the CDs matured. Scutillo and Jensen knew about these issues and had made the transaction the first of their critical audit areas. The auditors were concerned about whether or not the Russian bank could actually pay Sky the $40 million plus interest in four years. Auditing the Russian CDs included four steps. First, Scutillo inspected the purchase agreement and the CDs. He found it unusual that the CDs stated on their face that they had been purchased for cash when, in fact, they had been obtained for preferred stock. Scutillo never followed up on this discrepancy. Second, Scutillo received a faxed copy of a standard bank confirmation on June 9, 1994. Scutillo was surprised to get the confirmation because he had not actually requested it and did not know if a prior auditor had asked for it. The fax came from Sky's offices. The agent representing the Russian bank had sent the fax and provided a cover sheet in which he promised to send an original confirmation when he received it. Scutillo was concerned about the fact the bank itself had not sent the fax directly to him. Third, Scutillo asked Sky for the Russian bank's financial statements. When they arrived they were written in English but did not indicate whether they had been prepared in accordance with GAAP. A brief investigation by Scutillo led him to conclude that Russian banks were not required to have audited financial statements. Finally, Scutillo contacted Richard Greene, Sky's outside corporate and securities attorney, to find out more about the CDs. Greene provided his personal assurance that the CD transaction was legit- imate and claimed to have met with the Russian bank official when the agreements were being completed (SEC 2001a). Before the audit work was completed, Scutillo, Jensen, and Dorow participated in a teleconference to discuss the Russian CD transactions and how they should be valued. Both auditors had expressed their serious doubts about the CDs. Jensen said the CDs did not pass the smell test. Then the auditors told Dorow that they were considering doing addi- tional procedures related to the CDs, but Dorow reminded them that the June 15th filing deadline was fast approaching. Scutillo and Jensen felt a great deal of pressure from Dorow since he made it very clear that he expected the auditors to agree with his presentation of the CDs and their value. In the SEC's release it is noted that "Scutillo considered estab- lishing a reserve against the CDs, but concluded that there was no need for a reserve and no basis for determining an appropriate amount. He then told Jensen that because there was no evidence that the CDs were invalid, they should remain on Sky's financial statements as assets worth $40 million" (SEC 2001a, 8). The audited financial statements treated the CDs as a noncurrent, restricted asset, included a footnote disclosure of the CDs uninsured status, and incorporated the CD transaction into the audit report's going-concern paragraph (SEC 2001a). Valuing Sky's Mines Another critical audit area was the valuation of Sky's mining properties in California and Nevada. Scutillo and Jensen needed to decide if the par value of the issued stock was the correct basis for valuation of the assets. Since these properties had been bought almost exclusively with Sky, Inc. preferred stock, it was difficult to determine their market value. The auditors knew that Sky's preferred stock was not publicly traded and because of this it was difficult to determine a market value for it. The audit of the mining properties involved several steps. Scutillo and Jensen studied estimates provided by Sky's technical staff of estimated ore reserves, ore recovery, and the cost of mining, milling, refining, and overheads per ton at several of the properties. In addition to these estimates, some independent verification of the staff estimates was provided by an engineering geologist named Charles Schultz, who had been engaged by Sky. The auditors were wary of the fact that Sky's estimates of the net present value of the mines were considerably higher than the face value of the preferred stock it issued to acquire them. Scutillo asked for additional information from Schultz about the estimates, who responded by explaining that the numbers fell within industry standards. Scutillo and Jensen then visited three mining properties to verify their existence. Several employees of Sky drove the auditors to the sites and explained why each had been selected. The auditors saw no equipment or operations at two of the mines. Moreover, there was no evidence of recent operating activity, such as waste rock or tailings, at either location. In July 1994 Scutillo and Jensen visited the Tallulah mine, where Sky miners staged an op- eration. As later recounted by a neighboring landowner: Sky miners waited for the auditors to show up, and at that point the miners tumed the mill on. They had about enough water to run the mill for 30 minutes. They really didn't have any material to run through the mill at that time. The configuration of the equipment that they had at that time was not working properly, so they tumed it on ... (T)he reverse screw wouldn't even turn on so several members of the crew stood next to the screw ... pushing the screw by hand so that it would turn while the auditors were there ... The auditors were there for about 30 minutes, [they] left, and the miners] turned the mill off. (SEC 1999) After the site visits the auditors returned their attention to Sky's estimations of the net present value of the mines. Scutillo still could not understand why the valuation of the mines was so much greater than the par value of the preferred stock that was issued to buy the mines. The net present value calculations assumed that full-scale mining operations would begin almost immediately and, based on what he saw at the site visit, he knew this was not likely. Additional evidence that the mines could not start operations in the near future was the lack of cash and environmental issues that were still unresolved. Neverthe- less, after considerable deliberation Scutillo decided that the net present value calculations were a valid method of determining the fair value of the three mines. He concluded that since the market value of the mines, as shown by the net present value calculations, was higher than the cost as shown by the face value of the preferred stock and notes Sky issued to acquire the mines, he would accept the lower cost valuation as the fair value of the properties in the audited financial statements (SEC 2001a). Unrecorded Expenses: Shares Issued for Services Rendered During the fiscal year 1994, Sky issued over 14.7 million shares of common stock, thereby increasing its outstanding common stock from about 1.6 million shares to about 16.3 million shares. Sky issued the stock to pay for services it received from consultants and to compensate its management and employees. The consultants routinely received stock in exchange for their services; however, the value of the stock issued to the consultants greatly exceeded the value of the services they rendered. Therefore, Sky was required to record the difference between these amounts as an expense on its financial statements (SEC 1999). However, Sky did not record as an expense the difference between the prices paid by the consultants and the market value of the stock when it was issued (SEC 1999). Scutillo obtained a schedule from Sky that identified all common stock issued during the year, and the amount paid by the recipient. The management-prepared schedule did not calculate the difference between the amount paid and the market price of the stock even though Scutillo knew that there were significant differences. In conducting the audit, Scutillo and Jensen relied on audit procedure checklists (audit programs) that had been created by McGladrey and Pullen, a national accounting firm. Scutillo & Blake frequently used McGladrey & Pullen's audit programs, supplemented by forms published by Commerce Clearing House and Practitioner's Publishing Company, and then tailored the audit programs to the specific audit client (SEC 2001a). One checklist indicated that there was a requirement to disclose stock issued at a discount. Another checklist alerted auditors to consider the treatment of deferred compensation resulting from the sale of capital stock to officers or employees at prices below market." In what they later described as an oversight in completing the forms, Scutillo and Jensen marked both items as not applicable. The work papers showed that a significant amount was paid to consultants, but there was no computation to show how these payments were determined. As a result of this omission no other efforts were made to determine if expenses should be recorded in connection with Sky's issuance of common stock and no expenses were re- corded in the financial statements (SEC 2001a). Scutillo & Blake Issue Their Audit Report for Sky, Inc. On June 13, 1994, Scutillo & Blake issued its independent audit report addressed to Sky's board of directors. As they had indicated would likely be the case when accepting the audit, a going-concern paragraph was included in the audit report: The accompanying financial statements have been prepared assuming that [Sky] will con- tinue as a going concern. As discussed in Note 19 to the financial statements, [Sky's] principal assets consist of investments in or leases for mineral properties consisting of unpatented mining claims and a restricted $40,000,000 certificate of deposit that raise substantial doubt about its ability to continue as a going concern. Before signing off on the audit opinion, Scutillo made several adjustments to the fi- nancial statements. "Scutillo's largest adjustment to Sky's financial statements was revers- ing [a] $16 million ... mine transaction. He accomplished this by crediting mineral prop- erties for $16 million and debiting notes payable by $250,000 and preferred stock by $15,750,000. Scutillo made several other audit adjustments to correct errors, omissions, and misallocations by Sky's in-house accountants. He estimated that these other adjustments collectively increased Sky's net losses by approximately $600,000" (SEC 2001a, 12).' SEC Charges In late July 1994, a senior geologist on the Commission's staff visited and photographed all five mining operations. At three of those properties she found no evidence of current or recent mining activity, no equipment, and no personnel. At another mine she found equipment and personnel but no tailings that might indicate that recent operations had existed (SEC 1999; SEC 2001a). As a result of these observations and the recent filing of Sky's audited financial statements, the SEC opened its investigation of Sky on August 26, 1994 (SEC 1999). In 1999 the SEC charged several members of Sky management with fraudulent ac- counting practices and for filing false and misleading financial statements with the Com- mission (SEC 1999). The SEC also charged American Capital Network and Robert Schlien with violations of several federal securities laws. Barry Scutillo and Mark Jensen were charged with engaging in improper professional conduct in that they intentionally, know- ingly, and recklessly violated the applicable professional standards when auditing a public company. Specifically, Scutillo and Jensen were charged with recklessly failing to see that most of Sky's assets were fictitious or massively overvalued and that millions of dollars in expenses had not been recorded on Sky's books (SEC 1999). CONCLUSION "In the Matter of Barry C. Scutillo, CPA, and Mark F. Jensen, CPA," was decided by an SEC administrative law judge in May 2001 (SEC 2001a). In making his decision, Judge James T. Kelly considered the definition of recklessness as it applies to the auditing pro- fession. He noted that "recklessness is narrowly defined. It involves not merely simple, or even inexcusable negligence, but an extreme departure from the standard of ordinary care which presents a danger of misleading buyers or sellers that is either known to the actor or is so obvious that the actor must have been aware of it." Judge Kelly identified four key issues pertaining to the establishment of recklessness: (1) was the audit conducted in ac- cordance with generally accepted auditing standards, (2) were the financial statements pre- sented in conformity with generally accepted accounting principles, (3) were the misrep- resentations material, and (4) did the Commission establish scienter (i.e., did the auditor knowingly commit fraud) (SEC 2001a)? Judge Kelly determined that while the issue was a close one, Scutillo's audit of Sky's mining properties was not shown to be reckless. Kelly concluded that Scutillo did not follow GAAS and that the Sky financials statements were not presented in accordance with GAAP. However, he determined that the SEC failed to present evidence sufficient to establish materiality or scienter (SEC 2001a). Nevertheless, Scutillo was denied the privilege of appearing and practicing before the Commission for a period of three years. He appealed the decision, but the initial decision was affirmed in 2003 (SEC 2003). Jensen negotiated a settlement, which also included a three-year ban from practicing before the Commission (SEC 2001b). Scutillo continued to practice accounting in Florida. SEC enforcement proceedings against Sky officials were held in 1997 and 1998. One or more Sky officials failed to show up and were deemed fugitives; other participants invoked the Fifth Amendment and refused to testify (SEC 1999). The SEC action resulted in monetary fines (up to $5 million), public censure, cease-and-desist orders, and disbarment for over 30 participants in the scheme. CFO Jerry Foster was fined $120,000 and prevented from serving as a CFO for a public company. Schlien was ordered to return $2.6 million (SEC 1999). Sky Scientific, Inc. eventually declared bankruptcy