AC 440; CASE

Case 5.8. Caesars Entertainment Corporation

the early 1930s, the Great Depression forced engineering student William Harrah to drop out of UCLA. Known as a hustler by his friends, Harrah began operating a bingo parlor to support himself. After repeated confrontations with law enforcement authorities that centered on the legality of his bingo games, Harrah moved his business operations to Nevada, which had less restrictive gambling laws than California. Over the next several decades, the resourceful and enigmatic entrepreneur assembled an impressive collection of gaming properties.

Harrah eventually took his company public in 1971 to raise the funds he needed to build the crown jewel of his business empire, the five-star hotel and gaming resort Harrahs Lake Tahoe.

In 1973, William Harrah registered Harrahs Inc. with the New York Stock Exchange, making it the first gaming company listed on the Big Board. In 2005, long after its founders death, the renamed Harrahs Entertainment Inc., became the nations largest gaming company when it acquired the opulent Caesars Palace in Las Vegas and dozens of other major gaming properties operated by one of its primary competitors. The companys executives eventually renamed the firm Caesars Entertainment Corporation and listed its common stock on the NASDAQ under the ticker symbol CZR.

Over the years, Caesars and its predecessors have had more than their fair share of run-ins with regulatory authorities due to the companys aggressive business practices. In early 2013, the Securities and Exchange Commission (SEC) launched an investigation involving Caesars. Ironically, the investigation was not prompted by any actions or decisions by the companys executives but rather by the conduct of James T. Adams, a former partner of the companys audit firm, Deloitte & Touche (Deloitte).

Adams had served as the advisory partner on Deloittes 2008 and 2009 audits of Caesars. During 2009, Adams had allegedly engaged in certain gaming activities at a Caesars casino that made the SEC question Deloittes independence during the 2009 audit. presents the one-paragraph disclosure made by Caesars of the SEC investigation while it was in progress.

Exhibit 1

Details

Source: Caesars Entertainments Form 10-Q filed with the SEC on May 8, 2013

Disclosure of Ongoing SEC Investigation by Caesars Entertainment in May 2013

As noted in , Caesars and Deloitte performed their own independent investigations and concluded that Adams actions had not impaired Deloittes independence. Also, notice Caesars reported that if a contrary conclusion was ultimately reached by the SEC, there could be material adverse consequences for the company.

After graduating with an accounting degree in 1974, James Adams accepted an entry-level position with an accounting firm that was one of the many predecessors of Deloitte. In June 1985, Adams accomplished his primary career goal by being promoted to audit partner. In 2005, Adams achieved another career milestone when he was named the Chief Risk Officer (CRO) of Deloitte LLP, the parent firm of Deloitte.

Following this appointment, Adams served in a dual capacity as Deloitte LLPs CRO and as an audit partner with Deloitte. Deloitte LLP does not publicly disclose the responsibilities assumed by its CRO, but various online sites suggest that, among other tasks, a CRO monitors, assesses, manages, and mitigates the strategic and operating risks faced by an organization.

In January 2009, Adams joined Deloittes audit engagement team for Caesars Entertainment

midway through the companys 2008 audit. He remained a member of that team through early January 2010 when the 2009 Caesars audit was in progress. In his role as the advisory partner, the SEC reported that Adams primarily served as a liaison between D&T and [Caesars] management and audit committee.

Adams principal duties on the Caesars audits included attending the companys audit committee meetings, participating in conference calls of that committee, and reviewing the documents and other materials audit committee members relied on, in carrying out their responsibilities.

In June 2004, well before Adams became a member of the Caesars audit team, he arranged for a $100,000 line of credit at one of the companys many casinos. During 2009, Adams drew down on his line of credit at that casino on multiple occasions. On his first visit in July 2009, he borrowed $85,000. That loan remained outstanding for more than six weeks until he repaid it in early September 2009. Over the next several months, Adams visited the casino four more times, each time drawing a loan against his line of credit. On the first three of those occasions, the loans remained outstanding for as long as a month before he repaid them.

On December 16, 2009, Adams visited the casino and borrowed $110,000 after Caesars increased his line of credit to that amount. Adams subsequently defaulted on that loan. On January 13, 2010, Deloitte removed Adams from the Caesars audit engagement team. Deloittes decision to remove Adams from that team was unrelated to his gaming activities at a Caesars casino or the $110,000 loan he had outstanding from the casino. In fact, at the time, Deloittes senior management was unaware Adams had borrowed funds from Caesars, although at least one Deloitte partner suspected Adams had done so. According to the SEC, Adams lied to a D&T partner when he was asked generally if he had casino markers from attest clients of the firm.

In May 2010, four months after being removed from the Caesars audit team, Adams retired from Deloitte.

In late 2013, Mary Jo White, the Chairwoman of the SEC, announced that her agency had initiated a new program entitled Operation Broken Gate. Chairwoman White stated that the purpose of the program was to identify auditors who neglect their duties and the required auditing standards.

Six months later, the SEC announced the results of its investigation of James Adams in Accounting and Auditing Enforcement Release No. 3554. In that AAER, the SEC stressed the critical importance of auditor independence. Public faith in the reliability of a corporations financial statements depends upon the public perception of the outside auditor as an independent professional. The SEC went on to note that any loan to or from an audit client is inconsistent with auditor independence.

Because of Adams loans from the Caesars casino, the SEC ruled that he had engaged in improper professional conduct by violating its auditor independence rules. Without admitting or denying the charges filed against him by the SEC, Adams consented to the sanction imposed on him by the agency, which was a two-year ban from appearing or practicing before the Commission as an accountant. That penalty was inconsequential since Adams had retired from practice four years earlier.

The SEC also ruled Adams had caused Deloitte to violate both the SECs regulations and the PCAOBs auditing standards that require an auditor to be independent of its client. Finally, without naming Caesars Entertainment specifically, the SEC ruled Adams had caused the given audit client to violate the federal mandate that requires SEC registrants to have their financial statements audited by an independent accounting firm. The SEC did not impose any sanctions on either Deloitte or Caesars, nor did the agency require Caesars to have its 2009 financial statements re-audited.

In an interview with the New York Times on the day the SEC issued AAER No. 3554, a Deloitte spokesperson sharply criticized James Adams. This former partners conduct plainly violated Deloittes policies, and he lied to Deloitte to conceal his actions. Mr. Adams is no longer part of our organization, and we strongly condemn his conduct.

Case 6.5. Leigh Ann Walker, Staff Accountant

Leigh Ann Walker graduated from a major state university with a bachelors degree in accounting.

During her college career, Walker earned a 3.9 grade point average and participated in several extracurricular activities, including three student business organizations. Her closest friends often teased her about the busy schedule she maintained and the fact that she was, at times, a little too intense. During her final year of college, Walker interviewed with several public accounting firms and large corporations and received six job offers. After considering those offers, she decided to accept an entry-level position on the auditing staff of a major international accounting firm. Walker was not sure whether she wanted to pursue a partnership position with her new employer. But she believed that the training programs the firm provided and the breadth of experience she would receive from a wide array of client assignments would get her career off to a fast start.

Walkers start date was June 4, exactly one month following her graduation date. She spent the first two weeks on her new job at her firms regional audit staff training school. On returning to her local office in mid-June, she was assigned to work on the audit of Saint Andrews Hospital, a large sectarian hospital with a June 30 fiscal year-end. Walkers immediate superior on the Saint Andrews engagement was Jackie Vaughn, a third-year senior. On her first day on the Saint Andrews audit, Walker learned that she would audit the hospitals cash accounts and assist with accounts receivable. Walker was excited about her first client assignment and pleased that she would be working for Vaughn. Vaughn had a reputation as a demanding supervisor who typically brought her engagements in under budget. She was also known for having an excellent rapport with her clients, a thorough knowledge of technical standards, and for being fair and straightforward with her subordinates.

Like many newly hired staff auditors, Walker was apprehensive about her new job. She understood the purpose of independent audits and was familiar with the work performed by auditors but doubted that one auditing course and a two-week staff-training seminar had adequately prepared her for her new work role. After being assigned to work under Vaughns supervision, Walker was relieved. She sensed that although Vaughn was demanding, the senior would be patient and understanding with a new staff auditor. More importantly, she believed that she could learn a great deal from working closely with Vaughn. Walker resolved that she would work hard to impress Vaughn and had hopes that the senior would mentor her through the first few years of her career.

Early in Walkers second week on the Saint Andrews engagement, Jackie Vaughn casually asked her over lunch one day whether she had taken the CPA examination in May. After a brief pause, Walker replied that she had not but planned to study intensively for the exam over the following five months and then take it in November.

Vaughn indicated that was a good strategy and offered to lend Walker a set of CPA review manualsan offer Walker declined. In fact, Walker had returned to her home state during the first week of May and sat for the CPA exam, but she was convinced that she had failed it. Fear of failure, or, rather, fear of admitting failure, caused Walker to decide not to tell her coworkers that she had taken the exam. She realized that most of her peers would not pass all sections of the exam on their first attempt. Nevertheless, Leigh Ann wanted to avoid the embarrassment of admitting throughout the remainder of her career that she had not been a first-timer.

Walker continued to work on the Saint Andrews engagement throughout the summer. She completed the cash audit within budget, thoroughly documenting the results of the audit procedures she applied. Vaughn was pleased with Walkers work and frequently complimented and encouraged her. As the engagement was winding down in early August, Walker received her grades on the CPA exam in the mail one Friday evening. To her surprise, she had passed all parts of the exam. She immediately called Vaughn to let her know of the impressive accomplishment. To Walkers surprise, Vaughn seemed irritated, if not disturbed, by the good news. Walker then recalled having earlier told Vaughn that she had not taken the exam in May. Walker immediately apologized and explained why she had chosen not to disclose that she had taken the exam. Following her explanation, Vaughn still seemed annoyed, so Walker decided to drop the subject and pursue it later in person.

The following week, Vaughn spent Monday through Wednesday with another client, while Walker and the other staff assigned to the Saint Andrews engagement continued to wrap up the hospital audit. On Wednesday morning, Walker received a call from Don Roberts, the office managing partner, and Saint Andrews audit engagement partner. Roberts asked Walker to meet with him late that afternoon in his office. She assumed that Roberts simply wanted to congratulate her on passing the CPA exam.

The usually upbeat Roberts was somber when Walker stepped into his office that afternoon. After she was seated, Roberts informed her that he had spoken with Jackie Vaughn several times during the past few days and that he had consulted with the three other audit partners in the office regarding a situation involving Walker. Roberts told Walker that Vaughn was very upset by the fact that she (Walker) had lied regarding the CPA exam. Vaughn had indicated that she would not be comfortable having a subordinate on future engagements that she could not trust to be truthful. Vaughn had also suggested that Walker be dismissed from the firm because of the lack of integrity she had demonstrated.

After a brief silence, Roberts told a stunned Walker that he and the other audit partners agreed with Vaughn. He informed Walker that she would be given 60 days to find another job. Roberts also told Walker that he and the other partners would not disclose that she had been counseled out of the firm if they were contacted by employers interested in hiring her.

Case 6.6. Bill DeBurger, In-Charge Accountant

Bill, will you have that inventory memo done by this afternoon?

Make it three or so. Okay, Bub?

Bill responded with a smile and a nod. He had a good relationship with Sam Hakes, the partner supervising the audit of Marcelle Stores.

Bill DeBurger was an in-charge accountant who had 18 months experience with his employer, a large national accounting firm. Bills firm used the title in-charge for the employment position between staff accountant and audit senior. Other titles used by accounting firms for this position include advanced staff and semi-senior. Typically, Bills firm promoted individuals to in-charge after one year. An additional one to two years experience and successful completion of the CPA exam were usually required before promotion to audit senior.

The title in-charge was a misnomer, at least in Bills mind. None of the in-charges he knew had ever been placed in-charge of an audit, even a small audit. Based upon Bills experience, an in-charge was someone a senior or manager expected to work with little or no supervision. Heres the audit program for payables. Go spend the next five weeks completing the 12 program steps and dont bother me, seemed to be the prevailing attitude in making work assignments to in-charges.

As he turned back to the legal pad in front of him, Bill forced himself to think of Marcelle Stores inventoryall $50 million of it. Bills task was to summarize, in a two-page memo, 900 hours of work that he, two staff accountants, and five internal auditors had done over the past two months. Not included in the 900 hours was the time spent on eight inventory observations performed by other offices of Bills firm.

Marcelle Stores was a regional chain of 112 specialty stores that featured a broad range of products for do-it-yourself interior decorators. The companys most recent fiscal year had been a difficult one. A poor economy, increasing competition, and higher supplier prices had slashed Marcelles profit to the bone over the past 12 months. The previous year, the company had posted a profit of slightly less than $8 million; for the year just completed, the companys preaudit net income hovered at an anemic $700,000.

Inventory was the focal point of each audit of Marcelles financial statements. This year, inventory was doubly important. Any material overstatement discovered in the inventory account would convert a poor year profit-wise for Marcelle into a disastrous year in which the company posted its first-ever loss.

Facing Bill on the small table that served as his makeshift desk were two stacks of workpapers, each two feet tall. Those workpapers summarized the results of extensive price tests, inventory observation procedures, year-end cutoff tests, an analysis of the reserve for inventory obsolescence, and various other audit procedures. Bills task was to assimilate all of this audit evidence into a conclusion regarding Marcelles inventory. Bill realized that Sam Hakes expected that conclusion to include the key catch phrases present fairly, in all material respects and in accordance with accounting principles generally accepted in the United States of America.

As Bill attempted to outline the inventory memo, he gradually admitted to himself that he had no idea whether Marcelles inventory dollar value was materially accurate. The workpaper summarizing the individual errors discovered in the inventory account reflected a net overstatement of only $33,000. That amount was not material even in reference to Marcelles unusually small net income. However, Bill realized that the $33,000 figure was little more than a guess.

The clients allowance for inventory obsolescence particularly troubled Bill. He had heard a rumor that Marcelle intended to discontinue two of the 14 sales departments in its stores. If that were true, the inventory in those departments would have to be sold at deep discounts. The collective dollar value of those two departments inventory approached $6 million, while the clients allowance for inventory obsolescence had a year-end balance of only $225,000. Earlier in the audit, Bill had asked Sam about the rumored closing of the two departments. The typically easygoing partner had replied with a terse, Dont worry about it.

Bill always took his work assignments seriously and wanted to do a professional job in completing them. He believed that independent audits served an extremely important role in a free market economy. Bill was often annoyed that not all of his colleagues shared that view. Some of his coworkers seemed to have an attitude of just get the work done. They stressed form over substance: Tic and tie, make the workpapers look good, and dont be too concerned with the results. A clean opinion is going to be issued no matter what you find.

Finally, Bill made a decision. He would not sign off on the inventory account regardless of the consequences. He did not know whether the inventory account balance was materially accurate, and he was not going to write a memo indicating otherwise. Moments later, Bill walked into the clients office being used by Sam Hakes and closed the door behind him.

Whats up? Sam asked as he flipped through a workpaper file.

Sam, Ive decided that I cant sign off on the inventory account, Bill blurted out.

What? was Sams stunned, one-word reply.

Bill stalled for a few moments to bolster his courage as he fidgeted with his tie. Well like I said, Im not signing off on the inventory account.

Why? By this point, a disturbing crimson shade had already engulfed Sams ears and was creeping slowly across his face.

Sam I just dont think I can sign off. I mean, Im just not sure whether the inventory number is right.

Youre just not sure? After a brief pause, Sam continued, this time pronouncing each of his words with a deliberate and sarcastic tone. You mean to tell me that you spent almost 1,000 hours on that account, and youre just not sure whether the general ledger number is right?

Well yeah. Ya know, its just tough to to reach a conclusion, ya know, on an account that large.

Sam leaned back in his chair and cleared his throat before speaking. Mr. DeBurger, I want you to go back into that room of yours and close the door. Then you sit down at that table and write a nice, neat, very precise and to-the-point inventory memo. And hear this: Im not telling you what to include in that memo. But youre going to write that memo, and youre going to have it on my desk in two hours. Understood? Sams face was entirely crimson as he completed his short speech.

Uh, okay, Bill replied.

Bill returned to the small conference room that had served as his work area for the past two months. He sat in his chair and stared at the pictures of his two-year-old twins, Lesley and Kelly, which he had taped to the wall above his workspace. After a few minutes, he picked up his pencil, leaned forward, and began outlining the inventory memo.

Case 6.3. Madison Wells, Audit Manager

Madison Wells should have been happy.

Another hectic busy season was coming to an end, which meant the audit managers standard workload would drop from 55 to 65 hours per week to a much more reasonable 45 hours. But Madison wasnt thinking of the end of busy season or the spare time that she would now have each week or the beautiful weather in coming months.

As she sat in the audit conference room that Monday morning in early March, Madisons world seemed to be crumbling around her. She was staring at her cell phone that lay in front of her on the conference room table. The speaker was not on, but it didnt matter. She could easily hear the expletives being screamed at her by the audit partner who was on the other end of the line.

Transitioning from the Trenches

The busy season that was winding down had been notable for Madison because it was her first as an audit manager for her employer, a large practice office of a Big Four accounting firm. Her promotion from audit senior to audit manager had become effective five months earlier on October 1, one month following her five-year anniversary with the firm.

During each of the previous two busy seasons, Madison had served as the supervising audit senior on the audit of Smith & Kinder Manufacturing, a privately-owned company that produced a line of household appliances. As the onsite audit supervisor, her primary responsibilities had been encouraging and cajoling her five subordinates to complete their assignments within budget, bailing them out when they got stuck on tough technical issues, reviewing their completed workpapers, and keeping the audit manager informed of the overall progress being made on the engagement. She had also served as the primary contact person with the clients accounting staff and controller. On a few occasions, she had dealt directly with the clients C-suite executives, most notably the chief financial officer (CFO).

Madison was ecstatic when she received the news that she had been promoted to audit manager. Rather than working in the trenches on one audit engagement during busy season, in her new position, she would coordinate multiple audits at once. In addition to frequent visits to the audit teams she was overseeing, Madison would spend considerable time working from her private office at her employers downtown locationfor the past three years, she had shared a cubicle in the audit senior bullpen.

Madisons first unpleasant surprise had come in early October when she was transferred off the Smith & Kinder audit team. She had assumed she would replace the audit manager on that team and be assigned to serve as the audit manager on two to four smaller jobs. Transitioning from audit senior to audit manager on the Smith & Kinder engagement would have allowed her to ease gradually into her new work role. But when her practice office unexpectedly picked up a new oil and gas client, Daniel Alanis, an audit partner with whom she had worked in the past, requested that she be assigned to that new client, Le Prix Oil & Gas. Madison realized Alanis made that request because he respected her and the quality of her work. Nevertheless, in her mind, she was a questionable choice for the new engagement since she had only worked on two oil and gas audits during her five-year public accounting career. And those assignments had been during her first two years with her employer when she was an entry-level auditor.

Making the Le Prix assignment even more challenging for Madison was the high-risk nature of the engagement. During the past year, a sudden downturn in oil prices had slashed Le Prixs revenues and forced its management team to hurriedly down-size the companys operations and workforce. Le Prixs rapidly deteriorating operating results magnified its overall business riskthe company was highly leveraged with a debt-to-equity ratio topping 4.0. The most ominous audit risk factor, though, was the aggressive stances that the companys accounting staff apparently took on accounting and financial reporting issues. During a brief telephone conversation after Madison was assigned to the Le Prix audit, Daniel Alanis told her that the company had twice been forced to issue financial restatements over the previous seven years.

I can imagine that in the current environment, these guys will ratchet up their earnings management efforts several-fold, Alanis warned Madison before adding, so, buckle your seatbelt, this may be a bumpy ride.

At the time, Madison wondered to herself why her practice office would take on such a high-risk client. She didnt raise the issue with Alanis because she didnt believe it was appropriate to do so. In her firms culture, it was not considered kosher to challenge or criticize decisions made by partners.

On the bright side, Alanis arranged for Madison to have a light schedule of other audit assignments during the busy season. Her only other audit clients during the winter months were a small, family-owned chain of clothing stores and a regional healthcare company that owned and operated walk-in medical clinics. Neither of those clients proved to be particularly challenging for Madison. The same could not be said for Le Prix Oil & Gas.

Hostile Work Environment

Throughout the Le Prix audit, Madison repeatedly skirmished with the companys controller and CFO over accounting and financial reporting issues. Some of those issues required her to spend considerable time gaining a better understanding of technical accounting and financial reporting topics unique to the oil and gas industry. Despite her inexperience as an audit manager and her relative unfamiliarity with the industry, Madison held her own during those confrontations. On two occasions, the clients CFO went over her head and insisted on a sit-down conference with Alanis. During those meetings, which Madison attended, Alanis was fully supportive of her and the stance she had taken on the issue at hand.

Prevailing in the confrontations with the client was not without some downside for Madison and her subordinates. By the end of the audit, Le Prixs CFO, controller, and other key members of the companys accounting staff were clearly unhappy with the team of auditors. Madison realized the client perceived her as inflexible, if not downright stubborn, when it came to resolving questions concerning the materiality of financial statement amounts, revenue recognition issues, and other technical matters. Madison came to suspect that the clients relationship with its prior audit firm was responsible for the difficulty she and her colleagues encountered on the Le Prix audit.

The companys previous auditor was a regional accounting firmduring the past year, Le Prixs principal lender had required the company to retain a Big Four auditor as a condition for approving a new long-term loan. The copies of the prior year workpapers that the predecessor audit firm provided to Madisons firm suggested that client personnel had often bullied the previous auditors into submission when differences of opinion arose during the audit. Despite that impression, the Form 8-K that Le Prix had filed with the Securities and Exchange Commission (SEC) to announce the change in auditors had not reported any disagreements between the company and its prior audit firm.

Over lunch one day, Alanis told Madison he planned to meet with Le Prixs CFO and controller after the audit was completed to try to soothe the hard feelings that had cropped up during the engagement. Because Le Prix was a large client, it was apparent to Madison that Alanis wanted to minimize the risk that the companys management team would dump their firm after just one year. Later in that same lunch, Alanis candidly admitted to Madison that their practice office would take a bath on the Le Prix engagement because the audit fee was considerably below market. The audit partner confessed that he personally wasnt a big fan of lowballing to obtain new clients. Alanis then explained that the office managing partner was using the Le Prix engagement as a loss leader to enhance the practice offices chances of adding other local oil and gas companies to its client portfolio. The practice office was playing catch up with the other Big Four firms in the local market when it came to acquiring a proportionate number of audit clients in Texass huge oil and gas industry.

Frequent disagreements with client personnel over accounting and financial reporting issues were not the most significant challenge Madison faced during the Le Prix audit. William Blackwell, the supervising audit senior on the engagement, shocked his team membersMadison and Alanis, in particularby resigning as of January 15. His resignation had left the Le Prix audit team in a huge bind. Because there were no unassigned seniors available in the practice office, Alanis had been forced to replace Blackwell with an inexperienced audit associate and have Madison step in and supervise the remainder of the fieldwork on the engagement while, at the same time, continuing to serve as the audit manager.

In exchange for her increased workload on the Le Prix audit, Alanis arranged to have Madison replaced on the healthcare audit to which she had been assigned. Because her principal subordinate on her only other audit clientthe small retail companywas a heavy senior, she spent only a few hours each week at that clients site.

A Perfect Storm

On a Monday morning in early March, Madison and her subordinates were wrapping up loose ends on the Le Prix audit. She expected that they would be leaving the clients headquarters office for good by the end of the week. Three days earlier, on the prior Friday afternoon, Le Prix had issued its earnings press release and filed its Form 10-K for the year under audit with the SEC. Daniel Alanis had signed the unqualified audit opinion that accompanied Le Prixs audited financial statements in its 10-K.

As Madison sat in the client conference room that had served as Audit Central for the past four months, she was skimming through the lengthy Le Prix audit program. She wanted to make sure one final time that each audit procedure had been initialed and dated by the individual who had completed the procedurea few of the wrap-up audit tests were not yet completed. Suddenly, something caught her attention. There were two audit steps that dealt with reviewing the minutes of the clients board of directors meetings. The first step referred to all meetings that had taken place during the year under audit, while the second step referred to any meetings between year-end and the date the client filed its 10-K with the SEC. Madison noticed for the first time that both steps had been initialed and dated by William Blackwell on January 10.

What concerned Madison was a board meeting that had taken place on February 4. She realized that since Blackwell had left the Le Prix audit team on January 15, there was no way he could have reviewed the minutes of the February 4 board meeting. There had been a board meeting on January 6, and Blackwell had apparently signed off on the second audit step after reviewing the minutes of that meeting.

Momentarily panic-stricken, Madison forced herself to calm down. It was very unlikely any major events or circumstances affecting Le Prixs just-released financial statements had been documented in the minutes of the February 4 board meeting. Nevertheless, she intended to investigate that possibility immediately.

Madison went to the office of the chief executive officers secretary and asked for a copy of the minutes of the February 4 meeting. The helpful secretary retrieved those minutes and made a copy for her.

As she was re-entering the audit conference room a short while later, Madisons heart sank. The final paragraph of the minutes referred to technical violations of debt covenants in the Amended Loan Agreement at year-end. The paragraph went on to indicate that the violations involved certain debt covenants that had been modified in the revised loan agreement. Nine months earlier, when Le Prix obtained an additional long-term loan from its principal lender, which was a syndicate of insurance companies, the two parties had renegotiated their existing long-term debt agreement. One feature of the amended debt agreement was the requirement that Le Prix obtain a Big Four auditor.

According to the minutes of the February 4 board meeting, the company had cured the debt covenant violations during the first week of the new fiscal year by selling marketable securities and then using the cash proceeds to pay down certain current liabilities. Because the violations were minor and had only existed for a brief time, Le Prixs board concluded there was no need to inform members of the lending syndicate of the violations or to disclose the violations in the year-end financial statements.

Par for the course for these bozos, Madison angrily mumbled as she flung the copy of the board minutes onto the cluttered surface of the audit conference room table. She was angry with herself for not discovering the debt covenant violations but furious at Le Prixs officers and accounting staff for not having brought the violations to the attention of herself or her subordinates.

Madison knew that the degree to which any debt covenant was violated or the length of time that the violation existed were non-issues since there was no clause in Le Prixs loan agreement regarding minor debt covenant violations. And she was aware the only way for Le Prix to properly cure or resolve a debt covenant violation ex post was to obtain a waiver from each member of the lending syndicate. Absent waivers from all syndicate members, the cumulative long-term loans from the syndicate became immediately due and payable, meaning that they should have been reflected as a current rather than a long-term liability in the financial statements Le Prix had filed three days earlier with the SEC. That change would have grosslyand adverselyimpacted Le Prixs reported financial condition.

After digging into the large audit trunk in the rear of the audit conference room, Madison finally found and retrieved a folder labeled Amended Loan Agreement among the permanent workpaper files. She then flipped to the debt covenant pages marked with a red tab. Embedded in the covenants were the minimum levels of several liquidity ratios Le Prix had to maintain at the end of each quarter to avoid triggering a technical default of its cumulative long-term loans.

Next, Madison retrieved the long-term debt workpaper file and turned to the spreadsheet where William Blackwell had tested Le Prixs compliance with the liquidity ratio provisions in the debt covenantsshe recalled having reviewed that workpaper two weeks earlier. As always, Blackwells workpaper appeared flawless. The spreadsheet included a detailed legend, cross-references to other workpapers and documents, and meticulous footnotes that precisely explained the procedures he had performed. On the spreadsheet, Blackwell had computed the liquidity ratios relevant to Le Prixs debt covenants at the end of each quarter and compared them to the minimum levels for those ratios established by the covenants. The spreadsheet demonstrated that in each case, Le Prixs quarter-ending ratio was above the designated minimum.

Because of the apparently high quality of Blackwells work, the tight budget for the Le Prix audit, and the fact that she was often overwhelmed by her dual responsibilities on the engagement, Madison had spent minimal time reviewing the workpapers the senior had prepared. Instead, she had allocated the bulk of her review time to the workpapers prepared by the audit associates assigned to the Le Prix engagement. In fact, she recalled having only scanned Blackwells debt covenant spreadsheetshe didnt check any of his mathematical calculations or track the cross-referenced items to other documents such as Le Prixs loan agreement. She regretted that decision now as she stared at the workpaper spread before her on the conference room table.

After cross-checking the spreadsheet with the tabbed pages in the Amended Loan Agreement, Madison discovered that the minimum levels of the liquidity ratios Blackwell had used in his debt covenant tests did not match up with those listed in that document. After taking a deep breath, Madison retrieved from the audit trunk another folder labeled Loan Agreement, which was the earlier and now outdated agreement between Le Prix and the syndicate of insurance companies. Sure enough, in testing the debt covenants Blackwell had referred to the minimum level required for each liquidity ratio in the old loan agreement instead of in the new loan agreement. In fact, a footnote on Blackwells spreadsheet indicated that those minimum levels were drawn from Le Prixs Loan Agreement. There was no reference on the workpaper to Le Prixs Amended Loan Agreement.

In the revised debt covenants included in the Amended Loan Agreement, the minimum levels of the given liquidity ratios had been raised by 10 to 15 percent each. At the end of each quarter during the year under audit, Le Prix had exceeded the minimum thresholds established for those ratios in the previous loan agreement, as documented by Blackwell. Madison determined that the company had also surpassed the minimum thresholds for those ratios in the new loan agreement for the first three quarters of the year. Unfortunately, two of Le Prixs liquidity ratios at the end of the fourth quarter were nearly 10 percent below the minimum level dictated by the new loan agreement.

After checking and re-checking all of the relevant documents and computations, Madison leaned back in her chair and closed her eyes. She knew what she had to do next and she wasnt looking forward to it.

Verbal Violence

How could this happen? Alanis screamed over the phone. Before Madison could respond, the audit partner shouted again. Do you understand that youre telling me that the financial statements that Le Prix just filed with the SEC are wronger than wrong!?

Daniel, like I said, Im sorry that

Sorry? Alanis cut off Madison in mid-sentence. What in the ____ do you mean, sorry? Youre sorry when you spill coffee on someones new shirt. Youre sorry when you ding the door of your friends new sports car. Sorry doesnt ____ apply in this set of ____ circumstances, ____!

Before calling Alanis, Madison had been very concerned he would not react well to the news she was about to give him. But she hadnt expected him to react this badly. She liked and respected the young partner who was no more than eight or nine years older than herself. He was a family man with two young daughters, was outgoing and articulate, and was well-respected within their practice office and the downtown business community. On a few occasions, Madison had seen him upset, but he had never raised his voice in anger or used improper language of any kind in her presence.

For several moments, Madisons cell phone, which she had laid on the conference room table, fell silent. She pictured Alanis sitting in his leather chair in his downtown office, trying to regain control of his emotions.

Okay okay, he finally muttered through gritted teeth. Tell me exactly what happened.

Over the next few minutes, a shellshocked Madison unraveled the sequence of events relevant to the quandary she and Alanis now faced. Because her nerves were frazzled, her timeline was not linear. At one point, she backtracked to explain that she had been reviewing the audit program that morning to ensure each audit procedure had been initialed and dated. That revelation detonated Alaniss temper once more.

So, you are _______ telling me that you just got around this morning to _______ reviewing the _______ audit program to _______ determine that the audit procedures had been properly signed off on!?

Madison bit her lip and took a deep breath before responding. I had checked the audit program on multiple occasions in the past few weeks. I was just checking it again one more time. Madison paused to allow the audit partner sufficient time to process that information before continuing. Like I was saying, when I checked the audit program earlier, it hadnt occurred to me that William couldnt have reviewed the minutes of the February fourth board meeting since he had resigned three weeks earlier. He obviously signed off on that second audit step after he reviewed the January sixth minutes. After another pause, Madison added softly, He just made an honest mistake and then I I made another one by Madisons voice trailed off before she had completed her mea culpa.

So, each of you just made an honest mistake? Alanis asked in a mocking tone. Moments later, he thundered, We arent allowed to make honest _______ mistakes! We are _______ professionals!

The line fell silent for an extended time before Alanis finally spoke again, this time in short, wrathful bursts. Now why didnt the tests of the debt covenants uncover these violations?

Madison swallowed hard and then quietly but precisely explained to the partner why Blackwell had failed to uncover the debt covenant violations. Then she explained why her review of the seniors work had failed to uncover his error in testing the debt covenants.

After finishing her explanations, Madison waited for Alanis to respond. As she waited, she heard muffled noises on the other end of the line that sounded like a fist being pounded against a desktop.

You never _______ noticed that on the workpaper, he referred to the wrong _______ loan agreement? Alanis had whispered the word you and then slowly built to a crescendo that culminated with him shouting the word agreement.

Madison briefly contemplated defending herself and William Blackwell by pointing out that the similar titles of the two loan agreements had contributed to the oversights that each of them made. She quickly dismissed that idea after realizing it had been their responsibility to take steps to prevent the similar titles of the loan agreements from triggering such mistakes on their part. Then she considered reminding Alanis that he, too, had reviewed Blackwells workpaper, but he beat her to the punch.

Oh, I see, Alanis said as his voice quaked in anger. I guess you expected me to do the _______ detailed review of his _______ work.

Alanis had every right to be angry, immensely angry. But, despite the terrible circumstances they were facing, Madison didnt believe he had the right to speak to her so harshly, berating her with the ugliest of gutter language.

Listen, someone is going to take the blame for this _______ disaster, Alanis continued, and it sure as hell isnt going to be me!

By this point, Madison decided she had absorbed enough of Alaniss rage and disrespect. She had reached her tipping point.

After a long pause, Madison spoke in a tone tinged with sarcasm. Dont worry about it. Im the audit manager, and youre the audit partner. So, by definition, everything is my fault. Madison intentionally used the inflammatory Dont worry about it line in hopes that it would prompt Alanis to once more curse a blue streak in which case she intended to hang up on him.

Alanis, no doubt, sensed that Madison was on the verge of ending the conversation. With a herculean effort, he tamped down his emotions once more. After coughing and clearing his throat, he responded in as civil a tone as he could muster.

I have a few things to do here. Once I wrap them up, I will be driving over there to meet with you in the audit conference room. I should be there in 45 minutes. In the meantime, dont mention this to anyone, including anyone else on the audit team. When Madison didnt respond, Alanis added, Okay?

The sudden change in Alaniss tone had an unexpected impact on Madison. Rather than anger and resentment, she now felt shame. Because she didnt want Alanis to realize she was tearing up, she cleared her throat and responded Okay before disconnecting the line.

When Alanis arrived at the audit conference room, he closed the door and then took off his suit jacket and tossed it on an empty chair.

I would like to start by reviewing Williams workpaper where he documented his tests of the debt covenants, the partner said calmly as he avoided making eye contact with Madison.

I have already pulled that workpaper for you, Madison responded as she tried to keep her voice from trembling. I also dog-eared the specific sections of the new and old loan agreements that pertain to the liquidity ratio provisions within the debt covenants. After handing the workpaper and the two loan agreements to Alanis, Madison asked if there was anything else that he needed.

No, not right now. I will let you know, though, if I need something else.

Madison was thankful Alanis was making a concerted effort to maintain his composure. Despite that effort, the tension in the conference room was almost more than she could bear.

After Alanis sat down on the other side of the conference room table, Madison noticed the first thing he did was glance at the small box in the upper right-hand corner of the preformatted workpaper. Ten days earlier, Alanis had initialed and dated the workpaper, indicating that he had reviewed it. Madisons initials and a corresponding date were also included in that box.

Alanis studied the workpaper and read and re-read the relevant sections of both loan agreements. He then retrieved the audit program and turned to the section that included the two audit steps mandating that the minutes of board of directors meetings be reviewed.

After spending 20 minutes or more examining the documents, Alanis leaned back in his chair and muttered a vulgar, one-syllable expletive under his breath. Madison heard the expletive but ignored it as she continued to work on updating a digital audit workpaper on her laptop computer.

Moments later, Alanis wearily got to his feet and put on his suit jacket. Im going back to the office now, he said in a subdued tone.

As Alanis spoke, Madison looked up from her work. It was the first and only time during the brief meeting that the two of them made direct eye contact. After nodding her head, Madison refocused her attention on her laptop computer. Alanis then left the conference room without saying another word.

website, where public companies electronically file their SEC documents. Le Prix never posted an 8-K information filing or any other SEC filing that disclosed its debt covenant violations. In early October, just as the planning for year-end audit engagements was commencing, Madison resigned from her Big Four employer after accepting a considerably higher-paying position as a financial analyst with a major downtown bank.

Case 6.7. Hamilton Wong, In-Charge Accountant

After spending much of the previous three months working elbow-to-elbow with as many as six colleagues in a cramped and poorly ventilated conference room, Hamilton Wong was looking forward to moving on to his next assignment.

Wong served as an in-charge accountant on the audit staff of a large international firms San Francisco practice office, the same firm that had offered him a job two years earlier as he neared completion of his accounting degree at San Jose State University. His current client, Wille & Lomax, Inc., a public company and the second-largest client of Wongs office, owned a chain of retail stores in the western United States that stretched from Seattle to San Diego and as far east as Denver and Albuquerque.

Although Wille & Lomaxs stores operated under different names in different cities, each stocked the same general types of merchandise, including briefcases and other leather goods, luggage and travel accessories, and a wide range of gift items, such as costume jewelry imported from Pacific Rim countries. The company also had a wholesale division that marketed similar merchandise to specialty retailers throughout the United States. The wholesale division accounted for approximately 60 percent of the companys annual sales.

A nondescript building in downtown San Francisco, just one block from bustling Market Street, served as Wille & Lomaxs corporate headquarters. The companys fiscal year-end fell on the final Saturday of January. With the end of March just a few days away, Hamilton and his fellow Williesthe nickname that his office assigned to members of the Wille & Lomax audit engagement teamwere quickly running out of time to complete the audit. Wong was well aware that the audit was behind schedule because he collected, coded, and input into an electronic spreadsheet the time worked each week by the individual Willies. He used the spreadsheet package to generate a weekly time and progress report that he submitted to Angela Sun, the senior who supervised the fieldwork on the Wille & Lomax audit.

In addition to Wong and Sun, another in-charge accountant, Lauren Hutchison, and four staff accountants had worked on the Wille & Lomax audit since early January. Wong and Hutchison knew each other well. They shared the same start date with their employer, and the past two summers had attended the same weeklong staff and in-charge training sessions at their firms national education headquarters. Hutchisons primary responsibility on the current years audit was the receivables account, but she also audited the PP&E (property, plant, and equipment) and leases accounts. Besides his administrative responsibilities, which included serving as the engagement timekeeper and maintaining the correspondence file for the audit, Wong supervised and coordinated the audit procedures for inventory, accounts payable, and a few smaller accounts.

Hamilton was thankful that it was late Friday afternoon. In recent weeks, with the audit deadline looming, Angela Sun had required the Wille & Lomax crew to work until at least 7 p.m. each weekday except Friday, when she allowed them to leave early at 5 p.m. The engagement team had spent three consecutive Saturdays in the clients headquarters and would be spending both Saturday and Sunday of the coming weekend hunched over their workpapers. Wong had just completed collecting and coding the hours worked during the current week by the other members of the engagement team. Now it was time for him to enter in the electronic spreadsheet his chargeable hours, which he dutifully recorded at the end of each workday in his little black book.

Before entering his own time, Wong decided to walk across the hall and purchase a snack in the employees break room. In fact, he was stalling, trying to resolve a matter that was bothering him. Less than 30 minutes earlier, Lauren Hutchison had told him that during the current week, which included the previous weekend, she had spent 31 hours on the receivables account, 18 hours on the leases account, and three hours on PP&E. What troubled Wong was the fact that he knew Hutchison had worked several additional hours on the Wille & Lomax audit during the current week.

This was not the first time Hutchison had underreported her hours worked. On several occasions, Wong had noticed her secretively slipping workpaper files into her briefcase before leaving for home. The next morning, those files included polished memos or completed schedules that had not existed the previous day. Wong was certain that Hutchison was not reporting the hours she spent working at home on her audit assignments. He was just as certain that each week she consciously chose to shave a few hours off the total number she had spent working at the clients headquarters. Collectively, Wong estimated that Hutchison had failed to report at least 80 hours she had worked on the audit.

Eating time was a taboo subject among auditors. Although the subject was not openly discussed, Wong was convinced that many audit partners and audit managers subtly encouraged subordinates to underreport their time. By bringing their jobs in near budget, those partners and managers enhanced their apparent ability to manage engagements. The most avid time-eaters among Wongs peers were those individuals who had been labeled as fast-track superstars in the office.

After Hutchison reported her time to Wong that afternoon, he had nonchalantly but pointedly remarked, Lauren, who are you trying to impress by eating so much of your time? His comment had caused the normally mild-mannered Hutchison to snap back, Hey, Dude, you are the timekeeper, not the boss. So just mind your own _____ business. Immediately, Wong regretted having offended Hutchison, whom he considered his friend, but she had stomped away before he could apologize.

Wong knew who Hutchison was trying to impress. Angela Sun would almost certainly be promoted to audit manager in the summer and then become the audit manager on the Wille & Lomax engagement, meaning that there would be a vacancy in the all-important senior position on the engagement team. Both Hutchison and Wong also anticipated being promoted during the summer. The two new seniors would be the most likely candidates to take over the job of overseeing the fieldwork on the Wille & Lomax audit.

The in-charge accountant who handled the administrative responsibilities on the Wille & Lomax engagement was typically the person chosen to take over the seniors role when it came open. But Wong worried that the close friendship that had developed between Lauren Hutchison and Sun might affect his chances of landing the coveted assignment. Almost every day, Hutchison and Sun went to lunch together without extending even a token invitation to Wong or their other colleagues to join them. John Berardo, the audit engagement partner, would choose the new senior for the Wille & Lomax engagement, but Angela Sun would certainly have a major influence on his decision.

There was little doubt in Wongs mind that Hutchison routinely underreported the time she worked on the Wille & Lomax audit to enhance her standing with Sun and Berardo. Not that Hutchison needed to spruce up her image. She had passed the CPA exam shortly after joining the firm, had a charming personality that endeared her to her superiors and client executives, and, like both Sun and Berardo, was a Stanford graduate. Wong, on the other hand, had struggled to pass the CPA exam, was shy by nature, and had graduated from a public university.

What irritated Wong the most about his subtle rivalry with Hutchison was that during the past two weekends, he had spent several hours helping her research contentious technical issues for Wille & Lomaxs complex lease contracts on its retail store sites. Earlier in the engagement, Hutchison had also asked him to help analyze some tricky journal entries involving the clients allowance for bad debts. In each of those cases, Wong had not charged any time to the given accounts, both of which were Hutchisons responsibility.

Before entering his time for the week, Wong checked once more the total hours that he had charged to date to his major accounts. For both inventory and accounts payable, he was already over budget. By the end of the audit, Wong estimated that he would bust the assigned time budgets for those two accounts by 20 to 25 percent each. On the other hand, Hutchison, thanks to her superior time management skills, would likely exceed the time budget on her major accounts by only a few hours. In fact, she might even come in under budget on one or more of her accounts, which was almost unheard of, at least on the dozen or so audits to which Wong had been assigned.

After finishing the bag of chips he had purchased in the snack room, Wong reached for the computer keyboard in front of him. In a few moments, he had entered his time for the week and printed the report that he would give to Angela Sun the following morning. After briefly glancing at the report, he slipped it into the appropriate work-paper file, turned off the light in the empty conference room, and locked the door behind him as he resolved to enjoy his brief 16-hour weekend.

Case 6.8. Tommy OConnell, Audit Senior

One month after being promoted to audit senior, Tommy OConnell was assigned to the audit engagement team for the Altamesa Manufacturing Company.

Tommy worked out of his Big Four employers Fort Worth practice office, while Altamesa was headquartered in Amarillo, the capital of the Texas Panhandle. The young senior realized that being assigned to the tough Altamesa engagement signaled that Jack Morrison, the Altamesa audit partner, and the office managing partner, regarded his work highly. Serving as the audit senior on the Altamesa job would allow Tommy to become better acquainted with Morrison. Despite the opportunity presented by his new assignment, Tommy did not look forward to spending three months in Amarillo, a five-hour drive from Fort Worth. This would be his first assignment outside of Fort Worth since his marriage six months earlier. He dreaded breaking the news to his wife, Suzie, who often complained about the long hours his job required.

Altamesa manufactured steel girders used in the construction and renovation of bridges in West Texas, New Mexico, Colorado, and Oklahoma. The companys business was very cyclical and linked closely to the funding available to municipalities in Altamesas four-state market area. To learn more about the company and its personnel, Tommy arranged to have lunch with Keri Hansel, the audit senior on the Altamesa engagement the two previous years. According to Keri, Altamesas management took aggressive positions regarding year-end expense accruals and revenue recognition. The company used the percentage-of-completion method to recognize revenue since its sales contracts extended over two to five years. Keri recounted several disputes with the companys chief accountant regarding the estimated stage of completion of jobs in progress. In an effort to front-load as much of the profit on Altamesas long-term contracts as possible, the chief accountant typically insisted that projects were further along than they actually were.

Speaking with Keri had made Tommy even more apprehensive about tackling the Altamesa audit. But he realized that the job gave him an excellent chance to strengthen his fast-track image within his office. To reach his goal of being promoted to manager by his fifth year with the firm, Tommy needed to prove himself on difficult assignments such as the Altamesa engagement.

An Unpleasant Surprise for Tommy

It was late May, just two weeks before Tommy would be leaving for Amarillo to begin the Altamesa auditthe company had a June 30 fiscal year-end. Tommy, Jack Morrison, and an audit manager were having lunch at the Cattlemans Restaurant in the Cowtown district of north Fort Worth.

Tommy, Ive decided to send Carl with you out to Amarillo. Is that okay? asked Jack Morrison.

Uhh sure, Jack. Yeah, thatll be fine, Tommy replied. Of all people, Tommy thought to himself, he would send Carl Wilmeth to Amarillo with me. Carl was a staff accountant with only a few months experience, having been hired in the middle of the just-completed busy season. Other than being auditors and approximately the same age, the two young men had little in common. Tommy was from Lockettville, a small town in rural West Texas, while Carl had been raised in the exclusive Highland Park community of north-central Dallas. Texas Tech, a large state-supported university, was Tommys alma mater. Carl had earned his accounting degree from a small private college on the East Coast.

Tommy did not appreciate Carls cocky attitude, and his lack of experience made him a questionable choice in Tommys mind for the Altamesa engagement. A

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