“STAR TECHNOLOGIES, INC AND
ROCKY MOUNT UNDERGARMENT COMPANY, INC.”
(In order to accomplish the Auditing Seminar’s assignment)
Muhammad Arief Fauzi 8335123535
Rico Bobman 8335123531
S1 Accounting Reguler 2012
UNIVERSITAS NEGERI JAKARTA
CASE 1.9 STAR TECHNOLOGIES, INC.
By the end of fiscal 1989 – March 31, 1989, Star face a financial crisis. Among the company’s major products was a computer designed for use in petroleum exploration. Company officials forecast that Star would sell 29 of the computers during 1989, but they sold only one of these computers during 1989 and had no outstanding sales orders for the product at year-end.
Clark Childers, an audit partner with Price Waterhouse since 1984, served as the engagement partner on the annual audits of Star’s financial statements from 1987 through 1989. Childers’ principal subordinate during the 1989 Star audit was Paul Argy, a senior audit manager who was to be considered for promotion to partner the following year.
The disagreements between the Price Waterhouse auditors and client executives during the 1989 audit involved the following items: R&D expenditures, the reserve for inventory obsolescence, the reserve for bad debts, certain “mystery assets” included in Star’s accounting records, and the balance sheet classification of a large note payable.
In 1989, Star established a joint R&D effort with Glen Culler & Associates, a small company that developed supercomputers. Star advanced nearly $900,000 to Culler during fiscal 1989. Culler pledged all of its assets as collateral for the $900,000 advance.
Star’s management maintained that the $900,000 advanced to Culler during 1989 qualified as a note receivable and included it in “other” assets on Star’s 1989 balance sheet. Childers agreed with this decision. As required by Price Waterhouse, a second audit partner reviewed the 1989 Star workpapers before Childers released the audit opinion on the company’s financial statements. This partner questioned the decision to report the $900,000 advance to Culler as an asset in Star’s 1989 balance sheet and suggested instead writing off the advance as R&D expense in Star’s 1989 income statement.
To provide additional support for his position that the $900,000 advance to Culler should be expensed, the review partner cited the description of the agreement between Star and Culler that was included in the draft of Star’s 1989 financial statement footnotes. That description specifically referred to the arrangement as a “joint research and development agreement”.
After meeting with the review partner, Childers consulted with Star’s chief financial officer (CFO) to tell the CFO that the description of the Star-Culler agreement included in the draft of the financial statement footnotes suggested that the $900,000 advance should be treated as R&D expense by Star.
During fiscal 1990, Star acquired Culler. While reviewing this transaction, Childers and Angry discovered that Star’s 1989 financial statement footnotes had not accurately described the Star-Culler agreement. Childers and Argy contact Price Waterhouse’s national office for advice on this matter. After studying those documents, a Price Waterhouse partner in the firm’s national office concluded that, at a minimum, $400,000 of the $900,000 advanced to Culler by Star during fiscal 1989 should have been treated as R&D expense by Star
Childers also told the national partner that an adjustment had been proposed during the 1989 audit to write off a portion of the $900,000 Culler receivable to expense. According to Childers, that adjustment had been waived due to its immaterial effect on Star’s financial statements.
Reserve for Inventory Obsolescence
During 1989, Star added $3.5 million to the reserve for inventory obsolescence for the its remaining inventory of ST-100s, reducing that inventory to a net book value of $2 million. Argy and other members of the Star engagement team believed that the ST-100 inventory was still overvalued. Argy recommended an additional $1.5 million write down for that inventory.
Star’s management resisted Argy’s suggestion to write the ST-100 inventory down to a net book value of $500,000. The client’s executives persuaded Childers that the company would sell ST-100s in the future despite not having any existing orders for that product and despite having sold only one ST-100 during 1989. Star’s management also provided Childers with a list of $1 million of spare parts included in the ST-100 inventory that would allegedly be needed by Star to service previously sold ST-100s.
Reserve for Bad Debts
Star reported slightly more than $5 million of net accounts receivable at the end of fiscal 1989. Two of Star’s largest receivables had been outstanding for more than four years. These receivables, both in litigation at the time, totaled $1,062,000 and resulted from earlier sales of ST-100 computers. Before year-end adjusting entries, Star’s allowance for doubtful accounts totaled $673,000. After analyzing Star’s receivables, Argy determined that the allowance should be increased by approximately $400,000. That figure roughly equaled the total of the two disputed receivables less the existing balance of the allowance account.
In previous years, Price Waterhouse had reduced any proposed adjustment to the allowance account by the value of the collateral for potentially uncollectible receivables. Since the collateral for the disputed receivables, two ST-100 computers, was minimal, Argy decided that the proposed adjustment for uncollectible receivables should not be reduced.
Childers advised Star’s management that he agreed with Argy’s analysis of the allowance for doubtful accounts. The client’s executves balked at making the $400,000 addition to the allowance and instead referred Childers to the company’s attorneys. Those attorneys insisted that the proposed adjustment was excessive. As a compromise, Star’s chief executive officer (CEO) recommended increasing the allowance account $65,000 at the end of fiscal 1989. Childers agreed to that adjustment. The SEC later challenged Childers’ decision to accept the modest increase in the allowance account.
During the 1989 Star audit, a Price Waterhouse staff auditor discovered an accountant entitle “Assets in Process” having a balance of approximately $435,000. A Star official told the staff auditor that the assets represented by the account involved computer equipment purchased and placed in service in 1985. However, Star could not provide invoices or other documentation to support the existence of valuation of these assets, nor were any depreciation records available for these assets. In fact, the client could not locate the assets or describe them in detail to the Price Waterhouse audit team. Star’s CFO claimed that the equipment could not be identified because it had been fully integrated into the company’s existing computer facilities.
The staff auditor who uncovered the Assets in Process account noted in the 1989 workpapers that Star depreciated computer equipment over five years and began depreciating such assets in the year they were placed into service. Since the equipment purportedly represented by the account had been placed in service in 1985, the staff auditor reasoned that it should have been fully depreciated by the end of fiscal 1989. Argy agreed with his subordinate’s analysis and concluded that mystery assets should be immediately written off to expense.
When Childers brought the Assets in Process account to the attention of Star’s CFO, the CFO refused to accept the proposed adjustment to write off the balance of the account. At this point, the CFO claimed the assets had actually been placed in service in 1987 rather than 1985, although he could provide no evidence to support that assertion. Instead of accepting the proposed $435,000 adjustment, the CFO offered to record $100,000 of depreciation expense on the assets in 1989 and write off the remaining $225.000 cost of those assets over the following four years. Childers accepted the CFO proposal.
Classification of Notes Payable
Star’s poor operating result for fiscal 1989 resulted in the company violating seven debt covenant included in the loan agreement with its principal bank. These debt covenant violating caused a $5.8 million bank loan to be immediately due and payable, as noted earlier. On June 15, 1989, Price Waterhouse completed the 1989 Star audit; however, Childers refused to issue an audit report on Star’s financial statements until the company’s bank waived the debt covenant violations. On June 29, 1989, star taxed Price Waterhouse a waiver obtained two days earlier from its bank.
Childers disagreed with the audit senior’s conclusion. Because the bank stated that it had no intention of making the $5.8 million loan immediately due and payable, Childers believe the loan qualified as long-term liability shortly after receiving the bank waiver. Childers signed the unqualified audit opinion on Star’s 1989 financial statements, dating the opinion as of June 15. Star included that opinion in its 1989 Form 10-K filed with the SEC.
Where Was Argy?
Paul Argy left the Star audit engagement approximately one week before the 1989 audit was complete to begin work on a new assignment in another city. Argy returned to Price Waterhouse’s Washington D.C., office on July 10, more than 10 days after Childers issued the unqualified opinion on Star’s 1989 financial statements.
Upon Argy’s return, Childers instructed him to complete his review of the workpapers for the Star’s audit and to sign off on the “audit summary” for the engagement. A Price Waterhouse policy required the audit manager on an engagement to sign off on the audit summary document after completing his or her review of the workrpapers. Agry initially refused to sign off on the Star audit. Agry had contested several of the questionable decisions made by Childers during 1989 Star audit and believed that the 1989 workapapers contained “materially incorrect” conclusion. Finally after several confrontations with Childers, Agry capitulated and signed off on the Star workpapers and the audit summary.
Price Waterhouse recalled its opinions on Star’s audit 1989 statements on March 9, 1990. The following month, the company’s management issued financial statements for fiscal 1989 that contained appropriate adjustment for the item discussed earlier. Star’s amended 1989 income statement reported a net loss of $7.4 million rather than $4.4 million loss originally reported. On March 28, 1990, Price Waterhouse issued unqualified audit opinion on Star’s restated 1989 financial statements. One week later, Star dismissed Price Waterhouse and retained Coopers & Lybrand as its independent audit firm.
The SEC’s investigation of Stars original 1989 financial statements and its 1989 audit culminated in sanctions being imposed on both Star and the two key members of 1989 audit engagement team. The SEC issued a cease and desist order against Star that prohibited the company from future violations of the federal securities laws. Paul Agry received an 18 months suspension from practicing before the SEC, while Clark Childers received a five years suspension.
Following are the specific allegations of misconduct that the SEC filed against Childers.
- Failing to ensure that sufficient competent evidential matter was obtained to afford a reasonable basis for his conclusion
- Failing to exercise due professional care and sufficient professional skepticism in the performance of the audit
- Failing to assure that the financial statement on which Price Waterhouse issued unqualified opinion were prepared in accordance with GAAP
- Responding without an adequate basis to the question of the second partner reviewer when issued were raised about agreement with Culler
- Making misleading statement to Price Waterhouse national office concerning its investigations on Star’s agreement with Culler
- Instructing Agry to sign off on the audit regardless of Agry’s stated disagreement with the conclusion reached by Childers
CASE 5.1 ROCKY MOUNT UNDERGARMENT COMPANY, INC.
In early 1986, several employees of Rocky Mount Undergarment Co., Inc. (RMUC), came face to face with an ethical dilemmas. RMUC, a North Carolina-based company, manufactures undergarments another apparel product. Approximately, one-half of the company’s annual sales were to three large merchandisers: Kmart (29%), Wal-mart (11%), and Sears (9%). RMUC employed nearly 1300 workers in its production facilities and another 40 individuals in its administrative functions. Between 1981 and 1984, RMUC realized steady growth in revenues and profits. In 1981, RMUC reported net income of $378.000 on net sales of $ 17.9 million. Three year later, the company reported a net income of $ 1.5 million on net sales of $ 32 million.
Unfortunately, RMUC failed to sustain its impressive profit trend in 1985. Disproportionately high productions cost cut sharply into the company profits margin during that year. These high production costs resulted from cost overruns on several large customer orders and significant start-up costs incurred due to the opening of a new factory.
A subsequent investigation by the Securities and Exchange Commission (SEC) revealed that the company’s senior executive and another high ranking officer had refused to allow the firm to report its actual net income of $ 452.000 for 1985. To participate inflate the company’s 1985 net income, these executive instructed three of their lower level subordinates to overstate the firm’s year-end inventory and thereby understated its cost of goods sold. When the three subordinates were reluctant to participate in the scheme, the two executives warned them that unless they cooperated, the company might “cease operations and dismiss its employees”. After much prodding, the three subordinates capitulated and began systematically overstating the firm’s 1985 year-end inventory.
While the three lower-level employees were overstating RMUC’s inventory, the two company executive who concocted the scheme periodically telephoned them to check on their progress. At one point, the three subordinates indicated that they were unwilling to continue falsifying RMUC’s year-end inventory, quantities. However, after additional coaxing and cajoling by the two executives, they resumed their fraudulent activities. Eventually, the three employees “manufactured” more than $ 900.000 of bogus inventory. After RMUC’s senior executive reviewed and approved the falsified inventory count sheet, the count sheet were forwarded to the company’s independent audit firm.
To further overstate RMUC’s December 31, 1985, inventory the company’s senior executive instructed another RMUC employee to obtain a false confirmation letter from Stretchlon Industries, Inc. Stretchlon supplied RMUC with most of the elastic needed in its manufacturing processes. At the time, RMUC had an agreement to purchase 50 percent of Strechlon’s common stock at net book value. On December 31, 1985, Strechlon had in its possession only a nominal amount of RMUC inventory. Nevertheless, a Strechlon executive agreed to supply a confirmation letter to RMUC’s independent auditor indicating that his firm held approximately $165.000 of inventory at the end of 1985. As a condition providing the confirmation, the Strechlon executive insisted that RMUC prepared and forward to him a false shipping document to corroborate the existence of the fictitious inventory. After receiving this shipping document, the Strechlon executive signed the false confirmation and mailed it to RMUC’s independent audit firms.
The fraudulent schemes engineered by RMUC executive overstated the firm’s December 31, 1985, inventory by approximately $ 1.076.000. Instead of reporting inventory of $12.158.000, in its original December 31, 1985, balance sheet, RMUC’s reported net income for 1985 to $ 1.059.000, which was more than $ 600.000 higher than the actual figure.
Near the completion of the 18985, audit RMUC’s auditor asked the company’s senior executive to sign a letter representation. Among other items, this letter indicated that the executives was not aware any irregularities (fraud) involving the company’s financial statement. The letter also stated that RMUC’s financial statement fairly reflected its financial condition as of the end of 1985 and its operating result for the year. Shortly after receiving the signed letter of representation, RMUC’s audit firm issued an unqualified opinion on the firm’s1985 financial statements.
Following the SEC’s discoveries of the fraudulent misinterpretations in RMUC’s 1985 financial statements, the federal agency filed civil charges against the firm’s two executives involved in the fraud, the SEC eventually settled these charges by obtaining a court order that prohibited the executives from engaging in any further violations of federal securities laws. RMUC also issued corrected financial statements for 1985.