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JACK GREENBERG, INC.
In the mid-1980s, Emanuel and Fred Greenberg each inherited a 50 percent ownership
interest in a successful wholesale business established and operated for decades by their father.
Philadelphia-based Jack Greenberg, Inc., (JGI) sold food products, principally meat and cheese,
to restaurants and other wholesale customers up and down the eastern seaboard. The company‟s
largest product line was imported meat products. Following their father‟s death, Emanuel
became JGI‟s president, while Fred accepted the title of vice-president. In the latter role, Fred
was responsible for all decisions regarding the company‟s imported meat products. When JGI
purchased these products, they were initially charged to a separate inventory account known as
Prepaid Inventory, the company‟s largest account. When these products were received weeks or
months later, they were transferred to the Merchandise Inventory account.
In 1986, the Greenberg brothers hired Steve Cohn, a former Coopers & Lybrand employee,
to modernize their company‟s archaic accounting system. Cohn successfully updated each
segment of JGI‟s accounting system with the exception of the module involving prepaid
inventory. Despite repeated attempts by Cohn to convince Fred Greenberg to “computerize” the
prepaid inventory accounting module, Fred resisted. In fact, Fred had reason to resist since he
had been manipulating JGI‟s periodic operating results for several years by overstating its
From 1986 through 1994, Grant Thornton audited JGI‟s annual financial statements, which
were intended principally for the benefit of the company‟s three banks. Grant Thornton, like
Steve Cohn, failed to persuade Fred Greenberg to modernize the prepaid inventory accounting
module. Finally, in 1994, when Fred refused to make certain changes in that module that were
mandated by Grant Thornton, the accounting firm threatened to resign. Shortly thereafter, Fred‟s
fraudulent scheme was uncovered. Within six months, JGI was bankrupt and Grant Thornton
was facing a series of allegations filed against it by the company‟s bankruptcy trustee. Among
these allegations were charges that the accounting firm had made numerous errors and oversights
in auditing JGI‟s Prepaid Inventory account.
Case 2.1 Jack Greenberg, Inc. 119
Jack Greenberg, Inc.–Key Facts
1. Emanuel and Fred Greenberg became equal partners in Jack Greenberg, Inc., (JGI)
following their father‟s death; Emanuel became the company‟s president, while Fred assumed
the title of vice-president.
2. JGI was a Philadelphia-based wholesaler of various food products whose largest product line
was imported meat products.
3. Similar to many family-owned businesses, JGI had historically not placed a heavy emphasis
on internal control issues.
4. In 1986, the Greenberg brothers hired Steve Cohn, a former Coopers & Lybrand auditor and
inventory specialist, to serve as JGI‟s controller.
5. Cohn implemented a wide range of improvements in JGI‟s accounting and control systems;
these improvements included “computerizing” the company‟s major accounting modules with
the exception of prepaid inventory—Prepaid Inventory was JGI‟s largest and most important
6. Since before his father‟s death, Fred Greenberg had been responsible for all purchasing,
accounting, control, and business decisions involving the company‟s prepaid inventory.
7. Fred stubbornly resisted Cohn‟s repeated attempts to modernize the accounting and control
decisions for prepaid inventory.
8. Fred refused to cooperate with Cohn because he had been manipulating JGI‟s operating
results for years by systematically overstating the large Prepaid Inventory account.
9. When Grant Thornton, JGI‟s independent auditor, threatened to resign if Fred did not make
certain improvements in the prepaid inventory accounting module, Fred‟s scheme was
10. Grant Thornton was ultimately sued by JGI‟s bankruptcy trustee; the trustee alleged that
the accounting firm had made critical mistakes in its annual audits of JGI, including relying
almost exclusively on internally-prepared documents to corroborate the company‟s prepaid
Case 2.1 Jack Greenberg, Inc. 120
1. To introduce students to the key audit objectives for inventory.
2. To demonstrate the importance of auditors obtaining a thorough understanding of a client‟s
accounting and internal control systems.
3. To examine the competence of audit evidence yielded by internally-prepared versus
externally-prepared client documents.
4. To identify audit risk issues common to family-owned businesses.
5. To demonstrate the importance of auditors fully investigating suspicious circumstances they
discover in a client‟s accounting and control systems and business environment.
Suggestions for Use
One of my most important objectives in teaching an auditing course, particularly an
introductory auditing course, is to convey to students the critical importance of auditors
maintaining a healthy degree of skepticism on every engagement. That trait or attribute should
prompt auditors to thoroughly investigate and document suspicious circumstances that they
encounter during an audit. In this case, the auditors were faced with a situation in which a client
executive stubbornly refused to adopt much needed improvements in an accounting module that
he controlled. In hindsight, most of us would view such a scenario as a “where there‟s smoke,
there‟s likely fire” situation.
Since the litigation in this case was resolved privately, the case does not have a clear-cut
“outcome.” As a result, you might divide your students into teams to “litigate” the case
themselves. Identify three groups of students: one set of students who will argue the point that
the auditors in this case were guilty of some degree of malfeasance, another set of students who
will act as the auditors‟ defense counsel, and a third set of students (the remainder of your class?)
who will serve as the “jury.”
Suggested Solutions to Case Questions
1. PCAOB Auditing Standard No. 8, “Audit Risk,” defines audit risk as the “risk that the
auditor expresses an inappropriate audit opinion when the financial statements are materially
misstated, i.e., the financial statements are not presented fairly in conformity with the applicable
financial reporting framework” (paragraph 4). “Inherent risk,” “control risk,” and “detection”
risk are the three individual components of audit risk, according to AS No. 8. Following are
brief descriptions of these components that were also taken that standard:
•Inherent risk: refers to the susceptibility of an assertion to a misstatement, due to error or fraud,
that could be material, individually or in combination with other misstatements, before
consideration of any related controls.
Case 2.2 Golden Bear Golf, Inc. 127
•Control risk: the risk that a misstatement due to error or fraud that could occur in an assertion
and that could be material, individually or in combination with other misstatements, will not be
prevented or detected on a timely basis by the company‟s internal control. Control risk is a
function of the effectiveness of the design and operation of internal control.
•Detection risk: the risk that the procedures performed by the auditor will not detect a
misstatement that exists and that could be material, individually or in combination with other
misstatements. Detection risk is affected by (1) the effectiveness of the substantive procedures
and (2) their application by the auditor, i.e., whether the procedures were performed with due
According to the AICPA Professional Standards, the phrase “audit risk” refers to the
likelihood that “the auditor expresses an inappropriate audit opinion when the financial
statements are materially misstated” (AU-C 200.14). “Inherent risk,” “control risk,” and
“detection” risk are also the three individual components of audit risk within the AICPA
Professional Standards. Following are brief descriptions of these components that were taken
from AU-C 200.14:
•Inherent risk: the susceptibility of an assertion about a class of transaction, account balance, or
disclosure to a misstatement that could be material, either individually or when aggregated with
other misstatements, before consideration of any related controls.
•Control risk: the risk that a misstatement that could occur in an assertion about a class of
transaction, account balance, or disclosure and that could be material, either individually or when
aggregated with other misstatements, will not be prevented, or detected and corrected, on a
timely basis by the entity‟s internal controls.
•Detection risk: the risk that the procedures performed by the auditor to reduce audit risk to an
acceptably low level will not detect a misstatement that exists and that could be material, either
individually or when aggregated with other misstatements.
(Note: Both PCAOB AS No. 8 and the AICPA Professional Standards point out that the product
of inherent risk and control risk is commonly referred to as the “risk of material misstatement.)
Listed next are some examples of audit risk factors that are not unique to family-owned
businesses but likely common to them.
•I would suggest that family-owned businesses may be more inclined to petty infighting and
other interpersonal “issues” than businesses overseen by professional management teams.
Such conflict may cause family-owned businesses to be more susceptible to intentional
financial statement misrepresentations.
•The undeniable impact of nepotism on most family-owned businesses may result in key
accounting and other positions being filled by individuals who do not have the requisite skills
for those positions.
•Many family-owned businesses are small and financially-strapped. Such businesses are
more inclined to window-dress their financial statements to impress bankers, potential
suppliers, and other third parties.
Case 2.2 Golden Bear Golf, Inc. 128
•The potential for “petty infighting” and other interpersonal problems within family-owned
businesses may result in their internal control policies and procedures being intentionally
subverted by malcontents.
•Likewise, nepotism tendencies in small businesses can affect the control risk as well as the
inherent risk posed by these businesses. A business that has a less than competent controller
or accounts receivable bookkeeper, for that matter, is more likely to have control “problems.”
•The limited resources of many family-owned businesses means that they are less likely than
other entities to provide for a comprehensive set of checks and balances in their accounting
control systems. For example, proper segregation of duties may not be possible in these
•I would suggest that it may be more difficult for family-owned businesses to establish a
proper control environment. Family relationships, by definition, are typically built on trust,
while business relationships require a certain degree of skepticism. A family business may
find it difficult to establish formal policies and procedures that require certain family
members to “look over the shoulder” and otherwise monitor the work of other family
•The relatively small size of many family-owned businesses likely requires them to bargain
with their auditors to obtain an annual audit at the lowest cost possible. Such bargaining may
result in auditors “cutting corners” to complete the audit.
•Independent auditors often serve as informal business advisors for small, family-owned
audit clients. These dual roles may interfere with the ability of auditors to objectively
evaluate such a client‟s financial statements.
How should auditors address these risk factors? Generally, by varying the nature, extent, and
timing of their audit tests. For example, if a client does not have sufficient segregation of key
duties, then the audit team will have to take this factor into consideration in planning the annual
audit. In the latter circumstance, one strategy would be to perform a “balance sheet” audit that
places little emphasis or reliance on the client‟s internal controls. (Note: Modifying the nature,
extent, and timing of audit tests may not be a sufficient or proper response to the potential
detection risk factors identified above. Since each of those risk factors involves an auditor
independence issue, the only possible response to those factors may simply be asking the given
client to retain another audit firm.) Final note: Recall that the federal judge in this case
suggested that “subjecting the auditors to potential liability” is an appropriate strategy for society
to use to help ensure that family-owned businesses prepare reliable financial statements for the
benefit of third-party financial statement users. You may want to have your students consider
how this attitude on the part of judges affects audit firms and the audits that they design and
perform for such clients. In my view, this factor is not a component of “audit risk” but clearly
poses a significant economic or “business” risk for audit firms.
2. The primary audit objectives for a client‟s inventory are typically corroborating the
“existence” and “valuation” assertions (related to account balances). For the Prepaid Inventory
account, Grant Thornton‟s primary audit objective likely centered on the existence assertion.
Case 2.2 Golden Bear Golf, Inc. 129
That is, did the several million dollars of inventory included in the year-balance of that account
actually exist? Inextricably related to this assertion was the issue of whether JGI management
had achieved a proper “cutoff” of the prepaid inventory transactions at the end of each fiscal
year. If management failed to ensure that prepaid inventory receipts were properly processed
near the end of the year, then certain prepaid inventory shipments might be included in the yearend balances of both Prepaid Inventory and Merchandise Inventory. For the Merchandise
Inventory account, both the existence and valuation assertions were likely key concerns of Grant
Thornton. Since JGI‟s inventory involved perishable products, the Grant Thornton auditors
certainly had to pay particularly close attention to the condition of that inventory while observing
the year-end counting of the warehouse.
3. The controversial issue in this context is whether Grant Thornton was justified in relying on
the delivery receipts given the “segregation of duties” that existed between JGI‟s receiving
function and accounting function for prepaid inventory. In one sense, Grant Thornton was
correct in maintaining that there was “segregation of duties” between the preparation of the
delivery receipts and the subsequent accounting treatment applied to those receipts. The
warehouse manager prepared the delivery receipts independently of Fred Greenberg, who then
processed the delivery receipts for accounting purposes. However, was this segregation of duties
sufficient or “adequate”? In fact, Fred Greenberg had the ability to completely override (and did
override) that control.
You may want to reinforce to your students that the validity of the delivery receipts as audit
evidence was a central issue in this case. Clearly, the judge who presided over the case was
dismayed by Grant Thornton‟s decision to place heavy reliance on the delivery receipts in
deciding to “sign off” on the prepaid inventory balance each year. The problem with practically
any internally-generated document, such as the delivery receipts, is that they are susceptible to
being subverted by two or more client employees who collude with each other or by one selfinterested executive who has the ability to override the client‟s internal controls. On the other
hand, externally-prepared documents (such as contracts or external purchase orders) provide
stronger audit evidence since they are less susceptible to being altered or improperly prepared.
4. The phrase “walk-through audit test” refers to the selection of a small number of client
transactions and then tracking those transactions through the standard steps or procedures that
the client uses in processing such transactions. The primary purpose of these tests is to gain a
better understanding of a client‟s accounting and control system for specific types of
transactions. Likewise, walk-through tests can be used by auditors to confirm the accuracy of
flowchart and/or narrative depictions of a given transaction cycle within a client‟s accounting
and control system. (Note: as pointed out by the expert witness retained by JGI‟s bankruptcy
trustee, if Grant Thornton had performed a walk-through audit test for JGI‟s prepaid inventory
transactions, the audit firm almost certainly would have discovered that the all-important Form
9540-1 documents were available for internal control and independent audit purposes.)
PCAOB Auditing Standard No. 2, “An Audit of Internal Control Over Financial Reporting
Performed in Conjunction with an Audit of Financial Statements,” mandated that auditors of
SEC registrants perform a walk-through audit test for “each major class of transactions”—see
paragraph 79 of that standard. However, that standard was subsequently superceded by PCAOB
Auditing Standard No. 5, “An Audit of Internal Control Over Financial Reporting That is
Integrated with An Audit of Financial Statements.” AS No. 5 does not require walk-throughs.
Case 2.2 Golden Bear Golf, Inc. 130
The AICPA Professional Standards have never mandated the performance of walk-throughs.
5. As a point of information, I have found that students typically enjoy this type of exercise,
namely, identifying audit procedures that might have resulted in the discovery of a fraudulent
scheme. In fact, what students enjoy the most in this context is “shooting holes” in suggestions
made by their colleagues. “That wouldn‟t have worked because . . .,” “That would have been too
costly,” or “How could you expect them to think of that?” are the types of statements that are
often prompted when students begin debating their choices. Of course, such debates can provide
students with important insights that they would not have obtained otherwise.
•During the interim tests of controls each year, the auditors could have collected copies of a
sample of delivery receipts. Then, the auditors could have traced these delivery receipts into the
prepaid inventory accounting records to determine whether shipments of imported meat products
were being recorded on a timely basis in those records. For example, the auditors could have
examined the prepaid inventory log to determine when the given shipments were deleted from
that record. Likewise, the auditors could have tracked the shipments linked to the sample
delivery receipts into the relevant reclassification entry prepared by Steve Cohn (that transferred
the given inventory items from Prepaid Inventory to Merchandise Inventory) to determine if this
entry had been made on a timely basis. (Granted, the effectiveness of this audit test would likely
have been undermined by Fred‟s fraudulent conduct.)
•Similar to the prior suggestion, the auditors could have obtained copies of the freight documents
(bills of lading, etc.) for a sample of prepaid inventory shipments. Then, the auditors could have
tracked the given shipments into the prepaid inventory records to determine whether those
shipments had been transferred on a timely basis from the Prepaid Inventory account to the
Merchandise Inventory account. (There would have been a lower risk of Fred‟s misconduct
undercutting the intent of this audit test.)
•During the observation of the physical inventory, the auditors might have been able to collect
identifying information for certain imported meat products and then, later in the audit, have
traced that information back to the prepaid inventory log to determine whether the given items
had been reclassified out of Prepaid Inventory on a timely basis. This procedure may have been
particularly feasible for certain seasonal and low volume products that JGI purchased for sale
only during the year-end holiday season.
•In retrospect, it seems that extensive analytical tests of JGI‟s financial data might have revealed
implausible relationships involving the company‟s inventory, cost of goods sold, accounts
payable, and related accounts. Of course, the judge who presided over this case suggested that
the auditors should have been alerted to the possibility that something was awry by the dramatic
increase in prepaid inventory relative to sales.
6. An audit firm (of either an SEC registrant or another type of entity) does not have a
responsibility to “insist” that client management correct internal control deficiencies. However,
the failure of client executives to do so reflects poorly on their overall control consciousness, if
not integrity. Similar to what happened in this case, an audit firm may have to consider
resigning from an engagement if client management refuses to address significant internal
control problems. (Of course, in some circumstances, client management may refuse to address
internal deficiencies because it would not be cost-effective to do so.)
Note: PCAOB Auditing Standard No. 5, “An Audit of Internal Control Over Financial
Case 2.2 Golden Bear Golf, Inc. 131
Reporting That is Integrated with An Audit of Financial Statements,” provides extensive
guidance to auditors charged with auditing a public client‟s financial statements while at the
same time auditing that client‟s “management‟s assessment of the effectiveness of internal
control over financial reporting.” For example, AS No. 5 mandates that auditors report all
“material weaknesses” in writing to client management and to the audit committee (paragraph
78). Likewise, auditors must report to the client‟s audit committee all “significant deficiencies”
in internal controls that they discover (paragraph 80). But, again, AS No. 5 does not require
auditors to “insist” that their clients eliminate those material weaknesses or significant
Final note: the reporting responsibilities of auditors for internal control related matters are
discussed in AU-Section 265, “Communicating Internal Control Related Matters Identified in an
Audit,” of the AICPA Professional Standards.
Case 2.2 Golden Bear Golf, Inc. 132
GOLDEN BEAR GOLF, INC.
According to one sports announcer, Jack Nicklaus became “a legend in his spare time.”
Nicklaus still ranks as the best golfer of all time in the minds of most pasture pool aficionados—
granted, he may lose that title soon if Tiger Woods continues his onslaught on golfing records.
Despite his prowess on the golf course, Nicklaus has had an up and down career in the business
world. In 1996, Nicklaus spun off a division of his privately-owned company to create Golden
Bear Golf, Inc., a public company whose primary line of business was the construction of golf
courses. Almost immediately, Golden Bear began creating headaches for Nicklaus. The new
company was very successful in obtaining contracts to build golf courses. However, because the
construction costs for these projects were underestimated, Golden Bear soon found itself facing
huge operating losses. Rather than admit their mistakes, the executives who obtained the
construction contracts intentionally inflated the revenues and gross profits for those projects by
misapplying the percentage-of-completion accounting method.
This case focuses principally on the audits of Golden Bear that were performed by Arthur
Andersen & Co. An SEC investigation of the Golden Bear debacle identified numerous “audit
failures” allegedly made by the company‟s auditors. In particular, the Andersen auditors naively
relied on feeble explanations provided to them by client personnel for a series of suspicious
transactions and circumstances that they uncovered.
Case 2.2 Golden Bear Golf, Inc. 133
Golden Bear Golf, Inc.–Key Facts
1. Jack Nicklaus has had a long and incredibly successful career as a professional golfer, which
was capped off by him being named the Player of the Century.
2. Like many professional athletes, Nicklaus became involved in a wide range of business
interests related to his sport.
3. In the mid-1980s, Nicklaus‟s private company, Golden Bear International (GBI), was on the
verge of bankruptcy when he stepped in and named himself CEO; within a few years, the
company had returned to a profitable condition.
4. In 1996, Nicklaus decided to “spin off” a part of GBI to create a publicly owned company,
Golden Bear Golf, Inc., whose primary line of business would be the construction of golf
5. Paragon International, the Golden Bear subsidiary responsible for the company‟s golf course
construction business, quickly signed more than one dozen contracts to build golf courses.
6. Paragon incurred large losses on many of the golf course construction projects because the
subsidiary‟s management team underestimated the cost of completing those projects.
7. Rather than admit their mistakes, Paragon‟s top executives chose to misrepresent the
subsidiary‟s operating results by misapplying the percentage-of-completion accounting method.
8. In 1998, the fraudulent scheme was discovered, which resulted in a restatement of Golden
Bear‟s financial statements, a class-action lawsuit filed by the company‟s stockholders, and SEC
sanctions imposed on several parties, including Arthur Andersen, Golden Bear‟s audit firm.
9. The SEC charged the Andersen auditors with committing several “audit failures,” primary
among them was relying on oral representations by client management for several suspicious
transactions and events discovered during the Golden Bear audits.
10. The Andersen partner who served as Golden Bear‟s audit engagement partner was
suspended from practicing before the SEC for one year.
Case 2.2 Golden Bear Golf, Inc. 134
1. To demonstrate the need for auditors to have an appropriate level of skepticism regarding
the financial statements of all audit clients, including prominent or high-profile audit clients.
2. To demonstrate that management representations is a weak form of audit evidence.
3. To examine audit risks posed by the percentage-of-completion accounting method.
4. To illustrate the need for auditors to thoroughly investigate suspicious transactions and
events that they discover during the course of an engagement.
5. To examine the meaning of the phrase “audit failure.”
Suggestions for Use
Many, if not most, of your students will be very familiar with Jack Nicklaus and his sterling
professional golf career, which should heighten their interest in this case. One of the most
important learning points in this case is that auditors must always retain their professional
skepticism. Encourage your students to place themselves in Michael Sullivan‟s position.
Sullivan had just acquired a new audit client, the major stockholder of which was one of the true
superstars of the sports world. I can easily understand that an audit engagement partner and his
or her subordinates might be inclined to grant that client the “benefit of the doubt” regarding any
major audit issues or problems that arise. Nevertheless, even in such circumstances students
need to recognize the importance of auditors‟ maintaining an appropriate degree of professional
You may want to point out to your students that because of the subjective nature of the
percentage-of-completion accounting method, it is easily one of the most abused accounting
methods. Over the years, there have been numerous “audit failures” stemming from misuse or
misapplication of this accounting method.
Suggested Solutions to Case Questions
1. Notes: I have not attempted to identify every management assertion relevant to Paragon‟s
construction projects. Instead, this suggested solution lists what I believe were several key
management assertions for those projects. When auditing long-term construction projects for
which the percentage-of-completion accounting method is being used, the critical audit issue is
whether the client‟s estimated stages of completion for its projects are reliable. As a result, most
of the following audit issues that I raise regarding Paragon‟s projects relate directly or indirectly
to that issue. In this suggested solution, I apply the set of assertions included in AU-C Section
315.A114 of the AICPA Professional Standards. Recall that rather than 13 assertions spread
across three categories (classes of transactions and events, account balances, and presentation
and disclosure), PCAOB Auditing Standard No. 15, “Audit Evidence,” identifies only five types
of financial statement assertions, namely, existence or occurrence, completeness, valuation or
allocation, rights and obligations, and presentation and disclosure (AS No. 15, paragraph 11).
Case 2.3 Take-Two Interactive Software, Inc. 133
(Of course, these latter assertions were the “official” assertions recognized by the AICPA at the
time this case transpired.)
•Existence/occurrence: According to AU-C 315.A114, “existence” is an “account balancerelated” assertion that refers to whether specific assets or liabilities exist at a given date.
“Occurrence,” on the other hand, is a “transaction-related” assertion that refers to whether a
given transaction or class of transactions actually took place. On the Golden Bear audits, these
two assertions were intertwined. The existence assertion pertained to the unbilled receivables,
while the occurrence assertion related to the corresponding revenue linked to those receivables,
each of which Paragon booked as a result of overstating the stages of completion of its
construction projects. To investigate whether those unbilled receivables actually existed and
whether the related revenue transactions had actually occurred, the Andersen auditors could have
made site visitations to the construction projects. Andersen could also have contacted the given
owners of the projects to obtain their opinion on the stages of completion of the projects—if the
stages of completion were overstated, some portion of the given unbilled receivables did not
“exist” while the corresponding revenues had not “occurred.” (Of course, this procedure was
carried out for one of the projects by subordinate members of the Andersen audit team.) The
auditors could have also discussed the stages of completion directly with the onsite project
managers and/or the projects‟ architects.
•Valuation (and allocation): This account balance assertion relates to whether “assets, liabilities,
and equity interests are included in the financial statements at appropriate amounts” and whether
“any resulting valuation or allocation adjustments are appropriately recorded” (AU-C 315.A114).
This assertion was relevant to the unbilled receivables that Paragon recorded on its construction
projects and was obviously closely linked to the existence assertion for those receivables. Again,
any audit procedure that was intended to confirm the reported stages of completion of Paragon‟s
construction projects would have been relevant to this assertion. Michael Sullivan attempted to
address this assertion by requiring the preparation of the comparative schedules that tracked the
revenue recorded on Paragon‟s projects under the earned value method and the revenue that
would have been recorded if Paragon had continued to apply the cost-to-cost method. Of course,
client management used the $4 million ruse involving the uninvoiced construction costs to make
it appear that the two accounting methods produced effectively the same revenues/unbilled
•Occurrence: The occurrence assertion was extremely relevant to the $4 million of uninvoiced
construction costs that Paragon recorded as an adjusting entry at the end of fiscal 1997. The
uninvoiced construction costs allowed Paragon to justify booking a large amount of revenue on
its construction projects. To test this assertion, the Andersen auditors could have attempted to
confirm some of the individual amounts included in the $4 million figure with Paragon‟s
•Classification and understandability: This presentation and disclosure-related assertion was
relevant to the change that Paragon made from the cost-to-cost to the earned value approach to
applying the percentage-of-completion accounting method. By not disclosing the change that
was made in applying the percentage-of-completion accounting method, Golden Bear and
Paragon‟s management were making an assertion to the effect that the change was not required
to be disclosed to financial statement users. The Andersen auditors could have tested this
134 Case 2.3 Take-Two Interactive Software, Inc.
assertion by researching the appropriate professional standards and/or by referring the matter to
technical consultants in their firm‟s national headquarters office.
•Completeness: Although not addressed explicitly in the case, the SEC also briefly criticized
Andersen for not attempting to determine whether Paragon‟s total estimated costs for its
individual construction projects were reasonable, that is, “complete.” To corroborate the
completeness assertion for the estimated total construction costs, Andersen could have discussed
this matter with architects and/or design engineers for a sample of the projects. Alternatively,
Andersen could have
reviewed cost estimates for comparable projects being completed by other companies and
compared those estimates with the ones developed for Paragon‟s projects.
2. The term “audit failure” is not expressly defined in the professional literature. Apparently,
the SEC has never defined that term either. One seemingly reasonable way to define “audit
failure” would be “the failure of an auditor to comply with one or more generally accepted
auditing standards.” A more general and legal definition of “audit failure” would be “the failure
to do what a prudent practitioner would have done in similar circumstances.” The latter principle
is commonly referred to as the “prudent practitioner concept” and is widely applied across
professional roles to determine whether a given practicing professional has behaved negligently.
“No,” Sullivan alone was clearly not the only individual responsible for ensuring the integrity
of the Golden Bear audits. Sullivan‟s subordinates, particularly the audit manager and audit
senior assigned to the engagement, had a responsibility to ensure that all important issues arising
on those audits were properly addressed and resolved. This latter responsibility included directly
challenging any decisions made by Sullivan that those subordinates believed were inappropriate.
Audit practitioners, including audit partners, are not infallible and must often rely on their
associates and subordinates to question important “judgment calls” that are made during the
course of an engagement. The “concurring” or “review” partner assigned to the Golden Bear
audits also had a responsibility to review the Golden Bear audit plan and audit workpapers and
investigate any questionable decisions apparently made during the course of the Golden Bear
audits. Finally, Golden Bear‟s management personnel, including Paragon‟s executives, had a
responsibility to cooperate fully with Sullivan to ensure that a proper audit opinion was issued on
Golden Bear‟s periodic financial statements.
3. Most likely, Andersen defined a “high-risk” audit engagement as one on which there was
higher than normal risk of intentional or unintentional misrepresentations in the given client‟s
financial statements. I would suggest that the ultimate responsibility of an audit team is the same
on both a “high-risk” and a “normal risk” audit engagement, namely, to collect sufficient
appropriate evidence to arrive at an opinion on the given client‟s financial statements. However,
the nature of the operational responsibilities facing an audit team on the two types of
engagements are clearly different. For example, when a disproportionate number of “fraud risk
factors” are present, the planning of an audit will be affected. Likewise, in the latter situation,
the nature, extent, and timing of audit procedures will likely be affected. For example, more
extensive auditing tests are typically necessary when numerous fraud risk factors are present.
4. “Yes,” auditors do have a responsibility to refer to any relevant AICPA Audit and
Accounting Guide when planning and carrying out an audit under the auspices of the AICPA
Case 2.3 Take-Two Interactive Software, Inc. 135
Professional Standards. These guides do not replace the authoritative guidance included in
AICPA Professional Standards but rather include recommendations on how to apply those
standards in specific circumstances. AICPA Audit and Accounting Guides have the same
standing for audits performed under the auspices of the PCAOB‟s Auditing Standards and
Interim Standards. See a discussion of this issue at AU 150.03 of the PCAOB‟s Interim
5. The following footnote was included in Accounting and Auditing Enforcement Release No.
1676, which was a primary source for the development of this case. “Regardless of whether the
adoption of the „earned value‟ method was considered a change in accounting principle or a
change in accounting estimate, disclosure by the company in its second quarter 1997 interim
financial statements and its 1997 annual financial statements was required to comply with
GAAP.” In the text of the enforcement release, the SEC referred to the switch from the cost-tocost method to the earned value method as a change in “accounting methodology,” which seems
to suggest that the SEC was not certain how to classify the change. However, APB Opinion No.
20, “Accounting Changes,” which was in effect during the relevant time frame of this case, and
SFAS No. 154, “Accounting Changes and Error Corrections,” the FASB standard that replaced
APB No. 20 (pre-codification), point out that the phrase “accounting principle” refers to
accounting principles or practices and “to the methods of applying them.” This statement
implies, to me at least, that Paragon‟s switch from the cost-to-cost approach to the earned value
approach of applying the percentage-of-completion accounting method was a “change in
Under SFAS No. 154, a change in accounting principle “shall be reported by retrospective
application unless it is impracticable to determine either the cumulative effect or the periodspecific effects of the change.” This is an important difference with the prior standard, APB No.
20, that required a “cumulative effect of a change in accounting principle” to be reported by the
given entity in its income statement for the period in which the change was made. SFAS No.
154 requires that a change in accounting estimate “shall be accounted for in the (a) period of
change if the change affects that period only or (b) the period of change and future periods if the
change affects both.”
In terms of financial statement disclosure, SFAS No. 154 mandates that the “nature of and
justification for the change in accounting principle shall be disclosed in the financial statements
of the period in which the change is made.” Regarding changes in accounting estimates, this
standard notes that, “When an entity makes a change in accounting estimate that affects several
future periods (such as a change in service lives of depreciable assets), it shall disclose the effect
on income before extraordinary items, net income, and related per-share amounts of the current
136 Case 2.3 Take-Two Interactive Software, Inc.
TAKE-TWO INTERACTIVE SOFTWARE, INC.
Grand Theft Auto is the sixth best-selling video game “franchise” of all time and easily
ranks among the most controversial as well. The game‟s “adult” content has resulted in caustic
and unrelenting criticism by prominent politicians, public service organizations, and major media
outlets. Despite that criticism, Grand Theft Auto has been hugely profitable for Take-Two
Interactive Software, Inc., its maker and distributor. Take-Two was founded in 1993 by 21-yearold Ryan Brant, the son of a billionaire businessman.
An SEC investigation of Take-Two‟s financial statements resulted in the company being
forced to issue restated financial statements twice in two years shortly after the turn of the
century. Then, just a few years later, Take-Two was caught up in the huge “options backdating”
scandal and forced to restate its financial statements a third time. This case focuses on the
underlying cause of the initial restatement, which was primarily a series of fraudulent sales
transactions booked by the company in 2000 and 2001. Take-Two executives recorded those
sham sales transactions to ensure that the company met or surpassed its consensus quarterly
earnings forecasts established by Wall Street analysts.
Take-Two‟s longtime audit firm, PwC, was also caught up in the company‟s financial
reporting scandal. One of many SEC enforcement releases issued regarding that scandal focused
on the alleged misconduct of Robert Fish, the PwC partner who had supervised the 1994 through
2001 Take-Two audits. In particular, the SEC criticized the audit tests applied to Take-Two‟s
domestic receivables by Fish and his subordinates. In addition, the PwC auditors were chastised
by the SEC for their alleged failure to properly audit Take-Two‟s reserve for sales returns.
An interesting feature of this case is the close relationship between Robert Fish and Ryan
Brant. In addition to serving as the Take-Two audit engagement partner, Fish was apparently the
much younger Brant‟s most trusted business advisor. In fact, in an interview with a business
publication Fish suggested that he and Brant effectively had a father-son type relationship. Also
interesting is the fact that PwC sharply discounted the professional fees that it charged TakeTwo. Those discounted fees almost certainly helped to cement PwC‟s relationship with the
rapidly growing company.
Take-Two Interactive Software, Inc.–Key Facts
Case 2.3 Take-Two Interactive Software, Inc. 137
1. In 1993, when he was only 21-years-old, Ryan Brant organized Take-Two Interactive
Software, a company that produced and distributed video games.
2. Robert Fish, a PwC audit partner, supervised the annual audits of Take-Two from 1994-
2001; Fish also served as one of Brant‟s principal business advisors and, when interviewed,
suggested that he had a father-son type relationship with the much younger Brant.
3. While Take-Two was in a developmental stage, PwC sharply discounted the professional
fees that it charged the company.
4. Brant took his company public in 1997 to obtain the funding necessary to fuel Take-Two‟s
5. A video game produced by a company acquired by Take-Two would become Grand Theft
Auto, one of the most controversial but best-selling video games of all time.
6. An SEC investigation revealed that Take-Two executives recorded a large volume of bogus
sales transactions during 2000 and 2001 to ensure that the company achieved its consensus
earnings forecasts each quarterly reporting period.
7. Take-Two would ultimately be required to restate its financial statements three times over a
five-year period to correct material misrepresentations resulting from bogus sales transactions
and improper “backdating” of stock option grants.
8. The SEC issued an enforcement release that criticized PwC‟s 2000 Take-Two audit; the
enforcement release focused on improper decisions allegedly made by Robert Fish during that
9. Fish identified “revenue recognition” and “accounts receivable reserves” as areas of “higher
risk” for the 2000 audit, according to the SEC, but failed to properly respond to those high risk
areas during the engagement.
10. The “alternative audit procedures” that PwC applied after realizing an extremely low
response rate on its accounts receivable confirmation requests were flawed and inadequate.
11. PwC also failed to properly audit Take-Two‟s reserve for sales returns, which may have
prevented the firm from discovering the bogus sales recorded by the company.
12. The SEC sanctioned Fish, Brant, and three other Take-Two executives; Brant resigned from
Take-Two during the SEC‟s investigation of the company‟s scheme to backdate its stock option
grants, a scheme that he had masterminded.
138 Case 2.3 Take-Two Interactive Software, Inc.
1. To provide students with an opportunity to use analytical procedures as an audit planning
2. To examine the nature of, and key audit objectives associated with, accounts receivable
confirmation procedures and related “alternative audit procedures.”
3. To examine the meaning of “negligent,” “reckless,” and “fraudulent” as those terms relate to
auditor misconduct or malfeasance.
4. To identify circumstances that may threaten the de facto and apparent independence of
Suggestions for Use
You might begin class coverage of this case by asking for a show of hands of those students
who have played one or more versions of Grand Theft Auto. If you have “age appropriate”
college students, you will likely find that most of your male students have played the game,
while just a smattering of your female students have experienced the game. After asking for the
show of hands, I typically single out individual students and ask them to comment on whether or
not they believe the game is morally objectionable. More often than not, I receive a reply similar
to the following: “It‟s only a game!” [By the way, I have never played the game myself,
although I was well aware of it and its controversial content before I developed this case.] Next,
I tend to segue into a discussion of the final case question, namely, whether audit firms should
accept “ethically-challenged” companies and organizations as clients. That issue often spawns a
far-ranging, if not raucous, debate among students. I have found that students also enjoy
debating and discussing the two auditor independence issues raised in this case: the question of
whether the “father-son” relationship between the client CEO and the audit engagement partner
was problematic and the question of whether PwC‟s independence was in any way impaired by
the heavy discounting of fees charged to Take-Two when it was in a developmental stage.
Although this case raises some interesting ethical issues that you could discuss in class, its
central focus is on a relatively “plain vanilla” topic, namely, the application of accounts
receivable confirmation procedures and related “alternative audit procedures.” I like to couple
these topics together with the issue of what type of auditor misconduct was evident on the part of
the PwC auditors (see case question #4). It is often difficult to convey to students the literal
meaning or interpretation of terms such as “auditor negligence” or “auditor recklessness,” but
this case provides a real-world setting that gives students a better contextual understanding of
what those terms imply or suggest. Consider launching your discussion of case question #4 by
asking for a show of hands of students who believe the PwC auditors were (1) negligent or (2)
Case 2.3 Take-Two Interactive Software, Inc. 139
Suggested Solutions to Case Questions
1. Following are the requested financial ratios for Take-Two for the period 1998-2000. Notice
that the accounts receivable turnover and inventory turnover ratios are also provided.
Financial Ratios for Take-Two:
2000 1999 1998
Age of Accts Receivable* 114.4 93.6 80.4
Age of Inventory* 63.5 57.2 57.9
Gross Profit Percentage 36.0% 29.7% 24.0%
Profit Margin Percentage 6.5% 5.3% 3.7%
Return on Assets 8.6% 9.6% 8.7%
Return on Equity 18.3% 27.1% 30.2%
Current Ratio 1.41 1.28 1.30
Debt to Equity Ratio .88 1.72 2.08
Quality of Earnings Ratio -2.21 -1.03 -1.12
* In days
Accts Receivable Turnover 3.19 3.90 4.54
Inventory Turnover 5.75 6.38 6.30
A/R Turnover: net sales / average accounts receivable
Age of A/R: 365 days / accounts receivable turnover
Inventory Turnover: cost of goods sold / average inventory
Age of Inventory: 365 days / inventory turnover
Gross Profit Percentage: gross profit / net sales
Profit Margin Percentage: net income / net sales
Return on Assets: net income / average total assets
Return on Equity: net income / average stockholders’ equity
Current Ratio: current assets / current liabilities
Debt to Equity: total liabilities / total stockholders‟ equity
Quality of Earnings: net operating cash flows / net income
The most prominent red flag revealed by these ratios is the extremely poor “quality of
earnings” being produced by Take-Two over this three-year time frame. Investors want and
expect a company to have a quality of earnings ratio higher than 1.0. Simply from a
mathematical standpoint, you would expect a company to have a greater than 1.0 quality of
earnings ratio because of noncash expenses, principally depreciation expense. A large number of
factors may collectively or individually produce a negative quality of earnings ratio for a given
company. One such factor is the recording of fraudulent sales—the bogus accounts receivable
140 Case 2.3 Take-Two Interactive Software, Inc.
due to fraudulent sales simply “pile up” on the given company‟s balance sheet in such
circumstances and cause net income to be higher than net operating cash flows. Notice that the
negative quality of earnings ratios being experienced over the time frame 1998-2000 was
accompanied by a telltale slowdown in accounts receivable turnover (which, in turn, caused
Take-Two‟s age of receivables to increase significantly).
Notice also that Take-Two‟s age of inventory was increasing between 1998 and 2000 but not
as consistently or dramatically as the company‟s age of receivables. One cause of an increasing
age of inventory is the fact that a company is overstating its period-ending inventory.
Consequently, an increasing age of inventory should prompt auditors to focus more attention on
the existence and valuation assertions for that account. Note: The SEC did not allege that TakeTwo was overstating its inventories. However, given that the company was recording bogus
sales/receivables, it is certainly a possibility that it was also overstating its period-ending
inventory, particularly given the slowing inventory turnover.
Another key red flag that suggested something may have been awry in Take-Two‟s reported
operating results was the significant increases in the company‟s gross profit percentage and
profit margin percentage during the year 2000. As noted in the case, many of Take-Two‟s
competitors went out of business as a direct result of the challenging economic conditions that
accompanied the “tech crash” that began in early 2000. Auditors of a company that is “bucking”
such a trend by reporting impressive financial data should definitely consider the possibility that
the client is somehow window-dressing its financial statements.
2. “Existence” and “valuation” are the primary management assertions that auditors hope to
corroborate when confirming a client‟s accounts receivable. Confirmation procedures are
particularly useful for supporting the existence assertion. A client‟s customer may readily
confirm that a certain amount is owed to the client (existence assertion), however, whether that
customer is willing and/or able to pay the given amount (valuation assertion) is another issue.
The key difference between positive and negative confirmation requests is that the given
third party is asked to respond to a positive confirmation request whether or not the information
to be confirmed is accurate, while for a negative confirmation request the third party is asked to
respond only if the information to be confirmed is not accurate. Auditors must perform other
audit procedures (alternative audit procedures) in those instances in which the third party does
not return a positive confirmation request. No follow-up procedures are necessary when the
auditor does not receive a response to a negative confirmation request. Given the fundamental
difference between positive and negative confirmation requests, the audit evidence yielded by
the former is of much higher quality (much more reliable) than audit evidence yielded by the
AU Section 330, “The Confirmation Process,” of the PCAOB‟s Interim Standards is the
authoritative source in this context for audits of SEC registrants, such as Take-Two. AU-C
Section 505, “External Confirmations,” of the AICPA Professional Standards discusses at length
the use of confirmation procedures to collect audit evidence in audits of other types of entities.
Both of these sections of the respective sets of standards suggest that negative confirmations
provide less persuasive audit evidence than positive confirmations. AU 330.20 notes that
negative confirmation requests may be used by auditors when the following three circumstances
are present: “(a) the combined assessed level of inherent risk and control risk is low, (b) a large
number of small balances is involved, and (c) the auditor has no reason to believe that the
recipients of the requests are unlikely to give them consideration.”
Case 2.3 Take-Two Interactive Software, Inc. 141
3. Paragraph 32 of AU Section 330, “The Confirmation Process,” of the PCAOB‟s Interim
Standards identifies the following “alternative procedures” that may be applied by an auditor
when a positive confirmation request has failed to produce a response: “examination of
subsequent cash receipts (including matching such receipts with the actual items being paid),
shipping documents, or other client documentation.” Notice the parenthetical statement which is
very relevant to the Take-Two case. The SEC specifically criticized the PwC auditors for failing
to “match up” subsequent cash receipts with the actual amounts being paid. Likewise, PwC only
examined $18 million of subsequent cash receipts when the total recorded value of the
unconfirmed receivables was approximately $100 million. (Note: Paragraph A.24 of AU-C
Section 505, “External Confirmations,” of the AICPA Professional Standards identifies the same
“alternative procedures” in this context as AU 330.32.)
Ironically, the results of alternative audit procedures may, in fact, yield stronger audit
evidence than that yielded by a properly returned and signed positive confirmation. This is
particularly true when the auditor examines subsequent cash collections and is able to trace those
cash receipts to the specific items that were included in the given receivable. Despite this
possibility, however, auditors typically prefer that the client‟s customers confirm their periodending balances by signing and returning a positive confirmation request. Why? Because
considerably less audit effort is required in such circumstances and the quality of the audit
evidence provided is almost always deemed acceptable.
4. The following list of alleged and/or potential deficiencies in the 2000 PwC audit of TakeTwo will be helpful in responding to this question: failing to properly respond to high audit risk
areas identified during the planning phase of the engagement, failing to investigate why such a
modest response rate was received from the positive confirmation requests, failing to determine
that the one positive confirmation request received was invalid (see footnote 18), accepting as
audit evidence for the unconfirmed receivables subsequent cash receipts that could not be traced
to specific invoiced sales amounts, identifying and reviewing only a modest amount of
subsequent cash receipts related to the unconfirmed accounts receivable, failing to track the
sample of five sales returns to specific invoiced sales transactions or otherwise investigate the
validity of those sales returns. Of course, more general, broad-brush allegations were included in
the SEC enforcement release. The case notes, for example, that the SEC charged that Fish
“failed to exercise due professional care and professional skepticism.”
Following are definitions/descriptions that I have found very useful in helping students
distinguish among the three key types of auditor misconduct. These definitions were taken from
the following source: D.M. Guy, C.W. Alderman, and A.J. Winters, Auditing, Fifth Edition
(San Diego: Dryden, 1999), 85-86.
Negligence. “The failure of the CPA to perform or report on an engagement with
the due professional care and competence of a prudent auditor.” Example: An
auditor fails to test a client’s reconciliation of the general ledger controlling
account for receivables to the subsidiary ledger for receivables and, as a result,
fails to detect a material overstatement of the general ledger controlling account.
Recklessness (a term typically used interchangeably with gross negligence and