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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. Philadelphiabased 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 prepaid inventory.
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
Case 2.1 Jack Greenberg, Inc.
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 vicepresident.
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 account.
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 discovered.
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 inventory.
94 Case 2.1 Jack Greenberg, Inc.
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
uncover 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. No doubt, in
hindsight, most of us would view such a scenario as a “where there’s smoke, there’s likely fire”
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
Suggested Solutions to Case Questions
1. The phrase “audit risk” refers to the likelihood that an auditor “may unknowingly fail to
appropriately qualify his or her opinion on financial statements that are materially misstated” [AU
312.02]. “Inherent risk,” “control risk,” and “detection risk” are the three individual components of
audit risk. Following are brief descriptions of these components that were taken from AU 312
(paragraphs 21 and 24):
Inherent risk: the susceptibility of a relevant assertion to a misstatement that could be
material, either individually or when aggregated with other misstatements, assuming that there
are no related controls.
Case 2.1 Jack Greenberg, Inc.
Control risk: the risk that a misstatement that could occur in a relevant assertion and that
could be material, either individually or when aggregated with other misstatements, will not
be prevented or detected on a timely basis by the entity’s internal control.
Detection risk: the risk that the auditor will not detect a material misstatement that exists in a
relevant assertion that could be material, either individually or when aggregated with other
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.
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 business means that they are less likely than
other entities to provide for a comprehensive set of checks and balances in their accounting
and 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 members.
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.
96 Case 2.1 Jack Greenberg, Inc.
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 complete 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 federal 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. 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 year-end 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) the control served by having the
delivery receipts prepared and processed by different individuals.
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
Case 2.1 Jack Greenberg, Inc.
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 self-interested 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 superseded by PCAOB Auditing
Standard No. 5, “An Audit of Internal Control Over Financial Reporting That is Integrated with An
Audit of Financial Statements.” PCAOB No. 5 does not require walk-throughs. The ASB has never
issued a standard that mandates 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.
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
98 Case 2.1 Jack Greenberg, Inc.
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.
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 federal 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 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, PCAOB 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, PCAOB No. 5 does not require auditors to “insist” that their clients eliminate those
material weaknesses or significant deficiencies.
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.
100 Case 2.2 Golden Bear Golf, Inc.
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 courses.
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.
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.
Case 2.2 Golden Bear Golf, Inc.
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 skepticism.
You may want to point out to your students that because of the subjective nature of the
percentage-of-completion accounting method, it is arguably one of the most easily 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. Note: 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. Additional note: 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.
Existence/occurrence: In SAS No. 106, “existence” is an “account balance-related” 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 unbilled revenue, 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.”
(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
102 Case 2.2 Golden Bear Golf, Inc.
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 Section 326.15). 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 persuade Sullivan that his
analysis was incorrect.
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
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 was 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 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
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
Case 2.2 Golden Bear Golf, Inc.
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
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
Guides when planning and carrying out an audit. These guides do not replace the authoritative
guidance included in Statements on Auditing Standards but rather include “recommendations on the
application of SASs in specific circumstances.” Following is an excerpt from the prologue of one
Audit and Accounting Guide.
“Auditing guidance included in an AICPA Audit and Accounting Guide is an interpretive
publication pursuant to Statement on Auditing Standards (SAS) No. 95, ‘Generally Accepted
Auditing Standards.’ Interpretive publications are recommendations on the application of SASs
in specific circumstances, including engagements for entities in specialized industries. Interpretive
publications are issued under the authority of the Auditing Standards Board. The members of the
Auditing Standards Board have found this guide to be consistent with existing SASs.
The auditor should be aware of and consider interpretive publications applicable to his or her
audit. If the auditor does not apply the auditing guidance included in an applicable interpretive
publication, the auditor should be prepared to explain how he or she complied with the SAS
provisions addressed by such auditing guidance.”
104 Case 2.2 Golden Bear Golf, Inc.
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-to-cost 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 accounting principle.”
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 period-specific
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 period.”
HAPPINESS EXPRESS, INC.
In 1989, two longtime sales reps in the toy industry, Joseph and Isaac Sutton, founded
Happiness Express, Inc. The business model developed by the Sutton brothers involved acquiring the
licensing rights to market toys and other merchandise featuring popular characters appearing in
movies, television programs, and books and other publications intended principally for children. The
company got off to a quick start, thanks to the uncanny ability of the Sutton brothers to identify
children’s characters, such as The Little Mermaid and Barney, that would have tremendous appeal
among children. By 1994, the company had annual sales of $40 million. That same year, the Sutton
brothers took Happiness Express public with a successful IPO.
By 1995, the company’s “hottest” line of merchandise featured the Mighty Morphin Power
Rangers. In fact, 75 percent of the company’s reported revenues for fiscal 1995 resulted from sales
of Power Rangers toys and merchandise. Unfortunately for the Sutton brothers and their fellow
stockholders, sales of Power Rangers merchandise began falling dramatically near the end of the
company’s 1995 fiscal year as children’s interest in the enigmatic crusaders subsided. To sustain their
company’s impressive profit and revenue trends, Happiness Express booked several million dollars of
fictitious sales and accounts receivable near the end of fiscal 1995. (Ironically, the fraudulent scheme
resulted in Happiness Express being named the “#1 Hot Growth Company” in the United States by
Public allegations of insider trading involving Happiness Express’s executives and hints of
financial irregularities in its accounting records prompted an SEC investigation and ultimately resulted
in the company filing for bankruptcy in the fall of 1996. A class-action lawsuit by Happiness
Express’s stockholders targeted Coopers & Lybrand, which had issued unqualified opinions on the
company’s financial statements each year through fiscal 1996. The principal thrust of the lawsuit was
that Coopers & Lybrand had recklessly audited Happiness Express’s sales and accounts receivable,
which prevented the firm from discovering the bogus sales and receivables entered in the company’s
accounting records near the end of fiscal 1995. This case examines the audit procedures that Coopers
& Lybrand applied to Happiness Express’s sales and receivables, with a particular focus on the firm’s
receivables confirmation and sales cut-off procedures.
106 Case 2.3 Happiness Express, Inc.
Happiness Express, Inc.—Key Facts
1. In 1989, Joseph and Isaac Sutton founded Happiness Express, Inc., a small toy company that
marketed licensed merchandise featuring popular children’s characters.
2. During the early 1990s, Happiness Express’s revenues grew rapidly; in May 1995, Happiness
Express was named the “#1 Hot Growth Company” in the United States by Business Week.
3. Happiness Express was heavily dependent on the continued popularity of certain children’s
characters for which it had purchased licensing rights; for example, in fiscal 1995, sales of Mighty
Morphin Power Rangers merchandise accounted for 75% of the company’s total revenues.
4. Happiness Express began experiencing financial problems during the spring of 1995 when sales
of its Power Rangers merchandise began falling sharply.
5. To conceal Happiness Express’s deteriorating financial condition, company executives booked
several million dollars of fictitious sales near the end of fiscal 1995.
6. When the fraudulent scheme was uncovered, Happiness Express’s stockholders filed a classaction lawsuit against Coopers & Lybrand, which had issued unqualified opinions on the company’s
financial statements through fiscal 1996.
7. The primary focus of the lawsuit was on the audit procedures that Coopers & Lybrand had
applied to Happiness Express’s sales and year-end receivables for fiscal 1995.
8. Plaintiff attorneys argued that Coopers & Lybrand had overlooked key red flags regarding
Happiness Express’s sales and receivables and, consequently, failed to develop a proper audit plan for
the 1995 audit engagement.
9. Coopers & Lybrand was also charged with recklessly performing year-end sales cutoff tests and
accounts receivable confirmation procedures during the 1995 audit.
10. In 2002, Coopers & Lybrand agreed to pay $1.3 million to resolve the class-action lawsuit.
Case 2.3 Happiness Express, Inc.
1. To make students aware of the need for auditors to identify the unique or atypical audit risks
posed by specific industries and client business models.
2. To demonstrate the importance of auditors’ obtaining a thorough understanding of their client’s
operations and any major changes in those operations that have occurred since the prior year’s audit.
3. To demonstrate the need for auditors to thoroughly investigate large and/or suspicious year-end
transactions recorded by a client.
4. To discuss the nature of, and audit objectives associated with, sales cutoff tests and accounts
receivable confirmation procedures.
Suggestions for Use
Consider using this case to illustrate the audit objectives related to accounts receivable and sales
as well as the audit procedures that can be used to accomplish those objectives. In particular, this
case can be used to provide your students with a solid understanding of the nature and purpose of
year-end sales cutoff tests and accounts receivable confirmation procedures. Another important
feature of this case is that it demonstrates the need for auditors to identify and carefully consider
important “red flags” present in their clients’ accounting records or in key circumstances surrounding
those records. No doubt, one of the “top 10” red flags associated with financial frauds is large and
unusual year-end transactions. In this case, the auditors apparently did not carefully scrutinize large
and unusual sales transactions recorded by the client on the final day of its fiscal year. Another
important feature of this case is that it clearly demonstrates that auditors should take a “big picture”
view of their client when planning an audit. Key features of a client’s industry (for example, in this
case, the difficulty of predicting children’s taste in toys) and critical elements of a client’s business
model (in this case, the heavy reliance of Happiness Express on one or a few lines of merchandise)
can have significant implications for the successful completion of an audit.
Suggested Solutions to Case Questions
1. “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.
Not surprisingly, year-end sales cutoff tests are used to corroborate the “cutoff” assertion for
individual transactions or classes of transactions. These tests are designed to determine whether
transactions have been recorded in the proper accounting period. The “completeness” assertion is
also a primary focus of year-end cutoff tests, particularly for expense and liability transactions.
When examining a client’s year-end sales cutoff, auditors intend to determine whether the client
properly sorted sales transactions near the end of the fiscal year into the proper accounting period—
108 Case 2.3 Happiness Express, Inc.
either the fiscal year under audit or the “new” fiscal year. If a sales transaction recorded on the last
day of a client’s fiscal year actually occurred on the following day, then the cutoff assertion has been
violated. A sales transaction that was recorded on the first day of the new fiscal year but that was
actually a valid transaction of the “old” fiscal year is another example of a violation of the cutoff
assertion. [You might point out that both types of errors—when they are “honest” errors—are
typically due to client personnel improperly applying the FOB shipping point/FOB destination features
of year-end sales or improperly applying other criteria that clients have established to determine when
“a sale is a sale.” As a general rule, companies can establish any reasonable cutoff criteria for year-end
sales as long as those criteria are applied consistently from period to period.]
2. I would suggest that Coopers & Lybrand made three mistakes or errors in judgment vis-à-vis the
Wow Wee confirmation. First, from the facts reported in the legal transcript used to prepare this
case, the auditors effectively allowed Goldberg to take control of the confirmation process for the
Wow Wee account. Throughout the confirmation process, auditors should maintain control over the
confirmation requests and responses to minimize the risk that client personnel will attempt to
intercept and/or alter those requests and responses. Second, the auditors apparently did not take all
necessary precautions regarding the acceptance of facsimile confirmations. “Facsimile responses
involve risks because of the difficulty of ascertaining the sources of the responses. To restrict the
risks associated with facsimile responses and treat the confirmations as valid audit evidence, the
auditor should consider taking certain precautions, such as verifying the source and contents of a
facsimile response in a telephone call to the purported sender. In addition, the auditor should
consider requesting the purported sender to mail the original confirmation directly to the auditor.”
[AU 330.28] Third, given the circumstances, the auditors likely should have considered performing
additional procedures to corroborate the existence assertion for the Wow Wee receivable. For
example, the auditors could have reviewed subsequent payments made on that account.
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,
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
constructive fraud). “A serious occurrence of negligence tantamount to a flagrant or
reckless departure from the standard of due care.” Example: Evidence collected by
an auditor suggests that a client’s year-end inventory balance is materially overstated.
Because the auditor is in a hurry to complete the engagement, he fails to investigate
the potential inventory overstatement and instead simply accepts the account balance
as reported by the client.
Fraud. “Fraud differs from gross negligence [recklessness] in that the auditor does
not merely lack reasonable support for belief but has both knowledge of the falsity and
Case 2.3 Happiness Express, Inc.
intent to deceive a client or third party.” Example: An auditor accepts a bribe from a
client executive to remain silent regarding material errors in the client’s financial
I do not have access to all of the facts pertinent to this case since it never went to trial, as a result,
I do not feel comfortable characterizing Coopers & Lybrand’s misconduct as negligent, reckless, or
fraudulent. But, I assure you, your students will be more than happy to complete this task for me.
[Note: The information presented in this case was drawn from a preliminary ruling issued by Judge
Robert Patterson who had been assigned to preside over the lawsuit filed by Happiness Express’s
former stockholders. Much of the information presented in his ruling was simply a rehash of the key
allegations made by the plaintiff legal counsel.]
3. Given the size of the West Coast receivable—it represented approximately 13% of Happiness
Express’s year-end accounts receivable, which, in turn accounted for 32% of the company’s total
assets—it certainly seems reasonable to conclude that the account should have been confirmed. Since
this case never went to trial, Coopers & Lybrand did not have an opportunity to give a full accounting
for, or justification of, its decision not to confirm the West Coast account. In responding to an early
legal brief in the case, Coopers & Lybrand did report, according to Judge Patterson’s preliminary
ruling in the case, that it “examined cash receipts that West Coast paid after year-end.” However,
Judge Patterson’s ruling indicates that the accounting firm did not “cite workpapers or other evidence
to support this claim,” nor did the firm challenge plaintiff counsel’s allegation that the failure to
confirm the West Coast account was a violation of a generally accepted auditing procedure.
Plaintiff counsel criticized Coopers & Lybrand for not including any of the bogus West Coast
sales transactions in its year-end sales cutoff tests. However, apparently none of those sales occurred
in the year-end cutoff period defined by Coopers & Lybrand—although the case does not indicate the
length of the year-end cutoff period, it typically includes the five business days on either side of the
client’s fiscal year-end. [Note: As pointed out in the case, the bulk of the bogus West Coast sales
were booked in the last month of fiscal 1995, but apparently not in the final few days of fiscal 1995—
which was the case for the bogus Wow Wee sales. So, you would not have expected any of the
bogus West Coast sales to be included in the year-end sales cutoff test.]
4. Examination of subsequent cash receipts and inspection of shipping documents are the two most
common “alternative” procedures auditors apply when a confirmation cannot be obtained for a large
receivable. Another alternative procedure in such circumstances is simply to sit down with
appropriate client personnel and have a heart-to-heart discussion regarding the given receivable. The
purpose of this discussion would be to determine whether the client is aware of any unusual risks or
circumstances regarding the given receivable that have important audit implications.
Generally, a positive confirmation received from an independent third party, such as a client’s
customer, is considered to be more reliable than the evidence yielded by the alternative procedures
identified in the prior paragraph. For example, a deceitful audit client may “fake” shipping documents
and subsequent cash receipts to conceal the true nature of bogus sales transactions.
5. You will not find a reference to “insider trading” in the topical index to the professional auditing
standards. Nevertheless, insider trading is clearly an “illegal act” that may have significant
implications for a client and significant implications for the client’s independent audit firm. AU
110 Case 2.3 Happiness Express, Inc.
Section 317 discusses at length auditors’ responsibilities regarding illegal acts perpetrated by a client.
AU 317.05 notes that auditors’ responsibilities for illegal acts that have a direct and material effect on
a client’s financial statements are the same as auditors’ responsibilities for misstatements caused by
error or fraud as described in AU Section 110. The principal focus of AU Section 317 is on illegal
acts that have a material but indirect effect on a client’s financial statements. AU 317.06 refers
specifically to insider trading as an example of an illegal act that may have such an effect on a client’s
According to AU 317.07, auditors “should be aware of the possibility that such illegal acts [those
having a material and indirect effect on financial statement amounts] may have occurred.” That
paragraph goes on to suggest that if specific information comes to the auditor’s attention that
provides evidence concerning the existence of such illegal acts, “the auditor should apply audit
procedures specifically directed to ascertaining whether an illegal act has occurred.”
In summary, I would suggest that “yes” auditors do have a responsibility to “consider” the
possibility that client executives have engaged in insider trading. Additionally, if they uncover
evidence suggesting that insider trading has occurred, auditors have a responsibility to investigate that
possibility. [AU Section 317 lists various audit procedures that can be used to investigate potential
This case examines an embezzlement scheme involving CapitalBanc Corporation, a publiclyowned bank holding company based in New York City. The principal operating unit of CapitalBanc
was Capital National Bank, a bank that had five branch offices scattered across the New York City
metropolitan area. CapitalBanc’s CEO, Carlos Cordova, embezzled at least $400,000 from the firm’s
177th Street Branch office. Cordova’s embezzlement was discovered after the bank was declared
insolvent in 1990 and taken over by the Federal Deposit Insurance Corporation (FDIC). Cordova
subsequently pleaded guilty to several counts of bank fraud.
In 1987, CapitalBanc retained Arthur Andersen to audit the financial statements to be included in
its 10-K. Ironically, Arthur Andersen selected the 177th Street Branch to perform a surprise year-end
cash count. When the auditors arrived, they discovered that $2.7 million, more than one-half of the
branch’s cash funds, were not accessible. Allegedly, those funds were segregated in a locked cabinet
within the branch’s main vault. According to branch personnel, three keys were required to unlock
the cabinet, one of which was in Cordova’s possession. Since Cordova was out of the country at the
time, the employees were unable to unlock the cabinet. After consulting with their superiors on the
audit engagement team, the Arthur Andersen auditors informed the branch’s personnel that they
would count the cash funds in the locked cabinet when Cordova returned.
Upon returning to New York City, Cordova had