(Solution Manual) Contemporary Auditing

Knapp, 11

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Solution Manual

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Solution Manual for Contemporary Auditing, The downloadable file consists of 417 pages, and the total size of the file is 3.15 MB. Purchase now only for highly discounted price.

Author(s): Knapp

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Case 1. 3 Just for Feet, Inc. 1 CASE 1.1 ENRON CORPORATION Synopsis Arthu r Edward Andersen built his firm, Arthur Andersen & Company, into one of the largest and most respected accounting firms in the world through his reputation for honesty and integrity. “Think straight, talk straight” was his motto and he insisted that his clients adopt that same attitude when preparing and issuing their periodic financial statements. Arthur Andersen’s auditing philosophy was not rule-based, that is, he did not stress the importance of clients complying with specific accounting rules becaus e in the early days of the U.S. accounting profession there were few formal rules and guidelines for accountants and auditors to follow. Instead, Andersen invoked a substance -over-form approach to auditing and accounting issues. He passionately believed that the primary role of the auditor was to ensure that clients reported fully and honestly to the public, regardless of the consequences for those clients. Ironically, Arthur Andersen & Co.’s dramatic fall from prominence resulted from its association with a client known for aggressive and innovative uses of “accounting gimmicks” to window dress its financial statements. Enron Corporation, Andersen’s second largest client, was involved in large, complex transactions with hundreds of special purpose entit ies (SPEs) that it used to obscure its true financial condition and operating results. Among other uses, these SPEs allowed Enron to download underperforming assets from its balance sheet and to conceal large operating losses. During 2001, a series of ci rcumstances, including a sharp decline in the price of Enron’s stock, forced the company to assume control and ownership of many of its troubled SPEs. As a result, Enron was forced to report a Case 1. 3 Just for Feet, Inc. 2 large loss in October 2001, restate its earnings for the previ ous five years, and, ultimately, file for bankruptcy in December 2001. During the early months of 2002, Andersen became the focal point of attention among law enforcement authorities searching for the parties responsible for Enron’s sudden collapse. The ac cusations directed at Andersen centered on three key issues. The first issue had to do with the scope of professional services that Andersen provided to Enron. Critics charged that the enormous consulting fees Enron paid Andersen impaired the audit firm’ s independence. The second issue stemmed from Andersen’s alleged role in Enron’s aggressive accounting and financial reporting treatments for its SPE -related transactions. Finally, the most embarrassing issue was the massive effort of Andersen’s Houston office to shred Enron audit documents, which eventually led to the demise of the firm. Enron Corporation --Key Facts 1. Throughout Arthur E. Andersen’s life, “Think Straight, talk straight” served as a guidi ng principle for himself and Arthur Andersen & Co., the accounting firm that he founded. 2. Arthur Andersen’s reputation for honesty and integrity resulted in Arthur Andersen & Co. gaining stature in the business community and growing into one of the n ation’s leading accounting firms by the time of his death in 1947. 3. Leonard Spacek succeeded Arthur Andersen as managing partner of Arthur Andersen & Co. in 1947 and continued Andersen’s legacy of lobbying for more rigorous accounting, auditing, and eth ical standards for the public accounting profession. 4. When Spacek retired in 1973, Arthur Andersen & Co. was one of the largest and, arguably, the most prominent accounting firm worldwide 5. The predecessor of Enron Corporation was an Omaha -based natur al gas company created in 1930; steady growth in profits and sales and numerous acquisitions allowed Enron to become the largest natural gas company in the United States by the mid -1980s. 6. During the 1990s, Kenneth Lay, Enron’s CEO, and his top subo rdinate, Jeffrey Skilling, transformed the company from a conventional natural gas supplier into an energy trading company. Case 1. 3 Just for Feet, Inc. 3 7. Lay and Skilling placed a heavy emphasis on “strong earnings performance” and on increasing Enron’s stature in the business wor ld. 8. Enron executives used hundreds of SPEs (special purpose entities) to arrange large and complex related party transactions that served to strengthen Enron’s reported financial condition and operating results. 9. During 2001, Enron’s financial condition deteriorated rapidly after many of the company’s SPE transactions unraveled; in December 2001, Enron filed for bankruptcy. 10. Following Enron’s collapse, the business press and other critics began searching for parties to hold responsible for what, at the time, was the nation’s largest corporate bankruptcy. 11. Criticism of Andersen’s role in the Enron debacle focused on three key issues: the large amount of consulting revenue the firm earned from Enron, the firm’s role in many of Enron’s SP E transactions, and the efforts of Andersen personnel to destroy Enron audit documents. 12. Andersen’s felony conviction in June 2002 effectively ended the firm’s long and proud history in the public accounting profession. Instructional Objectives 1. To provide students with a brief overview of the history and development of the public accounting profession in the United States. 2. To examine the “scope of services” issue, that is, the threats to auditor independence posed by audit firms providing consulting services to their audit clients. 3. To examine the extent to which independent auditors should be involved in their clients’ decisions regarding important accounting and financial reporting issues. 4. To review recent recommendations made to strengthen the independent audit function. Case 1. 3 Just for Feet, Inc. 4 5. To review auditors’ responsibilities regarding the preparation and retention of audit workpapers. Suggestions for Use I typically begin an auditing c ourse by discussing a major and widely publicized audit case. Clearly, the Enron case satisfies those criteria. The purpose of presenting such a case early in the semester is not only to acquaint students with the nature of auditing but also to make them aware of why the independent audit function is so important. Many accounting students are not well acquainted with the nature of the independent auditor's work environment, nor are they generally familiar with the critical role the independent audit funct ion plays in our national economy. Hopefully, cases such as this one provide students with a "reality jolt" that will stimulate their interest in auditing and, possibly, make them more inclined to pursue a career in the auditing field. The Enron case als o serves as a good starting point for an auditing course since it provides students with an overview of how the auditing profession developed and evolved in the United States over the past century. The vehicle used to present this overview is the history of Arthur Andersen & Co. You will find that the case attempts to contrast the “Think straight, talk straight” philosophy of Arthur E. Andersen, the founder of the Andersen firm, with the more business -oriented approach to auditing that his predecessors adopted in the latter decades of the twentieth century. Consider asking one or more of your students to interview former Andersen personnel who are graduates of your school. I have found that many former Andersen partners and employees are more than willing to discuss their former employer and the series of events that led to the firm’s sudden collapse. These individuals typically suggest that federal prosecutors’ efforts to “bring down” the entire Andersen firm as a result of the document -shredding inci dent was not only unnecessary but also inequitable, an argument that many members of the accounting profession —including academics —find difficult to refute. Suggested Solutions to Case Questions 1. A large number of parties b ore some degree of respon sibility for the problems that the Enron fiasco ultimately posed for the public accounting profession and the independent audit function. The following bullet items identify several of these parties [see bold -facing] and the role they played in the Enron drama. The leadership of the Andersen firm that allegedly focused too much attention on practice development activities at the expense of the public service ideal embraced by Arthur E. Andersen and other early leaders of the profession. Impertinen t corporate executives who insisted on aggressive, if not illegal, accounting and financial reporting treatments. Case 1. 3 Just for Feet, Inc. 5 Individual auditors who made shortsighted and/or unprofessional decisions that tainted the perceived integrity of all auditors. Regulat ory authorities that failed to take proactive measures to limit the ability of rogue corporate executives, accountants, and auditors to circumvent their professional responsibilities. 2. One approach to answering this question is to review with your stu dents the eight specific types of non-audit services that the Sarbanes -Oxley Act of 2002 prohib ited auditors of public companies from providing to their clients. Listed next are those eight non -audit services. Bookkeeping or other services related to the accounting records or financial statements of the audit client Financial information systems design and implementation Appraisal or valuation services, fairness opinions, or contribution -in-kind reports Actuarial services Internal audit outs ourcing services Management functions or human resources functions Broker or dealer, investment adviser, or investment banking services Legal services and expert services unrelated to the audit Many of these services would eventually place auditors in situations in which they had to effectively audit their own work. For example, auditors providing “financial information systems design services” could be forced to evaluate the integrity of an accounting system they had designed for an audit client. Likewise, p roviding “human resources” functions, such as executive search services, to audit clients could threaten auditors’ independence by causing them to evaluate the work product of high -ranking client employees who they had recommended that a client hire. 3. Given the assumption that the Powers Report excerpts included in Exhibit 3 are accurate, one could plausibly argue that Andersen ’s involvement in Enron’s accounting and financial reporting decisions violated several of the ten generally accepted auditing standards that were in effect at the time. Th e specific standards violated would have included , at a minimum, those involving, independence, due professional care, planning and supervision, audit evidence, and audit reporting. Each of the latte r standards are now integrated into the PCAOB’s auditing standards. Next, I list these standards, indicating Case 1. 3 Just for Feet, Inc. 6 parenthetically where they can be found in the PCAOB’s auditing standards, and then briefly review how each was likely or possibly violated by the Andersen auditors. Independence ( AS 1005 ): by becoming too involved in Enron’s decisions for important accounting and financial reporting treatments, the Andersen auditors may have forfeited some degree of objectivity when they reviewed those decision s during the course of subsequent audits. Due professional care (AS 1015) : any violation of another auditing standard, by definition, results in a violation of this broad -brush standard. Planning (AS 2101) and supervision (AS 1201) : a reliable qualit y control function, including proper audit planning decisions and effective supervision/review during an audit, should result in the identification of problematic situations in which auditors have become too involved in client accounting and financial rep orting decisions. Audit evidence (AS 1105): m any critics suggest that Andersen’s deep involvement in Enron’s aggressive accounting and financial reporting treatments may have precluded the firm from collecting sufficient appropriate evidence to support the audit opinions issued on the company’s financial statements (that is, the Andersen auditors may have been less than objective in reviewing/corroborating the client’s aggressive accounting and financial reporting treatments). Reporting ( AS 3101 ): If Andersen did not maintain its independence and objectivity while auditing Enron, the audit firm should have issued a disclaimer of opinion on the company’s periodic financial statements. 4. Note: The PCAOB has established the documentation requirements f or the audits of publicly owned companies in AS 1215, “Audit Documentation.” The documentation requirements that pertain to audits of other organizations can be found in AU-C Section 230, “Audit Documentation ,” of the AICPA Professional Standards. AU-C Section 230: Paragraph .0 8 of AU -C Section 230 provides the following general guidance to independent auditors regarding audit workpapers or “audit documentation.” “The auditor should prepare audit documentation that is sufficient to enable an experien ced auditor, having no previous connection with the audit, to understand a. the nature, timing and extent of the audit procedures performed to comply with GAAS and applicable legal and regulatory requirements; b. the results of the audit procedures performed, and the audit evidence obtained; and Case 1. 3 Just for Feet, Inc. 7 c. significant findings or issues arising during the audit, the conclusions reached thereon, and significant professional judgments made in reaching those conclusions.” Paragraph s 15-19 of AU -C Section 230 discuss the “assembly” and “retention” of audit workpapers. For example, paragraph 17 notes that the “retention period ” for audit documentation “should not be shorter than five years from the report release date.” AS 1215 : This standard defines aud it documentation as “the written record of the basis for the auditor’s conclusions that provides the support for the auditor’s representations, whether those representations are contained in the auditor’s report or otherwise” (para. .02). “Examples of aud it documentation include memoranda, confirmations, correspondence, schedules, audit programs, and letters of representation. Audit documentation may be in the form of paper, electronic files, or other media” (para. .04). AS 1215 notes that there are thre e key objectives of audit documentation: “demonstrate that the engagement complied with the standards of the PCAOB, support the basis for the auditor’s conclusions concerning every major relevant financial statement assertion, and demonstrate that the und erlying accounting records agreed or reconciled with the financial statements” (para. .05). Similar to AU -C Section 230, AS 1215 establishes an explicit benchmark that auditors can use to determine whether audit documentation is “sufficient.” “Audit do cumentation must contain sufficient information to enable an experienced auditor, having no previous connection with the engagement: a) to understand the nature, timing, extent, and results of the procedures performed, evidence obtained, and conclusions r eached, and b) to determine who performed the work and the date such work was completed as well as the person who reviewed the work and the date of such review” (para. .06). AS 1215 generally requires auditors to retain audit documentation for seven year s from the date the auditor gave the client permission to use the relevant audit report in connection with the issuance of a set of financial statements . Regardless of whether an audit client is a publicly owned company or another type of organization, the audit workpapers are the property of the audit firm. 5. During and following the Enron debacle, wide -ranging recommendations were made by many parties to strengthen the independent audit function. Listed next are several of these recommendations, incl uding certain measures that were incorporated in the Sarbanes -Oxley Act of 2002. Establish an independent audit agency. Some critics have suggested that to “cure” the paradoxical nature of the auditor -client relationship (that is, to eliminate the eco nomic leverage that clients have on their auditors), the independent audit function should be performed by a government agency comparable to the Internal Revenue Service. Permit audit firms to provide only audit, reviews, compilations, and other “pu re” attestation services to their clients, that is, prohibit the provision of all non -audit services to audit clients. (As mentioned in the suggested solution to Question 2, Sarbanes -Oxley prohibits audit firms from providing eight specific consulting services to their audit clients.) Case 1. 3 Just for Feet, Inc. 8 Require that audit clients periodically rotate or change their independent audit firms. (Sarbanes -Oxley requires that engagement and review partners be rotated every five years on audit engagements involving public companies.) Establish an independent board to oversee the audits of public companies. (Sarbanes -Oxley resulted in the creation of the Public Company Accounting Oversight Board “to oversee the audit of public companies that are subject to the securit ies laws . . .”) Require independent auditors to work more closely with their clients’ audit committees. (Section 204 of Sarbanes -Oxley is entitled “Auditor Reports to Audit Committees” and delineates the information that auditors should exchange wi th a client’s audit committee, including any alternative accounting treatments “preferred” by the auditors.) Establish more explicit statutory requirements that prohibit client executives from interfering with the work of their independent auditors. ( Section 303 of Sarbanes -Oxley is entitled “Improper Influence on Conduct of Audits.” This section of the federal law makes it unlawful for corporate executives “to fraudulently influence, coerce, manipulate, or mislead” their company’s independent audi tors.”) 6. Many critics of our profession suggest that beginning in the latter part of the twentieth century certain accounting firms gradually turned away from the public service ideal embraced by Arthur E. Andersen and other early pioneers within the p rofession and, instead, adopted a somewhat mercenary attitude toward the independent audit function. A key factor that certainly accelerated this trend was the profession’s decision in the 1970s, with the goading of the Federal Trade Commission and the co urts, to drop bans on competitive bidding, client solicitation, and other ethical rules that effectively restrained competition among audit firms. The elimination of those rules enticed audit firms to begin competing against each other for the finite numb er of large corporate audits. Practices such as “lowballing” to gain such clients allegedly resulted in audit firms “cutting corners” on audits. Likewise, audit firms began vigorously marketing non -audit services to supplement their suddenly low -margin au dit services. A related factor that allegedly contributed to the move away from the public service ideal was the growing tendency for large audit firms to consider marketing skills, as opposed to technical skills, as the key criterion in determining whi ch individuals would be promoted to partner. Finally, pure and simple greed is a factor that motivates most of us. The large and lucrative market for business consulting services over the past few decades may have enticed audit firms to focus more on beco ming “strategic business advisers” to their clients rather than placing an unrelenting emphasis on the quality of their audits of those clients’ financial statements. 7. In the spring of 2000, the SEC began requiring public companies to have their qua rterly financial reports (typically included in Form 10 -Q filings) reviewed by their independent auditors. Should quarterly reports be audited? In fact, many parties have advocated an even more extreme measure, namely, that independent auditors continua lly monitor and report on the integrity of their clients’ financial disclosures. In the current environment when information is distributed so readily and widely to millions of investors and other decision makers, the validity or utility of independent au dits that focus on discrete time periods has been challenged. As recent history has proven, by the time that auditors issue their reports on a client’s financial statements for some discrete period, the “horse may already be out of the barn” —the “horse” i n this case being the damage to investors and other parties resulting from oversights and other misrepresentations in the given financial statements. This problem Case 1. 3 Just for Feet, Inc. 9 could be cured, or, at least, mitigated to some extent, by requiring auditors to provide real -time disclosures of potential problems in their clients’ financial records. CASE 1.2 LEHMAN BROTHERS HOLDINGS INC. Synopsis Wall Street was stunned in September 2008 when this iconic investment banking firm filed for bankruptcy. Two years later, there was a similar reaction within the invest ment community when Lehman’s court -appointed bankruptcy examiner released his 2200 -page rep ort, the purpose of which was to identify the parties that could possibly be held civilly liable for the enormous losses suffered by Lehman’s investors and creditors. The focus of th e bankruptcy examiner’s report was hundreds of billions of dollars of a llegedly “accounting -motivated” transactions that Lehman had used to enhance its apparent financial condition. Lehman’s Repo 105s were short -term repurchase agreements that the company had chosen to record as “true sales” of securities under the auspices of the relevant accounting standard , namely, SFAS No. 140 . The normal accounting treatment for repos is for the “seller” to record them as short -term loans. Why? Because most repos are , in substance, short -term loans in which the securities being “sold” are, in reality, simply the collateral for the given loan. An exception to SFAS No. 140 permit s repo borrowers (sellers) to record these transactions as true sales of securities if they c an demonstrate that they ha ve “surrendered” control of the secu rities involved in the transactions . Lehman ’s management used this “loophole” in SFAS No. 140 to significantly reduce its “net leverage ratio” and its reported liabilities by engaging in a huge volume of Repo 105 transactions . Case 1. 3 Just for Feet, Inc. 10 At the time, the most impor tant metric that analysts used in monitoring the financial health of large investment banks was their degree of financial leverage —Lehman touted its net leverage ratio as the best measure of its financial leverage. This case provides a brief historical overview of Lehman Brothers and then dissects the accounting and financial reporting issues related to the company’s controversial use of Repo 105s. Of course, the principal purpose of this case is to examine the auditing issues raised by the Lehman deba cle. The company’s audit firm, Ernst & Young, was among the parties most criticized by Lehman’s bankruptcy examiner. The bankruptcy examiner identified three “colorable claims” involving professional malpractice or negligence that could potentially be pu rsued in lawsuits filed against Ernst & Young. This case examines the auditing issues embedded in each of those claims. Lehman Broth ers Holdings, Inc. --Key Facts 1. Lehman Brothers, one of Wall Street’s most prominent investment banking firms, became the largest corporate failure in U.S. history when it filed for bankruptcy in September 2008. 2. The release in March 2010 of a report by Lehman’s court -appointed bankruptcy examiner prompted a public outcry when it revealed that Lehman had used multi -billion dollar “accounting -motivated” transactions to embellish its apparent financial condition during 2007 and 2008. 3. Similar to other investment banks, a key business risk factor for Lehman was the high degree of financial leverage that it employed; Lehman management persuaded financial analysts and other third parties that its “net leverage ratio” was the best measure of its degr ee of financial leverage. 4. The business risk faced by Lehman and the other major investm ent banks was amplified duringt the 1990s and beyond when they became heavily involved in the rapidly evolving and high -risk financial derivatives markets. 5. When housing prices began plummeting in the U.S. in 2007, Lehman’s financial condition worsened dramatically since it had large investments in RMBS (residential mortgage -backed securities). Case 1. 3 Just for Feet, Inc. 11 6. To enhance its reported financial condition and its net leverage r atio, Lehman developed a plan to engag e in a large volume of Repo 105 s, which were rep urchase agreements accounted for as sales of securities (the customary accounting treatment for repos was to record them as short -term loans). 7. Accounting for repos a s sales of securities was permitted under certain restrictive conditions identified by the relevant accounting standard, SFAS No. 140 ; however, Lehman could not find a U.S. law firm that would issue an opinion confirming that Repo 105s could be treated as sales. 8. Lehman executed the Repo 105s in Great Britain after finding a British law firm that would issue an opinion that the y qualified as sales of securities; the Repo 105s allowed Lehman to reduce its net leverage ratio by as much as 10 percent and i ts reported liabilities by as much as $50 billion. 9. Among the parties that were most heavily criticized by Lehman’s bankruptcy examiner in his report was the company’s audit firm, Ernst & Young. 10. The bankruptcy examiner concluded that E&Y could po tentially be held liable for failing to properly investigate a whisteblower’s allegations that Lehman’s financial statements were materially misstated and for allegedly failing to properly investigate the impact of Repo 105s on Lehman’s quarterly and annua l financial statements. 11. Numerous lawsuits stemming from Lehman’s collapse named E&Y as a defendant or co -defendant ; to date, E&Y has made more than $100 million in payments to settle such lawsuits . Instructional Objectives 1. To examine the respon sibility of auditors when a client implements a new and controversial accounting policy that has significant financial statement implications. 2. To examine the responsibilit y of auditors when clients have engaged in significant “accounting - motivated” t ransactions. Case 1. 3 Just for Feet, Inc. 12 3. To identify auditors’ responsibility to review or otherwise evaluate important “other information” that accompanies a client’s audited financial statements. 4. To identify factors that should influence key materiality decisions made by auditors. 5. To identify the responsibilities of auditors when the integrity of a client’s financial statements is challenged by a whistleblower. 6. To examine auditors’ differing legal exposure in lawsuits filed in state courts versus federal courts. Suggestions for Use Here’s another case that you could use as a launching pad for an undergraduate or graduate auditing course. This case will readily demonstrate to your students the huge ch allenges that auditors can face in carrying out their responsibilities and the critical importance of independent audits for not only individual companies but the national economy as well. Ernst & Young’s audits of Lehman Brothers literally had economic implications for practically every U.S. citizen. In sum, I believe a case such as this can be used as an “attention grabber” for auditing students by conveying to them the importance of the professional responsibilities that they will soon be assuming. The focal point of this case involves a critically important issue for accountants and auditors alike, namely, the bottom line objective of accounting and financial reporting standards. Lehman Brothers engaged in hundreds of billions of dollars of complex transactions that apparently had no express business purpose. Instead, the transactions were used ostensibly to window dress the company’s financial statements, that is, to improve Lehman’s critical net leverage ratio at a point in time when the company was literally coming apart at the seams . Although there is still some disagreement on this matter, there seems to be a general consensus that the “ accounting loophole” that Lehman used to “pull off” this accounting charade was “legal” or permissible under SFAS No. 140 , which was the relevant accounting standard. In fact, I tell my students to make that assumption prior to addressing the following question, which I use to kickoff the discussion of this case: Is it permissible for reporting entities to use a ccounting standards to intentionally misrepresent their financial statements? It is surprising to me that there is not complete consensus within the profession or even among academics within our profession on th is issue — as pointed out in the case. As a poi nt of information, I have found that the majority of my students typically express the view that entities should be allowed to apply a given accounting or financial reporting rule even if their express intent is to use that rule to embellish their apparent financial condition and/or operating results. Case 1. 3 Just for Feet, Inc. 13 You may want to point out to your students that U.S. accounting standards do not currently include a rule equivalent to the “true and fair override” rule embedded in IFRS —that rule requires reporting entities to not apply a n accounting standard if it would result in the given financial statements being misleading . However, the AICPA Code o f Professional Conduct , “Accounting Principles,” effectively includes such an “override” rule —see “Accounting Principles R ule,” ET 1.320.001. Suggested Solutions to Case Questions 1. No, auditors do not have an explicit responsibility to be involved in an audit client’s process of developing new accounting policies. In the PCAOB’s auditing standards, AS 1001.03 notes tha t “The financial statements are management’s responsibility . . . [and] that management is responsible for adopting sound accounting policies. . .” AS 2110.07 requires auditors to obtain an understanding of “the company’s selection and application of acco unting principles .” AU-C 315.12 of the AICPA Professional Standards observes that “The auditor should obtain an understanding of the . . . entity’s selection and application of accounting policies, including the reasons for changes thereto. ” In addition to obtaining an understanding of a client’s accounting policies, auditors should consider whether each accounting policy is “appropriate” as noted by AS 2110.12 and AU-C 315.12 . Recognize that a uditors’ need to obtain an understanding of a given accoun ting policy is enhanced when the policy involves “unusual ” transactions or when a “significant ” accounting policy involves “controversial” or “emerging ” areas for which there is a lack of authoritative guidance or consensus [see AS 2110.13 ]. These circums tances certainly seem to apply to the situation that existed when Lehman was developing its Repo 105 accounting policy. 2. Again, for me, this question or issue is the focal point of the case —from both an accounting/financial reporting point of view and from an auditing perspective . In my view, the economic reality of a given transaction should be reflected in the accounting treatment applied to it. That is, I believe that “intent does matter” and that the underlying intent of the accounting treatme nt applied to a given transaction should be to ensure that the economic substance of the transaction is properly reflected in the given entity’s financial statements and accompanying notes. The principal conceptual basis for the argument outlined in the p revious paragraph is the FASB’s conceptual framework, that is, the Statement of Financial Accounting Concepts, in particular, SFAC No. 8, “Conceptual Framework for Financial Reporting.” For example, SFAC No. 8 notes that “ To be useful, financial informati on not only must represent relevant phenomena, but it also must faithfully represent the phenomena that it purports to represent. To be a perfectly faithful representation, a depiction would have three characteristics. It would be complete, neutral, and free from bias.” [QC12] Of course, as pointed out by E&Y’s legal counsel in lawsuits filed against the firm, the conceptual framework is not considered a component of GAAP. So, a violation of the “ faithful representation” requirement is technically not c onsidered a GAAP violation. [Note: SFAC No. 8 was issued in Case 1. 3 Just for Feet, Inc. 14 September 20 10. SFAC No. 8 replaced SFAC No. 2 which included a discussion of “representational faithfulness” that paralleled the “faithful representation” concept presented in SFAC No. 8 .] 3. Recall that the SEC has specifically defined “accounting -motivated structured transactions” as follows: ‘Accounting -motivated structured transactions ’ are ‘transactions that are structured in an attempt to achieve reporting results that are not consis tent with the economics of the transaction, and thereby impair the transparency of financial reports. ’ [Attempts] to portray the transactions differently from their substance do not operate in the interests of investors, and may be in violation of the se curities laws. Auditors have an explicit responsibility to investigate whether the key management assertions underlying a given account balance, transaction, or financial disclosure is consistent with the presentation of that item in the relevant f inancial statements. By definition, accounting -motivated transactions would almost definitely violate one or more of those management assertions. For example, the classification assertion mandates that transactions and events be recorded in the proper acc ounts. You can imagine that a large proportion of accounting -motivated transactions would result in violations of the classification assertion. So, my answer to this case question would be that auditors do have a responsibility to investigate wheth er client transactions are accounting -motivated. However, that responsibility is simply a by - product of applying an assertion -based audit strategy. 4. There was not a specific auditing standard that mandated that Schlich or one of his subordinates review the legal opinion issued by the British law firm. Having said that, given the critical importance of the Repo 105 transactions to Lehman’s financial statements, it certainly seems that doing so would have been a “good idea.” Reviewing that legal opin ion would certainly have provided Ernst & Young with an enhanced “understanding” of the Repo 105 transactions [see answer to Question No. 1]. Granted, this observation is being made ex post. Recognize that Lehman developed the Repo 105 accounting policy shortly after SFAS No. 140 was adopted in 2000. The company didn’t begin engaging in a large volume of the Repo 105 transactions until several years later. So, even though it may not have seemed imperative for Ernst & Young to have reviewed the Linklater s’ legal opinion when it was originally issued, years later when the volume of the Repo 105s increased dramatically, it seems reasonable to suggest that Ernst & Young should have at least considered reviewing that document. On a large engagement involving multiple practice offices of an accounting firm, the engagement audit partner has the responsibility for overseeing the division of responsibilities on that engagement. In Case 1. 3 Just for Feet, Inc. 15 this case, that individual would have been William Schlich. Of course, on a large audit the engagement partner may delegate that administrative task to a subordinate. Nevertheless, the key point here is that the ultimate responsibility for administering the 2007 Lehman audit, including the allocation of the specific audit procedures t o the practice offices involved in that audit, apparently rested with Schlich. Note s: AU-C 600, “Special Considerations —Audits of Group Financial Statements (Including the Work of Component Auditors)” is relevant for audits of non -public companies. That relatively new auditing standard discusses the division of responsibilities on audits of “group financial statements,” including the overarching responsibilities of the “group engagement partner.” In the PCAOB’s auditing standards, AS 1205, “Part of the Audit Performed by Other Independent Auditors,” addresses circumstances in which multiple accounting firms are involved in an audit of an SEC registrant. AI 10 of the PCAOB’s auditing standards includes “Interpretations” of AS 1205. 5. The relevant secti on of the PCAOB’s auditing s tandards in this context is A S 2710 , “Other Information in Documents Containing Audited Financial Statements.” AS 2710.04 : “Other information in a document may be relevant to an audit performed by an independent auditor or t o the continuing propriety of his report. The auditor’s responsibility with respect to information in a document does not extend beyond the financial information identified in his report, and the auditor has no obligation to perform any procedures to corr oborate other information contained in a document. However, he should read the other information and consider whether such information, or the manner of its presentation, is materially inconsistent with information, or the manner of its presentation, appe aring in the financial statements. If the auditor concludes that there is a material inconsistency, he should determine whether the financial statements, his report, or both require revision.” AS 2710 goes on to discuss additional responsibilities that auditors have for “other information.” For example, paragraph .05 discusses an auditor’s responsibility when he or she discovers a “material misstatement” in “other information.” In the AICPA Professional Standards, AU -C Section 720, “Other Informatio n in Documents Containing Audited Financial Statements,” would be relevant to this question in the context of audits of entities other than public companies. AU -C Section 720 imposes responsibilities on auditors that are very similar to those included in AS 2710 . 6. Since there isn’t a “definitive” answer to this question, one objective you may want to accomplish in addressing it is to acquaint your students with the principal materiality “rules” or guidelines in the technical literature. Following are multiple viewpoints on materiality . NOTE: SFAC No. 2 was in effect when the key events in the Lehman case transpired. Included below is the FASB’s reference to materiality in SFAC No. 2 and in SFAC No. 8 , which superseded SFAC No. 2 . Finally, recognize that in early 2016, the FASB indicated that it might shift to a more legalistic definition