Contemporary Auditing, 9th Edition solutions manual by Michael C. Knapp

Contemporary Auditing, 9th Edition solutions manual by Michael C. Knapp 

 

CASE 1.10

GEMSTAR-TV GUIDE INTERNATIONAL, INC.

Synopsis

Born in war-torn China in 1948, Henry Yuen, known then as Che-Chuen, was forced to flee that country with his family. After Communist forces took over China, large numbers of supposed counter-revolutionaries were banished from the country, including Henry’s father who moved his family and their few belongings to Hong Kong. Nearly five decades later, Henry Yuen found himself listed in the Forbes 400 with an estimated net worth exceeding one billion dollars.

After immigrating to the United States, the low-key and studious Yuen earned a doctorate in mathematics as well as a law degree. At the age of forty, Yuen and a close friend teamed together to develop a simplified method for programming VCRs. That simple technology would eventually result in U.S. News and World Report labeling Yuen the “Bill Gates of television.” The company co-founded by Yuen, Gemstar, acquired almost one hundred patents that allowed it to control electronic programming and search technologies that are vital to companies in many industries. In 2000, Yuen acquired TV Guide International and renamed his company Gemstar-TV Guide International, Inc. (GTGI).

Yuen and many other industry insiders expected that interactive TV would be the wave of the future in the television industry. Since electronic programming technology would be indispensable to creating interactive TV services, many securities analysts believed that GTGI would rack up huge profits as those services proliferated. Unfortunately for Yuen, to date interactive TV has been a bust.

To conceal the discouraging financial performance of GTGI’s over-hyped “Interactive Platform” division, Yuen and his key subordinates used a variety of methods to inflate that division’s operating results. Most of these methods involved fairly mundane accounting gimmicks designed to overstate the IP division’s revenues.

KPMG audited GTGI’s financial statements and, as a result, was caught up in the accounting fraud perpetrated by the company’s management team. The SEC berated KPMG for its deficient audits of GTGI and for its failure to uncover the generally less-than-clever methods used to distort the company’s operating results. The SEC’s investigation revealed that KPMG auditors often relied on management representations to support questionable revenue amounts when other, much more reliable evidence was available. Four KPMG auditors—three partners and one manager—were sanctioned for their role in the “repeated audit failures” of GTGI. KPMG, as a firm, was slapped with a $10 million fine.

73

Gemstar-TV Guide International, Inc. -- Key Facts

1. In 1988, Henry Yuen and a close friend developed VCR Plus, a new technology for programming VCRs; this technology would become the flagship product of Gemstar Development Corporation, a company that the two friends created.

2. During the late 1990s, Gemstar acquired nearly 100 patents; these patents allowed the company to exercise effective control over programming and search technologies that are vital to most companies in the electronic communications and broadcasting industries.

3. In 2000, Gemstar acquired TV Guide International, creating GTGI (Gemstar-TV Guide International); Yuen and media magnate Rupert Murdoch, who had previously been a major stockholder of TV Guide, were the two largest stockholders of GTGI.

4. Yuen, GTGI’s CEO, focused his energies on promoting the company’s new Interactive Platform (IP) Sector that marketed EPG (electronic programming guide) technologies while paying little attention to the company’s largest operating unit, the Media and Services Sector.

5. Murdoch, who was the leader of the GTGI faction made up of former TV Guide executives, believed that Yuen’s focus on the unproven EPG services was misguided since the company’s Media and Services Sector produced the bulk of the company’s revenues.

6. Shortly after the 2000 merger that created GTGI, Yuen and several of his subordinates began using a variety of accounting gimmicks to enhance the operating results of the IP Sector, including diverting revenues to that sector from the Media and Services Sector.

7. After GTGI’s accounting fraud was uncovered by the SEC, the company was forced to restate its prior financial statements.

8. In addition to Yuen and several of his top subordinates, the SEC maintained that KPMG bore some degree of responsibility for GTGI’s fraudulent financial statements.

9. The SEC charged that KPMG was guilty of “repeated audit failures” during its GTGI audits.

10. Specifically, the SEC charged that GTGI’s KPMG auditors had failed to uncover abusive revenue recognition policies used by the client, had failed to consider key qualitative issues in making materiality decisions, and that the audit firm’s “consultation” policy was inadequate.

11. The SEC fined KPMG $10 million for its role in the GTGI debacle and suspended three audit partners and an audit manager who had been assigned to the GTGI audits.

12. To date, Yuen has been convicted of obstruction of justice and has had a $22 million civil judgment imposed on him for his role in the GTGI scandal.

Instructional Objectives

1. To examine the principal concepts and guidelines that should be followed in making revenue recognition decisions.

2. To identify fraudulent methods commonly used to overstate revenues.

3. To demonstrate the importance of considering qualitative and quantitative factors in making materiality decisions.

4. To identify quality control mechanisms for independent audits.

5. To illustrate the limitations of client representations as audit evidence.

Suggestions for Use

This is a case that revolves around a small sliver of everyday life in American culture, namely, the ubiquitous television scroll that many of us check numerous times per day to find a flick, sporting event, or random television program to while away a few mindless minutes . . . or hours. Although a nominal aspect of the case, that fact does seem to prompt students’ interest in the case. The major technical topic in this case is revenue recognition. The variety of abusive recognition revenue gimmicks used by GTGI provides you an opportunity to comprehensively discuss that topic and examine audit evidence issues relevant to revenue.

Each semester in my graduate auditing seminar I engage my students in a (hopefully) rigorous discussion of the meaning of the phrase “audit failure.” The SEC charged the GTGI auditors with “repeated audit failures” so this case provides you an opportunity to explore exactly what that term means to your students—of course, “audit failure” is not explicitly defined in the technical literature. Some students will argue that anytime that an inappropriate audit opinion is issued, an audit failure has occurred. Other students typically define an audit failure as the lack of compliance with GAAS. Dissecting those two alternative definitions of “audit failure” will provide you an opportunity to tie in related issues or topics such as auditor negligence, detection risk, and audit risk.

Suggested Solutions to Case Questions

1. We are all familiar with the basic revenue recognition rule: revenue should generally be recognized when it is realized or realizable and when it is earned. Although seemingly simple, that rule can be difficult to apply, particularly in rapidly evolving high-tech industries. Revenue recognition within the software industry has been a complex and controversial issue since the inception of that industry during the latter part of the twentieth century. The FASB addressed that issue at length in Statement of Position 97-2 (pre-codification GAAP), which was released in October 1997. A more general discussion of revenue recognition can be found in the SEC’s Staff Accounting Bulletin No. 101 that was issued in December 1999.

SOP 97-2 identified four conditions that must be met to recognize revenue on the sale of software and related “arrangements,” which would include the licensing of technology:

Persuasive evidence exists of an arrangement: In most cases, such evidence will be provided by a written contract between the software vendor and customer.

Delivery has occurred: Since software may be delivered electronically, SOP 97-2 provides guidance on when this criterion is met. For example, if a customer has been provided access codes to download the given software off the Internet, then delivery is generally assumed to have occurred (whether or not the download has actually taken place).

The vendor’s fee is fixed or determinable: Again, SOP 97-2 provides interpretive guidance for this revenue recognition criterion. For example, the vendor’s fee is not considered to be fixed or determinable if the total revenue from the sale of the software will be a function of the number of copies of that software ultimately distributed to the buyer. Likewise, if the buyer has a right to return the software, then before revenue can be recognized on the sale of the software there must be a means to reasonably estimate the expected sales returns.

Collectibility is probable: The term “probable” in this context has the same meaning as in SFAS No. 5, Accounting for Contingencies. That pre-codification standard equates “probable” with “likely to occur.”

In addition to these specific rules, the broad conceptual guidelines of accounting can be and should be applied in determining when to record revenue for software sales or for the licensing of software or technology. “Conservatism” is clearly among the most applicable accounting concepts in this context. If there is significant doubt that revenue has been realized or earned, then that revenue should likely be deferred. Another critical concept in this context is “representational faithfulness,” that is, does the accounting for a given transaction “square up” with what really happened or took place. Too often, software companies have manufactured elaborate scenarios to justify the recording of revenue. Accountants and auditors should be extremely leery when the circumstances surrounding a given software sale appear to be overly contrived.

A final important point here is that SOP 97-2 indicates that in certain cases, particularly when software licensing is involved, a sale of software may be analogous to a long-term construction contract. That is, the given software may be subject to required modification or customization over the entire licensing period. In such cases, the revenue should be recognized similarly to revenue under long-term construction contracts.

2. If you study a sample of audit failures or breakdowns, I believe you will find that a fairly small set of factors or circumstances are responsible for most deficient audits. The following list is not intended to be comprehensive, but, nevertheless, I believe that these items are easily among the most common antecedents to audit failures. [As a sidebar: students are better equipped to address this question if they have already studied several problem audits. If your students have studied several such audits, then you might require them to defend the items they list with references to specific cases in which those factors were present. If your students have not studied several problem audits, consider focusing this question on the Gemstar case alone. That is, instruct your students to identify the key factors that contributed to the deficient audits of GTGI.]

--An aggressive client management team that is committed to fulfilling their company’s revenue and

profit forecasts.

--A client that is experiencing declining profitability or recurring losses.

--A client that needs to raise additional debt or equity capital.

--Highly competitive conditions in a client’s market.

--A client that has engaged in a series of large and unusual transactions, particularly near the end of a

financial reporting period.

--Weak internal controls that can be easily overridden by client personnel.

--An audit engagement team that lacks the proper degree of professional skepticism.

--One or more members of the audit engagement team lack the proper training to carry out their

assigned responsibilities and/or are not supervised properly by their superiors.

--Lack of a proper degree of auditor independence. This condition is likely a product of other

factors, such as the existence of a high profile client that the audit firm is intent on retaining. (Before the passage of the Sarbanes-Oxley Act, a common precursor to audit failures for

large public companies was the provision of a large amount of non-audit services by the given

company’s audit firm.)

You may have recognized the first several items on this list as “fraud risk factors” discussed in the professional auditing standards. No doubt, when such factors are present, the likelihood of an audit failure or breakdown increases significantly. The final three items relate to auditors themselves. Audit failures are much more likely when members of the audit engagement team lack a proper degree of professional skepticism, competence (or adequate familiarity with the client’s business and industry), or independence. When the two sets of “audit failure” factors intersect, then the risk of a defective audit soars.

Hopefully students recognize that the “quality control mechanisms” that are the most effective in preventing audit failures are the profession’s auditing standards and ethical mandates. In fact, the “ten commandments” of auditing, that is, the ten GAAS, are the principal guidelines established by the profession to prevent or, at least, minimize the likelihood of audit failures.

Consider asking your students to identify specific measures that audit firms and auditors can use to avoid audit failures. After listing these items on the blackboard or overhead, relate that list to GAAS. You will almost certainly find that each of the items listed in some way correlates with one or more of the individual GAAS. For example, one of your students will almost certain identify the workpaper review process as an example of an important audit quality control mechanism. Audit workpaper review relates directly to multiple GAAS, particularly the three field work standards.

3. Statement of Financial Accounting Concepts No. 2 (pre-codification GAAP) defines materiality as follows: “the magnitude of an omission or misstatement of accounting information that, in the light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.” The phrase “surrounding circumstances” ostensibly refers to key nonfinancial or qualitative factors in a given decision context involving materiality.

The SEC’s principal statement regarding materiality can be found in Staff Accounting Bulletin No. 99 issued in 1999. Here’s a key excerpt from SAB No. 99.

An assessment of materiality requires that one views the facts in the context of the “surrounding circumstances,” as the accounting literature puts it, or the “total mix” of information in the words of the Supreme Court. In the context of a misstatement of a financial statement item, while the “total mix” includes the size in numerical percentage terms of the misstatement, it also includes the factual context in which the user of the financial statements would view the financial statement item. The shorthand in the accounting and auditing literature for this analysis is that financial management and the auditor must consider both “quantitative” and “qualitative” factors in assessing an item’s materiality.

Finally, SAS No. 107, Audit Risk and Materiality in Conducting an Audit” notes that “the auditor’s consideration of materiality is a matter of professional judgment and is influenced by the auditor’s perception of the needs of financial statement users.” In terms of specific factors to consider in making materiality judgments, SAS No. 107 notes that auditors should consider, among other factors, the specific needs of the financial statement users that will be relying on the financial statements and the nature and causes of any apparent financial statement misstatements.

Despite the extent of technical literature that examines the materiality concept, making “good” materiality decisions is still more of an art than a science, to make use of a timeworn cliché. I would suggest, however, that auditors should place particular importance on qualitative issues when there appears to be a higher than normal risk of intentional misstatement. When fraud risk is elevated, auditors should recognize that the given financial data may have been sculpted to achieve a given purpose, one of which may be to mislead or deceive the auditors. In addition, during the final review of a client’s financial statement data, the audit review partner would be well served to place a particularly heavy emphasis on qualitative factors that may have been given short shrift by field work auditors who for expediency and efficiency purposes placed a disproportionate emphasis on quantitative materiality measures. (That is, field work auditors may be disinclined to take a “big picture view” of the client’s financial data when they are focusing exclusively on inventory, receivables, or some other financial statement line item that they have been assigned to audit.)

It seems reasonable to suggest that quantitative measures may be most useful to auditors when fraud risk is low. Likewise, quantitative measures are particularly appropriate when auditors are making “first pass” audit planning decisions to identify financial statement items that may demand more attention than others.

In any case, regardless of the auditing context, auditors should not focus exclusively on quantitative measures or qualitative factors in arriving at audit judgments. With experience, auditors hopefully gain the insight to ascertain what “mix” of the two materiality considerations are most important in each unique client situation.

4. No doubt, Yuen’s point of view is one that is shared by many businesspeople and professionals. An “anything goes if it is legal” mindset is certainly not consistent with the major ethical paradigms of which I am aware. Consider placing this general issue in a context that your students should be very familiar with. Are “earnings management” techniques or accounting gimmicks “ethical” as long as they are not specifically prohibited by accounting standards. For example, is it ethical for corporate management to defer year-end maintenance expenditures on production equipment so that the company will reach its predetermined earnings goal?

To address this question more directly, a reasonable starting point is to compare the definition of “legal” and “ethical.” My dictionary defines “legal” as something that is permitted by law, while “ethical” is defined as being in accordance with the rules or standards for right conduct or practice. Laws are intended to provide for, or, at least, contribute to, social order. As such, laws are not necessarily intended to define or enforce “right conduct.” A brief review of U.S. history will identify many instances of laws that were clearly intended for some other purpose other than to enforce “right conduct” on the part of U.S. citizens.

I would suggest that even today practically every U.S. citizen if asked would identify at least one law that they believe to be “unethical.” In fact, if you want to prompt a lively discussion among your students, ask them to identify a law that they consider to be unethical—instruct them to be ready to defend that choice. Or, if you want, start with an example of your own drawn from the accounting and financial reporting domain, namely, the Foreign Corrupt Practices Act of 1977. That law specifically prohibits U.S. companies from paying bribes to officials of foreign governments to establish business relationships. Although most U.S. citizens may believe that law enforces “right conduct,” certainly a large number of businesspeople believe that it is unjust or unfair (unethical?) to hold U.S. companies to higher standards of moral conduct than many of their foreign competitors.

Several years ago, an empirical study reported in the California Management Review compared and contrasted U.S. and Russian business ethics. That study found that whistleblowing is generally, but not always, considered ethical in the U.S., while that practice is generally, but not always, considered unethical in Russia. Likewise, a large disparity in salaries within corporations (from low-level employees to top corporate executives) was considered ethical by a majority of U.S. businesspeople, while a majority of Russian businesspeople considered that phenomenon unethical. The point here is even if we all agreed that laws should be designed to provide for social order and to enforce “right conduct,” differences of opinion on what is considered proper or right conduct would make accomplishing that goal very difficult.

In summary, I would answer “no” to this question. Just because someone is complying with all applicable laws and regulations does not suggest, necessarily, that he or she is behaving ethically.

TABLE OF CONTENTS, 9^th Ed.

SECTION 1 Comprehensive Cases

1.1 ....................................................................................................................................... Enron Corporation 1

1.2 ....................................................................................................................................... Lehman Brothers Holdings Inc.. 9

1.3 ....................................................................................................................................... Just for FEET, Inc. 17

1.4 ....................................................................................................................................... Health Management, Inc. 27

1.5 ....................................................................................................................................... The Leslie Fay Companies 33

1.6 ....................................................................................................................................... NextCard, Inc.. 41

1.7 ....................................................................................................................................... Lincoln Savings and Loan Association 49

1.8 ....................................................................................................................................... Crazy Eddie, Inc. 57

1.9 ZZZZ Best Company, Inc. 66

1.10 Gemstar-TV Guide International, Inc.................................................................. 73

1.11 New Century Financial Corporation.................................................................... 80

1.12 Madoff Securities................................................................................................. 90

SECTION 2 Audits of High-Risk Accounts

2.1 Jack Greenberg, Inc.. 96

2.2 ....................................................................................................................................... Golden Bear Golf, Inc. 103

2.3 ....................................................................................................................................... Happiness Express, Inc. 109

2.4 ....................................................................................................................................... General Motors Company. 115

2.5 ....................................................................................................................................... Lipper Holdings, LLC. 120

2.6 ....................................................................................................................................... CBI Holding Company, Inc. 126

2.7 ....................................................................................................................................... Geo Securities, Inc. 131

2.8 ....................................................................................................................................... Belot Enterprises. 136

2.9 ....................................................................................................................................... Regina Company, Inc.. 142

SECTION 3 Internal Control Issues

3.1 ....................................................................................................................................... The Trolley Dodgers 151

3.2 ....................................................................................................................................... Howard Street Jewelers, Inc. 154

3.3 United Way of America 158

3.4 ....................................................................................................................................... First Keystone Bank. 163

3.5 ....................................................................................................................................... Goodner Brothers, Inc. 167

3.6 ....................................................................................................................................... Buranello’s Ristorante 173

3.7 ....................................................................................................................................... Foamex International Inc.. 179

iii

SECTION 4 Ethical Responsibilities of Accountants

4.1 ....................................................................................................................................... Creve Couer Pizza, Inc. 185

4.2 ....................................................................................................................................... F&C International, Inc. 189

4.3 ....................................................................................................................................... Suzette Washington, Accounting Major 194

4.4 Freescale Semiconductor, Inc. 198

4.5 ....................................................................................................................................... Wiley Jackson, Accounting Major 203

4.6 ....................................................................................................................................... Arvel Smart, Accounting Major 207

4.7 ....................................................................................................................................... David Quinn, Tax Accountant 210

SECTION 5 Ethical Responsibilities of Independent Auditors

5.1 ....................................................................................................................................... Cardillo Travel Systems, Inc. 214

5.2 ....................................................................................................................................... American International Group, Inc. 220

5.3 ....................................................................................................................................... The North Face, Inc. 224

5.4 ....................................................................................................................................... Waverly Holland, Audit Senior. 230

5.5 ....................................................................................................................................... Phillips Petroleum Company... 234

5.6 American Fuel & Supply Company, Inc. 238

SECTION 6 Professional Roles

6.1 ....................................................................................................................................... Leigh Ann Walker, Staff Accountant 242

6.2 ....................................................................................................................................... Bill DeBurger, In‑Charge Accountant 247

6.3 ....................................................................................................................................... Hamilton Wong, In-Charge Accountant 251

6.4 ....................................................................................................................................... Tommy O'Connell, Audit Senior 256

6.5 ....................................................................................................................................... Avis Love, Staff Accountant 261

6.6 Charles Tollison, Audit Manager................................................................... 267

SECTION 7 Professional Issues

7.1 Ligand Pharmaceuticals 271

7.2 ....................................................................................................................................... Sarah Russell, Staff Accountant 276

7.3 ....................................................................................................................................... Bud Carriker, Audit Senior 280

7.4 ....................................................................................................................................... Hopkins v. Price Waterhouse 284

7.5 ....................................................................................................................................... Fred Stern & Company, Inc. (Ultramares) 289

7.6 First Securities Company of Chicago (Hochfelder) 295

SECTION 8 International Cases

8.1 ....................................................................................................................................... Livent, Inc. 300

8.2 ....................................................................................................................................... Parmalat Finanziaria, S.p.A.. 307

8.3 ....................................................................................................................................... Kansayaku 315

8.4 ....................................................................................................................................... Registered Auditors, South Africa 320

8.5 ....................................................................................................................................... Zuan Yan 326

iv

8.6 ....................................................................................................................................... Kaset Thai Sugar Company 333

8.7 ....................................................................................................................................... Republic of Somalia 337

8.8 ....................................................................................................................................... OAO Gazprom 342

8.9 Societe Generale 349

8.10 Institute of Chartered Accountants of India 356

8.11 Republic of the Sudan 363

8.12 Shari’a 367

8.13 Mohamed Salem El-Hadad, Internal Auditor 372

8.14 Tae Kwang Vina 376

v