Auditor ZZZZ Best
What specific mistakes (apart from failure to notice “red flags”) did the auditor make? For each mistake, describe what the auditor should have done. If you were the Managing Partner for the CPA firm and had full knowledge of all the facts and events in the case, what changes in policy or procedures would you implement to make sure this audit failure does not occur in the future?
The first mistake that the auditors made involved Mr. George Greenspan during the 1986 audit. This was the first audit that ZZZZ Best had as a public company and the mistake involved the inspection of the insurance restoration sites. Mr. Greenspan had talked with Tom Padgett, and even though Mr. Padgett confirmed the insurance contracts were real and showed proper documents to back them up, Mr. Greenspan never actually inspected any of the actual insurance restoration sites. Had the sites been checked, Mr. Greenspan could have stopped the scam from ever hurting the public stockholders. After looking at this mistake, Greenspan should have made it a very high priority to inspect the insurance sites, especially because they amounted for such a huge percentage of income for ZZZZ Best.
The second mistake involved Ernst & Whinney, which was the auditor for ZZZZ Best after Greenspan was let go. During the interview between Greenspan and the congressional subcommittee, Greenspan reported that Ernst & Whinney never got in touch with him to talk about ZZZZ Best and to hear his side of the story as to the reason of ZZZZ Best letting him go. Had this conversation occurred, Greenspan might have been able to discuss his neglection to inspect the insurance restoration sites, which therefore could have given Ernst & Whinney a heads up to do so. Ernst & Whinney should have contacted Greenspan because it's a normal protocol to adhere to, and because it could have stopped the fraudulent acts of ZZZZ Best from getting out of hand.
The third mistake involved Ernst & Whinney while visiting one of the larger contract sites that ZZZZ Best had. Besides not noticing the “red flag” created when Mr. Minkow and his associates would continually discourage Ernst & Whinney to visit their sites, the biggest mistake was letting ZZZZ Best know when the inspection of their site was going to take place. By allowing ZZZZ Best to know when the inspection was taking place, Mr. Minkow was able to pull off a sting operation and fully trick Larry Gray, who was the engagement audit partner for ZZZZ Best. Ernst & Whinney should never have let Minkow and his associates know when the inspection of the sites was going to take place. If Minkow had never known when Gray was doing the inspection, there never would have been a sting operation and Gray would have caught the fraudulent activities very fast.
Another mistake made by Ernst & Whinney was signing a confidentiality agreement with ZZZZ Best's law firm. This agreement was signed before the inspection of the insurance site took place and therefore stopped Gray from making phone calls to the contractors involved on the site. This also stopped Gray from contacting the insurance companies and the building owner that was involved in the restoration sites. If this agreement had never been made, Ernst & Whinney could easily have found out about the fraudulent activities. Ernst & Whinney should never have signed such an agreement. Just being asked to sign such an agreement from ZZZZ Best should have been a huge “red flag” for fraudulent activities taking place.
Another mistake that Ernst & Whinney made was the amount of time it took them to file a letter that would be filed with ZZZZ Best's 8-K auditor change announcement. An 8-K is a report required to be filed by public companies with the United States Securities and Exchange Commission (SEC) pursuant to the Securities Exchange Act of 1934, as amended (Form 8-K). When ZZZZ Best reported their change in auditors, they did not mention the fraud allegations made by Ernst & Whinney in their 8-K. After ZZZZ Best filed their 8-K, Ernst & Whinney had thirty days to report their letter reacting to the accuracy and completeness of ZZZZ Best's 8-K. I found it to be very irresponsible and wrong for Ernst & Whinney to wait the full thirty days until providing their letter. Since they felt ZZZZ Best was involved in fraudulent activities and they knew that ZZZZ Best did not report that in their 8-K, Ernst & Whinney should have felt a moral responsibility to let the public know a lot sooner about the allegations made regarding fraudulent activities. In my opinion, Ernst & Whinney should have had their letter filed a lot faster than thirty days.
The last mistake Ernst & Whinney made was not disclosing to Price Waterhouse the actual reasons why they resigned as ZZZZ Best's auditor. They told Price Waterhouse that “they did not want to become associated with the financial statements,” but in reality, they left due to evidence that supported their allegations of fraud by ZZZZ Best.
After looking at this case, the ZZZZ Best Co. collapse was thought “to provide the most vivid proof that the present system for independent auditors reporting financial fraud did not work (Young). If I was the Managing Partner for the CPA firm, I would definitely make my auditors work harder and closer at their work and during inspections. After looking at this case, I would make a lot of changes. First of all, if my firm was about to become an auditor to a business that just had an auditor resign, I would be very cautious before accepting the business as a client for my firm. I would try my best to communicate with the previous auditor on the reasons of their resignation.
Second, I would never let my client know when my auditors or I were making inspections on their business sites. By letting the business know when the inspection is going to take place, they now have plenty of time to try and scam my firm, which is what Barry Minkow did to Ernst & Whinney.
I would never allow my firm to sign a confidentiality agreement with our client before inspecting one of their sites that produce a majority of their income. In my opinion, this sends a big “red flag” about their site. If they want to sign a confidentiality agreement before having my auditors inspect it, they are obviously hiding something and do not want the public stockholders to find out about it.
Another major change I would implement would involve how fast my firm discloses to the public about our previous client's fraudulent activities. Once the client files their 8-K, I would make sure that our firm files our letter that comments on their 8-K's accuracy and completeness very quickly. I would never wait the maximum allowed time, especially when feeling that they are involved in fraudulent activities.
"Form 8-K." Wikipedia: the Free Encyclopedia. 1 June 2008 <http://en.wikipedia.org/wiki/Form_8-K>.
Young, Joni. "Defining Auditors' Responsibilities." BNet.Com. Dec. 1997. Accounting Historians Journal. 2 June 2008 <http://findarticles.com/p/articles/mi_qa3657/is_199712/ai_n8780367/pg_18>.
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