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Case 1.11 United States Surgical Corporation
In 1981, USSC extended the useful lives of several of its fixed assets and adopted salvage values for many of the same assets for the first time. Are theses changes permissible under generally accepted accounting principles? Assuming these changes had a material effect on USSC’s financial condition and results of operations, how should the changes have been disclosed in the company’s financial statements? How should these changes have affected Ernst and Whinney’s 1981 audit?
The USSC is permitted to extended the useful lives of fixed assets and introduce new salvage values under a few specific conditions. The first is that they will have to calculate each fixed asset’s cost of being acquired for the fixed assets that are being used since the USSC has not retired similar fixed assets that they leased or loaned off the books.
Instead they have the cost associated with these retired loaned assets being debited to accounts of other assets still in service. This then leads to an overstatement of the fixed assets accounts. This problem will need to be fixed first by crediting the cost of retired assets out of the account they have previously been debited to. Then they are ready to properly start extending the useful lives of the fixed assets that are being used in service and putting a first time salvage value on each fixed asset.
After extending the lives of the fixed assets and creating a salvage value the next step is to take the cost of each fixed asset account and then compute the book value of each asset. The book value includes all the costs incurred to get the assets ready for their intended uses. Then calculate through estimation the amount of future cash flows from the initial useful life of each fixed asset. After that you are ready to test for impairment or recoverability.
Depending on whether the future cash flows is more or less then the book value you may arrive at two different results. Since the book value will usually be more than future cash flow then you will have to test the fair market value (FMV) against book value. If book value is more then FMV then we take a loss that is down to the fair market value. After USSC records the impairment loss, they can then take each fixed asset’s initial cost and extend the useful life of the asset assigning a salvage value for reporting their new deprecation expenses.
For USSC there was another way to do this by finding the initial cost of each asset (crediting out the misplaced retired assets from the still-in-service fixed assets) then subtracting the salvage value. Then the remaining amount is divided by the number of extended life years (assuming they use straight line depreciation) which gives you the depreciable amounts on each fixed asset.
You would then take each individual years extended life depreciable amount and substitute it for the prior deprecation amount for each year that these fixed assets have been in service which changes prior years’ net income. This is the longer way to do it and it would cost USSC more money. USSC did not comply with either of these two ways and instead misrepresented a huge chunk of money.
Due to the changes in the fixed asset accounts the event must be disclosed. When the financial statements were drafted, it would have created the changes to their fixed assets as previously noted. The disclosure of this information would come from and audit report which would be reported by an auditor. There are a few steps to how this audit report would have been filled out. First they would have to decide among standard unqualified reporting, unqualified with explanatory paragraph reporting, qualified reporting, or adverse with disclaimer reporting. Since we are assuming the changes are material the first two reporting methods would not be used.
Qualified reporting is stated as, “The auditor concludes that the overall financial statements are fairly presented, but the scope of the audit has been materially restricted or generally accepted accounting principles were not followed in preparing the financial statements.” This quote would be only half correct to me as it is true that they did not follow GAAP but the fact of the matter is that the overall financial statements were not fairly presented.
So the correct reporting method to use is the adverse reporting method which says, “ the auditor concludes that the financial statements are not fairly presented,” because the changes in fixed assets created the miscounting of retired assets and the extended life plus salvage issue was not fairly presented on the financial statements.
When the adverse report is used it has four different paragraphs which include introductory, scope, the added definition paragraph, and the opinion. Once the report and statements are completed, they disclose this report on the financial statement as a footnote. Then the SEC will look at the disclosure and make sure it’s supported with all of the proper documentation and that all of the financial statements are correct.
Next Ernst and Whinney is responsible for changing the audit reports and must disclose there findings. The first thing about that Ernst and Whinney (E&W) audit report is that they will need (after the change of fixed assets) to draft a new report. When they know all the changes that are needed they would have to note them on the financial statement. I believe that they would file an adverse report in light of the changes in fixed assets.
Although in light of all the other situations going on, they should file a disclaimer as they had been lied to by USSC in a number of different ways. In the adverse report, E&W would have disclosed the misappropriation of asset and depreciation expenses and would have written it into the third paragraph (the definition paragraph) after writing the first two paragraphs. Then in the final paragraph they would have written that they felt that because of the incorrect accounting issue in the fixed assets accounts, they believed that the financial statements are not presented fairly for their stockholders.
Also I think the E&W audit opinion should also have been more closely scrutinized regarding the five elements of quality control. I think E&W needs to take a closer look towards presenting all of these five elements in their report. One of them is integrity not only in the fixed asset area but in all the other areas where USSC has misstated the true numbers. E&W should report that USSC failed to show assets to increase the company’s net income and recommend that USSC be put on watch for several years. They should also include within the report that the internal controls of USSC are very poor and that a better structure of internal control is needed that is more difficult to circumvent.
Ernst and Whinney is partially responsible for not catching most if not all of these misappropriation of funds inaccuracies because the SEC believes they had a variety of ways in which to determine something was not right. So E&W should be found partially liable for the 1981 audit report being incorrect. I believe E&W should be required to report the way in which they approached this audit and show proper cause for why they were not able to catch the inaccuracies in the financial reporting of USSC during the audit.
In conclusion, USSC is allowed to extend the useful lives of assets and apply salvage values as long as they follow the GAAP’s impairment loss procedures, reporting them in the financial statements with a note on how and why these procedures were used. The audit reports for USSC must be disclosed in the form of an adverse report. Lastly, E&W should do an adverse report on the adjustments. These changes should hold E&W partially liable for not finding misstatements or inaccuracies with the USSC financials.