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Question: 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 this case, what changes in policy or procedures would you implement to make sure this audit failure does not occur in the future?
The Crazy Eddie's financial statements had many fraudulent over and understatements done in many ways that the auditors should have caught. They created fictitious revenues by a number of means. They prepared phony invoices showing sales which overstated their revenues to show the company was growing faster than they actually were. Their vendors collaborated in the fraud by lying to the auditors when the auditors attempted to confirm some of these receivables. The auditors were not diligent when they verified these invoices. They should have probed further into the vendors to verify that these sales occurred. They also should have understood the relationship between Cray Eddie's and their vendors to understand if there were motives for fraud.
They overstated their assets by overvaluing inventory. They would borrow merchandise from suppliers to inflate the ending inventory. The suppliers would ship the merchandise to the Crazy Eddie's stores and hold the billing until after the end of the accounting period. The employees of Crazy Eddie went to great extents to deceive the auditors. They would move inventory to the stores or warehouses that were being audited to conceal the shortages. The auditors should have caught that the merchandise was not billed and understood what accounts they charged in the books when the merchandise was received. Another means of overstating the inventory was they shipped inventory from one store to another store so it could be double counted. This should have been caught by the auditors by having the entire inventory verified in parallel. The employees included in their inventory consigned merchandise and goods being returned to suppliers. This could have been found by understanding the details of Crazy Eddie's inventory. The auditor should have identified the consigned merchandise and goods being return to separate it from the normal inventory.
Crazy Eddie used the accounting periods to overstate assets and income. They held off closing the books past the end of the accounting period to overstated assets and income by boosting sales. The other means used was to reduce liabilities and expenses by not recording them until the next period. The auditors should have verified books at the end of the accounting periods to make sure that all transactions were recorded. The auditors needed to verify the transactions around the end of the period to verify their timing accuracy.
Another category of fraudulent activities was when they were completing their financial statements. They didn't adequately disclose facts in the financial statements according to GAAP. The footnote during one period stated that certain income was recognized when received and the following period disclosed that income was recognized when earned. The auditors should have added an explanatory paragraph or a modification of wording for lack of consistent application of GAAP.
Main Hurdman was the auditor for the company's annual audits and its consulting division was charging Crazy Eddie millions of dollars to computerize Crazy Eddie's inventory system. This violates rule 102 for integrity and objectivity. Auditors can't objectively audit an inventory system they developed which means this is a conflict of interest. They should have chosen to develop the inventory system or be the auditor but not both.
Crazy Eddie's employees later stopped using the computer based inventory system designed by Main Hurdman and used their manual inventory system. The auditors should have noticed the change in the inventory system being used and understood why they changed. This should have been a signal that they were removing some of the quality controls in the inventory system.
Many of Crazy Eddie's accountants were former members of Main Hurdman accounting firm. The SEC added a requirement in the Sarbanes-Oxley Act that requires a member of the audit team not work at the client for one-year in certain key management positions. The firm is not independent with respect to the audit client if a former auditor accepts employment with the client.
There were several reported instances where the auditor requested the client documents and were told that those documents were lost or inadvertently destroyed. Sarbanes-Oxley Act states that all working papers must be retained for 7 years. The inadvertent destruction of working papers that are less than 5 years has a penalty of 10 years in prison.
The collusion of key personnel at Cray Eddie's made it very difficult for auditors to uncover the fraud. If the auditors would have done a risk assessment prior to engaging with the client they would have identified a risk with so many family members employed at the company.
The success and growth rate of Crazy Eddie was not normal. The auditors should have completed a comparative analysis of other electronic retailers. This would have shown that their high growth rate wasn't typical compared to others. This would have prompted the auditor to look closer at why they were outperforming the competitors.
To prevent the CPA firm from having this occur in the future, they should follow the elements of quality control. The one element is the policies and procedures before accepting or continuing a new client relationship. They should complete a client evaluation form which includes evaluation of the client's management. If this was done in the Crazy Eddie's case, they would have found that it was a risky client based on his selling techniques alone.
The firm should follow the element of personnel management where all new personnel should be qualified to perform their work competently. The personnel should have adequate training and proficient. The field auditors for Crazy Eddie's were young and inexperienced. The management team was able to manipulate and influence the auditors.
The auditor needs to follow the procedure of verifying the inventory count by observing it. Precautions must be taken to avoid allowing the inventory to be moved by verifying it in parallel if multiple locations exist. Crazy Eddie's auditors were fooled by not taking precautions to avoid double counting the inventory.
The firm must follow the Generally Accepted Auditing Standards. One of the standards of field work is to obtain a sufficient understanding of the entity and its environment including its internal control. If this was done, the auditors could have seen that Crazy Eddie had influence over his suppliers to cooperate in inflating the assets. The change in the inventory system back to the manual system showed a lack of internal control.
The firm must follow the rules of conduct. They must keep their objectivity by not providing other services such developing or advising an inventory system. They must remain independent by not auditing a client that has former members of the audit team working at the client within one-year.