CASES INVOLVING AUDITORS’ NEGLIGENCE

Convince
Confuse
con

Case study 1

One of the puzzling features of the Barings’ Bank collapse was the external auditors'
apparent failure to question possible evidence of fraud. The facts are as follows. In
early January 1995, Coopers & Lybrand, Barings' external auditors in Singapore,
discovered a £50m discrepancy in the accounts. The auditors duly contacted Nick
Leeson, the office manager (and also Barings' star trader), for an explanation.
Leeson replied that it was probably a computer error and promised to investigate.
During the next fortnight, however, he eluded the auditors' repeated attempts to
follow the matter up.

Finally, on 27 January, a meeting was arranged and Leeson changed his story. He
now claimed that the outstanding £50m represented an uncollected debt from a US
firm of brokers known as Spear, Leeds and Kellogg (SLK). The auditors accepted
the explanation subject to receipt of supporting documentation, including
confirmation of the transaction directly from SLK.

In fact, there was no sum of money owing. The ‘hole’ in the balance sheet reflected
part of what Leeson had lost through unauthorized trading, and he subsequently
forged the letter that the auditors had demanded. To make it look as if the letter had
been sent directly from SLK, Leeson then faxed it to the external auditors from his
own home.(no due diligence ) (over rely confirmation)

The document that reached the auditors bore the imprint 'From Nick and Lisa' -
clearly it could not have come directly from SLK, but it is a matter of record that the
auditors did not question the fax and, the next day, 3 February, cleared the accounts.
Barings collapsed before the audit was completed. It is possible; therefore, that
Leeson's malfeasance might have been exposed later.

Post period receipt trade receivables receipt accuracy

Case study 2

ZZZZ Best was a Los Angeles based company specializing in carpet cleaning and
insurance restoration. Prior to allegations of fraud and its declaration of bankruptcy
in 1988, ZZZZ Best was touted as one of the hottest shares on Wall Street. In 1987,
after only six years in business, the company had a market valuation exceeding
$211 million, giving its ‘genius’ president a paper fortune of $109 million. Lawsuits,
however, alleged that the company was nothing more than a massive fraud scheme
that fooled major banks, two CPA firms, an investment banker, and a prestigious law
firm.

ZZZZ Best was started as a carpet-cleaning business by Barry Minkow, a 15-year-

old high school student, in 1981. Although ZZZZ Best had impressive growth as a
carpet-cleaning business, the growth was not nearly fast enough for the impatient

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Minkow. In 1985, ZZZZ Best reported that it was expanding into the insurance
restoration business, restoring buildings that had been damaged by fire, floods and
other disasters. During 1985 and 1986, ZZZZ Best reported undertaking several
large insurance restoration projects. The company reported high profits from these
restoration jobs. An Initial Public Offering (IPO) in 1986 stated that 86% of ZZZZ
Best Corporation’s business was in the insurance restoration area.

Based on the company’s high growth and reported income in 1987, a spokesperson
for a large brokerage house was quoted in Business Week as saying that ‘Barry
Minkow is a great manager and ZZZZ Best is a great company’. He recommended
that his clients buy ZZZZ Best shares. That same year, the Association of Collegiate
Entrepreneurs and the Young Entrepreneurs’ Organization placed Minkow on their
list of the top 100 young entrepreneurs in America and the mayor of Los Angeles
honored Minkow with a commendation that said that Minkow had ‘set a fine
entrepreneurial example of obtaining the status of a millionaire at the age of 18’.

Unfortunately, ZZZZ Best’s insurance business, its impressive growth and its high
reported income were totally fictitious. In fact, the company never once made a
legitimate profit. Barry Minkow himself later said that he was a ‘fraudster’ who
convincingly deceived almost every one involved with the company. Through the
use of widespread collusion among company officials, Minkow was even able to hide
the fraud from ZZZZ Best’s external auditor. For example, when ZZZZ Best reported
an $8.2 million contract to restore a building in San Diego, the external auditor
demanded to see the building, this was difficult since neither the building nor the job
existed. However, officials of ZZZZ Best gained access to a construction site and
led the auditor through a tour of an unfinished building in San Diego to show that the
restoration work was ongoing. The situation became very complicated for ZZZZ
Best when the auditor later requested to see the finished job. ZZZZ Best had to
spend $1 million to lease the building and hire contractors to finish six of the eight
floors in ten days. The auditor was led on another tour and wrote a memo saying
‘Job looks very good’. The auditor was subsequently faulted for looking only at what
ZZZZ Best officials chose to show, without making independent inquiries.

Minkow’s house of cards finally came crashing down as it became apparent to

banks, suppliers, investors and the auditors that the increasing difficulty ZZZZ Best
was having with paying its bills was entirely inconsistent with a company reporting so
much revenue and profit. In January 1988, a federal grand jury in Los Angeles
charged 11 individuals – including ZZZZ Best founder and president, Barry Minkow
with engaging in a massive fraud scheme.(con)(equal chance population )(seasonal
factors) (select sample from them ) (audit standard sample must from auditor)

Case study 3

The US accountancy firm Arthur Anderson has in 2001 paid a US$7 million penalty
to end a Security and Exchange Commission probe into charges it falsified audits for
Waste Management Inc to protect lucrative business relations.

The US financial watchdog, the SEC, suspected that AA and four of its current and
former partners, knowingly ignored irregular accounting practices by Waste
Management that inflated its profit levels.

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AA was accused of failing to stand up to company management and thereby
betrayed their ultimate obligation to Waste Management’s shareholders and the
investing public. The SEC claimed that between 1992 and 1996 Waste
Management inflated its pre-tax profits of US$1.48 billion and underestimated its
expenses by US$148 million – a state of affairs the SEC said AA could hardly
overlook.

Above all, the SEC stressed the very close and long-standing relationship between
AA and the waste disposing firm it had been auditing since 1971 and considered a
privileged client. Until 1997, all Waste Management financial and accounting
directors were former AA employees. Also, AA received hefty commissions for its
consulting work. In all, the accountancy firm billed Waste Management for US$3.7
million for a report on how to improve share values.
(teaching client how to manipulate , audit the manipulated f/s)

Case study 4

This case involved the audit of an airline. The audit manager, suspicious that direct
confirmation of overdue debts faxed by a Florida travel agency was not genuine,
attempted to phone the agency immediately prior to signing off on the regulatory
deadline. There was no reply - possibly because it was 4.30 am in Florida - but he
took comfort from the fact that the telephone rang at all! Needless to say, the faxed
confirmation for debts owed on bookings for 'up leg' flights totaling over £500,000,
was fraudulent. Yet another auditors' negligence claim was born.

Case study 5

In this case, auditors faced allegations of negligent work following their acceptance,
as evidence, of written confirmations of quantities of diesel that a third party storage
company held. It was apparent from their files that the auditors had concerns about
the authenticity of the documentation, which they attempted to relieve through written
correspondence with the third party.

Had they dialed the phone number or arranged for someone to visit the address
shown on the confirmation letter the auditors might have discovered that their
suspicions were well founded. Neither the third party nor the diesel existed, and they
had actually been corresponding with the company's managing director! The fact that
purchases during the entire year were less than the quantity said to be held off-site
should have persuaded the auditors of the need for more robust investigations. The
motivation for the director's dishonesty was, all too typically, a vain attempt to
prevent his loss-making company from going into liquidation.(purchases less than
closing inventory )

Why opening inventory high why still buy

Case study 6

Company X, a general insurance broker found its dishonest bookkeeper failed to

transmit certain premiums received from clients to the relevant insurance companies,

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leaving the clients uninsured. Further investigation uncovered a host of irregularities
and misappropriations that had been going on for years. The simplest yet most
pervasive of these was perpetrated in the following manner:

 The bookkeeper accurately recorded premium receipts from client in the manual
cash book.

 The manual cash book was then cast and an understated daily total was
recorded, and this sum was then banked.
 The bookkeeper stole the difference.(computation)

 The bookkeeper relied on delays between receipt of premiums and their onward
transmission to insurers to facilitate such teeming and lading as was necessary
for his purpose.(insured money is not given )

In this case, the auditor performed every test their auditing system prescribed but still
could not detect the fraud. Why? The auditor has failed to check the casts in the
manual cash book. If they had done so the fraud would have been discovered at the
outset.

Case study 7

A major bank is involved in advancing large sums in the form of invoice discounting
to a company involved in the export of marine communication and radar equipment
to Australia and the Americas. It subsequently transpired that the company's
directors had utilized no fewer than 14 fraudulent methods of obtaining funds from
the bank in respect of equipment they purported to have supplied to overseas
customers. These included:

 generating fictitious invoices for non-existent equipment;

 grossly overstating the value of genuine sales invoices in order to persuade the
bank to raise its facility limits;

 raising sales invoices in respect of equipment actually sold by a different but

related company; and

 'selling' equipment to family members living abroad, or companies under their

control, who had no intention of paying for it.

The bank became concerned that the dramatic rise in the level of debt funding was
not being matched by any comparable rise in collections from customers. It
eventually contacted certain customers directly; they responded that they had no
knowledge of the transactions in question. The house of cards collapsed - the
company went into liquidation, the directors went to prison, and the bank was left
with a huge debt, which it could hope to recover only by means of an action against
the company's auditors brought by its liquidators in the company's name.
(most are fraudulent )
When auditors are unwittingly drawn into such an intricate web of deceit and
falsehood it can be difficult to assess their culpability. What opportunities existed for

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discovering the fraud? Can the fact that a high proportion of documents examined
were fictitious, and nothing was, as it seemed to be, be used as a viable defense?
Much will depend in practice on the effectiveness of the auditors' assessment of risk,
including their knowledge of heavy external funding dependency.

Only have sales can sell the debt

Without recourse

Has Auditor skeptism have done ?

Case study 8

In the case in question a law firm was defrauding clients. The Law Society, through
its compensation fund, paid out more than £8.5m to compensate the victims of fraud
and then alleged that the accountants-KPMG-had acted negligently in preparing the
Accountant's Report under the Solicitors' Accounts Rules (SARs).

The ruling set a new precedent by confirming that KPMG owed a duty of care to the
Law Society's compensation fund. This is because the Law Society relies upon the
accountant's work for its own purposes, i.e. to ensure that solicitors comply with the
SARs on clients' monies, so that the clients of the law firm are not being defrauded.
Practitioners preparing financial reports on members of regulatory bodies-such as
the Law Society will thus owe a duty of care to such bodies.

In this case, the preparer knows or ought to know that his or her work may be relied
upon by the third party, and that the third party may suffer a loss if the work has been
carried out negligently. Practitioners undertaking such work should therefore ensure
that they are fully aware of the SARs and their obligations under them.

Account firm cannot be audited not sdn bhd so cannot be audited

Unlimited liability

Compliance audit

Knew existence ,lack duty of care