Project #85922 - The SEC’s Case against California Micro Devices:

. He worked many long hours during his

20-year career as a CPA. Finally, he was a partner at Coopers & Lybrand. In fact, many young accountants in his firm aspired to this position. The year was 1994, and he was

the engagement partner on the audit for a company called California Micro Devices, Inc. (CMD).1

Michael was teamed up with Brian Berry, an audit manager, for the 1994 audit. Michael was comfortable with this arrangement. After all, Brian was licensed as a CPA for nearly ten years and worked on a few of CMDs audits before becoming the audit manager in 1994.

Michael and Brian were very familiar with CMDs employees and financial information. CMD was an audit client of Coopers & Lybrand since 1990. CMD seemed to be a growing company in the fast-changing technology industry. In fact, CMD recorded an increase of $3 million in net income from fiscal year 1993 ($2 million) to fiscal year 1994 ($5 million) on their Form 10K. Most auditors welcome a client in the growth stage. As Michael and Brian embarked on this particular engagement, they did not realize how much this client and the events of the audit would impact their careers. 

Michael and Brian were aware of a couple of changes this year relating to CMDs customers. Unfortunately, CMD lost a large customer who paid their bills timely. This customer, Apple Computer, Inc. (hereafter, Apple), represented 32 percent of product sales during fiscal year 1993 and only 6 percent of sales during the first half of fiscal year 1994. Michael was not concerned about the loss of Apple, since CMD just entered into a new agreement to license new technology to Hitachi Metals, Ltd. Accordingly, the revenue from this license (i.e., non-product sales) would offset the lost revenue from Apple. In addition to losing a major customer, CMD started selling more goods to foreign customers, many of whom were located in the Far East. Since shipments to these customers took longer (i.e., sometimes as long as six weeks), CMD started offering extended payment terms of 90 to 120 days or more to a number of these customers.

 

 

 

 

 

 

Jill M. D’Aquila and Kim Capriotti are Associate Professors at Jacksonville University.

 

The authors gratefully acknowledge the comments of the editors and two anonymous reviewers. The authors also thank

Charles Cullinan for class testing this case and providing valuable feedback.

Editor’s note: Accepted by Kent St. Pierre.

 

 

1    The enforcement release issued by the Securities and Exchange Commission (SEC) provided the background for this case. Unless indicated otherwise, the quotations in this case are drawn from the following source: Securities and Exchange Commission, Accounting and Auditing Enforcement, Release No. 1823 (July 29, 2003).

 


 

 

Michael and Brian noticed some things during prior audits that they wanted to keep in mind this year. Previously, CMD recognized revenues on products that were ready to be shipped on the last day of the fiscal year, but were actually shipped subsequent to year-end. During these previous audits, Brian found it difficult to determine which goods were shipped and which goods were not shipped at year-end. Historically, CMD recognized 70 to 90 percent of their sales in the third month of each quarter. Michael made sure to discuss the importance of proper revenue recognition with CMDs audit committee when preparing for the 1994 audit. He was sure to focus on accounts receivable, since it was a critical area in this audit.

Michael and Brian finished the 1994 fiscal year audit and issued an unqualified audit opinion dated August 25, 1994. A few weeks prior to issuing the audit report, a shareholder filed a lawsuit against CMD for accounting improprieties related to a large write-off of accounts receivable near the end of fiscal year 1994. This event did not deter the auditors from issuing the audit report.

 

COMPANY BACKGROUND

CMD, which was formed in 1980, designs and sells semiconductors. Given its nature, the semiconductor industry is characterized by rapid changes in technology, customer needs, and industry standards. CMD is a relatively small player in this industry and relies on a few core markets for the bulk of their sales. These core markets include mobile handsets, personal com- puting, and digital consumer electronics, and are characterized by intense competition. CMD sells their products to original equipment manufacturers, such as Dell, Inc.; Hewlett-Packard Company; Motorola, Inc.; and Sony Corporation.

According to published financial reports, CMD was unprofitable for ten consecutive quarters prior to the second quarter of fiscal year 1994. CMDs average loss during this period was $3.8 million per quarter. During fiscal year 1994, however, CMD reported revenues of $45 million, profits of $5 million, and assets of $75 million. In a press release on August 4, 1994, CMD noted an increase in an existing product, as well as strong sales of new products. CMD also noted strong non-product sales to Hitachi Metals, Ltd. These sales were related to the new agreement to license technology. Select financial information is more disclosed in a subsequent section of this paper.

 

COOPERS & LYBRAND’S AUDIT OF CMD

Michael and Brian were particularly impacted by three areas of the CMD audit: (1) write-off of accounts receivable, (2) confirmation of accounts receivable, and (3) sales returns and allow- ances.

 

Write-Off of Accounts Receivable

Ronald Romito, CMDs chief accounting officer, told Michael and Brian that CMD would write off $12 million in accounts receivable near the end of the fourth quarter. Michael was dumbfounded by the size of this write-off. Accordingly, he and Brian met with Ronald numerous times to discuss how to allocate the write-off among various accounts. Some possibilities were to reverse sales, record sales returns, or record bad debt expense. Under CMDs proposed plan, the

$12 million write-off would include $4 million in bad debt expense. Ronald as well as his management teams goal was to maximize revenue by allocating a larger portion of the write-off to bad debt expense and a smaller portion to returns.

Michael was not comfortable with this proposal. He asked Ronald to recalculate the write-off and advised him to prepare a line-by-line analysis listing the receivables and the reason for each write-off. Ronald revised the amount of the write-off and met with Michael and Brian several more times to discuss how to allocate the write-off. The final allocation of the $12 million was as follows: $1.8 million to cost of sales; $1.3 million to bad debt expense; $7.2 million to sales returns and price adjustments; $1.7 million to sales reversals; and the remainder to freight, adver- tising, and commission expense.

 

Much later, Brian did not remember reviewing the spreadsheet or other documentation to support the write-off. In fact, it is unclear whether Ronald ever provided the requested analysis. The senior auditor on Michael and Brians audit team concluded in the work papers that the write-off appeared reasonable. However, she did not elaborate any further. Later, she could not remember whether she based her conclusion on observation, or only conversations with Michael and Brian. A junior auditor on the team briefly referred to the write-off. There was little mention of the write-off elsewhere in the work papers.

During the second week of fieldwork, CMD gave Michael and Brian a draft of a press release

that disclosed fourth-quarter earnings. Brian checked the mathematical accuracy of the draft and discussed it with Michael. CMD issued the actual press release the next day and explained the write-off as follows:

Offsetting non-product sales were product returns and related expense charges totaling $8,300,000 for the quarter. As a result of the success of establishing second source to thin film IPEC products, the company decided to reduce its emphasis on certain distribution channels by terminating se- lected distributors. The company authorized these terminated distributors and others who were unable to pay for the product on a timely basis to return the product ($5,300,000) and, in certain cases, these distributor balances were written off to cost of sales ($1,700,000) or bad debt expense ($1,300,000).

CMD included the italicized portion after the auditors reviewed the draft. Interestingly, CMD was still selling products to customers who had returned products in May 1994 and, as a result, helped create a need for this write-off.

Michael and Brian reviewed and initialed this August 4, 1994, press release. Later, they could not remember if they compared the information in the draft and final press release with the spreadsheets Ronald presumably gave them earlier. Michael reviewed the sampling criteria for confirming accounts receivable, but did not believe any changes were warranted.

CMDs stock price immediately dropped and a shareholder filed a lawsuit against CMD for accounting improprieties related to this write-off. A senior auditor questioned both Ronald and CMDs lawyers about the lawsuit and recorded in the work papers that the likelihood of an unfavorable outcome or settlement was unknown. Michael and Brian did not believe that any changes to the audit plan were warranted.

 

Confirmation of Accounts Receivable

Michael knew that accounts receivable was a critical audit area. The auditors selected for

positive confirmation, all accounts with balances greater than or equal to $100,000, as well as a random sample of 20 accounts with balances under $100,000. This selection represented over 92 percent of CMDs accounts receivable balance. Of the 54 accounts receivable customers selected for testing, 25 confirmed their full balance, 12 confirmed only a portion of their balance, and 17 did not confirm any portion of their balance.2 Although Michael and Brian performed alternative procedures for each account balance not confirmed, the SEC does not believe the auditors per- formed adequate procedures in six cases, which are described more in the enforcement. In fact, the SEC believes the auditors accepted CMDs explanations without obtaining corroborating evi- dence.

Some of the discrepancies raised questions. For instance, one customer, Solectron, Inc., con- firmed a balance of only $33,017 out of the $148,067 claimed by CMD. Solectron, Inc. reported that it had no record of two shipments totaling $115,050, the amount in dispute. Solectron, Inc. requested copies of purchase orders for these two shipments. The SEC later commented that there was no evidence that the auditors ever looked for these purchase orders or investigated why these shipments were not received by Solectron, Inc. 42 days later (even though they were shipped ten miles away). The senior auditor documented that she reviewed shipping documents showing that

$115,050 in product had been shipped “right before year-end.” She did not disclose details.

In another instance, a customer, GSS/Array Technology, initially confirmed the full balance of

 

$204,465, but then disputed $193,909 later in the week. The auditors documented that this cus- tomer subsequently confirmed $100,000 of the disputed receivable. All in all, GSS/Array Tech- nology provided three different answers regarding their balance. Ronald was able to provide a satisfactory explanation and Michael and Brian accepted this balance.

 

Sales Returns and Allowances

CMDs contracts indicated that customers could return merchandise within one year after purchase. Michael and Brian analyzed CMDs sales returns to determine the reasonableness of estimates made by CMDs management for the allowance for returns amount. In analyzing the ratio of returns to sales, the auditors factored in CMDs statement that almost all of the sales returns were made within two months of the purchase date.

Michael and Brian accepted CMDs amount of sales returns for the fiscal year of $4.5 million. However, sales returns for the fourth quarter alone were $5.3 million, as stated in the August 4th press release. In addition, when calculating their own estimate of sales returns, Michael and Brian used a product sales figure of $7 million for two months, per a management trend report. CMDs aged trial balance for the end of the fiscal year disclosed $12 million in accounts receivable 30 days or less.

 

CMD’S FRAUD AND THE SEC’S CASE AGAINST COOPERS & LYBRAND

After CMD became aware of the shareholder lawsuit, their board of directors appointed a special committee of independent directors, who then hired Ernst & Young as forensic accountants to investigate possible accounting irregularities. This investigation revealed that CMD wrote off accounts receivable as a result of numerous transactions where there was no realistic prospect of getting paid. The goods were either not shipped by CMD, not likely to be paid for, or were of inferior quality. Accordingly, CMD used the write-off to clean their books. CMD went so far as to have their sales, shipping, and accounting personnel, as well as their customers, create false shipping documents and invoices to disguise some of the improperly recorded sales. 

In January 1995, Coopers & Lybrand resigned as auditors, and CMD hired Ernst & Young. Michael and Brian did not reissue the audit opinion. On February 6, 1995, CMD restated their

1994 financial statements with the SEC. Published financial information revealed the following select financial results before and after the restatement (in thousands):

 

Originally

 

Stated

 

Restated

Total Revenues

$45,319

 

$30,073

Cost of Sales

24,307

 

31,919

Gross Margin

21,012

 

(1,846)

Total Expenses

37,563

 

45,325

Net Income (Loss)

5,058

 

(15,227)

Current Assets

61,966

 

42,536

Total Assets

74,527

 

52,097

Current Liabilities

11,053

 

8,868

Total Liabilities

24,094

 

20,630

Retained Earnings

 

 

 

(Accumulated Deficit)

9,581

 

(10,705)

Stockholders’ Equity

50,433

 

31,467

 

 

 

 

2    It is not clear from the SEC enforcement release whether these 17 customers were unable to confirm any of the balance or failed to respond to the confirmation.


 

 

The SEC charged Michael and Brian with “engaging in improper professional conduct by engaging in intentional or knowing conduct, including reckless conduct that results in violations of applicable professional standards.” The SEC believes that Michael and Brian did not exercise due professional care or employ an adequate level of professional skepticism when performing CMDs

1994 fiscal year audit. Also, they did not obtain sufficient appropriate evidence relating to CMDs write-off of accounts receivable, the accounts receivable balance, and the sales returns amount. As a result of these audit deficiencies, the SEC permanently denied Michael and Brian the privilege of practicing before the SEC. Michael and Brian believe that they could not have uncovered this fraud, since CMD fabricated and destroyed documents and since there was collusion between CMD and third parties. The SEC does not believe Michael and Brians argument is relevant since ultimately, Michael and Brian were not diligent and consistent with the accounting professions responsibility to the public.

 

QUESTIONS

 

1.   Professional standards: The SEC concluded that Michael and Brian engaged in im- proper professional conduct as a result of their reckless failure to comply with profes- sional standards. Identify one general standard and one standard of fieldwork that was violated. Explain the nature of the violations. Organize your response according to the three specific areas of the audit discussed in the case.

2.   Professional skepticism: In addition to the three areas of concern for the 1994 audit (write-off of accounts receivable, confirmation of accounts receivable, and sales returns and allowances), there were other events discussed in the case where Michael and Brian failed to exercise professional skepticism. First, explain the term “professional skepti- cism,” as described in Consideration of Fraud in a Financial Statement Audit, SAS No.

99 (AICPA 2002, AU Section 316). Second, identify two additional events where Michael and Brian should have used more professional skepticism during the audit of CMD.

3.   Analytical procedures: The first step in performing analytical procedures is to develop an expectation of an account or ratio balance. Trend analysis, or reviewing the changes in an account balance over time, is one technique used in developing such an expectation. Explain the challenges in using financial information from previous periods in this audit.

4.   Estimates: The SEC challenged the steps taken by Michael and Brian in evaluating the reasonableness of accounting estimates. Reference the appropriate authoritative standards and describe how auditors should evaluate the reasonableness of estimates. Identify the specific items in this audit where Michael and Brian were deficient in evaluating the reasonableness of accounting estimates.

5.   Work papers: The auditors’ work papers were deficient in several respects. Had the audit occurred more recently, they would have had to adhere to standards of the Public Com- pany Accounting Oversight Board (PCAOB). Consult PCAOB Standard No. 3 to explain the objectives of audit documentation (PCAOB 2004, paragraph 2). Describe the specific deficiencies with the work papers in this audit.

6.   Fraud risk: The auditors assessment of risk of material misstatement due to fraud should be ongoing throughout the audit. Read Consideration of Fraud in a Financial Statement Audit, SAS No. 99 (AICPA 2002, AU Section 316A). Describe conditions that existed during this audit that were indicative of such risk.

7.   Responses to fraud risk: When auditors have identified fraud risk, describe the actions they should take in response to these risks based on Consideration of Fraud in a Finan- cial Statement Audit, SAS No. 99 (AICPA 2002, AU Section 316A). Did these auditors respond appropriately? Use specific examples from the case to explain your answer.

 

8.   Confirmations: When confirming accounts receivable balances, describe alternative pro- cedures that should be performed after replies to second requests have not been received. Optional: Obtain the actual Accounting and Auditing Enforcement release (Release No.

1823) on the SEC website (http://www.sec.gov) to describe the deficiencies with respect to the specific cases where the SEC has challenged the adequacy of procedures performed (SEC 2003).You will find the details in the “Marrie and Berry Recklessly Failed to Comply with Applicable Standards in Their Confirmation of CMDs Accounts Receiv-

able” section.

9.   How were the auditors in this case punished? Provide your opinion about the appro- priateness of this punishment.

 

 

 

APPENDIX

 

American Institute of Certified Public Accountants (AICPA). 1989a. Analytical Procedures. SAS No. 56. New York, NY: AICPA.

——. 1989b. Auditing Accounting Estimates. SAS No. 57. New York, NY: AICPA.

——. 1992. The Confirmation Process. SAS No. 67. New York, NY: AICPA.

——. 2001. Generally Accepted Auditing Standards. SAS No. 95. New York, NY: AICPA.

——. 2006a. Amendment to Statement on Auditing Standards No. 95, Generally Accepted Audit- ing Standards. SAS No. 105. New York, NY: AICPA.

——. 2006b. Performing Audit Procedures in Response to Assessed Risks and Evaluating the

Audit Evidence Obtained. SAS No. 110. New York, NY: AICPA.

——. 2006c. Omnibus—2006. SAS No. 113. New York, NY: AICPA.

 

 

 

 

REFERENCES

 

American Institute of Certified Public Accountants (AICPA). 2002. Consideration of Fraud in a

Financial Statement Audit. SAS No. 99. New York, NY: AICPA.

Public Company Accounting Oversight Board (PCAOB). 2004. Audit Documentation. Standard

No. 3. New York, NY: AICPA.

Securities and Exchange Commission (SEC). 2003. Accounting and Auditing Enforcement. Re- lease No. 1823. Washington, D.C.: SEC. Available at: http://www.sec.gov/litigation/opinions/34-48246.htm.

 

 

 

 

 

 

 

 

 

 

3    To navigate the SEC website, click on the following links: “Divisions/Offices; Enforcement; Accounting and Auditing

Enforcement Release.”

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