The case analysis of Equity Funding Essay

The case analysis of Equity Funding Essay.

The collapse of Equity Funding had a far-reaching influence on business practices and institutions. Although it happened over 30 years ago, the lessons from Equity Funding are still meaningful and constructive nowadays. Auditors of Equity Funding failed to collect sufficient evidence, check internal control and substantiate computer system.

The audit premise—– understanding internal control system AUS 402.41 requires the auditor to obtain an understanding of internal control relevant to the audit. The effective internal control can provide “protection against human errors and reduce errors or irregularities’ (Leung et al, 2007), as well as provide reasonable assurance to auditors for relying on internal control to audit under limit of economic fee.

In order to support an opinion on the financial statement, auditors need a sufficient knowledge of internal control, which includes design of policies and procedures of internal control, and then determine whether they are in operation in assessing audit risk and making audit plans. (Leung et al, 2007).

The internal control procedures can be eroded and invalidated resting with management override and collusion.

As to EFCA, a considerable amount of personnel involved in collusion. This should have been detected by auditors if they assessed the control environment of the company, including the ethics and integrity of management and employees, and checked whether segregation of duties was carried out.

Unfortunately, the auditors of EFCA poorly understood the internal control procedures in EFCA, especially its computerized accounting system (Lee and Marc, 2002). There were glaring inconsistencies and irregularities in the inter-company accounts of EFCA and its subsidiaries. The auditors should have detected the lack of internal control if they reconcile the parent’s account with subsidiary’s accounts; and the computer fraud would not be hidden long had they kept update their technological skills and observed or gone through the data running process to make sure data are reliable.

Once the internal control system isn’t fully understood, the preliminary assessment of control risk is problematic. It was unpractical for auditors to make a judgment on control risk and design an appropriate audit strategy. The wrong judgment on control system and audit strategy may be the direct reason of failure of auditing in EFCA. The auditors wrongly trusted the effectiveness of control systems and relied on management. One of example was Haskins and Sells, the auditors of EFLIC, who total relied upon print-outs and similar data produced by EFLIC’s computer (Lee et al, 2002).

In addition, the auditors also failed to test the effectiveness of the design an operation of internal control according to their judgment on control risk. The mainly test procedures base on audit evidence collection. ASA 330 requires the lower assessment of control risks, the more support the auditor should obtain. However, the auditors failed to obtain sufficient and competent evidence to support their judgment, which will be discussed in next section.

The audit basis—-audit evidence collection

ASA 500.5 (ISA 500.2) requires that auditors collect and evaluate “sufficient and competent evidential matter” in the formation of an opinion on financial statements.

In areas where auditors find suspicious or involving material issues, they should collect more audit evidence. The cash-flow figures are hard to manipulate as auditors can check it by contrasting it with bank statements. However, as there are usually so many items in under assets, it the area the auditor should focus on and collect certain evidence. Like the account receivable in EF, a “25 million’s increase in California subsidiary’s account receivable” was cooked to solve the cash shortage problem. Had the auditors reconciled financial reports with legers and original document and re-performed a variety of calculations, such as totaling the accounts receivable subsidiaries, it is not hard to discover the inconsistency between parent and subsidiary account.

External evidence is generally more reliable than internal generated evidences due to its independent source. As to Equity Funding, such evidence could have been sought from affiliated companies and independent third parties like policyholders (Dean and Wolnizer, 1978). Unfortunately, the most criticisms on auditors of EFCA are that they failed to collect sufficient and competent external evidence to support their judgment on effectiveness of control system and highly rely on management representation. The auditors tried to send out policy confirmations to a sample of policyholders, while the letter was not sent by auditors but the officers of EFCA. They then filled out the forms for the fictitious policyholders (Dean and Wolnizer, 1978). Had the auditors collect sufficient external evidence, the fraud can be detected in early stage.

Once the audit evidence is not sufficient to support the judgment on internal control and assessment on audit risks, the audit procedures and audit strategy built on those would be invalid and problematic. Consequently, the auditors would not be able to draw a correct opinion on truth and fairness of financial statements.

Biggest characteristic of EFCA fraud—–The eroded of computerized systems One of the most common forms of computer crime is data diddling. And one of the classic data diddling frauds was the Equity Funding case (M. E. Kabay, 2002). EFCA lacked the assertion of inherent risk and internal control on computerized systems. Sound controls over a computerized system should include general controls and application controls (Gay and Simnett, 2005).

In case of general controls in EFCA, as the frauds were collusive by the management and employees either actively or passively, there were almost no internal controls throughout the company. For example, segregation of duties means the separation of incompatible functions within the IT department. However in EFCA, The director had instructed a programmer to write a computer program to create fictitious policies, and then the phony policies holders were “killing off” by the programmer without producing a pattern of “deaths” that would arouse the reinsurers’ suspicions (Lee et al, 2002). In this way, the incompatible functions were combined, leading to an easier way for fraud eventually.

As to application controls, it consist of user controls and IT controls. The IT staffs should implement input controls through implementing control totals, key verification and key entry validation. EFCA obviously did not, or at best weak, implement these input controls, as the data inputted were combined with real and fictitious information. Furthermore, output controls, outputs should be proper, reasonable and only accessible to authorized users. As a computer program had been used in EFCA, auditors seem did not have enough knowledge on this highly technical and rapidly expanding subject. The specialists should be required to help the auditors generate the evidences instead of using evidences given by EFCA. Alternatively, they should decline such an engagement because they do not possess the skills necessary to adequately complete the job.

The implications for auditors are obvious. Though it is the management’s duty to enforce satisfactory internal controls, however, AUS 402.41 requires the auditor to obtain an understanding of internal control relevant to the audit. Auditors should discharge their duties reasonably with professional skills and cares, noting the doubtful points which may indicate the risk of frauds, as such, the fraud in Equity Funding would not have been last for such a long time.


Auditors’ poor understanding of internal control in EFCA and failure to obtain sufficient and competent evidence to test and support their judgment were the key reasons of fraud in EFCA in auditor side. Computerized system played a critical part in control systems. The lack of knowledge and technology skills on this system deteriorated the ability of auditors in discharging their obligations.


1. Leung, Coram and Cooper (2007) Modern Auditing & Assurance Services, 3rd Edition 2. Lee, J S. Fredrick, A. Marc, J E. 2002, [Book Chapter] The Equity Funding Papers. DOI 10.glsnp736/5028 3. Robert M. Loeffler, 1974, Trustee Report of the Trustee of Equity Funding Corporation of America Pursuant to Section 167(3) of the Bankruptcy Act (11 U.S. C. §567(3)) 4., “Equity Funding: Could it happen again” (accessed 29/09/2007) 5. G. Gay and R. Simnett, 2005, Auditing and Assurance Services in Australia, McGraw Hill 6. G W Dean, P W Wolnizer March 1978, The Securities Fraud of the Century ,The Chartered Accountant, The Chartered Accountant ,DOI 10.glsnp763/5003 7. U.S. Securities and Exchange Commission 2002, Study Pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the Adoption by the United States Financial Reporting System of a Principles-Based Accounting System, DOI 10.glsnp266/2584 8. AUS210 (accessed 29/09/2007) 9. Ray Dirks and the Equity Funding Scandal
10. (accessed 29/09/2007)
11. The Woman CPA, July 1976, Page 11, “Equity Funding: The Profession Reacts”

The case analysis of Equity Funding Essay

Checklist For Evaluating Internal Controls Essay

Checklist For Evaluating Internal Controls Essay.

For publicly traded companies, the Sarbanes-Oxley Act of 2002 requires an audit of internal controls. The purpose of an internal control evaluation is to evaluate risk, which offers auditors a basis for audit planning and provides useful information to management (“Sox Law”, 2006). Auditors typically use the five basic components of internal control to approve the entire system. According to Louwers, Ramsay, Sinason, and Strawser (2007) the five components to internal controls include control environment, risk assessment, control activities, monitoring, and information and communication.

Control environment involves the tone of the organization and includes “the integrity, ethical values, and competence of the company’s people” (Louwers, Ramsay, Sinason, & Strawser, 2007). Risk assessment involves a thorough assessment which “identify(s) risks, estimate their significance and likelihood, and consider how to manage the risks” (Louwers, Ramsay, Sinason, & Strawser, 2007).

Control activities involve specific actions which help ensure that management’s goals and projections are met. Monitoring involves the continuous assessment of internal controls. Information and communication relates to the efficiency and reliability of information and communication regarding how the information is presented and communicated to users.

Internal controls protect the financial information and operations of a business. The development and implementation of these controls are typically the responsibility of the business owners. Internal or external audits may be used to gauge the efficiency of internal controls. This audit generally takes place following a standard process of risk measurement regarding the business operations and financial information. The measurement data is most effectively determined by using an internal control checklist.


Phase One: Understand and Document the Client’s Internal Control Obtaining an Understanding
Control Environment Evaluation
Risk Assessment Evaluation
Information and Communication Assessment
Phase Two: Assess the Control Risk
Phase Three: Test Controls and Review Control Risk
Reassess Controls
Direction of the Test of Controls
Reassess the Control Risk

Checklist For Evaluating Internal Controls Essay

The Leslie Fay Companies Essay

The Leslie Fay Companies Essay.


The Leslie Fay Companies was a women’s apparel manufacturer established by Fred Pomerantz, a former Women’s Army Corps uniform maker during World War II. Despite the “volatile and intensely competitive” (Knapp 34) nature of the industry, Leslie Fay grew to have the second largest annual sales compared to any of the other publicly owned women’s apparel manufacturers, only behind Liz Claiborne. Fred Pomerantz hired Paul Polishan for a position in the accounting department where Polishan befriended Pomerantz’s son, John.

After Fred Pomerantz’s death in 1982, John Pomerantz became CEO and chairman of the board, having been president of the company and overseeing operations ten years prior. Polishan was also promoted and became the company’s CFO and senior vice president of finance. Although Leslie Fay’s headquarters was situated in New York City’s garment district, the accounting office was off-site in Wilkes-Barre, Pennsylvania. Polishan was known for his “strict and autocratic” (33) rule in this location, demanding much from his employees and tolerating very little.

In Polishan’s absence, the accounting office was run by Donald Kenia, the company controller. Contrary to Polishan’s demeanor, Kenia was meek and soft-spoken.

The women’s apparel industry suffered during the late 80s and early 90s due to the “casualization” (Knapp 35) of American fashion as well as the economic recession. The desire for more casual-looking clothes led to declining sales of dresses and other high-end attire. The recession also caused “many consumers to curtail their discretionary expenditures, including the purchase of new clothes” (35). This was a major blow to Leslie Fay’s principal customers—department stores. When some of these department stores filed for bankruptcy, Leslie Fay incurred material losses. “In October 1991, John Pomerantz announced that Leslie Fay had achieved record earnings for the third quarter of the year” (36). These earnings were achieved despite the crippling economic situation and John Pomerantz’s old-fashioned business practices that shunned “extensive market testing” (35) and the use of computers. While many competitors were financially struggling, Leslie Fay was growing. On January 29, 1993, Polishan informed Pomerantz of a major financial issue; apparently Kenia had “secretively carried out” (Knapp 36) an accounting hoax for several years, overstating earnings “by approximately $80 million from 1990 through 1992” (33) and submitting “approximately $130 million of bogus entries” (39). Leslie Fay’s inventory was inflated, understating cost of goods sold and therefore increasing the gross profit margin.

In addition to the forging of “inventory tags for nonexistent products” (39) and the fabrication of “large amounts of bogus in-transit inventory” (39), orders were prerecorded, discounts were omitted from financial statements, and expenses and liabilities at the period-end were not reported. Almost all of Leslie Fay’s journal entries relating to cost were tampered with in some way. Donald Kenia claimed full responsibility for the fraud, but because of his compliant nature and low stakes in the company, many believed this to be false. Polishan, as CFO, “was directly responsible for the integrity of Leslie Fay’s accounting records” (Knapp 37), and since he ruled the accounting office with an iron fist, he was thought to have played a greater role in the scam. Kenia lacked an obvious incentive in orchestrating this large-scale fraud since he was not compensated based on earnings, but other executives, such as Polishan and Pomerantz, who owned a significant amount of shares in company stock, did benefit. They received “substantial year-end bonuses, in some cases bonuses larger than their annual salaries, as a result of Kenia’s alleged scam” (34).

Pomerantz and Polishan claimed to have known nothing about these accounting errors. After the fraud was uncovered, the audit committee investigated and released a report that exonerated Pomerantz (40), but Kenia later confessed, in opposition to his original testimony, that Polishan “had overseen and directed every major facet of the fraud” (42). Polishan and Kenia were convicted. In 1997, Leslie Fay was ruled to pay $34 million in settlements and filed for bankruptcy, but the company was able to return to a “profitable condition” (42) before being bought out in 2001. The role of Leslie Fay’s external auditor in the midst of this fraud naturally comes into question. BDO Seidman had been Leslie Fay’s “audit firm since the mid-1970s and issued unqualified opinions each year on the company’s financial statements” (Knapp 39).

After the revealing of the fraud, BDO Seidman withdrew these unqualified opinions for 1990 and 1991. The accounting firm took on a similar defense to that of John Pomerantz, claiming themselves as victims of deception. Leslie Fay stockholders sued BDO Seidman for reckless auditing in 1993. Leslie Fay’s financial statements had been “replete with red flags” (40), contributing to the lawsuits. These pending legal battles led to questionable auditor independence, thus causing BDO Seidman to resign as Leslie Fay’s auditor. Numerous misstatements in almost all cost and liability line items leads to the question of whether the lack of sufficient internal controls was largely responsible for the fraud and if the external auditor’s failure to check Leslie Fay’s internal controls caused them to miss such errors.

Business Risk Assessment

Nature of the Entity

The Leslie Fay Companies was a publicly traded firm on the New York Stock Exchange in the business of manufacturing women’s apparel. From its inception, Leslie Fay’s focus was on producing “moderately priced and conservative dresses for women aged 30 through 55” (Knapp, 34). In 1982, John Pomerantz, son of Fred, became the company’s CEO and chairman of the board following a leveraged buyout after the death of his father. The firm re-listed on the NYSE in 1986. Pomerantz, Polishan, and other company executives held large portions of company stock, and as a result, they had a direct financial interest in the continued financial success of Leslie Fay. Top executives were also the recipients of frequent and large year-end bonuses. In some cases, these bonuses were greater than their annual salaries.

Structurally, the company CFO and controller, Polishan and Kenia, had large overriding powers over financial data. Internal controls were severely lacking, allowing management to skew almost all transactions related to cost. Polishan “‘dominated’ Kenia through intimidation and fear” (Knapp 42), convincing Kenia to inflate Leslie Fay’s gross margins. Until the fraud was uncovered, Leslie Fay produced the second largest earnings in the industry, placing the company in the leaderboard.

Industry, Regulatory, & external factors

To understand the position of Leslie Fay in the late 1980s and early 1990s, it is important to look at the state of the women’s fashion industry at that time. Leslie Fay’s key competitors included Oscar de la Renta, Donna Karan, and others. However, the firm’s top rival was Liz Claiborne, “the only publicly owned women’s apparel manufacturer in the late 1980s that had larger annual sales than Leslie Fay” (Knapp 34). The firm’s principal customers, which were also shared by its competitors, were the large department store chains. Several industry trends contributed to economic hardship. The most impactful of these trends was the “casualization” (Knapp 35) of America. This was a trend that had developed a few years earlier and was in full force by the late ’80s. Millions of consumers began to shun the traditional notions of women’s fashion and opted instead to dress in more comfortable clothing. This movement began with younger women but then hit women in the 30 to 55 year-old segment, Leslie Fay’s target market. More specifically, this shift toward casual clothing significantly impacted women’s dress sales.

In the early 1970s dress sales began to decline as a result of the popularity of pantsuits, and by the late 1980s the shift toward casualwear had permanently damaged the sales of dresses. All of this was bad news for Leslie Fay. Since they were a manufacturer of “stylishly conservative dresses,” (Knapp 34) they were stuck in a current towards casual clothing with a business model attempting to swim upstream. The culture of deregulation in the United Sates that began in the 1970s, took off in the 1980s, and flourished in the 1990s and early 2000s had an affect on the financial and accounting departments of many companies. Specifically regarding accounting, the PCAOB did not exist until 2002. This meant the lack of a regulatory body to oversee the creation of and compliance with accounting and auditing standards. In addition, law did not yet require the modern, SOX-created version of the audit committee, responsible for the hiring and firing of the external auditors among other things.

The CFO and CEO were not required to personally attest (with a signature) to the accuracy of the company’s financial statements, giving them less accountability. The overall lack of accountability for CFOs and CEOs and the more laid-back approach that auditors took during that time period enabled Leslie Fay’s scandal to pass through unnoticed for that long. A variety of external factors influenced Leslie Fay. Most important was the recession of the late 1980s and early 1990s. The recession only heightened the problems in the women’s fashion industry, as consumers began to watch their spending and spent less on new clothes.

There was an overall economy-wide decline in retail spending, which hurt business for the major department stores that were Leslie Fay’s customers. As a result of weak retail sales, many department store chains were forced to either merge with competitors or to liquidate. This hurt Leslie Fay because the surviving department stores, with which the firm did business, “wrangled financial concessions from their suppliers” (Knapp 35). As Leslie Fay’s primary customers took hits during the economic recession, the manufacturing firm also suffered great losses.

Internal Control

From the information presented in the case by Knapp, it is evident that Leslie Fay did not have an effective system of internal controls. First and foremost is the fact that the firm’s accounting offices were located 100 miles away from corporate headquarters. Being this far away from the Garment District in Manhattan would have made it difficult for internal and external auditors to have a complete understanding of how Leslie Fay’s business operated since they could not physically observe it. In addition, most accounting personnel located in PA could not discuss issues face-to-face with people in corporate headquarters. Paul Polishan made frequent trips to New York, however he was ultimately responsible for orchestrating the accounting fraud, and his autocratic leadership style exacerbated the issue.

Anyone who asked for records had to immediately answer to Polishan, providing a reason why they needed to know that information. This gave Polishan the possible ability to cover up information before anyone else could see them. Leslie Fay also had a lack of any type of information technology system. In an age where it had become commonplace in the industry to use computer networks to monitor daily sales, the firm was still making calls to customers on a weekly basis to record sales numbers (Knapp 35).

This made it easier to manipulate sales and inventory numbers towards the end of accounting periods, especially when considering Polishan’s conviction, because a lack of IT meant less-precise numbers. In addition, the accounting offices in PA were not up to speed with modern data processing; rather they did more work by hand. Lastly, the extent of the influence that Polishan had over Kenia, the controller, and ultimately the entire accounting process, indicated a lack of checks and balances within the system. Knapp states in the case that Kenia and other subordinates followed any order given by Polishan simply due to his intimidation factor. A good system of internal controls would guard against this, a key arrangement Leslie Fay clearly lacked.

Objectives, Strategies, & Business Risks

Leslie Fay had received complaints from consumers that its clothing line was too “old-fashioned,” “matronly,” and “overpriced” (Knapp, 36). Given these circumstances, the firm should have sought to revamp their product line and manufacture more trendy clothing while staying true to the basic ideas about fashion that Leslie Fay was known for. Unfortunately for the company, John Pomerantz insisted on doing business the old-fashioned way and relied on himself and his designers to forecast fashion trends. This might have worked had Pomerantz known what the overall trend in the women’s fashion industry was, but he did not make use of market testing to see what women were really looking for in clothing. The firm faced many business risks during this time period. The recession heightened competition as many firms were all targeting the same market segment that was spending less on new clothing.

There was also pressure to overcome Liz Claiborne as the sales leader in the industry. Leslie Fay was also pushed to develop trendier clothing in a changing set of consumer demands. The liquidation and mergers of department stores led to many write-offs and loss of income for the manufacturing firm. Leslie Fay was also subject to less-advantageous sales terms forced upon them by the stores such as longer payment terms, more lenient return policies, and increased financial assistance (Knapp 35).

As always, the pressure is on keeping costs down in the market they are in. Since they aimed for moderately priced clothing, the firm needed to drive down costs in order to make a profit on their merchandise. The firm had to keep sales and profits up all while factoring in these changes in the economy and in their specific marketplace. Leslie Fay faced the pressures of meeting analysts’ projections, since they were a publicly traded company. If they did not meet projections, they were subject to a loss of investor capital. Healthy financial numbers were also important to maintain for the sake of keeping creditors happy. The firm needed financing from both lenders and investors in its common stock to support the design and manufacture of its clothing.

Entity Performance Measures

The state of the economy and industry in the late 1980s and early 1990s led to reduced spending, which would have translated to lower sales and earnings for most firms in the fashion industry. However, as noted in the case and as seen by Leslie Fay’s financials, the firm was achieving record earnings despite a slow retail industry (Knapp 36). Some key financial ratios and observations are presented in Exhibit 1. An analysis of these ratios shows that, according to Leslie Fay’s doctored financial statements, they were more liquid than the industry average, but less solvent.

They had lower inventory, accounts receivable, and asset turnover ratios than the industry, and the ages of their inventory and accounts receivable were higher than the industry average. Their gross margin percentage was about on par with industry average, however they showed a higher profit margin on their sales (by 1.31%) as well as a significantly higher ROA (9.79% higher). Their ROE was lower than the industry average. A higher profit margin on sales, together with decreased sales from 1990 to 1991, suggests that Leslie Fay manipulated cost-side entries.

Fraud Triangle


Changes in consumer behavior of the women’s apparel industry pressured Leslie Fay as it suffered a decline in customers in the 1970s and 1980s. During this time, fashion trends were shifting to become more casual, and new styles included more comfortable, well-worn garments like jeans and t-shirts. Even Leslie Fay’s target market of women between the ages of 30 and 55 were dressing more casually and purchasing less dresses. As one-third of Leslie Fay’s total sales are attributed to dresses, Leslie Fay felt the pressure of the change in the apparel industry (The Leslie Fay Company Inc. History). It was also affected by the economic recession of the late 1980s and early 1990s. The company’s major customers, department store chains, experienced a decline in retail spending due to this recession (Knapp 35).

The financial strain on department stores caused them to demand financial concessions from suppliers like Leslie Fay. The company was asked to allow the department stores longer payment terms and more lenient return policies, and to provide more financial assistance for in-store displays, kiosks, and apparel boutiques (Knapp 35). Retailers criticized Leslie Fay of manufacturing clothes that were overpriced and old-fashioned. The company was forced to give rebates to wholesale customers that could not sell all of the apparel they had purchased. Pressure from retailers created an environment that burdened Leslie Fay with finding new ways to keep up profits.

Executive compensation is another incentive to commit fraud. Executives including Pomerantz and Polishan had substantial interests in the Leslie Fay Companies as they owned large blocks of the company’s stock. In addition, executive bonuses were extremely generous, sometimes exceeding annual salaries (Knapp 34). Top executives whose financial interests were heavily invested in Leslie Fay through stock ownership and these large bonuses were more likely to commit fraud for their own personal benefit.


A significant aspect of Leslie Fay’s operations was the geographical difference between corporate headquarters and the accounting offices. Corporate headquarters were located in Manhattan, while the accounting offices were 100 miles northwest in Wilkes-Barre, Pennsylvania. Paul Polishan dominated the Wilkes-Barre office, nicknamed “Poliworld,” as the CFO and senior vice president of finance. This physical separation between the accounting department and other executives and top management created an opportunity for fraud. Finance and accounting employees were not as closely supervised as those in the corporate headquarters due to this geographical disconnect.

This also limited the internal controls that could be implemented over the accounting department (Knapp 33). Public accounting firms were not yet regulated by Sarbanes-Oxley, creating an opportunity for Leslie Fay Companies to commit Fraud. SOX mandates that public companies obtain an integrated audit, including an audit of financial statements and internal controls over financial reporting (Messier 43). BDO Seidman was not required to conduct an audit of internal controls as there was no existing regulation. This means that management’s actions relating to financial reporting were not necessarily being investigated by its external auditor. This lack of regulation affected the audit procedures performed by BDO Seidman, which left the internal control system unchecked.


Paul Polishan’s dominating personality made him a powerful influence over his subordinates, especially Donald Kenia. Polishan strictly ruled the Wilkes-Barre offices and when senior managers from the corporate headquarters asked him for financial information he often demanded the reason they needed the information (Knapp 33). This defensiveness which should have been a red flag created an environment where people were hesitant to question Polishan. The relationship between Kenia and Polishan was also closely examined during the investigation of Leslie Fay. Kenia claimed to have been “dominated” by Polishan through intimidation and fear (Knapp 42). Polishan’s daunting personality allowed him to intimidate Kenia and his staff into falsifying financial transactions and commit fraud. Polishan’s dominance at Leslie Fay put a strain on internal controls.

Case Questions

1. A common size balance sheet and income statement, as well as key financial ratios are detailed in Exhibits 2 through 4. Key ratios that should draw auditor attention include inventory turnover and age of inventories, accounts receivable turnover and age of accounts receivable, gross margin, and profit percentage. The low and continuously decreasing inventory turnover and similar accounts receivable turnover that the ratio spreadsheet shows means that inventory is sitting for 85.68 days in stock before it is sold, and when it is eventually sold Leslie Fay is not receiving the money owed to them for 56.33 days. While this is to be expected in the recession that the company was facing during this time period, it is significantly longer than the industry averages of 53.7 days for inventory and 45.5 days for accounts receivable.

This should draw auditor attention to the inventory and accounts receivable lines on the balance sheet, making sure they are valued correctly and completely, including appropriate allowances. With customers buying less and taking longer to pay for it, how does the company maintain the steady gross margin and profit margin in line with and exceeding industry norms, respectively? This is the key question that should have drawn auditor attention and where auditors should have exercised their professional skepticism. Decreasing inventory turnover and accounts receivables turnover is to be expected in hard times when customers want to buy less and some are even going bankrupt, but more attention should have been focused on how Leslie Fay managed to exceed the rest of the industry in profit margin (Leslie Fay’s 3.5% compared to the industry average of 2.2%) under these conditions.

2. In addition to the balance sheet, income statement, and financial ratios, an auditor would like to have other key financial information to perform the actual audit. For the auditor to decide what additional financial information was needed, he would first perform a comparison similar to that in Question 1, which evaluated the risks on the financial statements, especially in relation to industry norms. Through this analysis, the auditor would have decided that physical inventory counts and substantive analysis of the inventory would be important information to have because Leslie Fay is a merchandising company whose business completely relies on its inventory. During a recession, it would also be important to verify sales and the gross margin, to ensure that gross margin is actually higher than industry averages as the company claims.

The auditor should scan for large and unusual entries, especially at the end of the period, to ensure that Leslie Fay is not just manufacturing additional inventory at the end of the period to bring down the cost of goods sold. Auditors should also confirm sales with the customers both for occurrence and completeness of the transactions that were recorded. During this check it would be important to read sales contracts to ensure that revenue was recognized accordingly. Finally, the auditor would need to verify that Leslie Fay included a large enough allowance for doubtful accounts. During this period there was a recession and many customers were unable to pay or were going out of business, a major concern for company.

3. When evaluating a company’s industry, it is important to note the current economy and the riskiness of the industry itself. Even before the recession hit, Leslie Fay was not big on change; it did business without the use of much technology or consumer tracking, even in the accounting departments. In the highly volatile fashion industry, how did Leslie Fay cope with constantly changing styles and tastes? They tried to predict changing styles on their own, without any tracking of consumer preferences to help guide them (Knapp 35). Leslie Fay was taking a risky approach to a risky market. As the economy declined, this fashion industry only became more risky. The industry was clearly in a downfall due to the recession and the culture’s movement away from dresses, both of which caused a decrease in how many dresses were purchased by retail customers.

In this kind of market, it would be important for the auditors to not only gather non-financial information about Leslie Fay and the fashion industry, but they should also gather information about Leslie Fay’s clients, the big department stores, to determine whether or not they will be able to pay for outstanding accounts receivable. This information would help determine an appropriate allowance for doubtful accounts, which would influence the amount of sales recorded in the income statement and the accounts receivable balance on the balance sheet.

The downward pressure on the industry would greatly increase the incentives and pressures to maintain good financials, which in turn, would increase the risk of fraud. All of these factors should influence the type and quantity of the tests performed by the auditors. Auditors should confirm purchases with customers, and inquire inside and outside the firm for how Leslie Fay products fit in the market. The downturn of the economy should also increase the testing done to the sales account to ensure that they actually happened to answer this question: How did Leslie Fay profit when all other companies in the market were losing revenue?

4. As previously mentioned, Paul Polishan played a very dominant role in the accounting and finance departments in addition to his subordinates at Leslie Fay. When there is such a dominant person at the top, especially one that has great control over subordinates, the reliability of the financial information decreases. The commanding figure decreases the checks and balances within the company that ensure correct information, which increases opportunities for fraud. Auditors need to recognize this figure and plan accordingly to inquire about company information from both internal and external independent sources, keeping in mind that the dominant person could also compromise internal inquiries. The auditors must recognize the authoritative force and try to examine the aspects that he had definite control over deeper. The auditor should seek out the motivations that the dominant player may have and examine areas that he would want to have altered.

For example, Polishan’s personal income was greatly influenced by stock price, meaning that he would want to inflate profits to increase market value. Auditors must, therefore, decrease detection risk and sample potentially affected accounts more. The auditor should then take the time to carefully evaluate management assertions about completeness, rights and obligations, valuation and allocation, and existence of account balances and transactions that have taken place. Overall, the auditors need to begin to audit a company with a dominant figure like Polishan with a good level of professional skepticism, realizing that the tone at the top decreased the internal controls and they will have to increase the amount of testing and inquiring done to get an accurate picture of the company’s financials.

5. Independence and objectivity are two of the most important external auditor characteristics. The SEC ruled that BDO Seidman’s independence had been jeopardized by the lawsuits that named BDO Seidman and Leslie Fay as defendants because of the lack of objectivity that the accounting firm would have if they performed the next year’s external audit. Because the shareholders’ lawsuit against them put BDO Seidman and Leslie Fay on the same side, BDO Seidman now had a personal stake in Leslie Fay’s financial statements and was no longer independent of the firm’s financials. If BDO Seidman were to perform the audit, the shareholders would not be able to rely on or trust the financial statements; they would assume that BDO Seidman would alter the auditing process to their benefit.

The lawsuit was not the only object of conflicting interest between BDO Seidman and Leslie Fay. GAAS #2 states that an external auditor must be independent in the way of thinking. After the fraud was revealed, BDO Seidman retracted two unqualified opinions for the past two years and publicly stated that they were victims of the Leslie Fay fraud, blaming Leslie Fay’s upper management for the entire scheme. This blame game back and forth between Leslie Fay and BDO Seidman clearly eliminates any possibility for auditors to go into a Leslie Fay audit with an independent mindset.

Additional Questions

1. The fraud would have been more detectable to the external auditors had SOX been implemented at that time. Howard Schilit, a forensic accounting specialist, “suggested…that Leslie Fay’s financial data had been replete with red flags” (Knapp 40), indicating that enough irregularities were present to justify further scrutiny. One of the largest components of SOX is the investigation of internal controls. Such an investigation would have helped the external auditors realize that the information they were given was not fully reliable. BDO Seidman should have evaluated the checks in Leslie Fay’s system, making sure that neither Donald Kenia, the controller, nor Paul Polishan, the CFO and senior vice president of finance, were able to tamper with the financial data without regulation.

The lack of any sort of IT system due to the CEO’s particular affinity to “old-fashioned” (Knapp 35) tradition also gave more power to executive management—they had absolute control over the financial data without electronic evidence of tampering. The numerous red flags described by Schilit make it apparent that BDO lacked professional skepticism in this case, resulting in the unqualified audit reports for Leslie Fay’s financial statements.

2. The proper execution of audit tests would have enabled BDO Seidman to uncover the accounting errors. Inquiry of Leslie Fay personnel would have quickly indicated that Polishan had absolute control over the financial data, causing the auditor to then test internal controls. An observational inspection of the application of internal controls should have been administered so BDO Seidman could see what checks Leslie Fay had in place to regulate their financial data. If this was properly observed, executive management’s control over the fraud may have been revealed. Many substantive procedures could have been implemented to further uncover errors. A test of details would have shown errors in all the major line items regarding cost and liabilities. Substantive tests of individual transactions, such as with purchase invoices, could show that the inventory reportedly in-transit did not actually exist.

A walkthrough and inspection of documents and activities would reveal that much of the inventory reported was falsely recorded because there would be no organic process in which actual inventory entered the warehouse and was recorded—since they were fabricated, the observer would have recognized this key step. A test of account balances would also show that the inventory on hand did not match up to the reported amounts. Substantive analytical procedures are key in this case. Due to poor economic circumstances and competitor struggles, a red flag should have been raised when Leslie Fay continued to report earnings growth but failed to explain how.

Since bonuses were tied to earnings, executives had incentive to inflate their numbers. Pomerantz’s “total salary and bonuses of “3.6 million [was] three times more than the 1991 compensation of Liz Claiborne’s CEO, whose company reported sales more than double those of Leslie Fay’s” (Knapp 40). BDO should have compared Leslie Fay to other companies in the women’s apparel industry, noting differences in trend lines. The gargantuan bonuses may have indicated that company operations were not management’s largest concern.


The accounting fraud engineered by Paul Polishan, CFO and SVP of finance at Leslie Fay, undoubtedly tarnished the reputation of Leslie Fay and its management, as well as BDO Seidman as its auditor. Many factors ultimately contributed to the $80 million accounting hoax that was finally uncovered in the early 1990s. One of the major factors included a severe lack of internal controls. No employee would contest the domineering Polishan, especially the second-in-command at the office, Donald Kenia, the controller. In addition, whenever an employee or management at the corporate headquarters would request financial information from Polishan, he would question them about why they needed the information, which should have been a sign that perhaps something illegal was happening behind the scenes. Not only was there a large communication problem between the executives of the company, but also the lack of transparency between executives was astounding, as other executives were in the dark concerning the fraud. Leslie Fay’s continued success in a struggling women’s fashion industry should have sparked BDO Seidman to look more closely into the financial information provided by Polishan, and perhaps conduct substantive analytical procedures on a more detailed level.

BDO Seidman also should have actively compared Leslie Fay to its close competitors, and the industry as a whole, to see that key financial ratios did not match the general trend. The opportunity and incentives for Paul Polishan to commit fraud were both present. The physical distance of Polishan from headquarters opened up a large opportunity for him to commit fraud. In addition, he had an employee willing to take the fall for him when the fraud was uncovered. With this opportunity, Polishan was able to evade bad financial statements that the declining women’s fashion industry would have given him and increase his bonus, which was tied directly to the earnings of Leslie Fay. Had the Sarbanes-Oxley (SOX) legislation been implemented prior to the accounting scandal at Leslie Fay, the fraud would have been more easily detectable. SOX would have held executives accountable for the accuracy of financial statements The external auditor would also have been held to a higher standard of providing reasonable assurance as to the accuracy of the company financial statements.

Even though BDO Seidman only provided an “unqualified opinion” on the accuracy of the statements, SOX would have prevented BDO Seidman from being so careless in their auditing of Leslie Fay. Lastly, SOX would have required an in-depth review of internal controls, which Leslie Fay was lacking. The lack of internal controls at Leslie Fay, and BDO Seidman’s ignorance of this problem, was a major contribution to the fraudulent accounting scheme that took place. If the external auditor, BDO Seidman, had performed a proper review of Leslie Fay’s internal controls, they would have uncovered a complete lack of said controls, including a lack of checks and balances between top management. This deficiency caused a major disconnect between the CFO and other company executives, with the critical problem being information asymmetry between the two parties.

The accounting offices of Leslie Fay were located a hundred miles from the corporate headquarters, furthering the gap between the CFO and other top management, and not allowing the accounting team to physically see the operations of the company. Additionally, Leslie Fay lacked any type of information technology system, and instead tracked daily sales and inventory counts by hand. This allowed for easier manipulation of data linked to the earnings process of the company. As seen through the situation at Leslie Fay, strong internal controls, and the regulation of these controls, is essential to the uncovering and prevention of fraud within any company. The effectiveness of the internal controls should be tested by the external auditor, as well as periodically evaluated by executives of the company.

The Leslie Fay Companies Essay

Crazy Eddie, Inc. financial fraud case Essay

Crazy Eddie, Inc. financial fraud case Essay.

Crazy Eddie was an American retail store chain run by the Antar family, which was established as a private company in 1969 in Brooklyn, New York by businessmen Eddie and Sam M. Antar. The fraud at Crazy Eddie was one of the longest running in modern times, lasting from 1969 to 1987. Crazy Eddie became a known symbol for corporate fraud in its time, but has since been eclipsed by the Enron, Worldcom and Bernie Madoff accounting scandals.

Commencement of fraud

The fraud began almost immediately, with the management of Crazy Eddie underreporting taxable income through skimming cash sales, paying employees in cash to avoid payroll taxes and reporting fake insurance claims to the company’s carriers.

Eddie Antar, the CEO of the company who was the mastermind in the fraud, was skimming money from sales taxes that he only partially remitted to the government, while using part of the money to give steep discounts to customers. Much of the rest of the money he used to fund a partying lifestyle, while secreting a fortune at home and abroad.

He also repackaged used and damaged electronics and resold them to customers as new. When electronics companies refused to supply him because he was selling the products to his customers below list price, he instead sourced the products from suppliers in other countries on the gray market.

He used massive sales promotion strategy to promote his company’s name and products. The television ad of the company was very much popular that time. The company began to grow rapidly and had several branches across the country. As the chain grew in size, the Antar family started planning for an initial public offering (IPO) of Crazy Eddie and scaled back the fraud so that the company would be more profitable and get a higher valuation from the public market.

This strategy was a success and Crazy Eddie went public in 1984 at $8 per share. The final phase of the Crazy Eddie fraud began after the IPO and was motivated by a desire to increase profits so the stock price could move higher and the Antar family could sell its holdings over time. Management now reversed the flow of skimmed cash and moved funds from secret bank accounts and safety deposit boxes into company coffers, booking the cash as revenue. The scheme also involved inflating and creating phony inventory on the books and reducing accounts payable to boost profits at the company.

Concealment of fraud

The electronics chain used the young, inexperienced, undereducated and under skilled auditors for the audit purpose. The chain was able to fool young auditors by showing them inventory stock rooms filled with empty boxes of electronics gear, while distracting them with attractive female workers so they wouldn’t bother to look at what was inside or behind the stacks of boxes. They had a concept that if the auditor was wearing a suit, it was sure he wasn’t going to get it dirty by moving the boxes.

Eddie Antar was the mastermind behind the various schemes and hired his relatives to work at the electronics chain to help aid and abet the fraud. Eddie Antar paid for his cousin Sam E. Antar to learn accounting so he could eventually work at the growing company’s small auditing firm, Penn and Horowitz. In 1981, Sam passed the CPA examination with a 90% and scored in the top 1% in the country. He later became the Penn and Horowitz Company’s CFO in 1986. All the family members were bound together by a culture of crime and were working as a team for commitment and concealment of crime.

Exposure of fraud

The company was making so much money that Eddie Antar was having trouble finding places to put it. He ran out of hiding places in his office and home, and eventually began traveling to Israel and Switzerland to stash the money in secret bank accounts. However, the scheme began to unravel when his wife found out he was cheating on her, and the family took sides in the dispute. The fraud was finally uncovered in 1987 after the Antar family was ousted from Crazy Eddie after a successful hostile takeover by an investment group. The acquirer found out how overvalued Crazy Eddie really was and hired another outside auditor to look closely at the books.

Crazy Eddie limped along for another year before being liquidated to pay creditors. Eddie Antar, the CEO of Crazy Eddie, was charged with securities fraud and other crimes, but fled to Israel before his trial. He spent three years in hiding until he was eventually tracked down by authorities in 1992 and extradited back to the U.S. to face criminal charges. Antar and two other family members were also convicted for their role in the fraud. In 1997, Antar was sentenced to eight years in prison and paid large fines. He was later released in 1999.

Crazy Eddie Red Flags

The red flags in the Crazy Eddie, Inc. financial fraud case which could notify the potential fraud were as follows:- The tight knit Antar family ruling Crazy Eddie had virtual absolute control over all aspects of the business. Very poor audit trails and documentation.

Major self-dealing transactions and related party transactions by family members. Substantial increases in wages from below market wages before the company went public. In 1985, an attempt was made to falsify certain store inventories which was uncovered by the auditors. The auditors accepted an excuse that it was not sanctioned by management. Substantial increases in gross margins, profits, inventories, debit memos etc. from prior periods for no logical reason. Significant volume of outstanding deposits in transit at fiscal year end. Individual deposits in transit extremely high in relation to normal amounts at fiscal year end. Unusually high inventory volumes in stores where physical counts were not observed by outside auditors. Inventories in many individual stores were in excess of space capacity.

Major differences between amounts confirmed from vendors for accounts payable and amounts reported on Crazy Eddie’s books and records. Use of “gross margin method” to value inventories during interim periods instead of taking interim inventory counts. Change of accounting methods for purchase discounts and trade allowances in 1987 from cash basis to accrual basis noted in footnotes with no accounting adjustments. Small CPA firm that conducted Crazy Eddie audits before (then big eight firm took over audits) had a significant revenue base from Crazy Eddie. Controller and later CFO for Crazy Eddie (Sam E. Antar) worked for small CPA firm that audited Crazy Eddie books.

Biggest Crazy Eddie Audit Errors

The reason, Crazy Eddie was able to conceal and commit the fraud for such a long time could be the inefficiencies of the auditor and the government to uncover the fraud. The government, auditors and investors were fooled by the company’s flamboyant founder and CEO, Eddie Antar and his family. Some of the biggest Crazy Eddie Audit Errors were as follows:- Assuming a proper audit can be conducted in the absence of credible internal controls. Under educated, under skilled, and under experienced audit staff. Over using audits as training grounds for inexperienced audit staff. Lack of investigative or forensic accounting skills by auditors. Failure to ask proper questions to the concerned persons.

Assuming the answers to good questions as correct without verification. Failure to ask follow up questions.
Lack of professional skepticism.

Allowing company staff to distract auditors from doing filed work by engaging in social conversations, thereby wasting time during audits so they have to rush their work in the end to meet the audit deadline. Failure to simultaneously observe inventory counts in all locations. From 1984 to 1987, the auditors did not observe all store inventories or inventories at all locations. Failure to take copies of full inventories taken when leaving the premises. Failure to conduct proper test counts of inventories by relying on company staff to count boxes and allowing company staff to take possession of test counts to make copies on behalf of auditors. Failure to follow through on analytical test issues.

Failure to conduct all required analytical testing.
Failure to conduct sales cut off testing at year end.
Failure to examine items listed as deposits in transit at year end. Failure to age accounts payable.

Failure to conduct adequate verification of accounts payable balances. Failure to contact vendors when major discrepancies were identified as vendors sent back verification requests. Failure to secure audit work papers left on premises during the audit by leaving keys to trunks containing audit documents on company premises. Allowing company personnel to view audit work papers in process. Auditors signed off on financial reports to outside directors and allowed the issuance of financial statements before the fiscal year 1987 audit was completed and backed into the numbers.

Auditors made misrepresentations to the outside directors about certain questionable practices and directions from the outside directors to investigate them. Auditors made misrepresentations to the SEC about directions from the audit committee to investigate questionable accounting practices. The auditors failed to follow up on recommendations of Crazy Eddie’s outside counsel law firm Paul, Weiss, Rifkind to investigate irregularities concerning sales to a trans-shipper in 1987. The auditors disagreed with recommendations by Crazy Eddie’s outside counsel law firm Paul, Weiss, Rifkind to provide more detailed disclosure on Crazy Eddie sales to trans-shippers and other issues.

The Fraud Triangle
The Crazy Eddie, Inc. financial fraud case, if linked up with the fraud triangle, following result can be obtained:-
a. Incentives/Pressures
Desire of Luxurious Lifestyle
Expensive extramarital relationships of Eddie Antar
Pressure to maintain social status
Pressure to sustain in competitive market
b. Opportunities
Lack of internal and external controls
Lack of audit trail
Inability of the auditors to judge performance quality
Lack of outsiders’ access to information

c. Rationalization

Sam Antar, former CFO of Crazy Eddie gave a statement, – “we committed crime simply because we could. Criminologists like to analyze white collar crime in terms of the ‘fraud triangle’ — incentive, opportunity, and rationalization. We had no rationalization. Simply put, the incentive and opportunity was there, but the morality and excuses were lacking. We never had one conversation about morality during the 18 years that the fraud was going on.” This statement shows that there was no rationalization used while committing the fraud, we could assume that following rationalizations could have been used by them:- Whatever they were doing did not hurt anybody else.

Whatever they were doing was not wrong.
Moral justification like, “Everyone else is doing it, so it must not be so bad to do this” could have been used.

4 Massive Frauds You’ve Probably Never Heard Of. (n.d.). Retrieved from A Convicted Felon Speaks Out about White Collar Crime. (n.d.). Retrieved from Crazy Eddie – Wikipedia, the free encyclopedia. (n.d.). Retrieved May 6, 2014, from Crazy Eddie Masterminds [Video file]. (2012, January 7). Retrieved from Weirich, T. R., Pearson, T. C., & Churyk, N. T. (2010). Accounting & auditing research: Tools & strategies. Hoboken, NJ: Wiley.

Crazy Eddie, Inc. financial fraud case Essay

First Keystone Bank Essay

First Keystone Bank Essay.

1. Prepare a list of internal control procedures that banks and other financial institutions have implemented, or should implement, for their ATM operations.

Financial institutions should implemented the following internal control procedures. The first one is Risk Assessment, which means financial institutions’ management should identifies, analyzes, and manages risks that can affect the company. The second one is Control Environment, this procedure require management of the institutions attitude toward, awareness of, and actions concerning the internal control structure to in order to reduce the fraud and error.

The third one is Control Activities, which means that institutions’ management should enact specific policies and procedures to achieve the management objectives.

What’s more, they should take necessary procedures to target the risks. The forth step is information and communications. Institutions should gather all necessary information to carry out internal controls. Providing, sharing and obtaining information is also very important, which is called communication. The last step is Monitoring. Which is an ongoing process to evaluate controls and determine whether all the operations are as intended.

They changed when operating conditions change.

2. What general conditions or factors influence the audit approach or strategy applied to a bank client’s ATM operations by its independent auditors?

The auditor should consider the nature, timing, and extent of further audit procedures to make decision. The nature of an audit procedure include its purpose and its type. So the purpose and the type of an audit procedure will influence the audit approach. The purpose of audit procedure determines whether it is a risk assessment procedure, a test of controls, or a substantive procedure. The types of audit procedures include inspection of documentation, inspection of assets, observation , external confirmation, recalculation, reperformance, analytical procedure, scanning, and inquiry.

Timing refers to when audit procedures are performed or the period or data to which the audit evidence applies. The higher the risk of material misstatement, the more likely it is that the auditor may decide it is more effective to perform substantive procedures nearer to the period end rather than at an earlier date. On the other hand performing audit procedures before the period end may assist the auditor in identifying significant matters at an early stage of the audit.

Extent refers to the quantity of a specific audit procedure to be preformed. The extent of audit procedure is determined by the judgment of the auditor after considering the tolerable misstatement, the assessed risk of material misstatement, and the degree of assurance the auditor plans to obtain.

3. Identify specific audit procedures that may be applied to ATM operations. Which, if any, of these procedures might have resulted in the discovery of the embezzlement scheme at First Keystone’s Swarthmore branch? Explain.

Inspection of documentation, observation, recalculation, analytical procedures, scanning, and inquiry may be applied to ATM operations.

I think the following procedures can resulted in the discovery of the embezzlement scheme. The first one is inspection of documentation. Auditors can examine a client document and compare it with the exact money they save and take out from the ATM. The second one is observation. Looking the procedure of using the ATM to make sure whether it is used with authority. The third one is analytical procedures. Auditors can analyzing plausible relationships among both financial and nonfinancial data of the ATM. The forth one is scanning. Performing a type of analytical procedure which involves reviewing accounting data to identify unusual items. For example, the amount of money that put in the ATM is not match the money that actually take out by customers.

First Keystone Bank Essay

Evaluating Internal Controls Essay

Evaluating Internal Controls Essay.

An organization’s internal controls are comprised of five components, which include: the control environment, risk assessment, control activities, monitoring, and information and communication. The five components of internal control are considered to be criteria for evaluating an organization’s financial reporting controls and the bases for auditors’ assessment of control risk as it relates to an organization’s financial statements (Lowers, et. al., 2007). “Thus, auditors must consider the five components in terms of (1) understanding a client’s financial reporting controls and documenting that understanding, (2) preliminarily assessing the control risk, and (3) testing the controls, reassessing control risk, and using that assessment to plan the remainder of the audit work” (Lowers, et.

al., 2007, p. 161).

Phase I – Understanding

Throughout the course of Phase I an audit team will work to obtain a clear understanding of a company’s internal control environment and management’s risk assessment. The audit team will review the flow of transactions through the company’s accounting system, and the design of some client control procedures (Lowers, et.

al., 2007). In this step the audit team will perform their assessments in a top-down risk-based manner that first examines company-level controls (CLCs) and then controls of significant business units within the company (Lowers,, 2007). Controls within the control environment and companywide programs include:

• Management’s risk assessment
• Centralized processing and controls including shared service environments • Period-end financial reporting process
• Controls to monitor results of operations
• Controls to monitor other controls
• Board-approved policies that address significant business control and risk management practices (Lowers, et. al., 2007, p. 161). Once the audit team has completed their examination of CLCs the audit team will then document their understanding through the use of narrative descriptions or flowcharts. The audit team will then use one of those tools to design a preliminary program of substantive procedures for auditing assertions related to the company’s account balances, which is conducted in Phase II (Lowers, et. al., 2007).

Phase II – Assessment

After the audit team has completed Phase I the audit team will move into Phase II or the preliminary assessment of the company’s control risks. Throughout the course of Phase II the audit team will analyze the control strengths and weaknesses of the company. A company’s strengths are considered as specific features of good general and application controls while its weaknesses are considered as a lack of controls in particular areas (Lowers, et. al., 2007). The audit team’s findings and preliminary conclusions should then be written up and documented in audit files known as the bridge workpapers.

In Phase II the audit team will seek to answer the following questions through its assessment. Can control risk be low or less than maximum? Is reduction of the control risk assessment cost-effective? Once the audit team arrives at the answers of those questions it will then specify the controls to be tested and the degree of compliance required. “The distinction between the understanding and documenting phase and the preliminary control risk assessment phase is useful for understanding the audit work. However, most auditors in practice do the two together, not as separate and distinct audit tasks” (Lowers, et. al., 2007).

Phase III – Testing

In the third and final phase the audit team will then perform tests of controls of the specified controls and reassess control risk. During the testing phase the audit team will seek to answer the question of how the actual degree of company compliance compares with the required degree of compliance with the company’s control policies and procedures. The audit team will then document the basis for assessing the company’s control risks, which are less than 100% or assess the company’s high or maximum control risk and design an audit program for the company with more effective substantive procedures. The audit team will then perform a test on the planned or revised substantive procedures.


An effective evaluation of a company’s internal controls will provide the company with a reasonable assurance regarding the achievement of its objectives in the following three categories: reliability of financial reporting; effectiveness and efficiency of its operations; and compliance with applicable laws and regulations.

Lowers, T.J., Ramsay, R.J., Sinason, D. H., Strawser, J.R. (2007). Internal Control and Evaluation. Auditing and Assurance Services. 2nd ed. The McGraw-Hill Companies.
New York City, NY.

Evaluating Internal Controls Essay

The Public Company Accounting Oversight Board Essay

The Public Company Accounting Oversight Board Essay.

The Sarbanes-Oxley Act created the Public Company Accounting Oversight Board (PCAOB) to assume the responsibility of overseeing the auditors of public companies. The PCAOB is a private-sector, non-profit corporation. It was established to “protect the interests of investors and further the public interests in the preparation of informative, fair, and independent audit reports”. (The PCAOB) Although the PCAOB is a private sector organization, it has many government-like regulatory functions. The PCAOB was created in response to an increasing number of accounting restatements by public companies during the 1990s and a series of recent high-profile scandals like Enron and WorldCom.

Prior to the PCAOB, the audit industry was self-regulated through the Public Oversight Board of the AICPA, but with the recent scandals and restatements something had to be changed.

The PCAOB consists of five members, of which one of them is the chairperson. All members are appointed by the Securities and Exchange Commission and serve a five year term. Two members of the PCAOB must be or have been a certified public accountant.

However, if the chairman is one of the CPAs, they may not have been a practicing CPA for at least five years. The organization has a staff of over 500 and its headquarters is in Washington D.C. The PCAOB has been given many powers and responsibilities under section 101 of the Sarbanes-Oxley Act. They have the power to register public accounting firms that prepare audit reports for public companies. The PCAOB sets auditing, quality control, ethics, independence and other standards relating to the preparation of audit reports.

They conduct inspections of registered public accounting firms. They also conduct investigations and disciplinary proceedings concerning violations of rules and impose appropriate sanctions where needed against public accounting firms. The PCAOB has the power to perform other duties or functions that are determined necessary to promote high professional standards. The PCAOB conducts its operations and exercises its power throughout the United States. Under Section 105 of the Sarbanes-Oxley Act, the PCAOB has the power to investigate and discipline registered firms and their associated members.

The PCAOB’s enforcement staff conducts investigations into possible violations of any provisions of the Sarbanes-Oxley Act, any professional standards, any rules of the PCAOB or the SEC, or any provisions of the United States securities laws relating to the preparation and issuance of audit reports. When violations are detected, the PCAOB will hold a hearing and, if necessary, impose sanctions against the organization. In December of 2006, Ibarra Firm was imposed sanctions like board members being revoked, a two year suspension, and a requirement of 200 hours of continuing professional educating before being allowed to issue any audits of financial statements. These sanctions were imposed by the PCAOB because they offered an unqualified opinion of Triad’s financial statements even though they were substantially inaccurate.

In 2005, the PCAOB adopted “Ethics and Independence Rules Concerning Independence, Tax Services, and Contingent Fees.” (Holstrom & Ray) This was their first independence and ethics rulemaking document. It addressed issues regarding tax services, contingent fees, personal accountability for independence infractions, and certain general independence and ethics roles. After the adoption of this document, Rule 3523 was created. Rule 3523: “Tax services for persons in financial reporting oversight roles”, states that if auditors or their affiliates provide tax services to public company managers during the audit and professional engagement period, their independence is impaired. The rule will not become fully in effect until April 30, 2007, so firms have the opportunity to finish their current tax service obligations.

Rule 3523 has brought up some controversy because this rule limits the number of tax service engagements a firm may perform. The rule does not allow firms to provide tax services to managers or their families. Many firms are upset by this rule because of its limitations. However, I believe that this new rule is a good idea. Previous engagements between firms and clients have been given a large notice of when the rule will be in effect. They are given plenty of time to finish their engagements. This new rule may allow small firms more possibilities to increase their clientele. We may be moving away from having a small number of large firms doing all the services to having many firms providing the services. Also, Rule 3523 will ensure independence.

Another issue that has arisen since the establishment of the PCAOB is the increased compliance costs. In 2007, the PCAOB has been awarded a budget of 136,429,000 dollars by the SEC. Of that amount, 79,514,000 dollars will be used to pay for salaries. (The PCAOB) The PCAOB’s budget is paid by public companies through fees and audit firms through fines. These fines can reach 100,000 dollars for individual auditors and up to 2 million dollars for audit firms. Many firms have increased their audit fees due to the increase in costs, partly due to the PCAOB. The PCAOB continues to grow each year. Their powers and responsibilities continue to grow, which in turn will lead to a larger budget. The SEC should take into consideration these additional fees for businesses and auditing firms when they determine the salaries of employees. The average salary for each employee is over 150,000 dollars, which is a substantial amount considering the organization is only a few years old and that at the rate they are growing, their budget will greatly increase.

I believe the PCAOB has been effective and will continue to be in regaining the trust from investors and those who look at financial statements. Recent scandals and numerous restatements of financial reports have hurt the accounting industry. The PCAOB has established many new regulations regarding independence and financial reporting that should minimize and prevent future scandals and restatements. I believe that the PCAOB will continue to grow and review more and more audit reports.

With the increase in the number of reviews, it should become less likely that an organization or audit firm may create a scandal because of the likelihood of being caught. Right now, audits may take longer and include more work, but after a few years they may become more efficient. Many audit failures may be due to isolated errors or systematic factors. These errors may be corrected by a further review by the auditors. Supervisors should inspect the reports before they turn to audit failures. This procedure could greatly reduce the need for financial report restatements and reduce the need for the PCAOB.

The PCAOB has had some criticisms brought forward since their creation, but audit firms must work with them to ensure their profession continues to serve the business community and its investors. The organization is designed to regain the trust of investors and of the accounting profession itself by ensuring informative, fair, and independent audit reports.


Holstrom, Gary & Ray, Thomas. PCAOB Standards-Setting Update Prepared for the Auditor’s Report (Summer 2006). Retrieved on February 7, 2007, from, Patrick. The PCAOD and the Future of Oversight. Retrieved February 7, 2007, from PCAOB. Annual Report for 2005 & 2007 Annual Budget. Retrieved on February 7, 2007, from http://www.pcaobus.orgWebCPA. Online Expo Center. Retrieved on February 12, 2007 from

The Public Company Accounting Oversight Board Essay

Accounting Scandals in the early 2000s Essay

Accounting Scandals in the early 2000s Essay.

During the early 2000s, the role of accounting and the auditing profession changed and several accounting scandals were uncovered.

a.What conditions caused accounting and the audit profession role to change during this time?The Enron scandal is one of the biggest from the early 2000s. Everything about this fiasco is huge, including a $50 billion bankruptcy, and employee retirement accounts drained of more than $1 billion. Enron’s auditor, Arthur Andersen, was indicted on criminal charges in 2002 as a result. Arthur Andersen was assigned to Enron as both internal and external auditor.

While working on internal controls, they had to attest to their own figures. This resulted in huge doubts being placed upon the accounting profession. Additionally, earnings restatements doubled between 1997 and 2000, and Enron reported $600 million in losses. Investors were also losing on market capitalization from audit failures.

b.What major changes occurred as a result of the accounting scandals at that time?The Sarbanes Oxley Act of 2002 (SOX) was created in response to the large corporate scandals, including Enron.

SOX was engineered to set rules for compliance. The stringent new rules were put in place “to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes” (SOX, 2002). The most fundamental reform of SOX was the Public Company Accounting Oversight Board (PCAOB), which was created to oversee auditors of public companies in order to protect the interests of U.S. investors. Arthur Anderson went out of business following their decline and indictment, and this was the second major change that occurred as a result of the Enron scandal.


Byrnes, N., et. Al. (January 28, 2002). Accounting in Crisis: reform is urgent. Retrieved August 22, 2007, from BusinessWeek website: Act of 2002. Retrieved August 24, 2007, from AICPA website:, R. G., Clark, M. W., Cathey, J. M. (2005). Financial accounting theoryand analysis 8e. United States: John Wiley & Sons, Inc.a

Accounting Scandals in the early 2000s Essay