ACCOUNTING-TheSEC’sCaseagainstCaliforniaMicro Devices:ALessoninUsingProfessional

TheSEC’sCaseagainstCaliforniaMicro Devices:ALessoninUsingProfessional
SkepticismandObtainingSufficient AppropriateEvidence

JillM.D’AquilaandKimCapriotti

M

CASE
ichaelMarriewasintheprimeofhiscareer.Heworkedmanylonghoursduringhis
20-year careerasaCPA.Finally,
hewasapartner atCoopers&Lybrand.Infact,many
youngaccountantsinhisfirmaspiredtothisposition.Theyearwas1994,andhewas
theengagementpartnerontheaudit foracompanycalledCaliforniaMicroDevices,Inc.(CMD).1
MichaelwasteamedupwithBrianBerry,anauditmanager, forthe1994audit.Michaelwas
comfortablewiththisarrangement.Afterall,BrianwaslicensedasaCPAfornearly tenyearsand workedonafewofCMD’sauditsbeforebecomingtheaudit
managerin1994.
MichaelandBrian wereveryfamiliarwithCMD’semployeesandfinancialinformation.CMDwasanauditclientof
Coopers&Lybrandsince1990.CMDseemedtobeagrowingcompany
inthefast-changing technology industry.Infact,CMDrecordedanincreaseof$3millioninnetincomefromfiscal
year1993($2million)tofiscalyear1994($5million)ontheir Form 10K. Most auditorswelcome
aclientinthegrowthstage.AsMichaelandBrianembarkedonthisparticularengagement,they
didnotrealizehowmuchthisclientandtheeventsoftheauditwouldimpacttheircareers.
Michael andBrianwereawareofacoupleofchanges thisyearrelating
toCMD’scustomers. Unfortunately,CMDlostalargecustomerwhopaidtheirbillstimely.Thiscustomer, Apple
Computer,Inc.(hereafter,Apple),represented32percentofproductsalesduringfiscalyear1993
andonly6percentofsalesduringthefirst halfoffiscal
year1994.Michaelwasnotconcerned
aboutthelossofApple,sinceCMDjustenteredintoanewagreementtolicensenewtechnology
toHitachiMetals,Ltd.Accordingly,therevenuefromthislicense(i.e.,non-productsales)would offsetthelostrevenuefrom
Apple.Inadditiontolosingamajorcustomer,CMDstartedselling
moregoods toforeigncustomers,manyofwhom
werelocatedintheFarEast.Sinceshipmentsto thesecustomerstooklonger(i.e.,sometimesas longas six weeks),CMDstartedofferingextended
paymenttermsof90to120daysormoretoanumberofthesecustomers.

.gif”>.gif”>JillM.D’AquilaandKimCapriottiareAssociateProfessorsatJacksonvilleUniversity.

Theauthorsgratefullyacknowledgethecommentsoftheeditorsandtwoanonymousreviewers.Theauthorsalsothank
CharlesCullinanforclasstestingthiscaseandprovidingvaluablefeedback.
Editor’snote:AcceptedbyKentSt.Pierre.

.gif”>1 TheenforcementreleaseissuedbytheSecuritiesandExchangeCommission(SEC)providedthebackgroundforthis
case.Unlessindicatedotherwise, thequotations inthiscasearedrawnfromthefollowing
source:Securities and ExchangeCommission,AccountingandAuditingEnforcement,ReleaseNo.1823(July29,2003).

Michael
andBriannoticedsomethingsduringpriorauditsthattheywantedtokeepinmind thisyear.Previously, CMDrecognized revenuesonproductsthatwerereadytobeshippedonthe
lastdayof the fiscalyear,butwereactuallyshippedsubsequentto
year-end.Duringtheseprevious
audits,Brianfounditdifficulttodeterminewhichgoodswereshippedandwhichgoodswerenot
shippedatyear-end.Historically,CMDrecognized70to90percentoftheirsalesinthethird
monthofeachquarter.Michaelmadesure
todiscusstheimportanceofproperrevenuerecognition withCMD’sauditcommitteewhenpreparingfor the 1994audit.He wassureto
focuson accounts receivable,sinceitwasacriticalareainthisaudit.
MichaelandBrianfinishedthe1994fiscalyearauditandissuedanunqualifiedauditopinion
datedAugust25,1994.Afewweekspriortoissuingtheauditreport,ashareholderfiledalawsuit
againstCMDforaccountingimproprieties relatedtoalargewrite-offofaccountsreceivablenear
theendoffiscalyear1994.Thiseventdidnotdetertheauditorsfromissuingtheauditreport.

COMPANYBACKGROUND
CMD,whichwasformedin1980,designsandsellssemiconductors.Givenitsnature,the
semiconductor industryischaracterizedbyrapidchangesintechnology,customerneeds,and
industrystandards.CMDisarelativelysmallplayerinthisindustryandreliesonafewcore
marketsforthebulkoftheirsales. Thesecoremarketsincludemobilehandsets,
personalcom-
puting,anddigitalconsumerelectronics,andarecharacterizedbyintensecompetition.CMDsells
theirproductstooriginalequipmentmanufacturers,suchasDell,Inc.;Hewlett-PackardCompany;
Motorola,Inc.;andSonyCorporation.
Accordingtopublishedfinancialreports,CMDwasunprofitablefortenconsecutivequarters
priortothesecondquarteroffiscal year1994.CMD’saveragelossduringthisperiodwas$3.8
millionperquarter.Duringfiscalyear1994,however,CMDreportedrevenuesof$45million,
profitsof$5million,andassetsof$75million.InapressreleaseonAugust4,1994,CMDnoted
anincreaseinanexistingproduct,aswell asstrongsalesofnew products.CMDalso
notedstrong non-productsales toHitachiMetals,Ltd.Thesesales were
relatedtothenewagreementtolicense technology.Selectfinancialinformationismoredisclosedinasubsequentsectionofthispaper.

COOPERS&LYBRAND’SAUDITOFCMD
MichaelandBrianwereparticularlyimpactedbythreeareasoftheCMDaudit:(1)write-off ofaccountsreceivable,(2)confirmation ofaccountsreceivable,and(3)salesreturnsandallow- ances.

Write-OffofAccountsReceivable
RonaldRomito,CMD’schiefaccountingofficer,toldMichaelandBrianthatCMDwould writeoff$12millioninaccountsreceivable
neartheendofthefourthquarter.Michaelwas
dumbfoundedbythesizeofthiswrite-off.Accordingly,heandBrianmetwithRonaldnumerous
timestodiscusshowtoallocatethewrite-offamongvariousaccounts.Somepossibilities
wereto reversesales,recordsalesreturns,orrecordbaddebtexpense.UnderCMD’sproposedplan,the
$12millionwrite-off wouldinclude$4millioninbaddebtexpense.
Ronaldaswellashis managementteam’sgoalwastomaximizerevenuebyallocatingalargerportionofthewrite-off
tobaddebtexpenseandasmallerportiontoreturns.
Michael wasnotcomfortablewiththisproposal.
HeaskedRonaldtorecalculatethewrite-off
andadvisedhimtopreparealine-by-line analysislistingthereceivables
andthereasonforeach write-off.Ronaldrevisedtheamountofthewrite-offandmetwithMichaelandBrianseveral
moretimestodiscusshowtoallocatethewrite-off.Thefinalallocationofthe$12millionwasas
follows:$1.8milliontocostofsales;$1.3milliontobaddebtexpense;$7.2milliontosales
returnsandpriceadjustments;
$1.7milliontosalesreversals;andtheremaindertofreight,adver- tising,andcommissionexpense.

Muchlater,Briandidnotrememberreviewingthespreadsheetorotherdocumentationto
supportthewrite-off.
Infact,itisunclearwhetherRonaldeverprovidedtherequested analysis.
TheseniorauditoronMichaelandBrian’sauditteamconcludedintheworkpapersthatthe
write-offappearedreasonable. However,shedidnotelaborateanyfurther.Later,shecouldnot
rememberwhethershebasedherconclusiononobservation,oronlyconversations
withMichael andBrian.Ajuniorauditorontheteambrieflyreferredtothewrite-off.Therewaslittlemention ofthewrite-offelsewhereintheworkpapers.
Duringthesecondweekoffieldwork,CMD
gaveMichaelandBrianadraftofapressrelease
thatdisclosedfourth-quarter
earnings.Briancheckedthemathematical accuracyofthedraftand discussed
itwithMichael.CMDissuedtheactualpressreleasethenextdayandexplained the write-offasfollows:
Offsettingnon-product
saleswereproductreturnsandrelatedexpensechargestotaling$8,300,000
forthequarter.Asaresultofthesuccessofestablishing
secondsourcetothinfilmIPECproducts, thecompanydecidedtoreduceitsemphasisoncertaindistributionchannelsbyterminatingse-
lecteddistributors.Thecompanyauthorizedtheseterminateddistributorsandotherswhowere unabletopayfortheproductonatimelybasistoreturntheproduct($5,300,000)and,incertain cases,thesedistributorbalanceswerewrittenofftocostofsales($1,700,000)orbaddebtexpense($1,300,000).
CMDincluded
theitalicized portionaftertheauditorsreviewed thedraft.Interestingly,CMDwas
stillsellingproductstocustomerswhohadreturnedproductsinMay1994and,asaresult,helped
createaneedforthiswrite-off.
MichaelandBrianreviewedandinitialedthisAugust4,1994,
pressrelease.Later, theycould
notrememberiftheycomparedtheinformationinthedraftandfinal pressreleasewiththe
spreadsheetsRonaldpresumablygavethemearlier.Michaelreviewedthesamplingcriteriafor
confirmingaccountsreceivable,butdidnotbelieveanychangeswerewarranted.
CMD’sstockpriceimmediatelydroppedandashareholderfiled
alawsuitagainstCMDfor accountingimproprietiesrelatedtothiswrite-off.AseniorauditorquestionedbothRonaldand
CMD’slawyersaboutthelawsuitandrecordedintheworkpapersthatthelikelihood
ofan unfavorable
outcomeorsettlementwasunknown.MichaelandBriandidnotbelievethatany
changestotheauditplanwerewarranted.

ConfirmationofAccountsReceivable
Michaelknewthataccountsreceivablewasacriticalauditarea.Theauditorsselectedfor
positiveconfirmation,allaccountswithbalancesgreaterthanorequalto$100,000,aswellasa
randomsampleof20accountswithbalancesunder$100,000.
Thisselectionrepresentedover92 percentofCMD’saccountsreceivable
balance.Ofthe54accountsreceivable customers selected fortesting,25confirmedtheirfullbalance,12confirmedonlyaportionoftheirbalance,and17
didnotconfirm anyportionoftheirbalance.2AlthoughMichaelandBrianperformedalternative
proceduresforeachaccountbalancenotconfirmed, theSECdoesnotbelievetheauditorsper- formedadequateproceduresinsixcases,whicharedescribedmoreintheenforcement.Infact,the
SECbelievestheauditorsacceptedCMD’sexplanationswithoutobtainingcorroborating
evi- dence.
Someofthediscrepancies raisedquestions.Forinstance,onecustomer,Solectron,Inc.,con-
firmedabalanceofonly$33,017outofthe$148,067claimedbyCMD.Solectron,Inc.reported
thatithadnorecordoftwoshipments totaling$115,050,
theamountindispute.Solectron, Inc. requestedcopiesofpurchase
ordersforthesetwoshipments.TheSEClatercommentedthatthere
wasnoevidencethattheauditorseverlookedforthesepurchaseordersorinvestigatedwhythese
shipments werenotreceivedbySolectron, Inc.42dayslater(eventhoughtheywereshippedten milesaway).Theseniorauditordocumentedthatshereviewedshippingdocumentsshowingthat
$115,050inproducthadbeenshipped“rightbeforeyear-end.”Shedidnotdisclosedetails.
In anotherinstance,acustomer,GSS/ArrayTechnology,initiallyconfirmedthe
fullbalanceof

$204,465,butthendisputed$193,909laterintheweek.Theauditorsdocumented
thatthiscus- tomersubsequentlyconfirmed$100,000ofthedisputedreceivable.
Allinall,GSS/ArrayTech-
nologyprovidedthreedifferentanswersregardingtheirbalance.Ronaldwasabletoprovidea
satisfactoryexplanationandMichaelandBrianacceptedthisbalance.

SalesReturnsandAllowances
CMD’scontractsindicatedthatcustomerscouldreturnmerchandise
withinoneyearafter purchase.MichaelandBriananalyzedCMD’ssalesreturnstodeterminethereasonablenessof estimatesmadebyCMD’smanagementfortheallowanceforreturnsamount.Inanalyzingthe
ratioofreturnstosales,theauditorsfactoredinCMD’sstatementthatalmostallofthesales
returnsweremadewithintwomonthsofthepurchasedate.
MichaelandBrianacceptedCMD’samountof
salesreturnsfor the fiscalyearof $4.5million. However,salesreturnsforthefourthquarteralonewere$5.3million,asstatedinthe
August4th pressrelease.Inaddition, whencalculatingtheirownestimate
ofsalesreturns,Michael andBrian
usedaproductsalesfigureof$7millionfortwomonths,peramanagementtrendreport.CMD’s
agedtrialbalancefortheendofthefiscalyeardisclosed$12millioninaccountsreceivable30
daysorless.

CMD’SFRAUDANDTHESEC’SCASE AGAINSTCOOPERS&LYBRAND
AfterCMDbecameawareoftheshareholderlawsuit,theirboardofdirectorsappointeda
specialcommitteeof independentdirectors,whothenhiredErnst&Youngas forensicaccountants
toinvestigatepossibleaccountingirregularities. ThisinvestigationrevealedthatCMDwroteoff
accountsreceivableasaresultofnumeroustransactions
wheretherewasnorealisticprospectof gettingpaid.
ThegoodswereeithernotshippedbyCMD,notlikelytobepaidfor,orwereof inferiorquality.Accordingly,CMD usedthewrite-offtocleantheirbooks. CMD wentsofarasto
havetheirsales,shipping,andaccounting personnel, aswellastheircustomers,
createfalse
shippingdocumentsandinvoicestodisguisesomeoftheimproperlyrecordedsales.
InJanuary1995,Coopers&Lybrandresignedasauditors,andCMDhiredErnst&Young. MichaelandBriandidnotreissuetheauditopinion.OnFebruary6,1995,CMDrestatedtheir
1994financialstatementswiththeSEC.Publishedfinancialinformationrevealedthefollowing
selectfinancialresultsbeforeandaftertherestatement(inthousands):

Originally

Stated

Restated

TotalRevenues

$45,319

$30,073

CostofSales

24,307

31,919

GrossMargin

21,012

(1,846)

TotalExpenses

37,563

45,325

NetIncome(Loss)

5,058

(15,227)

Current Assets

61,966

42,536

TotalAssets

74,527

52,097

CurrentLiabilities

11,053

8,868

TotalLiabilities

24,094

20,630

RetainedEarnings

(AccumulatedDeficit)

9,581

(10,705)

Stockholders’Equity

50,433

31,467

.gif”>2 ItisnotclearfromtheSECenforcementreleasewhetherthese17customers
wereunabletoconfirmanyofthebalance orfailedtorespondtotheconfirmation.

TheSECchargedMichaelandBrianwith“engaginginimproperprofessionalconductby
engaginginintentionalorknowingconduct,includingrecklessconductthatresultsinviolationsof
applicable
professionalstandards.”TheSECbelievesthatMichaelandBriandidnotexercisedue
professionalcare
oremployanadequatelevelofprofessionalskepticismwhenperformingCMD’s
1994fiscalyearaudit.Also,theydidnotobtainsufficientappropriateevidencerelatingtoCMD’s write-offofaccountsreceivable,theaccountsreceivablebalance,andthesales
returnsamount.As aresultoftheseauditdeficiencies,theSECpermanentlydeniedMichaelandBriantheprivilege
ofpracticing beforetheSEC.MichaelandBrianbelievethattheycouldnothaveuncovered
this fraud,sinceCMDfabricatedanddestroyeddocumentsandsincetherewascollusionbetween
CMDandthirdparties.TheSECdoesnotbelieveMichaelandBrian’sargument
isrelevantsince ultimately,
MichaelandBrianwerenotdiligentandconsistentwiththeaccounting profession’s responsibilitytothepublic.

QUESTIONS

1. Professionalstandards:TheSECconcludedthatMichaelandBrianengagedinim-
properprofessionalconductasaresultoftheirrecklessfailuretocomplywithprofes-
sionalstandards.Identifyonegeneralstandardandonestandardoffieldworkthatwas violated.Explainthenatureoftheviolations.
Organizeyourresponseaccording tothe
threespecificareasoftheauditdiscussedinthecase.
2. Professionalskepticism:Inadditiontothethreeareasofconcernforthe1994audit
(write-offofaccountsreceivable,confirmationofaccountsreceivable,andsalesreturns
andallowances),
therewereothereventsdiscussedinthecasewhereMichaelandBrian
failedtoexerciseprofessionalskepticism.First,explaintheterm“professionalskepti-
cism,”asdescribedinConsiderationofFraudinaFinancialStatementAudit,SASNo.
99(AICPA2002,AUSection316).Second,identifytwoadditionaleventswhereMichael
andBrianshouldhaveusedmoreprofessionalskepticismduringtheauditofCMD.
3. Analyticalprocedures:Thefirststepinperforminganalyticalproceduresistodevelop
anexpectationofanaccountorratiobalance. Trendanalysis,orreviewingthechangesin
anaccountbalanceovertime,isonetechniqueusedindeveloping suchanexpectation.
Explainthechallengesinusingfinancialinformation frompreviousperiodsinthisaudit.
4. Estimates:TheSECchallengedthestepstakenbyMichaelandBrianinevaluatingthe
reasonablenessofaccountingestimates.Referencetheappropriateauthoritativestandards
anddescribehowauditorsshouldevaluatethereasonableness ofestimates.Identifythe
specificitemsinthisauditwhereMichaelandBrianweredeficientinevaluatingthe reasonablenessofaccountingestimates.
5. Workpapers:Theauditors’workpapersweredeficientinseveralrespects.Hadtheaudit
occurredmorerecently,theywouldhavehadtoadheretostandards
ofthePublicCom- panyAccountingOversightBoard(PCAOB).ConsultPCAOB Standard
No.3toexplain theobjectivesofauditdocumentation(PCAOB 2004,paragraph2).Describe thespecific deficiencieswiththeworkpapersinthisaudit.
6. Fraudrisk:Theauditor’sassessmentofriskofmaterialmisstatementduetofraud
shouldbeongoingthroughouttheaudit.ReadConsiderationofFraudinaFinancial
StatementAudit,SASNo.99(AICPA2002,AUSection316A).Describeconditions that
existedduringthisauditthatwereindicativeofsuchrisk.
7. Responsestofraudrisk:Whenauditorshaveidentified
fraudrisk,describetheactions theyshouldtakeinresponsetotheserisksbasedonConsideration ofFraudinaFinan-
cialStatementAudit,SASNo.99(AICPA 2002,AUSection316A).Didtheseauditors
respondappropriately?Usespecificexamplesfromthecasetoexplainyouranswer.

8. Confirmations:When
confirmingaccountsreceivablebalances,describealternativepro- cedures
thatshouldbeperformedafterrepliestosecond requestshavenotbeenreceived. Optional:ObtaintheactualAccountingandAuditingEnforcementrelease(ReleaseNo.
1823)ontheSECwebsite(.sec.gov/”>http://www.sec.gov)todescribethedeficiencieswithrespect
tothespecificcaseswheretheSEChaschallengedtheadequacyofproceduresperformed(SEC2003).3 Youwillfindthedetailsinthe“MarrieandBerryRecklesslyFailedto
ComplywithApplicableStandardsinTheirConfirmationofCMD’sAccountsReceiv-
able”section.
9. Howweretheauditorsinthiscasepunished?Provideyouropinionabouttheappro-
priatenessofthispunishment.

APPENDIX

AmericanInstituteofCertifiedPublic
Accountants(AICPA).1989a.AnalyticalProcedures.SAS
No.56.NewYork,NY:AICPA.
——.1989b.AuditingAccountingEstimates.SASNo.57.NewYork,NY:AICPA.
——.1992.TheConfirmationProcess.SASNo.67.NewYork,NY:AICPA.
——.2001.GenerallyAcceptedAuditingStandards.SASNo.95.NewYork,NY:AICPA.
——.2006a.Amendment
toStatementonAuditingStandardsNo.95,GenerallyAcceptedAudit- ingStandards.SASNo.105.NewYork,NY:AICPA.
——.2006b.PerformingAuditProceduresinResponsetoAssessedRisksandEvaluatingthe
AuditEvidenceObtained.SASNo.110.NewYork,NY:AICPA.
——.2006c.Omnibus—2006.SASNo.113.NewYork,NY:AICPA.

REFERENCES

AmericanInstituteofCertifiedPublicAccountants(AICPA).2002.ConsiderationofFraudina
FinancialStatementAudit.SASNo.99.NewYork,NY:AICPA.
PublicCompanyAccountingOversightBoard(PCAOB).2004.AuditDocumentation.Standard
No.3.NewYork,NY:AICPA.
SecuritiesandExchangeCommission(SEC).2003.AccountingandAuditingEnforcement.Re- leaseNo.1823.Washington,D.C.:SEC.Availableat:.sec.gov/litigation/opinions/34-48246.htm”>http://www.sec.gov/litigation/opinions/34-48246.htm.

.gif”>3 TonavigatetheSECwebsite,clickonthefollowinglinks:“Divisions/Offices;
Enforcement;AccountingandAuditing
EnforcementRelease.”

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