Case 2.

5 - Sunbeam: Due Care

Solution Manual for Auditing and Accounting Cases

Investigating Issues of Fraud and Professional Ethics 4th
Edition Thibodeau Freier 0078025567 9780078025563
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Case #2.5– Sunbeam: Due Care

I. Technical Audit Guidance

To maximize a student’s knowledge acquisition of this material, this book has been designed to
be read in conjunction with the post–Sarbanes-Oxley technical audit guidance. All of the
PCAOB Auditing Standards that are referenced in this book are available for free at
http://pcaobus.org/STANDARDS/Pages/default.aspx. In addition, a summary of the provisions
of the Sarbanes-Oxley Act of 2002 is available for free on the book’s website at
www.mhhe.com/thibodeau4e or at http://www.aicpa.org/Pages/Default.aspx.

II. Recommended Technical Knowledge

The Sarbanes-Oxley Act of 2002

Section 204
Section 301

PCAOB Auditing Standard No. 14

Paragraph #17-23

PCAOB Auditing Standard No. 15

Paragraph #4-8

III. Classroom Hints

This case provides students with the opportunity to understand what is meant by an audit

firm exercising due care in completing the audit and the consequences associated with a failure

to do so. It is important to emphasize to students that the consequences attach to both the firm

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Case 2.5 - Sunbeam: Due Care

and the individual auditor. In addition, the case provides a context to discuss what is meant by

an adjusting journal entry proposed by an auditor and the issues associated with an auditor’s

decision about whether to require that such entries be recorded. Finally, the case provides an

opportunity for instructors to discuss the role of the audit committee in helping to prevent these

types of situations. To meet these objectives, this case illuminates a number of relevant

accounting issues that surfaced during the audits of Sunbeam and the client’s refusal to record

the adjusting journal entries proposed by Arthur Andersen.

We believe it is essential for students to carefully read over the recommended technical

knowledge, along with this case reading. The educational psychology literature suggests that the

acquisition of technical/factual type knowledge increases dramatically when such knowledge can

be applied in a realistic context. Thus, we urge instructors to use this case as a mechanism to

impart the relevant post-Sarbanes technical audit knowledge, outlined above.

This case assignment will work best if it is scheduled to coincide with the auditors'

professional responsibilities topic in the auditing course. Alternatively, the case can be used in

connection with a discussion of quality control at an audit firm. Or, this case could be used when

discussing the completion of the audit topic as a way to illustrate the issues involved when asking

clients to record adjusting journal entries.

We recommend that instructors spend time explaining the nature of adjusting journal

entries proposed by auditors. Depending on the point of the semester where this case is used,

students may need to gain an understanding of what is meant by an auditor’s proposed adjusting

journal entry. This can be accomplished quite effectively while going over questions number one

and two. Interestingly, Sunbeam’s first year improprieties were designed to decrease net income,

while Sunbeam’s second year improprieties were designed to increase net income. The case

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 Case 2.5 - Sunbeam: Due Care

provides a mechanism to explain the different motivations of managers in each of these different

years.

We also recommend that instructors spend time discussing the nature of the quality control

process at an audit firm. This discussion can be accomplished quite effectively while going over

the response to question number three in the case. That is, it is useful to ask students how they

think Harlow was able to justify his decision to the concurring review partner. This may provide

an opportunity to discuss materiality and the subjectivity associated with estimating materiality.

Finally, question four provides instructors with an opportunity to discuss the increased role of the

audit committee in the post-Sarbanes environment and whether that would have made a difference

on the Sunbeam audit.

IV. Assignment Questions & Suggested Answers

1. Consult Paragraphs 4-8 of PCAOB Auditing Standard No. 15. Next, consider the alleged
accounting improprieties related to increased expenses from the 1996 audit. If you were
auditing Sunbeam, what type of evidence would you like to review to determine whether
Sunbeam had recorded the litigation reserve amount and the cooperative advertising
amount in accordance with GAAP?

According to paragraph #4 of PCAOB Auditing Standard No. 15, “The auditor must plan and

perform audit procedures to obtain sufficient appropriate audit evidence to provide a reasonable

basis for his or her opinion.” Next, according to paragraph #6 of PCAOB Auditing Standard No.

15, “To be appropriate, audit evidence must be both relevant and reliable in providing support for

the conclusions on which the auditor's opinion is based.” The relevance of audit evidence

specifically relates to whether the evidence gathered actually relates to the financial statement

assertion being tested. That is, will the evidence allow the auditor to reach conclusions related to

that financial statement assertion?

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Case 2.5 - Sunbeam: Due Care

The reliability of the evidence specifically relates to whether the evidence gathered can truly

be relied upon as providing a true indication about the financial statement assertion being tested.

There are a number of factors that should influence an auditor’s conclusions about reliability, the

most important of which is the source (e.g., is it from a third party?) of the audit evidence. Finally,

according to paragraph #5 of PCAOB Auditing Standard No. 15, “sufficiency is the measure of

the quantity of audit evidence.” All things being equal, the greater the risk of material misstatement

related to the financial statement assertion, the more audit evidence will be gathered by the auditor.

In 1996, Sunbeam failed to comply with GAAP by recording a $12 million reserve for a

lawsuit that alleged Sunbeam’s potential obligation to cover a portion of the cleanup costs for a

hazardous waste site. Sunbeam’s management did not take appropriate steps to determine

whether the amount should be recorded in accordance with FASB Statement #5. Had they done

so, the reserve would not have passed either of the criteria.

According to FASB statement #5, an accrual and related expense needs to be recorded if the

loss is probable and the amount of the loss is able to be reasonably estimated. Thus, the auditor

would need to determine whether each of these criteria had been met for the $12 Million

litigation reserve. Thus, among other factors, the auditor would want to be sure that the cleanup

costs for the hazardous waste represented a reasonable estimate of the cleanup costs. In order to

be assured of this, the auditor must obtain sufficient and competent evidential matter. According

to the generally accepted auditing standards of field work number three, “Sufficient, competent

evidential matter is to be obtained through inspection, observation, inquiries, and confirmations

to afford a reasonable basis for an opinion regarding the financial statements under audit.”

Andersen did not obtain sufficient, competent evidential matter regarding the hazardous waste

contingency. This could be accomplished in part by reviewing documents such as the following:

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Case 2.5 - Sunbeam: Due Care

 Statements made by Sunbeam’s lawyers about the range of estimated liability, including

the most likely amount. One of the primary substantive tests to obtain comfort over the

valuation of an estimated liability is to obtain written, third party confirmation from the

client’s attorneys. If the attorney refuses access to the information on basis of

attorney/client privilege, the auditor should consider this a scope restriction.

 Review all independent estimates of the cleanup costs obtained by management. If an

independent estimate has not been obtained by management, it may be appropriate for the

auditor to hire a valuation expert to provide an estimate of the cleanup costs.

 Review copies of all correspondence with pertinent regulatory agencies regarding the

hazardous waste sight. The auditor should confirm the correspondence with pertinent

regulatory agencies in order to confirm the document validity.

 Review any board of director meeting minutes that relate to the cleanup process.

 Review the process that management follows to determine whether a liability and related

expense need to be recorded in accordance with FASB #5.

 Any other evidence that may help to determine whether the criteria in FASB Statement

#5 has been met.

In 1996, Sunbeam also recognized an excessive figure for a “cooperative advertising” reserve

that was established to fund a portion of its retailers’ costs of running local promotions. The

amount recorded, $21.8 million, was approximately 25% higher than the prior year’s accrual

amount. Andersen should have identified the increase during a horizontal analysis of the

financial statements while performing analytical procedures.

Under GAAP, the matching principle does require that an estimate be made for all expenses

incurred that relate to revenue of that period. Thus, the recording of an estimated “cooperative

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Case 2.5 - Sunbeam: Due Care

advertising” reserve would have been reasonably expected by the auditor. However, the auditor

must determine that the estimate that was recorded as an accrual and the related expense must be

a close approximation of the expected actual costs. In order to test the estimate recorded by

Sunbeam, the auditor would need to fully understand the causal factors associated with this

expense. By understanding the causal factors, the auditor can then determine whether the

estimate made is appropriate under GAAP. For example, given the nature of “cooperative

advertising” expenses, it is likely that sales volume would be a key determinant for the expense

amount. However, in 1996, while the sales volume did not change drastically, the “cooperative

advertising” amount increased by 25%. Andersen should have identified that there was not a

correlation in the change of “cooperative advertising” and sales volume during the analytical

procedures of the audit engagement.

Sufficient and competent evidential matter to assess the valuation of “cooperative

advertising” expense could be accomplished in part by reviewing the following documents:

 Contractual agreements between Sunbeam and retailers that outlined the agreement

related to “cooperative advertising”.

 Board of Director meeting minutes that relate to Sunbeam’s policy regarding

“cooperative advertising”.

 Internal documentation of management’s existing policy and procedures regarding

“cooperative advertising”.

2. For the excessive litigation reserves and excessive cooperative advertising amount,
identify the journal entry that is likely to have been proposed by Andersen to correct
each of these accounting improprieties. Why would Sunbeam be interested in recording
journal entries that essentially reduced its income before tax in 1996?

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Case 2.5 - Sunbeam: Due Care

For the excessive litigation reserve, Andersen is likely to have proposed a journal entry to

reduce the amount of the reserve and the related expense account. The journal entry proposed

would be:

Debit Litigation Reserve (Liability) XXXX

Credit Litigation Expense (Expense) XXXX

For the excessive “cooperative advertising” amount, Andersen is likely to have proposed a

journal entry to reduce the amount of the accrual and the related expense account. The journal

entry proposed would be:

Debit Cooperative Advertising Accrual (Liability) XXXX

Credit Advertising Expense (Expense) XXXX

In this particular situation, since Sunbeam’s new upper management team was hired during

1996, it is likely that they were interested in trying to make themselves look the best that they

could during 1997. Thus, by overstating the liability accounts in 1996, the upper management

team created a mechanism to reduce the amount of recorded expenses in 1997. As a result of

reducing recorded expenses in 1997, this provided the opportunity for management to look better

in 1997 by sacrificing the “bottom line” in 1996 for which they were not responsible.

3. Consult Paragraphs 17-23 of PCAOB Auditing Standard No. 14. As discussed in the case,
during both the 1996 and 1997 audit, Phillip Harlow allegedly discovered a number of
different accounting entries made by Sunbeam that were not compliant with Generally
Accepted Accounting Principles (GAAP). Speculate about how Harlow might have
explained his decision not to require Sunbeam to correct these alleged misstatements in
the audit working papers.

This question is designed to get the students to think about documenting their rationale in the

working papers for professional judgments. According to paragraph #17 of PCAOB Auditing

Standard No. 14, “The auditor should evaluate whether uncorrected misstatements are material,

individually or in combination with other misstatements. In making this evaluation, the auditor

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Case 2.5 - Sunbeam: Due Care

should evaluate the misstatements in relation to the specific accounts and disclosures involved

and to the financial statements as a whole, taking into account relevant quantitative and

qualitative factors.” This implies that Mr. Harlow should have critically thought through the

overall implications of these accounting entries. Indeed, since Mr. Harlow discovered these

accounting entries that were not compliant with GAAP, he would have had no choice but to

carefully document his rationale for passing on the audit adjustments in the working papers. He

might have used any or all of the following explanations:

 He may have argued that the journal entries were each immaterial and thus would not be

of interest to the readers of the financial statements. By doing so, Mr. Harlow would

have to argue that the journal entry would not change or influence the judgment of a

reasonable person. To do so, he may have arbitrarily increased the assessed materiality

level in the work papers and tried to justify the increase in a number of different ways.

 He may have argued that he relied on management’s assessments as probable and

reasonable (with regard to the reserve) or by trying to find “independent” experts that

would essentially support management’s conclusions. In addition, he may have argued

that the procedure management used to reasonably estimate the amount of the reserve

was appropriate.

 He may have argued that management’s refusal to record the proposed adjustments was

based on the notion that the proposed adjustments were based upon subjective estimates,

as opposed to objective factors and that management’s subjective estimates were

appropriate.

4. Consult Sections 204 and 301 of SARBOX. In the post-Sarbanes audit environment,
which of the issues that arose in 1996 and 1997 would have to be reported to the audit
committee at Sunbeam? Do you believe that communication to the audit committee
would have made a difference in Harlow’s decision not to record the adjusting journal
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Case 2.5 - Sunbeam: Due Care

entries? Why or why not?

According to Section 301 of SARBOX, the “audit committee of an issuer shall be directly

responsible for the appointment, compensation, and oversight of the work of any registered

public accounting firm employed by that issuer.” Moreover, according to Section 204, the

auditing firm must report all “critical accounting policies and practices” and “all alternative

treatments of financial information within [GAAP] that have been discussed with management”

as well as the “ramifications of the use of such alternative disclosures and treatments, and the

treatment preferred” by the auditing firm. This is an important component of the oversight role

played by the audit committee. Based on the revised technical guidance, for Sunbeam,

communication of each of these proposed adjustments to the audit committee would have likely

led to the recording of these adjustments in the financial statements.

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