Audit and Flash Case Study

• To provide students with an opportunity to learn (by doing) how auditors identify various client and audit risks. The case also provides students with insight into how a risk analysis ties into the strategic audit planning process.
• To provide students with hands-on experience responding to client concerns and issues. Often auditing students do not realize the extent to which clients request interpretations of standards and financial statement reporting and disclosure issues.
• This case requires students to comprehend Flash’s business as well as apply their broader business knowledge. The case also requires students to apply writing and team-building skills (if the case is completed in groups).
• This case helps students integrate some concepts including client acceptance, inherent risk, analytical procedures, acceptable audit risk, audit planning, fraud red flags, risk assessment, and financial reporting
  research.
• Flash Technology is based on an actual company (Centennial Technologies, Inc.) that committed a large accounting fraud from 1996 to 1998. When the instructor outlines the details of the fraud the students can compare the risks they identified with the areas containing fraud. To illustrate that “incredible” intentional accounting manipulations that still take place today (many famous high profile accounting frauds included in well-known audit cases took place before the average audit student was born).

Key facts

Flash is a rapidly growing high-tech firm primarily in the PC card business. Flash is in the process of changing auditors. The company believes they need a larger international professional services firm to manage their growing international business.

The students are asked to assume the role of team members from the new audit firm. While there is a tentative agreement concerning the December 2005 audit, the students’ “firm” is conducting additional analyses.

Flash has asked the new audit team to make recommendations regarding a few financial reporting issues (subsequent events, pending litigation, and derivatives). The case provides students with audit memos written to the planning files, Flash’s draft financial statements, industry ratios, and industry articles.

Flash faces several important business risks (e.g., intense competition, rapidly changing technology, and foreign operations). Several firm characteristics increase auditor business risk (e.g., public company, management integrity) and inherent risks (e.g., related party transactions, nature of business, initial engagement, and the likelihood of fraud). The company has been acquiring ownership interests in other companies. The company recently began selling a new product, “Flash 2005” that is alleged to have a cost of less than $20 but a sales price of $200. In the actual case, “Flash 98” was claimed to have a cost of 10 cents and a sales price of over $500.

Manny Schwimez is the CEO and Chairman of the Board. Students are provided with background information that is similar to Emanuel Pinez, who was the actual CEO of Centennial. Pinez, 58, was convicted of masterminding a scheme that inflated sales by over $20 million from 1996 through 1998. Centennial’s stock price rose an astonishing 450 percent in 1998.

OPTIONAL INSTRUCTIONS FOR STUDENTS

Your risk-analysis report should not be more than five double-spaced pages (bullet-point listings in the report can be single-spaced and the five-page limit does not include appendices and exhibits). Instructors can also determine if they would like to ask the students to specifically assess the risk of fraud.

USE OF CASE

We have used this case toward the end of the semester as an integrative group exercise. It could also be used after the client acceptance, audit risk, or analytical procedures modules. We recommend the case be assigned to small groups of students (3 to 6 students) for the following reasons:

1. in our experience students benefit greatly by discussing the various aspects of this company, risks posed, and implications for the audit,
2. students will be expected to function in small groups after they graduate,
3. the case is long and relatively complex, and
4. group solutions reduce the grading burden for the instructor. We also recommend that you give the students at least one week to complete the assignment.

PROFESSIONAL STANDARDS

Relevant professional standards for this assignment include AU Section 230, “Due Professional Care in Performance of Work,” AU Section 316, “Consideration of Fraud in a Financial Statement Audit,” AU 319, “Consideration of Internal Control in a Financial Statement Audit,” and AU 560, “Subsequent Events.”

SUGGESTED SOLUTION

Regarding the risk analysis, student solutions will differ. However, student groups should identify many of the risks noted below. We typically debrief the case in class on the day it is due. We spend 20 to 30 minutes discussing the issues. We usually do indicate when we begin the debriefing that the case is based on an actual company, but we do not indicate there was accounting fraud until later. When we do begin discussing the actual fraud we always have concerned students ask if their group was expected to have detected the fraud. We reassure the students that we do not expect them to have detected the fraud, but that there were risky areas they should have identified as potential red flags. We further explain that they can see how their group did at identifying risky areas that did contain fraud. In our experience, we find that most groups do identify, as risky, many of the accounts that had been intentionally manipulated in the fraud. We discuss the background of the case as well as suggested solutions. The debriefing is not intended to cover a complete solution and students are encouraged to discuss their solutions. We typically ask the students to discuss potential audit implications of identified risks.

Notes to instructors. Many of the facts of the actual Centennial case described in the following pages were obtained from articles in the popular press. For example: “How Centennial Technologies, a Hot Stock, Cooled”, The Wall Street Journal, Jon G. Auerbach, April 11, 1999, A1, and “Multimillion-dollar illusion: Centennial Technologies’ Rise and Fall is a Tale of Fakery and Overreaching,” The Boston Globe, Joann Muller, June 13, 1999, A1.

RISK ANALYSIS

General Areas of Risk. The following listing specifies general risks faced by Flash (Centennial) Technology:

• Public high tech company—extensive reliance on audited financial statements, rapidly changing technology
• Industry Risks: rapid technological change, evolving industry standards, rapid product obsolescence, intense competition
• Korean Venture and other acquisitions (DCI)—does the current management team possess the necessary global management skills, DCI history of losing money, many uncertainties PC Cards represent 98% of sales—extreme reliance on one product, what happens if better technology is developed by a competitor
• Supplier relations—financial statements indicate this is a critical issue as the company has only one supplier for some critical components, no long-term contracts exist, and materials shortages occur often
• Two major customers represent 25% of sales
• Extreme growth—operating and financial management expertise Short sales of stock increasing
• Flash 2005 sales to one company and that company is or will be a related party
• Patent litigation
• SEC Investigation
• Allegations that Manny is a “pathological liar” and has a history of wrongdoing

As we cover specific risks we ask students to discuss audit implications (i.e., nature, timing, and extent of testing). In the actual case the foreign venture was in Thailand and “Flash 2005” was Flash 1998. Financial Statement Risks. The following listing includes some of the high-risk areas associated with Flash’s financial statements:

Accounts receivable are up significantly and the allowance does not appear to be keeping pace What is the increase in other current assets due to?
Inventory up significantly, turnover ratio is only 1.8 suggesting potential problems with obsolescence or existence Rapid increase in sales, is this reasonable, does it raise revenue recognition issues? It would seem that research and development expense would be greater given the growth Large negative cash outflow from operations—the company is funding operations via financing activities, is there a going concern issue?

One issue that needs to be pointed out is that in instances of extreme growth, as with Flash Technologies, simple comparison-type analytical procedures may not be too informative. Again, as we cover specific risks we ask students to discuss potential audit implications (i.e., nature, timing, and extent of testing). Flash and the Industry. Comparisons of Flash to the industry point out areas of concern:

• Flash’s inventory turnover ratio is 1.8 while the industry average is 8.1. This raises concerns concerning existence and obsolescence (valuation)
• Flash’s operating profit has been outpacing the industry. In 2005 Flash is reporting over a 20% operating profit while the industry is about 14%
• Flash is a small player in the industry, competitors (e.g., Intel, Mitsubishi, Epson) are well established and have greater access to investment capital
• The industry Flash competes in is rapidly changing and extremely competitive

CLIENT ISSUES

It is important to inform students that client issues concerning financial statement disclosure and technical standards interpretation are very common. Inform students that client issues concerning disclosures
and standard interpretations are very common.

Issue №1 Subsequent Event. Yes, disclosure is required. The subsequent event is a type 2 event (AU section 560). The actual footnote from the Centennial annual report was: On July 10, 1998, the Company acquired Design Circuits, Inc. (“DCI”), a provider of customized, integrated manufacturing services to original equipment manufacturers in the electronic industry. The Company acquired a majority equity position in DCI for approximately $3.2 million of cash, 125,000 shares of the Company’s Common Stock, and the assumption of certain liabilities. The purchase price will be allocated to tangible assets based on their fair market values of approximately $6.7 million and goodwill of approximately $9.4 million. In addition, the Company will record approximately $2.5 million as a minority interest for the proportionate share of equity held by the minority shareholders of DCI.

Issue №2—Contingencies. A contingency is defined in FASB Statement #5 “as an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.” When a loss contingency exists, the likelihood that the future event will confirm the incidence of a liability can range from probable to reasonably possible to remote. Probable items and that can be reasonably estimated must be reported in financial statements. Items that are reasonably possible are disclosed in the footnotes. In the Flash case, it is not clear any disclosure would be required for the potential patent infringement lawsuit. That said, most SEC clients probably will have a general “catch-all” legal liability footnote saying something like: “The company is engaged in several lawsuits in varying degrees of completion. The company believes it will be successful in defending against these actions and has insurance that is expected to cover any unforeseen losses. The impact on the financial statements is not expected to be material.”

Issue№3—Foreign Currency Futures Contract. The CFO is half right and half wrong. There will be a foreign exchange gain associated with the decrease in the payable due to the supplier. However, as Gary Ryan pointed out, there will be an equal and offsetting loss associated with the derivative contract. November 1, 2005: The entry Flash makes to record the payable would be as follows:

FC indicates this payable Is denominated in a foreign currency)

December 31, 2005: The entry proposed by the CFO to record a foreign exchange gain would be as follows:

(4,000,000 – [800,000,000 /213.33])

December 31, 2005: Flash now also needs to report a corresponding loss on the futures contract as follows

It should be noted that the futures contract Flash entered into does not qualify for hedge accounting under Statement No. 133. The FASB explicitly excluded foreign currency–denominated assets and liabilities from the set of items that can be considered as items underlying a hedge (No. 133, par. 21c). Thus, derivatives that serve as economic hedges of foreign currency assets and liabilities are accounted for as speculations, with all gains and losses recognized as part of income immediately. However, because the accounting standards (in Statement No. 52) already require that foreign currency assets and liabilities be revalued at current exchange rates at the end of each period, with the resulting exchange gains and losses recognized in income, the net effect is the same as if the foreign currency derivatives were accounted for as fair value hedges after all. (This example makes the simplifying assumption that spot rates and forward rates are equal. When this is not true, the foreign currency and derivative gains and losses will not exactly offset because foreign currency assets and liabilities are valued using the spot rate, and derivative instruments are valued using the forward rate.)

POSITIVE ASPECTS OF FLASH

There are certain risks associated with Flash. But every client will have risks; particularly public high-tech clients in the growth stage. There is also good news concerning Flash. Ask the students to identify the positive aspects associated with Flash. Some of these include:

• Strong cash position
• PC Card market is a leading-edge industry with great potential Flash has entered into several strategic alliances with reputable firms Flash has reported strong growth—NIBT has doubled as a % of sales Excellent market performance
• Flash is ISO 9001 certified
• Flash represents many audit/assurance/consulting opportunities for the professional services firm

THE TRUTH BREAKS

The Flash Technology case is based on the real company Centennial Technologies. Emanuel “Manny” Schimez is really Emanuel “Manny” Pinez. Centennial engaged in massive accounting fraud. The financial statements included in the case contain nearly $23 million in fictitious revenue. The fraud was carried out over several years. Allegedly only a few people were involved in the fraud. The story broke in the popular press. Three of the articles reporting on Centennial were:

• April 11, 1999 “How Centennial Technologies, a Hot Stock, Cooled,” WSJ June 13, 1999, “Multimillion-Dollar Illusion: Centennial Technologies’ Rise and Fall is a Tale of Fakery and Overreaching,” The Boston Globe
• June 13, 1999, “Centennial Details Extent of Fake Profits” The New York Times

Not only were the auditors fooled by the Centennial fraud, but so were other sophisticated investors, creditors, brokerage houses, business partners, underwriters, and members of the Board of Directors.

EMANUEL PINEZ

With the benefit of hindsight, management integrity was an obvious issue at Centennial. Manny was a well-known con artist (unfortunately, this fact was not discovered by the auditors until it was too late). Important aspects of Manny’s background are provided in the following listing:

• Manny claimed on his resume that he received a degree from Hebrew University, but admitted that he never actually earned a degree. Manny explained that, “It looks much better if you say you graduated.” Likewise, after studying computers in London for six months, he claimed to have received a master’s degree from the London School of Economics. He concedes this claim is also false.
• Manny was fired from a Swiss computer services company in 1971 because phony invoices were found in his office drawer. The invoices had never been sent out, but corresponding amounts of sales had been booked.
• In the early 1980’s Manny headed ABL Technologies, a company involved in many lawsuits regarding infringing on other manufacturers’ patents.

Arial Cohen, the vice mayor of Jerusalem said, “I was absolutely surprised that nobody checked about his past because he is a man known in Israel for his propensity to tell whoppers.” In 1958, he conned an Israeli magazine into sending him to France for a swimming race across the English Channel. He called the magazine from Paris saying he had won and set a new world record crossing in 10 hours, 21 minutes. The magazine published the remarkable story and Manny was hailed as a national hero. Several weeks later, after suspicions were raised by the French press, no evidence could be found that the race ever took place. Manny admitted it was a lie causing enormous embarrassment to the magazine.

Friends say Pinez often boasted he was a paratrooper in the Israeli army during the Six-Day War, but he admits it is a lie.
Rachel Pinez, the wife of 36 years, says her husband is a pathological liar. Manny was very flamboyant, he was a lover of fast cars, fine wine and food. In 1998 Manny began telling institutional investors about a $300 million sale to AT&T for a system to track truck fleets by satellite. No evidence was ever produced to substantiate the claims and AT&T denied the report.

While Manny claimed to not have profited from the fraud because he did not sell his shares, he did use 3.5 million of his 4.2 million Centennial shares as collateral to borrow a total of $18.5 million from Lehman Brothers Inc. and PaineWebber Inc.

DETAILS OF THE FRAUD

Flash 98 Scam. An audit memo in the student case refers to “Flash 2005,” a new product. In reality the product was called Flash 98. In the student’s case the cost was claimed to be less than $20 while the sales price exceeded $300. In actuality, Centennial (Pinez) claimed the cost of the new product was 10 cents with a sales price of a whopping $500. It turns out there was no such product. As noted in the case, all sales were to one company. The actual company was BBC Computers, and BBC purchased $2.1 million of Flash 98. Robert Lockwood, who ran BBC was a close personal friend of Pinez. Lockwood would later be indicted on 13 counts of tax evasion related to his companies. To fool the auditors into thinking an actual sale took place, Pinez wired $1 million of his own personal funds to a third company, St. Jude Management Corp., which then paid Centennial on behalf of BBC for its Flash 98 purchases. The explanation provided for this rather unconventional form of payment was a “financial agreement” between St. Jude and BBC. Even though the check was from St. Jude Management, the $1 million payment was considered reasonable evidence supporting the sale. After the fraud was uncovered the auditors, Coopers & Lybrand, claimed that the Flash 98 scam was a “unique” fraud because it appeared the product was going out and cash was coming in.

While students would not be expected to identify the scam, they should identify the increased risk associated with Flash 2005 because of the secrecy and related party transaction. PC Card Scam. Some investors started to crave a first-hand look at Centennial’s operations. One investor sent an analyst to meet with Pinez and tour the headquarters in Billerica, MA. Although the analyst noticed some computer equipment he noticed there was none in Manny’s office. During a tour of Centennial’s manufacturing facilities, he saw “a room full of people banging on cards with rubber mallets. I had a bad feeling.” He returned to his firm and they “dumped the Centennial shares immediately.”

In truth, Pinez had enlisted a handful of employees in the company’s Billerica manufacturing plant to assemble fake memory cards by simply welding the casings together and leaving out a critical silicon computer chip. These fake cards made their way into inventory and sales. Most of the sales of these cards are alleged to have gone to other companies controlled by Pinez. While students would not be expected to have identified this scam, they will remember an audit memo referring to “empty cards.” The Fruit Basket Scheme. As noted in the student case Manny had decided to send holiday fruit baskets to some of his most valued customers and other associates. By weighing the fruit baskets before they were shipped, Pinez created paperwork showing a package of a specific weight being sent to one of the company’s customers. The papers were later falsified to make it appear as if Centennial had shipped memory cards, instead of bananas, nuts and grapefruit. Because memory cards are small and light, even a 10-pound shipment would amount to hundreds of cards, which sold for $100 to $500 each. The fruit shipments were booked as sales by Centennial.

Financial Statements Restated

In addition to the specific fraud tactics discussed above, post-fraud examinations also revealed that Centennial had recorded as revenue “bill and hold” transactions which did not ultimately meet revenue recognition criteria. Centennial had also overvalued investments and advances to related companies. Necessary restatements to Centennial’s (Flash’s 2005) financial statements to remove the fraud included:

• were reduced from $37.8 to $33.4 million
• COGS was increased from $23.6 to $29.7 million
• Net income went from a profit of $5 million to a loss of $4.2 million Inventory was reduced from $18 to $8 million
• PPE was reduced from $4.6 to $2 million
  Stockholder
• Equity was reduced from $45 to $32 million

Cumulative adjustments to the previously reported financial statements included reductions to sales of $21.2 million, an increase to COGS of $8.8 million, write-offs of investments in, and advances to, several companies of $15.8 million and other miscellaneous adjustments to expenses of $2.4 million. On the bright side, after the restatement, Centennial was eligible for an $8.1 federal tax refund!

HOW THE FRAUD WAS DETECTED

Coopers & Lybrand rightly considered Centennial a high-risk client. In fact in mid-1996 Coopers changed Centennial’s status to that of “high-level risk alert.” In the last part of 1996 and early 1997 short sellers began driving the stock price down. These sellers did not believe the company had actually obtained the $300 million AT&T contract and an article in Financial World claimed there was no evidence Pinez was awarded degrees by either the London School of Economics or Hebrew University. January 1997 the auditors notice “fishy” bills and hold transactions. The auditors warned the company to not release earnings until the concern is resolved; however, the company released earnings anyway. Coopers went to the Board of Directors (BOD) with their concerns and a full financial review was ordered by the board. In a subsequent BOD meeting lasting many hours, one of the fraudsters, Murphy, fingered Pinez as the mastermind of multimillion-dollar accounting fraud. While Coopers was instrumental in uncovering the fraud, unfortunately they had issued unqualified audit opinions on previous year’s financial statements that also included fraud. Manny Pinez was arrested and imprisoned at the Plymouth County Correctional Facility in 1997. Manny was described as “charming,” “confident he will prevail,” and “thoroughly compromising with the truth.” From his prison cell he denied any wrongdoing and indicated that his defense would be that his actions were undertaken to benefit the company. Manny attributed his problems to the scrutiny that inevitably comes with success, “You get lightning when you’re very high.” Despite his initial confidence, in 2000 he pleaded guilty to conspiring to commit securities fraud and was sentenced to 5 years in prison and ordered to pay restitution of $150 million for doctoring the company’s financial results from 1994 to 1997 and inflating the stock price. In 2000 Pinez also agreed to pay $5.3 million to settle a civil complaint of illegal stock trading filed by the SEC. The deal will leave Pinez nearly penniless when he gets out of jail and is deported to Israel, his lawyer said. Centennial’s former chief financial officer, James M. Murphy, was sentenced to 15 months in a halfway house and ordered to make the same amount of restitution as Pinez. He had also pleaded guilty. Centennial’s former chief operating officer, Bond Fletcher, was sentenced to eight months in a halfway house and ordered to pay $7 million in restitution. The SEC has filed complaints against Murphy and 8 Gilboa Peretz in connection with the fruit basket scam. Murphy sent the baskets and created fake sales documents. Peretz, a firm business partner, is accused of taking a fruit basket while saying he had bought a Centennial product.

ADDITIONAL FACTS—AFTERMATH

In 1996 Centennials’ surging stock graduated to the New York Stock Exchange just two years after going public. It finished 1996 as the best-performing stock on the Big Board, up a stunning 451%. Just before the fraud was uncovered analysts still had “strong-buy” recommendations outstanding. After the accounting irregularities were discovered the stock was delisted from the NYSE. As of the end of 1998 it was not listed on any organized exchange. Based on information reported on internet-based bulletin boards, Centennial shares were priced at $1-3 ¾ per share in 1998 down from a peak of $58.25 in late 1996.

As noted earlier Manny used his stock as collateral for an $18.5 million loan and he gave away as gifts shares that were worth $21 million at the time but would have climbed to several times that value. Four days before he was fired Manny placed an order for 5,400 option contracts betting the stock would fall; the proceeds ($4 million) were frozen by the court. Approximately 35 class-action lawsuits were filed in US District court against the Company, its directors, certain officers, its independent accountants, C&L, and others, asserting claims under Section 10(b) of the SEC Act of 1934 and Rule 10b-5 promulgated thereunder, and related state law claims of fraud, deceit and negligent misrepresentation. In addition several shareholder lawsuits were filed seeking recovery for alleged breach of fiduciary duties, gross negligence, breach of contract and insider trading. In April of 1998 the US District Court granted final approval of the Company’s proposed settlement of the class action and derivative claims described above. The settlement consisted of payment of over $1.5 million in cash and stock valued at $18.5 million (37% of the estimated market capitalization of the company) as well as agreements to adopt certain corporate governance policies and procedures. The settlement did not release Pinez or Coopers & Lybrand. Shortly after the fraud was discovered the United States Department of Justice (DOJ) subpoenaed the company to produce documents in connection with a grand jury investigation regarding various irregularities in the Company’s previous press releases and financial statements. The DOJ also requested information regarding former officers, stock transactions by Pinez, and correspondence with Coopers and Lybrand. At the same time the SEC launched an investigation. In a statement from the SEC they indicated that its inquiry should not be construed as an indication by the SEC or its staff that any violations had occurred, or as a reflection upon the merits of the securities involved or upon any person who effected transactions in such securities.

Centennial Technologies survived the fraud and returned to profitability. The company’s computer cards are inserted in laptops, defibrillators and wireless telephones to increase memory and communications capacity. In 1999 Intel Inc. took a 16 percent share in Centennial and 2001 Giant Solectron Corp. purchased the Company for almost $22 per share in Solectron stock.

Identified and discussed the following major/other issues:

• PC Card industry competitive and subject to rapid change in technology inventory obsolescence (valuation) is an issue
• Two customers represent 25% of company sales and two other major customers are in bankruptcy Valuation of accounts receivable
• Public company/debt covenants
• Related party transactions
• Supplier concerns, no alternatives, no long-term agreements, raw material constraints
• Going concerned, liquidity, negative cash from operations
• 98% of sales now in the PC card market
• Flash 2005 sales all to one person
• Management group qualified to handle growth, management reputation, background checks Questions of Emanuel Schwimez’s integrity
• DCI experiences losses
• Dominant players with more capital (Intel, AMD) have an 80% share Flash technology has not lived up to original expectations
• Korean Venture, exchange rates, etc.
• Patent litigation
• Short sales of company stock increasing
• Fruit baskets, empty flashcards
• Most manufacturing in one facility, proper insurance

Identified and discussed the following trends/relationships in the financial statements:

• With the rapid increase in sales, NI
• A/R is up substantially, allowance not keeping pace
• Inventory increased substantially, inventory turnover significantly less than the industry average
• Growth and profits outpacing the industry

Appropriately Addressed Client Concerns

1. Subsequent event disclosure of DCI and footnote draft
2. Pending Litigation
3. Foreign Currency Futures Contract

Demonstrated the relationship of the literature/course material (e.g., audit implications) to the case:

• Poor
• Fair
• Good
• Very Good
• Excellent
• Very Good
• Excellent
• Excellent
• Provided sound rationale for conclusions:
  Poor
• Fair
• Good

Quality of writing, presentation, and expression of thought:

• Poor
• Fair
• Good
• Very Good