Accounting Fraud and Litigation of Phar-Mor Analysis

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This case can be used in a legal liability module as it points to the large dollar amounts involved in lawsuits against professional accountants. It can also be used to effectively discuss the differences between statutory (e. g. , U. S. Federal Securities Acts of 1933 and 1934) and common law. Within common law, the case can facilitate discussions about the differences in liability to third parties between jurisdictions and countries.

The attorney for Sears, Sarah Wolff, of Chicago’s Sachnoff & Weaver, said under U. S. ederal securities law and Pennsylvania State common law, a plaintiff alleging fraud must prove that the defendant made a misrepresentation or omission of a material fact, and that the plaintiff relied substantially on that misrepresentation or omission in making investment decisions. She added that scienter—which includes recklessness—is an element of both causes of action. However, while U. S. federal securities laws require that recklessness be proved by a preponderance of the evidence, Pennsylvania state common law requires proof by a clear and convincing standard, a higher hurdle.

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The jury concluded that under either standard, Coopers had been reckless. Ms. Wolff added that the case could prove to be the model for getting a jury to find that a respected accounting firm behaved “recklessly. ” Other legal liability issues that can be addressed include the trend to “socialize losses” by holding external auditors liable for losses incurred by investors and creditors.

Coopers & Lybrand’s attorney, Robert J. Sisk, chairman of New York’s Hughes Hubbard & Reed, said: The jury [rightly] saw that a corporate fraud had been committed, but it mistakenly blamed the outside auditor for not uncovering something no one but the perpetrators could have known about. ” He added, “It’s a first . . . that effectively turns outside auditors into insurers against crooked management. ” The verdict is significant because Coopers claimed the investors did not rely on the audited financial statements—and that Coopers never expected investors to rely on those reports—in making investment decisions, Wolff observed.

A clean opinion by an independent outside auditor, however, is relied upon by investors like Sears because it contains information about the company’s history, an “extremely important” factor in investment decisions, Wolff said. Cases such as the Phar-Mor and Waste Management frauds, as well as the savings and loan debacles in the U. S. have put independent auditors under considerable pressure to do more than certify that a company’s books meet accepted accounting principles.

Major accounting firms, as well as major law firms and other professional consultants, frequently are targets of people with grievances against their clients, in part because the professional firms may have more money to pay claims than the primary miscreants. In February 1997 the American Institute of Certified Public Accountants (AICPA) issued SAS 82, “Consideration of Fraud in a Financial Statement Audit,” outlining new guidelines to help auditors spot fraud and determine how they should treat the information. We want auditors to focus more on suspicious situations and carry a healthy skepticism with them when they do their job,” Richard Miller, the AICPA’s general counsel, told the Wall Street Journal.

At the writing of this edition, the AICPA has a project underway to further revise AU 316, “Consideration of Fraud in a Financial Statement Audit” to improve the guidance relative to auditor’s responsibilities to detect fraud. Auditor Independence. This case can also be used to discuss auditor independence. Auditor independence has received significant attention in the U. S. Walter Schuetze, then Chief Accountant to the Securities and Exchange Commission (SEC), wrote a pointed commentary, “A Mountain or a Molehill? “.

Several other SEC speeches and commentaries followed until November 2000 when the SEC adopted new rules governing the auditor’s independence. The amendments modernize the Commission’s rules for determining whether an auditor is independent in light of investments by auditors or their family members in audit clients, employment relationships between auditors or their family members and audit clients, and the scope of services provided by audit firms to their audit clients.

The amendments also identify certain non-audit services that, if provided by an auditor to public company audit clients, impair the auditor’s independence. Finally, the new rules identify non-audit services that might impair an auditor’s independence. For all annual proxy statements filed after February 5, 2001, a public company is required to disclose information related to the non-audit services provided by the auditor during the most recent fiscal year.

One of the screening steps suggested in this article is to check all potential client’s references to determine such things as “reputation,” “cooperativeness,” “management quality,” and “personality. ” Mickey Monus spent most of his life in Youngstown, Ohio. This is also where he located the main office for Phar-Mor.

The case can also be used to discuss firm’s response to cases such as Phar-Mor. Firms should follow quality control guidelines as set forth in the professional standards. These include correct hiring, development, supervision and advancement practices, peer and quality reviews, partner rotation, consultation on difficult matters with other partners, and appropriate attention to auditor independence. The response of Coopers & Lybrand to audit and litigation risk is useful in answering how firms can reduce the likelihood of being associated with management fraud and resulting litigation.

In an address to the American Accounting Association in August 1996, Vin O’Reilly, a leading partner with C spoke about some of Coopers new methods of assessing and managing audit and litigation risk. These methods have been carried over to the merged firm PricewaterhouseCoopers (PwC). Mr. O’Reilly indicated that: The Firm has a firm-wide department of risk management. All new clients with risk factors must be approved by this department prior to acceptance, preferably prior to the proposal.

One major advantage of using this approval system is that the client acceptance decision is more objective. In the late 1980s, 25 percent of the clients the Firm accepted had experienced problems with the previous auditor. By the mid 1990s, that percentage was down to four percent. Partners are continuously reminded they are not alone. Difficult matters should be discussed with other partners at the local and national levels. Each year the Firm identifies the 200 highest risk continuing clients.

These engagements go through intense scrutiny as the firm challenges whether the client should be retained. The Firm has “fired” several high-risk clients in the last few years. Partners are taught that it is cause for celebration when they lose a “bad” client. The Firm’s engagement planning process specifically identifies factors that might indicate incentive, or the existence of management fraud. Based on a study of auditor litigation, the Firm has found that 85 percent of lawsuits against auditors are initiated when the client company fails.

Therefore, the Firm runs prospective and continuing clients through viability screens including sophisticated quantitative failure prediction models. In addition to the quantitative measures, the Firm considers several qualitative factors such as industry risk, company risk, management risk, corporate governance, oversight risk, etc. The Firm studies the personality factors of the client and the engagement team to ensure a proper match. The Firm has found that most audit failures have resulted because partner objectivity is compromised.

With this in mind, they conducted studies of partners who have been highly successful as well as those who have had problems with former audits to begin to understand the warning signs. They now monitor more closely partner traits and situations that may compromise objectivity. When necessary, the Firm provides objectivity counseling to the auditors. For example, an audit team may need counseling before an audit of a high-risk client that has aggressive and domineering management.

The Firm demands better documentation of audit decisions. They have found they can defend decisions that are written in the working papers easier than they can defend auditors’ recollections stated years after the fact.

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Accounting Fraud and Litigation of Phar-Mor Analysis. (2019, May 01). Retrieved from

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