1)Which “management assertions” were relevant to Paragon’s construction projects? Describe an audit procedure that Arthur Anderson could have employed to corroborate that assertion for each. Professional auditing standards identify 5 “management assertions” that commonly underlie a set of financial statements. These 5 assertions are: occurrence, completeness, valuation/allocation, rights/obligations, and presentation/disclosure. With respect to the audit of Paragon’s construction project, some of these key assertions were overlooked by auditor Arthur Anderson.
The main assertions that Anderson should have focused on for this audit include occurrence, valuation, and disclosure. Occurrence is a relevant assertion in the audit of Paragon because it ensures that all recorded transactions have actually taken place. In order to inflate its revenues and profits, Paragon was recording revenues for nonexistent projects. More specifically, Anderson auditors failed to adequately investigate $4 million of uninvoiced construction costs. Lead partner, Michael Sullivan did not employ any procedures to determine whether these uninvoiced costs had actually been incurred as of year-end.
Anderson could have demanded that Golden Bear produce invoices for these transactions and then Anderson could have confirmed these transactions with vendors/clients. Valuation was another relevant assertion to Paragon’s construction projects because it ensures that transactions are recorded at the appropriate amounts. Paragon took advantage of the percentage-of-completion revenue recognition method that construction companies typically use to value revenue earned throughout a project. Paragon switched from its “cost-to-cost” method to what they referred to as the “earned value” method.
This latter method enabled the company to rely on subjective estimates of costs incurred rather than objective criteria. Thus, enabling the company to materially misstate its revenues and profit. Anderson should have examined the contracts between Paragon and its clients to determine that the costs and revenues match up. Anderson should have also contacted clients regarding the various change in fees that Paragon had apparently incurred. Finally, disclosure was a very relevant assertion for the Paragon audit.
Paragon failed to disclose much information regarding their switch to the “earned-value” method. Paragon continued billing its customers on a cost-to-cost basis while reporting financial results in the earned-value method. Arthur Anderson should have required Paragon to remain consistent and charge its customers based on the earned-value method. 2) Define what you believe the SEC meant by “Sullivan’s Audit Failures”. Do you believe Sullivan, alone, was responsible for the deficiencies that the SEC noted in the 1997 audit of Golden Bear?
According to the SEC, Michael Sullivan was fully aware that the decision to use the earned value method would result in accelerating revenue by material amounts. It is very clear that the SEC believed that Sullivan acted in a very reckless manner throughout the audit and was very negligent to important audit procedures that are typically performed for the audits of construction companies. I think that by “Sullivan’s Audit Failures”, the SEC meant the Sullivan failed to perform these key audit procedures that are crucial to the audit of construction projects.
Although I do agree that Sullivan acted recklessly during the audit, I do not believe that he, alone, was responsible for the deficiencies noted by the SEC in the 1997 audit of Golden Bear. The case states that Sullivan was very concerned about Paragons decision to switch from the “cost-to-cost” method to the “new and untested” earned value method. It also states that, in order to monitor the impact of the earned value method on Paragon’s operating results, Sullivan required the client’s accounting staff to provide detailed schedules showing Paragon’s project-by-project results under both methods.
Of course this doesn’t excuse Sullivan for failing to examine significant uninvoiced construction costs; he clearly was concerned about this new method of revenue recognition. Sullivan also did not act alone; he had other audit team members who were also responsible for the audit. Additionally, collusion by Golden Bear’s management to disguise the fraud sure didn’t help Sullivan’s cause. 3) Sullivan identified the 1997 Golden Bear audit as a “high-risk” engagement. How do an audit engagement team’s responsibilities differ, if at all, on a high-risk engagement ompared with a “normal” engagement? During the initial phase of planning of the 1997 Golden Bear audit, Sullivan designated it as a “high risk” engagement. However, the SEC noted that Sullivan had failed to mind any attention to these concerns while planning the actual audit procedures. Due to this “high risk” audit, Sullivan and his team should have been extra cautious during the audit and most definitely should have performed a more aggressive and thorough set of substantive audit procedures.
A possible strategy that audit teams can consider on “high-risk” audits is involving a forensic auditor to provide a more in-depth perspective of how and why a fraud may be perpetrated and also to raise the level of professional skepticism; which in this case was severely lacking. Also, an audit team could compare revenues recorded per month in the current year to prior years and then investigate the unusual or unexpected differences. Finally, an audit team may also want to compare the client’s profitability, accounts receivable, revenues and other accounts with industry averages to identify any unexplained relationships. ) Do auditors have a responsibility to refer to Audit and Accounting Guides issued by the ACIPA when auditing clients in specialized industries? Do these guides override or replace the guidance included in Statements on Auditing Standards (SASs)? I believe that auditors definitely have a responsibility to refer to these guides when auditing a client in a specialized industry. This is because these audits are usually more complex and usually involve greater risks. Therefore, auditors should refer to these guidelines in order to perform the audit to the best of their ability.
Specifically for the construction contractor industry, auditors will find revenue recognition under the percentage-of-completion and completed-contract methods, and financial statement presentations in the guide. The guide offers clear and practical guidance on recent developments in areas such as risk assessment, fair value measurements, and internal controls. Clearly, these guides can prove to be extremely helpful during an audit. I don’t think these guides override or replace the guidance included in
SASs; I think they act more as a recommendation of applying SASs in specific circumstances, including engagements for entities in specialized industries. These guides are there to do exactly what they say, to “guide an auditor” through the engagement of a client in a more complex and specialized industry. 5) Was the change that Paragon made in applying the percentage-of-completion accounting method a “change in accounting principle” or a “change in accounting estimate”? Briefly describe the accounting and financial reporting treatment that much be applied to each type of change.
Paragon’s change in applying the percentage-of-completion accounting method was a change in accounting principle. This is because the firm changed the method in which it accounted for its construction revenues based on the percentage-of-completion. According to AU Section 420. 06, this type of change requires the addition of an explanatory paragraph in the auditor’s report on the audited financial statements. If this change was considered a “change in accounting estimate”, according to AU Section 420. 5, no comment or disclosure on the estimate change is required unless this type of change has a material effect on the financial statements. In that case, an auditor must disclose the estimate change in a note to the financial statements. Regardless of whether the adoption of the “earned value” method was considered a change in accounting principle or a change in accounting estimate, disclosure by the Company in its second quarter 1997 interim financial statements and its 1997 annual financial statements was required to comply with GAAP.