Resolving difficult accounting issues: a case study in client-auditor interaction.
Auditors and their clients often encounter situations in which professional standards allow for different judgments about the appropriate treatment of accounting transactions. For example, auditors and their clients may disagree on the proper valuation of inventory or accounts receivable, because both parties may make different judgments regarding inventory obsolescence or the allowance for doubtful accounts. In such situations, auditors and their clients generally seek ways to resolve their disagreements. Statement on Auditing Standards (SAS) No. 57, Auditing Accounting Estimates (AICPA 1988), provides guidance for auditors in this regard. SAS No. 57 describes management's responsibility for making accounting estimates based upon its knowledge and expectations of past and future events and states that auditors are responsible for evaluating the reasonableness of those estimates. (1)
Auditors have become increasingly responsible for assessing the quality of management's financial accounting choices and judgments, including accounting estimates (see, e.g., Jonas and Blanchet 2000). For example, SAS No. 90, Audit Committee Communications (AICPA 2000), requires that auditors of public clients discuss with clients' audit committees the auditor's judgments about the quality, rather than just the acceptability, of management's financial accounting choices and judgments. Consistent with the auditor's important role in assessing management's accounting choices and judgments, financial statements are sometimes viewed as the joint product of both client and auditor (Antle and Nalebuff 1991). This view is due, in part, to the fact that both parties have mutual interests. Auditors are paid by the companies they audit, and public companies are required to obtain an audit. Further, both parties generally benefit from a strong, long-term relationship with the other; auditors gain valuable client-specifi c knowledge that enables them to conduct their audits effectively and efficiently, and clients avoid the costs associated with switching auditors. Therefore, it is in both parties' interest to resolve via negotiation difficult accounting issues whenever possible. However, it is important to note that in situations where companies issue financial statements that are materially incorrect or that are inappropriately aggressive, there are very significant legal and reputational costs to both client management and the auditor. As such, negotiating within the boundaries of generally accepted accounting principles (GAAP) in order to present a representationally faithful view of the client's financial status should be an important goal for both auditors and client management.
Negotiating within the boundaries of GAAP is complicated by the fact that client management may undertake a variety of earnings management strategies that "stretch" those boundaries, although not rising to the level of outright fraud (Public Oversight Board 2000, section 3.12). There are three such strategies that are commonly used: income smoothing, aggressive accounting, and "big bath" behavior. Income smoothing (also known as "cookie-jar reserves") refers to situations in which client management increases the amounts in reserve accounts during very profitable periods, so that those reserves can be used to bolster income during less profitable periods (Levitt 1998). Aggressive accounting refers to situations in which client management uses ambiguity in GAAP to justify aggressive financial-reporting alternatives (Levitt 2000; Johnstone et al. 2002). For example, situations involving significant estimates (i.e., valuation allowances), alternative measurement criteria (i.e., estimated restructuring liabilities ), or emerging issues (i.e., accounting for hybrid securities) provide management flexibility in reporting because these items involve a high degree of judgment or are not authoritatively defined by GAAP (Johnstone et al. 2001). "Big bath" behavior occurs when client management adjusts earnings downward in one period so that future earnings will be greater. For example, client management may record a variety of expenses in one period and inaccurately attribute them to a particular cause (e.g., a corporate restructuring or a change in management) so that future earnings will not be reduced ("burdened") by the items expensed during the "big bath" period.
Considering this background information about the client-auditor interaction setting, there are three objectives of this case. First, the case will help you understand the relationship between financial accounting and auditing by encountering a situation in which an auditor and client have differing views about the appropriate judgment to make for two difficult accounting issues. Auditors and their clients are often faced with circumstances where multiple difficult accounting issues require resolution in a given year. Such cases provide rich settings for negotiation because they expand resolution strategies from simple compromise to include a variety of possible trade-offs (Jensen 2001). Second, the case illustrates how different financial assumptions within GAAP can have dramatically different effects on balance sheet and income statement outcomes. Relatedly, you will see how auditors and their clients may develop different judgments based upon their private incentives. For example, an auditor's legal liabil ity may lead to more conservative judgments, while a client's compensation structure may encourage more aggressive judgments. Third, you will gain practice in developing and defending alternative accounting judgments to people with differing incentives because you will engage in an actual "negotiation" with students assuming a different role from your own.
The authors thank participating personnel from the accounting firm that provided data for this case. The authors appreciate the comments of Helen Brown and Sally Wright, and acknowledge the research assistance of Judy Ho. The authors also appreciate the comments of David E. Stout (editor), Frank Buckless (associate editor), and two anonymous reviewers.
Editor's Note: This paper was received, processed, and accepted by the previous editor, David E. Stout.
Karla M. Johnstone is an Assistant Professor at the University of Wisconsin--Madison and Steven R. Muzatko is an Assistant Professor at the University of Wisconsin--Green Bay.
(1.) Particularly relevant to this issue, the auditing standards (SAS No. 57, AU 342.04) state that "the auditor is responsible for evaluating the reasonableness of accounting estimates made by management in the context of the financial statements taken as a whole. As estimates are based on subjective as well as objective factors, it may be difficult for management to establish controls over them. Even when management's estimation process involves competent personnel using relevant and reliable data, there is potential for bias in the subjective factors. Accordingly, when planning and performing procedures to evaluate accounting estimates, the auditor should consider, with an attitude of professional skepticism, both subjective and objective factors." In evaluating the reasonableness of accounting estimates, auditors generally use a combination of approaches including: (1) reviewing and testing the process used by management in developing the estimate, (2) developing an independent estimate to assess the reas onableness of management's estimate, and (3) reviewing subsequent events or transactions that occur prior to the completion of the audit function.
American Institute of Certified Public Accountants (AICPA). 1988. Auditing Accounting Estimates. Statement on Auditing Standards No. 57. New York, NY: AICPA.
-----. 2000. Audit Committee Communications. Statement on Auditing Standards No. 90. New York, NY: AICPA.
Antle, R., and B. Nalebuff. 1991. Conservatism and auditor-client negotiations. Journal of Accounting Research 29 (Supplement): 31-54.
Jensen, K. L. 2001. Conflicting accountability and auditors' decision behaviors. Working paper, University of Oklahoma.
Johnstone, K. M., M. Sutton, and T. Warfield. 2001. Antecedents and consequences of independence risk: Framework for analysis. Accounting Horizons 15 (March): 1-18.
-----, J. C. Bedard, and S. F. Biggs. 2002. Aggressive client reporting: Factors affecting auditors' generation of financial reporting alternatives. AUDITING: A Journal of Practice & Theory (March, forthcoming).
Jonas, G. J., and J. Blanchet. 2000. Assessing quality of financial reporting. Accounting Horizons 14 (September): 353-363.
Levitt, A. 1998. The numbers game. Remarks at the New York University Center for Law and Business. New York, NY, September 28. Available at: http://www.sec.gov/news/speech/speecharchive/spch220.txt
-----. 2000. Renewing the covenant with investors. Remarks at the New York University for Law and Business. New York, NY, May 10. Available at: http://www.sec.gov/news/speech/spch370.htm.
Public Oversight Board (POB). 2000. Panel on Audit Effectiveness Report and Recommendations. Stamford, CT: POB.
RELATED ARTICLE: CASE ASSIGNMENT
The following information is provided to all groups of students.
College Wear Novelties (CWN) is a subsidiary of the public company Johnstone Capital Corporation (JCC). When consolidated, CWN constitutes about 20 percent of the revenues of the combined entity. Although CWN does not publicly issue separate financial statements (because it is a subsidiary of the overall entity), its financial results are material to the consolidated financial statements of JCC. CWN began originally as a manufacturing company. It acquired licensing agreements with universities to assemble clocks, wooden products, and other "gimmick" type items. CWN would then distribute these products through a large number of specialty shops on or located near college campuses. JCC acquired CWN, when the latter was at the brink of bankruptcy, in hopes of turning the company around. However, CWN remained relatively unsuccessful and has become a financial drain on JCC. Table 1 provides CWN's financial statements for 2000.
In September 2000, CWN replaced its president. The new president, Chris Daniels, initiated a significantly different product-marketing strategy, with a gradual phase-in during the fourth quarter of 2000. Based on this new strategy, CWN became an importer and distributor of products to a few major retailers rather than a manufacturer and distributor to many small retailers. Despite the strategic change, sales for 2000 were still poor. To add to the problem, inventory levels related to the products sold under the prior marketing strategy had built up throughout 2000.
Total inventory quantities increased from $551,000 at December 31, 1999 (audited) to approximately $1,200,000 at December 31, 2000 (unaudited). Of the $1,200,000 of inventory, 58 percent of the dollar value included products related to the new marketing strategy, while 42 percent of the dollar value included products related to the old marketing strategy (mostly clock parts that would require additional investment to make into saleable finished products). The license agreements related to most of the inventory marketed under the old strategy had already expired, so in addition to production costs, additional licensing fees would be necessary for that portion of the inventory to be saleable.
In late November 2000, the XYZ Audit Firm (as JCC's auditors) began performing substantive tests of inventory as part of the audit of CWN. Testing continued into January 2001. At that time, XYZ discovered that much of the inventory from the prior year still remained in the warehouse. XYZ then asked for a report showing slow-moving inventory. However, CWN's accounting system could not adequately track inventory and thus could not provide an aging analysis on slow-moving goods. Inventory was a material amount on CWN's balance sheet, but there was not enough time to construct an inventory system to track and value the existing inventory for audit purposes. As an alternative, XYZ sent the Vice-President, the Chief of Operations, and the Chief Financial Officer of CWN to the warehouse to identify obsolete inventory and estimate a possible write-off amount. Table 2 shows a truncated view of the results of the inventory obsolescence review process conducted by CWN's personnel.
Based on this process, CWN proposed to book an adjusting write-off entry as follows:
Loss Due to Market Decline of Inventory $97,000
Allowance to Reduce Inventory to Market $97,000
Note: This entry is not yet reflected in the unaudited financial statements for the year ended 12/31/00.
However, there is current debate between XYZ and JCC/CWN regarding whether this kind of write-off would be appropriate, and, if appropriate, the exact dollar amount of the write-off.
Accounts receivable is another significant balance on the financial statements of CWN affected by the change in marketing strategy. Under the old strategy, CWN sold to numerous smaller customers. Under the new strategy, most sales are made to four large retailers. A schedule prepared by CWN's management showing the detail and aging of the accounts receivable balance at December 31, 2000, is provided in Table 3.
You will be assigned to a group in which you will receive additional information regarding either the auditor's point of view or the client's point of view. After considering this additional information, you will begin a discussion with the students who have assumed the opposite point of view. Please be aware that the other students may not have received the same additional information as you have, and that in their assigned role, the other students may not have the same preferences as you have. In particular, if you are assigned to the auditor point-of-view role, then you are to assume the preferences of the auditor. In contrast, if you are assigned to the client point-of-view role, then you are to assume the preferences of the client. To provide perspective on client-auditor issue resolution processes, you will read an article describing an auditor-independence risk framework, and you will learn how the issues in this case fit into that framework.
TABLE 1 College Wear Novelties Income Statement For the Year Ended 12/31/00 (UNAUDITED) Sales $2,080,500 Cost of Sales 1,731,639 Gross Margin 348,861 Operating Expense 105,406 Net Income $ 243,455 College Wear Novelties Balance Sheet 12/31/00 (UNAUDITED) Assets Cash $ 32,753 Accounts Receivable $ 627,480 Less: Allowance for Doubtful Accounts 435,608 Net Accounts Receivable 191,872 Inventory $1,203,483 Less: Allowance to Reduce Inventory to Market -- Net Inventory 1,203,483 Property, Plant, and Equipment (net of accumulated depreciation) 267,362 Total Assets $1,695,470 Liabilities Accounts Payable $ 351,770 Accrued Payroll 10,700 Note Payable #1 3,300,322 Note Payable #2 190,000 Note Payable #3 857,422 Total Liabilities $4,710,214 Owners' Equity Common Stock 1,000 Accumulated Earnings (Deficit) (3,259,199) Net Income-Current Year 243,455 Total Liabilities and Owners' Equity $1,695,470 TABLE 2 Estimate of Obsolete Inventory by CWN Personnel Based on Physical Inspection Quantity Item Number Item Description on Hand Unit Cost PL-12-BMUG Bucky Mug 1,728 $0.90 DI-09-1-10012 Wisconsin Snow Globe 26 $0.20 PK-09-CHSE Wisconsin Cheese Wedge Hats 154 $3.02 DI-42-STBKY Stuffed Bucky toys 100 $5.00 * etc. * * * * etc. * * * * etc. * * * TOTAL Extended Item Number Cost PL-12-BMUG $ 1,555.20 DI-09-1-10012 $ 5.20 PK-09-CHSE $ 465.08 DI-42-STBKY $ 500.00 * etc. * * etc. * * etc. * TOTAL $96,993.00 TABLE 3 College Wear Novelties (CWN) Accounts Receivable Aging Schedule Unaudited Balance Under 61-90 Name of Customer 12/31/00 60 days days Super Colossal $148,372 $ 93,526 $36,243 Discount Suburbia 172,109 157,204 14,905 Mega Department 133,720 95,320 18,200 Ultra Stores 98,582 97,946 636 All Others (37 customers) 74,697 28,303 4,507 Total $627,480 $472,299 $74,491 Percent collectible based on 70%-90% 60%-80% past years' collection history collectible collectible Percent collectible based on 85%-95% 75%-88% fourth quarter 2000 collectible collectible collection history 91-120 Over Name of Customer days 120 days Super Colossal $17,561 $ 1,042 Discount Suburbia -- -- Mega Department 14,023 6,177 Ultra Stores -- -- All Others (37 customers) 11,861 30,026 Total $43,445 $37,245 Percent collectible based on 5%-50% 5%-50% past years' collection history collectible collectible Percent collectible based on 25%-75% Not yet fourth quarter 2000 collectible available collection history
The following information is provided only to those students assuming the auditor role.
Pat Gibson, the XYZ partner on the JCC engagement, was happy to have gained JCC as a new client two years ago. Recently acquired, JCC had a well-established name in the community and the fact that JCC was an XYZ client would enhance XYZ's reputation in the local business community. Additionally, experience with a large, public company was considered invaluable in attracting other companies as new clients.
When the inventory-obsolescence issue arose, Pat was concerned about maintaining a positive relationship with the client, particularly since it offered the "visibility" benefits described above. Pat also knew that such clients sometimes use the fact that they provide audit firms with such visibility as a way to increase their negotiating power with auditors. Despite all these concerns, Pat's most important objective was ensuring the appropriateness of the financial statements that he would have to approve via the audit opinion. For example, he was concerned that understating the allowance for obsolete inventory would overstate earnings and assets. Still, given that JCC/CWN was a new client, Pat was concerned about getting the client-auditor relationship off to a good start.
The CWN inventory-obsolescence issue might materially affect the consolidated financial statements of JCC; for clients similar to JCC the XYZ Audit Firm has a policy of determining materiality thresholds of 1/2 percent of revenue. While CWN's own inventory-testing results supported the $97,000 inventory write-off, Pat was concerned that the allowance needed to be higher. To generate an alternative estimate of obsolete inventory, Pat used statistical inference from the results of XYZ's price testing of CWN's inventory. This process involved observing the dates of the most recent invoices to estimate the age of the inventory. Pat knew that approximately 42 percent of the ending inventory dollar value was for manufactured products relating to the old product lines. Since the total ending inventory was $1,200,000, the amount relating to the old inventory was approximately $504,000 (0.42 x $1,200,000). He felt that at best, approximately 25 percent of the dollar value of the old inventory could be sold as scrap, at about its original cost. The other 75 percent of the dollar value of the old inventory could not be recovered because the parts were either unique to CWN's products in such a way that they could not be sold in their present state, or they contained logos covered under expired licensing agreements. Pat based these estimates on his knowledge of the industry and current market conditions. He knew that the old products would require additional investment, either by transforming them into saleable products or by renewing the expired licensing agreements. There was no supporting evidence that management had plans in place to make either of these investments.
When Pat approached the President (Chris Daniels) and the Controller (Lee Wright) of CWN about the inventory-obsolescence issue, they both wanted more time to ascertain the value of the inventory. They expressed a preference for writing off $97,000 this year and waiting to see what would ultimately be sold in 2001. They stated that if the inventory still was not sold in 2001, then they would write off the inventory in that period. Pat was unsatisfied with their preference.
He felt that in order to report on OWN's financial status, the inventory amount needed to be appropriately estimated at this time, with no "waiting around to see what happens next year."
Pat was also aware that the change in business strategy undertaken by CWN during the year might affect the valuation of accounts receivable, because of the potential shift in the collectibility of accounts with the new customer base. In reviewing the allowance for doubtful accounts, Pat noted that it had been increasing over the past several years because the provision for bad debts exceeded annual write-offs of accounts receivable. Because CWN's high estimates of bad debts resulted in conservative income estimates, Pat had previously been reluctant to insist that OWN reduce the allowance for doubtful accounts. Although he felt that the balance in the allowance for doubtful accounts was probably somewhat excessive in prior years, he did not believe that the financial statements had been materially misstated. In thinking about the issue, Pat wondered if CWN had been using an income-smoothing strategy (i.e., "cookie-jar reserves") because, in discussions with the prior auditor, he had learned that the adjustme nts to CWN's allowance accounts sometimes appeared to be timed in response to reported earnings. Pat wondered if CWN would push for bringing a large amount of the allowance back into income this year as a way to "cushion" the inventory valuation write-down.
Since the change in marketing strategy occurred during the fourth quarter of 2000, it was difficult to predict future collections of accounts receivable based upon the previous years' collection rates. For the current year audit, the confirmation tests provided adequate evidence of the validity of the ending accounts receivable balance. Because the audit was due to be completed shortly after the fiscal year-end, the testing of the subsequent receipt of receivables provided less evidence regarding valuation. This made it difficult to assess, with a great degree of precision, CWN's estimate of the net realizable value of accounts receivable. Ultimately, Pat felt that the allowance for doubtful accounts should be reduced, but he preferred a conservative adjustment. He felt that an estimate based on the low end of the range of percent collectible (Table 3) would be appropriate.
Any potential entry to reduce the allowance for doubtful accounts would be as follows:
Allowance for Doubtful Accounts
Other Revenue-Reduction in allow. for doubtful accts.
Note: This entry is not yet reflected in the unaudited financial statements for the year ended 12/31/00.
The following information is provided only to those students assuming the client role.
Pat Gibson (the XYZ partner on the JCC engagement) met with Lee Wright (Controller of CWN) and Chris Daniels (President of CWN), to discuss the inventory issue. Lee and Chris trusted XYZ's technical expertise, but felt that XYZ was somewhat insensitive to how a large write-off would affect CWN's bottom line, particularly at this time since the company was already in financial difficulty.
When Chris Daniels came on board as President, he had aggressive sales goals and was eager to turn the company around. Lee knew that Chris would not be pleased with a large inventory write-off because of its effect on the bottom line. Lee talked to Chris about the issue. They knew that approximately 42 percent of the ending inventory dollar value was for manufactured products relating to the old product lines. Since the total ending inventory was $1,200,000 (unaudited), the amount relating to the old inventory was approximately $504,000 (0.42 x $1,200,000). Lee and Chris knew that the old products would require additional investment, either by transforming them into saleable products or by renewing expired licensing agreements. Chris stated that he would approve making such investments, but Lee had a feeling that it was unlikely such investments would ever really be made since there were currently no plans to do so. They both felt that if they did not transform the old inventory, then at least 80 percent of it could be sold as scrap, at about its original cost. This estimate was based on their knowledge of the inventory, the industry, and current market conditions. However, since the time that CWN had changed its marketing strategy no buyers had expressed interest in purchasing the old inventory, and only holders of specific licensing agreements previously held by OWN would have a viable use for many of the products.
Lee was also concerned about another valuation issue, which involved accounts receivable. Over the past several years, the allowance for doubtful accounts had increased significantly, from about $100,000 in 1997 (audited) to approximately $450,000 in 2000 (unaudited). The allowance had been increased due to slowing payments from an increasing number of retail customers. By December 31, 1999, the number of retailers had grown to over 120. However, when CWN moved to a new marketing strategy, it also acquired a new type of retail customer. Instead of the multitude of small retailers (120), CWN now sold primarily to just four large retailers. These large retailers were more timely and dependable in their payments, although their payment history was certainly not perfect. However, fewer write-offs were now needed. Lee, therefore, felt the allowance for doubtful accounts should be reduced by approximately $400,000, which reflected his judgment concerning the aging analysis of the accounts receivable ledger, and hi s assessment of the general dependability of the large retailers' payments. He arrived at this estimate by assuming that collectibility would continue to increase, perhaps reaching an even higher collectibility percentage than had been achieved during the fourth quarter of 2000, although he admitted that he was being rather optimistic. Lee suggested to Chris that they consider bringing the allowance back into income this year, particularly since it would "cushion" the income-decreasing effects of the inventory write-off.
The entry to reduce the allowance for doubtful accounts would be as follows: Allowance for Doubtful Accounts: $400,000
Other Revenue--Reduction in allowance for doubtful accounts: $400,000
Note: This entry is not yet reflected in the unaudited financial statements for the year ended 12 131/00.
CASE REQUIREMENTS AND INSTRUCTOR EXPECTATIONS
The following information is provided to all groups of students.
This case consists of three sections, which are described below.
1. TIMING: OUTSIDE OF CLASS
PROCESS: Complete this part of the case within your respective client or auditor group.
Read the paper titled "Antecedents and Consequences of Independence Risk: Framework for Analysis" (by K. M. Johnstone, M. H. Sutton, and T. D. Warfield, Accounting Horizons, March 2001, pp. 1-18). Consider and discuss the relationship between client-auditor issue resolution processes and auditor independence risk, particularly as it relates to the facts in this case. Your typed response should not exceed one page in length. Attach a cover page that includes your group members' names. Keep a copy of what you hand in, for use during the in-class portion of the exercise.
2. TIMING: OUTSIDE OF CLASS
PROCESS: Complete this part of the case with your respective client or auditor group.
(a) Based on the information that you have received, identify alternative accounting solutions for the inventory valuation and accounts receivable valuation issues.
(b) For each alternative accounting solution, identify the income statement and balance sheet implications of that alternative. Describe whether you believe each alternative is consistent with (a) a representationally faithful view of the client's actual financial status, (b) income smoothing, (c) aggressive accounting, or (d) "big bath" behavior.
(c) From your presumed perspective (i.e., client or auditor), rank the alternatives in order of preference and be prepared to state the rationale for your ranking.
(d) For each alternative, consider how the other party (i.e., the client or the auditor, depending on which group you are in) might react to your alternatives.
(e) Consider what alternatives the other party might identify.
(f) Develop a "game plan" for getting the other party to see your point of view and adopt your preferred alternative(s) for resolving the issue.
Write out your responses for parts (a), (b), and (c). There is not a "correct" set of answers. Your job is simply to identify and articulate a variety of defensible alternatives. Your responses do not have to be typed. Two to three pages of handwritten material and calculations should be long enough for this portion of the case. Each group should hand in one set of answers with a cover page listing all members of the group. Keep a copy of what you hand in, for use during the in-class portion of the exercise (see below). You do not have to hand in your answers for parts (d), (e), and (f), but you will use your responses to these questions in completing the in-class portion of the case.
3. TIMING: IN CLASS
PROCESS: Complete this part of the case (in class) within your respective client or auditor group, while interacting with your instructor-assigned opposing group.
Engage in a discussion with your opposing group and decide how to resolve the inventory valuation issue and the accounts receivable valuation issue. You need to leave the discussion having jointly made some type of decision (i.e., agree to an alternative or come to some other resolution to the situation). Have one member of your group take notes (you will give those to the instructor, for evaluation, at the end of the case) on the process that the two groups went through as they engaged in the discussion. The instructor will evaluate the notes as well as the level and quality of your in-class discussion.
The Teaching Notes associated with cases published in Issues in Accounting Education will no longer be printed in the journal. Access is protected by password and is limited to full members of the American Accounting Association (AAA) at http://aaahq.org/pubs/issues/feb2002.htm. The username and password will be emailed to full members of the AAA in February 2002.
Starting in May 2002 the Teaching Notes will be available through the American Accounting Association's new electronic publications system at http://aaahq.org/ic/browse.htm. Full members can use their personalized usernames and passwords for entry into the system where the Teaching Notes can be reviewed and printed.
If you are a full member of AAA and have any trouble accessing this material please contact the AAA headquarters office at firstname.lastname@example.org or (941) 921-7747.
|Printer friendly Cite/link Email Feedback|
|Author:||Johnstone, Karla M.; Muzatko, Steven R.|
|Publication:||Issues in Accounting Education|
|Date:||Feb 1, 2002|
|Previous Article:||The association between the directional accuracy of self-efficacy and accounting course performance.|
|Next Article:||Big customers and their suppliers: a case examining changes in business relationships and their financial effects.|