AUDITING CASE

“STAR TECHNOLOGIES, INC AND

ROCKY MOUNT UNDERGARMENT COMPANY, INC.”
(In order to accomplish the Auditing Seminar’s assignment)

PREPARED BY:

Muhammad Arief Fauzi 8335123535

Rico Bobman 8335123531

S1 Accounting Reguler B 2012

FAKULTAS EKONOMI
UNIVERSITAS NEGERI JAKARTA
2015
CASE 1.9 STAR TECHNOLOGIES, INC.

Economic ups and downs are a fact of life for companies in high-tech
industries. Take the case of Star Technologies, Inc., a Virginia-based computer
manufacturer incorporated in 1981 that went public in 1984. In its early years,
Star marketed scientific computers or “supercomputers” for highly specialized
uses, including military surveillance and petroleum exploration. Star’s operating
results gyrated wildly during the 1980s

A Fallen Star

By the end of fiscal 1989 - March 31, 1989, Star face a financial crisis.
Among the company’s major products was a computer designed for use in
petroleum exploration. Company officials forecast that Star would sell 29 of the
computers during 1989. Because of changes in computer technology and a
slowdown in petroleum exploration activities, Star sold only one of these
computers during 1989 and had no outstanding sales orders for the product at
year-end. Star’s poor operating results for 1989 caused the company to violate
several covenants of a lending agreement with its principal bank. That bank had
extended Star a $5.8 million long term loan. The debt covenant violations
accelerated the maturity date of the loan, making it immediately due and payable
at the end of fiscal 1989.

Price Waterhouse audited Star’s financial statements throughout the late

1980s. During the fiscal 1989 audit, several contentious issues arose between
Price Waterhouse and Star’s top executives. Among these issues were the refusal
of Star’s management to reclassify the $5.8 million bank loan as a current liability,
disagreements over the adequacy of Star’s reserves for bad debts and inventory
obsolescence, and the capitalization of R&D expenditures by the company.
Eventually, the company’s management team and the Price Waterhouse partner
who oversaw the 1989 Star audit resolved these issues to their mutual satisfaction,
allowing Price Waterhouse to issue an unqualified opinion on Star’s 1989
financial Statements. Exhibit 2 contains the company’s 1988 and 1989 balance
sheets. Exhibit 3 presents the company’s income statements and statement of cash
flows for the period 1987-1989.

In January 1990, Price Waterhouse’s national office received an anonymous

letter alleging that the 1989 audit of Star Technologies was an “audit failure”.
After a brief investigation, the national office deemed the allegation unfounded.
An executive partner in Price Waterhouse’s Washington DC office, which had
issued the 1989 Star audit opinion, was not satisfied with the national office’s
investigation and decided to pursue the matter further. Following a lengthy
discussion with the individual who served as the audit manager on the 1989 Star
audit, the executive partner concluded that the audit had been inadequate and
reported this finding to the national office. In early 1990, Price Waterhouse
notified Star that it was withdrawing the audit opinion issued on the company’s
1989 financial statements. Price Waterhouse also informed Star that those
financial statements contained material errors. Although Star’s executives initially
disagreed with the audit firm’s conclusion, they later accepted that decision and
issued restated financial statements for 1989.

Price Waterhouse’s 1989 Audit of Star Technologies

Clark Childers, an audit partner with Price Waterhouse since 1984, served as
the engagement partner on the annual audits of Star’s financial statements from
1987 through 1989. Childers’ principal subordinate during the 1989 Star audit was
Paul Argy, a senior audit manager who was to be considered for promotion to
partner the following year. Argy assumed responsibility for planning and
coordinating the 1989 audit, supervising the staff assigned to the engagement, and
serving as Price Waterhouse’s on-site liaison with Star’s executives.

The Star audit proved to be a difficult engagement for Argy. Throughout the
audit, he clashed with client management over several accounting and financial
reporting issues. During one of those confrontations, Star’s management
demanded that Argy be removed from the audit. Childers refused to remove Argy,
but from that point assumed a larger role in dealing with client officials when
dispute arose. Following one particularly heated encounter between Childers and
Star management, the company’s executives decided to dismiss Price Waterhouse.
A subsequent investigation by the SEC revealed that Star’s audit committee
interceded and vetoed that decision. The disagreements between the Price
Waterhouse auditors and client executives during tory obsolescence, the reserve
for bad debts, certain “mystery assets” included in Star’s accounting records, and
the balance sheet classification of a large note payable.

R&D Expenditures

In 1989, Star established a joint R&D effort with Glen Culler & Associates,
a small company that developed supercomputers. Star advanced nearly $900,000
to Culler during fiscal 1989. The agreement between the two companies required
those funds to be repaid in 10 years and obligated Culler to use the funds to
develop a new computer that Star would have an exclusive right to manufacture.
Culler pledged all of its assets as collateral for the $900,000 advance. This
stipulation of the agreement was inconsequential since Culler had no source of
revenue or working capital other than Star, its sole customer; had a negative net
worth of nearly $200,000 and had few tangible assets. Finally, the agreement
between the two companies granted Star the right to acquire Culler.

Star’s management maintained that the $900,000 advanced to Culler during

1989 qualified as a note receivable and included it in “other” assets on Star’s 1989
balance sheet. Childers agreed with this decision. As required by Price
Waterhouse, a second audit partner reviewed the 1989 Star workpapers before
Childers released the audit opinion on the company’s financial statements. This
partner questioned the decision to report the $900,000 advance to Culler as an
asset in Star’s 1989 balance sheet and suggested instead writing off the advance as
R&D expense in Star’s 1989 income statement. The review partner then referred
Childers to paragraphs 11 and 12 of Statement of Financial Accounting Standards
No. 2, “Accounting for Research and Development Costs”. Listed next are
excerpts from those two paragraphs.
 The costs of services performed by others in connection with the research
and development activities of an enterprise, including research and
development conducted by others on behalf of the enterprise, shall be
included in research and development costs. If repayment to the
enterprise of any loan or advance by the enterprise to the other parties
depends solely on the results of the research and development having
future economic benefit, the loan or advance shall be accounted for as
costs incurred by the enterprise. The costs shall be charged to research
and development expense…

To provide additional support for his position that the $900,000 advance to
Culler should be expensed, the review partner cited the description of the
agreement between Star and Culler that was included in the draft of Star’s 1989
financial statement footnotes. That description specifically referred to the
arrangement as a “joint research and development agreement”.

After meeting with the review partner, Childers consulted with Star’s chief
financial officer (CFO). Childers told the CFO that the description of the Star-
Culler agreement included in the draft of the financial statement footnotes
suggested that the $900,000 advance should be treated as R&d expense by Star.

Following that conversation, Star’s CFO caused all references to the

transaction as a research and development agreement to be deleted from
the final version of the financial statement. The final version described
the agreement as a “working capital agreement”.

Childers accepted this revision without referring to the actual contract

between the two parties. An inspection of that document would have revealed that
the CFO’s updated description of the Star-Culler relationship was misleading. The
change in the footnote description of the Star-Culler agreement apparently
satisfied the review partner, causing him to drop his objection to Star’s financial
statement treatment of the $900,000 advance to Culler.
 During fiscal 1990, Star acquired Culler. While reviewing this transaction,
Childers and Angry discovered that Star’s 1989 financial statement footnotes had
not accurately described the Star-Culler agreement. Childers and Argy contacte
Price Waterhouse’s national office for advice on this matter. To provide a clear
understanding of the Star-Culler agreement, Argy forwarded to the national office
copies of relevant documents pertaining to that agreement. After studying those
documents, a Price Waterhouse partner in the firm’s national office concluded
that, at a minimum, $400,000 of the $900,000 advanced to Culler by Star during
fiscal 1989 should have been treated as R&D expense by Star

The national office partner then addressed the issue of whether Star’s 1989
financial statements should be restated. The partner asked Childers if an
adjustment to write off $400,000 of the Culler receivable to R&D expense would
have materially impacted Star’s 1989 financial statements. Childers convinced the
national partner that such an adjustment would have had an immaterial effect on
Star’s financial statements. Childers also told the national partner that an
adjustment had been proposed during the 1989 audit to write off a portion of the
$900,000 Culler receivable to expense. According to Childers, that adjustment had
been waived due to its immaterial effect on Star’s financial statements.

The SEC’s subsequent investigation found no evidence of the proposed

adjustment in Price Waterhouse’s 1989 workpapers. Following his interaction with
the national partner, Childers had instructed a subordinate to include such a
proposed adjustment in the 1989 Star workpapers. Despite that explicit
instruction, the subordinated had refused to change the workpapers.

Reserve for Inventory Obsolescence

One of Star’s original products was the ST-100 computer. Although a state-
of-the-art computer when first marketed in 1982, by 1989 the ST-100 was
outmoded. During 1989, Star added $3.5 million to the reserve for inventory
obsolescence for the its remaining inventory of ST-100s, reducing that inventory
to a net book value of $2 million. Argy and other members of the Star engagement
team believed that the ST-100 inventory was still overvalued. Argy recommended
an additional $1.5 million write down for that inventory.

Star’s management resisted Argy’s suggestion to write the ST-100 inventory

down to a net book value of $500,000. The client’s executives persuaded Childers
that the company would sell ST-100s in the future despite not having any existing
orders for that product and despite having sold only one ST-100 during 1989.
Star’s management also provided Childers with a list of $1 million of spare parts
included in the ST-100 inventory that would allegedly be needed by Star to
service previously sold ST-100s.

Childers accepted the $1 million spare parts requirement at face value

and failed to perform any procedures or make additional inquiries to
support the value. With regard to the remaining $1 million of obsolete
ST-100 inventory, Childers agreed, apparently in a compromise with
Star’s management, to an arbitrary reserve increase of $350,000 without
any documentation as to the basis for, or the rationale behind, the
adjustment.

Reserve for Bad Debts

Star reported slightly more than $5 million of net accounts receivable at the
end of fiscal 1989. Two of Star’s largest receivables had been outstanding for
more than four years. These receivables, both in litigation at the time, totaled
$1,062,000 and resulted from earlier sales of ST-100 computers. Before year-end
adjusting entries, Star’s allowance for doubtful accounts totaled $673,000. After
analyzing Star’s receivables, Argy determined that the allowance should be
increased by approximately $400,000. That figure roughly equaled the total of the
two disputed receivables less the existing balance of the allowance account.

In previous years, Price Waterhouse had reduced any proposed adjustment

to the allowance account by the value of the collateral for potentially uncollectible
receivables. Since the collateral for the disputed receivables, two ST-100
computers, was minimal, Argy decided that the proposed adjustment for
uncollectible receivables should not be reduced.

Childers advised Star’s management that he agreed with Argy’s analysis of

the allowance for doubtful accounts. The client’s executves balked at making the
$400,000 addition to the allowance and instead referred Childers to the company’s
attorneys. Those attorneys insisted that the proposed adjustment was excessive. As
a compromise, Star’s chief executive officer (CEO) recommended increasing the
allowance account $65,000 at the end of fiscal 1989. Childers agreed to that
adjustment. The SEC later challenged Childers’ decision to accept the modest
increase in the allowance account.

Childers had an inadequate basis to accept the CEO’s proposition to

increase the bad debt reserve by only $65,000. There was insufficient
audit evidence to suggest that the remaining $335,000 of the receivables
in question were collectible. In circumstances such as these, opinions of
counsel are not dispositive evidence of collectability.

“Mystery” Assets

During the 1989 Star audit, a Price Waterhouse staff auditor discovered an
accountant entitle “Assets in Process” having a balance of approximately
$435,000. A Star official told the staff auditor that the assets represented by the
account involved computer equipment purchased and placed in service in 1985.
However, Star could not provide invoices or other documentation to support the
existence of valuation of these assets, nor were any depreciation records available
for these assets. In fact, the client could not locate the assets or describe them in
detail to the Price Waterhouse audit team. Star’s CFO claimed that the equipment
could not be identified because it had been fully integrated into the company’s
existing computer facilities.

The staff auditor who uncovered the Assets in Process account noted in the
1989 workpapers that Star depreciated computer equipment over five years and
began depreciating such assets in the year they were placed into service. Since the
equipment purportedly represented by the account had been placed in service in
1985, the staff auditor reasoned that it should have been fully depreciated by the
end of fiscal 1989. Argy agreed with his subordinate’s analysis and concluded that
mystery assets should be immediately written off to expense.

When Childers brought the Assets in Process account to the attention of

Star’s CFO, the CFO refused to accept the proposed adjustment to write off the
balance of the account. At this point, the CFO claimed the assets had actually been
placed in service in 1987 rather than 1985, although he could provide no evidence
to support that assertion. Instead of accepting the proposed $435,000 adjustment,
the CFO offered to record $100,000 of depreciation expense on the assets in 1989
and write off the remaining $225.000 cost of those assets over the following four
years. Childers accepted the CFO proposal.

Classification of Notes Payable

Star’s poor operating result for fiscal 1989 resulted in the company violating
seven debt covenant included in the loan agreement with its principal bank. These
debt covenant violating caused a $5.8 million bank loan to be immediately due
and payable, as noted earlier. On June 15, 1989, Price Waterhouse completed the
1989 Star audit; however, Childers refused to issue an audit report on Star’s
financial statements until the company’s bank waived the debt covenant
violations. On June 29, 1989, star taxed Price Waterhouse a waiver obtained two
days earlier from its bank.

Childers disagreed with the audit senior’s conclusion. Because the bank
stated that it had no intention of making the $5.8 million loan immediately due
and payable, Childers believe the loan qualified as long-term liability shortly after
receiving the bank waiver. Childers signed the unqualified audit opinion on Star’s
1989 financial statements, dating the opinion as of June 15. Star included that
opinion in its 1989 Form 10-K fled with the SEC.

Where Was Argy?

 Paul Argy left the Star audit engagement approximately one week before the
1989 audit was complete to begin work on a new assignment in another city. Argy
returned to Price Waterhouse’s Washington D.C., office on July 10, more than 10
days after Childers issued the unqualified opinion on Star’s 1989 financial
statements.

Upon Argy’s return, Childers instructed him to complete his review of the
workpapers for the Star’s audit and to sign off on the “audit summary” for the
engagement. A Price Waterhouse policy required the audit manager on an
engagement to sign off on the audit summary document after completing his or
her review f the workerpapers. Agry initially refused to sign off on the Star audit.
Agry had contested several of the questionable decisions made by Childers during
1989 Star audit and believed that the 1989 workapapers contained “materially
incorrect” conclusion. Finally after several confrontations with Childers, Agry
capitulated and signed off on the Star workpapers and the audit summary.

Epilogue

Price Waterhouse recalled its opinions on Star’s audit 1989 statements on

March 9, 1990. The following month, the company’s management issued financial
statements for fiscal 1989 that contained appropriate adjustment for the item
discussed earlier. Star’s amended 1989 income statement reported a net loss of
$7.4 million rather than $4.4 million loss originally reported. On March 28, 1990,
Price Waterhouse issued unqualified audit opinion on Star’s restated 1989
financial statements. One week later, Star dismissed Price Waterhouse and
retained Coopers & Lybrand as its independent audit firm.

The SEC’s investigation of Stars original 1989 financial statements and its
1989 audit culminated in sanctions being imposed on both Star and the two key
members of 1989 audit engagement team. The SEC issued a cease and desist
order against Star that prohibited the company from future violations of the
federal securities laws. Paul Agry received an 18 months suspension from
practicing before the SEC, while Clark Childers received a five years suspension.
 In commenting on Agry’s involvement in the1989 Star audit, the SEC
complimented him for recommending that Star make several large and necessary
adjustment to its 1989 financial statements.

The SEC went to chastise Argy for signing off on the 1989 Star audit
workpapaers when he believed they contained materially incorrect conclusions

Instead of shining off in the Star workapapers, the SEC maintained that
Agry should have dissociated himself for Star audit. That option was available to
him since Price Waterhouce had a “disagreement procedure” allowing auditors on
an engagement to explicitly dissociate themselves from any decision with which
they did not agree. The SEC suggested that Agry may have allowed his desire to
be promoted to partner cloud his professional judgment.

By imposing a five year suspension on Childers, the SEC affirmed that the
audit partner shouldered a greater degree of responsibility for the 1989 Star audit
than did his subordinate, Agry. Following are the specific allegations of
misconduct that the SEC filed against Childers.

1. Failing to ensure that sufficient competent evidential matter was obtained

to afford a reasonable basis for his conclusion
2. Failing to exercise due professional care and sufficient professional
skepticism in the performance of the audit
3. Failing to assure that the financial statement on which Price Waterhouse
issued unqualified opinion were prepared in accordance with GAAP
4. Responding without an adequate basis to the question of the second
partner reviewer when issued were raised about agreement with Culler
5. Making misleading statement to Price Waterhouse national office
concerning its investigations on Star’s agreement with Culler
6. Instructing Agry to sign off on the audit regardless of Agry’s stated
disagreement with the conclusion reached by Childers
7. Instructing a Price Waterhouse auditor manager to make inappropriate
alterations to workpapers

Star Technologies financial statement condition steadily worsened in the

years following its unpleasant encounter with the SEC. the company’s computer
manufacturing operations never become economically viable. At last report, the
company had fewer than two dozen employee and its principal line of business
was the development of computer software.

CASE 5.1 ROCKY MOUNT UNDERGARMENT

COMPANY, INC.

Employees involved in the accounting and control functions of

organizations often face ethical dilemmas. Typically, at some point in each of
these dilemmas an employee must decide whether he or she will “do the right
thing”. Consider the huge scandal involving Equity Funding Corporation of
America in the early 1970s. In that scandal, dozens of the life insurance
company’s employees actively participate in a fraudulent scheme intended to
grossly overstate Equity Funding’s revenue and profit. These employees routinely
prepared phony insurance application, invoices, and other fake documents to
conceal the fraud masterminded by the firm’s top executives. When questioned by
a reporter following the disclosure of the fraud, one of Equity Funding’s
employees meekly observed, “I simply lacked the courage to do what was right”.

In early 1986, several employees of Rocky Mount Undergarment Co., Inc.

(RMUC), came face to face with an ethical dilemmas. RMUC, a North Carolina-
based company, manufactures undergarments another apparel product.
Approximately, one-half of the company’s annual sales were to three large
merchandisers: Kmart (29%), Wal-mart (11%), and Sears (9%). RMUC employed
nearly 1300 workers in its production facilities and another 40 individuals in its
administrative functions. Between 1981 and 1984, RMUC realized steady growth
in revenues and profits. In 1981, RMUC reported net income of $378.000 on net
sales of $ 17.9 million. Three year later, the company reported a net income of $
1.5 million on net sales of $ 32 million.

Unfortunately, RMUC failed to sustain its impressive profit trend in 1985,

as reflected by the financial data presented for the firm in Exhibit 1.
Disproportionately high productions cost cut sharply into the company profits
margin during that year. These high production costs resulted from cost overruns
on several large customer orders and significant start-up costs incurred due to the
opening of a new factory.

A subsequent investigation by the Securities and Exchange Commission

(SEC) revealed that the company’s senior executive and another high ranking
officer had refused to allow the firm to report its actual net income of $ 452.000
for 1985. To participate inflate the company’s 1985 net income, these executive
instructed three of their lower level subordinates to overstate the firm’s year-end
inventory and thereby understated its cost of goods sold. When the three
subordinates were reluctant to participate in the scheme, the two executives
warned them that unless they cooperated, the company might “cease operations
and dismiss its employees”. After much prodding, the three subordinates
capitulated and began systematically overstating the firm’s 1985 year-end
inventory.

While the three lower-level employees were overstating RMUC’s inventory,

the two company executive who concocted the scheme periodically telephoned
them to check on their progress. At one point, the three subordinates indicated that
they were unwilling to continue falsifying RMUC’s year-end inventory, quantities.
However, after additional coaxing and cajoling by the two executives, they
resumed their fraudulent activities. Eventually, the three employees
“manufactured” more than $ 900.000 of bogus inventory. After RMUC’s senior
executive reviewed and approved the falsified inventory count sheet, the count
sheet were forwarded to the company’s independent audit firm.

To further overstate RMUC’s December 31, 1985, inventory the company’s

senior executive instructed another RMUC employee to obtain a false
confirmation letter from Stretchlon Industries, Inc. Stretchlon supplied RMUC
with most of the elastic needed in its manufacturing processes. At the time,
RMUC had an agreement to purchase 50 percent of Strechlon’s common stock at
net book value. On December 31, 1985, Strechlon had in its possession only a
nominal amount of RMUC inventory. Nevertheless, a Strechlon executive agreed
to supply a confirmation letter to RMUC’s independent auditor indicating that his
firm held approximately $165.000 of inventory at the end of 1985. As a condition
providing the confirmation, the Strechlon executive insisted that RMUC prepared
and forward to him a false shipping document to corroborate the existence of the
fictitious inventory. After receiving this shipping document, the Strechlon
executive signed the false confirmation and mailed it to RMUC’s independent
audit firms.

The fraudulent schemes engineered by RMUC executive overstated the

firm’s December 31, 1985, inventory by approximately $ 1.076.000. Instead of
reporting inventory of $12.158.000, in its original December 31, 1985, balance
sheet, RMUC’s reported net income for 1985 to $ 1.059.000, which was more
than $ 600.000 higher than the actual figure.

Near the completion of the 18985, audit RMUC’s auditor asked the
company’s senior executive to sign a letter representation. Among other items,
this letter indicated that the executives was not aware any irregularities (fraud)
involving the company’s financial statement. The letter also stated that RMUC’s
financial statement fairly reflected its financial condition as of the end of 1985 and
its operating result for the year. Shortly after receiving the signed letter of
representation, RMUC’s audit firm issued an unqualified opinion on the
firm’s1985 financial statements.

Following the SEC’s discoveries of the fraudulent misinterpretations in

RMUC’s 1985 financial statements, the federal agency filed civil charges against
the firm’s two executives involved in the fraud, the SEC eventually settled these
charges by obtaining a court order that prohibited the executives from engaging in
any further violations of federal securities laws. RMUC also issued corrected
financial statements for 1985.