A REPORT

ON
Star Technologies, Inc. : A Case Study
Course Name: Audit, Risk and Control
Course Code: AIS 5204

Prepared For:
Prepared For:
Abdul Alim Baser
Associate Professor
Department of Accounting and Information Systems
University of Barishal

Prepared By:
Prepared By:
Group No.06
Group Members ID No.
Md. Sagir Hossain 21 AIS 010
Md. Rejaul Karim 21 AIS 029
Sujan Miah 21 AIS 031
Md. Abu Easha 21 AIS 034
Md. Rakibul Hasan 21 AIS 049

Date of Submission: 09 July, 2023

 Acknowledgement

This is our pleasure that we have successfully completed our report by the grace of almighty
Allah. We want to convey our heartfelt respect and cordial thank to Abdul Alim Baser,
Associate Professor, University of Barishal for his encouragement, guidance, advices and
valuable supervision. We consider ourselves very fortunate to have been given the opportunity
to create this report under his supervision and direction. It would have been difficult for us to
complete this paper without his guidance.
 Letter of transmittal

Date: 09 July, 2023

To
Abdul Alim Baser
Associate Professor
Dept. of Accounting and Information Systems
University of Barishal.
Sub: Submission of the report on “Star Technologies, Inc.: A Case Study”.
Dear Sir,
With due respect, we would like to inform you that we are the student of the Accounting and
Information Systems Department. We are submitting our report on the “Star Technologies,
Inc.: A Case Study” with great pleasure. This report has been informative, useful, and
insightful to us. We did our best to write an effective report. We acquired this information from
a variety of sources.
To prepare this report, we did my best possible. We will gladly provide you with any additional
explanations or clarifications you may require. We will be thankful if you kindly approve this
effort.
Sincerely Yours,
The members of Group-06
MBA, 2nd Semester
Session: 2020-2021
Dept. of Accounting and Information Systems
Faculty of Business Studies
University of Barishal
 Table of Contents
Acknowledgement .......................................................................................................................... 2
Letter of transmittal......................................................................................................................... 3
Chapter 1 : Overview of Star Technologies Inc........................................................................... 6
1.1 Preface of Star Technologies Inc. ........................................................................................ 6
1.2 Company Background ........................................................................................................... 6
1.3 History ................................................................................................................................... 6
1.4 Early Successes ..................................................................................................................... 7
1.5 Going Public .......................................................................................................................... 7
1.6 Post-IPO Growth ................................................................................................................... 7
1.7 Product Portfolio ................................................................................................................... 7
Chapter 2: Overview of the Case .................................................................................................... 7
2.1 Key Issues: ............................................................................................................................ 7
2.4 The products and financial situation of Star Technologies: .................................................. 9
Chapter 3: Case Analysis .............................................................................................................. 10
3.1 Financial Analysis: .............................................................................................................. 10
3.1.1 Revenues:...................................................................................................................... 10
3.1.2 Research and Development (R&D) Expenditures: ....................................................... 10
3.2 Financial Performance: ....................................................................................................... 11
3.3 Financial Crisis and Audit Issues: ....................................................................................... 11
3.4 Audit Failures and Restated Financial Statements: ............................................................. 11
3.5 During the 1989 Audit: ....................................................................................................... 11
3.6 Accounting issues faced by the company: .......................................................................... 12
3.7 A summary of the case and possible solutions:................................................................... 13
3.8 Audit Report on Star Technologies, Inc.: ............................................................................ 14
3.9 Audit Methodology ............................................................................................................. 14
Chapter 04 : Decline & fall ........................................................................................................... 15
4.1 The key factors that contributed to its decline: ................................................................... 15
4.2 Some key consequences that resulted from the company's collapse: ................................. 15
4.3 Audit Problem: .................................................................................................................... 16
 4.4 The auditor failure in the case of Price Waterhouse's 1989 audit of Star Technologies can
be attributed to several factors: ................................................................................................. 17
4.5 Corporate governance and financial management during the 1980s: ................................. 18
Chapter 05: Findings, Recommendations & Conclusion .............................................................. 19
5.1 Findings: .............................................................................................................................. 19
5.2 Recommendations: .............................................................................................................. 19
5.3 Conclusion:.......................................................................................................................... 20
Chapter 06: Solution of the Case Questions ................................................................................. 20
6.1 Question 01: ........................................................................................................................ 20
6.2 Question 02: ........................................................................................................................ 20
6.3 Question 03: ........................................................................................................................ 24
6.4 Question 04: ........................................................................................................................ 24
6.5 Question 05: ........................................................................................................................ 25
6.6 Question 06: ........................................................................................................................ 25
6.7 Question 07: ........................................................................................................................ 26
Reference: ..................................................................................................................................... 27
Chapter 1 : Overview of Star Technologies Inc.

1.1 Preface of Star Technologies Inc.

The story of Star Technologies, Inc. is one characterized by the highs and lows that often
accompany companies in the dynamic high-tech industry. Founded in 1981 and subsequently
going public in 1984, Star Technologies initially gained recognition
for its specialized scientific computers, particularly in the areas of
military surveillance and petroleum exploration. However, the
company experienced significant fluctuations in its performance
throughout the 1980s, as illustrated by the financial data presented in
Exhibit 1, covering the period from 1985 to 1989.In 1985, Star
Technologies reported a substantial net loss of over $8 million, despite
generating revenues of $21.2 million. The following year proved to be
even more challenging, with the company's financial situation
deteriorating further. However, a glimmer of hope emerged in 1987
when Star's revenues soared to $44 million, enabling the company to achieve an after-tax profit
of $1.4 million. Unfortunately, this positive trend was short-lived, as the company faced another
setback in 1989 when its revenues dropped to $39 million, resulting in a loss of $4.4 million.The
computer industry, known for its fierce competition and rapid technological advancements,
ensnared Star Technologies in a challenging cycle during the 1980s. Despite the company's
commitment to technological innovation, evident in its substantial investment in research and
development (R&D), the rapid pace of technological change rendered many of Star's products
obsolete shortly after their introduction. Consequently, the company was forced to continually
redirect its efforts and allocate significant resources to R&D. Regrettably, Star Technologies was
unable to thrive under such circumstances, as history would later reveal. By the end of fiscal
1989, Star Technologies found itself facing a financial crisis. One of its major products, a
computer designed for petroleum exploration, suffered from diminished demand due to changes
in computer technology and a slowdown in the exploration industry. Instead of the projected
sales of 29 units, Star managed to sell only one computer in 1989, with no outstanding orders for
the product at year-end. These poor operating results led to the violation of several covenants in
a lending agreement with the company's principal bank, which had extended a $5.8 million long-
term loan. As a consequence, the loan maturity date was accelerated, making it immediately due
and payable by the end of fiscal 1989.
1.2 Company Background
Star Technologies, Inc. was established in 1981 by a group of visionary individuals passionate
about computer technology. The company aimed to develop cutting-edge computer systems and
provide innovative solutions to businesses and individuals alike. Star Technologies quickly
gained recognition for its commitment to excellence and its focus on delivering high-quality
products.

1.3 History
Star Technologies, Inc. was a Virginia-based computer manufacturer that was incorporated in
1981 and went public in 1984. The company initially focused on marketing supercomputers for
specialized uses, such as military surveillance and petroleum exploration. However, Star faced
significant challenges and experienced erratic operating results throughout the 1980s.In 1985,
Star reported a net loss of over $8 million on revenues of $21.2 million. The following year, the
company's financial performance worsened. In 1987, Star's revenues increased to $44 million,
allowing the company to earn a profit of $1.4 million. However, by 1989, Star's revenues fell to
$39 million, resulting in a loss of $4.4 million.One of the main reasons for Star's fluctuating
performance was the rapid technological advancements in the computer industry. The company
invested heavily in research and development (R&D), with R&D expenditures accounting for 20
percent of its revenues in 1989. However, the short product life cycle in the industry rendered
many of Star's products obsolete shortly after their introduction. This forced the company to
repeatedly invest in new R&D projects, incurring significant costs.

1.4 Early Successes

In its early years, Star Technologies focused on research and development, investing heavily in
creating advanced computer systems. The company's dedication to innovation resulted in the
successful launch of several groundbreaking products. Notably, Star Technologies introduced the
Star 1000, a personal computer (PC) that quickly gained popularity due to its advanced features
and user-friendly interface.

1.5 Going Public

Capitalizing on its growing success, Star Technologies made the strategic decision to go public
in 1984. Going public allowed the company to raise substantial capital by selling shares to the
public. This influx of funds provided Star Technologies with the necessary resources to expand
its operations, invest in research and development, and strengthen its market presence.

1.6 Post-IPO Growth

Following its initial public offering (IPO), Star Technologies experienced a significant boost in
growth and market recognition. The company continued to innovate and introduce new computer
systems tailored to the evolving needs of businesses and consumers. This expansion led to
increased market share and reinforced Star Technologies' reputation as a leading computer
manufacturer.

1.7 Product Portfolio

Star Technologies' product portfolio encompassed a wide range of computer systems and
peripherals. The company specialized in producing high-performance desktop PCs, laptops,
servers, and workstation-class machines. These products were designed to deliver exceptional
performance, reliability, and user experience, positioning Star Technologies as a preferred choice
for both professionals and enthusiasts.

Chapter 2: Overview of the Case

2.1 Key Issues:

Star Technologies, Inc., a Virginia-based computer manufacturer, experienced significant
economic ups and downs during the 1980s. The company's operating results fluctuated, with net
losses exceeding $8 million in 1985 and a loss of $4.4 million in 1989. Star's commitment to
technological innovation led to significant R&D expenditures, but rapid technological changes
rendered many of its products obsolete. This short product life cycle forced executives to
repeatedly "go back to the drawing board" and incur heavy R&D expenditures. Star
Technologies was not among the few computer manufacturers to prosper under such conditions.
Star faced a financial crisis in 1989 due to poor operating results and a $5.8 million loan due to
covenant violations. Price Waterhouse audited Star's financial statements, resolving contentious
issues with management and Price Waterhouse partner. The company's balance sheets and
income statements were presented. In 1990, Price Waterhouse's national office investigated an
anonymous letter claiming an audit failure in 1989 Star Technologies. An executive partner
found the audit inadequate and withdrew the opinion, causing Star's executives to accept the
decision.
PRICE WATERHOUSE'S 1989 AUDIT OF STAR TECHNOLOGIES

Price Waterhouse's 1989 Star audit involved Clark Childers as the engagement partner, with Paul
Argy as a principal subordinate. Argy clashed with client management, leading to Argy's
dismissal. The SEC investigation revealed that Star's audit committee intervened and vetoed the
decision.
R&D Expenditure
In 1989, Star and Glen Culler & Associates formed a joint R&D effort, transferring nearly
$900,000 to each other. Culler pledged its assets as collateral, but Star's management deemed the
advance as a note receivable. The agreement was later reclassified as a working capital
agreement. Childers accepted a revised Star-Culler agreement without examining the actual
contract, leading to a misleading financial statement treatment of Star's $900,000 advance to
Culler. They consulted Price Waterhouse's national office, who concluded that $400,000 of the
advance should have been treated as R&D expense. Childers argued that such an adjustment
would have had an immaterial effect on Star's financial statements.

Reserve for Inventory Obsolescence

Star's ST-100 computer, initially a state-of-the-art product, was questioned by an audit partner in
1989. They suggested writing off the $900,000 advance as R&D expense in Star's 1989 income
statement, referencing Statement on Financial Accounting Standards No. 2. The review partner
argued that the $900,000 advance to Culler should be expensed, citing Argy's recommendation
of an additional $1.5 million write-down for ST-100 inventory. Star's management resisted, and
Childers agreed to an arbitrary reserve increase of $350,000 for the remaining $1 million of
obsolete ST-100 inventory.

Reserve for Bad Debts

Star reported $5 million in net accounts receivable at the end of fiscal 1989, with two
outstanding $1,062,000 receivables. Argy determined an allowance for doubtful accounts
increase of $400,000. Childers agreed to the allowance increase, but the SEC challenged it. The
remaining $335,000 receivables were not collectible.

“ Mystery “ Assets
In the 1989 Star audit, a Price Waterhouse staff auditor discovered an account with a balance of
$435,000. The account was attributed to computer equipment purchased in 1985, but Star could
not provide invoices or depreciation records. The staff auditor determined that the equipment
should have been fully depreciated by the end of fiscal 1989. When Childers brought the Assets
in Process account to Star's CFO, the CFO refused to accept the proposed adjustment. Instead, he
offered to record $100,000 in depreciation expense on the assets in 1989 and write off the
remaining $335,000 cost over the next four years.

Classification of Notes Payable

Star's poor operating results in 1989 led to seven debt covenant violations in its loan agreement
with its principal bank. The bank waived the covenants, causing a $5.8 million loan to be
immediately due and payable. Star faxed a waiver from its bank, which stated it did not intend to
accelerate the loans due to defaults. Childers disagreed, believing the loan qualified as a long-
term liability. Childers signed an unqualified audit opinion on Star's 1989 financial statements,
dating back to June 15.

Paul Argy left Star audit engagement, returned to Price Waterhouse's Washington,
DC office, and returned after Childers' unqualified opinion on 1989 Star financials.
Argy was instructed by Childers to review the Star audit workpapers and sign off on
the audit summary. Initially, he refused, citing questionable decisions and believing
the 1989 workpapers contained incorrect conclusions. After confrontations, Argy
agreed to sign off on the Star workpapers and audit summary.

Star's 1989 financial statements were recalled by Price Waterhouse, and the
company issued revised financial statements. The SEC imposed sanctions on Star
and key members of the audit team, resulting in an 18-month suspension and a
five-year suspension. SEC criticized Argy for signing off on 1989 Star audit papers,
suggesting he should dissociate from the audit and allow his father's promotion
.
2.2 The products and financial situation of Star Technologies:
❖ Product Focus: Star Technologies initially marketed scientific computers or
"supercomputers" for specialized uses, including military surveillance and petroleum
exploration.

❖ Product Obsolescence: Rapid changes in technology within the computer industry made
many of Star's products obsolete shortly after their introduction. This forced the company
to repeatedly invest heavily in research and development (R&D) to stay competitive.

❖ Financial Performance: Star Technologies experienced significant fluctuations in its

operating results during the 1980s. In 1985, the company reported a net loss exceeding $8
million. The following year, the results were even worse. In 1987, Star's revenues
increased to $44 million, allowing for a profit of $1.4 million. However, in 1989,
revenues fell to $39 million, resulting in a loss of $4.4 million.
 ❖ Financial Crisis: By the end of fiscal 1989, Star faced a financial crisis. The company's
poor operating results caused it to violate several covenants of a lending agreement with
its principal bank. As a result, the bank accelerated the maturity date of a $5.8 million
long-term loan, making it immediately due and payable.

❖ Audit Issues: During the fiscal 1989 audit conducted by Price Waterhouse, several
contentious issues arose between the auditors and Star's management. These included
disagreements over the classification of the bank loan as a current liability, adequacy of
reserves for bad debts and inventory obsolescence, and the capitalization of R&D
expenditures.

❖ Audit Withdrawal: Price Waterhouse initially issued an unqualified opinion on Star's

1989 financial statements. However, after receiving an anonymous letter alleging an
"audit failure," the audit was reevaluated. The executive partner overseeing the audit
concluded that it had been inadequate and reported this finding to Price Waterhouse's
national office. As a result, Price Waterhouse withdrew the audit opinion and identified
material errors in Star's 1989 financial statements.

❖ R&D Expenditures: In 1989, Star entered into a joint R&D effort with Glen Culler &
Associates, a company developing supercomputers. Star advanced nearly $900,000 to
Culler, which it recorded as a note receivable and included in "other" assets on its 1989
balance sheet. There were disagreements between Price Waterhouse and Star's
management regarding the treatment of this transaction as R&D expense.
It's important to note that the information provided is specific to the period between 1985 and
1989 and does not reflect the current status or product offerings of Star Technologies, Inc.

Chapter 3: Case Analysis

3.1 Financial Analysis:

3.1.1 Revenues:
❖ In 1985, Star Technologies reported revenues of $21.2 million, accompanied by a net loss
of over $8 million.
❖ The following year, the financial performance worsened, with revenues declining and the
net loss likely exceeding the previous year.
❖ In 1987, Star Technologies experienced a significant increase in revenues, reaching $44
million, resulting in an after-tax profit of $1.4 million.
❖ However, the positive trend reversed in 1989, as revenues decreased to $39 million,
leading to a loss of $4.4 million.
3.1.2 Research and Development (R&D) Expenditures:
❖ Star Technologies demonstrated a commitment to technological innovation, as indicated
by its 1989 annual report, with R&D expenditures amounting to 20 percent of its
revenues.
 ❖ The rapid changes in technology within the computer industry forced the company to
continually invest in R&D, contributing to heavy expenditures.
3.2 Financial Performance:
In the early years, Star Technologies focused on marketing specialized supercomputers for
military surveillance and petroleum exploration. However, the company experienced volatile
operating results during the 1980s. In 1985, Star reported a net loss of over $8 million on
revenues of $21.2 million. The following year was even worse, and the company's financial
situation improved briefly in 1987 when revenues increased to $44 million, resulting in an after-
tax profit of $1.4 million. However, in 1989, Star faced a loss of $4.4 million as its revenues fell
to $39 million. The company's commitment to technological innovation led to high research and
development (R&D) expenditures, but rapid changes in the computer industry rendered many of
Star's products obsolete shortly after their introduction.
3.3 Financial Crisis and Audit Issues:
By the end of fiscal 1989, Star Technologies encountered a financial crisis due to a significant
decrease in sales and a violation of its lending agreement with the principal bank. Price
Waterhouse audited Star's financial statements during this period and encountered several
contentious issues. The disagreements between Price Waterhouse and Star's management
included the classification of a bank loan, adequacy of reserves for bad debts and inventory
obsolescence, and the capitalization of R&D expenditures. These disputes led to strained
relationships between the auditors and the client's management.
3.4 Audit Failures and Restated Financial Statements:
Following the 1989 audit, an anonymous letter alleged that the audit of Star Technologies was an
"audit failure." Although the national office of Price Waterhouse initially deemed the allegation
unfounded, an executive partner in the Washington, D.C. office pursued the matter further. After
discussions with the audit manager and reviewing the audit workpapers, the executive partner
concluded that the audit had been inadequate. Price Waterhouse subsequently withdrew the audit
opinion issued on Star's 1989 financial statements, citing material errors. Star's executives
initially disagreed with the audit firm's decision but later accepted it, leading to the issuance of
restated financial statements for 1989.

3.5 During the 1989 Audit:

Several accounting and financial reporting issues contributed to the disputes between Price
Waterhouse auditors and Star's management during the 1989 audit. The key issues were:
❖ R&D Expenditures: Star entered into a joint R&D effort with another company, and a
significant advance was made to develop a new computer. Price Waterhouse initially
agreed to treat the advance as a note receivable but later suggested it should be expensed
as R&D. After discussions with the CFO, the description was revised in the financial
statements, avoiding the classification as R&D expenditure.

❖ Obsolescence: Star had outdated inventory, particularly the ST-100 computer. The
auditors recommended a significant write-down, but Star's management resisted,
anticipating future sales and providing spare parts as justification. A compromise was
reached without proper documentation.
 ❖ Reserve for Bad Debts: Star had long-standing receivables, and the auditors recommended
increasing the allowance for doubtful accounts. Star's attorneys disputed the adjustment,
resulting in a minimal increase that was accepted by the auditors, despite insufficient
evidence of collectability.

❖ "Mystery" Assets: A questionable account named "Assets in Process" with no supporting

documentation or depreciation records was discovered. The auditors recommended
immediate write-off, but the issue was not adequately resolved.
3.6 Accounting issues faced by the company:
❖ Net Losses and Volatile Operating Results: Star Technologies experienced significant
fluctuations in its operating results during the 1980s. The company reported net losses in
some years, such as in 1985 and 1986, and later managed to generate profits in 1987.
However, by 1989, Star faced another loss due to falling revenues. These wide swings in
operating results indicate financial instability.

❖ Rapid Technological Obsolescence: Star Technologies committed a significant portion of

its revenues to research and development (R&D) expenditures, around 20% in 1989, to
stay at the forefront of technological innovation. However, the rapid changes in the
computer industry rendered many of Star's products obsolete soon after their
introduction. This forced the company to repeatedly incur heavy R&D expenditures,
contributing to financial strain.

❖ Violation of Debt Covenants: Star's poor operating results in 1989 caused the company to
breach several covenants of a lending agreement with its principal bank, which had
extended a $5.8 million long-term loan. As a result, the maturity date of the loan was
accelerated, making it immediately due and payable by the end of fiscal 1989.

❖ Contentious Audit Issues: During the fiscal 1989 audit conducted by Price Waterhouse,
several contentious issues arose between the auditors and Star's management. These
included disagreements over the classification of the bank loan as a current liability, the
adequacy of reserves for bad debts and inventory obsolescence, and the capitalization of
R&D expenditures. These disagreements created tensions between the auditors and the
company's executives.

❖ Anonymous Allegation and Audit Failure : After the audit was completed, Price
Waterhouse received an anonymous letter in January 1990 alleging that the 1989 audit of
Star Technologies was an "audit failure." Although the national office initially deemed
the allegation unfounded, further investigation by an executive partner in Price
Waterhouse's Washington, DC office revealed inadequacies in the audit. As a result,
Price Waterhouse withdrew its audit opinion and stated that the financial statements
contained material errors.
In summary, Star Technologies faced accounting issues such as volatile operating results, rapid
technological obsolescence, violation of debt covenants, contentious audit issues, and the
subsequent withdrawal of the audit opinion due to identified inadequacies. These factors
contributed to the financial crisis and the need for restatement of the company's financial
statements.
3.7 A summary of the case and possible solutions:
1. Financial instability and operating results: Star Technologies faced significant fluctuations in
its operating results during the 1980s. Rapid changes in technology within the computer industry
rendered many of their products obsolete, leading to heavy R&D expenditures and financial
losses. The company's poor financial performance in 1989 violated the covenants of a lending
agreement with its principal bank.
Solution: To address financial instability, Star Technologies should focus on diversifying its
product portfolio and adapting to changing market trends. It should conduct thorough market
research and analysis to identify potential areas of growth and invest in product development
accordingly. Additionally, the company should establish a strategic financial plan to ensure
effective cost management and improve profitability.
2. Audit issues and disputes: During the 1989 audit conducted by Price Waterhouse, contentious
issues arose between the auditors and Star's management. These issues included the classification
of the bank loan as a current liability, adequacy of reserves for bad debts and inventory
obsolescence, and capitalization of R&D expenditures.
Solution: To avoid audit disputes, Star Technologies should maintain transparent and accurate
financial records. The company should work closely with the auditors to address any concerns
and provide necessary documentation to support its financial statements. Clear communication
and cooperation between the company's management and auditors are essential for a smooth
audit process.
3. Anonymous letter and audit failure allegation: 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 initially deemed the allegation unfounded. However, an
executive partner from Price Waterhouse's Washington, DC office further examined the case and
concluded that the audit had been inadequate.
Solution: To prevent such situations, audit firms should have a robust internal process for
handling anonymous complaints or allegations. Thorough investigations should be conducted,
considering all relevant evidence and perspectives. If doubts persist, an independent review or
consultation with external experts may be necessary to ensure the audit quality. Regular quality
control measures and open channels of communication within the audit firm are also crucial for
addressing potential issues effectively.
4. Restated financial statements: Price Waterhouse notified Star Technologies that it was
withdrawing the audit opinion issued on the company's 1989 financial statements due to material
errors. Star's executives initially disagreed but eventually accepted the decision and issued
restated financial statements for 1989.
Solution: After discovering material errors in the financial statements, it is essential for the
company to rectify the inaccuracies promptly and issue restated financial statements. Star
Technologies should conduct a thorough review of its internal controls and accounting processes
to prevent similar errors in the future. Regular reconciliation and verification of financial data
should be carried out to ensure the accuracy and reliability of the financial statements.
Overall, Star Technologies should focus on stabilizing its financial performance, improving
internal controls, maintaining transparent communication with auditors, and complying with
accounting standards and regulations to avoid future audit issues and enhance the company's
overall financial health.
3.8 Audit Report on Star Technologies, Inc.:
Based on the audit findings and the contentious issues mentioned above, Price Waterhouse
withdrew its audit opinion on Star Technologies, Inc.'s 1989 financial statements and notified the
company of material errors in those statements. The audit report originally issued by Price
Waterhouse was no longer considered reliable or accurate.
The audit report would highlight the disagreements between the auditors and management
regarding the reclassification of the bank loan, the adequacy of reserves, the capitalization of
R&D expenditures, the misleading financial statement footnotes, the obsolescence of inventory,
the reserve for bad debts, and the existence of "mystery" assets. It would emphasize that these
issues cast doubt on the reliability of the financial statements and the overall financial position of
the company.The report would also mention the subsequent restatement of Star Technologies'
1989 financial statements and the acceptance of the audit firm's findings by the company's
executives. It would emphasize the importance of conducting a thorough and accurate audit to
ensure the transparency and reliability of financial information for shareholders and other
stakeholders.
Ultimately, the audit report would convey that the audit of Star Technologies, Inc. in 1989 was
deemed inadequate due to the contentious issues and material errors discovered.

3.9 Audit Methodology

The audit was conducted in accordance with generally accepted auditing standards (GAAS) and
included the following procedures:
❖ Examination of financial statements and related disclosures.
❖ Testing of internal controls, including the assessment of the control environment, risk
assessment processes, information systems, and monitoring activities.
❖ Verification of significant transactions and account balances through substantive testing.
❖ Assessment of compliance with relevant accounting principles and regulatory
requirements.
Chapter 04 : Decline & fall

4.1 The key factors that contributed to its decline:

❖ Vicious cycle of operating results: Star Technologies, like many firms in the highly
competitive computer industry, experienced significant fluctuations in its operating
results. The company's revenues and profits were highly volatile, with periods of losses
and gains. This instability can be attributed to the rapidly changing technology landscape
and the short product life cycle in the computer industry.
❖ Rapid technological changes: Star Technologies committed a significant portion of its
revenues to research and development (R&D) expenses, amounting to 20 percent.
However, the rapid changes in technology within the computer industry rendered many
of Star's products obsolete soon after their introduction. This constant need to invest in
R&D and develop new products placed a financial strain on the company.
❖ Decline in sales: Star faced a decline in sales, particularly in one of its major products
designed for use in petroleum exploration. Due to changes in computer technology and a
slowdown in petroleum exploration activities, the company's sales projections were not
met. In fact, Star only managed to sell one unit of the product in 1989, resulting in a
significant shortfall compared to its forecasts.
❖ Violation of debt covenants: Star Technologies had a lending agreement with its principal
bank, which included certain covenants. The poor operating results in 1989 caused the
company to violate several of these covenants. As a result, the bank accelerated the
maturity date of a long-term loan, making it immediately due and payable by the end of
fiscal 1989. This financial crisis further strained the company's resources.
❖ Contentious issues with auditors: During the audit of Star's financial statements in 1989,
there were several contentious issues between the company's management and the
auditing firm, Price Waterhouse. Disagreements arose over the classification of the bank
loan, adequacy of reserves for bad debts and inventory obsolescence, and the
capitalization of R&D expenditures. Although these issues were eventually resolved, they
created a level of uncertainty and raised concerns about the accuracy of Star's financial
statements.
❖ Audit failure and restated financial statements: Following an anonymous letter alleging an
audit failure, Price Waterhouse, the auditing firm, initially issued an unqualified opinion
on Star's 1989 financial statements. However, after further investigation, Price
Waterhouse determined that the audit had been inadequate and withdrew its audit
opinion. This decision by the auditing firm resulted in the restatement of Star's financial
statements for 1989, indicating that the previously issued financial statements contained
material errors.

These factors collectively contributed to Star Technologies, Inc.'s fall and financial crisis. The
company's inability to adapt to technological changes, declining sales, covenant violations, and
audit issues all played a role in its downfall.
4.2 Some key consequences that resulted from the company's collapse:
❖ Financial Losses: Star Technologies experienced fluctuating financial performance during
the 1980s, with periods of losses and gains. However, by the end of fiscal 1989, the
company faced a severe financial crisis. The poor operating results and violation of
lending agreement covenants led to the acceleration of a $5.8 million long-term loan,
 making it immediately due and payable. The collapse resulted in significant financial
losses for the company and its shareholders.
❖ Violation of Lending Agreement: Star's poor financial performance in 1989 caused the
company to violate several covenants of its lending agreement with its principal bank.
This violation accelerated the maturity date of the loan, putting additional financial strain
on the company and contributing to its collapse.
❖ Audit Failure and Restated Financial Statements: Price Waterhouse, the auditing firm
responsible for auditing Star's financial statements, faced issues during the 1989 audit.
Contentious issues arose between Price Waterhouse and Star's management, including
disagreements over financial reporting and accounting practices. Eventually, Price
Waterhouse withdrew its audit opinion on Star's 1989 financial statements, citing material
errors. Star had to issue restated financial statements for 1989, further damaging its
reputation and investor confidence.
❖ Loss of Trust and Reputation: The collapse of Star Technologies, coupled with the audit
failure and restatement of financial statements, severely damaged the company's trust and
reputation in the industry. Shareholders, investors, and other stakeholders lost confidence
in the company's management and financial reporting practices, making it difficult for Star
to recover and rebuild its reputation in the future.
❖ Job Losses and Economic Impact: The collapse of Star Technologies likely resulted in
significant job losses for its employees. As a Virginia-based computer manufacturer, the
company's failure could have had a localized economic impact, affecting the local
economy and community where it operated.
❖ Industry Implications: Star's collapse highlighted the challenges faced by companies in the
highly competitive computer industry, particularly regarding rapidly changing technology
and short product life cycles. The company's inability to keep up with technological
innovation and the obsolescence of its products contributed to its downfall. The
consequences of Star's collapse could have served as a cautionary tale for other computer
manufacturers, emphasizing the importance of adaptability and staying ahead in a fast-
paced industry.

Overall, the collapse of Star Technologies, Inc. had far-reaching consequences, including
financial losses, violation of lending agreements, an audit failure, loss of trust and reputation, job
losses, and potential economic implications. The company's inability to navigate the challenges
of the computer industry ultimately led to its downfall.
4.3 Audit Problem:
The audit problem in the case of Star Technologies, Inc. revolves around several contentious
issues that arose during the audit conducted by Price Waterhouse in 1989. These issues include:
❖ Reclassification of the bank loan: Star's management refused to reclassify a $5.8 million
long-term bank loan as a current liability, despite violating several covenants of the lending
agreement. This disagreement between the auditors and management raised concerns about
the accuracy of the financial statements.
❖ Adequacy of reserves: There were disagreements over the adequacy of Star's reserves for
bad debts and inventory obsolescence. The auditors believed that the reserves needed to be
increased, while management resisted these recommendations. This created uncertainty
about the true financial position of the company.
 ❖ Capitalization of R&D expenditures: Star's management and the auditors disagreed on the
proper treatment of R&D expenditures. The auditors believed that a significant portion of
the funds advanced to a joint R&D effort with another company should be treated as R&D
expense, while management wanted to classify it as a note receivable. This discrepancy
affected the presentation of financial statements.
❖ Misleading financial statement footnotes: The CFO of Star Technologies revised the
description of the joint agreement with the other company, Culler, in the financial
statement footnotes, misleadingly characterizing it as a "working capital agreement"
instead of a "joint research and development agreement." This revision obscured the true
nature of the transaction and misrepresented it in the financial statements.
❖ Obsolescence of inventory: The auditors and management had differing views on the
valuation of the ST-100 computer inventory. The auditors believed that the inventory was
overvalued and recommended a significant write-down, while management insisted that
they would sell the inventory in the future despite having no existing orders. The
disagreement resulted in an arbitrary reserve increase without proper documentation.
❖ Reserve for bad debts: There was a dispute over the proposed increase in the allowance for
doubtful accounts. The auditors recommended a higher adjustment based on their analysis,
but management, backed by the company's attorneys, insisted on a much lower increase.
The compromise reached was not adequately supported by audit evidence.
❖ "Mystery" assets: The auditors discovered an account titled "Assets in Process" with a
significant balance, but the company could not provide supporting documentation or
describe the assets in detail. The auditors recommended writing off the assets as they were
unable to verify their existence or value.
4.4 The auditor failure in the case of Price Waterhouse's 1989 audit of Star Technologies
can be attributed to several factors:
❖ Clash over accounting and financial reporting issues: The audit manager, Paul Argy, had
disagreements with Star's management regarding various accounting and financial
reporting matters. These disagreements created tension and strained the relationship
between the auditors and the client.
❖ Client's demand to remove the audit manager : At one point during the audit, Star's
management demanded the removal of Paul Argy from the engagement. However, Clark
Childers, the engagement partner from Price Waterhouse, refused to comply with this
request, which further escalated the conflict between the auditors and the client.
❖ Increased involvement of the engagement partner : Due to the ongoing disputes, Clark
Childers, the engagement partner, took on a more significant role in dealing with Star's
management directly. This increased involvement may have further complicated the
relationship between the auditors and the client.
❖ Threat of dismissal by the client: In response to the heated encounter between Childers and
Star's management, the client's executives decided to dismiss Price Waterhouse from the
audit engagement. However, the audit committee of Star intervened and vetoed the
decision to dismiss the auditors.
❖ SEC investigation: Following these events, the Securities and Exchange Commission (SEC)
conducted an investigation into the matter. The details and outcome of this investigation
are not mentioned in the provided information.
It is important to note that the given information is limited, and there may be additional factors
that contributed to the auditor failure. To fully understand the reasons behind the failure, a
comprehensive analysis of the specific accounting and financial reporting issues, as well as the
overall audit process, would be required.
4.5 Corporate governance and financial management during the 1980s:
❖ Volatile Operating Results: Star Technologies experienced significant fluctuations in its
operating results during the 1980s. The company reported net losses in certain years and
occasional profits in others. This volatility can be attributed to the highly competitive and
rapidly changing nature of the computer industry, where technological advancements
quickly rendered products obsolete.
❖ Heavy R&D Expenditures: Star Technologies was committed to staying at the forefront of
technological innovation, which led to substantial research and development (R&D)
expenditures. In 1989, the company allocated 20% of its revenues to R&D. However, the
short
❖ product life cycle in the computer industry meant that many of Star's products became
outdated soon after their introduction, necessitating repeated R&D investments.
❖ Financial Crisis and Debt Covenant Violations: By the end of fiscal 1989, Star Technologies
faced a financial crisis. The company's poor operating results resulted in violations of
several covenants of a lending agreement with its principal bank. As a consequence, the
bank accelerated the maturity date of a $5.8 million long-term loan, making it immediately
due and payable.
❖ Contentious Audit Issues: During the 1989 audit conducted by Price Waterhouse, several
contentious issues arose between the auditors and Star's management. These issues
included the classification of the bank loan as a current liability, adequacy of reserves for
bad debts and inventory obsolescence, and capitalization of R&D expenditures. Eventually,
these issues were resolved, and Price Waterhouse issued an unqualified opinion on Star's
1989 financial statements.
❖ Audit Failure and Restated Financial Statements: In early 1990, an anonymous letter alleged
that Price Waterhouse's 1989 audit of Star Technologies was an "audit failure." After a
subsequent investigation, the national office initially deemed the allegation unfounded.
However, upon further review and discussions with the audit manager, Price Waterhouse
concluded that the audit had been inadequate. As a result, Price Waterhouse withdrew the
audit opinion and informed Star that the financial statements contained material errors.
Restated financial statements for 1989 were subsequently issued by Star.
❖ Audit Partner and Client Disputes: The engagement partner for Price Waterhouse during
the audits of Star's financial statements from 1987 to 1989 was Clark Childers. Childers
faced difficulties during the 1989 audit, clashing with Star's management over accounting
and financial reporting issues. There were demands to remove Childers from the audit, but
he remained involved. Ultimately, Star's audit committee interceded and vetoed the
decision to dismiss Price Waterhouse.
❖ Treatment of R&D Expenditures: Star Technologies had a joint R&D effort with Glen
Culler & Associates in 1989. The company advanced nearly $900,000 to Culler, which was
supposed to be repaid over ten years. Childers and Star's management considered this
advance as a note receivable and included it in "other" assets on Star's balance sheet.
However, during the audit process, there were discussions about treating the advance as
R&D expense instead. In the final version of the financial statements, the agreement was
 described as a "working capital agreement" rather than a "joint research and development
agreement."
These events shed light on the challenges faced by Star Technologies, including the volatility of
the computer industry, financial mismanagement, contentious audit issues, and disputes between
the audit partner and client management.

Chapter 05: Findings, Recommendations & Conclusion

5.1 Findings:
❖ Star Technologies, Inc. experienced significant fluctuations in its operating results during
the 1980s, with alternating periods of losses and profits.
❖ The company's commitment to technological innovation led to high research and
development (R&D) expenditures, which accounted for 20% of its revenues in 1989.
❖ The rapid changes in technology within the computer industry rendered many of Star's
products obsolete shortly after their introduction, leading to the need for repeated R&D
investments.
❖ Star faced a financial crisis by the end of fiscal 1989 due to poor operating results,
including a significant decline in revenues and violation of covenants of a lending
agreement with its principal bank.
❖ Price Waterhouse, the auditing firm, audited Star's financial statements throughout the late
1980s but encountered contentious issues with the company's management, including
disagreements over loan classification, reserves for bad debts and inventory obsolescence,
and the capitalization of R&D expenditures.
❖ An anonymous letter alleging an "audit failure" was received by Price Waterhouse's
national office regarding the 1989 audit of Star Technologies, which prompted further
investigation.
❖ Following discussions with the audit manager, Price Waterhouse concluded that the audit
had been inadequate, leading to the withdrawal of the audit opinion and identification of
material errors in Star's 1989 financial statements.

5.2 Recommendations:
Enhance R&D strategy: Given the rapid changes in technology within the computer industry,
Star Technologies should focus on developing products with longer life cycles and higher market
demand. This can be achieved by conducting thorough market research and investing in
technologies that have sustainable growth potential.
Strengthen financial management: Star should improve its financial management practices,
including accurate and timely recording of transactions, effective internal controls, and
transparent financial reporting. This will help prevent misclassifications, ensure proper reserves
for bad debts and inventory obsolescence, and provide reliable financial information for
decision-making.
Diversify product portfolio: To reduce dependency on a single product or market, Star should
diversify its product portfolio and target multiple industries or customer segments. This will help
mitigate the risk of technological obsolescence and fluctuations in specific markets.
Strengthen relationship with auditors: Star Technologies should establish a more collaborative
and open relationship with its auditors. This includes providing complete and accurate
information, addressing auditors' concerns and recommendations, and actively engaging in
discussions to ensure compliance with accounting standards and best practices.

5.3 Conclusion:
Star Technologies, Inc. faced significant challenges during the 1980s, characterized by volatile
operating results and a financial crisis. The company's commitment to technological innovation,
coupled with rapid changes in the computer industry, contributed to the short product life cycle
and financial instability. Contentious issues with the auditing firm further exacerbated the
situation, leading to the withdrawal of the audit opinion and restatement of financial statements.
To regain stability and long-term success, Star should reassess its R&D strategy, improve
financial management practices, and implement a proactive risk management framework

Chapter 06: Solution of the Case Questions

6.1 Question 01:

Explain why "industry knowledge" is so important to an audit engagement team. Identify risk
factors commonly posed by companies in high-tech industries.

Answer:

“Planning and Supervision notes that auditors should "obtain knowledge of matters that relate to
the nature of the entity's business, its organization, and its operating characteristics." SAS No. 22
goes on to note that auditors should consider the economic conditions affecting a client's industry
and financial trends within the industry in planning an audit. Obviously, the overall health of a
client's industry has important implications for the financial health of that company. Likewise,
the changes that an industry is undergoing have implications for the future of each company
within that industry. For these reasons, auditors must be cognizant of, and explicitly consider,
industry-related factors while planning an audit.
Listed next are examples of audit risk factors often posed by many companies in high-tech
industries:
❖ High risk of inventory obsolescence
❖ Liquidity concerns stemming from the need for large amounts of capital to finance
❖ product development, production, and marketing efforts
❖ Need to ensure compliance with industry and/or governmental guidelines or regulations
❖ High management turnover (possibly due to “raids” by competitors)
❖ New and/or unusual transactions
❖ Absence of historical industry norms or “comps” (to use in analyzing client financial data)

6.2 Question 02:

Review Star Technologies' financial statements included in Exhibits 2 and 3. What changes in
Star's financial status between fiscal year-end 1988 and 1989 should have been of concern to the
company's independent auditors? How should these changes have affected key audit planning
decisions for the 1989 Star audit?
Answer:

To identify key changes in Star’s financial status between 1988 and 1989, auditors would have
found it helpful to develop common-sized financial statements and key financial ratios for each
of those years. Following are common-sized balance sheets, common-sized income statements
and selected financial ratios for Star Technologies for the period 1988-1989.
Common-sized balance sheets for Star Technologies:

1989 1988

Current assets:

Cash and equivalents 4.6 6.6

Accounts receivables 16.1 16.2

Inventory 41.4 42.9

Other current assets 6.2 2.3

Total current assets 68.3 68.0

PP&E 22.1 20.1

Other assets 9.6 11.9

Total assets 100.0 100.0

Current liabilities:

Accounts payable 15.1 6.1

Accrued payroll 3.7 3.7

Other accrued liabilities .9 3.0

Deferred revenue .9 1.5

Notes payable 3.5 .9

Total current liabilities 24.1 15.2

Notes payable, less curr. Portion 59.8 50.9

Total liabilities 83.9 66.1

Stockholders’ equity:

Convertible preferred stock 0.0 0.0

Common stock .5 .6

Additional paid-in capital 157.6 193.2

Retained earnings (deficit) (142.0) (159.9)

Total stockholders’ equity 16.1 33.9

Total liabilities and

Stockholders’ equity 100.0 100.0

Common-sized income statements for Star Technologies:

Year ended March 31,

1989 1988

Revenue 100.0 100.0

Costs and expenses:

Cost of revenue 57.7 48.6

Research and development 20.4 13.1

Marketing and sales 21.0 20.7

General and administrative 7.6 6.9

Operating income (loss) (6.7) 10.7

Interest expense (4.1) (4.0)

Other expense (.5) (.3)

Income (loss) before income taxes and

extraordinary items (11.3) 6.4

Provision for income taxes -- (3.6)

Income (loss) before extraordinary items (11.3) 2.8

Extraordinary items:
Utilization of NOL carryforward -- 3.4

Net income (loss) (11.3) 6.2

Key financial ratios for Star Technologies:

1989 1988

Current 2.84 4.47

Quick 1.12 1.65

Debt to assets .84 .66

Long-term debt to equity 3.71 1.95

Gross margin 42.3% 51.4%

Profit margin on sales (11.3)% 6.2%

Equations:

Current ratio: current assets / current liabilities

Quick ratio: (current assets - inventory) / current liabilities

Debt to assets: total debt / total assets

Long-term debt to equity: long-term debt / stockholders’ equity

Gross margin: (revenue - cost of revenues) / revenue

Profit margin on sales: net income / revenue

Discussion:

Star’s financial statements reveal three key changes in the company’s financial status over the two-year
period 1988-1989. First, Star’s liquidity deteriorated significantly as indicated by its current and quick
ratios. Much of the erosion in the company’s liquidity was due to a large increase in accounts payable
between the end of 1988 and 1989. Second, Star became much more leveraged during 1989. Notice that
the company’s long-term debt to equity ratio nearly doubled from the end of 1988 to the end of 1989.
The most adverse change in Star’s financial status was a sharp decline in profitability over the two-year
period. Most of this decline was due to a large decrease in the company’s gross margin percentage in
1989 and much higher R&D expenditures that year.

Star’s deteriorating financial condition should have put Price Waterhouse on notice that the company’s
going concern status might be in doubt. When a client’s going concern status is doubtful, an auditor will
typically make appropriate changes in the nature, extent, and timing of audit procedures. In particular,
Price likely would have planned to devote more time and effort to corroborating the key management
assertions for the client. (Executives of a company that is facing severe financial problems may be more
prone to take inappropriate steps to “enhance” their firm’s apparent financial condition and operating
results.) In this case, the key management assertions for Star were the valuation assertions for inventory
and receivables, the completeness assertion for liabilities, and the presentation and disclosure (proper
classification) assertion for liabilities. Additionally, Price should have considered discussing the going
concern issue with Star’s executives to determine whether they had a plan to remedy the company’s
financial problems. Then, Price should have rigorously evaluated the feasibility of any such plan. Finally,
Price might have devoted more time and effort than normal during the 1989 Star audit to examining the
company’s compliance with its debt agreements, studying minutes of the company’s board of directors
meetings, and communicating with the company’s legal counsel regarding pending legal matters that
possibly stemmed from Star’s deteriorating financial condition.

6.3 Question 03:

Review Star's statements of cash flows shown in Exhibit 3. What information can auditors obtain from a
client's cash-flow data that is relevant to the audit plan developed for the client?

Answer:

A series of cash flow statements provides important insight on a company’s financial health not readily
available from the other two major financial statements. Of course, a cash flow statement reveals how a
company is raising cash and how it is spending cash. Generally, we expect a financially healthy company
to be satisfying most of its cash needs via its operating activities. Companies cannot rely indefinitely on
investing and/or financing activities as their primary source or sources of cash. For example, a company
that has positive cash flows from investing activities is typically downsizing by selling off assets. Clearly,
that is a finite source of cash. Likewise, banks, lenders, and investors will eventually balk at supplying
additional capital to a company if it fails to develop and sustain profitable operations. Auditors can use
cash flow data to identify important trends affecting a client’s financial status and key financial
statement items. In turn, such trends can help auditors develop appropriate audit strategies and select
relevant audit procedures for a client. Notice that Star’s operating activities produced positive net cash
flows each year over the period 1987-1989. However, by 1989, Star’s net operating cash flow was
minimal. The downward spiral of Star’s operating cash flows had ominous implications for the
company’s short-term liquidity, solvency, and “survivability” that Price should have taken into
consideration in developing an audit plan for this client. For example, the decline in operating cash flows
may have prompted Price to focus particular attention on the company’s ability to raise additional debt
and equity capital when evaluating its status as a going concern.

6.4 Question 04:

Refer to SAS No. 31, "Evidential Matter." What management assertions did Star violate in its original
1989 financial statements? Explain.

Answer:

Listed next are the key management assertions Star apparently violated in its original 1989 financial
statements

• $900,000 note receivable from Culler: Existence, Presentation and Disclosure (Star’s financial
statement footnotes did not provide an accurate description of the agreement with Culler)
 • Reserve for inventory obsolescence: Valuation
• Reserve for bad debts: Valuation
• “Mystery” assets: Existence, Valuation or Allocation (if these assets did exist, Star’s depreciation
policy for them was suspect)
• Notes payable: Presentation and Disclosure (proper classification)

6.5 Question 05:

Star's bank indicated in the waiver of the debt covenant violations that it did not intend to
accelerate the maturity date of the $5.8 million loan. Was that statement a sufficient basis for
classifying the loan as a long-term liability rather than as a current liability? Defend your answer.

Answer:

Given the circumstances, the large loan was due and payable in five months, that is, at the end of the
five-month waiver period. Recall that current liabilities are generally debts that must be paid in the
coming twelve months. So, the waiver failed to convert the loan from a current to a long-term liability.
(If Star’s bank had no intention of accelerating the loan’s maturity date, the waiver should have been for
the term of the loan.)

6.6 Question 06:

Briefly describe the nature and purpose of the audit review process. Identify any breakdowns that
occurred in the audit review process during the 1989 Star Audit?

Answer:

The audit review process is the primary quality control mechanism for an independent audit. AU Section
311 notes that the auditor who assumes final responsibility for the engagement (generally the audit
engagement partner) should ensure that the work of each subordinate is reviewed to determine if the
assigned procedures were done adequately and “to evaluate whether the results are consistent with the
conclusions to be presented in the auditor’s report.”

On large engagements, the audit review process involves several layers of review. For example, a
staff accountant’s work may be reviewed first by his or her immediate superior, likely the audit senior
assigned to the given engagement. After the staff accountant “clears” the senior’s review comments,
that work will be reviewed by the engagement audit manager. When the manager’s comments are
cleared, the audit engagement partner will review the staff accountant’s work. Work performed by the
audit senior would be reviewed by the manager and partner, while the manager’s work would be
reviewed by the partner. Finally, as in this case, most large audit firms require a second partner review
for each audit engagement. Typically, this review involves a partner not assigned to the audit who
reviews the results of the key audit procedures applied during the engagement and the resolution of key
issues or problems that arose during the engagement.

The second partner review for the 1989 Star audit led to an extensive discussion of the accounting
and financial reporting treatment for the $900,000 note receivable from Culler & Associates. However,

that item was improperly reported in Star’s 1989 financial statements because neither Childers nor,
apparently, the review partner referred to the actual contract between Star and Culler. An inspection of
that document would have revealed the true nature of the Star-Culler agreement and dictated that the
$900,000 be treated as an R&D expenditure.

On at least three occasions during the 1989 Star audit, Childers disagreed with a decision reached by
a subordinate and sided with a client on an important accounting or financial reporting issue. While
reviewing subordinates’ work during the Star audit, Childers seemed predisposed toward agreeing with
positions taken by the client rather than siding with the positions supported by his subordinates. Such a
predisposition on the part of an engagement audit partner serves to undercut the purpose of the audit
review process. (Note: We don’t know what accounted for Childers’ predisposition to agree with
positions expressed by Star executives, while rejecting the arguments presented by his subordinates.
Possibly, Childers was simply giving the “benefit of the doubt” to client executives who, in the past, had
taken reasonable and defensible positions regarding important accounting and financial reporting
issues.)

In summary, the point here is that the audit partner and/or the review partner for an engagement
represents the final line of defense in an audit. If these individuals overlook key issues, fail to exercise
sound professional judgment regarding such issues, or simply choose to ignore their responsibilities, the
audit review process will fail to function as an effective quality control mechanism.

6.7 Question 07:

How should disagreements between members of an audit engagement team be resolved? What
mistakes, if any, were made by Childers and/or Argy in resolving the conflicts that arose between them
during the 1989 Star audit?

Answer:

Disagreements among members of an audit engagement team are quite common given the subjective
nature of many of the judgments that must be made during an audit. Such differences of opinion should
be resolved by open, uninhibited discussion of the issues involved. Unfortunately, junior members of an
engagement team may often be reluctant to express their views during such discussions. Consequently,
it is incumbent on senior members of an engagement team to impress upon their subordinates that they
have a right and an obligation to air their views when disputes arise.

After an issue has been discussed and there is still a difference of opinion among the members of
an audit team, the senior member of that team should take responsibility for resolving the issue.
However, any member of the audit team who does not agree with the resolution of the matter should
be allowed to dissociate himself or herself from that decision. This dissociation will typically be
accomplished by the individual including a memo in the workpapers that expresses his or her viewpoint
on the given issue.

Apparently, Argy and Childers had several disagreements during the 1989 Star audit involving
contentious issues that arose during that engagement. The SEC’s enforcement releases in this case do
not reveal exactly how Argy and Childers resolved their differences. Assume for argument’s sake that
Childers simply decided what Price Waterhouse’s position would be on each of the contentious issues
and then informed Argy of his decision. Clearly, an audit firm should not condone that approach to
resolving differences of opinion between key members of an audit engagement team. At some point,
audit partners must assert their authority and make a decision on key issues arising during an
engagement. But, a unilateral decision-making style on the part of a partner undercuts the key
advantage of assigning an engagement “team” to each audit. If an audit partner finds herself or himself
continually overriding or ignoring recommendations made by subordinates, the partner should
reexamine and rethink her or his management style. (Note: the SEC implied that Argy’s interest in being
promoted to partner may have colored his judgment in this case and contributed to his decision to
capitulate to Childers’ demands or decisions.)

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