Case 1. 9 ZZZZ Best Company, Inc, 1. Ernst & Whinney audit firm suffered tremendously from the backlash of ZZZZ Best’s case. One of the issues stemming from ZZZZ Best’s case is the difference between a review and an audit as evidence by civil suit filed by a California bank against the firm. The bank claimed that its decision to grant ZZZZ Best’s loan was based on the opinion of Ernst & Whinney review of ZZZZ Best’s financial statements period ending July 31, 1986.
The case was ruled in favor of Ernst & Whinney as the audit firm had expressly stated in their report that it was not issuing an opinion and the bank should not have rely heavily on the review report. Also, ZZZZ Best was a public company at the time, a review of its financial statements should not have been used as a basis for granting a loan. Reviews only offer a limited assurance at a much cheaper fee, and are usually used by private companies.
As stated in the report, Ernst & Whinney had only performed “analytical procedures and making inquiries of persons responsible for financial and accounting matters”. This is another difference between a review and an audit. An auditor cannot accumulate enough evidence through a review to issue an opinion. In order to express an opinion on the financial statements through an audit, an auditor has to get additional types of evidence such as physical counting of inventory, observation of assets, confirmations of bank statements and account receivables, etc… 2.
Managerial assertions play a big role in ZZZZ Best’s case, particularly the occurrence assertions of the insurance restoration contracts. The evidence obtained by ZZZZ Best’s auditors through confirmations to support the contract, reviewing contract documents, analytical procedures to evaluate the reasonableness of revenue recorded on the contracts, and observation of selected sites was limited due to the fraudulent nature of the company. Although confirmations are usually a very reliable type of evidence since it involves an independent third-party.
However, ZZZZ Best’s auditors overlooked the fact that all of the insurance restoration contracts were from the same party, which evidently was not independent. Ernst & Whinney should have evaluated the reliability of the insurance restoration contracts since it was created internally by ZZZZ Best. Furthermore, the limited details in the contracts as noted in the ten red flags that ZZZZ Best’s auditors allegedly overlooked should have raised ertain professional skepticism of the auditors. While performing analytical procedures on ZZZZ Best’s financial statement, its auditors failed to notice the substantial excess in its profit margin for restoration projects comparing to the rest of the industry. Physical examination, although a very reliable type of evidence for auditors, was unreliable in this case. Barry Minkow and his accomplices went to great length to cover up their fraud and successfully deceived their auditor.
Moreover, the auditors did not have the authority to corroborate evidence with outside third-party due to the confidentiality agreement with ZZZZ Best. 4. The Congressional subcommittee showed interest in whether there were any communications between the predecessor-successor auditors. Greenspan, a predecessor auditor of ZZZZ Best stated that it is protocol for a successor auditor to initiate communications. However, it is now required by auditing standards (AU 315) that a successor auditor has to communicate with predecessor auditor for prospective client.
The purpose for this communication is to help the successor auditor evaluate whether to accept the engagement. Under auditing standard (AU 315) the successor auditor should inquire from predecessor: (1) any information relating to the integrity of the client’s management; (2) any disagreements between the previous auditor and management concerning accounting principles, audit procedures, or fees; (3) communications to management regarding frauds, illegal acts, and any deficiency of internal control; (4) reasons for changing auditors.
However, it should be noted that the predecessor auditor may not be able to divulge any information unless authorized by the client. 5. The confidentiality agreement that Minkow required Ernst & Whinney to sign may have limited the scope of the audit. The agreement restricted the auditors from validate evidence from the site visit with any independent third-party such as contractors, insurance companies, the building owner, or any individuals involved in the project.
This was a major scope limitation regarding the case; however, since Ernst & Whinney auditors agreed to the terms, they might have thought otherwise. Ernst & Whinney dropped ZZZZ Best as a client not because of a scope limitation but because of many alarming evidence concerning Barry Minkow’s integrity. Some companies are cautious about certain information which could lead to a scope limitation.
Scope limitation can result in either a qualified audit opinion or a disclaimer of opinion depending on the materiality of the subject and the auditor’s judgment. When limit of scope occurs, the auditor must use other means to gather sufficient evidence to express an opinion which may increase the audit fees. A disclaimer of opinion must be issued if the auditor cannot satisfies himself/herself that the overall financial statements are fairly presented due to the severe limitation on the scope of the audit.