Case 1.4 Health Management, Management, Inc. 23
CASE 1.4
HEALTH HEALTH MANAGEMENT, INC.
Synopsis
This case profiles an imaginative accounting fraud orchestrated b t!o top e"ecutives of Health Management, Inc. #HMI$, a %e! &or'(based &or'(based pharmaceuticals distributor. The HMI fraud is note!orth because it led to the first ma)or test of an important federal statute, the *rivate +ecurities itigation -eform ct of 1//0 #*+-$, that !as intended to alleviate the gro!ing burden of class(action class(action la!suits la!suits filed filed against accounting firms firms and other third parties under the +ecurities "change ct of 1/34. #The *+- amended 'e provisions provisions of the 1/34 ct.$ The *+- ma'es it more difficult for plaintiffs to successfull plead a case under the 1/34 ct, that is, to have such a la!suit la!suit proceed to trial. trial. mong mong other provisio provisions ns in the *+- is a proportionate liabilit liabilit rule. rule. nder this liabi liabilit lit standard, standard, a defendant that is guilt of no more than rec'lessness is generall responsible for onl a percentage of a plaintiff5s losses, the percentage of those losses produced b the defendant5s rec'less behavior. HMI5s former stoc'holders filed a class(action la!suit against 678 +eidman, HMI5s former audit firm. firm. The plaintif plaintifff attornes attempted to prove that the 678 +eidman auditors had been rec'less during the 1//0 HMI audit, !hich prevented them from discovering discovering the large large inventor fraud carried out b Clifford Hotte, HMI5s C8, and 7re! 6ergman, the compan5s C98. The plaintiff attornes repeatedl pointed to a series of red flags that the 678 +eidman auditors auditor s had allegedl allegedl overloo'ed overloo 'ed or discounted discount ed during the 1//0 audit. dditionall, dditionall, the plaintiff plaintiff attornes charged that a close relationship bet!een 6ergman and Mei(a Tsai, the audit manager assigned to the 1//0 HMI audit engagement team, had impaired 678 +eidman5s independence during the 1//0 audit. 6ergman had previousl been emploed b 678 +eidman and had served as the audit manager on prior HMI audits. 9ollo!ing a )ur trial in federal court, 678 +eidman !as absolved of an responsibilit for the large losses that HMI5s stoc'holders had suffered as a result of the 1//0 inventor fraud. 678 +eidman +eidman55s lead lead attorne attributed attributed that outcome of the case to the *+-. bsent bsent the proportionate liabil liabilit it rule incorporated in the *+-, the attorne suggested that 678 +eidman !ould li'el have chosen to pa a si:able settlement to resolve the la!suit rather than contest it in the federal courts.
24 Case 1.4 Health Management, Inc. Health Management, Inc.—ey !acts
1. Clifford Hotte and 7re! 6ergman engineered an accounting fraud to allo! HMI to reach its 1//0 earnings target. 2. The 'e element of the HMI fraud !as an elaborate in(transit inventor sham that resulted in a material overstatement of HMI5s ear(end inventor. 3. The HMI fraud triggered the first ma)or test of an important federal statute, the *rivate +ecurities itigation -eform ct #*+-$ of 1//0, !hich amended the +ecurities "change ct of 1/34. 4. Congress intended the *+- to alleviate the burdensome legal liabilit that accounting firms and other defendants faced under the 1/34 ct b raising the pleading standard for la!suits filed under that la! and b establishing proportionate liabilit for defendants found liable in such la!suits. 0. The 'e ob)ective of the plaintiff attornes in the HMI la!suit filed b the compan5s former stoc'holders against 678 +eidman !as to convince the )ur that the 678 +eidman auditors, at a minimum, had been rec'less during the 1//0 HMI audit. ;. 678 +eidman5s attornes used a three(pronged defense strateg< #1$ insisting that the auditors !ere victims of the fraud, #2$ arguing that there !as no evidence of specific =+ violations b the auditors, and #3$ contending that the auditors had made a good faith effort to investigate HMI5s suspicious financial statement items. >. 'e issue during the trial !as !hether the 678 +eidman auditors should have performed an inventor rollbac' to corroborate the ear(end in(transit inventor. ?. nother 'e issue that arose during the trial !as !hether a relationship bet!een 6ergman and the audit manager assigned to the HMI engagement, !ho !as his former co!or'er at 678 +eidman, had undermined 678 +eidman5s independence. /. ventuall, the )urors ruled in favor of 678 +eidman after deciding that the auditors had not been rec'less. 1@. 678 +eidman5s lead attorne suggested that the *+-5s proportionate liabilit rule !as a 'e factor that gave his client the courage to contest and ultimatel defeat the HMI la!suit.
Case 1.4 Health Management, Inc. 20 Inst"#ctional $%&ecti'es
1. To e"amine the implications that the *rivate +ecurities itigation -eform ct of 1//0 has had, and is e"pected to have, for the public accounting profession. 2. To illustrate 'e strategies that plaintiff and defense attornes use in la!suits filed against auditors. 3. To define rec'lessness as it relates to audit(related la!suits filed under the +ecurities "change ct of 1/34. 4. To e"amine the impact that close relationships bet!een auditors and client personnel can have on independent audits. 0. To demonstrate that auditor )udgment is the ultimate determinant of the specific audit procedures applied during an audit engagement. S#ggestions (o" )se
This case includes dialogue e"cerpted from the transcripts of the HMI trial in late 1///. Ahen possible, I attempt to incorporate such dialogue into cases because it results in a heightened sense of realism. The dialogue in the case also provides an opportunit for instructors to set up realistic role(plaing e"ercises. 9or e"ample, ou might consider having one student assume the role of the plaintiff attorne !ho interrogated Bill arnic', the 678 +eidman semi(senior !ho audited inventor, !hile another student steps into the shoes of Ms. arnic'. Instruct the attorne to Dui: Ms. arnic' regarding the audit procedures she applied to inventor, in particular her aborted effort to complete an inventor roll for!ard. i'e!ise, ou could use role(plaing to recreate some of the test e"changes that too' place bet!een Michael &oung and Mr. Moore, the plaintiff5s e"pert !itness. lthough man students are hesitant at first to participate in such e"ercises, I have found that most of them Duic'l !arm to the role the are as'ed to assume. feature of this case that tpicall spa!ns considerable discussion is the close friendship that e"isted bet!een 7re! 6ergman and Mei(a Tsai. Clearl, the professional auditing standards do not prohibit auditors from being friends !ith client personnel. 6ut such friendships can be ver problematic. To e"tend Euestion F1, ou might as' students to develop a set of general rules or guidelines that audit firms should include in their polic and procedures manual to ensure that auditor(client relationships do not )eopardi:e the independence of an audit team or the independenceG ob)ectivit of individual auditors.
S#ggeste* Sol#tions to Case +#estions
2; Case 1.4 Health Management, Inc. 1. The t!o dimensions of auditor independence are relevant to this conte"t< appearance of independence and de facto independence. close friendship bet!een an auditor and a client emploee can )eopardi:e the auditor5s appearance of independence #and that of the entire audit team$ even though the auditor scrupulousl protects his or her de facto independence. If third parties lose confidence in an auditor5s independence, then the purpose of the audit is undermined, period. I !ould suggest that the de facto independence of an auditor has been compromised b a relationship !ith a client emploee !hen that relationship begins to influence important decisions of the auditor. 9or e"ample, if an auditor decides not to pursue a suspicious transaction or other item because doing so might result in negative conseDuences for his or her friend, clearl the actual independence of the auditor has been compromised. More globall, I !ould suggest that an auditor5s de facto independence has been impaired b a client relationship !hen that relationship results in the auditor violating one or more =+. oss of independence ma result in an auditor failing to gain a proper understanding of a client5s internal controls, deciding not to collect sufficient appropriate evidence to support an audit(related decision, or even issuing an inappropriate audit opinion. 2. Interpretation 1@1(2, mploment or ssociation !ith ttest Clients,of the IC* Code of Professional Conduct addresses the situation in !hich an auditor is considering the possibilit of emploment !ith an audit client during the course of an audit engagement. Ahen a member of the attest engagement team or an individual in a position to influence the attest engagement intends to see' or discuss potential emploment or association !ith an attest client, or is in receipt of a specific offer of emploment from an attest client, independence !ill be impaired !ith respect to the client unless the person promptl reports such consideration or offer to an appropriate person in the firm, and removes himself or herself from the engagement until the emploment offer is re)ected or emploment is no longer being sought. s a point of information, +ection 2@; of the +arbanes(8"le ct of 2@@2 prohibits an audit firm from providing audit services to a compan that has recentl hired an emploee of the audit firm to serve in a top accounting position. It shall be unla!ful for a registered public accounting firm to perform for an issuer an audit service . . . if a chief e"ecutive officer, controller, chief financial officer, chief accounting officer, or an person serving in an eDuivalent position for the issuer, !as emploed b that registered independent public accounting firm and participated in an capacit in the audit of that issuer during the 1(ear period preceding the date of the initiation of the audit. 3. The most common situation in !hich an inventor roll bac' is performed is !hen an audit firm has been retained to audit a compan follo!ing that compan5s ear(end phsical inventor. If the inventor is a material item in the client5s financial statements, the audit firm must devise a test or series of tests to corroborate the 'e management assertions for that inventor. +ince re( ta'ing the phsical inventor ma not be feasible or ma be too costl, auditors in such situations !ill tpicall use the client5s purchases and sales documentation during the intervening period since the phsical inventor to roll bac' the e"isting inventor Duantities and dollar amounts to the corresponding amounts on the inventor date. +ection 32; discusses the factors that impact the reliabilit or validit of audit evidence. 9ollo!ing is a brief e"cerpt from that discussion. udit evidence obtained directl b the auditor
Case 1.4 Health Management, Inc. 2> is more reliable than audit evidence obtained indirectl or b inference # 32;.@?$. This observation !ould suggest that the documentar evidence provided b an inventor rollbac' is not as persuasive as the phsical evidence that auditors obtain b observing a client5s phsical inventor. 4. s Michael &oung noted during the HMI trial, the decision of !hat audit procedures to appl in a given conte"t is ultimatel a matter of professional )udgment on the part of individual auditors. +o, Bill arnic' and the other members of the HMI audit engagement team !ere !ell !ithin their rights to decide !hether to complete an inventor rollbac' or roll for!ard. 8ne troubling aspect of arnic'5s decision not to complete the inventor roll for!ard !as that the decision !as apparentl not approved or even revie!ed b her superiors. =iven the importance of that decision, it !ould seem that arnic'5s superiors !ould have been involved in, or, at a minimum, revie!ed that decision. Certainl, it is possible that Tsai andGor 6ornstein !ere involved in that decision and that the trial transcripts simpl failed to comment on their involvement. +ection 32;.12 notes that cost considerations are a valid issue for auditors to !eigh !hen deciding on the specific audit procedures to appl in a given setting. Ho!ever, that same paragraph also e"plicitl states that cost considerations should not be the ultimate factor in such decisions. The auditor ma consider the relationship bet!een the cost of obtaining audit evidence and the usefulness of the information obtained. Ho!ever, the matter of difficult or e"pense involved is not in itself a valid basis for omitting an audit procedure for !hich there is no appropriate alternative. 0. +ection 33/, udit 7ocumentation, discusses the form and content of audit !or'papers. That section of the auditing standards does not specificall address the Duestion of !hether the results of inconclusive audit tests should be included in audit !or'papers. Most directl relevant to this case Duestion ma be the suggestion in paragraph .@> that superseded or preliminar notes or documents need not be retained b auditors. Ho!ever, paragraph .1; e"plicitl reDuires auditors to address in their !or'papers the results of an audit procedures that !ere inconsistent !ith their final conclusions. %ote< +ection 33/ addresses the audit documentation standards for audit clients other than publicl o!ned companies. *lease refer to the suggested solution to Euestion F4 of Case 1.1, nron Corporation, for a discussion of the *C865s audit documentation standards. ;. The term red flags is used to refer to various factors, variables, or other items that suggest there is a higher than normal ris' that a given audit client5s financial statements have been distorted b intentional misstatements. The term fraud ris' factors is essentiall interchangeable !ith red flags. The ppendi" to 31;, Consideration of 9raud in 9inancial +tatement udit, lists numerous e"amples of fraud ris' factors. "amples of these items include high degree of competition or mar'et saturation accompanied b declining margins, high vulnerabilit to rapid changes . . . in technolog . . . or interest rates, operating losses ma'ing the threat of ban'ruptc, foreclosure, or hostile ta'eover imminent. 7uring the planning phase of an audit, auditors !ill consider the e"istence of red flags in developing the planned nature, e"tent, and timing of their audit tests. -ed flags identified b auditors during the planning phase !ill tpicall result in more e"tensive and rigorous tests applied b auditors during the substantive testing phase of an audit. In the internal control evaluation phase of an audit, auditors should consider !hether given red flags have resulted in a
2? Case 1.4 Health Management, Inc. client5s internal controls being undercut or subverted. 9inall, during the !rap(up phase of an audit, an audit engagement team must consciousl !eigh once more the potential impact of e"isting red flags or fraud ris' factors on a client5s financial statements. In this final stage of an audit, auditors can step bac' and ma'e a big picture assessment of the given client5s financial statements. 7uring the course of an audit, an audit team ma overloo' individual hints or signals that something is amiss in the client5s accounting records and financial statements. %ear the end of the audit, ho!ever, an audit manager or partner should be able to lin' such items together to ma'e a more informed )udgment regarding the li'elihood that fraud has affected the client5s financial data. %ote< This paragraph summari:es the general strateg or approach that 31; suggests auditors follo! in considering the impact of fraud ris' factors on the 'e phases of an audit. -efer to 31; for a much more in(depth discussion of this sub)ect. >. +ection 1@, udit -eDuirements, of the +ecurities "change ct of 1/34 discusses auditors5 responsibilities for investigating and reporting illegal acts b an audit client. +ection 1@ provides the follo!ing crptic definition of an illegal act< the term illegal act means an act or omission that violates an la!, or an rule or regulation having the force of la!. The 'e issue in this conte"t is that an illegal act discovered b an audit team must have a material effect on the financial statements of the given compan to trigger reDuired disclosure to the +C again, such disclosure is not necessar if the given compan informs the +C of the matter. isted ne"t are three #hpothetical$ illegal acts and m )udgment of !hether the given audit team should insist that client management report each item to the +C. retail compan holds open its sales records at the end of a fiscal ear to ensure that it reaches its sales and earnings target for that ear. nalsis< this is an illegal act that almost certainl should be reported to the +C. T!o issues that !ould be relevant in determining !hether +C disclosure !ould be necessar are the level of management involved in the fraud and the magnitude of the fraud5s impact on the compan5s sales and earnings. The more important issue is the fraud5s impact on sales and earnings. 9or e"ample, if absent the fraudulent scheme the given compan !ould not have achieved its sales and earnings targets, then it !ould be difficult to sustain an argument that the scheme did not have a material effect on the compan5s financial statements, regardless of the absolute magnitude of the amounts involved. In toda5s capital mar'ets, a small revenue or earnings miss can result in a compan5s stoc' being battered b investors. • manufacturing compan admits that a racial discrimination charge filed against a production( line supervisor b a minorit !or'er is valid. nalsis< nless racial discrimination is seemingl rampant !ithin the given organi:ation, this is an illegal act that li'el !ould not have to be reported to the +C. • manufacturing compan violates legall enforceable regulations issued b the nvironmental *rotection genc. nalsis< nless the violation is indicative of a pervasive problem and unless the monetar sanctions to be imposed on the compan are material, this item !ould li'el not have to be reported to the +C. •
