Read the case and answer the following questions

Please answer question 3 and 4, be more specific and more content.

CASE 6.3
Madison Wells, Audit Manager
Madison Wells should have been happy.1 Another hectic busy season was coming to
an end, which meant the audit manager’s standard workload would drop from 55 to
65 hours per week to a much more reasonable 45 hours. But Madison wasn’t thinking
of the end of busy season or the spare time that she would now have each week or
the beautiful weather in coming months.
As she sat in the audit conference room that Monday morning in early March,
Madison’s world seemed to be crumbling around her. She was staring at her cell
phone that lay in front of her on the conference room table. The speaker was not on,
but it didn’t matter. She could easily hear the expletives being screamed at her by the
audit partner who was on the other end of the line.
Transitioning from the Trenches
The busy season that was winding down had been notable for Madison because
it was her first as an audit manager for her employer, a large practice office of a
Big Four accounting firm. Her promotion from audit senior to audit manager had
become effective five months earlier on October 1, one month following her five-year
anniversary with the firm.
During each of the previous two busy seasons, Madison had served as the supervising audit senior on the audit of Smith & Kinder Manufacturing, a privately-owned
company that produced a line of household appliances. As the onsite audit supervisor, her primary responsibilities had been encouraging and cajoling her five subordinates to complete their assignments within budget, bailing them out when they
got “stuck” on tough technical issues, reviewing their completed workpapers, and
keeping the audit manager informed of the overall progress being made on the
engagement. She had also served as the primary contact person with the client’s
accounting staff and controller. On a few occasions, she had dealt directly with the
client’s C-suite executives, most notably the chief financial officer (CFO).
Madison was ecstatic when she received the news that she had been promoted to
audit manager. Rather than working in the “trenches” on one audit engagement during busy season, in her new position, she would coordinate multiple audits at once.
In addition to frequent visits to the audit teams she was overseeing, Madison would
spend considerable time working from her private office at her employer’s downtown location—for the past three years, she had shared a cubicle in the audit senior
“bullpen.”
Madison’s first unpleasant surprise had come in early October when she was transferred off the Smith & Kinder audit team. She had assumed she would replace the
audit manager on that team and be assigned to serve as the audit manager on two
to four smaller jobs. Transitioning from audit senior to audit manager on the Smith &
Kinder engagement would have allowed her to ease gradually into her new work role.
But when her practice office unexpectedly picked up a new oil and gas client, Daniel
Alanis, an audit partner with whom she had worked in the past, requested that she
1. This case was developed from information provided by a former audit manager. The names,
location, and certain other information, including the industry of the audit client, have been changed.
493
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be assigned to that new client, Le Prix Oil & Gas. Madison realized Alanis made that
request because he respected her and the quality of her work. Nevertheless, in her
mind, she was a questionable choice for the new engagement since she had only
worked on two oil and gas audits during her five-year public accounting career. And
those assignments had been during her first two years with her employer when she
was an entry-level auditor.
Making the Le Prix assignment even more challenging for Madison was the highrisk nature of the engagement. During the past year, a sudden downturn in oil prices
had slashed Le Prix’s revenues and forced its management team to hurriedly downsize the company’s operations and workforce. Le Prix’s rapidly deteriorating operating results magnified its overall business risk—the company was highly leveraged
with a debt-to-equity ratio topping 4.0. The most ominous audit risk factor, though,
was the aggressive stances that the company’s accounting staff apparently took on
accounting and financial reporting issues. During a brief telephone conversation after
Madison was assigned to the Le Prix audit, Daniel Alanis told her that the company
had twice been forced to issue financial restatements over the previous seven years.
“I can imagine that in the current environment, these guys will ratchet up their
earnings management efforts several-fold,” Alanis warned Madison before adding,
“so, buckle your seatbelt, this may be a bumpy ride.”
At the time, Madison wondered to herself why her practice office would take on
such a high-risk client. She didn’t raise the issue with Alanis because she didn’t
believe it was appropriate to do so. In her firm’s culture, it was not considered kosher
to challenge or criticize decisions made by partners.
On the bright side, Alanis arranged for Madison to have a light schedule of other
audit assignments during the busy season. Her only other audit clients during the
winter months were a small, family-owned chain of clothing stores and a regional
healthcare company that owned and operated “walk-in” medical clinics. Neither of
those clients proved to be particularly challenging for Madison. The same could not
be said for Le Prix Oil & Gas.
Hostile Work Environment
Throughout the Le Prix audit, Madison repeatedly skirmished with the company’s
controller and CFO over accounting and financial reporting issues. Some of those
issues required her to spend considerable time gaining a better understanding of
technical accounting and financial reporting topics unique to the oil and gas industry. Despite her inexperience as an audit manager and her relative unfamiliarity
with the industry, Madison held her own during those confrontations. On two occasions, the client’s CFO “went over her head” and insisted on a sit-down conference
with Alanis. During those meetings, which Madison attended, Alanis was fully supportive of her and the stance she had taken on the issue at hand.
Prevailing in the confrontations with the client was not without some downside for
Madison and her subordinates. By the end of the audit, Le Prix’s CFO, controller, and
other key members of the company’s accounting staff were clearly unhappy with the
team of auditors. Madison realized the client perceived her as inflexible, if not downright stubborn, when it came to resolving questions concerning the materiality of
financial statement amounts, revenue recognition issues, and other technical matters.
Madison came to suspect that the client’s relationship with its prior audit firm was
responsible for the difficulty she and her colleagues encountered on the Le Prix audit.
The company’s previous auditor was a regional accounting firm—during the past
year, Le Prix’s principal lender had required the company to retain a Big Four auditor as a condition for approving a new long-term loan. The copies of the prior year
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CASE 6.3
M ADISON WELLS, AUDIT M ANAGER
workpapers that the predecessor audit firm provided to Madison’s firm suggested that
client personnel had often bullied the previous auditors into submission when differences of opinion arose during the audit. Despite that impression, the Form 8-K that Le
Prix had filed with the Securities and Exchange Commission (SEC) to announce the
change in auditors had not reported any disagreements between the company and its
prior audit firm.
Over lunch one day, Alanis told Madison he planned to meet with Le Prix’s CFO
and controller after the audit was completed to try to soothe the hard feelings that
had cropped up during the engagement. Because Le Prix was a large client, it was
apparent to Madison that Alanis wanted to minimize the risk that the company’s management team would dump their firm after just one year. Later in that same lunch,
Alanis candidly admitted to Madison that their practice office would “take a bath” on
the Le Prix engagement because the audit fee was considerably “below market.” The
audit partner confessed that he personally wasn’t a “big fan” of “lowballing” to obtain
new clients. Alanis then explained that the office managing partner was using the Le
Prix engagement as a “loss leader” to enhance the practice office’s chances of adding other local oil and gas companies to its client portfolio. The practice office was
playing “catch up” with the other Big Four firms in the local market when it came to
acquiring a proportionate number of audit clients in Texas’s huge oil and gas industry.
Frequent disagreements with client personnel over accounting and financial
reporting issues were not the most significant challenge Madison faced during the
Le Prix audit. William Blackwell, the supervising audit senior on the engagement,
shocked his team members—Madison and Alanis, in particular—by resigning as of
January 15. His resignation had left the Le Prix audit team in a huge bind. Because
there were no unassigned seniors available in the practice office, Alanis had been
forced to replace Blackwell with an inexperienced audit associate and have Madison
step in and supervise the remainder of the fieldwork on the engagement while, at the
same time, continuing to serve as the audit manager.
In exchange for her increased workload on the Le Prix audit, Alanis arranged to
have Madison replaced on the healthcare audit to which she had been assigned.
Because her principal subordinate on her only other audit client—the small retail
company—was a “heavy” senior, she spent only a few hours each week at that
client’s site.
A Perfect Storm
On a Monday morning in early March, Madison and her subordinates were wrapping up loose ends on the Le Prix audit. She expected that they would be leaving the
client’s headquarters office for good by the end of the week. Three days earlier, on the
prior Friday afternoon, Le Prix had issued its earnings press release and filed its Form
10-K for the year under audit with the SEC. Daniel Alanis had signed the unqualified
audit opinion that accompanied Le Prix’s audited financial statements in its 10-K.
As Madison sat in the client conference room that had served as Audit Central for
the past four months, she was skimming through the lengthy Le Prix audit program.
She wanted to make sure one final time that each audit procedure had been initialed
and dated by the individual who had completed the procedure—a few of the “wrapup” audit tests were not yet completed. Suddenly, something caught her attention.
There were two audit steps that dealt with reviewing the minutes of the client’s board
of directors meetings. The first step referred to all meetings that had taken place during the year under audit, while the second step referred to any meetings between yearend and the date the client filed its 10-K with the SEC. Madison noticed for the first
time that both steps had been initialed and dated by William Blackwell on January 10.
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What concerned Madison was a board meeting that had taken place on February 4.
She realized that since Blackwell had left the Le Prix audit team on January 15, there
was no way he could have reviewed the minutes of the February 4 board meeting.
There had been a board meeting on January 6, and Blackwell had apparently signed
off on the second audit step after reviewing the minutes of that meeting.
Momentarily panic-stricken, Madison forced herself to calm down. It was very
unlikely any major events or circumstances affecting Le Prix’s just-released financial
statements had been documented in the minutes of the February 4 board meeting.
Nevertheless, she intended to investigate that possibility immediately.
Madison went to the office of the chief executive officer’s secretary and asked for a
copy of the minutes of the February 4 meeting. The helpful secretary retrieved those
minutes and made a copy for her.
As she was re-entering the audit conference room a short while later, Madison’s
heart sank. The final paragraph of the minutes referred to “technical violations of
debt covenants in the Amended Loan Agreement at year-end.” The paragraph went
on to indicate that the violations involved certain debt covenants that had been modified in the revised loan agreement. Nine months earlier, when Le Prix obtained an
additional long-term loan from its principal lender, which was a syndicate of insurance companies, the two parties had renegotiated their existing long-term debt
agreement. One feature of the amended debt agreement was the requirement that Le
Prix obtain a Big Four auditor.
According to the minutes of the February 4 board meeting, the company had “cured”
the debt covenant violations during the first week of the new fiscal year by selling
marketable securities and then using the cash proceeds to pay down certain current
liabilities. Because the violations were “minor” and had “only existed for a brief time,”
Le Prix’s board concluded there was no need to inform members of the lending syndicate of the violations or to disclose the violations in the year-end financial statements.
“Par for the course for these bozos,” Madison angrily mumbled as she flung the
copy of the board minutes onto the cluttered surface of the audit conference room
table. She was angry with herself for not discovering the debt covenant violations but
furious at Le Prix’s officers and accounting staff for not having brought the violations
to the attention of herself or her subordinates.
Madison knew that the degree to which any debt covenant was violated or the
length of time that the violation existed were non-issues since there was no clause in
Le Prix’s loan agreement regarding “minor” debt covenant violations. And she was
aware the only way for Le Prix to properly “cure” or resolve a debt covenant violation
ex post was to obtain a waiver from each member of the lending syndicate. Absent
waivers from all syndicate members, the cumulative long-term loans from the syndicate became immediately due and payable, meaning that they should have been
reflected as a current rather than a long-term liability in the financial statements Le
Prix had filed three days earlier with the SEC. That change would have grossly—and
adversely—impacted Le Prix’s reported financial condition.
After digging into the large audit trunk in the rear of the audit conference room,
Madison finally found and retrieved a folder labeled “Amended Loan Agreement”
among the permanent workpaper files. She then flipped to the debt covenant pages
marked with a red tab. Embedded in the covenants were the minimum levels of several liquidity ratios Le Prix had to maintain at the end of each quarter to avoid triggering a technical default of its cumulative long-term loans.
Next, Madison retrieved the long-term debt workpaper file and turned to the spreadsheet where William Blackwell had tested Le Prix’s compliance with the liquidity ratio
provisions in the debt covenants—she recalled having reviewed that workpaper two
weeks earlier. As always, Blackwell’s workpaper appeared flawless. The spreadsheet
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CASE 6.3
M ADISON WELLS, AUDIT M ANAGER
included a detailed legend, cross-references to other workpapers and documents,
and meticulous footnotes that precisely explained the procedures he had performed.
On the spreadsheet, Blackwell had computed the liquidity ratios relevant to Le Prix’s
debt covenants at the end of each quarter and compared them to the minimum levels
for those ratios established by the covenants. The spreadsheet demonstrated that in
each case, Le Prix’s quarter-ending ratio was above the designated minimum.
Because of the apparently high quality of Blackwell’s work, the tight budget for the
Le Prix audit, and the fact that she was often overwhelmed by her dual responsibilities on the engagement, Madison had spent minimal time reviewing the workpapers
the senior had prepared. Instead, she had allocated the bulk of her review time to the
workpapers prepared by the audit associates assigned to the Le Prix engagement. In
fact, she recalled having only scanned Blackwell’s debt covenant spreadsheet—she
didn’t check any of his mathematical calculations or track the cross-referenced items
to other documents such as Le Prix’s loan agreement. She regretted that decision
now as she stared at the workpaper spread before her on the conference room table.
After cross-checking the spreadsheet with the tabbed pages in the Amended
Loan Agreement, Madison discovered that the minimum levels of the liquidity ratios
Blackwell had used in his debt covenant tests did not match up with those listed in
that document. After taking a deep breath, Madison retrieved from the audit trunk
another folder labeled “Loan Agreement,” which was the earlier and now outdated
agreement between Le Prix and the syndicate of insurance companies. Sure enough,
in testing the debt covenants Blackwell had referred to the minimum level required
for each liquidity ratio in the old loan agreement instead of in the new loan agreement. In fact, a footnote on Blackwell’s spreadsheet indicated that those minimum
levels were drawn from Le Prix’s “Loan Agreement.” There was no reference on the
workpaper to Le Prix’s “Amended Loan Agreement.”
In the revised debt covenants included in the Amended Loan Agreement, the minimum levels of the given liquidity ratios had been raised by 10 to 15 percent each. At
the end of each quarter during the year under audit, Le Prix had exceeded the minimum thresholds established for those ratios in the previous loan agreement, as documented by Blackwell. Madison determined that the company had also surpassed the
minimum thresholds for those ratios in the new loan agreement for the first three
quarters of the year. Unfortunately, two of Le Prix’s liquidity ratios at the end of the
fourth quarter were nearly 10 percent below the minimum level dictated by the new
loan agreement.
After checking and re-checking all of the relevant documents and computations,
Madison leaned back in her chair and closed her eyes. She knew what she had to do
next and she wasn’t looking forward to it.
Verbal Violence
“How could this happen?” Alanis screamed over the phone. Before Madison could
respond, the audit partner shouted again. “Do you understand that you’re telling me that
the financial statements that Le Prix just filed with the SEC are wronger than wrong!?”
“Daniel, like I said, I’m sorry that—”
do you mean,
“Sorry?” Alanis cut off Madison in mid-sentence. “What in the
sorry? You’re sorry when you spill coffee on someone’s new shirt. You’re sorry when
you ding the door of your friend’s new sports car. Sorry doesn’t
apply in this set
of
circumstances,
!”
Before calling Alanis, Madison had been very concerned he would not react well to
the news she was about to give him. But she hadn’t expected him to react this badly.
She liked and respected the young partner who was no more than eight or nine years
older than herself. He was a family man with two young daughters, was outgoing and
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articulate, and was well-respected within their practice office and the downtown business community. On a few occasions, Madison had seen him upset, but he had never
raised his voice in anger or used improper language of any kind in her presence.
For several moments, Madison’s cell phone, which she had laid on the conference
room table, fell silent. She pictured Alanis sitting in his leather chair in his downtown
office, trying to regain control of his emotions.
“Okay . . . okay,” he finally muttered through gritted teeth. “Tell me exactly what
happened.”
Over the next few minutes, a shellshocked Madison unraveled the sequence of
events relevant to the quandary she and Alanis now faced. Because her nerves were
frazzled, her timeline was not linear. At one point, she backtracked to explain that
she had been reviewing the audit program that morning to ensure each audit procedure had been initialed and dated. That revelation detonated Alanis’s temper once
more.
“So, you are
telling me that you just got around this morning to
reviewing the
audit program to
determine that the audit procedures had been properly signed off on!?”
Madison bit her lip and took a deep breath before responding. “I had checked the
audit program on multiple occasions in the past few weeks. I was just checking it
again . . . one more time.” Madison paused to allow the audit partner sufficient time
to process that information before continuing. “Like I was saying, when I checked the
audit program earlier, it hadn’t occurred to me that William couldn’t have reviewed
the minutes of the February fourth board meeting since he had resigned three weeks
earlier. He obviously signed off on that second audit step after he reviewed the
January sixth minutes.” After another pause, Madison added softly, “He just made an
honest mistake . . . and then I . . . I made another one by . . .” Madison’s voice trailed
off before she had completed her mea culpa.
“So, each of you just made an honest mistake?” Alanis asked in a mocking tone.
Moments later, he thundered, “We aren’t allowed to make honest
mistakes!
We are
professionals!”
The line fell silent for an extended time before Alanis finally spoke again, this time
in short, wrathful bursts. “Now . . . why . . . didn’t the tests . . . of the debt covenants . . .
uncover . . . these violations?”
Madison swallowed hard and then quietly but precisely explained to the partner why Blackwell had failed to uncover the debt covenant violations. Then she
explained why her review of the senior’s work had failed to uncover his error in testing the debt covenants.
After finishing her explanations, Madison waited for Alanis to respond. As she
waited, she heard muffled noises on the other end of the line that sounded like a fist
being pounded against a desktop.
“You . . . never
noticed that on the workpaper, he referred to the wrong
loan agreement?” Alanis had whispered the word “you” and then slowly
built to a crescendo that culminated with him shouting the word “agreement.”
Madison briefly contemplated defending herself and William Blackwell by pointing
out that the similar titles of the two loan agreements had contributed to the oversights
that each of them made. She quickly dismissed that idea after realizing it had been
their responsibility to take steps to prevent the similar titles of the loan agreements
from triggering such mistakes on their part. Then she considered reminding Alanis
that he, too, had reviewed Blackwell’s workpaper, but he beat her to the punch.
“Oh, I see,” Alanis said as his voice quaked in anger. “I guess you expected me to
detailed review of his
work.”
do the
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CASE 6.3
M ADISON WELLS, AUDIT M ANAGER
Alanis had every right to be angry, immensely angry. But, despite the terrible circumstances they were facing, Madison didn’t believe he had the right to speak to her
so harshly, berating her with the ugliest of gutter language.
“Listen, someone is going to take the blame for this
disaster,” Alanis continued, “and it sure as hell isn’t going to be me!”
By this point, Madison decided she had absorbed enough of Alanis’s rage and disrespect. She had reached her tipping point.
After a long pause, Madison spoke in a tone tinged with sarcasm. “Don’t worry
about it. I’m the audit manager, and you’re the audit partner. So, by definition, everything is my fault.” Madison intentionally used the inflammatory “Don’t worry about it”
line in hopes that it would prompt Alanis to once more curse a blue streak in which
case she intended to hang up on him.
Alanis, no doubt, sensed that Madison was on the verge of ending the conversation.
With a herculean effort, he tamped down his emotions once more. After coughing
and clearing his throat, he responded in as civil a tone as he could muster.
“I have a few things to do here. Once I wrap them up, I will be driving over there to
meet with you in the audit conference room. I should be there in 45 minutes. In the
meantime, don’t mention this to anyone, including anyone else on the audit team.”
When Madison didn’t respond, Alanis added, “Okay?”
The sudden change in Alanis’s tone had an unexpected impact on Madison. Rather
than anger and resentment, she now felt shame. Because she didn’t want Alanis to
realize she was tearing up, she cleared her throat and responded “Okay” before disconnecting the line.
When Alanis arrived at the audit conference room, he closed the door and then
took off his suit jacket and tossed it on an empty chair.
“I would like to start by reviewing William’s workpaper where he documented his
tests of the debt covenants,” the partner said calmly as he avoided making eye contact with Madison.
“I have already pulled that workpaper for you,” Madison responded as she tried
to keep her voice from trembling. “I also dog-eared the specific sections of the new
and old loan agreements that pertain to the liquidity ratio provisions within the debt
covenants.” After handing the workpaper and the two loan agreements to Alanis,
Madison asked if there was anything else that he needed.
“No, not right now. I will let you know, though, if I need something else.”
Madison was thankful Alanis was making a concerted effort to maintain his composure. Despite that effort, the tension in the conference room was almost more than
she could bear.
After Alanis sat down on the other side of the conference room table, Madison
noticed the first thing he did was glance at the small box in the upper right-hand
corner of the preformatted workpaper. Ten days earlier, Alanis had initialed and
dated the workpaper, indicating that he had reviewed it. Madison’s initials and a corresponding date were also included in that box.
Alanis studied the workpaper and read and re-read the relevant sections of both
loan agreements. He then retrieved the audit program and turned to the section that
included the two audit steps mandating that the minutes of board of directors’ meetings be reviewed.
After spending 20 minutes or more examining the documents, Alanis leaned back
in his chair and muttered a vulgar, one-syllable expletive under his breath. Madison
heard the expletive but ignored it as she continued to work on updating a digital
audit workpaper on her laptop computer.
Moments later, Alanis wearily got to his feet and put on his suit jacket. “I’m going
back to the office now,” he said in a subdued tone.
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As Alanis spoke, Madison looked up from her work. It was the first and only time
during the brief meeting that the two of them made direct eye contact. After nodding
her head, Madison refocused her attention on her laptop computer. Alanis then left
the conference room without saying another word.
EPILOGUE
Madison and her subordinates completed their
remaining work on the Le Prix audit late on
Friday afternoon, four days after she informed
Daniel Alanis of the company’s debt covenant
violations. The following week, Madison spent
each day in her downtown office planning and
organizing two new audit assignments she had
been given for companies with June 30 fiscal
year-ends. Late on Thursday afternoon of that
week, Madison summoned the courage to go
to Alanis’s office—she had not heard anything
from him over the previous 10 days.
When Madison knocked on his open door,
Alanis looked up and then asked matter-offactly,“Can I help you?”
“I was just wondering, if . . . if . . . you needed
me to do anything more on the Le Prix audit.”
“No,” Alanis replied firmly.
For several moments, Madison lingered at
Alanis’s door. Finally, she took the initiative.
“Have you resolved the issue that . . . uh . . . uh . . .
came up at the end of that audit?”
“Yep,” the partner replied tersely.
As the two of them stared at each other, it
quickly became evident to Madison that Alanis
was not going to share with her how the issue
had been resolved. Instead of pursuing the matter, Madison turned and walked away.
Over the next several months, Madison
accessed on multiple occasions the www.sec.
gov/edgar website, where public companies
electronically file their SEC documents. Le Prix
never posted an 8-K information filing or any
other SEC filing that disclosed its debt covenant
violations. In early October, just as the planning for year-end audit engagements was commencing, Madison resigned from her Big Four
employer after accepting a considerably higherpaying position as a financial analyst with a
major downtown bank.
Questions
1. What steps should auditors take when they discover circumstances which were
unknown to them at the audit report date that might have affected the report
they issued?
2. Do you agree with Daniel Alanis that auditors are not entitled to make “honest
mistakes”? Defend your answer.
3. Characterize the errors made by William Blackwell and Madison Wells as
either “honest mistakes,” negligence, or recklessness. Defend each of your
characterizations.
4. While reviewing the long-term debt workpapers, neither Madison nor Alanis
discovered the critical error Blackwell had made when testing Le Prix’s
compliance with its debt covenants. What auditing standards, if any, dictate that
audit workpapers be reviewed by senior members of an audit team? What is the
overall nature and purpose of the audit workpaper review process, and how
thorough or detailed should workpapers be reviewed?
5. In your opinion, how should Madison have reacted to Alanis’s temper tantrum?
What would you do in a similar set of circumstances?
6. When Alanis refused to discuss with Madison how Le Prix’s debt covenant
violations had been addressed, what alternatives were available to her? Place
yourself in her position. Which of those alternatives would you have chosen?
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