Review the Auditing in Practice feature focusing on the inappropriate actions of Robert A. Putnam, the engagement partner on the HBOC audit. In this case, we expand on the problems detected in the audit.
Summarizing the facts from the SEC's Administrative Proceeding against Putnam dated April 28, 2008, we know the following about the quarterly and year-end audits that led to the problems for Arthur Andersen LLP on the HBOC engagement:
— Andersen's Review of HBOC's financial statements- First Quarter 1997 HBOC reported $68 million of software revenue during Q1, and the engagement team tested the account balance and found that $14 million was improperly recorded, which overstated pretax income by 9.4%. Most of the improperly recognized revenue related to board contingencies, and the remainder related to revenue recognized on a contract signed after quarter end. HBOC management refused to eliminate the improperly recorded revenue, and Putnam did not insist that they do so. Putnam approved an unqualified quarterly review report.
— Andersen's Review of HBOC's financial statements- Second Quarter 1997 The engagement team learned that HBOC continued to improperly recognize revenue on contracts containing board contingencies, and that the company was improperly recording revenue on sales subject to side letter contingencies that allowed for contract cancellation. Further, the engagement team learned that at least one such audit). The confirmations requested customers to confirm amounts owed to HBOC and to confirm that no revenue contingencies existed on software purchased from HBOC. Only three customers responded, and two of those noted contingencies included in side letters. Putman did not direct the team to send any additional confirmations or to perform any additional audit procedures.
In addition, the engagement team learned that HBOC was recognizing too much revenue on maintenance contracts and that material amounts should have been deferred to later periods. Putnam asked Gilbertson to increase deferred revenue, but Gilbertson refused, promising to do so in later periods. In addition, HBOC acquired other companies during 1997 and recorded "acquisition reserves" of $95.3 million associated with the expenses of the acquisition. Putnam proposed that HBOC reverse $16 million of the reserves because they were excessive, overstating expenses by 20% (i.e., a cookie jar reserve). Gilbertson refused to make the proposed adjustment. Despite all these problems, Putnam approved an unqualified audit report and disclosed none of the issues to the audit committee.
— Andersen's Review of HBOC's financial statements-First Quarter 1998 During the review, Putnam discovered that HBOC was misusing the acquisition reserve to offset current period operating expenses, which is in violation of GAAP and had the effect of overstating HBOC's net income. The engagement team also identified another instance of improper revenue recognition associated with a contract involving a side letter. Once again, Putnam proposed an adjusting entry to correct the problems, but Gilbertson refused to make the entry. Putnam again approved an unqualified quarterly review report.
By April 1998, the engagement manager (Putnam's subordinate) expressed concerns about the earnings management issues occurring at HBOC to Putnam, and Putnam shared the same concerns despite doing nothing to address them. In May 1998, Putnam and the engagement team called a special meeting with Gilbertson and others at HBOC to discuss the issues, and Gilbertson expressed promises to begin properly recording the various transactions. engagement team again discovered the same types of earnings management issues as in prior quarters, but Putnam did not require HBOC to make corrections.
Further, Putnam approved an unusual transaction in which HBOC simultaneously sold to and purchased a product from another company. Putnam advised Gilbertson that the accounting for the transaction would only be correct if the sale and purchase were not linked and if there was a defined end user for the HBOC software. Neither of these conditions was true, and Putnam was aware of this fact (and this transaction ultimately led to a restatement of $30 million about a year later). However, Putnam still approved the issuance of the quarterly review report.
— At the November 1998 meeting of HBOC's audit committee, the CEO informed the audit committee that Gilbertson was resigning as CFO, which was an unexpected event. The CEO asked Putnam if he "had a Cendant on his hands," referring to a widely reported financial fraud case at the time. Putnam responded that he knew of no problems or disagreements with Gilbertson. In October 1998, McKesson and HBOC announced their merger. Putnam approved the use of Andersen's reports in related filings and made no mention of the associated accounting errors.
— Andersen's Audit of McKesson's financial statements- 1998 Year End McKesson hired Andersen to complete the audits, and Putnam and the engagement team continued to discover various accounting errors. Still, Putnam did not require the team to expand the scope of audit testing. Putnam again approved the issuance of an unqualified audit report.
During the spring of 1999, McKesson initially disclosed some of the revenue recognition issues and by the summer of 1999, McKesson reported restatements of the 1997 and 1998 financial statements. Ultimately, six members of upper management of HBOC were charged with securities fraud. The SEC issued a cease and desist order against Putman and denied him the privilege of appearing or practicing before the commission as an accountant for at least five years.
In many instances of fraudulent financial reporting, the auditor is completely unaware of the fraud until it ultimately unravels. That is certainly NOT the case for the HBOC fraud. Rather, it is very clear that Putnam and his Andersen engagement team were well aware of the fraud and possessed detailed knowledge of precisely how it was accomplished. Yet, they did virtually nothing to address the situation.
Required
1. What was Putnam's critical mistake in the review of Q1 1997? How did that critical mistake affect his willingness to take action to address the problems in the HBOC audit in later periods?
2. What do you think could have motivated Putnam to act as he did? Why do you think that after all the problems that he encountered, he was still willing to acquiesce to the obviously inappropriate sale/purchase transaction in Q3 1998?
3. What other elements of corporate governance failed in the HBOC situation?
4. The confirmation process in the 1997 year-end audit was clearly flawed. What did the engagement team and Putnam do wrong?
5. The McKesson acquisition of HBOC provided an opportunity for Putnam to "come clean" with what he knew. Obviously, McKesson management would have been eager to know about the earnings management issues at HBOC prior to acquiring the company. Instead, Putnam did not reveal the problems he had been encountering, even when asked directly by the CEO and the audit committee. Use the seven-step Decision Analysis Framework introduced in Chapter 3 to make a recommendation about a course of action that would have enabled Putnam to "come clean" during the acquisition process and alert the other parties involved in corporate governance of HBOC and McKesson about the problematic behaviors he had been encountering. Recall that the framework is as follows:

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1. Structure the audit problem 2. Assess consequences of decision 3. Assess risks and uncertainties of the audit problem 4. Evaluate information/audit evidence- gathering alternatives 5. Conduct 6. Gather information/audit evidence analysis 7. Make decision about audit problem