During the 1980s, CBI Holding Company, Inc., a New York–based firm, served as the parent company for several wholly owned subsidiaries, principal among them Common Brothers, Inc. CBI’s subsidiaries marketed an extensive line of pharmaceutical products. The subsidiaries purchased these products from drug manufacturers, warehoused them in storage facilities, and then resold them to retail pharmacies, hospitals, long-term care facilities, and related entities. CBI’s principal market area stretched from the northeastern United States into the upper Midwest.

In 1991, Robert Castello, CBI’s president and chairman of the board, sold a 48 percent ownership interest in his company to Trust Company of the West (TCW), a diversified investment fi rm. The purchase agreement between the two parties gave TCW the right to appoint two members of CBI’s board; Castello retained the right to appoint the three remaining board members. The purchase agreement also identified several so-called “control-triggering events.” If any one of these events occurred, TCW would have the right to take control of CBI. Examples of control-triggering events included CBI’s failure to maintain certain financial ratios at a specified level and unauthorized loans to Castello and other CBI executives.

Castello engaged Ernst & Young as CBI’s independent audit firm several months before he closed the TCW deal. During this same time frame, Castello was named “Entrepreneur of the Year” in an annual nationwide promotion co-sponsored by Ernst & Young. From 1990 through 1993, Ernst & Young issued unqualified opinions on CBI’s annual financial statements.

Castello instructed several of his subordinates to misrepresent CBI’s reported operating results and financial condition for the fiscal years ended April 30, 1992 and 1993.1 The misrepresentations allowed Castello to receive large, year-end bonuses to which he was not entitled for each of those fiscal years. CBI actively concealed the fraudulent activities from TCW’s management, from TCW’s appointees to CBI’s board, and from the company’s Ernst & Young auditors because Castello realized that the scheme, if discovered, would qualify as a control-triggering event under the terms of the 1991 purchase agreement with TCW. Several years later in a lawsuit prompted by Castello’s fraud, TCW executives testified that they would have immediately seized control of CBI if they had become aware of that scheme.

Understating CBI’s year-end accounts payable was one of the methods Castello and his confederates used to distort CBI’s 1992 and 1993 financial statements. At any point in time, CBI had large outstanding payables to its suppliers, which included major pharmaceutical manufacturers such as Burroughs-Wellcome, Schering, and FoxMeyer. At the end of fiscal 1992 and fiscal 1993, CBI understated payables due to its large vendors by millions of dollars. Judge Burton Lifl and, the federal magistrate who presided over the lawsuit stemming from Castello’s fraudulent scheme, ruled that the intentional understatements of CBI’s year-end payables were very material to the company’s 1992 and 1993 financial statements. 

In both 1992 and 1993, Ernst & Young identified the CBI audit as a “close monitoring engagement.” The accounting firm’s audit manual defined a close monitoring engagement as “one in which the company being audited presents significant risk to E&Y... there is a significant chance that E&Y will suffer damage to its reputation, monetarily, or both.”2 Ernst & Young’s workpapers for the 1992 and 1993 audits also documented several “red flags” suggesting that the engagements posed a higher-than-normal audit risk. Control risk factors identified for the CBI audits by Ernst & Young included the dominance of the company by Robert Castello,3 the absence of an internal audit function, the lack of proper segregation of duties within the company’s accounting department, and aggressive positions taken by management personnel regarding key accounting estimates. These apparent control risks caused Ernst & Young to describe CBI’s control environment as “ineffective.” Other risk factors identified in the CBI audit workpapers included the possible occurrence of a control-triggering event, an “undue” emphasis by top management on achieving periodic earnings goals, and the fact that Castello’s annual bonus was tied directly to CBI’s reported earnings.

For both the 1992 and 1993 CBI audits, the Ernst & Young engagement team prepared a document entitled “Audit Approach Plan Update and Approval Form.” This document described the general strategy Ernst & Young planned to follow in completing those audits. In 1992 and 1993, this document identified accounts payable as a “high-risk” audit area. The audit program for the 1992 audit included two key audit procedures for accounts payable:

a. Perform a search for unrecorded liabilities at April 30, 1992, through the end of field work.

b. Obtain copies of the April 30, 1992, vendor statements for CBI’s five largest vendors and examine reconciliations to the accounts payable balances for such vendors as shown on the books of CBI.

The 1993 audit program included these same items, although that program required audit procedure “b” to be applied to CBI’s 10 largest vendors. During the 1992 audit, the Ernst & Young auditors discovered numerous disbursements made by CBI in the first few weeks of fiscal 1993 that were potential unrecorded liabilities as of April 30, 1992. The bulk of these disbursements included payments to the company’s vendors that had been labeled as “advances” in the company’s accounting records. CBI personnel provided the following explanation for these advances when questioned by the auditors: “When CBI is at its credit limit with a large vendor, the vendor may hold an order until they receive an ‘advance.’ CBI then applies the advance to the existing A/P balance.”.......

Questions 

1. Most of Judge Lifl and’s criticism of Ernst & Young focused on the audit procedures Ernst & Young applied to CBI’s accounts payable. Generally, what is an auditor’s primary objective in auditing a client’s accounts payable? Do you believe that the two principal audit tests applied to CBI’s accounts payable would have accomplished that objective if those tests had been properly applied? Why or why not?

2. Do you believe that the Ernst & Young auditors should have used confi rmations in auditing CBI’s year-end accounts payable? Defend your answer. Briefl y explain the differing audit objectives related to accounts receivable and accounts payable confi rmation procedures and the key differences in how these procedures are applied.

3. In early 1994, Ernst & Young offi cials discovered that the CBI auditors had failed to determine the true nature of the “advances” they had uncovered during the 1992 and 1993 audits. In your view, did Ernst & Young have an obligation to inform CBI management of this oversight prior to seeking the “reaudit” engagement? More generally, does an auditor have a responsibility to inform client management of mistakes or oversights made on earlier audits?

4. Under what circumstances, if any, should an audit engagement partner acquiesce to a client’s request to remove a member of the audit engagement team?

5. Ernst & Young officials believed that the CBI audits were high-risk engagements.
Under what general circumstances should an audit fi rm choose not to accept a high-risk engagement?