1. Assume that a third party(ies) is considering whether to sue the external auditors of QSGI. What could they allege...
1. Assume that a third party(ies) is considering whether to sue the external auditors of QSGI. What could they allege in their lawsuit and why?
2. Assuming a third party(ies) files the lawsuit, what defenses could the external auditors use to rebut the charges?
3. Did SOX fail to protect investors and other users of QSGI’s financial statements? Explain.
QSGI, Inc., is in the business of purchasing, refurbishing, selling, and servicing used computer equipment, parts, and mainframes. During its 2008 fiscal year (FY) and continuing up to its filing for Chapter 11 bankruptcy on July 2, 2009 (the “relevant period”), Mark Sherman was the CEO and chairman of the board of directors. The SEC alleged that Sherman was aware of deficiencies in and the circumvention of internal controls for inventory and the resulting falsification of the Company’s books and records. The SEC alleged that Sherman withheld this information from the Company’s external auditors in connection with their audit of the financial statements for the FY 2008 and review of the financial statements for the quarter ended March 31, 2009, and made affirmative material misrepresentations and statements that were materially misleading as a result of his omission of information in management representation letters to the auditors about the design, maintenance, and operation of internal controls. It was further alleged that Sherman signed a Form 10-K and Form 10-K/A for the 2008 fiscal year, each containing a management’s report on ICFR as required by Section 404 of SOX and Exchange Act rule 13a-15(c), which falsely represented that he, in his capacity as CEO, had participated in assessing the effectiveness of the ICFR. Sherman also signed certifications required under Section 302 of SOX and Rule 13a-14 of the Exchange Act included in filings with the SEC falsely representing that he had evaluated ICFR and, based on this evaluation, disclosed all significant deficiencies to the auditors. The certifications were attached to the 2008 Forms 10-K and 10-K/A, and to the first quarter 2009 Form 10-Q filed with the Commission, which Sherman also signed.
Facts of the Case
Leading up to its bankruptcy in 2009, QSGI experienced recurring inventory control problems. Throughout the relevant period, Company personnel: (1) shipped certain inventory out to customers without making the appropriate entries and (2) removed items from physical inventory without reducing inventory on the Company’s books. Company personnel removed component parts from the physical inventory for such parts without recording the parts removed and occasionally stripped component parts from operating systems without recording the parts removed. As a result, the Company’s books and records incorrectly reflected certain components in inventory and operating systems as intact systems. These component parts were then sold by the Company or used for the Company’s maintenance services. These internal control problems resulted in the falsification of QSGI’s books and records relating to its inventory.
QSGI’s efforts to introduce new controls during FY 2008 largely failed. The Company failed to design procedures taking into consideration the control environment, including the qualifications and experience level of persons employed to handle accounting. Controls were mostly ignored during FY 2008 and well into FY 2009. For example, sales and warehouse personnel often failed to document their removal of items from inventory or, to the extent they did prepare paperwork, accounting personnel often failed to process the paperwork and to adjust inventory in the company’s financial reporting system. The Company’s attempts to monitor compliance on an ongoing basis were also inadequate. Company personnel regularly circumvented controls.
Financial statements are the standardized formats to present the financial information related to a business or an organization for its users. Financial statements contain the historical information as well as current period’s financial...
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