Running head: AUDIT FAILURE CASE STUDIES 1

Audit Failure Case Studies

Elisabeth J. Page

Southern New Hampshire University

Advanced Auditing
AUDIT FAILURE CASE STUDIES 2

ABSTRACT

Accounting professionals should use the term audit failure with caution. The Public

Company Accounting Oversight Board (the PCAOB) and the Government Accountability Office

(the GAO) interpret this expression very differently. In his speech entitled, An Overview of

PCAOB Priorities, Jay D. Hanson addresses this discrepancy and the negative influence it has

over investor confidence. He implores the Board to consider updating the definition or limiting

the use of the term audit failure in inspection reports because it is currently defined as follows:

findings that are of such significance that it appeared that the Firm, at the time it issued its

audit report, had failed to obtain sufficient appropriate audit evidence to support its audit

opinion (Handson 2014). In other words, according to the PCAOB, audit failure is does not

necessarily imply that the financials are misstated. It speaks only for the auditors responsible for

obtaining and evaluating evidence, not the integrity of the financial statements in question.

Often, investors assume that audit failure implies that financial information is materially

misstated or unreliable, which is not always the case. These investors subscribe to the GAOs

definition of audit failure. According to the GAO, an audit failure refers to, audits for which

audited financial statements filed with the SEC contained material misstatements whether due to

errors or fraud (Mandatory audit firm rotation study: 2004), which aligns more closely with the

definition assumed for this analysis. Moving forward, audit failure refers to audits during

which material weaknesses and/or fraud were not detected and/or the auditors issued an

unqualified opinion on financial statements that were materially misstated.

Audit failures are a cause of concern for many reasons including the personal and

professional ramifications to auditors themselves. The responsible firms book of business can

suffer considerably as a result of an audit failure. According to an article in The Accounting

AUDIT FAILURE CASE STUDIES 3

Review, restatements impair the office's ability to both attract and retain audit clients

(Swanquist 2015). Simply put, audit failure is bad for business. Stiff penalties and professional

ruin face those unfortunate enough to be involved.

When audit teams fail to detect material weaknesses in financial statements and internal

controls, the credibility of the entire profession suffers. This puts auditors at risk of becoming

irrelevant in a fast changing world. For the sake of the audit profession, radical changes must be

made to the way engagements are executed; the highest premium should be placed on

maintaining objectivity and independence.

Investors, employees, senior management, and others with a vested interest in the

business also suffer from audit failure. It is the responsibility of audit professionals to issue an

opinion that accurately reflects the risk of material misstatement in a companys financials.

Investors rely heavily on these opinions to make important financial decisions and lose trust in

the integrity of financial information when audit failures are discovered.

Employees face financial devastation in severe cases of audit failure. If employees are

enrolled in stock incentive or retirement plans, plummeting stock prices and bankruptcy can

obliterate their investment. They may even find themselves unemployed if the situation is dire

enough.

Executive leadership endures intense scrutiny in the wake of an audit failure. Statistically

speaking, director turnover increases dramatically after material misstatements are discovered.

According to an article from the Journal of Accounting Research, overall, the evidence is

consistent with outside directors, especially audit committee members, bearing reputational costs

for financial reporting failure (Srinivasan 2005).

AUDIT FAILURE CASE STUDIES 4

SAXON INDUSTRIES: COMPANY BACKGROUND

Saxon Industries was a paper and office equipment company until the early 1980s. Once

a Fortune 500 company, Saxon became engulfed in scandal after a decade-long fraud was

uncovered. According to an article in Forbes magazine, although Saxon was listed by Fortune

as the 381st largest industrial company in 1981, it was a mostly imaginary firm. In its 1982

bankruptcy, shareholders and creditors lost more than $200 million (Stern 1986). To put that

into perspective, $200 million in 1982 would be roughly $500 million today.

Fox & Co. was Saxons auditor for over 10 years before the massive fraud came to light.

According to an article from the New York Times published in 1982, the company's auditors,

Fox & Company, are to be replaced by Touche Ross & Company as soon as Fox completes its

audit of Saxon's 1981 results the change was being made partly because of unanswered

questions regarding Fox's performance in previous audits (Lueck 1982). Saxon suddenly filed

for bankruptcy in 1982 after the company, had reported profits in each of the first three quarters

of 1981 (Lueck 1982). The scandal unraveled quickly after it was discovered that, true

earnings and revenues often had no relationship to what headquarters reported in consolidated

statements (Lueck 1982).

ALLEGATIONS AGAINST SAXON

Saxon officials allegedly inflated inventories during its reorganization under Chapter 11,

by creating non-existent inventory, which amounted to $64 million in one division (Treadway

1983). In his 1983 remarks to the SEC, "COOKED BOOKS": JUST OLD, UNAPPETIZING

RECIPES, James C. Treadway explained that, most of the fictitious inventory was created

through false computer runs and not only was wholly fictitious inventory created, but as Saxon

transferred the fictitious inventory through intercompany accounts, fictitious earnings were
AUDIT FAILURE CASE STUDIES 5

recorded on the transfers of non-existent inventory (Treadway 1983). The elaborate, company-

wide fraud, which is rumored to have begun in the 1970s, managed to go undetected for over a

decade.

Internal controls were not a priority at Saxon. All internal accounting was performed at

Saxons corporate headquarters and, the division's financial officers did not operate

autonomously but were answerable to top management (Treadway 1983). The fraud at Saxon

started at the very top. Executive management then directed lower level employees to facilitate

the fraud through falsifying financial information. For example, rumor has it that the phony

inventory counts were done under orders from Saxon's chairman, Stanley Lurie (Stern 1982).

Fox & Co., Saxons auditor, did not exercise due professional care during its numerous

engagements at Saxon Industries. The audit team failed to document the existence of millions of

dollars worth of inventory and, apparently, in some divisions the auditors failed to take a

physical inventory (Treadway 1983). According to an excerpt from the journal, Issues in

Accounting Education; Sarasota, the SEC notes repeatedly that there were numerous "red flags"

that should have made the auditors more skeptical (Licata 1997).

When Saxon Industries began to fail, members of the Board of Directors did not have a

fair chance to turn things around. Stanley Lurie, Chief Executive Officer at Saxon before the

scandal was uncovered, was notorious for withholding important financial results for as long as

possible. According to an article published in Computerworld, a magazine published in 1982,

materials submitted came so late and in such volume that board members could not read the

materials prior to taking action Information requested or promised was simply never

delivered (Zientara 1982). The official stance of Fox & Co. was that, accountants should not

be expected to police companies through audits (Stern 1983). Based on the limited evidence
AUDIT FAILURE CASE STUDIES 6

available, it appears that Fox & Co. did not take the failure seriously and continued to plan its

engagements in the same fashion as the Saxon audits. When the massive fraud came to light, it

sparked controversy surrounding the duty of audit professionals to provide reasonable assurance

of the reliability of financial information being reported by public companies.

Fraudulent activity mainly took place in the Management Information Systems (MIS)

department. Select employees who facilitated the fraud were allegedly compensated for their

involvement. The Fox & Co. audit team should have exercised due professional care and

assessed the level of fraud risk before planning its testing in the MIS department. There is no

excuse for Fox & Co.s neglecting to verify the existence of huge quantities of inventories that

turned out to be fictional. The fraud took place over a period of 13 years, contributing to

widespread concern about auditor negligence and its impact on stakeholders.

IXIA: COMPANY BACKGROUND

Ixia, a developer of network testing, visibility and security products, was founded in

1977. Victor Alston, Chief Executive Officer at Ixia until the fall of 2013, served the company in

various capacities from 2004 until his fraud was discovered. Pricewaterhouse Coopers LLP was

Ixias auditor until May 3rd of 2013 when the firm, notified Ixia (the Company) of PwCs

decision to decline to stand for re-appointment as the Companys independent registered public

accounting firm for the fiscal year ending December 31, 2013 (CURRENT REPORT 2013). It

was later discovered that the fraud was unfolding as early as 2012.

ALLEGATIONS AGAINST IXIA

According to the SECs Accounting and Audit Enforcement Release published in

February of 2017, Alston resigned from Ixia in October 2013 following certain findings from an

internal investigation conducted by Ixia into whether Alston had misrepresented his educational
AUDIT FAILURE CASE STUDIES 7

and professional experience prior to joining Ixia (ACCOUNTING AND AUDITING

ENFORCEMENT release no. 3858. 2017). In addition to misrepresenting himself, Alston was

allegedly guilty of, [providing] misleading representations and omissions to Ixias auditors,

circumvention of internal accounting controls, and falsification of books and records

(ACCOUNTING AND AUDITING ENFORCEMENT release no. 3858. 2017).

Alston was well aware of Ixias revenue recognition policy, which was reported in Ixias

financial statements and conformed to U.S. GAAP. Under this method of accounting, whenever

Ixia sold a combination of software and professional services in a multi-element arrangement,

Ixia could not recognize revenue from its sale of the software element until the professional

services element of the transaction was fully delivered (ACCOUNTING AND AUDITING

ENFORCEMENT release no. 3858. 2017). Under Alstons authority, Ixia began recognizing

revenue prematurely.

According to the Accounting and Audit Enforcement Release, in approximately October

2012, Alston (along with others at Ixia) fundamentally changed the way Ixia did business by

instructing his team to artificially separate all professional services from sales (ACCOUNTING

AND AUDITING ENFORCEMENT release no. 3858. 2017). Under U.S. GAAP software

revenue recognition accounting rules, it is required that the company defer revenue from both

its software and professional services until its professional services were delivered to its

customer (ACCOUNTING AND AUDITING ENFORCEMENT release no. 3858. 2017). In an

effort to accelerate Ixias revenue recognition, Alston ordered that revenue be recognized on

software sales before the bundled professional services were delivered. Alston achieved this by

authorizing his staff to, artificially break apart these services onto separate purchase orders in
AUDIT FAILURE CASE STUDIES 8

instances where professional services were included in any sale (ACCOUNTING AND

AUDITING ENFORCEMENT release no. 3858. 2017).

Insufficient internal controls were detected by Ixias auditor, PricewaterhouseCoopers

LLP. Two in particular were materially weak and had to be reported. Ixia had no controls in

place to evaluate the degree to which the companys accounting differed from its official U.S.

GAAP revenue recognition policy. In addition, Ixia failed to, review changes to the Companys

previous implied warranty and software maintenance arrangement with one of its customers to

properly determine the impact on revenue recognition when the implied arrangement ceased to

exist. Because of these weaknesses, the Companys management concluded, as reported in the

2012 Form 10-K, that the Company did not maintain effective internal control over financial

reporting (CURRENT REPORT 2013). As previously discussed, PricewaterhouseCoopers LLP

reported material weaknesses in Ixias internal controls. Internal controls were deemed

ineffective based on, criteria in Internal Control Integrated Framework issued by the COSO

(ACCOUNTING AND AUDITING ENFORCEMENT release no. 3858. 2017).

Ixias CEO, Alston, was not a model of corporate responsibility. His dishonesty can be

traced back to the beginning of his career at Ixia in 2004 when, "Alston had claimed to hold both

bachelor's and master's degrees in computer science from Stanford, and lied about his age (Gold

2013). Under his leadership, employees at Ixia were directed to adopt questionable accounting

practices. The collusion between Alston and management is well documented. On April 21,

2013, Alston sent an email to Ixia management stating, deals that involve services need to be

quoted with [professional services] on a separate quote. We cannot have [hardware/software] and

[professional services] quoted on the same order. That includes [professional services], RE, or
AUDIT FAILURE CASE STUDIES 9

any other custom work (ACCOUNTING AND AUDITING ENFORCEMENT release no.

3858. 2017).

PWC later dropped Ixia as a client after identifying material control weaknesses that

called for the restatement of two years worth of financial statements. Alston stepped down as

CEO in late 2013 amid mounting suspicion surrounding his age and credentials. He was

succeeded by Errol Ginsberg, Chief Innovation Officer and Chairman of the Board.

As a result of the fraud, the SEC imposed sanctions on Ixia including, a civil money

penalty in the amount of $750,000.00 (ACCOUNTING AND AUDITING ENFORCEMENT

release no. 3858. 2017). The SEC officially, prohibited [Alston] for five years from acting as

an officer or director of any issuer and ordered Alston to, pay a civil money penalty in the

amount of $100,000.00 (ACCOUNTING AND AUDITING ENFORCEMENT release no.

3858. 2017).

ADELPHIA COMMUNICATIONS: COMPANY BACKGROUND

Adelphia Communications was a successful cable television company until the early

2000s. The founder and CEO, John Rigas, and three his sons ran the business until, after the

Enron scandal, the SEC launched an investigation into Adelphia. John, the Rigas family

patriarch, was revered by those who knew him as an exceedingly generous and caring individual.

His lavish parties and philanthropy earned him much adoration in his hometown. Behind the

scenes, Rigas used Adelphia like a personal checking account and borrowed massive amounts of

money to support the business. According to an article in Fortune magazine, in 1996, Adelphia's

debt was 11 times its market capitalization, an off-the-chart number. (By contrast, Comcast's

ratio was 1.28; Cox Communication's was 0.45.) (Leonard 2002). Adelphias off-balance-sheet

debt was discovered in the wake of the Enron scandal, which ultimately sent Enrons investors
AUDIT FAILURE CASE STUDIES 10

and employees into financial ruin. The SEC feared another financial collapse and began an

investigation. After failing to submit a form 10-K for the year 2001, Adelphias stock price

tumbled to a meager $0.79 per share.

ALLEGATIONS AGAINST ADELPHIA COMMUNICATIONS

The Rigas family repeatedly took out personal loans from the company and, similar to

Enron, hid its debt on the books of its unconsolidated affiliates. In addition to understating its

liabilities, the Rigas family tried to improve the appearance of Adelphias financial condition,

by inflating: (1) Adelphia's basic cable subscriber numbers; (2) the extent of Adelphia's cable

plant "rebuild" or upgrade; and (3) Adelphia's earnings, including its net income and quarterly

EBITDA. Each of these represents key "metrics" by which Wall Street evaluates cable

companies (SEC Charges Adelphia and Rigas Family With Massive Financial Fraud 2002). The

Rigas family also perpetrated fraud by failing to disclose the numerous transactions it made with

family members. According to the SEC press release announcing its investigation into Adelphia,

such self-dealing included the use of Adelphia funds to finance undisclosed open market stock

purchases by the Rigas Family, purchase timber rights to land in Pennsylvania, construct a golf

club for $12.8 million, pay off personal margin loans and other Rigas Family debts, and purchase

luxury condominiums in Colorado, Mexico, and New York City (SEC Charges Adelphia and

Rigas Family With Massive Financial Fraud 2002).

Deloitte & Touche was Adelphias auditor for two straight decades; in hindsight, it

appears that the audit team lost its independence at some point during this period. Ironically,

prior to reviewing the completed audit, the firm had declared the just-completed review our

best audit ever (Cauley 2007) and Vice President of Finance, James Brown, threw an

extravagant soiree for the auditors to celebrate. This relationship continued until Deloitte
AUDIT FAILURE CASE STUDIES 11

ultimately, refused to sign Adelphia's federal 10-K filing, causing company shares to be

delisted (Cauley 2007).

According to an article from Fortune magazine, the Rigases structured Adelphia so that

there were no checks and balances at the top (Leonard 2002). Rigas, his three sons, and his son-

in-law had seats on the Board of Directors. To complicate matters further, Tim Rigas, the second

son of John Rigas, was both Chief Financial Officer of Adelphia and Chairman of its Audit

Committee. Although the Rigases appointed the remaining four directors from outside of the

family, they maintained control over substantially everything.

The audit team was either unaware of or unwilling to recognize Rigass self-dealing and

misappropriation of Adelphias resources. Deloitte maintained that its team had no knowledge of

the fraudulent activity; however, Mark K. Schonfeld disagrees, Deloitte was not deceived in this

case The findings in the order show that the relevant information was right in front of their

eyes (Deloitte settles suit for $50 million. 2005). Deloittes response was to deny knowledge of

any wrongdoing at Adelphia. Quigley, CEO of Deloitte & Touche, made several statements

following the discovery of the audit failure implying that Adelphia concealed evidence of

fraudulent activity from the audit team.

In an effort to come out ahead of the scandal, Deloitte announced it would be

implementing measures to mitigate the risk of fraud, including, more tailored audit procedures

in response to identified risks and improved documentation of the conclusions regarding the

issues raised; the completion of specialized training for all audit professionals in detecting

potential fraud; and deploying forensic specialists to assist audit teams" (Deloitte settles suit for

$50 million. 2005).

AUDIT FAILURE CASE STUDIES 12

Deloitte was fined to compensate Adelphias investors and to comply with additional

regulatory guidance. According to an article in the Baltimore Sun, specifically, according to the

SEC's administrative order, Deloitte will adopt a process for analysis of potentially risky aspects

of an audit and a proposal for ensuring the audit's accuracy. The order also requires Deloitte to

hire an independent consultant in 18 months to analyze the firm's compliance with the order's

terms (Deloitte settles suit for $50 million. 2005). Pursuant to the SECs administrative order,

Deloitte was required to make two payments of $25 million each. At that time, this was the

largest fine ever paid by an accounting firm.

OVERALL RISK ASSESSMENT

Saxon Industries, Ixia, and Adelphia all had poor control environments. In each case, the

auditors should have recognized the heightened control risk sustained by the weak control

environment. It is critical that auditors maintain professional skepticism, especially when

opportunities to commit fraud are discovered over the course of an engagement. According to a

study in the Journal of Accountancy; New York, In 24% of the cases, the SEC alleged the

auditors over relied on internal controls. It said that they typically had failed to expand testing in

light of identified weaknesses in the client's internal controls. In other cases, the auditors seemed

to implicitly assume the presence of a baseline level of internal controls, even though the auditor

documented that the client essentially had no controls in place (Beasley 2001). It is imperative

that auditors remain vigilant in light of these trends.

The study goes on to report that, the most common problem-alleged in 80% of the cases-

was the auditor's failure to gather sufficient evidence and the SEC claimed that auditors failed

to exercise due professional care in 71% of the enforcement cases and to maintain an attitude of

professional skepticism in 60% of the cases (Beasley 2001). While fraud is commonly hidden in
AUDIT FAILURE CASE STUDIES 13

asset valuation accounts and related party transactions, the underlying issues seem to be lack of

competence and neglect of the most fundamental duties of the profession.

AUDIT PLANNING

According to the article, Top 10 audit deficiencies, deficiencies in audit planning were

cited in 44% of the cases (Beasley 2001). As previously discussed, the audit teams in each case

study failed to design an audit program that adequately addressed the control and fraud risk at

each company. A quality audit program consists of procedures that match the level of risk

associated with each business function. Without the sufficient evidence, it is impossible to vouch

for the accuracy of a companys financial reports. Per the article, another common deficiency

the SEC alleged, present in 40% of cases, involved overreliance on inquiry as a form of audit

evidence. The agency cited auditors for failing to corroborate management's explanations or to

challenge explanations that were inconsistent or refuted by other evidence the auditor had

already gathered The SEC claimed auditors failed to gather corroborating evidence and to

challenge management's assumptions and methods underlying the development of those

estimates (Beasley 2001). The audit plan should include in-depth testing for areas identified as

high risk during the risk assessment.

SPECIFIC AUDIT PROGRAM STEPS

Greater emphasis should have been placed on verifying the inventory reported on

Saxons books. There is no other excuse for why Fox & Co. did not detect the massive fraud

taking place. PWC should have verified that Ixia was abiding by the accounting policies set forth

in its financials. A sample of purchase orders for professional services could have determined

whether or not they were stand-alone contracts and if revenue recognition was improperly

accelerated. Deloittes audit team missed many opportunities to identify and prevent related
AUDIT FAILURE CASE STUDIES 14

party transactions from being recorded as legitimate negotiations. Adelphias debt was hidden in

numerous unconsolidated affiliates and due care was not exercised to assess how leveraged the

company was. Substantive testing should have alerted the audit team to the fraud being

perpetrated; however, it appears that Deloitte was no longer independent when the fraud was

exposed.

AUDIT TIME BUDGETS

Fox & Co. should have identified the weak control environment at Saxon Industries and,

as a result, devoted more time to performing substantive testing of the companys inventory and

information systems. PricewaterhouseCoopers LLP should have evaluated Ixias accounting

against its stated revenue recognition policy and performed more substantive tests to in response

to the discovery of material weaknesses in Ixias internal controls. At Adelphia, Deloittes audit

team should have devoted more time to analyzing Adelphias numerous transactions with Rigas

family members. A study from the Journal of Accountancy; New York found that, another

common problem (in 27% of cases) was the auditor's failure to recognize or disclose transactions

with related parties. The auditor was either unaware of the related party or appeared to cooperate

in the client's decision to conceal a transaction with this party. Such transactions often resulted in

inflated asset values (Beasley 2001).

According to Pickett, setting a time budget acts as a principal control over the

assignment and is the single most important concern of audit management (Pickett 2011). Time

budgets force auditors to assess for risk, the determining factor for how much time and resources

should be allocated to an audit. If sufficient time and resources are not available based on the risk

profile of the company, the firm should either decline the engagement or note the limited scope

of the audit in the opinion issued.

AUDIT FAILURE CASE STUDIES 15

CONSEQUENCES OF AUDIT FAILURE

Audit failures hurt everyone, especially audit professionals. According to an article in the

peer-reviewed journal, The Accounting Review; Sarasota, analysis indicates that restatements

impair the office's ability to both attract and retain audit clients We also examine auditor

retention decisions at the client level and find that the likelihood of auditor dismissal increases

with contamination, even for non-restating clients... clients dismissing their auditor select less

contaminated audit offices. Taken together, our results suggest that market forces penalize

auditors for association with audit failures, thereby providing an incentive to maintain high-

quality audits and protect reputational capital (Swanquist 2015).

Members of the Board of Directors also suffer reputational damage as a result of audit

failures and the discovery of fraud. A study from the Journal of Accounting Research; Chicago

found that, overall, the evidence is consistent with outside directors, especially audit committee

members, bearing reputational costs for financial reporting failure (Srinivasan 2005). Those

guilty of financial fraud can expect sanctions imposed by the SEC, including steep fines and

potential incarceration, if caught.

Stakeholders are the most vulnerable when it comes to audit failure. Investors rely on

financial reports to make significant financial decisions. While trading is inherently risky,

stakeholders should have assurance that financial information is timely and accurate. When

auditors fail to identify material weaknesses, investor dollars and confidence are in jeopardy.

CONCLUSION

Audit failure is serious and has wide-reaching consequences. In an effort to prevent audit

failures from happening in the future, we must study audit failures of the past. We learn from

cases like Saxon, Ixia, and Adelphia that auditors must not only identify areas of heightened risk
AUDIT FAILURE CASE STUDIES 16

but also recognize the extent of their responsibility to shareholders when issuing an audit

opinion. We see time and time again that professional skepticism should be one of the auditors

most fiercely guarded qualities. Auditors should expect the unexpected and resist being lured

into a false sense of security. We can identify areas of heightened risk based on historical fraud,

however, the auditor must never disregard evidence of fraud no matter how low fraud risk may

seem. Proceed with caution!

AUDIT FAILURE CASE STUDIES 17

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