thi79492_fm_i-xx.qxd 1/8/08 2:29 AM Page i Rev. Confirming Pages Auditing After Sarbanes-Oxley Illustrative Cases thi79492_fm_i-xx.qxd 1/8/08 2:29 AM Page ii Rev. Confirming Pages thi79492_fm_i-xx.qxd 1/8/08 2:29 AM Page iii Rev. Confirming Pages Auditing After Sarbanes-Oxley Illustrative Cases Second Edition Dr. Jay C. Thibodeau Deborah Freier Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. Louis Bangkok Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto thi79492_fm_i-xx.qxd 1/8/08 2:29 AM Page iv Rev. Confirming Pages AUDITING AFTER SARBANES-OXLEY: ILLUSTRATIVE CASES Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2009, 2007 by The McGraw-Hill Companies, Inc. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 DOC/DOC 0 9 8 ISBN 978-0-07-337949-4 MHID 0-07-337949-2 Editorial director: Stewart Mattson Senior sponsoring editor: Alice Harra Editorial assistant: Christina Lane Marketing manager: Scott S. Bishop Senior project manager: Susanne Riedell Lead production supervisor: Michael R. McCormick Design coordinator: Joanne Mennemeier Lead media project manager: Cathy Tepper Typeface: 10/12 Palatino Compositor: Laserwords Private Limited Printer: R. R. Donnelley Library of Congress Cataloging-in-Publication Data Thibodeau, Jay C. Auditing after Sarbanes-Oxley : illustrative cases / Jay C. Thibodeau, Deborah Freier.—2nd ed. p. cm. ISBN-13: 978-0-07-337949-4 (alk. paper) ISBN-10: 0-07-337949-2 (alk. paper) 1. Corporations—Accounting—Corrupt practices—United States—Case studies. 2. Corporations—United States—Auditing—Case studies. 3. Corporations—Moral and ethical aspects—United States—Case studies. 4. Professional ethics—United States—Case studies. 5. United States. Sarbanes-Oxley Act of 2002. I. Freier, Deborah. II. Title. HF5686.C7T48 2009 657'.45—dc22 2007049262 www.mhhe.com thi79492_fm_i-xx.qxd 1/8/08 2:29 AM Page v Rev. Confirming Pages This book is dedicated to Ellen, my extraordinary wife of 17 years, and my children, Jenny, Eric, and Jessica. You have all provided the inspiration for me to undertake and complete this project. I could not have accomplished it without your love. Thank you. Jay C. Thibodeau I dedicate this book in loving memory of my father, Martin Freier, who inspired me to work hard and to strive for excellence. He also inspired me and others with his strength, his integrity, his dedication to family and friends, his desire to help others, his deep abiding love for learning, his wide array of talents and interests, and his appreciation for life. He was a great man and will truly be missed. This book is also dedicated to Matt, who always believed in me and was a constant source of support. Deborah Freier thi79492_fm_i-xx.qxd 1/8/08 2:29 AM Page vi Rev. Confirming Pages thi79492_fm_i-xx.qxd 1/8/08 2:29 AM Page vii Rev. Confirming Pages About the Authors Dr. Jay C. Thibodeau, CPA Dr. Thibodeau is the Edward F. Gibbons Research Professor of Accountancy at Bentley College. He received his B.S. degree from the University of Connecticut in December 1987 and his Ph.D. from the University of Connecticut in August 1996. He joined the faculty at Bentley College in September of 1996 and has worked there ever since. During his sab- batical in the fall semester of 2003, Jay worked with Price- waterhouseCoopers’ Learning & Education group to help deliver critical knowledge about the post–Sarbanes-Oxley technical audit guidance to professionals throughout the firm. He has consulted with Pricewaterhouse Coopers ever since. At Bentley College, he serves as the coordinator for all audit and assurance curriculum matters. Dr. Thibodeau currently serves on the Auditing Stan- dards Committee and as the past chair of the Education Committee for the American Accounting Association’s Auditing Section. He also serves on the editorial boards of Current Issues in Auditing and Advances in Accounting Educa- tion. He has been published in Auditing: A Journal of Practice & Theory, Accounting Horizons, Issues in Accounting Educa- tion, Managerial Auditing, Bank Accounting & Finance, Commercial Lending Review, Advances in Accounting Educa- tion, Asian-Pacific Journal of Accounting, Practical Accountant, and Journal of Financial Education. He has received national recognition for his work three times: first, for his doctoral dissertation, winning the 1996 Outstanding Doctoral Dis- sertation Award presented by the American Accounting Association’s ABO Section; second, for curriculum innova- tion, winning the 2001 Joint AICPA/AAA Collaboration Award; and third, also for curricular innovation, winning the 2003 Innovation in Assurance Education Award. Deborah Freier Deborah Freier is currently a student in the MBA program at the Wharton School at the University of Pennsylvania. She graduated as the valedictorian of her undergraduate class at Bentley College. She was honored by the Financial Executives Institute as the Outstanding Graduating Student and received The Wall Street Journal Student Achievement vii thi79492_fm_i-xx.qxd 1/8/08 2:29 AM Page viii Rev. Confirming Pages viii About the Authors Award. She was also inducted into Beta Gamma Sigma, Beta Alpha Psi, Omicron Delta Epsilon, and the Falcon Society. Ms. Freier placed in the semifinals of the Institute for Management Accountants 2000 National Student Case Competition and was the co-chair of Beta Alpha Psi’s student leadership conference during her senior year. Ms. Freier worked for several years as a research associate in the Strategy department at Harvard Business School. She collaborated with professors to create content for case studies, presentations, and articles that explored issues related to competitive advantage, intellectual property strategies, network effects and standards wars, and expansion into new geographic and strategic markets. She also developed teaching materials for an elective course about game theory and its application to business strategy. After Harvard Business School, she worked as a senior analyst in the Strategy and Product Develop- ment department at Tufts Health Plan, where she played a key role in developing and presenting financial and competitive analyses for senior management. thi79492_fm_i-xx.qxd 1/8/08 2:29 AM Page ix Rev. Confirming Pages Table of Contents SECTION ONE FRAUD CASES: VIOLATIONS OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) 1 Case 1.1 Waste Management: The Matching Principle 3 Case 1.2 WorldCom: The Revenue Recognition Principle 7 Case 1.3 Qwest: The Full Disclosure Principle 11 Case 1.4 Sunbeam: The Revenue Recognition Principle 17 Case 1.5 Waste Management: The Definition of an Asset 21 Case 1.6 Enron: The Revenue Recognition Principle 25 Case 1.7 WorldCom: The Matching Principle 29 Case 1.8 The Fund of Funds: The Conservatism Constraint 33 Case 1.9 Qwest: The Revenue Recognition Principle 41 Case 1.10 The Baptist Foundation of Arizona: The Conservatism Constraint 45 ix thi79492_fm_i-xx.qxd 1/8/08 2:29 AM Page x Rev. Confirming Pages x Table of Contents SECTION TWO ETHICS AND PROFESSIONAL RESPONSIBILITY CASES 49 Case 2.1 Enron: Independence 51 Case 2.2 Waste Management: Due Professional Care 55 Case 2.3 WorldCom: Professional Responsibility 59 Case 2.4 Enron: Quality Assurance 63 Case 2.5 Sunbeam: Due Professional Care 67 Case 2.6 The Fund of Funds: Independence 71 thi79492_fm_i-xx.qxd 1/8/08 2:29 AM Page xi Rev. Confirming Pages Table of Contents xi SECTION THREE FRAUD AND INHERENT RISK ASSESSMENT CASES 75 Case 3.1 Enron: Understanding the Client’s Business and Industry 77 Case 3.2 The Baptist Foundation of Arizona: Related Party Transactions 81 Case 3.3 WorldCom: Significant Business Acquisitions 85 Case 3.4 Sunbeam: Incentives and Pressure to Commit Fraud 89 Case 3.5 Qwest: Understanding the Client’s Business and Industry 93 Case 3.6 The Fund of Funds: Related Party Transactions 97 Case 3.7 Waste Management: Understanding the Client’s Business and Industry 103 thi79492_fm_i-xx.qxd 1/8/08 2:29 AM Page xii Rev. Confirming Pages xii Table of Contents SECTION FOUR INTERNAL CONTROL SYSTEMS: ENTITY-LEVEL CONTROL CASES 109 Case 4.1 Enron: The Control Environment 111 Case 4.2 Waste Management: Information Technology General Controls 115 Case 4.3 The Baptist Foundation of Arizona: The Whistleblower Hotline 119 Case 4.4 WorldCom: The Internal Audit Function 123 Case 4.5 Waste Management: Top-Side Adjusting Journal Entries 127 thi79492_fm_i-xx.qxd 1/8/08 2:29 AM Page xiii Rev. Confirming Pages Table of Contents xiii SECTION FIVE INTERNAL CONTROL SYSTEMS: CONTROL ACTIVITY CASES 131 Case 5.1 The Fund of Funds: Valuation of Investments 133 Case 5.2 Enron: Presentation and Disclosure of Special Purpose Entities 137 Case 5.3 Sunbeam: Completeness of the Restructuring Reserve 143 Case 5.4 Qwest: Occurrence of Revenue 147 Case 5.5 The Baptist Foundation of Arizona: Presentation and Disclosure of Related Parties 153 Case 5.6 Waste Management: Valuation of Fixed Assets 157 Case 5.7 Qwest: Occurrence of Revenue 163 thi79492_fm_i-xx.qxd 1/8/08 2:29 AM Page xiv Rev. Confirming Pages xiv Table of Contents APPENDIX COMPANY CASES 167 Case A.1 Enron 169 Case A.2 Waste Management 183 Case A.3 WorldCom 199 Case A.4 Sunbeam 213 Case A.5 Qwest 225 Case A.6 The Baptist Foundation of Arizona 239 Case A.7 The Fund of Funds 251 thi79492_fm_i-xx.qxd 1/8/08 2:29 AM Page xv Rev.