Learning Objectives

Related parties and unrecorded liabilities.

Adelphia Communications, the sixth largest cable television provider in the USA was the subject of a Securities and Exchange Commission (SEC) and federal grand jury investi- gation into its finances as its accounting practices were questioned. The company was founded and managed by John Rigas and his family.

Adelphia had fraudulently excluded from the Company’s annual and quarterly con- solidated financial statements portions of its bank debt, totaling approximately $2.3 billion in undisclosed, off-balance-sheet bank debt as of December 31, 2001, by systematically recording those liabilities on the books of unconsolidated affiliates, which were controlled by the Rigas family (Rigas Entities). They included in those financial statements a footnote disclosure implicitly misrepresenting that such portions had been included on Adelphia’s balance sheet (SEC 2002). Adelphia and its executives created sham transactions backed by fictitious documents to give the false appearance that Adelphia had actually repaid debts, when, in truth, it had simply shifted them to unconsolidated Rigas-controlled entities.
Since at least 1998, Adelphia used fraudulent misrepresentations and omissions of material fact to conceal rampant self-dealing by the Rigases, the family which founded and ran Adelphia, including use of Adelphia funds to: pay for vacation properties and New York City apartments; develop a golf course mostly owned by the Rigases; and purchase over $772 million of Adelphia shares of common stock and over $563 million of Adelphia notes for the Rigases’ own benefit. (SEC 2002)
In addition to Adelphia’s own business operations, it also managed and maintained virtually every aspect of the Rigas Entities that owned and operated cable television systems, including maintaining their books and records on a general ledger system shared with Adelphia and its subsidiaries. The Rigas Entities did not reimburse or otherwise compensate Adelphia for these services.
Adelphia and the Rigas Entities, including those that are in businesses unrelated to cable systems, participated jointly in a cash management system operated by Adelphia (the “Adelphia CMS”). Adelphia, its subsidiaries, and the Rigas Entities all deposited some or all of their cash generated or otherwise obtained from their operations, borrowings and other sources in the Adelphia CMS, withdrew cash from the Adelphia CMS to be used for their expenses, capital expenditures, repayments of debt and other uses, and engaged in transfers

of funds with other participants in the Adelphia CMS. This resulted in the commingling of funds among the Adelphia CMS participants, including Adelphia subsidiaries and Rigas Entities, and created numerous related party payables and receivables among Adelphia, its subsidiaries, and the Rigas Entities. (SEC 2002) To conceal that the Rigases were engaged in rampant self-dealing at Adelphia’s expense, Adelphia misrepresented or concealed a number of significant transactions by which the Rigases used Adelphia resources with no reimbursement or other compensation to Adelphia. The defendants engaged in these practices to afford Adelphia continued access to commercial credit and the capital markets. In November 2002, Adelphia Corporation filed suit against its former auditor, Deloitte & Touche, claiming the firm was partly responsible for the alleged fraud that cost company shareholders billions of dollars. “If Deloitte had acted consistently with its professional responsibilities as Adelphia’s outside auditor, these losses could have been preventable,” according to the complaint. The complaint alleges that some of the Rigas family’s (which controlled Adelphia) acts of self-dealing were apparent to Deloitte on the books and records which Deloitte reviewed and that Deloitte knew or should have known of such acts! During its 2000 audit, for which an unqualified audit opinion was given, Deloitte asked the Rigases to disclose the full amount of the loans, which totaled $1.45 billion at the time but later amounted to more than $3 billion. The Rigases refused, and Deloitte never disclosed this issue or any disagreement to the audit committee. Adelphia’s cash management system had a pool of corporate funds that the Rigases used as their personal bank account. The complaint alleges that Deloitte knew about the system and didn’t report it to the audit committee. (Frank 2002)

Discussion ^■^What^audit^procedures^could^the^auditor^undertake^to^detect^the^Adelphia^related-party Questions ^transactions? What kind of control environment encourages related-party transactions? At what point would the auditor report related-party dealings to the board of directors?

References ^Frank, R., 2002, “The Economy: Adelphia Sues Deloitte & Touche, Accusing Former Auditor ofFraud,” Wall Street Journal (Eastern edition), New York, NY, November 7, p. A.2. SEC, 2002, Litigation Release No. 17837 Accounting Auditing Enforcement Release No. 1664, “Securities And Exchange Commission V. Adelphia Communications Corporation, John J. Rigas, Timothy J. Rigas, Michael J. Rigas, James P. Rigas, James R. Brown, and Michael C. Mulcahey,” US Securities and Exchange Commission, November 14.

The auditor should review information provided by the directors and management identifying related party transactions and should be alert for other material related party transactions. He should review management information identifying the names of all known related parties.

The auditor is required under ISA 550 to perform the following procedures in respect of the completeness of this information: ²⁷

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  review prior year working papers for names of known related parties;
  
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  review the entity’s procedures for identification of related parties;
  
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  inquire as to the affiliation of directors and officers with other entities;
  
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  review shareholder records to determine the names of principal shareholders or, if appropriate, obtain a listing of principal shareholders from the share register;
  
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  review minutes of the meetings of shareholders and the board of directors and other relevant statutory records such as the register of directors’ interests;
  
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  inquire of other auditors currently involved in the audit, or predecessor auditors, as to their knowledge of additional related parties;
  
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  review the entity’s income tax returns and other information supplied to the regulatory agencies.
  

The auditor should also carry out procedures which may identify related party trans- actions such as those shown in Illustration 11.7.
The auditor should obtain a written representation from management (as part of the management representation letter) concerning the completeness of information pro- vided regarding the identification of related parties and the adequacy of related party disclosures in the financial statements. ²⁸ If the auditor is unable to obtain sufficient audit evidence concerning related parties and transactions or concludes that their disclosures in the financial statements are not adequate, the auditor should modify the audit report.

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Review for Discovery of Subsequent Events

Review for subsequent events are the auditing procedures performed by auditors to iden- tify and evaluate subsequent events. Subsequent events are transactions and other pertinent events that occurred after the balance sheet date and which affect the fair presentation or disclosure of the statements being audited. Under International Standard on Auditing (ISA) 560 ³⁰ the auditor should consider the effect of subsequent events on the financial statements and on the auditor’s report.

Arabian American Development Company – the undisclosed event

Arabian American Development Company – the undisclosed event (continued)

million in total assets. The lease agreement requires Arabian to build the mine, and begin mining operations, pursuant to a work schedule, and if Arabian fails to comply with the work schedule, the Saudi government may have the right to terminate the lease. (SEC 2003) In the late 1990s the economic crisis in Southeast Asia caused a sharp drop in mineral prices, making it uneconomical for Arabian to comply with the work schedule required by the lease. In May 2000, the Ministry for Petroleum and Mineral Resources of Saudi Arabia, an agency of the Saudi Arabian government, notified Arabian, via correspondence sent to El-Khalidi in Saudi Arabia, that Arabian must implement the Al Masane Project, as required by the lease agreement. If Arabian failed to do so, the Ministry would begin procedures to terminate the lease. (SEC 2003) Ignoring this correspondence, in April 2002, El-Khalidi signed a management repre- sentation letter with Grant Thornton, Arabian’s outside auditor, representing, among other things: (1) that Arabian has complied with all aspects of contractual agreements that would have a material effect on the company’s financial statements in the event of non- compliance; (2) that no events have occurred which would impair the company’s ability to recover its investment in the Al Masane Project and other interests in Saudi Arabia; and (3) there is no impairment of the company’s investment in the Al Masane Project. (SEC 2003) In late November 2002, El-Khalidi disclosed to Arabian’s Treasurer that the Saudi government was threatening to terminate the Al Masane lease. The Treasurer promptly informed Arabian’s other officers and directors and, on December 23, 2002, Arabian filed a Form 8-K with the SEC that publicly disclosed for the first time that the Saudi government was threatening to terminate Arabian’s lease. The Treasurer also informed Grant Thornton, which subsequently withdrew its audit reports for Arabian’s 2000 and 2001 financial statements and resigned as Arabian’s outside auditor. (SEC 2003)

Discussion ^■^Why should^the problems^with^the mining^lease^be disclosed,^even though^it^had no^current Questions ^impact^on^Arabian? After Grant Thornton learned of the lease problem, what were their options in relation to their prior audit opinions? Why do you think Grant Thornton resigned as auditor?

References ^All material from SEC, 2003, Litigation Release No. 48638,^Accounting and Auditing EnforcementRelease No. 1898, “In the Matter of Arabian American Development Company and Hatem El- Khalidi,” US Security and Exchange Commission, October 16.

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  Types of Events After the Balance Sheet Date
  

International Financial Reporting Standard IAS 10 ³¹ deals with the treatment of financial statement of events, favorable and unfavorable, occurring after period end. It identifies two types of events:

1. 
   those that provide further evidence of conditions that existed at period end;
   
2. 
   those that are indicative of conditions that arose subsequent to period end.
   

The first type requires adjustment to the financial statements and the second type, if material, requires disclosure.
Events Relating to Conditions that Existed at Period End
Events relating to assets and liabilities conditions that existed at period end may require adjustment of the financial statements. For example, adjustments may be made for a loss on a trade receivable account that is confirmed by the bankruptcy of a customer that occurs after the balance sheet date. Other examples of these events that require adjust- ment of financial statements are:

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  settlement of litigation at an amount different from the amount recorded on the books;
  
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  disposal of equipment not being used in operations at a price below current book value;
  
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  sale of investments at a price below recorded cost.
  

Events Not Affecting Conditions at Period End
Events that fall into the second category, i.e. those that do not affect the condition of assets or liabilities at the balance sheet date, but are of such importance that non- disclosure would affect the ability of the users of the financial statements to make proper evaluations and decisions, should be disclosed. Examples of these types of events are:

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  a decline in the market value of securities held for temporary investment or resale;
  
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  issuance of bonds or equity securities;
  
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  a decline in the market value of inventory as a consequence of government action barring further sale of a product;
  
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  an uninsured loss of inventories as a result of fire.
  

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  Events Up to the Date of the Auditor’s Report
  

The auditor should perform procedures designed to obtain sufficient appropriate audit evidence that all events up to the date of the auditor’s report that may require adjustment of, or disclosure in, the financial statements have been identified. Some of these proce- dures are described in Illustration 11.8. When the auditor becomes aware of events which materially affect the financial statements, the auditor should consider whether such events are properly accounted for and adequately disclosed in the financial statements.

ILLUSTRATION 11.8

Procedures to Identify Events That May Require Adjustment of, or Disclosure in, the Financial Statements ³³

The procedures to identify events that may require adjustment of, or disclosure in, the financial statements would be performed as near as practicable to the date of the auditor’s report and ordinarily include the following:

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  Reviewing procedures management has established to ensure that subsequent events are identified.
  
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  Reading minutes of the meetings of shareholders, the board of directors and audit and executive committees held after period end and inquiring about matters discussed at meetings for which minutes are not yet available.
  
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  Reading the entity’s latest available interim financial statements and, as considered necessary and appropriate, budgets, cash flow forecasts and other related management reports.
  
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  Inquiring, or extending previous oral or written inquiries, of the entity’s lawyers concerning litigation and claims.
  
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  Inquiring of management as to whether any subsequent events have occurred which might affect the financial statements. Examples of inquiries of management on specific matters are:
  
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    the current status of items that were accounted for on the basis of preliminary or inconclusive data;
    
  • 
    whether new commitments, borrowings or guarantees have been entered into;
    
  • 
    whether sales of assets have occurred or are planned;
    
  • 
    whether the issue of new shares or debentures or an agreement to merge or liquidate has been made or is planned;
    
  • 
    whether any assets have been appropriated by government or destroyed, for example, by flood or fire;
    
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    whether there have been any developments regarding risk areas and contingencies;
    
  • 
    whether any unusual accounting adjustments have been made or are contemplated;
    
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    whether any events have occurred or are likely to occur which will bring into question the appropriateness of accounting policies used in the financial statements as would be the case, for example, if such events call into question the validity of the going concern assumption.
    

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  Events Between the Balance Sheet Date and the Issuance of the Statements
  

The auditor does not have any responsibility to perform procedures or make any inquiry regarding the financial statements after the date of the auditor’s report but before approval of the statements by shareholders. During this period it is the responsibility of management to inform the auditor of facts that may affect the financial statements. However, if the auditor becomes aware of a fact that may materially affect the financial statements during this period, he should discuss the matter with management and consider the possibility of amending the existing financial statements.
When Management Amends the Financial Statements
When management amends the financial statements, the auditor would carry out the procedures necessary in the circumstances and would provide management with a new report on the amended financial statements dated not earlier than the date the amended financial statements are signed or approved. The procedures outlined in Illustration 11.8 would be extended to the date of the new auditor’s report.
When Management Does Not Amend the Financial Statements
When management does not amend the financial statements in circumstances where the auditor believes they need to be amended and the auditor’s report has not been released, the auditor should express either a qualified or an adverse opinion. If the auditor’s report has been released to the entity’s governance body, the auditor would notify those persons not to issue financial statements and the auditor’s report. If the financial statements are subsequently issued to the regulators or public, the auditor needs to take action to prevent reliance on that auditor’s report.

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  Discovery of Facts After The Financial Statements Have Been Issued (After the Shareholders’ Meeting)
  

After the financial statements have been issued the auditor has no obligation to make any inquiry regarding such financial statements. If, however, after the statements have been issued, the auditor becomes aware of a fact which existed at the date of the auditor’s report and which, if known then, may have caused the auditor to issue a modified auditor’s report, the auditor should discuss it with management and consider revision of the financial statements.
The new auditor’s report should include an emphasis of a matter paragraph referring to a note to the financial statements that more extensively discusses the reason for the revision of the previously issued financial statements and to the earlier report issued by the auditor. The new auditor’s report would be dated not earlier than the date the revised financial statements are approved. The procedures listed in Illustration 11.8 would ordinarily be extended to the date of the new auditor’s report.


Review Financial Statements and Other Report Material

The final review of the financial statements involves procedures to determine if disclosures of financial statements and other required disclosures (for corporate governance, manage- ment reports, etc.) are adequate. The auditor is responsible for all information that appears with the audited financial statements, so therefore the auditor must also see if there are any inconsistencies between this other information and the financial statements.

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  Financial Statement Disclosures
  

An important consideration in completing the audit is determination of whether the disclosures in the financial statements are adequate. Adequate disclosure includes consideration of all the financial statements, including related footnotes.
Under the Sarbanes-Oxley Act (SOX) auditors have the responsibility of considering certain financial statement disclosures connected with the financial statements. ³⁴ In Section 404, ³⁵ SOX requires that each annual report of a publicly traded company contain an internal control report. The report should state the responsibility of management for establishing and maintaining an adequate internal control structure, and contain an

assessment of the effectiveness of the internal control structure and the financial statement accounting procedures of company. Each public accounting firm that prepares or issues the audit report for these companies according to PCAOB Audit Standard #2 must attest to, and report on, the assessment made by the management. Companies must disclose all material correcting adjustments and off-balance sheet transactions. Pro-forma information included in any report must not contain an untrue statement of material fact, reconciled with the financial condition of the company.

Adequate Disclosure Ongoing

Review for adequate disclosure is an ongoing activity of the audit. For example, as part of the audit of accounts receivable, the auditor must be aware of the need to separate notes receivable and amounts due from affiliates and trade accounts due from customers because all of these may require different disclosure. Furthermore, there must be a segre- gation of current and non-current receivables and a disclosure of the factoring or discounting of notes receivable. An important part of verifying all account balances is determining whether financial accounting standards were applied on a basis consistent with that of the preceding year.

Financial Statement Disclosure Checklist

Many audit firms use a financial statement disclosure checklist. An independent partner or director designs these questionnaires to remind the auditor of common disclosure problems encountered on audits and also to facilitate the final review of the entire audit. Illustration 11.9 shows a partial financial statement disclosure checklist. Of course, in any given audit some aspects of the engagement require much greater expertise in accounting than can be obtained from such a checklist.

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  Corporate Governance Disclosures
  

Recently, there has been worldwide concern by shareholders that corporations should be governed in their best interests. This has led to a requirement on the London Stock Exchange for companies to report that they have followed a Code of Best Practice that was suggested by the Cadbury Committee. ³⁶ The London Stock Exchange requires all listed companies registered in the UK, as a continuing obligation of listing, to state whether they are complying with the Code and to give reasons for any areas of non-compliance. The areas of greatest concern to auditors are the requirements that the directors report on internal control and going concern.

The London Stock Exchange Code of Best Practice states that ³⁷ the directors should report on the effectiveness of the company’s system of internal control and that the business is a going concern, with supporting assumptions or qualifications as necessary.

SOX Governance Disclosures
Under the Sarbanes-Oxley Act (SOX) auditors have responsibility regarding certain governance disclosures connected with the financial statements. ³⁸ The company must also disclose whether or not – and if not, the reason why – it has adopted a code of ethics ³⁹ for senior financial officers, applicable to its principal financial officer and comptroller or principal accounting officer, or persons performing similar functions. ⁴⁰ SOX section 407⁴¹ requires company disclosure of whether or not – and if not, the reasons why – their audit committee is comprised of at least one member who is a financial expert.
In other countries similar developments took place. For example in France, the Netherlands, South Africa and Canada reports about corporate governance were pub- lished and broadly discussed. The expected roles of auditors vary between countries and, in most cases, they are less highly profiled than in the UK.
Governance Issues are discussed in Chapter 14 Corporate Governance.

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  Other Information in Annual Reports
  

ISA 720 states that the auditor should read the other information (in documents contain- ing audited financial statements) to identify material inconsistencies with the audited

financial statements. ⁴² “Other information,” on which the auditor may have no obliga- tion to report but which he must check for material inconsistencies, includes documents such as an annual report, a report by management or the board of directors on operations, financial summary or highlights, employment data, planned capital expenditures, finan- cial ratios, names of officers and directors, selected quarterly data, and documents used in securities offerings.

Material Inconsistency
A material inconsistency exists when other information contradicts information con- tained in the audited financial statements. A material inconsistency may raise doubts about the audit conclusions drawn from audit evidence obtained and, possibly, about the basis for the auditor’s opinion on the financial statements.
If the auditor identifies a material inconsistency on reading the other information, he should determine whether the audited financial statements or the other information needs to be amended. If an amendment is necessary in the other information and the entity refuses to make the amendment, the auditor should consider including in the auditor’s report an emphasis of matter paragraph describing the material inconsistency or taking other action. If an amendment is necessary for the audited financial statements and the entity refuses to allow it, the auditor should express a qualified or adverse opinion.
Material Misstatement of Fact
If the auditor becomes aware that the other information appears to include a material mis- statement of fact he should discuss the matter with the company’s management. If the auditor still considers there is an apparent misstatement of fact, he should request that management consult with a qualified third party, such as the entity’s legal counsel, and should consider the advice received. If management still refuses to correct the misstate- ment, the auditor should take appropriate action that might include notifying the board of directors.


Wrap-Up Procedures

Wrap-up procedures are those procedures done at the end of an audit that generally cannot be performed before the other audit work is complete. Wrap-up procedures include: supervisory review, final analytical procedures (discussed in Chapter 9 Analytical Procedures), working paper review, evaluating audit findings for material misstatements, client approval of adjusting entries, review of laws and regulation, and evaluation of the company as a going concern.

Illustration 11.10 summarizes the wrap-up procedures normally undertaken.

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  Supervisory Review
  

Wrap-up procedures start with the in-charge (senior) accountant reviewing the work of the staff accountant. In turn, the manager and partner in charge of the audit review the work submitted by the in-charge accountant. Often, for larger audits, an additional

ILLUSTRATION 11.10

Typical Wrap-up Procedures