Case 1.6 Star Technologies, Inc.
Q7. How should disagreements between members of an audit engagement team be resolved? What mistakes, if any, were made by Childers and/or Argy in resolving the conflicts that arose between them during the 1989 Star audit?
A. An approach that I would suggest to resolving disagreements between audit engagement members would be to refer to the American Institute of Certified Public Accountants Code of Professional Conduct. The Code provides both general standards as well rules of conduct that AICPA members must follow. The Code has four parts: Principles, Rules of Conduct, Interpretations of the Rules of Conduct, and Ethical Rulings. The Principles are six ethical standards to which CPAs should adhere to when practicing the profession. The Rules of Conduct are explicit rules that CPAs must follow. Unlike the Principles that are not enforceable, the Rules of are enforceable. The Rules of Conduct contain very defined wording, and, because they are enforceable, they are often referred to as the Code of Professional Conduct. Although not enforceable, the Interpretations of the Rules of Conduct are published by the Professional Ethics Executive Committee of the AICPA. The Interpretations provide AICPA members insight when there are questions that arise about a specific rule. Again, the Interpretations are not enforceable, but any departure must be justified. Lastly, Ethical Rulings are explanations of the Professional Ethics Executive Committee to specific questions about the Rules of Conduct. The questions, submitted by AICPA members, seek advice on ethical requirements. Similar to Interpretations with respect to enforceability, Ethical Rulings are not enforceable but departure from them must be justified.
Of particular interest as it applies to this case, Rule 102 - Integrity and Objectivity of the Code would provide the audit engagement members assistance in resolving their disagreements. Rule 102 states that while in performance of any professional service, an AICPA member must maintain objectivity and integrity, must be free of conflicts of interest, and must not knowingly misrepresent facts or subordinate his or her judgment to others. In reading through this case, many arguments can be made as to the conduct of both Clark Childers and Paul Argy violating Rule 102.
The Interpretations under Rule 102 provide additional support for the Rule. Interpretation 102-1, knowing misrepresentations in the preparation of financial statements or records, states that an AICPA member violates Rule 102 by knowingly misrepresenting facts if the member knowingly makes or directs another to make materially false or misleading entries in the client's financial statements or records. Failure to correct a client's financial statements or records that are materially false or misleading is also a violation of Rule 102. The Rule is also violated if a member signs or directs another to sign any documents that contain materially false or misleading information.
There are many examples in the case of Childers making or allowing Star to make materially false or misleading entries in the Star financial statements. Many of these center on Childers incorrectly determining that that amounts are immaterial with respect to the financial statements, or agreeing to a compromise with Star management to record a substantially lower figure. Both Childers and Argy failed to correct the false or misleading entries, resulting in misrepresented Star financial statements. Childers was responsible for directing a subordinate to include a document in the workpapers after the fact. Childers also pressured Argy into signing off on the Star workpapers and audit summary. Argy surrendered to the pressure and knowingly signed the documents even though he knew them to be misleading.
Interpretation 102-2, conflicts of interest, states that a conflict of interest could occur if an AICPA member performs a professional service for a client or an employer and the member has a relationship with another person or entity that could be viewed by the client or employer that damages the objectivity of the member. If the member concludes that the service can be objectively performed and the relationship is disclosed to the client or the employer and consent is given, the conflict can be waived. For audit engagements, independence is required. Rule 101 - Independence discusses this requirement. Independence can be viewed in two ways: independence in fact and independence in appearance. Disclosure and consent of the conflict does not eliminate impairments in independence.
Although not specifically defined by the Interpretation, it could be viewed that Argy could have had a conflict of interest with his employer, or at least violated independence. As stated in the case, Argy was to be considered for a promotion to partner. An argument could be made that this clouded his judgment in preparing for and in the performance of the 1989 Star audit engagement. With the potential to be promoted to partner looming, Argy may have felt the need to keep quiet and not rock the boat. Argy could be considered to have violated independence in appearance because his performance on the audit may have impacted his consideration to be made a partner. The promotion may also explain the reason why Argy yielded to Childers and signed off on the Star workpapers and audit summary.
The last point that Argy surrendered to the demand by Childers to sign off on the Star engagement suggests that he subordinated his judgment. As stated in the case, Argy disagreed with many of the decisions that Childers had made, but did nothing to reverse them. As a result, an argument could be made that Argy subordinated his judgment to Childers. Interpretation 102-4 Subordination by a member states that if an AICPA member and his or her supervisor has a disagreement or dispute relating to the preparation of client financial statements or recording of transactions, several steps should be taken by the member to ensure that the issue does not cause the member to subordinate his or her judgment.
In applying Interpretation 102-4, the first step that the member should take is to consider whether the recording or omission of the recording of the transaction or the presentation, disclosure or omission in the financial statements, as proposed by the supervisor, would materially misrepresent the facts. If the member, after researching the matter, determines that the proposal is supported and does not misrepresent the facts, there is no subordination of judgment. Argy had felt that the Star workpapers contained materially incorrect conclusions. Argy did not, however, question or research the conclusions to determine if they were in fact material or misrepresented the facts.
If the member determines that the financial statements would be materially misrepresented if the proposal of the supervisor were to be followed, the member should take the concern to a higher authority for resolution. The higher level could be represented by the senior supervisor of the firm or by senior management, the audit committee or the board of directors of the client. The member should document his or her comprehension of the facts, the respective accounting principles involved and their application to the matter and reference to supportive research and consultation of the parties involved. The documentation should be contained within the workingpapers of the engagement. As a result of not researching the conclusions, Argy did not consult a higher authority and therefore did not afford himself the opportunity to document his disagreement with Childers.
If the member, after discussing the matter with the higher level, determines that the matter was not appropriately handled, the member should consider his or her disassociation or withdrawal from the engagement. The member may also reconsider employment with the firm. Consideration should also be made to the liability the member has to the law (such as fraud under Sarbanes-Oxley) and to other authorities (such as the SEC). In the ensuing SEC investigation, the SEC did acknowledge the recommendations of Argy that Star make several large and necessary adjustments to 1989 financial statements, but admonished him for yielding to Childers and signing off on the workpapers when he believed them to materially incorrect. The SEC felt that he should have disassociated himself from the audit engagement, and even commented that it was an option under Price Waterhouse procedure. In addition, the SEC noted that the ambition to be promoted may have clouded his judgment.
As noted earlier, both Childers and Argy made many mistakes in resolving their conflicts while performing the 1989 Star audit engagement. Most outstanding of these mistakes was the failure of Argy to question Childers about the decisions that Childers made. Argy not only should have questioned the decisions, he should have investigated if a more appropriate treatment was called for, and if so, took the matter to a superior. Under no circumstances should Argy have signed off on the Star working papers and audit summary if he had any reservations that the Star financial statements would be misrepresented.
