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General Technologies Group LTD.: CASE 2.5
General Technologies Group LTD.: CASE 2.5
Each year, the Securities and Exchange Commission (SEC) issues dozens of Account-
ing and Auditing Enforcement Releases (MERs). These releases, which the SEC
began issuing in 1982, report major violations of generally accepted accounting
principles (GAAP) and/or generally accepted auditing standards (GAAS). In August
1984, Frederick S. Todman & Company, a New York- based accounting firm, found
itself the subject of MER No.36.
In MER No. 36, the SEC charged Todman with "improper professional conduct"
during its audits of a large brokerage firm,Bell & Beckwith. From 1977 through 1982,
Todman issued unqualified audit opinions on Bell & Beckwith's annual financial
statements. The SEC alleged that those audit opinions were "false and misleading"
since Bell & Beckwith's financial statements contained material errors resulting from
management fraud. Following are the specific charges the SEC leveled against
Todman for its audits of Bell & Beckwith.
1. Todman failed to perform the audits with sufficient personnel having adequate
technical training and auditing proficiency.
2. The Bell & Beckwith audits were not adequately planned and the staff auditors
assigned to the engagements were not properly supervised.
3. A proper study and evaluation of Bell & Beckwith's internal control was not
performed during the audits.
4. Todman auditors relied on management representations in the face of records
and information evidencing those representations to be false.
5. The workpapers for the Bell & Beckwith audits did not adequately document the
procedures performed and the conclusions drawn.
The SEC publicly censured Todman for the deficient Bell & Beckwith audits and
required the firm to retain an"independent reviewer" to study its audit practices and
procedures. The SEC also required Todman to implement any recommendations
made by that reviewer. Among the reviewer's recommendations was that Todman
establish a quality control function. The individual staffing this function would per-
form a"pre-issuance review" on all Todman audits involving SEC registrants to ensure
compliance with GAAS on those engagements.Thisindividual would also approve the
assignment of personnel and the issuance of audit reports on all SEC engagements.
169
170 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS
EXHIBIT 1
SELECTED FINANCIAL
1988 1987 1986 1985
DATA REPORTFD Net sales $11,389,530 $13,638,344 $17,271,738 $10,899,202
BY GENERAL Cost of goods sold 5,181,583 7,027,710 12,299,634 6,120,298
\ T ECHNOLOGIES, Income before
1985-1988 income taxes 768,597 907,010 632,051 769,524
Net income 439,867 803,845 177,599 496,424
14,213,658 12,521,206 9,818,797 6,149,137
/ Total inventories
Work-in-pro
invento ry
cess
11,080,004 9,611,879 6,567,158 3,418,748
A Fraud Is Born
Three indi vidua ls plotted and executed the fraud used to misrepresent General
Tech's financial statement data during the late 1980s. Two of these three men were
General Tech executives , the company's chief executive officer (CEO) and its vice
president of operations (VPO). The third schemer was an accountant but not an
employee of General Tech. General Tech had outsourced its principa l accounting
and financial reporting functions to this latter individual's accounting firm. SEC en-
forcement releases focusing on the General Tech fraud referred to this individual
simply as the company's "Consultant:'
Shortly after the close of General Tech's 1986 fiscal year, the company's CEO and
Consultant discussed General Tech's poor operating results for that year. After decid-
ing that reporting a loss for 1986 was unacceptable, the two men came up with a plan
to dramatically-and fraudulently- improve the company's reported financial data for
that year. The fraudulent scheme centered primarily on General Tech's inventory. At
the end of each year,General Tech prepared a Labor Inventory Report (UR) for its
work-in-process (WIP) inventory; which was histo ricall y the largest component of the
company's total inventories. The UR, a computer-generated report, listed each WIP
item and its three cost elements: labor, overhead, and materials. This report dis-
played the quantity, total cost per unit,and total extended cost of each WIP item. Sep-
arate computations (extensions) were reported for each cost element.For example,
the amount of labor charged to each item was extended by the per-unit cost of that
labor. The UR also reported the total cost of the year-end WlP inventory.
General Tech's Consultant instructed the VPO to materially overstate the dollar
value of the company's WIP inventory on December 31, 1986. The VPO initially
resisted but then complied with the Consultant's request when told to do so by
General Tech's CEO. To overstate the year-end WIP inventory; the VPO modified the
computer program that produced the UR. This change in the computer program
doubled the per-unit labor cost charged to each WIP item at the end of 1986.
Alt hough the per-unit labor cost was doubled by the program, the UR reported the
CASE 2.5 GENERAL TECHNOLOGIES GROUP LTD.
actual labor cost per unit. In other words, multiplying the per-unit labor cost and
labor quantity listed on the LIR for any given WIP item resulted in an amount equal
to exactly one-half of the product of those amounts reported on the LIR. The over-
head assigned to each WIP item was equal to 164 percent of the labor cost charged
to that item. As a result, the overstatement of the labor charges triggered an even
larger overstatementof the overhead assigned to each WIP item.
The fraudulent inventory scheme understated General Tech's 1986 cost of goods
sold by approximately $2,375,000.This understatement of cost of goods sold, when
combined with a few smaller errors, converted the company's estimated net loss of
nearly $2 million for 1986 into a reported net income of $177,000 for the year.A simi-
lar scheme was used to misrepresent General Tech's reported operating results for
1987 and 1988.However, in both of those years, the labor cost assigned to each WIP
item was inflated by a factor of four. Of course, quadrupling the assigned labor costs
resulted in an even larger overstatement of the overhead charged to WIP items.The
net understatement of cost of goods sold for 1987 was approximately $1,373,000,
while the comparable figure for 1988 was $1,430,0001.
In both 1987 and 1988, General Tech's reported operating results were affected by
the fraudulent understatement of cost of goods sold and other irregularities perpe-
trated by company executives.In 1987, General Tech reported a net income of
$804,000,while the company actually experienced a net loss estimated at $2 million.
For fiscal 1988, the company reported a net income of $440,000, while suffering an
actual loss of more than $8 million.
1. The understatements of cost of goods sold for 1987 and 1988 were net amounts. These amounts
equaled the difference between the end-of-the-year and beginning-of-the-year overstatement of inventory
in each case.
2. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No.552,
22 April 1994. Unless indic ated otherwise, the remaining quotes in this case were taken from this source.
172 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS
Kappel reportedly neverreviewed the 1986 year-end UR that was the focal po int of
the General Tech inventory fraud. However,a Todman staff acco untant , apparently on
his own initiative, obtained the UR and applied limited audit procedures to that
report. Among these procedures was a test of the clerical accuracy of the materials
)
costs listed on the UR for selected WIP items. For the items selected for testing, the
staff accountant multiplied the quantity of materials charged to each item by the per-
unit cost of those materials.The staff accountant failed to apply a comparable test to
the labor component of the WIP items.If such a test had been performed, the inven-
tory fraud would have been easily detected since the labor extension for each WIP
item did not equal the product of the item's labor quantity and per-unit labor cost
reported on the UR.
Had the auditors performed an arithmetic test of the extension of labor on the UR,
the test would have revealed labor values equal to one-half of the actual amount
reported in the total column of the LIR.
Another audit procedure that would have detected the overstatement of labor
assigned to the WIP inventory would have been comparing the UR to the count
sheets prepared during General Tech's year-end physical inventory. These count
sheets reflected the proper labor chargesfor each WIP it em. A quick comparison of
the two records would have revealed that the labor charges report ed on the UR for
each WIP item were exactly double the labor charges reported on the count sheets
for those items.
During the 1986 audit, one of the two Todman staff accountants assigned to the
engagement did find a material inventory error.This error involved the raw materials
inventory, not the client's WIP inventory.The auditor discovered that the dollar value
of the raw materials inventory in General Tech's accounting records exceeded by
$270,000 the dollar value determined by a physical count.Although the auditor doc-
umented this difference in the General Tech workpapers, the error was apparently
never investigated and General Tech's accounting records were not corrected.
Despite performing limited, and often flawed, audit procedures on General Tech's
accounting records, Todman issued an unqualified opinion on the client's 1986
finan ci al statements.That opinion was dated March 27, 1987.
=
General Tech engaged Cooper, Selvin & Strassberg, Certified Public Accountants ("Cooper Au::- ;;;JIIJ[
Selvin") to audit its 1987 financial statements and to issue their report with respect thereto. "'
Prior to the completion of the audit, it was mutually agreed to terminate Cooper Selvin's L"-Cl.UE) 1'li
engagement and the audit was completed by Frederick S. Todman & Company, Certified Public Gr:-.:I:R...:.
Accountants ("Todman"). (Todman also audited General Tech's financial statements for the TE
years ended December 31, 1982 through 1986 and issued their reports thereto.) In 1 98 7 10-K
connection with their engagement, Cooper Selvin advised General Tech management as to
what they regarded as weaknesses in internal controls and their concerns about the
reliability of management information. These concerns about weaknesses in internal controls
and the reliability of management information were addressed by Todman in connection with
their audit of the 1987 financial statements and all adjustments which Todman believed
necessary were made.
Cooper Selvin pointed out that the co mpa ny failed to accrue certain expenses at the
end of 1987. No doubt, General Tech's executives were unhappy with the inquisitive
and persistent Cooper Selvin auditors, which likely explains why those executives
dismissed the firm before it completed the 1987 audit.
After dismissing Cooper Selvin, General Tech contacted Alan Kappel and began
negotiations to reengage Todman as its independe nt audit firm. Following disc us-
sions with Todman's senior executives, Kappel agreed to replace Cooper Selvin as
General Tech's audit firm. During the negotiations with General Tech, Kappel learned
that Cooper Selvin had questioned the accuracy of the company's inventory valua-
tion. Ne vertheless, neither Kappel, nor any other Todman auditor, discussed this mat-
ter with Cooper Selvin personnel. Kappel did obtain copies of the workpapers that
Cooper Selvin completed prior to its dismissal.
As required by the SEC, General Tech included information in its 1987 10-K regis-
tration statement regarding its auditor cha nges. Exhibit 2 presents that information.
Notice that this disclosure did not specifically reveal Cooper Selvin's concern regard-
ing the valuat ion of General Tech's inventory.
knew that Cooper Selvin had identified errors in the per-unit costs of WIP inven tory
items in that accounting record. According to the SEC, had Kappel studied the Gen-
eral Tech workpapers prepared by Cooper Selvin, the fraudulent overstatement o f
inventory would have been readily apparent.
Moreover; had Kappel adequately reviewed [Cooper Selvin'sj workpapers which he
obtained he would have discovered a roadmap clearly delineating the doubling and
quadrupling of General Tech 's value of the work-in-process inventory.
Instead of investigating the alleged errors in General Tech'sinventory records, the SEC
charged that Kappel "simply accepted" the client's false explanation for those errors.
General Tech's management convinced Kappel that there was a simple explana-
tion why the labor costs charged to the WIP items in the 1987 year-end invento ry
were twice the comparable labor charges assigned to the WIP items in the 1986 year-
end inventory.3 According to management, the items in the 1987 WIP inven tory were
100 percent complete with respect to labor, while the items in the 1986 WIP inven-
tory had been only 50 percent complete.The SEC noted that this explanation was far-
fetched for two reasons. First, it was statistically improbable that each item in the
1986 WIP inventory was 50 percent complete with respect to labor, whi le each item
in the 1987 WIP inventory was 100 percent complete for that cost element. Second,
and more important, Kappel and the other Todman auditors never discovered that
labor was assigned to a WIP item only when 100 percent of the labor chargeshad
been incurred for that item.Thus, no labor charges should have been applied to the
1986 year-end WIP inven tory if, as management alleged, each of thoseitemswas on ly
50 percent complete.
Todman comp leted the 1987 General Tech audit approximately six weeks after
being reengagedas the company's audit firm.On May 3, 1988,Todman issued an un-
qualified opinion on General Tech's 1987 financial statements.
3. Recogn ize that the labor costs assigned to the 1986 WIP inventory were double the amounts that
should have been assigned, wh ile the labor costs charged to the 1987 WIP inventory had been
intentionally quadrupled.
CASE 2.5 GENERAL TECHNOLOGIES GROUP LTD.
The independent reviewer's criticism prompted Young to take a much more active
role in the 1988 General Tech audit compared with his role in the 1987 audit.Young
identified several potential flaws in the 1988 audit while it was in progress and
brought these items to the attention of both Alan Kappel and Irv Weiner,Todman's
managing partner.The SEC reported that Kappel failed to address many of the issues
raised by Young. When Young informed Weiner that Kappel was "dragging his feet" in
responding to quality control issues on the General Tech audit, Weiner complained
that Young was "spending too much time" on that engagement4.
In early May 1989,Kappel calledYoung at home and insisted that the audit opinion
on General Tech's 1988 financial statements had to be released immediately. Many of
the concernsYoung had previously raised regarding the 1988 General Tech audit were
still unresolved at this point. After obtaining an oral commitment from Kappel to
address those matters,Young concurred with Kappel's decision to release the audit
opinion. Despite the commitment he made to Young, Kappel did not adequately ad-
dress the unresolved issues. In addition,Young never followed up to determine that
Kappel had properly dealt with those issues.Finally, although Young realized that Tod-
manhad agreed not to issue anyadditional audit opinions from itsValley Stream office,
he did not take any action to prevent that office from releasing the 1988 General Tech
audit opinion.
One of the several SEC enforcement releases that dealt with the General Tech
fraud focused exclusively on Paul Young. The SEC severely criticized Young's perfor-
mance asTodman's quality control director.
Young failed to perform his quality review function in a professionally responsible
manner Moreover, Young undermined the integrity of the follow-up independent
review ... by misdating documents to create the impression he had reviewed them
before Todman's audit report on General Tech's 1987 financial statements. Accord-
ingly,Young's failure to perform properly as quality control director on the 1987 and
1988 audits demonstrates his improper professional conduct.5
EPILOGU
By late 1989, General Tech's executives cou ld engaging in future violations of federal securi-
no longer conceal the company's true financial ties laws.
condition. General Tech filed for bankruptcy in Alan Kappel, Paul Young, and Irv Weiner also
December 1989 and was liquidated in 1994. settled charges filed against them by the SEC
Among the lawsuits resulting from the General without admitting or denying the reported facts
Tech fraud were civil complaints filed by the of the case. Kappel agreed to be permanently
SEC against the company's Consultant and its banned from practicing before the SEC. Young
executives who actively participated in the was banned for one year from practicing be-
fraud or were aware of the fraud. The SEC fore the federal agency, while Weiner received a
charged each of these individuals with defraud- five-year ban. The SEC also censured both
in g General Tech's investors. Without either · Young and Weiner.
admitting or denying the charges, each man On December 31,1993,Frederick S.Todman &
agreed to a court order that barred him from Company disbanded and a new partnership
4. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 663,
12 April 1995.
5. Ibid.
CASE 2.5 GENERAL TECHNOLOGIES GROUP LTD.
entitled Todman & Co. was formed. Two of the a requirement that Todman retain an indepen-
eight partners of Todman & Co. had served as dent consultant to review its quality control
partners of the original Todman firm. In early policies and procedures. All recommenda tions
1994, the SEC and the new Todman firm agreed made by the consultant had to be implemented
to a series of stipulations to ensure that the firm by Todman within 60 days.Todman also agreed
established and maintained an adequate sys- to undergo two follow-up reviews of its quality
tem of quality controls.This agreement included controls by the independent consultant.
Questions
1. When auditing a client's inventory, which of the management assertions
identified by SAS No. 31, "Evidential Matter," is of primary concern to an auditor?
Why?
2. General Tech's LIR was a computer-generated report. What steps should auditors
take to test the reliability of key accounting software programs of a client?
3. Identi fy additional audit tests that the Todman auditors could have,and
probably should have, applied to General Tech's year-end L!Rs.
4. List the generally accepted auditing standards that one or more Todman
audi tors apparently viola ted. Briefly indicate how each standard was violated.
5. Do you believe that General Tech's auditor change disclosure shown in Exhibit 2
was sufficient? Are investors, creditors, and other third parties entitled to"full
and fair disclosure"regarding audit or changes? Defend your answer.
6. Define "audit quality." Identify three important quality control procedures, other
than those mentioned in this case, that audit firms can implement.
7. Briefly describe the SEC's oversightresponsibiliti es for the financial reporting
domain.Do you believe the SEC too k appropriate measures when dealing with
the parties involved in the General Technologies fraud?