Case Analysis 1
The suggested outline for the assignment is as follows:
(1) An introduction covering the background information of the case (1-2 paragraphs).
(2) Key issues of the case (about two pages).
Discuss the following issues:
A) List the “red flags” that indicated the audit was a “high-risk audit” and explain why each was
a red flag. For example, the dominance of Robert Costello in the operations of the company
was a red flag because he could do anything he wanted to do, even if he had to override internal
B) Discuss the “non-independence issue” brought up by the judge. What factors contributed to
this issue? Do you believe that these factors actually impaired E&Y’s independence? Explain
C) What audit procedures should E&Y have performed to satisfy themselves as to the validity
and appropriate accounting treatment of the “advances”?
Provide additional insights based on our class discussions and from other sources such as
your textbook, professional auditing and ethical standards and court decisions.
(3) Conclusion (1-2 paragraphs)
Include a cover page with your name on it. The report should not exceed three pages (doublespaced with sufficient margins), excluding the cover page. It should be formatted using Times
New Roman 12-point font. Your name should appear on the cover page only. Please do not write
your name on any other page.
The assignment will be graded on three dimensions: (1) Content, (2) Structure, Organization and
Development, and (3) Style.
Addresses the topic; provides sufficient textual evidence to
support the argument.
Introduction is present in the paper; includes the summary;
indicates how the paper is organized.
Each paragraph includes a topic sentence; develops one main
idea; has a transition sentence, where necessary, linking it to
the next paragraph.
The conclusion recaps the thesis statement and the essay’s
main points; presents a closing statement of the writer’s
The entire composition is logically organized; has a solid
argument with supporting evidence.
Main points are relevant to the thesis statement; are discussed
without too much repetition.
Is concise and precise; is free of misspellings; is free of
grammatical mistakes; lacks incomplete sentences; uses correct
punctuation; is free of jargon and clichés; cites references
1. All papers should be formatted using Times New Roman 12-point font. The text should be
double-spaced, except for indented quotations.
2. Please limit the paper to a maximum of three (double-spaced) pages.
3. Margins should be at least one inch from top, bottom, and sides.
4. Your name should appear on a separate cover page.
5. References should be listed on a separate page (not included in the 3 page limit)
6. In nontechnical text use the word percent; in tables and figures, the symbol % is used.
7. Use a hyphen to join unit modifiers or to clarify usage. For example: a well-presented
analysis; re-form. See Webster’s for correct usage.
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should be flush left, bold, italic, and both uppercase and lowercase. Fourth-level headings should
be paragraph indent, bold, and lower case. Headings and subheadings should not be numbered. For
A CENTERED, BOLD, ALL CAPITALIZED, FIRST-LEVEL HEADING
A Flush Left, Bold, Uppercase and Lowercase, Second-Level Heading
A Flush Left, Bold, Italic, Uppercase and Lowercase, Third-Level Heading
A paragraph indent, bold, lowercase, fourth-level heading.
Tables and Figures
Please note the following general requirements:
1. Each table and figure (graphic) should appear on a separate page and should be placed at the
end of the text. Each should bear an Arabic number and a complete title indicating the exact
contents of the table or figure.
2. Tables or figures should be reasonably interpretable without reference to the text.
3. Notes should be included as necessary.
Work cited should use the “author-date system” keyed to a list of works in the reference list (see
below). You should make an effort to include the relevant page numbers in the cited works.
1. In the text, works are cited as follows: author’s last name and date, without comma, in
parentheses: for example (Jones 1987); with two authors: (Jones and Freeman 1973); with more
than two: (Jones et al. 1985); with more than one source cited together: (Jones 1987; Freeman
1986); with two or more works by one author: (Jones 1985, 1987).
2. Unless confusion would result, do not use “p.” or “pp.” before page numbers: for example:
(Jones 1987, 115).
3. When the reference list contains more than one work of an author published in the same year,
the suffix a, b, etc., follows the date in the text citation: Example: (Jones 1987a) or (Jones 1987a;
4. If an author’s name is mentioned in the text, it need not be repeated in the citation, for
example: “Jones (1987, 115) says …”
5. Citations to institutional works should use acronyms or short titles where practicable: for
example, (AAA ASOBAT 1966); (AICPA Cohen Commission Report 1977). Where brief, the
full title of an institutional work might be shown in a citation: for example, (ICAEW The
Corporate Report 1975).
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reviews should be used.
You must include a list of references containing only those works cited. Each entry should contain
all data necessary for unambiguous identification. With the author-date system, use the following
format recommended by the Chicago Manual:
1. Arrange citations in alphabetical order according to surname of the first author or the name of
the institution responsible for the citation.
2. Use authors’ initials instead of proper first names.
3. Dates of publication should be placed immediately after authors’ names.
4. Titles of journals should not be abbreviated.
5. Multiple works by the same author(s) should be listed in chronological order of publication.
Two or more works by the same author (s) in the same year are distinguished by letters after the
Footnotes are not to be used for documentation. Textual footnotes should be used only for
extensions and useful excursions of information that if included in the body of the text might
disrupt its continuity. Footnotes should be consecutively numbered throughout the paper with
superscript Arabic numerals. Use single space for footnotes.
All information (ideas, facts, interpretations etc.) obtained from all sources that you consult for your
paper must be cited even if you made substantial changes in the author’s original wording or if you
are quoting from professional standards, such as an SAS or PCAOB statement. If you have any
doubts as to whether or not to cite a source, cite it. One of the most common causes of low grades
on papers is inadequate (or non-existent) citations. In addition, failure to cite the work of others that
you incorporate into your paper may be viewed as being plagiarism. By citing your sources you
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All direct quotes of three lines or less should be double spaced with quotation marks. Direct
quotes of more than three lines should be single spaced and indented five spaces on either side.
CBI Holding Company, Inc.
During the 1980s, CBI Holding Company, Inc., a New York-based firm, served as the parent company for
several wholly owned subsidiaries, principal among them Common Brothers, Inc. CBI’s subsidiaries
marketed an extensive line of pharmaceutical products. The subsidiaries purchased these products from
drug manufacturers, warehoused them in storage facilities, and then resold them to retail pharmacies,
hospitals, long-term care facilities, and related entities. CBI’s principal market area stretched from the
northeastern United States into the upper Midwest.
In 1991, Robert Castello, CBI’s president and chairman of the board, sold a 48 percent ownership
interest in his company to Trust Company of the West (TCW), a diversified investment firm. The
purchase agreement between the two parties gave TCW the right to appoint two members of CBI’s
board; Castello retained the right to appoint the three remaining board members. The purchase
agreement also identified several so-called “control-triggering events.” If any one of these events
occurred, TCW would have the right to take control of CBI. Examples of control-triggering events
included CBI’s failure to maintain certain financial ratios at a specified level and unauthorized loans to
Castello and other CBI executives.
Castello engaged Ernst & Young (E&Y) as CBI’s independent audit firm several months before he closed
the TCW deal. During this same time frame, Castello was named “Entrepreneur of the Year” in an annual
nationwide promotion cosponsored by E&Y. From 1990 through 1993, E&Y issued unqualified opinions
on CBI’s annual financial statements.
Castello instructed several of his subordinates to misrepresent CBI’s reported operating results and
financial condition for the fiscal years ended April 30, 1992, and 1993.1 Those misrepresentations
allowed Castello to receive large, year-end bonuses to which he was not entitled. CBI actively concealed
the fraudulent activities from TCW’s management, from TCW’s appointees to CBI’s board, and from the
company’s E&Y auditors because Castello realized that the scheme, if discovered, would qualify as a
control-triggering event under the terms of the 1991 purchase agreement with TCW. Several years later
in a lawsuit prompted by Castello’s fraud, TCW executives testified that they would have immediately
seized control of CBI if they had become aware of that scheme.
Understating CBI’s year-end accounts payable was one of the methods Castello and his confederates
used to distort CBI’s 1992 and 1993 financial statements. At any point in time, CBI had large outstanding
payables to its suppliers, which included major pharmaceutical manufacturers such as BurroughsWellcome, Schering, and FoxMeyer. At the end of fiscal 1992 and fiscal 1993, CBI understated payables
due to its large vendors by millions of dollars. Judge Burton Lifland, the federal magistrate who presided
over the lawsuit stemming from Castello’s fraudulent scheme, ruled that the intentional
understatements of CBI’s year-end payables were very material to the company’s 1992 and 1993
E&Y’s 1992 and 1993 CBI Audits
In both 1992 and 1993, E&Y identified the CBI audit as a “close monitoring engagement.” The
accounting firm’s audit manual defined a close monitoring engagement as “one in which the company
being audited presents significant risk to E&Y … there is a significant chance that E&Y will suffer damage
to its reputation, monetarily, or both.”2 E&Y’s workpapers for the 1992 and 1993 audits also
documented several “red flags” suggesting that the engagements posed a higher-than-normal audit risk.
Control risk factors identified for the CBI audits by E&Y included the dominance of the company by
Robert Castello,3 the absence of an internal audit function, the lack of proper segregation of duties
within the company’s accounting department, and aggressive positions taken by management personnel
regarding key accounting estimates. These apparent control risks caused E&Y to describe CBI’s control
environment as “ineffective.” Other risk factors identified in the CBI audit workpapers included the
possible occurrence of a control-triggering event, an “undue” emphasis by top management on
achieving periodic earnings goals, and the fact that Castello’s annual bonus was tied directly to CBI’s
For both the 1992 and 1993 CBI audits, the E&Y engagement team prepared a document entitled “Audit
Approach Plan Update and Approval Form.” This document described the general strategy E&Y planned
to follow in completing those audits. In 1992 and 1993, this document identified accounts payable as a
“high risk” audit area. The audit program for the 1992 audit included two key audit procedures for
a. Perform a search for unrecorded liabilities at April 30, 1992, through the end of fieldwork.
b. Obtain copies of the April 30, 1992, vendor statements for CBI’s five largest vendors, and
examine reconciliations to the accounts payable balances for such vendors as shown on the
books of CBI.
The 1993 audit program included these same items, although that program required audit procedure
“b” to be applied to CBI’s 10 largest vendors.
During the 1992 audit, the E&Y auditors discovered numerous disbursements made by CBI in the first
few weeks of fiscal 1993 that were potential unrecorded liabilities as of April 30, 1992. The bulk of these
disbursements included payments to the company’s vendors that had been labeled as “advances” in the
company’s accounting records. CBI personnel provided the following explanation for these advances
when questioned by the auditors: “When CBI is at its credit limit with a large vendor, the vendor may
hold an order until they receive an ‘advance.’ CBI then applies the advance to the existing A/P balance.”
In truth, the so-called advances, which totaled nearly $2 million, were simply payments CBI made to its
vendors for inventory purchases consummated on, or prior to, April 30, 1992. Castello and his
confederates had chosen not to record these transactions—their purpose being to strengthen key
financial ratios of CBI at the end of fiscal 1992 and otherwise embellish the company’s apparent financial
condition. The conspirators developed the advances ruse because they feared that E&Y would discover
the material understatements of accounts payable at year-end.
Subsequent court testimony revealed that after reviewing internal documents supporting the advances
explanation—documents that had been prepared to deceive E&Y—the E&Y auditors readily accepted
that explanation and chose not to treat the items as unrecorded liabilities. This decision prompted
severe criticism of the audit firm by Judge Lifland.
The federal judge pointed out that the auditors had failed to rigorously investigate the alleged advances
and consider the veracity of the client’s explanation for them. For example, the auditors did not
investigate the “credit limit” feature of that explanation. The E&Y auditors neglected to determine the
credit limit that the given vendors had established for CBI or whether CBI had “maxed out” that credit
limit in each case as maintained by client personnel. Nor did the auditors attempt to analyze the given
vendors’ payable accounts or contact those vendors directly to determine if the alleged advances
applied to specific invoice amounts, particularly invoice amounts for purchases made on or before April
30, 1992. Instead, the auditors simply chose to record in their workpapers the client’s feeble explanation
for the advances, an explanation that failed to address or resolve a critical issue. “The advance
explanation recorded in E&Y’s workpapers, even if it were true, did not tell the E&Y auditor the essential
fact as to whether the merchandise being paid for by the advance had been received before or after
April 30, 1992.”
Because of the lack of any substantive investigation of the advances, the E&Y auditors failed to
determine “whether a liability should have been recorded for each such payment as of fiscal year-end,
and whether, in fact, a liability was recorded for such payment as of fiscal year-end.” This finding caused
Judge Lifland to conclude that E&Y had not properly completed the search for unrecorded liabilities. The
judge reached a similar conclusion regarding the second major audit procedure for accounts payable
included in the 1992 audit program for CBI.
The 1992 audit program required the E&Y auditors to obtain the year-end statements sent to CBI by the
company’s five largest vendors and to reconcile the balances in each of those statements to the
corresponding balances reported in CBI’s accounting records. E&Y obtained year-end statements mailed
to CBI by five of the company’s several hundred vendors and completed the reconciliation audit
procedure. However, the vendors involved in this audit test were not the company’s five largest
suppliers. In fact, E&Y never identified CBI’s five largest vendors during the 1992 audit. The federal judge
scolded E&Y for this oversight and maintained that the “minimal” amount of testing applied by E&Y to
the small sample of year-end vendor statements was “not adequate.”
The audit procedures that E&Y applied to CBI’s year-end accounts payable for fiscal 1993 suffered from
the same flaws evident during the firm’s 1992 audit. Similar to the previous year, CBI’s management
attempted to conceal unrecorded liabilities at year-end by labeling subsequent payments of those
amounts as “advances” to the given vendors. Once more, Judge Lifland noted that the “gullible” auditors
readily accepted the explanation for these advances that was relayed to them by CBI personnel. As a
result, the auditors failed to require CBI to prepare appropriate adjusting entries for approximately $7.5
million of year-end payables that the client’s management team had intentionally ignored.
The 1993 audit program mandated that E&Y obtain the year-end statements for CBI’s 10 largest vendors
and reconcile the balances in those statements to the corresponding accounts payable balances in CBI’s
accounting records. Again, E&Y failed to identify CBI’s largest vendors and simply applied the
reconciliation procedure to a sample of 10 CBI vendors.
One of CBI’s 10 largest vendors was Burroughs-Wellcome. If the E&Y auditors had reconciled the
balance due Burroughs-Wellcome in its year-end statement with the corresponding account payable
balance in CBI’s accounting records, the auditors would have discovered that a $1 million “advance”
payment made to that vendor in May 1993 was actually for an inventory purchase two weeks prior to
April 30, 1993. This discovery would have clearly established that the $1 million amount was an
unrecorded liability at year-end.
E&Y Held Responsible for CBI’s Bankruptc
In March 1994, E&Y withdrew its opinions on CBI’s 1992 and 1993 financial statements after learning of
the material distortions in those statements that were due to Castello’s fraudulent scheme. Almost
immediately, CBI began encountering difficulty obtaining trade credit from its principal vendors. A few
months later in August 1994, the company filed for bankruptcy. In early 2000, Judge Lifland presided
over a 17-day trial in federal bankruptcy court to determine whether E&Y would be held responsible for
the large losses that CBI’s collapse inflicted on TCW and CBI’s former creditors. Near the conclusion of
that trial, Judge Lifland ruled that E&Y’s conduct during the 1992 and 1993 CBI audits was the
“proximate cause” of those losses.
The demise of CBI was a foreseeable consequence of E&Y’s failure to conduct its audits in fiscal 1992 and
1993 in accordance with GAAS, which was the cause of its failure to detect the unrecorded liabilities,
which in turn foreseeably caused it to withdraw its opinions in March 1994. As direct and reasonably
foreseeable consequences thereof, CBI’s vendors restricted the amount of credit available, CBI’s
inventory and sales declined, its revenues declined, its value as a going concern diminished, and
ultimately it filed for bankruptcy and was liquidated.
Judge Lifland characterized E&Y’s conduct as either “reckless and/or grossly negligent” and identified
several generally accepted auditing standards that the accounting firm violated while performing the
1992 and 1993 CBI audits. Although the bulk of the judge’s opinion dealt with the audit procedures E&Y
applied to CBI’s accounts payable, his harshest criticism focused on the firm’s alleged failure to retain its
independence during the CBI engagements.
Several circumstances that arose during E&Y’s tenure as CBI’s audit firm called into question its
independence. For example, Judge Lifland referred to an incident in 1993 when Robert Castello
demanded that E&Y remove the audit manager assigned to the CBI engagement. Apparently, Castello
found the audit manager’s inquisitive and probing nature disturbing. The CBI audit engagement partner
“submissively acquiesced” to Castello’s request and replaced the audit manager.
Shortly after the completion of the 1993 audit, Castello hired a new chief financial officer (CFO). This
individual resigned eight days later. The CFO told members of the E&Y audit team he was resigning
because of several million dollars of “grey accounting” he had discovered in CBI’s accounting records.
Judge Lifland chided E&Y for being slow to pursue this allegation. Nearly five months passed before the
CBI audit engagement partner contacted the former CFO. By that point, E&Y had already discovered
Castello’s fraudulent scheme and withdrawn its 1992 and 1993 audit opinions.
In February 1994, the audit engagement partner met with Castello to discuss several matters. E&Y’s
unpaid bill for prior services provided to CBI was the first of those matters, while the second issue
discussed was E&Y’s fee for the upcoming audit. The last topic on the agenda was the allegation by CBI’s
former CFO regarding the company’s questionable accounting decisions. According to Judge Lifland, the
audit partner “wanted to speak to [the former CFO] in order to ask him whether his leaving the post of
chief financial officer and his allegations of ‘grey accounting’ had anything to do with the financial
statements that E&Y had just certified; however, [the audit partner] obligingly allowed himself to be put
off.” In Judge Lifland’s opinion, the E&Y audit partner was “more concerned about insuring E&Y’s fees
than he was about speaking to [the former CFO].”
The final matter Judge Lifland discussed in impugning E&Y’s independence was the accounting firm’s
effort to retain CBI as an audit client after discovering that the 1992 and 1993 audits had been deficient.
Judge Lifland charged that E&Y officials realized, when they withdrew the audit opinions on CBI’s 1992
and 1993 financial statements, that the CBI audits had been flawed. In the days prior to withdrawing
those opinions, two individuals, a former CBI accountant and CBI’s controller at the time, informed E&Y
that the “advances” discovered during the 1992 and 1993 audits had been for payment of unrecorded
liabilities that existed at the end of CBI’s 1992 and 1993 fiscal years. After investigating these
admissions, E&Y determined that they were true. E&Y also determined that the CBI auditors “had failed
to detect the unrecorded liabilities because they had failed to properly perform the search [for
E&Y failed to notify CBI’s board of directors of the flaws in the 1992 and 1993 audits.5 According to
Judge Lifland, E&Y did not inform the board members of those flaws because the accounting firm
realized that doing so would lower, if not eliminate, its chance of landing the “reaudit” engagement for
CBI’s 1992 and 1993 financial statements. “E&Y’s egocentric desire to get the reaudit work is illustrated
by the fact that it prepared an audit program for the reaudit two days before E&Y met with the CBI
board of directors and one day before they withdrew their opinion.”
CBI’s board ultimately selected E&Y to reaudit the company’s 1992 and 1993 financial statements. Given
the circumstances under which E&Y obtained that engagement, Judge Lifland concluded that the
accounting firm’s independence was likely impaired. “Thus, E&Y knew prior to agreeing to perform the
reaudit work that it had not complied with GAAS. E&Y also knew that CBI’s board of directors did not
know of E&Y’s failure to comply with GAAS. It is reasonable to infer that if CBI’s board of directors knew
of such failure, E&Y and CBI would be in adversarial positions.”
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