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Overstock.com, Inc. In March 2000, the Securities and Exchange Commission (SEC) began requiring public companies to have their quarterly financial statements “reviewed” by their independent auditors. The broad purpose of this new requirement was to improve the quality and credibility of quarterly financial reporting. A more specific goal was to reduce the frequency of accounting restatements by SEC registrants. In addition, the SEC hoped the new rule would serve to counteract the “increasing pressure” being imposed on public companies to “manage” their interim financial results. On November 16, 2009, Overstock.com shocked its stockholders, regulatory authorities, and Wall Street by filing an “unreviewed” Form 10-Q with the SEC. In a press release issued that same day, Patrick Byrne, Overstock’s mercurial chief executive officer (CEO), reported that the decision to file the unreviewed 10-Q had been necessary because of an unresolved dispute with Grant Thornton LLP, the company’s audit firm. That dispute centered on the proper accounting treatment to apply to an unusual transaction involving one of Overstock’s business partners. Byrne also revealed that the company had dismissed Grant Thornton as a result of that dispute–later that day, Overstock filed a Form 8-K with the SEC reporting the audit firm’s dismissal. Overstock’s surprising decision to file an unreviewed 10-Q with the SEC caused the investment community to wonder what would happen next. How would the SEC react to Overstock’s decision to seemingly thumb its nose at the federal securities laws? Would the NASDAQ stock exchange suspend the trading of Overstock’s common stock? When or would Overstock be successful in retaining another accounting firm to serve as its independent auditor? Buffett, Byrne & The Bubble Before entering the business world, Patrick Byrne, the son of a wealthy associate of Warren Buffett, lived the life of a bon vivant and Renaissance man. After spending time as a student in China, Byrne earned an undergraduate degree from Dartmouth, a Master’s degree from Cambridge, and a doctorate in philosophy from Stanford. In addition to accumulating an impressive educational portfolio, Bryne traveled the world, earned a black belt in martial arts, made a brief foray into professional boxing, and served as a university instructor. Warren Buffet launched Patrick Byrne’s career in the field of corporate management in 1998 when he asked him to serve as the interim CEO of a financially troubled subsidiary of Berkshire Hathaway, Buffett’s flagship company. Eighteen months later, Byrne struck out on his own when he acquired a controlling interest in a small online company based in Salt Lake City that marketed “excess” and “closeout” merchandise over the Internet. Byrne was convinced that with the proper business plan, capitalization, and management team in place, the company’s core concept could be wildly profitable. Over the following few months, Byrne appointed himself CEO, invested several million dollars to expand the company’s operations, and renamed it Overstock.com. In 2000 and 2001, the spectacular bursting of the “dot.com bubble” decimated hundreds of New Age Internet-based companies that had sprung up like wild mush-rooms over the prior decade. The resulting carnage caused the NASDAQ Composite Index that is laced with e-commerce companies to decline by approximately 80 percent in less than three years. While most online companies were either being forced to shut down or significantly curtail their operations, Patrick Byrne recognized that the dot.com debacle created an opportunity for his company. Overstock began liquidating the unsold merchandise of failing online businesses at fire sale prices. In 2002, the company’s growing revenues and apparently strong business model caused Business Week to name Byrne one of the 25 most influential corporate executives in the rapidly evolving e-commerce sector of the national economy. That same year, Patrick Byrne took Overstock public, the first online retailer to do so in almost two years. The company raised $40 million with its initial public offering (IPO) and listed its common stock on the NASDAQ stock exchange. Gradually, two distinct lines of business emerged within Overstock’s exclusively online operations. Overstock’s “Direct” line of business sold merchandise that it had acquired from other sources to individuals and companies. In Overstock’s much larger “Partner” line of business, the company served as an intermediary or sales agent for more than 3,000 “business partners.” Overstock earned a commission on the merchandise sales that it arranged or facilitated for those partners. For accounting and financial reporting purposes, Overstock recorded most sales of partners’ merchandise as gross revenue and then subtracted the cash remittances made to those partners as cost of goods sold; the differences between those amounts represented the commissions earned by Overstock on the sales transactions. Overstocked on Problems By 2009, Overstock’s annual revenues were approaching $1 billion; one decade earlier when Patrick Byrne acquired the company, it had annual revenues of a few hundred thousand dollars. Despite the company’s impressive revenue growth, the company struggled to become profitable. When the controversy arose regarding Overstock’s unreviewed 10-Q in November 2009, the company had yet to report a profit for a full fiscal year. Making matters worse, the company’s stock had been pummeled in the market over the previous several years, falling from a high of $76 per share in December 2004 to less than $15 per share by November 2009. Several factors in addition to Overstock’s recurring operating losses caused investors to shy away from the company’s common stock. Patrick Byrne, himself, attracted a storm of negative attention to the company by the relentless attacks that he unleashed on major Wall Street firms and regulatory authorities. Byrne claimed that several hedge funds and other large institutional investors were driving down the price of Overstock’s common stock and attempting to destroy the company. Those parties’ efforts allegedly involved “naked short selling” of Overstock’s common stock, a tactic that in most circumstances is illegal. Byrne insisted that regulatory authorities responsible for policing the nation’s stock markets, including the SEC, were involved in the conspiracy to destroy Overstock and other companies targeted by the alleged cartel of naked short sellers. According to Byrne, those regulatory authorities refused to prosecute or otherwise rein in the naked short sellers. Byrne’s fierce and highly public crusade caused Overstock to take the unprecedented step of listing its CEO as a “risk factor” faced by the company; public companies are required to identify in their periodic SEC filings the major risk factors that could undermine them. Overstock reported in multiple SEC registration statements that controversial public statements made by Byrne, particularly those directed at the SEC, might focus unwarranted regulatory attention on the company. Even more disconcerting to potential investors than Byrne’s bombastic persona were the company’s recurring accounting problems. During its first several years as a public company, Overstock restated prior financial statements multiple times. Audit Integrity, a forensic consulting firm, reports “accounting and governance risk” (AGR) measures for public companies that are intended to be predictive of financial statement fraud. Overstock’s repeated restatements caused Audit Integrity to assign Overstock an “aggressive” AGR rating. The November 2009 disclosure of Overstock’s dispute with Grant Thornton raised the possibility that the company might be forced to restate its prior financial statements once more. Overstock was also criticized for using pro forma accounting measures—earnings before interest, taxes, depreciation, and amortization (EBITDA) in particular—to draw investors’ attention away from, and downplay the significance of, its recurring operating losses. Sam E. Antar, a self-appointed crusader against financial reporting fraud and the author of a blog entitled “White Collar Fraud,” charged that Overstock improperly and opportunistically computed the EBITDA amounts that it reported to investors. “Cookie Jar” Accounting The dispute that culminated in Overstock’s audit committee firing Grant Thornton was triggered by an error made by the company’s accounting staff in 2008—company officials readily admitted that the error resulted from a deficiency in Overstock’s internal controls. The accounting error caused Overstock to remit a $785,000 overpayment to one of its business partners which overstated Overstock’s cost of goods sold for 2008 by the same amount. Because of uncertainty regarding whether the $785,000 would be recovered, Overstock’s accounting staff characterized the overpayment as a “gain contingency” and chose not to record a correcting entry for it. Overstock recovered the overpayment from its business partner during the first quarter of 2009. The company’s accountants recorded the offsetting credit for the $785,000 cash receipt as a reduction in costs of goods sold for that period. To assess the impact of the $785,000 amount on Overstock’s 2008 and first-quarter 2009 financial statements, refer to Exhibit 1which presents selected financial data initially reported by Overstock in its 2008 Form 10-K and its 10-Q for the first quarter of 2009. Exhibit 1Overstock.com, Inc. Selected Financial Data Overstock’s frequent and harsh critic, Sam E. Antar, suggested that the $785,000 accounting error was actually an intentional ploy to create a “cookie jar” reserve to overstate Overstock’s 2009 operating results. Floyd Norris, a prominent business journalist for the New York Times, offered a similar explanation for the accounting treatment that Overstock applied to the $785,000 overpayment. Again, at this point in time, Overstock had yet to report a profit for a full fiscal year, but company officials were hoping 2009 would prove to be the company’s breakthrough year. PricewaterhouseCoopers (PwC), which had served as Overstock’s audit firm since prior to the company’s IPO in 2002, agreed with the accounting treatment applied by the company to the $785,000 overpayment and issued an unqualified opinion on Overstock’s 2008 financial statements. Following the completion of the 2008 audit, Byrne reported that Overstock had decided to retain a new audit firm because of concern that company management and the PwC audit staff were becoming too “cozy” after having worked together for the previous several years. In March 2009, Overstock’s audit committee selected Grant Thornton as the company’s new audit firm. He Said, They Said On October 1, 2009, Overstock received a letter of inquiry from the SEC regarding several accounting decisions that the company had made, including the accounting treatment applied to the $785,000 overpayment. Overstock’s accounting staff consulted with both the Grant Thornton auditors assigned to the 2009 Overstock engagement team and with the company’s former PwC auditors before responding to the SEC inquiry. According to a subsequent Form 8-K filed by Overstock with the SEC, Grant Thornton and PwC reportedly agreed the accounting treatment that had been applied to the overpayment was reasonable. On November 3, 2009, Overstock received a second letter of inquiry from the SEC. This inquiry asked for additional information regarding the accounting treatment for the $785,000 overpayment. Again, Overstock’s accounting staff consulted with both Grant Thornton and PwC in preparing the company’s response to the SEC inquiry. At this point, a Grant Thornton representative reportedly informed Overstock that the accounting firm had “revised its earlier position of agreement with the Company’s accounting treatment” for the overpayment. Grant Thornton then recommended that the company restate its 2008 financial statements and record the $785,000 amount as both a receivable and a reduction in the company’s cost of goods sold in those financial statements. The firm also recommended that the company restate its 10-Q for the first quarter of 2009 to eliminate the $785,000 reduction in cost of goods sold that was recorded when the 2008 overpayment was recovered. Overstock and PwC disagreed with Grant Thornton’s recommendation to restate the company’s prior financial statements for the overpayment error as Patrick Byrne explained in a press release included as an exhibit to an 8-K filed with the SEC on November 17, 2009. “We, along with PwC, continue to believe that we accounted for the $785,000 correctly…. Both we and PwC believe that it is not proper to reopen our 2008 Form 10-K.” Byrne went on to explain the “quandary” that the dispute with Grant Thornton posed for his company. “Thus, we are in a quandary: one auditing firm won’t sign off on our Q3 Form 10-Q unless we restate our 2008 Form 10-K, while our previous auditing firm believes that it is not proper to restate our 2008 Form 10-K.” Byrne reported that the dispute with Grant Thornton had resulted in Overstock deciding to “engage another independent audit firm.” In the meantime, the company had decided to file an unreviewed 10-Q for the third quarter of 2009 with the SEC. Exhibit 2 presents an “Explanatory Note” that Overstock included as a prologue to that 10-Q. The note identified the potential “consequences” that Overstock might face as a result of filing a “deficient” 10-Q with the SEC. Those potential consequences included the inability to sell registered securities because of a failure to comply with federal securities laws and the delisting of the company’s common stock by the NASDAQ stock exchange. Exhibit 2 “Explanatory Note” Included with Overstock’s Initial Form 10-Q for the Third Quarter of 2009 On November 13, 2009, Overstock.com, Inc. (“The Company”), dismissed Grant Thornton LLP (“Grant Thornton”) as the Company’s independent registered public accounting firm. At the time of the dismissal, the Company and Grant Thornton had a disagreement on a matter of an accounting principle or practice. See Note 15 – “Subsequent Events.” The Company has not yet engaged a successor accounting firm. As a result of Grant Thornton LLP’s dismissal, the accompanying 2009 unaudited interim financial statements and notes thereto for the quarterly period ended September 30, 2009, have not been reviewed in accordance with Statement of Auditing Standards No. 100 (“SAS 100”), as required by Rule 10-01(d) of Regulation S-X promulgated under the Securities Exchange Act of 1934. The Company intends to file an amendment to this Form 10-Q to file unaudited interim financial statements for the quarterly period ended September 30, 2009, reviewed in accordance with SAS 100 as required by Rule 10-01(d) as promptly as practicable after it has resolved outstanding matters addressed in a comment letter it has received from the Division of Corporation Finance of the Securities and Exchange Commission (“SEC”) and has engaged a successor independent registered public accounting firm. Because the financial statements contained in this Form 10-Q do not meet the requirements of Rule 1001(d) of Regulation S-X, the Company may not be considered current in our filings under the Securities Exchange Act of 1934. Filing an amendment to this report, when the independent registered public accountants’ review is complete, would eliminate certain consequences of a deficient filing, but the Company may become ineligible to use Form S-3 to register securities until all required reports under the Securities Exchange Act of 1934 have been timely filed for the 12 months prior to the filing of the registration statement for those securities. The Company is evaluating the impact of filing a deficient Form 10-Q due to lack of a review by an independent registered public accounting firm on its covenants under its contractual commitments, its obligations under the NASDAQ Stock Market listing standards, and the Securities Exchange Act. Source: Overstock.com, Inc., initial Form 10-Q for the third quarter of 2009. During Overstock’s November 18, 2009, quarterly earnings conference call, Byrne justified his decision to file the unreviewed 10-Q with the SEC. He maintained that providing investors with an unreviewed 10-Q was better than providing them nothing at all. He then went on to explain that Overstock would file an amended 10-Q after retaining a new audit firm and resolving the issues raised by the SEC letters of inquiry. As required by the SEC, Overstock asked Grant Thornton to prepare an exhibit letter to be filed as an attachment to the 8-K announcing the company’s decision to dismiss the accounting firm as its independent auditor. In that exhibit letter, Grant Thornton was required to indicate whether or not it agreed with Overstock’s discussion of the circumstances and events that had preceded the decision to change auditors. In Grant Thornton’s exhibit letter dated November 20, 2009, the firm stated that it had never agreed with the accounting treatment applied by Overstock to the $785,000 overpayment. According to the accounting firm, it had become aware of the overpayment for the first time in October 2009 when Overstock brought that item to its attention. Grant Thornton also indicated repeatedly in the exhibit letter that it disagreed with Overstock’s description of other circumstances and events preceding the company’s decision to change auditors. Grant Thornton’s statements in the exhibit letter prompted a caustic reply by Patrick Byrne. In a press release included as an exhibit to an 8-K filed by Overstock with the SEC on November 25, 2009, Byrne contested Grant Thornton’s assertion that it had never acquiesced to the accounting treatment initially applied to the $785,000 overpayment by characterizing that assertion as a “falsehood.” Byrne reported that Grant Thornton had reviewed Overstock’s 10-Q for the first quarter of 2009 and informed “the audit committee before we filed those financial statements that it had no changes to those financial statements.” Byrne went on to flatly contest most of the other assertions made by Grant Thornton in the exhibit letter filed with Overstock’s earlier 8-K. Near the end of the lengthy press release, Byrne summarized his views regarding his company’s spat with its former audit firm. “We are surprised by these inconsistencies and inaccurate statements in Grant Thornton’s November 20 letter to the SEC. I take them as proof (as though further proof was needed) that our audit committee made the correct decision to dismiss Grant Thornton.” The SEC did not publicly comment on the deficient 10-Q filed by Overstock for the third quarter of fiscal 2009. On November 19, 2009, three days after filing that 10-Q, Overstock was notified by the NASDAQ that it had violated the organization’s “listing rules.” The NASDAQ informed Overstock it had 60 days to submit a plan to reestablish its compliance with those rules. If that plan was approved, Overstock would have an additional four months to implement the plan. Epilogue On December 30, 2009, Overstock filed an 8-K with the SEC disclosing that it had hired KPMG as its new audit firm. Overstock filed another 8-K on February 4, 2010, quietly announcing that it intended to restate its prior financial statements for 2008 and for each of the first three quarters of 2009. The 8-K indicated that those prior financial statements should not be relied upon and that the restated financial statements would be released “as soon as practicable.” The items that required correction in Overstock’s prior financial statements included overpayments made to certain of the company’s business partners; the $785,000 overpayment that had been central to the dispute between Grant Thornton and Overstock was not identified separately. The company admitted the “gain contingency accounting” applied to those overpayments had been determined to be “inappropriate.” According to the 8-K, “Correction of these errors is expected to shift approximately $1.7 million of income recognized in fiscal 2009 back to fiscal year 2008.” Overstock’s promised financial restatements were included in SEC filings made by the company on March 31, 2010. One week later, Overstock issued a press release reporting that it had received a letter from the NASDAQ. The letter indicated that following the filing of the restated financial statements with the SEC, the company was in compliance with the NASDAQ’s listing rules. In April 2012, the SEC notified Overstock that its investigation of the company’s accounting affairs initiated in October 2009 had been completed. The SEC informed Overstock that it would take no enforcement action against the company as a result of that investigation. After reporting a $7.7 million net income for 2009, its first-ever annual profit, Overstock reported a significant net income in four of the following five years, the exception being 2011. During that five-year period, the company’s annual revenues steadily increased, reaching almost $1.5 billion in 2014. Overstock did not restate any prior financial statements during that time frame and KPMG issued an unqualified opinion each year on the company’s financial statements. Patrick Byrne remains the company’s CEO at last report. Questions 1. The Overstock-Grant Thornton dispute was publicly aired via disclosure statements filed with the SEC. What impact do you believe those disclosures had on the investing public’s confidence in the financial reporting domain and the independent audit function? Were the interactions between Overstock and Grant Thornton unprofessional or otherwise inappropriate? Explain. 2. Do you believe that the $785,000 amount at the center of the Overstock-Grant Thornton dispute was material? Defend your answer. What factors other than quantitative considerations should have been considered in deciding whether the $785,000 amount was material? 3. Briefly compare and contrast the nature and purpose of an independent audit versus a quarterly review. 4. The SEC requires registrants to have their quarterly financial statements reviewed by an independent accounting firm but does not mandate that a review report be included in a Form 10-Q. Under what circumstances must a review report accompany quarterly financial statements in a 10-Q? Why doesn’t the SEC routinely require public companies to include their review reports in their 10-Q filings? 5. What is the purpose or purposes of Form 8-K filings by SEC registrants? What specific items of information must be included in an 8-K that announces a change in audit firms? 6. Do you agree with the accounting treatment that Overstock typically applied to the revenues generated by its “Partner” line of business? Why or why not? Take-Two Interactive Software, Inc. Grand Theft Auto ranks among the best-selling video games of all time as well as one of the most controversial. By the time Grand Theft Auto V was released in 2013, over 125 million copies of the video game had been sold worldwide since the original version of the game was introduced in 1997. Wikipedia provides the following general description of the game. Game play focuses on an open world where the player can choose missions to progress an overall story, as well as engaging in side activities, all consisting of actionadventure, driving, occasional role-playing, stealth, and racing elements. The subject of the game is usually a comedic satire of American culture, but the series has gained controversy for its adult nature and violent themes. Prominent public officials, major media outlets, and public service organizations have condemned Grand Theft Auto. Senator Hillary Clinton urged the Federal Trade Commission (FTC) to assign a rating of “Adults Only” to the game because of its “pornographic and violent content,” which includes one setting that “encourages them [game players] to have sex with prostitutes and then murder them.” Senator Joseph Lieberman denounced the game as “gruesome, and grotesque.” The mayor of New York City, Michael Bloomberg, bluntly noted that the game “Teaches children to kill.” In fact, law enforcement authorities have linked the commission of serious crimes to Grand Theft Auto. A teenager killed three police officers in Alabama in June 2003 in a set of circumstances similar to a scene in the game. The teenager, who played the game “day and night” and had no previous criminal record, calmly told his captors that, “Life is like a video game. Everybody’s got to die sometime.” In referring to that case, a CNN commentator branded Grand Theft Auto a “cop killing simulator.” Mothers Against Drunk Driving (MADD) have criticized the game for encouraging drunk driving. “Drunk driving is not a game, and it is not a joke.” A spokesperson for Take-Two Interactive Software, Inc., the producer of the game, responded by maintaining that MADD’s criticism was unfair since the given version of Grand Theft Auto involved only one drunk driving scene. “For the same reason that you can’t judge an entire film or television program by a single scene, you can’t judge Grand Theft Auto IV by a small aspect of the game.” Take-Two’s executives have been the target of most of the emotionally charged criticism of Grand Theft Auto. A Wall Street analyst who tracked Take-Two’s stock for years suggested that, “You’d be hard-pressed to find a worse set of guys.” Despite repeated challenges to the suitability of Grand Theft Auto filed with the FTC by various parties, the federal agency that eventually posed the most significant challenge for the company’s management team was the Securities and Exchange Commission (SEC). The SEC sanctioned several of Take-Two’s top executives for issuing a series of financial statements that contained fraudulent misrepresentations. Those sanctions resulted in Take-Two restating its financial statements three separate times between 2001 and 2004. Striking Out on His Own In 1992, Ryan Brant graduated from the University of Pennsylvania’s Wharton School of Business with a degree in economics. The 20-year-old Brant began his business career by working for a company owned by his father, Peter Brant, a billionaire businessman. Eighteen months later, Brant decided to leave that company and establish his own business. After raising $1.5 million from family members and “angel” investors, Brant organized Take-Two Interactive Software, Inc., in late 1993. Robert Fish, a partner with Price Waterhouse, Take-Two’s audit firm, served as one of Brant’s principal business advisors from the inception of his company. Following the merger of Price Waterhouse with Coopers & Lybrand in 1998 to form PricewaterhouseCoopers (PwC), Fish became the Senior Managing Partner of the Venture Capital Practice of PwC’s New York City office. That unit provided a wide range of professional services to developmental stage companies. In addition to serving as a general business advisor to the much younger Brant, Fish supervised the annual audits of Take-Two’s financial statements from 1994 through 2001. In a 1998 interview with Crain’s New York Business, Fish suggested that he and Brant had a father–son type relationship. In discussing PwC’s relationship with Take-Two, Fish noted that, “We [PwC] make an investment of our time in growth-oriented companies.” He went on to observe that, “Most start-ups coming to larger accounting firms know they don’t just want the accountants to handle debits and credits, but to focus on the structure of the enterprise.” PwC’s “investment” in Take-Two included initially discounting the fees that it charged the company for its professional services. According to Brant, PwC billed Take-Two “a mere $20,000” for the services provided annually to the newly formed company, a figure that was “roughly one-third what the firm would have charged had it applied its standard hourly rate.” For the first few years of Take-Two’s existence, the company realized modest success with several video games including Ripper and Hell: A Cyberpunk Thriller. To survive in the ultra-competitive video gaming industry, Brant realized that his company had to grow, and quickly. Brant decided that the best strategy for achieving that goal was to acquire other video game companies, which would require a considerable amount of external financing. To raise those funds, Brant took his company public in 1997 with an initial public offering (IPO). Brant relied heavily on Fish for professional advice regarding accounting and financial reporting issues related to the IPO and the subsequent series of acquisitions made by the company. Among the nearly 20 acquisitions that Take-Two made in the late 1990s was a small operating unit of Bertelsmann, a large German mass media company. The video games owned by that entity included the game that would become Grand Theft Auto, which would prove to be Take-Two’s first major gaming “franchise.” Every few years, Take-Two releases a new version of the game. On April 29, 2008, the date that Grand Theft Auto IV was released, the game established the single-day sales record for the video gaming industry, selling 3.6 million units with a total revenue of $180 million. Grand Theft Auto resulted in Take-Two becoming one of the leading worldwide developers and distributors of video games. The successful game also allowed Take-Two to survive the “tech crash” that began in early 2000 with the bursting of the “dot-com bubble” in the stock market. That financial crisis proved to be the death knell for many of Take-Two’s competitors. Despite the challenging circumstances faced by Take-Two during that time frame, the company continued to post surprisingly strong operating results. Exhibit 1 presents key financial data for Take-Two that document the company’s rapid growth from 1998 through 2000, the first three full fiscal years that it was a public company. A footnote to that exhibit includes selected amounts included in Take-Two’s 1997 financial statements. Exhibit 1Take-Two Interactive Software, Inc. Financial Highlights 1998–2000 (000s Omitted) “Parking” Violations In 2000 and 2001, a stock analyst who tracked Take-Two’s financial statements and public earnings releases noted apparent discrepancies between the company’s reported sales and data reported by the NDP Group, a market research company that monitors video game sales. That analyst’s concerns prompted an SEC investigation of Take-Two’s 2000 and 2001 financial statements. The federal agency’s investigation revealed that TakeTwo executives had recorded millions of dollars of sham sales transactions to inflate their company’s reported operating results, transactions that involved Take-Two temporarily “parking” large amounts of inventory with its customers. On October 31, 2000, the final day of Take-Two’s fiscal year 2000, the company’s chief operating officer (COO) and chief financial officer (CFO) arranged a bogus sale of $5.4 million of video games to Capitol Distributing, a video game distributor based in Virginia. The transaction was the largest individual sale ever recorded by TakeTwo. To make the sale appear legitimate to the company’s PwC auditors, Take-Two shipped 230,000 video games to Capitol. Both parties agreed prior to the shipment that the games would be returned by Capitol to Take-Two over the following few months. When the video games were returned to Take-Two in fiscal 2001, the two parties forged various documents to make the returns appear as if they were purchases of new product inventory by TakeTwo from another company—this latter company was an affiliate of Capitol. In 2001, Take-Two recorded three additional fictitious sales of video games to Capitol that totaled more than $9 million. Similar to the $5.4 million transaction, the merchandise shipped to Capitol as a result of these “sales” was returned to Take-Two under the guise of inventory purchases. During fiscal 2000 and 2001, Take-Two recorded dozens of smaller bogus sale transactions to four other video game distributors. Nearly all of this merchandise was subsequently reacquired by Take-Two—some of these transactions were camouflaged as purchases of new inventory, while others were processed and recorded as normal sales returns. Take-Two also recorded sales during 2000 and 2001 for video games that were still in production and that would not be delivered to the given customers until a subsequent quarterly reporting period. Take-Two’s fraudulent accounting during 2000 allowed the company to meet or surpass its consensus quarterly earnings forecasts for that year. For the fourth quarter of 2000, for example, Take-Two reported earnings of $.42 per share, slightly higher than the company’s consensus earnings forecast of $.41 per share and considerably higher than the company’s actual earnings per share of $.27. The accounting fraud also allowed Take-Two to report a net income for that quarter that was higher than the figure reported for the prior quarter. This fact was significant to Take-Two’s CFO since his bonus each quarterly reporting period was contingent on the company increasing its net income over the previous quarter. In February 2002, Take-Two issued restated financial statements for fiscal 2000 and for the first three quarters of fiscal 2001 to eliminate the fraudulent sales transactions recorded during those periods and to correct other instances of improper accounting treatments. Two years later, in February 2004, Take-Two issued restated financial statements for fiscal years 1999 through 2003 after additional improper accounting decisions were discovered for those years. The two restatements materially reduced Take-Two’s revenues and earnings from 1999 through 2003, but the company’s reported operating results for 2000 bore the brunt of those restatements. Take-Two’s 2000 sales were reduced from $387 million to $358 million, while its net income for that year was lowered from $25 million to $4.6 million. PwC’s 2000 Audit of Take-Two Despite the fact that Take-Two actively concealed its fraudulent schemes from PwC, the SEC alleged that PwC failed to comply with generally accepted auditing standards (GAAS) while auditing the company’s financial statements. The SEC’s allegations centered on the role that Robert Fish had played in supervising PwC’s 2000 audit of Take-Two. In preparing for the 2000 engagement, Fish identified “revenue recognition” and “accounts receivable reserves” as “areas of higher risk” that would be given “special attention” during that audit. Following its investigation of the 2000 audit, the SEC concluded that, “Fish did not properly respond to those risks as he failed to exercise due professional care and professional skepticism, and failed to obtain sufficient competent evidential matter.” The SEC ruled that as a result of Fish’s poor decisions, PwC improperly issued an unqualified opinion on Take-Two’s 2000 financial statements. A major focus of the 2000 audit was the $104 million of “domestic” accounts receivable that represented the majority of Take-Two’s total receivables at the end of fiscal 2000. The principal audit test applied to the domestic receivables was the mailing of positive confirmation requests to 15 of Take-Two’s customers that accounted for approximately 70 percent of those receivables. The PwC auditors received only one confirmation from that sample of customers, a confirmation that represented less than 2 percent of the company’s domestic receivables. Capitol Distributing was among the 14 customers that failed to respond to PwC’s confirmation requests. Because of the poor response rate to the confirmation requests, Fish decided that PwC would apply alternative audit procedures to TakeTwo’s domestic receivables. The principal alternative audit procedure employed by Fish and his subordinates was reviewing payments that Take-Two received in the new fiscal year from the 14 customers who had failed to return a confirmation. The PwC auditors identified $18 million of cash payments received by Take-Two from those 14 customers over the first 6 weeks of the new fiscal year. During its investigation, the SEC determined that the auditors had failed to track many of those payments to specific invoiced sales transactions because Take-Two’s accounting records often reflected only “aggregate” cash collections for individual customers. As a result, Fish knew, or should have known, that he could not be certain whether the cash he examined from November 1 through December 8, 2000, related to the accounts receivable balances that existed as of October 31, 2000, or to sales recorded after that date…. The fact that Take-Two’s records often showed only aggregate cash collected was a red flag to Fish that any subsequent cash receipts testing relying on this data would prove ineffective. The SEC also harshly criticized the audit procedures PwC used to test the sufficiency of the client’s reserve for sales returns. One of these tests involved examining five sales returns received by TakeTwo during the first few days of fiscal 2001. Because Fish and his subordinates did not track these returns to the original sales invoices, they failed to discover evidence suggesting that Take-Two was grossly underestimating its year-end reserve for sales returns. Of the five specific returns tested, Fish did not compare the returns with the original sales invoices. Had he done so, he would have discovered that in four of the five instances, much more than 75% of the games purportedly purchased had been returned … when Take-Two only reserved for returns at the rate of 5%. Fish determined, nonetheless, that Take-Two’s reserves were adequate without, for instance, examining other returns from fiscal year 2000, or inquiring of the customers regarding these particular sales. The SEC went on to point out that the four sales returns in question involved “parking transactions” that Take-Two had used to inflate its 2000 sales and earnings. Epilogue In June 2005, the SEC sanctioned Take-Two’s vice president of sales and three of its former executives for their role in the company’s accounting fraud. These latter individuals included Ryan Brant, Take-Two’s former chief executive officer, as well as the company’s former COO, and former CFO. Take-Two was fined $7.5 million, while the four executives paid fines ranging from $50,000 for the vice president of sales to $500,000 for Brant. Brant was also ordered to forfeit $3.1 million of stock market gains he had earned on Take-Two’s common stock. The company’s former CFO, who was a CPA, was also suspended from practicing before the SEC for 10 years. In Februar y 2008, the SEC issued an Accounting and Auditing Enforcement Release focusing on Robert Fish’s role as Take-Two’s audit engagement partner. The federal agency imposed a one-year suspension on Fish, who had previously resigned from PwC. In 2007, the SEC filed dozens of civil cases against companies and individual executives involved in the “backdating” of stock option grants. Over the previous two decades, these defendants had identified specific dates on which a given company’s stock price was at a relatively low level and then retrospectively issued stock option grants on those dates. This ex post dating of stock option grants allowed the grantees to receive “in the money” stock options that they subsequently exercised, resulting in large stock market gains. Take-Two and Ryan Brant were among the parties that the SEC filed charges against in the huge options backdating scandal. The SEC alleged that Brant was the master-mind of Take-Two’s options backdating scheme. “From 1997 to September 2003, Brant awarded himself 10 backdated option grants, representing a total of approximately 2.1 million shares of Take-Two common stock.” Brant exercised all of those options before he left the company during the midst of the SEC’s investigation of Take-Two’s stock option grants. The SEC fined Brant $1 million for his role in the scheme and required him to forfeit more than $5 million in stock market gains that he realized as a result of it. In a related criminal case, Brant pleaded guilty to a felony charge filed by a New York state prosecutor. Brant’s plea bargain agreement required him to pay a $1 million fine and serve five years of probation. In April 2009, Take-Two reached an agreement with the SEC to settle the charges filed against it for the backdating of options by paying a $3 million fine. Prior to reaching that settlement, the company had restated its financial statements for the third time in five years to correct the misrepresentations linked to the improper stock option grants. Take-Two weathered the fraudulent financial reporting and options backdating scandals and retained its prominent position in the video gaming industry. In 2008, Electronic Arts, the largest video gaming company in the U.S., launched a $2 billion hostile takeover bid for Take-Two. Electronic Arts dropped that take-over bid in late 2008 after it met with fierce resistance from the management team that had replaced Ryan Brant and his former colleagues. Analysts’ expectations of continued strong revenue growth for the video gaming industry pushed Take-Two’s stock price to an all-time high by early 2016 despite sharp declines in most market indices during that time. Questions 1. Analyze Take-Two’s 1998-2000 financial data included in Exhibit 1. Compute the following financial ratios for each of those years: age of accounts receivable, age of inventory, gross profit percentage, profit margin percentage, return on assets, return on equity, current ratio, debt-to-equity ratio, and the quality-ofearnings ratio. What major “red flags,” if any, were present in Take-Two’s financial statements given these ratios? Explain. 2. Identify the primary audit objectives that auditors hope to accomplish by confirming a client’s year-end accounts receivable. Explain the difference between “positive” and “negative” confirmation requests and discuss the quality of audit evidence yielded by each. 3. Identify audit tests that may be used as alternative audit procedures when a response is not received for a positive confirmation request. Compare and contrast the quality of audit evidence yielded by these procedures with that produced by audit confirmation procedures. 4. In your opinion, did the apparent mistakes made by the PwC auditors in auditing Take-Two’s receivables and reserve for sales returns involve “negligence” on their part? Would you characterize the mistakes or errors as “reckless” or “fraudulent”? Justify your answers. 5. Is it appropriate for audit firms to sharply discount their professional fees for developmental stage companies? Why or why not? What problems, if any, may this practice pose for audit firms? 6. Do you believe that the relationship between Robert Fish and Ryan Brant was inappropriate? Explain. 7. Should audit firms accept “ethically challenged” companies and organizations as audit clients? Defend your answer. Howard Street Jewelers, Inc. Lore Levi was worried as she scanned the most recent monthly bank statement for the Howard Street Jewelers. For decades, she and her husband, Julius, had owned and operated the small business that they had opened after fleeing Nazi Germany during World War II. Certainly the business had experienced ups and downs before, but now it seemed to be in a downward spiral from which it could not recover. In previous times when sales had slackened, the Levis had survived by cutting costs here and there. But now, despite several measures the Levis had taken to control costs, the business’s cash position continued to steadily worsen. If a turnaround did not occur soon, Lore feared that she and her husband might be forced to close their store. Lore had a theory regarding the financial problems of Howard Street Jewelers. On more than one occasion, she had wondered whether Betty the cashier, a trusted and reliable employee for nearly 20 years, might be stealing from the cash register. To Lore, it was a logical assumption. Besides working as a part-time sales clerk, Betty handled all of the cash that came into the business and maintained the cash receipts and sales records. If anybody had an opportunity to steal from the business, it was Betty. Reluctantly, Lore approached her husband about her theory. Lore pointed out to Julius that Betty had unrestricted access to the cash receipts of the business. Additionally, over the previous few years, Betty had developed a taste for more expensive clothes and more frequent and costly vacations. Julius quickly dismissed his wife’s speculation. To him, it was preposterous to even briefly consider the possibility that Betty could be stealing from the business. A frustrated Lore then raised the subject with her son, Alvin, who worked side by side with his parents in the family business. Alvin responded similarly to his father and warned his mother that she was becoming paranoid. Near the end of each year, the Levis met with their accountant to discuss various matters, principally taxation issues. The Levis placed considerable trust in their CPA because for years he had given them solid, professional advice on a wide range of accounting and business matters. So, it was only natural for Lore to confide in him about her suspicions regarding Betty the cashier. The accountant listened intently to Lore and then commented that he had noticed occasional shortages in the cash receipts records that seemed larger than normal for a small retail business. Despite Julius’s protestations that Betty could not be responsible for any cash shortages, the accountant encouraged the Levis to closely monitor her work. Embezzlements are often discovered by luck rather than by design. So it was with the Howard Street Jewelers. Nearly two years after Lore Levi had suggested that Betty might be stealing from the business, a customer approached the cash register and told Alvin Levi that she wanted to make a payment on a layaway item. Alvin, who was working the cash register because it was Betty’s day off, searched the file of layaway sales tickets and the daily sales records but found no trace of the customer’s layaway purchase. Finally, he apologized and asked the customer to return the next day when Betty would be back at work. The following day, Alvin told Betty that he was unable to find the layaway sales ticket. Betty expressed surprise and said she would search for the ticket herself. Within a few minutes, Betty approached Alvin, waving the sales ticket in her hand. Alvin was stumped. He had searched the layaway sales file several times and simply could not accept Betty’s explanation that the missing ticket had been there all along. Suspicious, as well, was the fact that the sale had not been recorded in the sales records—a simple oversight, Betty had explained. As Alvin returned to his work, a troubling and sickening sensation settled into the pit of his stomach. Over the next several weeks, Alvin studied the daily sales and cash receipts records. He soon realized that his mother had been right all along. Betty, the trusted, reliable, longtime cashier of the Howard Street Jewelers, was stealing from the business. The estimated embezzlement loss suffered by Howard Street Jewelers over the term of Betty’s employment approached $350,000. Questions 1. Identify the internal control concepts that the Levis overlooked or ignored. 2. When Lore Levi informed the CPA of her suspicions regarding Betty, what responsibilities, if any, did the CPA have to pursue this matter? Alternately, assume that, in addition to preparing tax returns for Howard Street Jewelers, the CPA (a) audited the business’s annual financial statements, (b) reviewed the annual financial statements, and (c) compiled the annual financial statements. 3. Assume that you have a small CPA firm and have been contacted by a husband and wife, Chris and Brooke Arbeitman, who are in the final stages of negotiating to purchase a local jewelry store. Chris will prepare jewelry settings, size jewelry for customers, and perform related tasks, while Brooke will be the head salesclerk. The Arbeitmans intend to retain four of the current employees of the jewelry store—two salesclerks, a cashier, and a college student who cleans the store, runs errands, and does various other odd jobs. They inform you that the average inventory of the jewelry store is $300,000 and that annual sales average $1,400,000, 30 percent of which occur in the six weeks prior to Christmas. The Arbeitmans are interested in retaining you as their accountant should they purchase the store. They know little about accounting and have no prior experience as business owners. They would require assistance in establishing an accounting system, monthly financial statements for internal use, annual financial statements to be submitted to their banker, and all necessary tax returns. Chris and Brooke are particularly concerned about control issues—given the dollar value of inventory that will be on hand in the store and the significant amount of cash receipts that will be processed daily. You see this as an excellent opportunity to acquire a good client. However, you have not had a chance to prepare for your meeting with the Arbeitmans because they came in without an appointment. You do not want to ask them to come back later since that may encourage them to check out your competitor across the street. Required: Provide the Arbeitmans with an overview of the key internal control issues they will face in operating a jewelry store. In your overview, identify at least five control activities you believe they should implement if they acquire the store. You have never had a jewelry store as a client but you have several small retail clients. Attempt to impress the Arbeitmans with your understanding of internal control issues for small retail businesses.
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Explanation & Answer

Hello buddy, here is case 12

Question 1.
Age of Accounts Receivable:
1. 1998- ($49139 x 365) / $194052 = 92.4 Days. When rounded of its 92 Days.
2. 1999- ($107799 x 365) / $305,932 = 128.6 Days. When rounded of its 129 Days.
3. 2000- ($134877 x 365) / $387006 = 127.2 Days. When rounded of its 127 Days.
Age of Inventory:
1. 1998 – (365 / 7.43) = 49.1 Days. When rounded of its 49 Days
2. 1999 – (365 / 7.40) = 49.3 Days. When rounded of its 49 Days
3. 2000 – (365 / 8.61) = 42.4 Days. When rounded of its 42 Days
Gross Profit Percentage:
1. 1998 – ($46,496 / $194,052) x 100 = 23.96%
2. 1999 – ($90,810 / $305,932) x 100 = 29.68%
3. 2000 – ($139,210 / $387,006) x 100 = 35.97%
Profit Margin Percentage:
1. 1998 – ($7,181 / $194,052) x 100 = 3.7%
2. 1999 – ($16,332 / $305,932) x 100 = 5.33%
3. 2000 – ($24,963 / $387,006) x 100 = 6.45%
Return on Assets:
1. 1998 – ($7,181 / $109,385) = .065
2. 1999 – ($16,332 / $231,712) =.071
3. 2000 – ($24,963 / $351,641) =.071
Return on Equity:
1. 1998 – ($7,181 / $11,935) = .60
2. 1999 – ($16,332 / $11,935) = 1.37
3. 2000 – ($24,963 / $11,935) = 2.09
Current Ratio:
1. 1998 – ($95,302 / $73,505) = 1.29
2. 1999 – ($187,970 / $146,531) = 1.28
3. 2000 – ($214,908 / $152,023) = 1.41
Debt-to-Equity Ratio:
1. 1998 – ($73,820 / $11,925) = 6.19
2. 1999 – ($146,609 / $11,925) = 12.29
3. 2000 – ($164,639 / $11,925) = 13.80
Quality-of-Earnings ratio:

1. 1998 – ($8,022 / $7,181) = 1.11
2. 1999 – ($16,748 / $16,332) = 1.03
3. 2000 – ($55,259 / $24,963) = 2.21
“Red flags” are any detected indicators through the statements of finance. The “red flags” to be
pinpointed within Take-Two’s statements of finance are;
1. The operations negative cash flows
2. The rise of account receivables on sales.
3. The rise of debts by the debt-to-equity ratio increase.
Question 2
The first objective to be confirmed by the auditors is the existence and completeness of
the balance. Existence simply confirms that the debtor's balance is accurately represented on the
financial statements in the total. While the completeness confirms the accuracy of the
transactions and the transaction record. The second objective of the audit is to carry out the yearend revenue reduction test by addressing the time and completeness of the occurrence. The time
of occurrence consists of tracing and vouching the transactions and events recorded for the
current fiscal year in question throughout the entity. In this case, the completeness shows that all
transactions have been recorded in the correct accounting period
A positive confirmation is that the audit team sends a letter to the company concerned
and asks for a bank document. This bank document must either confirm the amount at issue or
dispute the amount at issue and why. This also entails more long-term ...


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