We are conducting a study to understand the effects of different work procedures on juror assessments of auditor liability in cases of financial statement fraud.
This online research instrument will take approximately 30 minutes to complete. Please do not indicate your name or provide any identifying information in order to remain anonymous. There are no "right" or "wrong" answers; we are only interested in your personal opinion. Your participation is voluntary and you may refuse to participate or refuse to answer any of the questions. You may discontinue the task at any time. Please be honest and thoughtful with all responses so that we may properly evaluate the results in the context of our study.
Please work independently on the research task and make your best attempt to answer all questions. Remember that your answers will be completely anonymous and that we will report the findings of this research only in a consolidated format.
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General Instructions for Study Participants
The next page introduces accounting concepts that pertain to relevant case law. The subsequent two pages then introduce summary case facts about a lawsuit against a hypothetical accounting firm that failed to detect a fraud that occurred at one of their clients and provided an unqualified opinion on the client's financial statements.
You will then be required to complete four review questions about the case facts that have been provided.
You will be allowed to proceed ONLY if you correctly answer these four questions, so please read carefully the content included in the next three pages.
After successful completion of the review questions, opening statements by the plaintiff and defendant as well as accounts by their respective witnesses will be provided. You will then be asked to make several judgments about the lawsuit, assuming that you are one of the jurors for the case. The task will finish with a demographic questionnaire.
It should take approximately 30 minutes to complete this entire study task. We emphasize that it is very important that the task be completed in one sitting and by you individually.
Again, we thank you for your time.
Background Information
This task involves making judgments as a juror for a lawsuit against a hypothetical accounting firm that failed to detect a fraud that occurred at one of their clients and provided an unqualified opinion on the client's financial statements. In order to make such a judgment, it is essential to be informed about the following issues:
Nature and Purpose of Financial Statements
Companies prepare financial statements for investors, lenders, and other users. Financial statements provide information about the financial position, financial performance, and cash flows of the company.
Material Misstatements
A company's financial statements might occasionally be materially misstated. Material misstatements are those misstatements large enough to alter the decisions of those individuals who rely on the financial statements.
Material misstatements could include unintentional errors and/or intentional (fraudulent) misrepresentations made in the financial statements by the company's management.
Purpose of the External Audit Process
Auditors examine the assertions included and then express an opinion about the company's financial statements.
An unqualified audit opinion should give investors, lenders, and other individuals who rely on the financial statements reasonable assurance that the financial statements are free from material misstatements. Another common description for an unqualified audit opinion is a "clean" audit opinion.
Reasonable assurance is not the same as absolute assurance. Therefore, even if a high-quality audit is performed, a company's financial statements could still contain a material misstatement.
Auditor Negligence
A high-quality audit involves auditors exercising due professional care. Auditors exercise due professional care when they follow generally accepted auditing standards. If auditors fail to exercise due professional care, they are considered negligent.
With regard to determining auditors' due professional care, standards state that "an auditor should possess the degree of skill commonly possessed by other auditors and should exercise it with reasonable care and diligence (AS 230.5)"
Details of the Material Misstatement from the Fraud by Hills Energy
This case involves financial accounting and reporting fraud, as well as accused audit failures, related to the valuation of certain oil and gas assets acquired by Hills Energy, an oil and gas company headquartered in Texas.
Hills Energy acquired oil and gas assets in Alaska for $5 million in cash. The company subsequently reported these assets at an overstated value of $80 million for its fiscal year ended April 2014.
K&C, a national auditing firm hired by Hills Energy, audited Hills Energy's 2014 financial statements and concluded that its financial statements were free from any material misstatements. As a result, K&C issued an unqualified opinion on Hills Energy's 2014 financial statements.
In May 2017, an SEC (the U.S. Securities and Exchange Commission) investigation indicated that Hills Energy intentionally overstated its oil and gas asset (and consequently its net income) by $75 million and thus its financial statements were materially misstated.
This misstatement caused Hills Energy to appear to be financially secure, when in fact it was in danger of going bankrupt.
As a result of Hills Energy's eventual bankruptcy, Boell Ltd., a lender who provided Hills Energy with $10 million, was unable to collect any of the amount loaned.
Boell Ltd. alleges that, if K&C had identified the misstatement and had issued a different opinion for Hills Energy's financial statements, Boell Ltd. would have never provided the loan to Hills Energy. Based on this assertion, Boell Ltd. is suing K&C for $10 million.
Details of the Conduct of the Audit by K&C
K&C, a national audit firm hired by Hills Energy, is accused of having failed to adequately audit the acquisition of the Alaska asset by Hills Energy. Details of the conduct of the audit are noted below.
A staff member at K&C obtained the asset replacement cost study completed by Hills Energy and submitted it to another local accounting firm called Patrick Partners that focuses on processing and analyzing inconsistencies and irregularities in such documents.
The staff in the other local accounting firm (Patrick Partners) evaluated possible inconsistencies between the various assumptions supporting the valuations for the oil and gas assets of Hills Energy but failed to identify any.
Given the technical difficulties in valuing oil and gas assets, K&C also sought advice from a petroleum engineering firm, Biller & Associates, about whether Hills Energy's estimated value for the Alaska asset was a reasonable possibility. Biller & Associates indicated that, given the huge fluctuation in the values of oil and gas assets, the estimated value by Hills Energy was a possibility.
The staff in the other local audit firm (Patrick Partners) received and included this advice in their workpaper, ultimately concluding that there was no irregularity in the estimated values of the oil and gas assets of Hills Energy.
K&C is accused of having failed to properly supervise the audit, having inappropriately relied upon the audit workpaper prepared by the staff in another local audit firm (Patrick Partners), which is based on the cost study artfully fabricated by Hills Energy.
Transcript from a Subsequent Auditor Negligence Lawsuit
Boell, Ltd. v. K&C
Summary, Case #95210
Plaintiff Opening Statement: This case is about auditor negligence. You are about to find out what can happen when auditors do not do their jobs properly and serious fraud causes errors in the financial statements.
K&C reported that the 2014 financial statements of Hills Energy were not materially misstated. In other words, K&C gave Hills Energy a "clean" report. My client, Boell, Ltd., received and relied upon the misstated financial statements when it loaned $10 million to Hills Energy. Hills Energy's financial statements listed an asset balance that was $75 million too high. K&C failed to find this huge inaccuracy because they did not perform an audit of sufficient quality; that is, they did not exercise the same degree of care that other auditors in their position would have used.
When Hills Energy's financial problems came to light, the company declared bankruptcy and my client received nothing. Boell, Ltd. feels that the auditor who negligently allowed the overstatement to occur should reimburse it for its $10 million loss.
I will present an expert witness, Professor Evans, a respected professor specializing in auditing at a major university, who will point out several areas in which the performance of K&C was substandard and will describe how such substandard procedures led to misstatement of financial statements, which led to my client's losses.
Defense Opening Statement: We assert that K&C complied with generally accepted auditing standards in its audit of Hills Energy's financial statements, and that K&C was, therefore, not negligent. Auditors reduce the probability that people receive misstated financial statements. Auditors provide reasonable assurance, not absolute assurance that the financial statements are free from material misstatements. That is, even after a high-quality audit has been performed, a company's financial statements could still contain a material misstatement.
The plaintiff has alleged that K&C was negligent in its audit of Hills Energy's 2014 financial statements. Negligence can be established only when an auditor fails to exercise the usual judgment, care, skill, and diligence employed by other Certified Public Accountants (CPAs) in the community. CPAs use auditing standards to determine the type and amount of work they do. We assert that, if an auditor complies with auditing standards, he has not been negligent.
The plaintiff notes the loss experienced by his client, Boell, Ltd. That loss is not relevant in determining whether K&C was negligent in performing its audit of the 2014 financial statements of Hills Energy. In our view, only the actions and decisions made by K&C, as compared with those that would have been made by other competent CPAs in similar circumstances, are relevant. I will argue that K&C did at least as much as any other auditor in this circumstance would have done, and that they did not violate auditing standards.
I will prove my case by calling a witness. Ms. Brecht, a respected former partner with a large accounting firm, will establish that K&C made appropriate use of professional judgment in making the decisions that they did, and that it in no way violated professional standards. I am confident that you will find in K&C's favor.
Professor Irene Evans, Expert Witness for the Plaintiff: Hills Energy overstated its oil and gas asset by $75 million, and K&C failed to discover this material misstatement. Hills Energy gave K&C an asset replacement cost study, which suggests that $80 million worth of cash is to be generated from the oil and gas asset, although the actual purchase cost was just $5 million. The cost study provided by Hills Energy included management's overly optimistic assumptions as well as an asset valuation by their internal experts. $80 million versus $5 million reflects a huge difference, and a proper audit would have revealed these irregularities including the overly optimistic assumptions.
Initially, the staff in another local accounting firm called Patrick Partners who focus on analyzing inconsistencies contained in management documents assessed irregularities and inconsistencies between the assumptions supporting the cost valuation of Hills Energy. This staff failed to notice the excessively optimistic management assumptions used in determining the fair value. K&C then inappropriately relied upon the audit workpaper prepared by the staff in another local audit firm called Patrick Partners, which simply summarizes and agrees with the cost study artfully fabricated by Hills Energy. A careful supervision and check of the audit workpaper could have identified the mistake.
Cross-Examination: Yes, but auditing standards do acknowledge that it is more difficult for an auditor to discover fraud than errors. Valuation of oil and gas assets is an especially technical area, and if the cost report is carefully fabricated in such a way that there is no inconsistency or irregularity between different assumptions, it would be difficult for any other competent CPA to identify any irregularities in the valuation. Auditors can test every management assumption to the finest detail, but if they do so, the audit cost, and audit fee to be charged to the client, would be extremely high.
Ms. Joanne Brecht, Expert Witness for the Defense: Auditing employs the use of professional judgment rather than checking each and every management assumption to the finest detail, and K&C did that. K&C gathered a vast amount of information to evaluate whether the oil and gas asset valuation was justifiable. The cost study report provided by Hills Energy was carefully fabricated, and any other competent CPA in K&C's position would have found it difficult to identify any irregularity hidden between the complex facts and assumptions supporting the valuation of the oil and gas asset.
What Professor Evans did not note is that K&C performed more than the minimal audit requirements in that it recognized the complications involved in estimating the value of oil and gas assets and called upon an engineering firm for help. The petroleum engineering firm, Biller & Associates, used technical estimation procedures to estimate the value of the oil and gas site. Because Biller & Associates suggested that the estimated value of $80 million is a possibility, K&C accepted the value estimate of Hills Energy.
Cross-Examination: An oil and gas asset cannot be counted or weighed, and it is probably more usual than not for auditors to bring in specialists in cases such as this. In fact, K&C used a petroleum engineer, not a fair value appraiser, when estimating the value of the oil and gas asset. A fair value appraiser would have provided more realistic estimate.
Plaintiff Closing Statement: The testimony you have heard today established that K&C was negligent in its audit of the 2014 financial statements of Hills Energy. A well-respected auditing professor, Professor Evans, has told you that the procedures that K&C used in evaluating the oil and gas asset were substandard. We expect auditors to maintain an attitude of professional skepticism in dealing with their clients. We expect auditors to find $75 million irregularities such as the one in Hills Energy's financial statements. Why would we hire auditors if they were not able to find huge irregularities in financial statements? The negligence of K&C resulted in a $10 million loss for Boell, Ltd. Boell, Ltd. counted on K&C to do their job, and K&C failed them. Therefore, I urge you to find for the plaintiff in this case.
Defense Closing Statement: The plaintiff has told you that K&C made some mistakes in its audit of the 2014 financial statements of Hills Energy. It is your job to evaluate whether the actions taken were actually mistakes. Is it a mistake to follow commonly-used judgmental procedures in determining the value of an oil and gas asset? Is it a mistake to call in a specialist for help in estimating the value of a newly located oil and gas repository? None of these is a mistake; moreover, auditing standards require nothing more than these actions. K&C performed an audit that complies with the auditing standards, and any other CPA would have found it difficult to identify the misstatement of Hills Energy. The plaintiff has failed to demonstrate otherwise. Accordingly, I urge you to find in favor of the defendant, K&C.
Judge's Instructions to the Jury: It is your responsibility to determine the facts from the evidence presented to you. You should consider the evidence in light of your own observations and experiences in life. You may draw any reasonable inferences from the proven facts.
The burden of proof lies with the plaintiff. In order to be successful on a claim of professional negligence, the plaintiff must prove by a preponderance of the evidence that K&C failed to exercise the usual judgment, care, skill, and diligence employed by other CPAs in the community. If you decide that the defendant, K&C, did exercise the usual judgment, care, skill, and diligence employed by other CPAs in the community, you must find in their favor. If you decide that K&C did not exercise the usual judgment, care, skill, and diligence employed by other CPAs in the community, you must find for the plaintiff, Boell, Ltd.