Joseph and Isaac Sutton started Happiness Express, Inc. in 1989. The company appeared a success, reporting $40 million in revenue in 1994. The company attained these revenue levels through various profitable licensing agreements. Most notably, the signing of the Mighty Morphing Power Rangers in the mid ‘90s posted record numbers for the toy store. With the Power Ranger line accounting for 75% of the firm’s revenue, analysts became skeptical about their future performance. With the Power Ranger sales declining, the brothers took their next bet on Budgie the Helicopter and Dudley the Dragon. In 1995, with the help of the remaining Power Ranger sales, Happiness Express posted revenues of $60 million, a 50% increase from the prior year; half of which came in the fourth quarter. In 1996, the brothers watched their new toys fail. The company issued a statement estimating future losses that year to be between $14 and $17 million. As stock prices plummeted, executives came under scrutiny for insider trading and price inflation. Subsequently, the SEC began a formal investigation. As this ensued the company’s independent auditors retracted their unqualified opinion. False sales and bogus accounts receivables were found creating a significant portion of the company’s revenue, including a $2.4 million dollar sale on the last day of fiscal year 1995. Joseph pleads guilty and was sentenced to 30 months in jail, along with other who engaged in the insider trading. He and the auditing firm also were fined. However, Isaac pleads not guilty and was found innocent.
a. One of the primary objectives of confirming a client’s year-end accounts receivable is to comply with the guidelines enforced by the SEC. The main goal is to establish whether the accounts receivable account has been earned and whether it is realizable. Paragraph 83(a) of FASB Concepts Statement No. 5 states that revenue and gains are realized when products (goods or services), merchandise, or other assets are exchanged for cash or claims to cash. That paragraph also states that revenue and gains are realizable when related assets received or held are readily convertible to known amounts of cash or claims to cash (pwccomperio.com). Additionally, Paragraph 83 part “b” states that revenues are earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues, thus delivering the goods or rendering services (pwccomperio.com).
b. The primary objective of performing year-end sales cutoff tests is to avoid cut-off errors that will usually arise when companies try to determine the correct time period according to the revenue recognition rules of the applicable financial reporting framework.
Coopers & Lybrand failed in properly confirming the Wow Wee receivable by allowing the CFO to take control of the confirmation process as well as failing to recognize indicators that would otherwise prove the receivable to be nonexistent. This includes overlooking the large drop in Happiness factored sales from 88% in 1991 to 19% in 1995, as well as the exclusion of Wow Wee from its list of ‘Top 25’ companies it conducts business with, despite Wow Wee being among their top 5 customers.
Negligence is the accountant’s failure to conduct an audit with due care. Coopers & Lybrand requested proof of accounts receivable from the Wow Wee Liquidators, which resulted in no reply from the company. An audit with due care would have led the auditor to reach out to Michael Goldberg and further insist on receiving proof of transaction and its confirmation.
In this case the auditor did not intentionally approve or ignore any misstatements for an exchange of any sort of compensation from the audit client. However, he did uncover proof of misstatements, but failed to follow up on investigation, which leads to the conclusion that his actions were reckless.