Koger Properties Inc. Case

ETHICS AND CORPORATE GOVERNANCE SEMESTER II 2011/2012 TAKE-HOME QUIZ

COMPREHENSIVE CASE (Koger Properties Inc

Koger Properties Inc Case from „Contemporary Auditing: Real Issues and Cases’ by Michael C. Knapp 1. The SEC charged that Goodbread violated its independence rules, the AICPA’s Code of Professional Conduct, and generally accepted auditing standards. Explain the SEC’s rationale in making each of those allegations. The SEC has a strong case against Goodbread for violating his independence because as it is stated on the AICPA‟s website, “Independence shall be considered to be impaired if: During the period of the professional engagement a covered member was committed to acquire any direct or material indirect financial interest in the client.” (aicpa.org 101-1).

In

Goodbread‟s case this refers to the fact that he had shares of stock (direct financial interest) in his possession when he was the audit engagement partner who oversaw the audit of Koger Properties, Inc. Under the Generally Accepted Auditing Standards (GAAS) there are three

sections,

Reporting.

General

Standards,

Standards

of

Fieldwork,

and

Standards

of

Under the General Standards section of GAAS there is a specific standard for

independence and it reads, “The auditor must maintain independence in mental attitude in all matters relating to the audit.” Often times a distinction will be made between independence in fact and independence in appearance. What this means is that an auditor must not only be independent in fact (objectively), but must also avoid actions that may appear to affect independence. The fact that Goodbread owned stock in Koger, no matter how many shares, still affects the appearance of his independence relating to the audit of that company. Third parties, such as potential buyers of Koger stock, cannot observe whether Goodbread is acting objectively during the audit.

Because of that, it will lead to questions about whether Goodbread is

really independent due to his partial ownership in Koger Properties. After evaluating the codes and standards set before auditors in regards to independence, it is not hard to see why the SEC took action against Michael Goodbread.

2. In your opinion, did Goodbread’s equity interest in Koger Properties likely quality as a “material” investment for him? Was the materiality of that investment a relevant issues in this case? Explain. To Michael Goodbread personally I believe that the investment was of material interest.

Rule 2-01(b) of SEC states, "an accountant will be considered not independent

with respect to any person...in which...he, his firm or a member of his firm had, or was committed to acquire, any direct financial interest or any material indirect financial interest..." Thus, owning shares of stock in an entity such Koger Properties is clearly a direct financial

interest in the entity. Accordingly, Section 602(2)(b) of the Codification of Financial Reporting Policies (FRC) states that any stock ownership in a client impairs independence, and that "materiality is not a consideration in the case of a direct financial interest."

3. Given that Goodbread purchased stock of Koger Properties in 1988, under what conditions, if any, could he have later served as the audit engagement partner for that company? At the time of his purchase, Koger was an audit client of Deloitte, Haskins & Sells. However, after the effective date of the combination, Koger became an audit client of the new merged entity, Deloitte & Touche. After the combination of the two firms, Goodbread was assigned to be the audit partner in connection with Deloitte & Touche's audit of Koger's financial statements for the fiscal year ended March 31, 1990. In that capacity, Goodbread had final responsibility within the firm for planning and supervising the performance of the audit in accordance with generally accepted auditing standards (GAAS). Goodbread signed the Koger Audit Planning Memorandum on February 21, 1990.

Audit planning for the

engagement and/or field work was conducted from that time until June 26, 1990, on which date Goodbread signed the Audit Report Record, signifying completion of the Koger audit. Notwithstanding Goodbread's capacity as a partner in the combined firm of Deloitte & Touche after the combination, and particularly his final responsibility for the independent audit of Koger beginning on or about February 21, 1990, Goodbread did not sell his 400 shares of Koger stock until May 10, 1990. The AICPA Code of Professional Conduct expressly prohibited Goodbread's Koger stock ownership during the time of the Koger audit. The Code states that "independence shall be considered to be impaired if…..during the period of a professional engagement, or at the time of expressing an opinion, a member or a member's firm…..had or was committed to acquire any direct or material indirect financial interest in the enterprise". If an auditor is not independent, "any procedures he might perform would not be in accordance with generally accepted auditing standards and he would be precluded from expressing an opinion on such statements."

Accordingly, under such

circumstances, GAAS requires an accountant to "disclaim an opinion with respect to the financial statements" and to "state specifically that he is not independent."

4. During much of the 19th century in Great Britain, independent auditors were not only allowed to have an equity interest in their clients but were required to invest in their clients in certain circumstances. Explain the rationale likely underlying that rule. Would such a rule “make sense” in today’s business environment in the United States? Defend your answer. It may “make sense” if there is an exclusionary rule that would prohibit an audit firm from providing non-audit or non-tax services, except in very limited circumstances, to its public audit clients. Under this view, there is a fundamental conflict of interest because, in reality, the audit firm is serving two different sets of clients: management, in the case of management consulting services, and the audit committee, the shareholders, and others who rely on the audited financial statements in deciding whether to invest, in the case of an audit. As in this case, Goodbread held a direct ownership interest in Koger stock while participating in the initial phases of the audit of Koger's financial statements. Notwithstanding this lack of independence from Koger, Goodbread caused Deloitte & Touche to issue an unqualified audit report, contained in Koger's Form 10-K for the fiscal year ended March 31, 1990, stating that Deloitte & Touche was independent and that the audit was conducted in accordance with GAAS. Under the circumstances, Goodbread's ownership of stock specifically precluded any representation that the audit was conducted in accordance with GAAS and required Goodbread to make sure that Deloitte & Touche disclaimed an opinion on the financial statements and disclosed the lack of independence.