Question

Please read the attached case: Navistar International and prepare answers to the following four questions

In a bizarre twist to a bizarre story, on October 22, 2013, Deloitte agreed to pay a $2 million penalty to settle civil charges—brought by the PCAOB—that the firm violated federal audit rules by allowing its former partner to continue participating in the firm’s public company audit practice, even though he had been suspended over other rule violations. The former partner, Christopher Anderson, settled with the PCAOB in 2008 by agreeing to a $25,000 fine and a one-year suspension for violating rules during a 2003 audit of the financial statements for a unit of Navistar International Corp. According to the charges, “Deloitte permitted the former partner to conduct work precluded by the Board’s order and put investors at risk.”

After he settled the case and agreed to a one-year suspension, the PCAOB said Deloitte placed Anderson into another position that still allowed him to be involved in the preparation of audit opinions. Allowing a suspended auditor to continue working in that capacity is a violation of PCAOB rules, unless the SEC gives the firm permission. During the suspension, Anderson rendered advice on assignments involving three other Deloitte clients, according to the PCAOB. Deloitte said that it had taken “several significant actions to restrict the deployment” of Anderson. “However, we recognize more could have been done at that time to monitor compliance with the restrictions we put in place.”

In January 2013, Deloitte had settled a lawsuit alleging it committed fraud and negligence, forcing Navistar to restate earnings between fiscal year 2002 and the first nine months of 2005. Deloitte was dropped by Navistar in 2006, and the company was delisted by the New York Stock Exchange.

In response to charges by Navistar that sought to hold Deloitte liable for an incompetent audit, deceptive business practices, fraudulent concealment and basically everything that went wrong for Navistar, the Deloitte spokesman Jonathan Gandal, expressed the firm’s position as follows:

“A preliminary review shows it to be an utterly false and reckless attempt to try to shift responsibility for the wrongdoing of Navistar’s own management. Several members of Navistar’s past or present management team were sanctioned by the SEC for the very matters alleged in the complaint.”

Early in the fraud, Navistar denied wrongdoing and said the problem was with “complicated” rules under SOX. Cynics reacted by saying it is hard to see how the law can be blamed for Navistar’s accounting shortcomings, including management having secret side agreements with its suppliers who received “rebates;” improperly booking income from tooling buyback agreements, while not booking expenses related to the tooling; not booking adequate warranty reserves; or failing to record certain project costs.

It is clear that Navistar employees committed fraud and actively took steps to avoid discovery by the auditors. The auditors did not discover the fraud, according to Navistar, and in retrospect, the company wanted to hold the auditors responsible for that failure. Deloitte maintained that in each case, the fraudulent accounting scheme was nearly impossible to detect because the company failed to book items or provide information about them to the auditors.

Deloitte may have been guilty of failing to consider adequately the risks involved in the Navistar audit. After SOX was passed in mid-2002, all the large audit firms did some major cleanup of their audit clients and reassessed risk, an assessment that should have been done more carefully at the time of accepting the client. Big Four auditors, in particular, wanted to shed risky clients to protect themselves from new liability. Interestingly, to accomplish that goal with Navistar, Deloitte brought in a former Arthur Andersen partner to replace the engagement partner who might have become too close to Navistar and its management, thereby adjusting to the client’s culture.

Whether because of his experience with Andersen’s failure, fear of personal liability, a “not on my watch” attitude, or possibly a heads-up on interest by the SEC in some of Navistar’s accounting, this new partner cleaned house. Many prior agreements between auditor and client and many assumptions about what could or could not be gotten away with were thrown out.

One problem for Navistar was that it was too dependent on Deloitte to hold its hand in all accounting matters, even after the SOX prohibited that reliance. According to Navistar’s complaint, “Deloitte provided Navistar with much more than audit services. Deloitte also acted as Navistar’s business consultant and accountant. For example, Navistar retained Deloitte to advise it on how to structure its business transactions to obtain specific accounting treatment under GAAP . . . Deloitte advised and directed Navistar in the accounting treatments Navistar employed for numerous complex accounting issues apart from its audits of Navistar’s financial statements, functioning as a de facto adjunct to Navistar’s accounting department. . . . Deloitte even had a role in selecting Navistar’s most senior accounting personnel by directly interviewing applicants.”

The audit committee’s role is detailed in the 2005 10-K filed in December 2007:

“The audit committee’s extensive investigation identified various accounting errors, instances of intentional misconduct, and certain weaknesses in our internal controls. The audit committee’s investigation found that we did not have the organizational accounting expertise during 2003 through 2005 to effectively determine whether our financial statements were accurate. The investigation found that we did not have such expertise because we did not adequately support and invest in accounting functions, did not sufficiently develop our own expertise in technical accounting, and as a result, we relied more heavily than appropriate on our then outside auditor. The investigation also found that during the financial restatement period, this environment of weak financial controls and under-supported accounting functions allowed accounting errors to occur, some of which arose from certain instances of intentional misconduct to improve the financial results of specific business segments.^”

The complaint against Deloitte also references audit discrepancies cited in PCAOB inspections of Deloitte. Navistar believed the discrepancies related to Deloitte’s audit of the company. However, the names of companies in PCAOB inspections are not made publicly available due to confidentiality and proprietary information concerns.

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Questions

1. Would you characterize the Deloitte audit of Navistar a failed audit? Refer to the ethics rules of conduct in the AICPA Code as they pertain to audit engagements and the facts of the Navistar case.                                                               (6 marks)

2. Evaluate the deficiencies in internal controls and corporate governance at Navistar. Do you believe external auditors should be expected to discover fraud when a company, such as Navistar, is so poorly run that its personnel did not have the necessary training and expertise, its internal controls were deficient, and it relied too heavily on Deloitte to determine GAAP compliance? Explain.                                       (6 marks)

3. If you were the CEO of Navistar what action you would take to improve the internal control mechanisms and mitigate risk associated with accounting fraud. Do you think Audit committee can be used as the substitute for internal control department (4 marks)   
   

What is the purpose of the PCAOB audit firm inspection program with respect to ensuring that auditors meet their ethical and professional responsibilities and obligation to place the public interest above all else? (4 marks)

Answer 1

D As per the given data :- P. No. 1 According to the AicpA code, auditors should enhance public confidence by performing their professional responsibilities with the highest degree of integrity. * The DEL's NAV audit does not comply with the mentioned AICPA Code of Conduct due to the following reasons :- 1. DEL allegedly performed an incompetent audit, indulged in deceptive business Practices, and fraudulent Concealment 2. DEL Continued to engage a partner who had been fred and Suspended by PCAOB. DEL admitted to this charge. 3. 24 was appedent that some Nay employees had committed fraud and took steps to conceal them. However, despite being one of the best in the business, DEL Could not discover the froud. Since the DEL partner was too close to the

P.NO.2 NAV management, It is plausible that there Some both sides. collusion on 4. DEL to NAV Continued to extend Support in all accounting matters, even though the extra reliance was non - Compliant with Sox guidelines. are some 1. booking in come a The following Some of the alleged frauds on the on the side of NAV :- Some NAV employees allegedly had Secret side agreements with its suppliers, improperly from toding buyback agreements, while not booking expenses related to the tooling not maintaining adequate warranty reserves, or omission of Certain project costs. was too dependent on DEL in all accounting matters, even after the sox prohibited that reliance, This, in turn, led to of interests between NAV and DEL and further Collusion. 9. NAV a web vested

P. No.3 3. As mentioned in the audit Committee report, NAV management had effort to develop it Competencies to internally audit and validates Some of there mal practices. This is unthinkable for a Company of the size of Nay, which was listed on the NYSE. As the CEO of NAV, one should do the following: 1. Recruit and train an internal Control team Comparising of accountants and auditors who can Continuourly maintain and Scrutinize transaclions and body of accounte. managar external auditat relationship in a way that it remaine independent and unbiased. 3. Invest in digital platforms that can be integrated with supplier Systems to track the entire flow of transactione with requisite reporting and approvals.

P.No.4 The POMOR inspection program's objective is to investigate the firm's Compliance with PCAOB Standards and rules and all other applicable regulatory and profesional requirement as applicable to the firm's quality Control and in the audits selected for inspection. The areas Considered for PCAOB inspection review are 1. Audit firm's organizational structure and “ Process 2. Practices for partney Su-povi Son 3. policies and procedures for coneidering and addressing the risks involved in accepting and retaining audit engagements, including any risk - rating System used by the firm. 4. The firm's Process for morlitoning audit performance, including for identifying and assering indicators of deficiencies in audit

P.NO.S performance, independence policies and procedures, and processes for responding to defects of potential defects in quality control. 5. Evaluate whether identified whether identified gaps in individual audits indicate a flow in a firm's system of quality Control , 6. Determine of any obcervatróns ar gaps should be included in the PCAOB inspection report. me please, vote positively. It's help a lot. Thank you.