Case 1.

2
ESM Government Securities, Inc

Prepared by:
Alexa Rodriguez

for
Professor C.E. Reese
in partial fulfillment of the requirements for
ACC502-- Advanced Auditing
College of Business/Graduate Studies
St. Thomas University
Miami Gardens, Fla

Term SP2/Spring, 2020

April 7, 2020

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 Table of Content
Issues 3
Facts 4
Analysis/Authority 6
Conclusions/Recommendations 11
References 13

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Issues:
1. What measures can audit firms take to ensure that even their own firm partners do not
become corrupt and succumb to pressure from external sources?
2. Are auditors required to review the company’s tax returns? If the same firm is providing
auditing and tax services are the two entities required to communicate with each other
regarding potential financial statement issues?
3. Based on the ESM case, should audit firm have quality control strategies in place to
prevent partners from being dishonest? If so, what kind of controls could they
implement?
4. When an audit firm discovers that their opinion is incorrect and has severe financial
implications for the company, should they do something else other than withdraw their
opinion?
5. When a client engages in repo transactions or reverse repo transactions what are the main
audit objectives when sending out confirmations?
6. In this case with ESM, which party would prevail in the lawsuit against the law firm for
not informing the audit firm that ESM was insolvent? Why?
7. Should all the audit partners of a firm be held liable for the inappropriate and illegal
actions of one partner? Should society be allowed to impose joint and several liability on
all the partners of these large audit firms?
8. Are loans for the company’s executives supposed to be shown separately on the balance
sheet? If it is a requirement, why?

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Facts:
Jose Gomez became partner at Alexander Grant & Company in 1979, but shortly after he

was serving a 12-year prison sentence. Alan Novick, an officer at ESM, informed Gomez that

the brokerage firm that specialized in government securities had hidden millions in losses and

that the financial statements contained several material errors. Gomez was under serious

pressure having just been named partner, and was having financial troubles, so Novick agreed to

pay him in exchange for his silence. Novick gave Gomez about $200,000 so he would not

withdraw the audit opinion. What started off as small losses in 1977 and 1978 grew quickly into

losses of $300 million by 1985. This financial scandal did not just affect stockholders and

creditors of this company, but also caused a ripple effect that led the U.S. dollar to plunge 14%

in value.

ESM was known for buying and selling customer accounts debt securities. Most of the

transactions at ESM were known as repurchase agreements. Repos are when a government

dealer sells a customer a block of securities and promises to repurchase them later at an agree

upon price. Reverse repos occur when ESM would purchase government securities from

customer and promise to repurchase them at a later date for an agreed upon price. Besides

securities, ESM also participated in speculative transactions where they had to predict the

potential profit from fluctuations in the market interest rates. In doing so, Novick lost $80

million, which wiped out the company’s equity. Instead of admitting that the company was

bankrupt, ESM stole customers securities for their own use to try to make back the lost money.

In order to conceal these schemes, Novick had the losing transactions posted in ESM’s

other companies that were not audited. He also used these companies to hide the theft of funds.

There were many individuals involved in this scheme besides Novick; they would establish

personal trading accounts with ESM where Novick dumped millions from repo and reverse repo

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transactions. Novick and the other coconspirators stole more than $100 million from ESM,

banks and municipalities, making the total deficit of ESM somewhere around $300 million. The

downfall of ESM arose when Novick suddenly died of a heart attack and when a major customer

of ESM insisted on having its securities turned over, but ESM no longer had them.

There was much surprise since the fraud was detected rather quickly once investigated

even though Alexander Grant had failed to notice the scam for the seven years that they audited

ESM. The scheme was discovered by comparing the balance sheets with the tax returns, which

did not match at all. The tax returns showed that ESM was losing tend of millions of dollars

annually. The auditors also failed to check related party transactions like those recorded with the

other companies. Furthermore, they did not realize that there was always a shortage of securities

because they never did a box count to confirm the amount of actual securities ESM had on hand.

While the audit firm conducted confirmation procedures, they were all directed to Gomez, who

was willing to overlook the material misstatements in exchange for money, so the confirmations

were not done appropriately. The lack of internal controls in the audit firm made it so that

Gomez was able to be dishonest and continue releasing unqualified opinions for a company that

was clearly failing. Other suspicious factors include ESM’s officer’s exorbitant lifestyles, and

the fact that Ronnie Ewton was previously involved in distrustful activities and had been

investigated by the SEC.

Those involved in this scandal were punished with jail time and multiple members

committed suicide. Alexander Grant was suspended from accepting new clients for 60 days and

submitted to a peer review by a CPA firm selected by the state board.

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Analysis:
1.
While it may be true that new partners are subject to immense pressure that does not give them a

right to engage in illegal activity. Unfortunately, the audit firm in this case did not have any

measures in place to ensure that dishonest partners would be caught. Auditors are responsible

for looking at the internal controls in place in a company; that is, they make sure companies have

sufficient and appropriate rules and procedures in place to “ensure the integrity of financial and

accounting information, promote accountability, and prevent fraud” (Kenton, 2019). Just

because audit firms review other company’s internal controls, does not mean that they should not

have internal control procedures of their own. One of the major internal control functions is the

separation of duties, which means separating the responsibilities of different tasks to different

individuals (Ingram, 2019). When collecting confirmations, they were all handed off to Gomez,

instead of being analyzed by the audit team and then reviewed by Gomez; this is a clear violation

of separation of duties; had the audit team collected the confirmations themselves they may have

become aware that something was wrong. Another key internal controls aspect is requiring

proper authorization (Ingram, 2019). Although Gomez technically would be a considered proper

authorization as he is a partner, audit firms should make sure that cases are approved by two or

even three different audit partners to ensure that it is being reviewed properly, and to help

prevent any one audit partner from committing fraud. Members of an engagement team should

feel comfortable reporting any suspicious or fraudulent behavior to other partners in the firm, so

creating an anonymous hotline or having an audit committee like the company’s they review,

would help in this matter.

2.

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Looking at comparative financial statements is helpful to auditors as they can spot changes in

data over the years that look strange (Loughran, pg. 319). While auditors are not required to

look at tax returns, it would be equally helpful in determining if there is suspicious behavior.

The same way that auditors look at previous financial statements to analyze changes, reviewing

the tax return could also help point out any significant changes or differences that need to be

investigated further. Although there is no rule specifying that tax practitioners and the audit

team of a CPAS firm must communicate, it is always helpful to keep the lines of communication

open. Auditors can significantly improve the quality of their reports by maintaining

communication with each member of the engagement team and with the company’s audit team

(Fornelli, 2017). Similarly, if audit team members and those preparing the taxes would

communicate it could help the auditors have a complete understanding of the company,

recognize if there were any major differences, have the ability to question pending issues further,

and therefore create a more complete audit report.

3.

As discussed in issue one, CPA firms cannot hope that their audit partners will act with honesty

and integrity. While it is expected that they uphold the standards outlined by the AICPA and

GAAP, there must be procedures in place to detect any partners who do not act accordingly.

Especially after the events that occurred in the ESM case, auditors need to implement internal

control procedures to ensure that audit partners to compromise the quality of the audit report.

4.

Alexander Grant’s first response to withdraw its audit opinion was correct, but it was not their

only responsibility. Once the audit firm knew about the fraud and the extent of its damage, they

did the right thing to withdraw the audit opinion so that third parties knew that they were

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unreliable. There were two other key steps that they did not necessarily adhere to. First, they

should have communicated the decision to modify their opinion with ESM’s audit committee

and those charged with governance (AU-C Section 705 Modifications to the Opinion in the

Independent Auditor’s Report). Furthermore, they should have reported the fraudulent activity

to the SEC to notify the proper authorities and that way the SEC could investigate the situation

further (McKenna, 2012).

5.

A repurchase (repo) agreement is one in which securities are sold to investors and then

repurchased at a later date; the difference in the price is caused by fluctuations in the interest rate

and this is a method used by companies to generate short term capital (Reiff, 2020). The party

selling the security and repurchasing it later is engaging in the repo transaction, the party buying

the security and then selling it at a later date is engaging in a reverse repo transaction (Reiff,

2020). Regardless of what kind of transaction is occurring confirmation procedures can and

should be done by the audit firm. If the company is performing repo transactions the audit firm

can send confirm the amounts with the customers with whom they sold and repurchased the

securities from to determine that the amounts are the same (Sherman, 2016). If the company is

performing reverse repo transactions the audit firm can confirm with the company who sold the

securities and is agreeing to buy them back; again, this is done to make sure that the price

matches what the company has recorded (Sherman, 2016). Finally, another method of

confirming for both types of transactions would be counting the amount of securities that are

recorded to make sure that they have all been accounted for and they all exist (Sherman, 2016).

6.

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Arky did not have an obligation to tell Alexander Grant that ESM was insolvent because of

attorney-client privilege (Michmerhuizen, 2007). Lawyers are required to keep client

information private and ensure that clients can confide freely (Michmerhuizen, 2007). The

exception to this privilege is known as the crime-fraud exception in which the client attempts to

use the lawyer to help commit or cover up their crime or fraud (Michmerhuizen, 2007). Simply

telling the lawyer that the company is bankrupt is not sufficient for the lawyer to disclose that

information; if Arky was involved in covering up the fraud or crime in any way then there could

be an appropriate law suit (Michmerhuizen, 2007). While Arky’s close personal relationship

with Ewton of ESM makes his knowledge of the crime questionable, without sufficient evidence

that the law firm was actually involved in covering up the criminal acts then there is no case.

Unfortunately, if Arky was really not involved at all, the reputation of the firm will greatly suffer

because of the relationship with ESM and the law suits blaming them for not disclosing the

insolvency.

7.

Joint and several liability occurs when several parties can be considered liable for the same event

and are held responsible for the required restitution (Kenton, 2018). Audit firms are responsible

for reviewing a company’s financial records and assuring the public that what has been recorded

is accurate and appropriate. It is appropriate that audit firms be held liable for mistakes they

made, especially when they do not have their own set of internal controls. While the other

partners at Alexander Grant had nothing to do with the audit of ESM and were unaware of the

fraud committed, they should still be held responsible for Gomez’s failure because the audit firm

as a whole failed. In order to provide quality audit reports the firm needs to implement internal

controls to help detect when there are errors or if an audit partner is committing fraud.

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Unfortunately, auditing is a lot of responsibility and all those involved can be held liable, but that

means that the firms need to implement procedures to ensure that they are doing the best they

can in assuring the public of their client’s financial situation, as there are individuals heavily

relying on this information.

8.

A related party transaction is known as a deal “between two parties who are joined by a

preexisting business relationship or common interest” (Kenton, 2020). According to the AICPA,

lending money on an interest free basis or making loans with no scheduled terms for when and

how the money is to be repaid are all forms of related party transactions (AU Section 334

Related Parties). In this case, ESM officers with million-dollar loans from ESM are considered

related party transactions and therefore should have been disclosed of properly on the financial

statements (AU Section 334 Related Parties). Ensuring that the related party transactions are

adequately disclosed on the financial statements is a vital role of the auditing firm since the

transactions do not have to be recorded separately on the balance sheets (AU 334 Related

Parties). Because related party transactions can cause conflicts of interest and can lead to other

people benefiting from the company instead of the shareholders, it is required that these

transactions be disclosed in the financial statements so third party individuals are aware of them

and can make informed decisions about investing in the company (Smith). These disclosures

should include information regarding the nature of the relationship, a description of the

transaction, a dollar amount related to the transaction and the remaining amount owed from the

related party (Smith).

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Conclusions:
There are some key takeaways from the ESM case beginning with the fact that audit

firms are wholly responsible for the actions of just one partner, so there should be internal

control procedures in place to prevent fraudulent activity on behalf of the partners; this will

allow for better quality audit reports and will detect members of the firm that are not abiding by

the standards. Because auditors have such a great responsibility of assuring the public that the

financial statements of a company are accurate, they must be held liable for failing to complete

their work effectively, which makes the implementation of these control policies that much more

important.

There were several other aspects where Alexander Grant failed to perform its auditing

duties and led to its unqualified opinion of ESM when it should not have been granted. Although

it is not required, the audit firm should have looked at the tax returns for ESM to be aware of any

discrepancies and further investigate them; if they had done this, they would have discovered the

fraudulent activity since the tax returns reported losses whereas the financial statements did not.

Maintaining communication between the auditors and the tax preparers is vital in fully analyzing

a company’s financial situation.

While Alexander Grant did perform confirmations, because they were all handled by

Gomez, they were never appropriately completed and reviewed. This goes hand in hand with the

control procedures mentioned previously; no one person should be in charge of multiple tasks

and there should be more than one person reviewing information to keep a system of checks and

balances. Without the adequate confirmation tests the audit firm was unable to ensure that ESM

was correctly accounting for the repo and reverse repo transactions. They also never did an

inventory count to make sure that all the listed securities were present and existed. These small

audit tests can make a big difference in providing quality reports.

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 Finally, the audit firm also did not acknowledge the presence of related party transactions

and failed to require that ESM make appropriate disclosures of these transactions in their

financial statements. Furthermore, they failed to look into the details of these transactions

further because if they had, they would have discovered that ESM’s losses were being booked to

those other unaudited companies. Once Alexander Grant became aware of the dire situation with

ESM, they had the appropriate response in withdrawing its opinion; however, they failed to take

the further necessary actions. Not only did they need to withdraw the opinion, but they needed

to communicate the reasons with the audit committee, and because they were aware of fraudulent

activity, they should have reported it to the SEC.

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References:

AU 334 Related Parties. (n.d.). Retrieved April 7, 2020, from

https://pcaobus.org/Standards/Archived/Pages/AU334.aspx

AU Section 334 Related Parties. (n.d.). Retrieved April 7, 2020, from

https://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-
00334.pdf

AU-C Section 705 Modifications to the Opinion in the Independent Auditor’s Report. (n.d.). Retrieved

April 7, 2020, from

https://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-C-
00705.pdf

Fornelli, C. (2017, November 1). Improving Audit Quality through Auditor Communication. Retrieved

April 7, 2020, from https://www.cpajournal.com/2016/02/01/improving-audit-quality-auditor-

communication/

Ingram, D. (2019, January 25). What Are the Seven Internal Control Procedures in Accounting? Retrieved

April 7, 2020, from https://smallbusiness.chron.com/seven-internal-control-procedures-

accounting-76070.html

Kenton, W. (2020, March 30). Understanding Internal Controls. Retrieved April 7, 2020, from

https://www.investopedia.com/terms/i/internalcontrols.asp

Kenton, W. (2020, January 29). What Is Joint and Several Liability? Retrieved April 7, 2020, from

https://www.investopedia.com/terms/j/joint-and-several-liability.asp

Kenton, W. (2020, February 5). Why Related-Party Transactions Are Monitored Carefully. Retrieved April

7, 2020, from https://www.investopedia.com/terms/r/related-partytransaction.asp

Loughran, M. (2010). Auditing for dummies. Hoboken, NJ: Wiley.

McKenna, F. (2012, February 23). Are Auditors Reporting Fraud And Illegal Acts? The SEC Knows But Isn't

Telling. Retrieved April 7, 2020, from

https://www.lexisnexis.com/legalnewsroom/corporate/b/blog/posts/are-auditors-reporting-
fraud-and-illegal-acts-the-sec-knows-but-isn-t-telling

Michmerhuizen, S. (2007, May). Confidentiality, Privilege: A Basic Value in Two Different Applications.

Retrieved April 7, 2020, from

https://www.americanbar.org/content/dam/aba/administrative/professional_responsibility/con
fidentiality_or_attorney.authcheckdam.pdf

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Reiff, N. (2020, March 18). Repurchase Agreement (Repo) Definition. Retrieved April 7, 2020, from

https://www.investopedia.com/terms/r/repurchaseagreement.asp

Sherman, F. (2016, October 26). Alternative Audit Procedures. Retrieved April 7, 2020, from

https://smallbusiness.chron.com/alternative-audit-procedures-41632.html

Smith, B. (n.d.). Why do we disclose related party transactions? Retrieved April 7, 2020, from

http://blog.frazerllp.com/related-party-transactions

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