Case 1.

10

United States Surgical Corporation

Prepared By

Chris Diaz

for Professor C.E. Reese

in partial fulfillment of the requirements for

ACC 502- Advanced Auditing

School of Business/Graduate Studies

St. Thomas University

Miami Gardens, Fla.

Term SP1/Spring, 2021

January 19, 2021

 Table of Contents

Issues

Facts

Analysis and Law

Recommendation/Conclusion
 Issues

1. What are the audit procedures that, if employed by Ernst & Whinney during the 1981

USSC audit, might have detected the overstatement of the leased and loaned assets

account that resulted from the improper accounting for asset retirements?

2A. In 1981, USSC extended the useful lives of several of its fixed assets and adopted salvage

values of many of these same assets for the first time, are these changes permissible under

generally accepted accounting principles?

2B. Assuming these changes had a material effect on USSC’s financial condition and results of

operations, how should the changes have been disclosed in the company’s financial statements?

2C. How should these changes have affected Ernst & Whinney’s 1981 audit opinion? (Assume

that the credit audit reporting standards were in effect at the time.)

3.Can you prepare a common-sized financial statement for USSC for the period 1979-1981,

while also computing key liquidity, solvency, activity, and profitability ratios for 1980 and 1981?

Give these data, what do you believe were the high risk financial statement items for the 1981

USSC audit?

4A. What factors in the auditor-client relationship create a power imbalance in favor of the

client?

4B. What measures that the profession could take to minimize the negative consequences of this

power imbalance?
5A. Regarding the costs incurred for USSC by Barden, can you identify the evidence Hope

collected that supported USSC’s claim that the costs involved tooling modifications, and the

audit evidence that supported the position that the costs were generic production expenses?

5B What do generally accepted auditing standards suggest are the key evaluative criteria that

auditors should consider when assessing audit evidence?

5C. Given these criteria, do you believe Hope was justified in deciding that the costs in question

were for tooling modifications? Why or why not?

6A. In your opinion did Hope satisfactorily investigate the possibility that there were additional

suspicious tooling charges being paid and recorded by USSC?

6B. If not, what additional steps should have taken to further explore this possibility?

6C. If Hope believed there was some likelihood that his client had committed an illegal act, what

additional audit procedures, if any, would have been appropriate? (Assume that current auditing

standards were in effect at the same time.)

7. When a CPA Firm has two audit clients that transact business with each other, should the two

audit teams be allowed to share information regarding their clients? Why or why not?
 Summary of Facts

In less than two decades, Leon Hirsch transformed a small company with four employees and

one product into a large and very profitable publicly owned firm that dominated the relatively

small, but important, surgical stapling industry. In fact, Hirsch’s company, United States surgical

Corporation (USSC), literally created the surgical stapling industry in the 1960s. Like many

small companies that experience explosive growth, USSC eventually became captive of its own

success. In the early 1980s, USSC began an aggressive counterattack to repel Blackmans

intrusion into its markets. First, USSC adopted a worldwide litigation strategy to contest

Blackmans right to manufacture and marketing his competing products. Second, the company

embarked on a large research and development program to create a line of new products

technologically superior to those being manufactured by Blackman. Hirsch overcome the major

challenges facing his company. USSC maintained its dominant position in the surgical stapling

industry, while continuing to report record profits and sales each year. In 1985, the Securities and

Exchange Commission (SEC), after a lengthy investigation, concluded that USSC management

had deliberately and materially overstated the profits of the company for the period resulting in a

$26 million reduction in its previously reported earnings. Additionally, Hirsch and other USSC

executives were forced to repay large bonuses they had earned on the overstated profits. The

SEC for failing to discover the various methods used to manipulate the company’s reported

operating results 1970s and early 19802, criticized the audit firm of Ernst and Whinney during

the late. The SEC investigation also revealed that USSC recorded inventory shipments to its

sales force as consummated sales transactions. Until the mid 1970s, USSC had marketed its

products through a network of independent dealers. Historically; inventory shipments to theses

dealers had been treated as arm’s length transactions and thus reportable as revenue. The United
States Surgical Corporation have many essential facts such as that the USSC’s management was

growth-oriented and dominated by an aggressive chief executive. The USSC’s dominance in the

surgical stapling industry was being contested in the early 1980s by several competitors. In the

early 1980s, USSC needed to raise additional capital to keep away the challenges of its

competitors and to finance its expansion plans for the future. The USSC had an incentive

compensation scheme for its key executives that were tied to reported earnings. In between 1980

and 1981, there were significant changes, both on an absolute and relative basis, in the year-end

balances of several of USSCs key accounts. The auditing Ernst &Whinney apparently failed to

obtain and review a copy of the standard employment contract signed by USSC’s sales

employees, which would have provided important evidence regarding the validity of sales made

by the company to those employees. The USSC improperly accounted for a large amount of

production expenses by treating them as “tooling modification” expenditures and capitalizing

them in a long-term asset account. Several of USSC’s vendors were involved in the fraudulent

deferred tooling expenditures scheme. Much of the evidence collected by Ernst & Whinney to

support the validity of the questionable deferred tooling costs failed to support the client’s

position regarding those costs. Although the SEC found that USSC officials had lied repeatedly

to the audit engagement partner, the federal agency sanctioned that partner and maintained that

he and his subordinates should have discovered USSC’s fraudulent financial statement

misrepresentations.
 Analysis and Law

1.The following audit procedures along with test of controls would help increase the possibility

of detecting the overstatement. Control Objective: Determines whether the company has

adequate and effective disposal policies and procedures, which will aid in maintaining accurate

fixed asset records. The auditors previous to performing year -end substantive tests on such an

account should first assess the level of control risk for that account taking into matter the two

primary considerations regarding the design effectiveness and operating effectiveness. For

example, the auditor is worried with the controls for given accounts are adequately designed to

minimize the material errors affecting the account balance. When considering operating

effectiveness, the auditor should determine the controls that have been established by the client

are operating as intended in the first place. Also, the auditors must have identified the controls

that U.S.S.C had established to guarantee that the cost of retired leased and loaned assets was

removed from the subsidiary ledger. For example, the company should have had a procedure for

authorizing the retirement of such assets, or any related procedure to ensure that the retired assets

were placed properly and are under a control policy to ensure that retirement transactions

triggered the proper accounting entries. Test of control (procedure): Review the policies for

disposing of/retiring capital assets. Review the authorization policies for capital asset

disposal/retirements. Review the policies for reporting items that are retired or abandoned. Make

a note of how applicable gains/losses are recognized. One a sample basis, select 5 retired capital

assets from the fixed assets records and perform the following tests: Assess whether the assets

retirement was properly approved and whether this was done on a timely basis. Establish

whether record of the asset retired was properly removed from the general ledger and fixed asset
register (if no longer in use). Check whether any applicable gains and losses were recognized and

reported on a timely basis.

2A. For U.S. Surgical Corporation to extend the useful lives of several of its fixed assets and

adopt a salvage value for many of these same assets for the first time, is permissible under

generally accepted accounting principles. Any changes to useful lives and salvage values are

allowed under generally accepted accounting principles so long as impairment test whenever

there has been a material change in the way an asset is used.

2B. The changes materially affected U.S. Surgical corporation’s financial condition and results

of operations, the changes should have been disclosed in the company’s financial statements.

The changes should have been disclosed in the financial statements with a note on how and why

the procedure was used.

2C. The changes should have been affected Ernst and Whinney’s 1981 audit opinion. The

changes should have resulted in E&W’s audit opinion to become an adverse opinion. The

opinion would have stated that with financial statements do no present the information fairly.

3.The Financial Statements are as follows and used the following formulas to compute the ratios

and equations:

Current Ratio: Current assets / current liabilities

Quick Ratio: (current assets-inventory)/ current liabilities

Debt to Assets: total debt / total assets

Time interest Earned: Earnings before interest and taxes / interest charges

Long- term Debt to equity: long term debt / stock. Equity

Inventory Turnover: Costs of Goods Sold / average inventory

Age of Inventory: 360 days / inventory turnover

Account Receivable Turnover: net sales / average accounts receivable

Age of Accounting Receivable: 360 days / accounts receivable turnover

Total Asset Turnover: net sales / total assets

Gross Margin: Total gross margin / net sales

Profit Margin on Sales: net income / net sales

Return on Total Assets: (net income + interest expense) / total assets

Return on equity: net income / average stockholders’ equity

Consolidated balance sheets 1979-1981

Current Assets: 1981 1980 1979

Cash .20% 1.00% .80%

Receivables (Net) 17.70% 25.60% 32%

Inventories

Finished Goods 14.10% 8.30% 8.10%

Work In Process 2.50% 2.20% 1.60%

Raw Materials 10.10% 15.80% 10.40%

Total Inventories 26.70% 26.30% 20.10%

Other Current Assets 3.80% 1.30% 2.60%

Total Current Assets 48.40% 54.30% 55.60%

Property Plant and Equipment:

Land 1.20% 2.00% 1.50%

Buildings 15.60% 15.50% 18.50%

Molds and Dies 15.50% 13.40% 12.40%

Machinery and Equipment 19.40% 20.00% 17.50%

Total Property Plant and Equip 51.70% 50.90% 49.90%

Allowance for Depreciation -7.20% -8.40% -9.00%

Total with Depreciation 44.50% 42.50% 40.90%

Other assets 7.10% 3.20% 3.50%

Total Assets 100% 100% 100%

Current Liabilities:

Accounts Payable 5.90% 5.80% 8.90%

Notes Payable 0.00% 0.00% 2.30%

Income Taxes Payable 0.00% 1.40% 0.00%

Current Portion of Long Term Debt .30% .60% .60%

Accrued Expenses 2.70% 4.30% 7.30%

Total Current Liabilities 9.00% 12.10% 19.00%

Long-Term Debt 38.90% 39.90% 47.50%

Deferred Income Taxes 3.60% 2.50% 2.00%

Stockholders equity:

Common Stock .50% .80% .50%

Additional Paid-in Capital 35.00% 17.50% 18.70%

Translation Allowance -.50% 0.00% 0.00%

Deferred Compensation-form

Issuance of Restricted Stock -2.30% -2.20% -2.90%

Total Stockholders’ equity 48.50% 45.50% 31.50%

Total Liabilities and Stockholders Equity 100.0% 100.00% 100.00%

Consolidated Income Statements 1979-1981

1981 1980 1979

Net Sales 100.00% 100.00% 100.00%

Costs and Expenses:

Cost of Products Sold 42.90% 37.50% 42.10%

Selling, General, and administrative 40.30% 43.80% 39.30%

Interest 5.30% 4.70% 5.60%

Total 88.50% 86.00% 87.10%

Totals 11.50% 14.00% 12.90%

Income Taxes

Federal and Foreign .70% 4.00% 3.70%

State and Local .30% 1.00% .80%

Total 1.00% 4.90% 4.50%

Net income 10.50% 9.10% 8.40%

Net Income per common share 0 0 0

And common share equivalent

Average number of common shares

And common share equivalents outstanding 10,403,392 8,816,986 7,555,710

U.S. surgical Corporation liquidity, solvency, activity, profitability ratios 1980-1981

Liquidity 1981 1980

Current Ratio 5.37% 4.48%

Quick Ratio 2.41% 2.31%

Profitability Analysis Ratios

Gross Margin 57.01% 62.50%

Profit Margin on sale 10.50% 9.10%

Return on total assets 8.5% 10.0%

Return on Equity 15.2% 20.6%

Solvency

Debt to Assets .52 .55

Time Interest Earned 3.19 3.98

Long Term Debt to Equity .80 .88

Activity

Inventory Turnover 1.11 1.42

Age of Inventory 324 days 253 days

Account Receivable Turnover 3.33 3.25

Age of Account Receivable 108 days 111 days

Total Assets Turnover .54 .72

4A. There are factors in the auditor-client relationship that create a power imbalance in favor of

the client. The client hires the auditor, compensates the auditor and has the ability to fire the

auditor at the company’s discretion. These factors create the imbalance of power favoring the
client in which, companies can use to influence when technical disputes arise. In addition, the

same auditor offers other services for the client and creates an additional influence over the audit

firm.

4B. There are measures in the profession that can be taken to minimize the negative

consequences on power imbalances. To help balance out these powers and increase auditor’s

independence the SEC has adopted some rules that include limiting auditors to have direct

investments with the client. Setting audit controls to help increase auditor’s independence, is

another measure.

5A. Auditing evidence is essential to performing an audit. Audit evidence, according to the

AICPA, is all the information used by the auditor in arriving at conclusions on which the audit

opinion is based and includes the information contained in the accounting records underlying the

financial statements and other information.

5B. The auditor’s evidence to support capitalizing generic tooling modifications was inquiry and

the touring of a factory. The auditor toured the plant where these items were made, and based on

limited inquiry, decided to accept the capitalization of generic tooling modifications. This

decision was made even after invoices were reviewed that suggested that these amounts should

not be capitalized. The auditor failed to support the capitalization of these tooling costs with

substantive test work. The auditor relied on the comments of management, which at this point in

the audit, was subject to integrity issues. Thus, the auditor Mr. Hope was not justified in allowing

these costs to remain capitalized.

5C. Another common deficiency the SEC alleged, present 40% of cases, involved overreliance

on inquiry as a form of audit evidence. The agency cited auditors for failing to corroborate
managements explanations or to challenge explanations that were inconsistent or refuted by other

evidence the auditor had already gathered.

6A. The Barden board had concerns that USSC may terminate their contract if USSC perceives

that their company brought the problem to Ernst and Whinney’s attention. Hope did not

satisfactorily investigate the possibility that there were additional suspicious tooling charges

being paid and recorded by USSC. Concerns of confidentiality with the Barden Corporation’s

investigation on mislabeled invoices could have influenced not investigating the issue further

under the USSC audit.

6B. The additional steps that should he have taken to further explore this possibility is to get a

large sample size of the invoices in question and do a vertical and horizontal analysis to compare

1980 and 1981 other asset accounts and the molds & dies accounts. By doing this analytical

review, the issues should surface and the appropriate adjustment to financials would be requested

by Ernst & Whinney.

6C. If Hope believed there was some likelihood that his client had committed an illegal act,

additional audit procedures would be necessary to handle to situation. Whether an act is, in fact

illegal is a determination that is normally beyond the auditor’s professional competence. An

auditor, in reporting on financial statements, presents himself as one who is proficient in

accounting and auditing. The auditor’s training, experience, and understanding of the client and

its industry may provide a basis for recognition that some client acts coming to his attention may

be illegal. However, the determination as to whether a particular act is illegal would generally be

based on the advice of an informed expert qualified to practice law or may have to wait final

determination by a court of law.

7 According to the facts sharing this type of information with the clients about the other clients

creates huge risk and conflicts of interest issues. The independence of the audit would be

affected greatly and the overall outcome potential risks could lead to misstatements and

incentives to defraud the accounting system. Not only that, it is unethical to discuss the financial

findings or information about a company to another company whether they be affiliated with

each other or rivals. I would consider actions such as these like insider trading risk or inherent

risks. Trading information, whether it be in the expenditure cycle, investing and financing cycle

or the production and personal services cycle, gives incentives to companies to mislead and take

advantage of cutting corners and deceiving auditors. As an accounting firm, it should not be

allowed and highly looked down upon.

 Conclusion

During the past thirty years, we have seen an increase in the number of companies that have

committed some form of financial shenanigans. Some of these companies have manipulated

GAAP to present themselves as financially sound. Some auditors that worked in public firms and

then are hired by their clients take advantage of their inside knowledge and try to manipulate the

books to make it less obvious to other auditors since they know what auditors are looking for.

Companies that are involved with shareholders and want to make it look like their company is

doing well may also cook their books to give the appearance the company is doing well when in

reality that is not the case. Higher ups in the company as well may try to convince accountants

and others involved with the books to give that false representation so it looks like the company

is doing well. It is important for auditors to notice these trends and find the red flags in these

situations so they are able to stop the fraud when it is realized. Others have also committed fraud

in the objective to make their company flourish which is why auditors are so essential. With this

type of behavior and lack of ethics in the corporate would there is an increasing need for better

auditing and more reliable auditors examining to financial statements to catch fraud wherever it

is present.