Case 1.4: Health Management, Inc.

Question 1

An auditor’s independence entails the ability from the influence of third parties with an interest in the business by way of being objective and enhancing integrity. In PCAOB, independence falls under rule 3520 which states that “a registered public accounting firm or associated person’s independence obligation with respect to an audit client encompasses not only an obligation to satisfy the independence criteria applicable to the engagement set out in the rules and standards of the PCAOB, but also an obligation to satisfy all other independence criteria applicable to the engagement, including the independence criteria set out in the rules and regulations of the Commission under the federal securities laws” ( A relationship is likely to violate an auditor’s independence rules and guidelines when the relationship starts to influence the important decisions being made by the auditor. A good example is when an auditor fails to pursue suspicious transactions since they fear of the negative consequences that might accrue to their “friends”.

Question 2

Yes, this situation would have presented an independence “problem” for BDO Seidman. AICPA’s code provides some pointers regarding independence and impeding employment by a given client in which the audit is being performed. The code asserts that independence will be impaired if an individual in a position to influence an audit engagement or a member of an engagement team intends to discuss potential employment with a client. An exemption occurs if the person reports such considerations promptly to an appropriate individual in the firm or removes herself/himself from the engagement until a point where the employment is no longer required, or the offer is rejected.

Question 3

Inventory rollback is usually performed when a firm is retained to perform audit in a company following the year’s end physical inventory. The result yielded by this audit procedure is valid. This is because an auditor uses rollback to verify the cost of sale and purchases records. Through the procedure, it is possible to detect discrepancies between the value of the inventory recorded in the company’s books and the value obtained after the application of the rollback.

Question 4

GAAS asserts that reporting accountants ought to ascertain that there were objective situations and conditions that prompted them to resort to the usage of alternative auditing procedures to ascertain inventory. Jill Karnick should have continued to complete an inventory roll forward. This is based on the fact that she had identified several red flags that would have prompted her to continue with the procedure. The red flags that had been noticed had the ability to have material effect on the records. Cost considerations are a valid factor for auditors to make a decision on an audit procedure, but should not be the only factor of consideration.  It is important for an auditor to determine the relationship between cost involved in obtaining information and usefulness of the obtained information. The matter of expense or difficulty should not be the basis of omitting an audit procedure when there is no an appropriate alternative.

Question 5

Working papers showcase the procedures applied by auditors, the information obtained, tests performed and the conclusions reached. PCAOB asserts that the auditor ought to maintain the working papers whose content should aim at meeting the circumstances of a given engagement. In this case, yes, the inconclusive audit tests should be included. There is a reason why the tests were initiated, and there is also a reason why they were not concluded. This ought to be mentioned so that it does not appear as if there is something fishy going on. Including the inconclusive tests in the work papers helps to bring more insight.

Question 6

“Red flags” involve suspicious transactions that are found in financial statements. The red flags involved in this case included premature press release regarding earnings, allowance of doubtful accounts and anonymous letter received regarding HMI. The red flags should have impacted the need for extensive research while conducting the audit. The financial statements should not have been signed after the anonymous letter was received.

Question 7

  1. In case the auditor notices that a company is not depreciating production plants, large warehouses and other large assets that are likely to bring about material misstatements in the amounts of total assets.
  2. If the auditor identifies that the company is hiding significant amounts of inventory to misstate the financial report intentionally.
  3. When the top executives are miss-reporting large amounts of payroll. This might be an indication of tax evasion or the prospect of increasing profits.

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