Octavia Henry:

CBI Holding Company, Inc. / Case 2.6

October 26, 2008

Brief Description:
The auditing case investigated involved CBI Holding Company, Inc., a New York
based firm, which served as the parent company for several wholly-owned subsidiaries,
principal among them Common Brothers, Inc. CBI’s subsidiaries marketed an extensive
line of pharmaceutical products. CBI’s principal market area stretched from the
northeastern United States into the upper Midwest.
In 1991 Robert Castello, CBI’s president and chairman of the board, sold 48
percent ownership interest in his company to Trust Company of the West (TCW), a
diversified investment firm. The purchase agreement between the two parties gave TCW
the right to appoint two members of CBI’s board; Castello retained the right to appoint
the three remaining board members. The purchase agreement also identified several
so–called “control-triggering events.” If any one of these events occurred, TCW would
have the right to take control of CBI. Examples of control-triggering events included
CBI’s failure to maintain certain financial ratios at a specified level and unauthorized
loans to Castello and other CBI executives.
Several of Castello’s subordinates intentionally misrepresented CBI’s reported
operating results and financial condition for the company’s fiscal years ended April 30,
1992 and 1993. In March 1994, Ernst & young withdrew its opinion on CBI’s 1992 and
1993 financial statements after learning of the material distortions in those statements
that were due to Castello’s fraudulent schemes. A few months later in August 1994 the
company filed for bankruptcy.

Facts and Related Statement of Auditing Standards:

In both 1992 and 1993, Ernst & Young identified the CBI audit as a “close
monitoring engagement.” The accounting firm’s audit manual defined a close monitoring
engagement as “ one in which the company being audited presents significant risk to
E&Y…there is a significant chance that E&Y will suffer damage to its reputation,
monetarily or both.” Control risk factors identified included the dominance of the
company by Robert Castellio, the absence of internal audit function, the lack of proper
segregation of duties, aggressive positions by management regarding key accounting
estimates. The nature of these risks should have rose suspicion in regard to:
• Statement of Auditing Standards 109, Understanding the Entity and Its
Environment and Assessing the Risks of Material Misstatement
• Statement of Auditing Standards 110, Performing Audit Procedures in Response
to Assessed Risks and Evaluating the Audit Evidence Obtained
• SAS 47 Audit Risk and Materiality in Conducting an Audit
During the 1992 and 1993 audits E&Y discovered numerous disbursements
made by CBI in the first few weeks of the next fiscal year that were potential unrecorded
liabilities. The bulk of these disbursements included payments to the company’s vendors
that had been labeled as “advances in the company’s accounting records. CBI personnel
provided the following explanation for these advances when questioned by the auditors.
“When CBI is at its credit limit with a large vendor, the vendor may hold an order until
they receive an ‘advance’. CBI then applies the advance to the existing A/P balance.
E&Y auditors readily accepted the explanation and chose not to record the items as
unrecorded liabilities this was in violation of:
• SAS 1, Due Professional Care in the Performance of Work
This states that the auditor must exercise due professional care in the performance of
the audit and the preparation of the report.
• SAS 106, Audit Evidence
This says the auditor must obtain sufficient appropriate audit evidence by performing
audit procedures to afford a reasonable basis for an opinion regarding the financial
statements under audit.
• SAS 26, Association With Financial Statements
Which states The auditor must either express an opinion regarding the financial
statements, taken as a whole, or state that an opinion cannot be expressed, in the
auditor's report. When the auditor cannot express an overall opinion, the auditor
should state the reasons therefore in the auditor's report. In all cases where an
auditor's name is associated with financial statements, the auditor should clearly
indicate the character of the auditor's work, if any, and the degree of responsibility the
auditor is taking, in the auditor's report.
• SAS 32, Adequacy of Disclosure of Financial Statements
Which says when the auditor determines that informative disclosures are not
reasonably adequate, the auditor must so state in the auditor's report.
• SAS 1, Adherence to Generally Accepted Accounting Principles
States that the auditor must state in the auditor's report whether the financial
statements are presented in accordance with generally accepted accounting principles.
• SAS 99, Consideration of Fraud in a Financial Statement Audit
section 110 , Responsibilities and Functions of the Independent Auditor,
paragraph .02, states "The auditor has a responsibility to plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement, whether caused by error or fraud.
• SAS 85 Management Representations
During an audit, management makes many representations to the auditor, both
oral and written, in response to specific inquiries or through the financial
statements. Such representations from management are part of the audit evidence
the independent auditor obtains, but they are not a substitute for the application of
those auditing procedures necessary to afford a reasonable basis for an opinion
regarding the financial statements.
There were several circumstances that arose during E&Y’s tenure as CBI’s
audit firm such as:
1. when Robert Castello demanded that E&Y remove the audit manager assigned
to the CBI engagement and the audit engagement partner submissively
acquiesced to Castello’s request and replaced the audit manager.
 2. When the new CFO resigned after eight days because of several million dollars
of “grey accounting” and E&Y failed to follow up on the allegation.
3. E&Y’s effort to retain CBI as an audit client after discovering that the 1992 &
1993 audits had been deficient and they did not inform the board of directors of
the flaws in the 1992 &1993 audits.
These actions on the behalf of E&Y appeared to violate:
• SAS 1, Independence
Which states The auditor must maintain independence in mental attitude in all matters
relating to the audit.

Discussion and Analysis:

Understanding CBI’s year-end accounts payable was one of the methods
Castello and his confederates used to distort CBI’s 1992 and 1993 financial statements.
At any point in time, CBI had large outstanding payables to its suppliers, which included
major pharmaceutical manufacturers. At the end of the fiscal 1992 and fiscal 1993, CBI
understated payables due to its large vendors by millions of dollars.

Conclusion and Recommendations:

The accounting gimmicks authorized by Castello allowed him to receive large,
year end bonuses to which he was not entitled for each of those fiscal years. CBI
actively concealed these fraudulent activities from TCW’s management, from TCW’s
appointees to CBI board, and from the company’s Ernst & Young auditors because
Castello realized that the scheme, if discovered, would qualify as a control -triggering
event under the terms of the 1191 purchase agreement with TCW. Several years later in
a lawsuit prompted by Castello’s fraud, TCW executives testified that they would have
immediately seized control of CBI if they had become aware of the scheme.

I would recommend that the audit engagement team follow the following
guidelines in the future:
• Ensure that sufficient competent evidential matter is obtained
• Exercise due professional care and sufficient professional skepticism when
performing an audit.
• Assure that all financial statements are prepared in accordance with GAAP.
• Have industry knowledge of the company you will be auditing.
• Follow the audit review process.
• Maintain Independence at all times

Relation to the week’s learning outcomes:

This case relates to learning outcomes regarding the need for auditors to follow up on
suspicious items discovered during the audit and the impact of client management
efforts to intimidate the auditor on audit quality.