Questions ZZZZ best

1. Do you believe that auditors should be held liable for failing to discover fraud in situations such as

ZZZZ Best, where top management goes to great lengths to fool the auditors? Answer this question

with respect to the ethical and professional responsibilities of audit professionals when conducting an

audit.

Auditors should be held liable for failing to plan and perform the audit to discover material fraud. There were

many red flags that the auditors could have observed and been tipped off to the fraud. The amount and type of

restoration work by ZZZZ Best defied common sense. The auditors could have done a reasonableness test by

determining the amount of square footage under restoration in the area; the newspapers coverage of the

occurrences; and how much market share ZZZZ Best had of the work. Also all the water damages on the

restoration contracts were on top floors but there were not any damages on the lower floors. Most important, the

auditors never looked at construction contracts, abatement issues, and whether ZZZZ Best had the necessary

permits to do the work. To say the auditors failed to exercise professional skepticism is an understatement.

The auditors should have been liable for signing a confidentiality agreement that was a limitation of scope. The

auditors had an obligation to conduct the audit with integrity, objectivity, skepticism, independence, due care

and with competence. Objectivity requires that an auditor should be skeptical and obtain independent evidence

to verify information from the client. Ernst & Whinney failed to meet this obligation when they did not require

corroboration of the insurance restoration contracts from independent third parties. When Ernst & Whinney

resigned from the audit engagement, they had a professional obligation to disclose the reason for the

withdrawal.

2. Discuss the red flags that existed in the ZZZZ Best case and evaluate Ernst & Whinney’s efforts with

respect to fraud risk assessment. Do you think Ernst & Whinney’s relationship with ZZZZ Best

influenced risk assessment and the work done on the audit?

The red flags include rapid growth, kiting of bank transfers, cohorts confirming insurance restoration jobs,

consistency of all the invoices, extravagant life style, a bigger than life founder, cash flow problems, and

problems meeting loan payments.

Ernst & Whinney did not want to lose ZZZZ Best as an audit client; after all Barry Minkow was the wiz kid on

Wall Street. In his book, Clean Sweep: The Inside Story of the Zzzz Best Scam... One of Wall Street's Biggest
Frauds, Minkow discusses having parties with partners and managers of Ernst & Whinney and inviting their

wives. He knew that the wives would talk about what a nice young man Barry was. Being in awe of Minkow

and his company, the audit firm did not maintain objectivity and skepticism. The audit firm did not

independently verify the insurance contracts, restoration work, revenue sources, all of which were high risk

items for ZZZZ Best.

3. These are selected numbers from the financial statements of ZZZZ Best for fiscal years 1985 and 1986:

1985 1986

Sales $1,240,524 $4,845,347

Cost of goods sold 576,694 2,050,779

Accounts receivable 0 693,773

Cash 30,321 87,014

Current liabilities 2,930 1,768,435

Notes payable— 0 780,507

current

What calculations or analyses would you make with these numbers that might help you assess whether the

financial relationships are “reasonable”? Given the facts of the case, what inquiries might you make of

management based on your analysis?

Between 1985 and 1986 there is a 390% increase in Sales and 350% increase in Cost of goods sold. The auditors

should question the increase in accounts receivable, which was 33% of sales and represents four months on an

annualized basis. The auditors should question where the cash is from the collection of sales (Sales of $4,845

less A/R of $693 less Cost of goods sold of $2,050). The company should have approximately $2 million to pay

down liabilities or invest in assets. With the cash flow with borrowings of current liabilities and notes payable,

the company had approximately $6.5 million before paying cost of goods sold or approximately $4.5 to pay

down liabilities or invest in the company, yet cash only increased $50,000 for the year. Where was the cash

used?

4. What factors do you think motivated Minkow to return to his evil ways after becoming a respected

member of the community following his release from prison in the ZZZZ Best fraud?

Minkow may have enjoyed being the center of attention and being admired for his business acumen. He may also
have enjoyed thinking that he out-smarted people. Or as the case said he may have missed the adrenalin rush of

committing fraud. Whatever the reason, Minkow must have thought he could get away with fraud a second time.

Perhaps Minkow believed having been a preacher and helped the government by utilizing his fraud identification

skills, he had built up trust that never existed before and he could use it to his advantage.

5. Using Kohlberg’s stages of moral development, how would you characterize Minkow’s actions after

being released from prison in the ZZZZ Best fraud? Explain the effects of Minkow’s actions on the

stakeholders who relied on him to act in a professional manner.

After being released from prison, Minkow took a position as senior pastor of a church. Minkow was being

egoistical and enjoyed the attention of his congregation. He was trying to reason at stage 5, social contract, but

that didn’t last long. He violated the trust placed in him by the community when he admitted to the congregation

of no longer being “beyond reproach.” His efforts with the Fraud Discovery Institute while seemingly designed

to help others, a stage 4 or 5 approach to decision-making, ultimately brought back the old feelings of “I can do

whatever I want without checks on my behavior.” Minkow’s pursuit of self-interests motivated his unethical

actions in the Lennar case and he reverted back to a stage 2 way of thinking and acting.