Star Technologies, Inc. Audit Case Study

Star Technologies, Inc.

        This Virginia-based computer manufacturer found itself trapped in its industry’s short product life cycle. The company incurred heavy Research and Development expenditures to develop new products, only to have those products soon become obsolete. Management began tampering with the company’s accounting records to conceal its deteriorating financial condition.

Fallen Star

By the end of fiscal 1989, Star faced a financial crisis. Because of changes in computer technology and a slowdown in petroleum exploration activities, Star sold one out of 29 products on 1989 and had no outstanding sales order for the product at year end. The poor operating resulted to violation of several covenants of a lending agreement within its principal bank accelerating the maturity date of the loan amounted to $5.8 million long term loan making it immediately due and payable at the end of fiscal 1989 Several issues arose between Price Waterhouse who audited the Star`s financial statements and Star`s management.

Several issues were refusal to

• classify the loan as current liability,
• disagreements of the adequacy of Star`s reserves for bad debts and inventory obsolescence, and the
• Capitalization of R&D expenditures by the company.

Eventually, Price issued an unqualified opinion on financial statement to resolve the issues.

In January 1990, Price Waterhouse national police`s received a letter alleging that audit of Star was an “audit failure”

Price informed Star that those FS contained material error, and later accepted that decision and issued restated FS on 1989.

Price Waterhouse’s 1989 Audit of Star Technologies

        Clark Childers, an audit partner with Price Waterhouse served as the engagement partner on the annual audits of Star`s FS led by Paul Argy, a senior audit manager.

Throughout the audit, he clashed with client management over several accounting and financial reporting issues so Star`s management demanded to removed Argy from the audit.

The disagreements between the Price Waterhouse auditors and client executives during inventory obsolescence, the reserve for bad debts, certain “mystery assets” included in Star’s accounting records, and the balance sheet classification of a large note payable.

Research and Development Expenditure

Star advanced nearly $900,000 to Glen Culler & Associates. Star’s management maintained the advance qualified as a note receivable and included it in “other” assets on Star’s 1989 balance sheet.

Childers questioned it because according to him, it should be written off as R&D expense. Childers and Angry discovered that Star’s FS footnotes that, at a minimum, $400,000 of the $900,000 advanced to Culler had been treated as R&D expense by Star. Childers stated that written off of $400,000 has immaterial effects on FS.

Reserve for Inventory Obsolescence

Star reduced the value of ST-100 to net book value of $2M and Childers thinks that it is still overvalued and should be $500,000 which was refused by Star.

Reserve for Bad Debts

        Allowance for bad debts before adjustments was recorded as $673,000 but Argy believed that it should be increased by $400,000.        

Mystery Assets

Price Waterhouse discovered an account “Assets in Process” of $435,000 of computer equipment purchased and placed in service in 1985. Star could not provide invoices or other documentation to support the existence of the assets and depreciation. Star could not locate and describe the asset and depreciation

The staff auditor reasoned that it should have been fully depreciated by the end of fiscal 1989. Argy agreed and concluded that it should be written off to expense. CFO refused and offered to record $100,000 of depreciation expense and write off the $335.000 cost over the following four years. Childers accepted the CFO proposal.

Classification of Notes Payable

Star’s poor operating results for fiscal 1989 resulted in the company violating seven debt covenants included in the loan agreement with its principal bank. These debt covenant violations caused a $5.8 million bank loan to be immediately due and payable, as note earlier. Star classify the note as long term note despite of the violation but Childers disagreed and believe the $5.8 million loan qualified as long-term liability because the bank stated that it had no intention of making the loan immediately due and payable.

Where was Argy?

        Paul argy left the Star audit engagement approximately one week before the 1989 audit was completed to begin work on a new assignment in another city. On July 10, more than ten days after Childers issued the unqualified opinion of Star’s 1989 FS, Argy returned to Price Waterhouse’s Washington, D.C.. Childers instructed him to complete his review of the work papers and to sign off on the audit summary for the engagement. Argy refused to sign off on the Star audit due to several questionable decisions made by Childers in 1989 Star’s FS, it contained “materially incorrect conclusions. After several confrontations with Childers, Argy capitulated and signed off on the Star work papers and the audit summary.

Star’s amended 1989 income statement reported a net loss of $7.4 million rather than the $4.4 million loss originally reported. On March 28, 1990, PWH issued unqualified audit opinion on Star’s restated 1989 financial statements. One week later, Star dismissed PWH and retained Coopers & Lybrand as its independent audit firm.

After SEC’s investigation, Argy received 18 months suspension from practicing before SEC while Clark Childers received a five-year suspension.

SEC criticizes Argy for allowing desire to be promoted to cloud professional judgement.  

Following are the specific allegations of misconduct that the SEC filed against Childers.

1. Failing to ensure that sufficient competent evidential matter was obtained to afford a reasonable basis for his conclusions.
2. Failing to exercise due professional care and sufficient professional scepticism in the performance of the audit.
3. Failing to assure that the financial statements on which Price Waterhouse issued an unqualified opinion were prepared in accordance with GAAP.
4. Responding without an adequate basis to the questions of the second partner reviewer when issues were raised about the agreement with Culler.
5. Instructing argy to sign off on-the audit regardless of Argy's stated disagreement with the conclusions reached by Childers.
6. Making misleading statements to the Price Waterhouse national office concerning its investigation of Star's agreement with Culler
7. Instructing a Price Waterhouse audit manager to make inappropriate alterations to workpapers.

Star tech’s financial condition steadily worsened in the year’s following its unpleasant encounter with SEC.  The company’s computer manufacturing operations never became economically viable. At last report, the company had fewer than 2 dozen employees and its principal line of business was the development of computer software.

QUESTIONS
        1.Review Star Technologies’ FS included in Exhibit 2 and 3. What changes in Star’s financial status between fiscal year-end 1988-1989 should have been of concern to the company’s independent auditors? How should these changes have affected key audit planning decisions for the 1989 star audit?