(a)The auditors considered Phar-Mor to be an inherently “high risk” client. List several factors at Phar- Mor that would have contributed to a high inherent risk assessment. (b) Should auditors have equal responsibility to detect material misstatements due to errors and fraud? (c) Which conditions, attitudes, and motivations at Phar-Mor that created an environment conducive for fraud could

Question

have been identified as red flags by the external auditors?

What will be an ideal response?

Answer 1

[a] Some of the factors that would have contributed to a high inherent risk assessment include the following:
Phar-Mor was competing in a highly competitive industry (too good to be true).
Phar-Mor was rapidly expanding the number of stores; however, the accounting system was not
keeping pace.
Management was highly motivated to meet budgets and maintain growth.
Previous audits had identified misstatements and system weaknesses.
Phar-Mor was extensively involved with a number of related parties.
Judgment was required for many of the accounting transactions (e.g., Tamco, inventory valuation,
exclusivity payments).
Inventory was a significant account. Physical observation occurred at times other than year-end,
and valuation was based on cost complement.
[b] It is obviously more difficult to uncover frauds because of their intentional nature. Professional
auditing standards around the globe recognize that the function of the auditor is not to prevent and
detect all irregularities or fraud. However, an audit is considered to have the responsibility to act as a
deterrent. Professional standards do require auditors to plan and perform an audit with professional
skepticism and standards require that an audit be designed and conducted to provide a reasonable
assurance of detecting material misstatements (AU-C 240, “Consideration of Fraud in a Financial
Statement Audit”). Interestingly, while international standards and standards of many other countries
have explicitly described auditors’ responsibility for assessing the risk of fraud, the U.S. standards did
not use the word “fraud” until SAS 82 which was issued in February 1997. SAS 82 was superseded by
SAS 99 and the guidance on the auditors responsibility to detect fraud is found in AU-C 240. AU-C
240 requires auditors to have fraud “brainstorming” meetings and to add additional inquiries, as well as
some additional audit procedures related to fraud detection. Auditors are required to document their
assessment of the risk of fraud; and when the risk is high, to tailor the audit plan to address the risk.
The U.S. standards are now similar to standards in Australia, the U.K. and Canada. At the writing of this
edition, the PCAOB has on its agenda a project to further to improve the guidance relative to auditor’s
responsibilities to detect fraud.
[c] Some of the conditions and attitudes at Phar-Mor that made it conducive to the commission of fraud
are provided in the following list.5

Items preceded by a flag appear to have been identifiable “red flags”

to the auditors:
3 Decisions were dominated by one person (Monus).
3 Key executive involved in significant speculation (Monus’ investment in the now defunct World
Basketball League).
Key executive involved in excessive or habitual gambling.
Key executive exhibits greed as evidenced by overwhelming desire for self-enrichment and fame.
3 Key executive is a “wheeler dealer” who enjoys feeling of power, influence, social status, and
excitement associated with financial transactions involving large sums of money.
Key executives had low moral character and lacked personal code of honesty.
Key executive created overly optimistic expectations for the company
3 Significant related-party transactions exist.
An attitude that success is more important than ethics.
3 Rapid expansion of company.
3 Heavy competition experienced.
3 Inadequate internal control system, and/or failure to enforce existing internal controls.
Assets subject to misappropriation (money to WBL and Monus).
3 Inexperienced management. (non-financial management’s participation in accounting and finance)
3 Inventory increases on paper, with empty shelf space.
3 Key executive have close association with suppliers.
Too much trust placed in key employees (Shapira’s hands-off style).
Liberal accounting practices (exclusivity fees booked up front).
Weak internal audit function
Some of the (c) motivations at Phar-Mor that made it conducive to the commission of fraud are listed
below. Items those preceded by a pointing finger appear to have been identifiable “red flags” to the
auditors:
Inadequate profits relative to past performance and budgets.
3 Rapid growth of company.
3 Management job threatened by poor performance.
3 Strong emphasis on earnings growth.
Management believes there is a need to gloss over “temporarily bad situations” in order to maintain
management position and prestige.