CASE 1.

AMRE, INC.

Synopsis

During the mid-1980s, AMRE, Inc., was a rapidly growing company in the competitive
home siding industry. In 1987, the company went public and immediately began to fall short of
optimistic revenue and profit projections made by its executives. To prevent the companys stock
price from declining, AMREs executives began misrepresenting the companys operating results
and financial condition in its periodic financial statements. Among the principal means used by
the executives to distort AMREs financial status was overstating deferred advertising costs and
inflating inventory. AMREs executives convinced the firms independent auditors to bypass
EDP tests that might have uncovered the overstatement of deferred advertising costs and also
persuaded the auditors to limit their inventory observation procedures.
In March 1989, AMRE hired Mac Martirossian, a former manager with their audit firm, to
serve as the companys chief accounting officer. Shortly after hiring Martirossian, AMREs
executives revealed their fraudulent scheme to him. Martirossian insisted that AMREs
accounting records be immediately corrected. The executives involved in the fraud acquiesced to
his demands but refused to publicly disclose their fraudulent scheme by issuing corrected
financial statements for the affected years. Instead, the errors were largely eliminated through the
preparation of year-end adjusting entries. When AMREs auditors questioned these adjustments,
Martirossians superiors provided false explanations for the adjustments in the presence of
Martirossian, who remained silent. Martirossian was uncomfortable with misleading the auditors
and eventually arranged a secret meeting with them. During this meeting, Martirossian subtly
hinted that AMREs accounting records had been manipulated. However, the auditors failed to
grasp what Martirossian was attempting to communicate to them and thus failed to learn the true
nature of the large period-ending adjustments.
In 1990, the SEC began an investigation of AMREs financial statements for the previous
few years. Ultimately, each of the executives who participated in the fraud was sanctioned by the
SEC. The SEC was especially critical of Martirossian for his silent role in the fraud. The SEC
also sanctioned the audit partner and audit manager who had been assigned to the AMRE
engagements for failing to comply with generally accepted auditing standards.

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2 Case 1.1 AMRE, Inc.

AMRE, Inc.--Key Facts

1. AMRE, Inc., was a rapidly growing company in a very competitive industry.

2. AMRE routinely capitalized advertising expenditures related to "unset leads."

3. After going public in 1987, AMRE's financial results fell short of earlier projections, which
prompted company executives to begin inflating AMRE's earnings.

4. AMRE executives persuaded their auditors, Price Waterhouse, to eliminate selected audit
tests and to reduce the scope of other tests.

5. In the spring of 1989, AMREs top executives revealed their fraudulent scheme to the
companys new chief accounting officer, Mac Martirossian, a former Price Waterhouse manager.

6. Near the end of fiscal 1989, AMREs executives decided to correct the companys accounting
records, principally with several large adjustments during the fourth quarter of that year.

7. During Price Waterhouses 1989 AMRE audit, Martirossian met secretly with the auditors
and suggested to them that the large fourth-quarter adjustments did not pass the "smell test."

8. The Price Waterhouse auditors failed to grasp what Martirossian was suggesting and thus
did not discover the true nature of the fourth-quarter adjustments.

9. Martirossian and other AMRE executives signed a letter of representations indicating that
they were not aware of any irregularities in the companys 1989 financial statements.

10. The SEC ruled that the audit engagement partner and the senior audit manager who oversaw the
annual AMRE audits had failed to comply with GAAS during the 1988 and 1989 engagements.

2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from
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 Case 1.1 AMRE, Inc. 3

Instructional Objectives

1. To stress the importance of auditors maintaining a high degree of skepticism when dealing with
client executives who have strong incentives to manipulate their company's financial statements.

2. To emphasize the hazards of allowing a client to influence key audit planning decisions.

3. To illustrate the potential for abuse of the percentage-of-completion accounting method.

4. To illustrate the critical importance of auditors remaining strictly independent of their clients.

5. To demonstrate the need for auditors to test a client's EDP controls and to consider the
resulting implications for year-end substantive audit procedures.

6. To demonstrate the SECs willingness to impose sanctions on private accountants for failing
to satisfy their ethical and professional responsibilities.

7. To examine the auditors responsibility for quarterly financial data included in a clients
audited financial statements.

Suggestions for Use

This case could be assigned during coverage of the AICPAs Code of Professional Conduct.
One of the most important aspects of this case, in my view, is Martirossians role in the cover up
of the fraud. This case clearly demonstrates that even an individual with integrity may not
respond appropriately to an ethical dilemma. I believe that it is important for instructors to point
out to students that they may face these types of situations during their careers and, consequently,
should have a strategy for coping with such scenarios.
Since a major focus of this case is management fraud, the case could be assigned during
classroom discussion of auditors responsibilities for uncovering fraudulent misrepresentations. In
addition, this is another case that could be used during the first week of an auditing course to
acquaint students with the nature of the independent audit function and the problematic
circumstances that auditors often encounter. This case is also well suited for discussion during
classroom coverage of audit evidence. Key features of this case include Price Waterhouses failure to
obtain sufficient competent evidence to corroborate AMREs deferred advertising costs and the weak
evidence collected to support the large write-offs recorded by AMRE during fiscal 1989.

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4 Case 1.1 AMRE, Inc.

Suggested Solutions to Case Questions

1. Generally, ethics refer to moral principles and values. Random House Websters College
Dictionary notes that ethics are the rules of conduct recognized in respect to a particular class of
human actions or governing a particular group, culture, etc. An individual's ethics generally define

what that individual believes to be right and wrong. Professional ethics are typically expressed
by a code of conduct adopted by an organization that represents a profession. Professions adopt
such codes to encourage moral conduct among their members.

Following is a list of the individuals involved in the AMRE case:

Robert Levin, Chief Operating Officer

Dennie Brown, Chief Accounting Officer
Walter Richardson, Vice President of Data Processing
Steven Bedowitz, Chief Executive Officer
Mac Martirossian, Chief Financial Officer
Edward Smith, audit engagement partner
Joel Reed, senior audit manager

My experience has been that students differ markedly in their assessments of the ethics of
these individuals. In particular, students generally have difficulty arriving at a consensus
assessment of Martirossians conduct in this case. I believe that the lively debate typically
produced by this exercise is healthy for students since such debates allow them to begin
developing or "fleshing out" their attitudes regarding important ethical issues and concepts.

2. The executives involved in the AMRE fraud agreed in a consent order to refrain from
violating federal securities laws in the future. In addition, Robert Levin and Dennie Brown
forfeited funds they realized from sales of AMRE stock during the fraud. Levin also paid $1.8
million to the federal government, including a $500,000 fine for insider trading. Finally, Levin
and Steven Bedowitz contributed approximately $9 million to a settlement pool to resolve a large
class-action lawsuit. Most students conclude that the AMRE executives who participated in the
fraud were appropriately punished. Their actions were motivated by greed and self-interest and
they paid a heavy price for their indiscretions.
The two auditors involved in this case, Edward Smith and Joel Reed, were prohibited from being
assigned to audits of SEC registrants for nine months. Again, students typically find that this
punishment was appropriate given the apparent mistakes made during the AMRE audits. These
mistakes included failing to adequately test the computerized lead bank, allowing AMRE personnel
to observe certain inventory sites, accepting client explanations without applying sufficient audit
procedures, and failing to require the client to disclose large and suspicious period-ending accounting
2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from
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 Case 1.1 AMRE, Inc. 5
adjustments in the financial statements.
The SEC issued a separate enforcement release criticizing Martirossian for his failure to take
appropriate measures upon learning about the fraud. Students frequently disagree with the SECs
criticism of Martirossian. Many of them view him as an ethical person who just happened to be
in the wrong place at the wrong time. It is important to point out to students that it is not unusual
for accountants to find themselves in these types of ethical dilemmas. Martirossians experience
provides an excellent example of the potential consequences an accountant may face if he or she
violates the Code of Professional Conduct.

3. Among the alternative courses of action available to Martirossian were the following:

a. Aid in the cover up of the fraud.

b. Demand that the executives involved disclose the fraud to the auditors. If they refused
to comply, report the fraud to the SEC.
c. Report the fraud to the auditors and to the Board of Directors immediately.
d. Secretly report the fraud to the auditors.
e. Resign his position with AMRE, Inc.

Probably the best course of action for Martirossian would have been to demand that the
executives disclose the fraud to the auditors. If they refused, Martirossian should have
considered disclosing the fraud directly to the SEC. This action would have resulted in
Martirossian upholding his professional responsibilities as a CPA. Although he may have lost his
job, he would have avoided being sanctioned by the SEC. Most important, this course of action
would have prevented innocent parties, such as potential AMRE investors and creditors, from
being harmed by the fraudulent scheme.

4. The relevant accounting concept in this context was the matching principle. The matching
principle requires that expenses be matched with the revenues they produce. A cost can be deferred--
treated as an asset--when it is expected that the cost will produce future economic benefits
(generally, revenue). It seems reasonable that a portion of AMREs advertising costs benefited
future periods and, thus, could be appropriately deferred. Nevertheless, AMREs policy of
deferring all of the advertising costs related to unset leads was very aggressive and probably
resulted in the booking of assets that would provide no future benefits for the company.

5. Listed next are key audit risk factors that were present during the 1988 and 1989
AMRE audits.

a. AMRE's management had a strong incentive and desire to maintain the company's stock
price at a high level.
b. AMREs unset leads increased dramatically during 1988.
c. The companys inventory also increased significantly during 1988 and increased much
more rapidly than the companys sales.
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6 Case 1.1 AMRE, Inc.

d. The efforts of AMREs executives to influence important audit planning decisions

should have been of concern to the auditors.
e. The percentage-of-completion accounting method was an unusual method to apply to
AMREs installation jobs since those jobs typically required only four to ten days to
complete.
f. AMRE had several large and unusual fourth-quarter adjusting entries in 1989.
g. Martirossians secret meeting with the AMRE auditors should have caused them to
question the integrity of the clients financial statements.

When taken together, these items suggest that the overall audit risk for the AMRE audits was
relatively high. Most of these risk factors were discovered by Price Waterhouse or were apparent
to the audit firm. For example, the audit planning memo for the 1988 audit identified the large
increase in inventory as a key risk factor and called for an increase in the number of inventory
observation sites. Likewise, the AMRE audit partner originally requested that the company
disclose the large period-ending adjustments in its 1989 10-K.
Although the auditors identified these risk factors, it appears that they failed to adequately
consider them during the performance of fieldwork. For example, company executives
convinced the auditors to allow client personnel to observe several of the inventory sites selected
for observation at the end of 1988. During the 1989 audit, client management persuaded the
auditors not to require disclosure of the large fourth-quarter adjustments in AMREs financial
statements. Why did the auditors apparently defer to AMREs executives in several situations
and fail to adequately question their decisions in others? Possibly, the auditors simply succumbed
to client pressure in each of these instances. During the 1989 audit, the auditors may have relied
too their detriment on Martirossian, a former colleague, to inform them of any major problems in
AMREs financial statements.

6. Whether Price Waterhouse was justified during the 1988 audit in agreeing to allow client
personnel to observe the physical counts at certain inventory sites is a matter of professional
judgment. Apparently, members of the audit team did not believe that the clients request posed a
major problem--that is, did not result in a material scope limitation, otherwise they would not
have agreed to it.
Client management should not be allowed to influence key audit decisions such as sample
size determinations, assignments of auditors to given areas of the audit, and the types of audit
tests applied to specific accounts. Generally, any time a client request would prevent an auditor
from satisfying the requirements of the third standard of fieldwork--obtaining sufficient
competent evidential matter to support his or her audit opinion, that request should be denied.

7. Note: the relevant U.S. auditing standards presently for audits of public companies are those
issued/endorsed by the Public Company Accounting Oversight Board (PCAOB). Although SAS No.
31 has been superseded by a new standard issued by the Auditing Standards Board, the PCAOB still
endorses the regime of management assertions included in that standard. In particular, the SAS No.
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 Case 1.1 AMRE, Inc. 7
31 list of management assertions is now embedded in Auditing Standard No. 15 issued by the
PCAOB.
In most situations, the key management assertion for an expense item is the completeness
assertion. That is, auditors are generally concerned that a client may attempt to understate
expenses. However, in this case the fourth-quarter write-offs in 1989 were initiated by AMRE
management. When management voluntarily recognizes a large and unusual expense item, an
auditor may want to consider the possible motives underlying managements decision. Certainly,
an auditor in such a case will want to investigate the completeness assertion, but the
existence/occurrence assertion should also be examined by the auditor in such circumstances. In
recent years, many large firms have taken big bath write-offs to improve their chances of
returning to a profitable or more profitable position in the near future.
In fact, the management assertion of most concern to Price Waterhouse regarding the 1989
fourth-quarter write-offs may have been the presentation and disclosure assertion. This
assertion addresses whether particular components of the financial statements are properly
classified, described, and disclosed (AS No. 15, paragraph 11). The large year-end adjustments
that resulted in AMRE reporting a net loss for 1989 were clearly not adequately described in the
companys financial statements.

8. Listed next are the key responsibilities an auditor assumes for quarterly financial
information included in the footnotes to a client's audited financial statements. Refer to AU
Section 722 for a more detailed discussion of these responsibilities.

a. The auditor should apply review procedures to the interim financial information. (Such
procedures consist principally of inquiries of client personnel and analytical procedures.)
b. The auditor should ensure that the quarterly data are presented as supplementary
information and that each page of the data is clearly marked as unaudited.
c. If the results of the review procedures are satisfactory, the auditor does not need to modify
his or her report on the audited financial statements to make reference to the review of the
interim financial information. However, if the interim financial information does not appear
to be in conformity with generally accepted accounting principles, including adequate
disclosure, the auditors report should generally be expanded to address this issue.
[Note: See AU 722.50b for an exception to the latter general requirement.]

2013 Cengage Learning. All Rights Reserved. This edition is intended for use outside of the U.S. only, with content that may be different from
the U.S. Edition. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.