Case 1 â Hamilton Corporation Overview Hamilton Corporation (theCompany) is a multinational auto parts supplier headquartered inthe Midwest. Hamilton began its operations as a wholly ownedsubsidiary of Motor Company (MC), and was ultimately spun off andincorporated in 1999. Shortly after the separation, MC informedHamilton that the Company owed an estimated $350 to $800 million inwarranty claims related to automotive sales that had occurred priorto the separation in 1999. Hamiltonâs management team believed thatany warranty claims related to sales prior to the separation shouldbe limited to the reserve amount that was agreed to at the time ofseparation. However, because MC remained Hamiltonâs largest client,the management team was motivated to find a solution that wouldappease MC. As a direct result, the management team at Hamiltonworked hard to convince MC to cap warranty claims related to priorautomotive sales at $100 million. Unfortunately, MC rejected theidea and instead continued to assert the full warranty claimagainst Hamilton. Recognizing that the Company could not afford tomake warranty payments in excess of $100 million without asignificant reduction in operating income, management hadsignificant incentives to mask the true level of warranty expensein order to meet analystsâ forecasts. Damaged Goods The managementteam at Hamilton fully understood that the Companyâs performance inits first several quarters was vital to the long-term success ofthe Company. Because the marketplace often views spin-offs asâdamaged goodsâ in the early stages, the demonstration ofimpressive financial results, right away, was believed to beimperative to the Companyâs ability to raise future capital.Management quickly realized that a series of challenges existedthat were likely to prevent the Company from reporting favorableresults in its first several quarters of operation as a stand-aloneentity. To start, management believed that the warranty claimsasserted by MC had the potential to cripple the Company. Inaddition, management had to address a sharp and unexpected drop inautomotive demand that affected its sales volume during the sametime period. Unwilling to report adverse results and risk theCompanyâs ability to continue as a going concern, management madethe decision to report favorable results, no matter what. WarrantyClaims Faced with mounting pressure from the warranty claimsasserted by MC, management increased Hamiltonâs warranty reserve by$112 million during the second quarter of 2000. The increase inwarranty reserve should have been charged as an expense under GAAPsince the company Hamilton did not have a written agreement statingthat the claims reflected a correction to its 1999 spin- offagreement with MC. However, in an effort to limit the effect onreported net income, management booked the entry directly toretained earnings as a net adjustment to the spin-off transaction.In so doing, management failed to reveal the true nature of thecharge to investors. As deliberations with MC continued throughout2000, Hamilton eventually agreed to settle 27 warranty claims for atotal of $237 million in the third quarter. Recognizing thatanother spin-off related adjustment to retained earnings mightraise a red flag, management developed a more elaborate accountingscheme to mitigate the effects of the additional warranty claims onnet income. To do so, management decided to focus on thesubjectivity that existed in the determination of pension expense.More specifically, management determined that if it revisedassumptions used in determining pension expenses prior to thespin-off, the payment to MC could be disguised primarily as aâtrue-upâ of the pension liability. To support this scheme,management obtained a letter from the Companyâs actuary thatprovided the âreasonable rangeâ for pension assumptions that hadbeen made in the past. Management then deliberately selected a newpoint estimate within each range to make it appear that the Companyactually owed MC $202 million for its past pension liabilities.Additionally, management convinced MC to allow the meeting minutesbetween the two companies to reflect an erroneous discussion ofpast pension estimates to further support the unfounded pensionloss claim. As a result, management was able to book $202 of the$237 million warranty settlement as an actuarial loss in itspension plan. Only the remaining $35 million was recognized asadditional warranty expense in the financial statements.Off-Balance Sheet Financing As the end of 2000 was drawing near,management decided to take additional actions to boost reportedearnings. Specifically, Hamilton devised a scheme to remove $200million of high-value precious metals inventory (used in theproduction of auto parts) from the balance sheet through acollateralized loan agreement with Culpepper Bank late in 2000.According to the agreement, which was deliberately designed tomislead balance sheet readers, Hamilton would receive the cashproceeds of the sale, but was then required to buy the inventoryback from the bank 30 days later for the original purchase priceplus $3.5 million in interest. Prior to executing the agreement,Hamiltonâs auditor advised the Company that the transaction couldonly be accounted for as a sale and repurchase under GAAP if bothprices were based on market, and the transaction costs did notinclude Culpepper Bankâs interest costs. Hamilton agreed to theconditions set forth by the auditor and then made sure that theform of the transaction would meet the auditorâs conditions. Toconvince the auditor that the financing transaction qualified as asales and repurchase agreement under GAAP, management created falsedocuments including a memo that provided Hamiltonâs rationale forthe below market prices for the sale of inventory under theagreement. The memo stated that the below market prices weresupported by large volume discounts and one-month future prices ofmetals â neither of which were justified by the actual market data.However, the analysis was elaborate and management convinced theauditors that the transaction qualified as a sale and repurchaseagreement under GAAP. Almost concurrently, Hamiltonâs managementused a very similar strategy to remove an additional $70 million ofbatteries and generators from its reported inventory balance. SinceHamilton used LIFO, each of these liquidating transactions allowedHamilton to artificially boost net income with LIFO liquidationgains that were improperly realized under GAAP with the sale andrepurchase transactions. Fraud Discovery Initially, managementoverstated net income by $69 million in booking the warranty claimsadjustment to retained earnings and then improperly increased netincome by an additional $130 million through its treatment of thesubsequent warranty claims settlements with MC. In addition, due tothe LIFO gains realized with the fourth quarter inventorytransactions, Hamilton recognized an additional $81 million dollarsto its bottom line. Taken together, the misstatement totaledapproximately $280 million dollars in 2000. As noted, managementâsfinancial statement fraud was not limited to a single transaction.Rather each time that pressure existed to meet market expectations,management appeared to devise a scheme to boost net income. Theschemes were supported by skillfully crafted evidence provided tothe auditor by the management team. In the end, it was awhistleblower, believed to be from a vendor involved in afraudulent transaction, which objected to the Companyâs inaccuratereporting of a specific transaction that turned management into theSEC. The ensuing SEC investigation uncovered the full extent ofmanagementâs wrongdoings over a four-year period of time. CaseQuestions 1.Based on your understanding of fraud risk assessmentand the case information, identify at least three specific fraudrisk factors related to Hamilton Company. 2.If you were responsiblefor planning the audit of Hamilton Company, how would the fraudrisk factors identified in question #1 have influenced the nature,timing, and extent of your audit work? 3.Please consider the fivesteps of the KPMG Judgment Framework. For each step, thinkcarefully about what the auditors could have done to help detectthe fraudulent activity related to the warranty reserve account atHamilton Company. Please use the following questions to guide yourcritical thinking about this case: a)Clarify the issues and theobjectives related to auditing the warranty reserve account atHamilton. To do so, please ask yourself what specific problem needsto be solved by the auditor? What assumptions would have thebiggest impact on the overall judgment to be made? How does thisjudgment relate to the overall audit process? b)Consider thevarious alternatives that should be thought about when auditing thewarranty reserve account at Hamilton. To do so, please ask yourselfabout each of the alternatives that are reasonably possible, evenwhen they might contradict the clientâs point of view. Are thereany external factors that should be considered? c)Consider the typeof information and evidence that should be gathered when completingthe audit of the internal control activities related to thewarranty reserve account at Hamilton. To do so, please ask yourselfabout the type of information that would be helpful to determinewhether the internal control activities were operating effectively.How can you be sure that the information gathered is reliable? Inaddition, how can you be sure that the evidence is appropriate inthis situation? Finally, what evidence could be gathered that mightreveal that the internal controls were NOT operating effectively?d)Consider the type of information and evidence that should begathered when completing the substantive testing procedures relatedto the warranty reserve account at Hamilton. To do so, please askyourself about the type of information that would be helpful todetermine whether the warranty reserve account was fairly stated inthe financial statements. How can you be sure that the informationis reliable? In addition, how can you be sure that the evidence isappropriate in this situation? Finally, what evidence could begathered that might disconfirm your belief that the warrantyreserve account was fairly stated? e)Consider the factors thatwould have to be thought about when reaching a final conclusionabout the warranty account at Hamilton. Although you do not haveaccess to the actual evidence, what âbig pictureâ issues would haveto be thought about before reaching a final conclusion? Finally,what could possibly go wrong in this situation? f)Consider theimportance of documenting the rationale for your final conclusion.Why do you think it is important to document your rationale whenfinalizing your judgment? In addition, describe what is expected tobe documented to support an auditorâs professional judgment.4.Describe the availability tendency in your own words, and give anexample of how the tendency could result in a lack of auditeffectiveness. How can the tendency be mitigated? 5.Describe theconfirmation tendency in your own words, and give an example of howthe tendency could result in a lack of audit effectiveness. How canthe tendency be mitigated? 6.Describe the overconfidence bias inyour own words, and give an example of how the bias could result ina lack of audit effectiveness. How can the bias be mitigated?7.Describe the anchoring bias in your own words, and give anexample of how the bias could result in a lack of auditeffectiveness. How can the bias be mitigated? 8.What tendency orbias is most likely to have manifested in the Hamilton caseexample? Please provide support for your answer.
Case 1 â Hamilton Corporation Overview Hamilton Corporation (theCompany) is a multinational auto parts supplier headquartered inthe Midwest. Hamilton began its operations as a wholly ownedsubsidiary of Motor Company (MC), and was ultimately spun off andincorporated in 1999. Shortly after the separation, MC informedHamilton that the Company owed an estimated $350 to $800 million inwarranty claims related to automotive sales that had occurred priorto the separation in 1999. Hamiltonâs management team believed thatany warranty claims related to sales prior to the separation shouldbe limited to the reserve amount that was agreed to at the time ofseparation. However, because MC remained Hamiltonâs largest client,the management team was motivated to find a solution that wouldappease MC. As a direct result, the management team at Hamiltonworked hard to convince MC to cap warranty claims related to priorautomotive sales at $100 million. Unfortunately, MC rejected theidea and instead continued to assert the full warranty claimagainst Hamilton. Recognizing that the Company could not afford tomake warranty payments in excess of $100 million without asignificant reduction in operating income, management hadsignificant incentives to mask the true level of warranty expensein order to meet analystsâ forecasts. Damaged Goods The managementteam at Hamilton fully understood that the Companyâs performance inits first several quarters was vital to the long-term success ofthe Company. Because the marketplace often views spin-offs asâdamaged goodsâ in the early stages, the demonstration ofimpressive financial results, right away, was believed to beimperative to the Companyâs ability to raise future capital.Management quickly realized that a series of challenges existedthat were likely to prevent the Company from reporting favorableresults in its first several quarters of operation as a stand-aloneentity. To start, management believed that the warranty claimsasserted by MC had the potential to cripple the Company. Inaddition, management had to address a sharp and unexpected drop inautomotive demand that affected its sales volume during the sametime period. Unwilling to report adverse results and risk theCompanyâs ability to continue as a going concern, management madethe decision to report favorable results, no matter what. WarrantyClaims Faced with mounting pressure from the warranty claimsasserted by MC, management increased Hamiltonâs warranty reserve by$112 million during the second quarter of 2000. The increase inwarranty reserve should have been charged as an expense under GAAPsince the company Hamilton did not have a written agreement statingthat the claims reflected a correction to its 1999 spin- offagreement with MC. However, in an effort to limit the effect onreported net income, management booked the entry directly toretained earnings as a net adjustment to the spin-off transaction.In so doing, management failed to reveal the true nature of thecharge to investors. As deliberations with MC continued throughout2000, Hamilton eventually agreed to settle 27 warranty claims for atotal of $237 million in the third quarter. Recognizing thatanother spin-off related adjustment to retained earnings mightraise a red flag, management developed a more elaborate accountingscheme to mitigate the effects of the additional warranty claims onnet income. To do so, management decided to focus on thesubjectivity that existed in the determination of pension expense.More specifically, management determined that if it revisedassumptions used in determining pension expenses prior to thespin-off, the payment to MC could be disguised primarily as aâtrue-upâ of the pension liability. To support this scheme,management obtained a letter from the Companyâs actuary thatprovided the âreasonable rangeâ for pension assumptions that hadbeen made in the past. Management then deliberately selected a newpoint estimate within each range to make it appear that the Companyactually owed MC $202 million for its past pension liabilities.Additionally, management convinced MC to allow the meeting minutesbetween the two companies to reflect an erroneous discussion ofpast pension estimates to further support the unfounded pensionloss claim. As a result, management was able to book $202 of the$237 million warranty settlement as an actuarial loss in itspension plan. Only the remaining $35 million was recognized asadditional warranty expense in the financial statements.Off-Balance Sheet Financing As the end of 2000 was drawing near,management decided to take additional actions to boost reportedearnings. Specifically, Hamilton devised a scheme to remove $200million of high-value precious metals inventory (used in theproduction of auto parts) from the balance sheet through acollateralized loan agreement with Culpepper Bank late in 2000.According to the agreement, which was deliberately designed tomislead balance sheet readers, Hamilton would receive the cashproceeds of the sale, but was then required to buy the inventoryback from the bank 30 days later for the original purchase priceplus $3.5 million in interest. Prior to executing the agreement,Hamiltonâs auditor advised the Company that the transaction couldonly be accounted for as a sale and repurchase under GAAP if bothprices were based on market, and the transaction costs did notinclude Culpepper Bankâs interest costs. Hamilton agreed to theconditions set forth by the auditor and then made sure that theform of the transaction would meet the auditorâs conditions. Toconvince the auditor that the financing transaction qualified as asales and repurchase agreement under GAAP, management created falsedocuments including a memo that provided Hamiltonâs rationale forthe below market prices for the sale of inventory under theagreement. The memo stated that the below market prices weresupported by large volume discounts and one-month future prices ofmetals â neither of which were justified by the actual market data.However, the analysis was elaborate and management convinced theauditors that the transaction qualified as a sale and repurchaseagreement under GAAP. Almost concurrently, Hamiltonâs managementused a very similar strategy to remove an additional $70 million ofbatteries and generators from its reported inventory balance. SinceHamilton used LIFO, each of these liquidating transactions allowedHamilton to artificially boost net income with LIFO liquidationgains that were improperly realized under GAAP with the sale andrepurchase transactions. Fraud Discovery Initially, managementoverstated net income by $69 million in booking the warranty claimsadjustment to retained earnings and then improperly increased netincome by an additional $130 million through its treatment of thesubsequent warranty claims settlements with MC. In addition, due tothe LIFO gains realized with the fourth quarter inventorytransactions, Hamilton recognized an additional $81 million dollarsto its bottom line. Taken together, the misstatement totaledapproximately $280 million dollars in 2000. As noted, managementâsfinancial statement fraud was not limited to a single transaction.Rather each time that pressure existed to meet market expectations,management appeared to devise a scheme to boost net income. Theschemes were supported by skillfully crafted evidence provided tothe auditor by the management team. In the end, it was awhistleblower, believed to be from a vendor involved in afraudulent transaction, which objected to the Companyâs inaccuratereporting of a specific transaction that turned management into theSEC. The ensuing SEC investigation uncovered the full extent ofmanagementâs wrongdoings over a four-year period of time. CaseQuestions 1.Based on your understanding of fraud risk assessmentand the case information, identify at least three specific fraudrisk factors related to Hamilton Company. 2.If you were responsiblefor planning the audit of Hamilton Company, how would the fraudrisk factors identified in question #1 have influenced the nature,timing, and extent of your audit work? 3.Please consider the fivesteps of the KPMG Judgment Framework. For each step, thinkcarefully about what the auditors could have done to help detectthe fraudulent activity related to the warranty reserve account atHamilton Company. Please use the following questions to guide yourcritical thinking about this case: a)Clarify the issues and theobjectives related to auditing the warranty reserve account atHamilton. To do so, please ask yourself what specific problem needsto be solved by the auditor? What assumptions would have thebiggest impact on the overall judgment to be made? How does thisjudgment relate to the overall audit process? b)Consider thevarious alternatives that should be thought about when auditing thewarranty reserve account at Hamilton. To do so, please ask yourselfabout each of the alternatives that are reasonably possible, evenwhen they might contradict the clientâs point of view. Are thereany external factors that should be considered? c)Consider the typeof information and evidence that should be gathered when completingthe audit of the internal control activities related to thewarranty reserve account at Hamilton. To do so, please ask yourselfabout the type of information that would be helpful to determinewhether the internal control activities were operating effectively.How can you be sure that the information gathered is reliable? Inaddition, how can you be sure that the evidence is appropriate inthis situation? Finally, what evidence could be gathered that mightreveal that the internal controls were NOT operating effectively?d)Consider the type of information and evidence that should begathered when completing the substantive testing procedures relatedto the warranty reserve account at Hamilton. To do so, please askyourself about the type of information that would be helpful todetermine whether the warranty reserve account was fairly stated inthe financial statements. How can you be sure that the informationis reliable? In addition, how can you be sure that the evidence isappropriate in this situation? Finally, what evidence could begathered that might disconfirm your belief that the warrantyreserve account was fairly stated? e)Consider the factors thatwould have to be thought about when reaching a final conclusionabout the warranty account at Hamilton. Although you do not haveaccess to the actual evidence, what âbig pictureâ issues would haveto be thought about before reaching a final conclusion? Finally,what could possibly go wrong in this situation? f)Consider theimportance of documenting the rationale for your final conclusion.Why do you think it is important to document your rationale whenfinalizing your judgment? In addition, describe what is expected tobe documented to support an auditorâs professional judgment.4.Describe the availability tendency in your own words, and give anexample of how the tendency could result in a lack of auditeffectiveness. How can the tendency be mitigated? 5.Describe theconfirmation tendency in your own words, and give an example of howthe tendency could result in a lack of audit effectiveness. How canthe tendency be mitigated? 6.Describe the overconfidence bias inyour own words, and give an example of how the bias could result ina lack of audit effectiveness. How can the bias be mitigated?7.Describe the anchoring bias in your own words, and give anexample of how the bias could result in a lack of auditeffectiveness. How can the bias be mitigated? 8.What tendency orbias is most likely to have manifested in the Hamilton caseexample? Please provide support for your answer.
