Stratified Sampling and Red Flags
Thank you for your great postings sharing your opinions with others. Many of you already have commented to these issues, but I would like to recap once more for your own organization and study aid. 1. What are several red flags that E&Y either was or should have been aware of in the audit of HealthSouth? E&Y was aware that there was an undue emphasis on analysts' reaction to quarterly profits. They were also aware of the centralized power exerted by Scrushy. Other red flags included the high turnover in the CFO position, and the rapid growth in net income. They also accepted explanations of whistle-blower accusations that might have revealed the fraud if followed up. 2. What procedures can auditors perform to detect fraudulent entries made during the consolidation process? Auditors should understand and test controls over the consolidation process just as they do over purchasing, sales, payroll, etc. SAS 99 requires specific procedures to ensure against management override of controls, which occurred at the consolidation process. These procedures would include reviewing the consolidation entries, adjusting journal entries, as well as the controls over such entries. 3. HealthSouth has sued Ernst & Young and Ernst & Young is also the target of a federal securities class action suit. What are Ernst & Young’s likely defenses against HealthSouth? Against the class action suit? In March 2009, E&Y settled with HealthSouth Shareholders for $109 million. If the case would go to court, E&Y’s first defense should be that they performed their work in accordance with professional standards. They also should be able to claim HealthSouth contributed to, and was the primary cause, of any damages it incurred. In the securities suit, they should only have to show that plaintiffs’claims of Scienter are untrue. 4. HealthSouth concealed the fraud by keeping the fraudulent transactions below $5,000. What recommendation would you have to Ernst & Young to improve its sampling practices?