978-0077862213 Major Case Teaching Note Adelphia

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Notes on Major Case 1

Adelphia Communications Corp

This case discusses a complex and high risk audit engagement. The

auditors had to consider related party transactions and their effect on

the application of GAAP and footnote disclosures. The case deals with

the ethical obligations of management of Adelphia and the auditors.

Ethical Issues (Overview): Deloitte and Dearlove, the audit engagement partner, had a

duty and obligation of due care in conducting the audit; to approach the audit with a

healthy dos of skepticism; and to identify risks of possible problems with the clients’

business model or the existence of material misstatements in the financial statements.

The auditors failed on all accounts.

The actions by Deloitte and Dearlove were motivated by egoism and the clients’ best

interests, not the interests of the shareholders and creditors. The auditors failed in their

public interest obligations. The actions of Rigas management were designed to promote

their interests regardless of the cost and ethics of accounting and financial reporting

techniques. Using rule-utilitarianism, GAAP and GAAS must be followed regardless of

any utilitarian benefits that may exist for the company by developing its own (self-

interest) way of accounting and financial reporting for the related party transactions, co-

borrowed debt, and receivable-payable offsets. From a justice perspective, the audit was

biased towards the interests of the Rigas family. In treating equals, equally and

unequals, unequally, the fact is the shareholders and creditors had a greater claim to

accurate and reliable financial statements and their rights should have been stressed

above all else. Using virtue theory, honesty requires that the statements should be

truthful and fully disclose all relevant information on related parties’ transactions. The

accounting and reporting of other transactions should be consistent with diligence,

responsibility, and transparency. Impartiality requires that Deloitte should not be biased

towards the Rigas family. Perhaps the auditors feared losing a major client and allowed

client interests and pressures on the auditor to rule the day. This would be a stage 3

reasoning approach to moral decision-making.

Questions

1. Dearlove and Deloitte had identified the audit as posing much greater risk

than normal. Describe the audit risk factors in the case that most likely

would have led to this conclusion.

For several years, Deloitte had concluded that the Adelphia engagement posed a “much

greater than normal” risk of fraud, misstatement, or error; this was the highest risk

category that Deloitte recognized. Risk factors that Deloitte specifically identified in

reaching this assessment for the 2000 audit included the following:

Adelphia operated in a volatile industry, expanded rapidly, and had a large

number of decentralized operating entities with a complex reporting structure;

To help manage the audit risk, Deloitte planned, among other things, to increase

Deloitte’s management involvement at all stages of the audit and to heighten professional

Deloitte had specifically identified areas posing high risk including Adelphia’s rapid

expansion, substantial debt load, and significant related party transactions. The high risk

2. Classify each of the accounting issues in the case into the financial

shenanigans identified by Schilit in Chapter 7. Are there any accounting

procedures that do not fit into one of the shenanigans? If not, make up a

category to describe such procedures in a general way as did Schilit.

Comment on the earnings management effects as well.

The Adelphia case has three accounting transactions not in compliance with GAAP. The

offsetting receivables and payables is a form of shenanigan number 5, failing to record

or improperly reducing liabilities. This failure to account for offsetting receivables and

A key issue in the case is the proper reporting of the co-borrowed debt and

related party transactions. A review of the contingent liability rules seems to indicate

Describe each of the auditing standards and procedures the auditors failed to

adhere to given the facts of the case. How did the failure of the auditors to follow

them violate Deloitte’s ethical standards as evidenced by the deficiencies in the

work of Dearlove and other members of the audit engagement team?

The accepted auditing standards require the auditors to plan the audit adequately and to

properly supervise any assistants. Auditors must exercise due professional care in

performing an audit and preparing a report. They must maintain an attitude of

professional skepticism, which includes a questioning mind and a critical assessment of

Specifically, in the area of the offsetting or netting of receivables and payables, the

SEC found no evidence in the audit workpapers that Deloitte gave any consideration to

the propriety of Adelphia’s netting during the 2000 audit or that the audit team

conducted any analysis of FASB Interpretation 39, Offsetting of Amounts Related to

properly done; he did not exercise appropriate skepticism despite circumstances

requiring heightened scrutiny; and he did not properly supervise the audit team to ensure

that significant related party transactions, like this netting, were afforded appropriate

review. Sufficient audit evidence was lacking in some cases and the auditors allowed

In the area of co-borrowed debt, the SEC found that Deloitte and Dearlove created

no workpapers documenting its examination of Adelphia’s decision. There is no

evidence that Dearlove or the audit team conducted an analysis of Adelphia’s potential

for liability under the credit agreements; nor is there evidence that Dearlove directed the

audit team to conduct such an analysis. Instead, Dearlove’s conclusion was based on a

series of assumptions about the Rigas Entities’ and the Rigas family’s willingness and

In the area of the adequacy of the note disclosure of Adelphia’s contingent liability,

the SEC found that Dearlove and Deloitte failed to exercise the level of professional

These failures by Deloitte and Dearlove violate the ethical standards of

independence (rule 101), objectivity and skepticism (rule 102), due care and

Optional Question

3. Do you believe that Deloitte violated its ethical and professional

responsibilities in the audit of Adelphia by being liable for negligence, gross

negligence, or fraud? Explain the reasons for your answer using the

discussion in Chapter 6 for support.

Negligence is a violation of a legal duty to exercise a degree of care that an ordinary

prudent person would exercise under similar circumstances. For a CPA, negligence is

failure to perform a duty in accordance with applicable standards; it may be viewed as

failure to exercise due professional care. Gross negligence is the lack of even slight care,

In the Adelphia case, Deloitte and Dearlove violated ethical and professional

responsibilities and were liable for negligence. The audit was performed without

exercise of due professional care and with reckless disregard for GAAS and proper

financial reporting. Deloitte was found guilty of fraud in a case brought by the U.S.