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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.
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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
2
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
3
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
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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
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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,
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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.
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