978-0077862213 Major Case Teaching Note Navistar

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Notes on Major Case 5

Navistar International

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

looks at the consulting and auditing of complex audit issues.

Ethical Issues:

Deloitte had a duty and obligation of independence and due care in conducting the audit.

Deloitte had consulted on the accounting treatments used by Navistar and may not have been

objective in auditing those treatments. From a utilitarian perspective, the interests of all

stakeholders were not considered; just the interest of the management. Using rule-utilitarianism,

GAAP and GAAS should be followed. From an act-utilitarianism, the greatest good for the

greatest number of stakeholders should be selected; at the end of the day all stakeholders were

harmed by the actions of Navistar and Deloitte in the 2002 – 2005 audits. From a justice

perspective, the audit was biased towards the interests of management and the accounting

treatments that Deloitte consulted on. Using virtue theory, honesty requires that the statements

should be truthful and fully disclose all relevant information, and that the financial statement be

in compliance with GAAP. Impartiality requires that Deloitte should not be biased.

Trustworthiness means that the auditors should not violate the investors’ faith that the

statements are accurate and reliable. Integrity requires that Deloitte should have the moral

courage to withstand client pressures, and not subordinate judgment.

Questions

1. Would you characterize the Deloitte audit of Navistar a failed audit? Why or why

not?

The 2002 – 2004 audits of Navistar had unqualified audit opinions when the financial statements

were materially misstated. That is the definition that many use for a failed audit. Did Deloitte fail

to perform an audit with due care? Did Deloitte plan and perform the audit to test and detect

material mistakes and misstatements? Was the firm sufficient skeptical of the evidence provided

by Navistar management? These are the factors to consider in determining whether a business

failure is also an audit failure. It appears that Deloitte may have been negligent in this case

2. Discuss the weaknesses in internal controls and the corporate governance system at

Navistar. How should these deficiencies have affected the Deloitte audit assuming

the firm was aware of these deficiencies?

Exhibit 1 notes that there were 15 material weaknesses in internal controls at Navistar, including

the insufficient number of accounting personnel with an appropriate level of accounting

knowledge, experience and training in the application of GAAP, inadequate segregation of

On August 5, 2010, the SEC announced settlements with Navistar International Corporation and

several of its current and former officers and other executives. The SEC alleged that from

2001–2005, Navistar overstated pre-tax income by about $137 million as the result of fraud in

To settle the matter, the company agreed to cease and desist from committing or causing

violations of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-

20, 13a-1, and 13a-13 thereunder. The Commission declined to impose a civil penalty against

the company in light of its remedial efforts and cooperation, which included: (1) terminating or

removing from financial reporting responsibilities various employees alleged to have

3. The PCAOB audit firm inspection program was discussed in Chapters 4 and 5.

What is the purpose of that program with respect to ensuring that auditors meet

their ethical and professional responsibilities and obligation to place the public

interest above all else? As mentioned in the case, the name of a company (client)

mentioned in specific inspection report is not made publicly available. Do you

believe that PCAOB inspection reports on registered CPA firms should permit the

disclosure of specific details about named clients? Why or why not?

PCAOB inspects actual audit workpapers, memos, and opinions to ensure that the auditors are

planning and performing the audit with independence, objectivity, skepticism, due and

competency. The inspection report includes an examination of the workpapers to assess

The inspection process helps to assess the quality of the audit and the auditors who conducted the

engagement. It is an essential quality control for all firms that audit public companies and

enhances the trust of the public in the independent audit. The emphasis of the inspection is the

auditors’ work and workpapers; the clients are incidental to the inspection and give the context

and accounting issues. The client is kept confidential to keep the focus on the work of the

4. What is the purpose of Section 304’s clawback provision in SOX? Do you think the

provision is an ethical one? Use ethical reasoning to support your answer.

The intent of SOX section 304 clawback is to make sure that a company’s management does not

enrich itself through financial statement fraud, either through bonuses or sale of stock at inflated

prices due to the fraud. The provision is consistent with the policy of disgorgement that was

Clawbacks are an ethical practice because they hold officers accountable for actions they took to

enrich themselves, such as sell stock ownership, during the time that a financial fraud exists. An

An interesting question to pursue with students is whether an action taken by an

Optional Question

5. Answer the following questions as directed by your instructor:

a. Vendor rebates: Do you believe Navistar was motivated by earnings

management in its accounting for the vendor’s rebates?

The vending rebates were recorded upfront by Navistar when they would be earned over future

b. Vendor tooling: Evaluate Deloitte’s role with respect to ethics and

professionalism in providing guidance to Navistar employees on accounting

for the vending tooling costs.

Deloitte consulted with Navistar about the accounting treatment for the vending tooling. The

correspondence indicted that recapture and booking of previously-paid amortization into income

was improper. When Navistar went ahead book the tooling improperly, it was suggested that

Note: Under SOX Deloitte should not have been consulting on accounting treatments and then

auditing those transactions. This is a good example on why auditors should not help the client

c. Warranty reserve: Did the company’s accounting for the warranty reserve

comply with GAAP?

Navistar started calculating warranty reserve in accordance with GAAP, but then was decided

that it was too high. Navistar understated warranty reserve by including anticipated vendor

d. Deferred start-up costs: Evaluate the accounting for the deferred start-up

costs from a matching perspective. What was the nature of the accounting

that should have taken place after the automaker cancelled the agreement

with Navistar in October 2002?

Navistar deferred start-up costs of V-6 engine that was not in compliance with GAAP. Start-up

costs can only be deferred if an objectively verified and measured contractual guarantee of