Accounting Chapter 1 Homework John Rigas had founded Adelphia, the Greek word for brothers

Unlock access to all the studying documents.

View Full Document

Ethical Obligations and Decision Making in Accounting, 4/e 1

Major Case 1 Adelphia Communications Corporation

On July 24, 2009, the U.S. Court of Appeals for the District of Columbia upheld the finding of

the SEC that Gregory M. Dearlove, a certified public accountant and formerly a partner with the

accounting firm Deloitte & Touche LLP, engaged in improper professional conduct within the

meaning of Rule of Practice 102(e). Dearlove served as the engagement partner on Deloitte’s

audit of the financial statements of Adelphia Communications Corporation, a public company,

for the fiscal year ended December 31, 2000. The SEC confirmed its original ruling that

Adelphia’s financial statements were not in accordance with generally accepted accounting

Background Issues

John Rigas had founded Adelphia, the Greek word for brothers, in 1952, and Rigas and his

children were the controlling shareholders in 2000. By the year 2000, Adelphia was one of the

largest cable television companies in the United States. It had doubled the number of cable

subscribers that it served by acquiring several other cable companies in late 1999. Although its

assets were growing, Adelphia’s debt grew substantially as well. The SEC found that, prior to

2000, Adelphia, its subsidiaries, and some Rigas-affiliated entities entered as coborrowers into a

series of credit agreements. By 1999, Adelphia and the entities had obtained $1.05 billion in

credit; in 2000, they tripled their available credit and drew down essentially all the funds

available under the agreements.

Ethical Obligations and Decision Making in Accounting, 4/e 2

SEC Charges

In September 2005, the SEC charged Dearlove with improper conduct resulting in a violation of

applicable professional standards, including his approval of Adelphia’s method of accounting for

transactions between itself and one or more Rigas entities (i.e., related-party transactions). The

matter was referred to the ALJ, who presided at an administrative trial-type hearing to resolve

the dispute between the SEC and Adelphia. The ALJ determined Dearlove had engaged in one

instance of “highly unreasonable” conduct and repeated instances of “unreasonable” conduct,

SEC Rule 102(e) provides the SEC may “deny, temporarily or permanently, the privilege of

appearing or practicing before [the SEC] in any way to any person who is found by the

Commission . . . to have engaged in unethical or improper professional conduct.” The rule

defines three classes of “improper professional conduct” for accountants: (1) “Intentional or

knowing conduct, including reckless conduct, that results in a violation of applicable

professional standards,” (2) “a single instance of highly unreasonable conduct that results in a

violation of applicable professional standards,” and (3) “repeated instances of unreasonable

conduct, each resulting in a violation of applicable professional standards, that indicate a lack of

Deloitte’s Audit

Deloitte served as the independent auditor for Adelphia, one of its largest audit clients, from

1980 through 2002. The audits were complex. Several of Adelphia’s subsidiaries filed their own

Ethical Obligations and Decision Making in Accounting, 4/e 3

Form 10-K annual reports with the SEC. 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.

• Adelphia carried substantial debt and was near the limit of its financial resources, making

Charges against Rigas Family and Deloitte

In the wake of Adelphia’s decline, the DOJ brought criminal fraud charges against several

members of the Rigas family and other Adelphia officials. The DOJ declined to file criminal

charges against Adelphia as part of a settlement in which Adelphia agreed to pay $715 million in

stock and cash to a victims’ restitution fund once the company emerged from bankruptcy.

The SEC brought several actions related to the decline of Adelphia. On April 25, 2005,

Adelphia, John Rigas, and Rigas’s three sons settled a civil injunctive action in which the

respondents, without admitting or denying the allegations against them, were enjoined from

Ethical Obligations and Decision Making in Accounting, 4/e 4

Violation of GAAS: General, Fieldwork, and Reporting Standards

In determining whether to discipline an accountant under Rule 102(e)(1)(iv), the commission has

consistently measured auditors’ conduct by their adherence to or deviation from GAAS. Certain

audit conditions require auditors to increase their professional care and skepticism, as when the

audit presents a risk of material misstatement or fraud. When an audit includes review of related-

party transactions, auditors must tailor their examinations to obtain satisfaction concerning the

Ethical Obligations and Decision Making in Accounting, 4/e 5

Violation of Accounting and Reporting Standards

Having determined that Dearlove’s conduct was unreasonable, the SEC turned to the applicable

professional accounting and reporting standards. The GAAS required that when an audit posed

greater than normal risk—as Dearlove had determined the Adelphia audit did—there must be

Offsetting Receivables and Payables

Accounting Principles Board Opinion No. 10 states that “it is a general principle of accounting

that the offsetting of assets and liabilities in the balance sheet is improper except where a right of

setoff exists.” Rule 5–02 of the commission’s Regulation S–X requires that issuers “state

separately” amounts payable and receivable. Interpretation 39, Offsetting of Amounts Related to

Ethical Obligations and Decision Making in Accounting, 4/e 6

Coborrowed Debt

Between 1996 and 2000, several Adelphia subsidiaries and some of the Rigas entities had

entered as coborrowers into a series of three credit agreements with a consortium of banks.

Although the agreements differed in the amount of credit available, their terms were substantially

the same: each borrower provided collateral for the loan; each could draw funds under the loan

agreement; and each was jointly and severally liable for the entire amount of funds drawn down

under the agreement, regardless of which entity drew down the amount. By year-end 2000, the

total amount of coborrowed funds drawn under the credit agreements was $3.751 billion, more

than triple the $1.025 billion borrowed at year-end 1999. Of this amount, Adelphia subsidiaries

had drawn approximately $2.1 billion, and Rigas entities had drawn $1.6 billion.

Dearlove also believed that, although the Rigas family was not legally obligated to contribute

funds in the event of a default by the coborrowers, the family would be economically compelled

to protect their Adelphia holdings by stepping in to prevent a default by the entities. Dearlove did

not, however, conduct any inquiry into whether the family would, in fact, use their personal

assets to prevent a default by Adelphia. Dearlove estimated the value of the Rigas family’s

holdings of Adelphia stock by multiplying the number of shares the Rigases owned by the price

per Class A share, resulting in a figure of approximately $2.3 billion, which he concluded was by

itself ample to cover the debt and conclude his SFAS 5 analysis. However, Dearlove did not

determine if these Rigas family assets were already encumbered by other debt; he saw no

financial statements or other proof of the family’s financial condition other than local media

reports that the Rigases “were billionaires.” Dearlove testified that he “never asked them: Are

you worth $2 billion, $3 billion, or $10 billion?” Dearlove also did not consider whether

Ethical Obligations and Decision Making in Accounting, 4/e 8

At the end of March 2001, as Deloitte was concluding its audit of the 2000 financials, Brown—

despite his agreement in November 2000 to disclose the amount of Rigas entities’s borrowing—

informed the audit team that he did not think that the additional disclosure was necessary.

Instead, Brown proposed adding a phrase explaining that each of the coborrowers “may borrow

up to the entire amount available under the credit facility.” Brown argued that his proposed

language was more accurate than Deloitte’s proposal because the lines of credit could fluctuate

and, as a result, it would be better to disclose Adelphia’s maximum possible exposure. Caswell

agreed to take Brown’s language back to the engagement team, but he told Brown that he did not

agree with Brown and did not think that Deloitte would accept his proposed language.

Notwithstanding Caswell’s reaction, Brown soon afterward presented his proposed language to

the audit team, including Dearlove, Caswell, and Hofmann, during the audit exit meeting on

March 30, 2001. Brown claimed that his proposed disclosure language had been discussed with,

and approved by, Adelphia’s outside counsel. Although Dearlove characterized the disclosure

Adequacy of the Note Disclosure of Adelphia’s Contingent Liability

The SEC also considered whether Adelphia’s footnote disclosure of Rigas entities’ coborrowings

was appropriate under GAAP. Adelphia disclosed the total amount of credit available to the

coborrowers (“up to” $3.75 billion) without indicating whether any portion of that available

credit had actually been drawn down, much less that all of it had. This disclosure was inadequate

to inform the investing public that Adelphia was already primarily liable for $2.1 billion and a

Ethical Obligations and Decision Making in Accounting, 4/e 9

to corroborate management explanations or representations concerning material matters—such

as further analytical procedures, examination of documentation, or discussion with others within

or outside the entity” when audit risk increases. The accounting for Adelphia’s coborrowed debt

implicated the extensive related-party transactions and high debt load that were part of the basis

for Deloitte’s high–risk assessment for the Adelphia audit. Management’s insistence on its own

accounting interpretation was precisely the behavior identified by the audit plan as presenting a

much higher than normal risk of misstatement in the audit.

Debt Reclassification

After the end of the second, third, and fourth quarters of 2000, Adelphia’s accounting department

transferred the reporting of approximately $296 million of debt from the books of Adelphia’s

subsidiaries to the books of various Rigas entities. In exchange, Adelphia eliminated from its

books receivables owed to it by the respective Rigas entities in the amount of debt transferred.

The three transfers were in the amounts of $36 million, approximately $222 million, and more

than $38 million, respectively. In each instance, the transaction took place after the end of the

quarter, and each transfer involved a post-closing journal entry that was retroactive to the last

day of the quarter.

Ethical Obligations and Decision Making in Accounting, 4/e 10

A checklist prepared by Deloitte in anticipation of the 2000 audit showed that Deloitte was

aware of a significant number of related-party transactions that had arisen outside the normal

course of business and that past audits had indicated a significant number of misstatements or

correcting entries made by Adelphia, particularly at or near year-end. An audit overview

memorandum recognized as a risk area that “Adelphia records numerous post-closing adjusting

When the Adelphia subsidiaries posted the debt in question to their books, they acknowledged

their primary liability for the amounts posted. They could not remove the debt properly from

their books without first satisfying the requirements of SFAS 125 that either the Adelphia

subsidiaries repaid the debt to the creditor during the relevant reporting periods or a creditor had

released the subsidiaries from their liability for repayment. The evidence does not show, and

Dearlove did not contend, that either of these events occurred. Adelphia’s attempt to extinguish

Ethical Obligations and Decision Making in Accounting, 4/e 11

125 is complex where entities are jointly and severally liable for an obligation, and it did not

apply where an entity is secondarily or contingently rather than primarily liable. He asserted that

Adelphia was arguably not required to recognize debt in cases where co-borrowed funds were

intended to be used by other co-borrowers. He stopped short, however, of saying that the funds at

issue were so intended, and our review of the record yields nothing to support such a contention.

The record did not establish that all the reclassified debt was c-borrowed debt, and the ALJ

With respect to the direct placement of stock transactions, on at least four occasions

corresponding with public offerings by Adelphia, Adelphia removed a portion of Co-Borrowing

Credit Facility Debt from its books as part of sham transactions in which a Rigas Entity non–co–

borrower received Adelphia securities and a Rigas Entity co-borrower “assumed” debt of

Adelphia. In each instance, Adelphia claimed in Commission filings and other public statements

that Adelphia had applied some or all of the proceeds from these securities transactions actually

to pay down debt, when — in fact — these transactions were shams with no bona fide proceeds,

and resulted only in the transfer of Adelphia’s debt to the books of Rigas Entity co-borrowers.

The commission also found that Dearlove’s conduct in his audit of Adelphia’s accounting for

debt was at least unreasonable, resulting in several GAAS violations. As explained, Dearlove

knew that Adelphia had a large number of decentralized operating entities with a complex

reporting structure, carried substantial debt, and engaged in significant related-party transactions

with affiliated entities that Deloitte would not be auditing. He also knew that Adelphia

management tended to interpret accounting standards aggressively. Moreover, the audit plan

Ethical Obligations and Decision Making in Accounting, 4/e 12

Postscript

On April 21, 2005, it was announced that Time Warner and Comcast were buying bankrupt cable

company Adelphia Communications in a $17.6 billion cash-and-stock deal. As a result of a

settlement of actions against Adelphia and members of the Rigas family for securities fraud and

other violations, and a related criminal forfeiture action, the U.S. Department of Justice and the

U.S. Securities and Exchange Commission obtained a recovery consisting of cash of

approximately $729 million. The funds were distributed to eligible claimants who suffered a

financial loss as a direct result of the circumstances surrounding the Adelphia fraud.

This is a good case to have students review the SEC complaint against Deloitte and expand

the scope of the case to enhance its usage as an end-of-course project. Here is the link to the

complaint: https://www.sec.gov/litigation/complaints/complr17627.htm.

Instructors may want to add a fifth question if Chapter 6 is assigned in the course.

Optional Question

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.

Case Questions

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

normal. Describe the 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;

• Adelphia carried substantial debt and was near the limit of its financial resources,

making it critical that the company comply with debt covenants;

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

payables means that interest expense may be understated. The reporting of co-borrowed

debt is a form of shenanigan number 5, failing to record or improperly reducing liabilities.

This failure to record co-borrowed debt also indicates that interest expense may be

understated. Adelphia also failed to adequately disclose relevant information about these

A key issue in the case is the proper reporting of the coborrowed debt and related party

transactions. A review of the contingent liability rules seems to indicate that the disclosures

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?

Ethical Obligations and Decision Making in Accounting, 4/e 15

The generally 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 audit evidence.

They must obtain sufficient competent evidential matter to afford a reasonable basis for an

opinion with respect to the financial statements under review. Auditors are expected to

develop procedures to identify fraud in the financial statements, especially those related to

material misstatements.

In the area of coborrowed 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 ability to pay the coborrowing

Rigas Entities’ debt — assumptions that were either untested or inadequately tested. Each of

Dearlove’s failures to meaningfully review Adelphia’s chances of suffering a loss on the

Ethical Obligations and Decision Making in Accounting, 4/e 16

4. Analyze the actions of Deloitte and Dearlove from an ethical reasoning perspective.

Reviewing the professional/ethical standards, Deloitte and Dearlove: had a duty and

obligation of due care in conducting the audit; to approach the audit with a healthy dose 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

Instructors may want to add a fourth question if Chapter 6 is assigned in the course.

Optional Question

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

Ethical Obligations and Decision Making in Accounting, 4/e 17