CASE 1.14
NAVISTAR INTERNATIONAL CORPORATION
Synopsis
Navistar International Corporation traces its roots back to Cyrus McCormick, the famous 19th
century American inventor. This case, however, begins in the 21st century when Navistar fired its
During the midst of Navistar’s accounting scandal, the company sued its former audit firm,
Deloitte, for $500 million. The harsh allegations included in the 134-page complaint filed against
Deloitte included the suggestion that the prominent audit firm was incompetent. Deloitte was less
than happy with that allegation and similar statements made by Navistar’s attorneys and blamed the
company’s accounting scandal on the senior executives who were sanctioned by the SEC as a result
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Navistar International Corporation—Key Facts
1. Deloitte replaced the audit engagement partner on the 2005 audit as that engagement was nearing
completion; the replacement audit partner effectively began the audit over, refusing to “accept any of
the work” that had been supervised by the previous audit partner.
2. Five months later, in April 2006, Navistar fired Deloitte and hired KPMG as its audit firm; due
3. Navistar ultimately restated its 2003-2004 financial statements and disclosed 15 material
4. In 2005, the SEC inadvertently disclosed that the PCAOB was investigating Deloitte’s 2003
Navistar audit; that was the first formal investigation of a Big Four firm by the PCAOB.
6. In addition to investigating alleged audit failures, the PCAOB periodically inspects the audit
practices of all accounting firms that audit companies with securities traded on U.S. stock exchanges.
8. Part I of PCAOB inspection reports identify deficiencies specific to individual audits, while Part
9. The PCAOB fined and suspended two audit partners involved in the 2003 audit of Navistar; the
10. In October 2011, the PCAOB surprised the accounting profession by releasing Part II of
11. Navistar eventually filed a $500 million lawsuit against Deloitte; among other harsh allegations,
the lawsuit charged Deloitte with “lying” as to the competency of its audit and accounting services.
12. The Navistar-Deloitte debacle apparently contributed to the PCAOB’s decision to propose
mandatory audit firm rotation for SEC registrants in 2011.
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Instructional Objectives
2. To consider the nature of material weaknesses in internal control and their impact on
independent audits.
3. To examine the nature of the auditor-client relationship and how that relationship may influence
the performance of independent audits.
Suggestions for Use
This is another case that I have used as an initial assignment for my graduate auditing course.
This case provides students who have a limited understanding of the independent audit function in
the U.S. with a “big picture” view of independent auditing in a free market economy—I typically
have several foreign students in my graduate auditing class from “controlled economy” nations.
The Navistar case provides insight on both the internal and external environments of independent
Suggested Solutions to Case Questions
1. The key disadvantage of mandatory auditor rotation is the “learning curve effect.” That is, a
new audit firm will automatically have less understanding of a client’s business practices, internal
control system, and accounting methods than the “old” audit firm. Several years may pass before the
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material errors in a client’s accounting records. Another important advantage of mandatory auditor
2. Notes: PCAOB Auditing Standard No. 2 was the initial internal control standard adopted by the
PCAOB (this standard went into effect for large SEC registrants in late 2004). AS No. 2 introduced
the terms “material weakness” and “significant deficiency” in internal controls. In 2007, the
65.]
Following are definitions of three key terms that were taken directly from AS No. 5:
Internal control deficiency: “A deficiency in internal control over financial reporting exists when
the design or operation of a control does not allow management or employees, in the normal course
of performing their assigned functions, to prevent or detect misstatements on a timely basis.”
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Exhibit 1 typically represent only a small portion of the narrative discussion for each item.
Certainly, a client can have such inadequate internal controls that it is not “auditable.” In such
cases, an audit team might be effectively forced to reconstruct the client’s accounting records, which
means that they would not have the necessary independence to then audit those records. The
weaknesses in Navistar’s internal controls were so extensive that it does make one wonder how
Deloitte was capable of auditing the company’s financial statements in the years prior to 2005.
3. Absolutely not. Because of a lack of independence, an accounting firm cannot audit accounting
records that it effectively maintained.
4. PCAOB Auditing Standard No. 11, “Consideration of Materiality in Planning and Performing an
Audit,” is the authoritative standard in this context for audits of SEC registrants. The phrase
“planning materiality threshold” is not found in AS No. 11. The phrase that the PCAOB uses that is
most equivalent to “planning materiality threshold” is “materiality level for the financial statements
as a whole.” Paragraph No. 6 of AS No. 11 provides the following discussion of that phrase.
Among the factors that may influence the planning materiality level for a given client, according
to AS No. 11, are the existence of related-party transactions and conflicts of interests. “Other
relevant factors” that may influence planning materiality decisions would be an usually low amount
for an important materiality benchmark (such as net income) in a given year, external circumstances
that draw particular attention to the given entity’s financial statements such as a planned offering of
securities, and changes in laws or regulations or industry conditions that impact investors’
expectations for the entity.
5. The decision not to sanction Deloitte does not seem consistent with the logic of the former
PCAOB official (apologies for the double negative). In my view, it appears that there was a “failure
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of oversight or supervision.” No doubt, we can criticize the oversight or supervision that Linden
provided to Anderson. Likewise, where was the concurring or review partner? It seems that
individual should have “weighed in” on the decision to revise the materiality threshold at the last
moment.
6. QC Section 20, “System of Quality Control for a CPA Firm’s Accounting and Auditing
Practice” in the PCAOB’s Interim Standards provides an overview of the nature and purpose of a
CPA firm’s quality control system. (Note: the quality control standards integrated into the AICPA
Professional Standards are very similar to those included in the PCAOB’s Interim Standards.) QC
20.02 notes that CPAs “should practice in firms that have in place internal quality-control procedures
to ensure that services are competently delivered and adequately supervised.” QC 20.07 identifies
the following five elements of quality control for a CPA firm registered with the PCAOB:
a. Independence, Integrity, and Objectivity
The key factor that influences an accounting firm’s culture is the “tone at the top,” that is, the
overall competence, integrity, and professionalism of the organization’s leaders. As noted in the
case, the PCAOB reported that Deloitte’s “senior leadership” had apparently embraced the need to
7. The PCAOB has faced considerable controversy since it was established in 2003. As you are
well aware, a legal challenge to the new agency’s constitutionality was ultimately resolved in the
federal courts, including a ruling issued in 2010 by the U.S. Supreme Court. As a prologue to
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discussing this case question, you might provide your students with the PCAOB’s “mission” and
“vision” statements that are presented on the organization’s website:
Not being an attorney or a governmental affairs expert, I am less than confident in providing
affirmative answers to this case question. Then again, even the so–called “experts” quarrel over the
proper scope and nature of the PCAOB’s regulatory role and responsibilities. The key goal in
having students respond to this question is raising their awareness of the PCAOB and the
controversy over its regulatory role and responsibilities.
8. This question is related to the prior one in that it addresses the nature and scope of the PCAOB’s
regulatory role and responsibilities. I believe there is a definitive answer to this question, however.
In my view, the PCAOB inspection teams have the right, as well as a responsibility, to “second
guess” judgments of the professionals whose work they are reviewing. In fact, if the PCAOB did not
have that right or responsibility, what purpose would be served in having the regular inspections of
audit firms? I also understand the point being made by Deloitte, namely, that two skilled and