CASE 1.6
NEXTCARD, INC.
Synopsis
In November 2001, Arthur Andersen & Co. employees in that firm’s Houston office shredded
certain Enron audit workpapers during the midst of a federal investigation of the large energy
tended to be high credit risks, which resulted in the company absorbing much higher than normal
bad debt losses. When the company’s management team attempted to conceal those large credit
losses, the SEC and other federal regulatory authorities uncovered the scam. By 2003, the once
high-flying Internet company was bankrupt and its former officers were facing a litany of federal
charges.
2002. In October 2004, Trauger pleaded guilty to one count of impeding a federal investigation and
was sentenced to one year in federal prison and two years of supervised release.
40
Case 1.6 NextCard, Inc. 41
NextCard, Inc.—Key Facts
2. Initially, Lent’s business model for NextCard seemed to be a financial success as the company
obtained a large customer base and became recognized as a leader of the e-commerce “revolution.”
4. NextCard effectively became a lender of last resort for individuals who could not obtain credit
elsewhere; as a result, the company’s credit losses were much higher than the industry norm.
5. NextCard executives attempted to conceal the company’s large credit losses by understating its
7. The announcements of the federal investigations prompted Thomas Trauger, the NextCard audit
engagement partner, to alter NextCard’s 2000 audit workpapers.
9. Trauger and his subordinates manipulated E&Y’s computer system to produce an appropriate
electronic time stamp on the revised NextCard workpapers.
10. Trauger instructed his subordinates to dispose of any incriminating evidence but Oliver
11. In October 2004, Trauger pleaded guilty to impeding a federal investigation and was sentenced
12. NextCard was liquidated by a federal bankruptcy court in the summer of 2003; five of the
company’s former executives were indicted on various fraud charges.
42 Case 1.6 NextCard, Inc.
Instructional Objectives
2. To help students understand the enormous pressures that auditors, particularly audit partners,
can face on high-profile audit engagements.
3. To allow students to identify, and discuss the implications of, fraud risk factors that are present
on a given audit engagement.
Suggestions for Use
This case allows auditing instructors to cover the following three “hot” topics in the auditing
profession: (1) ethical responsibilities of auditors, (2) auditors’ fraud detection responsibilities, and
(3) the Sarbanes-Oxley Act. This is a good case to assign early in the semester of an undergraduate
auditing course, possibly as a prelude to the ethics and legal liability chapters (which are typically
presented back-to-back in an undergraduate auditing text). You might consider using a role-playing
exercise to introduce the case. Choose two students to assume the role of Thomas Trauger and
Suggested Solutions to Case Questions
1. The professional auditing standards do not explicitly require auditors to “evaluate the
soundness” of a client’s business model. Nor do the standards require auditors to document the
client’s business model in their workpapers. Nevertheless, AU-C Section 315, “Understanding the
Case 1.6 NextCard, Inc. 43
2. When identifying fraud risk factors for a given case, I typically require my students to classify
those factors into the A’s, I’s and O’s of fraud. That is, students are required to classify those factors
as either “attitudes,” “incentives” (pressures), or “opportunities.”
Listed next are specific fraud risk factors that were apparently present during the 2000 NextCard
audit.
•The high degree of subjectivity required to arrive at NextCard’s allowance for bad debts
(opportunities)
• NextCard’s management team did not have a proper appreciation of the importance of internal
controls and honest financial reporting (attitudes and opportunities)
AU-C Section 240 of the AICPA Professional Standards points out that auditors have an
obligation to obtain “reasonable assurance” regarding whether a client’s financial statements are
“free of material misstatement, whether caused by error or fraud” (AU-C 240.05). The same
responsibility is imposed on auditors by AU Section 316.01 of the PCAOB’s Interim Standards.
After having identified specific audit risk factors, an auditor must consider how those factors
should impact the nature, extent and timing of his or her subsequent audit procedures. Following are
44 Case 1.6 NextCard, Inc.
3. The audit documentation responsibilities imposed on auditors and the related objectives of audit
documentation are discussed in AU-Section 230 of the AICPA Professional Standards and PCAOB
Auditing Standard No. 3.
AU-C Section 230:
Paragraph AU-C 230.02 notes that the “nature and purposes” of audit documentation include
•“Assisting auditors to understand the work performed in the prior years as an aid in planning
and performing the current engagement”
Paragraph .08 of AU-C Section 230 provides the following general guidance to independent
auditors regarding audit workpapers or “audit documentation.”
“The auditor should prepare audit documentation that is sufficient to enable an experienced
auditor, having no previous connection with the audit, to understand
PCAOB Auditing Standard No. 3:
This standard defines audit documentation as “the written record of the basis for the auditor’s
conclusions that provides the support for the auditor’s representations, whether those representations
are contained in the auditor’s report or otherwise” (paragraph .02). “Examples of audit
documentation include memoranda, confirmations, correspondence, schedules, audit programs, and
letters of representation. Audit documentation may be in the form of paper, electronic files, or other
media” (para. .04).
Case 1.6 NextCard, Inc. 45
4. An efficient way to address this question is to simply “walk” through the ten generally accepted
auditing standards incorporated in AU Section 150 of the PCAOB’s Interim Standards with your
students and point out apparent or potential violations of each standard.
General Standards
1. Proper technical training and technical proficiency: one could question whether the NextCard
audit was properly staffed since a relatively inexperienced individual, Oliver Flanagan, was serving
as the senior audit manager on that engagement
Field Work Standards
1. Adequate planning and proper supervision: Clearly, Thomas Trauger failed to provide proper
supervision of his two subordinates, Oliver Flanagan and Michael Mullen. Although the SEC did
not criticize E&Y’s planning of the 2000 NextCard audit, in retrospect, it seems apparent that the
planning phase of that audit failed to identify the huge audit (inherent) risk posed by the client’s
Reporting Standards
46 Case 1.6 NextCard, Inc.
2. Consistent application of GAAP: N/A
3. Proper disclosures: In retrospect, E&Y likely should have required NextCard to discuss in the
footnotes to the company’s 2000 financial statements the inordinate collectibility risk posed by its
credit card receivables.
5. A mentor is defined in Random House Webster’s College Dictionary as “a wise and trusted
counselor or teacher.” The professional standards do not refer directly to the term “mentor;”
however, the standards seem to suggest that “mentoring” is an important feature of the quality
control process within the auditing profession. For example, the first standard of field work in the
PCAOB’s Interim Standards requires that “assistants” be “properly supervised.” Likewise, the
6. We all recognize that Oliver Flanagan had a professional responsibility to not blindly acquiesce
to Thomas Trauger’s instructions to alter the 2000 NextCard workpapers. However, the intent of
this question is to require students to place themselves in Flanagan’s situation before responding.
Case 1.6 NextCard, Inc. 47
obvious measure that Flanagan could have and probably should have taken would have been to
consult other audit partners within the San Francisco office. Almost certainly, this would have
solved Flanagan’s dilemma. The audit partners he contacted would have discussed the matter with
Trauger and very likely convinced him that altering the NextCard workpapers was not a reasonable
Following is a list of individuals who were affected by Oliver Flanagan’s decision to cooperate
with Trauger in altering the NextCard workpapers.
(a) Himself: Students often overlook the responsibility that an accountant has to herself or
himself. An individual who exercises poor ethical or moral judgment may lose not only the
respect of others, but more importantly, his or her self-respect.
(b) Partners and employees of his firm: Recent history suggests that unethical or otherwise
unprofessional conduct by a public accountant can cost his or her employer considerable