CASE 1.4
HEALTH MANAGEMENT, INC.
Synopsis
This case profiles an imaginative accounting fraud orchestrated by two top executives of
Health Management, Inc. (HMI), a New York-based pharmaceuticals distributor. The HMI fraud is
audit firm. The plaintiff attorneys attempted to prove that the BDO Seidman auditors had been
reckless during the 1995 HMI audit, which prevented them from discovering the large inventory
fraud carried out by Clifford Hotte, HMI’s CEO, and Drew Bergman, the company’s CFO. The
plaintiff attorneys repeatedly pointed to a series of red flags that the BDO Seidman auditors had
allegedly overlooked or discounted during the 1995 audit. Additionally, the plaintiff attorneys
charged that a close relationship between Bergman and Mei-ya Tsai, the audit manager assigned to
the 1995 HMI audit engagement team, had impaired BDO Seidman’s independence during the 1995
audit. Bergman had previously been employed by BDO Seidman and had served as the audit
manager on prior HMI audits.
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Case 1.4 Health Management, Inc. 27
Health Management, Inc.—Key Facts
1. Clifford Hotte and Drew Bergman engineered an accounting fraud to allow HMI to reach its
1995 earnings target.
2. The key element of the HMI fraud was an elaborate in-transit inventory sham that resulted in a
material overstatement of HMI’s year-end inventory.
1934.
4. Congress intended the PSLRA to alleviate the burdensome legal liability that accounting firms
5. The key objective of the plaintiff attorneys in the HMI lawsuit filed by the company’s former
6. BDO Seidman’s attorneys used a three-pronged defense strategy: (1) insisting that the auditors
8. Another key issue that arose during the trial was whether a relationship between Bergman and
9. Eventually, the jurors ruled in favor of BDO Seidman after deciding that the auditors had not
been reckless.
10. BDO Seidman’s lead attorney suggested that the PSLRA’s proportionate liability rule was a key
factor that gave his client the courage to contest and ultimately defeat the HMI lawsuit.
28 Case 1.4 Health Management, Inc.
Instructional Objectives
2. To illustrate key strategies that plaintiff and defense attorneys use in lawsuits filed against
auditors.
3. To define firecklessness” as it relates to audit-related lawsuits filed under the Securities
Exchange Act of 1934.
Suggestions for Use
This case includes dialogue excerpted from the transcripts of the HMI trial in late 1999. When
possible, I attempt to incorporate such dialogue into cases because it results in a heightened sense of
realism. The dialogue in the case also provides an opportunity for instructors to set up realistic role–
playing exercises. For example, you might consider having one student assume the role of the
plaintiff attorney who interrogated Jill Karnick, the BDO Seidman semi-senior who audited HMI’s
inventory, while another student fisteps into the shoes” of Ms. Karnick. Instruct the attorney to quiz
Ms. Karnick regarding the audit procedures she applied to inventory, in particular her aborted effort
to complete an inventory rollforward. Likewise, you could use role-playing to recreate some of the
testy exchanges that took place between Michael Young and Mr. Moore, the plaintiff’s expert
Suggested Solutions to Case Questions
1. The two dimensions of auditor independence are relevant to this context: appearance of
independence and de facto independence. A close friendship between an auditor and a client
employee can jeopardize the auditor’s appearance of independence (and that of the entire audit team)
even though the auditor scrupulously protects his or her de facto independence. If third parties lose
Case 1.4 Health Management, Inc. 29
2. Interpretation 101-2, fiEmployment or Association with Attest Clients,”of the AICPA Code of
Professional Conduct addresses the situation in which an auditor is considering the possibility of
employment with an audit client during the course of an audit engagement.
fiWhen a member of the attest engagement team or an individual in a position to influence the
attest engagement intends to seek or discuss potential employment or association with an attest
client, or is in receipt of a specific offer of employment from an attest client, independence will
be impaired with respect to the client unless the person promptly reports such consideration or
offer to an appropriate person in the firm, and removes himself or herself from the engagement
3. The most common situation in which an inventory rollback is performed is when an audit firm
has been retained to audit a company following that company’s year-end physical inventory. If the
inventory is a material item in the client’s financial statements, the audit firm must devise a test or
series of tests to corroborate the key management assertions for that inventory. Since re-taking the
4. As Michael Young noted during the HMI trial, the decision of what audit procedures to apply in
a given context is ultimately a matter of professional judgment on the part of individual auditors.
30 Case 1.4 Health Management, Inc.
So, Jill Karnick and the other members of the HMI audit engagement team were well within their
rights to decide whether to complete an inventory rollback or rollforward. One troubling aspect of
Karnick’s decision not to complete the inventory rollforward was that the decision was apparently
not approved or even reviewed by her superiors. Given the importance of that decision, it would
seem that Karnick’s superiors would have been involved in, or, at a minimum, reviewed that
decision. [Certainly, it is possible that Tsai and/or Bornstein were involved in that decision and that
the trial transcripts simply failed to comment on their involvement.]
5. AU–C Section 230.A6 of the AICPA Professional Standards includes the following statement:
fiThe auditor need not include in audit documentation superseded drafts of working papers and
financial statements, notes that reflect incomplete or preliminary thinking, previous copies of
documents corrected for typographical or other errors, and duplicates of documents.” This statement
suggests that the results of inconclusive audit tests do not have to be included in audit workpapers.
Paragraph 230.A17 reinforces this conclusion by noting that auditors do not need to firetain
attempt to perform an inventory rollforward.
6. The term fired flags” is generally used to refer to various factors, variables, or other items that
suggest there is a higher than normal risk that a given audit client’s financial statements have been
distorted by intentional misstatements. The term fifraud risk factors” is essentially interchangeable
with fired flags.” The Appendix to AU 316, fiConsideration of Fraud in A Financial Statement
Audit,” of the PCAOB’s Interim Standards lists numerous examples of fraud risk factors. Examples
of these items include fihigh degree of competition or market saturation accompanied by declining
margins,” fihigh vulnerability to rapid changes . . . in technology . . . or interest rates,” fioperating
Case 1.4 Health Management, Inc. 31
losses making the threat of bankruptcy, foreclosure, or hostile takeover imminent.” A comparable
list of fraud risk factors can be found in the AICPA Professional Standards at AU-C 240.A75.
During the planning phase of an audit, auditors will consider the existence of red flags in
7. Section 10A, fiAudit Requirements,” of the Securities Exchange Act of 1934 discusses auditors’
responsibilities for investigating and reporting illegal acts by an audit client. Section 10A provides
the following cryptic definition of an illegal act: fithe term illegal act means an act or omission that
violates any law, or any rule or regulation having the force of law.” The key issue in this context is
that an illegal act discovered by an audit team must have a fimaterial effect on the financial
statements” of the given company to trigger required disclosure to the SEC [again, such disclosure is
not necessary if the given company informs the SEC of the matter]. Listed next are three
(hypothetical) illegal acts and my judgment of whether the given audit team should insist that client
management report each item to the SEC.