CASE 2.6
CBI HOLDING COMPANY, INC.
Synopsis
Ernst & Young audited the pharmaceutical wholesaler CBI Holding Company, Inc., in the early
1990s. In 1991, Robert Castello, CBI’s owner and chief executive, sold a 48% stake in his company
to TCW, an investment firm. The purchase agreement between Castello and TCW identified certain
“control–triggering” events. If one such event occurred, TCW had the right to take control of CBI.
qualified as a “control–triggering” event.
This case examines the audit procedures that Ernst & Young applied to CBI’s year–end accounts
payable for fiscal 1992 and 1993. The principal audit test that Ernst & Young used in auditing CBI’s
accounts payable was a search for unrecorded liabilities. Although Ernst & Young auditors
discovered unrecorded liabilities each year that resulted from Castello’s fraudulent scheme, they did
not properly investigate those items and, as a result, failed to require CBI to prepare appropriate
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CBI Holding Company, Inc.—Key Facts
1. In 1991, TCW purchased a 48% ownership interest in CBI from Robert Castello, the company’s
owner and chief executive.
3. During CBI’s fiscal 1992 and 1993, Castello oversaw a fraudulent scheme that resulted in him
receiving year-end bonuses to which he was not entitled.
4. A major feature of the fraud was the understatement of CBI’s year-end accounts payable.
5. Castello realized that the fraudulent scheme qualified as a control-triggering event.
8. Because the auditors accepted the “advances” explanation provided to them by client personnel,
they failed to require CBI to record adjusting entries for millions of dollars of unrecorded liabilities
at the end of fiscal 1992 and 1993.
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Instructional Objectives
1. To illustrate methods that client management may use to understate accounts payable.
2. To examine the audit objectives related to accounts payable and the specific audit tests that may
be used to accomplish those objectives.
Suggestions for Use
This case focuses on accounts payable and, consequently, is best suited for coverage during
classroom discussion of the audit tests appropriate for that account. Alternatively, the case could be
integrated with coverage of audit evidence issues. Finally, the case also raises several interesting
auditor independence issues.
Suggested Solutions to Case Questions
1. “Completeness” is typically the management assertion of most concern to auditors when
investigating the material accuracy of a client’s accounts payable. Generally, clients have a much
stronger incentive to violate the completeness assertion for liability and expense accounts than the
other management assertions relevant to those accounts. Unfortunately for auditors, a client’s
financial controls for accounts payable are typically not as comprehensive or as sophisticated as the
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2. Before answering the explicit question posed by this item, let me first address the “explanation”
matter. In most circumstances, auditors are required to use confirmation procedures in auditing a
client’s accounts receivable. Exceptions to this general rule are discussed in AU Section 330, “The
Confirmation Process,” of the PCAOB’s Interim Standards and include cases in which the client’s
accounts receivable are immaterial in amount and when the use of confirmation procedures would
likely be ineffective. On the other hand, confirmation procedures are not generally required when
The differing objectives of accounts payable and accounts receivable confirmation procedures
require an auditor to use different sampling strategies for these two types of tests. For instance, an
auditor will generally confirm a disproportionate number of a client‘s large receivables. Conversely,
because completeness is the primary concern in a payables confirmation procedure, the auditor may
send out confirmations on a disproportionate number of accounts that have relatively small balances
or even zero balances. Likewise, an auditor may send out accounts payable confirmations to inactive
vendor accounts and send out confirmations to vendors with which the client has recently established
a relationship even though the client’s records indicate no outstanding balance owed to such vendors.
A final technical difference between accounts payable and accounts receivable confirmation
procedures is the nature of the confirmation document used in the two types of tests. A receivable
3. AU Section 561 of the PCAOB’s Interim Standards discusses auditors’ responsibilities regarding
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the “subsequent discovery of facts” existing at the date of an audit report. That section of the
professional standards suggests that, as a general rule, when an auditor discovers information that
would have affected a previously issued audit report, the auditor has a responsibility to take
appropriate measures to ensure that the information is relayed to parties who are still relying on that
report. In this particular case, AU Section 561 almost certainly required Ernst & Young to inform
4. The key criterion in assigning auditors to audit engagements should be the personnel needs of
each specific engagement. Certainly, client management has the right to complain regarding the
assignment of a particular individual to an audit engagement if that complaint is predicated on the
5. Determining whether high-risk audit clients should be accepted is a matter of professional
judgment. Clearly, “economics” is the overriding issue for audit firms to consider in such
circumstances. An audit firm must weigh the economic benefits (audit fees and fees for ancillary
services, if any) against the potential economic costs (future litigation losses, harm to reputation,
etc.) in deciding whether to accept a high-risk client. Complicating this assessment is the fact that
many of the economic benefits and the economic disincentives related to such decisions are difficult
to quantify. For example, quite often one of the best ways for an audit firm to establish a foothold in
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