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EVALUATE the audit planning process and the role that risk assessment plays in the overall design of the audit plan.
Something went Sour at Parmalat
Problem
There was much confusion when Italian dairy food giant Parmalat defaulted on a $187 million bond payment in mid-November 2002. Default on a bond payment seemed difficult to believe considering that a Parmalat subsidiary in the Cayman Island had $4.9 billion cash balance in a Bank of America account. The problem was that the cash account did not exist.
Subsequent investigation revealed that over a 15-year period, Parmalat’s management had falsified accounts and created assets to hide losses of $10 billion from Parmalat’s Latin American operations. Other allegations charged that Parmalat’s management had lied about repurchasing $3.6 billion in bonds, which they had never done. Bu hiding losses and increasing assets on its balance sheet, Parmalat was able to continue to borrow enough money from investors and creditors to conceal and perpetuate the massive funds.
AUDIT APPROACH
From 1990 to 1999, the Italian branch of Grant Thornton audited Parmalat. Under Italian law, however, Parmalat was forced to change auditors periodically and chose the Italian branch of Deloitte Touche Tohmatsu (Deloitte & Touche SpA) to be the company’s new auditor in 2000. Grant Thornton, however, continued to audit Parmalat’s offshore subsidiaries located in the Cayman Island.
Auditors first inquired about the Cayman Island account in December 2002 and received a letter on Bank of America letterhead in March 2003, confirming the existence of the account. The letter however, was a forgery, created in Parmalat’s headquarters. Nevertheless, the $4.9 billion was listed on the subsidiary’s balance sheets dated December 31, 2002, and June 30, 2003.
The auditors missed several red flags. First the size of the account, on its own, should have been a red flag. It is very unusual for a large company to have so much cash in a single bank account. In addition, between January 2000 and September 2003, Parmalat raised more than $5 billion in debt offerings. With so much cash available in the Cayman Island, why was Parmalat continuing to borrow money?
Second, the communication received from the Bank of America was in form of a facsimile, which raises two issues. First, a fax transmission is not subject to the same level of control as returning an original confirmation. Essentially, a fax can be sent from almost anywhere and the originating phone number can be falsified by simply changing the phone number in the transmitting machine. A mailed confirmation, however, passes through the federal mail system and is post marked with the originated ZIP code. Also, this particular fax was smudged, raising more suspicions. Forgers routinely “age” their “originals” by repeatedly photocopying them to obscure any telltale photocopying lines. Given these circumstances, the auditors should have followed up directly with the bank.
Third, when such large balances represent a significant portion of a company’s balance sheet (in this case, 38 percent of Parmalat’s assets were in the subsidiary’s bank accounts), auditors, should take additional care to obtain further corroboration. All told, the combination of a large bank account and a questionable form of confirmation would have provided Deloitte & Touche SpA sufficient warning to dig deeper.
DISCOVERY
Parmalat management also told Deloitte & Touche SpA that the company had $617 million investment in an open-ended mutual fund that it could assess at any time. The company, however, was unsuccessful in its attempts to retrieve the funds. Because no evidence was available to support management’s claims, Deloitte & Touche SpA included a qualification in its audit review report highlighting the lack of evidence and alerted regulators of suspicious of a larger fraud.
Initial investigation revealed that massive amounts (estimates as high as 19 billion) of assets were missing or nonexistent. Parmalat and its subsidiaries filed for bankruptcy protection in Italy on December 27, 2003.
During the ongoing investigation, a Parmalat employee who had disobeyed orders to destroy company documents turned over a number of incriminating computer disks to investigators, with evidence mounting, Parmalat’s founder and CEO Calisto Tanzi admitted to prosecutors that he was aware of the fraud, he also admitted to misappropriating Parmalat assets (more than $1 billion, prosecutor believe) to cover losses in other family-owned companies. It is unlikely that investigators will ever know for certain what happened to the missing funds (whether they were used to cover operating losses, pay creditors, or illegally enrich management). Twenty other Parmalat executives including members of Tanzi’s family, and company’s former CFO, former board members, and even lawyers, were indicted on charges including fraud, embezzlement, false accounting, and misleading investors. On June 28, 2005, a judge accepted plea bargains from 11 of those charged and sentenced them to prison ranging from 10 months to 2.5 years. In his January 2008 trial, Calisto Tanzi was found guilty of securities laws violations and sentenced to 10 years in prison for his role in the fraud. More than two years later, in December 2010, Tanzi was found guilty of fraudulent bankruptcy and criminal association and sentenced to an additional 18 years in jail. After unsuccessfully appealed that verdict in 2011, the court added another nine years to his sentence. He should be about 105 years old when he is finally released.
Discussion
1. What steps does an auditor ordinary take when conforming cash balances held on deposits with financial institutions?
2. What additional steps should the auditors have taken when they received the smudged fax copy printed on Bank of America letterhead?
3. What red flags did the auditors miss?
4. What steps should Deloitte & Touche SpA have taken with the respect to Grant Thornton’s audit of the Cayman Island subsidiaries?
Assignment: Case Study – Something Went Sour at Parmalat
This assignment will assess the following competency:
EVALUATE the audit planning process and the role that risk assessment plays in the overall design of the audit plan.
Directions
Refer to the case study on page C20 and write a paper to address the 4 questions at the end of the case. Your paper should be 400-500 words and written in the APA format citing your references.
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When conforming cash balances held on deposits with financial institutions, auditors typically take the following steps:
Obtain a bank confirmation directly from the financial institution holding the account, preferably through a mailed confirmation that passes through the federal mail system and is postmarked with the originated ZIP code. This confirmation should be sent directly to the auditor, rather than through the client company.
Verify the authenticity of the confirmation received by performing follow-up procedures, such as contacting the financial institution by phone or fax to confirm the details of the account balance.
Compare the balance reported on the confirmation with the balance recorded in the client’s accounting records to ensure that they match.
Investigate any discrepancies or unusual transactions, such as large or frequent deposits or withdrawals, to determine if they are legitimate and properly accounted for.
In the case of Parmalat, the auditors missed several red flags and did not take sufficient care to obtain further corroboration of the cash balances held on deposits with financial institutions. They could have taken the following additional steps to improve their audit approach:
Recognize the unusual size of the account and investigate why Parmalat was continuing to borrow money despite having such a large cash balance in the Cayman Island.
Perform more rigorous follow-up procedures on the fax confirmation received from Bank of America, such as contacting the bank directly to verify the authenticity of the confirmation and requesting additional documentation.
Take additional care to obtain further corroboration when large balances represent a significant portion of a company’s balance sheet, as was the case with Parmalat’s subsidiary.
Investigate the lack of evidence supporting management’s claims of a $617 million investment in an open-ended mutual fund.
Be more skeptical of management’s representations and consider the possibility of fraud when red flags are present.
References
Albrecht, W. S., Albrecht, C. C., Albrecht, C. O., & Zimbelman, M. F. (2018). Fraud examination. Cengage Learning.
Singleton, T. W., Singleton, A. J., & Bologna, J. C. (2017). Fraud auditing and forensic accounting. John Wiley & Sons.
