Case 1.4 Health Management, Inc.

26

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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
noteworthy because it led to the first major test of an important federal statute, the Private Securities
Litigation Reform Act of 1995 (PSLRA), that was intended to alleviate the growing burden of class-
action lawsuits filed against accounting firms and other third parties under the Securities Exchange
Act of 1934. (The PSLRA amended key provisions of the 1934 Act.) The PSLRA made it more
difficult for plaintiffs to successfully “plead” a case under the 1934 Act, that is, to have such a
lawsuit proceed to trial. Among other provisions in the PSLRA is a proportionate liability rule.
Under this liability standard, a defendant that is guilty of no more than “recklessness” is generally
responsible for only a percentage of a plaintiff’s losses, the percentage of those losses produced by
the defendant’s reckless behavior.
HMI’s former stockholders filed a class-action lawsuit against BDO Seidman, HMI’s former
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

Following a jury trial in federal court, BDO Seidman was absolved of any responsibility for
the large losses that HMI’s stockholders had suffered as a result of the 1995 inventory fraud. BDO
Seidman’s lead attorney attributed that outcome of the case to the PSLRA. Absent the proportionate
liability rule incorporated in the PSLRA, the attorney suggested that BDO Seidman would likely
have chosen to pay a sizable settlement to resolve the lawsuit rather than contest it in the federal
courts.

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.

3. The HMI fraud triggered the first major test of an important federal statute, the Private
Securities Litigation Reform Act (PSLRA) of 1995, which amended the Securities Exchange
Act of 1934.

4. Congress intended the PSLRA to alleviate the burdensome legal liability that accounting firms
and other defendants faced under the 1934 Act by raising the “pleading standard” for lawsuits
filed under that law and by establishing proportionate liability for defendants found liable in
such lawsuits.

5. The key objective of the plaintiff attorneys in the HMI lawsuit filed by the company’s former
stockholders against BDO Seidman was to convince the jury that the BDO Seidman auditors, at
a minimum, had been reckless during the 1995 HMI audit.

6. BDO Seidman’s attorneys used a three-pronged defense strategy: (1) insisting that the auditors
were victims of the fraud, (2) arguing that there was no evidence of specific violations of
auditing standards by the auditors, and (3) contending that the auditors had made a good faith
effort to investigate HMI’s suspicious financial statement items.

7. A key issue during the trial was whether the BDO Seidman auditors should have performed an
inventory rollback to corroborate the year-end in-transit inventory.

8. Another key issue that arose during the trial was whether a relationship between Bergman and
the audit manager assigned to the HMI engagement, who was his former co-worker at BDO
Seidman, had undermined BDO Seidman’s independence.

9. Eventually, the jurors ruled in favor of BDO Seidman after deciding that the auditors had not
been reckless.

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 Case 1.4 Health Management, Inc. 28

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.

Instructional Objectives

1. To examine the implications that the Private Securities Litigation Reform Act of 1995 has had,
and is expected to have, for the public accounting profession.

2. To illustrate key strategies that plaintiff and defense attorneys use in lawsuits filed against
auditors.

3. To define “recklessness” as it relates to audit-related lawsuits filed under the Securities

Exchange Act of 1934.

4. To examine the impact that close relationships between auditors and client personnel can have
on independent audits.

5. To demonstrate that auditor judgment is the ultimate determinant of the specific audit
procedures applied during an audit engagement.

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 “steps 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, BDO’s lead attorney, and Mr. Moore, the
plaintiff’s expert witness. Although many students are hesitant at first to participate in such
exercises, I have found that most of them quickly “warm” to the role they are asked to assume.
A feature of this case that typically spawns considerable discussion is the close friendship that
existed between Drew Bergman and Mei-ya Tsai. The professional auditing standards do not
prohibit auditors from being friends with client personnel, but such friendships can be very
problematic. To extend Question 1, you might ask students to develop a set of general rules or
guidelines that audit firms should include in their policy and procedures manual to ensure that
auditor-client relationships do not jeopardize the independence of an audit team or the independence/
objectivity of individual auditors.

Suggested Solutions to Case Questions

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 Case 1.4 Health Management, Inc. 29

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
confidence in an auditor’s independence, then the purpose of the audit is undermined, period.
I would suggest that the de facto independence of an auditor has been compromised by a
relationship with a client employee when that relationship begins to influence important decisions of
the auditor. For example, if an auditor decides not to fully investigate a suspicious transaction or
other item because doing so might result in negative consequences for his or her friend, clearly the
actual independence of the auditor has been compromised. Likewise, loss of independence may
result in an auditor failing to gain a proper understanding of a client’s internal controls, ignoring
pertinent fraud risk factors that are present, or even issuing an inappropriate audit opinion for the
given client.

2. Interpretation 1.279.010, “Considering Employment or Association with an Attest Client,” 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. In such
situations, the given individual faces an unacceptable threat of violating his or her independence. To
mitigate that threat, four “safeguard” conditions have to be met:

a. “The individual promptly reports such consideration or offer to an appropriate person

in the firm.
b. The individual immediately ceases participation in the engagement and does not
provide any services to the attest client until the employment or offer is rejected or
employment is no longer sought.
c. If a covered member becomes aware that an individual is considering employment or
association with an attest client, the covered member should notify an appropriate person in
the firm.
d. The appropriate person in the firm should consider whether, based on the nature of
the engagement and the individual involved, the firm should perform any additional
procedures to provide reasonable assurance that any work that the individual performed for
the attest client was performed in compliance with the ‘Integrity and Objectivity Rule.’” [ET
1.279.010.02]

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
physical inventory may not be feasible or may be too costly, auditors in such situations will typically
use the client’s purchases and sales documentation during the intervening period since the physical
inventory to “rollback” the existing inventory quantities and dollar amounts to the corresponding
amounts on the inventory date.
AS 1105.08 of the PCAOB auditing standards discusses the factors that impact the reliability or
validity of audit evidence. Following is a brief excerpt from that discussion. “Evidence obtained
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 Case 1.4 Health Management, Inc. 30

from a knowledgeable source that is independent of the company is more reliable than evidence
obtained only from internal company sources.” (A similar statement is found in AU-C Section
500.A8 of the AICPA Professional Standards.) This observation would suggest that the
documentary evidence provided by an inventory rollback is not as persuasive as the physical
evidence that auditors obtain by observing a client’s physical inventory.

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.
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.]
AU-C Section 200.A52 of the AICPA Professional Standards notes that cost considerations are a
valid issue for auditors to weigh when deciding on the specific audit procedures to apply in a given
setting. However, that same paragraph also explicitly states that cost considerations should not be
the ultimate factor in such decisions. “The matter of difficulty, time, or cost involved is not in itself
a valid basis for the auditor to omit an audit procedure for which there is no alternative or to be
satisfied with audit evidence that is less than persuasive. Appropriate planning assists in making
sufficient time and resources available for the conduct of the audit. Notwithstanding this, the
relevance of information, and thereby its value, tends to diminish over time, and there is a balance to
be struck between the reliability of information and its cost . . . Therefore, there is an expectation by
users of financial statements that the auditor will form an opinion on the financial statements within
a reasonable period of time and so as to achieve a balance between benefit and cost, recognizing that
it is impracticable to address all information that may exist or to pursue every matter exhaustively on
the assumption that information is fraudulent or erroneous until proved otherwise.” (AS 1105,
“Audit Evidence,” in the PCAOB auditing standards does not contain an equivalent discussion of the
tradeoff between the costs and benefits of audit evidence.)

5. AU-C Section 230.A6 of the AICPA Professional Standards includes the following statement:
“The 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 “retain
documentation that is incorrect or superseded.”
AS 1215, “Audit Documentation,” of the PCAOB auditing standards does not include a
discussion directly comparable to that just highlighted in AU-C Section 230 of the AICPA
Professional Standards. However, AS 1215.06 includes the following blanket statement: “The
auditor must document the procedures performed, evidence obtained, and conclusions reached with
respect to relevant financial statement assertions.” AS 1215.12 also observes that audit
documentation should include a discussion of “circumstances that cause significant difficulty in
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 Case 1.4 Health Management, Inc. 31

applying auditing procedures.” This latter statement would certainly have been relevant to Ms.
Karnick’s aborted attempt to perform an inventory rollforward.

6. The term “red 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 “fraud risk factors” is essentially interchangeable
with “red flags.” The Appendix to AS 2401, “Consideration of Fraud in A Financial Statement
Audit,” of the PCAOB’s auditing standards lists numerous examples of fraud risk factors. Examples
of these items include “high degree of competition or market saturation accompanied by declining
margins,” “high vulnerability to rapid changes . . . in technology . . . or interest rates,” “operating
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
developing the planned nature, extent, and timing of their audit tests. Red flags identified by
auditors during the planning phase will typically result in more extensive and rigorous tests applied
by auditors during the substantive testing phase of an audit. In the internal control evaluation phase
of an audit, auditors should consider whether given red flags have resulted in a client’s internal
controls being undercut or subverted. Finally, during the “wrap-up” phase of an audit, an audit
engagement team must consciously weigh once more the potential impact of existing red flags or
fraud risk factors on a client’s financial statements. In this final stage of an audit, auditors can step
back and make a “big picture” assessment of the given client’s financial statements. During the
course of an audit, an audit team may overlook individual hints or signals that something is amiss in
the client’s accounting records and financial statements. Near the end of the audit, however, an audit
manager or partner should be able to link such items together to make a more informed judgment
regarding the likelihood that fraud has affected the client’s financial data.

7. Section 10A, “Audit 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: “the 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 “material 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.

A retail company “holds open” its sales records at the end of a fiscal year to ensure that it reaches
its sales and earnings target for that year. Analysis: this is an illegal act that almost certainly should
be reported to the SEC. Two issues that would be relevant in determining whether SEC disclosure
would be necessary are the level of management involved in the fraud and the magnitude of the
fraud’s impact on the company’s sales and earnings. The more important issue is the fraud’s impact
on sales and earnings. For example, if absent the fraudulent scheme the given company would not
have achieved its sales and earnings targets, then it would be difficult to sustain an argument that the
scheme did not have a material effect on the company’s financial statements, regardless of the
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 Case 1.4 Health Management, Inc. 32

absolute magnitude of the amounts involved. In today’s capital markets a small revenue or earnings
“miss” can result in a company’s stock being battered by investors.
A company admits that a racial discrimination charge filed against a production-line supervisor by a
minority worker is valid. Analysis: Unless racial discrimination is seemingly rampant within the
given organization, this is an illegal act that likely would not have to be reported to the SEC.
A manufacturing company violates legally enforceable regulations issued by the Environmental
Protection Agency. Analysis: Unless the violation is indicative of a pervasive problem and unless
the monetary sanctions to be imposed on the company are material, this item would likely not have
to be reported to the SEC.

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posted to a publicly accessible website, in whole or in part.