CASE 2.2 Golden Bear Golf, Inc. Jack Nicklaus electrified sports fans worldwide in 1986 when he won the prestigious Masters golf tournament at the ripe old age of 46. Over the previous several years, the “Golden Bear” had been struggling to remain competitive with the scores of talented young players who had earned the right to play in the dozens of golf tournaments sponsored each year by the Professional Golfers’ Association (PGA). Regaining his golden touch on the golf course was not the only challenge that Nicklaus faced during the mid-1980s. In 1985, Richard Bellinger, an accountant employed by Golden Bear International, Inc. (GBI), the private company that oversaw the famous golfer’s many business interests, mustered the courage to approach his employer. Bellinger told Nicklaus that his company was on the verge of bankruptcy. Nicklaus, who had allowed subordinates to manage his company’s operations, was startled by the revelation. In a subsequent interview with the Wall Street Journal, Nicklaus admitted that after a brief investigation he realized that he had allowed his company to become a tangled knot of dozens of unrelated businesses. “We were an accounting nightmare … I didn’t know what any of them did and ­neither did anyone else.”1 Nicklaus immediately committed himself to revitalizing his company. The first step that he took to turn around his company was naming himself as its chief executive officer (CEO). Nicklaus then placed Bellinger in charge of GBI’s day-to-day operations. Within a few years, the two men had returned GBI to a profitable condition by focusing its resources on lines of business that Nicklaus knew best, such as golf course design, golf schools, and the licensing of golf equipment. In the late 1990s, Jack Nicklaus once again found himself coping with an “accounting nightmare.” This time, Nicklaus could not blame himself for the predicament he faced. Instead, the responsibility for the new crisis rested squarely on the shoulders of two of Nicklaus’s key subordinates who had orchestrated a fraudulent accounting scheme that jeopardized their employer’s corporate empire. Player of the Century Jack Nicklaus began playing golf as a young boy and had mastered the game by his mid-teens. After graduating from high school, the golf prodigy accepted a scholarship to play collegiately for Ohio State University in his hometown of Columbus. At the age of 21, Nicklaus joined the professional golf tour and was an instant success, racking up more than one dozen victories within a few years. Shortly after joining the professional golf tour, the business-minded Nicklaus realized that winning golf tournaments was not the most lucrative way to profit from his enormous skills. At the time, the undisputed “king” of golf was Arnold Palmer, who endeared himself to the golfing public with his easy smile and affable manner on the golf course. Adoring legions of fans known as “Arnie’s Army” tracked Palmer’s every move during a tournament. Palmer’s popularity with the public translated into a 1. R. Lowenstein, “A Golfer Becomes an Executive: Jack Nicklaus’s Business Education,” Wall Street Journal, 27 January 1987, 34. 199 Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 20 0 SECTION TWO Audits of High -R isk Accounts series of high-profile and profitable endorsement deals. On the other hand, golf fans generally resented Nicklaus’s no-nonsense approach on the golf course. Those same fans resented Nicklaus even more when it became evident that the burly Ohioan with the trademark crew cut would likely replace Palmer as the world’s best golfer, which he did. Nicklaus would ultimately win a record 18 major golf championships and edge out Palmer for the “Player of the Century” award in the golfing world. With the help of a professional sports agent, Nicklaus worked hard to develop a softer, more appealing public image. By the mid-1970s, Nicklaus’s makeover was complete and his popularity rivaled that of Palmer. As his popularity with the public grew, Nicklaus was able to cash in on endorsement deals and other business opportunities. Eventually, Nicklaus founded GBI to serve as the corporate umbrella for his business interests. In 1996, Nicklaus decided to expand his business operations by spinning off a subsidiary from GBI via an initial public offering (IPO). Nicklaus named the new public company Golden Bear Golf, Inc. (Golden Bear). One of Golden Bear’s principal lines of business would be the construction of golf courses. GBI would remain a privately owned company that would continue to manage Nicklaus’s other business ventures. Because Nicklaus planned to retain more than 50 percent of Golden Bear’s common stock, he and his subordinates would be able to completely control the new company’s operations. Nicklaus chose his trusted associate Richard Bellinger to serve as Golden Bear’s CEO. Bellinger then appointed John Boyd and Christopher Curbello as the two top executives of Paragon International, Golden Bear’s wholly owned subsidiary that would be responsible for the company’s golf course construction business. Boyd became Paragon’s president and principal operating officer, while Curbello assumed the title of Paragon’s vice president of operations. On August 1, 1996, Golden Bear went public. The company’s stock traded on the NASDAQ exchange under the ticker symbol JACK. Triple Bogey for Golden Bear Shortly after Golden Bear’s successful IPO, Paragon International’s management team was inundated with requests to build Jack Nicklaus–designed golf courses. In a few months, the company had entered into contracts to build more than one dozen golf courses. Wall Street analysts, portfolio managers, and individual investors expected these contracts to translate into sizable profits for Golden Bear. Unfortunately, those profits never materialized. Less than one year after Golden Bear’s IPO, Boyd and Curbello realized that they had been much too optimistic in forecasting the gross profit margins Paragon would earn on its construction projects. Instead of earning substantial profits on those projects, Paragon would incur large losses on many of them. To avoid the embarrassment of publicly revealing that they had committed Paragon to a string of unprofitable construction projects, the two executives instructed Paragon’s accounting staff to embellish the subsidiary’s reported operating results. A key factor that may have contributed to Boyd and Curbello’s decision to conceal Paragon’s financial problems was the incentive compensation package each had received when they signed on with the company. The two executives could earn sizable bonuses if Paragon met certain operating benchmarks. In addition, Boyd had been granted a large number of Golden Bear stock options. Because Paragon’s construction projects required considerably more than one year to complete, the company used percentage-of-completion accounting to recognize the revenues associated with those projects. Initially, Paragon applied the widely used “cost-to-cost” percentage-of-completion method that requires a company to Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 CASE 2.2Golden Bear Golf, Inc. determine the percentage of a project’s total estimated construction costs incurred in a given accounting period. Then, the same percentage of the total revenue (and gross profit) to be earned on the project is booked that period. During the second quarter of fiscal 1997, Boyd and Curbello determined that Paragon would have a large operating loss if the cost-to-cost method was used to recognize revenue on the golf course construction projects. At that point, the two executives instructed Paragon’s controller to switch to what they referred to as the “earned value” percentage-of-completion accounting method. “In developing its percentage-of-completion estimates under the earned value method, Paragon relied not on objective criteria, such as costs incurred, but instead relied on management’s subjective estimates as to its [a project’s] progress.”2 Throughout the remainder of fiscal 1997 and into fiscal 1998, Paragon’s management routinely overstated the percentage-of-completion estimates for the company’s golf course construction projects each quarter. To further enhance Paragon’s operating results, the company’s accounting staff inflated the contractual revenue amounts for most of the company’s construction projects. These increased revenue amounts were allegedly attributable to “change orders” that amended the original construction contracts between Paragon and the company’s clients. A final window-dressing scheme used by Paragon was recording revenue for potential construction projects. In some cases, Paragon recognized revenue in connection with potential projects that Paragon had identified while looking for new work, even though Paragon had no agreements in connection with these projects. In other cases, Paragon recognized revenue in connection with projects where the project’s owners were either entertaining bids from Paragon and other contractors or were negotiating with Paragon regarding a project yet to be awarded.3 During the spring of 1998, John Boyd and several of his top subordinates, including Christopher Curbello, attempted to purchase Paragon International from Golden Bear. When that effort failed, Boyd and Curbello resigned their positions with Paragon. After their departure, Paragon’s new management team quickly discovered that the subsidiary’s operating results had been grossly misrepresented. A subsequent investigation carried out jointly by Arthur Andersen & Co. (Paragon’s audit firm), PricewaterhouseCoopers, and Golden Bear’s external legal firm resulted in Golden Bear issuing restated financial statements in October 1998 for fiscal 1997 and for the first quarter of fiscal 1998. For fiscal 1997, Golden Bear had initially reported a $2.9 million net loss and golf course construction revenues of $39.7 million; the restated amounts included a $24.7 million net loss for fiscal 1997 and golf course construction revenues of only $21.8 million. For the first quarter of fiscal 1998, Golden Bear had reported an $800,000 net loss and golf course construction revenues of $16.0 million. Those amounts were restated to a $7.2 million net loss and golf course construction revenues of $8.3 million. “Audit Failures” The Securities and Exchange Commission (SEC) launched its own investigation of Golden Bear shortly after the company issued the restated financial statements. A primary target of the SEC investigation was Michael Sullivan, the Arthur Andersen 2. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 1604, 1 August 2002. 3. Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 1603, 1 August 2002. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 201 202 SECTION TWO Audits of High -R isk Accounts audit partner who served as the Golden Bear engagement partner. Sullivan had been employed by Andersen since 1970 and had been a partner in the firm since 1984. The SEC enforcement release that disclosed the results of its investigation of Andersen’s Golden Bear audits included a section entitled “Sullivan’s Audit Failures.” According to the SEC, Sullivan was well aware that the decision to use the earned value method “accelerated revenue recognition by material amounts” for Paragon.4 In fact, Sullivan was very concerned when Paragon decided to switch from the cost-tocost method to the “new and untested” earned value method. This concern prompted him to warn Paragon’s management, at the time the switch was made, that the earned value method should produce operating results approximately in line with those that would have resulted from the continued application of the cost-to-cost method. To monitor the impact of the earned value method on Paragon’s operating results, Sullivan required the client’s accounting staff to “provide detailed schedules showing Paragon’s project-by-project results under both methods for each reporting period from the second quarter of 1997 through the first quarter of 1998.” By the end of fiscal 1997, the comparative schedules prepared by Paragon’s accountants clearly revealed that the earned value method was allowing Paragon to book much larger amounts of revenue and gross profit on its construction projects than it would have under the cost-to-cost method. When Sullivan questioned Paragon’s executives regarding this issue, those executives maintained that “uninvoiced” construction costs had caused the cost-to-cost method to significantly understate the stages of completion of the construction projects. To quell Sullivan’s concern, in early fiscal 1998 Paragon’s management recorded $4 million of uninvoiced construction costs in a year-end adjusting entry for fiscal 1997. These costs caused the revenue that would have been recorded under the cost-to-cost method to approximate the revenue that Paragon actually recorded by applying the earned value method. Unknown to Sullivan, the $4 million of uninvoiced construction costs booked by Paragon were fictitious.5 The SEC criticized Sullivan and his subordinates for failing to adequately investigate the $4 million of uninvoiced construction costs that materialized at the end of fiscal 1997. According to the SEC, Sullivan relied almost exclusively on management’s oral representations to corroborate those costs. Sullivan knew that Paragon booked costs for which no invoices had been received and which were not reflected in the company’s accounts payable system, and that recording these uninvoiced costs would have substantially reduced the gap between the results produced by the two estimation methods. . . . While procedures with respect to invoiced and paid costs were performed, Sullivan did not employ any procedures to determine whether the uninvoiced costs had actually been incurred as of year-end. Paragon’s scheme to overstate its reported revenues and profits by applying the earned value method resulted in a dramatic increase in unbilled revenues by the end of 1997. Approximately 30 percent of the revenues reported in Golden Bear’s 1997 income statement had not been billed to its customers. When Paragon’s executives switched to the earned value method, they had assured Sullivan that they would bill their customers on that basis. Despite that commitment, Paragon continued to bill 4. The remaining quotations in this case were taken from Securities and Exchange Commission, Accounting and Auditing Enforcement Release No. 1676, 26 November 2002. 5. Recognize that the $4 million of uninvoiced construction costs that were accrued in the adjusting entry did not reduce Golden Bear’s gross profit that it recognized for fiscal 1997 under the earned value method. The $4 million of construction costs simply replaced an equal amount of expenses that had been recorded to produce the “proper” amount of gross profit under the earned value method. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 CASE 2.2Golden Bear Golf, Inc. their customers effectively on a cost-to-cost basis. (Paragon could not bill customers for the full amount of revenue that it was recording on the construction projects since those customers were generally aware of the actual stages of completion of those projects.) The SEC maintained that Sullivan and his subordinates should have rigorously tested Paragon’s large amount of unbilled revenues at the end of 1997. “A significant unbilled revenue balance requires adequate testing to determine the reason that the company is not billing for the work it reports as complete and whether unbilled amounts are properly recognized as revenue.” Instead, the SEC charged that Sullivan relied “excessively” on oral representations from Paragon management to confirm the unbilled revenues and corresponding receivables. In at least one case, the SEC reported that members of the Golden Bear audit team asked the owner of a Paragon project under construction to comment on the reasonableness of the $2 million unbilled receivable that Paragon had recorded for that project at the end of 1997. The owner contested that amount, alleging that Paragon had overestimated the project’s stage of completion. “Despite this significant evidence that a third party with knowledge of the project’s status disputed Paragon’s estimated percentage-of-completion under the contract, the audit team did not properly investigate this project or otherwise expand Andersen’s scope of testing of Paragon’s unbilled revenue balances.” According to the SEC, Sullivan did not believe the unbilled revenue posed major audit issues but instead was a “business issue” that Paragon had to resolve with its clients. A second tactic Paragon used to inflate its reported profits was to overstate the total revenues to be earned on individual construction projects. During the 1997 audit, Andersen personnel selected 13 of Paragon’s construction projects to corroborate the total revenue figures the company was using in applying the earned value percentage-of-completion accounting method to its unfinished projects. For 11 of the 13 projects selected, the Andersen auditors discovered that the total revenue being used in the percentage-of-completion computations by Paragon exceeded the revenue figure documented in the construction contract. Paragon’s management attributed these differences to unsigned change orders that had been processed for the given projects “but could not produce any documents supporting these oral representations.” Sullivan accepted the client’s representations that the given revenue amounts were valid. “In each instance, Sullivan failed to properly follow up on a single undocumented amount; instead, Sullivan relied solely on Paragon management’s oral representations that the estimated revenue amounts accurately reflected the economic status of the jobs.” Another scam used by Paragon to inflate its revenues and profits was to record revenue for nonexistent projects. In the enforcement release that focused on Sullivan’s role in the Paragon scandal, SEC officials pointed out that the publication AICPA Audit and Accounting Guide—Construction Contracts is clearly relevant to the audits of construction companies such as Paragon. This publication recommends that auditors visit construction sites and discuss the given projects with project managers, architects, and other appropriate personnel. The purpose of these procedures is to assess “the representations of management (for example, representations about the stage of completion and estimated costs to complete).” Despite this guidance, the Andersen auditors did not visit any project sites during the 1997 audit.6 Such visits may have resulted in Andersen discovering that some of Paragon’s projects were purely imaginary. 6. As a point of information, most of Paragon’s golf construction projects were outside of the United States. During 1996, auditors employed by foreign affiliates of Andersen visited some of these sites. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 203 204 SECTION TWO Audits of High -R isk Accounts In addition, Andersen would likely have determined that Paragon was overstating the stages of completion of most of its existing projects. The SEC reprimanded Andersen for not visiting any of Paragon’s jobsites or discussing those projects with knowledgeable parties. “Failing to discuss project status, including percentage-of-completion estimates, with project managers and other on-site operating personnel was, under the circumstances, a reckless departure from GAAS.” The SEC also criticized Sullivan for not insisting that Golden Bear disclose in its 1997 financial statements the change from the cost-to-cost to the earned value method of applying percentage-of-completion accounting. Likewise, the SEC contended that Sullivan should have required Golden Bear to disclose material related-party transactions involving Paragon and Jack Nicklaus, Golden Bear’s majority stockholder. Finally, the SEC noted that Sullivan failed to heed his own concerns while planning the 1997 Golden Bear audit. During the initial planning phase of that audit, Sullivan had identified several factors that prompted him to designate the 1997 Golden Bear audit a “high-risk” engagement. These factors included the subjective nature of the earned value method, Paragon’s large unbilled revenues, the aggressive revenue recognition practices advocated by Golden Bear management, and severe weaknesses in Paragon’s cost accounting system. Because of these factors, the SEC maintained that Sullivan and his subordinates should have been particularly cautious during the 1997 Golden Bear audit and employed a rigorous and thorough set of substantive audit procedures. EPILOGUE In August 1998, angry Golden Bear stockholders filed a class-action lawsuit against the company, its major officers, and its principal owner, Jack Nicklaus. That same month, the NASDAQ delisted the company’s common stock, which was trading for less than $1 per share, dramatically below its all-time high of $20. Richard Bellinger resigned as Golden Bear’s CEO two months later to “pursue other interests.” In December 1999, Golden Bear announced that it had reached an agreement to settle the classaction lawsuit. That settlement required the company to pay its stockholders $3.5 million in total and to purchase their shares at a price of $0.75. In 2000, Golden Bear, by then a private company, was folded into Nicklaus Companies, a new corporate entity that Jack Nicklaus created to manage his business interests. In November 2002, Michael Sullivan was suspended from practicing before the SEC for one year. Sullivan’s employer, Andersen, had effectively been put out of business a few months earlier when a federal jury found it guilty of obstruction of justice for destroying audit documents pertaining to its bankrupt client Enron Corporation.7 In August 2002, Paragon’s former controller received a two-year suspension from practicing before the SEC. At the same time, the SEC sanctioned three former Golden Bear executives by ordering them to “cease and desist” from any future violations of the federal securities laws. One of those executives was Richard Bellinger. The SEC maintained that Bellinger approved Paragon’s change from the cost-to-cost to the earned value method. Additionally, the SEC charged that Bellinger knew the change would materially increase Golden Bear’s reported revenues and gross profit but failed to require that the change be disclosed in the company’s financial statements. 7. As discussed in Case 1.1, Andersen’s conviction was subsequently overturned by the U.S. Supreme Court. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203 CASE 2.2Golden Bear Golf, Inc. Finally, in March 2003, a federal grand jury indicted John Boyd and Christopher Curbello on charges of securities fraud and conspiracy to commit securities fraud. Curbello was arrested in San Antonio, Texas, on March 14, 2003, while Boyd was apprehended in Bogota, Colombia, a few days later by Secret Service 205 and FBI agents who immediately flew him to the United States. In June 2003, Curbello pleaded guilty to conspiracy to commit securities fraud and was sentenced to three and onehalf years in prison. A few months later, Boyd pleaded guilty to similar charges and was given a five-year prison sentence. Questions 1. Professional auditing standards identify the “management assertions” that commonly underlie a set of financial statements. Which of these assertions were relevant to Paragon’s construction projects? For each of the assertions that you listed, describe an audit procedure that Arthur Andersen could have employed to corroborate that assertion. 2. The SEC referred to several “audit failures” that were allegedly the responsibility of Michael Sullivan. Define what you believe the SEC meant by the phrase “audit failure.” Do you believe that Sullivan, alone, was responsible for the deficiencies that the SEC noted in Andersen’s 1997 audit of Golden Bear? Defend your answer. 3. Sullivan identified the 1997 Golden Bear audit as a “high-risk” engagement. How do an audit engagement team’s responsibilities differ, if at all, on a high-risk engagement compared with a “normal” engagement? Explain. 4. The AICPA has issued several Audit and Accounting Guides for specialized industries. Do auditors have a responsibility to refer to these guides when auditing clients in those industries? Do these guides override or replace the authoritative guidance included in the professional auditing standards? 5. Was the change that Paragon made in applying the percentage-of-completion accounting method a “change in accounting principle” or a “change in accounting estimate”? Briefly describe the accounting and financial reporting treatment that must be applied to each type of change. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203
