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SEC Fined Grant Thornton and Assisted Living Concepts (2015)
Enlivant, the new name for a senior housing provider that was formerly known as Assisted Living Concepts LLC, was founded in 1981; its headquarters is in Chicago, IL (seniorhousingnews). In 2015, ALC was charged by the SEC for committing a fraudulent financial reporting. To be able to meet a leasing requirement, ALC included fictitious occupants for some residences in the calculation of occupancy ratios. SEC also charged Grant Thornton who was ALC’s external auditor for failing to detect the fraud.
According to a SEC Press Release, Grant Thornton and the two partners, Jeffrey Robinson and Melissa Koeppel in charge for the audit engagement on ALC. On ALC’s side, the two former CEO Laurie Bebo and the former CFO John Buono were involved in the fraud. Melissa Koeppel, one the partners in charge for the audit engagement, was suspended from practicing as an accountant for minimum five years and was also charged for $10,000 penalty. The other partner, Jeffrey Robinson was charged with a two-year suspension and $2,500 penalty. In addition, the SEC also pursued the charge against the two ALC’s CEOs alleged for faking occupants in the ratio calculations to meet the lease requirements (reuters).
The ALC’s financial statements were prepared for various third-party users such as their creditors and their investors. Among the financial statement users, ALC’s lessor who was Ventas, Inc. – a Chicago based real estate investment trust, heavily relied on the audited financial statements information to determine whether ALC met the lease agreement for the lease continuing purposes.
According to the SEC Enforcement Division, the Bebo – the CEO, strongly advocated the expansion of the new eight facilities and the enter into the lease with Ventas facilities while other officers went against the expansion and the lease because of foreseeable burdensome requirements that ALC could default. Some of the burdensome provisions include requiring ALC to maintain 0.8 to 1.0 of quarterly and calendar year (12 months) occupancy rates and coverage ratios, both at each facility and all eight facilities level. In the agreement, Ventas defined “coverage ratio” as cash flow to the facilities divided by rent payments to Ventas. In addition, the lease also required ALC to comply with the covenants on a quarterly basis: (1) ALC financial statements prepared in compliance with the general accepted accounting principles (“GAAP”); (2) documentation supporting the compliance with the financial covenants; and (3) a certificate signed by an ALC’s executive to attest the completeness and fairness of financials statements and supporting document (lawinsider). Despite the disagreements, the CEO and other officers eventually followed the CEO. They signed the lease with Ventas. As a result, back in the early 2008, ALC began operating eight more facilities consisting of 540 units which were owned by Ventas, Inc. These facilities were located in four states: Alabama, Florida, Georgia, and South Carolina.
As the officers expected, after less than a year entering the lease agreement, the CEO and the CFO soon realized that it was likely for ALC could not meet the lease covenant agreements with Ventas. As a result, the fraud began in 2009 and continued into 2011 since if ALC had never misstatement the occupancy rates, they would miss the covenant requirements for several quarters. To help ALC, the two executives therefore had involved in false disclosures on financial statements and manipulation of the internal books and records by misstating the occupancy rates, causing Ventas to be misled. Since ALC committing the fraud by intentionally manipulating the occupancy rates calculations, it committed fraudulent financial reporting. Not only did ALC include employees, the calculation also included: the CEO’ friends and family members including a seven-year-old child – the CEO’s nephew, ALC’s employees who did not stay at the facility, former employees and employees who had not been hired yet ALC was a senior housing, which meant (sec).
To understand better why the fraud is classified to be a fraudulent financial reporting, it is important to understand different types of fraud. There are two types of fraud: misappropriation of assets and fraudulent financial reporting. Misappropriation of assets involves the thefts or misuses of an entity’s assets (pcaob). In ALC case, there was no theft or misuse of ALC’s assets so it should not be classified as misappropriation of assets. Rather, it is a fraudulent financial reporting because the fraud involved the manipulation and falsification of the supporting documents of the list of occupants staying at the eight new expanded facilities based on which, the financial statements were prepared. The management intentionally misled the users of financial statement information, especially its landlord, Ventas.
To explain for the reasoning why the key executives at ALC commit to fraudulent financial reporting to mislead users of its financial statements information, PCAOB auditing standards provides a framework called the Fraud Triangle (cpa journal). The Fraud Triangle includes three elements for a fraud to be committed: incentive, opportunity, and rationalization. The first element of the framework to be applied to the fraud is incentive. There are countless incentives for management to commit a fraud such as personal interests, compensation scheme, or debt or lease covenants. In the ALC’s case, the incentive for the two key executives to commit the fraud was to meet the lease covenants with Ventas. As mentioned above, under the lease terms, ALC must meet a minimum occupancy rate and coverage ratio, otherwise, it would default on the lease. If ALC failed to meet the covenants, it would have to pay the due rent amount for the lease term which was estimated to be 10 millions of dollars (cite). The two key executives realized that ALC was not able to meet the minimum rate and they were trying to avoid paying the 10 millions of dollars; therefore, they had the incentive to falsify the calculations. The second element to be analyzed is opportunities. The key executives were able to commit the fraud because there was a lack of effective internal control at ALC. The two executives at ALC directed the accounting staff to include fictitious occupants. Their action of directing the accounting personnel to override the number of occupants without any authorization from a separate authorized officer or department illustrated that there was no such thing as a segregation of duties at ALC. The accounting staff calculated the rates and ratios under the CEO’s directions, and then the CEO and CFO were also the ones who reviewed the calculations and supporting documents. At the time committing the fraud, ALC was publicly traded company. It was not clear if the Board of Directors or the audit committee at ALC knew about the fraud when the internal audit reported to them or ALC’s corporate governance at ALC was so ineffective that it allowed at the internal audit to report to the CEO. In addition to the poor internal control, the CEO’s power was to centralized. At first, Bebo wanted to include ALC’s employees who stayed the night at the facility in the calculations. The CEO and CFO presented this practice to the ALC’s counsel and were advised by the ALC’s counsel that they should disclose the practice and obtain approval from Ventas. However, they never did and it seemed like no one reviewed their work since they had too much power. The last element is rationalization. To justify that they were not doing anything wrong, the CEO and CFO probably thought they were just helping ALC to keep the lease agreement and to be able continue in operations. They thought other organizations also cheated on their financial statements so they were just playing the same game as they did.
In the risk assessment and brainstorming before conducting the audit, Grant Thornton, ALC’s external auditor, could have at least analyzed the fraud triangle above besides other assessments to find some red flags, questioned the effectiveness of internal control, and had the audit planned accordingly to detect any frauds and material misstatements. Therefore, Grant Thornton had failed to exercise professional skepticism to detect the fraud. More specifically, Grant Thornton audit team on ALC failed to take the appropriate procedures to determine ALC’s agreement with Ventas or confirmed if the occupants claimed on ALC financial statements were valid occupants.
In fact, ALC’s key executives had bring up the intent to include ALC’s employees who stayed at the facility at night in the covenant calculation to Grant Thornton and its counsel. Since the executives said they were allowed to do that according to the lease agreement with Ventas even though such practice was never allowed, Grant Thornton failed to proceed further audit procedures to confirm that claim. During its audit for ALC in 2009, 2010, and 2011, Grant Thornton issued unqualified opinion on ALC’s financial statements in three years 2009, 2010, and 2011. The fraud was not discovered until 2012 by Ventas and it sued Assisted Living Concepts for violating the terms of the lease covenants (jsonline) in the same year. With that being said, during the three years as being the external auditor for ALC, Grant Thornton missed considerable red flags and failed to exercise professional due care to detect the fraud.
More importantly, the practice of including employees in the calculation of occupancy rates was brought up to Grant Thornton; the accounting firm just needed to take a further step to inspect the documents regarding the lease covenants with Ventas or confirm with Ventas on the validity of the practice. According to David Glockner, the director of the SEC’s Chicago regional office, Grant Thornton auditors noticed that the financial statements of ALC were questionable but it eventually accepted the CEOs’ misleading explanations as the truth because it failed to demonstrate adequate professional skepticism or obtain substantive and appropriate audit evidence (courthousenews). There are some important components of the audit procedures that Grant Thornton could have done a better job on. The first component is Risk Assessment. Grant Thornton could have done a better job in assessing the risks in ALC’s internal control. There were some red flags that the power was centralized to the key executives that Grant Thornton could have discovered by testing the effectiveness of internal control. They could have known that there was an insufficient in segregation of duties because the accounting personnel was directed to add fictitious occupants in the covenants calculations and no one other than the CEO and CFO reviewed it. It seemed like either the organization lacked an audit committee or the existing audit committee failed to exercise its oversight function regarding the managers’ prepared financial statements and internal audit. It also could be because the existing audit committee did not meet the requirement of independence and was influenced by the key executives.
In addition, in performing the risk assessment procedures and in the audit planning process, Grant Thornton could have performed the analytical procedures and inspection of documents to identify the risks relating to the lease agreements. By inspection of documents, Grant Thornton would know there was a lease term with Ventas with some burdensome requirements for ALC; by doing that, it would signal Grant Thornton to perform extensive audit procedures on the covenant calculations. Performing analytical procedures in the planning stage of an audit is critical since it helps the auditor in planning the nature, timing, and extent of the audit. It also serves as substantive test tool to test assertions for some account balances or transactions (pcaob). With the analytical procedures, Grant Thornton could perform trend analysis by calculating and comparing the occupant ratios from year to year to set an expected value for the ratios as well. If during the audit substantive tests, there was a significant different, they could inspect more on the differences.
Although Grant Thornton was not aware of the fraud when it first audited the financial statements in 2009, it failed to establish and deploy effective audit procedures in 2010 and 2011. They ignored repeated red flags that might have uncovered the fraud sooner. To illustrate, the two partners in charged of the audit, Koeppel and Robinson, never asked their engagement team to verify or inspect the validity of the list of occupants who were included in the calculations.They couldhave done this by take a sample of occupants and verify the social security numbers which would give them red flags about their age or confirm by contacting them by a phone call. In addition to that, they could also physically visit the facilities to verify the number of employees staying at the facilities.Grant Thornton could have also visited to the facilities to observe or physically count how many people actually stayed. The two partners in charged also consistently relied on verbal representations made by the two executives instead of asking for the supporting documentation. The assumption that every one is being honest is a foe of practicing professional skepticism. This is an important lesson for auditors. Moreover, the supporting documentation provided by ALC repeatedly failed to mention the Ventas lease covenants or to demonstrate that ALC had communicated its occupancy calculations practices to Ventas. Again, since the documents were provided by the internal auditors, it was important for the engagement team to verify the accuracy of the document provided since ALC’s executives knew their organization and financial statements better than Grant Thornton, if they would want to alter or misstate financial statements, they could easily to do. External documents or confirmation by third-party, in this case, Ventas were the most reliable source.By confirming with Ventas about the covenant agreements of whether including employees who stayed at night for the calculations were permissible, Grant Thornton could have avoided the millions of dollars in penalty.
In addition to the red flags that could have been discovered in the risk assessment, Grant Thornton should have done a better job in the making its acceptance or continuance decision. They could have done that by assessing the business risk, the management integrity or corporate structure by researching. Grant Thornton could have paid more attention to the company’s scandals regarding the misstated financial statements that could raise some questions concerning about ALC’s internal control weakness. To illustrate, in 1998, ALC was about to be acquired by American Retirement but the deal failed because American Retirement discovered that ALC misstated significant start-up losses the financial statements for several years. That year Wilson resigned as president and CEO of the company (Hoovers). Additionally, Grant Thornton could also do some more research to have a better understanding of ALC’s operations in 2008, the year before Grant Thornton provided ALC with first audit service. The research could have been done easily since it was not so hard to pull up an article or news about ALC’s scandals regarding of its bad services or people were trying to avoid ALC during that time. ALC also had to deal with the regulators in some states due to its inadequate care, staffing and other violations (js online). Based on the research, Grant Thornton could have figured the unreasonableness in the management’s move for the expansion and entering to the lease agreement with Ventas. If Grant Thornton noticed that and made the assumption that ALC would have a really low chance of success in the expansion, Grant Thornton would have been questioned for the success of the expansion in four states with all the negative news. If Grant Thornton did the research more carefully, it could at least help them to plan the audit procedures more appropriate and gear more attention towards the occupancy rates and the lease covenants.
In addition to assessing the risk in ALC’s internal control and client business risk, Grant Thornton could also avoid the audit failure in the assigning partners and staff step. Even though there are various factors that can negatively impact the audit quality on every engagement, the role of the partners in charge of the engagement is vital. It is also important for an accounting firm such as Grant Thornton to take timely and appropriate actions to address some partners who have repeatedly commit to audit failures, so that it keep only partners who can successfully practice professional skepticism and lead the team. According to Andrew Ceresney, enforcement director at the Securities and Exchange Commission, Grant Thornton prioritized the career of its partner and keep the partner’s clients over the interests of investors (Chicago). The partner on ALC, Melissa Koeppel, had repeatedly failed to exercise her professional skepticism to assure reasonable assurance on her audit engagements; she did not only fail to detect the fraud on ALC’s audit but she also failed to detect accounting frauds in other two public companies: Koss and Broadwind. By the third quarter of 2010, Ms. Koeppel’s public company audit clients had restated financials four times. Those financial statements restatements were due to the accounting irregularities that were brought to Ms. Koeppel’s attention by subordinates, but were ignored. With her negative quality indicators for an audit partner, in 2010, she was on an internal monitoring list at Grant Thornton for partners. Her track record was so bad that Grant Thornton switched most of her audits to other engagement partners, but it eventually kept her on the audit engagement of ALC which resulted to the fraud on ALC (pomerantz).
To respond to the scandals regarding poor quality indicators for an audit partner, in December 2015, PCAOB adopted rules that require the disclosure of engagement partner. The rule now requires audit firms to file forms indicating the name of the engagement partner. The rule also requires audit firms to identify any other firms that will assist the engagement team in the audit, and the extent of their participation (pcaob). Potential companies looking for an audit firm, investors and any third-party users of audited financial statements now have a new tool to help identify bad auditors like Ms. Koeppel.
In the current complex business environment, it is important for the Board of Directors, audit committee, internal auditors, and managers of a company, and external auditors to give special attention in figuring out the answers for these two questions. First, whether the effective of the corporate governance and internal controls of the company can lead to potential misstatements in the financial statements and do those who responsible understand them? Second, how effective is the interaction between companies, key personnel such as CEO or CFO, and external auditors?
As recent SEC enforcement actions continue to show, key personnel of companies must be available and accessible for auditors to discuss, and auditors must exercise a strong professional skepticism about information received from their audit clients. Otherwise, it may be a short matter of time before the SEC takes action
- https://www.cpajournal.com/2019/04/15/rationalizing-fraud/ fraud triangle
- https://pcaobus.org/Standards/Archived/Pages/AU329A.aspx – analytical procedures
- https://www.lawinsider.com/contracts/754fc5COfazNnbkB61X63H/assisted-living-concepts-inc/master-lease-agreement/2008-01-07 – contract term that might link to going concern phrase
- “Assisted Living Concepts.” Hoover’s, Inc. University of Maryland, n.d. Web. 8 Oct. 2019
- Barlyn, Suzanne. “Audit Firm Grant Thornton Settles SEC Charges over Audits.” Reuters, Thomson Reuters, 2 Dec. 2015, https://www.reuters.com/article/us-grantthornton-sec/audit-firm-grant-thornton-settles-sec-charges-over-audits-idUSKBN0TL23F20151202?il=0.
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