Refer to the Auditing in Practice feature "Improper Capitalization of Operating Expenses: The Case of Safety-Kleen Corporation." In addition to the information provided in the feature, consider the following information.
At the close of each quarter, Safety-Kleen executives met to discuss the results of operations. Typically, they discussed what the targeted earnings amount was, and then they discussed potential accounting adjustments to help them achieve the target.
Although the company had always made legitimate quarterly adjusting entries in preparing its financial statements, the magnitude and nature of the adjustments changed dramatically during fiscal year 1999. As time went on, the discrepancy between the company's projected results and the actual results increased, and they made several improper adjustments each quarter to reach the earnings targets. As the following table indicates, Safety-Kleen's quarterly earnings were materially increased as a result of the accounting adjustments (in other words, the legitimate adjustments and the improper adjustments combined). In some reporting periods, the company's reported earnings were increased by more than 100%.
As an example of inappropriate entries, at the end of the third quarter of fiscal 1999, they improperly capitalized approximately
$4.6 million of payroll expenses relating to certain marketing and start-up activities. At the close of the fourth quarter of fis- cal 1999, they improperly capitalized $1.8 million of salaries and wages incurred in connection with the development and implementation of various software systems. Not only did this adjusting entry fail to comply with GAAP, it ultimately was recorded twice.
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Earnings Before Adjustments (in Millions)
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Earnings as Reported After Adjustments (in Millions)
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Total Adjustments (in Millions)
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%
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First Quarter FY 1999
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$90.9
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$127.5
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$36.6
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40.3
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Second Quarter FY 1999
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$76.7
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$107.6
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$30.9
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40.3
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Third Quarter FY 1999
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$47.9
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$123.4
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$75.5
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157.6
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Fourth Quarter FY 1999
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$57.3
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$110.4
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$53.1
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92.7
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First Quarter FY 2000
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$47.0
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$116.8
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$69.8
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148.5
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Total
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$319.8
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$585.7
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$265.9
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83.1
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On March 6, 2000, after Safety-Kleen's board of directors had received information concerning possible accounting irregu- larities, the company announced that it had initiated an internal investigation of its previously reported financial results and certain of its accounting policies. On March 10, 2000, Safety- Kleen filed a Form 8-K stating that the company's independent accounting firm, PricewaterhouseCoopers LLP, had withdrawn its audit reports on the financial statements for fiscal years 1997, 1998, and 1999.
In 2005, a lawsuit brought by a group of institutional investors against former officers of Safety-Kleen Corporation ended with a $200 million judgment against two former officers and more than $84 million in settlements against the company's former auditor and directors. PricewaterhouseCoopers, Safety-Kleen's former audi- tors, agreed to settle and pay $48 million, and the directors agreed to pay $36 million.
a. What were likely factors contributing to the fraud?
b. What audit procedures might have identified the inappropriate adjustments?