Question

The Securities and Exchange Commission (SEC) found that Bally Total Fitness Holding Corporation, a nationwide commercial operator of fitness centers, fraudulently accounted for three types of revenues it received from members. The SEC also charged the audit firm and six partners for their roles in the accounting violations. Visit the SEC’s website (www.sec.gov) and search the link to “Litigation Releases” to locate Litigation Release 20470 issued on February 28, 2008 against Bally Total Fitness Holding Corporation to learn more about this revenue fraud.

a. Read the release and the accompanying compliant in this matter and briefly summarize the types of alleged frauds. For each fraud, identify the management assertion(s)/or the audit objective(s) that was violated.

b. Return to the opening page on the SEC website and search the link for “ press Releases” to locate the December 17, 2009, announcement of the SEC charges against the audit firm and the six partners. Summarize the SEC charges against the audit partners.

c. Read the press release and briefly summarize the SEC description for the nature of risks associated with the Bally’s audit engagement.

d. Read the complaint against the audit engagement partner, who served as the 2001 and 2002 engagement partner. What factors caused the audit firm to recognize Bally as a high risk audit client for 1996–2003?

Answer 1

a) Type of Frauds

More than two dozen Accounting Improprieties in Financial Statements between 1997 to 2003 such as :-

a) Overstating of Owners Equity by $1.8 bn for the period ended 2001

b) Understatement of Net Losses by $92.4 m in 2002

c) Fraudulent accounting for its Revenues from its members

d) FAilure to comply with Generally Accepted Accounting Principles for more than 20 expnese and revenue items.

In these cases Management Assertions regarding the recognition, measurement and presentation of classes of transactions and events, account balances and disclosures are violated. These assertions cover Purchases, Sales,and wages paid during the accounting period. Account balances include all the asset, liabilities and equity interests included in the statement of financial position at the period end.

b) Press Release by SEC on Charges against E&Y and 6 of its partners

THe SEC's findings were that the Auditor issued their Audit Report without any qualifications on the Financial Statements issued by Bally Total Fitness Holding Corporation during the period 2001 to 2003 and confirmed that the auditing were carried out as per Generally Accepted Auditing Standards. It charged the firm and its partners for not detecting the fraudulent accounting and disclosures. The settlement amount arrived was $ 8.5 m , one of the highest during that period.

c) SEC description for the nature of risks associated with the Bally’s audit engagement

E&Y failed to carry out tests on the accuracy of the clients basis for recognising revenue . This led to recognition of revenue much before it accrued to the business thereby overstatement of revenue much before it earned the income .E&Y’s audits of Bally’s reactivation accounting and initiation fee revenues were deficient and not performed in accordance with GAAS. E&Y relied solely on the assertions of the client management without doing its own audit to assess the accuracy of its revenue recognition procedures.

d)Factors that led to recognize Bally as a high risk audit client for 1996–2003

During the year 2001 and 2002 , E&Y strategised to focus on risky audits to   assess its audit risks and the firm took steps to identify and resign from or focus on certain of its riskiest clients. Accordingly , Bailey was identified as a high risk client. But the firm did not resign and continued to engage itself as the auditor.Instead, E&Y tried to reduce the risk that Bally’s accounting practices posed to E&Y by, among other things, insisting for the first time that Bally record the numerous accounting errors that had historically placed under summary of audit differences.

From 1997 through 2002, Bally consistently used a 41% reserve rate, despite changes in the economy and in market conditions. The resulting ADA was always at the low end of the range that E&Y had deemed to be reasonable.In the QTR4 of 2002, collections slumped leading to a additional provisioning of $55 m which it misleadingly called additiona charges instead of deteriorating receivable. E&Y knew about it and did not qualify its Audit Report.