FOUR SEASONS NURSING CENTERS OF AMERICA, INC.

Transcription

1 CASE 2.10 FOUR SEASONS NURSING CENTERS OF AMERICA, INC. On February 7, 1974, Kenneth Wahrman, an audit partner with Arthur Andersen, was sitting in an Oklahoma City federal courthouse. After a ten-week trial, Wahrman was awaiting a jury s verdict a verdict that could mean he would spend the next five years of his life in a federal prison. Wahrman and two other Arthur Andersen employees had been indicted on criminal fraud and conspiracy charges. These charges stemmed from Arthur Andersen s audits of Four Seasons Nursing Centers of America, Inc., a company s whose bankruptcy cost investors and creditors an estimated $200 million. U.S. Attorney Gary Naftalis, the federal prosecutor in the Wahrman trial, alleged that Wahrman and his two subordinates conspired with Four Seasons executives to conceal material misrepresentations in the company s audited financial statements. Naftalis had previously obtained guilty pleas on similar charges from four other defendants in the Four Seasons case, two officers of Four Seasons and two individuals who served as the company s investment bankers. THE SHORT AND TROUBLED HISTORY OF FOUR SEASONS Four Seasons Nursing Centers of America was incorporated in The two principal founders of the firm, Jack Clark and his half-brother, Tom Gray, perceived a tremendous need for high-quality extended care for the elderly in the United States. At that time, the nursing home industry was a disorganized amalgamation of mom-and-pop operations. The typical nursing home of the mid- 1960s was a converted motel or bowling alley that was operated by individuals with little or no medical training. Clark and Gray developed a prototype nursing home design with a physical layout in the shape of the letter X. This layout allowed nursing personnel in a central station to monitor all four corridors of the nursing home simultaneously. Clark and Gray s prototype design, which included other innovative features, was quickly recognized within the medical

2 202 SECTION TWO AUDITS OF HIGH-RISK ACCOUNTS AND INTERNAL CONTROL ISSUES profession as a significant step forward in providing humane and cost-efficient extended care for the nation s elderly. Four Seasons built and operated several nursing homes, but its officers were most interested in building the homes and then selling them to investors. Initially, physicians were the primary group toward which Four Seasons executives directed their marketing efforts. Clark traveled from city to city in the Southwest and made his sales pitch to small groups of doctors. Although this approach was successful, it did not allow Four Seasons to expand

3 CASE 2.10 FOUR SEASONS NURSING CENTERS OF AMERICA, INC. 203 completion method, management could manipulate the profit recognized in a given year by distorting the expenditures incurred on construction projects in process. 2 During the criminal trial of Wahrman and his subordinates, Naftalis proved that Four Seasons included huge amounts of fictitious construction expenditures in its cost reports for 1969, which resulted in illicit profits being reported in that year. Naftalis charged that Arthur Andersen auditors were aware that these costs were false, and that the auditors were thus a party to the conspiracy to defraud individuals relying on Four Seasons financial statements. Attorneys for Wahrman and his associates disputed this contention by submitting as evidence copies of audit workpapers for the Four Seasons engagement. These workpapers indicated that on several occasions the auditors challenged fictitious costs they discovered and persuaded the client to make the proper financial statement adjustments for those costs. Four Seasons also misrepresented its financial results by including de facto intercompany sales transactions in its income statement. Naftalis established that from 1968 to 1970, Four Seasons controlled the operations of its principal customer, FSE. In Jack Clark s guilty plea that he conspired to violate federal securities laws, he admitted that major decisions made by FSE s management were dictated by key executives of Four Seasons. In reality, Four Seasons was selling nursing homes to itself, meaning that the gains on these transactions were nonreportable intercompany revenues. During the Wahrman trial, Naftalis attempted to prove that the Arthur Andersen auditors were aware of the bogus nature of these sales transactions. FOUR SEASONS COLLAPSES The Four Seasons scam came to an abrupt end in Industry insiders had alleged repeatedly that Clark s profit projections for his ventures were grossly overstated. These allegations were substantiated in early 1970 by security analysts who obtained reliable cost and revenue data for several of Four Seasons nursing homes. The revelation that nursing homes, even the modern, cost-efficient ones built by Four Seasons, were low-profit-margin operations quickly stemmed the public s and bankers enthusiasm for Four Seasons. As a result, the company was soon left without a source of new investment capital or a market for its nursing homes under construction. Four Seasons collapse in June 1970 caused a sudden change in the public s perception of Jack Clark and Tom Gray. Once hailed as successful and forwardlooking entrepreneurs, they were castigated by the press as unscrupulous opportunists. Investigations of their backgrounds revealed that neither had the requisite training or skills to oversee a multimillion-dollar operation. In fact, it was discovered that only a few years before founding Four Seasons, Clark had 2. Ironically, the SEC was at least partially responsible for Four Seasons switch to the cost-tocost version of the percentage-of-completion method. Prior to the switch, the SEC had complained to company officials that they were overestimating the physical state of completion of construction projects and, as a result, recognizing excessive amounts of profit during the early years of those projects.

4 Z04 SECTION TWO AUbITS OF HIGH-RISK ACCOUNTS AND INTERNAL CONTROL ISSUES worked as a milkman in Oklahoma City, and Gray had operated a small motel in Henrietta, Texas. Judge Luther Bohanon, the federal magistrate who presided over the trial of Wahrman and his associates, concluded that Four Seasons was simply an elaborate stock manipulation scheme designed to enrich Four Seasons officers. Clark alone earned more than $10 million in capital gains on the sale of Four Seasons stock during the short time it was publicly traded. The evidence that most clearly supported Judge Bohanon s conclusion was an intercompany memo found in records subpoenaed by the court, a memo which was written by a Four Seasons executive: Let s get Walston s [one of Four Seasons investment bankers] opinion as to when we could sell a sizable portion of our stock, while the stock is at a good price, to guard against having to sell after the public realizes that nursing homes will not meet [profit] expectations. 3 After reading this memo, Judge Bohanon remarked that the Four Seasons scandal would damage the investing public s confidence in the credibility of the securities markets for many years to come. FOUR SEASONS: A COSTLY SCANDAL FOR ARTHUR ANDERSEN On February 7, 1974, Kenneth Wahrman s two subordinates were found innocent of fraud and conspiracy charges; however, a hung jury caused the judge to declare a mistrial on the charges against Wahrman. Nine months later, Judge Bohanon dismissed the indictment against Wahrman on the advice of a federal prosecutor. Although no Arthur Andersen employees or partners were convicted in the Four Seasons case, the lengthy scandal exacted a heavy price on the prominent CPA firm. Public records disclosed that the federal government spent more than $1 million prosecuting the threearthur Andersen auditors. Arthur Andersen reportedly spent several times that amount defending Wahrman and his two subordinates.4 The heaviest cost imposed on Arthur Andersen by the Four Seasons scandal was the damage inflicted on the CPA firm s reputation. Arthur Andersen officials were particularly disturbed by their firm being named a co-conspirator in the Four Seasons federal indictment no charges were ever filed against the firm. The managing partner of Andersen s Oklahoma City office at the time was also named as a co-conspirator, although he was not involved in the Four Seasons audit. This individual was named a co-conspirator on the grounds that he was responsible for the supervision and ultimately the professional conduct of his subordinates. Andersen s national managing partner charged that the Justice Department had purposefully used the Four Seasons case to send a warning signal to auditors nationwide. That warning was that auditors could be held criminally liable when clients release materially misstated financial statements. 3. R. Tempest, Giant Fraud Probe Set, Oklahoma Journal, 29 February 1972, Arthur Andersen was also a defendant in a large civil suit filed by Four Seasons stockholders. The defendants in that case collectively agreed to pay $~O.6 million to the plaintiffs, although the portion of the settlement paid by each defendlant was not publicly disclosed.

5 CASE 2.10 FOUR SEASONS NURSING CENTERS 0F AMERICA, INC. 205 QUESTIONS 1. Arthur Andersen and certain of its personnel were defendants in both civil and criminal lawsuits for their involvement in the Four Seasons case. Compare and contrast the level of proof (certainty) that a plaintiff must establish in a civil suit versus a criminal suit. 2. Identify other litigation cases involving audit firms in which individual auditors faced criminal charges. What was the eventual outcome in each of those cases? 3. What responsibility does an office managing partner have for the performance of his or her subordinates? What responsibility does an audit senior have for the professional conduct of his or her subordinates on an engagement? 4. SAS No. 31, Evidential Matter, identifies five key management assertions that underlie a set of financial statements. Which of these assertions was violated in the Four Seasons case? 5. Four Seasons used both the physical and cost-to-cost variations of the percentageof-completion method of accounting for long-term construction contracts. Which, if either, of these two variations of the percentage-of-completion method is preferable? Why?