CBI Holding Company, Inc.

Synopsis Ernst Young audited the pharmaceutical wholesaler CBI Holding Company, Inc., in the early 1990s. In 1991, Robert Castello, CBIs owner and chief executive, sold a 48 stake in his company to TCW, an investment firm. The purchase agreement between Castello and TCW identified certain control-triggering events. If one such event occurred, TCW had the right to take control of CBI. In CBIs fiscal 1992 and 1993, Castello orchestrated a fraudulent scheme that embellished the companys reported financial condition and operating results. The scheme resulted in Castello receiving bonuses for 1992 and 1993 to which he was not entitled. A major feature of the fraud involved the understatement of CBIs year-end accounts payable. Castello and several of his subordinates took steps to conceal the fraud from CBIs Ernst Young auditors and from TCW (two of CBIs directors were TCW officials). Concealing the fraud was necessary to ensure that Castello did not have to forfeit his bonuses. Likewise, the fraud had to be concealed because it qualified as a control-triggering event. This case examines the audit procedures that Ernst Young applied to CBIs year-end accounts payable for fiscal 1992 and 1993.

The principal audit test that Ernst Young used in auditing CBIs accounts payable was a search for unrecorded liabilities. Although Ernst Young auditors discovered unrecorded liabilities each year that resulted from Castellos fraudulent scheme, they did not properly investigate those items and, as a result, failed to require CBI to prepare appropriate adjusting entries for them. A subsequent lawsuit examined in detail the deficiencies in Ernst Youngs accounts payable-related audit procedures during the 1992 and 1993 CBI audits. Following a 17-day trial, a federal judge ruled that Ernst Youngs deficient audits were the proximate cause of CBIs bankruptcy and the resulting losses suffered by TCW and CBIs creditors. CBI Holding Company, Inc.Key Facts 1.In 1991, TCW purchased a 48 ownership interest in CBI from Robert Castello, the companys owner and chief executive. The TCW-CBI agreement identified certain control-triggering events if one of these events occurred, TCW would be permitted to take control of CBI. During CBIs fiscal 1992 and 1993, Castello oversaw a fraudulent scheme that resulted in him receiving year-end bonuses to which he was not entitled. A major feature of the fraud was the understatement of CBIs year-end accounts payable.

Castello realized that the fraudulent scheme qualified as a control-triggering event. Castello and his subordinates attempted to conceal the unrecorded liabilities by labeling the payments of these items early in each fiscal year as advances to the given vendors. Ernst Young auditors identified many of the alleged advances during their search for unrecorded liabilities. Because the auditors accepted the advances explanation provided to them by client personnel, they failed to require CBI to record adjusting entries for millions of dollars of unrecorded liabilities at the end of fiscal 1992 and 1993. The federal judge who presided over the lawsuit triggered by Castellos fraudulent scheme ruled that Ernst Youngs deficient audits were ultimately the cause of the losses suffered by TCW and CBIs creditors. 10.The federal judge also charged that several circumstances that arose during Ernst Youngs tenure as CBIs auditor suggested that the audit firms independence had been impaired.