CBI Holding Company, Inc. is a New York based firm marketing an extensive line of pharmaceutical products. CBI’s principal market area stretched from the northeastern United States into the upper Midwest. In 1991 Robert Castello, CBI’s president and chairman of the board, sold 48 percent ownership interest in his company to Trust Company of the West (TCW), a diversified investment firm. The purchase agreement between the two parties gave TCW the right to appoint two members of CBI’s board with Castello retaining the right to appoint the remaining three. The purchase agreement also identified several control-triggering events. If any one of these events occurred, TCW would have the right to take control of CBI. Examples of control-triggering events included CBI’s failure to maintain certain financial ratios at a specified level and unauthorized loans to Castello and other CBI executives. Several of Castello’s subordinates intentionally misrepresented CBI’s operating results and financial condition for fiscal years ending April 30, 1992 and 1993.
During the 1992 and 1993 audits Ernest & Young (E&Y), the accounting firm hired by CBI, discovered numerous disbursements that were potential issues. The bulk of these disbursements were payments to the company’s vendors and labeled as advances in the company’s records. The advances were explained as such, “When CBI is at its credit limit with a large vendor, the vendor may hold an order until they receive an ‘advance’. CBI then applies the advance to the existing A/P balance” (Knapp, 2012, pp 254).
E&Y auditors willingly accepted this explanation rather than investigating further, choosing not to record the items as unrecorded liabilities. E&Y issued unqualified opinions stating they performed the audits in accordance with Generally Accepted Accounting Standards but later withdrew those opinions when it was discovered they did not include, in the opinions, those items that were not accounted for as unrecorded liabilities. Shortly after, CBI filed for bankruptcy and E&Y was held responsible for the bankruptcy. They did not inform CBI board executives of the discrepancies they discovered and did so in order to continue the business relationship with CBI. E&Y was also accused of not maintaining independence from CBI due to the substantial amount of revenue earned outside the scope of auditing.
System of Quality Control Standards (SQCS) No. 8 calls for a CPA firm to form and document policies and procedures for accepting new clients as well as the continuation of current clients (AICPA, SQCS 8-.27-.36). The standard underscores the importance of how the client’s reputation could affect the reliability of their financial records and statements thereby affecting the CPA firm’s reputation. A CPA firm needs to consider the risks involved: the client’s risk, the audit’s risk, and its own personal risk (Kerr et al., 2007). All of these factors can be assessed with creation of a client evaluation system which E&Y either didn’t have or didn’t adhere to.
An evaluation system should provide the CPA firm with a reasonable confidence the client‘s risk factor is low. This confidence should come from evaluating the client’s employees’ integrity and its own capabilities to perform the services being offered. Once a client has been deemed to be a reasonably safe risk, the findings of the evaluation should be clearly communicated to the client.
There are several different things to consider when evaluating a client and the more information that can be gathered the better more reliable the decision. Information can be gathered from many sources: credit information of the client and its executives, interviews with the client’s bankers and attorneys, interviews with the client’s internal auditors, and interviews with any of the client’s former CPA firms. There are many different ways to conduct an evaluation but the purpose of one remains the same: * Develop a model of the client’s strategic environment * Gain an understanding of the client’s method for implementing their strategy * Relate this understanding to the client’s financial statement assertions.
(Allen et. al., 2006)
The two parties most affected by E&Y’s decision to continue a business relationship with CBI were CBI and TCW. If the board executives had known of the discrepancies it is reasonable to say they would have fixed the problems internally and restated those financial statements affected by the discrepancies. TCW would have a valid argument to take control of CBI through the restatement of these financials. E&Y’s lack of client acceptance standards and internal quality controls led to CBI filing bankruptcy, destroying itself, CBI, and TCW all at once.

References
AICPA (American Institute of CPAs). SQCS No. 8-.27-.36. Retrieved October 12, 2014, from the AICPA QC database.
Allen, R. D., Hermanson, D. R., Kozloski, T. M., & Ramsay, R. J. (2006). Auditor risk assessment: Insights from the academic literature. Accounting Horizons, 20(2), 157-177. Retrieved October 10, 2014.
Kerr, S. G., Grupe, F. H., Jooste, S., & Vreeland, J. M. (2007). A case-based approach to the evaluation of new audit clients. Journal of Computer Information Systems, 47(4), 19-27. Retrieved October 10, 2014 from EBSCOHOST.
Knapp, M.C. (2012). Contermporary auditing. (10th Edition). University of Oklahoma: Cengage Learning. ISBN: 128506608