case matle

CASE 1.1MATTEL, INC.

In 1945,Elliot andRuth Handler,alongwith a friend, Harold Matson,foundedasmall toy company.Within a few months,Matsondecidedto pursueother inter-estsand left Mattel, Inc., to the Handlers.For the nextdecade,the husband-and-wife teamstruggledto maketheir small companya success.Elliot Handler,anartist, designedthe toys the companyproduced,while Ruth Handlermanagedthe company’sbusinessaffairs, concentratingmuchof her time on finding salesoutlets for their products.By 1955, Mattel’s net worth was a little more than$500,000.Thatyear,Ruth Handlerdecidedto takeadaringsteptoexpandthesizeof thecompany.Herplanwasto advertiseMattel’s toyson thepopularchildren’stelevisionprogram,TheMickeyMouseClub. Thecostof the advertisingcampaignwas severalhundredthousanddollars and if unsuccessfulcould havebank-rupted the small company; however,Ruth Handler’s gamble paid off hand-somely. Within a few months,Mattel’s salesordersincreaseddramatically,andthe companywason its way to establishingitself as a major playerin the verycompetitivetoy industry.

In 1959, Ruth Handler took a secondgambleby introducinga full-figured,teenagedoll namedafter herdaughterBarbara.Industryexpertsmaintainedthatthe doll would notappealto its targetmarketof three- to eleven-year-oldgirls.The expertswerewrong. Barbie wasan instantsuccess,with morethan 350,000sold the first year it was on the market.By Barbie’sthirtiethbirthday,morethan500 million dolls hadbeensold.

RuthHandler, the youngestof ten childrenof Polish immigrants, wasnevermodestabout explaining the successof Mattel. During an interview, she oncenotedmatter-of-factlythat shewas“a marketinggenius.”A short and intenselycompetitivewoman,Ruth Handlerhatedfailure andrefusedto acceptit. Duringthe early 1970s, however,she and her companyencountereda set of circum-stancesthat would eventuallytakeMattel to thevergeof bankruptcy.

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SECTION ONE COMPREHENSIVE CASES

TRYING TIMES AT MATTEL

By 1971,Mattel wasrecognizedby financialanalystsasoneof thepremiergrowthcompaniesin the UnitedStates.In thatyear,thecompanyreportedpretaxprofitsof $34 million on salesapproaching$275million. Investorsweresoinfatuatedbythecompanyand its prospectsthat Mattel commonstock tradedat anenormousprice-earningsratio, often exceeding50 to 1. The Handlersandotherkey Mattelexecutivesbecamefabulouslywealthyas a result. By 1971, the Mattel stockcon-trolled by Elliot andRuth Handlerhada marketvalueapproaching$300 million.

Despitethe recordearningsreportedby Mattel for eachsuccessiveyear from1967 through 1971, the companybeganexperiencingseriousproblemsin theearly 1970s.Many of theseproblemscould be tracedto the Handlers’ decisionin the late 1960sto hire SeymourRosenbergas the company’sexecutivevice-presidentandchieffinancial officer. Rosenberg,formerly with Litton Industries,hadearneda reputationfor his skill in identifying andacquiringunderperÿÿrm-ing companiesandmaking them financialsuccesses.Shortlyafter joining Mattel,he convincedthe Handlersto diversify into severalindustriesandto completelyoverhaulthe organizationalstructureof the company,breakingits operationsdowninto numerousdecentralizeddivisions.Unfortunately,four of the six com-paniesacquired by Mattel on the recommendationof Rosenbergproved to beverypoorinvestments,andhisdecentralizationplanincreasedMattel’s operatingcoststremendously.

Besides the problems createdby Rosenberg,who was dismissed by theHandlersin late 1972,Mattel encountereda seriesof largely uncontrollablecir-cumstancesin theearly1970sthatdamagedthecompany’sprofitability. First,oneof thecompany’slargewarehousesin Mexicali, Mexico, burnedto thegroundin1970. Then, the following year, a dockworkers’strike preventedthe companyfrom receivinganytoy shipmentsfrom its largeHong Kong plant. Finally, there-cessionof theearly1970scut significantly into the company’ssales.ThesefactorscausedMattel to registera lossof approximately$30 million in fiscal 1972,whichendedJanuary29, 1972.

A large banking syndicatethat had significant loans outstandingto Mattelwasinstrumentalin convincing the Handlersto dismissRosenberg.FollowingRosenberg’sdismissal,Albert SpearwasnamedMattel’s executivevice-presidentandplacedin chargeof thecompany’sday-to-dayoperations.Spearquickly dis-coveredthat Mattel’s financial statushad been grosslymisrepresentedto thepublic. Shortly beforeSpearacceptedhis new position in early1973,Mattel hadissueda pressreleasestatingthat thecompanyhadundergonea dramaticturn-aroundin fiscal 1973 comparedwith fiscal 1972.However,an intensivestudyofMattel’s financial recordsby Spearrevealedthat the companyhadactuallysuf-feredahugelossin fiscal1973—largerthanthelossreportedtheprior year..WhenSpearreleasedthis information to the public, panickedinvestorsreactedimme-diately by dumping their Mattel stock. Spear’sdisclosuresalso resultedin fiveclassactionlawsuitsbeingfiled againstMattel and its executivesby angrystock-holders. Finally, Spear’srevelations spurred the Securities and ExchangeCommission(SEC)to beginan investigationof the company’sfinancialaffairs.

In October1975,Elliot andRuthHandlerresignedtheir positionswith Mattel.One month later, the outside directorson the Mattel board releaseda five-hundredpage report that detailed a massiveearningsmanipulationscheme

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CASE 1.1 MATrEL, INC. 5

mastermindedby the company’sexecutiveofficers. According to the report, theHandlersandotherkeyMattel officials issued“financial statementsthat werede-liberately false and misleading” to give an illusion of continued spectaculargrowth.’ The lengthy report also discussedArthur Andersen’sauditsof Mattelduring the period in which the company’searningswerebeing manipulated.Price Waterhouse,which reviewedthe Mattel audits, harshlycriticized ArthurAndersen.

In general,Price WaterhouseconcludedthatArthur Andersen’saudit proceduresandtestsweren’tascomprehensiveas theyshouldhavebeenin manyareasandthat certaininformation containedin the accountant’sworking papersshouldhavebeenfurtherpursued.If this hadbeendone,the reportsaid it could haveled to the discoveryofirregularitiesin the fiscal 1971 and 1972 financialstatements.2

In March 1976,a federaljudge approvedanout-of-courtsettlementto the classactionlawsuitsfiled by Mattel’s stockholders.The$30 million settlementrequiredmultimillion-dollar paymentsby severalformer executivesof Mattel, principallythe Handlersand Rosenberg,as well as evenlargerpaymentsby the insurancecompaniesof theseexecutives.The only defendantthat refusedto participateinthesettlementwasArthur Andersen,which maintainedthat it wasnot responsi-ble for the hugelossessufferedby Mattel’s stockholdersfollowing the disclosureof the eamingsmanipulation scheme.Nevertheless,in April 1977, ArthurAndersenagreedto makea cashpaymentof approximately$900,000to Mattelstockholdersto resolvethematter.

In February 1978, a federal grand jury indicted Ruth Handler, SeymourRosenberg,andfourother formerMattel executives.Theexecutiveswerechargedwith falsifying Mattel’s financial statementsfor the period 1969 to 1974. In re-spondingto the indictment,Ruth Handlerproclaimedher innocenceandmain-tamedthat shewas“deeply offended”by the charges.Later that year,however,Handlersubmitteda pleaof no contestto eachof the ten countsof fraud filedagainsther.Handler’spleabargainagreementallowedhertoescapea prison sen-tencebut requiredherto perform2,500hoursof communityserviceandto paya$57,000fine. A similarpleabargainarrangementwasmadewith Rosenbergin thefall of 1978.’

ALLEGED DEFICIENCIES IN ARTHURANDERSEN’S AUDITS OF MATTEL

In June1981,the SEC releasedthe resultsof its lengthy investigationof Mattel’sfraudulent earningsmanipulationschemeand its report on Arthur Andersen’sauditsof Mattel. TheSEC criticized Arthur Andersen’sauditsof Mattel,particu-

1. R. Lindsey, “A Million-Dollar Businessfrom a Mastectomy,”The New York Times. 19 June1988. F3.

2. S. Sansweet,“Mattel Ex-Aides Tried Cover-Up,ReportAsserts,” The Wall StreetJournal,4November1975. 10.

3. Elliot Handlerwasneverindictedfor criminal fraud. The federal grandjury that investi-gatedtheMattel earningsmanipulationschemeapparentlyconcludedthathewasnot involvedin thefraud.

6 SECTION ONE COMPREHENSIVE CASES

larly the 1971and1972engagements.Accordingto theSEC.numerouserrorsandoversightsduring thoseauditshadpreventedArthur Andersenfrom discoveringthe fraudulent methodsusedby Mattel managementto manipulatethe com-pany’sreportedoperatingresults. Mattel’s illicit accountingmethodsandthere-lated deficienciesin Arthur Anderson’s auditsare discussedin the followingsections.

Improper SalesCutoff at Year-End

For fiscalyear1971,which endedJanuary30, 1971,Mattel managementwasfac-ing the unpleasantprospectof informing stockholdersthat the companyhadfailedfor the first time in severalyearsto postrecordsalesand earnings.To in-flate the company’s reported earnings, Mattel’s top executives instituted inJanuary1971 what becameknown as the “bill andhold” program.Mattel usedthisprogramto overstateits fiscal 1971 salesby almost$15 million andits pretaxearningsby approximately$8 million. In simpleterms,thebill andholdprograminvolvedbilling customersfor futuresalesandthenrecordingthe salesimmedi-ately. The SEC identified the following six reasonswhy the bill and hold salesshouldnothavebeenrecordedby Mattel in January1971:

1. The merchandisewasnotshippedasof January30, 1971.2. The customerdid not haveto makeany paymentsuntil the goodswere re-

ceived andaccepted.3. The merchandisewasnot physically segregatedfrom Mattel’s inventorynor

labeledas thepropertyof thecustomer.4. The customercould cancelthe order without penaltyat anytime prior to his

receiptandacceptanceof the merchandise.5. The risksof ownershipremainedwith Mattel, including the risk of lossdueto

damage,theft,or destructionof the merchandise.6. In manyinstances,theinvoiceswerepreparedwithoutprior consultationwith,

or participationby, thecustomeras to the contentof the order.4

To providedocumentarysupportfor the bill and holdsales,Mattel preparedcustomerorder forms,salesinvoices,andbills of lading. Bills of ladingnormallyrequiredthe signatureof botha Mattel shippingemployeeanda representativeof the commoncarrier transportingthe goods.However,for the bogusbills oflading, Mattel shippingemployeessignedfor boththemselvesandthe commoncarrier.

Themagnitudeof thebill andhold programcreatedtremendousconfusionforMattel accountingpersonnel.When the bill and hold saleswere recordedinJanuary1971, theinventoryquantitiesfor the itemsallegedlysoldwerea~Ijusteddownward,althoughthe goodswerenotsegregatedfrom the remaininginven-tory items.Whenthe bill andhold goodswereactually shipped,weeksor evenmonthslater, Mattel’s inventoryrecordsbecamelacedwith errorsresulting fromemployeesrecordingthe inventoryshipmentsa secondtime. Theendresult wasthatMattel’s inventoryrecordswereunreliable.

4. This information was takenfrom Securitiesand ExchangeCommission,AccountingSeriesReleaseNo. 292, 22 June 1981. All subsequentquotations,unlessindicated otherwise,arereprintedfrom this source.


To resolvethe inventorycontrol probl~m~createdby the bill and hold sales,Mattel executiveswere forced to reversethose sales in fiscal 1972. The firstreversingentry was booked in May 1971 and involved $12 million in sales.Approximatelyone-halfof this total wasforbill andhold salesrecordedin fiscal1971,while the otherone-halfwasforbill andhold salesrecordedneartheendofthefirst quarterof fiscal1972.The largereversingentrycreatedanotherproblem:thenet salesfor May 1971 wassuddenlya negativefigure. Mattel executivesde-cidedto booka fictitious $11,000,000saleinMay toconcealthe largeimpactof thereversingentry on the recordedsalesfor that month. This fictitious transactionwasrecordedonly in the generalledger,not in the accountsreceivablesubsidiaryledger,meaningthat therewasan unreconcileddifferenceof $11,000,000betweenthe two accountingrecords.

In August1971,Mattelreversedthe approximately$7,000,000of remainingbilland hold salesrecordedin fiscal 1971. Then, in September,a month in whichMattel typically experienceda very high volume of sales,companymanagementreversedthe fictitious $11,000,000generalledgersalesentry recordedin May otthat year.This entry eliminated the largedifferencebetweenthe balanceof thegeneralledgercontroUingaccountfor receivablesandthebalanceof theaccountsreceivablesubsidiaryledger. The net effect of this seriesof bogusentriesandcorrectingentrieswas that eamingsand salesfor fiscal 1972 wereunderstatedby approximatelythe sameamountsthat those itemswereoverstatedfor fiscal1971.

Arthur Andersenrepresentativesstaunchly maintainedthat their personnelwerenotawareof the fraudulentbill andhold salesuntil Mattel executivespub-liclv revealedthe schemein 1974.However,theSECpointedtoseveralaudit testsperformedby Arthur Andersenduring the 1971 and 1972 Mattel audits thatshould haveresultedin the discoveryof the bill and hold sales.Among theseaudit testswereArthur Andersen’sreceivablesconfirmationprocedures.

Severalof the accountsreceivableconfirmationsmailed by Arthur Andersenduring the 1971 audit were retumedwith discrepanciesnoted by Mattel’s cus-tomers—discrepanciescausedby bill andhold salesthat hadbeenchargedim-properly to the customers’accountsas of January30, 1971. In resolving thesediscrepancies,the Arthur Andersenauditorsobtainedcopiesof thebills of ladingfor the disputedchargesto determinewhether the goodshad actually beenshippedas of January30, 1971.The SECpointed out that althoughthesebills oflading were clearly marked“bill andhold,” theArthur Andersenauditorsap-parentlyneveraskedclient personnelto explainthe significanceof that phrase.5

TheArthur Andersenauditorsalso failedto noticethat ‘the bills of lading theyobtained to clear the confirmation discrepanciesconspicuouslylacked the re-quired routing or delivery instructions. Finally, the auditorsfailed to recognizethat the two requiredsignatureson thebogusbills of lading werethoseof Mattelemployeesratherthanonebeingthesignatureof acommoncarrier representativeandthe otherbeingthatof a Mattel employee.Theauditorseventuallyclearedtheconfirmationdiscrepanciescausedby the bill and hold saleswith the followingtickmarkexplanation:“Traced to Mattel invoice andbill of ladingnoting agree-ment of amountandthat shipmentmadeprior to 1/30/71.”

5. However,anArthur Andersenmanagerwho reviewedtheaccountsreceivableworkpaperswrotea reviewcommentaddressedto anaudit senior:“What does‘Bill andHold’ mean?”Thisreviewcommentwasapparentlyneverclearedby theaudit senior.

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Arthur AndersentestedMattel’s year-endsalescutoff for fiscal 1971 by select-ing eighty-two largesalesinvoices processedneartheendof that yearaTwenty-six of theseinvoices werefor bill andhold sales.Despitethe phrase“bill andhold” written distinctly on the face of eachof these invoices,and despitetheearlier-notedproblemswith the relatedbills of lading,Arthur Andersenfailedtorecognizethat thesetwenty-sixsaleswerefictitious.

During the internal control phaseof the fiscal 1972 Mattel audit, ArthurAndersenselectedthe month of August 1971 to perform its testsof controlsforthesalescycle. Ironically, Augustwasthemonthin which Mattel recordedoneofthelargereversingentriesto eliminatea portionof thebill andholdsalesbookedin January1971. This reversing entry of nearly $7 million causedthe total ofAugust’s general ledger sales to be that much less than the correspondingmonthlysalesfigure reportedby a supplementaryledgermaintainedby Mattel,thesalesinvoiceregister.An Arthur Andersenstaff personincludedin the auditworkpapersthe following explanationfor this largedifference—anexplanationgivento him by a Mattel employee:

This amountis anoffset to salesdue to “invoicing errors” uncoveredby client whencomparingcomputer-preparedinvoicestobills of lading.Clienterrorssuchasitemsnotbeingshippedandwrongamountarethetypesfound.At this time clientdoesnotknowwhethercredit memoswere issuedor not. May createa cutoff problem for accountsreceivableat year-end.

To his credit, the Arthur Andersensenior who reviewedthis explanationnotedthat it wasunsatisfactoryandwrotethe staffpersonthefollowing note: “Need abetterexplanation.This looks like a big problem.” The SEC could find no evi-dencein the auditworkpapersthat theproblemhadbeenfurther investigated.

Finally, the SEC criticizedArthur Andersenfor not utilizing analyticalproce-duresto evaluatethe overall reasonablenessof Mattel’s monthly sales.If suchtestshadbeenperformed,the Mattel auditorswould havediscoveredthat theclient’s monthly salesvarieddramaticallyfrom 1970through1972.This volatilitywaslargelya result of theerrorsintroducedinto theaccountingrecordsby thebillandhold programandthe subsequenterrorscreatedwhenthebill andhold saleswerereversed.

Intentional Understatementof Inventory ObsolescenceReserve

The SEC determined that Mattel’s management intentionally understated thecompany’s reservefor inventoryobsolescenceby severalmillion dollarsoverthetwo-yearperiod 1971—1972.Inventoryobsolescenceis historically a major prob-lem for the largetoy manufacturers,given the inherentdifficulty of predictingchildren’stastein toys.Forexample,in fiscal 1971,Mattel executivesfacedahugeandunexpectedinventorybuildupof the Hot Wheelstoy, whichhadtraditionallybeenoneof thecompany’sbest-sellingproducts.Thefollowing year,Mattel wasforcedto disposeof approximately5.6million of the Hot Wheelstoys by sellingthem to a largeoil companyat a lossof morethan $11 million.

In arriving at its year-endreservefor obsoleteinventory, Mattel preparedweeklysalesforecastsfor thenext severalmonthsfor eachtoy that wasconsid-eredan“excessinventory” item.A reservefor obsolescencewasthenrecordedforthosetoyswhoseexpectedsalesin thefollowing monthswereless than theyear-end inventory In 1971 and1972, theSECfoundthat Mattel inflated the projected


futuresalesof severalexcessinventoryitemsto justify notrecordinga reserveforobsolescencefor thosetoys.

Whenauditingthe reservefor inventoryobsolescence,Arthur Andersenper-sonnel comparedthe weeklysalesforecastsfor certainexcessinventory toys totheactualsalesrealizedby those toys in the first severalweeksof the newfiscalyear. For eightof the toys selectedfor testingduring the 1972 audit,five hadnorecordedsalesin thefirst severalweeksof thenewyear,andthreeothersactuallyhadnegativenet salesduring that time. Mattel’sweeklysalesforecastspreparedat theendof fiscal 1972hadprojectedsignificantsalesfor theseitems.Despitetheresults of this audit test,Arthur Andersenfailed to challengethe sufficiency ofMattel’s inventoryobsolescencereserve.

Overstatementof Deferred Tooling Costs

For eachnew toy Mattel produces,thecompanyincurssignificant“tooling” costs~during thedevelopmentalphaseof theproduct.Thesecostsincludeexpendituresrelatedto producingthemoldsanddie castsneededfor thenewproductandtheexpendituresrequiredto establishthe production line for the product.Mattel’stooling costsaredeferredin an assetaccountandamortizedover the estimateduseful life of thenew toy. Theproportionof thetoolingcostsamortizedeachyearfor a given toy is equalto the ratio of that year’ssalesfor the toy to the total ex-pectedsalesover the life of the toy. From 1970 through1972,Mattel executivesmanipulatedthe company’sdeferredtooling coststo overstateMattel’s reportedearnings.In 1971, for example,the amortizationof deferredtooling costswasunderstatedby approximately$3.7 million. According to the SEC.the misstate-ment of the deferredtooling costs in 1971 was accomplishedby the followingmeans:

1. By reallocatingtooling costsfrom variousproductswith low forecastedsalesto thosewith sizableforecastedsales.

2. By adjustingthe ratio of various products’currentsales to their forecastedsales.

3. By deferringall tooling costsincurredduring thelastthreemonthsof theyear.4. By deferringcertaintoolingcoststwice.

Arthur Andersen~saudit of Mattel’s deferredtooling costsfor 1971 involvedobtainingandreviewingclient-preparedschedulesof thesecostsby product.Theauditorsthen testedtheproprietyof the amortizationamountsfor a smallnum-berof the productsthat had largedeferrals.Among the mostimportantof theseaudit testswere simple comparisonsof actualcurrent year salesto total fore-castedsalesfor individual productsto determinethat the amountof tooling costsamortizedduring the yearwasreasonable.The SEC suggestedthat moreexten-sive andrigorousaudit testsshould havebeenappliedto Mattel’s deferredtool-ing costsduring the 1971 audit,giventhelargeincreasein thosecostsin 1971 andthe inherentlysubjectivenatureof that item.

Arthur Andersendid uncoverat leasttwo instancesof materialoverstatementsof Mattel’s deferredtooling costs.Arthur Andersenrefusedto acceptcertainoftherevisedsalesforecaststhat Mattel usedto justify reducingthe amountof de-ferredtooling costswritten off for severalproducts.In 1971, for example,ArthurAndersen’sworkpapersdocumenteda $2 million overstatementof deferredtool-ing costsresultingfrom improperrevisionsof certainproducts’expectedlifetime


sales. However, Mattel adjusted the account balanceby only $1.4 million.According to the SEC.Arthur Andersen’sworkpapersdid not revealhow thatfigurewasdetermined,nor did theworkpapersprovideanyevidencesuggs~stingthat the $1.4 million adjustmentwassufficient to correctthenotedproblem.

Mattel’s auditors also discoveredduring the 1972 audit that more than$1.2million of tooling costshadbeendeferredtwice. This discoverywasmadeby aseniormemberof the Arthur Andersenengagementteam,who thenwrote a re-view commentinstructinga subordinateto makesurethat the proper adjustingentrywasrecorded.In respondingto thereview comment,the subordinatesub-sequentlynoted,“Tooling write-off adjustedfor this fact.” Despitethis assertion,theSEC determinedthat theadjustmentwasnevermade.

Underpaymentof Royalties

Mattel acquiredthe productionrightsto itspopularHot Wheelsproductfrom thegentlemanwho inventedthat toy. The contractbetweenMattel and theinventorcalled for him to begin receivingsignificant royaltieson Hot Wheelssaleswhentheproduct reachedthe break-evenpoint. In 1970, the break-evenpoint for theHot Wheelstoy wasreached;however,to avoid payingroyaltiesto theinventor,Mattel managementfabricatedan additional $4.4 million in expensesrelatedtothat product.Theseexpensesconsistedprimarily of bogusadvertisingexpendi-turesand increasesin the operatinglossesallegedly incurredby the product inthe first few years following its introduction. Becauseof thesefraudulentex-penses,Mattel avoidedpaying the inventornearly$2 million in royaltiesthat hehadrightfully earnedfrom 1970 through1972.

TheSECchargedthatArthur Andersenfailed to properly investigatethe con-tractualarrangementbetweenthe inventorandMattel andthe relatedfinancialstatementimplications.In particular,Arthur Andersenapparentlydid not ques-tion the additional $4.4 million in expensesaddedin 1970 to the schedulethatsummarizedthe operatingresults of the Hot Wheels product—expenseslaterprovedtobefictitious. Additionally, theauditorsfailedto obtaina copyof acom-puter-generatedroyaltiesreportthatdisclosedtheproperamountof royaltiesduetheinventor.

ImproperComputationof BusinessInterruptionInsuranceClaim

Mattel’s largewarehousein Mexicali,Mexico, which wasdestroyedby a fire inSeptember1970,wasfully insured,aswereitscontents.Thecompany’sinsurancepolicy also includedabusinessinterruptionclauseprovidingup to $10 million incoveragefor revenueslost as a resultof damageto thefacility or its destruction.In its financial statementsfor the fiscal yearendedJanuary30, 1971, Mattel in-cludeda $10 million receivablefrom its insurancecompanyfor a businessinter-ruptioninsuranceclaim,a figure thatwasacceptedby Arthur Andersen.TheSECchargedthatneitherMattel nor Arthur Andersenshould haveexpectedthe in-surancecompanyto paythe full amountof theclaim. Thefederalagencyarguedthat the methodusedby Mattel to computetheamountrecoverablefrom the in-surancecompany,a methodapprovedby Arthur Andersen,wasnotcredible.Infact, Mattel did not receiveanypaymentfrom its insurancecompanyuntil 1977andthenwaspaid only $4.4 million.

CASE 1.1 MATTEL, INC. 11

ADDITIONAL SEC CRITICISM OF

ARTHUR ANDERSEN’S MATTEL AUDITS

Besidesthe specific criticismsof Arthur Andersen’sMattel auditsalreadynoted,theSEC also chastisedthe audit firm for other,moregeneraldeficienciesin thoseaudits.First, theSEC criticized theArthur Andersenauditorsfor repeatedlyfail-ing to sufficiently investigatesuspicioustransactionsanddocumentscomingtotheir attention.An examplenotedearlierwasthe failure of the auditorsto ade-quatelyresearchthenatureof Mattel’s bill andholdsales.Second,theSECmain-tained that Arthur Andersenfailed to “apply industry knowledge” during thecourseof theMattel audits.Forexample,if ArthurAndersenhadbeencloselyfol-lowing its client’s sales markets, the firm would likely haverecognizedthatMattel’s largeinventory of Hot Wheelsat the endof 1970 requireda significantwrite-down,given the inability of retailers to sell their own inventoriesof thatproduct. In commentingon this point, the SEC made the following remarks:“Auditors mustacquireand apply sufficient knowledgeof their clients’ indus-tries to enablethemto intelligently audit their businessoperationsandto evalu-ate theclient’s explanationsof thoseoperations.”

The SEC also criticized Arthur Andersenfor being overly willing to acceptclient representationsas audit evidence“with little or no verification or docu-mentation.”As an example,the SEC noted the audit firm’s acceptanceof thespuriousexplanationgiven for the largediscrepancybetweenthe salesreportedforAugust1971 by thegeneralledgercontrollingaccountandby thesalesinvoiceregister.Finally, the SECobservedthat seniormembersof theArthur Andersenengagementteam had exhibited “insufficient control,coordination,and super-vision” during the Mattel audits. In particular, the SEC was concernedthatArthur Andersen’saudit review processhad failed to ensurethat importantproblemsdiscoveredby staff auditorsduring the Mattel auditswere resolvedsatisfactorily.

EPILOGUE

Under the leadershipof new management,Mattel slowly recoveredfrom itsnearlydisastrousexperiencesof the early1970s.In 1994,Mattel overtookHasbroas the nation’s largesttoy maker. Two yearslater, Mattel’s annualrevenuessur-passed$4.5billion, nearly40percentof whichwasattributableto theBarbieprod-uct line. That productline includedmorethan100 different Barbiedollsby late1997. Among thesedolls wereHula Hair Barbie,Workin’ Out Barbie,CountryRoseBarbie,and Harley-DavidsonBarbie.

Ruth Handleralsostageda dramaticcomebackfollowing hertraumaticexpe-riencesof theearly1970s.After herforcedretirementfrom Mattel, shefoundedacompany,RuthtonCorporation,that manufacturesprostheticdevicesfor womenwho,like herself,haveundergonemastectomies.Althoughasmallcompanywitha relatively small market, Ruthton Corporationquickly establisheditself andwithin a few yearswasreportingannualsalesof severalmillion dollars.In 1989,Ruth and Elliott Handlerwererecognizedfor their contributonsto the toy in-dustry by being inductedinto the industry’s hall of fame.

SECTION ONE COMPREHENSIVE CASES

In 1981, the SEC censuredArthur Andersenfor its allegeddeficientauditsofMattel, Inc. The SEC apparentlychoseonly to censureArthur Andersenbecausethe audit firm demonstratedthat it had undertakensignificantcorrectivemea-suresto preventtherecurrenceof theproblemsthathadarisenduring the Mattelaudits.Exhibit 1 containsthelist of thesecorrectivemeasuresthatwasappendedto theSECenforcementreleasein which Arthur Andersenwascensured.

QUESTIONS

1. Identify the key variablesthat influenced the level of inherentrisk ArthurAndersenfacedduring the 1971 and1972 auditsof Mattel.2. The SEC notedsix reasonswhy the bill andhold salesrecordedby Mattel didnot as cussthe generalqualify consummatedsalestransactions.Identify anddisconditionsfor recognizingrevenuefrom salestransactions.Also, identifycircum-stancesin which revenuesmay be recognizedon salestransactionseventhoughoneor moreof theseconditionsare not met.3. Identify anddiscussthe principalaudit objectivesassociatedwith the perfor-manceof year-endsalescutoff tests.In general,is it appropriateto perform thesetestsat an interimdate?Why or why not?4. SAS No. 31. “Evidential Matter,” identifies five key managementassertionsthat underliea set of financial statements.Identify the managementassertionsthat would havebeenof primaryconcernto Arthur Andersenregardingthefol-lowing items: thereservefor inventoryobsolescence,royaltyexpense,andthe re-ceivablerecordedby Mattel for thebusinessinterruption insuranceclaim. Why isit importantfor anauditor to identify theunderlyingmanagementassertionsforeachmajor accountof a client?5. In at leasttwo instances,key issuesraisedduring thereviewof Mattel’swork-papersby Arthur Andersenpersonnelwerenotresolvedsatisfactorilyprior tothecompletionof the audit. Which memberof the audit engagementteamhasthe

EXHIBIT 1Measures Taken byArthur Andersen toStrengthen Its AuditProcess Following theMattel Audits

• Consultation within the Firm. in 1978, the firm’s policies on Intra-firm consultatlonregard-ing complex or unusual transactions were formalized and restated in a single source provid-ing concise guidelines on specific practice problems where consultation is appropriate.

• Rotation of Audit Partners. in 1976, Arthur Andersen voluntarily adopted a policy requir-ing rotation of audit engagement partners every five years. A similar rule was adopted by theSEC Practice Section of the AIOPA in 1977.

• Second Partner Reviews, in 1975, Arthur Andersen began requiring an extensive reviewof audit reports and supporting materials by a second partner not engaged in the audit. Asimilar requirement was subsequently adopted by the SEC Practice Section of the AICPA. ~

• Personnel Training Programs. in the early 1970s, Arthur Andersen opened a large train-ing facility in St. CharIes~Illinois, on a former college campus. This facility is used on a contin-uing basis to provide training for Arthur Andersen partners and professionaiejnployees.

• Updating of Practice and Procedure Manuals. Arthur Andersen updated all of its majorpractice and procedure manuals to provide a set of readily accessible guidelines to firm policyon financial reporting issues, accounting prindples, auditing procedures, and ethical issues.’

~ PublIc Review Board. In 1974, Arthur Andersen established a Public Review board, an in-dependent body consisting of indMduals from business,the professions, andgovernment. ~-~:

The Board establishes its own program for reviewing the professional operations of the firm,and has in each year of its existence focused on a different area of the firm’s Practij~.~ -,

CASE 1.1 MATTEL, INC.

primary responsibilityto ensurethatsuchissuesareproperlyresolvedanddocu-mentedin the auditworkpapers?Defendyour answer.6. Assumethat Arthur AndersenhadcomparedMattel’s monthly salesduringthe early1970swith the comparablemonthiysalesfiguresof prior years.Whatadditionalaudit proceduresshouldArthur Andersenhaveperformedonceit dis-coveredtheextremevolatility in thesemonthlysalesfigures?7. Arthur Andersenproposeda $2 million adjustingentryto thedeferredtoolingcostsaccountduring its 1971 audit of Mattel. However,Mattel adjustedthe bal-anceof that accountby only $1.4 million. Identify the conditionsunder whichArthur Andersenwould havebeenjustified in acceptingthis smaller adjustingentry.

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case matle

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