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ACC/546 Auditing - Crenshaw Properties Bankruptcy

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Discuss the steps that Ralph Smalley could have taken to prevent the bankruptcy of Crenshaw Properties.

Do you believe these steps would have been reasonable and logical to take at that time. why or why not?


Story line:

Crenshaw Properties was a real estate developer that specialized in self-storage facilities that it sold to limited partner investors. Crenshaw's role was to identify projects, serve as general partner with a small investment, and raise capital from pension funds. Crenshaw had an extensive network of people who marketed these investments on a commission basis. As general partner, Crenshaw earned significant fees for related activities, including promotional fees, investment management fees, and real estate commissions. As long as the investments were successful, Crenshaw prospered. Because the investments were reasonably long-term, the underlying investors did not pay careful attention to them. However, in the mid-1980s, the market for self-storage units in many parts of the country became oversaturated. Occupancy rates, rental rates, and market values declined. Ralph Smalley, of Hambusch, Robinson & Co., did the annual audit of Crenshaw. As part of the audit, Smalley obtained financial statements for all of the partnerships in which Crenshaw was the general partner. He traced amounts back to the original partnership documents and determined that amounts agreed with partnership records. Smalley also determined that they were mathematically accurate. The purpose of doing these tests was to determine that the partnership assets, at original cost, exceeded liabilities, including the mortgage on the property and loans from investors. Under the law, Crenshaw, as general partner, was liable for any deficiency. Every year, Smalley concluded that there were no significant deficiencies in partnership net assets for which Crenshaw would be liable. What Smalley failed to recognize in the late 1980s, however, was that current market prices had declined significantly because cash flows were lower than those projected in the original partnership offering documents. In fact, Crenshaw went bankrupt in 1989, and Hambusch, Robinson & Co. was named in a suit to recover damages filed by the bankruptcy trustee.

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Solution Preview

Discuss the steps that Ralph Smalley could have taken to prevent the bankruptcy of Crenshaw Properties.

The auditors should have assessed this audit at an elevated level of risk during the planning phase. First, the firm paid the network of people on commission which naturally put pressure on teams to perform in ways that salary does not. This would be the first leg in the fraud triangle (pressure, opportunity, rationalization). Second, the underlying investors did not pay attention to the investments or Crenshaw's strategies. Third, the industry had declined. Finally, the business as decentralized, operating in small partnerships of which Crenshaw was the general partner. All these remote partnership that just reported ...

Solution Summary

Your tutorial is 435 words and discusses how the inherent risk and control risk should have been assessed at high during the planning phase and how this would have indicated a need for much more testing of transactions and balances than Smalley conducted to give an overall audit risk at an acceptable level. Suggested substantive tests are included in the response as well as a discussion of how reasonable and logical they might have been at the time.