Albrecht 4e Ch11 Solutions
Albrecht 4e Ch11 Solutions
Albrecht 4e Ch11 Solutions
Chapter 11
FINANCIAL STATEMENT FRAUD
Discussion Questions
1. Below are the most notable abuses that occurred between 2000 and 2002:
Misstated financial statements and “cooking the books”: Examples include
Qwest, Enron, Global Crossing, WorldCom, and Xerox, among others. Some of
these frauds involved 20 or more people helping to create fictitious financial
results and mislead the public. While not all related to fraud, the number of
financial statement restatements were 323 in 2003, 330 in 2002, 270 in 2001, and
233 in 2000.
Inappropriate executive loans and corporate looting: Examples include John
Rigas (Adelphia), Dennis Kozlowski (Tyco), and Bernie Ebbers (WorldCom).
Insider trading scandals: The most notable example was Martha Stewart and
Sam Waksal, both of whom have been convicted for selling ImClone stock.
Initial Public Offering (IPO) favoritism, including spinning and laddering:
Spinning involves giving IPO opportunities to those who arrange quid pro quo
opportunities, and laddering involves giving IPO opportunities to those who
promise to buy additional shares as prices increase. Examples include Bernie
Ebbers of WorldCom and Jeff Skilling of Enron.
Excessive CEO retirement perks: Companies including Delta, PepsiCo, AOL
Time Warner, Ford, GE, and IBM were highly criticized for endowing huge,
costly perks and benefits, such as expensive consulting contracts, use of corporate
planes, executive apartments, and house cleaners to retiring executives.
Exorbitant compensation (both cash and stock) for executives: Many
executives, including Bernie Ebbers of WorldCom and Richard Grasso of the
Chapter 11 1
Albrecht: Fraud Examination, 4e
NYSE, received huge cash and equitybased compensation that has since been
determined to be excessive.
Loans for trading fees and other quid pro quo transactions: Financial
institutions such as Citibank and JP Morgan Chase provided favorable loans to
companies like Enron in return for the opportunity to make hundreds of millions
of dollars in derivatives transactions and other fees.
Bankruptcies and excessive debt: Because of the abuse described above and
other similar problems, seven of the United States’ ten largest corporate
bankruptcies in history occurred in 2001 and 2002. These seven bankruptcies
were WorldCom (largest ever at $101.9 billion), Enron (second largest ever at
$63.4 billion), Global Crossing (fifth largest ever at $25.5 billion), Adelphia
(sixth largest ever at $24.4 billion), United Airlines (seventh largest at $22.7
billion), PG&E (eighth largest at $21.5 billion), and Kmart (tenth largest at $17
billion). Four of these seven include some kind of known fraud.
Massive fraud by employees: While not in the news nearly as much as financial
statement frauds, there has been a large increase in fraud against organizations;
some of these frauds are as high as $2 to $3 billion.
2. The fraud triangle provides insight into why recent ethical compromises occurred. We
believe there were nine factors that came together to create what we call the “perfect fraud
storm.” In explaining this perfect storm, we will use examples from recent frauds.
The first element of the perfect storm was the masking of many existing problems and
unethical actions of the prosperous economy in the 1990s and early 2000s. During this time,
most businesses appeared to be highly profitable, including many fledgling “dotcom”
companies that were testing new (and many times unprofitable) business models. The
economy was booming, and investment was high. In this period of perceived success, people
made nonsensical investments and other illogical decisions. The advent of “investing over the
Internet” for a few dollars per trade brought many new, inexperienced people to the stock
market. History has now revealed that several frauds committed since 2002 actually started
during the boom years but the apparent booming economy hid the fraudulent behavior. The
HealthSouth fraud, for example, began in 1986 and was not caught until 2003.
The booming economy also caused executives to believe that their companies were more
successful than they were and that their companies’ success was primarily a result of good
Chapter 11 2
Albrecht: Fraud Examination, 4e
management. Academic researchers have found that extended periods of prosperity can
reduce a firm’s motivation to comprehend the causes of success, raising the likelihood of
faulty attributions. In other words, during boom periods, many firms do not correctly ascribe
the reasons behind their successes. Management usually takes credit for good company
performance. When company performance degrades, boards often expect results similar to
those in the past without new management styles or actions. Since management did not
correctly understand past reasons for success, they incorrectly think past methods will
continue to work. Once methods that may have worked in the past only because of external
factors fail, some CEOs may feel increased pressure. In certain cases, this pressure
contributed to fraudulent financial reporting and other dishonest acts.
The second element of the perfect fraud storm was the moral decay that has been occurring
in the United States and the rest of the world in recent years. Whatever measure of integrity
one uses, dishonesty appears to be increasing. For example, researchers have found that
cheating in school, one measure of dishonesty, has increased substantially in recent years.
The following table (which is not given to the students in the text) summarizes some of
these studies.
Chapter 11 3
Albrecht: Fraud Examination, 4e
The third element of the perfect fraud storm was misplaced executive incentives. Executives
of the most fraudulent companies were endowed with hundreds of millions of dollars in stock
options and/or restricted stock that made it far more important to keep the stock price rising
than to report financial results accurately. In many cases, this stockbased compensation far
exceeded executives’ salarybased compensation. For example, in 1997, Bernie Ebbers, the
CEO of WorldCom, had a cashbased salary of $935,000. Yet, during that same period, he
was able to exercise hundreds of thousands of stock options, making millions in profits and
received corporate loans totaling $409 million for purchase of stock and other purposes.1 The
attention of many CEOs shifted from managing the firm to managing the stock price. At the
cost of countless billions of dollars, managing the stock price all too often turned into
fraudulently managing the financials.
The fourth element of the perfect storm, and one closely related to the last, was the often
unachievable expectations of Wall Street analysts that targeted only shortterm behavior.
Company boards and management, generally lacking alternative performance metrics, used
comparisons with the stock price of “similar” firms and attainment of analyst expectations as
important de facto performance measures. These stockbased incentives compounded the
pressure induced by the analyst expectations. Each quarter, the analysts, often coached by
companies themselves, forecasted what each company’s earnings per share (EPS) would be.
The forecasts alone drove price movements of the shares, imbedding the expectations in the
price of a company’s stock. Executives knew that the penalty for missing the “street’s”
estimate was severe; even falling short of expectations by a small amount would drop the
company’s stock price by a considerable amount. Consider the following example of one of
the frauds that occurred recently.
1
Gary Strauss, “Execs Reap Benefits of Cushy Loans,” USATODAY.com, December 2002,
< www.usatoday.com/money/companies/management/2002-12-23-ceo-loans_x.htm>.
Chapter 11 4
Albrecht: Fraud Examination, 4e
For this company, the “street” made the following EPS estimates for three consecutive
quarters2:
Based on these estimates, the consensus estimate was that the company would have EPS of
$0.17 in the first quarter, $0.22 in the second quarter, and $0.23 in the third quarter. As has
now been shown, the company’s actual earnings during the three quarters were $0.08, $0.13,
and $0.16, respectively. In order not to miss the “street’s” estimates, management committed
a fraud of $62 million or $.09 per share in the first quarter, a fraud of $.09 in the second
quarter, and a fraud of $0.07 in the third quarter.
The complaint in this case read (in part) as follows:
“The goal of this scheme was to ensure that [the company] always met Wall Street’s
growing earnings expectations for the company. [The company’s] management knew
that meeting or exceeding these estimates was a key factor for the stock price of all
publicly traded companies and therefore set out to ensure that the company met Wall
Street’s targets every quarter regardless of the company’s actual earnings. During
the period 1998 to 1999 alone, management improperly inflated the company’s
operating income by more than $500 million before taxes, which represents more
than onethird of the total operating income reported by [the company].”
The fifth element in the perfect storm was the large amounts of debt and leverage each of
these fraudulent companies had. This debt placed tremendous financial pressure on
executives not only to have high earnings to offset high interest costs but also to report high
earnings to meet debt and other covenants. For example, during 2000, Enron’s derivatives
2
The data relating to this case are real but proprietary. Because litigation is still ongoing, the source and name
of the company have not been revealed.
Chapter 11 5
Albrecht: Fraud Examination, 4e
related liabilities increased from $1.8 billion to $10.5 billion. Similarly, WorldCom had over
$100 billion in debt when it filed history’s largest bankruptcy. During 2002 alone, 186
public companies, including WorldCom, Enron, Adelphia, and Global Crossing, filed for
bankruptcy in the United States with $368 billion in debt.3
The sixth element of the perfect storm was the nature of U.S. accounting rules. In contrast to
accounting practices in other countries such as the U.K. and Australia, U.S. generally
accepted accounting principles (GAAP) are much more rule based than principles based.4
One perspective on having rulesbased standards is that if a client chooses a particular
questionable method of accounting that is not specifically prohibited by GAAP, it is hard for
auditors or others to argue that the client cannot use that method of accounting. The existing
general principles already contained within GAAP notwithstanding, when auditors and other
advisors sought to create competitive advantages by identifying and exploiting possible
loopholes, it became harder to make a convincing case that a particular accounting treatment
is prohibited when it “isn’t against the rules.” Professional judgment lapsed as the general
principles already contained within GAAP and SEC regulations were ignored or minimized.
The result was that rather than deferring to existing, more general rules, specific rules (or the
lack of specific rules) were exploited for new, often complex financial arrangements as
justification to decide what was or was not an acceptable accounting practice.
As an example, consider the case of Enron. Even if Arthur Andersen had argued that
Enron’s Special Purpose Entities (SPEs) were not appropriate, it would have been
impossible for them to make the case that they were against any specific rules. Some have
suggested that one of the reasons it took so long to get plea bargains or indictments in the
Enron case was because it was not immediately clear whether GAAP or any laws had
actually been broken.
A seventh element of the perfect fraud storm was the opportunistic behavior of some CPA
firms. In some cases, accounting firms used audits as loss leaders to establish relationships
with companies so they could sell more lucrative consulting services. The rapid growth of
the consulting practices of the “Big 5” accounting firms, which was much higher than the
growth of other consulting firms, attested to the fact that it is much easier to sell consulting
services to existing audit clients than to new clients. In many cases, audit fees were much
smaller than consulting fees for the same clients, and accounting firms felt little conflict
between independence and opportunities for increased profits. In particular, these alternative
3
“Bankruptcy Filings Reach All-Time High in 2002,” The Business Journal, January 2002,
<http://www.bizjournals.com/portland/stories/2002/12/30/daily17.html>.
4
In 2003, the SEC acknowledged that U.S. GAAP may be too “rule-based” and wrote a position paper arguing
for more “principles” or “objectives-based” accounting standards.
Chapter 11 6
Albrecht: Fraud Examination, 4e
services allowed some auditors to lose their focus and become business advisors rather than
auditors. This is especially true of Arthur Andersen, which had spent considerable energy
building its consulting practice only to see that practice split off into a separate firm.
Privately, several Andersen partners have admitted that the surviving Andersen firm and
some of its partners had vowed to “out consult” the firm that separated from them and
became preoccupied with that goal.
The eighth element of the perfect storm was greed by executives, investment banks,
commercial banks, and investors. Each of these groups benefited from the strong economy,
the high level of lucrative transactions, and the apparently high profits of companies. None
of them wanted to accept bad news. As a result, they sometimes ignored negative news and
entered into bad transactions.5 For example, in the Enron case, various commercial and
investment banks made hundreds of millions from Enron’s lucrative investment banking
transactions on top of the tens of millions in loan interest and fees. None of these firms
alerted investors about derivative or other underwriting problems at Enron. Similarly, in
October 2001, after several executives had abandoned Enron and negative news was
reaching the public, 16 of 17 security analysts covering Enron still rated the company a
“strong buy” or “buy.”6 Enron’s outside law firms were making high profits from Enron’s
transactions as well. These firms also failed to correct or disclose any problems related to
the derivatives and special purpose entities but in fact helped draft the requisite associated
legal documentation. Finally, the three major credit rating agencies, Moody’s, Standard &
Poor’s, and Fitch/IBC—who all received substantial fees from Enron—did nothing to alert
investors of pending problems. Amazingly, just weeks prior to Enron’s bankruptcy filing,
after most of the negative news was out and Enron’s stock was trading for $3 per share, all
three agencies still gave investment grade ratings to Enron’s debt.7
Finally, the ninth element of the perfect storm was three types of educator failures. First,
educators had not provided sufficient ethics training to students. By not forcing students to
face realistic ethical dilemmas in the classroom, graduates were ill equipped to deal with the
real ethical dilemmas they faced in the business world. In one allegedly fraudulent scheme,
for example, participants included virtually the entire senior management of the company,
5
A March 5, 2001 Fortune article included the following warning about Enron: “To skeptics, the lack of clarity
raises a red flag about Enron’s pricey stock…the inability to get behind the numbers combined with ever higher
expectations for the company may increase the chance of a nasty surprise. Enron is an earnings-at-risk story…”
Bethany McLean, “Is Enron Overpriced,” Fortune.com, 5 March, 2001,
<http://www.fortune.com/fortune/print/0,15935,369278,00.html>. Even with this bad news, firms kept investing
heavily in Enron and partnering or facilitating Enron’s risky transactions.
6
Peter G. Fitzgerald, “Stock Analyst Disclosure,” Peter G. Fitzgerald, U.S. Senator, Illinois,
<http://fitzgerald.senate.gov/legislation/stkanalyst/analystmain.htm>.
7
Ben White, “Do Rating Agencies Make the Grade? Enron Case Revives Some Old Issues,” Council of
Development Finance Agencies, 31 January 2002, <http://www.cdfa.net/cdfa/press.nsf/pages/275>
Chapter 11 7
Albrecht: Fraud Examination, 4e
including but not limited to its former chairman and chief executive officer, its former
president, two former chief financial officers and various other senior accounting and
business personnel. In total, it is likely that there were over twenty individuals involved in
the earnings overstatement schemes. Such a large number of participants points to a
generally failed ethical compass for this group. Consider another case of a chief accountant.
A CFO instructed the chief accountant to increase earnings by an amount somewhat over
$100 million. The chief accountant was skeptical about the purpose of these instructions but
did not challenge them. Instead, the chief accountant followed directions and allegedly
created a spreadsheet containing seven pages of improper journal entries—105 in total—that
he determined were necessary to carry out the CFO’s instructions. Such fraud was not
unusual. In many of the cases, the individuals involved had no prior records of dishonesty,
and yet when they were asked to participate in fraudulent accounting, they did so quietly and
of free will.
A second educator failure was not teaching students about fraud. One of the authors has
taught a fraud course to business students for several years. It is his experience that most
business school graduates would not recognize a fraud if it hit them between the eyes. The
large majority of business students do not understand the elements of fraud, perceived
pressures and opportunities, the process of rationalization, or red flags that indicate the
possible presence of dishonest behavior. And, when they see something that does not look
right, their first reaction is to deny a colleague could be committing dishonest acts.
A third educator failure is the way we have taught accountants and business students in the
past. Effective accounting education must focus less on teaching content as an end unto
itself and instead use content as a context for helping students develop analytical skills. As
an expert witness, one of the authors has seen too many cases where accountants applied
what they thought was appropriate content knowledge to unstructured or different situations
only to find out later that the underlying issues were different than they had thought and that
they totally missed the major risks inherent in the circumstances.
Because of these financial statement and other problems that caused such a decline in the
market value of stocks and a loss of investor confidence, a number of new laws and
corporate governance changes have been implemented by the SEC, PCAOB, NYSE,
NASDAQ, FASB, and others.
3. Financial statements are important to the efficiency of America’s capital markets because
they provide meaningful disclosures of where a company has been, where it is currently, and
where it is going. For the markets to work efficiently, accurate information about the
Chapter 11 8
Albrecht: Fraud Examination, 4e
companies whose stocks are listed must be publicly available. Information makes the markets
operate efficiently, and financial information is some of the most important information to
help investors and creditors make investment and credit decisions.
4. Financial statement fraud is intentional misstatements or misrepresentations about the
financial position or financial results of an organization in an organization’s financial
statements. Financial statement fraud can result from manipulation, falsification, or alteration
of accounting records or from omitting critical information from the financial statements. For
misrepresentations in the financial statements to represent financial statement fraud, the
misrepresentations must be intentional. Unintentional misrepresentations are called errors
and are different than financial statement fraud.
5. Top executives and officers of an organization most often commit financial statement fraud.
The most common person involved, according to empirical research, is the CEO, but CFOs
and other executives are often involved as well.
6. CEOs are often perpetrators of financial statement fraud because they have ultimate
responsibility for the success of an organization. In that position, they often perceive and
personalize the kinds of fraud pressures and opportunities that were discussed in the chapter
(e.g., the need to meet Wall Street earnings expectations.)
7. Creating fictitious journal entries, fictitious documentation, and altering the numbers in the
financial statements often conceal financial statement frauds. The most common financial
statement frauds are misstatements of revenues and receivables followed by misstatements of
inventory and cost of goods sold.
8. An audit committee provides a thirdparty view to the financial situation of a company. The
audit committee has an intimate knowledge of the company that is not matched by outsiders.
An audit committee should ensure that appropriate controls are in place and provide a check
and balance to the major decisions of management. Management generally has a tougher
time hiding fraud from an actively involved audit committee.
9. Some examples of motives/pressure to commit financial statement fraud are:
To meet analyst’s expectations
CEO bonuses are often tied to performance
High stock prices may need to be supported by high income
Chapter 11 9
Albrecht: Fraud Examination, 4e
CEOs typically have stock option packages or hold large amounts of company
stock, tying their personal net worth to the success of the company
Debt covenants may require certain levels of financial performance
10. The four different areas that must be examined when trying to detect financial statement
fraud are management and directors, relationships with others, organization and industry, and
financial results and operating characteristics. For each of these, there are several elements
that must be examined as discussed in the chapter.
11. Some of the ways that financial statement fraud schemes can be identified are by looking for
relatedparty transactions, using various means such as horizontal and vertical analysis to
look for unusual relationships or balances in the financial statements, investigating the
backgrounds and motivations of executives and officers, and looking for organization
structures that do not make sense.
12. The reason members of management and the board of directors must be examined when
searching for financial statement fraud exposures is because it is people, specifically
management and board members, who commit financial statement fraud. Without such
individuals manipulating the financial statements, there would be no financial statement
fraud. To determine if management or board members are involved in financial statement
fraud, it is important to examine their motivations, backgrounds, and decisionmaking ability
and power within the organization.
13. Relationships with others are important areas to look at when searching for financial
statement fraud. Hiding the truth in related companies (such as the relatedparty partnerships
(SPEs) in the Enron case) or using sham or unrealistic transactions with related parties to
overstate revenues, inventories, or other financial statement accounts often are ways of
committing financial statement fraud. One of the easiest ways to commit financial statement
fraud is to enter into transactions with fictitious organizations that appear to be independent
but are really related parties. In addition, relationships with financial institutions, auditors, or
lawyers that appear unusual or problematic can often signal that something is not right.
14. It is always important to evaluate the relationship between a company and its auditors when
considering financial statement fraud. Fraud can occur much more easily if auditors lack
independence. Auditors also have a difficult time detecting fraud if their access to a company
and its records is unreasonably limited. Another factor impacting an auditor’s ability to
uncover fraud is unreasonable time constraints. Disputes with auditors about accounting
issues can also be indicative of fraud. It is especially important to evaluate the
Chapter 11 10
Albrecht: Fraud Examination, 4e
company/auditor relationship when there has been a change in auditors. Companies rarely
change auditors without a major motivation to do so. As a result, auditor changes can often
signal underlying fraud problems.
True/False
1. False. Like other frauds, financial statement fraud is rarely seen and may be concealed
through collusion among management, employees, third parties, or in other ways.
2. True
3. True
4. False. The most common methods used involve improper revenue recognition, the
overstatement of assets, and the understatement of expenses and liabilities, in that order.
5. True
6. True
7. False. The Fraud Exposure Rectangle is used in identifying management fraud exposures. In
addition to the three corners mentioned above, the rectangle includes Financial Results and
Operating Characteristics.
8. False. Financial statement fraud is usually committed by the highest individuals in an
organization and most often on behalf of the organization as opposed to against it.
9. True
10. False. Relationships with others (e.g., related parties) should be examined because unrealistic
and non–“arm’s length” transactions are some of the easiest ways to perpetrate financial
statement fraud.
11. True
Chapter 11 11
Albrecht: Fraud Examination, 4e
12. False. While CFOs are often involved, the CEO (Chief Executive Officer) of an organization
is the person that commits, motivates and instigates most financial statement fraud.
13. False. On behalf of an organization, top management almost always commits financial
statement fraud.
14. False. Most people who commit management fraud are firsttime offenders.
15. False. Most financial statement fraud occurs in smaller organizations where one or two
individuals have almost total decisionmaking ability.
16. False. A person engaged in zeroorder reasoning only considers conditions that directly affect
himself or herself and not other people.
17. True
18. True
19. True
Multiple Choice
1. e
2. d
3. e
4. c
5. d
6. d
7. a
Chapter 11 12
Albrecht: Fraud Examination, 4e
8. c
9. a
10. d
11. c
12. a
13. b
Short Cases
Case 1
Most of the fraud symptoms in this case relate to management, the board of directors, and
relationships with others.
Management and the board of directors: The senior officers were friends. They had a lot of power
in the new company, which allowed them to collude if needed. Their positions in the company
allowed them to influence decisions and override internal controls as they wished. They owned a
large percentage of the common stock, so they had a personal motivation for the stock price to be as
high as possible. They comprised a large percentage of the board of directors, so they were insiders.
Relationships with others: The fact that the president of the local bank was appointed to the board
of directors not only represented a “grey” member in the board (because he had loaned the company
money), but it could also represent a concern about how valid the transactions are between the
company and the bank. Is the bank giving the company extremely lax credit terms or an
unreasonably low interest rate? Are the transactions with the bank arm’s length? One might also be
concerned about the company’s relationship with city officials, who feel a strong motivation to keep
this company in town because it boosts the city’s economy, provides jobs, etc.
Case 2
Chapter 11 13
Albrecht: Fraud Examination, 4e
1. In determining whether or not a good system of internal controls would have prevented
fraudulent backdating practices, it is important to understand who the perpetrators were.
Internal controls are most effective in preventing or detecting employees who commit fraud
when acting alone. When collusion (two or more people are involved), internal controls are
less effective. When top management and the directors are involved, as was the case with
option backdating, they can often “override” internal controls. Internal control activities
(procedures) such as segregation of duties, proper authorizations, and so forth, wouldn’t be
nearly as effective in preventing this type of fraud as would a good control environment (tone
at the top.) While a few of these firms’ backdating practices were caught by auditors or
outsiders, most backdating revelations have come from companies themselves after
thoroughly examining all options granted in the past.
2. The question of why executives and directors would have allowed this fraudulent practice is
a tough one. Hopefully, in most cases, the option backdating was known by only a few
people. Those individuals probably engaged in the practice because of the elements of the
fraud triangle: (1) they felt a pressure to increase their compensation—greed, (2) they
perceived an opportunity to backdate without getting caught—no one had been paying
attention to option dating in the past, and (3) they rationalized that it was okay—everyone
else was doing it. With respect to the rationalization, they were correct. While everyone
wasn’t doing it, lots of companies were. The fact that many others are acting illegal doesn’t
make it right.
3. A whistleblower system allows individuals to call in anonymously to report suspected
violations. A whistleblower system would probably be the most effective way to catch this
kind of fraud because individuals who saw the dishonest acts could report violations by
company executives without fear of reprisal because no one knows who the anonymous
caller is. Whistleblower systems are most important where internal controls can be
overridden. The fact that a whistleblower system is in place helps prevent or deters
dishonest acts. Providing a way for everyone who could see fraud to easily report that fraud
significantly increases the likelihood that dishonest acts will be reported.
Case 3
Below are some of the red flags that fraud may be occurring:
Success since beginning operations
Rapid growth in revenues
Pressure to perform well for the IPO
Chapter 11 14
Albrecht: Fraud Examination, 4e
Increased commissions as a way to increase revenue
Personal relationships between executives
Change in auditors
Dispute with auditor over revenue recognition accounting
Infrequent board of director and audit committee meetings
Close relationships between the board and management
High level of stock options held by management
Case 4
Financial statement fraud is very different than embezzlement and misappropriation. Perpetrators of
financial statement fraud are usually members of top management who manipulate financial
statements in order to boost earnings and increase stock prices. On the other hand, embezzlement
and misappropriation take place when employees steal from the organizations for which they are
working. Top management benefits from financial statement fraud whereas the benefactors of
embezzlement and misappropriation are the middle management, frontline workers, and others who
engage in the misappropriation and embezzlement.
Case 5
1. Management and directors
2. Organization and industry
3. Organization and industry
4. Relationships with others
5. Financial results and operating characteristics
6. Relationships with others
7. Management and directors
Case Studies
Case Study 1
1.
The Chipmunk Company
Ratio Analysis
Chapter 11 15
Albrecht: Fraud Examination, 4e
PERCENT INDUSTRY
LIQUIDITY RATIOS 12/31/10 12/31/09 CHANGE
CHANGE AVERAGE
Current ratio: current
assets/current liabilities 2.310 2.491 0.181 7.27% 1.21
Quick ratio: (current assets—
inventory–prepaid
expenses)/current liabilities 0.416 0.402 0.014 3.46% 0.35
Sales/receivables: net
sales/net ending receivables 16.05 17.78 1.73 9.73% 23.42
Number of days sales in A/R:
net ending receivables/(net
sales/365) 22.74 20.53 2.21 10.76% 15.58
Inventory turnover: cost of
sales/average inventory 1.48 1.39 0.09 6.37% 1.29
2. ANALYSIS: The current ratio has declined by more than 7 percent during the year, which
raises a few questions. There might be a possibility of fraud in cash or near cash (current
assets). The collection period of accounts receivable is also questionable. There is almost an
11 percent increase in days sales in accounts receivable, and the company is taking much
longer than the industry average to collect its receivables. This also could indicate that fraud
is occurring as the company may be channel stuffing or creating fictitious sales and accounts
receivable.
Case Study 2
1.
a. Although this information is not in the case for students to learn, a financial analyst
would have greatly benefited by investigating management and directors, because the
major players in BreX had histories of fraud, unethical, and illegal acts. Chances are
that if they were unethical in the past, they would continue that behavior. By
investigating management and directors, an analyst would have identified an
immediate red flag of fraud.
b. Although investigating the company’s relationship with other entities may not have
signaled any immediate red flags, an analyst could have understood more about the
company, its affiliates, and the risks involved.
c. Although this information is not in the case for students to learn, an analyst who
would have investigated the organization and its industry would have realized that
mining in Canada has a long history of scandals and fraud. Penny stock scandals and
Chapter 11 16
Albrecht: Fraud Examination, 4e
other such scandals are often perpetrated via the Canadian stock exchanges. An
analyst who would have investigated the industry would realize the inherent risk that
is associated with mining.
d. By investigating the financial results and operating characteristics of BreX Minerals,
an analyst may have realized that the financial results were especially high for pure
speculation. The company was brand new and had no history of financial results. The
quantity of gold that they were supposed to have discovered had never in fact been
mined in large quantities. The only gold that had actually been taken was small
samples, which could easily have been tampered with.
2. At BreX Minerals’ height, the price of gold on the open market dropped because of the
anticipation of the new gold supply. When the entire operation proved to be a scam, many
investors lost money. Furthermore, the Canadian stock market lost credibility and reputation.
As a result of the scam and the chaos that followed, the entire Canadian stock market was
forced to shut down for a period of time.
3. Greed by executives, investment banks, commercial banks, and investors; educator failure;
unachievable expectations of investors and others; unrealistic compensation for executives;
moral decay; and the good economy of the 1990s all contributed to both the perfect fraud
storm as well as the BreX Minerals scandal.
4. The major motivation to commit fraud was the greed and moral decay of the executives. This
was not the first time that these individuals had been convicted of fraud. The executives
loved to live a lavish lifestyle and would do just about anything to maintain their desired
lifestyle.
Case Study 3
1.
a. If zeroorder reasoning were employed, an independent auditor would not consider
conditions that affect the auditee. The independent auditor would only be interested in
conditions that directly affect him or her. The audit plan often takes into account costs
and benefits associated with specific assurance levels in the audit. Therefore, zero
order reasoning would most likely be that the auditor simply follows the already
established audit plan.
Chapter 11 17
Albrecht: Fraud Examination, 4e
b. If firstorder reasoning were employed, the auditor would consider conditions
affecting the auditee when planning the audit. The auditor should notice that the level
of returned product was quite high for the previous year. Also, because allowances
for future returns were too low on the books compared to the actual returns from the
prior year, the auditors should consider altering the audit plan. The auditor should
have tried to observe the location where the actual returned goods were stored. The
auditor should also try to trace the steps of several returns through the accounting
process to determine if all appropriate recordings are made. The auditor could also do
more extensive analytical and substantive testing to make sure that allowances for
returns and sales of product are at appropriate levels. In performing these procedures,
the auditor would likely rely heavily on typical procedures performed in prior audits
and not consider that the client may be concealing a fraud in a manner that the typical
procedures won’t detect.
c. If higherorder reasoning were employed, the auditor considers additional layers of
complexity, including how management may anticipate the auditor’s behavior. The
auditor may adjust the audit plan by introducing unexpected audit procedures in
response to what the auditor believes management may be doing to conceal a fraud
based on management’s strategic reasoning. Thus, the auditor may perform an
unexpected inspection of the location of where returned goods are held. The auditor
would realize that management would steer the auditor away from storage locations
of returned goods because management realized that the auditor would want to
perform physical inspection of inventory. Realizing that management was applying
strategic reasoning to conceal a fraud, the auditor would interview employees who
worked where these goods may be stored and perform unexpected inspections of
these goods to get an accurate count of the magnitude of returned goods and attempt
to unveil a fraud.
The auditor could also use technology such as ACL or Picalo to look for transactions that are
abnormal in nature or that have abnormal timing. The auditor could also interview other
personnel regarding their job functions, performance of tasks, and the recording of nonroutine
accounting entries in order to determine if discrepancies exist between stories. This may provide
the auditors with further insight into which areas of the audit to alter in their attempt to uncover
the concealment of a fraud.
Internet Assignments
Chapter 11 18
Albrecht: Fraud Examination, 4e
1. The first part of the assignment has no prescribed answer because student searchers will go
several different directions, depending on word combinations used. Some of the key points of
the CFO.com article are as follows:
While auditors do not mention fraud in their standard audit report, investors expect
auditors to detect fraud. The profession has tried to minimize their responsibility for
fraud but the public has held them responsible. This is known as the “expectation
gap.”
The PCAOB is trying to close this expectations gap by requiring the standard audit
report to mention auditors’ responsibility for detecting fraud.
PCAOB rules require auditors to provide reasonable assurance that the financial
statements are not materially misstated due to fraud but the standard audit report does
not tell investors they are responsible for material misstatements due to fraud.
Users are asking auditors to identify their clients’ key risk areas but auditors are
reluctant due to liability reasons.
The PCAOB is working to establish a financial reporting fraud center for collecting
information on preventing and detecting fraud.
Debates
1.
a. Pro: Yes, this is true. Just ask an average person on the street what they think about
the accounting industry, and they will likely give you a derogatory response. Even
informed users will argue that there is no good way to account for intangibles such as
goodwill, which make up much of certain companies’ financial statements these days.
Proof that companies are playing the earnings game with financial statements is all
around us. How else would companies meet earnings forecasts set by analysts such a
high percentage of the time?
a. Con: It is a complex world and a complex business environment in which we find
ourselves. There are no easy answers as to how we can represent the true financial
position of a company. The accounting profession has done an amazing job at
capturing this information and at holding companies to strict standards; however, this
Chapter 11 19
Albrecht: Fraud Examination, 4e
is not to say that everything is perfect. Accounting standards will have to continually
evolve to match the business environment. Companies will have to be held to higher
standards, since they are the ones who are trying to play the earnings game and not
necessarily the auditors. In addition, it is the companies themselves who guide Wall
Street’s forecasts.
2.
a. Earnings management is acceptable for the reasons below:
Increased stock value for meeting forecasted earnings.
Giving management a chance to correct a bad quarter (period).
Less pressure on management for missed earnings.
GAAP providing legitimate ways to manage earnings.
GAAP is not that precise and there are lots of acceptable accounting
alternatives.
b. With earnings management:
Financial statements are not accurate.
Stockholders are misled.
Earnings management is a precursor to fraud, especially if results do not
improve.
Some earnings management is fraud and other types of earnings
management are precursors to fraud.
Based on the evidence and the definition of financial statement fraud,
earnings management may or may not be financial statement fraud. The
most problematic part of earnings management is that it often leads to
management fraud because management gets in the habit of changing
numbers to meet expectations (as in the PharMor case).
Answers to Stop & Think Questions
1. Had Finn not complied with Monus’s expense manipulation requests early on, would
the PharMor fraud have progressed to the extent it did? Also, how would Finn’s career
have been different?
Chapter 11 20
Albrecht: Fraud Examination, 4e
a. Had Finn not complied with Monus’ expense manipulation requests early on, then the
PharMor fraud may have not happened or at least continued for very long. Had Finn
reported Monus’ actions early on to the proper people, then the perpetuated fraud may
not have happened. Finn may have prevented the eventual downfall of PharMor and
retained his position. Conversely, Finn may have been fired by Monus because he
would not agree to participate in the fraudulent financial reporting. The outcome of
how Finn’s career would have ended up is uncertain, but he probably would not have
had to face the consequences, such as prison time, for participating in fraudulent
activities.
2. If auditors and investigators modified their typical procedures and regularly used a few
unexpected procedures to look for fraud, how would this affect a potential
perpetrator’s opportunity to conceal a fraud?
a. If auditors and investigators modified the typical procedures used to look for fraud
and regularly used a few unexpected procedures to look for fraud, it would be more
difficult for fraud to be perpetrated. Potential fraud perpetrators would need to be
more creative and need to engage in strategic reasoning themselves to prevent getting
caught. This limits the perpetrators opportunity to commit fraud.
Chapter 11 21