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Katharine Walls, CFA, works as an auditor for Pindale Accounting. She is concerned about Smith Fabrics, a company she audits. During her last visit to Smith Fabrics, the accounting director, Bob Fox, rudely ushered her into a tiny conference room with no telephone or computer, and gave her no key to the main accounting office. She was given only three days to finish what is normally a five-day job. Before he left Walls, Fox gave her a 150-page manual of Smith’s accounting policies for its various overseas divisions. After she finished her audit, Walls prepared a report for Pindale’s executive director, recommending that the firm drop Smith Fabrics as a client because she saw evidence of attitudes that could lead to fraudulent accounting. Walls cited three of Fox’s actions in her report, most likely leaving out:

A) the policy manual.

B) her rude welcome.

C) her isolation from the accounting department.

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A strained relationship between the auditor and management is a sign of a company with an attitude that could lead to accounting fraud. Domineering behavior such as the rude welcome is a sign of that strained relationship, as is the unrealistic deadline and isolation from the accountants. But providing Walls with the policy manual was a good idea. The fact that the manual is 150 pages long bespeaks problems with the complexity of the company’s accounting, but that is not evidence of a bad attitude. As such, the manual is least relevant to Walls’ argument.

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Based on her analysis of Maxwell Research’s internal operations and business climate, analyst Jane Kilgore is concerned about management’s opportunities to commit fraud. Which of the following characteristics should worry Kilgore least?

A) More than half of Maxwell’s revenue is generated in emerging markets.

B) More than a third of Maxwell’s total sales go to its own consolidated subsidiaries.

C) Maxwell’s market penetration gives it the ability to dictate terms to vendors.

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High levels of related-party transactions are worrisome, particularly when those parties are not audited. But transactions within the company between subsidiaries consolidated in a company’s audited financial statements are neither unusual nor a particularly fertile ground for fraud. Both remaining characteristics are legitimate risk factors.

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Karl Decker, CFA, is analyzing Keystone Semiconductor to determine if the stock would be a good investment. He has determined the following:

• Management owns 15 percent of the outstanding shares.
• Internal growth targets are aggressive.
• In recent quarters, profit growth has been exceptionally high.
• The company’s debt covenants are quite lax.

All of these characteristics are positives from the perspective of an investor looking for profit growth. But Decker is concerned about pressure on management to manipulate results. Which of the following should least concern Decker?

A) Recent operating results.

B) Debt covenants.

C) Management’s share holdings.

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Aggressive growth targets and high management ownership represent incentives to manipulate earnings. Extremely high growth often goes hand in hand with financial instability. But while strict debt covenants could drive management to manipulate earnings, lax covenants give management less reason to manipulate earnings.

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Samantha Cameron, CFA, is part of a team reviewing the finances of Redd Networks, a computer-services company known for its complex accounting. Her task is to analyze the company’s operational results, including a recent decline in profits and cash flows. She must also determine how the company is responding to strict debt covenants. Lastly, Cameron is to investigate executives’ holdings of stock and options in the firm, which are believed to be quite high. Which portion of the fraud triangle is Cameron investigating?

A) Incentives.

B) Opportunity.

C) Policies.

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The fraud triangle has three points. Incentives/pressure, opportunity, and attitudes/rationalization. The issues Cameron is investigating represent potential incentives for management to commit accounting fraud.

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Charles Nicholls, chief investment officer of Gertmann Money Management, is reviewing the year-end financial statements of Zartner Canneries. In those statements he sees a sharp increase in inventories well above the sales-growth rate, and an increase in the discount rate for its pension assets. To determine whether or not Zartner Canneries is cooking the books, what should Nicholls do?

A) Calculate Zartner’s turnover ratios and review the footnotes of its competitors.

B) Check Zartner’s cash-flow statement and review its footnotes.

C) Analyze trends in Zartner’s receivables and consider the changing characteristics of its work force.

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To assess the meaning of the inventory increase, look for declines in industry turnover. And if Zartner changes its pension assumptions, Nicholls should see how those new assumptions compare to those found in the footnotes of financial statements from other companies in the same industry.

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Junior analyst Xander Marshall sends an e-mail to his boss, Janet Jacobs, CFA, suggesting that Peterson Novelties is manipulating its results to artificially inflate profits. He cites four reasons for his conclusion:

• The LIFO reserve is declining.
• Earnings are much higher in the September quarter than in other quarters.
• Many nonoperating and nonrecurring gains are being recorded as revenue.
• Much of Peterson’s earnings come from equity investments not reflected on the cash-flow statement.

Jacobs is less concerned about Peterson’s earnings than Marshall is, though she does resolve to check out one of his concerns. Which of Marshall’s observations best supports his conclusion?

A) Nonoperating and nonrecurring gains recorded as revenue.

B) The declining LIFO reserve.

C) Equity investment earnings not reflected on the cash-flow statement.

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On its own, a declining LIFO reserve is not a sign of fraud. Peterson Novelties could have simply moved a lot of inventory and disclosed the LIFO liquidation in its footnotes. When unusual gains are recorded as revenue they will artificially boost sales growth. Each of the above issues are potential danger signs, but can also be easily explained in a manner beyond reproach. However, earnings from equity investments that do not generate cash flow are of very low quality and warrant further examination.

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Frank Brill, CFA, is concerned that Moses Aviation is overstating its profits. The best indicator of such action would be Moses Aviation’s:

A) recognition of revenue from barter transactions.

B) sales-growth rate of nearly twice the industry average.

C) rising inventory.

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While an unusually high sales-growth rate may indicate fraud, it could also indicate good management. It’s a yellow flag, but not the best indicator of accounting shenanigans. Rising inventory is also a dual signal. It could be meant to overstate profits, or it could simply reflect an actual buildup of inventory in response to market forces or corporate operations. However, companies should not recognize revenue from barter transactions. The additional revenue is likely to improperly boost profits.

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Jane Kilgore, a stock analyst, is concerned about Maxwell Research’s organizational structure. To investigate the stability of that structure, Kilgore would be best served by looking at:

A) management turnover.

B) the amount of judgment calls used in company accounting.

C) accounting-department turnover.

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All of the factors listed above are of concern to an analyst looking at the possibility of fraudulent accounting. But to assess the stability of the organizational structure, the best option is a look at management turnover. High turnover rates in the accounting department may be indicative of deficient internal controls, but are too localized to be a true indicator of organizational stability. Excessive judgment calls in accounting are worrisome, but is not likely to be a direct reflection of an unstable organizational structure, as much as poor operational policies.

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Risk factors that provide incentives for management to manipulate financial statements include:

A) threats to financial stability, excessive third-party pressures, and threats to management’s personal wealth.

B) pressure to meet internal goals, weak internal controls, and threats to management’s personal wealth.

C) threats to profitability, weak internal controls, and pressure to meet internal goals.

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The risk factors include threats to financial stability or profitability, excessive third-party pressures, threats to management’s personal wealth, and pressure to meet internal financial goals. Weak internal controls represent an opportunity for fraud, but not an incentive.

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Katharine Walls, CFA, works as an auditor for Pindale Accounting. She is concerned about Smith Fabrics, a company she audits. During her last visit to Smith Fabrics, the accounting director, Bob Fox, rudely ushered her into a tiny conference room with no telephone or computer, and gave her no key to the main accounting office. She was given only three days to finish what is normally a five-day job. Before he left Walls, Fox gave her a 150-page manual of Smith’s accounting policies for its various overseas divisions. After she finished her audit, Walls prepared a report for Pindale’s executive director, recommending that the firm drop Smith Fabrics as a client because she saw evidence of attitudes that could lead to fraudulent accounting. Walls cited three of Fox’s actions in her report, most likely leaving out:

A) her rude welcome.

B) her isolation from the accounting department.

C) the policy manual.

---

A strained relationship between the auditor and management is a sign of a company with an attitude that could lead to accounting fraud. Domineering behavior such as the rude welcome is a sign of that strained relationship, as is the unrealistic deadline and isolation from the accountants. But providing Walls with the policy manual was a good idea. The fact that the manual is 150 pages long bespeaks problems with the complexity of the company’s accounting, but that is not evidence of a bad attitude. As such, the manual is least relevant to Walls’ argument.