Reading 40: Financial Reporting Quality: Red Flags and Accou factors, fraudulent, accounting, 2011

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Session 10: Financial Reporting and Analysis: Applications and International Standards Convergence
Reading 40: Financial Reporting Quality: Red Flags and Accounting Warning Signs

LOS d: Describe the risk factors that may lead to fraudulent accounting related to 1) incentives and pressures, 2) opportunities, and 3) attitudes and rationalizations.

 

 

During Parlex Chemicals’ media day, four executives spoke. Here are excerpts from all four executives speeches.

Calvin Baynard, CEO: “I’ve been a scientist all my life, but I want to assure shareholders that as CEO I am actively involved in both managing operations and setting accounting policy.”
Kristan Lenz, CFO: “I work closely with our auditors to make sure we are always on the same page.”
Melvin Jackson, COO: “In the past I have told you that Parlex would meet aggressive growth targets. I am proud to say that we have met those targets.”
Sally Yu, compliance director: “All of our executives are required to review Parlex’s ethics policy every year.”

Reporter John Bustard, CFA, is concerned that three of the executives are exhibiting attitudes or rationalizations that can lead to accounting fraud. Bustard should be least concerned about:

A) Lenz.

B) Jackson.

C) Yu.

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Working closely with auditors is a good thing. All of the other statements reflect behavior that can lead to fraudulent accounting. Jackson made a commitment to the media that the company would meet targets – that promise could spark a rationalization to falsify numbers to meet the target. Yu said all executives must review Parlex’s ethics policy, but what about everybody else? Most of the employees are not executives, and if the rank and file, including those in the accounting department, are not familiar with the firm’s ethical standards, it could breed ethical problems throughout the organization.

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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) Management’s share holdings.

C) Debt covenants.

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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 cheat.

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The Statement on Accounting Standards No. 99, Consideration of Fraud in a Financial Statement Audit, identified nine risk factors related to attitudes and rationalizations that can lead to fraudulent accounting. The risk factors include:

A) management obsession with a rising stock price, high management turnover, frequent use of materiality to justify leaving items off the books.

B) management obsession with a rising stock price, failing to fix problems promptly, strained relationships with auditors.

C) commitments to third parties regarding operational results, high management turnover, obsession with minimizing taxes.

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High management turnover is related to the opportunity to commit fraud, rather than attitudes or rationalizations. All remaining factors cited are listed in SAS 99 as related to attitudes and rationalizations.

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Professor Paula King teaches accounting at South Central Coastal Idaho Polytechnic. In her lecture this morning, she passes out sheets containing facts about Consolidated Industries. From those fact sheets, she identifies four signs that could indicate financial fraud:

• Executives have personally guaranteed some of the firm’s debt.
• The company’s organizational chart is complex.
• The company’s monopoly status allows it to charge any price it desires.
• Turnover is high in the information-technology department.

After presenting those observations, King concludes that because of the four characteristics, executives at Consolidated have a greater opportunity than most to commit fraud. Student Mukesh Ghari believes one of King’s examples does not help her argument. Which of the four facts is least compelling in support of King’s argument?

A) The company’s monopoly status allows it to charge any price it desires.

B) Executives have personally guaranteed some of the firm’s debt.

C) Turnover is high in the information-technology department.

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Executive guarantees of debt represent an incentive to commit fraud, but not necessarily an enhanced opportunity to do so. Both remaining examples are each legitimate risk factors related to opportunities that can lead to fraudulent accounting. Computers are important to financial reporting, and high turnover in that department could be sign of disorganization or dissatisfaction with technical systems. Outdated or badly designed computer systems make it easier to commit fraud. In addition, the company’s pricing power would make it much easier to conduct transactions that are not at arm’s length.

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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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The Statement on Auditing Standards No. 99, Consideration of Fraud in a Financial Statement Audit, identified four risk factors that provide incentives for management to manipulate financial statements. The risk factors include:

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

B) threats to financial stability, excessive third-party pressures, 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) 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 a third of Maxwell’s total sales go to its own consolidated subsidiaries.

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

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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Analyst Jane Kilgore is worried that some of Maxwell Research’s accrual accounting practices will lead to excessive operating earnings recognition in the near-term. Examples of Kilgore's concerns include the following:

• Accelerated revenue recognition of service agreements.
• Classification of recurring revenue as nonrecurring revenue.
• Understated inventory obsolescence.

Which of Kilgore’s concerns is least likely to overstate current operating earnings?

A) Classification of recurring revenue as nonrecurring revenue.

B) Accelerated revenue recognition of service agreements.

C) Understated inventory obsolescence.

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Classification of recurring revenue as nonrecurring revenue will understate current operating earnings. The other two items act to overstate revenue and understate expenses.

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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) the amount of judgment calls used in company accounting.

B) accounting-department turnover.

C) management 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.