FINANCIAL STATEMENT FRAUD

Chapter 11
FINANCIAL STATEMENT FRAUD
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

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 whistle-blower system allows individuals to call in anonymously to report suspected violations. A whistle-blower 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. Whistle-blower systems are most important where internal controls can be overridden. The fact that a whistle-blower 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
• 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

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