Kowal Manufacturing Company AssignmentTutorOnline | Good Grade Guarantee!
(Objectives 11-2, 11-4, 11-6) The Kowal Manufacturing Company employs about 50 production workers and has the following payroll procedures. The factory foreman interviews applicants and on the basis of the interview either hires or rejects them. When applicants are hired, they prepare a W-4 form (Employee’s Withholding Exemption Certificate) and give it to the foreman. The foreman writes the hourly rate of pay for the new employee in the corner of the W-4 form and then gives the form to a payroll clerk as notice that the worker has been employed. The foreman verbally advises the payroll department of rate adjustments. A supply of blank time cards is kept in a box near the time clock at the entrance to the factory. Each worker takes a time card on Monday morning, fills in his or her name, and
punches the time clock upon their daily arrival and departure. At the end of the week, the workers drop the time cards in a box near the door to the factory. On Monday morning, the completed time cards are taken from the box by a payroll clerk. One of the payroll clerks then enters the payroll transactions into the computer, which records all information for the payroll journal that was calculated by the clerk and automatically updates the employees’ earnings records and general ledger. Employees are automatically removed from the payroll when they fail to turn in a time card. The payroll checks that are not directly deposited into employees’ bank accounts are manually signed by the chief accountant and given to the foreman. The foreman distributes the checks to the workers in the factory and arranges for the delivery of the checks to the workers who are absent. The payroll bank account is reconciled by the chief accountant, who also prepares the various quarterly and annual payroll tax reports.
a. List the most important deficiency in internal control and state the misstatements that are likely to result from the deficiency.
b. For each deficiency that increases the likelihood of fraud, identify whether the likely fraud is misappropriation of assets or fraudulent financial reporting.*
CONDITIONS FOR FRAUD
Three conditions for fraud arising from fraudulent financial reporting and misappro – priations of assets are described in SAS 99 (AU 316). As shown in Figure 11-1 (p. 338), these three conditions are referred to as the fraud triangle.
Incentives/Pressures. Management or other employees have incentives or pres – sures to commit fraud.
Opportunities. Circumstances provide opportunities for management or employees to commit fraud. 3. Attitudes/Rationalization. An attitude, character, or set of ethical values exists that allows management or employees to commit a dishonest act, or they are in an environment that imposes sufficient pressure that causes them to rationalize committing a dishonest act.
An essential consideration by the auditor in uncovering fraud is identifying factors that increase the risk of fraud. Table 11-1 (p. 338) provides examples of these fraud risk factors for each of the three conditions of fraud for fraudulent financial reporting. In the fraud triangle, fraudulent financial reporting and misappropriation
of assets share the same three conditions, but the risk factors differ. We’ll first address the risk factors for fraudulent financial reporting, and then discuss those for misappropriation of assets. Later in the chapter, the auditor’s use of the risk factors in uncovering fraud is discussed. Incentives/Pressures A common incentive for companies to manipulate financial statements is a decline in the company’s financial prospects. For example, a decline in earnings may threaten the company’s ability to obtain financing. Companies may also manipulate earnings to meet analysts’ forecasts or benchmarks such as prior-year earnings, to meet debt covenant restrictions, or to artificially inflate stock prices. In some cases, management may manipulate earnings just to preserve their reputation.
Figure 11-2 highlights an Oversight Systems Inc. survey finding that the pressure to do “whatever it takes” to meet goals and the desire for personal gain are often cited as primary incentives to engage in fraudulent actions. Opportunities Although the financial statements of all companies are potentially subject to manipulation, the risk is greater for companies in industries where sig – nificant judgments and estimates are involved. For example, valuation of inventories is subject to greater risk of misstatement for companies with diverse inventories in many locations. The risk of misstatement of inventories is further increased if those inventories are at risk for obsolescence. A turnover in accounting personnel or other weaknesses in accounting and infor – mation processes can create an opportunity for misstatement. Many cases of fraudulent financial reporting were caused by ineffective audit committee and board of director oversight of financial reporting. Attitudes/Rationalization The attitude of top management toward financial reporting is a critical risk factor in assessing the likelihood of fraudulent financial statements. If the CEO or other top managers display a significant disregard for the financial reporting process, such as consistently issuing overly optimistic forecasts, or they are overly con cerned about meeting analysts’ earnings forecasts, fraudulent financial reporting is more likely. Management’s character or set of ethical values also may make it easier for them to rationalize a fraudulent act. The same three conditions apply to misappropriation of assets. However, in assessing risk factors, greater emphasis is placed on individual incentives and opportunities for theft. Table 11-2 (p. 340) provides examples of fraud risk factors for each of the three condi tions of fraud for misappropriation of assets.
Incentives/Pressures Financial pressures are a common incentive for employees who misappropriate assets. Employees with excessive financial obligations, or those with drug abuse or gambling problems, may steal to meet their personal needs. In other cases, dissatisfied employees may steal from a sense of entitlement or as a form of attack against their employers. Opportunities Opportunities for theft exist in all companies. However, oppor – tunities are greater in companies with accessible cash or with inventory or other valuable assets, especially if they are small or easily removed. For example, casinos handle extensive amounts of cash with little formal records of cash received. Similarly, thefts of laptop computers are much more frequent than thefts of desktop systems. Weak internal controls create opportunities for theft. Inadequate separation of duties is practically a license for employees to steal. Whenever employees have custody or even temporary access to assets and maintain the accounting records for those assets, the potential for theft exists. For example, if inventory storeroom employees also maintain inventory records, they can easily take inventory items and cover the theft by adjusting the accounting records. Fraud is more prevalent in smaller businesses and not-for-profit organizations because it is more difficult for these entities to maintain adequate separation of duties. However, even large organizations may fail to maintain adequate separation in critical areas. Barings Bank collapsed after incurring losses in excess of $1 billion from the activities of one trader because of inadequate separation of duties.
CORPORATE GOVERNANCE OVERSIGHT TO REDUCE FRAUD RISKS
Management is responsible for implementing corporate governance and control procedures to minimize the risk of fraud, which can be reduced through a combina tion of prevention, deterrence, and detection measures. Because collusion and false docu – mentation make detection of fraud a challenge, it is often more effective and economical for companies to focus on fraud prevention and deterrence. By implementing antifraud programs and controls, management can prevent fraud by reducing oppor tunity. By communicating fraud detection and punishment policies, management can deter employees from committing fraud. Guidance developed by the AICPA identifies three elements to prevent, deter, and detect fraud:
Culture of honesty and high ethics
Management’s responsibility to evaluate risks of fraud
Audit committee oversight Let’s examine these elements closely, as auditors should have a thorough under – standing of each to assess the extent to which clients have implemented fraud-reducing activities. Research indicates that the most effective way to prevent and deter fraud is to implement antifraud programs and controls that are based on core values embraced by the company. Such values create an environment that reinforces acceptable behavior and expecta – tions that employees can use to guide their actions. These values help create a culture of honesty and ethics that provides the foundation for employees’ job responsi bilities. Creating a culture of honesty and high ethics includes six elements. Setting the Tone at the Top Management and the board of directors are responsible for setting the “tone at the top” for ethical behavior in the company. Honesty and integrity by management reinforces honesty and integrity to employees throughout the organization. Management cannot act one way and expect others in the company to behave differently. Through its actions and communications, management can show that dishonest and unethical behaviors are not tolerated, even if the results benefit the company. A tone at the top based on honesty and integrity provides the foundation upon which a more detailed code of conduct can be developed to provide more specific guidance about permitted and prohibited behavior. Table 11-3 provides an example of the key contents of an effective code of conduct. Creating a Positive Workplace Environment Research shows that wrongdoing occurs less frequently when employees have positive feelings about their employer than when they feel abused, threatened, or ignored. A positive workplace can generate improved employee morale, which may reduce employees’ likelihood of committing fraud against the company. Employees should also have the ability to obtain advice internally before making decisions that appear to have legal or ethical implications. Many organizations, including all U.S. public companies, have a whistle-blowing process for employees to report actual or suspected wrongdoing or potential violations of the code of conduct or ethics policy. Some organizations have a telephone hotline directed to or monitored by an ethics officer or other trusted individual responsible for investigating and reporting fraud or illegal acts.
Hiring and Promoting Appropriate Employees To be successful in preventing fraud, well-run companies implement effective screening policies to reduce the likeli – hood of hiring and promoting individuals with low levels of honesty, especially those who hold positions of trust. Such policies may include background checks on individuals being considered for employment or for promotion to positions of trust. Background checks verify a candidate’s education, employment history, and personal references, including references about character and integrity. After an employee is hired, con – tinuous evaluation of employee compliance with the company’s values and code of conduct also reduces the likelihood of fraud. Training All new employees should be trained about the company’s expectations of employees’ ethical conduct. Employees should be told of their duty to communicate actual or suspected fraud and the appropriate way to do so. In addition, fraud aware – ness training should be tailored to employees’ specific job responsibilities with, for example, different training for purchasing agents and sales agents. Confirmation Most companies require employees to periodically confirm their responsibilities for complying with the code of conduct. Employees are asked to state that they understand the company’s expectations and have complied with the code, and that they are unaware of any violations. These confirmations help reinforce the code of conduct policies and also help deter employees from committing fraud or other ethics violations. By following-up on disclosures and non-replies, internal auditors or others may uncover significant issues. Discipline Employees must know that they will be held accountable for failing to follow the company’s code of conduct. Enforcement of violations of the code, regardless of the level of the employee committing the act, sends clear messages to all employees that compliance with the code of conduct and other ethical standards is important and expected. Thorough investigation of all violations and appropriate and consistent responses can be effective deterrents to fraud. Fraud cannot occur without a perceived opportunity to commit and conceal the act. Management is responsible for identifying and measuring fraud risks, taking steps to miti gate identified risks, and monitoring internal controls that prevent and detect fraud. Identifying and Measuring Fraud Risks Effective fraud oversight begins with management’s recognition that fraud is possible and that almost any employee is capable of committing a dishonest act under the right circumstances. This recognition increases the likelihood that effective fraud prevention, deterrence, and detection programs and controls are implemented. Figure 11-5 summarizes factors that manage – ment should consider that may contribute to fraud in an organization. Mitigating Fraud Risks Management is responsible for designing and implementing programs and controls to mitigate fraud risks, and it can change business activities and processes prone to fraud to reduce incentives and opportunities for fraud. For example, management can outsource certain operations, such as transferring cash collections
from company personnel to a bank lockbox system. Other programs and controls may be implemented at a company-wide level, such as the training of all employees about fraud risks, and strengthening employment and promotion policies. Monitoring Fraud Prevention Programs and Controls For high fraud risk areas, management should periodically evaluate whether appropriate antifraud programs and controls have been implemented and are operating effectively. For example, management’s review and evaluation of results for operating units or subsidiaries increases the likelihood that manipulated results will be detected. Internal audit plays a key role in monitoring activities to ensure that antifraud programs and controls are operating effectively. Internal audit activities can both deter and detect fraud. Internal auditors assist in deterring fraud by examining and evaluating internal controls that reduce fraud risk. They assist in fraud detection by performing audit procedures that may uncover fraudulent financial reporting and misappropriation of assets. The audit committee has primary responsibility to oversee the organization’s financial reporting and internal control processes. In fulfilling this responsibility, the audit committee considers the potential for management override of internal controls and oversees management’s fraud risk assessment process, as well as antifraud programs and controls. The audit committee also assists in creating an effective “tone at the top” about the importance of honesty and ethical behavior by reinforcing management’s zero tolerance for fraud. Audit committee oversight also serves as a deterrent to fraud by senior management. For example, to increase the likelihood that any attempt by senior management to involve employees in committing or concealing fraud is promptly disclosed, oversight may include:
• Direct reporting of key findings by internal audit to the audit committee
• Periodic reports by ethics officers about whistle-blowing
• Other reports about lack of ethical behavior or suspected fraud Because the audit committee plays an important role in establishing a proper tone at the top and in overseeing the actions of management, PCAOB Standard 5 requires the auditor of a public company to evaluate the effectiveness of the board and audit committee as part of the auditor’s evaluation of the operating effectiveness of internal control over financial reporting. As part of the evaluation, the auditor might consider the audit committee’s independence from management and the level of understanding between management and the audit committee regarding the latter’s responsibilities. An external auditor may gather insights by observing inter actions between the audit team, the audit committee, and internal audit regarding the level of audit committee commitment to overseeing the financial reporting process. PCAOB Standard 5 notes that ineffective oversight by the audit committee may be a strong indicator of a material weakness in internal control over financial reporting.
SPECIFIC FRAUD RISK AREAS
Depending on the client’s industry, certain accounts are especially susceptible to manipu – lation or theft. Specific high-risk accounts are discussed next, including warning signs of fraud. But even when auditors are armed with knowledge of these warning signs, fraud remains extremely difficult to detect. However, an awareness of warning signs and other fraud detection techniques increases an auditor’s likelihood of identifying mis – statements due to fraud. Revenue and related accounts receivable and cash accounts are especially susceptible to manipulation and theft. A study sponsored by the Committee of Sponsoring Organi – zations (COSO) found that more than half of financial statement frauds involve revenues and accounts receivable. Similarly, because sales are often made for cash or are quickly converted to cash, cash is also highly susceptible to theft. Fraudulent Financial Reporting Risk for Revenue As a result of the frequency of financial reporting frauds involving revenue recognition, the AICPA and SEC issued guidance dealing with revenue recognition. SAS 99 specifically requires auditors to identify revenue recognition as a fraud risk in most audits. Several reasons make revenue susceptible to manipulation. Most important, revenue is almost always the largest account on the income statement, therefore a misstatement only representing a small percentage of revenues can still have a large effect on income. An overstatement of revenues often increases net income by an equal amount, because related costs of sales are usually not recognized on fictitious or prematurely recognized revenues. Another reason revenue is susceptible to manipulation is the difficulty of determining the appropriate timing of revenue recognition in many situations. Three main types of revenue manipulations are:
Premature revenue recognition
Manipulation of adjustments to revenues Fictitious Revenues The most egregious forms of revenue fraud involve creating fictitious revenues. You may be aware of several recent cases involving fictitious revenues,
but this type of fraud is not new. The 1931 Ultramares case described in Chapter 5 (p. 121) involved fictitious revenue entries in the general ledger. Fraud perpetrators often go to great lengths to support fictitious revenue. Fraudu – lent activity at Equity Funding Corp. of America, which involved issuing fictitious insurance policies, lasted nearly a decade (from 1964 to 1973) and involved dozens of company employees. The perpetrators held file-stuffing parties to create the fictitious policies. Premature Revenue Recognition Companies often accelerate the timing of revenue recognition to meet earnings or sales forecasts. Premature revenue recognition, the recognition of revenue before accounting standards requirements for recording revenue have been met, should be distinguished from cutoff errors, in which trans actions are inad vertently recorded in the incorrect period. In the simplest form of accelerated revenue recognition, sales that should have been recorded in the subsequent period are recorded as current period sales. One method of fraudulently accelerating revenue is a “bill-and-hold” sale. Sales are normally recognized at the time goods are shipped, but in a bill-and-hold sale, the goods are invoiced before they are shipped. Another method involves issuing side agreements that modify the terms of the sales transaction. For example, revenue recog – nition is likely to be inappropriate if a major customer agrees to “buy” a significant amount of inventory at year-end, but a side agreement provides for more favorable pricing and unrestricted return of the goods if not sold by the customer. In some cases, as a result of the terms of the side agreement, the transaction does not qualify as a sale under accounting standards. Two notable examples of premature revenue recognition involve Bausch and Lomb and Xerox Corporation. In the Bausch and Lomb case, items were shipped that were not ordered by customers, with unrestricted right of return and promises that the goods did not have to be paid for until sold. The revenue recognition issues at Xerox were more complex. Capital equipment leases include sales, financing, and service components. Because the sales component is recognized immediately, Xerox attempted to maximize the amount allocated to this aspect of the transaction. Manipulation of Adjustments to Revenues The most common adjustment to revenue involves sales returns and allowances. A company may hide sales returns from the
auditor to overstate net sales and income. If the returned goods are counted as part of physical inventory, the return may increase reported income. In this case, an asset increase is recognized through the counting of physical inventory, but the reduction in the related accounts receivable balance is not made. Companies may also understate bad debt expense, in part because significant judg – ment is required to determine the correct amount. Companies may attempt to reduce bad debt expense by understating the allowance for doubtful accounts. Because the required allowance depends on the age and quality of accounts receivable, some com – panies have altered the aging of accounts receivable to make them appear more current. Warning Signs of Revenue Fraud Many potential warning signals or symptoms indicate revenue fraud. Two of the most useful are analytical procedures and docu – mentary discrepancies. Analytical Procedures Analytical procedures often signal revenue frauds, especially gross margin percentage and accounts receivable turnover. Fictitious revenue over – states the gross margin percentage, and premature revenue recognition also overstates gross margin if the related cost of sales is not recognized. Fictitious revenues also lower accounts receivable turnover, because the fictitious revenues are also included in uncollected receivables. Table 11-4 includes comparative sales, cost of sales, and accounts receivable data for Regina Vacuum, including the year before the fraud and the two fraud years. Notice how both a higher gross profit percentage and lower accounts receivable turnover ratio in the most recent two years that include the fraud helped signal fictitious accounts receivable. In some frauds, management generated fictitious revenues to make analytical procedures results, such as gross margin, similar to the prior year. In frauds like this, analytical procedures are typically not useful to signal the fraud.
Documentary Discrepancies Despite the best efforts of fraud perpetrators, fictitious transactions rarely have the same level of documentary evidence as legitimate trans – actions. For example, in the well-known fraud at ZZZZ Best, insurance restoration contracts worth millions of dollars were supported by one or two page agreements and lacked many of the supporting details and evidence, such as permits, that are normally associated with these types of contracts. Auditors should be aware of unusual markings and alterations on documents, and they should rely on original rather than duplicate copies of documents. Because fraud perpetrators attempt to conceal fraud, even one unusual transaction in a sample should be considered to be a potential indicator of fraud that should be investigated. Misappropriation of Receipts Involving Revenue Although misappropriation of cash receipts is rarely as material as fraudulent reporting of revenues, such frauds can be costly to the organization because of the direct loss of assets. A typical misappro – priation of cash involves failure to record a sale or an adjustment to customer accounts receivable to hide the theft. Failure to Record a Sale One of the most difficult frauds to detect is when a sale is not recorded and the cash from the sale is stolen. Such frauds are easier to detect when goods are shipped on credit to customers. Tracing shipping documents to sales entries in the sales journal and accounting for all shipping documents can be used to verify that all sales have been recorded. It is much more difficult to verify that all cash sales have been recorded, especially if no shipping documents exist to verify the completeness of sales, and no customer account receivable records support the sale. In such cases, other documentary evidence is necessary to verify that all sales are recorded. For example, a retail establishment may require that all sales be recorded on a cash register. Recorded sales can then be com – pared to the total amount of sales on the cash register tape. If the sale is not included in the cash register it is almost impossible to detect the fraud. Theft of Cash Receipts After a Sale is Recorded It is much more difficult to hide the theft of cash receipts after a sale is recorded. If a customer’s payment is stolen, regular billing of unpaid accounts will quickly uncover the fraud. As a result, to hide the theft, the fraud perpetrator must reduce the customer’s account in one of three ways:
Record a sales return or allowance
Write off the customer’s account
Apply the payment from another customer to the customer’s account, which is also known as lapping Warning Signs of Misappropriation of Revenues and Cash Receipts Relatively small thefts of sales and related cash receipts are best prevented and detected by internal controls designed to minimize the opportunity for fraud. For detecting larger frauds, analytical procedures and other comparisons may be useful. Inventory is often the largest account on many companies’ balance sheets, and auditors often find it difficult to verify the existence and valuation of inventories. As a result, inventory is susceptible to manipulation by managers who want to achieve certain financial reporting objectives. Because it is also usually readily saleable, inventory is also susceptible to misappropriation. Fraudulent Financial Reporting Risk for Inventory Fictitious inventory has been at the center of several major cases of fraudulent financial reporting. Many large companies have varied and extensive inventory in multiple locations, making it relatively easy for the company to add fictitious inventory to accounting records. While auditors are required to verify the existence of physical inventories, audit testing is done on a sample basis, and not all locations with inventory are typically
tested. In some cases involving fictitious inventories, auditors informed the client in advance which inventory locations were to be tested. As a result, it was relatively easy for the client to transfer inventories to the locations being tested. Warning Signs of Inventory Fraud Similar to deceptions involving accounts receivable, many potential warning signals or symptoms point to inventory fraud. Analytical procedures are one useful technique for detecting inventory fraud. Analytical Procedures Analytical procedures, especially gross margin percentage and inventory turnover, often help uncover inventory fraud. Fictitious inventory understates cost of goods sold and overstates the gross margin percentage. Fictitious inventory also lowers inventory turnover. Table 11-5 is an example of the effects of fictitious inventory on inventory turnover based on the Crazy Eddie fraud. Note that the gross profit per – centage did not signal the existence of fictitious inventories, but the significant decrease in inventory turnover was a sign of fictitious inventories. Cases of fraudulent financial reporting involving accounts payable are relatively common although less frequent than frauds involving inventory or accounts receivable. The deliberate understatement of accounts payable generally results in an understate ment of purchases and cost of goods sold and an overstatement of net income. Signi ficant misappropriations involving purchases can also occur in the form of payments to fictitious vendors, as well as kickbacks and other illegal arrangements with suppliers. Fraudulent Financial Reporting Risk for Accounts Payable Companies may engage in deliberate attempts to understate accounts payable and overstate income. This can be accomplished by not recording accounts payable until the subsequent period or by recording fictitious reductions to accounts payable. All purchases received before the end of the year should be recorded as liabilities. This is relatively easy to verify if the company accounts for prenumbered receiving reports. However, if the receiving reports are not prenumbered or the company deliberately omits receiving reports from the accounting records, it may be difficult for the auditor to verify whether all liabilities have been recorded. In such cases, analytical evidence, such as unusual changes in ratios, may signal that accounts payable are understated. Companies often have complex arrangements with suppliers that result in reduc – tions to accounts payable for advertising credits and other allowances. These arrangements are often not as well documented as acquisition transactions. Some companies have used fictitious reductions to accounts payable to overstate net income. Therefore.
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