Exercise 3-1: Understanding Management and Director Backgrounds
Exercise 3-2: Relationships with Others
Exercise 3-3: Organization and Industry
Exercise 3-4: Financial Results and Operating Characteristic Exposures
Once management decides that it will commit fraud, the particular schemes used are usually determined by the nature of the business's operations. While we usually focus on the schemes and the financial results around those schemes, it is important to remember that the decision to commit fraud in the first place was management's or other officers'. The following chart summarizes the kinds of questions that must be asked about management and directors in examining fraud exposures.
Exercise 3-1: Understanding Management and Director Backgrounds
1. Have any of the key executives or Board Members been associated with other organizations in the past and what was the nature of those organizations and relationships?
2. Were key members of management promoted from within the organization or recruited from the outside?
3. Have any key members of management had past regulatory or legal problems, either personally or with organizations they have been associated with?
4. Have there been significant changes in the makeup of management or the Board of Directors?
5. Has there been a high turnover of management and/or Board members?
6. Do any members of management or the Board have criminal backgrounds?
7. Other issues related to the backgrounds of key members of management or the Board of Directors.
Understanding What Motivates Management and the Board of Directors
1. Are any of the key executives' personal worth tied up in the organization?
2. Is management under pressure to meet earnings or other financial expectations or does management commit to analysts, creditors, and others to achieve what appears to be unduly aggressive forecasts?
3. Is management's compensation primarily performance based (bonuses, stock options, etc.)?
4. Are there significant debt covenants or other financial restrictions that management must meet?
5. Is the job security of any key members of management at serious risk?
6. Is the organization's reported financial performance decreasing?
7. Is there an excessive interest by management in maintaining or increasing the entity's stock price?
8. Does management have an incentive to use inappropriate means to minimize reported earnings for tax reasons?
9. Other significant issues related to the motivations of management and Board members.
Understanding the Degree of Influence of Key Members of Management and/or the Board of Directors
1. Who are the key members of management and/or the Board of Directors who have the most influence?
2. Are there one or two key people who have dominant influence in the organization?
3. Is the management style of the organization more autocratic or democratic?
4. Is the organization's management centralized or decentralized?
5. Does management use ineffective means of communicating and supporting the entity's values or ethics, or do they communicate inappropriate values or ethics?
6. Does management fail to correct known reportable conditions in internal control on a timely basis?
7. Does management set unduly aggressive financial targets and expenditures for operating personnel?
8. Does management have too much involvement in or influence over the selection of accounting principles or the determination of significant estimates?
9. Other significant issues related to the degree of influence of key members of management and/or the Board of Directors.
Relationships with Others
Financial statement fraud is often perpetrated with the help of other real or fictitious organizations. Relationships with related parties are problematic because they often allow for other than arms-length transactions. It is always important to carefully consider relationships with financial institutions, related organizations and individuals, external auditors, lawyers, investors, and regulators.
The following table summarizes the kinds of questions that must be asked about a company's relationships with others.
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Exercise 3-2: Relationships with Others
Relationships with Financial Institutions
1. What financial institutions does the organization have significant relationships with?
2. Is the organization highly leveraged through bank loans?
3. Are there loan or debt covenants or restrictions that pose significant problems for the organization?
4. Do the banking relationships appear normal or are there unusual attributes about the relationships (strange geographical locations, too many banks, etc.)?
5. Do members of management or the Board have personal or other close relationships with officers of any of the major banks used by the company?
6. Have there been significant changes in the financial institutions used by the company? If so, why?
7. Are there significant bank accounts or subsidiary or branch operations in tax-haven jurisdictions for which there appears to be no clear business justification?
8. Have critical assets of the company been pledged as collateral on risky loans?
9. Other questionable financial institution relationships.
Relationships with Related Parties
1. Are there significant related-party transactions not in the ordinary course of business or with related entities not audited or audited by another firm?
2. Are there large and/or unusual transactions at or near the end of a period that significantly improve the reported financial performance of the company?
3. Are there significant receivables and/or payables between related entities?
4. Has a significant amount of the organization's revenues and/or income been derived from related-party transactions?
5. Is a significant part of the company's income or revenues derived from one or two large transactions?
6. Other questionable related-party relationships.
Relationships with Auditors
1. Have there been frequent disputes with the current or predecessor auditors on accounting, auditing, or reporting matters?
2. Has management placed unreasonable demands on the auditor including unreasonable time constraints?
3. Has the company placed formal or informal restrictions on the auditor that inappropriately limit his/her access to people or information or his/her ability to communicate effectively with the Board of Directors or the Audit Committee?
4. Is there domineering management behavior in dealing with the auditor, especially involving attempts to influence the scope of the auditor's work?
5. Has there been an auditor change and for what reason?
6. Other questionable auditor relationships.
Relationships with Lawyers
1. Has there been significant litigation involving the company in matters that could severely and adversely effect the company's financial results?
2. Has there been an attempt to hide litigation from the auditors or others?
3. Has there been a change in outside counsels and for what reasons?
4. Other questionable lawyer relationships.
Relationships with Investors
- Is the organization in the process of issuing an initial or secondary public debt or equity offering?
- Are there any investor-related lawsuits?
- Are there any problematic or questionable relationships with investment bankers, stock analysts or others?
- Has there been significant "short selling" of the company's stock and for what reasons?
- Other questionable investor relationships.
Relationships with Regulatory Bodies
1. Does management display a significant disregard for regulatory authorities?
2. Has there been a history of securities law violations or claims against the entity or its senior management alleging fraud or violations of securities laws?
3. Have any 8-Ks been filed with the SEC and for what reasons?
4. Are there any new accounting, statutory, or regulatory requirements that could impair the financial stability or profitability of the entity?
5. Are there significant tax disputes with the IRS or other taxing authorities?
6. Is the company current on paying its payroll taxes and other payroll-related and other liabilities?
7. Other questionable relationships with regulatory bodies.
Organization and Industry
Financial statement fraud is sometimes masked by creating an organizational structure that makes it easy to hide fraud. Attributes of an organization that present fraud exposures include such things as an unduly complex organizational structure, an organization without an internal audit department, a Board of Directors with no or few outsiders on the Board and/or audit committee, an organization where one or a small group of individuals control related entities, an organization that has off-shore entities with no apparent business purpose, and an organization that is new. It is extremely important that auditors and accountants really understand who the owners of an organization are. Sometimes there are silent or hidden owners that are using the organization in illegal or other questionable activities.
The industry of the organization must also be carefully examined. Some industries are much more risky than others. In addition, the organization's performance relative to that of similar organizations in the same industry must also be examined. The kinds of questions that should be asked in order to understand the exposure to management fraud because of organizational structure and industry are provided below.
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Exercise 3-3: Organization and Industry
1. Does the company have an overly complex organizational structure involving numerous or unusual legal entities, managerial lines of authority, or contractual arrangements without apparent business purpose?
2. Is there a legitimate business purpose for each separate entity of the business?
3. Is the Board of Directors comprised primarily of officers of the company or other related individuals?
4. Is there a passive or active, independent Board of Directors?
5. Is the audit committee comprised primarily of insiders or outsiders?
6. Is the audit committee passive or active and independent?
7. Does the organization have an independent and/or active internal audit department?
8. Does the organization have off-shore activities without any apparent business purpose?
9. Is the organization a new entity without a proven history?
10. Have there been significant, recent changes in the nature of the organization?
11. Is there adequate monitoring of significant controls?
12. Is there an effecting accounting and information technology staff and organization?
13. Is there a high degree of competition or market saturation, accompanied by declining margins?
14. Is the client in a declining industry with increasing business failures and significant declines in customer demand?
15. Are there rapid changes in the industry, such as high vulnerability to rapidly changing technology or rapid product obsolescence?
16. Is the performance of the company similar or contrary to other firms in the industry?
17. Other significant issues related to organization and industry.
Financial Results and Operating Characteristics
Using financial statements to assess fraud exposures requires that you know the nature of the client's business, the kinds of accounts that should be included, the kinds of fraud that could occur in the organization, and the kinds of symptoms those frauds would generate. For example, the major activities of a manufacturing company could probably be subdivided into sales and collections, acquisition and payment, financing, payroll, and inventory and warehousing. I often find it helpful to break an organization down into various activities or cycles such as these and then, for each cycle, identify the major functions that are performed, the major risks inherent in each function, the kinds of abuse and fraud that could occur, and the kinds of symptoms those frauds would generate. I then use active detection techniques to determine if there is a likelihood of fraud in those cycles.
In the following discussions, we will focus primarily on financial performance and operating characteristics to detect financial statement fraud, with a segment on each major fraud type (such as revenue-related frauds, inventory frauds, etc.). While management, relationships, and organization exposures tend to be the same for all types of financial statement fraud, we will use an entire segment to identify the kinds of symptoms that result from various fraud schemes and constructive ways to detect such fraud.
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Exercise 3-4: Financial Results and Operating Characteristic Exposures
1. Are there unrealistic changes or increases in financial statement account balances?
2. Are the account balances realistic given the nature, age, and size of the company?
3. Do actual physical assets exists in the amounts and values indicated on the financial statements?
4. Have there been significant changes in the nature of the organization's revenues or expenses?
5. Do one or a few large transactions account for a significant portion of any account balance or amount?
6. Are there significant transactions near the end of the period that positively impact results of operations, especially transactions that are unusual, highly complex or that pose "substance over form" questions?
7. Do financial results appear consistent on a quarter-by-quarter or month-by-month basis or are there unrealistic amounts in a sub-period?
8. Is there an inability to generate cash flows from operations while reporting earnings and earnings growth?
9. Is there significant pressure to obtain additional capital necessary to stay competitive considering the financial position of the entity S including need for funds to finance major research and development or capital expenditures?
10. Are reported assets, liabilities, revenues, or expenses based on significant estimates that involve unusually subjective judgments or uncertainties, or that are subject to potential significant change in the near term in a manner that may have a financially disruptive effect on the entity S such as ultimate collectibility of receivables, timing of revenue recognition, realizability of financial instruments based on the highly subjective valuation of collateral or difficult-to-assess repayment sources, or significant deferral of costs?
11. Is there an usually rapid growth or profitability, especially compared with that of other companies in the same industry?
12. Is the organization highly vulnerability to changes in interest rates?
13. Are there unrealistically aggressive sales or profitability incentive programs?
14. Is there a threat of imminent bankruptcy or foreclosure, or hostile takeover?
15. Is there a high possibility of adverse consequences on significant pending transactions, such as a business combination or contract award, if poor financial results are reported?
16. Is there a poor or deteriorating financial position when management has personally guaranteed significant debts of the entity?
17. Does the firm continuously operate on a "crisis" basis or without a careful budgeting and planning process?
18. Is the organization dependent on one or two key products or services, especially products or services that can become quickly obsolete or where other organizations have the ability to adapt more quickly to market swings?
19. Do the footnotes contain information about difficult-to-understand issues?
20. Are there adequate disclosures in the footnotes?
21. Other questionable or suspicious factors relating to financial results or operating characteristics.
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