Aud App1-Ch2- Review Questions & Short Cases
Fraud is an intentional act involving the use of deception that results in a misstatement of the financial statements. Two types of misstatements are relevant to auditors' consideration of fraud: (a) Misstatements arising from misappropriation of assets and (b) Misstatements arising from fraudulent financial reporting. Intent to deceive is what distinguishes fraud from errors.
2-1 LO 1 Define fraud and explain the two types of misstatements that are relevant to auditors' consideration of fraud
Refer to Exhibit 2.3 for brief descriptions. a. Enron: fraudulent financial reporting b. WorldCom: fraudulent financial reporting c. Parmalat: fraudulent financial reporting d. HealthSouth: fraudulent financial reporting e. Dell: fraudulent financial reporting f. Koss Corporation: asset misappropriation g. Olympus: fraudulent financial reporting h. Longtop Financial Technologies: fraudulent financial reporting i. Peregrine Financial Group: asset misappropriation j. Sino-Forest Corporation: fraudulent financial reporting k. Diamond Foods, Inc.: fraudulent financial reporting l. Wells Fargo: asset misappropriation m. Weatherford Int'l: fraudulent financial reporting n. Lime Energy: fraudulent financial reporting
2-11 LO 1, 3 Refer to Exhibit 2.3 and briefly describe the frauds that were perpetrated at the following companies. For each company, categorize the fraud as involving primarily: (1) asset misappropriation or (2) fraudulent financial reporting. a. Enron b. WorldCom ' c. Parmalat d. HealthSouth e. Dell f. Koss Corporation g. Olympus h. Longtop Financial Technologies i. Peregrine Financial Group j. Sino-Forest Corporation k. Diamond Foods, Inc. l. Wells Fargo m. Weatherford Int'l n. Lime Energy
If a company has good products, it would be expected that it should have comparable profitability with other industry participants. The fact that it does not have that profitability, coupled with a weakness in internal controls over disbursements, should lead the auditor to embrace the idea that there is an opportunity for a disbursement fraud and that such a fraud could be hurting the reported profitability of the company.
2-13 LO 3 For each of the following situations indicating heightened fraud risk, discuss how a professionally skeptical auditor might interpret the situation. a. The company is not as profitable as its competitors, but it seems to have good products. However, it has a deficiency in internal control over r disbursements that makes it subject to management override.
Some of the key findings by COSO: · The amount and incidence of fraud remains high · The median size of the company perpetrating the fraud rose tenfold to $100 million during the 1998-2007 time period · There was heavy involvement in the fraud by the CEO and/or CFO · The most common fraud involved revenue recognition · Many of the companies committing fraud changed auditors · The majority of the frauds took place at companies that were listed on the over-the-counter (OTC) market rather than those listed on the NYSE or NASDAQ
2-14 LO 3 Describe some major findings regarding financial reporting frauds that the COSO studies reveal.
The various failures and environmental characteristics during the time of the Enron fraud include: • Weak management accountability • Weak corporate governance • Accounting became more rule-oriented and complex • The financial analyst community was unduly influenced by management pressure • Bankers were unduly influenced by management pressure • Arthur Andersen was unduly influenced by management pressure, especially since consulting revenues at Enron were very high
2-15 LO 2, 3 Many consider the Enron fraud to be one of the most significant frauds of the early 2000s. a. Describe the various failures and environmental characteristics during this time that enabled the Enron fraud to happen.
The three ways in which individuals involved in the financial reporting process, including the external auditor, can mitigate the risk of fraudulent financial reporting include: • Acknowledging that a strong, highly ethical tone needs to exist at the top of an organization that permeates the corporate culture, including an effective fraud risk management program. • Continually exercising professional skepticism, a questioning mindset that strengthens professional objectivity, in evaluating and/or preparing financial reports. • Remembering that strong communication among those involved in the financial reporting process is critical. Will these actions be effective? This should promote a lively debate among students if this question is discussed in class. Some will argue that frauds happen no matter what, so these types of actions will be futile. Others will be more optimistic, arguing that these actions, if consistently applied, could help to mitigate fraud risk.
2-17 LO 4 The text notes three ways in which individuals involved in the financial reporting process (management, audit committee, internal audit, external audit, and regulatory authorities) can mitigate the risk of fraudulent financial reporting. Describe these three ways. Do you think that these three approaches will be effective, given your knowledge of frauds discussed in the text (such as Enron, WorldCom, Parmalat, and Koss)?
Independent directors are more likely to stand up to management and report fraud than those directors that are not independent.
2-22 LO 6 Following is a summary of the NYSE corporate governance requirements of companies listed on this stock exchange. For each requirement, state how it is intended to address the risk of fraud in publicly traded organizations. a. Boards need to consist of a majority of independent directors.
incentive
2-10 LO 2 Each of the following scenarios is based on facts in an actual fraud. Categorize each scenario as primarily indicating: (1) an incentive to commit fraud, (2) an opportunity to commit fraud, or (3) a rationalization to commit fraud. State your reasoning for each categorization. a. There was intense pressure to keep the corporation's stock from declining further. This pressure came from investors, analysts, and the CEO, whose financial wellbeing was significantly dependent on the corporation's stock price.
Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence; requires an ongoing questioning of whether the information and audit evidence obtained suggests that a material misstatement due to fraud may exist.
2-12 LO 3 Refer to the Why It Matters feature "The Crucial Role of Professional Skepticism." a. What is professional skepticism?
Auditing standards historically have reflected a belief that it is not reasonable for auditors to detect cleverly implemented frauds. However, it is increasingly clear that the general public expects that auditors have a responsibility to detect and report on material frauds. Professional auditing standards do require the auditor to plan and perform an audit that will detect material misstatements resulting from fraud. As part of that requirement, auditors will begin an audit with a brainstorming session that focuses on how and where fraud could occur within the organization. Auditors also need to communicate with the audit committee and management about the risks of fraud and how these risks are addressed. The auditor should then plan the audit to be responsive to an organization's susceptibility to fraud.
2-16 LO 4 What is the responsibility of the external auditor to detect material fraud?
The financial literacy, integrity, and reputation of board members enhance credibility of the regulation and oversight of the auditing profession. Inspections by the PCAOB act as a highly visible enforcement mechanism, hopefully leading to higher quality audits. Furthermore, information that is learned through the inspection process can be used as a basis for modifying and enhancing auditing standards.
2-18 LO 5 Refer to Exhibit 2.5. a. (Sections 101, 104, and 105) How does the establishment and operation of the PCAOB help to ensure quality external audits? How will audit firm inspections and investigations by the PCAOB help ensure high audit quality?
No, nonpublic organizations are not required to abide by the Sarbanes-Oxley Act. However, many organizations view these requirements as "best practice," and so nonpublic organizations sometimes voluntarily adhere to certain requirements of the Sarbanes-Oxley Act.
2-19 LO 5 Are nonpublic organizations required to adhere to the requirements of the Sarbanes-Oxley Act? Explain
Three common ways that fraudulent financial reporting can be perpetrated include: • Manipulation, falsification, or alteration of accounting records or supporting documents • Misrepresentation or omission of events, transactions, or other significant information • Intentional misapplication of accounting principles Common types of fraudulent financial reporting include: • Improper revenue recognition • Improper deferral of costs and expenses • Improper asset valuation • Concealed liabilities • Misrepresentations or omissions in financial statement footnotes of MD&A
2-2 LO 1 What are the most common approaches that perpetrators use to commit fraudulent financial reporting? What are the common types of fraudulent financial reporting?
Refer to Exhibits 2.6 and 2.7.
2-20 LO 6 Corporate governance is the process by which the owners and creditors of an organization exert control over and require accountability for the resources entrusted to the organization. Refer to Exhibits 2.6 and 2.7. a. List the major parties involved in corporate governance. b. b. Describe the general roles and activities for each party
These principles include: · The board's fundamental objective should be to build long-term sustainable growth in shareholder value for the corporation. • Successful corporate governance depends upon successful management of the company, since management has the primary responsibility for creating a culture of performance with integrity and ethical behavior. • Effective corporate governance should be integrated with the company's business strategy and not viewed as simply a compliance obligation. • Transparency is a critical element of effective corporate governance, and companies should make regular efforts to ensure that they have sound disclosure policies and practices. • Independence and objectivity are necessary attributes of board members; however, companies must also strike the right balance in the appointment of independent and non-independent directors to ensure an appropriate range and mix of expertise, diversity, and knowledge on the board.
2-21 LO 6 Describe the broad key principles of effective corporate governance articulated in the 2010 report of the NYSE
A Ponzi scheme occurs when the deposits of current investors are used to pay returns on the deposits of previous investors; no real investment is happening.
2-4 LO 1 Refer to Exhibit 2.1 a. What is a Ponzi scheme?
Some auditing firms try to 'game the system' by providing an audit report without really conducting an audit. This is called a 'sham audit,' whereby the audit firm is essentially providing its opinion without performing the appropriate procedures. Clients that desire a low-quality audit hire these types of very low quality auditors because they know that the auditor will not do a quality audit. So, there is really fraud going on with both the client and the audit firm.
c. Auditing firms heavily rely on their reputation to attract clients. Why might Bravo Multinational Incorporated have sought to purchase the auditing services of W.T. Uniack CPA? What does it mean to perform a "sham audit"?
Problems noted: 1. Auditors sometimes do not address known fraud risk factors via evidence. 2. Auditors sometimes collect evidence, but do not tie it to specific known fraud risk factors.
c. Auditors' responses to fraud risk factors
By having a nominating/corporate governance committee composed of independent directors, the organization is more likely to attract high quality board members that are not unduly influenced by management. And by having a corporate governance committee, this important element of control achieves prominence in the organization and acts as a deterrent to fraud.
c. Boards must have a nominating/corporate governance committee composed entirely of independent directors
Analyst interactions and the pressure to meet their expectations provide incentives for fraud. By requiring that the audit committee discuss the earnings release process, this ensures that audit committees have more control over how management engages with analysts, and this control should assist in deterring fraud.
c. Discussing in its meetings the company's earnings press releases, as well as financial information and earnings guidance provided to analysts
incentive
d. Managing specific financial ratios is very important to the company, and both management and analysts are keenly observant of variability in key ratios. Key ratios for the company changed very little even though the ratios for the overall industry were quite volatile during the time period.
Having a written charter and an annual performance evaluation ensures that the committee responsibilities are appropriate, and that the responsibilities are actually accomplished (or shareholders are alerted if they are not accomplished). Accomplishing such activities acts as a deterrent to fraud.
d. The nominating/corporate governance committee must have a written charter that addresses the committee's purpose and responsibilities, and there must be an annual performance evaluation of the committee.
By having an independent compensation committee, top management will be less able to inappropriately influence compensation decisions for themselves.
e. Boards must have a compensation committee composed entirely of independent directors.
Removing Mr. Dell from his CEO position may not be as likely as removing him from his board position. Student discussion will likely not come to a consensus on this point.
e. Given the SEC settlement, should Mr. Dell be removed from his CEO position?
Meeting separately with these groups encourages frank conversations about concerns, and such communication is helpful to deterring or detecting fraud.
e. Meeting separately with management, internal auditors, and the external auditor on a periodic basis
Problems noted: 1. Failure to evaluate the risk of management override of controls. 2. Failure to evaluate the fraud risk potential associated with end of period journal entries or accounting estimates. 3. Failure to document or test management's assumptions about accounting estimates.
e. Risk of management override of controls
It addresses off-balance sheet transactions and special purpose entities, which were the main mechanisms used to conduct the Enron fraud.
f. (Section 401) How does this section relate to the Enron fraud?
opportunity
f. Accounting records were either nonexistent or in a state of such disorganization that significant effort was required to locate or compile them.
By understanding the nature of any problems that the external auditor is having with management, the audit committee gets a good sense of potential management aggressiveness and the sources of disagreement between the auditor and management. In addition, this requirement gives the external auditor someone to turn to in reporting fraud on the part of management.
f. Reviewing with the external auditor any audit problems or difficulties that they have had with management
Whenever an organization uses corporate credit cards, there should be controls over their use. Most typically, such controls involve review and approval of payment by a senior official. In Sachdeva's case, senior management allowed her to use the credit cards without review, and she was the individual in charge of making payments on the cards. Thus, basic controls involving review and segregation of duties were not used at Koss.
f. Sachdeva paid for her purchases using corporate credit cards. What internal controls could the company have used to prevent inappropriate use of the credit cards?
A strong internal control system is critical to preventing fraud. These sections of the Sarbanes-Oxley Act mandate the disclosure of weak internal controls, thereby providing a strong motivation to managers to ensure that controls are effective. By requiring external auditor assurance on management's assessment, financial statement users can believe in management's assertions about controls.
g. (Section 404) How do the management assessment and auditor attestation of internal controls contained in this section help to address the risk of fraud in publicly traded organizations?
One member of the audit committee needs to be a financial expert to ensure that there is the knowledge necessary on the audit committee to critically evaluate management's financial reporting and internal control choices. Without that knowledge, the committee may be unduly influenced by management's preferences.
h. (Section 407) Why is it important that at least one member of the audit committee be a financial expert? What are the financial reporting implications if the audit committee does not have any individuals serving on it who possess financial expertise?
By reporting regularly to the board of directors, the audit committee is put in a position of power in the organization, thereby giving it the clout necessary to oversee management and deter fraud.
h. Reporting regularly to the board of directors
These requirements encourage a high quality set of corporate governance behaviors, which taken together act as a deterrent to fraud.
i. Companies must adopt and disclose corporate governance guidelines addressing director qualification standards, director responsibilities, director access to management and independent advisors, director compensation, director continuing education, management succession, and an annual performance evaluation of the board.
By making the ethics issue a prominent disclosure, it encourages management and other individuals within the organization to take it more seriously. It acts to encourage a high quality "tone at the top."
j. Companies must adopt and disclose a code of business conduct and ethics for directors, officers, and employees.
This requirement forces audit committees to take internal controls seriously, and to consider any potential independence impairments for the external auditor. Both internal controls and high quality external auditing are critical for the prevention and/or detection of fraud.
2-23 LO 6 Following is a summary of the NYSE listing requirements for audit committee responsibilities of companies listed on this stock exchange. For each requirement, state how it is intended to address the risk of fraud in publicly traded organizations. a. Obtaining an annual report by the external auditor that addresses the company's internal control procedures, any quality-control or regulatory problems, and any relationships that might threaten the independence of the external auditor
The audit committee must be comprised of "outside" independent directors, one of whom must be a financial expert. The audit committee now has the authority to hire and fire the external auditor, and will therefore serve as the auditor's primary contact, especially for accounting and audit-related issues. In addition, at many organizations the audit committee sets the scope for and hires internal auditors. It would also review the work of both internal and external auditors.
2-24 LO 6 Audit committees are an important element of corporate governance and have taken on additional responsibilities following the passage of the Sarbanes-Oxley Act. a. Describe the changes in audit committee membership, and list duties mandated by the Sarbanes-Oxley Act. Also, describe any other increased responsibilities of audit committees following the passage of the Sarbanes-Oxley Act.
Factors- Explain Your Reasoning and Indications of Poor Governance a. The company is in the financial services sector and has a large number of outstanding consumer loans, including mortgages,. This is not necessarily poor governance. However, the auditor needs to determine the amount of risk that is inherent in the current loan portfolio and whether the risk could have been mitigated through better risk management by the organization. The lack of good risk management by the organization increases the risk that the financial statements will be misstated because of the difficulty of estimating the allowance for loan losses. b. The CEO's and CFO's compensation is based on three components: (a) base salary, (b) bonus based on growth in assets and profits, and (c) significant stock options. This is a rather common compensation package and, by itself, is not necessarily poor corporate governance. However, in combination with other things, the use of 'significant stock options' may create an incentive for management to potentially manage reported earnings in order to boost the price of the company's stock. The auditor can determine if it is poor corporate governance by determining the exte
2-25 LO 6 The following factors describe a potential audit client. For each factor, indicate whether it is indicative of poor corporate governance. Explain the reasoning for your assessment. Finally, identify the risks to reliable financial reporting that are associated with each factor. a. The company is in the financial services sector and has a large number of consumer loans, including mortgages, that are outstanding. b. The CEO's and CFO's compensation is based on three components: (a) base salary, (b) bonus based on growth in assets and profits, and (c) significant stock options. c. The audit committee meets semiannually. It is chaired by a retired CFO who knows the company well because she had served as the CFO of a division of the firm. The other two members are local community members—one is the president of the Chamber of Commerce and the other is a retired executive from a successful local manufacturing firm. d. The company has an internal auditor who reports directly to the CFO and makes an annual report to the audit committee. e. The CEO is a dominating personality—not unusual in this environment. He has been on the job for six months and has decreed that he is streamlining the organization to reduce costs and centralize authority (most of it in him). f. The company has a loan committee. It meets quarterly to approve, on an ex-post basis, all loans over $300 million (top 5% for this institution). g. The previous auditor has resigned because of a dispute regarding the accounting treatment and fair value assessment of some of the loans.
Management at Koss may have placed a high level of trust in Sachdeva because they knew her for a long period of time and she did not exhibit behaviors that caused concern. Furthermore, management at the company was reportedly quite relaxed in its approach to monitoring and control. These behaviors led to a lack of professional skepticism on the part of management.
2-26 KOSS CORPORATION, GRANT THORNTON (LO 1, 2, 3, 4, 6) In the Why It Matters feature "Examples of Theft and Financial Reporting Frauds" at the beginning of the chapter, we introduced you to the Koss Corporation fraud. In this problem, we provide you with further details about that fraud. During the fall of 2009, Koss Corporation, a Wisconsin-based manufacturer of stereo headphone equipment, revealed that its vice president of finance (Sujata "Sue" Sachdeva) had defrauded the company of approximately $31 million over a period of at least five years. Grant Thornton LLP was the company's auditor, and the firm issued unqualified audit opinions for the entire period in which they worked for Koss. According to reports, Sachdeva's theft accelerated over a period of years as follows: FY 2005 $2,195,477 FY 2006 $2,227,669 FY 2007 $3,160,310 FY 2008 $5,040,968 FY 2009 $8,485,937 Q1 FY 2010 $5,326,305 Q2 FY 2010 $4,917,005 To give you a sense of the magnitude of the fraud, annual revenues for Koss Corporation are in the range of $40 to $45 million annually. Previously reported pre-tax income for fiscal years 2007 through Q1 2010 was as follows: FY 2007 $8,344,715 FY 2008 $7,410,569 FY 2009 $2,887,730 Q1 FY 2010 $928,491 How could Sachdeva have stolen so much money and fooled so many people over a long period? It is thought that Sachdeva hid the theft in the company's cost-of-goods-sold accounts, and that weak internal controls and poor corporate governance and oversight enabled her to conceal the theft from corporate officials. Certainly, there must have been questions raised about the company's deteriorating financial condition. But any number of excuses could have been used by Sachdeva to explain the missing money. For example, she might have blamed higher cost of goods sold on a change in suppliers or rising raw materials prices. Another contributing factor in Sachdeva's ability to conceal her thefts was that top management of Koss had a high degree of trust in her, so they did not monitor the accounts that she controlled at the company. Sachdeva's total compensation for fiscal year 2009 was $173,734. But according to published reports, Sachdeva was known for her unusually lavish lifestyle and shoppin
Yes, the members of the audit committee appear to be professionally qualified. They have all held financially responsible leadership positions at large companies in industries similar to those as Koss Corporation. The committee meets less frequently than quarterly, which is fairly infrequent. Prior to SOX, this level of audit committee involvement was common, but it is now more likely for audit committees of public companies to meet at least bi-monthly, if not monthly. Without frequent meetings, committee members are not able to generate sufficient questions and then gather sufficient evidence in order to develop a professionally skeptical view of the true situation at the company, and that is what appears to have happened at Koss. You might consider gathering evidence to support your conclusions about the professional qualifications of audit committee members. For example, you might observe the questions that they ask during meetings, and their level of preparedness. You might inquire about their continuing professional education and experiences. You will obtain this information in various ways, but personal observation will likely be very important.
2-27 KOSS CORPORATION (LO 3, 5, 6) Read the facts of the case in Problem 2-26 to become familiar with the fraud involving Koss Corporation. From the company's October 7, 2009, proxy statement (Def 14A filing with the SEC), we know the following facts about the company's audit committee and its members Thomas L. Doerr 65, has been a director of the company since 1987. In 1972, Mr. Doerr co-founded Leeson Electric Corporation and served as its president and CEO until 1982. The company manufactures industrial electric motors. In 1983, Mr. Doerr incorporated Doerr Corporation as a holding company for the purpose of acquiring established companies involved in distributing products to industrial and commercial markets. Currently, Mr. Doerr serves as president of Doerr Corporation. Mr. Doerr owns no stock in Koss Corporation and received $24,000 in cash compensation during 2009 to serve on the audit committee. Lawrence S. Mattson 77, has been a director of the company since 1978. Mr. Mattson is the retired president of Oster company, a division of Sunbeam Corporation, which manufactures and sells portable household appliances. Mr. Mattson is the designated audit committee financial expert. Mr. Mattson owns no stock in Koss Corporation and received $23,000 in cash compensation during 2009 to serve on the audit committee. Theodore H. Nixon 57, has been a director of the company since 2006. Since 1992, Mr. Nixon has been the CEO of D.D. Williamson, which is a manufacturer of caramel coloring used in the food and beverage industries. Mr. Nixon joined D.D. Williamson in 1974 and was promoted to president and chief operating officer in 1982. Mr. Nixon is also a director of the Nonprofit Center for Quality of Management. Mr. Nixon owns 2,480 shares of common stock of the company (less than 1% of outstanding shares) and received $21,000 in cash compensation during 2009 to serve on the audit committee. John J. Stollenwerk 69, has been a director of the company since 1986. Mr. Stollenwerk is the chairman of the Allen-Edmonds Shoe Corporation, an international manufacturer and retailer of high-quality footwear. He is also a director of Allen-Edmonds Shoe Corporation; Badger Meter, Inc.; U.S. Bancorp; and Northwestern Mutu
The following are the corporate governance principles presented in the chapter. Students could argue that many of the principles could be in question at Dell. Of great concern is that management has a great deal of control over the governance, and there are questions about management's ethics and integrity. If the financial statements were intentionally misstated, this calls into question the company's commitment to transparency. Furthermore, given Mr. Dell's roles, there are questions about the independence of the board. • The Board's fundamental objective should be to build long-term sustainable growth in shareholder value for the corporation. • Successful corporate governance depends upon successful management of the company, as management has the primary responsibility for creating a culture of performance with integrity and ethical behavior. • Good corporate governance should be integrated with the company's business strategy and not viewed as simply a compliance obligation. • Transparency is a critical element of good corporate governance, and companies should make regular efforts to ensure that they have sound disclosure policies and practices. • Independence and objectivity ar
2-28 DELL, INC. (LO, 1, 3, 4, 6) In August 2010, Michael Dell, Dell, Inc.'s CEO and chairman of the board, was reelected to Dell's board of directors by Dell's shareholders. However, not all of the shareholders were happy with Mr. Dell's reappointment. Specifically, two labor groups that own shares of Dell stock wanted Mr. Dell removed from the board because of an action and settlement of the SEC involving the company and Mr. Dell. The SEC complaint alleged various accounting manipulations that called into question Dell's reported financial success from 2002 to 2006. In July 2010, Dell, Inc. agreed to pay $100 million to settle SEC charges, without admitting or denying guilt. Mr. Dell agreed to pay a $4 million fine, also without admitting or denying guilt. This exercise is based on an article in the Wall Street Journal ("Dell Investors Protest CEO in Board Vote," by Joann S. Lublin and Don Clark, Aug. 18, 2010). The article provides more details on shareholder voting for directors if the instructor is interested in pursuing that aspect of governance. In terms of the specific questions: a. What principles of corporate governance appear to have been missing at Dell?
Yes, auditors can commit fraud through their deliberate, negligent actions. When auditors sign an audit opinion, they are asserting that they have complied with professional auditing standards in arriving at their conclusion. In this case, it is clear that William Uniack failed to comply with professional auditing standards; thus, we can conclude that he provided a knowingly false and misleading audit report, which constitutes fraud.
2-29 PCAOB, W.T. UNIACK CPA (LO 4) Obtain a copy of the PCAOB's enforcement Release No. 105-2017-028 (May 24, 2017), with respect to the matter of W.T. Uniack CPA and the audit of Bravo Multinational incorporated. To find it, go to the PCAOB website, look under "Enforcement" and "Settled Disciplinary Orders." a. While we often think of client management as committing fraud, is it possible that auditors commit fraud by neglecting their professional duties?
The reporter's statement makes sense. Asset misappropriations are much easier to accomplish in small organizations that don't have sophisticated systems of internal control. Fraudulent financial reporting is more likely to occur in large organizations because management often has ownership of or rights to vast amounts of the company's stock. As the stock price goes up, management's worth also increases. However, the reporter may have the mistaken sense that financial fraud only occurs rarely in smaller businesses. That is not the case. Many smaller organizations are also motivated to misstate their financial statements in order to (a) prop up the value of the organization for potential sale, (b) obtain continuing financing from a bank or other financial institution, or (c) to present a picture of an organization that is healthy when it may be susceptible to not remaining a going concern. Finally, smaller organizations may conduct a fraud of a different sort; i.e., misstating earnings by understating revenue or masking owner distributions as expenses. This approach is often used to minimize taxes. It would also be a mistake to think that asset misappropriations do not happen in larger o
2-3 LO 1 Assume that you are interviewed by a student newspaper regarding the nature of accounting fraud. The reporter says, "As I understand it, asset misappropriations are more likely to be found in small organizations, but not in larger organizations. On the other hand, fraudulent financial reporting is more likely to be found in larger organizations." How would you respond to the reporter's observation?
The student will be able to obtain insights on this case from a variety of online news sources. News accounts of this case indicate the following red flags: Beazer's culture was to "make the numbers" during a time when housing sales had significantly slowed; the company's employees were dealing with unrealistic budgets and pressure to achieve financial goals; the company had weak internal controls; Beazer was likely not recording impairments on its land assets in a timely manner; and Beazer's financial periods were regularly held open or re-opened.
2-30 DELOITTE, BEAZER HOMES (LO 3, 4) In June 2009, Deloitte agreed to pay almost $1 million to settle a class action lawsuit related to its audits of Beazer, a homebuilding company. The lawsuit claims that Deloitte should have noticed that the homebuilder was issuing inaccurate financial statements as the housing market began to decline. A spokesperson for Deloitte indicated that the firm denies all liability and settled to avoid the expense and uncertainty of continued litigation. a. Using online sources, research this case and identify fraud risk red flags that the auditor should have been aware of in these audits. One source that can get you started is www.cfo.com/article .cfm/13612963?f5search
The skepticism continuum is founded on the belief that professional skepticism is related to a questioning mind, and that an individual's mindset may range from neutral to presumptive doubt to complete doubt. Complete trust would be outside the range on the continuum of professional skepticism. The continuum then relates to evidence collection, whereby lower skepticism is associated with less audit evidence and documentation and higher skepticism is associated with more audit evidence and documentation.
2-31 CAQ (LO 3, 4) Obtain a copy of the report by the Global Public Policy Committee, "Enhancing Auditor Professional Skepticism" (November 2013) at http://www.thecaq.org/enhancing-auditor-professional-skepticism a. Explain the professional skepticism continuum. How does it relate to the extent of audit evidence collection and audit documentation?
Problems noted: 1. Auditors often document their consideration of fraud merely by checking off items on standard audit programs and checklists rather than by considering unique features of their individual clients. 2. Lack of involvement by senior members of the engagement team. 3. Failure to expand audit procedures despite recognition of heightened fraud risk.
2-32 PCAOB (LO 4, 5) Obtain a copy of the PCAOB's report titled "Observations on Auditors' Implementation of PCAOB Standards Relating to Auditors' Responsibilities with Respect to Fraud." You can use any search engine or go to https://pcaobus.org/Inspections/Documents/2007_01-22_ Release_2007-001.pdf http://pcaobus.org/Inspections/Documents/2007_01-22_Release_2007-001.pdf The PCAOB's report summarizes findings from inspections of audit engagements as they relate to the performance of fraud detection audit procedures. The PCAOB report comments on auditor deficiencies in each of the following six areas a. Auditors' overall approach to the detection of fraud
Management perpetrated the fraud by filling large containers with water and placing a layer of salad oil on top. Furthermore, they transferred the oil from tank to tank in the order in which they knew the auditors would proceed through the location.
2-5 LO 1, 2 Refer to the Focus on Fraud feature "The Great Salad Oil Swindle of 1963." a. How did management perpetrate the fraud?
Incentives relate to the rationale for the fraud; e.g., need for money, desire to enhance stock price. Opportunities relate to the ability of the fraudster to actually accomplish the fraud; e.g., through weak internal controls, complex transactions. Rationalization is the psychological process of justifying the fraud.
2-6 LO 2 The fraud triangle identifies incentives, opportunities, and rationalizations as the three elements associated with frauds. Describe how these elements relate to the occurrence of fraud.
Common incentives for fraudulent financial reporting include: • Management compensation schemes • Other financial pressures for either improved earnings or an improved balance sheet • Debt covenants • Pending retirement or stock option expirations • Personal wealth tied to either financial results or survival of the company • Greed—for example, the backdating of stock options was performed by individuals who already had millions of dollars of wealth through stock
2-7 LO 2 List some common incentives for managers to commit fraudulent financial reporting.
Factors, or red flags, that would be strong indicators of opportunity to commit fraud include: • inadequate segregation of duties • opportunities for management override • absence of monitoring controls • complex organizational structure • unauthorized access to physical assets • inadequate reconciliations of key accounts, especially bank accounts • access to cash that is not supervised or reconciled by someone else
2-8 LO 2 Identify several factors (red flags) that would be strong indicators of opportunities to commit fraud.
The ability to rationalize is important. Unless fraudsters are outright criminals, they will often want to come up with an excuse for their behavior. "Accounting rules don't specifically disallow it" or "the company owes me" are potential rationales. Other common rationalizations include: • Unfair financial treatment (perceived) in relationship to other company employees • "It is only temporary," or "it's a loan from the company" • "I deserve it" • "The company is so big, it won't miss anything" • " The company is unethical" • "The company comes by its profits in a way that exploits people"
2-9 LO 2 Is the ability to rationalize the fraud an important aspect to consider when analyzing a potentially fraudulent situation? What are some of the common rationalizations used by fraud perpetrators?
These sections improve auditor independence by separating consulting and auditing by the same audit firm. The partner rotation requirement ensures that a "fresh set of eyes" will be responsible for oversight on the engagement.
b. (Sections 201-203) How do Sections 201-203 address auditor independence concerns?
incentive
b. A group of top-level management was compensated (mostly in the form of stock options) well in excess of what would be considered normal for their positions in this industry.
Holding meetings without management present enables a frank and open discussion, including enabling board members with concerns about potential fraud or weak management to alert other board members and express these concerns.
b. Boards need to hold regular executive sessions of independent directors without management present.
Problems noted: 1. Engagement teams have been found not to conduct brainstorming sessions. 2. Brainstorming sessions were sometimes conducted AFTER audit evidence collection had begun, rather than as an integral part of the planning process. 3. Key members of the engagement team did not attend the brainstorming session.
b. Brainstorming sessions
The key elements of the Bernie Madoff fraud include the following actions Madoff perpetrated, which led to the PCAOB now having oversight of the audits of SEC-registered brokers and dealers: • Fabricated "gains" of almost $65 billion • Defrauded thousands of investors • Took advantage of his high-profile investment leader status to establish trust in his victims • Accomplished the scheme by keeping all the fraudulent transactions off the real financial statements of the company • Employed a CPA who conducted a sham audit
b. Describe the key elements of the Bernie Madoff fraud.
This requires the audit committee to be engaged and informed about financial accounting at the company; being engaged and informed enhances the ability of the audit committee to detect fraud.
b. Discussing the company's financial statements with management and the external auditor
The discussion in part a. suggests that Dell's auditors should have some concerns about the quality of governance at Dell. In turn, this concern suggests that the audit might have heightened risk of fraud.
b. Given the apparent actions of Mr. Dell, along with his management and board roles, should Dell's external auditor expect the corporate governance at Dell to be effective?
See paragraph 12 of the enforcement action, which reads as follows: "In connection with the audit, Respondents failed to exercise due professional care, including professional skepticism, and failed to plan and perform the audit in accordance with PCAOB standards. During audit planning, Respondents failed to develop and document an audit plan that included a description of the planned nature, timing, and extent of risk assessment procedures. Consistent with this planning deficiency, Respondents failed to identify and assess the risks of material misstatement at the financial statement and assertion levels. Respondents also failed to plan and perform any analytical procedures as risk assessment procedures. Respondents also failed to identify any risks with respect to revenue recognition and management override of controls, even though PCAOB standards provide that the auditor should presume that there is a fraud risk involving improper revenue recognition and should include the risk of management override of controls in his identification of fraud risks. Respondents also failed to perform audit procedures in a manner that addressed the assessed risks of material misstatement for each rele
b. How did William Uniack, CPA, neglect his professional duties?
When red flags are present, auditors need to alter the nature, timing, and extent of auditing procedures to adequately address the heightened risk of misstatement indicated by the red flags. In the case of many red flags, auditors should employ a heightened degree of professional skepticism.
b. If these fraud risk red flags were indeed present during Deloitte's audit, what were the auditors' responsibilities in conducting the audit?
The audit committee certainly takes on much more responsibility with the new regulation. It will now be much more informed about the audit function and financial reporting processes within the company it evaluates. The auditor must report all significant problems to the audit committee. For auditors, the reporting relationship should reinforce the need to keep the third-party users in mind in dealing with reporting choices.
b. The audit committee now has ownership of the relationship with the external auditor. What are the implications of this change for the audit committee and for the external auditor?
The company is doing better than its competitors, and it appears to have achieved these better results through cost control. While cost control might be a valid explanation, the auditor should consider other potential explanations such as inappropriately capitalizing expenses, inappropriately recognizing revenue, etc.
b. The company is doing better than its competitors. Although sales are about the same as competitors, net income is significantly more. Management attributes the greater profitability to better control of expenses.
Threats to individual auditor professional skepticism include judgment biases, lack of knowledge and expertise, deadline pressures, auditor character/personal attributes, cultural attributes, and performance incentives. Mitigating factors include professional education and licensing requirements, supervision, review, performance metrics that reward the auditor for quality work, effective recruiting requirements, effective engagement partner leadership, and training.
b. What are some threats to individual auditor professional skepticism? How can these threats be mitigated?
In terms of the fraud triangle, • Incentives: Management was very concerned about managing stock prices through keeping debt off the balance sheet; the underlying business model of the company was not working; the company had strayed too far away from its "utility" roots; and employees were taking significant risks in the financial markets that did not yield expected profits, thereby creating strong incentives for top management to conduct the fraud. • Opportunity: Corporate governance and external auditor accountability were lacking. • Rationalization: Although not discussed in the text specifically, there have been speculations in the press that management thought they were smarter than everyone else and that they were very confident that they could get away with the fraud. It is difficult to know the internal rationalizations of top management.
b. What elements of the fraud triangle seem most relevant to the Enron fraud?
Grant Thornton was obligated to uncover the fraud in the sense that it ignored red flags (weakening financial condition, poor internal control and monitoring) that should have alerted it to problems in the company. Grant Thornton experienced an audit failure because it issued unqualified audit opinions on materially misstated financial statements. It appears that Grant Thornton may not have employed an appropriate level of professional skepticism.
b. What was Grant Thornton's obligation to uncover the fraud?
The goal was to overstate inventory assets, thereby understating cost of goods sold and overstating income.
b. What was management's incentive to perpetrate the fraud?
Lawrence Mattson is the audit committee financial expert. He is a retired president of a large consumer products company, which should make him financially knowledgeable. However, the fact that he has clearly been retired for quite some time (he is in his late 70's) calls into question whether he is currently "up to speed" on the financial reporting demands faced by a public company. Without adequate financial knowledge, it is nearly impossible to exercise adequate professional skepticism - knowledge is one of the bases upon which skepticism rests. Financial expertise is important for audit committee members because they play a significant role in corporate governance over financial matters - they are a key defense in potential problems with financial reporting.
b. Who was the audit committee financial expert? Do you think that the experiences of this individual as described should ensure that he is truly a financial expert capable of fulfilling his roles in this regard? Why is financial expertise important for audit committee members in general?
Professional skepticism is helpful in detecting fraud, because without it the external auditor will be easily convinced of alternative explanations that management will provide to conceal the fraud.
b. Why is professional skepticism helpful for detecting fraud?
The "cooling-off" period helps to avoid conflicts of interest between top members of the engagement team and the client. By requiring a cooling-off period, an auditor will not be unduly influenced (or appear to be unduly influenced) by the possibility of high-level employment with the client.
c. (Section 206) What is a cooling-off period, and how does it address auditor independence concerns?
The audit committee is basically in a position of mediator, but not problem solver. One member must be a financial expert, but all members must be well versed in the field. This financial knowledge can help the audit committee to understand the disagreement. Ultimately, the company would like to receive an unqualified audit opinion. If the external auditor believes a certain accounting treatment to be wrong, the committee does not have to give an unqualified opinion. The audit committee's responsibility is to assist in resolution of the dispute so that financial reporting is accurate. Skills of audit committee members that would assist in this type of situation include interpersonal skills, negotiation skills, and communication skills.
c. Assume that management and the auditor disagree on the appropriate accounting for a complex transaction. The external auditor has conveyed the disagreement to the audit committee and provided an assessment that the disagreement is on the economics of the transaction and has nothing to do with earnings management. What is the responsibility of the audit committee? What skills of audit committee members do you think might be helpful in this type of situation?
Dell's auditor can respond in various ways. At the extreme, the auditor may decide to not retain Dell as a client. Another approach would be to increase the audit work and audit rigor to mitigate any risks that may be associated with the lower quality governance. However, if the governance is really poor, extra audit work may not be sufficient. Furthermore, if the auditors have reason to question the integrity and ethics of Mr. Dell, it could be hard to "audit around that." This is a setting where it is important that the auditors employ an appropriate level of professional skepticism.
c. How might Dell's external auditor respond to concerns about the quality of governance at Dell?
Their compensation is very low given the important role that they play in the company, and the fact that this is a public board. Furthermore, many audit committee members at public companies receive stock options or stock grants to align their interests with the long-term goals of stockholders. These audit committee members receive no stock options, and hold very few (if any) shares.
c. In your opinion, was the compensation that the audit committee members received for their services adequate?
The Bernie Madoff fraud is primarily a case of asset misappropriation. However, it is important to note that asset misappropriation then led Madoff to commit fraudulent financial reporting to hide the asset misappropriation.
c. Is this fraud primarily a case of asset misappropriation or fraudulent financial reporting?
The Great Salad Oil Swindle is primarily a case of fraudulent financial reporting.
c. Is this fraud primarily a case of asset misappropriation or fraudulent financial reporting?
The company would appear to be using 'window dressing' in order to bypass debt covenants. It is doing so by sharply discounting current sales. These actions are not necessarily fraudulent, but they may be created to portray a misleading picture of the current economic health of the organization.
c. The company is financially distressed and is at some risk of defaulting on its debt covenants. The company improves its current ratio and other ratios by making an unusually large payment against its current liabilities, accompanied by highly discounted sales if their customers paid before year end.
opportunity
c. Top management of the company closely guards internal financial information, to the extent that even some employees on a needto-know basis are denied full access
Common human judgment tendencies that can weaken individual auditor professional skepticism include the following: • Overconfidence—The tendency of individuals to overestimate their own abilities. Overconfidence can lead the auditor to not spend enough time critically thinking about client-related facts that would otherwise raise red flags. • Confirmation—The tendency of individuals to seek information and evidence that supports their initial beliefs or preferences. If individual auditors do not seek contradictory evidence, their professional skepticism is not heightened because the auditor does not detect discrepancies. • Anchoring—The tendency of individuals to evaluate information from a starting point and then not adjusting sufficiently away from that starting point despite evidence to the contrary. For example, the individual auditor may anchor on last year's account balance or procedures used last year and insufficiently adjust for new information. • Availability—The tendency of individuals to consider information that is more easily available from memory to be more likely, relevant, or important. By focusing on more readily available information, the individual auditor may not
c. What are some common human judgment tendencies that can weaken individual auditor professional skepticism?
The key behaviors necessary to successfully exercise professional skepticism include validating information through probing questions, critically assessing evidence, and paying attention to inconsistencies.
c. What are the key behaviors needed to successfully exercise professional skepticism during the performance of the audit?
Students will likely vary in their reactions to Deloitte's settlement. Some will take the position provided by the firm's spokesperson. Others will suggest that Deloitte was indeed liable and that a court case would have resulted in a guilty verdict, thereby subjecting Deloitte to even higher settlement costs.
c. What is your reaction to the fact that Deloitte settled the case rather than going to court? Do you think that implies that they are admitting their guilt? Or are they just trying to avoid the negative publicity of a trial? Does it seem fair that Beazer was committing a fraud, concealing it from Deloitte, and yet Deloitte was still penalized?
Sachdeva's lavish lifestyle should have raised suspicions because her level of conspicuous consumption far exceeded her apparent ability to pay, given her relatively modest salary. However, her lifestyle may have been explained away or ignored because of her husband's prominent medical practice. People likely assumed that her lifestyle was none of their business and that she simply used her family's joint money to fund her lavish purchases. Even when confronted with a known fraud, individuals that know a fraudster often have difficulty believing that it is true - denial is a common factor even in the face of seemingly obvious signs of fraud.
c. Why should Sachdeva's lavish lifestyle have raised suspicions? Why might it have been ignored or explained away by her professional colleagues?
Audit committees clearly serve the role of the "client" of the auditor. They act as surrogates for the shareholders who are the actual audit client. They act as the liaison between management and the external auditor. By being independent, they gain credibility and ensure that the external auditor can rely on them to perform their governance role. By requiring that audit committees can hire their own attorneys and by ensuring that they have adequate monetary resources, the external auditor has confidence that they will act as truly independent monitors of management.
d. (Section 301) How do the audit committee requirements help ensure effective corporate governance?
This brief description mirrors that of the Koss case where the CFO was very intimidating, not a CPA, and possessed limited accounting experience. The company did not increase profit during her tenure. The external auditor should consider these factors to suggest a heightened risk of fraud.
d. A smaller public company has a CFO who has centralized power under her. Her style is very intimidating. She is not a CPA, and she has limited accounting experience. The company has not been able to increase profitability during her time with the company.
Theodore Nixon is the only audit committee member who is still an active, working financial professional. The other members of the audit committee are relatively older, and are no longer working in the public sector. This certainly does not disqualify them, but coupled with the relatively few meetings that the committee has, it calls into the question whether the audit committee is really functioning in a strong oversight capacity. The responsibilities that the proxy statement outlines seem reasonable, but it seems impossible that an audit committee with these characteristics could carry out those responsibilities in so few meetings.
d. Based on the information that you have learned in Parts a., b., and c. of this problem, what weaknesses in the audit committee governance structure existed at Koss Corporation immediately preceding the discovery of fraud?
Understanding risk assessment and risk management should alert the audit committee to weaknesses in the company, thereby encouraging positive change, which should thereby deter fraud.
d. Discussing in its meetings policies with respect to risk assessment and risk management
Problems noted: 1. Failure to appropriately determine whether items are material or not. 2. Failure to investigate known departures from GAAP to determine if those departures were indicative of fraud. 3. Failure to post material items to a summary sheet indicating material misstatements, or inappropriately netting misstatements. This causes senior engagement personnel and audit committee members to be unaware of problems that engagement teams encountered on the engagement that could be indicative of fraud.
d. Financial statement misstatements
In general, having an independent board chair would improve governance. Given the alleged behavior of Mr. Dell, it may be even more important at Dell, Inc. Recall, however, that no individual or company admitted wrongdoing in this case.
d. Given the SEC settlement, should Dell's board have an independent chair?
Management and the audit committee should have been skeptical of Sachdeva because of the weak internal controls in place, coupled with deteriorating financial conditions at the company. The auditors should have been more skeptical of her explanations for the financial condition of the company. They should have collected more audit evidence to better understand the increase in cost of goods sold. Also, the auditors should have realized that there was a risk of fraud given the lack of monitoring and the high level access to corporate bank accounts that Sachdeva had.
d. How could the other members of management, the audit committee, and the auditors have been more professionally skeptical in this situation?
It is difficult to exercise professional skepticism in practice for a variety of reasons, including the natural tendency to trust people (especially client personnel with whom you have worked), lack of repeated exposure to fraud, and many repeated exposures to situations that do NOT involve fraud.
d. Why is it sometimes difficult for auditors to exercise appropriate levels of professional skepticism in practice?
The certification requirements of the Sarbanes Oxley Act of 2002 help address the risk of fraud by forcing the CEO and CFO to take internal controls and high quality financial reporting seriously. The Act requires the CEO and CFO to affirmatively sign the financial statements. As such, they will likely require individuals below them to provide assurance that those departments or organizational units are each committed to internal controls and high quality financial reporting as well. Of course, a signature is just a signature! So, the likelihood that a CFO who is committing fraud will certify falsely is probably 100%. Thus, this mechanism is not without practical flaws.
e. (Section 302) How do the officer certification requirements help to address the risk of fraud in publicly traded organizations? What is the likelihood that a CFO who is committing fraudulent financial reporting would sign the certification falsely, and what are your reactions to that possibility?
Personal characteristics and behaviors that might make you skeptical about an individual include some of the following: • Providing inaccurate or conflicting evidence • Interacting in a difficult or unhelpful manner • Acting in an untrustworthy fashion • Engaging in conspicuous consumption of material possessions beyond the level to which his/her salary would normally make that lifestyle possible. Publicly available evidence exists that might help you assess whether an individual warrants increased skepticism. Information can include: tax liens, credit scores, and legal filings.
e. Imagine that you are working on an audit engagement. What are the personal characteristics and behaviors of management or other client employees that might make you skeptical about whether or not they are providing you accurate audit evidence? Aside from personal observations, what publicly available information about management or other client employees could you obtain to determine whether you should exercise heightened professional skepticism in your dealings with these individuals?
rationalization
e. In an effort to reduce certain accrued expenses to meet budget targets, the CFO directs the general accounting department to reallocate a division's expenses by a significant amount. The general accounting department refuses to acquiesce to the request, but the journal entry is made through the corporate office. An accountant in the general accounting department is uncomfortable with the journal entries required to reallocate divisional expenses. He brings his concerns to the CFO, who assures him that everything will be fine and that the entries are necessary. The accountant considers resigning, but he does not have another job lined up and is worried about supporting his family. Therefore, he never voices his concerns to either the internal or external auditors.
The audit committee plays an important oversight role in any organization. The benefit of the audit committee should be that it is independent from the daily operations of the organization, and should therefore be in a position to more critically evaluate the personalities and behaviors of senior management, including the CFO in this particular case. Furthermore, audit committees of public companies are required to have at least one financial expert, and it is the obligation of that individual to consider and initiate investigation of anomalies in the financial statements. Clearly this oversight did not occur in the case of Koss.
e. What was the audit committee's responsibility in noticing that something looked amiss in the financial statements?
Having a written charter and an annual performance evaluation ensures that the committee responsibilities are appropriate, and that the responsibilities are actually accomplished (or shareholders are alerted if they are not accomplished). Accomplishing such activities acts as a deterrent to fraud.
f. The compensation committee must have a written charter that addresses the committee's purpose and responsibilities, which must include (at a minimum) the responsibility to review and approve corporate goals relevant to CEO compensation, make recommendations to the board about non-CEO compensation and incentive-based compensation plans, and produce a report on executive compensation; there must also be an annual performance evaluation of the committee.
This requirement ensures an adequate size and independence of the audit committee, which acts to strengthen governance and deter fraud.
g. Boards must have an audit committee with a minimum of three independent members.
By setting hiring policies pertaining to employees of the external audit firm, the audit committee can ensure that management is not exerting undue influence over the members of the audit team by possibly promising them employment at the company.
g. Setting clear hiring policies for employees or former employees of the external auditors
Top-level managers should have been skeptical about the reasons for Sachdeva's behavior. In retrospect, it seems that she was purposely trying to intimidate her subordinates through this dominating behavior. Management may have questioned why she was trying to intimidate her subordinates. Was there something that she was trying to cover up? This tactic was also used at Enron, whereby top-level management would explicitly indicate that any questioning of its actions (from employees, external analysts, etc.) was an indication of how dense the questioner was. Top-level managers should have wondered why she felt the need to behave in this manner, and they should have objected to it in person or at least told her in private to eliminate the behavior if for no other reason than to establish and maintain a more professional tone in the workplace. This kind of behavior puts subordinates in a very awkward position. In Sachdeva's case, she reportedly acted domineering to the vast majority of her subordinates. In such a setting where one individual is not singled out, it should be easier for the group to act cohesively and approach senior management privately to complain about the situation. In a s
g. Some reports have described Sachdeva as having a very dominating personality, and revelations were made about the fact that she would often be verbally abusive of her subordinates in front of top-level managers at Koss. How should top-level managers have responded to this behavior? What actions could the subordinates have taken to respond to this behavior? Why might this behavior be a red flag indicating a heightened risk of fraud?
Having a written charter and an annual performance evaluation ensures that the committee responsibilities are appropriate, and that the responsibilities are actually accomplished (or shareholders are alerted if they are not accomplished). Accomplishing such activities acts as a deterrent to fraud.
h. The audit committee must have a written charter that addresses the committee's purpose and responsibilities, and the committee must produce an audit committee report; there must also be an annual performance evaluation of the committee.
By requiring this disclosure, users of the financial statements can evaluate for themselves whether the foreign companies' governance is adequate, or gain an appreciation for governance differences. This knowledge encourages companies to adopt corporate governance mechanisms that they otherwise may not, thereby affecting the control environment and the opportunity for fraud. It also helps users know where deficiencies may exist, making them more skeptical.
k. Foreign companies must disclose how their corporate governance practices differ from those followed by domestic companies
It attempts to ensure that top-level executives place appropriate importance on corporate governance and that they would be required to disclose if their company is not compliant, which would alert users to heightened fraud risk.
l. CEOs need to provide an annual certification of compliance with corporate governance standards.
An internal audit function is important to the control environment. Having that oversight internally improves internal control, thereby deterring fraud.
m. Companies must have an internal audit function, whether housed internally or outsourced.
