A CASE STUDY ON DETECTING FRAUD IN A FINANCIAL STATEMENT AUDIT

By Darryl C. Spurlock and Craig R. Ehlen

In February, 1997, SAS No. 82, Consideration of Fraud in a Financial Statement Audit, was issued by the Auditing Standards Board (ASB). Although SAS No. 82 does not increase an auditor's responsibility for detecting fraud, it does clarify it by requiring a specific assessment of the risk of material misstatement of the financial statements due to fraud.

A major portion of SAS No. 82 is devoted to describing the process of conducting the risk assessment, and includes a comprehensive listing of risk factors that an auditor should consider in that assessment. It also provides specific guidance in other areas, such as responding to the results of the risk assessment, evaluating the results of audit tests, documenting the auditor's risk assessment and response, and communicating evidence of fraud to management, the audit committee, or others as appropriate.

How the risk assessment process and identification of specific risk factors were applied in an actual audit environment are described below. The factual situation presented is based on circumstances in which one of the authors was the primary engagement partner. Although the audit described predates the issuance of SAS No. 82, it is used here to illustrate how the concepts embodied in it can assist the auditor in the detection of fraud.

The Audit Situation

The client was a public company required to have an annual external audit. During the course of the year under audit, the company had issued numerous news releases regarding earnings increases and other positive developments, including a series of acquisitions, the introduction of new products, and improved operations. The company's quoted stock price during the year reflected these developments, rising from around $2 per share to more than $8 per share.

The CPA firm had conducted an independent audit in each of the prior two years but had not been engaged to perform limited reviews on the quarterly Form 10-Q filings. Audit issues raised in prior years included technical problems with purchase versus pooling-of-interests accounting, inventory valuation (inappropriate overhead rates and subjective valuation reserves), and stock-based compensation. Although these prior-year issues were all resolved satisfactorily, they served to heighten the firm's level of skepticism approaching the current year's audit.

In the planning phase of an audit, SAS No. 82 specifically requires auditors to evaluate the risk factors relating to management's characteristics and influence over the control environment. In this case, the following indications of heightened risk were noted:

* The president and CEO (who was also chairman of the board of directors) was a very strong-willed individual.

* The other members of the board of directors did not seem to have the business background or personal temperament to stand up to the CEO.

* The CFO was not well versed on technical FASB pronouncements and also lacked knowledge and experience in dealing with routine SEC matters.

* Inventories were material to the balance sheet and deferred charges were increasing rapidly.

* Although basic accounting procedures and controls were in place and functioning normally, there was concern that these controls were subject to management override and vulnerable to errors from "nonroutine" transactions (acquisitions, stock-based compensation, etc.).

SAS No. 82 also provides guidance on how the auditor should respond when an assessment indicates a heightened risk of material misstatement due to fraud. In this instance, the CPA firm responded by increasing the scope of audit procedures designed to uncover and evaluate unusual or nonroutine transactions. The results of some of those tests were very enlightening, as noted below.

Review of Journal Entries. One simple technique used to uncover unusual or nonroutine transactions is to obtain the general journal and review all journal entries for the year, being alert for entries to unusual combinations of accounts, entries for unusually large amounts, entries with incomplete or questionable descriptions, and entries that ordinarily would be found in special journals. When the auditors applied this procedure, they noted an entry in the last month of the company's fiscal year with the explanation "to reverse previous journal entry." This reversing entry debited sales and credited accounts receivable for $1 million and debited inventory and credited cost of sales for $400,000, thus resulting in a reduction in gross profit of $600,000. The auditors searched for the earlier journal entry and discovered it was originally recorded at the end of the previous quarter. The pretax profit impact of the $600,000 was material to each of the quarters involved.

Having found these questionable entries, the auditors requested the client to provide support for the transactions recorded. The "support" took an unusually long time to produce and its authenticity was questionable (i.e., the sales invoice was manually typed and the customer order information was incomplete). Further investigation uncovered some documentation that indicated the inventory in question was shipped from one company warehouse to another company warehouse the day after the end of the previous quarter, but there was no evidence the inventory was ever shipped to an actual customer. Although the customer order documentation provided to the auditors appeared to have some validity, the order was from a foreign-country customer, and the paperwork did not address any shipping or payment terms. Assuming the order was legitimate, this raised the question of whether the company had recorded an order rather than a sale. The company CEO and CFO were adamant that the original sale transaction was legitimate but that the merchandise was returned for some unspecified reason, which resulted in the reversal identified in the journal entries. Since there was no documentation supporting the alleged return of merchandise, at this point the auditors began to question the credibility of certain corporate officers.

Nonroutine Transactions. The auditors also attempted to identify any obvious nonroutine transactions through discussions with management, review of the corporate minutes, and a careful reading of the company-prepared financial statements. These procedures revealed that the company had made compensation payments during the year to the chairman, CFO, and others in the form of shares of the company's stock. The auditors identified issues related to the recording of stock compensation expense, including the market value used to record the cost of the plan. The combined impact of errors noted in these entries was a material understatement of compensation expense.

The company had also recorded substantial amounts of deferred charges and prepaid costs as assets, including preoperating expenses and start-up costs related to new facilities. When the auditors examined the support for these deferrals, a material portion could not be justified.

At this point, the auditors thought the problems associated with each of these nonroutine transactions may have been linked to the CFO's lack of technical expertise rather than a conscious attempt to manipulate the financial statements. However, the auditors' professional skepticism was on alert even as management's credibility began to fall.

Analytical Review. Meanwhile, the auditors were also performing analyses of the financial statements of all the company's subsidiaries. The analytical procedures revealed gross profit percentages at several subsidiaries that seemed excessively high when compared to historical trends. Further investigation led to the discovery of a number of problems with the inventories: addition of inventory quantities to count sheets after the physical inventories were taken, valuation of certain raw materials at replacement cost, use of inflated overhead rates, unsupported reversals of prior years' inventory reserves, errors in sales and inventory cutoff, and revenue recorded for advance payments received on orders for merchandise not yet shipped. The materiality and pervasive nature of these items prompted the auditors to demand that a complete new physical inventory count be conducted at all company locations, with the auditors present at each location.

Review of Consolidation. While testing the company's consolidation procedures, the auditors noted that a material amount of intercompany sales had not been eliminated. While this oversight had no impact on bottom-line profit, it did materially overstate sales, a number the company had targeted for growth and emphasized in news releases.

Other Procedures. The CPA firm's routine audit procedures also uncovered a number of additional problems that required adjustments to the financial statements. For instance, normal sales and inventory cutoff procedures revealed that the company had recorded post year-end sales invoices as current year sales--with the related inventory still on the books--but had failed to record current year sales returns and allowances. Audit testing also revealed that the company had underprovided both accrued payroll and vacation pay and was delinquent on payroll taxes (a violation of loan covenants). Accounts receivable audit procedures resulted in the determination that the allowance for doubtful accounts was understated, and the search for unrecorded liabilities revealed numerous unrecorded expenses. The combined effect of these errors was a material overstatement of earnings.

Communicating the Outcome

As the initial list of audit issues to be resolved grew, the auditors held meetings with senior management to develop plans and assign responsibilities for resolution of these issues. The auditors first requested a meeting with the chairman of the audit committee. The auditors also met repeatedly with the board of directors to discuss the status of the audit and the listing of unresolved issues. The number of unresolved audit issues and the potential cumulative material adverse impact on the financial statements continued to grow, seemingly with each additional audit procedure. At the same time, concerns about the integrity of certain senior and financial management personnel continued to rise. It became apparent that information provided to the auditors in response to routine audit inquiries was being screened, and questions were raised regarding the veracity of the responses. The auditors asked the audit committee to remove the CFO and chief accountant from the audit process and assign a new coordinator to represent the company in dealings with the auditors.

Eventually, based on the audit adjustments accepted by the client, the earnings of several million dollars reported by the company in news releases had been recast as a multimillion dollar loss, with several million dollars of additional potentially negative adjustments yet to be resolved. The auditors therefore advised the board of directors to consult with legal counsel regarding the need to publicly disclose the audit issues, the pending restatement of previous quarters' financial statements, and the expected final audited financial results for the year compared with the previously issued earnings releases. Ultimately, the auditors also requested that the board of directors engage outside legal counsel to conduct a special investigation into a number of unresolved issues, and advise the company and auditors as to possible violations of federal securities laws and the ramifications of any such violations.

The auditors also alerted the board to possible legal issues related to several acquisitions of small companies made during the year through exchanges of stock. It was apparent the company's quarterly financial statements and earnings releases had been materially misstated. The market trading value of the company's stock had begun a decline and was falling rapidly. Since all the acquisition agreements contained the company's representations regarding "no materially false or misleading" information, the potential for legal action to rescind these transactions seemed high.

As matters continued to deteriorate, the board of directors, on the advice of legal counsel, replaced the CEO. As the marketplace learned the scope of these problems through a series of press releases, the stock price collapsed and the board of directors was substantially reconstituted, with representatives of certain major investors taking hands-on control. At this point, the relationship between the auditors and the board of directors became adversarial and eventually the auditors were terminated, without issuing a final opinion on the financial statements for the year under audit. Ultimately, the company filed for bankruptcy, and the SEC brought charges against the CEO, CFO, and others. No shareholder suits or other actions were filed against the auditors. *

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