Fraudulent Activity Conducted by Fortune 1000 Company - Research Paper Example

? Capstone Research Project of the of the Table of Contents Introduction 3 Negative impact of the fraudulent activity on the company followed by recommendations to CFO 3 Framework related to Inventory write downs 5 GAAP related to stock option accounting 5 GAAP and IFRS requirements for lease financing 6 Argument in favor of IFRS in terms of lease agreements 9 Major implications for SAS 99 12 Issues related to the material misstatement in financial statement 13 Recommendations 13 Economic effect of restatement of the financial statements on investors, employees, customers, and creditors 14 References 15 Introduction The research paper deals with discussion of the fraudulent activity conducted by a Fortune 1000 Company. The company has been accused for conducting a number of fraudulent activities. It has been found to violate tax regulations when the tax audit was performed by IRS. After the audit it was found that the inventory write downs in the total tax returns were not reflected in the financial statements. The company was exercising a share based compensation plan for its top executives comprising of stock options. These were also not reflected in the financial statements. The company is planning to enter into partnership for which it requires presenting financial report to IFRS. Negative impact of the fraudulent activity on the company followed by recommendations to CFO The inventory write downs are often associated with various negative impacts on the organization. It negatively impacts the operating performance of the organizations. It has been seen that the extreme sales growth in companies lead to higher chances of experiencing future inventory write down as compared to the moderate growing firms. The inventory is an important portion in the financial statement of any organization. The cost of goods sold contains inventory portion, which an organization sells during an accounting period. The inventory stands out to be paramount for the business as it helps in the computation of the company’s gross profit indirectly. After the gross profit, the net income of the company is obtained by subtracting all the operating expenses from the gross profit figure. Thus, missing entire inventory value in the financial statement leads to misinterpretation of the growth profit as well as the net income of the company. Underestimation or overestimation of the cost of goods sold results in huge differences in the profit figure as well. The manipulation in the financial statements may lead to several consequences. The company might manipulate its financial data in order to hide the actual financial performance. The financial statement of any organization reflects its financial information based on which the stock prices are changed. This information assists the investors in making their investing decisions. The GAAP reflects true and fair view related to the financial information of any particular company. But many times it has been seen that the figures in the financial statements get manipulated by the managers of the organizations in such manner that it bears no resemblance with real performance of the company. This can also be termed as the creative accounting method. The manipulation in the real figures of the items presented in the financial statement has a negative impact on the stock prices in the financial market and due to which the values get deviated from the actual values. This displays a misleading picture for the market which in turn misleads the investor’s decisions. Many research studies in the past have reflected positive abnormal returns because of the changes made in the actual earnings of the organization. The returns get altered depending on the validity of alteration in the total earning gained. If the accounting process is conducted in fair manner then this statement becomes highly profitable for an organization. But in case if manipulations or alterations have been done on the actual earnings figure then this statement appears to be false. There have been a number of methodologies implemented by various researchers for detecting the true and fair view of the data available on the financial statements. A group of researchers conducted an analysis related to the management of fraudulent activity in best possible manner. The logit regression analysis has been conducted by various research scholars like Beasley (1996). Many researchers such as Hollman & Patton (1997) and Zimbelman (1997) conducted analysis on the basis of ratios obtained from financial data. Another group paid attention on carrying out analysis on the accruals. Accrual is the difference in between the total earnings of a corporation and its cash flow. When the accrual is very high it signifies that the total earning figure of the organization is very high in comparison to its cash flow. It is mainly because of the manager’s decision related to the disclosure time and total costs and revenues. Many researchers stated that the organizations, which have extremely high accruals, respond badly in respect of the stock returns and those organizations which have low accruals, give high value as stock return (Hribar, 2000). Thus, it is essential for the organizations to reflect the actual facts and figures in its process of accounting, which would otherwise result in the decline of stock prices. The above analysis methods should be adopted by the company to remove the fraudulent activities. Framework related to Inventory write downs One of the underlying principles of the accrual accounting is the matching principle. The inventory is often measures as the lower of the market or cost value. There are two modes of inventory valuation termed as LIFO and FIFO. In case of the occurrence of any write down, new cost basis establishes. However, reversal of inventory write down is prohibited. GAAP related to stock option accounting The stock based compensation plan is used for motivating as well as rewarding the managers. This helps in influencing or engaging them in making better performances. The predominant cost related to most of the companies is cost associated with human capital. In such case seeking the attraction of the talented employees as well as retaining those leads to the implementation of the stock based compensation plan. It helps in aligning the work culture and performance with the interest of the investors. The drawback or risk associated with the stock based compensation plan is that it involves a complex accounting process with such economic payouts, which result in drastic differences in the accounting outcomes. There are two types of stock compensation plans. One is the employee stock option plan and the other is stock appreciation right plan. ESOP is an effective succession planning tool for increasing the talent of the employees. It helps in developing a liquidity event for the entrepreneurs by drastic minimization of tax consequences of transaction related to the stocks, elimination of the corporate income tax etc. However, there are some financial risks associated with this plan. The employee stock option plan might lead to several cash flow issues for the company. For example- if any company is accustomed with conservative debt equity ratio then it can bring about a significant change. The stock appreciation right plan is a rewarding technique, which provides the holder with capability of seeking profit from appreciated value of shares of the company’s stock within a specified period of time. One of the major advantages of using SARs is that it does not require money for being exercised for cash. GAAP and IFRS requirements for lease financing The IFRS as well as the GAAP principle based rules and frameworks have many principles in common. However, there are some places where the framework of IFRS is different from the GAAP principles. The recognition and measurement of leases under GAAP and IFRS are different where it becomes very important to understand the measurement of leases and their presentation in the financial statement based on GAAP principles and IFRS (BDO, n. d.). The differences have been shown below: Generally Accepted Accounting Principles IFRS Leases can be classified based on the substantial risk and rewarding incidental to the ownership of such lease. From the view point of lessee; operating lease and total capital. From the view point of lessor; direct financing and operating lease, sales type. The lease is classified based on the inception of the previous date of the lease agreement and also the date of commitment by parties to basic provisions of lease (be it an operating lease or a finance lease). According to GAAP rules at least one of the following conditions are required to be fulfilled for the lessee in order to classify the lease as sales type lease, capital lease or direct financing lease: The ownership gets transferred to the lessee at the end of the term of agreement or else the lease offers for bargaining purchase option. The lessee obtains all the economic benefits from the property when the lease agreement exceeds 75 percent of the economic life of the property. This standard has not provided any special guidance for the determination or classification of lease. Instead there have been examples provided which provide various situations that would consider the lease to be financial lease. The lease agreement transfers the asset’s ownership to the lessee at the end of lease term. The lessee possesses the option of purchasing the asset at such price, which is expected to be lower than that of the fair value on the date when the option will become exercisable. The lease agreement is for the maximum part of the total economic life of the asset. It requires lease payments or rentals made under the operating lease, where the operating lease is recognized as an expense on the straight line method over the lease agreement. In case of IFRS, the standards related to the lease rentals or payments are the same. Differences in the terminologies for lease agreement under GAAP and IFRS are given below: For Lessor Under GAAP Operating Lease Direct Financing Lease Sales type Lease Leveraged Lease Under IFRS Operating Lease Finance Lease Finance lease Finance Lease For Lessee Operating Lease Capital lease Operating Lease Finance Lease Method of calculation of interest rate under GAAP and IFRS Under GAAP The discount rate that is used for calculation of present value of minimum lease payment is interest rate implicit in lease. In case if it is not practicable to be determined then the incremental borrowing rate is taken into consideration. Under IFRS Lessor uses interest rate implicit in lease. The lessee makes use of ‘lower of implicit interest rate’ or ‘incremental borrowing rate’. Argument in favor of IFRS in terms of lease agreements The IFRS sets the best standards for the lease agreements where the classification of leases also becomes easy under IFRS. Moreover the set of rules and regulations defined under IFRS are easier as compared to GAAP and helps in the maintenance of simplicity as well as transparency while conducting and carrying out the lease agreements. Stakeholders and IFRS Recently there is increasing demand related to implementation of International Finance Regulatory Standards (IFRS) that have been issued by IASB. The growth and expansion of international business includes investments and other financial transactions, which in turn includes the formation and presentation of financial reports that would be required across the national borders. This has lead to the increase in demand for adoption of IFRS by both developing and developed countries (Jermakowicz, 2004; Street & Larson, 2004; Sucher & Jindrichovska, 2004). This process of adopting IFRS has received a boost in 2002 by the implementation of the regulation (1606/2002) by European Union. According to this legal framework all the public companies were bound to convert themselves by adopting IFRS. The adoption of these international standards definitely have specific benefits like reducing the cost of auditing and processing of available financial information by users in the capital market, familiarity, soundness and less complexity with the utilization of one single international standard rather than utilizing different local standards by the Accountants or the Auditors of the financial reports, uniformity as well as transparency of the data available in the financial statements making it easy for the investment analysts and finally attracting many foreign investors because of liberalization of the capital market. It is a known fact that FDI generates high investments which may not be possible by other local resources only. It helps in associating the recipient’s economy with the world economy in such way that would otherwise not be possible to be achieved by the existing or new firms of totally local origin. FDI helps in improving the competitiveness of the countries by means of transfer of technology which enhances alteration of their competitive advantage. In those countries which are suffering badly due to corruption or the countries having slow moving governments, the possibilities or chances of adapting to the technological and other changes is very low. Since the opportunity cost and the switching cost is low, the implementation of IFRS becomes easy and advantageous for these countries. The foreign capital has the potentiality of providing enormous benefits to the developing countries as well as covering the gap between the savings and investments in various capital scarce countries as capital always brings in with it the modern technologies which would advance the investment plans. The capital flows are advantageous in promoting growth or productivity in those countries that possess increased number of skilled workers and good quality infrastructure. But for getting benefited by all the above mentioned advantages, it becomes very important to maintain transparency and fairness of financial records showing the real view of the capital markets to the market investors. It is because of this reason that implementation of IFRS has been highly encouraged by the International Accounting Standards Board. Advantages of IFRS Advantages for the Companies It helps in providing improved or high quality reliable financial information for the purpose of decision making. It helps in high accessibility to the capital (involving the foreign resources). It helps in lowering down the cost of capital Implementation of IFRS makes the entire process very simple by using one single and consistent reporting standard for all the subsidiaries of any organization across all the countries where it operates. It helps in advanced mergers and acquisitions. It enhances competitiveness. Advantages for the investors It helps in reflecting better information for appropriate decision making to the investors. It helps in the proper understanding of the risk and return concept. Major implications for SAS 99 SAS 99 is the framework which not only needs the auditors to be sure about the fact that the financial statements are totally free of the material misstatements but also provides them with clarified and focused guidance related to meeting up the responsibilities for uncovering the fraudulent activities. The findings of the fraudulent activities of the company will have severe consequences. The company is under high risk related to the actions that would be taken. Strict review of the financial statement would take place in frequent manner. Issues related to the material misstatement in financial statement Three issues related to the manipulation of the data present in the financial statement are: 1) The manipulation in the figures of the items present in the financial statement has a negative impact on the stock prices in the financial market and due to which the values get deviated from the actual values. 2) The changes or manipulations display a misleading picture for the market misleading the investor’s decisions. Many research studies in the past have reflected positive abnormal returns because of the changes made in the actual earnings of the organization. 3) It results in the misinterpretation in sales figure for attracting the customers by providing them with misleading information. Recommendations It is very important for the audit company to perform the audit for the financial statements of the company in a frequent manner by keeping a note on the simplest adjustments to the most complex ones. This would lead to the avoidance of the manipulations conducted by the company. The accounting principles are being followed in an appropriate manner or not are required to be checked frequently so the scope of fraudulent activity gets reduced. Economic effect of restatement of the financial statements on investors, employees, customers, and creditors The decreased scope of mis utilization of the financial data would lead to increase in the reliability of the investors, loyalty of the customers and creditors. This would also reduce the fear among the employees related to the loss of their jobs. The increase in the reliability of the investors would enable higher investments for the company. The increase of loyalty of the customers and creditors would help the company in increasing the sales value as well as its debt capital (if required). The reduced fear of the employees would improve their performance level leading to improved financial performance for the organization. References BDO. (n. d.). Canadian GAAP - IFRS comparison series issue 8 – leases. Retrieved from http://www.bdo.ca/en/Library/Services/assurance-and-accounting/IFRSGAAP/IFRS-Canadian-GAAP-Differences-Series-Issue-08.pdf Beasley, M. S. (1996). An empirical analysis of the relation between the board of director composition and financial statement fraud. The Accounting Review, 71(4), 443-66. Hollman, V.P., & Patton, J.M. (1997). Accountability, the dilution effect and conservatism in auditors’ fraud judgments. Journal of Accounting Research, 35(2), 227-37. Hribar, P. (2000). The market pricing of components of accruals. Ithaca, New York: Cornell University. Jermakowicz, E.K. (2004). Effect of adoption of international reporting standards in Belgium: the evidence from BEL-20 companies. Accounting in Europe, 1, 121-31. Street, D.L., & Larson, R. (2004). Large accounting firms’ survey reveals emergence of ‘two standard’ system in the European Union. Advances in International Accounting, 17, 1-29. Sucher, P., & Jindrichovska, I. (2004). Implementing IFRS: a case study of the Czech Republic. Accounting in Europe, 1(1), 109-41. Zimbelman, M.F. (1997). The effects of SAS no. 82 on auditors’ attention to fraud risk factors and audit planning decisions. Journal of Accounting Research, 35(5), 75-9. Read More