Audit Assessment through the Fraud Triangle - Assignment Example

Audit Assessment Name Date Course Question 1 Fraud triangle plays an important role in terms of providing the casual factors that should be removed in order to deter fraud. In every situation of fraud the three factors are usually present. According to the fraud triangle, the three factors include motive, rationalization and opportunity (Morales, et al, 2014). In the WorldCom Saga, the three factors were present and could best explain the behavior of Bernie Ebbers who was the Chief Executive Officer and Scott Sullivan who was the Chief Financial officer. The motive for committing the fraud is as a result of pressure. Sullivan was under pressure to ensure that the financial report of the company looks good to the investors as well as members of the public. This is considering that the company had already created a good public image and Fortune Magazine had also indicated that the company was performing well. The pressure to please the investors and the members of the public was therefore one of the major motives for the fraud (Dellaportas, 2013). This is considering that the he willingly manipulated figures in order to make the financial report of the company to look good. Ebber was also under pressure from the investors as well as his own personal financial issues. The CEO was facing a lot of pressure from the analyst as well as the investors. The financial wellbeing of the CEO was dependant on the stock prices and hence the pressure. The company was also being marketed as a high growth company and hence pilling more pressure on the CEO and CFO. Rationalization is one of the situations that are found in every fraud situation and it is mainly about the mindset of the fraudster. The fraudsters usually try to justify their actions due to their mindset (Kassem & Higson, 2012). Sullivan indicated that he had done nothing wrong despite clear indication that he had falsified the financial report of the company. He even went further and tried to justify his actions by claiming that the company was not receiving revenue and the cost for leasing the lines could be deferred until the company starts producing revenue. This is an indication that he was trying to justify his fraudulent actions. Ebbers on the other hand acquired loans through the stock of the company. He therefore overlooked some of the issues in order to ensure that he continued making profits. His justifications for his actions were mainly based on the privileges he was supposed to enjoy as the CEO. Opportunity which is a situation that causes the fraud to occur is also one of the factors that have been highlighted in the fraud triangle (Lou & Wang, 2011). There was a perfect opportunity for fraud to occur at the company since Ebber and Sullivan had great influence on the employees and the members of the board. Most of the decision could not be questioned. This was therefore a perfect opportunity for fraud to occur as no one could question their actions. Although the discrepancies were noted by some of the personnel, the feared raising the issue as it would have impacted negatively on their employment. Close the gap project also played an important role in terms of providing the opportunity for fraud to take place. This is considering that it was aimed at ensuring that shortfall in the revenue could be made up for. The capitalization of the line cost also provided an opportunity for fraud to take place within the organization. The fraud scale places a lot of emphasis on personal integrity as opposed to rationalization (Free, 2015). Personal integrity is one of the factors that have been highlighted in the fraud scale and it influences the individuals in terms of fraud. Sullivan and Ebber were of low personal integrity. In some instances, they were awarding the board members as well as the employees in order to gain their loyalty. This is an indication of low levels of personal integrity. Situational pressures are also part of the fraud scale. Ebber depended on the stock process of the company and this situation could have been a motivation for committing fraud. This is considering that he would not benefit financially if the stock prices of the company went down. Personal issues such as debts as well as the lifestyle are also one of the components of the fraud scale (Murphy & Free, 2015). Ebber was dependant on the stock prices to secure loans and would have been unable to secure loans incase stock prices fell. Achieving double digit was a factor that determined the ability of the CEO to earn bonuses and it could be influential in terms of the fraud. Ebber was free spending and over-zealous which is an indication of luxurious lifestyle. In order to maintain his lavish lifestyle he required huge amount of money and this could have contributed to the fraud. According to the fraud scale, the lowest threshold for ethical decision making has also been identified (Dellaportas, 2013). A professional code of ethics of an accounting organization has to be in place. However, Ebber and Sullivan had lowered the profession code by allowing some of the irregularities to take place and hence contributing to the fraud. Ebber and Sullivan failed to observe the codes of conduct and hence contributing to the fraud in the company. Both Ebber and Sullivan used to provide excessive compensations to the employees and board members in order to win their support. As a result of this, their decision s could not be questioned regardless of whether it was right or wrong. It is for this reason that the vice president had difficulties in questioning some of the accounting information after some concerns were brought to his attention. Law is an important aspect of fraud scale (Free, 2015). Ebber and Sullivan were in contravention of various laws. The Securities exchange Commission highlighted that fraud was committed as a result of contravention of different laws. The codes of conduct guided trust and values were not respected by Ebber and Sullivan leading to the fraud. Question 2 In Australia, false accounting is a crime under the Crimes Act 1958. According to section 83(b), false accounting involves the furnishing information or producing accounting information that is misleading, false or deceptive with the full knowledge of the person producing the report. A person engaged in false accounting is liable for a maximum of 10 years imprisonment. In Australia, false accounting also involves altering or destroying the account or presenting accounts that do not reflect the true value of the financial activities of the organization (Ashok, 2014). Hiding the losses, covering up for theft as well as portraying the company to be more successful than it is constitutes to false accounting. False accounting is also a crime since it is mainly used to cover up losses or fraudulent activities together with the criminal activities causing the fraud. The International Financial Reporting Standards are in place for the purposes of providing guideline with regards to the accounting standards as well as the principles. It is used in Australia as well as other parts of the world since it is an international standard. Action 1 which involves WorldCom employees Dan Renfroe and Angela Walter making journal entries in the amount of $150 million and $771 million without detailed support amounts to false accounting. The IFRS requirement is mainly principle based when it is consistent with the IASB conceptual framework. The principles require that the journal entries should be fully supported in order to ensure transparency. Full disclosure which is an important principle of IFRS is required in order to ensure that the information provided is credible and correct. The IFRS principles require honesty as well as full disclosure of the financial information. In the case of WorldCom employees, there was lack of full disclosure with regards to the journal entities. This can be translated as lack of honesty by the employees of the company. The lack of full disclosure can also be interpreted as cover up for the losses which has been incurred by the company. In Australia, this amounts to false accounting on the part of the employees. It was also the responsibility of the employees to ensure that they have full information before making the journal entries. An employee of a company is responsible for false accounting if they inflate expenses claims or the accounting figures (Nobes, 2014). The journal entries that were made by the employees could be inflated as it lacks adequate support. It is difficult for the shareholders to fully understand the statement if the lacks adequate detailed support with regards to the information. False accounting is motivated by the need to falsify the records and ensure that the figures are altered. This is also considering that the $ 150 million entry was made after instruction from Sullivan. This is despite the refusal from the vice president of Wireless Finance. It is therefore an indication that Sullivan was trying to cover up for some irregularities with regards to the financial information. Renfroe who was a subordinate entered the journal without adequate information after the vice president refused to do so due to the lack of detailed support information. This is an indication of false accounting as the process was carried out irregularly contrary with the IFRS principles. Angela Walter received instruction from the Director in General accounting to book an entry that would reduce the line cost by $ 771 million. Angela made entry to the journal without any support or explanation from the entry. At the time of entering the information, she did not raise any concerns as she was used to receiving instructions from the Director of General accounting. The results for entering the information led to a reduction of the line cost by $ 771 million. This was however not correct and hence an indication of false accounting. The lack of detailed information was for the purposes of cover up and hence resulting to false accounting. The amount was entered in order to cover up for the losses that the company was making and ensuring that the financial information of the company looks good to the shareholders and the members of the public. This is considered an offence in Australia as it has the potential of misleading the shareholders as well as the members of the public (Van Greuning, et al, 2011). The information entered had the potential of indication that the company was making profits which was unrealistic. It is also important to note that the principles of full disclosure were ignored by Walter although she was receiving g the information from her boss. The junior employees were intentionally involved in the process of making the entries as they would not have questioned their bosses. This is considering that the organizational culture that was in place gave the bosses a lot of powers. The IFRS principles encourage transparency in the financial reporting. However, this was lacking in the case as the information lacked detailed support for the transactions. Transparency requires that detailed support should be provided for all the information entered in the journal. The lack of transparency was an indication that the fraud being committed was being covered up by the senior members of the management including Sullivan who was involved in giving the orders that the entries should be made. There was total lack of accountability during the process which is an indication that fraud was being committed and the entries were purely for covering up the fraud. This is considering that the organizational culture promoted fraud as the decision of the Chief Executive Officer and the Chief Financial Officer were never questioned by the employees of the company. In Australia, the Australian Securities and investment Commission would have been involved in the investigations as a result of the fraud being committed (Biddle, 2011). The falsification of the accounting information is therefore an indication that there was false accounting at the company. The employees of the company were equally responsible as they took no action despite the lack of detailed support for the entries. Question 3 Part A a. Horizontal and vertical analysis The horizontal analysis is a financial statement analysis technique that mainly shows changes in the amounts of the corresponding financial statement over a period of time (Morales, et al, 2014). The changes are usually shown in terms of the dollar change. Dollar change= Amount of the item in comparison year- Amount in the base year. The vertical analysis shows each item on a statement as a percentage of the base figure. Percentage base= Amount of individual item/ Amount base X 100 December 31st 2000 December 31st 2001 Dollar change Horizontal analysis Percentage base Vertical analysis 2000 Percentage base Vertical analysis, 2001 Assets $ (Millions) $ (Millions) $ (Millions) % % Current Assets Cash and cash equivalents 761 1,416 (655) 0.77 1.36 Accounts receivable 6,815 5,308 1,507 6.89 5.11 Differed tax assets 172 251 (79) 0.17 0.24 Other current assets 2,007 2,230 (223) 2.03 2.15 Total Current Assets 9,755 9,205 550 9.86 8.86 Property and equipment Transmission Equipment 20,288 23,814 (3,526) 20.51 22.92 Communications equipment 8,100 7,878 222 8.19 7.58 Furniture, fixture and other 9,342 11,263 (1,921) 9.45 10.84 Construction in progress 6,897 5,706 1,191 7.00 5.49 Accumulated depreciation (7,204) (9,852) (2648) 7.28 9.48 Goodwill and other intangible assets 46,594 50,532 (3,938) 47.11 48.62 Other Assets 5,131 5,363 (232) 5.19 5.26 Total Assets 98,903 103,914 (5,011) 100.00 100.00 Liabilities and Shareholders’ investment Current liabilities Short term debt and current maturities of long term debts 7,200 172 7,028 7.28 0.17 Accrued interest 446 618 (172) 0.45 0.61 Accounts payable and accrued line costs 6,022 4,844 1,178 6.09 4.75 Other current liabilities 4,005 3,576 429 4.05 3.51 Total current liabilities 17,673 9,210 8,463 17.88 9.04 Long term liabilities less current portion Long term debt 17,696 30,038 (12,342) 17.89 29.47 Differed tax liability 3,611 4,066 (455) 3.65 4.00 Other liabilities 1,124 576 548 1.14 0.57 Total long term liabilities 22,431 34,680 (12,249) 22.68 34.03 Commitments and contingencies Minority interests 2,592 101 2,491 2.62 0.01 Company obligated mandatorily redeemable and other preferred securities 798 1,993 1,195 0.81 1.92 Shareholders’ investment Additional paid-in capital 52,877 54,297 (1,420) 53.46 52.25 Retained earnings 3,160 4,400 (1,240) 3.20 4.23 Unrealized holding 345 (51) 294 0.35 0.05 Cumulative foreign currency (817) (562) (255) 0.83 5.41 Treasury stock (185) (185) - Total shareholders’ investment 55,409 57,930 (2521) 56.02 55.75 Total liabilities and shareholders’ investments 98,903 103,914 (5,011) 100.00 100.00 b. Beneish ratio The Beneish ratio involves 8 financial ratios that are obtained through the use of mathematical models (Morales, et al, 2014). The ratios are used for the purposes of determining whether the company has managed or manipulated its earnings. The following are the eight ratios for the company. i). DSRI= Day’s sales in receivables index =Days sales in receivables year 1/Days sales receivable year 2 Accounts receivables turnover ratio= sales/accounts receivables Y 2000=4153/1126=3.69 Y 2001=1501/281=5.34 Days sales receivables=365/accounts receivables turnover ratio Y2000=365/3.69=98.92 Y 2001=365/5.34=68.35 DSRI=68.35/98.92=0.70 ii). GMI=Gross margin index =Gross margin ratio year1 /Gross margin ratio year 2 Gross margin ratio =Gross profit/ net sales Y 2000= (39090-30937)/39090 =0.21 Y 2001= (35179-31665)/35179 =0.10 GMI= 0.10/0.21 =0.48 iii). AQI=Asset Quality Index =Non current assets/total assets Y 2000= 9755/98903 =0.10 Y 2001=9205/103914 =0.09 AQI= 0.09/0.10 =0.9 iv). SGI= Sales Growth Index =Sales year 1/Sales Year 2 =1501/4153 =0.36 v). DEPI= Depreciation index =Rate of depreciation year 1/ Rate of depreciation year 2 =5880/4878 = 1.21 vi). SGAI= Sales, General and administrative expenses =SGA expenses Year 1/ SGA expenses Year 2 =31665/30937 =1.02 vii). LVGI=Leverage index =Total debt / Total Assets Y 2000 =22431/98903 =0.22 Y=2001=34680/103914 =0.33 LVGI= 0.33/0.22 =1.5 Viii). TATA= Total Accruals to Total Assets =Net Operating Assets year 1-Net Operating Assets Year 2 Net operating Assets= (Total Assets-cash)-(Total liabilities- Total Debt) Y 2000= (98903-761)-(40104-24896) =82934 Y 2001= (103914-1416)-(43890-30210) =88818 TATA= (88818-82934)/ (88818+82934)/2 =5884/85876 =0.07 c. M-Score 8 variable methods M-score=0.404(AQI) +0.892(SGI) +0.115(DEPI)-0.172(SGAI) +4.679(TATA)-0.327(LVGI) =0.404(0.09) +0.892(0.36) +0.115(1.21)-0.172(1.02) +4.679(0.07)-0.327(1.5) =0.16 5 Variable methods M-Score=0.593(AQI) +0.717(SGI) +0.107(DEPI) =0.593(0.09) +0.717(0.36) +0.107(1.21) =0.44 The calculations indicate that there is a strong likelihood of the firm being a manipulator. This is because the M-Score is greater than -1.78 and it is also less positive. The use of Beneish ratio has a success rate of about 75%. This is an indication that its levels of accuracy are quite high and it can be used for the purposes of detecting fraud within an organization. All the variables are usually constructed from the financial statement of the company. The variables play an important role in terms of detecting any form of manipulation by the company. The variables have been successfully been used in for other companies and it has been able to detect fraud. However the levels of accuracy may when the two methods are used. Any figure that is above the -1.78 indicates that the company is participating in fraudulent activities. Part B December 31st 2000 December 31st 2001 Dollar change Horizontal analysis Percentage base Vertical analysis 2000 Percentage base Vertical analysis, 2001 Assets $ (Millions) $ (Millions) $ (Millions) % % Current Assets Cash and cash equivalents 6.33 1,416 (655) 0.77 1.36 Accounts receivable 6,815 5,308 1,507 6.89 5.11 Differed tax assets 172 251 (79) 0.17 0.24 Other current assets 2,007 2,230 (223) 2.03 2.15 Total Current Assets 8,475 9,205 550 9.86 8.86 Property and equipment Transmission Equipment 20,288 23,814 (3,526) 20.51 22.92 Communications equipment 8,100 7,878 222 8.19 7.58 Furniture, fixture and other 9,342 11,263 (1,921) 9.45 10.84 Construction in progress 6,897 5,706 1,191 7.00 5.49 Accumulated depreciation (7,204) (9,852) (2648) 7.28 9.48 Goodwill and other intangible assets 46,594 50,532 (3,938) 47.11 48.62 Other Assets 5,131 5,363 (232) 5.19 5.26 Total Assets 97,623 103,914 (5,011) 100.00 100.00 Liabilities and Shareholders’ investment Current liabilities Short term debt and current maturities of long term debts 7,200 172 7,028 7.28 0.17 Accrued interest 446 618 (172) 0.45 0.61 Accounts payable and accrued line costs 6,022 4,844 1,178 6.09 4.75 Other current liabilities 4,005 3,576 429 4.05 3.51 Total current liabilities 17,673 9,210 8,463 17.88 9.04 Long term liabilities less current portion Long term debt 17,696 30,038 (12,342) 17.89 29.47 Differed tax liability 3,611 4,066 (455) 3.65 4.00 Other liabilities 1,124 576 548 1.14 0.57 Total long term liabilities 22,431 34,680 (12,249) 22.68 34.03 Commitments and contingencies Minority interests 2,592 101 2,491 2.62 0.01 Company obligated mandatorily redeemable and other preferred securities 798 1,993 1,195 0.81 1.92 Shareholders’ investment Additional paid-in capital 52,877 54,297 (1,420) 53.46 52.25 Retained earnings 3,160 4,400 (1,240) 3.20 4.23 Unrealized holding 345 (51) 294 0.35 0.05 Cumulative foreign currency (817) (562) (255) 0.83 5.41 Treasury stock (185) (185) - Total shareholders’ investment 55,409 57,930 (2521) 56.02 55.75 Total liabilities and shareholders’ investments 98,903 103,914 (5,011) 100.00 100.00 The figures provided by SEC leads to changes in the assets as well as the liabilities of the company. The changes indicate that the figures had been manipulated in order to indicate that the company was making profits. However, the figures indicates that the losses were not reported and hence misleading the stakeholders. The figures failed to indicate that the company was making loses of up to $ 401 million in the second quarter of 2001. In the last quarter of 2001, a loss amounting to $ 622 was not reported by the company as a result of the manipulation of the figures. The levels of debt at the company was on the increase and this i). DSRI= Day’s sales in receivables index =Days sales in receivables year 1/Days sales receivable year 2 Accounts receivables turnover ratio= sales/accounts receivables Y 2000=4153/1126=3.69 Y 2001=1501/281=5.34 Days sales receivables=365/accounts receivables turnover ratio Y2000=365/3.69=98.92 Y 2001=365/5.34=68.35 DSRI=68.35/98.92=0.70 ii). GMI=Gross margin index =Gross margin ratio year1 /Gross margin ratio year 2 Gross margin ratio =Gross profit/ net sales Y 2000= (6333-622)/6333 =0.90 Y 2001= (35179-31665)/35179 =0.10 GMI= 0.10/0.90 =0.11 iii). AQI=Asset Quality Index =Non current assets/total assets Y 2000= 9755/98903 =0.10 Y 2001=9205/103914 =0.09 AQI= 0.09/0.10 =0.9 iv). SGI= Sales Growth Index =Sales year 1/Sales Year 2 =-622/217 =-2.87 v). DEPI= Depreciation index =Rate of depreciation year 1/ Rate of depreciation year 2 =5880/4878 = 1.21 vi). SGAI= Sales, General and administrative expenses =SGA expenses Year 1/ SGA expenses Year 2 =31665/30937 =1.02 vii). LVGI=Leverage index =Total debt / Total Assets Y 2000 =22431/98903 =0.22 Y=2001=34680/103914 =0.33 LVGI= 0.33/0.22 =1.5 Viii). TATA= Total Accruals to Total Assets =Net Operating Assets year 1-Net Operating Assets Year 2 Net operating Assets= (Total Assets-cash)-(Total liabilities- Total Debt) Y 2000= (98903-761)-(40104-24896) =82934 Y 2001= (103914-1416)-(43890-30210) =88818 TATA= (88818-82934)/ (88818+82934)/2 =5884/85876 =0.07 a. M-Score 8 variable methods M-score=0.404(AQI) +0.892(SGI) +0.115(DEPI)-0.172(SGAI) +4.679(TATA)-0.327(LVGI) =0.404(0.09) +0.892(-2.87) +0.115(1.21)-0.172(1.02) +4.679(0.07)-0.327(1.5) =-2.72 5 Variable methods M-Score=0.593(AQI) +0.717(SGI) +0.107(DEPI) =0.593(0.09) +0.717(-2.87) +0.107(1.21) =-1.87 The introduction of the changes gives negative values which are less than -1.78 which is therefore an indication that the financial report is correct and it reflects on the true financial position of the company. This is therefore a further indication that the financial reports of the company had been manipulated and falsified in order to hide the fraud. List of References Morales, J, et al, 2014, The construction of the risky individual and vigilant organization: A genealogy of the fraud triangle, Accounting, Organizations and Society, 39(3), 170-194. Dellaportas, S, 2013, Conversations with inmate accountants: Motivation, opportunity and the fraud triangle, In Accounting forum (Vol. 37, No. 1, pp. 29-39). Elsevier. Kassem, R, & Higson, A, 2012, The new fraud triangle model, Journal of Emerging Trends in Economics and Management Sciences (JETEMS), 3(3), 191-195. Lou, Y, I, & Wang, M, L, 2011, Fraud risk factor of the fraud triangle assessing the likelihood of fraudulent financial reporting, Journal of Business & Economics Research (JBER), 7(2). Free, C, 2015, Looking Through the Fraud Triangle: A Review and Call for New Directions, Available at SSRN 2590952. Murphy, P, R, & Free, C, 2015, Broadening the fraud triangle: Instrumental climate and fraud, Behavioral Research in Accounting. Ashok, K, K, 2014, International Financial Reporting Standard (IFRS): Prospects and Challenges, J Account Mark, 3(111), 2. Nobes, C, 2014, International Classification of Financial Reporting 3e, Routledge. Van Greuning, H, et al, 2011, International financial reporting standards: a practical guide, World Bank Publications. Biddle, G, C, 2011, Does mandatory adoption of International Financial Reporting Standards increase investment efficiency, In The University of Hong Kong, University of Memphis, and Texas State University Working paper. Read More