Accounting

CHAPTER 10:

It is early Monday morning, and Jake is preparing to conduct his first interview as a fraud examiner. He is to meet with Lin, a laborer in the factory his firm is investigating. She is neither a suspect nor thought to be connected with the fraud. Her name simply came up in another investigator’s interviews as someone who might be able to provide additional insight. They have arranged to meet at Jake’s office, so he is simply awaiting her arrival.

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“Hello,” he hears someone say through his partially open door. “I’m Lin.”

“Come in,” he replies, remaining seated behind his large, oak desk. She enters and takes the empty seat across the desk from Jake. “Let me get right to the point,” are his next words. “Are you aware of any reasonably credible or plausible evidence that the allegations of embezzlement at your place of employment are tenable?”

After a brief pause and a look of concern on Lin’s face, Jake asks, “Do you know what embezzlement means?”

“Yes,” replies Lin.

“Okay, then, do you know anyone who has embezzled from your employer?”

“No.”

Lin becomes nervous as she sees Jake begin to take notes on a pad. He continues, “Specifically, have you seen Tom perpetrating fraud?”

“No.”

“Are you sure? You know that this is a big deal,” he says as he stands and begins to pace around the room. “I can’t imagine why anyone would steal from his own company, but he deserves to be caught if he has. It’s wrong and bad, and only a horrible person would do something like this.”

“I’m sure.”

“Have you embezzled?”

“No,” Lin states again.

“Well, then, I don’t see any reason to continue. Goodbye.”

Lin stands, excuses herself, and leaves the room.

Question: What are some of the things Jake did wrong during this interview?

 

 

CHAPTER 11:

 

After Enron, WorldCom, and other major corporate scandals that rocked America in the recent past, it seemed that nothing would surprise investors or regulators. However, almost everyone was shocked by revelations that as many as 20 percent of all public corporations may have allowed their officers and directors to “backdate” their stock option awards and account for the awards improperly. For a time, hardly a day went by without another public company’s fraudulent stock option practices being revealed.

A stock option is an award granted under which key employees and directors may buy shares of the company’s stock at the market price of the stock at the date of the award. As an example, assume that Company A’s stock price is $15 per share on January 1, 2007. Further assume that the company’s CEO is awarded 200,000 stock options on that date. This means that after a certain holding (vesting) period, the CEO can buy 200,000 shares of the company’s stock at $15 per share, regard- less of what the stock price is on the day he or she buys the stock. If the stock price has risen to, say $35 per share, then the CEO can simultaneously buy the 200,000 shares at a total price of $3 million (200,000 times $15 per share) and sell them for $7 million ($35 per share times 200,000 shares), pocketing $4 million. Stock options are a way to provide incentives to executives to work as hard as they can to make their companies profitable and, therefore, have their stock price increase.

Until 2006, if the option granting price ($15 in this case) were the same as the market price on the date the option was granted, the company reported no compensation expense on its income statement. (Under accounting rule FAS 123R, effective in 2006, the required accounting changed.) However, if the options were granted at a price lower than the market share price (referred to as “in-the-money” options) on the day the options were granted, say $10 in this example, then the $5 difference between the option granting price and the market price had to be reported as compensation expense by the company and represented taxable income to the recipient.

The fraudulent stock option backdating practices involved corporations, by authority of their executives and/or boards of directors, awarding stock options to their officers and directors and dating those options as of a past date on which the share price of the company’s stock was unusually low. Dating the options in this post hoc manner ensured that the exercise price would be set well below market, thereby nearly guaranteeing that these options would be “in the money” when they vested and thus provided the recipients with windfall profits. In doing so, many companies violated accounting rules, tax laws, and SEC disclosure rules. Almost all companies that were investigated “backdated” their options so that they would appear to have been awarded on the low price date despite having actually been authorized months later.

  1. Would a good system of internal controls have prevented these fraudulent backdating practices?
  2. Why would executives and directors of so many companies have allowed this dishonest practice in their companies?
  3. Would a whistle-blower system have helped to prevent or reveal these dishonest practices?

 

CHAPTER 12:

After graduating from college with your MBA, you decide to take your grandma’s secret cinnamon roll recipe and open up a bakery. You grew up devouring your grandma’s rolls, and you have convinced her to give you the secret. You are confident that your bakery will be the next big hit in the fast-food business.

You take out a business loan for the maximum amount your bank will give you, hire several employees, and open a beautiful store that is designed to look like your grandma’s home. After eight months of hard work and diligence, you are crushed when you realize that your store manager has been stealing from you. One of your recent hires tells you that during her last shift, the manager, Stephanie, voided a sale of two-dozen cinnamon rolls, stamped the receipt as a return, and pocketed the money. Stephanie warned the new hire not to say anything and told her she deserved the money because she didn’t get paid enough. Encouraged by your open- door policy, the employee confides in you.

  1. Identify what symptoms this fraud will generate. In addition, identify how this fraud will directly affect your revenue and inventory accounts.
  2. Explain the steps you should take to search for each symptom you identified in part (1). In particular, describe the computer queries and transactions that should be searched to find this fraud.
  3. After you have identified several symptoms, do you have enough evidence to prove that she is guilty? What other evidence is required or useful in this case?
  4. Besides searching for symptoms of the fraud, what other investigative steps can be taken to elicit a confession or otherwise prove the fraud?
  5. What steps could have been taken to prevent this fraud from occurring in the first place?

 

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