Ethical Obligations And Decision Making in Accounting Text And Cases 4th Edition By Mintz Chair – Test Bank

One of the older and more basic concepts in fraud deterrence and detection is the “fraud triangle.” While researching his doctoral thesis in the 1950s, famed criminologist Donald R. Cressey came up with this hypothesis to explain why people commit fraud.

The three key elements in the fraud triangle are opportunity, motivation, and rationalization. Opportunity is the element over which business owners have the most control. Limiting opportunities for fraud is one way a company can reduce it.

The opportunity to commit fraud is possible when employees have access to assets and information that allows them to both commit and conceal fraud typically because of weak internal controls including a lack of segregation of duties or oversight. Top management typically overrides the controls when committing financial statements fraud while employees may use the weaknesses to their advantage in perpetrating fraud.

Motivation is a pressure or a “need” felt by the person who commits fraud. It might be a personal financial or other type of need, such as high medical bills or debts, or as a result of bad personal habits as occurred in ZZZZ Best and Tyco where CEOs misappropriated company resources for personal gain.

Motivators can also be financial oriented that affects business results. Pressures may exist to meet or exceed financial analysts’ earnings estimates or to qualify for high bonuses and/or to inflate share prices and make stock options more valuable.

Lastly, employees may rationalize this behavior by determining that committing fraud is OK for a variety of reasons. For those who are generally dishonest, it’s probably easier to rationalize a fraud. For those with higher moral standards, it’s probably not so easy. They have to convince themselves that fraud is OK with “excuses” for their behavior.

Common rationalizations include making up for being underpaid or replacing a bonus that was deserved but not received. A thief may convince himself that he is just “borrowing” money from the company and will pay it back one day. Some embezzlers tell themselves that the company doesn’t need the money or won’t miss the assets. Others believe that the company “deserves” to have money stolen because of bad acts against employees.

Business owners and executives must take control of fraud by working on the portion of the fraud triangle over which they have the most control: the opportunity to commit fraud. It may be difficult for management to do anything about an employee’s needs or rationalizations, but by limiting opportunities for fraud, the company can reduce it to some extent.

This question provides an opportunity to review the GVV reasons and rationalizations framework.

As you read the case, think about the following series of questions for the protagonist to address after identifying the right thing to do including:

• How can they get it done effectively and efficiently?
• What do they need to say, to whom, and in what sequence?
• What will the objections or push-back be and, then,
• What would they say next? What data and examples do they need?
 

(a) Unmodified opinion
(b) Unmodified opinion with an emphasis-of-matter paragraph
(c) Qualified opinion
(d) Adverse opinion
 

1) The company has been using free, unsecured public WiFi to take orders via the Internet. The customer may pay via the Internet. Several students, who all happen to be members of the same student organization on campus, are claiming that using Campus Fast has allowed their identity to be stolen. One student is claiming that she had $12,000 of charges on her credit card to the unsecured Internet site of Campus Fast. Management plans to pay off the complaining students and keep the true liability off the balance sheet. The reason is Campus Fast is concerned that an interested buyer may become concerned about the unsecured site and might get scared by the student complaints.

2) The company guarantees fast delivery. It has offered to pay any speeding or other moving violation tickets to its delivery drivers. Unfortunately, one of the drivers was involved in an accident due to running a red light. The passenger in the other car is in critical condition and the intensive care unit in the hospital. The driver has promised the family of the passenger that the company will make good on any expenses and admitted the company policy on repaying all traffic tickets. Attorneys for the injured party are threatening to sue and publicize the situation. The founders do not have enough cash to take care of this problem but are still trying to keep the situation from the auditors and potential buyer.

Using the internal control framework assess the internal controls at Campus Fast and risk environment.

Report of the Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders, XYZ Company
We have audited the accompanying consolidated financial statements of XYZ Company and its subsidiaries, which comprise the consolidated balance sheets as of December 31, 2015 and 2014, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for the years then ended, and the related notes to the financial statements. These statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

Management’s Responsibility for the Financial Statements

Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, whether due to fraud or error.

Auditor’s Responsibility

Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards of the Public Company Accounting Oversight Board. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement.

An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the management’s judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal controls relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by during the audit, as well as evaluating the overall presentation of the consolidated financial statements.

We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.

Opinion

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of XYZ Company and its subsidiaries as of December 31, 2013, and 2012, and the results of its operations and its cash flows for the years then ended in accordance with auditing standards of the Public Company Accounting Oversight Board.

Optional Paragraph

Report on Other Legal and Regulatory Requirements

[Auditor’s signature]

[Auditor’s city and state]
 

One of the older and more basic concepts in fraud deterrence and detection is the “fraud triangle.” While researching his doctoral thesis in the 1950s, famed criminologist Donald R. Cressey came up with this hypothesis to explain why people commit fraud.

The three key elements in the fraud triangle are opportunity, motivation, and rationalization. Opportunity is the element over which business owners have the most control. Limiting opportunities for fraud is one way a company can reduce it.

The opportunity to commit fraud is possible when employees have access to assets and information that allows them to both commit and conceal fraud typically because of weak internal controls including a lack of segregation of duties or oversight. Top management typically overrides the controls when committing financial statements fraud while employees may use the weaknesses to their advantage in perpetrating fraud.

Motivation is a pressure or a “need” felt by the person who commits fraud. It might be a personal financial or other type of need, such as high medical bills or debts, or as a result of bad personal habits as occurred in ZZZZ Best and Tyco where CEOs misappropriated company resources for personal gain.

Motivators can also be financial oriented that affects business results. Pressures may exist to meet or exceed financial analysts’ earnings estimates or to qualify for high bonuses and/or to inflate share prices and make stock options more valuable.

Lastly, employees may rationalize this behavior by determining that committing fraud is OK for a variety of reasons. For those who are generally dishonest, it’s probably easier to rationalize a fraud. For those with higher moral standards, it’s probably not so easy. They have to convince themselves that fraud is OK with “excuses” for their behavior.

Common rationalizations include making up for being underpaid or replacing a bonus that was deserved but not received. A thief may convince himself that he is just “borrowing” money from the company and will pay it back one day. Some embezzlers tell themselves that the company doesn’t need the money or won’t miss the assets. Others believe that the company “deserves” to have money stolen because of bad acts against employees.

Business owners and executives must take control of fraud by working on the portion of the fraud triangle over which they have the most control: the opportunity to commit fraud. It may be difficult for management to do anything about an employee’s needs or rationalizations, but by limiting opportunities for fraud, the company can reduce it to some extent.

This question provides an opportunity to review the GVV reasons and rationalizations framework.

As you read the case, think about the following series of questions for the protagonist to address after identifying the right thing to do including:

• How can they get it done effectively and efficiently?
• What do they need to say, to whom, and in what sequence?
• What will the objections or push-back be and, then,
• What would they say next? What data and examples do they need?
To assist you in the process of analyzing what actions should be taken by the protagonist, here are the most frequent categories of argument or rationalization that we face when we speak out against unethical practice.

Expected or Standard Practice: “Everyone does this, so it’s really standard practice. It’s even expected.”

Materiality: “The impact of this action is not material. It doesn’t really hurt anyone.”

Locus of Responsibility: “This is not my responsibility; I’m just following orders here.”

Locus of Loyalty: “I know this isn’t quite fair to the stakeholders, but I don’t want to hurt my reports/team/boss/company.”

Isolated Incident: “This is a one-time request; you won’t be asked to do it again.”

Prior to SOX, most boards of directors were not independent of management and, in many cases including Tyco, board members were beholden to management for their positions. It was highly unlikely the board served as a check on unethical behavior or fraudulent financial statements. SOX requires an independent audit committee with one member being a financial expert. The New York Stock Exchange requires a majority of board members to be independent of management. These outside directors should meet separately with the internal auditors and external auditors to get candid comments about management’s performance, whether the internal controls are operating as intended, and whether the financial statements are accurate and reliable. PCAOB Standard No. 16 also requires specific communications between the external auditors and the audit committee. Corporate governance has been tightened up in almost all companies thereby making it less likely that, at least in the corporate governance arena, the opportunity will exist to commit fraud.

Another factor that influences opportunity is organizational dissonance. Dissonance creates an unhealthy organizational culture that can lead to fraud because employees so affected feel more justified in committing fraud. When organizational ethics are low and an individual’s ethics are low, fraud is more likely to occur. On the other hand, if organizational ethics are high while an individual’s are low, there must be mechanisms built into the corporate governance system such as a hot line and/or compliance officer to monitor ethical systems. Other employees should be encouraged to speak up when they notice another employee violating ethical standards. The hot line helps in that regard.

(a) Unmodified opinion
(b) Unmodified opinion with an emphasis-of-matter paragraph
(c) Qualified opinion
(d) Adverse opinion
Unmodified Opinion

Unmodified opinions are given when the financial statements present fairly financial position and results of operations in accordance with GAAP and there are no material misstatements that need to be corrected to conform to GAAP.

Unmodified opinion with an emphasis-of-matter paragraph

An emphasis-of-matter issue arises when questions exist about the going concern nature of a client’s operations perhaps because of a declining level of earnings, lack of adequate cash flows to meet operating needs, and/or the inability of the client to raise needed funds. When a going concern issue exists, the auditor should address management’s plans to overcome the problem in the future in the audit report.

An emphasis of matter issue also exists when GAAP have not been consistently applied. For example, if a company changes the way they account for capitalized costs, such as capitalizing them in one year and then expensing them in another, the change should be disclosed as well as its effects of the financial results. Auditors should approve such changes; otherwise, a modified opinion may be necessary.

Qualified opinion

A qualified opinion is generally given when a departure exists from GAAP that has a material effect on the financial statements. The amount must be material but event(s) not pervasive enough to issue an adverse opinion. If, in the previous example, a company was capitalizing costs instead of expensing them in order to improve earnings, then a GAAP deficiency exists and should be disclosed if it has a material effect on the financial statements. GAAP issues are disclosed in the audit report with language “except for the GAAP departure…the financial statements present fairly…”

A qualified opinion also may be necessary when a scope limitation exists that prevents the auditor from evaluating whether a GAAP deficiency exists. In such cases the language would be “except for the scope limitation…the financial statements present fairly…”

Adverse opinion

An adverse opinion means the financial statements do not present fairly financial position and results of operations because material differences exist on GAAP matters that have a pervasive effect on the financial statements. For example, inventory differences over a period of time will affect both the balance sheet and income statements through both the beginning and ending inventories. If two or more differences on GAAP matters exist, then the effects also may be pervasive. When such differences exist, the reasons for the adverse opinion must be given.

The PCAOB has no jurisdiction over audit committees, so PCAOB Auditing Standard 16, Communications with Audit Committees, has requirements which are aimed strictly at external auditors. The standard requires auditors to:

• Establish the understanding of the terms of the audit engagement with the audit committee. The terms of the engagement must be recorded in an engagement letter.
• Provide audit committees with an overview of the overall audit strategy, including the timing of the audit, significant risks the auditor identified, and significant changes to the planned audit strategy or risks.
• Provide information about others involved in the audit, including internal auditors or other independent public accounting firms.
• Give information regarding the company’s accounting policies, practices, estimates, and significant unusual transactions.
• Provide an evaluation of the quality of the company’s financial reporting, including conclusions regarding critical accounting estimates and the company’s financial statement presentation; difficult or contentious matters for which the auditor consulted outside the engagement team; the auditor’s evaluation of the company’s ability to continue as a going concern; and difficulties encountered in performing the audit.

Given the importance of an independent audit in detecting fraud in financial statements, the auditor should discuss with the audit committee relationships that create threats to auditor independence and the related safeguards that have been applied to eliminate or reduce those threats to an acceptable level.

Another important area for communication is about accounting estimates. Certain accounting estimates are particularly sensitive because of their significance to the financial statements and because of the possibility that future events affecting them may differ significantly from management’s current judgments. In communicating with those charged with governance about the process used by management in formulating sensitive estimates, including fair value estimates, and about the basis for the auditor’s conclusions regarding the reasonableness of those estimates, the auditor should consider the following:

• The nature of significant assumptions
• The degree of subjectivity involved in the development of the assumptions, and
• The relative materiality of the items being measured to the financial statements as a whole.

If the auditor, as a result of the assessment of the risks of material misstatement, has identified such risks due to fraud that have continuing control implications the auditor should consider whether these risks represent significant deficiencies or material weaknesses in the entity’s internal controls that should be communicated to management and those charged with governance. The auditor should also consider whether the absence of or deficiencies in controls to prevent, deter, and detect fraud represent significant deficiencies or material weaknesses that should be communicated to management and those charged with governance.

1) The company has been using free, unsecured public WiFi to take orders via the Internet. The customer may pay via the Internet. Several students, who all happen to be members of the same student organization on campus, are claiming that using Campus Fast has allowed their identity to be stolen. One student is claiming that she had $12,000 of charges on her credit card to the unsecured Internet site of Campus Fast. Management plans to pay off the complaining students and keep the true liability off the balance sheet. The reason is Campus Fast is concerned that an interested buyer may become concerned about the unsecured site and might get scared by the student complaints.

2) The company guarantees fast delivery. It has offered to pay any speeding or other moving violation tickets to its delivery drivers. Unfortunately, one of the drivers was involved in an accident due to running a red light. The passenger in the other car is in critical condition and the intensive care unit in the hospital. The driver has promised the family of the passenger that the company will make good on any expenses and admitted the company policy on repaying all traffic tickets. Attorneys for the injured party are threatening to sue and publicize the situation. The founders do not have enough cash to take care of this problem but are still trying to keep the situation from the auditors and potential buyer.

Using the internal control framework assess the internal controls at Campus Fast and risk environment.
The students should discuss the control environment of Campus fast (founders’ intent on making goals) risk assessment (two potential contingent and actual liabilities that the founders are trying to cover up and keep off the balance sheet), control activities, information and communications systems (liability of using unsecured WiFi), and monitoring. Corporate governance issues exist although we do not know whether oversight mechanisms were in place to serve as a check on management behavior.

This is a case where the two students suffered from ethical blindness. They did not consider that their policies and practices had (negative) consequences for the stakeholders and cutting corners to achieve a goal is never a good idea. There appears to be no oversight of the internal controls. The culture of the company seems to be do whatever it takes to grow and become an attractive IPO candidate. The owners are acting out of egoism and practicing dangerous advertising and delivery systems. It could be that the culture filters down to the workers who are careless in making deliveries and, perhaps, with Internet activity.

Report of the Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders, XYZ Company
We have audited the accompanying consolidated financial statements of XYZ Company and its subsidiaries, which comprise the consolidated balance sheets as of December 31, 2015 and 2014, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for the years then ended, and the related notes to the financial statements. These statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

Management’s Responsibility for the Financial Statements

Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, whether due to fraud or error.

Auditor’s Responsibility

Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards of the Public Company Accounting Oversight Board. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement.

An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the management’s judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal controls relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by during the audit, as well as evaluating the overall presentation of the consolidated financial statements.

We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.

Opinion

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of XYZ Company and its subsidiaries as of December 31, 2013, and 2012, and the results of its operations and its cash flows for the years then ended in accordance with auditing standards of the Public Company Accounting Oversight Board.

Optional Paragraph

Report on Other Legal and Regulatory Requirements

[Auditor’s signature]

[Auditor’s city and state]
Deficiencies

• Title should be Independent Auditor’s Report
• Introductory Paragraph is not labeled
• Responsibilities of management and the auditor are included in the introductory paragraph not in the separate Management’s Responsibility for the Financial Statements paragraph.
• Reference in Management’s Responsibility section to PCAOB standards should be replaced with generally accepted in the United States of America.
• Auditor’s Responsibility section indicates it is management’s judgments as to which auditing procedures are selected; it should say auditor’s judgment
• The statement in the Auditor’s Responsibility section “In making those risk assessments, the auditor considers internal controls relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances” fails to include: but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal controls. This makes it seem the report also opines on internal controls.
• Related to the point above, the following statement is omitted after the sentence in the point: “Accordingly, we express no such opinion.”
• Reference to “reasonable estimates made” in the last sentence of the Auditor’s Responsibility paragraph indicates those estimates are made by the auditors; it should be management.
• The opinion paragraph refers to PCAOB standards not accounting principles generally accepted in the United States of America.
• Date of auditor’s report is omitted 

The following is taken from a response issued by the Center for Audit Quality (CAQ) to the PCAOB proposal.
 
 Due to the dynamic nature, inherent complexity, and variability of public companies and their audits, audit quality indicators (AQIs) alone (whether input or output measures) without context cannot adequately communicate factors relative to the audit of any particular engagement or firm. However, the right AQIs as determined by the audit committee could provide perspective on factors that may contribute to or detract from audit quality. Quantitative AQIs can only inform this perspective when accompanied by appropriate context. The context is best achieved through dialogue between the audit engagement team and the audit committee.
 
 Given this need for context through dialogue, and the audit committee’s important audit oversight role on behalf of investors, the CAQ believe that the right set of AQIs as determined by the audit committee can help promote and enhance the audit committee’s and auditor’s focus on audit quality. The audit committee is best positioned to receive, interpret, and ultimately respond, if necessary, based on the information provided by AQIs.
 
 The CAQ believes that AQIs should be used and reported voluntarily given that the development of AQIs is in the early stages. Furthermore, there is insufficient evidence of the correlation between any one set of AQIs and audit quality outcomes. A voluntary approach would give audit committees the most flexibility and opportunity both to tailor the information to matters that are most relevant to their oversight and to engage in the necessary two-way dialogue that can provide the appropriate context to enable them to interpret the AQIs and ultimately respond if necessary. Moreover, mandating the communication or reporting of specific AQIs could burden audit committees with required communication of AQIs which may not be relevant to the particular facts and circumstances of their audit engagement.
 
 CAQ also believes that mandatory public reporting of AQIs is not appropriate due to the early-stage nature of AQI concepts and the necessity of the contextual discussion to interpreting AQIs. AQIs are a data point or collection of data points that may be directional in nature. Any AQI or set of AQIs needs to be evaluated in their complete context. As a result, CAQ concludes that focusing efforts on providing the audit committee with additional information about the audit is a prudent step with respect to any AQI effort to (1) allow the audit committee to determine what information is relevant to their oversight of the audit, (2) take into account the audit’s particular facts and circumstances and (3) allow for the two-way dialogue that is necessary to put the AQIs into context.
 
 Also, CAQ is concerned that mandatory public reporting may create a perception that an arbitrarily selected measurement, or a range of measurements, could serve as a “benchmark.” For instance, a ratio of audit partners to staff varies from audit engagement to audit engagement. Staffing decisions require context and principally reflect the auditor’s judgment. The engagement team’s dialogue with the audit committee allows the audit committee to consider whether the ratio is appropriate based on the specific facts and circumstances; without this context and dialogue, one might erroneously presume that a particular number is more indicative of audit quality.