Chapter 4 Homework

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Jared Dimock Forensic Accounting Professor Pettit Chapter 4: Detecting Fraud in Financial Reporting Homework Question 1: What change in auditing may have caused Enron, WorldCom, Xerox, and other fraudulent situations? The change that has caused Enron, WorldCom, and any other fraudulent situations was the gradual change in the 1980s and 1990s in how outside auditors examined customer records. Auditors were forced to reduce labor-intensive processes including analyzing millions of transactions and hundreds of corporate accounts as auditing competition grew and businesses shifted to computerized record- keeping. They worked less with account balances and entries and more with internal controls. Question 12: Why are Cynthia Cooper and Scott Sullivan significant in detecting financial reporting fraud? Cynthia Cooper and Scott Sullivan are significant in detecting financial reporting fraud is because Cynthia ended up uncovering one of the biggest accounting fraud scams in U.S. history. Scott Sullivan was in the process of executing fraud at the company of WorldCom for 3.8 billion dollars and to ensure the plan come to fruition, he told Cynthia to delay the audit. However, Cynthia did not delay the audit and thus the auditors ended up uncovering the $3.8 million in misallocated expenses and false accounting entries. This ultimately got Sullivan to get fired and was charge by the Justice Department with securities fraud and making false fillings. Question 13: What are some of the requirements for audit committees under the Sarbanes-Oxley Act? The requirements for audit committees under the Sarbanes-Oxley Act are as follows:  Each member of the audit committee of the issuer must be independent according to specified criteria and at least one member should have an accounting background;  The audit committee of each issuer must be directly responsible for the appointment, compensation, retention, and oversight of the work of any registered public accounting firm engaged for an audit report and such accounting firm must report directly to the audit committee;  Each audit committee must establish procedures for complaints on accounting, internal accounting controls, or auditing matters (e.g., a hotline);  Each audit committee must have the authority to engage independent counsel and other advisors, as it determines necessary to carry out its duties;  Each issuer must provide appropriate funding for the audit committee; and  With a few exceptions, listed issuers must be in compliance with the new listing rules by the earlier of (1) their first annual shareholders meeting after January 15, 2004, or (2) October 31, 2004.

Question 15: What are pro forma financial statements? Pro forma financial statements are made to highlight particular numbers in a company's earnings announcement to the public or to reflect a prospective change, like a merger or acquisition. Pro-forma financial statements for a corporation should be carefully analyzed by investors as the numbers may not adhere to generally accepted accounting practices (GAAP). The pro-forma values may in some situations be very different from those obtained using GAAP. Question 16: What is a red flag with respect to earnings? A declining trend in earnings is a very important warning sign when it comes to earnings. Forensic accountants must avoid focusing solely on the "bottom line" because companies are compelled to declare earnings for the previous three years in the income statement. Just as significant as the growth in earnings is the trend in operating income. Question 20: The following information is taken from the accounting records of Donald Company. Average receivables .................................. $700,000 Cost of goods sold .................................. $2,900,000 Sales ...................................................... $8,000,000 Average inventory ................................. $1,100,000 Net credit sales ...................................... $1,200,000 Operating income ..................................... $900,000 The inventory turnover is: Inventroy Turnover = Cost of GoodsSold Average Inventory Inventroy Turnover = $ 2,900,000 $ 1,100,000 = 2.64 a. 1.81 b. 2.20 c. 2.64 d. 2.92 e. None of the above

Question 24: Define these terms: a. Cooking the books. b. Cookie jar accounting. c. Bottom line. d. EBIT. e. EBITDA. f. Off-balance sheet financing g. Channel stuffing h. Bid rigging i. Big bath Answer: a. Cooking the books : An expression used to describe deceptive actions taken by businesses to fabricate their financial results. Cooking the books typically entails adding financial information to produce previously unrealized earnings. Accelerating revenues, postponing expenses, fiddling with pension schemes, and establishing synthetic leases are a few examples of accounting tricks. b. Cookie jar accounting : A dishonest accounting technique whereby profitable financial periods are utilized to build reserves that support earnings in difficult years. A business that uses "cookie jar accounting" to smooth out financial result volatility gives investors the false impression that it is routinely hitting earnings targets. Investors typically reward this consistent earnings achievement by giving the company a higher valuation. c. Bottom line : Refers to the net income, net profit, or earnings per share of a corporation (EPS). The word "bottom" refers to the position of the net income figure on an income statement of a corporation. Most businesses seek to increase their bottom lines by simultaneously increasing efficiency and revenues (i.e., top-line growth) (or cutting costs). d. EBIT (Earnings Before Interests and Taxes) : Is used to describe all net income before interest and tax payments. EBIT's ability to neutralize the effects of various capital structures and tax rates employed by various businesses is a significant factor in its widespread adoption. The figure narrows in on the company's capacity for profit and so facilitates easier cross-company comparisons by removing both taxes and interest payments. e. EBITDA (Earnings Before Interests, Taxes, Depreciation, and Amortization) : It is essentially net income with interest, taxes, depreciation, and amortization added back to it, and can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions. f. Off-balance sheet financing : A form of financing in which large capital expenditures are kept off of a company's balance sheet through various classification methods. Companies will often use off-balance-sheet financing to keep their debt to equity (D/E) and leverage ratios low, especially if the inclusion of a large expenditure would break negative debt covenants. g. Channel stuffing : A dishonest business technique used by a company to artificially inflate its sales and profit figures by sending merchants along its distribution channel more merchandise than they can really sell to customers. Distributors temporarily bolster their accounts receivables by channel stuffing. As a result of their inability to sell the extra merchandise, merchants will return it to the distributor in the form of the extra goods rather than cash, forcing it to reevaluate its accounts receivable and eventually its bottom line.

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h. Bid rigging : A plan where companies conspire to acquire a contract for goods or services at a predetermined price for a rival company. Rigging bids prevents competition on the free market since the rigged price will be excessively high. Under American antitrust law, bid rigging is prohibited by the Sherman Act of 1890. Rigging bids is a felony that carries fines, jail time, or both. i. Big bath : The tactic of altering an organization's revenue statement to make dismal results appear even worse. In a dismal year, the large bath is frequently employed to artificially boost revenues the next year. Executive bonuses could increase as a result of the significant increase in earnings. The big bath is occasionally used by new CEOs so they may place the blame for the company's bad performance on the outgoing CEO and claim credit for the improvements made the following year.