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The PCAOB recently released a concept statement on audit quality indicators (PCAOB Release No. 2015-005). In it they list 28 potential indicators of audit quality. One of those 28 indicators is “Fraud and other Financial Reporting Misconduct”. In an appendix, they list the following ways that they think fraud related metrics might serve as indicators of good or bad audit quality:
- Number of significant deficiencies or material weaknesses in controls designed to address the risk of material misstatement due to fraud, raised by the audit firm in the absence of an error or fraud that has already occurred.
- Number and severity of material or immaterial errors in financial reporting from fraud or other financial reporting misconduct discovered by the audit firm early enough to avoid errors in published financial statements.
- Number of restatements for errors resulting from fraud or other financial reporting misconduct with no previously reported material weakness in internal control.
- Number and severity of material errors in financial reporting from fraud or other financial reporting misconduct that the audit firm did not detect prior to restatements of financial statements.
Based on our fraud discussions and cases this semester, analyze the reasonableness of, and deficiencies in, the suggested metrics.
Question 2: Benford’s Law
Part A: For each of the following three fraud scenarios, discuss whether and why a fraud investigation using Benford’s Law would be appropriate:
An employee is submitting numerous fake purchase orders and pocketing the cash.
The company has attempted to overstate revenues by recording numerous sales from the first week of the following year as sales in the current year.
The company has attempted to hide significant debt by omitting the monthly payments from the accounting records.
Part B: A forensic technique that is starting to become very popular is the application of Benford’s Law to the overall financial statements (i.e., Balance Sheet, Income Statement, Cash Flow Statement, notes, etc.) rather than to individual transaction records. As you have seen in this class, financial statements for real companies tend to be pretty large, and on average have several hundred numbers in them if the notes are included. This technique has recently come under criticism. Two of the complaints are (1) that any given financial statement number is usually the aggregate of other numbers (for instance, the balance in Accounts Receivable is the aggregate of all of the underlying receivables from customers); and (2) that tests on financial statements usually use data which has been re-scaled for easy comparison (e.g., all amounts divided by the company’s total assets, or total sales). Required: Discuss the validity of these two criticisms.
Discuss how an analysis of the non-cash component(s) of a company’s earnings can be used to identify red flags for financial statement fraud.