PROFESSIONAL JUDGMENT IN CONTEXT Examples of Fraud in Organizations Milwaukee-based Koss Corporation

PROFESSIONAL JUDGMENT IN CONTEXT

Examples of Fraud in Organizations

Milwaukee-based Koss Corporation reported an embezzlement of funds orchestrated by its CFO of approximately $31 million over a five-year period of time when the company’s reported earnings were only $26 million. The CFO used the funds to buy personal goods, such as expensive coats, jewelry, and other personal items that were mostly kept in storage facilities. Interestingly, the CFO was neither an accountant nor a CPA; the CEO had a college degree in anthropology; most of the board members had served on the board for 20-30 years; and the company made highly technical products that were in very competitive markets. In another recent fraud, a senior benefits executive at Hitachi America, Inc. diverted approximately $8 million from Hitachi by creating a separate bank account that included the Hitachi name, but that was controlled by him. The funds that were diverted included payments from health providers and insurance companies intended for the Hitachi’s employee benefit plans. The executive used the $8 million in the new account to purchase an expensive vacation home and a new Lexus automobile, among other items. In addition to outright thefts, fraud can also involve inaccurate financial reporting. For example, WorldCom orchestrated its fraud, in part, by capitalizing items that should have been recorded as expenses, thereby increasing current-period income. Charter Communications inflated revenue by selling control boxes back to its supplier and then repurchasing them later. Dell, Inc. admitted to manipulating its reported income by not accurately disclosing payments that it received from computer chip maker Intel. The payments were in exchange for Dell’s agreement not to use chips from Intel’s rival, Advanced Micro Devices. These payments accounted for 76% of Dell’s operating income in early 2007. Dell also covered earnings shortages by dipping into reserves and claimed the seemingly strong financial results were due to high quality management and efficient operations. Fraudulent financial reporting can also involve financial-related reports that are not a formal part of the financial statements. As an example, publicly traded oil companies are required to report changes in their proved reserves each year. A proved reserve is the discovery of an oil field in which the company has determined it is economically feasible to extract the oil from the field at current oil prices. The amount of proved reserves are a best estimate of the millions (or billions) of barrels of crude oil that can economically be extracted from the field. During 2004, the SEC successfully brought action against Shell Oil Company, alleging that the company had falsely reported its proved reserves in an effort to make the company look more successful and to maintain the stock price. As you read through this chapter, consider the following questions:

What are the major types of fraud? What are the major characteristics of fraud that auditors should consider? (LO 1, 2)

To what extent should the auditor be responsible for identifying the risk of fraud, and then determining whether material fraud actually exists? How can a quality audit prevent or detect these types of frauds? (LO 4)

How can society as a whole, and the external auditing profession in particular, act to prevent and detect fraud? (LO 4, 5, 6)

What is corporate governance, and how can effective corporate governance prevent these types of frauds? (LO 6)

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