Case 1.6 NextCard, Inc.
- The 2000 audit had several fraud risk factors based on how the case unfolded. Among them is that the company never registered profits. Despite this occurrence, the company’s stock continued to increase in value with preceding financial years. The aspect should have made auditors skeptic on the nature of operations being conducted. Another fraud risk factor is that the company incurred high expenses with regards to internet advertising and acquisition of new clients. These aspects should have raised eyebrows based on the fact the company had limited access to equity and debt markets. NextCard also possessed high credit risk customers in its portfolio. Based on the company’s business model, they were more focused on quantity rather than quality. This was a risk fraud factor since the more the presence of loose credit the higher the probability of accruing bad debts. There were also skeptical inquiries by Wall Street analysts regarding the company’s financial performance. The management only made promises that profits would accrue the following financial quarters. Appointment of Oliver Flanagan as the senior audit manager; despite having a few years of experience also showcased some aspects of a fraud risk factor. It would be easy to manipulate and limit the independence of the auditor.
- AU-C section 240 asserts that the primary responsibility for detection and prevention of fraud rests with both the management and individuals charged with the responsibility to govern the entity. Section 315 asserts that auditors have the responsibility to identify material misstatements resulting from either error or fraud. This is attained by having an understanding of the company at hand and the environment of operation, including the internal controls. Steps that might have been taken by the auditors in the NextCard case in order to address the fraud risk factors is to assess the internal controls. Determining whether the internal controls are strong or weak would have helped in adopting appropriate mechanisms during the planning stage. Internal controls that can be put into consideration include segregation of duties, authorization, approval and personnel involved with various activities among others. In the case of NextCard, there did not seem to be much segregation of duties. Much of the important tasks were left on the hands of few individuals. This creates a high possibility of manipulation of various transactions. Based on the red flags, the auditors should have assembled a competent engagement team with some years of experience. This would make the implementation process swift and minimize the possibility of not detecting various misstatements contained in NextCard’s financial statements.
Case 2.5 Lipper Holdings, LLC
- There are specific fraud factors at Lipper Holdings that the auditors should have seen as red flags while conducting their activities. Among them is the fact that Lipper Holdings used insiders to value their investment portfolios instead of deploying a third party. This creates a possibility of overvaluation since the company wants to maintain a favorable image in the eyes of its investors. Another fraud factor is the appointment of Strafaci to manage large hedge funds. Initially, Lipper was managing these funds, and they were delivering the desired results. Strafaci managing these funds would come with a lot of pressure since he would be expected to replicate previous track records and maybe improve the results more. He had the responsibility of attracting more high profile clients and satisfying the existing ones. The pressure built on Strafaci would easily prompt him to indulge in manipulation of transactions in order to present what people are expecting to see. Strafaci’s resignation should have acted as a red flag to the auditors too. How does a hedge fund manager of a high profile company that is doing so well resign abruptly? This was an indication of something fishy going on. Dealing with high profile clients in such an industry also acts as a possible fraud factor. This is because the company has to impress such clients at all times since the withdrawal of even a single client would be felt based on the amounts invested.
- Among the things that the auditors should have done in order to address the fraud risk factors is to investigate the organization before accepting the auditing position. This would have helped in identifying whether Lipper Holdings had been involved in fraud cases in their past operations. As a result, the possible risk areas of the organization would have been identified. More time would be assigned to those risk areas hence make it possible to identify prospective fraud exhibited by the management. AU-C section 330 asserts that an auditor has the objective of obtaining sufficient evidence regarding risks by designing and implementing suitable responses to the risks. The auditors should have also included experts in their engagement team. These are people with sufficient knowledge regarding hedge funds. They would be well placed to identify various misstatements presented by the organization. AU-C section 336 asserts that an auditor’s education enables him or her to have general knowledge regarding business matters. Auditors are not anticipated to have the expertise of an individual that is qualified to work in a certain profession. This situation makes the inclusion of relevant experts while implementing an audit process more helpful.
Case 1.10 DHB Industries, Inc
- DHB’s case has several fraud factors including the sudden financial success that the organization experienced despite the scandals of manufacturing life threatening vests. It is usually expected that when a company is facing media scrutiny for negative reasons, the financial position tends to slump a little bit. Another fraud factor emerges when the COO and the CFO sell their stocks, which fetch very high profits. It is not normal for top-level company officials to sell a huge percentage of their stocks when the company is believed to be doing exemplary well. The prospect of making even more profits in future would act as an incentive to hold on to the stocks. Having four different auditors in a span of four years also raises eyebrows. Something might not be right somewhere and it is prompting the auditors to lose interest in continuing their engagement with the company. DHB also recalled 2003 and 2004 financial statements and warned third parties that they should not rely on the information contained in the statements. Any incoming auditor should view this as a red flag. Why should the company take the risk of executing such an action? It is likely to raise suspicion. Something big must have happened, and the company is not able to contain it.
- AS 12 requires auditors to perform risk assessment procedures for any auditing engagement that they will be involved in. In the case of DHB, an auditor should have assessed all factors that are likely to contribute to material misstatements risks. This would have helped in the planning for the audit. Understanding the company and the environment it operates in would go a long way in helping this cause. Identifying whether the internal controls are weak or strong is also paramount. Weak internal control systems are usually characterized by minimal supervision, minimal segregation of duties and management autonomous. In DHB’s case, the internal controls were weak since it took the board quite some time to realize that things were not heading in the right direction. This is was the case despite there being various red flags from the beginning. Ascertaining that the internal controls are weak would prompt the auditor to plan for a thorough review of all the relevant documents. During the planning process, the auditor should also make contact with the previous company’s auditor in order to identify why they resigned. This approach would help to find information on whether there are issues that the auditor should spend more time analyzing due to their peculiar nature. During the implementation process, the auditor should have included competent staff with some years of experience. This is because it is quite easy for inexperienced auditors to miss key issues even when they are outright.
- There usually exist a gap between the professional responsibility that an auditor has in detecting fraud and what is expected of them by the public. The primary responsibility of an auditor is not to uncover fraud, but to give an opinion whether the financial statements portray a true and fair position of the company. This means that he or she is not obliged to investigate all the transactions made by the company. It is usually the responsibility of the management to take adequate steps that help prevention of fraud. However, things are changing, and the responsibility that auditors have is becoming even more complex. If it’s a fraud being perpetrated by the management, auditors have the responsibility to plan and conduct an audit that results to reasonable assurances to relevant stakeholders. They are not blood-bound to detect fraud concealed by the management if it did not come to their attention while conducting the audit process. They are shielded from any liability that might arise if they followed the prescribed standards, sent engagement letters to clients explaining their degree of responsibility, planned for the audit, made temporary and permanent files, engaged competent staff, had an understanding of the potential risk areas among others.
- When an auditor detects aspects of illegal acts, he or she should try to seek an understanding of the circumstances within which they occurred. The auditor should inquire with the management at a higher level above those involved. If the information obtained is not sufficient, the auditor should seek the client’s legal counsel with regards to application of relevant laws. If the auditor ascertains that an illegal act has occurred after the consultation, he or she should determine the effect that it has on financial statements. This should also apply to the impact it would bring to other audit aspects. The auditor should also ensure that the audit committee is adequately informed regarding the issue before issuing an auditor’s report. If the auditor believes that the act has a material effect on the company’s financial statements, and it has not been disclosed appropriately, he or she should express an adverse or a qualified opinion.
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