522 - Exam 1 - Chapter 4 (10)

Question 1

Fraud Triangle:

Answer 1

Conditions contributing to Fraud:

1. Incentives (motivation)
2. Opportunity
3. Rationalization (excuse/justify self)

Question 2

What does the 3C’s model describe?

Answer 2

Describes the specific likelihood of FS fraud

1. Conditions (Fraud Triangle: Opportunity & Incentives)
2. Corporate Culture (Fraud Triangle: Opportunity) (ex. weak corp. governance)
3. Choice (Fraud Triangle: Incentive & Rationalization)

More Factors Present = Greater Likelihood of Fraud

Question 3

how can opportunity be created?

Answer 3

A. Management Override
1. Improper JEs
2. Misuse of discretion (think estimates)
3. Mis-accounting for unusual 1-time transactions
B. Collusion

Question 4

Examples of rationalizations

Answer 4

1. Nobody is getting hurt (the big players can afford losses)
2. The shareholders & the company will benefit
3. The situation is unique – people would understand if they knew
4. The ends justify the means – it’s for a good purpose
5. Everyone else is doing it

Question 5

Conditions that make fraud more likely:

Answer 5

1. Benefits > Costs (Given the probability of detection and possible consequences)
2. Economic pressure from downward trend in earnings
3. Downturn in organizational performance
4. Continuous decline in industry performance
5. General economic recession

Question 6

Tactical vs. Strategic management focus

Answer 6

Tactical
	- ST “fix” with no LT focus
	- “get it done” (ex. earning mgmt)
Strategic
	- LT holistic approach
	- ST + LT focus

Question 7

Conditions That Typically Signal Increased Likelihood of Fraud (15)

Answer 7

1. Poor Corp. Governance (opportunity)
   a. BoD
   a1. Ineffective BoD
   a2. Ineffective Audit Committee
   b. CEO/CFO
   b1. Dominant/little accountability
   b2. Activities are unmonitored/no executive disclosures required
2. Related-party transactions, lacking transparency and/or oversight (opportunity)
3. Internal audit ineffective
4. External auditors inexperienced, change frequently, or “too comfortable” (opportunity)
5. Unable to secure credit (pressure)
6. Unfavorable economic conditions (pressure)
7. Insufficient Cash Flows (especially if earnings growth is reported) (pressure)
8. Restrictive Loan Agreements (pressure)
9. Excessive Bad Debt Expenses (Poor AR collection) (pressure)
10. Excessive investment and/or losses (pressure)
11. Dependent on a few customers (Sales too concentrated) (pressure)

Question 8

Poor Corporate Governance Results in:

Answer 8

1. Aggressiveness and Opportunism
2. Cohesiveness and Loyalty
3. Trust and Ineffective Controls

Question 9

Purpose of IC (3)

Answer 9

Prevent
Detect
Correct

Question 10

VIEs (FASB ASC 810-10, formerly FIN 46 (Revised))

Answer 10

Off-Balance Sheet Transactions - Various Interest Entity

…an entity (the investee) in which the investor holds a controlling interest that is not based on the majority of voting rights. The importance of identifying a VIE is that a company needs to consolidate such entities if it is the primary beneficiary of the VIE.
https://en.wikipedia.org/wiki/Variable_interest_entity

Question 11

How does Corp. Culture relate to Fraud?

Answer 11

Opportunity - Certain Corporate Cultures Make Fraud More Likely

1. Effective Corporate Governance increases     probability of prevention and/or detection
2. Corporate Governance – proper accountability for managerial & financial performance

Question 12

Ways to alter Corp. Culture

Answer 12

SOX, Recent SEC Rules, Stock-Exchange Listing Standards Are Intended to Alter Corporate Cultures and to Decrease Likelihood of Fraud

Question 13

Purpose of Correction Procedures

Answer 13

1. Restate current & prior-year FS accurately
2. Assess contributing factors, in order to limit future threats
3. Restore public confidence

Question 14

General Post-Fraud Responses

Answer 14

1. Update & refine Internal Controls
2. Improve Corporate Governance
3. Institute Fraud Awareness Education program

Question 15

Fraud Awareness Education Topics on Slides (10)

Answer 15

1. Principles vs. Rules-Based Accounting
2. Fair Value Accounting
3. Off-Balance Sheet Transactions (VIEs)
4. Wall St. Analysts Have Limited Insight
5. Rating Agency System is ineffective
6. Unexpected executive resignations are NOT a good sign
7. Whistle-blowers are important sources of information
8. Objective, independent Board inquiries are a necessity
9. Ethical character can’t be faked or compartmentalized
10. Should you trust an unethical individual? Post-fraud betrayals are common in FS fraud cases