PrinciplesACC 461 Auditing Financial Statement Fraud: Lessons from the ZZZZ Best Case The video “Cooking the Books” discussed the ZZZZ Best case of fraud, it tells how and why fraud was perpetrated by Barry Minkow and why it was undetected for so long. According to the video, ZZZZ Best was founded by Barry Minkow in 1982; when he was sixteen years old, it started as a carpet cleaning company. But, due to high competition in the industry, low entry barriers, and bad internal control, this young entrepreneur started to have cash flow problems, thus creating a shortage of working capital.
As a result of the financial pressure, he started to commit fraud by creating false accounts receivable and sales, false documents (using photocopies of real documents); he also forged credit card applications, staged theft, used bogus financial statements. Moreover, he created two property management companies, and used these two companies to generate paper profit. The falsified paper profit accounted for almost 90% of ZZZZ Best’s revenue.
Discussion Questions: 1. Discuss an auditor’s responsibility for detecting material misstatement of financial statements.
An auditor must gather all information needed to identify risks of material misstatement of financial statements. They have to assess these risks after taking into account an evaluation of the company’s books, industry trends and internal control. It is also an auditor’s responsibility to gather and consider much more information to assess than they have in the past. They need to present a professional skeptical mind on their engagements, particularly during audit planning and evaluation of audit evidence. They must set aside past relationships/friendships and not assume that all clients are honest.
At the end of the audit, the auditors must make sure that they have obtained reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error. 2. Discuss typical Financial Statement Fraud. Financial statement fraud is the manipulation/falsification of the information used to prepare financial statements; that will be released to the public. The manipulation of those statements allows businesses to look attractive to investors and creditors. The majority of these frauds fall into two major categories. Manipulating Timing: In the manipulation of timing, revenues from a later period are recorded into the current period, increasing revenues for the current period. Also Expenses are recorded in later period decreasing the expenses for the current period. * Falsifying Entries: For falsifying entries, a company will enter transactions that seem to affect it accounts receivable, but when the whole transaction is considered, they do not create any gain. For example, non-revenue gains may be recorded as sales. Investment income, gains on the sale of assets will be recorded as sales revenue to make the core business appear healthy.
Items like discounts and rebates from suppliers and other non-revenue injections of money from loans will also be recorded as sales. 3. Discuss common reasons why financial statement fraud is committed Financial statement fraud is committed by individuals either by need or greed. For example, the following factors can trigger individuals or companies to falsify their financial statements thus committing fraud: * Personal pressure to pay for lifestyle and vices. * Employment pressure from contingent compensation structures, or management’s financial interest. External pressure such as threats to the business’ financial stability, financier covenants, and market expectations and competitors Also, a person who has motives to perpetrate fraud will not be able to complete his/her action without being given an opportunity. Some industry-specific factors, such as having valuable near-cash assets, can increase the organization’s vulnerability. Also they will need to rationalize the actions as justifiable. The individuals committing the fraud must first convince themselves that their behavior is acceptable or will be temporary.
For example, Barry Minkow’s believed that the lies and deceit are for the betterment of his company and that with time everything will eventually return to normal. 4. What was Barry Minkow’s primary motivation to commit financial statement fraud? Barry Minkow’s primary motivation was the fact that he needed money to pay all his debts. He had a lot of competition and there was a low margin of profit in his line of business, therefore, he needed money to keep his business running as a result he tried to get any amount of money from anywhere and anyone. He tarted using user loans-borrowing money from person A and give to person B and borrowing money from person C to pay back the loan for person B. As a result, he got himself in debts; and he started looking for ways to make his company appear more lucrative than it was. He created 10,000 phony documents to cheat creditors for money, and started his Perpetration Restoration Fraud-(making more money than really exists and borrowing more money than the company really needs to borrow) it is also called Building Excuse. He made the bankers believe, that his company had the ability to pay back the loans. 5.
How did Minkow use the competition of CPA firms to get his auditors less willing to press difficult issues? Then auditors wanted to verify ZZZZ Best financial statements, Barry Minkow would tell them that other CPA firms want to have business with his company. He would say that there are two or three other firms who have informed him that they want to audit his company. Therefore; he gave CPA firms the impression that he can easily switch to their competitor if they gave him a hard time. Also, the video stated that Barry Minkow would make a good impression to the auditors’ wives when they visit each other.
The wives think Barry Minkow was a nice boy, as a result; the auditors would not want to go against their own wives. This is a big mistake because when it comes to important issues about a company’s financial statements and audits, business should never be mixed with pleasure. 6. What was one of Minkow’s tricks when the auditors wanted to verify the customers for his non-existent restoration jobs? When the auditor wanted to check whether or not the company exists and the details of the statements, he tells the auditors that they called his customers and business associates the last time the auditors came to review his business.
And if they call them again, it would affect and hurts his business. “They would not want to have business with me anymore he says”. The auditor would stops checking the process because they do not want to be held accountable for his loss of customers/ business. He would also ask the auditor for some advice for his company and how to make the company better. He made the auditors feel good and put them in a respectful position, thus diverting their attentions from problem areas. 7. What three characteristics did Barry Minkow say the auditor should be alert to when examining a company’s balance sheet?
Barry Minkow offered the following as red flags that should alert auditors to an increased likelihood of fraud: * The company is highly leveraged; a lot of debt relative to the assets * A large proportion of the fixed assets are leased and not owned. * Unbelievable growth, if it looks too good to be true, it probably is, for example, ZZZZ Best, was in a low-margin industry, the auditors should have examined how they were growing so fast. Also; Barry Minkow notes that if growth is essential, this should be a red flag to auditors. 8. What industry trends, according to Joe Domanick, would have made the auditors suspicious?
Joe Domanick states the industry comparisons should have pointed out abnormalities, also; past and historical trends analysis would have indicated that something was quite different and wrong. For example, trend analysis; which measures changes over time in a company’s financial statements or ratio analysis; which compares different items in a company’s financial statement with other companies operating the same industry would have warned the auditors to take a careful look at ZZZZ Best method of recognizing revenue when their books showed a revenue growth than the rest of their competitors and industry.
Cite this Financial Statement Fraud: Lessons from the Zzzz Best Case
Financial Statement Fraud: Lessons from the Zzzz Best Case. (2017, Jan 06). Retrieved from https://graduateway.com/financial-statement-fraud-lessons-from-the-zzzz-best-case/