Financial statement fraud

Question

A former chairman, CFO, and controller of Donnkenny, Inc., an apparel company that makes sportswear for Pierre Cardin and Victoria Jones, pleaded guilty to financial statement fraud. These managers used false journal entries to record fictitious sales, hid inventory in public warehouses so that it could be recorded as "sold," and required sales orders to be backdated so that the sale could be moved back to an earlier period. The combined effect of these actions caused $25 million out of $40 million in quarterly sales to be phony.

a. Why might control procedures listed in this chapter be insufficient in stopping this type of fraud?

b. Would an audit committee made up of representatives from senior management be effective in stopping this type of fraud?

Answer 1

a. Insufficiency of Control Procedures

Control procedures in an organization are designed to prevent, detect, and correct errors or fraud. However, they may be insufficient to stop financial statement fraud for several reasons:

1. Collusion Among Employees: The managers involved in the fraud scheme were in senior positions (chairman, CFO, and controller), which gave them significant authority and control over financial reporting processes. They could easily collude to override internal controls, circumvent established procedures, and conceal their fraudulent activities.

2. Weak Internal Controls: If internal control procedures are not robust or are poorly enforced, they may not be effective in detecting or preventing sophisticated fraud schemes. For example, if the organization does not regularly review journal entries or lacks a segregation of duties, there may be opportunities for fraud to go undetected.

3. Limited Oversight: If employees know that control procedures are not regularly monitored or enforced, they may feel emboldened to commit fraud. A lack of oversight by board members or external auditors can also create an environment where fraudulent activities can flourish.

4. Management Override: Senior management has the ability to override internal controls. Even the best systems can be compromised if top executives engage in unethical behavior, as they often have the authority to bypass checks and balances.

5. Inadequate Whistleblower Policies: If employees are afraid to report suspicious behavior due to fear of retaliation or lack faith in the reporting process, fraud may go unnoticed. Effective control procedures should include robust whistleblower protections to encourage reporting.

b. Effectiveness of an Audit Committee Made Up of Senior Management

An audit committee that is composed solely of representatives from senior management may not be effective in preventing or stopping financial statement fraud for a few key reasons:

1. Lack of Independence: An audit committee needs to be independent from the management team to provide objective oversight. If the committee consists solely of senior management, there may be conflicts of interest, and its ability to challenge or investigate the actions of its members could be compromised.

2. Groupthink: A management-dominated committee may lead to a culture of groupthink, where dissenting opinions are discouraged, and oversight may be more about maintaining consensus rather than critically evaluating financial practices.

3. Insufficient Scrutiny: Senior management may have a vested interest in the financial outcomes they report. As a result, they may lack the necessary dispassionate scrutiny required to identify and address potential fraud or irregularities in financial statements.

4. Reduced Accountability: If senior management is not held accountable by independent board members, there is a risk that they may feel emboldened to engage in fraudulent behavior, believing they can evade detection.

To be effective, an audit committee should ideally include independent members who are not part of the company's management. These individuals can provide unbiased scrutiny of financial practices and the integrity of financial statements, which is essential in detecting and preventing fraud.