When a Potential Accounting Fraud Arises: The Responsibilities of the Entity, Auditors and Lawyers - Jeffrey L. Johanns
CASE
Company Profile
Consumer Products Company (CPCo or the Company) is a public company listed on a major United States stock exchange which manufactures and sells various consumer products. The Company has a long, successful track record of selling its products domestically and internationally to retailers through a network of established distributors. CPCo is audited by a "Big 4" accounting firm and has never had a material error requiring restatement in previously issued financial statements.
As part of its strategic expansion plan, CPCo develops a new product in an attempt to compete in the fast growing fitness industry. The new product is a wearable activity tracker, branded as the "Shapeup". In connection with the launch of Shapeup, CPCo enters into an agreement with a newly-formed distribution company (NewDistributor). Under the agreement, NewDistributor will buy Shapeup products from CPCo and then resell the products to retailers.
CPCo has no equity ownership interest in NewDistributor. NewDistributor is a thinly-capitalized entity owned by a single stockholder.
During the first year of the Shapeup launch, CPCo recognizes material amounts of revenue and gross profit from sales to NewDistributor and highlights the success of the launch of Shapeup on conference calls with analysts and investors.
The Critical Accounting Policies
Revenue Recognition:
CPCo discloses in its financial statements that it recognizes revenue in accordance with SEC Staff Accounting Bulletin 104 (SAB 104). Under SAB 104, revenue is recognized when (i) Persuasive evidence of an arrangement exists (ii) Delivery has occurred or services have been rendered (iii) The Seller's price to the buyer is fixed or determinable and (iv) Collectability is reasonably assured. CPCo states that all four criteria are met for revenue recognition when its products are shipped from its warehouses. In accordance with this policy, revenue for Shapeup is recognized when shipped to NewDistributor.
Consolidation of Variable Interest Entities (VIEs).
Under US GAAP (ASC 810), a reporting entity must consolidate any entity in which it has a controlling financial interest. Under the voting interest model, generally the investor that has voting control (usually more than 50 percent of an entity's voting interests) consolidates the entity. Under the VIE model, the party that has the power to direct the entity's most significant economic activities and the ability to participate in the entity's economics consolidates the entity. This party could be an equity investor, some other capital provider, or a party with contractual arrangements. An entity is considered a VIE if it possesses one of the following characteristics: (i) the entity is thinly capitalized (ii) residual equity holders do not control the entity (iii and iv) equity holders are shielded from economic losses or do not participate fully in an entity's residual economics or (v) the entity was established with non-substantive voting interests.
CPCo does not consolidate any of its distributors in its financial statements because the Company's conclusion is (i) they do not have any voting interest in the distributor; (ii) they do not have the power to direct any distributor's activities; and (iii) they do not participate in the distributors' economics.
The Relevant Auditing Standards
In connection with planning and performing the annual audit of CPCo, the Big 4 engagement team follows the interim Auditing Standards issued by the PCAOB (available at www.pcaobus.org). Relevant standards considered by the engagement team include the following:
AU 316 Consideration of Fraud in a Financial Statement Audit
AU 317 Illegal Acts by Clients
AU 561 Subsequent Discovery of Facts Existing at the Date of the Auditor's Report
Part I - The Initial Allegations
Not long after the public disclosures by CPCo regarding the successful launch of Shapeup, articles and posts begin to appear in the business press and on social media questioning Shapeup's actual success in the marketplace, including questions regarding how many sales of the product are actually being made by NewDistributor to retailers and from retailers to end consumers (after sale of Shapeup by CPCo to NewDistributor). Allegations are made that (a) NewDistributor is actually controlled by CPCo and (b) revenue from sales of Shapeup to NewDistributor should not be recognized upon shipment because of the issue of control of NewDistributor by CPCo and/or the existence of extended (and perhaps contingent) payment terms between CPCo and NewDistributor.
The allegations made in blogs are general in nature, providing few specific details supporting the allegations. Management of CPCo actively denies that NewDistributor is controlled by CPCo and maintains that its revenue recognition policies fully comply with SAB 104.
Required
Part I: Based only upon the information known as described in Part I, answer the following questions:
1. What are the responsibilities of CPCo's (a) management and (b) audit committee in response to the allegations of improper accounting (potential fraud)? In other words, what actions, if any should be taken upon becoming aware of the initial general allegations?
2. What are the responsibilities of CPCo's external auditors? Do the allegations impact the auditor's previously issued reports or current year audit procedures, including fraud related procedures?
3. Although you are not attorneys, what advice would you expect external securities legal counsel to be providing to management and the audit committee at this point?
Part II - The Stock Exchange Becomes Interested
Approximately six months after the initial allegations surface, the major exchange upon which CPCo's stock is listed and traded becomes aware of the allegations in the press and on social media and asks CPCo to respond in writing and in person to the allegations. CPCo's management provides a response letter and a meeting is held with the stock exchange at the exchange's offices to discuss the letter. The Company defends its previously stated positions regarding each issue and asserts that no changes in previously reported results of operations, balance sheet presentation or disclosures are required in their financial statements.
Required
Part II: Based on the new major development that the Company's stock exchange has become involved and requested a written and in-person response, answer the following questions:
1. Have the responsibilities of CPCo's management or audit committee changed? What should management do to prepare the written response to the stock exchange - e.g. investigate the allegations further? Who might perform an investigation?
2. Have the responsibilities of the Company's external auditor changed from Part I?
3. What role, if any, should the Company's external legal counsel play in connection with drafting the response and/or attending the meeting with the exchange?
Part III - The Whistleblower
The Company's response to the inquiry from the stock exchange is deemed satisfactory by the exchange and results in the exchange closing its inquiry into the matter without any action taken. CPCo publicly announces that the inquiry by the exchange has been closed. Following the public announcement, a whistleblower sends a series of faxes directly to the Company's external auditor. The faxes repeat the general allegations outlined in Part I, plus provide some new specific details underlying the allegations which name the CEO and CFO as directly involved. Specific details contained in the faxes include the following:
• Shipments from CPCo to NewDistributor significantly exceeded amounts which could be resold by NewDistributor to retailers within any reasonable period of time (a practice referred to as "channel stuffing"). These shipments were directed to be made by CPCo's CEO and CFO with full knowledge that the shipments exceeded amounts required by NewDistributor in the normal course of its business.
• NewDistributor was granted payment terms with due dates of six months or longer after receipt of products. (Note: The Company's normal payment terms for other products and distributors are net 30 days.) In some instances, payment to CPCo was not required until after NewDistributor was paid by retailers for the products.
• If retailers had any issues relating to the products, they were instructed to call a telephone number which they believed was for NewDistributor's offices. In fact, it was actually a CPCo telephone number and the personnel answering the phone were actually CPCo employees, not NewDistributor employees.
The Company's reaction is that the information sent to the auditor is "old news" involving issues already adequately addressed by the Company.
Required
Part III: Based on the additional facts that the Company's auditor has received notice of the allegations directly along with specific details supporting the allegations, answer the following questions:
1. What should the auditor do upon receipt of the faxes and supporting documentation from the whistleblower?
2. Should the Company investigate further, considering their view that the information provided to the auditor is "old news" already addressed in their response to the stock exchange's investigation? Be specific in your discussion of potential investigation procedures which might be undertaken by the Company.
3. What advice do you think external legal counsel should provide to the Company considering these new developments?
References:
DiBianco, G. and Lawrence A. 2006. Investigation and Reporting Obligations under 10A of the Securities Exchange Act: What Happens when the Whistle is Blown?
Securities Fraud National Institute (September 29, 2006)
Audit Committee Leadership Network in North America. 2010. ViewPoints. The audit committee's role in overseeing investigations. (Issue 30: March 23, 2010).
PwC, LLP. 2015. Audit Committee Excellence Series. Achieving excellence: Dealing with investigations. (June 2015)
The Institute of Internal Auditors. Managing the Business Risk of Fraud: A Practical Guide. (Section 5: pp. 39-44).