Focuses on financial statement fraud. As you read about ABC Company below, think about ways in which you think financial statement fraud may be occurring.
ABC Company manufactures and sells software packages to small businesses. The company has enjoyed great success since it began business in 1998. Last year, the firm doubled its revenues, and its management is now looking closely at going public by making an initial public offering (IPO) next September. Senior management has been putting a lot of effort into further increasing sales by offering the company's sales representatives a generous commission as an incentive to increase their selling efforts.
The CFO, CEO, and the COO of the company have been in business together for 20 years. Two of them were high school "buddies," and the other joined the threesome in college. They still interact socially with one another, and their respective wives are also close.
In completing a background check on the company, you find that the company has a positive relationship with private investors, who are excited about the proposed IPO next September. One of the investors did inform you, however, that the company changed auditors last year because of a dispute the CEO had with the audit partner regarding some "strict revenue recognition rule."
The company has a board of directors and audit committee that meets twice a year to discuss how the business is doing. The board has decided to meet four times over the next year, because it may be necessary to discuss issues regarding the upcoming IPO. The board seems to speak highly of management and compensates them generously with stock options for their "good work".
What are two of the red flags that indicate that financial statement fraud may be occurring (try to choose two that have not already been identified)? For each red flag you identify explain why it is a red flag (don't simply provide a list of red flags).