Question

ABCable, Inc. is a publicly traded cable provider. Among its current services are providing cable services, including television, Internet access and local telephone service. ABCable experienced rapid growth in all markets beginning in the late 1990s and continuing through now.

While revenues continue to grow, income is showing signs of declining to a level beneath that expected by analysts who follow the company. In an analysis of why, Sally Bens, financial vice president, discovered that maintenance of cable systems has become an increasingly large cost—particularly in new cable coverage areas. She pointed out to Bill Jones, the president, that in the relatively new areas maintenance is high, particularly when viewed from the perspective that the areas currently have few customers. Jones has suggested that it doesn’t seem right to face such high expenses when “everyone knows we will have a larger customer base in a few years in those areas.”

Shortly thereafter, Bens and Jones decided to transfer out of Cable Maintenance Expense and into the Capitalized Cable account enough of these expenses to enable net income to meet analysts’ forecasts. Documentation in some cases was created indicating a correction of an error and in some cases no documentation was created to support the entries.

Subsequently, these types of transactions were posted quarterly, on an “as needed” basis. Bens rationalized that it was indeed unfair to expense so much of the maintenance cost in rapidly growing areas. Jones didn’t give it a lot of thought other than to periodically remind Bens of how important meeting EPS growth rates was.

The above scheme does not meet generally accepted accounting principles and led to materially misstated financial statements. Under generally accepted accounting principles, these transactions should have been expensed. Thus, the ABCable overstated assets and income.

1.​Is this an example of fraudulent financial reporting or misappropriation of assets?

2.​The Institute of Internal Auditor’s guideline requires a number of inquiries of management, the audit committee, internal auditors, and others. Which, if any, individuals responding to these inquiries might be likely to reveal this scheme to the auditors?

3.​This is an example of management override. What types of procedures does IIA standard practices prescribe for management override? Which, if any, of these procedures would have a possibility of detecting the scheme?

4.​In the following given table, which fraud risk factors are present in this case? List them and cite the example from the case.

Misstatements Arising from Misappropriation of Assets

Incentives/Pressures	Opportunities	Attitude/Rationalization
1. Personal financial obligations 2. Adverse relationship between company and employees • Known or anticipated layoffs • Changes in compensation • Promotions, compensation or other rewards inconsistent with expectations	1. Characteristics of assets • Large amounts of cash on hand or processed • Small, high value, or high demand inventory items • Easily convertible assets (bearer bonds, diamonds, computer chips) • Small marketable fixed assets 2. Inadequate internal control, including inadequate: • Segregation of duties • Job applicant screening of employees with access to assets • Recordkeeping for assets • Authorization or approval of transactions • Reconciliation of assets • Documentation of transaction s(e.g., credits for merchandise returns • Requirements for mandatory vacations • Management understanding of information technology • Access controls over automated records	Attitude or behavior of those with access to assets susceptible to misappropriation • Disregard for need for monitoring or reducing risks • Disregard for internal control • Behavior indicating displeasure or dissatisfaction with company or its treatment of employees • Changes in behavior or lifestyle that indicate assets may have been misappropriated

Answer 1

1	Fraud can occur in 2 ways - Fradulent financial reporting and Misappropriation of assets. Misappropriation occurs when there is embezzlement of funds or assets due to weak controls. Fradulent financial reporting occurs when financial statements are misstated by manipulations. In the given situation, the company has decided to capitalize maintenance expenses to meet profit tragets. Hence, it is a case of fradulent financial reporting.
2	In this situation, the inquiries from management and Internal auditors should ideally receal the misstatement. The management needs to be asked about the treatment of maintenance expenses, reasons for its capitalization. Internal auditors need to understand this during their periodical audits. Hence, inquiries from them will mostly reveal this.
3	The audit procedures to be implemented to identify this are as follows: - Examining entity's financial stability or profitability - Pressure on management to meet the requirements or expectations of third parties - Management's personal finance situation affected by entity's financial performance - Perception of adverse consequences
4	Inadequate financial controls relating to documentation of transactions - Transfer of expenses into Asset account without adequate documentation Inadequate financial control relating to authorization or approval of transactions - Transfer of expenses without proper approvals