All appeared well at Comptronix Corporation; a Guntersville, Alabama based electronics company; until word hit the streets November 25, 1992 that there had been a fraud. When reports surfaced that three ofthe company’s top executives had inflated company earnings for the past three years, the company’s stock price plummeted 72% in one day, closing at $61/8 a share down from the previous day’s closing at $22 a share.1 The Securities and Exchange Commission’s (SEC) subsequent investigation determined that Comptronix’s chief executive officer (CEO), chief operating officer (COO), and controller/ treasurer all colluded to overstate assets and profits by recording fictitious transactions. The three executives overrode existing internal controls so that others at Comptronix would not discover the scheme. All this unraveled when the executives surprisingly confessed to the company’s board that they had improperly valued assets, overstated sales, and understated expenses. The three were immediately suspended from their duties.

Within days, class action lawsuits were filed against the company and the three executives. Immediately, the company’s board of directors formed a special committee to investigate the alleged financial reporting fraud, an interim executive team stepped in to take charge, and Arthur Andersen, LLP was hired to conduct a detailed fraud investigation.

Residents of the small Alabama town were stunned. How could a fraud occur so close to home? Were there any signs of trouble that were ignored?

BACKGROUND Comptronix based its principal operations in Guntersville, a town of approximately 7,000 residents located about 35 miles southeast of Huntsville, Alabama. The company provided contract manufacturing services to original equipment manufacturers in the electronics industry. Its primary product was circuit boards for personal computers and medical equipment. Neighboring Huntsville’s heavy presence in the electronics industry provided Comptronix a local base of customers for its circuit boards. In addition to the Alabama facility, the company also maintained manufacturing facilities in San Jose, California, and Colorado Springs, Colorado. In total, Comptronix employed about 1800 people at the three locations and was one of the largest employers in Guntersville.
The company was formed in the early 1980s by individuals who met while working in the electronics industry in nearby Huntsville. Three of those founders became senior officers of the company. William J. Hebding became Comptronix’s chairman and CEO, Allen L. Shifflet became Comptronix’s president and COO, and J. Paul Medlin served as the controller and treasurer. Prior to creating Comptronix, all three men worked at SCI Systems, a booming electronics maker. Mr. Hebding joined SCI Systems in the mid-1970s to assist the chief financial officer (CFO). While in that role, he met Mr. Shifflet, the SCI Systems operations manager. Later, when Mr. Hebding become SCI Systems’ CFO, he hired Mr. Medlin to assist him. Along with a few other individuals working at SCI Systems, these three men together formed Comptronix in late 1983 and early 1984.2 The local townspeople in Guntersville were excited to attract the startup company to the local area. The city enticed Comptronix by providing it with an empty knitting mill in town. As an additional incentive, a local bank offered Comptronix an attractive credit arrangement. Comptronix in turn appointed the local banker to its board of directors. Town business leaders were excited to have new employment opportunities and looked forward to a boost to the local economy.
The early years were difficult, with Comptronix suffering losses through 1986. Local enthusiasm for the company attracted investments from venture capitalists. One of those investors included a partner in the Massey Burch Investment Group, a venture capital firm located in Nashville, Tennessee, just more than 100 miles to the north. The infusion ofventure capital allowed Comptronix to generate strong sales and profit growth during 1987 and 1988. Based on this strong performance, senior management took the company’s stock public in 1989, initially selling Comptronix stock at $5 a share in the over-the-counter markets.3.............

REQUIRED [1] Professional auditing standards present the audit risk model, which is used to determine the nature, timing, and extent of audit procedures. Describe the components of the model and discuss how changes in each component affect the auditor’s need for evidence.
[2] One of the components of the audit risk model is inherent risk. Describe typical factors that auditors evaluate when assessing inherent risk. With the benefit of hindsight, what inherent risk factors were present during the audits of the 1989 through 1992 Comptronix financial statements?
[3] Another component of the audit risk model is control risk. Describe the five components of internal control. What characteristics of Comptronix’s internal control increased control risk for the audits of the 1989 - 1992 year-end financial statements?
[4] The board of directors, and its audit committee, can be an effective corporate governance mechanism.
[a] Discuss the pros and cons of allowing inside directors to serve on the board. Describe typical responsibilities of audit committees.
[b] What strengths or weaknesses were present related to Comptronix’s board of directors and audit committee?
[5] Public companies must file quarterly financial statements in Form 10-Qs, that have been reviewed by the company’s external auditor. Briefly describe the key requirements of Auditing Standards (AU) Section 722, Interim Financial Information. Why wouldn’t all companies (public and private) engage their auditors to perform timely reviews of interim financial statements?
[6] Describe whether you think Comptronix’s executive team was inherently dishonest from the beginning. How is it possible for otherwise honest people to become involved in frauds like the one at Comptronix?
[7] Auditing Standards (AU) Section 316, Consideration of Fraud in a Financial Statement Audit, notes that three conditions are generally present when fraud occurs. Research the authoritative standards for auditors (which are available for free on the AICPA’s Web site organized by both SAS or AU - www.aicpa.org) and provide a brief summary of each of the three fraud conditions. Additionally, provide an example from the Comptronix fraud of each of the three fraud conditions.
[8] Auditing Standards (AU) Section 316, Consideration of Fraud in a Financial Statement Audit, notes that there is a possibility that management override of controls could occur in every audit and accordingly, the auditor should include audit procedures in every audit to address that risk.
[a] What do you think is meant by the term “management override”?
[b] Provide two examples of where management override of controls occurred in the Comptronix fraud.
[c] Research AU Section 316 to identify the three required auditor responses to further address the risk of management override of internal controls.