CASE 4.2 Comptronix Corporation Identifying Inherent Risk and Control Risk Factors Mark S. BEASLEY FRANK A. BUCKLESS STEVEN M. GLOVER DOUGLASE. PRAWIT LEARNING OBJECTIVES After completing and discussing this case you should be able to 19 Understand how managers can fraudulently 14 Understand the importance of effective manipulate financial statements corporate governance for overseeing the actions 12 Recognize key inherent risk factors that increase of top executives the potential for financial reporting frada Identify auditor responsibilities for addressing - Recognize key control risk factors that increase the risk of management override of internal the potential for financial reporting fraud control INTRODUCTION 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 of the 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 $6 a share down from the previous day's closing at $22 a share The Securities and Exchange Commission's (SEC) subsequent investigation determined that Comptronix's chief executive officer (CFO), chief operating officer (COO), and controller/ treasurer all colluded to overstate assets and profits by recording fictitious transactions. The three ecutives overede 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 frod, an interim executive team BOM DBDE offen BACKGROUND Comptronix based its principal operations in Guntersville, a town of approximately 7,000 residen located about 35 miles southeast of Huntsville, Alabama. The company provided contra manufacturing services to original equipment manufacturers in the electronics industry. Its primar 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 1 "Company's profit data efl, The New York Times, November 26, 1992, D.L The case was prepared by Mark S. Be h D. Frank A. Bucide, Ph.D. of North Carolina State University and Steven M. Glover, PhD. and Des . P h D. of Bigham Young w a basis for class discussion is not intended to strate the effective or effective handling of a sinistrative s on Copyright 2012 by Pearson Education, Inc., Upper Solide River, IU 07458 Section 4: Accounting Fraud and Auditor Legal Liability 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 The local townspeople in Guntersville were excited to attract the startup company to the L a mill in town. As a BODO D 1800 people at the three locations and was one of the largest employers in Guntersvine. The company was formed in the early 1980s by individuals who met while working in electronics industry in nearby Huntsville. Three of those founders became senior officers of company. William J. Hebding became Comptronix's chairman and CEO, Allen L. Shifflet bec Comptronix's president and Coo, and J. Paul Medlin served as the controller and treasurer. P to creating Comptronix, all three men worked at SCI Systems, a booming electronics maker. Hebding joined SCI Systems in the mid-1970s to assist the chief financial officer (CFO). While that role, he met Mr. Shifflet, the SCI Systems operations manager. Later, when Mr. Hebding becon SCI Systems' CFO, he hired Mr. Medlin to assist him. Along with a few other individuals working 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 th local area. The city enticed Comptronix by providing it with an empty knitting mill in town. As a additional incentive, a local bank offered Comptronix an attractive credit arrangement. Comptronis 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 of venture 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. THE ACCOUNTING SCHEME According to the SEC's investigation, the fraud began soon after the company went public in 1989 and was directed by top company executives. Mr. Hebding as chairman and CEO, Mr. Shifflett as president and COO, and Mr. Medlin as controller and treasurer used their positions of power and influence to manipulate the financial statements issued om early 1989 through November 1992 They began their fraud scheme by first manipulating the quarterly statements filed with the SEC during 1989. They misstated those statements by inappropriately transferring certain costs from cost of goods sold into inventory accounts. This technique allowed them to overstate inventory and understate quarterly costs of goods sold, which in turn overstated gross margin and net income for the period. The three executives made monthly manual journal entries, with the largest adjustments occurring just at quarter's end. Some allege that the fraud was motivated by the Loss of a key customer in 1989 to the three executives' former employer, SCI. The executives were successful in manipulating quarterly financial statements partially because their quarterly filings were unaudited. However, as fiscal year 1989 came to a close, the war that the company's external auditors might discover the fraud when auditing BD00 luse 4.2. LUIT OMX LOL The net effect of these activities was that interim financial statements included understa cost of goods sold and overstated inventories, while the annual financial statements contain overstated sales and receivables. Once they had tasted success in their manipulations of year-es sales and receivables, they later began recording fictitious quarterly sales in a similar fashion. To convince the auditors that the fictitious sales and receivables were legitimate, the thre company executives recorded cash payments to Comptronix from the bogus customer accounts. I order to do this, they developed a relatively complex fraud scheme. First, they recorded fictitiou: purchases of equipment on account. That, in turn, overstated equipment and accounts payable Then, Hebding, the chairman and CEO, and Medlin, the controller and treasurer, cut checks to the bogus accounts payable vendors associated with the fake purchases of equipment. But they did not mail the checks. Rather, they deposited them in Comptronix's disbursement checking account and recorded the phony payments as debits against the bogus accounts payable and credits against the bogus receivables. This accounting scheme allowed the company to eliminate the bogus payables and receivables, while still retaining the fictitious sales and equipment on the income statement and balance sheet, respectively. This scheme continued over four years, stretching from the beginning of 1989 to November 1992, when the three executives confessed to their manipulations. The SEC investigation noted that the Form 10-K filings for the years ended December 31, 1989, 1990, and 1991 were materially misstated as follows: 1989 1990 1991 $ 42,420 37,275 5,145 13.8% $ 70,229 63,444 6,785 10.7% $102,026 88,754 13,272 14.9% Sales (ln 000's) Reported Sales Rostated Sales Overstatement of Sales Percentage Overstatement Net Income (in 000's) Reported Not Income Restated Net Income Overstatement of Net Income Earnings Per Share (EPS) Reported EPS Restated EPS (3) Overstatement of EPS Property, Plant, & Equipment (in000's) Reported PPE Restled PPLE $ $ 1.470 (3.524) 4,994 3,028 (3.647) 6,675 $ 5,071 (3,225) 8,296 $ 19 (47) $ 35 (34) $ 18,804 13,856 $ 25,627 15,846 $ 38,720 20.303 BODO Em 03 B RIRE VIDIT UI DIOXIOUS Equity Percentage Overstatement A e 4,994 35.3% 11,669 110.4% ALEBORDE 20,898 111.3% The executives' fraud scheme helped the company avoid reporting net losses in each of the three years, with the amount of the fraud increasing in each of the three years affected. The fraud scheme also inflated the balance sheet by overstating property, plant, and equipment and stockholders' equity. By the end of 1991, property, plant, and equipment was overstated by over 90%, with stockholders' equity overstated by 111%. Information about fiscal year 1992 was not reported because the fraud was disclosed before that fiscal year ended. Section 4: Accounting Froud and Auditor Logol Liability THE COMPANY'S INTERNAL CONTROLS The three executives were able to perpetrate the fraud by bypassing the existing accounting system They avoided making the standard entries in the sales and purchases journals as required by the existing internal control, and recorded the fictitious entries manually. Other employees were excluded from the manipulations to minimize the likelihood of the fraud being discovered According to the SEC's summary of the investigation, Comptronix employees normally created a fairly extensive paper trail for equipment purchases, including purchase orders and receiving reports. However, none of these documents were created for the bogus purchases. Approval for cash disbursements was typically granted once the related purchase order, receiving report, and vendor Invoice had been matched. Unfortunately, Mr. Shifflett or Mr. Medlin could approve payments based solely on an invoice. As a result, the fraud team was able to bypass internal controls over cash disbursements. They simply showed a fictitious vendor invoice to an accounts payable clerk, who in to prepared a check for the amount indicated on the invoice Internal controls were also insufficient to detect the manipulation of sales and accounts receivable. Typically, a shipping department clerk would enter the customer order number and the entina estem The accounting BDDDD THESE E BOX E A FE #Itt invoice had been matcnea. UTILUL LUILALCHY, VA based solely on an invoice. As a result, the fraud team was able to bypass internal controls disbursements. They simply showed a fictitious vendor invoice to an accounts payable cl in turn prepared a check for the amount indicated on the invoice. Internal controls were also insufficient to detect the manipulation of sales and a receivable. Typically, a shipping department clerk would enter the customer order number quantity to be shipped to the customer into the computerized accounting system. The acca system then automatically produced a shipping document and a sales invoice. The merchand shipped to the customer, along with the invoice and shipping document. Once again, Mr. as controller and treasurer, had the ability to access the shipping department system. This a. him to enter bogus sales into the accounting system. He then made sure to destroy all sh documents and sales invoices generated by the accounting system to keep them from being mai the related customers. The subsequent posting of bogus payments on the customers' accoun posted personally by Mr. Medlin to the cash receipts journal and the accounts receivable subsi ledger The fraud scheme was obviously directed from the top ranks of the organization. Like companies, the senior executives at Comptronix directed company operations on a day-to-day b with only periodic oversight from the company's board of directors. The March 1992 proxy statement to shareholders noted that the Comptronix board directors consisted of seven individuals, including Mr. Hebding who served as board chairman. those seven individuals serving on the board, two individuals, Mr. Hebding, chairman and CEO a Mr. Shifflett, president and COO, represented management on the board. Thus, 28.6% of the boa consisted of inside directors. The remaining five directors were not employed by Comptron However, two of those five directors had close affiliations with management. One served as ti company's outside general legal counsel and the other served as vice president of manufacturing fe a significant customer of Comptronix. Directors with these kinds of close affiliations with compan management are frequently referred to as "gray" directors due to their perceived lack of objectivity The three remaining "outside directors had no apparent affiliations with company management. One of the remaining outside directors was a partner in the venture capital firm that owned 574,978 shares (5.396) of Comptronix's common stock. That director was previously a partner in a Nashville law firm and was currently serving on two other corporate boards. A second outside director was the vice chairman and CEO of the local bank originally loaning money to the company He also served as chairman of the board of another local bank in a nearby town. The third outside director was president of an international components supplier based in Taiwan. All of the board members had served on the Comptronix board since 1984, except for the venture capital partner who joined the board in 1988 and the president of the key customer who joined the board in 1990. Each director received an annual retainer of $3,000 plus a fee of $750 for each meeting attended. The company also granted each director an option to purchase 5,000 shares of common stock at an exercise price that equaled the market price of the stock on the date that the option was Em maio - A ESSEXUEE Case 4.2: Comptronix Corporation The board met four times during 1991. The board had an audit committee that was charged with recommending outside auditors, reviewing the scope of the audit engagement, consulting with the external auditors, reviewing the results of the audit examination, and acting as a liaison between the board and the internal auditors. The audit committee was also charged with reviewing various company policies, including those related to accounting and internal control matters. Two outside directors and one gray director made up the three-member audit committee. One of those members was an attorney, and the other two served as president and CEO of the companies where they were employed. There was no indication of whether any of these individuals had accounting or financial reporting backgrounds. The audit committee met twice during 1991. CFO at SCH a with a demo left SCI to MANAGEMENT BACKGROUND The March 1992 proxy statement provided the following background information about the three executives committing the fraud: Mr. Hedding, Mr. Shifflett, and Mr. Medlin. William J. Hebding served as the Comptronix Chairman and CEO. He was responsible for sales and marketing, finance, and general management of the company. He also served as a director from 1984 until 1992 when the fraud was disclosed. He was the single largest shareholder of Comptronix common stock by beneficially owning 6.7% (720,438 shares of Comptronix common stock as of March 2, 1992. Before joining Comptronix, Mr. Hebding worked for SCI Systems Inc. from 1974 until October 1983. He held the title of treasurer and CFO at SCI from December 1976 to October 1983. In October 1983, Mr. Hebding left SCI to form Comptronix. He graduated from the University of North Alabama with a degree in accounting and was a certified public accountant. Mr. Hebding's 1991 cash compensation totaled $ 187,996. Allen L. Shifflett served as Comptronix's president and COO, and was responsible for manufacturing, engineering, and programs operations. He also served as a director from 1984 until 1992 when the fraud unfolded. He owned 4% (433,496 shares) of Comptronix common stock as of March 2, 1992. Like Mr. Hebding, he joined the company after previously being employed at SCI as a plant manager and manufacturing manager from October 1981 until April 1984 when he left to help form Comptronix. Mr. Shifflett obtained his B.S. degree in industrial engineering from Virginia Polytechnic Institute. Mr. Shifflett's 1991 cash compensation totaled $162,996. Paul Medlin served as Comptronix's controller and treasurer. He also previously worked at SCL, as Mr. Hebding's assistant after graduating from the University of Alabama Mr. Medlin did not serve on the Comptronix board. The 1992 proxy noted that the board of directors approved a company loan to him for $79,250 on November 1, 1989, to provide funds for him to repurchase certain shares of common stock. The loan, which was repaid on May 7, 1991, bore interest at an annual rate equal to one percentage point in excess of the interest rate designated by the company's bank as that bank's "Index Rate The 1992 proxy did not disclose Mr. Medlin 1991 cash compensation as B DOOD EQUIRED [1] Professional auditing standards present the audit risk model, which is used to determine th 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. The PCAOB embraced existing auditing standards in place at April 2003 as its Interim Standards. Guidance for auditors of public companies in regards to reviews of public company interim statements is contained in the Interim Standards (AU) Section 722, Interim Financial Information, which is available online at the PCAOB's website (www.pcaob.org) under the Standards link. Research the content in that Interim Standard and briefly describe the key requirements for reviews of interim financial information of a public company. Why wouldn't all companies (public and private) engage their auditors to perform timely reviews of interim financial statements? (0) 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? m Auditing standards note that three conditions are generally present when fraud occurs. Research the authoritative standards for auditors and provide a brief summary of each of the three fraud conditions. Additionally, provide an example from the Commif c .L t & DOOD