FRAUD BRAINSTORMING AT TESLA MOTORS

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INTRODUCTION

One of the most important skills needed by accountants today is the ability to analyze and

detect fraud risks (Carpenter 2007; CAQ 2010; PwC 2015). The Association of Certified Fraud

Examiners (2016) estimates that the typical organization loses five percent of its revenues every

year to fraud. Beyond these losses, financial statement frauds also have far reaching negative

consequences on investors, employees, suppliers, and other stakeholders of the corporation.

Because of the importance of fraud detection to the integrity of our markets, auditing standards

require that accountants fulfill their responsibility to obtain reasonable assurance about whether

or not the financial statements they audit are free of material misstatement due to error or fraud

(AS 2401, AU-C Section 240, International Auditing Standards 240). In particular, Auditing

Standard 2401 (formerly Statement on Auditing Standards No. 99),

Consideration of Fraud in a

Financial Statement Audit

, requires that fraud brainstorming sessions be incorporated into every

audit engagement. These sessions are designed to increase the probability that auditors will

detect intentional misstatements and to help set the right tone for professional skepticism and

heightened sensitivity to fraud risk throughout the engagement (Ramos 2003).

YOUR TASK

This case requires you to imagine that you have been asked to participate in a fraud

brainstorming session as part of a financial statement audit of Tesla Motors. This case has two

parts. In Part I, you will learn how the concept of the "fraud triangle" is used to identify fraud

risk factors, read background information on Tesla Motors, and work to complete the Part I case

requirement questions designed to help you identify some of the financial statement fraud risks

associated with this company. Part I is an individual assignment to be turned in as Deliverable 1.

In Part II, you will learn about the process of conducting a fraud brainstorming session

and how to adapt your planned procedures to respond to identified fraud risks. After reading Part

II, you will work as part of an audit team to conduct a fraud brainstorming session. During this

session, your team will be responsible for completing a fraud risk matrix and writing up a memo

for the audit file that documents the results of your fraud risk assessment and identifies how your

team believes the nature, timing, and extent of the audit procedures should be altered to respond

to these identified risks. Part II is a group assignment to be turned in as Deliverable 2.

It is important to note that as of the time of the writing of this case, Tesla Motors has not

been accused of financial statement fraud. Nevertheless, you and your team should resist the

natural inclination to presume that management is honest, and exercise professional skepticism

in evaluating fraud risks at this company. Auditing standards remind us that we should conduct

the engagement with a mindset that recognizes the possibility that a material misstatement due to

fraud could be present, regardless of any past experience with the entity and regardless of the

auditor's belief about management's honesty and integrity (PCAOB AS 2401, paragraph 13).

PART I

Using the Fraud Triangle to Identify Fraud Risk Factors

Auditing standards define fraud as an intentional act that results in a material

misstatement in the financial reports (PCAOB AS 2401, paragraph 5). Research shows that fraud

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is more likely when three conditions are present: incentives or pressures, opportunities, and

attitudes or rationalizations.

These three conditions are known collectively as the "fraud

triangle" (Cressey 1953). Auditors use the fraud triangle as a tool to help identify areas of risk

during the fraud risk brainstorming process, these risks are referred to as

fraud risk factors

. The

next section describes each of the three conditions in more detail and provides highlights from

recent research about how each condition has been linked with fraud.

The first leg of the fraud triangle is

incentives

or

pressures

. This condition is present

whenever management and/or employees have incentives or are under pressures to commit fraud

(Arens, Beasley, and Alvin 2010). Research shows that when management compensation is tied

to earnings and/or stock performance (e.g., bonuses, stock options) the likelihood of fraud is

higher (Healy and Wahlen 1999; Fields, Lys, and Vincent 2001). Other incentives besides greed

can also contribute to fraud risk. A recent study finds that CFOs may become involved in

deceptive accounting practices not for personal financial gain, but rather to appease their CEOs

and protect their jobs (Feng, Ge, Luo, and Shevlin 2011). Performance pressures also cause

managers and employees to engage in fraud. A recent survey also finds that 64 percent of

employees engage in unethical behavior because they feel pressure to "do whatever it takes" to

meet business targets (KPMG, 2013).Changes in the external environment, such as declines in

customer demand, increased competition, or new regulations can threaten the financial stability

of a firm and create pressure to "cook the books" and create the appearance of success while the

firm attempts to adapt to the environmental changes. Paradoxically, both high performing firms

(e.g., MacLean 2008; Mishina,, Dykes, Block, and Pollock 2010) and low performing firms (e.g.,

Harris and Bromiley 2007; Zhang, Bartol, Smith, Pfarrer, amd Khanin 2008) have a higher risk

of financial statement fraud, because both situations put pressure on executives to meet or exceed

last period's earnings. Managers at poorly performing firms may also feel pressure to manipulate

earnings or inflate asset balances in order to meet debt covenant requirements and avoid

defaulting on loans.

The second leg of the fraud triangle is

opportunities

. This condition is present whenever

circumstances allow management or employees to commit and conceal fraudulent behavior

(Arens et al. 2010). Many different factors create opportunities for fraud. The use of significant

accounting estimates creates opportunities for earnings management and fraud, especially in the

area of reserves, allowances, and depreciation calculations (PCAOB AS 2501 2016). Difficulty

in verifying estimates and valuations also create opportunities for manipulation, particularly in

areas such as intangible assets and level three fair market valuations (PCAOB 2502 2016). In

addition, fraud risks are higher when internal controls are weak or ineffective, when company

policies are ambiguous or enforced unevenly, or when oversight of financial reporting is

inadequate, as all of these circumstances make it easier to commit and conceal fraudulent

activity. Finally, transactions and financial relationships with related parties can create

opportunities to commit and conceal fraud (PCAOB AS 2410 2016).

The last leg of the fraud triangle is

attitudes

or

rationalizations

. This condition is present

whenever management or employees exhibit an attitude, character, or set of ethical values that

would enable committing a dishonest act (i.e., "bad apples") or whenever the environment

imposes sufficient pressure on management or employees to cause good people to rationalize

engaging in bad behavior (i.e., "bad barrels") (Arens et al. 2010; Trevio and Youngblood 1990).

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Auditors should be alert to the risk of bad apples when management has a history of being

dishonest, for violating laws and regulations, or a reputation for making overly aggressive or

unrealistic forecasts. In these circumstances, auditors should be skeptical of management's

integrity and the veracity of their statements. Auditors also need to identify circumstances where

good people may be tempted to make bad choices. Under the right pressures, managers and

employees can rationalize fraudulent activity as acceptable or even necessary, and thus disengage

from the feelings of guilt and regret that normally prevent people from behaving dishonestly. For

example, management might rationalize financial statement fraud if it prevents the loss of jobs or

the closure of the business.

Employees can also rationalize stealing from a company as "getting

what they are due" if they feel under-paid or under-appreciated.

Finally, managers might

rationalize committing fraud if they suspect that competitors are doing the same.

It is difficult to detect rationalization risks, but auditors should be alert for potential

indicators such as the use of euphemistic language, social norms in the company and/or industry

that treat dishonesty as a part of doing business, and the tone at the top set by the company's

CEO. A CEO that explicitly values ethics and honesty and emphasizes not only results but the

just means used to reach those results can foster ethical choices, whereas a CEO that is perceived

as being unethical or even ethically-neutral can foster an environment where fraud is more easily

rationalized (Trevino, Hartman, and Brown 2000).

By examining fraud risk factors through the three legs of the fraud triangle, auditors may

develop more accurate fraud risk assessments and become better prepared to alter the nature,

timing, and extent of their audit procedures to respond to these identified risks.

Tesla Motors Case Background

Founding and History of Tesla Motors

Tesla Motors (NASDAQ: TSLA) was founded in 2003 by a group of engineers in Silicon

Valley with the vision of accelerating the world's transition to sustainable transport. To that end,

Tesla Motors has created "cars without compromise" - that is, all electric vehicles that offer all

of the torque, power, and style of high-end automobiles with none of the emissions. The

company's mission is "to accelerate the advent of sustainable transport by bringing compelling

mass market electric cars to market as soon as possible" (Tesla Motors 2015). Tesla's first release

was the Roadster in 2008, which offered 0 to 60 mph acceleration in 3.7 seconds and a range of

245 miles per charge of its lithium ion battery.

In 2012, Tesla launched the Model S, a four-door

sedan that was named

Motor Trend's

2013 Car of the Year. At the beginning of 2016, with more

than 107,000 vehicles on the road worldwide, Tesla's product line has expanded to include the

Model X, a crossover vehicle that entered volume production at the end of 2015, and the Model

3, a lower-priced vehicle expected to be released in 2017. However, Tesla does not limit its

vision to only automobiles. It describes itself as "a technology and design company with a focus

on energy innovation" (perTesla Motors 2016).

Tesla has revolutionized the automobile industry in many ways. In addition to proving

that all-electric vehicles can perform as well, if not better than, gas-powered vehicles, Tesla has

challenged the conventional approach of how vehicles are sold. Rather than selling through

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dealership franchises, Tesla sells and services its vehicles through its own sales and service

network, including acceptance of online orders. To help establish the value of the Tesla brand

and encourage early adopters to buy their vehicles, Tesla offers "resale value guarantees" to

customers. Under this program, customers have the option of selling their vehicle back to Tesla

Motors during the period of 36 to 39 months after delivery for a pre-determined resale value

(Tesla Motors 2016).

Due to widespread publicity and generally positive reviews of the vehicles, Tesla has

enjoyed greater demand for its vehicles than it can fulfill. As such, it has been collecting deposits

from customers at the time they place an order for a vehicle and, in some locations, at certain

additional milestones up to the point of delivery. In addition, a closer look at Tesla's income

statement reveals that Tesla sells much more than just cars. Tesla also earns revenue from related

services, including access to its Supercharging network and software updates on its vehicles.

Tesla also earns revenue from the sale of regulatory credits from energy tax credits and from the

sale of components to other manufacturers. Lastly, Tesla earns revenue from "Tesla Energy," a

division of the company offering battery-powered energy solutions for home, businesses, and

utilities (Tesla Motors 2016). Tesla's Income Statement and Balance Sheet for the past three

years are presented in Exhibit 1 and 2, respectively.

Tesla launched its initial public offering in June of 2010, raising $226 million in equity.

At the time, the company employed less than a thousand employees and had less than $150

million in revenue. The company has since experienced rapid growth. Over the past five years,

revenues have grown more than 1,000 percent from $204 million in 2011 to $4.1 billion in 2015.

After several years of trading between $22 and $33 per share, Tesla's surprise announcement of

quarterly profits in 2013 drove the stock into the triple-digits (Taylor III 2013). In March of

2016, the company enjoyed a market capitalization of almost $30 billion and traded at about

$200 per share. Tesla Motors stock performance for the past two years is provided in Exhibit 3.

Tesla's Leadership

Tesla Motors is led by CEO and co-founder Elon Musk. Musk made his fortune as a co-

founder of PayPal, which was acquired by eBay in 2002 for $1.4 billion. Musk is also the CEO

of Space Exploration Technologies, better known as SpaceX, a company that aims to develop the

world's first private spacecraft for commercial space travel, and he is Chairman of the Board of

SolarCity, a company that aims to expand the availability of clean, affordable energy. A self-

made man and serial entrepreneur, Musk's innovations and charisma have earned him the

areputation as a "real life Iron Man" in reference to the Marvel Comics super hero (Smith 2014).

Musk is known for his bold vision and his even bolder proclamations. In a live interview

in 2009, Musk called a

New York Times

journalist that wrote a critical review of Tesla a

"douchebag" and an "idiot" (

https://www.youtube.com/watch?v=ajP3B0gYJlo

). In an early 2015

earnings call with analysts, Musk also declared that he thought Tesla's market capitalization

could rival Apple's $700 billion in the next ten years, which would be more than the market

capitalizations of Ford, GM, Honda, Toyota, BMW, and Mercedes Benz combined. Musk made

this declaration in the face of production delays, weakening market conditions, and falling gas

prices, which has traditionally made the sale of electric cars more difficult.

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Tesla's future prospects appear to depend on Musk's ability to achieve feats that other car

makers would never dream of. As an incentive for Musk to make his bold vision a reality, Tesla's

Board of Directors granted 5,274,901 stock options to Musk that will "vest" or become available

to him to exercise based on his ability to lead the company towards meeting specific production

and performance goals, including the successful completion of the Model X and Model 3

prototypes and reaching 100,000 units in total vehicle production (Tesla Motors 2016).

In addition to overseeing Musk's plans and providing the company with guidance, Tesla's

Board of Directors is also tasked with protecting the interests of Tesla's stockholders, to include

having responsibility for risk oversight. Following best practices for corporate governance,

Tesla's guidelines suggest that the majority of Tesla's directors be "outsiders," meaning non-

company employees, and it has a standing Audit Committee to whom both internal and external

auditors report directly (Tesla Corporate Governance Guidelines 2016). Some have raised

concerns, however, about whether Tesla's board is as independent as it appears. CtW Investment

Group, which works with union-based pension funds and holds 200,000 shares of Tesla, recently

called on the company to separate the Chairman of the Board and CEO roles, both of which

Musk now holds, and to prohibit immediate family members from serving on the board (Sage

2016). Elon Musk's brother, Kimbal Musk, currently serves on the boards of both Tesla and

SpaceX. Board member Brad Buss is also a former employee of SolarCity, Elon Musk's related

company.

Tesla's Employee Culture

Tesla's culture has been described as "high risk, high reward," and the company prides

itself on operating like an internet startup, despite having been public for five years

(Fehrenbacher 2015). Employees regularly work long hours and the atmosphere has been

described as "grueling."

Nevertheless, many employees have enjoyed big payouts as a result of

their association with Tesla. In mid-2015, Jerome Guillen, then Tesla's Vice President of Sales

and Services, exercised options and sold shares netting him $4 million. Guillen has subsequently

taken a leave of absence from Tesla. In addition, Tesla's longtime CFO, Deepak Ahuja, has

recently retired from Tesla after making millions exercising his stock options in 2015. While the

environment may be one of high pressure for employees, many may enjoy working in the

innovative and mission-driven environment Tesla promotes. As an example of Tesla's

commitment to transparency and the advancement of energy alternatives, Tesla made the radical

announcement that it would not initiate patent lawsuits against anyone who, in good faith,

wanted to use its technology (Tesla 2015).

Challenges for Tesla and Its Future

Despite its rapid growth and popularity, Tesla has also experienced a number of set-

backs. It has struggled to reach its desired production levels, resulting in lengthy delays for

customers. Competitors, such as BMW, Nissan, and General Motors, have been developing all

electric alternatives and boast much higher production and distribution capabilities than Tesla.

Exhibit 4 presents a peer comparison of Tesla's financials with its current competitors. In

addition, analysts have raised questions about Tesla's reliance on emissions credits to shore up

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losses and its exposure to lawsuits and lobbying by dealership unions to block states from

allowing direct automotive sales to consumers (Taylor III 2013).

Moreover, while Tesla's Model S achieved an overall five star safety rating by the

National Highway Traffic Safety Administration, questions about the safety of Tesla's new

technology have continued to plague the company. In November 2013, a class action lawsuit was

filed against Tesla and its CEO alleging that Mr. Musk had made false and/or misleading

representations with respect to the safety of the Model S. The case was dismissed in September

2014 by the trial court, but the plaintiff's appeal is still pending as of early 2016 (Tesla Motors

2016).

Tesla has big plans for the future of its business. With the popularity of its vehicles

continuing to climb, Tesla has begun to expand its operations. Among these expansions, the

company has invested in an assembly facility in the Netherlands and a specialized production

plant in Lathrop, California. Tesla has also entered into strategic partnerships with companies

like Panasonic to focus on reducing the costs of lithium ion battery packs. In addition, Tesla

recently announced the beginning of construction on its multi-billion dollar investment in a

"Gigafactory" in Nevada that will facilitate production of more affordable electric vehicles and

battery powered energy alternatives (Tesla Motors 2015).

According to its 2015 annual report, Tesla plans to continue expanding stores and its

service infrastructure worldwide. It will invest

$1.5 billion in capital expenditures in equipment

to support cell production at the Gigafactory, to begin installation of Model 3 vehicle production

machinery, to open about 80 retail locations and service centers, and to energize about 300 new

Supercharger locations (Tesla Motors 2016). These bold expansion plans could put Tesla at the

center of an energy revolution, or they could cause the company to implode under the weight of

significant debt levels and even greater expectations.

Part I Case Requirements:

Identifying Fraud Risk Factors

Could you please help me with the question that we identify fraud risk factor is reward structure, but what is possible fraud schemes, balances affected, Likelihood of fraud, significant of fraud related to reward structure? Thank you