Question
The TechTennis-USA case was developed for first year professionals in practice and graduate forensic accounting students. Its primary purpose is to expose students to a
The TechTennis-USA case was developed for first year professionals in practice and graduate forensic accounting students. Its primary purpose is to expose students to a variety of evidence that will assist in their assessment and judgment of risk. They will develop plausible scenarios that created the risk, and then construct a plan to further investigate and explain the identified risk. Case participants should have background in SAS 99 (AU 316), as well as exposure to the topics of analytical procedures, risk, types of interviews used in forensic investigations, the triangle of fraud,and the culture of honesty.
TechTennis-USA updates an earlier 2001 published case (Green and Calderon, 2001), edited for changes in audit standards and adding an internal audit focus. The case takes into consideration AU 316 (AICPA, 2002) and AS 12 (PCAOB, 2010). It was developed to incorporate risk elements identified in three actual multi-year financial statement frauds.The company names, industry, locations, and all other names and numbers used in the case are fictitious.
The TechTennis-USA Inc. Case
You began working for TechTennis-USA three years ago in their internal auditing department.Your department has grown with the company to six professionals.Two months ago, the director of internal auditing, your boss, left the company. You were asked to lead the internal audit team on a special project. Your performance on this project could have long-term implications for your career and could possibly fast-track you to the top of the internal audit department.With your internal audit experience and five years of prior public accounting experience, you feel confident in leading the team.
Gathering Evidence Part I: Past Information
You are now beginning an annual risk assessment review of your company. The purpose of the review is to recognize existing risk, and act on the risk determining whether further investigation is needed, or corrective/preventive control procedures need to be put in place. As part of the normal planning process you begin to review last year's risk assessment file.The first section includes an up-dated company history in memorandum form. The risk assessment file review will help in both planning the audit, as well as background materials for initial meetings with key members of management.
TechTennis-USA's History
Prior to 2013,TechTennis-USA was a subsidiary of General Merchandise Product Corporation (GMPC), a large diversified retail company whose customers were primarily mall retail stores and big box stores that sell clothing. GMPC saw the sporting unit as a poor fit for its customer base.In June, 2013 TechTennis-USA was taken private through a $31.433 million leverage buy-out led by Jack Remington who injected $12,250,000 into the buy-out for a substantial stake in the company. TechTennis-USA's 2013 and 2014 annual reports disclose the transactions that led to the creation of TechTennis-USA Company as follows:
Effective June 29, 2013, TechTennis-USA Inc. (TTC), a wholly-owned subsidiary of American Products Corporation (APC) acquired the outstanding capital stock from General Merchandise Products Corporation (GMPC) for $31.433 million. The company was headquartered in Albuquerque, New Mexico. Corporate headquarters and manufacturing and distribution facilities were located in a 227,000 square foot building in Albuquerque. The company also operated a manufacturing facility in Grand Cliffs, Michigan (105,000 square feet) and a distribution facility in Schoenher, Tennessee (30,000 square feet). Over 800 people were employed by the TechTennis-USA Company from the beginning of 2012 to the end of 2014.
Jack Remington, elected Chairman of the Board and President after the 2013 management buy-out. The company had first gone public in 2011.Remington was a business graduate of the University of South Columbia and had an MBA from Sycamore State University. He first joined TechTennis-USA in 2008 as Vice President of Marketing, was promoted to Executive Vice President in June 2012, and then to President in 2013.His work experience before joining TechTennis-USA included three years as a stockbroker and about seven years with a Fortune 500 company, where he worked in accounting and other areas. Remington was 37 when he became president of TechTennis-USA in 2013, holding a 39.7% beneficial ownership in the company's stock.
Products
After Jack Remington took over TechTennis-USA in 2013, financial analysts and persons connected with the industry predicted that the company was on the verge of becoming a highly profitable, multi-product enterprise. TechTennis-USA had traditionally been a single-product company. It manufactured light-weight, tennis racquets and was an industry leader in the production and sale of tennis racquets. The Power-Racquet, a favorite tennis racquet series, had been the company's primary product since the 1980s. It was light-weight, had been used by several past professionals, and was supported by an aggressive media campaign. Competitors included Wilson, Prince, and Head.
In the middle of 2013, TechTennis-USA introduced a new series of ultra-light titanium racquets called the ULT-Racquet. It was roughly 30 percent lighter than other tennis racquets that were currently available on the market. The ULT-Racquet's light-weight, plus its retail prices of $80 to $140 made it a very attractive alternative to competitor's high end racquets. By late 2013, TechTennis-USA moved away from over-size, back to mid-size tennis racquets, consistent with the professional tennis circuit.
In September of 2013, TechTennis-USA again launched new products. This time, TechTennis-USA entered the sports apparel market. The clothing series was called Power-T's, while a separate shoe series was calledPowerFeet. The Power-T's Series were low-cost collared sports shirts that provided the company with its first shot at competing directly in the conventional sports apparel market. TechTennis-USA advertised the Power-T's as "the only sports shirt to offer style and dress versatility at a low price." The Power-T's weighed less than 8 ounces and sold for approximately $12. Its weight and retail price made it one of the lightest and least expensive sports shirts in its market.There were over twenty-five other competing brand-name sportswear shirts on the market. According to Jack Remington, TechTennis-USA would use the Power-T's as a catalyst for becoming a leader in the profitable sportswear market.
PowerFeet was the company's first high end product that was unrelated to its tennis racquet line of business. This product used jell packs in the shoe's soles to absorb and redirect force away from the user's feet and ankles. The PowerFeet series of shoes were ranked one of the best on the market. A pair of the shoes weighed less than 14 ounces and retailed for under $100. These features made it one of the best buys in the market. When the first PowerFeet shoes were launched in 2013, Jack Remington and his management thought that market demand for the product would be sufficiently buoyant to increase corporate sales by more than 50 percent.
TechTennis-USA products were sold in over 5,000 retail outlets, including stores operated by the major retail and sporting goods chains in the United States.The company's products were designed to appeal to the sports active consumers. The products combined a lightweight, functional design with ergonomic com-fort, and lower price range. The PowerFeet shoe series was rated in the industry as a "best buy" because of its low price, comfort, and overall quality. However, its latest tennis racquet was rated as having handle vibrations and the racquet's factory supplied strings tended give a stiff feeling. In addition, the Power-T's, while relatively inexpensive, having a three button front with collar, also had problems. The shirt's sleeve stitching tended to unravel after several washings.
By the late 2013, Jack Remington had transformed TechTennis-USA from a single product company to a tightly integrated, three product line company. Eighty-three percent of its sales were from light-weight tennis racquets, 11 percent from sport shirts, and six percent from sport shoes. Sales of sport shirts had been increasing along with the increase in sales of the ULT-Racquet. The company's stock grew from just over $5 a share in 2012 to over $22 in 2013. By TechTennis-USA's fiscal year end, June 2014, the stock reached a high of $27.50.
Operating Results and Financial Position
The operating results reported by the company suggested that TechTennis-USA's new products were very well received by the market. By the end of the second quarter of fiscal 2013 (December 31, 2013), sales had increased by 70 percent. This contrasted sharply with the 14 percent sales increase for the first quarter. Thus, much of the increased sales for the second quarter were attributable to the success of the Power-T's and the PowerFeet product lines. Comparative financial statements for the years 2011 to 2014 are provided in Table 1.During fiscal 2011, a charge of $2,891 million was included in the income statement (shown separately in Table 1) for write-down of inventory to reflect the difference between the fair value and historical cost of inventory.
Between 2011 and 2014, reported performance showed significant increases. Reported sales increased by 13 percent, 68 percent and 41 percent during 2012, 2013, and 2014, respectively. According to the company's 2014 annual report (page 1), fiscal 2014 was "the eighth consecutive year of record sales and earnings." Reported income and earnings per share (EPS) also showed significant increases during that period. Both reported net income and reported EPS increased by over 260 percent in 2012. These numbers did not rise as sharply in 2013 and 2014, but the reported growth rates for these items were still in excess of 50 percent in both of those years. Sales to one customer aggregated approximately 20.4% of net sales in 2014 and 15% in 2013. Allowance for doubtful accounts as of June 30, 2014, 2013, 2012, and 2011 were $4.26 million, $4.76 million, $2.00 million, and $1.91 million, respectively.
A comparative balance sheet for TechTennis-USA is also presented in Table 2.
QUESTIONS
1.Review the financial information in the attached Tables 1 and 2. Explain why you may or may not be concerned? Perform a complement of procedures to gather analytical evidence of risk. These procedures should include trends for all assets, liabilities, sales, cost of goods sold, gross margin, and total operating expenses, in addition to select ratio analysis. Though you have a comparative income statement and balance sheet, common size statements and comparisons to industry averages may be useful. Does the quantitative evidence indicate accounts or account groups that have expectantly changed over the past two or three years? Do these initial results justify "specific" further investigation?
2.Given the above discussion, identify factors in this case, if any, that point to the risk of fraudulent financial reporting. Using the format presented below, classify any identified risk based on the Triangle of Fraud categories of Incentives/Pressures, Opportunities, and Attitudes/Rationalizations. See Appendix A for examples of risk factors. Your identified risk factors must be specific to this case.
Risk Factors Identified During Part I
Risk Classification
Identified Risk Factor
3.Using a scale of one (low risk) to ten (high risk) assign an overall ranking to the cumulative risk factors identified in Question 1 and 2. Last year's assessment was "four," a moderate risk of fraudulent financial reporting. Does the source of a risk factor affect its weight in the overall assessment?You should justify your assessment by integrating both the qualitative evidence from Question 2, and quantitative evidence from Question 1 to develop potential risk scenarios.
4.How do you respond to the level risk?Specifically, support the need for specific investigations on the risk scenarios developed in Question 3. Be specific!
5.Given the above risk factors, are there accounting, analytical, or behavioral symptoms that should be followed up on? Are there "culture of honesty" issues that raise concerns? Are there potential "prevention" issues that should be considered?
APPENDIX A
SAS No. 99 Example Fraud Risk Factors
Incentives/Pressures:
A.Financial stabilityor profitability is threatened by economic, industry, or entity operating conditions, such as (or as indicated by):
High degree of competition or market saturation, accompanied by declining margins
High vulnerability to rapid changes, such as changes in technology, product obsolescence, or interest rates
Significant declines in customer demand and increasing business failures in either the industry or overall economy
Operating losses making the threat of bankruptcy, foreclosure, or hostile takeover imminent
Recurring negative cash flows from operations or an inability to generate cash flows from operations while reporting earnings and earnings growth
Rapid growth or unusual profitability, especially compared to that of other companies in the same industry
New accounting, statutory, or regulatory requirements
B.Excessive pressure exists for managementto meet the requirements or expectations of third parties due to the following:
Profitability or trend level expectations of investment analysts, institutional investors, significant creditors, or other external parties (particularly expectations that are unduly aggressive or unrealistic), including expectations created by management in, for example, overly optimistic press releases or annual report messages
Need to obtain additional debt or equity financing to stay competitive-including financing of major research and development or capital expenditures
Marginal ability to meet exchange listing requirements or debt repayment or other debt covenant requirements
Perceived or real adverse effects of reporting poor financial results on significant pending transactions, such as business combinations or contract awards
C.Information available indicates that management or the board of directors'personal financial situation is threatenedby the entity's financial performance arising from the following:
Significant financial interests in the entity
Significant portions of their compensation (for example, bonuses, stock options, and earn-out arrangements) being contingent upon achieving aggressive targets for stock price, operating results, financial position, or cash flow
Personal guarantees of debts of the entity
D.There isexcessive pressureon management or operating personnelto meet financial targetsset up by the board of directors or management, including sales or profitability incentive goals.
Opportunities:
A.Thenature of the industry or the entity'soperations provides opportunities to engage in fraudulent financial reporting that can arise from the following:
Significant related-party transactions not in the ordinary course of business or with related entities not audited or audited by another firm
A strong financial presence or ability to dominate a certain industry sector that allows the entity to dictate terms or conditions to suppliers or customers that may result in inappropriate or non-arm's-length transactions
Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate
Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult "substance over form" questions
Significant operations located or conducted across international borders in jurisdictions where differing business environments and cultures exist
Significant bank accounts or subsidiary or branch operations in tax-haven jurisdictions for which there appears to be no clear business justification
B.There isineffective monitoringof management as a result of the following:
Domination of management by a single person or small group (in a non-owner, managed business) without compensating controls
Ineffective board of directors or audit committee oversight over the financial reporting process and internal control
C.There is acomplex or unstable organizational structure, as evidenced by the following:
Difficulty in determining the organization or individuals that have control-ling interest in the entity
Overly complex organizational structure involving unusual legal entities or managerial lines of authority
High turnover of senior management, counsel, or board members
D.Internal control components are deficientas a result of the following:
Inadequate monitoring of controls, including automated controls over interim financial reporting (where external reporting is required)
High turnover rates or employment of ineffective accounting, internal audit, or information technology staff
Ineffective accounting and information systems, including situations involving reportable conditions
Attitudes/Rationalizations:
A.Risk factors reflective ofattitudes/rationalizations by board members, management, or employees,that allow them to engage in and/or justify fraudulent financial reporting, may not be susceptible to observation by the auditor:
Ineffective communication, implementation, support, or enforcement of the entity's values or ethical standards by management or the communication of inappropriate values or ethical standards
Nonfinancial management's excessive participation in or preoccupation with the selection of accounting principles or the determination of significant estimates
Known history of violations of securities laws or other laws and regulations, or claims against the entity, its senior management, or board members alleging fraud or violations of laws and regulations
Excessive interest by management in maintaining or increasing the entity's stock price or earnings trend
A practice by management of committing to analysts, creditors, and other third parties to achieve aggressive or unrealistic forecasts
Management failing to correct known reportable conditions on a timely basis
An interest by management in employing inappropriate means to minimize reported earnings for tax-motivated reasons
Recurring attempts by management to justify marginal or inappropriate accounting on the basis of materiality
B.Therelationship between management andthe current or predecessorauditoris strained, as exhibited by the following:
Frequent disputes with the current or predecessor auditor on accounting, auditing, or reporting matters
Unreasonable demands on the auditor, such as unreasonable time constraints regarding the completion of the audit or the issuance of the auditor's report
Formal or informal restrictions on the auditor that inappropriately limit access to people or information or the ability to communicate effectively with the board of directors or audit committee
Domineering management behavior in dealing with the auditor, especially involving attempts to influence the scope of the auditor's work or the selection or continuance of personnel assigned to or consulted on the audit engagement
Adapted from: Appendix: "Examples of Fraud Risk Factors." American Institute of Certified Public Accountants (AICPA), Statement on Auditing Standards No. 99, (AU 316.85) Consideration of Fraud in a Financial Statement Audit, AICPA, December 15th, 2002.
GATHERING EVIDENCE PART II: OTHER INFORMATION
Jack Remington stood well over six feet tall. He had a highly competitive and winner-take-all approach to business. He was an ambitious, hard-working executive who worked long hours and bragged publicly about his and his family's successes. He brought some brilliant ideas to TechTennis-USA, and aggressively implemented many of them. He often stated in public that his primary management goal was to be the leading seller of tennis rackets in the U.S. and global markets. Fiscal 2016 was his unofficial target date for achieving the number one spot in the industry. He systematically and aggressively pursued that goal. He monitored internal operating performance closely, followed the stock price performance with the eye of an eagle, and was always eager to take direct action to keep his stock buoyant. Remington subscribed to the principle that in order to maintain investor confidence and keep the stock buoyant, earnings must always be moving upward. The company's budgets reflected this principle and Remington assertively monitored performance to ensure that profit targets were always met. In his first annual report to the stockholders (2012), Remington wrote the following:
The "TechTennis-USA Personality" is one characterized by our basic approach to business?Commitment to ambitious goals and an aggressive pursuit of those goals.We set ambitious goals fully expecting to achieve them. We establish high performance standards for our employees and reward them based on their contributions. "Trying your best" is not enough at TechTennis-USA: you must make a contribution to the achievement of company goals.
Commitment to goals, however, must be accompanied by an aggressive approach to problems and opportunities. We are not afraid to take calculated gambles or to make mistakes. We believe we have set up controls and systems to minimize the downside. We also believe that the highest rewards go to those companies that recognize opportunities and take well thought out chances.
People who worked directly with Remington often complained that his drive to succeed intimidated and alienated them. During his tenure at TechTennis-USA, particularly in his capacity as CEO, he always let people know that he was in charge. He developed a reputation among his subordinates for going after and eventually getting exactly what he wants. Turnover in the management ranks, and in departments headed by the CEO were high. Table 3 lists the officers and directors of the company from 2011 to 2014 and provides some insight into the levels of turnover among their ranks.
Management Compensation
The ratio of senior management compensation to sales in their industry averaged between 3% and 8% of net sales. TechTennis-USA's executive compensation statistics are provided in Table 3. Executive compensation at TechTennis-USA included both a cash and deferred component. The deferred component included a savings plan, a retirement plan, and a stock option plan.
Over 40% of the cash compensation paid to senior officers came from bonuses that were directly tied to reported sales and earnings. The stock option plan, established in July 2011 and before TechTennis-USA was formed, provided for the issuance of up to 200,000 shares of common stock to qualified senior officers and employees. A 2:1 stock split in August 2011 increased the number of shares committed to the plan to 400,000. The option plan was administered by a three-member committee of the board of directors. Largely as a result of the 2011 stock option plan, over 93% of salaried employees and more than 50% of non-unionized employees held stock in the company. All senior officers and directors listed in Table 3 had beneficial ownership of the company's stock at the time of their tenure.
Senior management at TechTennis-USA, and in particular Jack Remington (who had a 39.7% interest), had significant holdings in the stock of the company. As a group, the directors and officers held a 51.1% beneficial ownership of the company. Thus, their wealth and compensation were directly affected by the company's reported sales and profit performance.
The company advertised extensively. The advertising budget for the fiscal year 2014 was approximately $25 million, up from approximately $9 million in each of the previous two previous years. Actual advertising expense for 2014, 2013, and 2012 was $26.4 million, $18.56 million, and $9.42 million, respectively. The 44.18% increase in advertising expense between 2013 and 2014 resulted from new campaigns to promote domestic sales and from costs incurred to expand into Canada, Great Britain and Italy. Growth in research and development (R&D) averaged over $400,000 between 2011 and 2013.R&D expenses grew from $673,000 in 2011 to $1.18 million, $1.53 million, and $2.4 million in 2012, 2013, and 2014, respectively. The company had a reliable and stable source of raw materials. Significant raw material purchases included titanium mesh for the racquets, ultra-light cloth for the shirts, leather for the shoes and racquet handles, and corrugated containers for shipping. As of 2012, management expected no significant increases in the cost of raw material for the foreseeable future, and no raw material procurement problems were expected.
In the 2014 Remington stated:
I feel especially good about the significant change in the company's product mix over the past four years. As early as 2011, virtually 100% of earnings came from just one line--Power-Racquets. Now, four years later, we have a broad base with three major lines contributing to our growth. TechTennis-USA is no longer the 'runt' of the tennis racquet and apparel industry in the United States. We have now positioned ourselves as a leader in the industry, as we continue our drive to become "the leader."
Significant portions of the company's assets were pledged to secure long-term financing. Various loan agreements contained several restrictive covenants, including restrictions on the incurrence of debt, declaration of cash dividends, maintenance of working capital, tangible net worth, retained earnings, and many revenue and operating income based ratios.
Internal Audit
For efficiency, TechTennis-USA internal audit department was an integral part of the accounting department. The audit committee, which met once a year to hire the external auditor, had three outside directors and two other members of the standing board of directors.
QUESTIONS
6.Identify and classify any additional risk factors that came to light through the information in Part II of the case. Do not repeat factors already identified in Part I. Document the new risk factors using the same Triangle of Fraud format found in Part I, Question 2.
7.Risk assessment is a cumulative process. Does the information in Question 6 change your risk assessment in Question 3?
8.Are risks due to control issues different from risk due to non-control issues?
9.Discuss your specific response, if any, to the newly identified risk factors.Use Question 4 as a guideline.
10.List three individuals you would like to interview to obtain more information. Discuss all parameters of each interview...purpose of interview, types of questions, and strategies when facing a difficult interviewee.
11.Do you have enough evidence to determine if fraud occurred?
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Introduction to Managerial Accounting
Authors: Peter C. Brewer, Ray H Garrison, Eric Noreen
8th edition
1259917061, 978-1259917066
