Question

ABC Company manufactures and sells software packages to small businesses. The company has enjoyed great success since it began business in 1998. Last year, the firm doubled its revenues, and its management is now looking closely at going public by making an initial public offering (IPO) next September. Senior management has been putting a lot of effort into further increasing sales by offering the company’s sales representatives a generous commission as an incentive to increase their selling efforts. The CEO, CFO, and COO of the company have been in business together for 20 years. Two of them were high school“buddies,”and the other joined the group in college. They still interact socially with one another, and their respective spouses are also very close. In completing a background check on the company, you find that it has a positive relationship with private investors, who are excited about the proposed IPO next September. One of the investors did inform you, however, that the company changed auditors last year because of a dispute the CEO had with the audit partner regarding some“strict revenue recognition rule.” The company has a board of directors and audit committee that meets twice a year to discuss how the business is doing. The board has decided to meet four times over the next year, since it may be necessary to discuss issues regarding the upcoming IPO. The board seems to speak highly of management and compensates them generously with stock options for their“good work.”What are some red flags that indicate that financial statement fraud may be occurring?

Answer 1

Some of the red flags that indicate the financial statement fraud are:

1. In a service industry the revenues must be recognized on a percentage completion method rather than recognizing as a whole. The firm has doubled its revenue since last year which may be an indication that it may be a book revenue only with out completion of the service.

2. Also the auditor has been dispute due to a dispute with the CEO over the revenue recognition rule which supports the above point. The company may have indulged in recognizing revenues with out actually rendering the services or on agreement basis.

3. The company has a positive relationship with private investors.

4. There is personal relationship between the top executives of the firm

5. The company is pressured to do well for an IPO hence decides to meet four times a year than the usual two times.

6. There are generous commissions paid to the salesman for their efforts.