Assume that you are the auditor of ABC Inc, for the fiscal year 2006. No audit procedures have been performed other than general information gathering. Please read all the information given below carefully and then identify any possible material misstatements that exist in the accompanying financial statements and the notes.
Brief Description of Operations and Management obtained during general information gathering:
ABC Inc. is a large publicly held corporation that is involved in manufacturing operations. ABC’s manufacturing operations are spread over 4 states and 2 foreign countries. The net worth of the company is approximately 500 million dollars.
The company has reasonably reliable internal controls. It maintains an in-house internal audit function, which is run by an experienced and well trained group of company employees, who are answerable only to an audit committee comprised of independent directors. The divisional managers of the company decide the timing and scope of all internal audit work. The internal auditors also spend a significant amount of time on consulting work in addition to their usual internal audit compliance work. Due to the large geographical coverage and international operations, the divisional managers have to deal with complex revenue recognition, asset valuation and, transfer pricing issues. This makes it necessary for the divisional managers to use their judgment and discretion to come up with various estimates for some of the company’s complex transactions. The company’s external audit is performed by a Big 4 accounting firm. ABC Inc. is the largest client for the Big 4 accounting firm office, located in the region where the company is incorporated. The company rotates its external auditors at regular intervals.
The divisional managers’ compensation plans consist of a relatively low fixed salary. A significant part of the compensation consists of generous and large bonuses that are dependent on meeting aggressive earnings and performance targets. Through this compensation scheme, the board of directors hopes to encourage the divisional managers to improve ABC’s overall earnings performance. The divisional managers have struggled to meet these earnings targets in the past 3 quarters. The manufacturing industry as a whole has experienced a marginal growth in sales for the last three years amidst increasing competition from local and foreign companies.
The following are the financial statements, explanations and the notes, as provided by the management of ABC Inc. Please read them carefully and answer all the questions following the financial statements
Income Statement (All numbers are in millions unless specified)
Year Ended December 31, 2006 2005 2004
NET OPERATING REVENUES $24,088.0 $ 23,104.0 $ 21,742.0
Cost of goods sold $ 8,164.0 $ 8,195.0 $ 7,674.0
GROSS PROFIT $15,924.0 $14,909.0 $14,068.0
GROSS PROFIT MARGIN % 66.1 64.5 64.7
Selling, general and administrative expenses $ 9,431.0 $ 8,739.0 $ 7,890.0
Other operating charges $ 185.0 $ 85.0 $ 480.0
OPERATING INCOME $ 6,308.0 $ 6,085.0 $ 5,698.0
OPERATING MARGIN % 26.2 26.3 26.2
Interest income $ 193.0 $ 235.0 $ 157.0
Interest expense $ 220.0 $ 240.0 $ 196.0
Equity income — net $ 102.0 $ 680.0 $ 621.0
Other income (loss) — net $ 195.0 $ (93.0) $ (82.0)
Gains on issuances of stock by equity investees — $ 23.0 $ 24.0
INCOME BEFORE INCOME TAXES $ 6,578.0 $ 6,690.0 $ 6,222.0
Income taxes $ 1,498.0 $ 1,818.0 $ 1,375.0
Effective tax rate % 22.8 27.2 22.1
NET INCOME $ 5,080.0 $ 4,872.0 $ 4,847.0
PERCENTAGE OF NET OPERATING REVENUES % 21.1 21.1 22.3
NET INCOME PER SHARE:
Basic $ 2.16 $ 2.04 $ 2.00
Diluted $ 2.16 $ 2.04 $ 2.00
Gross Profit
Our gross profit margin increased to 66.1 percent in 2006 from 64.5 percent in 2005. Our gross margin was favorably impacted by improvements in the business model. Specifically, we decided to change the method of recognizing gross profit from a version of the Installment Sales method to a modified version of Point of Sale method. Although the Installment Sales method has been applied consistently in previous years, this change was implemented because the Point of Sale method is considered more appropriate. By changing to the Point of Sale recognition method, we were able to recognize additional gross profits of $585. Our gross margin in 2006 was also impacted favorably by price increases, partially offset by increases in the cost of raw materials and freight, primarily in North America, and by an unfavorable product mix. In 2007, the Company expects the cost of raw materials to increase, primarily in North America. We will attempt to mitigate the overall impact on our business through appropriate pricing and other strategies.
Gross profit margin in 2006 was favorably impacted by the receipt of approximately $109 million in proceeds related to a class action lawsuit settlement concerning price-fixing in the sale of high fructose corn syrup (“HFCS”) purchased by the Company during the years 1991 to 1995. The Company’s portion of the settlement was approximately $87 million, which was recorded as a reduction of cost of goods sold.
Our gross profit margin decreased to 64.5 percent in 2005 from 64.7 percent in 2004, primarily due to higher raw material and freight costs driven by rising oil prices. As discussed above, in 2006, this decrease was partially offset by the receipt of net settlement proceeds of approximately $87 million.
Selling, General and Administrative Expenses
The following table sets forth the significant components of selling, general and administrative expenses (in millions):
Year Ended December 31, 2006 2005 2004
Selling expenses $3,924 $3,453 $3,031
Advertising expenses $2,553 $2,475 $2,165
General and administrative expenses $2,630 $2,487 $2,349
Stock-based compensation expense $ 324 $ 324 $ 345
Selling, general and administrative expenses $9,431 $8,739 $7,890
Total selling, general and administrative expenses were approximately 8 percent higher in 2006 versus 2005. The increases in selling and advertising expenses were primarily related to increased investments in marketing activities, combined with new product innovation activities. General and administrative expenses in 2006 also reflected the impact of a $100 million donation made to ABC Inc Foundation. Stock-based compensation expense was flat in 2006 compared to 2005. Stock-based compensation expense in 2005 included approximately $50 million of expense due to a change in our estimated service period for retirement-eligible participants in our plans. This amount was offset primarily by the impact of the timing of stock-based compensation grants in prior years.
As of December 31, 2006, we had approximately $376 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under our plans. This cost is expected to be recognized as stock-based compensation expense over a weighted-average period of 8 years. This amortization of the cost is in accordance with industry practices. This expected cost does not include the impact of any future stock-based compensation awards.
Other Operating Charges
During 2006, our Company recorded other operating charges of $185 million. Of these charges, approximately $108 million were primarily related to the impairment of assets and investments in our bottling operations, approximately $53 million were for contract termination costs related to production capacity efficiencies and approximately $24 million were related to other restructuring costs. The company decided to capitalize other operating charges worth $96 million, which related to costs of replacement of small value items in its manufacturing facilities. The company will depreciate these assets over a period of 6 years on a straight-line basis.
Operating Income and Operating Margin
In 2006, price increases across the majority of operating segments favorably impacted both operating income and operating margins, while increased spending on marketing and innovation activities negatively impacted operating income and operating margins. Although operating margin was at a healthy rate, it was slightly below the industry levels and analysts’ expectations.
Other Income
Other income indicated a net income of $195 million for 2006 compared to a net loss of $93 million for 2005, a difference of $288 million. In 2006, other income (loss) included a net gain of approximately $175 million resulting from the sale of a portion of our shares held as long-term investments and a gain of approximately $123 million resulting from the sale of a portion of our investment in an IPO of a competitor company. Other income was also significantly affected by the inclusion of gain of $75 million from sale of company’s operational assets, which were damaged in a fire, to some of its own customers.
Based on your reading of the case, please answer the following questions:
Based on the reading of only the “Brief Description of Operations and Management obtained during general information gathering” list all possible fraud risk factors included in that section. Do not refer to, or base your answer, on the accompanying financial statements and related notes and management explanations. For each factor also indicate the probability of it driving the management to commit fraud (The number of spaces given is not indicative of the actual number of factors present in the case above).
1. ___________________________________________________________________
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6. ___________________________________________________________________
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9. Please classify the above recognized factors as either “pressures/incentives,” or “opportunities,”. Please put the serial number of each driver under their respective headings
Pressures/Incentives Opportunities
Please indicate any potential material misstatements noted during the reading of the financial statements and brainstorming session. You may refer to the case information, perform calculations, and make assumptions, if necessary. Feel free to refer to the case booklet at any time while completing this task. Additionally, the calculations provided in the common sized balance sheet, income statement and cash flow statements have been recalculated and are accurate. (The number of spaces given is not indicative of the actual number of instances of material misstatements).
How and where you believe the client’s financial statements might be susceptible to material misstatement?