BF3394 — Auditing and Professional Ethics Group Nine An insight in to the fraud by AstunIT PLC in an ethical context Candidates: 356239 461237 640662 102733 319538 Word Count: 1997Table of Contents Section 1. Part A - Financial Ratio Analysis Discussion of Ratios. Section 2 srs Part A~ Identification of Fraud i- Understated Expenses. ii- Overstated Inventory. ili - Overstated Equipment Accounts... Iv- Overstated Sales ...cnnnennennn Part B — Evidence of Fraud. Part C—The Role and Composition of AstuniT plc’s Audit Committee Section 3 srs Part A— Identification of Risk Factors Part B — Discussion of Risk Factors. Section 4 sss 1 - Identification of the Ethical Dilemma li- Discussion of the Ethical Dilemma References Appendices.. 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The auditor must use ratios in conjunction with one another and compare results from one period to the next in order to identify fraudulent or suspicious activity. In this particular case, we have computed indexes to identify any unusual behaviour. Ratio Indexes AstunIT PLC 2001 2000 1999 A Receivables Turnover 0.38 -035 187 B_ Inventory Turnover 0.05 -0.40 0.74 C_ Gross Profit 0.05 0.16 -0.09 D__ Net Income as a Percentage of Sales 015 024 0.01 E Inventory as a Percentage of Sales 0.05 0.67 -0.42 F Property, Plant, and Equipment as a Percentage of Sales 0.00 -0.14 0.83 G Inventory as a Percent of Current Assets 0.08 0.06 0.34 H_ Property, Plant, and Equipment as a Percent of Total Assets 0.07 -0.24 1.36 1 Machinery and Equipment as a Percentage of Sales -1.00 -0.04 0.91 J Working Capital 057 164 0.88 K Current Ratio 0.48 0.02 0.93 L Quick Ratio 0.29 -0.07 0.42 Refer to Appendix 1.1 for computational methodolo3y and formulae. Base year taken as 1998. As the table above illustrates, the auditors could have recognised the fraud by considering large fluctuations between financial periods in: Gross Profit Index (C) where there was a sharp decrease of 9% from year 1998 to 2000 and subsequent sharp increase of 16% from year 2000 to 2001. Net Income Index (D) which exhibits a sharo rise of 24% from 1999 to 2000. It is evident that Net Income increased by a greater rate than Gross Profit no apparent reason. Both Index E and F which illustrate that inventory decreased significantly (42%) in 1989 and rose quite sharply (67%) thereafter, whilst the reverse occurred in Property, Plant and Equipment without any apparent reason. Section 1 Word Count: 185 “Thomas, 2005 Page 4| of 23Section 2 Part A ~ Identification of Fraud i- Understated Expenses During the floatation of AstunIT on the LS.E.” in the middle of 1999, the company encountered substantial start-up costs and William Hebing, CEO’, intentionally misreported ‘operating expenditure as capital purchases by asking Paul Fedlin, Controller, to record these items as increases in inventory instead. Therefore, transactions that should have appeared ‘as expenses and had actually been recorded as fictitious assets. - Overstated Inventory (On a monthly basis, Hebing would review the prelimin ry financial statements and instruct Fedlin to record certain operating expenses as fictitious increases in inventory. This would result in the overstatement of inventory that did not exist in tangible form. Consequently, ‘there would be a simultaneous reduction in operating expenses and Inflated profit figures. - Overstated Equipment Accounts Before an imminent physical inventory count towards the end of 1999, at the instruction of Hebing, Fedlin created fictitious invoices for equipment purchases. This was another method of shifting fictitious inventory items in to the equipment account in a way that would not affect operating expenses and overall income. iv- Overstated Sales Fedlin is reported as selling fictitious inventory and re-depositing cheques that were made out for the payment for fictitious equipment purchases, as the payments received for the sale of fictitious inventory. Simultaneously, these fictitious sales were recorded in accounts receivable, which resulted in the overstatement of sales during this time. * London Stock Exchange ° Chief Executive Officer Page 5| of 23Part B ~ Evidence of Fraud The understatement of expenses, and consequent overstatement of gross profit, should have become evident to the auditors by the large increase in the value for closing inventory increase of over 276%* for closing inventory, and an uncharacteristic increase of the total assets between these two periods. and total assets in year 2000. There was a substar Similarly, we can observe a large increase of 145%° in PPE® during years 2000 and 2001 without any tangible evidence in the acquisition of such assets. In addition, it is evident that sales revenue continued to increase year on year, increasing 145%” in years 1999 and 2001, and 165%° in year 2000 without justification. The auditors should have questioned management regarding the lack of supporting documents and sound paper trails in relation to the increase in PPE. This would have uncovered the misstatement and reallocation of fictitious inventory from year 1999 to PPE in year 2000. A physical inventory check should have been conducted in every period which would have minimised the risk associated with inflated figures. Similarly, Une was ue Justification for increases in revenue and this should have prompted the auditors to seek clarity from management for the underlying reason to this phenomenon. The auditors should have conducted nurrerous tests by taking large random samples of supplier invoices, payment receipts and associated paper trails. The use of advanced sampling techniques would minimise the risk associated with the concealment of operating expenditure and inflated revenue figures. * See Appendix 1.2 5 See Appendix 1.3 ® Property, Plant and Equipment 7See Appendix 1.4 * See Appendix 15 Page 6| of 23Part C- The Role and Composition of AstunIT plc's Audit Committee The role of the Audit Committee at AstunlT should have been to proactively monitor, advise and oversee the activities of management in the preparation of financial statements. They are responsible for the appointment, compensation, retention, and oversight of independent auditors who should report directly to the Audit Committee’, ‘The Audit Committee is charged with the corporate governance of the company and as such it needs to ensure accountability of the tianagement team, as well as the internal and external auditors. This includes, but is not limited to, the engagement of certain groups involved in the financial reporting and internal controls process and the development of sound and reliable risk management systems to safeguard the overall objectivity of the financial reporting and internal controls process”. It is also essential to establish specific procedures for handling complaints received by the company regarding accounting procedures and controls including a medium that enables employees to confidentiality submit concerns regarding questionable accounting or auditing matters". ‘The Audit Committee should have been composed of at least three members, all of which should be either non-executive members or independent external members, including at least one committee member with recent and relevant financial experience and expertise; that is, the member should have 4 deeper understanding of, and experience with, following and applying GAAP” in relation to the preparation of a companies financial statements. Section 2 Word Count: 684 ° Gray and Manson, 2009 ® institute of Chartered Accountants in England and Wales, 2004 * Generally Accepted Accounting Principles Page 7| of 23