In 2009, the SEC charged VeriFone Holdings, Inc., a technology company, with falsifying the company's financial statement to improve gross margins and income.
VeriFone relied on gross margin as an indicator of its financial results and provided forecasts of its quarterly gross margins to investment analysts.
In early February 2007, during the quarterly closing process for the fiscal year ending January 31, 2007, preliminary financial results revealed a gross margin of 42.8%, which was about four percentage points below internal forecasts that had been communicated to analysts. Paul Periolat was a mid-level controller at Veri Fone, and his responsibilities included forecasting gross margins, and making final inventory-related valuation adjustments relating to royalties, warranty reserves, and inventory obsolescence. When the CEO and CFO learned of the unexpectedly low gross margins in the preliminary financial results, they sent emails calling the issue an "unmitigated disaster" and instructed VeriFone managers beneath them to "figure it [and related low results] out."
Periolat determined that the problem in gross margin was due to incorrect accounting by a foreign subsidiary. He made a manual adjusting entry to record an increase to ending inventory of $7 million, thereby decreasing cost of goods sold and increasing gross margin. He failed to confirm the adjustments with the foreign subsidiary's controller, and knew that the adjustments were incorrect.
Periolat continued to make large manual adjustments to inventory balances quarterly for which there was no reasonable basis over the next two quarters. These adjustments allowed the company to continue to meet its internal forecasts and its earnings guidance made to analysts. Periolat was able to make his unwarranted adjustments, in part, because VeriFone had few internal controls to prevent them. Neither the employee's supervisor nor any other senior manager reviewed the employee's work. Further, effective controls were not in place to prevent the person responsible for forecasting financial results from making adjustments that allowed the company to meet the forecasts.
Ultimately, when the misstatements were revealed and VeriFone restated its financial statements, the company's operating income fell from $65.6 million to $28.6 million, a reduction of 129%.When the misrepresentations were revealed in December 2007, VeriFone's stock price dropped 46%, which represented a one-day drop in market capitalization of $1.8 billion. With this much at stake, auditors need to remember to be professionally skeptical about manual entries and to require that appropriate documentation supporting the entries be available for their review. Further, in areas where internal controls are not effective, the auditor should implement appropriate substantive procedures due to the heightened risk of misstatement. For further information, see SEC AAER No. 3044, September 1, 2009.
a. List the inherent, control, and fraud risk factors relevant to this case.
b. What substantive audit procedures would have detected the fraud? Would preliminary or substantive analytics have been helpful in detecting the fraud?