Nexquirk is a developer of game software based on television game shows. Nexquirk has been selling the games on CD ROMs for computers, and they also make software for game-playing machines. The software has been sold primarily by a variety of retail outlets. The company was a small, publicly held company traded over the counter for the past eight years, but with modest earnings in good years and losses for the past four years. They filed for Chapter 11 bankruptcy protection last year and recently received a sizeable cash investment from a small private equity firm that sees potential in the ailing company. Many of Nexquirk's previous vendors will no longer ship materials because they did not get paid on old bills because of the bankruptcy.
The company is planning a secondary offering in a few months to raise funds so they can expand development of game software for new electronic devices. In addition to selling the game software based on television game shows, Nexquirk has also been developing their own game software, which they believe can be competitive with other game software. Future sales will be primarily by download directly to the buyers' devices via the Internet. The company also plans to use the funds to market a new productivity software package similar to MS Office, with features such as word processing, spreadsheet applications, and presentations. This productivity software package is being developed primarily by one of Nexquirk's vice presidents, who has been working on it for several years.
The company's president and CFO roles are currently covered by one person who was installed by the private equity firm to turn the company around after they booted out the former president and senior management. The president and CFO, Bob Williams, is a commanding presence at over 6 feet 6 inches tall, with a wide girth and loud booming voice. His abusive management style is described as "management by raising his voice," which causes each of the senior officers and everyone on the accounting staff to do whatever Bob demands.
Because of his caustic and abusive nature, Bob got into an argument with the holder of the copyright on the game shows for which they develop software, and the copyright owner decided not to renew Nexquirk's rights to produce the software. Instead, the copyright owner will contract with another software company to produce the software and they will market it after the current agreement with Nexquirk expires in six months.
The equity firm wants sales and profits to look good for the pending stock offering and have been pressuring Bob for results. He, in turn, has been pressuring staff to do anything and everything to increase sales and profits for the current year. Bob is worried about how the loss of the rights to produce game show software might impact future sales. He has decided not to mention the loss of the license to the auditors or disclose it in the SEC filings for the stock registration. Also, being rather vindictive, he does not want the new developer of the game show software to have solid sales immediately after their production, so he has directed the sales and marketing team to offer special deals to their current retailers so they can flood the market with more than a year's worth of inventory to block the new developer from quickly entering the market. In addition to offering special pricing, the terms of sale also provide that payment is not due for 180 days on purchases above prior year purchases by each retailer, and they may return the software at any time.
To further boost the sales and profit numbers, Bob decided to use the productivity software to generate some official-looking purchase orders worth several million dollars from other large retailers just prior to the end of Nexquirk's fiscal year. The phony purchase orders directed shipments of the CDs to a storage facility a few miles away. He personally rented the storage facility for the purpose of receiving the shipments.
1. What substantive procedures should the auditors employ in the revenue cycle, and how would they possibly detect the transactions described above?
2. What red flags in the fraud triangle should the auditors consider when planning this audit?