All appeared well at Comptronix Corporation, a Guntersville, Alabama based electronics company, until word hit the streets November 25, 1992 that there had been a fraud. When reports surfaced that three of the company’s top executives had inflated company earnings for the past three years, the company’s stock price plummeted 72% in one day, closing at $61/8 a share down from the previous day’s closing at $22 a share.

The Securities and Exchange Commission’s (SEC) subsequent investigation determined that Comptronix’s chief executive officer (CEO), chief operating officer (COO), and controller/treasurer all colluded to overstate assets and profits by recording fictitious transactions. The three executives overrode existing internal controls so that others at Comptronix would not discover the scheme. All this unraveled when the executives surprisingly confessed to the company’s board that they had improperly valued assets, overstated sales, and understated expenses. The three were immediately suspended from their duties.

Within days, class action lawsuits were filed against the company and the three executives. Immediately, the company’s board of directors formed a special committee to investigate the alleged financial reporting fraud, an interim executive team stepped in to take charge, and the accounting firm of Arthur Andersen, LLP was hired to conduct a detailed fraud investigation.

Residents of the small Alabama town were stunned. How could a fraud occur so close to home? Were there any signs of trouble that were ignored?

REQUIRED

[1] Auditing standards note that three conditions are generally present when fraud occurs. Research the authoritative standards for auditors and provide a brief summary of each of the three fraud conditions. Additionally, provide an example from the Comptronix fraud of each of the three fraud conditions. 

[2] PCAOB AS 1101, Audit Risk provides guidance about the auditor's consideration of audit risk in an audit of financial statements. Visit the PCAOB's website (www.pcaob.org) to obtain the standard to address the following questions. 

[a] What is audit risk? 

[b] Audit risk is a function of what other types of risks? 

[c] PCAOB AS 1101 notes that the risk of material misstatements at the assertion level consist of two components. What are they? 

[d] How does detection risk differ from the two components of the risk of material misstatement? 

[3] Describe typical factors that auditors evaluate when assessing inherent risk. With the benefit of hindsight, what inherent risk factors were present during the audits of the 1989 through 1992 Comptronix financial statements? 

[4] Describe the five components of internal control. What characteristics of Comptronix’s internal control increased control risk for the audits of the 1989 – 1992 year-end financial statements? 

[5] The Committee of Sponsoring Organizations of the Treadway Commission (widely known as COSO) revised its Internal Control - Integrated Framework to update its guidance to reflect a number of advancements in best practices, including those related to information technologies. Visit COSO's website (www.coso. org) to obtain a copy of the Executive Summary of the Internal Control - Integrated Framework. Review that summary to answer the following questions: 

[a] Which component of internal control contains a principle(s) related to the board of directors? 

[b] Summarize the primary responsibilities related to board of director oversight noted in the COSO summary. 

[6] The board of directors, and its audit committee, can be an effective corporate governance mechanism. 

[a] Discuss the pros and cons of allowing inside directors to serve on the board. Describe typical responsibilities of audit committees. 

[b] What strengths or weaknesses were present related to Comptronix’s board of directors and audit committee? 

[7] Public companies must file quarterly financial statements in Form 10-Qs that have been reviewed by the company’s external auditor. Guidance for auditors of public companies in regards to reviews of public company interim statements is contained in the PCAOB's AS 4105, Interim Financial Information, which is available online at the PCAOB's website (www.pcaob.org) under the Standards link. Research the content in that standard and briefly describe the key requirements for reviews of interim financial information of a public company. Why wouldn’t all companies (public and private) engage their auditors to perform timely reviews of interim financial statements? 

[8] Describe whether you think Comptronix’s executive team was inherently dishonest from the beginning. How is it possible for otherwise honest people to become involved in frauds like the one at Comptronix?

[9] The PCAOB's AS 2201, An Audit of Internal Control Over Financial Reporting That is Integrated with an Audit of Financial Statements, describes the auditor's responsibility to use a "top-down approach" and describes the auditor's responsibility for testing "entity level controls." Refer to PCAOB AS 2201 to answer the following questions: 

[a] What is a top-down approach? 

[b] What are entity-level controls? 

[c] What is the auditor's responsibility regarding the testing of entity-level controls? 

[10] Auditing standards note that there is a possibility that management override of controls could occur in every audit and accordingly, the auditor should include audit procedures in every audit to address that risk. 

[a] What do you think is meant by the term “management override”? 

[b] Provide two examples of where management override of controls occurred in the Comptronix fraud. 

[c] Research auditing standards to identify the three required auditor responses to further address the risk of management override of internal controls. 

It is recommended that you read the Professional Judgment Introduction found at the beginning of the book prior to responding to the following questions. 

[11] The Committee of Sponsoring Organizations of the Treadway Commission (COSO) issued a thought paper titled, "Enhancing Board Oversight: Avoiding Judgment Traps and Biases." Visit COSO's website (www.coso.org) to download a free copy of this paper to answer the following questions: 

[a] What must individuals who serve on the board of directors demonstrate in order to avoid liability under the business judgment rule? 

[b] How does the COSO thought paper define "judgment"? 

[c] What are the primary steps in the professional judgment process? 

[d] How might consideration of these steps in the judgment process help improve board judgments?