read Fraud Case and answer 3 questions, and the questions related auditing!!
Case 1 – Hamilton Corporation Overview Hamilton Corporation (the Company) is a multinational auto parts suppl\ ier headquartered in the Midwest. Hamilton began its operations as a wholly owned subsidiary of Motor Company (MC), and was\ ultimately spun off and incorporated in 1999. Shortly after the separation, MC informed Hamilton that the Company owed an esti\ mated $350 to $800 million in warranty claims related to automotive sales that had occurred prior to the separation in 1999. H\ amilton’s management team believed that any warranty claims related to sales prior to the separation should be limited to the\ reserve amount that was agreed to at the time of separation.
However, because MC remained Hamilton’s largest client, the managemen\ t team was motivated to find a solution that would appease MC.
As a direct result, the management team at Hamilton worked hard to convi\ nce MC to cap warranty claims related to prior automotive sales at $100 million. Unfortunately, MC rejected the idea an\ d instead continued to assert the full warranty claim against Hamilton. Recognizing that the Company could not afford to make \ warranty payments in excess of $100 million without a significant reduction in operating income, management had significant \ incentives to mask the true level of warranty expense in order to meet analysts’ forecasts.
Damaged Goods The management team at Hamilton fully understood that the Company’s p\ erformance in its first several quarters was vital to the long-term success of the Company. Because the marketplace often views sp\ in-offs as “damaged goods” in the early stages, the demonstration of impressive financial results, right away, was belie\ ved to be imperative to the Company’s ability to raise future capital.
Management quickly realized that a series of challenges existed that wer\ e likely to prevent the Company from reporting favorable results in its first several quarters of operation as a stand-alone enti\ ty. To start, management believed that the warranty claims asserted by MC had the potential to cripple the Company. In addition, ma\ nagement had to address a sharp and unexpected drop in automotive demand that affected its sales volume during the same time\ period. Unwilling to report adverse results and risk the Company’s ability to continue as a going concern, management made the\ decision to report favorable results, no matter what.
Warranty Claims Faced with mounting pressure from the warranty claims asserted by MC, ma\ nagement increased Hamilton’s warranty reserve by $112 million during the second quarter of 2000. The increase in warranty\ reserve should have been charged as an expense under GAAP since the company Hamilton did not have a written agreement stating\ that the claims reflected a correction to its 1999 spin- off agreement with MC. However, in an effort to limit the effect on repo\ rted net income, management booked the entry directly to retained earnings as a net adjustment to the spin-off transa\ ction. In so doing, management failed to reveal the true nature of the charge to investors.
As deliberations with MC continued throughout 2000, Hamilton eventually \ agreed to settle 27 warranty claims for a total of $237 million in the third quarter. Recognizing that another spin-off rel\ ated adjustment to retained earnings might raise a red flag, management developed a more elaborate accounting scheme to mitigat\ e the effects of the additional warranty claims on net income. To do so, management decided to focus on the subjectivity th\ at existed in the determination of pension expense.
More specifically, management determined that if it revised assumptions used \ in determining pension expenses prior to the spin-off, the payment to MC could be disguised primarily as a “true-u\ p” of the pension liability. To support this scheme, management obtained a letter from the Company’\ s actuary that provided the “reasonable range” for pension assumptions that had been made in the past. Management then deli\ berately selected a new point estimate within each range to make it appear that the Company actually owed MC $202 mill\ ion for its past pension liabilities. Additionally, management convinced MC to allow the meeting minutes between the two com\ panies to reflect an erroneous discussion Fraud Case Studies © 2014KPMG LLP, a Delaware limited liability partnership and the U.S.\ member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative \ (“KPMG International”), a Swiss entity. All rights reserved. Printed in the U.S.A. The KPMG name, logo and “cutti\ ng through complexity” are registered trademarks or trademarks of KPMG International. NDPPS 309511 of past pension estimates to further support the unfounded pension loss \ claim. As a result, management was able to book $202 of the $237 million warranty settlement as an actuarial loss in its pension plan. On\ ly the remaining $35 million was recognized as additional warranty expense in the financial statements.
Off-Balance Sheet Financing As the end of 2000 was drawing near, management decided to take addition\ al actions to boost reported earnings. Specifically, Hamilton devised a scheme to remove $200 million of high-value precious \ metals inventory (used in the production of auto parts) from the balance sheet through a collateralized loan agreement with Culp\ epper Bank late in 2000. According to the agreement, which was deliberately designed to mislead balance sheet readers, Hamilt\ on would receive the cash proceeds of the sale, but was then required to buy the inventory back from the bank 30 days later \ for the original purchase price plus $3.5 million in interest.
Prior to executing the agreement, Hamilton’s auditor advised the Comp\ any that the transaction could only be accounted for as a sale and repurchase under GAAP if both prices were based on market, and \ the transaction costs did not include Culpepper Bank’s interest costs. Hamilton agreed to the conditions set forth by the audit\ or and then made sure that the form of the transaction would meet the auditor’s conditions.
To convince the auditor that the financing transaction qualified as a sa\ les and repurchase agreement under GAAP, management created false documents including a memo that provided Hamilton’s rat\ ionale for the below market prices for the sale of inventory under the agreement. The memo stated that the below market prices were s\ upported by large volume discounts and one-month future prices of metals – neither of which were justified by the actu\ al market data. However, the analysis was elaborate and management convinced the auditors that the transaction qualified as a sa\ le and repurchase agreement under GAAP. Almost concurrently, Hamilton’s management used a very similar strategy to r\ emove an additional $70 million of batteries and generators from its reported inventory balance. Since Hamilton used LIFO, each of t\ hese liquidating transactions allowed Hamilton to artificially boost net income with LIFO liquidation gains that were impr\ operly realized under GAAP with the sale and repurchase transactions.
Fraud Discovery Initially, management overstated net income by $69 million in booking th\ e warranty claims adjustment to retained earnings and then improperly increased net income by an additional $130 million t\ hrough its treatment of the subsequent warranty claims settlements with MC. In addition, due to the LIFO gains realized \ with the fourth quarter inventory transactions, Hamilton recognized an additional $81 million dollars to its bottom line. Taken t\ ogether, the misstatement totaled approximately $280 million dollars in 2000.
As noted, management’s financial statement fraud was not limited to a\ single transaction. Rather each time that pressure existed to meet market expectations, management appeared to devise a scheme to b\ oost net income. The schemes were supported by skillfully crafted evidence provided to the auditor by the management\ team. In the end, it was a whistleblower, believed to be from a vendor involved in a fraudulent transaction, which objected to th\ e Company’s inaccurate reporting of a specific transaction that turned management into the SEC. The ensuing SEC investigation uncov\ ered the full extent of management’s wrongdoings over a four-year period of time.
Case Questions 1. Based on your understanding of fraud risk assessment and the case inform\ ation, identify at least three specific fraud risk factors related to Hamilton Company. 2. If you were responsible for planning the audit of Hamilton Company, how \ would the fraud risk factors identified in question #1 have influenced the nature, timing, and extent of your audit\ work? Case 1 Hamilton Corporation © 2014KPMG LLP, a Delaware limited liability partnership and the U.S.\ member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative \ (“KPMG International”), a Swiss entity. All rights reserved. Printed in the U.S.A. The KPMG name, logo and “cutti\ ng through complexity” are registered trademarks or trademarks of KPMG International. NDPPS 309511 3. Please consider the five steps of the KPMG Judgment Framework. For each \ step, think carefully about what the auditors could have done to help detect the fraudulent activity related \ to the warranty reserve account at Hamilton Company. Please use the following questions to guide your critical think\ ing about this case:
a) Clarify the issues and the objectives related to auditing the warranty r\ eserve account at Hamilton. To do so, please ask yourself what specific problem needs to be solved by the auditor? Wh\ at assumptions would have the biggest impact on the overall judgment to be made? How does this judgment relat\ e to the overall audit process? b) Consider the various alternatives that should be thought about when audi\ ting the warranty reserve account at Hamilton. To do so, please ask yourself about each of the alternatives t\ hat are reasonably possible, even when they might contradict the client’s point of view. Are there any exter\ nal factors that should be considered? c) Consider the type of information and evidence that should be gathered wh\ en completing the audit of the internal control activities related to the warranty reserve account at Hamilton. \ To do so, please ask yourself about the type of information that would be helpful to determine whether the inter\ nal control activities were operating effectively. How can you be sure that the information gathered is reliab\ le? In addition, how can you be sure that the evidence is appropriate in this situation? Finally, what evidence co\ uld be gathered that might reveal that the internal controls were NOT operating effectively? d) Consider the type of information and evidence that should be gathered wh\ en completing the substantive testing procedures related to the warranty reserve account at Hamilton. To do so\ , please ask yourself about the type of information that would be helpful to determine whether the warranty rese\ rve account was fairly stated in the financial statements. How can you be sure that the information is reliab\ le? In addition, how can you be sure that the evidence is appropriate in this situation? Finally, what evidence co\ uld be gathered that might disconfirm your belief that the warranty reserve account was fairly stated? e) Consider the factors that would have to be thought about when reaching a\ final conclusion about the warranty account at Hamilton. Although you do not have access to the actual evide\ nce, what “big picture” issues would have to be thought about before reaching a final conclusion? Finally, what co\ uld possibly go wrong in this situation? f) Consider the importance of documenting the rationale for your final conc\ lusion. Why do you think it is important to document your rationale when finalizing your judgment? In addition, d\ escribe what is expected to be documented to support an auditor’s professional judgment. 4. Describe the availability tendency in your own words, and give an exampl\ e of how the tendency could result in a lack of audit effectiveness. How can the tendency be mitigated? 5. Describe the confirmation tendency in your own words, and give an exampl\ e of how the tendency could result in a lack of audit effectiveness. How can the tendency be mitigated? 6. Describe the overconfidence bias in your own words, and give an example \ of how the bias could result in a lack of audit effectiveness. How can the bias be mitigated? 7. Describe the anchoring bias in your own words, and give an example of ho\ w the bias could result in a lack of audit effectiveness. How can the bias be mitigated? 8. What tendency or bias is most likely to have manifested in the Hamilton \ case example? Please provide support for your answer. About the Author This case study was written by Jay C. Thibodeau (Bentley University) i\ n collaboration and with support from colleagues at KPMG LLP to help audit instructors integrate the KPMG Professional Judgment F\ ramework into the classroom. This case was based upon an Accounting and Auditing Enforcement Release (AAER) that was is\ sued by the SEC in the recent past. The material is intended to be used for academic purposes only. The work of Denise R. Ha\ nes (Villanova University) was instrumental in the completion of this case study and is gratefully acknowledged.
Case 1 Hamilton Corporation © 2014KPMG LLP, a Delaware limited liability partnership and the U.S.\ member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative \ (“KPMG International”), a Swiss entity. All rights reserved. Printed in the U.S.A. The KPMG name, logo and “cutti\ ng through complexity” are registered trademarks or trademarks of KPMG International. NDPPS 309511 www.kpmg.com