Exam I Flashcards
(152 cards)
1
Q
How does audit risk play out in practice? Namely, there are four possible scenarios in an audit, but in reality, only two really play out. What are those two scenarios?
A
(1) Okay: conclude account is fairly stated and it actually is; conclude it’s materially misstated and it actually is but can correct during testing with adjusting J/E
(2) Risk of Incorrect Acceptance: conclude account fairly stated but it is actually materially misstated
2
Q
Define audit risk.
A
Risk that an auditor may issue unqualified report due to the auditor’s failure to detect material misstatement either due to error or fraud
3
Q
What are the three components of audit risk?
A
Inherent Risk * Control Risk * Detection Risk
4
Q
Define control risk.
A
Risk that a misstatement could occur but may not be detected and corrected or prevented by entity’s internal controls
5
Q
Define inherent risk.
A
Risk without considering internal controls
Or alternatively “a raw risk that has no mitigation factors or treatments applied to it”.
6
Q
Define detection risk.
A
Risk that the auditor will conclude that no material errors are present when in fact there are
7
Q
If you conclude that an account is materially misstated, but the account is actually fairly stated, what do you call this risk?
A
Risk of incorrect rejection
8
Q
If you conclude that an account is fairly stated, but the account is actually materially misstated, what do you call this risk?
A
Risk of incorrect acceptance
9
Q
What can you do to reduce sampling risk?
A
Increase sampling size
10
Q
If you conclude that an account is materially misstated, and it actually is, what can you do to correct this during testing?
A
Book an adjusting J/E to fix the error
11
Q
How do F/S add value?
A
Reduce cost of capital
12
Q
What did Bamber and Stratton note in their 1997 study on audit uncertainty and interest rates?
A
Significant relation b/w uncertainty (modified audit report) and higher interest rates
13
Q
What did Blackwell sample and find in his 1998 study that provides convincing positive evidence that F/S audits add value?
A
- Sampled 212 revolving credit loans at 6 private banks
- Dependent variable was loan interest rates
- Found that:
(1) loan interest savings are inversely related to size (bigger banks saw less savings because they are deemed less risky by creditors), and
(2) average interest savings from audit was 25 basis points (28%-50% of audit fee)
14
Q
What did Chaney and Philipich sample and find in their 2002 study that provides convincing negative evidence that F/S add value?
A
- Sampled Andersen clients’ market cap 2 to 3 days after 1/10/2002 admittance of document shredding at Enron
- Found: market punished auditor’s clients around an audit failure because auditor is no longer reliable (average market cap decline 2 days later was $31.6m and 3 days later was $37.1m)
15
Q
Since any audit firm can reduce a company’s cost of capital with an audit, why should a company not switch auditors to get the best deal?
A
High switching costs as market penalizes for switching auditors
16
Q
What is the enabling mechanism for firms to manage earnings, financial position, and cash flow?
A
Accruals (which are estimates and uncertainties)
17
Q
1998 Waste Management Scandal:
(1) What Happened
(2) How They Did It
(3) How They Got Caught
A
(1) Reported $1.7 billion in fake earnings
(2) Falsely increased the depreciation time length for their PPE on the B/S
(3) New CEO and management team went through books and caught it
18
Q
2001 Enron Scandal
(1) What Happened
(2) How They Did It
(3) How They Got Caught
A
(1) S/H lost $74 billion; thousands of employees and investors lost their retirement accounts; many employees lost their jobs
(2) Kept huge debts off B/S
(3) Turned in by whistleblower; high stock prices fueled suspicions
19
Q
2002 WorldCom Scandal
(1) What Happened
(2) How They Did It
(3) How They Got Caught
A
(1) Inflated assets by as much as $11 billion (hidden in two J/E)
(2) CEO underreported line costs by capitalizing rather than expensing, and inflated revenue with fake accounting entries
(3) WorldCom’s internal auditing department uncovered $3.8 billion in fraud
20
Q
What are two things Sunbeam did to engage in income smoothing?
A
(1) Channel stuffing: Grills sold on consignment but Sunbeam accounted for them as if they’d been sold in most recent quarter and inflated revenues by $71 million
(2) Bill and Hold: Sunbeam inflated revenues by 19% by billing customer for products but did not ship the product until a later date; controversial practice because allowing the seller to receive payment now, but making them wait a length of time before transferring the product could be used to inflate revenues meant for subsequent quarters
21
Q
How did Priceline engage in income smoothing? Explain.
A
- Grossed up revenue: Summed full amount customers paid for tickets, rooms, and cars instead of just the spread between customers’ accepted bid and price it paid to travel and lodging providers and inflated revenue by $134 million
22
Q
How did Motorola engage in income smoothing? Explain.
A
- Vendor financing: Motorola loaned its service provider TelSim money to buy its equipment, but Motorola shouldn’t have extended so much credit to TelSim in an emerging market economy as it couldn’t pay Motorola back
23
Q
How did IBM engage in income smoothing?
A
- One-time gains: IBM beat analyst expectations by a penny by selling a business for $340 million on the last day of a quarter; no disclosure about the sale which IBM used to lower operating costs instead of reporting as non-recurring one time gain
24
Q
What B/S maneuver did Coke and American Airlines use to accomplish income smoothing?
A
Off balance sheet financing
25
What B/S maneuver did AOL use to accomplish income smoothing? Explain.
- Capitalizing marketing costs instead of showing them as expenses and was able to report profits instead of losses for six of eight quarters by deferring these advertising costs
26
What other B/S maneuvers did companies use to accomplish income smoothing? (e.g. WR Grace, Sears, AIG, Sunbeam, Borden)
- WR Grace: Cookie Jar Reserves
- Sears: Credit Card Reserves
- AIG: Insurance Reserves
- Sunbeam and Borden: Restructuring Reserves
27
How did Sunbeam manage its cash flows? Explain.
- By factoring:
(1) companies facing cash flow squeeze and slow paying customers often sell A/R to specialized companies called factors
(2) factor advances most of invoice amount (70%-90%) after checking out credit worthiness of billed customer
(3) when bill paid, factor remits balance minus a transaction/factoring fee
28
What are three problems with F/S today?
- Obsolete
- Reflect industrial era assets
- Ignore capacity for innovation and information
29
Are F/S relevant?
Yes, but it is a healthy product line with an obsolete product
30
What are three reasons by F/S are obsolete?
- Other sources of info available
- Audit report lag
- Assumes one-size-fits-all
31
What is a key difference b/w F/S during the industrial revolution and F/S post-revolution?
- Industrial revolution: emphasis on controlling costs
| - Post-revolution: emphasis on adding value
32
How are entity relationships changing in the information age?
Need to find different metrics to measure a company by (some companies may not carry A/R, A/P rending traditional F/S useless to creditors and investors)
33
What is the risk that errors will occur due to? Is it controllable?
- Inherent risk and control risk
| - Uncontrollable
34
What is the risk that errors will not be detected due to? Is it controllable?
- Detection risk
| - Controllable (with tests of controls and analytical procedures)
35
Why do we multiply "risk that errors will occur" by "risk that errors will not be detected"?
Multiply because errors occur sequentially
36
Define sampling risk.
- Risk that what you're looking for is not where you're looking
- Varies inversely with sample size (impractical and costly to examine 100% of a client's records)
37
Define non-sampling risk. What is it due to?
- Attaches to transactions sampled
- Results from an incomplete examination of the available data
- Due to human error (it is the failure of an auditor to catch a mistake or a misstatement generally from inexperience)
38
What are two risks in sampling?
(1) Risk of Incorrect Rejection (reject account balance that is fairly stated; overstates error rate)
(2) Risk of Incorrect Acceptance (accept account balance that is not fairly stated; understates error rate)
39
What are 3 questions to always ask yourself in auditing a transaction?
(1) Business Purpose: What are the economics underlying the transaction?
(2) GAAP/IFRS Rules: What are the rules surrounding the transaction?
(3) Industry Practice: What do competitors do in like-kind transactions?
40
What are some red flags that should've popped up with Sunbeam?
- Of the pop in revenue, only a small percentage made it to NI
- Restructuring accrual decreased meaning cash should've gone down, but cash went up
- Days sales outstanding high at 79.5 days meaning co. not getting paid and may have liquidity issues
- 38% increase in A/R but only 19% increase in sales
41
What was Coca-Cola's problem that led them to engage in some off B/S financing? Solution?
- Problem: no pricing power and a lot of debt on F/S
| - Solution: spun off bottling co and accrued two benefits (had a little pricing power and spun off most of LT debt)
42
What was American Airlines' problem that led them to engage in some off B/S financing? Solution?
- Problem: had over $10 billion in liabilities which would impact their ratios and loan covenants if all this liability remained on B/S
- Solution: Classified certain capital leases (B/S liability) as operating leases (footnote only)
43
What are three things that matter in a restatement?
(1) Legal liability to the auditor
(2) GAAP implications
(3) Auditing implications
44
How far back is a company going to have to restate?
Class period gets bigger as "n" increases
45
In GAAP ASC 250 "Accounting Changes and Error Corrections," a change in accounting principle calls for (1) what type of adjustment and (2) what period is affected?
(1) Retrospective adjustment
| (2) Past & Current
46
In GAAP ASC 250 "Accounting Changes and Error Corrections," a change in accounting estimate calls for (1) what type of adjustment and (2) what period is affected?
(1) None: Prospective
| (2) Current and Future
47
In GAAP ASC 250 "Accounting Changes and Error Corrections," a change in reporting entity calls for (1) what type of adjustment and (2) what period is affected?
(1) Retrospective adjustment
| (2) Past
48
In GAAP ASC 250 "Accounting Changes and Error Corrections," a correction of an error calls for (1) what type of adjustment and (2) what period is affected?
(1) Retrospective adjustment
| (2) Past and Current
49
What are 3 things that GAAP requires in a restatement for correction of an error?
(1) Reflect in opening assets and liabilities balance the cumulative effect on prior periods
(2) Reflect in opening RE balance the offsetting adjustment
(3) Correct each presented prior-period F/S
50
What are two things that GAAP says an error in the F/S of a prior period generally results from?
(1) Misuse of facts
| (2) Misapplication of accounting principle
51
With Analytical Surveys, what did management do that was fraudulent?
- Materially overstated revenue by using methods not permissible under the percentage of completion method for recognizing revenue and engaged in cost shifting
52
What does the A stand for in Form 10K/A?
Amended
53
What does GAAP ASC 855-10 "Subsequent Events" require?
- That management recognize the effects of all subsequent events in the F/S
54
What does GAAS AU Sec. 561 "Subsequent Discovery of Facts" require?
- If auditors discovers facts after report date, should take action if:
(1) info is reliable
(2) facts existed at report date
(3) if known, report would've changed
(4) outsiders are relying on report
55
What are two forms the auditor can file if there are subsequent events/subsequent discovery of facts?
(1) Form 8-K
| (2) Restated Form 10-K/A
56
Can restatement lead to securities litigation?
Yes
57
What are the six key steps in the SEC's enforcement process?
(1) Leads
(2) Inquiry
(3) Investigation
(4) District Office recommendation
(5) Commission authorization
(6) Civil action or administrative proceeding
58
In the SEC enforcement process, what are 2 things you're looking for when looking for leads? Is this formal or informal?
- Outliers w/i industry
- Investor complaints
- Informal (non-public and no subpoena power)
59
In the SEC enforcement process, what do you do in the inquiry stage? Is this formal or informal?
- Follow up on outliers and investor complaints
- Evaluate information
- Informal (non-public and no subpoena power)
60
In the SEC enforcement process, what do you do in the investigation stage? Is this formal or informal?
- Investigate further
- Starts out informal (non-public and no subpoena power)
- Becomes formal if SEC suspects something (subpoena power)
61
In the SEC enforcement process, what happens in the enforcement process?
- District office has to decide if they want to recommend that SEC authorize civil action or administrative proceeding
- District office sends client "Wells Notice" if they may have prima facie case against them
62
What does the Well Notice say?
- We're going to make a recommendation to the commissioners to take action against you but you have 30 days for a counterargument
- Counterargument can come in the form of a 30-age memo or a 20-minute video
63
What does the District Office do if client sends back a counterargument to the Wells Notice?
Review and decide if they should pass it along to the SEC commissioners
64
Who takes criminal cases?
Dept. of Justice
65
Who takes civil cases?
SEC
66
What is a civil action? Is it public or private?
- Lawsuit brought to enforce, redress, or protect rights of private litigants
- Public
67
What is an administrative proceeding? Is it public or private?
- Non-judicial determination of fault or wrongdoing
| - Private
68
What are an auditor's seven general responsibilities?
(1) Exercise professional skepticism
(2) Discuss among staff the risk of fraud driving material misstatement
(3) Obtain info needed to identify risk
(4) Id risks that may cause material misstatement
(5) Assess the risks
(6) Respond to assessment
(7) Evaluate audit evidence
69
Distinguish errors from frauds.
- Errors: unintentional misstatements or omissions (e.g. mistakes in gathering data)
- Frauds: intentional misstatements or omissions (e.g. embezzlement)
70
According to AU Sec. 316, "Consideration of Fraud in a F/S Audit" what are an auditor's four main responsibilities to mitigate the risk of fraud?
(1) Expand inquiries of management
(2) Expand fraud risk assessment
(3) Increase professional skepticism
(4) Respond to risk of management override
71
In responding to the risk of management override, what are three things an auditor should do?
Check:
(1) J/E for propriety
(2) Estimates for bias
(3) Unusual transactions for business purpose
72
What do auditors need to do in documentation?
Document compliance with substantially ALL major requirements
73
Is it plausible to adjust testing to account for the fact that frauds are committed at levels material to an individual? Why or why not?
No; decreasing materiality, increases hours, which increases costs
74
What was necessary for the auditors to do to catch the Waste Management fraud?
Expand inquiries of management and others
75
Why does earnings management occur?
Because of management override
76
What are three key things auditors should do to better detect potential fraud?
(1) Shift focus from w/p to person (think in terms of Fraud Triangle)
(2) Require team meetings to talk through likely intentional misstatements
(3) Acknowledge Revenue Recognition as a likely risk
77
Distinguish misstatements from omissions.
- Misstatement: about recorded transactions
| - Omissions: about omitted transactions
78
In exercising professional skepticism, what are two fraud risks auditors should PRESUME?
- Improper rev. recognition
| - Internal control override
79
In looking for improper rev. recognition, what are 4 things auditors should do in testing?
- Apply analytical procedures to disaggregated data
- Confirm sales contract terms
- Inquire of sales and shipments near year end
- Witness shipments at year end
80
In looking for management override of internal controls, what are 3 things auditors should do?
(1) Examine J/E for propriety
(2) Review accounting estimates
(3) Evaluate unusual transactions for business purpose
81
In discussing among audit staff the potential risks of fraud causing material misstatement, what is something to consider?
The Fraud Triangle (incentives/pressures, opportunity, rationalization)
82
What are incentives/pressures that affect the risk of fraudulent financial reporting?
Incentives/Pressures:
- Profitability threatened by economic conditions
- Excessive pressure to meet earnings forecasts or analyst expectations
- Management or BOD finances are threatened by entity's financial position
83
What are opportunities that affect the risk of fraudulent financial reporting?
Opportunities:
- Ineffective monitoring of management
- Complex org. structure
- Deficient internal control
84
What are attitudes/rationalizations that affect the risk of fraudulent financial reporting?
Attitudes/Rationalizations:
| - Ineffective implementation or enforcement of values by management
85
What are incentives/pressures that affect the risk of misappropriation of assets?
Incentives/Pressures:
| - Motivated by poor relationship b/w management and employees
86
What are opportunities that affect the risk of misappropriation of assets?
Opportunities:
- Large amounts of cash on hand
- Inventory items that are small in size, valuable, or in demand (diamonds)
- Easily convertible assets (diamonds)
- Inadequate internal control over assets
87
What are attitudes/rationalizations that affect the risk of misappropriation of assets?
Attitudes/rationalizations:
| - Attitudes or behaviors of employees with access to assets
88
In identifying risks that may cause material misstatement, what are 4 general things to consider?
(1) Type of fraud (fraudulent fin. reporting or misappropriation of assets?)
(2) Significance of fraud
(3) Likelihood of fraud
(4) Pervasiveness of fraud (does it affect an assertion or whole F/S?)
89
In responding to an assessment of potential fraud, what are 3 things an auditor should do to reduce the risk of fraud?
- Alter (1) nature, (2) timing, and (3) extent of audit procedures
90
In altering the nature of auditing procedures to reduce the risk of fraud, what is something an auditor can do?
- Replace analytical procedures with substantive procedures
91
In altering the timing of auditing procedures to reduce the risk of fraud, what is something an auditor can do?
- Observe inventory on unexpected dates
92
In altering the extent of auditing procedures to reduce the risk of fraud, what is something an auditor can do?
- Confirm orally written confirmations received from customers
93
How have auditors traditionally approached managements' assertions?
- Using a transactions lens
94
Why are transactions lenses problematic?
Focuses narrowly on recorded transactions rather than broadly on business context
95
Why was using a transactions lens problematic in auditing Lincoln and Loan Savings?
- Lincoln went into speculative real estate ventures and were mortgaging both sides
- Auditors tested management assertions and found nothing out of the ordinary
- But missed how management could sell recently purchased, remotely located, undeveloped land for 400-500% above cost
96
What two approaches do contemporary auditors use to supplant the transactions lens?
- Strategic lens
| - Balanced scorecard
97
What is the strategic advantage of the strategic lens over the transactions lens?
- Strategic lens shifts risk assessment from transaction risk to client's strategic business risk (shifts view of firm from w/i client to a web of interrelationships)
98
What is the strategic advantage of the balanced scorecard over the transactions lens?
- Balanced scorecard shifts performance from a single financial measure (F/S) to balanced operational measures (F/S and on-time delivery, production defects)
99
What does the transactions lens mainly focus on?
```
Financial measures
(AR = CR * IR * DR)
```
100
Does the risk lie at the transaction level in an audit?
Risk lies at the strategy level, not at the transaction level
101
Where was the risk with Sunbeam?
- Sunbeam's strategy was to restructure the company
| - Risk with restructuring is how to recognize different items under the new structure
102
What are six questions to ask yourself to see from the manager's viewpoint?
(1) Form of leadership?
(2) Strategic objective?
(3) Economic constraint?
(4) Org. structure?
(5) Means to meet goals?
(6) Value driver?
103
What is the primary form of leadership for more traditional companies? for more contemporary companies?
- Traditional: command & control (McDonald's)
| - Contemporary: articulation of vision
104
What is a typical strategic objective for more traditional companies? for more contemporary companies?
- Traditional: consistency (Microsoft)
| - Contemporary: constant improvement (IBM)
105
What is a typical economic constraint for more traditional companies? for more contemporary companies?
- Traditional: capital (P&G)
| - Contemporary: creativity (Google)
106
What is a typical organizational structure for more traditional companies? for more contemporary companies?
- Traditional: hierarchies
| - Contemporary: self-organizing teams
107
What is a typical means to meet goals for more traditional companies? for more contemporary companies?
- Traditional: division of labor
| - Contemporary: synthesis of minds
108
What is a typical value driver for more traditional companies? for more contemporary companies?
- Traditional: Lands & materials
| - Contemporary: Info & knowledge
109
What types of companies are easier to audit?
More traditional companies because we have a lot of data on these companies
110
What types of companies are harder to audit?
More contemporary companies (but there is an impulsion by auditors to audit such companies as they would a traditional company)
111
What are four different value drivers for companies? Give an example of a company for each.
(1) Financing Assets (GE Commercial)
(2) Employee Assets (Starbucks - employee benefits - full healthcare benefits and stock options - these benefits cost firm very little)
(3) Customer Assets ( Charles Schwab - customer base)
(4) Property Assets (McDonald's - largest commercial landholder in US)
112
What do a companies' metrics tell us?
Where its interests lie (the leads drive the lags)
113
What are certain financial measures a company looks at to measure performance? What are the metrics used to account for these measures? Use the Chevron example.
(1) Competitive operating advantage (metric = operating expense per barrel)
(2) Financial performance (metric = earnings growth)
(3) S/H return (metric = total S/H return)
114
What are certain non-financial measures a company looks at to measure performance? What are the metrics used to account for these measures? Use the Chevron example.
(1) Committed team (metric = worldwide employee survey)
(2) Delighted customers (metric = customer satisfaction survey)
(3) Public favorability (metric = public favorability index)
115
What does BMP stand for?
Business Measurement Process
116
What is a BMP?
- The strategic lens is a business measurement process.
117
What are the two factors you look at using the strategic lens?
AR + Risk of Economic Shock
118
What are three things to look at when using a strategic lens approach? Expand.
(1) Driver: what can they achieve? take fin. measures, connect with non-fin. measures, and project risk
(2) System: how can they achieve it? perhaps co. has process advantage.
(3) Result: how can they assess achievement?
119
How do auditors see company from prism of F/S?
- SE, CF, I/S, B/S
120
Where does risk come from?
The story behind the numbers
121
What are the 5 management assertions?
(1) Existence or occurence
(2) Rights and obligations
(3) Valuation or allocation
(4) Completeness
(5) Presentation and disclosure
122
Differentiate occurrence and completeness.
- Occurrence: did recorded transactions actually occur?
| - Completeness: did everything that occurred get recorded?
123
In ASC 840, "Accounting for Leases," how do you account for a lease?
```
Lease Payment Receivable
+ Residual Value
- Unearned Interest
- Allowance for Lease Losses
= Lease Balances
```
124
In accounting for a lease, where does the risk lie?
Lease Payment Receivable (easy, just look at lease k)
+ Residual Value (risky, potential of overstatement)
- Unearned Interest (easy, just calculate)
- Allowance for Lease Losses (risky, it's an estimate)
= Lease Balance
125
How do we test management assertions for leases?
Inspection, confirmation, observation, tests, analysis, comparison, inquiries, mechanical tests, refer to GAAP for presentation/disclosure
126
What are four different types of evidence? Give an example of each type of evidence.
- Physical (observation)
- Documentary (inspection, confirmation, mechanical tests)
- Analytical (comparisons)
- Testimonial (inquiries)
127
What are the two most common types of evidence?
Documentary and Analytical
128
What is the most concrete type of evidence?
Physical (observation of inventory)
129
What is the most abstract type of evidence?
Testimonial (like inquiries of management)
130
What are the two types of evidence you can get to propose adjusting J/E's?
Physical (observation) and Documentary (inspection, confirmation)
131
What two types of evidence only give you leads?
Analytical (comparisons) and Testimonial (inquiries)
132
How is a "risk-based approach" vs. a "procedures-based approach" changing how we audit? How is the PCAOB addressing this issue?
- Reducing documentary evidence to analytical evidence (assess risk) to save on costs
- PCAOB attempting to correct with PCAOB inspections (being hard on insufficient documentary evidence)
133
Referring to the Waste Management case, how might an independent auditor leverage off a measure for WM bidding on a contract for a municipal landfill?
- Measure = economical rates (what city will negotiate for)
- Audit implications = constraint on revenue (zero pricing power so WM may play with expenses - earnings management problem here)
134
A bill and hold sales affects which management assertion?
Rights assertion (relative to A/R since a bill and hold is a sale that may or may not go through)
135
Identify the risks that may cause material misstatement in Sunbeam's case (type, significance, likelihood, and pervasiveness of fraud).
- Type: Fraudulent Financial Reporting
- Significance: Yes, can potentially lead to material misstatement
- Likelihood: Yes, likely to lead to material misstatement
- Pervasiveness: Affects F/S taken as a whole
136
Identify the risks that may cause material misstatement in Global Crossing's case (type, significance, likelihood, and pervasiveness of fraud).
- Type: Fraudulent Financial Reporting
- Significance: Yes, can potentially lead to material misstatement
- Likelihood: Yes, likely to lead to material misstatement
- Pervasiveness: Affects F/S taken as a whole
137
In responding to the risks that may cause material misstatement in Sunbeam's case, what could the auditors have done to alter the nature, timing, and extent of auditing procedures to reduce the risk of fraud?
- Nature: Confirmations to audit A/R
- Timing: Test at year end
- Extent: 100% testing by sending confirmations to all
138
In responding to the risks that may cause material misstatement in Global Crossing's case, what could the auditors have done to alter the nature, timing, and extent of auditing procedures to reduce the risk of fraud?
- Nature: Make our own calculations and inquire of management to explain how they're selling above industry calculations
- Timing: Test at year end
- Extent: Test whole co. and confirm with all round-trippers
139
Why did MGM Grand Hotel buy retroactive insurance in the 1980s?
- Purpose of their controversial accounting was to keep $170 million of litigation expense off the books
- In place of the $170 million, MGM recorded the insurance premium fee of $39 million
140
In response to MGM's controversial accounting, SFAS No. 133, "Accounting & Reporting for Reinsurance on Short and Long Duration Contracts" was issued. What does SFAS No. 133 require?
For co. to book a transaction as reinsurance, the reinsurance contract must meet 2 criteria:
(1) Transfer risk: both underwriting risk and timing risk
(2) Subject reinsurer to reasonable possibility of significant loss
141
Define underwriting risk.
Risk that future CFs vary from current expectations
142
Define timing risk.
Risk that future CFs occur in periods different from current expectations
143
What was the underwriting risk in MGM's case?
Risk was that $170 million was too low an estimate for litigation expense
144
While Global Crossing did meet GAAP rules with their capacity swaps, what were the two areas they had shortcomings in?
- Business Purpose
| - Industry Practice
145
Does the risk of fraudulent financial reporting usually occur at the individual or group level?
Group
146
Does the risk of misappropriation of assets usually occur at the individual or group level?
Individual
147
What were the incentives/pressures that affected the risk of fraudulent financial reporting at Global Crossing? What did they fail to predict?
Incentives/Pressures:
- Market saturation
- Vulnerability to rapid changes in tech
- Failed to predict that machines would become more efficient and wouldn't require as much bandwidth
148
What were the incentives/pressures that affected the risk of fraudulent financial reporting at Sunbeam? What did Dunlap do that created this pressure?
Incentives/Pressures:
- Excessive pressure to meet expectations of third parties
- Unduly aggressive or unrealistic profitability or trend expectations
- Dunlap created co-conspirators by giving employees stock so they had a vested interest in the company
149
What were the opportunities that affected the risk of fraudulent financial reporting at Global Crossings?
Opportunities:
| - Significant related-party transactions (round-tripping)
150
What were the opportunities that affected the risk of fraudulent financial reporting at Sunbeam?
Opportunities:
- Ability to dictate terms to suppliers (Dunlap had unbelievable payment terms with Walmart; transaction was OK but accounting was NOT OK as Sunbeam should not have accounted for the sale in that quarter)
- Management dominated by one person
- Ineffective board or audit committee oversight over fin. reporting and internal control (Dunlap gave stock to BOD and made it ST)
151
What were the attitudes/rationalizations that affected the risk of fraudulent financial reporting at Global Crossings?
Attitudes/Rationalizations:
| - Excessive interest by management in earnings trend (wanted to keep upward earnings trend going)
152
What were the attitudes/rationalizations that affected the risk of fraudulent financial reporting at Sunbeam?
Attitudes/Rationalizations:
- Management's preoccupation with S/H value and the selection of accounting principles (made up accounting along the way)
