Attention to detail required for view of the big picture
While the phrase "You can't see the forest for the trees" is often used to refer to an inability to recognize something that is seemingly obvious, it is more traditionally equated with the difficulty of seeing the "big picture" when you are immersed in the detail. In some respects, auditing is akin to trying to see a forest while amidst the trees.
The big picture is the ultimate goal, but it must be created through observation of the detail. As discovered by Andy Accountant, when the detail is not accurately observed, the resulting picture is distorted.
Andy and his firm audited the financial statements of XYZ Corporation, a local farm equipment distributor, for many years. While Andy had never had any significant problems with the engagement, shortly before Andy was to begin work on the 2003 audit, XYZ was unexpectedly taken over by its primary creditor, Big Bank.
The resulting investigation revealed that XYZ's financial statements had been fraudulently overstated for the last three years and that its debts significantly exceeded its assets. As a result, Big Bank was insufficiently collateralized and lost millions of dollars. Subsequently, Big Bank filed a lawsuit against Andy.
Expert analysis disclosed that XYZ's CFO accomplished the fraud through the interrelated mechanisms of delaying the recording of accounts receivable payments and fraudulently overstating rebates due from vendors. With regard to the accounts receivable, customer payments went directly to a "lock box" maintained by Big Bank where they were credited against XYZ obligations or deposited in XYZ accounts.
Despite this arrangement, the CFO was able to overstate accounts receivable by delaying the posting of payment information received from Big Bank. This allowed the CFO to double count receivables by including them both as part of lock box cash and as outstanding accounts receivable.
To allow for reconciliation at year's end, the accounts receivable overstatement was eliminated and the reduction in accounts receivable was then offset with an equivalent reduction in company payables, the latter being accomplished by recording fraudulent vendor rebate entitlements. To support the rebates, the CFO forged rebate documentation and presented it to Andy as evidence of the entitlement.
Although hindsight is 20/20, in retrospect, Andy recognized that a number of red flags had been present. First, during the last three audits, the CFO was very slow to produce the accounts receivable reconciliation at year's end. This may have been particularly significant given that XYZ's industry was somewhat depressed.
Second, while Andy confirmed nearly 100 percent of the rebates, he did so through third-party documentation. Since most of the supporting documents the CFO provided were photocopies, Andy should have considered direct confirmations.
Third, while Big Bank had not taken any action, XYZ was frequently out of compliance with its loan covenants. Although the deviations were not substantial, they did suggest a marginal ability to meet debt obligations.
Fourth, the debt confirmed by Big Bank was less than the debt shown on XYZ's books. Despite the discrepancy, Andy did not attempt to reconcile the balances or conduct further inquiry or testing.
Finally, although not evident in the work papers, it appears that Andy's long association with the CFO and overconfidence in the security provided by the lock box arrangement contributed to his failure to conduct more extensive testing.
While the bank's failure to require monthly reconciliations of accounts receivable and other negligence by both the bank and XYZ's senior management enabled the case to be settled for a fraction of the alleged loss, the situation might have been avoided entirely if Andy had been more attentive to some of the red flags that were present.
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