Crisis at the Mill 1

ACC691 – Final Project

Crisis at the Mill:

Cash Flow Forecasting Exercise

Antonio Testa

Southern New Hampshire University

Crisis at the Mill 2

TABLE OF CONTENTS

Crisis at the Mill: Cash Flow Forecasting Exercise 1

Abstract 4

Keywords 4

Introduction 5

Main Participants in WoolEx Mills Fraud 5

Foundations of Fraud Theory 6

Fraud Triangle 7

The Triangle of Fraud Action 7

Fraud Motivation 8

The Fraud Diamond 8

Analysis of Financial Statement Fraud 9

How Financial Statement Fraud is Committed 9

Procedures & Methods 10

Risk Factors11

Internal Control Weaknesses 12

Internal Controls 13

Red Flags 14

Fraud Discovery 15

Impact and Auditor Responsibility 15

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Evidence 16

Professional Responsibilities 17

Professional Standards 18

Legal 19

Social 20

Economic 21

Financial Statements 22

Current Ratio 23

Quick Ratio 23

Collection Ratio 23

Non-Financial Measures 24

Fraud Case Outcome 25

Works Cited 27
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Abstract

This case study explores the financial statement fraud that occurred at WoolEx Mills, a textile

manufacturer located in India. The perpetrated fraud by executives at the company were made

aware to Sapphire Capital (SC), a private equity firm, who manages WoolEx Mills as a portfolio

company, by a former employee. Once Sapphire Capital was made aware of the alleged financial

statement fraud, they contacted a professional service firm, Alvarez & Marshal (A&M), to

investigate WoolEx Mills of the alleged acts. The investigation lead to the evidence of financial

statement fraud throughout the company as a result of poor internal controls. The management

team of A&M subsequently took over the day-day operations of WoolEx Mills when SC let go

the executives indicted in the financial statement fraud. The new executives are tasked to

improve the financial and non-financial aspects of WoolEx Mills while improving internal

controls, ethical standards, and a failing infrastructure.

Keywords. WoolEx Mills, internal control, financial statement fraud, foundations of

fraud theory, auditor responsibility, Sarbanes-Oxley

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Introduction

The company discussed in the case study is WoolEx Mills, a “leading woolen textile

manufacturer and exporter” with operations in Northern India (Alvarez & Marsal, 2015, p. 1).

WoolEx Mills is an Indian portfolio company, which is managed by Sapphire Capital (SC), a

large U.S. based distress private equity firm. The situation; potential fraudulent acts by

management at WoolEx Mills, was brought to the attention of Alvarez & Marsal (A&M), a

global professional services firm who has SC as a client (Alvarez et al., 2015, p. 1).

The alleged fraudulent acts were first brought to the attention of SC by a former

employee who had claimed he had “witnessed irregular activities during his time at the

company” (Alvarez et al., 2015, p. 1). To determine if any fraudulent acts were being committed,

SC hired investigators to assess the claims made by the former employee. Once the initial

investigation by the SC team had concluded that the accusations of the former employee had

substance, A&M proceeded to further investigate by developing a plan to takeover operations of

WoolEx Mills. This case study will explore the type of fraud known as financial statement fraud;

misstatements arising from fraudulent financial reporting (Lou & Wang, 2009, p.63). Coenen

(n.d.), defines this type of fraud as “the manipulation of financial statements in order to create

financial opportunities for an individual or entity”.

Main Participants in WoolEx Mills Fraud

According to Krishnan and Shah (2016), “the top five members of WoolEx Mills’ senior

management team were reportedly involved in irregular activities”, this resulted in WoolEx

Mills’ shareholders’ losses (p.2). What would motivate these executives to commit the fraud in
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this case study? This question is often asked when companies are examined after-the-fact as to

what went on that resulted in the fraudulent activity.

In fraud cases like WoolEx Mills; the relationship between managers, shareholders, and

the board of directors can often be broken down into two theories of management; agency theory

and stewardship theory (Albrecht, Albrecht, & Albrecht, 2004, pp. 111-113). Agency theory; the

relationship between shareholders and management, is aligned by structuring management

incentives to match shareholder goals (Albrecht et al., 2004, p. 112). Those using stewardship

theory tend to “choose the interests of the shareholders, perhaps psychologically identified as the

best interest of the company over the interest of self, regardless of personal motivations or

incentives” (Albrecht et al., 2004, p. 113). While these two theories provide some explanation

why fraud occurs there are other more complementary theories that answer why individuals are

motivated to commit fraud versus other forms of financially motivated crimes. I will discuss four

theories that provide a perspective of fraud and an insight into why these executives may have

committed the fraud at WoolEx Mills (Dorminey, Fleming, Kranacher, & Riley, 2012, p.556).

Foundations of Fraud Theory

According to Dorminey, Fleming, Kranacher, and Riley (2012), “white-collar crime” can

be associated with economic and business activity (p. 557). These type of criminals are different

from other criminals in three major ways; first their rank in society creates an atmosphere of

admiration and intimidation, second, because of status they often have it easier in the justice

system and pay less penalties, and third, their acts are less obvious, can last for long periods, and

the victims can be difficult to identify (Dorminey et al., 2012, p. 557). Using these characteristic

provides an insight why the fraud occurred at WoolEx Mills based on the following theories.
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Fraud Triangle

Using the fraud triangle developed by Cressy, the executives may have committed the

fraud based on the following criteria researchers have found to understand why fraud occurs. The

three elements common to all fraud are (Albrecht et al., 2004, pp. 117-118; Dorminery et al.,

2012, pp. 557-558):

 Pressure. A non-shareable financial problem

 Opportunity. Knowledge of the company and the opportunity to violate a position of trust

 Rationalization. Violating the trust of board of directors and shareholders did not

constitute a criminal act

According to Albrecht et al. (2004), the elements of the fraud triangle are interactive meaning;

“the greater the perceived opportunity or the more pressure, the less rationalization it takes for

someone to commit fraud” (p. 118).

The Triangle of Fraud Action

Where the fraud triangle identifies the conditions that lead to fraud, the triangle of fraud

action focuses on the actions by the perpetrator in committing the fraud. The components of the

triangle of fraud action; “are the act, concealment, and conversion (Dorminey et al., 2012, p.

559). In the WoolEx Mills fraud case study; the act was the fraudulent financial reporting, the

executives concealed the fraud through falsifying journal entries, and while we are not privy to

how the executives converted these “ill-gotten gains” into something usable, there are enough

red flags throughout the study to suggest these executives profited from the fraud. The advantage

of using the triangle of fraud action is it documents specific actions as well as means to prevent,

detect, and remedy the fraud (Dorminey et al., 2012, p. 559).

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Fraud Motivation

According to Dorminey, Fleming, Kranacher, and Riley (2012), the motivations for fraud

have progressed beyond a non-shareable financial pressure (p. 563). The authors suggest that

white-collar crimes maybe motivated more by social status comparisons as “wealth and success

become more than goals, but rather a part of the identity of the individual” (Dorminey et al.,

2012, p. 563). Because of the culture in India, a failure at any level within a corporation could

result in being social outcast, the motivation to continue to show a healthy bottom line becomes

the motivating factor. This expanded view of the motivation of fraud perpetrators can be

identified using the following acronym M.I.C.E. (Dorminey et al., 2012, p. 563):

M = money

I = ideology

C = coercion

E = ego (entitlement)

As we saw in the fraud cases exposed throughout the 1990s and early 2000s (Enron, WorldCom)

money and ego became the prime motivation for fraud.

The Fraud Diamond

The premise behind this theory of fraud “suggest that many frauds, especially some of the

multibillion-dollar ones, would not have occurred without the perpetrator(s) having the right

capabilities” (Dorminey et al., 2012, p. 564). Using the WoolEx Mills executives in the case

study we can theorize that the fraud was able to be committed since these individuals; were in

the position within the organization to create an opportunity to fraud, knowledge of the internal
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control weaknesses and take advantage of the lapses, intelligence and creativity to exploit

vulnerabilities in the company, and ability to handle the stress of committing and concealing the

fraud (Dorminey et al., 2012, p. 565).

Analysis of Financial Statement Fraud

According to Kennedy (2012), the misrepresentation of financial statements “occurs

when the financial statements are internationally misstated in order to make the financial position

of the company look better than it actually is” (p. 7). The fraud is often carried out by upper

management who deliberately misrepresent or omit financial statements on the behalf of the

company (Dominguez, 2011, p. 8; Ashraf, 2011, p. 25). Long-term, financial statement fraud can

ruin a company by causing stock prices to fall and bring to light the true value of the company to

investors.

How Financial Statement Fraud is Committed

According to Ashraf (2011), financial statement fraud is committed to “increase the

company’s stock price, meet cash flow needs, or hide company’s losses and problems” (p. 25).

The fraud is perpetrated by managers through; improper revenue recognition, manipulating

liabilities and expenses, improper disclosures and overstating assets (Bradford, n.d). Improper

revenue recognition, the most common financial statement fraud scheme, is the manipulation of

revenue figures through; side agreements, roundtrip transactions, bill and holds, the alteration of

shipping documents (Deloitte, 2009, p. 2). The manipulation of expenses and liabilities involves

delaying recognition of operating expenses by listing capital on balance sheets or failing to

record accounts payable on financial statements. Also “keeping certain liabilities and leaving

notes or loans off-the-books” would fall under this type of scheme (Bradford, n.d.). “Fraudulent
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disclosures may include providing false information or the failure to disclose required

information” (Deloitte, 2009, p. 5). Management does this through press releases, company

filings, or in commentary sections of annual reports; these are considered improper disclosures as

they depict a false representation of the company’s standing. Inventory schemes include;

inflating the value of inventory, and the creation of false off-site inventory in an attempt to

overstate the company’s assets. According to Deloitte (2009), “Companies may participate in

these schemes to decrease cost of sales as a percentage of sales or maintain inventory balances

for debt covenants or other reasons” (p. 3).

Procedures and Methods

According to the Center for Audit Quality (CAQ) (2011), the risk assessment of financial

statements involves “performing analytical procedures, such as a comparison of a company’s

current financial statement account balances to prior year financial statements” (p.9). The

substantive analytical procedures can be applied to obtain the financial statement assertions by

the company’s executives. These assertions can help assess potential financial statement fraud by

examining the following categories (CAQ, 2011, p. 14):

 Existence and Occurrence. Provide the information if assets and liabilities exist on a

given date and if the transactions were recorded in the current period

 Completeness. All transactions and accounts that should appear in the financial

statements are included

 Valuation. The appropriate amounts for financial components are included in the

financial statements
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 Rights and Obligations. Assets are under the control of the company and any liabilities

are obligations of the company on a given date

 Presentation and Disclosure. Financial statements are properly classified, described, and

disclosed

By applying substantive analytical procedures, forensic accountants “gather evidence about

relationships among various accounting and non-accounting data such as industry and economic

information” (CAQ, 2011, p. 14).

An organization can be proactive according to the ACFE (2016), in detecting financial

statement fraud by “examining the relationship between detection methods and other factors” (p.

20). This would include the various fraud schemes; magnitude and duration. The bigger the

company, the means to which fraud is detected varies. For example, WoolEx Mills included a

workforce of more than 2,200 employees (Krishnan, S. and Shah, 2015, p. 3). According to the

ACFE (2016), a company of this size would rely on tips and internal audits to detect fraud; in the

2016 Report to Nations, the ACFE cases in Southern Asia showed 53.1% of the cases reporting

fraud was through tips and 21.9% fraud was detected during internal audits (Fig.29, p. 24).

Risk Factors

To manage risk within an organization, the organization should continue to identify

fraud-risk factors; using the fraud triangle elements to review fraud-risk factors to financial

misstatement fraud can help with this assessment. The fraud triangle is composed of three

elements the “pressure/incentive to perpetrate fraud, opportunity to carry out the fraud, or

attitude/rationalization to justify fraudulent action” (Lou & Wang, 2009, p. 63). According to

Lou and Wang (2009), “fraud-risk factors do not necessarily imply the existence of fraud, they
Crisis at the Mill 12

often are present in circumstance where fraud exists” (p.63). The pressure to commit the fraud at

WoollEx Mills may have arisen from the following three conditions (Lou & Wang, 2009, p. 64):

 Their financial stability was threatened by the economy and industry

 Management felt pressured for meeting expectations of third parties

 Executives personal financial situation was intimidated by WoolEx’s financial

performance

According to Lou and Wang (2009), “effective internal control can maintain reliability of firms’

financial statements and prevent fraud” (p.65). The lack of effective and strong internal controls

at WoolEx Mills increased the opportunity of material financial misstatement. When there are

complicated transactions, an organization faces a higher opportunity for fraudulent activity as

these type of transactions become susceptible to manipulation by management due to a high

degree of management judgement and subjectivity (Lou & Wang, 2009, p. 65). The attitude or

integrity of executives running an organization can factor in to the rationalization to commit

fraud. According to Lou and Wang (2009), executives whose integrity often is questioned, often

signifies that the organization has a greater probability of fraud (p. 66). Additionally, if an

organization has a bad relationship with its auditors, the organization is at risk for greater

probability of fraud.

Internal Control Weaknesses

The SEC has made an effort to devote substantial resources to investigating public

companies which have inadequate internal controls. According to Halper and Foley (2016),

“internal controls are the procedures and practices instituted by a company to manage risk,

conduct business, protect assets, and ensure that its practices comply with the law and company
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policy”. The Foreign Corrupt Practice Act states that companies maintain the proper accounting

record of transactions which “are recorded in accordance with management’s authorization and

in conformity with Generally Accepted Accounting Principles” (Halper and Foley, 2016).

Examining the WoolEx Mills case, we see that the company had inadequate internal controls that

lead to “several issues in the company’s finances”; the assessment by Nikhil Shah, the new CFO

determined the following weaknesses (Krishnan and Shah, 2015, p. 5; Markgraf, n.d.):

 Separation of Duties. A lack of effective checks and controls by the former executives

 Financial Reporting. Failure to record discounts, lack of detail in budgeting, understating

or overstating revenue, and manually maintaining the Management Information System

(MIS)

 Quality Control. Lack of technological advances and use of outdated equipment resulted

in inferior products and quality issues with customers

Internal Controls

According to the ACFE (2016, pp. 48-49), financial statement fraud is more likely to be

committed by the owner or top executives within an organization, then by employees. These

high-level fraudsters have greater access to the company’s assets, “as well as a better ability to

evade or override anti-fraud controls” (ACFE, 2016, p. 48). Based on this assumptions, fraud

schemes caused by poor internal controls are harder to detect and often last longer than anyone

suspects. The ACFE 2016 Global Fraud Study shows the median duration of fraud schemes by

managers to be 18 months, while owners/executives lasting up to 24 months (ACFE, 2016, p.

49).
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Financial statement fraud within an organization often is caused by poor internal controls

relating to three probable explanations. First, the overall weaknesses of the organization’s

internal control structure. Although the Sarbanes-Oxley Act (SOX) attempted to reduce fraud

within companies by mandating internal control audits, there have been several cases since SOX

went into effect that shows companies suspect to poor internal control in specific areas provide

opportunities to commit financial statement fraud (Donelson, Ege, and McInnis, 2015, pp. 1-3).

Second, when there are poor entity-level controls, no particular account maybe at greater risk,

however the opportunity to commit fraud by upper management can occur since they have the

ability to override any account. Third, “whether internal control weaknesses represent a more

systemic, cultural characteristic of the firm or its management (Donelson et al., 2015, p. 3).

Reducing internal control weaknesses by increasing substantive procedures by internal auditors

can detect potential material misstatements in the company’s accounting transactions (Ashraf,

2011, pp. 14-16).

Red Flags

The lack of effective internal controls had adversely affected WoolEx Mills financial

condition and its’ ability to remain profitable. The first red flag was the executives’ relationship

with the vendors who allegedly took kick-backs to remain the supplier of the dye needed for

woolen textile manufacturing. Krishnan and Shah (2016) reported that the company could save

5-10% by changing vendors but the management team continued to use the same vendors (p.5).

Secondly, failure to record credit notes and the amount of the credit notes would lead an auditor

examine if the credit notes were actually occurring. Third, the irregularities in sales practices

were damaging WoolEx Mills’ liquidity. Finally, the failure of the management to; allow a

capital expenditure to update the technology within the company despite old equipment, use
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resources to full potential, and failing to improve the infrastructure of the manufacturing plant

(Krishnan & Shah, 2016, pp. 5-6).

Fraud Discovery

According to Clements (2012), many companies make an effort to prevent external fraud,

however when the fraud is internal, the resulting collateral damage; loss of reputation, brand

damage, seniority of suspect(s), and reduced employee morale can be more serious (p.13). The

alleged irregular activities by senior executives were brought to the attention of Sapphire Capital

(SC) by a former WoolEx Mills employee who reported they had witnessed potential fraudulent

acts while employed at the textile manufacturer (Krishnan & Shah, 2016, p.1). Once fraud is

suspected, it is important to “obtain as much information as possible before anyone is

questioned, confronted, or interviewed” (Clements, 2012, p.15). The SC team; realized this was a

sensitive matter, treated the alleged fraud seriously, and hired an outside firm to conduct the

initial investigation. Once the initial investigation had concluded, the investigated report was

given to SC. According to Clements (2012), “as part of their overall fraud control plan,

organizations, should assign responsibility for fraud incident management to an appropriate

person(s) as a precursor to adopting an incident management plan” (p. 17). The SC fund

managers turned to Alvarez & Marsal (A&M), to act as the fraud response team; A&M assigned

personnel to lead the forensic investigation into the accusations at WoolEx Mills (Krishnan &

Shah, 2016, p.2). See Figure 1 for a typical fraud response plan. Future investigation would

benefit from the steps taken by SC and A&M in the future upon discovery of fraud or tip-off by

following the attached checklist. See Figure 2 (Clements, 2012, p. 17-Figure 1&2).

Impact and Auditor Responsibility

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In 2002, the Sarbanes-Oxley Act, under section 404 required “management to organize

and assess internal control systems and the independent auditor to assess their effectiveness”

(Koehn & Del Vecchio, 2004, p. 37). As an auditor reviewing the WoolEx Mills fraud case,

consideration must be made on the financial statement fraud that resulted from misappropriations

of assets and financial reporting fraud by the former executives of the company. According to

Zack (2011), the “standard of due professional care requires that auditors observe the standards

of fieldwork in conducting an audit” (p.1). The following areas will describe how the fraud

committed at WoolEx Mills impacted the auditing profession.

Evidence

According to the International Anti-Corruption Resource Center (IACRC), “the two most

important principles of evidence for investigators are relevance and weight” (IACRC, 2016).

Relevant evidence in a fraud case will prove or disprove an element of proof. Weight of evidence

in a fraud case will determine; source of evidence, whether evidence is direct or circumstantial,

and finally the credibility of the witness (IACRC, 2016). Investigators of fraud cases will

determine the source of the evidence, additionally, which type of evidence (direct or

circumstantial) are needed to best make their case. For the fraudulent acts at WoolEx Mills,

documentary evidence would be most useful in proving the financial misstatement fraud.

Documentary evidence based on the collected evidence by Nikhil Shah, the new CFO,

would show manipulation of financial accounts (Krishnan, S. and Shah, 2015, p. 5). According

to the IACRC (2016), for documentary evidence to be persuasive and admissible in court, it must

be:

 Relevant
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 Contain admissible direct or circumstantial evidence of the facts

 Authenticated

By analyzing original documents, forensic accountants could determine if financial statements

were overstated or understated. The more accurate the document, the more admissible the

document will be. Documentary evidence can also include the absence of entries or documents

that are kept on a daily basis that would “be used as evidence that an event did not occur, or that

document does not exist or was not received” (IACRC, 2016).

Professional Responsibilities

In detecting financial misstatement fraud, an auditor’s “overarching goal is to provide

financial statement users with reasonable-but not absolute-assurance that the financial statements

prepared by management are fairly represented” (CAQ, 2011, p. 3). SAS 99 requires auditors

have reasonable assurance about whether the financial statements “are free of material

misstatement, whether caused by error or fraud” (Brickner & Pearson, 2003). According to

Brickner and Pearson (2003), an auditor is required to look for fraud; in the case of WoolEx

Mills misstatements resulting from fraudulent financial reporting, throughout the entire fraud

process as stated in SAS 99 (Krishnan, S. and Shah, 2015, pp. 3-5). Additionally, SAS 99

requires auditors to; exercise professional skepticism throughout the audit, identify the risks of

material misstatement due to fraud, assess internal controls to prevent fraudulent acts, design and

perform audit procedures, and protect investors from improper financial reporting (Brickner et

al., 2003; CAQ, 2011, pp. 10-15). The impact of an audit can solidify the integrity of an

organizations financial statements and the reporting process of financial statements by

executives. As the business environment changes, markets will need to be able to depend on
Crisis at the Mill 18

accurate financial reporting to provide confidence to investors. Audits that result in suspicion of

fraudulent acts, such as financial statement fraud can impact organizations as well as industries

for many years.

Professional Standards

SOX, in 2002 created the PCAOB, which sets the standards for audits of publicly traded

companies. Zack (2011) presents the “PCAOB follows all standards issued by the AICPA

through April 16, 2003 and has subsequently issued 15 standards of its own” (p. 4). However, in

2003, the SEC exempted foreign companies from all SOX requirements; CEOs are still required

to “certify financial results and accept personal criminal responsibility of the statements are

proven invalid” (Koehn & Del Vecchio, 2004, p. 37). In doing so, auditors must exercise

professional skepticism by having an open mind and assume management is neither dishonest or

have unquestioned honesty (Zack, 2011, p.2). WoolEx Mills is a foreign company; auditors are

advised to follow the International Standards on Auditing (ISA), which are issued by the

International Federation of Accountants (IFAC) through the International Auditing and

Assurance Board (IAASB) (Zack, 2011, p. 4). The following ISA were impacted by the fraud

committed at WoolEx Mills (ISA 240, 2015):

 Fraud Definition. “An intentional act by one or more individuals among management,

those charged with governance, employees, or third parties, involving the use of

deception to obtain an unjust or illegal advantage”

 Responsibilities for Fraud. The prevention and detection of fraud is the responsibility

falls to those that govern and manage the organization. Also includes the auditors who
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are charged with “obtaining reasonable assurance that the financial statements as a whole

are free from material misstatement, whether caused by fraud or error”

 Professional Skepticism. Under ISA 240, auditors must maintain an attitude of

professional skepticism throughout the audit

 Engagement Team. Puts the emphasis on “how and where the entity’s financial

statements may be susceptible to material misstatement due to fraud, including how the

fraud occurred”

 Risk Assessment. Auditors must “perform risk assessment procedures to obtain

information for use in identifying the risks of material misstatement due to fraud”

Legal

One of the responsibilities of an auditor is using significant judgement when conducting

an audit; “simple errors in judgement on the part of auditors may or may not result in liability”

(Zack, 2011, p. 19). According to Zack (2011), when auditors fail to follow established auditing

standards, they risk facing liability in certain areas (p. 19). As a result of the fraud case at

WoolEx Mills, the auditors who failed to detect the financial misstatement fraud by failing to

follow auditing standards exposed themselves and the company to litigation. Some of those

plaintiffs could include (Zack, 2011, p. 2):

 Initial and subsequent purchases and sellers of the WoolEx Mills publicly-traded stock

 WoolEx Mills

 Third-party primary beneficiaries

 Foreseen third-parties

 Foreseeable third parties

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By failing to adhere to the auditing standards, the auditors could be subject to breach of

contract or tort liability claims. With breach of contract, the auditors will face claims they

violated the auditing standards that the company and auditor had agreed in the engagement letter.

Tort claims (ordinary or gross negligence) also claim the auditors failed to follow the auditing

standards. The auditors at WoolEx Mills if charged with ordinary negligence would be as a result

of a lack of reasonable care in performing the audit. However, if the tort claims are for gross

negligence, it will be asserted the auditors engaged in reckless departure from the auditing

standards, showing no-little care in performing their duties (Zack, 2011, p.2).

Social

In their paper, Cohen, Ding, Lesage, and Stolowy (2015), describe what is known in the

auditing world as the expectation gap; “the differences between what the public expects from an

audit and what the auditing profession prefers the audit objectives to be” (p. 1). This difference

between what the public expects and what an auditing profession prefers is; the public feels the

auditor is responsible in preventing fraud while the auditors argue in their investigating of fraud,

they should not be “obliged to detect every instance of fraud” (Cohen et al., 2015, p. 1).

At WoolEx Mills, the former executives and auditors prevalent in the perpetrated fraud

showed characteristics of what Cohen, Ding, Lesage, and Stolowy (2015), describes as

unreasonable expectations (p. 12). These traits (e.g., personality, lifestyle, etc.) reflect and shape

how the public perceives the fraud committed at the company (Cohen et al., 2015, pp. 13-16):

 Living Standards. Executives commit fraud to maintain a high living standard; greed also

falls into this section, using the company as a “cash cow” for personal gain
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 Reputation. By making the company appear to be doing well, the executives preserve the

company image as well their own reputation as a successful executive

 Influence. How executives influence their managers can affect how fraud is manipulated

or promoted

 Prize. Praise or recognition from outsiders often lead to believing their own image, so

they go out of their way to keep it favorable

Economic

According to Simunic, Minlei, and Ping (2016), although they adopted ISA, India’s legal

system currently makes it difficult to recover damages from auditors (p. 2). The implementation

of ISA was thought to have improved the high level of audit quality. The importance of the legal

system in India centers around; “the degree of uncertainty or vagueness in interpreting auditing

standards by courts in determining whether an auditor is liable for a failed audit, and the

expected damage award size paid to investors by auditors deemed liable for investors’ losses”

(Simunic et al., 2016, p. 2). It appears according to the research conducted by Simunic et al.

(2016) that when standards for compliance are low, the corresponding damage award will also be

small thus making the noncompliance effort more attractive to the auditor (p. 15). The authors

write, “it is impossible to induce the auditor to exert the first-base audit effort by increasing the

toughness of auditing standards since the auditor can always opt for noncompliance effort when

the toughness exceeds a certain level” (Simunic et al., 2016, p. 15). The case of fraud at WoolEx

Mills shows the damage award playing a very important role; auditors opted to not adhere to

auditing standards by being non-compliant as a result of a lack of first-best effort. The impact to

the auditing profession shows “to achieve the desirable first-best effort, the size of the damage

awards must be reasonably large” (Simunic et al., 2016, p. 15).

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Sufficient Competent Evidence

In a fraud examination, any evidence that is collected must meet generally accepted

accounting standards. According to AU Section 326 (PCAOB 2010), “sufficient competent

evidential matter is to be obtained through inspection, observation, inquiries, and confirmations

to afford a reasonable basis for an opinion regarding the financial statements under audit” (para. .

01). Sufficient evidence is measured by the quantity of evidence while competent or appropriate

evidence measures the quality of the evidence. Together, any evidence collected in a fraud

examination that would be used to form an opinion on alleged acts would need to be valid and

relevant. Having A&M conduct the internal investigation once in control of the company

provided; a greater assurance of the reliability of the evidence gathered, evidence to reliability of

the accounting data and financial statements, and a personal knowledge they obtained through

physical examination, observation, computation, and inspection (PCAOB, 2010, para. .21). The

evidence that was collected included (Krishnan & Shah, 2016, pp. 3-6)

 Finding accounts receivable were high and outdated

 Cash flow issues as a result of customers taking an average of 130-days to pay

 Failure to record discounts and credit notes in the accounting journals

 No scientific inventory management or ordering practices

 Inefficient costing protocols and management information systems

Financial Statements

Auditors use financial statement analysis to examine the information reported by

management to interpret how the company is performing. According to the ACFE (n.d.), “ratio

analysis is a means of measuring the relationship between two different financial statement
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amounts” (p. 121). Auditors use ratio analysis (ACFE, n.d., pp. 121-122); to compare current

year numbers to previous years, in detecting red flags in the fraud examinations, for internal

evaluations using financial statement data, and to find anomalies in ratios leading to the

existence of fraudulent actions. The following ratio analysis of the financial statements reported

by WoolEx Mills indicates possible fraudulent activities (ACFE, n.d., pp. 122-123; Baker, 2014):

Gross Profit margin

When a company makes more money on each product it sells, it has a higher gross profit margin.

If it starts to get less per product sold, its gross profit margin decreases.

The gross profit margin: the percentage of sales available to cover general and administrative

expenses and other operating costs: FY09=63%, FY010=61%, AND FY TO DATE Nov 10=

59.6%.

The company's executive management team was no successful in generating revenue.

Current Ratio

Comparing the current assets divided by the current liabilities will allow auditors to

examine the ability of the company to meet short-term liabilities. This type of ratio analysis

measures the liquidity within the company. The numbers reflected in the balance sheet shows a

decline in the current ratio over a 20-month period. The current ratio for; year one is 3.70, 3.36

12 months later, and 2.68 as of November 2010. This steady decrease suggests there may be
Crisis at the Mill 24

fraudulent acts occurring within inventory management or collection of accounts receivable

which has led cash flow issues.

Quick Ratio

As with the current ratio formula, the quick ratio analysis examines the liquidity of an

organization. This ratio compares assets owned by the company that could be liquidated

immediately to liabilities due in the following fiscal year. Calculating the quick ratio, we find; in

year one to be 2.09, 2.05 twelve months later, and 1.46 after twenty months. This steady decline

is another red flag that the accounts receivable is increasing perhaps due to the average number

of days for collection being 130 days. Other possibilities are that company is failing to find

customers for their products, pressuring the executives into reporting fraudulent financials.

Collection Ratio

To detect if there are fictitious receivables or skimming schemes, an auditor would use

the collection ratio. This ratio measures the accounts receivable aging by dividing 365 by the

receivable turnover ratio. Examining the financial statements, the receivable turnover ratio for;

year one equaled 2.782 (1,613.6/579.9), 2.508 (1,633.9/651.4) in year two, and as of November

2010, 1.89 (1,249.5/663.8). To examine the collection days, an auditor would divide each

receivable ratio by 365 days. This results in collections days for WoolEx Mills for each period to

be; 131 days for year one, 146 days for year two, and as of November 2010, 194 days. This

unfavorable increase in collection days between fiscal years along with increased inventory

indicates possible fraud in the financial statements.

Other ratio analysis calculations were made including solvency and profitability ratios

however, there appeared to be no significant increase or decrease in either to indicate fraud. In

Crisis at the Mill 25

performing the debt to equity ratio analysis, the total debt of WoolEx Mills in each fiscal year

was divided by the total equity reported. The results showed no significant increase (Year 1 –

1.71 vs. 1.65 in Year 2) however the high ratio indicates the company is insolvent. Examining

the profit margin ratio, we find that year one (0.14) was similar to year two (0.15). Both years the

low profit margin ratios indicate the business is continuing to not achieve profits and operating

costs are most likely too high.

Non-Financial Measures

Both the AICPA and PCAOB have suggested that “inconsistency between a company’s

financial performance and related nonfinancial measures (e.g., number of retail outlets,

warehouse space, employee headcount) represents a potential red flag with respect to financial

statement fraud” (Brazel, Jones, & Prawitt, 2014, p.132). Non-financial statements should be

considered by auditors in evaluating companies’ financial statements. An auditor must correlate

the non-financial measures with the information reported by management to examine more

closely this relationship. According to Brazel, Jones, and Prawitt (2014), by identifying

inconsistencies in these relationships, red flags could appear which should lead the auditor to;

“ask pointed questions of client management, increase their professional skepticism, corroborate

and test managements responses with reliable evidence, assign forensic specialists to the

engagement, and increase the overall likelihood of fraud detection” (p.134). The non-financial

red flags pointing to fraud at WoolEx Mills included; a declining infrastructure, declining

manufacturing efficiencies of 50%, rising raw material costs, and failure to command a strong

market presence despite name recognition within India (Krishnan & Shah, 2016, pp. 5-7).

Fraud Case Outcome

Crisis at the Mill 26

The result of the initial investigation of irregular activities at WoolEx Mills conducted by

SC using an outside investigation firm concluded, “there was indeed substance to the

accusations, but to gain definitive proof inside access to the company’s operations was required”

(Krishnan & Shah, 2016, p. 2). At this point, SC turned to the A&M to facilitate an intervention

at WoolEx Mills, with the goal of having the firm takeover WoolEx Mills daily operations. This

was done by assembling two teams; an interim management team to handle the daily operations,

and a forensic team to evaluate any financial misstatements at the company (Krishnan & Shah,

2016, p 2). Each of the executives who had been involved in the fraudulent acts at WoolEx Mills

were; suspended by the board of directors, banned from returning to the corporates offices, and

denied all charges levelled against them (Krishnan & Shah, 2016, pp.2-3). By implementing new

strategies; replacing unethical employees, using cash flow forecasting, and strengthening internal

controls, the CFO is ensuring the stakeholders that WoolEx Mills could be turned around and

become a profitable enterprise while reducing the instances of future fraudulent activity.
Crisis at the Mill 27

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