Case #3.

4 - Sunbeam – Incentives and Pressure to Commit Fraud

Case #3.4 – Sunbeam – Incentives and Pressure to Commit Fraud

I. Technical Audit Guidance

To maximize the knowledge acquired by students, this book has been designed to be read in
conjunction with the post-Sarbanes-Oxley technical audit guidance. All of the post-Sarbanes-
Oxley technical guidance is available for free at http://www.pcaobus.org/Standards/index.aspx.
In addition, a summary of the Sarbanes-Oxley Act of 2002 is also available for free at
http://thecaq.aicpa.org/Resources/Sarbanes+Oxley/Sarbanes-Oxley+–+The+Basics.htm.

II. Recommended Technical Knowledge

PCAOB Auditing Standard No. 5

Paragraph #9
Paragraph #11
Paragraphs #29-30
Paragraph #32
Paragraph #A8 (in Appendix A)

III. Classroom Hints

This case provides students with an opportunity to apply their technical knowledge about

inherent risk and fraud risk to Sunbeam's business model during the 1990's. By providing details

about Sunbeam business during this time, students are able to see the relationship between an

audit client's business strategy and inherent risk assessment at the financial statement assertion

level. In addition, this case provides students with an opportunity to think about fraud risk

assessment during times of significant change at an audit client. To meet these objectives, this

case illuminates a number of relevant issues about the development of Sunbeam. In particular,

the case focuses on the changes that occurred at Sunbeam after hiring Albert J. Dunlap as its

chairman and CEO in 1996.

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Case #3.4 - Sunbeam – Incentives and Pressure to Commit Fraud

We believe it is essential for students to carefully read over the recommended technical

knowledge, along with this case reading. The educational psychology literature suggests that the

acquisition of technical/factual type knowledge increases dramatically when such knowledge can

be applied in a realistic context. Thus, we urge instructors to use this case as a mechanism to

impart the relevant post-Sarbanes technical audit knowledge, outlined above.

This case assignment will work best if is scheduled to coincide with the inherent risk or

the fraud risk topic in the auditing course. While much has changed in the audit environment at

publicly traded companies as a result of SOX, an auditor still must take the time to carefully

acquire knowledge about a client’s business, industry and their strategy to achieve competitive

advantage within that industry. This foundation of company and industry-specific knowledge is

essential towards the completion of an effective and efficient integrated audit.

First, the company and industry-specific knowledge enables the auditor to carefully

assess the organization's business risk, which is a precursor to assessing all aspects of audit risk,

including the assessment of inherent risk at the financial statement assertion level. In our view,

this task is absolutely critical in the post-Sarbanes audit environment. Thus, we recommend that

instructors be explicit in illustrating the linkage between what is learned during the risk

assessment stage and the identification of relevant financial statement assertions. The discussion

of student responses to questions #2-4 provides a terrific opportunity to make this point clear to

students.

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Case #3.4 - Sunbeam – Incentives and Pressure to Commit Fraud

In addition, the company and industry-specific knowledge provides a platform that

enables an auditor to effectively brainstorm (as required by SAS No. 99) about the possible ways

in which a fraud could be perpetrated at the audit client. The discussion of student responses to

question #5 provides an opportunity to illustrate this point to students. In addition, the

discussion of student responses to question #1 provides an opportunity to explore the root causes

of fraud (i.e., the fraud triangle) as it applies to Sunbeam. Finally, when completing the audit of

internal control over financial reporting, the company and industry-specific knowledge provides

the auditor with an initial map of the mission-critical business processes and the support business

processes that have been put in place by the audit client. The discussion of student responses to

questions #3 and #4 provides an opportunity to discuss the importance of such knowledge to the

completion of an internal control audit.

The impact of strategy, business risk and industry factors on the various components of

audit risk is a complex consideration. We therefore encourage instructors to allocate an

appropriate amount of time to this topic and to use multiple different cases to help illustrate your

points. In our experience, it is very difficult for audit students to make the connection between

the strategic direction of a client and the identification of key audit risks. In fact, we would

suggest that this can be a hard linkage for more experienced audit professionals as well. So,

please consider assigning at least 2 or 3 (and perhaps even 4 or 5) cases from this section of the

book to provide the repetition that is needed for students to master this important topic. It is

hoped that such repeated task performance will help to better sensitize students to the importance

of understanding the client’s business, industry and strategy to the assessment of inherent risk

and fraud risk.

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IV. Assignment Questions & Suggested Answers

1. Based on your understanding of fraud risk assessment, what are the three
conditions that are likely to be present when a fraud occurs (i.e., the fraud triangle)?
Based on your understanding of the Sunbeam audit, which of these three conditions
appears to be the most prevalent, and why?

The three conditions that are likely to be present comprise what is commonly referred to as

the “fraud triangle”. The first condition (incentives/pressure) recognizes that an employee or a

manager of a company is likely to either have incentives in place (e.g., bonus compensation) or

be under significant pressure to meet specific estimates, forecasts, or expectations. The second

condition (opportunity) recognizes that in order for a fraud to be perpetrated, the internal control

environment must provide an opportunity for an employee or a manager of a company to commit

a fraudulent act. In order to have an opportunity to commit fraud, there must be a weakness in

the operating effectiveness of a control or a non-existent control. Finally, the third condition

(rationalization) recognizes that for an employee or a manager of a company to perpetrate a

fraud, the individual (or individuals) must possess an “attitude” that allows them to rationalize

that they are knowingly committing a crime.

For Sunbeam, based on the case information presented, the incentives/pressure component

appears to be the most prevalent condition. Both Dunlap and the CFO, Russell Kersh, entered

into lucrative three-year employment agreements that gave them strong financial incentives to

raise the share price of the company. In addition, Dunlap gave strong financial incentives to all

of Sunbeam’s new upper managers to help raise the share price. In addition, besides Dunlap’s

contractual employment financial incentive, he invested $3 million of his own money in

Sunbeam shares and boldly claimed that he intended to make a significant amount of money on

his own investment as well.

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Case #3.4 - Sunbeam – Incentives and Pressure to Commit Fraud

2. Consult Paragraph #9 of PCAOB Auditing Standard No. 5. Based on your

understanding of inherent risk assessment and the case information, please identify
three specific factors about Sunbeam that might cause you to elevate inherent risk.

Paragraph #9 of PCAOB Auditing Standard No. 5 emphasizes the importance of planning the

audit. The paragraph explicitly mentions twelve specific matters that should be evaluated during

the planning stage by auditors when determining the procedures that need to be performed.

While the list is not necessarily intended to be exhaustive, it does include most of the significant

matters that should be considered during the planning stages of an internal control audit. For that

reason, we believe that the list provides a terrific mechanism to help reinforce the importance of

risk assessment for students of auditing.

For example, the paragraph explicitly identifies the following relevant factors that apply to

the Sunbeam audit: 1) Matters affecting the industry in which the company operates, such as

financial reporting practices, economic conditions, laws and regulations, and technological

changes; 2) Matters relating to the company's business, including its organization, operating

characteristics, and capital structure; 3) Legal or regulatory matters of which the company is

aware; and 4) The extent of recent changes, if any, in the company, its operations, or its internal

control over financial reporting.

Importantly, the factors that are likely to impact the audit of internal control over financial

reporting mirror the factors that are also likely to impact the overall assessment of inherent risk.

This is a key learning point for this question and will help students to understand the

applicability of paragraph #9 to this question. At Sunbeam, there were a number of factors that

are likely to impact the audit of internal control over financial reporting, including:

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Case #3.4 - Sunbeam – Incentives and Pressure to Commit Fraud

 Several top managers have strong financial incentives to improve the company’s
share price. The pressure and/or incentives to meet profitability and income targets
could lead a manager to overstate revenues and/or understate expenses; the personal
financial stake in Sunbeam that top managers hold creates an agency problem. There
is an increased risk that financial statements will not be presented fairly to users
dependent on the financial information. The agency problem arises out of
management’s personal interest in meeting performance or earnings expectations;

 Profitability is threatened because of a high degree of competition in their market and

declining margins. The development of discount chains as market competitors
increases the likelihood that revenues may decline. In addition, as a result of the
competitive nature of product development, Sunbeam inventory is at an increased
inherent risk for obsolescence;

 Excessive pressure for management to meet unrealistic goals like doubling the
revenue to 2 billion in only 2 years and improving the operating margins to 20% of
sales;

 CEO Dunlap has significant financial interest in the entity because he invested $3
million of his own money in Sunbeam shares. There is excessive pressure placed by
Dunlap and Kersh on the top management to meet the financial targets because their
compensation includes “strong financial incentives” to improve the company’s share
price;

 Unstable organizational structure because there is almost a complete turnover of

senior management. This represents an increase in inherent risk level because of the
technical knowledge about the industry required by senior management;

 The company just disposed of several lines of business, 39 facilities, and 87% of their
products. There would clearly be expenses related to such an extensive
reorganization that might be difficult to account for. In addition, related to the
disposal of product lines, there is an inherent risk that anticipated levels of demand
for disposed products were underestimated and that the wrong lines of business were
disposed of;

 Current revenue mix is potentially risky as approximately 87% of the product lines
have been cut. This puts substantial pressure on the remaining product lines.

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3. Consult Paragraph #11 of PCAOB Auditing Standard No. 5. Comment about how
your understanding of the inherent risks identified at Sunbeam (in Question #2)
would influence the nature, timing, and extent of your audit work at Sunbeam.

Paragraph #11 of PCAOB Auditing Standard No. 5 (AS 5) clearly states that “a direct

relationship exists between the degree of risk that a material weakness could exist” and “the

amount of audit attention that should be devoted to that area.” Since risk assessment “underlies

the entire audit process” outlined in AS 5 (see paragraph 10), it is important for students to see

the linkage that does exist between decisions about the nature, timing, and extent of work

performed and the assessed amount of risk for a particular account. Stated simply, “the lower the

risk that a material weakness could exist”, the less audit attention is needed in that area.

Moreover, “the higher the risk that a material weakness could exist”, the more audit attention is

needed in that area.

In addition, Paragraph #46 of AS 5 also provides some relevant guidance for this question.

Specifically, the paragraph states that “the evidence necessary to persuade the auditor that the

control is effective depends upon the risk associated with the control.” Specifically, if the risk is

lower, the evidence needed to persuade the auditor about its effectiveness decreases. On the

other hand, as the risk increases, the evidence needed to persuade the auditor will clearly

increase.

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The technical audit guidance is particularly salient to the areas where inherent risk has been

elevated for Sunbeam. For example, when testing the revenue accounts at Sunbeam, the auditor

should obtain more persuasive evidence, complete the audit procedures as close as possible to

the year-end date and increase the extent of audit testing for the revenue accounts. The bottom

line is that for Sunbeam, the nature, timing, and extent of control testing related to the revenue

account would have to be adjusted as a result of the elevated inherent risk related to revenue.

Another example would involve the increased inherent risk for inventory obsolescence as a

result of Sunbeam’s decision to cut product lines. When CEO Dunlap began cutting numerous

Sunbeam product lines, there is an increased risk that Sunbeam would not be able to sell its

discontinued product lines without offering massive discounts. Such discounts would give rise

to elevated inherent risk for the control testing related to the valuation assertion for inventory.

4. Consult Paragraphs #29 and #32 of PCAOB Auditing Standard No. 5. Next, briefly
identify the types of revenue earned by Sunbeam. Do you believe that any of the
different types of revenue earned by Sunbeam “might be subject to significantly
differing” levels of inherent risk? Why or why not?

Paragraph #29 of PCAOB Auditing Standard No. 5 (AS 5) outlines nine specific risk factors

that are “relevant to the identification of significant accounts and disclosures and their relevant

assertions.” Since risk assessment “underlies the entire audit process” outlined in AS 5 (see

paragraph 10), it is important that students take the time to understand the risk factors outlined in

paragraph 29. Importantly, paragraph #32 extends this line of thinking by recognizing that there

are often multiple components that make up a particular significant account or disclosure.

Moreover, that each of the different components (making up a financial statement account

balance) may very well be “subject to differing risks.” As a result, the standard suggests that

different controls may be needed to support the achievement of producing reliable financial

statement information related to different components making up the same account.

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For example, at a company whose sales may be initiated by customers through personal

contact in a retail store or electronically through use of the internet, these types of sales might be

thought of as different components of the financial statement line item, revenue. Interestingly,

Sunbeam offers a variety of products including household appliances, health care products,

personal care and comfort products, and away from home products. In addition, international

sales accounted for 19% of its total net sales. Although more information is needed to accurately

depict each of the different types of revenues, it is likely that, once identified, the different types

of revenue may very well be subject to different levels of inherent risk.

For example, it is likely that international sales would be subject to a different level of

inherent risk than domestic sales. That is, international sales may be subject to elevated inherent

risk because of environmental factors such as political pressures or political instability,

differences in economies, or exchange rates and calculations. As a result, an auditor must

consider treating international sales as a separate component of revenue when completing the

internal control audit and would have to consider altering the nature, timing or extent of testing

related to the controls for international revenue transactions.

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5. Consult Paragraph #30 and Paragraph A8 (in Appendix A) of PCAOB Auditing

Standard No. 5. For one of Sunbeam’s revenue types (please choose one),
brainstorm about how a fraud might occur. Next, identify an internal control
procedure that would prevent, detect, or deter such a fraudulent scheme?

Paragraph #30 of PCAOB Auditing Standard No. 5 requires auditors to “determine the likely

sources of potential misstatements that would cause the financial statements to be materially

misstated.” In so doing, the standard states that the “auditor might determine the likely sources

of potential misstatements by asking himself or herself ‘what could go wrong?’ within a given

significant account or disclosure.” The feeling is that if auditors are able to identify the likely

sources of potential misstatement for each significant process, they will be in a terrific position to

understand if management has designed their system of internal control to prevent or detect such

a misstatement (which they are required to do). Paragraph A8 of PCAOB Auditing Standard No.

5 provides the definition of a preventative and a detective control and is helpful for students to

review before answering the final part of the question.

There are a number of possible answers for this question. The absolute key to answering this

question appropriately is to focus on one of the relevant financial statement assertions (as listed

in Paragraph #28). In addition, it is important to differentiate between detection controls and

prevention controls (see paragraph #A8). That is, in the post-Sarbanes environment, students

must be able to identify a control procedure that would prevent specific misstaments from

occurring related to specific assertions. For example, a possible revenue recognition fraud that

could occur would be if revenue was actually recognized for product that had not yet been

shipped. This type of premature revenue recognition would overstate sales revenue. An internal

control procedure that could be designed to prevent a fraud related to the existence or occurrence

assertion related to revenue would be to insure that sales are only recorded if a valid shipment of

product actually occurred.

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