The document discusses Phar-Mor, a company that engaged in accounting fraud to disguise losses and maintain the appearance of success between 1985 and 1992. It provides a framework for detecting financial statement fraud using a "fraud exposure rectangle" examining management, relationships, organization/industry, and financial results. Strategic reasoning considers how fraud perpetrators may conceal fraud and how auditors can modify typical tests to detect concealed schemes.

1. By Jaspreet Bassan

2.  Phar-Mor Case example
 Motivations for Financial Statement Fraud
 Framework for detecting financial statement
fraud
 Fraud Exposure rectangle

3.  Company started in 1982 selling a variety of
household products and prescription drugs at
low prices
 Idea of “Power Buying”
 1985 Phar Mor had 15 stores
 By 1992, 310 stores with revenue of $3billion
 About 6 years later they started losing money
and engaged in creative accounting too
disguise this to maintain their appearance of
success

4.  Had Finn not agreed to Micahel Monus’s
expense manipulation early on in 1985,
before the bigger frauds started, do you think
the Phar-Mor fraud would have progressed to
the extent that it did?

5.  Support high stock price
 Increase stock price
 Maximize management bonus or net worth
 Pressure on Management too perform

6.  Strategic Reasoning- ability of a fraud perpetrators
likely method of concealing a fraud.
 Use of game theory- Predicting behaviour based on
an individuals best response given that individuals
motivations and the individuals beliefs regarding the likely
behaviour of their opponent.

7.  Zero-order reasoning- occurs when an auditor and
auditee consider only conditions that directly affect
themselves but not the other party. i.e. their own incentives
such as audit fees
 First-order Reasoning- means that the auditor
considers conditions that directly affect the auditee.
 Higher order reasoning- occurs when the auditor
considers additional layers of complexity, including how
management may anticipate the auditor’s behaviour.

8.  What types of fraud schemes is management
likely to use to commit financial statement
fraud?
 What typical tests are used to detect these
schemes?
 How could management conceal these
schemes?
 How could the typical test be modified so as
to detect the concealed scheme?

10. Management Backgrounds:
• Have any of the key executives been involved with
other organizations in the past? If so of what
nature?
• Are most board members independent?
• Is the Chairperson independent from the CEO?
• Do any of members of management have criminal
background?
• Have any members of management had
any past regulatory or legal troubles?

11. Managements Motivations:
 Is the personal worth of any of the key executives tied up in
the organization?
 Is management compensation performance based?
 Do they have a reputation for guiding companies to higher
expectations?
 Are the jobs of Management at risk?
 Is the organizations reported financial
performance decreasing?

12. Managements influence in Making Decisions
for the Organization:
 Who are the key members of management and the board of
directors who have the most influence?
 Do one or two people have dominant influence within the
organization?
 Is the management style more authoritative or democratic?
 Is the organizations management centralized or
decentralized?

13. Relationship with financial institutions
 Is the organization highly leveraged through bank or other
loans?
 Do the banking relationships appear normal? Or are their
unusual attributes? Such as geographical location
 With what financial institutions does the organization have
significant relationships with?

14. Relationship with Auditors
 Have frequent disputes occurred with the current or predecessor
auditors?
 Has auditor change occurred? If so, for what reason?
 Has management placed unreasonable demands on the auditor,
including unreasonable time constraints?
Relationship with Lawyers
 Has any attempt been made to hide litigation from the auditors?
 Has the company been involve in litigation concerning matters
that could adversely affect the company’s financial results?
 Are any other lawyer relationships questionable?

15. Relationship with investors
 Is the organization in the process of issuing an initial or
secondary public debt offering?
 Are-any investor related law suits pending?
 Are any investor relationships questionable?
Relationship with Regulatory bodies
 Do management show a disregard for regulatory
authorities?
 Are their significant disputes with tax authorities?
 Has their been a history of security law violations?

16.  Does the company have an overly complex organizational
structure involving numerous or unusual legal?
 Is a legitimate business purpose apparent for each separate
entity of the business?
 Is the audit committee primarily comprised of insider or
outsiders?
 Is the audit committee passive or active and independent
 Does the organization have offshore business activities
without any apparent business purpose?
 Is the performance of the company similar or contrary to
other firms in the industry?

17.  Are Unrealistic changes or increases present in
financial statement account balances?
 Are the account balances realistic? Given the nature,
age, and size of the company?
 Have their been significant changes in the nature of
the organizations revenues and expenses?
 Does growth or profitability appear rapid?
Especially compared with that of other companies
in the same industry?
 Are unrealistically aggressive sales or profitability
incentive programmes in place?

18.  Motivations behind financial statement fraud
 The use of strategic reasoning to expose
fraud
 The fraud exposure rectangle
1. Management and directors
2. Relationship with others
3. Organization and Industry
4. Financial results and operating
characteristics