POINT OF VIEW: Regulator – National Commission on Fraudulent Financial Reporting
Regina Vacuum Cleaner Co. seemed to be doing excellent as manifested in its healthy 1988 annual Financial Statements. However, Regina Company ended up as a tragic story that served as cautionary epic to investors, creditors, auditors, the public and the government.
The Company was acquired through a leveraged buyout by a group of Top Executives led by Donald Sheelen, former head of the Marketing department of Regina’s parent company. He was appointed CEO and became the majority stockholder after investing only $750,000.
Sheelen had big plans of increasing Sales and diversifying the product line. He had a tremendous forecast of the Company’s growth which unfortunately fell short due to product quality issues, only months after it went public. Rather than tell the shareholders’ of the shortfall, CEO chose to show that the company was making money than it really was by illegally inflating Regina’s financial picture.
Based on the causal factors identified, what are the recommendations to prevent fraudulent financial reporting in public companies?
A well-orchestrated fraud will often succeed, at least for a certain period of time even against well-intentioned, hard working and the most diligent professionals. This is true with the case of Regina Company where the auditors were not able to discover, nor even recognize the material misstatements in the financial statements.
Sheelen’s small and high-performance management team was able to perpetuate anomalies in financial reporting through premature revenue recognition and huge understatement of expenses. This could have been prevented and the investor’s interests could have been preserved had the public, auditors and the government been able to look beyond the numbers to see if the financial statements really made sense.
FRAMEWORK FOR ANALYSIS
I.Identify and understand the factors that lead to Fraudulent Financial Reporting -examination of Management condition, motivation and attitude are tools in assessing the likelihood and magnitude of management fraud. This is based on the idea that management fraud occurs when conditions exist for fraud to occur and management has the motivation and attitude to commit fraud.
II.Assessment of Internal Control – Involves identification of the dependencies and influences amongst various departments within the company that could possibly undermine the integrity of the financial reporting.
III.Risk Assessment – Includes the study of industry-related investigation and ratio analysis. It will provide viable information that will or will not support the performance data presented in the Financial Statements.
Management condition, motivation, attitude and the Industry
CEO Donald Sheelen is the company's majority stockholder. He emerged with 54% ownership through personal loan guarantees, bank loans and a minimal cash investment as opposed to the $38 million dollar worth of the company.
Regina went from a one product company with $60 million in sales in 1985 to a five product company with $181 million in sales in 1988 thus significantly lowering its debt-to-assets ratio to 74% from an initial height of 96%. Sheelen focused in increasing sales by introducing new products. Product quality was sacrificed in the order to boost its sales. Metal parts was replaced with plastic since plastic was cheaper, thus increasing sales returns due to faulty product.
So instead of being rewarded for advertising and wider product variety, Sheelen faced an inundation of angry distributors and retailers. These manufacturing and product-quality problems started in 1987 undercut the rosy sales predictions, thus placed Sheelen in a dilemma to either report the shortfall to shareholders or paint a healthy financial picture to be able to retain the confidence of the securities market....