Vaughan Enterprises Inc. has grown from its beginnings in the steel fabrication business to become a multinational manufacturer and supplier of all types of packaging, including metal, plastic, and paper-based products. It has also diversified into a range of other businesses, including household appliances in Europe, Australia, and Asia. The growth in the size of the business occurred gradually under the leadership of the last two CEOs, both of whom were promoted from within the business. At the beginning of last year, the incumbent CEO died of a heart attack and the board took the opportunity to appoint a new CEO from outside the company. Despite the company’s growth, returns to shareholders have been stagnant during the last decade. The new CEO has a reputation of turning around struggling businesses by making tough decisions. The new CEO has a five-year contract with generous bonuses for improvements in various performance indicators, including sales/assets, profit from continuing operations/net assets, and stock price.

During the first year, the new CEO disposed of several components of the business that were not profitable. Very large losses on the discontinued operations were recorded, and most noncurrent assets throughout the business were written down to recognize impairment losses. These actions resulted in a large overall loss for the first year, although a profit from continuing operations was recorded. During the second year, recorded sales in the household appliances business in Europe increased dramatically, and, combined with various cost-saving measures, the company made a large profit.

The auditors have been made aware through various conversations with middle management that there is now an extreme focus on maximizing profits through boosting sales and cutting costs. The attitude toward compliance with accounting regulations has changed, with more emphasis on pleasing the CEO rather than taking care to avoid breaching either internal policies or external regulations. The message is that the company has considerable ground to make up to catch up with other companies in both methods and results. Meanwhile, the share price over the first year-and-a-half of the CEO’s tenure has increased 65%, and the board has happily approved payment of the CEO’s bonuses and granted the CEO additional stock options in recognition of the change in the company’s results.

Analyze the incentives, pressures, and opportunities to commit financial reporting fraud, and attitudes and rationalizations to justify a fraud in the above case.

What fraudulent financial reporting would you suspect could have occurred at Vaughan?

Explain why professional skepticism would be critical in assessing the risk of fraud.