In 2009, the SEC charged VeriFone Holdings, Inc., a technology company, with falsifying the com- pany’s financial statement to improve gross margins and income. VeriFone relied on gross margin as an indicator of its financial results and provided forecasts of its quarterly gross margins to investment analysts.
In early February 2007, during the quarterly closing process for the fiscal year ending January 31, 2007, preliminary financial
results revealed a gross margin of 42.8%, which was about four
percentage points below internal forecasts that had been communi- cated to analysts. Paul Periolat was a mid-level controller at Veri- Fone, and his responsibilities included forecasting gross margins, and making final inventory-related valuation adjustments relating to royalties, warranty reserves, and inventory obsolescence. When the CEO and CFO learned of the unexpectedly low gross margins
in the preliminary financial results, they sent emails calling the issue an “unmitigated disaster” and instructed VeriFone managers beneath them to “figure it [and related low results] out.”
Periolat determined that the problem in gross margin was due to incorrect accounting by a foreign subsidiary. He made a manual adjusting entry to record an increase to ending inventory of $7 mil- lion, thereby decreasing cost of goods sold and increasing gross margin. He failed to confirm the adjustments with the foreign sub- sidiary’s controller, and knew that the adjustments were incorrect. Periolat continued to make large manual adjustments to inventory balances quarterly for which there was no reasonable basis over the next two quarters. These adjustments allowed the company to con- tinue to meet its internal forecasts and its earnings guidance made
to analysts. Periolat was able to make his unwarranted adjustments, in part, because VeriFone had few internal controls to prevent
them. Neither the employee’s supervisor nor any other senior man- ager reviewed the employee’s work. Further, effective controls were
not in place to prevent the person responsible for forecasting finan-
cial results from making adjustments that allowed the company to meet the forecasts.
Ultimately, when the misstatements were revealed and VeriFone restated its financial statements, the company’s operating income fell from $65.6 million to $28.6 million, a reduction of 129%. When the misrepresentations were revealed in December 2007, VeriFone’s
stock price dropped 46%, which represented a one-day drop in market capitalization of $1.8 billion. With this much at stake,
auditors need to remember to be professionally skeptical about
manual entries and to require that appropriate documentation
supporting the entries be available for their review. Further, in areas where internal controls are not effective, the auditor should imple- ment appropriate substantive procedures due to the heightened risk of misstatement. For further information, see SEC AAER No. 3044, September 1, 2009.
a. List the inherent, control, and fraud risk factors relevant to this case.
b. What substantive audit procedures would have detected the
fraud? Would preliminary or substantive analytics have been helpful in detecting the fraud?