Starbucks Red Flags of Fraud

Starbucks Coffee Company Stephanie Deacon Colorado Technical University Online: ACCT 320-1203A-01 Professor White 6 August 2012 Abstract This paper will provide an overview of Starbucks Coffee Company and identify seven red flags of possible fraudulent behavior within the organization. Steps to design a fraud prevention program will also be discussed based on the identified red flags. Starbucks Coffee Company opened its first store in Seattle, Washington in 1971 offering fresh-roasted whole bean coffees. Howard Schultz (Starbucks chairman, president and chief executive officer) joined Starbucks in 1982 as director of retail operations and marketing. Starbucks begins providing coffee to fine restaurants and espresso bars” (Starbucks, 2012). In 1985, “Howard founds Il Giornale, offering brewed coffee and espresso beverages made from Starbucks coffee beans“ (Starbucks, 2012). Two years later Howard Schultz purchases Starbucks assets with the help of local investors and Il Giornale changes its name to Starbucks Corporation and stores open in Chicago and Vancouver, Canada increasing the total number of stores to 17.

Starbucks currently has over 16,000 stores in 50 countries and considers the company “the premier roaster and retailer of specialty coffee in the world“ (Starbucks, 2012). Starbucks mission statement is “ to inspire and nurture the human spirit-one person, one cup, and one neighborhood at a time“ (Starbucks, 2012). Starbucks refers to their employees as partners and their focus is to create a workplace that values and respects people from diverse backgrounds and to conduct business in an ethical manner.

Starbucks has a business and ethics compliance program in place to help ensure that all employees make ethical decisions in the workplace. In addition to its retail outlets, the Starbucks brand of gourmet coffees, ready to drink Frappuccino and double shot drinks and ice creams are also sold in grocery and convenience store outlets. Starbucks total net revenues as of “fiscal year ending Oct 2, 2011 was $11,700. 4 (in millions) which was an increase from both 2010 fiscal year end of $10,707. 4 and $9,774. 6 from 2009 respectively“ (Starbucks Annual Report, 2012).

As of “three quarters ended July 1, 2012, Starbucks unaudited net revenue was $9,935. 4 (millions), up from $8,668. 7 from July 3, 2011. Seven red flags of possible fraud Starbucks appears to have a good tone at the top with its established core values; however there can be instances of fraud going undetected by the auditors due to management’s override of controls. For example, with concerns about competition in the market, upper management could engage in creating fictitious revenues to make Starbucks look as if the company was performing better than it actually is. “McDonald’s 2011 annual revenues were $27. 1 billion” (Hoovers, 2012) in comparison to Starbucks $11. 70 billion and since McDonald’s introduced the McCafe line in 2009 to compete with Starbucks, it has captured a sizeable portion of the coffee drinker’s market. According to Keith O’Brien from the New York Times, “beverages, thanks to smoothies and espresso drinks, are now a $9 billion annual business for McDonald’s in the United States” (O’Brien 2012). This type of competition could pressure Starbucks management to inflate the company’s earnings and one key area where this could be accomplished is with improper revenue recognition.

Starbucks sells store valued gift cards called Starbucks cards where customers load money on the cards for future use in any participating Starbucks location. “Revenues from…stored value cards, primarily Starbucks Cards, are recognized when redeemed, or when we recognize breakage income” (Starbucks Annual Report, 2011). Breakage income is typically recognized when the redemption of the cards is likely to be remote based on past history. Outstanding card balances are included in deferred revenue on the balance sheet.

Management could record this deferred revenue on the income statement instead at year end, thus turning a potentially weak quarter into a much stronger one. Revenue recognition has a profound impact on a company’s income statement, and “not adhering to revenue recognition criteria could result in overstating revenue and net income in one reporting period and understating revenue and net income in a subsequent period” (Spiceland, Sepe, & Nelson, 2011, p. 30). “Typically, a senior executive who is inclined to “cook the books” possesses ow ethical standards, though this trait may often be difficult to detect prior to the commission of a crime” (White Collar Crime Fighter, n. d. ). Another red flag would be management unwilling to provide requested material to auditors, such as financial reports for fear they will uncover the fraud. The second area of concern for red flags of fraud would attribute to employee behavior. For instance, an employee who refuses to take vacation or sick time could be engaging in fraudulent activities.

If an employee were embezzling from the company, “he would refuse vacation or promotion for fear of detection” (Hancox, n. d. ). Additional red flags to watch out for with employee behavior changes would be borrowing money from co-workers, “excessive gambling or drinking, or bragging about significant new purchases” (Hancox, n. d. ). High employee turnover is another indicator of potential fraud especially in an area of the organization that is more vulnerable to fraud such as payroll.

High employee turnover can also be attributed to low morale and this could be a red flag of abusive management who may be engaging in fraudulent activity and should not be overlooked. High turnover at the executive level of the company would also be a red flag indicator that fraud might be occurring. Internal controls related to inventory encompass a large area ripe for fraud within Starbucks. Inventory deals with purchasing, receiving, shipping, processing and disbursements and if controls are overlooked it could seriously impact the company’s financial health.

For example, high volumes of purchases from new vendors could be a red flag for fraud as this could indicate a fictitious company has been created and goods could be shipped to a fake address then stolen. Another red flag would be “purchasing agents that pick up vendor payments rather than have it mailed” (Hancox, n. d. ). Unusual increase in the book value of inventory or slow inventory turnover could be a red flag for fraud. For example, Starbucks inventory for “year end 2010 was $543. 3(millions) and $965. 8 for year end 2011” (Starbucks Annual Report, 2012).

The COSO report indicated that “about 50 percent of the studied fraud companies overstated assets by recording fictitious assets or assets not owner or capitalized items that should have been expensed…and the most commonly misstated asset was inventory” (Rezaee & Riley, 2010, p. 101). Payroll is another area that can be highly susceptible to fraud. A number of things to look for would be the personnel department reporting new hires or terminated employees to the payroll department to ensure that paychecks are going to the right people and that fictitious employees have not been created.

Another issue would be having pre-numbered checks and having the sequence checked. If this internal control is not in place then it is possible to issue checks that have not been recorded in the system. Payroll checks should alos be authorized by two persons signatures to ensure that unauthorized payments are not made as a result of error or fraud. The company’s organizational structure could be an indicator of red flags for fraud. The first thing to look for would be the tone at the top of the company.

Unethical business conduct by executives is a key red flag in addition to high turnover of top executives. A clear line of authority is not present, “irresponsible corporate governance, and nonexistent corporate code of conduct and a decentralized organization structure without adequate monitoring” (Rezaee & Riley, 2010, p. 107). The corporate mission consists of maximizing profits and nothing else. The audit committee is ineffective, inexperienced and not capable of performing their duties. Financial performance red flags could include unusual rapid growth during an industry economic slump. Unexpected and sharp decreases in earnings or market share by the industry” (Rezaee & Riley, 2010, p. 110). Adverse legal circumstances could also lead to fraudulent behavior. Starbucks is engaged in a court hearing with Kraft Foods alleging a material breach of contract by Kraft and Starbucks discontinued their distribution arrangement with Kraft as of March 1, 2011. “On December 6, 2010, Kraft commenced a federal court action against Starbucks, entitled Kraft Foods Global, Inc. v. Starbucks Corporation, in the U. S.

District Court for the Southern District of New York (the “District Court”) seeking injunctive relief to prevent Starbucks from terminating the distribution arrangement until the parties’ dispute is resolved through the arbitration proceeding” (Starbucks Annual Report, 2012). The injunction was denied and Starbucks has since maintained control of their packaged coffee distribution. Starbucks is unsure of the financial damage that the breach by Kraft has caused and will most likely be able to estimate the damages in mid-2012. Fraud Prevention Program It is the organization’s responsibility to create a culture of honesty and high ethics and to clearly communicate acceptable behavior and expectations of each employee” (AICPA, 2012). The tone at the top of Starbucks must consist of honorable, honest people with high integrity, and committed to competence as they set the example. Having strong core values at the top of the company and sharing those values throughout the organization will show Starbucks employees how the company operates. The board of directors and audit committee must be skilled, educated and qualified to perform their duties such as auditors having a CPA license.

Roles of authority and responsibility must be clearly defined. Starbucks should have a tip telephone line established so that employees can confidentially report any violations of the code of conduct, suspected fraud or ethics violations. The integrity, ethical values and competence of Starbucks employees; management’s philosophy and operating style of the organization will help reinforce the company’s culture as a strength and not a weakness. “Internal control is not merely documented by policy manuals and forms. Rather, it is put in by people at every level of an organization” (COSO, 2011).

Policies and procedures covering financial and operational activities in place at Starbucks must be adhered to by employees at every level of the company to ensure the company is being run effectively and efficiently. For example, the procedures may “encompass a range of manual and automated activities such as authorizations and approvals, verifications, reconciliations, and business performance reviews” (COSO, 2011). Information processing controls, physical controls and segregation of duties should also be in place to ensure that risks are mitigated so Starbucks can meet its objectives.

Management should create a positive work environment with good hiring, training and promotion practices to ensure all employees are capable of performing their jobs. “Research results indicate that wrongdoing occurs less frequently when employees have positive feelings about an entity than when they feel abused, threatened, or ignored” (AICPA, 2012). Creating a team-oriented environment where employees are involved in the decision-making process, positive feedback from management, recognition for good job performance and rewards for achievements all contribute to reducing the risks of fraud in the workplace.

Effective communication of Starbucks objectives across the entire company is essential to its continued successful operations. Management must ensure that information is conveyed in a clear and understandable manner so the employees comprehend the importance of the internal control procedures and that they must be followed. Communication of information also includes “communicating with external parties regarding matters affecting the functioning of other components of internal control” (COSO, 2011).

Starbucks upper management must monitor the control activities and confirm the effectiveness of its internal controls. Manual and ongoing evaluations monitor the internal control process activities throughout the normal dad-to-day operation of the company. Ongoing evaluations are “generally performed by line operating or functional managers who are competent and have sufficient knowledge to understand what is being evaluated and… considering the implications of information they receive“ (COSO, 2011).

If the controls are inadequate, management must immediately communicate this information to the responsible party in order to take immediate action and employ corrective measures to ensure that controls are being followed as intended. “To effectively prevent or deter fraud, an entity should have an appropriate oversight function in place” (AICPA, 2012). An audit committee can strengthen a weak company environment by assessing the fraud risks identified by Starbucks management, evaluate the company`s anti-fraud policies and ensure that the tone at the top is conducting business with the highest level of integrity.

Oversight by the audit committee “helps to ensure that senior management fulfills its responsibility, but also can serve as a deterrent to senior management engaging in fraudulent activity“ (AICPA, 2012). References AICPA. (2012). AU Section 316 Consideration of Fraud in a Financial Statement Audit. Retrieved from http://www. aicpa. org/Research/Standards/AuditAttest/DownloadableDocuments/AU-00316. pdf COSO. (2011). Internal Control-Integrated Framework. Retrieved from http://www. coso. org/documents/coso_framework_body_v6. pdf COSO. (2011).

Committee of Sponsoring Organizations of the Treadway Commission About us. Retrieved from http://www. coso. org/aboutus. htm Hancox, S. (n. d. ) Red Flags for Fraud. Retrieved from http://www. osc. state. ny. us/localgov/pubs/red_flags_fraud. pdf Hoovers. (2012). Starbucks company overview. Retrieved from http://subscriber. hoovers. com/H/company360/overview. html? companyId=15745000000000 O`Brien, K. (2012). How McDonald`s Came Back Bigger Than Ever. Retrieved from http://www. nytimes. com/2012/05/06/magazine/how-mcdonalds-came-back-bigger-than-ever. html? r=1&pagewanted=all Rezaee, Z. , & Riley, R. Financial Statement Fraud Prevention and Detection (2nd ed. ). John Wiley & Sons Inc. Hoboken: New Jersey. Starbucks. (2012). Starbucks Annual Report. Retrieved from http://investor. starbucks. com/phoenix. zhtml? c=99518&p=irol-irhome White-Collar Crime. (n. d. ) Financial Statement Fraud: Detecting the Red Flags. Retrieved f http://www. wccfighter. com/FinancialStatementFraudRedFlags. html . . Spiceland, J. D. , Sepe, J. F. , & Nelson, M. W. (2011). Intermediate Accounting. New York: McGraw-Hill/Irwin.