(973) 822822-2220
Overview
Objectives of this program
i. Sarbanes-Oxley Act
ii. SAS 99: the new auditing standard with respect
to fraud
iii. Private Securities Litigation Reform Act (1995)
Advance Preparation: None
Type of Delivery: Live and Group-Internet-Based
Amount of Recommended CPE Credits: 3 - Auditing
A. Introduction
The general duties with regard to fraud mandated by the
Sarbanes-Oxley act, the new Statement on Auditing Standards
(SAS) No. 99, and the Private Securities Litigation Reform Act.
B. Management within a company
a. Officers and directors: General responsibilities
a. Duty of care:
Officers and directors occupy a fiduciary
relationship with the corporation. Directors and
officers are required to act in good faith and
with due care. Legally, they are required to
exercise that degree of care usually expected of
a reasonably prudent and diligent person under
similar circumstances.
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Sec. 301
Corporate Responsibility
Title 3, Sections 301-308
Adds a new provision to the Securities Exchange Act
of 1934 relating to Audit Committee Standards:
Makes the Audit Committee responsible for the
appointment, compensation and oversight of the work of
any registered public accounting form employed by the
issuer
Requires members of the Audit Committee be on the
Board of Directors and otherwise independent
Requires Audit Committees to establish procedures for
the receipt, retention and treatment of complaints
received concerning accounting, internal accounting
controls or auditing matters as well as the anonymous
submission by employees concerning questionable
accounting or auditing matters
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Sec. 302
Corporate Responsibility
Title 3, Sections 301-308
Requires the CEO and CFO to certify with respect to
each annual or quarterly report of the issuer, that:
The signing officer has reviewed the report, and
The report fairly presents, in all material respects, the
operations and financial condition
Sec. 304
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Sec. 306
Sec. 307
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3.
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7.
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b.
c.
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Polling Question #1
In your opinion, has the initiatives of SOX, Section 404, added value
to financial reporting and been financially (cost) worth the effort:
A.
B.
C.
D.
Added Value
Yes
Yes
No
No
Yes
No
Yes
No
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b.
c.
4.
5.
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7.
b.
c.
8.
9.
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Polling Question #2
In your opinion, what should be the CPA/Auditors level of
responsibility regarding fraud:
A. CPA/Auditor should be responsible for detecting all material fraud
B.
C.
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2.
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3.
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4.
Assess Results
Reassess control risk and document
this assessment.
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5.
Substantive Testing
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(a)
(b)
(c)
No
Less Than
Maximum
Yes
Maximum
Level
P
A
No
Yes
PERFORM ADDITIONAL
TESTS OF CONTROLS
(a) Reassess control risk
(b) Document assessment
PLAN EXTENSIVE
SUBSTANTIVE TESTS
DESIGN SUBSTANTIVE TESTS
AT A REDUCED LEVEL
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3. Perform tests of
controls*
4. Assess results
(based on tests of controls)
5. Substantive testing
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Polling Question #3
In your opinion, in regards to SOX, Section 404, the CPA/Auditor
should:
A. Express an audit opinion on internal control
B. Express an audit opinion on managements assertion regarding
internal control
C. Provide assurance regarding the effectiveness of internal control
D. Should only be responsible for assessing internal control in order to
perform the audit of the financial statement
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Pressures/Incentives
Pressure is caused by a financial need. The financial problem can be
personal (excessive personal debt) or professional (their employment
or business is in jeopardy).
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2.
3.
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Employee Fraud
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Employee Fraud
A. Financial statement fraud defined:
2.
Atypical method:
The overall objective of the misrepresentation may
occasionally require the opposite action (e.g., concealing
over-budget results in a good year in order to have
cushions for the next year that is expected to be more
competitive).
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Employee Fraud
B. The impact of financial statement fraud:
Financial statement fraud will have a devastating effect
on the reputation and the financial condition of the
company and employees. The stock market valuation
impact of the financial statement fraud will result in the
companys stock value falling dramatically overnight,
losing billions of dollars for shareholders.
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Employee Fraud
C.
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Employee Fraud
D.
E.
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Employee Fraud
4.
5.
6.
7.
8.
9.
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Employee Fraud
12. Demonstrate growth to support a planned stock or
bond offering or sale of the business
13. Shift surplus earnings to the next year when current
period budgets have been achieved and there is no
incentive for additional performance, managers may
direct additional earnings into the next year to ensure
they meet new goals
14. Take all write-offs in one big slam thus future
earnings should be consistently higher
15. Reduce market expectations, so future growth will be
rewarded
16. Avoid volatile results, maintain consistency
17. Reduce the value of a small/family company during a
divorce
18. If management is planning a buyout, reduce the value
of a corporate unit
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Employee Fraud
F. Methods of Financial Statement Fraud
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Employee Fraud
2. Accounting system: Lies
The violator submits false and fictitious data and
transactions into the accounting system to manipulate
results in a manner greater than can be achieved by simply
tricking the accounting system. Examples are:
a. Fictitious sales may be recorded to real or fake
customers
b. Inventory and receivables amounts may be created,
with documents later being forged to support the
lies
c.
Journal entries might be hidden or miscoded in an
attempt to conceal the fraud
d. Transactions can be concealed through use of
intercompany accounts
e. Transactions in the system have no basis in fact or are
improperly recorded
Key Point
No documentary trail to support certain transactions or balances will be
located unless the violator prepares forged or altered documents to help
support this fraud.
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Employee Fraud
3. Accounting system: Beyond the system
The violator produces whatever financial statements they
desire by using a personal computer.
Key Point
To catch this type of fraud, trace the financial statements
back to the trial balance and related general ledger from
the accounting system. There should be no documentary
trail to support transactions or balances reported in the
financial statements unless the fraudsters prepare forged
or altered documents to help support this fraud.
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Employee Fraud
G.Financial Statement Fraud: Statistics
2.
3.
4.
Revenue Fraud
a. 50% involved manipulation of revenue recognition
b. 26% involved fictitious revenues
c. 24% involved premature revenue recognition
Asset Fraud
a. 50% involved overstatement of assets
b. 37% involved overstatement of existing assets
c. 12% involved fictitious or unowned assets
d. 6% involved improperly capitalized costs
Liability and Expense Fraud
a. 18% involved understatement of liabilities/expenses
Disclosure Fraud
a. 8% involved inappropriate disclosure
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Polling Question #4
In your opinion, by whom should the audit of managements
assessment of internal control be performed:
A. The same firm that performs the audit of the financial statements
B. A different firm then the one that performs the audit of the financial
statements
C. The company should be able to select any CPA firm they want
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Employee Fraud
H. Financial Statement Fraud: Methods
The five types of financial statement fraud are:
1.
Fictitious Revenues
Timing Differences
Improper Asset Valuations
Concealed Liabilities and Expenses
Improper Disclosures
Fictitious Revenues
Fictitious sales typically involve fake or non-existent
customers, however it could involve actual customers.
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Employee Fraud
Key Point
In December 1999, the Securities and Exchange Commission
issued Staff Accounting Bulletin No. 101, Revenue Recognition
in Financial Statements (SAB 101) which gives additional
guidance on revenue recognition and to cease some
inappropriate practices that had been noted. SAB 101 indicates
that revenue generally is realized or realizable and earned when
all of the following criteria are met:
Persuasive evidence of an arrangement exists;
Delivery has occurred or services have been rendered;
The sellers price to the buyer is fixed or determinable; and
Collectibility is reasonably assured.
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Employee Fraud
a. Indirect Methods: Fictitious Sales
These methods do not attempt to
overstate gross sales, instead, they
understand those accounts which reduce
gross sales to arrive at net sales. For
example, by understating discounts,
returns and allowances, it will artificially
overstate net sales. There are two basic
methods:
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Employee Fraud
b. Warning Signs, indicating the possibility of
fictitious revenues
Excessive growth or unusually high profitability,
when compared to other companies in the same
industry
Repeatedly reporting negative cash flows from
operations while reporting earnings and earnings
growth.
Large transactions with related parties or special
purpose entities not in the ordinary course of business
Significant, unusual, or highly complex transactions,
typically those close to period end that pose difficult
substance over form issues
Unusual increase in the number of days sales in
receivables
A large volume of sales to companies whose
ownership is not known
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Employee Fraud
2. Timing Differences
Financial statement fraud often involves timing
differences, such as, the recording of revenue and/or
expenses in improper periods. This is done to move
revenues or expenses from one period and the next,
thereby increasing or decreasing earnings.
a. Premature Revenue recognition
Revenue should be recognized when the four
criteria set out in Staff Accounting Bulletin No. 101
have been satisfied:
Persuasive evidence of an arrangement exists;
Delivery has occurred or services have been
rendered;
The sellers price to the buyer is fixed or
determinable; and
Collectibility is reasonably assured
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Employee Fraud
1.
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Employee Fraud
2. Delivery has occurred or services have been rendered:
a.
b.
2)
3)
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Employee Fraud
c.
d.
e.
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Employee Fraud
f.
g.
h.
1)
Acceptance
2)
Substantial completion
1)
2)
3)
1)
2)
Must allocate the contract price to each element based on vendorspecific objective evidence (VSOE) of fair value
Recognize the allocated revenue when all the revenue recognition
criteria have been met, on an element-by-element basis
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Employee Fraud
i.
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Employee Fraud
j. Vendor-specific objective evidence of fair value
1)
2)
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Employee Fraud
3. The sellers price to the buyer is fixed or determinable:
a. Price is stated, not subject to change, and payable in accordance with
normal terms.
b. Any extended payment terms in a software arrangement may indicate
that the price is not fixed or determinable
1) Normal payment terms are net 30 days
2) Need to determine the reason does that reason jeopardize revenue
recognition?
c. If payment extends for more than twelve months after delivery, the
entire price should be presumed not to be fixed or determinable
d. If payments are a function of the number of units copies or the expected
number of users, the price is not fixed or determinable at the outset of the
arrangement
e. Rationale: the longer the payment terms the greater the risk of price
concessions due to the technological obsolescence of the delivered
software or the introduction of new and improved software
f. Revenue Recognition: if it is determined that the contract price is not
fixed or determinable, revenue is recognized as non-refundable,
contractual payments become due
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Employee Fraud
4. Collectibility is not reasonably assured:
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Employee Fraud
2. Timing Differences (continued)
b. Long-term Contracts
Managers can play with the percentage of completion
and the estimated costs to complete a construction project,
hence, the company will recognize revenues prematurely
and cover-up contract cost overruns.
c. Channel Stuffing/Trade Loading
The sale of an unusually large volume of a product to
customers who are encouraged to over purchase through
the use of large discounts or extended financing terms.
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Employee Fraud
Key Point
The negative consequence is that by robbing from the next periods
sales, it is more difficult to achieve sales goals in the following period, this
leads to increasingly aggressive levels of channel stuffing and ultimately a
restatement. Issues include:
Unrecorded side agreements that grant a right of return, effectively making
the sales into consignment sales
Greater risk of returns for certain products if they cannot be sold before
their shelf life expires.
d. Postponing the proper recording of expenses
The timely recording of expenses is often violated
due to excessive pressures to meet goals and
budget projections
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Employee Fraud
e. Warning Signs of Possible Timing Difference Fraud
Excessive growth or unusual high profitability, when
compared to other companies in the same industry
Repeated reporting negative cash flows from
operations while reporting earnings
Significant, unusual, or highly complex transaction,
especially near the end of the period end that pose
difficult substance over form questions
Unusual spike in gross margin or margin in excess of
industry standards
Unusual increase in the number of days sales in
receivables
Unusual decrease in the number of days purchases in
accounts payable
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Polling Question #5
Have you (and/or the business you worked for) ever been involved
in an issue regarding revenue recognition?
A.
B.
C.
D.
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Employee Fraud
3. Failure to properly value assets
Applying the lower of cost or market value rule, where
an assets cost exceeds its current market value (example:
obsolete technology), it must be written down to lower
market value.
Key Point
It is often necessary to use estimates in accounting. For example,
estimates are used in determining the residual value and the useful life of a
depreciable asset, the uncollectible portion of accounts receivable or the
excess or obsolete portion of inventory. Whenever estimates are used,
there is an additional opportunity for fraud by manipulating those estimates.
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Employee Fraud
3.
Inventory Valuation
Inventory must be valued at cost except when the cost is higher than the
current market value, inventory should be written down to its current
value which is lower.
Method of Manipulation
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
Employee Fraud
3. Improper Asset Valuation (continued)
b. Accounts Receivable
The two most common fraud methods involving
accounts receivable are fictitious receivables and failure
to write off accounts receivable as bad debts.
1) Fictitious Accounts Receivable
The entry for a fictitious accounts receivable is to
debit accounts receivable credit sale. These schemes
occur most often at the end of the accounting period,
because accounts receivable should be paid in cash
within a reasonable time after period end.
DR: Accounts Rec.
CR:
Sales
$XXX
$XXX
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Employee Fraud
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Employee Fraud
c.
d.
Business Consolidations
Violators may attempt to misappropriate the purchase price. Violators
may create excessive reserves for various expenses at the time of
acquisition, planning to utilize those cookie jars into earnings at a
future date.
Fixed Assets
Fixed assets can be fictitiously created by a variety of schemes. They
are subject to misstatement through many different fraudulent
methods:
1) Recording Fictitious Assets
The false reporting of assets affects the asset balance on a
business balance sheet. The most common fictitious asset
schemes are:
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Employee Fraud
3)
4)
5)
Misclassifying Assets
Due to budget requirement, and many other reasons, assets
are misclassified into general ledger accounts which are
improper. The manipulation affects financial ratios and
conceals non-compliance with loan covenants or other
borrowing requirements.
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Employee Fraud
6)
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Employee Fraud
Unusual spike in gross margin or margin in
excess of industry standards
Unusual increase in the number of days sales in
receivables
Unusual increase in the number of days
purchased in inventory
Allowances for bad debts, excess and obsolete
inventory, that are decreasing in percentage
terms or are out of line with industry standards
Unusual change in the ratios between fixed assets
and depreciation
Adding to assets while the industry is reducing
capital expenditures
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Employee Fraud
4. Understating Liabilities and Expenses
Pre-tax income will increase when an expense or liability
not recorded. This is less difficult to commit than falsifying
sales transactions. Missing transactions are harder for
auditors to detect than improperly recorded ones because
there is no audit trail.
Key Point
There are three common schemes for understating liabilities and
expenses:
A. Liability/Expense Omissions
B. Capitalized Expenses
C. Failure to Disclose Warranty Costs and Liabilities.
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Employee Fraud
a. Liability/Expense Omissions
Under this method of understating liabilities/expenses the
violator fails to record them. Debit memos can be created for
chargebacks to vendors, for claim permitted rebates or
allowances or simply to create additional income.
Key Point
Wrong-doers often plan to make up for their omitted liabilities with
expectations of other income sources such as profits from future price
increases.
Because they are easy to conceal, understated liabilities are often the
most difficult to uncover. A detailed review of all post-financialstatement-date transactions can aid in the discovery of omitted
liabilities. Further, the auditor should carefully review the clients files,
a physical search may uncover concealed invoices and unposted
liabilities.
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Employee Fraud
V O U C H
Testing for Existence
Testing for Support
ouch
Financial Statements
Trial Balance
General Ledger
Subsidiary Ledger
Books of Original Entry
Source of Documents
Execution of Event
Transaction Approved
race
T R A C E
Testing for Completeness
Testing for Coverage
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Employee Fraud
b. Capitalized Expenses
Capitalizing expenses will result in an
increase to income and assets since
capitalized items are depreciated over a
period of years rather than expensed in
the current period.
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Employee Fraud
1) Capital expenditures may be expensed
The privately owned business may want to
minimize its net income due to tax issues, or to
increase earnings in future periods.
c. Returns and Allowances and Warranties
A certain percentage of products sold will, be returned. In
warranty liability fraud, the liability is either omitted or
substantially understated.
d. Warning Signs of Possible Liability & Expense Fraud
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Employee Fraud
3. Nonfinancial managements excessive participation
in or preoccupation with the selection of accounting
principles or the determination of significant
estimates
4. Unusual spike in gross margin or margin in excess of
industry standards
5. Allowances for sales returns, warranty claims that
are decreasing in percentage terms or are out of line
with industry standards
6. Unusual decrease in the number of days purchases in
accounts payable
7. Reducing accounts payable reduction while the
industry is delaying payments to vendors
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Employee Fraud
5. Improper Disclosures
Improper disclosures associated with financial statement fraud will
typically involve the following: Liability Omissions, Subsequent
Events, Management Fraud, Related-Party Transactions, and
Accounting Changes.
a. Liability Omissions
Omissions include the failure to disclose loan covenants or contingent
liabilities. These agreements usually contain various types of covenants
including certain financial ratio limits and restrictions.
b. Subsequent Events
Violators ill fail to disclose court judgments and regulatory decisions
that adversely effect the reported values of assets, that indicate
unrecorded liabilities, or that negatively reflect upon management.
c. Management Fraud
Management has the responsibility to disclose to the shareholders
significant fraud committed by officers, executives, and others in
positions of trust. Failure to disclose such information from auditors
would involve lying to auditors, an illegal act in itself.
d. Related-Party Transactions
There is nothing inherently wrong with related-party transactions,
however they must be fully disclosed.
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Employee Fraud
e.
f.
Accounting Changes
Violators will fail to restate financial statements or disclose the
cumulative effect of a change in accounting principle made, simply to
improve earnings. They will fail to disclose significant changes in
estimates such as:
1) Depreciable assets useful lives and estimated salvage values
2) Estimates of warranty
3) Change the reporting entity.
Warning Signs of Possible Disclosure Fraud
1) Domination of management by a single person or small group (in
a nonowner-managed business) without compensating controls
2) Ineffective board of directors or audit committee oversight over
the financial reporting process and internal control
3) Ineffective communication, implementation, support, or
enforcement of the entitys values or ethical standards by
management or the communication of inappropriate values or
ethical standards
4) Rapid growth or unusual profitability, especially compared to
that of other companies in the same industry
5) Significant, unusual, or highly complex transactions, especially
those close to period end that pose difficult substance over form
questions
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Employee Fraud
6)
7)
8)
9)
10)
11)
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The 1999 COSO study indicated that either the CEO or the CFO
was involved in 83% of the financial statement frauds studied.
Individuals with high level management positions can use
their authority to override most internal controls, so those
controls can be of limited value in preventing financial
statement fraud. A CPAs approach to reducing financial
statement fraud is:
i. Reduce pressures
ii. Reduce the opportunity
iii. Reduce rationalization
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Polling Question #6
In your opinion, should SOX have adopted the COSO-Internal
Control/Integrated Framework:
A.
B.
C.
D.
90a
3.
4.
5.
6.
7.
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Polling Question:
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