Commentaries are prepared by corporate executives and experts in business ethics and fraud detection who provide analysis and—
- Offer alternatives on how to face unfamiliar situations
- Demonstrate some empathy for management's position
- Expose potential dangers in the situation's
resolution
Many states require CPA licensees to have a minimum number of CPE credits in ethics in each reporting period, but do these CPAs know to how apply ethics rules? While we do not have all the facts concerning recent business failures, experience has shown us that there are many issues in business and our profession that must be addressed to minimize the number and impact of future corporate scandals.
Moreover, in tough economic times some members may experience situations where there may be coercion or temptation to back away from unclear and ambiguous business issues.
Ethics and Fraud in Business: Cases and Commentary were developed with support from the AICPA Foundation. Learn more about the AICPA Foundation at http://www.aicpa.org/ members/ aicpafoundation.htm.
You can send your feedback to Hadassah Baum at hbaum@aicpa.org.
TABLE OF CONTENTS
List of Cases- A Young CPA Stands His Ground: Revenue Recognition for a High-Tech Startup
- Loose Controls at an NPO: Internal Controls and Fictitious Invoices
- Cybrealty: Revenue Recognition of Stock Options and Stock Placement
- A Star Employee's Indiscretions: Unethical Behavior By a Star Employee
- Due Diligence and Buying An Enterprise: Due Diligence Engagement—Importer Tax Avoidance Scheme
- Good Works, Bad Accounting: Failure to Disclose Significant Information to Improve the Financial Picture of the Organization to the Outside
- Conservative Recognition or Cookie Jar Reserves: Multi-Element Revenue Recognition and Creating Reserves
- Accounting and Ethical Problems at Walax: Revenue Recognitiion—Multi Elements
- Rising Sun Construction Company: Expense Transaction Problems for an International Company
- Accounting and Ethical Problems at Sigma Industries: Revenue Recognition—Loans, Guarantees for Personal Asset Acquisitions
- Manager Persuades Employees to Unknowingly Allow Embezzlement: Making Detection of Embezzlement Difficult By Misappropriating Financial Records
- Strike Two: You're Out—Again! Revenue
Recognition for Nonmonetary Transactions
Revenue Recognition for a High-Tech Startup
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—A Young CPA Stands His Ground
Abstract
Advanced Tech, Inc., is a start-up. The venture capital owners have agreed to another round of funding and brought in a new management team. The president, vice president of sales and vice president of operations are all good friends. To reduce expenses, the operations V.P. is also the acting V.P. of finance, even though he has no accounting background. After an unsatisfactory audit, the controller is fired and Manuel Gonzales, a young CPA, becomes the interim controller. Manuel has worked there less than a year and feels out of his league. Miraculously, on the last day of a critical month, the V.P. of sales announces receipt of an order that provides the business needed to meet the expectations of the venture capital owners. Manuel has to decide how far to push his opinions regarding proper cut offs for shipments-with little support among the management team for his conservative views.
Background
After two years as an auditor for a large national accounting firm, Manuel Gonzales wants to jump into industry. Advanced Tech, Inc., a small start-up company, just won a second round of venture capital money and is looking for an assistant controller. Even a non-technical person like Manuel can see the demand for their product and, if the product is a hit in the market place, Advanced Tech could become a major corporation.
"I could be in on the ground floor," he thought to himself. Advanced Tech had all the ingredients for a big win.
The venture capital company brought in very experienced management from Fortune 500 companies and promised sufficient money to sustain operations for at least a year. If the new product sold well, Advanced Tech could expect a third round of funding. Also, the plant was near his new home. This was important as Manuel and his wife were expecting their second child and Manuel did not want a long commute. Even the worst-case scenario was not so bad. If the company went bankrupt, Manuel could return to public accounting or get a job with another high tech start-up in the area. This was an opportunity he could not pass up.
Growing Excitement
Time passed and Manuel became a solid contributor. Though the controller had all the direct contact with management, as assistant controller, Manuel helped prepare the monthly financials and slides. He understood them and could explain them, too. Advanced Tech grew to 150 employees. Each month, everyone felt the excitement grow as orders and revenue increased. About one year passed and the venture capital owners granted a third round of financing based on a promising new revision of the product. The pressure was intense to increase orders, but Manuel knew that the venture capital owners concentrated most of all on shipments or revenue to indicate the health of the start-up. Shipments meant that Advanced Tech could actually manufacture a product, delight customers, create a brand, establish a market for the products, make money and, ultimately, go public. This would make the venture capital owners and the employees successful.
Because of his CPA experience, Manuel knew about long hours and deadlines. What was new was the sense of power he felt when the monthly results were altered by several percentage points due to his estimates for bad debt and obsolete inventory. Manuel felt like a real businessman. He also realized his responsibility to be truthful and fair when reporting the monthly results. This was troublesome at times, especially when he changed his method of estimating. Judgment was the only guiding light. Manuel took comfort in knowing that the controller reviewed all estimates and had ultimate responsibility for the financial statements.
Then it happened. In an effort to keep expenses low, the accounting department always had insufficient people. The accounts payable and accounts receivable were not clean and reconciled. The year-end audit results reflected these weaknesses. When the controller reported the situation to the new management team, the controller was fired and Manuel was named the interim controller until a permanent replacement could be found. Unfortunately, the month-end close was coming up and it was a critical month. The venture capital partners expected growth in revenue this month. The management staff was highly experienced so they did not encourage unethical behavior, but Manuel felt very uncomfortable being the sole judge of whether the financial statements were fairly stated. Moreover, as the lame duck interim controller, Manuel felt out of his league-and believed that everyone knew it.
The Problem
As the month-end approached and a visit from the venture capital owners loomed, Manuel anxiously watched shipment levels. The manufacturing facility was located a mile away, and after long days at the office Manuel did not normally go to the plant at month-end to review for proper shipment cutoffs. Manuel had not worried about cutoffs very much except for the annual wall-to-wall physical inventories. About 4:00 pm on the last day of the month, Manuel received word that marketing had just received a large order. Marketing felt this order and the shipment it represented would provide the revenue Advanced Tech's owners required for the month. Manuel didn't see how manufacturing could convert an order to a shipment so quickly and he felt that the accounting rules were being stretched. Would he need to monitor the manufacturing plant this weekend for proper cutoff of shipments?
"I have plans this weekend with the family." he thought to himself.
Manuel went to his office, closed the door and asked himself several questions. When does a shipment physically occur? When it rolls off the production line? When the product is placed in a box and the box taped shut? When the address label is put on the box? When the box is placed on the loading dock? When the box is placed in the freight truck? When the truck leaves the premises? If the freight company's last pickup is at noon; should you count boxes that are labeled and placed on the shipping dock that afternoon and ready for pickup by the freight company the following workday? What if the freight truck only came twice a week and month-end was two days after the last freight pickup? His CPA training did not touch on these questions.
The Options
Manuel tried to call two audit managers at the CPA firm where he once worked. Neither one was available. Manuel had to act immediately, but he was on his own and didn't have a lot of experience. He had done inventories back in his audit days, but that did not prepare him for this dilemma. Manuel knew that the V.P. of marketing was a very experienced, hard-charging salesman who avoided accountants and focused totally on winning deals. He took pride in solving problems, meeting sales objectives and openly viewed accounting rules as anti-sales. Manuel knew that the V.P. of marketing would not listen.
"Maybe the order came from his friend who will cancel the order in a month or two," Manuel thought to himself cynically. "This would allow Advanced Tech's sales team to make their numbers for the month and, in their eyes, save the company. That would work for this month but would put us in a bigger hole next month."
Manuel dismissed this thought as it was not year-end and he would give them the sales team the benefit of the doubt. Besides, he monitored order cancellations and returns each month. If the order was bogus, he would see the cancellations when they came in. He realized that a natural tension existed between sales and accounting and that he was the company police. Like it or not, he had the final say.
"And what would that final say be?" he wondered.
Executive Input
The V.P. of operations, Duane Phipps, was the acting V.P. of finance, so Manuel quietly walked to his office and knocked.
Duane was at this desk. "Come in Manuel. How are you doing?"
"Hello, Mr. Phipps. I am doing fine, thanks. Mr. Phipps, we have a problem. Regarding this new order that just came in, I'm not sure manufacturing can get the products boxed and labeled and on the truck before midnight tonight so I can count them as shipments."
"Now Manuel, let me tell you that many companies count shipments if the product has an order attached and it is in the finished goods area essentially ready to ship," countered Duane.
"Oh, really. I thought the product had to be physically on the truck in legal possession of the carrier and on its way to the customer," said Manuel.
"Oh no. That is not how it is done in my experience," Duane said.
"Well, I am in a tight spot here, Mr. Phipps, but I will not let us count a product as a shipment just because it is in the finished goods area," said Manuel, with more confidence in his voice than he really felt.
Manuel and Duane discussed industry practices for a few more minutes. The V.P. of operations was unconvinced but relented and said he would notify management.
That night after dinner, Manuel finally reached his contacts at his old CPA firm. One contact said that the shipments had to be on a third-party truck and the other said that the product didn't need to be in a box but could be counted if it was in the finished goods/shipping area and had an order attached to it at midnight. In other words, there was no clear answer and it was up to Manuel's judgment. That evening, Manuel and his wife and two sons drove to the manufacturing plant to see what was going on. Outside the plant, Manuel noticed the following people's cars: V.P. of operations, V.P. of marketing, V.P. of research and development and the chief executive officer. Manuel entered the manufacturing plant and saw all of the management staff plus their spouses placing products in boxes and affixing address labels. Sheepishly, Manuel approached the V.P. of operations and asked, "How is it going?"
"Fine. We appreciate your ethics even though we may not agree. As a management staff we felt you were young and we did not want to override your authority. You are just trying to do your job, too, so the shipper is on his way now to pick up these boxes" the V.P. said.
Manuel explained, "The two audit managers I discussed this with disagree slightly on exactly when an order converts to a month-end shipment, but I feel that during the year, this is a workable policy. At year-end, however, we will be very clean and the goods must be on the truck. Agreed?"
"Agreed." said the V.P. of operations.
On the way home, Manuel looked at his wife and sons and sighed with relief. It would be a good weekend after all.
Internal Controls And Fictitious Invoices
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—Loose Controls at an NPO
Abstract
Senior accountant George Shaw finds evidence of poor internal controls and, ultimately, fraud, at a family of not-for-profits. In order to solve all of the problems with the organization's books, he ends up joining the staff.
Background
George Shaw, a senior accountant for the public accounting firm of Kettle & Company, was assigned as the in-charge auditor on a family of not-for-profits with primary operations in the healthcare and college industries. The client was made up of a parent corporation, JTL, Inc., and four subsidiaries (Rural Healthcare, the College of Advanced Nursing, JTL Foundation and JTL Assets).
JTL and Subsidiaries grossed over $30 million in annual revenue and held assets totaling over $30 million. The chief executive officer of JTL and Subs was Louise Robbins, who had been with the company for approximately ten years. The accounting department was headed by the accounts manager, Barbie White, who had been out of college for just under two years. Her live-in boyfriend, Butch Smith, was the administrator of Rural Healthcare, Inc. (RHI), and also functioned as the chief operating officer for all five companies. These three people had signature authority for all five companies, including a $750,000 county bond.
It is important to understand that the CEO was based in Knoxville, while the hospital, college and all other operations were located two and a half hours away in the mountains. Butch and Barbie, who were living together, essentially had control over all assets of the company with minimal oversight from Louise. These facts, along with the prior year audit workpapers, made George wonder about the internal control structure and the relatively high potential for collusion.
A Lack of Cooperation
George started his fieldwork before his two associates joined him in the field. When he arrived on site to meet with Barbie, he discovered that the client assistance list that was faxed to her two weeks earlier had not been completed. In fact, Barbie had only closed the books of one company and stated that she would get to the other companies at her earliest convenience. She was very short with George and seemed extremely agitated.
As George's second day in the field began, Barbie entered the basement where he had set-up his remote office. "Here is the school's trial balance," she said as she dropped the binder on the table. "I should have the rest by tomorrow, but who knows."
George said "Thank you" just as the door shut behind her.
After finally receiving trial balances for all five companies, George discovered Barbie had posted the prior year audit entries incorrectly. After correcting them, George proceeded with a preliminary analytical review. He and Barbie sat down to review the analyticals so that George would have more insight into the companies' past year of operations and overall financial health.
"Barbie," George began, "can you explain to me why the school's tuition revenue has dropped by over 20%?"
"I wasn't even aware that tuition had decreased," Barbie responded. "I'll have to look into that and get back with you."
George continued with similar questions, but Barbie was unable to answer any of them directly. However, she did tell George that the financial statements were actually incomplete because she had not completed her year-end entries.
During the initial conversation, Barbie said the employee who oversaw all of the school had recently quit and therefore would not be able to answer many questions. Barbie's own lack of knowledge of the school and RHI was especially alarming, because these two companies comprised a large percentage of the transactions and contained a majority of the risk and liabilities of JTL and Subs.
George continued to probe through the audit and eventually his two associates joined him in the field. Due to Barbie's ignorance of the companies' operations, George decided to perform extensive testing. During one test, George discovered large dollar entries posted to cash and miscellaneous income that Barbie was unable to explain or support.
"Barbie, I am really concerned about these entries to cash and miscellaneous income and the fact that miscellaneous income has increased so dramatically over the prior year," he told her. "I need to see some sort of support for these transactions or, at a minimum, a verbal justification."
"I gave you my answer and I don't know anything else," she said angrily. "I have no idea why those entries were posted." Barbie turned her back on George as a clear signal that this conversation was finished.
George left her office, once again failing to shed any light on the matter. He decided to contact the audit partner, Charles Brown.
"I am becoming very frustrated with the progress I am making on this audit," he told Charles. "When I arrived on site, Barbie White did not have any of the trial balances ready, which already has put me behind schedule. Now that I have started asking questions and requesting supporting documents, all I get from Barbie is a show of agitation and disgust with my very presence. If I am unable to resolve some of these issues, I will be in the mountains for the entire summer."
Charles responded in his usual calming tone. "George, let me contact Louise and see how she can help us. I do know how frustrating it can be to work with a client that is completely uncooperative. We ran into the same problems on last year's audit. I will let you know how my conversation with Louise goes."
Charles contacted Louise to discuss the lack of cooperation and the inability to get any questions answered or supporting documentation from Barbie. The CEO told Barbie to address all of George's questions and concerns, but Louise failed to address any of the questions herself. Barbie never adequately addressed any of the issues George raised, and she seemed to grow more and more agitated as the audit progressed.
As George and his associates continued to follow-up on unresolved matters with RHI, George received a telephone call from RHI's administrator, Butch Smith.
"George," Butch shouted through the phone, "let me tell you something. When you have questions or concerns about the hospital, you call me. I am in charge of the hospital, not Barbie, so leave her alone and let her do her job. I assume you understand me."
"Butch," George started tentatively, "Barbie is the accounts manager and we have addressed our accounting questions to her. However, if you feel that you can shed some light on the unresolved issues, I will be happy to discuss them with you."
George sent a fax with his questions to Butch, but he also was unable to resolve any of the remaining open items.
The Decision
During the audit, George came across numerous items that raised his suspicions about Barbie, Louise and Butch, as well as the entire organization. Near the end of the audit, George decided that he needed to document all of his concerns. He was fully aware that the income derived from JTL as a client was material to Kettle, his CPA firm employer, but issuing an unqualified opinion was not a viable option, and George refused to compromise his ethics and values. He knew that a CPA's integrity was an invaluable commodity and asset to companies, investors, management, clients and boards. Thus, he decided to request a meeting with Butch and Louise.
"There is a risk of fraud and abuse at JTL, Inc," George began in a tentative voice. "However, due to an overall lack of internal controls, sloppy record keeping and a general lack of cooperation during the audit, I am unable to determine the extent of the fraud. I recommend we issue disclaimer of opinions on the audits and request a meeting with the audit committee of the board of governors."
There, it was out in the open. George had taken the first step. In addition to his presentation at the meeting, George documented his concerns in a narrative. In his conversations with Charles at the CPA firm, George questioned the integrity of Louise, Butch and Barbie.
Charles never approached George about the narrative and never inquired any further about any of the difficulties that were incurred while working on the audit. Instead, the firm elected to issue unqualified opinions with no exceptions on all four of the audits (JTL Consolidated, RHI, the College and the JTL Foundation). Furthermore, to George's knowledge, Charles never discussed any of the audit issues with any of the members of the board of governors. Instead, they discussed some of the issues with Louise but none of the suggestions of fraud and abuse.
A Series of Fraud and Abuse
In response to recommendations for better accounting systems and controls, the board followed up on its earlier decision to move the accounting offices to Knoxville. This move would allow the company to recruit and retain qualified accounting personnel. Louise's intent was to relocate the accounts manager to Knoxville as well, because she truly believed in Barbie's abilities. However, Louise would require Barbie to work with someone from the CPA firm as a mentor. When Barbie learned about this condition, she quit within the week.
Louise was forced to ask Charles to assign someone from Kettle to be the interim chief financial officer/controller while she recruited for the position. George was selected because of his familiarity with the client and his overall skill level and abilities.
George immediately began working to clean up the accounting records. He instituted the necessary controls and systems to ensure the accuracy of the accounting records and to safeguard the companies' assets. During implementation of the internal controls, George uncovered a series of fraud and abuse.
He found that the plant operations manager, Buck Short, had set up multiple fictitious companies and was submitting invoices to JTL and Subs for work that was never performed. The fictitious invoices totaled over half a million dollars spanning a three-year period.
RHI was having major cash problems during this time and therefore its accounts payable were over sixty days. However, Butch would always approve the fictitious invoices for immediate payment and the accounts payable clerk was instructed to hand deliver the checks to Buck.
It was further discovered that Buck had a heating and cooling business on the side. RHI and JTL Assets were purchasing all of the heating and cooling units and necessary supplies for installation. Buck used his maintenance staff at RHI to install these systems while RHI paid their salaries.
George also discovered that Buck used RHI supplies, equipment and maintenance staff to renovate his house from a purchase price of $60,000 to an appraised value of over $240,000. On some invoices, the "ship-to address," was Buck's home address.
Conservative estimated costs for the heating and cooling supplies and the supplies and equipment used for renovating Buck's house totaled over $500,000. These figures do not include the wages of Buck and his maintenance staff.
Several of the fictitious invoices were submitted for payment through the county bond that was being managed by Seventh Street Bank. One invoice said that it was for the purchase of a new generator for $80,000. However, Barbie never recorded the new generator as a fixed asset. Instead, she recorded the $80,000 expenditure and the receipt of the bond money to the same expense account in the same month.
This "washing" of the $80,000 essentially left no trail in the financial statements. It was just one example of many questionable transactions that George discovered while functioning as the interim CFO/controller. He uncovered many more questionable activities, but due to collusion and the lack of clean accounting and paper trails, these were never pursued.
The fraud and abuse case was eventually handed over to the Federal Bureau of Investigation and the Internal Revenue Service Criminal Investigation Division. Buck was sentenced to three to five years in federal prison. Butch was forced to resign shortly after the discovery of the fictitious invoices because the theft occurred on his watch. No action was ever taken against Louise, and she still is the CEO of all five companies. In fact, the board of governors frequently praised her for her efforts in seeing the internal investigation through to the end.
George's refusal to compromise his ethics and values was the key reason that the fraud and abuse at JTL and Subs was uncovered. He eventually was offered a position with JTL and Subs as the CFO/controller over all five companies. He accepted because he felt board members and the CEO had a keen interest in strengthening the accounting and financial systems of the companies, including the internal control structure.
The internal control systems that George implemented and continually reviewed while employed by JTL created the foundation to catch and deter further fraud and abuse.
Revenue Recognition of Stock Options and Stock Placement
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—Cybreality, Inc.
Abstract
JoAnne Jones, CPA, a manager with Alan Smith & Associates, LLP, went into the field to review the staff work on the audit of the 20X2 financials of Cybreality, Inc. When she introduced herself to client management they urged her to expedite her review so that they could be sure to file the company's first 10-K well before the due date. They pointed out that the stock of this newly pubic company was doing well, and they didn't want anything to jeopardize that success. When she met with the audit staff, they assured her that all of the important fieldwork had been done and that the draft financials were ready for her review. Cybreality was an interesting company and she was looking forward to a stimulating day's work.
Background
Cybreality (or just 'Cybr') was established in 1992 by two UCLA undergraduates who were bored with the selection of electronic games then on the market. They made a bet with each other to see who could build a better game. The results were wonderful, and when their friends saw how imaginative their new games were everyone wanted copies. As time went by, new ideas for games seemed to fall into their laps. Before they knew it, the young men were in business. They dropped out of school and devoted themselves full time to producing new, more complex games. The actual programming was farmed out to student friends and the production was contracted out to a local shop that made CDs for the underground rock community.
Several years later, Cybr had so much business that it was out of control. The father of one of the young men suggested that they develop a relationship with a banker, an attorney and an accountant. One thing led to another, and Cybr was a $1 million business. The attorney suggested that the two young people might want to consider selling the company, cashing out their sweat equity and returning to school--or at least taking their lives in a different direction. The attorney had a friend who was in the business of buying fledgling companies and taking them to the next step. The two young people agreed and Cybr was sold to Greenfield Enterprises, Inc.
Greenfield brought in several managers who continued Cybr's product development and rationalized the production and distribution systems. Game design was contracted to per-diem designers; coding was contracted out to an offshore company; production and marketing was contracted out to a software house. Sales grew, and the company established a buzz in the world of electronic games. Although Cybr was still a small dot in the electronic game business, the industry was huge--global sales of games were more than $30 billion. Sony, Nintendo and Microsoft were in fierce competition for the hardware side of the industry, and that visible battle between the giants focused popular attention on the industry. More important, it encouraged game software sales. After several years of steady growth, Greenfield decided that it was time for them to cash in their Cybr equity.
As it had in similar situations in the past, Greenfield management decided to execute a back-door registration for its investee: Cybr allowed itself to be acquired by a dormant Nevada mining company that was registered with the Securities and Exchange Commission; Cybr transferred all of its assets to that company, and changed that company's name to New Cybreality. All of that was completed by June 30, 20X2, and, shortly thereafter, New Cybr was available for trading on the NASDAQ Bulletin Board.
Over the next several months, Greenfield sold 500,000 of its New Cybr shares in several private placements, at $0.70 a share. After those sales, Greenfield owned 80% of the 5 million shares outstanding. New Cybr engaged an investor relations firm to develop a plan to publicize the arrival on the NASDAQ Bulletin Board of this "new" public company. The investor relations firm suggested that New Cybr hire seven different consultants to work on this project; most of these companies were offshore entities. New Cybr agreed to hire the consultants and, on October 1, 20X2, signed two-year contracts with each firm. The contracts called for the consultants to be paid with options on New Cybr stock, with an exercise price of $0.01. When the contract was signed, New Cybr issued two-year options to the consulting firms, aggregating 750,000 shares.
At about that same time, New Cybr sold six-month options on 250,000 shares to Golden Gate Investors, a San Francisco-based company, exercisable at $0.75 per share. Golden Gate paid $25,000 for those options. This price, according to New Cybr's 20X2 10-K, was "established in arms-length negotiations."
An Audit Is Needed
Cybr's financials had been audited by a small Los Angeles-based CPA firm, but the firm declined to go forward with the audit for the year ended December 31, 20X2, because they did not have experience with SEC filings. Because of the back-door registration in June 20X2, New Cybr would be obligated to file a 10-K with the SEC for the current year. This was not the first time the attorney had encountered this problem and he turned to his friend, Alan Smith, who had a multi-office accounting firm headquartered in Orange County. Alan looked through the records at New Cybr, studied the system and decided that his firm could audit New Cybr's statements for the three years ended December 31, 20X2.
New Cybr was really a pretty simple company. Most receipts and disbursements were easy to document, and the only asset of consequence was the accumulated program development cost. As it turned out, the three-year audit was not difficult--time consuming but not difficult. After a good bit of overtime in March the audit staff was exhausted but done. On March 16, they called the office to say that they were ready for a field review. (Copies of the draft balance sheet and income statement can be found in Exhibits I and II.) Alan had a full schedule all that week, so he asked JoAnne Jones, a rising manager in the firm, to go to New Cybr's offices, meet the client management and complete the work paper review. Alan promised to be available by phone. She had to rearrange her own schedule to make that visit, but she was happy to do so because it appeared that she might become the client manager on New Cybr. Having first line responsibility for a new client--especially a technology client--was sure to help her career.
JoAnne went to the client's offices and visited first with New Cybr managers. After some pleasantries, New Cybr's chief executive officer (who was also an officer at Greenfield) congratulated the audit staff for the effort they had put in, and remarked, "I hope you can wrap this thing up quickly so that we file our first 10-K not just on time but before the deadline. Our investor relations consultants have been talking about what a mature company we are, and they are anxious that we demonstrate that maturity by meeting our filing obligations. The stock has been doing very well, and we don't want anything to happen that might derail the stock price climb."
The Investor Relations
The consultants had been active. Several of the consulting companies maintained Web sites where they talked about emerging companies, and one published a newsletter, The MicroCap News, that provided background and analysis of featured companies. The News and the Web sites had run stories on New Cybr, describing the complexity, the sophistication and the variety of games it produced, commenting on how "marvelously inventive" the games were. They also provided data describing the industry, emphasizing its growth and its appeal to a more adult audience. Unfortunately, they did not talk about the intense competition between the major companies, nor did they mention that competition was forcing down the retail prices of games and increasing the upward pressure on costs. Similarly, there was only an incomplete disclosure of the fact that each of the consulting companies owned options on New Cybr stock at $0.01.
All of the consultants exercised their options before December 31, 20X2. Shortly after the beginning of the new year, the stock had begun to trade much more vigorously than it had in the fall, with bid/ask prices of $1.00/$1.50. In fact, by March 16, the stock was trading with bid and asked prices of $3.00/$3.50. That trading activity was disclosed in the New Cybr 10-K for 20X2.
The Audit Review
JoAnne assured the Greenfield people that she would try very hard to complete her review promptly, and promised to get the audit report to them before March 25, 20X3.
JoAnne sat down with the staff and heard what they had done regarding the various assets and liabilities, and how they had worked their way through the prior years' financials. For example, they showed her the detailed analysis they had completed on the deferred product cost asset, testing for compliance with Financial Accounting Standards Board Statement No. 86, Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed. They explained how they had tested those capitalized costs for lower-of-cost-or-market problems, project by project. They were obviously proud of their work and perhaps felt a little too entitled to praise.
However, JoAnne knew that she needed to become a little more familiar with the situation. She glanced through the forepart of the 10-K and noted the stock price movement and the sale of the Golden Gate options. She leafed through the permanent file the staff had created and noted the usual incorporation documents and the contracts with the stock relations consultants. She asked the staff how New Cybr had accounted for the $0.01 options granted to the consultants. The senior knowingly said they had asked about just that. The chief financial officer had told the audit staff that the New Cybr stock hadn't really begun to trade when those options were granted, so there was no value to the options. When the company received the option proceeds, they increased cash and common stock. The senior couldn't explain why there were so many consultants, or why they were located off shore. JoAnne made some notes, and got ready to dig into the work papers. She asked for some quiet time --and for a cup of coffee.
Exhibit I: Cybreality, Inc. Balance Sheets (In $)
Years Ended Dec 31
2002 2001
Cash and Short Term Investments 62,500 88,000Accounts Receivables, less allowance
for uncollectible accounts 383,000 360,500Prepaid Expenses 52,500 41,000
Total Current Assets 498,000 489,500
Furniture and Equipment, net of
accumulated depreciation 228,500 208,000Total Assets 726,500 697,500
Accounts Payable 152,000 137,500Accrued Expenses and Taxes Payable 22,000 10,000
Current Payments on Bank Debt 5,000 5,000
Total Current Liabilities 179,000 152,500
Bank Loan 435,000 440,000
Common Stock, par $.01 57,500 50,000
Paid in Capital 55,000 55,000
Total Equity 112,500 105,000
Total Liabilities and Shareholders' Equity 726,500 697,500
Exhibit II: Cybreality, Inc. IncomeStatements (In $)
For the Years Ended Dec 31
2002 2001 2000
Product Sales 2,640,000 2,413,000 1,964,000Design and Production Costs
(including amortization of deferred production costs) 1,283,000 1,080,000 990,000Distribution Costs 174,400 152,400 131,650
Gross Margin 1,182,600 1,180,600 842,350
Gross Margin % 45% 49% 43%
Selling and Administrative Costs 812,400 822,650 503,483
Interest Expense 86,500 87,000 88,500
Income Before Taxes 283,700 270,950 250,367
Tax Expense 113,480 108,380 100,147
Net Income 170,220 162,570 150,220
Average Shares Outstanding 5,125,000 5,000,000 5,000,000
Earnings Per Share, Basic and Diluted 0.0332 0.0325 0.0300
Unethical Behavior by a Star Employee
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—A Star Employee's Indiscretions
Abstract
A bank CEO owes his success to a star employee, Mark, whose management produces admirable returns. Mark has inappropriate relationships with several employees—and he uses bank funds to pay for his dalliances. What should the CEO do when faced with covering up for this key player's fraud—or possibly losing his job?
Background
It had been another long and sleepless night, not at all what Robbie expected when he became chief executive officer of the bank two years ago. His wife, Beth, had noticed that something seemed to be bothering him. "What is it, honey?"
"I was thinking about how good life was a couple of years ago," Robbie answered. "I was the CEO of a small, local, financial institution with seven offices and about fifty employees. Assets were less than $500 million. The challenging operational systems, such as asset/liability management and information technology, were outsourced to another bank. The truth of the matter was I didn't have to work too hard and there were few difficult decisions. I had plenty of time to promote myself as the successor to the retiring CEO of the much larger bank that provided the support systems to my old bank. You know what I mean, Beth. You used to be a banker."
Now Robbie was the CEO of a bank with operations in more than twelve states, 1,000 locations and more than 4,500 employees. Only 300 of these employees were at the main office. Assets were in excess of $10 billion and growing rapidly. Robbie was responsible for a highly complex environment he really didn't know much about. The support of the bank's two executive vice presidents, especially Mark, was what saved him from bad decisions, and, at the same time, caused him sleepless nights.
A Difficult Key Employee
Mark had been one of the finalists to replace the retiring CEO, having worked his way up in the financial and lending areas of the bank. Everyone agreed that his intellectual abilities were strong, as was his vision for the future direction of the bank. Mark was also strong willed and determined to implement his vision no matter what the obstacles. He had been the dominant manager in the bank before Robbie arrived, and continued in this role after Robbie was hired.
"Why do you think Mark wasn't selected for the top job?" Beth asked. Robbie believed Mark's biggest problem was a total absence of tact combined with a volatile temper. Mark was fond of telling people how stupid they were when he was irate about something. Worse, Mark didn't distinguish between clerical employees, managers, customers or even members of the board of directors.
In addition, there was Liz, Sarah, Leslie and possibly others. Mark had sexual relationships with these employees and didn't trouble himself to attempt to be discreet. The affairs were carried out during work hours, at bank functions and while traveling extensively throughout the country at bank expense. The total cost was easily in excess of six figures, all of which hit the bank's income statement as legitimate bank expenses.
Worse, these three employees were so inept at their assigned responsibilities that it was clear they were being retained for sexual favors. This brought the total cost up to more than $250,000 per year.
Liz was a high school graduate who had worked as a secretary at a small law firm before coming to work at the bank. She was married to a plumber, lived in a small town not too far from the main office of the bank, and hadn't been exposed to extensive travel or expensive hotels and meals. Her sexual relationship with Mark didn't take long to develop and it had continued for at least six years.
Liz's life at the bank was excellent. She was deeply feared because of her relationship with Mark, and was frequently rude to other employees and managers at all levels. Liz had told Robbie off twice since he became CEO, and neither experience had been pleasant. She went to conferences throughout the country with Mark, which were designed for financial executives, not secretaries. Liz spent her time shopping rather than attending the programs, anyway, though. She was included in the bank's senior management bonus program, the only clerical employee on the list, over the protests of many other managers. During the bank's internal education programs, which were usually held at resort locations, Liz was often at the pool, where she was easily seen by other employees on their way to attend training sessions.
Liz steadily progressed up the management ladder despite many grim exit interviews with her former employees, who complained about the way they had been treated. Not only was she extremely unpleasant to work for, she also lacked even basic knowledge about the functional activities she managed. She reported directly to Mark, who approved her travel plans and expenses as legitimate bank expenses.
Robbie shook his head and told Beth, "Liz is a real management problem and an excellent example of fraudulent use of bank funds. I really don't know what to do about her."
"And what about Sarah?" Beth asked. Sarah was employed as a senior financial manager at the bank. She met Mark at conferences out of town when Liz wasn't able to attend.
"Beth, let me tell you about a couple of situations involving Mark and Sarah. During a small break-out session at one conference, Sarah and Mark sat in the back of the room and talked about how drunk they had been when they were together the night before. The conversation was easily heard by everyone in the room. At another conference, Mark told the person in charge of the meeting he had to leave for the bank's main office immediately due to an emergency. Within a minute, Sarah told the same person she had an office emergency and would be working in her hotel room for the afternoon. When the training class took a break several hours later and moved outside to enjoy the beautiful weather, the hotel valet was just delivering Mark's car to him. Mark laughed and said he had waited more than two hours for the valet to retrieve his car from the hotel garage. The employees who heard the explanation weren't nearly as stupid as Mark thought they were. Can you imagine this happening at the old bank, Beth?"
And then there was Leslie. She was the bank's most senior female officer. She had previously had sexual relationships with both Mark and William, the bank's other executive vice president, and was thus "double-protected." She reported to William and managed the bank's public relations area. Robbie had received many complaints about Leslie's work, even from the bank's customers. Leslie also had a habit of failing to complete performance appraisals on time or authorize the salary increases that went with the reviews. She was often more than a year late with these and her employees had reached the point of mutiny. The salary increases were so far overdue the employees' retirement contributions and 401(k) matches were understated. This control weakness had been reported to the audit committee twice, and each time Robbie told them the problem had been corrected. He knew it continued to exist, but holding Leslie accountable would mean conflict with both Mark and William. Still, one of Leslie's employees had written a letter of complaint to one of the bank's directors and it could prove troublesome.
"I don't know how much longer I can cover for her, Beth."
"That sounds like a real mess, Robbie."
The Dilemma
Robbie started thinking about the general auditor, who had been with the bank for nearly ten years. The auditor had received nothing but praise from the retiring CEO, the external auditors and the regulators. His credibility and stature with the audit committee and the board of directors were excellent.
The auditor, Fred, had talked with Robbie twice about the use of bank resources to facilitate Mark's sexual relationships. Fred pointed to bank regulations, the Financial Institutions Reform Recovery and Enforcement Act, the bank's internal policies and employee perceptions as support for preventing the use of bank funds to pay for sexual relationships. He also commented at length on the use of promotions as rewards for Liz, Sarah and Leslie in spite of their well-known lack of qualifications and ability. The bank's clerical employees and managers believed the only reason these three employees remained employed was to provide sexual favors and companionship during business travel. Fred concluded the meeting by saying, "There isn't any gray area on this one Robbie. Using bank funds and resources in this manner is plain old fraud."
The human resources director was also highly regarded by the bank's board. Sam had talked with Robbie on several occasions regarding complaints about the sexual relationships and the exceedingly favorable treatment extended to Liz, Sarah and Leslie. It was clear to other female employees the surest way to win a promotion wasn't through excellent job performance, it was through sex--if you were relatively young and attractive. "I'm very concerned about the possible legal implications," Sam told Robbie, "as well as the example being set for our employees, to say nothing of the improper use of bank funds."
"How are you going to handle this, Robbie?" Beth asked, when he had explained it all.
"I'm not exactly sure yet. Please listen to what I've been thinking."
Robbie was having sleepless nights because he knew that Fred and Sam were right on target in their assessments of the situation. But Robbie also knew Mark would most likely seek other employment if questioned about his relationships, and without Mark, Robbie's days as CEO might be numbered. Only Mark was capable of managing the bank to the earnings records that had been achieved recently. Mark had also been able to convince the board to greatly increase salaries and bonuses for the CEO and two executive vice presidents.
Mark and William were close personal friends and Robbie had talked with William about the situation. William reinforced Robbie's conclusion that Mark would leave the bank if approached about his relationships and agreed the bank's financial results would not be nearly as strong without Mark. "Robbie, Mark's ego is too strong to be dragged through the mud over these women. He'd leave for sure," William said.
Robbie told William that he had decided to ignore Mark's "personal behavior" and hope that it would soon be forgotten.
Several months later, William's new girlfriend, also an employee at the bank, received a very poor performance appraisal. Susie was in danger of being terminated soon unless her performance improved dramatically. William quickly transferred his secretary to another area and put Susie in the position. Her new office was a few feet from Robbie's office and he noticed she only worked about 20 hours per week rather than full-time. Although the bank did not allow children of employees in the building, Susie's three children were in her office when she was there. She used a couple of other bank employees to help her kids with their schoolwork, and Susie spent most of her time planning field trips and working on other school functions.
Susie and William took two hour lunch breaks together every day and traveled together frequently. At company functions, they ate food from each other's plates in front of bank employees. Susie wielded power in William's name and became feared.
William and Susie worked late often. An hour or so after the bank closed, they would leave the bank together and get in William's car. A couple of hours later, the car would return to the bank, Susie would get out and head for home in her own car. The bank's second shift of security personnel enjoyed watching this on their cameras and it became widely known through the bank's grapevine.
Since Robbie had seemingly condoned Mark's behavior, it appeared that William thought he had permission to become completely indiscreet about Susie. Now more trouble was on the horizon.
Fred, the auditor, and Sam, the HR director, had agreed to give Robbie time to end bank funding for the relationships. Robbie had talked with each of them twice about Mark's importance to the bank, and he asked for their patience to give him time to straighten things out. He promised Fred and Sam they would see changes over time implemented in such a way that no one would lose face. He did change Liz's reporting relationship away from Mark to the chief financial officer. But that was the only change he had made after several months.
Fred and Sam had talked with him again, but Robbie was firm in his decision. "I don't plan any further corrective action because I fear losing Mark. The risk of losing a star performer is too great, especially since it's simply based on personal indiscretions." Both Fred and Sam were asked to cover up the situations with Mark and William for the good of the bank and to ignore the regulatory, legal and policy violations. Robbie had closed the meeting by saying he was confidant things would work out for the best, and he appreciated their support.
When Beth heard the entire sorry tale, she was worried. "Robbie, we're in trouble, aren't we?"
Due Diligence Engagement—Importer Tax Avoidance Scheme
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—Due Diligence and Buying An Enterprise
Abstract
A newly minted senior auditor discovers tax avoidance issues while performing due diligence in a deal involving her firm's largest client.
Background
Gloria Scheps was excited and somewhat panicked at the same time. Just two months ago, in April, she was promoted to senior auditor at Broderick, Samuels and Underhill (BSU), a regional full-service accounting firm headquartered in Indianapolis. She was starting her third year with the firm and was on the fast track. Gloria was bright, energetic and out to prove she was better than her peers and friends who took jobs with the large national accounting firms. She had her heart set on working for one of those large firms coming out of college, but now she was committed to her work and to BSU, determined to make partner someday.
She had just received an assignment to plan and perform a due diligence engagement for BSU's largest client, American Artifacts, a $500 million manufacturer and distributor of household consumer goods based in Columbus, Indiana. American Artifacts was in the middle of negotiating to purchase Sito, a $50 million Toronto-based importer of high-quality cutlery from China.
Gloria was thrilled to get such high-profile work and couldn't wait to get started. She was also worried about being successful with this opportunity while also meeting her other commitments, primarily audit wrap-up "to-do's" that somehow seem never to get done. When she was promoted, her mentor partner, Debby Quan, had explained that being a senior would challenge Gloria to develop her style to effectively manage others. For the time being, Gloria was being challenged simply to manage herself and juggle priorities.
Gloria's first step was to discuss the project with BSU's audit manager, senior manager and partner assigned to American Artifacts. She learned that American Artifacts was very excited about the opportunity to add the Sito line to its stable. Sito was eager to leverage American's sales and marketing prowess to grow Sito's revenues in the United States. The transaction terms were largely negotiated and, with regulatory approval issues believed to be nonexistent, due diligence was the last major step to complete the deal. Gloria quickly surmised that she didn't have a lot of time and, in fact, was told due diligence needed to be wrapped up by the end of June-only eighteen days away. She also learned that she would get one staff auditor--her choice from whoever was available on the schedule--to assist with the engagement in Toronto.
Gloria later met with her audit manager to choose a staff accountant to assist the due diligence effort in Toronto. There were five medium and senior staff accountants available. Gloria picked Jim Harris, who had just completed his first busy season and was the star of his incoming class. Gloria then scheduled her client visit for the week of June 17. She would spend the remainder of the current week planning the due diligence, bringing Jim up to speed and completing some of her open wrap-up "to-do's" from her busy-season audits.
Examining Sito
Gloria and Jim traveled to Sito on Monday, ready to begin. Gloria had created an extensive due diligence program for her and Jim to follow. She would spend her time in discussions with Sito's owner and key managers and helping Jim establish support for Sito's financial statements. Jim was responsible for gathering detailed financial reports and reconciling them to Sito's financial statements, including reviewing transactional support documents.
When they arrived, Sito's owner, Sam Proctor, warmly greeted Gloria and Jim. After some initial conversation and a quick tour, Sam introduced Gloria and Jim to Sito's accounting manager, Sheri Landon. Sam had started the business five years ago after securing the North American distribution rights for the Sito product line from Tsingto Enterprises in China. Sheri had worked with Sam over the past five years as they grew the business from less than $1 million in annual revenues to just over $50 million today.
Sam, Gloria and Jim went out for lunch to discuss the due diligence plan and the upcoming week's events. During lunch Gloria learned that Sam, a successful entrepreneur now sixty-one years old, had started several businesses with international ties, the last of which led to his relationship with Tsingto. Gloria also learned that while Sam was a lifelong Canadian resident and very much enjoyed life in Canada, he was also displeased with Canada's taxation policies that, at the margin, were over 50% for business and individuals. She also noticed that the restaurant patrons were all paying in cash, as did Sam. Sam intimated that much business was transacted in cash in Canada due to the high tax rates. He said that if the government's taxing policies were more reasonable, more taxes would ultimately be collected because businesses would employ fewer tax avoidance schemes. Gloria thought this was interesting and wondered how Canada's taxes and Sam's views and actions might affect her due diligence plan.
The Problem
It was now Wednesday and Gloria and Jim were well into their due diligence plan. Clearly Sito was a very profitable business with simple operations. Gloria was thinking the acquisition made sense for her client when Jim approached her. "Gloria, this is weird. As I look through my inventory work papers, I have two detailed perpetual inventory listings with the same date but materially different quantities and inventory values. I need to discuss this with Sheri. I can tie one of the inventory listings, the higher one, to the review report issued by their New York CPA." Gloria thought about this and said, "Yes, Jim, let's discuss this with Sheri right away, but let's also keep this quiet until we can talk to her." Gloria felt it was no accident Jim had the two inventory listings, and that Sheri might be trying to tell them something.
When Jim began asking about the inventory listings, Sheri was visibly uncomfortable. "Jim, we made some top-level changes to the perpetual inventory."
"Okay," Jim said, "what are the reconciling items to explain the adjustments?"
"I think you should discuss this with our accountant, Mr. Kirkpatrick," Sheri told him.
Jim briefed Gloria, who now knew something was not right. Gloria stopped by to see Sheri. "Okay Sheri, what's up? You know we have a problem with the inventory listings. Will you help me sort it out?"
"Listen Gloria," Sheri replied, "Sam Proctor is a good man. Sometimes he can be a little too creative in order to mitigate his tax payments. It is not uncommon in Canada. I really can't discuss this. That second perpetual listing that you found is all you need. Talk to Sam and talk to Mr. Kirkpatrick." Then Sheri handed Gloria a piece of paper. The look on her face said, "You didn't get this from me." Gloria thanked Sheri and headed back to her conference room work area.
As Gloria was reviewing the paper she received from Sheri, she was thinking, "Now things really get interesting." The piece of paper was a statement for a Sito-owned Swiss bank account showing deposits from Tsingto. As Gloria checked the due diligence work papers, she learned that in fact this account was not included in the assets of Sito. Now Gloria was excited again but also very anxious. She had clearly uncovered some troublesome financial transactions that she knew American Artifacts would be interested in, but she was beginning to feel that she was getting in over her head.
Gloria phoned her audit manager, Tom McCarr. "Tom, I think we have a few problems with Sito. They may be hiding some income through misstated financials and unreported product purchase rebates. I really need some help to sort this out. Sito's CPA is a Mr. Kirkpatrick in New York. I'm pretty sure he is in the loop on this." Gloria went on to explain all that she knew. Tom processed Gloria's update and said, "Okay Gloria. It sounds like you have uncovered some tax avoidance schemes. Good work! I want you to call Mr. Kirkpatrick and confront him on these issues. I will call Sam Proctor and discuss our issues with him. Please do not discuss this with anyone else until we talk again. Please call me right after you finish your discussion with Mr. Kirkpatrick. Thanks, and hang in there. You are handling this perfectly."
Gloria was not looking forward to her call with Mr. Kirkpatrick. "Mr. Kirkpatrick, I am Gloria Scheps from Broderick, Samuels and Underhill. We are performing the Sito purchase due diligence for American Artifacts. I think Mr. Proctor said you would be available as needed." Mr. Kirkpatrick said he was aware of the ongoing due diligence and would help in any way he could. "Mr. Kirkpatrick, I have discovered some potential problems with your last review report and the underlying inventory values. I have two perpetuals, one significantly higher than the other, for the financials review date. I discussed this with Sheri and she asked me to call you. Also, I found a Swiss bank account statement with deposits to Sito from Tsingto. According to Sito's financials, this account doesn't exist, although the statement suggests it has been around since Sito started."
"Ms. Scheps, I understand your questions," Mr. Kirkpatrick said. "I know they are important for you to resolve to complete your due diligence. I would like to discuss them in person rather than over the phone. I will clear my calendar any day next week to meet with you here in New York." Gloria had hoped there was a logical and legal explanation for what was going on. She now knew from Mr. Kirkpatrick's reaction that the situation was real and would not go away. She also had a deadline. "Thanks Mr. Kirkpatrick, I appreciate your offer. This cannot wait until next week. I will plan to be in your offices tomorrow morning by 10 a.m. I will see you tomorrow." Mr. Kirkpatrick reluctantly agreed and the meeting was set.
Gloria was hoping she had done the right thing. She called Tom to discuss her meeting. "I spoke with Sam and he was forthright about the whole thing," he told her. "Let's just say he has taken some very aggressive tax positions. I am not yet sure how this affects the purchase, if it does at all. I have discussed this with American Artifacts and their attorneys are evaluating. How did your call go?"
Gloria was greatly relieved that Tom seemed to have everything under control. "Well, Mr. Kirkpatrick was pleasant enough, but he wouldn't discuss anything over the phone. I set up a meeting with him tomorrow morning in his office in New York. Do you think I should still go?"
"Yes, Gloria, go ahead," Tom told her. "Let's plan to finish our onsite work by the end of the week. We'll wrap up everything in the office next week. How does that sound?" Gloria agreed and they hung up.
Failure to Disclose Significant Information to Improve the Financial Picture of the Organization to the Outside
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—Good Works, Bad Accounting?
Abstract
Jill Lassiter is the newly appointed executive director of a charity dedicated to helping single mothers. She must get the financial statements in order so that they satisfy the organization's largest donor. Should she restate her budget using faulty estimates—or should she be candid about the organization's difficulties and face losing a crucial donation?
Background
Jill Lassiter pressed a fingertip to her already throbbing temple and wondered for the fourth time if she'd made a mistake in her addition. If she hadn't, Good Works for Women was in trouble. And trouble was not something Jill needed, least of all now, in the middle of her second week as the charity's executive director.
She'd known she faced a challenge when she accepted the job offer. When the last executive director quit, the board had been slow to look for a replacement. By the time the search began, three months had gone by. When they hired Jill, another month after beginning their search, the board had admitted the accounting records were in a tangle.
Make that a full-fledged knot, Jill thought. She pushed a curl of blond hair behind one ear and stared at the calculator tape in her hand, thinking about her reasons for taking the position at Good Works for Women. She'd been drawn by the charity's dedication to helping single mothers find meaningful employment. In addition to maintaining a computerized job bank database, Good Works provided assistance with résumé preparation, interview techniques, wardrobe, childcare, transportation and job skills improvement.
Though the pay was less than Jill had earned as the accounting manager at Crestview Hospital, she'd jumped at the chance to become part of an organization that she believed would allow her to make a difference in so many lives. Since she was a single mother herself, being part of the solution held a strong attraction.
But now, after two weeks spent updating and reviewing the accounting records, Jill could see exactly how much of a challenge she'd taken on. Over the past four and a half months, finances had fallen into disarray.
She'd made enough sense of what records there were to chart the decline in fundraising efforts, and--as a natural consequence--the way contributions had dwindled. The loss of income was bad enough, but then she'd discovered administrative expenses had grossly exceeded the budget. To round out her problems, when she checked the contract with Good Works' largest donor, Lyndelle Oakes, she realized the charity was behind in providing the quarterly financial statements necessary to continue receiving funds. In fact, Lyndelle Oakes had not seen any statements since the audit conducted at the charity's prior year-end, eight months before.
"There's someone here to see you." Alice Hunt, the Wednesday morning volunteer receptionist, walked into Jill's office, her round face beaming with her usual good humor. A tall, slender woman with steel-gray hair and stern blue eyes magnified behind silver-rimmed glasses followed her. Alice said, "Jill, this is Lyndelle Oakes. She's one of our Angels."
Trying to ignore her growing headache, Jill stood, came around her desk and held out her hand. "I've heard of you," she said. "And I want to thank you for all you've done for Good Works for Women."
Lyndelle shook Jill's hand, but her expression remained unchanged. "You can thank me by getting my accountant the information I need in order to make this quarter's donation. I know you were only hired two weeks ago, but I was certain the financial records would be your first priority."
"Let me assure you they are." Jill gestured toward her paper-strewn desk. "In fact, I'm working on last quarter's statements now. But it's a bigger job than you might think, Ms. Oakes. I have four months of records to review. I also intend to go over the records for the four prior months, back to the last audited statements."
"Is there some problem?"
"I like being thorough," Jill said. Having to be evasive annoyed her, but she was certain she was going to figure out a way to solve the mess she'd uncovered. She was equally certain the success of Good Works depended on it. She added, "Good Works is very important to me. I'm a single mother, so I understand--and have a personal interest in--the value of the work we do here. I'm going to make darn sure we fulfill our mission, Ms. Oakes."
Lyndelle studied her. Her face softened. "Please, call me Lyn. I apologize if I seemed harsh, but I've been very frustrated by not being able to get an answer about Good Works' finances. You see, my mother struggled for years to make ends meet after my father died. She was a wonderful woman, a true role model. I owe my success to her, and I've dedicated myself to making life easier for women like her. But my accountant says I can't donate any more to Good Works until I get those financials."
"You'll have them next week," Jill promised.
"I'd better." Lyndelle's voice tightened. "Even though I think the world of what Good Works does, there are plenty of other organizations with the same goals. They can use my help just as much."
The Problem
"I realize we have a problem," Charlene Pinero said. A tiny, energetic woman, she perched on the chair opposite Jill's desk, slender jeweled hands fluttering, one small foot tapping on the carpeted floor. "But I honestly don't believe it's as bleak as you're making it out to be, Jill. After all, we've been in a tight spot before--maybe even tighter. Why, I can remember having barely enough cash to keep going on a day-to-day basis. At least now Good Works has enough cash to support our programs for another week, until Lyndelle makes her next contribution."
"Just barely, Charly," Jill said. Despite the short time she'd been with Good Works, Jill had quickly come to realize how dedicated Charlene "Charly" Pinero was to the cause. As one of the initial three board members who had conceived the idea for the charity, Charly had spent countless hours--and much of her own money--over the years making the dream a reality. That was why she was the first one Jill had called when she'd discovered the overspending.
"We're required to meet specific guidelines in order to continue receiving those donations," Jill reminded her.
"Of course we are. I don't enjoy accounting, but I have enough not-for-profit experience to know that much." Charly wiggled her fingers, setting faux gemstones flashing under the fluorescent lighting. Rumor had it that the real jewels had been sold to fund Good Works. "We'll give Lyndelle the financial statements for the past two quarters, and then we're caught up with our obligations. You said you could have them done by next week. She'll hand over a check the same day, as long as the financials look okay." Charly leaned forward, interrupting when Jill would have spoken. "Look, I understand what you were saying about management expenses going over budget. I also know our fundraising efforts slowed down while we were looking to fill the executive director position. Put those two facts together, and we're looking at a potential shortfall."
"A definite shortfall," Jill corrected her. "In fact, if Lyndelle hadn't made her second quarter contribution despite not having financial statements, we would have already run out of money."
"Okay," Charly agreed. "A definite shortfall. So the financials don't look so hot."
"Right," Jill said. "It's a round robin. We need Lyndelle's contribution to stay in operation. But we need solid financials to get her contribution."
"So all we have to do is make the financial statements look good for the short term. And I have a simple solution." Pleased with herself, Charly smiled. "Just transfer some of the surplus in the restricted funds to cover the management and general expenses. We're not talking about actual cash here, just a journal entry between accounts--a bit of accounting sleight of hand, if you will. Then, presto, we'll get our money."
"Not a good solution, for several reasons," Jill said. "In the first place, I don't perform magic accounting tricks. Second, we're ethically required to follow the restrictions Lyndelle put on her donations. And third, as you're well aware, Good Works signed a contract when Lyndelle made her promise to give, so we're legally bound, as well. Lyndelle's contributions are restricted for use in our childcare program, meaning we're not allowed to spend her money to fund management activities or anything else."
Jill picked up the guidelines Good Works had to follow in order to receive Lyndelle's donations and handed them across the desk to Charly. "If the financial statements show we've used the funds for other activities, Lyndelle can not only stop the next donation, but she can ask for the last one back."
"I'd forgotten." Charly's face paled. Instead of looking at the papers she held, she stared at Jill. "Paying back last quarter's donation would mean the end of Good Works. There's no way we can come up with the money. But there must be a way to make the numbers work out." She thought for a moment, then brightened. "I believe you're overlooking something, Jill. If I remember correctly, we can spend Lyndelle's donations on any aspect of our childcare program. Why not allocate a larger percentage of management and general expenses to all our programs, including childcare? Those percentages are just estimates anyway. Technically, we'd be following the legal terms of the contract, and we'd still be in compliance."
Jill felt her headache coming back. "What you're suggesting is more accounting hocus pocus."
"Not really," Charly said. "It's perfectly acceptable accounting practice to revise estimates--that's why they're called estimates, after all. We're not changing the net assets, we're not misappropriating funds or anything else, and we can reverse course easily, when we choose. Who's to know?"
"The board, for one," Jill replied. "We'd have to restate the budget for the year, which would mean board approval."
"You let me take care of the board. You just work out the numbers so Lyndelle makes her next contribution. By the end of this quarter we'll be back on track."
"What if we aren't?" Jill asked.
"We will be." Charly rose from the chair. "Over 200 women count on us every day, Jill. There's no way I'll let Good Works be de-railed by something so easily fixed."
The Dilemma
Alone in her office, Jill swiveled her chair to look out the window. She was not entirely comfortable with Charly's proposal. While the expense allocations were estimates, changing them just to make the numbers work felt wrong, even though the overall picture, as Charly had pointed out, was unaffected.
But Jill was well aware that if Lyndelle chose to stop making donations, Good Works would be in dire straits. The problem would mushroom from there. Any hint of financial problems, whether real or not, could ruin the reputation--and the effectiveness-- of the charity. She'd hate to see that happen.
Considering all the women whose futures depended upon the existence of Good Works, could she risk losing Lyndelle's donations? Or should she go along with Charly's suggestion, and make a simple, temporary change in her expense allocations?
Multi-Element Revenue Recognition and Creating Reserves
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—Conservative Recognition Or Cookie Jar Reserves?
Abstract
Nick O'Brian begins work at his family's software company and quickly finds evidence of revenue recognition questions. Should he ignore them or should he recommend that the audit committee be notified? If he chooses the latter, an important upcoming product launch could be ruined.
Background
Figuratively speaking, O'Brian Software's books smelled a little funny. Nick O'Brian, newest member of the accounting department, pushed the stack of financial statements away and ran a hand through his already rumpled hair. He had a feeling the numbers he'd been analyzing wouldn't pass what his professors had called the "sniff test." Nick rubbed his eyes and wondered if he was overreacting. After all, his Aunt Amelia, the company's founder, was the most honest person he knew--though she would be the first to admit she was no accounting expert.
Nick believed the person his aunt relied on--Lee Marchetti, O'Brian Software's chief financial officer, a man with years of experience in finance and accounting--was equally honest. Judging from the documentation Nick had found in the accounting files, Lee certainly kept a tight watch over every aspect of O'Brian's finances.
In addition, from what Nick had learned in his position as junior internal auditor at O'Brian, the company's accounting controls were effective. Though family members still owned the majority of the stock, decisions regarding material aspects of the financial statements were discussed with the audit committee of the board of directors. The board itself was made up of five very respected members of the business community.
And, to top off the case for overreaction on his part, the financials had received a clean opinion from the outside auditors for each of the three years the company had been listed on the stock exchange.
But he still thought those numbers had an odor ... and might well be misleading investors. Nick was determined O'Brian Software would never find itself in the same situation as so many companies these days. He was too proud of what his aunt had created to allow a Securities and Exchange Commission investigation to happen.
He leaned back in his chair and remembered when O'Brian had been little more than a dream of Aunt Amelia's. She'd started out in her spare bedroom, providing software consulting services to local businesses. Next, she'd expanded into the development and sale of custom software systems. Then, with family members recruited as her sales force, she'd begun selling the licenses to her software. At that point she realized the company was headed for an eventual initial public offering. With typical foresight, she'd decided experienced management was needed. Lee Marchetti had come on board as CFO.
Now, five years since its inception, and three years after going public, O'Brian Software earned millions in revenues from Aunt Amelia's initial product licenses, along with fees for maintenance, support and technical training, and consulting and development services. With the next step--the release of BrainWave, an innovative, multi-dimensional software system compatible with industry standard platforms--O'Brian would surge ahead in another growth spurt. Wall Street buzz had the company poised on the forefront of the technology sector. Yes, Nick thought, O'Brian Software had definitely expanded beyond Aunt Amelia's wildest expectations. Yet in many ways the company was as family oriented as it had been when it started. Nick was living proof.
Though his aunt had officially hired him only after his college graduation two months earlier, he'd been part of the company since the day she founded it. He knew Aunt Amelia expected him to work his way up the management ladder. It was a challenge he was looking forward to.
Asking Questions
But right now there was a question he needed answered. And since Aunt Amelia was less than enthusiastic about accounting, the person to ask was O'Brian's CFO, Lee Marchetti. Nick grabbed the stack of papers, and headed out the door of his cubicle.
"Always glad to answer questions, Nick." Lee Marchetti shuffled the papers on top of his walnut desk off to one side. "But I have to say you've picked a difficult topic to start with. Software revenue recognition is complex. Throw in the mix of application development and consulting services we have at O'Brian, and we could be here for days discussing it."
"I'll try not to take up that much of your time," Nick said, with a grin. He leaned forward, his hands on his knees. "I think I understand the general idea of multiple element transactions. Basically, revenue is broken down between product and services. O'Brian recognizes revenue on the software if the sale is distinct from the service portion. Right so far?"
Lee nodded. "Right. When we enter contracts involving a combination of software and consulting services, we end up with revenue deferral. And of course, as you know, we defer revenue for other reasons, as well. We have reserves for product returns and warranties, among others."
"Which leads to my question," Nick said. "O'Brian Software has a significant amount of unearned revenue sitting on the balance sheet. It seems to me we've been overly conservative in estimating the amount of income we've been deferring."
Lee blinked, than chuckled. "Conservatism in financial reporting is generally considered a good thing, Nick. In fact, most folks are concerned about just the opposite effect--they worry companies report too much income. You're saying you think we haven't been reporting enough?"
"I'm just trying to follow the methodology we're using," Nick replied. He could tell he'd surprised Lee with his question, so he went on. "You have a lot more experience than I do, Lee, I know that. Heck, Aunt Amelia told me you've been running companies since before I was born, and I know how much she relies on you. But I'm worried. Overly conservative reporting could leave the impression we're trying to create cookie jar reserves. With all the corporate accounting problems in the news lately, the last thing we need is to face rumors of suspect accounting. Especially with BrainWave almost ready for release."
Lee's smile vanished. "You're exactly right--we definitely do not need any hint of problems. Now or at any time." He eyed Nick, his face grim. "Despite what most people believe, accounting is not an exact science. A lot of judgment is involved."
"I understand," Nick said. "There's no clear line spelling out exactly what's right and what's wrong. But don't you agree that since O'Brian is affected by the cyclical buying patterns in our industry it might seem we have incentive to smooth our earnings?"
"I can assure you the accounting practices here at O'Brian will never cast doubt on the integrity of this company's financial statements. Our deferrals and estimates are well documented, and in accordance with SEC rules." Lee stood up. "Now, if you'll excuse me, I have a meeting with our bankers."
Meeting with Aunt Amelia
"Nick, you know my specialty is software, not accounting." Though Aunt Amelia was facing him, Nick could see her fingers were still dancing across her keyboard. For as long as he could remember, she'd been an expert at doing two things at once. He'd always thought her drive was the main reason O'Brian Software was a success. She tipped her head toward the papers he held and added, "If you want to discuss a problem with your PC software, I'm your woman. But financial statements--if you have questions on those, you'll need to talk to Lee Marchetti."
"I did," Nick replied. "I'm surprised he didn't mention it to you. In fact, my talk with him is one reason I'm here."
His aunt was startled enough to stop her keystroking. "You sound serious."
"I am," Nick said. Confident he had her full attention, he settled into the chair opposite her desk and repeated the discussion he'd had with Lee.
When he was finished, she was frowning. "I'm not sure I understand why you're concerned, Nick. As I've said many times, I don't know much about accounting. But I know enough to grasp one thing--we're not underreporting expenses, or inflating our income by prematurely recognizing revenue. In fact, it sounds like O'Brian Software is doing precisely the opposite of what most companies get in trouble for."
"My point exactly." Nick tapped the statements with his forefinger. "These reports are supposed to provide useful information, Aunt Amelia. Being too conservative is simply the opposite side of being too aggressive--neither position gives an accurate picture. In fact, they may even give investors an unrealistic view of our actual financial situation." He paused. "Have you looked at the financial statements since O'Brian went public?"
She made a sound halfway between a snort and a chuckle. "Please, Nick, I'm sure you know the answer."
He smiled at her, rose, and set the statements down on her desk. "Well, take a look now." He shuffled the pages, pointed out numbers. "Our growth and revenue are fairly smooth, and always upward. It's kind of unusual in a new company, especially a new technology company, wouldn't you say?"
"I certainly know the software business has ups and downs," Aunt Amelia said. "All businesses do. But I still don't quite see the problem. After all, we're meeting our earnings projections, aren't we? We're keeping our analysts happy, aren't we?"
"Consistently," Nick agreed. "But I'm not sure we're doing it based on economic performance. In effect, what's happening is we're understating profits when times are good, and building artificial reserves we can use in lean times."
The Dilemma
"You're saying we're playing games with the numbers. That is a serious charge, Nick." Aunt Amelia looked up and studied him. "I have complete confidence in Lee. But if we're doing something improper, I want to get to the bottom of it. Is this a problem I should take to the auditing committee?"
Nick had been sure of himself until she asked. Now he hesitated. He was convinced O'Brian Software's financial statements were not presenting an accurate picture to investors. But, as Lee Marchetti had pointed out, accounting revenue recognition rules were subject to judgment. And, in applying that judgment, management could make decisions easily proven wrong by subsequent events. Of course, clarity of hindsight didn't necessarily mean the decisions were improper.
What if he was wrong? If O'Brian disclosed a change in accounting for revenue recognition at this critical stage, the launch of BrainWave could be seriously compromised, causing big problems for O'Brian's future.
Nick stared at his aunt, pondering his answer. Was he making a big deal out of a legitimate practice? Or should he stick to his belief that O'Brian Software was smoothing income?
Revenue Recognition—Multi Elements
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—Accounting & Ethical Issues at Walax
Abstract
Kate McMasters recently began her corporate accounting career at Walax, a large international corporation that may be on the verge of a possible Securities and Exchange Commission inquiry into accounting irregularities. Determine your own position on how Kate should handle her responsibilities concerning the firm's practices and policies and then see how experts in the field would react to these same circumstances.
Background
Kate McMasters joined the accounting staff at Walax after having worked for several years at a small CPA firm. She was drawn to the corporate side of the profession because of the growth potential, including stock options, and the opportunity to work for a multinational business. She was taking classes in a part-time MBA program. Her short- and long-term goals included learning as much as she could about accounting at a large international company and developing the skills to one day become a chief financial officer at a midsize or large business. Shortly after joining Walax she realized that accounting in today's economic climate could involve issues much more than complex accounting principles.
Walax, a mid-Western company, manufactured, sold and leased a wide range of information-based technology products, including hardware, services, software and supplies, in the Unites States and throughout the world. Due to intense competition at home and abroad, the company had recently fallen on hard times, as evidenced by the significant drop in its stock price since its peak in 2000. Many members of the accounting and finance staffs wondered if the company's problems were behind them.
Kate had been involved in several projects since joining the company. She had a good working relationship with her boss, chief financial officer Edward Norton, who this morning asked Kate to stop by his office to discuss a new assignment.
"Come in, Kate." Ed smiled, gesturing toward the coffee machine. "I've been reviewing our needs at the end of this quarter and I would like you to work on a series of new lease valuation adjustments. They are based on our return on assets approach, which has been in effect since 1997. You will have to use the corporate data for input variables that I have supplied in this folder. I don't think you will have any problems, but if you do, talk with me or Beth, who has done these in the past. We are up against a deadline, so please talk to one of us if you have any concerns or questions."
Over the last decade, these types of transactions had represented the majority of the company's revenues, and Kate's initial reaction was to follow Ed's instructions and make the changes. After examining the details, though, Kate decided to talk to Beth Samuels of finance for some additional information.
The Problem
In Beth's office, Kate pulled out a pencil and notepad. "Hi, Beth. Ed has asked me to work on lease valuations and suggested I talk with you if I have any questions."
Looking across the desk, Kate wondered if Beth's wrinkled brow spelled trouble. "Yes, I've worked on lease valuations several times," Beth said. "Walax has adopted a total-cost-of-ownership approach to leases, with the bundled price for equipment, service, supplies and financing sometimes revalued according to corporate dictates. These changes are often made late in the quarter, and in the past seemed to accelerate the equipment portion of the total from previous estimates. It seems that every quarter the percentage of the equipment portion of new leases increases, thereby accelerating the revenue and profit for the current period."
As Beth continued, her gestures grew wilder and her voice began to crack a little. "Initially these amounts were small, often affecting earnings by only a cent or two per share. Gradually they increased. The pressure to meet Wall Street expectations seemed to coincide with the original switch to the ROA approach."
"You seem a little troubled. Is something else bothering you?" Kate asked.
"These changes originally seemed reasonable, but the switch to the new methodology was not disclosed in company filings. I thought that since the amounts in aggregate were significant, some disclosure would have been required. Let's face it, if someone looks at the annuals and sees higher revenues and earnings, that would appear to indicate an increase in sales volume, or at least prices. Under this ROA approach, that may not be the case."
Kate wondered if this practice was widespread throughout the company and how operating personnel felt about it, so she contacted Jim Stanton of U.S. operations. "Jim, this is Kate McMasters of accounting and finance. I'm relatively new at Walax and I was hoping I might ask you some questions about the lease valuation process."
"What is it you wanted to know?" Jim shouted at his speakerphone.
"What is your opinion of the valuation adjustments?"
Jim eagerly expressed his opinion "I don't like the ROA approach. However, we still use the older approach at our level. The ROA adjustments are made by corporate at consolidation."
"What is it you don't like?"
"They don't reflect operations at the local level. I've heard that in some cases, particularly abroad, there is no attempt to really value the financing portion relative to the individual country risk. As a result, the allocations for financing are often smaller, with the equipment side allocated a top side share of the agreement."
Jim had another call coming in so he put Kate on hold. The words "top side share" began to resonate in Kate's head.
Jim returned to the line. "This issue actually came to a head several months ago when Brian Elkins of accounting was fired because of "top siding" and other accounting issues. Brian complained that changes in equipment values that resulted from finance costs and residual adjustments were violations of generally accepted accounting principles and unfair as a performance barometer. The previous controller, Bill Watkins, disagreed. Brian was ultimately dismissed and Bill was transferred out of accounting into the finance or treasurer's department. The auditors were concerned about some of these adjustments and may have called for Bill's transfer. I believe that Brian got a raw deal since company policy had been not to punish employees in such a situation. The company fired our previous auditors due to accounting disagreements and their unwillingness to sign off on the financial report, so the new auditors are taking extra care to avoid these kinds of problems. Consequently, as you know, there has been a delay in the filing of last year's financial statements."
Seth Armstrong, the new controller, called and asked Kate to work on specific disclosures for the upcoming filing.
"What kind of help do you need for the upcoming disclosures?" Kate wondered why Seth was delegating the responsibility to her. Didn't he know about the issues Brian had with changes in equipment values?
"I want you to take these facts and draft footnotes for the upcoming annual report. If you have any language issues, get back to me." When Kate opened the folder Seth sent her she learned that accounting problems at a European subsidiary discovered last year led to the termination of several managers. At the same time, a re-evaluation of lease transactions from Latin American operations disclosed that leases originally accounted for as sales-type leases should have been recorded as operating leases. Kate learned that in some regions, such as South America, negotiated price increases and lease extensions were recorded as additional income rather than deferred as required under GAAP.
Kate decided to call on CFO Norton.
"I've been working through the lease valuation process and I need you to explain the approach now used by the company," she said.
"The ROA approach, while unique, allocates the lease payments among the equipment price, financing and service elements of the lease agreements," Ed told her. "The company began using this method in 1997 and was satisfied that it represented the underlying value of each component."
"But what about the increasing portion of equipment value-the top siding--and the lack of economic justification for some of these inputs?"
"The accelerating revenues from this approach are acceptable given the economic circumstances," Edward told her.
Kate wondered about the specifics of these "economic circumstances."
"Have any attempts been made to substantiate some of these values?" she asked.
"The lower discount rates now used represent declining capital costs. They are within a reasonable range given the circumstances. We make no attempt to judge each local market but instead use one corporate rate. This lower consolidated rate is easier to apply and provides some consistency among our operating units. The company's position is that a reasonable return on investment is appropriate for bundled lease transactions, and that resulting equipment values are appropriate given the variables used for the service and finance components."
"Shouldn't the change to ROA have been disclosed?" Kate countered.
"That was a change in how we applied or allocated components of the lease. It was a methodology based on estimates that did not necessitate a full blown disclosure."
"What about recording revenue immediately from negotiated price increases and lease extensions?" Kate asked.
"We are still working on that issue with the auditors. Don't concern yourself with that, since we may make an adjustment for it." That was all the information Ed volunteered.
The Memo
In Kate's research she came across references to a memo about the initial use of ROA and another approach to help close the "earnings gap." She learned from Beth that the term referred to the difference between operating results and the results expected by Wall Street analysts. This troubled Kate the most, since she knew the Securities and Exchange Commission was investigating companies whose use of accounting principles might be linked to meeting analysts' expectations or earnings targets. She feared that the memo, if discovered, might turn out to be a smoking gun. In Kate's mind, the use of the ROA methodology allowed the company to accelerate lease revenues despite the lack of any apparent increase in units sold or changes in economic conditions to justify the change in assumptions.
In her review of accounting transactions, Kate also discovered proposed adjustments for reversing charges in 2000 and 2001 for activities related to exiting certain businesses. A review of those charges determined that certain adjustments made to the original charges were not in accordance with GAAP. The changes involved reversing the applicable reserves in 2000 rather than in 2001. Kate also discovered the department tracked a composite reserve account consisting of overaccruals from vacation pay policy changes, original Financial Accounting Standards Board Statement No. 106 reserves, and other current asset items. Those reserves were systematically allocated to income over the last few years in a way that was consistent with some of her suspicions about earnings management.
Kate's research revealed several lawsuits initiated by shareholders. The company and a number of individual officers were defendants in a class action shareholder lawsuit that alleged deceptions involving economic capabilities, sales proficiencies and overall company common stock growth prospects. The suit also claimed that insiders were allowed to sell shares based on insider information. While the defendants denied any wrongdoing, Kate worried that she might be dragged into the fray over the pattern of irregularities she was uncovering.
Litigation was also pending against company directors for alleged breach of their fiduciary duties to the company and its shareholders by, among other things, ignoring indications of a lack of company oversight and the existence of flawed accounting practices. Seth told Kate that the company denied any wrongdoing in these cases, but that caused her to consider her role in corporate activities even more.
Kate again went to Ed Norton about these and other matters at a luncheon meeting.
"Edward, I recently came across an internal memo showing that company employees were encouraged to consider projects and accounting methods that accelerated revenues."
"Kate, that memo involved broad suggestions and topics. Employees were never encouraged to violate GAAP but merely to think outside the box when it came to developing business projects and the accounting for them. The memo was a vehicle for brainstorming purposes and not one that recommended any specific action."
Kate was not convinced by his explanation but understood he was probably complying with an overall company response to the issues. It was clear that the leases largely responsible for the majority of the company's accelerated revenue were transactions that would result in future cash flow and income to the company. Thus, unlike the companies involved in some of the other accounting scandals now finding their way into the media, Walax's business was sound and its accounting transactions reflected business activities. At issue was the timing of these revenues and the earnings trends that resulted from the accounting approaches chosen. Consequently, Kate was concerned about the level of attention shown by the accounting staff to these items. Furthermore, given the information in the memo, Kate felt the accounting staff's attention to detail was less than what she expected to find in a high-powered corporate environment with the resources to devote to such matters.
Kate's knowledge of auditing left her concerned about the company's board of directors and audit committee. She had discovered that one-third of the company's directors were insiders and the audit committee only met three times in the previous year to discuss critical accounting issues. She believed that management may have pushed for aggressive accounting in order to maintain the company's reputation and enhance its stock value, and that board composition and audit committee expertise did little to serve the shareholders.
While Kate knew that shareholders were angry about the huge losses they had realized during the last 18 months and might be looking for scapegoats, she was more than a bit concerned about Brian Elkins' departure. She wondered what that situation said about the company and its adherence to corporate policy and ethical standards.
Expense Transaction Problems for an International Company
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—Rising Sun Construction Company
Abstract
Rising Sun Construction is a California company that is anxious to expand its business by entering the Japanese market. Opportunities for overseas companies are tightly limited in Japan, however. When Jerry Blank, the company's business development officer, begins a successful networking effort in Japan, questions are raised about whether his efforts are ethically—and legally—sound.
Background
Arthur Ono, chief operating officer, had dedicated his working years to Rising Sun Construction, a family-owned California corporation established by his father, Dale Ono, 45 years ago that specializes in heating and air conditioning. He is anticipating that in five years he will replace his father as the chief executive officer, and Jerry Blank, Vice President for Business Development, will be COO. Sitting in his office on the top of the 15-story building, Arthur was browsing through the reports on the top of his desk. He lifted his eyes and saw Jerry Blank entering his office.
"My travel plans to Japan have been finalized," Jerry said. "I will be leaving this evening for Tokyo."
Arthur looked hopeful. "I wish you success. You seem thrilled to revisit Japan. Keep in mind our need to capture a contract in Japan."
"Securing a contract is my goal."
Both shook hands, and Jerry hurriedly left the office to talk with his executive secretary before his departure to Japan.
Jerry Blank was a mechanical engineer who joined Rising Sun on graduation from a state university. During his years at Rising Sun he established a good professional and personal relationship with Arthur. He had, however, ultimately left Rising Sun to pursue a PhD in mechanical engineering. After completing his PhD, Jerry went to work for a multinational construction company headquartered in Chicago, with construction contracts in Indonesia, Thailand and the Philippines. During his years in graduate school and afterwards, he remained in touch with Arthur, and on a few occasions they met for dinner.
On a cold February day Jerry received a telephone call from Arthur offering him the newly created position of Vice President for Business Development. Jerry ultimately accepted the position. The warm weather of central California was one attraction, but the deciding factor was the chance to earn a bonus based on contracts received.
Arthur had an impressive understanding of the construction business and had assumed many business leadership positions nationally and in California. He had dedicated most of his time to developing opportunities for obtaining contracts. With Jerry's background in business development, he thought Jerry was the right person to succeed him as the business development officer. The accounting and finance area was under Kenneth Gaylord, Vice President of Finance. Arthur did not really enjoy looking at financial and accounting reports. Consequently, he relied heavily on the competence and integrity of Kenneth, a CPA. The financial reporting system used by the company had not been changed since the company was created.
Rising Sun was facing a decline in the dollar value of contracts received in the early 1990s. Arthur had been concerned about the effect of any restructuring on his talented and dedicated staff. Across the Pacific, the central, prefectural and local governments in Japan had been expanding their construction of public projects to assist in that country's economic recovery.
Arthur had discussed construction opportunities in Japan with Jerry, along with the organizational arrangements that must be established to handle business in Japan. Jerry thought that returning to Japan would be exciting. In college, he spent a year at a Japanese university in Tokyo as an exchange student.
The Construction Business in Japan and U.S. Construction Firms
Many public construction projects in Japan use limited general competitive bidding, which means only selected qualified bidders are allowed to bid. To be a qualified bidder, one has to have experience in construction in Japan. It is not unusual for contractors who have been invited to bid to participate in dango, literally meaning allowing one contractor to win (called bid-rigging by some). It is not unusual for the winning bid to be close to the cost estimates.
The U.S. government had pressured the Japanese government during the U.S.-Japan Structural Impediment Talks to make it possible for U.S. construction companies to participate in construction projects in Japan. A subsidiary of a U.S. company in Japan lacked the construction experience needed to bid for a contract. As a result of U.S. pressure, the required experience in construction would now be evaluated not only on the experience of the subsidiary but also on the experience of its parent company in the U.S.
The U. S. Commerce Department had been organizing trade missions to Japan to meet government officials and business leaders to establish personal contacts and to acquaint members of the mission with business opportunities. Arthur selected Jerry to join the latest mission to Japan. The Commerce Department briefed mission members on Japanese business and society and on trade conflicts. Jerry also got a list of readings. Jerry attended all the briefings. He asked his executive secretary to order a number of books on Japan and a subscription to the Nikkei Weekly for corporate use.
The mission members stayed four days in Tokyo, and three days each in Nagoya and Osaka. In all three major cities, the delegation met with government officials and discussed a long list of construction projects. Official receptions offered opportunities to establish contacts with government and business leaders.
The most enjoyable occasion was when Jerry met Masatoshi Kanemaru on his first day in Nagoya. Kanemaru, 54, was the section head of the planning office of Aichi ken (Aichi Prefecture). Jerry and Kanemaru were both sumo fans. They were able to obtain tickets through close associates to watch the Nagoya sumo tournament.
Jerry was impressed with Kanemaru's knowledge of construction in Aichi ken, which confirmed the good reputation of civil servants. Jerry, who knew that civil servants had a great deal of influence on decision making by government units, was determined to establish a lasting friendship with Kanemaru and invited him to a lavish dinner.
Kanemaru thought of himself as technically superior to many of his contemporary section heads who had accepted positions with private enterprises that did business with the prefecture. Traditionally, civil servants who retired, usually around the age of 50-55, obtained a position with a company operating in an industry supervised by the civil servant's agency. This was called amakudari or "descent from heaven."
When Jerry returned to California he pronounced his trip a success and promised Arthur a written report in few days. Jerry organized the bills he had accumulated and sent them to Sidney Clapp, the chief accountant, with instructions to include them in miscellaneous expenses. Sidney meticulously examined the bills received and immediately included them in the miscellaneous expenses account, since no account number existed for bills written in Kanji (the Chinese characters used in written Japanese).
Expansion Potential
In a meeting the top officers---Arthur, Jerry and Kenneth--discussed the potential for expanding their business to Japan.
"We need Jerry, with his impressive background in Japan, to aggressively pursue contracts there," Arthur said. "I have assigned Jerry to plan for a new venture in Japan. I have decided to send Jerry back to Japan soon to pursue the possibility of being allowed to bid for contracts."
Kenneth seemed serious as he responded, "Operating in Japan would require the creation of appropriate financial reports and a management control system. We would also need to examine the applicability of the Foreign Corrupt Practices Act (FCPA). Maybe it is the time to draft a code of professional conduct for the company."
Although Arthur thought he might be hesitant to support Kenneth's proposals on a financial reporting and a management control system, he said, "I would like Kenneth to prepare a report on FCPA for the top officers." He dusted off a folder he pulled from his cabinet and began to read the three sentences his father had written as the code of professional conduct for the company he created: "We strive to maintain our good reputation; we abide by all the laws of the U.S.; and we refrain from any activity that might involve a conflict of interest."
Approximately three months later, Jerry returned to Nagoya for five days. Kanemaru picked him up at the airport. At his hotel, before he left the car, Jerry pulled out a small bag from his brief case and left it on the seat he occupied. Jerry's days in Nagoya were busy but enjoyable. At lunch, Kanemaru briefed him on the few contracts that the prefecture would allow American firms to bid on, mainly due to political pressure. Jerry handed Kanemaru his gift. Kanemaru, following the American tradition of opening gifts when they are received, asked for permission to open it. The box contained a pair of hand blown crystal vases with cherry blossoms imposed on them. In the next few days, while dining and watching a sumo tournament, they talked in greater detail about the contracts.
On his departure, Jerry felt that given the trade negotiations between the U.S. and Japan and the support of Kanemaru, there was a great probability that Rising Sun would be among the American firms invited to bid for construction projects.
Jerry once again sent all his bills to Sidney. However, a few days later Jerry received a call from Kenneth. "Jerry, I have concerns regarding the increased size of the miscellaneous expense since you began your trips to Japan," Kenneth said.
"My expenses in Japan were legitimate development expenses for a privately held company," Jerry insisted.
References and Sources for Information:
Amaha, Eriko, Building Hope. Far Eastern Economic Review, v. 162, Apr. 15, 1999,
pp. 83-84.
Donaldson, Thomas and Thomas W. Dunfee, Ties That Bind. Boston, Massachusetts: Harvard Business School Press, 1999.
Geva, Aviva, Moral Decision Making In Business: A Phase-Model. Business Ethics Quarterly. Oct. 2000, v. 10, no. 4, pp. 773-803.
Martin, Keith and Sheila Malkani Walsh, Beware the Foreign Corrupt Practices Act. International Commercial Litigation, no. 13, Oct. 1996, pp. 25-27.
Merchant, Kenneth A., Modern Management Control Systems. New Jersey: Prentice-Hall, 1998.
Revenue Recognition—Loans, Guarantees for Personal Asset Acquisitions
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—Accounting & Ethical Problems at Sigma Industries
Abstract
Sigma Industries recently suffered a series of telling blows to its corporate empire including the resignation from the company and likely prosecution of founding family members. Lenders to the company are suffering from defaults on loans to the firm, and investors have seen the value of their holdings almost disappear. Follow the work of Jerry Kramer as he tries to unravel some of the causes for this breakdown, and how company policies allowed many of these transgressions to occur.
Background
With a strong background in accounting and finance as well as audit experience in public accounting, Jerry Kramer has high hopes of becoming a financial VP in the computer networking industry. He believes that networking firms will benefit from increased business spending as the country comes out of the recent recession and once again looks for increased productivity. Despite the recent slowdown in technology he reasons that more and more firms will be willing to spend heavily on bigger, more sophisticated wireless based systems as they seek new efficiencies in order to more successfully compete in their respective industries. Thus, he believes that his recent switch in employment to Sigma Industries will give him the opportunity to break into the management side of the business. He hopes that his current position as assistant controller will give him the opportunity to learn more about the overall scope of the business as he prepares for advanced responsibilities. Little did he know that working at Sigma would soon begin to resemble the former television soap opera Dallas, in which family members had greater concern for their own well-being than for that of others.
Sigma Industries is a networking computer and services firm with customers throughout the world that has grown in recent years through a series of acquisitions. Founded by George Collins in 1985, it continues its expansion into all areas of the industry including wireless networking and systems development consulting. The company's nine board of directors until recently included five of its founder's family with day to day operations also heavily managed by several family members. These members in addition to George Collins include his daughter and two sons: Diane Collins, the company's CFO, Michael Collins, the firm's executive president for operations, and Tom Collins, the firm's executive vice president for strategic planning. The company's vice president of finance and its assistant treasurer are also close associates of the Collins family. Recent events have uncovered business relationships with even more family members.
Jerry has been assisting the controller in providing the special independent committee of the board with new and sensitive information. His responsibilities have increased as the company seeks to provide this data so that new auditors can complete their work and sign off on the annual financial report. Dave Leno, the controller, is counting on Jerry and a few others to help restore the integrity of the company and to help get to the heart of certain items in question.
The Discussion
Sitting down to lunch after a morning round of golf, Jerry begins "Dave, my initial findings indicate we have a serious problem with some transactions, and the widespread use of company funds by some of our directors. Foremost among these are the large loans to founding family members guaranteed by the company. In one instance the use of those funds by family members to buy back corporate shares was unknown to the company's board. Other transactions include company guarantees for board members' personal asset acquisitions.
Dave frowns, "Those are serious accusations."
Jerry pauses to order a roast beef on rye and then continues quietly. "There are more. Other transactions also involved transfers of funds to partnerships that were partially owned by family members. This related party involvement was unknown by some board members at the time, and was not completely disclosed in company filings. Furthermore, activities between the firm and these partnerships helped conceal substantial corporate debt and sham transactions masking substantial risk to our lenders and stockholders."
Dave leans forward in his chair. "It is imperative we have all necessary backup for those transactions, and knowledge of exactly where funds went and for what purpose. I'm sure that "legal" will need a detailed accounting for all of those transactions."
As a result of these types of transactions and others related to internal control, legal and ethical business dealings, and improper accounting, Jerry and other members of the finance team have spent several weeks trying to better understand the complexities of certain transactions and entities, and how the company can comply with generally accepted accounting principles including their required disclosures. The entire governing structure of the company is now an issue and great care must be exercised if the company is to move forward.
As Jerry gathers information for the committee, he learns that several interest payments required by debt agreements have not been met. These defaults and other disclosures already released by the company have shaken the confidence of its lenders. As a result of this, the company is preparing for a Chapter 11 filing in order to keep it operating, and to provide time to satisfy all creditors.
Though Jerry is discouraged by these new revelations and the possibility of other discoveries of accounting improprieties, based on recent acquisitions he is not completely surprised at the debt default since the company has substantial debt. He believes it is the goal of satisfying analysts that has driven the corporate behavior that goes beyond some of the obvious personal benefits to officers.
Because the company's stock price has dropped over 90% during the past year there is seldom a day that portfolio managers, brokers, and the news media have not inquired about the firm's financial condition and steps the company is taking to meet its obligations. Unlike some other accounting scandals based primarily on fraudulent financial reporting, Sigma's problems seem multi-faceted including, but not limited to, deceptive accounting, conflicts of interest between the board and owners, and a lack of oversight by management and the board. During discussions with Tim Blake of finance, Jerry begins to wonder how some of these events were not discovered earlier and how those perpetuating these activities expected not to be caught.
With recent events pointing further to an SEC inquiry, Jerry is gathering his findings for an upcoming meeting with Tim. Unfortunately, he is realizing that great effort went into the design of these deceptive activities and the term "forensic accounting" is more appropriate for his current job. Nevertheless, Jerry is pleased that his background enables him to seek out the back- up and underlying information to answer the questions now being posed.
"Tim, I have been trying to locate some of the legal documentation for loan guarantees to the Collins family. Do you have any of those papers?"
Tim grimaces, "Yes I do. I think the extent of those additional guarantees will surprise you. By my calculations there are about $900 million of co-borrowings by entities affiliated with the Collins family as of March 31, 2002 for which Sigma is jointly and severally liable. That amount is substantially higher than the previously reported amount since it now includes an additional $305 million of co-borrowing by entities affiliated with the Collins family for which Sigma is jointly and severally liable."
At this point Jerry is not surprised. "I just discovered that beginning at least as early as the year 2000, Sigma entered into agreements with our two main manufacturers of Ethernet switches to raise the price paid by the company by $15, and to separately receive the same amount from the vendors as marketing support in exchange for such payments. The company provided no such support for those payments. The payments for the switches were treated as capital expenses while the marketing support payments to the company were treated as a reduction of operating expenses. The proper accounting for that arrangement would reduce profit by approximately $12 million in 2001 and $9 million in 2000."
Tim is astounded. "What prompted the vendors to do this?"
Jerry replies, "Promises of increased future business appear to be the answer to that question. If that weren't enough, some customers for which we provided services on their networks paid the company with financial instruments whose value has been impaired. The previous quarterly statement included those payments as revenues. As a result of those impairments revenues should be reduced by an amount of $13 million for 2001 and $7 million for 2000."
Tim decides to question further even though he looks apprehensive. "How could these agreements have been approved?"
Jerry confidently asserts, "It seems pretty clear that a concerted effort was made to manage earnings via sham or overvalued transactions." Jerry looked at Tim attempting to read his reaction to the troubling revelations and then adds, "Also, in previous periods we capitalized certain labor expenses involving repair and service center arrangements. Those amounts should have been expensed rather than capitalized which would have resulted in a reduction to reported profit for both 2000 and 2001 of approximately $4 million."
Tim, now more somber, scrutinizes Jerry carefully as he says, "My research shows that transactions between the company and various Collins entities and other parties, had the effect of increasing the company's profits. Those transactions included management fee charges to the company by Collins entities and expenses transferred to a joint venture controlled by the Collins family. Because those amounts cannot be substantiated we should not include the fee income for both 2001 and 2000, which would result in a reduction to profit of approximately $7 million and $6 million, respectively."
Jerry calmly responds, "There seems to be a trend here."
Tim seems more relaxed as he continues. "As soon as we finish our determination of the dollar amounts in question, we will have to review all of these transactions from a control standpoint."
Jerry had done his homework. "In previous years the company recognized revenue ratably over expected periods of service including the free service period offered during the initial months of new or enhanced service arrangements. We are now going to postpone this revenue recognition until customer payments begin. This change will reduce revenue by approximately $3 million in 2001 and $4 million for 2000."
Visually disturbed by the proposed restatement Tim seemed almost ineffectual when he spoke. "We will also have to reflect that Sigma, through the Collins family, committed $300,000 of company funds for a partnership interest in a resort club. This expenditure appears to be primarily for the family's personal use rather than business purposes."
Jerry and Tim, as well as Dave Leno, will be meeting shortly to discuss the above findings and how they expect the committee and board members to react to those developments. They have already agreed among themselves that the cash management system and related controls were abused by Collins family members and that new and stronger controls are imperative. They also believe a stronger more independent board with an active audit committee would have helped to uncover many of the problems earlier. The three are distressed by the previous auditors' accusations that Sigma employees withheld important information from them, as well as Sigma's audit committee. The committee contends the auditors should have discovered some of those items and brought them to their attention. While it will take even more time to unravel all elements of Sigma's problems, there is little doubt that many factors contributed to the downfall of the company. The three co-workers wonder if the company can be saved in view of future litigation likely to result from all of these activities.
Making Detection of Embezzlement Difficult by Misappropriating Financial Records
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—Manager Persuades Employees to Unknowingly Allow Embezzlement
Abstract
Businesses today rely heavily on computers to cut costs, increase transaction speed, create competitive advantages and store vital information. This embrace of computer technology often means moving to large systems and networks. Although these systems and networks come with built-in controls, such as segregation of duties, they can never replace honest management. In this case, a manager under financial pressure used his influence over his employees to bypass the system controls. He was able to embezzle money until one employee courageously stood up to his questionable procedures.
Background
Duarf, Inc. owned several media businesses, such as newspapers, radio stations and magazines. It operated in many of the largest markets in the United States and Canada. The company had grown primarily through acquisitions over the past ten years and still used several of the acquired business systems.
Last year, the company decided to centralize all of its accounts payable processing, such as purchase orders, vendor maintenance, invoice processing and check printing. To accomplish this centralization plan, the company purchased the latest technology. Following the purchase, training sessions were held to ensure all processors and management could use all of the system's functions.
This technology included a robust database software package. The software provided internal controls, including matching invoices to purchase orders and receiving reports, signature dollar limits, segregation of processing duties and a controlled vendor list. All of the internal controls associated with the software were adequately designed. They were tested and found to be functioning properly within the system.
Before the centralization, Duarf, Inc. had eight separate accounts payable departments throughout the subsidiaries that processed approximately 7,000 transactions per month. At month-end, each department had to submit a consolidation package to corporate accounting. After the centralization, the accounts payable department was processing approximately the same number of transactions but was staffed with fewer full-time employees. Also, the consolidation process had been reduced to one package each month instead of eight. Duarf, Inc. had realized the planned cost savings and management was delighted with the results.
The Problem
Sandy Blanquet was a senior manager supervising the accounts payable process at Duarf, Inc. Sandy started at Cloudy News, a mid-size newspaper, about ten years ago. When Duarf, Inc. acquired Cloudy News two years ago, Sandy was the accounting controller. As a result of the acquisition, Sandy was offered the opportunity to take part in centralizing the accounts payable processing for all of Duarf, Inc.'s subsidiaries. After the centralization process was completed, Sandy took on the responsibility of overseeing the entire department, from opening mail to processing payables to cutting checks. He managed 20 employees through four supervisors. In addition to managing the department, he was a check signer.
Sandy's system access only allowed him to view accounts payable data. He could not process any transactions, edit the vendor list or print checks. However, he did review all voucher packages requiring a second signature. All checks had a facsimile signature printed by the computer system's check printers. Checks over $5,000 required a second signature (in other words, Sandy's signature). Checks over $50,000 required a third signature (i.e., vice president or above).
Financial Pressure
Sandy had always enjoyed the high life. He drove a new sports car. He lived in an upscale home. He took great vacations. Some might have said he lived just barely within his means. Having just returned from an extended vacation to Hawaii with his credit cards closing in on their limits, Sandy found that the advertising market had taken a turn for the worse. A couple of months later Sandy was in trouble because most of his savings were invested in Duarf, Inc. stock. He was overdue on his car payment and his mortgage. "If I can just get some money, a loan or something, for a couple of months, I could get ahead," he thought, sitting at his desk on the fourth floor at Duarf, Inc.'s headquarters. He rubbed his eyes. "Think," he murmured, knocking the side of his head with his knuckles. Then it dawned on him. "Ah. Maybe I can borrow some money from Duarf. A check. No one will miss it and I will repay it as soon as I can." He turned to his computer screen and started to form a plan.
Employee 1
Jack Cross started at Duarf, Inc. three years ago as a corporate accounts payable associate. His primary responsibility was to process invoices paid by the corporate headquarters. His work ethic and knowledge of the process were valuable assets to Sandy during the centralization process. After the centralization was completed, Jack was promoted to senior associate responsible for maintaining the approved vendor list.
"Hey Jack, this 'Designing Pluz' invoice was just overnighted to me with a rush on it from some vice president at our Los Angeles printing site. Is this an approved vendor?" asked Sandy, sounding a little irritated. Jack looked up, slightly startled to see Sandy enter his cubicle.
"No, I don't see them in here," Jack said, fumbling with the keyboard. "Do you want me to add them to the vendor list?"
"Yeah, could you do that right now? I am going to walk this over to Mabali for processing. Don't bother with the verification form, it will take too much time," Sandy added somewhat curtly, knowing that if Jack completed the verification form, he would call the telephone number on the invoice to verify the vendor's information. Jack quickly added the vendor to the list.
Employee 2
Mabali Smith recently returned from her honeymoon. She had spent three weeks in India, touring and visiting relatives. Mabali started with Duarf, Inc. at the time of the centralization and was an accounts payable associate with invoice processing responsibilities. Chris Topper, a senior associate, reviewed her vouchers for posting.
"Mabali, I have a rush invoice here from the L.A. printing site. Are you busy?" Sandy asked as he approached Mabali's desk. Mabali, who was talking to her husband on the telephone, quickly hung up.
"Oh, hi, Sandy. Uh, no, I'm not busy. Who's it from?" sputtered Mabali, obviously surprised by Sandy's presence.
"It's from some V.P. over there. He thinks he can just send me an invoice and expect it to be processed immediately. Here is his signature." Sandy pointed to the invoice. "Are you sure you are not too busy?"
"Oh no. I'm not too familiar with this signature. Should I look him up in the authorization limits file to make sure he can approve this invoice?" asked Mabali.
"Don't worry about it. If he's a V.P., he's authorized up to $50,000," counseled Sandy. Mabali entered the invoice into the system.
"I can put this in Chris's in-box and let him know it's a rush job."
Mabali suggested.
"Actually, I'm going to have Juan post it. I have to talk with him anyway." Sandy took the invoice and walked towards Juan's cubicle, knowing that Juan had authority to override the purchase order matching process.
Employee 3
Juan Namkaps started with Cloudy News five years ago, and had known Sandy for most of those years. When Cloudy News was acquired by Duarf, Inc., Juan was offered a supervisor position in the accounts payable department. His primary responsibilities were to review all of the purchase order matching exceptions and to supervise five associates.
"Juan, what going on?" Sandy announced as he approached Juan's cubicle. Sandy sat down across from Juan.
"Hey, Sandy. What's up?" Juan said.
"Some V.P. at the L.A. printing site overnighted me an invoice and demanded that I run it through ASAP," Sandy explained while tossing the invoice across Juan's desk. Juan picked it up. "Can you post it?" Juan attempted to post the invoice, but it did not match any purchase orders in the system.
"No P.O., Sandy." Juan looked up and saw Sandy's face starting to get red.
"What? You have got to be kidding me! He overnights me an invoice and there's no P.O. in the system," Sandy blurted, looking past Juan at the computer screen. "Well, just override it and I'll have a chat with our L.A. friend." Juan overrode the matching exception and posted the invoice for payment. Sandy grabbed the invoice and stomped back to his office.
Employee 4
Darlene Beau was primarily responsible for printing the afternoon check run. She was hired only three months ago but had experience with the system Duarf, Inc. used to process payments. Knowing the check for this Designing Pluz invoice would require his signature, Sandy telephoned Darlene. Sandy explained to her that there would be a special check in the afternoon run and, since it would require his signature, he would save her time by reviewing the voucher package himself. She willingly accepted and even thanked him for his thoughtfulness.
Getting the Check Out the Door
The check was printed, signed and mailed following the normal operating procedures. However, it was mailed to a post office box owned by Sandy and he deposited the $32,450 into his new business account-"Designing Pluz."
Repeating the Job
Although the money did help alleviate Sandy's financial pressures, he found himself wanting to try it again. He realized that with the fake Designing Pluz account already on the approved vendor list, he could easily push another invoice through the process. Less than two weeks after the first phony invoice was paid, he attempted it again.
Sandy created another Designing Pluz invoice for $12,945. He was careful to keep the amount low enough that both checks combined would not stand out on the L.A. printing site's monthly budget for actual analysis. He decided to use different accounts payable associates to process the payment but to tell the same story.
Employee 5
Rachel Nicki had been with Duarf, Inc. for two years. She was an associate whose primary responsibility was processing supply invoices, such as paper, ink and press materials. Most people did not know that she was married to one of Duarf, Inc.'s senior internal auditors because she did not take his last name. Her husband had been working on implementing a fraud hotline for the company and spoke to her often about it.
"Rachel, I have a rush invoice here from the L.A. printing site. Are you busy?"
"No, not too busy. Hold on, just a second," Rachel said. Sandy had interrupted her in the middle of processing an invoice. She finished up with what she was doing and asked, "Why the rush?"
"Some V.P. over there wants it processed ASAP. Here is his signature." Sandy pointed to the invoice as he handed it to her. Rachel studied the invoice and the signature. She began to open the authorization limits file on her computer, but Sandy stopped her. "Rachel, I really don't have time for that now. He's a V.P."
"I'm sorry Sandy. I have to check him out to see if he's authorized to approve invoices," Rachel explained, looking curiously at Sandy. She found the file and began to scan it for the name. She looked back at the signature and asked, "Is this Sandman or Zachvan?"
"Look, I appreciate your insisting on processing this by the book, but I really need this processed now. Take my word for it, he's authorized." Sandy said.
Somewhat shocked by what Sandy had said, Rachel began, "When I process something, my initials are input into the data record and I don't put my name on anything unless it's by the book." However, Sandy snatched the invoice and walked away before she could finish.
Two hours later, Rachel was still puzzled by Sandy's behavior. She had a funny feeling about that invoice and decided to call the company's fraud hotline. The operator was pleasant and let her know she could remain anonymous. The operator inquired about the situation, then thanked her for the information. He explained that he would recommend an internal review of the Designing Pluz vendor.
Discovery
Two months later, Rachel received a department-wide e-mail saying that Sandy was leaving the company. The e-mail added that Sandy would be prosecuted for allegedly embezzling over $40,000.
Revenue Recognition for Non-Monetary Transactions
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—Strike Two: You're Out—Again!
Abstract
A CFO loses her job because she uncovers problems with revenue recognition. In her next job—with a promising Internet company—she believes her problems are over. Then she begins to raise questions about the new company's revenue figures.
[AICPA Note: AICPA Code of Conduct Rule 501 reads—a member shall not commit an act discreditable to the profession.]
Background
"This can't be happening again. Not just three weeks into my new job!" Donna Butler's mind was racing as she laid down the sales contract that she was reading. How did she get herself into this precarious position--again? Could she be jumping to conclusions too quickly?
"Okay, calm down," she coaxed herself. "It can't be that bad." Barter transactions were not new to Donna. She had seen these types of arrangements many times before, but this was different. Almost 25% of this year's revenue was related to non-monetary transactions. Even more startling was the fact that they represented over 40% of the fourth quarter's revenue. That fact combined with what she had found out today during her meeting with Jack Nelson, the outgoing chief financial officer, sent a shiver down her spine. As she stared out her office window at the bleak February day, she thought back to the events of the past few months that had brought her to this point.
Just a couple of weeks ago, Donna's situation had been quite different. She had landed a job as the CFO of a young public company--ABC.com Company--one of the new breed of businesses that offered their services over the Internet. She would be able not only to help build a new company, but also a new industry. That had been Donna's dream since leaving her position at a well-known publication where, as CFO, she had pioneered the introduction of the publication using two new publishing mediums--CD-ROMs and the Internet--even before the World Wide Web had emerged. After leaving that company, she had had a few false starts with other start-up "new media" companies, but this one was going to be different, she just knew it. What was even more gratifying was the fact that she had been able to find this job so quickly after her embarrassingly short tenure in her last position as CFO of a dot.com company that had not yet had a public offering. Getting this job so soon after that disaster proved she had been right. She could now hold her head high again.
The Price of Telling It Like It Is
What a nightmare her last job had been! Donna had been wined and dined for almost four months before finally accepting the position as CFO. The chief executive officer and the board of directors really seemed to want her. She supposed that their interest was related to her experience as an audit manager at a large national accounting firm, as well as her years as CFO of the publication. Another lure was the fact that she had experience with the Internet--a rare accomplishment for any senior officer, much less a CFO. All this would play very well for the road show, and the CEO knew it.
Unfortunately, Donna had realized fairly early on that there were some problems with revenue recognition at her new company. Donna was not too concerned at first since this was why she had been hired--to get the company ready to go public by ensuring that the accounting policies would stand up to the Security and Exchange Commission's scrutiny. Besides, it wasn't really surprising at a company of this size with such a young and inexperienced accounting staff. As she had done in her prior jobs when things of this nature came up, she immediately went to the CEO to tell him about her discovery. During their meeting, Donna had matter-of-factly stated that some of the revenue figures would have to be reevaluated and most likely reduced before the company would be ready to go public. In addition, it was likely that prior years' figures would need to be restated, too.
Before she knew what was happening, the rug was pulled out from under her. Within a few days of her meeting, the CEO was telling her that she "just wasn't working out." Even though Donna knew that her opinion of the revenue recognition policies was not arguable, she had never before been punished for doing the right thing. After all, she had graduated as the top of her accounting class and this was pretty basic accounting theory. Maybe the revenue recognition issue wasn't really the problem and she really wasn't working out? Either way, Donna was devastated and just wanted to put this experience behind her. Then came the offer from ABC.com Company.
A New Opportunity
ABC.com Company produced and published Web-based distance learning courses and sold them to businesses and universities. The company had gone public a year ago last November and was about to report its first full year of earnings as a public company. In evaluating the position, Donna had meticulously read through all of ABC.com's SEC filings. It was a comfort to her that the company was already public and under the watch of the SEC. She was also impressed with the apparent level of candor in the company's financial statement disclosures and management's discussion and analysis. It was no doubt a risky move to go to another start-up, particular one with an unproven business plan and sales just under $1 million the year it went public. But this year, sales would reach $14 million and the industry experts estimated that the total distance learning market was about $20 billion. With a market size that large, there was plenty of room for growth. That potential was critical in Donna's opinion since cash was rapidly being used to develop courseware and ABC.com needed to begin to produce more sales and generate a profit.
During her interviews she had met with the CEO, Ivan Green, who founded the distance learning company years ago but changed the model for use on the Internet. Ivan was obviously very intellectual and the epitome of an entrepreneur. His entire fortune was tied up in the company and he believed in the concept beyond a doubt. The president, Dan Cole, had been recruited by Ivan about two years ago and had been hired to take the company public. Dan seemed like a very affable person despite his intimidating size of 6'7" and weight of 300+ pounds. Dan was anxious to get the position filled since the outgoing CFO had committed to stay only until the audit and the SEC filings were completed. Dan also felt that it would be nice to have some overlap for the incoming CFO, which Donna really appreciated. And Jack, the outgoing CFO, seemed like a nice person, too. He was leaving to spend more time with his new family and have a much-needed break after taking the company public and living through three acquisitions during the last year. Nice people, candid disclosures, a growing industry-ABC.com Company seemed like a perfect fit.
The Problem
The meeting with Jack had been cancelled twice before. She had been on the job almost three weeks now and Jack was finally getting around to meeting with her to tell her all he knew about the company. There was much to discuss and time was running out. His last day was rapidly approaching, with the audit going very well, according to Jack, even though the audit team was a little green. More important, revenue was on track to meet the analyst's expectations. Jack also reassured her that, although the company had missed a few of the bank covenants, he had already talked with the bank officers and they were okay with the slight deviation from the original business plan. All this was a relief to Donna because she really needed to focus on the follow-on offering since time was of the essence. Cash was definitely in short supply--even more so than she had suspected before accepting the position. A clean audit opinion and meeting investors' expectations would be key to a successful secondary stock offering.
Then Jack revealed something that took Donna completely by surprise.
"So, Jack, what you're saying is that Dan doubled the price of our courses last September?"
"Yup."
"What did you say when he told you?"
" Nothing really. When Dan says jump, I have learned to merely ask how high. He IS the boss, you know, and he won't let you forget it, I can assure you of that."
"But the old price hadn't really been tested yet, had it?" Donna asked.
"No," Jack said quickly, "but Dan was able to sell the courses at the new price, no problem."
"How and to whom? Particularly when sales weren't going all that well at the lower price?" she asked incredulously.
"Well, a lot of it he bartered. And all of it totally legit," Jack seemed proud to say.
"How much of it?" she asked. When Jack told her the extent of the bartered revenue she immediately started to get a sinking feeling. What was going on here?
There was no doubt that Jack was looking forward to having some time off with his family, but Donna now knew the truth about why he was leaving the company. In a meeting with Dan earlier in the week, Dan had alluded to his lack of respect for Jack's skills. Although she wasn't sure of the exact nature of the disagreement, the two apparently did not see eye-to-eye on a few things and it had been a mutual decision for them to part ways. At the time, she was not too worried because she had always been easy to get along with and very diplomatic when stating her point. Good thing, too, particularly since she had witnessed Dan's temper the previous day in a in a meeting with the vice president of sales. Dan took umbrage at something that was said and in an instant his anger was unmistakable. In fact, he was so upset that he got up to pace the room, only to literally break the chair when he finally sat back down. Dan obviously used his size to his advantage when he felt the need.
"Can I see the sales contracts, Jack?"
"Sure, no problem!" Jack responded. As Donna walked out of his office, she muttered under her breath, "I sure hope you're right about that, Jack."
Now What?
Donna couldn't help but think of the consequences of what she had just uncovered. She believed that although the transactions had theoretically been recorded in accordance with generally accepted accounting principles, those rules were never intended to address companies whose net income--or in this case, net loss--was not important. Accounting for nonmonetary transactions required an offset to revenue in the expense line. However, in the world of the dot.com company, revenue was the key figure--not the bottom line. Dan had obviously figured out this subtle point somewhere along the way. But perhaps even more disturbing was the fact that none of the products or services that Dan had traded had a proven fair market value as far as she could tell. So accurately valuing the transactions was not that easy.
Regardless of the accounting theory, once the bank found out that such a large portion of this year's revenue had nothing to do with bringing in cash they would probably call the note. Of course, the company could not pay it off without a secondary offering. And in just two days the company was scheduled to announce earnings-having offered no hint to investors that they would miss the revenue projections. In fact, in a recent speech made by Ivan, he had reassured the audience that everything was looking good. There was no doubt that missing the revenue target this late in the game would cause the stock price to plummet and ultimately eliminate the possibility of a follow-on offering.
The Dilemma
Maybe Donna was taking too tough a stand. This, was after all, a matter of opinion, not the straightforward issues she had experienced in her last job, where she had paid a price for doing the right thing. Donna knew that she was on the verge of getting a reputation for being a troublemaker. Maybe the auditors would figure it out? Maybe it would be best for her to resign her position? It had only been about three weeks and no one would need to know why she left. Besides, she wasn't responsible for last year's numbers anyway. One thing was certain--if the barter revenues were reversed, ABC.com Company would probably not survive.
COMMENTARIES BY EXPERTS
Commentaries: Revenue Recognition for a High-Tech Startup
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—A Young CPA Stands His Ground
Commentaries by:
- Jerry D. Guthrie, Corporate Director, Ethics & Compliance, BellSouth Corporation, Board Member Ethics Officer Association
- Elizabeth Sanders, Sole Proprietor, E. A. Sanders, CPA
- Susan M.
Hinds, CPA, MBA, Business Analysis,
Corporate Strategy Division, Toyota Motor Mfg. North America
Jerry D. Guthrie, Corporate Director, Ethics & Compliance, BellSouth Corporation, Board Member Ethics Officer Association
"When faced with the question of what determined a shipment, Manuel first examined his own experience. Then he followed one of the most common tenets of ethical decision making: If you don't know what is right, ask someone".What we see here is first-hand evidence of ethics at work! Top management is demonstrating by their actions that ethical behavior takes priority at their company. The acceptance of the interim controller's decision demonstrates real ethical support by management.
The dilemma Manuel faced is typical of ethical issues in the work place, with no easy answer and no real expert available to provide helpful assistance. Let's examine Manuel's decision-making process to see what else, if anything, might have been done.
When faced with the question of what determined a shipment, Manuel first examined his own experience. Then he followed one of the most common tenets of ethical decision making: If you don't know what is right, ask someone. He attempted to contact two experienced people in the audit arena. As it turned out, the advice he received from the two expert auditors did not provide him with a clear solution. Manuel had to rely on his own experience and judgment to make the decision.
The next critical element, and another opportunity to see ethics at work, occurred when he went to see his boss, the vice president of operations, with the problem and his proposed solution. Mr. Phipps' attempt to persuade Manuel was to be expected from a vice president of operations. The real critical point is Mr. Phipps' acceptance of Manuel's decision. Obviously, Mr. Phipps could have overruled Manuel's authority and imposed his own viewpoint, but he did not. Given his support for Manuel's decision and the late-night work by the company's senior team to get the shipment out, the senior managers demonstrated that ethics were a priority for their company.
Elizabeth Sanders, Sole Proprietor, E. A. Sanders, CPA
"Manuel was tested when on the last day of a critical month, the VP of sales announced receipt of an order that would meet the expectations of the venture capital owners"Manuel Gonzales, a young CPA, has been placed in a difficult situation. Although lacking experience, he was appointed interim controller after less than a year at Advanced Tech, Inc. Advanced Tech was a small startup very dependent on venture capital funding. As usual, the vice president of operations, also serving as VP of finance, had no accounting background.
Manuel was tested when on the last day of a critical month, the VP of sales announced receipt of an order that would meet the expectations of the venture capital owners. The question: Should this transaction be included in the revenue for the current period? Because the transaction did not occur at the end of the year, would the owners or others who might depend on the financial statements make certain decisions assuming this transaction would be included in the current period? What is the correct definition of the end of a "critical" month: quarter end? Are certain decisions made based on quarter-end numbers? Could the sale be bogus?
It is troubling that Manuel enjoyed a sense of power when estimating bad debts and obsolete inventory. Both of these transactions can be used in a limited manner to manipulate financial results. Manuel should refer to an intermediate accounting and business law textbook to determine the timing for realization of revenue.
Revenue can be defined as the value of goods that a business transfers to customers. Any definition of revenue raises questions as to timing--the essence of the revenue realization principle. At what point during product creation should revenue be recorded? What is the critical event that indicates revenue has been realized and justifies recording a change in net assets by replacing the carrying amount of assets, such as inventories, with a higher valuation representing their current fair value? As a practical matter, objective evidence is needed to support the recording of revenue, and for most business enterprises that evidence lies in an arm's-length transaction in which title to the goods passes to the customer. 1
Under common law, when the buyer receives the goods and makes payment, title is transferred. However, expressed provisions in a sales contract can change when title is transferred. For example, terms of the transaction concerning delivery of the goods can affect transfer of title. The terms of the contract may obligate the seller to deliver the goods at a particular place or make delivery at a destination. Most sales contracts only require that the goods be sent or shipped to the buyer or stipulate when the seller makes shipment.
Title does not pass when the product rolls off the production line or when it is placed in a box and the box is taped shut or the address label is put on. The sale does not occur when the box is placed on the loading dock or when the truck leaves the premises or when the product is in the finished goods/shipping area and has an order attached to it at midnight.
The seller's part is performed when goods are handed over to a carrier for shipment to the buyer. If the contract carries a destination provision, the seller's part of the contract is not fulfilled until the goods are brought to that destination and tendered to the buyer. Ordinarily, only delivery to the carrier is required in the absence of an expressed requirement of delivery at destination. 2
FOOTNOTES:
1 Intermediate Accounting, A. N. Mosich and E. Johnson Larson, Fifth Edition
2 Business Law Principles and Cases, Ronald A. Anderson, Walter A. Kumpf, Robert E. Kendrick, Fifth Edition
Susan M. Hinds, CPA, MBA, Business Analysis, Corporate Strategy Division, Toyota Motor Mfg. North America
"Despite potential retribution, Manuel maintained his conservative position on the accounting for the shipment cutoff".
In organizations, doing what's right is often more challenging because individuals and groups have to make decisions in a highly complex context in which roles and norms, authority and power relationships, competitive pressures, profit motives, and organizational structures all come into play. Ethics is driven by individual human behavior but is highly influenced by the corporate culture and the organization's power structure. It takes a bold and determined employee to oppose the powers that be, an employee such as the one in this case, Manuel Gonzales, a young CPA.What is the critical issue?
Manuel must decide how far to push his opinions regarding proper cutoffs for shipments-with little support among the management team for his conservative views. Remember that Manuel is young and is only acting as interim controller due to a recent termination. The vice presidents view him as unseasoned in business and question his opinions and views accordingly. In spite of his shortcomings, he was aware of the strong motivation for Advanced Tech, Inc. to go public, thereby making everyone successful. This placed tremendous pressure on the executives to hit the growth and profit targets.
Is Manuel's conservative opinion shaped by terminated employees mishaps?
Consider for a moment the trend that has formed within the last two years. One controller has been terminated due to inadequate audit results at year-end. It is easy to imagine why Manuel would be a little nervous. Typically this motivates one to err on the side of conservatism, especially in light of the harsh treatment of the former controllers.
Manuel needs the financial security and local stability that his job offers. This is important because he and his wife are expecting their second child, which will add to their financial burden. Additionally, Manuel likes the shorter commute to work and does not have any desire to relocate. Not to mention that Manuel quit an auditing job at a large national accounting firm to take this risk with a new company in hopes of hitting it big. "I could be in on the ground floor," Manuel imagined about Advanced Tech.
Manuel may perceive that the former controllers were liberal and ineffective in their financial practices, which led to their failures. As a result, he is likely to take a more conservative approach. He wants to play it safe and avoid an inadequate audit report at year-end.
Why does Manuel get the final say in this decision?
Manuel approached Duane, VP of operations, to discuss the shipment cutoff policy, and they had contradictory opinions. Manuel felt a product had to be on the truck to be considered shipped in the month. Duane believed the product needed only to be in the finished goods area with an attached order. After Manuel investigated further he found that his external contacts, two audit managers at the CPA firm where he once worked, also had contradictory opinions. Without a clear answer, Manuel had to use his judgment to make the final decision.
Let's consider whether Manuel's opinion is in fact correct. The practice that he believes is incorrect has been past practice for the organization, which supports the VP's opinion. However, in support of Manuel, recall that the two controllers were fired due to inaccurate audits and this type of activity may be contributing to the accounting professionals' demise.
Manuel focused at one point on whether manufacturing could convert an order to a shipment as quickly as needed--or were the VPs playing accounting games by stretching the rules? Manuel sees a red flag because this particular shipment, which is needed to "make the numbers" for the additional funding from the venture capital owners, miraculously comes in at a critical time. Manuel's suspicions actually drive him to observe the year-end cutoff. He was quite surprised to find the VPs and their spouses labeling the boxes in order to get them on the truck in time. This surely leaves Manuel in a politically incorrect position and he is likely to lose support in the future.
Despite potential retribution, Manuel maintained his conservative position on the accounting for the shipment cutoff. Equally important, Manuel should continue to explain his rationale in the hopes that others will make better decisions after learning all the facts and understanding the potential consequences of improper accounting. Manuel has final say in the matter, as it is an accounting control issue that falls directly in the interim controller's area of control. Manuel would be wise to obtain the prior year's audit reports to determine the reason for the insufficient audits. This may help him to avoid becoming the third failure and to keep his desperately needed stable income.
Commentaries: Internal Controls And Fictitious Invoices
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—Loose Controls at an NPO
Commentaries by:- Curtis C. Verschoor, CPA, CIA, CMA, CFE, PhD, Professor, DePaul University, Chicago
- Brenda Hildreth, Manager of Business Practices, Baxter International, Inc., Deerfield, IL
- Michael A.
Santoro, Assistant Professor at the
Rutgers Business School
Curtis C. Verschoor, CPA, CIA, CMA, CFE, PhD, Professor, DePaul University, Chicago"George took a very significant personal risk by virtually accusing Butch and Louise of fraud and abuse without first informing Charles Brown, the Kettle partner on the engagement that he was running into difficulties early in the engagement".
George Shaw, the senior accountant at Kettle & Company, seems to lead a charmed life. Every aspect of this case study works out in a manner favorable to him. He was able to act in accordance with his own ethical beliefs and the AICPA Code of Professional Conduct while still maintaining good relationships with the client. Real-world senior accountants should not automatically expect their auditing and ethical challenges always to work out as well.
George took a very significant personal risk by virtually accusing Butch and Louise of fraud and abuse without first informing Charles Brown, the Kettle partner on the engagement that he was running into difficulties early in the engagement. George may not have been aware of the consequences of being accused of slander. Fortunately for George, he was later able to obtain strong partner support from Charles. Without that support, George's actions might have resulted in a far different outcome. Friction between client personnel and the auditor is not unusual when the auditor finds improper circumstances that reflect unfavorably on client personnel. Senior auditors are probably well advised to leave sensitive client situations to a partner of the firm.
Charles' decision to issue unqualified audit opinions without really delving into many of George's audit findings is somewhat surprising, particularly in view of the audit problems that were encountered in prior years. However, to his credit, George appeared to be able to balance his distrust of Butch, Barbie, and even Louise with loyalty to Charles, his employer. Senior accountants need to have the opportunity to fully present their concerns to a partner, but once the firm has decided on a particular course of action, everyone on staff needs to publicly support the firm's decision.
As the case unfolded, it was fortuitous that Barbie resigned her position for reasons unrelated to any problems hinted at in the audit. As a consequence, George was able to serve as a "white knight" for Louise and not be looked upon as a policeman out to prove his case. George also correctly refrained from performing himself all of the investigative work necessary to determine whether a crime had been committed. Relying on professionals experienced in such matters—such as the FBI, local law enforcement or IRS criminal investigation division--is a far better choice.
George's ability to function well as CFO under Louise's general supervision is also somewhat surprising, as he seemed to have grave doubts earlier about her integrity. He also must have had some second thoughts about whether she had the oversight skills necessary to serve as CEO. To his credit, George was able to keep any negative thoughts to himself and retain his professionalism under Louise's direction.
In summary, George made the most of his opportunities to 1) serve a client of Kettle & Company, 2) overcome any discouragement to dig diligently into questionable items he found during the audit, and 3) blend into the client's organization and continue to pursue to a successful conclusion the doubts that arose during the audit.
Ms. Brenda Hildreth, Manager of Business Practices, Baxter International, Inc., Deerfield, IL.
"As an ethics officer, I would question the integrity of the audit. I would want to understand the factors that justified the decision. Was the audit partner's decision based on a desire to retain the NPO as a client or other business factors".George, throughout the audit, remained true to his principles and professional ethics. He accurately documented both the audit results and his concerns. He expressed his concerns to the NPO's senior management. So why then did his firm elect to issue unqualified opinions with no exceptions on all four audits?
Many times it is difficult, if not impossible, for senior management to accept that a favored employee is capable of participating in unethical behavior. In this case Louise, the CEO and principle decision maker, believed in Barbie's abilities even in light of evidence to the contrary from a neutral third party. She trusted her management team and viewed George's suspicions as process or implementation issues rather than alleged misconduct by her management team. As will be discovered later, her trust was misplaced. The question here is how far can a third-party—in this case the CPA—push a client to change their way of thinking based on the CPA's suspicions? The CPA has no decision-making authority at the client's company. He or she can only document the facts and try to influence the client's decisions, as George did.
From his firm, however, he deserves some answers about why they chose to issue an unqualified opinion with no exceptions against George's recommendation to the contrary. Being an ethics officer and not a finance professional, I am not clear on what if any legal implications there are when this happens. As an ethics officer, I would question the integrity of the audit. I would want to understand the factors that justified the decision. Was the audit partner's decision based on a desire to retain the NPO as a client or other business factors? As we have seen in the news, a desire to make the client happy can lead to inappropriate conduct. The subsequent fraud and abuse discovered by George should be incorporated into a "lessons learned" model used by the CPA firm.
The NPO board did respond to George's recommendations for better accounting systems and controls. George was able to prove significant fraud and abuse at the NPO, evidence of which was turned over to the FBI and IRS for prosecution. As a CPA, George was diligent in completing his duties and responsibilities. He maintained his commitment to his professional ethics. George's initial impression of Louise's abilities and integrity must have changed once he began working with her, as he ended up accepting a job with the NPO as CFO/controller. George's obvious commitment to his profession brought great benefit to the NPO and contributed to its continued success.
Michael A. Santoro, Assistant Professor at the Rutgers Business School
"Often the very best weapons that an accountant has in confronting ethical problems are his or her professional training, standards and methods".One of the things that makes this case interesting is that it takes place in "the trenches." Not all accounting is done at large, international firms for multi-billion dollar public companies. Many important ethical issues emerge in smaller, regional firms serving small, privately held, not-for-profit or family-run businesses. The ethical issues and economic pressures arising in such contexts are often even more challenging than those present with big firms with large clients. This case provides a really good example of how these kinds of pressures work since Kettle, even after George documented his concerns for the audit partner, issued an unqualified opinion with no exceptions on all four of its JTL audits. It's hard not to think that this clean opinion might be due in part to the fact that JTL represented a material portion of Kettle's income.
The fact that George stuck to his ethical principles and eventually cleaned up JTL under such difficult circumstances is especially impressive. So it is worth trying to understand how George succeeded in a situation that was fraught with all sorts of risks for him and his firm—the risk of losing a client, the risk of getting embroiled in an ethical scandal and, for George, the risk of being fired.
George succeeded, in short, because he acted like a professional accountant at all times. Take, for example, his response to Barbie. Barbie was obviously hostile about the audit process, reflecting her own inexperience. Instead of viewing the audit as a learning opportunity she was defensive. Since she wasn't a professional herself, she knew no other way of conducting herself. Her personal relationship with Butch also no doubt contributed to her inappropriate, unprofessional interactions with George. Simply put, Barbie has a very skewed vision of the way not-for-profits are managed. By contrast, George's responses to Barbie were extremely professional. He relied on proven professional routines, such as testing the accounting ledger system. He kept his cool and did not get dragged into Barbie's game.
In a similar vein, when Butch, rather inappropriately, confronted George about his discussions with Barbie, George responded in a very measured and professional manner, following up with a memo outlining his questions and concerns. George did what every good accountant is trained to do—he followed professional procedures and documented his activities at every stage. After he met with Butch and Louise to express his concerns about possible fraud, he followed up with a written narrative.
George's carefully documented professional approach ultimately led to a mandate from the board to clean up the organization. George knew that the documents he was generating left a paper trail that would eventually empower him. Indeed, the financial control problems at JTL were a result of incomplete and untimely record-keeping.
George's high degree of professionalism continued when he became CFO/controller. When he discovered possible criminal fraud, he understood that it was his professional duty to immediately turn over the investigation to the proper authorities.
George demonstrated that it really means something to be a professional. Often the very best weapons that an accountant has in confronting ethical problems are his or her professional training, standards and methods. By rigorously adhering to professional standards, George never wavered from doing the right thing. He never left himself open to question because he never questioned his own professional duties. It's not always easy for accountants do the right thing, but it's a whole lot easier if they remember they are professionals who must follow the work standards of their profession.
Commentaries: Revenue Recognition of Stock Options and Stock Placement
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—Cybreality, Inc.
Commentaries by:
- Steven M. Mintz, PhD, Professor of Accounting, California State University, San Bernardino
- Joanne O'Rourke Hindman, President and Chief Executive Officer of Roundtable Advisors, Inc.
- Jean
Fitzsimon, Bridge Associates LLC,
formerly CCO and VP-Law, Sears, Roebuck and Co.
Steven M. Mintz, PhD, Professor of Accounting, California State University, San Bernardino
"The audit firm did not adequately assess the inherent risk of taking on New Cybr as a client".Executive Summary
Cybreality (Cybr) evolved from a small electronic games business started by two UCLA graduates to a publicly owned company, New Cybreality (New Cybr), after being acquired by a dormant Nevada mining company that is a Securities and Exchange Commission registrant in a "back-door" registration. The company is required to file a 10-K with the SEC for the three years ended December 31, 20X2. A multi-office accounting firm in Orange County takes on the engagement. JoAnne Jones, a rising manager in the firm, is assigned to meet with client personnel and coordinate the audit.
Stakeholders and Interests
JoAnne Jones and the audit firm are major stakeholders. It appears that the firm may have been too hasty in accepting New Cybr as a client. The head of the firm, Alan Smith, agreed to consider undertaking the audit after a friend of his, who is an attorney for New Cybr, asked him to do it. In making the decision to take on New Cybr as a client, Smith looked at company records and systems. It does not appear that he carefully assessed the potential risks of taking on New Cybr as a client given that several of its business relationships may have warranted greater scrutiny. These include:
- Being acquired by the Nevada mining company in a back-door registration that may have been chosen to avoid an initial public offering.
- Using seven different consultants, most of whom are located offshore, to help publicize the company's activities.
- Failing to review the consultants' Web sites associated with New Cybr, which appear to have omitted important information about competition that creates downward pressure on New Cybr's retail prices and upward pressure on costs.
- Selling Golden Gate Investors six-month options on 250,000 shares for $25,000.
- New Cybr's accounting for stock options.
- The relationship between New Cybr's
chief executive officer and Greenfield Enterprises, the company
that acquired Cybr before its acquisition by the Nevada mining
company. The CEO was also an officer of Greenfield.
Since Greenfield sold 500,000 of its New Cybr shares in several private placements at $0.70 a share, these investors have an interest in the accuracy and reliability of New Cybr's financial statements and the adequacy of disclosures. Their investment could be at risk if the statements do not present fairly the financial position, results of operations and cash flows for the three years ended December 31, 20X2.
New Cybr has a $435,000 bank loan outstanding, and those creditors have a stake in the accuracy of the financial statements. Their concern is whether New Cybr is able to pay interest on a timely basis and repay the loan when due.
The consultants and Golden Gate Investors hold options to buy New Cybr stock. The consultants already have exercised their options. The investment value of their holdings, and that of Golden Gate should it exercise its holdings in the future, may depend on whether New Cybr is able to meet its obligation on the bank loan.
The future of New Cybr may be at stake since the amount of the bank loan is slightly lower than the combined amount of outstanding cash and the net realizable value of accounts receivable ($445,500). Moreover, the company has $179,000 in current liabilities. Depending on how rapidly New Cybr is able to collect on its receivables, the company could face a credit crunch in the future. The auditors should fully investigate New Cybr's liquidity and solvency to determine whether a going concern alert may be required.
Between 1998 and 1999, the company's level of selling and administrative costs increased by about 60%. The increase should be carefully scrutinized since the auditors can't explain why seven different consultants are needed to work on publicity for the company.
Ethical Issues
The audit firm did not adequately assess the inherent risk of taking on New Cybr as a client. JoAnne Jones, the manager in charge of the audit, met client management for the first time before reviewing the fieldwork of the audit team. At that time she became aware of certain issues pertaining to the consultants that appear not to have been well understood in advance of the audit.
JoAnne should carefully review the workpapers to ensure that the audit team has exercised due care in carrying out its audit responsibilities. As the audit manager, it is JoAnne's responsibility to properly supervise the audit team. It appears that this may be a problem since she has not been managing the engagement on-site.
JoAnne is told by the CEO that the company wants its 10-K form filed before the deadline to support the stock price and enhance the company's apparent standing as a "mature company." However, this could be a ploy to pressure JoAnne into completing her review as soon as possible. It also could mask an attempt to make it more difficult for her to adequately assess footnote disclosures about stock options, related-party transactions--especially between the CEO and Greenfield--and the role of the consultants. JoAnne should discuss these matters with Alan Smith before signing off on the audit.
Investors and creditors rely on auditors' objectivity and care in developing the audit opinion. JoAnne should carefully evaluate whether New Cybr can be expected to repay its debts when due. She should calculate the receivables turnover ratio and number of days' sales in receivables to get a better idea whether collections will be available on a timely enough basis to help pay the interest and repay debt on time. She also needs to consider whether there are any debt covenants that might place restrictions on the company and warrant disclosure in the financial statements.
JoAnne also should ask why the selling and administrative costs increased significantly from 1998 to 1999. There may be unauthorized payments to the consultants. These need to be carefully examined and corrected, if necessary.
Decision
JoAnne should review these issues and then contact Alan Smith to decide how to approach the client. All of the increase in gross margin from 1998 to 1999 was wiped out by the increase in selling and administrative costs. The auditors were unable to determine why there are so many consultants and why they are located off shore. The company has only paid $5,000 a year on $440,000 of outstanding debt. Its level of cash is low, and has declined by almost 30% from 1999 to 2000. The financial statements do not present a picture of a healthy company. Moreover, there is increased competition in the marketplace and greater pressure on prices and operating costs. The future viability of the company appears to be in doubt. JoAnne should determine how management expects to deal with these uncertainties before wrapping up the audit.
Joanne O'Rourke Hindman, President and Chief Executive Officer of Roundtable Advisors, Inc.
"It is hoped that JoAnne has access to a full pot of coffee for her long nights ahead. More important, however, JoAnne should call Alan Smith, the audit firm's partner, to let him know that she is going to need his help".JoAnne Jones may need more than just one cup of coffee to decipher the entire Cybreality story. She may also need more than just ten days to deliver the audit report she promised. More important, JoAnne needs to slow down the process to make certain that she has enough time to absorb all the information, particularly since this is the first year that her firm has audited the company. Complicating matters further is the fact that there was no Form S-1 Registration Statement filed when this company went public because of the "back door" approach that was used. This indicates a level of sophistication on the part of Greenfield Enterprises that should cause JoAnne to consider their objectives in taking the company public. In fact, there are many questions that need to be answered and some complicated accounting issues that must be reviewed before JoAnne should allow the audit report to be issued.
For example, if the management team was truly interested in building the company by taking it public in order to raise capital through private placements, why would they need an investor relations firm? The need for these specialists is especially perplexing considering that the private placements represented 10% of the outstanding stock, while Greenfield held 80%. In addition, why would Greenfield significantly dilute its ownership by providing approximately 13% of the company in the form of options to seven different offshore consultants just to tell the Cybreality story? Thanks to these consultants the overall atmosphere is one of hype rather than of full and fair disclosure. It is probably not a coincidence that the stock price soared after the consultants exercised their options. In addition, selling six-month options to Golden Gate generates additional concerns about the company's approach to raising capital. JoAnne should ask management about the company's cash needs and how the private placements and the sale of options serve those needs. In addition, JoAnne should research the background of all the players and the relationships that these entities had with Greenfield before their involvement with Cybreality.
Turning to some of the accounting issues, JoAnne's focus should center on the way that the company recorded the options that were granted to the consultants. JoAnne no doubt knows that the value of the options should have been recorded as an expense, in accordance with Financial Accounting Standards Board Statement No. 123,Accounting for Stock-Based Compensation. This would require that the value of the options be "...based on the fair value of the consideration [or services] received or the fair value of the equity instruments issued, whichever is more reliably measurable." The CFO's statement that the stock had not really begun to trade was both inaccurate--because of the recent private placements--and irrelevant, since the value of the consultants' service certainly could have been determined.
With regard to the capitalized product costs, there was no mention of whether the capitalized costs were reviewed to determine compliance with all aspects of FASB Statement No. 86,Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed. Specifically, JoAnne must determine if her staff ascertained that the costs related to each product were capitalized only after each product had established technological feasibility and all the research and development activities for that product had been completed. In addition, no additional costs should have been capitalized once the product was available for general release. Finally, there was no mention of any testing to make certain that the related amortization costs were calculated in accordance with Statement No. 86.
Given the facts surrounding Cybreality, JoAnne needs to make certain that there are no underlying pressures to keep expenses artificially low. In fact, her research related to the company's cash needs; the relationships between Greenfield and the company's private investors and the consultants; and the accounting issues may show that management's objectives are closely tied to Greenfield's desire to "cash in their equity." While the initial perception may have been that this was a simple audit, it rapidly unraveled into a complicated assignment and it is imperative that JoAnne not compromise her standards just because the client wants the 10K filed as soon as possible. That fact alone may be a bad sign. It is hoped that JoAnne has access to a full pot of coffee for her long nights ahead. More important, however, JoAnne should call Alan Smith, the audit firm's partner, to let him know that she is going to need his help.
Jean Fitzsimon, Bridge Associates LLC, formerly CCO and VP-Law, Sears, Roebuck and Co.
"JoAnne's task will be even more difficult as her staff, who should know the answers to her questions, apparently are rather smug about their work and disinclined to believe there are problems they have not already addressed".The good news about this situation is that it has more red flags than any auditor should need in order to recognize the potential problems: too many cozy relationships, odd accounting methodologies, unexplained transactions, inconsistent stories and outright lies. The bad news is that JoAnne is under a lot of pressure to work fast and produce a certain result. She has less than 10 days to review the work of an unsupervised field audit team and the prospect of first line responsibility for a new client. The only surprise is her failure to ask for aspirin to go with her coffee!
Greenfield's use of a back-door registration deprives JoAnne-and the first investors--of information about the company's prior value. Its subsequent hiring of seven consulting firms to publicize the stock in exchange for improperly valued options can only be viewed as an attempt to hide more information from investors or creditors. JoAnne's task will be even more difficult as her staff, who should know the answers to her questions, apparently are rather smug about their work and disinclined to believe there are problems they have not already addressed.
Stock Issues
In the latter half of 20X2, 500,000 shares were placed at $0.70 per share. During this same period, the seven consultants were given two-year options to purchase 750,000 shares at $0.01 per share - not $0.70, the market price; not apparently the value of the services to be performed by the consultants; and not the $0.75 per share for the shorter-term options sold to Golden Gate in an "arms-length" transaction. Finally, the consultants created quite a market for their penny shares by touting the company without disclosing the increasing industry competition or adequately disclosing their option holdings so that investors could take their self interest into account.
JoAnne's Issues
JoAnne is considered a rising star at her firm. She knows that first line authority for a client, especially a new client and a technology firm to boot, can really help her career. She knows her boss personally made the decision to take this client on, that he is friendly with the company's attorney and that he has entrusted this important matter to her. The first thing she hears from the company's management is the need for speed and how much the stock price hinges on the 10-K. In other words, her firm's ability to keep this client appears to depend on her approval of the audit team report promptly and without significant change. She will have to be extremely careful not to be improperly influenced by these facts.
The Consultant Issues
The use of offshore consultants suggests an attempt to mislead investors and, therefore, the likelihood of securities fraud. These consultants appear to be beyond the reach of the Securities and Exchange Commission and state securities regulators. Since they clearly put in a great deal of effort without pay, they obviously anticipated making their profit from the sale of shares once they exercised their options, giving them plenty of reason to be less than candid about any shortcomings of the company or its stock. As noted above, while they made some disclosure of their options, it probably was insufficient to put investors on notice that the consultants would only recoup their costs and make a profit if they could make a market for their options/stock.
Audit Approach Issues
The company's explanation to the staff about why the consultant options were valueless should have raised concerns, given its patent untruthfulness. There clearly was a discernable market value at the time (either $0.70 or $0.75 per share). Also, it is likely the consultants were available for hire on a cash basis and, therefore, the value of their labors could have been established. This points out three flaws in the auditors' approach:
- The field team needed more senior leadership on the ground with them,
- The time allotted for the field work was too short (they were exhausted after much overtime) and
- There was insufficient preparation for the audit in the first place.
- At least some of the red flags were
there for Alan to see, yet he does not seem to have noted any of
them. JoAnne also has been allotted too little time for her
review. One can also assume she will be somewhat distracted by
all of the other duties she readjusted to take on this
assignment. She will need a clear head and a strong will to
approach this engagement properly. Alan never should have put
his firm in this position.
Commentaries: Unethical Behavior by a Star EmployeeFrom the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—A Star Employee's Indiscretions
Commentaries by:
- Elizabeth Sanders, Sole Proprietor, E. A. Sanders, CPA
- David Messick, Director, Ford Motor Company Center for Global Citizenship at the Kellogg Graduate School of Management at Northwestern University
- Rushworth M.
Kidder, Founder and
President of the Institute for Global Ethics
Elizabeth Sanders, Sole Proprietor, E. A. Sanders, CPA
"Given Mark's behavior, the only possible way Robbie can survive as chief operating officer is if Mark resigns".This is Robbie's situation:
- He has been chief executive officer for two years.
- He owes his success to Mark, one of two executive vice presidents. Robbie is overwhelmed with his new responsibilities and allows Mark to make decisions for him.
- Mark's management produces admirable results. However, Mark is strong willed and determined to implement his vision. He has worked his way up in the financial and lending areas of the bank.
- Mark has indiscreet sexual relationships with bank employees. For example, Mark approves travel by clerical employees to accompany him to training designed for bank executive management.
- Robbie believes Mark lacks tact
and has a volatile temper.
Evidence of inappropriate sexual relations:
- Liz has a high school diploma and was hired as a secretary. She is frequently rude to other employees and managers, including Robbie. At a conference designed for financial executives, instead of attending the training program, Liz was observed shopping and at the pool. She is included in the bank's senior management bonus program. There have been several negative exit interviews with her former employees. Liz lacks basic knowledge about the functional activities she manages.
- Sarah is a senior financial manager at the bank. Mark and Sarah walked out of one conference to have a dalliance in a hotel room.
- Leslie is a senior bank
officer. In addition to Mark, she also had a relationship
with William, the other executive vice president. She
manages the bank's public relations area. There have been
complaints about her behavior, including some from
customers. In addition, she did not complete performance
appraisals on time or authorize the salary increases that
are required with reviews. Some of the reviews were more
than a year late. One employee has written a letter of
complaint to one of the bank's directors.
Given this behavior, the only possible way Robbie can survive as chief executive officer is if Mark resigns. Fred, the bank's general auditor, has already warned Robbie about actions that violate the Financial Institutions Reform Recovery and Enforcement Act, and about violations of the bank's internal policy. Sam, the human resources director, has noted the improper use of bank funds. In addition, the story does not mention that any other employee could file a complaint with the Equal Employment Opportunity Commission. Other bank employees are entitled to redress due to damage they suffered because of the special relationship between Mark and these female employees. An investigation by the board of directors or any of these government agencies would most likely result in Robbie's involuntary resignation.
David Messick, Director, Ford Motor Company Center for Global Citizenship at the Kellogg Graduate School of Management at Northwestern University
"It is clear from the outset that Robbie has to put an end to Mark's atrocious behavior. The toxic impact such behavior can have on morale alone is enough to condemn it".Robbie is in very deep trouble indeed. He has known about the transgressions of both Mark and Mark's pal, William, but he has not put a stop to the illicit hanky-panky. It's easy to imagine a lawsuit being brought by a disgruntled female employee who finds the bank's culture demeaning and intolerable. When the suit explodes into the corporate offices, many employees will be deposed, including Fred and Sam, who will tell plaintiff's lawyers that they discussed Mark and William's troubles with Robbie and that he decided that he needed Mark too much to let him go. The end result will be that Robbie will be gone, Mark will be gone, William will be gone, several inept employees that they hired will be gone, other employees may well lose their jobs, and the shareholders will take a colossal hit. Robbie does not deserve to have a leadership role in the bank if this is his understanding of responsibility and ethics.
It is clear from the outset that Robbie has to put an end to Mark's atrocious behavior. The toxic impact such behavior can have on morale alone is enough to condemn it. Putting a stop to this behavior calls for diplomacy, tact, persuasion and a steady hand. If Mark can be kept and his talent and energy levels maintained, that is great. But Robbie must be willing to lose Mark if he cannot stop his scandalous behavior. Robbie should create a coalition of the influential leaders in the bank to remind Mark about the consequences of using employees, even willing ones, for sexual target practice. If he is truly valuable to the bank's business mission, Robbie could provide him with a coach to help him develop more effective strategies for interacting with others. Robbie should remind Mark that it is said that people get hired for their skills and fired for their personalities, and that Mark's personality is in serious need of a tune-up or overhaul. But none of this implementation advice can be convincingly given if Robbie is not willing to pull the trigger and fire Mark.
Just as it is true that one will do badly in a negotiation that one is unwilling to walk away from, a leader will always be held hostage by an employee he (or she) is afraid to fire. Robbie is afraid to take real control and that is why he will fail.
Rushworth M. Kidder, Founder and President of the Institute for Global Ethics
"As chief executive officer, Robbie can't engage in or condone behavior that disregards the law and undermines trust within his organization".Robbie's dilemma is about making a choice between right and wrong, despite the difficult consequences that entails. As chief executive officer, Robbie can't engage in or condone behavior that disregards the law and undermines trust within his organization. The outrageous behavior of his star performer, Mark, is obviously demoralizing to many of the other excellent performers in the company. People such as Fred and Sam are complaining to Robbie about Mark's indiscretions, not only because much of it represents regulatory, legal and policy violations, but also because their ethics are offended. They think Mark is wrong, and that it's Robbie's responsibility to set things right. If Robbie's board realizes what Mark is really like, they will not only remove Mark from his position of influence, but also remove Robbie from a position that demands the utmost in integrity and ethical clarity.
What could possibly motivate Robbie to recommend overlooking Mark's constant transgressions? Robbie feels he is caught in a difficult balancing act. When he decides not to address Mark's behavior for fear of losing him, he is clearly engaging in short-term thinking. But "short term" is the operative word here. Apparently, Robbie depends on Mark not only for his stellar earnings records but also for a positive relationship with the board. This is the crucial stumbling block for Robbie. His best course of action under the circumstances is to actively seek to establish a values-based culture for his company, starting directly with the board. Robbie's immediate actions must be:
1. Communicate directly with Mark. Robbie must share his concerns about Mark's behavior and give him the opportunity to change. Robbie can couch this within the context of his intention to establish a values-based culture.
2. Approach the board with a proposal to establish a values-based organization. There is plenty of evidence, particularly since the recent corporate scandals, pointing to the importance of values-based corporate cultures. Robbie can introduce this evidence and propose change that is immediate and effective. Reform would be based on leadership modeling, determining shared values and ethical standards, and training in ethical decision making, all at minimal cost to the company. The board is unlikely to argue against a values-based culture, or to argue for unethical standards and decision making.
3. Robbie must go public with his plan as soon as the board approves it. He can circulate the plan within any of his professional associations, take it to the press and make it widely known to all of his staff and clients. Telegraphing these intentions ensures that:
a. Mark is put on notice for his behavior not only by Robbie but by the court of public opinion at the office. In other words, Robbie is establishing some recourse for employees who may be outraged by Mark's behavior but unsure of the risk for complaining about it.
b. Robbie is protecting himself in the event that Mark turns to the board for retribution.
c. Robbie is leveraging the board's support of his proposal through public relations pressure.
d. Perhaps most important, Robbie is contributing to improving business practices everywhere by educating his community about this positive culture shift.
These are the first crucial steps in gradually instilling a values-based culture throughout Robbie's organization. With the board's support, he must continue building trust across the company. For Mark, this may eventually involve termination if he chooses not to change, but Robbie will have the board on his side, and many other star performers are more likely to emerge in a positive culture that is actively raising the bar for each individual.
In a values-based culture, each person feels empowered to engage in open, direct communication, and the expectations for the group are clearly modeled by the leadership. When issues arise that may be more effectively resolved confidentially and with a limited group of decision makers, members of an effective, values-based culture readily accept and support decisions because they trust the individuals making them. Robbie's decision to continue overlooking Mark's behavior was not really a sustainable plan. It forced people like Fred and Sam, who could not communicate openly and directly to Mark, to bring their complaints to Robbie in closed door sessions. Meanwhile, Robbie's failure to address Mark's behavior was an ambiguous signal that left employees with many questions. "Is he condoning Mark's behavior?" "Does he care what Mark does?" "Is he so clueless that he hasn't noticed Mark's behavior?" "Is he so spineless that he can't control or confront Mark?" Any of these questions in employees' minds ultimately undermine leadership effectiveness. That's why ethical issues must be confronted, not skirted, and why only a culture based on trust is effective over the long term.
Commentaries: Due Diligence Engagement—Importer Tax Avoidance Scheme
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—Due Diligence and Buying an Enterprise
Commentaries by:
- Steven M. Mintz, PhD, Professor of Accounting, California State University, San Bernardino
- Ida R. Backmon, PhD, CPA, Associate Professor, Accounting, University of Baltimore
- Betty L. Brewer, DBA, CFP, Associate Professor of Finance, North Carolina A&T State University
- Joanne
O'Rourke Hindman,
President and Chief Executive Officer of Roundtable
Advisors, Inc.
Steven M. Mintz, PhD, Professor of Accounting, California State University, San Bernardino
"Sheri Landon, Sito's accounting manager, and Mr. Kirkpatrick, the company's outside accountant, are stakeholders. It appears that they may have gone along with Sam Proctor's scheme to hide income from the Canadian government".Executive Summary
Gloria Scheps is the senior auditor in charge of a due diligence engagement for a purchase by American Artifacts, a client of her firm--Broderick, Samuels and Underhill (BSU)--of Sito, a $50 million Toronto-based importer of high-quality cutlery from China. During the course of her audit team's examination of documents supporting Sito's financial statements, Gloria discovers dual records of perpetual inventory and a Sito-owned Swiss bank account showing deposits from Tsingto Enterprises in China. Tsingto sold distribution rights for the Sito product line to Sam Proctor, who founded Sito five years earlier. Proctor's explanation for the questionable transactions is that Sito adopted an aggressive tax position. The audit manager on the engagement, Tom McCarr, questioned Proctor and asked American Artifacts' attorneys to evaluate the matter so that the auditors can determine whether it should affect the purchase.
Stakeholders and Interests
American Artifacts is the major stakeholder. It may be acquiring a company that has kept a second, higher set of inventory numbers in order to hide from the Canadian government cash received from Tsingto for purchase product rebates and that possibly covered the shortfall in actual perpetual inventory records. The motivation appears to be avoiding high government tax rates. American Artifacts has a right to know about Sito's possibly illegal acts.
Gloria and BSU are major stakeholders because their professional reputations are on the line. The accountants have an ethical responsibility to exercise due care in their review of Sito's financials and should not compromise their integrity by giving in to the pressure Sam Proctor is likely to apply.
Sheri Landon, Sito's accounting manager, and Mr. Kirkpatrick, the company's outside accountant, are stakeholders. It appears that they may have gone along with Sam Proctor's scheme to hide income from the Canadian government. Their integrity is on the line and, if either one holds a professional certification such as CPA, CMA or CIA, he or she may be violating professional ethics for failure to cooperate with Gloria and BSU.
Tsingto Enterprises also may be affected by whatever decision BSU makes since Tsingto made the questionable payments that might be exposed. Also, the entity's future relationship with Sito hangs in the balance.
The Canadian government is a stakeholder. It appears that the government is not receiving its fair share of tax payments from Sito.
Ethical Issues
American Artifacts has a right to receive accurate and reliable information about Sito before completing its purchase. Gloria and BSU have an ethical obligation to ensure that the client receives all the information necessary to decide whether it wants to proceed with the acquisition. American Artifacts should be concerned about Proctor's honesty. He appears to be rationalizing his decision to evade taxes. If Proctor believes tax rates are unfair, then he should relocate Sito to a lower-taxing jurisdiction.
American Artifacts also should be concerned about Sito's control environment. Gloria's audit team appears to have already identified two improprieties--the Swiss bank account and the overstated perpetual inventory records. Sito's internal control system should have detected the fraud and corrected the records. It is quite possible that Proctor overrode the controls and pressured Landon to go along with the scheme. If it happened once it may occur again, and American Artifacts' investment in Sito might be further jeopardized.
Gloria and BSU are obligated to uphold the ethical standards of the accounting profession. To meet their ethical responsibilities, the auditors must carefully investigate the Swiss bank account and two sets of perpetual inventory records and advise American Artifacts whether their findings should affect the company's planned purchase of Sito.
The auditors should know that if American Artifacts acquires Sito and Sito engages in improper transactions with Tsingto, then American Artifacts would be liable for those transactions. Moreover, any improper payments made to Tsingto (for example, to government officials in China) could place Sito and American Artifacts in violation of the Foreign Corrupt Practices Act.
Sheri Landon's job may be on the line since she provided Gloria with documentation of the Swiss bank account. Nevertheless, Sheri did the right thing. External auditors should be able to rely on the honesty and integrity of their clients' internal accountants and auditors to assist in carrying out their professional responsibilities.
Whatever advice Gloria and BSU give to the management of American Artifacts is likely to affect Tsingto's relationship with Sito and the Canadian government. Therefore, the auditors should carefully evaluate the consequences of their actions on these and the other stakeholders.
Decision
Gloria is scheduled to meet with Kirkpatrick the next day to discuss the accounting issues. The attorneys for American Artifacts are looking into the how these issues may affect the purchase. McCarr asked Gloria to wrap up the fieldwork by the end of the week. He hopes to complete the due diligence review the following week.
The alternatives available to Gloria should not depend on Kirkpatrick's explanation for the accounting improprieties. She should not allow herself to be pressured by Kirkpatrick or McCarr to overlook these matters. There can be no adequate reason for a legitimate company either to maintain a Swiss bank account that contains cash payments from a supplier or create a second set of perpetual records that inflates inventory numbers.
Gloria should insist that the firm's findings be fully disclosed to the American Artifacts' management, with a recommendation that it not become involved with Sito because such a relationship could create unjustified business and legal risks for American Artifacts.
Ida R. Backmon, PhD, CPA, Associate Professor, Accounting, University of Baltimore
Betty L. Brewer, DBA, CFP, Associate Professor of Finance, North Carolina A&T State University
"Ethically, it would seem that Gloria must assure herself that the authorities are properly notified, which will be very difficult for a young auditor to do without career consequences".Gloria Scheps, the senior auditor, appears to have carried out the due diligence investigation in a thorough and responsible manner. She clearly has identified the tax avoidance issues. Generally accepted accounting principles (GAAP) provide leeway to managers to make choices that will affect their earnings. However, in Sito's case, it seems that the earnings management is inappropriate because it involves fraudulent avoidance of tax liability. Ms. Scheps has kept her supervisor advised of all relevant information. He has informed her that the potential acquirer knows that Sito has used tax avoidance methods. Now Ms. Scheps has arranged a meeting with Sito's CPA.
The primary issue in this case is the consequences forthcoming once the Canadian authorities become aware of the tax avoidance practices. This discovery will raise ethical questions about the auditor's role. Tax avoidance practices affect Sito's potential value to American Artifacts. It can be argued that Sito's value, ignoring the legal ramifications of tax avoidance, is much higher than the accounting records indicate. However, fraudulent tax avoidance creates the possibility of significant penalties for Mr. Proctor. Is it enough for Ms. Scheps to identify the problem and communicate it to American Artifacts and Sito, letting them work out the effects on the Sito's value? Does she have ethical and/or legal responsibility to ensure that the Canadian authorities are informed, or does the responsibility lie with American Artifacts or her employer, Broderick, Samuels and Underhill?
Gloria should consider her future and the consequences of any unprofessional behavior. The American Institute of CPAs sets forth rules that its members must adhere to, including having integrity, adhering to GAAP, and avoiding "acts discreditable" to the profession. In essence, any professionally certified member who had knowledge of fraudulent activities and does nothing violates the code of conduct. A certified member committing such acts would face disciplinary action, including suspension or loss of their license to practice. [AICPA Note: See AICPA Code of Conduct Rule 501 - A member shall not commit an act discreditable to the profession; Interpretation 501-4b-A member shall be considered to have committed an act discreditable to the profession in violation of rule 501when, by virtue of his or her negligence, such member fails to correct an entity's financial statements that are materially false and misleading when the member has the authority to record an entry; and Interpretation, under Rule 102-Integrity and Objectivity, 102-3-Obligations of a member to his or her employer's external accountant. Under rule 102, a member must maintain objectivity and integrity in the performance of a professional service. In dealing with his or her employer's external accountant, a member must be candid and not knowingly misrepresent facts or knowingly fail to disclose material facts. This would include, for example, responding to specific inquiries for which his or her employer's external accountant requests written representation.] Ethically, it would seem that Gloria must assure herself that the authorities are properly notified, which will be very difficult for a young auditor to do without career consequences. Life is not fair and Ms. Scheps is learning that lesson right now.
Joanne O'Rourke Hindman, President and Chief Executive Officer of Roundtable Advisors, Inc.
"It is too late to apply the typical "trust but verify" standard, since trust is no longer an option for Gloria when dealing with either the owner or the outside accountant".Gloria Scheps certainly has all the right instincts. What seems to be the key question here is whether Sito is using legitimate tax avoidance methods or whether the company really is caught up in illegal tax evasion schemes. Taking into account the reactions of the accounting manager and the outside accountant when Gloria questioned them about the inventory listing discrepancies, the latter certainly seems likely. However, the situation seems to be even more serious than just tax avoidance issues. More disturbing is the fact that company assets were excluded from the balance sheet of the "reviewed" statements. That is certainly an indication that Gloria is dealing with an unethical owner, as well as an unethical outside accountant. Given that fact, it is possible that there are even more issues that she will not have an opportunity to uncover given her time constraints.
In performing effective due diligence reviews--as well as effective audits--the auditor is relying on the honesty of the company's management and its outside advisers. Once an auditor realizes that information has been intentionally withheld or is misleading, the audit risks increase dramatically. Full disclosure by management is the key to an effective review and/or audit, and Gloria has already documented that Sito does not believe in that approach.
Somewhat counterbalancing Gloria's concerns is the fact that the audit manager has suggested that the owner is merely taking some "very aggressive tax positions." Still, if that were the case, why would Sam be "forthright" only after he was confronted with the information? If he had nothing to hide, why wouldn't he have shared the information with Gloria right away rather than wait until the auditors found the documentation? While the audit manager may be anxious to get the due diligence review done quickly, nothing should be concluded until Gloria has had an opportunity to meet with the outside accountant, Mr. Kirkpatrick. Even a very aggressive tax position would not explain why a company bank account does not show up on a balance sheet that has been reviewed by an outside accountant. There is obviously more to this story that needs to be ferreted out and Gloria should continue her due diligence with a very skeptical attitude. It is too late to apply the typical "trust but verify" standard, since trust is no longer an option for Gloria when dealing with either the owner or the outside accountant.
That said, given what she has discovered so far, Gloria's responsibility to her client is to try to identify the extent of the activity and the amounts involved. She also needs to ask the company and the outside accountant to revise the financial statements, as appropriate. If Gloria determines that the tax avoidance schemes were illegal, she should then notify the company that the taxing authorities should be--and will be--contacted. If the identified issues can be satisfactorily resolved, then American Artifacts may still want to purchase Sito, provided the purchase agreement contains provisions to allow for the additional tax exposure. Either way, Gloria has done an excellent job of protecting her client in performing her due diligence review.
Commentaries: Failure to Disclose Significant Information to Improve the Financial Picture of the Organization to the Outside
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—Good Works, Bad Accounting?
Commentaries by:
- Steven M. Mintz, PhD, Professor of Accounting, California State University, San Bernardino
- Susan M. Hinds, CPA, MBA, Business Analysis, Corporate Strategy Division, Toyota Motor Mfg. North America
- Joanne
O'Rourke Hindman,
President and Chief Executive Officer of Roundtable
Advisors, Inc.
Steven M. Mintz, PhD, Professor of Accounting, California State University, San Bernardino
"If Jill gives in to Pinero's pressure, she would be participating in a scheme to manage the charity's unrestricted cash position and its earnings".Executive Summary
Jill Lassiter, the newly appointed executive director of Good Works for Women, a charity that provides childcare and job search support for single mothers, faces an ethical dilemma about whether to revise estimated allocations of management and general expenses to free up some of the surplus in a restricted fund to make the charity's unrestricted cash position look better and to improve income. Charlene Pinero, a board member and frequent contributor to the charity, pressures Jill to make the adjustment. Without it, the charity may not receive a scheduled donation from Lyndelle Oakes. Oakes is anxious to make her quarterly donation but first her accountant has to review Good Works' financial statements.
Stakeholders and Interests
Good Works is a major stakeholder since its future existence depends on Oakes' continued financial support. Oakes may not make her quarterly contribution unless the financials are adjusted to free up unrestricted cash.
If Oakes finds out that Good Works used her funds for activities other than the childcare program for which they were designated, then she can stop all donations and ask for a return of any prior donations that were used for unauthorized purposes. That action would likely ruin Good Works.
Oakes relies on Good Works' honesty and integrity to use her donation only for the purpose to which it has been restricted. If Oakes finds out that the charity used the money to cover other expenses, she could bring a lawsuit against the charity for violating its contractual agreement with her.
Jill Lassiter is a major stakeholder since she is being asked by a member of the board, Charlene Pinero, to make an improper adjustment to the allocated estimated expenses so that Good Works' unrestricted cash position and income look better than they really should. Charlene Pinero has devoted a great deal of her time and money to the charity. She has a personal stake in the outcome of Jill's decision.
If Jill gives in to Pinero's pressure, she would be participating in a scheme to manage the charity's unrestricted cash position and its earnings. The management of earnings is unethical since it makes earnings look the way top organization officials want them to look, rather than the way they should be rendered according to proper accounting standards.
Ethical Issues
Some managers might apply a cost-benefit analysis approach (utilitarianism) to evaluate the ethical issues facing Jill Lassiter. Good Works provides a needed service to women who depend on the charity's financial and training support to find employment. If Good Works and the women it helps do not receive continued funding from Lyndelle Oakes, the cost will be the likely end of this important community service. The benefit of receiving Oakes' funding is that Good Works can continue servicing its clients.
From a utilitarian perspective, Jill might weigh the potential costs to Good Works of manipulating financial statement numbers to receive the additional funding against the benefits of continuing to support single women. However, Jill should not forget that the charity opens itself to a potential lawsuit if Oakes finds out about the reallocation of expenses. Moreover, Jill may jeopardize her reputation and be a target of the lawsuit.
Pinero argues that Good Works would be in technical compliance with the legal terms of the contract with Oakes since her donated funds can be spent on any aspect of the childcare program, including being used to absorb a larger amount of management and general expenses. Jill is concerned about revising the budget and securing board approval, but Pinero tells her that it's acceptable to revise estimates. "We're not misappropriating funds or anything else, and we can reverse course easily, when we choose," she says.
For Jill, an important point to consider is that legal compliance is a minimum standard of ethical behavior. Ethical decision makers go beyond mere compliance with laws and regulations, especially when those laws and regulations are unclear about the right thing to do. Jill would be violating her fiduciary responsibilities to a major donor if she reallocated expenses to manage the unrestricted cash position and earnings in a way that misleads Oakes into thinking the charity has performed better than it really has.
Decision
Regardless of the possible utilitarian benefits of managing financial results to secure needed donations, Jill's decision should emphasize the rights of the stakeholders. Oakes relies on the accuracy of the charity's financial statements to provide evidence that her funds are being used for designated purposes and not to fund reallocated expenses from other activities. Good Works' reputation could be irreparably harmed if it becomes known that the charity's financials have been manipulated to secure continued funding from Oakes.
Jill's own integrity may hang in the balance since other charities are not likely to hire her if it becomes known that she carried out Pinero's request to manage earnings. Such an action deceives the board of directors and lacks honesty, integrity, trustworthiness and due care in carrying out one's professional responsibilities.
Susan M. Hinds, CPA, MBA, Business Analysis, Corporate Strategy Division, Toyota Motor Mfg. North America
"We must consider whether Good Works is no longer a sustainable business model that will generate sufficient income to support its goals and objectives"Why waste time--let's get right to the critical issue: What action should Jill take? Should she either alter the estimates, thus saving the donation, or provide an honest disclosure that may be disastrous to the organization's future financial health? This case has many stakeholders at risk and the proper use of corporate resources is the center point.
What Is the Issue?
The use of corporate resources involves fulfilling the employer-employee "contract." It means being truthful with your employer, management and shareholders. It means providing honest information and taking the necessary actions to enable the organization to minimize its risk or improve profits.
Employees sometimes face situations in which a CFO says, "These numbers aren't meeting expectations. Let's adjust them to satisfy senior management." Some CFOs feel it necessary to put a positive spin on financials before submitting them up through the ranks. As a result, companies have suffered serious financial penalties because their numbers no longer reflected reality (WorldCom is an example). "Fudging" numbers can have serious consequences, since senior management may make crucial decisions based on flawed data. Typically, anyone asked to skew any kind of corporate information is best advised to consult with someone outside the direct chain of command, such as the legal department, human resources or internal audit.
In Jill's case, although she feels obligated to Good Works and the many women who depend on its success, she must realize honesty is the best policy. She may want to carefully examine the reasonableness of the accounting estimates and, if they are in fact inaccurate, then make necessary corrections in compliance with GAAP. She must not feel personally responsible for the success of Good Works. Her true role is to provide honest and accurate information to all stakeholders, and that is what she must do. There is no compromising the truth.
The Long-Term Consequences
In this case, there is tremendous pressure to do the wrong thing for the right reasons. However, good ethical principles will guide you to the correct decision: to tell the truth no matter how painful it is.
We must consider whether Good Works is no longer a sustainable business model that will generate sufficient income to support its goals and objectives. Failure to provide truthful information is criminal, and the fact that decisions are being made based on faulty information leads to trouble. This has tremendous costs and has led many good organizations into bankruptcy, with innocent people's lives and dreams being crushed in the process. Unemployment, stress, crime and hopelessness increases as these employees fight for survival in tough economic times.
A Simple Conclusion
The conclusion should be simple for Jill: Tell the truth. Of course, this is not an acceptable response for Charly. Jill must take care to try to preserve her relationships with other involved in Good Works while also standing firm on her decision not to skew the numbers. Jill would be wise to contact legal counsel to discuss alternatives. She should remember that those who violate a trust by being dishonest in their information face consequences that may even include serving prison time for their unethical/criminal behavior.
Joanne O'Rourke Hindman, President and Chief Executive Officer of Roundtable Advisors, Inc.
"Before even addressing the accounting issues, Jill should take a few moments to ponder some of the red flags that she has witnessed during her short two-week tenure and start to consider whether there could be a governance issue at Good Works for Women".Jill Lassiter is certainly facing quite a dilemma. Without the funding promised by Lyndelle Oakes, Good Works for Woman is most likely destined to close its doors, but Jill's course of action is far from clear. Deciphering right from wrong gets particularly difficult in circumstances like this one because the end seems to justify the means. What could be more benevolent than providing assistance to single mothers? Isn't that reason enough to ensure that the organization doesn't fail--particularly when the problem would be so easy to fix with a minor change in a simple accounting estimate? After all, it is not unusual or improper to periodically analyze overhead allocation percentages and re-evaluate their appropriateness. Allocating overhead has always been somewhat of a guessing game. Even with sophisticated time-keeping methodologies, there is a certain art to determining the appropriate "charge" for each line of business. This is where it becomes difficult to know what to do because the answer is engulfed in that infamous shade of gray. The key issue here, however, is not whether it is inappropriate to adjust overhead allocation rates but, rather, what is the motivation behind the timing of such a "change in estimate"?
Before even addressing the accounting issues, Jill should take a few moments to ponder some of the red flags that she has witnessed during her short two-week tenure and start to consider whether there could be a governance issue at Good Works for Women. For example, it is never appropriate for a board member to recommend accounting tricks under any circumstance and, while there is no doubt that Charly's heart is in the right place--as evidenced by her willingness to contribute both her time and money--she is obviously demonstrating poor judgment by suggesting that Jill fix the accounting problem until the organization can get back on track. In addition, when the last executive director resigned, the board was slow to begin the search for a replacement. Worse yet, during that time, the organization apparently limped along without any leadership, which is most likely why contributions are down and expenditures are up. More upsetting, however, is the fact that the board allowed the organization to miss critical financial reporting deadlines with its primary donor, Lynette Oakes, when its very existence depended on her contributions. Because of the board's apparent lack of leadership, Jill is facing a very frustrated donor as well as an unreasonable time constraint. Considering these facts, Jill should be very concerned about the tone at the top that the board is setting. It is clear that the situation grew worse because of poor governance and it is now up to Jill to correct the ship's course. To do that, she has to demand that the organization operate at a level of integrity beyond reproach. Ironically, this crisis is the perfect opportunity for Jill to let the board know that she intends to operate at that higher level.
Turning back to the accounting issues, the real problem here is that the organization has not complied with the donor's agreement, both in terms of timely financial statement submissions and in overspending on administration. Jill's first task should be to finalize the quarterly statements and then use them in the way that financial statements were meant to be used: to analyze the organization's operating results. Why were the administrative expenses more than expected? If the overspending is merely a result of the lack of leadership while the board searched for the new executive director, then reducing the spending level to comply with the Oakes funding agreement may be fairly straightforward. If, however, the overspending is the result of more complex problems with the organization's structure and operating approach, then Jill needs to develop a plan to adjust the way in which the organization does business. Once Jill has determined the appropriate approach, she should review her findings with the board and obtain approval to proceed with her proposed plan of action.
Jill should then set up a meeting with Oakes to personally deliver the financial statements and review the results in detail, explaining the variances and presenting the action plan to improve on past performances. Open, honest and full disclosure is the key to retaining Oakes' commitment to the organization. Oakes is clearly dedicated to the cause and wants to help. Her complaints and frustration were caused by the lack of timely financial information, not by the organization's accomplishments. Good Works for Women's future depends on Oakes' generosity, which would certainly cease the moment she discovered that she had been temporarily fooled by misleading or incomplete information. Jill's candor will reassure Oakes that she can now be certain that her donations are being spent appropriately. In short, Jill must set the correct tone at the top--one of open, honest disclosure--because that is the only way to ensure that help for single mothers will be available for a long time to come.
Commentaries: Multi-Element Revenue Recognition and Creating Reserves
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—Conservative Recognition Or Cookie Jar Reserves?
Commentaries by:
- Michael A. Santoro, Assistant Professor at the Rutgers Business School
- Elizabeth Sanders, Proprietor, E. A. Sanders, CPA
- Robert
O'Connor,
President and CEO, Softrax Corporation
Michael A. Santoro, Assistant Professor at the Rutgers Business School.
"If there is one thing we have learned in the post-Enron world, it is that CEOs can no longer claim that they don't understand their company's accounting methods".Kudos to young Nick for having the courage and savvy to raise a legitimate accounting question to the highest levels of the company. Of course, it doesn't hurt that his Aunt Amelia runs the company (presumably with the title, as well as power, of the chief executive officer). Realistically, it might be harder for a young person just out of college to get the kind of attention for an accounting issue that Nick has gotten at O'Brian. This is too bad because every company, even those run efficiently and honestly, could use a good test of its ethical systems now and then.
The good news is that in this organization, when a young person--admittedly one related to the boss--questions the company's ethical practices he is taken seriously. Both Lee and Aunt Amelia heard Nick out thoroughly and responded to his concerns forthrightly. Regardless of how this problem is resolved, Nick has learned that he can speak up when something is bothering him. The more experienced executives in the company seem comfortable when they are challenged. Lee doesn't agree ultimately with Nick's conclusions, but he is willing to defend his actions when challenged. There is, moreover, a functioning audit committee and an independent board of directors that would appear to act as a check on management.
Nick's assertions that (1) "in effect" the company was understating in good times and thereby building artificial reserves for lean times; and that (2) this practice is misleading investors are certainly issues that ought to be taken up by the audit committee. The fact that the BrainWave launch is imminent is irrelevant. Ironically, what makes this a perfect issue for the audit committee is precisely the fact that Aunt Amelia doesn't have an opinion about it. She is, in fact, wrong to put Nick in the position of deciding whether or not it should go to the audit committee. Nick has done her a favor by calling the possible problem to her attention, but she knows enough about the nature of the issues to make her own judgment about whether they should go to the committee. Clearly it should, because she is unsure herself about the propriety of the current accounting methods.
Indeed, one potential ethical problem within this company is Aunt Amelia's professed lack of knowledge about accounting. If there is one thing we have learned in the post-Enron world, it is that CEOs can no longer claim that they don't understand their company's accounting methods. Indeed, new federal legislation requires the CEO to sign and acknowledge personal responsibility for the company's financial statements. Aunt Amelia clearly needs to devote more attention to this aspect of her business or else turn over the CEO duties to someone who will exercise appropriate oversight over O'Brian's accounting practices.
Presented with the issue, the audit committee may or may not agree with Nick. Lee will have a chance to defend his accounting methods. He will be able to show whether relevant accounting rules allow the company discretion to present the deferred revenue as it has done in the past. Certainly the fact that the company has three years of public operating experience without any apparent surprises for investors is encouraging. That suggests that the way the company is providing information may not, as Nick fears, be misleading to investors. The audit committee can make a judgment about the practice and, if necessary, seek the advice of the company's independent auditors. All in all, what we are witnessing in this case is how the corporate governance system works when it is working well. Even if it turns out Nick's concerns about the company's accounting don't require restatement of the financials, Nick is still to be commended for giving the company a chance to check its corporate governance systems. Even honest people can sometimes make ethical mistakes. Good corporate governance systems can help catch those mistakes, and invoking the duties of an audit committee should not be viewed as impugning the character or honesty of corporate officers.
Elizabeth Sanders, Proprietor, E. A. Sanders, CPA
"Using conservatism to build reserves for hard times misstates income during a particular period and would mislead users of financial statements".Are the financial statements of O'Brian Software deceptive? Facts to consider:
- Aunt Amelia O'Brian has no accounting expertise and is interested in meeting projections and keeping the Wall Street analysts happy.
- Aunt Amelia is perceived to be honest by the family.
- The majority of the stock is owned by the family.
- O'Brian Software went public three years ago and has received a clean opinion from the outside auditors for each accounting year.
- Accounting controls are considered effective.
- Chief financial officer Lee Marchetti is perceived to be honest and has many years of financial experience.
- Marchetti was involved
in the initial public offering.
In most cases, it is a good thing to be conservative in the recognition of revenue. Conservatism is part of the foundation of the accounting profession. However, using conservatism to build reserves for hard times misstates income during a particular period and would mislead users of financial statements.
To determine if Marchetti is being overly conservative, Nick should examine what is included in deferred revenue. He should determine if the numbers currently included in the balance sheet are realistic. In reviewing the numbers in the deferred accountings on the balance sheet, Nick should review software agreements with customers.
Normally in software agreements, a customer pays a fee to use software for a predetermined period (for example, one to three years). When the sale occurs, recognition in the financials would include entries to receivables and deferred revenue. Revenue would then be recognized during the financial statement period when the agreement is in effect, with entries between deferred revenue and revenue. Nick should determine if deferred revenue accounts include dollars that apply to expired agreements. If that is the case, Marchetti is using conservatism to smooth revenue and misstating revenue for a particular period. This would create misleading and deceptive financial statements. The Wall Street analysts may be happy with the constant growth, but this is not realistic. Unfortunately, the analysts' influence may encourage such behavior.
Depending on what Nick's analysis of the deferred accounts determines, the launch of new product may have to be delayed. If Nick determines that amounts in the deferred accounts apply to expired agreements and are materially overstated (a judgment call), he should recommend to Aunt Amelia that she notify the audit committee. If the audit committee does not take a positive position to make adjustments to the prior financial statements, Nick may have to notify the Securities and Exchange Commission.
Robert O'Connor, President and CEO, Softrax Corporation
"The burden of executive management does not fall to him, and neither can he expect to abruptly change the way the company runs because he has a suspicion".Smoothing revenue is as illegal as any other revenue manipulation. Fundamental fiduciary responsibility requires that full financial disclosure must occur, and knowingly reporting inaccurate revenue is both unethical and illegal. But is that what's really happening here? Nick knows just enough to suspect a real problem but not enough to definitely determine its existence on his own. The complex multi-element contracts prevalent in the software industry are easy to mishandle from a revenue allocation and reporting perspective. Is there an error in the current internal controls, or is there intentional manipulation?
It would appear that a change in revenue recognition accounting procedures must be made. The upcoming product launch cannot and should not impede that change. It must be disclosed, regardless of the timing. For a publicly traded company, the legal obligation is as strong as the moral imperative. But the chief financial officer's resistance to questions about his accounting judgment is quite strong, and Nick cannot force a change. Neither should he attempt to without understanding if, in truth, revenue is being smoothed. Does Nick understand the full parameters of the guidance at play? Does he know where interpretation can vary, and where the regulations are crystal clear? He needs to learn more.
My recommendation to Nick is that he should begin by documenting his concerns in a memo that he does not yet distribute. If he goes to the audit committee, external auditors or the Securities and Exchange Commission, he needs to have his facts and timeline in order. He must set about increasing his knowledge of the regulations, getting outside opinions and receiving training from the CFO to understand how the business runs. Then he needs to look at the financial statements again.
After this due diligence, if Nick is convinced that Lee is underreporting revenues and, in effect, cooking the books, he must present that assertion in writing to his aunt. Together they can decide what to do. But the burden of executive management does not fall to him, and neither can he expect to abruptly change the way the company runs because he has a suspicion. If he has documented concerns and evidence, then real change must be brought about. The key to a successful resolution will be Nick's willingness to do his homework and to involve his aunt.
Commentaries: Revenue Recognition—Multi Elements
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—Accounting & Ethical Issues at Walax
Commentaries by:
- David Messick, Director, Ford Motor Company Center for Global Citizenship at the Kellogg Graduate School of Management at Northwestern University
- Joanne O'Rourke Hindman, President and Chief Executive Officer of Roundtable Advisors, Inc.
- Robert O'Connor, President and CEO, Softrax Corporation
- Rushworth M. Kidder, Founder and President of the
Institute for Global Ethics
David Messick, Director, Ford Motor Company Center for Global Citizenship at the Kellogg Graduate School of Management at Northwestern University
"She is obligated to decline to perform any task that she knows is dishonest, illegal or unethical, but she should also clearly explain her refusal to her boss".Kate, a relative newcomer to Walax, is being asked to work on a project that involves adjustments to lease valuations, about which she (like this author) knows relatively little. Hence, she has few resources on which she can rely-including the social network that a relative veteran might have or the expertise that would derive from having worked on similar projects in the past. She begins to get the impression, starting with her conversation with Beth, that the revenue and profit associated with the leases are being accelerated to meet financial analysts' earnings expectations. She appears to understand how this type of process encumbers the future and creates an escalating cycle. This realization makes her nervous, as it should. She discovers that Walax switched its accounting standards to a "return on assets" (ROA) approach, whatever that may mean, but that the company failed to inform the Wall Street watchers of the switch, an omission that may cause Wall Street to misconstrue the revenues and profits being reported. She also learns that some of the employees are uncomfortable with the accounting standards being used and that one person, Brian Elkins, reportedly was fired because he disagreed with Walax accounting practices. She is also told that the previous auditors were fired for refusing to endorse the financial report.
Things get more complicated when she is asked to prepare some footnotes for an annual report and discovers that there had been irregularities at a European subsidiary that led to the termination of some managers, as well as inappropriate accounting for some leases in South America. Yet her boss assures her that everything is acceptable. What should she believe? The problem becomes even more challenging when she hears about a memo that purportedly indicates that the ROA approach was used to close the earnings gap. This memo might prove to be a "smoking gun" if it truly does describe and endorse the use of accounting gimmicks to stroke the numbers being reported to Wall Street. Although she never sees the memo, she does learn that there are lawsuits and unhappy shareholders who contend that there have been harmful irregularities.
Kate's challenge is twofold: Whom to believe and whom to obey. Nearly everything she has learned is hearsay. At the worst, this might be a corporate conspiracy to commit and conceal accounting fraud (with Edward's collusion), and she is being set up and lied to by her bosses. If this is true she, along with others, is in a serious and vulnerable position and her best strategy would be to get out and blow the whistle. But it is also possible that her bosses are telling the truth, and that the suspicions and reservations voiced by other employees are rooted in unknown grievances. In this case, she should perform the tasks that she is given by her managers to the best of her ability. She is obligated to decline to perform any task that she knows is dishonest, illegal or unethical, but she should also clearly explain her refusal to her boss. We owe others, including our bosses, the presumption of honesty and integrity until we have clear grounds to conclude that they are dishonest or lack integrity. Kate owes her bosses her best efforts (as long as she is accepting their paychecks). At the same time, she has a broader obligation to be mindful and vigilant of the allegations and insinuations that have been directed against the corporation. She should know that if the rumored memo materializes, it will be assumed she knew about it and the illegal practices it describes. Critics will assert that employees should have known of the practices because there was evidence of these irregularities scattered about the company. If Kate accepts this risk, she should continue to do her job to the best of her ability; if she cannot accept this risk, she should leave Walax. If she has contacts within the Securities and Exchange Commission or Financial Accounting Standards Board, which would be unlikely for a junior person, she could leak information to seek an external assessment of the situation. But as a novice and a newcomer to Walax, she is relatively uninformed and vulnerable.
Joanne O'Rourke Hindman, President and Chief Executive Officer of Roundtable Advisors, Inc.
"Notably, the Sarbanes-Oxley Act of 2002 addresses many of the issues that Kate has uncovered at Walax. For example, the chief executive officer and the chief financial officer sign a statement certifying that the financial statements are in accordance with generally accepted accounting principles (GAAP) and provide adequate disclosures. There are criminal penalties of up to 20 years' imprisonment if they knowingly sign a false statement".This is a fairly complicated case in that there are so many pieces to the puzzle. Not only is Kate dealing with numerous accounting issues, but she has also discovered that the company's governance structure may not necessarily provide an environment for effective oversight. In addition, Kate is unraveling a long history of earnings management, which at first may have appeared to be merely "thinking outside of the box," but which has definitely escalated into something much more egregious. On top of all that, one person has already been terminated for voicing his concerns that earnings were being manipulated. The ultimate question is what should Kate do with all this knowledge, particularly since she reports directly to the one who seems to be a major source of the problems--the chief financial officer?
Notably, the Sarbanes-Oxley Act of 2002 addresses many of the issues that Kate has uncovered at Walax. For example, starting with the financial statements, not only does the Act require that all company senior financial officers comply with a code of ethics, but it also mandates that the chief executive officer and the chief financial officer sign a statement certifying that the financial statements are in accordance with generally accepted accounting principles (GAAP) and provide adequate disclosures. There are criminal penalties of up to 20 years' imprisonment if they knowingly sign a false statement. The Act further requires that the audit committee set up whistleblower protection procedures, which would have provided Brian Elkins with a confidential way to express his concerns. Furthermore, the Act specifically places responsibility for hiring the external auditors with the audit committee, which may have prevented Walax's termination of the previous auditors because of accounting disagreements. With regard to director independence, it is now a requirement that the audit committee consist of independent members only. Finally, Kate's concern about the audit committee's lack of expertise would now have to be disclosed in the company's Securities and Exchange Commission filings. The company would have to state in those filings that no one serving on the audit committee was a "financial expert."
However, many of the Act's provisions are still being implemented and are, therefore, not immediately helpful to Kate. She is obviously in a difficult position since she is questioning the ethics of her direct supervisor, the CFO, and there were repercussions for a previous naysayer. Since she has already had numerous conversations with the CFO, it is probably time for Kate to address her concerns by sending him a written memorandum. Furthermore, because the CFO's previous responses to her questions have not been productive, it is likely that Kate will also need to provide a copy of her memorandum to the internal auditors, the external auditors and/or the audit committee, as appropriate, with the essential goal being to alert the audit committee. Once the audit committee is informed of the concerns, it then becomes their responsibility to respond accordingly by taking corrective action. Obviously, this task will not be easy, but, because of the extent of the problems, Kate really has no choice except to reveal her findings to those with ultimate responsibility to the shareholders to provide financial statements that are prepared in accordance with GAAP.
At the heart of this issue, however, is something that is not easily fixed. The problem is a fundamental flaw in investor expectations. In today's environment, if a company does not meet the analysts' earnings expectations, then the stock price gets hammered. This forces the management team to focus on managing expectations; that is, in essence, managing the stock price rather than managing the business. Meeting analysts' expectations becomes the crucial goal for financial officers rather than accounting for the business operations. It creates extreme pressure to stretch the limits of the standards while remaining within the boundaries of GAAP. Stretching the rules over and over again tends to distort right from wrong until the financial reporting is so far out of line that the company can't turn back. Notably, Coca Cola Company's recent decision to stop providing guidance to analysts is a big step in the right direction. Instead, Coca Cola intends to provide investors with a perspective on the company's value drivers, its strategic initiatives and factors critical to understanding the business. In their own words, "...providing short-term guidance prevents a more meaningful focus on the long-term strategic approaches...[and we want to manage] the business for the long-term." One thing is certain-as the system currently works, there is more reward for meeting the numbers than running the business, and that environment is a breeding ground for earnings manipulation. In the long run, that approach can't be good for any of us.
Robert O'Connor, President and CEO, Softrax Corporation
"Since passage of the Sarbanes-Oxley Act, those who act as whistleblowers are protected. Can Kate rely on that safety net and aggressively go after the source of the suspect methods being applied?"Kate is correct in believing that the ROA lease accounting approach Walax employs is suspect and needs to be changed. Everything described in this case leads to the conclusion that unethical and in some cases illegal, practices are being used, and that Walax is manipulating revenue by taking advantage of the existence of its multiple business units and numerous Profit & Loss Statements to artificially assign or report revenue among them.
Since passage of the Sarbanes-Oxley Act, those who act as whistleblowers are protected. Can Kate rely on that safety net and aggressively go after the source of the suspect methods being applied? The problem is obviously at the top, where there is an emphasis on manipulating the stock price through earnings trends and "accelerated revenues." Kate doesn't have access to or hold sway with that echelon of employees. And the extent of her fiduciary responsibilities does not enable her to enact large-scale change on her own.
Her focus should be what increased corporate governance will mean for Walax. Will this mess get cleaned up? Will the problem take care of itself? Kate cannot crusade for correction completely by herself. From an ethical standpoint, she should be commended for her desire to be proactive on the company's behalf. But the problem is a serious breach of responsibility to shareholders and needs to be urgently addressed by the audit committee, at a minimum. Kate's only choice is to document her concerns as thoroughly as possible, and if she is convinced she has uncovered illegal activity, to take her findings to them.
Sarbanes-Oxley will potentially create several significant opportunities for Kate to promote change while not allowing more adroit concealment of the accounting infractions. Most corporations are now facing the reality of widespread staff education at multiple levels to enhance compliance with Sarbanes-Oxley's many mandates. With that education comes the ability to identify and potentially rectify actions that conflict with the act's mandates. Kate will soon be in good company, and she can help jump-start reform by becoming as involved as possible in internal committees, task forces, training sessions and corporate communication opportunities.
Rushworth M. Kidder, Founder and President of the Institute for Global Ethics
Challenge: What would you do in Kate's situation? What might the company do in order to reduce tensions among employees such as Kate and Beth and help ensure that the kinds of conflicts identified in the case are not likely to occur in the future?What's a nice accountant like Kate doing in a place like this? All the real danger signals for an honest employee are flashing like the neon on Broadway! Management loses casually worded memos intended to encourage "creative accounting." Accounting policy decisions are made behind closed doors and seem directly aimed at raising share price rather than accurately depicting performance. Employees who challenge truly questionable practices are fired.
Kate really has three choices. She can look for another job-pronto--and this time pay a little more attention to her due diligence. She can do what she's told, keep out of sight and hope that everything pulls together in a positive future. Or, she can resist the company's efforts to sidetrack her questions about curious accounting procedures that seem to inflate the company's performance.
If she takes the third course-the tough one-she might start by having a long conversation with the fired accountant Brian Elkins to determine his findings and his position. Then she might continue her investigation to completely understand all the facts and the implications about the change in ROA and the affected lease valuations over the years, ending with two complete-and different-pictures of financial performance. Moving on, she might discover other areas where people have used the best possible outcomes-pictures of hopefulness, not reality-to create an unrealistic image of the company and its future.
With documentation of the changes in accounting practices and the resulting positive impact, Kate might be in a position to talk off line with a sympathetic board member, preferably one on the audit committee. Unfortunately, accounting management seems comfortable with what is going on, even endorsing the changes and the lack of transparency. No matter how she chooses to reveal her doubts, Kate is putting her job and maybe her career on the line, and she knows it.
There are two possible resources available to Kate that might offer good counsel and some confidentiality. One is her professional association, which has probably addressed such matters before and might be able to direct her to a listening post where she can tell her story and receive guidance about what to do. The other is the corporate ethics officer, who may be in a position and may have the clout-the ear of the audit committee-to do something about her concern while keeping her protected. Corporate accounting is such an important issue these days, not only because it can inspire or destroy investor trust but also because it has attracted the interest of government regulatory bodies. Someone in Kate's company should want to diminish the risk of wrongdoing or, just as important, the appearance of wrongdoing.
What Should the Company Do?
Just as athletic games are best won on the field and not on the scoreboard (a thinly disguised reference to the inefficiency of cheating), business should be successful in the marketplace. Market success and good management will drive investment and growth. Shuffling the numbers only delays the inevitable. Poor products, bad distribution, ineffective marketing and lackluster management will finally kill the company in spite of the accountants' best (or worst) schemes.
This company should start by revealing to investors that changes in accounting practices for valuing leases have been in place for several years. At first, the impact on reporting was minor, but now it has reached a point where investors need to understand the change and the practical and positive reasons for making the change.
Second, the company needs to stop encouraging creative accounting. All units need to agree on and adopt reasonable standards they would be confident to share with the outside world. Transparency is coming and they will be well served by leading rather than following.
Next, management needs to explain procedures and changes in procedure to the employees who will be called on to implement the changes. Inviting comment may reveal problems or discrepancies. Frontline employees, especially trained professionals such as accountants with auditing experience, benefit the decision-making process. It's not enough, even for a parent, to say, "Because I said so."
Fourth, employees need a safe method of disclosing dangerous company practices to an office that is entrusted with managing the company's risks. An ombudsman or ethics office with a confidential helpline can handle this vital employee communication function. Also, company standards and practices concerning retribution and punishment for reporting bad news need to be aligned and reviewed annually.
Finally, the board needs to take its fiduciary responsibility more seriously, with particular respect to the audit committee. William Webster's story is most illuminating. Although he had a distinguished career in government, Webster had to withdraw from being considered as head of the new Public Company Accounting Oversight Board because of financial fraud allegations against a company for which he had served as a member of the audit committee.
Commentaries: Expense Transaction Problems for an International Company
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—Rising Sun Construction Company
Commentaries by:
- Michael A. Santoro, Assistant Professor at the Rutgers Business School
- Curtis C. Verschoor, CPA, CIA, CMA, CFE, PhD, Professor, DePaul University, Chicago
- Bob
J. Sack,
Professor Emeritus of Business Administration,
University of Virginia, Darden
Michael A. Santoro, Assistant Professor at the Rutgers Business School
"Not knowing what Jerry is up to in Japan creates a huge risk for Rising Sun involving potential violations of the Foreign Corrupt Practices Act (FCPA)".This is an intriguing case that looks at a number of prototypical ethical and legal issues in a growing family-owned company that is tip-toeing into international markets for the first time.
The senior Mr. Ono has done quite well during 45 years in business with his simple, homespun ethical precepts, which call for maintaining a good reputation, obeying the law and avoiding conflicts of interest. As the operation of Rising Sun passes on to a new generation—including the younger Arthur Ono and Jerry—these values are being tested. Certainly, the power of such simple ethical precepts might be lost on Jerry, who earns a good portion of his compensation from bonuses related to sales. It is clear that the company's initial foray into Japan requires it to rethink and restructure its accounting and control systems which, like the elder Mr. Ono's ethical compass, had served the company well thus far.
It's hard to tell exactly what Jerry has been up to in Japan. Hard to tell, that is, because as Kenneth, a CPA and vice president of finance, correctly points out, Rising Sun has very loose financial control and management reporting systems. Jerry has managed to convince Sidney, the chief accountant, to record his Japanese travel expenses as "miscellaneous". Among other things, this means that the company doesn't know how much Jerry is spending on gifts and entertainment for his new friend, Kanemaru, the sumo-loving, bureaucratic section head in Nagoya.
Not knowing what Jerry is up to in Japan creates a huge risk for Rising Sun involving potential violations of the Foreign Corrupt Practices Act (FCPA). The company could be liable for million of dollars, and corporate officers who knowingly violate the act could even face jail. So Kenneth is very wise to suggest that that the company set up an adequate reporting and control system, familiarize itself with the law, and also draft a code of conduct so that company employees know exactly what the company expects of them when it comes to obeying the FCPA.
Jerry is off the mark when he suggests that, as a private company, Rising Sun faces a different standard when it comes to paying bribes to officials. While the FCPA does have different financial reporting obligations for public companies than it does for private ones, the bribery provisions apply with equal force to public and private companies. Thus, even if Rising Sun is not technically required by law to upgrade its accounting and controls, it is in the company's interest to do so. The company would be wise to take whatever steps it can to make sure that Jerry and other employees obey the law, since the company and possibly company officers such as Kenneth and Arthur could be criminally liable for Jerry's actions. In fact, under the Federal Sentencing Guidelines, the financial penalties a business faces if an employee violates the law depend crucially on whether the company has set up an ethics program to try to prevent such violations. That is probably why Kenneth is recommending that the company develop a code of conduct. The bottom line is that the company needs to set up financial controls so that it can determine whether Jerry's gifts and entertainment expenses amount to a bribe. Too much is riding on that determination for Rising Sun to rely on loose and vague accounting entries.
Beyond coming to grips with Jerry's activities in Japan, Kenneth is also right in suggesting that the company needs to study the legal issues involved. Jerry's actions raise a number of interesting legal questions that Rising Sun officials must understand thoroughly. Only a superficial account of some of the most obvious questions can be given here. Is Kanemaru making only ministerial decisions, in which case payments to him might be considered facilitating payments, which are legal under the FCPA? Probably not. Is bribery legal in Japan? This is a tricky question because although there appears to be more cultural tolerance for bribery in Japan than in the United States, bribery violates Japanese law. As a result, Jerry and Rising Sun couldn't claim a safe harbor from the FCPA on the grounds that bribery is legal in Japan.
A final point to be made about this case is that it raises the very important question of what ethics one should follow in a foreign country. Even if the risk of violating the FCPA does not persuade Rising Sun to account for and control corporate bribery, the company has to ask itself how it wants to do business in other countries. Is it acceptable to bribe officials in Japan even if it's not legal to do so in the United States? While it's important to respect the cultural context when operating overseas, it is also important to stick to a core set of values. For 45 years, Rising Sun has operated on the elder Mr. Ono's strong belief in maintaining a corporate reputation and avoiding conflicts of interest. Bribery creates a conflict of interest for the official taking the bribe. One suspects that the elder Mr. Ono would not want the company to violate his core principles, even in another culture where those principles might not be as strongly held.
Curtis C. Verschoor, CPA, CIA, CMA, CFE, PhD, Professor, DePaul University, Chicago
"During his year as an exchange student in Japan, Jerry would likely have learned all he needed to know about gift giving and how to participate in it gracefully".This case illustrates the need to understand not only the laws of a new country in which a company may wish to do business but also the social and cultural mores. As I understand the Japanese culture, gift giving is undertaken not as an expression of esteem or concern for another's well-being but, rather, often reflects only a sense of duty and obligation. To fail to participate in a widespread practice such as reciprocal giving would likely torpedo the chances of a new company, already viewed as an outsider, from gaining a market foothold.
During his year as an exchange student in Japan, Jerry would likely have learned all he needed to know about gift giving and how to participate in it gracefully. Jerry would know that his gifts should be of appropriate value for the situation to avoid making their recipient uncomfortable. Embarrassment should be avoided if at all possible. It should be noted that gifting practices in Japan are not the same as those in countries on the Arabian Peninsula. There, monetary "gifts" of significant value are not only expected, but demanded by sheiks in authority as a kind of "tax".
One concern for the Rising Sun Company is the ownership of gifts that may be given to Jerry as representative of the company. Jerry would need to understand that any gift of value does not belong to him personally. Rather, it should be considered an asset of the company and be displayed in the company's premises as appropriate.
The company might have considered whether to comply with the Foreign Corrupt Practices Act as a business strategy. There is not enough information in the case to clearly determine whether Jerry's actions complied with the act. The friend he made in Nagoya may not have a position high enough to meaningfully influence whether Rising Sun would be granted a contract if allowed to bid on it.
Bob J. Sack, Professor Emeritus of Business Administration, University of Virginia, Darden
"At a very technical level, we can't simply put a significant sum in "miscellaneous expenses", because it will make the financial statements look silly".This is a very good case that focuses on a set of very real issues. As business becomes more global, and as smaller, family-held companies move into the global marketplace, the question of cultural ethics will be more and more important. Larger, multinational companies (e.g., Shell) are so diverse that they have a culture of their own that transcends national boundaries. Smaller, more localized companies will be forced to cope with other countries' cultures as they find them. This case is a good vehicle for a study of this issue, for both accounting students and practitioners.
I would be inclined to take the fact pattern one more step, and ask the participants in the class or the continuing professional education session to assume that Kenneth decided to take his concerns about Jerry's expense report to Arthur, along with a summary of the Foreign Corrupt Practices Act, such as the one found on Professor Nissan's web site. I would then divide the participants into two groups (the chief financial officer and the chief executive officer) and ask:
What should Kenneth say to Arthur? How might Arthur respond?
I would encourage a discussion between the two groups, noting salient points on the board. I would look for comments such as:
From Kenneth:
- The law says it's a crime to give significant gifts to a government official with the goal of influencing a business decision. The penalties are severe for anyone involved--and that means you and me, as well as Jerry.
- If it comes out that Jerry tried to buy influence in this way, we will not only be in trouble here but also have a very hard time ever doing business in Japan.
- When Lockheed paid a bribe to a Japanese official, they thought that bribery was an accepted practice in Japan. But when it all came out, political heads rolled and everyone then said, "No, it is absolutely not accepted practice to pay bribes in Japan." Lockheed was very naive, and was taken to the cleaners. Let's not have that happen to us.
- To be really honest with each other, we don't know how much cash Jerry may have included in that envelope, and so we don't really know how much to reimburse him. We would never reimburse any employee--even you--for a significant sum based only on the word of the employee. But in these circumstances, Jerry has us over a barrel. We obviously can't ask our Japanese contact for a receipt!
- At a very technical level, we can't simply put a significant sum in "miscellaneous expenses", because it will make the financial statements look silly. The CPAs will be all over that account, as will the Internal Revenue Service.
- And don't suggest
that we charge that reimbursement to payroll or
advertising expense--it's a bribe.
From Arthur:
- Wait a minute, I know something about doing business in Japan, and I believe that it is not only expected that the contracting officer be bought off, but it is also mandatory that we play the game, if we are to do business there.
- The law is only to be used in extreme situations--when someone has been caught with their hand in the cookie jar. It was passed in a flurry of excitement over Lockheed and United Fruit. It is not now being enforced. Given Washington's focus on terrorism right now, no one is going to make a big deal over an outdated law.
- Look, I trust Jerry. If he gets us the business, I don't care what it costs or how he gets it.
- Why are you making such a big deal over the cash portion of Jerry's gift? Why make a distinction between the glassware and the cash?
- Let's charge some of
the cost to travel to Japan and some to business
development--and defer some to be charged
against the profit on the contract, which I am
sure we are going to get.
With that conflict on the classroom board, the participants should then be asked to step out of their earlier roles and act as a member of the company's board of directors, perhaps an old friend of Arthur's Dad, and work through how they will deal with the conflict. That discussion might consider:
- The company and all of the people involved are very vulnerable. It's not fair nor is it smart for Arthur to put the company, Kenneth and Jerry in such a dangerous position.
- It may well be that
the FCPA has not been invoked against a
privately held company in recent years, but the
odds of being caught are irrelevant: The costs
of losing that bet far outweigh any benefit that
might be derived. Some of the costs include:
1. Legal penalties for everyone.
2. Terrible publicity here and in Japan.
3. Possible disqualification for government work here.
4. A dangerous precedent within the company. The employees will see it as a place where expediency is the rule.It's clear that Arthur cannot ask for the money back, but it is also clear that he cannot proceed with the bid on this or any other contracts where this official might be in a position of influence. He will simply have to write off Jerry's "gifts" as an educational expense.
The participants might then be asked:
Suppose Arthur ignores this sage advice, and decides to go forward with the contract proposal and to charge the costs to miscellaneous expense. What should Kenneth do?
The managers of Ashland Oil faced that same question some years back. It had been proposed that the company buy a chrome mine from someone who claimed to have an in with the Sheik of Oman, and who could influence the Sheik to sign a long-term crude supply contract with Ashland. Some employees agreed to go along with the plan; some disagreed and quit when it became clear that the CEO was going to implement the idea; and some stayed on but raised objections with the board of directors. They were fired but much later won a large wrongful-discharge suit against the company. The company and the CEO were both sanctioned by the Securities and Exchange Commission.
At a minimum, Kenneth has to resign if Arthur refuses to follow his advice. If Kenneth has a strong relationship with members of the board, he may be able to get them involved in an effort to derail this project, but he must recognize that he jeopardizes his working relationship with Arthur if he goes over that executive's head. The same would be true if Kenneth alerted the CPA firm to the transaction, even subtly. Still, Kenneth has a professional responsibility to see that the law is followed and that the company's financial system and financial statements are not compromised. That conflict is an inevitable consequence of his acceptance of the CFO role.
There is one additional resource that instructors might find helpful. Tom Donaldson has a strong reputation in the field of international ethics and, in addition to the article cited in the case, he has written "Moral Minimums for Multinationals" (Ethics and International Affairs, 1989), in which he argues that:
"If the practice is morally and/or legally permitted in the host country [in this case Japan] but not in the home country, then either (1) the moral reasons underlying the host country's view that the practice is permissible refers to the host country's relative level of economic development or (2) the moral reasons underlying the host country's view that the practice is permissible are independent of the host country's relative level of economic development."
In other words, we can see that a developing country might temporarily tolerate a higher degree of noise or air pollution than would otherwise be the case because of a desperate need for the cheapest possible fuel (a type 1 issue) and we can see that nepotism prevails in other countries because of the strength of family or clan in the society (a type 2 issue).
He then posits this guideline, to help Arthur and Kenneth:
"The practice is permissible if and only if the members of the home country would, under conditions of economic development similar to those of the other host country, regard the practice as permissible."
Using Professor Donaldson's guideline, it seems clear that, FCPA or not, Sun ought not participate in the practice of paying for business, which appears to be the practice in Japan.
Commentaries: Revenue Recognition—Loans, Guarantees for Personal Asset Acquisitions
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—Accounting & Ethical Problems at Sigma Industries
Commentaries by:
- Jerry D. Guthrie, Corporate Director, Ethics & Compliance, BellSouth Corporation, Board Member Ethics Officer Association
- Susan M. Hinds, CPA, MBA, Business Analysis, Corporate Strategy Division, Toyota Motor Mfg. North America
- Bob
J. Sack,
Professor Emeritus of Business Administration,
University of Virginia, Darden
Jerry D. Guthrie, Corporate Director, Ethics & Compliance, BellSouth Corporation, Board Member, Ethics Officer Association
"Given these kinds of dealings, it is not difficult to understand why the government stepped in and quickly passed the Sarbanes-Oxley Act".This company is exemplary of all the corporate scandals that have made the headlines during the last year. In this one fictional company, we find examples of some of the kinds of practices seen at Enron, WorldCom, Tyco, and other companies that have become household names...all for the wrong reasons.
We wonder how a company can get away with being so corrupt, but the answer can be found by looking at the make-up of the board of directors. The founding family members hold a majority of the seats on the board. While many boards have insiders, we see here that the lack of independence clouded the board's oversight responsibilities. The presence of a special independent committee of the board shows an attempt to regain some control, as do the resignations of the family members.
With the family members and close family friends also running the day-to-day company operations, conflicts of interest is a serious problem. Having a family member or a close family associate in the key financial positions obviously made it easier for them to commit accounting improprieties. At Sigma, the Collins family members are using the company for personal gain and effectively running the company into the ground. The hundreds of millions of dollars of loans guaranteed by the company and the guarantees of board members' personal acquisitions were some of the things that eventually led to the resignation of the family members and their likely prosecution.
Accounting improprieties are a common theme among the numerous companies in trouble and those that have filed for bankruptcy. At Sigma, we see undisclosed use of partnerships to conceal debt and to help manage earnings; fake deals with vendors to show non-existent income; and numerous transactions with various partnerships that falsely inflated earnings. It is not surprising that this company defaulted on debt payments and faced bankruptcy and has seen a 90% drop in stock price over the previous year.
Given these kinds of dealings, it is not difficult to understand why the government stepped in and quickly passed the Sarbanes-Oxley Act. Its primary objectives are to prevent corporate and accounting fraud; address lack of oversight by self-interested senior corporate management; and restore investor confidence in the public markets. There were too many companies like Enron, Tyco, WorldCom or Sigma Industries. Now public companies across America are working to implement the provisions of this Act to restore investor confidence.
Susan M. Hinds, CPA, MBA, Business Analysis, Corporate Strategy Division, Toyota Motor Mfg. North America
It is hard to inspire people to contribute their maximum when the family is seen repeatedly misappropriating company assets.This case ends with Sigma Industries filing for Chapter 11. If Chapter 11 status were granted, it would allow Sigma a grace period to keep operating and to satisfy creditors. How did the company get to this point? What were the significant influences that allowed this corporation to collapse amid its own greed and corruption? After all, there were many stakeholders that should have seen the signals of a deteriorating condition or, at a minimum, the red flags. Let's examine this case from the lens of those stakeholders and see how they contributed to Sigma's demise by avoiding their own corporate responsibilities.
Lens of Understanding - Views from Multiple Perspectives
Even though we will discover that there are multiple perspectives on the same issue, we will also find one similar characteristic among these differing stakeholders--greed!!!
Lens One: Collins Family Members
The bottom line of this case is that the family members were corrupt and participated in white-collar crime by defrauding the organization, as Jerry Kramer discovered. Sigma was plagued with related-party transactions, improper accounting with intent to defraud, improper loans and weak internal controls. The family knew about it, and was deeply involved in it. Another big pitfall in this case is the high representation of Collins family members on the Sigma board. The problem was worsened by the fact that the family and their close associates were involved in day-to-day operations. This provided tremendous power and opportunity to create a culture of corruption and unethical business practices. As the adage says, ultimate power yields ultimate corruption.
A final flaw in this case is the Collins family's complete disregard for ethics and the corporate responsibility entrusted to them by the other stakeholders. Again, the family had significant influence and control, which gave them ample opportunity to make things right rather than continue to misappropriate company assets. They knowingly performed these unethical acts with complete disregard for the consequences or the pain and suffering of the injured parties in the transactions. Their actions included criminal activity such as fraud, which is punishable by law. The Collins family should be fully prosecuted for their corporate misdeeds.
Lens Two: Sigma Industries Employees
It should be duly noted that not all of the employees are completely innocent in this case, either. There were likely ample opportunities to report the fraud to the company auditors, but employees chose to refrain from seeking outside counsel. One could argue that this makes these employees accomplices to the unethical activity. If employees knew or had strong reason to suspect corporate misdeeds, they had the ethical responsibility to report it to management or, at a minimum, to an outside party for counsel.
Assuming that Chapter 11 will likely cause significant job losses and restructurings, the employees stand to lose a great deal, including their jobs and income. Job loss is difficult to explain to a child who doesn't understand why Mom and Dad are no longer able to pay for a comfortable lifestyle. Unscrupulous and unethical behavior hurts a cross section of stakeholders of all ages, including members of the local community.
Lens Three: Corporate Management
The role of corporate management is to provide an ethical and safe environment in which employees' contributions are recognized fairly and company assets are safeguarded for investors' security. When management begins to deviate from the ethical code of conduct, as in the Sigma case, they are opening a Pandora's Box. One corporate misdeed after another will result in scandals and lies that destroy company morale.
Having corrupt, unethical controlling family members involved in day-to-day management decisions is like poison to an organization's culture. It is hard to inspire people to contribute their maximum when the family is seen repeatedly misappropriating company assets. The management team was responsible for implementing proper internal controls that would monitor, detect and ultimately report the corporate misdeeds. The Sigma management team failed to meet these corporate governance standards and failed to take corrective action-that's the bottom line. Of course, with the strong family influence in key positions, blowing the whistle was a rather difficult situation for any brave manager needing to keep the weekly paycheck. Managers tend to expend a great deal of energy avoiding blame and escaping political battles for fear of losing their jobs.
Sigma management should have set a positive ethical tone for the organization, which requires taking personal responsibility for one's actions. This sense of personal responsibility is a prerequisite for ethical moral action. There are four reasons why Sigma managers may not feel personally responsible for their organizational actions. Responsibility can be:
1. Diffused because it is taken away.
2. Shared with others in decision-making groups.
3. Obscured by the organizational hierarchy or
4. Obscured by psychological distance from potential victims.Whatever the reason, avoidance of corporate responsibility and unethical behavior should not be tolerated within the work environment. Imagine what the future could have been for Sigma had it not been for the unethical behavior of a few bad apples that was condoned by the management team.
Lens Four: Board of Directors
The board is the ultimate power and should be held responsible for the fraudulent criminal activity that left Sigma in Chapter 11. When wrongdoing occurs in any type of organization, top managers are frequently held accountable even if they weren't personally involved. Most specifically, the audit committee activities should be closely examined with an emphasis on the related-party transactions. There was a red flag: A complaint was received from the company auditors, who accused the audit committee of withholding important information from the auditors when requested. This is completely unacceptable and should be closely investigated.
The fact that family members were well represented on the board should have sent up red flags to the casual observer. Because of their board representation, they were allowed to take actions such as directing activities, delegating responsibility, conducting performance appraisals and ultimately making the decisions on pay and promotions of key management. In this case, it also allowed for an unethical and corrupt culture to develop among the Collins family and related parties.
Lens Five: Auditors
The audit firm is ultimately responsible for detecting fraud and related-party transactions in order to protect the investment community. Investors have faith that standard audit practices ensure a clean, healthy balance sheet and properly stated earnings with full disclosure footnotes. In the event of auditor negligence, investors will likely sue the CPA firm for damages. Since Sigma is filing for Chapter 11, the audit firm will likely be facing shareholder action soon.
The auditors are responsible for a professional and thorough audit, but in this case the auditors failed to properly conduct their audit when information that was requested was withheld. At this point, the audit partner should have met with the audit committee and informed them that without this information, the firm would not be able to issue an opinion on the financial statements. This would have allowed the auditors to take control of this unhealthy situation.
Lens Six: Suppliers
The suppliers contributed to Sigma's demise by participating in the marketing support mark up scheme. This was clearly unethical. The suppliers should have known that price fixing and altering invoices for customer benefit were not sound ethical business practices.
What motivated the two Ethernet switch manufacturers to enter into such an agreement? The supplier stood to gain increased future business as a result, which is an appealing prospect for some business executives. Unfortunately, Sigma's management improperly accounted for this supplier price fixing/false marketing support services transaction, which altered income by over $20 million. This is what most investors would consider a significant, material alteration of profit, which would falsely influence investors' decision making.
Lens Seven: Customers
Customers are only good ones if they pay their bills. In the case of Sigma, there is over $20 million of impaired asset value due to customers' inability to pay. This places unnecessary burden on an already stressed organization since these lost profits will have to be replaced by new efforts.
Lens Eight: Investors
The lenders suffered greatly from the loan defaults and the investors watched their share value plummet to nearly nothing. The shareholders are going to ask what caused Sigma to enter Chapter 11 with little forewarning. Upon learning of the fraud, corruption and unethical conduct of the board and management, as well as the family founders, the investors may want to take legal action to protect their financial interests. Additionally, the company auditors will have a lot of explaining to do to ease concerns about the quality of the audit work performed. When investors lose a significant portion of their capital, they are going to demand answers and accountability.
An Ethics Failure
Ethics involves building trust between stakeholders and their organizations. It is very difficult to do business with an unethical company because it cannot be trusted. You cannot be sure if a commitment is really a commitment. In the Sigma case, all the stakeholders contributed to its demise but also had a vested interest in its survival. Unfortunately, only a few greedy stakeholders walked away with the company treasures. The Collins family members have a lot of explaining to do.
Bob J. Sack, Professor Emeritus of Business Administration, University of Virginia, Darden
The protagonist in this case, Jerry Kramer, faces a very difficult ethical dilemma. Sigma is clearly rotten at the core and he risks being sucked into that morass. On the other hand, it appears that there may be an opportunity for cultural change, and Jerry may have a chance to help that change occur.
What is the decision Jerry has to make today? What would his decision have been when Jerry first came to work for Sigma and before the family's self-dealing became public knowledge?
Every new employee needs to assess the environment of his or her new employer and, if that environment appears risky (the risk must have been apparent at Sigma, given the family's heavy management involvement), to make the difficult decision to:
- Stay and conform to this environment.
- Stay and try to change the environment.
- Leave before he or
she gets caught up in the game.
Deciding whether an accountant ought to try to fix a tough situation or leave before becoming a part of it is a difficult ethical choice. It focuses on the contest between loyalty to one's self and loyalty to a company, or the profession. We need to be realistic about our ability to effect change in a difficult environment. If Jerry concluded that his junior staff position would not allow him to dig into the facts and influence company direction, I believe he is entitled--and in fact obligated--to leave.
If, however, he concludes that he is in a position to influence the environment--as it appears he may be, based on the timing described in the case--then he has a professional obligation to use his skills to direct that change.
After considering Jerry's choices had he been confronted with these problems before the fraud became public knowledge, I would go back to the first question:
What decision does Jerry have to make now, at the time of the case?
Given the apparent openness of the situation, Jerry has a clear opportunity to help make change happen at Sigma--and he has an ethical and professional obligation to use his skills to do so. Consider the following questions:
1. To whom does Jerry owe his loyalty? In the personal power struggle that is sure to unfold in this situation, Jerry must be careful to consider the constituencies involved and be sure that he focuses his attention on those who need his help the most; that is, the public investors and other outsiders who stand to lose so much if Sigma is not rescued.
2. How does Jerry maintain his own integrity in this situation? This could be a never-ending saga, and Jerry needs to set limits on how much of himself he will give to the effort. He needs to define for himself what a healthy environment within Sigma might look like, and decide how long he might be willing to work toward that end. He will need to monitor the progress the company is making, and be prepared to remove himself if none is made. He does no one a service, least of all himself and his family, by staying around and participating in an ineffectual reform effort.
3. How can Jerry best equip himself for this effort? It will be tempting for Jerry to look for some professional standards on related party disclosure to make sure that the company is in compliance with Securities and Exchange Commission rules and generally accepted accounting principles and auditing standards. (e.g., Financial Accounting Standards Board Statement No. 57, Related Party Disclosures; AU 334 of the AICPA Professional Standards; and Montgomery's Auditing, pages 844-846) But he needs to go well beyond compliance and push the company toward reforms in corporate governance and internal controls. It may be helpful for him to study the New York Stock Exchange rules on boards of directors and the Sarbanes-Oxley guidance on audit committees.
4. There are some rather nasty precedents that might bear on Jerry's decision. The SEC has brought a number of cases against chief financial officers who were complicit in a fraud by simply going along with it. The Regina and the Oak Industries cases come to mind quickly, but also the massive case against 16 officers and employees at MiniScribe. The MiniScribe case is most instructive because it appears that the line managers were simply caught up in the game (see SEC Civil Action 91-1393).
You will want to enumerate the ethical failures that brought Sigma to this juncture. While there is some satisfaction to be gained in an analysis of another's failures, it will be more productive, however, to focus on the decisions that Jerry must make based on issues that he-and each of us-can control.
Commentaries: Making Detection of Embezzlement Difficult by Misappropriating Financial Records
Joanne O'Rourke Hindman, President and Chief Executive Officer of Roundtable Advisors, Inc.
"The importance of management's commitment to implementing strong internal controls is precisely why the Sarbanes-Oxley Act of 2002 requires that all public companies include a report of management's assessment of internal controls in their annual Securities and Exchange Commission filings".Duarf, Inc. should be congratulated on doing many things right. Not only did the company implement sound internal controls while streamlining accounts payable processing and reducing overhead costs, it also created a safety net in the form of a fraud hotline. And having an internal audit department speaks volumes about management's commitment to preventing fraud. Good employees sometimes do bad things when under pressure--whether it comes from financial pressures, as in Sandy's case, or from "just following orders," as is the case for the innocent but contributing employees who helped Sandy get around the system of internal controls.
The importance of management's commitment to implementing strong internal controls is precisely why the Sarbanes-Oxley Act of 2002 requires that all public companies include a report of management's assessment of internal controls in their annual Securities and Exchange Commission filings, as well as quarterly updates on internal controls in their quarterly filings. Management must be dedicated to creating an environment in which effective internal controls are in place, similar to those found within the recommendations of the Committee of Sponsoring Organizations of the Treadway Commission (COSO) report on internal controls. Sarbanes-Oxley also requires public companies, through their audit committees, to establish confidential complaint procedures in order to provide whistle-blowers with an opportunity to report concerns or questionable behavior without fear of retribution. These steps are critically important to safeguarding company assets. So there is no doubt that Duarf, Inc. was on the right track.
That said, there are additional steps that Duarf could have taken to prevent Sandy's embezzlement. After all, Sandy's initial success prompted him to try it again, which is ultimately the only reason he got caught. As part of the changes in processing accounts payables, an assessment, preferably prepared by the internal auditors, should have been completed to identify any risk areas associated with the implementation of a new system. Once these risk areas were identified, steps could have been taken to mitigate those exposures during the transition period. For example, one obvious risk as a result of the consolidation was the fact that there were fewer employees to process the same number of payments. This meant that the accounts payable staff was now processing payments to unfamiliar vendors for purchases authorized by unfamiliar employees with less time to complete each transaction. In addition, while giving Sandy check-signing authority is not necessarily inappropriate in normal circumstances, during this transition period it might have been a good idea to require another more senior manager to be the second signer temporarily until the staff gained more familiarity with the new system. Finally, unless someone knew Sandy personally it would have been difficult to tell whether he was living beyond his means. Of course, if someone was familiar with Sandy's lifestyle, having a general question in the internal auditors' risk assessment review may have brought this risk to light. In addition, anyone with check-signing authority should be required to sign a statement confirming that they have read and fully understand the company's code of ethics.
Fortunately, Sandy's second attempt exposed him not only because Rachel refused to bypass internal control procedures but also because she called the fraud hotline. Rachel had a slight advantage over her fellow employees, however, because of her husband's involvement in the hotline. Requiring employees to attend a training class on recognizing the signs of fraudulent activities such as unusual behavior, anger, unreasonable demands and impatience, is a good way to heighten employee awareness. This knowledge coupled with access to the fraud hotline would have given Sandy's staff the courage and the support to insist that he follow procedures.
By taking these additional steps, Duarf, Inc. would have sent a clear message that no one has the authority to bypass procedures. More important, however, is the expectation that all employees are responsible for recognizing the signs of trouble and reporting their concerns immediately through the fraud hotline, which may have prevented the embezzlement in the first place.
Susan M. Hinds, CPA, MBA, Business Analysis, Corporate Strategy Division, Toyota Motor Mfg. North America
"We all know that embezzlement of company assets is punishable by law, so we wonder why Sandy tried it".Typically, business leaders do care about preventing and managing unethical behavior. Interestingly, this case demonstrates that the reverse can also be true. What went wrong? What led Sandy to jeopardize his career and personal well-being, knowing full well that what he was doing was wrong? Let us explore a little more closely.
What Went Right?
First, let's look at what went right from an ethical point of view.
- Duarf Inc. provided an anonymous fraud hotline. This was truly the reason for a successful investigation and resulting prosecution for the embezzlement. It is a very strong deterrent for employees who may be prone to acting unethically.
- Rachel was not only
alert but also was proactive. She picked up on
the red flags and spent time contemplating her
best course of action. She took the right path
by reporting this incident to the fraud hotline.
However, in all fairness, due to her husband's
position in internal audit, Rachel may have been
more knowledgeable than the average employee
about the fraud hotline. It is important to make
sure the hotline information is understood by
all employees and the process is easy to follow.
What Was Really Wrong?
We all know that embezzlement of company assets is punishable by law, so we wonder why Sandy tried it. Granted he was hurting for cash, but let's look beyond the obvious.
- Clearly Sandy allowed his personal needs to jeopardize his professional standards and taint his judgment on the proper means to secure needed funds. In hindsight, Sandy surely realizes that there were legitimate alternative sources of funds that he should have pursued rather than risk his entire livelihood on the embezzlement scheme.
- Sandy used his position of power and authority to intimidate or influence his employees to unknowingly comply with his embezzlement. Fear or intimidation can motivate employees to do things that they may not do otherwise. This is not an excuse for misbehavior but a reality. Specifically, intimidation by a senior manager can cause subordinates to abandon standard operating procedures and circumvent the necessary controls.
- Sandy has too much
control over the accounts payable process. Duarf
needs better segregation of control.
An Ongoing Problem
More workers may cross into unethical behavior during tough economic times. Whatever its cause, however, unethical employee behavior is a management problem that won't go away. It may become even more of a challenge as downsizing reduces management layers, leaving fewer managers to supervise more workers. With so many workers to oversee, a manager can't directly observe behavior. In addition, these workers are likely to feel less loyalty to the organization and may be prone to engage in unethical behavior, such as embezzlement. That is why having a hotline and alert employees such as Rachel guarding company assets are critical to encouraging ethical behavior and preventing departures from it.
Jean Fitzsimon, Bridge Associates LLC, formerly CCO and VP-Law, Sears, Roebuck and Co.
"Unfortunately, Sandy's problem and his solution to it are not uncommon. Employees who handle large sums regularly often begin to feel as if it's their money and that the lifestyle that goes along with such sums is theirs by right".The situation presented here is one of the toughest issues a corporation can face: How to embed controls into processes without also embedding distrust into office relationships. At first blush, it seems there are only two options: Teach your staff to distrust each other or create redundant systems as fail-safes. Obviously, no company wants to teach distrust; that would only lead to less ethical behavior, not more. Just as obviously, however, redundant systems not only cost more, but, by disempowering staff, tend to reduce personal responsibility. Indeed, Duarf had implemented human controls in addition to the system's internal controls, and still the system failed to protect the company. This is every company's worst nightmare, as it involves the head of the department, someone in whom, by definition, the company places great trust.
Unfortunately, Sandy's problem and his solution to it are not uncommon. Employees who handle large sums regularly often begin to feel as if it's their money and that the lifestyle that goes along with such sums is theirs by right. Furthermore, the notion that he'll just "take a loan" is more common than is imagined. This is a rationalization that allows people to do something they would never do--that is, steal. Often employees actually repay these "loans" the first few times, before the amounts get out of control and/or they no longer need to rationalize their behavior.
One of the flaws in the system here was that the controls were completely contained within the department for all amounts less than $50,000. One possible solution would be to have the system automatically generate override or exception reports to Sandy's boss or someone whose job it is to examine each such transaction. This is highly preferable to requiring individual employees to report exceptions, especially, as in this case, when the exception is requested by the supervisor. While all employees should be encouraged to report any transaction they find questionable, it is unreasonable to expect them to feel they can comfortably report on their supervisor.
While system controls are important, they also contribute to the problem because they don't enable employees to think of themselves as the protectors of the company, rather than merely one of many steps in the process. This doesn't mean companies should abandon process. It does mean that they need to emphasize the role each employee plays in the control process. Here, only Rachel felt personally accountable for her role in the accounts payable process.
It is extremely important to note here the existence and importance of the fraud hotline. Even with a spouse in audit, Rachel was more comfortable going through the hotline. This should not be surprising when you realize she's reporting on her boss, a person the company put in charge, and her report is based on a feeling generated by an odd encounter, not a clear "help me steal from the company" conversation. It is critical that companies make it easy for employees to report troubling behavior even at the highest levels without putting themselves in jeopardy.
Finally, there is one other process check that should be implemented here: a periodic review of the lifestyles of financial personnel. As noted above, the company places great temptation in the way of such employees, yet lodges them in positions that demonstrate great trust. It is only logical to keep a watchful eye on them.
Commentaries: Revenue Recognition for Non-Monetary Transactions
From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright © 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York.
Case and Commentary—Strike Two: You're Out—Again!
Commentaries by:
- Ida R. Backmon, PhD, CPA, Associate Professor, Accounting, University of Baltimore and Betty L. Brewer, DBA, CFP, Associate Professor of Finance, North Carolina A&T State University
- Michael A. Santoro, Assistant Professor at the Rutgers Business School
- Robert O'Connor, President and CEO, Softrax Corporation
- Bob
J. Sack,
Professor Emeritus of Business Administration,
University of Virginia, Darden
Ida R. Backmon, PhD, CPA, Associate Professor, Accounting, University of Baltimore and Betty L. Brewer, DBA, CFP, Associate Professor of Finance, North Carolina A&T State University.
"Donna could communicate to the top executives the consequences of violations of generally accepted accounting principles. She could use as leverage the requirements of the Sarbanes-Oxley Act of 2002, which dictates that CEOs and CFOs must certify the financials. She could further mention the SEC penalties for CEOs and CFOs who violate the Sarbanes-Oxley Act".The CFO, Donna Butler, is plagued by a history of revenue recognition problems in her present and previous jobs. She appears to have had difficulty obtaining complete and honest explanations from her fellow professionals.
The ABC.com financial prediction forecasts a tremendous growth in revenues. Notably, in the year of the IPO, ABC.com had less than $1 million and now predicts sales of $14 million, a substantial increase. This is likely a "red flag" indicating inflated revenues. Donna has legitimate concerns, since inflation of revenues may be associated with improper recognition of revenues. Moreover, it does not appear that the barter transactions are properly recorded or realized. While she can theoretically plead innocent regarding the past year's accounting practices and financial statements, it seems inevitable that she will face pressures to support the accounting practices associated with bartering or she will lose her job.
As the CFO, she should take into account all aspects of the company's reporting to resolve her dilemma. As a course of action, Donna should investigate matters thoroughly and consider all options:
1. Determine why the company missed a few of the bank covenants. Document explanations and conversations with the CFO and the bank.
2. Analyze/document the company's cash position (inflows and outflows).
3. Speak with the president. Inquire about the company's financial operations, bartering policy and method for pricing the courses.
4. Objectively evaluate the auditor's findings. Question the auditors about all disclosures and restatements made or those that she determines should have been made. The auditors' analysis of the cash flow statement should send a powerful message that something is wrong. Prior year financial statements are available and a comparative analysis should again raise questions about the company's financial condition.
5. Consider whether evidence of violations or incomplete answers to her inquiries indicate that ABC.com is not a good fit for her. She is professionally qualified and can likely find new employment with minimum difficulty.
6. Lastly, as an alternative, Donna could communicate to the top executives the consequences of violations of generally accepted accounting principles. She could use as leverage the requirements of the Sarbanes-Oxley Act of 2002, which dictates that CEOs and CFOs must certify the financials. She could further mention the SEC penalties for CEOs and CFOs who violate the Sarbanes-Oxley Act.
Donna should consider her future and present responsibilities and the consequences of any unprofessional behavior. Professional ethics applies to Donna as a CPA. The AICPA sets forth rules that its members must adhere to, including requirements for integrity, adherence to generally accepted accounting principles, and the avoidance of "acts discreditable." In essence, any professionally certified member who participates in or has knowledge. of fraudulent activities violates this code of conduct.
Donna has to decide on her priorities. What is more important: professional responsibility to shareholders and lenders or reducing the personal and career consequences to herself? If she places her personal and career concerns above her professional responsibilities, she may benefit in the short run but she will likely face similar dilemmas in the long run and negative consequences to her reputation and personal integrity. She has a responsibility to the company's employees and investors and an obligation to behave ethically and ensure that accurate information is properly disclosed. If she fails to challenge the practices she will likely be held accountable once the effects of these practices become apparent.
Michael A. Santoro, Assistant Professor at the Rutgers Business School.
"Donna needs not to fear the bully Dan. As CFO, she has duties to shareholders and powers that are independent of her relationship with Dan".In one respect, Donna's ethical quandary is very typical. Ethical dilemmas are often embedded in complex situations that are difficult to decipher and disentangle. In this case there are numerous factors complicating Donna's ethical decision making--personal history (Donna's job-hopping and past experience with barter transactions), interpersonal dynamics (Dan's temper and intimidating management style), legal and accounting issues (how to report barter transactions), and, last but not least, business exigencies (ABC's relationship with its lenders and its impending secondary offering).
As for her prior bad experience with the dot.com company, Donna needs to put this behind her. She has to realize that she is dealing with different legal and accounting issues, a different stage of company development and, perhaps most important, a different group of people. She also needs not to fear the bully Dan. As CFO, she has duties to shareholders and powers that are independent of her relationship with Dan. She owes it to herself and the shareholders to stand up to Dan.
If Donna puts her fears behind her, she might see the situation for what it is-an opportunity to correct accounting and legal problems before they get out of hand and ruin the company. It would appear from the case that when ABC went public it did so with accurate financial statements. So, unlike the case in her previous job, it would seem that ABC's historical financials do not need to be restated. The issue of revenue recognition for barter transactions is relevant to the secondary offering since it bears upon the future valuation of the company.
Dan seems to be using the barter transactions as a way to drive up the price of the stock for the secondary offering, but in the process he has jeopardized the company's future. If the barter transactions are presented accurately in the financial statements, the company will still be able to tap into the financial markets. The valuation may not be at the level Dan wants to achieve, but the company would still be able to raise money. Unfortunately, Dan's single-minded emphasis on using barter transactions to inflate the company's valuation and his intimidation of the outgoing CFO have brought ABC to the brink.
In Donna's previous experience with the dot.com, recognition of the barter revenue was not arguable. At ABC, however, the barter transactions would appear to fall into a gray accounting area. No clear and unequivocal technical accounting principle, in other words, appears to control the exact way that the company's financial condition must be presented. In deciding how to value the barter transactions and present them in financial statements, Donna must bear in mind that proper disclosure would certainly matter a great deal both to potential investors in the secondary offering and ABC's current lenders. To the extent that a strict reading of the relevant accounting principles might technically allow some discretion to overvalue the barter income, Donna should decline to exercise her professional discretion in this way. Instead she should insist that the company present the information about the barter income in the most transparent fashion so that lenders and prospective investors can understand the company's true financial prospects. One suspects that if this discipline had been imposed on the company, Dan might not have depended so heavily on bartering as a means of growing company revenues and profitability but would instead have relied on more sustainable strategies. Since the case suggests that the basic business model is sound, there is a good chance another more straightforward strategy might have worked.
If Donna is able to act quickly and decisively here she might win the lenders' confidence and negotiate with them to stand still until the company is able to complete a secondary offering. The company's basic business model would appear to be working, and she could perhaps convince the lenders that it would be in their interest to allow ABC to go forward with the offering. The offering may wind up taking more time to complete since the financial community will have to become comfortable with ABC's new accounting practices and revenue projections.
The key player in all of this will be Ivan, the company founder. Donna may well find that Ivan will be an ally once he understands how Dan has put the company's very survival at risk. The company is, after all, Ivan's baby, and he will be concerned that Dan's actions threaten to ruin it.
While she is confiding in Ivan, Donna might also talk with him about the responsibilities of running a public company, especially when it comes to insisting everything is going well when it really isn't. Ivan might have made this statement based on what Dan was telling him about company revenues. When Donna tells Ivan that relying on Dan in this way could subject him to personal liability and the company to lawsuits for misrepresenting its condition, Ivan will have his own ethical decision. He can either blame Donna, the messenger, or he can realize that Donna is doing him a big favor and start asking Dan some tough questions. If Ivan is the intellect that Donna thinks he is, then she may find that he will take the steps that are necessary to save the company from Dan's aggressive tactics. Perhaps together Ivan and Donna can save this company by dealing more straightforwardly with lenders, analysts and shareholders.
Robert O'Connor, President and CEO, Softrax Corporation.
"My recommendation to Donna would be that she resign immediately from the company."Clearly, Donna is right to be alarmed by the fast-and-loose manner in which ABC.com has recorded barter transactions as revenue. Without established "fair market value" for the products and services the company has bartered, accurate valuation for each transaction would be near impossible. In fact, without formalized and documented initial pricing as the foundation for the subsequent price increases put into effect by the company's president, the entire pricing schema is practically fictitious. Accounting Principles Board Opinion No. 29, Accounting for Non-Monetary Transactions., is the revenue recognition guidance that cannot be followed closely (as required for compliance in this circumstance), and therefore any revenue numbers now on the books are extremely suspect.
The intense need for cash and the almost complete lack of true sales before the initial public offering obviously drove the use of these dodgy accounting methods, but any short-term gains from this approach would be more than nullified by a restatement of the annual figures. One would have to assume that this knowledge, and the decision to obscure the true financial standing of ABC.com, was the reason that the former chief financial officer, Jack, was driven out by the president, Dan. Donna is correct when she estimates that a proper restatement of the fiscal year's statements would, in effect, ruin the company. And Dan will obviously do whatever it takes to prop up the revenue numbers and keep the stock price elevated.
Although barter transactions were prevalent in the dot.com era, their legacy has been a raft of confusing and manipulated accounting methods that even today result in large-scale corporate disasters, such as the demise of Global Crossings. Are the problems a result of a loophole in the rules, or unethical executive behavior? In the case of ABC.com, it's evidently both, used to their greatest advantage.
My recommendation to Donna would be that she resign immediately from the company. But she must not walk away without a good-faith attempt to effect change, in such a way as to leave no doubt that she fulfilled her fiduciary responsibilities as CFO. My second and equally urgent recommendation would be to initiate a meeting with Ivan, the CEO, and Dan, the president, with documented evidence of financial wrongdoing in hand. She must succinctly state the accounting issues involved. She must interpret the relevant accounting guidance for them, and expose those aspects of Financial Accounting Standards Board and Securities and Exchange Commission guidance that are not being followed. She must also make recommendations for corrective actions. A written resignation letter that leaves no doubt as to why she is leaving her position should accompany her memo. In the final analysis she must both explain and strongly recommend.
This is not her quarter, and she's barely on board yet with ABC. With the new signoff/accountability provisions in the Sarbanes-Oxley Act, she will soon be required to certify financials that don't fairly represent the financial status of her new employer. There are big personalities at play, including an overbearing and volatile president who pushed out the last CFO because he wouldn't cooperate with unethical directives on pricing and revenue. There is negligible respect at the executive level for the financial rules governing their business, but Donna is living up to her professional obligation to strictly interpret accounting guidance and to act in an ethical manner.
Bob J. Sack, Professor Emeritus of Business Administration, University of Virginia, Darden.
The CFO in this case appears to be facing a two-pronged dilemma. On the one hand, she is beginning to suspect that her new employer is misusing barter transactions in an effort to meet Wall Street's revenue expectations. On the other hand, she is especially sensitive to the possibility of a confrontation with her new management team because she has just left a startup company after confronting its management with the need to clear up revenue recognition problems. She does seem to be heading for another rocky session--and perhaps a reputation as a troublemaker.
Unfortunately, we do not know much about the barter transactions in question, and so we do not know how serious the conflict with management might be. The basic generally accepted accounting principles for such swap transactions are outlined in Accounting Principles Bulletin No. 29, Accounting for Non-Monetary Transactions. In effect, the standard says that non-monetary transactions are to be recorded at the fair value of the assets exchanged or the assets received, whichever asset value can be determined most reliably. But there are several caveats attached to that overall guideline:
- The transaction must meet the normal revenue recognition rules applicable to all exchanges, and
- If there is no reliable measure of fair value for either assets given or received, then the transaction is to be recorded at the cost of the assets given, and
- Transactions between
related parties must be recorded at the cost of
the asset given up, at least until the asset is
exchanged with a bona fide third party.
Swap transactions became very popular during the most recent telecom-stock boom because the companies did not have the cash required for a normal transaction, and because some players in the stock market were making investment decisions based on revenue growth rather than net income. So, for example, a company might barter capacity on its broadband system in exchange for advertising services. Even if the advertising was charged to expense at the same time as the broadband time sale was recorded as revenues, with no net increase in the bottom line, the deal was attractive because it boosted the top line. In some situations, the swaps were not nearly so benign: Some companies recorded the revenue from the swap at the time the deal was struck but amortized the cost of the asset acquired over time (as prepaid advertising!) so that the barter transaction boosted the top line and the bottom line. 1
The protagonist in this case has reason to be concerned about her new company and its reliance on barter transactions in the fourth quarter. But rather than worry about "what if..." she needs to investigate the transactions carefully and then decide on her best course of action. Here are some additional questions for you to consider related to this case: