Ethical Obligations

Business

Quiz 7 :

Earnings Management

Quiz 7 :

Earnings Management

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Dell Computer Background For years, Dell's seemingly magical power to squeeze efficiencies out of its supply chain and drive down costs made it a darling of the financial markets. Now we learn that the magic was at least partly the result of a huge financial illusion. On July 22, 2010, Dell agreed to pay a $100 million penalty to settle allegations by the SEC that the company had "manipulated its accounting over an extended period to project financial results that the company wished it had achieved." According to the commission, Dell would have missed analysts' earnings expectations in every quarter between 2002 and 2006 were it not for its accounting shenanigans. This involved a deal with Intel, a big microchip maker, under which Dell agreed to use Intel's central processing unit chips exclusively in its computers in return for a series of undisclosed payments, locking out Advanced Micro Devices (AMD), a big rival. The SEC's complaint said that Dell had maintained cookie-jar reserves using Intel's money that it could dip into to cover any shortfalls in its operating results. The SEC said that the company should have disclosed to investors that it was drawing on these reserves, but it did not. And it claimed that, at their peak, the exclusivity payments from Intel represented 76 percent of Dell's quarterly operating income, which is a shocking figure. The problem arose when Dell's quarterly earnings fell sharply in 2007 after it ended the arrangement with Intel. The SEC alleged that Dell attributed the drop to an aggressive product-pricing strategy and higher than expected component prices, when the real reason was that the payments from Intel had dried up. The accounting fraud embarrassed the once-squeaky- clean Michael Dell, the firm's founder and CEO. He and Kevin Rollins, a former top official of the company, agreed to each pay a $4 million penalty without admitting or denying the SEC's allegations. Several senior financial executives at Dell also incurred penalties. "Accuracy and completeness are the touchstones of public company disclosure under the federal securities laws," said Robert Khuzami of the SEC's enforcement division when announcing the settlement deal. "Michael Dell and other senior Dell executives fell short of that standard repeatedly over many years." In its statement on the SEC settlement the company played down Dell's personal involvement, saying that his $4 million penalty was not connected to the accounting fraud charges being settled by the company, but was "limited to claims in which only negligence, and not fraudulent intent, is required to establish liability, as well as secondary liability claims for other non-fraud charges." 1 Accounting Irregularities The SEC charged Dell Computer with fraud for materially misstating its operating results from FY2002 to FY2005. In addition to Dell and Rollins, the SEC also charged former Dell chief accounting officer (CAO) Robert W. Davis for his role in the company's accounting fraud. The SEC's complaint against Davis alleges that he materially misrepresented Dell's financial results by using various cookie-jar reserves to cover shortfalls in operating results and engaged in other reserve manipulations from FY2002 to FY2005, including improper recording of large payments from Intel as operating expense- offsets. This fraudulent accounting made it appear that Dell was consistently meeting Wall Street earnings targets (i.e., net operating income) through the company's management and operations. The SEC's complaint further alleged that the reserve manipulations allowed Dell to misstate materially its operating expenses as a percentage of revenue-an important financial metric that Dell highlighted to investors. 2 The company engaged in the questionable use of reserve accounts to smooth net income. Davis directed Dell assistant controller Randall D. Imhoff and his subordinates, when they identified reserved amounts that were no longer needed for bona fide liabilities, to check with him about what to do with the excess reserves instead of just releasing them to the income statement. In many cases, he ordered his team to transfer the amounts to an "other accrued liabilities" account. According to the SEC, "Davis viewed the 'Corporate Contingencies' as a way to offset future liabilities. He substantially participated in the 'earmarking' of the excess accruals for various purposes." FASB 5 states that a loss accrual should be recognized with a charge to income when a loss is probable and reasonably estimable. The maintenance of reserves for unspecified business risks (i.e., cookie-jar reserves) is not permitted under GAAP. Beginning in the 1990s, Intel had a marketing campaign that paid its vendors certain marketing rebates to use their products according to a written contract. These were known as market developing funds (MDFs), which according to accounting rules, Dell could treat as reductions in operating expenses because these payments offset expenses that Dell incurred in marketing Intel's products. However, the character of these payments changed in 2001, when Intel began to provide additional rebates to Dell and a few other companies that were outside the contractual agreements. Intel made these large payments to Dell from 2001 to 2006 to refrain from using chips or processors manufactured by Intel's main rival, AMD. Rather than disclosing these material payments to investors, Dell decided that it would be better to incorporate these funds into their component costs without any recognition of their existence. The nondisclosure of these payments caused fraudulent misrepresentation, allowing Dell to report increased profitability over these years. These payments grew significantly over the years making up a rather large part of Dell's operating income. When viewed as a percentage of operating income, these payments started at about 10 percent in FY2003 and increased to about 76 percent in the first quarter of FY2007. When Dell began using AMD as a secondary supplier of chips in 2006, Intel cut the exclusivity payments off, which resulted in Dell having to report a decrease in profits. Rather than disclose the loss of the exclusivity payments as the reason for the decrease in profitability, Dell continued to mislead investors. Audit Considerations In 2006, Dell issued a press release announcing that its audit committee had begun an independent investigation of Dell's accounting and financial reporting practices. After a year of investigation, the audit committee concluded that the financial statements for 2003, 2004, 2005, and 2006 should no longer be relied upon. PricewaterhouseCoopers (PwC) had been Dell's independent auditor since 1986 and had signed off on every one of Dell's financial statements that were on file with the SEC. From 2003 to 2007, Dell paid PwC more than $50 million to perform auditing and other services. PwC issued clean (unmodified) audit opinions for the 2003 to 2006 financial statements, saying that they fairly represented the financial position of Dell. However, these statements did not fairly represent Dell, as evidenced by the audit committee statement that the financial statements for these years should no longer be relied upon. In a suit by shareholders against the firm, PwC was accused of a variety of charges, including not being truly independent and ignoring red flags. These charges were dismissed on a basis of lack of evidence to support the accusations. Questions 1. How would you characterize Dell's accounting for the exclusivity payments with respect to the financial shenanigans discussed in this chapter? 2. Joseph E. Abbott, the vice president and controller of West Pharmaceuticals Services, Inc., in Lionville, Pennsylvania, once said: "Investors should remember that if we do see companies start hitting estimates and not beating them, that wouldn't be such a bad thing. It could mean there is less earnings management going on." How does this statement relate to the actions of Dell in this case? 3. Identify the red flags that should have alerted PwC that Dell may have been engaging in fraud. Given that Dell issued clean opinions during the fraud years, do you think it is possible that the firm conducted its audit in accordance with GAAS? Why or why not? Optional Question 4. Do you agree with the statement from Dell that the actions taken were only negligent and not fraudulent? Explain your reasoning by using the discussion of legal liability in Chapter 6 for support. 1 Facts of the case are Available at www.economist.com/blogs/newsbook/2010/07/dellssec_settlement. 2 Securities and Exchange Commission, Securities and Exchange Commission v. Robert W. Davis , Civil Action No. 1:10-cv-01464 (D.D.C.) and Securities and Exchange Commission v. Randall D. Imhoff , Civil Action No. 1:10-cv-01465 (D.D.C.), Accounting and Auditing Enforcement Release No. 3177 / August 27, 2010. Available at www.sec.gov/litigation/litreleases/2010/lr21634.htm.
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1. Financial Shenanigans term was used for the actions or omissions by an entity to hide or distort the financial condition of such entity. Financial shenanigans were ranged from minor deceptions to serious implications in the accounting of the entity. D's accounting would also be categorized as financial shenanigans as there was material misstatement of the financial statements by using cookie jar reserve to cover the loss in the revenue. Therefore, D constantly appeared its financial statement as they are earning profit each year by using such reserve. Hence, D's accounting for the exclusivity payment would be characterized as a financial shenanigan. 2. The statement is very accurate as any company who is not beating their own estimates and is only hitting its estimates shows that company is not involving in earning management and if the company is involving in the earning management then it will show the record profit earning. However, in this case, it clearly shows that D provided its financial statement as they were beating their estimates and were gaining profit every year. But if we peep inside, it shows that there was earning management going on in the company by maintaining the reserve from I's payment in order to show the profit. Hence, this proves the statement of A to be true. 3. There were several red flags ignored by the P. There was no disclosure of the payment received by I as D received the payment from I in order to refrain from using the chips from their rival company. This was not mentioned by the D in the financial statement which should be considered by the auditors as this would lead to the material misstatements in the financial statements. It was clearly shown that firm was not conducting its audit properly and in accordance with the GAAS requirement. It is not permitted by the by GAAS to maintain the reserve and the D was engaged in maintaining reserve so as to prove that they were beating its estimates and were earning profits. This shows that D was not properly conducting its internal audit and despite continuing with the reserve D was issued clean audit reports. 4. Author is not agreed with the statements of the D that actions performed by the management of D regarding its financial statements were negligent and not fraudulent. The auditor or CPAs have certain responsibility regarding the audit. They are responsible for detecting and preventing fraud. If the auditors found in the first year that there was reserve maintaining in the financial account then it should be reported and must be mentioned in the reports but was not done by them. But the auditors did not exercise reasonable care and due diligence to find out the reserve which is against the company policies. This reserve will made them to materially show misstatement in the financial statement and audit reports as well. Therefore, this shows that it is not negligence but they fraudulently engaged in the activity.

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Comment on the statement that what a company's income statement reveals is interesting, but what it conceals is vital.
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A company's income statement reflects its earning from the projects and future ability to meet its cash requirement. It becomes very interesting to see that what company is reporting in its income statement especially when company is growing. But it shows more dangerous side by concealing and not showing things which should be disclosed in such income statement. Financial Shenanigans are acts or actions that are formed to misinterpret true financial performance or actual financial position of a company. A company may use any of the strategies out of two to manipulate income statement viz. a company may inflate its current income by inflating current revenues or deflating current expense. And deflate current income by deflating current revenues or inflating expense. Therefore, it becomes very critical for a person who is going to analyze income statement to see what company is concealing.

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Solutions Network, Inc. "We can't recognize revenue immediately, Paul, since we agreed to buy similar software from DSS," Sarah Young stated. "That's ridiculous," Paul Henley replied. "Get your head out of the sand, Sarah, before it's too late." Sarah Young is the controller for Solutions Network, Inc., a publicly owned company headquartered in Sunnyvale, California. Solutions Network has an audit committee with three members of the board of directors that are independent of management. Sarah is meeting with Paul Henley, the CFO of the company on January 7, 2014, to discuss the accounting for a software systems transaction with Data Systems Solutions (DSS) prior to the company's audit for the year ended December 31, 2013. Both Young and Henley are CPAs. Sarah has excluded the amount in contention from revenue and net income for 2013, but Henley wants the amount to be included in the 2013 results. Henley told Sarah that the order came from the top to record the revenue on December 28, 2013, the day the transaction with DSS was finalized. Sarah pointed out that Solutions Network ordered essentially the same software from DSS to be shipped and delivered early in 2014. Therefore, according to Sarah, Solutions Network should delay revenue recognition on this "swap" transaction until that time. Henley argued against Sarah's position, stating that title had passed from the company to DSS on December 31, 2013, when the software product was shipped with FOB shipping point terms. Background Solutions Network, Inc., became a publicly owned company on March 15, 2011, following a successful initial public offering (IPO). Solutions Network built up a loyal clientele in the three years prior to the IPO by establishing close working relationships with technology leaders, including IBM, Apple, and Dell Computer. The company designs and engineers systems software to function seamlessly with minimal user interface. There are several companies that provide similar products and consulting services, and DSS is one. However, DSS operates in a larger market providing IT services management products that coordinate the entire business infrastructure into a single system. Solutions Networks grew very rapidly during the past five years. The revenue and earnings streams during those years are as follows: img Young prepared the following estimates for 2013: img The Transaction On December 28, 2013, Solutions Network offered to sell its Internet infrastructure software to DSS for its internal use. In return, DSS agreed to ship similar software 30 days later to Solutions Network for that company's internal use. The companies had conducted several transactions with each other during the previous five years, and while DSS initially balked at the transaction because it provided no value added to the company, it did not want to upset one of the fastest-growing software companies in the industry. Moreover, Solutions Network might be able to help identify future customers for DSS's IT service management products. The $30 million of revenue would increase net income by $1.9 million over the projected amount for 2013. For Solutions Network, the revenue from the transaction was enough to enable the company to meet targeted goals, and the higher level of income would provide extra bonus money at year end for Young, Henley, and Ed Fralen, the CEO. Accounting Considerations In her discussions with Henley, Sarah points out that the auditors will arrive on February 1, 2014; therefore, the company should be certain of the appropriateness of its accounting before that time. After all, says Sarah, "the auditors rely on us to record transactions properly as part of their audit expectations." At this point Henley reacts angrily and tells Sarah she can pack her bags and go if she doesn't support the company in its revenue recognition of the DSS transaction. To defuse the matter, Henley suggests that they meet in one week on January 14 to "put this matter to bed." Normally, Sarah wouldn't object to Henley's proposed accounting for the transaction with DSS. However, she knows that regardless of the passage of title to DSS on December 31, 2013, the transaction is linked to Solutions Network's agreement to take the DSS product 30 days later. While she doesn't anticipate any problems in that regard, Sarah is uncomfortable with the recording of revenue on December 31 because DSS did not complete its portion of the agreement by that date. She has her doubts whether the auditors would sanction the accounting treatment. Sarah is also concerned about the fact that another transaction occurred during the previous year that she questioned but, in the end, Sarah went along with Henley's accounting for this transaction. On December 28, 2012, Solutions Network sold a major system for $20 million to Laramie Systems but executed a side agreement with Laramie on December 29, 2012, which gave the customer the right to return the product for any reason after January 1, 2013, and for 27 additional days. Even though Solutions Network recorded the revenue on December 29, 2012, and Sarah felt uneasy about it, she did not object because Laramie did not return the product. Sarah never brought it up again. Now, she is concerned that a pattern may be developing. Questions 1. Describe the rules in accounting for revenue recognition in general and relate them to the two transactions mentioned in the case. Do you believe the transactions have been accounted for properly? 2. Prepare the following schedules: a. Percentage change in revenues from 2009 through the projected amounts in 2013 b. Percentage of net income to revenues from 2008 through the projected amounts in 2013 c. Redo parts (a) and (b), assuming that the DSS transaction is included in the projected results for 2013 What questions might you raise from an ethical perspective with respect to these calculations and the motivation for Paul Henley to include the DSS transaction in 2013? 3. Assume you are Sarah Young and have decided to try to change Paul Henley's mind with respect to the accounting for the December 28, 2013 transaction. What steps might you take to counteract the position of Henley prior to the auditors' arrival on February 1, and why?
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1. Recording of revenue by the companies is to help meet analyst's earning projections, improve the share price, and increase yearend bonus. The rules regarding revenue recognitions are as follows:
• When cash are received in exchange for goods or services then revenues are realized.
• Revenues are only earned when such goods or services are transferred. For revenue recognition, both payment assurance and final delivery is required. After considering the rules, the two transactions were not recognized as revenue. The first transaction was with DSS which was not completed till December 31 st. Hence, it would be difficult to account such revenue. The second transaction is with L but have the side agreement giving right to the customer to return the product after 30 days. Therefore, in first transaction the services was not finally delivered and in second transaction, the customer can return the system before 30 days. In this way, revenue cannot be recognized properly. This also shows that revenue is not accounted properly according to the rules for accounting revenue recognition. 2.a. The percentage changes in revenue from 2009 through the projected amounts (in millions) in 2013 are as follows:
In the year 2009 change in revenue (in millions) is $27.8
img The percentage changes in revenue for 2009:
img Therefore, percentage change in revenue from 2008 to 2009 is
img In the year 2010 change in revenue (in millions) is $26.4
img The percentage changes in revenue in the year 2010:
img Therefore, percentage change in revenue from 2009 to 2010 is
img In the year 2011 change in revenue (in millions) is $27.6
img Percentage changes in revenue in the year 2011:
img Therefore, percentage change in revenue from 2010 to 2011 is
img In the year 2012 change in revenue (in millions) is $37.7
img Percentage changes in revenue in the year 2012:
img Therefore, percentage change in revenue from 2011 to 2012 is
img In the year 2013 change in revenue (in millions) is $20
img Percentage changes in revenue in the year 2013:
img Therefore, percentage change in revenue from 2012 to 2013 is
img b. The percentages of net income to revenues from 2008 through the projected amount in 2013 are as follows:
The percentage of net income to revenues for the year 2008:
img Therefore, percentage of net income to revenues for the year 2008 is
img The percentage for the year 2009:
img Therefore, percentage of net income to revenues for the year 2009 is
img The percentage for the year 2010:
img Therefore, percentage of net income to revenues for the year 2010 is
img The percentage for the year 2011:
img Therefore, percentage of net income to revenues for the year 2011 is
img The percentage for the year 2012:
img Therefore, percentage of net income to revenues for the year 2012 is
img The percentage for the year 2013:
img Therefore, percentage of net income to revenues for the year 2013 is
img c. Sometimes mangers disagree on considering the earning management as ethically acceptable. It is also reflected by them to consider manipulating earning via operating decisions more ethically than manipulation by accounting method. Therefore, it will be considered ethical if P will include DSS transactions in 2013 year. 2. If author was S and has decided to change the mind of P then firstly author will make him aware about the accounting principles, rules and regulations regarding fraud and allegations of fraud. The author will discuss the effects of such manipulations with P as it will have distortion effect which compromises the dependability of the statements. Moreover, author will also give examples of various other companies who were engaged in such manipulations and suffered in future. Author believes that P will definitely change his mind regarding the accounting for December transactions after considering the ill effects of false accounting.

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Diamond Foods On November 14, 2012, Diamond Foods Inc. disclosed restated financial statements tied to an accounting scandal that reduced its earnings during the first three quarters of 2012 as it took significant charges related to improper accounting for payments to walnut growers. The restatements cut Diamond's earnings by 57 percent for FY2011, to $29.7 million, and by 46 percent for FY2010, to $23.2 million. By December 7, 2012, Diamond's share price had declined 54 percent for the year. A press release issued by the company explains in great detail the accounting and financial reporting issues. 1 Diamond Foods, long-time maker of Emerald nuts and subsequent purchaser of Pop Secret popcorn (2008) and Kettle potato chips (2010), became the focus of an SEC investigation after The Wall Street Journal raised questions about the timing and accounting of Diamond's payments to walnut growers. The case focuses on the matching of costs and revenues. At the heart of the investigation was the question of whether Diamond senior management adjusted the accounting for the grower payments on purpose to increase profits for a given period. The case arose in September 2011, when Douglas Barnhill, an accountant who is also a farmer of 75 acres of California walnut groves, got a mysterious check for nearly $46,000 from Diamond. Barnhill contacted Eric Heidman, the company's director of field operations, on whether the check was a final payment for his 2010 crop or prepayment for the 2011 harvest. (Diamond growers are paid in installments, with the final payment for the prior fall's crops coming late the following year.) Though it was September 2011, Barnhill was still waiting for full payment for the walnuts that he had sent Diamond in 2010. Heidman told Barnhill that the payment was for the 2010 crop, part of FY2011, but that it would be "budgeted into the next year." The problem is under accounting rules, you cannot legitimately record in a future fiscal year an amount for a prior year's crop. That amount should have been estimated during 2010 and recorded as an expense against revenue from the sale of walnuts. An investigation by the audit committee in February 2012 found payments of $20 million to walnut growers in August 2010 and $60 million in September 2011 that were not recorded in the correct periods. The $20 million payments to growers in 2010 caught the eye of Diamond's auditors, Deloitte Touche. However, it is uncertain whether the firm approved the accounting for the payments. It is an important determination because corporate officers can defend against securities fraud charges by arguing they did not have the requisite intent because they relied on the approval of the accountants. The disclosure of financial restatements in November 2012 and audit committee investigation led to the resignation of former CEO Michael Mendes, who agreed to pay a $2.74 million cash clawback and return 6,665 shares to the company. Mendes's cash clawback was deducted from his retirement payout of $5.4 million. Former CFO Steven Neil was fired on November 19, 2012, and did not receive any severance. As a result of the audit committee investigation and the subsequent analysis and procedures performed, the company identified material weaknesses in three areas: control environment, walnut grower accounting, and accounts payable timing recognition. The company announced efforts to remediate these areas of material weakness, including enhanced oversight and controls, leadership changes, a revised walnut cost estimation policy, and improved financial and operation reporting throughout the organization. An interesting aspect of the case is the number of red flags, including unusual timing of payments to growers, a leap in profit margins, and volatile inventories and cash flows. Moreover, the company seemed to push hard on every lever to meet increasingly ambitious earnings targets and allowed top executives to pull in big bonuses, according to interviews with former Diamond employees and board members, rivals, suppliers and consultants, in addition to reviews of public and nonpublic Diamond records. Nick Feakins, a forensic accountant, noted the relentless climb in Diamond's profit margins, including an increase in net income as a percent of sales from 1.5 percent in FY2006 to more than 5 percent in FY2011. According to Feakins, "no competitors were improving like that; even with rising Asian demand... it just doesn't make sense." 2 Reuters did a review of 11 companies listed as comparable organizations in Diamond's regulatory filings and found that only one, B G Foods, which made multiple acquisitions, added earnings during the period. Another red flag was that while net income growth is generally reflected in operating cash flow increases, at Diamond, the cash generation was sluggish in FY2010, when earnings were strong. This raises questions about the quality of earnings. Also, in September 2010, Mendes had promised EPS growth of 15 percent to 20 percent per year for the next five years. In FY2009, FY2010, and FY2011, $2.6 million of Mendes's $4.1 million in annual bonus was paid because Diamond beat its EPS goal, according to regulatory filings. It was expected that the company would likely face a civil enforcement action by the SEC for not maintaining accurate books and records and failing to maintain adequate internal controls to report the payments properly, both of which are required for public companies. If the SEC decides to bring a civil fraud case against any individuals at Diamond Foods, the Dodd-Frank Act gives it the option of filing either an administrative case or a civil injunctive action in Federal District Court. An administrative proceeding is generally considered a friendlier venue for the SEC. Questions 1. One of the red flags identified in the case was that operating cash flow increases did not seem to match the level of increase in net income. Explain the relationship between these two measures and why it raised questions about the quality of earnings at Diamond Foods. 2. Why were the actions of Diamond Foods with respect to its 'accounting for nuts' unethical? 3. The role of Deloitte Touche is unclear in the case. We do not know whether the firm approved the accounting for the payments to walnut growers and periods used to record these amounts. Assume that the firm identified the improper payments and discussed the matter with management (i.e., CFO and CEO). What levers might Deloitte use to convince top management to correct the materially misstated financial statements? 1 Available at www.investor.diamondfoods.com/phoenix.zhtml?c=189398 p=irol-newsArticle id=1758849. 2 Available at www.reuters.com/article/2012/03/19/us-diamond-tax-idUSBRE82I0AQ20120319.
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Solway, Inc. Ben Davis is an internal accountant at Solway, Inc., a publicly owned company headquartered in Fresno, California. Ben reports to Chris Hodgins, the controller of the company; Hodgins reports to the CFO, Harry Benson; and Benson reports to George Lee, the CEO. Solway has a three-person independent audit committee that deals with financial oversight issues, including being a direct access group for matters of concern for the chief internal auditor, Sam Vines. On January 15, 2014, Davis is approached by Hodgins and told to record an accrual for unpaid bonuses and severance payments of $50 million to be included in the December 31, 2013, financial statements. Davis asked Hodgins to explain the reason for what appeared to be an unusually high amount of money and was told the company planned to shut down a division in 2014 and the severance payments would be significant. This was the first Davis heard about a shutdown of any division, and he found it strange because the company's operating income in all divisions had set record levels in fiscal year 2013. Moreover, the bonus and severance amounts are five times the annual payroll of the division. The numbers below show the operating income levels and accruals for 2011 through 2013: img Davis did not commit to recording the accruals because he wanted more time to think about the situation. Fortunately, Hodgins was called away on an urgent matter, bringing the meeting to an abrupt halt. Davis decided to speak to Gloria Olson, a fellow internal accountant who graduated with Davis from college. Olson also found the amount of accruals unusually high. Davis asked Olson what the projected operating income was for December 31, 2014 based on her recent calculations. Olson told him that it was determined to be $160 million. They briefly talked about the projected decline in operating income after five straight years of increases. Davis wondered whether the reason for this could be attributable to the shutdown of the division mentioned by Hodgins. Questions Assume that Davis, Hodgins, Benson, Vines, and Olson are all CPAs and hold the certificate in management accounting (CMA). 1. Review the definitions of earnings management by Schipper, Healy and Wahlen, Dechow and Skinner, and McKee that are discussed in this chapter. How would you characterize the proposed accrual for unpaid bonuses and severance payments from an earnings management perspective? 2. Place yourself in Ben Davis's shoes and consider the following in deciding whether to support Hodgins's position on the accrual: a. Who are the stakeholders in this case? b. What are the accounting issues of concern to you? c. What are ethical issues of concern to you with respect to your ethical and professional obligations and stakeholder interests? 3. Assume you meet with Hodgins and he instructs you in no uncertain terms to record the accrual. What would you do and why? Would whistleblowing be a consideration for you? Why or why not?
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The North Face, Inc. The North Face, Inc. (North Face) is an American outdoor product company specializing in outerwear, fleece, coats, shirts, footwear, and equipment such as backpacks, tents, and sleeping bags. North Face sells clothing and equipment lines catered towards wilderness chic, climbers, mountaineers, skiers, snowboarders, hikers, and endurance athletes. The company sponsors professional athletes from the worlds of running, climbing, skiing and snowboarding. North Face is located in Alameda, California, along with an affiliated company, JanSport. These two companies manufacture about half of all small backpacks sold in the United States. Both companies are owned by VF Corporation, an American apparel corporation. The North Face brand was established in 1968 in San Francisco. Following years of success built on sales to a high-end customer base, in the 1990s North Face was forced to compete with mass-market brands sold by the major discount retailers. It was at that point the company engaged in accounting shenanigans that led to it being acquired by VF Corporation. Barter Transactions 1 North Face entered into two major barter transactions in 1997 and 1998. The barter company North Face dealt with typically bought excess inventory in exchange for trade credits. The trade credits could be redeemed by North Face only through the barter company, and most often the trade credits were used to purchase advertising, printing, or travel services. North Face began negotiating a potential barter transaction in early December 1997. The basic terms were that the barter company would purchase $7.8 million of excess inventory North Face had on hand. In exchange for that inventory, North face would receive $7.8 million of trade credits that were redeemable only through the barter company. Before North Face finalized the barter transaction, Christopher Crawford, the company's CFO, asked Deloitte Touche, North Face's external auditors, for advice on how to account for a barter sale. The auditors provided Crawford with the accounting literature describing GAAP relating to non-monetary exchanges. That literature generally precludes companies from recognizing revenue on barter transactions when the only consideration received by the seller is trade credits. What Crawford did next highlights one of the many ways a company can structure a transaction to manage earnings and achieve the financial results desired rather than report what should be recorded as revenue under GAAP. Crawford structured the transaction to recognize profit on the trade credits. First, he required the barter company to pay a portion of the purchase price in cash. Crawford agreed that North Face would guarantee that the barter company would receive at least a 60% recovery of the total purchase price when it re-sold the product. In exchange for the guarantee, the barter company agreed to pay approximately 50% of the total purchase price in cash and the rest in trade credits. This guarantee took the form of an oral side agreement that was not disclosed to the auditors. Second, Crawford split the transaction into two parts on two days before the year-end December 31, 1997. One part of the transaction was to be recorded in the fourth quarter of 1997, the other to be recorded in the first quarter of 1998. Crawford structured the two parts of the barter sale so that all of the cash consideration and a portion of the trade credits would be received in the fourth quarter of 1997. The barter credit portion of the fourth quarter transaction was structured to allow profit recognition for the barter credits despite the objections of the auditors. The consideration for the 1998 first quarter transaction consisted solely of trade credits. On December 29, 1997, North Face recorded a $5.15 million sale to the barter company. The barter company paid $3.51 million in cash and issued $1.64 million in trade credits. North Face recognized its full normal profit margin on the sale. Just ten days later on January 8, 1998, North Face recorded another sale to the barter company, this time for $2.65 million in trade credits, with no cash consideration. North Face received only trade credits from the barter company for this final portion of the $7.8 million total transaction. Again, North Face recognized its full normal profit margin on the sale. Materiality Issues Crawford was a CPA and knew all about the materiality criteria that auditors use to judge whether they will accept a client's accounting for a disputed transaction. He realized that Deloitte Touche would not challenge the profit recognized on the $3.51 million portion of the barter transaction recorded during the fourth quarter of fiscal 1997 because of the cash payment. Crawford also realized that Deloitte would maintain that no profit should be recorded on the $1.64 million balance of the December 29, 1997, transaction with the barter company for which North Face would be paid exclusively in trade credits. However, Crawford was aware of the materiality thresholds that Deloitte had established for North Face's key financial statement items during the fiscal 1997 audit. He knew that the profit margin of approximately $800,000 on the $1.64 million portion of the December 1997 transaction fell slightly below Deloitte's materiality threshold for North Face's collective gross profit. As a result, he believed that Deloitte would propose an adjustment to reverse the $1.64 million transaction but ultimately "pass" on that proposed adjustment since it had an immaterial impact on North Face's financial statements. As Crawford expected, Deloitte proposed a year-end adjusting entry to reverse the $1.64 million transaction but then passed on that adjustment during the wrap-up phase of the audit. In early January 1998, North Face recorded the remaining $2.65 million portion of the $7.8 million barter transaction. Crawford instructed North Face's accountants to record the full amount of profit margin on this portion of the sale despite being aware that accounting treatment was not consistent with the authoritative literature. Crawford did not inform the Deloitte auditors of the $2.65 million portion of the barter transaction until after the 1997 audit was completed. The barter company ultimately sold only a nominal amount of the $7.8 million of excess inventory that it purchased from North Face. As a result, in early 1999, North Face reacquired that inventory from the barter company. Audit Considerations The auditors did not learn of the January 8, 1998 transaction until March 1998. Thus, when the auditors made the materiality judgment for the fourth quarter transaction, they were unaware that a second transaction had taken place and unaware that Crawford had recognized full margin on the second barter transaction. In mid-1998 through 1999, the North Face sales force was actively trying to re-sell the product purchased by the barter company because the barter company was unable to sell any significant portion of the inventory. North Face finally decided, in January and February of 1999, to repurchase the remaining inventory from the barter company. Crawford negotiated the repurchase price of $690,000 for the remaining inventory. Crawford did not disclose the repurchase to the 1998 audit engagement team, even though the audit was not complete at the time of the repurchase. During the first week of March 1999, the auditors asked for additional information about the barter transaction to complete the 1998 audit. In response to this request, Crawford continued to mislead the auditors by failing to disclose that the product had been repurchased, that there was a guarantee, that the 1997 and 1998 transactions were linked, and that the company sales force had negotiated almost all of the orders received by the barter company. Crawford did not disclose any of this information until he learned that the auditors were about to fax a confirmation letter to the barter company that specifically asked if any of the product had been returned or repurchased. Crawford then called the chair of North Face's audit committee, to explain that he had withheld information from the auditors. A meeting was scheduled for later that day for Crawford to make "full disclosure" to the auditors about the barter transactions. Even at the "full disclosure" meeting with the auditors, Crawford was not completely truthful. He did finally disclose the repurchase and the link between the 1997 and 1998 transactions. He did not, however, disclose that there was a guarantee, nor did he disclose that the company's employees had negotiated most of the orders for the product. Deloitte Touche Richard Fiedelman was the Deloitte advisory partner assigned to the North Face audit engagement. Pete Vanstraten was the audit engagement partner for the 1997 North Face audit. Vanstraten was also the individual who proposed the adjusting entry near the end of the 1997 audit to reverse the $1.64 million barter transaction that North Face had recorded in the final few days of fiscal 1997. Vanstraten proposed the adjustment because he was aware that the GAAP rules generally preclude companies from recognizing revenue on barter transactions when the only consideration received by the seller is trade credits. Vanstraten was also the individual who "passed" on that adjustment after determining that it did not have a material impact on North Face's 1997 financial statements. Fiedelman reviewed and approved those decisions by Vanstraten. Shortly after the completion of the 1997 North Face audit, Vanstraten transferred from the office that serviced North Face. In May 1998, Will Borden was appointed the new audit engagement partner for North Face. In the two months before Borden was appointed the North Face audit engagement partner, Richard Fiedelman functioned in that role. Fiedelman supervised the review of North Face's financial statements for the first quarter of fiscal 1998, which ended on March 31, 1998. While completing that review, Fiedelman became aware of the $2.65 million portion of the $7.8 million barter transaction that Crawford had instructed his subordinates to record in early January 1998. Fiedelman did not challenge North Face's decision to record its normal profit margin on the January 1998 "sale" to the barter company. As a result, North Face's gross profit for the first quarter of 1998 was overstated by more than $1.3 million, an amount that was material to the company's first-quarter financial statements. In fact, without the profit margin on the $2.65 million transaction, North face would have reported a net loss for the first quarter of fiscal 1998 rather than the modest net income it actually reported that period. In the fall of 1998, Borden began planning the 1998 North Face audit. An important element of that planning process was reviewing the 1997 audit workpapers. While reviewing those workpapers, Borden discovered the audit adjustment that Vanstraten had proposed during the prior year audit to reverse the $1.64 million barter transaction. When Borden brought this matter to Fiedelman's attention, Fiedelman maintained that the proposed audit adjustment should not have been included in the prior year workpapers since the 1997 audit team had not concluded that North Face could not record the $1.64 million transaction with the barter company. Fiedelman insisted that, despite the proposed audit adjustment in the 1997 audit workpapers, Vanstraten had concluded that it was permissible for North Face to record the transaction and recognize the $800,000 of profit margin on the transaction in December 1997. Borden accepted Fiedelman's assertion that North Face was entitled to recognize profit on a sales transaction in which the only consideration received by the company was trade credits. Borden also relied on this assertion during the 1998 audit. As a result, Borden and the other members of the 1998 audit team did not propose an adjusting entry to require North Face to reverse the $2.65 million sale recorded by the company in January 1998. After convincing Borden that the prior year workpapers misrepresented the decision that Vanstraten had made regarding the $1.64 million barter transaction, Fiedelman began the process of documenting this revised conclusion in the 1997 working papers that related to the already issued financial statements for 1997. The SEC had concluded in its investigation that Deloitte personnel prepared a new summary memorandum and proposed adjustments schedule reflecting the revised conclusion about profit recognition, and replaced the original 1997 working papers with these newly-created working papers. SEC Actions against Crawford In the SEC action against Crawford, 2 the commission charged that Crawford committed a fraud because his actions violated Section 10(b) of the Exchange Act of 1934, in that he knew or was reckless in not knowing, that (1) it was a violation of GAAP to record full margin on the trade credit portion of the sale and (2) that the auditors would consider the amount of the non-GAAP fourth quarter profit recognition immaterial and would not insist on any adjusting entry for correction. A second charge was that Crawford aided and abetted violations of Section 13(a) of the Exchange Act that requires every issuer of a registered security to file reports with the SEC which accurately reflect the issuer's financial performance and provide other information to the public. A third charge dealt with record-keeping and alleged violations of Section 13(b) in that the Exchange Act requires each issuer of registered securities to make and keep books, records, and accounts which, in reasonable detail, accurately and fairly reflect the business of the issuer and to devise and maintain a system of internal controls sufficient to provide reasonable assurances that, among other things, transactions are recorded as necessary to permit preparation of financial statements and to maintain the accountability of accounts. The SEC asked the United States District Court of the Northern District of California to enter a judgment: • permanently enjoining Crawford and the vice president of sales, Todd Katz, from violating Sections 10(b) and 13(b) (5) of the Exchange Act; • ordering Crawford to provide a complete accounting for and to disgorge the unjust enrichment he realized, plus prejudgment interest thereon; • ordering Crawford and Katz to pay civil monetary penalties pursuant to Section 21(d)(3) of the Exchange Act; and • prohibiting Crawford and Katz from acting as an officer or director of a public company pursuant to Section 21(d)(2) of the Exchange Act. Crawford agreed to the terms in a settlement with the SEC that included his suspension from appearing or practicing before the Commission as an accountant for at least five years after which time he could apply to the commission for reinstatement. Questions 1. A variety of definitions of earnings management are given in this chapter. Discuss the accounting techniques used by North Face by evaluating whether and why earnings management existed using the definitions provided by: Schipper, Healy Wahlen, Dechow Skinner, and McKee. 2. An important issue in this case is the application of materiality standards to revenue recognition on the barter transaction. Evaluate the ethics of Deloitte Touche first proposing an audit adjustment on the $1.64 million balance of the December 29, 1997, transaction with the barter company and then passing on the adjustment based on it not having a material effect on the financial statements. Be sure to include both quantitative and qualitative materiality considerations. 3. Deloitte Touche made audit decisions related to the barter transactions that can be criticized from an ethics perspective because of violations of the AICPA Code of Professional Conduct. Evaluate those decisions and explain the nature of the criticisms. 1 The information in this case was taken from: Securities and Exchange Commission, A Civil Complaint filed in the United States District Court Northern District of California against Christopher F. Crawford and Todd F. Katz, February 20, 2003, http://www.sec.gov/litigation/complaints/comp17978.htm. 2 In the matter of Christopher F. Crawford, U.S. Securities and Exchange Commission Accounting and Auditing Enforcement Release No. 1751 (AAER No. 1751) April 4, 2003. Available at www.sec.gov/litigation/admin/34-47633.htm.
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Comment on the statement that materiality is in the eye of the beholder. How does this statement relate to the discussion in this chapter of how to gauge materiality in assessing financial statement restatements? Is materiality inconsistent with the notion of representational faithfulness?
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Relevance and faithful representation are the qualitative characteristics of useful information under SFAC 8. 57 Evaluate these characteristics from an ethical perspective. That is, how does ethical reasoning enter into making determinations about the relevance and faithful representation of financial information?.
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Sunbeam Corporation One of the earliest frauds during the late 1990s and early 2000s was at Sunbeam. The SEC alleged in its charges against Sunbeam that top management engaged in a scheme to fraudulently misrepresent Sunbeam's operating results in connection with a purported "turnaround" of the company. When Sunbeam's turnaround was exposed as a sham, the stock price plummeted, causing investors billions of dollars in losses. The defendants in the action included Sunbeam's former CEO and chair Albert J. Dunlap, former principal financial officer Russell A. Kersh, former controller Robert J. Gluck, former vice presidents Donald R. Uzzi and Lee B. Griffith, and Arthur Andersen LLP partner Phillip Harlow. The SEC complaint described several questionable management decisions and fraudulent actions that led to the manipulation of financial statement amounts in the company's 1996 year-end results, quarterly and year-end 1997 results, and the first quarter of 1998. The fraud was enabled by weak or nonexistent internal controls, inadequate or nonexistent board of directors and audit committee oversight, and the failure of the Andersen auditor to follow GAAS. The following is an excerpt from the SEC's AAER 1393, issued on May 15, 2001: From the last quarter of 1996 until June 1998, Sunbeam Corporation's senior management created the illusion of a successful restructuring of Sunbeam in order to inflate its stock price and thus improve its value as an acquisition target. To this end, management employed numerous improper earnings management techniques to falsify the Company's results and conceal its deteriorating financial condition. Specifically, senior management created $35 million in improper restructuring reserves and other "cookie-jar" reserves as part of a year-end 1996 restructuring, which were reversed into income the following year. Also in 1997, Sunbeam's management engaged in guaranteed sales, improper "bill and hold" sales, and other fraudulent practices. At year-end 1997, at least $62 million of Sunbeam's reported income of $189 million came from accounting fraud. The undisclosed or inadequately disclosed acceleration of sales through "channel- stuffing" also materially distorted the Company's reported results of operations and contributed to the inaccurate picture of a successful turnaround. 1 A brief summary of the case follows. 2 Chainsaw Al Al Dunlap, a turnaround specialist who had gained the nickname "Chainsaw Al" for his reputation of cutting companies to the bone, was hired by Sunbeam's board in July 1996 to restructure the financially ailing company. He promised a rapid turnaround, thereby raising expectations in the marketplace. The fraudulent actions helped raise the market price to a high of $52 in 1997. Following the disclosure of the fraud in the first quarter of 1998, the price of Sunbeam shares dropped by 25 percent, to $34.63. The price continued to decline as the board of directors investigated the fraud and fired Dunlap and the CFO. An extensive restatement of earnings from the fourth quarter of 1996 through the first quarter of 1998 eliminated half of the reported 1997 profits. On February 6, 2001, Sunbeam filed for Chapter 11 bankruptcy protection in U.S. Bankruptcy Court. Accounting Issues Cookie-Jar Reserves The illegal conduct began in late 1996, with the creation of cookie-jar reserves that were used to inflate income in 1997. Sunbeam then engaged in fraudulent revenue transactions that inflated the company's record-setting earnings of $189 million by at least $60 million in 1997. The transactions were designed to create the impression that Sunbeam was experiencing significant revenue growth, thereby further misleading the investors and financial markets. Channel Stuffing Eager to extend the selling season for its gas grills and to boost sales in 1996, CEO Dunlap's "turnaround year," the company tried to convince retailers to buy grills nearly six months before they were needed, in exchange for major discounts. Retailers agreed to purchase merchandise that they would not receive physically until six months after billing. In the meantime, the goods were shipped to a third-party warehouse and held there until the customers requested them. These bill-and-hold transactions led to recording $35 million in revenue too soon. However, the auditors (Andersen) reviewed the documents and reversed $29 million. In 1997, the company failed to disclose that Sunbeam's 1997 revenue growth was partly achieved at the expense of future results. The company had offered discounts and other inducements to customers to sell merchandise immediately that otherwise would have been sold in later periods, a practice referred to as "channel stuffing." The resulting revenue shift threatened to suppress Sunbeam's future results of operations. Sunbeam either didn't realize or totally ignored the fact that by stuffing the channels with product to make one year look better, the company had to continue to find outlets for their product in advance of when it was desired by customers. In other words, it created a balloon effect, in that the same amount or more accelerated amount of revenue was needed year after year. Ultimately, Sunbeam (and its customers) just couldn't keep up, and there was no way to fix the numbers. Sunbeam's Shenanigans Exhibit 1 presents an analysis of Sunbeam's accounting with respect to Schilit's financial shenanigans. Red Flags Schilit points to several red flags that existed at Sunbeam but either went undetected or were ignored by Andersen, including the following: 3 1. Excessive charges recorded shortly after Dunlap arrived. The theory is that an incoming CEO will create cookie- jar reserves by overstating expenses, even though it reduces earnings for the first year, based on the belief that increases in future earnings through the release of the reserves or other techniques make it appear that the CEO has turned the company around, as evidenced by turning losses into profits. Some companies might take it to an extreme and pile on losses by creating reserves in a loss year, believing that it doesn't matter whether you show a $1.2 million loss for the year or a $1.8 million loss ($0.6 million reserve). This is known as the "big-bath accounting." 2. Reserve amounts reduced after initial overstatement. Fluctuations in the reserve amount should have raised a red flag because they evidenced earnings management as initially record reserves were restored into net income. 3. Receivables grew much faster than sales. A simple ratio of the increase in receivables to the increase in revenues should have provided another warning signal. Schilit provides the following for Sunbeam's operational performance in Exhibit 2 that should have created doubts in the minds of the auditors about the accuracy of reported revenue amounts in relation to the collectibility of receivables, as indicated by the significantly larger percentage increase in receivables compared to revenues. 4. Accrual earnings increased much faster than cash from operating activities. While Sunbeam made $189 million in 1997, its cash flow from operating activities was a negative $60.8 million. This is a $250 million difference that should raise a red flag, even under a cursory analytical review about the quality of recorded receivables. Accrual earnings and cash flow from operating activity amounts are not expected to be equal, but the differential in these amounts at Sunbeam seems to defy logic. Financial analysts tend to rely on the cash figure because of the inherent unreliability of the estimates and judgments that go into determining accrual earnings. Quality of Earnings No one transaction more than the following illustrates questions about the quality of earnings at Sunbeam. Sunbeam owned a lot of spare parts that were used to fix its blenders and grills when they broke. Those parts were stored in the warehouse of a company called EPI Printers, which sent the parts out as needed. To inflate profits, Sunbeam approached EPI at the end of December 1997, to sell it parts for $11 million (and book an $5 million profit). EPI balked, stating that the parts were worth only $2 million, but Sunbeam found a way around that. EPI was persuaded to sign an "agreement to agree" to buy the parts for $11 million, with a clause letting EPI walk away in January 1998. In fact, the parts were never sold, but the profit was posted anyway. Paine Webber, Inc. analyst Andrew Shore had been following Sunbeam since the day Dunlap was hired. 4 As an analyst, Shore's job was to make educated guesses about investing clients' money in stocks. Thus, he had been scrutinizing Sunbeam's financial statements every quarter and considered Sunbeam's reported levels of inventory for certain items to be unusual for the time of year. For example, he noted massive increases in the sales of electric blankets in the third quarter of 1997, although they usually sell well in the fourth quarter. He also observed that sales of grills were high in the fourth quarter, which is an unusual time of year for grills to be sold, and noted that accounts receivable were high. On April 3, 1998, just hours before Sunbeam announced a first-quarter loss of $44.6 million, Shore downgraded his assessment of the stock. By the end of the day, Sunbeam's stock prices had fallen 25 percent. Questions 1. Is there a difference between aggressive accounting and earnings management? Would the motivation for using the techniques described in this case influence whether they should be labeled as aggressive accounting or earnings management? Incorporate ethical considerations in your answer. 2. How did pressures for financial performance contribute to Sunbeam's culture, where quarterly sales were manipulated to influence investors? To what extent do you believe the Andersen auditors should have considered the resulting culture in planning and executing its audit? 3. Chapter 3 addresses issues related to corporate governance and ethical management. Given the facts of the case, identify the deficiencies in ethics and corporate governance failures at Sunbeam. 4. Given the variety of income adjusting techniques described in the case that were used by Sunbeam to manipulate the numbers, do you think it was proper for the Andersen auditors to dismiss $2 million of the $5 million income from the sale of the spare parts inventory? What factors do you think Andersen should have considered in addition to materiality in making the determination? Optional Question 5. Why is it important for auditors to use analytical comparisons such as the ratios in the Sunbeam case to evaluate possible red flags that may indicate additional auditing is required? 1 Securities and Exchange Commission, In the Matter of Sunbeam Corporation, Respondent , Accounting and Auditing Enforcement Release No. 1393, May 15, 2001, Available at www.sec.gov/litigation/admin/33-7976.htm. 2 Securities and Exchange Commission, Litigation Release 17001, Securities and Exchange Commission v. Albert J. Dunlap, Russell A. Kersh, Robert J. Gluck, Donald R. Uzzi, Lee B. Griffith, and Phillip E. Harlow , 01-8437-CIV-Dimitrouleas (S.D. Fla., May 15, 2001), www.sec.gov/litigation/admin/33-7977.htm. 3 Howard M. Schilit, Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports , 2d ed. (New York: McGraw-Hill, 2002).
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Explain how the quality of corporate governance, risk management, and compliance systems is critical in controlling financial restatement risk within organizations.
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Evaluate the following statements from an ethical perspective: "Earnings management in a narrow sense is the behavior of management to play with the discretionary accrual component to determine high or low earnings." "Earnings are potentially managed, because financial accounting standards still provide alternative methods."
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In Arthur Levitt's speech, referred to in the opening quote, he also said, "I fear that we are witnessing an erosion in the quality of earnings, and therefore, the quality of financial reporting. Managing may be giving way to manipulation; integrity may be losing out to illusion." Explain what you think Levitt meant by this statement. What role do financial analysts' earnings expectations play in the quality of earnings?
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Vivendi Universal "Some of my management decisions turned wrong, but fraud? Never, never, never." This statement was made by the former CEO of Vivendi Universal, Jean-Marie Messier, as he took the stand in November 20, 2009, for a civil class action lawsuit brought against him, Vivendi Universal, and the former CFO, Guillaume Hannezo, that accused the company of hiding Vivendi's true financial condition before a $46 billion three-way merger with Seagram Company and Canal Plus. The case was brought against Vivendi, Messier, and Hannezo after it was discovered that the firm was in a liquidity crisis and would have problems repaying its outstanding debt and operating expenses (contrary to the press releases by Messier, Hannezo, and other senior executives that the firm had "excellent" and "strong" liquidity); that it participated in earnings management to achieve earnings goals; and that it had failed to disclose debt obligations regarding two of the company's subsidiaries. 1 The jury decided not to hold either Messier or Hannezo legally liable because "scienter" could not be proven. In other words, the court decided it could not be shown that the two officers acted with the intent to deceive other parties. The stock price of the firm dropped 89 percent, from €84.70 on October 31, 2000, to €9.30 on August 16, 2002, over the period of fraudulent reporting and press releases to the media. 2 Vivendi is a French international media giant rivaling Time Warner Inc. that spent $77 billion on acquisitions, including the world's largest music company, Universal Music Group (UMG). Messier took the firm to new heights that came with a large amount of debt through mergers and acquisitions. The Vivendi Universal case raises a few ethical issues. For example, was it wrong for Vivendi to make improper adjustments to its earnings before interest, taxes, depreciation, and amortization (EBITDA) to meet ambitious earnings targets in 2001? Was Messier correct in stating that he made some decisions that just turned out poorly and that he was not participating in an extensive fraud scandal? In December 2000, Vivendi acquired Canal Plus and Seagram, which included Universal Studios and its related companies, and became known as Vivendi Universal. At the time, it was one of Europe's largest companies in terms of assets and revenues, with holdings in the United States that included Universal Studios Group, UMG, and USA Networks Inc. These acquisitions cost Vivendi cash, stock, and assumed debt of over $60 billion and increased the debt associated with Vivendi's Media Communications division from approximately €3 billion ($4.32 billion) at the beginning of 2000 to over €21 billion ($30.25 billion) in 2002. In July 2002, Messier and Hannezo resigned from their positions as CEO and CFO, respectively, and new management disclosed that the company was experiencing a liquidity crisis that was a very different picture than the previous management had painted of the financial condition of Vivendi Universal. This was due to senior executives using four different methods to conceal Vivendi Universal's financial problems: issuing false press releases stating that the liquidity of the company was "strong" and "excellent" after the release of the 2001 financial statements to the public, using aggressive accounting principles and adjustments to increase EBITDA and meet ambitious earnings targets, failing to disclose the existence of various commitments and contingencies, and failing to disclose part of its investment in a transaction to acquire shares of Telco, a Polish telecommunications holding company. On March 5, 2002, Vivendi issued earnings releases for 2001, which were approved by Messier, Hannezo, and other senior executives, that their Media Communications business had produced €5.03 billion ($7.25 billion) in EBITDA and just over €2 billion ($2.88 billion) in operating free cash flow. These earnings were materially misleading and falsely represented Vivendi's financial situation because, due to legal restrictions, Vivendi was unable unilaterally to access the earnings and cash flow of two of its most profitable subsidiaries, Cegetel and Maroc Telecom, which accounted for 30 percent of Vivendi's EBITDA and almost half of its cash flow. This contributed to Vivendi's cash flow actually being "zero or negative," making it difficult for Vivendi to meet its debt and cash obligations. Furthermore, Vivendi declared a €1 ($1.44) per share dividend because of its excellent operations for the past year, but Vivendi borrowed against credit facilities to pay the dividend, which cost more than €1.3 billion ($1.87 billion) after French corporate taxes on dividends. Throughout the following months before Messier and Hannezo's resignations, senior executives continued to lie to the public about the strength of Vivendi as a company. In December 2000, Vivendi and Messier predicted a 35 percent EBITDA growth for 2001 and 2002, and, in order to reach that target, Vivendi used earnings management and aggressive accounting practices to overstate its EBITDA. In June 2001, Vivendi made improper adjustments to increase EBITDA by almost €59 million ($85 million), or 5 percent of the total EBITDA of €1.12 billion ($1.61 billion) that Vivendi reported. Senior executives did this mainly by restructuring Cegetel's allowance for bad debts. Cegetel, a Vivendi subsidiary whose financial statements were consolidated with Vivendi's, took a lower provision for bad debts in the period and caused the bad debts expense to be €45 million ($64.83 million) less than it would have been under historical methodology, which in turn increased earnings by the same amount. Furthermore, after the third quarter of 2001, Vivendi adjusted earnings of UMG by at least €10.125 million ($14.77 million) or approximately 4 percent of UMG's total EBITDA of €250 million ($360.15 million) for that quarter. At that level, UMG would have been able to show EBITDA growth of approximately 6 percent versus the same period in 2000 and to outperform its rivals in the music business. They did this by prematurely recognizing revenue of €3 million ($4.32 million) and temporarily reducing the corporate overhead charges by €7 million ($10.08 million). Vivendi failed to disclose in their financial statements commitments regarding Cegetel and Maroc Telecom that would have shown Vivendi's potential inability to meet its cash needs and obligations. They were also worried that if they disclosed this information, companies that publish independent credit opinions would have declined to maintain their credit rating of Vivendi. In August 2001, Vivendi entered into an undisclosed current account borrowing with Cegetel for €520 million ($749.11 million) and continued to grow to over €1 billion ($1.44 billion) at certain periods of time. Vivendi maintained cash pooling agreements with most of its subsidiaries, but the current account with Cegetel operated much like a loan, with a due date of the balance at December 31, 2001 (which was later pushed back to July 31, 2002), and there was a clause in the agreement that provided Cegetel with the ability to demand immediate reimbursement at any time during the loan period. If this information would have been disclosed, it would have shown that Vivendi would have trouble repaying its obligations. Regarding Maroc Telecom, in December 2000, Vivendi purchased 35 percent of the Moroccan government-owned telecommunications operator of fixed line and mobile telephone and Internet services for €2.35 billion ($3.39 billion). In February 2001, Vivendi and the Moroccan government entered into a side agreement that required Vivendi to purchase an additional 16 percent of Maroc Telecom's shares in February 2002 for approximately €1.1 billion ($1.58 billion). Vivendi did this in order to gain control of Maroc Telecom and consolidate its financial statements with their own because Maroc carried little debt and generated substantial EBITDA. By not disclosing this information on the financial statements, Vivendi's financial information for 2001 was materially false and misleading. The major stakeholders in the Vivendi case include (1) the investors, creditors, and shareholders of the company and its subsidiaries-by not providing reliable financial information, Vivendi misled these groups into lending credit, cash, and investing in a company that was not as strong as it seemed; (2) the subsidiaries of Vivendi and their customers-by struggling with debt and liquidity, Vivendi borrowed cash from the numerous subsidiaries all over the globe, jeopardizing their operations; (3) the governments of these countries-because some of Vivendi's companies were government owned (such as the Moroccan company Maroc Telecom), and these governments have to regulate the fraud and crimes that Vivendi committed; and (4) Vivendi, Messier, Hannezo, and other senior management and employees-Messier was putting his future, the employees of Vivendi, and the company itself in jeopardy by making loose and risky decisions involving the sanctity of the firm. On August 11, 2008, the SEC announced the distribution of more than $48 million to more than 12,000 investors who were victims of fraudulent financial reporting by Vivendi Universal. Investors receiving checks resided in the United States and 15 other countries. More than half bought their Vivendi stock on foreign exchanges and received their Fair Fund distribution 3 in euros. In the Fair Funds provisions of SOX, Congress gave the commission increased authority to distribute ill-gotten gains and civil money penalties to harmed investors. These distributions reflect the continued efforts and increased capacity of the commission to repay injured investors, regardless of their physical location and their currency of choice. Questions 1. Why do financial analysts look at measures such as EBITDA and operating free cash flow to evaluate financial results? How do these measures differ from accrual earnings? Do you believe auditors should be held responsible for auditing such information? 2. Given the major stakeholders mentioned in the Vivendi case, evaluate the ethics of the actions taken by Messier and Hannezo as it effected stakeholder interests. Consider in your answer the fiduciary obligations of these managers. 3. Evaluate the accounting issues discussed in this case from the perspective of Schilit's financial shenanigans. Which of the various accounting decisions made by Vivendi through Messier and Hannezo can be categorized as one of the shenanigans? 1 Securities and Exchange Commission v. Vivendi Universal, S. A., Jean-Marie Messier, and Guillaume Hannezo , www.sec.gov/litigation/complaints/comp18523.htm. 2 As of May 15, 2013, 1 euro = $1.29, or $1 = €0.775. 3 A Fair Fund is a fund established by the SEC to distribute "disgorgements" (returns of wrongful profits) and penalties (fines) to defrauded investors. Fair Funds hold money recovered from a specific SEC case. The commission chooses how to distribute the money to defrauded investors, and when completed, the fund terminates.
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Cubbies Cable Ernie Binks is a big baseball fan, so it is quite natural for him, at a time like this, to recall a phrase attributed to Yogi Berra: "It was deja vu all over again." Binks is the partner in charge of the Cubbies Cable audit for the accounting firm of Santos Williams LLP. Cubbies is a publicly-owned cable company headquartered in Chicago. A situation arose with the client over the proper accounting for cable installation costs in the year-ended September 30, 2013, financial statements. The client wants to expense the costs while the audit manager has recommended capitalization. It is important to resolve the issue quickly because the client will use the September 30, 2013, audited annual statements to apply for a $10 million loan at one of two banks-Chicago First National or Bankers Trust. Binks reviewed a memorandum prepared by John Kessinger, the audit manager, that details the accounting issues. This memo is presented in Exhibit 1. The revenue earned from the cable installation job enabled the company to complete the fourth quarter of 2013 with record earnings. Revenues at September 30, 2013, exceeded revenues at September 30, 2012, by 22 percent. Net income for the twelve months ended September 30, 2013, was 24 percent above the same amount in the prior year. Binks is now preparing for a meeting with Rod Hondley, the advisory partner on the Cubbies Cable audit. Hondley has already made it known that he supports the client's position on the cable installation costs. Binks knows Santos Williams operates by the simple philosophy that you have to let the client win one somewhere along the line or you may lose that client. The dilemma for Binks is he is in the uncomfortable position of going against the recommendation of the audit manager if he agrees to the client's position that Hondley supports. Binks thinks about the fact that the situation is unique in that the client's preferred accounting treatment would actually lower earnings for the year-ended September 30, 2013, and increase it in subsequent years. He considers his options and reflects on another "Yogi-ism": "When you come to a fork in the road, take it." Questions 1. What do you think was the motivation for Cubbies Cable in taking the position to expense all cable costs during the year ended September 20, 2013. Would you characterize the position as an attempt to manage earnings? Why or why not? 2. Who are the stakeholders in this situation? Identify the major ethical issues that should be of concern to Binks in deciding whether to just go along with the firm in its support of the client (based on Hondley's position) or support the position of the audit manager. What would you do if you were in Binks's position? Why? 3. Do you think it is ethical for CPAs to "horse trade" when negotiating with a client about the proper GAAP to apply in a particular situation? How does such negotiating relate to the accepted auditing standards of the AICPA and PCAOB discussed in Chapter 5?
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Needles talks about the use of a continuum ranging from questionable or highly conservative to fraud to assess the amount to be recorded for an estimated expense. Discuss his concept of a continuum and the choices within a range from an ethical perspective. That is, how might a decision about the selection of one or another amount in the continuum relate to it being an ethical position to take?
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Evaluate earnings management from a utilitarian perspective. Can earnings management be an ethical practice? Discuss why or why not.
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In 2010, LinkedIn reported trade payable obligations totaling $10.8 million in other accrued expenses within accrued liabilities instead of accounts payable. In 2011, note 2 in the 10-K financial statements described the use of accrued liabilities instead of accounts payable as a classification. Do you believe LinkedIn's accounting qualifies as a financial shenanigan? Why or why not?
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Maines and Wahlen 94 state in their research paper on the reliability of accounting information:" Accrual estimates require judgment and discretion, which some firms under certain incentive conditions will exploit to report non-neutral accruals estimates within GAAP. Accounting standard scan enhance the information in accrual estimates by linking them to the underlying economic constructs they portray." Explain what the authors meant by this statement with respect to the possible existence of earnings management.
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Sweat Construction Company During the past few years, due to increasing competition, Sweat Construction Company has been more aggressive in seeking out new business opportunities. One such opportunity is the Computer Assistance Vocational Training School. It has contracted for a new 1-million-square-foot facility in San Marcos, Texas. Computer Assistance trains computer programmers for jobs in business and government. It is the largest computer training school in the southwestern United States. Gabe Kohn is the passive owner of Sweat Construction. The company began operating in 2000, when Kohn hired Michael Woody to be the president of the company. Sweat Construction is a family-owned business that has been very successful as a mechanical contractor of heating, ventilation, and air-conditioning systems. However, increased competition has put pressure on the company to diversify its operations. Although it made a profit in 2011, the company's net income for the year was 50 percent lower than in previous years. As a result of these factors, the company decided to expand into plumbing and electrical contract work. In March 2012, Sweat Construction successfully bid for the Computer Assistance job. The company bid low in order to secure the $3 million contract that is expected to be completed by June 30, 2013. Woody knows that the company has little margin for error on the contract. The estimated gross margin of 11.5 percent is on the low side of historical margins, which have been between 10 to 15 percent on heating, ventilation, and air-conditioning contracts. Because it is a fixed-price contract, the company will have to absorb any cost overruns. The Computer Assistance contract is an important one for Sweat Construction. It represents about 20 percent of the average annual revenues for the past five years. Moreover, First National Bank of Texas has been pressuring the company to speed up its interest payments on a $2 million term loan payable to the bank that is renewable on March 15, 2013. The company has been late in five of its last six monthly payments. The main reason is that some of the company's customers have been paying their bills later than usual because of tight economic conditions. However, the company expects to get back on the right track very soon after the Computer Assistance job begins. Everything started out well on the contract. For the quarter ended June 30, 2012, Sweat Construction had an estimated cumulative gross profit of $75,000 on the contract under the percentage-of-completion method. This represents a 20 percent gross margin. Costs started to increase during the September quarter and, even though cumulative gross margin decreased to 10 percent, it was still within projected amounts. Unfortunately, the $54,000 estimated gross profit for the nine months ended December 31, 2012, represents only a 3 percent gross margin for the first year of the contract. Exhibit 1 contains cost data, billings, and collections for the year. Vinny Barbieri is a CPA and the controller of Sweat Construction. Barbieri knows that cash collections on the Computer Assistance project have been slowing down-in part, because the company is behind schedule-and tension has developed between the company and Computer Assistance. He decides to contact Juan Santos, general manager for the project. Santos informs Barbieri that the tension between the company and Computer Assistance escalated recently when Santos informed top management of Computer Assistance that the electrical work may not be completed by the June 30, 2013, deadline. If the facility does not open as scheduled for the summer months, Computer Assistance may be required to return deposits from students. Consequently, it may lose out on the revenue that is projected for the July and August summer term. Woody calls for a meeting with Santos and Barbieri on February 6, 2013, to discuss the Computer Assistance contract. Woody knows that Sweat Construction's external auditors will begin their audit of the December 31, 2012, year-end financial statements in two weeks. Woody wants to make sure the problems with the contract have been corrected. He asks Barbieri to bring him up to date on the recent cost increases on the contract. Barbieri informs Woody that the internal job cost data indicate that $420,000 was incurred for the month of January 2013. About 10 percent of the work was completed during that month. Barbieri emphasizes that this is consistent with recent trend data that indicate the estimated costs to complete the contract have been significantly understated. In fact, for the quarter ended December 31, 2012, the company lost approximately $40,000 on the contract, although there is a cumulative gross margin of about $60,000 for 2012. However, this cumulative margin represents only 2 percent of revenue, and the gross margin percentage is declining. Barbieri analyzed the cost data in preparation for the meeting. He estimates that total costs on the contract may be as high as $4.2 million. He recommends that the $1.17 million estimate to complete the contract should be increased by at least $1 million. Woody is stunned by this information. He cannot understand how the company got into this predicament. The company has consistently made profits on its contracts, and there has never before been any tension with clients. The timing is particularly troublesome because First National Bank is expecting audited financial statements by March 1, 2013. Woody asks Santos whether he agrees with Barbieri's assessment about the anticipated higher level of future costs. Santos hesitates at first, but he eventually admits to the likelihood of cost overruns. He points out that the workers are not as skilled with electrical work as they are with heating, ventilation, and air-conditioning work. Consequently, some degree of learning is taking place on the job. Woody dismisses Santos at this point and asks Barbieri what would happen if the company reports the estimated costs at December 31, 2012, without any adjustments. Woody emphasizes that the company would make the necessary adjustments in the first quarter of 2013, and gross profit on the contract with Computer Assistance ultimately will be correct. This approach would enable the company to renew its loan and give it some time to rethink its business strategy. Barbieri immediately tells Woody that he is not comfortable with this approach because the profit on the contract for the nine months ended December 31, 2012, would be significantly overstated. He points out that the auditors are likely to question the low cost estimates. Woody becomes a bit irritated with Barbieri at this point. He tells Barbieri that the bank is not likely to renew the company's $2 million loan if the statements reflect what Barbieri suggests. He concludes by stating: "The auditors have never been a problem before. I do not expect any problems from them on this issue either, given that the firm has gone along with whatever we've asked of them in the past." Question Use the integrated ethical decision-making process described in Chapter 2 to evaluate the ethical and professional issues in the case. What would you do if you were in Vinny Barbieri's position?
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Nortel Networks Canada-based Nortel Networks was one of the largest telecommunications equipment companies in the world prior to its filing for bankruptcy protection on January 14, 2009, in the United States, Canada, and Europe. The company had been subjected to several financial reporting investigations by U.S. and Canadian securities agencies in 2004. The accounting irregularities centered on premature revenue recognition and hidden cash reserves used to manipulate financial statements. The goal was to present the company in a positive light so that investors would buy (hold) Nortel stock, thereby inflating the stock price. Although Nortel was an international company, the listing of its securities on U.S. stock exchanges subjected it to all SEC regulations, along with the requirement to register its financial statements with the SEC and prepare them in accordance with U.S. GAAP. The company had gambled by investing heavily in Code Division Multiple Access (CDMA) wireless cellular technology during the 1990s in an attempt to gain access to the growing European and Asian markets. However, many wireless carriers in the aforementioned markets opted for rival Global System Mobile (GSM) wireless technology instead. Coupled with a worldwide economic slowdown in the technology sector, Nortel's losses mounted to $27.3 billion by 2001, resulting in the termination of two-thirds of its workforce. The Nortel fraud primarily involved four members of Nortel's senior management as follows: CEO Frank Dunn, CFO Douglas Beatty, controller Michael Gollogly, and assistant controller Maryanne Pahapill. At the time of the audit, Dunn was a certified management accountant, while Beatty, Gollogly, and Pahapill were chartered accountants in Canada. Accounting Irregularities On March 12, 2007, the SEC alleged the following in a complaint against Nortel: 1 • In late 2000, Beatty and Pahapill implemented changes to Nortel's revenue recognition policies that violated U.S. GAAP, specifically to pull forward revenue to meet publicly announced revenue targets. These actions improperly boosted Nortel's fourth quarter and fiscal 2000 revenue by over $1 billion, while at the same time allowing the company to meet, but not exceed, market expectations. However, because their efforts pulled in more revenue than needed to meet those targets, Dunn, Beatty, and Pahapill selectively reversed certain revenue entries during the 2000 year-end closing process. • In November 2002, Dunn, Beatty, and Gollogly learned that Nortel was carrying over $300 million in excess reserves. The three did not release these excess reserves into income as required under U.S. GAAP. Instead, they concealed their existence and maintained them for later use. Further, Beatty, Dunn, and Gollogly directed the establishment of yet another $151 million in unnecessary reserves during the 2002 year-end closing process to avoid posting a profit and paying bonuses earlier than Dunn had predicted publicly. These reserve manipulations erased Nortel's pro forma profit for the fourth quarter of 2002 and caused it to report a loss instead. 2 • In the first and second quarters of 2003, Dunn, Beatty, and Gollogly directed the release of at least $490 million of excess reserves specifically to boost earnings, fabricate profits, and pay bonuses. These efforts turned Nortel's first-quarter 2003 loss into a reported profit under U.S. GAAP, which allowed Dunn to claim that he had brought Nortel to profitability a quarter ahead of schedule. In the second quarter of 2003, their efforts largely erased Nortel's quarterly loss and generated a pro forma profit. In both quarters, Nortel posted sufficient earnings to pay tens of millions of dollars in so-called return to profitability bonuses, largely to a select group of senior managers. • During the second half of 2003, Dunn and Beatty repeatedly misled investors as to why Nortel was conducting a purportedly "comprehensive review" of its assets and liabilities, which resulted in Nortel's restatement of approximately $948 million in liabilities in November 2003. Dunn and Beatty falsely represented to the public that the restatement was caused solely by internal control mistakes. In reality, Nortel's first restatement was necessitated by the intentional improper handling of reserves, which occurred throughout Nortel for several years, and the first restatement effort was sharply limited to avoid uncovering Dunn, Beatty, and Gollogly's earnings management activities. The complaint charged Dunn, Beatty, Gollogly, and Pahapill with violating and/or aiding and abetting violations of the antifraud, reporting, and books and records requirements. In addition, they were charged with violating the Securities Exchange Act Section 13(b)(2)(B) that requires issuers to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that, among other things, transactions are recorded as necessary to permit the preparation of financial statements in conformity with U.S. GAAP and to maintain accountability for the issuer's assets. Dunn and Beatty were separately charged with violations of the officer certification provisions instituted by SOX under Section 302. The commission sought a permanent injunction, civil monetary penalties, officer and director bars, and disgorgement with prejudgment interest against all four defendants. Specifics of Earnings Management Techniques From the third quarter of 2000 through the first quarter of 2001, when Nortel reported its financial results for year-end 2000, Dunn, Beatty, and Pahapill altered Nortel's revenue recognition policies to accelerate revenues as needed to meet Nortel's quarterly and annual revenue guidance, and to hide the worsening condition of Nortel's business. Techniques used to accomplish this goal include: 1. Reinstituting bill and hold transactions. The company tried to find a solution for the hundreds of millions of dollars in inventory that was sitting in Nortel's warehouses and offsite storage locations. Revenues could not be recognized for this inventory because U.S. GAAP revenue recognition rules generally require goods to be delivered to the buyer before revenue can be recognized. This inventory grew, in part, because orders were slowing and, in June 2000, Nortel had banned bill and hold transactions from its sales and accounting practices. A bill and hold transaction is one where the customer agrees to purchase a product but the seller (Nortel in this case) retains physical possession until the customer can accept delivery. The company reinstituted bill and hold sales when it became clear that it fell short of earnings guidance. In all, Nortel accelerated into 2000 more than $1 billion in revenues through its improper use of bill and hold transactions. 2. Restructuring business-asset write-downs. Beginning in February 2001, Nortel suffered serious losses when it finally lowered its earnings guidance to account for the fact that its business was suffering from the same widespread economic downturn that affected the entire telecommunications industry. As Nortel's business plummeted throughout the remainder of 2001, the company reacted by implementing a restructuring that, among other things, reduced its workforce by two-thirds and resulted in a significant write-down of assets. 3. Creating reserves. In relation to writing down the assets, Nortel established reserves that were used to manage earnings. Assisted by defendants Beatty and Gollogly, Dunn manipulated the company's reserves to manage Nortel's publicly reported earnings, create the false appearance that his leadership and business acumen was responsible for Nortel's profitability, and pay bonuses to these three defendants and other Nortel executives. 4. Releasing reserves into income. From at least July 2002 through June 2003, Dunn, Beatty, and Gollogly released excess reserves to meet Dunn's unrealistic and overly aggressive earnings targets. When Nortel internally (and unexpectedly) determined that it would return to profitability in the fourth quarter of 2002, the reserves were used to reduce earnings for the quarter, avoid reporting a profit earlier than Dunn had publicly predicted, and create a stockpile of reserves that could be (and were) released in the future as necessary to meet Dunn's prediction of profitability by the second quarter of 2003. When 2003 turned out to be rockier than expected, Dunn, Beatty, and Gollogly orchestrated the release of excess reserves to cause Nortel to report a profit in the first quarter of 2003, a quarter earlier than the public expected, and to pay defendants and others substantial bonuses that were awarded for achieving profitability on a pro forma basis. Because their actions drew the attention of Nortel's outside auditors, they made only a portion of the planned reserve releases. This allowed Nortel to report nearly break-even results (though not actual profit) and to show internally that the company had again reached profitability on a pro forma basis necessary to pay bonuses. Role of Auditors and Audit Committee In the second half of 2003, Nortel's outside auditors raised concerns about Nortel's handling of reserves and, from that point forward, the defendants' scheme began to unravel. To appease the auditors, Nortel's management-led by Dunn and Beatty-conducted a purportedly comprehensive review of Nortel's assets and liabilities. This resulted in an announcement, on October 23 , 2003, that Nortel would restate its financials for FY2000, FY2001, and FY2002. Shortly after Nortel's announced restatement, the audit committee commenced an independent investigation and hired outside counsel to help it "gain a full understanding of the events that caused significant excess liabilities to be maintained on the balance sheet that needed to be restated," as well as to recommend any necessary remedial measures. The investigation uncovered evidence that Dunn, Beatty, and Gollogly and certain other financial managers were responsible for Nortel's improper use of reserves in the second half of 2002 and first half of 2003. In March 2004, Nortel suspended Beatty and Gollogly and announced that it would "likely" need to revise and restate previously filed financial results further. Dunn, Beatty, and Gollogly were terminated for cause in April 2004. On January 11, 2005, Nortel issued a second restatement that restated approximately $3.4 billion in misstated revenues and at least another $746 million in liabilities. All of the financial statement effects of the defendants' two accounting fraud schemes were corrected as of this date, but there remained lingering effects from the defendants' internal control and other nonfraud violations. Nortel also disclosed the findings to date of the audit committee's independent review, which concluded, among other things, that Dunn, Beatty, and Gollogly were responsible for Nortel's improper use of reserves in the second half of 2002 and first half of 2003. The second restatement, however, did not reveal that Nortel's top executives had also engaged in revenue recognition fraud in 2000. In May 2006, in its Form 10-K for the period ending December 31, 2005, Nortel admitted for the first time that its restated revenues in part had resulted from management fraud, stating that "in an effort to meet internal and external targets, the senior corporate finance management team... changed the accounting policies of the company several times during 2000," and that those changes were "driven by the need to close revenue and earnings gaps." Throughout their scheme, the defendants lied to Nortel's independent auditor by making materially false and misleading statements and omissions in connection with the quarterly reviews and annual audits of the financial statements that were materially misstated. Among other things, each of the defendants submitted management representation letters to the auditors that concealed the fraud and made false statements, which included that the affected quarterly and annual financial statements were presented in conformity with U.S. GAAP and that they had no knowledge of any fraud that could have a material effect on the financial statements. Dunn, Beatty, and Gollogly also submitted a false management representation letter in connection with Nortel's first restatement, and Pahapill likewise made false management representations in connection with Nortel's second restatement. The defendants' scheme resulted in Nortel issuing materially false and misleading quarterly and annual financial statements and related disclosures for at least the financial reporting periods ending December 31, 2000, through December 31, 2003, and in all subsequent filings made with the SEC that incorporated those financial statements and related disclosures by reference. Settlement On October 15, 2007, Nortel, without admitting or denying the SEC's charges, agreed to settle the commission's action by consenting to be enjoined permanently from violating the antifraud, reporting, books and records, and internal control provisions of the federal securities laws and by paying a $35 million civil penalty, which the commission placed in a Fair Fund 3 for distribution to affected shareholders. 4 Nortel also agreed to report periodically to the commission's staff on its progress in implementing remedial measures and resolving an outstanding material weakness over its revenue recognition procedures. In settling the matter, the SEC acknowledged Nortel's substantial remedial efforts and cooperation. After Nortel announced its first restatement, the audit committee launched an independent investigation that later uncovered the improper accounting. Nortel's board took extensive remedial action that included promptly terminating employees responsible for the wrongdoing, restating its financial statements four times over four years, replacing its senior management, and instituting a comprehensive remediation program designed to ensure proper accounting and reporting practices. Nortel also shared the results of its independent investigation with the SEC. As part of the settlement, Nortel agreed to report to the commission staff every quarter until it fully implements its remediation program, and the company and its outside auditor agreed that the existing material weakness has been resolved. The commission acknowledged the assistance of the Ontario Securities Commission, which conducted its own separate, parallel investigation. Nortel in Canada After a four-year investigation, on June 20, 2008, Canadian authorities arrested three high-level ex-Nortel executives on fraud charges for their alleged part in what has been described as the worst stock scandal in Canadian history. The Royal Canadian Mounted Police in Toronto arrested ex-CEO Dunn, ex-CFO Beatty, and former corporate controller Gollogly, who were each charged with seven counts of fraud. The charges include "fraud affecting public market; falsification of books and documents; and false prospectus, pertaining to allegations of criminal activity within Nortel Networks during 2002 and 2003." The three pleaded innocent and were released on bail. On January 14, 2009, Nortel filed for protection from creditors in the United States, Canada, and the United Kingdom in order to restructure its debt and financial obligations. In June, the company announced that it no longer planned to continue operations and that it would sell off all of its business units. Nortel's CDMA wireless business and long-term evolutionary access technology (LTE) were sold to Ericsson, and Avaya purchased its Enterprise business unit. The final indignity for Nortel came on June 25, 2009, when Nortel's stock price dropped to 18.5¢ a share, down from a high of $124.50 in 2000. Nortel's battered and bruised stock was finally delisted from the S P/TSX composite index, a stock index for the Canadian equity market, ending a colossal collapse on an exchange on which the Canadian telecommunications giant's stock valuation once accounted for a third of its value. Postscript The three former top executives of Nortel Networks Corp. were found not guilty of fraud on January 14, 2013. In the court ruling, Justice Frank Marrocco of the Ontario Superior Court found that the accounting manipulations that caused the company to restate its earnings for 2002 and 2003 did not cross the line into criminal behavior. Accounting experts said the case is sure to be closely watched by others in the business community for the message it sends about where the line lies between fraud and the acceptable use of discretion in accounting. The decision underlines that management still has a duty to prepare financial statements that "present fairly the financial position and results of the company" according to a forensic accountant, Charles Smedmor, who followed the case. "Nothing in the judge's decision diminished that duty." During the trial, lawyers for the accused said that the men believed that the accounting decisions they made were appropriate at the time, and that the accounting treatment was approved by Nortel's auditors from Deloitte Touche. Judge Marrocco accepted these arguments, noting many times in his ruling that bookkeeping decisions were reviewed and approved by auditors and were disclosed adequately to investors in press releases or notes added to the financial statements. Nonetheless, the judge also said that he believed that the accused were attempting to "manage" Nortel's financial results in both the fourth quarter of 2002 and in 2003, but he added he was not satisfied that the changes resulted in material misrepresentations. He said that except for $80 million of reserves released in the first quarter of 2003, the rest of the use of reserves was within "the normal course of business." Judge Marrocco said the $80-million release, while clearly "unsup- portable" and later reversed during a restatement of Nortel's books, was disclosed properly in Nortel's financial statements at the time and was not a material amount. He concluded that Beatty and Dunn "were prepared to go to considerable lengths" to use reserves to improve the bottom line in the second quarter of 2003, but he said the decision was reversed before the financial statements were completed because Gollogly challenged it. In a surprising twist, Judge Marrocco also suggested the two devastating restatements of Nortel's books in 2003 and 2005 were probably unnecessary in hindsight, although he said he understood why they were done in the context of the time. He said the original statements were arguably correct within a threshold of what was material for a company of that size. Darren Henderson, an accounting professor at the Richard Ivey School of Business at the University of Western Ontario, said that a guilty verdict would have raised the bar for management to justify their accounting judgments. But the acquittal makes it clear that "management manipulation of financial statements is very difficult to prove beyond a reasonable doubt in a court of law," he said. It is clear that setting up reserves or provisions is still subject to management discretion, Henderson said. "The message... is that it is okay to use accounting judgments to achieve desired outcomes, [such as] a certain earnings target." Questions 1. Auditors are required to assess fraud risks as part of their ethical and professional responsibilities. What characteristics of Nortel might have caused it to be identified as a high-risk audit? Use the fraud triangle in answering this question. 2. I n the Ontario Superior Court ruling, Justice Marrocco "found that the accounting manipulations that caused the company to restate its earnings for 2002 and 2003 did not cross the line into criminal behavior." Morrocco added he was "not satisfied beyond a reasonable doubt" that the trio [i.e., Dunn, Beatty, and Gollogly] had 'deliberately misrepresented' financial results. Review the accounting manipulations in the case and answer the following questions: a. What types of "financial shenanigans" were used by the trio to manipulate earnings? b. Do you agree with the decision of Judge Morrocco in not holding the trio legally liable? Why or why not? 3. Trust is an essential element in the relationship between the external auditor and top management. Evaluate the actions taken by the top officers with respect to their relationship with the Deloitte Touche auditors, their fiduciary responsibilities as the head of Nortel and corporate governance in general. 1 U.S. District Court for the Southern District of New York, U.S. Securities and Exchange Commission v. Frank A. Dunn, Douglas C. Beatty, Michael J. Gollogly, and Maryanne E. Pahapill, Civil Action No. 07-CV-2058, www.sec.gov/litigation/complaints/2007/comp20036.pdf. 2 Pro forma means literally as a matter of form. Companies sometimes report income to the public and financial analysts that may not be calculated in accordance with GAAP. For example, a company might report pro forma earnings that exclude depreciation expense, amortization expense, and nonrecurring expenses such as restructuring costs. In general, pro forma earnings are reported in an effort to put a more positive spin on a company's operations. Unfortunately, there are no accounting rules on just how pro forma should be calculated, so comparability is difficult at best, and investors may be misled as a result. 3 A Fair Fund is a fund established by the SEC to distribute "disgorgements" (returns of wrongful profits) and penalties (fines) to defrauded investors. Fair Funds hold money recovered from a specific SEC case. The commission chooses how to distribute the money to defrauded investors, and when completed, the fund terminates. 4 Theresa Tedesco and Jamie Sturgeon, "Nortel: Cautionary Tale of a Former Canadian Titan," Financial Post , June 27, 2009, www.nationalpost.com/life/travel/sun-destinations/story.html?id=1739799#ixzz0mtBaFszD.
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