Fundamentals of Cost Accounting 3rd Edition by William N. Lanen, Shannon W. Anderson, Michael Maher

Exercise 27

Incentives, Illegal Activities, and Ethics

An article in The Wall Street Journal indicated that dressmaker Fallo Me (name changed) backdated invoices to record revenue in the quarter before sales were actually made. As long as sales remained strong, the practice went undetected. When a recession hit retailers, however, revenue sagged and it became more difficult to cover one quarter’s shortfall with anticipated revenue from the next quarter.

Fallo Me’s compensation plan included bonuses for the chief operating officer and the chief financial officer if the company’s net income reached $16 million (approximately 2 percent of sales). The company reported a net income of $23 million, and the two executives received bonuses.

The fraud occurred away from corporate headquarters (in New York) at the company’s Cleveland, Ohio, office where the company’s financial affairs are handled. Fallo Me’s chief financial officer was establishing something of an autocratic rule in Cleveland. What the growing operation lacked in organization, he evidently tried to make up through frenzied effort. Employees say they were sometimes pushed to work 16-hour days, including many weekends and holidays, and were sometimes reprimanded for arriving as little as two minutes late to work.

The chief executive officer of the company was paid $3.6 million, mostly in the form of a bonus. He stated that he was bewildered by the accounting scandal. “We just don’t know why they would do it,” he said of the mid-level employees whose scheme concealed Fallo Me’s sliding fortunes.

Required

a. Describe how the invoice back-dating could have affected reported profits. Would those profits have been overstated permanently or just for a period?

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b. What effect might the bonus plan for the chief operating officer and chief financial officer have had on the fraud, if any?

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c. How might the location of financial operations in Cleveland, instead of at corporate headquarters in New York, have made it easier for someone to commit fraud?

Step 1 of 4

Management control system

Management control system is needed to manage the complications arising out of decentralization like dysfunctional decision making. Owners of the organization use structure and procedures of management control system to influence the actions of its managers and other employees to ensure smooth implementation of organizational strategies. Management controls system comprises of three elements such as delegation fo decision making authorities, evaluation of performance and measurement systems and finally awarding compensation and rewards for performance.

Compensation system

Compensation system are made effective and attractive for managers in order to motivate for them for the best performance and achieve organizational objectives. Contingent compensation is part of compensation system where part of remuneration is based on performance. Paying commission to sales person based on sales revenue is part of compensation system that motivates sales teams to deliver their best, which eventually helps to achieve organizational objectives.

Contingent compensation may result in dysfunctional results also. Sales managers may take some decisions to meet their individual goals, that are not in the interest of organization. For example, sale managers may make false commitments or mislead customers about the benefits of sales schemes so that they can meet their sales targets.