Virtually there technologies: a case study of earnings management and fraud.
DiGregorio, Dean W. ; Stallworth, H. Lynn ; Braun, Robert L. 等
CASE DESCRIPTION
The primary subject matter of this case concerns recognizing and
correcting earnings management and fraud. Secondary issues include
helping students to develop professional judgment and to become aware of
typical reporting problems experienced by growing companies. The case
has a difficulty level of three and is appropriate for junior-level
students in intermediate financial accounting courses. It could also be
used at level four in a senior-level auditing class. The case is
designed to be taught in 2.5 class hours and is expected to require 4
hours of outside preparation by students. Alternatively, the case can be
assigned as a project that requires minimal classroom time.
CASE SYNOPSIS
Earnings management has received a great deal of publicity by the
press and increased scrutiny by the SEC. However, many students do not
understand how earnings management and frauds are perpetrated, the
extent to which "gray" areas exist in accounting practice, and
the role that professional judgment plays in determining the correct
course of action. This instructional case is designed to help students
learn to recognize earnings management and fraud, to develop
professional judgment, and to become aware of typical reporting problems
experienced by growing companies. Students are required to identify
problem situations and differentiate between unintentional errors and
omissions, aggressive accounting practices and fraud. They must also
propose adjusting journal entries and determine the effect on income.
The case is based on a fictional fast-growing high tech company,
Virtually There Technologies, which manufactures and markets virtual
reality game systems. In the wake of the abrupt departures of the CFO and controller, students assume the role of the new controller. Their
job is to get the financial records in order before the annual audit of
the company financial statements begins.
VIRTUALLY THERE TECHNOLOGIES: BACKGROUND INFORMATION
You have been hired as the controller for Virtually There
Technologies (VTT), a small high tech company that has demonstrated
steady growth since it introduced its first products in the mid-1990s.
Your job is to get the financial records in order before the annual
audit of the company financial statements. You are assuming the role of
controller at an important and exciting time for the company. The
previous CFO and controller resigned during the last month of the fiscal
year citing "personal reasons" for their abrupt departures.
There have also been quite a few contentious issues with the audit firm
in recent years. To help manage the audit situation, the Interim CFO has
asked that his office clear all information requested by the auditors
before it is passed along to the auditors.
Virtually There Technologies develops, manufactures and markets
virtual reality game systems. Its product line occupies a high-end niche
by utilizing high definition video output technology and total sensory
involvement. In addition, the company has created a line of software
products for owners of the systems. VTT participates in B2B commerce
through its efforts to place its hardware products in electronics
retailing chains and B2C commerce through its on-line retail software
enterprises.
The Board of Directors, consisting primarily of top management and
members of their immediate families, appointed the Vice President of
Marketing to serve as the Interim Chief Financial Officer (CFO). The
assistant controller filled in until you were hired one month after the
end of the fiscal year. As is common with many start-up companies,
compensation comes mainly in the form of stock options and bonuses and
varies significantly from year to year.
The President of VTT has an engineering background and recently
completed an Executive Master of Business Administration degree at a
local university. Although originally focused on technical innovation
and research, his recent focus has been on the fiscal affairs of the
business. He exercises strong control over all aspects of the company,
and has been especially preoccupied with increasing quarterly earnings
and entertaining the financial analysts who have become increasingly
interested in the organization. This interest has been fueled by reports
that the company will make an initial public offering of its stock this
year. He has impressed the financial community with the depth of his
knowledge of technical and financial affairs of the organization and his
bold predictions for unprecedented growth with the development of new
products.
A new major competitor entered the high-definition, integrated
virtual reality market late in the third quarter of the last fiscal
year. This competitor is very well established with the younger end of
its demographic group. In fact, most of VTT's younger customers
grew up playing on game systems created by the competitor. Analysts are
observing this issue closely. Failure to maintain market share in light
of increased competition could be detrimental to VTT's hopes of
going public. As competition in the industry heats up, analysts expect
to see increased consolidation through business failures and
acquisitions.
Central to its hopes of competing effectively in the increasingly
competitive market is VTT's new product line. Although it has not
yet reached viability due to problems with the memory modules on the
product, the company has scheduled a press conference to unveil the
prototype in two months and is assembling products without the
troublesome memory modules. In addition, they have developed software
products to be used by the new hardware unit and are producing new
titles in anticipation of demand for the product following its
introduction.
REQUIREMENTS
Before beginning the assignment, you may want to review the
Supplemental Instruction Materials included at the end of the case.
These materials discuss specific accounting practices that can be used
to manipulate earnings and perpetrate fraud.
A. For each item presented after this section, identify the problem
and discuss how it should be handled. The descriptions should be written
in the form of a memo to the president and numbered. Address only the
adjustments for the year-ended December 31, 2001. For each item, state
whether it appears to be the result of an unintentional error or
omission, a potentially intentional misstatement, a fraudulent action
(intentional), or an aggressive interpretation of generally accepted
accounting principles.
B. Prepare any necessary adjusting journal entries and determine
the effect of each entry on net income (record in a format similar to
the following example). The company uses the perpetual inventory system.
However, in cases where an adjusting journal entry would normally be
made to the "inventory short/over" account, the "cost of
goods sold" account should be used instead. After all required
entries have been prepared, the effect on income column should be
totaled and net income before taxes should be calculated. The net income
before taxes for the year, before any required adjusting journal entries
is $1,864,000.
ADDITIONAL INFORMATION
While reviewing the preliminary December 31, 2001 financial
statements, several items caught your attention. Net income before taxes
for the year was $1,864,000 compared to a net loss of $5,171,000 in the
prior year. Both sales and the gross profit ratio have increased
significantly compared to the prior year. The average collection period
for accounts receivable has increased as a result of the increase in the
average accounts receivable. The inventory turnover has decreased due to
the increase in the average inventory. The asset turnover has increased
because of the large increase in sales. As you continued to perform
account analysis, you became aware of a number of accounting issues.
SALES AND SALES RETURNS
You were concerned whether the sales cut-off had been performed
properly and that all sales returns received before year-end were
properly recorded. During your investigations you discovered the
following items:
1. While testing items in the December sales journal, you noted
that shipping documents indicated that $800,000 worth of the goods (cost
of $640,000) were not actually shipped until the second week of January
in the new year. Upon further investigation, you determined that the
inventory was included in the year-end physical inventory.
2. While reviewing the accounting procedures for sales made on the
company's website, you determined that when the order is placed,
the customer's credit card is charged and the sale is immediately
recorded. Goods sold through the website are typically shipped once a
week. When the goods are shipped, the inventory account is adjusted and
cost of goods sold is charged. While reviewing the general ledger, you
noted that there was no balance in the unearned revenue account. Upon
further investigation, you determined that software sales of $250,000
were made through the website during the last week of the 2001 and
shipped on January 2, 2002.
3. As part of performing the year-end sales cut-off procedures you
identified a large sales return that was recorded early in the new year.
Upon further investigation, you determined that the sales manager had
asked a favorite customer to accept the delivery of game systems before
year-end and had told the customer to "Just return them later, and
I will take them off your bill." The systems were invoiced for
$600,000 and cost $480,000 to manufacture. You also learned that the
sales manager was afraid of being fired because sales for the year were
below the forecasted amount.
4. While working in your office, you received a call from an irate customer. The customer complained that she was still being billed for
systems that had been previously returned. After speaking with the
warehouse supervisor you determined that the systems were returned
during the week before year-end. The sales manager had told the
warehouse manager not to worry about preparing a return slip until the
new year. The warehouse manager also asked you whether it was OK to
prepare the return slip now. You further determined that the systems
were counted during the year-end inventory and valued at $250,000. The
original sale was recorded at $310,000.
RECEIVABLES
Your main concerns regarding accounts receivable were that the
balances recorded on the books were correct and that the allowance for
doubtful accounts was reasonable. In addition to the sales cut-off
procedures previously performed, you also reviewed the accounts
receivable aging at December 31, 2001 and the subsequent cash receipts
received in January and February of 2002. During your investigations you
discovered the following items:
5. While reviewing accounts receivable, you learned that several
vendors have complained about charges listed on their statements. Upon
further investigation, you determined that no documentation was
available for the sales in question and that there were no entries made
for the related cost of goods sold. The sales in question total
$350,000. The employee that posted the entries said that they were told
to do it by the sales manager.
6. While reviewing the accounts receivable aging you noticed
several large 180 day outstanding balances for accounts that were
otherwise current. Upon questioning the accounts receivable supervisor
you were told that there had been a problem with the orders. The systems
shipped were defective and had been returned. The production manager
said "New systems would be shipped out so don't worry about
adjusting the books." Unfortunately, the customers canceled the
orders and bought similar systems from a competitor. You also learned
that the defective systems could not be economically repaired but were
still counted and included in the ending inventory. The inventory was
valued at $320,000. The original sales were recorded at $400,000.
7. The company uses the allowance method to record bad debts. The
accounts receivable aging is reviewed and a reasonable percentage, based
on experience, is applied to each of the various age categories. The
allowance for doubtful accounts per the general ledger is then adjusted
to its estimated balance. After reviewing the accounts receivable aging
and subsequent collections, you estimated that problem accounts
receivable totaled $540,000. The allowance for doubtful accounts per the
general ledger had a balance of $320,000.
8. While reviewing the accounts receivable system you realized that
certain high volume customers were eligible for rebates based on the
total annual purchases over a specific dollar amount. You calculated
that $300,000 of unrecorded rebates were due at year-end. The rebates
were paid in January 2002 and recorded as an expense at that time.
INVENTORY
The introduction of new products and improved versions of existing
products occurs frequently in high tech industries. You were concerned
that obsolete inventory was properly written off and that a proper
classification was made between work-in-process inventory and research
and development costs. During your investigations you discovered the
following items:
9. While reviewing the perpetual inventory records you noted that
several game systems and software products had very little or no
activity. The inventory in question had a recorded value of $210,000.
Upon discussions with sales and warehouse personnel, you learned that
the items were prior versions of current systems and software, and were
no longer offered for sale in the product catalog. You were also told
that they will probably be thrown out rather than be sold through
alternative distribution channels.
10. The newest version of the game system is being produced without
memory modules because the "bugs" have not yet been worked out
of that part of the system. After inquiring where the costs incurred for
the partially completed units were recorded, you were told that they
were included in the work-in-process inventory (WIP). Upon further
analysis you determined that WIP includes $1,200,000 of costs related to
the newest version of the game system. This amount includes components
with a cost of $800,000 that can be used in other VTT products. The
remaining components of the partially completed units are not compatible
with any other game systems produced by the company. In addition, the
software that is to be used exclusively by this game system is
capitalized as finished goods inventory. The costs associated with the
software are $280,000.
11. In your discussions with the marketing department, you found
out that they just rolled out a new campaign in which they made
shipments of game systems to several major electronics retailers under
terms that they could take, display, and sell the systems for three
months. Any systems that were not sold in the three-month "trial
period" could be returned. Payment for the systems sold (or
additional systems that they wanted to keep on hand) would need to be
paid for during the fourth month of the special promotion. The shipments
were made on December 1. Sales were recorded in the amount of $750,000
and the related cost of goods sold were recorded in the amount of
$600,000.
FIXED ASSETS AND INTANGIBLES
You were concerned that fixed assets and intangibles were properly
recorded, that related period costs were properly expensed, and that the
capitalized costs were properly allocated over the economic useful life
of the assets. During your investigations you discovered the following
items:
12. While reviewing the depreciation schedules you noted that all
of the estimated useful lives and salvage values had been increased
during the year to unrealistic levels. After correcting and updating the
depreciation schedules, you determined that depreciation expense for the
year was $2,100,000. While reviewing the general ledger, you noted that
a standard journal entry in the amount of $100,000 had been posted to
depreciation expense each month during the year.
13. While reviewing intangible assets you noted an account labeled
"customer acquisition costs" with a balance of $250,000. Upon
further investigation you determined that the costs were related to
creating and mailing a CD containing several of the company's
lesser-known games to individuals who had registered with the company
when they joined the users group. The software automatically expires 30
days after it is accessed for the first time. None of the costs had been
amortized during the year.
14. While reviewing the patents account you noted that $200,000 had
been capitalized in connection with the purchase of a patent that
related solely to the memory modules for the new game systems. At
year-end, the memory module still did not function properly.
15. While reviewing computer software costs which had been
capitalized, you noted that outside programmers had been paid $700,000
to develop new software programs for the virtual reality game systems.
Upon further investigation you determined that $500,000 had been
incurred before working versions were created.
ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
You were concerned that all December 31, 2001 liabilities were
recorded in the proper period. As such you reviewed the January and
February 2002 purchase journals and cash disbursement journals for a
proper accounts payable cut-off. You also searched for unrecorded
liabilities. During your investigations you discovered the following
items:
16. While reviewing the accounts payable cutoff, you were informed
that all invoices received in January 2002 for purchases of component
parts and other materials were recorded as January purchases. After spot
checking the large invoices you determined that $250,000 of purchases
were delivered in December, but were recorded as January payables.
17. While inquiring if there were any vendor invoices that had not
been entered into the system, a nervous employee mentioned that you
might want to look in the former controller's file cabinet. When
you investigated you found a thick folder containing invoices for that
never been given to the accounts payable department. The invoices were
for purchases of electronic components to be used in manufacturing a
variety of the company's successful products and totaled $350,000.
They all related to the year just ended.
18. The company uses commissioned salespeople to handle all sales
to electronics retail chain stores. While inquiring about the existence
of accrued commissions, you were told that salespeople are not paid
until the accounts receivable are collected. At year-end, the relevant
accounts receivable totaled $3,200,000 and the commission rate was 5%.
You also noticed that commission payments of $150,000 were paid and
expensed during the first week of the new year. They were based on
December collections. At year-end, there was no liability recorded on
the books for accrued commissions.
19. While reviewing the January 2002 payroll journal you noticed
that payroll of $80,000, for the week ending December 31, 2001, was
actually paid and expensed on January 4th, 2002. There was no other
unpaid payroll. At December 31, 2001, there was a $20,000 CR balance in
the accrued payroll account
SUPPLEMENTAL INSTRUCTIONAL MATERIALS
The goal of earnings management and fraudulent financial reporting,
or financial statement fraud, is usually to materially overstate
reported net income in order to make a business look stronger than it
actually is. To overstate net income, net revenues can be overstated,
and expenses can be understated. Some of the usual methods used do each
are described in detail in the paragraphs below.
It should be noted that not all material misstatements and
omissions are a result of fraud or inappropriate earnings management.
Care should be taken to differentiate between aggressive accounting
practices, alternative interpretations in "gray" areas,
errors, omissions, and fraud. There may be aggressive but legitimate
accounting practices which increase reported net income. There are also
honest differences in opinion regarding how certain types of
transactions should be reported. Mistakes are unintentional and should
be in both directions. That is, they may increase or decrease reported
income. If all the mistakes are in the same direction and increase net
income, then there is a question of whether they were unintentional or
intentional. Fraud is the result of intentional misstatement or
omission, and the effect on income is usually only in one direction.
Earnings management and fraudulent reporting may be done in order
to benefit a particular individual, or the company as a whole. For
example, executives or employees who are afraid of losing their jobs, or
whose level of compensation (for example, bonuses or the value of stock
options) is contingent on operating results, may be tempted to overstate
the company's reported earnings. Similarly, a business owner that
desires to sell the company or obtain additional financing may face the
same temptation. Likewise, if the company is close to violating debt
covenants, management may feel pressured to inflate net income.
The following sections review various means by which a company can
manage earnings or perpetrate fraud.
OVERSTATEMENT OF NET REVENUES
Some of the methods used to overstate net revenues for a period
include performing an improper sales cutoff, recognizing income too
early, recording fictitious sales, not recording actual sales returns,
and misclassifying the proceeds from the sale of assets, debt or equity.
The purpose of the sales cutoff is to ensure that all sales are
recorded in the period in which the revenue was earned. This is
generally, the period in which the goods were shipped or the services
provided. By performing an improper sales cut-off, actual sales from the
following period can be recorded in the current period. This is done by
keeping the sales journal for the current period, open into the next
period. In addition, goods can be billed before they are actually
shipped. Services can be billed before they are actually performed.
Customer deposits received can be classified as sales, even though the
goods or services have not yet been provided. Many desperate people have
justified these types of actions by believing that it is just a timing
difference and that the problem will reverse itself out in the following
period. In fact, they usually start a vicious cycle that requires even
larger misstatements in the following periods. The income overstatements
created by the above actions are compounded when a periodic inventory
system is used because both, the sales are overstated, and the related
cost of goods sold are understated.
When revenues can not be increased sufficiently by performing an
improper sales cutoff, the next step often taken is to record fictitious
sales to either actual customers, or customers which do not exist. For
example, legitimate invoices can be recorded more than once, actual
orders can be over billed by overstating the quantity shipped and/or the
price per unit, or totally fictitious sales can be recorded.
When sales returns are not recorded, net sales are overstated. The
problem is further compounded by the effect of the returned goods on
ending inventory and cost of goods sold. Excuses for not recording sales
returns may range from the potentially legitimate "The return was
not approved" or "We were going to reship the correct goods
within the same period without charge," to the more severe problem
"Joe told me not to do anything until next year." It should
also be noted that even if sales returns were not approved before being
accepted, there is a high likelihood that the customer will not pay the
invoice and the valuation of the accounts receivable will become an
issue. Also, a high level of sales returns may also indicate a problem
with the quality of the inventory and require a valuation adjustment.
When proceeds from the sale of fixed assets are reported as sales,
many problems can arise. First, sales are overstated and the gain/ loss
is understated. Second, the net book value of the assets
(cost--accumulated depreciation) is often not removed from the books and
this results in an overstatement of the net fixed assets and an
understatement in the cost related to the sale of the asset. Third,
depreciation expense may be calculated on assets that are no longer
owned. And fourth, profit margins may become misleading since revenues
are misclassified between operating and non-operating items.
If the issuance of debt is misclassified as a normal sale, net
revenues and retained earnings will be overstated, and liabilities will
be understated. If the issuance of equity is misclassified as a sale,
net revenues and retained earnings will be overstated and common stock
will be understated.
UNDERSTATEMENT OF EXPENSES
Some of the methods used to understate expenses include overstating
inventory, failing to properly adjust the carrying value of assets,
capitalizing items which should be expensed, and understating normal
liabilities. In addition, if losses are expected as a result of
litigation, claims, and assessments, and they are not recorded, then
expenses may be materially understated.
When inventory is overstated, the related cost of goods sold is
understated. Inventory can be overstated by overstating the counts,
costs, or extensions on the inventory listing for actual and fictitious
inventory. It can also be overstated by treating inventory held on
consignment as being owned by the consignee.
By failing to properly adjust the carrying value of assets such as
accounts receivable, inventory, and investments, then expenses such as
bad debts, inventory holding losses, unrealized losses, and other
impairment losses can be understated.
When transactions are capitalized, they are recorded as assets,
instead of expenses. If done inappropriately, assets will be overstated,
and expenses will be understated. For example, transactions that should
be recorded as repairs and maintenance may be capitalized as fixed
assets.
When liabilities are not recorded, or are not properly adjusted,
then usually expenses will be understated. Some of the ways that
liabilities can be understated include performing an improper accounts
payable cutoff, intentionally not recording all legitimate bills
received, and not adjusting accrued liabilities to their proper
balances.
The purpose of the accounts payable cutoff is to ensure that
liabilities are recorded in the period in which they were incurred. This
is generally the period in which the goods or services were received. By
performing an improper accounts payable cutoff, purchases in the current
period can be recorded in the following period. This is done by either
closing the current purchase journal before all the bills for the period
are received or by choosing to record current invoices in the purchase
journal for the following period.
When performing an accounts payable cutoff, usually, the purchase
journals and cash disbursements journals for the one or two months after
year-end are reviewed to determine if any material items have been
recorded in the wrong period. If a client is familiar with this audit
technique, and wants to intentionally understate liabilities, he or she
may hold invoices and not give them to the accounts payable clerk to
enter into the system. If legitimate bills are not entered into the
system in the proper period, then expenses and liabilities will be
understated.
When accrued liabilities are not adjusted to their proper balances,
usually both the liabilities and the related expenses are understated.
Frequently, the unrecorded accrued liabilities will be recorded as
direct distributions (i.e. expenses) in the cash disbursements journal,
in the period when actually paid.
As part of an audit, the auditor sends legal letters to the
client's legal representation. The attorneys are expected to
disclose matters related to current and pending litigation, claims, and
assessments. For example, the attorneys should address the client's
expected response (settle, contest), the expected results (win, lose),
and the range of expected losses. Examples of litigation, claims, and
assessments include: lawsuits related to the nonperformance of
contracts, product liability lawsuits, product warranty liabilities,
workman's compensation claims, personal injury claims, construction
contract disputes, and environmental cleanup cost assessments. The
expected damages can be material. To conceal the problem, clients may
either not disclose potential problems to their auditor or attorneys, or
may pay attorneys off the books so that auditors do not know about the
related litigation.
Dean W. DiGregorio, Southeastern Louisiana University H. Lynn
Stallworth, Southeastern Louisiana University Robert L. Braun,
Southeastern Louisiana University
AJE Description DR CR Effect on
net income
Income per trial balance $1,864,000
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