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  • 标题:Virtually there technologies: a case study of earnings management and fraud.
  • 作者:DiGregorio, Dean W. ; Stallworth, H. Lynn ; Braun, Robert L.
  • 期刊名称:Journal of the International Academy for Case Studies
  • 印刷版ISSN:1078-4950
  • 出版年度:2004
  • 期号:May
  • 语种:English
  • 出版社:The DreamCatchers Group, LLC
  • 摘要: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.
  • 关键词:Controllers (Accounting);Controllers (Persons);Fraud;Profit;Profits;Video game industry;Video games industry

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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