Virtually there technologies: a case study of earnings management and fraud.

DiGregorio, Dean W. ; Stallworth, H. Lynn ; Bruan, 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.

INSTRUCTORS' NOTES

Recommendations for Teaching Approaches

This case can be discussed in class or assigned as a project to be completed outside of class. The requirement to prepare a memorandum of their findings was designed to improve written communication skills and professional judgement. The requirements to prepare adjusting journal entries and determine the effect on income were designed to improve the students critical thinking skills and to reinforce the necessity of being aware of how proposed journal entries effect income per the books.

The case may also be used to improve analytical and verbal communication skills by requiring students to present or discuss in class, the problems encountered, their proposed corrections, and the effect on income. For example, students can be required to make a presentation to the company's Board of Directors to discuss their investigation and explain their findings. Versions of this case have been used for the last two years in one of the author's Intermediate Financial Accounting II classes. The vast majority of the students felt that the case helped them integrate and apply the materials covered in the course. The case was distributed approximately three-quarters of the way through the course and collected on the last day of class. It was weighted at approximately 7% of the final grade for the course.

The basic methods of manipulating income were discussed in class. Students were expected to complete the requirements of the case outside of class. However, they were also strongly urged to have their journal entries reviewed before handing in the case. This gave the instructor the opportunity to meet with the students, evaluate their reasoning processes, and reinforce critical concepts. In cases where several students had difficulties with the same journal entry, the issue was discussed in class. This required students to logically express their reasoning process and to develop their verbal communication skills. An additional benefit was that the students were exposed to audit procedures that would be covered later in their course work.

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.

AJE Description DR CR Effect on net income
 Income per trial balance $1,864,000
1
2

SOLUTIONS: REQUIREMENT A

1. It appears that the sales journal for December was kept open into January. The $800,000 of sales should not have been recorded in December because the goods had not been shipped by year-end. The sales and related accounts receivable should be removed from the books. The inventory of $640,000 was still owned and was correctly included on the books. The adjusting journal entry will reduce income by $800,000. This could be an intentional misstatement.

2. Sales were recorded before the income was earned. The sales should be reversed and unearned revenue should be recorded. The adjusting journal entry will reduce income by $250,000. This is probably an unintentional error.

3. The original transaction of $600,000 was not a real sale and should be removed from the books along with the related accounts receivable. The inventory was owned by the company but was not counted at year-end (it wasn't there) or included in ending inventory. The $480,000 of inventory should be added to the inventory per the books. The adjusting journal entry will reduce income by $120,000. This is a fraudulent misstatement.

4. The sales return and reduction of accounts receivable in the amount of $310,000 should have been recorded before year-end. The inventory was correct and no adjustment is needed for inventory or cost of goods sold. The adjusting journal entry will reduce income by $310,000. This is a fraudulent misstatement.

5. The sales and related receivables appear to be fictitious and should be removed from the books. The adjusting journal entry will reduce income by $350,000. This is a fraudulent misstatement.

6. The sales return should have been recorded, but was not. The sales return and related reduction of accounts receivable of $400,000 should be recorded on the books. In addition, inventory should be reduced and cost of goods sold increased by $320,000. The adjusting journal entry will reduce income by $720,000. This could have been an intentional misstatement.

7. The allowance for doubtful accounts and the related bad debt expense are understated by $220,000. The allowance for doubtful accounts should be adjusted to its estimated balance. The adjusting journal entry will reduce income by $220,000. This was probably an aggressive interpretation of generally accepted accounting principles.

8. Rebate expenses should be reported as incurred. The expense and related liability should be recorded on the books in December. The adjusting journal entry will reduce income by $300,000. This was an infrequent transaction and was probably an unintentional error. In addition, an adjusting entry would be required in January (not required for this project).

9. The ending inventory contains obsolete inventory that should be written off. Inventory should be reduced and the related cost of goods sold should be increased by $210,000. The adjusting journal entry will reduce income by $210,000. This was probably an unintentional error.

10. The components of the partially completed units included in work-in-process inventory (WIP) that are not yet operable and which are not compatible with any other game systems produced by the company, should be expensed as research and development expenses. The adjusting journal entry will reduce income by $400,000. The finished goods inventory costs associated with the software to be used exclusively by this game system of $280,000 should also be expensed as research and development expenses because a working model has still not been developed. These are probably unintentional errors.

11. These transactions were in effect sales on consignment. Accounts receivable related to consignment sales should not be recorded until the consignee sells the goods. The accounts receivable and related sales of $750,000 should be reversed. Also, the inventory of $600,000 should be put back on the books and cost of goods sold should be reduced. The adjusting journal entry will reduce income by $150,000. This could be an intentional misstatement.

12. Depreciation expense and the related accumulated depreciation account are understated and should be increased by $900,000 (i.e. $2,100,000 - (12 x $100,000) = $900,000). The adjusting journal entry will reduce income by $900,000. This appears to be an overly aggressive interpretation of generally accepted accounting principles.

13. The "customer acquisition costs" should be classified as advertising costs and should be expensed in the period incurred. The adjusting journal entry will reduce income by $250,000. This appears to be an overly aggressive interpretation of generally accepted accounting principles.

14. The cost of the patent should be expensed as research and development expense. The adjusting journal entry will reduce income by $200,000. This appears to be an unintentional error.

15. The $500,000 incurred before working versions were created should be expensed and not capitalized. Computer software should be reduced and research and development expense increased by $500,000. The adjusting journal entry will reduce income by $500,000. This could be an intentional misstatement.

16. Liabilities should be recorded in the period they are incurred. The related inventory was already received and counted. Cost of goods sold and accounts payable should be increased by $250,000. The adjusting journal entry will reduce income by $250,000. This appears to be an unintentional error.

17. Liabilities should be recorded in the period they are incurred. The related inventory was already received and included in the year-end inventory counts. Cost of goods sold and accounts payable should be increased by $350,000. The adjusting journal entry will reduce income by $350,000. This appears to be a fraudulent misstatement.

18. Commission expense and the related liability should be reported in the period in which the services were rendered. The timing of the expense should be matched to the period in which the sales were recorded. Accrued commissions should be recorded in the amount of $310,000 [$150,000 + $160,000 (i.e. $3,200,000 x .05 = $160,000)]. The adjusting journal entry will reduce income by $310,000. An adjusting entry would also be required in January (not required for this project). This appears to be an unintentional error.

19. Payroll expense and the related liability should be reported in the period in which the services were rendered. The liability should be adjusted to its estimated balance and the related expense should be recorded on the books in December. The adjusting journal entry will reduce income by $60,000. An adjusting entry would also be required in January (not required for this project). This appears to be an unintentional error.

Note: If all of the errors go in the same direction (i.e. to increase income), then they may actually be intentional misstatements.

SOLUTIONS: REQUIREMENT B

AJE Description DR CR

 Income per trial balance
1 Sales 800,000
 Accounts receivable 800,000
2 Sales 250,000
 Unearned revenue 250,000
3 Sales 600,000
 Accounts receivable 600,000
 Inventory 480,000
 Cost of goods sold 480,000
4 Sales returns 310,000
 Accounts receivable 310,000
5 Sales 350,000
 Accounts receivable 350,000
6 Sales returns 400,000
 Accounts receivable 400,000
 Cost of goods sold 320,000
 Inventory 320,000
7 Bad debts 220,000
 Allowance for doubtful accounts 220,000
8 Rebate expense 300,000
 Rebates payable 300,000
9 Cost of goods sold 210,000
 Inventory 210,000
10 Research and development expense 680,000
 Inventory 680,000
11 Sales 750,000
 Accounts receivable 750,000
 Inventory: Consigned 600,000
 Cost of goods sold 600,000
12 Depreciation expense 900,000

 Accumulated depreciation 900,000

 Income per trial balance
13 Advertising expense 250,000
 Customer acquisition costs 250,000
14 Research and development expense 200,000
 Patents 200,000
15 Research and development expense 500,000
 Computer software 500,000
16 Cost of goods sold 250,000
 Accounts payable 250,000
17 Cost of goods sold 350,000
 Accounts payable 350,000
18 Commission expense 310,000
 Commissions payable 310,000
19 Payroll expense 60,000
 Accrued payroll 60,000
 Net income (loss) before taxes

AJE Description Effect on income

 Income per trial balance 1,864,000
1 Sales (800,000)
 Accounts receivable
2 Sales (250,000)
 Unearned revenue
3 Sales (600,000)
 Accounts receivable
 Inventory
 Cost of goods sold (480,000)
4 Sales returns (310,000)
 Accounts receivable
5 Sales (350,000)
 Accounts receivable
6 Sales returns (400,000)
 Accounts receivable
 Cost of goods sold (320,000)
 Inventory
7 Bad debts (220,000)
 Allowance for doubtful accounts
8 Rebate expense (300,000)
 Rebates payable
9 Cost of goods sold (210,000)
 Inventory
10 Research and development expense (680,000)
 Inventory
11 Sales (750,000)
 Accounts receivable
 Inventory: Consigned
 Cost of goods sold 600,000
12 Depreciation expense (900,000)

 Accumulated depreciation

 Income per trial balance 1,864,000
13 Advertising expense (250,000)
 Customer acquisition costs
14 Research and development expense (200,000)
 Patents
15 Research and development expense (500,000)
 Computer software
16 Cost of goods sold (250,000)
 Accounts payable
17 Cost of goods sold (350,000)
 Accounts payable
18 Commission expense (310,000)
 Commissions payable
19 Payroll expense (60,000)
 Accrued payroll
 Net income (loss) before taxes (5,066,000)

Dean W. DiGregorio, Southeastern Louisiana University H. Lynn Stallworth, Southeastern Louisiana University Robert L. Braun, Southeastern Louisiana University