Accounting ethical: read the cases first, then answer the questions. (read the power point as needed, no less than 150 words per question) for #4-6: answer the questions (read the powe

Case 4-4 Threats to Audit Independence

Katy Carmichael, CPA, was just promoted to audit manager in the technology sector at a large public accounting firm.

She started at the firm six years ago and has worked on a number of the same client audits for multiple years. She prefers being placed on same client audits year over year as she believes her knowledge about the client grows each year, resulting in a better audit. Public accounting firms tend to do this as it provides continuity between the firm and the client and often results in a more efficient (less costly) audit as well.

Katy was thrilled to learn that she would be retaining three of her prior audit clients, including what she considers her favorite client (DGS – Drako Gaming Solutions). She has friendships with those in the financial reporting area including the CFO with whom she has makes joint business investments.

The audit planning for DGS's next audit is about to begin. As is common practice with all audits, each member of the audit engagement team is asked to fill out a questionnaire about any type of relationship (personal, business, or financial) they might have (or any other member of the engagement team might have with the client company, any of its customers, suppliers, employees, or direct family members of their employees. Katy will soon be meeting with the firm's compliance partner assigned to the DGS audit to go through the completed questionnaire. In that regard, answer the following questions.

1. Identify any potential threats to independence that exists based on the facts of the case. [150 words]

Case 5-1

Assume Vick and Ethan are CPAs. Ethan Lester was seen as a “model employee” who deserved a promotion to CFO, according to Kelly Fostermann, the CEO of Fostermann Corporation, a Maryland-based, largely privately held company that is a prominent global designer and marketer of stereophonic systems. Kelly considered Lester to be an honest employee based on performance reviews and his unwillingness to accept the promotion, stating that he wasn’t ready yet for the position. Little did she know that Lester was committing a $50,000 fraud during 2015 by embezzling cash from the company. In fact, no one seemed to catch on because Lester was able to override internal controls. However, the auditors were coming in and to solidify the deception, he needed the help of Vick Jensen, a close friend who was the accounting manager. Lester could “order” Jensen to cover up the fraud but hoped he would do so out of friendship and loyalty. Besides, Lester knew Jensen had committed his own fraud two years ago and covered it up by creating false journal entries for undocumented sales, returns, transactions, and operating expenses.

Lester went to see Jensen and explained his dilemma. He could see Jensen’s discomfort in hearing the news. Jensen had thought he had turned the corner on being involved in fraud after he quietly paid back the $20,000 he had stolen two years ago. Here is how the conversation went.

“Vick, I need your help. I blew it. You know Mary and I split up 10 months ago.”

“Yes,” Vick said.

“Well, I got involved with another woman who has extravagant tastes. I’m embarrassed to say she took advantage of my weakness and I wound up taking $50,000 from company funds.”

“Ethan, what were you thinking?”

“Don’t get all moral with me. Don’t you recall your own circumstances?”

Vick was quiet for a moment and then asked, “What do you want me to do?”

“I need you to make some entries in the ledger to cover up the $50,000. I promise to pay it back, just as you did. You know I’m good for it.”

Vick reacted angrily, saying, “You told me to skip the bank reconciliations—that you would do them yourself. I trusted you.”

“I know. Listen, do this one favor for me, and I’ll never ask you again.”

Vick grew increasingly uneasy. He told Ethan he needed to think about it … his relationship with the auditors was at stake.

QUESTION:

2. Analyze the facts of the case using the Fraud Triangle. Include a discussion of the weaknesses in internal controls. [150 words]

Case 6-2 Solutions Network, Inc. (a GVV case)

"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, 2019, 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, 2018. Both Young and Henley are CPAs.

Young has excluded the amount in contention from revenue and net income for 2018, but Henley wants the amount to be included in the 2018 results. Without it, Solutions Network would not meet earnings expectations. Henley tells Young that the order came from the top to record the revenue on December 28, 2018, the day the transaction with DSS was finalized. Young points out that Solutions Network ordered essentially the same software from DSS to be shipped and delivered early in 2019. Therefore, according to Young, Solutions Network should delay revenue recognition on this "swap" transaction until that time. Henley argues against Sarah's position, stating that title had passed from the company to DSS on December 31, 2018, when the software product was shipped FOB shipping point.

Background

Solutions Network, Inc., became a publicly owned company on March 15, 2014, 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 Network grew very rapidly during the past five years, although sales slowed down a bit in 2018. The revenue and earnings streams during those years are as follows:

The Transaction

On December 28, 2018, 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 $15 million of revenue would increase net income by $1.0 million. For Solutions Network, the revenue from the transaction would be 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. Young points out that the auditors will arrive on January 15, 2019; therefore, the company should be certain of the appropriateness of its accounting before that time. After all, says Young, "the auditors rely on us to record transactions properly as part of their audit expectations." At this point Henley reacts angrily and tells Young she can pack her bags and go if she doesn't support the company in its revenue recognition of the DSS transaction. Young is taken aback. Henley seems unusually agitated.

Perhaps he was under a lot more pressure to "meet the numbers" than she anticipated. To defuse the matter. Young makes an excuse to end the meeting prematurely and asks if they could meet on Monday morning, after the weekend. Henley agrees.

Over the weekend, Sarah Young calls her best friend, Shannon McCollough, for advice. Shannon is a controller at another company and Sarah would often commensurate with Shannon over their mutual experiences. Shannon suggests that Sarah should explain to Paul Henley exactly what her ethical obligations are in the matter. Shannon thinks it might make a difference because Paul is a CPA as well.

After the discussion with Shannon, Sarah considers whether she is being too firm in her position. On the one hand, she knows that regardless of the passage of title to DSS on December 31. 2018, 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.

On the other hand, Sarah is also concerned about the fact that another transaction occurred during the previous year that she questioned but, in the end, went along with Paul's accounting for this transaction. On December 28, 2017, Solutions Network sold a major system for $20 million to Laramie Systems but executed a side agreement with Laramie on that date which gave Laramie the right to return the product for any reason within 30 days. Even though Solutions Network recorded the revenue in 2017 and Sarah felt uneasy about it, she did not object because Laramie did not return the product; her acceptance was motivated by the delay in the external audit until after the

30-day period had expired. Now, however, Sarah is concerned that a pattern may be developing.

3. Evaluate whether the actions of Paul Henley of Solutions Network represent ethical or unethical earnings management. [150 words]

4. Describe the basic features of the Revised AICPA Code of Professional Conduct. [100 words]

5. Campus Fast is a new audit client. Campus Fast uses public WiFi to place and deliver restaurant take out for students at the Up and Coming State University. Campus Fast was founded by three highly ambitious MBA students at the university. The business plan is to find a buyer or place an IPO of the company by graduation in two years. The founders expect to pay off all student loans, take a tour around the world, and then start another company. In order for the business plan to work on the timeline for graduation, the business must meet highly ambitious earnings numbers. Additionally, the company is dealing with two situations that the founders would like to keep from the auditors: [100 words]

6. Categorize the financial shenanigans in the fraud case at Lucent. [100 words]

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Questions for Consideration

What motivates fraudulent financial reporting?

How are financial statements manipulated to achieve a desired goal?

What are the red flags to look out for in spotting techniques that can lead to material misstatements of the financial statements?

Why do companies provide non-G A A P earnings?

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Ethics Reflections 1

Financial statements must be relevant and reliable. Relevance means the information being reported is meaningful. Reliability refers to the accuracy with which financial data is reported so that users know that information can be trusted.

An important quality of useful information is representational faithfulness. To represent the transactions and events faithfully in the financial statements, the effects of transactions and events should be reported on the basis of economic substance of the transactions instead of legal form of the transaction.

Fraudulent financial reporting occurs for a variety of reasons including to make the company look like it’s doing better than it really is. Some companies manipulate G A A P to achieve a higher level of earnings and mislead investors and creditors about the company’s current and expected future earnings.

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Ethics Reflections 2

Companies use a variety of techniques to produce fraudulent financial reports including accelerating the reporting of revenues and delaying the reporting of expenses, oftentimes by manipulating accrual amounts. These are called financial shenanigans.

Companies seem to look for an any advantage when they report G A A P earnings results. One approach that has caught on with virtually all public companies is to report non-G A A P earnings.

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Motivation to Manage Earnings

Companies manage earnings when they ask, “How can we best report desired results?” rather than “How can we best report economic reality?”

Pressure to “make the numbers”.

Emerged during 1990s and early 2000s.

Stock market awards firms that meet or beat analysts’ forecasts and punishes firms that miss earnings targets.

Management may also use earnings management to maximize bonuses and the value of stock options.

Another objective can be avoiding consequences of violation of debt covenants.

Board of Directors should focus on long term strategic goals and shield managers from short-term pressure.

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Nonfinancial Measures of Earnings

Constant pressure to report favorable earnings performance motivates many companies to report income numbers that exclude unusual events that almost always seem to be costly and depress earnings.

These non-G A A P numbers put a positive spin on what otherwise might not be such good results under G A A P.

Regulation G requires public companies that disclose or release non-G A A P financial measures to include a presentation of the most directly comparable G A A P financial measure and a reconciliation of the non-G A A P measure to the comparable G A A P measure.

Auditors should be tasked with at least reviewing non-G A A P measures as part of their annual audit requirements.

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Characteristics of Earnings Management

Gaa and Dunmore denote two basic possible earnings managements.

Alter the numbers in the financial records by using discretionary accruals and other adjustments.

Create or structure transactions to alter reported numbers.

Another perspective is to divide the techniques into two categories.

Operating earnings management – altering operating decisions to affect cash flows and net income for a period.

Accounting earnings management – using the flexibility in accounting standards to alter earnings numbers.

The end result of earnings management is to distort the application of G A A P, bringing into question the quality of earnings.

Earnings manipulation is a form of earnings management and can be legitimate, marginally ethical, unethical, or illegal.

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Income Smoothing

Motivation to smooth net income over time.

Steady increase each year over a period of time is ideal.

Investors are willing to pay premium for stocks with steady and predictable earnings streams.

These practices lead to erosion in quality of earnings.

Accelerate recognition of revenue.

Delay recognition of expenses.

“Cookie jar reserves”

Set aside reserves in good years.

Used to prop up earnings in bad years.

HealthSouth case.

Banks more aggressive using loan-loss reserves.

Companies also smooth tax liability over years.

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Definition of Earnings Management

Schipper defines it in a negative light- “purposeful intervention in the external reporting process, with the intent of obtaining some private gain”.

Healy and Wahlen define it as “when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers”.

Dechow and Skinner believe that a distinction should be made between making choices in determining earnings that may comprise aggressive, but acceptable, accounting estimates and judgments, as compared to fraudulent accounting practices that are clearly intended to deceive others.

McKee characterizes it as “reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results”.

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How Do Managers and Accountants Perceive Earnings Management? 1

Akers, Giacomino, and Bellovary Survey.

Accounting manipulation is much less ethically acceptable than operating decision manipulation.

Practitioners have few ethical qualms about operating decision manipulation.

Operating decisions that influenced expenses were more suspect than those that influenced revenues.

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How Do Managers and Accountants Perceive Earnings Management? 2

Survey by Elias:

Accountants in organizations with high ethical values perceive earnings management as more unethical.

Accountants in industry significantly less likely than C P As in public practice to perceive high ethical values in their organizations.

Survey by Bruns and Merchant:

Managers disagree about ethics of earnings management.

Manipulation of operating decisions was more ethical than manipulation by accounting method.

Survey by Rosenzweig and Fischer:

Accounting manipulation.

Changing accounting methods.

Recording expense in wrong year.

Changing inventory valuation.

Operating decisions.

Deferring necessary expenditures to subsequent year.

Attracting customers at year-end to draw sales into current year.

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Ethics of Earnings Management 1

Use ethics framework to judge acceptability.

Virtue ethics examines reasons for the actions taken by decision maker AND the action itself.

McKee’s explanation is merely a rationalization.

Doesn’t hold true to virtues of honesty and dependability.

Ignores rights of shareholders and stakeholders to receive fair and accurate information.

Masks true performance.

Hopwood says ethics issue can be mitigated by disclosing aggressive accounting assumptions.

Nothing more than rationalization for unethical behavior: disclosure should not be used to cure ills of earnings management.

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Ethics of Earnings Management 2

Act Utilitarian

A decision made by weighing benefits of management/company to smooth net income versus. costs of providing false information to shareholders.

Rule Utilitarian.

Financial statements should never be manipulated for personal gain.

The problem is there is no clear limit between what is ethical and what isn’t.

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Needles Continuum of Earnings Management

Needles points out that the difference between an ethical and an unethical accounting choice is often merely the degree to which the choice is carried out.

The problem with many accounting judgments is that there is no clear limit beyond which a choice is obviously unethical.

A perfectly routine accounting decision, such as expense estimation, may be illegal if the estimated amount is extreme, but it is perfectly ethical if it is reasonable.

Needles provides an interesting example of how a manager might use the concept of an earnings continuum to decide whether to record the expense amount at the conservative end or aggressive end.

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Earnings Guidance

Earnings guidance reflects the comments management makes about what it expects the company will do in the future.

Earnings guidance is given by management to provide investors and financial analysts with data that indicates expected future earnings and earnings per share. These comments are known broadly as forward-looking statements.

Earnings guidance can be given in conference calls with investors and analysts and in press releases available to the public.

One concern with earnings guidance statements is they represent management’s subjective view of the company’s future financial performance, which is exposed to uncertainties and risks.

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Forward-looking Statements

“Forward-looking” statements focus on sales revenues or earnings expectations in light of industry and macro-economic trends.

Guidance to investors and financial analysts about the company’s earnings potential.

Can create liability for issuers, underwriters, officers and directors if material misstatements of fact or omissions are made for public offerings.

P S L R A enacted safe harbor provisions if forward-looking statements are identified as such and accompanied by meaningful cautionary statements that could cause actual results to differ from the statements.

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Green Mountain Coffee Roasters

Green Mountain used conference calls that provided earnings guidance to shareholders and analysts to mask a financial fraud.

Manufacturer of the Keurig brewing system and K-Cup portion packs.

Represented to investors that it was straining to meet consumer demand without accumulating excess inventory.

Deceived P w C auditors on inventory levels by hiding bags and bags of coffee loaded on trucks, and blocking parts of the plant from auditor access.

Hedge fund manager, David Einhorn, and Sam Antar, former C F O of Crazy Eddie, used analytical procedures to spot and warn of the red flags on inventory.

Should auditors monitor conference calls with investors, analysts, and the financial press to determine whether something is said that could be false, fraudulent, or deceptive?

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Using Social Media to Report Earnings Guidance and Financial Results

The S E C said in April 2013, that postings on sites such as Facebook and Twitter are just as good as news releases and company Web sites as long as the companies have told investors which outlets they intend to use.

The S E C guidelines on these matters are under the fair disclosure rule (Regulation F D) that requires companies to disseminate information in a way that wouldn’t be expected to give an advantage to one group of investors over another.

Filing an 8-K form or holding an earnings call are both ways to ensure compliance with the regulation.

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Audit Committee Responsibilities

Audit committee oversight of forward-looking guidance is part of the board of directors' overall ongoing risk assessment process.

The audit committee should understand management's processes for (1) developing assumptions and estimates, (2) accumulating guidance information, and (3) ensuring management judgment's are reasonable. The audit committee should also inquire of possible earnings management to meet the guidance.

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Pull-in Sales

One technique used to meet earnings guidance is accelerating (or "pulling-in") sales from a future quarter to the present in order to close the gap between actual and forecasted revenue.

Typically, this earnings management technique is triggered by offering various incentives, such as price rebates, discounted prices, and extended payment terms to entice customers to accept products in the current quarter that they would not need until next quarter.

Efforts to pull-in sales from a future quarter to a current one only delays the bad news and can create a more spectacular market disappointment when, after a few quarters, there were no more future sales to cannibalize.

Sunbeam Corporation learned this lesson the hard way by using the pull-in revenue technique known as “channel stuffing”.

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Red Flags

Auditors need to be attuned to the red flags that fraud may exist because of overly aggressive accounting and outright manipulation of earnings.

There are many examples of red flags including:

One-time sources of income.

Unexpected increase in accounts receivable.

Slowdown of inventory turnover.

Reduction in reserves.

Reduction in discretionary costs at year-end (i.e., advertising; R&D).

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Earnings Quality

Another way to spot potential fraud in the financial statements is through an assessment of earnings quality.

Dichev et al. conducted a survey in 2016 that examined the views of 375 C F Os on the prevalence and identification of earnings misrepresentation.

The C F Os were asked to rank order specific characteristics of earnings quality.

The leading answers were consistent reporting choices through time and the absence of long-term estimates, both features of sustainable earnings.

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Financial Statem

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