Solution Manual for Detecting Accounting Fraud: Analysis and Ethics

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1Chapter 1Introduction to the Problem of Accounting FraudSOLUTIONSTrue/False Questions:1.False2.False3.False (The Sarbanes-Oxley Act was passed in 2002.)4.True5.False6.False7.True8.False (The Dodd-Frank Act revised and increased the power of the SEC.)9.False (Theyusuallyneitheradmit nor deny the findings.)10.TrueFill-in-the-Blank Questions:11.Section 40412.audit13.banking14.damages15.201016.agents17.lower(But not by much.Byrne, Lavelle, Byrnes, and Vickers, May 2002, reported that in2001, “CEOs of large corporations made 411 times as much as the average factoryworker.”The Institute for Policy Studies pointed out: “The pay gap between CEOs andaverageAmerican workers has grown from 195-to-1 in 1993 to 354-to-1 in 2012.”)18.Volcker19.Adelphia20.toxicor risky

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DETECTING ACCOUNTING FRAUD2Multiple-Choice Questions:21.cExplanation:The SEC is a government regulatory bodyandwas not complicit in the fraud,nor was its role examined or faulted by the Bankruptcy Examiner.•Answers a, b, and d are incorrect becauseThornburgh foundgatekeepingfailures inWorldCom‘sinternalaudit structureandwith itsexternalauditorsand itsboardofdirectors.22.bExplanation:In manycases, senior management compensation agreements included stockoptions that would provide significant additional remuneration if analysts’ earningsexpectations were met.•Answers a, c, and dare incorrect because theywere notcited ascommonreasons toorchestratefrauds.23.bExplanation:•Answers a, c, and daretrue statements.24.dExplanation:Directors with no stake in the company,and who are not officers in thecompany,would be least likely to succumb to pressures.•Answersa,b, and care incorrect because Levitt believedthat situations described in a, b,and c could underminemanydirectors’abilitiesto act autonomously.25.aExplanation:The major objectives of Dodd-Frank are to “reshape the U.S. regulatory systemin a number of areas including but not limited to consumer protection, trading restrictions,credit ratings, regulation of financial products, corporate governance and disclosure, andtransparency” (“The Laws” 2012).•Answer a iscorrectbecause Dodd-Frank does not attempt to increase the number of auditfirms.26.dExplanation:All of thechangesmentioned, plus others, haveresulted from Dodd-Frank.27.a

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Chapter 1: Introduction to the Problem of Accounting Fraud3Explanation:ThroughDodd-Frank’swhistleblower program,whistleblowersareofferedmore protection than under Sarbanes-Oxley, andthey can now receivemonetary awards fromthe SEC which is pursuing whistleblower tips very seriously.•Answers b, c, and d are incorrect because whistleblowers are taken seriously by the SECand they can receive monetary awards.28. aExplanation:The director who works for a competing company,Raining Raisins, may havea conflict of interests.•The employment status of the other directors would be unlikely to result in conflicts ofinterest.29.dExplanation:According to SOX, an audit partner cannot be the lead or reviewing auditor ofthe same company for more than five years.•Answers a, b, and c would be unlikely to influence the ability of Ethical Auditors to carryout an impartial audit.30.aExplanation:Answers b and c were instituted by the SEC only after the Dodd Frank Act of2010.

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Chapter 2: Ethics at Work11Chapter 2Ethics at WorkSOLUTIONS1True/False Questions:1.FalseExplanation:Virtue ethics focuses on character traits of a virtuous personand thus offers nostrict rules on how to act.2.FalseExplanation:Virtue ethics is agent centered, whileconsequentialismis concernedwiththeeffects of an action.3.FalseExplanation:Business ethics is a type of applied ethics. Metaethics is concerned with whatconstitutesthe good and the bad, while business ethics deals with the ethics of particularsituationsandwithina particular discipline.4.FalseExplanation:This is one of the limits ofconsequentialism. Although it judges an action bythe consequences, it is unable to predict every possibleconsequence.5.FalseExplanation:Utilitariansjudge actions by the utility they produce, thus it is a form ofconsequentialism.6.TrueExplanation:This is the hallmark ofdeontology.7.FalseExplanation:This is the goal of virtueethics.8.FalseExplanation:The purpose of the auditis to give an independent opinion onthe financialstatements.9.False1Solutions for this chapter provided by Kate Jackson, Ph.D. student in Theological Ethics, Boston College.

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DETECTING ACCOUNTING FRAUD22Explanation:Therights approach is often combined with the duties approach since a rightoften produces a reciprocal duty.10.TrueExplanation: A specific transaction can cause a specific person to have the right to have aloan repaid.Fill-in-the-Blank Questions:11.Kant12.maximize13.allocated14.need15.character16.Aristotle17.utilitarianism18.hedonism19.stakeholders20.telosMultiple-Choice Questions:21.aExplanation:Utilitarianism is aform of consequentialism thatrefers to all the approaches inthestudy of morality that evaluate conduct or actions in terms of the consequences that theyproduce.•Answers b. and c. are incorrect because they do not refer totheconsequences of anaction.22.bExplanation:According to Kant’s categoricalimperative, the end does not justify the means.•Answers a, b, and c are all consistent with Kant’s categorical imperative.If Kant thoughtthe end justified the means, he would have been a consequentialist.23.c

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Chapter 2: Ethics at Work33Explanation:According to the virtue theory of ethical behavior, the most important aspect ofmorality is found within an individual’s character.•Answer a is incorrect because deontology emphasizes duty•Answer b is incorrect be utilitarianism emphasizesconsequences24.bExplanation:An unwavering commitment to duty is the hallmark of deontology.•Answers a, c, and d are all associated with virtue.According to Aristotle, virtues aredevelopedby habit,adhering tothe mean between extremes, andbehaviorrelated tohuman flourishing.25.aExplanation: Anne would be usingsome ofthe consequences of herpossibleresponse toguide her behavior.26.bExplanation: She would be using her sense of duty (in this case telling thetruth)to guide herbehavior.Duty is the guiding principle of deontology.27. aExplanation: Thistype of thinkingisconsidereda shortcoming ofconsequentialism. Attimes, it can permit egregious acts in the name of the greater good.28.aExplanation:Anotherlimit ofconsequentialismisthatthescopeof the consequences isoftenunclear.29.bExplanation: Autonomyisnot acardinal virtue.•The cardinal virtues are: courage,temperance, wisdom,and justice.30.cExplanation:Self-defense rights were not identified by Sterba•Sterba identified action rights,in personarights,in remrights, and recipient rights.For Discussion:31.Reponses will vary. Here are some possible reactions:

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DETECTING ACCOUNTING FRAUD44Possible VirtuePossible DescriptionHonestyPreparingfinancialstatements that fairlyrepresent the entity’s financial position and theresults of its operationsDiligenceWorking hard and with accuracyto get a jobdone; finishing a task one is givenCourageSpeaking out against unethical businesspractices; refusing to prepare fraudulentfinancial statements.WisdomKnowing when to speak outFairnessNot having favorites; keeping all users offinancial statements in mindGenerositySpending time on mentoringless experiencedaccountants.Considering the cultivation of virtues, sincevirtue ethics is about the virtuous person, oftenvirtue ethics is taught by example and/or through narrative. A way to teach business virtuesmight be through a story about a virtuous accountant. Students may elect to write a tale about avirtuous accountant that teaches lessons about how a virtuous person may respond to difficultethical business dilemmas.Aristotle thought virtues were cultivated through habit. In this view, small and regularbehaviors shape character. To cultivate the virtue of generosity, for example, one might start ona small-scale by giving a dollar to a homeless person on the street, bringing brownies to give outat work, or being generous with one’s time by genuinely asking and listening to how a co-workeris doing. Also in this view, one does not magically become a courageous whistle-blower, forexample, but rather the virtue of courage is fostered through day-to-day courageous acts, such asspeaking out against gossip, admitting when one makes a mistake, and offering one’ssuggestions at a work meeting.32.Reponses will vary. Here are some possible reactions:Those who assert that virtues in business are related to virtues inpersonal life may supporttheir answerswith some of the following beliefs: virtues exist in unity; virtues are developed

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Chapter 2: Ethics at Work55through habit;a person’s life cannot be compartmentalized, but must be treated as anintegrated whole. If someone believes virtues are developed through habit, as Aristotlethought, that person is likely to assume that vices in one’s personal life will lead to vices inone’s business practice. For example, if a husband lies to his wife, he will becomehabituated to lying, making it easier to lie on balance sheets.Conversely, the husband who isa good communicator and who is always honest with his wife is more likely to communicatewell and value honesty in the workplace.Others may regard one’s personal life as distinct from one’s professional life. Thisgroup may believe that personal and professional lives have an impermeable barrier and/orare governed by entirely different, and thus unrelated, virtues. For instance, one may believethat intimate relationships require a totally different set of virtues than business relationships,and thus these are unrelated. And/or one may not think virtues are acquired throughhabitand so lying to one’s spousedoes not make it easier or more likely that one will lie onbalance sheets.Some may think that the virtues exist in unity because they belong to one agent. Inthis view, it is unlikely that one is very honest and at the same time lacks courage. Forexample, one could not be very honest without courage because courage is necessary to tellthe truth in difficult situations. Also, being honest can help to foster courage as acommitment to honesty inspires courage.Others may think it is entirely possible to possess some virtues and some vicesbecause they regard the virtues as unrelated. This group may choose seemingly disparatevirtues to make this case. For example, a person who is honest, but not just, such as amanager who is very honest about hisor herbiases against certain employees.33.Reponses will vary. Here are some possible reactions:Some may think intention matters in so far as a right action is not truly right unless it ismotivated by good intentions.Othersmay think intention matters insofar as awrong action ispermissible if it is for the right reasons. This logic follows thesaying, “The end justifies themeans.”Some may think intention is important, but that it does not determine if an action isright or wrong.

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DETECTING ACCOUNTING FRAUD66A strict consequentialist may believe that only consequences count, so even if one’sintentions are coming from a good place, it is only the outcome that matters. For example,someone wants to improve the business of a group of farmers and gives them a popular grainseed that unintentionally wipes out all their crops. Although the person meantwell, theconsequentialist mayassert that the consequences indicate that the person acted wrongly.(Issues of intent also bring up notions of culpability, which are beyond the scope of thischapter. However, it is important to note that there is a distinction between causalculpability—causing the destruction of crops, in this case—and moral culpability, i.e.theextent to which one is morallyresponsiblefor the destruction of the crops.)To the strict deontologist,an action performed out of a sense of duty has more moralvalue than the same action taken because of its likely consequences in that specific situation.Virtue ethics is most able to take into account intent because it is concerned with thecharacter of thewhole person and with all of that person’s character traits.34.Reponses will vary. Here are some possible reactions:The best answer will first define happiness. One definition ofhappiness is that it is atypeof persistent, peaceful joy (as opposed to an ecstatic, manic, euphoric, and fleetingfeeling).This background joy remains constant during temporary disappointments anddifficulties.For some, acting ethically is accompanied by happiness even when acting ethically ishard. For example, standing up for a co-worker who is being picked on may not make onepopular at work and it may not be easy, but it may also be accompanied by a senseof calmand satisfactionknowing that one actedethically.Wrong actions may be accompanied bygreat anxiety, such as when one is involved in a weboflies or when one cheats on a test.Others will thinkthat the costs of right action may betoogreat. For example, it doesnot feel good to become apariah at work for standing up for a co-worker who ispicked on.It is possible that some maythink that they would feel happier if theycheatedon a test ratherthanfailed a class and hadto repeat it.35(a).Reponses will vary. Here are somepossible reactions:

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Chapter 2: Ethics at Work77For some, this example is the quintessential reason why duty ethics are vital. Here, themanager’s sense of duty overrides hernegative feelings for the employee, enabling theemployee to receive the deserved promotion based on timely and accurate work over thelast two years. Thus, this example illustrates why duty and reason are crucial to businesspractice.Others will feel slighted that the promotion is not inspired by the manager’sopinion that the employee is a likeable and congenialworker. These people may want tobe promoted because the bosshas a positive attitude towards them, and not because theboss is following protocol,rules, and duty.35(b).Reponses will vary. Here are some possible reactions:For some, the managing partner’s ability to offer a promotion in spite of her biasedfeelings will show great integrity and fairness. Letting reason and not emotions guide herdecisions will be looked upon by some as very ethical.Others will not be impressed that the boss gave the promotiononlybecauseshefelt duty-bound to do so. They will think that her lack of authentic and genuineenthusiasm for the employee underminesthe morality behindher actions. These peoplemay think that abiding by rules andduties arenot enough to make someone an ethicalperson and that the boss should feel the genuine desire to give the promotion.36.Reponses will vary.Some things toconsider includepay discrepancies between men and women;promotions for men and women; the presence of a ‘glass ceiling’ for women;howmaternityleave is treated for fathers and mothers in theworkplace;andsocial expectations of men andwomen in the workplace. For instance,are womenand mensometimes held to differentstandards of dressin the business world?Are they held to different standards of behavior?Isthere a difference between how co-workers perceivealong responsefrom a woman versusalong response from a man? If there is a difference, which attitude is rewarded? Is there adifference or a perceived difference in the way women and men approach takingrisks inbusiness?If thereis a difference, which approachis rewarded?Is there a difference or aperceived difference in the waywomen and men promote themselves? If thereis a difference,

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DETECTING ACCOUNTING FRAUD88which approachis rewarded? Is there a difference or a perceived difference between male andfemale styles ofmanagement? If so, which style ismost likely to berewardedor respected?CASE STUDY:Peter Madoff, Brother of Bernard Madoff and Former Chief ComplianceOfficer and Senior Managing Directorof Bernard L. Madoff InvestmentSecurities, LLCa (i).StakeholderConsequenceSourcePeter MadoffTemporary gain ofwealth, luxuriouslifestyle, prestige;Followed bylong-term money loss,imprisonment,embarrassment,separation fromfamily, despised byclients & formerfriendsU.S. AttorneyPreet Bharara said, “Hewill now be jailed well into old age,and he will forfeit virtually everypenny he has.”Law abiding taxpayersPaid taxes whenMadoff did notIRS-CI Acting Special Agent inChargeToni Weirauch said, “One ofthe consequences of the concealmentis that the IRS was hindered fromperforming its lawful duty, thusharming our nation’s law abidingtaxpayers, along with the defraudedvictims.”Special Agent Robert L. Panella said,“During today’s plea, Peter Madoffadmitted to his role in a fraud schemethat harmed the savings of thousandsof investors.”IRSIRS was hinderedfrom performing itslawful duty; publicmoney was lostThousands of investorswho were defraudedLost money,sometimes lost mostof their retirementsavings & had toreturn to work;fooled, cheated, liedto

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Chapter 2: Ethics at Work99EmployeesEconomicsecuritylost, benefits lost,Inability to supportfamilySpecial Agent Robert L. Panella saidthat Madoff “undermine[d] thefinancial well-being of workers.”Madoff also “Failed to protect theintegrity of employee benefit planassets….”RegulatorsWere all tricked intobelievingfalsehoods; wereunable to performtheir jobsappropriately“Madoff created numerous falsecompliance documents in which hestated that he had performedcompliance reviews of the trading inthe BLMIS IA business on a regularbasis, when, in reality, the reviewswere never performed. The falsestatements were designed to misleadregulators, auditors, and IA clients”AuditorsWere all tricked intobelievingfalsehoods; wereunable to performtheir jobsappropriatelyThought they wereinvesting in an elite,thriving companySee above quote.“The numerous false statements in theForms ADV created the falseappearance that BLMIS’s IA businesshad a small number of highlysophisticated clients and far fewerassets under management than wasactually the case.”IA [Investment Advisory]clientsBernard L. MadoffInvestment Securities(BLMIS) clientsHis wife MarionShort-term gain ofmoney;long-term loss ofmoney and life-style,separationfrom father/husband,severeembarrassment“The government has entered into asettlement with Madoff’s family thatrequires the forfeiture of all of his wifeMarion’s and daughter Shana’s assetsand assets belonging to other familymembers.”Daughter ShanaShort-term gain ofmoney;long-term loss ofmoney and life-style, separationfrom father/husband,See above quote.

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DETECTING ACCOUNTING FRAUD1010a (ii).Based on the consequencesdiscussed above, it seems as if allstakeholderssufferednegative consequences. The positive consequences for Madoff and his family wereenjoyed in the short-term only. Based on the utilitarian notion to choose the action thatgives the greatest good to the greatest number, Madoff should not have committed hiscrimes.a (iii).Egoism is a type of consequentialism that judges actions by the benefitsforonlyoneself.According to the article, Madoff was only concerned about himselfand his favorites:“DOL-EBSA New York Regional DirectorJonathan Kay said, ‘Today’s plea is atestament to the good work and strong collaboration among multiple federal agencies.This agency remains committed to protecting worker benefit plans from those who woulddefraud them forpersonalgain.’”Special Agent Panella said that Peter Madoff“personally benefited from proceeds gained as a result of these false statements.”Manypeople suffered for Madoff’s narcissistic actions: “Manhattan U.S. Attorney PreetBharara said, ‘Peter Madoff enabled the largest fraud in human history….We are not yetfinished calling to account everyone responsible for the epic fraud of Bernard Madoff andthe epic pain of his many victims.’” IfPeterMadoff had considered the consequences forpeopleother than himself, hemay have acted differently.b (i).Responses shouldtake the following into account:DutyHow MadoffFell Shortof His DutyFulfill his commitment toconduct reviews“He certified that periodic reviews established thefirm’s compliance with internal and regulatory rules.In fact, Peter Madoff conducted no reviews. Hesevereembarrassment

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Chapter 2: Ethics at Work1111certified that his examination of the firm’s tradingprocess established its integrity. He did not—indeed,he could not—conduct any such examination:”“He made a pretense of compliance; he was reallyabout complicity.” (Janice K. Fedarcyk)Honesty•“Madoff created false and misleading BLMIScompliance documents.”•“False reports that were filed withthe U.S.Securities and Exchange Commission (SEC)….”•“The numerous false statements in the Forms ADVcreated the false appearance that BLMIS’s IAbusiness….”Civic responsibilityEvading taxes:•PeterMadoff received approximately $15,700,000from Bernard L. Madoff and his wife and executedsham promissory notes to make it appear that thetransfers were loans, in order to avoid payingtaxes;•Madoff gave approximately $9,900,000 to familymembers, and in order to avoid paying taxes,executed sham promissory notes to make it appearthat the transfers of these funds were loans;•Madoff did not pay taxes on approximately$7,750,000 that he received from BLMIS;•Madoff received approximately $16,800,000 fromBernard L. Madoff from two sham trades, anddisguised the proceeds of the trades as long-termstock transactions in order to take advantage of thelower tax rate for long-term capital gains;•Madoff charged approximately $175,000 inpersonal expenses to a corporate American Expresscard and did not report those expenses as income.Madoff also arranged for his wife to have a “no-show” job at BLMIS from which she receivedbetween approximately $100,000 to $160,000 peryear in salary, a 401(k), and other benefits towhich she was not entitled.Fairness“Madoff agreed with others to send the $300 millionthat remained in the IA accounts to preferredemployees, family members, and friends”

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DETECTING ACCOUNTING FRAUD1212Duty totake care of hisemployeesRobert L. Panella saidthatMadoff, “Failed to protectthe integrity of employee benefit plan assets andpersonallybenefited from proceeds gained as a resultof these false statements.”b (ii).Responsesmay vary. Some students may argue that reason and duty were not sufficientto prevent Madoff from unethical behavior and thatcompanies need more oversightand/or there should be stricter laws governing accounting practices and/or we need bettercompliance ofthe lawsalready in place.Others may maintain that Madoff lacked amoral compass and a character strong enough to withstand the temptationto enrichhimself. Others may argue that he did not consider the consequences of his actions.c (i).Responseswill vary, but should include that consequentialism accounts for the far-reaching repercussions ofMadoff’sspecificactions and deontology does not.Consequentialismidentifies all of the stakeholders affected by Madoff’s fraud as well asthe far-reaching consequences. On the other hand, deontology focuses on the unwaveringcommitment to principle and duty, in this case, for example, the moral imperative to behonest at all times.c (ii).Some students may find consequentialism more persuasive for the reason thatit forcesone to considerthe far-reaching consequences toall the stakeholders.Some may thinkthe consequences are the most egregious parts of the act, while others will think skirtingobligations are the worst parts of the crime.They may believe that a commitment to themoral imperative to always tell the truth would best prevent this kind of offense.c (iii).Somestudentswill think one system is best for all cases, while others will think eachissue needs its own system.There are also those who may believe that when faced withan ethical dilemma, one should analyze it in terms of all three frameworks.d.

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Chapter 2: Ethics at Work1313Responsesmay vary, but should include the following:(Answersare in bold)Using theAmerican Accounting Association Ethical Decision-Making Model:1.Determine the facts—who,what, when, where,and how?What do we know or need to know, if possible, that will help define the problems?Who? A chief compliance officerworking for MadoffWhat?Securities fraud, tax fraud conspiracy, falsifying books and records, andmaking false statements to investorsWhen?1996-2008Where? Bernard L. Madoff Investment Securities (BLMIS),New York, NY.How?“Madoffcreated false and misleading BLMIS compliance documents, aswellas false reports that were filed with the U.S. Securities and ExchangeCommission (SEC) that materially misstated the nature and scope of BLMIS’sInvestment Advisory (IA) business.”2.Define the ethical issue.a)List the significant stakeholdersSeeanswerto Case StudyQuestion a(i) aboveb)Define the ethical issuesMake sure precisely what the ethical issue is; for example:conflicts involving rights,questions over limits of an obligation, etc.Securities fraud, tax-fraud conspiracy, falsifying books and records,makingfalse statements to investors, lying to family and friends3.Identify major principles, rules, or values.For example, integrity, quality, respect for persons, and profit.Honesty, fairness, integrity, duties to employees4.Specify the alternatives.List the major alternative courses of action, including those that represent some form ofcompromise or point between simply doing or not doing something.In this case, it does notseem that a moralcompromise was possible—it is neverpermissible tomisrepresent one’s company, or to cheat and steal from one’sclients.5.Compare values and alternatives. See if a clear decision is evident.Determine if there is one principle or value, or combination, which is so compelling thatthe proper alternative is clear—for example, correcting a defect that is almost certain tocause loss of life.All major ethical frameworks would appear to leadto the conclusion that the chiefcompliance officer should not turn a blind eye to the fraud.

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DETECTING ACCOUNTING FRAUD14146.Assess the consequences.Identify short and long, and positive and negative consequences for the majoralternatives. The common short-run focus on gain or loss needs to be measured againstlong-run considerations. This step will often reveal an unanticipated result of majorimportance.See answer to Case Study Question a(i) above7.Make your decision.Balance the consequences against your primary principles or values and select thealternative that best fits.It is likely that all approaches will lead to the decision that this fraud was morallywrong and should not be committed.

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1Chapter3The Sizzling Saga of SunbeamSOLUTIONSEthics at Work:a.Suggested response:Developed by Jeremy Bentham (1748–1832), utilitarianism maintains that the right actionethically is the action that maximizes the “good.” Asconsequentialist philosophy hasdeveloped over the years, different philosophers have specified different definitions of the“good,” or what should be maximized, but the unifying thread is that all consequentialistsjudge actions according the sum of the net “good” that actions cause among all those who areaffected by the action. To the strict utilitarian, it is the aggregate “pleasure” for all partiesconcerned that will determine whether the action is right.Therefore, when applying thisframework, we have to consider all of thestakeholders in the decision by Sunbeam’smanagementto issuefinancial statements thatincluded future periods’ sales revenue in Sunbeam’s then current periods’ income statements.According to John Stuart Mill, we have to consider all the people (stakeholders)—or groupsof people—who would enjoy an increase in pleasure or suffer an increase in pain as a resultof the overstatement of sales and accounts receivable in Sunbeam’s income statements andbalance sheets.Sunbeamwas unethical in issuing financial statements that improperly timedSunbeam’s revenue recognition because this increased only Sunbeam’sown short-termfinancial gains and did not consider how this unethical behavior could eventually affect thelong-term health of the company, as well as its employees, investors, and family members ofanyone with connections to the company. In addition, before Sunbeam was forcedto declarebankruptcy, itintroduced itsnotorious and ruthless downsizing strategy, leading to theclosure of a number of plants.At the time of these downsizings, cookie-jar reserves werecreated that were later reversed into earnings.Here is how these moves affected potential stakeholders:

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DETECTING ACCOUNTING FRAUD2•Investors―Recognizingfuturesalesinthecurrentperiodinflatescurrentearnings and usually inflates the stock price.Investors bought stock at inflatedprices and lost money because future sales had already been taken into the currentperiod’s sales. When Sunbeam eventually declared bankruptcy, shareholdersreceived nothing.•Employees of the company—Many at Sunbeam lost their jobs and also lost theirbenefits, such as health-care insurance and pensions.•Family members—Relatives of Sunbeam’s employees suffered hardships whenfamily members lost their jobs.•Financial institutions—Banks that lent Sunbeam money lost about 66 percent oftheir loans.•Other businesses—Companies doing business with Sunbeam lost money whenSunbeam went bankrupt.b.Suggested response:The justice decision-making model aims to identify the right or the moral action. Once all thestakeholders are identified, this model emphasizes that all parties involved must be treatedequally and fairly. This model focuses on distributive justice, or the fair distribution ofjustice. When it comes to insider trading, it can be argued that the seller and the buyer of theshares are not being treated equally. The true information as to the company’s sales andearnings is not equally distributed to the two parties involved in the sale. Because of thisunequal treatment, it would be argued under the justice approach that insider trading isunethical.ASSIGNMENTSTrue/FalseQuestions:1.False2.True3.True4.True

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Chapter 3: The Sizzling Saga of Sunbeam35.False6.False7.True8.True9.False10.TrueFill-In-the-BlankQuestions:11.allocated12.remainingor continuing13.memory14.accelerating15.reserve for returns16.inconclusive17.deductions18.quarter-end19.excess20.specialMultiple ChoiceQuestions:21.cExplanation: Ownership will only pass from Ace to itscustomer once the goods have beenshipped from Ace to the customer (FOB shipping). If the goods have been shipped fromAce’s head office to its branch office, this does not constitute shipping to the customer. OnDecember 31, the inventory belonged to Ace.•Answers a and b are incorrect because Ace cannot recognize a sale before January 5.•Answer d is incorrect because the packing case should be included in Ace’s inventory.22.b

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DETECTING ACCOUNTING FRAUD4Explanation: Item I inventory is part of Bolt’s inventory becauseownership of the goods onconsignment remains with Bolt until the retail customer sells the goods. Item II inventorypassed to Bolt’s customer when Bolt shipped the goods to its customer (FOB shipping).•Answer a is incorrect because Item II inventory has passed from Bolt to its customer.•Answer c is incorrect because the goods sent on consignment have not been sold until theconsignee sells them.•Answer d is incorrect because Item II inventory has been sold (FOB shipping).23.dExplanation:Both a and b are correct. Answer a is correct because the buyer, not the seller,must request a bill and hold sale for it to be recognized as revenue before the goods areshipped. Answer b is correct because the buyer must have a substantial business reason forrequesting a bill and hold sale for the seller to recognize the sale before shipping.•Answer c is incorrect because with a bill and hold sale the seller recognizes the cost ofgoods sold.24.cExplanation: A sale can only be recognized once the risks of ownership have passed to thebuyer, and the FOB destination clause delays thistransferuntil the goods are shipped inMarch.•Answer a is incorrect because, in this case, the buyer does have a legitimate, substantialbusiness reason for placing the order early.•Answer b is incorrect because, with bill and hold sales, the cost of goods sold andthesales revenue are both recognized.•Answer d is incorrect because sales do not have to be paid for in order to be recognizedas sales.25.aExplanation: The back-dated order increases sales by $10,000 and increases operatingincome by $6,000 ($10,000-$4,000).•Answer b is incorrect because net CFFO would not be overstated.•Answer c is incorrect because CFFO would not be overstated.

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Chapter 3: The Sizzling Saga of Sunbeam5•Answer d is incorrect because net income would beoverstated by $6,000, excludingincome tax effects.26.bExplanation: Operating income would increase by $6,000 ($10,000 less $4,000). CFFOwould not increase.To arrive at CFFO, deduct the increase in account receivable of $10,000and add the$4,000 decrease in inventory from the extra operating income of $6,000.•Answers a, c, and d are incorrect. See the explanation for Answer b above.27.dExplanation: Operating income will be stated as $25,000 + $15,000-$10,000 = $30,000,which is an increase of $5,000.•Answer a is incorrect because CFFO will not increase.•Answerb is incorrect because CFFO will not increase.•Answerc is incorrect. See the explanation for Answer d above.28.aExplanation: The accounts receivable balance will be $65,000 ($50,000 +$15,000)•Answerb is incorrect, because operating income will be $30,000($25,000 + $15,000-$10,000).•Answerc is incorrect because CFFO will not increase.•Answerd is incorrect because operating income will be $30,000 ($25,000 + $15,000-$10,000).29.dExplanation: Sunbeam’s restructuring expense decreased net income. The other side of theentry increased the restructuring reserve on the balance sheet.•Answera isincorrect; net income decreased.•Answerb is incorrect; the reserves increased.•Answer c is incorrect; an expense does not increase income.30.aExplanation: Sunbeam provides an example of improper revenue recognition via impropertiming of revenue. The sales revenue that it recorded related to real orders for goods that

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DETECTING ACCOUNTING FRAUD6ordinarily would have been placed in later periods. (The next chapter deals with improperrevenue recognition via recording fictitious revenue and the improper valuation of revenue.)•Answers b, c, and d all describe methods that Sunbeam did use to recognize futureperiods’ sales.For Discussion31.Suggested response:It must be understood that the recognition of future revenue in the current period takes thenext period’s revenue into this period. As a consequence, that portion of the next period’srevenue cannot be reorganized in the later period. Even if the fraud is repeated in the nextperiod, that period would only recognize one period’s revenue and earnings, whereas thecurrent period recognizes more than one period’s revenues and earnings. The result of thiswill likely be an increase in the stock price in the current period and a decrease in the stockprice in a later period. Shareholders who purchased stock at the inflated price will suffer aloss as the stock price falls after the spike in revenues and earnings.The perpetrators of early recognition of revenue frauds prepare misleadingfinancial statements. Whenever anyone intentionally misleads another person and thatdeception causes a financial loss, a fraud has been committed. Since early recognition ofrevenue can cause others financial loss, the perpetrators bear the same responsibility forfraud.32.Suggested response:Managers have an incentive to understate net income in one period in order to overstate it ina future period because, with this scheme, the expense for the creation of the restructuringreserve is often disclosed “below the line” of operating income. As a result, it is regarded asa “non-recurring” expense. Therefore, it may not impact the stock price as much as if theexpense were recognized before the calculation of operating income. Perpetrators of thiskind of fraud often release the overstated reserve into earnings “above the line” of operatingincome in the future period where the income is considered to be recurring. This makes thecompany appear to be more profitable than it really is and falsely boosts the stock price.

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Chapter 3: The Sizzling Saga of Sunbeam7Short-Answer Questions:33.Typically, when companies overstates a restructuring reserve for the purpose of creating acookie-jar reserve to reverse into profits in a later period, they disclose the restructuringexpense in the income statement as a special charge below operating income. Although thisreduces net income, it does not reduce operating income.34.The sale and the cost of goods sold are recognized in the current period in the incomestatement. As long as the goods are sold at a mark-up, operating income is increased.Because the customer pays only in the later period, there is no increase in CFFO in the periodthat the bill and hold sale is recognized. Looking at the indirect method, the amount statedfor CFFO is derived by beginningwith the net income and deducting the increase in accountsreceivable and other current assets.Decreasesin currentassets are added back.The bill andhold sale increases accounts receivable and decreases inventory.The net effect is that thetransaction doesnotincrease CFFO.35.When a segment or product line is closed,allof its revenue is lost. Many fixed costs that areallocated over segments are not directly traceable to a particular segment. As a result, even ifthe expense could be avoided if the entire company were liquidated, closing just one segmentmight not reduce the cost. For example, a CEO’s salary will probably not decrease if onesegment is closed. If the salary cost remains constant, it will be allocated over the remainingsegments, which now carry more costs and might report less profit after a segment wasclosed. In this instance, the remaining revenue is decreased by a greater amount thanexpenses are decreased.36.The increase in this ratio shows that recorded sales are increasing at a faster percentage thanpayments by customers. This could be caused by a decreasing ability of customers to pay, orit could be that the revenue has been recorded earlier than in the past or that the revenue iscompletely fictitious. While the signal is not proof of any of these items, it is not a good

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DETECTING ACCOUNTING FRAUD8sign. Unless one can identify a legitimate reason behind an increase in this ratio, it is a signalthat the quality of the revenue reported may be deteriorating.37.Often, a restructuring reserve includes a write-down of inventory below cost, on the groundsthat the company expects the inventory to be sold at aloss. When companies overstate thisexpected loss and write down the inventory in the current period—and then sell the inventoryclose to the regular selling price in the future period—it causes a large gross margin to bereported in the later period if the company includes the recording of these sales in itsdisclosure of operating income.

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Chapter 3: The Sizzling Saga of Sunbeam9Exercises:38.Year 1Year 2Year 3Accounts receivable as a percentage of sales:15%20%37.5%39.Netincome$100,000Depreciation5,000Decrease in inventory10,000Increase in accounts receivable(40,000)Increase in accounts payable5,000Cash flow from operations$ 80,00040(a).Debit restructuring expense$20,000Credit restructuring reserve$20,00040(b).Income StatementSales$160,000Cost of goods sold60,000Gross margin100,000Selling & administrative expenses40,000Operating income60,000Restructuringexpense20,000Income before taxation40,000Taxation12,000Net income$ 28,000CASE STUDY:Beazer HomesUSA, INC.NOTE: Question a (below)refers tothe sale and leaseback transactions.a (1).

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DETECTING ACCOUNTING FRAUD10Themodel homes were eventually truly sold at the end of the lease term.Therefore, therevenue was eventually earned.However, the sale-leaseback agreement enabled Beazerto recognize the sale at the beginning of the lease term,while the company was still usingthe homes as marketing modelsand while it still participated in the appreciation of thevalue of the homes. Therefore, this was a case of “improper timing of revenue.”a (2).Beazer built a few model homes in each housing development for marketing purposes.Historically, Beazer entered into sale-leaseback agreements for 20 percent to 30 percentof these model homes. These agreements allowed Beazer to recognize revenue on the saleof the model homes while it was still using the homes as marketing models. However, in2006, Beazer began to increase the percentage of the model homes for which it enteredinto sale-leaseback agreements to 70 percent. In this way, it was able to recognize salesrevenue of $117 million onmore of thehomesit had not yet sold outright.This was, ofcourse, a much higher percentage of homes than normally had been leased back asmarketing models.Further, in terms ofthese sale-leaseback agreements, Beazer retainedthe “right to receive a percentage of the appreciation of the model home upon its sale atthe end of the lease term” (AAER 2884, par. 1.4). This disqualified the agreementsfrombeing recognized as salesat the beginning of the lease term.a (3).Signals ofBeazer’s Fraudulent Reporting for Scheme #1: Improper Recognition ofRevenue via Sales-Leaseback Arrangements:oSignal #1:The first signal of an overstatement of revenue is when acompany’s accounts receivable increases as a percentage of sales▪Beazer’s Accounts Receivable-to-Sales Ratios:2004: 1.81%($70,574/$3,907,109)2005: 3.24%($161,880/$4,995,353)2006: 6.11%($333,571/$5,462,003)2007:1.3%($45,501/$3,490,819)From 2004 to 2006, Beazer’s accounts receivable as a percentage ofsales more than tripled.

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Chapter 3: The Sizzling Saga of Sunbeam11oSignal #2:Another signalofimproper revenue recognition, or of a severeoperating problem,is a sudden change in gross profit margin as a percentageof sales. The situation becomes even more severeif there is a suddendownward fluctuation of the gross margin.In 2006, Beazer’s gross profitmargin was 23.08%; one year later, the gross profit margin had plunged to-1.87%.▪Beazer’s Gross Profit Margins:2004: 20.66%($807,377/$3,907,109)2005: 23.46%($1,172,053/$4,995,353)2006: 23.08%($1,260,685/$5,462,003)2007:-1.87%(-$65,430/$3,490,819)oSignal #3:Athird signal of improper revenue recognition occurs whencash flow from operations (CFFO) lags behind operating income. In thecase of Beazer Homes, theacceleratedsales were simply not turning intocash received at the rate that they should have beenif they were legitimatesales. CFFO wassignificantlynegative while operating income waspositivefor the fiscal years 2004-2006.This signal was an extremelystrong indication that income was overstated.b (1).Beazer Homes recorded its landinventory in “land inventory accounts” in itsgeneral ledger.The land inventory accounts were debited with the purchase cost of the land plus commondevelopments costs,such asthe cost of sewer systems, including future estimateddevelopment costs. As the houses were sold, the associated land inventory account wasreduced and a cost-of-sales expense was recognized. However, the “land expense recordedfor any particular house sale was necessarily an estimate” (AAER 2884, par. 3). According tothe SEC’s action, “in various quarters during fiscal years 2000 through 2005, Beazeroverallocated land inventory expense to individual properties sold” (AAER 2884, par. 9).This overstatement caused the land inventory account to eventually record a negativebalance. These credit balances on the land inventory accounts acted “in effect as improper

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DETECTING ACCOUNTING FRAUD12reserves …. Beginning atleast by the second quarter of 2006, Beazer … began to reverse theexcess reserves existing in the land inventory account, which increased their current periodearnings” (AAER 2884, par. 10).According to the SEC complaint, these manipulations understated Beazer’s netincome by $42million between fiscal years 2000 and 2005 and overstated net income byover $1.2 million during 2006. The company alsoreduced its cumulative net lossfor the firsttwo quarters of 2007 by $1 million (AAER 2884, par. 12).b (2).The inflated credits to the land inventory account acted as an overstated inventory reserve.This is similar to Sunbeam’s overstated restructuring reserves, and they werelaterpartlyreversedintoearnings, asSunbeam’s cookie-jarreserves were released into earningsin laterperiods.b (3).On creation of the reserve, Beazer increased cost of sales, whichwould clearly be seen as anormal recurring expense, whereas on the creation of its restructuring reserve, Sunbeamdisclosedthe restructuring expense as a special charge, which would likely be seen as a non-recurring expense.Sunbeam’s restructuring expense, at the time of the creation of thecookie-jar reserve, could have had less of a negative effect on investors’ expectations ofSunbeam’s future recurring profits.

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1Chapter4Hocus PocusSOLUTIONSEthics at Worka.Suggested response:The deontologist (from theGreekdeon,which means “duty”) chooses moral action notbecause of its consequencesin the specific circumstances, butbecause it is the right thingto do. Kant, the leading deontologist, went even further by saying that if you perceivetelling the truth as a duty, you must always tell the truth for that reason itself. Moreover,you must tell the truth at all times, even if telling the truth could cause negativeconsequences.Few would argue that financial statements should not be truthful. To thedeontologist, once you accept truth telling as a maxim, you must always present truthfulfinancial statements. In fact, there is a moral imperative to present truthful financialstatements. Therefore, according to deontology, any scheme to manipulate Xerox’sfinancial statements would have been regarded as unethical.b.These are broadquestions and can be answered in a numberof ways. Here is one possibleresponse:It is important to note a distinction between legal behavior and ethical behavior. Everyonecan think of situations in which one has to go beyond merely keeping within the letter of thelaw. Ultimately, GAAP rules aim to fairly and accurately present a company’s financialposition and the results of its operations. When GAAP rules do not achieve this, thecompany’s annual report must find a way to disclose this. For example, the ManagementDiscussion and Analysis (MD&A) can and should present further clarification on variousissues. Companies need to be aware that they should abide by both the letter of the law andthe spirit of the law.For example, PepsiCo’s 2011 Annual Report addresses this issueas follows:

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