Solution Manual for Detecting Accounting Fraud: Analysis and Ethics
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1
Chapter 1
Introduction to the Problem of Accounting Fraud
SOLUTIONS
True/False Questions:
1. False
2. False
3. False (The Sarbanes-Oxley Act was passed in 2002.)
4. True
5. False
6. False
7. True
8. False (The Dodd-Frank Act revised and increased the power of the SEC.)
9. False (They usually neither admit nor deny the findings.)
10. True
Fill-in-the-Blank Questions:
11. Section 404
12. audit
13. banking
14. damages
15. 2010
16. agents
17. lower (But not by much. Byrne, Lavelle, Byrnes, and Vickers, May 2002, reported that in
2001, “CEOs of large corporations made 411 times as much as the average factory
worker.” The Institute for Policy Studies pointed out: “The pay gap between CEOs and
average American workers has grown from 195-to-1 in 1993 to 354-to-1 in 2012.”)
18. Volcker
19. Adelphia
20. toxic or risky
Chapter 1
Introduction to the Problem of Accounting Fraud
SOLUTIONS
True/False Questions:
1. False
2. False
3. False (The Sarbanes-Oxley Act was passed in 2002.)
4. True
5. False
6. False
7. True
8. False (The Dodd-Frank Act revised and increased the power of the SEC.)
9. False (They usually neither admit nor deny the findings.)
10. True
Fill-in-the-Blank Questions:
11. Section 404
12. audit
13. banking
14. damages
15. 2010
16. agents
17. lower (But not by much. Byrne, Lavelle, Byrnes, and Vickers, May 2002, reported that in
2001, “CEOs of large corporations made 411 times as much as the average factory
worker.” The Institute for Policy Studies pointed out: “The pay gap between CEOs and
average American workers has grown from 195-to-1 in 1993 to 354-to-1 in 2012.”)
18. Volcker
19. Adelphia
20. toxic or risky
1
Chapter 1
Introduction to the Problem of Accounting Fraud
SOLUTIONS
True/False Questions:
1. False
2. False
3. False (The Sarbanes-Oxley Act was passed in 2002.)
4. True
5. False
6. False
7. True
8. False (The Dodd-Frank Act revised and increased the power of the SEC.)
9. False (They usually neither admit nor deny the findings.)
10. True
Fill-in-the-Blank Questions:
11. Section 404
12. audit
13. banking
14. damages
15. 2010
16. agents
17. lower (But not by much. Byrne, Lavelle, Byrnes, and Vickers, May 2002, reported that in
2001, “CEOs of large corporations made 411 times as much as the average factory
worker.” The Institute for Policy Studies pointed out: “The pay gap between CEOs and
average American workers has grown from 195-to-1 in 1993 to 354-to-1 in 2012.”)
18. Volcker
19. Adelphia
20. toxic or risky
Chapter 1
Introduction to the Problem of Accounting Fraud
SOLUTIONS
True/False Questions:
1. False
2. False
3. False (The Sarbanes-Oxley Act was passed in 2002.)
4. True
5. False
6. False
7. True
8. False (The Dodd-Frank Act revised and increased the power of the SEC.)
9. False (They usually neither admit nor deny the findings.)
10. True
Fill-in-the-Blank Questions:
11. Section 404
12. audit
13. banking
14. damages
15. 2010
16. agents
17. lower (But not by much. Byrne, Lavelle, Byrnes, and Vickers, May 2002, reported that in
2001, “CEOs of large corporations made 411 times as much as the average factory
worker.” The Institute for Policy Studies pointed out: “The pay gap between CEOs and
average American workers has grown from 195-to-1 in 1993 to 354-to-1 in 2012.”)
18. Volcker
19. Adelphia
20. toxic or risky
DETECTING ACCOUNTING FRAUD
2
Multiple-Choice Questions:
21. c
Explanation: The SEC is a government regulatory body and was not complicit in the fraud,
nor was its role examined or faulted by the Bankruptcy Examiner.
• Answers a, b, and d are incorrect because Thornburgh found gatekeeping failures in
WorldCom‘s internal audit structure and with its external auditors and its board of
directors.
22. b
Explanation: In many cases, senior management compensation agreements included stock
options that would provide significant additional remuneration if analysts’ earnings
expectations were met.
• Answers a, c, and d are incorrect because they were not cited as common reasons to
orchestrate frauds.
23. b
Explanation:
• Answers a, c, and d are true statements.
24. d
Explanation: Directors with no stake in the company, and who are not officers in the
company, would be least likely to succumb to pressures.
• Answers a, b, and c are incorrect because Levitt believed that situations described in a, b,
and c could undermine many directors’ abilities to act autonomously.
25. a
Explanation: The major objectives of Dodd-Frank are to “reshape the U.S. regulatory system
in a number of areas including but not limited to consumer protection, trading restrictions,
credit ratings, regulation of financial products, corporate governance and disclosure, and
transparency” (“The Laws” 2012).
• Answer a is correct because Dodd-Frank does not attempt to increase the number of audit
firms.
26. d
Explanation: All of the changes mentioned, plus others, have resulted from Dodd-Frank.
27. a
2
Multiple-Choice Questions:
21. c
Explanation: The SEC is a government regulatory body and was not complicit in the fraud,
nor was its role examined or faulted by the Bankruptcy Examiner.
• Answers a, b, and d are incorrect because Thornburgh found gatekeeping failures in
WorldCom‘s internal audit structure and with its external auditors and its board of
directors.
22. b
Explanation: In many cases, senior management compensation agreements included stock
options that would provide significant additional remuneration if analysts’ earnings
expectations were met.
• Answers a, c, and d are incorrect because they were not cited as common reasons to
orchestrate frauds.
23. b
Explanation:
• Answers a, c, and d are true statements.
24. d
Explanation: Directors with no stake in the company, and who are not officers in the
company, would be least likely to succumb to pressures.
• Answers a, b, and c are incorrect because Levitt believed that situations described in a, b,
and c could undermine many directors’ abilities to act autonomously.
25. a
Explanation: The major objectives of Dodd-Frank are to “reshape the U.S. regulatory system
in a number of areas including but not limited to consumer protection, trading restrictions,
credit ratings, regulation of financial products, corporate governance and disclosure, and
transparency” (“The Laws” 2012).
• Answer a is correct because Dodd-Frank does not attempt to increase the number of audit
firms.
26. d
Explanation: All of the changes mentioned, plus others, have resulted from Dodd-Frank.
27. a
Chapter 1: Introduction to the Problem of Accounting Fraud
3
Explanation: Through Dodd-Frank’s whistleblower program, whistleblowers are offered
more protection than under Sarbanes-Oxley, and they can now receive monetary awards from
the SEC which is pursuing whistleblower tips very seriously.
• Answers b, c, and d are incorrect because whistleblowers are taken seriously by the SEC
and they can receive monetary awards.
28. a
Explanation: The director who works for a competing company, Raining Raisins, may have
a conflict of interests.
• The employment status of the other directors would be unlikely to result in conflicts of
interest.
29. d
Explanation: According to SOX, an audit partner cannot be the lead or reviewing auditor of
the same company for more than five years.
• Answers a, b, and c would be unlikely to influence the ability of Ethical Auditors to carry
out an impartial audit.
30. a
Explanation: Answers b and c were instituted by the SEC only after the Dodd Frank Act of
2010.
3
Explanation: Through Dodd-Frank’s whistleblower program, whistleblowers are offered
more protection than under Sarbanes-Oxley, and they can now receive monetary awards from
the SEC which is pursuing whistleblower tips very seriously.
• Answers b, c, and d are incorrect because whistleblowers are taken seriously by the SEC
and they can receive monetary awards.
28. a
Explanation: The director who works for a competing company, Raining Raisins, may have
a conflict of interests.
• The employment status of the other directors would be unlikely to result in conflicts of
interest.
29. d
Explanation: According to SOX, an audit partner cannot be the lead or reviewing auditor of
the same company for more than five years.
• Answers a, b, and c would be unlikely to influence the ability of Ethical Auditors to carry
out an impartial audit.
30. a
Explanation: Answers b and c were instituted by the SEC only after the Dodd Frank Act of
2010.
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Chapter 2: Ethics at Work
11
Chapter 2
Ethics at Work
SOLUTIONS1
True/False Questions:
1. False
Explanation: Virtue ethics focuses on character traits of a virtuous person and thus offers no
strict rules on how to act.
2. False
Explanation: Virtue ethics is agent centered, while consequentialism is concerned with the
effects of an action.
3. False
Explanation: Business ethics is a type of applied ethics. Metaethics is concerned with what
constitutes the good and the bad, while business ethics deals with the ethics of particular
situations and within a particular discipline.
4. False
Explanation: This is one of the limits of consequentialism. Although it judges an action by
the consequences, it is unable to predict every possible consequence.
5. False
Explanation: Utilitarians judge actions by the utility they produce, thus it is a form of
consequentialism.
6. True
Explanation: This is the hallmark of deontology.
7. False
Explanation: This is the goal of virtue ethics.
8. False
Explanation: The purpose of the audit is to give an independent opinion on the financial
statements.
9. False
1 Solutions for this chapter provided by Kate Jackson, Ph.D. student in Theological Ethics, Boston College.
11
Chapter 2
Ethics at Work
SOLUTIONS1
True/False Questions:
1. False
Explanation: Virtue ethics focuses on character traits of a virtuous person and thus offers no
strict rules on how to act.
2. False
Explanation: Virtue ethics is agent centered, while consequentialism is concerned with the
effects of an action.
3. False
Explanation: Business ethics is a type of applied ethics. Metaethics is concerned with what
constitutes the good and the bad, while business ethics deals with the ethics of particular
situations and within a particular discipline.
4. False
Explanation: This is one of the limits of consequentialism. Although it judges an action by
the consequences, it is unable to predict every possible consequence.
5. False
Explanation: Utilitarians judge actions by the utility they produce, thus it is a form of
consequentialism.
6. True
Explanation: This is the hallmark of deontology.
7. False
Explanation: This is the goal of virtue ethics.
8. False
Explanation: The purpose of the audit is to give an independent opinion on the financial
statements.
9. False
1 Solutions for this chapter provided by Kate Jackson, Ph.D. student in Theological Ethics, Boston College.
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DETECTING ACCOUNTING FRAUD
22
Explanation: The rights approach is often combined with the duties approach since a right
often produces a reciprocal duty.
10. True
Explanation: A specific transaction can cause a specific person to have the right to have a
loan repaid.
Fill-in-the-Blank Questions:
11. Kant
12. maximize
13. allocated
14. need
15. character
16. Aristotle
17. utilitarianism
18. hedonism
19. stakeholders
20. telos
Multiple-Choice Questions:
21. a
Explanation: Utilitarianism is a form of consequentialism that refers to all the approaches in
the study of morality that evaluate conduct or actions in terms of the consequences that they
produce.
• Answers b. and c. are incorrect because they do not refer to the consequences of an
action.
22. b
Explanation: According to Kant’s categorical imperative, the end does not justify the means.
• Answers a, b, and c are all consistent with Kant’s categorical imperative. If Kant thought
the end justified the means, he would have been a consequentialist.
23. c
22
Explanation: The rights approach is often combined with the duties approach since a right
often produces a reciprocal duty.
10. True
Explanation: A specific transaction can cause a specific person to have the right to have a
loan repaid.
Fill-in-the-Blank Questions:
11. Kant
12. maximize
13. allocated
14. need
15. character
16. Aristotle
17. utilitarianism
18. hedonism
19. stakeholders
20. telos
Multiple-Choice Questions:
21. a
Explanation: Utilitarianism is a form of consequentialism that refers to all the approaches in
the study of morality that evaluate conduct or actions in terms of the consequences that they
produce.
• Answers b. and c. are incorrect because they do not refer to the consequences of an
action.
22. b
Explanation: According to Kant’s categorical imperative, the end does not justify the means.
• Answers a, b, and c are all consistent with Kant’s categorical imperative. If Kant thought
the end justified the means, he would have been a consequentialist.
23. c
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Chapter 2: Ethics at Work
33
Explanation: According to the virtue theory of ethical behavior, the most important aspect of
morality is found within an individual’s character.
• Answer a is incorrect because deontology emphasizes duty
• Answer b is incorrect be utilitarianism emphasizes consequences
24. b
Explanation: An unwavering commitment to duty is the hallmark of deontology.
• Answers a, c, and d are all associated with virtue. According to Aristotle, virtues are
developed by habit, adhering to the mean between extremes, and behavior related to
human flourishing.
25. a
Explanation: Anne would be using some of the consequences of her possible response to
guide her behavior.
26. b
Explanation: She would be using her sense of duty (in this case telling the truth) to guide her
behavior. Duty is the guiding principle of deontology.
27. a
Explanation: This type of thinking is considered a shortcoming of consequentialism. At
times, it can permit egregious acts in the name of the greater good.
28. a
Explanation: Another limit of consequentialism is that the scope of the consequences is often
unclear.
29. b
Explanation: Autonomy is not a cardinal virtue.
• The cardinal virtues are: courage, temperance, wisdom, and justice.
30. c
Explanation: Self-defense rights were not identified by Sterba
• Sterba identified action rights, in persona rights, in rem rights, and recipient rights.
For Discussion:
31. Reponses will vary. Here are some possible reactions:
33
Explanation: According to the virtue theory of ethical behavior, the most important aspect of
morality is found within an individual’s character.
• Answer a is incorrect because deontology emphasizes duty
• Answer b is incorrect be utilitarianism emphasizes consequences
24. b
Explanation: An unwavering commitment to duty is the hallmark of deontology.
• Answers a, c, and d are all associated with virtue. According to Aristotle, virtues are
developed by habit, adhering to the mean between extremes, and behavior related to
human flourishing.
25. a
Explanation: Anne would be using some of the consequences of her possible response to
guide her behavior.
26. b
Explanation: She would be using her sense of duty (in this case telling the truth) to guide her
behavior. Duty is the guiding principle of deontology.
27. a
Explanation: This type of thinking is considered a shortcoming of consequentialism. At
times, it can permit egregious acts in the name of the greater good.
28. a
Explanation: Another limit of consequentialism is that the scope of the consequences is often
unclear.
29. b
Explanation: Autonomy is not a cardinal virtue.
• The cardinal virtues are: courage, temperance, wisdom, and justice.
30. c
Explanation: Self-defense rights were not identified by Sterba
• Sterba identified action rights, in persona rights, in rem rights, and recipient rights.
For Discussion:
31. Reponses will vary. Here are some possible reactions:
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DETECTING ACCOUNTING FRAUD
44
Possible Virtue Possible Description
Honesty Preparing financial statements that fairly
represent the entity’s financial position and the
results of its operations
Diligence Working hard and with accuracy to get a job
done; finishing a task one is given
Courage Speaking out against unethical business
practices; refusing to prepare fraudulent
financial statements.
Wisdom Knowing when to speak out
Fairness Not having favorites; keeping all users of
financial statements in mind
Generosity Spending time on mentoring less experienced
accountants.
Considering the cultivation of virtues, since virtue ethics is about the virtuous person, often
virtue ethics is taught by example and/or through narrative. A way to teach business virtues
might be through a story about a virtuous accountant. Students may elect to write a tale about a
virtuous accountant that teaches lessons about how a virtuous person may respond to difficult
ethical business dilemmas.
Aristotle thought virtues were cultivated through habit. In this view, small and regular
behaviors shape character. To cultivate the virtue of generosity, for example, one might start on
a small-scale by giving a dollar to a homeless person on the street, bringing brownies to give out
at work, or being generous with one’s time by genuinely asking and listening to how a co-worker
is doing. Also in this view, one does not magically become a courageous whistle-blower, for
example, but rather the virtue of courage is fostered through day-to-day courageous acts, such as
speaking out against gossip, admitting when one makes a mistake, and offering one’s
suggestions at a work meeting.
32. Reponses will vary. Here are some possible reactions:
Those who assert that virtues in business are related to virtues in personal life may support
their answers with some of the following beliefs: virtues exist in unity; virtues are developed
44
Possible Virtue Possible Description
Honesty Preparing financial statements that fairly
represent the entity’s financial position and the
results of its operations
Diligence Working hard and with accuracy to get a job
done; finishing a task one is given
Courage Speaking out against unethical business
practices; refusing to prepare fraudulent
financial statements.
Wisdom Knowing when to speak out
Fairness Not having favorites; keeping all users of
financial statements in mind
Generosity Spending time on mentoring less experienced
accountants.
Considering the cultivation of virtues, since virtue ethics is about the virtuous person, often
virtue ethics is taught by example and/or through narrative. A way to teach business virtues
might be through a story about a virtuous accountant. Students may elect to write a tale about a
virtuous accountant that teaches lessons about how a virtuous person may respond to difficult
ethical business dilemmas.
Aristotle thought virtues were cultivated through habit. In this view, small and regular
behaviors shape character. To cultivate the virtue of generosity, for example, one might start on
a small-scale by giving a dollar to a homeless person on the street, bringing brownies to give out
at work, or being generous with one’s time by genuinely asking and listening to how a co-worker
is doing. Also in this view, one does not magically become a courageous whistle-blower, for
example, but rather the virtue of courage is fostered through day-to-day courageous acts, such as
speaking out against gossip, admitting when one makes a mistake, and offering one’s
suggestions at a work meeting.
32. Reponses will vary. Here are some possible reactions:
Those who assert that virtues in business are related to virtues in personal life may support
their answers with some of the following beliefs: virtues exist in unity; virtues are developed
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Chapter 2: Ethics at Work
55
through habit; a person’s life cannot be compartmentalized, but must be treated as an
integrated whole. If someone believes virtues are developed through habit, as Aristotle
thought, that person is likely to assume that vices in one’s personal life will lead to vices in
one’s business practice. For example, if a husband lies to his wife, he will become
habituated to lying, making it easier to lie on balance sheets. Conversely, the husband who is
a good communicator and who is always honest with his wife is more likely to communicate
well and value honesty in the workplace.
Others may regard one’s personal life as distinct from one’s professional life. This
group may believe that personal and professional lives have an impermeable barrier and/or
are governed by entirely different, and thus unrelated, virtues. For instance, one may believe
that 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 through habit
and so lying to one’s spouse does not make it easier or more likely that one will lie on
balance sheets.
Some may think that the virtues exist in unity because they belong to one agent. In
this view, it is unlikely that one is very honest and at the same time lacks courage. For
example, one could not be very honest without courage because courage is necessary to tell
the truth in difficult situations. Also, being honest can help to foster courage as a
commitment to honesty inspires courage.
Others may think it is entirely possible to possess some virtues and some vices
because they regard the virtues as unrelated. This group may choose seemingly disparate
virtues to make this case. For example, a person who is honest, but not just, such as a
manager who is very honest about his or her biases 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 is
motivated by good intentions. Others may think intention matters insofar as a wrong action is
permissible if it is for the right reasons. This logic follows the saying, “The end justifies the
means.” Some may think intention is important, but that it does not determine if an action is
right or wrong.
55
through habit; a person’s life cannot be compartmentalized, but must be treated as an
integrated whole. If someone believes virtues are developed through habit, as Aristotle
thought, that person is likely to assume that vices in one’s personal life will lead to vices in
one’s business practice. For example, if a husband lies to his wife, he will become
habituated to lying, making it easier to lie on balance sheets. Conversely, the husband who is
a good communicator and who is always honest with his wife is more likely to communicate
well and value honesty in the workplace.
Others may regard one’s personal life as distinct from one’s professional life. This
group may believe that personal and professional lives have an impermeable barrier and/or
are governed by entirely different, and thus unrelated, virtues. For instance, one may believe
that 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 through habit
and so lying to one’s spouse does not make it easier or more likely that one will lie on
balance sheets.
Some may think that the virtues exist in unity because they belong to one agent. In
this view, it is unlikely that one is very honest and at the same time lacks courage. For
example, one could not be very honest without courage because courage is necessary to tell
the truth in difficult situations. Also, being honest can help to foster courage as a
commitment to honesty inspires courage.
Others may think it is entirely possible to possess some virtues and some vices
because they regard the virtues as unrelated. This group may choose seemingly disparate
virtues to make this case. For example, a person who is honest, but not just, such as a
manager who is very honest about his or her biases 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 is
motivated by good intentions. Others may think intention matters insofar as a wrong action is
permissible if it is for the right reasons. This logic follows the saying, “The end justifies the
means.” Some may think intention is important, but that it does not determine if an action is
right or wrong.
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DETECTING ACCOUNTING FRAUD
66
A strict consequentialist may believe that only consequences count, so even if one’s
intentions 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 grain
seed that unintentionally wipes out all their crops. Although the person meant well, the
consequentialist may assert that the consequences indicate that the person acted wrongly.
(Issues of intent also bring up notions of culpability, which are beyond the scope of this
chapter. However, it is important to note that there is a distinction between causal
culpability—causing the destruction of crops, in this case—and moral culpability, i.e. the
extent to which one is morally responsible for the destruction of the crops.)
To the strict deontologist, an action performed out of a sense of duty has more moral
value 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 the
character of the whole 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 of happiness is that it is a
type of persistent, peaceful joy (as opposed to an ecstatic, manic, euphoric, and fleeting
feeling). This background joy remains constant during temporary disappointments and
difficulties.
For some, acting ethically is accompanied by happiness even when acting ethically is
hard. For example, standing up for a co-worker who is being picked on may not make one
popular at work and it may not be easy, but it may also be accompanied by a sense of calm
and satisfaction knowing that one acted ethically. Wrong actions may be accompanied by
great anxiety, such as when one is involved in a web of lies or when one cheats on a test.
Others will think that the costs of right action may be too great. For example, it does
not feel good to become a pariah at work for standing up for a co-worker who is picked on.
It is possible that some may think that they would feel happier if they cheated on a test rather
than failed a class and had to repeat it.
35 (a). Reponses will vary. Here are some possible reactions:
66
A strict consequentialist may believe that only consequences count, so even if one’s
intentions 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 grain
seed that unintentionally wipes out all their crops. Although the person meant well, the
consequentialist may assert that the consequences indicate that the person acted wrongly.
(Issues of intent also bring up notions of culpability, which are beyond the scope of this
chapter. However, it is important to note that there is a distinction between causal
culpability—causing the destruction of crops, in this case—and moral culpability, i.e. the
extent to which one is morally responsible for the destruction of the crops.)
To the strict deontologist, an action performed out of a sense of duty has more moral
value 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 the
character of the whole 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 of happiness is that it is a
type of persistent, peaceful joy (as opposed to an ecstatic, manic, euphoric, and fleeting
feeling). This background joy remains constant during temporary disappointments and
difficulties.
For some, acting ethically is accompanied by happiness even when acting ethically is
hard. For example, standing up for a co-worker who is being picked on may not make one
popular at work and it may not be easy, but it may also be accompanied by a sense of calm
and satisfaction knowing that one acted ethically. Wrong actions may be accompanied by
great anxiety, such as when one is involved in a web of lies or when one cheats on a test.
Others will think that the costs of right action may be too great. For example, it does
not feel good to become a pariah at work for standing up for a co-worker who is picked on.
It is possible that some may think that they would feel happier if they cheated on a test rather
than failed a class and had to repeat it.
35 (a). Reponses will vary. Here are some possible reactions:
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Chapter 2: Ethics at Work
77
For some, this example is the quintessential reason why duty ethics are vital. Here, the
manager’s sense of duty overrides her negative feelings for the employee, enabling the
employee to receive the deserved promotion based on timely and accurate work over the
last two years. Thus, this example illustrates why duty and reason are crucial to business
practice.
Others will feel slighted that the promotion is not inspired by the manager’s
opinion that the employee is a likeable and congenial worker. These people may want to
be promoted because the boss has a positive attitude towards them, and not because the
boss 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 biased
feelings will show great integrity and fairness. Letting reason and not emotions guide her
decisions will be looked upon by some as very ethical.
Others will not be impressed that the boss gave the promotion only because she
felt duty-bound to do so. They will think that her lack of authentic and genuine
enthusiasm for the employee undermines the morality behind her actions. These people
may think that abiding by rules and duties are not enough to make someone an ethical
person and that the boss should feel the genuine desire to give the promotion.
36. Reponses will vary.
Some things to consider include pay discrepancies between men and women;
promotions for men and women; the presence of a ‘glass ceiling’ for women; how maternity
leave is treated for fathers and mothers in the workplace; and social expectations of men and
women in the workplace. For instance, are women and men sometimes held to different
standards of dress in the business world? Are they held to different standards of behavior? Is
there a difference between how co-workers perceive a long response from a woman versus a
long response from a man? If there is a difference, which attitude is rewarded? Is there a
difference or a perceived difference in the way women and men approach taking risks in
business? If there is a difference, which approach is rewarded? Is there a difference or a
perceived difference in the way women and men promote themselves? If there is a difference,
77
For some, this example is the quintessential reason why duty ethics are vital. Here, the
manager’s sense of duty overrides her negative feelings for the employee, enabling the
employee to receive the deserved promotion based on timely and accurate work over the
last two years. Thus, this example illustrates why duty and reason are crucial to business
practice.
Others will feel slighted that the promotion is not inspired by the manager’s
opinion that the employee is a likeable and congenial worker. These people may want to
be promoted because the boss has a positive attitude towards them, and not because the
boss 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 biased
feelings will show great integrity and fairness. Letting reason and not emotions guide her
decisions will be looked upon by some as very ethical.
Others will not be impressed that the boss gave the promotion only because she
felt duty-bound to do so. They will think that her lack of authentic and genuine
enthusiasm for the employee undermines the morality behind her actions. These people
may think that abiding by rules and duties are not enough to make someone an ethical
person and that the boss should feel the genuine desire to give the promotion.
36. Reponses will vary.
Some things to consider include pay discrepancies between men and women;
promotions for men and women; the presence of a ‘glass ceiling’ for women; how maternity
leave is treated for fathers and mothers in the workplace; and social expectations of men and
women in the workplace. For instance, are women and men sometimes held to different
standards of dress in the business world? Are they held to different standards of behavior? Is
there a difference between how co-workers perceive a long response from a woman versus a
long response from a man? If there is a difference, which attitude is rewarded? Is there a
difference or a perceived difference in the way women and men approach taking risks in
business? If there is a difference, which approach is rewarded? Is there a difference or a
perceived difference in the way women and men promote themselves? If there is a difference,
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DETECTING ACCOUNTING FRAUD
88
which approach is rewarded? Is there a difference or a perceived difference between male and
female styles of management? If so, which style is most likely to be rewarded or respected?
CASE STUDY:
Peter Madoff, Brother of Bernard Madoff and Former Chief Compliance
Officer and Senior Managing Director of Bernard L. Madoff Investment
Securities, LLC
a (i).
Stakeholder Consequence Source
Peter Madoff Temporary gain of
wealth, luxurious
lifestyle, prestige;
Followed by long-
term money loss,
imprisonment,
embarrassment,
separation from
family, despised by
clients & former
friends
U.S. Attorney Preet Bharara said, “He
will now be jailed well into old age,
and he will forfeit virtually every
penny he has.”
Law abiding taxpayers Paid taxes when
Madoff did not
IRS-CI Acting Special Agent in
Charge Toni Weirauch said, “One of
the consequences of the concealment
is that the IRS was hindered from
performing its lawful duty, thus
harming our nation’s law abiding
taxpayers, along with the defrauded
victims.”
Special Agent Robert L. Panella said,
“During today’s plea, Peter Madoff
admitted to his role in a fraud scheme
that harmed the savings of thousands
of investors.”
IRS IRS was hindered
from performing its
lawful duty; public
money was lost
Thousands of investors
who were defrauded
Lost money,
sometimes lost most
of their retirement
savings & had to
return to work;
fooled, cheated, lied
to
88
which approach is rewarded? Is there a difference or a perceived difference between male and
female styles of management? If so, which style is most likely to be rewarded or respected?
CASE STUDY:
Peter Madoff, Brother of Bernard Madoff and Former Chief Compliance
Officer and Senior Managing Director of Bernard L. Madoff Investment
Securities, LLC
a (i).
Stakeholder Consequence Source
Peter Madoff Temporary gain of
wealth, luxurious
lifestyle, prestige;
Followed by long-
term money loss,
imprisonment,
embarrassment,
separation from
family, despised by
clients & former
friends
U.S. Attorney Preet Bharara said, “He
will now be jailed well into old age,
and he will forfeit virtually every
penny he has.”
Law abiding taxpayers Paid taxes when
Madoff did not
IRS-CI Acting Special Agent in
Charge Toni Weirauch said, “One of
the consequences of the concealment
is that the IRS was hindered from
performing its lawful duty, thus
harming our nation’s law abiding
taxpayers, along with the defrauded
victims.”
Special Agent Robert L. Panella said,
“During today’s plea, Peter Madoff
admitted to his role in a fraud scheme
that harmed the savings of thousands
of investors.”
IRS IRS was hindered
from performing its
lawful duty; public
money was lost
Thousands of investors
who were defrauded
Lost money,
sometimes lost most
of their retirement
savings & had to
return to work;
fooled, cheated, lied
to
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Chapter 2: Ethics at Work
99
Employees Economic security
lost, benefits lost,
Inability to support
family
Special Agent Robert L. Panella said
that Madoff “undermine[d] the
financial well-being of workers.”
Madoff also “Failed to protect the
integrity of employee benefit plan
assets….”
Regulators Were all tricked into
believing
falsehoods; were
unable to perform
their jobs
appropriately
“Madoff created numerous false
compliance documents in which he
stated that he had performed
compliance reviews of the trading in
the BLMIS IA business on a regular
basis, when, in reality, the reviews
were never performed. The false
statements were designed to mislead
regulators, auditors, and IA clients”
Auditors Were all tricked into
believing
falsehoods; were
unable to perform
their jobs
appropriately
Thought they were
investing in an elite,
thriving company
See above quote.
“The numerous false statements in the
Forms ADV created the false
appearance that BLMIS’s IA business
had a small number of highly
sophisticated clients and far fewer
assets under management than was
actually the case.”
IA [Investment Advisory]
clients
Bernard L. Madoff
Investment Securities
(BLMIS) clients
His wife Marion Short-term gain of
money;
long-term loss of
money and life-
style, separation
from father/husband,
severe
embarrassment
“The government has entered into a
settlement with Madoff’s family that
requires the forfeiture of all of his wife
Marion’s and daughter Shana’s assets
and assets belonging to other family
members.”
Daughter Shana Short-term gain of
money;
long-term loss of
money and life-
style, separation
from father/husband,
See above quote.
99
Employees Economic security
lost, benefits lost,
Inability to support
family
Special Agent Robert L. Panella said
that Madoff “undermine[d] the
financial well-being of workers.”
Madoff also “Failed to protect the
integrity of employee benefit plan
assets….”
Regulators Were all tricked into
believing
falsehoods; were
unable to perform
their jobs
appropriately
“Madoff created numerous false
compliance documents in which he
stated that he had performed
compliance reviews of the trading in
the BLMIS IA business on a regular
basis, when, in reality, the reviews
were never performed. The false
statements were designed to mislead
regulators, auditors, and IA clients”
Auditors Were all tricked into
believing
falsehoods; were
unable to perform
their jobs
appropriately
Thought they were
investing in an elite,
thriving company
See above quote.
“The numerous false statements in the
Forms ADV created the false
appearance that BLMIS’s IA business
had a small number of highly
sophisticated clients and far fewer
assets under management than was
actually the case.”
IA [Investment Advisory]
clients
Bernard L. Madoff
Investment Securities
(BLMIS) clients
His wife Marion Short-term gain of
money;
long-term loss of
money and life-
style, separation
from father/husband,
severe
embarrassment
“The government has entered into a
settlement with Madoff’s family that
requires the forfeiture of all of his wife
Marion’s and daughter Shana’s assets
and assets belonging to other family
members.”
Daughter Shana Short-term gain of
money;
long-term loss of
money and life-
style, separation
from father/husband,
See above quote.
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DETECTING ACCOUNTING FRAUD
1010
a (ii).
Based on the consequences discussed above, it seems as if all stakeholders suffered
negative consequences. The positive consequences for Madoff and his family were
enjoyed in the short-term only. Based on the utilitarian notion to choose the action that
gives the greatest good to the greatest number, Madoff should not have committed his
crimes.
a (iii).
Egoism is a type of consequentialism that judges actions by the benefits for only oneself.
According to the article, Madoff was only concerned about himself and his favorites:
“DOL-EBSA New York Regional Director Jonathan Kay said, ‘Today’s plea is a
testament to the good work and strong collaboration among multiple federal agencies.
This agency remains committed to protecting worker benefit plans from those who would
defraud them for personal gain.’” Special Agent Panella said that Peter Madoff
“personally benefited from proceeds gained as a result of these false statements.” Many
people suffered for Madoff’s narcissistic actions: “Manhattan U.S. Attorney Preet
Bharara said, ‘Peter Madoff enabled the largest fraud in human history….We are not yet
finished calling to account everyone responsible for the epic fraud of Bernard Madoff and
the epic pain of his many victims.’” If Peter Madoff had considered the consequences for
people other than himself, he may have acted differently.
b (i).
Responses should take the following into account:
Duty How Madoff Fell Short of His Duty
Fulfill his commitment to
conduct reviews
“He certified that periodic reviews established the
firm’s compliance with internal and regulatory rules.
In fact, Peter Madoff conducted no reviews. He
severe
embarrassment
1010
a (ii).
Based on the consequences discussed above, it seems as if all stakeholders suffered
negative consequences. The positive consequences for Madoff and his family were
enjoyed in the short-term only. Based on the utilitarian notion to choose the action that
gives the greatest good to the greatest number, Madoff should not have committed his
crimes.
a (iii).
Egoism is a type of consequentialism that judges actions by the benefits for only oneself.
According to the article, Madoff was only concerned about himself and his favorites:
“DOL-EBSA New York Regional Director Jonathan Kay said, ‘Today’s plea is a
testament to the good work and strong collaboration among multiple federal agencies.
This agency remains committed to protecting worker benefit plans from those who would
defraud them for personal gain.’” Special Agent Panella said that Peter Madoff
“personally benefited from proceeds gained as a result of these false statements.” Many
people suffered for Madoff’s narcissistic actions: “Manhattan U.S. Attorney Preet
Bharara said, ‘Peter Madoff enabled the largest fraud in human history….We are not yet
finished calling to account everyone responsible for the epic fraud of Bernard Madoff and
the epic pain of his many victims.’” If Peter Madoff had considered the consequences for
people other than himself, he may have acted differently.
b (i).
Responses should take the following into account:
Duty How Madoff Fell Short of His Duty
Fulfill his commitment to
conduct reviews
“He certified that periodic reviews established the
firm’s compliance with internal and regulatory rules.
In fact, Peter Madoff conducted no reviews. He
severe
embarrassment
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Chapter 2: Ethics at Work
1111
certified that his examination of the firm’s trading
process established its integrity. He did not—indeed,
he could not—conduct any such examination:”
“He made a pretense of compliance; he was really
about complicity.” (Janice K. Fedarcyk)
Honesty • “Madoff created false and misleading BLMIS
compliance documents.”
• “False reports that were filed with the U.S.
Securities and Exchange Commission (SEC)….”
• “The numerous false statements in the Forms ADV
created the false appearance that BLMIS’s IA
business….”
Civic responsibility Evading taxes:
• Peter Madoff received approximately $15,700,000
from Bernard L. Madoff and his wife and executed
sham promissory notes to make it appear that the
transfers were loans, in order to avoid paying
taxes;
• Madoff gave approximately $9,900,000 to family
members, and in order to avoid paying taxes,
executed sham promissory notes to make it appear
that 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 from
Bernard L. Madoff from two sham trades, and
disguised the proceeds of the trades as long-term
stock transactions in order to take advantage of the
lower tax rate for long-term capital gains;
• Madoff charged approximately $175,000 in
personal expenses to a corporate American Express
card 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 received
between approximately $100,000 to $160,000 per
year in salary, a 401(k), and other benefits to
which she was not entitled.
Fairness “Madoff agreed with others to send the $300 million
that remained in the IA accounts to preferred
employees, family members, and friends”
1111
certified that his examination of the firm’s trading
process established its integrity. He did not—indeed,
he could not—conduct any such examination:”
“He made a pretense of compliance; he was really
about complicity.” (Janice K. Fedarcyk)
Honesty • “Madoff created false and misleading BLMIS
compliance documents.”
• “False reports that were filed with the U.S.
Securities and Exchange Commission (SEC)….”
• “The numerous false statements in the Forms ADV
created the false appearance that BLMIS’s IA
business….”
Civic responsibility Evading taxes:
• Peter Madoff received approximately $15,700,000
from Bernard L. Madoff and his wife and executed
sham promissory notes to make it appear that the
transfers were loans, in order to avoid paying
taxes;
• Madoff gave approximately $9,900,000 to family
members, and in order to avoid paying taxes,
executed sham promissory notes to make it appear
that 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 from
Bernard L. Madoff from two sham trades, and
disguised the proceeds of the trades as long-term
stock transactions in order to take advantage of the
lower tax rate for long-term capital gains;
• Madoff charged approximately $175,000 in
personal expenses to a corporate American Express
card 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 received
between approximately $100,000 to $160,000 per
year in salary, a 401(k), and other benefits to
which she was not entitled.
Fairness “Madoff agreed with others to send the $300 million
that remained in the IA accounts to preferred
employees, family members, and friends”
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DETECTING ACCOUNTING FRAUD
1212
Duty to take care of his
employees
Robert L. Panella said that Madoff, “Failed to protect
the integrity of employee benefit plan assets and
personally benefited from proceeds gained as a result
of these false statements.”
b (ii).
Responses may vary. Some students may argue that reason and duty were not sufficient
to prevent Madoff from unethical behavior and that companies need more oversight
and/or there should be stricter laws governing accounting practices and/or we need better
compliance of the laws already in place. Others may maintain that Madoff lacked a
moral compass and a character strong enough to withstand the temptation to enrich
himself. Others may argue that he did not consider the consequences of his actions.
c (i).
Responses will vary, but should include that consequentialism accounts for the far-
reaching repercussions of Madoff’s specific actions and deontology does not.
Consequentialism identifies all of the stakeholders affected by Madoff’s fraud as well as
the far-reaching consequences. On the other hand, deontology focuses on the unwavering
commitment to principle and duty, in this case, for example, the moral imperative to be
honest at all times.
c (ii).
Some students may find consequentialism more persuasive for the reason that it forces
one to consider the far-reaching consequences to all the stakeholders. Some may think
the consequences are the most egregious parts of the act, while others will think skirting
obligations are the worst parts of the crime. They may believe that a commitment to the
moral imperative to always tell the truth would best prevent this kind of offense.
c (iii).
Some students will think one system is best for all cases, while others will think each
issue needs its own system. There are also those who may believe that when faced with
an ethical dilemma, one should analyze it in terms of all three frameworks.
d.
1212
Duty to take care of his
employees
Robert L. Panella said that Madoff, “Failed to protect
the integrity of employee benefit plan assets and
personally benefited from proceeds gained as a result
of these false statements.”
b (ii).
Responses may vary. Some students may argue that reason and duty were not sufficient
to prevent Madoff from unethical behavior and that companies need more oversight
and/or there should be stricter laws governing accounting practices and/or we need better
compliance of the laws already in place. Others may maintain that Madoff lacked a
moral compass and a character strong enough to withstand the temptation to enrich
himself. Others may argue that he did not consider the consequences of his actions.
c (i).
Responses will vary, but should include that consequentialism accounts for the far-
reaching repercussions of Madoff’s specific actions and deontology does not.
Consequentialism identifies all of the stakeholders affected by Madoff’s fraud as well as
the far-reaching consequences. On the other hand, deontology focuses on the unwavering
commitment to principle and duty, in this case, for example, the moral imperative to be
honest at all times.
c (ii).
Some students may find consequentialism more persuasive for the reason that it forces
one to consider the far-reaching consequences to all the stakeholders. Some may think
the consequences are the most egregious parts of the act, while others will think skirting
obligations are the worst parts of the crime. They may believe that a commitment to the
moral imperative to always tell the truth would best prevent this kind of offense.
c (iii).
Some students will think one system is best for all cases, while others will think each
issue needs its own system. There are also those who may believe that when faced with
an ethical dilemma, one should analyze it in terms of all three frameworks.
d.
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Chapter 2: Ethics at Work
1313
Responses may vary, but should include the following:
(Answers are in bold)
Using the American 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 officer working for Madoff
What? Securities fraud, tax fraud conspiracy, falsifying books and records, and
making false statements to investors
When? 1996-2008
Where? Bernard L. Madoff Investment Securities (BLMIS), New York, NY.
How? “Madoff created false and misleading BLMIS compliance documents, as
well as false reports that were filed with the U.S. Securities and Exchange
Commission (SEC) that materially misstated the nature and scope of BLMIS’s
Investment Advisory (IA) business.”
2. Define the ethical issue.
a) List the significant stakeholders
See answer to Case Study Question a (i) above
b) Define the ethical issues
Make 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, making
false statements to investors, lying to family and friends
3. Identify major principles, rules, or values.
For example, integrity, quality, respect for persons, and profit.
Honesty, fairness, integrity, duties to employees
4. Specify the alternatives.
List the major alternative courses of action, including those that represent some form of
compromise or point between simply doing or not doing something.
In this case, it does not seem that a moral compromise was possible—it is never
permissible to misrepresent one’s company, or to cheat and steal from one’s
clients.
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 that
the proper alternative is clear—for example, correcting a defect that is almost certain to
cause loss of life.
All major ethical frameworks would appear to lead to the conclusion that the chief
compliance officer should not turn a blind eye to the fraud.
1313
Responses may vary, but should include the following:
(Answers are in bold)
Using the American 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 officer working for Madoff
What? Securities fraud, tax fraud conspiracy, falsifying books and records, and
making false statements to investors
When? 1996-2008
Where? Bernard L. Madoff Investment Securities (BLMIS), New York, NY.
How? “Madoff created false and misleading BLMIS compliance documents, as
well as false reports that were filed with the U.S. Securities and Exchange
Commission (SEC) that materially misstated the nature and scope of BLMIS’s
Investment Advisory (IA) business.”
2. Define the ethical issue.
a) List the significant stakeholders
See answer to Case Study Question a (i) above
b) Define the ethical issues
Make 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, making
false statements to investors, lying to family and friends
3. Identify major principles, rules, or values.
For example, integrity, quality, respect for persons, and profit.
Honesty, fairness, integrity, duties to employees
4. Specify the alternatives.
List the major alternative courses of action, including those that represent some form of
compromise or point between simply doing or not doing something.
In this case, it does not seem that a moral compromise was possible—it is never
permissible to misrepresent one’s company, or to cheat and steal from one’s
clients.
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 that
the proper alternative is clear—for example, correcting a defect that is almost certain to
cause loss of life.
All major ethical frameworks would appear to lead to the conclusion that the chief
compliance officer should not turn a blind eye to the fraud.
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DETECTING ACCOUNTING FRAUD
1414
6. Assess the consequences.
Identify short and long, and positive and negative consequences for the major
alternatives. The common short-run focus on gain or loss needs to be measured against
long-run considerations. This step will often reveal an unanticipated result of major
importance.
See answer to Case Study Question a (i) above
7. Make your decision.
Balance the consequences against your primary principles or values and select the
alternative that best fits.
It is likely that all approaches will lead to the decision that this fraud was morally
wrong and should not be committed.
1414
6. Assess the consequences.
Identify short and long, and positive and negative consequences for the major
alternatives. The common short-run focus on gain or loss needs to be measured against
long-run considerations. This step will often reveal an unanticipated result of major
importance.
See answer to Case Study Question a (i) above
7. Make your decision.
Balance the consequences against your primary principles or values and select the
alternative that best fits.
It is likely that all approaches will lead to the decision that this fraud was morally
wrong and should not be committed.
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1
Chapter 3
The Sizzling Saga of Sunbeam
SOLUTIONS
Ethics at Work:
a. Suggested response:
Developed by Jeremy Bentham (1748–1832), utilitarianism maintains that the right action
ethically is the action that maximizes the “good.” As consequentialist philosophy has
developed over the years, different philosophers have specified different definitions of the
“good,” or what should be maximized, but the unifying thread is that all consequentialists
judge actions according the sum of the net “good” that actions cause among all those who are
affected by the action. To the strict utilitarian, it is the aggregate “pleasure” for all parties
concerned that will determine whether the action is right.
Therefore, when applying this framework, we have to consider all of the
stakeholders in the decision by Sunbeam’s management to issue financial statements that
included 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 groups
of people—who would enjoy an increase in pleasure or suffer an increase in pain as a result
of the overstatement of sales and accounts receivable in Sunbeam’s income statements and
balance sheets.
Sunbeam was unethical in issuing financial statements that improperly timed
Sunbeam’s revenue recognition because this increased only Sunbeam’s own short-term
financial gains and did not consider how this unethical behavior could eventually affect the
long-term health of the company, as well as its employees, investors, and family members of
anyone with connections to the company. In addition, before Sunbeam was forced to declare
bankruptcy, it introduced its notorious and ruthless downsizing strategy, leading to the
closure of a number of plants. At the time of these downsizings, cookie-jar reserves were
created that were later reversed into earnings.
Here is how these moves affected potential stakeholders:
Chapter 3
The Sizzling Saga of Sunbeam
SOLUTIONS
Ethics at Work:
a. Suggested response:
Developed by Jeremy Bentham (1748–1832), utilitarianism maintains that the right action
ethically is the action that maximizes the “good.” As consequentialist philosophy has
developed over the years, different philosophers have specified different definitions of the
“good,” or what should be maximized, but the unifying thread is that all consequentialists
judge actions according the sum of the net “good” that actions cause among all those who are
affected by the action. To the strict utilitarian, it is the aggregate “pleasure” for all parties
concerned that will determine whether the action is right.
Therefore, when applying this framework, we have to consider all of the
stakeholders in the decision by Sunbeam’s management to issue financial statements that
included 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 groups
of people—who would enjoy an increase in pleasure or suffer an increase in pain as a result
of the overstatement of sales and accounts receivable in Sunbeam’s income statements and
balance sheets.
Sunbeam was unethical in issuing financial statements that improperly timed
Sunbeam’s revenue recognition because this increased only Sunbeam’s own short-term
financial gains and did not consider how this unethical behavior could eventually affect the
long-term health of the company, as well as its employees, investors, and family members of
anyone with connections to the company. In addition, before Sunbeam was forced to declare
bankruptcy, it introduced its notorious and ruthless downsizing strategy, leading to the
closure of a number of plants. At the time of these downsizings, cookie-jar reserves were
created that were later reversed into earnings.
Here is how these moves affected potential stakeholders:
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DETECTING ACCOUNTING FRAUD
2
• Investors―Recognizing future sales in the current period inflates current
earnings and usually inflates the stock price. Investors bought stock at inflated
prices and lost money because future sales had already been taken into the current
period’s sales. When Sunbeam eventually declared bankruptcy, shareholders
received nothing.
• Employees of the company—Many at Sunbeam lost their jobs and also lost their
benefits, such as health-care insurance and pensions.
• Family members—Relatives of Sunbeam’s employees suffered hardships when
family members lost their jobs.
• Financial institutions—Banks that lent Sunbeam money lost about 66 percent of
their loans.
• Other businesses—Companies doing business with Sunbeam lost money when
Sunbeam went bankrupt.
b. Suggested response:
The justice decision-making model aims to identify the right or the moral action. Once all the
stakeholders are identified, this model emphasizes that all parties involved must be treated
equally and fairly. This model focuses on distributive justice, or the fair distribution of
justice. When it comes to insider trading, it can be argued that the seller and the buyer of the
shares are not being treated equally. The true information as to the company’s sales and
earnings is not equally distributed to the two parties involved in the sale. Because of this
unequal treatment, it would be argued under the justice approach that insider trading is
unethical.
ASSIGNMENTS
True/False Questions:
1. False
2. True
3. True
4. True
2
• Investors―Recognizing future sales in the current period inflates current
earnings and usually inflates the stock price. Investors bought stock at inflated
prices and lost money because future sales had already been taken into the current
period’s sales. When Sunbeam eventually declared bankruptcy, shareholders
received nothing.
• Employees of the company—Many at Sunbeam lost their jobs and also lost their
benefits, such as health-care insurance and pensions.
• Family members—Relatives of Sunbeam’s employees suffered hardships when
family members lost their jobs.
• Financial institutions—Banks that lent Sunbeam money lost about 66 percent of
their loans.
• Other businesses—Companies doing business with Sunbeam lost money when
Sunbeam went bankrupt.
b. Suggested response:
The justice decision-making model aims to identify the right or the moral action. Once all the
stakeholders are identified, this model emphasizes that all parties involved must be treated
equally and fairly. This model focuses on distributive justice, or the fair distribution of
justice. When it comes to insider trading, it can be argued that the seller and the buyer of the
shares are not being treated equally. The true information as to the company’s sales and
earnings is not equally distributed to the two parties involved in the sale. Because of this
unequal treatment, it would be argued under the justice approach that insider trading is
unethical.
ASSIGNMENTS
True/False Questions:
1. False
2. True
3. True
4. True
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Chapter 3: The Sizzling Saga of Sunbeam
3
5. False
6. False
7. True
8. True
9. False
10. True
Fill-In-the-Blank Questions:
11. allocated
12. remaining or continuing
13. memory
14. accelerating
15. reserve for returns
16. inconclusive
17. deductions
18. quarter-end
19. excess
20. special
Multiple Choice Questions:
21. c
Explanation: Ownership will only pass from Ace to its customer once the goods have been
shipped from Ace to the customer (FOB shipping). If the goods have been shipped from
Ace’s head office to its branch office, this does not constitute shipping to the customer. On
December 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
3
5. False
6. False
7. True
8. True
9. False
10. True
Fill-In-the-Blank Questions:
11. allocated
12. remaining or continuing
13. memory
14. accelerating
15. reserve for returns
16. inconclusive
17. deductions
18. quarter-end
19. excess
20. special
Multiple Choice Questions:
21. c
Explanation: Ownership will only pass from Ace to its customer once the goods have been
shipped from Ace to the customer (FOB shipping). If the goods have been shipped from
Ace’s head office to its branch office, this does not constitute shipping to the customer. On
December 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 FRAUD
4
Explanation: Item I inventory is part of Bolt’s inventory because ownership of the goods on
consignment remains with Bolt until the retail customer sells the goods. Item II inventory
passed 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 the
consignee sells them.
• Answer d is incorrect because Item II inventory has been sold (FOB shipping).
23. d
Explanation: 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 are
shipped. Answer b is correct because the buyer must have a substantial business reason for
requesting 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 of
goods sold.
24. c
Explanation: A sale can only be recognized once the risks of ownership have passed to the
buyer, and the FOB destination clause delays this transfer until the goods are shipped in
March.
• Answer a is incorrect because, in this case, the buyer does have a legitimate, substantial
business reason for placing the order early.
• Answer b is incorrect because, with bill and hold sales, the cost of goods sold and the
sales revenue are both recognized.
• Answer d is incorrect because sales do not have to be paid for in order to be recognized
as sales.
25. a
Explanation: The back-dated order increases sales by $10,000 and increases operating
income 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.
4
Explanation: Item I inventory is part of Bolt’s inventory because ownership of the goods on
consignment remains with Bolt until the retail customer sells the goods. Item II inventory
passed 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 the
consignee sells them.
• Answer d is incorrect because Item II inventory has been sold (FOB shipping).
23. d
Explanation: 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 are
shipped. Answer b is correct because the buyer must have a substantial business reason for
requesting 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 of
goods sold.
24. c
Explanation: A sale can only be recognized once the risks of ownership have passed to the
buyer, and the FOB destination clause delays this transfer until the goods are shipped in
March.
• Answer a is incorrect because, in this case, the buyer does have a legitimate, substantial
business reason for placing the order early.
• Answer b is incorrect because, with bill and hold sales, the cost of goods sold and the
sales revenue are both recognized.
• Answer d is incorrect because sales do not have to be paid for in order to be recognized
as sales.
25. a
Explanation: The back-dated order increases sales by $10,000 and increases operating
income 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 Sunbeam
5
• Answer d is incorrect because net income would be overstated by $6,000, excluding
income tax effects.
26. b
Explanation: Operating income would increase by $6,000 ($10,000 less $4,000). CFFO
would not increase. To arrive at CFFO, deduct the increase in account receivable of $10,000
and 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. d
Explanation: 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.
• Answer b is incorrect because CFFO will not increase.
• Answer c is incorrect. See the explanation for Answer d above.
28. a
Explanation: The accounts receivable balance will be $65,000 ($50,000 + $15,000)
• Answer b is incorrect, because operating income will be $30,000($25,000 + $15,000 -
$10,000).
• Answer c is incorrect because CFFO will not increase.
• Answer d is incorrect because operating income will be $30,000 ($25,000 + $15,000 -
$10,000).
29. d
Explanation: Sunbeam’s restructuring expense decreased net income. The other side of the
entry increased the restructuring reserve on the balance sheet.
• Answer a is incorrect; net income decreased.
• Answer b is incorrect; the reserves increased.
• Answer c is incorrect; an expense does not increase income.
30. a
Explanation: Sunbeam provides an example of improper revenue recognition via improper
timing of revenue. The sales revenue that it recorded related to real orders for goods that
5
• Answer d is incorrect because net income would be overstated by $6,000, excluding
income tax effects.
26. b
Explanation: Operating income would increase by $6,000 ($10,000 less $4,000). CFFO
would not increase. To arrive at CFFO, deduct the increase in account receivable of $10,000
and 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. d
Explanation: 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.
• Answer b is incorrect because CFFO will not increase.
• Answer c is incorrect. See the explanation for Answer d above.
28. a
Explanation: The accounts receivable balance will be $65,000 ($50,000 + $15,000)
• Answer b is incorrect, because operating income will be $30,000($25,000 + $15,000 -
$10,000).
• Answer c is incorrect because CFFO will not increase.
• Answer d is incorrect because operating income will be $30,000 ($25,000 + $15,000 -
$10,000).
29. d
Explanation: Sunbeam’s restructuring expense decreased net income. The other side of the
entry increased the restructuring reserve on the balance sheet.
• Answer a is incorrect; net income decreased.
• Answer b is incorrect; the reserves increased.
• Answer c is incorrect; an expense does not increase income.
30. a
Explanation: Sunbeam provides an example of improper revenue recognition via improper
timing of revenue. The sales revenue that it recorded related to real orders for goods that
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DETECTING ACCOUNTING FRAUD
6
ordinarily would have been placed in later periods. (The next chapter deals with improper
revenue 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 future
periods’ sales.
For Discussion
31. Suggested response:
It must be understood that the recognition of future revenue in the current period takes the
next period’s revenue into this period. As a consequence, that portion of the next period’s
revenue cannot be reorganized in the later period. Even if the fraud is repeated in the next
period, that period would only recognize one period’s revenue and earnings, whereas the
current period recognizes more than one period’s revenues and earnings. The result of this
will likely be an increase in the stock price in the current period and a decrease in the stock
price in a later period. Shareholders who purchased stock at the inflated price will suffer a
loss as the stock price falls after the spike in revenues and earnings.
The perpetrators of early recognition of revenue frauds prepare misleading
financial statements. Whenever anyone intentionally misleads another person and that
deception causes a financial loss, a fraud has been committed. Since early recognition of
revenue can cause others financial loss, the perpetrators bear the same responsibility for
fraud.
32. Suggested response:
Managers have an incentive to understate net income in one period in order to overstate it in
a future period because, with this scheme, the expense for the creation of the restructuring
reserve is often disclosed “below the line” of operating income. As a result, it is regarded as
a “non-recurring” expense. Therefore, it may not impact the stock price as much as if the
expense were recognized before the calculation of operating income. Perpetrators of this
kind of fraud often release the overstated reserve into earnings “above the line” of operating
income in the future period where the income is considered to be recurring. This makes the
company appear to be more profitable than it really is and falsely boosts the stock price.
6
ordinarily would have been placed in later periods. (The next chapter deals with improper
revenue 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 future
periods’ sales.
For Discussion
31. Suggested response:
It must be understood that the recognition of future revenue in the current period takes the
next period’s revenue into this period. As a consequence, that portion of the next period’s
revenue cannot be reorganized in the later period. Even if the fraud is repeated in the next
period, that period would only recognize one period’s revenue and earnings, whereas the
current period recognizes more than one period’s revenues and earnings. The result of this
will likely be an increase in the stock price in the current period and a decrease in the stock
price in a later period. Shareholders who purchased stock at the inflated price will suffer a
loss as the stock price falls after the spike in revenues and earnings.
The perpetrators of early recognition of revenue frauds prepare misleading
financial statements. Whenever anyone intentionally misleads another person and that
deception causes a financial loss, a fraud has been committed. Since early recognition of
revenue can cause others financial loss, the perpetrators bear the same responsibility for
fraud.
32. Suggested response:
Managers have an incentive to understate net income in one period in order to overstate it in
a future period because, with this scheme, the expense for the creation of the restructuring
reserve is often disclosed “below the line” of operating income. As a result, it is regarded as
a “non-recurring” expense. Therefore, it may not impact the stock price as much as if the
expense were recognized before the calculation of operating income. Perpetrators of this
kind of fraud often release the overstated reserve into earnings “above the line” of operating
income in the future period where the income is considered to be recurring. This makes the
company 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 Sunbeam
7
Short-Answer Questions:
33. Typically, when companies overstates a restructuring reserve for the purpose of creating a
cookie-jar reserve to reverse into profits in a later period, they disclose the restructuring
expense in the income statement as a special charge below operating income. Although this
reduces 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 income
statement. 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 period
that the bill and hold sale is recognized. Looking at the indirect method, the amount stated
for CFFO is derived by beginning with the net income and deducting the increase in accounts
receivable and other current assets. Decreases in current assets are added back. The bill and
hold sale increases accounts receivable and decreases inventory. The net effect is that the
transaction does not increase CFFO.
35. When a segment or product line is closed, all of its revenue is lost. Many fixed costs that are
allocated over segments are not directly traceable to a particular segment. As a result, even if
the expense could be avoided if the entire company were liquidated, closing just one segment
might not reduce the cost. For example, a CEO’s salary will probably not decrease if one
segment is closed. If the salary cost remains constant, it will be allocated over the remaining
segments, which now carry more costs and might report less profit after a segment was
closed. In this instance, the remaining revenue is decreased by a greater amount than
expenses are decreased.
36. The increase in this ratio shows that recorded sales are increasing at a faster percentage than
payments by customers. This could be caused by a decreasing ability of customers to pay, or
it could be that the revenue has been recorded earlier than in the past or that the revenue is
completely fictitious. While the signal is not proof of any of these items, it is not a good
7
Short-Answer Questions:
33. Typically, when companies overstates a restructuring reserve for the purpose of creating a
cookie-jar reserve to reverse into profits in a later period, they disclose the restructuring
expense in the income statement as a special charge below operating income. Although this
reduces 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 income
statement. 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 period
that the bill and hold sale is recognized. Looking at the indirect method, the amount stated
for CFFO is derived by beginning with the net income and deducting the increase in accounts
receivable and other current assets. Decreases in current assets are added back. The bill and
hold sale increases accounts receivable and decreases inventory. The net effect is that the
transaction does not increase CFFO.
35. When a segment or product line is closed, all of its revenue is lost. Many fixed costs that are
allocated over segments are not directly traceable to a particular segment. As a result, even if
the expense could be avoided if the entire company were liquidated, closing just one segment
might not reduce the cost. For example, a CEO’s salary will probably not decrease if one
segment is closed. If the salary cost remains constant, it will be allocated over the remaining
segments, which now carry more costs and might report less profit after a segment was
closed. In this instance, the remaining revenue is decreased by a greater amount than
expenses are decreased.
36. The increase in this ratio shows that recorded sales are increasing at a faster percentage than
payments by customers. This could be caused by a decreasing ability of customers to pay, or
it could be that the revenue has been recorded earlier than in the past or that the revenue is
completely fictitious. While the signal is not proof of any of these items, it is not a good
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DETECTING ACCOUNTING FRAUD
8
sign. Unless one can identify a legitimate reason behind an increase in this ratio, it is a signal
that the quality of the revenue reported may be deteriorating.
37. Often, a restructuring reserve includes a write-down of inventory below cost, on the grounds
that the company expects the inventory to be sold at a loss. When companies overstate this
expected loss and write down the inventory in the current period—and then sell the inventory
close to the regular selling price in the future period—it causes a large gross margin to be
reported in the later period if the company includes the recording of these sales in its
disclosure of operating income.
8
sign. Unless one can identify a legitimate reason behind an increase in this ratio, it is a signal
that the quality of the revenue reported may be deteriorating.
37. Often, a restructuring reserve includes a write-down of inventory below cost, on the grounds
that the company expects the inventory to be sold at a loss. When companies overstate this
expected loss and write down the inventory in the current period—and then sell the inventory
close to the regular selling price in the future period—it causes a large gross margin to be
reported in the later period if the company includes the recording of these sales in its
disclosure of operating income.
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Chapter 3: The Sizzling Saga of Sunbeam
9
Exercises:
38. Year 1 Year 2 Year 3
Accounts receivable as a percentage of sales: 15% 20% 37.5%
39.
Net income $100,000
Depreciation 5,000
Decrease in inventory 10,000
Increase in accounts receivable (40,000)
Increase in accounts payable 5,000
Cash flow from operations $ 80,000
40 (a). Debit restructuring expense $20,000
Credit restructuring reserve $20,000
40 (b). Income Statement
Sales $160,000
Cost of goods sold 60,000
Gross margin 100,000
Selling & administrative expenses 40,000
Operating income 60,000
Restructuring expense 20,000
Income before taxation 40,000
Taxation 12,000
Net income $ 28,000
CASE STUDY:
Beazer Homes USA, INC.
NOTE: Question a (below) refers to the sale and leaseback transactions.
a (1).
9
Exercises:
38. Year 1 Year 2 Year 3
Accounts receivable as a percentage of sales: 15% 20% 37.5%
39.
Net income $100,000
Depreciation 5,000
Decrease in inventory 10,000
Increase in accounts receivable (40,000)
Increase in accounts payable 5,000
Cash flow from operations $ 80,000
40 (a). Debit restructuring expense $20,000
Credit restructuring reserve $20,000
40 (b). Income Statement
Sales $160,000
Cost of goods sold 60,000
Gross margin 100,000
Selling & administrative expenses 40,000
Operating income 60,000
Restructuring expense 20,000
Income before taxation 40,000
Taxation 12,000
Net income $ 28,000
CASE STUDY:
Beazer Homes USA, INC.
NOTE: Question a (below) refers to the sale and leaseback transactions.
a (1).
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DETECTING ACCOUNTING FRAUD
10
The model homes were eventually truly sold at the end of the lease term. Therefore, the
revenue was eventually earned. However, the sale-leaseback agreement enabled Beazer
to recognize the sale at the beginning of the lease term, while the company was still using
the homes as marketing models and while it still participated in the appreciation of the
value 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 percent
of these model homes. These agreements allowed Beazer to recognize revenue on the sale
of the model homes while it was still using the homes as marketing models. However, in
2006, Beazer began to increase the percentage of the model homes for which it entered
into sale-leaseback agreements to 70 percent. In this way, it was able to recognize sales
revenue of $117 million on more of the homes it had not yet sold outright. This was, of
course, a much higher percentage of homes than normally had been leased back as
marketing models. Further, in terms of these sale-leaseback agreements, Beazer retained
the “right to receive a percentage of the appreciation of the model home upon its sale at
the end of the lease term” (AAER 2884, par. 1.4). This disqualified the agreements from
being recognized as sales at the beginning of the lease term.
a (3).
Signals of Beazer’s Fraudulent Reporting for Scheme #1: Improper Recognition of
Revenue via Sales-Leaseback Arrangements:
o Signal #1: The first signal of an overstatement of revenue is when a
company’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 of
sales more than tripled.
10
The model homes were eventually truly sold at the end of the lease term. Therefore, the
revenue was eventually earned. However, the sale-leaseback agreement enabled Beazer
to recognize the sale at the beginning of the lease term, while the company was still using
the homes as marketing models and while it still participated in the appreciation of the
value 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 percent
of these model homes. These agreements allowed Beazer to recognize revenue on the sale
of the model homes while it was still using the homes as marketing models. However, in
2006, Beazer began to increase the percentage of the model homes for which it entered
into sale-leaseback agreements to 70 percent. In this way, it was able to recognize sales
revenue of $117 million on more of the homes it had not yet sold outright. This was, of
course, a much higher percentage of homes than normally had been leased back as
marketing models. Further, in terms of these sale-leaseback agreements, Beazer retained
the “right to receive a percentage of the appreciation of the model home upon its sale at
the end of the lease term” (AAER 2884, par. 1.4). This disqualified the agreements from
being recognized as sales at the beginning of the lease term.
a (3).
Signals of Beazer’s Fraudulent Reporting for Scheme #1: Improper Recognition of
Revenue via Sales-Leaseback Arrangements:
o Signal #1: The first signal of an overstatement of revenue is when a
company’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 of
sales more than tripled.
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Chapter 3: The Sizzling Saga of Sunbeam
11
o Signal #2: Another signal of improper revenue recognition, or of a severe
operating problem, is a sudden change in gross profit margin as a percentage
of sales. The situation becomes even more severe if there is a sudden
downward fluctuation of the gross margin. In 2006, Beazer’s gross profit
margin 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)
o Signal #3: A third signal of improper revenue recognition occurs when
cash flow from operations (CFFO) lags behind operating income. In the
case of Beazer Homes, the accelerated sales were simply not turning into
cash received at the rate that they should have been if they were legitimate
sales. CFFO was significantly negative while operating income was
positive for the fiscal years 2004-2006. This signal was an extremely
strong indication that income was overstated.
b (1).
Beazer Homes recorded its land inventory in “land inventory accounts” in its general ledger.
The land inventory accounts were debited with the purchase cost of the land plus common
developments costs, such as the cost of sewer systems, including future estimated
development costs. As the houses were sold, the associated land inventory account was
reduced and a cost-of-sales expense was recognized. However, the “land expense recorded
for any particular house sale was necessarily an estimate” (AAER 2884, par. 3). According to
the SEC’s action, “in various quarters during fiscal years 2000 through 2005, Beazer
overallocated land inventory expense to individual properties sold” (AAER 2884, par. 9).
This overstatement caused the land inventory account to eventually record a negative
balance. These credit balances on the land inventory accounts acted “in effect as improper
11
o Signal #2: Another signal of improper revenue recognition, or of a severe
operating problem, is a sudden change in gross profit margin as a percentage
of sales. The situation becomes even more severe if there is a sudden
downward fluctuation of the gross margin. In 2006, Beazer’s gross profit
margin 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)
o Signal #3: A third signal of improper revenue recognition occurs when
cash flow from operations (CFFO) lags behind operating income. In the
case of Beazer Homes, the accelerated sales were simply not turning into
cash received at the rate that they should have been if they were legitimate
sales. CFFO was significantly negative while operating income was
positive for the fiscal years 2004-2006. This signal was an extremely
strong indication that income was overstated.
b (1).
Beazer Homes recorded its land inventory in “land inventory accounts” in its general ledger.
The land inventory accounts were debited with the purchase cost of the land plus common
developments costs, such as the cost of sewer systems, including future estimated
development costs. As the houses were sold, the associated land inventory account was
reduced and a cost-of-sales expense was recognized. However, the “land expense recorded
for any particular house sale was necessarily an estimate” (AAER 2884, par. 3). According to
the SEC’s action, “in various quarters during fiscal years 2000 through 2005, Beazer
overallocated land inventory expense to individual properties sold” (AAER 2884, par. 9).
This overstatement caused the land inventory account to eventually record a negative
balance. These credit balances on the land inventory accounts acted “in effect as improper
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DETECTING ACCOUNTING FRAUD
12
reserves …. Beginning at least by the second quarter of 2006, Beazer … began to reverse the
excess reserves existing in the land inventory account, which increased their current period
earnings” (AAER 2884, par. 10).
According to the SEC complaint, these manipulations understated Beazer’s net
income by $42 million between fiscal years 2000 and 2005 and overstated net income by
over $1.2 million during 2006. The company also reduced its cumulative net loss for the first
two 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 were later partly
reversed into earnings, as Sunbeam’s cookie-jar reserves were released into earnings in later
periods.
b (3).
On creation of the reserve, Beazer increased cost of sales, which would clearly be seen as a
normal recurring expense, whereas on the creation of its restructuring reserve, Sunbeam
disclosed the 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 the
cookie-jar reserve, could have had less of a negative effect on investors’ expectations of
Sunbeam’s future recurring profits.
12
reserves …. Beginning at least by the second quarter of 2006, Beazer … began to reverse the
excess reserves existing in the land inventory account, which increased their current period
earnings” (AAER 2884, par. 10).
According to the SEC complaint, these manipulations understated Beazer’s net
income by $42 million between fiscal years 2000 and 2005 and overstated net income by
over $1.2 million during 2006. The company also reduced its cumulative net loss for the first
two 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 were later partly
reversed into earnings, as Sunbeam’s cookie-jar reserves were released into earnings in later
periods.
b (3).
On creation of the reserve, Beazer increased cost of sales, which would clearly be seen as a
normal recurring expense, whereas on the creation of its restructuring reserve, Sunbeam
disclosed the 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 the
cookie-jar reserve, could have had less of a negative effect on investors’ expectations of
Sunbeam’s future recurring profits.
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1
Chapter 4
Hocus Pocus
SOLUTIONS
Ethics at Work
a. Suggested response:
The deontologist (from the Greek deon, which means “duty”) chooses moral action not
because of its consequences in the specific circumstances, but because it is the right thing
to do. Kant, the leading deontologist, went even further by saying that if you perceive
telling 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 negative
consequences.
Few would argue that financial statements should not be truthful. To the
deontologist, once you accept truth telling as a maxim, you must always present truthful
financial statements. In fact, there is a moral imperative to present truthful financial
statements. Therefore, according to deontology, any scheme to manipulate Xerox’s
financial statements would have been regarded as unethical.
b. These are broad questions and can be answered in a number of ways. Here is one possible
response:
It is important to note a distinction between legal behavior and ethical behavior. Everyone
can think of situations in which one has to go beyond merely keeping within the letter of the
law. Ultimately, GAAP rules aim to fairly and accurately present a company’s financial
position and the results of its operations. When GAAP rules do not achieve this, the
company’s annual report must find a way to disclose this. For example, the Management
Discussion and Analysis (MD&A) can and should present further clarification on various
issues. Companies need to be aware that they should abide by both the letter of the law and
the spirit of the law.
For example, PepsiCo’s 2011 Annual Report addresses this issue as follows:
Chapter 4
Hocus Pocus
SOLUTIONS
Ethics at Work
a. Suggested response:
The deontologist (from the Greek deon, which means “duty”) chooses moral action not
because of its consequences in the specific circumstances, but because it is the right thing
to do. Kant, the leading deontologist, went even further by saying that if you perceive
telling 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 negative
consequences.
Few would argue that financial statements should not be truthful. To the
deontologist, once you accept truth telling as a maxim, you must always present truthful
financial statements. In fact, there is a moral imperative to present truthful financial
statements. Therefore, according to deontology, any scheme to manipulate Xerox’s
financial statements would have been regarded as unethical.
b. These are broad questions and can be answered in a number of ways. Here is one possible
response:
It is important to note a distinction between legal behavior and ethical behavior. Everyone
can think of situations in which one has to go beyond merely keeping within the letter of the
law. Ultimately, GAAP rules aim to fairly and accurately present a company’s financial
position and the results of its operations. When GAAP rules do not achieve this, the
company’s annual report must find a way to disclose this. For example, the Management
Discussion and Analysis (MD&A) can and should present further clarification on various
issues. Companies need to be aware that they should abide by both the letter of the law and
the spirit of the law.
For example, PepsiCo’s 2011 Annual Report addresses this issue as follows:
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Subject
Accounting