Reference no: EM133188170

Making the Numbers or Faking the Numbers

Will sales and profits meet the expectations of investors and Wall Street analysts? Managers at public corporations must answer this important question quarter after quarter, year after year. In an ideal world-one in which there is never an economic crisis, expenses never go up, and customers never buy competing products-the corporation's price for a share of its stock would soar, and investors would cheer as every financial report showed ever-higher sales revenues, profits, and earnings.

In the real world, however, many uncontrollable and unpredictable factors can affect a corporation's performance and its stock price. For example, when technology giant IBM announced lower-than-expected earnings in late 2014, analysts and investors were disappointed and the value of its stock dropped by 7 percent in just one day. Other factors include customers purchasing fewer products or services or postponing purchases, competitors lowering their prices or introducing superior products, increasing expenses, climbing interest rates, and plummeting buying power. Faced with the prospect of releasing financial results that fall short of Wall Street's expectations, managers may feel intense pressure to "make the numbers" using a variety of accounting techniques. In some cases, managers may even resort to accounting fraud to increase sales and profits and reduce expenses. A recent study by the accounting firm PricewaterhouseCoopers found that accounting fraud is on the increase when compared to a similar study conducted three years ago.

For example, executives and board members at Groupon-the premier source for consumers who want to take advantage of daily deals-found themselves having to answer difficult questions about how it reported revenues and expenses. As a result of increased scrutiny by both regulators and investors, the company was forced to reexamine its accounting practices and tighten its audit procedures.

Another company-Diamond Foods-was also accused by the Securities and Exchange Commission (SEC) of underreporting expenses and the cost of raw materials to boost profits and meet Wall Street and investor expectations. Eventually, Diamond Foods was forced to restate its earnings and its executives faced both SEC scrutiny and civil lawsuits filed by investors.

Under the Sarbanes-Oxley Act, the CEO and CFO now must certify the corporation's financial reports. Immediately after this legislation became effective, hundreds of companies restated their earnings, a sign that stricter accounting controls were having the intended effect. Now that stricter regulation has been in force for some time, fewer and fewer corporations are announcing restatements. The chief reason for the decline is that corporations and their accounting firms have learned to dig deeper and analyze the process used to produce the figures for financial statements, as well as check the numbers themselves.

Because accounting rules are open to interpretation, managers sometimes find themselves facing ethical dilemmas when a corporation feels pressure to live up to Wall Street's expectations. Consider the hypothetical situation at Commodore Appliances, a fictional company that sells to Home Depot, Lowe's, and other major retail chains. Margaret, the vice president of sales, has told Rob, a district manager, that the company's sales are down 10 percent in the current quarter. She points out that sales in Rob's district are down 20 percent and states that higher-level managers want him to improve this month's figures using "book and hold," which means recording future sales transactions in the current period.

Rob hesitates, saying that he needs more time to get sales momentum going. He thinks "book and hold" is not a good business practice, even if it is legal. Margaret hints that Rob will lose his job if his sales figures don't look better and stresses that he will need the book-and-hold approach for one month only. Rob realizes that if he doesn't go along, he won't be working at Commodore for very much longer.

Meeting with Kevin, one of Commodore's auditors, Rob learns that book and hold meets GAAPs. Kevin emphasizes that customers must be willing to take title to the goods before they're delivered or billed. Any book-and-hold sales must be real, backed by documentation such as e-mails to and from buyers, and the transactions must be completed in the near future.

Rob is at a crossroads: His sales figures must be higher if Commodore is to achieve its performance targets, yet he doesn't know exactly when (or if) he actually would complete any book-and-hold sales he might report this month. He doesn't want to mislead anyone, but he also doesn't want to lose his job or put other people's jobs in jeopardy by refusing to do what he is being asked to do. Rob is confident that he can improve his district's sales over the long term. However, Commodore's executives are pressuring Rob to make the sales figures look better right now. What should he do?*

Questions

1- What are the ethical and legal implications of using accounting practices such as the book-and-hold technique to accelerate revenues and inflate corporate earnings?

2- Why would Commodore's auditor insist that Rob document any sales booked under the book-and-hold technique?

3- If you were in Rob's situation, would you agree to use the book-and-hold technique this month to accelerate revenues? Justify your decision.

4- Imagine that Commodore has taken out a multimillion-dollar loan that must be repaid next year. How might the lender react if it learned that Commodore was using the book-and-hold method to make revenues look higher than they really are?