Suggested Assignment Questions 1 What went wrong?
A. Assignment Question
I like to begin class by asking students the “what went wrong?” question. I phrase it as follows: “As you could tell from reading the case, FFI had some problems. Let’s focus first on the company. Is there anything unusual about this company that would lead you to believe that it would have the problems it did? Did the company set itself up to have problems?”
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructor’s Manual
This question will evoke a number of responses. One explanation is that unreasonable pressures for performance combined with a lucrative incentive program and a “no excuses” management style motivated the division managers to take steps to boost performance in the short run at the expense of the long run. Their actions are common examples of the “operating myopia” problem that is discussed in Chapter 10 in the text. Some of the actions are relatively harmless, but others can have significant negative effects.
After students have identified the causal factors, ask if these characteristics are unusual. I think they will conclude that these factors exist, to a greater or lesser degree, in most corporations. Then some specific game-playing actions should be identified, described, and discussed. One way to get into this discussion is to ask, “What was the first questionable activity that you read about that suggested to you that something was wrong in this company?” A student will pick something out, and the discussion will be underway. If an item is missed, another student will likely bring it up. An alternate approach is for the instructor to choose which activities to discuss.
The case provides many examples of earnings management or gamesmanship, including the following:
Drink Division
1. 2007: Shipping moratorium, build-up of reserves, and the prepayment of some discretionary expenses.
2. 2008: Early-order program, reduction of reserves. 3. 2009: Re-build-up of reserves.
Cookie Division
1. 2008: Early-order program, shipping around the clock at the end of a quarter, ship unordered products, fraudulent orders with attempts to make the orders “stick.”
2. 2009: Capitalize parts costs.
These specific actions provide opportunities for instructors to ask the following questions: (1) Is this action in the best interest of the division?
(2) Is it in the best interest of the corporation?
(3) Is it an acceptable business practice? Unethical? Fraudulent?
Question (1) will surface the short-term vs. long-term trade-offs faced in many managerial situations.
Question (2) will cause students to identify a suboptimization problem—a business unit serving its own selfish interest. Most of these examples provide good illustrations of the “behavioral displacement” problem discussed in Chapter 5 in the text. The corporation’s control system actually motivates managers to take the wrong actions.
Question (3) opens the ethics issue that is the focus of Chapter 15. (Thus, obviously, this case can be used in conjunction with Chapter 5, 10, or 15.) The nonfraudulent actions, such as those taken in the Drink Division in 2007 are a particularly interesting ethics issue to discuss because the division is not overstating profits, and the accounting is done correctly. Still, managers are taking actions to make themselves look better cosmetically—for example, higher likelihood of achieving performance targets, smoother earnings pattern—while taking actions that actually have negative economic effects, including a build-up in inventory and harmed customer relations. If students have a background in ethics, or if this case is used in conjunction with Chapter 15, instructors could do a full ethical analysis of this situation, with identification of stakeholders, analyses of the situation in light of one or more ethical reasoning models, and discussion of possible alternate courses of action. The word “fraudulent” is defined by the legal system. It is usually interpreted as a willful manipulation with an intent to deceive.
As the discussion unfolds in class, instructors can make any of the following points: 1. Research has shown that some of these actions are quite common.
a. Do managers judge the benefits of these actions greater than the costs? Or are these actions just unavoidable control system side-effects?
b. If everyone is doing something, does that mean it is ethical?
2. Top management and the board of directors must bear ultimate responsibility for what took place in FFI even though they were not directly involved in the deceptive practices.
3. Is income smoothing valuable? Most managers think it is, and they will argue that the stock market values, and even demands, it. But smoothing distorts the numbers in the company’s financial intelligence system. It disguises trends and can severely harm the company’s early warning system.
4. Are “early shipments” acceptable if the customer authorizes the shipments? (Yes.) What if the authorization is only verbal? (Still acceptable, although this clearly provides an opportunity for abuses.) Can revenue be declared if the goods are stored in a truck or at an FFI warehouse? (Probably not, unless title has passed to the customer. Here the auditors seem to have concluded that title has passed.) Are the terms so liberal that the shipments should essentially be considered to be on consignment? If so, they are not sales.
5. Shipping unordered items should not generate revenues because of the lack of proper authorizations from the customers. But some transgressions were probably covered up by “making the sales stick.”
6. Unanimous agreement as to whether certain actions are acceptable or unacceptable does not exist. Judgments vary significantly with experience, across roles, across cultures, and more generally, just across people.
7. Some people believe that if managing income upward affects compensation, it should be considered theft.
8. Is it acceptable to manage earnings down (i.e., be ultraconservative) than to manage them up? (Probably not.)
9. Why would auditors accept the manipulations of reserves? Possibly because:
a. They would probably not be aware that FFI personnel manipulated the analyses to yield the answers they wanted. Probably the justification was credible. Judgments about reserves require estimates of the future, and there is a range of “acceptable” answers.
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructor’s Manual
b. Auditors judge materiality at the corporate level. Auditors might neglect to investigate items that are material at the division level unless there is a possibility that if one division is doing something, other divisions might be doing something similar.
10. Capitalizing the cost of spare parts is improper, fraudulent accounting.
11. With tax accounting, most people are comfortable with the idea that taxable income should be minimized through all legal means. For financial reporting, is it acceptable to maximize income through all legal means?
12. As a division manager, what should you do if you think the accounting rules (e.g., requiring the expensing of R&D investments) are wrong?
13. How should a CEO define to middle management what is an appropriate “management” of profit and sales figures? Don’t do anything that compromises the long-term interests of the corporation? Don’t hurt customers? Don’t distort the fundamental trends in long-term profitability?
B. Assignment Question 2
Joe Jellison, FFI’s CFO, must take some strong actions now that the gameplaying has been discovered. He should immediately inform the authors and the audit committee of the company’s board of directors of the problems. Company finance staff and the auditors will have to investigate the problems in the Cookie Division to determine what adjusting journal entries should be made. They should also investigate whether similar problems were occurring in the other FFI divisions. Fixing the problems will probably require public disclosures of the problems and restatements of prior period financial statements. These are serious problems. Certainly some members of management, certainly including most of the Cookie Division managers, and possibly also Joe Jellison himself, should lose their jobs. Should the Drink Division managers, and possibly even Sean Wright, suffer a similar fate?
More broadly, someone, perhaps Sean (or his replacement) must take steps to re-establish supplier, customer, creditor, employee, and investor confidence in the company. It is probably time to introduce an internal audit function to FFI. Accounting policies need to be written/clarified/reconsidered. The external auditors probably should be replaced, and the new auditors’ audit scope needs to be expanded. The board of directors needs to become more diligent. None of these improvements is sufficient by itself.
As students present their suggestions, it is useful to have them consider the costs of their recommendations. FFI was a small, very responsive, entrepreneurial company. Some of the student recommendations, such as for more extensive policies and procedures, will change the nature of doing business in this firm. The students should be made to consider these costs. They will probably conclude that companies like FFI are forced to rely, to a considerable extent, on ethical, professional managers.
C. Assignment Question 3
Clearly the problems should have surfaced earlier. There are multiple failures. Identifying these failures will help the students think about what can be done so that FFI does not face these problems in the future.
One failure is on the part of the external auditors. Their audit plan seems to have been insufficient to detect the problems. FFI is a public company. Even if the game-playing was not discovered directly, the internal control weaknesses should have been identified in the Sarbanes–Oxley Section 404 audit.
The FFI division controllers failed to fulfill their fiduciary obligations. Their management service role seems to have been dominated. But while division managers have the responsibility to bring deceptive practices to light, doing so often costs them their jobs.
Another problem is that FFI does not have an internal audit function. Internal auditors with the right audit plan would detect these problems. In the absence of an in-house internal audit function, FFI should have either outsourced the internal audit function, either to a specialist consulting company or another auditing firm, or otherwise compensated by conducting controller reviews of the operations in the divisions.
The audit committee of the board of directors failed in its oversight role. While the committee members probably could not have detected the problems themselves, they probably should have been aware of the pressures being put on the divisions, which raise game-playing risks, and insisted that some kind of division-level audit procedures or reviews be conducted. Someone on the board needs to understand why this audit committee failure occurred. Does the committee not have people with the right expertise? Was the committee not getting the right information? Did the committee not meet often or long enough to consider such issues?
Near the end of class, it is time to ask students what should be done. All of the solutions (e.g., hire internal auditors) have costs, and the discussion should be pushed far enough so that students see that there is no panacea, and the judgments about benefits and costs are difficult. If a student suggests that the company needs a Code of Ethics, ask how the code should be worded, and enforced. Students should see that some risk of manipulative behaviors will always exist in decentralized organizations, particularly, because it is not cost effective to reduce the cost to zero.
Pedagogy
On the face of it, this is not a difficult case, and it is one that students find inherently interesting to discuss. Thus it lends itself well to an unstructured teaching style.
Addressing the issues effectively is not easy, though. Indeed, the prevalence of game-playing activities suggests that most companies are unable to solve these types of problems.
In closing, instructors can make the following points:
This case raises a number of issues about proper financial reporting and effective corporate governance. The discussion process of this case provides the greatest pedagogical benefits, and I do not think it is necessary (and perhaps not even desirable) for the instructor to provide a neat summary. But here are some general observations that might be made:
1. Research has shown that the types of game-playing taking place in the Drink Division, particularly, are quite common. It is a rare organization that does not encounter at least some game-playing activities. The accounting numbers are not as precise as many people believe them to be.
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructor’s Manual
2. Most companies do not have fraudulent financial reporting problems as serious as those faced in the Cookie Division of FFI, but fraudulent reporting is a very visible problem that has attracted the attention of many people, including lawmakers and regulators.
3. Most people who get caught up in frauds are not bad people. They get caught up in the demands of the situation and/or temptations provided by control weaknesses. How do they convince themselves that their manipulative actions are acceptable?
a. They don’t even think about it. b. They think about self-preservation.
c. Rationalization: They feel they are doing what is best for the corporation.
d. They use the materiality argument—a little is OK, particularly where gray judgment areas are involved.
4. Multiple forms of controls are necessary to reduce the likelihood of deceptive financial reporting. However, each form of control has costs that should not be ignored. Adding controls should only be done after making judgments about costs and benefits. Because controls are costly, it is not possible to entirely eliminate all the various forms of game- playing.
This note was prepared by Professors Kenneth A. Merchant (University of Southern California) and Wim A. Van der Stede (London School of Economics) for the sole purpose of aiding classroom instructors in the use of the Diagnostic Products Corporation case. It provides analysis and questions that are intended to present alternative approaches to deepening students' comprehension of business issues and energizing classroom discussion.
Copyright 2007 by Kenneth A. Merchant and Wim A. Van der Stede. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means without permission.