Detecting Accounting Fraud Analysis

and Ethics 1st Edition Jackson

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Chapter 6
Abracadabra

SOLUTIONS
Ethics at Work

a. Suggested response:
Noonan appears to see his initial failure to tell the full truth to the internal investigator’s
lawyers about a backdated severance package and about pharmacy rebates as his biggest
mistakes. He also wonders whether he should have left the company when he saw suspicious
and possibly illegal surcharges on medical prescriptions. It is important to note that Noonan
did not exercise his severance package from Rite Aid, and he was not personally involved in
the incorrect recording of the pharmacy vendor rebates. He was, however, not forthcoming
about these issues. Eventually, he told the government what he knew and pleaded guilty to a
felony misprision charge.
In addition, Noonan also appears to wonder whether he should have seen some of the
red flags more clearly and been proactive, before the situation at Rite Aid became a full-
blown ethical crisis. Although he was not actively involved in the fraud, he now asks himself
whether he should have acted differently at the time.

b. Suggested response:
There was a failure in the corporate governance structure at Rite Aid that included the
following:
• There was no communication or discussion of ethics at Rite Aid before the
crisis.
• Rite Aid’s Code of Conduct and its ethics hotline were ineffective and existed
merely for show.
• There were no positive leadership role models in the company.
• The gatekeepers had no effect.
• The company stressed short-term profit rather than long-term stability.

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DETECTING ACCOUNTING FRAUD

In addition, the seven signs of ethical collapse, as described by Marianne Jennings, were
in evidence:
o Pressure to achieve numbers.
o Pervasive fear and silence.
o Larger-than-life CEO.
o Weak board.
o Conflicts of interest.
o Innovation like no other.
o Goodness “there” atones for wrongdoing “here”.

ASSIGNMENTS
True/False Questions:
1. True
2. True
3. False
4. True
5. False
6. True
7. True
8. False
9. False
10. True

Fill-in-the-Blank Questions:
11. override
12. removed
13. amortization or depreciation
14. rebates
15. shrinkage
16. increases
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17. Securities
18. quarterly
19. sold
20. impairments
Multiple-Choice Questions:
21. a
Explanation: There was no allegation against Livent regarding improper use of reserves.
• Answers b, c, and d all describe methods identified by the SEC Enforcement Action
against Livent.
22. c
Explanation: Spreading the depreciation expense over a longer period of time decreases the
stated depreciation amount in the current period and defers it to a later period.
• Answer a is incorrect because improper capitalization of expenses refers to the
misallocation an expense as an asset, not to its amortization.
• Answer b is incorrect because removal of invoices from the records does not refer to
depreciation.
• Answer d is incorrect because slow depreciation generally refers to fixed assets, not to
inventory valuation.
23. d
Explanation: All the methods described in a, b, and c were the subject of the SEC’s
Enforcement Action against Rite Aid.

24. c
Explanation: An increase in accounts payable would likely result from the recognition of
expenses, not from understating expenses.
• Answer a is incorrect because an increase in inventory does decrease cost of goods sold.
• Answer b is incorrect because a sudden increase in gross margin could be due to an
understatement of cost of goods sold.

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DETECTING ACCOUNTING FRAUD

• Answer d is incorrect because a decrease in the reserve for obsolescence of inventory

does decrease cost of goods sold.
25. a
Explanation: The SEC did not identify Rite Aid’s accounting for bad debts as a problematic
area of its financial reporting.
• Answers a, c, and d all describe issues identified by the SEC in its Enforcement Action
against Rite Aid.
26. c
Explanation: The SEC’s Enforcement Action alleged that Allegheny should have increased
its reserves for doubtful debts by a significant amount.
• Answers a, b, and d are incorrect because there were no allegations that Allegheny had
used any of those methods to understate its expenses.
27. c
Explanation: The reserve decreases net accounts receivable. Therefore, as the net amount
decreases, it does not indicate that the reserve was understated.
• Both answers a and b are consistent with the reserve for bad debts decreasing and
therefore are signals that the reserve is understated. The question asks for items that
are NOT signals that the reserve is understated.
28. a
Explanation: Lockheed failed to record the impairment of development costs for its TriStar
jet.
• Answers b, c, and d are incorrect because there were no allegations that Lockheed had
used any of those methods of improper accounting.
29. c
Explanation: Brace Company must write-down the asset by the full amount of $4 million in
the quarterly financial statements in the quarter that it discovers that the asset is impaired.
30. b
Explanation: The overstatement of beginning inventory will increase the cost of goods sold,
which will decrease the gross margin amount.

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• Answer a is incorrect because beginning inventory is added to purchases or cost of goods

manufactured in the calculation of cost of goods sold.
• Answer c is incorrect because cost of goods sold would be overstated and the gross
margin would be understated.
• Answer d is incorrect because answer b is correct.
For Discussion:
31. Suggested response:
Lockheed incurred its development costs in connection with the development of its TriStar
jet on the expectation that once the jet was fully designed and built, the company would earn
revenue from this developed asset over many years of sales. It intended to write off the
development costs as the planes were sold. Lockheed, of course, initially believed that the
planes would be sold at a profit. Once it became clear that the aircraft were going to make a
loss, it also became clear that the development-cost asset was impaired and that it should
have been written off at that time.
Livent’s preproduction costs related to shows and were required to be amortized over
the expected life of the show to which they related. Once a show ended, any remaining
preproduction cost needed to be expensed immediately. However, Livent transferred the
preproduction costs for the shows that had ended to other shows that were still running, in
order to defer the amortization of the preproduction cost.
In Lockheed’s case, from 1975 to 1981, the development costs related to aircraft that
were still being sold, but the development-cost asset was impaired because the aircraft that
were being sold were not producing a profit and it was possible that the program would end
without recovering the development costs. In Livent’s case, the shows to which the
preproduction costs were related had actually ended.

32. Suggested response:

In the cases of Lockheed and Livent, the capitalized costs were costs that were incurred on
their own companies’ behalf with the intention of earning future revenue from their own end-
user customers.

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DETECTING ACCOUNTING FRAUD

“Emerging Issues Task Force [EITF], Issue No. 99-5,” addressed preproduction costs
that are incurred by manufacturers who enter into long-term contracts to supply users who
are not end-user customers. In such a case, EITF 99-5 stipulated that the preproduction costs
incurred in long-term supply contracts can only be capitalized if the other party agrees to
reimburse costs with a written guarantee. For more details, EITF 99-5 can be accessed at
www.fasb.org.
With Livent and Lockheed, there was no third party to reimburse them for the
development costs. While Livent’s and Lockheed’s customers would pay for a product or a
service, there was no intent on the part of their customers to reimburse them for any of their
expenses. Livent and Lockheed did not need a specific guarantee from any party to capitalize
preproduction costs, because they were not going to be repaid for expenses by any party.

Short-Answer Questions:
33. According to the SEC, Livent transferred costs from one show currently running to another
show that had not yet opened or would run for longer. This reduced the amortization charge
in current periods and delayed them to later periods. The effect in the current period was to
understate expenses and overstate earnings by shifting expenses to later periods.
Rite Aid was entitled to receive rebates on amounts owing to certain vendors
contingent upon the sale of the vendor’s products. Rite Aid applied the rebates to purchases
of goods that had not yet been sold. This understated its cost of goods sold expense in the
current period. Therefore, it understated expenses and overstated earnings in the period of the
improper recognition of the rebates.
In Livent’s case, the deferred amortization costs in one period increased these costs in
later periods. In Rite Aid’s case, the early recognition of rebates decreased cost of goods sold
in the period before the sale of the goods, but increased the cost of goods sold in the later
period of the actual sale.

34. Rite Aid conducted periodic physical inventory counts at its stores. To the extent that the
counts revealed less inventory on hand than reflected in its records, Rite Aid wrote-down the
inventory via a “shrink expense.” When Rite Aid failed to record the shrink expense, it
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caused its ending inventory values to be overstated. This, in turn, understated its cost of
goods sold expense, which overstated its reported income.

35. Sudden changes in gross margin percentages should be accompanied by simple, logical
explanations such as the adoption of a new manufacturing technique, or a decrease in raw
material cost, or a change in selling price. For most publicly traded companies, a decrease in
the price of the major raw material that it uses or an increase in its selling price would be
transparent and often newsworthy events. A sudden, unexplained increase in gross margin
percentage is suspicious and could indicate that cost of goods sold is understated.

36. According to the SEC, AHERF should have increased its reserve for bad debts by $40
million in October 1996. Therefore, its balance sheet overstated accounts receivable by $40
million. The other side of the entry would have been a debit to its bad debt expense.
However, the SEC alleged that AHERF did not fully recognize this expense in its Q3 1996
financial statements and instead decided to write-off the uncollectible accounts receivable in
quarterly installments. This understated its expenses, overstated its reported income, and
overstated its assets.

37. Lockheed had a policy of capitalizing the TriStar’s development costs with the intention of
writing them off as the planes were sold. An average development cost per airplane was
calculated by dividing estimated total development costs by the total estimated number of
airplanes it would sell. As each plane was sold, this average development cost was expensed
and a corresponding amount was written off the development-cost asset.
However, once it became clear that future sales were not going to be sufficient to
recover their developments costs and that the planes were going to be sold at a loss, the
remaining development costs should have been written off immediately. Lockheed wrote-off
the development costs in installments. This failure to recognize the impairment loss
immediately understated its expenses and overstated its reported income. It must be noted
that there was no record of intentional misreporting in the Lockheed case.

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DETECTING ACCOUNTING FRAUD

Exercises:
38 (a).
All of the remaining $225,000 ($300,000 original costs less accumulated depreciation of
$75,000) must be written off in the financial statements in Q4 of 2012. LivePlay must
recognize an amortization expense of $225,000 in its income statement in Q4 of 2012.

38 (b).
If LivePlay transfers the production costs to the Dogs production on October 1, 2012, it will
estimate that the asset has a future life of two years and three months at the date of transfer. It
will amortize the asset by the amount of $25,000 per quarter. Therefore, in Q4 of 2012,
LivePlay will recognize an amortization expense of $25,000 if it transfers the asset, instead
of $225,000 if it admits that the scenery’s useful life ended on December 31, 2012. As a
result, the transfer causes LivePlay to understate its expense/loss by $200,000 in the Q4
2012, income statement.

39 (a).
[Note: Formulae are given in the RiteAid section, under “Signals of the Fictitious Reporting
Schemes of Reducing Cost of Goods Sold.]

Q2 Q3 Q4
Average Inventory: ($20,000+$30,000) ($30,000+$40,000) ($40,000+$50,000)
2 2 2

= $25,000 $35,000 $45,000

COGS: $62,000 $60,000 $60,000
INVENTORY
TURNOVER RATIO
PER QUARTER: 2.48 1.71 1.33

39 (b).
90 90 90

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2.48 1.71 1.33

DAYS SALES
IN INVENTORY: 36.23 days 52.63 days 67.67 days

For Inventory Turnover

# of days in period
(approximated at 30 days per month): 90 90 90

40.
Development costs: (10 x $1 million) = $ 100,000
100
Other COGS: (10 x $2 million) = $ 20,000,000
$ 20,100,000
The company must recognize COGS of $20,100,000 for the year.
CASE STUDY
NAVISTAR INTERNATIONAL CORPORATION
a.
Year Ended Year Ended
2002 2003
(in millions) (in millions)

Product Warranty Accrual $ 185 $ 173

Sales of Manufactured $ 6,493 $ 7,033
Products

Product Warranty as a 2.85% 2.46%

Percentage of Sales

Comment: Navistar’s warranty accrual amount actually decreased, while sales increased.
As a percentage, the warranty liability decreased from 2.85% of sales to 2.46% of sales.
One of the signals of understating expenses and current liabilities is a decrease in current
liabilities as a percentage of sales. This signal also states that if the makeup of current
liabilities is given in a note, one should check whether the accruals for the individual

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itemized current liabilities decrease as a percentage of sales compared to previous

periods. Warranty payments, of course, follow the period in which the sales are made,
because it takes time before customers discover problems that cause warranty claims to
be filed. Navistar’s actual amount paid for warranty expenses in 2003 was $189 million.
This followed 2002 in which sales were only $6,493 million. It is strange that, at the end
of 2003, a year in which sales were $7,033 million, Navistar estimated that it would incur
a decrease in warranty payments relating to these sales in the following year. Although
this understatement of Navistar’s warranty reserve was not a very material amount,
compared to its total expenses and total sales, it is important to note that it was the subject
of an SEC enforcement action.
In order to find a signal for a relatively small understatement of expense such as
this, the individual accrual for warranty liability had to be compared to total sales, as
opposed to comparing current liabilities as a whole to total sales. Although the amount is
not very material to the financial statements, it raises concern about the quality of
earnings. It is an indication that the company may be aggressive in maximizing reported
income or in minimizing its reported loss. It is a signal as to the quality of earnings that
the company is reporting. [Note: since the “product liability and warranty” accrual
amount is larger than the “product warranty” accrual amount, it seems reasonable to
assume that the product warranty accrual is a subsection of the “product liability and
warranty” accrual.]

b (1).
Navistar’s note to the financial statements on Restructuring and other Non-Recurring
Charges discusses its write-off of deferred preproduction costs. This is an example of
Signal # 3 (for Livent’s Scheme # 3) of understating expenses via capitalization of
expenses. This signal states that one should be on the alert for aggressive capitalization of
costs when a company writes off costs that were formerly capitalized. Such a write-off
shows that the company has been wrong in the past about the ability of a current cost to
hold value in future periods.
b (2).

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This should alert the reader to the possibility of aggressive minimization of reported costs
because the question of whether or not to capitalize preproduction expenses is very
subjective. As a result, this is a very tempting area of accounting for a company that is
under pressure to understate its reported expenses. The expense is often incurred years
before it will either be reimbursed or before revenue will be earned as a result of the
transaction that caused the expense. This time lag increases the risk that the actual
reimbursement of the expense may never occur, or that future revenue may never be
earned. The future is always uncertain, and the greater the distance between the time that
an expense is incurred and the future receipt of the reimbursement or the resulting
revenue, the greater the likelihood that future payment will not be received and that any
capitalized cost will have to be written off. For this reason, if preproduction costs are
being incurred for a third party, EITF 99-5, required that such preproduction expenses
“could be deferred only if there existed an objectively verified and measured contractual
guarantee or reimbursement” (AAER 3165, par. 39). According to the SEC, Navistar
“never received from the Automaker a specific, written guarantee of reimbursement”
(AAER 3165, par. 41). The SEC further concluded, “These deferred start-up costs were
not in compliance with GAAP” (AAER 3165, par. 43). The write-off of previously
capitalized preproduction costs shows that the company has been wrong previously in
capitalizing costs in expectation of the receipt of future reimbursement or revenue. This
should act as an alert that the company may be aggressive in minimizing its reported
expenses.

c (1).
Both Rite Aid and Navistar recognized vendor rebates in their income statements
before they were entitled to recognize them. In Rite Aid’s case, the vendor rebates
related to purchases of inventory that had not yet been sold. In Navistar’s case, the
rebates mainly related to payments that they received, or anticipated receiving in future
periods, from the vendors as a result of Navistar awarding new business to the vendors
in the future. In both cases, the rebates that were recognized actually applied to future
periods.

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c (2).
Rite Aid accounted for the rebates on purchases of inventory that had not yet been sold
by decreasing cost of goods sold and accounts payable. Navistar accounted for much of
the rebates that were contingent upon placing future purchase orders with the vendors
by increasing receivables and income in the period of the signing of the rebate letters.
According to the SEC, “While these [Navistar’s] rebates and receivables took different
forms … all were improperly booked as income in their entirety upfront” (AAER 3165,
par. 18).
c (3).
Journal Entry for Rite Aid:
Debit accounts payable: $ xxx
Credit cost of goods sold: $ xxx
[Note: Part of Rite-Aid’s amount included in the credit to cost of goods sold was for
rebates on inventory that had been purchased, but would be sold only in future periods.]

Journal Entry for Navistar:

Debit accounts receivable or cash: $ xxx
Credit other income: $ xxx

[Note: Some of the amounts allocated to Navistar’s income included amounts that would be
repaid in future periods to Navistar if certain conditions were fulfilled. Sometimes, the amounts
had been repaid to Navistar, but Navistar agreed to refund the amount if it did not fulfill its
obligations.]

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