Question

It’s November 15, and Gary, brand manager for a major consumer products firm, is contemplating his year‐end bonus. It is becoming increasingly obvious that unless he takes action, he will not achieve his brand profitability target for the year. Gary’s eyes fall to the expense estimate for the new coupon “drop” slated for later in the month. His hand trembles slightly as he erases the 4 percent anticipated redemption rate on his estimate sheet and replaces the figure with 2 percent. Gary knows from experience that 2 percent is an unrealistically low figure, but he also knows that neither the firm’s independent nor internal auditors will seriously challenge the estimate. This way, Gary’s product profitability report will reflect the increased revenue associated with the coupon “drop” this year, but the entire redemption cost will not be expressed until next year.

“That should put me over,” he muses. A wry smile crosses his face. “If the auditors question the rate, I’ll give them a story about seasonality and shifting consumer patterns. They won’t know enough about marketing to question my story.” Eventually, of course, the real cost of the coupon drop will have to be expensed, and that will hurt next year’s profit figure. “But, that’s next year,” Gary reasons, “and I can always figure out a way to make it up. Besides, by the end of next quarter, I’ll be handling a bigger brand—if I can show a good profit this year.” A brief description of coupons and proper accounting for coupons might help us to interpret the situation just presented. Coupons are “cents‐off” privileges, such as $0.50 off when you buy a certain brand of yogurt. When a company offers coupons to consumers, it must estimate the redemption rate and record an expense and the corresponding liability. This is similar in concept to warranty expenses

.Required:

a. Discuss whether the situation described can happen to a company with a good control environment.

b. Describe any steps a company could take to prevent such abuse.

c. List those parties who might be harmed by this situation.

d. Do you consider this example to be management fraud or employee fraud? Describe how it fits the definition of your choice.

Answer 1

a.

This situation would not be likely to happen to a company with a good control environment. In a conservative control environment, management would not place so much emphasis on profitability, would not likely tie compensation to profitability and then give employees responsibility for preparing their own profitability reports, and would have likely provided for other controls (such as supervision and review of Gary’s figures).

b.

If the firm was going to compensate brand managers based on profitability of their brands, then those managers should not have responsibility for preparing their own profitability reports. Rather, an independent accounting function should be in place to account for Gary’s brands. In addition, independent reconciliations should be performed with specific emphasis on risky financial items such as coupon drops.

c.

The following parties are likely to be harmed as a result of Gary’s fraud:

• Investors and creditors who rely upon the fair presentation of the firm’s financial statements as a basis for business decisions
• Shareholders to whom the firms owes a stewardship obligation, especially as they are deceived with respect to the firm’s current financial status
• Fellow employees in the firm who will begin the next year with an inflated expense for the coupon drop (and whose compensation will be tied to financial performance)
• Fellow employees who share in Gary’s bonus pool, whose bonuses would have been larger had Gary’s figures been accurate

 

d.

This case describes management fraud, as it involves misstatement of financial records, which is typically perpetrated by managers who are attempting to realize benefits (such as increased compensation).