Question

Various Types of Forensic and Non-forensic Audits

Case 2

Heather Lockard is the CFO of the Keel Company in Fort Lauderdale, Florida. The company is a privately-held manufacturer of custom recreational vehicles with about 175 workers (engineers, vehicle designers, mechanics, and so on), and nine employees in its main office. Heather’s primary responsibility is to prepare the financial statements. Two full-time accountants work for her. She follows GAAP in most cases, but she sometimes deviates from GAAP when she thinks it does not lead to what she considers to be the best financial results for the family members who own the company.

For many years, the company was owned by three cousins. All three cousins were on the board of directors. One of the three, Yvonne Keel, was the CEO during that period. The other two cousins were less involved with the company.

Three weeks ago, Yvonne’s cousins were killed in a car accident. Their wills specified that all of their shares in the Keel Company were to be transferred to a single trustee at a large regional bank. Each cousin had held her shares in a revocable living trust with the bank named as Successor Trustee.

Heather and Yvonne recently met with the trustee, Cathy Nelson. Cathy has many connections in the recreational vehicle business, and she wants to bring her experience to bear in managing the Keel Company. She feels that a custom recreational vehicle building business would be better off in Mexico where it is closer to the parts manufacturers. Heather and Yvonne are concerned that Cathy might take the company in a direction they don’t want it to go.

In recent years, Keel’s stock had been valued at about $15 per share and had paid $9 per share in dividends. Yvonne was paid a competitive salary, but she depended on the dividends to support a comfortable lifestyle. With this change in circumstances and with a new trustee in the mix, she felt she could no longer depend on her salary and dividends meeting her needs.

Now Heather was working on the current annual report, and the earnings had declined. Preliminary calculations showed earnings per share somewhere around $9. Earnings had declined because of defaulted contracts from the two large dealers who had gone bankrupt. Keel had completely financed the contracts for these dealers because of their previous excellent credit history. Now Keel was on the hook for a whole fleet of custom recreational vehicles without buyers.

Considering the issue of the drop in the earnings, Yvonne asked Heather to find a way to report stable earnings. She was concerned that Cathy might respond negatively to the decline in earnings and complicate the relationship. Heather considered various options:

Increase the estimated percentage of completion on all custom recreational vehicles in work-in-process inventory by 15 percent. This would erase most of the loss. She could justify this because she always felt that work-in-process estimates had been conservative.

Recognize revenue on the fleet of custom recreational vehicles in default. It would be difficult to sell them quickly at a good price, but she could argue that they could be sold. It would be best to find new buyers for them, but that could take well over a year.

Switch to mark-to-market accounting for some of the recreational vehicles in progress so the company could recognize all of the profit when contracts with other clients are signed.

1.Are any of the options that Heather is considering acceptable under generally accepted accounting principles? Why or why not?

2.Do any of the options being considered by Heather constitute financial statements fraud?

3. How would you handle the entire situation if you were in Heather’s position?

Answer 1

Q1. Are any of the options that Heather is considering acceptable under generally accepted accounting principles? Why or why not?

Solution

Situation: Company’s earning has dropped to $9 per dollar. Large fleet of custom recreational vehicles lying without any buyer.

Reason: Default of contracts from two large dealers.

Company is considering way to hide the losses and report stable income.

Option 1: Increase work in process inventory by 15%

Generally accepted accounting principles (GAAP) mandates that inventory reserves should be valued either as per its cost or market value. So technically value of the large fleet of completed vehicles should be equal to the cost expended to produce them. The company however is trying to hide these costs by classifying these vehicles as “work in process” and reporting their value to be less than what they are actually worth. This is unacceptable as per GAAP.

Option 2: Recognize revenue on the fleet in default, assuming they can be sold.

This is unacceptable as per GAAP since it is not in accordance with Revenue Recognition Requirement. Revenue recognition principle states that a revenue is recognized and reported in financial statements only after it has been earned or realized. Here it is clear that stipulated buyers have defaulted hence revenue hasn’t been realized. Company expects to find buyers and sell its goods in future, expected earnings for such an arrangement cannot be reported as revenue in current financial statements.

Question 2 Do any of the options being considered by Heather constitute financial statements fraud?

Solution

Trying to hide or under report company’s losses is a fraud. It paints a false picture of the company’s financial health and deceives different stakeholders. So, both the options Heather is considering constitute financial statement fraud.

Question 3 How would you handle the entire situation if you were in Heather’s position?

Solution

The case states that Heather adheres to GAAP in most cases but occasionally deviates to suit the interests of the owners of the company. While this bears fruits in the short term it can put the company, its owners as well as Heather in legal trouble. Therefore I would have chosen to strictly adhere to GAAP. In addition to this the case also reveals that the company has lost two of its big dealers. In such a scenario it would be good to take suggestions from Cathy and leverage her experience as well as her contacts from the industry. This will put the company back on growth trajectory.