Question

Grainiacs, Inc. is a diversified commodity merchandising company located in the upper mid-west with fiscal operations conducted on a calendar-year basis. The company primarily buys and sells corn and soybeans and operates multiple storage facilities in several states. Each storage facility is individually registered as a Licensed Federal Warehouse with the US Department of Agriculture. This licensing allows each facility to legally sell all or a portion of its physical grain inventory for cash, effectively shifting ownership of those particular stocks to the purchasing company while maintaining physical control of the assets (hence becoming consigned goods belonging to the purchaser).

Each sale is consummated at arms-length. That is, the purchaser transfers cash to Grainiacs equal to the value of the grain purchased and Grainiacs in-turn transfers to the purchaser a Federal Warehouse Receipt (a federally issued negotiable instrument representing ownership of the inventory). At this point, Grainiacs will record this transaction as a sale of the inventory and will no longer formally recognize the inventory on its financial statements. However, Grainiacs is required by law to maintain a report showing owned and non-owned inventory located at the facility.

In addition, the facility cannot allow total physical stocks to fall below the amount owned by the purchaser until it is shipped to the purchaser. Once the purchaser receives all the grain, the Warehouse Receipt is canceled and returned to Grainiacs. The entire transaction is supported by a formal written sales/purchase contract outlining all the specifics of the trade including quality and volume amounts and pricing conditions.

Bubba Bean is Grainiacs’ senior executive responsible for storage facility operations. At the beginning of the year, Bean was assigned the task of reducing the carrying value of inventory by 20%. As an incentive, completion of this task was tied to a performance bonus of 15% of Bean’s annual salary (a bonus amounting to over $35,000). Therefore, completing this task and meeting the goal would prove to be very lucrative to Bean. As of the middle of December, the goal had not been achieved, falling short by around $60 Million.

Realizing that the goal might not be realized which would result in no bonus, Bean devised a plan to solve his problem. Bean entered into a verbal agreement with another grain merchandiser stipulating that on December 30th, Grainiacs would sell at cost $70 Million of existing inventory (located at several locations) for cash and issue Federal Warehouse Receipts (one from each facility affected), all supported by binding written contracts in accordance with legal requirements. This would effectively reduce the inventory on Grainiacs’ December 31st Balance Sheet to the desired goal (although the inventory would physically remain in place), and allow Bean to earn the bonus. Then, on January 2nd, Grainiacs would repurchase the inventory at the original selling price plus a premium equal to 1% of the original selling price ($700,000). Once the repurchase was executed, the issued Federal Warehouse Receipts would be canceled and the inventory would be reinstated to Grainiacs’ financial statements at the new, higher value.

Approval of grain contracts was stratified according to the size of the contract. Contracts of $1 million or less could be approved at the local level. Contracts between $1 million and $5 million had to be approved at the next level on the organizational chart. Bean’s contract went to the fourth level due to the size of the transaction and Bean himself was responsible for approving contracts at this level. Although several of Bean’s subordinates questioned the validity of the contract, Bean told them that “we can’t do this” was not a justification for canceling the contract and the transaction was completed.

Bean’s transaction came under scrutiny during a routine internal audit, and top management was notified.

Required:

Analyze Bean’s plan of action, discuss the underlying intent. Discuss any ethical issues present.

In particular, will the transactions be recorded in accordance with GAAP? Does the transaction have economic substance?

How, when, and in what amounts would revenues and expenses be recorded?

Can the inventory be recorded at the new price that is 1% higher? If not, how should the 1% premium be treated?

Assume you are the CEO of Grainiacs and Mr. Bean is your direct report. How would you handle this case?

Assume you are a CPA employed as a consultant, and your become aware of the plan before it is set I motion. What should you do? What would you do if you find out after the plan has been initiated?

Answer 1

a) Mr. Bean was promised a 15% bonus on his annual salary which amounts to 35,000 if he could achieve the goal of reducing the carrying value of the inventory by 20% as of December 31st . In the middle of December, he realized that he was lacking behind by 60 millions to achieve the goal of reducing the inventory by 20% and might not get the incentive. With an intent to show that he achieved the goal and deceive the management, he made a verbal agrrement with a grain merchandiser to sell the merchandiser a 70 million worth of inventory on December 30 and repurchase it back with a premium of 1%on January 2. In this way he would get rid of 60 milions shortage to attain his goal and earn the 15% bonus from the management.

Mr. Bean stipulating the sale and repurchasing it back with an intent to misinterpret the carrying value of inventory is ethically wrong and considered as fraud. He deceive the management and users of the financial information of the company for his financial benefit.

b) No, the transaction will not be recorded in accordance with GAAP. According to GAAP, A sale transaction is completed when physical goods are transferred from the seller to the buyer with excahnge of ownership. It means the goods must delivered to the buyer whether it is FOB shipping point or FOB destination. The transactions never occurred because the inventory did not move from the warehouses. There was no economic subatance between the merchandisers because Mr. Bean sold those inventory with intention to repurchase it after few days to decrease value of inventory and even add back an additional value of $700,000 to deceive the management and the user of the financial information.

c) When the inventory was delivered to the buyer considerng the delivery term of FOB shipping point or destination, th sale revenue should be recorded at 70 millions. At the time of repurchase, the inventory ahould be received by Grainaics, inc. and recorded at the same amount without any premium.