53. Mary Milken is the CFO of the Rbeck Company in Miami, Florida. The company i

Question

53. Mary Milken is the CFO of the Rbeck Company in Miami, Florida. The company is a closely held custom yacht builder with about 200 technical workers (engineers, marine architects, mechanics, boat workers, and so on), and 12 employees in its main office staff. Her primary job is to prepare the financial statements with the assistance of two full-time accountants. She normally follows generally accepted accounting principles, but she sometimes ignores them when she thinks they do not lead to what she considers best practices for the small number of her company’s shareholders. In the previous decade, the company was owned by three sisters, each of whom served on the board of directors. One of the three, Vanessa Rbeck, served as the CEO during that period. The other two have always deferred to her with respect to her operational management decisions. Only a month ago, however, Vanessa’s sisters were killed when their private plane crashed en route to the Bahamas, which they frequently visited on weekends for relax-ation. Upon their death, all of their shares in the Rbeck company transferred to a single trustee in one of the large South Florida banks. Each sister had held her shares in revo-cable living trusts with the same bank named as successor trustee. As soon as the funerals were over, Mary and Vanessa met with the trustee, Annie Crusher. The meeting did not go well. Annie had grown up working in a family-owned retail boat business, and she thought her knowledge of the industry transferred to the yacht-building business. She began asking Vanessa a rapid succession of unfriendly questions in an adversarial tone of voice. Her questions strongly implied that a yacht-building business did not belong in South Florida but offshore where labor is cheaper. After the meeting, both Mary and Vanessa became afraid that Annie would do some-thing crazy like fire them both or liquidate the business. For the previous five years, Rbeck’s stock had sold for a steady $12 per share, with$8 per share in dividends. Vanessa received a good salary, but she depended on the dividends to send her children to private schools and to pay the large mortgage on her waterfront home in South Beach. She immediately realized that she was now at Annie’s mercy; she could easily cut off Vanessa’s dividends, lower her salary, or put her out of work. To make things worse, Mary was almost finished with the most recent annual report, and it appeared that earnings were down for the first time ever. Her preliminary calcu-lations showed earnings per share somewhere near $8. The problem with earnings had been caused by large bad debts from three clients who had been arrested for drug trafficking. Rbeck had entirely financed luxury yachts for the three clients because of their excellent credit history and prominence in the busi-ness community. However, the federal government seized all of the clients’ assets, leaving nothing for Rbeck but the three half-built yachts. After thinking things over, Vanessa asked Mary to find a way to avoid having to report lower earnings because of her concern as to how Annie might respond to the decline in earnings. Mary considered various options: • Increase the estimated percentage of completion on all yachts in work-in-process inven-tory by 15 percent. This would wipe out most of the loss. Work in process estimates have always been very conservative anyway. • Recognize revenue on the three yachts in default. It would be very difficult to sell them at a good price, but she could always argue that they could be sold if she could 438 Part III Occupational and Organizational Fraudkeep a straight face. The best strategy would be to find new buyers for them, but that could take a couple of years. • Switch to mark-to-market accounting for some of the yachts in progress so the com-pany could recognize all of the profit when contracts with other clients are signed.

a. Is any option that Mary is considering acceptable under generally accepted account-ing principles? Why or why not?

b. Do any of the options being considered by Mary constitute financial statements fraud?

c. How would you handle the entire situation if you were in Mary’s shoes?

Explanation / Answer

Answer:a Yes, the option three that Mary is considering is acceptable under generally accepted accounting principles. The reason why option three is acceptable under GAAP will be discussedas follows.

Mark-to-market Accounting Complying with GAAP:

Mark-to-market accounting, also called fair value accounting. Statement of Financial Accounting Standards (SFAS) 157 defines fair value as “the price that would be received to sellan asset or paid to transfer a liability in an orderly transaction between market participants at themeasurement date” (Power, 2010, p.199). That is, mark-to-market accounting is the practice ofaccounting that values certain assets and liabilities at their current market value. Mark-to-marketaccounting has been a part of the generally accepted accounting principles (GAAP) since theearly 1990s, and has been used increasing since then (Campbell, Owens-Jackson, & Robinson,2008). The Financial Accounting Standards Board (FASB) released SFAS No.157, Fair Value Measurements, which provides significantly more comprehensive guidance to assist companiesin estimating fair values. SFAS 157 contains essentially all of the current GAAP guidance regarding establishing a framework for fair value measurement, making the definitions of fairvalue, and expanding disclosures about fair value measurements (Trussel & Rose, 2009). Inaddition, this standard was established to increase comparability and improve the relevance and reliability of fair value measures (Campbell, Owens-Jackson, & Robinson, 2008).

The Reason of Using Mark-to-market Accounting:

In option three, company switches to mark-to-market accounting for some of the yachts in progress so the company could recognize all of the profit when contracts with other clients aresigned. Since fair value always is higher than original price paid or received, this action willimprove the company’s revenue and thus could recognize the profit when contracts with other clients are signed. As business environments are changing rapidly and become increasinglyvolatile, the financial statements of company should portray the underlying economic reality ofthe company rather than the summary of past transactions. Mark-to-market financial reportingmay be less reliable due to the subjectivity of certain measurements, but it could provide muchmore relevant and meaningful information about financial assets and liabilities to the users, ascompared to values based only on their historical cost. For example, financial disclosures thatuse fair value provide investors with insight into prevailing market values. “Investors generallysupport measurements at fair value as providing the most transparent financial reporting of aninvestment, thereby facilitating better investment decision making and more efficient capital allocation among firms” (Elifoglu, Fitzsimons, & Ramanujam, 2009, p.44). However, themarket-to-market accounting better presents the economic reality of transactions and, therefore,tends to provide more useful and relevant information than does historical cost financial reporting.

Answer:b Yes, the option one and two being considered by Mary constitute financial statements fraud. The reason why the two options constitute financial statements fraud will be addressed inthe following items.

1.Definition of financial statement fraud

2.Undisclosed material intentional deviation from GAAP

3.Agreeing with the three fraud elements

Definition of Financial Statement Fraud: Before discussing this case, we need to know what financial statement fraud is.According Hopwood, Leiner, and Young (2008), financial statement fraud (FSF) is defined as“any undisclosed intentional or grossly negligent violation of generally accepted accountingprinciples (GAAP) that materially affects the information in any financial statement” (P.265).This definitiion includes three fruad elements: “(a) intentional misrepresentaion of fact by aperpetrator, (b) reliance on the misrepsentation b a victim, and (c) injury to the victim resultingfrom reliance on the misrepresentation” (Hopwood, Leiner, & Young, 2008, p.265). In otherwords, financial statement fraud is a materially false statement, which is knowingly made, reliedupon by the victim, and which givies rise to damages.

Undisclosed Materal Intentional Deviation from GAAP.

Option one.Both of the two options involve improper revenue recognition that will leadthe company overstates revenues and won’t conform to GAAP. In option one, the companyincreases the estimated percentage of completion on all yachts in the work-in-process inventoryby 15 percent in order to wipe out most of the loss. Under the percentage-of-completion method,revenue is considered to be earned according to the estimated percentage of the projectscompleted. In this case, the company overstates the percentage that projects are completed andthus overstates revenue. This overstating revenue is an undisclosed material intentional deviationfrom GAAP. Accounting for long-term contractual work by percentage-of-completion method isan exception to the basic realization principle. This exception is based on that the ultimaterevenues are available and the consensus that a better measure of periodic income results the matching principle in accounting, where revenues and expenses are matched in the applicableaccounting period (Hartford Construction Accountants CPA, 2010). The percentage-of-completion method applies only if management can reliably estimate progress toward completion of a contract. When management cannot provide reasonble estimates, GAAP calls forthe completed-contract method, which requires the company to postpone recongintion of revenue until the contractual obligations have been met.Option two.

In option two, the company recognizes revenue on the three yachts in defaultbefore these yachts are sold. The premature recognition of revenue will lead the revenue to beoverstated and won’t comply with the revenue recognition principle under GAAP.

The three yachts in default cannot be recognized revenue through the percentage of completion methodbecause the following two conditions cannot be met: (a) there is a long-term legally enforceablecontract, and (b) it is possible to estimate the percentage of the project complete, revenues andcosts. The company should recognize revenue in the accounting period in which it is earned(Weygandt, Kimmel, & Kieso, 2008). That is, the company should adopt sales basis method tothe three yachts in default to recognize revenue. Under the sales basis method, revenue isrecognized at the point of sale, defined as the moment when the title of the goods or services istransferred to the buyer.

Two practical requirements exist for revenue recognition. The first is that revenue must be earned; the second is that the amount must be realized or realizable(Bukics, 2000). This sales basis involves an exchange transction between the seller and buyer.The sales price is an objective measure of the amount of revenue realized.

Agreeing with the Three Fraud Elements: “Any undisclosed material intentional deviation from GAAP automatically involves allthree fraud elements” (Hopwood, Leiner, & Young, 2008, P.265). The three fraud elements areaddressed as blew. First, the company intentionally misrepresents the fact. Financial statementfraud is the deliberate fraud committed by management that injures investors and creditors withmaterially misleading financial statements (Kerwin, 1995). Errors or omissions are not considered fraud. Error referes to an unintentional mis-statement in financial statements,including the omission of an amount or a disclosure. Fraud cannot be unintentional;consequently, fraud cannot be made by error. Second, victims such as present investors, potentialinvestors, creditors will rely on the misleading financial statements, because they believe thestatements comply with GAAP when in fact they do not. Fraudulent statements must be reliedupon. If a reasonable person would not rely upon statements made, they will not support a causeof action for fraud. Third, the misleading financial statements will injure victims because theyrely on the misrepresentation and therefore their decisions are affected by the misleadingfinancial statements. Fraud must give rise to damages. Generally, a victim cannot sue if he/she did not suffer damages.

Answer:c If I were in Mary’s shoes, I would refuse the CEO’s request, provided that the way themanagement takes to avoid reporting lower earnings constitutes financial statement fraud.Financial statement fraud is caused by a number of factors occurring at the same time, the most significant factor of which is the pressure on upper management to show earnings. In this case,Vanessa Rbeck, as a CEO, asked Mary Milken, as a CFO, to do things that they don’t think is right in their conscience.Mary is faced with a difficult dilemma. Mary should not conceal thetrue business performance by increasing the estimated percentage of completion or byrecognizing revenue on the three yachts in default in order to wipe out most of the large baddebts losses or improve the net income in the financial statements. The large bad debts fromthree clients who had been arrested for drug trafficking involve uncollectible accounts. However,they should be written off from the accounts receivable because the accounts receivable are actual uncollectible. Furthermore, this bad debts expense should be listed in the incomestatement and the accounts receivable having been deducted by the bad debts should be listed in.

On the other hand, Mary should adopt option three in which the company switches tomark-to-market accounting for some of the yachts in progress so the company could recognizeall the profit when contracts with other clients are signed. The reason why the company shouldchoose this option is that it is acceptable under GAAP and doesn’t constitute financial statementsfraud. If Vanessa doesn’t agree with the choice, Mary should think about leaving her job,because it challenges her integrity and she should not succumb to pressures that can potentiallydestroy her career.Mary should understand the responsibility of a CFO. A CFO is a corporateofficer responsible for financial planning, record-keeping, financial reporting to highermanagement, as well as managing the financial risks of the corporation (Connelly & Burrage,2009). Accurate and reliable reporting is the basis of corporate credibility today so the externalusers, such as investors and creditors, can rely on them for making financial decision. Corporatemanagement teams, including CEOs and CFOs, of course, are responsible for preventing fraudand for designing an effective internal control structure that enables them to detect and correctfraudulent reporting. From top executives to line employees, everyone should understand thatfinancial statement fraud is a crime that the company will prosecute. A CFO that heavily valueshis/her reputation should not engage accounting irregularities and dubious revenue recognitionpractices. Accounting abuses can tarnish and even ruin a CFO’s career. As a result, he/she shouldmake a career decision to go to another job to maintain credibility.

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