Legality and Ethicality of Financial Reporting

ETH 376

Legality and Ethicality of Financial Reporting

Excello Telecommunication is a company that has historically been

successful. However, due to rising competition in their industry they

may not meet their earnings estimates. The failure to meet earnings

estimates can wreak havoc on an organization. Shareholders get

nervous, stock prices decrease, and analysts could give the company

negative press. On top of that, executives are worried about how the

failure to meet these estimates could impact their stock options and

bonuses. In order to meet expectations, there is a critical sale that is

taking place. However, the sale requires the goods to be delivered in

the subsequent accounting period, not the current period. In following

GAAP, the company cannot recognize revenue during the current

period. However, Terry Reed, the CFO, requires that the accounting

team figure out a way to book the sale during the current accounting

period. The accounting team is lead by Marty Fuller. We are going to

look at the legal and ethical ramifications of undertaking this route.

We will look not only at the moral consequence, but also at whether

or not the company is breaking the law.

Legal Issues and Applicable Laws

Excello Telecommunication must adhere to many laws and

regulations. Among them are Sarbanes-Oxley Act of 2002 (SOX),

Generally Accepted Accounting Principles (GAAP), and the AICPA

code of Conduct. These rules impact not only the financial reporting

mechanism of the company, but also the actions of key accounting

personnel. Because of this, the accounting team must search for the

best method that will legally maximize shareholder wealth. Although

earnings estimates could be met by using illegal accounting

treatment, it would be of little use as the company would lose value

once Wall Street got wind of the illegal activity.

Sarbanes-Oxley and Excello Telecommunications

The accounting scandals of 2001, namely Worldcom, Enron, and

Tyco, gave birth to the Sarbanes-Oxley legislation. This act,

spearheaded by Senator Paul Sarbanes and Representative Mark

Oxley, reshaped the role of corporate governance in America and

strengthened controls over financial reporting and executive

accountability. The consequences of violating SOX are severe – both

for the company and the executives involved.

Terry Reed, the CFO of the company, wants to post a sale of $1.2

million during 2010. The customer is Data Equipment Systems, and

they do not have the facilities to store the stock. In order to show the

sale as a 2010 sale there are several illegal things that could happen.

For example, Excello could document the deal prior to the date that

the actual transaction takes place. This action could violate several

key components of SOX, including Sections 302, 401, and 807.

Section 302 deals with corporate responsibility for fiscal reports.

Excello has a duty to release factual and accurate financial

statements. Section 401 deals with disclosures in periodic reports,

and section 807 covers the criminal penalties for executives who are

involved in corporate accounting fraud. Under that section, any

executive that signs statements that contain known material

misstatements could face hefty fines and incarceration for their

actions. Under section 302 CEOs and CFOs are held personally

accountable for the contents of fiscal reports. Gone are the days of

corporate plausible deniability. If you sign it, you’re responsible for it.

GAAP and Excello Telecommunications

Generally Accepted Accounting Principles, aka GAAP, is a body of

accounting principles that must be followed when preparing financial

reports. When Excello releases their statements, they must comply

with GAAP.

The accounting department must comply with GAAP when they

account for the $1.2 million sale. Key components of GAAP that

directly apply to this case are the accrual basis, revenue recognition

rules, dependability, and regularity. Under the accrual basis of

accounting, revenues are recognize when earned and expenses are

matched to the revenues they generate. Most people are used to the

cash basis of accounting where revenues are recognized when cash

is received and expenses are recognized when cash is paid out.

Under the revenue recognition principle revenues should be

recognized during the accounting period in which the services were

rendered, or in the case of a manufacturer, when the title of the goods

changes hands from the seller to the buyer. The transaction currently

under discussion cannot be reported during the 2010 period because

the sale happened in 2011. Excello is still in possession of the goods

at year end, therefore the sale has not occurred.

Perhaps more importantly, the financial statements must be reliable

and consistent. Investors need to make informed decisions and need

accurate information to do so. In reporting the sale during 2010 the

statements would not be reliable for investors. Furthermore the

consistency principle states that accounting principles must be

applied the same way during all periods reported. Including this one

sale in 2010 would not make the financial statement of 2010

consistent with the reports of prior years.

AICPA Code of Professional Conduct and Excello

Telecommunications

CPAs who are members of the AICPA area also governed by the

AICPA Code of Professional Conduct, which takes into consideration

the needs of financial statement users. The goal of the AICPA is to

ensure that the general public’s interests are looked after and that

they remain safe and secure from misleading financial statements.

Excello’s accounting department must follow professional duties,

protect the public interest, and be honest in their financial reporting.

This will keep Excello in excellent ethical status and protect the best

interests of the public.

Ethics of the Events

Terry Reed wants to report the $1.2 million sale during 2010 so that

the end of the year profit will be higher, and therefore management

will get better bonuses. In addition, share prices would remain high

which would also serve the interest of various managers who have

stock options.

Reed wants to make the company profitable by any means

necessary. Marty Fuller has discussed GAAP with Terry Reed, and

Reed just wants to make the company more profitable regardless of

the cost. He is demanding a solution to report the sale during 2010.

The accounting department knows that they must comply with GAAP,

and also adhere to other ethical and legal requirements.

Excello Telecommunications Alternatives and their ethicality

The accountants at Excello come up with three scenarios that the

company can use to get the sale in the period that Terry Reed wants

it in:

1. Transfer the machines sold in the transaction to an

off-site storage facility on December 31. Hold the

merchandise there until January of 2011 when it is

delivered to the customer. This makes the inventory

move from the physical location that the auditors will

be observing.

2. Send the equipment directly to the customer

knowing that they can send the merchandise right

back for a full refund once it arrives at their location.

3. Offer the customer a discount of 10% if the product is

accepted by December 31 instead of January of 2011

In looking at these decisions the first one seems unethical. Even

though the goods are at an off-site storage facility, they are still in the

hands of Excello. They still have legal title, therefore the sale hasn’t

taken place yet.

The 2nd option isn’t ethical, either. When you have the chance that

goods can be sent back because they were delivered too early then

that must be disclosed in the financial statements. Furthermore, if the

customer returns the merchandise between the end of the year and

when the financial statements are issued that may need to be

disclosed in the footnotes to the financial statements if $1.2 million is

material to Excello..

The last option is the most ethical scenario that the accounting

department came up with. It’s a win-win in that the customer will get

a hefty discount and the company will be able to book the $1.2 million

sale by the end of the year. Even though the customer doesn’t have

the space for the product, they can make arrangements for storage.

Hopefully, the storage wouldn’t cost more than the discount received.

Conclusion

Terry Reed, the CFO of Excello Telecommunications, was going

down a slippery slope. The accounting department had to think fast

on their feet to come up with a way to post the sale by the end of the

year in a way that would preserve shareholder wealth. They

accomplished that by offering the customer a discount if they agreed

to take possession of the product by December 31.