Case 7-4
Solway, Inc.
Ben Davis is an internal accountant at Solway Inc.., a publicly-owned company headquartered in Austin, California. Ben reports to
Chris Hodgins, the controller of the company. Hodgins reports to the CFO, Harry Benson. Benson reports to George Lee, the CEO.
Solway has a three-person independent audit committee that deals with financial oversight issues including being a direct access group
for matters of concern for the chief internal auditor, Sam Vines.
On January 15, 2014, Davis is approached by Hodgins and told to record an accrual for unpaid bonuses and severance payments of
$50 million to be included in the December 31, 2013, financial statements. Davis asked Hodgins to explain the reason for what
appeared to be an unusually high amount and was told the company planned to shut down a division in 2014 and the severance
payments would be significant. This was the first Davis heard about a shutdown of any division and found it strange because the
company’s operating income in all divisions had set record levels in fiscal year 2013. Moreover, the bonus and severance amounts are
five times the annual payroll of the division.
The numbers below show the operating income levels and accruals for 2011 through 2013.
12/31/11 12/31/12 12/31/13
Operating Income $ 100 million $120 million $200 million
Accrued bonus & severance $ 10 million $ 12 million ???
Davis did not commit to recording the accruals because he wanted more time to think about the situation. Fortunately, Hodgins was
called away on an urgent matter, bringing the meeting to an abrupt halt.
Davis decided to speak to Gloria Olson, a fellow internal accountant who graduated with Davis from college. Olson also found the
amount of accruals unusually high. Davis asked Olson what the projected operating income was for December 31, 2014 based on her
recent calculations. Olson told him it was determined to be $160 million. They briefly talked about the projected decline in operating
income after five straight years of increases. Davis wondered whether the reason could be attributable to the shutdown of the division
mentioned by Hodgins.
Questions
Assume Davis, Hodgins, Benson, Vines and Olson are all CPAs and hold the certificate in management accounting (CMA).
1. Review the definitions of earnings management by Schipper, Healy and Whalen, Dechow and Skinner, and McKee
that are discussed in this chapter. How would you characterize the proposed accrual for unpaid bonuses and severance
payments from an earnings management perspective?
There are a variety of definitions of earnings management. Schipper defines it as a “purposeful intervention in the external reporting
process, with the intent of obtaining some private gain (as opposed to say, merely facilitating the neutral operation of the process).”
Healy and Wahlen define it as “when managers use judgment in financial reporting and in structuring transactions to alter financial
Dechow and Skinner note the difficulty of operationalizing earnings management based on the reported accounting numbers
because they center on managerial intent, which is unobservable. Dechow and Skinner offer their own view that a distinction should
be made between making choices in determining earnings that may comprise aggressive, but acceptable, accounting estimates and
judgments, as compared to fraudulent accounting practices that are clearly intended to deceive others. These authors provide a link
Thomas E. McKee wrote a book on earnings management from the executive perspective. He defines earnings management as
“reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results.” McKee
believes earnings management reflects a conscious choice by management to smooth earnings over time and it does not include
The proposed accrual for unpaid bonuses and severance payments from an earning management is very conservative accounting
towards the shutdown of a division but very aggressive accounting on the recording of accruals of bonuses and severance pay; it is an
2. Place yourself in Ben Davis’ shoes and consider the following in deciding whether to support Hodgins’s position on the
accrual:
a. Who are the stakeholders in this case?
b. What are the accounting issues of concern to you?
The accounting issues of concern are the timing of the accrual for bonuses and severance; the aggressive nature of the accrual and the
amount; the shutdown of the division, and impairment of assets with the shutting of the division. Earnings management concerns exist
c. What are ethical issues of concern to you with respect to your ethical and professional obligations and stakeholder
interests?
The ethical issues are objectivity and integrity, which both the AICPA and IMA require of their members. The stakeholders are owed
3. Assume you meet with Hodgins and he instructs you in no uncertain terms to record the accrual. What would you do
and why? Would whistleblowing be a consideration for you? Why or why not?
Davis needs to be firm express his concerns to Hodgins. If he is not comfortable with the explanation from Hodgins, then he should
take his concerns to Benson, the CFO. Benson is a CPA and CMA and should know that his integrity is at risk if he sanctions Hodgins’
desired recording of the accrual. Davis may have to go to George Lee, the CEO, if Benson supports Hodgins. He may even consider
The whistleblower provisions of Dodd-Frank exclude internal accountants from award eligibility because of their
Individuals with internal compliance or audit responsibilities at an entity, including
However, these individuals will not be excluded from receiving a whistleblower award where:
oDisclosure to the SEC is needed to prevent “substantial injury” to the financial interest of an entity or its
investors,