11. Safety-Kleen is a North American company that offers environmental products and
services. The company issued a major financial restatement in 2001. In 2000, the
company’s board of directors initiated an investigation of possible accounting fraud
within the company. The next year, Safety-Kleen restated (reduced) previously
reported net income by $534 million for the period 1997-99. In the week
surrounding the announcement of Safety-Kleen’s investigation, the company’s stock
price dropped over 70% and its auditor, PricewaterhouseCoopers (PwC), withdrew
its financial statement audit reports for the previous three years. PwC agreed to
settle a shareholder lawsuit for failing to discover the fraud in the amount of $48
million. PwC said the audit firm admitted no wrongdoing but settled to avoid the
uncertainty of a trial. Do you believe that financial restatements and withdrawing
an audit report are prima facie indicators that a failed audit has occurred? Explain
why or why not.
Audit failure occurs when the auditor issues an incorrect audit opinion because it failed to
comply with the requirements of auditing standards. How does one decide if the audit is a failure
when the audit is properly planned and performed to detect material misstatements but there was
financial statement fraud by top management? It is possible to have a proper audit and a
misstatement goes undetected. It is also possible to have a problematic audit and the financial
Financial statement restatements and withdrawing an audit report are indicators that the auditors
failed to catch a material misstatement until after the financials were issued. It may indicate a
failed audit if the auditors did not follow GAAS, failed to exercise due care, failed to approach
The reality is the public typically expects the audit to identify all such problems while the
profession’s view is it can only be expected to catch financial fraud (and avoid the need for
12. Revenue recognition for multiple-element arrangements as occurred in the Xerox
case discussed in this chapter calls for determining the stand-alone selling price for
each of the deliverables and using it to separate out the revenue amounts. Why do
you think it is important to separate out the selling prices of each element of a
bundled transaction? How might the separation affect recorded revenue in the
period of sale and in future periods? How do these considerations relate to what
Xerox did to manage its earnings?
Bundled transactions may have two or more components that require different accounting
methods (or treatments). An example might be the lease of equipment under an operating lease,
the maintenance of the leased equipment throughout the lease term, and the sale of addition
equipment unrelated to the leased equipment. The maintenance of the leased equipment would be
accounted for as executory (future contingency) costs. Another example would be a cell phone
Xerox used different methods to increase the amount of lease revenues at the inception of the
lease and reduced the amount it recognized over the life of the lease. Xerox would bundle the
lease of copiers, pre-sale copier supplies, and maintenance service all into the same contract; it
13. Tinseltown Construction just received a $2 billion contract to construct a modern
football stadium in the City of Industry located in southern California for a new
National Football League (NFL) team called the Los Angeles Devils of Industry. The
company estimates it will cost $1.5 billion to construct the stadium. Explain how
Tinseltown can make revenue recognition decisions that enable it to manage
earnings over the three-year duration of the contract.
Tinseltown should follow the percentage-of-completion method and recognize revenue over the
life of the contract based on a ratio of costs incurred to date to total estimated costs on the
contract. In this way a proper matching occurs. The alternative of using the completed contract
Since the percentage-of-completion method involves costs estimates, it allows for manipulation
of the numbers and earnings management. For example if the company legitimately incurs $500
million in costs the first year, then 1/3 of the revenue ($666,667) should be recognized assuming
the estimate of total costs remains at $1.5 billion. The net income is $166,667. However, what if
14. Explain how the use of available-for-sale securities can lead to managed earnings.
A debt or equity security that is purchased with the intent of selling before it reaches maturity, or
selling prior to a lengthy time period in the event the security does not have a maturity is
classified as available-for-sale. The classification of securities is made at the time of purchase.
However, if the company intends to sell the securities within one year, the fair value adjustments
go directly to the income statement. Clearly, earnings management is possible because the
auditor accepts management’s word on the intent to hold the securities, although some
15. In the Enron case the company eventually turned to “back-door” guaranteeing of
the Chewco, one of its SPE, to satisfy equity investors. Assume that one guarantee
was for a $16 million loan. The loan agreement required that Enron stock should
not fall below $40 per share. If the share price did decline below that trigger
amount, either the loan would be called by the bank or the bank could choose to
increase the guaranteed number of Enron shares based on the new price (assume
$32). If the bank decides to increase the number of shares guaranteed, what would
be: (1) the original number of shares in the guarantee and (2) the new number of
shares? Why would it be important for Enron to disclose information about the
guarantee in its financial statements?
By guaranteeing the SPE’s debt, Enron was still at risk for repayment of the SPE’s doubt thereby
failing to transfer the risk. At a minimum, the situation should have been fully disclosed in the
In the example originally given, Enron would have pledged 400,000 shares of stock at $40 per
share to collateralize the $16 million loan. When the share price was reset to $32 per share,
16. On August 9, 2005, a special committee comprised of two independent
directors of Krispy Kreme (the “Special Committee”) presented a report
of its investigation into an accounting fraud to the board of directors.
The following numbers were included in the Krispy Kreme Special
Committee report with respect to reversals of accruals during the
fraud period.
Estimated Restatement Adjustments
Increase (decrease) in pretax earnings (in millions)
FY00 FY FY FY FY Nine
Months
And ended ended ended ended ended
Devise a scenario to explain how and why the Krispy Kreme
accruals were made in the amounts that they were. What might have
been the motivation for such action?
Schilit’s shenanigan number 4, shifting current expenses to a later period, could result in accrued
liabilities like above. The accruals to employee vacation pay may have been inflated by including
17. Explain whether you believe fraudulent reporting is positively
correlated with each of the following conditions: (1) more financial
pressure imposed by a supervisor of a firm; (2) higher percentage of
complex transactions of a firm; (3) more questionable integrity of a
firm’s managers; and (4) more deterioration in the relationship
between a firm and its auditor.
Yes, all of the above conditions are positively correlated with possible fraudulent
financial reporting. With increased pressure comes the incentive to commit fraud,
the first element of the fraud triangle. Complex transactions, such as those
engaged in by Enron, create uncertainties in proper accounting and disclosure
18. Schilit recognizes that cash flow shenanigans also exist when a
company takes actions to send their desirable cash inflows to the
most important section (Operating) and all of the unwanted cash
outflows to the other sections (Investing and Financing). Given that
regardless of the classification of the cash flows, the result is the same
with respect to the amount of change in cash flows during the
designated period, what motive might exist to shift investing and/or
financing cash flows to the operating section? Is this an ethical
practice? Why or why not?
Cash flows from operating activities are used by analysts to judge the company’s ability
to continue to generate operating results in the future. To increase its operating cash flow, a
company can classify an operating expenditure as an item of investment or financing. Similarly,
Whether the practice of increasing operating cash flows by capitalizing software
development costs is ethical depends on the intent. If the practice is intended to manipulated
19. In the study of earnings quality by Dichev et al., CFOs stated that
“current earnings are considered to be high quality if they serve as a
good guide to the long-run profits of the firm.” Discuss how and why
current earnings may not be a good barometer of the long-term
profits of the firm.
Current earnings of a firm may not be a good barometer of the long-term profits
of a firm if those earnings are fraudulent. Examples of firms like Enron,
WorldCom are firms who had profitable currents earnings based upon fraud.
When earnings are manipulated in a given year, the shareholders may believe
future earnings will show a similar trend. However, if a technique such as
20. Explain what is meant by the following two statements and why they may be true:
Where management does not try to manipulate earnings, there is a
positive effect on earnings quality. The absence of earnings
management does not, however, guarantee high earnings quality.
When management does not try to manipulate earnings, then the earnings are reliable, assuming
it has been properly recorded in conformity with GAAP, and earnings quality is high. However,
even though management does not manage earnings it does not mean the earnings quality is high
because errors may exist in the financial statements or important disclosures omitted that affects
the quality of earnings in future years. Also, discretionary accruals can be used to manage