978-0136118671 Chapter 6 Solution Manual Part 1

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Chapter 6

1. Too much pressure. Hank Kolb was put in charge of quality assurance at a

plant where practices were not up to par. The most immediate issue facing him

was what to do about some pressurized cans of lubricant that had just been

shipped out. The cans had been overpressurized by faulty equipment. When this

was discovered, one of the production supervisors vented the excess by hand

without taking measurements to make sure the pressure was within tolerances.

One option was to recall the cans and check them systematically, but this would

be an expensive and time-consuming process, and it would antagonize customers.

Should Kolb recall the cans? Hints. See Case 6.2 for guidance on how to

analyze this case. The utilitarian test can perhaps be applied by the use of

statistical sampling to estimate the cost of possible injuries. Kolb could recall a

random sample of the cans for this purpose. However, you must ask whether

statistical sampling alone can enable Kolb to promise safety, as required by the

generalization principle, or whether a complete recall is necessary. Statistical

sampling presupposes that uncontrolled defects are random.

The utilitarian test balances the utility cost of making a product safe against the

expected disutility of injuries. This requires an estimate of the probability of

injuries, as explained in Case 6.2. Unfortunately, Kolb has no basis for assigning

a probability to injury, because he doesn’t know the pressure in the cans. So we

One remedy would be to recall some of the cans, enough to form a statistically

significant sample, and check the pressure. This may allow Kolb to estimate the

probability that any of the cans could cause problems, and then he could apply the

The generalization test can also be applied. As noted in Case 6.2, selling a

product implies a promise that it is safe, but one can promise only what is under

2. Fraud at Interspeed Corporation. Interspeed Corporation had just gone

public, and Senior Vice-President for Sales Arthur Goodwin was keen to meet

annual revenue targets. The fourth quarter target, for example, was $3 million,

but the books showed only $1.9 in revenue. Goodwin decided he had to do

something. He persuaded Solunet Inc. to take delivery of $1.2 million in

inventory and hold it until another Interspeed customer bought it shortly after the

new year began. Solunet was allowed to return the goods to InterSpeed if it

couldn’t sell them to the third party. Goodwin counted the $1.2 million as

revenue and so pushed fourth-quarter revenue to $3.1 million, slightly above the

target. Goodwin’s conduct was a clear violation of GAAP. Solunet didn’t actually

buy the goods, because it didn’t commit itself to paying for them. So there was no

revenue to report. As it turned out, the customer Goodwin counted on wouldn’t

buy the inventory. So Goodwin arranged for another company, I-Way, to buy or

lease the equipment. When I-Way could not come up with the money, Goodwin

transferred funds to I-Way, which leased the goods from a leasing agent. The

leasing agent bought the goods from Solunet, which used the money to pay

Interspeed, completing the circle.

Goodwin kept digging himself into a hole. In another incident, he forged a

signature on an altered contract to create the impression that Interspeed had

made a $6.4 million sale. Before it was all over, he had overstated the company’s

revenues by 60%, or $9 million. In a June 2006 Federal jury trial, Goodwin was

convicted of securities fraud for his activities at Interspeed. He was sentenced to

30 months in jail, followed by a three-year supervised release. The Securities and

Exchange Commission (SEC) also brought a civil action against Goodwin for the

same offenses. In May 2007, he settled with the SEC by agreeing never to serve

as an officer or director of a public corporation and by turning over $100,521 in

earnings that resulted from his fraud. The payment was waived on grounds of

financial hardship.

It doesn’t take rocket science to show that Goodwin’s conduct was unethical. In

fact, the business scandals we hear so much about may give the false impression

that it is normally easy to recognize the right decision. We hear about these

scandals precisely because they make a sensational story of egregious

wrongdoing. Many real-life decisions are murky and difficult to sort out even

when one has the best of intentions. In the Interspeed case, for example, there are

several hypothetical scenarios in which the right decisions would not be so clear:

1. Interspeed would be forced into bankruptcy if it didn’t show additional

revenue in the current period, but it has very good prospects for the future.

2. In addition to the previous scenario, Interspeed makes products that save

lives.

3. There is a signed contract in which the third party agrees to buy the goods

at the beginning of the new year.

4. Interspeed offers Solunet a percentage of the final sales for buying the

product before the end of the year and passing it on to the other customer

at the beginning of the new year.

Your task is to analyze the case under each of these scenarios.

Hints. For Scenario 1, look at the conditions under which income smoothing can

be ethical in the analysis of Case 6.1. Scenario 2 asks in effect whether the end

Let’s first deal with the issue that Goodwin actually faced. Exactly why was it

unethical for him to fabricate revenue? Because it was deceptive, and deception

Question 1. Imagine that Interspeed’s low revenue in the current period is a

temporary thing. There are large orders in the pipeline, and prospects for the

company are bright. Yet if Interspeed reports the bad news now, investors and

lenders will abandon the company, and it will go under. One might argue that a

little income smoothing would be more honest, as discussed in Case 6.1. The case

Question 2. This question asks whether the end can justify the means—whether

deceptive reporting can be justified by the harm it would prevent. Let’s try to

imagine a situation in which a company, say PharmaLife Pharmaceuticals, could

Chapter 2 of the text points out that the end can never justify an unethical means.

The utilitarian principle cannot override the other conditions for rational choice,

because it asks us to select the act that maximizes utility, and behavior that

Actually, deception is sometimes generalizable. Suppose, for example, that the

secret police of an oppressive regime are seeking out dissidents for torture and

execution. You know where some of them are hiding. When the police come to

your house and ask where they are hiding, you say you don’t know. This is a lie,

One might argue that deceiving the public about PharmaLife’s revenue, solely for

the sake of saving lives, is generalizable. Maybe this is such a rare occurrence

For saving lives to be a rationale for deception, there must be something in the

rationale that explains why this and not other things (such as profitability) justify

Furthermore, if saving lives is really PharmaLife’s reason for deception, it must

be the only reason PharmaLife is fudging the numbers. If GlaxoSmithKline

Question 3. This question asks whether Goodwin’s scheme is ethical if there is a

signed contract for a third party to buy the goods from Solunet after the beginning

of the year. There is nothing new here. The sale will not be made until next year,

Question 4. Here we have a deal in which Solunet agrees to buy the goods now,

and InterSpeed promises a Solunet percentage of the sale revenue if Solunet

resells them. I take this to mean that Solunet assumes the risk. If it cannot resell

the goods, then it is stuck with them. If it does resell them, it gets a “commission”

from InterSpeed that in effect provides Solunet a markup. As I understand it, this

So if the firm is making a good faith effort at accurate reporting, then this could

be the kind of ethical income smoothing discussed above. In particular, it satisfies

(a) because it is intended to provide investors a truer picture of the firm, and (d)

because it accords with GAAP. I will assume (b) it is legal and (c) it will result in

In conclusion, Arthur Goodwin’s conduct is unethical because it fails both the

utilitarian and generalization tests. Income smoothing can be ethical under certain

There are extreme hypothetical conditions under which deceptive revenue

reporting could be ethical, but showing that this would save lives does not

necessarily justify it. At a minimum, the firm must also be prepared to show that

3.* Celebrity endorsement. L&L Advertising just signed a contract with movie

star Lance Willard for celebrity endorsements of Bud’s Best bacon. The president

of the firm assigns the account to Annie, who soon learns the awkward fact that

Lance has just become a vegetarian. The president assures her that all legal

requirements for the endorsement are satisfied, but Annie is uneasy and consults

the American Advertising Federation’s Advertising Ethics and Principles. It

states that “advertising containing testimonials shall be limited to those of

competent witnesses who are reflecting a real and honest opinion or experience.”

When Annie interviews Lance, he assures her that Bud’s Best has been his

favorite brand of bacon since he was a kid. However, he learned during a recent

medical checkup that his cholesterol is dangerously high, and his doctor advised

him to avoid such high-cholesterol foods as bacon and eggs. He decided to avoid

all meat, for good measure. Annie diplomatically asks Lance if he is comfortable

endorsing bacon. Lance responds that his conscience is clean, because he will

describe only the taste and quality of the product, which he genuinely believes are

tops, and say nothing about whether bacon is healthy. If consumers are going to

eat bacon, they may as well eat the best. Besides, many persons can eat a

reasonable amount of bacon without adverse health effects. It is up to consumers

to decide what kind of diet is right for them. Is it ethical for L&L to use Lance’s

endorsement? Is it ethical for Lance to give it?

We can begin with how professional ethics applies, because the case provides

some evidence. Lance seems to meet the stated criteria for an endorsement. I

The endorsement may nonetheless seem dishonest because Lance doesn’t eat

bacon himself. Granted, he won’t say anything in the ad about the health effects

The analogy may seem inexact because we accept the auto expert’s endorsement

on the strength of his expertise, where Bud really has no real “expertise” in bacon.

Expertise could be relevant if the expert refuses to drive on principle, because in

The conclusion seems to be that Lance’s endorsement is ethical if he would be

willing to eat bacon if his cholesterol were normal. Otherwise, it is misleading

There is uncertainty in this analysis, but the uncertainty is due to a question of

23. The MasterDept lockbox problem. MasterDebt, a credit card company,

receives thousands of payment checks from cardholders every month. The

company wants to exploit float so as to earn as much as possible in interest and

fees. Float is the time lapse between the deposit of a payment check and crediting

the amount to MasterDept. Cardholders pay interest on any outstanding balance,

and MasterDebt wants to maximize float to collect more interest from them, and

perhaps late fees as well. The plan is to maximize float by establishing lockboxes

in several cities. Cardholders in each region will be instructed to send their

checks to a certain lockbox, perhaps a distant one to maximize float. The

company is considering six cities as possible lockbox locations, each of which

carries a certain annual fixed cost. The company asked its technical staff to

select lockbox locations and assignments that maximize the difference between

interest earned from float and the cost of the lockboxes. The solution is far from

obvious, but the lockbox problem can be formulated as an uncapacitated facility

location problem, a well-known mathematical model used in operations research.

Solution of the problem reveals that the location of the lockboxes makes a

substantial difference in net benefit to the company. Lockbox location problems

have been solved for many years but raise ethical issues. The interest gained by

MasterDebt is interest lost by its customers. One can ask whether MasterDebt

has the right to collect this interest at the customer’s expense. But this is only an

assertion, not an argument. Even if we accept it, we must decide how much delay

is artificial. Two days? Three days? There are also legal issues involved, partly

due to new credit card regulations recently enacted in the United States. We take

it for granted that credit card companies should abide by regulations. Let’s focus

here on what would be their ethical obligations without specific laws governing

the float period. Your task: arrive at an ethical lockbox location and assignment

policy. Hint. Delay in processing checks incurs social costs because it introduces

uncertainty, makes it more difficult for people to manage cash flow, and may

result in less-than-optimal use of their funds. The interest earned by the credit

card company due to delay may be a rough indication of these social costs, which

can be balanced against the cost of locating lockboxes close to customers. Utility

might be roughly maximized by modifying the facility location model so that it

minimizes the sum of the interest cost to consumers and the cost of the lockboxes.

You should also apply the generalization principle and virtue ethics (think about

why we have financial services professionals).

Let’s begin with a utilitarian analysis. One effect of maximizing float is to

increase the credit card interest charges and late fees, because cardholders must

pay finance charges for a few additional days after they write the check, and their

The issue is how these larger fees affect utility. Credit card interest rates and fees

have sparked controversy for some time. Critics have claimed that the rates are

usurious, and they would in fact be illegal in many states were it not for a U.S.

Another problem with extended float is the general inefficiency that results from

delayed processing. Customers must plan ahead to make sure that their account

will contain sufficient funds several days after they write the check. This

Maximizing float appears to be generalizable. If customers pay more in finance

charges if one company maximizes float, then there is no reason to doubt that

customers would continue to pay more in finance charges if all card issuers

maximized float. The company would therefore continue to achieve the purpose

of its action if all companies with the same purpose acted similarly. Maximizing

Maximizing float is problematic virtue from a virtue ethics point of view. In fact,

one might argue that fast and efficient processing is an essential part what of what

In summary, maximizing float passes the generalization test if it does not increase

As for the issue of how much float is too much, the utilitarian test governs.

The credit card industry raises more general ethical issues. As already noted, there