Accounting Chapter 3 Homework Madison Gilmore Major Stakeholder Because She The

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Ethical Obligations and Decision Making in Accounting, 4/e 1

Major Case 3 Madison Gilmore’s Ethical Dilemma

South City Electronics is involved in printed circuit board assembly (PCBA) dealing with the

assembly of complex electronic system processes. The electronics company, based in the city of

South San Francisco, is publicly owned with three other locations in the San Francisco Bay Area.

Josh Goldberg is the chief executive officer of the company.

Ethical Dilemma

It’s March 30, 2017 and Madison Gilmore, controller for South City Electronics, has just gotten

off the phone with her supervisor, South City’s CFO David Levin, who reiterated the points he

made in a face-to-face meeting with her earlier that day—that the company would be in default

on a $10 million loan if its cash flow and earnings for the quarter ended March 31, 2017, did not

meet set goals in the loan agreement. Right now the company’s cash flow is $620,000 and the

earnings are $160,000. This is $380,000 and $240,000, respectively, below prescribed levels.

Gilmore knows her boss wants her to agree to revenue treatment for an arrangement with Victor

Facts of the Case

Levin and Gilmore’s face-to-face meeting featured an acrimonious dispute over whether to

record the $1.2 million as revenue:

“Madison, we have fallen below debt covenant requirements,” Levin said. “The only option is to

accelerate the sale to Victor Systems. I’ve already spoken to Bob Victor, and he has agreed to the

transaction and cash payment by the close of business tomorrow so long as we discount the sale

by 10 percent. Even with that discount we will be above debt covenant requirements.”

“The accounting rules are quite clear on this matter,” Gilmore said. “Generally accepted

accounting principles require us to record the transactions as of March 31 as deferred revenue

because the sale will not be completed until April 5.”

“What’s that?”

Ethical Obligations and Decision Making in Accounting, 4/e 2

“We are going to ship the merchandise to an off-site distribution warehouse that we oftentimes

use as a holding facility until a customer asks for goods to be sent to its location.”

“Who is the end user?” Gilmore asked.

“Victor Systems.”

“In my mind that means we still can’t record the revenue this quarter.”

“Can you point to any specific accounting standard that supports your opinion?” Levin asked.

“Maybe not a specific opinion, but it is my professional judgment that the entry should be

recorded as deferred revenue and a footnote added to the quarterly statements describing the

warehouse holding arrangement.”

“That’s not going to happen. There is no way Josh will agree. Asking him to defer the revenue is

bad enough, but throwing in a footnote disclosure will not only place us in default on the loan

terms but also will unnecessarily create some doubt in the mind of others who might read that

note and wonder about our accounting practices. Besides, this is simply an operational decision

and not an accounting manipulation.”

At that point Levin received a call from Bob Victor, who wanted to review the terms of the

shipment. Levin excused himself and told Gilmore they would talk later in the day—the follow-

up phone call referred to above.

Ethical Obligations and Decision Making in Accounting, 4/e 3

Questions

1. Is the accounting for revenue in the Victor transaction a case of operational earnings

management or accounting earnings management? Explain. Briefly address auditing

challenges of this kind of a transaction.

We could say that an operational decision led to the accounting earnings management and

that is true. However, in the end it is a case of accounting earnings management. While not

Extended Discussion of Bill-and-Hold Transactions

“Bill and Hold” schemes are a common method of bypassing the delivery requirement. As

its name implies, a legitimate sales order is received, processed, and ready for shipment. The

customer however, for whatever reason, may not be ready, willing, or able to accept delivery

of the product at that particular point in time. The seller holds the goods in its facility or

ships them to a different location, such as a third party warehouse for storage until the

customer.

South City Electronics wants to recognize revenue immediately upon shipment to Kelly’s

warehouse. In auditing such transactions to assess whether the revenue recognition rules

have been met, the auditor must consider whether the seller has met (or is seeking to

circumvent) enumerated specific criteria established by the SEC, including whether:

• Risk of ownership has passed to the buyer;

• Customer has made a fixed commitment to purchase the goods, preferably in written

documentation;

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• Delivery must be fixed and on a schedule that is reasonable and consistent with the

buyer’s business purpose;

• Seller must not retain any specific performance obligations under the agreement such that

the earning process is not complete;

• Ordered goods must be segregated from the seller’s inventory and not be subject to being

used to fill other orders; and

• Product must be complete and ready for shipment.

In addition to the above factors, the SEC also recommends preparers of financial statements

to consider:

• The date by which the seller expects payment, and whether the seller has modified its

normal billing and credit terms for this buyer;

Auditors coming across agreements that do not meet the above criteria should be wary of

potential bill and hold schemes. Auditors should consider whether:

• Bills of lading are signed by a company employee rather than shipping company;

• Review of shipping documents indicates excessive shipments made to warehouses rather

than to a customer’s regular address (which could mean that shipments are made to the

seller’s warehouses rather than customer locations);

When confronted with the above indicators, the auditor should first inquire of management

regarding any bill and hold policies and any customers with bill and hold arrangements. The

auditor should also make inquiry of warehouse personnel regarding “customer” inventory

being held on the premises in a third party warehouse, or shipped to another company

Ethical Obligations and Decision Making in Accounting, 4/e 5

If additional investigation is warranted, the auditor should review the customer contracts to

determine whether they meet the requirements of SAB 101 enumerated above. The auditor

should also:

• Review underlying shipping documents for accuracy and verify existence of transactions;

• Compare shipping costs to prior periods for reasonableness.

2. Who are the stakeholders in this case and what are their interests? Use ethical

reasoning to evaluate the appropriateness of Levin’s request.

South City Electronics is a major stakeholder because it is its position about the

appropriateness of recording revenue on the shipment of goods to Kelly Electronics to be

held for Victor Systems that is being discussed between Madison Gilmore (controller) and

David Levin (CFO). The company needs to boost its revenue numbers to increase cash flows

by $380,000 and earnings by $240,000 in order to avoid violating debt covenant

requirements.

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Victor Systems is the customer that is being asked to accept the bill-and-hold arrangement

with Kelly Electronics that is designed to prematurely recognize revenue on the transfer of

goods to Kelly to be held for delivery to Victor on April 5, 2017.

A rule utilitarian approach holds that the rules should never be violated regardless of any

utilitarian benefits to the stakeholders. The ethics rules would be violated, and the financial

statements as of March 31, 2017, would not present fairly financial position, results of

operations, and changes in cash flows for that quarter. In this case the ethical reasoning under

rule utilitarianism leads to a different conclusion than that under act utilitarianism.

Assume you are in Madison Gilmore’s position. Answer the following questions as you

prepare for the meeting with Levin and Goldberg.

• What are the main arguments you are trying to counter?

Gilmore is trying to counter the argument of Levin that somehow recording the revenue in

the March 31, 2017 period is acceptable under the terms of the agreement with Victor

Systems because the goods were shipped off site by the end of the quarter. The argument by

Levin is the holding arrangement with Kelly Electronics is simply a detail and not one that

Ethical Obligations and Decision Making in Accounting, 4/e 7

• What is at stake for the key parties, including those who disagree with you?

South City Electronics will be in default of its debt covenant requirements if it doesn’t

accelerate the revenue into the March 31, 2017 quarter. The company’s debt may be called in

and South City would need to gather sufficient cash to pay off its debts. Levin disagrees with

Gilmore’s suggested accounting. If Gilmore holds true to her values and beliefs about proper

• What levers can you use to influence those who disagree with you?

Gilmore should discuss the accounting treatment with Levin from GAAP, professional

judgment, and ethical obligation perspectives. She should try and convince Levin that he will

be in violation of a number of rules if he persists in recording the revenue prematurely. His

reputation is at stake and, as a CPA, he might lose his license. Gilmore should also explain

the internal reporting process under the AICPA Code that was discussed in Chapter 3 in

Exhibit 3.13. The exhibit sets forth the rules for a CPA to follow to avoid subordinating

judgment to a superior (s). Briefly, Gilmore should explain that she will go to Josh Goldberg

(probably a useless step since the CEO undoubtedly knows about Levin’s plan to accelerate

• What is your most powerful and persuasive response to the reasons and

rationalizations you need to address?

Levin is pushing accelerating the recording of revenue to meet debt covenant requirements.

Levin is attempting to convince Gilmore that the structure of the bill-and-hold transaction

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4. At this point would you recommend to Gilmore that she should go to the audit

committee with her concerns? Explain your reasoning.

Gilmore should go to the audit committee because their role is to help resolve internal

differences over proper accounting and differences between the external auditors and

Assume Gilmore goes to the audit committee and nothing changes. The revenue was

recorded as earned revenue as of March 31. The goods were shipped to the warehouse

on that day. The sale was completed on April 5. A refinancing of the $10 million loan

was made shortly after April 5.

5. If you were in Madison Gilmore’s position, would you blow the whistle on what you

perceive to be the manipulation of the earnings for the quarter ended March 31? Under

what circumstances might you blow the whistle? Who would you contact to inform

them of what you consider to be earnings manipulation?

The issue as previously mentioned is whether to blow the whistle to the SEC under the Dodd-

Frank provisions. Since Gilmore would have already followed the prescribed internal

reporting process (an essential first requirement of compliance officers under Dodd-Frank

and under AICPA rules), she can evaluate the three conditions, any one of which justifies

reporting the matter to the SEC. A brief review of whistleblowing under Dodd-Frank

follows.

Ethical Obligations and Decision Making in Accounting, 4/e 9

One major concern with this new provision is that it may cause would-be whistleblowers to

go external with the information rather than internal using the organization’s prescribed

reporting mechanisms. Employees have a loyalty obligation to their employers that include

maintaining confidentiality and not doing anything to harm their employers. Assuming the

internal reporting process has played out and nothing has been done to correct for the

wrongdoing, we believe from an ethical perspective external whistleblowing is the proper

course of action especially if it is the only way for the public to know. An employee should

not fall victim to the bystander effect and assume others will report it. Along with knowledge

comes the responsibility to correct wrongdoings, which is in the best long-term interests of

the organization.