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P
rofessor Kenneth A. Merchant wrote this teaching note as an aid to instructors using the Fit Food, Inc. case.
Marshall School of Business
University of Southern California
Fit Food, Inc.
Teaching Note
Purpose of Case
The Fit Food, Inc. (FFI) case was written to raise issues related to fraudulent and unethical
financial reporting at business unit levels in divisionalized firms. The case provides context that
Suggested Assignment Questions
1. What went wrong?
2. What should Joe Jellison, Fit Foods CFO, do now that he knows of the problems?
3. Should the problems have surfaced earlier? If so, who should have done what? When?
Case Analysis
A. Assignment Question 1
I like to begin class by asking students the what went wrong? question. I phrase it as follows:
As you could tell from reading the case, FFI had some problems. Lets focus first on
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
This question will evoke a number of responses. One explanation is that unreasonable pressures
for performance combined with a lucrative incentive program and a no excuses management
style motivated the division managers to take steps to boost performance in the short run at the
expense of the long run. Their actions are common examples of the operating myopia
problem that is discussed in Chapter 10 in the text. Some of the actions are relatively harmless,
but others can have significant negative effects.
After students have identified the causal factors, ask if these characteristics are unusual. I think
they will conclude that these factors exist, to a greater or lesser degree, in most corporations.
The case provides many examples of earnings management or gamesmanship, including the
following:
Drink Division
2. 2008: Early-order program, reduction of reserves.
Cookie Division
1. 2008: Early-order program, shipping around the clock at the end of a quarter, ship
unordered products, fraudulent orders with attempts to make the orders stick.
(1) Is this action in the best interest of the division?
(2) Is it in the best interest of the corporation?
(3) Is it an acceptable business practice? Unethical? Fraudulent?
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
Question (3) opens the ethics issue that is the focus of Chapter 15. (Thus, obviously, this case
can be used in conjunction with Chapter 5, 10, or 15.) The nonfraudulent actions, such as those
taken in the Drink Division in 2007 are a particularly interesting ethics issue to discuss because
As the discussion unfolds in class, instructors can make any of the following points:
1. Research has shown that some of these actions are quite common.
a. Do managers judge the benefits of these actions greater than the costs? Or are these
actions just unavoidable control system side-effects?
b. If everyone is doing something, does that mean it is ethical?
2. Top management and the board of directors must bear ultimate responsibility for what took
place in FFI even though they were not directly involved in the deceptive practices.
3. Is income smoothing valuable? Most managers think it is, and they will argue that the stock
4. Are early shipments acceptable if the customer authorizes the shipments? (Yes.) What if
the authorization is only verbal? (Still acceptable, although this clearly provides an
opportunity for abuses.) Can revenue be declared if the goods are stored in a truck or at an
FFI warehouse? (Probably not, unless title has passed to the customer. Here the auditors
5. Shipping unordered items should not generate revenues because of the lack of proper
6. Unanimous agreement as to whether certain actions are acceptable or unacceptable does not
8. Is it acceptable to manage earnings down (i.e., be ultraconservative) than to manage them
9. Why would auditors accept the manipulations of reserves? Possibly because:
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10. Capitalizing the cost of spare parts is improper, fraudulent accounting.
11. With tax accounting, most people are comfortable with the idea that taxable income should
be minimized through all legal means. For financial reporting, is it acceptable to maximize
income through all legal means?
12. As a division manager, what should you do if you think the accounting rules (e.g., requiring
the expensing of R&D investments) are wrong?
13. How should a CEO define to middle management what is an appropriate management of
profit and sales figures? Dont do anything that compromises the long-term interests of the
corporation? Dont hurt customers? Dont distort the fundamental trends in long-term
profitability?
B. Assignment Question 2
Joe Jellison, FFIs CFO, must take some strong actions now that the gameplaying has been
discovered. He should immediately inform the authors and the audit committee of the
companys board of directors of the problems. Company finance staff and the auditors will have
to investigate the problems in the Cookie Division to determine what adjusting journal entries
should be made. They should also investigate whether similar problems were occurring in the
other FFI divisions. Fixing the problems will probably require public disclosures of the
problems and restatements of prior period financial statements. These are serious problems.
Certainly some members of management, certainly including most of the Cookie Division
managers, and possibly also Joe Jellison himself, should lose their jobs. Should the Drink
Division managers, and possibly even Sean Wright, suffer a similar fate?
C. Assignment Question 3
Clearly the problems should have surfaced earlier. There are multiple failures. Identifying these
failures will help the students think about what can be done so that FFI does not face these
problems in the future.
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
One failure is on the part of the external auditors. Their audit plan seems to have been
insufficient to detect the problems. FFI is a public company. Even if the game-playing was not
discovered directly, the internal control weaknesses should have been identified in the
SarbanesOxley Section 404 audit.
The FFI division controllers failed to fulfill their fiduciary obligations. Their management
service role seems to have been dominated. But while division managers have the responsibility
to bring deceptive practices to light, doing so often costs them their jobs.
Pedagogy
On the face of it, this is not a difficult case, and it is one that students find inherently interesting
to discuss. Thus it lends itself well to an unstructured teaching style.
Addressing the issues effectively is not easy, though. Indeed, the prevalence of game-playing
activities suggests that most companies are unable to solve these types of problems.
In closing, instructors can make the following points:
This case raises a number of issues about proper financial reporting and effective corporate
governance. The discussion process of this case provides the greatest pedagogical benefits, and I
do not think it is necessary (and perhaps not even desirable) for the instructor to provide a neat
summary. But here are some general observations that might be made:
1. Research has shown that the types of game-playing taking place in the Drink Division,
particularly, are quite common. It is a rare organization that does not encounter at least
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2. Most companies do not have fraudulent financial reporting problems as serious as those
3. Most people who get caught up in frauds are not bad people. They get caught up in the
demands of the situation and/or temptations provided by control weaknesses. How do they
convince themselves that their manipulative actions are acceptable?
4. Multiple forms of controls are necessary to reduce the likelihood of deceptive financial
reporting. However, each form of control has costs that should not be ignored. Adding
5. Being ethical usually pays off in the long run, but not necessarily in the short run.
