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P
rofessor Kenneth A. Merchant wrote this teaching note as an aid to instructors using the Don Russell: Experiences of a
Controller/CFO case.
Marshall School of Business
University of Southern California
Don Russell:
Experiences of a Controller / CFO
Teaching Note
Purpose of Case
The Don Russell case was written to motivate a discussion of the economics and ethics of
"managing" earnings and the roles of finance professionals (and general managers and auditors)
in the financial reporting process. The case is compelling because Don Russell, a chief financial
officer, has to make a decision that has significant company and personal consequences.
After they have discussed the case, the students can hear Don Russell's thoughts directly by
watching a 22-minute videotape. Alternatively, the instructor can use a follow-up case, Don
Suggested Assignment Questions
Assignment questions are not included in the case to allow instructors to tailor the assignment to
fit their focus, but the following questions have been used successfully to motivate a class
discussion on the major case issues:
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1. Was Don Russell a good controller for Cook and Spector, Inc.? Why or why not?
2. Does Don have the power to force ETI top management to make a correcting accounting
entry? If not, what should he do? If so, should he force the entry to be made, and how large
should it be?
Summary of Case
The case relates a true story (only the names and some figures have been disguised) about one
chief financial officer's (Don Russell's) agonizing decision about whether to allow substantial
earnings management to persist at his company, a small satellite broadcasting company. In
making his decision, he had to consider the consequences to his company, users of his
company's financial statements, and his career and personal finances.
The case starts by describing Don's educational and CPA-firm experiences: He did well at the
CPA firm and completed an evening MBA. It then goes into considerable detail in describing
Analysis of Question 1
The question as to whether Don was a good controller at C&S can be addressed either by
comparing Don's activities against a set of criteria that define controllership effectiveness or by
letting the class infer the meaning of effective controllership by analyzing the case descriptions
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
reporting/internal control (fiduciary) responsibilities. A strong controller model would seem to
apply at C&S. The eight characteristics are:
2. Personal integrity and professional commitment. (Is the conscience of the organization.)
4. Analytical skills. (Is able to spot trends before they become a reality.)
6. Ability to judge what is important to management and to make recommendations. (Thinks
the way general managers think.)
8. Ability to challenge management constructively. (Knows when to pick fights and when to
give in.)
If this model is used, Don can be evaluated in terms of each of these desirable characteristics.
Students will probably conclude that Don scores high in terms of criteria #1, 3, 5, and 7. The
earnings management practices in which Don engaged may raise questions about his personal
Strengths (evidence that Don was a good controller):
1. Clearly demonstrated good systems skills. Successfully implemented major changes in the
firm's accounting information systems:
a. Chart of accounts
2. Made major cost reductions in controller's department (from 250 to 110 people).
4. Part of the management team. Attended the key meetings. Was rewarded for his
performance in money, recognition, and autonomy.
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
393
Potential weaknesses
1. Appeared to have little sense of fiduciary responsibility to parent company (Queen's
Industries), at least at first.
3. Apparently unaware of division-level earnings management practices until he did his fact-
finding study.
4. Was not able to convince top management that they needed to implement a different form of
financial measurement system and to fix the earnings management problem. Left company
Analysis of Question 2
Question 2 focuses on the decision Don has to make at ETI. As he became involved in the
company's budgeting process, Don learned that ETI had been reporting profits with "an
extremely aggressive financial reporting strategy." Among other things, ETI management had
been capitalizing many questionable expenditures (and some that were not so questionable).
Don's action alternatives and their consequences are probably as follows:
1. Make an accounting entry to write off what he has concluded are some inappropriate assets
that exist because of past earnings overstatements. But if he made the entries without top
2. Discuss with the auditors what he knows. Let them force top management to act. This
3. Delay. Continue to argue for less aggressive accounting. Don would keep his job and could
cash in some of his options in two months. But he would have a potential legal problem if
and when the scheme was subsequently discovered.
If Don forces a correcting entry to be made, he also has to decide how large a correction he will
Analysis of Question 3
Question 3 asks if earnings management is smart or ethical. No large body of evidence exists to
link earnings management activities with economic outcomes, but there is some theory and a
growing body of anecdotal evidence that allows us to make predictions about the effects. But
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
before discussing the answer to question 3, it is important for the students to understand what
earnings management is.
I define earnings management as follows:
Actions taken to make performance look better than it otherwise would in the short-run, plus
those engaging in them know the actions have no real economic benefits and may actually be
Earnings management is just one common and important form of gameplaying. Managers also
play games with other measures, including balance sheet items ("window dressing"), sales, and
quality measures. The basic points are the same about all of these forms of gameplaying.
Regarding the economics of earnings management: It seems clear that earnings management can
lead to some short-term benefits for companies and their managers if the manipulative actions
are not disclosed or are not well understood. If one believes in an efficient stock market and the
actions are adequately disclosed to the market, then managers of public corporations probably
While they may provide some short-term benefits, it is apparent that earnings management
actions pose significant dangers for the long term. If discovered, they could cause a company to
earn a reputation for reporting "low quality" earnings; analysts will discount anything the
company says. They ruin a key element in the company's system of intelligence because it
distorts (usually smooths) all the trend lines and hinders managers' abilities to detect problems
early. They may create a gameplaying culture because there is the danger that the people who
Not too long ago I was on top of the world. I implemented modern accounting systems in a
company whose systems had been antiquated; I cut overhead costs sharply; and my accounting
reporting skills made it possible for the company to continue its record of reporting steadily
increasing earnings.
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
395
But all of a sudden I went from viewing myself as a herothe team player whose skill in
manipulating reserves got everybody their bonusesto the greatest villain of all time, a large
contributor to the company's problems. It dawned on me that I was hurting our owner [Queen's]
by feeding them erroneous information, and I was hurting the whole management control
I came to realize that if you allow the numbers to be manipulated, the company's whole
management control system disintegrates. It has nothing to do with ethics. It's just that you can't
conduct a business that way. You will avoid making the hard decisions you need to make. I
don't think it's coincidence that C&S was taken over by Queen's, not the reverse, even though at
one time C&S was larger than Queen's. C&S was gobbled up by a more successful international
competitor.
While Don seemingly did not want to consider ethics, many people conclude that some earnings
management practices are unethical. The key ethics words are probably potential or actual harm,
Other Questions that Might Be Raised in Class
1. How could the auditors have been fooled so easily at ETI? Or if they were not fooled, why
did they go along with the aggressive financial reporting?
2. Where was the ETI board of directors?
3. Do cash flow measures provide a better focus than accounting earnings measures? Are they
less manipulable?
Don Russell argues yes. He believed that a focus on cash flow numbers would render the
accrual gameplaying impotent. He also believed that the cash flow numbers could be used
as the basis for forecasting future cash flows for the purpose of estimating entity values
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
396
After the Students View the Video or Read the (A) Case
The video and (A) case inform the students that Don conservatively forced ETI to show a
$1 million loss for the quarter and he was quickly fired. This case again raises the issue as to
Subsequent Events
Don Russell was unemployed for approximately six months. Then he took a job as division
controller of a Fortune 500 company. He instituted some business process re-engineering
projects and was quickly recognized as a top performer. A few years later he was promoted to
an officer position at corporate headquarters.
ETI continued to report record earnings for over two more years, and the stock price continued
to increase. On the videotape, Don Russell laments that his decision to leave cost him quite a bit
of money.
Eventually, however, the scheme unraveled. ETI's auditors resigned in 1994 over "accounting
disputes." ETI's chairman was quoted in the newspaper as being "astonished" that the auditors
could have quit "over accounting issues which were limited to the first quarter of the year,
without as much as a phone call to me." The story that came out, however, was that the auditors
challenged a list of items accounting for more than half the first quarter profits reported by ETI.
When the auditors resigned, the stock price plunged approximately 50%, but it recovered about
30% of that amount after the company released its response to the auditors' resignation letter.
Shortly thereafter, ETI hired another "Big-6" firm as auditors. But 2 months later, ETI agreed to
be acquired by a long-distance telephone company.
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
Pedagogy
The major decision an instructor has to make in teaching this case is how directive to be, and the
choice of style probably should depend on the type of students in the class. My preference is for
an unstructured case because the issues come out naturally and easily with mature students. But
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Marshall School of Business
University of Southern California
Don Russell (A): The Outcome
On February 12, 1991, Don Russell, CFO of ETI sat at home contemplating the decision he had
to make. As he looked at his six children playing in the backyard, he thought to himself, You
are going to end up in jail. This is stupid. He felt he was in quicksand and just needed to get
out. So the next day, Don told Joe Blevins, ETIs president, You are going to report this profit
numbera $1 million loss for the second quarter of FY 1991 (ended December 31). Joe said,
No! You cant do this. But Don insisted, You are going to report this number because I wont
go to jail.
Don actually felt that the reported profit should have been a loss of $2 million, or more, because
a lot of engineering and interest costs were still capitalized. But, he said,
Joe immediately called ETIs chairman, who was in San Francisco on a business trip, and the
chairman quickly called Don. He was furious. He asked, Whats changed since last week?
Youve just got cold feet. Weve got a plan to cut expenses and shore up our financing. Lets
just work the plan. But Don had heard those promises before, and he did not change his mind.
And he knew the company had no choice but to make the changes he wanted:
The quarterly report had to be delivered to the SEC on the 15th. They had no time to
react, and I knew that was in my favor. If they had time, they would fire me and then
report the numbers any way they wanted to.
Dons demand forced Joe to call the bankers, analysts, and auditors immediately, and ETI
reported the $1 million loss for the second quarter of FY 1991.
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
399
A few hours later, Joe told Don that he was fired, on the order of the chairman. Dons reply was,
About his ETI experience Don noted:
So now Im out of a job. But I know that what I did was right. By allowing ETI management to
manipulate the numbers, I was allowing the same thing that happened at C&S. People werent
