Essay, Pages 11 (2552 words)
The Campbell Soup Company has dominated the soup “industry” since the company developed a cost-effective method of producing condensed soup products in 1899. Throughout most of the twentieth century, Campbell was known as one of the most conservative companies in the United States. In 1980, Campbell startled the business world by selling debt securities for the first time and by embarking on a program to lengthen and diversify its historically “short” product line. Despite a sizable increase in revenues, the diversification program failed to improve Campbell’s profitability, which prompted the company’s executives to refocus their attention on their core business, namely, manufacturing and marketing soup products.
Unfortunately, by the end of the twentieth century, the public’s interest in soup was waning.
Faced with a shrinking market for its primary product, Campbell’s management team allegedly began using a series of questionable business practices and accounting gimmicks to prop up the company’s reported profits. A class-action lawsuit filed in early 2000 by disgruntled Campbell stockholders charged top company executives with misrepresenting Campbell’s operating results in the late 1990s.
The principal allegation was that the executives had used a variety of methods to inflate the company’s revenues, gross margins, and profits during that time frame. Eventually, PricewaterhouseCoopers (PwC), Campbell’s independent audit firm, was named as a co-defendant in the case.
The plaintiffs in the class-action lawsuit claimed that PwC had recklessly audited Campbell, which effectively allowed Campbell’s executives to continue their illicit schemes. This case examines the allegations filed against PwC by Campbell’s stockholders with the primary purpose of illustrating the audit objectives and procedures that can and should be applied to a client’s revenue and revenue-related accounts.
The case also provides students with important insights on how the Private Securities Litigation Reform Act of 1995 has affected auditors’ civil liability in lawsuits filed under the Securities and Exchange Act of 1934.
Campbell Soup Company–Key Facts
- During much of its history, Campbell Soup was known as one of the most conservative large companies in the U.S. economy.
- Campbell’s conservative corporate culture abruptly changed in the 1980s when the company sold debt securities for the first time and embarked on an ambitious program to diversify and expand its product line.
- In the late 1990s, after the diversification program had produced disappointing financial results and when market data indicated that the public’s interest in soup was waning, Campbell executives allegedly began using several illicit methods to meet Wall Street’s earnings targets for the company.
- A class-action lawsuit filed in 2000 charged that Campbell had offered customers large, period-ending discounts to artificially inflate sales, accounted improperly for those discounts, recorded bogus sales, and failed to record appropriate reserves for anticipated sales returns.
- PwC, Campbell’s audit firm, was named as a defendant in the class-action lawsuit and was charged with recklessly auditing Campbell’s financial statements.
- Because the class-action lawsuit was filed under the Securities Exchange Act of 1934, the federal judge presiding over the case had to decide whether the allegations involving PwC satisfied the new “pleading standard” established by the Private Securities Litigation Reform Act of 1995.
- The PSLRA’s pleading standard requires plaintiffs to plead or allege facts suggesting that there is a “strong inference of scienter” on the part of a given defendant.
- To satisfy the PSLRA pleading standard in the Third Circuit of the U.S. District Court in which the Campbell lawsuit was filed, a plaintiff, at a minimum, must allege that the given defendant acted with “recklessness.”
- After reviewing PwC’s audit workpapers, the federal judge ruled that the plaintiffs had failed to satisfy the PSLRA pleading standard, which resulted in PwC being dismissed as a defendant in the case.
- In February 2003, Campbell settled the class-action lawsuit by agreeing to pay the plaintiffs $35 million, although company executives denied any wrongdoing.
- To demonstrate that even the largest and highest profile audit clients can pose significant audit risks.
- To identify discretionary business practices and accounting “gimmicks” that can be used to distort a company’s reported operating results.
- To identify audit procedures that should be applied to a client’s sales and sales-related accounts.
- To examine the implications that the Private Securities Litigation Reform Act of 1995 has for the civil liability of independent auditors in lawsuits filed under the Securities Exchange Act of 1934.
- To examine the concepts of recklessness and negligence in the context of auditors’ civil liability.
Suggestions for Use
The “high-risk” accounts that are the focus of this case are sales and sales-related accounts. This case focuses students’ attention on schemes that companies can use to enhance their reported operating results. These schemes involve both “discretionary” business practices and accounting gimmicks. Auditing textbooks generally ignore the fact that audit clients often manage or manipulate their reported profits by using discretionary business practices—such as delaying advertising or maintenance expenditures. This case requires students to address this possibility and consider the resulting audit implications. After discussing this case, I hope my students recognize that companies that use discretionary business practices to “rig” their profits are likely inclined to use accounting gimmicks for the same purpose.
As an out-of-class assignment, you might ask students to find in the business press recent examples of companies that have attempted to manage their earnings without violating any accounting or financial reporting rules. Have students present these examples and then discuss them when addressing case question No. 1. I think you will find that students have very different opinions on whether it is ethical for public companies to “massage” their income statement data while complying with the technical requirements of GAAP. You might consider packaging this case with the Health Management, Inc., case (Case 1.4). The Health Management case provides a general discussion of the PSLRA. The Campbell Soup case contributes to students’ understanding of the PSLRA by examining in more depth the “pleading standard” established by that federal statute and the impact that standard has on lawsuits filed against auditors under the Securities Exchange Act of 1934.
Suggested Solutions to Case Questions
Here are a few examples of discretionary business practices that corporate executives can use to influence their company’s revenues and/or expenses.
- Deferring advertising, maintenance, or other discretionary expenditures until the following period.
- Slowing down (or accelerating) work on long-term construction projects or contracts for which the percentage-of-completion accounting method is used to recognize revenue.
- Using economic incentives to stimulate sales near the end of an accounting period (a technique used by Campbell).
Are the practices just listed “ethical”? Typically, students suggest that since these practices do not violate any laws, GAAP, or other “black and white” rules, the practices cannot be considered “unethical”—a roundabout way of arguing that they are ethical. That general point-of-view seems consistent with the following comment that Judge Irenas made regarding Campbell’s period-ending “trade loading:” “There is nothing inherently improper in pressing for sales to be made earlier than in the normal course . . . there may be any number of legitimate reasons for attempting to achieve sales earlier.”
For what it is worth, I believe that corporate executives who defer needed maintenance expenses or who postpone advertising programs that would likely produce sizable sales in future periods are not acting in the best interests of their stockholders. In other words, I do not believe such practices are proper or “ethical.” Likewise, corporate executives who take advantage of the inherent flexibility of the percentage-of-completion accounting method, ostensibly to serve their own economic interests, are not individuals who I would want serving as stewards of my investments.
In my view, it is a little more difficult to characterize the “trade loading” practices of Campbell as unethical. Why? Because, allegedly, the company’s competitors were using the same practice. If Campbell chose not to offer large, period-ending discounts to their customers, the company would likely have lost sales to its competitors. [Note: Campbell’s CEO who resigned in 2000 announced in mid-1999 that his company was discontinuing trade loading.]
I would suggest that companies that use various “legitimate” business practices to “manage” their earnings are more prone to use illicit methods (accounting gimmicks, etc.) for the same purpose. As a result, auditors could reasonably consider such business practices as a “red flag” that mandates more extensive and/or rigorous audit tests. [Note: Professional auditing standards suggest that corporate executives who place excessive emphasis on achieving earnings forecasts may be prone to misrepresenting their company’s financial statement data.]
SAS No. 106, “Audit Evidence,” identifies three categories of management assertions implicit in an entity’s financial statements that independent auditors should attempt to corroborate by collecting sufficient appropriate audit evidence. The third of these categories is “presentation and disclosure.” Included in the latter category is the following item: “Classification and understandability. Financial information is appropriately presented and described and disclosures are clearly expressed.” [AU 326.15] Likewise, one of the five transaction-related assertions is entitled “Classification.” This latter assertion suggests that, “Transactions and events have been recorded in the proper accounts.”
Here are examples of “spin” techniques that can be used to enhance income statement data without changing net income:
- Classifying cost of goods sold components as SG&A expenses to inflate gross profit on sales.
- Reporting items that qualify as operating expenses/losses as nonoperating expenses/losses to inflate operating income. (One of the most common variations of this “trick” in recent years has been including legitimate operating expenses in “restructuring” losses.)
- Treating “other losses” as extraordinary losses to inflate income from continuing operations.
Shipping to the yard: Year-end sales cutoff tests are intended to identify misclassification of sales occurring near the end of a client’s fiscal year. Auditors will typically choose a small sample of sales that the client recorded in the final few days of the fiscal year and a comparable sample of sales that occurred in the first few days of the new fiscal year. Then, the relevant shipping and other accounting documents for those sales will be inspected to determine that they were recorded in the proper period. This standard test might have revealed the fact that Campbell was booking some unusually large sales near the end of accounting periods.
Even though the shipping documents for these sales might have suggested that they were valid period-ending sales, a curious auditor might have investigated the sales further. For example, that auditor might have attempted to determine whether the resulting receivables were collected on a timely basis. During the course of such an investigation, the auditor would likely have discovered that the sales were reversed in the following period or dealt with in some other nonstandard way.
Accounts receivable confirmation procedures might also have resulted in the discovery of these “sales.” Customers to whom such sales were charged would likely have identified them as differences or discrepancies on returned confirmations. Subsequent investigation of these items by the auditors may have revealed their true nature. As pointed out by the plaintiffs in this case, during physical inventory counting procedures auditors typically take notice of any inventory that has been segregated and not counted—for example, inventory that is sitting in parked trucks. If there is an unusually large amount of such segregated inventory—which was apparently true in this case, the auditors should have inquired of the client and obtained a reasonable explanation. The old, reliable “scanning year-end transactions to identify large and/or unusual transactions” might also have led to the discovery of Campbell’s sales “shipped to the yard.”
Guaranteed sales: During the first few weeks of a client’s new fiscal year, auditors should review the client’s sales returns and allowances account to determine whether there are any unusual trends apparent in that account. Auditors should be particularly cognizant of unusually high sales returns and allowances, which may signal that a client overstated reported sales for the prior accounting period. Accounts receivable confirmation procedures may also result in auditors discovering an unusually high rate of “charge-backs” by the client’s customers.
In some cases, clients will have written contracts that document the key features of sales contracts. Reviewing such contracts may result in the discovery of “guaranteed sales” or similar transactions. Finally, simply discussing a client’s sales policies and procedures with client personnel may result in those personnel intentionally or inadvertently “tipping off” auditors regarding questionable accounting practices for sales, such as shipping to the yard or guaranteed sales.
Here are definitions of “negligence” and “recklessness” that I have referred to in suggested solutions for questions in other cases. These definitions were taken from the following source: D.M. Guy, C.W. Alderman, and A.J. Winters, Auditing, Fifth Edition (San Diego: Dryden, 1999), 85-86.
Negligence: “The failure of the CPA to perform or report on an engagement with the due professional care and competence of a prudent auditor.” Recklessness: “A serious occurrence of negligence tantamount to a flagrant or reckless departure from the standard of due care.”
After reviewing the definition of “negligence,” ask your students to define or describe a “prudent auditor.” Then, ask them whether they believe that definition/description applies to the PwC auditors assigned to the 1998 Campbell audit.
Here are two hypothetical examples drawn from this case involving what I would characterize as “reckless auditors.”
- A client employee tells PwC auditors that many year-end sales are “guaranteed” and that no reserve has been established for the large amount of returns that will likely be produced by those sales. PwC decides not to investigate this allegation because of manpower constraints on the engagement.
- While reviewing receivables confirmations returned by Campbell customers, PwC auditors discover that approximately one-fourth of those customers indicate that their balances include charges for large amounts of product purchased near the end of the year, product that they did not order or receive. PwC dismisses this unusually large number of similar reported differences as a “coincidence.”
Here is a list of key parties that have been affected by the PSLRA.
- Investors who suffer large losses that they believe were caused by reckless or fraudulent conduct on the part of a given company’s management team, its auditors, or other parties associated with the company’s financial statements. At least some of these investors have likely found it more difficult and costly to recover their losses because of the barrier to securities lawsuits erected by the PSLRA. [Note: Granted, the PSLRA has little impact on the ability of investors to recover losses in those cases involving obvious gross fraud or malfeasance by corporate management or other parties.]
- Some parties have argued that the PSLRA diminishes the overall efficiency of the stock market. These parties argue that by making it more difficult for investors to file lawsuits under the 1934 Securities Act, the PSLRA has resulted in a larger portion of scarce investment capital being squandered by irresponsible corporate executives, which, in the long run, diminishes the strength of our economy and our nation’s standard of living.
- Generally, corporate executives have benefited from the PSLRA since it has reduced, to some degree, their exposure to civil liability.
- As pointed out in the Health Management, Inc., case (Case 1.4), the PSLRA apparently has not been very beneficial to large accounting firms. For whatever reason, in recent years, there has been a general upward trend in federal securities cases alleging accounting irregularities. Not only are independent auditors more likely to be named as defendants in such cases, the settlements in those cases tend to be considerably higher than in other lawsuits filed under the federal securities laws.