Legality and Ethicality of Financial Reporting Essay
Legality and Ethicality of Financial Reporting
As the case of Excello Telecommunications is reviewed it can be seen that the CFO was facing financial difficulties due to increased competition. In 2010 the earnings estimate was not going to be met and this would have affected the bonuses, stock options, and the share prices of the Excello stocks. After discovering a large sale that was pending until the shipment could be made for the following year the CFO asked the company controller to find a way to capitalize on the sale in the current year so that the budget shortfall could be met. The only way to accomplish the task was to work around the rules of accounting. The intent to find a way around the rules presents possible legal issues. This case can be evaluated by the Sarbanes-Oxley Act and the AICPA and we look at the financial reporting standards and ethics involved.
The CFO of Excello, Terry Reed, discovered that the company made a sale of $1.2 million dollars on December 20, 2010 but it could not be recorded until January 11, 2011 because the purchasing company’s warehouse capacity could not accommodate the equipment. After this discovery Reed determined that the monetary shortfall for 2010 could be solved if the company could record the sale for 2010 instead of in 2011. The Controller, Marty Fuller, for the company approached the accounting department and there were three possible ways found to work around the dilemma. The first was to transfer the product to an off-site warehouse that was owned by Excello by December 31 and hold it there until January 11 when it could be shipped to the purchaser. The second would be to transfer the product to the purchaser by December 31 and offer a full refund upon return. The third option is to offer a ten percent discount to the purchaser if they accept the product by December 31.
In reviewing this case it can be seen that there are legal issues that are involved. The controller of the company is fully aware of the rules of accounting and is willing to work around them at the request of the CFO practicing earning management in an effort to achieve the company financial goal. Excello cannot legally report the income of the $1.2 million dollar sale in 2010 due to the fact that it will not be shipped until 2011. If the sale is recorded the way the CFO wants it to appear the company would be artificially inflating the profits for the year 2010. If the sale is recorded in 2010 it will be overstated earnings and will violate the GAAP for revenue recognition. The revenue recognition rule is stated so that the goods are to be delivered to the buyer before revenue can be recorded. Falsely reporting this will artificially inflate the revenue and is deceiving to the shareholders. The Sarbanes-Oxley Act (SOX) was designed so that it could regulate the rules and regulations and appropriately guide companies in reporting their financial statements and performing audits.
The CFO for Excello decided to use earning management practices and falsely inflate the financial statement from 2010 in order to meet the earnings estimate it and in doing so breached Section 302 of the SOX codes. Section 302 of the SOX is the Corporate Responsibility for Financial Reports and states “This section requires the certification of periodic reports filed with the SEC by the CEO and CFO of public companies. (Mintz & Morris, 2011)” The reports that will be filed by Excello for the 2010 year with the SEC will contain false information and in doing so will violate the code. The goal of the SEC is to protect activities and interests of investors, lenders, and companies. The artificial inflation for earned revenue in 2010 by Excello causes risks to the investors, lenders, and shareholders as it is fraudulent information that is reported and is an unethical practice. The unethical financial reporting that Excello considered in this case goes against the AICPA Code of Professional Conduct.
The AICPA holds Certified Professional Accountants to a high ethical standard. As the Excello Company reports revenue prematurely it violates several of the principles that the AICPA is built on. The reasoning of the decision to prematurely record $1.2 million dollars was based on bonuses, stock, and shareholders and was not done in the interest of the public. This decision could have affected the integrity of the company as the trust to the public, clients, and lenders would be broken. The decision to artificially inflate the profits for the year 2010 proves to be unethical in the terms of the AICPA. Putting the bonuses, stock options, and the share prices ahead of the public interest is unethical behavior and unaccepted by the AICPA, GAAP, or SEC. The accounting department for Excello came up with three ways that the rules of the GAAP could be bent in order to accommodate recording profits earlier than appropriate. The first was to ship to an offsite warehouse owned by Excello by December 31, 2010 and ship it again on the requested January 11, 2011 date.
The second was to transfer the product to the buyer by December 31 and offer a full refund if retuned to Excello. The third option was to offer the buyer a ten percent discount to take the product by December 31, 2010. Of the three options the best alternative seems to be offering a discount if the customer takes the product by December 31, 2010. Giving discounts to a buyer is not an uncommon practice and is not an illegal practice that is defined by the GAAP or the SEC. If the product is delivered to the buyer by the December 31, 2010 deadline the sale will be legitimate and the $1.2 million dollars can be appropriately recorded in 2010. Transferring the product to the buyer before January in order to make the earnings estimate and procure the bonuses and stock options is not the most ethical reason but does not appear to be illegal.
The CFO of the company asked the controller to find a way around the GAAP regulations in order to record a large sale by the end of the 2010 year that would have been otherwise legally recorded in 2011. After reviewing the GAAP regulations it is seen that recording a sale before the buyer takes ownership is a fraudulent recognition of profit. The process of recording and recognizing revenue before it is actually due is illegal in the eyes of the SEC. This artificial inflation of profits can affect the public and investors in the company. The unethical behavior of fraudulent profit recording goes against the AICPA Code of Professional Conduct as well because it puts the company ahead of the public interest.
There were three options given by the accounting department to solve the issue of the year-end profit earnings. Of the three options presented, the third was to offer a discount in order for the customer to take delivery of the product by the deadline allowing for profits to be recorded legally. It is understandable that a company needs to make the earnings estimate, however it should be done legally and no CFO or CPA should consider bending the rules set forth by the GAAP. The idea of trying to work around the rules and guidelines set forth by the GAAP is unethical behavior.
Mintz, S. M., & Morris, R. E. (2011). Ethical Obligations and decision making in accounting (2nd ed.). New York, NY: McGraw-Hill/Irwin.