Evaluating an Ethical Dilemma: Earnings, Inventory Purchases, and Management Bonuses

Micro Warehouse was a computer software and hardware online and catalog sales company. * A Wall Street Journal article disclosed the following:

MICRO WAREHOUSE IS REORGANIZING TOP MANAGEMENT

Micro Warehouse Inc. announced a “significant reorganization” of its management, including the resignation of three senior executives. The move comes just a few weeks after the Norwalk, Conn., computer catalogue sales company said it overstated earnings by $28 million since 1992 as a result of accounting irregularities. That previous disclosure prompted a flurry of shareholder lawsuits against the company. In addition, Micro Warehouse said it is cooperating with an “informal inquiry” by the Securities and Exchange Commission.

Source: Stephan E. Frank, The Wall Street Journal, November 21, 1996, p. B2.

Its Form 10-Q quarterly report filed with the Securities and Exchange Commission two days before indicated that inaccuracies involving understatement of purchases and accounts payable in current and prior periods amounted to $47.3 million. It also indicated that, as a result, $2.2 million of executive bonuses for 1995 would be rescinded. Micro Warehouse’s total tax rate is approximately 40.4 percent. Both cost of goods sold and executive bonuses are fully deductible for tax purposes.

Required:

As a new staff member at Micro Warehouse’s auditing firm, you are assigned to write a memo outlining the effects of the understatement of purchases and the rescinding of the bonuses. In your report, be sure to include the following:

1. The total effect on pretax and after-tax earnings of the understatement of purchases.

2. The total effect on pretax and after-tax earnings of the rescinding of the bonuses.

3. An estimate of the percentage of after-tax earnings management is receiving in bonuses.

4. A discussion of why Micro Warehouse’s board of directors may have decided to tie managers’ compensation to reported earnings and the possible relation between this type of bonus scheme and the accounting errors.

* Micro Warehouse declared bankruptcy in 2003.