AF611 Earnings Management Report

Lets take the DeLorean (the car that can do the time travel in the movie, Back to the Future) and go back to July 1996. Suppose you are the notorious turnaround specialist, Chainsaw Al Dunlap. On July 1, 1996, you are appointed as CEO (Chief Executive Officer) for Sunbeam Corporation to turn the company around. In your compensation package, the bonus will be calculated based on the increases in the stock price and the earnings per share (i.e., net income). Also you received 2.5 million shares of stock options in the pay package that you can exercise after one year of service. Sunbeams fiscal year ends on Dec. 31. As you will be working as CEO for only 6 months in 1996, your bonus will start from the next full fiscal year, i.e., start from the fiscal year 1997, based on your performance of year 1997. Regarding the earnings per share (EPS) component in your bonus, your bonus will be calculated as $10,000 per every $0.01 increase in EPS from the average EPS of the last three years, 1994, 1995, and 1996, for example, $10,000 x [actual EPS of 1997 minus average EPS of 1994, 1995, and 1996]. There is no upper limit in your bonus plan. The basic EPS were $1.02 and $0.46 in 1994 and 1995, respectively.

Additional Information:

Sunbeam has been using the aging method to estimate the bad debt expenses.

Sunbeam has been using the LIFO method for some inventories and the weighted average

method for other inventories. During 1996, input prices have been rising, but are

forecasted to decrease in year 1997.

Sunbeam has a huge amount of PP&E purchased before 1996 and still needs to purchase

additional PP&E in year 1996 for the operation.

Sunbeam has issued many bonds during the past 10 years when the market interest rates

were generally low. The market interest rate has gone up recently and is expected to

keep going up in 1997.

Sunbeam offers defined benefit retirement plan for its employees.

Required:

A. (50 points) Your goal is to maximize the bonus that you will receive at the end of year 1997. Remember that your bonus will start from the fiscal year 1997, not 1996. Provide how you can maximize your bonus in the year 1997 by playing with the following accounts in both years 1996 and 1997. (You have to provide your answers for two years. If you provide your answers only for one year, you will get partial credits.) Everything has to be legal as you dont want to spend time in prison.

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(1) Accounts Receivable 1996

1997

(2) Inventory 1996

1997

(3) PP&E 1996

1997

(4) Bond Payable 1996

1997

(5) Pension plan 1996

1997

B. (10pointsandmore)Inadditiontoyoursuggestionsontheaccountslistedabove, provide (at least two) other clever ways that you can think of based on your learning from the class to maximize your bonus. Again, they have to be legal.