Assume you work as a staff member in a large accounting department for a multinational public company. Your job requires you to review documents relating to the company's equipment purchases. Upon verifying that purchases are properly approved, you prepare journal entries to record the equipment purchases in the accounting system. Typically, you handle equipment purchases costing $50,000 or less.

This morning, you were contacted by the executive assistant to the chief financial officer (CFO). She says that the CFO has asked to see you immediately in his office. Although your boss's boss has attended a few meetings where the CFO was present, you have never met the CFO during your three years with the company. You are anxious about the meeting.

Upon entering the CFO's office, you are warmly greeted with a smile and friendly handshake. The CFO compliments you on the great work that you've been doing for the company. You soon feel a little more comfortable, particularly when the CFO mentions that he has a special project for you. He states that he and the CEO have negotiated significant new arrangements with the company's equipment suppliers, which require the company to make advance payments for equipment to be purchased in the future. The CFO says that, for various reasons that he didn't want to discuss, he will be processing the payments through the operating division of the company rather than the equipment accounting group. Given that the payments will be made through the operating division, they will initially be classified as operating expenses of the company. He indicates that clearly these advance payments for property and equipment should be recorded as assets, so he will be contacting you at the end of every quarter to make an adjusting journal entry to capitalize the amounts inappropriately classified as operating expenses. He advises you that a new account, called Prepaid Equipment, has been established for this purpose. He quickly wraps up the meeting by telling you that it is important that you not talk about the special project with anyone. You assume he doesn't want others to become jealous of your new important responsibility.

A few weeks later, at the end of the first quarter, you receive a voicemail from the CFO stating, The adjustment that we discussed is $900,000 for this quarter. Before deleting the message, you replay it to make sure you heard it right. Your company generates over $9 million in revenues and incurs $8 million in operating expenses every quarter, but you've never made a journal entry for that much money. So, just to be sure there's not a mistake, you send an e-mail to the CFO confirming the amount. He phones you back immediately to abruptly inform you, There's no mistake. That's the number. Feeling embarrassed that you may have annoyed the CFO, you quietly make the adjusting journal entry.

For each of the remaining three quarters in that year and for the first quarter in the following year, you continue to make these end-of-quarter adjustments. The magic number, as the CFO liked to call it, was $500,000 for the second quarter, $700,000 for the third quarter, $1,000,000 for the fourth quarter, and $900,000 for first quarter of the following year. During this time, you've had several meetings and lunches with the CFO where he provides you the magic number, sometimes supported with nothing more than a Post-it note with the number written on it. He frequently compliments you on your good work and promises that you'll soon be in line for a big promotion.

Despite the CFO's compliments and promises, you are growing increasingly uncomfortable with the journal entries that you've been making. Typically, whenever an ordinary equipment purchase involves an advance payment, the purchase is completed a few weeks later. At that time, the amount of the advance is removed from an Equipment Deposit account and transferred to the appropriate equipment account. This hasn't been the case with the CFO's special project. Instead, the Prepaid Equipment account has continued to grow, now standing at $4 million. There's been no discussion about how or when this balance will be reduced, and no depreciation has been recorded for it.

Just as you begin to reflect on the effect the adjustments have had on your company's fixed assets, operating expenses, and operating income, you receive a call from the vice president for internal audit. She needs to talk with you this afternoon about a peculiar trend in the company's fixed asset turnover ratio and some suspicious journal entries that you've been making.

Required (dollars are in thousands):

1. Complete the blank cells in the first table in the Excel document on D2L to determine what the company's accounting records look like after you made the journal entries as part of the CFO's special project. Note that when you made the journal entry, the Property and Equipment, Net account accumulated the magic numbers each quarter. For example, in Q1 Year 1 the entry to Property and Equipment, Net account results in a balance of $38,000 plus $900 or $38,900. In Q2 Year 1 the amount would be $33,000 plus $900 from the prior quarter plus another $500 for the current quarter or $34,400 and so on. Included in your workbook spreadsheet are the adjustment amounts for each of the 5 quarters so you can refer to those cells when doing your calculations. Also note the operation expenses will be reduced each period by the amount capitalized in that period. For example, in Q1 Year 1 operating expenses would be reduced by the $900 and in Q2 Year 2 operating expenses would be reduced by $500.

2. Complete the second table in the Excel document on D2L using the before the magic entry numbers. You will need to compute the fixed asset turnover ratio (rounded to three decimal places) for the periods ended Q2Q4 of year 1 and Q1 of year Note you cant answer this for Q1 of Year 1 because you dont have beginning Property and Equipment, Net. For these same 4 quarters also calculate the net profit margin before the magic entry.

3. Before your meeting with the vice president for internal audit, you think about the variety of peculiar circumstances surrounding the special project for the CFO. Discuss at least three things you think are peculiar circumstances surrounding the special project.

4. Your meeting with internal audit was short and unpleasant. The vice president indicated that she had discussed her findings with the CFO before meeting with you. The CFO claimed that he too had noticed the peculiar trend in the fixed asset turnover ratio, but that he hadn't had a chance to investigate it further. He urged internal audit to get to the bottom of things, suggesting that perhaps someone might be making unapproved journal entries. Internal audit had identified you as the source of the journal entries and had been unable to find any documents that approved or substantiated the entries. She ended the meeting by advising you to find a good lawyer. Discuss in a few sentences, how should you have handled the situation with the CFO in order to avoid your lawsuit.

5. In the real case on which this one is based, the internal auditors agonized over the question of whether they had uncovered a fraud or whether they were jumping to the wrong conclusion. The Wall Street Journal mentioned this on October 30, 2002, by stating, it was clear . . . that their findings would be devastating for the company. They worried about whether their revelations would result in layoffs. Plus, they feared that they would somehow end up being blamed for the mess. Beyond the personal consequences mentioned in this quote, discuss in a few sentences what other groups could be affected by the findings of the internal auditors and how the findings would potentially affect them.

Epilogue:

This case is based on a fraud committed at WorldCom (now called Verizon). The case draws the magnitude of its numbers, the nature of the unsupported journal entries, and the CFO's role in carrying out the fraud from a report issued by WorldCom's bankruptcy examiner. Year 1 in this case was actually 2001 and year 2 was 2002. This case excludes other fraudulent activities that contributed to WorldCom's $11 billion fraud. The 63-year-old CEO was sentenced to 25 years in prison for planning and executing the biggest fraud in the history of American business. The CFO, who cooperated in the investigation of the CEO, was sentenced to five years in prison.

agic entry amounts by quarter mounts in thousands of US dollars Q1 Year 1 900 Q2 Year 1 500 Q3 Year 1 700 Q4 Year 1 1,000 Q1 Year 2 900 Hestion #1 (fill in the blank cells) Amounts in thousands of US dollars perty & Equipment, net les Revenue perating Expenses come from Operations (before taxes) Q1 Year 1 (March 31) Before your After your magic entry magic entry $ 38,000 9,000 8,000 1,000 Q2 Year 1 (June 30) Before your After your magic entry magic entry $ 33,000 9,100 8,500 600 Q3 Year 1 (Sept 30) Before your After your magic magic entry entry $ 35,000 8,900 8,600 300 Q4 Year 1 (Dec 31) Before your After your magic entry magic entry $ 36,000 8,700 8,900 (200) Q1 Year 2 (March 31) Before your After your magic magic entry entry $ 37,000 8,800 8,200 600 agic entry amounts by quarter mounts in thousands of US dollars Q1 Year 1 900 Q2 Year 1 500 Q3 Year 1 700 Q4 Year 1 1,000 Q1 Year 2 900 Hestion #1 (fill in the blank cells) Amounts in thousands of US dollars perty & Equipment, net les Revenue perating Expenses come from Operations (before taxes) Q1 Year 1 (March 31) Before your After your magic entry magic entry $ 38,000 9,000 8,000 1,000 Q2 Year 1 (June 30) Before your After your magic entry magic entry $ 33,000 9,100 8,500 600 Q3 Year 1 (Sept 30) Before your After your magic magic entry entry $ 35,000 8,900 8,600 300 Q4 Year 1 (Dec 31) Before your After your magic entry magic entry $ 36,000 8,700 8,900 (200) Q1 Year 2 (March 31) Before your After your magic magic entry entry $ 37,000 8,800 8,200 600