Case 7-3 Managing Earnings and Putting Ethical Leadership to the Test

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Jeremy Strong, CPA was recently hired as the new CFO of Imageware Consolidated (IC) a small publicly owned company. This is Jeremys first job outside of public accounting, leaving Deloitte after ten years, where he rose in the ranks to senior audit and assurance manager. IC is a rapidly growing and trend setting company in the sportswear industry. They are being compared to an early-stage Nike or Under Armour and Jeremy is excited by the prospect of working for a company that appears to have tremendous growth potential.

During Jeremys recruitment, he was told by the CEO, that the old CFO was forced to retire for health reasons. The CEO stated that IC really needed someone who would hit the ground running. Specifically, the CEO said that IC needed someone to step into this role who had a firm grasp of SEC reporting requirements and was comfortable speaking with all the various stakeholder groups including industry analysts who were following the company closely.

One of Jeremys first tasks was to prepare for an earnings-call where he would be introduced as the new CFO. He had just one week to prepare for that call. Jeremy spent that first week in meetings with ICs Controller, Samantha (Sam) Bee, CPA and other executives who provided him with reams and reams of financial and operational data to help bring him up to speed and prepare him for the call.

In one discussion with Sam, Jeremy was told that the company has been able to meet or exceed the analysts consensus EPS estimates every quarter since going public two and a half years ago. She explained that the company relies heavily on a continuous flow of financial data (actual and forecasted) from the financial reporting group that she oversees. Sam explained that their expertise in forecasting provides the company with an early warning system of sorts that has enabled the sales and marketing department to make very sound operational decisions quarter after quarter, resulting in their ability to meet or beat analysts expectations. She was clearly proud of the work she was doing. The hairs on the back of Jeremys neck rose a little as he listened to what Sam was telling him.

In response, Jeremy asked Sam to explain what she meant by operational decisions. Sam stated that while there has been a steady increase in demand for their products year over year, there are seasonal swings and other trends that can impact monthly and quarterly sales demand in the sportswear industry. She explained that the sales and marketing department have the authority to use a variety of techniques to entice ICs customers to purchase their products (earlier then they would have otherwise) including things like rebates, discounts, free products, and even extended payment terms.

Jeremy then asked Sam whether these practices had been disclosed publicly. Without realizing it he held his breath as we waited for her response.

1. Explain how the sales and marketing incentives used by IC represent earnings management. In your response explain why Jeremy asked about disclosure of these practices.
2. The case states that the hair on the back of Jeremys neck rose during a discussion with ICs Controller when he learned about the first of several red flags outlined in the case. Identify and discuss at least three actual and two potential red flags.
3. What additional questions should Jeremy ask to help assess the ethical culture within the organization?