Expense Transaction Problems for an International Company

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Expense Transaction Problems for an International Company From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York. Case and CommentaryRising Sun Construction Company Abstract Rising Sun Construction is a California company that is anxious to expand its business by entering the Japanese market. Opportunities for overseas companies are tightly limited in Japan, however. When Jerry Blank, the company's business development officer, begins a successful networking effort in Japan, questions are raised about whether his efforts are ethicallyand legallysound. Background Arthur Ono, chief operating officer, had dedicated his working years to Rising Sun Construction, a familyowned California corporation established by his father, Dale Ono, 45 years ago that specializes in heating and air conditioning. He is anticipating that in five years he will replace his father as the chief executive officer, and Jerry Blank, Vice President for Business Development, will be COO. Sitting in his office on the top of the 15story building, Arthur was browsing through the reports on the top of his desk. He lifted his eyes and saw Jerry Blank entering his office. "My travel plans to Japan have been finalized," Jerry said. "I will be leaving this evening for Tokyo." Arthur looked hopeful. "I wish you success. You seem thrilled to revisit Japan. Keep in mind our need to capture a contract in Japan." "Securing a contract is my goal." Both shook hands, and Jerry hurriedly left the office to talk with his executive secretary before his departure to Japan. Jerry Blank was a mechanical engineer who joined Rising Sun on graduation from a state university. During his years at Rising Sun he established a good professional and personal relationship with Arthur. He had, however, ultimately left Rising Sun to pursue a PhD in mechanical engineering. After completing his PhD, Jerry went to work for a multinational construction company headquartered in Chicago, with construction contracts in Indonesia, Thailand and the Philippines. During his years in graduate school and afterwards, he remained in touch with Arthur, and on a few occasions they met for dinner. On a cold February day Jerry received a telephone call from Arthur offering him the newly created position of Vice President for Business Development. Jerry ultimately accepted the position. The warm weather of central California was one attraction, but the deciding factor was the chance to earn a bonus based on contracts received. Arthur had an impressive understanding of the construction business and had assumed many business leadership positions nationally and in California. He had dedicated most of his time to developing opportunities for obtaining contracts. With Jerry's background in business development, he thought Jerry was the right person to succeed him as the business development officer. The accounting and finance area was under Kenneth Gaylord, Vice President of Finance. Arthur did not really enjoy looking at financial and accounting reports. Consequently, he relied heavily on the competence and integrity of Kenneth, a CPA. The financial reporting system used by the company had not been changed since the company was created. Rising Sun was facing a decline in the dollar value of contracts received in the early 1990s. Arthur had been concerned about the effect of any restructuring on his talented and dedicated staff. Across the Pacific, the central, prefectural and local governments in Japan had been expanding their construction of public projects to assist in that country's economic recovery. Arthur had discussed construction opportunities in Japan with Jerry, along with the organizational arrangements that must be established to handle business in Japan. Jerry thought that returning to Japan would be exciting. In college, he spent a year at a Japanese university in Tokyo as an exchange student. The Construction Business in Japan and U.S. Construction Firms Many public construction projects in Japan use limited general competitive bidding, which means only selected qualified bidders are allowed to bid. To be a qualified bidder, one has to have experience in construction in Japan. It is not unusual for contractors who have been invited to bid to participate in dango, literally meaning allowing one contractor to win (called bid-rigging by some). It is not unusual for the winning bid to be close to the cost estimates. The U.S. government had pressured the Japanese government during the U.S.-Japan Structural Impediment Talks to make it possible for U.S. construction companies to participate in construction projects in Japan. A subsidiary of a U.S. company in Japan lacked the construction experience needed to bid for a contract. As a result of U.S. pressure, the required experience in construction would now be evaluated not only on the experience of the subsidiary but also on the experience of its parent company in the U.S. The U. S. Commerce Department had been organizing trade missions to Japan to meet government officials and business leaders to establish personal contacts and to acquaint members of the mission with business opportunities. Arthur selected Jerry to join the latest mission to Japan. The Commerce Department briefed mission members on Japanese business and society and on trade conflicts. Jerry also got a list of readings. Jerry attended all the briefings. He asked his executive secretary to order a number of books on Japan and a subscription to the Nikkei Weekly for corporate use. The mission members stayed four days in Tokyo, and three days each in Nagoya and Osaka. In all three major cities, the delegation met with government officials and discussed a long list of construction projects. Official receptions offered opportunities to establish contacts with government and business leaders. The most enjoyable occasion was when Jerry met Masatoshi Kanemaru on his first day in Nagoya. Kanemaru, 54, was the section head of the planning office of Aichi ken (Aichi Prefecture). Jerry and Kanemaru were both sumo fans. They were able to obtain tickets through close associates to watch the Nagoya sumo tournament. Jerry was impressed with Kanemaru's knowledge of construction in Aichi ken, which confirmed the good reputation of civil servants. Jerry, who knew that civil servants had a great deal of influence on decision making by government units, was determined to establish a lasting friendship with Kanemaru and invited him to a lavish dinner. Kanemaru thought of himself as technically superior to many of his contemporary section heads who had accepted positions with private enterprises that did business with the prefecture. Traditionally, civil servants who retired, usually around the age of 50-55, obtained a position with a company operating in an industry supervised by the civil servant's agency. This was called amakudari or "descent from heaven." When Jerry returned to California he pronounced his trip a success and promised Arthur a written report in few days. Jerry organized the bills he had accumulated and sent them to Sidney Clapp, the chief accountant, with instructions to include them in miscellaneous expenses. Sidney meticulously examined the bills received and immediately included them in the miscellaneous expenses account, since no account number existed for bills written in Kanji (the Chinese characters used in written Japanese). Expansion Potential In a meeting the top officers---Arthur, Jerry and Kenneth--discussed the potential for expanding their business to Japan. "We need Jerry, with his impressive background in Japan, to aggressively pursue contracts there," Arthur said. "I have assigned Jerry to plan for a new venture in Japan. I have decided to send Jerry back to Japan soon to pursue the possibility of being allowed to bid for contracts." Kenneth seemed serious as he responded, "Operating in Japan would require the creation of appropriate financial reports and a management control system. We would also need to examine the applicability of the Foreign Corrupt Practices Act (FCPA). Maybe it is the time to draft a code of professional conduct for the company." Although Arthur thought he might be hesitant to support Kenneth's proposals on a financial reporting and a management control system, he said, "I would like Kenneth to prepare a report on FCPA for the top officers." He dusted off a folder he pulled from his cabinet and began to read the three sentences his father had written as the code of professional conduct for the company he created: "We strive to maintain our good reputation; we abide by all the laws of the U.S.; and we refrain from any activity that might involve a conflict of interest." Approximately three months later, Jerry returned to Nagoya for five days. Kanemaru picked him up at the airport. At his hotel, before he left the car, Jerry pulled out a small bag from his brief case and left it on the seat he occupied. Jerry's days in Nagoya were busy but enjoyable. At lunch, Kanemaru briefed him on the few contracts that the prefecture would allow American firms to bid on, mainly due to political pressure. Jerry handed Kanemaru his gift. Kanemaru, following the American tradition of opening gifts when they are received, asked for permission to open it. The box contained a pair of hand blown crystal vases with cherry blossoms imposed on them. In the next few days, while dining and watching a sumo tournament, they talked in greater detail about the contracts. On his departure, Jerry felt that given the trade negotiations between the U.S. and Japan and the support of Kanemaru, there was a great probability that Rising Sun would be among the American firms invited to bid for construction projects. Jerry once again sent all his bills to Sidney. However, a few days later Jerry received a call from Kenneth. "Jerry, I have concerns regarding the increased size of the miscellaneous expense since you began your trips to Japan," Kenneth said. "My expenses in Japan were legitimate development expenses for a privately held company," Jerry insisted. References and Sources for Information: Amaha, Eriko, Building Hope. Far Eastern Economic Review, v. 162, Apr. 15, 1999, pp. 83-84. Donaldson, Thomas and Thomas W. Dunfee, Ties That Bind. Boston, Massachusetts: Harvard Business School Press, 1999. Geva, Aviva, Moral Decision Making In Business: A Phase-Model. Business Ethics Quarterly. Oct. 2000, v. 10, no. 4, pp. 773-803. Martin, Keith and Sheila Malkani Walsh, Beware the Foreign Corrupt Practices Act. International Commercial Litigation, no. 13, Oct. 1996, pp. 25-27. Merchant, Kenneth A., Modern Management Control Systems. New Jersey: Prentice-Hall, 1998. Commentaries: Expense Transaction Problems for an International Company From the series Ethics and Fraud in Business: Cases and Commentary. Names used are fictitious and do not represent any real person or company. The AICPA neither approves nor endorses this case. The case was developed with support from the AICPA Foundation. Copyright 2003 by the American Institute of Certified Public Accountants, Inc., New York, New York. Case and CommentaryRising Sun Construction Company Commentaries by: Michael A. Santoro, Assistant Professor at the Rutgers Business School Curtis C. Verschoor, CPA, CIA, CMA, CFE, PhD, Professor, DePaul University, Chicago Robert J. Sack, Professor Emeritus of Business Administration, University of Virginia, Darden [Return to Case] Michael A. Santoro, Assistant Professor at the Rutgers Business School "Not knowing what Jerry is up to in Japan creates a huge risk for Rising Sun involving potential violations of the Foreign Corrupt Practices Act (FCPA)". This is an intriguing case that looks at a number of prototypical ethical and legal issues in a growing familyowned company that is tip-toeing into international markets for the first time. The senior Mr. Ono has done quite well during 45 years in business with his simple, homespun ethical precepts, which call for maintaining a good reputation, obeying the law and avoiding conflicts of interest. As the operation of Rising Sun passes on to a new generationincluding the younger Arthur Ono and Jerrythese values are being tested. Certainly, the power of such simple ethical precepts might be lost on Jerry, who earns a good portion of his compensation from bonuses related to sales. It is clear that the company's initial foray into Japan requires it to rethink and restructure its accounting and control systems which, like the elder Mr. Ono's ethical compass, had served the company well thus far. It's hard to tell exactly what Jerry has been up to in Japan. Hard to tell, that is, because as Kenneth, a CPA and vice president of finance, correctly points out, Rising Sun has very loose financial control and management reporting systems. Jerry has managed to convince Sidney, the chief accountant, to record his Japanese travel expenses as "miscellaneous". Among other things, this means that the company doesn't know how much Jerry is spending on gifts and entertainment for his new friend, Kanemaru, the sumo-loving, bureaucratic section head in Nagoya. Not knowing what Jerry is up to in Japan creates a huge risk for Rising Sun involving potential violations of the Foreign Corrupt Practices Act (FCPA). The company could be liable for million of dollars, and corporate officers who knowingly violate the act could even face jail. So Kenneth is very wise to suggest that that the company set up an adequate reporting and control system, familiarize itself with the law, and also draft a code of conduct so that company employees know exactly what the company expects of them when it comes to obeying the FCPA. Jerry is off the mark when he suggests that, as a private company, Rising Sun faces a different standard when it comes to paying bribes to officials. While the FCPA does have different financial reporting obligations for public companies than it does for private ones, the bribery provisions apply with equal force to public and private companies. Thus, even if Rising Sun is not technically required by law to upgrade its accounting and controls, it is in the company's interest to do so. The company would be wise to take whatever steps it can to make sure that Jerry and other employees obey the law, since the company and possibly company officers such as Kenneth and Arthur could be criminally liable for Jerry's actions. In fact, under the Federal Sentencing Guidelines, the financial penalties a business faces if an employee violates the law depend crucially on whether the company has set up an ethics program to try to prevent such violations. That is probably why Kenneth is recommending that the company develop a code of conduct. The bottom line is that the company needs to set up financial controls so that it can determine whether Jerry's gifts and entertainment expenses amount to a bribe. Too much is riding on that determination for Rising Sun to rely on loose and vague accounting entries. Beyond coming to grips with Jerry's activities in Japan, Kenneth is also right in suggesting that the company needs to study the legal issues involved. Jerry's actions raise a number of interesting legal questions that Rising Sun officials must understand thoroughly. Only a superficial account of some of the most obvious questions can be given here. Is Kanemaru making only ministerial decisions, in which case payments to him might be considered facilitating payments, which are legal under the FCPA? Probably not. Is bribery legal in Japan? This is a tricky question because although there appears to be more cultural tolerance for bribery in Japan than in the United States, bribery violates Japanese law. As a result, Jerry and Rising Sun couldn't claim a safe harbor from the FCPA on the grounds that bribery is legal in Japan. A final point to be made about this case is that it raises the very important question of what ethics one should follow in a foreign country. Even if the risk of violating the FCPA does not persuade Rising Sun to account for and control corporate bribery, the company has to ask itself how it wants to do business in other countries. Is it acceptable to bribe officials in Japan even if it's not legal to do so in the United States? While it's important to respect the cultural context when operating overseas, it is also important to stick to a core set of values. For 45 years, Rising Sun has operated on the elder Mr. Ono's strong belief in maintaining a corporate reputation and avoiding conflicts of interest. Bribery creates a conflict of interest for the official taking the bribe. One suspects that the elder Mr. Ono would not want the company to violate his core principles, even in another culture where those principles might not be as strongly held. [Return to Case] Curtis C. Verschoor, CPA, CIA, CMA, CFE, PhD, Professor, DePaul University, Chicago "During his year as an exchange student in Japan, Jerry would likely have learned all he needed to know about gift giving and how to participate in it gracefully". This case illustrates the need to understand not only the laws of a new country in which a company may wish to do business but also the social and cultural mores. As I understand the Japanese culture, gift giving is undertaken not as an expression of esteem or concern for another's well-being but, rather, often reflects only a sense of duty and obligation. To fail to participate in a widespread practice such as reciprocal giving would likely torpedo the chances of a new company, already viewed as an outsider, from gaining a market foothold. During his year as an exchange student in Japan, Jerry would likely have learned all he needed to know about gift giving and how to participate in it gracefully. Jerry would know that his gifts should be of appropriate value for the situation to avoid making their recipient uncomfortable. Embarrassment should be avoided if at all possible. It should be noted that gifting practices in Japan are not the same as those in countries on the Arabian Peninsula. There, monetary "gifts" of significant value are not only expected, but demanded by sheiks in authority as a kind of "tax". One concern for the Rising Sun Company is the ownership of gifts that may be given to Jerry as representative of the company. Jerry would need to understand that any gift of value does not belong to him personally. Rather, it should be considered an asset of the company and be displayed in the company's premises as appropriate. The company might have considered whether to comply with the Foreign Corrupt Practices Act as a business strategy. There is not enough information in the case to clearly determine whether Jerry's actions complied with the act. The friend he made in Nagoya may not have a position high enough to meaningfully influence whether Rising Sun would be granted a contract if allowed to bid on it. Robert J. Sack, Professor Emeritus of Business Administration, University of Virginia, Darden "At a very technical level, we can't simply put a significant sum in "miscellaneous expenses", because it will make the financial statements look silly". This is a very good case that focuses on a set of very real issues. As business becomes more global, and as smaller, family-held companies move into the global marketplace, the question of cultural ethics will be more and more important. Larger, multinational companies (e.g., Shell) are so diverse that they have a culture of their own that transcends national boundaries. Smaller, more localized companies will be forced to cope with other countries' cultures as they find them. This case is a good vehicle for a study of this issue, for both accounting students and practitioners. I would be inclined to take the fact pattern one more step, and ask the participants in the class or the continuing professional education session to assume that Kenneth decided to take his concerns about Jerry's expense report to Arthur, along with a summary of the Foreign Corrupt Practices Act, such as the one found on Professor Nissan's web site. I would then divide the participants into two groups (the chief financial officer and the chief executive officer) and ask: What should Kenneth say to Arthur? How might Arthur respond? I would encourage a discussion between the two groups, noting salient points on the board. I would look for comments such as: From Kenneth: The law says it's a crime to give significant gifts to a government official with the goal of influencing a business decision. The penalties are severe for anyone involved--and that means you and me, as well as Jerry. If it comes out that Jerry tried to buy influence in this way, we will not only be in trouble here but also have a very hard time ever doing business in Japan. When Lockheed paid a bribe to a Japanese official, they thought that bribery was an accepted practice in Japan. But when it all came out, political heads rolled and everyone then said, "No, it is absolutely not accepted practice to pay bribes in Japan." Lockheed was very naive, and was taken to the cleaners. Let's not have that happen to us. To be really honest with each other, we don't know how much cash Jerry may have included in that envelope, and so we don't really know how much to reimburse him. We would never reimburse any employee--even you--for a significant sum based only on the word of the employee. But in these circumstances, Jerry has us over a barrel. We obviously can't ask our Japanese contact for a receipt! At a very technical level, we can't simply put a significant sum in "miscellaneous expenses", because it will make the financial statements look silly. The CPAs will be all over that account, as will the Internal Revenue Service. And don't suggest that we charge that reimbursement to payroll or advertising expense--it's a bribe. From Arthur: Wait a minute, I know something about doing business in Japan, and I believe that it is not only expected that the contracting officer be bought off, but it is also mandatory that we play the game, if we are to do business there. The law is only to be used in extreme situations--when someone has been caught with their hand in the cookie jar. It was passed in a flurry of excitement over Lockheed and United Fruit. It is not now being enforced. Given Washington's focus on terrorism right now, no one is going to make a big deal over an outdated law. Look, I trust Jerry. If he gets us the business, I don't care what it costs or how he gets it. Why are you making such a big deal over the cash portion of Jerry's gift? Why make a distinction between the glassware and the cash? Let's charge some of the cost to travel to Japan and some to business development--and defer some to be charged against the profit on the contract, which I am sure we are going to get. With that conflict on the classroom board, the participants should then be asked to step out of their earlier roles and act as a member of the company's board of directors, perhaps an old friend of Arthur's Dad, and work through how they will deal with the conflict. That discussion might consider: The company and all of the people involved are very vulnerable. It's not fair nor is it smart for Arthur to put the company, Kenneth and Jerry in such a dangerous position. It may well be that the FCPA has not been invoked against a privately held company in recent years, but the odds of being caught are irrelevant: The costs of losing that bet far outweigh any benefit that might be derived. Some of the costs include: 1. Legal penalties for everyone. 2. Terrible publicity here and in Japan. 3. Possible disqualification for government work here. 4. A dangerous precedent within the company. The employees will see it as a place where expediency is the rule. It's clear that Arthur cannot ask for the money back, but it is also clear that he cannot proceed with the bid on this or any other contracts where this official might be in a position of influence. He will simply have to write off Jerry's "gifts" as an educational expense. The participants might then be asked: Suppose Arthur ignores this sage advice, and decides to go forward with the contract proposal and to charge the costs to miscellaneous expense. What should Kenneth do? The managers of Ashland Oil faced that same question some years back. It had been proposed that the company buy a chrome mine from someone who claimed to have an in with the Sheik of Oman, and who could influence the Sheik to sign a long-term crude supply contract with Ashland. Some employees agreed to go along with the plan; some disagreed and quit when it became clear that the CEO was going to implement the idea; and some stayed on but raised objections with the board of directors. They were fired but much later won a large wrongful-discharge suit against the company. The company and the CEO were both sanctioned by the Securities and Exchange Commission. At a minimum, Kenneth has to resign if Arthur refuses to follow his advice. If Kenneth has a strong relationship with members of the board, he may be able to get them involved in an effort to derail this project, but he must recognize that he jeopardizes his working relationship with Arthur if he goes over that executive's head. The same would be true if Kenneth alerted the CPA firm to the transaction, even subtly. Still, Kenneth has a professional responsibility to see that the law is followed and that the company's financial system and financial statements are not compromised. That conflict is an inevitable consequence of his acceptance of the CFO role. There is one additional resource that instructors might find helpful. Tom Donaldson has a strong reputation in the field of international ethics and, in addition to the article cited in the case, he has written "Moral Minimums for Multinationals" (Ethics and International Affairs, 1989), in which he argues that: "If the practice is morally and/or legally permitted in the host country [in this case Japan] but not in the home country, then either (1) the moral reasons underlying the host country's view that the practice is permissible refers to the host country's relative level of economic development or (2) the moral reasons underlying the host country's view that the practice is permissible are independent of the host country's relative level of economic development." In other words, we can see that a developing country might temporarily tolerate a higher degree of noise or air pollution than would otherwise be the case because of a desperate need for the cheapest possible fuel (a type 1 issue) and we can see that nepotism prevails in other countries because of the strength of family or clan in the society (a type 2 issue). He then posits this guideline, to help Arthur and Kenneth: "The practice is permissible if and only if the members of the home country would, under conditions of economic development similar to those of the other host country, regard the practice as permissible." Using Professor Donaldson's guideline, it seems clear that, FCPA or not, Sun ought not participate in the practice of paying for business, which appears to be the practice in Japan