Fit Food, Inc.

Our shareholders are demanding better performance form us. Our market evaluation has been basically flat for most of the last decade. At the same time, we need to be making larger investments in our sources of organic ingredients. So we need to ratchet up the performance pressure. We need to do better.

(Sean Wright, CEO, Fit Food, Inc.)

Sean made this pronouncement in May 2008 at a management meeting held just after the Fit Food annual shareholders' meeting. The division managers responded to Sean's call to action, but not all of their responses were what Sean had in mind.

The Company.

Sean Wright founded Fit Food, Inc. (FFI) in 1972. Sean had been working as the Vice President Research and Development (VP, R&D) in a large food company, but he had always wanted to start his own business. In his spare time, he developed a new line cookies, called "Smart Cookies", that he could advertise as being healthier because they were lower in fat and calories. After many struggles to get Smart Cookies placed in major supermarket chains, by the year 2000, Sean and his growing team were able to declare proudly that the Smart Cookies brand were distributed nationally. With more products in development, and taking advantage of the good stock market environment in year 2000, Sean launched FFI IPO. The company's stock was listed on NASDAQ.

By the year 2009, FFI was a medium-sized food company that targeted "tasty-but-healthier" market segments. In 2001, Sean introduced several new snack products and started a Savory Snacks Division. In 2003, he acquired an energy drinks company, which became FFI's Sport and Energy Drinks Division. By 2009, FFI's annual revenues were approaching $500 million. The company was consistently profitable but heavily leveraged, as Sean has funded energy drinks acquisition by increasing the company's debt load significantly.

FFI used divisionalized organizational structure (see Exhibit 1). The general managers of the three relatively autonomous divisions- Cookies& Crackers, Savory Snacks and Sports and Energy Drinks- reported directly to Sean, the CEO. Each division had its own sales and marketing, productions and R&D departments and controller. The corporate staff included human resources, Management Information System, finance, R7D and legal departments. FFI did not have an internal auditing function. It had outsourced the documentation and testing work needed to comply with the Section 404 requirements of the Sarbanes-Oxley Act. Recently, however, Joe Jellison, FFI's Chief Financial Officer (CFO), had suggested that the company was becoming large enough that it should start bringing this work in-house.

2

In 2008, Kristine Todden was assigned as the external auditing firm partner on the FFI account. Kristine considered FFI not to be a particularly desirable client because of persistent request to reduce auditing fees amid threats to solicit bids from competing firms.

FFI's board of directors included five members. Sean was a chair. The other outside directors included in a small company CEO, a CFO of a medium-sized public company, a vice president of marketing at a large supermarket chain, and a practitioner in holistic nutrition. All of the outside directors had been suggested by Sean but approved by the Board's nominating and governance committee. The Board met in person four times a year and also by conference call as needed.

Plan, Reviews and Incentives.

FFI's planning process began in August when corporate managers sent to ach division economic forecast, other planning assumptions, and preliminary sales targets. The sales targets reflected investor expectations of steady growth. Typically each division was expected to increase annual revenues and profits by at least 5%.

Over the following two months, division management created formal strategic plan, which included both a strategic narrative and a high level summary profit and loss statement. The strategic plans were approved by corporate managers in early October. Then division managers developed the elements of their Annual Operating Plans (AOP) for the coming year, which included detailed marketing and new product development plans and pro forma income statements and balance sheets.

Developing the AOPs required many discussions between corporate and division management. The division managers typically argued that they needed to increase their expense budgets to be able to achieve their sales goals, and corporate typically wanted to squeeze expenses to generate increased profits. A fairly standard planning exercise was to ask each division what program or plans they would cut if their profit budget was cut by 10%. Once these programs were identified, the division managers had to justify adding them back to the budget. Tensions between divisions and corporate management increased in 2008 because corporate was asking the divisions to increase their growth rates to 7% to allow some new corporate investment initiatives to be funded internally. At the end of the negotiation processes, the AOPs were presented to the board of directors for approval. The meeting was held in early December.

During the year, performance review meeting were held quarterly. The focus of the meeting tended to be explaining variances between revenue and profit performance goals and actual performance. The meeting was quick and painless when the performance matched and exceeded expectations, but the tone was dramatically different when the quarterly profit goals were not achieved. Catherine Elliot (marketing manager, Cookies and Crackers Division) explained:

Corporate pushes us hard to make our numbers. There is never a

good reason for not making our goals. We're paid to be to be

creative and come up with solutions, not excuses. Sean calls it "no

excuses management."

3

Division presidents and their direct management reports could earn annual bonuses based on achievement of AOP profit targets. The target bonuses ranged from 25% to 100% of the manager's base salary, depending on organization level. No bonuses were paid if division profits fell below 85% of AOP plans. Maximum bonuses 150% of the target bonus amounts were paid if profits exceeded AOP by 25%. Average bonuses exceeded target bonus levels in seven of the first eight years of FFI's history as a public corporation.

Some corporate managers and division presidents were also included in a stock option plan. FFI stock had performed well in the early 2000s, but virtually all the gains were lost in the stock market downturn of 2008-2009. Most of the options were underwater.

The recession of 2008-2009 stressed company operations at the same time that Sean was calling for better financial performance. The Savory Snacks Division performed well and achieved the higher growth rates called for in the both 2008 and 2009. The other two divisions experienced more challenges, however, as is explained below. (Summary income statements for these divisions are shown in Exhibit 2).

Sports & Energy Drinks Division.

The Sports & Energy Drinks Division (Drink Division) was formed in 2003 when FFI acquired a successful. Regional energy drink brand. As part of the deal, Jack masters the former CEO of the acquired company, became a president of the division. Performance in the first few years after the acquisition was good. The targeted drink categories continued to grow; two brand extensions were successfully launched; the Drink Division sales nearly doubled between 2003 and 2006. The division achieved its AOP profit targets easily, and Jack was able to operate without much interference from corporate.

By early 2007, however, Jack saw some clouds on the horizon. The energy drink category was becoming more and more competitive as more players, including some large, well capitalized corporations, entered the category. AT the same time retailers were consolidating and becoming more powerful, increasing pressure on manufacturers to lower prices. Jack began to worry that he might not able to deliver the growth that was expected of his division.

2007

Despite Jack's worries, 2007 was another stellar year, with sales growth exceeding even Sean's increased expectation. The category momentum continued, and Jacks band gained market share, due in part to a successful grassroot advertising campaign.

With performance far exceeding the AOP target and excellent bonuses assured for the year 2007, Jack thought that would be prudent to try to position the division to success in the future. He

4

met with his management team to discuss his concerns and to come up with ideas to get better control over reported profits. Jack and his team decided on three courses of action. The first was to declare a shipping moratorium at the end of the year, which shifted some sales that would normally have been recorded in 2007 and 2008.

Not all Jack's managers are happy about the shipping moratorium plan of action. The production team was unhappy because the moratorium would cause scheduling problems. Some employees would have to be furloughed temporarily at the end of the year to minimize the build up in inventory. Then, in early 2008, they would have to incur some overtime cost for both to accelerate the production and to ship the orders that had accumulated. The sales department were concerned that they would have to deal with customer complaints about shipment delays and product outages. Nevertheless, Jack decided to move forward with the shipping moratorium regardless of the cost, which he considered relatively minor.

The second plan is to build up accounting reserves against account receivable and inventory balances. In 2007, the Drink Division was able to provide a justification for increasing reserves by $1,000,000 over 2006 levels.

The third plan is to repay some expenses that would have normally been incurred in 2008. Among other things, some facility maintenance programs were accelerated, and supplies inventories were replenished before the end of the year. These items were not material, amounting to expenditures of only about $100,000. But, as Jack noted. "Every little bit helps".

2008.

In 2008, some of Jack's fears were realized. As the economy slowed down, customer became more frugal. The once exploding energy drink category began to stagnate; competition of market share grew fierce; and margin declined. In addition, there were rumblings of an impending soft drink "obesity" tax that cut put even more pressure on profits.

The was able to make its annual revenue target in 2008, but the division managers did so by offering an "early ordering program" developed by Sales and Marketing Department. Customers were offered discounts and liberal payment terms if they placed orders scheduled to be delivered before year ended. Discounts range from 5-20% and customers were given 120 days to pay their invoices without incurring interest, rather than the traditional 30 days. However Jack learned later that some of the more aggressive salespeople had told customers to accept the shipments now and "just pay us whenever you sell the products".

While sales remained strong, profit margins decreased significantly. In order to make sure the Division would hit its AOP target, Jack and his controller began to liquidate some of its accounting reserves in the third quarter, and by the end of the year, the reserves were reduced by a total of $1.7 million. The auditors noticed and questioned the change, and brought it to the attention of Joe Jellison, FFI's CFO. Joe looked into the issue and concluded the new reserve levels seemed justified based on historical performance level.

5

2009

Sales started out slowly in 2009, but in the second quarter the sales team landed a major new national account. Because of the uptake in demand, Jack had now become more concerned about meeting production schedules than he was about achieving sales goals. Thus, the early order programs and almost all other promotions and discounts were eliminated.

Jack also told his controller to rebuild reserves, and a total of $2 million in reserves were restored in 2009.Once again the auditors questioned the changed, but the controller provided a justification based on uncertainty in the economy and irregularities in some new customers' payment pattern, Jack believed that his division was well positioned for success going to 2010.

Cookies and Crackers Division.

The Cookies & Crackers Division (Cookie Division) was built around the "Smart Cookie" product, once FFI's flagship brand. But the Smart Cookies product had been struggling for the last several years. Cookies was a slow growth, low margin product category with a strong private label presence, though quality health oriented brands commanded a small price premium. The biggest problem for the Cookie Division, however, was shift in customer mindset. In recent years, "healthy" was likely was to be associated with healthful ingredients such as whole grains, nuts and natural anti-oxidants, a the trend that the Cookie Division management had largely missed.

Scott Hyot, the Cookie Division president, had been with FFI since its inception. Scott had a strong background in sales and was credited with selling Smart Cookie to national accounts, but he was perceived as resistance to change, and his accounting and finance knowledge was relatively weak.

The Cookie Division traditionally relied heavily on a variety of seasonal trade promotions to achieve their volume targets. By 2008, Catherine Elliot, head of Marketing Department, was concerned that the new required 7% growth rate was probably not attainable without both some aggressive marketing and development of some good new products. During the annual planning process, she made a case for increasing the division's advertising and new product development budgets, but her requests were denied. Sean explained that he did not think the advertising was necessary. He also believed that the projects being funded at the corporate level would yield better returns than the proposed investments in Cookies, and FFI could not afford both investments.

2008.

It became obvious early in the first quarter of 2008 that Cookie sales were falling well below the levels forecast in the AOP. The Cookie sales department initiated the promotion to meet the first quarter goals. The specifics of the program were similar to those of the early order program being used in Drink Division- generous discounts and extended payment terms for early orders. The early order program was implemented aggressively. The sales team was told to contact all of their customers and convince them to take early delivery product. Many of these contacts were successful. In most cases, the sales staff received written authorization from their customers, but in some cases the authorizations were only verbal.

6

In the final days of the first quarter, Catherine and Mitch Michaels, head of Sales Department asked shipping to work around the clock to ship as much products as possible before the quarter end. In the last hours of the quarter, trucks filled with cookies drove a few blocks away from the loading docks and parked, so that products was technically "shipped" and sales could be booked.

The heavy sales volume at the end of the quarter attracted the auditor's attention. They concluded, however, that the accounting treatment conformed to GAAP since ownership of the product officially changed at the time of shipment.

In the second quarter of 2008, Scott, Catherine, and Mitch knew they had problem. Second- quarter orders were predictably slow given the amount of extra products had been shipped in the first quarter. The three managers then decided to ship additional, unordered products to their customers. The additional order volumes were generated either by increasing the quantities of actual orders or by entering orders into the company's billing system twice. When customers complained about the unordered shipments, blame was attributed to human errors, and the sales team was charged with the task of making the unordered shipments "stick". They were offered number of tools towards the end, such as special pricing and credit terms and products exchange.

The program worked surprisingly well. Returns increased, but the program still effectively increased revenue by $2.3 million and profit by $460,000. Scott, Catherine and Mitch were encouraged by the results and praised the sales team for their heroic efforts. They continued the program throughout 2008, being careful to rotate the "mistaken" shipment between customers. At the end of the year, the team managed to deliver 97% of the AOP sales and profits.

please answer

No Issues Scenario Discussion/Alternatives Solution I Sales and Marketing Business Strategy 2 Ethics 3 Internal auditing