Madison Gilmores Ethical Dilemma

South City Electronics is involved in printed circuit board assembly (PCBA) dealing with the assembly of complex electronic system processes. The electronics company, based in the city of South San Francisco, is publicly owned with three other locations in the San Francisco Bay Area. Josh Goldberg is the chief executive officer of the company.

Ethical Dilemma

It's March 30, 2017 and Madison Gilmore, controller for South City Electronics, has just gotten off the phone with her supervisor, South Citys CFO David Levin, who reiterated the points he made in a face-to-face meeting with her earlier that daythat the company would be in default on a $10 million loan if its cash flow and earnings for the quarter ended March 31, 2017, did not meet set goals in the loan agreement. Right now the companys cash flow is $620,000 and the earnings are $160,000. This is $380,000 and $240,000, respectively, below prescribed levels. Gilmore knows her boss wants her to agree to revenue treatment for an arrangement with Victor Systems to prepay revenue on a scheduled $1.2 million sale that would put the company above the debt covenant requirements. The goods are scheduled to be sent to an offsite distribution warehouse on March 31, 2017. The sale is scheduled to be completed and goods shipped to the customer on April 5, 2017.

Gilmore is agonizing about what she should do. She knows it would be wrong to record the transaction as revenue in the first quarter of 2017. However, she is under a great deal of pressure to do so. Her boss said it was a one-time request and that she needed to be a team player in this instance.

Facts of the Case

Levin and Gilmores face-to-face meeting featured an acrimonious dispute over whether to record the $1.2 million as revenue: Madison, we have fallen below debt covenant requirements, Levin said. The only option is to accelerate the sale to Victor Systems. Ive already spoken to Bob Victor, and he has agreed to the transaction and cash payment by the close of business tomorrow so long as we discount the sale by 10 percent. Even with that discount we will be above debt covenant requirements. The accounting rules are quite clear on this matter, Gilmore said. Generally accepted accounting principles require us to record the transactions as of March 31 as deferred revenue because the sale will not be completed until April 5. I understand your concerns, Madison, and respect your position. I am a CPA as well and am quite clear on the GAAP rules. However, there is an extra feature in this arrangement that justifies the recording of revenue this quarter. Whats that? Ethical Obligations and Decision Making in Accounting, 4/e 2 2017 by McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. We are going to ship the merchandise to an off-site distribution warehouse that we oftentimes use as a holding facility until a customer asks for goods to be sent to its location. Is it our warehouse or Victor Systems warehouse? Gilmore asked. Neither. The warehouse is owned by Kelly Electronics, a company located next door to Victor. So you see, Madison, we can record the sale as if it went to Kelly, and that company will sell it to Victor. Who is the end user? Gilmore asked. Victor Systems. In my mind that means we still cant record the revenue this quarter. Can you point to any specific accounting standard that supports your opinion? Levin asked. Maybe not a specific opinion, but it is my professional judgment that the entry should be recorded as deferred revenue and a footnote added to the quarterly statements describing the warehouse holding arrangement. Thats not going to happen. There is no way Josh will agree. Asking him to defer the revenue is bad enough, but throwing in a footnote disclosure will not only place us in default on the loan terms but also will unnecessarily create some doubt in the mind of others who might read that note and wonder about our accounting practices. Besides, this is simply an operational decision and not an accounting manipulation. At that point Levin received a call from Bob Victor, who wanted to review the terms of the shipment. Levin excused himself and told Gilmore they would talk later in the daythe followup phone call referred to above. As Gilmore contemplates the phone call and meeting earlier that day with Levin, Sue Block, the assistant controller, drops by and asks if Gilmore had heard about the phone call between Levin and Bob Victor. Gilmore says she hasnt. She figures Block has dropped by her office because she had shared her concerns with Block earlier about what she was being asked to do after the meeting with Levin. Block fills Gilmore in in on the details of the conversation. Gilmore asks how Block knows the details. Block says she overheard a conversation in the office of Josh Goldberg between the CEO and Levin. Figuring the less she knows the way Block found out about that conversation, the better, Gilmore changes the topic. Gilmore brings Block up to date on the follow-up phone conversation with Levin and asks Block for her advice. Block reminds her that she has always preached acting on ones values. Gilmore nods, adding I know. That has been my mantra for the past five years since I joined the company. Block says this might be one of those times in life when Gilmore should act on her conscience regardless of the consequences. Gilmore seems to understand quite well what she has to do. After the discussion with Block, Gilmore starts to prepare for a 5:00 p.m. meeting between Josh Goldberg, David Levin, and herself to resolve the matter of accounting for revenue on the Victor sale. She is trying to develop a game plan to voice her values and convince Levin and Goldberg why the company should not record the revenue in the March 31, 2017, quarter.

1. Is the accounting for revenue in the Victor transaction a case of operational earnings management or accounting earnings management? Explain. Briefly address auditing challenges of this kind of a transaction. Extended Discussion of Bill-and-Hold Transactions such as GAAP and SEC criteriaWhat should the auditor do?

2. Who are the stakeholders in this case and what are their interests? Use ethical reasoning to evaluate the appropriateness of Levins request.

3. Assume you are in Madison Gilmores position. Answer the following questions as you prepare for the meeting with Levin and Goldberg.

What are the main arguments you are trying to counter?

What is at stake for the key parties, including those who disagree with you?

What levers can you use to influence those who disagree with you?

What is your most powerful and persuasive response to the reasons and rationalizations you need to address?

4. Assume the meeting concludes and nothing has changed. Gilmore failed to change the minds of Levin and Goldberg.

5. At this point would you recommend to Gilmore that she should go to the audit committee with her concerns? Explain your reasoning.

Assume Gilmore goes to the audit committee and nothing changes. The revenue was recorded as earned revenue as of March 31. The goods were shipped to the warehouse on that day. The sale was completed on April 5. A refinancing of the $10 million loan was made shortly after April 5.

-. If you were in Madison Gilmores position, would you blow the whistle on what you perceive to be the manipulation of the earnings for the quarter ended March 31? Under what circumstances might you blow the whistle? Who would you contact to inform them of what you consider to be earnings manipulation?