Question 2. (30 marks)

Zero Cold Storage operates a system of refrigerated warehouses across Canada and the United States. During June 2014, the Ontario Securities Commission filed charges under the Ontario Securities Act against four senior officials of the company, including its CEO. The company itself was not charged; it cooperated with the investigation, taking steps to remedy the problems.

The OSC charged that during 2011-2013, Zero had engaged in several types of financial statement manipulations. One tactic was to capitalize certain costs that, according to GAAP, should have been charged to expense. Another involved deferring recognition of a large customer claim for damaged goods from 2011, where the OSC argued that it belonged, to 2012. A third tactic was to disguise breaches of debt covenants by a subsidiary company by advancing money to the subsidiary at financial statement dates. These advances were repaid shortly thereafter. According to revised financial statements filed by the company, net income was originally reported too high by $5.2 million for 2011 and $32.4 million for 2012. The company officials charged by the OSC are fighting these charges.

The company also faced a class-action lawsuit by investors. In 2015, this lawsuit was settled, without admission of liability, by a deposit from Zero of $5.5 million into a fund to reimburse investor losses.

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(10 marks) Evaluate the short-run (i.e., one year) and long-run effectiveness of capitalizing expenses as an earnings management device.

(15 marks) It was suggested that the motivation for some of the claimed manipulations was to meet earnings targets. Why is it important to managers to meet earnings targets? Is it justified?

(5 marks) Who was intended to be benefitted by these actions? Explain briefly.