The Case of Mattel and Internal Controls!

When he joined Mattel in May 2017, Brett Whitaker2 shadowed Mattels Vice President of Tax, Clara Wong, to familiarize himself with the companys processes. Whitaker immediately observed problems in Mattels internal controls for tax and accounting, such as: (1) critical documents stored in unorganized boxes without electronic backups; (2) employees responsible for inputting underlying financial statements could not answer basic questions; and (3) inexplicable accounting blunders. Wong reported to Joseph Euteneuer, Mattels CFO, and frequently discussed these deficiencies with Whitaker. PwC, Mattels outside auditor, and Joshua Abrahams, its lead audit partner, could not explain how past quarters numbers were reconciled, and they had been signing off on Mattels financial statements for years. There was ineffective communication between the tax department and the Financial Planning and Analysis department, and Mattel lacked an informal control or formal process for determining, documenting, and confirming its tax valuation allowance. Mattels audit manager told Whitaker in July 2017 that Mattels controls for compliance with the Sarbanes- Oxley Act of 2002 were either non-existent or extremely dated and agreed that the problem needed to be addressed. On September 30, 2017, Mattel evaluated whether to record a valuation allowance against its $580,000,000 of deferred tax assets. Whitaker reported that recording a valuation allowance against Mattels deferred tax assets would have negatively impacted Mattels earnings, tanked Mattels financial performance, and tells investors that you do not see the ship turning around any time soon. Following extensive discussion, but without an internal control in place to assess an allowance, Mattel and PwC initially declined a valuation allowance. But with approximately one week left in the closing process, Mattel and PwC decided that Mattel was required to record a valuation allowance, largely because Mattel decided to write-off approximately $100,000,000 in receivables from Toys R Us, Mattels biggest customer, following its recent bankruptcy filing. Given Mattels control deficiencies and the one-week timeline to calculate the allowance, Whitaker had little confidence in what [they] were reporting because, [t]ypically, there is a trail of documentation that supports what you are reporting, and that just did not exist. Whitaker and his team ultimately calculated a valuation allowance of roughly $175,000,000 to $200,000,000. Days before Mattel was to report third quarter earnings on October 26, 2017, PwC discovered a material error in the way the valuation allowance was calculated that required Whitaker and his team to quickly and haphazardly redo the entire tax entry. The error arose because Mattel wrongly offset its deferred tax assets by netting out the value of certain deferred tax liabilities. The recalculation increased the tax valuation allowance to $562,000,000 and reduced Mattels 1 All information in this Case is copied verbatim from a court filing with the United States District Court in the Central District of California (Case No. 2:19-cv-10860-MCS-PLA, document 74 filed January 26, 2021). 2 Brett Whitaker is an experienced tax professional with a Master of Professional Accountancy - Taxation from the University of Washington, 8 years of experience working with Ernst & Young and 6 years of experience in the tax departments of large public corporations. 2 income by the same amount. Throughout this process, draft financial statements were regularly shared with senior Mattel executives and those statements varied significantly by hundreds of millions of dollars. Despite the errors severity, PwC did not require the disclosure of any material weakness, and nothing was done to repair the Companys internal controls. Mattel filed its third quarter Form 10-Q on October 26, 2017, reporting the $562,000,000 valuation allowance, a $603,000,000 quarterly loss, and CFO Euteneuer and Margaret Georgiadis, Mattels CEO certified that Mattels internal controls were effective as of September 30, 2017. In January 2018, Whitaker and another Mattel tax executive, Dermot Martin, set up a meeting to review all existing documentation relating to the netting issue and the classification of Mattels intangible assets. It was concerning to Whitaker that Mattel had just published its third quarter 2017 financials and relied on a solitary spreadsheet to calculate a $562 million entry for which Martin did not even know where the supporting documentation was. Whitaker eventually found a chart with numbers and values listed on it that referenced the intellectual property assets and values that were set forth on the spreadsheet that Martin had supplied to support the recalculation of the third quarter valuation allowance. The chart described Mattels HiT Entertainment Ltd. Asset (HiT IP), valued

at $311,000,000, which Mattel treated in the third quarter as having a finite life (i.e., amortizing over a fixed period) and therefore netted the deferred tax liability resulting from the HiT IP against Mattels deferred tax assets, thereby reducing its valuation allowance. Whitaker noticed that the HiT IP was listed on the [chart] as having no amortization, meaning that the deferred tax liability related to this asset should not have been used to reduce/net against Mattels deferred tax assets or the Companys allowance in the third quarter. This error meant that Mattels valuation allowance and third-quarter loss were understated by roughly $109,000,000. Whitaker immediately called Wong to walk her through the error and scheduled a meeting with Mattel executives, who all agreed that this was a serious error in Mattels financial statements. Even so, Mattels Senior Vice President of Accounting stated, We cannot have a material weakness. That would be the kiss of death. The team was holding out a thin sliver of hope that perhaps Mattel might be able to find a way to characterize it differently. After a later meeting, Mattel leadership determined that Mattels third-quarter financials would have to be restated, and Mattel would have to disclose a material weakness. This determination was reaffirmed in a subsequent meeting with Mattels legal team. The meeting participants decided to communicate this conclusion to CFO Euteneuer, and then set up a meeting with PwC to communicate the findings to them. Wong later told Whitaker that during the meeting with PwC, Josh Abrahams immediate response, to everyones surprise, was that we cannot have a material weakness and we need to figure out a way for that not to be the result. "the mandate from Abrahams was for everyone to see what kind of a technical argument we could make to avoid a restatement and avoid reporting a material weakness. Wong later communicated to Whitaker that PwC had manufactured a plan to avoid a restatement - to change the classification of the HiT IP asset from an indefinite-lived asset to a finite-lived asset retroactively as of October 1, 2017. Although both Mattel and PwC concluded that Mattels third-quarter 2017 financial statements contained a material misstatement, none of the senior Mattel executives involved in this determination... informed Mattels Audit Committee of the misstatement. Moreover, CFO Euteneuer and PwC audit partners failed to report the known errors and material weaknesses to the Audit Committee despite the fact that they met with the Audit Committee specifically to discuss the accuracy of the Companys 2017 financial statements, including the existence of any material weaknesses, so that the Audit Committee could approve their filing with the SEC.

Before Mattel filed its 2017 Form 10-K, Martin discovered a third error valued at roughly $20,000,000 stemming from Mattel wrongly netting certain deferred tax liabilities related to indefinite-lived assets. PWC netted other, immaterial errors against this one to take it below the materiality threshold and avoid having to report it. When the issue was resolved and the audit was completed, a primary PwC partner walked through the halls of Mattel high-fiving people to celebrate the fact that there would be no restatement and the 2017 audit was finally signed off on. Mattels 2017 Form 10-K did not disclose the material weaknesses in internal controls from which it suffered, that it had concocted a plan to avoid restating its third quarter results, or other inadequacies.

Please answers this questions.

QUESTIONS 1. Identify the section in the AICPA Codification that addresses Bretts ethical issues. 2. What are the threats that Brett must address? 3. What actions should Brett take in this situation to assure that the threats are at an acceptable level? 4. Identify other ethical concerns regarding the actions and decisions of the other parties in the case (e.g., Clara Wong, Joseph Euteneuer, Josh Abrahams, Margaret Georgiadis, etc.).