An article in The Wall Street Journal indicated that dressmaker Fallo Me (name changed) backdated invoices to record revenue in the quarter before sales were actually made. As long as sales remained strong, the practice went undetected. When a recession hit retailers, however, revenue sagged and it became more difficult to cover one quarter’s shortfall with anticipated revenue from the next quarter.
Fallo Me’s compensation plan included bonuses for the chief operating officer and the chief financial officer if the company’s net income reached $16 million (approximately 2 percent of sales). The company reported a net income of $23 million, and the two executives received bonuses. The fraud occurred away from corporate headquarters (in New York) at the company’s Cleveland, Ohio, office where the company’s financial affairs are handled. Fallo Me’s chief financial officer was establishing something of an autocratic rule in Cleveland. What the growing operation lacked in organization, he evidently tried to make up through frenzied effort. Employees say they were sometimes pushed to work 16-hour days, including many weekends and holidays, and were sometimes reprimanded for arriving as little as two minutes late to work.
The chief executive officer of the company was paid $3.6 million, mostly in the form of a bonus.
He stated that he was bewildered by the accounting scandal. “We just don’t know why they would do it,” he said of the mid-level employees whose scheme concealed Fallo Me’s sliding fortunes.
Required
a. Describe how the invoice back-dating could have affected reported profits. Would those profits have been overstated permanently or just for a period?
b. What effect might the bonus plan for the chief operating officer and chief financial officer have had on the fraud, if any?
c. How might the location of financial operations in Cleveland, instead of at corporate headquarters in New York, have made it easier for someone to commit fraud?
SOLUTION
This situation is based on the alleged fraud at the company, Leslie Fay.
a. Invoice backdating records revenues in periods earlier than they should be recorded. The dressmaker would have reported revenues and cost of goods sold for Year 1 that should have been reported in Year 2. Profits are overstated just for that period. The profits that were “moved’ into Year 1 are no longer available to be reported in Year 2. Consequently, frauds sometimes grow because managers continue to backdate invoices to make up for profits moved into earlier periods.
b. The bonus plan provided the executives with a lot of benefits if the company met its earnings goals. Also, the chief executive officer put a lot of pressure on his subordinates to achieve short-term results. (This is not unusual in companies.) Statements of shock and dismay, such as those made by the CEO, are usually not sincere (in our experience.) On the other hand, the CEO did not commit the fraud, himself. The tone in the organization and top management pressure are not sufficient excuses to commit fraud.
c. Distant locations are more difficult to monitor than those close by. If he desired, the CEO could have made frequent visits to the nearby location to observe activities. If he opposed the fraudulent activities, he could have had a personal hand in preventing them if he were personally observing the operations. Here is a real example. An employee who is uncomfortable engaging in fraudulent activities bumps into a top executive on the way to the parking lot. She tells the chief executive about the fraudulent activities. The chief executive in that case was able to learn about and put a stop to the fraudulent activities because the financial operations were in the same location as he. The distance between the financial operations and the corporate headquarters substantially reduced the probability of such chance encounters at Fallo Me (i.e., Leslie Fay).