Option #1: Don’t Leave Your Hand in the Cookie Jar
Read the following case:
McDonald, R. (2011, December). Don’t leave your hand in the cookie jar Download Don’t leave your hand in the cookie jar
. IMA Educational Case Journal, 4(4), ART. 2. (Located in this module)
Case Requirements:
Prepare a paper (memo) that addresses the following questions:
How can John use the IMA Standards of Ethical Professional Practice to evaluate his own ethical behavior? Be specific. What steps could John take to resolve the ethical dilemma he faces? Be specific. Concerning the three accounting adjustments, whose arguments are more persuasive, Karl’s or John’s? Again, be specific. Calculate the difference between Karl’s and John’s recommended adjustments for bad debt, product returns, and warranties. Do you consider each individual difference material? Is the combination of the three amounts material?
Assignment Paper Requirements:
- Write a paper (memo) of a minimum of six double-spaced pages, not counting the title and reference pages, which you must include separately.
- Copy and paste each one of the questions into your paper in bold type to ensure you have answered each of the assignment requirements.
- Use terms, evidence, and concepts from class readings, including professional business language.
- Cite at least three credible, academic or professional sources for this assignment. The CSU Global LibraryLinks to an external site. is a great place to find resources, as well as the FASB Codification.
ISSN 1940-204X
TEACHING NOTE
Don’t Leave Your Hand in the Cookie Jar
Robert McDonald
University of New Haven
JOHN DAVIES, ASSISTANT CONTROLLER, WAS CONCERNED ABOUT an upcoming meeting with his boss about
year-end accounting adjustments. He had noticed over the past two years that the controller was adding to three
reserve accounts: bad debt, product returns, and warranties. “Cookie jar” accounting came to mind as John thought
through his arguments against the practice. Cookie-jar accounting sets aside reserves in good times to be dipped into
in bad times when the firm needs a boost to earnings—a classic example of earnings management.
John knew the controller would cite conservatism in accounting, industry practice, and materiality in his defense of
the added reserves. John was concerned that an ulterior motive for the controller was to present earnings growth to
the venture capital firms that had funded the start-up firm.
There still is a gray area that allows differing interpretations of what should be recorded for these estimates. In this
case, the student will balance off IMA Ethical Standards, SEC rulings on reserve accounting, conservatism in accounting, industry practice, and materiality to arrive at a solution of the proper accounting for the three accounts.
Keywords: IMA Ethical Standards, cookie jar reserves.
CASE OVERVIEW
needs a boost to earnings. These rainy-day funds are classic
examples of earnings management. Some managers believe
that Wall Street analysts will look beyond the initial hit to
earnings in good economic times and will look to smoother
future earnings.
As John thought about the SEC actions to curb the worst
abuses of cookie jar accounting, he knew the controller
would cite conservatism in accounting, industry practice, and
materiality in his defense of the added reserves. John was
concerned that an ulterior motive for the controller was to
present earnings growth to the venture capital firms that had
funded the start-up firm. The firm’s management was hoping
John Davies, assistant controller, was concerned about
an upcoming meeting with his boss, the controller, about
year-end accounting adjustments. John had noticed over
the past two years that the controller was adding to three
reserve accounts, and he could not justify the need for the
additions. The three accounts in question were bad debt,
product returns, and warranties. “Cookie jar” accounting
came to mind as John thought through his arguments against
the practice. Cookie jar accounting sets aside reserves in
good times to be dipped into in bad times when the firm
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for a successful initial public offering (IPO) after the venture
capital funding, and a record of strong and steady earnings
growth would be necessary for the IPO.
While the accounting regulators have tried to reign in
the recording of excess reserves, there still is a gray area that
allows differing interpretations of what should be recorded. In
this case, the student will balance off SEC rulings on reserve
accounting, conservatism in accounting, industry practice, and
materiality to arrive at a solution to the proper accounting for
the three accounts.
This case is intended for an undergraduate course in
financial statement analysis or intermediate accounting.
and warranties. Do you consider each individual difference
material? Is the combination of the three amounts material?
Question 1 answer: We would use the Standards of
Competence, Integrity, and Credibility to evaluate John’s
ethical behavior. Under the standard of Competence
(“Perform professional duties in accordance with relevant
laws, regulations, and technical standards, and prepare
decision support information and recommendations that are
accurate, clear, concise, and timely”), John would receive
a passing grade. John is preparing his set of adjusting
entries in compliance with what he views as the SEC
concern with cookie jar accounting. He is aware of the
SEC announcements and prosecutions in the area. He
supports his estimates for the adjusting entries with recent
historical data, rather than Karl’s estimates of possible future
adjustments.
Under the Standard of Integrity (“Refrain from engaging
in any conduct that would prejudice carrying out duties
ethically”), John might have a question. He had accepted
the offer of employment from ClearPix partially due to the
stock options in his compensation package. Subconsciously,
John might be trying to eliminate last year’s loss and increase
this year’s small profit to show a longer period of profitability
before the attempted IPO. Karl had commented on the fact
that all of John’s recommendations increase income. John
might be planning on an earlier IPO with income from the
exercise of options. In his mind, John should be aware of
this possibility and he should try to reconcile his view of
adjustments versus Karl’s view. This reconciliation comes
down to using past actual data or trying to anticipate future
problems with bad debt, product returns, and warranties.
Under the Standard of Credibility (“Communicate
information fairly and objectively”), John gets a passing
grade. He tried to communicate the adjustment information
fairly and objectively. He again used the objective data of
recent performance by the firm, rather than the possible
future performance as suggested by Karl.
CASE OBJECTIVES:
1)
Have the student confront the ethical issues with cookie
jar accounting from the perspective of a young assistant
controller new to the high-tech industry. The IMA’s
Standards of Ethical Professional Practice can be used to
measure the assistant controller’s ethical behavior.
2)
Introduce the student to the potential problems with
what appear to be simple adjusting entries of bad debt,
product returns, and warranty expense. These entries
could open the door to earnings management through
cookie jar accounting.
3) H
ave the student evaluate the arguments for setting up
small or large reserves for bad debt, product returns, and
warranty expense.
4) P
ut the student in a management position in which a final
decision must be made about adjusting entries for bad
debt, product returns, and warranty expense. The student
will see how easy it is to set up cookie jars or rainy-day
reserves to smooth the firm’s earnings.
5) Introduce the student to the major pronouncements from
the SEC showing its concern about the setting up of
excess reserves or cookie jars.
Question 2 answer: John finds himself in an uncomfortable
Question 1: How can John use the IMA Standards of Ethical
ethical dilemma as assistant controller in a small start-up firm
in the high-tech industry. In the early years of this start-up
firm, most of the effort went into developing commercial
products that met a customer need that resulted in higher
demand for the firm’s products. Ramping up production
and hiring key personnel would be concerns for senior
management and the board. It is likely that management
and the board were not as concerned with establishing a
code of conduct for all employees, staffing an internal audit
department, setting aside an audit committee within the board
Professional Practice to evaluate his own ethical behavior?
Question 2: What steps could John take to resolve this ethical
dilemma he faces?
Question 3: Concerning the three accounting adjustments,
whose arguments are more persuasive, Karl’s or John’s?
Question 4: Calculate the difference between Karl’s and John’s
recommended adjustments for bad debt, product returns,
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of directors, or providing coverage for a whistle-blower in the
organization. All of these features would be lacking in the
start-up firm and left for future years to develop. A larger and
established firm, such as a Fortune 500 firm, has gone through
all the growing pains and most likely would have set up those
ethical provisions. John was attracted to the start-up firm for
its novelty and the promise of stock options. So in his career
choice, he opted for possible wealth in place of policies and
procedures that now would ease his ethical problems.
John could continue to work out these issues with his
supervisor, the controller, Karl Schumaker. At least in this
year’s discussions, Karl backed off from increasing the
adjustment percentages and held the line on the allowance
amounts. So their differences have not widened appreciably.
The problem here is Karl, with his inclination to add to
the allowance accounts for bad debt, product returns, and
warranties. John is concerned that Karl is trying to build up
large reserves to be dipped into in future years when the firm
needs a boost to earnings. This would occur near the date of
the expected IPO or after the IPO when the firm is starting
out as a public, listed corporation. Maybe in time the two
accountants could further reduce their differences on the
yearly adjustments and the amounts previously built up.
If disagreements continue with Karl, John could try
speaking to Karl’s supervisor, the president of the firm.
Senior officers of the firm accepted lower salaries in place
of generous stock options. They hoped a successful IPO
would create millionaires out of the entire senior staff. None
of them had accounting backgrounds, so they were not
inclined to let small accounting issues get in the way of a
successful IPO. The officers of the firm hired Karl and they
have confidence in his recommendations, all gained from
his 20 years of experience. The president and other officers
might not accept John’s contrary arguments on preparing the
financial statements.
John could next try speaking to the board of directors or
one of the directors who holds himself out as the accounting
expert. The accounting expert is a manager from a venture
capital firm in New York City. John has heard indirectly that
the three venture capital firms have confidence in ClearPix’s
statements and Karl’s management of the finances. The
venture capital representative might not accept John’s
questioning of Karl’s recommendations.
John’s final course of action could be to contact a lawyer
for advice on this problem. He should be concerned if he has
any liability for what has been recorded so far, since he has
taken the formal responsibility for transactions in the general
ledger. At this point he might decide if continuing his quest
is worth it to him. It might be easier to just quit this position
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and look for another accounting position at a different firm.
The next job search should include a realistic awareness
of start-up firms with high wealth opportunities versus an
established firm with lower wealth possibilities but with
advanced systems and procedures in place.
Question 3 answer: In defending his larger estimates, the
controller frequently stated that the difference between his
estimate and the amount the assistant controller prefers is
small in relation to the size of the firm or that the amount is
immaterial. All three of the differences understate income due
to the controller’s conservative estimates. If we take bad debt,
product return, and warranty differences for 2009 alone, we
have $467,000 in added expense. If the assistant controller’s
estimates were used, the pre-tax income would increase by
$467,000 to $4,042,000 or an increase of 13%. If we do the
same for 2008, the increase in income is $375,000, thus turning
a $250,000 loss into income of $125,000. Since the differences
between controller and assistant controller are all in the same
direction, we could say the total amount is material, even
though each separate adjustment might be immaterial.
The controller argues that the high-tech business is risky
and volatile, and that the adjusting entries should take that
into account. He follows a more conservative approach to
accounting in which, if there are choices in the accounting,
you should adopt the method with the lower sales, higher
expenses, and lower assets. The controller also argues
that the start-up status of the firm adds to the need for
conservatism with start-up firms showing greater volatility
in sales and income. He does not want the blame from the
venture capital investors that earnings were overstated;
if anything, he wants the venture capital investors to feel
confident about the accounting and expect positive surprises
in the future.
The controller also believes that his generous reserves
resulting from a conservative approach in accounting will add
to the firm’s perceived quality of earnings. He is counting on
the venture capital investors’ appreciation of the generous
reserves and the feeling that, if anything, the income is
understated. If there is any surprise in earnings to the venture
capitalists, it would be higher earnings. The controller
believes this conservatism and quality of earnings would carry
over in the future to security analysts when the firm goes
public and has a following on Wall Street. The controller also
believes that the differences between his recommendations
and those of the assistant controller are too small to be
concerned about. In his mind they are immaterial differences.
The assistant controller believes the accounting is
distorted too much in the direction of conservatism. He
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believes the expenses have been overstated and income
understated. If you have accurate numbers, then use them.
If you have set up a liability (reserve) for some event and
that event fails to occur, then you should reverse or close
out the liability. If you leave these reserves on the balance
sheet, then you would be tempted to use them to smooth
earnings in the future. The assistant controller believes that
when the firm goes public through an initial public offering,
the investment bank will require a “due diligence” review,
which might eliminate the excessive expenses and reserves.
The assistant controller believes that the controller wants
a “cookie jar” for the time when the firm goes public and in
the first couple of years would need a boost to earnings.
Question 4 answer: The accumulated difference for bad debt
estimates versus actual bad debt charge-offs is $93,000 plus
$75,000 or $168,000.
The accumulated difference for product return estimates
versus actual product returns is $187,000 plus $150,000, or
$337,000.
The accumulated difference for warranty estimates
versus actual warranty expense is $187,000 plus $150,000, or
$337,000.
The total for the difference between these three
estimates and actual experience is $842,000. In each one
of these differences, the controller’s estimates reduce net
income. If we reverse out these differences in the three
accounts, 2009’s income increase by 13% or $467,000 and last
year’s loss of $250,000 are turned into a profit of $125,000.
An increase of 13% in net income could easily be considered
material, as well as a change from a loss to a profit.
Some instructors might consider reviewing the journal
entries for the three adjustments. The 2009 amounts are
reflected in the following journal entries:
Question 4 answer:
($000)
2009
2008
Sales
2007
37,500
30,000
23,000
1,031
825
575
Bad debt estimate
2.75%, 2.75%, 2.5%
Bad debt charge-offs
2.5%, 2.5%, 2.5%
938
750
575
Excess
93
75
—
375
300
—
Excess
188
150
—
Allowance for bad debt
938,000
Accounts receivable
938,000
b) Product return estimate
Accounts receivable
37,500,000
Sales
37,500,000
Sales return & allow
375,000
Allowance for returns
375,000
187
150
—
Actual returns
Question 6 answer:
($000)
2009
2008
Allowance for returns
188,000
Accounts receivable
188,000
c) Warranty estimate
Warranty expense
375,000
Liability for warranty
375,000
Liability for warranty
188,000
2007
Actual warranty work
Warranty estimate
1%, 1%, ½ of 1%
1,031,000
Actual returns
½ of 1%, ½ of 1%
1,031,000
Allowance for bad debt
2007
Product returns
1%, 1%
Bad debt expense
Bad debt charge-off
Question 5 answer:
($000)
2009
2008
a) Bad debt estimate
375
300
115
1/2 of 1%, 1/2 of 1 %, 1/2 of 1 %
188
150
115
Excess
187
150
—
Parts inventory, cash, labor… 188,000
Warranty charge-offs
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SEC CONCERNS
Xerox settled the charges without admitting or denying
wrongdoing and agreed to pay a $10 million civil penalty, at
the time the largest levied on a company for financial reporting
violations. The company then restated five years of financial
results, showing pre-tax income over that period was inflated
by 36% or $1.4 billion. An audit of the restated period showed
that $6.4 billion of income had been improperly allocated over
the five-year period. In 1998, for example, Xerox reported $579
million pre-tax profit, but in fact had a pre-tax loss of $13 million.
The SEC then went on to charge KPMG, Xerox’s auditor,
of fraud in a civil suit for knowingly allowing Xerox to
mislead its shareholders by filing false financial statements.
KPMG settled the case in April 2005, paying $22.5 million
in fines, without admitting or denying the allegations. At the
same time, six Xerox executives paid a fine of $22 million.
In early 2006, the SEC levied cash penalties on several
KPMG auditors and restricted their ability to practice before
the SEC. By this time, there were four sets of charges and
settlements: against Xerox itself, its senior executives, the
audit firm KPMG, and several audit partners at KPMG. Left
unsettled and unresolved were several stockholder suits
against Xerox and KPMG alleging hundreds of millions of
dollars of stockholder losses.
While Xerox is an outstanding example of the
temptations and consequences of cookie jar reserves from
the 1990s until 2006, there were a number of other firms
caught with their hands in the cookie jar. Examples include
Microsoft, W.R. Grace, Bristol-Myers-Squibb, Nortel
Networks, and Paracelsus Healthcare.
In a thought-provoking speech on September 28, 1998, at
NYU, Arthur Levitt, Chairman of the SEC, outlined SEC
concerns about increasing examples of earnings management
during the strong stock market of the late 1990s. He
mentioned five areas of concern: big bath restructuring
charges, creative acquisition accounting, cookie jar reserves,
misuse of the term “immaterial,” and premature recognition
of revenue. Levitt thought that Wall Street analysts and
corporate managers were winking and nodding to each other
when a firm announced any of these five transactions. The
overriding pressure was to achieve the earnings per share
that Wall Street was expecting. Firms missing the expected
earnings-per-share number were severely punished; Chairman
Levitt gave the example of a firm that missed earnings per
share by one penny and lost 6% of its market value.
For the cookie jar reserve issue, he specified sales returns,
loan losses, and warranty costs. In good times, firms would
record very conservative, or large, losses from these three areas.
The firms in effect were setting up rainy-day funds. Then in
future years, when the firm’s profits were declining, the firm
could dip into the reserve account to reduce losses at that future
time. For example, if a firm had a large allowance for doubtful
accounts, management could convince itself that it had overreserved for bad debt. Future bad debt adjustments could be
reduced from the earlier and higher adjustment amount until
the allowance account was in line with the firm’s experience. Or
in an extreme case, the firm could immediately eliminate the
excess in the allowance account, possibly eliminating any bad
debt expense for that year.
Six months later, in April 1999, Walter Scheutze, Chief
Accountant of the SEC, continued the SEC attack on cookie
jar accounting in a major speech. Mr. Scheutze stated that
these excessive reserves are leeched, undisclosed into
subsequent operating income, and at a rate that keeps them
under anyone’s radar.
RECENT EVENTS
The instructor could also update the cookie jar topic with a
quick reference to the very recent case of Dell Computers.
After several years of investigation, the SEC charged Dell
with a whole list of cookie jar infractions. Dell decided to
settle the case and agreed to pay a $100 million fine. Michael
Dell and other senior executives have likewise agreed to
pay millions in penalties. If Dell follows the Xerox example,
yet to come would be restrictions or penalties on the public
accounting firm and the suits by shareholders for monetary
relief. The charges and suits could continue for years. It would
be instructive to attempt a schedule of assumed benefits
from whatever cookie jar transactions Dell originated versus
the very definite fines and penalties. After matching cost
versus benefit, I would expect the final result would argue
strenuously against the lures of cookie jar accounting.
IFRS Added Note: In an article in the July 2010 issue
of Strategic Finance, Curtis C. Verschoor raises IFRS issues
XEROX
In April 2002, the SEC charged Xerox with erroneous
reporting over the period 1997-2000 that accelerated
revenue by $3 billion and increased pre-tax earnings by $1.4
billion. Included in these charges was the improper use of
reserves to the extent of $496 million: vacation pay accruals,
post-retirement benefit reserve, current asset reserves of
inventory, custom duty reserve, miscellaneous reserve, and
an unidentified Brazil reserve.
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relevant to cookie jar accounting. He fears that the adoption
of a principles-based IFRS system replacing the rules-based
system of US GAAP will allow weaker accounting principles
to drive out higher quality standards of US GAAP. An already
debatable area of setting up various reserves becomes more
challenging when professional judgment is the basis of
choosing accounting treatments rather than following specific
rules. An accountant would have more specific guidelines in
choosing the accounting treatment within the rules based
system of US GAAP. Verschoor is worried that corporate
accountants will be pressured to use professional judgment to
present the firm in the best possible light, and that the same
event could be presented differently by several corporations.
The instructor could finish up the case discussion with
a poll of the students to see if they agree with Verschoor,
and how the accountant could operate within the principlesbased system.
Of the two suitors, Cisco is probably the better
benchmark due to its smaller size and narrower product
line—both are closer to ClearPix. IBM is one of the largest
firms in the world, with a vast product line.
Cisco shows its allowance for doubtful accounts as a
percentage of gross receivables ranging from 4.4% to 6.4% from
fiscal 08 to fiscal 09, averaging 5.4% for the two years. For its
most recent year, ClearPix shows a 2.9% allowance for doubtful
accounts to gross receivables—almost half Cisco’s percentage.
John attributed ClearPix’s better experience with bad
debt to its high percentage of sales to governmental agencies
and universities- both groups under less pressure to cut
costs. He thought Cisco might have a higher percentage
of commercial accounts that would aggressively argue for
returns, allowances, and adjustments to billings.
For warranty expense as a percentage of sales, Cisco
shows 1.5% down to 1.3% in 08 and 09. This averages to
1.4% versus ClearPix’s rate of 1%- again better than Cisco’s
performance, but relatively close. John was unsure of the
reason for ClearPix’s better warranty experience.
IBM shows bad debt as a percentage of revenues averaging
at 0.23% of sales versus 2.5% of sales for ClearPix. IBM’s rate
is one-tenth that of ClearPix, a difference due to different
products, industry segments, and the huge size of IBM, which
allows scale efficiency in managing credit expenses.
IBM shows the allowance for doubtful accounts as a
percentage of gross receivables at 2%, versus 2.9% for ClearPix.
IBM’s warranty provision as a percentage of sales is 0.4%,
versus 0.5% to 1% for ClearPix.
INDUSTRY NORMS
Management at ClearPix followed Cisco and IBM as two
potential suitors if a public offering did not materialize
and the firm had to be sold to cash out the venture capital
investors. If an IPO were not feasible, ClearPix management
wanted the firm sold to an industry giant with excess cash
for the acquisition. It was thought that Cisco and IBM had
secretly expressed an interest in ClearPix’s technology, and
ClearPix could have fit easily into several divisions of either
firm. We have gathered some information on bad debt and
warranty expense from both companies’ financial statements
to give an idea of industry averages for key ratios. No
financial data on product returns were available.
Cisco
year ending
Gross receivables
Allowance for Doubtful accounts
Allowance as % of Gross receivables
Product sales
Warranty provision
Provision as % of sales
7/25/09
3,393
216
6.4%
29,131
374
1.3%
7/26/08
3,998
177
4.4%
33,099
511
1.5%
IBM
Revenues
Bad debt expense
Bad debt as % of Revenues
Gross receivables
Allowance for Doubtful accounts
Allowance as % of Gross receivables
Warranty provision
Provision as % of sales
2009
95,758
147
0.15%
10,953
217
2.00%
374
.39%
2008
103,630
306
0.30%
11,132
226
2.03%
390
.38%
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PREREQUISITE KNOWLEDGE
The case was intended for students in intermediate
accounting or financial statement analysis courses. The
intermediate accounting students should have had a short
discussion of bad debt, product returns, and warranty expense.
The financial statement analysis students will probably have
to research the limited accounting rules on the three items.
Both groups of students would find very limited rules on how
to estimate and record these accounting accruals.
The textbooks I have referenced for this case are:
Intermediate Accounting, by Kieso, Weygandt, and Warfield,
13th edition, published by Wiley; and Financial Statement
Analysis, by K. R. Subramanyam and John J. Wild, 10th
edition, published by McGraw-Hill Irwin.
Materiality and conservatism are major aspects of the
case, and to a lesser degree, industry practice. According to
Kieso, all three of these issues are considered “constraints”
in the accounting standards superstructure. Their definitions
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are somewhat vague and not very helpful when facing a
real-life example. These terms come from the accounting
profession and are part of the theoretical superstructure
of accounting. Earnings quality, on the other hand, comes
from outside the accounting profession—–from users of the
financial statements, such as portfolio managers and security
analysts. earnings quality, similar to materiality, conservatism,
and industry practice, is a subjective and qualitative term. It
is not exactly defined, and it can have different meanings to
different observers of accounting results.
Subramanyam lists two definitions for earnings quality:
“…as the extent of conservatism adopted by the company.
… An alternative definition of earnings quality is in terms of
accounting distortions—a company has high earnings quality
if its financial statement information accurately depicts
its business activities.” We have used the definition for
conservatism in our approach to the case.
According to Kieso, “an item is material if its inclusion
or omission would influence or change the judgment of a
reasonable person. It is immaterial, and therefore irrelevant,
if it would have no impact on a decision maker.”
Materiality comes into the case when the controller
suggests that the difference of opinion between him and
John does not rise to a substantial amount and should not
be considered further. Conservatism comes into the case
when the controller believes his pessimistic views toward
bad debt, product returns, and warranties call for higher
expenses and higher reserves for future losses. He claims
it would be better to show higher expenses and lower asset
values than to show unrealistically high asset values and
low expenses. He has a pessimistic view that takes into
account what he sees as deteriorating economy and industry
conditions. Industry practice in the case is an issue when the
controller is respected and listened to since he has had years
of experience in the high-tech start-up industry. He knows
the turning points in business and knows the signs of peaks
in good times and the lows in bad times. He claims to have
seen the high-tech industry change direction quickly and
change more than anyone anticipated.
Kieso specifically lists bad debt and warranty expense as
contingent losses. To record these items, it must be probable
(probability over 50% likely) that an asset has been impaired
or a liability incurred that will be confirmed by a future
event, and that we can reasonably estimate the amount
in question. Product returns are not specifically called a
contingent loss, but they are covered in the same section as
the bad debt, and they meet the requirement for contingent
losses. Returned goods’ reduced treatment in textbooks is
due to the fact that most firms do not have a large returned
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goods exposure. Certain industries, such as food, toys,
and publishers have large returned goods exposure, and
that exposure has to be analyzed. On the other hand, all
industries have bad debt exposure, which demands more
coverage in the accounting textbooks.
Kieso says that bad debt losses can be estimated by
reviewing past history of the firm, but that review must be
tempered with judgment. The judgment addresses current
industry/economy conditions and the individual customer’s
condition, which could differ from the historical conditions.
Past history may not be sufficient to adequately reflect the
bad debt adjustment entry.
So now we have the situation where the contingent
losses of bad debt, returned goods, and warranty provisions
converge with the constraints of materiality, conservatism,
and industry practice. The contingent losses require
dependence on past performance along with judgment
of current conditions mixed in with consideration of the
vague guides of materiality, conservatism, and to a lesser
degree, industry practice. John and Karl should see that
the accounting standards help only to a limited point, and
the constraints might not help the decision makers. Finally,
the contingent losses along with the constraints must be
addressed under an overhanging cloud of ethical violations.
John sees more than an honest difference of opinion
between two professionals. He is concerned that all of Karl’s
arguments are directed at building a rainy day fund or a
cookie jar to be dipped into in later years when a boost to
income is needed. The imprecise guides for recording bad
debt, returned goods, and warranty expense, along with the
equally imprecise constraints of materiality, conservatism,
and industry practice, all conspire to enable the creation of
cookie jars in accounting.
STAKEHOLDER PERSPECTIVE
The stakeholders at this time in the life of ClearPix were
management, with generous stock options, and the venture
capital firms, with stock options and large positions of stock.
John and Karl were the only members of management with
any degree of accounting knowledge. Most of the venture
capital representatives also had extensive accounting and
finance experience. The other members of management
had engineering or marketing backgrounds and were not
interested in the fine points of financial reporting. The case
mentions that those non-accounting members of management
were in no mood to let accounting fine points get in the way of
a successful IPO or a profitable sale of the firm to an industry
giant, such as Cisco or IBM. This group of managers agreed
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VOL. 4, N O. 4, ART. 2 TN , DECEMBER 2011
with whatever would deliver a successful IPO and whatever
would increase their wealth from stock options.
John and Karl would get no assistance from the nonaccountants in management to resolve their differences in
proper reporting. If anything, those members would side
with Karl to manage earnings for an IPO and to smooth out
any bumps in the reported income stream.
The venture capital representatives did not interfere in
John and Karl’s disagreement. The venture capital members
dealt with Karl as chief financial officer, and all indications
were that they were satisfied with his control of reporting
and his grasp of the operating performance and its reporting.
John does not have much support from these
stakeholders in his resolution of the ethical questions. If
anything, there would be annoyance at his disturbing a
history of impressive financial reporting. Most of these
stakeholders would benefit financially from managed
earnings through a cookie jar approach. It would not be in
their interest to get involved in this ethical question.
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CLASSROOM EXPERIENCE
I have used this case three times in MBA classes and for
the most part it worked well. I have inserted this case in the
topic of liquidity, when I cover current assets and current
liabilities. The issues of bad debt and product returns are
under the discussion of accounts receivable, and the issues
of warranty liability are under current liabilities. Bad debt
and product returns are briefly covered as examples of contra
accounts on the balance sheet as examples of increased
transparency on the balance sheet.
One challenge in discussing the case in class was the
tendency of the class to strongly agree with the assistant
controller’s approach, with less consideration of the controller’s
approach. I have tried to get the class to see the reasons for
and merits of the controller’s conservative approach, and I
recently revised the case to balance the arguments both for
and against the attempts to set up cookie jar reserves. I am not
sure whether the younger MBA students tended to agree with
the young assistant controller, or just that his arguments were
more convincing and fact-based.
IM A ED U C ATIO NA L C A S E JOURNAL
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VOL. 4, N O. 4, ART. 2 TN , DECEMBER 2011
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