Earnings Management and Ethical Challenges at the Succulent Cooking Inc.-A Case Study

By Tang, Charles Y.; Elson, Raymond J. et al. | Journal of the International Academy for Case Studies, January 2015 | Go to article overview

Earnings Management and Ethical Challenges at the Succulent Cooking Inc.-A Case Study


Tang, Charles Y., Elson, Raymond J., O'Callaghan, Susanne, Walker, John P., Higgins, Leslee N., Journal of the International Academy for Case Studies


CASE DESCRIPTION

The primary subject matter of this case is earnings management that often takes place in financial reporting for business enterprise and ethical issues involved therein. It demonstrates to students that reported accounting earnings can be managed by seemly innocent actions such as increasing production and building up inventories. This case will expand students' understanding of the motivation of earnings management and raise their awareness of ethical issues involved in financial reporting for business enterprise. The case is appropriate for the second course in managerial accounting at the undergraduate level or similar courses at the graduate level. It can also be used in advanced level financial accounting courses or in auditing seminar on contemporary accounting issues. The case requires approximately three hours of outside preparation by students to arrive at reasonable solutions. The case could then be debriefed in class using calculations and discussions. This would require one class hour.

CASE SYNOPSIS

Earnings management occurs when firm management attempts to alter reported earnings for reasons other than objective reporting of firm performance. This opportunistic behavior is motivated by managers who seek job security and/or financial rewards. It is in direct violation of professional ethical standards and, in many cases, could be in violation of law. The purpose of the Succulent Cooking, Inc., ("the company") case is to demonstrate to students that earnings can be managed by seemly innocent actions such as increasing production and building up inventory levels. During the process of solving this case, students develop an understanding of the role of overhead and how overhead is allocated to determine reported accounting earnings. Students will be intellectually challenged as the case does require strong analytic skills and good understanding of accounting concepts related to product costing.

As described in the case, the company is about to miss the Wall Street earnings expectations which can adversely affect firm stock prices. The company is considering two alternative course of action to manage earnings by either reducing the commission rate paid to its sales force or increasing production level. Students are first required to apply analytic skills to provide a specific solution to the question. Then they will realize that all the proposed actions are forms of earnings management which are either illegal or unethical.

INTRODUCTION

Succulent Cooking, Inc., ("the company") produces barbecue ovens. The company's common stocks are actively traded on the stock exchange and closely followed by financial analysts on Wall Street. Analysts' average earnings forecast for the firm's current fiscal quarter, ending June 30, 20X5, is 11.5 cents per share of common stock outstanding or $4.025 million in net income available to common stockholders, before any extra-ordinary items and discontinued operations. Since Wall Street has a short term focus, the investment community places great attention on companies' quarterly earnings. Missing the market earnings expectation could cause the financial analysts to downgrade the stock, which, in turn, could have a devastating effect on Succulent's stock price.

THE ACCOUNTING SITUATION

On June 5, 20X5, about 25 days before the end of the fiscal quarter, the controller, James Butler, was asked by the company's chief executive officer, Marshall Adler, to attend a senior management meeting to explain and discuss some management accounting issues. At the meeting, the CEO points out that sales have been disappointing for the quarter so far and that the company is operating below its production capacity. The total sales revenue for the quarter is projected at $33.25 million with an average selling price of $350 per unit for each barbecue oven. The sales revenue includes all sales that are completed to date and all the pending sales that are expected to be completed before the end of the quarter. …

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