Management Issues and the Accounting Discrepancies in SmartTool Inc - Essay Example

SmartTool Inc Abstract This paper presents an analysis of the Management issues and the accounting discrepancies in SmartTool Inc with respect to Generally Accepted Accounting Principles and the code of ethics for a Financial Controller. The paper critically analyzes the accounting gaps in SmartTool Inc. and the corresponding impact on the overall performance & growth of the company. This paper also presents the legal issues that the stakeholders can face in the event of the discrepancies that they were carrying forward. Table of Contents: Background and Facts: The beginning of Eb’s association with SmartTools itself was not clean. Proposing finance for an organization undergoing lawsuit pertaining to one of the fundamental components of the business (Land) is itself a high risk. The fate was in favor of NFP that SmartTools prevailed in the trial; legal decisions could have swung towards any side in a trial. It is not the job of a CPA to conclude on legal issues not amounting to finance alone (like land conflicts); Eb and NFP should had waited for the results of the trial. The company initially did well but problems started purely due to gross mismanagement of the business by Doug. Given the way Doug allowed discrepancies in the financial statements cannot qualify his claim to do so in the interest of the company. A thorough risk assessment could have proved that the decisions that he was taking were disastrous putting both Doug and Eb behind bars. The Sarbanes Oxley act in US (applicable on SmartTools as the revenues exceeded $5 Million) does not spare the CEO as such even if he/she blames the Financial Controller for all the discrepancies. The major issues were serious non-compliance against GAAP and also conflict of interest by the Financial Controller who was a stakeholder in the company. Business Management and Operational Issues Doug has been taking high risks in business especially in bagging orders that cannot be delivered readily using the core-competencies of the organization. Such orders would either require structured R&D mechanisms, or else uncontrolled costs in trial & errors. The findings of Elwood pertaining to a loss of $190000 on seven projects pertaining to 3D dies present the objective evidence against this conclusion. Also, the company took the route to ISO 9000 certification while the processes in a mess and were not automated. In this scenario, the certification doesn’t qualify the organization to have an efficient QMS system. Overall, Doug is competent to start a business and run it till enough cash is generated but his money management skills were not adequate. From the gravy stamping job, SmartTools achieved financial flexibility which means there was surplus cash for self funding of the working capital. Doug could have made the company debt free but instead preferred to expand into areas that were lesser known to SmartTools thus increasing risk of uncertainty in order processing. Doug was technology savvy person and he wanted to expand the technology horizon and competency of the organization. He did not value the value of self reliance thus ensuring operating profitability. Moreover, he was poor in handling working capitals efficiently for the growth of the organization. He kept on realizing more and more working capital loans from the Bank and losing profits and cash in the backend. He along with Janet tried to cover up the slumping profitability by inducing the accounting discrepancies detailed below and in this process risked the wealth of the shareholders as well as serious legal issues that could have put both Doug and Eb behind bars. Accounting Issues Operationally, Doug and Eb didn’t manage the accounting system properly. Given the requirements of section 404 of Sarbanes Oxley, spreadsheets with macros cannot fulfill the needs of the act especially the constraints and reporting requirements. Access control is a major requirement of this act while the SmartTools accounting system didn’t had any access control at all. Moreover, the practices did not conform to GAAP given that WIP inventories were released against invoices for the jobs that still have work in progress. Moreover, amount not received were shown as received in the books. As the mess increased, the attempt was to show more WIP inventories over & above the actuals by transfer of labor cost from invoiced jobs to un-invoiced jobs. Overall, the accounting system was in such a mess that it had become almost impossible to clear it. In the context, following are the answers to the questions asked: Answer to Question 1: The applicable Generally Accepted Accounting Principle state that “Revenue principle requires companies to record when revenue is realized or realizable and earned, not when cash is received. [Crovitz, Gordon. 2008; http://online.wsj.com/article/SB122083366235408621.html?mod=hpp_us_inside_today] This way of accounting is called accrual basis accounting. Moreover, IFRS definition of Revenue recognition states that “Revenue from the sale of goods is recognized when the entity has transferred the significant risks and rewards of ownership to the buyer and it no longer retains control or managerial involvement in the goods” [KPMG LLP. 2008. pp102]. In the context of SmartTools case study, the booking of revenues against the dies being manufactured completely breaches these accounting principles because the revenue is “not yet earned” because the “risk and reward ownership of the dies are still with SmartTools”. Answer to Question 2a: The total revenues (invoiced amount) from jobs completed in quarter 1 is $17500 + $19000 = $36500. The cost of goods manufactured in quarter 1 = 1000 + 8000 + 4000 + 2500 + 11500 + 5750 + 4000 + 17000 + 8500 = $62250 Hence, the partial income in quarter 1 =  $25750 = ($25750) The total revenue (invoiced amount) from jobs completed in quarter 2 is $35000 + $32000 + $32000 = $99000 The cost of goods manufactured in quarter 2 = 2000 + 8000 + 4000 + 4000 + 15000 + 7500 + 7500 + 20000 + 10000 + 8000 + 15000 + 7500 = $108500 Hence, the partial income in quarter 2 =  $9500 = ($9500) Answer to Question 2b: If job 3 is invoiced in quarter 1 and job 6 invoiced in quarter 2, then: The total revenues from jobs completed in quarter 1 is $17500 + $19000 + $35000 = $71500 Hence, partial income in quarter 1 = $9250 The total revenue from jobs completed in quarter 2 is $35000 + $32000 + $32000 + $45000 = $144000 Hence, the partial income in quarter 2 = 144000 – 108500 = $35500 Answer to Question 2c: Account receivables in case a: Quarter 1: Invoiced amount – Amount received = $36500 WIP inventory in quarter 1 = 4000 + 17000 + 8500 = $29500 Quarter 2: Invoiced amount – Amount received = $99000 + $36500 – $36500 = $99000 WIP inventory in quarter 2 = 8000 + 15000 + 7500 = $30500 Account receivables in case b: Quarter 1: Invoiced amount – Amount received = $71500 WIP inventory in quarter 1 = NIL (because all jobs are shown as closed & invoiced and hence the WIP inventory is released completely) Quarter 2: Invoiced amount – Amount received = $144000 + $71500 – $36500 = $179000 WIP inventory in quarter 2 = residual cost of job 3 = $16000 (jobs 4, 5, and 6 are already shown as closed & invoiced and hence their WIP inventories are released) Answer to Question 2d: In spite of adequate orders in hand, both the quarters were showing in losses and hence Doug insisted that he is permitted to control the dates when jobs would be invoiced in the system. Eb insisted to follow GAAP because in this example both quarters are appearing to be in good profits & also WIP is showing only in quarter 2, but the outstanding statement at the end of second quarter has become hefty. This gives very negative understanding to the stake holders that the company has registered good profits but the outstanding pending is quite large. If this process cascades, the actual turnover of the company by end of the year would be higher than the actuals with lesser WIP whereby the outstanding can never be closed within the financial year. What if one such WIP stretches much longer than expected being high risk order (like the 3D dies)? The company would have registered profit against such orders long back while the receivables would remain pending. The difference between booked revenue and actual revenue would keep on widening thus one day messing up the whole accounting system. Answer to Question 2e: In case of b, the account receivables were showing much higher than actuals while WIP is showing much lower than actual inventory thus justifying for higher working capital loans to continue the business and processing orders. In fact Doug would have been trapped in this cascade because his cash in hand to run the company would have slowly drained down while the statements would continuously be showing higher revenues and lower WIP. Thus, the company would ideally be running on Bank’s money only. Answer to Question 2f: It is easy to catch this misrepresentation if the actual DM, DL and OH are accredited to the right job in actuals. However, if Doug does a mix-up in this as well whereby these costs are distributed to orders at his will, then it is almost impossible to catch this misrepresentation especially when the worker timesheet and inventory system is totally manual. The Bank insisted to audit the inventories and account receivables because it was for sure that the inventories would come out to be much higher if matched with the receivables (there would not be any delivery receipts/customer acknowledgements against the revenues booked on WIP dies). In this way, a hidden cost of inventory maintenance would also be surfaced which definitely must not have appeared in any statements. Answer to Question 3: Janet was reflecting payments in the account statements against checks that were not yet realized. Thus, the accounts started showing more money than actually received. Further to this, she used to delay the checks to IRS (till the time enough money is there in the account to avoid check bounce) thus delaying their realization as well. In this process, the tax to be paid in current month actually is paid in subsequent months. Such backlogs accumulated gradually to reach $200000 (including penalties). It was easy for her to cover up this accumulation because the amount received in the statements in a month would be higher while the taxes paid in subsequent months thus ensuring an extra cushion for the cover up. This would actually reduce margins shown on the balance sheet by the outstanding tax value because the same is not appearing as a cost anywhere. Answer to Question 4: Terry’s proposal make the statements as partially GAAP compliant provided footnotes are inserted. It was OK for Ed to allow this solution in the statements provided forward looking statements (example, likely to be realized) are included in them and a footnote like the following is included: “All statements in this balance sheet that do not directly relate to historical facts constitute “forward-looking statements”. The words “believe”, “likely”, “expect”, “intend”, “plan” and similar words, expressions and variations thereof, identify few of such forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements and request for further clarifications” [Cooper, Paul. 2006]. Ethical and Professional Issues Eb is not supposed to be the CPA of the company in which he is a shareholder amidst conflict of interest scenario [http://www.aicpa.org/pubs/tpcpa/jul_aug2002/rmr/avoid.htm]. This positioning of Eb itself is against the professional responsibility of a CPA. Both Eb and Doug are liable for punishment under Sarbanes Oxley Act section 404. Moreover, under “Contracts in Violation of Public Policy” in Contracts Law (sections 674, 675 and 676), all the terms signed with the customer can be made void by the court thus enabling customers to forfeit their payments [http://chestofbooks.com/business/law/Law-Of-Contracts-Treatise/Contracts-In-Violation-of-Public-Policy.html; http://www.expertlaw.com/library/business/contract_law.html]. Unfortunately, public policy has not been defined specifically and hence the courts can always treat non-compliance to GAAP as violation to public policy. Moreover, they are guilty of breach of section 1001 (statements of entry generally), section 1005 (bank entries, reports & transactions) and section 1014 (Loan and Credit Applications generally) of chapter 47: Fraud and False Statements. [http://www.law.cornell.edu/uscode/html/uscode18/usc_sup_01_18_10_I_20_47.html]. Elwood’s advice to Eb on contacting the financiers without first contacting Doug was ethical because he had already warned Doug through his memos and had witnessed the fraudulent transactions for some time. Having said so, Eb cannot claim innocence against involvement in the fraud because he didn’t take timely steps to control them. Conclusion and Recommendations Whatever be the compulsion, the GAAP rules should never be breached in the accounting and balance sheet statements. The time of invoicing is the key to accuracy of accounting statements which, if shifted deliberately will induce serious errors in the statements that will go on multiplying thus leading to serious uncontrolled losses in the business whereby the root cause can never be found out. Also, non-compliance to GAAP is serious ethical as well as statutory issue whereby various punishments can be enforced against business laws, contract laws and Sarbanes Oxley act. Hence, it is recommended to hire a competent accounting personnel who understands the seriousness of these implications and also apply multiple computer controlled constraints on the accounting software such that even inadvertent mistakes leading to GAAP non-compliance can be avoided. Reference List: Cooper, Paul. (2006) Management Discussion and Analysis of WellPoint systems Inc. Crovitz, Gordon. (2008). Closing the Information GAAP. The Wall Street Journal. Retrieved on 17 December 2008. Available at http://online.wsj.com/article/SB122083366235408621.html?mod=hpp_us_inside_today. IFRS compared to U.S. GAAP: An overview. (2008). KPMG LLP. pp102. Larson, Aaron. (2003) Contract Law – An Introduction. Retrieved on 17 December 2008. available at http://www.expertlaw.com/library/business/contract_law.html. Read More