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Chapter 15
MANAGEMENT CONTROL-RELATED ETHICAL
ISSUES AND ANALYSES
M
anagers involved in designing and using management control systems (MCSs) should
have a basic understanding of ethics. Ethics is the field of study that is used to prescribe morally acceptable behavior. It provides methods of distinguishing between right and
wrong and of systematically determining the rules that provide guidance as to how individuals and groups of individuals should behave. Its systematic nature goes beyond what
even thoughtful people do in making sense of their own and others’ moral experiences.
Ethics is important for managers involved with MCSs because ethical principles can provide a useful guide for defining how employees should behave. Further, employees’ ethics
are an important component of personnel or cultural controls. If good ethics can be encouraged in an organization, they can substitute for, or augment, actions or results controls.
Ethics is a difficult subject for many managers to understand. One important reason
for this is that most managers’ basic discipline training is in economics. Two common
assumptions in economics are that rational people should act to maximize their own
self-interest and that the primary purpose of employees in for-profit organizations is to
maximize shareholder value.1 Ethics, however, provides alternative assumptions about
how people should and do behave. It assumes that ethical individuals must consider the
impact of their actions on other stakeholders; those affected by their actions. (Table 15.1
shows a list of corporations’ most common stakeholders.)
Ethical behavior and value-maximizing behavior are not equivalent. While the commonly cited aphorism, “good ethics is good business,” is usually true, it is not always true.
Good ethics does not always pay either for the individuals or organizations involved.
TABLE 15.1 Typical stakeholders of a corporation
Shareholders
Bondholders
Creditors
Employees
Management
Board of directors
Customers
Suppliers
Government
Local communities
Other users of shared resources: people and animals that might be
affected by corporate use of land, water, and air
Source: K. A. Merchant, Modern Management Control Systems: Text and Cases (Upper
Saddle River, NJ: Prentice Hall, 1998), p. 698.
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Good ethics definitely do not always pay in the short-run. Ethical individuals sometimes
must take actions that are not in their own self-interest or their organization’s owners’ best
interest because of some legitimate interests of other stakeholders.2 They are accountable
to these non-ownership stakeholders as well, and no group, not even owners, automatically has priority over the other stakeholders.3 Indeed, it is the struggle between being
selfish and doing “what is right” that provides the most interesting and important ethical
issues that we must consider.
It would be comforting to think that people will be rewarded for doing what is right, at
least in the long run. But that does not always happen. Many employees who do what is right
sometimes earn lower bonuses, are passed over for promotions, and are even fired. As an
example of the latter situation, why else would we need laws (such as, in the United States,
the whistleblower protection provisions in the Sarbanes-Oxley Act) to protect the rights
of employees who did the right thing, who exposed fraud or abuse by employee(s) of an
organization? Conversely, many people who act unethically benefit from their unethical
actions and never suffer any consequences. In many, perhaps most, cases, the probability
of being caught or turned in as a result of performing an unethical act is quite low.
The potential for personal sacrifice while acting ethically is reflected in many codes
of professional conduct. The preamble of the Code of Professional Conduct of the
American Institute of Certified Public Accountants (AICPA) states, “The Principles call
for an unswerving commitment to honorable behavior, even at the sacrifice of personal
advantage.”4 But when are the ethical principles so important that one must consider other
than self-interest or one’s organization’s best interest? That is a core ethical question.
This chapter provides an introduction to the complex subject of ethics. It starts with a
discussion about the importance of good ethical analyses. Then it briefly describes some
models of ethical behavior that can be used to analyze ethical issues related to MCSs. The
chapter concludes with some suggestions for encouraging ethical behavior from employees.
THE IMPORTANCE OF GOOD ETHICAL ANALYSES
Unethical behaviors are costly to individuals, organizations, markets, and societies.5 They
create a need for extra laws and standards from governments and regulatory agencies,
and extra rules, reviews, or supervision within organizations. These extra enforcement
mechanisms are incomplete, imperfect, and expensive, and have the typical drawbacks
of rigid action controls. Good ethics is the glue that holds organizations and societies
together. It causes people not to be “unreservedly opportunistic [but to] constrain their
own behavior out of an ethical sensibility or conscience.”6
Lapses in ethics are often precursors of more serious problems, such as fraud. In a
financial reporting context, one study found that companies that were guilty of violating
generally accepted accounting principles (GAAP) were likely to be aggressive in their
financial reporting in periods prior to the violation.7 The aggressive financial reporting,
which many interpret as less than ethical, but not quite illegal, seems to be one step on
a “slippery slope” that can lead to costly, fraudulent activities.8 As Warren Buffett, chairman of Berkshire Hathaway, puts it:
Once a company moves earnings from one period to another, operating shortfalls that occur
thereafter require it to engage in further accounting maneuvers that must be even more “heroic.”
These can turn fudging into fraud.9
To control unethical behaviors within an organization, managers need well developed
ethical reasoning skills. Just as they need good skills in their technical disciplines in order
to make good business judgments, managers need moral expertise to make good ethical
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Ethical models
judgments. Senior managers should serve as moral exemplars, or role models, within their
organizations. They should also design their MCSs to promote moral points of view and
ethical behaviors. A number of highly specific controls, including some policies and procedures and elements of measurement and reward systems, stem from ethical analyses. But
these need to be supplemented with some other controls that help ensure ethical behaviors
in areas where totally precise organizational prescriptions are impossible. Training
sessions, codes of conduct, and credos help employees identify and think through
ethical issues.
Managers without a solid foundation in ethics can make any of a number of mistakes
that can lead to high probabilities of unethical behaviors within their organizations. First,
they sometimes fail to recognize ethical issues when they arise. One common problem is
that untrained people sometimes equate ethical and legal issues; they conclude that if an
action is not illegal, it must be ethical. This is clearly not true. While many laws do,
indeed, prohibit immoral practices, it is impossible to write laws to prohibit all unethical
actions. It is not even desirable to do so. Lying is usually considered to be immoral; however, laws prohibiting lying would not be enforceable, and even if they were, the enforcement would not be cost effective. As a consequence, lying is against the law only in the
most important circumstances, such as perjury. On the other hand, many would argue that
some laws themselves, such as those allowing abortion or those causing huge payments
to be made to victims of relatively minor accidents, are not morally defensible.
Second, some untrained people try to address ethical issues with simple rules, such as
“always tell the truth,” “do no harm,” or “do unto others as you would have them do unto
you.” Such simple, conscience-based rules only work when the values of the person
invoking the rule are shared by the others who are or might be affected. As a consequence, they rarely provide guidance for ethical behaviors in specific (management
control) situations because people’s values often vary widely.
ETHICAL MODELS
The first challenge in adapting ethical thinking to managerial settings is in recognizing
the ethical issues that do or might exist. The ethics literature includes numerous normative models of behavior. Almost all of these models recognize that in a social context,
ethics is about how actions affect the interests of other people. Every ethical issue
involves multiple parties, some of whom benefit while others are harmed or put at risk
by a particular action. The characterizations of harm or risk are made in terms of one
or more major ethical principles, rules, or values that are embedded in one or more
normative models of behavior.
The following sections describe briefly four common cited ethical models – utilitarianism, rights and duties, justice/fairness, and virtues. Each model has merit, but none is
perfect; each also has its limitations.
Utilitarianism
Using the utilitarianism (or consequentialism) model, the rightness of actions is judged
solely on the basis of their consequences. Utilitarian-type thinking has been accepted by
many businesses because of its tradition in economics, and it has been embedded in
many public policy decision procedures, such as welfare economics and cost-benefit
analyses. In this model, an action is morally right if it maximizes the total of good in the
world; that is, if it produces at least as much net good (benefits less costs and harms) as
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any other action that could have been performed. Sometimes this objective is phrased as
“the greatest good for the greatest number of people.” Utilitarianism does not mean that
the right action is the one that produces the most good for the person performing the act,
but rather the one that produces the most good for all parties affected by the action.
Utilitarian models are not without their limitations, however. Quantifying net good is
difficult because the benefits of some actions or decisions, such as job satisfaction, freedom from stress, or a risky possibility of additional profits sometime in the future, are
difficult to measure, aggregate, and compare across individuals.
Further, using utilitarian-type thinking makes it easy to sacrifice the welfare of a few
individuals for the good of a larger number of people. For example, in a famous case
from the 1970s, Ford Motor Company’s management decided not to do a safety retrofit
of the company’s Pinto subcompact car to prevent gas tank rupturing in cases of rear-end
collisions. They used the logic that the expensive retrofit of 11 million Pintos would save
only a maximum of 180 deaths, so it would not be cost effective from a societal point of
view. But in this case scores of people did suffer a fiery, presumably painful, death.
Rights and duties
The rights and duties model maintains that every individual has certain moral entitlements
in virtue of their being human. Commonly cited basic rights in most modern societies
include the rights to dignity, respect, and freedom. (Some societies also believe that people
should have welfare rights, such as the right to be educated, to have access to health care
and good housing.) Every right that an individual has creates a duty for someone else to
provide, or at least not to interfere. So if an individual is said to have a right to privacy,
then everyone else has a duty not to interfere with that person’s privacy. If top management has a right to be given informative performance reports from lower-level managers,
then those lower-level managers have the duty to provide those reports.
Like all the other models, rights and duties models have their limitations. It is sometimes
difficult to get agreement as to what rights different individuals or groups of individuals
should have because rights can proliferate, and they can conflict. Do smokers have the
right to smoke, or do others have the right to be free of secondhand smoke? Does top
management really have a right to receive totally informative performance reports, or
should lower-level managers have the right to retain some of their private information to
themselves in order to, for example, create some hidden reserves, up to some limit?
Justice/fairness
The justice or fairness model maintains that people should be treated the same except when
they are different in relevant ways. Most societies conclude that processes, not necessarily outcomes, should be fair. Most people are not concerned when the richest person in a
country wins a lottery because the process was fair. Having a fair process, such as in
evaluating employees’ performances, depends on impartiality and consistency.
But people differ in many ways, and determining which of these differences should be
considered relevant is a core issue that must be dealt with in applying the justice/fairness
model. Generally people are not concerned when employees’ compensation packages
differ based on differences in the tasks being performed. It is seen as fair for people with
jobs that are more difficult, more stressful, or riskier to be paid a premium. But most
people do not think it is fair for people who have greater needs, such as a single mother
with six children or a worker who has to support elderly parents, to be paid more than
others. Taking care of such needs is generally seen as a responsibility of government.
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Another limitation of the justice/fairness model is that it is easy to ignore effects on
both aggregate social welfare and specific individuals. Perceived justice for one group
may harm another group. For example, some pharmaceutical companies were ordered to
pay large judgments to plaintiffs who allegedly suffered physical ills even in cases where
there was little or no credible evidence linking their drugs causally to those ills. Do such
judgments provide justice for the plaintiffs but not the companies?
Virtues
A final commonly used model of moral behavior is rooted in virtues.10 Prominent examples
of virtues are integrity, loyalty, and courage. Individuals with integrity have the intent to
do what is ethically right without regard to self-interest. Integrity has many components,
including honesty, fairness, and conscientiousness. Loyalty is faithfulness to one’s
allegiances. People have many loyalties, to other persons, organizations, religions, professions, and causes. When loyalties conflict, their relative strength dictates how the conflict
is resolved. Courage is the strength to stand firm in the face of difficulty or pressure.
Virtues are often reflected in codes of conduct. The Standards of Ethical Conduct for
Management Accountants published by the Institute of Management Accountants is
shown in Figure 15.1.11 These standards, which describe role-related norms, are organized
FIGURE 15.1 Institute of Management Accountants: Standards of Ethical Conduct for Practitioners of
Management Accounting and Financial Management
Practitioners of management accounting and financial management have an obligation to the public, their profession,
the organizations they serve, and themselves, to maintain the highest standards of ethical conduct. In recognition of
this obligation, the Institute of Management Accountants has promulgated the following standards of ethical conduct for
practitioners of management accounting and financial management. Adherence to these standards, both domestically
and internationally, is Integral to achieving the Objectives of Management Accounting. Practitioners of management
accounting and financial management shall not commit acts contrary to these standards nor shall they condone the
commission of such acts by others within their organizations.
COMPETENCE
Practitioners of management accounting and financial management have a responsibility to:
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Maintain an appropriate level of professional competence by ongoing development of their knowledge and skills.
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Perform their professional duties in accordance with relevant laws, regulations, and technical standards.
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Prepare complete and clear reports and recommendations after appropriate analysis of relevant and reliable
information.
CONFIDENTIALITY
Practitioners of management accounting and financial management have a responsibility to:
Refrain from disclosing confidential information acquired in the course of their work except when authorized, unless
legally obligated to do so.
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Inform subordinates as appropriate regarding the confidentiality of information acquired in the course of their work
and monitor their activities to assure the maintenance of that confidentiality.
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Refrain from using or appearing to use confidential information acquired in the course of their work for unethical or
illegal advantage either personally or through third parties.
t
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FIGURE 15.1 continued
INTEGRITY
Practitioners of management accounting and financial management have a responsibility to:
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Avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict.
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Refrain from engaging in any activity that would prejudice their ability to carry out their duties ethically.
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Refuse any gift, favor, or hospitality that would influence or would appear to influence their actions.
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Refrain from either actively or passively subverting the attainment of the organization’s legitimate and ethical
objectives.
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Recognize and communicate professional limitations or other constraints that would preclude responsible judgment
or successful performance of an activity.
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Communicate unfavorable as well as favorable information and professional judgments or opinions.
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Refrain from engaging in or supporting any activity that would discredit the profession.
OBJECTIVITY
Practitioners of management accounting and financial management have a responsibility to:
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Communicate information fairly and objectively.
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Disclose fully all relevant information that could reasonably be expected to influence an intended user’s understanding
of the reports, comments, and recommendations presented.
___________________________
RESOLUTION OF ETHICAL CONFLICT
In applying the standards of ethical conduct, practitioners of management accounting and financial management may
encounter problems in identifying unethical behavior or in resolving an ethical conflict. When faced with significant
ethical issues, practitioners of management accounting and financial management should follow the established
policies of the organization bearing on the resolution of such conflict. If these policies do not resolve the ethical conflict,
such practitioners should consider the following courses of action:
l
Discuss such problems with the immediate superior except when it appears that the superior is involved, in which
case the problem should be presented initially to the next higher managerial level. If a satisfactory resolution cannot
be achieved when the problem is initially presented, submit the issues to the next higher managerial level. If the
immediate superior is the chief executive officer, or equivalent, the acceptable reviewing authority may be a group
such as the audit committee, executive committee, board of directors, board of trustees, or owners. Contact with
levels above the immediate superior should be initiated only with the superior’s knowledge, assuming the superior
is not involved. Except where legally prescribed, communication of such problems to authorities or individuals not
employed or engaged by the organization is not considered appropriate.
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Clarify relevant ethical issues by confidential discussion with an objective advisor (e.g. IMA Ethics Counseling
Service) to obtain a better understanding of possible courses of action.
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Consult your own attorney as to legal obligations and rights concerning the ethical conflict.
l
If the ethical conflict still exists after exhausting all levels of internal review, there may be no other recourse on
significant matters than to resign from the organization and to submit an informative memorandum to an appropriate
representative of the organization. After resignation, depending on the nature of the ethical conflict, it may also be
appropriate to notify other parties.
INSTITUTE OF MANAGEMENT ACCOUNTANTS
Statements on Management Accounting
Statement Number IC
(revised)
April 30, 1997
Source: Institute of Management Accountants (1997) IMA Statement of Ethical Professional Practice (www.imanet.org/pdf/3432.pdf). Statements on Management
Accounting. Statement 1C (revised), April 30, 1997.
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into four areas of virtue: competence, confidentiality, integrity, and objectivity. The
Financial Executives Institute’s code of ethics also uses virtue concepts. It requires
members to “conduct [their] business and personal affairs at all times with honesty and
integrity.”
Similarly, the document describing the code of conduct for Google Inc., the large
search-engine company, starts by describing the company’s “informal corporate motto”
– Don’t be evil. It then goes on to describe a number of corporate principles or values.
In the area relating to “Serving Our Users,” Google employees are asked to have their
actions guided by the following principles: usefulness (of products, features, and services), honesty, responsiveness (to users), and taking action.12 Parts of many corporate
codes of conduct define how individuals ought to behave; in other words, duties. Pure
virtue theory does not deal directly with duties, but it is often easy to derive duties from
individual virtues.
Virtues provide their own intrinsic rewards. Some economists deal with the whole
subject of ethics by just assuming a “virtuous behavior” parameter in individuals’ utility
functions. Virtuous individuals value, and hence pursue, these rewards. But organizations
are typically comprised of some people who do not value virtuousness. That is why other
forms of controls are necessary.
Publicized sets of virtues can be a valuable part of organizations’ control systems. Action
controls, such as policies and procedures, cannot always be made both specific and complete. Thus, as is spelled out in the conclusion to the Google, Inc. code of conduct:
It’s impossible to spell out every possible ethical scenario we Googlers might face, so we rely
on one another’s discretion and judgment to uphold this policy. We expect all Googlers to
accept and be guided by both the letter and the spirit of this Code. Often this will mean
making judgment calls about situations.13
Virtues fill in the gaps and provide guidance as to what is the right thing to do. They are
an element of personnel or cultural control.
But, of course, virtue theory also has its limitations. One problem is that the list of
potential virtues is long. For example, in addition to those mentioned in the codes
mentioned above, one might consider character, generosity, grace, decency, commitment,
frugality, independence, professionalism, idealism, compassion, responsibility, kindness,
respectfulness, and moderation. Critics of the virtue model argue that it is not obvious
which set of virtues should be applied in any given setting. In addition, some characteristics considered virtues can actually impede ethical behavior. Courage, for example, is
sometimes essential to commit fraud, and respect for elders (superiors) might actually
stop someone from exposing a fraud. It is also difficult to know whether particular
virtues exist in any individuals, how to develop virtues in individuals and groups of individuals, and how to recognize when day-to-day pressures are eroding the virtues.
ANALYZING ETHICAL ISSUES
Good ethical behavior needs to be guided by more than people’s opinions, intuitions, or
“gut feel.” Where the ethics of an action is in question, individuals should structure their
situational analysis by using a formal reasoning/decision model.
Various decision making models have been proposed, but most involve the following
sequence of steps:
1. Clarify facts. What is known, or what needs to be known, to help define the problem? The
facts should identify what, who, where, when, and how.
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2. Define the ethical issue. What about the situation causes an ethical issue to be raised? This
logic should be phrased using the terms of one or more of the ethical models. What stakeholders are harmed or put at risk? Are there conflicts over rights? Is someone being treated
unfairly? Is someone acting with less than total integrity?
3. Specify the alternatives. List the major alternative courses of action, including those that
represent some form of compromise.
4. Compare values and alternatives. See if there is a clear decision. If one course of action
is so compelling, then the analysis can be concluded.
5. Assess the consequences. Identify short- and long-term, positive and negative consequences for the major alternatives. This step will often reveal an unanticipated result of
major importance as, for example, short-term benefits will be shown to be dwarfed by
long-run costs.
6. Make a decision. Balance the consequences against the primary ethical principles or values and select the alternative that best fits.
It is important to recognize that different people can consider identical situations and
reach different conclusions even after structuring their decision processes equally carefully and thoroughly. This can occur because different people place different priority on
the various ethical principles. None of the ethical models is perfect and complete, and the
models sometimes lead to different conclusions. That insight is important by itself.
Managers need to be open to different approaches because different people will be viewing and judging their actions through different lenses.
WHY DO PEOPLE BEHAVE UNETHICALLY?
People behave unethically for any of four basic reasons. First, some people are just
basically dishonest; they are “bad apples.” For some people, greed, for example, seems
to dominate all of their virtuous thoughts, or at least good ethics costs more than they are
willing to pay.
A second cause is moral disengagement. Many people have no foundation in ethics.
They are ignorant. They might not even recognize an ethical issue when they face one,
so their conscience does not stop them from behaving unethically.
Third, some people who recognize ethical issues develop rationalizations to justify
their perhaps unethical behaviors.14 Here are some examples of such rationalizations:
“I need to pull some profits out of reserves this quarter to make our budget target because if
I don’t, we’ll have to lay off some employees.”
“Sure I’m playing games with the numbers, but everybody does it.”
“It’s true that I take some supplies home from the office, but some of my coworkers are stealing a lot more than I am by padding their expense accounts.”
“My boss told me to do it.”
“We decided as a team that this was all right.”
“It’s not really hurting anybody.”
“It’s so small, nobody will notice.”
Some of these rationalizations stem from a poor corporate culture. Unethical behaviors
are contagious.
And, finally, some people who are well trained in ethics and who know they are doing
something wrong are not able to stop because they lack moral courage. Moral courage
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can be defined as the strength to do the right thing despite fear of the consequences. It is
well known that those who insist on acting ethically can suffer any of many negative consequences, including shame, ostracism, and even loss of job. People with poorly formed
ethical beliefs and/or little moral courage may easily capitulate.
Those who wish to build up their moral courage should clarify their core values, those
they are willing to uphold regardless of the consequences. And those who recognize that
they do not have much moral courage should choose their work environments carefully.
They should choose environments in which it is unlikely they will be pressured to act
unethically.
SOME COMMON MANAGEMENT CONTROL-RELATED
ETHICAL ISSUES
Many ethical issues are embedded within and around MCSs. Some people use ethics
arguments to question the basic foundations of management control systems and, indeed,
capitalistic economies that empower management to make economic decisions. Many
critics argue that corporate restructurings and downsizings are unethical because they put
profits (and management bonuses) before employee welfare. Others counter, however,
that the restructurings are necessary responses to changes in the environment. While they
may cause pain to displaced employees, they help ensure that the restructured businesses
remain competitive and, thus, able to gainfully employ their remaining employees. Such
large political economy-related ethics questions are, however, beyond the scope of this
book. The following sections identify and briefly discuss four smaller, but common and
important, management control-related ethical issues: (1) creating budget slack, (2) managing earnings, (3) responding to flawed control indicators, and (4) using results measures that are “too good.” These issues are important, and the analyses required to deal
with them are also representative of those that could be used to analyze other issues that
might be faced.15
The ethics of creating budgetary slack
Many performance targets, particularly those used at managerial organization levels, are
negotiated between employees and their superiors. Negotiation processes provide opportunities for lower-level employees to “game” the process, that is, to distort their positions
in order to be given more easily achievable targets. This distortion is commonly known
as sandbagging or creating slack. As was discussed in Chapter 5, putting slack in budgets
is quite common.16
Is slack creation ethical? When employees create slack, they are exploiting their position of superior knowledge about business possibilities. They are failing to disclose to
their superiors all of their information and informed insights and are actually presenting
a distorted picture of the possibilities.17 Thus, creating budget slack can be interpreted to
be in violation of several of the obligations listed under integrity and objectivity in the
IMA’s Standards of Ethical Conduct (Figure 15.1).18 The integrity standard requires management accountants to “refrain from either actively or passively subverting the attainment
of the organization’s legitimate and ethical objectives.” The objectivity standard requires
management accountants to “communicate information fairly and objectively.”
Analysis in a utilitarianism framework also suggests that slack creation constitutes an
ethical issue. Typically, employees creating budget slack will benefit personally from their
act. Slack protects employees against unforeseen bad luck, such as an economic downturn
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or an increase in costs, thus increasing the probability that the employees will meet their
performance targets and earn performance-dependent rewards. If the reward-performance
function is continuous, as is typical, slack increases the size of the rewards that will be
earned.
An ethical issue is also raised because slack creation is often costly to some stakeholders,
especially the firm, its owners, and possibly creditors. Budgets containing slack are often
less than optimally motivating. When achievement of an organization’s goals is assured,
the effort of the employees in the organization may decline. For example, achievement
of a downward-biased annual profit target may be largely assured by August. What are
then the effects on the employees’ behaviors for the remainder of the budget period?
Managers know they do not want to exceed their target by too much because that might
cause them to be given a higher, more difficult target the following year. They may not
work as hard; they may make unnecessary expenditures to consume the excess; or they
may be motivated to play games to “save” the profit not needed in the current year.19
Slack creation also appears less than fair to the users of the budget submissions: upper
management. The users will rely on the information in the budget to make investment,
resource allocation, and performance evaluation decisions that will become distorted.
On the other hand, some arguments can be raised to support the position that slack
creation is ethical. Many managers, perhaps even a vast majority of them, argue that
creating slack is a rational response within a results control system. They do not view
slack as a distortion but as a means of protecting themselves from the downside potential
of an uncertain future. Viewed this way, slack serves a function identical to that of the
accepted management accounting practices of variance analysis and flexible budgeting, both
of which are used to eliminate the effects on the performance measures of some uncontrollable factors, and in so doing shield managers from the risk these factors create. This
protection from risk is particularly valuable in firms that treat the budget forecasts as
“promises” from the manager to the corporation, with dismissal the penalty for failure.20
Some managers also argue that budget slack is sometimes necessary to address the
imbalance of power that is inherent in a hierarchical organization. It helps protect lowerlevel managers from evaluation unfairness that can be caused by imperfect performance
measures or evaluation abuses by superiors.
Finally, managers who defend the creation of slack also point out that it is an accepted
part of their organization’s budget negotiating process. Managers at all levels of the organization negotiate for slack in their budgets, and everyone is aware of the behavioral norm.
Indeed, they point out, many top-level managers were promoted into their positions precisely because they were good at negotiating for slack and, hence, for achieving their
budget targets consistently. In many organizations, superiors actually want their subordinates to create slack because they also benefit from it. The superiors’ targets are
usually consolidations of targets of their subordinates, so they enjoy the same reduction
in risk and increase in the expected values of their rewards as the slack creators. When
creation of slack is widespread and the practice is encouraged, can we say that the
organization’s culture is encouraging unethical behavior, or does it indicate that in this
community, at least, creation of slack is an acceptable behavioral norm?
Thus in making judgments as to whether slack creation is ethical in any specific
setting, many factors must be considered, including:
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how good the performance measures are (the extent to which they reflect the manager’s or
entity’s “true” performance and are unaffected by factors the managers cannot control);
whether budget targets are treated as a rigid promise from managers to the corporation;
whether the manager’s intent in creating the slack primarily reflects self-interest;
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whether (or how much) superiors are aware of the slack;
whether the superiors encourage the creation of slack;
whether the amount of slack is “material”; or
whether the individual(s) involved are bound by one or more of the sets of standards of
professional conduct. (Most accountants are, whereas most managers are not.)
The ethics of managing earnings
A second important ethical issue involves the data manipulation problem discussed in
Chapter 5. A common form of manipulation is earnings management, which includes
any action that changes reported earnings while providing no real economic advantage
to the organization and, sometimes, actually causing harm.21 Generally, earnings management actions are designed either to boost earnings, such as to achieve a budget target
or increase stock price, or to smooth earnings patterns to give the impression of higher
earnings predictability and, hence, lower corporate risk. Some actions might also be
designed to reduce earnings, such as to “save” profits for a future period when they might
be needed or to lower stock price to facilitate a management buyout.22
As with slack creation, earnings management can be seen as unethical, at least sometimes, for any of several reasons. First, most of the actions are not apparent to either
external or internal users of financial statements. Thus, those engaging in earnings management may be deriving personal advantage through deception. Second, many people,
and most professional associations, believe that professional managers and accountants
have a duty to disclose fairly presented information. Third, the distortions can be interpreted as not being consistent with managers’ and accountants’ integrity obligations to
be honest, fair, and truthful. Fourth, the rewards earned from managing earnings are not
fair when the reported performance is only cosmetic, not real.
As in the area of slack, however, managers may have good justifications for managing earnings. They might be using their private information about company prospects
to smooth out some meaningless, short-term perturbations in the earnings measures to
provide more, rather than less, informative performance signals to financial statement
users.23 They might be taking actions necessary to protect themselves from rigid, unfair
performance evaluations. They might also be taking actions that make it unnecessary for
them to take other, more damaging actions, such as laying off employees or suspending
research and development expenditures in the face of a budget shortfall.
Interestingly, most people judge accounting methods of managing earnings more
harshly than they do the operating methods. This is true even though the purposes of the
two earnings management methods are identical, and the economic effects of the operating methods are typically far more costly to the firm.24 (As discussed in Chapter 5,
accounting methods of managing earnings involve the selection of accounting methods
and the flexibility in applying those methods to affect reported earnings. Operating
methods involve the altering of actual operating decisions, such as the timing of sales or
discretionary expenditures.) Clearer standards for judging accounting performance (such
as consistency with GAAP) could explain this finding. It is also in line with the contention that employees are more likely to engage in earnings management (or other questionable behaviors) when they believe it does not violate any established rules, policies,
or procedures, such as GAAP.25 This suggests that many people use clarity of standards
or laws as a basis for reaching an ethical conclusion. However, it is not true that standards
and laws (both of which may be flawed) should cause people to abandon good ethical
analyses and judgments.
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It is easy to see that many situational factors are likely to influence judgments as to
when earnings management actions are ethical. Some of the most important considerations probably include: (1) the direction of the manipulation (boost, shrink, or merely
smooth profits); (2) the size of the effect (materiality); (3) the timing (quarter vs. yearend,
random timing vs. immediately preceding a bond offering); (4) the method used (play with
reserves, defer discretionary expenditures, change accounting policies); (5) the managers’
intent regarding the informativeness of the numbers (and disclosures); (6) the clarity of
the rules prohibiting the action; and (7) the degree of repetition (one-time use vs. ongoing
use of the action after a warning). Because it is difficult to distinguish right from wrong,
it is difficult for managers to develop a set of rules to control earnings management
actions. This lack of control undoubtedly contributes to the high incidence of earnings
management. Because of their high incidence, Arthur Levitt, former chairman of the
Securities and Exchange Commission (SEC), spoke out and called the issue of earnings
management so serious that “we need to embrace nothing less than a cultural change.”26
The incidence and size of recent corporate scandals seem to have proven him right, as
Charles Niemeier, then-head of accounting in the SEC’s enforcement division, confirms:
Every year we have had progressively more financial fraud cases. That is not the big story. The
bigger story is the size of the companies being investigated. We are investigating more Fortune
500 companies than we ever have.27
The ethics of responding to flawed control indicators
Results targets and action prescriptions provide signals to employees as to what the
organization considers important, be it profits, growth, or quality. When the targets and
prescriptions are not defined properly, they can actually motivate behaviors that employees
know are not in the organization’s best interest. The employees earn the rewards for
doing what they are asked to do, but the organization suffers. These situations seem
to be relatively common. Recent surveys have shown that nearly 10% of employees
admitted that in the last year they had done things at work they would be ashamed or
embarrassed to tell their children, and nearly one-third of the employees sometimes feel
pressured to engage in misconduct to achieve business objectives.28 Many fraud cases
involve employees taking unethical and illegal actions that they perceive to be necessary for their company to thrive or survive, sometimes under pressure from upper
management.29
One commonly cited flawed-response example, myopia, was discussed in detail in
Chapter 11. It occurs when companies place a high emphasis on the achievement of
short-term profit targets, even though some profit-increasing activities (such as, reducing
investments in research and development) diminish shareholder value. Some managers
engage in myopic behaviors even knowing that they are doing long-term harm to their
entity and their company.
What should employees do if they know the results measures or action prescriptions
are flawed? Should they act to generate the results for which they will be rewarded, or
should they sacrifice their own self-interest in favor of what they believe to be best for
the organization? When they face this classic conflict of interest, most employees will
choose to follow the rules of the reward system, perhaps while lobbying to get the
measures changed. This behavioral norm may not be ethical. Management accountants
have professional standards of ethical conduct (duties) that require them to further their
organization’s “legitimate interests.” Managers are not bound by those standards, but
they should be bound by a sense of loyalty (a virtue) to their organization.
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Spreading good ethics within an organization
The ethics of using control indicators that are “too good”
Another ethical issue relates to the use of control indicators that are too good. Highly,
perhaps excessively, tight control indicators have been made possible by advances in
technology. Networking Dynamics of Glendale, California, a software company, sells
computer surveillance programs to allow supervisors to look at employees’ personal
computer screens,30 and there are many other technological examples that make electronic eavesdropping possible. Supervisors can listen in on employees’ telephone conversations or sales calls; cameras can record all the actions some employees take; computers
can count the number of keystrokes by data entry clerks and telephone operators to gauge
productivity; and location devices can track an employee’s whereabouts throughout
the work day. The US Federal Office of Technology Assessment has estimated that about
10 million employees are monitored by their employers for the time they spend on computers or on the phone with customers.31
What is the ethical issue? The number of correct keystrokes and reports of employees’
locations-by-time may be good results measures in certain situations. They may describe
what the organizations want from their employees, and they can be measured accurately
and on a timely basis. But there may be a conflict between the employer’s right to know
what is going on and the employees’ rights to autonomy or freedom from controls that
they consider oppressive.32 Some employees’ have described the use of such tight controls as creating electronic sweatshops. A study of telephone operators found that knowing that somebody might be listening significantly increases stress-related health
complaints.33 Thus, questions relevant to determinations of whether use of such measures
is ethical probably include:
l
l
l
l
Is the use of the measures secret or disclosed to employees? For example, are supervisors
listening after they have assured employees of privacy?
Were the employees involved in establishing the system (making it fair)?
When supervisors use such tight controls, do they emphasize quality, and not just quantity?
Do they use the measures just for monitoring employees in training, or do they also
monitor experienced employees?
SPREADING GOOD ETHICS WITHIN AN ORGANIZATION
Ethical progress within an organization typically proceeds in stages.34 In an early stage,
when the organization is small, the organization becomes an extension of the founder or
top management group. The founder acts as a role model, setting the ethical tone, and is
usually able to monitor employees’ compliance with that tone.
In a later stage of development, organizations predominantly use action accountabilitytype controls. Corporate specialists develop lists of specific standards, rules, and regulations embodying good ethical principles. They communicate these lists either through
corporate policies and procedures manuals, corporate codes of conduct, or less formal sets
of memoranda. These rules clarify the meaning of good ethics, make it clear that ethical
behavior is valued, and provide guidance to employees to think through ethical issues.35
After the rules are communicated, the managers take steps to ensure that the employees
follow the rules. Sometimes companies ask key employees to sign a statement certifying
that they have abided by the rules. At The Boeing Company, the large aircraft manufacturer, for example, employees are asked to certify annually that they will adhere to
the company’s code of conduct, which outlines the ethical business conduct required of
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employees in the performance of their company responsibilities. The company website
explains that “Individuals certify that they will not engage in conduct or activity that may
raise questions as to the company’s honesty, impartiality or reputation or otherwise cause
embarrassment to the company, among other things.”
However, even excellent codes of ethics and signed employee certification statements
are not sufficient. Consider the following excerpt from the Statement of Vision and
Values Principles of a large publicly held corporation:
Because we take our responsibilities to our fellow citizens seriously, we act decisively to ensure
that all those with whom we do business understand our policies and standards. Providing
clearly written guidelines reinforces our principles and business ethics. [Our] employees at all
levels are expected to be active proponents of our principles and are trained to report without
retribution anything they observe or discover that indicates our standards are not being met.
Compliance with the law and ethical standards are conditions of employment, and violations
will result in disciplinary action, which may include termination. New employees are asked to
sign a statement indicating that they have read, understand and will comply with this statement,
and employees are periodically asked to reaffirm their commitment to these principles.
What company espoused these principles and required signed statements certifying
understanding and compliance with the principles? Enron, a corporation now held up as
the epitome of corporate evil!
It should be obvious that merely having a set of ethical standards and rules and taking
steps to ensure that employees have read them is not sufficient. Top-level managers must
set a good “tone at the top,” and they must endeavor to maintain a good internal MCSs so
that potential violators know there is a high probability they will be caught. Monitoring
should be done by both employees’ superiors and internal auditors. Violators of the rules
must be sanctioned. These sanctions help give people the courage to resist counterproductive pressures.
Organizations at more advanced stages of ethical development place a higher emphasis
on personnel or cultural controls. Their managers recognize that it is dangerous to try to
induce employees to act ethically only because of economic reasoning. The expected costs
to employees of engaging in unethical behaviors is often low because the probability of
getting caught is generally quite low. This is a major reason why the incidence of
unethical behaviors is so high; it is easily discernable in most organizations. Managers
of companies at more advanced stages of ethical development recognize that virtues are
often learned by observations of exemplary behavior, so they identify and publicize
moral exemplars. They ensure that the proper tone is set at the top. They often appoint
an ombudsperson who is designated to help employees facing ethical issues. This more
advanced stage of corporate ethical development tends to produce a higher commitment to
ethical standards and a continuous improvement of the ethical structures and environment.
CONCLUSION
This chapter has provided a brief introduction to the topic of ethics as it relates to the
design and use of MCSs. To create the right ethical environment, the managers must have
moral expertise and know where and how to use it.
The sampling of issues discussed in this chapter should have made it obvious that many
important ethical issues are not black or white. One cannot conclude unequivocally that,
for example, creating budget slack or managing earnings is always unethical. Many situational factors must be considered in making ethical judgments. For example, judgments of
what is ethically acceptable vary across national cultures, suggesting that multinational
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Notes
companies wishing to achieve similar levels of ethicalness across divisions located in
different countries should probably rely on different ethical models or implement different controls.36 (The impact of multinationality on MCS-design is further discussed in
Chapter 16.)
Rational, well-informed individuals can reach different conclusions because they use or
emphasize different ethical models. The “greyness” of the answers, however, makes it even
more important for managers to subject the various ethical issues to a formal analysis.
They must understand how and why individuals will reach different ethical conclusions,
and, importantly, they must take a stand as to how they want employees in their organization to behave.
Once managers have conducted their ethical analyses and reached their conclusions as
to what is right, they must create a good ethical environment.37 Employees face many
pressures and temptations that can cause them to act unethically. They can easily bow to
performance deadlines and crises, reward temptations, pressures for conformity, and
even counterproductive direct orders from their superiors. Unless managers act to
minimize and deflect these pressures and temptations on a fairly consistent basis, their
company’s ethical climate will be weakened. Managers must help guide the behaviors of
their employees who are incapable of thinking through ethical issues (distinguishing
right from wrong) themselves.
Every organization has an ethical climate of some sort; either good, bad, or mixed.
It is important for managers to build a good ethical climate, one that respects the rights,
duties, and interests of stakeholders inside and outside the firm. A company that fosters
unethical behaviors from its employees, even those that benefit the company in the shortrun, will probably eventually find itself the victim of its own policies. This company is
more likely to attract people who feel comfortable bending rules. This company will
probably also tempt highly ethical, honest people to bend the rules.38 Weakened ethical
climates can lead to unethical behaviors that can damage or destroy individual and organizational reputations. Once ethical climates are weakened and reputations are damaged,
they can be quite difficult to rebuild.39
Notes
1. See R. W. Rutledge and K. E. Karim, “The Influence of
Self-Interest and Ethical Considerations on Managers’
Evaluation Judgments,” Accounting, Organizations and
Society, 24, no. 2 (February 1999), pp. 173–84; and
J. L. Luft, “Fairness, Ethics and the Effects of Management Accounting on Transaction Costs,” Journal of Management Accounting Research, 9 (1997), pp. 199–216.
2. J. C. Gaa and R. G. Ruland, “Ethics in Accounting: An
Overview of Issues, Concepts and Principles,” in J. C. Gaa
and R. G. Ruland (eds), Ethical Issues in Accounting
(Sarasota, FL: American Accounting Association, 1997).
3. R. E. Freeman, Strategic Management: A Stakeholder
Approach (Boston: Pitman, 1984).
4. American Institute of Certified Public Accountants,
Code of Professional Conduct, 2000. See also S.
Moriarity, “Trends in Ethical Sanctions within the
Accounting Profession,” Accounting Horizons, 14, no.
4 (December 2000), pp. 427–39.
5. C. Coleman and C. Bryan-Low, “Audit Fees Rise, and
Investors May Pay Price,” The Wall Street Journal
(August 12, 2002), p. C1.
6. E. Noreen, “The Economics of Ethics: A New Perspective on Agency Theory,” Accounting, Organizations and
Society, 13, no. 4 (1988), pp. 359–69.
7. M. D. Beneish, “Detecting GAAP Violations: Implications For Assessing Earnings Management Among
Firms With Extreme Financial Performance,” Journal
of Accounting and Public Policy, 16, no. 3 (Fall 1997),
pp. 271–309.
8. K. A. Merchant, Fraudulent and Questionable Financial Reporting: A Corporate Perspective (Morristown,
NJ: Financial Executives Research Foundation, 1987).
9. “Why Honesty Is the Best Policy,” The Economist
(March 9, 2002), p. 9.
10. This section is adapted from J. C. Gaa and R. G. Ruland,
“Ethics in Accounting: An Overview of Issues, Concepts and Principles,” in J. C. Gaa and R. G. Ruland
(eds) Ethical Issues in Accounting (Sarasota, FL:
American Accounting Association, 1997).
11. See also S. M. Mintz, “Ethical Obligations of Management Accountants,” Management Accounting, 76, no. 9
(March 1995), p. 42. A similar code of professional
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Chapter 15 · Ethical Issues and Analyses
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
700
conduct also has been issued by the Chartered Institute
of Management Accountants (CIMA) in the UK For a
comparison of the US (IMA) and UK (CIMA) codes,
see R. L. Madison and J. R. Boatright, “Comparing IMA
and CIMA Ethical Standards,” Management Accounting,
76, no. 10 (April 1995), p. 61.
Google, Inc. website.
Google, Inc. website.
Some of these examples are adapted from class notes
from Professor James Detert, Pennsylvania State
University.
This section is adapted from K. A. Merchant and W. A.
Van der Stede, “Ethical Issues of ‘Results-Oriented’
Management Control Systems,” Research on Accounting Ethics, 6 (2000), pp. 153 – 69.
S. Umapathy, Current Budgeting Practices in U.S. Industry: The State of the Art (New York: Quorum, 1987).
See also P. Brownell, “Participation in the Budgeting
Process: When It Works and When It Doesn’t,” Journal
of Accounting Literature, 1 (1982), pp. 125 –53.
K. Lukka, “Budgetary Biasing in Organizations:
Theoretical Framework and Empirical Evidence,”
Accounting, Organizations and Society, 13, no. 3
(1988), pp. 281–301.
Institute of Management Accountants, “IMA Revises
SMA 1C, Standards of Ethical Conduct,” Management
Accounting (July 1997), pp. 20 –1.
See also M. C. Jensen, “Corporate Budgeting Is Broken:
Let’s Fix It,” Harvard Business Review (November
2001), pp. 94–101; and M. C. Jensen, “Why Pay People
to Lie?,” The Wall Street Journal (January 8, 2001),
p. A32.
K. A. Merchant and J. F. Manzoni, “The Achievability
of Budget Targets in Profit Centers: A Field Study,” The
Accounting Review, 64, no. 3 (July 1989), pp. 539–58;
T. J. Rodgers, “No Excuses Management,” Harvard
Business Review (July–August 1990), pp. 84–98; W. L.
Accola, “Ethics: The Foundation of Internal Control,”
Management Accounting, 74, no. 6 (December 1992),
p. 15.
K. A. Merchant and J. Rockness, “The Ethics of Managing Earnings: An Empirical Investigation,” Journal of
Accounting and Public Policy, 13, no. 1 (Spring 1994),
pp. 79–94. Other performance measures can also be
“managed” in the same way. For example, studies have
shown evidence of balance sheet “window dressing,”
particularly by banks. The ethical principles are the
same, regardless of the measure being manipulated.
L. N. Bitner and R. Dolan, “Does Smoothing Earnings
Add Value?,” Management Accounting (October 1998),
pp. 44–7; K. Brown, “Creative Accounting: How to
Buff a Company,” The Wall Street Journal (February
21, 2002), p. C1. For a more extensive discussion of
earnings management practices, see C. W. Mulford and
E. E. Comiskey, The Financial Numbers Game:
Detecting Creative Accounting Practices (John Wiley
& Sons, 2002).
23. Evidence suggesting this result has been provided by
D. W. Collins and L. DeAngelo, “Accounting Information and Corporate Governance: Market and Analyst
Reactions to Earnings of Firms Engaged in Proxy
Contests,” Journal of Accounting and Economics, 13,
no. 3 (1990), pp. 213–47.
24. K. A. Merchant and J. Rockness, “The Ethics of
Managing Earnings: An Empirical Investigation,”
Journal of Accounting and Public Policy, 13, no. 1
(Spring 1994), pp. 79–94; and K. Rosenzweig and M.
Fischer, “Is Managing Earnings Ethically Acceptable?”
Management Accounting, 75, no. 9 (March 1994),
p. 31. For a related study (in another setting) of how
ethical judgments of earnings management vary across
different user groups (shareholders vs. nonshareholders),
see S. E. Kaplan, “Further Evidence on the Ethics of
Managing Earnings: An Examination of the Ethically Related Judgments of Shareholders and NonShareholders,” Journal of Accounting and Public
Policy, 20, no. 1 (Spring 2001), pp. 27–44. The results
of this study indicate that shareholders assessed earnings management less unethically when the earnings
management was intended for company benefit. The
intended benefit of the earnings management, however,
did not seem to influence the ethical assessments by
nonshareholders.
25. D. H. Clary and R. E. Welton, “Which Came First: An
Unethical Employee or a Bad Rule?,” Management
Accounting (July 1998), p. 59.
26. A. Levitt, The “Numbers Game,” Speech at New York
University Center for Law and Business (September 28,
1998), New York. See also C. J. Loomis, “Lies, Damned
Lies, and Managed Earnings,” Fortune (August 2, 1999),
pp. 74–92.
27. S. Pulliam, “SEC Broadens Accounting Practices
Inquiry,” The Wall Street Journal (April 3, 2002), p. A3.
28. Employees Say It’s Hard to Be Ethical in Some
Organizations,” Internal Auditor (February 1995), p. 9.
29. Y. J. Dreazen and D. Solomon, “WorldCom Alerts
About Accounting Went Unheeded,” The Wall Street
Journal (July 15, 2002), p. A3; Y. J. Dreazen,
“WorldCom Official Tried to Quash Employee’s
Accounting Concerns,” The Wall Street Journal
(August 27, 2002), p. B6.
30. G. Bylinsky, “How Companies Spy on Employees,”
Fortune (November 4, 1991), pp. 131–40.
31. A. Bernstein, “How to Motivate Workers: Don’t Watch
‘Em,” Business Week (April 29, 1991), p. 56.
32. G. Bylinsky, “How Companies Spy on Employees,”
Fortune (November 4, 1991), pp. 131–40.
33. Ibid.
34. J. A. Petrick and G. E. Manning, “Paradigm Shifts in
Quality Management and Ethics Development,” Business
Forum, 18, no. 4 (September 1993), p. 15.
35. J. M. Stevens, H. K. Steensma, D. A. Harrison and
P. L. Cochran, “Symbolic or Substantive Document?
The Influence of Ethics Codes on Financial Executives’
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Two Budget Targets
Decisions,” Strategic Management Journal, 26, no. 2
(February 2005), pp. 181–96.
36. J. J. Schultz, D. A. Johnson, D. Morris and S. Dyrnes,
“An Investigation of the Reporting of Questionable
Acts In an International Setting,” Journal of Accounting
Research, 31 (Supplement 1993), pp. 75–103; M. Islam
and M. Gowing, “Some Empirical Evidence of Chinese
Accounting System and Business Management
Practices from an Ethical Perspective,” Journal of
Business Ethics, 42, no. 4 (February 2003), pp. 353–78.
37. J. C. Collins and J. I. Porras, Built to Last: Successful
Habits of Visionary Companies (Harper Business,
1997); and T. B. Bell and L. A. Ponemon, “Building an
Effective Business Ethics Process,” Management
Accounting, 77, no. 12 (June 1996), pp. 16–20; E.
Schnebel and M. A. Bienert, “Implementing Ethics in
Business Organizations,” Journal of Business Ethics,
53, no. 1–2 (August 2004), pp. 203 –11.
38. A possible example of such a “contagion effect” can be
found in WorldCom where Scott Sullivan was perceived
as “. . . one of the best chief financial officers around.
He was seen as the key to WorldCom’s financial credibility, known for having straight answers to even the
most obscure financial questions – and being willing to
have substantive discussions about them. [ . . . ]
Investors now wonder if Mr. Sullivan’s allegiance to
Bernard Ebbers, WorldCom’s former chairman and
chief executive, helped lead him overboard as he tried
to stabilize the company during its deepening crisis.”
– From: S. Young and E. Perez, “Finance Chief of
WorldCom Got High Marks on Wall Street,” The Wall
Street Journal (June 27, 2002), p. B1. Another example
of “pressure to conform” might be found in J. Bandler
and J. Hechinger, “Executive Challenged Xerox’s
Books, Was Fired,” The Wall Street Journal (February
6, 2001), p. C1.
39. “Why Honesty Is the Best Policy,” The Economist
(March 9, 2002), pp. 9–13.
Case Study
In the three years since he had been appointed
manager of the Mobile Communications Division
(MCD) of Advanced Technologies Corporation
(ATC), Joe supervised the preparation of two sets
of annual budget numbers. When ATC’s bottom-up
budgeting process began Joe instructed his subordinates to set aggressive performance targets
because he believed such targets would push everyone to perform at their best.
Then, before Joe presented his budget to his
superiors, he added some management judgment.
He made the forecasts of the future more pessimistic, and he added some allowances for performance contingencies to create what he called the
easy plan. Sometimes the corporate managers
questioned some of Joe’s forecasts and asked him
to raise his sales and profit targets somewhat.
However, MCD operated in a rapidly growing,
uncertain market that Joe understood better than his
superiors, and Joe was a skillful and forceful negotiator. In each of the past three years the end result
was that the targets in the official budget for MCD
were highly achievable. MCD’s performance had
exceeded the targets in the easy plan by an average
of 40%, and Joe earned large bonuses. Joe did not
show his superiors the targets his subordinates were
working toward, but some of Joe’s direct reports
were aware of the existence of the easy plan.
In his subjective evaluations of his subordinates’
performances for the purposes of assigning bonuses
and merit raises Joe compared actual performance
with the aggressive targets. In the last three years
only approximately 25% of the aggressive targets
had been achieved. Joe did not fire any of his
managers for failing to achieve their targets, but
he reserved the vast majority of the discretionary
rewards for the managers who had achieved their
targets.
This case was prepared by Professor Kenneth A. Merchant.
Copyright © 1996 by Kenneth A. Merchant.
701
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Two Budget Targets
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Case Study
Conservative Accounting in the General Products Division
The year 1991 was a good one for the General
Products Division (GPD) of Altman Industries,
Inc., a large industrial products manufacturer. Sales
and profits in the division were significantly above
plan due largely to unexpectedly brisk sales of a
new product introduced at the end of last year. The
good fortune started Robert Standish, the GPD general manager, thinking about how he could save
some of this year’s profits for periods in which he
might need them more. He believed that GPD’s
plan for next year would be tough to achieve
because the corporation as a whole was not doing
well, and corporate managers would expect GPD to
show growth even above this year’s abnormally
high sales and profit levels. And already in
September he was sure that his division’s profit
would exceed the level above which no additional
bonuses were awarded for higher performance –
120% of plan – and he wanted to save some of this
year’s profits so that he could report them in a year
in which they would augment his bonus and those
of his direct reports.
Robert asked his staff to do what they could before
the end of the year to stash some acorns that he could
use in future years. He suggested to Joanne, his
controller, that she start preparing the pessimistic
scenarios that could be used to justify additional
reserves and start thinking about how expenses could
be accelerated and revenues deferred at yearend.
Joanne was uncomfortable. She reminded Robert
that among the company accounting policies was a
statement that assets and reserves should be fairly reported based on the existing facts and circumstances
and not be used to manage income. Furthermore,
because of continuing order declines, the company
was looking for ways to report higher, not lower,
profits in the current year and that if the situation
did not turn around quickly layoffs were threatened.
But Robert explained that GPD would still be
reporting very high profits; he just wanted to save
a portion of the excess above plan. And in any
case, GPD couldn’t help the corporation much
because it was so small in comparison with the
entire corporation.
This case was prepared by Professor Kenneth A. Merchant.
Copyright © 1996 by Kenneth A. Merchant.
Case Study
Education Food Services at Central Maine State University
Pam Worth, Manager of Education Food Services
at Central Maine State University (CMSU), is
meeting with a researcher to explain some apparent
discrepancies in last year’s budgeted figures and
the actuals. The researcher, a faculty member at
This case was prepared by Professor Kenneth A. Merchant.
Copyright © 1996 by Kenneth A. Merchant.
702
another university, is doing field studies in the food
service business. Pam is explaining why she always
tries to hide some slack in her numbers when she
prepares her budget. She says that it is her understanding that she is just doing what others in
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Education Food Services
her company and in her industry do. She agreed
to speak to the researcher only with guarantees of
strict confidentiality.
I like to have a moderate cushion in my budget. The
stakes are high. If I make my budget my performance
review will be good, almost regardless of whatever
else I do during the period, and I will earn my 20%
bonus. If I miss my budget without valid reasons I
may not be allowed to keep my job.
More than that, however, the cushion in the budget
allows me to do a better job. I don’t have to worry that
my staff is working at peak efficiency all the time, so
I don’t have to supervise every action. That is better
for the staff, also; they hate it when I’m looking over
their shoulders. The cushion also allows me to buy
things that I can use to provide the university with
better service. For example, this year I was able to
buy several portable bars that we have used already
for some parties.
Pam, an accounting graduate of Northern
University, is an employee of Contract Food
Services Corporation (CFSC), a large corporation
that provides food on a contract basis to universities, hospitals, and businesses. Pam runs a profit
center that provides services only to one university
– CMSU. Her operation provides food at two
major, on-campus cafeterias serving 12,000 students and nearly 2,000 faculty and staff. Pam also
has responsibility for the vending machine business
on campus, and her employees sometimes provide
catering services for on-campus business meetings.
Pam’s operation employs 59 regular employees and
between 150 and 180 students on a part-time
basis. Annual revenues are slightly in excess of $3
million.
Relations between CFSC and CMSU are governed by a contract that is renegotiated each
January for the following academic year. The
contract defines the responsibilities of each party.
For example, CMSU administrators are given the
power to review and approve CFSC’s service plans
and prices. The university provides all equipment
costing over $100. CFSC sets the menus and hires
the employees.
The contract also defines limits on the profits
CFSC can earn from the CMSU operation. CFSC
earns 100% of the profits from the food operation
up to a limit of 10% profit on sales. Beyond that
limit, profits are split equally with CMSU. The contract is set this way as an incentive to CFSC man-
agers to provide extra quality and services after
they have ensured themselves a reasonable profit.
Budgets are prepared on a bottom-up basis. In
July corporate headquarters personnel send planning guidelines and assumptions (e.g. employee
benefits, inflation) to all operating units. The
operating managers forecast their customer counts,
which determines their food requirements, and
then estimate their operating costs for the 18-month
period starting in January. Since the university
owns the buildings and equipment the bulk of
CFSC’s costs are for food and labor.
After the units’ budgets are prepared a series
of budget challenge rounds are held to review the
numbers at successively higher CFSC consolidation levels – district, region, division, group, and
corporate. If the numbers meet the managers’ profit
expectations the budgets are accepted. Typically,
however, each of the managers in the hierarchy is
asked to raise his or her profit targets. These
requests lead to a series of meetings designed to
explore whether revenue projections should be
raised or cost projections cut. The size of these
profit increase requests are not predictable, but in
recent years they have ranged from zero to 15%.
Pam explains that she routinely hides some
cushion in both labor and food costs:
I can build the budget cushion in a lot of places. This
year for example:
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I kept the proportion of meals served on board
contracts (which are more lucrative for us) equivalent to last year’s level even though I know that
proportion will be growing because the trend is to
have more students living on campus.
I planned for a number of labor hours at $7.15
when I knew that I would hire students for those
hours, and students don’t earn that much.
I planned no efficiency improvements when I
know we almost always improve our efficiency.
There is a learning curve in this business. My
superiors know about this learning curve too – they
ran operations just like this – but they don’t object
to my having a cushion. It is to their advantage to
have me meet my budget too.
These types of things add up. I put just enough in so
that I am sure I will be able to meet my budget targets
even after corporate management squeezes some of
my cushion out in their reviews.
I know more about what is happening at CMSU
than anyone else. My bosses can’t come here and
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check every assumption that I have in the plan. They
don’t have the time. My immediate boss, for example,
is responsible for nine units spread over a fairly large
geographic area.
You can easily identify new managers – they submit budgets that are realistic. Experienced managers
build in pads for themselves. It’s a bit devious, sure,
but it’s not theft. It’s just playing with projections.
The money’s there. Besides, if you don’t build a
cushion for yourself you’re not going to survive for
long in this business.
Case Study
The “Sales Acceleration Program”
In early October, Priscilla Musso, general manager
of the Specialty Products Division (SPD) of Consolidated Furniture Corporation (CFC), was studying
the division’s third quarter financial reports. Sales
were running significantly below plan, and it became
quite clear to Priscilla that SPD would need strong
performance in the last quarter of the year in order
to reach its annual profit target. Meeting budget was
very important to Priscilla and her management
team because they were included in CFC’s lucrative
executive bonus program, and they would lose all
of their bonus opportunities if SPD did not achieve
the profit targets.
To brainstorm for ideas, Priscilla called her management team together. At first the managers on the
team expressed only discouragement. Everybody had
been working hard, but the market was softening,
and competitors were being very aggressive.
Then, after some delay with nobody else suggesting any options, Jonathan Robbins, SPD’s manager
of sales and marketing, suggested that the division
could implement a new sales program to pull some
sales that might ordinarily be made next year into
the current year. Any customers who accepted
delivery in the fourth quarter would not have to pay
their invoice for six months. (Normally payments
in the industry were to be made within 30 days.)
Priscilla’s first reaction was favorable; this
program might, indeed, achieve the desired result.
This case was prepared by Professor Kenneth A. Merchant.
Copyright © 2005 by Kenneth A. Merchant.
704
But she asked the members of her team for their
reactions.
Shirley Covey, manager of human resources
noted that if this program was successful, it would
probably cause SPD’s employees to have to work
overtime at the end of the year, and that was something they traditionally did not want during the
holiday season. But Priscilla reminded Shirley that
the employees would be paid time-and-a-half for
all the overtime hours that they worked.
Priscilla asked Bill Bennett, SPD’s controller, if
this program would violate any accounting rules. Bill
said there would be no problem recording the sales
as long as the items were shipped and billed before
December 31. The accounting would be consistent
with GAAP. But Bill cautioned that this program
was probably only providing a short-term, cosmetic
profit improvement. While it might well make the
current year look better, it would probably cause
significantly lower sales to be recorded in the first
quarter of next year. So next year the division
would start in a deep hole. They would be scrambling all year to trying to dig themselves out of that
hole, with no guarantees that they could pull it off.
It was just postponing the problem. In addition,
Bill reminded the team that this program would be
very expensive. On top of the overtime expense
that would have to be incurred in the production
areas, the program would greatly increase SPD’s
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accounts receivable. CFC was currently paying
about 12% on its lines of credit, so this increase in
working capital would be quite expensive for the
corporation.
But Priscilla cut Bill short. She reminded him
that CFC did not allocate interest expenses to SPD,
so she was not particularly concerned about the
corporation’s increased borrowing costs. She was
more worried with her superiors’ negative reactions
if she did not make this year’s profit plan than she
was about their reactions to her allowing the receivables’ balance to increase in the early part of the
year. And while she acknowledged that they might
be creating a problem for next year, she suggested
it would be best to worry about that problem when,
and if, it became real.
With no other options on the table to solve the
current year’s budget problem, the SPD managers
decided, unanimously, to implement what they
called the “Sales Acceleration Program.”
Case Study
On September 30, Jianxin (Jimmy) Wu, manager of
the Information Systems Department for Southwest
Industries (SWI), was in panic mode. SWI was a
medium-size manufacturer of portable shelters, tents,
and awnings. Jimmy was panicking because the
company’s Citrix software had just died. Because
of his oversight, an invoice had not been paid, and
the SWI’s license to use the software had expired.
Jimmy knew that something had to be done very
quickly. Many of the company’s information systems users, who were situated at three different
locations, relied heavily on the Citrix software. All
of SWI’s applications ran under Citrix. The Citrix
software gave all employees access to the SWI
applications they needed no matter where they
were, as long as they had access to the Internet. The
Citrix license renewal would cost $3,600, but going
through the purchasing department to get a requisition issued would take several days. The users could
not be without the Citrix capability for that long.
Then Jimmy thought about using his purchasing card. The card, which worked like a credit
card, was intended for small purchases, not including travel, hotels, or food. SWI issued the card
to some of its key personnel to avoid the costs of
processing the paperwork required for many small,
incidental purchases. The company only had to
make one single payment to the credit card
company, and the credit card company did all the
processing.
The maximums placed on Jimmy’s card were
$2,000 for any single purchase, and $5,000 per
month. Jimmy knew that these limits were strictly
enforced. Personnel in the accounting department
scanned the bills monthly looking for violations.
But Jimmy thought that he could get Citrix to split
the bill in two, and then the accounting department
personnel would not raise any objections.
With no other apparent options at hand, Jimmy
decided to try to use his card to renew the license.
The Citrix salesman agreed to charge the card in
two transactions of $1,800 each. The license was
renewed quickly, and few of SWI’s Citrix users
were ever aware that there had been a problem.
This case was prepared by Professors Kenneth A. Merchant and Leslie R. Porter.
Copyright © 2005 by Kenneth A. Merchant and Leslie R. Porter.
705
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Case Study
The Platinum Pointe Land Deal
In early December 2006, Harry Hepburn, president
of the Southern California Division of Robinson
Brothers Homes, was faced with a significant challenge. The markets his division served had slowed
considerably. To sell its homes, the division often
had to make significant price concessions. But construction costs were continuing to rise, so margins
were getting squeezed. It was clear that the division
was not going to achieve its 2006 sales and profit
plan. But what was worse, corporate executives
were recommending a significant downsizing of the
division in 2007 to wait until the housing market
rebounded. Harry resisted this idea. He thought he
had assembled a great employee team. The division’s performance had been outstanding during the
good years in the early 2000s. He wanted to keep
his team intact. But that required finding a continuing stream of good projects for them to work on.
One promising project on the horizon was
called Platinum Pointe. It was a large project that
promised to provide over $100 million in revenue
and nearly $14 million in profits in the 2008–11
time period. It would keep a lot of employees
productively busy. Harry really wanted to do the
project. However, the financial projections suggested that the project would not quite earn the
returns that the corporation required for projects
with this level of risk. He contemplated preparing
projections that were a “little more optimistic” to
ensure that the project would be approved.
THE COMPANY
Robinson Brothers Homes (RBH) was a mediumsized homebuilder. The company built single-family
and higher-density homes, such as townhouses
and condominiums. By 2006, RBH built almost
2,000 homes per year. Because it was much smaller
This case was prepared by Professor Kenneth A. Merchant.
Copyright © 2007 by Kenneth A. Merchant.
706
than the largest homebuilders who had economiesof-scale advantages,1 RBH focused on building
higher quality/higher price homes for first and second move-up buyers. In 2006, the average closing
sales price for an RBH home was slightly more
than $400,000.
RBH’s stock had been traded publicly since 1995.
The company had been highly profitable throughout
the past decade, but finances were expected to be
much tighter in 2007 because of the homebuilding
slowdown that had started in early 2006. The stock
price had declined almost 50% from the all-time
peak in 2005.
RBH’s organization was comprised of a headquarters staff located in Denver, Colorado, and 15
divisions located in most of the metropolitan areas of
the Central, Mountain, and Southwest areas of the
United States. The headquarters staff was small, comprised mainly of specialists in the areas of finance,
accounting, legal, information systems, sales and
marketing, and customer service, and their staffs.
Each division was largely self-contained, with its
own construction supervision, customer care, purchasing, sales and marketing, land development, land
acquisition, and accounting staffs. The only major
function that was outsourced was construction.
RBH’s construction superintendents supervised the
general contractors who built the homes to RBH’s
specifications.
Exhibit 1 shows the organization chart for the
Southern California division. This division, one of
RBH’s largest, employed approximately 120 people.
In 2006, it was projected to sell 637 homes, generating $235 million in revenue and $40 million in
net income.
1
For example, D. R. Horton, Inc., the largest homebuilder in the
United States, was building over 50,000 homes per year.
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LAND ACQUISITION
Land acquisition was a key function in the homebuilding business. RBH’s land acquisition personnel had to find land on which the company could
build homes that could be sold at a good profit. The
lag between acquisition of the land and sale of
the final house built was typically three–five years.
Sometimes the permit-acquisition process itself
dragged on for years, with the company fighting
lengthy, emotional battles with city councils and
other permit-granting organizations. On the other
hand, sometimes land was acquired at “retail price,”
with all the permits already having been granted.
As a standard part of the land acquisition process, RBH’s land acquisition personnel were
required to prepare a detailed land acquisition
proposal. These proposals provided detailed information on:
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the nature of the request;
the location;
entitlements;
infrastructure;
product design;
market overview;
environmental considerations;
development fees and costs;
special assessments and homeowner association dues
(if any);
school information;
project milestones;
risk evaluations; and,
financial projections.
Many of the detailed proposals were 100 or more
pages in length and often included detailed maps,
product sketches, and excerpts from consultants’
reports.
An important part of the proposal-writing
process was a detailed evaluation of the project’s
risk in four areas: political, development, market,
and financial. The risk in each area was evaluated
subjectively into three categories: low, moderate, or
high. The risk assessments in these areas were
translated into a minimum internal rate of return
(IRR) requirements for the project, according to the
procedure shown in Exhibit 2.
Many land acquisition ideas failed to progress
to the approval stage for any of a number of reasons, including inadequate financial returns, excess
risk in the permit-granting process, or a mismatch
between the needs of the market and the company’s
capabilities. If the proposals were approved by
the division president and RBH’s CEO and CFO,
the division president then presented them to the
Executive Land Committee of the Board of
Directors for final approval. Only then could the
monies be released.
THE PLATINUM POINTE SITE
The Platinum Pointe site was identified by Michael
Borland, the vice president of land acquisition for
the Southern California Division. The Platinum
Pointe site was located in the Emerald Estates
master planned community being developed by
Jackson Development Company.
Jackson Development was recently formed by
Tom Jackson, who had formerly worked as division
president of one of RBH’s competitors. Michael
Borland and Tom Jackson were long-time friends,
back to their time together as fraternity brothers at
San Diego State University. Michael called Tom
soon after he learned of the formation of Jackson
Development. He looked forward to developing
some projects jointly with Tom.
Michael discussed with Tom several sites in the
planned Emerald Estates community. They finally
settled on a 21-acre site on the northeast corner of the
master planned community. The proposed purchase
price was $22,500,000 plus a profit participation by
Jackson Development in the amount of 50% above
9% net profit, with a soft cost allowance of 20%.2
Michael’s experience suggested to him that
higher density housing, rather than single-family
detached homes, would provide the best use of this
site. Over the forthcoming several months, he fleshed
out the idea with the division and corporate specialists, particularly in the areas of sales and marketing
and construction. He also contracted for special
2
Soft costs are costs related to items in a project that are necessary
to complete the nonconstruction needs of the project, which
typically include such items as architecture, design, engineering,
permits, inspections, consultants, environmental studies, and regulatory demands needing approval before construction begins.
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studies from two outside consulting firms. One consulting firm prepared a report detailing projections
of the costs needed to develop the site. The other
prepared a marketing study that provided pricing
and absorption rate estimates based on analyses of
competitive offerings and forecasts of market
trends in the geographical area.
Michael wrote a detailed proposal for building
195 homes in two formats: a triplex townhome and
a six-plex cluster home. Other RBH divisions had
produced similar homes, but the format had not been
previously offered in Southern California, and some
modifications were made to appeal to southern
California buyers. The homes would range from
1,628 to 2,673 square feet and be priced from
$445,000 to $705,000. The executive summary of the
detailed proposal, with the required risk assessments
and financial projections, is shown in Exhibit 3.
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Michael was disappointed when he saw the projected IRR for the project. It was only 21%, which
was below the minimum required for a project with
this level of risk – 24.5%. He decided to discuss the
problem with Harry Hepburn to see what, if anything, could be done.
WHAT TO DO?
Harry, too, was disappointed. He had hoped that the
Platinum Pointe project would provide a significant
proportion of the revenues and profits that the division would need over the next four-year period. He
still wanted to do the project. So he and Michael sat
down to take another look at the detailed proposal.
What modifications could they make to lower the
required IRR or to raise the projected IRR to ensure
that the project would be approved?
EXHIBIT 1 Robinson Brothers Homes, Southern California Division, organization chart
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EXHIBIT 2 IRR requirements
Land acquisition opportunities and the related product choices continue to expand for Robinson
Brothers Homes. Given that risks can vary greatly from opportunity to opportunity, guidelines to
assess risk and the required minimum returns have been established. The risks to be assessed
are as follows:
1. Political/Entitlement – ability to achieve expected entitlements and timing;
2. Development – site conditions and ability to accurately project development costs;
3. Market – experience with proposed product type, product price points, buyer types, current
market conditions both current and future;
4. Financial/Financing – ability to achieve projected results and obtain proposed financing.
Based on these factors, a minimum unleveraged IRR is to be established. Risk ratings are to be
assessed based on the projects’ specific characteristics. Each area is to be rated as Low,
Moderate, or High. A numerical value is to be attached to assessment as follows:
Political
Development
Market
Financial/Financing
Low
Moderate
High
5.0
5.0
5.0
4.0
6.5
6.5
6.0
5.0
8.0
8.0
7.0
6.0
The minimum IRR for the project is assessed as the sum of the ratings assigned in each of the
four assessment areas.
EXHIBIT 3 Platinum Pointe investment proposal – executive summary (initial draft)
The Southern California Division is requesting approval to acquire the 21-acre site known as Platinum Pointe in
Carlsbad, CA. The site will yield 198 detached and attached homes. The purchase price is $22,500,000. The projected
IRR is currently 21%, and the required IRR is 24.5%. Close of escrow is projected to occur in June 2007.
LOCATION
The site is located on the east side of Interstate 5 in the City of Carlsbad, located 30 miles north of San Diego. The site
is in the Emerald Estates community being master planned by Jackson Development Company, Inc. The master planned
community is comprised of just over 200 acres to yield approximately 1,000 units. The community will have a range of
product from townhomes to duplexes, as well as single-family homes on lots ranging in size from 4,500–7,500 s.f.
PURCHASE
The Seller is Jackson Development Company, Inc. The purchase price of the property is $22,500,000 for 21 net acres.
The purchase price is not tied to unit count. We are currently projecting construction of 123 townhome units and
72 cluster units. The Master Development Plan approval is a closing contingency. Should the Master Development
Plan not be approved, we have the option to waive the condition or terminate the Agreement. The close of escrow
is targeted for June 1, 2007. We have the option to purchase two non-refundable nonapplicable 30-day extensions
should our tentative tract map not yet be approved. Should the Seller cause a delay that would prevent us from
processing our entitlements in a timely manner, we will be granted the right to have the extensions without payment
of the extension fee. This project includes profit participation by the Seller for the amount of 50% above 9% net profit,
with a soft cost allowance of 20%. We have run multiple scenarios to include interest rate increases, financing
options, construction delays, and a slow down in absorption. We are comfortable that we will stay below the 20%
threshold.
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EXHIBIT 3 continued
We have explored the option of negotiating this deal with no profit participation. Jackson was open to negotiations
where we would increase the land price and move forward with no profit participation on the back end of the deal. But
the increase in land price would decrease the projected IRR on the project.
RISK EVALUATION
Political
The property is located within the Emerald Estates Master Plan area. It is zoned PCD (Planned Community
Development). The Seller is preparing a detailed Master Development Plan (MDP) that will be submitted to the City of
Carlsbad in early January 2007. Our proposed project will be part of that submission. The Seller has been working with
the City throughout the creation of the MDP and has gained support of the project. If one contingency – preservation
of habitat for the Western Speckled Toad possibly located in the area – can be solved, the Seller projects that the
guidelines will be approved by the City in March 2007. A neighbor claims that the site is habitat for the Toad, but the
Environmental Impact report has not yet been completed. If the Toad issue is real, we will have to place a permanent
habitat on the property. We think we can do this without losing any buildable lots.
With the approval of the MDP, our review by the Design Review Committee will be expedited. Our proposed project
will be designated R-M (Medium Residential, 8–10 duplexes/acre). Our current site plan shows a total of 195 units,
which is approximately 9.29 duplexes/acre. We have met with the Director of Development Services three separate
times. We believe that our latest site plan incorporates the City’s requests. We will need to process a tentative map
and to obtain approval from the Design Review Board for the site plan and architecture. The tentative map is expected
to be received by May 2007, and all appeal periods are expected to expire before we close in June 2007.
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Development
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The site is currently raw land, but it will be delivered as a mass-graded pad. The Seller received the grading permit on
November 7, 2006, and has started grading. Grading will be completed in January 2007. The Seller will construct all
offsite backbone sewer, water, storm drain, dry utility, street improvements, and perimeter landscaping. The street
and storm drain plans are approved, as well as the sewer and water plans. Backbone utility plans are currently being
designed. The Seller will provide utility stubs to the site if we are able to give them fixed entry locations prior to their
installing the improvements. Otherwise, we will have to connect to the systems. The Emerald Estates master
development infrastructure will not be completed prior to our close, but the Seller will soon begin the improvements.
The improvements are being funded by the CFD [Community Facilities District]. Should the Seller fail to make the
improvements in the timeline presented in the agreement and their failure to complete the improvements affects our
site specifically, we have the right to assume responsibility for completion of the remaining Seller work, and Seller shall
reimburse Buyer at 110% of the third party direct costs. In addition to cooperating with Buyer without limitation, Seller
shall insure that Buyer is able to draw against or obtain reimbursement from the CFD for completing the remaining
improvements.
As mentioned above, the CFD will be funding the entire infrastructure for the site. The CFD has an approved
Resolution of Intent. The Resolution of Formation went to City Council and was continued to January 12, 2007. The
CFD is confident that the formation will be heard at the January 13th meeting. The bonds will be sold in two issues. The
first bond sale, expected to be $30–35 million will cover backbone infrastructure, including sewer, water, streets, and
storm drain. This is expected to occur in March 2007. The second bond sale will occur approximately six months later
and will include dry utilities and landscaping. The CFD has told us that the appraisal is underway and should be
completed shortly. They do not see any issues with the appraisal meeting the 3:1 coverage requirement. The bid
package for the first bond sale is complete and will be submitted for City review in January/February 2006.
Furthermore, the City of Carlsbad is the lead agency and is pushing to get the backbone infrastructure constructed.
The improvement plans have been through multiple plan checks and the tax rate will be approximately 1.8%.
In addition to the infrastructure, the CFD will be funding certain impact fees. We are expecting to receive a $8,500
plus credit per unit from the CFD to cover a portion of the fees. The fees that will be covered by the CFD include webbed
toed lizard, drainage fees, signalization fees, sewer and water connection fees, supplemental water fees, and Art in
Public Places fee. Our in-tract development costs are derived from a cost estimate based on our current site plan, which
was prepared for us by the Evensen Group. These costs, including fees and net of the planned CFD reimbursement,
come to $63,088 per unit. This total includes a 15% contingency on construction items and a 10% contingency on fees.
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EXHIBIT 3 continued
A site visit was performed by an environmental consultant and previous Phase I report were also reviewed. Other
than the possible Western Speckled Toad issue, there are no potential environmental concerns and no additional
assessment appears to be necessary. A geotechnical investigation concluded that the site was suitable for the
intended use.
The Seller will also be establishing a Master Homeowners Association to maintain the perimeter and median
landscaping. We will create our own sub-association to maintain our on-site landscaping detention basin and
recreation facilities.
The Seller will be mass grading the well and park sites and designing the park. We will be responsible for
constructing the well site improvements, excluding the well itself, and construction of the park. We have included $1.0
million for the park and well site. The well site improvements consist of a block perimeter wall, some landscaping iron
drive gates and drive approach. The park improvements are in the preliminary planning stages and are expected to
include landscaping, a tot lot, picnic tables, shade structures, walkways and lighting, and possible restroom facilities.
The costs of the park and well site will be initially funded from equity in the short term but will be reimbursed through
the CFD. The well site will be deeded to the Carlsbad Water District (CWD), and the park will be deeded to the City of
Carlsbad. Both the well site and the park will be maintained by each entity respectively.
Direct Construction
The townhome product consists of new plans that we have not built before and direct construction costs continue to
rise. However, the cluster product is a modification of product our Phoenix Division has built before. The direct
construction estimates we have used are derived from our actual costs in building the 10-plex product in El Cajon,
which is coming in at about $80 psf. There we added an additional $10 psf to account for the increased specs we are
including in these new townhomes.
Overall we conclude that the risks associated with both site development and direct construction are moderate.
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Competitive Analysis/Market Risk
We will be building two product types, a triplex townhome and a six-plex cluster product. The triplex townhome ranges
in square footage from 1,753 square feet to 2,442 square feet and will be priced from $445,000 to $595,000. We feel
this product will appeal to buyers who work in north San Diego County and second home owners (weekend or
seasonal) who are attracted to a low maintenance home with a larger yard. The cluster will range in square footage
from 1,628 square feet to 2,673 square feet and be priced from $450,000 to $705,000. These pricing projections are
the exact prices recommended from our marketing consultant, the Blackfield Group. This is an upgrade version of a
product that was very successful in Phoenix. It will be highly amenitized. The master baths have been revised to meet
the new “wow” factor that is pervasive in this submarket. There is currently very little competition for attached or middensity product in the Carlsbad area. We are currently unaware of any other 8–10 units/acre development projected
within the City of Carlsbad at this time, but we continue to monitor new development projects within the City. We have
a completed marketing study by the Blackfield Group that supports our product type and pricing. We are comfortable
with the absorption recommendation from Blackfield given the two very separate product lines. The models in our
estimates are currently slated to open in July 2008. Our absorption would maintain 15 homes per month average as
recommended by the Blackfield Group. But there is risk. The north San Diego County market has experienced a
noticeable downturn in the last 12–18 months. If interest rates continue to increase and if prices in markets throughout
north San Diego County continue to moderate, we may not be able to maintain our absorption rate, or we will have to
shave our margins.
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Financial/Financing Risk
All indications are that interest rates will continue to rise. In the event that interest rates increase substantially during
the life of this project, our product will still be positioned in a more affordable segment of the market. Given the size of
the transaction ($48 million at March 2009), some form of outside capital will be used. Lot option and or joint venture
will be considered and leads to the moderate financial risk.
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EXHIBIT 3 continued
IRR REQUIREMENTS
Based on the above analysis and assessed risk, the IRR requirements are as follows:
Political
Moderate
6.5
Development
Moderate
6.5
Market
Moderate/High
6.5
Financial
Moderate
5.0
Required IRR
24.5%
FINANCIAL SUMMARY
Total Sales Revenue:
Profit ($):
Profit (%):
Equity Required:
Home Size Triplex:
Home Size Cluster:
Direct Costs Triplex:
Direct Costs Cluster:
Base Sales Price Triplex:
Base Sales Price Cluster:
Base Sales Price Triplex: ($/sf)
Base Sales Price Cluster: ($/sf)
IRR Leveraged:
IRR Unleveraged:
$112,050,000
$13,707,000
12.2%
$8,722,000
2,151 sf weighted average
2,126 sf weighted average
$93/sf weighted average
$82/sf weighted average
$531,667/unit weighted average
$571,667/unit weighted average
$247.17/sf weighted average
$268.89/sf weighted average
41.4%
21.0% (Required 24.5%)
TOTAL PEAK EQUITY
$11,809,000
713
MANC_C15.qxd 08/01/2007 11:39 AM Page 714
Chapter 15 · Ethical Issues and Analyses
Case Study
Lernout & Hauspie Speech Products
This case is a tragic blow not just for Belgium but
also for all of Europe. It shows how badly we need
much greater transparency and a sense of corporate
governance. For too long, banks and businesses did
not feel they should be held accountable to shareholders. That has to change.1
Philippe De Buck,
Executive Director, Belgium Federation of Industries
Mr. De Buck was referring to the demise of Lernout
& Hauspie Speech Products (L&H), which had
been considered one of Belgium’s most promising
high technology companies. The company declared
bankruptcy in October 2001 after the discovery of
a massive accounting fraud that implicated many
L&H managers, including the top management
team. Like many others Mr. De Buck wondered
how this could have happened and what might be
done to avoid scandals like this in the future.
THE COMPANY
The entrepreneurs
L&H was founded in 1987 when Jo Lernout, then
a sales executive with the Belgian arm of Wang
Laboratories, Inc., grew intrigued by an early Wang
voice-mail system. The system was not selling well
because many Europeans still had rotary phones
and could not use them to select amongst the voicemail choices. Mr. Lernout’s idea was to create
software that allowed users to make voice-mail
selections by speaking into the phone. He set up a
company to commercialize speech technology.
Pol Hauspie, who owned a small firm that made
accounting software, joined him. Belgium seemed
a good location from which to operate the company because the country was home to many
software engineers fluent in multiple languages.
The two partners based their company in Ieper,
Belgium.
To finance the business Mr. Hauspie sold his
software firm and Mr. Lernout sold his house.
Mr. Lernout, an ebullient chain-smoker with ruddy
cheeks and a mop of sandy-blond hair, recalled in
an interview that convincing his wife “was the
hardest road show I’ve had.”2 The company barely
survived several early financial crises. At one point
it couldn’t make the payroll and bailiffs came to
seize property, Mr. Lernout recalled. But he seemed
to thrive on crisis. One of his favorite sayings is,
“The grass is always greener on the other edge of
the precipice.”3
Starting any new company is difficult, but two
factors helped L&H survive in its early years. The
first was Belgium’s national pride. Like much of
Europe, Belgium envied the United States’ great
high-tech engine of wealth. And now here were
two guys with ambitions to turn a rural corner of
Flanders into a Silicon Valley of language technology. In L&H’s early years Flanders, Belgium’s
Dutch-speaking region, formed a tax-exempt zone
in Ieper – which gradually became known as
the “Flanders Language Valley” – and showered
L&H with research grants. The Flanders regional
government became a major L&H investor through
a venture capital arm. During one of L&H’s cash
2
1
W. Drozdiak, “Lost in the Translation; Voice-Recognition Firm’s
Failure Holds Painful Lesson for Europeans,” The Washington
Post (December 17, 2000).
3
M. Maremont, J. Eisinger and J. Carreyrou, “Muffled Voice: How
High-Tech Dream at Lernout & Hauspie Crumbled in Scandal,”
The Wall Street Journal (December 7, 2000), p. A1.
Ibid.
This case was prepared by Professors Kenneth A. Merchant, Wim A. Van der Stede, and Research Assistant Xiaoling
(Clara) Chen.
Copyright © 2003 by Kenneth A. Merchant and Wim A. Van der Stede.
714
MANC_C15.qxd 08/01/2007 11:39 AM Page 715
Lernout & Hauspie Speech Products
crunches it guaranteed 75% of a bank loan to the
company. “Without that,” Mr. Lernout says, “we
would have gone broke.”4 Stefaan Top, a Belgian
venture capitalist, says the combination of ambitious entrepreneurs and a government that sorely
wanted “a local tech champion was a combustible
mix – it was dangerous.”5
The second factor was a series of complex
financing plans dreamed up by Mr. Hauspie. The
taciturn former tax accountant set up an intricate
holding company structure that let the founders
retain control while selling various minority
interests. Devising such structures is “Pol’s forte,”
Mr. Lernout says. “He’s very creative. Legally it’s
all right, and it helps you survive.”6
In late 1995 the company went public with a
listing on the NASDAQ Stock Exchange, even
though it had never been profitable and had just
a few million dollars in annual revenue. As with
many high technology firms, the hope lay in a
glittering future. “Natural speech interface is the
next technology wave,” one securities analyst
wrote, “a potential multimillion dollar market.”7
L&H’s managers dreamed of creating software
that would let computers effortlessly understand
human speech, speak back, and translate among
the world’s tongues.
The company seemed to face many challenges.
Technical development was painstakingly slow, as
the systems had to cope with many different
accents and speech patterns, not to mention the
need to sort out homonyms such as “wait” and
“weight.” And industry demand was sluggish.
Many rivals struggled. One, Kurzweil Applied
Intelligence, Inc., in Massachusetts, imploded after
auditors found that its managers had faked a large
proportion of the company’s sales. Another
Massachusetts rival, Dragon Systems, Inc., eked
out only slow growth in the mid-1990s. At L&H,
however, sales quadrupled in 1996 to $31 million.
Though some small acquisitions produced part of
the growth, L&H seemed to be relying on sales to
customers with which it had financial ties.
Over the years many of L&H’s customers
received investments from Flanders Language
4
5
6
7
Ibid.
Ibid.
Ibid.
Ibid.
Valley Fund (FLV Fund), a venture capital pool that
Mr. Lernout and Mr. Hauspie helped create the year
L&H went public. Mr. Lernout and Mr. Hauspie
were directors of the fund’s management arm until
1997, and even afterward they maintained considerable sway over its affairs. Michael Faherty, a former L&H salesman in the United States, says he
and others were encouraged to refer potential customers who were cash poor to the FLV Fund. “If
FLV invests $1 million in the customer,” he says,
“it was understood that we’d get about $300,000”
[in the form of license fees paid by that customer to
L&H].8 Though the FLV Fund denied financial
links between L&H and FLV the close dealings
between the two were evident to some informed
parties from the start. In 1995, for example, FLV
took a 49% stake in the Belgian unit of Quarterdeck
Corp., a high-flying California software company.
This Belgian unit became L&H’s largest customer,
accounting for 30% of revenue that year, and
Quarterdeck in California accounted for another
6.5% of L&H’s sales.9
The CEO
In late 1996 Gaston Bastiaens was hired as L&H’s
president and CEO. Mr. Bastiaens was an engineer
who led the failed Newton project at Apple
Computer, Inc. But he flourished at L&H. Around
the time Mr. Bastiaens joined L&H the company
discovered a new and unusual source of revenue:
its own research and development needs. This
required an intricate accounting maneuver, one that
L&H had continued to lean on throughout its tenure
as a public company. L&H knew it was trailing
competitors in developing software to recognize
words spoken at an ordinary speed. “If we didn’t
catch up, we were cooked,” Mr. Lernout recalled in
an interview. “But we couldn’t catch up, because
we didn’t have enough R&D dollars.”10
The solution was to start a company and have it
contract with L&H to develop the software. L&H
said it gathered outside investors to fund the startup, called Dictation Consortium, NV. But L&H
employees wrote its business plan and did the software work under contract. When the software was
8
9
10
Ibid.
Ibid.
Ibid.
715
MANC_C15.qxd 08/01/2007 11:39 AM Page 716
Chapter 15 · Ethical Issues and Analyses
finished L&H had an option to buy the Dictation
Consortium at a profit to the investors. The arrangement ensured that L&H could claim to be growing
at a rapid pace. Dictation Consortium provided
L&H with $26.6 million in revenue in 1996 and
1997, about one-quarter of its 1996 sales and 19%
of its 1997 sales. Since Dictation Consortium bore
the R&D costs they didn’t burden L&H’s bottom
line. In 1998 L&H bought Dictation Consortium
for $40 million, gaining control of the software it
so badly wanted. Since Dictation Consortium had
few assets and almost the entire price represented
goodwill, it could be amortized over seven years,
further shielding L&H’s bottom line.
Buoyed by such deals and a spate of fresh acquisitions L&H’s revenue mushroomed to $211.16
million in 1998, more than double 1997’s. The
stock soared. Mr. Lernout and Mr. Hauspie became
entrepreneurial celebrities, Belgium’s answer to
Microsoft’s Bill Gates and Paul Allen.
With the stock price up Mr. Bastiaens bought
technology leaders Kurzweil Technologies, Inc., a
speech-recognition company in Wellesley Hills,
Massachusetts, and Mendez Translation Group of
Brussels, Belgium. In 1997, a year after he came on
board, Mr. Bastiaens landed an important investor:
Bill Gates. Microsoft invested $45 million in L&H,
ending up with an 8% stake. The early Microsoft
investment gave L&H much needed credibility and
revenues. In 1999 Intel invested $30 million in
L&H and formed a venture with it to develop ecommerce and telecommunications products.
Though all seemed well from the outside, internally there were continuing glitches with L&H’s
technology. A 1998 presentation Mr. Lernout gave
to French executives in Paris turned into a debacle
when the software failed to recognize many words,
an L&H insider recalled. “The bottom line was that
the technology wasn’t ready and the market wasn’t
ready,” this person says, “but management had to
deliver every quarter.”11 Under Mr. Bastiaens, it
did. L&H kept reporting growth. Its sales rose 63%
in 1999 to $344 million. Its Asian sales exploded to
more than $150 million from less than $10 million
in 1998. In March 1998 its stock hit $72.50, up
2,500% from its initial offering price four and a
half years earlier.12
However, financial analysts had been suspicious
of L&H’s financial results as far back as 1997. In
February 1997 Lehman Brothers’ Brian Skiba
issued a report, claiming that L&H’s growth in the
United States and Europe was much lower than
investors had assumed, and that the company was
not coming clean. Mr. Bastiaens denied it, but in a
conference call he refused to give a geographic
breakdown of sales.13
Still investors ignored financial analysts’ warnings and applauded the 1998 acquisitions of
Dictaphone, based in Stratford, Connecticut, and
Dragon Systems, of Newton, Massachusetts. The
future did, indeed, look bright. L&H seemed to
have a lock on some of the best speech-recognition
software, and the company was powerfully positioned as the Web migrated into phones and cars,
where people would talk to machines and machines
would talk back. At the time, Mr. Bastiaens assured
anybody who would listen, “This market is going to
explode.”14 With the purchase of the company’s
two main US rivals L&H was suddenly a software
company with $1 billion in annual sales, and it was
poised to follow SAP and Nokia Corp. into
Europe’s technology elite.
The Dictaphone purchase, however, meant more
than half of L&H’s business was in the United
States. This obliged the company to file detailed
accounts with the SEC. Analysts learned that sales
in Korea had soared from a mere $97,000 in 1998
to $58.9 million in the first quarter of 2000, some
52% of the total sales of the company. Suspecting
an attempt to pump up results, investors began to
dump the stock in 2000.15
The Wall Street Journal report
In August 2000 The Wall Street Journal reported
that some Korean companies L&H described as
customers denied doing business with it, while
others said they had bought less than L&H said
they had:
In all, the Journal contacted 18 of about 30 companies claimed by L&H as customers. Three of the companies said they weren’t, in fact, L&H customers . . .
13
14
11
12
Ibid.
Ibid.
716
15
Ibid.
W. Echikson and I. Moon, “How to Spook Investors,” Business
Week (September 18, 2000), pp. 69–72.
Ibid.
MANC_C15.qxd 08/01/2007 11:39 AM Page 717
Lernout & Hauspie Speech Products
Three more companies said their purchases from
L&H over the past three quarters were smaller than
figures provided by Mr. Bastiaens or Sam Cho, vice
president of L&H Korea. One additional company
said it is in a joint business with L&H that produces
considerably less revenue than L&H claims. Officials
from an eighth company initially said it had formed
a joint venture with L&H and that the joint venture,
not the company itself, had purchased products from
L&H . . .
Of the other 10 companies, three confirmed they
were customers but wouldn’t give the size or timing
of their purchases. Officials at another six confirmed
total purchases totaling $450,000 to $5.5 million in
the period since [September 1999]. One company
says it signed a $10 million contract with L&H and
paid in May 2000.
All told, of the 12 companies that responded to
inquiries about their purchases from L&H in the
period since [September 1999], the revenue tallied
roughly $32 million. From all of its customers in
Korea, in 1999 and the first quarter of 2000, L&H
posted $121.8 million of Korea sales, and it had said
that it expected second-quarter revenue from that
country to exceed the first quarter’s $58.9 million.16
L&H responded with a statement saying that
comments attributed to L&H customers were
“misquoted or factually incorrect” and that other
information in the article was “distorted.”17 To
buttress its case L&H commissioned a midyear
audit by KPMG.
After the Korea scandal broke Mr. Bastiaens
rushed to restore confidence. He contacted several
of the Korean customers interviewed for the
Journal story, and they publicly said they were
misquoted. A trip to Korea was arranged for two
financial analysts, both of whom were impressed
with the company’s business there. “I met customers and saw L&H products really being used,”
says Kurt Janssens of KBC Securities in Brussels.18
Most important, Mr. Bastiaens asked for the KPMG
special audit. “He wouldn’t be so stupid as to ask
for an audit if he had something to hide,” says
16
17
18
M. Maremont, J. Eisinger and M. Song, “Tech Firm’s Korean
Growth Raises Eyebrows,” The Wall Street Journal (August 8,
2000), p. C1.
M. Maremont, “Lernout & Hauspie Shares Fall 19% As It Attacks
Article,” The Wall Street Journal (August 9, 2000), p. A16.
W. Echikson and I. Moon, “How to Spook Investors,” Business
Week (September 18, 2000), pp. 69–72.
Pierre-Paul Verelst, an analyst at Brussels brokers
Vermeulen Raemdonck.19
By this time founders Mr. Lernout and Mr.
Hauspie thought Mr. Bastiaens had become a liability. On August 25, 2000 he was replaced by
John Duerden, a British-born US citizen who had
worked at Xerox Corp. and Reebok International,
Ltd., before running Dictaphone.20
DISCOVERY OF A MASSIVE FRAUD
L&H’s new management team called for an
investigation by PricewaterhouseCoopers (PwC).
The PwC report was released on April 6, 2001.
It revealed that 70% of the nearly $160 million
in sales booked by L&H’s Korean unit between
September 1999 and June 2000 were fictitious. In
an effort to earn rich bonuses tied to sales targets
the Korean unit’s managers developed highly
sophisticated schemes to fool L&H’s regular auditor, KPMG International. One especially egregious
method involved funneling bank loans through
third parties to make it look as though customers
had paid when in fact they had not.
L&H’s new chief executive, Philippe Bodson,
who replaced Duerden in January 2001, said that
upon learning of PwC’s findings he “was very
impressed by the level of sophistication” of the
fraud and “the amount of imagination that went
into it.”21 Mr. Bodson said the fraud at L&H
Korea should become a case study in business
schools.
To fool auditors L&H-Korea used two types of
schemes. The first involved factoring unpaid
receivables to banks to obtain cash up front. Side
letters that were concealed from KPMG gave the
banks the right to take the money back if they
couldn’t collect from L&H Korea’s customers.
Hence the factoring agreements amounted to little
more than loans.
The second, more creative scheme was set in
motion after auditors questioned why L&H Korea
wasn’t collecting more of its overdue bills from
customers. L&H Korea told many customers to
19
20
21
Ibid.
Ibid.
J. Carreyrou, “Lernout Unit Book Fictitious Sales, Says Probe,”
The Wall Street Journal (April 9, 2001), p. B2.
717
MANC_C15.qxd 08/01/2007 11:39 AM Page 718
Chapter 15 · Ethical Issues and Analyses
transfer their contracts to third parties. The third
parties then took out bank loans, for which L&H
Korea provided collateral, and then “paid” the
overdue bills to L&H Korea using the borrowed
money. The upshot is that L&H Korea was paying
itself. When the contracts were later cancelled
L&H Korea paid “penalties” to the customers and
the third parties to compensate them “for the inconvenience of dealing with the auditors.”22
The probe also found that the bulk of L&H
Korea’s sales came from contracts signed at the end
of quarters, so managers could meet ambitious
quarterly sales targets and receive multimilliondollar bonuses. For instance, 90% of the revenue
recorded by L&H Korea in the second quarter of
2000 was booked in 30 deals signed in the final
nine days of the quarter. But L&H Korea was
forced to subsequently cancel 21 of those contracts
because the customers – most of them tiny start-ups
– didn’t have the means to pay.
The fraud appears to have begun in earnest when
L&H bought a small Korean firm called Bumil
Information & Communication Co. in September
1999 and put Bumil’s management, headed by Joo
Chul Seo, in charge of L&H Korea. L&H Korea,
which had been reporting negligible sales until
then, recorded nearly $160 million in license revenue between the time Bumil was acquired and
June 30, 2000. Mr. Seo made $25 million from the
sale of Bumil to L&H and earned another $25 million in bonuses for meeting sales targets while at
the head of L&H Korea.23
WHERE WERE THE AUDITORS?
In the aftermath of the accounting scandal at L&H
angry investors turned their gaze on KPMG
International, the giant accounting firm that audited
L&H’s books and gave the company clean opinions
in 1998 and 1999. KPMG also gave a clean 1999
opinion regarding the accounting for L&H’s South
Korean operations, where sales had grown improbably to $62.8 million from just $245,000 in the previous year. Michael G. Lange, a partner at a Boston
law firm that was leading one of the shareholder
lawsuits seeking class-action status against L&H,
said that the accounting irregularities at L&H
“were so pervasive and included so many aspects
of the business” that “there had to be red flags” that
KPMG auditors missed.24
KPMG, in its defense, accused the former top
management of L&H of signing off on revenue
over-inflation tactics, of lying about key business
structures within the company, of influencing
others to give false information to KPMG auditors,
and of orchestrating a campaign to minimize their
involvement in the events that had led to the
calamitous downfall of the company. In April 2001,
a few hours before the release of an abridged version of PwC’s report, KPMG filed a lawsuit against
L&H’s former management in a Belgian court. The
complaint alleged that former senior L&H executives “deliberately” provided “false or incomplete
information” to KPMG and conspired to obstruct
the firm’s audits.25
In its complaint KPMG said that L&H’s former
top management “was fully aware and actively
involved in the irregularities and that these people
have wittingly given false information to
KPMG.”26 KPMG alleged that Mr. Hauspie was
implicated in a scheme to illegally raise money for
a fund he participated in. The scheme involved a
complex web of Korean banks, L&H subsidiaries
and Joo Chul Seo, the company’s former head of
Korean operations. KPMG also alleged that the
company co-founder Jo Lernout, at the very least,
participated in the campaign to conceal information
from its auditors.
In addition, KPMG commented that the practice
of inflating revenues was a common one at L&H.
“Afterwards [referring to a period in 1999] it
appeared that the antedating of contracts to increase
the turnover of the relevant quarter was common
practice,” said the KPMG report.27 “The company,
on a regular basis, increased its turnover of a particular year or quarter by means of various kinds of
irregularities.”28
24
25
22
23
Ibid.
Ibid. According to the PwC report investigators have been
unable to track down Mr. Seo since L&H fired him in November
2000. Mr. Bodson said Mr. Seo was last spotted in China.
718
26
27
28
M. Maremont, “KPMG, Former Auditor of L&H, May Draw
Investor Ire,” The Wall Street Journal (January 18, 2001), p. C1.
R. Conlin, “KPMG: Lernout & Hauspie Top Management Lied,”
www.CRMDaily.com (May 11, 2001).
Ibid.
Ibid.
Ibid.
MANC_C15.qxd 08/01/2007 11:39 AM Page 719
Lernout & Hauspie Speech Products
THE AFTERMATH
In April 2001 Jo Lernout and Pol Hauspie were
arrested in Belgium on charges of forgery and stock
price manipulation. The arrests came after a new
round of audit uncovered an additional $96 million
in fictitious sales, which brought the tally of fake
sales from early 1998 to mid-2000 to $373 million,
or 45% of reported revenue.29
L&H was declared bankrupt in October 2001
after the commercial court in Belgium rejected the
company’s request for bankruptcy protection.
29
J. Carreyrou, “Lernout & Hauspie Figures Are Arrested,” The
Wall Street Journal (April 30, 2001), p. A15.
EXHIBIT 1 Appendix to the August 8, 2000 The Wall Street Journal report
A Kick from Korea
Lernout & Hauspie’s sales by region or country for the three months ended March 31, 2000 ($000).
The company’s South Korean business soared after an acquisition in September 1999.
Europe (excluding Belgium)
US
Belgium
Singapore
Other Far East
South Korea
1999
22,435
20,154
14,739
10,430
2,853
97
2000
19,748
19,939
9,178
501
2,396
58,932
Source: The Wall Street Journal (August 8, 2000), p. C1.
719
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Chapter 15 · Ethical Issues and Analyses
EXHIBIT 2 10 steps to Chapter 11
A Lernout & Hauspie Chronology
June 30, 2000
L&H reveals that nearly all of its overall growth in recent quarters came from
South Korea and Singaporean business.
Aug. 8, 2000
The Wall Street Journal reports that some Korean customers claimed by Lernout
& Hauspie do no business with the company. Others said their purchases were
smaller than L&H reported.
Aug. 25, 2000
CEO Gaston Bastiaens steps down; former Dictaphone CEO John Duerden
steps in. The company’s stock falls 9% to $31.
Sept. 20, 2000
The SEC launches a formal investigation of L&H’s accounting practices.
Sept. 22, 2000
The Wall Street Journal reveals that 25% of L&H’s 1999 revenue came from
start-up companies that it helped create.
Sept. 25, 2000
Europe’s Easdaq launches a formal investigation into L&H.
Sept. 27, 2000
L&H issues a profit warning for the third quarter.
Nov. 9, 2000
L&H says it will revise financial statements for 1998, 1999, and the first half of
2000 to make up for past accounting “errors and irregularities;” cochairmen Jo
Lernout and Pol Hauspie resign their executive posts; trading of L&H stock is
suspended.
Nov. 16, 2000
The company’s accounting firm KPMG International withdraws its audits of 1998
and 1999 results.
Nov. 29, 2000
L&H files for Chapter 11 bankruptcy protection along with its Dictaphone unit,
after $100 million is discovered missing in the firm’s South Korean unit.
Source: The Wall Street Journal (November 30, 2000), p. A3.
EXHIBIT 3 Accounting for auditing problems: recent large settlements paid by auditors
Company audited
Year
Allegations
Ernst & Young
Cendant
1999
Inflated revenue,
understated expenses
Ernst & Young
Informix
1999
Inflated revenue
$34
Arthur Anderson
Waste
Management
1998
Overstated assets and
other accounting problems
$75
Coopers &
Lybrand*
Centennial
Technologies
1998
Bogus sales
$20
* Now part of PwC.
Source: The Wall Street Journal (January 18, 2001), p. C1.
720
Settlement amount
($millions)
Auditor
$335