Chapter_15_Video_caseThe_Ethics_of_Making_the_NumbersWill_sales

Chapter 15 Video case

The Ethics of “Making the Numbers”

Will sales and profits meet the expectations of investors and Wall Street analysts? Managers at public corporations must answer this vitally important question quarter after quarter, year after year. In an ideal world—one in which the economy never contracts, expenses never go up, and customers never buy competing products—the corporation’s share price would soar, and investors would cheer as every financial report showed ever-higher sales revenues, profit margins, and earnings. In the real world, however, many uncontrollable and unpredictable factors can affect a corporation’s performance. Customers may buy fewer units or postpone purchases, competitors may introduce superior products, energy costs and other expenses may rise, interest rates may climb, and buying power may plummet. Faced with the prospect of releasing financial results that fall short of Wall Street’s expectations, managers may feel intense pressure to “make the numbers” using a variety of accounting techniques. For example, some executives at WorldCom made earnings look better by booking billions of dollars in ordinary expenses as capital investments. The company was forced into bankruptcy a few weeks after the accounting scam was exposed. As another example, top managers at the drug retailer Rite Aid posted transactions improperly to inflate corporate earnings. Ultimately, Rite Aid had to lower its earnings figures by $1.6 billion, and investors fled, driving the share price down. Under the Sarbanes-Oxley Act, the CEO and CFO now must certify the corporation’s financial reports. This has led hundreds of companies to restate their earnings in recent years, a sign that stricter controls on accounting practices are having the intended effect. “I don’t mean to sugarcoat the figure on restatements,” says Steve Odland, CEO of Office Depot, “but I think it is positive—it shows a healthy system.” Yet not all earnings restatements are due to accounting irregularities. “The general impression of the public is that accounting rules are black and white,” Odland adds. “They are often anything but that, and in many instances the changes in earnings came after new interpretations by the chief accountant of the SEC.” Because accounting rules are open to interpretation, managers sometimes find themselves facing ethical dilemmas when a corporation feels pressure to live up to Wall Street’s expectations. Consider the hypothetical situation at Commodore Appliances, a fictional company that sells to Home Depot, Lowe’s, and other major retail chains. Margaret, the vice president of sales, has told Rob, a district manager, that the company’s sales are down 10 percent in the current quarter. She points out that sales in Rob’s district are down 20 percent and states that higher level managers want him to improve this month’s figures using “book and hold,” which means recording future sales transactions in the current period. Rob hesitates, saying that the company is gaining market share and that he needs more time to get sales momentum going. He thinks “book and hold” is not good business practice, even if it is legal. Margaret hints that Rob will lose his job if his sales figures don’t look better and stresses that he will need the book-and-hold approach for one month only. Rob realizes that if he doesn’t go along, he won’t be working at Commodore for very much longer. Meeting with Kevin, one of Commodore’s auditors, Rob learns that book and hold meets generally accepted accounting principles. Kevin emphasizes that customers must be willing to take title to the goods before they’re delivered or billed. Any book-and-hold sales must be real, backed by documentation such as e-mails to and from buyers, and the transactions must be completed in the near future. Rob is at a crossroads: His sales figures must be higher if Commodore is to achieve its performance targets, yet he doesn’t know exactly when (or if) he actually would complete any book and-hold sales he might report this month. He doesn’t want to mislead anyone, but he also doesn’t want to lose his job or put other people’s jobs in jeopardy by refusing to do what he is being asked to do. Rob is confident that he can improve his district’s sales over the long term. On the other hand, Commodore’s executives can’t wait they are pressuring Rob to make the sales figures look better right now. What should he do? For more information about the Sarbanes-Oxley Act, go to www.aicpa.org. (This is the website for the American Institute of Certified Public Accountants and is a good source of information about the act.)

Questions

1. What are the ethical and legal implications of using accounting practices such as the book-and-hold technique to inflate corporate earnings?

2. Why would Commodore’s auditor insist that Rob document any sales booked under the book-and-hold technique?

3. If you were in Rob’s situation, would you agree to use the book-and-hold technique this month? Justify your decision.

4. Imagine that Commodore has taken out a multimillion dollar loan that must be repaid next year. How might the lender react if it learned that Commodore was using the book-and-hold method to make revenues look higher than they really are?

Chapter 16 Video case

Pizzeria Uno

Profit margins in the restaurant business average three to five cents of every dollar of revenue. When you’re managing pennies, accounting for them is critical to growing a successful business. Pizzeria Uno has learned to manage its financials effectively and grow dramatically. The Pizzeria Uno Restaurant Corporation started in 1943 and was taken public in 1987. Currently the chain operates in 31 states and four foreign countries with more than 200 restaurants, both franchised and company-owned. Its average restaurant generates $2 million in revenues annually. Financial management for Uno starts at the store level, where the firm employs sophisticated accounting mechanisms to manage the cost structure of the business. The management team in each restaurant is primarily responsible for collecting data through point-of-sale computers that send information to a corporate database every night. These computers collect data about sales (what people are buying), supplies needed to replenish inventories (what items have been sold that day), and employees’ hours and wage rates. Uno has developed a cost control model that determines what its food and drink costs should be, based on experience and the current menu mix. For example, based on the model, Uno expects each restaurant to sell twenty ounces of Jack Daniels liquor in a particular day. However, if the cost control system shows one restaurant incurring a cost for twenty-five ounces but selling only twenty, the company is paying for five ounces that cannot be accounted for. If Uno is planning to run the business at 25 percent of the cost of sales, and the data indicate one of the restaurants is actually running at 27 percent of the cost of sales, then corporate management will want to know why there is a discrepancy. Either the drink has been given away or the bartenders have been over portioning the beverages. The restaurant business is a cash business, and Uno is able to use working capital to its advantage. Because the company is dealing with rapidly consumed products, it has the luxury of using its vendors’/suppliers’ money to fund its operations. If the restaurants buy a food product on a thirty-day net pay basis and sell the item within a day, Uno can have the use of that money for more than three weeks before it has to pay the supplier. Compare that to a manufacturing company. When an auto company builds an automobile, it has to buy the steel to make the car long before it sells the car. Manufacturing companies have to spend working capital to build up their inventory before they can sell that inventory for cash. Effectively managing its balance sheet is a key component in ensuring that Uno continues to improve shareholder value. Debt is an important tool that it uses to build equity. If Uno can borrow money at 7 percent and put it to use in its restaurants that return 30 percent, it has earned 23 percent on someone else’s money an impressive return on debt. Building restaurants is capital-intensive. The average Uno restaurant costs $1.6–$1.7 million in upfront capital to build, excluding the land. The company has typically bought the land, which can be a risk since ownership does not result in a high return on assets. However, it does allow the company to control its own destiny and future, and to lock in a large component of its expansion costs. The company uses long-term debt and, in some cases, mortgage debt to finance its land purchases. By using debt, Uno increases its return on equity as long as its earnings are higher than the interest charged for the borrowed money. And history shows that, more often than not, land values increase over time. The bottom line is that Uno has been able to manage its balance sheet and avoid tipping its debt-equity ratio. Pizzeria Uno’s goal is to operate in the top echelon of restaurant companies. The company believes that despite a recession that has hammered the restaurant industry, it can continue to manage its business to improve profitability, return on sales, and return on capital and to drive net income and earnings per share. Uno’s stated goal is to grow its business 20–25 percent annually, measured in earnings per share. For more information on this company, go to

www.pizzeria-uno.com.

Questions

1. What are the primary sources of funds that Pizzeria Uno uses to run its business, and how does it use these funds?

2. How does Uno monitor and evaluate the financial performance of its restaurants?

3. Pizzeria Uno typically buys the land on which it builds new restaurants because it allows the company “to control its own destiny and future.” What are some possible disadvantages to this practice?

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