Case Study 11

Potential Earnings Management

Intended audience: Professional Accountants in Business


You are the Financial Controller in a local manufacturing business, X Pte Ltd, which like many businesses in Singapore is beginning to feel the impact of the credit crunch. The business is a medium-sized private company with 80 employees and has an annual turnover of S$50 million. You prepare the quarterly management accounts and provide these to Mr Y, the Financial Director (FD), for his comments. A few months ago, you had noted that the balance sheet position was slightly below that required by the covenant over the company’s long-term bank loan and you made Mr Y aware of this. He thanked you for your vigilance and for raising the issue but told you not to worry.

A few days later, a set of quarterly management accounts were sent to the bank. Mr Y provided you with a set of accounts for the file. You noted that the stock figure on the balance sheet had been increased by S$1,850,000. Without this adjustment, the banking covenant would have been breached that particular quarter. Whilst you trust Mr Y and have a good working relationship with him, you found the stock adjustment surprising as you had made all the usual checks to ensure that the cut-off and valuation procedures were properly adhered to. Such an adjustment had never been made in previous quarters. You thought about questioning Mr Y on this issue but as you have a great deal of respect for him and he is a very busy man, you decided not to say anything.

At the end of the next quarter, the same thing happened again, although the adjustment on this occasion had risen to S$3,770,000. This time you asked Mr Y why the stock adjustment was necessary. He advised you that, at the quarter-end the company held stocks at external premises, which was not included in the stock count. You found this strange as Mr Y has never mentioned this to you before and it would have been helpful if he had informed you of any stocks held externally before you finalised the quarterly stock figures for the management accounts. However, you decided not to pursue this matter any further.

At the end of the next quarter, things get even worse and you once again highlight to Mr Y that the company is failing to comply with the terms of the bank covenant. Mr Y tells you not to worry and a few days later, you note that the set of accounts sent to the bank has again been altered to include a higher stock figure. This time, an additional S$5,500,000 has been added to the figure that you supplied which ensures that the company meets its banking covenant. You ask Mr Y to properly explain the stock adjustments which have been made in recent months but he tells you to, “Mind your own business and get on with your own job.”

He also informs you that if you ever question his judgment again then, “You won’t have a job to go to!”

What do you do now?

Analysis of Scenario: What are the readily-identifiable ethical issues for your decision?

I.     For you personally

Can you allow this situation to continue without seeking a full explanation from Mr Y? If you do not believe that you can raise the matter with him again, then who can you discuss it with within the organisation? Does the company have a policy for such matters? Is there another director that you could approach?

II.    For the Company

Is there a supportive environment for open discussion of practical dilemmas without a recriminatory, or ‘blame’, culture? Is Mr Y putting through these adjustments on his own behalf or is someone else exerting pressure on him to do so?

III.   Who are the key parties who can influence, or will be affected by, your decision?

‘You’, the FD, the other directors, the shareholders, the employees, customers and suppliers, and the bank.

IV.  What fundamental ethical principles for accountants are most applicable and is there an apparent conflict between them?

  • Integrity: Can you retain your integrity by ignoring this issue? Have you already done enough by raising the issue with the FD? (he has warned you not to raise the issue with him again) What will happen if the external auditors start to ask questions about the stock adjustments?
  • Objectivity: The ability to be able to question senior personnel when there is something which does not appear right.
  • Professional behaviour: The need to display professional courage by getting to the bottom of the matter.

V.    Is there any further information (including legal obligations) or discussion that might be relevant?

The possibility exists that the FD is telling the truth and that X Pte Ltd does have stocks located at another company’s premises. However, if this is the case then why is he not providing evidence to justify his stock adjustments?

VI.  Is there a conflict between the ‘Guardian’ and ‘Commercial’ strands of an accountant’s responsibilities?

If the FD is falsifying the quarterly management accounts then he is bowing to the commercial pressure to ensure that X Pte Ltd is satisfying the funding conditions placed on it by the bank. If the bank covenant terms were breached, the bank could of course take action and the risk would be that X Pte Ltd might be put out of business if the funding package was withdrawn or not renewed. The requirements of the ‘Guardian’ role are for the accountant to ensure that the monthly management accounts are a fair representation of the company’s financial performance and position.

Acknowledgement: This case study was published by the Technical Policy Board of The Institute of Chartered Accountants of Scotland (ICAS), and adapted by the Institute of Singapore Chartered Accountants (ISCA) with the permission of ICAS