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, Roblearns 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?