You are a CPA on the audit staff of a multinational public accounting firm. You are the senior auditor on an annual audit of a manufacturing company that is a small subsidiary of a larger company that is a significant client of your firm. In addition to a sizable fee for the annual audit, the parent company pays your firm additional fees each year for tax consultation and return preparation as well as other management consulting services. With this particular audit, as with many parent-subsidiary relationships, you are aware that there is a tremendous amount of pressure on the subsidiary company’s management to reach certain projected sales goals for the year. Because of this, the climate at the subsidiary is tense as you begin your annual examination of the year-end financial statements.
During the course of the audit, you perform a sales cutoff test to ensure that all sales transactions at year-end were recorded in the proper period. Since title to the company’s products passes when they are shipped to customers, shipments are required in order for a sale to be properly recorded. Accordingly, a standard audit procedure is to cross-reference sales recorded prior to year-end to related shipping records and to similarly trace information from shipping records to sales journals. The sales cutoff test revealed that numerous shipments made after the company’s year-end were recorded as sales prior to year-end, which resulted in significantly higher revenue during the year you are auditing.
You are aware that as an independent auditor, you have a responsibility to your client and to those who might make decisions based on the company’s financial statements, such as investors and lenders. When you inform the subsidiary’s controller of the results of your sales cutoff test and that an adjustment to annual revenues and profits would likely be warranted, he takes the matter to the president of the subsidiary. During a follow-up meeting with the controller and president, the president attempts to get you to reconsider your proposed adjustment with the following arguments:
1. The amount of the adjustment you were proposing was not material to the parent company’s financial statements.
2. All of the subsidiary’s competitors did the same thing in recording shipments just after year-end as sales in the previous year.
3. It really didn’t matter in the long run if sales were moved from the current year to the next year, since sales and profits for the next year would be greater.
At the end of the meeting, the president drops a not-so-subtle reminder that his company is a substantial client of your firm. You call the partner from your firm who is in charge of the audit for advice, and he tells you to “handle the situation on your own.”
Questions for Discussion
1. Evaluate each of the three arguments made by the subsidiary president for not making the proposed adjustment to sales. Are there any merits to his arguments that are worth considering in making your decision?
2. Should the significance of the company as a client of your firm, in terms of the amount of fees paid to your firm each year, matter in making your decision?
3. What if, after considering all factors, you continue to feel that an adjustment to the company’s financial statements is warranted, but after a closed door meeting with the client, the partner on the audit (your boss) decides to agree with the client and tells you not to make the adjustment. How should you react?
Margaret began a retail business about a decade ago that specializes in making competitively priced customized wedding dresses. Customers loved her designs, and soon, through word of mouth alone, she had a very loyal but small customer base. At this point, however, her business was still struggling to make more than just a small profit.
Having also completed a few photography courses in college and getting lots of practice by taking photos of brides-to-be wearing her custom-made dresses for her portfolio, Margaret decided to try her hand at photographing weddings to increase her revenue. Over a few years, this too became a reliable source of income for her business.
But now, designing wedding dresses and doing wedding photography has Margaret spread way too thin. Her family life is feeling stressed, and she is often hurrying from one place to another, so she decides to try to make more economically efficient use of her time by attempting to focus her attention on fewer but higher-paying customers.
Over her years in business, Margaret has noticed that a couple of “tricks” usually make customers more amenable to higher dollar purchases (i.e., a more expensive dress design or ordering more photos). With respect to wedding gowns, Margaret has noticed that “vanity sizing” (telling a client that she is several sizes smaller than she really is) works to put clients in the mood to spend more money. On the photography side of her business, she has observed that clients will order a larger photo package if she takes the time to use software tools to make them appear thinner and younger.
Question for Discussion and Reflection
1. Knowing what she does, would Margaret cross any ethical lines by using appeals to “vanity” to sell more to her customers? Vanity sizing is a common practice among fashion merchandisers.
2. Can one reasonably argue that it is up to customers to protect themselves from such tactics?