Question

Read the LDC Cloud Systems Case Study and answer the question below:

THE EMAIL

The email had been sent from one mid-level accounting manager at headquarters to another about six months earlier. The message read:

Bill, here are the accounting issues I mentioned, and as you know, some of these go back a ways. The data that supports these accounts are not always clear and keep changing, and we are not sure what the correct accounting treatment is for these issues. I just wish we had more time to think and make sure everything is right. Trying to keep up with the everyday rush here is like drinking from a fire hose. And the big shots have their own problems and don’t want to hear about these types of things. I have never seen Filippe (Arizmendi, CFO) so much as open an account to look into the details. They just want us to get it done, and I can’t imagine them asking any questions about this unless we don’t get it done. For these accounting issues, we recorded our best guess when we could and plan to get more clarity and correct any problems when we have more time. Fortunately, I don’t think any of these are material. And when we figure this out, we might also find an opportunity to keep everyone happy. Any thoughts you have are welcome.

The email also contained an attachment marked “For Accounting Eyes Only.” The attachment contained a list of 16 accounts and each of the 16 had some descriptive text and a dollar range of potential financial statement impact. (See Appendix 1.) For example, one item involved a computer equipment amortization expense and had an estimated range of $50,000 to $250,000. Individually, each of the 16 accounts appeared to be immaterial, with estimates ranging from zero to a few thousand dollars; however, a few had higher amounts. The largest item had a range of $0.8 million to $1.2 million. When Darnal read the email, he quickly became concerned and contacted his colleagues on the audit committee. Given the short period in which they had to take any action before the quarter-end filing deadline and the potential seriousness of the situation, they decided to call together the entire board. (See Appendix 2 for a timeline of key events.) THE BOARD MEETING Board Chair Dale Torchian: “Thank you for coming together on short notice, and Deon (Khoo) and Hulbart (Vogel) for joining by telephone. And thank you Ross (Trela) for sitting in as well. I asked Shep (LeDuc) to sit this one out, and he agreed, but he asked me to tell you that he trusts us to do what is right for the company. Ross can you get us started?” General Counsel Ross Trela: “Yes. You all have the most recent report on our FCPA investigation. The email referenced in the report is the primary reason why we are here. Frankly, I am not sure if we have a significant issue in front of us or not. The email on its face gets my attention, but I don’t know what it means, and can’t advise on the accounting. When I showed the email to Lester (Darnal), he was concerned enough to bring us together. The time pressure is that we need to submit our quarterly financial report in two days.” Audit Committee Chair Lester Darnal: “I have not had much time to dig into this, but the email was sent six months ago and discovered three months ago, and it is just coming to our attention now. As some of you know, our business model makes some of our accounting a bit challenging. The accounting items in the email appear to be among those that are more difficult for our less experienced managers to understand, but it is not obvious to me why they might appear together in an email. My fear is that because these issues are difficult to understand, they provide a good opportunity to play with the numbers, to change assumptions or make entries to show certain results depending on how a quarter is going. In essence, they could be used to manage earnings coming out of certain units of the business. Also, while this is not completely clear, it appears that many of the accounting issues in the email originated in, or involved, our unit in Asia, though in the email they are being discussed by two of our managers here at headquarters. Director Wade Beckley (US): “Is this even important? The dollar value of these items seems fairly small. They don’t appear to be material.” Darnal: “You could be right. Individually, these items are not material. However, collectively it is possible that they are material because depending on where each item falls in the range, they could very well have resulted in LDC over stating its earnings last year.” Director Hulbart Vogel (Germany): “We don’t have time for this now. We don’t have clear evidence that this email indicates intentional wrongdoing on anyone’s part. If you want to look into this further, then fine, let’s get started on that. Give those guys a call and ask them, but let’s not hold up filing our quarterly report. It is critical that we file on time, and I am not seeing anything that should prevent that.” Director Darby Gillam (UK): “I agree, let’s wrap up the financials on time, let Ross pursue the bribery investigation, and let our CFO figure out what his people are doing in this email. This email was sent six months ago and the attachment does not contain any dates. For all we know, whatever issues it describes could have been taken care of many months ago.” Darnal: “These are all good points. Maybe this is nothing, maybe any problems have already worked themselves out, and I agree that it is very important to file on time. But the problem is, we don’t know, and it is clear to me that we need to find out.” Director Deon Khoo (South Korea): “I don’t see what the issue is here. Why are we even talking about an email? We got a hotline report about a possible bribe, and it appears that we are thoroughly investigating that. After six months of investigating, we still don’t know what happened. I am not convinced that a bribe did occur, and remember, business gets done a little differently in Asia than it does in the US. It appears that our managers in Asia are actively ensuring that our business there does not get delayed. Isn’t that what we want them to do? But even if there was a bribe, what does that have to do with this email? Why are we even considering this? Let’s finish the FCPA investigation and move on.” As the discussion continued, Trela thought about what action he might recommend to the board

APPENDIX 1

Email Attachment - FOR ACCOUNTING EYES ONLY

YEAR QUARTER POSSIBLE ACCOUNT

IMPACTED BY ISSUE DESCRIPTION ESTIMATED FINANCIAL

STATEMENT IMPACT

ONE YEAR AGO

Restructuring Accrual -Cost of reorganizing branches within European offices after restructuring efforts, not yet accrued    $10,000 - $35,000

Revenue- Sales recognized after inventory shipment with FOB destination in the Incoterms $0 - $6,000

Contingent Liability- DartSpot Settlement loss based on current lawsuit outcome $800,000 - $1,200,000

Revenue- Sending inventory at end of month into our channels to meet sales targets

$250,000 - $500,000

Consulting fee -Cost of interpreter when traveling in Asia to visit LDC local operations $15,000 - $70,000

Revenue- Revenue recognition potential cutoff exposure from future sales $100,000 - $300,000

Differed Tax Asset-Writedown of deferred tax asset because the tax law changed, and we have

surpassed the deadline to utilize the DTA $200,000 - $400,000

Inventory-Reserves in our inventory that haven’t moved in a few months; not sure what to

do with it $50,000 - $100,000

Payroll Expense- Employee benefits added for recruiting top engineer talent, but not yet accrued $100,000 - $175,000

TWO YEARS AGO

Amortization Expense- Computer equipment used that should have been allocated and expensed $50,000 - $250,000

Lease Expense- Leasehold agreement increase not yet recognized on the books $200,000 - $350,000

Tax Credit -Timing of research and development tax credit opportunity potential $0 - $80,000

Litigation Expense- Settlement with ABC Technology Inc. outside of courts and covering attorney

Fees $0 - $1,000

Tax Expense- Backlogged potential tax expense as payroll is recognized $5,000 - $16,000

THREE YEARS AGO

Inventory Writedown -Obsolete inventory still on the books to stabilize current assets $3,000 - $9,000

Revenue-Revenue recognized on books, although it is placed on consignment currently with

our retailers $15,000 - $30,000

Question:

Identify at least four specific analytical procedures that may be performed on the financial statements. (In addition to listing the procedure, explain why it is relevant to the LDC case.)

Answer 1

Analytical procedure establishes relation between financial information and other financial or non financial information. It identifies any significant error or fraud. Following analytical procedures can be applied in the given scenario :-

1 Inventory turnover ratio can be used to find out the average time taken to sale any item of inventory. This will particularly be helpful incase of inventories which haven't moved for past few months.

2 .percentage of inventory turning obsolete every year can be find out by comparing inventories of various years.

3 .Industry vide trend of penalty payable in case of litigation can be compared.

4 .tax exp. With reference to pay of employees for several can be compared