Incentives and Pressures

Prior to commencing an audit, an accountant must assess whether a company's management has incentives to commit fraud or faces pressures to do so. Research has shown that enticements, such as the prospect of a year-end bonus for attaining specified growth targets, may tempt management to commit fraud. Pressures to cope with a changing business environment, meet investor expectations, and forestall bankruptcy provide similar temptations.

Opportunity

In most aspects of life, opportunity is the key to achieving prosperity. As philosopher Ayn Rand once wrote, “The ladder of success is best climbed by stepping on the rungs of opportunity.”²

In the world of financial reporting, though, the opportunity to commit fraud can lead to disastrous consequences. Consequently, auditors always have to be alert to situations that create opportunities for fraudulent financial reporting.

Complexity often is a breeding ground for fraud. Intricate transactions, such as an acquisition of a foreign subsidiary, and transactions involving estimates often provide a forum for deliberate exaggeration. Lax monitoring of corporate activities, high employee turnover, and changes in auditing firms also create fertile reporting environments for fostering fraud.³

Related party transactions between a corporation and a controlling shareholder likewise pose elevated opportunities for fraud. For example, when a shareholder actively influences company decision making, asset sales and compensation arrangements between the corporation and this shareholder have to be carefully scrutinized to ensure that they do not take undue advantage of other shareholders. As a commentator observed, “Opportunity only dances with those on the dance floor.”⁴

Attitudes and Rationalizations

Skilled poker players learn to detect opposing players' tells. Good auditors must do likewise to ferret out fraud.

In poker, an opposing player might inadvertently tip off a winning hand of cards by repeatedly blinking his eyes, tensing his lips, or breathing heavily. In detecting financial fraud, similar kinds of clues warn accountants that trouble lies ahead.

Sometimes, key employees openly rationalize their entitlement to enjoy the fruits of their fraudulent activities. Some claim that they are “not paid what they are worth” or are “just temporarily taking money, but will pay it back later.”

Brash rationalizations, however, are relatively rare. More typically, auditors must look for subtle clues that exhibit management's indifference toward candor and honesty. Some tells include top executives who announce unrealistic earnings forecasts, compulsively micromanage accounting personnel, or insist on overly aggressive tax-minimization strategies.

Another tipoff is executives who live lavish lifestyles that would embarrass even the gluttonous Roman emperors of yesteryear. Before publicly traded Adelphia Communications declared bankruptcy, for instance, corporate money was spent to build an 18-hole golf course on the expansive estate of an influential executive's personal mansion. Or, consider the opulent lifestyle of Dennis Kotlowski who, as CEO of publicly traded Tyco, spent company money to decorate a company-owned apartment with trinkets such as a $6,000 gold-plated shower curtain.⁵ According to an old adage, “Extravagance is fraud's close companion, but frugality makes fraud an orphan.”

An Overview

Charles Dickens's often-quoted statement, “It was the best of times and the worst of times,” easily could have described the turn of the 21st century in America. At the start of 2000, the Internet was in its infancy, and the growth potential of many companies seemed boundless. The world began to change, however, in 2001 as economic prosperity and a buoyant stock market faltered. The terrorist attacks of September 11, 2001, further devastated the national psyche, and unfolding corporate scandals rocked investor confidence.

Due to the impetus of the Internet, Enron Corporation began shifting its traditional business model from producing natural gas to developing online transaction systems for energy and industrial commodities. Enron's stock price soared 89% in 2000, trading at a sky-high 70 times earnings. Seemingly overnight, Enron became the seventh-largest company in America, and it was heralded on a list of Most Admired Companies for its “transformative power of innovation.”⁶

In 2000, Arthur Andersen, CPAs, also was a well-respected international accounting firm that had been founded by its namesake nearly a century earlier. It had prospered in part due to the eye-popping $1 million in fees it earned weekly from its lucrative relationship with Enron.

In 2001, though, it became clear that natural gas company Enron had become a combustible mixture of greed, deception, and arrogance. In response to discoveries of fraudulent financial reporting, Enron's stock price imploded to mere pennies by fall 2001, destroying thousands of jobs and billions of dollars in stock market wealth.

Arthur Andersen, CPAs, also was complicit in Enron's fraudulent financial reporting. A court found it guilty of intentionally obstructing justice by destroying documents relating to its Enron dealings. Because of this felony conviction, the firm's reputation was irreparably tarnished, and its future dimmed as its license to practice accounting was revoked in various jurisdictions.⁷

Enron's Business Model

Enron had humble beginnings as an energy producer that sold natural gas at prevailing wholesale prices. Its traditional accounting practices were unnoteworthy, and its financial statements were straightforward.

All of that changed when CEO Jeffrey Skilling and others transformed Enron into a central hub for conducting energy and related transactions. The new business model was ambitious, yet simple. Much like online dating sites match people up for romance, Enron became a centralized matchmaker for the sellers and purchasers of long-term energy contracts. Power producers desiring certainty would make binding commitments to deliver natural gas and electricity at fixed prices over multiyear intervals, and buyers desiring assured energy supplies could lock in fixed-price contracts. Enron thus created an active market that reduced the volatility and uncertainty associated with the wholesale distribution of energy. By doing so, Enron improved the marketability of these investment contracts, much like stock exchanges increase the liquidity of corporate stock.

Buoyed by its success, Enron then turned its attention to creating an active marketplace for other industrial commodities, from paper to plastics. Much like Amazon began to dominate online sales of consumer products, Enron sought to dominate online sales of industrial commodities.

The stock market had high expectations for Enron, and Enron in turn imposed these high expectations on its employees.

Publicly, Enron emphasized strict adherence to a Code of Conduct encompassing “Respect, Integrity, Communication, and Excellence.” This Code of Conduct, commonly called the RICE code, proclaimed that “relations with the Company's many publics—customers, stockholders, governments, employees, suppliers, press and bankers—will be conducted in honesty, candor, and fairness.”

Privately, though, Enron fostered a ruthless culture that embraced a win at all costs attitude. Enron employees were subjected to rigorous performance evaluations in which they were classified into one of five tiers. This policy inspired the relentless pursuit of short-term profit, and it engendered fear. Internally, this rating system was referred to as rank and yank because workers ranked in the lowest tier typically were fired, or yanked, soon thereafter.

Enron's Deceptive Accounting Practices

To prop up its stock price, Enron engaged in numerous accounting irregularities.

The Use of Special-Purpose Entities

The centerpiece of Enron's accounting trickery was the creation of special-purpose entities (SPEs). An SPE is a separate legal entity that functioned essentially like a subsidiary. Due to specialized accounting rules then in effect, though, SPEs were not accounted for in the same manner as subsidiaries.

When a corporation has a true subsidiary, two separate legal entities exist, but accountants blend together the two companies' books as if they were a single, unified business. For example, Apple's manufacturing operations and its retail stores are each separate legal entities, but Apple's income statement combines both companies into a single consolidated income statement. Thus, when Apple's Manufacturing Segment “sells” products to Apple's Retail Segment, this transaction does not appear on Apple's consolidated statements because the purported sale is viewed as a mere internal movement of goods within overall Apple.

When a dominant corporation assisted in creating an SPE, in contrast, the SPE was not included in the sponsoring corporation's consolidated statements. Therefore, despite their resemblance to subsidiaries, SPEs prepared their own distinct financial statements and were considered to be separate entities. Therefore, under GAAP of that era, SPE assets and liabilities were not combined into Enron's books. Furthermore, for financial reporting purposes, gains on sales between Enron and an SPE were recognized, despite both parties' close interconnection.⁸

Accounting Trickery Using Special-Purpose Entities

Enron took advantage of the separate accounting status of its SPEs in several ways.

SPE:	ENRON:
Cash 50 [No entry]
Note Payable 50

To keep debts off its own books, Enron arranged for banks to loan money to Enron's SPEs rather than to Enron itself. Banks were happy to do so because Enron guaranteed repayment of these loans, much like a parent might cosign a car loan for a teenage child. To illustrate, a hypothetical loan of, say, $50 from a bank to an Enron SPE would be journalized only on the SPE's books, as shown in Figure 7-3.

Thus, even though bank loans increased Enron's legal responsibilities by $50, Enron successfully hid this obligation from investors because the debt exclusively appeared on the SPE's books.⁹

Also, to hide losses, Enron would sell underperforming assets to its SPEs for inflated prices. For example, assume that land originally purchased by Enron at a $13 cost had fallen to a $10 market value. If Enron were to sell this land to a truly independent buyer, it would only collect $10 and would have to report a $3 loss. However, by selling this land to a friendly SPE for, say, $14, Enron would hide this loss—and even recognize a gain, as illustrated in Figure 7-4.¹⁰

Moreover, Enron asked its ever-so-helpful SPEs to buy Enron stock as an investment. In essence, Enron violated GAAP by issuing its own stock to itself and boosting its assets accordingly.¹¹ As the SEC's former Chief Accountant asked quizzically, “How did both partners and the manager on this audit miss this simple Accounting 101 rule?”¹²

Enron and Theatrics

Beyond accounting trickery, Enron staged an annual event that would have made Hollywood proud. Prior to its annual presentation to investment analysts, Enron would construct a Hollywood-style set in its offices that resembled a Wall Street trading floor. When analysts later toured Enron's facilities, trusted Enron employees pretended to be busily executing trades for clients when, in fact, they were just staging a mock event to fool analysts. To add realism, these actor–employees even decorated their fake trading desks with family photos. As one employee said: “It was absurd that we were doing this. But to me the most absurd part was that it worked.”¹³

Lessons Learned from Enron

In the aftermath of Enron's demise, many companies realized that a corporate culture that imposes excessive pressure on employees and overemphasizes short-term goals creates an environment that is conducive to fraud. The public accounting profession and regulators also realized that an excessively cozy relationship between clients and their auditors poses major risks to the auditor's objectivity and vigilance. In recognition of these concerns, Congress enacted the Sarbanes–Oxley Act in 2002. This Act toughened the auditing standards for public companies and established the Public Company Accounting Oversight Board regulatory body.¹⁴

As for the Arthur Andersen CPA firm, the world will never know the full extent of its complicity in Enron's financial schemes. By engaging in mass document destruction, Andersen personnel forever concealed the trail of deceit that led investigators to Andersen's doorstep.

Manipulating Revenues

General Techniques for Overstating Revenues

According to a comprehensive study, over 60% of companies found guilty of accounting fraud manipulated their reported revenues.¹⁷ Some of the most common techniques used to inflate revenues are

• Creating fictitious customers and phony sales invoices
• Channel stuffing, which means deliberately selling more merchandise to customers than they need, and then rewarding customers for their cooperation
• Recording sales before goods have been shipped
• Recording the full amount of a sale, even though customers are likely to return a substantial portion of the goods purchased
• Recording revenues currently on long-term contracts that will not economically be earned until a later period
• Recording excessively generous mark-to-market gains by exaggerating the market value of appreciating assets
• Recording sales on credit to customers with poor credit, knowing that many of the resulting accounts receivable later will prove to be uncollectible

Many cases of misreported revenue should have been spotted easily, at least in hindsight. In the largest accounting fraud in Europe's history, for example, Italian dairy producer Parmalat claimed to sell absurdly high quantities of powdered milk to Cuba. If Parmalat's auditors simply had compared the reported sales quantities to the tiny size of Cuba's population, they would have realized that Parmalat's thirst for exaggerated profits far exceeded Cuba's thirst for milk. The fraud eventually was discovered, but only after investors had lost $20 billion dollars in what is often called Europe's Enron.¹⁸

In another revenue-related scandal, health care provider HealthSouth booked as revenue its full stated charges for patient medical services, even though it knew that health insurance companies were contractually entitled to a substantial discount off the stated charges. As one disgruntled HealthSouth shareholder wrote to the SEC: “You bring the smoke, I'll bring the mirrors…[Isn't this] something that a novice auditor should catch?”¹⁹

Side Agreements

Side agreements pose an especially challenging problem for auditors and forensic accountants. A side agreement is a secret deal that parties form to undermine the full scope of their main agreement. As an illustration, imagine that a seller sells goods for $100 on December 27, but a side agreement alters their deal by allowing the buyer to “deduct $25 off the price if it so desires.” The seller will show its auditor the main agreement to justify fraudulently recording $100 of revenue even though, in reality, the seller knows that it ultimately will collect only $75. Auditors struggle to detect this type of fraud, especially if the seller and buyer jointly act in collusion.

Manipulating Expenses

Manipulating Multi-Item Allocations

Every cost accountant knows that the joint price paid for a basket transaction must be allocated among the various items that comprise the set. For example, if a building and the land on which it is situated are sold for one overall price, the buyer has to apportion this price between the building and the land based on these assets' respective fair values.

When the fair value of the component items in a set are not readily verifiable, however, a company might be tempted to skew the price allocation in a deceptive manner. In a revenue setting, the accounting profession has attempted to curb this abusive practice by adopting strict rules for so-called multiple-deliverable arrangements.

Similarly, on acquiring a set of assets for a single price, a purchaser might be tempted to rig the cost allocation to report fewer near-term expenses.

As an illustration, assume that a large automotive sales company purchased a newly built car dealership. The purchased dealership's assets consist principally of the building, land, and equipment.

Because all the purchased assets are depreciable except the land, the acquirer might try for financial reporting purposes to allocate excessively large amounts to the land. Because land is nondepreciable, the company's depreciation write-offs shrink, which increases reported profits.²³

Hiding Debts

Investors and lenders alike know that burdensome levels of debt often threaten a company's survival. Consequently, companies often attempt to disguise the degree to which they rely on borrowed funds.

Undisclosed debts, commonly called off-balance-sheet liabilities, were at the heart of investment bank Lehman Brothers' demise. In 2007, Lehman Brothers was one of the largest financial institutions in the world, earning Fortune magazine's top ranking as the Most Admired Securities Firm. By fall 2008, however, Lehman Brothers received a more ignominious ranking—its disintegration created the largest bankruptcy in U.S. history.

Lehman's demise engendered widespread panic, causing investors to flee already shaky world financial markets. In the three-day aftermath of Lehman Brothers' bankruptcy filing, stocks fell by 7%. Then, two weeks later, as news spread that Congress was voting to reject bank bailout legislation, the stock market went into a freefall, plummeting 4% in five minutes. As the governments of Germany, Great Britain, and Belgium valiantly attempted to save key financial institutions, the U.S. stock market ended the day down 9%.²⁴ In a matter of hours, over $1 trillion of global wealth had vanished.

Although Lehman Brothers' attempt to disguise its debt load often is called by arcane names such as Repo 105, its actions were rather straightforward. Just before an upcoming quarterly balance sheet date, Lehman Brothers would purportedly sell some of its poorly performing financial assets for cash and then use this cash to repay outstanding liabilities. To illustrate, Lehman would record a sale and debt repayment of, say, $100, in substance as reflected in Figure 7-7.

As you will note, cash simply flowed in and out of Lehman's bank account, but the company's total cash balance did not change overall. Thus, as the net effect, Lehman effectively removed questionable assets from its balance sheet and shrank its reported debts.²⁵ Investors found this comforting.

Lehman called these transactions repos because, shortly after a balance sheet date had passed, it would essentially reverse these transactions by repurchasing, or repo-ing, the transferred assets and reestablishing large debts. In short, Lehman Brothers did what many brides and grooms do before their wedding day—they diet to look their best just before snapping wedding photos and then return to their usual ways once the photographer leaves.²⁶

Creating Ponzi Schemes

The Nature of a Ponzi Scheme

The phrase Ponzi scheme is named after the clever, but crooked, acts of Charles Ponzi, a slick newcomer to America in the early 1900s.

In a Ponzi scheme, a devious promoter entices gullible investors by promising expected profits that are too good to be true. For example, a promoter might promise investors a 5% monthly return from investing in, say, supposedly rare minerals or exotic jungle plants.

After raising investment capital, the promoter makes good on his promise by giving skeptical, but greedy, investors their expected return. For example, if the promoter guaranteed investors a 5% monthly dividend return, he will meticulously pay $5 on every $100 investment each and every month during the early days of the Ponzi scheme.

Pleased by their good fortune, gloating investors in turn proclaim their financial success to friends and relatives, leading others to make similar investments. Eventually, after grabbing all this investment money, the swindler simply disappears with the purloined funds.

Ahh, you ask, how did the promoter manage to generate such extraordinary returns in the first place? The answer is: He never did. The promoter would take, say, $100 upfront and tell investors that their $5 monthly check was a dividend distribution of profit. However, in reality, the $5 payment was merely a partial return of the same dollars that the investor had just transferred in. In short, the promoter fooled investors by mislabeling their monthly checks as profits when, in reality, investors were just receiving a portion of their original investment money back!

EXERCISES

General Principles

1. “One who speaks a portion of the truth to deceive you is a craftsman of destruction.” Can you identify an advertisement that gave you only a portion of the truth? Would you have preferred that the advertisement told a bold lie rather than a lie that had elements of truth? Why or why not?
2. Which element of the Fraud Triangle corresponds to each of the following items? State Incentives and Pressures, Opportunities, Attitudes and Rationalizations, or None.
   1. A company pays its top executives bonuses if the company's stock outperforms the annual returns of the Standard and Poor's 500 Index.
   2. A company's stock currently trades at price of only $1.14 per share. If the company's stock price goes below $1, the stock exchange on which it trades will likely halt it from trading by “delisting” it.
   3. The top developer of a company's information systems infrastructure chose to reject a job offer at a higher salary with another company because she “loves her current job” operating the company's accounts receivable and payable processing systems.
   4. A privately held real estate rental company charges off capital improvements, such as new furnaces and water heaters, for tax purposes to “be conservative.”
   5. The company's CEO requested that the company keep a custom-painted burgundy Rolls Royce in the garage of the company-owned home that she uses while conducting company business in Paris, so she won't have to use taxis.
   6. The company changed its fiscal year-end from December 31 to July 1. In a press release, it said that the reason for the change was to shift its audit into “slow season,” thereby lowering its audit fees.
   7. A company changed auditors without disclosing the reason for the change.

   Fraud Techniques

3. A cellular service provider gives customers a “free” cell phone if they sign a two-year service contract. You are a state tax auditor. The provider records income on this sale by prorating the sales price on a straight-line basis over the period of the service contract. Do you have any concerns about how this provider records this sale?
4. Xinkwabbly, a privately held software company, was started by a brilliant software programmer six years ago. The founder remained the sole shareholder of Xinkwabbly at all times.

   When Acquiro, Inc., purchased this privately held software company, Acquiro bought all of its outstanding stock and required the founder to serve as a consultant to the company for the two-year period following the purchase. Acquiro paid the founder a total sum of $3 million. Acquiro reported the entire $3 million as Investment in Subsidiary Stock.

   1. Did Acquiro account for this acquisition correctly?
   2. If not, did it gain a financial accounting reporting advantage by recording the acquisition in the manner that it did?
   3. From a financial accounting viewpoint, do you believe that Acquiro had the intent to commit fraud?
   4. From a tax accounting viewpoint, do you believe that Acquiro had the intent to commit tax fraud?
5. Spudville Co. has held a land in Idaho called Potatoland for decades. Over time, Potatoland appreciated in value from $3 million to $10 million. Spudville decided to sell this land to Idaho Private Equity Investors, Inc. and rent it back by signing a 40-year lease. Investors applauded Spudville for realizing such a large gain on its books. Would you characterize Spudville's actions as constituting a round-trip transaction?
6. What is a side agreement? Should side agreements be legally enforceable?
7. A company sold merchandise to a wholesaler for $4 million. In a side agreement, it agreed to reimburse the wholesaler for any lost gross profit if it was unable to resell these goods for at least an 80% markup on cost. In the industry, the usual average markup is about 65% on cost.

   In the company's files, the CFO of the company wrote on the side agreement: “Do not show this to auditors!”

   1. Why do you think that the CFO did not want the auditors to see this side agreement?
   2. By how much was this company's gross profit overstated?
   3. What was the proper accounting for this sale?
8. A dentist offers an in-office teeth brightening service for a cash fee of $500. As part of this offer, the dentist will provide patients with a home teeth brightening kit that uses a special professional-grade bleaching solution. Patients receive a tube of this bleaching solution at no additional charge “for life.” To receive this tube, patients must come to the dentist's office for their annual teeth cleaning and checkup appointment.
   1. How should this dentist recognize revenue on this transaction?
   2. Do you see any opportunities for the dentist to commit accounting fraud?
9. Backdato, Inc. is a start-up company with low profits and a history of operating losses. It compensates its top executives, in part, by giving them shares of company stock in the month of January, after the prior year's financial results are known. For tax and financial reporting purposes, assume that the value of the stock received by these executives is considered a form of compensation as of the date on which they receive it.

   During January, Backdato's stock traded on the New York Stock Exchange at $33 early in the month and rose steadily to $37 by the end of the month.

   Although Backdato issued shares to its executives at the end of the month, the company's Board of Directors decided to back-date these issuances as if they had occurred toward the start of January. Backdato's directors do not receive any shares themselves as compensation.

   What do you believe were the motivations of Backdato's directors for back-dating the issuance of these shares?

10. An acquirer recently purchased a software design firm that has a wonderful reputation and skilled workforce. The acquirer paid a lump sum to buy the entire company. The software firm's two main assets are its patents and its goodwill. The acquirer dishonestly wants to boost its reported near-term profits.
    1. For financial reporting purposes, would you expect it to allocate disproportionately more, or less, of the purchase price to the patents?
    2. For tax reporting purposes, would you expect it to pursue the same strategy that you determined in question a? What further information would you need to know before making that decision?
11. In order to continue to qualify for low-cost government-provided financing, your company must maintain a debt-to-equity ratio of less than 3 to 1 at the end of each calendar quarter.

    When you recently noticed that the company's debts are too high to achieve the required debt-to-equity ratio, your boss, the CFO, told you to contact “Friendly Freddy” at your local bank. According to “Friendly Freddy,” at the end of each quarter, the bank takes legal ownership of your company's $4 million fleet of trucks and cancels the $4 million Note Payable owed to it. This removes the bank debt from your company's books and shrinks the debt-to-equity ratio to acceptable levels. Then, as the new quarter begins, the bank restores your ownership of the trucks and reinstates your debt. As your CFO puts it, “We temporarily get rid of the debt and the trucks from our books each quarter…without ever having to move the parked trucks even one inch!”

    According to the Code of Conduct, this practice is:

    1. Acceptable because the bank legitimately cancels the debt owed by your company
    2. Acceptable because quarterly financial statements are subject to more lax rules than annual financial statements
    3. Unacceptable because your company's intent is to mislead government lending sources
    4. Unacceptable, unless $4 million is immaterial relative to the size of the company's total debts

    Tax Fraud

12. Assume that your top marginal tax rate increased from 15% last year to 35% this year. Are you now more likely, or less likely, to claim fraudulent deductions on your tax return? Does the reasons that your tax rate increased influence your answer to this question?
13. Just before filing a tax return, Person A has determined that she owes the IRS $700 on April 15. Similarly, Person B has determined that she is entitled to receive a tax refund of $700. Which of these two people is more likely to knowingly claim a tax deduction that they don't deserve?
14. Joe Bettalia, a general contractor, has struggled in recent years due to a downturn in the construction market in his region of the country.

    During the past two years, Joe has failed to file tax returns. He now has come to your office and asked you to prepare his tax return for the current year. You have agreed to do so. Joe also made an unusual request. He has asked you to deliberately overreport his income and tax liability on his tax return.

    When you expressed surprise at his request, he told you that “he feels guilty about not having filed with the government” in recent years. Also, he told you that his father “never has shown him much respect,” so he wants to leave his tax return lying around on the kitchen table, where his father will see it. “That way, my Dad will think I'm a success and show me at least some of the respect that I'm owed.”

    Are you willing to intentionally prepare a tax return for Joe that overstates his income and related tax liability?

15. While preparing a tax return for a gentleman named Tafoya, he surprised you when he told you that he is a “Paid Assassin” and that you should, accordingly, enter that phrase on the “Type of Business” line on his schedule of proprietorship income. When you asked him if he was joking, he told you that he was being sincere. He further told you that, during the prior year, he had earned income from shooting a foreign spy in the eye with a .22 caliber gun, had firebombed a home in Canada, and had procured a poison serum that was capable of “killing a 200-pound animal.”

    You have no reason to doubt that your client is fully reporting his income and being entirely truthful. Are you willing to prepare his tax return?

    Comprehensive Problems

16. As the newest member of your company's Budgeting and Forecasting Division, you try to be respectful and helpful to all of your colleagues.

    When you complimented your supervisor Sarah on her tan, she said, “Thanks, but it was a tough business trip to Phoenix. A crazy amount of work got done.” Then, she asked you to submit several hotel and airfare bills on her behalf to the company for reimbursement. You gladly did so.

    The following day, when Sarah's husband Ramon stopped by the office to meet her for lunch, you overheard him tell the company receptionist that the “two of them had an awesome time golfing all day and partying all night long” in Phoenix.

    Sarah is in charge of your work assignments. She is not on the Personnel Committee that decides raises and promotions. What, if anything, should you do?

17. Xerox Corporation sells, leases, and repairs photocopying machines for business customers. When a customer acquires a photocopying machine, it usually makes monthly payments over a three-year period. These payments provide the customer with the use of the machine, the financing benefit of not having to pay upfront, and maintenance and repair services.

    During 2002, Xerox paid a $10 million fine to the SEC because it had overstated revenues by $6 billion. Xerox had been recording these transactions as sales on credit, rather than as rental agreements.

    1. Assume that these photocopiers have a three-year useful life and no salvage value. Xerox treated these transactions as if it sells machines, but allows its customers three years to pay for their purchases. How would this change Xerox's reported revenues each year?
    2. Did Xerox's total revenues over the combined three-year period differ depending on whether it recorded these transactions as leases or sales?
18. Krispy Kreme Doughnut, Inc. sells donuts through its network of stores owned and operated by independent franchisees. Franchisees criticized Krispy Kreme's former CEO, Scott Livengood, for forcing companies with which Krispy Kreme did business to contribute $500,000 to sponsor a “storytelling festival” in the hometown of Mr. Livengood's wife. According to an independent investigation, this expenditure benefited Mr. Livengood and his wife, but did not provide Krispy Kreme with any marketing or promotional benefits.
    1. Was Mr. Livengood's insistence that these companies fund the storytelling festival ethical?
    2. Did Mr. Livengood likely have an improper tax motivation for structuring the funding of the storytelling festival in this manner?