VIRTUALLY THERE TECHNOLOGIES: A CASE STUDY OF EARNINGS MANAGEMENT AND FRAUD Dean W. DiGregorio, Southeastern Louisiana University H. Lynn Stallworth, Southeastern Louisiana University Robert L. Braun, Southeastern Louisiana University CASE DESCRIPTION The primary subject matter of this case concerns recognizing and correcting earnings ‘management and fraud, Secondary issues inelude helping students to develop professional judgment and to become aware of typical reporting problems experienced by growing companies. The case hhas a difficulty level of three and is appropriate for junior-level students in intermediate financial accounting courses, It could also be used at level four ina senior-level auditing class, The case is designed 10 be taught in 2.5 class hours and is expected to require 4 hours of outside preparation by students. Alternatively, the case can be assigned as a project that requires minimal classroom time. CASE SYNOPSIS Earnings management has received a great deal of publicity by the press and increased scrutiny by the SEC. However, many students do not understand how earnings management and frauds are perpetrated, the extent to which “gray” areas exist in accounting practice, and the role that professional judgment plays in determining the correct course of action. This instructional case is designed to help studenis learn to recognize earnings management and fraud, to develop professional judgment, and to become aware of typical reporting problems experienced by growing companies. Studems are required to identify problem situations and differentiate beween unintentional errors and omissions, aggressive accounting practices and fraud. They must also propose adjusting journal entries and determine the effect on income. The case is based on a Fictional fast-growing high tech company, Virtually There Technologies, which manufactures and ‘markets virtual reality game systems. In the wake of the abrupt departures of the CFO. and comroller, studems assume the role of the new controller. Their job is to get the financial records in order before the annual audit of the company financial statements begins Journal of the International Academy for Case Studies, Volume 10, Number 3, 200416 VIRTUALLY THERE TECHNOLOGIES: BACKGROUND INFORMATION You have been hired as the controller for Virtually There Technologies (VTT), a small high tech company that has demonstrated steady growth since it introduced its first products in the mic 1990s. Your job is to get the financial records in order before the annual audit of the company financial statements. You are assuming the role of controller at an important and exciting time for the company. The previous CFO and controller resigned during the last month of the fiscal year citing “personal reasons” for their abrupt departures. There have also been quite a few contentious issues with the audit firm in recent years. To help manage the audit situation, the Interim CFO has asked that his office clear all information requested by the auditors before it is passed along to the auditors. Virtually There Technologies develops, manufactures and markets virtual reality game systems. Its product line occupies a high-end niche by utilizing high definition video output technology and total sensory involvement. In addition, the company has created a line of software products for owners of the systems. VT participates in B2B commerce through its efforts to place its hardware products in electronies retailing chains and B2C commerce through its on-line retail software enterprises. ‘The Board of Directors, consisting primarily of top management and members of theit immediate families, appointed the Vice President of Marketing to serve as the Interim Chief Financial Officer (CFO). The assistant controller filled in until you were hired one month after the end of the fiscal year. As is common with many start-up companies, compensation comes mainly in the form of stock options and bonuses and varies significantly from year to year. ‘The President of VTT has an engineering background and recently completed an Executive Master of Business Administration degree at a local university. Although originally focused on technical innovation and research, his recent focus has been on the fiscal affairs of the business. He exercises strong control over all aspects of the company. and has been especially preoccupied increasing quarterly earnings and entertaining the financial analysts who have become increasing interested in the organization. This interest has been fueled by reports that the company will make an initial public offering of its stock this year. He has impressed the financial community with the depth of his knowledge of technical and financial affairs of the organization and his bold predictions, for unprecedented growth with the development of new products, ‘A new major competitor entered the high-definition, integrated virtual reality market late in the third quarter of the last fiscal year. This competitor is very well established with the younger end of its demographic group. In fact, most of VTT"s younger customers grew up playing on game systems created by the competitor. Analysts are observing this issue closely. Failure to maintain market share in light of increased competition could be detrimental to VIT’s hopes of going public. As competition in the industry heats up, analysts expect to see increased consolidation through business failures and acquisitions Journal of the International Academy for Case Studies, Volume 10, Number 3, 200417 Central to its hopes of competing effectively in the increasingly competitive market is VTT’s new product line, Although it has not yet reached viability due to problems with the memory modules on the product, the company has scheduled a press conference to unveil the prototype in ‘nwo months and is assembling products without the troublesome memory modules. In addition, they have developed software products to be used by the new hardware unit and are producing new titles in anticipation of demand for the product following its introduction. REQUIREMENTS Before beginning the assignment, you may want to review the Supplemental Instruction Materials included at the end of the case. These materials discuss specific accounting practices that can be used to manipulate earnings and perpetrate fraud. For each item presented afier this section, identify the problem and discuss how it should be handled. The descriptions should be written in the form of a memo to the president and numbered. Address only the adjustments for the year-ended December 31, 2001. For each item, state whether it appears to be the result of an unintentional error or omission, a potentially intentional misstatement, a fraudulent action (intentional), or an aggressive interpretation of generally accepted accounting principles. Prepare any necessary adjusting journal entries and determine the effect of each entry on net income (record in a format similar to the following example). The company uses the perpetual inventory system. However, in cases where an adjusting journal entry would normally be made to the “inventory shortiover” account, the “cost of goods sold” account should be used instead. Afterall required entries have been prepared, the effect on income column should be totaled and net income before taxes should be calculated. The net income before taxes for the year, before any required adjusting journal entries is $1,864,000. AIE Description DR cR Effect on net income Income per tial balance $1,864,000 ADDITIONAL INFORMATION While reviewing the preliminary December 31, 2001 financial statements, several items caught your attention. Net income before taxes for the year was $1.864,000 compared to a net loss, of $5,171,000 in the prior year. Both sales and the gross profit ratio have i creased significantly Journal of the International Academy for Case Studies, Volume 10, Number 3, 2004