Caterpillar Inc. is the largest manufacturer of construction equipment in the world. In the course of growing its business, the company often purchased other companies. ERA Mining Machinery Limited (Siwei) was one such purchase. In June 2012, Caterpillar paid US$ 653.4 million, including US$ 475 million in cash, for all of Siwei’s shares. Often when companies such as Caterpillar acquire other companies, they pay a premium over the fair value of the net assets acquired. The premium is called goodwill and the goodwill, associated with the Siwei acquisition was reported by Caterpillar at US$ 625 million.
By November 2012, Caterpillar disclosed its concerns regarding accounting fraud and, in particular, the misrepresentation of the value of inventory reported by Siwei. Siwei undertook improper cost allocation and revenue recognition methods as well, leading to an overstatement of net earnings as well as assets, including an overstatement of inventory by US$ 17 million. Caterpillar discovered the discrepancy following a physical inventory count after it had purchased Siwei. Caterpillar’s chief financial officer noted publicly that a physical count was not a normal part of due diligence. This led some observers to conclude that in China, a physical inventory count should become part of the due diligence process.
The fraud appears to have been deliberate and occurred over several years. Siwei manufactures hydraulic roof supports to prevent the roofs of coal mines from collapsing. Caterpillar announced a write- down of US$ 580 million in the value of Siwei, which affected its earnings for the fourth quarter of 2012.
Caterpillar conducted its own internal investigation and subsequently dismissed all the senior management at Siwei, replacing them with management personnel from Caterpillar. Deloitte and Ernst & Young were the auditors acting for Caterpillar during the acquisition of Siwei, and RSM Nelson Wheeler of Hong Kong was Siwei’s auditor.
The chief executive officer of Caterpillar, Mr. Doug Oberhelman, has taken full responsibility for the current situation. The company is considering what steps it should take to recover losses and enforce accountability on those responsible for the alleged fraud.
Required:
A number of news articles have been written about this alleged fraud. Access some of these articles to answer the following questions.
1. As a new staff member at Caterpillar Inc.’ s auditing firm, you are assigned to write a memo on the effect of the overstatement of the value of inventory. Illustrate this effect with the use of adjusting entries to the appropriate financial statement accounts. Assume that Caterpillar is subject to an income tax rate of 30 percent.
2. Assume that both the CFO and the CEO of Caterpillar receive cash bonuses based on net earnings at the end of the year. What effect, if any, did the write- down of US$ 580 million have on the net earnings of Caterpillar Inc.? What effect, if any, did the write- down have on the share price?