Auditors are responsible for verifying that public companies' financial statements are presented in accordance with generally accepted accounting principles (GAAP). This responsibility includes proper revenue recognition as well as proper absorption costing for inventories and cost of goods sold. In this chapter, a number of real cases of channel stuffing were presented. For Harley-Davidson, analysts were concerned about channel stuffing because stock was building up at dealerships, and Harley-Davidson's stock price declined. However, sales in the next period picked up, reassuring analysts and investors that Harley- Davidson's product sales were continuing to grow. Harley-Davidson is no longer under Securities and Exchange Commission (SEC) investigation, and no actions were recommended to be taken against Harley-Davidson.
McAfee, Inc. tried a similar practice but was hit with several rounds of income restatements and inquiries from the SEC. In the McAfee case, sales did not increase in the next period. In fact, sales slowed down for a number of periods, but managers kept pushing inventory onto distributors. Investigations against Intel and Coca-Cola are ongoing. When the SEC investigates and asks companies to restate income, it alleges fraudulent behaviour on the part of managers. When companies restate income, they often explain that they were not behaving fraudulently, but they are restating income to appease the SEC. When auditors discover a misstatement (a situation in which the financial statements do not comply with GAAP), they must determine whether it is caused by an error or by fraud. An error is defined as an unintentional mistake, while fraud is intentional.
REQUIRED
A. In your own words, define channel stuffing.
B. Explain why the managers of companies such as McAfee and Harley-Davidson cannot know for sure what their sales will be next period, or how much inventory to produce.
C. Explain why the customers of companies such as McAfee and Harley-Davidson might be willing to purchase excess inventories.
D. Assume that you are a manager at Coca-Cola and are defending the decision to encourage dealers to stock up on inventory. Write a brief paragraph defending Coca-Cola's behaviour. (You might want to do some Internet research to support your position. Be sure to interpret the situation in your own words, as you believe a manager might respond. The SEC website, www.sec.gov, might be a good place to start.)
E. In both the Harley-Davidson and McAfee cases, the companies shipped merchandise to their customers and recognized the shipments as revenue. How could the SEC claim that McAfee had improperly recognized revenue? In other words, does channel stuffing violate revenue recognition under GAAP? In your answer, discuss and provide references to relevant financial accounting standards and concepts.
F. From an auditor's perspective, discuss the likelihood that McAfee's US$622 million overstatement of revenue resulted from error versus fraud.
G. Explain why it might be considered so important to continue showing sales and earnings growth that managers might behave in an allegedly fraudulent manner.
H. Describe the costs for the kind of behaviour described in Part G, in addition to negative reputation effects for the company.