Near the end of each quarter, many publicly traded companies unveil performance numbers in a Wall Street ritual known as “earnings season.” Interest is high as media outlets race to report the announcements, analysts pore over the figures, and investors trade on the implications. The most anticipated metric is normally earnings per share (EPS), which for each firm is compared to the consensus forecast of market analysts. Firms beating the forecast tend to enjoy jumps in share prices while those falling short, by even a small amount, tend to suffer price declines. Pressure to meet or beat market expectations can push executives to unethical, and sometimes illegal, acts of financial misrepresentation. In April 2016, Logitech International S.A., a leading producer of peripherals for computers (like its famous mouse) and other electronics, agreed to a $7.5 million penalty to settle with the U.S. Securities and Exchange Commission (SEC) for fraudulently under reporting losses on a new product in 2011 and, more generally, understating likely expenses on product warranties in 2012/2013–– all just to meet earnings expectations. In October 2010, Logitech launched “Revue”––a device for streaming online media on a television. Demand fell far short of expectations, resulting in well over 100,000 unsold units by fourth quarter 2011. Generally Accepted Accounting Principles (GAAP) require valuing such inventory at market value if the firm foresees slashing the sales price below cost. Yet Logitech failed to fully mark down unsold Revues, thereby seriously overstating 2011 operating income. On a broader scale, Logitech also artificially boosted income in 2012 and 2013 by understating the number of its products covered by warranties as well as the size of likely claims on defective devices. In his 2002 letter to shareholders, Berkshire Hathaway President, CEO, and Board Chairman Warren Buffett shared three enduring nuggets of wisdom to keep in mind when looking at financials: (i) weak accounting practices typically signify bigger problems, (ii) unintelligible information usually indicates shifty management, and (iii) earnings often fall short of rosy forecasts because firms seldom operate in predictable environments. The Sage of Omaha closed the newsletter on a prophetic note: “Managers that always promise to ’make the numbers’ will at some point be tempted to make up the numbers.”

Logitech understated potential warranty expenses by assuming customers would submit defective product claims within one quarter–– even though warranties extended for many years. Suppose instinct tells you the assumption is reasonable and ethical because problems with electronic devices occur soon after purchase or not at all. What evidence might you compile to challenge your instincts and satisfy auditors?