Cases Covered: Avon Products, First Keystone, Suzette Washington, Wiley Jackson, Arvel Smart, Zane Corbin, Dell, Inc. (From Knapp’s Contemporary Auditing, 12th Edition).
Case 3.3. Avon Products, Inc.
During the early 1880s, David McConnell, the son of Irish immigrants, eked out a livelihood in New York City by selling books door to door. The persistent McConnell tried one gimmick after another to boost his sales. One evening, he prepared a homemade batch of rose oil perfume. He planned to give a small sample of the perfume to each housewife willing to spend a few minutes listening to his sales pitch. The gimmick worked; in fact, it worked too well. McConnell’s prospective customers were much more intrigued by his free samples of perfume than the books he was offering for sale. So, the enterprising businessman quit selling books and began peddling his homemade perfume from door to door.
In 1886, at the age of 28, the growing demand for his perfumes—which by this time included five fragrances—convinced McConnell to hire his first employee, Persis Albee, a 50-year-old housewife. Shortly after hiring Mrs. Albee, it became apparent to McConnell that she was more proficient at selling his merchandise than he was. McConnell eventually realized that Mrs. Albee’s success stemmed from her ability to quickly establish a personal rapport with potential customers, something he struggled to do. With the help of Mrs. Albee, McConnell began recruiting other middle-aged women who displayed her charming and unpretentious demeanor to market his perfume products. From that humble beginning, Avon Products, Inc., was born.
Over the next century and beyond, the buoyant neighborhood “Avon lady” became a part of Americana and served as the foundation of a global, multibillion-dollar merchandising company.
In 1920, McConnell’s business reached the $1 million annual sales plateau for the first time. By the close of the twentieth century, a sales force of more than three million Avon representatives marketed the company’s products to nearly one billion customers scattered around the globe in 140 countries. By the year 2000, the company had reached another historic landmark. In November 1999, Andrea Jung, a first-generation American just like David McConnell, was named Avon’s first female chief executive officer (CEO).
New CEO Energizes Avon
Andrea Jung earned a degree in English literature from Princeton in 1979. Before pursuing a law degree, the 20-year-old Jung decided to take a short break from academics to gain some real-world experience. During a college career fair, Jung landed a job as a management trainee with Bloomingdale’s, an upscale New York-based retailer. Jung soon became fascinated by the retail industry and decided to forego law school.
During the first few years of her career, Jung earned a reputation as a marketing savant, which allowed her to move rapidly up Bloomingdale’s employment hierarchy. After leaving Bloomingdale’s in 1985, Jung accepted a series of progressively higher-ranking marketing positions with other major retailers. In 1994, Jung left Neiman Marcus to become the president of Avon’s U.S. product marketing group, a position she held for two years before being promoted to president of global marketing for the company. In 1999, Avon’s board chose Jung to serve as CEO after a dismal earnings report caused a sharp drop in the company’s stock price.
The new CEO quickly energized Avon. During the first two quarters that Jung oversaw the company, its sales increased by nearly 10 percent while its earnings leaped by 40 percent. Those impressive results would be overshadowed by the company’s performance over her first five years as CEO. Over that time frame, Avon’s net income and stock price each increased nearly 300 percent. Jung would eventually become the longest-serving female CEO of a Fortune 500 firm, remain a permanent fixture on the “most powerful” women in business rankings, and be widely recognized as the most prominent Chinese-American in the U.S. business world.
A series of bold initiatives launched by Jung were responsible for the company’s quick turnaround after she was promoted to CEO. One of those initiatives was giving Avon a sleeker, more “hip” image to attract younger women to its products. That strategy included introducing a line of products specifically designed for women in their 20s and hiring prominent young women to serve as company spokesmodels, such as Academy Award–winning actress Reese Witherspoon and sports celebrities Serena and Venus Williams.
Another strategic measure Jung implemented was expanding Avon’s international operations. The new CEO placed particular emphasis on extending Avon’s presence in such large and potentially lucrative markets as China, India, Russia, and Latin America. She took a personal interest in Avon Products China (APC), the company’s largest operating unit in its Asia-Pacific sales region.
Jung, whose parents had emigrated to the United States from China via Canada, was asked during an interview why she focused so much time and energy on developing the Chinese market for Avon’s products. “It’s a huge opportunity, not just to sell our products but to do this … by teaching women to be self-sufficient and economically independent. Nowhere is this more important than in China.”
The Chinese subsidiary was so important to Jung that she required its top official to report directly to her.
The Guanxi Solution
Avon faced a major obstacle that stymied Jung’s plan to exploit the Chinese market. In 1998, the year before Jung became Avon’s CEO, the Chinese government had outlawed the “direct selling” of merchandise. Because Avon used direct or person-to-person selling as the principal marketing method for its products, the new Chinese policy posed a major setback for the company. Following the implementation of the direct selling ban, Avon established small retail outlets or “Beauty Boutiques” in major Chinese cities. But Jung and other top company executives were convinced that the only way to maximize Avon’s sales in the huge Chinese market was to somehow regain direct selling privileges in the country. To help achieve that goal, APC established a “Direct Selling Task Force.”
Jung became personally involved in Avon’s goal of convincing the Chinese government to lift its ban on direct selling. Because she was fluent in Mandarin and spoke other Chinese dialects as well, she traveled to China to personally meet with high-ranking Chinese government officials to discuss that issue with them.
Another strategy Avon used to regain direct selling privileges in China was hiring an executive for APC’s Corporate Affairs Department to serve as a liaison between Avon and key Chinese government officials. This individual’s employment contract mandated that he “help open doors and develop the required ‘guanxi’ to successfully conduct business [in China].”
Guanxi is a Chinese term that refers to a system of exchanging favors to establish and strengthen social networks and relationships. The key feature of guanxi is reciprocity.
The norm of reciprocity is … ingrained in the very fabric of Chinese society which is not necessarily the case in the United States. As a matter of fact, in the United States, the reciprocity norm has been deemed unfair in the business world as it violates rules of fair competition. Therefore in the United States, reciprocity is viewed as more of a hindrance or obstacle to business—an unethical act.
A final measure Avon implemented to regain direct selling privileges in China was the hiring of a consulting firm. That firm’s responsibility was to manage public relations issues that might arise from Avon’s pursuit of its direct selling initiative. Avon’s management realized that Chinese government officials are averse to public criticism. Chinese regulatory officials are particularly averse to any suggestions that they are catering to the economic interests of large foreign corporations intent on establishing or expanding operations in China. The consulting firm’s mandate was open-ended. For example, the contract with Avon did not “contractually bind the consulting company to comply with the FCPA [Foreign Corrupt Practices Act].”
After several years of lobbying the Chinese government, Avon received good news when a government official told a company representative that China would be lifting its ban on direct selling.
The official also indicated that Avon would be the first company to receive a direct selling license. In April 2005, China’s Ministry of Commerce officially granted Avon the right to use direct selling to market its products on a test basis in two large Chinese provinces. One year later, in March 2006, the Chinese government granted Avon a direct selling license that was national in scope. Nine months passed before any other foreign companies were granted such a license.
Avon took full advantage of its head start. In October 2006, Andrea Jung reported that APC already had nearly 250,000 licensed sales representatives in China and that the subsidiary had realized a nearly 70 percent increase in quarterly sales within the country following the lifting of the direct selling ban.
FCPA Allegations
Andrea Jung received a startling letter in May 2008 from a former APC employee. That individual, who had served as the Associate Director of APC’s Corporate Affairs Department, told Jung that over a period of several years his department had made improper payments to Chinese government officials “in the form of meals, entertainment, travel, sponsorship of cultural events, gifts of art, and cash.”
The payments had been made allegedly to influence the decisions of those officials in carrying out their assigned responsibilities.
If the whistleblower’s allegations were true, the improper expenditures had violated the FCPA. The FCPA prohibits companies registered with the SEC from bribing government officials in foreign countries. The federal statute also requires SEC registrants to maintain reliable accounting records and effective internal control systems. If a company violates the FCPA’s anti-bribery provision, it typically violates the accounting records and internal control provisions as well.
Jung forwarded the letter to Avon’s legal department and corporate audit committee. Five months later, the audit committee launched an internal investigation of the allegations. Avon also reported the allegations to the U.S. Department of Justice (USDOJ) and the Securities and Exchange Commission (SEC). The USDOJ and SEC jointly enforce the FCPA and coordinate their investigations of potential FCPA violations.
Avon’s internal investigation and the parallel investigations by the USDOJ and the SEC revealed that the issue of improper payments by APC to Chinese government officials had surfaced within the company as early as April 2005. Routine audit procedures by members of Avon’s global internal audit staff had uncovered a series of suspicious expenditures made directly to, or for the benefit of, such officials. Subsequent to that discovery, Avon’s global internal audit staff considered the “need to provide training on the provisions of the FCPA in the Asia-Pacific region, including China.” This training was never provided because of budgetary constraints.
During the fall of 2005, Avon’s internal auditors performed a limited scope audit that focused on “discretionary payments” made by APC’s Corporate Affairs Department. An initial draft report of that audit indicated that “it was a common business practice for Avon Products China to offer gifts and meals to various government officials and that the majority of the government-related activities at Avon Products China were not adequately documented.” The report also suggested that the “gifts and meals might be construed as the company’s intent to expedite licenses from the government or to avoid unfavorable rulings against the company, therefore potentially violating the provisions of the FCPA.”
The internal audit of APC’s Corporate Affairs Department prompted complaints from that department to Avon’s corporate headquarters. In one such complaint, an APC official insisted that the internal auditors’ “unrealistic questioning” threatened not only his and his colleagues’ “job security” but also their efforts to create a “favorable business environment for the company.”
The official went on to suggest that the “CA department is like a fighting brigade, we are most of the time have to fight [sic] in a muddy field, if we get our hands on some dirt, it is not our fault! We should be much protected.”
In another letter to Avon corporate headquarters executives, this same individual claimed that “Corporate Affairs Group would lose all of its guanxi ” if it was required to change its operating policies and procedures as a result of the internal audit.
A copy of the internal audit draft report prepared during the fall of 2005 was given to a senior member of Avon’s global internal audit staff. That individual, in turn, forwarded the report to Avon’s legal staff in New York City.
Avon’s Legal Department took the position that conclusions about potential FCPA violations fell within the purview of Legal, and not Internal Audit. The V.P. Internal Audit directed the internal audit team to have the FCPA conclusions removed from the draft pending further study of the issues. After the V.P. Internal Audit conferred with the Vice President of Finance, Asia Pacific, the internal audit team was directed to redraft the report, recall and destroy all hard copies, and delete any e-mail to which the draft was attached.
Following additional discussion of the internal audit draft report among APC executives and officials in Avon’s corporate headquarters, Avon’s internal auditors were instructed to return to APC’s Corporate Affairs Department and expand their investigation into the potentially improper payments. “The internal audit team was told not to create any electronic documents, not to send any emails regarding the follow-up review, and not to use the term ‘FCPA’ in any written document.”
A revised and updated internal audit report was “hand-carried” by an Avon official on a flight to New York City. According to the USDOJ, after reviewing the report and discussing it with outside legal counsel, officials in Avon’s corporate headquarters decided to close the APC investigation of the suspicious payments because they were “unsubstantiated.”
After the investigation of the suspicious payments was terminated, an official of Avon’s Asia-Pacific region and an Avon corporate executive decided that “remedial measures at Avon Products China” were needed. Although several such measures were discussed, they were never implemented. “Moreover, there was no instruction to the employees at Avon Products China to otherwise change the practice of providing things of value to Chinese government officials.”
In December 2006, an APC executive informed a senior member of Avon’s global internal audit staff by email that APC’s Associate Director of Corporate Affairs had been dismissed. The Associate Director was fired for “submitting false expense reports” that sought “reimbursement for gifts and entertainment provided to government officials.” A copy of this email communication was forwarded to Avon’s corporate legal staff in New York City.
After consulting with Avon’s legal staff, the senior member of Avon’s global internal audit staff instructed two subordinates to do “follow-up work” at APC’s Corporate Affairs Department to determine whether questionable activity was still ongoing within that department. The two internal auditors subsequently reported that the “problematic payments and inadequate recordkeeping” previously documented within that department were continuing. “No remedial measures were implemented” as a result of this follow-up report. Approximately one year later, the former Associate Director of APC’s Corporate Affairs Department sent the letter to Andrea Jung that alerted her to the improper payments that had been made by APC.
The Feds Weigh In
The investigations by Avon and federal law enforcement agencies revealed that from 2004 through late 2008, APC had made improper expenditures directly to, or on behalf of, numerous Chinese government officials. Payments were also made to state-owned media outlets to suppress news articles that might reflect negatively on those government officials or APC. The improper expenditures totaled approximately $8 million. The SEC charged Avon with multiple violations of the FCPA,
including the failure to maintain accounting records that fairly reflected the purpose and nature of the improper expenditures and failing to maintain internal controls that would have prevented or detected such expenditures on a timely basis.
Federal prosecutors with the USDOJ added to the criticism of Avon’s internal controls, focusing particular attention on the company’s inadequate internal audit function. “Avon lacked sufficient controls to ensure the integrity of its internal audit process, particularly with regard to its review of allegations of, and testing for, improper payments made to government officials. Avon’s internal audit group also failed to devote adequate funding, staffing, and resources to Avon China.”
The USDOJ went on to report that “Avon executives and employees, including high-level executives” were aware that APC employees “routinely provided things of value to Chinese government officials” but refused to take the appropriate measures to end those payments or to ensure that they were properly reflected in the company’s consolidated accounting records.
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that included the payment of an additional $67 million fine. The nearly $135 million of FCPA-related fines paid by Avon rank among the largest ever imposed on a public company. But those fines were dwarfed by the reported $350 million that Avon spent on its internal FCPA investigation.
U.S. Attorney Preet Bharara oversaw the USDOJ’s investigation of the Avon foreign payments scandal. In commenting on the case, Bharara observed that “Avon China was in the door-to-door influence-peddling business in return for business benefits, and for years its corporate parent, rather than putting an end to the practice, conspired to cover it up.”
Andrew McCabe, the Assistant Director of the Federal Bureau of Investigation (FBI), which assists the USDOJ in criminal investigations, also commented on the case. “Companies who attempt to advance their businesses through foreign bribery should be put on notice. The FBI, with our law enforcement partners, is continuing to push this unacceptable practice out of the business playbook by investigating companies who ignore the law.”
In May 2011, Avon notified the SEC that it had dismissed four executives connected to the APC bribery scandal—each of those executives had been suspended by the company the prior year. The four individuals included three former APC officers and a former senior member of Avon’s global internal audit staff. In December 2011, Avon’s board announced that it was initiating an executive search to find a replacement for Andrea Jung as the company’s CEO. Jung left the company in late 2012, a few months after Avon hired a new CEO.
Industry observers suggested that Jung’s dismissal was due to both the FCPA scandal and the company’s steadily worsening operating results. After earning a record $875 million net income in 2008, Avon’s profitability had steadily eroded. In 2012, Avon’s sales declined, and the company reported a loss for the first time since 1988. From a high of $46 per share in 2004, the company’s stock price had fallen to near $14 per share when Jung left the company in 2012.
A series of strategic missteps by Jung were responsible for Avon’s poor operating results during her final few years as the company’s CEO. Among those missteps was Jung’s decision to begin placing less emphasis on direct selling in Avon’s established markets, including the United States. Another misstep was Jung’s decision to extend Avon’s product line. In 2010, for example, Avon acquired Silpada, a company that marketed silver jewelry. When that “experiment” quickly failed, Avon sold Silpada for a loss of almost $500 million. These and other decisions caused Bloomberg Business to name Jung one of the nation’s five “worst CEOs”
in 2012. In commenting on Jung’s sudden fall from grace, Fortune magazine observed, “It is a stunning reversal of fortune for one of corporate America’s stars.”
Case 3.4. First Keystone Bank
A Japanese bank introduced the concept of around-the-clock access to cash in the 1960s when it installed the world’s first cash-dispensing machine. In 1968, the first networked ATM appeared in Dallas, Texas.
Two generations later, there are more than two million “cashpoints,” “bancomats,” and “holes-in-the-wall” worldwide, including one in Antarctica.
Not surprisingly, ATMs have been a magnet for thieves since their inception. In 2009, an international gang of racketeers used a large stash of counterfeit ATM cards to steal $9 million from hundreds of ATMs scattered around the globe in a well-planned and coordinated 30-minute crime spree. Several high-tech thieves have hacked into the computer networks of banks and modified their ATM software. One such miscreant reprogrammed a network of ATMs to change the denomination of bills recognized by the brainless machines—the ATMs treated $20 bills as if they were $5 bills. High-powered video cameras and miniature electronic devices attached to ATMs have been used to steal personal identification numbers (PINs) from a countless number of unsuspecting bank customers.
A variety of low-tech schemes have also been used to rip off banks and their customers via ATMs, including forced withdrawals and post-withdrawal armed robberies. “Ram-raiding” involves using heavy-duty equipment to rip an ATM from its shoring. The ram-raiders then haul the ATM to a remote location and blast it open with explosives. The most common and lowest-tech type of ATM pilfering involves the aptly named tactic of “shoulder-surfing.”
Many banks have suffered losses from their ATM operations due to embezzlement schemes perpetrated by employees. One such bank was the Swarthmore, Pennsylvania, branch of First Keystone Bank. Swarthmore, a quiet suburb of Philadelphia, is best known for being home to one of the nation’s most prestigious liberal arts colleges. Forbes Magazine recently ranked Swarthmore College as the sixth-best institution of higher learning in the United States—two slots below Yale, but two slots higher than Harvard.
In January 2010, three tellers of First Keystone’s Swarthmore branch were arrested and charged with stealing more than $100,000 from its ATM over the previous two years. The alleged ringleader was Jean Moronese, who had worked at the branch since 2002 and served as its head teller since 2006. According to media reports, Moronese told law enforcement authorities that she initially began taking money from the branch’s ATM in 2008 to pay her credit card bills, rent, and day care expenses.
No doubt emboldened by the ease with which she could steal the money, Moronese reportedly began taking cash from the ATM “just to spend” because she “got greedy.”
Prior to taking a vacation in the fall of 2008, a tearful Moronese approached one of her subordinates and fellow tellers, Kelly Barksdale, and confessed that she had been stealing from the ATM. Moronese “begged” Barksdale to help her conceal her thefts “because she didn’t want her children to see her go to jail.”
Barksdale was apparently persuaded by Moronese’s tearful plea and agreed to help her cover up the embezzlement scheme.
In fact, the cover-up was easily accomplished. According to the local police, Moronese and Barksdale simply changed the ledger control sheets that were supposed to report the amount of cash stored in the ATM and in the locked vault within the ATM. First Keystone’s internal control procedures mandated that two employees be involved in resupplying the ATM and its locked vault and in maintaining the ATM ledger control sheets. However, either Moronese or Barksdale completed those tasks by themselves.
In early 2009, a third teller, Tyneesha Richardson, overheard Moronese and Barksdale discussing the embezzlement scheme. Richardson then reportedly asked Moronese for money to pay off her car loan. Moronese agreed to give Richardson the money and told her that she shouldn’t worry because “the bank had a lot of money and they would never miss it.”
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After telling Barksdale that she had given money to Richardson, Moronese told Barksdale that if she ever needed any money “to let her know.”
Not long thereafter, Barksdale allegedly asked Moronese for $600 to pay her rent.
An internal audit eventually uncovered the embezzlement scheme at First Keystone’s Swarthmore branch. That internal audit revealed that $40,590 was missing from the branch’s ATM, while another $60,000 was missing from the locked vault within the ATM’s interior.
While being interrogated by law enforcement authorities, Barksdale reportedly confessed that she and her colleagues had also stolen money from the local municipality. City employees periodically dropped off at the First Keystone branch large bags of coins collected from Swarthmore’s parking meters. Tellers at the branch were supposed to feed the coins into a coin-counting machine and then deposit the receipts printed by the machine into the city’s parking account. According to Barksdale, she and her two fellow conspirators diverted money from Swarthmore’s parking funds and split it among themselves. The police estimated that the three tellers stole approximately $24,000 of the parking funds.
In January 2010, when the three tellers were arrested, they did not have far to go since the Swarthmore police station was across the street from the First Keystone branch where they worked. In commenting on the case, the local district attorney observed that Barksdale and Richardson had a choice to make when they learned of Moronese’s embezzlement scheme and that each had made the wrong choice. “So, the lesson is you can either be a witness or you can be a defendant. These two chose to be defendants.”
, Case 4.3. Suzette Washington, Accounting Major
Suzette Washington financed her college education by working as an inventory clerk for Bertolini’s, a clothing store chain located in the southeastern United States.
Bertolini’s caters primarily to fashion-conscious young men and women. The company’s stores carry a wide range of clothing, including casual wear, business suits, and accessories. The Bertolini’s store for which Suzette worked is located a few blocks from the campus of the large state university that she attended. Except for management personnel, most of Bertolini’s employees are college students. Suzette’s best friend and roommate, Paula Kaye, worked for Bertolini’s as a sales clerk. Paula majored in marketing, while Suzette was an accounting major.
During Suzette’s senior year in college, Bertolini’s began experiencing abnormally high inventory shrinkage in the store’s three departments that stocked men’s apparel. Suzette’s supervisor, an assistant store manager, confided in her that he believed one or more of the sales clerks were stealing merchandise. Over lunch one day in the student union, Suzette casually mentioned the inventory problem to Paula. Paula quickly changed the subject by asking Suzette about her plans for the weekend.
“Paula, rewind for just a second. Do you know something that I don’t?”
“Huh? What do you mean?”
“Missing inventory … shrinkage … theft?”
After a few awkward moments, Paula stopped eating and looked squarely into her friend’s eyes. “Suzette, I don’t know if it’s true, but I’ve heard a rumor that Alex and Matt are stealing a few things each week. Polo shirts, silk ties, jeans. Occasionally, they take something expensive, like a hand-knit sweater or sports jacket.”
“How are they doing it?”
“I’ve heard—and don’t repeat any of this now—I’ve heard that a couple of times per week, Alex stashes one or two items at the bottom of the trash container beneath the number two cash register. Then Matt, you know he empties the trash every night in the dumpster out in the alley, takes the items out and puts them in his car.”
“Paula, we can’t let them get away with this. We have to tell someone.”
“No ‘we’ don’t. Remember, this is just a rumor. I don’t know that it’s true. If you tell a manager, there will be questions. And more questions. Maybe the police will be brought in. You know that eventually someone’s going to find out who told. And then … slashed tires … phone calls in the middle of the night.”
“So, don’t get involved? Don’t do anything? Just let those guys keep stealing?”
“Suze, you work in inventory. You know the markup they put on those clothes. They expect to lose a few things here and there to employees.”
“Maybe the markup wouldn’t be so high if theft wasn’t such a problem.”
Now, there was no doubt in Paula’s mind that Suzette was going to report the alleged theft scheme to management. “Two months, Suze. Two months till we graduate. Can you wait till then to spill the beans? Then we can move out of state before our cars are spray-painted.”
One week following Suzette and Paula’s conversation, a Bertolini’s store manager received an anonymous typed message that revealed the two-person theft ring rumored to be operating within the store. Bertolini’s immediately retained a private detective. Over a four-week period, the detective documented $500 of merchandise thefts by Alex and Matt. After Bertolini’s notified the police, the local district attorney filed criminal charges against the two young men. A plea bargain agreement arranged by their attorneys resulted in suspended prison sentences for Alex and Matt. The terms of that agreement included making restitution to Bertolini’s, completing several hundred hours of community service, and a lengthy period of probation.
Case 4.5. Wiley Jackson, Accounting Major
Wiley Jackson spent three months as an audit intern with a local practice office of a major accounting firm while he was earning an undergraduate accounting degree at the University of Wisconsin–Milwaukee.
Wiley thoroughly enjoyed the three-month internship. He made several friends and, more importantly, gained valuable work experience and insight into the nature and work environment of independent auditing. On the final day of his internship, Wiley had an exit interview with the office managing partner (OMP). The OMP told Wiley that he had impressed his superiors and coworkers. Wiley’s performance reviews indicated that he had strong technical and interpersonal skills and always conducted himself in a professional and ethical manner. At the end of the exit interview, the OMP offered Wiley a full-time position with the firm once he completed his master’s degree in accounting at UWM. Wiley was thrilled by the offer and accepted it immediately.
While working on his graduate degree, Wiley received a packet of documents from his future employer that he was to complete and return. The packet contained standard insurance forms, 401(k) elections, a W-4 form, a personal investments worksheet for independence-compliance purposes, and a “Statement of Arrests and Convictions” form. Wiley recalled having completed an earlier version of the latter document before beginning his internship. Among the questions included in this form was the following:
Have you ever been convicted of a misdemeanor (excluding minor traffic violations) or a felony, or driving while intoxicated in this or any other state, or are criminal charges currently pending against you?
The form required a full explanation if this question was answered “Yes.” Wiley had previously responded “No” to this question because, at the time, he had a “clean” record, except for a few parking tickets and one speeding violation. But now, as he sat at his desk staring at the form, he was not sure how to respond to the question.
After completing his internship, Wiley had been invited to a graduation party at an off-campus location. Although he was not a “party animal,” Wiley had decided to accept the invitation since it would likely be his final opportunity to see many of his friends who were graduating from UWM. When he arrived at the site of the party, Wiley was surprised by the large number of people there. In fact, because the older, two-story home could not accommodate all the partygoers, several dozen of them were congregated in the front yard and on the residential street on which the house was located.
As he made his way through the boisterous crowd, Wiley suddenly came face to face with Sally Jones. Sally, a UWM alumna, had been the audit senior assigned to Wiley’s largest client during his internship. While Wiley was talking to Sally, an acquaintance thrust a cold beer into his hand and slapped him on the shoulder. “No talking business here, Dude. It’s party time!” As luck would have it, just a few minutes later, the party was “busted” by the local police. Before Wiley realized exactly what was happening, a policeman approached him and asked for his I.D. As he handed over his driver’s license, Wiley, who was three days short of his 21st birthday, realized that he was in trouble. Moments later, the stone-faced policeman began writing out a minor-in-possession citation. The citation ordered Wiley to appear before a local judge the following month.
Wiley was distraught and had a difficult time sleeping that night. The next morning, he called an attorney and told him what had happened. The attorney informed Wiley that he had dealt with many similar situations involving college students and that Wiley should not be “stressed out” by the incident. For first-time offenders, like Wiley, the attorney had always been successful in persuading a judge to approve “deferred adjudication.” As long as Wiley stayed out of trouble over the following two years, the minor-in-possession charge would be expunged from his record, “just like it never happened,” according to the attorney.
Case 4.7. Zane Corbin, Accounting Major
12:55 P.M., Friday, April 30
“The final undergraduate award today is the William J. Upchurch Medal, which is given annually to the outstanding senior in the Hopkins College of Business.
Nominations are made by Hopkins faculty members and the criteria considered in choosing the winner include overall GPA, GPA in business courses, and involvement in student organizations.” Dean Rodney Brown paused to build suspense among the nearly 500 faculty members, students, parents, and donors present at the annual spring awards luncheon being held in the Student Union Ballroom of the large state university. “I know that every year the Undergraduate Awards Committee struggles to choose the winner of the Upchurch Medal because there are so many deserving recipients. Professor John Goggans of the Finance Department chaired that committee this year. Let’s give him a round of applause,” Brown said as he motioned for Goggans to stand. A few moments later, Brown continued. “Drum roll, please. … This year’s winner of the William J. Upchurch Medal—which is accompanied by a $1,000 check—is … Michael Zane Corbin, an accounting major.”
As Zane Corbin wound his way through the maze of tables set up in the ballroom to receive his award and check, Dean Brown read Zane’s credentials for the award, including the five student organizations of which he was a member. The final organization listed by Dean Brown was Beta Alpha Psi, the College of Business’s honors organization for accounting majors. Ann Herrick, an accounting professor, immediately stopped clapping. Why? Because Professor Herrick served as the faculty advisor of the college’s Beta Alpha Psi chapter, and she knew that Zane Corbin was not a member of that organization.
1:20 P.M., Friday, April 30
Ann Herrick went to John Goggans’ office following the awards luncheon to discuss Zane Corbin’s alleged membership in Beta Alpha Psi.
“There it is, Ann, ‘Beta Alpha Psi,’ the final line under the heading ‘Memberships,’” Goggans said as he pointed to Zane’s vita—students nominated for the Upchurch Medal were asked to submit a vita to the Undergraduate Awards Committee.
“John, I can assure you Zane Corbin is not and has never been a member of Beta Alpha Psi.”
“How could this happen?” Goggans asked.
“Well, it isn’t too difficult to figure out what happened, at least for me. The kid was obviously trying to increase his chances of winning the Upchurch Medal.”
Goggans, the former chairman of the Finance Department, was mildly offended by Herrick’s condescending tone.
“By the way, I made several phone calls this afternoon,” Herrick continued. “Everything else appears to check out on Zane’s vita.”
“So, we are only dealing with this one minor item?”
“One minor item?” Herrick mimicked Goggans’ matter-of-fact tone. “To me, it’s not minor. In the accounting profession, we have a code of ethics that has as its core something known as integrity.”
“Ann, I can assure you that the accounting profession doesn’t have a patent on ethics or morality within the business world,” Goggans snapped.
“Are you suggesting we just ignore this?” Herrick responded in kind.
Goggans took off his reading glasses and tossed them on his cluttered desktop. He was upset with himself for allowing his emotions to get the better of him. After taking a deep breath, he responded calmly. “No. I am not … suggesting that at all. I probably used the term minor because it’s the final item on his vita and the shortest entry.”
“Well, what are we going to do about it?” Unlike Goggans, Herrick had not yet regained control of her emotions.
“I suggest that we first cool off. And then … we can talk our way through this.”
Goggans’ conciliatory tone had a soothing effect on Herrick as she visibly relaxed.
“Ann, it has been four weeks since my committee met and made the decisions on the student awards, including the Upchurch Medal. I will do my best to recall exactly how we settled on Zane as the winner of that award. Is that a reasonable starting point?”
“Yes,” Herrick replied cordially and then added, “I believe there are two issues here. The first is whether his reported Beta Alpha Psi membership influenced your committee’s decision. The second is addressing the issue of his dishonesty.”
“I agree. Totally.” Goggans leaned back in his chair and stared at the ceiling of his office for several moments. “Let’s see. Ten of the twelve students who were nominated for the Upchurch Medal submitted a vita for my committee to consider. I gave everyone on the committee a copy of those vitas and asked that they review them before we met as a group. Then, during our meeting, I think we … uh … we … uh … decided first to pare down the nominees to a set of five finalists.” Goggans scratched his forehead as he struggled to recall the Upchurch Medal deliberations. “Yes, I remember now. That’s exactly what we did. And then, we discussed each of the five finalists before we voted.”
“Seems like a reasonable process,” Herrick interjected.
“Each member of the committee voted for their first, second, and third choice. After that first round of voting, we wound up with a tie between Zane Corbin and a young lady by the name of …” Goggans scratched his forehead again as he struggled to recall the given student’s name. “Oh yes, her name is Alisha Buchanan. She is a marketing major.”
Goggans hesitated as he realized what he was about to tell Herrick would make her even more convinced Zane Corbin’s apparent dishonesty was a serious matter. “So, we narrowed our choice down to those two students. The six of us voted again, and we wound up with a three to three tie. To break the tie, as chairman, I excused myself and asked the five committee members to vote one final time. In fact, I had voted for Alisha. Anyway, the final vote was three to two in Zane’s favor.” Goggans wearily shook his head. “So, in looking back, it is possible that one line item on Zane’s vita, namely, the bogus Beta Alpha Psi membership, may have swayed the committee’s decision.”
“Hmm … I see.” Herrick resisted the temptation to verbally congratulate herself for exposing what now appeared to be a potential scandal for the Hopkins College of Business. “In my opinion, we should meet with Marilyn to discuss this matter and decide how to proceed.” Associate Dean Marilyn McGrew chaired the Academic Misconduct Council of the Hopkins College of Business.
Goggans nodded his head in agreement as he resisted the urge to make some sarcastic remark to his thoroughly self-righteous colleague. “Well, we only have two weeks left in the semester, including finals week, which means we have to move rapidly on this. I will call Marilyn’s secretary and try to arrange a meeting with her before she leaves today. Will you be available later this afternoon?”
“Sure. Just text me when you have the meeting set up.”
“Ann,” Goggans said as Herrick got up to leave his office. “Do you know Zane Corbin? Have you had him in class or interacted with him in any way?” Goggans suspected that Herrick was waging a personal vendetta against Zane, given the zeal with which she was pursuing the matter at hand.
“No. When I saw him earlier today, he looked familiar. But I have never had him in any of my courses and certainly never met him.” After Herrick stepped to the door of Goggans’ office, she turned back toward him. “Why do you ask?”
“Oh, I was just wondering,” Goggans replied nervously. Given the tone of Herrick’s voice, there was no doubt in Goggans’ mind that she realized what had prompted his question.
5:05 P.M., Friday, April 30
“Is there no other possible explanation for this? Could it just be some type of misunderstanding?” Dean McGrew asked John Goggans and Ann Herrick as she stared at the copy of Zane Corbin’s vita that Goggans had given her. McGrew had agreed to meet with the two faculty members at 5 p.m. on Friday afternoon, but for no more than ten minutes because she had travel plans that evening.
“Marilyn, I don’t know how you could characterize it as a misunderstanding,” Herrick responded emphatically. “We send an email to potential Beta Alpha Psi members at the beginning of each fall semester. Attached to that email is a list of the requirements for becoming a member, including classification as a junior and a 3.0 GPA. Pledges also have to attend the pledge class orientation meeting, five professional meetings, and participate in one community service event. Students who satisfy those requirements and pay their dues are initiated into Beta Alpha Psi during the final meeting of the spring semester.”
“Well, this is troubling, but let’s remember,” McGrew said as she purposefully fixed her gaze on Ann Herrick, “Zane is innocent until proven guilty.” Herrick didn’t flinch as the two women briefly stared at each other. “After I return on Sunday evening, I will notify him by email that he is going to be charged with academic misconduct. Since we have very little time to deal with this matter, I will arrange a meeting early next week with him. I would like each of you to attend that meeting. If he will admit to the misconduct allegation, we may be able to resolve this matter quickly.”
“And if he doesn’t?” Herrick asked.
“In that case, I will be forced to arrange a hearing. As mandated by our bylaws, I will randomly select two faculty members and three students from the Academic Misconduct Council.
Then the matter, including the potential sanctions to impose on Zane, will be in the hands of those five individuals.” As an afterthought, McGrew added, “Of course, the panel would not have the authority to rescind the Upchurch Medal. If necessary, John, you and I can deal with that issue at the appropriate time.”
3:00 P.M., Tuesday, May 4
The ad hoc meeting involving Zane Corbin, Professor John Goggans, Professor Ann Herrick, and Associate Dean Marilyn McGrew was held on Tuesday afternoon, four days after Zane had been announced as the winner of the Upchurch Medal. After introducing everyone present and providing a brief summary of the purpose of the meeting, McGrew invited Zane to comment on the matter at hand.
“Dean McGrew, this was just an honest mistake. I can’t understand why you are making such a big deal of this.”
“Quite frankly, Zane, this doesn’t have the trappings of an honest mistake. It appears to be an intentional effort on your part to embellish your vita to improve your chances of winning the Upchurch Medal.” McGrew paused momentarily before adding, “And the $1,000 check accompanying the award.”
“Wait a minute, wait a minute. I attended the orientation session for pledges during the fall semester of my junior year, I went to two career fairs each of the past two years, and, most importantly, I was on the email distribution list for Beta Alpha Psi the past two years. In fact, before every meeting, I received an email from the chapter notifying me of the time, location, and the speaker. You can see why I thought I was a member because I was on that distribution list. I know it wasn’t right to not attend the regular meetings, but, quite honestly, all I wanted to do was have the Beta Alpha Psi membership on my vita.” Zane, whose face was flushed, stopped to catch his breath and muster sufficient courage to continue. “So, yes, I realized I wasn’t really participating in the organization, but, hey, look at my vita. I had four other organizations that were eating up a lot of my time. In two of those organizations, I held leadership positions. So, I … I … just decided to blow off Beta Alpha Psi after I thought that I had somehow become a member.”
“Ann, do you have—”
Before Dean McGrew could finish her question directed at Ann Herrick, Zane interrupted her. “I mean, you could charge me with being a lousy member of Beta Alpha Psi, but that doesn’t involve dishonesty.”
When it was apparent that Zane was finished, McGrew again addressed Ann Herrick. “Ann, do you have an attendance sheet for the orientation meeting Zane attended?”
“No. We don’t take attendance at the orientation meetings,” Herrick replied.
“What about the career fairs? Do you take attendance at those?”
“No, because we don’t consider them to be official events. All accounting majors are invited to the career fairs.”
“And what about the issue of Zane being on Beta Alpha Psi’s email distribution list the past two years?” McGrew continued quizzing Herrick.
“What we do is develop a roster of everyone who is eligible to apply for membership in Beta Alpha Psi at the beginning of each fall semester. That roster becomes the email distribution list for potential pledges,” Herrick explained. “I did check that roster and Zane’s name was on it the past two years. So, he is correct in that regard. He would have been notified in advance of every Beta Alpha Psi meeting since he became a junior.”
“See, like I said, I just assumed for the past two years I was a member because I received those regular emails.” The stress in Zane’s voice was becoming more elevated with each passing minute.
“But you received an email at the beginning of each fall semester that explained in detail the requirements for membership in Beta Alpha Psi.” Herrick’s accusatory tone made Zane even more stressed. “And if you attended the orientation meeting as a junior, you sat through a PowerPoint presentation that listed those requirements as well.”
When Zane failed to reply, McGrew prompted him. “Well, Zane. How do you respond to what Professor Herrick just said?”
Zane lowered his head and stared at the floor for several moments. “I don’t know. I mean, I guess I’m one of those students who doesn’t pay a lot of attention to administrative details.” Zane finally raised his head and made eye contact with McGrew. “I’m sure I received the emails Professor Herrick referred to, and I know I sat through the orientation session during the fall semester of my junior year. But I probably didn’t read … I mean, I’m sure I didn’t read the full text of the emails or pay attention during the orientation meeting. Given how busy I was over the past two years, I often took homework to work on during those types of meetings.”
Professor Goggans finally spoke for the first time. “Zane, you said a few moments ago that you ‘decided to blow off Beta Alpha Psi after I thought that I had somehow become a member.’ To me, that statement suggests you may have believed you were a member of Beta Alpha Psi but that you had been granted membership in the organization by mistake. Is that the case? Did you believe you had been admitted to Beta Alpha Psi by mistake?”
Zane’s face betrayed that he was rattled by Goggans’ questions. He coughed and twice cleared his throat, ostensibly to give himself additional time to respond. After an extended silence, he meekly replied, “No.”
Dean McGrew and the two professors glanced at each other after Zane’s less than convincing response. McGrew then addressed Zane. “At this point, my only option is to move forward with filing an allegation of academic dishonesty against you. If you will send me your schedule for the next two weeks, I will try to find a time slot for a hearing before a panel of the Academic Misconduct Council that will be least disruptive for you.”
2:30 P.M., Thursday, May 13
On Thursday afternoon of finals week, Zane Corbin appeared before the five-person academic misconduct panel. In addition to Zane, the panel heard from Professor Herrick and Professor Goggans. The panel spent 45 minutes listening to the testimony of those three individuals and questioning them. The panel then dissected and debated the case for more than one hour. Multiple votes were taken during that time, each ending with two votes in favor of finding Zane guilty of misconduct, two votes in favor of acquitting him, and one abstention. After the final vote, the chairperson dismissed the panel. He then called Dean McGrew and informed her that the five members had been hopelessly deadlocked. As a result of the panel’s failure to reach a decision, McGrew dismissed the academic misconduct charge filed against Zane Corbin.
Because the semester was effectively over, McGrew decided it was not feasible to ask the Undergraduate Awards Committee to reconsider its decision to award the Upchurch Medal to Zane Corbin. Instead, she called John Goggans to discuss that issue. After a brief conversation, McGrew unilaterally decided no further action would be taken in the case, meaning that Zane would retain the Upchurch Medal and the accompanying $1,000 stipend. McGrew told Goggans she would personally inform Ann Herrick of her decision, which she did—two weeks later.
Case 4.8. Dell Inc.
Accuracy and completeness are the touchstones of public company disclosures under the federal securities laws.Robert Khuzami, Director, SEC Division of Enforcement
Like most high school graduates, Michael Dell had a sense of anticipation, if not exhilaration, when he left home to begin his college career. Because Dell planned to become a doctor, like his father, he declared premed as his major when he enrolled in the University of Texas (UT) in the fall of 1983. Over the next few months, Dell’s interest in college waned as he began spending most of his time and energy on a hobby that he had pursued in high school, namely, tinkering with computers. By the end of his first semester at UT, Dell’s dorm room had become a workshop in which he and a few friends tore apart, reconfigured, and then reassembled personal computers (PCs).
In the spring of 1984, Dell decided to go into business for himself. By the end of the spring semester, Dell’s small business was producing more than $10,000 in revenues each month from the sale of PCs and PC-related products. The success of his business convinced him to drop out of college and create Dell Computer Corporation. Less than a decade later, Michael Dell, at age 27, became the youngest chief executive officer (CEO) of a Fortune 500 company. Dell’s company, which had been renamed Dell Inc., surpassed Compaq in 2001 as the world’s largest manufacturer of PCs. By 2012, Dell’s personal worth was estimated at nearly $15 billion, which placed him 22nd on the Forbes 400 list of the wealthiest Americans.
The critical feature of Dell Inc.’s business model that allowed it to grow so rapidly was the “Dell Direct” strategy of selling custom-designed PCs. The company’s sales force took purchase orders over the phone or the Internet and then transmitted those orders to a production facility that assembled the PCs and shipped them in a matter of days. Unlike competitors, Dell spent only modest amounts on research and development. Instead, Dell focused its operations on delivering state-of-the-art computer technology developed by other companies at the lowest cost possible by emphasizing operating efficiencies throughout its supply chain.
Increasing competition that caused profit margins to narrow dramatically on PC sales began undermining Dell’s business model during the late 1990s. In 2002, Dell faced the unhappy prospect of reporting disappointing earnings to its investors. At that point, Intel Corporation, which provided the microprocessors for Dell’s PCs, stepped into the breach and offered Dell “exclusivity payments” that would wipe out its earnings shortfall. Intel made these payments in exchange for a commitment from Dell that it would not purchase microprocessors from other suppliers, including Intel’s principal competitor, Advanced Micro Devices, Inc. (AMD). Because AMD was developing microprocessors that were reportedly superior to those of Intel, Intel’s management had become increasingly concerned that Dell would choose AMD as its primary supplier of microprocessors.
Over the next several years, Dell executives often asked Intel for additional exclusivity payments when it appeared that their company would fall short of its consensus Wall Street earnings forecast for a given quarter. According to the Securities and Exchange Commission (SEC), Dell management was “quite open with Intel”
about the reason it was requesting those payments. Officials of Intel and Dell used the tongue-in-cheek acronym MOAP (mother of all programs) to refer to their mutually beneficial arrangement that resulted in Intel paying Dell more than $4 billion between fiscal 2002 and fiscal 2007.
The exclusivity payments from Intel allowed Dell to meet or surpass its consensus earnings forecasts for 20 consecutive quarterly reporting periods. For fiscal 2003, Intel’s exclusivity payments accounted for 10 percent of Dell’s reported operating earnings. That figure rose to 38 percent for fiscal 2006 and to 76 percent for the first quarter of fiscal 2007. Dell’s impressive earnings trend produced sizable stock market gains for the company’s executives. During the time frame that Intel was making exclusivity payments to Dell, Michael Dell earned more than $450 million in compensation, most of which came in the form of gains on stock options granted to him by the company’s board.
In the company’s 2005 annual report, for example, Michael Dell boasted of the company’s “best-ever operating results” and alluded to the company’s superior business model: “Dell’s exceptional performance again demonstrated the … superb execution of a better way of doing business. … Our business is a model for customer focus, growth, and profitability.”
When Dell announced that it would purchase microprocessors from Intel and AMD beginning in the second quarter of 2007, Intel slashed the exclusivity payments, which caused Dell’s earnings to drop sharply. Instead of disclosing the true cause of the earnings decline, Dell attributed the decline to evolving competitive issues within its industry. Over the next two years, Dell’s stock price drifted downward. An SEC investigation eventually revealed the exclusivity payments made by Intel to Dell and the undisclosed impact those payments had on the company’s reported earnings from 2002 through early 2007.
The SEC investigation also revealed that Dell had used so-called cookie jar reserves to “smooth” its earnings from 2002 through 2005. Company officials intentionally overstated period-ending reserves for expenses such as warranty-related costs on the products it sold and then “withdrew” those reserves to “cover shortfalls in operating results” for subsequent periods.
Dell ultimately issued restated financial statements to properly reflect its operating results for the periods that had been affected by the improper accounting for the Intel exclusivity payments and period-ending reserves.
In July 2010, the SEC revealed that it had charged Dell and several of its top executives, including Michael Dell, with routinely misleading the investing public by issuing misleading financial statements.
Dell manipulated its accounting over an extended period to project financial results that the company wished it had achieved, but could not. Dell was only able to meet Wall Street targets consistently during this period by breaking the rules.
Revelations of Dell’s brazen earnings management schemes angered a wide range of parties and made many critics question how pervasive such schemes are among large public companies. One business professor suggested that their root cause is the pressure on public companies to consistently report impressive quarterly earnings.
The Dell case illustrates the perverse short-term view prevalent on Wall Street that dictates that growth must occur continuously, smoothly, and linearly every quarter. … Too often, the maniacal focus on creating ever-increasing quarterly earnings drives bad corporate behavior, as it apparently did at Dell. That behavior produces non-authentic earnings that obscure what is really happening in a business. Short-termism can result in a range of corporate and financial games that may enrich management at the expense of market integrity and efficient investor capital allocation.
A group of Dell Inc.’s stockholders filed a class-action lawsuit against Michael Dell, other Dell executives, Intel Corporation, and Dell’s audit firm PricewaterhouseCoopers (PwC), which had served as Dell’s auditor since 1986. The stockholders alleged that the defendants were responsible for the large stock market losses they had suffered as a result of Dell’s earnings management schemes.
The class-action lawsuit charged PwC with turning a “blind eye” to Dell’s “improper accounting” and with violating “fundamental” auditing standards.
These alleged violations included failing to maintain a proper attitude of independence during the Dell audits, failing to properly plan those audits, and failing to issue the appropriate audit opinions on Dell’s periodic financial statements. A federal judge eventually dismissed the lawsuit after ruling that the plaintiffs’ allegations against the defendants were “too vague.”
In February 2013, Michael Dell announced that he and a group of investors planned to purchase the outstanding shares of Dell Inc. and take the company private. Industry analysts and business journalists speculated that the move was being made to allow Michael Dell and his fellow Dell executives to escape the intense scrutiny and regulatory oversight faced by the management teams of public companies. Six months later, in August 2013, billionaire investor and Dell stockholder Carl Icahn filed a lawsuit to thwart Michael Dell’s effort to take the company private. Icahn insisted that the per-share buyout price being offered to Dell’s stockholders by Michael Dell was too low. One month later, however, a majority of Dell’s stockholders approved that buyout price, meaning that Michael Dell’s plan to take the company private had succeeded.
Questions
1. The Fraud Triangle Across Cases
Using Donald Cressey’s Fraud Triangle, identify how Pressure, Opportunity, and Rationalization contributed to fraudulent behavior in two different cases from the list. Compare how these factors influenced each fraud differently.
2. Internal Control Weaknesses & Failures
Internal control failures played a significant role in enabling fraud in many of these cases. Identify at least two cases where internal control weaknesses allowed fraud to occur. What specific internal control measures could have prevented the fraud?
3. Auditor Responsibilities & Professional Skepticism
In cases like First Keystone and Dell, Inc., auditors had a duty to detect and prevent financial misstatements. Discuss how auditors failed in these cases and what audit procedures should have been used to uncover the fraud.
4. The Role of Whistleblowers & Ethical Dilemmas
Some fraud cases involve whistleblowers who report financial misconduct, while in other cases, employees remain silent. Choose one case from the list where a whistleblower played a role or should have come forward. How do whistleblower protections like the Sarbanes-Oxley Act (SOX) Section 806 help prevent fraud?
5. Financial Statement Manipulation & Red Flags
Both Dell, Inc. and Avon Products were accused of manipulating financial statements. How did each company misrepresent its financials, and what were some red flags that auditors or investors should have noticed?
6. Fraud in Different Industries: Financial vs. Corporate Fraud
Compare a corporate fraud case (e.g., Dell, Avon Products) with a financial fraud case (e.g., First Keystone). How do fraud risks differ between traditional corporate fraud and banking/financial institution fraud?
7. Impact of Fraud on Stakeholders & Investors
Fraud does not only affect company executives—it impacts employees, investors, and customers. Choose two cases from the list and explain how fraud negatively affected key stakeholders. What were the long-term consequences for each compa