Toomer Energy Drink Project

ISSUES IN ACCOUNTING EDUCATION American Accounting Association Vol. 33, No. 1 DOI: 10.2308/iace-51870 February 2018 pp. 29–43

Toomer’s Energy Drinks: Fueling Earnings Management?

James H. Long Auburn University

Lasse Mertins Johns Hopkins University

DeWayne L. Searcy Cowin Equipment Company, Inc.

Brian Vansant Auburn University

ABSTRACT: Companies around the world commonly engage in earnings management. Some earnings management techniques comply with U.S. GAAP and do not violate financial reporting standards (e.g., real

earnings management techniques such as postponing research and development expenditures), other techniques

clearly cross the line (e.g., misclassifying repair and maintenance expenses as capital expenditures), and some fall

into a gray area (e.g., adjusting the allowance for bad debt). This case exposes students to an ethical dilemma that

involves earnings management: toward the end of its fiscal year, the executive management team at Toomer’s

Energy Drinks’ European division realize that they will fall just short of a short-term financial performance target, and

consider ways in which they can manage earnings to generate sufficient performance to meet the target. The case

exposes students to ways in which companies manage earnings, and encourages students to think critically about

the extent to which these techniques are ethical by requiring them to apply the IMA’s Statement of Ethical

Professional Practice and the AICPA’s Code of Professional Conduct to a realistic scenario.

Keywords: earnings management; ethics; ethical dilemma.

THE CASE: PART 1

T oomer’s Energy Drinks (TED) is a publicly traded company, founded by Joe and Payton Parker in 1994. The company

is headquartered in Baltimore, MD, and produces three different energy drink flavors that are popular both domestically

and internationally. The primary customer group is young adults between 18 and 29. The majority of the company’s

sales are in the Americas and Europe, and they have manufacturing and distribution facilities in Baltimore, MD, Los Angeles,

CA, Mexico City, Mexico, Sao Paulo, Brazil, and Frankfurt, Germany.

Matt Cameron is a Certified Management Accountant (CMA) and a member of the Institute of Management Accountants

(IMA). He has been with the company for 10 years, working his way up from an entry-level managerial accounting position in

Baltimore to his current position as the Production Manager at the Frankfurt manufacturing facility. One of Matt’s primary

responsibilities is to schedule European production to meet demand for the company’s drinks. European demand is cyclical,

with approximately 35 percent of the company’s sales occurring in the summer, 25 percent in the spring, 25 percent in the fall,

and 15 percent in the winter. The company’s general philosophy is to pursue a just-in-time inventory production approach;

however, in order to have enough lead time to produce and distribute the product in advance of heavy-demand periods,

production generally ramps up in March. To reduce excess inventory during low-demand periods, production generally slows

We thank Valaria P. Vendrzyk (editor), an anonymous associate editor, two anonymous referees, and participants at the 2016 AAA Management Accounting Midyear Meeting for providing helpful comments on this manuscript.

Supplemental material can be accessed by clicking the link in Appendix A.

Editor’s note: Accepted by Valaria P. Vendrzyk.

Submitted: February 2016 Accepted: June 2017

Published Online: July 2017

29

in October. 1

The company’s beverages do have a reasonably long shelf-life, so this production slowdown is intended to reduce

the company’s warehousing costs, rather than to protect against inventory obsolescence.

TED uses a standard costing system to assign costs to its products. 2

Each product is assigned standard fixed and variable

costs (see Exhibit 1). When production is completed, these costs are transferred into the Finished Goods inventory account.

When the inventory is sold, the company records Sales Revenue (which boosts Operating Income) and Cost of Goods Sold

(which reduces Operating Income). The company’s operations also generate period costs (costs that are not involved in the

production process, such as advertising costs, administrative salaries, and repair and maintenance costs for non-production

machinery). These costs are expensed as they are incurred, reducing Operating Income.

Stefanie Weiss is a Certified Public Accountant (CPA), and a member of the American Institute of Certified Public

Accountants (AICPA). She has been with the company for 14 years, working her way up from an entry-level financial

accounting position in Frankfurt to her current position as the European Finance Director. Stefanie is responsible for the

European subsidiary’s financial reporting, which is recorded and reported to the parent company in euros (€). Although the

Frankfurt production facility is located in Germany (a country that has adopted International Financial Reporting Standards), it

reports financial results according to U.S. Generally Accepted Accounting Principles (GAAP), consistent with the rest of the

company, which is headquartered in the United States and traded on a U.S. stock exchange. The European subsidiary’s

financial statements are then translated into U.S. dollars ($) (TED’s functional currency) and consolidated with and reported in

the parent company’s financial statements. TED’s fiscal year runs from January 1–December 31 (the calendar year).

Stefanie and Matt work closely with one another, and are good friends at work and outside of the office. They are highly

motivated to perform well in order to impress their bosses at corporate headquarters and to maximize their annual bonuses,

EXHIBIT 1 Fiscal Year 2016 Standard Cost Calculations

A full-size version of Exhibit 1 is available for download, please see Appendix A.

1 In Germany, labor laws are very strict and it is very difficult to hire and lay off workers periodically. However, seasonal-oriented companies often hire temporary workers during their busy season, and these employees are not permanently employed by the companies. Therefore, the direct labor costs vary throughout the year based on production volume.

2 For a review of general standard costing concepts, students may refer to: http://www.accountingcoach.com/costing/explanation/1

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which are tied to the European subsidiary’s GAAP-based operating income. Both are generally recognized as excellent

managers. Matt is hopeful that if the subsidiary has another good year, then he will be in line for a promotion to Plant Manager

of the Baltimore production facility, which will result in a big raise and allow him to be closer to his family. Stefanie believes

that she has a great chance to be promoted to Finance Director for the company’s global operations, if the European subsidiary

continues to produce strong financial performance. Ultimately, her goal is to become TED’s Chief Financial Officer (CFO).

In late October 2016, Matt and Stefanie attended a high-level, end-of-year planning meeting of the European executive

management team, which included Vice-President for European Operations Lena Neumann, Sales Director Phillip Mueller, and

Procurement Director Shelley Stanley. Stefanie was asked to open the meeting by presenting the company’s financial

information (see Exhibits 2 and 3).

After Stefanie concluded her presentation, and the executives had time to review this information, Lena Neumann opened

the discussion:

Lena: Thank you all for coming today. As you know, we have had an excellent year thus far. Sales are up across the board, and we are on pace to easily exceed our baseline financial performance target. In fact, we’ve done so well that

we are close to hitting our stretch goal of €10 million in operating income. In addition to demonstrating our ability to

the corporate office, achieving this target would double our year-end bonuses. I am sure I don’t have to sell you all on

the benefits of that. Today, I’d like to get some ideas on ways to ensure that happens. First, Stefanie will walk us

through how much incremental financial performance we need to hit our stretch goal.

Stefanie: Thank you, Lena. As you can see on our ‘‘Adjusted Fiscal Year 2016 Budgeted Income Statement,’’ we should easily hit our baseline performance goal of €7.5 million in operating income. However, our current projections

suggest that we may fall just short of our stretch goal unless we cleverly manage the business during the last two

months of the year. We need to find a way to generate approximately €500,000 in additional operating income above

and beyond our current projections for November and December. Let’s spend a few minutes to brainstorm ways we

can make that happen, starting with sales. Phillip?

Phillip: Well, as Lena noted, we have had a banner sales year. I attribute much of our success to the hard work of my sales team. In addition, our ‘‘Eye of the Tiger’’ incentive promotion for our customers has been extremely effective.

The ‘‘Adjusted Fiscal Year 2016 Budgeted Income Statement’’ numbers include the revenue and promotion costs

associated with this program. As you can see, we are beating our baseline goal by more than €2,000,000. At this point

in the year, I am not sure what we can do on the sales side to improve our financial performance. We are well into our

slow-sales months, and there just doesn’t seem to be much excess demand for our products. There are probably some

aggressive sales campaigns we could initiate, but I will need to confer with my team to determine what is feasible.

Lena: OK. Shelley, what are you seeing on the procurement side?

Shelley: Commodity prices for the primary ingredients in our beverages are holding steady. We are currently forecasting favorable changes in packaging materials costs beginning next year, based primarily on the discounts we

now qualify for as a result of our increased volume. We are a little concerned about increasing distribution costs,

particularly costs associated with additional warehousing requirements, but our just-in-time approach to inventory

management should mitigate these issues. Based on these factors, I think procurement is in good shape with respect to

its contribution to the subsidiary’s performance. However, I don’t think that there is a lot of room for us to boost our

financial performance further this year. Maybe Matt has some ideas as to how production can help us meet our stretch

goal?

Matt: That’s a really good question. As of today, the production schedule for the rest of the year aligns with the detailed income report (Exhibit 3). Our actual product costs closely match our standard product costs, so I do not

anticipate any large favorable or unfavorable variances. Nothing immediately comes to mind.

Lena: I have a few ideas, but I need some time to think them through before I commit myself. I’d also like you all to

do some brainstorming to try to come up with some ideas to help us achieve the performance required to double our

bonuses. Just remember, we are under a bit of time pressure given how rapidly the end of the year is approaching.

Could we get back together and discuss how we want to proceed by Friday?

All: Definitely.

Lena: Great! We will discuss everyone’s ideas on Friday. Alright, next, we need to discuss some issues we’ve been

having with the new TPS reports . . .

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Issues in Accounting Education Volume 33, Number 1, 2018

EXHIBIT 2 Fiscal Year 2016 Budgeted Income Statement and Baseline Bonus Calculation

Panel A: Revenue, Beginning Finished Goods Inventory, and Cost of Goods Manufactured

(continued on next page)

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Issues in Accounting Education Volume 33, Number 1, 2018

EXHIBIT 2 (continued) Panel B: Ending Finished Goods Inventory, Cost of Goods Sold, Gross Profit, SG&A, and Operating Income

A full-size version of Exhibit 2 is available for download, please see Appendix A.

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Issues in Accounting Education Volume 33, Number 1, 2018

MODULE 1

Requirement 1-1: What ideas do you think the management team might suggest to generate additional operating income in

the months of November and December? Specifically, think about business actions they could take, or financial

reporting choices they could make, to generate additional operating income. 3

Consider management’s likely actions

and choices under three different scenarios:

(a) Management always behaves ethically, and would never take actions or make financial reporting choices that

violate U.S. GAAP.

(b) Management is willing to bend (but not break) U.S. GAAP. Actions that bend (but do not break) U.S. GAAP ‘‘are

often viewed as aggressive if the tactics push the envelope and stretch the flexibility of GAAP beyond its intended

limits . . . [however] without objective evidence, it’s difficult to distinguish between legitimate choices made within GAAP and earnings management’’ (Ortega and Grant 2003, 52).

(c) Management is willing to act unethically, and would consider violating U.S. GAAP.

EXHIBIT 3 Adjusted Fiscal Year 2016 Budgeted Income Statement

October 31, 2016

Panel A: Revenue, Beginning Finished Goods Inventory, and Cost of Goods Manufactured

(continued on next page)

3 Operating income is broadly defined as earnings before interest and taxes; that is, Revenue � Operating Expenses � Depreciation and Amortization.

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Issues in Accounting Education Volume 33, Number 1, 2018

Requirement 1-2: Of the actions and methods you identified in Requirement 1-1, which idea(s) would you recommend

that TED-Europe implement? Justify your response. Are any of the actions you identified unethical? If so, why do you

believe that they are unethical?

THE CASE: PART 2

Lena called the management team together to discuss ideas to increase projected Operating Income by €500,000 by year

end. The team offered a number of their ideas for consideration. 4

These ideas involve ‘‘earnings management,’’ which refers to managerial ‘‘actions . . . which serve to increase (decrease) current reported earnings of the unit for which the manager is responsible without generating a corresponding increase

(decrease) in the long-term economic profitability of the unit’’ (Fischer and Rosenzweig 1995, 434). ‘‘Earnings management

occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either

mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes

that depend on reported accounting practices’’ (Healy and Wahlen 1999, 368). Earnings management frequently occurs in

practice: a recent survey found that 78 percent of executives indicated that they have managed earnings to some degree

(Graham, Harvey, and Rajgopal 2005).

Earnings management can involve either real (operating) earnings management or accrual (accounting) earnings

management. Roychowdhury (2006, 337) defines real earnings management as ‘‘departures from normal operations practices,

EXHIBIT 3 (continued)

Panel B: Cost of Goods Sold, Gross Profit, SG&A, and Operating Income

A full-size version of Exhibit 3 is available for download, please see Appendix A.

4 TED Management’s ideas to increase operating income are included in the Teaching Notes to prevent students from accessing them to answer Requirement 1-1.

Toomer’s Energy Drinks: Fueling Earnings Management? 35

Issues in Accounting Education Volume 33, Number 1, 2018

motivated by managers’ desire to mislead at least some stakeholders into believing certain financial reporting goals have been

met in the normal course of operations.’’ In other words, real earnings management involves decisions that affect the company’s actual operations in the current period and that increase or decrease current reported earnings that may be counterproductive to

sustained long-term profitability. Accrual earnings management, in contrast, does not involve any changes to real operational

activities, but instead is accomplished by applying accounting rules and methods in a biased manner to achieve a desired level

of earnings (Merchant and Rockness 1994; Merchant 1989). Accrual earnings management can also be thought of as a

purposeful intervention by management in the external reporting process in order for management to gain privately at the

expense of shareholders (Schipper 1989).

MODULE 25

Requirement 2-1: In your own words, describe ‘‘earnings management’’ and the difference between ‘‘real’’ and ‘‘accrual’’ earnings management. If earnings management benefits management through increased bonuses, then does it harm

any other stakeholders? If so, how?

Requirement 2-2: For each idea the management team proposed to increase earnings, identify whether it is a real earnings

management technique or an accrual earnings management technique.

Requirement 2-3: Which idea(s) do you believe comply with U.S. GAAP?

Requirement 2-4: Describe how action taken for each idea will result in an increase to U.S. GAAP operating income in the current period.

Requirement 2-5: Discuss the impact of each idea on TED’s future operational and financial performance (i.e., in the next fiscal year and beyond).

Requirement 2-6: Evaluate each idea using the following scale: 6

1 ¼ Ethical practice. 2 ¼ Questionable practice. I would not say anything to management, but it makes me uncomfortable. 3 ¼ Minor infraction. Management should not engage in the practice again if the idea is implemented. 4 ¼ Serious infraction. Management should be severely punished if the idea is implemented. 5 ¼ Totally unethical. Management should be fired if the idea is implemented.

Requirement 2-7: Instead of the current 2016 results, assume that TED-Europe’s financial performance far exceeded

management’s stretch goal. In this case, would it be ethical to utilize earnings management techniques to reduce

operating income (e.g., reschedule the routine maintenance on non-production machinery that is traditionally

performed in January to December of the current year)? Explain. What impact would this type of earnings

management have on future financial performance? Why might management be incentivized to engage in income-

decreasing earnings management?

Requirement 2-8: Should management’s bonuses drive their business decision-making? Their financial reporting choices?

MODULE 3

Requirement 3-1: Matt Cameron is a Certified Management Accountant (CMA) and a member of the Institute of

Management Accountants (IMA). As such, he is subject to the IMA Statement of Ethical Professional Practice: https://www.imanet.org/career-resources/ethics-center?ssopc¼1/. Does this statement raise any concerns with respect to earnings management? Justify your response.

Requirement 3-2: Assume that Matt determined that managing earnings was unethical, but the rest of the management

team was determined to engage in these activities. Refer to the IMA Statement of Ethical Professional Practice. How should Matt attempt to resolve this ethical conflict?

MODULE 4

Requirement 4-1: Stefanie Weiss is a Certified Public Accountant (CPA) and a member of the American Institute of

Certified Public Accountants (AICPA). As such, she is subject to the AICPA Code of Professional Conduct (hereafter, the Code): https://www.aicpa.org/research/standards/codeofconduct.html. Does the Code raise any concerns with

respect to earnings management? Justify your response.

Requirement 4-2: How does the Code suggest that the company address these concerns (threats)?

5 Instructors who want their students to complete Requirements 2-2 through 2-6 should provide them with Exhibit 1 that is included in the Teaching Notes.

6 Adapted from Harvard Business Review (1989).

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Requirement 4-3: Assume that Stefanie determined that managing earnings was unethical, but the rest of the management

team was determined to engage in these activities. Refer to the AICPA Code of Professional Conduct. How should Stefanie attempt to resolve this ethical conflict?

Requirement 4-4: Assume that Lena tells Stefanie that she (Lena) will take responsibility for the decision to manage

earnings, and that Stefanie should not worry about it. Does the Code address this scenario? Does this absolve Stefanie

of responsibility for the decision?

MODULE 5

Requirement 5-1: The impact on operating income of many of the strategies generated above is straight-forward. For

example, if Lena decides to reduce R&D expense, then each €1 reduction in R&D expense will result in a €1 increase

in operating income. However, the impact of other strategies is more complicated. Using the ‘‘TN2-Requirement 5’’ tab in the Excel file provided by the case instructor,

7 determine the following:

(a) What percentage increase in sales (November/December) would be required to exceed the €10 million operating income threshold (assuming that standard unit costs stay constant)?

(b) What percentage increase in production (November/December) would be required to exceed the €10 million operating income threshold (assuming that standard unit costs stay constant)?

(c) What bad debt expense percentage would be required to exceed the €10 million operating income threshold?

(d) Assume that Lena believes that anything more than a 6 percent sales increase is unrealistic, and that the auditors

will only allow a decrease in the bad debt percentage to 2.25 percent. Given those parameters, and assuming the

management team pursues these strategies, how much does Matt need to increase production to exceed the €10

million operating income threshold?

REFERENCES

Fischer, M., and K. Rosenzweig. 1995. Attitudes of students and accounting practitioners concerning the ethical acceptability of earnings

management. Journal of Business Ethics 14 (6): 433–444. doi:10.1007/BF00872085 Graham, J. R., C. R. Harvey, and S. Rajgopal. 2005. The economic implications of corporate financial reporting. Journal of Accounting

and Economics 40 (1-3): 3–73. doi:10.1016/j.jacceco.2005.01.002 Harvard Business Review. 1989. Ethics test for everyday managers. (March-April): 220–221. Healy, P. M., and J. M. Wahlen. 1999. A review of the earnings management literature and its implications for standard setting.

Accounting Horizons 13 (4): 365–383. doi:10.2308/acch.1999.13.4.365 Merchant, K. A. 1989. Rewarding Results: Motivating Profit Center Managers. Boston, MA: Harvard Business School Press. Merchant, K. A., and J. Rockness. 1994. The ethics of managing earnings: An empirical investigation. Journal of Accounting and Public

Policy 13 (1): 79–94. doi:10.1016/0278-4254(94)90013-2 Ortega, W. R., and G. R. Grant. 2003. Maynard Manufacturing: An analysis of GAAP-based and operational earnings management

techniques. Strategic Finance 85: 50–56. Roychowdhury, S. 2006. Earnings management through real activities manipulation. Journal of Accounting and Economics 42 (3): 335–

370. doi:10.1016/j.jacceco.2006.01.002

Schipper, K. 1989. Commentary on earnings management. Accounting Horizons 3 (4): 91–102.

APPENDIX A

Toomer’s Energy Drinks_Exhibits 1-3: http://dx.doi.org/10.2308/iace-51870.s01

7 Instructors will find the link to the downloadable Excel file in Appendix A of the Teaching Notes.

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