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Case 10-10 An Offer You Can’t Refuse Fast Eddie, a publicly held company, manufactures and installs refrigeration systems for governmental and commercial applications. Fast Eddie is being investigated by a governmental agency for overpricing on government sales during the period from 2003 through 2005 as well as allegations of misrepresentations by one of Fast Eddie’s former officers, Sweet Lou. The criminal and civil investigations began in late 2005. In the prior fiscal year, the company’s auditors, CPAs-R-Us, obtained management’s representation and a letter from Fast Eddie’s independent legal counsel that indicated that the ultimate outcome of the investigation could not be determined and that any potential payment for the alleged breaches would not have a material effect on the financial statements. Accordingly, no accrual was recorded in the financial statements, and CPAsR-Us issued a standard unqualified opinion on Fast Eddie’s 2006 financial statements. Fast Eddie’s fiscal year-end is March 31. The government commenced its investigation into the allegations in late 2005 by obtaining a subpoena for all of Fast Eddie’s corporate records (both hard copy documents and computer files) related to government sales during the period in question. In 2006, the government provided Sweet Lou with a report detailing the allegations of defective pricing. At that time, Sweet Lou alerted the other officers at Fast Eddie of the manner in which he had prepared the documents in question. Fast Eddie immediately began an internal investigation to ascertain whether proper procedures had been followed when completing the governmental sales forms. Fast Eddie also retained an expert legal counsel in the field of procurement law in an attempt to determine whether the company had any legal exposure as a result of Sweet Lou’s actions. Fast Eddie determined that the sales forms had been completed incorrectly; however, the government was not overcharged for any equipment or services. As a result of its findings, Fast Eddie dismissed Sweet Lou after 18 years of service with the company. Since then, all of Fast Eddie’s officers and employees have fully cooperated with the federal investigators by providing testimony of their knowledge and involvement in the transactions. As of March 31, 2007 (current-year period), the government had not filed any charges or specified a monetary penalty against Fast Eddie for these matters. In April 2007, Fast Eddie documented in a letter an offer to settle the government’s investigation of the company for the sum of $3.7 million. This letter was delivered to government officials in April 2007, before CPAs-R-Us completed its procedures and issued the audit report for the year ended March 31, 2007. Management contends that this offer was made solely to accelerate the process and serve as grounds for a future claim against the government to recover attorneys’ fees. In addition, management contends that it believed this offer would be rejected on the basis of previous discussions with government officials.

Copyright 2008 Deloitte Foundation All Rights Reserved.

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Management has demonstrated that the $3.7 million used in the settlement offer represents 100 percent of the pretax profits earned by Fast Eddie on government sales during the period from 2003 through 2005, plus an additional amount that is intended to represent a payment for penalties. Fast Eddie believes that if the investigation ultimately goes to trial, the government will not win entitlement to any monetary recovery. Fast Eddie’s defense includes the company’s inability to provide accurate pricing data because of the confusing nature of the forms and the technical requirements related to the standard contract price reductions clause. In addition, Eddie contends that since none of the equipment was defective and the prices charged were within the range of those charged by other government contractors for similar equipment, the government has not been harmed by this event. In fact, Fast Eddie has indicated that if anyone is guilty in this situation, it is Sweet Lou because he acted on his own in completing the forms without the company’s approval. Fast Eddie believes the first paragraph of the settlement offer adequately supports the company’s contention that this offer in no way obligates the company to the government and, therefore, the offer does not indicate that a liability should be accrued. The first paragraph states: Fast Eddie has offered a one-time payment of $3.7 million as a final settlement of the investigation in process by your department. If this amount is accepted by the government, it must represent a complete exoneration of all charges against Fast Eddie. The following letter summarizes the company’s understanding of our meeting in April 2007. At that time, you represented that the offer of settlement could not be accepted. Although we understand that the government does not generally accept offers to settle before finalizing its investigation, we believe it would be in everyone’s best interest to put this matter behind us. We believe that if this case goes to federal court, the company will be able to establish that it has no legal liability for this matter. However, CPAs-R-Us is concerned that the last paragraph of the settlement offer may indicate that the company fully intended the offer to represent an amount Fast Eddie was willing to pay to resolve the investigation. The last paragraph states: In conclusion, Fast Eddie believes the government has nothing further to gain by continuing to pursue the investigation, and in fact, will probably lose if the case goes to federal court. Accordingly, we believe you should give considerable thought to the final settlement offer that the company has submitted in the amount of $3.7 million. Further investigation by the government unfairly punishes the company, its employees, and its shareholders. We believe every effort should be made to bring this matter to an immediate conclusion. As demonstrated in this letter, the size of the offer that has been made by the company is more than adequate given the circumstances involved and acceptance of it is clearly in the best interest of all parties.

Copyright 2008 Deloitte Foundation All Rights Reserved.

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Additional information Fast Eddie believes it has always provided the government with a quality product at competitive prices. In fact, Fast Eddie has obtained a price list from its two primary competitors and determined that the prices it charges the government are actually less than those of its competitors. During the depositions taken from the government’s contracting officer that dealt with Sweet Lou, the officer indicated that he had no reason to believe the prices charged by the company were not fair and reasonable. In addition, Fast Eddie contends that there is no indication that the refrigeration products that it sold to the government were defective and it has never charged the government for products it did not deliver. Sweet Lou, acting in his role of vice president for the company, was solely responsible for completing and certifying the documents presented to the government. These documents were in Sweet Lou’s own handwriting and were not reviewed or approved by any other Fast Eddie officer.

Required: • Is Fast Eddie required to accrue a liability as of March 31, 2007, financial statements related to the ongoing government investigation? If so, how much? •

If Fast Eddie withdraws the settlement offer before it is accepted by the government and before the issuance of Fast Eddie’s financial statements, would that change your answer to the above question?

Copyright 2008 Deloitte Foundation All Rights Reserved.

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SUPPLEMENTAL INFORMATION MANAGEMENT GROUP Objectives • • You should be prepared to convince the auditors that the offer was only made as part of a negotiating strategy to force the government to expedite the process and reach a resolution in the matter. You should determine whether the settlement offer is a recognized or nonrecognized event under ASC 855 (FAS 165, Subsequent Events) and what amount, if any, you would be willing to record in your year-end financial statements. You should determine what combination of accruals (if any), disclosures, and auditor’s opinions are acceptable for a public company and your shareholders. You are aware that GAAP could require an accrual if an amount is determined to be reasonably estimable. However, you might consider whether there is any latitude in determining the low end of the range of acceptable values under the applicable literature. If the settlement offer actually represents the amount that will be paid for future legal costs to fight the investigation, consider whether there is an argument that the amount should not be accrued because it does not represent a liability yet.





Additional Information Fast Eddie believes Sweet Lou was aware that, after 18 years of service with the company, his position was in jeopardy. This may have motivated Sweet Lou to make improper or unlawful decisions on his own. Sweet Lou contends that the forms were completed as he had been instructed. However, he has stated that a government official said no one ever reviews the forms so it did not matter how they were completed. Management contends that the company offered to settle because the government appears to have put its investigation on hold and in the interim, the company, its employees, and its shareholders are all suffering from the uncertainty of the ultimate outcome. In submitting the offer, the company believes the government will recognize that the case against Fast Eddie is not very strong and that litigation may result in an unpredictable outcome. Therefore, you believe the government will be inclined to try to either settle the matter, or more likely, let the case simply fade away without further investigation or publicity. You have obtained a letter from the company’s outside legal counsel that indicates that the contract attorney is of the opinion that if the case goes to litigation the likelihood of an unfavorable outcome is remote. In meetings with management, your attorneys have said that a settlement could probably be reached immediately for between $4 and $6

Copyright 2008 Deloitte Foundation All Rights Reserved.

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million. However, they have also suggested that if the case goes to court and the company loses, the ultimate award could be as high as $80 million. Although Fast Eddie has had a respectable year, if the entire $3.7 million is accrued, the company will suffer a $500,000 loss for the year and that will violate certain covenants on its $15 million subordinated debt agreement. You have more information than the auditors. You must decide how much of the information you need to share with them.

Copyright 2008 Deloitte Foundation All Rights Reserved.

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SUPPLEMENTAL INFORMATION AUDITOR GROUP Objectives • • • • • • • As the auditor, you must complete whatever steps you consider necessary to audit this transaction. Assume that all information given to you by management thus far is verifiable. References to auditing literature (including textbooks that discuss audits of liabilities) might be helpful. Since management will most likely argue that the accounting is governed by its intent, you should be prepared to support your position according to the authoritative literature that governs the accounting in these circumstances. You should consider how practice has developed related to settlement offers, both in terms of an accrual and the potential modification to the auditor’s report. You should determine whether the settlement offer is a recognized or nonrecognized event under ASC 855 (FAS 165, Subsequent Events) and the loss recognition and disclosure that will be necessary under GAAP. You should consider whether management’s willingness to revoke the offer has any impact on the accounting or auditor’s report. You should evaluate how the auditor’s report will need to be modified, if at all, depending on the accounting treatment that you determine is appropriate and on management’s willingness to implement it.

Additional Information The management group may have more information on certain aspects of the transaction. If you need more information, you will have to ask them for it. You have asked a member of your Government Contracting Group, GI Jane, to review (1) the documents in question, (2) the legal opinion obtained from Fast Eddie’s legal counsel (see attached legal letter), and (3) Fast Eddie’s settlement offer. GI Jane also had discussions with Fast Eddie’s contract attorney and others within your firm that are knowledgeable in matters such as procurement law. Relative to Fast Eddie’s legal defenses, GI Jane noted that the company has responded to the initial request for proposal by signing various documents and then continued to sell goods to the government after receiving a detailed letter from the government in 2005. GI Jane indicated that this type of investigation is a very high-profile issue within the government and that, on the basis of her past experience, she believes Fast Eddie will ultimately have to pay some amount. She also believes that the settlement amount was significant enough that the government will seriously evaluate the offer; however, should the government prevail in the allegations, the penalty could be substantially higher than the amount offered.

Copyright 2008 Deloitte Foundation All Rights Reserved.

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Management has indicated its willingness to prepare and sign a management’s representation letter that says whatever is needed for you to accept the argument that the company’s only intent in sending the settlement offer was to “jump-start” the process. The calculated materiality for your current-year audit engagement is $600,000. You do not know of any other errors.

Copyright 2008 Deloitte Foundation All Rights Reserved.

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