Accounting for Managers Case 2.docx

Brown-Torrington and Emmett, Orr & Peterson One Giant Down…the other to fall?

Introduction

“I don’t think you understand. This could be the end of us,” said Noel Jameson, senior   partner of Emmett, Orr  !eterson ""!, ""!, to the president, #andy $ays. $ays responded, “Not necessarily Noel. %e can reco&er.” In early $arch '((), Emmett, Orr  !eterson ""! *EO!+, a leadin -.. auditin firm /as under 0uestion for not steppin in to pre&ent the accountin malpractice that had led led to the bankr bankrupt uptcy cy of 1ro/n 1ro/n2T 2To orrint rrinton, on, a 3ortu 3ortune ne 4(( pharm pharmace aceuti utica call company. The e&ents leadin up to the collapse of 1ro/n2Torrinton shocked the in&estment community as /ell as reulators /ho had heralded 1ro/n2Torrinton as a /ell2respected and ethical leader in the pharmaceutical industry. The do/nfall /as inited /hen 1ro/n2Torrinton manaement /as found to ha&e accounted for special  purpose enterprises *!Es+ off the balance sheet. These !Es had a hih le&el of  debt, /hich /as not fully transparent to 1ro/n2Torrinton’s shareholders. 5fter a series series of top manaem manaement ent fled fled from 1ro/n2To 1ro/n2Torrin rrinton ton,, it became became ob&ious ob&ious that somethin somethin had ran amok. %ithin %ithin /eeks, 1ro/n2Torri 1ro/n2Torrinton’ nton’ss share price plummeted lea&in shareholders and pensioners /ith /orthless stock and the company /ith a mountain ofdebt. %hen %hen the the acco accoun unti tin n issu issues es at 1ro/ 1ro/n2 n2T Torrin rrint ton on aros arose, e, the the spot spot lih lihtt /as /as th imme immedia diatel tely y turned turned on the the accou accounti ntin n firm firm EO! EO!. On Janua January ry '4 , '(() '((),, EO! EO! manaement manaement admitted to shreddin important documents that contained details about 1ro/n2Torrinton’s 1ro/n2Torrinton’s suspicious off2the2balance sheet transactions. EO! /as no/ on The precipice of disaster. %as it their responsibility for /hat had happened at 1ro/n2 Torrinton6 7ould they ha&e pre&ented the malpractice6 %hat should be done to maintain their client base6

Pharmaceutical Pharmaceutical Industr

The pharmaceutical industry /as one of the larest industries in the /orld /ith estim estimate ated d loba loball sales sales of 89( 89(( ( billi billion on -: -: per year. year. %hile %hile the indus industry try had e;perienced stron ro/th throuhout the <==(s, the rate of increase had slo/ed to about fi&e per cent per year in '((9. E&en thouh there /as tremendous opportunity /ith an ain population in North 5merica, %estern Europe and Japan *the /orld’s three larest markets+, many pharmaceutical companies /ere strulin to allocate rese resear arch ch and and de&e de&elo lopm pmen entt doll dollar arss and and de&e de&elo lop p the the ne;t ne;t “blo “block ckbu bust ster er”” dru dru.. >o&ernments, >o&ernments, health insurance companies and consumers had all put do/n/ard price  pressure on ne/ drus bein b ein released into the th e marketplace.

The proce The process ss of intro introduc ducin in ne/ ne/ drus drus /as /as an e;hau e;hausti sti&e &e proce process ss som someti etime mess e;ceedin ten years and costin up to 89(( million -: per dru. In order to de&elop ne/ drus, pharmaceuticals allocated up to <4 per cent of their sales in research and de&elopment. 5lthouh this allocation /as considerable, pharmaceutical companies /ere not necessarily uaranteed that their de&eloped drus /ould hit the marketplace. This process /as fre0uently referred to as the “pipeline” /hich had three ma?or   phases@ pre2clinical, clinical testin and the dru appro&al and reistration. The pre2 clinical phase took appro;imately four years and before mo&in into the clinical testin phase, pharmaceuticals took out a '(2year, non2rene/able patent. This meant that pharmaceutical companies had to be mindful of the time in the precedin t/o staes. The second stae of clinical testin in&ol&ed a series of tests on humans. The  phase typically lasted fi&e to si; years. 3inally, if the dru had made it throuh the other t/o staes, it /as ready for appro&al and reistration. The o&ernin body for   pharmaceuticals in the -.. /as the 3ood and :ru 5dministration *3:5+, /ho re0uired that companies demonstrate the superiority of their product o&er e;istin drus. The appro&al process took appro;imately
Ethical considerations in the Pharmaceutical Industr

The pharmaceutical pharmaceutical industry /as hea&ily reulated reulated by the o&ernment. o&ernment. >o&ernments le&i le&ied ed reu reula lati tion onss on the the test testin in, , cont conten ent, t, pric pricin in  and and rela relati tion onsh ship ipss that that  pharmaceuticals had /ith the rest of the health care industry. 5 number of ma?or  ethical debates e;isted /ithin the bioscience industry. The first in&ol&ed scientific and test testin in  issu issues es such such as ene eneti tica call lly y mo modi dify fyin in  food foodst stuf uffs fs,, test testin in  on anim animal als, s,  prematurely releasin a dru by skippin testin phases and the treatment of human embryos and the human enome. The second The second centr central al issue issue in&ol& in&ol&ed ed the actual actual bus busin iness ess practi practice cess of compan companies ies  participatin in the bioscience or pharmaceutical pha rmaceutical industry. e&eral scandals had come co me to liht in recent years such as insider tradin at Im7lone, misleadin business statements by 1io pure, chares of fraudulent acti&ity at 5straBeneca and $erck2 $edco and the 0uestionable marketin practices of Cfen2phen’, a diet dru produced  by %yeth25y %yeth25yerst. erst.

5n on2oin debate in the industry /as the e;tent to /hich physician incenti&es should be pro&ided by pharmaceutical companies. 5 study conducted in '((' by the Daiser 3amily 3oundation disco&ered that < per cent of doctors recei&ed free meals, tra&el and entrance to e&ents in e;chane for prescribin ne/ drus to their patients. The industry had also been prone to pharmaceutical companies offerin kickbacks to doctors for usin their drus. In response to risin pressure, the !harmaceutical #esearch and $anufacturers of 5merica *!h#$5+ put forth a &oluntary 7ode on Interactions /ith Fealthcare !rofessionals that stipulated appropriate e;penses for the  purpose of marketin to physicians.

!istor of Brown-Torrington

1ro/n !harma /as founded in <=' by Joseph #aymond 1ro/n. 1ro/n /as a leadin academic and scientific researcher from North/estern -ni&ersity. Fe /as one of the first pharmaceutical academics to form his o/n company and build a stand2 alone research staff. 1y the econd %orld %ar, the -.. o&ernment became more in&ol&ed in dru research. 1ro/n /as credited as forin positi&e relationships /ith the -.. o&ernment, de&elopin an anti2malarial dru in the <=)(s and bein on the ) forefront of commercially &iable penicillin in the <=4(s. 1ro/n’s undyin dedication to/ards pharmaceutical de&elopment /as the cornerstone of his oraniGation. Fe had instilled stron academic principles, /hile pushin his company’s scientists to/ards drus that /ould be profitable. %hen he died in <=H), 1ro/n had left behind a hihly successful scientific2dri&en enterprise. -nder ne/ manaement the company flourished throuhout the late <=H(s and <=A(s, until it /as in&estiated in <=A by the -.. o&ernment for its pricin practices. The company had priced a number of ne/ drus by claimin incorrect cateories that allo/ed for hiher prices. Industry obser&ers felt that 1ro/n !harma had made a ra&e error, /hich /ould cost them their company. Fo/e&er, the company paid out compensation, decreased its prices and reduced its o&erhead by cuttin back on its o&ersiGed sales department. 1y the late <=A(s, the company had returned to  profitability throuh the release of a “blockbuster” dru. 1y <==), its problem /as 0uite different  it had plenty of cash but it had no other blockbuster drus in the  pipeline. It tareted Torrinton tills for a takeo&er. Torrinton tills had been founded by a roup of pharmaceutical and aricultural scientists in <=H. The company /as 0uite different to 1ro/n !harma in that it had fostered roup acti&ities in its de&elopment, marketin and sales approaches. The company had become kno/n as an alternati&e to the larer corporate pharmaceuticals. 1y the early <==(s ho/e&er, some industry obser&ers felt that the company /as part of the mainstream. 5lthouh it /as credited in reconiGin ne/ trends in dru de&elopment and ha&in a stron research arm, the company had se&eral problems /ith late releases. 5nalysts 0uestioned Torrinton tills’ ability to compete in the industry, since industry players /ere constantly cuttin out time in the de&elopment

 process to brin ne/ drus to the market. 1y <==), Torrinton tills /as hihly le&eraed and could not meet its loan payment re0uirements, makin it ripe for a takeo&er. In No&ember <==), 1ro/n !harma purchased Torrinton tills and 1ro/n2 Torrinton /as the ne/ name i&en to the mered entity. The challene of the merer  /as to interate 1ro/n !harma’s e;pertise in marketin, sales and production, /hile utiliGin the roup de&elopment process at Torrinton tills. The interation process /as lon and ta;in. One senior manaer from 1ro/n !harma /ho participated on the interation team commented, “Just because they’re a bunch of lon2lost hippy scientists, does not mean that e&erythin can be effecti&ely done in a roup. There’s no accountability. They don’t seem to understand the dynamics in ettin a product’s cost do/n and ettin it out into the market.” 5 member from the Torrinton tills team recalled the interation process, “the 1ro/n !harma side /as &ery demandin and a little too 0uick. 7ontrary to popular belief, /e’re &ery a/are of the importance of ettin products out 0uickly. Fo/e&er, that should not come at the cost of  de&elopin a 0uality dru. It may cost 8< million per day for e&ery day, but that’s a lot  better than se&eral million if the dru pro&es to be harmful” 1ro/n2Torrinton had o&ercome its interation challenes and by <==H, it /as considered to be one of the fastest ro/in companies in the pharmaceutical industry. The company posted superb financial results from <==A throuh to '((', ro/in at a compound annual ro/th rate of '< per cent at a time /hen industry ro/th had slo/ed to fi&e per cent. In early '((<, an analyst report stated@ “%e feel that 1ro/n2 Torrinton is /ell positioned. They ha&e some reat blockbusters and ha&e sorted out their pipeline problem that plaued them a fe/ years ao. The company has manaed to inno&ate and build production capabilities to take ad&antae of makin eneric drus. %e belie&e that they /ill continue to outperform their earnins per share *E!+ estimates.” In '((', the company had posted record re&enues of 8
5uditin rose to prominence in the <=9(s as companies looked to independent firms to e&aluate their public financial statements on an ob?ecti&e basis. The role of auditin firms /as to pro&ide technical e;pertise and ob?ecti&ity in interpretin enerally

accepted accountin principles *>55!+. 5ccountin /as not deemed to be an e;act science. >55! pro&ided a frame/ork for companies to prepare their financial statements and for auditin firms to ensure that the financial statements /ere reliable. E;hibit < sho/s a list of >55! definitions. The reach of auditors /ork /as /ide as  banks, creditors and in&estors all made decisions based on a particular company’s financial statements. This ob?ecti&ity and coherence to a set of principles /as  particularly important to instill confidence in the eneral in&estin public /ho chose to buy and sell shares on security markets. In fact, the ro/th of the /orld/ide stock  markets /as often credited to auditin, /hich had /orked to allay the fears of the in&estin public by pro&idin an ob?ecti&e &ie/ of financial performance. The ecurities E;chane 7ommission *E7+ /as the o&ernin body in the -nited tates responsible for the public tradin of securities. E7 re0uired that any company enaed in public tradin of stocks, bonds or any type of security, submit a set of  audited financial statements on an annual basis. E7’s primary mission /as to “protect in&estors and maintain the interity of the securities markets.” E7 held the  belief that, “all in&estors, /hether lare institutions or pri&ate indi&iduals, should ha&e access to certain basic facts about an in&estment prior to buyin it.” 5s part of this concept, E7 disclosed all public documents on their /ebsite *///.sec.o&+ for  e&ery publicly traded company. Each year, E7 brouht bet/een )(( to 4(( ci&il enforcement actions aainst infractions like insider tradin, accountin fraud and the release of misleadin and false information. $a?or auditin firms had e;panded into stratey consultin and information technoloy consultin in the late <=H(s and early <=A(s in order to de&elop alternati&e re&enue streams. 5uditin /as becomin increasinly competiti&e, and as such, auditin firms started lo/erin prices to compete. 3or many firms, consultin  became more lucrati&e and attracti&e since each situation re0uired a custom solution, allo/in the consultants more fle;ibility in bill2out rates. Emmett, Orr & Peterson (EOP) LLP >odfrey Emmett, a Far&ard professor and one of his students #ichard Orr, a Far&ard $15, founded Emmett  Orr as an auditin firm in <='H. Emmett and Orr sa/ reat opportunity /ith the bureonin -.. stock market and belie&ed that corporations could benefit from an ob?ecti&e third party opinion. In the early days, clients /ere surprised at ho/ Emmett and Orr, t/o men /ith an ae difference of '( years had manaed to e0ually operate the firm. In a public speech at Far&ard, Emmett commented on his youner partner, “#ichard KOrrL and I are e0uals. %e both make decisions. %hile the circumstances of our initial ac0uaintance /as throuh the teacher2student dynamic, /e ha&e become business partners.” In another speech, Orr  talked about Emmett, “ome people find it strane that /e could both be in chare of  makin decisions. !eople, ha&e often take me aside, tu on my coat and say, Cno really, the bi uy makes the final call, riht6’ 3or me, it’s been an ideal partnershipM I brin hustle to the oraniGation and >odfrey brins calm.” 1oth Emmett and Orr emphasiGed the importance of strict confidence /ith their  clients. 5t the same time, they ne&er strayed from their role of i&in an ob?ecti&e

third party opinion. They recruited youn, aressi&e and briht auditors and imparted a doctrine of “be respectful, sho/ interity and be direct.” They souht indi&iduals /ho had technical acumen and people /ho could interpret financial information for manaement decision2makin. Orr had been 0uoted as sayin, “/e train our auditors to see the forest beyond the trees. If they need to count the number  of rins of a hundred year maple tree, fine, but they need to be able to then rise abo&e and tell the client /hy that’s important.” Emmett and Orr /ere e;tremely successful at buildin their oraniGation and by the <=(s had become one of the -nited tates’ pre2eminent accountin firms. In <=H, Emmett passed a/ay and the reins /ere turned o&er to Orr. Orr promoted a youn risin manaer named Joshua !eterson throuh the ranks and !eterson e&entually  became a senior partner in the late <=H(s. !eterson con&inced Orr to consider mo&in hea&ily into manaement and information technoloy consultin. !eterson recalled in an inter&ie/ years later, “I sa/ that /e /ere in there /ith top manaement of ma?or  multinationals. %e /ere already talkin about confidential and future strateic decisions. I felt that /e could do a lot more than &erify the numbers.” !eterson’s stratey /orked  by the mid2<=A(s, Emmett, Orr and !eterson had captured o&er <(( ma?or contracts accountin for o&er 8< billion in consultin re&enues. %hen Orr retired at ae A( in <=A', !eterson ran the company until <==H. !eterson /as ackno/leded for promotin the oriinal founders &ision of bein direct and maintainin “one face” to its customers, /hether the acti&ities /ere in consultin or auditin. 1y the time !eterson retired, EO! /as postin re&enues of 8 billion, /ith o&er half comin from consultin enaements. The presidential title /as handed to Timothy 1ayliss, /ho had a &ision of spinnin off the consultin arm from the oriinal auditin firm. In <===, 1ayliss formed Emmet, Orr, !eterson and 1ayliss 7onsultin and maintained the EO! name for the accountin acti&ities. The split /as lon and arduous and insiders had di&ided into one of the t/o camps. 5nimosity re/ /ithin the ranks and a once seamless “one face” oraniGation had split into t/o disparate companies /ith distinct corporate cultures. The consultin arm /as seen as aressi&e and cutthroat /hereas the accountin side had retained its conser&atism.

#elationshi$ %etween Brown-Torrington and EOP

The relationship bet/een the t/o enterprises dated back to both founders. Joseph 1ro/n and >odfrey Emmett /ere contemporaries@ both /ere born in the same month in
1y the end of '((', EO! had identified 1ro/n2Torrinton as a Cma;imum2risk’ client due to their potential e;posure to hih debt. One internal memo from audit team lead, 5le?andra einra to EO!’s president #andy $ays in early '((' read@ “%e’&e been studyin the !Es of 1ro/n2Torrinton for sometime no/. The documentation is liht in some areas and it looks as thouh they ha&e o&er  8<.< billion due in the ne;t three years. 1ut, all of their profits ha&e been  booked to 1ro/n2Torrinton on the net present &alues of drus that are still in the pipeline. I personally feel that this is not a ood idea. They’re e;posed and

I think /e need to con&ince them to sho/ some of this e;posure on their corporate balance sheet, instead of ha&in it hidden from public &ie/.”

"ccounting Practices at Brown-Torrington

In <===, 1ro/n2Torrinton had established special purpose enterprises *!Es+, /hich /ere intended to represent the de&elopment of each ne/ “blockbuster” dru in the pipeline. 1ro/n2Torrinton had also created other !Es for other companies’  blockbuster drus, /ith the plans that 1ro/n2Torrinton /ould be in a position to  produce eneric drus once their competitors’ patents e;pired. 1y '((', there /ere appro;imately '( !Es that had been created. 1ro/n2 Torrinton had been mo&in the research and de&elopment e;penses from the parent company to the !Es as assets. 1ro/n2Torrinton had been financin that de&elopment throuh pri&ate debt instruments, /hich became the !Es liability. 1ro/n2Torrinton then calculated the e;pected return in the form of Net !resent = alue of future free cash flo/s from each blockbuster and eneric dru and booked the profits immediately. This practice /as hihly speculati&e as 1ro/n2Torrinton /as not certain /hich drus /ould become blockbusters. 1ookin profits based on future earnins inflated 1ro/n2Torrinton’s yearly profits from <=== throuh to '(('. It /as estimated that the company had booked o&er 89 billion dollars in speculati&e re&enues o&er the past three years. Increased profits led to the company’s increase in share price as more in&estors /ere attracted to 1ro/n2Torrinton’s performance. %hen an EO! team member /orkin at the 1ro/n2Torrinton head office re0uested a bank document pro&in the assets of three !Es in late '((<, a 1ro/n2Torrinton e;ecuti&e submitted three separate letters from the same offshore bank /ith a statement of the !Es holdins. The EO! team member felt that there /as no need to in&estiate further. Fo/e&er, the 1ro/n2Torrinton e;ecuti&e had asked his teenae dauhter to make chanes to one bank letter /ith !hotoshop, alterin the amount of holdins and the !E name. Out of an estimated 8<.' billion in assets, there /as under 8'4 million in actual cash holdins. On the liabilities side, all of the !Es carried substantial debt loads. The total e;ceeded 8<.< billion, /hich /ere  payments due in '(() and '((4. E;hibit ' sho/s 1ro/n Torrinton’s financial statements and E;hibit 9 sho/s a sample of the e;posure of three of the company’s !Es.

Eents leading to the fall of Brown-Torrington

The first correspondence doubtin 1ro/n2Torrinton’s accountin treatment of !Es /as /ithin EO! and /as sent to the senior partner #andy $ays by 5le?andra einra in 3ebruary '(('. 5round the same time, $aurice "e&ine a 1ro/n2Torrinton

finance manaer and former auditor at EO! /rote an email to 5le; ury, 1ro/n2 Torrinton’s 73O, /hich read@  Net present &alue refers to a calculation that estimates the future free cash flo/s of a  particular pro?ect discounted at a rate reflecti&e of market and business risk.

“:ear 5le;, I /ould like to meet /ith you about some of our !Es. I kno/ /e ha&e the manaement re&ie/ comin up and I think it’s prudent to discuss mo&in some of the debt back to the parent company. Is there a plan to transfer more capital to the !Es6 :o /e feel that the income from 7odeH' Ka ne/ blockbuster druL /ill offset this risk6 I look for/ard to speakin /ith you about this. $aurice.” ury responded /ith an email@ “Thanks $aurice. 5aron K%heel/riht, the 7EOL and I are meetin tomorro/ on the !Es and /ill be discussin that &ery topic. I ha&e been keepin a close eye on those !Es to make sure that e&erythin is in check. 5nd, yes, to ans/er your 0uestion 222 7odeH' is oin to be our ne;t CTitanic’ 222 not the sinkin ship of course, but rather the cinematic blockbuster #eards, 5le;.” 5fter si; months in 5uust '((', another finance manaer #a?inder "ata /rote to 1ro/n2Torrinton’s roup of finance manaers statin@ “:oes anyone ha&e the documents based on the asset holdins of the follo/in!Es@ Jenby, >ano and "e/is6 I’&e been scourin this finance department and all I can come up /ith is a lot of debt for those holdinsM” $aurice "e&ine /as the only to respond to the roup email, “Fi #a?inder. I had spoken about this /ith 5le; a fe/ months ao, and he’s lookin after it. #eards, $aurice.” In January '((9, a month after manaement bonuses /ere paid out, 5le; ury, 1ro/n2Torrinton’s 73O resined abruptly. One ne/spaper reported@ “There seems to be no apparent reason for the sudden departure of 1ro/n2 Torrinton’s 73O 5le; ury. ury has put in fifteen successful years at the company. 7EO 5aron %heel/riht /as asked to comment, C5le; has mo&ed on for personal reasons.’ The departure seems out of character for the company. ury /as not a&ailable for comment.” ury’s departure left the finance department froGen. ury had maintained fre0uent informal communication /ith all of his manaers and none of the manaers /ere able to contact him after he left the company. %ithin a month, #a?inder"ata recei&ed an email from 1ro/n2Torrinton’s leal department askin to see some of the !Es assets holdins. This time, she decided to do a thorouh in&estiation talkin /ith e&ery member of the finance department and all of the EO! auditors. 1y $arch '((9, she had found the three bank letters /ith asset holdins that had been i&en to EO! 10

auditors by a finance manaer no loner /ith 1ro/n2Torrinton. he personally  phoned the offshore banks and learned that the assets did not e;ist. This prompted her  to /rite an email to 1ro/n2Torrinton’s 7EO 5aron %heel/riht. Itread@ “:ear 5aron@ I /ould like to meet /ith you about some of our !Es and their  asset holdins. 5lon /ith the help of some EO! auditors, I ha&e found letters, /hichIbelie&etobefored.Theystate/eha&eassetsupto8<.'

10

 billion. Fo/e&er, I ha&e follo/ed up /ith the banks and ha&e learned that those assets do not e;ist. ou may kno/ from ha&in met /ith 5le; before he left that our !Es o/e o&er 8<.< billion in the ne;t t/o years. I’m attachin all of the documents for your re&ie/. #eards,#a?inder.” 5lon /ith $aurice "e&ine and one of 1ro/n2Torrinton’s la/yer John :’5mico, #a?inder"ata met /ith 1ro/n2Torrinton’s 7EO, 5aron %heel/riht in 5pril '((9. "ata recalled the meetin@ “5aron seemed really open to listenin to us. 1ut, here /e /ere tellin him that /e had some ma?or debt to repay, and I couldn’t belie&e ho/ calm he /as. Fe thanked us for brinin it to his attention and said that he /ould look into it. 1ut, the problem is, /e didn’t see any action until much later.” "eal counsel, :’5mico commented, “5aron /as really hard to read that day. I /alked out of the meetin /onderin if he had understood the se&erity of /hat /e /ere all sayin.” 1y the second 0uarter of '((9, 1ro/n2Torrinton had missed all of its sales tarets and /as at risk for deli&erin the ne/ blockbuster 7odeH' dru. The in&estment community responded and 1ro/n2Torrinton’s share price slid from o&er 89( to 8<4.'(. 5n analyst commented, “1ro/n2Torrinton’s sales predictions /ere too hih for the first half of '((9. It’s unlikely they’ll be able to make up the remainder of the year, and if they falter for e&en a moment on the release of 7odeH', then there stock  /ill be se&erely bruised.” In late July '((9, %heel/riht resined from 1ro/n2Torrinton as 7EO. Fe had tried to lea&e raciously by sayin in a public statement, “1ro/n2Torrinton has had some recent short2term blips. 1ut, 7odeH' is on the &ere of happenin, and I lea&e the company in an e;tremely ood position to e;ceed second half and full2year '(() results.” Fo/e&er, a ne/spaper reporter did not belie&e %heel/riht’s partin line. Throuh an odd connection the reporter 0uoted a teenaer /ho said, “yeah, my friend is a /hiG at !hotoshop. I think her dad e&en ot her to chane bank letters for his company once. No one kne/ the difference.” The reporter /ent on to say@ “It turns out the company is actually 1ro/n2Torrinton, the pharmaceutical iant, /ho has recently lost its top t/o senior manaers to suspicious circumstances. %hy6 !erhaps there’s somethin to their sudden departures. %ho’s been playin in !hotoshop6 %hat are they hidin6”

Immediately after readin the ne/spaper, #andy $ays at EO! ordered that all documents pertainin to 1ro/n2Torrinton’s !Es be shred. $ost of the EO! employees had not seen the article, as it took a fe/ /eeks to be spread throuh the  popular press. 1y eptember '((9, the ne/s of %heel/riht and ury’s departure in connection to a potential fraud at 1ro/n2Torrinton /as e&ery/here. 1ro/n2Torrinton’s finance manaers, #a?inder "ata and $aurice"e&inalsoresined. "ata commented in an

Inter&ie/, “/hen both of key manaement resins /ithout /arnin or reason, it certainly does not i&e you a lot of confidence in the company.” "e&ine said, “I kept on thinkin of ury’s reference to the Titan tic. 5nd, I thouht, I’m on a sinkin ship I had to et out.” %hen interroated in eptember '((9, 1ro/n2Torrinton’s former 7EO %heel/riht stated, “"ook, you’&e ot to ask that 0uestion to Emmett, Orr and !eterson. They had  blessed all of our number and all our practices. They /ere /ell a/are /hat /as oin on.” EO!’s president #andy $ays claimed at first that he /as una/are that fored bank  documents e;isted. 1y January '((), he confirmed that he had commissioned EO!’s staff to shred documents relatin to 1ro/n2Torrinton’s !Es. $ays had put one of  his top performers Noel Jameson on the task of “sortin out 1ro/n2Torrinton.” 1ut, by 3ebruary '((), it /as too late. $anaers at both EO! and 1ro/n2Torrinton /ere strulin to sort out the problem and had realiGed that repayin the debt on the !Es /as oin to be impossible. They made the decision to transfer the debt to the  parent company and re&erse some of the profits that they had posted in the last three years. This left them insol&ent and /ith no other choice to file for bankruptcy. 7redit aencies do/nraded the company from triple 5 to 7, the lo/est rade of a company’s debt. The company had completely collapsed, lea&in o&er '9,((( employees, a number of pensioners and in&estors /ith nothin. 7ompetitors bouht the patents and de&elopment of 7odeH' and other products in the pipeline. The  proceeds did not e&en co&er 4 per cent of the secured debt. 5s the ecurities E;chane 7ommission *E7+ mo&ed in to in&estiate the accountin malpractice at 1ro/n2Torrinton, the blame /as mo&in to/ards EO!. %hy had they shred the documents6 %hy didn’t $ays act sooner /hen he recei&ed the email from his audit team lead 5le?andra einra6 %hy didn’t EO! speak up6

'onclusion

In $arch '((), both $ays and Jameson at EO! /ere spendin e&eryday tryin to re2  position their company. ince admittin to the shreddin of documents, they had been chared /ith an obstruction of ?ustice and lost a 0uarter of their client base. 5s both indi&iduals sat in the 1oston office of Emmett, Orr and !eterson, they /ondered /hat could be done to sa&e the company. Jameson said to $ays, “#andy,

/e ha&e a criminal chare aainst for obstruction of ?ustice. Fo/ in the /orld can /e claim to be a responsible accountin firm6” $ays responded@ “"ook, Noel, I stand behind my decision to shred those documents. If they /ere  bein fored by 1ro/n2Torrinton employees, the documents could simply not be trusted. 5nd, I fully intend to pro&e this in a court of la/. %hat I need is for you to et me all the facts and at the same time et on as many planes as you can to  personally &isit our client base. %e cannot afford to lose any more. E(hi%it ) Definitions of G""P The Business Entit 'once$t - The business entity concept pro&ides that the accountin for a business or oraniGation be kept separate from the personal affairs of its o/ner, or from any other business or oraniGation. This means that the o/ner of a business should not place any personal assets on the business  balance sheet. The balance sheet of the business must reflect the financial position of the business alone. 5lso, /hen transactions of the business are recorded, any  personal e;penditures of the o/ner are chared to the o/ner and are not allo/ed to affect the operatin results of the business. 'ontinuing 'oncern 'once$t - The continuin concern concept assumes that a  business /ill continue to operate, unless it is kno/n that such is not the case. The &alues of the assets belonin to a business that is ali&e and /ell are straihtfor/ard. 3or e;ample, a supply of en&elopes /ith the companyPs name  printed on them /ould be &alued at their cost. This /ould not be the case if the company /ere oin out of business. In that case, the en&elopes /ould be difficult to sell because the companyPs name is on them. %hen a company is oin out of business, the &alues of the assets usually suffer because they ha&e to  be sold under unfa&orable circumstances. The &alues of such assets often cannot  be determined until they are actually sold. The Princi$le of 'onser&atism - The principle of conser&atism pro&ides that accountin for a business should be fair and reasonable. 5ccountants are re0uired in their /ork to make e&aluations and estimates, to deli&er opinions, and to select  procedures. They should do so in a /ay that neither o&erstates nor understates the affairs of the business or the results of operation. The O%*ecti&it Princi$le 2 The ob?ecti&ity principle states that accountin /ill  be recorded on the basis of ob?ecti&e e&idence. Ob?ecti&e e&idence means that different people lookin at the e&idence /ill arri&e at the same &alues for the transaction. imply put, this means that accountin entries /ill be based on fact and not on personal opinion or feelins.

The source document for a transaction is almost al/ays the best ob?ecti&e e&idence a&ailable. The source document sho/s the amount areed to by the  buyer and the seller, /ho are usually independent and unrelated to each other. The Time Period 'once$t - The time period concept pro&ides that accountin take place o&er specific time periods kno/n as fiscal periods. These fiscal periods are of e0ual lenth, and are used /hen measurin the financial proress of a  business. The #e&enue #ecognition 'on&ention - The re&enue reconition con&ention  pro&ides that re&enue be taken into the accounts *reconiGed+ at the time the transaction is completed. -sually, this ?ust means recordin re&enue /hen the bill for it is sent to the customer. If it is a cash transaction, the re&enue is recorded /hen the sale is completed and the cash recei&ed.

It is not al/ays 0uite so simple. Think of the buildin of a lare pro?ect such as a dam. It takes a construction company a number of years to complete such a  pro?ect. The company does not /ait until the pro?ect is entirely completed before it sends its bill. !eriodically, it bills for the amount of /ork completed and recei&es payments as the /ork proresses. #e&enue is taken into the accounts on this periodic basis. It is important to take re&enue into the accounts properly. If this is not done, the earnins statements of the company /ill be incorrect and the readers of the financial statement misinformed. The +atching Princi$le - The matchin principle is an e;tension of the re&enue reconition con&ention. The matchin principle sates that each e;pense item related to re&enue earned must be recorded in the same accountin period as the re&enue it helped to earn. If this is not done, the financial statements /ill not measure the results of operations fairly.

The 'ost Princi$le 2 The cost principle states that the accountin for purchases must be at their cost price. This is the fiure that appears on the source document for the transaction in almost all cases. There is no place for uess/ork or /ishful thinkin /hen accountin for purchases.

The &alue recorded in the accounts for an asset is not chaned until later if the market &alue of the asset chanes. It /ould take an entirely ne/ transaction based on ne/ ob?ecti&e e&idence to chane the oriinal &alue of an asset. There are times /hen the abo&e type of ob?ecti&e e&idence is not a&ailable. 3or  e;ample, a buildin could be recei&ed as a ift. In such a case, the transaction /ould be recorded at fair market &alue /hich must be determined by some independent means. The 'onsistenc Princi$le - The consistency principle re0uires accountants to apply the same methods and procedures from period to period. %hen they chane

a method from one period to another they must e;plain the chane clearly on the financial statements. The readers of financial statements ha&e the riht to assume that consistency has been applied if there is no statement to the contrary. The consistency principle pre&ents people from chanin methods for the sole  purpose of manipulatin fiures on the financial statements. The +aterialit Princi$le - The materiality principle re0uires accountants to use enerally accepted accountin principles e;cept /hen to do so /ould be e;pensi&e or difficult, and /here it makes no real difference if the rules are inored. If a rule is temporarily inored, the net income of the company must not  be sinificantly affected, nor should the readerPs ability to ?ude the financial statements be impaired. The ,ull Disclosure Princi$le - The full disclosure principle states that any and all information that affects the full understandin of a companyPs financial statements must be include /ith the financial statements. ome items may not affect the leder accounts directly. These /ould be included in the form of  accompanyin notes. E;amples of such items are outstandin la/suits, ta; disputes, and company takeo&ers.

Exhibit 2 Brown-Torrington’s Financials in millions -: 8

2!!!

2!!"

2!!2

11341.7 5,807.0 5,534.7

14582.0 7,261.8 7,320.2

48.8%

50.2%

18,700.0 8,839.5 9,860.5 52.7%

2!!#

Proit & Loss

Sales COGS Gross Margin Gross Margin % SG&A Depreia!ion & A"or!i#a!ion Opera!ing $ro%i! Operating Margin %

1894.1 340.3 3300.4

 

29.1%

onopera!ion 'no"e onopera!ing ()penses 'no"e *e%ore +a)es 'no"e +a)es e! 'no"e a%!er +a)es Net Income as % of a!es

168.0 178.9 3289.5 954.0 2335.6

 

 

 

234.0 148.9 4576.4 1327.1 3249.2

456.0 247.9 6496.9 1884.1 4612.8 24.7%

22.3%

18.94 2.07 1127.9

23.56 2.84 1145.9

10573.4 12348.1 22921.5

11956.4 14219.8 26176.2

9812.9 6,839.6 2,973.3

 

30.3%

2917.2 654.5 6288.8 33.6%

30.8%

20.6%

S!o- $rie Dil!e/ ($S %ro" e! 'no"e Sares O!s!an/ing

2362.3 466.6 4491.3

 

2217.7 637.8 117.8  

1.2%

23.0 984.2 ,843.4 ,244.6 ,598.8  

"6.1%

32.80 3.64 1267.3

 

4.67 ,0.57 1045.6

Balance $heet

 Asse!s Crren! Asse!s e! i)e/ Asse!s +o!al Asse!s ia*ili!ies Crren! ong!er" De*!

     

12314.9 452.9

 

12876.2 698.3

 

8242.9 14632.1 22875

   

1093.2 5389.2 6482.4

11273.9 1294.78

 

11273.9 2423.3

O!er nonrren! ia*ili!ies +o!al ia*ili !ies Sareol/ers (i! $re%erre/ S!o- (i! Co""on S!o- (i! +o!al ( i! +o!al ia*ili!ies an/ (i!

e! e! e! e!

Opera!ing Cas lo 'nes!ing Cas lo inaning Cas lo Cange in Cas

 

     

12767.8

1345.7 14920.2

10153.7 10153.7 22921.5

345.9 10910.1 11256 26176.2

245.6 8381.82 8627.42 22875

2837.5 ,2149.3 ,1115.8 ,427.6

3784.2 ,3717.2 ,1636.4 ,1569.4

4902 ,2865.4 ,2345 ,308.4

 

1678.9 14247.58

1678.9 15376.1

     

246.6 ,9140.3 ,8893.7 6482.4

,1233.2 ,109 ,4578.4 ,5920.6

Exhibit # $%ecial Pr%ose Enter%rises ($PEs) ' Brown-Torrington in millions -: 8

 (E)* 2!!2

en*

Gano

eis

Total

Proit & Loss

Sales COGS Gross Margin Gross Margin % SG&A Depreia!ion & A"or!i#a!ion Opera!ing $ro%i! Operating Margin % onopera!ing 'no"e &onopera!ing ()penses 'no"e *e%ore +a)es 'no"e +a)es e! 'no"e a%!er +a)es Net Income as % of a!es

109.8 95.7 14.1  

28.9 23.4 5.5 19.0%

19.3 13.9 5.4 28.0%

0.6 0.9 4.0 13.8%

1.5 0.7 3.2 16.5%

479.4 ,475.4 ,137.9 ,337.5 "1168.0%

417.9 ,414.7 ,120.3 ,294.4 "1525.6%

239.1 1.3 240.4

123.9 2.6 126.5

789.2 1.8 791

""+22 +0 ""+0/

290.3

285.3

529.8

""!+.

290.3

285.3

529.8

""!+.

,49.9 ,49.9 240.4

,158.8 ,158.8 126.5

261.2 261.2 791

+2+ +2+ ""+0/

12.8%

5.5 3.3 5.3  

4.8%

123.4 ,118.1 ,34.3 ,83.9  

"76.4%

"+! "##" 2./  

15.8%

01"2 ./.# "2..#"  

7.9%

"!2!0 -"!!# -2/2. -0"+/  

-453.1%

Balance $heet

 Asse!s Crren! Asse!s e! i)e/ Asse!s +o!al Asse!s ia*ili!ies Crren! ia*ili!ies ong, O!er nonrren! ia*ili!ies +o!al ia*ili!ies Sareol/ers (i! $re%erre/ S!o- (i! Co""on S!o- (i! +o!al (i! +o!al ia*ili!ies an/ (i!

!

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