Case study: Cubbies Cable
Ernie Binks is a big baseball fan, so it is quite natural for him, at a time like this, to recall a phrase attributed to "Yogi Berra": It was déjà vu all over again.
Binks is the partner in charge of the Cubbies Cable audit for the accounting firm of Santos & Williams LLP. Cubbies is a family-owned regional cable company headquartered in Chicago. Binks is involved in a second dispute in three years with client management. The first dispute concerned the disclosure of a contingent liability on a class-action lawsuit against Cubbies for age discrimination in hiring. Cubbies did not disclose the possibility of loss even though all signs pointed to a verdict against the company. Cubbies argued there was nothing to confirm the CPA firm's position in that regard and the company would only disclose it if they lost the lawsuit.
The current dispute involves the capitalization of cable construction costs that the client wants to expense. Binks reviewed a memorandum in the workpapers prepared by John Kessinger, the audit manager. The document summarizes the facts on the second dispute. This memo is presented in Exhibit 1.
Cubbies recently completed a major cable installation project at a condominium complex across the street from Wrigley Field in Chicago. The revenue earned from that job enabled the company to complete the third quarter of 2010 with record earnings. Revenues at September 30, 2010 exceeded revenues at September 30, 2009 by 22 percent. Net income for the nine months ended September 30, 2010, was 24 percent above the same amount in the prior year.
Binks is now preparing for a meeting with Rod Hondley, the advisory partner on the Cubbies Cable audit. Hondley has already made it known that he supports the client's position. Binks knows Santos & Williams operates by the simple philosophy that: You have to let the client win one somewhere along the line or you may lose that client.
Binks contemplates his options - either to go along with the client's position (the option supported by Hondley) or to maintain his own position. It is at this point that he thinks about another "Yogi-ism"; "when you come to a fork in the road, take it."
EXHIBIT 1
Memo on Capitalization of Cable Equipment
November 30, 2006
1. Cubbies Cable is a locally owned cable television company that services the neighborhoods in Chicago that surround Wrigley Field, the home of the Chicago Cubs. Cubbies Cable was incorporated as a closely held company in 2004. We have audited the company's financial statements since September 30, 2005. The audited statements are used by Chicago First National Bank in granting short-term loans to Cubbies Cable. In particular, the company has a debt covenant agreement with the bank that obligates Cubbies to maintain a specified level of liquidity as indicated by the working capital and "quick" ratios.
2. During the twelve month period ending March 30, 2007 Cubbies constructed a new cable system in parts of Chicago that enabled it to increase its presence in that market. The revenue from the system through September 30, 2007, exceeded projections by more than 20%. The sharp increase over expected revenue was the cause of the conflict with the client.
3. A difference of opinion arose over the proper accounting for cable construction costs. The client wanted to expense all of the costs in the year ended quarter ended September 30, 2007. We suspect that the client wanted to decrease net income for the year. Two different types of costs were involved:
a. Cable television plant: Costs associated with constructing the cable television plant and providing cable service include head-end costs, cable, and drop costs. The client wanted to expense all of these costs. However, Statement of Financial Accounting Standards No. 51, "Financial Reporting by Cable Television Companies," requires that cable television plant costs incurred during the prematurity periods be capitalized in full. We had protracted discussions with Cubbies Cable regarding this issue, and we were told there was no way the company would agree to capitalize any of the costs. Given that Cubbies was not publicly-owned, our only recourse is to take the matter to the board of directors. Another concern is that nine of the eleven members of the board are family members of the CEO or past officers of Cubbies Cable. We expect this situation to work against us in convincing the client that its proposed accounting procedure is not in accordance with generally accepted accounting principles.
b. Interest cost: The client initially expensed all costs during the prematurity period. We convinced the client to change its accounting to capitalize costs during the construction period. We used for support our reference to SFAS No. 51. This Statement requires application of SFAS No. 34, "Capitalization of Interest Cost," to interest costs incurred during the construction of an asset. The application of paragraphs 13 and 14 of SFAS No. 34 to the client's situation requires that interest costs incurred during the prematurity period be capitalized in full by applying the interest capitalization rate to the average amount of accumulated expenditures for the asset during the period. The purpose of this procedure is to capitalize the amount of interest costs incurred during the prematurity period that theoretically could have been avoided if expenditures for construction of the cable television plant had not been made.
QUESTIONS
1. What do you think was the motivation for Cubbies Cable in taking the position to expense all cable costs during the nine months ended September 20, 2010? Would you characterize the position asan attempt to manage earnings? Why or why not?
2. Who are the stakeholders in this situation? Identify the major ethical issues that should be of concern to Binks in deciding whether to just go along with the firm in its support of the client, or to take some other action. What would you do at this point if you were in Binks's position? Why?
3. Would you question the company's integrity in this situation given that Cubbies did agree with the firm on the issue of capitalizing interest during the prematurity period? In other words, should CPAs be prepared to "horse trade" when dealing with a client about the proper GAAP to apply in a particular situation?