An insurance claim: a dispute over accounting rules.(Instructor's Note)
A grower, an individual, claiming damage to his grape crop, files an insurance claim. The claim is more than a million dollars and asserts that inclement weather forced a late harvest of the crop resulting in a loss. The grower sales the late harvested grapes to a corporation owned 100% by the grower based on an agreement that the corporation will pay the grower the amount of the sales proceeds of the concentrate after all expenses are paid. The corporation converts the grapes into concentrate and then sells the concentrate to an unrelated party. The corporation prepares and provides a worksheet to show that the amount available to be paid to the grower (the net income from the transaction) is clearly less than the insured amount. The worksheet is presented in an income statement like format and is purported to be in conformity with Generally Accepted Accounting Principles (GAAP) by a Certified Public Accountant (CPA) hired by the grower. The insurer disagrees that the worksheet appropriately reports the net income from this transaction and further disagrees with some of the assertions relied on to prepare the worksheet. The dispute goes to arbitration. The arbitration board has the difficult task of determining whether the worksheet appropriately reports the net income from the transaction and, further, whether the worksheet is in conformity with GAAP and whether it includes expenses that are reliable.
This dispute provides a practical example of an attempt to use accounting to justify an insurance claim, as well as an examination of the relevance and reliability of the accounting presented to justify the claim. This case has been used in a forensic accounting course and could also be used in intermediate accounting courses to provide a practical discussion of GAAP rules and auditing courses to provide a practical discussion of GAAP rules and auditing techniques used to analyze financial statement assertions. The case provides examples of cost allocations, related party transactions, adequate documentation and other accounting issues.
Recommendations for Teaching Approaches
Analysis of Expenses by the Forensic Accountant
Some of the expenses listed in the worksheet were analyzed by the forensic accountant hired by the insurance company to illustrate potential concerns with the objectivity principle:
Concentrating fees of $270,000 were paid to a processing plant that was 100 percent owned by the grower. The grower later allocated the fees to the corporation. The grower admitted that fees paid to the owned processing plant to reduce the grapes to juice and then to concentrate were allocated arbitrarily. In fact, the invoices totaled more than $270,000. The difference was explained by the grower to be an amount allocated to a different load of grapes also owned by the grower and processed at the same time.
The depreciation expense could not be supported by a depreciation schedule. There was also no support for the depreciable basis of the assets. The grower had contributed the assets to the corporation in an earlier year. A request for more detail concerning the computation of depreciation and the assets was not complied with.
The lease expense was presented as two separate line items, one "from outsiders" and the other from related parties. However, upon further inspection of the underlying documentation, all leases were with related parties. There were no lease agreements, just corporate resolutions. There was no basis for the lease payments. It appeared to be an arbitrary amount.
The $32,000 property tax was questioned because the corporation owned no real property and apparently very little personal property. The grower would not produce the property tax statements as requested.
The management fees are paid to the grower. There was no contract. The grower asserted that the monthly amount is based on allocated costs for employees' office space, and use of a helicopter but provided no details of how the amount was determined.
When questioned about the profit as an expense, the grower responded, "Any entity would be entitled to make a profit". Unfortunately, not all entities are profitable, especially those that are just beginning operations. When asked whether 20 percent was appropriate, the grower responded it is "going to be essential that it builds up some working capital." However, business entities dealing at arms'-length with their customers can't set profit simply on working capital needs.
The total of the six expenses listed above is $1,679,000.
Alternative Methods to Compute Sales Price
There are other methods besides the grower's worksheet method that can be used to determine whether the sales price of the grapes exceeds that of the insured amount, on a per ton basis. First, the grower expresses this transaction in his personal financial statements as a sale to his controlled corporation in 2004. A Note Receivable in the amount of $3,746,000 is explained in the footnotes, as follows:
"The company sold 23,537 tons of grapes to their solely owned corporation for processing and marketing. This sale was evidenced by a promissory note to be repaid from the proceeds of the sale of concentrate and juice."
The sale for $3,746,000 is the representation of the grower. According to Statements on Standards for Accounting and Review Services (SSARS), all information included in financial statements is the representation of the grower.
It is also interesting to note that the grower's CPA did report the financial statements to be in conformity with GAAP. This is the same transaction that the CPA reports to be in conformity with GAAP using the worksheet. This is the same transaction but there is a difference of $1,646,000 between the two methods of reporting the transaction (i.e., the $3,746,000 reported as a receivable in the grower's personal financial statements and the $2,100,000 reported on the worksheet).
A second approach to determine the sales price of the grapes would be to take the sales price of the concentrate and reduce it by the amount of the industry average cost to reduce grapes to concentrate. The sales price of the concentrate of $4,545,000 is objectively determined because the concentrate was sold to an unrelated party. There was some industry data available on expenses incurred to convert grapes into juice and then to concentrate. The expense data provided a range of total expense that when subtracted from the $4,545,000 resulted in an average net amount that was very close to the $3,746,000 amount.
A third alternative would use Exhibit 1, the revenues less expenses worksheet provided by the grower adjusted by the questionable expenses listed in the analysis section. The total of the six expenses is $1,679,000. When the $1,679,000 is added to the $2,100,000 remainder on the worksheet, the total of $3,779,000 exceeds the insured amount, on a per ton basis. This amount also becomes more consistent with the $3,746,000 receivable on the grower's personal financial statements.
This case has been used successfully in a forensic accounting course. It is especially effective to pass out and give students time to work on, either individually or in groups, the text of the case up to and including discussion question one. After the instructor covers discussion question one with the entire class the text of the case up to and including discussion question two can be passed out and worked on by the students. After the instructor covers discussion question two with the entire class the text of the case up to and including discussion questions three and four can be passed out and worked on by the students. After classroom discussion of discussion questions three and four is completed by the instructor the remainder of the case can be passed out and the discussion of the case by the entire class can be completed. Depending on how much time an instructor wants to give students to work on the discussion questions, individually or in groups, the case can easily take one or two hours of class time or even more. The three parts can also be given, separately, to students for out of class work. For example, the first part could be handed out at the end of class with instructions to be ready to discuss in the next class session, and so on.
This dispute provides a practical example of an attempt to use accounting to justify an insurance claim, as well as an examination of the relevance and reliability of the accounting rules used to justify the claim. A grower of grapes put in the insurance claim, asserting the sales price of grape juice concentrate was substantially below the insured amount. The sales price the grower used for the claim was the gross amount received for the sale of the juice concentrate less costs to convert the grapes into the concentrate the net amount, the net sales price. The grower submitted a worksheet showing the detail arriving at the net sales price. On its surface the worksheet appeared to be an appropriate attempt to arrive at the actual sales price of the grape juice. The format was a familiar one and was prepared by an experienced accountant and "blessed" by a CPA.
Upon closer scrutiny some troubling issues arose as to the objectivity of some of the expenses included in the worksheet. Most of the expense amounts were determined based on related party transactions. Expenses were arrived at by the use of allocations made between related parties or payments made to a related party without sufficient documentation to determine the objectivity of the expense. A substantial amount of the total expense appeared to be quite arbitrarily determined by the grower.
An arbitration board determined the worksheet not to be in conformity with GAAP, even though the grower's CPA made assurances that is was. The arbitration board further determined the worksheet not to be one of the financial statements listed as acceptable for GAAP and the worksheet's format not to be acceptable for GAAP purposes and that the principle of objectivity required for GAAP did not appear to be satisfied.
The dismissal of the use of the worksheet, however, was not sufficient for the insurance company to win the arbitration. The arbitration board still had to determine whether the grower received a price for the grapes that exceeded the insured amount. The board concluded that the price the grower reported as a sale in personal financial statements to his 100% owned corporation was appropriate even though it also represented a related party transaction. The sales price for the grapes exceeded the insured amount and there was no evidence that the grower was trying to accomplish any other objective other than sell the grapes.
SUGGESTED SOLUTIONS TO THE DISCUSSION QUESTIONS
1. Based on the facts as explained in the previous section if you were hired as a forensic accountant by the insurance company would you be concerned that the revenues and expenses reported in Exhibit I are not reliable? If not, why?
Exhibit 1, revenues less expenses, was used by the grower to support his contention that the remainder after expenses is subtracted from revenues is less than the insured amount. Exhibit 1 may not be appropriate because of concerns whether it is in conformity with GAAP, the effect of related party transactions and allocations, and control exerted by the owner. Also, there may be more appropriate methodologies to determine whether the grapes were sold at less than the insured amount.
2. Was Exhibit 1 prepared in conformity with GAAP? Why did the grower's CPA contend that is was in conformity with GAAP?
Exhibit 1, revenues less expenses, does not have to be in conformity with GAAP to be a useful source of information, especially in a cost accounting or special purpose setting. However, some credibility may be attached to any financial statement/worksheet by asserting that it is in conformity with GAAP. The grower's CPA did specifically testify that the worksheet is in conformity with GAAP and did so numerous times. The worksheet revenues less expenses, is not a financial statement that is acceptable for GAAP for three reasons:
According to Statements on Standards for Accounting and Review Services (SSARS) Number 1, AR 100.04, the acceptable financial statements are Balance Sheet (also Statement of Assets and Liabilities), Statement of Income (also Statement of Revenues and Expenses), Statement of Retained Earnings, Statement of Cash Flows, Statement of Changes in Owner's Equity (also Stockholder's Equity) and a few more that aren't relevant here. The worksheet is not one of the listed financial statements and therefore not GAAP.
Related to number 1 above is the format (methodology) of the worksheet, revenues less expenses. The worksheet format excludes from expenses the cost of grapes but includes profit as an expense. The profit "expense" is 20 percent of the gross sales of the concentrate. The cost of grapes should be considered a product cost and included in cost of goods sold. The exclusion of the cost of grapes as an expense is not GAAP. Profit is sometimes considered a cost for some cost accounting purposes, but is never considered an expense for GAAP purposes. For GAAP purposes, profit is always the difference between revenues and expenses.
There is also the concern that the principle of objectivity is being observed. GAAP relies on verifiable evidence to support accounting measurements, based on arms'-length exchange transactions. Because the corporation purchasing the grapes is 100 percent owned by the grower, it is possible that the transactions between the corporation and the grower were not arms'-length, and may not be verifiable.
The worksheet, revenues less expenses, is based on the format of an income statement as follows:
Cost of Grapes
Costs to produce concentrate
Net Income (Profit)
The single-step income statement format above is based on the relationship of sales less expense equals net income. This relationship can be used to accomplish objectives other than the preparation of an income statement. Cost accountants, for example, use a variation of this relationship to compute break-even, the quantity of units sold where total revenues and total costs are equal, that is, where the operating income is zero. More recently, another variation of the relationship, used first by Japanese companies, is target costing. Target costing is used primarily to determine whether a new product should be undertaken. The anticipated sales price is determined first. Next, the company's engineers and cost accountants estimate costs. Costs are subtracted from sales to estimate profit. If an estimated profit is not acceptable the engineers and cost accountants can attempt to reduce or eliminate costs to make the profit acceptable or the project can be abandoned if the desired profit cannot be achieved. Target costing is proving to be a useful cost accounting tool because of the speed at which technology is producing new products.
The above paragraph explains how the basic income statement relationship, revenues less expenses equals' net income, can be useful for cost accounting purposes. The preparation of the worksheet by the grower's accountants is a variation of that relationship. To better understand why the worksheet is not in conformity with GAAP, it may be useful to discuss what GAAP is and what it is used for. GAAP is useful primarily for financial accounting purposes and represents "the consensus at any time as to which economic resources and obligations should be recorded as assets and liabilities, which changes in them should be recorded, how the recorded assets and liabilities and changes in them should be measured, what information should be disclosed, and which financial statements should be prepared," according to Accounting Principles Board (APB) Statement Number 4, paragraph 27. To aid accountants in their application of GAAP and users to confidently depend on accounting information, broad principles relate to the basic accounting functions of measurement and disclosure. One such broad principle is the objectivity principle. The objectivity principle provides that measurements should be based on verifiable evidence. Such evidence enables an accountant to generate measures similar to those that other competent accountants would develop under the same circumstances. In other words, verifiable evidence helps to ensure that different accountants, working independently to solve the same measurement problem, reach similar conclusions. Information based on verifiable evidence is not significantly distorted by personal biases, and the possibility of serious measurement errors is reduced. Because of the need for verifiable evidence to support accounting measurements, financial accounting is based primarily on the results of arms'-length exchange transactions. Arms'-length transactions are between unrelated parties in which the parties behave in their own best economic interests.
3. Were the expenses in Exhibit 1 objectively determined? Your instructor will provide you with the forensic accountant's analysis of some of the expenses on Exhibit 1 (see Analysis of Expenses by the Forensic Accountant in Instructor Notes). Based on the analysis of the forensic accountant has your opinion changed regarding the objectivity of the expenses analyzed?
The methodology used in the preparation of Exhibit 1 may not be appropriate because many of the expenses listed on the worksheet were paid to or allocated from the grower's other extensive operations. Whenever transactions are between related parties there is a concern that the parties may not behave in their own best economic interests. In other words, the expenses listed on the worksheet may not satisfy the objectivity principle because many of the expenses are based on transactions between related parties.
4. Was the grower's control over all the operations an issue with the usefulness of Exhibit 1?
The overriding problem with the worksheet being used to determine the amount that could be paid for the grapes/concentrate is the control that the grower had over all aspects of the grapes from growing to converting into concentrate. Another example of the grower's control over the amount and timing of the transactions is the removal of cash from the corporation. During the period in question all cash received by the corporation, after expenses were paid, was paid to the grower. The corporation's working capital was never considered. There was an attempt by the grower to explain the cash payments as payments for the expenses listed above. However, the corporation could not produce the appropriate tax forms (1099s) for the payments made to the grower that would have been required by law.
5. Is the method used by the grower appropriate to determine the net income from the grapes? If not, are there other methods that could be used to determine the net income from the transaction? Your instructor will provide you with other methods the forensic accountant provided to the arbitration board for the purpose of determining the net income of the transaction (see Alternative Methods to Compute Sales Price in Instructor Notes). Which method do you think the arbitration board chose to apply to determine whether the grower's claim was justified?
The arbitration board agreed with the insurance company that the worksheet provided by the claimant is not appropriate for the purpose of determining the price to be paid for the grapes/concentrate. In arbitration, the worksheet was disregarded completely. The arbitration board agreed that the expenses as presented in the worksheet were too arbitrarily determined. The control exerted by the grower was such that the worksheet did not provide reliable information. The board also concluded that the worksheet was not prepared in accordance with GAAP as the grower asserted.
The dismissal of the use of the worksheet, however, was not sufficient for the insurance company to win the arbitration. The arbitration board still had to determine whether the grower received a price for the grapes that exceeded the insured amount. The board concluded that the first alternative would be used even though it also represented a related party transaction, a sale of the grapes to his 100 percent owned corporation. The $3,746,000 sales price provided a price per ton that exceeded the insured amount and there was no evidence that the grower in 2004 was trying to accomplish any other objective other than sell the grape crop.
Interestingly, the most objective method was discussed but used only in support of the sale for $3,746,000 by the grower of the grapes to the corporation. In the second method the sales of the concentrate by the corporation to an unrelated party for $4,545,000 was objectively determined because it was an arm's-length transaction. The arbitration board did not feel comfortable using industry average data but did note the similarity of the results of this method to the first method.
The third alternative was abandoned when the worksheet was disregarded. The worksheet was rendered irrelevant because of the subjectivity in arriving at most of the expenses.
John P. Osborn, California State University, Fresno
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|Title Annotation:||Instructor's Note|
|Author:||Osborn, John P.|
|Publication:||Journal of the International Academy for Case Studies|
|Article Type:||Case study|
|Date:||Oct 1, 2009|
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