Fit Food Inc.

Case Report

IAF841 NJJ Management Accounting-Advanced

Eric Acri, Anastasia Druzhina, Pavel Paduta, Aleksandr Evtushenko, and Arvind Ramessur
 Fit Food Inc.

Introduction: Company overview

Fit Food Inc. is a food company that produces “tasty-but-healthier” options for the health conscious
consumers. The company was founded in 1972 by Sean Wright, and the production started with “Smart
Cookies”, a line of cookies that were lower in fat and calories than its competitors. By 2000 FFI was
distributing its cookies nationally and launched an FFI IPO. FFI`s stock was listed on NASDAQ in the same
year.

The company had three divisions that operated relatively autonomous: Cookies & Crackers, Savory
Snacks (started in 2001), and Sports & Energy Drinks. By acquiring an energy drink company in 2003,
Sean significantly increased company’s debt load.

FFI did not have an internal auditing function and had to outsource the documentation and testing
required to comply with Sarbanes-Oxley Act. The FFI`s external auditing partner was Kristine Trodden,
who did not find FFI to be a particularly great client because they constantly requested to lower auditing
fees and threatened to solicit competing firms bids.

The board of directors included 5 members that were suggested by Sean, but approved by the board's
nominating and governance committee. The board held in-person meetings 4 times a year, but could
also have conference calls if needed.

In 2008, during management meeting, Sean pronounced that the company needs to perform better and
make large investments in order to develop new products and improve their sources of organic
ingredients.

Plans, Reviews, and Incentives

Background information
When FFI began their corporate planning process each division was sent forecasts, planning assumptions
and sales targets. Each division was expected to increase its annual revenues by at least 5% to show
steady growth. While Developing AOP the division managers argued with corporate because the
managers needed to increase expense budgets to achieve sales goals, while corporate wanted to reduce
expenses and generate increased profits. Tensions increased even more in 2008 when corporate asked
the divisions to increase the growth rate to 7% in order to fund a new investment. FFI also held quarterly
performance reviews. For those who met or exceeded expectations the meetings were rather short, but
for those who did not the meeting were quite stressful.

The incentives to reach the forecasted targets were bonuses ranging from 25% to 100% of the manager’s
base salary. The maximum bonus was 150% of the target bonus if profits exceeded Annual Operating
Plans by 25%. However, there was no bonus if division profits fell below 85% of AOP. On average bonuses
exceeded target levels in the first seven out of eight years.

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 Fit Food Inc.

Some corporate managers and division presidents were issued stock options. Unfortunately most of the
options were under water due to 2008-2009 market downturn. The CEO was also demanding better
financial performance while the company was stressed due to the 2008-09 recession. The only division
that performed well during this time was The Savory Snacks Division.

Issue: Possible fraud

Analysis
The first thing that is easily noticeable in FFI is the fact that the division managers are under a lot of
pressure from the corporate managers to continually increase their annual revenues. Corporate also
refuses to increase the expense budget for the divisions in order to maximize profits. Corporate often
tricks the divisions by asking them what programs they would cut if the profit budget was reduced by
10%. When the programs are identified, the managers are forced to justify adding them back into the
budget. To make the matters worse, during the market downturn of 2008-09 corporate asked the
divisions to increase their growth rates to 7% from 5%.

All of the above mentioned things show that there are severe tensions between corporate and the
division managers. Due to such high pressure tactics coming from corporate, the managers might not see
any other way but to think of fraudulent ways to meet the company goals. Catherine Elliot is quoted
saying that “Corporate pushes us hard to make our numbers. … We’re paid to be creative and come up
with solutions, not excuses.”

The large bonuses that are awarded for profits exceeding AOP by 25% create even more incentive for
fraud. Especially when everyone is used to receiving bonuses for the past seven years and now due to
the economy it is extremely hard to meet the corporate criteria.

Another thing that is a little strange is the fact that only The Savory Snacks division performed well and
achieved the high growth rates set by corporate amidst the market crash, while the other two divisions
did not do very well. Looking at the organization chart we can see that Sports and Energy Drinks division
has 3 different departments, Cookies and Crackers have 4 different departments, and only Savory Snacks
division has only one person running it. It is much easier to create fraud if you are responsible for all the
aspects of running a division than when there are more people involved. It could be a coincidence, but it
is highly unlikely that during a market wide crash one division is very profitable while the other two are
not even though they are in the same industry.

Alternatives
One of the alternatives could be to release the pressure from the division managers during the decline of
the market. This will help the managers to cope with their devalued stock options as well as reducing
their stress level. With too much stress and pressure the managers may simply see no other way out but
to commit fraud in order to satisfy corporate and not risking losing their jobs during this hard time.

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 Fit Food Inc.

The other alternative is to simply ignore this growing tension and hope the managers fulfill the high sales
targets. However, that is not the best choice because some fishy things are already starting to happen
among the divisions.

Recommendations
Out of the two alternatives above we would recommend the first one because in that scenario the
management is actually trying to solve the problem. It would not be a good idea to simply do nothing
and hope it solves itself.

Sports & Energy Drink Division

Background information
● One of the main divisions of Fit Food Inc. (FFI) was the Sports and Energy Drinks Division acquired in
2003 by Sean Wright, the CEO of FFI, and with the former CEO and current president, Jack Masters,
taking over with a positive sales growth and reach its goals, the AOP targets set at the beginning of the
year, and also generate above target profits, nearly doubled.
● Even though business was going well for the Sports and Energy Drinks Division, Jack Masters began to
observe trends in early 2007 that could put the AOP profit targets set by the CEO in jeopardy as retailers
and big corporations began to enter the market.
● Those trends affected the customer’s preference as they have more choices and to compete with the
sale price of the drinks had to be lowered but the Sports and Energy Drinks division recorded sales
growth above target profits again due to the excellent advertising methods put in place in 2007 which
allowed the president to plan for the future.
● With high AOP targets, there were three courses of action that the division came up with; declaring a
shipping moratorium, build up accounting reserves against accounts receivable and inventory balances,
and to prepay some expenses that would normally be incurred in 2008.
● The first plan was not approved by many of the employees at the division as it would cause many staff
scheduling problems even though this would cause a few problems in the production division of the
Sports and Energy Drinks division, Jack Masters continued with the plan as costs such as over-time for
employees during early 2008 and shipping delays were minor in comparison to the profits they will
generate.
● In 2007, the division’s controller increased some of the reserves by a significant amount of $1,000,000 in
comparison to the previous year which allowed the company to ready itself for future issues regarding
the AOP profit targets.
● As 2008 approached, the third plan was to prepay some of the expenses that would be incurred in 2008
in order to maintain the AOP profit targets at a constant level as it would be harder to reach such heights
with the competitive business.
● Jack Masters’ predictions came true in 2008 as sales began to drop due to the economic crisis and the
market that the Sports and Energy Drinks division is competing in began to slow down as well as new
regulations regarding companies in this industry.

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 Fit Food Inc.

● As the crisis began to get worst in 2008, the Sales and Marketing Department created an “early order
program” which gave customers more option on bulky items and also keep their loyalty to the company
which helped the division reach their targets for the year
● Even with all those deals and the period of slow economy, profits were lower than expected so Jack
Masters decided to liquidate some of its reserves in order to hit the AOP profit targets as he believed the
method was correct and his division was performing really well as approved by the company’s CFO, Joe
Jellison, after some questioning by various auditors on the methods.
● As FFI entered 2009, the economy was still slow but division was able to get a major deal which allowed
Jack Masters to eliminate the discounts and continue towards his AOP sales target. Since they had huge
production requests by the new deal, demand was high and the “early order program” was going to
cause issues.
● As 2009 came to an end, the controller of the Sports and Energy Drink division changed the reserves to
$2,000,000 which again lead to questions by the auditors.
● The explanation provided by Jack involved the payment patterns of the new customers and this allowed
the division to be successful in the next year, 2010, even in this economic crisis that the economy is still
recovering from.

Issue 1: There is an unethical issue as employees had to be put on temporary leave.

Analysis
As Jack Masters and his division created the plans for the future, they did not take in consideration the
opinions of the managers and employees. This is a key factor that should be addressed as many of the
employees may feel that they are not part of the team and morale may be lowered which in turn
decreases production quality. Another unethical issue that should be of concern is the fact that Jack
continued with the shipping moratorium even knowing that there will be customer complaints regarding
the delays and products. Since he only wanted to attain his goal, it looks as if Jack is only looking after his
own benefits, reach the AOP profit targets, rather than the company’s. As more customers’ complaints
pile up, the company may lose the customer’s loyalty which is a key factor to consider when the market
is becoming more competitive and there are more options on the horizon.

Alternative
Even though Jack Masters is the former CEO of the company and does have in-depth knowledge of the
industry, it would be better for Sean Wright to hire a new president as it may boost employee morale. It
may also bring with it new and innovative ideas whereby the company may excel even during the
unstable economy.
Jack Masters could potentially provide the employees an option of going on temporary leave as it around
the holiday break at the end of the year. There should be a meeting whereby employees sign up to take
their vacation with full pay around that period and employees that want to work can stay. Since morale is
very important in a work environment, this could potentially elevate their quality in production once
they come back as more inventories is needed at the beginning of year.

Recommendation

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 Fit Food Inc.

The best option would be to try and talk to the employees first before as it would allow the employees to
feel part of the company and also help Jack Masters reach his targets with their help. By not taking the
customers and employees suggestion, the Sports and Energy Drinks division will eventually fall in today’s
economy.

Issue 2: Setting up a program in order to boost their sales at the end of the year.
Analysis
The “early order program” should have not been approved by the CEO of FFI as it allows the president of
each division an easier method to boost their numbers before the year end instead of working hard
throughout the year. Jack Masters welcomed the idea of providing discounts with no interest until 120
days to their customers as his AOP profit targets are met regardless of what methods are being used.
Those methods are aggressive as it forces customers to buy a bulky portion and some customers may
not like the method being employed by the sales people.

Alternative
The CEO, Sean Wright, could have meetings every 2 weeks or monthly to check up on the status of each
division in terms of reaching the AOP profit targets at the end of the year. This provides more control
over the company plans and those meetings could be used to lower the high AOP targets as many
presidents are boosting their sales in order to just meet those goals and set up for unethical activities in
to achieve such high numbers during the recession period.
Before any programs are set up, the CEO should approve and have someone analyze in depth if such
methods would benefit the company or just benefit the president for their bonus.

Recommendation
Instead of not interfering with the managers who are doing great, the CEO should look more into the
methods used by the different presidents and managers in order to have a better understanding. It could
also boost the company as the other divisions could combine together and use the most effective
method. The meeting would allow the managers to talk things through and come up with ideal situations
and targets.

Issue 3: The controller of the division moved around the reserves in order to make the numbers look
better.

Analysis
There seem to be an issue regarding the reserves as every year, there is a change in the amount in order
to reach the AOP profit targets. In 2007, there was an increase of $1,000,000, in 2008, a decrease of
$1,700,000, then again in 2009, a rebuild with a total of $2,000,000. The explanation that the auditors
who questioned the information and accounting principles received was not concrete enough as it was
justified by the CFO, Joe Jellison and the controller based the economy state.

Alternative

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 Fit Food Inc.

Sean Wright should hire an external auditor in order to properly understand the methods the presidents
of each division are doing in order to reach their AOP profit goals. There should also be severe penalties
for managers that do indeed use unethical methods as this would ruin the reputation of the FFI and may
lead to further issues in the company's activities if caught doing illegal methods.
Sean Wright should fire the CFO as it doesn’t look like he is providing appropriate justification for the
constant changes in reserves. Even the auditors are questioning the information and methods so this
should be investigated.

Recommendation
In order understand why there is no concrete explanation why there are such changes constantly, the
best option would be to hire an external auditor who is qualified to investigate any fraud that could
occur. Since external auditors are known to be more independent, this would benefit Sean Wright in
discovering any issues before it becomes worst in the future.

The Cookies Division

Background information
The cookies division is FFI’s flagship brand. In 2008-2009 it was struggling. This was due largely to the low
growth, low margin market for cookies along with strong presence from private label competitors.
Another contributing factor to the division’s slow performance was the shift in consumer mindset from
low fat, of which their cookies were classified as, to more ingredients based preference of which their
brands were not a part of. This meant that in order to stay with consumer trends, a new sku of cookies
was required to be developed as suggested by marketing. Otherwise a 7% increase (AOP mandate) in
annual revenues and profits would be unobtainable by conventional means.

2008 Performance
First quarter results indicated that the 7% increase in revenues was unobtainable. In order to reach these
goals the cookie division management implemented a similar to the energy drinks sales program which
involved generous discounts and extended payment terms for early orders. Feeling the pressure from
executive management, the sales staff engaged in aggressive maneuvers and often relied on verbal
purchase order confirmation only. Coupled with fictitious purchase orders and an abuse of GAAP (loaded
trucks parked away from the company’s docks) meant that on paper the division was on track to meet
their performance targets.

These results were of course unsustainable. Naturally, second quarter performance slowed as customers
had a surplus of inventory and did not intend to order more. To counter this, managers forced the sales
staff to double ship inventory inciting human error. If a customer complained about the unwanted
product, the sales staff were then asked to “make it stick,” by offering special pricing, credit terms and
product exchanges. If they couldn’t, product would then be rotated amongst customers in order to
maintain the record of sale. In short, revenues increased by $2.3M, with profits of $460K.

Issues

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 Fit Food Inc.

● Unrealistic results oriented bonus initiative has made management divergent from the overall goals of
the company
● Poor direction of company's resources (marketing and R&D)

Symptoms
● Aggressive sales tactics, flooding distribution of channels
● Falsifying sales revenues and abuse of GAAP (data manipulation)

Analysis of Issues
There is an obvious disconnect between what is sustainable and what executive management wants. The
real underlying issue is instead of focusing on long-term growth strategies such as advertising and
research & development, an on paper performance oriented bonus approach has created incentives for
management to focus on short-term goals. With high operational targets and a slow market, managers
have felt that achieving these goals would only be accomplished with unconventional means. Ergo the
manipulation of data and forceful sales tactics to bolster the sales on paper.

This is an obvious divergence between management performance and public investor preferences. Share
value is often derived by the ability of the underlying asset. In this case the use of capital by FFI and the
decisions made by executives will determine how the market values the company. By creating incentives
for data manipulation, the managers have felt obligated to resort to creative tactics in order to report an
increase in sales on paper and offer no sustainable economic value to the company or its stakeholders.
Furthermore it exposes the company to several legal risks, public-capital regulatory bodies (from
fraudulent records), and risks customer retention due to their poor treatment.

Alternatives and Recommendations

1. Communicate to the stakeholders/investors that the increase in sales revenues and profits is
unsustainable, and the trade off for short term sales goals (1-3 years depending on economy wide
factors) is insignificant compared to the deterrents in the long-term goals. Material misstatements, and
jeopardizing customer turnover are in conflict with the ongoing concern of business prosperity because
they risk legal repercussions & reduce customer retention. This could result in the ending of the
business.
2. Reconstruct the bonus system for the executives from on-paper performance to a project completion
system. Because the marketing team has concluded that advertising and product development has a
higher yield, having a bonus system that is more congruent to these goals makes a lot of sense. This of
course means developing a system that mixes personnel, action, and results controls in order to ensure
that projects are not rushed but rather measured on their value add to the company. This would also
involve explaining to investors how and why the marketing executives have determined the shifts in
customer's preferences, and why it is important to stay current to consumer trends. By highlighting long
term goals and justifying short-term dips in performance, investors can fairly judge the company and
invest accordingly.

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 Fit Food Inc.

3. If project oriented goals are not an option, or if designing a system is not feasible due to the nature of
the company, create the AOPs so that they are tied to market performance. By marking their goals to the
market, management can visibly see what the opportunity is for the company for growth. If numbers are
low market wide, then it is reasonable to assume that FFI's numbers will be low to. This creates an even
benchmark.

2009 Performance
Background information
In 2008 by forcing of shipment, unordered products, generous discounts and extended payment terms
for early orders, at the end of the year division managed to deliver 97% of the AOP sales and profits.
Understanding weak economy, sluggish category growth and other difficulties faced last year, Scott
(general manager of division), Catherine (Marketing) and Mitch (Sales) argued with Sean in order to
reduce the target to flat revenue goal or to maximum 2% growth. However, Sean was unwilling to lower
the goal, even though he understood difficulties in the category, he believes that aggressive goals and
commitment to achieve them is what usually lead them to success, and he was also thinking about
shareholders who would be demanding an even better performance than 2% growth that was asked as a
possible maximum.

After AOP meeting division management team had to develop new ideas for increasing sales in order to
understand how to meet AOP’s requirements. A decision was made to continue the programs used in
2008. Also Irene Packard came up with idea to ask the suppliers of both machines and parts to reduce
parts expenses and charge this difference to machinery costs that would capitalize over $2 million
expenses.

Issue
After one of the junior accountants informed Joe Jellison that she is forced to create entries that are not
adequately supported by documentation, he asked one of his assistant controllers to examine the
accounting practices in the Cookie Division whereupon he reported multiple problems with potentially
material financial statement effects.

Analysis
As we can see from the case there is a lack of internal controls between Divisions and Corporate Staff,
lack of internal auditors and strong pressure to reach AOP’s goals. Because of all these issues we can see
a result, such as usage of unethical practices by division managers in order to increase bonus. Now as a
result we received:
1) Violation of GAAP on capitalizing principle,
2) Extra work in order to fix everything for this and previous years,
3) Ruined reputation among shareholders,
4) Ruined relationship with big important suppliers, who was asked to assist in fraud.

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 Fit Food Inc.

According to the GAAP, only additions, improvements, or replacements, that are usually cost
much more than ordinary spare parts and increase machinery life cycle, can be recorded not as Reported
and Maintenance expenses, but as a part of a capital.
But asking suppliers to make changes to invoice in order to hide violation and increase profit is
unethical, unprofessional and probably the most important, that it is against the law.

Alternatives
Joe now had two alternatives to choose from:

1) He should have his people calculate the size of the errors, make adjusting entries, and fix the processes.
That would help to reduce number of people who will know about this fraud and it would (probably)
prevent shareholders from finding out. However, there may not be enough manpower to fix all the issues
without external auditors and if shareholders knew about that incident later that would lead to a huge
scandal and loss of investors.

2) He should inform the external auditors and/or the audit committee of the board of directors.
That alternative would help to find and fix most issues, but Joe would have to explain what happened to
shareholders proving that they have enough manpower and time to fix all the issues that would lead for
some leak of information for sure and possible loss of investors.

Recommendations
In this situation we would recommend:

1) To fire all 4 managers involved in this scandal, because they were given an aggressive goals in order to
improve company performance and possibility to receive a bonus if they succeed. But they didn’t
improve sales, they only improved operating profit and they did it only on paper, furthermore they used
illegal ways to increase it in order to receive a bonus that they started to recognize as a mandatory
payment.
2)
3) Introduce this issue to external auditors in order to increase manpower working on it and to solve the
issue as soon as possible.

4) Sean should understand that his aggressive goals and bonus system is not working correctly, especially
during weak economy; and change it so that an increase in both sales and profit would lead to bonuses.

5) They should take a look on parts expenses from a legal point of view, while Irene was trying to hide this
expenses by adding them to machinery bills, they should take in account that some expensive additions,
improvements, or replacements that could lead to increase of economic life of an asset could be legally
capitalized.

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