Ethic of Accountants
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Logitech International

Logitech International S.A. (LOGI) is incorporated in Switzerland and has substantial operations in the United States. LOGI is primarily involved in manufacturing and selling peripherals for computers and electronic devices. Its shares are listed on both the Nasdaq Global Select Market, under the trading symbol LOGI, and the SIX Swiss Exchange, under the trading symbol LOGN. The company maintains an executive office and its Americas region headquarters in Newark, California. LOGI’s common stock is registered with the Securities Exchange Commission (SEC) pursuant to the Exchange Act of 1933.

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In the fourth quarter of 2010, LOGI released the Revue, a TV set-top box designed to integrate cable/satellite TV with internet content. The Revue Google search bar was designed to find any desired content from any provider and project that content to the TV screen. The Revue was manufactured by contract manufacturers, not LOGI itself. In the arrangement with the contract manufacturers, the company authorized the manufacturers to purchase about $11 million of parts before production of the Revue began. LOGI was gearing up for high sales during the 2010 holiday season.1

Overview of the Case

During the 2010 holiday season, sales of Revue were much less than LOGI anticipated. In the fourth quarter of 2010, 165,000 Revues were sold, far less than the 350,000 units the company expected to sell. The Revue’s high price, the blocking of content from Hulu, CBS, and ABC, and numerous software bugs doomed the Revue to be discontinued less than one year after its arrival. LOGI had millions of dollars invested in excess inventory of Revue component parts.

Despite knowing that the component parts in inventory would not be used in manufacturing other LOGI parts and that the market value of those components was minimal, the lower-of-cost-or-market (LCM) inventory write-down that the company did make fell far short of the actual decline in market value.

In 2016, the SEC alleged that some of LOGI’s executives and accounting staff committed accounting fraud. LOGI paid a fine of $7.5 million to settle with the SEC over this improper inventory accounting and two other accounting issues. Individuals from the company including the former CFO paid fines of $25,000–$50,000.2

In a separate filing, the SEC brought a case against Erik K. Bardman, former Senior Vice President of Finance, and Jennifer F. Wolf, CPA, Chief Financial Officer (CFO) and Acting Controller of LOGI. The SEC filing details facts about Revue, that it was projected to be a significant percentage of LOGI’s sales revenue, and that it represented a new strategic direction for the company—but the product failed to live up to expectations. Its sales were 70% lower than internal projections by the fourth quarter of the 2011 fiscal year (March 31, 2011). Compounding the poor sales performance of Revue, in March 2011, LOGI lowered its forecast of operating income to $140-150 million, causing an immediate 16% drop in the company’s share price. Given the shortfall, senior management, including Bardman and Wolf, were under substantial pressure to meet the lowered guidance. Rather than ensure that Logitech accurately account for its problems, Bardman and Wolf engaged in a scheme to materially inflate the operating income that the company reported to its investors in a late April 2011 earnings release and in its annual report, or Form 10-K, filed with the SEC on May 27, 2011, for the fiscal year ended March 31, 2011.

By this time, LOGI had 163,000 units of Revue in storage in the United States that the company had not sold, and it had halted production of additional units in light of the poor sales performance. LOGI’s current price for the product at that time—$299—was more than double the price of competing products and part of the reason Revue was not selling. Indeed, by at least May 19, 2011, Bardman knew that the company’s Chief Executive Officer had been evaluating whether to “shut [Revue] down now.”

Through their scheme, Bardman and Wolf concealed the extent of these problems by, among other forms of misconduct: (1) improperly calculating Revue’s inventory valuation reserves by falsely assuming that Logitech would build excess component parts it was trying to sell into finished units of Revue; (2) misrepresenting to LOGI’s independent auditor that the Company’s excess component parts would be used in production and the company’s future plans for Revue; and (3) misrepresenting to the independent auditor the proper amount of LOGI’s write-down of finished goods inventory by failing to incorporate probable future pricing adjustments. As a result of this misconduct, LOGI overstated its fiscal 2011 operating income by $30.7 million (over 27%).

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In addition, in a letter to LOGI’s independent auditors dated May 27, 2011, Bardman and Wolf falsely represented that the company’s accounting was compliant with GAAP. These representations, demanded by and relied upon by Logitech’s independent auditors, were designed to ensure that the company’s accounting was done in accordance with accepted standards and did not mislead the investing public. Bardman misled the company’s independent auditors regarding the extent of Logitech’s problems with Revue. He signed and certified the accuracy of Logitech’s 2011 financial statements, thereby misleading investors as to these same misstatements and omissions. At the time, Bardman knew, was reckless in not knowing, or should have known that the financial statements he was certifying were materially false or misleading.

Bardman and Wolf violated rules related to the antifraud provisions of the Securities Act of 1933 and Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. They violated the internal controls and books and records provisions of Section 13(b)(5) of the Exchange Act and aided and abetted Logitech’s violations of the antifraud, reporting, books and records, and internal controls provisions. The two also violated the lying to accountants’ provision of the Act. Bardman violated the certification provision of the Exchange Act and the clawback provision of the Sarbanes-Oxley Act of 2002.

The SEC sought injunctive relief, including an officer and director bar, disgorgement of ill-gotten gains, prejudgment interest, civil penalties, and other appropriate and necessary equitable relief from Bardman and Wolf. In addition, the Commission sought an order requiring Bardman to forfeit any bonus, incentive-based compensation, or stock sales profits received during the relevant period. The case against Bardman and Wolf was unresolved at the time of writing.

The following is a summary of the accounting issues in this case.3

Accounting for Revue Product/Components

From the outset, Revue sales were significantly below LOGI’s internal forecasts. By late November 2010, sales and finance personnel, including senior executives, were addressing whether the market price of $299 should be cut. LOGI’s CFO at the time and its acting controller were aware that LOGI might have to evaluate taking a “lower of cost or market” (LCM) charge if the value of Revue inventory was impaired.

Under GAAP, the Company was required to value its inventory at the lower of the inventory’s cost or market value. Specifically, if the market value of a company’s inventory (generally calculated for finished goods as the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation) is less than its cost, then the company must write-down the inventory value in its financial statements.

On or around December 7, 2010, because of high inventory levels and weak sales, LOGI directed the contract manufacturer to stop manufacturing Revue, including halting all work in progress. LOGI also instructed the manufacturer not to ship over 26,000 finished Revue units. Further, because the manufacturer, at LOGI’s direction, had purchased parts for future manufacturing, LOGI was liable for approximately $11 million of excess components.

At the end of the third quarter of fiscal year 2011 (December 31, 2010), Revue sales were only 40% of LOGI’s forecasts for that product. As part of its financial closing process, LOGI performed an LCM analysis of the Revue finished goods inventory and concluded that no adjustment, or write-down, was required.

On or around January 5, 2011, LOGI’s Senior Vice-President (SVP) of Operations informed several executives that he intended to “dispose of the components” awaiting assembly by the manufacturer in light of Revue’s “current trajectory.” Shortly thereafter, the SVP-Operations instructed the VP of Global Sourcing/Supplier Management (VP-Global Sourcing) to “sell all of the components we could.”

Later in January 2011, LOGI management informed the Board of Directors about the poor sales of Revue and about management’s future plans for the product, including a plan to lower the retail price of Revue to $249 in the first quarter of 2012 and to $199 in the third quarter. Management did not inform its independent auditor of this pricing plan strategy.

On January 27, 2011, LOGI issued its third quarter 2011 earnings release, reporting strong results, increasing its guidance for annual revenue for fiscal year-end March 31, 2011, and affirming its guidance for annual operating income in a range of $170-$180 million.

During LOGI’s fourth quarter fiscal 2011, Revue sales continued to be far below projections. For all of quarter four, despite regular discounting and promotions, Revue sales were 30% of internal product forecasts. By quarter end, retailers were selling fewer than 1,000 Revue units per week.

At the end of the fourth quarter 2011, LOGI had over 163,000 units of Revue finished inventory in its U.S. distribution centers, with another 52,000 finished and work-in-progress units in Asia. Based on the sales rate for that quarter, LOGI had over a year’s supply of Revue. At the quarter-end sales rate to retailers, LOGI had over three years of inventory.

In mid-March 2011, an accountant in LOGI’s Regional Finance area asked LOGI’s VP-Global Sourcing about financial risk for the Revue product and the number of units that could be built from on-hand components. The VP-Global Sourcing informed her that there was no plan to use the components and that Global Sourcing was attempting to sell whatever could be sold. He also noted: “If we need to scrap [work-in-progress] and components, we should assume a recoverable value of zero.”

On or around March 23, 2011, a LOGI Finance employee sent Wolf a summary of potential excess and obsolete inventory for contract manufacturers in preparation for a meeting the next day to discuss required accounting adjustments for the year-end financials. The summary highlighted a total potential excess inventory of $19.4 million for Revue units and components that “should be reserved.”

On March 31, 2011, LOGI announced that, for reasons unrelated to Revue, it would miss the guidance it had provided to the market two months earlier. LOGI lowered the previous guidance for operating income by $30 million (to a range of $140-$150 million). Internally, the CEO characterized the guidance miss as a “disaster” and informed his executive team, including Barden and Wolf, that management’s credibility with the market was damaged.

For its fiscal year 2011 year-end financial close process, LOGI initially prepared an LCM analysis indicating that no LCM adjustment was required for Revue finished-goods inventory. The company’s independent auditor arranged separate meetings with Barden and Wolf to discuss the importance of the assumptions in the LCM analysis. In the meetings, the independent auditor stressed the need to consider future pricing assumptions and strategies. Within days, LOGI revised the LCM analysis and, based on a planned price cut to $249 in the first quarter of 2012, recorded a $2.2 million adjustment. However, in the revised analysis, LOGI did not account for the planned third quarter of 2012 price cut to $199, nor did LOGI consider the excess component inventory.

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After receiving the revised LCM with the $2.2 million adjustment, the independent auditor noted the roughly $11 million of excess component inventory and informed Barden and Wolf that LOGI was also required to evaluate and, if necessary, record an adjustment for the component inventory.

LOGI’s Regional Finance accountant resisted adjusting for the component inventory. When the independent auditor persisted, Regional Finance again emailed the VP-Global Sourcing, notifying him there was “heated discussion” with the independent auditor about Revue and asking him to determine the number of Revue units that could be built from the component inventory.

The VP-Global Sourcing, who was responsible for managing the component inventory liability, informed Regional Finance and Wolf that production had been stopped for months and that he did not “see a chance that we are ever going to build [the components] into units.” He wrote that a build-out of components was a “far-fetched scenario that has never been formulated.”

On the next day (April 18, 2011), Wolf received a detailed list of the excess components. Less than an hour later, she sent a spreadsheet containing an LCM component analysis to the independent auditor, calculating an adjustment of $1.1 million, based on a hypothetical build-out of 79,000 additional finished units of Revue. Wolf ignored the fact (communicated to her two days earlier) that LOGI had been actively attempting to sell all o f the components, with only limited success and below cost. Instead, she based the Company’s accounting on the implausible scenario.

On or around April 18, 2011, after forwarding the component LCM analysis spreadsheet to the independent auditor, Wolf met with members of th e independent audit team. At that meeting, Wolf discussed LOGI’s plans to use the $11 million of excess components to build 79,000 finished Revue units. She also represented that LOGI could use excess components (beyond what was needed to make 79,000 Revue units) to manufacture even more Revue units. These representations were false.

During the week of April 18, 2011, Barden and Wolf met with senior members of the independent audit team, where they confirmed the assumptions used in the LCM analyses, and represented that LOGI was committed to the Revue product for the long-term and was going to build at least 79,000 additional units using excess components. These representations were false.

At the time the representations were made, Barden and Wolf knew or were reckless in not knowing that LOGI had no plan to produce additional units of Revue. They knew or were reckless in not knowing that the contract manufacturer had not shipped any Revue units since late November 2010 and had stopped production in early December 2010. In fact, they knew or were reckless in not knowing that LOGI had no timetable for re-starting production or even for completing the work-in-progress units and, for months, had been attempting to sell excess component inventory at substantial discounts.

On or around May 27, 2011, Barden and Wolf signed a management representation letter to the independent audit firm. The letter contained material misrepresentations concerning the valuation of inventory and the LCM analysis for Revue inventory. Specifically, with respect to the Revue LCM analysis, the letter represented that “we considered future pricing adjustments/discounts which are probable of occurring.” This representation was false because the LCM analysis did not consider the planned price drop to $199 in the third quarter of 2012 or other discounting or promotions that would likely be required to sell the excess finished goods inventory. The company acknowledged the falsehood in its November 2014 restatement of financial statements.

On May 27, 2011, LOGI filed its Form 10-K with the SEC. Wolf signed the Form 10-K as the Company’s CFO and Principal Accounting Officer. LOGI reported operating income of $142.7M, which was within the lowered range of $140M-$150M that LOGI had communicated to investors on March 31, 2011.

On November 14, 2014, LOGI restated its financial results for fiscal years 2011 and 2012 because of errors in the timing of the Revue-related inventory write-downs. At the time it initially filed its fiscal 2011 financial statements, LOGI overstated its operating income by $30.7 million (27%). If LOGI had properly accounted for Revue-related inventory in May 2011, it would have reported operating income of approximately $112 million, far below the lowered guidance of $140-$150 million.

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Questions

1. Analyze the corporate governance systems at Logitech. Describe any weaknesses in these systems and how they affected the work of the external auditors.

2. Identify the red flags that indicate earnings management took place at LOGI. Discuss the accounting for inventory in the context of financial shenanigans.

3. Can you identify any violations of the AICPA Code of Professional Conduct by Jennifer Wolf? How about the external auditors in their audit of LOGI? Be specific.

4. There is no indication that LOGI staff accountants knew of the improper inventory accounting during 2010-2011. However, assume that one LOGI staff accountant, who is a CPA, did know about it. What steps should the staff accountant have taken once aware of the inventory issue? Be sure to explain each of the steps and why they would be taken.bb

5. Notwithstanding your answer to #4, assume the staff accountant decides to blow the whistle on the improper inventory accounting to the SEC. What protections are available to the staff accountant under the (a) Sarbanes-Oxley Act and (b) Dodd-Frank Financial Reform Act? Are there any conditions for these protections?

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