CASE 5.1 ROCKY MOUNT UNDERGARMENT COMPANY, INC.

In early 1986, several employees of Rocky Mount Undergarment Co., Inc. (RMUC),
came face to face with an ethical dilemmas. RMUC, a North Carolina-based
company, manufactures undergarments another apparel product. Approximately, one-
half of the company’s annual sales were to three large merchandisers: Kmart (29%),
Wal-mart (11%), and Sears (9%). RMUC employed nearly 1300 workers in its
production facilities and another 40 individuals in its administrative functions.
Between 1981 and 1984, RMUC realized steady growth in revenues and profits. In
1981, RMUC reported net income of $378.000 on net sales of $ 17.9 million. Three
year later, the company reported a net income of $ 1.5 million on net sales of $ 32
million.

Unfortunately, RMUC failed to sustain its impressive profit trend in 1985.

Disproportionately high productions cost cut sharply into the company profits margin
during that year. These high production costs resulted from cost overruns on several
large customer orders and significant start-up costs incurred due to the opening of a
new factory.

A subsequent investigation by the Securities and Exchange Commission (SEC)

revealed that the company’s senior executive and another high ranking officer had
refused to allow the firm to report its actual net income of $ 452.000 for 1985. To
participate inflate the company’s 1985 net income, these executive instructed three of
their lower level subordinates to overstate the firm’s year-end inventory and thereby
understated its cost of goods sold. When the three subordinates were reluctant to
participate in the scheme, the two executives warned them that unless they
cooperated, the company might “cease operations and dismiss its employees”. After
much prodding, the three subordinates capitulated and began systematically
overstating the firm’s 1985 year-end inventory.

While the three lower-level employees were overstating RMUC’s inventory, the two
company executive who concocted the scheme periodically telephoned them to check
on their progress. At one point, the three subordinates indicated that they were
unwilling to continue falsifying RMUC’s year-end inventory, quantities. However,
after additional coaxing and cajoling by the two executives, they resumed their
fraudulent activities. Eventually, the three employees “manufactured” more than $
900.000 of bogus inventory. After RMUC’s senior executive reviewed and approved
the falsified inventory count sheet, the count sheet were forwarded to the company’s
independent audit firm.

To further overstate RMUC’s December 31, 1985, inventory the company’s senior
executive instructed another RMUC employee to obtain a false confirmation letter
from Stretchlon Industries, Inc. Stretchlon supplied RMUC with most of the elastic
needed in its manufacturing processes. At the time, RMUC had an agreement to
purchase 50 percent of Strechlon’s common stock at net book value. On December
31, 1985, Strechlon had in its possession only a nominal amount of RMUC inventory.
Nevertheless, a Strechlon executive agreed to supply a confirmation letter to RMUC’s
independent auditor indicating that his firm held approximately $165.000 of inventory
at the end of 1985. As a condition providing the confirmation, the Strechlon executive
insisted that RMUC prepared and forward to him a false shipping document to
corroborate the existence of the fictitious inventory. After receiving this shipping
document, the Strechlon executive signed the false confirmation and mailed it to
RMUC’s independent audit firms.

The fraudulent schemes engineered by RMUC executive overstated the firm’s

December 31, 1985, inventory by approximately $ 1.076.000. Instead of reporting
inventory of $12.158.000, in its original December 31, 1985, balance sheet, RMUC’s
reported net income for 1985 to $ 1.059.000, which was more than $ 600.000 higher
than the actual figure.

Near the completion of the 18985, audit RMUC’s auditor asked the company’s senior
executive to sign a letter representation. Among other items, this letter indicated that
the executives was not aware any irregularities (fraud) involving the company’s
financial statement. The letter also stated that RMUC’s financial statement fairly
reflected its financial condition as of the end of 1985 and its operating result for the
year. Shortly after receiving the signed letter of representation, RMUC’s audit firm
issued an unqualified opinion on the firm’s1985 financial statements.

Following the SEC’s discoveries of the fraudulent misinterpretations in RMUC’s

1985 financial statements, the federal agency filed civil charges against the firm’s two
executives involved in the fraud, the SEC eventually settled these charges by
obtaining a court order that prohibited the executives from engaging in any further
violations of federal securities laws. RMUC also issued corrected financial statements
for 1985

ROCKY MOUNT UNDERGARMENT COMPANY INC.

I. Facts of the Case:

In early 1986, several employees of Rocky Mount Undergarment Co., Inc (RMUC),
came face-to face with an ethical dilemma. RMUC, a North Carolina-based
company, manufactured undergarments and other apparel products.
 Between 1981-1984, RMUC realized steady growth in revenues and profits but
RMUC failed to sustain its impressive profits trend in 1985. Disproportionately
high production cut sharply into the company’s profit margin during the year.
A subsequent SEC investigation revealed that the company’s senior executive
and another high-ranking officer had refused to allow the firm to report its actual
net income of $452,000 for 1985. To inflate the comapany’s 1985 net income,
these executives instructed three of their lower level executives to overstate the
firms year-end inventory and thereby understate its cost of goods sold.
When the three subordinates were reluctant to participate in the scheme, the two
executives warned them that unless they cooperated, the company might “cease
operations and dismiss its employees”. After much prodding, the three
subordinates capitulated and began systematically overstating the firms 1958
year-end inventory.
To further overstate RMUC’s December 31, 1985 inventory, the company’s senior
executive instructed another RMUC employee to obtain a false confirmation letter
from Strethlon Industries Inc., indicating that his firm held approximately
$165,000 of RMUC inventory at the end of 1985.
The fraudulent schemes engineered by RMUC’s executives overstated the firm’s
December 31, 1985 inventory by approximately $1,076,000. Instead of reporting
inventory of $12,158,000 in its original December 31,1985, balance sheet, RMUC
reported inventory of $13,234,000. The overstatement of inventory boosted
RMUC’s reported net income for 1985 to $1,059,000, which was more than
$600,000 higher than the actual figure.
Shortly after receiving the signed letter of representations, RMUC’s audit firm
issued an unqualified opinion on the firm’s 1985 financial statements.
Following the SEC’s discovery of the fraudulent misrepresentations in RMUC’s
1985 financial statements, the federal agency filed civil charges against the firm’s
two executives involved in the fraud.

II. SWOT ANALYSIS

STRENGTHS
 Supplier to large merchandisers (Kmart, Wal-mart and Sears)
 Employed nearly 1300 workers in production and 40 individuals in its
administrative functions
  Impressive profit trend from 1981 to 1984.
WEAKNESSES
 Disproportionately high production cost
 Weak internal controls
 Failure to strategize the company’s operating deficiences
OPPORTUNITIES
 RMUC’s audit firm should have investigated more on the bogus inventory
 The company should have formulated strategies to overcome its weak
financial performance due to high production cost
THREATS
 The pressure provided by RMUC’s top executives
 The company’s weakening financial performance
III. Recommendations
The “success” of many, if not most, fraudulent accounting schemes hinges on the
willingness of lower-level employees to participate in them. The pressure provided by
RMUC’s executives left the employees with no choice but to concede and heed the
executives’ instructions to falsify the financial statements. Despite of these facts:
 To uncover the fraud proper audit procedures should have been made by the
external auditor/s especially on the significant increase in the ending inventory.
 The company should have resorted to other alternatives / strategized to cope with
its failing operating performance. For example, proper demand forecasting should
have been done to properly determine how many units to produce and as well as
to reduce inventory carrying cost. Another is by performing proper budgeting on
the production process to avoid cost overrun.
 The company should have implemented stricter internal controls between its
executives, employees and top executives
 ROCKY MOUNT UNDERGARMENT COMPANY INC.

I. Facts of the Case

In early 1986, several employees of Rocky Mount Undergarment Co., Inc. (RMUC), came
face to face with an ethical dilemmas. RMUC, a North Carolina-based company,
manufactures undergarments another apparel product. Approximately, one-half of the
company’s annual sales were to three large merchandisers: Kmart (29%), Wal-mart
(11%), and Sears (9%). RMUC employed nearly 1300 workers in its production facilities
and another 40 individuals in its administrative functions. Between 1981 and 1984, RMUC
realized steady growth in revenues and profits. In 1981, RMUC reported net income of
$378.000 on net sales of $ 17.9 million. Three years later, the company reported a net
income of $ 1.5 million on net sales of $ 32 million.

The executives of Rocky Mount Undergarment Company (RMUC) faced the unpleasant
realization that their firm’s operating results for that year would be unimpressive. In fact,
RMUC’s 1985 net income would fall short of $500,000, less than one-third of the
company’s reported profit for the previous year. The executives decided that RMUC’s
actual operating results were unacceptable and decided to change them. How? By
pressuring three of RMUC’s accounting clerks to significantly overstate the company’s
year-end inventory.
Initially, the three employees did not want to become involved in the fraudulent scheme.
However, the employees subsequently changed their minds. The executives told the
employees that unless they inflated the company’s reported net income, the company
might cease operations. Later, while the employees were actively involved in the
inventory fraud, they had changed their mind. They told RMUC’s executives that they
were unwilling to continue falsifying the company’s year-end inventory quantities. After
renewed coaxing and goading by the executives, the three employees once again became
active, if unwilling, participants in the fraud.
Following the SEC’s discovery of RMUC’s fraudulent scheme, the federal agency
sanctioned the two executives responsible for masterminding the fraud. RMUC was also
required to issue corrected financial statements for 1985.

II. Analysis of the case

STRENGTHS
 Has been a Supplier to large and leading merchandisers one of which is Walmart.
 Had resulted to high and impressive profit trend from the year 1981 to 1984.
WEAKNESSES
 Does have weak internal controls
 Not well-managed production cost
 Wasn’t able to solve operation’s deficiencies
OPPORTUNITIES
 The audit firm should have focused its investigation more on the bogus inventory
THREATS
 The pressure exerted by its top line management
 The company’s weakening financial performance
III. Recommendations
The “success” of many, if not most, fraudulent accounting schemes hinges on the
willingness of lower-level employees to participate in them. The pressure provided by
RMUC’s executives left the employees with no choice but to concede and heed the
executives’ instructions to falsify the financial statements. Despite of these facts:
 To uncover the fraud proper audit procedures should have been made by the
external auditor/s especially on the significant increase in the ending inventory.
 The company should have resorted to other alternatives / strategized to cope with
its failing operating performance. For example, proper demand forecasting should
have been done to properly determine how many units to produce and as well as
to reduce inventory carrying cost. Another is by performing proper budgeting on
the production process to avoid cost overrun.
 The company should have implemented stricter internal controls between its
executives, employees and top executives
I. Recommendations
 If I were in the case of the executives, I would not be worried if the company
has reported a lower income for that year because the cost that was incurred
for that year was partly used in opening a new factory. They can still report
their actual income if asked about the higher costs, they can defend that most
of the cost was necessary for the expansion of the company. Growth can’t be
achieve without cost.
 In the case of the subordinates, I would suggest that they should have other
sources of income so that they would not be cornered in a situation wherein
they have to choose between their principle and bringing food to their table.
That way, they can have the freedom to choose their option without the fear
of losing their job.
 In the perspective of the auditors, they have done the best they can do to
deliver their job correctly. Auditors are human too and they’re also bound to
commit mistakes or overlooked somethings. It is especially difficult in their part
because to detect the misstatement because there was a collaboration between
the supplier and the company itself.

 As for the executives, they should look for proper solutions other than falsifying
the income results since it is pretty normal for a company to have different levels
of income, sometimes it may be very high and sometimes it is low. They must
consider the factors on why it has become low, it may be because of the costs
they incur for that year.
 For the low level employees that were involved in the fraud, it is with their
conscience if they will follow the executives. Ethically, it would be better if they
would not follow such since their names would be forever involved if that
fraudulent act.
 As for the auditors side, to uncover the fraud proper audit procedures they should
have been made especially on the significant increase in the ending inventory.