Ethical Issue 13-1 Note: This case is based on an actual situation. Stan Sewell

Question

Ethical Issue 13-1

Note: This case is based on an actual situation.

Stan Sewell paid $50,000 for a franchise that entitled him to market software programs in the countries of the European Union. Sewell intended to sell individual franchises for the major language groups of Western Europe -- German, French, English, Spanish, and Italian. Naturally, investors consideringbuying a franchise from Sewell asked to see the financial statements of his business.

Believing the value of the franchise to be $500,000, Sewell sought to capitalize his own franchise at $500,000. The law firm of St. Charles & LaDue helped Sewell form a corporation chartered to issue 500,000 shares of common stock with par value of $1 per share. Attorneys suggest the following chain of transactions:

Sewell's cousin, Bob, borrows $500,000 from a bank and purchases the franchise from Sewell.

Sewell pays the corporation $500,000 to acquire all its stock.

The corporation buys the franchise from Cousin Bob.

Cousin Bob repays the $500,000 loan to the bank.

In the final analysis, Cousin bob is debt-free and out of the picture. Sewell owns all the corporation's stock, and the corporation owns the franchise. The corporation's balance sheet lists a franchise acquired at a cost of $500,000. This balance sheet is Sewell's most valuable marketing tool.

1. What is unethical about this situation?

2. Who can be harmed?

3. How can they be harmed?

4. What role does accounting play?

Explanation / Answer

In accounting you have to value assets at their historical cost. In stans case, this means that he can only value the asset on the balance sheet for $50,000 since that's what he purchased the franchise for.

By having cousin Bob "purchase" the franchise, in effect the value of the franchise has increased from $50,000 to $500,000 because the corporation re-purchased the franchise from Cousin Bob.

The economic reality of the situation is that no money changed hands. It was a series of phony transactions that were enacted solely with the intent of deceiving future investors or creditors.

The unethical part of the situation is the intent to deceive. Creditors and investors can be harmed by these actions as they will enter into transactions with the corporation with the belief that the value of the company is $500,000 when it's really $50,000.

The role of accounting is how assets are valued. You value your assets for what you purchase them for, not what you believe they are worth - and in most cases you can't write up assets to the fair market value, either.

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