John Smith, the president of Maryland Industries, a Fortune 500 company, was getting ready for a meeting with Alice, the assistant controller of...

    John Smith, the president of Maryland Industries, a Fortune 500 company, was getting ready for a meeting with Alice, the assistant controller of Maryland's compressor division. Since John had become president a year ago, he had followed an open door policy. Employees at corporate could get in to see him if they desired; in the geographically dispersed divisions people could contact John by phone or email. Today's meeting was unique in that Alice was in a division located 400 miles from corporate headquarters.

    John was a successful Harvard MBA with an engineering background. He had joined Maryland eight years ago and had directed several profitable acquisitions in the consumer products division. He was noted for his bottom line management style, which made him appealing to the investment community. The market had reacted favorably to his appointment as president because of his reputation for producing profits.

    Since becoming president, John has courted the financial community. He knows that Maryland's future growth will come from continued acquisitions, which will require external financing. The financial analysts with whom John has discussed Maryland's needs for additional financing have continued to remind John that the financial community does not like surprises. As a result, John has paid particular attention to providing accurate historical information and forecasts to the analysts.

    The compressor division, where Alice works, is an old line manufacturer of large industrial compressors and stationary diesel engines. The division has supplied a steady cash flow that has supported the expansion of other divisions. The compressor division sells its equipment domestically to municipalities, interstate pipelines, and military installations. Internationally, the division sells to various nationalized industries in Russia and Mexico.

    The compressor business was cyclical, and during the down times the division had experienced considerable turnover within key management positions.  John was not totally confident of the division president, Henry Hall. Not only was Henry relatively new to the position, but he represented the side of the business that had supported one of John's competitors for the position of president.

    Even though John's open door policy was well known, employees were still taking a risk if they brought complaints involving their superiors. John was a bit concerned that Alice was bypassing Henry Hall in coming to see him, but he had to stick to his policy. Alice had combined the visit to him with a meeting at corporate headquarters of staff controllers from all of the divisions. The conversion proceeded as follows:

Alice: "While at a cocktail party, I overheard a couple of field engineers talking about a broken crankshaft in the large high speed 1200 engine. A newly developed oil-cooled crankshaft has been installed in our large high speed engines. At sustained heavy loads, the crankshaft has failed in two of the first engines sold."

John: "Wait a minute, these engines have been a hot item and have provided much of the business for the compressor division over the last three years. My understanding is that the oil-cooled crankshafts are actually replacements for the originally installed shafts."

Alice: "Yes, the original shafts failed because of overheating under heavy loads. The oil-cooled shafts were actually the old style shafts that the factory drilled holes into. The drilling process had proven to cause the metal to weaken where the bearings are attached. So the correct solution is to alter the metallurgical content of the shaft, which means changing this second generation shaft."

John: "But, certainly, the oil-co0led crankshaft was tested before being installed."

Alice: "That's just the issue. The out-of-pocket costs of testing the new design were thought to be too great. Besides, the costs were not in the division's budget, so the plan was to acquire the new shaft and install them in the failed engines and do the testing under field conditions.

John: "But I've seen the R&D expenditures and they certainly look high enough to have covered the cost of testing these shafts."

Alice: "What you have seen is not R&D, but warranty expense."

John: "That can't be. The R&D expense is listed in the 10-K specifically to inform the investors, and these numbers are certainly audited by our external accountants."

Alice: "Yes, but the same department, field engineering, handles both R&D and warranty. To reduce costs, Hall combined the engineering efforts and closed the permanent test facility. Thus when a customer has a problem, the field office handles it. If repair parts are required, the field engineer orders it from the parts warehouse and it is picked up in our own trucks and charged to R&D. The rationalization is that, with faulty designs, they should have the opportunity to correct the designing. Besides, Hall has pushed to keep warranty expense as low as possible. You know that if an abnormal warranty problem exists accounting rules require reserving for the estimated costs."

John: "So if the warranty work is not recognized as warranty then there would be no accrual. And if there is no accrual, then the income has been overstated for the division."

Alice: "Exactly."

John: "But wouldn't the internal auditing department or the independent auditors catch this?"

Alice: "You know the audit process. Twice a year a junior member of the internal auditing staff comes to the customer service manager. The manager shows him information about warranty problems under the ninety-day guarantee. Things look the same year to year. But the major problems are resolved by the field engineers and never come to the customer service department. The internal auditors have never looked into this issue."

John: "What is the estimate of the warranty problem at present?"

Alice: "There are at least thirty engines out there that have the replacement crankshaft. By year end, the problem will be apparent to our customers and they will be screaming for correction. I would estimate the problem to be in excess of $3 million."

    John thanked Alice and sent her on her way. After she left, he sat and figured. The $3 million means a five cent reduction in earnings per share. Further, the five cent loss will cause Maryland's increase to be below the 10% increase in operating profits that was projected for the year in the last quarterly meeting with the financial analysts. The warranty problem was a real surprise.

What are the ethical issues? What should John do?