Case Overview – Hannington v. University of Pennsylvania, 809 1. 2d 406 (Pa. Super. 2002)

 

Hannington was a graduate student at the University of Pennsylvania and brought suit against the University for breach of contract. Hannington’s attorney sent Penn’s attorney a draft of a settlement agreement, which Penn signed and sent back to Hannington. But Hannington then refused to sign the settlement agreement, hired a new attorney, and opted to proceed to trial. The trial court refused to allow Hannington’s case to go forward, holding that Hannington’s former attorney had had “apparent authority” to settle the case. Hannington appealed, and the Superior Court of Pennsylvania affirmed the trial court’s decision, ruling in favor of Penn (Melvin and Katz, 2015).

From a legal aspect, this case involves the liability of the principal for acts of the agent, specifically touching on authority, and, in this case, apparent authority. The legal definition of apparent authority is when “an agent may also gain power to bind the principal from the appearance of legitimate authority to a third party,” and the key to understanding this party is “to determine whether a third party was objectively reasonable in her belief that the apparent agent is in fact authorized to act for the principal” (Melvin and Katz, 2015). The innocent party in this case, the University of Pennsylvania, had reasonable cause to believe that Hannington’s attorney was authorized to draft a settlement agreement. This led to their decision to rely on his attorney as an agent, and to thus agree with the terms of the settlement and sign it. As The National Public Accountant states, this type of liability can arise when either a former or current employee undertakes tasks which the firm does not sanction, endorse, or normally practice, but which appear to a 3rd party to constitute services approved and endorsed by the principal (1997). In these types of cases, the client (grad student Hannington,) usually asserts that he wouldn’t have entered into business with the agent and didn’t grant him the authority to make the settlement, in spite of the fact that the situation’s appearance suggested otherwise.

From a social aspect also, Hannington does not have the right in this case. The third party, Penn’s legal representatives, had every reason to believe that Hannington’s lawyer was acting as an agent with authority for his principal (Hannington.) He had apparent authority legally to offer the settlement, but it was also obvious from the social circumstances that the lawyer was Hannington’s agent. Penn had no reason to believe that Hannington’s lawyer was acting against his client’s wishes, because an attorney does not usually do this. Nor is Penn responsible for the situation between Hannington and his attorney. All they know is that an agent with apparent authority gave them a settlement agreement, and they wanted the settlement to happen, so they signed it.

From a business perspective, “the best first step for an association to take in protecting itself from unknowingly bestowing apparent authority upon volunteers is to adopt an official policy as to who may speak for the association” (Webster, 1996). A common business example of the relationship between an agent and a principal is the bond between employer and employee. Essentially, this is what Hannington’s attorney is to Hannington. These two allowed their miscommunication issues to affect their business relationship with a third party, the University of Pennsylvania, which was bad business conduct on their part. Hannington and his attorney could have avoided putting Penn into this position altogether if they had clearly expressed to Penn the type of authority that Hannington’s attorney actually had, or adopting “an official policy as to who may speak for the association,” as Webster suggests above. In a business context, the authority of the principal over the agent is an important concept, one that can endanger their relationships with each other, their business, and their relationships with third parties. It is best that this authority is clearly defined so that these types of issues don’t happen.

From an ethical standpoint also, Hannington has no right to bring a case against the University of Pennsylvania for signing a settlement agreement that they had every reason to believe was approved by Hannington himself. Giving off the impression that someone has the authority to act for you when they don’t, endangers your business relationship with them, as well as their trust in your authority. The Bible speaks to the principles of authority, which ability Hannington in effect gave to his attorney when he hired him. Penn reasonably assumed that Harrington’s attorney had authority – and due to their limited knowledge of the true situation, they cannot be held liable for signing a document that the principal did not approve, since they had every reason to assume he had.

            1.) Suppose in the middle of settlement negotiations, Hannington becomes frustrated with the impasse. He hires his neighbor, another attorney not yet involved in the case, to draft a settlement agreement and sends it to Penn. Is apparent authority created in this circumstance? Explain.

 

           Apparent authority would still be created in this circumstance, seeing as how Penn would still reasonably assume that Harrington’s new lawyer has authority to act as an agent for his principal by drafting a settlement agreement. Whether or not the lawyer was already involved in the case is a moot point, because either way the attorney is currently acting as an agent with authority for his principal Hannington.

            2.) Since Hannington never actually signed the agreement, was it reasonable for Penn to assume that Hannington’s attorney had obtained his express consent to the terms? Has the court effectively deprived Hannington of his right to proceed to trial?

           

           Even though Hannington’s signature was not on the settlement document, Penn could still reasonably assume that the attorney had obtained his client’s consent to the terms – he was, after all, acting as an agent for Hannington, meaning that he had appearance of authority to draft documents and speak for his client. Just because Hannington did not agree, does not mean that Penn is held liable. Hannington thus had no right to proceed to trial against Penn, since Penn was acting on the apparent authority assumption of Hannington’s relationship with his attorney.

Reference:

“Apparent authority". (1997). The National Public Accountant, 42(10), 6-8. Retrieved from http://search.proquest.com/docview/232353633?accountid=12085

Melvin, Sean P. and Katz, Michael A. (2015). The Legal Environment of Business: A Managerial Approach: Theory to Practice, 2^nd Edition. McGraw-Hill Education LLC.

The Bible. KJV. Retrieved from www.biblegateway.com

Webster, G. D. (1996). Apparent authority. Association Management, 48(7), 147. Retrieved from http://search.proquest.com/docview/229293862?accountid=12085

Income Smoothing - A Question of Right and Wrong

Since I am a junior accounting student, I'm going to bore you all with an accounting research paper on income smoothing. (Also because it's my blog and I can.) I hope you find it somewhat interesting, because I certainly did. 

One of the most important functions of an accountant is his or her ability to accurately report financial information. A vital characteristic of that function is what is defined as “earnings quality,” or “the ability of reported earnings (income) to predict a company’s future earnings” (Spiceland, Sepe, & Nelson, 2013). Important decisions about the prospects of a company are based on its financial reports, such as the income statement, statement of cash flows, and the statement of owners’ equity. External users of this information, like outside investors, look at these reports to determine how well the company is doing, whether or not to continue investing in its stock, and to make their own financial decisions based upon this reported data. Internal users of the information also make important decisions about the future of their company using these financial statements, such as whether or not to expand in certain sectors, whether or not they should adjust their business methods, and where changes need to be made. If this vital financial information is understated, overstated, or distorted in any way, it is considered dishonest financial reporting. Although GAAP (Generally Accepted Accounting Principles) sets high standards to ensure that financial information is reported as accurately and honestly as possible, managers have still found ways under GAAP to slip through the cracks.

Among several of the methods for doing this is a managerial tactic known as “income smoothing,” a form of income manipulation. As CPA Larry B. Godwin points out in The CPA Journal, managers have a strong incentive to manipulate income because it minimizes uncertainty in the eyes of the investing public about the future performance of the company. He states correctly that, “A company whose progress is predictable is capable of attracting capital more easily than one that moves forward by fits and starts” (Godwin, 1977). Investors and creditors are not looking to invest their money or credit in a company whose income seems to vary wildly from year to year – they are looking for “safe” investments in companies that are stable and have relatively comparative profits and losses from year to year. C.R. Beidelman expounds on this in the “Accounting Review” as well, explaining that smoothing represents an attempt on the part of management to reduce “abnormal variations in earnings” as far as they’re allowed under accounting guidelines (Beidelman, 1973). According to Beidelman, there are three relevant questions one must ask regarding income smoothing: is it desirable for management to have smooth earnings? If desirable, can management create the appearance of smooth earnings? And thirdly, if desirable and possible, do firms succeed in their attempt to normalize reported income? (1973).

However, the most important question does not seem to be whether or not this tactic is desirable, possible, or feasible, but simply, whether or not it is right. Income smoothing has been a controversial topic for many years, and it is one that’s still under debate today. As Spiceland et al. point out, many believe that manipulating income in this way reduces an important aspect of financial reporting – earnings quality (Spiceland et al., 2013). This is because it can mask permanent earnings. The former Chairman of the SEC, Arthur Levitt, Jr., criticizes income manipulation by managers rather harshly by claiming that, “In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking maybe be winning the day over faithful representation” (as cited in Spiceland et al., 2013, p. 178). He goes on to say that because of this obsession with “smooth” income, the accounting world is witnessing an erosion in the quality of earnings, and therefore, the quality of financial reporting – “managing maybe be giving way to manipulation; integrity may be losing out to illusion” (2013).

These are rather powerful charges to bring against managers who are simply trying to make their companies look more stable by evening out profits and loss. And yet, when the actual methods of income smoothing are analyzed, Levitt’s harsh words and calls for accounting reform seem justified, by all ethical standards. There are two main methods of manipulating, (and therefore smoothing) income. These are income shifting, and income statement classification. Income shifting is when the recognition of revenues or expenses before or after they’ve actually occurred. Income statement classification manipulation, (also referred to as “big bath” accounting) involves the inclusion of recurring operating expenses in special charge categories such as “restructuring costs.” These “restructuring costs” cause reductions in income that might appear as normal operating expenses in future years (Spiceland, Sepe, & Nelson, 2013).

The first method of income smoothing, income shifting, is clearly at odds with one of the most fundamental principles of accounting – the matching principle, which states that expenses must be reported on the income statement in the same period as revenues. The motivation behind this principle is the same behind all financial reporting guidelines – to ensure transparency in financial reporting. It is not so much the technical violation of the matching principle that matters in income shifting. Rather, it is the fact that the underlying reason of implementing the matching principle in the first place is being violated when income is shifted in such a manner to “even out” gains and losses.

“Big bath accounting” is not much better in terms of ethical motivation. In the Journal of Business Finance and Accounting, Walsh, Craig, and Clarke state that, “Big bath accounting has been used to describe large profit reducing write-offs, or ‘income-decreasing discretionary accruals’ in profit and loss statements,” and furthermore that, “particular companies are reported to have cleansed their corporate souls by engaging in the practice” (1991). It is called “big bath” as a reference to cleaning up company balance sheets, and is simply another way to even out a business’ costs in order to make it look like they weren’t higher or lower in one year than in another (Spiceland et al., 2013).  

Aside from these two prominent income-smoothing tactics are several others, as outlined by Godwin in The CPA Journal: the most obvious one is switching up accounting principles to even out profit and loss. Another involves changes in accounting estimates. A more flexible smoothing device involves timing of sales investments. Yet another method of smoothing involves timing of shipments of products at the end of an accounting period (Godwin, 1977). Obviously managers who manipulate income using these tactics have discovered multiple means of bending the rules and working in the gray. They may not be expressly violating any GAAP rules – but they are violating the spirit of honest financial reporting that led to these regulations being set in place. 

As mentioned above, Levitt expresses a call for change by standard setters to “improve the transparency of financial statements” – not to eliminate necessary flexibility in financial reporting, but to make it easier for financial statement users to “see through the numbers” (as cited in Spiceland et al., 2013). It should be easy for any user, whether it is an employee looking for financial information about his company, or an investor looking for a return on his capital, to look at a company’s income statement, balance sheet, and statement of cash flows and “see through the numbers.” This is the entire purpose of lucid, accurate financial reporting. When income is shifted and balance sheets are “cleaned up,” it becomes difficult to muddle through the numbers and attempt to interpret the data correctly. This in turn can lead to misconceptions about the company’s actual financial standing, and to bad decisions on the part of both external and internal users.

One would think that managers would want to manipulate income by maximizing it to make it look higher than it really was, but this is not the primary incentive to managers who utilize income-smoothing tactics. Rather, their main purpose is implied in the name – to smooth income so that profits and losses appear to stay consistent from year to year. “Smoothing,” explains Ronald Copeland, former assistant professor at Pennsylvania State University, “moderates year-to-year fluctuations in income by shifting earnings from peak years to less successful periods” (Copeland, 1968). This lowers the peaks and lifts the troughs, effectively creating an even income stream and making earnings fluctuations less volatile. According to Chambers in The Accounting Review as cited by Copeland, managers have more choices than they perhaps realize when it comes to their methods of financial reporting – he calculated that “it is possible to measure a given firm’s income as any one of 30,000,000 figures, all determined according to generally accepted accounting principles” (as cited by Copeland, 1968). This is a wide scope of responsibility indeed. Even under GAAP, managers have considerable leeway when it comes to their methods. This leeway, as lamented by individuals such as Levitt, can lead to dabbling in less-than-honest income manipulation methods when managers try a little too hard to make their company look, not merely profitable, but stable.

In conclusion, income smoothing is a tactic utilized by company managers to shift profits and losses and make their company appear to be a safe investment. While flexibility in reporting is not necessarily dishonest, as any manager should have the option of deciding his own accounting methods, this type of manipulation is, for Hashem states unequivocally that, “The L-rd detests dishonest scales, but accurate weights find favor with Him…The integrity of the upright guides them, but the unfaithful are destroyed by their duplicity” (Proverbs 11:1-3). 

References:

              Arthur Levitt, Jr., “The Numbers Game,” The CPA Journal, December 1998, p. 16.

             

              Beidleman, C. R. (1973). Income Smoothing: The Role of Management. Accounting Review, 48(4), 653-667.

Chambers, R. J. (1966). “A Matter of Principle.” The Accounting Review. 41 (July 1966). P. 443-57       

Copeland, R.M. (1968). “Income Smoothing.” Journal of Accounting Research. Vol. 6, Empirical Research in Accounting: Selected Studies 1968 pp. 101-116. Published by: Wiley on behalf of Accounting Research Center, Booth School of Business, University of Chicago. Retrieved from http://www.jstor.org/stable/2490073

Godwin, L. B. (1977). Income smoothing. The CPA Journal (Pre-1986), 47(000002), 27. Retrieved from http://search.proquest.com/docview/211776350?accountid=12085

Spiceland, J. D., Sepe, J. F., & Nelson, M. W. (2013). Intermediate accounting (7th ed.,combined ed.). New York: McGraw-Hill Irwin.

Walsh, P., Craig, R., & Clarke, F. (1991). “ ‘Big Bath Accounting’ Using Extraordinary Items Adjustments: Australian Empirical Evidence.” Journal Of Business Finance & Accounting, 18(2), 173-189.