Louise Stinson, the chief financial officer of Bostonian Corporation, was on her way to the president’s office. She was carrying the latest round of bad news. There would be no executive bonuses this year. Corporate profits were down. Indeed, if the latest projections held true, the company would report a small loss on the year-end income statement. Executive bonuses were tied to corporate profits. The executive compensation plan provided for 10 percent of net earnings to be set aside for bonuses. No profits meant no bonuses. While things looked bleak, Stinson had a plan that might help soften the blow.
After informing the company president of the earnings forecast, Stinson made the following suggestion: Since the company was going to report a loss anyway, why not report a big loss? She reasoned that the directors and stockholders would not be much more angry if the company reported a large loss than if it reported a small one. There were several questionable assets that could be written down in the current year. This would increase the current year’s loss but would reduce expenses in subsequent accounting periods. For example, the company was carrying damaged inventory that was estimated to have a value of $2,500,000. If this estimate were revised to $500,000, the company would have to recognize a $2,000,000 loss in the current year. However, next year when the goods were sold, the expense for cost of goods sold would be $2,000,000 less and profits would be higher by that amount. Although the directors would be angry this year, they would certainly be happy next year. The strategy would also have the benefit of adding $200,000 to next year’s executive bonus pool ($2,000,000 x 0.10). Furthermore, it could not hurt this year’s bonus pool because there would be no pool this year since the company is going to report a loss.
Some of the other items that Stinson is considering include
(1) Converting from straight-line to accelerated depreciation,
(2) Increasing the percentage of receivables estimated to be uncollectible in the current year and lowering the percentage in the following year, and
(3) Raising the percentage of estimated warranty claims in the current period and lowering it in the following period. Finally, Stinson notes that two of the company’s department stores have been experiencing losses. The company could sell these stores this year and thereby improve earnings next year. Stinson admits that the sale would result in significant losses this year, but she smiles as she thinks of next year’s bonus check.
Required
a. Explain how each of the three numbered strategies for increasing the amount of the current year’s loss would affect the stockholders’ equity section of the balance sheet in the current year. How would the other elements of the balance sheet be affected?
b. If Stinson’s strategy were effectively implemented, how would it affect the stockholders’ equity in subsequent accounting periods?
c. Comment on the ethical implications of running the company for the sake of management (maximization of bonuses) versus the maximization of return to stockholders.
d. Formulate a bonus plan that will motivate managers to maximize the value of the firm instead of motivating them to manipulate the reporting process.
e. How would Stinson’s strategy of overstating the amount of the reported loss in the current year affect the company’s current P/E ratio?