Midwest Industries produces and distributes industrial chemicals in its Belco Division, which is located in Michigan's Upper Peninsula. Belco's earnings increased sharply in 2016, and bonuses were paid to the management staff for the first time in three years. Bonuses are based in part on the amount by which reported income exceeds budgeted income.
Maria Gonzales, vice president of finance, was pleased with reported earnings for 2016 and therefore thought that pressure to "show" financial results would subside. However, Tom Lin, Belco's division manager, told Gonzales that he "saw no reason why bonuses for 2017 should not be double those of 2016." As a result, Gonzales felt pressure to increase reported income to exceed budgeted income by an even greater amount, a situation that would ensure increased bonuses.
Gonzales met with Bill Wilson of P&R, Inc., a primary vendor of Belco's manufacturing supplies and equipment. Gonzales and Wilson have been close business contacts for many years. Gonzales asked Wilson to identify all of Belco's purchases of perishable supplies as "equipment" on sales invoices issued by P&R. The reason Gonzales gave for her request was that Belco's division manager had imposed stringent budget constraints on operating expenses, but not on capital expenditures. Gonzales planned to capitalize (rather than expense) the cost of perishable supplies and then includes them in the equipment account on the balance sheet. In this way, Gonzales could defer the recognition of expenses to a later year. This procedure would increase reported earnings, which in turn would lead to higher bonuses (in the short run). Wilson agreed to do as Gonzales had asked.
While analyzing the second quarter financial statements, Gary Wood, Belco's director of cost accounting, noticed a large decrease in supplies expense from a year ago. Wood reviewed the Supplies Expense account and noticed that only equipment, not supplies, had been purchased from P&R, a major source for such supplies. Wood, who reports to Gonzales, immediately brought this to the attention of Gonzales.
Gonzales told Wood of Lin's high expectations and of the arrangement made with Wilson (from P&R). Wood told Gonzales that her action was an improper accounting treatment for the supplies purchased from P&R. Wood requested that he be allowed to correct the accounts and urged that the arrangement with P&R be discontinued. Gonzales refused the request and told Wood not to become involved in the arrangement with P&R.
After clarifying the situation in a confidential discussion with an objective and qualified peer within Belco, Wood arranged to meet with Lin, Belco's division manager. At that meeting, Wood disclosed the arrangement Gonzales had made with P&R.
Required
1. Explain why the use of alternative accounting methods to manipulate reported earnings is unethical, if not illegal.
2. Is Gary Wood, Belco's director of cost accounting, correct in saying that the supplies purchased from P&R, Inc., were accounted for improperly? Explain.
3. Assuming that the agreement of Gonzales with P&R was in violation of the IMA's Statement of Ethical Professional Practice (www.imanet.org), discuss whether Wood's actions were appropriate or inappropriate.