Management decisions and external financial reports. "Squeezing oranges in your idle time is not a by-product." said the Big Five partner in charge of the audit of Regent Company disapprovingly. "But," replied the president of Regent, "squeezing oranges is not our usual business, and your accounting plan will make us show a substantial decline in income. We all know that our decision this year to squeeze oranges was a good one that is paying off handsomely."

The argument concerned the accounting for income during the year 2000 by Regent Company.

Background: The Alcoholic Control Board (ACB) of Georgia, a state not known for its production of grapes and wines, wanted to encourage the production of wine within the state. The executives formed the Regent Company in response to the encouragement oft he ACB. The production process for wine involves aging the product.

The company commenced production in 1994, but did not sell its first batch of wine until 1996. At the start of 1994, Regent made a cash investment of $4,400,000 in grape-pressing equipment and a facility to house that equipment. The ACB has promised to buy Regent Company's output for 10 years, starting with the first batch in 1996. Regent Company decided to account for its operations by including in the cost of the wine all depreciation on the grape-pressing equipment and on the facility to house it. The firm judged the economic life of the equipment to be 10 years, the life of the contract with the ACB. Regent Company reported general and administrative expenses of $ 100,000 per year in external financial reports for both 1994 and 1995.

Regent Company's contract with the ACB promised payments of $1.8 million per year. The direct costs of labor and materials for each year's batch of wine were

$130,000 each year. Accounting charges depreciation on a straight-line basis over a 10-year life. The income taxes were 40 percent of pretax income.

The wine sales began in 1996 and operations proceeded as planned. The income statements for the years 1996 through 1999 appear in Exhibit 13.5.

Management of Regent Company was delighted with the offer from a manufacturer of f rozen orange juice to put its idle capacity to work. It contracted with the manufacturer to perform the services. At the end of 2000, it compiled the income statement shown in Exhibit 13.5 as "Management's View."

The Accounting Issue: Management of Regent Company suggested that the revenues from squeezing oranges are an incremental by-product of owning the winemaking machinery. The wine-making process was undertaken on its own merits and has paid off according to schedule. The revenues from squeezing oranges are a by-product of the main purpose of the business. Ordinarily, the accounting for by-products assigns to them costs equal to their net realizable value; that is, accounting assigns costs in exactly the amount that will make the sale of the by-products show neither gain nor loss. In this case, because the incremental revenue of squeezing oranges was $1 ()().()()(). Regent Company assigned $100,000 of the overhead to this process, reducing from $440. 000 to $340,000 the overhead assigned to the main product.

This will make the main product appear more profitable when it is sold.

Management of Regent Company was aware that its income for 2000 would appear no different from that of the preceding year. Management knew that the benefits from squeezing oranges began to occur in 2000 but allowed the benefits to appear on the financial statements later.

The Big Five auditor who saw management's proposed income statement disapproved.

The partner in charge of the audit spoke as quoted at the beginning of this case.

The auditor argued that squeezing oranges under these circumstances was not a by-product and that by-product accounting was inappropriate. Regent Company must allocate the overhead costs between the two processes of grape pressing and orange squeezing according to some reasonable basis. The most reasonable basis, the auditor thought, was the time devoted to each of the processes. Because grape pressing used about 20 percent of the year, whereas orange squeezing used 80 percent of the year, the auditor assigned $352,000, or 80 percent, of the overhead costs to orange squeezing and $88,000, or 20 percent, to the wine production. Exhibit 13.5 shows the auditor's income statement.

This statement upset the president of Regent Company. Reported net income in 2000 is down almost 30 percent from 1999, yet things have improved. The president fears the reaction of the board of directors and the shareholders. The president wonders what has happened and what to do.

a. Assuming that the Regent Company faces an after-tax cost of capital of 10-percent, did the company in fact make a good decision in 1993 to enter into an agreement with the state to produce wine? Explain.

b. Did the company in fact make a good decision in 1999 to enter into the agreement with the manufacturer of frozen orange juice?

c. Using management's view of the proper accounting practices, construct financial statements for the years 2001, 2002, and 2003, assuming that events occur as planned and in the same way as in 2000. Generalize these statements to later years.

d. Are management's statements correct given its interpretation of by-product accounting?
Ifn ot, construct an income statement for 2000 that is consistent with by-product accounting.

e. Is management correct in its interpretation that the orange juice is a by-product?

f. Using the auditor's view of the situation and assuming the same facts as in part

c, construct income statements for the years 2001, 2002, and 2003. Generalize these statements to later years.
g. Assuming that the auditor is right, what may management of Regent Company do to solve its problem?