Joe Duval was proud of the way he had guided Screen Technology Corporation over the past year since he had accepted the job as the company's president. Under Duval's direction, the privately held company's sales had grown each quarter, and several new sales contacts in Europe looked promising for future business. Duval had taken a personal interest in developing new business, and the company's future looked bright. Duval had also seen to it that the company's costs had remained in check. One of the new president's first moves had been to benchmark several of Screen Technology's performance measures against other high-tech electronics firms. Duval was convinced that the company's production technology and business practices were as efficient as any firm in the business.

Screen Technology Corporation had been formed some five years earlier to manufacture aperture masks, which are an important component in computer monitors and TV picture tubes. Aperture masks direct a beam of electrons to the red, blue, and green phosphor stripes on the inside face of a picture tube.

Thus, the aperture mask is a critical component in the creation of a color picture on the computer monitor or TV tube. Ranging in size from 18 to 90 centimeters, Screen Technology's masks are manufactured from nickel alloy. Several patented manufacturing steps are used to produce the aperture masks, including highly accurate photographic and etching processes, chemical coating processes, and cleaning processes. Screen Technology's masks already were being marketed in North America and Asia, and negotiations were proceeding with several potential European customers.

At the beginning of his second year on the job, Duval had been looking forward to the fourthquarter financial statements. Upon reading the financial reports, though, Duval was dismayed when he saw that Screen Technology's fourth-quarter profit was actually lower than that reported in the third quarter. "What's going on here?" he thought. Duval picked up the phone to call Alison West, Screen Technology's controller, for an explanation.

Shown here are the third- and fourth-quarter income statements that were perplexing Duval.

When Alison West arrived at Joe Duval's office, she could see the president was upset and puzzled.
"You're the controller, Alison," began Duval. "I hope you have a good explanation for this. When sales go up from one quarter to the next, and production efficiency and standard costs remain about the same, I would expect profits to increase also. And I can assure you that our owners will expect increased profits, too, when I go to the quarterly meeting next week."
West tried to explain to Duval why Screen Technology's profit had fallen, even though sales had risen substantially. "Our financial statements are prepared using absorption costing," explained West.
"This means that all manufacturing costs are treated as product costs. Direct material, direct labor, and all manufacturing overhead costs are stored in inventory until the units are sold. It's true that sales rose during the fourth quarter, but production did not keep pace with sales. In fact, actual fourth-quarter production was somewhat lower even than our planned production for the quarter. When that happens, we end up expensing fixed manufacturing overhead during the current period, even though it was incurred during a previous period."

"Well. I'm no accountant." retorted Duval. "I'm an engineer and I've spent most of m\ career in marketing. But this just doesn't seem reasonable to me. It sales go up. and production efficiency remains more or less the same, then I still think income ought to go up. I was counting on a bonus this quarter, and I would think you would' ve been expecting one. too. Can't you produce an income statement where profits increase when sales increase?"
"Yes. I can. Joe." replied the controller. "I can use a method called variable costing instead of absorption costing. Under that method, fixed manufacturing overhead is expensed during the period it's incurred.
That effectively eliminates the kind of distortion that's bothering you. Since Screen Tech is a privately held company, we can use either method we want. The owners should be informed if we change methods, though. And they should also be made aware of the effect of the change on executive bonuses."
"I think we should change to the other method, then." responded Duval. "What'd you call it?
Variable costing, was it 1" "That's right. Joe. It's called variable costing because only variable manufacturing costs arc inventoried."
"Okay, here's what I would like you to do. Alison. Please prepare third-quarter and fourth-quarter income statements for me using variable costing. Then come along w ith me to next week's meeting and explain to our bosses why the results differ."
"You got it." replied West. "And I'll show you the effect of the accounting method change on the balance sheet also."
"That sounds good." replied Duval. "By the way, is there a down side to variable costing'1 What do you see as the advantages and disadvantages ?"
Before West could respond. Duval got a phone call from an important customer. Before meeting with Duval again to answer his last question. West prepared the following third-quarter and fourth quarter income statements. She also summarized the effect of the proposed accounting method change on Screen Technology 's comparative balance sheets.

Required:
1. How would you respond to the president's last question to the controller regarding the pros and cons of variable and absorption costing?

2. Prepare a reconciliation oi the reported fourth-quarter income under variable and absorption costing.
3. Explain how and why the balance sheets differ under variable and absorption costing.
4. Would there be differences in reported income under variable and absorption costing if the statements had been annual statements instead of quarterly statements? Explain.
5. Roughly how busy was Screen Technology's production operation during the fourth quarter relative to the expected production volume? Explain.
6. Discuss the following comment made by Duval to West the next afternoon. Citing specific ethical standards for managerial accountants (given in Chapter 1), explain how West should respond.
"Alison, I've been thinking about this whole issue some more. Why don't we just choose between variable and absorption costing each quarter, depending on which will report the highest profit for the quarter and give us the biggest bonuses?"

Transcribed Image Text:

SCREEN TECHNOLOGY CORPORATION Income Statements For the 3rd and 4th Quarters of 20x3 Sales revenue Less: Cost of goods sold (at standard absorption cost). Gross margin (at standard) .... Adjust for: Fixed overhead volume variance* Gross margin (at actual).... Less: Selling and administrative expenses... 3rd Quarter 4th Quarter $5,040,000 $7,920,000 3,780,000 5,940,000 $1,260,000 $1,980,000 360,000 360,000 $1,620,000 $1,620,000 720,000 960,000 $ 900,000 $ 660,000 Net income... *There were no other variances during the 3rd or 4th quarters of 20x3. The 3rd-quarter volume variance is negative (or favorable), and the 4th-quarter volume variance is positive (or unfavorable).