Case 3-29 (45 minutes)

1. Shaving 5% off the estimated direct labor-hours in the predetermined overhead rate will result in an artificially high overhead rate. The artificially high predetermined overhead rate is likely to result in overapplied overhead for the year. The cumulative effect of overapplying the overhead throughout the year is all recognized in December when the balance in the Manufacturing Overhead account is closed out to Cost of Goods Sold. If the balance were closed out every month or every quarter, this effect would be dissipated over the course of the year.

2. This question may generate lively debate. Where should Terri Ronsins loyalties lie? Is she working for the general manager of the division or for the corporate controller? Is there anything wrong with the Christmas bonus? How far should Terri go in bucking her boss on a new job? While individuals can certainly disagree about what Terri should do, some of the facts are indisputable. First, understating direct labor-hours artificially inflates the overhead rate. This has the effect of inflating the Cost of Goods Sold in all months prior to December and overstating the costs of inventories. In December, the huge adjustment for overapplied overhead provides a big boost to net operating income. Therefore, the practice results in distortions in the pattern of net operating income over the year. In addition, because all of the adjustment is taken to Cost of Goods Sold, inventories are still overstated at year-end. This means, of course, that the net operating income for the entire year is also overstated. While Terri is in an extremely difficult position, her responsibilities under the IMAs Statement of Ethical Professional Practice seem to be clear. The Credibility Standard states that management accountants have a responsibility to disclose all relevant information that could reasonably be expected to influence an intended users understanding of the reports, analyses or recommendations. In our opinion, Terri should discuss this situation with her immediate supervisor in the controllers office at corporate headquarters. This step may bring her into direct conflict with the general manager of the division, so it would be a very difficult decision for her to make.

In the actual situation that this case is based on, the corporate controllers staff were aware of the general managers accounting tricks, but top management of the company supported the general manager because he comes through with the results and could be relied on to hit the annual profit targets for his division. Personally, we would be very uncomfortable supporting a manager who will resort to deliberate distortions to achieve results. If the manager will pull tricks in this area, what else might he be doing that is questionable or even perhaps illegal?