Chapter 1 Ethical Reasoning: Implications for Accounting 43 Case 1-9 Cleveland Custom Cabinets Cleveland Custom Cabinets is a specialty cabinet man facturer for high-end homes in the Cleveland Heights and Shaker Heights areas. The company manufactures cabinets built to the specifications of homeowners and employs 125 custom cabinet makers and installers. There are 30 admin- istrative and sales staff members working for the company James Leroy owns Cleveland Custom Cabinets. His accounting manager is Marcus Sims. Sims manages 15 accountants. The staff is responsible for keeping track of manufacturing costs by job and preparing internal and exter- nal financial reports. The internal reports are used by man agement for decision making. The external reports are used to support bank loan applications. The company applies overhead to jobs based on direct labor hours. For 2011, it estimated total overhead to be 9,600,000 and 80,00X) direct labor hours. The cost of direct materials used during the first quarter of the year is $600,000 and direct labor cost is $400,000 (based on 20.000 hours worked) The company's accounting system is old and does not provide actual overhead information until about four weeks after the close of a quarter. As a result, the applied overhead amount is used for quarterly reports. On April 10, 2011, Leroy came into Sims's office to pick up the quarterly report. He looked at it aghast. Leroy had planned to take the statements to the bank the next day and meet with the vice president to discuss a $1 million expan- sion loan. He knew the bank would be reluctant to grant the loan based on the income numbers in Exhibit 1. Leroy asked Sims to explain how net income could have gone from 14.2 percent of sales for the year ended December 31, 2010, to 14 percent for March 31, 2011. Sims pointed out that the estimated overhead cost had doubled for 2011 when compared with the actual cost for 2010. He explained to Leroy that rent had doubled and the cost of utilities sky- rocketed In addition, the custom-making machinery was wearing out more rapidly so the company's repair and main- tenance costs also doubled from 2010, Leroy understood but wouldn't accept Simss explanation Instead, he told Sims that as the sole owner of the company, there was no reason not to "tweak the numbers on a one- time basis. "I own the board of directors so no worries there. Listen, this is a one-time deal. I won't ask you to do it again." Leroy stated. Sims started to soften and asked Leroy just how he expected the tweaking to happen. Leroy flinched, held up his hands, and said, "I'll leave the creative accounting to you." Questions 1. Do you agree with Leroy's statement that it doesn't matter what the numbers look like since he is the sole owner? Even if it is true that Sims "owns" the board of directors, what should be their role in this matter? 2. a. Assume Sims is a CPA and holds the CMA. What are the ethical considerations for him in deciding whether to tweak the numbers? What should Sims do and why? b. Assume Sims did a utilitarian analysis to help decide what to do. Evaluate the harms and benefits of alterna tive courses of action 3. Assume Sims decided to reduce the estimated overhead for the year by 50 percent. How would that change the net income for the quarter? What would it be as a percentage of sales? Do you think Leroy would like the result? Do you think he will be content with the tweaking occurring just this one time? EXHIBIT 1 CLEVELAND CUSTOM CABINETS Net Income for the Quarter Ended March 31, 2011 Sales $6,400,000 Cost of goods manufactured 4,800,000 Gross margin $1,600,000 Selling and administrative expenses 1,510,000 Net Income $ 90,000 Chapter 1 Ethical Reasoning: Implications for Accounting 43 Case 1-9 Cleveland Custom Cabinets Cleveland Custom Cabinets is a specialty cabinet man facturer for high-end homes in the Cleveland Heights and Shaker Heights areas. The company manufactures cabinets built to the specifications of homeowners and employs 125 custom cabinet makers and installers. There are 30 admin- istrative and sales staff members working for the company James Leroy owns Cleveland Custom Cabinets. His accounting manager is Marcus Sims. Sims manages 15 accountants. The staff is responsible for keeping track of manufacturing costs by job and preparing internal and exter- nal financial reports. The internal reports are used by man agement for decision making. The external reports are used to support bank loan applications. The company applies overhead to jobs based on direct labor hours. For 2011, it estimated total overhead to be 9,600,000 and 80,00X) direct labor hours. The cost of direct materials used during the first quarter of the year is $600,000 and direct labor cost is $400,000 (based on 20.000 hours worked) The company's accounting system is old and does not provide actual overhead information until about four weeks after the close of a quarter. As a result, the applied overhead amount is used for quarterly reports. On April 10, 2011, Leroy came into Sims's office to pick up the quarterly report. He looked at it aghast. Leroy had planned to take the statements to the bank the next day and meet with the vice president to discuss a $1 million expan- sion loan. He knew the bank would be reluctant to grant the loan based on the income numbers in Exhibit 1. Leroy asked Sims to explain how net income could have gone from 14.2 percent of sales for the year ended December 31, 2010, to 14 percent for March 31, 2011. Sims pointed out that the estimated overhead cost had doubled for 2011 when compared with the actual cost for 2010. He explained to Leroy that rent had doubled and the cost of utilities sky- rocketed In addition, the custom-making machinery was wearing out more rapidly so the company's repair and main- tenance costs also doubled from 2010, Leroy understood but wouldn't accept Simss explanation Instead, he told Sims that as the sole owner of the company, there was no reason not to "tweak the numbers on a one- time basis. "I own the board of directors so no worries there. Listen, this is a one-time deal. I won't ask you to do it again." Leroy stated. Sims started to soften and asked Leroy just how he expected the tweaking to happen. Leroy flinched, held up his hands, and said, "I'll leave the creative accounting to you." Questions 1. Do you agree with Leroy's statement that it doesn't matter what the numbers look like since he is the sole owner? Even if it is true that Sims "owns" the board of directors, what should be their role in this matter? 2. a. Assume Sims is a CPA and holds the CMA. What are the ethical considerations for him in deciding whether to tweak the numbers? What should Sims do and why? b. Assume Sims did a utilitarian analysis to help decide what to do. Evaluate the harms and benefits of alterna tive courses of action 3. Assume Sims decided to reduce the estimated overhead for the year by 50 percent. How would that change the net income for the quarter? What would it be as a percentage of sales? Do you think Leroy would like the result? Do you think he will be content with the tweaking occurring just this one time? EXHIBIT 1 CLEVELAND CUSTOM CABINETS Net Income for the Quarter Ended March 31, 2011 Sales $6,400,000 Cost of goods manufactured 4,800,000 Gross margin $1,600,000 Selling and administrative expenses 1,510,000 Net Income $ 90,000