Compensation and earnings quality (LO 7-4)

Margaret Magee has served both as an outside director to Maxcor Manufacturing since 2010 and as a member of the company's compensation committee since 2014. Margaret has been reviewing Maxcor's 2017 preliminary earnings statement in preparation for the February 2018 board and compensation committee meetings. She is uneasy about the company's definition and computation of operating profits for 2017, particularly because management bonuses at Maxcor are based on achieving specific operating profit goals.

Maxcor Manufacturing

Consolidated Results of Operations

Years Ended December 31,

($ in millions)

2017

2016

Sales

$98.4

$111.2

Operating costs

Cost of goods sold

(81.5)

(92.2)

Selling, general, and administrative expenses

(12.5)

(12.9)

Operating profit

4.4

6.1

Research and development expenses (see note)

(5.7)

(2.4)

Provision for plant closings (see note)

(2.6)

-0-

Interest expense

(2.9)

(2.6)

Other income

0.7

1.2

Profit (loss) before taxes

(6.1)

2.3

Provision (credit) for income taxes

2.1

(0.8)

Profit (loss) of consolidated companies

(4.0)

1.5

Equity in profit of affiliated companies

0.2

0.3

Profit (loss)

$ (3.8)

$ 1.8

The preliminary financial statements also contained the following notes:

Research and Engineering Expenses. Research and engineering expenses include both amounts charged to Research and development expenses for new product development and charges originally made to Cost of goods sold for ongoing product improvements. The amounts (in millions) for 2017 and 2016 were:

2017

2016

Research and development expenses

$5.7

$2.4

Cost of goods sold

2.9

6.3

Research and engineering expense

$8.6

$8.7

Plant Closing Costs. In 2017, the Company recorded provisions for plant closing and staff consolidation costs totaling $2.62 million. Included in this total are charges related to the probable closing of the Company's York, Pennsylvania, facility ($1.75 million), the consolidation of the North American operations of the Building Construction Products Division ($0.63 million), and charges to reflect lower estimates of the market value of previously closed U.K. facilities ($0.24 million). These costs include the estimated costs of employee severance benefits, net losses on disposal of land, buildings, machinery and equipment, and other costs incidental to the closing and planned consolidation.

Maxcor Manufacturing is an established, privately held manufacturer that operates in two principal business segments: Building construction products, which involves the design, manufacturing, and marketing of construction and materials-handling machinery, and Engines for page 372various off-highway applications. Before 2017, the company had experienced 15 years of steadily increasing sales and operating profits.

The company was founded in 1938 by Hugh Maxwell, a former Ford Motor Company engineer. Neither Maxwell nor any members of his family are currently company officers. Maxcor's common stock is held by the Maxwell Family Trust (35%), the Maxwell Employee Stock Ownership Plan (ESOP) Trust (50%), a venture capital firm (13%), and current management (2%). Magee also serves as an outside trustee for the Maxwell ESOP Trust.

Maxcor's senior management participates in an incentive bonus plan that was first adopted in 2007. The bonus formula for 2017 was approved by the compensation committee at its February 2017 meeting. According to the plan, each senior manager's 2017 bonus is to be determined as follows:

Bonus as Percentage of 2017 Salary

2017 Operating Profits

($ in millions)

0%

Below $4.0

100

At least $4.0

200

At least $6.0

300

At least $8.0

The compensation committee can award a lower amount than that indicated by the plan formula if circumstances warrant such action. No bonus reductions have occurred since the plan was adopted in 2007.

Required:

Why might Magee feel uneasy about Maxcor's computation of 2017 operating profits? Should she approve the 100% bonus payment for 2017 as specified by the plan formula? What changes (if any) would you recommend be made to the bonus formula for next year?