Eric Johnson was recently promoted to Controller of Research and Development (R&D) for LUX Pharma, a Fortune 500 pharmaceutical company, which manufactures prescription drugs and nutritional supplements. The companys total R&D cost for 2012 was expected (budgeted) to be $5 billion. During the companys mid-year budget review, Eric realized that current R&D expenditures were already at $3.5 billion, nearly 40% above the mid-year target. At this current rate of expenditure, the R&D division was on track to exceed its total year-end budget by $2 billion!

In a meeting with CFO, James Clark, later that day, Johnson delivered the bad news. Clark was both

shocked and outraged that the R&D spending had gotten out of control. Clark wasnt any more understanding when Johnson revealed that the excess cost was entirely related to research and development of a new drug, Lyricon, which was expected to go to market next year. The new drug would result in large profits for LUX Pharma, if the product could be approved by year-end. Clark had already announced his expectations of third quarter earnings to Wall Street analysts. If

the R&D expenditures werent reduced by the end of the third quarter, Clark was certain that the targets he had announced publicly would be missed and the companys stock price would tumble. Clark instructed Johnson to make up the budget short-fall by the end of the third quarter using whatever means necessary. Johnson was new to the Controllers position and wanted to make sure that Clarks orders were followed. Johnson came up with the following ideas for making the third quarter budgeted targets:

a. Stop all research and development efforts on the drug Lyricon until after year-end. This change would delay the drug going to market by at least six months. It is also possible that in the meantime a

LUX Pharma competitor could make it to market with a similar drug.

b. Sell off rights to the drug, Markapro. The company had not planned on doing this because, under current market conditions, it would get less than fair value. It would, however, result in a onetime gain that could offset the budget short-fall. Of course, all future profits from Markapro would be lost.

c. Capitalize some of the companys R&D expenditures reducing R&D expense on the income statement. This transaction would not be in accordance with accounting standards, but Johnson thought it was justifiable, since the Lyricon drug was going to market early next year. Johnson would argue that capitalizing R & D costs this year and expensing them next year would better match revenues and expenses.

REQUIRED:

1. Referring to the Standards of Ethical Behavior for Practitioners of Management Accounting and Financial Management, which of the preceding items (ac) are acceptable to use? Which are unacceptable? EXPLAIN YOUR ANSWERS (9 marks)

2. What would you recommend Johnson do? Explain in details. (3 marks)