FREQUENCY, RATES, AND EFFECTS OF TOV REVISIONS

Toshiba's Accounting Manual stipulated that "In principle, TOV revisions shall be conducted once a year prior to budgeting, and revisions shall not be conducted during the same budget period, excluding special cases" (Investigation Report, page 295). Despite the stipulation, S&S Company typically conducted revisions twice each year. Also, it revised TOVs (i.e., standard costs) only for the front-end process but not for the back-end process. In the back-end process, it continued to use the original (non-revised) (1 per unit) overhead allocation rate. This practice resulted in a fixed overheads cost variance in the back-end process, a portion of which was allocated to the work-in-progress inventory of the front-end process. By allocating a portion of the variance to the front-end WIP inventory, Toshiba effectively recorded a lower cost of goods sold in the back-end process, a lower cost of finished goods in the back-end process, and a higher cost of the work-in-progress of the front-end process. This understatement of the cost of goods sold kept on increasing with the growth in the work-in- progress inventory in the front-end process.11

Given the drastic reduction in the budgeted production volumes (and a corresponding reduction in the plant utilization rates), the S&S Company revised the TOVs (standard costs) even more frequently, particularly during the period of earnings management (2011-2014). As an example, one plant had TOVs revisions between 162% and 258% in FY 2011, 105% and 735% in FY 2012, 203% and 785% in FY 2013, and between 129% and 348% in FY 2014 (Investigation Report, page 296). Using the average revision from each year, one can calculate the cumulative effect of these revisions over the four years as 10413%. To state the effect in absolute amounts, if the overhead application rate was 1 per unit at the beginning of FY 2011, it was more than 104 per unit at the end of FY 2014! Such a dramatic change in the overhead rate, and the Company's practice of TOV revisions being made only for the front-end process (but not for the back-end process), resulted in the pretax profits of S&S Company being overstated by 10.3 billion in FY 2011, and 35.9 billion in FY 2012. In FY 2013 and FY 2014, while, the profits were understated by 11.9 billion, and 0.5 billion, respectively.

The allocation of cost variances could have been acceptable had S&S Company used a practice the Investigation Committee referred to as a Process-Specific Allocation Method. This method

11 Please note from Section 1 of the case that the work-in-progress inventory is considered as manufacturing inventory by the S&S Company. It is not subjected to the devaluation rules of Toshiba.

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would allocate the cost variance from the front-end process to the front-end WIP inventory and the cost variance from the back-end process to finished goods inventory and cost of goods sold of the back-end process. However, the S&S Company combined the total cost variance for the front-end and back-end processes and allocated the total variance to "front-end term-end inventory", "back -end term-end inventory", and "cost of goods sold". This method was referred to as the "Combined Allocation Method". The Investigation Report mentioned the acceptability of the Combined Allocation Method only when there are no abnormal circumstances.

Requirement 3

1. A drastic reduction in the plant utilization rate resulted in a dramatic increase in the per- unit fixed overhead costs. Yet, the profits of S&S Company were overstated (by 10.3 billion and 35.9 billion in FY 2011 and 2012, respectively). Explain how Toshiba was able to report higher profits despite a drastic increase in the fixed overhead costs per-unit during FY 2011 and FY 2012. You do not need to provide a computational proof.
2. The reduction in plant utilization rate and the corresponding increase in the cost per unit prevailed in FY 2013 and 2014 as well. However, the income was understated in these two years. Explain the reason for the reversal in the profit effect in FY 2013 and FY 2014 compared with FY 2011 and 2012.
3. How could the timely recognition of impairment of manufacturing inventory by S&S Company have offset the overstatement of profits caused by the incorrect allocation of cost variances?