Managerial Accounting

Project 4 Costing Methods and Earnings Management

Map Machines manufactures GPS systems that are used in motor vehicles. They are a publicly traded company and must report GAAP financial statements accordingly. In 2016, Map Machines received a commitment for 300,000 GPS units over the 2017 and 2018 fiscal years. While the commitment looks solid, the buyer has the right to purchase fewer units should they receive fewer orders for cars with the GPS option. Although the volume per year is also not guaranteed under the contract, Map Machines management, as well as stock market analysts, expect the contract to yield sales of 150,000 units per year.

Below is Map Machines financial information and projected income statement based on 150,000 units of production and sales (i.e. production = sales).

Additional Information:

• Map Machines current production capacity is 160,000 units.
• The company has very little warehouse space and prefers to produce and sell the same amount of units to eliminate inventory costs.
• Map Machines CEO receives a salary plus a bonus of 50% of salary if the company meets or beats its projected GAAP income.
• The company keeps variable costing income records for management decision purposes, but does not currently use them for compensation purposes since the income from these methods have been typically very similar in the past.
• R&D expenses are treated as fixed costs for variable costing purposes, but the amount spent on R&D is 100% at management discretion.

As of mid-2017, management has been notified by their buyer that GPS orders for the year will total 145,000 units rather than the 150,000 expected. The CEO is worried about the prospects of not meeting expected financial targets and has called on you, his financial planning team, to calculate GAAP and Variable Costing income under various scenarios and to make suggestions.

1.Using the income statements from the previous page as templates, calculate the GAAP (absorption costing) and variable costing income statements under 145,000 units of sales and production. How much will Map Machines miss their target earnings by?

2.Map Machines CEO suggests that the company produce 158,000 units in 2017 as a way to increase reported GAAP income. Calculate the GAAP and variable costing income statements under 145,000 units of sales and 158,000 units of production. How do the GAAP and variable costing income differ? What explains this difference?

3. Assume that Map Machines' large client honors their agreement to buy the remainder of the 300,000 units (155,000) in the following year (2018). Calculate the GAAP and variable costing income statements for 2018 if the company produced 158,000 units in the previous year and Map Machine finished 2018 with no inventory.

4. Discuss amongst the team whether it was a good decision to overproduce in order to meet Map Machines' GAAP earnings targets. What assumptions would need to be made in order to justify the soundness of this decision? Provide 4-8 bullet points to summarize this discussion, listing at least two pros and two cons.

5. In an effort to reduce earnings management, the board of directors proposes to compensate the management team based on profit calculated under the variable costing method. As a team assess the potential effectiveness of this decision in reducing earnings management. Hint: A complete discussion would incorporate the proposal's effect on different types of earnings management.