Problem 936

Ethics; Budgetary Pressure; Management Bonuses; Budgetary Constraints

Transglobal Chemical Company (TCC) produces and distributes industrial chemicals. TCCs earnings increased sharply in 20x1, and bonuses were paid to the management staff for the first time in several years. Bonuses are based in part on the amount by which reported income exceeds budgeted income.

Priyanka Kumar, vice president of finance, was pleased with TCCs 20x1 earnings and thought that the pressure to show financial results would ease. However, Ellen North, TCCs president, told Kumar that she saw no reason why the 20x2 bonuses should not be double those of 20x1. As a result, Kumar felt pressure to increase reported income in order to exceed budgeted income by an even greater amount. This would assure increased bonuses.

Kumar met with Bill Keller of Pristeel, Inc., a primary vendor of TCCs manufacturing supplies and equipment. Kumar and Keller have been close business contacts for many years. Kumar asked Keller to identify all of TCCs purchases of perishable supplies as equipment on Pristeels sales invoices. The reason Kumar gave for her request was that TCCs president had imposed stringent budget constraints on operating expenses but not on capital expenditures. Kumar planned to capitalize the purchase of perishable supplies, and include them with the Equipment account on the balance sheet. In this way Kumar could defer the expense recognition for these items to a later year. This procedure would increase reported earnings, leading to increased bonuses. Keller agreed to do as Kumar had asked.

While analyzing the second quarter financial statements, Skylar Wood, TCCs controller, noticed a large decrease in supplies expense from one year ago. Wood reviewed the Supplies Expense account and noticed that only equipment and no supplies had been purchased from Pristeel, a major source for supplies. Wood, who reports to Kumar, immediately brought this to Kumars attention.

Kumar told Wood of the presidents high expectations and of the arrangement made with Keller of Pristeel. Wood told Kumar that her action was an improper accounting treatment for the supplies purchased from Pristeel. Wood requested that she be allowed to correct the accounts and urged that the arrangement with Pristeel be discontinued. Kumar refused the request and told Wood not to become involved in the arrangement with Pristeel.

After clarifying the situation in a confidential discussion with an objective and qualified peer within TCC, Wood arranged to meet with North, TCCs president. At the meeting, Wood disclosed the arrangement Kumar had made with Pristeel.

Required:

1. Explain why the use of alternative accounting methods to manipulate reported earnings is unethical.
2. Is Skylar Wood, TCCs controller, correct in saying that the supplies purchased from Pristeel, Inc., were accounted for improperly? Explain your answer.
3. Assuming that Priyanka Kumars arrangement with Pristeel, Inc., was in violation of the standards of ethical professional practice for managerial accountants, discuss whether the actions of Wood were appropriate or inappropriate. (The guidelines for Resolution of Ethical Conflict are given in Chapter 1.)