Tulsa Chemical Company (TCC) produces and distributes industrial chemicals, TCC's 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.
Jim Kern, vice president of finance, was pleased with TCC's 20x1 earnings and thought that the pressure to show financial results would ease. However, Ellen North, TCC's president, told Kern that she saw no reason why the 20x2 bonuses should not be double those of 20x1. As a result, Kern felt pressure to increase reported income in order to exceed budgeted income by an even greater amount. This would assure increased bonuses.
Kern met with Bill Keller of Pristeel, Inc., a primary vendor of TCC's manufacturing supplies and equipment. Kern and Keller have been close business contacts for many years. Kern asked Keller to identify all of TCC's purchases of perishable supplies as equipment on Pristeel's sales invoices. The reason Kern gave for his request was that TCC's president had imposed stringent budget constraints on operating expenses but not on capital expenditures. Kern planned to capitalize the purchase of perishable supplies, and include them with the Equipment account on the balance sheet. In this way Kern 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 Kern had asked.
While analyzing the second quarter financial statements, Gary Wood, TCC's 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 Kern, immediately brought this to Kern's attention.
Kern told Wood of North's high expectations and of the arrangement made with Keller of Pristeel. Wood told Kern that his action was an improper accounting treatment for the supplies purchased from Pristeel. Wood requested that he be allowed to correct the accounts and urged that the arrangement with Pristeel be discontinued. Kern 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, TCC's president. At the meeting, Wood disclosed the arrangement Kern had made with Pristeel.
Required:
1. Explain why the use of alternative accounting methods to manipulate reported earnings is unethical.
2. Is Gary Wood, TCC's controller, correct in saying that the supplies purchased from Pristeel, Inc. were accounted for improperly? Explain your answer.
3. Assuming that Jim Kern's arrangement with Pristeel, Inc. was in violation of the standards of ethical conduct for managerial accountants, discuss whether the actions of Wood were appropriate or inappropriate. (The standards are given in Chapter 1.)