Sun Energy produces and distributes chemicals in its Southwest Division, which is located in San Antonio, Texas. Southwest’s earnings increased sharply in 2010, 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.
John Smith, VP of Finance, was pleased with Southwest’s 2010 earnings and thought that the pressure to show financial results would ease. However, Kay Marvin, Southwest’s division manager, told Smith that she saw no reason why the 2011 bonuses should not be doubled those of 2010. As a result, Smith felt pressure to increase reported income to exceed budgeted income by an even greater amount. This would ensure increased bonuses.
Smith met with Tony Tiger of Millstone, a primary vendor of Southwest’s manufacturing supplies and equipment. Smith and Tiger have been close business contacts for many years. Smith asked Tiger to identify all of Southwest’s purchases of perishable supplies as equipment on Millstones’ sales invoices. The reason Smith gave for his request was that Southwest’s division manager had imposed stringent budget constraints on operating expenses but not on capital expenditures.
Smith planned to capitalize the purchase of perishable supplies and include them with the Equipment account on the balance sheet. In this way, Smith could defer the expense recognition for these items to a later year. This procedure would increase reported earnings, leading to increased bonuses. Tiger agreed to do as Smith had asked.
While analyzing the second quarter financial statements, Larry Lion, Southwest’s director of cost management, noticed a large decrease in supplies expense from one year ago. Lion reviewed the Supplies Expense account and noticed that only equipment but no supplies had been purchased from Millstone, a major source for supplies. Lion, who reports to Smith, immediately brought this to Smith’s attention.
Smith told Lion of Marvin’s high expectations and of the arrangement made with Tiger of Millstone. Smith told Lion that his action was an improper accounting treatment for the supplies purchased from Millstone. Lion requested that he be allowed to correct the accounts and urged that the arrangement with Millstone be discontinued. Smith refused the request and told Lion not to become involved in the arrangement with Millstone.
After clarifying the situation in a confidential discussion with an objective and qualified peer within Southwest, Lion arranged to meet with Marvin, Southwest’s division manager. At the meeting, Lion disclosed the arrangement Smith had made with Millstone.
Questions to Address:
- Explain why the use of alternative accounting methods to manipulate reported earnings is unethical?
- Is Larry Lion, Southwest’s director of cost management, correct in saying that the supplies purchased from Millstone were accounted for improperly? Explain?
- Assuming that John Smith’s arrangement with Millstone was in violation of the Standards of Ethical Conduct for Management Accountants (Links to an external site.), discuss whether Lion’s actions were appropriate or inappropriate?