M.K. Gallant is president of Kranbrack Corporation, a company whose stock is traded on a national exchange. In a meeting with investment analysts at the beginning of the year, Gallant had predicted that the company’s earnings would grow by 20% this year. Unfortunately, sales have been less than expected for the year, and Gallant concluded with two weeks of the end of the fiscal year that it would impossible to ultimately report an increase in earning as large as predicted unless some drastic action was taken. Accordingly, Gallant has ordered that wherever possible, expenditures should be postponed to the new year – including canceling or postponing orders with suppliers, delaying planned maintenance and training, and cutting back on end-of-the-year advertising and travel. Additionally, Gallant ordered the company’s controller to carefully scrutinize all costs that are currently classified as period costs and reclassify as many as possible as product costs. The company is expected to have substantial inventories of work in process and finished goods at the end of the year.
Why would reclassifying period costs as product costs increase this period’s reported earnings?
Do you believe Gallant’s actions are ethical? Why or why not?
Reclassifying period costs (which are mainly administrative and advertising costs) as product costs (costs that are more directly related to the manufacturing of products--duh) gives the impression that more money is going into manufacturing, rather than selling and administrative costs. That seems more or less redundant but what it means for the company's statements is a false inflation of reported earnings, which is obviously unethical. As a nationally traded business, Kranbrack Corporation is held to the standards placed by the Generally Accepted Accounting Principles, and lying on your statements to look better is a big fat no-no! But more than just being blatantly unethical, holding off a ton of expenses until the next year will just put them even more behind for that year, a way that'll only be fixable with more smudging! It's a very vicious cycle...
Hmm oh and one last point, while it might be okay to postpone or reduce things like end of the year advertising or travel, there are other aspects of running a business that are better kept on time, like maintenance. If a major piece of machinery breaks because they skipped a tune up or something, that will very much hurt the business more. They might also be weary of postponing orders with suppliers, because if there are already in a committed agreement with that supplier that could lead to damaged relationships or a lawsuit. I advice to them would be to tread carefully, cut back where it is ethical to do so, but know when they have to take the financial hit.
If they are product costs, they could be carried on the books until the product is sold, making a short term "reduction" in costs.
Ethical? It is smoke and mirrors, it is legal, and it does hide costs that ultimately will need to be paid.
If I were the accounting firm certifying the balance sheet, it would be worthy of an accounting note on the statement.
Reclassifying period costs as product costs would increase this period's reported earnings because product costs are typically allocated to the inventory of the company. By classifying more costs as product costs, these costs would be recognized as part of the cost of goods sold only when the inventory is eventually sold. This would delay the recognition of these costs as expenses, resulting in higher reported earnings in the current period.
As for whether Gallant's actions are ethical, it can be argued that they are not. Ethical considerations would include transparency and providing accurate information to investors and stakeholders. By manipulating costs and postponing expenditures to artificially inflate earnings, Gallant is not providing a true and fair representation of the company's financial performance. This could mislead investors and stakeholders, potentially leading to negative consequences in the long run.
Reclassifying period costs as product costs would increase this period's reported earnings because product costs are included in the calculation of the cost of goods sold (COGS), which is subtracted from revenue to calculate gross profit. By reclassifying some period costs as product costs, the COGS would be higher, which would reduce gross profit and ultimately lower reported earnings. This can make it appear as if the company is making more profit than it actually is.
In terms of ethics, Gallant's actions can be seen as questionable. By postponing expenditures, canceling or postponing orders, and cutting back on advertising and travel, Gallant is trying to manipulate the company's financial statements to meet his earlier predictions of 20% earnings growth. This can mislead investors and stakeholders who rely on accurate financial information to make decisions. Additionally, the reclassification of costs can be seen as an attempt to manipulate the reported earnings, which goes against the principles of transparency and accuracy in financial reporting.
However, it's important to note that the ethical implications would depend on the specific circumstances and the intention behind Gallant's actions. If Gallant genuinely believed that these actions were necessary to ensure the company's long-term survival or if they were taken to mitigate losses caused by unforeseen circumstances, it could be argued that his actions were justified. Nonetheless, it would be advisable for Gallant to consider the potential consequences of his actions and ensure that proper disclosure and transparency are maintained to avoid misleading stakeholders.