Question

> Ethical Issue 18-1 Rick Pines and Joe Lopez are the plant managers for High Mountain Lumber's particle board division. High Mountain Lumber has adopted a just-in-time man agement philosophy. Each plant combines wood chips with chemical adhesives to produce particle board to order, and all product is sold as soon as it is completed. Laura Green is High Mountain Lumber's regional controller. All of High Mountain Lumber's plants and divisions send Green their production and cost information. While reviewing the numbers of the two particle board plants, she is surprised to find that both plants estimate their ending Work-in-Process Inven- tories at 75% complete, which is higher than usual. Green calls Lopez, whom she has known for some time. He admits that to ensure their division would meet its profit goal and that both he and Pines would make their bonus (which is based on division profit), they agreed to inflate the percentage completion. Lopez explains, "Determining the percent complete always requires judgment. Whatever the percent complete, we'll finish the Work-in-Process Inventory first thing next year." Requirements 1. How would inflating the percentage completion of ending Work-in-Process Inven tory help Pines and Lopez get their bonus? 2. The particle board division is the largest of High Mountain Lumber's divisions. If Green does not correct the percentage completion of this year's ending Work- in-Process Inventory, how will the misstatement affect High Mountain Lumber's financial statements? 3. Evaluate Lopez's justification, including the effect, if any, on next year's financial statements. 4. Address the following: What is the ethical issue? What are the options? What are the potential consequences? What should Green do?

Answer 1

1 By inflating the percentage completion of ending Work-in-Process Inventory will actually lead to lower cost per unit for finished goods inventory since fewer cost will actually be allocated to finished goods. And since the finished goods cost per unit is lower It will drive lower cogs and thus profit will be higher and higher profit means higher bonus. 2 The inflation of the percentage completion of the ending work-in-process inventory would cause over valuation of the ending work-in-process inventory. This misstatement will cause the cost of goods sold for that year to be lower resulting in a higher gross profit for that year. Thus, the Income Statement of 'HML' company will show higher profits for that year. In addition, the ending work-in-process inventory will appear at a higher figure in the Balance Sheet of 'HML company. All these will make the financial statements of 'HML company misleading and incorrect The percentage completion for the ending work-in-process inventory should be corrected under all circumstances as the top management for various kinds of decision-making uses the financial statements. This will cause the future strategies of 'HML' Company in a wrong direction and may have long lasting impact in future. 3 When the percentage completion of the ending work-in-process inventory is manipulated, the cost, which should have been charged to completed goods, is being charged to ending work-inprocess inventory. In addition, the justification of 'L' plant manager regarding completion of work-in-process inventory next year will not be a solution to the problem created by inflating the ending work- inprocess inventory. This is because the product costs incurred next year for last year's ending work-in-process inventory will be charged to the cost of goods sold of next year. This will result in a higher cost of goods sold and a lower gross profit for the next year. Thus, the misstatement of the percentage completion cannot be justified in any way as it will also affect next year's financial statements besides affecting the financial stamens of this year. 4 The ethical issue is that by inflating the percentage completion of ending work-in-process inventory, the financial statements of the 'HML' company will present an incorrect and misleading picture of the financial position of the company. Inflating the percentage completion of ending work-in-process inventory should not be a way to increase the divisional profits of a company. Instead, the plant managers should either focus on reduction of product costs or increase in productivity to meet the profit targets of the company The presentation of incorrect and misleading financial statements may lead to serious legal consequences, as there are various statutory rules and regulations, which a company has to adhere. The regional controller 'G' should immediately ask for the correction of the percentage completion of the ending work-in-process inventory of the particleboard division of 'HML company so that the financial stamens of the company are not misstated. He should also advice the plant managers about the ways of increasing productivity and not resorting to manipulative practices for increasing the divisional profits.