Question

Cleveland Custom Cabinets is a specialty cabinet manufacturer for high-end homes in the Cleveland Heights and
Shaker Heights areas. The company manufactures cabinets built to the specifications of homeowners and employs
125 custom cabinetmakers and installers. There are 30 administrative and sales staff members working for the
company.
James Leroy owns Cleveland Custom Cabinets. His accounting manager is Marcus Sims, who reports to the
director of finance. Sims manages 15 accountants. The staff is responsible for keeping track of manufacturing
costs by job and preparing internal and external financial reports. The internal reports are used by management for
decision making. The external reports are used to support bank loan applications.
The company applies overhead to jobs based on direct labor hours. For 2016, it estimated total overhead to be $4.8
million and 80,000 direct labor hours. The cost of direct materials used during the first quarter of the year is
$600,000, and direct labor cost is $400,000 (based on 20,000 hours worked). The company’s accounting system is
old and does not provide actual overhead information until about four weeks after the close of a quarter. As a
result, the applied overhead amount is used for quarterly reports.
On April 10, 2016, Leroy came into Sims’s office to pick up the quarterly report. He looked at it aghast. Leroy had
planned to take the statements to the bank the next day and meet with the vice president to discuss a $1 million
working capital loan. He knew the bank would be reluctant to grant the loan based on the income numbers in
Exhibit 1. Without the money, Cleveland could have problems financing everyday operations.

Leroy asked Sims to explain how net income could have gone from 14.2 percent of sales for the year ended
December 31, 2015, to 1.4 percent for March 31, 2016. Sims pointed out that the estimated overhead cost had
doubled for 2016 compared to the actual cost for 2015. He explained to Leroy that rent had doubled and the cost of
Chapter 1 Ethical Reasoning: Implications for Accounting 57
utilities skyrocketed. In addition, the custom-making machinery was wearing out more rapidly, so the company’s
repair and maintenance costs also doubled from 2015.
Leroy wouldn’t accept Sims’s explanation. Instead, he told Sims that the quarterly income had to be at least the
same percentage of sales as at December 31, 2015. Sims looked confused and reminded Leroy that the external
auditors would wrap up their audit on April 30. Leroy told Sims not to worry about the auditors. He would take
care of them. Furthermore, “as the sole owner of the company, there is no reason not to 'tweak’ the numbers on a
one-time basis. I own the board of directors, so no worries there.” He went on to say, “Do it this one time and I
won’t ask you to do it again.” He then reminded Sims of his obligation to remain loyal to the company and its
interests. Sims started to soften and asked Leroy just how he expected the tweaking to happen. Leroy flinched,
held up his hands, and said, “I’ll leave the creative accounting to you.

Assume Sims decided to reduce the estimated overhead for the year by 50 percent:

• How would that change the net income for the quarter? 

• What would it be as a percentage of sales? 

• Do you think Leroy would like the result?

• Do you think he will be content with the “tweaking” occurring just this one time?