Accounting Changes and Error Corrections Overview

Chapter 4 provided an overview of accounting changes and error correction. Later, we discussed changes encountered in connection with specific assets and liabilities as we dealt with those topics in subsequent chapters.

Now, in this chapter, we revisit accounting changes and error correction with the intent to synthesize the way these are handled in a variety of situations that might be encountered in practice. We see that most changes in accounting principles are recorded and reported “retrospectively.” Changes in estimates are accounted for “prospectively. Both changes in reporting entities and the correction of errors are reported retrospectively.

Learning ObjectivesAfter studying this chapter, you should be able to:LO20-1 Differentiate among the three types of accounting changes and distinguish between the

retrospective and prospective approaches to accounting for and reporting accounting changes.

LO20-2 Describe how changes in accounting principle typically are reported.LO20-3 Explain how and why some changes in accounting principle are reported

prospectively.LO20-4 Explain how and why changes in estimates are reported prospectivelyLO20-5 Describe the situations that constitute a change in reporting entity.LO20-6 Understand and apply the four-step process of correcting and reporting errors,

regardless of the type of error or the timing of its discovery.LO20-7 Discuss the primary differences between U.S. GAAP and IFRS with respect to

accounting changes and error correction

Lecture OutlineI. Accounting changes fall into one of three categories. (T20-1)

A. Changes in principle.B. Changes in estimates.C. Changes in reporting entity.

Errors occur when transactions either are recorded incorrectly or not recorded at all. (T20-2)

II. Accounting changes can be accounted for in one of two ways depending on the nature of the change. A. Retrospectively (prior years revised)B. Prospectively (only current and future years affected)

III. Most voluntary changes in accounting principles are recorded and reported retrospectively. This means reporting all previous period’s financial statements as if the new method had been used in all prior periods. (T20-3)

A. For each year reported in the comparative statements, we revise those statements to appear as if the newly adopted accounting method had been applied all along. (T20-4) (T20-5) (T20-6)

B. In addition to reporting revised amounts in the comparative financial statements, we must also adjust the book balances of affected accounts. This means creating a journal entry to change those balances from their current amounts (from using the previous method) to what those balances would have been using the newly adopted method. (T20-7)

C. In the first set of financial statements after the change, a disclosure note is needed to provide that justification that the new method is clearly more appropriate. The footnote also should point out that comparative information has been revised, or that retrospective revision has not been made because it is impracticable, and report any per share amounts affected for the current period and all prior periods presented. (T20-8)

IV. EXCEPTIONS NECESSITATING THE PROSPECTIVE APPROACH A. Sometimes a lack of information makes it impracticable to report a change retrospectively so

the new method is simply applied prospectively. (T20-9)1. If it’s impracticable to adjust each year reported, the change is applied retrospectively as of

the earliest year practicable. 2. If full retrospective application isn’t possible, the new method is applied prospectively

beginning in the earliest year practicable. 3. Footnote disclosure should indicate reasons why retrospective application was

impracticable.B. Another exception to retrospective application is when an FASB Statement or another

authoritative pronouncement requires prospective application for specific changes in accounting methods.

C. We account for a change in depreciation method as a change in accounting estimate that is achieved by a change in accounting principle. Therefore, we account for such a change prospectively; that is, precisely the way we account for changes in estimates.

V. Changes in estimates are accounted for prospectively. A. When a company revises a previous estimate, prior financial statements are not revised.

(T20-10)B. Rather, the company merely incorporates the new estimate in any related accounting

determinations from then on. (T20-11)

VI. A change in reporting entity requires that financial statements of prior periods be retrospectively revised to report the financial information for the new reporting entity in all periods. (T20-12)

VII. Summary of ways accounting changes are accounted for: T20-13

VIII. When errors are discovered, they should be corrected and accounted for retrospectively. (T20-14) Illustrations: T20-15, T20-16, T20-17, T20-18A. A journal entry is made to correct any account balances that are incorrect as a result of

the error.B. Previous years' financial statements that were incorrect as a result of an error are

retrospectively restated. C. If retained earnings is one of the incorrect accounts, the correction is reported as a

“prior period adjustment” to the beginning balance in a statement of shareholders’ equity.

D. A disclosure note should describe the nature of the error and the impact of its correction on operations.

PowerPoint SlidesA PowerPoint presentation of the chapter is available at the textbook website.

An alternate version of the PowerPoint presentation also is available.

Teaching Transparency MastersThe following can be reproduced on transparency film as they appear here, or

you can use the disk version of this manual and first modify them to suit your particular needs or preferences.

ACCOUNTING CHANGES

Type of Change Description Examples

Change in accounting principle

Change from one generally

accepted accounting principle to

another

adopt a new FASB standard change methods of inventory

costing change from cost method to

equity method, or vice versa change from completed

contract to %-of-completion, or vice versa

Change in estimate

Revision of an estimate because

of new information or new experience

change depreciation methods change estimate of useful life

of depreciable asset change estimate of residual

value change estimate of warranty

expense percentage change estimate of periods

benefited by intangible assets change actuarial estimates

pertaining to a pension plan

Change in reporting

entity

Change from reporting as one type of entity to another type of

entity

consolidate a subsidiary not previously included in consolidated financial statements

report consolidated financial statements in place of individual statements

Graphic 20-1 T20-1

CORRECTION OF AN ERROR

Type Description Examples

Errorcorrection

Correction of an error caused by

a transaction being recorded incorrectly or

not at all

mathematical mistakes inaccurate physical count

of inventory change from the cash basis

of accounting to the accrual basis

failure to record an adjusting entry

recording an asset as an expense, or vice versa

fraud or gross negligence

T20-2

CHANGE IN ACCOUNTING PRINCIPLE

Although consistency and comparability are desirable, changing to a new method sometimes is appropriate.

We report most voluntary changes in accounting principles retrospectively. This means reporting all previous period’s financial statements as if the new method had been used in all prior periods.

T20-3

IllustrationAir Parts Corporation used the LIFO inventory costing method. At the beginning of 2013, Air Parts decided to change to the FIFO method. Income components for 2013 and prior years were as follows ($ in millions):

previous 2013 2012 2011 years

Cost of goods sold (LIFO) $430 $420 $405 $2,000Cost of goods sold (FIFO) 370 365 360 1,700 Difference $ 60 $ 55 $ 45 $ 300

Revenues $950 $900 $875 4,500Operating expenses 230 210 205 1,000

Air Parts has paid dividends of $40 million each year beginning in 2003. Its income tax rate is 40%. Retained earnings on January 1, 2011, was $700 million; inventory was $500 million.

For each year reported in the comparative statements, Air Parts makes those statements appear as if the newly adopted accounting method (FIFO) had been applied all along.

Income Statements ($ in millions) 2013 2012 2011Revenues $950 $900 $875 Cost of goods sold (FIFO) (370) (365) (360) Operating expenses (230 ) (210 ) (205 ) Income before tax $350 $325 $310 Income tax expense (40%) (140 ) (130 ) (124 ) Net income $210 $195 $186

T20-4

Balance Sheets

Inventory. Air Parts will report 2013 inventory by its newly adopted method, FIFO, and also will revise the amounts it reported last year for its 2012 and 2011 inventory. Each year, inventory will be higher than it would have been by LIFO.

Years ending Dec. 31: previous ($ in millions) 2013 2012 2011 yearsCost of goods sold (LIFO) $430 $420 $405 $2,000Cost of goods sold (FIFO) 370 365 360 1,700 Differences $ 60 $ 55 $ 45 $ 300Cumulative differences: Cost of goods sold $460 $400 $345 $ 300 Income taxes (40%) 184 160 138 120 Net income and retained earnings $276 $240 $207 $180

.......... 2011 inventory will be $345 million higher than it was

reported in last year’s statements. 2012 inventory will be increased by $400 million. 2013 inventory, being reported for the first time, will be

$460 million higher than it would have been if the switch from LIFO had not occurred.

Retained Earnings. Because cost of goods sold by FIFO is less than by LIFO, income and therefore retained earnings by FIFO are greater than by LIFO.

T20-5

Statements of Shareholders’ Equity

If adjustment due to a change in accounting principle (and it usually is), we must adjust the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders’ equity.

The January 1, 2011, retained earnings balance reported in the comparative statements of shareholders’ equity below has been adjusted from $700 million to $880 million, the cumulative effect of the change on years prior to that date.

($ in millions)

CommonStock

AdditionalPaid-inCapital

RetainedEarnings

TotalSE

Jan. 1, 2011 $ 880 Net income (revised to FIFO) 186 Dividends (40)

Dec. 31, 2011 $1,026 Net income (revised to FIFO) 195 Dividends (40)

Dec. 31, 2012 $1,181 Net income (using FIFO) 210 Dividends (40)

Dec. 31, 2013 $1,351

T20-6

Adjust Accounts for the Change

The journal entry updates inventory, retained earnings, and the income tax liability for revisions resulting from differences in the LIFO and FIFO methods prior to the switch, pre-2013.

Cumulative CumulativeDifference Difference

($ in millions) 2012 2011 pre-2011 pre-2013Cost of goods sold (LIFO) $420 $405 $1,000Cost of goods sold (FIFO) 365 360 700 Difference $ 55 $ 45 $ 300 $400

Journal entry to record the change in principle.

January 1, 2013 ($ in millions)

Inventory (additional inventory if FIFO had been used) 400Retained earnings (additional net income if FIFO had been used) 240Deferred tax liability ($400 x 40%) 160

The Internal Revenue Code requires that taxes saved previously ($160 million in this case) from having used another inventory method must now be repaid (over no longer than 6 years). In the meantime, there is temporary difference, reflected in the deferred tax liability.

T20-7

DISCLOSURE NOTE

In the first set of financial statements after the change, a disclosure note is needed to provide justification that the new method is clearly preferable.

Should point out that comparative information has been revised, or that retrospective revision has not been made because it is impracticable

Should report any per share amounts affected for the current period and all prior periods presented.

T20-8

EXCEPTIONS NECESSITATING THE PROSPECTIVE APPROACH

1. WHEN RETROSPECTIVE APPLICATION IS IMPRACTICABLE

Sometimes a lack of information makes it impracticable to report a change retrospectively so the new method is simply applied prospectively.

If it’s impracticable to adjust each year reported, the change is applied retrospectively as of the earliest year practicable.

If full retrospective application isn’t possible, the new method is applied prospectively beginning in the earliest year practicable.

Footnote disclosure should indicate reasons why retrospective application was impracticable.

2. WHEN MANDATED BY AUTHORITATIVE PRONOUNCEMENTS

Another exception to retrospective application is when a new authoritative pronouncement requires prospective application for specific changes in accounting methods.

3. CHANGING DEPRECIATION, AMORTIZATION, DEPLETION METHODS

We account for a change in depreciation method as a change in accounting estimate that is achieved by a change in accounting principle. Therefore, we account for such a change prospectively; that is, precisely the way we account for changes in estimates.

T20-9

CHANGE IN ACCOUNTING ESTIMATE

Changes in estimates are accounted for prospectively.

When a company revises a previous estimate, prior financial statements are not revised. Instead, the company merely incorporates the new estimate in any related accounting determinations from then on.

A disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per-share amounts for the current period.

T20-10

Illustration

CHANGE IN ACCOUNTING ESTIMATE

Universal Semiconductors estimates warranty expense as 2% of credit sales. After a review during 2013, Universal determined that 3% of credit sales is a more realistic estimate of its payment experience. Credit sales in 2013 are $300 million. The effective income tax rate is 40%.

Warranty expense reported in prior years is not restated.

No account balances are adjusted.

In 2013 and later years, the adjusting entry to record warranty expense simply will reflect the new percentage. In 2013, the entry would be:

($ in millions)Warranty expense (3% x $300 million) 9

Warranty liability 9

The effect of a change in estimate is described in a footnote to the financial statements.

T20-11

CHANGE IN REPORTING ENTITY A reporting entity can be a single company, or it can be a

group of companies that reports a single set of financial statements. A change in reporting entity occurs as a result of:

(1) Presenting consolidated financial statements in place of statements of individual companies.

(2) Changing specific companies that comprise the group for which consolidated or combined statements are prepared.

Reported by restating all previous periods’ financial statements as if the new reporting entity existed in those periods.

In the first set of financial statements after the change, a disclosure note should describe the nature of the change and the reason it occurred.

The effect of the change on net income, income before extraordinary items, and related per share amounts should be indicated for all periods presented.

T20-12

APPROACHES TO REPORTING ACCOUNTING CHANGES AND ERROR CORRECTIONS

Current Previous Years Year Later Years

______________________________________________________________

Retrospective {most changes in accounting principle}

{changes in reporting entity}{corrections of errors}

Prospective {changes in estimate, including changes in depreciation}

{changes in accounting principle when retrospective application is impracticable}{changes in accounting principle when prospective application is mandated}

T20-13

ERROR CORRECTION

Steps to Correct an Error:

A journal entry is made to correct any account balances that are incorrect as a result of the error.

Previous years' financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction (for all years reported again for comparative purposes).

If retained earnings is one of the accounts incorrect as a result of the error, the correction is reported as a “prior period adjustment” to the beginning balance in a statement of shareholders’ equity (or statement of retained earnings if that’s presented instead), for the earliest year being reported in the comparative financial statements.

A disclosure note should describe the nature of the error and the impact of its correction on net income, income before extraordinary items, and earnings per share.

T20-14

ERROR DISCOVERED IN THE SAME REPORTING PERIOD THAT IT OCCURRED

If an accounting error is made and discovered in the same accounting period, the original erroneous entry should simply be reversed and the appropriate entry recorded.

G.H. Little, Inc. paid $3 million for replacement computers and recorded the expenditure as maintenance expense. The error was discovered a week later.

To reverse erroneous entry($ in millions)Cash ........................................................................... 3

Maintenance expense ............................................ 3

To record correct entryEquipment ................................................................. 3

Cash ....................................................................... 3

T20-15

ERROR AFFECTING PREVIOUS FINANCIAL STATEMENTS, BUT NOT NET INCOME

Example: Incorrectly recording salaries payable as accounts payable, recording a loss as an expense, or classifying a cash flow as an investing activity rather than a financing activity on the statement of cash flows.

MDS Transportation incorrectly recorded a $2 million note receivable as accounts receivable. The error was discovered a year later.

To correct incorrect accounts.... ($ in millions)Note receivable .......................................................... 2

Accounts receivable .............................................. 2

T20-16

RECORDING AN ASSET AS AN EXPENSE

In 2013, internal auditors discovered that Seidman Distribution, Inc. had debited an expense account for the $7 million cost of sorting equipment purchased at the beginning of 2011. The equipment’s useful life was expected to be 5 years with no residual value. Straight-line depreciation is used by Seidman.

Analysis:($ in millions)

Correct Incorrect(Should Have Been Recorded) (As Recorded)

2011 Equipment 7.0 Expense 7.0Cash 7.0 Cash 7.0

2011 Expense 1.4 Depreciation entry omittedAccum. depr. 1.4

2012 Expense 1.4 Depreciation entry omittedAccum. depr. 1.4

T20-17

RECORDING AN ASSET AS AN EXPENSE(Illustration continued)

During the two-year period, depreciation expense was understated by $2.8 million, but other expenses were overstated by $7 million, so net income during the period was understated by $4.2 million. This means retained earnings is currently understated by that amount.

Accumulated depreciation is understated by $2.8 million.

To correct incorrect accounts.... ($ in millions)Equipment ................................................................. 7.0

Accumulated depreciation .................................... 2.8Retained earnings................................................... 4.2

o The 2011 and 2012 financial statements are retrospectively restated.

o The correction is reported as a “prior period adjustment.”

o A disclosure note describes the error and the impact of its correction.

T20-17 (continued)

INVENTORY MISSTATEDIn early 2013, Overseas Wholesale Supply discovered that $1 million of inventory had been inadvertently excluded from its 2011 ending inventory count.

Analysis: U = UnderstatedO = Overstated

2011 2012Beginning inventory Beginning inventoryUPlus: Net purchases Plus: Net purchases Less: Ending inventory U Less: Ending inventoryCost of goods sold O Cost of goods sold U

Revenues RevenuesLess: COGS O Less: Cost of goods sold ULess: Other expenses Less: Other expensesNet income U Net income O Retained earnings U Retained earnings corrected

If discovered in 2012 (before closing): ($ in millions)Inventory.................................................................... 1

Retained earnings .................................................. 1

If discovered in 2013 or later:.... No correcting entry needed

T20-18

Suggestions for Class Activities1. Critical Thinking Activity

It is alleged that not all accounting choices are made by management in the best interest of fair and consistent financial reporting.

Suggestion:

Ask students to speculate on other motives that might influence the choices among accounting methods and whether to change methods.

Points to note:

Your students should come up with a wide variety of motives. Among them will likely be the effect of choices on:

Reported income.Stock prices.Management compensation.Existing debt agreements.Union negotiations.

2. Real World ActivityThe following press release described a change in the way General Cable accounts for inventories:

HIGHLAND HEIGHTS, Ky., Mar 18, 2010 (BUSINESS WIRE) -- General Cable Corporation (NYSE: BGC), today announced a change in accounting for inventories from the last-in, first-out (LIFO) method to the average cost method. The Company believes the change is preferable because the average cost method provides better matching of sales and expenses, particularly during periods of metal and petrochemical price volatility, and enhances comparability with industry peers.

Suggestion:

Ask students to consult the footnotes to the 2010 financials of General Cable and describe the details of the change and to speculate on the motivation for the original method and the change.

Points to note:

The details are in the footnotes to 2010 financials, which state in part:

Inventories

Effective January 1, 2010, the Company changed its method of accounting for its North American inventories and non-North American metal inventories from the LIFO method to the average cost method. Inventories valued using the LIFO method represented approximately 57% of total inventories as of December 31, 2009 prior to the change in method. The Company believes the change is preferable because the average cost method improves financial reporting by better matching sales and expenses, particularly during periods of metal and petrochemical price volatility or reductions in inventory quantities and enhances comparability with industry peers. The Company applied this change in accounting principle retrospectively to all prior periods presented herein in accordance with ASC 250 Accounting Changes and Error Corrections. As a result of the accounting change, retained earnings increased from $597.9  million to $749.7 million as of January 1, 2009 and increased from $409.8 million to $575.3 million as of January 1, 2008. The Company converted its accounting systems on January 1, 2010, which effectively eliminated its LIFO pools prospectively.

As a result of the retrospective application of this change in accounting principle, certain amounts in the Company's year ended December  31, 2009 and December 31, 2008 consolidated statement of operations were adjusted as presented below:

Year Ended December 31, 2009

As Originally

(in millions, except per share data) Reported Adjustments As Adjusted

Cost of sales $ 3,787.9 $ 77.8 $ 3,865.7

Operating income 257.7 (77.8) 179.9

Provision for income taxes (58.4) 25.7 (32.7)

Net income including noncontrolling interest 116.6 (52.1) 64.5Net income attributable to Company common shareholders 108.4 (52.1) 56.3

Earnings per common share — basic 2.08 (1.00) 1.08

Earnings per common share — assuming dilution 2.06 (0.99) 1.07

Year Ended December 31, 2008

As Originally

(in millions, except per share data) Reported Adjustments As Adjusted

Cost of sales $ 5,427.7 $ 21.9 $ 5,449.6

Operating income 421.4 (21.9) 399.5

(Provision) benefit for income taxes (104.9) 8.2 (96.7)

Net income including noncontrolling interest 202.1 (13.7) 188.4Net income attributable to Company common shareholders 188.7 (13.7) 175.0

Earnings per common share — basic 3.59 (0.26) 3.33

Earnings per common share — assuming dilution 3.54 (0.26) 3.28

The

Year Ended December 31, 2009

As Originally

(in millions) Reported Adjustments As Adjusted

AssetsInventories $ 850.3 $ 152.1 $ 1,002.4

Deferred income taxes 114.7 (62.1) 52.6

Total assets 3,924.1 90.0 4,014.1

Liabilities and Total EquityAccrued liabilities 366.6 (4.7) 361.9

Deferred income taxes 208.5 1.0 209.5

Other liabilities 250.0 (1.9) 248.1

Total liabilities 2,509.9 (5.6) 2,504.3Accumulated other comprehensive loss (4.8) (4.1) (8.9)

Retained earnings 706.4 99.7 806.1

Total liabilities and equity 3,924.1 90.0 4,014.1

Company's December 31, 2009 consolidated balance sheet was adjusted as presented below:

The consolidated statement of cash flows for the year ended December 31, 2009 and December 31, 2008 was adjusted as presented below:

Year Ended December 31, 2009

As Originally

(in millions) Reported Adjustments As AdjustedNet income including noncontrolling interests $ 116.6 $ (52.1) $ 64.5

Deferred income taxes (29.9) (25.7) (55.6)

Inventory impairment charges (34.6) 34.6 —

Increase in inventories 192.8 43.2 236.0

Net cash flows of operating activities 546.3 — 546.3 

Year Ended December 31, 2008

As Originally

(in millions) Reported Adjustments As AdjustedNet income including noncontrolling interests $ 202.1 $ (13.7) $ 188.4

Deferred income taxes 3.5 (8.2) (4.7)

Inventory impairment charges 32.0 (32.0) —

Decrease in inventories (70.3) 53.9 (16.4)

Net cash flows of operating activities 229.4 — 229.4

There was no impact to net cash flows of operating activities as a result of this change in accounting policy.

Approximately 84% of the Company's inventories are valued using the average cost method and all remaining inventories are valued using the first-in, first-out (FIFO) method. All inventories are stated at the lower of cost or market value.

The Company has consignment inventory at certain of its customer locations for purchase and use by the customer or other parties. General Cable retains title to the inventory and records no sale until it is ultimately sold either to the customer storing the inventory or to another party. In general, the value and quantity of the consignment inventory is verified by General Cable through either cycle counting or annual physical inventory counting procedures.

3. Professional Skills Development Activities

The following are suggested assignments from the end-of-chapter material that will help your students develop their communication, research, analysis, and judgment skills.

Communication Skills. Ethics Case 20-5, Research Case 20-9, and Problem 20-10 are suitable for student presentation(s). In addition to Communication Case 20-7, Research Case 20-9 can be adapted to ask students to prepare a memo to the Controller outlining the findings of the research. Problems 20-12 and 20-13 work well as group assignments. Questions 20-15, 20-16 and 20-17, Problems 20-1 and 20-8, and Judgment Case 20-12 create good class discussions.

Research Skills. In their professional lives, our graduates will be required to locate and extract relevant information from available resource material to determine the correct accounting practice, perhaps identifying the appropriate authoritative literature to support a decision. In addition to Research Case 20-9, Judgment Case 20-12 can be adapted to require students to research the authoritative literature on accounting for the three types of accounting changes.

As a research activity, have students search the internet for examples of reported accounting changes. You might let them use their own creativity in deciding where to look for examples or you might suggest:1. A search engine such as Google.2. EDGAR at www.sec.com which offers 10K reports students can search for changes. 3. Annual reports from a variety of sources.

Analysis Skills. The “Broaden Your Perspective” section includes Analysis Cases that direct students to gather, assemble, organize, process, or interpret date to provide options for making business and investment decisions. In addition to Analysis Cases 20-10, 20-11, 20-8, and 20-6, Problem 20-12, 20-13, 20-14, and 20-16 also provide opportunities to develop analysis skills.

Judgment Skills. The “Broaden Your Perspective” section includes Judgment Cases that require students to critically analyze issues to apply concepts learned to business situations in order to evaluate options for decision-making and provide an appropriate conclusion. Judgment Cases 20-12 and 20-13 require students to exercise judgment.

4. Ethical Dilemmas

A. The chapter contains two ethical dilemmas. The first is:

ETHICAL DILEMMA

The net income of Union Carbide increased in in a single year by over $200 million, due almost entirely to three changes in accounting principle: (a) the depreciation method was changed, resulting in lower expense, (b) interest costs during construction were capitalized rather than expensed, and (c) the method for recognizing investment tax credits (not available under current tax law) was changed to a method that reduced expenses.

What ethical question does this situation suggest?

You may wish to discuss this in class. If so, discussion should include these elements.

Step 1 - The Facts:The increase in net income of Union Carbide was due almost entirely to: (1) a change in

depreciation method, (2) capitalization of construction interest costs, and (3) a reduction in expenses due to a change in the method for recognizing investment tax credits. According to Generally Accepted Accounting Principles all three items should be completely and fully described in the disclosure notes to prevent misinformation to users of the financial statements. Some users of financial statements, however, may overlook or not understand the disclosures and may believe that the increase in net income is due to improved company operations.

Step 2 - The Ethical Issue and the Stakeholders:The ethical issue or dilemma is whether Union Carbide made the changes for the purpose of

artificially increasing reported earnings and, if so, whether that course of action is appropriate.Stakeholders include the accountants of Union Carbide, external and internal auditors, the

accounting profession, company management, members of the Board of Directors, employees, current and future creditors, financial analysts, and current and future investors.

Step 3 - Values:Values include competence, integrity, objectivity, loyalty to the company, responsibility for

following accounting principles, and responsibility to users of financial statements.

Step 4 - Alternatives:1. Continue the use of previous accounting methods regarding depreciation, interest

capitalization, and the recognition of investment credit in the disclosure notes.2. Make the indicated changes.

Step 5 - Evaluation of Alternatives in Terms of Values:1. Alternative 1 would have caused significantly lower reported earnings, perhaps reflecting

objectivity and responsibility to users of the financial statements. 2. Alternative 2 would have caused significantly higher reported earnings, perhaps

reflecting a sacrifice of objectivity and responsibility to users of the financial statements in favor of catering to the interests of managers and shareholders.

Step 6 - Consequences:Alternative 1.

Would have caused significantly lower reported earnings, with possible negative impact on managerial performance evaluations and compensation and possible negative impact on stock prices and shareholders’ wealth (though academic research would suggest otherwise). Users of financial statements would be better informed. Management and the accountants would maintain their integrity.

Alternative 2. Would have caused significantly higher reported earnings, perhaps misleading investors,

creditors, and others. Positive consequences: the company would reflect a stronger net income. Creditors may be more willing to loan the firm money in the future and potential shareholders may be more willing to invest.

Step 7 - Decision: Student(s) must decide their course of action.

B. The chapter contains two ethical dilemmas. The second is:

ETHICAL DILEMMA

As a second-year accountant for McCormack Chemical Company, you were excited to be named Assistant Manager of the Agricultural Chemicals Division. After two weeks in your new position, you were supervising the year-end inventory count when the Senior Manager mentioned that two carloads of herbicides were omitted from the count and should be added. Upon checking, you confirm your understanding that the inventory in question had been deemed to be unsaleable. “Yes,” your manager agreed, “but we’ll write that off next year when our bottom line won’t be so critical to the continued existence of the Agricultural Chemicals Division. Jobs and families depend on our division showing well this year.”

Discussion should include these elements.

Step 1 - Facts: As a newly promoted Assistant Manager of the Agricultural Chemicals Division of McCormack

Chemical Company, you observe that two carloads of herbicides, deemed to be unsaleable, are omitted from the ending inventory count. The Senior Manager states that the inventory should be included in the count and not written off until the following year. Hopefully, next year’s net income will not be so critical to the continuation of the Agricultural Chemicals Division. By deferring the write-off of obsolete inventory until the following year, both current net income and ending inventory are overstated by the amount of the inventory devaluation. The following year’s net income will be understated by the amount of the write-down. Even though retained earnings at the end of the two years will be correct, the principle of periodicity has been violated.

Step 2 - The Ethical Issue and the Stakeholders:The ethical issue or dilemma is whether your obligations to obey your superior and support

fellow employees are greater than the obligation to correctly report the value of the inventory and current net income to users of the financial statements.

Stakeholders include you, the Assistant Manager, the Senior Manager, other company managers, other employees and their families, current and future creditors, and current and future investors in the McCormack Chemical Company.

Step 3 - Values: Values include competence, honesty, integrity, objectivity, loyalty to employees, loyalty to the

company, and responsibility to users of financial statements.

Step 4 - Alternatives:1. Follow the suggestion of the Senior Manager to defer the inventory write off until next

year.2. Insist that the unsaleable inventory be written off in the current year.3. Report the Senior Manager’s request to a higher level of management, the audit

committee, or the auditors.

4. Resign from the company and seek employment elsewhere.

Step 5 - Evaluation of Alternatives in Terms of Values:1. Alternative 1 illustrates loyalty to the employer and fellow employees. 2. Alternative 2 exhibits the values of competence, honesty, integrity, objectivity, and

responsibility to users of the financial statements. 3. Alternative 3 also illustrates loyalty to the employer at a level higher than that of the

Senior Manager, but also includes the values of honesty, integrity, and objectivity on the part of the Assistant Manager.

4. Alternative 4 supports the values of honesty and integrity, but does not reflect competence, objectivity, or responsibility to financial statement users.

Step 6 - Consequences:Alternative 1

Positive consequences: You would keep your job and please the Senior Manager. Fellow employees would keep their jobs and be able to support their families.

Negative consequences: Users of the financial statements would be misinformed. Users of financial statements may sue the company upon learning the truth if the amount of the write-off is material and the misinformation affects their financial decisions. You may lose your self-respect and the respect of co-workers.

Alternative 2Positive consequences: Users of financial statements would receive more reliable and

relevant information regarding assets and net income. You would maintain your integrity.Negative consequences: You may incur the disfavor of the Senior Manager and other top

management resulting in lack of future promotions and loss of your job. You also may lose the trust and support of other employees.

Alternative 3Positive consequences: You maintain your integrity. Users may receive more reliable and

relevant information regarding assets and net income if upper management levels or the audit committee compel fair presentation in the financial statements.

Negative consequences: You may incur the disfavor of the Senior Manager and other top management resulting in lack of future promotions and loss of your job. You may lose the trust and support of other employees. Whistle blowers often are not rewarded.

Alternative 4Positive consequences: You maintain your integrity and avoid conflict with management and

other employees.Negative consequences: You have no job and may have difficulty getting references for a

new job. Users of financial statements still do not receive reliable and relevant information regarding the unsaleable inventory.

Step 7 - Decision: Student(s) must decide their course of action.