Question

Ethical Scenario 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 management 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 inventory 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 bonuses (which are 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.” For this discussion you have the option to select TWO of the following questions as your initial response. You only need to select TWO of the four questions. You do NOT need to answer all four questions. In addition to your initial response, for full credit, please be sure to respond to more than two other student’s initial responses as well. How would inflating the percentage completion of ending work-in-process inventory help Pines and Lopez get their bonuses? The particle board division is the largest of High Mountain Lumber’s division. 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? Evaluate Lopez’s justification, including the effect, if any, on next year’s financial statements. Address the following: What is the ethical issue resulting from this situation? What should Green do?

Answer 1

ANSWER:

Requirement 1

By inflating the percentage of completion for the work in process, fewer costs would be allocated to the Finished Goods Inventory, thus lowering the cost per unit of board. This would then make the Cost of Goods Sold lower and inflate the Gross Profit. If the bonus is based on Gross Profit, then Pines and Lopez would have a higher bonus.

Requirement 2

The misstatement of the percentage of completion for the work in process will cause the company to show higher Gross Profit and higher net income on the Income Statement. It would also overstate the Work-In-Process Inventory on the Balance Sheet.

Requirement 3

Lopez’s justification that they would complete the work in process the next year is true, but costs would then be allocated to the next year’s income statement, thus showing a lower net income in the next year.

Requirement 4

The ethical issue is the willingness to misstate information in order to earn a bonus. If Lopez and Pines don’t have a problem with the misstatement, what other ethical decisions would they be willing to make to have the financials look better? Another consideration in this situation is the materiality of the amount. If the amount is immaterial to the financials of the company, then Green may not need to make an adjustment. If it is material, Green should report the information correctly when completing the company financials. This way management and external users would have better information on which to base their decisions.