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Toshiba’s Creative Accounting for Construction Contracts

Read the following case study:

Dugar, A., & Gujarathi, M. R. (2018). Toshiba’s creative accounting for construction contracts. Issues in Accounting Education, 33(3), 117–134.

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Case Requirements:

The FASB and the IASB have issued a joint standard on revenue recognition. Although the standard is not applicable to years discussed in the case, the substantive guidance for accounting on long-term contracts was not changed. Therefore, address all the requirements below, including FASB codification references, in accordance with the new U.S. standard (Toshiba follows U.S. GAAP). Read the requirements carefully and answer each part of the following requirements.

Requirement 1:

Are Toshiba’s accounting policies for long-term construction contracts—as described in the accounting policies section of the case—consistent with the U.S. GAAP? Cite authoritative pronouncements from the Accounting Standards Codification (ASC) in support of your answer. Your response should focus on Toshiba’s choice of accounting policies rather than its implementation of those policies.

Requirement 2:

For Project G, the $114 million and $107 million discrepancies were treated as ‘‘uncorrected misstatements’’ and hence were not disclosed. Under U.S. GAAP, is non-disclosure of unresolved differences in opinion between a company’s management and its auditors permissible? On what criterion should the decision to disclose (or not disclose) the unresolved differences be based? Explain.

Assignment Paper Requirements:

  • Write a paper (memo) of a minimum of six double-spaced pages, not counting the title and reference pages (which you must include).
  • Copy and paste each one of the questions into your paper in bold type to ensure you have answered each of the assignment
  • Use terms, evidence, and concepts from class readings, including professional business language.
  • Cite at least three credible, academic, or professional sources for this assignment. The TAMUCT Library is a great place to find resources, as well as the FASB
  • Format your paper according to APA

Running head: ace fertilizer company 1

ace fertilizer company 9

Case: Ace Fertilizer Company: Ethical Cost Allocations and Price Determination

Garrett S. Thibodeaux

Texas A&M University – Central Texas

ACCT 5395 – Current Topics in Accounting

Dr. Anthony Fulmore

December 11, 2020

Memorandum

To: Ace Fertilizer Company

From: Garrett Thibodeaux

Date: December 11, 2020

Re: Case: Ace Fertilizer Company: Ethical Cost Allocations and Price Determination

Facts

As the assistant director for the Ace Fertilizer Company, Abby Conroy is responsible for designing, estimating, manufacturing, and delivery special orders to the company’s customers. Abby is well qualified to hold the position of assistant director for the firm. Abby has a double undergraduate degree in accounting and in integrated supply management. She also has an MBA from a top business school and is a qualified CMA. Abby’s position at Ace is essential, as the delivery of special orders to customers has become one of the most profitable business operations for the company. One characteristic of Ace’s special orders is that for the most part, they are unrelated to the company’s normal business operations of producing lawn and garden fertilizers. Ace’s special orders require a significant amount of time and resources independent from those needed for Ace’s daily operations. Due to the firm’s hard work and success with special orders, Ace has become one of the industry’s leaders by consistently meeting and exceeding customer expectations.

Abby is the primary participant in the completion of Ace’s special orders. Once an estimate is drafted for a special order, it goes to the director of manufacturing for approval. Once the director approves the estimate, it goes to the chief operating officer for approval and is sent out to the customer. To help streamline the special-order process, a billing formula was created to develop the estimated cost for a specific special order. For example, all special orders have to be billed with an 80% mark up from the total cost of the order. Ace values their large mark up on orders because the majority of orders require the company to obtain and store raw materials. When constructing the order, the total cost of the materials purchased and its surpluses are billed to the customer. Ace allows the customer to keep the unused materials since their cost is included in the order; however, most customers decline to keep the unused materials. One exception to this rule is when there is another order that requires the same purchased raw materials. In this case, the cost of the materials is prorated between the orders. This rule exception only applies when there is another confirmed order when the initial order is signed by the chief operation officer and is sent to the customer.

The special orders developed by Abby are composed of both direct costs and indirect costs that impact the overall price of the special-order estimates sent to Ace’s customers. Direct costs are usually variable and mostly include direct materials and direct labor associated with the special order. Direct costs for a special order can also include the depreciation, electricity used, and maintenance of machinery and equipment used. In contrast to direct costs, indirect costs are those that are difficult to assign and allocate to a special order. Indirect costs can include those such as utilities and salaries. In addition, general production costs, lawn care, insurances, taxes, and supplies are also considered indirect costs for special orders. One of Abby’s responsibilities is to accurately allocate these direct costs and indirect costs for each special order to ensure that all costs are accounted for and that the special order will be profitable.

A major portion of the special-order estimates includes the allocation of the indirect costs associated with the order. One method that Abby could use to allocate the indirect costs is to use a company-wide overhead rate. When using this method, indirect costs are allocated by using an allocation base price for all of the company’s products and services. The overhead cost allocations are typically based on direct labor-hours and machine-hours. Another method that is preferred by Abby is to use activity-based costing (ABC) to allocate indirect costs to a special order. By using activity-based costing, the special order incorporates the most important information to make the special order more profitable to Ace.

Issues

1. Did Abby compute the cost of the Breeland Ltd. special order correctly before the weekend get-together? If not, how was her cost estimate and/or price determination flawed?

2. Whose assessment of the costing of this special order do you believe is correct – George Smilee’s or Abby Conroy’s? That is, should George’s conversations with Josh impact Abby’s cost estimate of the Breeland Ltd. special order?

3. Are there any ethical issues related to the costing determination on the Breeland Ltd. special order? If so, what issues are present? How should Abby resolve these conflicts? Should Abby go directly to Tom Brennen about this new development? How can Abby use the IMA Statement of Ethical Professional Practice as a guide for her actions?

4. If Abby were to modify her original cost estimate of the Breeland Ltd. special order to include Josh’s purchase of the remaining 10 gallons of XO-1600, what price determination would she have arrived at? What impact would that have had on Ace Fertilizer’s bottom line?

Analysis – Issue 1: Did Abby compute the cost of the Breeland Ltd. special order correctly before the weekend get-together? If not, how was her cost estimate and/or price determination flawed?

Abby recently received a request for a special order from a company called Breeland Ltd. to produce a unique and rather unstable cleaning solvent for steel. Breeland only needs a limited quantity of the cleaning solvent, and will not need more after the special order. In order to produce the solvent, Abby and the Ace Fertilizer Company will first need to purchase an acid material known as XO-1600. This acid material is a necessary component of the cleaning solvent. The specialty material however, can only be purchased in 50-gallons containers, and the special order only requires to use of 40-gallons. XO-1600 also only has a shelf life of roughly 20 days, meaning that if the remaining 10 gallons is not used within 20 days, it will have to be properly disposed. Abby estimates the cost for the disposal of the reimaging 10-gallons to be $10,000. At the time of preparing the special order, there were no other pending or potential orders that would require the use of the remaining 10 gallons of XO-1600. Breeland also does not want to keep the remining material. Below is the estimate for the Breeland special order that was approved by the director of manufacturing:

Direct Materials:

Non-XO-1600 $ 20,000

XO-1600: Purchase Price 80,000

Disposal Cost 10,000

Direct Labor 30,000

Unit-Level Activity Cost ($40 x 4,000 gallons) 160,000

Batch-Level Activity Cost ($5,000 x 4 batches) 20,000

Product-Level Activity Cost 80,000

Customer-Level Activity Cost 30,000

Organization-Sustaining Level Activity Cost 320,000

(20,000+80,000+10,000+30,000+160,000+20,000)

Total Cost of Special Order 750,000

Markup ($750,000 / .80) 900,000

Total Price Determination of Special Order 1,650,000

The estimate developed by Abby is appropriate and follows the activity-based costing model utilized by Ace. However, the 80% markup that is required by the management of the company is not followed in this estimate. An 80% markup on the $750,000 total cost of the special order should be $937,500 ($750,000 / .80) and the total price determination of the special order should be $1,687,500 ($750,000 + $937,500). By not correctly following the 80% markup rule on this order, the company’s profit was decreased by $37,500 ($937,500 – $900,000).

Conclusion – Issue 1

Before the weekend get together with the company, Abby did not correctly construct the estimate for the Breeland special order of a steel cleaning solvent. The markup on the cost of the order was not was accurate, as it was less than the 80% required by Ace. By not correctly allocating a markup on the order, Abby decreased the company’s potential profits by $37,500. All other components of the estimate were correct in regards to the direct costs, indirect costs, and activity-based costs.

Analysis – Issue 2: Whose assessment of the costing of this special order do you believe is correct – George Smilee’s or Abby Conroy’s? That is, should George’s conversations with Josh impact Abby’s cost estimate of the Breeland Ltd. special order?

After the Breeland special order was approved, Ace’s managers had a social get-together. At this get-together, one of the managers brothers named Josh heard that Ace has a surplus of 10 gallons of the XO-1600 material. Josh explains that he may have a potential customer to manufacturer a spray-on rust inhibitor which requires the use of XO-1600. Josh confirmed the order, and Ace will work with Josh to finalize the special order within the next couple of weeks. After the get-together, Ace’s managers notified Abby about the new upcoming special order for the remaining 10 gallons of XO-1600 that Breeland did not want. However, Abby noticed an issue with the two special orders. The Breeland order assumed that the 10-gallon excess of XO-1600 would have to be disposed at an additional cost. If Josh does purchase the remining quantity, then the original estimate would need to be adjusted to not include the material’s disposal.

As per Ace’s special-order policy, if there are multiple confirmed orders using the same material before any of the orders are finalized, the materials would be prorated to the two special orders. Now that Abby has new information pertaining to the XO-1600 material, Ace should have to redraft the estimate for Breeland to incorporate the special order for Josh. In other words, George’s conversation with Josh should have an impact on the order estimate for Breeland.

Conclusion – Issue 2

Since there is potentially a new order that utilizes the remining 10 gallons of XO-1600, the Breeland special order estimate should be revised. Even though Ace’s managers want to not revise the cost estimate, in order to follow the company’s policy a revision to the estimate would be required to incorporate the newly acquired information.

Analysis – Issue 3: Are there any ethical issues related to the costing determination on the Breeland Ltd. special order? If so, what issues are present? How should Abby resolve these conflicts? Should Abby go directly to Tom Brennen about this new development? How can Abby use the IMA Statement of Ethical Professional Practice as a guide for her actions?

The current Breeland estimate that Abby constructed before receiving the news of the new order does contain ethical issues. If the estimate is not revised and the new order for Josh is finalized, Ace would be getting paid twice for the 10 gallons of XO-1600. While this would increase the firm’s bottom line on the orders, it is not a proper accounting practice and can result to further ethical issues within the company. According the IMA’s Statement of Ethical Professional Practice, Abby should not ignore any unethical business practices, and should instead seek resolutions. The first step that Abby should take is to initiate a discussion with her immediate supervisor, which would be George Smilee, Ace’s director of manufacturing. Since George does not agree with altering the Breeland order, Abby should then go to Tom Brennen, Ace’s chief operating officer. Abby should then express her concerns with the ethical issues regarding the Breeland special order and Josh’s order.

Conclusion – Issue 3

The ethical issue with the Breeland order is that by not revising the estimate, Ace would be getting paid twice for the 10 gallons of XO-1600. Since Abby’s immediate supervisor is involved with the issue, Abby should discuss the issue with the next level of management. The next level of management would be Tom, the company’s chief operating officer. By discussing the issue with Tom, Abby would be able to highlight the ethical issues and make higher management aware of the issues. A proper resolution would then be developed so that all ethical issues are eliminated.

Analysis – Issue 4: If Abby were to modify her original cost estimate of the Breeland Ltd. special order to include Josh’s purchase of the remaining 10 gallons of XO-1600, what price determination would she have arrived at? What impact would that have had on Ace Fertilizer’s bottom line?

If Abby were to modify the original estimate for Breeland, the new price determination for the order would be $1,606,500 if Ace properly applied the 80% markup on the order. The new estimate for the Breeland special order would be as follows:

Direct Materials:

Non-XO-1600 $ 20,000

XO-1600: Purchase Price 80,000

Disposal Cost 0

Direct Labor 30,000

Unit-Level Activity Cost ($40 x 4,000 gallons) 160,000

Batch-Level Activity Cost ($5,000 x 4 batches) 20,000

Product-Level Activity Cost 80,000

Customer-Level Activity Cost 30,000

Organization-Sustaining Level Activity Cost 294,000

(20,000+80,000+10,000+30,000+160,000+20,000-26,000)

Total Cost of Special Order 714,000

Markup ($714,000 / .80) 892,500

Total Price Determination of Special Order 1,605,500

By revising the Breeland estimate, Ace would loose $81,000 in total profits from the special order. Ace would take an $81,000 hit on their bottom line if they decided to account for the two orders correctly and ethically. Since the revision of the estimate would result in fewer profits, Abby’s supervisor does not want to follow through with the revision. However, in order to not participate in any unethical business activities, Abby would need to proceed with the estimate correction even though it would not be best for the company financially.

Conclusion – Issue 4

Ace Fertilizer Company and other firms are subject to difficult ethical dilemmas that have a significant impact on their financial performance. In this specific case for Ace, they have to determine whether or not they will bill for the 10 gallons of XO-1600 twice to receive more income. Abby, a qualified accountant for the firm, recognizes this as an ethical issue and is arguing that the material should not be billed twice. By billing it twice however, the firm could receive nearly $100,000 more in profits, which is why Abby’s boss does not want to readjust the initial estimate for Breeland. By utilizing the IMA’s Statement of Ethical Professional Practice, Abby can seek resolutions on this ethical issue. In order to remain ethical, Abby needs to revise the Breeland estimate to eliminate the disposal costs and other costs associated with the 10 gallons of XO-1600.

References

IMA Statement of Ethical Professional Practice. The Association of Accountants and Financial Professionals in Business. (N.D.). Retrieved from https://www.imanet.org/-/media/b6fbeeb74d964e6c9fe654c48456e61f.ashx

Kreuze, J. (2009, September). Ace fertilizer company: Ethical cost allocations and price determination. IMA Educational Case Journal, 2(3), ART. 3. 

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