ATC 10-5   Ethical Dilemma   Product cost versus selling and administrative expense

Emma Emerson is a proud woman with a problem. Her daughter has been accepted into a pres- tigious law school. While Ms. Emerson beams with pride, she is worried sick about how to pay for the school; she is a single parent who has to support herself and her three children. She had to go heavily into debt to finance her own education. Even though she now has a good job, family needs have continued to outpace her income and her debt burden is staggering. She knows she will be unable to borrow the money needed for her daughter’s law school.

Ms. Emerson is the chief financial officer (CFO) of a small manufacturing company. She has just accepted a new job offer. She has not yet told her employer that she will be leaving in a month. She is concerned that her year-end incentive bonus may be affected if her boss learns of her plans to leave. She plans to inform the company immediately after receiving the bonus. She knows her behavior is less than honorable, but she believes that she has been underpaid for a long time. Her boss, a relative of the company’s owner, makes twice what she makes and does half the work. Why should she care about leaving with a little extra cash? Indeed, she is consider- ing an opportunity to boost the bonus.

Ms. Emerson’s bonus is based on a percentage of net income. Her company recently introduced a new product line that required substantial production start-up costs. Ms. Emerson is fully aware that GAAP requires these costs to be expensed in the current accounting period, but no one else in the company has the technical expertise to know exactly how the costs should be treated. She is consider- ing misclassifying the start-up costs as product costs. If the costs are misclassified, net income will be significantly higher, resulting in a nice boost in her incentive bonus. By the time the auditors discover the misclassification, Ms. Emerson will have moved on to her new job. If the matter is brought to the attention of her new employer, she will simply plead ignorance. Considering her daughter’s needs, Ms. Emerson decides to classify the start-up costs as product costs.

Required

a.     Based on this information, indicate whether Ms. Emerson believes the number of units of product sold will be equal to, less than, or greater than the number of units made. Write a brief paragraph explaining the logic that supports your answer.

b.     Explain how the misclassification could mislead an investor or creditor regarding the com- pany’s financial condition.

c.     Explain how the misclassification could affect income taxes.

d.     Identify the specific components of the fraud triangle the were present in this case.

e.     Review the Statement of Ethical Professional Practice shown in Exhibit 10.14 and identify at least two principles that Ms. Emerson’s misclassification of the start-up costs violated.

f.     Describe the maximum penalty that could be imposed under the Sarbanes-Oxley Act for the actions