Assume you work as an accountant in the merchandising division of a large public company that makes and sells athletic clothing. To encourage the merchandising division to earn as much profit on each individual sale as possible, the division manager’s pay is based, in part, on the division’s gross profit percentage. To encourage control over the division’s operating expenses, the man-ager’s pay also is based on the division’s net income.
You are currently preparing the division’s financial statements. The division had a good year, with sales of $ 100,000, cost of goods sold of $ 50,000, sales returns and allowances of $ 6,000, sales discounts of $ 4,000, and salaries and wages expenses of $ 30,000. (Assume the division does not report income taxes.) The division manager stresses that “it would be in your personal interest “to classify sales returns and allowances and sales discounts as selling expenses rather than as contra-revenues on the division’s income statement. He justifies this “friendly advice” by saying that he’s not asking you to fake the numbers— he just believes that those items are more accurately reported as expenses. Plus, he claims, being a division of a larger company, you don’t have to follow GAAP.
Required:
1. Prepare an income statement for the division using the classifications shown in this chapter. Using this income statement, calculate the division’s gross profit percentage.
2. Prepare an income statement for the division using the classifications advised by the manager. Using this income statement, calculate the division’s gross profit percentage.
3. What reason (other than reporting “more accurately”) do you think is motivating the man-ager’s advice to you?
4. Do you agree with the manager’s statement that “he’s not asking you to fake the numbers”?
5. Do you agree with the manager’s statement about not having to follow GAAP?
6. How should you respond to the division manager’s “friendly advice”?