Cleveland Custom Cabinets is a specialty cabinet manufacturer for high-end homes in the Cleveland Heights and Shaker Heights areas. The company manufactures cabinets built to the specifications of homeowners and employs 125 custom cabinetmakers and installers. There are 30 administrative and sales staff members working for the company.

James Leroy owns Cleveland Custom Cabinets. His accounting manager is Marcus Sims. Sims manages 15 accountants. The staff is responsible for keeping track of manufacturing costs by job and preparing internal and external financial reports. The internal reports are used by management for decision making. The external reports are used to support bank loan applications.

The company applies overhead to jobs based on direct labor hours. For 2014, it estimated total overhead to be $9.6 million and 80,000 direct labor hours. The cost of direct materials used during the first quarter of the year is $600,000, and direct labor cost is $400,000 (based on 20,000 hours worked). The company’s accounting system is old and does not provide actual overhead information until about four weeks after the close of a quarter. As a result, the applied overhead amount is used for quarterly reports.

On April 10, 2014, Leroy came into Sims’s office to pick up the quarterly report. He looked at it aghast. Leroy had planned to take the statements to the bank the next day and meet with the vice president to discuss a $1 million expansion loan. He knew the bank would be reluctant to grant the loan based on the income numbers in Exhibit 1.

Leroy asked Sims to explain how net income could have gone from 14.2 percent of sales for the year ended December 31, 2013, to 1.4 percent for March 31, 2014. Sims pointed out that the estimated overhead cost had doubled for 2014 compared to the actual cost for 2013. He explained to Leroy that rent had doubled and the cost of utilities skyrocketed. In addition, the custom-making machinery was wearing out more rapidly, so the company’s repair and maintenance costs also doubled from 2013.

Leroy understood but wouldn’t accept Sims’s explanation. Instead, he told Sims that as the sole owner of the company, there was no reason not to “tweak” the numbers on a one-time basis. “I own the board of directors, so no worries there. Listen, this is a one-time deal. I won’t ask you to do it again,” Leroy stated. Sims started to soften and asked Leroy just how he expected the tweaking to happen. Leroy flinched, held up his hands, and said, “I’ll leave the creative accounting to you.”

Questions

1. Do you agree with Leroy’s statement that it doesn’t matter what the numbers look like since he is the sole owner? Even if it is true that Sims “owns” the board of directors, what should be their role in this matter?

2. a. Assume Sims is a CPA and holds the CMA. What are the ethical considerations for him in deciding whether to tweak the numbers? What should Sims do and why?

b. Assume Sims did a utilitarian analysis to help decide what to do. Evaluate the harms and benefits of alternative courses of action.

3. Assume Sims decided to reduce the estimated overhead for the year by 50 percent. How would that change the net income for the quarter? What would it be as a percentage of sales? Do you think Leroy would like the result? Do you think he will be content with the tweaking occurring just this one time?